Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : November/December 1988, Volume XII, Issue 6

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

ECONOMIC

PERSPECTIVES




A review from
the Federal Reserve Bank
of Chicago
N O V EM BER/D ECEM BER 1988
The grass may not be greener:
C om m ercial banks
and in vestm en t banking
A note on th e increase in
noninsured com m ercial banks
Real boats rock: M o n e ta ry policy
and real business cycles

ECONOMIC PERSPECTIVES
November/December 1988
Volume XII, Issue 6
Karl A. Scheld, senior vice president
and director of research
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

Kathleen Solotroff, graphics coordinator
Roger Thryselius,
Thomas O ’Connell, graphics
Nancy Ahlstrom, typesetting coordinator
Rita Molloy,
Yvonne Peeples,
Gloria Powell,
Stephanie Boykin, typesetters

Economic Perspectives is
published by the Research Depart­
ment 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 multiplecopy subscriptions, back issues, and
address changes to Public Informa­
tion Center, Federal Reserve Bank
of Chicago, P.O. Box 834, Chicago,
Illinois 60690, or telephone (312)
322-5111.
Articles may be reprinted pro­
vided source is credited and The
Public Information Center is pro­
vided with a copy of the published
material.

ISSN 0164-0682



C ontents
The grass may not be greener:
3
Commercial banks
and investment banking
Betsy Dale
If, or when, the last regulatory barriers fall,
commercial banks may find investment bank­
ing tougher and less profitable than they hoped
A note on the increase in
16
noninsured commercial banks
Nancy N. Andrews,
George G. Kaufman, and Larry R. Mote
An apparent rise in noninsured commercial
banks provides a useful lesson for those who
must rely on government data
Real boats rock: Monetary policy
21
and real business cycles
Steven Strongin
After the shocks of recent years, economists
and policymakers are reworking the
conventional wisdom about business cycles

The grass m ay not be greener:
C om m ercial banks and investm ent banking
Betsy Dale
As profitability in traditional commercial
banking services has increasingly come under
pressure, some banks have attempted to bolster
shrinking profits by expanding into fee­
intensive activities, many of which have been
dominated by the securities industry since the
1930s. Persistently higher overall earnings in
this industry relative to others have led to a
widespread perception that at least certain
parts of the securities business are substantially
more profitable than commercial banking.1
(See Figure 1.) Consequently, some commer­
cial banks have increased their permissible se­
curities operations and they have escalated
their efforts to chip away at the legislative and
regulatory barriers that currently prohibit
them from engaging in a broader range of se­
curities activities.
The securities activities of commercial
banks are principally governed by the Banking
Act of 1933 (or Glass-Steagall Act) and the
Bank Holding Company Act of 1956. These
laws imposed limitations on bank and bank
holding company participation in many secu­
rities activities and prohibited others com­
pletely. But, through a succession of regulatory
rulings and court decisions over the years,
banking firms have won approval to engage in
many previously restricted activities. (See Ta­
ble 1.) Commercial banking organizations are
now able to participate in securities activities
that generate more than half of the gross re­
venues of all securities firms and may under­
write securities of types that account for at least
80 percent of the dollar value of all new
issues.2 Some of the investment banking activ­
ities of commercial banks, however, still have
restrictions and limitations placed on them that
do not apply to investment banks. As a result,
this hinders the ability of commercial banking
firms to compete successfully with investment
banks.
This article examines the success of com­
mercial banks in providing permissible invest­
ment banking services and analyzes the profit
potential for recently approved and currendy
proscribed activities. At this time, commercial
Federal Reserve Bank of Chicago



Figure 1
P ro fita b ility comparisons*
percent

banks seem to have done well in areas where
they are permitted to compete, but still do not
enjoy the market shares that investment banks
command. However, banks’ experience with
new underwriting powers is too recent to make
a fair judgement regarding their future success,
but immediate profitability in these areas does
not look too promising. As for commercial
bank entry into currently impermissible areas,
significant barriers will remain even if legal
prohibitions are removed. These barriers may
make it difficult for many banks to break suc­
cessfully into these markets and may delay their
profitability for several years while they gain
expertise and build market share.
Permissible activities
During the 1980s, an increase in nonbank
competition for certain types of lending services
and a booming securities market, which enBetsy Dale is an associate economist at the Federal Reserve
Bank of Chicago. The author would like to thank Christine
Pavel, Herbert Baer, George Kaufman, and Larry Mote for
helpful comments and suggestions. She also gratefully ac­
knowledges the assistance and data provided by IDD In­
formation Services and the Public Securities Association.
3

Table 1
Selected perm issible dom estic com m erical bank
securities activities*
(August 1988)

Year started'*
Underwriting, distributing, and dealing
U.S. Treasury securities
U.S. federal agency securities
Commercial paper (third party)
Mortgage and consumer
paper-backed securities
M unicipal securities
General obligation
Some revenue bonds
All revenue bonds
Private placement (agency capacity)
Mergers and acquisitions
Offshore dealing in Eurodollar securities
Brokerage
Limited customer
Public retail (discount)
Securities swapping
Financial and precious metal futures
brokerage and dealing
Financial advising and m anaging
Closed-end funds
Mutual funds
Restricted
Research advice to investors
Separate from brokerage
Combined w ith brokerage
Institutional
Retail

Always
Various years
1 98 8
1 98 8
Nearly always
1 96 8
1988
Always
Always
Always
Always
1 98 2
Always
f
1 98 3
1 97 4
1974
Always
1 98 3
1 98 6
198 7

‘ Federal Reserve member banks or bank holding company
affiliates.
" A fte r the Civil War. Different dates may apply to national and
state banks and among state banks. W ith some exceptions, the
earliest date is show n. Regulatory rulings frequently concluded
that a specific activity was permissible before the date of rul­
ing. If the activity was halted by enactm ent of the GlassSteagall Act, the date of renewed activity is given.
^Restricted to futures contracts for w hich banks may hold the
underlying security or that are settled only in cash.
SOURCE: Updated from George G. Kaufman and Larry R.
M ote, "Securities Activities of Commercial Banks: The Current
Economic and Legal Environment," S ta ff M em oranda, Federal
Reserve Bank of Chicago, 8 8 -4 (1 9 8 8 ).

couraged corporate borrowers to raise funds
directly through capital markets, narrowed
spreads on traditional commercial banking ser­
vices. Rather than lose valued clients, banks
found ways to unbundle their lending activities
and to play a role in their customers’ direct fi­
nancings in the capital markets. In addition
to providing off-balance-sheet guarantees and
selling loans, U.S. commercial banks have been
aggressively expanding the operations of the
securities activities in which they are permitted
to engage. Such activities include brokerage
services, advice on mergers and acquisitions,
private placement of securities, underwriting
4



general obligation bonds of states and munici­
palities, and investment banking activities
abroad. The lure of hefty fees and commissions
has prompted new interest in these activities
which, though they have long been open to
banks, were considered incidental to their pri­
mary services.
These activities not only offer attractive
fees, but are also logical areas for bank expan­
sion. Banks already have close contacts with a
large base of business and municipal customers
to whom they have provided credit and other
services over the years, putting them in a fa­
vorable position to expand the scope of services
they offer to an existing client base. Moreover,
banks have engaged in these activities to some
extent for many years and already have a de­
gree of expertise. Until recently, however,
banks played only a minor role in these non­
banking areas and active expansion came only
after banks recognized the need to develop
sources of noninterest income to augment de­
clining revenues from both domestic and inter­
national lending.
Overall, commercial banks have made
significant strides in most securities activities in
which they are competing directly. It has been
estimated that in 1986 commercial banks had
a composite market share of 10 to 30 percent
in such activities.1 Nevertheless, most banks are
still only minor players whose market shares
are dwarfed by Wall Street firms. (See Table
2.) Aside from the fact that commercial banks
have been aggressive competitors in these areas
for only a few years, a number of other reasons
can explain their current competitive position.
Municipals
In the tax-exempt market, for example,
a number of factors came into play that di­
minished both the opportunities and the prof­
itability in this area. Over the years, banks
have been active participants in underwriting
municipal bonds despite the fact that they have
been excluded from a large segment of this
market. Commercial banks may underwrite
general obligation (GO) bonds, which are
backed by the full credit and taxing power of
the issuing municipality, but until very recently
have been prohibited from underwriting most
kinds of municipal revenue bonds.0 Banks’
market share of the municipal GO market av­
eraged 60 percent in the early 1970s, but deEconomic Perspectives

Table 2
C o m parative m arket shares
1987
Top 10
commercial
banks
$volume
/ ................
M unicipal underwriting
GO bonds
Revenue bonds
Private placements*

deals

Top 10
investment
banks
$volume

deals

9.5

5.4

5 4.0

2 2.3

2 0.3
5 (e )

8.7
3 (e )

4 1.2
60.2

13.1
30.7

2 5.3

3 0.0

6 1.5

58.1

Mergers & acquisitions' '

4.0

4.5

7 7.3

30.1

Eurobond underwriting

6 (e )

n.a.

1 9 (e )

n.a.

'M a rk e t shares of 8 top commercial and investment banks.
" F ig u re s are approximations reflecting an adjustment for
m ultiple credits on advisory assignments,
n.a.—N ot available.
(e )—Estimate.
NOTE: Commercial and investment banks that rank among the
top 10 are not necessarily the same in each activity.
SO U R CE:
ID D
Information
Services;
ID D
Information
Services/PSA M unicipal Database; and author's estimate.

dined fairly steadily in the early 1980s to about
27 percent in 1984.6
While many large and medium-size banks
have been attempting to strengthen public fi­
nance operations during the last 10 years, some
investment banks, flush with profits from the
bull market of recent years, began aggressively
entering this market as a means of diversifying.
Profitability soon came under pressure because
some investment banks viewed their activities
in this market as a loss leader. Valuing
relationship-building more than profits, invest­
ment bankers were willing to cut margins very
thin/ Further compounding this situation was
a change in the tax law in 1986, which reduced
the attractiveness of municipal securities and
contributed to a dramatic decline in the vol­
ume of new issues.8 (See Figure 2.) The intense
competition created by an increasing number
of players competing for a declining volume of
business narrowed spreads and reduced profit­
ability to the point where some commercial and
investment banks pulled out of the tax-exempt
market.
As banks scramble for a bigger slice of a
shrinking pie, investment banking firms have
increasingly gone after smaller regional issues
that they would not have bothered with a few
years ago. In the past, these issues were han­
dled largely by commercial banks, but banks
have found it difficult to compete effectively
with the superior capital base, proven exper­
Federal Reserve Bank of Chicago



tise, and distribution capabilities of some Wall
Street firms now bidding for these deals. Banks
are recognized leaders in the distribution of
municipal bonds and are frequently included
in networks managed by others, but to increase
market share they must not only work to retain
existing relationships with local government
borrowers, but also convince a broader group
of issuers of their underwriting capabilities.
One thing holding them back is the shortage
of recognized talent in the field, together with
banks’ reluctance to change a corporate culture
that is unwilling to pay salaries adequate to
attract qualified personnel.9
Private placements
While there are still restrictions on the
kinds of public underwriting banks may engage
in, banks may privately underwrite virtually
all types of securities. These transactions in­
volve placing an entire issue with a limited
number of large investors rather than through
a public offering.111 In the past, many banks
viewed such placements as a consolation prize
for failing to win a corporation’s loan business
and neither welcomed nor solicited such busi­
ness. From 1975 to 1984, banks’ market share
of all placements was between 4 and 9
percent.11 More recently, banks have been at­
tracted by the fee income generated by such
services, usually based on a percentage of the
offering price. By 1986, their overall market
share of traditional deals involving debt securi­
ties had increased to an estimated 26 percent.12
Despite these recent gains, the private
placement market continues to be dominated
by the large Wall Street firms. In 1987, the
eight largest commercial bank competitors
placed $34 billion of the dollar value of securi­
ties placed by all firms. By contrast, the top
eight securities firms completed deals worth $83
billion, more than twice the value of place­
ments completed by the top banks. Banks have
made their greatest strides in placing “plain
vanilla” deals requiring only a small group of
investors. But, because banks’ network of con­
tacts with professional investors is still less ex­
tensive than that of their Wall Street rivals,
their ability to compete is impaired when wider
distribution outlets are needed. Industry ex­
perts also say that commercial banks have yet
to take full advantage of their contacts with
corporate borrowers because of poor coordi5

Figure 2
The municipal bond m arket
Volume of new issues has declined . . .

