Full text of Economic Policy Review (Federal Reserve Bank of New York) : Autumn 1987, Vol. 12, No. 3

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Federal
Reserve Bankof
NewVbrk

Quarterly Review




Autumn 1987
1

Volume 12 No. 3

Capital Requirements of Commercial and
Investment Banks: Contrasts in Regulation

11

The Economics of Securitization

24

Eurocommercial Paper and U.S. Commercial
Paper: Converging Money Markets?

36

Current Labor Market Trends and Inflation

49

Treasury and Federal Reserve
Foreign Exchange Operations

This Quarterly Review is published by
the Research and Statistics Group of
the Federal Reserve Bank of New
York. Among the members of the staff
who contributed to this issue are
GARY HABERMAN (on capital
requirements of commercial and
investment banks: contrasts in
regulation, page 1); CHRISTINE
CUMMING (on the economics of
securitization, page 11); ROBERT N.
McCAULEY and LAUREN A.
HARGRAVES (on Eurocommercial
paper and U.S. commercial paper:
converging money markets?, page
24); and RICHARD CANTOR and
JOHN WENNINGER (on current labor
market trends and inflation, page 36).
A quarterly report on Treasury and
Federal Reserve foreign exchange
operations for the period May through
July 1987 begins on page 49.




Capital Requirements of
Commercial and Investment
Banks: Contrasts in Regulation
Banking authorities in the United States and the United
Kingdom have made noteworthy progress toward con­
verging regulatory capital standards for multinational
banks. They are also seeking to include within the
standards explicit treatment of capital market activities,
an area in which commercial banks are in direct com­
petition with securities firms. Within the United States,
however, commercial banks and securities firms
(investment banks) must adhere to very different capital
requirements. As regulators address activities common
to both industries, they must be mindful of the com­
petitive effects of new requirements. Otherwise, activ­
ities will be pushed to the least restrictive environment,
which may be wholly unregulated.
Stockholders’ equity and other forms of capital
protect a company from insolvency by absorbing
losses. A strong capital base protects customers and
creditors by reducing the possibility that financial
problems at a firm would cause it to default on its
obligations. Government authorities use regulations to
encourage adequate capitalization for two reasons.
First, the public cannot easily evaluate the financial
strength of companies as complex as commercial and
investment banks. Second, the collapse of such
companies can be detrimental to the financial system
and cause undue financial loss.
To provide adequate protection against potential
losses, quantitative capital standards use proxies to
measure business risk. Such risk measures can be
simple or complex, but they can never be wholly accu­
rate. Many capital market professionals view the dif­
ferent capital requirements imposed on commercial and
investment banks as a source of competitive inequity.




Their calls to “level the playing field,” however, are often
disingenuous, focusing only on those disparities that
work to their disadvantage.
This article examines how the diverse nature of
commercial and investment banking has led regulators
to develop quite different capital standards for the two
industries. At a time when efforts are being made to
bring the standards into closer conformity, it is important
to emphasize that the capital requirements for these
industries are rooted in the traditionally distinct activities
of commercial and investment banking. The standards
use very different time horizons, each reflecting how
quickly managers within the industry can adapt to
change and adjust their risk profiles. The standards also
set the stage for differing treatment of weak and failing
institutions in each industry. This article, then, seeks to
clarify the logical basis of the capital requirements. The
analysis suggests that the task of reconciling the two
approaches to capital regulation may prove difficult.
The article begins with a brief review of the regulatory
agencies responsible for overseeing the commercial and
investment banking industries. The second section
highlights the chief differences between the capital rules
applied by the Securities and Exchange Commission
(SEC) and the U.S. banking authorities. Each capital
standard is then considered independently, with partic­
ular attention given to the methods used by regulators
to assess the components of capital and to establish a
standard of comparison.

Regulatory structure
Somewhat parallel federal oversight structures have
developed in the U.S. commercial and investment

FRBNY Quarterly Review/Autumn 1987

1

banking industries. Although the regulatory agencies
have different priorities, they are motivated by the same
basic concerns— protecting retail customers, safe­
guarding the integrity of the financial system, and
advancing macroeconomic goals. Moreover, both
industries face multiple government rulemakers, multiple
examining authorities, and a federal insurance agency
responsible for attending to failed firms.
The Securities and Exchange Commission has the
broadest responsibilities among the securities rule­
makers; it regulates diversified brokerage houses,
underwriters and dealers in corporate securities, stock
exchanges, and investment managers. The Commodities
Futures Trading Commission (CFTC) and the U.S.
Treasury regulate other aspects of the securities busi­
ness. Supervisory responsibilities over securities firms
are delegated to the various exchanges and the National
Association of Securities Dealers (NASD), while retail
customers are protected by the Securities Investor
Protection Corporation (SIPC). This article will focus on
the SEC’s capital regulations for diversified brokerdealers, the principal operating units of U.S. investment
houses. In this comparison of investment and commer­
cial banking rules, the differences among SEC, Treasury
and CFTC regulations are not material.
The principal federal authorities overseeing the com­
mercial banking industry are the Federal Reserve, the
Comptroller of the Currency, and the Federal Deposit
Insurance Corporation (FDIC). Almost all commercial
banks must join the FDIC, which provides protection for
deposits of $100,000 or less. In addition, individual
states charter and examine banks. Again, for the pur­
pose of this discussion, it is unnecessary to make dis­
tinctions among the several bank rulemakers.
The Federal Reserve regulates bank holding com­
panies and subjects them to consolidated supervision.
An important premise of bank holding company over­
sight has been that the health of a bank cannot, in the
final analysis, be separated from that of its parent and
affiliates. In contrast, the SEC statutory mandate is
limited to registered broker-dealer and investment
management units only; it does not reach to the holding
company level or to unlicensed affiliates. The Commis­
sion must depend on the premise that a broker-dealer
can be financially separated from its unregulated affil­
iates and parent.

Underlying differences
Traditional business: The two sets of capital require­
ments are logical outgrowths of the core business
activities of the banking and securities industries as they
were separated by the Glass-Steagall Act in 1933. Both
industries function as middlemen in the credit and
investment markets but traditionally specialize in dif­
Digitized for
2 FRASER
FRBNY Quarterly Review/Autumn 1987


ferent areas.1
Traditional commercial banking involves intermediation
in the primary credit market. Banks provide highly liquid
assets to the public (mostly as deposits) to raise money
that they usually lend directly rather than invest in
marketable securities. Most loans are held until maturity.
Asset turnover is, therefore, relatively slow.
Investment houses, in contrast, traditionally act as
principals for only temporary periods, and their assets
turn over extremely quickly. Their core activity in the
primary credit market has been underwriting new issues
of marketable securities. In this activity, investment
houses assume principal risk for only as long as it takes
to sell assets to final investors. Securities dealers incur
significant principal risk in the secondary market,
reflecting speculative trading or inventory held to
accommodate customers (market making), but the risk
is also temporary.
Both industries also have long established roles as
agent. Investment houses “broker” securities, effecting
transactions in the secondary securities markets at the
behest of their customers. Although this activity has
been centered on organized exchanges, direct dealerto-dealer transactions in the over-the-counter market
have become increasingly important in recent years.
Banks act as “trustees,” managing funds placed in their
care.
Time horizon: Securities firms and banks adjust to
internal and external changes over very different time
horizons. Since the most basic need for capital is to
protect an institution from the risk of insolvency, capital
should be sufficient to absorb losses while an institution
adapts to adverse developments. The time frames for
adjustment, therefore, are key determinants of the
structure of each capital standard.
Investment banks have very short time horizons:
trading is hour by hour, arbitrage spans several days,
and underwriting spans days or weeks. These firms can
adjust their risk profiles quickly. In contrast, commercial
bank risk profiles generally change much more slowly.
Although specific transactions may have short maturi­
ties, customer exposures regularly span many years. In
past years, both credit and interest rate risk varied with
economic conditions and the business cycle. Changes
in the local, national and international arenas developed
over time and banks were expected to stand by their
customers. As a result, the principal risks facing com­
mercial banks changed slowly; some adjustments
spanned several quarters while others spanned several
years. Credit risk remains relatively slow to change
although new financial techniques have reduced the
’ Both also provide important securities custody services for their
customers, but this activity is not addressed with capital
requirements.

time needed to adjust interest rate exposures.
The central difference between securities and banking
capital standards reflects these differing time perspec­
tives. Investment houses are evaluated on a liquidation
basis and their accounting is mark-to-market. Com­
mercial banks are evaluated as going concerns and their
accounting is based on original cost. That is, most bank
assets reflect contractual value rather than the value if
offered for immediate sale (market value). The differ­
ence between these two modes of evaluation has
practical significance beyond the structure of capital
standards because it also reflects how failing firms are
treated when the structure works properly.
The following sections discuss how differences in the
capital rules derive from the liquidation and going con­
cern approaches to evaluation as well as from differing
authority over holding companies.

Broker-dealer capital requirement:
a liquidation measure
The underlying logic of the SEC’s capital rule2 is that
a broker-dealer should be able to wind down its activ­
ities and protect its customers within one month. The
Commission evaluates the risk-adjusted liquidity of the
firm with a conservative view of those assets that can
be sold or collected in order to meet senior obligations
in the very near term. The SEC’s rule starts with total
capital, applies a series of deductions to derive “net
capital,” and compares this measure to a required safety
margin. Broker-dealers must operate with capital in
excess of the requirement. Because a firm must cease
operating if it fails the standard, the required margin is
quite small. The supervisory process, however, also
employs several higher "warning level” tests. Firms
operating with net capital at or below warning levels are
subject to special restrictions and close supervisory
scrutiny. They must scale down their activities in line
with their capital.
The permitted components of total capital reflect the
short time frame of the capital rule. Equity and subor­
dinated debt with more than one year to maturity are
the core elements, but other subordinated debt of quite
temporary duration is also allowed as capital. For
example, an unusually large underwriting may be cap­
italized with temporary subordinated debt repayable
within 45 days. Owners may also provide debt capital
by pledging marketable securities instead of investing
cash in the firm. Moreover, accrued liabilities for dis­
cretionary bonuses and some tax deferrals are allowable
additions to capital.
2SEC Rule 15c3-1, Net Capital Requirements for Brokers and Dealers.
Treasury requirements for specialized dealers in government
securities and CFTC rules for futures commission merchants are
quite similar to the SEC rule at the conceptual level discussed here.




The SEC requires three types of deductions from total
capital. The first set addresses liquidity and includes
intangible, fixed, and other illiquid assets, securities that
do not meet a stringent test of marketability, and “dis­
allowed” assets such as most unsecured receivables.
The deduction of unsecured receivables reflects both
liquidity and credit risk concerns. The next set of
deductions addresses other forms of credit risk and
introduces into the rule several incentives for efficient
market practices.3 Capital adjusted to this point in the
calculation can be viewed as “liquid capital.”
The third set of deductions from the total capital,
called haircuts, gauges potential trading risk, that is,
how much securities might decline in value prior to
being sold. Net capital, which remains after all deduc­
tions, is compared to a mininum requirement and higher
warning levels. The requirement is a small fraction of
a proxy for the size of the firm. Broker-dealers can
choose either a proxy for the size of senior obligations
(6.67 percent of aggregate indebtedness under the basic
method) or a proxy for the size of “customer” business
(2 percent of aggregate debit items under the alternative
method).4 The SEC rule is briefly described in the Box.
Liquid capital, as a measure, differs significantly from
total capital. Liquid capital is the excess of marketable
and easily liquidated assets over senior liabilities. Liq­
uidity, thereby, is given primary importance, and
unmarketable, unsecured assets are heavily penalized
with a 100 percent capital requirement. In this context,
the SEC applies a definition of marketability which is
quite stringent in most circumstances: the security must
be exchange traded, or bid and offer quotations must be
readily available and settlement of sales at such prices must
be possible within a relatively short time. Marketable assets
and liabilities must be valued at current prices and unreal­
ized gains and losses reflected in net worth each day.
Marketable assets are assumed to be saleable, but this is
not the point of the capital charge; liquidity is. A security
that does not pass the marketability test need not be
deducted from total capital to the extent that a bank has
already lent funds secured by the asset.
Most unsecured receivables and advances are also
deducted in full, although a few routine receivables are
only deducted when aged. To secure a receivable under
the rule, collateral must meet the same marketability
tests as inventory. This aspect of the rule helps insulate
broker-dealers from their affiliates because it encour­
ages firms to take marketable collateral to secure
3For example, there is a capital charge for securities purchased but
not yet received within 30 days, while the capital charge for
securities sold but not yet delivered applies after only 5 days.
‘ “Customers” are specifically defined within the SEC rules. Not all
counterparties are customers; principals of the firm and other
broker-dealers are excluded.

FRBNY Quarterly Review/Autumn 1987

3

Box: S ecurities and Exchange Com m ission Uniform Net Capital Rule fo r Brokers and Dealers
The SEC first adopted a capital rule in 1944 to establish
a standard of financial responsibility for registered bro­
kers and dealers. The most recent comprehensive
update of the rule was implemented in 1982. Firms that
provide retail brokerage services and that underwrite or
deal in corporate or municipal securities must abide by
the rule.
The capital rule is a liquidity test in the sense that it
seeks to ensure that liquid assets, adjusted for trading
risk, exceed senior liabilities by a required margin of
safety. A broker-dealer should be able to liquidate quickly
and to sa tisfy the claim s of its custom ers w ithout
recourse to formal bankruptcy proceedings. The test is
a tw o-step procedure: first, a determ ination of the
amount of net capital available to meet a firm’s capital
requirement, and second, a determination of the capital
requirement (that is, the margin of safety). Net capital
is total capital reduced by various charges and by hair­
cuts that measure trading risk. A firm may choose either
the basic or the alternative requirement. (See Figure 1.)