. . .

value of new issues of
long-term municipal bonds

average underwriter compensation for
fixed-rate issues of $10 million or more

billions of dollars

and underwriting has become less profitable

dollars per $1000

25 r

1980
SOURCE: F e d e r a l R e s e r v e B u lle tin .

nation between their commercial loan oper­
ations and capital markets groups.13
Mergers and acquisitions
Although some commercial banks have
made impressive strides in offering merger and
acquisition advisory services, even the largest
bank merger operations continue to be over­
shadowed by Wall Street firms in the
business.14 Bankers Trust, for example, was the
top ranked commercial bank advisor in 1987,
completing 42 deals worth $6.2 billion. By
contrast, the top investment bank advisor
(Goldman Sachs) completed 134 deals worth a
total of $63.5 billion. 5 While this provides a
good indication of the distance between the
most successful commercial and investment
bank advisors, the measurement of overall
market shares is more difficult. Many deals,
especially large ones, have a number of advisors
on both the acquirer and target sides, and
available data on rankings gives full credit to
each advisor on the deal. Nevertheless, by this
measure commercial banks were advisors in
only 7.4 percent of the $216.7 billion volume
completed in 1987, while the top four invest­
ment bank advisors were involved in 90 per­
cent.16 Based on these figures, it is clear that
banks are included in only a small portion of
advisory assignments, so far.
Aside from the relatively recent entry of
banks as active participants in this arena, se­
Digitized 6for FRASER


1981

1982

1983

1984

1985

1986

1987

SOURCE: W a ll S t r e e t J o u r n a l and Securities Data Co.

veral factors prevented them from being among
the top players. Once again, banks’ progress
has been slowed by their inability or unwill­
ingness to offer compensation adequate to at­
tract top deal makers. Another factor is that
banks have usually backed away from deals
involving hostile takeovers of longtime clients
that might jeopardize lending relationships.17
Banks are generally more active in friendly
deals, which tend to be at the low end of the
market in transaction size.
Perhaps the most significant factor, how­
ever, is the Glass-Steagall restrictions. Under­
writing and dealing in corporate securities are
fundamental to many merger strategies. The
fact that commercial banks are prohibited from
engaging in these activities has limited their
access to and experience with trading markets.
While banks are developing knowledge and
skill in these markets, they will have to over­
come the perception that they lack adequate
expertise to accurately gauge markets and pro­
vide sound advice in structuring a deal.
Overseas activities
Glass-Steagall prohibitions do not apply
to the activities of U.S. banks in the
Euromarket, and many of the nation’s largest
commercial banks have operated offshore out­
lets there for years. Until a few years ago,
however, their dominance in the market for
international syndicated loans kept their pri­
Economic Perspectives

mary focus on traditional lending services. In
the early 1980s, the percent of capital raised in
international markets by such loans fell dra­
matically while the share of capital raised by
bond issues rose sharply.18 This massive shift in
market preference for funding vehicles
prompted an attempt by banks to offset lost
interest income with fees from underwriting
and trading in Eurobonds and from currency
and interest rate swaps. Banks’ success in these
areas is far from uniform.
So far, the role of U.S. banks in under­
writing international bonds remains quite
small. In 1986, they were estimated to have
only 10 percent of this market.19 One reason for
this poor showing is the degree of competition
to participate in new Eurobond issues. Many
houses fiercely compete not only for the role of
lead manager but also for a position on
tombstones. Furthermore, aggressive bidding
for new issues has led to mispricing and low
profit margins.20
The intensity of this competition has
made breaking into the ranks of top managers,
or even being included in distribution syndi­
cates, particularly difficult.21 Subsidiaries of
U.S. banks are also disadvantaged by their
relatively short track record in this area. Even
U.S. investment banks, which have used their
domestic freedom to develop both expertise and
customer relationships in offshore markets,
have to fight for prominence among their
European and, increasingly, Japanese peers.22
Thus, the small Eurobond market share cap­
tured by U.S. banks may be explained partly
by a reluctance of some to expend a great deal
of effort in a market where the competition is
stiff and the profits are slim.
Although they have enjoyed little success
in Eurobond underwriting, U.S. banks have
found other international securities activities
more rewarding. In fact, some banks that
maintain a presence in this market have more
interest in secondary market trading than in
managing new issues.23 An increasing propor­
tion of international bond issues are driven by
currency and interest rate swaps, and commer­
cial banks are the clearly dominant partic­
ipants in this area. In 1986, U.S. banks
accounted for 70 percent of the activity in for­
eign exchange markets, and five money center
banks alone generated over $1 billion in foreign
exchange trading income that year.24
Federal Reserve Bank of Chicago



New underwriting powers
In 1987, rulings by two regulatory agen­
cies granted banks certain additional securities
underwriting powers. Banks were not imme­
diately able to launch into these new areas,
however, as there was considerable uncertainty
as to whether the courts and Congress would
allow these decisions to stand.
The first of these decisions was by the
Federal Reserve, which ruled in April that
commercial banks could underwrite commer­
cial paper, municipal revenue bonds (MRBs),
and mortgage-backed securities (MBSs).23 The
activities were to be conducted through non­
bank subsidiaries and limitations were imposed
on the extent to which banks could engage in
these new areas. In July, the Fed also ap­
proved underwriting of securities backed by
consumer receivables (CRBs).2(>But, after a suit
filed by the Securities Industry Association
(SIA) challenging the Fed’s initial ruling re­
sulted in a stay on the new powers being im­
posed by the courts, the Fed stayed the effect
of their approval to underwrite CRBs as well.
Even without this suit, however, implementa­
tion would have been delayed. Congress im­
posed a moratorium beginning in March which
prohibited all federal banking agencies from
granting any new nonbanking powers for one
year. The moratorium was designed to halt
bank entry into new areas until the Congress
could consider the issues further.27
The second ruling came in June when the
Office of the Comptroller of the Currency is­
sued its opinion that national banks could
underwrite and deal in MBSs and CRBs di­
rectly, without limitations on the extent of in­
volvement in such activities and without
segregating them in a nonbank subsidiary.28
This position was expressed in a letter to Secu­
rity Pacific supporting its bid to sell mortgage
pass-through securities under this interpreta­
tion. Security Pacific’s issuance and under­
writing of a major portion of that issue became
the subject of another suit by the SIA.29
However, even while the congressional
moratorium was in effect and challenges to the
legality of these powers were still before the
courts, several large banks began to participate
in the underwriting of issues they brought to
market. Marine Midland Bank co-managed a
$600 million issue backed by auto loans in
June30 and Citibank helped underwrite $150.1
7

million of mortgage-backed securities in Sep­
tember.31 In April 1988, Chemical Bank went
furthest in testing the limits of Glass-Steagall
when it became the first bank to lead-manage
a $257.4 million issue backed by its own auto
loans.32 Others expressed interest in lead­
managing their own receivables deals, but were
hesitant to do so until they had a clear goahead from regulators.
At this writing, the legal status of these
underwriting powers is only partially resolved.
The congressional moratorium ended without
any legislative action on this issue, so the ban
on further regulatory approvals was lifted. The
Fed’s ruling was allowed to stand when, in
June 1988, the Supreme Court refused to re­
view a lower court’s decision upholding Fed
approval of these activities.33 This cleared the
way for the twelve large banking companies
thus far granted authority to begin exercising
the new powers.34 The issue of whether national
banks can underwrite asset-backed securities
directly is still pending before the court. So,
while some banks continue to gingerly test the
waters under the Comptroller’s ruling, most
have chosen to remain inactive until the
legality of the new powers is clarified.
Meanwhile, commercial banks have
gained considerable experience in privately
placing asset-backed securities. In 1987, eight
commercial banks or subsidiaries of BHCs pri­
vately placed 136 issues (32 percent of the
market), valued at $7.9 billion. Three com­
mercial banks ranked among the top 10 firms
to privately place asset-backed securities.33
Small spreads
Unfortunately, spreads on these new
underwriting instruments appear small, and
anecdotal evidence on the profitability of
underwriting these securities is not encourag­
ing. In fact, profits from underwriting com­
mercial paper, mortgage-backed securities and
municipal revenue bonds were so slim that a
number of commercial and investment banking
firms have scaled back operations or pulled out
of these markets. Salomon Brothers, the
nation’s leading underwriter, created a stir in
the market when it announced in October 1987
that it was dismantling its commercial paper
operations and closing its 200-person municipal
finance department.36 But soon afterward,
other firms announced they were also exiting
8



the public finance business in whole or in part,
and several others announced plans to trim
commercial paper operations.
The commercial paper market is gener­
ally not a high-margin business, and spreads
have narrowed as a result of increased compe­
tition. Underwriting margins on new munici­
pal revenue bonds, suffering the pressures of the
tax-exempt market noted above, are half what
was common a few years ago,37 although
spreads may improve somewhat as players exit
the market. The spreads for underwriting
mortgage-backed pass-through type securities
have declined as this market has matured and
the deals have become standardized.
As for underwriting securities backed by
consumer loans, investment bankers are re­
porting only meager profits so far and do not
expect them to increase until deals in this
fledgling market become more standardized.
The structure of a deal depends in part on the
character of the underlying assets. It is also
affected by the objectives of the originator and
the legal, regulatory, and accounting environ­
ment in which the issuer operates. Vehicles are
being developed which allow issuers of assetbacked securities to make continuous offerings
with a minimum of additional work, but pack­
aging most deals is still very labor-intensive and
costly. Fees tend to be thin because while most
deals are similar, none are identical and they
can take up to a year to complete.38 Under­
writing spreads appear to be lower on repeated
transactions of a similar type by a particular
issuer, and to be higher on first issues and rise
with the complexity of the deal.
Implications for currently proscribed
powers
Of all the securities activities currently
prohibited for banks, perhaps the most coveted
is the ability to underwrite corporate stocks and
bonds. One reason for banks’ eagerness to en­
ter this area is that it appears to be highly
profitable.39 The ability to underwrite these se­
curities could also assist banks in strengthening
their foothold in other areas, such as mergers
and acquisitions, and enable them to develop
expertise that could enhance their competitive
position abroad. But, while this activity ap­
pears attractive, the obstacles to successful
entry are immense.
Economic Perspectives

Underwriting involves three major func­
tions: origination, underwriting, and distrib­
ution. Origination includes designing the issue
in terms of the type and quantity of the security
to be offered, pricing, timing, and other fea­
tures. This function also often includes handl­
ing the paperwork and administration, or
“managing the books,” for the issue. Under­
writing proper is a risk-bearing function, as the
underwriter purchases the new securities and
runs the risk of having to resell them at a lower
price than was paid to the issuer. The distrib­
ution function is the actual resale of the ac­
quired securities to the public. The origination
function is usually performed by one lead firm,
sometimes with a co-manager, and a group of
other firms is brought in on the deal to spread
the risk and help distribute the securities.
The most lucrative of these functions is
being the lead manager of an issue. The ben­
efits which accrue to this firm go beyond the
extra fee earned by managers, which is usually
20 percent off the top of the gross spread.40
Additionally, firms compete for this position
because it adds to a firm’s reputation and
prestige, thereby enhancing the chances of ac­
quiring the business of other issuers as well as
the repeat business of existing clients. More­
over, the managing firm’s ability to select the
other firms that may participate in the distrib­
ution syndicate, as well as set the size of each
firm’s participation, is perceived as a form of
market power.
Table 3
C o n cen tratio n in corporate
u n d erw ritin g m anagem ent
1987
Dollar volume of issues managed by:*
Top 5

Top 10

Top 15

( .............. — percent.................. )
All issues
Debt issues
Straight debt
Convertible debt
M ortgate-related debt
Asset-backed debt
Equity issues
Com mon stock
Preferred stock
Initial public offering

6 3.5

86.3

92.7

6 8.2
6 8.7
58.1

9 1.3
91.7
8 2.0

9 6.8
9 7.0
9 2.4

6 3.9
95.7

8 9.0
9 9 .9 "

9 6.6
--

5 0.4
4 6.4
6 4.9

7 7.0
7 2.5
9 3.4

8 7.5
84.3
99.3

4 9.3

6 9.2

81.7

'F u ll credit given to lead manager.
" R e fle c ts the top 8 lead underwriters.
SO U R CE: ID D Information Services, as reported in Investment
Dealers' Digest, January 1 1 ,1 9 8 8 .

Federal Reserve Bank of Chicago



Obstacles to banks
Breaking into the ranks of top managers
would be a formidable task for banks because
of the structure of this market and the barriers
that limit entry. Underwriting management is
highly concentrated in a small number of firms.
(See Table 3.) This situation has persisted for
years and is the result of many factors. Most
corporations solicit public funds infrequently;
the success of an issue can be critical to their
future prospects, so they must select a manag­
ing underwriter carefully. Issuers place a high
value on an investment bank’s reputation,
track record, personnel quality, and size. Ex­
pertise in the issuer’s industry is especially im­
portant. As investment banking firms often
specialize in certain industries, the number of
houses with qualified personnel is limited. The
result has been the relatively stable relation­
ships of issuing firms with particular under­
writers that have come to characterize this
market.41
Although becoming one of the top man­
agers would be very difficult, there could be
avenues open for new bank entrants to acquire
the necessary expertise that do not appear to
be insurmountable. Leading underwriters
cater mainly to the largest issuers, roughly the
Fortune 1000.42 Small and medium-sized firms
are not large enough to attract the attention
of large Wall Street firms, and rely on smaller
regional broker-dealers who act as managing
underwriters for local issuers. The number of
regional firms that perform as managing
underwriters is relatively small and banks
might find that they could enter these more
local markets with somewhat greater ease.
Participation in these smaller issues could then
aid banks in building a reputation for successful
deals that could earn them the attention of
larger corporations.
The requirements for entry into the cadre
of top distribution syndicates are slightly less
onerous, but not insignificant. The first re­
quirement is adequate capitalization. Not only
must firms have sufficient funds to commit to
large blocks of securities before they are resold,
but the SEC requires that underwriters also
have net excess capital to cover 30 percent of
the estimated value of the securities underwrit­
ten. In and of itself, this should not present a
serious obstacle for quite a number of banking
9

organizations, some of which are more highly
capitalized than large investment banking
firms. The resources needed to establish and
operate an underwriting affiliate are likely to
be quite high, however, and may eliminate
smaller organizations as potential entrants.
The greater risks associated with underwriting
and dealing in corporate securities is likely to
raise regulatory minimum capital requirements
for banks that establish such operations. In
addition, these nonbank operations would need
to be adequately insulated from the banking
activities of the organization, requiring addi­
tional capital to maintain separate personnel
and organizational structures.
The second requirement is the need for
extensive and proven capabilities to distribute
securities quickly. The success of major players
stems from their extensive retail outlets or net­
works of institutional investors who purchase
large blocks of securities. Though banks have
developed some distribution channels through
participation in municipals and private place­
ments, these activities do not bring them into
contact with some of the major investor cate­
gories of corporate securities. This suggests
that commercial bank distribution capabilities
would need to be broadened and strengthened
considerably before they could meet this re­
quirement. Barriers to entry are further rein­
forced by the underwriters’ desire for
cooperative relationships in distribution syndi­
cates, which leads them to rely repeatedly on
the same group.
Rule 415
A Securities and Exchange Commission
(SEC) rule that went into effect in March 1982
may have mixed implications for commercial
bank participation in both managing and dis­
tributing certain corporate issues. Rule 415
enables corporations to register their securities
with the SEC but leave them on the shelf for
up to two years until the markets are advanta­
geous. Use of this shelf registration rule has
increased since implementation, and in 1987
accounted for 46 percent of the dollar value of
publicly offered corporate securities.43 One re­
sult has been that issuers have shown more
willingness to shop around for underwriting
firms to handle deals still on the shelf.44 This
has caused some weakening in longstanding
70




client-firm relationships that could improve the
chances for commercial bank entry.
Another aspect of this off-the-shelf under­
writing does not augur as well for banks. Be­
cause securities are registered in advance, issues
can be brought to market more quickly than in
a traditional filing. The underwriter therefore
has a shorter time to price the issue, scout for
buyer interest, build a syndicate, or determine
the accuracy of information disclosed by the
issuer.45 This accelerated processing has tended
to lead to the use of smaller syndicates, more
“internalized” (or nonsyndicated) deals, and
more “bought deals” where the underwriter
takes the whole issue. Managing such issues
requires sufficient capitalization to carry large
blocks of the new issue, in-house distribution
capabilities, and personnel with appropriate
expertise to price the issue and gauge the mar­
ket quickly, all of which tend to favor the large
investment banks.
The preceding discussion illustrates that,
aside from the legal roadblocks to bank partic­
ipation in corporate underwriting, there are a
number of other obstacles as well. Time and
considerable resources would be needed to
build these operations. And, because it would
be new terrain for banks, the relative level of
expertise they could bring and the lack of a
successful track record would put them at a
considerable disadvantage, making it very dif­
ficult to make significant inroads. All of these
factors imply that if legal prohibitions to bank
entry into underwriting corporate securities
were lifted, banks would not only need to have
strong capitalization and trained personnel to
enter this market but would also have the dif­
ficult task of luring clients away from firms with
a 50-year head start both in establishing suc­
cessful client-firm relationships and in building
market share.
Impact of greater commercial bank pen­
etration
It is difficult to project how deeply com­
mercial banks will be able to penetrate into
these new markets or how profitable nonbank­
ing activities will be in the long run. It does
appear, however, that bank expansion and
profitability in these areas will be limited by
two factors. First, given the huge startup costs,
and in some instances the level of capitalization
required, it is quite possible that only a handful
Economic Perspectives

of the nation’s 14,000 commercial banks will
be able to establish significant investment
banking operations. Even in currently permis­
sible activities, not all banks have the willing­
ness or wherewithal to participate.46 Small
banks that do engage in these activities in their
local market are unlikely to do so on a scale
that would significantly affect the dominance
of Wall Street firms. This implies that the
number of new entrants that will be competing
for market share with the major investment
banks may be limited.47
Second, the legal ability to enter new
nonbanking areas is no guarantee of profitabil­
ity. The increased competition caused by
commercial bank entry into currendy pro­
scribed activities can be expected to reduce
spreads somewhat. Also, as banks gain experi­
ence and reputation, there could be more
competitive pressure in areas where they cur­
rently operate, reducing these spreads further.
Banks that commit substantial resources to
building nonbank operations and survive the
early lean years to achieve respectable market
shares may not be rewarded with the hefty fees
that previously prevailed.
Thus far, most commercial banks have
had only limited success in their quest for non­
interest income through nonbanking activities.
However, investment banking divisions at large
commercial banks have been in place for less
than 10 years, and it is obvious that these banks
already have some of the necessary ingredients
to succeed. Banks that have developed a strong
presence have done so in specific market niches,
largely because they developed strategies that
reflected their existing customer base and areas
of expertise.
Despite these encouraging advances, most
still report that expansion into these areas has
contributed only marginally to profitability.48
These banks have apparently been willing to
forego immediate rewards and remain in the
market for other reasons. Theirs is a longerterm strategy based on the hope that identifi­
cation with investment banking products and
a growing reputation will eventually lead to an
increase in market share and thus provide lev­
erage for entering into other areas.
Overall, though, bankers have discovered
that what they thought were the greener
pastures of high investment banking fees are
not so easily attained. Profitability is not as­
Federal Reserve Bank o / Chicago



sured to those who enter and years of unprofit­
able operation may be required.
1 One reason for these higher returns is that some
of the activities in which securities firms engage in­
volve more risk than permissible commercial bank
activities. Although the issue of risk is central to
the controversy surrounding the wisdom of repeal­
ing or liberalizing prohibitions against increased
bank participation in securities activities, it is be­
yond the scope of this article. See, for example,
Elijah Brewer, III, Diana Fortier, and Christine
Pavel, “Bank Risk From Nonbank Activities,” Eco­
nomic Perspectives, Federal Reserve Bank of Chicago,
(July/August 1988), pp. 14-26 and John H. Boyd
and Stanley L. Graham, “Risk, Regulation, and
Bank Holding Company Expansion into Nonbanking,” Quarterly Review, Federal Reserve Bank of
Minneapolis, Vol. 10 (Spring 1986), pp. 2-17.
2 George G. Kaufman and Larry R. Mote, “Secu­
rities Activities of Commerical Banks: The Current
Economic and Legal Environment,” Federal Re­
serve Bank of Chicago, Staff Memoranda 88-4
(1988), pp. 29-30.
3 Throughout this article, “commercial bank” refers
to banks as well as their nonbank affiliates.
4 Jed Horowitz, “There’s Life after Glass-Steagall
for Wall Street, Report Says,” American Banker,
December 2, 1987, pp. 3, 8.
5 Revenue bonds are issued to finance corporate
undertakings such as the construction of health
care, pollution control, and public power utilities.
This type of issue is considered more risky because
interest payments are tied to revenues from the
projects they finance and are not backed by the
governmental unit that issues them. Andrew
Albert, “Bankers Trust First in Tax-Exempt Fi­
nancing,” American Banker, July 16, 1987, pp. 1,
11-12, 15. A few exceptions to this general prohi­
bition were made in the late 1960s, permitting
banks to underwrite issues for housing and higher
education.
6 Recent Trends in Commercial Bank Profitability: A
Staff Study, Federal Reserve Bank of New York,
1987, p. 321.
Andrea Bennett, “Regionals Expect to Fill Gap
in Municipal Bonds,” American Banker, December
23, 1987, pp. 1, 2, 14.
8 The Tax Reform Act of 1986 ended the 80 per­
cent tax deduction banks could take for the cost of
buying and carrying municipal bonds and undercut
the tax-exempt status of the bonds for some inves­
tors. Matthew Kreps, “Tax Act Pushes Banks to
Cut Municipal Bond Holdings,” American Banker,
December 23, 1987, p. 16. See also Alexandra
77