Total capital
Total capital equals net worth plus subordinated liabilities
and is augmented by allowable credits. It is determined
by generally accepted accounting principles on a markto-market basis. To be counted as capital, subordinated
debt must have a minimum term of one year and may
not be prepayable without the prior written approval of
the broker-dealer’s examining authority (New York Stock
Exchange or NASD). Subordinated debt may be in the
form of either borrowed cash or borrowed securities, the
latter serving as collateral for "secured demand notes.”
The rule also allows two forms of temporarily borrowed
Figure 1

SEC Net Capital Computation
Total capital:

Equity
Allowable subordinated debt
Allowable credits

Less deductions: (Illiquid assets)
(Unsecured receivables)
(Charges for aged credit exposure)
(Market risk haircuts)
-> Net capital

Compared to

Requirement:

62/a percent aggregate indebtedness,
or 2 percent aggregate debit items

Excess capital:

Net capital less the requirement


FRBNY Quarterly Review/Autumn 1987


capital. Broker-dealers are permitted to obtain temporary
subordinations not exceeding 45 days in maturity as
often as three times a year to capitalize underwriting and
extraordinary activities. A firm may also have a revolving
subordinated loan agreement providing for prepayment
within a year.
All of the above are treated as satisfactory subordi­
nation agreements by the rule and thereby qualify for
total capital. However, the rule establishes more
demanding specifications that, if met, would qualify
subordinated borrowings from a partner or stockholder
as what can best be called “ near equity.” Net worth plus
this near equity must equal or exceed 30 percent of the
total of net worth and subordinated debt.
Allowable credits to total capital include certain
deferred income tax liabilities and accrued liabilities that
are payable solely at the discretion of the firm, such as
bonuses and profit sharing.
Broker-dealers are prohibited from distributing equity
capital (for example, through dividends or unsecured
loans to owners) if doing so would reduce the firm’s net
capital below warning levels. Supervisory authorities set
warning levels somewhat higher than the minimum
requirement; for example, one is 120 percent of the basic
requirement.
Capital charges: Total capital is reduced by nonal­
lowable assets and various special charges. An asset
is considered nonallowable if it cannot be immediately
or quickly converted into cash. This definition applies to
fixed and intangible assets, investments and unsecured
receivables from affiliates and subsidiaries, most other
unsecured receivables, and nonmarketable securities.
Special charges include specified types of receivables
from other broker-dealers not collected within 30 days
and other specified receivables aged beyond 11 or 60
days. Credit exposure is also deducted for purchased
securities not received within 30 days and for most sold
securities not delivered within 5 days. There are also
charges for giving excessive margin on repurchase
transactions when a dealer borrows. (If excessive margin
is taken when a dealer lends under a resale agreement,
the requirement is increased.) Such charges encourage
good business practices.
Haircuts: The rule recognizes that the prices of mar­
ketable assets and liabilities may move adversely during
liquidation, thereby reducing net capital available to
cover a firm’s obligations. The deduction for price risk
in the firm’s proprietary positions, haircuts, are percent­
ages of the market value of security and forward posi­
tions held by the broker-dealer. As a measure of price
risk, haircut factors vary in accordance with the type and
remaining maturity of securities held or sold short.
For government and high-grade corporate debt, some
forms of hedging serve to reduce haircuts. Moreover,

Box: Securities and Exchange Commission Uniform Net Capital Rule for Brokers and Dealers (continued)
Figure 2

Summary of Haircuts
Applied to Unhedged Positions
Government and agency securities:
0 to 6 percent in 12 maturity subcategories
6 percent applies to 25 year bonds
Municipal securities:
0 to 7 percent in 16 maturity categories
7 percent applies to 20 year bonds
Commercial paper, bankers acceptances, and certificates
of deposits:
0 to 0.5 percent in 5 maturity categories
0.5 percent applies to 9 month paper
Investment grade corporate debt:
2 to 9 percent in 9 maturity categories
9 percent applies to 25 year bonds
Preferred stock: 10 percent
Common stock and “ all other” :
30 percent under the basic method
15 percent under the alternative method

within the several maturity subcategories into which
government, high-grade corporate and municipal debt
securities are grouped, short positions serve to offset
long positions fully. Forward contracts receive the hair­
cuts applicable to their underlying securities. Futures and
options positions are also explicitly treated. The rule
specifies additional haircut charges where the brokerdealer has an undue concentration in securities of a
single issuer. For broker-dealers choosing the alternative
method of calculating required capital, lower haircut

receivables.
The capital rule’s focus on liquidity is designed to
work in concert with the SEC’s Customer Protection
Rule.5 Put simply, the Customer Protection Rule seeks
to compel a broker-dealer to (1) balance its liabilities
to customers with receivables due from customers plus
a segregated cash reserve, and (2) place all fully paid
for custom er securities in possession or control (a
custodial obligation).6 Moreover, if a firm maintains a
greater segregated cash reserve, it may choose the less
5Rule 15c3-3, the C ustom er P rotection Rule, was established in the
early 1970s in response to the back office problem s suffered on
Wall Street during the late 1960s.
*That is, custom er secu rities are those for w hich the broker has
already received full paym ent and exclud e securities purchased on
margin.




percentages may be taken on certain securities posi­
tions, including undue concentration and underwriting
commitments. Most important, the haircut on common
stock and "all other” securities is 15 percent instead of
30 percent.
Capital requirement: Net capital must exceed a min­
imum absolute dollar level and one of two standards that
relate to the size of a broker-dealer’s business.
The basic method requires that net capital exceed
6 2/3 percent of aggregate indebtedness, which includes
all liabilities less those specifically exempted. In essence,
aggregate indebtedness is any liability not adequately
collateralized, secured, or otherwise directly offset by an
asset of the broker-dealer. It also includes contingent,
off-balance sheet obligations. Few large investment
houses choose to use the basic method because, as
noted above, it requires a 30 percent haircut on common
stock and “ all other” securities. This method is usually
chosen by smaller retail-oriented brokerage firms.
The alternative method requires that net capital exceed
two percent of aggregate debit items computed in
accordance with the Reserve Formula under the Cus­
tomer Protection Rule. These debit items are the gross
debit balances of particular asset accounts and generally
represent good quality customer receivables. The rule
uses these debit items as a proxy for the size of cus­
tomer-related business. For small broker-dealers whose
business is heavily retail-oriented, these aggregate debit
items can represent a majority of a firm ’s assets. How­
ever, for most large broker-dealers who are not heavily
retail-oriented, these debit items usually constitute less
than 25 percent of total assets.
For major firms, the alternative method applies a lower
percentage factor to a smaller base than does the basic
method and permits a 15 percent haircut on “ all other”
securities rather than 30 percent. To qualify for this
method, however, a firm must hold a greater reserve
under the Customer Protection Rule calculation.

burdensome alternative capital requirement.
Trading risk is explicitly treated to gauge how mar­
ketable assets might decrease in value, and marketable
liabilities might increase in value, if a firm must be liq­
uidated. Risk factors (haircuts) for investment grade
securities have been developed from statistical meas­
ures of price volatility.7 For example, three-month
Treasury bills are haircut 0.5 percent and 30-year bonds
are haircut 6 percent of market value. Haircuts are also
applied to off-balance sheet market exposures such as
futures, forwards, and options. Many forms of hedging
and arbitrage are recognized as having less risk than
H'he haircuts reflect price volatility measured over several years and
cover relatively large price changes. The factors do not, however,
cover the extraordinary price movem ents that occu rred in O ctober
1987.

FRBNY Quarterly Review/Autumn 1987

5

uncovered positions. “All other” securities, such as
common stock and low-rated bonds, require 15 percent
capitalization.8
Credit risk is subsumed into this structure at several
points. The credit risk on marketable debt securities is
covered by the market risk haircuts. Broker-dealers
usually sell such assets long before a default occurs.9
Temporary credit exposures resulting from routine
transactions are not treated consistently by the SEC
because broker-dealers are presumed to avoid credit
losses rather than to reserve for them. Capital charges
for unsettled transactions, while based on credit risk,
are designed to encourage efficient business practices.
In contrast, most other unsecured receivables require
100 percent capital coverage, while secured receivables
and the default risk on forward trades incur no capital
charges. Finally, the 100 percent deduction for unmar­
ketable assets to meet the liquidity intent of the rule
more than sufficiently covers credit risk as well.
The structure of the SEC’s rules, coupling the Net
Capital Rule requirement for liquidity and the Customer
Protection Rule requirement for coverage of customer
payables, has practical application to the treatment of
a failing firm. As a securities house weakens toward
warning levels, it must constrain its business. It should
not be able to double its bets and risk tripling its losses.
Once a warning level is breached, the examining
authority would seek further constraint. Thus, a firm’s
ability to compete, already weak, would be further
undermined at a time when it still had positive liquid
capital, that is, liquid assets in excess of senior liabil­
ities. Facing an untenable position, management would
then seek to sell or merge the company before the sit­
uation required a SI PC-managed failure. This approach
has been used many times during the past two decades
and, when it worked as intended, SIPC faced little or
no loss. As a result, the insurance corporation operates
with a low level of reserves, $393 million (as of August
1987), and a minimal $100 per firm annual premium.
Of course, in cases of fraud neither this, nor most other
structures work neatly.
Observed cap ital levels: Market pressures, rather
than regulations, determine how much excess net cap­
ital securities firms need to compete successfully. Wall
Street firms place great importance on the absolute
amount of their excess net capital because it demon­
strates their ability to serve large customers and handle
•Most major houses choose the alternative requirement and are
subject to a 15 percent haircut on "all other” securities. Under the
basic requirement, this haircut is 30 percent.
'Defaulting debt securities usually trade at a small fraction of face
value. The broker-dealer would, therefore, reflect losses day by day
as the price dropped rather than wait until the asset was weak
enough to warrant a write-off.

6

FRBNY Quarterly Review/Autumn 1987




large transactions. Most firms have increased their
capitalization in recent years. At year end\1986 sixteen
diversified firms reported average net capital 7.3 times
larger than minimum requirements. In absolute terms,
average excess capital was $408 million, while the
average requirement was only $65 million. In compar­
ison, total capital averaged $1.4 billion, with a range
from under $300 million to over $3 billion. Equity constituted 61 percent of total capital in this sample,
The relationship between total, net and required
capital is determined by the composition of a firm’s
business. Dealing, arbitrage and underwriting generate
high haircuts thaf reduce net capital but change each
day. Haircuts may not be particularly high on those days
for which financial statements are pre pared. Firms
specializing in these activities tend to report more than
40 percent of their total capital as “excess.” In contrast,
retail brokerage causes other deduction:; and the final
requirement to be larger. Several of tljie large retail
houses report only 20 percent of their total capital as
excess.
Although the minimum requirement is a proxy for size,
it is not tied to assets. Among the sixteen firms, the
minimum requirement ranged from 0.1 to 1 percent of
total assets. The effective capital requirement of the
SEC standard can be viewed as the difference between
total and excess capital. This measure combines most
aspects of the SEC rule to show how much of the firm’s
total capital is in use. The effective requirement reported
by the sixteen firms averaged 5.1 percent of assets—
a figure on par with banking standards of 5.5 percent.
However, the effective requirements ranged from 1.6 to
16 percent.
Holding company implications: Because regulations
extend only to the licensed subsidiaries of investment
houses, the firms frequently perform in unregulated
affiliates activities that would be uneconomic if held to
SEC requirements. This consequence of securities
industry regulation has grown in importance with recent
capital market innovations. As investment houses have
broadened their activity to include new products that
entail nonmarketable credit exposure, the portion of their
business accomplished in unregulated affiliates has
grown. Swaps, whole-mortgage loan trading, and bridge
loans are among the innovations handled in affiliates.
In consequence, the SEC, the CFTC and the Treasury
have all written their capital rules to foster financial
separation of affiliates. Transactions between regulated
and unregulated affiliates are treated harshly; for
example, unsecured loans require a 100 percent capital
charge and have the effect of transferring liquid capital.
Moreover, even secured transactions are closely
reviewed by examining authorities. This structure,
however, does not forbid advances to or investments

in affiliates; it merely applies a strict capital evaluation.
A firm willing to move liquid capital out of its regulated
unit is not constrained by regulation so long as its net
capital remains above warning levels.
The investment houses usually publish consolidated
holding company financial statements that display gross
capital. The reports footnote the excess net capital
within the firms’ regulated broker-dealer subsidiaries.
Competitive pressures to report impressive excess
capital figures are a strong incentive to maximize the
liquid capital within registered broker-dealer subsidiaries.