From Cash Cow To a White Elephant,” American
Banker, December 4, 1987, pp. 1, 12.
9 For a discussion of the compensation issue and
other internal impediments banks must overcome,
see Terese Kreuzer, “Can Banks Be Top Notch In­
vestment Bankers?” Bankers Monthly, October 1987,
pp. 43-50.
10 The SEC does not require registration of securi­
ties involved in these private sales. In order to
qualify for this exemption, however, the issue must
meet certain criteria. Except for some smaller is­
sues, no general solicitation of the public is allowed,
and there are limitations on the number and so­
phistication of purchasers. Because disclosure laws
do not apply, a private sale of unregistered securi­
ties is generally limited to investors who are capable
of independent evaluation of the merits and risks
of a prospective investment.
11 Recent Trends in Commercial Bank Profitability: A
Staff Study, op. cit., p. 321.
12 “There’s Life after Glass-Steagall for Wall Street,
Report Says,” op. cit., p. 3.
13 Brad Rudin, “Investment Banks Retain
Dominance,” Pensions and Investment Age, October
5, 1987, pp. 17, 20.
14 Andrew Albert, “Citibank Tops Bankers Trust
as No. 1 in Mergers,” American Banker, July 14,
1986, pp. 1, 19.
10 Jed Horowitz, “Banks Garner Few Domestic
Merger Deals,” American Banker, April 7, 1988, pp.
1, 22-23.
16 Phyllis Feinberg, “M&A Rankings Show In­
creased Concentration,” Investment Dealers’ Digest,
January 25, 1988, pp. 44-47.
17 In 1988, however, Morgan Guaranty advised F.
Hoffmann-La Roche & Co. in an unsuccessful $4.2
billion bid for Sterling Drug Inc., a longtime client
of Morgan. “Banks Garner Few Domestic Merger
Deals,” op. cit., p. 23.
18 From 1982 to 1986, the percent of international
capital raised by syndicated bank loans fell from
55 percent to 13.5 percent. Over the same period,
the share of capital raised by bond issues rose from
about 42 to 65 percent. M. S. Mendelsohn, “US
Banks Keep a Hand in International Bonds,”
American Banker, July 18, 1986, pp. 1, 15.
19 “There’s Life after Glass-Steagall for Wall Street,
Report Says,” op. cit., p. 3.
20 Richard M. Levich, “A View from the Interna­
tional Capital Markets” in Deregulating Wall Street:
Commercial Bank Penetration of the Corporate Securities
Market, edited by Ingo Walter (New York: John
Wiley & Sons, 1985), p. 275.
72




21 This is significant because in Eurobond under­
writing, the returns are even more heavily skewed
toward managers than in the domestic market. In
a typical underwriting, the lead manager and co­
manager (if any) will claim half the fees, the
underwriting group would share about 38 percent
of the fees, and the selling group would share the
remaining 12 percent. Ibid, p. 275 (footnote 58),
quoting from M. S. Mendelsohn, Money on the Move,
(New York: McGraw-Hill, 1980, pp. 184-190).
22 In 1987, only three U.S. investment banks were
among the top 10 Eurobond bookrunners, and only
seven were included among the top 50. Five
Japanese firms ranked among the top 10 in 1987,
up from only three in 1986. “Annual Financing
Report,” Euromoney, March 1988, pp. 4-6.
23 “US Banks Keep a Hand in International
Bonds,” op. cit., p. 15.
24 “There’s Life after Glass-Steagall for Wall Street,
Report Says,” op. cit., p. 3.
25 This ruling was in response to a series of appli­
cations filed by three large bank holding companies
in 1987. The Fed held that underwriting and
dealing in commercial paper, MRBs, and MBSs
were permissible under the BHC Act and did not
violate the Glass-Steagall Act as long as a
subsidiaries’ underwriting and dealing in such se­
curities constituted no more than 5 percent of its
total gross revenues and the subsidiary underwrote
no more than 5 percent of the domestic market in
such securities. See “Citicorp, J. P. Morgan & Co.
Incorporated, and Bankers Trust New York Cor­
poration,” Federal Reserve Bulletin, Vol. 73 (June
1987), pp. 473-508.
26 Although the bank holding companies included
in the initial decision had also sought to underwrite
securities backed by consumer loans, the Fed de­
layed approval until it could consider the issue
further. Authorization to underwrite CRBs came
in July, and was made subject to similar limitations.
See “Chemical New York Corporation, The Chase
Manhattan Corporation, Bankers Trust New York
Corporation, Citicorp, Manufacturers Hanover
Corporation, and Security Pacific Corporation,”
Federal Reserve Bulletin, Vol. 73 (September 1987),
pp. 731-735.
27 The moratorium was contained in the Compet­
itive Equality Banking Act of 1987 (CEBA), and
prohibited regulatory approval of any new securi­
ties, real estate, or insurance activities. CEBA was
enacted in August, but the moratorium was im­
posed retroactively, to be in effect from March 6,
1987 to March 1, 1988.
28 The Comptroller’s decision was based, among
other things, on a national bank’s authority to sell
its own or “any other lawfully acquired assets.” Jed
Horowitz, “Comptroller Approves Asset-Backed
Economic Perspectives

Securities,” American Banker, June 19, 1987, pp. 1,
14.
29 The SIA had been pressing the Comptroller to
issue a written opinion on recent deals of this kind
so it would have a basis to bring a lawsuit against
the regulator. Ibid, p. 1.
30 “Marine Plays it Safe In Asset-Backed
Offering,” Asset Sales Report, November 16, 1987,
pp. 1, 5. This issue came to market before the
Comptroller’s letter to Security Pacific.
31 “Citibank Stretches the Limits,” Asset Sales Re­
port, October 19, 1987, p. 3.
1,2 “Chemical Bank Offers First Deal,” Asset Sales
Report, April 25, 1988, p. 5.
33 Robert Guenther, Robert E. Taylor, and
Stephen Wermiel, “Supreme Court Backs Fed’s
Approval for Securities Underwriting by Banks,”
Wall Street Journal, June 14, 1988, pp. 3, 18.
34 The twelve banks affected by this ruling are
Bankers Trust, Chemical, Citicorp, Chase, Man­
ufacturers Hanover, Morgan, Security Pacific,
PNC Financial Corp., Marine Midland Banks
Corp., First Interstate Bancorp., Bank of New En­
gland, and Bank of Montreal. Ibid, p. 18.
31 “First Boston Tops Private Placements,” Asset
Sales Report, March 21, 1988, p. 5.
36 “Salomon Sheds Low-Margin Businesses,” Amer­
ican Banker, October 13, 1987, pp. 1, 23.
37 Michael Quint, “Into the Breach,” United States
Banker, June 1988, pp. 12-13.
See Janet Lewis, “The Asset-Backed Explosion,”
Institutional Investor, April 1988, pp. 191-195.
39 Direct data on the profitability of investment
banking services is difficult to obtain, but studies
have suggested that there is a lack of competitive
vigor in certain types of underwriting that enables
investment banks to maintain spreads, and there­
fore profits, at levels that exceed the cost of pro­
viding such services and earning a reasonable rate
of return for the level of risk involved. For a dis­
cussion and further references, see Thomas A. Pugel
and Lawrence J. White, “An Analysis of the Com­
petitive Effects of Allowing Commercial Bank Af­
filiates to Underwrite Corporate Securities” in
Deregulating Wall Street: Commercial Bank Penetration
of the Corporate Securities Market, edited by Ingo
Walter (New York: John Wiley & Sons, 1985), pp.

Federal Reserve Bank of Chicago



93-139. See also Kaufman and Mote, op. cit., pp.
22-23.
40 The gross spread is the difference between the
price the issuer receives for its securities and the
price investors pay for them, usually expressed as
a percentage of the gross proceeds of the issue.
41 See Pugel and White, op. cit. pp. 100-112. The
authors discuss studies by Hayes, et al. on corporate
affiliations with investment banking houses.
[Samuel L. Hayes III, A. Michael Spence, and
David Van Praag Mark, Competition in the Investment
Banking Industry, (Cambridge: Harvard University
Press, 1983).] The results generally suggest that
larger, high-quality clients tend to affiliate with
leading firms.
42 Ibid, p. 106.
43 Based on data in SEC Monthly Statistical Review,
August 1988, Vol. 47 No. 8, tables M-450 and
M-465.
44 Pugel and White, op. cit., p. 116.
45 The Securities Act of 1933 requires issuers to
disclose information pertinent to the public’s deci­
sion about whether to purchase a firm’s securities.
It also requires investment banks to ascertain
whether the information is true and complete. The
shortened processing time of issues brought to
market under this rule leaves little time for this
“due diligence.” For this reason the SEC has lim­
ited the use of Rule 415 to larger, better known,
publicly owned corporations. Ibid, p. 114.
16 Indeed, where state regulators have granted
more liberal securities powers for state chartered
banks than are permitted for either federally char­
tered banks or bank holding companies, few banks
seem to be taking advantage of the expanded
powers. See Barbara A. Rehm, “State Banks Wary
of Using New Powers,” American Banker, April 11,
1988, pp. 1, 6.
47 Of course, if Glass-Steagall restrictions were to
be substantially eliminated, and with them the
prohibition against bank affiliation with securities
firms, major bank holding companies could “buy”
rather than compete for market share by acquiring
an existing securities firm.
18 See Andrew Albert, “Why Banks Bother with
Public Finance, and How the Big Three Are Suc­
ceeding,” American Banker, July 16, 1988, pp. 1, 12,
14 and “US Banks Keep a Hand in International
Bonds,” op. cit..

13

E C O N O M IC P E R S P E C T IV E S -In d ex fo r 1988
Banking, cred it, and finance
Does regulation drive innovation?......................................
Loan sales have little effect on bank ris k ..........................
Daylight overdrafts: Rationale and risks.............................
Banking 1987: A year of reckoning....................................
Bank risk from nonbank activities.......................................
Financial services in the year 2000.....................................
The grass may not be greener: Commercial
banks and investment banking...........................................
A note on the increase in noninsured commercial banks
Economic conditions
Economic events of 1987—A chronology..........................
Government spending and the "falling rate
of p ro fit" ................................................................................
Capital market imperfections and
investment fluctuations........................................................
New directions for economic
development—the banking industry...................................
M oney and m onetary policy
An interest rate-based indicator of
monetary p o licy.....................................................................
Looking back: The use of interest
rates in monetary policy.......................................................
A policymakers' guide to economic
forecasts..................................................................................
Real boats rock: Monetary policy
and real business cycle s......................................................

Digitized74for FRASER


Issue

Pages

Mar/Apr
Mar/Apr
M ay/Jun
Ju l/A u g
Jul/A u g
Sep/Oct

3-15
23-31
18-29
3-13
14-26
13-15

Nov/Dec
Nov/Dec

3-13
16-20

M ar/Apr

17-22

M ay/Jun

11-17

Sep/Oct

3-12

Sep/Oct

17-24

Jan/Feb

3-14

Jan/Feb

15-29

M ay/Jun

3-10

Nov/Dec

21-28

Economic Perspectives




CALL

FOR

PAPERS

The 25th Annual Conference on
Bank Structure and Competition
Chicago, Illinois, May 3-5, 1989
The Federal
Reserve Bank of
Chicago will hold its
25th annual Confer­
ence on Bank Struc­
ture and Competition
in Chicago, Illinois,
May 3-5, 1989. For a
quarter of a century,
the Conference has
provided a forum for
the exchange of ideas
among academics, regulators, and indus­
try participants with a strong interest in
public policy toward the financial services
industry. A major objective of this year s
Conference will be to place emerging trends
in financial system risk in historical per­
spective and to draw their implications
for regulatory policy and bank manage­
ment. More specific topics under this
heading include the extent to which the
recent increase in the volatility of finan­
cial markets is a permanent rather than a
temporary7phenomenon, the impact of
globalization of financial markets on risk,
and the implications of recent experience
for deposit insurance reform and lenderof-last-resort policy. We are seeking
papers on these issues as well as on other
issues in financial structure and regulation.
Please submit two copies of completed
papers or abstracts by December 31,1988
to Larry Mote, Program Chairman,
Research Department, Federal Reserve
Bank of Chicago, 230 South LaSalle
Street, Chicago, Illinois 60604-1413.
FEDERAL RESERVE BANK
OF CHICAGO

A note on the increase
in noninsured com m ercial banks
Nancy N. Andrews, George G. Kaufman, and Larry R. Mote
Both because of the increased value of
According to data published in the Annual
federal deposit insurance and because the
Statistical Digest of the Board of Governors of
number of banks in the country or in a partic­
the Federal Reserve System, the number of
ular local or regional market is widely used as
commercial banks that are not insured by the
a surrogate for the intensity of competition, it
Federal Deposit Insurance Corporation (FDIC)
is of interest to explore the reasons for the ex­
more than tripled between 1970 and 1986 from
traordinarily sharp increase in the reported
fewer than 200 to more than 600.1 Although
number of noninsured banks. Careful exam­
noninsured banks accounted for only 1 percent
ination of the data leads to the conclusion that
of all 13,688 commercial banks in 1970 and less
the increase is to a large extent illusory and
than 5 percent of all 14,866 reported commer­
reflects primarily the inclusion of noncommer­
cial banks in 1986, the increase in their num­
cial banking institutions and the double count­
bers accounted for almost 40 percent of the
ing of U.S. branches of foreign banks. Because
reported 1,200 increase in the total number of
noninsured banks are part of the total number
commercial banks.
of banks, the overstatement of noninsured
It is surprising that there should be such
banks also overstates the total number of banks
a strong demand for the services of noninsured
in
the country and in many local markets. If
depository institutions at this particular time.
the number of banks is to be used as a measure
The recent sharp increase in the number of
of bank market structure or competition, it
failures of depository institutions—commercial
needs to be corrected for this bias.
banks and thrift institutions—to the highest
The Board of Governors has collected
levels since the banking crisis of the early 1930s
data
on the total number of banking insti­
has increased the value to the public of the
tutions for many years. These data are ob­
protection afforded by federal deposit insur­
tained from many sources, including records of
ance. Authorized by the Banking Act of 1933
charters granted to new institutions. Bank
and implemented for banks in 1934, federal
organizers may obtain charters either from the
deposit insurance has been expanded through
Comptroller of the Currency, if they wish to
the years to cover larger and larger amounts
establish a national bank, or from the individ­
at a broader range of depository institutions.
ual state departments of financial institutions,
Today, it guarantees the par value of accounts
if
they wish to establish a state bank.
at chartered commercial banks, savings banks,
But, departments of financial institutions
savings and loan associations, and credit unions
in many states are also empowered to grant
up to $100,000 per separate account.
charters to other depository institutions, such
Federal deposit insurance is widely con­
as trust companies that do not conduct deposit
sidered to be a valuable advantage that these
and other banking business or industrial
institutions have over their competitors, such
(Morris Plan) banks, which are more like con­
as money market funds. Indeed, it is doubtful
sumer loan companies or credit unions than
whether, in the absence of such deposit insur­
commercial banks. These institutions are in­
ance, many (if any) depositors would maintain
cluded in the total number of noninsured banks
their funds in any of the many savings and loan
in
the Board’s data base. Clearly, if the numassociations that are currently insolvent by
generally accepted accounting principles
Nancy N. Andrews is banking data coordinator at the
(GAAP) but have not yet been closed by the
Federal Reserve Bank of Chicago. George G. Kaufman is
Federal Savings and Loan Insurance Corpo­
the John F. Smith, Jr., Professor of Economics at Loyola
University of Chicago and a consultant to the Federal Re­
ration. Without federal deposit insurance,
serve Bank of Chicago. Larry R. Mote is an economic ad­
these institutions would be unable to repay all
viser and vice president at the Federal Reserve Bank of
of their depositors in full and on time.
Chicago.
76




Economic Perspectives

Table 1
A djustm ents to num ber o f banks

Total commercial banks, A n n u a l S ta tis tic a l D ig e s t
Total commercial banks, current Board data base*
Less reported noninsured banks

1980

1986

14,836
14,884
436

14,866
14,879
640

14,448
14

14,239
13

Reported insured banks
Minus member nondeposit trust companies**
Plus insured branches of foreign banks,
adjusted for double counting***

+

Insured banks, adjusted
Plus noninsured banks, adjusted

14,448
+
115

14,249
+
214

Total commercial banks, adjusted

14,563

14,463

14

+

23

‘ Differs from figure in A n n u a l S ta tis tic a l D ig e s t because of revisions, the inclusion for 1980 of banks in Puerto Rico
and the Virgin Islands, and other unexplained discrepancies.
**Nondeposit trust companies that are members of the Federal Reserve System had been included in the number of
noninsured banks prior to 1986 but were included w ith insured member banks in the 1986 A n n u a l S ta tis tic a l D ig e s t
table.
" ‘ Although some U.S. branches of foreign banks obtained FDIC insurance after 1978, they continued to be reported
in the noninsured category. They must be added back to get the total number of insured banks.

ber of banks is to be consistent and econom­
ically meaningful, these institutions should be
excluded.
In addition, the U.S. branches of foreign
banks are included in the count of noninsured
commercial banks in the Board’s listing.2 Al­
though most U.S. branches of foreign banks do
engage in the business of commercial banking,
the reported number of noninsured banks is
greatly inflated by the way in which U.S.
branches of foreign banks are treated. Every
U.S. branch of a foreign bank is recorded as a
separate bank, even if two or more branches of
the same foreign bank are in the same state.
The basic reason for this treatment, which dif­
fers from that accorded branches of domestic
banks, is noneconomic. It occurs because
branches of foreign banks are required to sub­
mit separate call reports (financial statements)
to regulators. This gives rise to the potential
for two types of double counting: double
counting of multiple branches of a foreign bank
in the same state, and—because, in contrast to
U.S. banks, foreign banks are permitted to es­
tablish branches across state lines—double
counting of offices of the same foreign bank in
more than one state.
It is important to recognize that double
counting at the national level does not neces­
sarily constitute double counting at the state
level. For example, if a foreign bank has
Federal Reserve Bank of Chicago



branches both in California and in New York,
it is entirely appropriate that the bank be
counted in the totals for both states; it repres­
ents one of the competing banking organiza­
tions within each state. However, when the
data are aggregated to the national level, the
bank should be counted only once. Thus, the
national total should be smaller than the sum
of the state totals.
Some of the branches of foreign banks
should even be excluded from the state totals
because their banking activities are sharply
limited. Although the International Banking
Act of 1978 grandfathered the activities of ex­
isting out-of-state branches of foreign banks, it
required each foreign bank to declare a “home
state” and prohibited any newly established
branches in other states from engaging in
deposit-taking activities (except those related
to international business). Thus, branches of
foreign banks established in other states since
1978 do not offer a full line of commercial
banking services. They have been retained in
the state totals in this study because of the dif­
ficulty in identifying the scope of activities
conducted by individual branches.
Careful examination of the Board’s data
base for 1980 and 1986 revealed that many of
the noninsured institutions included could not
accurately be classified as commercial banks.
Industrial banks, primarily in Colorado, ac77

T a b le 2
N u m b e r o f noninsured banks in 1986, by state
Adjustments

ASD*

Board's
current
data
base

Economic Perspectives

AL
0
0
AK
1
1
AZ
7
7
AR
3
3
CA
50
50
79
CO
86"
CT
1
1
DE
3
3
DC
3
3
FL
13
13
GA
1
1
HI
4
4
ID
0
0
IL
69"
68
IN
3
3
IA
1
1
2
KS
2
KY
2
2
LA
1
1
ME
1
1
MD
1
1
MA
9
9
Ml
2
2
MN
2
2
MS
2
2
MO
5
5
MT
1
1
NE
5
5
NV
1
1
NH
3
3
NJ
3
3
NM
2
2
NY
237
237
NC
2
2
ND
2
2
OH
3
3
OK
8
8
9
OR
9
PA
16
16
Rl
14
14
SC
0
0
SD
0
0
TN
5
5
TX
14
14
UT
3
3
VT
1
2"
VA
0
0
WA
14
14
WV
0
0
Wl
7"
8
WY
1
1
PR
10
10
VI
6
6
50 states +
PR and VI
Total
632
640
Interstate double-counting

Less insured
branches of
foreign
banks

7

10

3

35

2

57

Reported
total
noninsured
banks
0
1
7
3
43
86
1
3
3
13
1
4
0
59
3
1
2
2
1
1
1
6
2
2
2
5
1
5
1
3
3
2
202
2
2
3
8
9
14
14
0
0
5
14
3
2
0
14
0
7
1
10
6
583

Less
industrial
banks

Less
nondeposit
trust
companies

1

1
81

1

1

10
1
1

96

7
2
18
5
1
3
0
13
1
4
0
20
1
1
1
1
1
1
1
0
0
1
2
5
1
4
1
3
3
2
24
2
1
2
5
4
7
3
0
0
3
8
3
2
0
3
0
7
1
1
1
181

U S. total, adjusted
‘ Data taken from the A n n u a l S ta tistica l D igest
"Differs from table in A n n u a l S ta tistica l D ig e st because of unexplained discrepancies.