Banking capital requirement:
a going concern measure
The capital base of a commercial bank protects the
institution from the risk of insolvency by absorbing
losses in times of poor performance. In so doing, capital
also enhances the safety of depositors’ funds, helps
maintain public confidence in the bank and the industry,
and supports expansion of the institution. If these pur­
poses are to be achieved, a bank’s capital must not
impose financial burdens when a bank is facing diffi­
culties (for example, dividends need not be paid in such
circumstances). In order to insure that a banking insti­
tution can weather adverse conditions and unexpected
losses, regulators impose capital regulations with a
multiyear time horizon. In this context, capital for com­
mercial banks must be permanent, and most subordi­
nated debt is included only in a secondary capital
measure. This structure is in sharp contrast with SEC
rules that give certain subordinated debt the same
weight as equity.
Existing standards for U.S. banks and their holding
companies emphasize the permanence of the capital
instrument. All common stockholders’ equity and general
(unallocated) loss reserves are included in primary
capital. Perpetual preferred stock and subordinated debt
that must be converted to or replaced with stock may
provide a portion of primary capital. Certain types of
perpetual debt may also provide a limited portion of
holding company capital. Secondary capital includes
perpetual and mandatory convertible instruments in
excess of the limits allowed as primary capital. It also
includes limited-life preferred stock and subordinated
debt with an original maturity in excess of seven years.
Unsecured senior debt with original maturities beyond
seven years is recognized as secondary capital at bank
holding companies but not at banks.
Bank supervisors evaluate the risk profile of an
organization within the examination process. They pay
careful attention to earnings, asset quality, management
factors, liquidity, and off-balance sheet activities as well
as capital. The quantitative measure of bank capital
against a set standard is only one aspect of the eval­




uation. Moreover, the relative importance of such
quantitative standards and their sophistication have
varied widely over the past few decades. Since 1981,
for example, the quantitative standard has been a
simple primary-capital-to-total-assets ratio.
The capital-to-assets ratio is a leverage standard
applied to on-balance sheet activity that can provide
indirect protection against liquidity risk. In recent dec­
ades, however, liquidity risk has been addressed through
other supervisory methods. During the 1960s, attention
was focused on the mix of liquid assets; in the 1970s,
it turned to the availability of managed liabilities. More
recent supervisory methods address both factors and
encourage increased use of longer-term borrowings. As
a result, term debt, whether or not subordinated, is
beneficial chiefly as a liquidity buffer at commercial
banks and is included only in secondary capital.
Although this structure is significantly different from the
SEC rules, which focus on liquidity and permit large
amounts of debt capital, liquidity risk is central to overall
supervisory standards in the banking industry as well.
In a series of steps from 1981 through 1985, the
banking authorities applied steadily tighter standards for
primary-capital-to-total-asset ratios of banking institu­
tions. Banks and bank holding companies are now
subject to a minimum standard of 5.5 percent. The
standard for total capital-to-total assets, which includes
secondary capital, is now 6 percent. In applying these
simple standards, bank regulators presume a moderate
degree of credit risk and prudent levels of liquidity and
off-balance sheet exposure. Banks with significant offbalance sheet exposures are expected to operate above
the minimum ratios. In recent years many larger banks
have raised significant amounts of new capital, reduced
low-profit balance sheet investments, and expanded offbalance sheet activities. The latter two trends justified
development of a risk-based proposal.
Early in 1986, U.S. banking authorities proposed a
quantitative capital measure that would be more
explicitly and systematically sensitive to the risk expo­
sure of individual banks. The Bank of England joined
in refining the proposal and a joint U.S.-U.K. version
was published in February 1987. The new risk-based
capital proposal centers on a ratio of primary capital to
weighted risk assets and encompasses both on- and offbalance sheet exposures. Risk weights vary from zero
for assets such as cash to 100 percent for standard risk
assets such as commercial loans. The proposal as
published in February 1987 is summarized in the
Appendix. This risk-based capital standard is still under
development, and banking authorities in several other
financial centers have joined the effort to establish a
consistent measure of bank capital.
Quantitative evaluations of bank capital, both estab­

FRBNY Quarterly Review/Autumn 1987

7

lished and proposed, focus almost wholly on credit risk
because such losses have been the dominant factor in
most banking problems. Even when the root cause was
management or macroeconomic problems, the usual
result was credit losses. Because trading risks are typ­
ically quite modest relative to most banks’ overall
strength, the system has addressed these exposures
through the examination process rather than the quan­
titative capital rule.
The dominance of credit risk in U.S. capital standards
reflects banks’ traditional economic purpose of providing
credit on both a secured and unsecured basis to a
broad mix of customers— some strong, some weak. A
modest amount of credit loss is viewed as a normal cost
of doing business, and a component of capital, the loan
loss reserve, is established to absorb such losses. In
this context, banks face only fractional capital require­
ments on standard commercial lending; under existing
rules the requirement is 5.5 percent of exposure. In
contrast, SEC requirements call for 100 percent capital
support of unmarketable, unsecured credit exposure.
The comparison between bank and SEC standards is
more complex for credit exposure in the form of mar­
ketable securities. For example, SEC haircuts on high
quality corporate bonds range from 2 percent (if due in
less than 1 year) to 9 percent (if due in 25 years), while
low quality marketable debt requires 15 percent capital
support. High grade commercial paper requires no
capital support at a dealer if it matures within 30 days
(and 0.25 percent if due in six months), compared to
the 5.5 percent required at banks for the floating primebased loan the commercial paper may have replaced.
Of course, broker-dealers are not presumed to be in
the business of holding term loans to maturity, and in
fact, most paper is sold within days.
Interest rate and trading risk are not treated system­
atically within the current bank capital standards; rather
they are addressed during on-site examinations. As
banks trade actively in more sectors of the secondary
capital markets, trading risk may warrant explicit treat­
ment. Viewed in terms of securities industry haircuts,
the existing 5.5 percent bank standard is, at best, a
rough average requirement for unhedged positions that
appear on the balance sheet. The price risk features
of forward contracts such as futures and options are
not captured. The proposed U.S.-U.K. calculation would
generally lead to lower requirements than those of the
SEC for a naked trading exposure but would be similar
when applied to the mix of inventory carried by a bank
dealer in government securities (see risk weights in the
Appendix).
Consolidated oversight: In order to implement the
Bank Holding Company Act of 1956, the Federal
Reserve established consolidated oversight of banking

8

FRBNY Quarterly Review/Autumn 1987




organizations. This approach reflects the importance of
public confidence in banks and a concern that the public
may be unable to distinguish a bank from its affiliates
for this purpose. Holding company activities are limited
by law and interaffiliate relationships are regulated.
Separation of bank and nonbank subsidiaries is
encouraged. Credit extended to nonbank affiliates must
be collateralized and is subject to strict limits.
Bank holding company regulation also differs from
securities industry rules by requiring that holding com­
pany activities be explicitly permitted. Thus, activities
deemed inappropriate by regulators are usually for­
bidden to banks or their affiliates. The SEC, in contrast,
writes its rules to make such activities uneconomic
within regulated broker-dealer units. Bank capital
standards are applied to both the bank and to the con­
solidated holding company. This constraint effectively
addresses those nonbank affiliates that perform limited
banking activities in states where the lead bank is not
permitted to do business. Other types of affiliates,
moreover, should be capitalized at levels appropriate to
their lines of business. Some activities, however, are
not appropriately treated by bank capital standards,
leading to excessive constraint on some affiliates and
little constraint on others.
As banks have become more active in capital mar­
kets, they have adapted their organizational structures.
In some cases, these changes alter the nature of their
capital requirements. For example, a recent ruling by
the Federal Reserve Board would permit bank affiliates
to underwrite municipal revenue bonds provided the
volume of such underwriting is only a small portion of
the affiliate’s business. Implementation of this new
power has been temporarily delayed by Congress, but
several banks have reorganized in anticipation of the
end of the moratorium. To meet the volume test, many
banks are transferring their existing securities trading
and municipal bond underwriting departments into a
holding company affiliate. Before these affiliates can
engage in new activities, they must be licensed by the
SEC and subject to its capital rule. Thus, a degree of
functional and overlapping regulation is evolving.
Observed capitalization: The ten largest bank holding
companies in the United States reported year-end 1986
ratios of primary capital to total assets averaging 7.0 per­
cent. The lead banks in these organizations reported slightly
lower ratios, averaging 6.8 percent. Capital ratios have been
improving in recent years; in 1982 when the standard was
first used, the average was only 4.8 percent. Capital ratios
for holding companies now range from roughly 6 to 8 per­
cent, and the spread is even narrower for the lead banks.
Their capital is far greater than that of the investment
houses in absolute terms; primary capital of this sample
averaged $5.8 billion.

Conclusion
The regulatory capital requirements imposed on com­
mercial and investment banks are designed to address
the traditional business activities of each industry. Direct
competition between these industries within the capital
markets, however, is not traditional. It involves products
which introduce risk elements from both arenas. Secu­
rities firms are assuming more term, nonmarketable
credit exposure, particularly for performance on complex
new instruments. In addition, investment banks have
begun to provide merchant banking services, investing
directly in their own deals either temporarily (bridge
loans) or permanently. Concommitantly, banks have
begun to deal in options and other difference contracts
in addition to their established trading presence in the
foreign exchange and public securities markets. The
turnover of bank assets has also been increased by
securitization of previously unmarketable assets. These
activities generate significant noncredit risk.
Although supervisors of both banking and securities
firms attempt to assess the credit and price risk of new
activities, they differ in the capital burden they now
require. It is not clear how the common risks could be

best included within both industries’ quantitative capital
calculations so as to place similar requirements on
banks and securities houses. Two approaches come to
mind. First, segments of one standard could be grafted
to the other, even though the resulting structure might
not be internally logical. For example, the SEC haircut
measure of trading risk could be includeu within the
bank calculation despite its shorter time horizon. Alter­
natively, activities could be segmented among separately
capitalized affiliates, with each affiliate subject to either
a bank or a securities style standard.
Authorities in the United Kingdom have perceived a
need to achieve greater consistency in the capital
requirements placed upon banks and securities firms.
As a result, the Bank of England and the Securities and
Investm ent Board have coordinated efforts while
implementing the Financial Services Act of 1986. Similar
coordination also would be beneficial within the United
States.

Gary Haberman

Appendix: Joint United States-United Kingdom Proposed Risk-Based Capital Standard
February 1987
In February 1987, the Federal Reserve published for
comment a proposed framework for evaluating the ade­
quacy of commercial bank and holding company capital
with regard to both on- and off-balance sheet risk.* It
was jointly developed with the Bank of England, the
Office of the Comptroller of the Currency and the FDIC.
This summary is presented because the framework is a
more informative structure than the simpler standard now
in use by U.S. bank regulators that uses a ratio of pri­
mary capital to total assets. The proposal is still under
development as part of a multinational effort to bring
consistency to the evaluation of capital at major banks
in all international financial centers.f

Capital-to-risk ratio
The proposal would create a capital-to-risk ratio to
relate a banking institution’s adjusted primary capital to
its weighted risk assets. Primary capital should be freely
available to absorb current losses while permitting an
organization to function as a going concern. Under the
proposal, it would consist of two classes of capital funds:
base primary capital and limited primary capital. The
latter would be limited to a specified percentage of base
primary capital.
*Federal Register, vol. 52, no. 33, p. 5119, February 19, 1987.
fO n D ecem ber 10, 1987, banking authorities released the next
version of this capital proposal.




Primary capital
The February 1987 proposal defined base primary
capital funds to include common stockholders’ equity,
general reserves for unidentified losses, and minority
interests in the equity accounts of consolidated subsi­
diaries. Other capital instruments would be qualified as
limited primary capital to the extent the total does not

Proposed Capital Standard
Risk ratio is compared to a requirement
Adjusted primary capital
Risk ratio - Weighted risk assets
Adjusted primary capital - Base primary capital
+ Limited primary capital
- Deductions
Weighted risk assets

= Sum (risk weights x assets)
+ Sum (risk weights x con­
version factors x o ff-b a l­
ance sheet exposures)

FRBNY Quarterly Review/Autumn 1987

9

Appendix: Joint United States-United Kingdom Proposed Risk-Based Capital Standard (continued)
exceed 50 percent of tangible base primary capital, that
is, base primary capital reduced by intangible assets.
Limited primary capital funds would include perpetual
preferred stock, limited-life preferred stock with an orig­
inal maturity of at least 25 years, and certain debt that
is subordinated to deposits. To qualify, subordinated debt
must be unsecured, repayable only with equity or similar
debt, and co n ve rtib le to equity if other capital is
depleted. It must also permit deferral of interest pay­
ments during periods of financial distress.

Deductions from primary capital
The February 1987 proposal would calculate adjusted
primary capital by adding base and limited primary cap­
ital and deducting intangible assets and equity invest­
ments in unconsolidated affiliates. When deducted from
capital, an equity investment in an affiliate would also
be deducted from the risk-weighted asset base.

Proposed risk weights
Each of a banking organization's assets would be
assigned to one of five risk categories and weighted

according to the relative risk of that category. The
determination of asset groupings and the assignment of
weights primarily would reflect credit risk considerations,
with some sensitivity to liquidity and interest rate risk.
The categories would distinguish among broad classes
of obligors and, to a lesser extent, among maturities and
types of collaterization. A credit equivalent approach
would be used in weighting the risks of off-balance sheet
activities. Under this approach, the face amount of an
off-balance sheet exposure would be multiplied by a
credit conversion factor, and the resulting credit equiv­
alent amount would be assigned to the appropriate risk
category as if it were a balance sheet item. Assets col­
lateralized by cash or U.S. government securities would
be accorded a lower risk weight, but the proposal would
not explicitly recognize other forms of collateral or
guarantees in weighting asset risk. However, examiners
would continue to consider all forms of collateral and
guarantees in evaluating asset quality and making an
overall assessment of capital adequacy.
The following tables provide a summary of major asset
and off-balance sheet weightings contained in the Feb­
ruary 1987 U.S.-U.K. proposal.