Less doublecounted
branches of
foreign banks

3

15

5
3
26

Total
noninsured
banks.
adjusted
0
0
0
0
22
0
0
0
3
0
0
0
0
39
1
0
1
1
0
0
0
6
2
1
0
0
0
0
0
0
0
0
163
0
1
1
3
5
7
1
0
0
1
5
0
0
0
11
0
0
0
4
2

Breakdown of noninsured banks
Incorporated banks
Noninsured
As defined
under Bank
branches
of foreign
Holding
Nonbank
banks
banks
Company Act

Private
banks

22

3

38

1

1

1
1

5
1
1

160

5
3

1

1

1

2

1
1
3

1

4

1
1
4

1

10

1
2

3

280
-66

249
-66

16

214

183

4

11

counted for 121 of the 414 noninsured banks
reported in 1980 and for 96 of the 583
noninsured banks for 1986. Nondeposit, non­
bank state-chartered trust companies ac­
counted for 95 of the total reported noninsured
banks in 1980 and for 181 in 1986.5
Double counting of noninsured foreign
branches within the same state, particularly in
New York, accounted for 30 reported
noninsured banks in 1980 and 26 in 1986. In
addition, 39 of the reported noninsured banks
represented double counting of the same for­
eign bank in more than one state in 1980. The
equivalent number was 66 in 1986.4 The in­
crease reflects rapid expansion across state lines
of branches of foreign banks.
If the reported number of noninsured
banks were adjusted to eliminate industrial
banks, nondeposit nonmember trust companies,
and double counting of noninsured U.S.
branches of foreign banks, the number would
decline by more than 50 percent from 414 to
154 in 1980 and from 583 to 280 in 1986. The
adjustments are detailed in Table 1. Of the
adjusted 154 non-FDIC insured banks in 1980,
130 were branches of different foreign banks,
11 were incorporated commercial banks, and
13 were nonincorporated or private banks. In
1986, the adjusted 280 noninsured banks con­
sisted of 249 branches of different foreign
banks; 20 incorporated banks, including 4
nonbank banks; and 11 private banks.’ Thus,
77 percent of the noninsured banks in 1980 and
89 percent of those in 1986 consisted of
branches of different foreign banks. Moreover,
all the growth in the actual number of
noninsured banks between 1980 and 1986 may
be attributed to increases in the number of
foreign banks operating branches in the United
States.
Although a similar analysis of reported
noninsured banks was not undertaken for other
years, it is unlikely that the results would differ
greatly. Thus, there appears to have been no
actual increase in the number of domestically
chartered noninsured banks in recent years. In
addition, both the number of commercial banks
in the country and its rate of growth are some­
what lower than is evidenced by the reported
figures. This is particularly true in Colorado,
where a large number of industrial banks were
included, and in New York State, where mul­
tiple branches of foreign banks were double
counted. For 1980, making the suggested ad­
Federal Reserve Bank of Chicago



justments to the number of noninsured banks
would reduce the total reported number of
commercial banks in the United States from
14,884 to 14,563 (noninsured banks would de­
cline from 436 to 115 and insured banks wrould
remain unchanged). In Colorado, the number
would decline from 442 to 323 and in New
York from 317 to 285. Similarly, in 1986, the
adjustments would reduce the total number of
banks in the country from 14,879 to 14,463
(noninsured would decline from 640 to 214 and
insured would increase from 14,239 to 14,249).
The number of banks in Colorado would de­
cline from 552 to 466, and the number in New
York from 441 to 402. The adjustments to the
data by individual state are shown in Table 2.
If similar adjustments were made to the num­
ber of insured banks, the numbers would de­
cline even further.
The Board of Governors has recently an­
nounced that the table, “Banks and
branches—Number in operation,” in the Annual
Statistical Digest will be revised. Beginning with
the data for December 31, 1987, all branches
of foreign banks will be excluded. This elimi­
nates the problem of double-counting, but, be­
cause many of the branches of foreign banks
offer all of the services offered by domestic
banks, it results in understating the number of
commercial banks. Thus, users of data on
number of banks would be well advised to pay
careful attention to how the data were com­
piled and what they do and do not include.
1 Table 76, “Banks and branches- Number in op­
eration, December 31, 1986, by state,” Annual Sta­
tistical Digest (Washington, D.C.: Board of
Governors of the Federal Reserve System, 1987),
p. 190. The number of the table varies for earlier
years.
2 Before the enactment of the International Banking
Act of 1978, U.S. branches of foreign banks were
not eligible for FDIC insurance. When they did
become eligible, the Board continued to list those
that obtained FDIC insurance as noninsured banks.
The number of insured U.S. branches of foreign
banks was 22 in 1980 and 57 in 1986. These have
been excluded from the data on noninsured banks
in this article. In addition, banks in Puerto Rico
and the Virgin Islands were added to the Board’s
1980 data base to make it comparable to the 1986
base. There are other minor discrepancies between
the Board’s current data base for the two years and
the figures published in the Annual Statistical Digest.
The term “total reported number of noninsured
19

banks,” as used in the remainder of this article, is
based on the Board’s data base rather than the Di­
gest table, excluding insured branches of foreign
banks and including banks in Puerto Rico and the
Virgin Islands for both years.
3 A number of these institutions are members of the
Federal Reserve System. Because they have no de­
posits, they are not subject to the usual requirement
that member banks be insured. Prior to 1986, they
were counted in the Annual Statistical Digest tables
as nonmember, noninsured banks. In 1986 they
were shifted to the state member bank category.
There were 14 such trust companies in 1980 and
13 in 1986.
4 The same types of double counting occur for in­
sured branches of foreign banks. Adjusting the
number of insured branches of foreign banks for

0 FRASER
Digitized2 for


double counting reduces the reported number of
insured banks by 8 in 1980 and by 34 in 1986. A
small number of foreign banks (one in 1980, three
in 1986) have some branches that are insured and
some that are noninsured. The data used here were
not adjusted for double counting across the two
categories.
5 Nonbank banks are institutions that, although
chartered as commercial banks, either do not ac­
cept demand deposits or do not make commercial
loans. Therefore, they were not considered banks
under the Bank Holding Company Act before its
amendment in 1987. However, in view of the small
number of nonbank banks and because most of
them do offer a broad range of banking services to
individuals, it was decided to retain them in the
final totals.

Economic Perspectives

Real boats rock: M onetary policy
and real business cycles
Steven Strongin
In the last fifteen years, economists’
understanding of the economy has changed
dramatically. Events have forced economists
to reassess many of their most cherished as­
sumptions about the way the economy works.
Key economic relationships seem to disappear
completely, only to reappear later with a casual
indifference to professional opinion. The econ­
omy has pointedly and repeatedly demon­
strated that it is a very complicated entity,
capable of a great range of behavior. And the
explanations that economists have developed
to cope with this rudely apparent complexity
bring into question the way economic policy
has traditionally been analyzed.
This article outlines some of the major
intellectual trends that have evolved in re­
sponse to recent experience, paying special at­
tention to how events have changed
economists’ understanding of economic policy,
specifically monetary policy.
Since 1973, we have experienced three
significantly different federal tax codes, three
significantly different monetary regimes, and
three different market assessments of basic
commodity price trends. The value of im­
ported goods as a percentage of total goods
purchased has risen from 18 percent in 1980 to
26 percent in 1986. Foreign capital flows now
account for 18 percent of U.S. capital needs.
It is still unclear how economic theory will ul­
timately be affected by these events. Yet, a
number of lessons are clear.
The U.S. economy is more sensitive to
international markets, both capital and goods
markets, than was commonly supposed. The
tremendous diversity of economic experience
among various sectors and regions, as well as
the more celebrated effects of changes in the
price of oil, have made it apparent that many
fluctuations in the economy have less to do
with changes either in domestic policy or de­
mand conditions than economists had thought.
The notion that supply conditions in terms of
either input prices, competitive conditions, or
technology are partially responsible for business
cycle fluctuations is no longer an easily dis­
Federal Reserve Bank o f Chicago



missed footnote in the history of economic
thought but a major focus of current research.
The idea that real economic events such
as oil shocks are responsible for some significant
part of the volatility in economic activity im­
plies directly that business cycle phenomena
(including recessions and certain accelerations
in inflation, as well as less dramatic events)
may be necessary and natural responses to
economic events. The policy implications of
this are neither subtle nor small. Policymakers
and economists have usually assumed that large
changes in real growth and inflation repres­
ented mistakes that policy should attempt to
correct. If this is not always the case, then the
policy debate must be revised to deal with the
possibility that bad economic news is not in it­
self sufficient reason for policy to act. In a
world where supply factors matter, stabilization
policy, while not necessarily wrong, is also not
necessarily right. No longer can someone
merely point to a recession and conclude that
policy failed. The source of the offending event
must be considered in order to evaluate
whether a better outcome was really possible.
In a world where changes in supply are
important, policy decisions are almost always
a series of trade-offs between different goals.
For instance, if policy seeks to make U.S. firms
more competitive with foreign corporations by
lowering the value of the dollar, it will generate
a higher inflation rate. The higher inflation
rate will reduce the standard of living of
American workers even as the lower dollar
creates more jobs for them. For business, the
consequences are just as double-edged. While
the lower dollar makes U.S. firms more com­
petitive and attracts foreign capital for U.S.
firms to build new factories with, it makes those
same firms vulnerable to foreign takeover.
The standards by which economic policy
is judged need to be revised. It can no longer
be maintained that the economy would chug
along at a solid 3-3.5 percent real growth rate
Steven Strongin is a senior economist and assistant vice
president at the Federal Reserve Bank of Chicago.
27

no inflation if policy were run correctly. As the
saying goes, “real boats rock.”
Pre-oil-shock notions
Policy as repairman. The Keynesian
notion of policy was one of managing an econ­
omy which, at least at the macroeconomic
level, was incapable of managing itself.
Greatly influenced by the Great Depression,
Keynesian theory1,2 believed the economy is
subject to large demand shocks that can inca­
pacitate much of the country’s production ca­
pacity. It followed from this view of the
economy that the primary goal of policy is to
offset demand shocks and prevent the resulting
recessions from endangering the economic
health of the nation. Fundamental to this
viewpoint was the notion that cyclical fluctu­
ations were due to largely unexplainable “ani­
mal spirits.” Simply put, recessions were due to
an economy in error and the goal of policy was
to correct that error.
The IS-LM models used by the
Keynesians, being primarily static in nature,
caused economists to emphasize the current
health of the economy rather than the pros­
pects for healthy growth. Thus, during the
heyday of Keynesian analysis, policy paid far
more attention to current unemployment than
to GNP growth.
Unemployment was viewed as a measure
of an economy’s failure to use all available re­
sources. Within this paradigm, it is clear that
the goal of policy is to create enough current
demand to assure that all available resources
are fully utilized. Tomorrow will be taken care
of by tomorrow’s policies. The intuitive appeal
of this approach to policymakers is clear: If re­
sources are not being used, then clearly they
are being wasted. Trade-offs through time
were largely ignored; they were not part of the
theory. Keynesians believed implicitly in im­
mediate and forceful counter-cyclical policies.
This gap in the Keynesian paradigm
leads to some well known difficulties, such as
policies biased toward inflation. The greatest
failure of the Keynesian approach was its com­
plete inability to cope with the stagflation of
the early 1970s. In the Keynesian world, in­
flation means growth. This failure paved the
way for the ascendancy of monetarism.
Policy as the problem In the monetarist’s
paradigm,3,4 the economy left to itself is a sta­
22



ble, healthy, dynamic entity that can be and
often is disrupted by inappropriate policies, es­
pecially monetary policies. The heart of this
analysis shares much with the Keynesian world
view in that most problems originate in inap­
propriate levels of demand and that those
problems manifest themselves in unnecessary
and harmful economic fluctuations. However,
the monetarist’s paradigm argues that the in­
appropriate level of demand is the result of bad
policy. Monetarists believe that if policy is
stable (a steady 4 percent money growth is the
most common definition of stable policy used
by monetarists) then demand will remain sta­
ble, and the economy will experience steady
non-inflationary growth.
The Keynesian and monetarist frame­
works differ primarily in their assumptions
about the ability of economic agents to make
good decisions about the economy as a whole.
Monetarists, unlike the Keynesians, hold that
economic agents will make good decisions un­
less they are misled by policymakers. Accord­
ing to monetarists, the primary way
policymakers mislead economic agents is by
printing excess money. The extra money leads
to excess spending that in turn leads to in­
creased inflation and lower growth.
The monetarist paradigm is more dy­
namic in outlook than the Keynesian but it still
does not have any formal structure for making
policy trade-offs through time. There is no
need in the monetarist paradigm to make
trade-offs. If policy follows a strict 4 percent
money-growth rule, the economy will do ev­
erything right.
Although it is hard to find policy pre­
scriptions more different than the monetarists’
and Keynesians’, they both share the funda­
mental belief that policy can achieve stable
growth, full employment, and zero inflation by
the constant application of their policy rec­
ommendations. They both hold that economic
outcomes can be consistently altered in a pre­
dictable way by policy. Thus, in their view,
policy is ultimately responsible for all that
happens in the macroeconomy.
Policy begins to lose its punch. The
stagflation of the early 1970s was monetarism’s
big break. The Keynesian framework which
had dominated macroeconomic policy for a
generation was in serious trouble. Monetarism
was in ascendancy. However, economic ideas
were germinating that would transform
Economic Perspectives

monetarism’s basic policy message into some­
thing that its originators would have trouble
recognizing.
The rational expectations hypothesis5 in­
troduced the idea that economic agents could
not be routinely fooled by policymakers. If
economic agents are as smart as the monetarists
hold, then they should also use information
about future policy in an efficient manner.
And if economic agents do rationally forecast
future policy, then it will be impossible for
policymakers to systematically fool those agents
into carrying out the policymakers’ wishes.
The implications of this observation for policy
analysis are large. If economic agents’ actions
are based on optimal forecasts of policymakers’
attempts to fool them, then they will only be
fooled by the random component of policy.
This clearly destroys the ability of policymakers
to “manage” the economy. Policymakers can
mess things up by following random policies
but they have no ability to systematically help
the economy. Deviations from a policy rule
hurt the economy because they are hard to
forecast. And, even stranger, it doesn’t really
matter what the rule is, as long as economic
agents can accurately forecast policy actions.
In this context, a 4 percent money growth rule
follows not from a classical monetarist argu­
ment, but from the observation that four is a
very easy number to predict.6 This framework,
more than any other, argued that having a rule
is the best policy.
The world becomes unstable. Within the
context of the rational expectations literature,
the new classical approach78 provides a more
complete theoretic structure. In the new clas­
sical paradigm, economic agents are dynamic
optimizing agents with full information proc­
essing capabilities. Every economic agent be­
comes not only a full service economic
forecasting firm but also a full service corporate
planning department. The primary policy
consequences of this approach are twofold. Not
only are economic agents difficult to mislead,
but structural relationships in the economy be­
came less stable. Because economic agents act
on implicit forecasts, different economic re­
gimes lead to whole new decision rules.
Policymakers have to deal with the expecta­
tions of economic agents but they can not count
on consistent responses even to surprises.
Policymakers in the new classical world were
in a two-party guessing game.
Federal Reserve Bank of Chicago



This rational expectations paradigm
formally introduced the notion that policy af­
fects macroeconomic welfare by distorting the
intertemporal allocation of resources. Eco­
nomic agents, by attempting to optimize,
would try to match opportunity costs across
periods and would err when policy caused
prices to be improperly set. Within the context
of these models, the markets are perfect, in the
sense that profit opportunities for intertemporal
arbitrage are equal between the market and the
government. As a result, policy, if it can do
anything, can only distort the prices at which
that arbitrage takes place and thus hinder the
economy.
A substantial subgroup9,10 of the profes­
sion took issue with these policy conclusions,
and pushed forward the notion that there were
sufficient non-neutralities in money growth in
the real world to allow plenty of room for con­
sistent counter-cyclical policy action. What is
interesting about this literature in terms of
policy is that this analysis, like all of that pre­
ceding, maintained with very few exceptions
that stability is good and instability is bad. The
goals of policy, up to this point, are uniformly
toward stability. The argument is centered
around the effects of policy. Does policy cor­
rect or create the instability? All sides still hold
that the economic nirvana of stable growth and
zero inflation is possible if policymakers would
follow their advice.
This is hardly surprising. From Keynes
onward there have been virtually no sources of
volatility in the real economy that have not
involved someone making a mistake, according
to economists. Although the questions about
who exactly was making the mistake created
many heated arguments, everyone agreed that
someone made a mistake. It is also hardly sur­
prising that, faced with the economic events
since 1973, this world view did not hold up too
well.
Post oil shock developments
Supply factors demand equal time.
Beginning with the first oil shock, the economy
has not behaved in ways that could be ex­
plained by previous demand-based models.
The oil shocks shifted supply curves, creating
upward price pressures at the same time they
drove output down. Demand shifts cannot
create that combination of events. The Reagan
23

Administration’s 1981 tax law changes may
have oversold their own direct supply-side ef­
fects, but the effect those tax law changes had
on the value of the dollar had substantial real
supply-side effects.
Many American firms simply could not
compete in world markets with the price wedge
that the 1981 tax bill created in the currency
market. And while it is not the role of this pa­
per to discuss exactly how the 1981 tax bill
created that wedge, the wedge did indeed exist
until the passage of tax reform, which returned
U.S. companies to competitive health with a
vengeance. Many subtle arguments may exist
about arbitrage and Purchasing Power Parity,
but nothing described the situation better dur­
ing the peak of the wedge at the end of 1986
than a Harrod’s department store ad. The ad
claimed that it was possible for an American to
fly to London and, by Christmas shopping in
Britain, save enough to pay for airfare and ho­
tel. The existence of such gross arbitrage op­
portunities provides more than a prima facie
case that there were some serious distortions in
the currency markets.
The effects of the price wedge were sub­
stantial. Policy efforts based on increasing the
level of demand had their effects leached away
by import growth. As a result, during much
of this period demand growth substantially
outstripped GNP growth. Inflation was re­
duced to artificially low levels as U.S. firms
were forced to cut profit margins below longrun equilibrium just to stay in business.
Today, with the advent of tax reform we
are seeing many of the price wedge effects in
reverse as the economy corrects itself: GNP
growth exceeding domestic demand growth,
inflation artificially high, and the Japanese
facing difficulties with their profit margins.
Since 1973 every aspect of macro per­
formance has been significandy affected by
“supply shocks”. Real growth has been both
helped and hindered by supply factors. In­
flation has been both elevated and lowered.
And, further, we have seen the effects of policy
become attenuated in the face of larger forces.
We do not yet have a clear understanding
of all of these supply-based phenomena.
Nonetheless, we need to consider what the ex­
istence of substantial supply shocks implies for
economic policy and for monetary policy in
particular.
24




Real business cycles, or optimally bad
times. A real business cycle is an aggregate
fluctuation whose root cause is a variation in
fundamental supply factors.11 The basic eco­
nomics of business cycles is very simple. If it
becomes harder to produce goods, because a
fundamental input such as oil has become
scarce or because there has been a sudden
change in international competitiveness, then
it may no longer pay to produce as much, and
a recession follows. As the shortage ends, or as
production techniques adjust to new circum­
stances, production will increase.
The key element in the notion is that the
increase in costs is, at least in part, only tem­
porary. Only if tomorrow’s goods will signif­
icantly undersell today’s is there a good
business reason for closing down. This is one
of the reasons why the first oil shock in 1973,
which was widely believed to be temporary,
had so much more impact on production than
the 1979 shock, which was viewed as perma­
nent. Thus, temporary supply shocks make it
perfectly possible to have a recession or a tem­
porary increase in inflation without any mis­
takes being made.
Two key aspects distinguish the real
business cycle models from all the paradigms
examined so far.12,13 First, business cycles exist
without any mistakes. Second, they are opti­
mal. Social welfare is maximized by allowing
non-trivial fluctuations in economic perform­
ance. The policy consequences of these two
aspects of real business cycle analysis are enor­
mous. They bring into question the whole
framework of stabilization policy. Economic
stability had been synonymous with good pol­
icy. Within a real business cycle context it is just as
easy to suppose that a countercyclical policy will over­
stabilize the economy.
The intellectual break here is hard to
overestimate. The whole policy goal structure
of the last 50 years is turned upside down by
taking changes in supply conditions seriously.
The Keynesian framework started with the as­
sumption that the mere existence of a business
cycle was sufficient to demonstrate a major
market failure that needed correcting. The
monetarists countered that the existence of a
business cycle was the result of misguided and
inappropriate policy and that if the Keynesian
types could just leave well enough alone busi­
ness cycles would largely disappear. Rational
expectations analysis took this argument one
Economic Perspectives

step further. It held that the market can correct
for all but random policy and that business cy­
cles were the result of random policy actions.
But, in all three cases the business cycle was the
symptom of a problem that it was the role of
economic policy to cure.
Now, the whole mind set of policy analy­
sis must be reassessed. The vocabulary of pol­
icy analysis may need to be rebuilt around the
possibility of “good” recessions or “good” in­
flation. The intellectual transition will not be
easy. We cannot say that all cycles are neces­
sarily optimal. Or that there is no role for sta­
bilization policy. But we can say that the
justifications will have to be very different from
what they have been.
The rest of this paper examines these is­
sues and makes some suggestions about that
new vocabulary. But a short digression to dis­
cuss how future real business cycle models may
differ from today’s is now in order.
New issues for old models. One obvious
thing about supply-based cycles is that they
may not be repeatable: A random disturbance
happens only once. It may be that most shocks
are enough alike that they can all be treated
the same, as today’s models assume, but it is
equally likely that many shocks, such as oil
shocks, may not be so amenable to models with
stable supply functions. While each of the
three oil shocks we have experienced in the last
15 years has been of approximately the same
size in terms of price movements, each has had
substantially different macroeconomic effects.
Many reasons exist to explain the difference
among oil shocks, yet the issues raised by the
differing responses cannot be dismissed.
A supply shock carries with it the poten­
tial for a fundamental shift in the economic
structure of an economy. As the supply curve
is shifted, wealth and earning power are redis­
tributed. While preferences may not actually
shift, the relative weights across consumers may
mimic such a shift at the macro level. (Saving
behavior on an international basis certainly
showed this kind of response after the first oil
shock.) Thus, one supply shock could, from an
economist’s viewpoint, be the equivalent of a
whole new economy. In the face of a whole
new economy, it would be unreasonable to hold
the policy regime constant. The current fash­
ion of developing macro models which hold
underlying structure as constant as possible
may need to be abandoned.
Federal Reserve Bank of Chicago