Table A

Summary of Risk Weights for On-Balance
Sheet Assets
0 percent
Cash— domestic and foreign
10 percent
Short-term (one year or less) claims on U.S. gov­
ernment and its agencies.
25 percent
Cash items in process of collection
Short-term claims on domestic and foreign banks
Long-term claims on and guarantees of the U.S.
government
Claims (including repurchase agreements) colla­
teralized by cash or U.S. government or agency
debt
Local currency claims on foreign governments to
the extent that bank has local currency liabilities
50 percent
Claims on or collateralized by U.S. governmentsponsored agencies
Municipal general obligations
100 percent
Claims on private entities and individuals
C laim s on foreign governm ents that involve
transfer risk


FRBNY Quarterly Review/Autumn 1987


Table B

Conversion Factors for Off-Balance
Sheet Exposures
100 Percent
Direct credit substitutes including financial guar­
antees and standby letters of credit
Repurchase agreements and other asset sales
with recourse, if not already included on the bal­
ance sheet
50 Percent
Trade-related contingencies including commercial
letters of credit and performance bonds
Other commitments with original maturity over five
years, including revolving underwriting facilities
25 Percent
Other commitments with original maturity of one
to five years
10 Percent
Other commitments with original maturities of one
year or less
Note: Swaps, over-the-counter options, and other dif­
ference contracts would be treated separately

The Economics of
Securitization

Without question, one of the most prominent recent
features of the financial sector has been the very strong
growth in securities markets transactions. These trans­
actions take a wide variety of forms. Investors may hold
security market claims on borrowers directly or buy
shares in mutual funds that acquire most, if not all, of
their assets in the financial markets. Alternatively, they
may own securities representing an undivided interest
in a pool of loans. Or, investors may hold either secu­
rities issued by banks or deposit claims on banks that
own securities rather than loans.
All of these transactions are types of securitization.
Securitization is a process hard to define generally. In
its broadest sense, securitization is financial interme­
diation that involves, at some stage the buying or selling
of financial claims. That definition is wide enough to
include the sale of loan participations among banks or
packages of commercial mortgages among thrifts, and
yet it excludes not only traditional bank lending but also
similar activities at finance and insurance companies.
A narrower definition refers to the packaging of gen­
erally illiquid assets of banks, thrifts, and other inter­
mediaries for sale in securities form.
But perhaps the best definition of securitization is the
matching up of borrowers and savers wholly or partly
by way of the financial markets. Such a definition covers
issuance of securities such as bonds and commercial
The author, Christine Cumming, completed this article while she
was a Research Officer and Senior Economist at the Federal
Reserve Bank of New York.




paper— a practice that entirely replaces traditional
financial intermediation— and also sales of mortgagebacked and other asset-backed securities— transactions
that rely on financial intermediaries to originate loans
but use the financial markets to seek the final holders.
Securitization is different in kind from disintermediation
and the difference provides some important clues to the
economic forces behind securitization. To draw this
distinction, it is necessary to define some terms used
in this paper. Financial intermediation is defined very
broadly as the bringing together of borrowers and
savers. Banks, thrifts, and finance companies, among
others, carry out traditional financial intermediation.
These institutions make a large number of loans and
fund them by issuing liabilities in their own name. Dis­
intermediation refers to a displacement of traditional
financial intermediation away from banks and thrifts
primarily to arrangements that are similar to bank
lending— loans by other financial intermediaries or direct
lending between agents in the same sector (for
example, trade credit)— rather than financial market
transactions. In the United States, disintermediation
usually took place when market interest rates rose
above the ceilings set by the old Regulation Q.
Broadly, securitization breaks with traditional financial
intermediation, while disintermediation tries to emulate
it. Unlike securitization, disintermediation does not
change the form of financial claims to any great extent.
Rather, it shifts the holding of particular kinds of claims
when the traditional holder is temporarily constrained
by institutional features such as deposit interest rate

FRBNY Quarterly Review/Autumn 1987

11

ceilings. Securitization, by contrast, changes the form
of claims, and through that change also alters the dis­
tribution of holdings among types of investors. Still,
securitization and disintermediation are not entirely
distinct, since both involve a shift of intermediation away
from banks and thrifts.
The range of transactions that replace traditional
financial intermediation today suggests that no single
economic force lies behind securitization. For example,
an increase in the relative cost of bank intermediation
in the wholesale lending markets may explain why some
firms issue more bonds and commercial paper but
cannot explain why some banks are major purchasers
of floating rate notes (FRNs) and Euronotes.
To identify the forces driving securitization, we break
traditional financial intermediation into three key ele­
ments: ( 1 ) the agreement between borrower and inter­
mediary, ( 2 ) the service provided by the intermediary
(its value-added), and (3) the agreement between the
intermediary and the investor.
In traditional bank lending, one financial claim, a loan,
represents the agreement between a borrower and the
bank, while a deposit represents the agreement between
the bank and the investor. The service of the bank is
matching up borrowers and lenders, which it can do
cheaply both by reducing search costs and by realizing
economies of scale in gathering and allocating funds.
The bank manages risks that arise in matching up bor­
rowers and lenders, because their preferences, and thus
the instruments the bank offers them, are not identical.
These risks include funding, market, and credit risk.
Frequently, the bank’s size gives it the capacity to pool
and thus reduce risks. In addition, the bank can offer
its customers payments services that enhance cus­
tomers’ liquidity.
The three elements of traditional financial interme­
diation suggest that securitization covers three separate
kinds of substitutions: securities for loans, direct
placement of debt claims for traditional financial inter­
mediation, and securities for deposits. In turn, three
economic forces emerge as important contributors to
securitization. The first is upward pressure on the cost
of bank intermediation, especially higher capital
requirements not accompanied by a fall in the cost of
capital at a time when transactions costs for both
securities placement and risk management are falling.
Second is an increase in financial risk, especially in the
volatility of interest rates. Third is increased competition
to relationship lenders from banks and nonbank financial
institutions.

Loans versus securities
No clearcut definition distinguishes a loan from a
security. The features associated with securities and not

12FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


with loans are transferability, a degree of standardization
and of disclosure imposed by securities laws, and often,
liquidity. But the real difference between loans and
securities lies not in the explicit contracts of the loan
agreement and the bond but in the existence of an
implicit contract between the borrower and the bank in
the case of a loan and the virtual absence of such an
implicit contract between the borrower and the investor
in the case of a security.
A loan is essentially a private, unpublicized agreement
between lender and borrower. While the loan agreement
is a legally binding document, both borrower and lender
understand that they can renegotiate the agreement.
The loan agreement thus offers great flexibility and
considerable discretion. The flexibility, discretion and
durability of these arrangements is what is termed a
“banking relationship.” Nor does the relationship stop
at a loan agreement; it also includes deposit, payment
and currency services.
Consider the commercial lending relationship. There
the bank can be viewed as writing options for its loan
customer. Through devices such as credit lines or
lending commitments, the borrower can choose the
timing and the amount of a loan; the borrower can often
prepay or refinance the loan with a small or even no
fee. Most important, the bank makes an implicit and
sometimes explicit commitment to provide funds in times
when the borrower finds them difficult to obtain: when
the borrower is experiencing difficulties or when liquidity
has dried up. In return, the borrower may agree to allow
the lender to monitor its performance over the life of
the loan and agree to financial covenants restricting its
behavior. While such covenants exist in bond indentures
as well, they are less flexible and less meaningful.
The economics literature has tended to emphasize the
importance of the bank’s access to private information
in distinguishing bank lending from other financial
intermediation.1 But provision of continuous access to
funds in banking relationships is also crucial. In partic­
ular, the development of instruments like note issuance
facilities (NIFs) and FRNs that replace bank lending
underscores its importance. A NIF provides more li­
quidity to investors than a syndicated loan but still
assures the borrower medium-term access to funds. The
FRN replaces generally short-term interbank deposits
with a medium-term instrument that, unlike interbank
lines, cannot be cut back.
A debt security is an agreement between a borrower
and lenders who are usually unspecified before the
’ See, for example, Eugene F. Fama, “What’s Different about Banks?"
J ournal o f M o n etary Econom ics, vol. 15 (1985), pp. 29-39, and
Joseph E. Stiglitz, “Credit Markets and the Control of Capital,”
Jo u rn a l o f M oney, C re d it a n d B anking, vol. 17, no. 2 (May 1985),
pp. 133-52.

terms of issue are set. No agreement is negotiated by
borrower and lenders. Instead, the underwriter negoti­
ates the terms with the borrower and attempts to find
investors at somewhat more favorable terms. The
security holders also have no implicit contract with the
borrower. They are not expected to purchase new issues
of securities or hold onto securities permanently. The
terms of securities issues are seldom renegotiated and
the borrower’s right to prepay exists only if there is an
explicit call option. The debt security’s documentation
may obligate the borrower to provide information to its
creditors or allow a third party to monitor its perfor­
mance, but the security holders are under no obligation
to keep such information confidential.
These conditions do not rule out the development of
a relationship in the issuance of a security. Borrowers
have relationships with their investment bank insofar as
the borrower provides confidential information and the
investment bank counsels the borrower and supports its
issues in order to assure continuous and low cost
access to the financial markets. But the investment bank
is not itself a source of funding nor is it a credit monitor
in the same sense that a bank is. To provide these
services, additional parties such as banks or rating
agencies must be drawn in.
Similarly, the investor has an implicit contract with the
investment bank. The investment bank may be expected
to make markets in its customers’ securities. In addition,
securities laws require underwriters to perform “due
diligence” to assure that disclosures represent the truth
fairly.
The distinction drawn here between loans and secu­
rities is extreme, of course. Syndicated loans are wellpublicized agreements between a borrower and a large
number of banks, many of which will have no other
customer relationship with the borrower. Private place­
ment securities generally require less disclosure and
also lack the liquidity associated with publicly-offered
securities. Since they are placed with a small number
of investors, issues can be tailor-made to investor
preferences. The investors may actively monitor the
creditworthiness of borrowers and manage any credit
problems. Moreover, the implicit contract nature of a
loan is not its only distinguishing feature. The structure
of transaction costs means that securities issues are
much larger in size than most loans.

Erosion of the banking relationship
One determinant of the degree to which securitization
can replace traditional bank lending is the relative
importance of relationship to both bank and borrower.
Recently many factors have reduced the value of the
banking relationship. Among these are the rise in
interest rate volatility, historically high nominal interest




rates in the early 1980s, asset quality problems at
banks, shifts in the international flows of funds, and
increased competition among banks and from other
financial firms.
For banks, the sharp rise in interest-rate volatility in
the late 1970s and early 1980s made the options
embedded in loan agreements much more expensive.
The unanticipated high level of interest rates increased
both the (foregone interest) cost of reserve requirements
and the effective cost of capital. As a result, the cost
of holding a loan on the balance sheet in many cases
exceeded the agreed lending rate, usually a base
interest rate plus a spread. Thus, if the borrower exer­
cised its right to borrow, the bank would be forced to
make an unprofitable loan.
Banks responded to the higher cost of the options by
withdrawing them in whole or in part where they could.
In particular, they could cancel or reduce credit lines.
Uncommitted lines eventually were replaced by com­
mitments for which borrowers had to pay. These could
be purchased separately from other banks that were not
the traditional relationship banks. For thrifts and banks
holding long-term assets that could not be called— but
that exposed the institutions to much greater interest
rate and prepayment risk than experienced before—
selling loans grew more attractive. In extending new
loans, thrifts and banks shifted from fixed-rate term
lending to floating-rate loans, passing the interest rate
risk to the borrower.
Interest rate volatility affected nonbank intermediaries
as well. For example, life insurance companies tradi­
tionally provided implicit and explicit options in their
contracts. With higher rates, however, policyholders let
low-yielding policies lapse and took out low-interest
policy loans in volume. The insurance companies
responded by altering their liabilities to resemble those
offered by depository institutions and mutual funds. To
match the duration of these new liabilities more closely
and to reduce their interest rate risk, life insurers have
sold off part of their long-term commercial mortgage
portfolio.
While banks sought to eliminate the unprofitable or
risky aspects of the traditional lending relationship, the
value to the bank of its other aspects has probably
increased, especially as the emphasis in measuring
bank performance has shifted from asset growth to rate
of return on equity. Many of the nonlending services
provided by banks produce fee income and are not
covered by capital requirements. Customers tend to
concentrate their purchases of financial services with
one provider or a few. Usually the main provider is a
lender. The need to offer the key service of lending
pushes banks to reshape their lending activity to retain
the element crucial to the borrower (access to funds)

FRBNY Quarterly Review/Autumn 1987

13

and eliminate the element unprofitable to the bank
(retention on balance sheet). Thus origination of loans
for sale as participations emerges as a business line.
For the borrower, the value of the banking relationship
has more clearly declined for a variety of reasons.
Actions such as cutting credit lines have reduced the
attractiveness of banks. Legally binding commitments
have replaced credit lines; NIFs and other underwritten
facilities have replaced some short-term and syndicated
lending; and the FRN market has replaced part of the
interbank market, as even bank borrowers have tried
to ensure their medium-term access to funds. In these
cases, the borrower is looking for less flexibility and
more certainty in the lending arrangement than under
a system of bank credit lines. But the demise of the
implicit contract means the demise of the distinguishing
feature of a loan.
The perception that asset quality has declined at
many banks and that some may be vulnerable to
liquidity problems in difficult market conditions has also
undermined bank credibility and the value of the banking
relationship. Many of the largest, most creditworthy
borrowers find that they can tap the markets at rates
more favorable than those offered by most of the largest
banks.
International flows of funds also affect the value of
the banking relationship by changing the identity of the
major lenders in the world. Traditional banking has
eroded much less overseas than in the United States.
In a country such as Germany, for example, banks’
equity investments in major borrowers help cement the
borrower-lender relationship. In addition, some foreign
banks, especially Japanese banks, have acquired assets
aggressively in the past few years.
But domestic borrowers may view foreign banks as
less credible in a banking relationship than domestic
banks for many reasons: questions regarding the lender
of last resort, a history of capital controls, or even
conflicts of national interest. In these cases, the bor­
rower may prefer to use an investment bank rather than
replace a domestic banking relationship with a foreign
one.
Since banks chiefly provide short-term funds, corpo­
rate and other borrowers will turn away from banks
when their needs call for longer-term finance. Following
increased reliance on short-term debt in the latter half
of the 1970s, firms turned to the long-term market in
1982 and again in 1984 through 1986, as long-term
rates declined.
Finally, sharper competition among banks, including
foreign banks, as well as encroachment by finance
companies and thrifts on traditional bank activities such
as consumer loans and commercial real estate lending,
has reduced the perceived cost of severing a banking

14

FRBNY Quarterly Review/Autumn 1987




relationship. Large, high-quality borrowers now have
little difficulty in finding new lenders. And the view that
plenty of liquidity is around in the banking system
amplifies that effect.
In particular, increased competition and a trend away
from specialization by financial institutions allow bor­
rowers to unbundle the banking relationship. By shop­
ping for individual services such as credit lines, loans,
and deposit services, the borrower can reproduce the
relationship at lower cost. This kind of unbundling is
separate from the unbundling of risks seen in the
financial markets, which is related to the development
of derivative products such as futures and options.
The weakened role of relationship is seen both in the
reduced share of large U.S. banks in the prime whole­
sale lending market and also in the decline of loyalty
among medium-size corporate customers. A recent
Board survey pointed to a decline in the share of
medium-size firms that bank with the institution from
which they borrowed.2
Moreover, as the palette of services offered by nonbank financial firms grows to resemble that offered by
banks, the customer views the “relationship” as more
similar. The loss of uniqueness means a loss of market
power. Banks can respond by bolstering their ability to
offer better access to funds or they can emulate to the
extent legally possible the unique product of investment
banks, underwriting, by selling loans or placing com­
mercial paper. That choice will depend on the cost of
intermediation.