It is also quite possible that a lack of data
or repeated experience with a particular type
of shock may force a return to some ad hoc
constructions in macro modeling. This is not
to say that economists will backtrack to
Keynesian-style models, but only that we may
need to use economic intuition to model the
instabilities directly and that the models of
those instabilities may have insufficient data to
be estimated or verified.
Another significant development will be
an effort to integrate industry and regional
considerations with macro models. Supply
shifts not only create macro disturbances but
also micro ones. (Just compare Boston’s and
Houston’s economies over the last 15 years.)
It is at this level rather than economy-wide
that structural stability is likely to be found.
This is not the micro foundations modeling of
the early 1970s or the representative agent op­
timization techniques of new classical analysis,
but industry-, geographic-, and demographicbased analysis that takes into account the micro
eddies in the macro ocean. We may be able to
build models of price adjustment and output
of individual sectors based on their own supply
conditions. These models will allow some of
the macro instabilities due to changes in in­
dustrial structure and shifts in the relative im­
portance of various demographic groups that
result from supply shifts to be analyzed if not
accurately predicted.
New ways of looking at policy
In analyzing the policy implications of
real business cycles, the first necessary adjust­
ment is to recognize that policy, aside from
being good or bad, random or predictable, is
unavoidable. The way in which many real
business cycle models have kept policy neutral
is to simply not include it. Other have in­
cluded it in very straightforward rational ex­
pectations usage as unexpected money. I
submit neither of these approaches is adequate.
The first, simply omitting policy, is clearly in­
sufficient. The second approach misses a fun­
damental aspect of the real business cycle
literature. By allowing events to create dis­
turbances in real intertemporal scarcity, signif­
icant uncertainty about real intertemporal
scarcity is created. Should policy obscure these
economic signals, it will have real effects.
While a money shock definition may or may
25

not be technically correct, it provides no insight
into the distortions created by inappropriate
policies.
An alternative approach14,15 is borrowed
from micro policy analysis. Monetary policy
should be interpreted as a price wedge in the
intertemporal asset market. Policy has an ef­
fect only if it distorts a market price, specifically
the intertemporal market price of credit. While
this is inherently a nominal interest rate policy
definition, it is very different from the classical
Keynesian one. Here rates are measured rela­
tive to the marginal product of capital. The key
point is the emphasis on intertemporal prices. Interest
rates are interpreted as a measure of intertemporal f i ­
nancial scarcity. Thus, a neutral monetary policy is
one where financial intertemporal scarcity equals real
intertemporal scarcity, and monetary policy is the
wedge between financial and real intertemporal scar­
city.
The links to past definitions are fairly
straightforward. In a world where real scarcity
is constant, a stable money demand function
without foresight would produce a monetarist
definition of policy, and a stable money de­
mand function with foresight gives you a ra­
tional expectations definition of policy. The
Keynesian notion of policy would hold if the
analysis were collapsed to one period. The key
is that policy only has effects by distorting
market prices, so that whether or not there are
significant non-neutralities in the money supply
process, the same notion of policy holds. In
addition, we gain the advantage of avoiding
the current difficulties by defining money in a
useful way in a deregulated electronic world.
Unfortunately, interest rates are not the
only prices that policy can distort. As we have
seen demonstrated dramatically in the last six
years, distortions in international currency
markets can have large effects on the U.S.
economy. Thus, the price distortion concept
will need to include more than one asset. In
some sense, it requires the inclusion of a whole
structure of intertemporal prices both in do­
mestic and foreign markets, although
financial-market arbitrage reduces the relevant
prices to the domestic term structure and cur­
rent and future foreign exchange prices.
However, new policy definitions and
supply-based models do not in any way invali­
date either the monetarist or rational expecta­
tions lessons about policy; they simply make
implementing them that much more difficult.
26




Policy can still clearly disturb the economy.
In an economy that has reasonably efficient
markets, it is difficult, though not impossible,
for policy to have positive marginal product
and the potential for significant social loss due
to policy-created price distortions remains quite
high.
So what is policy supposed to do?
The easier question is, “What is policy
not supposed to do?” Clearly, it should not seek
to destabilize the economy. Just because a cy­
cle may be optimal does not make it optimal.
Likewise, policy should not seek to automat­
ically stabilize the economy because real busi­
ness cycles clearly cause all economic variables,
both financial and real, to vary through time.
Policy should not seek to artificially stabilize
some particular variable above all others.
Real business cycle analysis points out a
whole new set of limitations of policy. Not only
can policy not create the full-employment
prosperity of the Keynesian models, it cannot,
or at least should not, seek to provide the
steady, even growth and steady prices that the
monetarists so value. Rather, it suggests a
world where policy should seek to fit in and be
as unobtrusive as possible. When supply shocks
hit, it may be best to batten the hatches and
sail into the wind.
Such a policy would clearly avoid the
dangers of systemic inflationary excesses that
seemed to characterize policy in the late 1970s.
Policy would be run so that everything in the
economy could be explained without reference
to policy. This is a sort of real business cycle
monetarism. It lacks only a mathematically
compact rule.
It is interesting to note just how close this
view of policy fits the Federal Reserve’s own
public statements. Academics have usually
viewed the Federal Reserve as a big fish in a
small pond. The internal view is of a small fish
in a large ocean. In some ways the real busi­
ness cycle literature is closer to the older insti­
tutional view of the role of Federal Reserve
policy, that of providing a sympathetic finan­
cial environment for the conduct of business.
If you examine the Federal Open Market
Committee’s reports to Congress, it is very clear
that it is trying to do exactly what has been
described in this article. Whether it has been
successful or not remains a question. Analysts
Economic Perspectives

outside the Federal Reserve have always
viewed this line of argument as mere bureau­
cratic hedging.
Changing justifications
In the context of real business cycles lit­
erature, justifications for more activist policies
require new arguments as well. Market
imperfection arguments have often been used
to explain the existence of business cycles or at
least their “exaggerated amplitude,” thus pro­
viding opportunity for activist policy. These
arguments take on new importance in a real
business cycle context. They also lose their
conclusions. In a real business cycle context,
activist policies require the same justification
that has always been required in economics,
save macro policy, a cost-benefit analysis. It
is no longer sufficient to demonstrate the ability
to stabilize the economy to justify action. It
must first be demonstrated that the fluctuation
under consideration is suboptimal. Then it
must be shown that the gain from intervening
in the economy is greater than the loss from
disrupting necessary adjustments in the econ­
omy. If the intervention dampens useful cycles,
that will be part of the cost of intervention.
I believe that it is precisely this type of
analysis that will come to dominate the policy
process in the years to come. We must consider
what is to be gained by action and what is to
be lost. It is possible that we may come to the
conclusion that economic policy has caused the
economy to be substantially less volatile than
it should be.
There will likely be arguments about the
human costs of instability being traded off
against the lower total social welfare that re­
sults from stabilization policies. This is a classic
economic argument that, up until now, has
been absent from the monetary policy debate,
which has historically assumed stable growth is
high growth.
The evaluation of policy
One of the more difficult aspects of this
line of argument is deciding how to judge the
success of policy. In a world where recessions
can be called good, what constitutes failure?
The obvious answer, that performance must be
measured against what other policies would
have produced, is perfectly true and largely
Federal Reserve Bank of Chicago



useless. The answer lies with the notion of
market distortion.
There are some things that only policycan do. Systemic inflations, massive trade
deficits unrelated to the true marginal product
of physical capital, and multi-year recessions
are clear evidence of failed policies, though not
necessarily of failed monetary policy. Marginal
judgments may not be possible, but an econ­
omy which is being severely disturbed is not
hard to spot. The inability to reallocate re­
sources from low-marginal-product industries
to high-marginal-product industries is a sign of
an economy which is growing too fast. An
economy where the size and volatility of price
increases are hindering investment planning is
suffering from an overactive monetary policy.
Resource allocation is critical. Policy can
harm the economy by interfering with the cor­
rect allocation of resources. Conversely, policy
can assist the economy by helping in the correct
allocation of resources. Thus, it is the easy flow
of resources that must be the final measure of
policy effectiveness. As suggested earlier, policy
must rely on common sense and so must its
evaluation. While it may be hard to formalize
the exact nature of bad policy, it is not that
difficult to spot bad policy by observing its bad
outcome. This is precisely the role of the Fed­
eral Reserve’s Humphrey-Hawkins testimony
before Congress. It is unlikely that the realbusiness-cycle paradigm will substantially quiet
Federal Reserve critics.
Conclusions
The policy implications of the real busi­
ness cycle literature are large. They point on
the whole to policies that in the literature have
always been referred to as discretionary.
However, there is a big difference between dis­
cretionary and random. Policy in a real busi­
ness cycle world must be very aware of its
limitations. The most important message to
policymakers from the real business cycle liter­
ature is, “Don’t try to do too much” and the
primary lesson for critics of monetary policy is,
“Don’t expect too much”.
1 See Keynes, John Maynard, The General Theory of
Employment, Interest, and Money, London: Macmillan,
1936.

27

See Hicks, John, “Mr. Keynes and the Classics:
A Suggested Interpretation,” Econometrica, Vol. 5,
April 1937, pp. 147-59.
3 See Freidman, Milton, “The Role of Monetary
Policy,” American Economic Review, Vol. 58, March
1968, pp. 1-17.
4 See Friedman, Milton, and Anna J. Schwartz, A
Monetary History of the United States: 1867-1960,
Princeton: Princeton University Press, 1963.
3 See Barro, Robert J., “Unanticipated Money,
Output and the Price Level in the United States,”
Journal of Political Economy, Vol. 86, August 1978,
pp. 549-80.
6 See Lucas, Robert E., Jr., “Roles, Discrection and
the Role of the Economic Advisor,” Rational Expec­
tation and Economic Policy, ed. Stanley Fischer. Na­
tional Bureau of Economic Research, Chicago,
1980, pp. 199-210.
7 See Lucas, Robert E., Jr., “Econometric Policy
Evaluation: A Critique,” Carnegie-Rochester Confer­
ence on Public Policy, Vol. 1, 1976, pp. 19-46.
8 See Sargent, Thomas, and Neil Wallace, “Ra­
tional Expectations, the Optimal Monetary Instru­
ment, and the Optimal Money Supply Rule,”
Journal of Political Economy, Vol. 83, April 1975, pp.
241-547.

28




I See Fischer, Stanley, “Long-term Contracts, Ra­
tional Expectations, and the Optimal Money Sup­
ply Rule,” Journal of Political Economy, Vol. 85,
February 1977, pp. 191-206.
10 See Taylor, John B., “Staggered Wage Setting in
a Macro Model,” American Economic Review, Vol. 69,
May 1979, pp. 108-13.
II This is a somewhat broader class of model than
the Kydland-Prescott real business cycle models in
that it allows for a larger variety of supply shocks.
12 See Long, John B., and Charles I. Plosser, “Real
Business Cycles,” Journal of Political Economy, Vol.
91, February 1983, pp. 39-69.
13 See Barro, Robert, and Robert King, “Time
Separable Preferences and Intertemporal Substi­
tution Models of the Business Cycle,” Quarterly
Journal of Economics, Vol. 99, November 1984, pp.
817-39.
14 See Laurent, Robert D., “An interest rate-based
indicator of monetary policy,” Economic Perspectives,
Federal Reserve Bank of Chicago, Vol. 12, No. 1,
January/February 1988, pp. 3-14.
15 See Mote, Larry R., “Looking back: The use of
interest rates in monetary policy,” Economic Perspec­
tives, Federal Reserve Bank of Chicago, Vol. 12,
No. 1, January/February 1988, pp. 15-29.

Economic Perspectives

E O H S ^ O O economic
PERSPECTIVES
Public Information Center
Federal Reserve Bank
of Chicago
P.O. Box 834
Chicago, Illinois 60690
Do Not Forward
Address Correction Requested
Return Postage Guaranteed




BULK RATE
U S. POSTAGE
PAID
CHICAGO. ILLINOIS
PERMIT NO. 1942