Bank versus market intermediation
Forms of intermediation
Almost all financial transactions are intermediated in
some form. The most significant exception is the direct
issuance of commercial paper, although even here the
holders are often financial intermediaries. The term
intermediation covers a number of functions. In its
simplest form, it is brokerage: borrowers are matched
with lenders for a fee. A second form of intermediation
is underwriting. Borrowers are again matched with
lenders, but the borrower receives a certain sum at a
certain interest rate at a certain time. The underwriter
therefore bears and absorbs uncertainties about the
demand for the securities in return for an uncertain
spread.
A third kind of intermediation is carried out by mutual
funds. It involves selling shares in a pool of assets,
where returns to the investor are based on the return
of the portfolio of assets the fund holds. Maturities of
assets and liabilities are generally matched and are
2Senior Loan Officer Opinion Survey, August 1986, Board of
Governors of the Federal Reserve System.

either based on some agreed-upon future date when the
fund will be liquidated, as in a closed-end fund, or on
the preferences of the fund’s investors, with assets liq­
uidated as shareholders make withdrawals. As the fund
grows in size, actual asset liquidation costs are mini­
mized by the reasonably predictable flow of payments
in and out of the fund and the continual reinvestment
of part of the portfolio. Besides matching lenders with
borrowers, the principal social benefit of a mutual fund
is that it can offer an investor a liquid and diversified
investment with a low minimum denomination.
A fourth kind of intermediation is that performed by
depository institutions, insurance companies, and
finance companies. Such financial firms make loans and
issue liabilities against the intermediary as a whole.
They absorb the interest rate and funding risk over the
life of their loans. They will generally also transform
maturities and absorb credit losses, and in the case of
banks, thrifts, and finance companies, issue fairly liquid
liabilities against rather illiquid assets.
The ability to offer a liquid liability with low credit risk
against illiquid, risky assets derives from the interme­
diary’s economies of scale, which enable it to pool risks
and generate liquidity, as well as from its capital, which
buffers losses. (A mutual fund makes use of these
economies of scale as well.) A sizable portfolio allows
diversification and thus a reduction of the variability of
returns and a minimization of capital needs. Since only
a fraction of depositors’ liabilities will be converted to
cash at any one time, cash or clearing balance needs
are fairly predictable and depositors do not usually have
to fear for the liquidity of their claims. The existence of
a lender of last resort and the presence of deposit
insurance or other forms of “safety net” arrangements
provide an added layer of protection.3
These four types of intermediation should not be
identified too closely with types of institutions, however.
An investment bank that funds a large inventory of
corporate and government bonds with overnight secu­
rities loans is carrying out maturity transformation. But
the business purpose of an investment bank is not to
bear credit risk or to fund a stock of assets, as it is for
other financial intermediaries.
A simple model of bank and market intermediation
Two key questions raised by the spread of securiti­
zation are: Has the cost of maturity and liquidity trans­
formation performed by depository institutions risen so
much that it is no longer economically profitable? And
has it risen sufficiently to allow the proliferation of
substitute forms of intermediation? Answers to these
•Originally, commercial loans were made against short-term bills. This
type of lending probably involved little maturity transformation and
possibly less credit risk than commercial lending today.




questions require a systematic analysis of costs.
This section presents a simple model of banking and
the commercial paper market, which is meant to be a
representative securities market. The model views the
cost of bank intermediation as the spread between
lending and deposit rates needed to cover costs and
earn a normal profit. The wider the spread, the greater
the opportunities for securities underwriting to channel
funds from investors to corporate borrowers.
A bank takes deposits from small and large investors,
makes commercial and other loans, perhaps conducts
nonloan fee income business, and holds capital. The
depositor searches for investments that provide an
attractive combination of liquidity, safety, and rate of
return. Convenience and flexibility in managing other
financial assets may also be important. The loan cus­
tomer has a fixed borrowing need and can choose
between the loan or commercial paper market. The
banking and commercial paper markets are reasonably
competitive, so that prices are close to marginal costs.
For a given deposit rate, the bank must earn an
interest rate that will cover its marginal costs and a
normal return to capital, the sum of which we will denote
BSC, the cost of holding a loan on balance sheet. That
cost is:
BSC = kE +
where k
E
R
D
q
A

(1-k)(R + P)
+ A + LL
(1-q)

=
=
=
=
=
=

capital to asset ratio
required rate of return on equity
market interest rate on deposits
FDIC insurance premium
required reserve ratio
origination and servicing cost, expressed
as a rate per dollar
LL = expected loan loss rate, net of recoveries.

For simplicity, this ignores income taxes and loan fees.
Changes in reserve and capital requirements, when
the requirements are binding, will influence the spread
between BSC and the deposit rate, which we denote
sb. The influence of these key variables is summarized
in Table 1. Movements in the spread sb may have a
loose connection to interest rate cycles. When nominal
interest rates rise, the cost of reserve requirements
(foregone interest) rises. A change in the cost of capital,
that is, the required rate of return determined in the
stock market, will also influence sb. The cost of capital
is tied only indirectly to interest rates. As interest rates
approach a cyclical peak, it seems likely that the
required return would rise since returns on alternative
investments will have increased. In general, the required
rate of return will always be at least as high as the
riskless rate of return, since the investor will view this

FRBNY Quarterly Review/Autumn 1987

15

as the opportunity cost of funds. But the required rate
of return may at times stay high as interest rates begin
to fall, because capital gains raise the return on existing
long-term instruments.
At its narrowest, the spread sb may still be large
enough to allow some borrow ers to finance more
cheaply in the commercial paper market. As sb widens,
the commercial paper market becomes attractive to a
broader group of borrowers. The cost of a commercial
paper borrowing will be
CCP = Rcp + U,
where Rcp is the rate of return to the investor and U is
the underw riting cost, expressed as a spread. The
borrower will prefer to use the commercial paper market
whenever BSC is greater than CCP. If we assume for
a moment that Rcp is greater than R, the deposit rate,
securitization will occur whenever
sb > U + (Rcp-R).4
4W ith m arginal cost pric in g , the borrow er pays RL = R + sb in the
loan m arket and R 'L = Rcp + U in the com m ercial paper market.
The borrow er will be ind iffe re n t betw een them when RL— R 'L = 0.
That im plies R + sb = U + Rcp or sb = U + (Rcp-R) at the margin.

Table 1

Factors Influencing the Spread between Loan
and Deposit Interest Rates
In a co m p e titiv e market, p rice will equal m arginal cost:
R,

kE + ^ 0 - q ) 1^

+ A + LL

(The v a ria b le s are th o s e d e fin e d in the te x t.) The sp re a d
betw een the bank lend ing rate and the deposit rate, sb, is:

Sh = kE + (i-k)(Rf.P}
Sb

Kt +

( 1 -q)

+ A + LL -

R.

In addition, we assume that the required rate of return on equity
is alw ays higher than d e posit interest rates by at least a small
m argin. The tab le below sum m arizes the dire ction of change
in the spread sb when key varia bles increase:
Variable
That C hanges

D irection of
C hange in sb

D eposit rate (R)

a rise in nominal rates
raises sb

C ost of ca p ita l (E)

a rise in the capital asset
ratio raises sb

C apital to asset
ratio (k)

+,
if E >

R+ D
1 -q

16

Comments

a ris e in th e c o s t of
c a p ita l ra ise s sb if the
rate of return on equity
is above the deposit rate
by a s u ffic ie n t m a rg in ,
w hich will generally hold

R eserve
requirem ents (q)

+

a ris e in th e re s e rv e
requirem ent raises sb

D eposit insurance
prem ium (D)

+

a ris e in th e d e p o s it
in s u r a n c e
p re m iu m
raises sb

FRBNY Quarterly Review/Autumn 1987




To make a commercial paper offering attractive to
investor and borrower, the marginal cost of underwriting
commercial paper must be less than sb, since the
investor must earn a higher rate of return than on a
bank deposit to compensate him for the somewhat
higher risk and the borrower must pay a rate below the
bank lending rate. If large investors at the margin
require a lower rate of return on commercial paper than
on bank deposits, this is an additional advantage to the
commercial paper market.5
If there are large fixed fees involved in setting up a
commercial paper program (for example, to obtain a
rating), then the discounted present value of interest
savings from borrowing through commercial paper must
be large enough to compensate for the fixed costs. A
narrow spread sb would allow access to the commercial
paper market only to large borrowers; a wider spread
would allow access to many more. In other words, the
borrower is likely to look at the total cost of a discrete
amount of borrowing and choose the cheapest alter­
native.
If the spread sb becomes sufficiently wide, more
complex arrangements can link borrowers and lenders.
Money market mutual funds can collect savings and
purchase commercial paper. Since the fund managers
will collect a fee that we can think of as a spread, hold
some funds in cash at a prudential level of reserves,
and earn a return to whatever capital underlies the fund
(generally none), the spread sb has to be wide enough
to accommodate both the underwriting cost of the
commercial paper and the cost of intermediating through
the mutual fund. If we denote the mutual fund’s spread
as smf, then the spread is wide enough when
sb > U + sm( and Rcp-smf is greater than the deposit
rate available to retail investors.6 The fairly simple
structure of a mutual fund suggests that the mutual
fund’s spread is probably low, and certainly lower than
at a bank. Some money funds charge only 50 basis
points.
This framework can be generalized further to include
the decision of an intermediary to sell its assets. An
investor is willing to purchase a risky asset or pool of
assets if the investor believes it has adequate protection
against the risks assumed. If the investor is a financial
institution used to assessing and bearing credit risk, it
considers its own capital and its funding costs in
determining the price to pay and the rate of return it
sOver the last ten years, to p -g ra d e com m ercial pa per rates have
som etimes been below both bank ce rtifica te of d e posit (CD) rates
and the London interbank offered rate (LIBOR).
'T h e spread sb = RL-R. A borrow er w ill sw itch to the com m ercial
paper market when RL > Rcp + U. A de positor w ill sw itch to m utual
funds if Rcp-sm( > R, if an institutional investor, or if Rcp-sm( > R0, the
retail de posit rate, if a retail investor.

the deposit rate is loosely tied to the level of interest
rates, then the share of securities in total credit
extended rises as interest rates are peaking and falls
as interest rates reach their trough. A certain amount
of cyclicality can be observed (Chart 1).7 Two factors
work to dampen this cycle, however. First, periods of
high interest rates usually coincide with periods of
scarce liquidity, low private borrowing, and a shift by
investors to safer, more liquid investments. Second,
profitable operation of a mutual fund requires large size
in order to take advantage of economies of scale
inherent in many forms of financial intermediation. To
gain sufficient size takes time, and the interest rate
cycle in an unregulated environment may normally be
too short to attain such a large scale.
These impediments to the securitization cycle have
weakened in the last decade. The combination of high
inflation and Regulation Q in the latter half of the 1970s
created ample opportunity for money market funds to
flourish. With low marginal and average costs once they
reach a large size, money market funds are unlikely to

earns. Most other investors, often lacking capital to
absorb losses, seek to avoid nonpayment of principal
by requiring greater protection from the seller: larger
price discounts or a recourse provision, possibly in the
form of a reserve fund. These investors also consider
funding or opportunity costs.
The bank selling the asset can express the charge
to income from a price discount or from setting up a
reserve fund as the equivalent of a level of capital held
over the life of the loan. It can compare this level with
the capital it is required to hold against the loan if the
loan is on its balance sheet. It can also compare the
return on the asset required by investors and the bank’s
cost of funds.
When the amount of credit protection required by the
investor is equivalent to less capital than the bank’s
targeted capital-asset ratio, or there are other funding
cost savings, there are potential gains in selling off the
asset to investors. Increases in the bank cost of capital
also promote a shifting of assets to holders requiring
less capital or having a lower cost of capital.
Funding and capital costs are not the only determi­
nants of asset sales. Sales of asset pools have also
grown because of the sharp reduction of costs in
packaging and servicing the assets.
If the spread between the cost of holding loans and

7Monthly and quarterly data sug gest that securitization takes off just
as corporate bond rates reach their peak. This pattern probab ly
reflects both increased bank interm ediation costs and the
resurgence of bond dem and in an ticip ation of cap ital gains.
A ggregating to annual data obscures this pattern, and an inverse
relationship between securitization and interest rates em erges.

C hart 1

Securities to Loans Borrowing Ratio
D om estic N onfin ancia l, N onfederal go vernm ent s e c to r
Ratio
0 .5 2 -----------------------------------------------------------------------------------------

q 35 In il 11111111 h 1111111111111111 ilill 1111li 1111ill ill 11ii111 ill 111ml i iiln ili.LiliiiJi.ii Ini li 1111ii I ii 11111 li 111111 li 111111 li 11li 111111 h 111111li 11111111111ii 111111
1947 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

S ource:

66

67

68

69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85

86

87

B oard o f G o v e rn o rs o f the F e d e ra l R eserve S ystem , Flow o f F u n d s .




FRBNY Quarterly Review/Autumn 1987

17

disappear. Their growth has expanded the market for
commercial paper, which might otherwise be limited by
the large minimum denomination of the instruments.
Behavior of the cost of bank intermediation
In the late 1970s, the spread sb widened to unprec­
edented postwar levels and remained large (Chart 2).
Since then, the spread has fallen. Under conservative
assumptions, sb was no wider in 1985-86 than it was
in 1975-76. Under other assumptions, the spread since
1982 has rise n beyond the 1975-78 le ve ls (see
Appendix).
In particular, the assumptions about the target level
of capital at banks and the target rate of return on
equity affect our perception of the importance of bank
interm e d iatio n costs since 1982. The base case
assumptions are that the desired bank capital-asset ratio
is fairly represented by actual capital-asset ratios up to
1981 and by bank regulatory guidelines since then and
that the rate of return on market equity has been con­
sta n t at 15 p e rc e n t o ver the w hole pe rio d . The
assumption about bank capital ratios after 1981 would
seem to understate the case somewhat since most
banks are targeting capital-asset ratios above the min­
imum required.
Under the base case assumptions, sb averaged 85

C h a rt 2

Spreads betw een Balance Sheet Cost
Estim ates and the Three-M onth C e rtific a te
of Deposit
B a sis p o in ts
300

0l i i i l i i i l i i i l i i i l m l i i i l i i i l i i i l m l i i i l i i i l i i J
1975 76
S o u rce :

77

78

79

80

81

82

83

84

85

86

F e d e ra l R e se rve B ank o f New Y o rk e s tim a te s .

18FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


basis points in 1975-78, spiked in 1980-81 under the
influence of the tem porary im position of marginal
reserve requirements on managed liabilities, and aver­
aged 70 basis points from 1982-85, with a rising trend.
Movements in sb have been larger than the movements
in the difference between high-grade 90-day commercial
paper and CD rates, which fluctuated trendlessly in a
range of -10 to 10 basis points over the whole period,
except for a brief dip to - 2 0 basis points in 1978.
The base case assumptions suggest at most that
bank intermediation costs remained at their high late1970s level and thus allowed securitization to spread
to new financial transactions. An argument for a costdriven wave of securitization after 1982 needs to
assume that banks were largely unconstrained by capital
in the period before 1981 or that their required rate of
return on capital rose after 1981. If these assumptions
are plausible, the role of bank intermediation costs may
be important in the latest wave of securitization.
Indeed, the rise in bank capital requirements alone
cannot explain the perceived increased cost of main­
taining a loan on the balance sheet. Higher capital
requirements should reduce the perceived riskiness of
banks and bring about a fall in the required rate of
return on equity. This fall does not appear to have
occurred, however, for several reasons. First, the rise
in capital requirements coincided with a reassessment
of the overall riskiness of banks— thus the increased
capital may have prevented a larger rise. Second, banks
expanded their off-balance sheet exposures even as
they raised their capital, undercutting much of the effect.
Third, the market for bank capital is most likely imper­
fect. The required rate of return may be slow to adjust
to positive changes and quick to respond to potentially
negative developments.8 Fourth, the relatively high
interest rates in the early 1980s no doubt put a floor
under bank capital costs, preventing higher capital
requirements from quickly producing a reduction in the
bank cost of capital.
But the most important reason may be common to all
financial firms and helps to explain the breadth of the
securitization phenomenon: strong upward pressures on
the cost of capital in the financial sector as a whole.
Many financial firms share a tendency to fund in shorterterm markets and to hold assets that are longer-term;
they tend to have some sort of negative gap. This links
their returns on equity and makes their equities close
substitutes in investor portfolios. In the 1980s, a broad
range of financial firms have sought to raise capital:
commercial banks, investment banks seeking public
•In particular, the required rate of return on equity may not fall if the
capital requirem ent of the regulator is higher than that required by
the market. H igher ca p ita l ratios provide a social benefit for w hich
investors cannot be com pensated.

ownership, finance companies, and a host of foreign
institutions. Falling barriers to entry, especially overseas,
a wave of new products, and the growth of secondary
market activity have all opened up opportunities that
require more financial capital. Moreover, the rate of
return on investment bank equities has been much
higher than on bank stocks, which puts additional
pressure on banks to raise return on equity.
Indeed, as banks have lost business in the prime
wholesale and in other loan markets, the loss overall
has been not so much to other financial intermediaries
as to institutional investors for whom capital is not really
a constraint.9 That is, as argued earlier, the loss of bank
share is not a symptom of classic disintermediation.
The sustained high level of bank intermediation costs
has occurred at the same time that many of the costs
of transacting in the securities markets have been
declining. The introduction of shelf registration through
Rule 415 and the opening up of the Euromarkets sig­
nificantly reduced the cost of underwriting and eased
access to the markets. The growth of risk management
product markets has made it easier for investment
banks to hedge risks in making markets, although higher
volatility may have raised those risks. Over the last 15
years, underwriting costs have fallen modestly in the
commercial paper market, and more considerably in the
bond markets, especially the Eurobond market. Infor­
mation costs have generally fallen, so that investors are
better able to evaluate borrowers. Orders are executed
more rapidly.
But capital requirements are not entirely beside the
point. Forms of securitization such as loan sales to
foreign banks, the expansion of thrift assets where
capital requirements until recently have been low (3
percent or less), and the growth of mutual funds with
essentially no capital show that capital constraints
matter. Even among finance companies, much of the
growth has been among special purpose issuers with
very thin capitalization.
As a consequence, the financial markets are inter­
mediating a large volume of transactions. Increasingly
complex chains of transactions are replacing lending by
intermediaries, including mutual funds that purchase
mortgage-backed bonds, high-return low-quality cor­
porate bonds, and other securities. Ample liquidity has
meant that the surge of securities issuance has not
come fully at the expense of bank lending, so that
overall credit has grown sharply.

•According to the flow of funds accounts, between 1975 and 1985
banks and thrifts lost about 7 percent of market share (measured in
holdings of total financial assets), while finance companies gained
1 percent; pension funds and insurance companies, 2 percent; and
mutual funds, 4 percent.




The analysis so far points to three conclusions. First,
a chain of transactions that uses less capital to inter­
mediate a financial claim than is needed to retain an
asset on a bank’s balance sheet can substitute for bank
lending. Thus, even complex or highly illiquid assets
could be securitized if the transformations needed to
make them marketable (for example, credit and liquidity
enhancements) and the underwriting cost involve lower
capital costs and fees than bank lending.
Second, even highly profitable lines of bank lending
could be sold to investors through the securities markets
if the costs of packaging, underwriting, and protecting
against credit losses are less than the difference
between the cost of booking the loan and the cost of
deposits. By selling the asset, the bank could capture
some part of the profits of lending and the reduction of
intermediation cost.
Third, the expectation that high spreads in traditional
intermediation will persist encourages a lasting shift
toward securitization. In the short run, a rise in St, directs
borrowers to the commercial paper market, increases
the demand for investment banking services, and raises
the rate of return on investment bank capital. If the high
returns persist, capital is attracted to investment banking
and rates of return begin to decline, enhancing the
competitiveness of securities relative to bank lending.
In the longer run, the investment bank sector is larger
and the commercial bank sector is smaller. Securitiza­
tion then becomes a structural feature of the financial
markets.
Gaining access to the securities market
Some bank loans are not really suitable for replace­
ment by securities. Such loans may be too small;
information about the debtor may be scarce; risks
assumed by the creditor may be too difficult to assess.
Nevertheless, certain kinds of asset-backed securities
can overcome these difficulties.
Pooling loans is one important means to reduce
transactions costs and improve risk assessment. Some
securities, such as mortgage-backed and auto-loanbacked issues, rely on the law of large numbers to
provide more reliable statistical probabilities of events
that affect the rate of return on the securities. These
events include default and prepayment. Pooling implies
that certain regularities of behavior can be observed
among the population at large. For example, while the
individual probabilities of default among all consumer
borrowers at a bank may be unknown, the distribution
of defaults is revealed over time and is not expected
to change much. Further, aggregating a large number
of loans reduces the investor’s transactions cost.
The process of pooling reduces uncertainty, but in
general it cannot be done without introducing new credit

FRBNY Quarterly Review/Autumn 1987

19

exposures. Most pooling arrangements lead to multiparty
exposures: the investor is relying on the past and future
performance of an originator, a servicer, a trustee, the
“due diligence” staff at the underwriter, and the ultimate
borrowers. Even if all the participants are top-quality and
entail only minor credit risks, these risks accumulate.10
Thus, the risk of multiple exposures is still greater than
any single exposure.
A second method of gaining access to the market is
collateralization or, more loosely, asset-backing.11 Col­
lateralization refers to a perfected security interest in
real or financial assets that could be liquidated if the
borrower defaults. Asset-backing is weaker than colla­
teralization. The investor has no security interest in the
assets but can rely on a transactions structure that
removes the assets from the control of the debtor to
assure repayment. Both methods substitute either the
credit standing of the issuer of the underlying claims
or the value of real property (or its cash flow) for the
credit standing of the borrower. The substitution may
be in whole or in part.
Except for first and refunding mortgage bonds, col­
lateralized securities have never been very common in
the United States. They have been common abroad, and
in some domestic markets, such as Japan, they are the
main form of corporate debt allowed. Recent efforts to
increase the use of collateral in the United States have
met with mixed success. Frequently, collateralized
funding is expensive enough to compare unfavorably to
other sources. For example, mortgage repurchase
transactions are now generally a cheaper source of
funds than collateralized commercial paper. The con­
servative reinvestment and prepayment assumptions of
the ratings agencies account for most of the higher cost
of a collateralized security. These conservative as­
sumptions reflect real risks that are hard to quantify.
The less stringent form of asset-backing reduces this
problem. In a typical asset-backed transaction, the firm
originates and sells assets to a special purpose entity
that is structured to be legally independent of the firm
and unaffected by the firm’s bankruptcy. The assets sold
are generally high-quality and self-liquidating. The entity
then issues a security that is backed by a letter of credit
from a bank or a guarantee from an insurance company.
The bank or guarantor looks, to the assets to provide
a cushion if the commercial paper is not paid off. In
10The risk of a failure of the security is the risk that any participant
fails. Assuming participant failures are independent and disjoint
events, the probability of default is the sum of the individual
probabilities of failure.
"Some pools are sold through collateralized bond issues (for
example, collateralized mortgage obligations) for tax reasons. Here
we mean that assets of various types are pledged to back a bond
issue with no reference to any pooling properties.

FRBNY Quarterly Review/Autumn 1987
Digitized 20
for FRASER


many ways, the letter of credit resembles a performance
bond since the main reason the funds generated by the
receivables would not be paid over to the commercial
paper holders would be if the seller/servicer failed to
perform the servicing function. It may also be a way to
deal with assets that are not self-liquidating.
Collateralization and asset-backing both reflect a
theory of segregation of the originating firm’s assets and
liabilities into pools or classes. Such a theory claims
to offer more security to new creditors, but it does so
at the expense of the firm’s existing creditors and per­
haps its owners. The theory would only work if all the
streams of income and expense of the firm were exactly
correlated. If the income streams produced by a firm’s
assets are random and even somewhat uncorrelated,
then the firm gains by diversification and the sum of
the flows is less variable than the individual flows. Even
if assets and liabilities were matched exactly and each
pair packaged as an asset-backed transaction, the gains
from pooling cash flows having a random component
would be foregone.
A disadvantage of collateralization and asset-backing
is that it may weaken the internal risk-pooling at already
weak firms. The reason for pledging or isolating assets
is that the overall sum of the flows is viewed as “too
risky.” In other words, the originating firm is not of suf­
ficiently high credit standing to gain access to the
market. The collateralized or asset-backed technique
removes the higher-quality and presumably more certain
income flows, weighting the firm’s remaining cash flows
toward more risky income. The firm can make this
problem better or worse depending on how it structures
the liabilities to take on interest rate risk. If asset sales
or pledges sufficiently reduce its total funding risk, the
firm could lower its overall risk.
In many cases, financial institutions are transforming
or reducing risk by assisting in securitizing assets (for
example, providing a letter of credit) and adding their
own credit exposure to them. As a consequence,
classes of very unrelated securities may in fact become
related. For example, if bank ABC issues commercial
paper, guarantees the commercial paper of XYZ, acts
as paying agent for AAA’s bond issue, and is trustee
for auto-loan-backed securities of a major auto finance
company, these securities have in common a credit
exposure to bank ABC. If the “weakest link” theory is
applied, as it is by rating agencies such as Standard
and Poor’s, a downgrading of a financial institution may
lead to downgradings of securities in which the insti­
tution plays a part.
This is not to say that investors may not benefit from
asset-backed securities. Such securities may offer a
better risk-return trade-off than many others. But the
reduction of risk— either by pooling or by segregation

from the parent— cannot be achieved without intro­
ducing new credit risks, however small they may be.
Failure to take account of these credit risks can lead
to overpricing of securities in the markets.
If the firm uses the asset-backed market to expand
its activities without expanding its balance sheet— a
reason cited for some mortgage-backed and receivables-backed transactions— it may also weaken existing
creditors. A firm expanding its activities does not
increase the burden on its capital if the expanded
activity is riskless. But activities financed by assetbacked securities are not riskless. No matter how short
the time period in which assets are accumulated for
packaging in securities form, some risk exists that
interest rates will change and the firm will incur some
loss. Unless it is hedged, more risk is borne by the
existing creditors and owners of the firm. Moreover,
assessing this additional risk is probably difficult.
In summary, complex transactions can replace bank
lending if the costs of intermediation are low enough.
But some transactions have spillover costs to existing
creditors, the firm’s owners, and the financial system.
They may have hidden risks that are hard to analyze
and price. The apparent cost of these transactions might
be well below the true cost.

Deposits versus securities
The last link between investor and borrower in the tra­
ditional bank lending relationship is between the bank
and the investor. Typically, savers have held claims on
a bank in the form of deposits. Investors have chosen
from an array of bank claims that includes subordinated
debt, preferred stock, and equity, as well as deposits.
But increasingly, savers and investors are replacing
deposits with securities claims on banks or bypassing
banks altogether. Ironically, the shift toward securities
comes at a time when banks have great freedom in the
type of deposit services they can offer.
The essential features of a deposit as opposed to a
security of any type are the absolute absence of price
risk and the low transactions costs. Certain types of
deposits, such as demand and some time deposits,
have a high degree of liquidity as well. Between FDIC
insurance and the supervision of the banking system,
bank deposits also have a very low level of credit risk.
Certificates of deposit (CDs) do not fit into this picture
very neatly, since they are deposits but have many of
the characteristics of securities. In particular, they can
be traded over their life and therefore involve some
price risk. Like other deposits, CDs have low transac­
tions costs and the credit risk benefits of supervision.
In general, securities offer a higher rate of return and
the potential for sale before maturity but carry far
greater risk than bank deposits. Investors assume price,




liquidity and credit risk. In well-developed, liquid mar­
kets, securities also increase flexibility in managing
assets.
A number of factors have served to weaken the
position of deposits as against securities. Investors have
learned that some of the ostensible advantages of
deposits do not in fact exist. While deposits are not
subject to nominal price risk, depositors suffered heavy
real losses in the highly inflationary years of the late
1970s and early 1980s. In this respect, deposits are no
different from any instrument with fixed nominal value.
The perception that deposits are extremely safe has
probably also diminished, at least in the eyes of some
large depositors. The decline in banking relationships
could lead to a reduction in required bank deposits such
as compensating balances held in lieu of fees for
services.
But these are not the major forces that are changing
the balance between deposits and securities. If they
were, then new securities would probably be largely
index-linked bonds or government-risk securities. Indexlinked securities could provide considerable protection
against inflation; government securities have no credit
risk. In fact, however, the markets have taken a different
direction.
Three major factors seem to be behind the stronger
growth of securities demand. The first is the institu­
tionalization of savings in the United States and other
industrial countries. Savers increasingly hold claims on
pension funds, insurance companies, savings plans and
mutual funds— all institutional investors that manage
large portfolios of assets and usually pay rates of return
on liabilities related to portfolio performance. Many such
holdings are favored by their tax-exempt status when
provided as part of employee compensation, but these
institutions also offer lower transactions costs and
greater diversification than individual investors can
achieve. Such institutionalization leads to the possibility
of diversification and management of a portfolio of
financial claims within the institution, instead of reliance
on deposit-based intermediaries. Institutionalization of
savings abroad, especially in Japan, is also important
in a period of strong capital inflows into the United
States.
Institutionalization of savings is enhanced by the
growth of wealth and by investor sophistication. Indeed,
the increase in investor sophistication has itself been
an important reason for growing securities demand.
Individual investors, motivated in part by income tax
considerations and by risk/return characteristics, have
shown particular interest in zero coupon bonds and
equity shares.
A second factor is the development of techniques
using options, futures and other hedging instruments to

FRBNY Quarterly Review/Autumn 1987

21

manage risks, especially price risks. This means that
institutional investors again are less reliant on banks
to achieve relatively liquid, safe portfolios; they can
perform more transformation within their portfolio and
hedge any resulting risks. If banks earn economic rents
in providing this transformation or are inefficient in their
use of capital or other resources, then the process of
transformation will shift outside the banks, not just to
near-banks like finance companies but also to the
portfolios of investors.
The development of risk management techniques has
been lopsided, however. Growing wealth and ample
liquidity have given investors the wherewithal to take
more risk into their portfolios. Still, no new method has
been found to hedge or diversify away credit risk any
more efficiently than banks have done for decades. This
lies behind the paradox of the simultaneous growth of
credit enhancement and development of the market for
“junk” bonds, bonds with higher returns reflecting pre­
sumably higher credit risk.
Some investors are unable or unwilling to bear much
credit risk. Examples are money market funds, which
publish a prospectus stating that they invest only in topquaiity assets so as to attract risk-averse shareholders;
some institutional investors that have fiduciary respon­
sibilities; and small retail investors. As their portfolios
expand rapidly, perhaps in response to favorable tax
benefits or a shift in intermediation costs, they begin
to exhaust the supply of quality credits. And this
problem can be made worse by a decline in the number
of good names, as has occurred in the United States.
With credit enhancement, lower-quality borrowers can
be made acceptable to such investors. Thus, if the
demand for high-quality credits expands faster than the
supply, demand for credit enhancement increases,
returns to capital in the credit enhancement sector rise,
and new capital is attracted, as seen in the entry of
foreign banks into the letter of credit business and the
incorporation of new bond insurers.
At the same time, some larger investors, including
less constrained institutional investors and high net
worth individuals, can manage their portfolios much like
banks, holding securities of all types and using the
diversification principles that banks use. Higher capital
requirements reduce the efficiency of banks relative to
many institutional investors, offsetting their comparative
advantage in credit analysis. If other efficiencies do not
counterbalance these higher capital needs, more
banklike portfolios are built up outside the banking
system. This expands the market for low quality assets.
Junk bonds become cheaper to borrowers than a bank
loan paired with a swap that fixes the interest rate.
The final type of change contributing to stronger
securities demand is an apparently sharply enhanced

FRBNY Quarterly Review/Autumn 1987
Digitized22
for FRASER


desire for liquidity or transferability on the part of
investors. When a security is compared to a deposit of
equal maturity, the security offers the option of resale
into a secondary market if conditions appear to be
changing adversely. The deposit generally does not,
although the CD is an important exception. Sometimes
it is possible to borrow against a deposit or to withdraw
it before maturity after paying a fee. But high penalties,
highly leveraged balance sheets, or the wide spread
between bank lending and deposit rates may make
those alternatives unattractive. Increased volatility in
interest rates— or even in the underlying creditworthi­
ness of borrowers— makes the option to transfer a
security more attractive to investors. This also helps to
explain why more capital is being employed to make
markets and enhance secondary market liquidity.
Developments in the last few years can account for
changes in the choice between securities and deposits
by savers. The wider spread for bank intermediation and
the advent of new risk management techniques mean
that management of banklike portfolios by investors can
also substitute for the transformation performed by
banks. That transformation has become more expensive
for the banks because of higher capital costs. Finally,
the higher volatility of interest rates experienced in
recent years, along with more volatility in perceived
credit quality, has enhanced the value of liquidity in the
market.

Conclusion
The degree of securitization appears to depend on the
relative importance of relationship in financial transac­
tions, on the cost of traditional financial intermediation,
especially bank intermediation, compared to the cost of
intermediation through securities markets or private
placement, and on the ability of institutional and other
large investors to manage or reduce financial risks. In
all three areas, changes in the last few years have
hastened the development of securitization.
Relationship with borrowers and with depositors, a key
aspect of commercial banking, has probably declined
in value over the last few years. The response of banks
and thrifts to the higher volatility of interest rates—
cutting credit lines, increasing prepayment penalties,
and selling assets— has resulted in contractual
arrangements more easily reproduced by the market.
In addition, increased competition in the financial sector
has reduced both the market power of banking insti­
tutions and the cost of severing ties to banks.
The spread between deposit rates and the cost of
holding loans on the balance sheet widened substan­
tially in the late 1970s and early 1980s at the major
commercial banks. By conservative measures, it has
remained large or even risen above the 1975-78 levels.

The widening spread reflects the generally high level
of interest rates in the early 1980s, the higher capital
requirements imposed by bank regulators, and the high
cost of capital. This last factor has probably contributed
to higher marginal costs at all financial intermediaries
and helps to explain securitization’s broad base.
These higher costs allow firms specializing in under­
writing and placement to capture business from tradi­
tional financial intermediaries. Underwriting securities,
which has traditionally been expensive relative to bank
lending, has become relatively less so. Increased
competition among underwriters has lowered fees; new
hedging techniques and shelf registration have reduced
underwriting cost. A combination of commercial paper
underwriting and mutual fund operations by money
market funds can in many cases intermediate short-term
commercial borrowing more cheaply than a bank.
The change in relative costs is large enough to make
it attractive to shift to the market even those activities
that are now profitable at banks, such as automobile
financing and credit card lending. The shift occurs in
part because such sales conserve on expensive capital
and in part because the cost of packaging small loans
has dropped so sharply. Moreover, banks can help less
creditworthy borrowers tap the financial markets by
backing securities issues with letters of credit. Banks
still exploit their absolute advantage at credit analysis,
while tying up relatively little capital.
The final major factor, the preference for securities
over deposits, stems from the institutionalization of

savings, improved techniques for analyzing and man­
aging risk, and strong demand for liquidity. Institutional
and retail investors are willing to assume risks that
previously had been taken largely by banks and other
depositories. This appetite for more complex instruments
has had the perhaps unintended result of increasing the
demand for credit enhancement, since no technological
breakthrough in analyzing and managing most forms of
credit risk, especially commercial credit risk, has been
made.
Some factors have been pervasive throughout this
analysis and by their nature suggest that securitization
is driven by both long- and short-run forces. Increased
competition from foreign banks and other intermediaries,
the institutionalization of savings, growing investor
sophistication, and declines in information and trans­
actions costs in the securities markets are clearly longrun secular changes that on balance favor securitization.
Other factors, such as higher volatility in financial asset
prices or a higher cost of capital in the financial sector,
may not be permanent and give securitization only a
temporary impetus. Together, these factors have per­
mitted the securities markets to replace traditional
financial intermediation in many ways. Once established,
these new intermediation methods are unlikely to dis­
appear soon.

Christine Cumming

Appendix: Assumptions behind the Marginal Cost of Capital in Chart 2
Base Cost Assumptions
Return on equity:

15 percent assumed target rate of
return on market equity

Three-month
CD rates:

Quarterly averages from Federal
Reserve Bank of New York

Capital/asset ratio:

B efore 1981, annual w eighted
averages for a banking universe of
13 banks: Bank of Boston, Bank
America, Bankers Trust, Chase
Manhattan, Chemical Bank, Citi­
corp, C ontinental Illin o is, First
C h ica g o , H a rris, J.R M organ,
Manufacturers Hanover, Mellon,
and Northern Trust; after 1981,
minimum capital-asset guidelines
and requirements, as recom­
mended by the Federal Reserve
System

Marginal reserve
requirements:

The reserve requirement on non­
personal time deposits with orig­
inal maturity of 18 months or less
fo r the largest banks, Federal
Reserve Bulletin

FDIC premium:

Federal Deposit Insurance Cor­
poration rate, including rebate




Unconstrained Cost Assumptions
Same as above, except the ca p ita l/a sse t ratio is
assumed to be a nonbinding constraint before 1981,
represented by a value of zero.

FRBNY Quarterly Review/Autumn 1987

23

Eurocommercial Paper and
U.S. Commercial Paper:
Converging Money Markets?
The showing of U.S. banks in securities markets abroad
has influenced the debate over new powers for banks
in the United States. Observers have for some time
looked to the Euromarket as an appropriate laboratory
for testing the performance of U.S. banks as underwri­
ters. To some, the test results from Eurobond under­
writing are positive: in 20 years of existence, with the
important participation by U.S. banks, the Eurobond
market has proven “orderly and efficient” and under­
writers have not taken on excessive risks.1 To others,
the recent record of “huge losses” suggests the pos­
sibility of a “disaster” that might prove costly to the
federal deposit insurance system.2
Attention is now shifting to the Eurocommercial paper
(ECP) market because the power of the test provided
by the Eurobond market has waned recently. In partic­
ular, U.S. banks have fallen in the ranks of Eurobond
underwriters in the face of stiff competition from affiliates
of Japanese securities firms and Continental banks. At
the same time, after years of rapid growth, Eurobond
issuance in 1987 is running well behind the 1986 pace.
Some investors are avoiding the Eurobond market
because of concern over market liquidity.
But even as they have ceded market share in Euro1Richard M. Levich, "The Experience with Unregulated Underwriting
Activities in the Eurobond Market and Recent International Financial
Market Innovations,” testimony before the Senate Banking
Committee, October 13, 1987; see also the same author’s “A View
from the International Capital Markets,” in Ingo Walter, ed.,
D e re g u la tin g W all S tre e t (New York: Wiley, 1985), pp. 255-92.
^Testimony of Robert Gerard, Managing Director of Morgan Stanley
and Company, before the Subcommittee on Telecommunications,
Consumer Protection, and Finance of the House Committee on
Energy and Commerce, October 14, 1987.

Digitized for
24FRASER
FRBNY Quarterly Review/Autumn 1987


bond underwriting, some U.S. banks have sought to
establish themselves as dealers in the rapidly-growing
market for short-term Euronotes or Eurocommercial
paper. And the performance of U.S. banks in the ECP
market, just as in the Eurobond market, can inform the
current debate on bank powers.
There is a danger, however, that the debate will take
the domestic and offshore paper markets to be basically
identical. This article underscores the differences
between the Eurocommercial paper market and the U.S.
commercial paper (CP) market. We point to significant
differences in credit assessment and quality, buyers,
liquidity, clearing, and settlement, and we argue that
these differences are unlikely to disappear.
Now is an opportune time to contrast and to compare
the two markets. While the amount of commercial paper
outstanding in London promises to double again in 1987
to over $60 billion,3 structure and practice in the ECP
market are becoming well established. If London is
coming through a formative period, New York may be
on the eve of a shake-up: banking powers may be
expanded to allow bank underwriting of commercial
paper.
Some differences between the two markets are likely
to persist while others disappear. Ongoing differences
include the following:
• Buyers of ECP, coming from a broad range of
countries, draw credit distinctions but do not divide
issuers consistently by nationality; U.S. investors
3For data on the growth of Europaper issuance, see “Statistics on
Euronotes and Eurocommercial Paper,” Bank of England Q uarterly
B ulletin, vol. 27 (November 1987), pp. 533-35.

•

•

•
•

•

in CP systematically require foreign issuers to offer
higher yields than like-rated U.S. issuers.
The distribution of U.S. issuers in the ECP market is
of significantly lower quality than the distribution of U.S.
issuers in the U.S. CP market; foreign issuers in the
United States show a distribution of quality significantly
better than that of U.S. issuers here.
Central banks, corporations, and banks are impor­
tant parts of the investor base for particular seg­
ments of the ECP market; the most important
holders of U.S. CP, money market funds, are not
very important abroad.
The average maturity of ECP remains about twice
as long as the average maturity of U.S. CP.
ECP continues to be actively traded in the sec­
ondary market; most U.S. CP is held to maturity
by the original investors.
Issuing, clearance, and payment of ECP are more
dispersed geographically and more time-consuming
than those same processes for U.S. CP.

The following differences are likely to prove transitory:
• Dealing is very com petitive in the Europaper
market; just two firms deal half of dealer-placed
U.S. CP
• To date, all ECP has been placed by third parties;
many U.S. CP issuers place paper directly with
investors.
• C redit ratings are necessary in the dom estic
market; in the Euromarket they are common but
not required.
• ECP has been and mostly continues to be priced
in relation to bank deposit interest rates; pricing in
the U.S. is based on absolute rates that vary in
relation to rates on Treasury bills and bank certif­
icates of deposit (CDs).
Permanent differences
The foreign premium
A cosm opolitan m arket, the ECP m arket brings
together issuers and investors from a wide range of
nations. Buyers and sellers in the U.S. market, by con­
trast, are overwhelmingly U.S.-based. Foreign banks,
companies and sovereigns and their U.S. affiliates have
issued only about one-tenth of outstanding U.S. CP
(Chart 1).
Buyers in the U.S. CP market have exacted a yield
premium from foreign issuers over like-rated U.S.
issuers. The premium started at almost one-half of a
percentage point in the mid-1970s and declined to
around one-quarter by the early 1980s.4 In the past year
4M arcia Stigum , The Money M arket (Hom ewood, Illinois: Dow JonesIrwin, 1983), p. 64.




it has reached eight to ten basis points.
The foreign premium in the U.S. CP market may be
traced to restrictions on buying foreign paper, to the
greater difficulty of analyzing foreign firms, and to dif­
ferences in name recognition. Some investors are pro­
hibited by articles of incorporation or by boards of
directors from buying foreign-issued paper. Most foreign
issuers of commercial paper have attempted to cir­
cumvent such restrictions by establishing financing
corporations, frequently in Delaware.5 But some inves­
tors abide by the spirit of such restrictions and even
refrain from buying paper issued by U.S. subsidiaries
of foreign entities. Other investors, including insurance
companies, have internal limits on foreign assets that,
defined broadly rather than legally, constrain their pur­
chase of such paper.
A second source of the foreign premium is the diffi­
culty faced by investors who must perform their own
analysis of foreign issuers of paper. Accounting stand­
ards differ, disclosure requirements vary, and available
information remains less accessible. While the rating
5See Peter V. Darrow and Michael Gruson, "E stab lish ing a U.S.
Com m ercial Paper Program m e,” Interna tiona l Financial Law Review,
A pril 1985, pp. 8-12.

C hart 1

U.S. C om m ercial Paper Outstanding
by Issuer
B illio n s o f d o lla rs

1970

72

74

76

78

80

82

84

86

87*

*1 9 8 7 data th ro u g h end o f S e p te m b e r.
S ources: Board o f G o v e rn o rs o f the F ederal R eserve
S ystem , Flow o f Funds.

FRBNY Quarterly Review/Autumn 1987

25

agencies may be given access to information not pub­
licly available, a buyer of foreign CP cannot easily form
an independent judgment.
A final source of the foreign premium is lack of name
recognition . Some investors in com m ercial paper
emphasize liquidity and safety; if they are not effort­
lessly assured of both, they will not buy paper, even
from a well-rated issuer.
Some of the same factors that created the foreign
premium in the first instance help to account for its
decline in recent years. As more information on foreign
companies becomes available, paper buyers should
require less of an inducement to buy foreign paper.
Several forces have worked to increase information over
the past twelve years. U.S. banks have widened their
relationships with foreign corporations and have thereby
given bank trust departments greater access to infor­
mation on foreign borrowers. In addition, U.S. securities
firms have stepped up research on foreign corporations
in line with the growing investment by pension funds,
mutual funds, and insurance companies in foreign
equities. To serve these investors, some foreign firms
issue English language annual reports. As for name
recognition, the mere presence of Electricite de France
in the U.S. CP market for over a dozen years should

have an effect.
Another development that has promoted acceptance
of foreign names in the U.S. CP market and has helped
to reduce the foreign premium is the rise of money
market mutual funds (MMMFs) to their current status
as the largest single type of CP buyer. The growth of
MMMFs has in fact closely paralleled the decline of the
foreign premium. MMMFs came out of nowhere in the
mid-1970s to comprise a $292 billion portfolio at end1986; the reduction in the foreign premium took place
over the same period.
Although this coincidence suggests a link between the
growth of MMMFs and the declining foreign premium,
the demonstrated readiness of the funds to buy foreign
CP provides more convincing evidence. An analysis of
the top ten MMMF portfolios shows that, while they vary
considerably in the weight given to foreign CP holdings,
in aggregate, they do overweight foreign CP. That is,
the top MMMFs have allocated 16 percent of their CP
holdings to foreign CP (Table 1). This portfolio share
stands quite a bit higher than the 10 percent share of
foreign CP in the market as a whole. If the top ten
funds, which have about half of all MMMF holdings of
CP, are representative, MMMFs hold almost half the
foreign CP outstanding, as against less than a third of

Table 1

The Holding of Foreign Commercial Paper by Top Ten Money Market Mutual Funds Investing in
Commercial Paper*
Total Assets

Total CP

Foreign CP

(In M illions of Dollars)

As Percent of
Total CP

M errill Lynch CMA Money F u n d f
M errill Lynch Ready Assets Trusty
D reyfus Liqu id Assets§
Dean W itter/Sears Liqu id Asset Fund||
Fidelity Cash R eservesll
Temporary Investm ent Fund**
Cash E quivalent Fund— Money M arket P o rtfo lio ff
Institutional Liquid Assets— Prime P o rtfo lio :^
Prudential-B ache M oneym art A s s e ts ^
Kem per Money M arket Fund§§

17,959
10,578
7,235
6,869
6,604
5,782
5,556
5,191
4,308
4,174

5,117
7,190
1,497
3,646
2,528
5,541
4,153
4,008
2,653
3,862

307
284
1029
25
1309
129
1540
0

0 .0

0 .0

520
1418

12.1

34.0

19.6
36.7

Total of top ten

74,256

40,195

6,561

8 .8

16.3

t
X
§
||
1
**
tt
§§

2 .2

27.7

6 .0

3.9
68.7
0.7
51.8
2.3
37.1

Two funds in the top ten, the Trust for Short-Term G overnm ent S ecurities and the Trust of U.S. Treasury O bligations, are spe cia lized
funds that invest only in s p e c ific go vernm ent-backed paper,
As of M arch 31, 1986.
As of June 30, 1986.
As of M arch 12, 1986.
As of February 28, 1986.
As of N ovem ber 30, 1986.
As of S eptem ber 30, 1986.
As of July 15, 1987.
As of D ecem ber 31, 1986.
As of July 31, 1986.

Sources: Fund Annual and Semiannual Reports.

26

Foreign CP
As Percent
of Assets
1.7
2.7
14.2
0.4
19.8

FRBNY Quarterly Review/Autumn 1987




all CP outstanding. So it seems fair to conclude that
the foreign premium fell as more money was channelled
to money managers quite prepared to accept a foreign
name.
It is understandable that managers of MMMFs have
been more willing than the average CP buyer to buy
the paper of foreign borrowers. Money fund managers
are viewed as more aggressive in seeking yield than
many CP buyers. A reason may be that MMMFs are
compared and judged exclusively on the basis of their
success in managing strictly short-term liquid funds.
Managers of insurance companies, bank trust accounts
or pension funds, by contrast, pay less attention to the
allocation among money-market instruments than to the
more consequential weighting of equities and bonds as
against money in managed portfolios.
That some sensitivity to foreign paper remains among
even MMMF managers is evident from the individual
fund portfolio weights. Despite the premium, no MMMF
held more than 69 percent of its total commercial paper
as foreign CP And only two funds had as much as onehalf of their CP in foreign names. At the same time,
the sixth-ranked fund, Goldman Sachs’ Institutional
Liquid Assets-Prime Portfolio, has virtually no foreign
CP. In managing the top two funds, Merrill Lynch sig­
nificantly underweights foreign CP. Thus, the two major
dealers in U.S. CP both avoid foreign CP in managing
their institutional and individual money funds.

as those rates fell toward U.S. CP rates.7 As a con­
sequence, non-U.S. names in the ECP market tended
to be among the best. But the first U.S. issuers in
London included electric utilities with unfinished or
unlicensed nuclear power plants that had found it hard
to obtain credit in the United States but found willing
lenders in banks across the Atlantic.
Looked at superficially, the ratings of issuers of ECP
appear better than those of CP issuers. A statistical
comparison8 of the distribution of ratings of all rated
issuers in the CP market to the distribution of ratings
in Europe appears to confirm that a better cut of bor­
rowers sells ECP (Table 2 ).9 But there is an adverse
selection problem: high quality European borrowers may
disproportionately pay the cost of recasting their
accounts, meeting with the raters and paying for the
ratings. Thus, that unrated issuers in Europe are gen­
erally worse credits than the rated invalidates the
comparison to the U.S. CP market, where all issuers
are rated.
More revealing is the comparison of non-U.S. bor­
rowers in the U.S. CP market to U.S. names in the
same market (Table 3). Non-U.S. CP issuers exhibit a
significantly better distribution of ratings than native
issuers. In particular, over 70 percent of the foreign firms
have the highest paper rating while less than half the
U.S. issuers do.
This skewed distribution is caused by the foreign
premium. This has kept most good-quality, as distinct
from top-quality, non-U.S. credits out of the U.S. market.
The distribution of the foreign names in the U.S. CP
market is truncated: since merely good-quality foreign
names are treated like medium-quality U.S. names, the
former do not go through the expense to enter the
market. By contrast, no set of borrowers is consistently
foreign to the purchasers of ECP.
Also revealing is the comparison of U.S. names in the
Euronote/ECP market and the distribution of U.S. CP

Credit quality
Starting with Electricity de France in 1974, relatively
high quality foreign corporations first entered the New
York CP market in search of a wider investment base
and better pricing. To this day, foreign issuers in the
U.S. market still have a significantly better distribution
of ratings than U.S. issuers in the U.S. market.
Consequently, it would be natural to assume that high
quality U.S. names predominate in the ECP market.
After all, the Eurobond market has for years skimmed
the cream of U.S. borrowers.6 In fact, in contrast to the
Eurobond market, the ECP market takes only the milk.
U.S. issuers in the Euromarket have a significantly
worse distribution of ratings than all U.S. issuers in the
U.S. CP market.
The contrasting behavior of New York and London
provides clues to the development of the ECP market.
Since top-rated European corporations always paid more
in the U.S. CP market than top-rated U.S. borrowers,
they were quick to seize the opportunity offered by the
emerging ECP market. This step allowed them to sell
paper at or below the London interbank rates in 1985

•The statistical test used here and throughout this article is the chisquare test. It determines whether factors—credit quality and
nationality of issuer or market of issue—covary. It tests whether the
distribution of observations is what one would expect knowing only
the marginal totals or whether knowing one factor helps predict the
other. In this case, a chi-square statistic comparing ECP issuers to
U.S. CP issuers was computed. It allowed us to reject the null
hypothesis that the rating of the firm and the market in which it is
issuing are independent. The probability of error of the test is less
than 0.01.

•See Hendrick J. Kranenburg, "Reaching for 'Quality' Debt,” Standard
and Poor’s C re d it W eek In te rn a tio n a l, Fourth Quarter 1984, pp. 11,
16.

•Note the existence of “junk” CR rated B and C. Issuers in these
rating categories are regarded as having only adequate or doubtful
capability for payment on maturity of the paper.




7For a discussion of cross-market arbitrage opportunities for U.S.
issuers, see Rodney H. Mills, “Euro-Commercial Paper Begins to
Compete,” E urom oney, February 1987, pp. 23-24. The foreign
premium renders the ECP market more competitive than Mills
reckons.

FRBNY Quarterly Review/Autumn 1987

27

Table 2

Ratings of U.S. and Eurocommercial Paper Issuers*
D ecem ber 1986
A-1 +

A-1

A-2

A-3

B

C

Total

Percent

529

301

184

12

2

7

1035

93.2

47

16

12

1

0

0

76

6 .8

Total

576

317

196

13

2

7

1111

Percent

51.8

28.5

17.6

1 .2

0 .2

0 .6

—

U.S. CP issuers
E urocom m ercial p a p e r is s u e rs t

—
■

■

H

‘ The com m erical pa per ratings used here consist of three categories, ranging from ‘A' for the highest qu ality oblig ation s to ‘C ‘ for the
lowest. The A ’ ca te g o ry is refined into four subcategories, ranging from A1 + ’ for the highest to A -3 ’ for the lowest. The universe of U.S.
CP issuers exclud es those w hose c re d it is supported by bank letters of cre d it and sim ilar guarantees.
fT h e ECP sam ple con tains only active program s. W here no ECP rating was available, the U.S. CP rating was substituted.
C om puted c h i-sq uare statistic: 194.2 (5 degrees of freedom ). A statistic in excess of 15.086 allow s the rejection of the null hypothesis
that the rating of the issuer and the market in w hich it is issuing are independent factors with a p ro b a b ility of error less than 0 .0 1 .
S ources: U.S.: S tandard & Poor's C om m ercial Paper Ratings Guide.
Euro: List of active program s was ob tained from m ajor market makers.

issuers from which they were selected. U.S. issuers
abroad are not representative of the run of U.S. credits
in the U.S. CP market (Table 4). U.S. issuers of ECP
show a significantly lower distribution of ratings than
U.S. CP issuers.
An explanation of this finding may lie in the impor­
tance of banks as buyers of less than prime paper in
the Euromarket. Some banks take the time to perform
their own credit assessment; less careful ones take
comfort in the size of a U.S. corporation or familiarity
with its name. In addition, unlike many buyers of U.S.
CP, few buyers of ECP are required to expose their

portfolios to public scrutiny.
A comparison of ECP issuance by the finance com­
panies of General Motors, Ford, and Chrysler supports
the conclusion drawn from the distribution of ratings at
a point in time. A2/P2-rated Chrysler Financial Corpo­
ration started selling ECP as early as 1984, and is one
of the largest ECP issuers. A 1 + /P 1 -ra te d General

Table 4

Ratings of U.S. Issuers of Eurocommercial
and U.S. Commercial Paper
D ecem ber 1986

Table 3

Ratings of U.S. Commercial Paper Issuers
D ecem ber 1986

U.S.
issuers

A-1 +

A-1

A-2

A-3

391

249

182

12

Total

Percent

834

81.3

Non-U.S.
issuers

138

52

2

0

192

18.7

Total

529

301

184

12

1026

—

Percent

51.6

29.3

17.9

1 .2

—

C om puted c h i-q u a re statistic: 5194.2 (3 degrees of freedom ).
A statistic in excess of 11.341 allows the rejection of the null
hypothesis tha t the rating of the issuer and its nationality are
inde pen den t fa c to rs w ith a p ro b a b ility of error less than 0 .0 1 .
Source: U.S.: S tandard & Poor's C om m ercial Paper Ratings
Guide.

FRBNY Quarterly Review/Autumn 1987
Digitized28
for FRASER


A-1 +

A-1

A-2

A-3

Total

Percent

391

249

182

12

834

96.9

8

6

12

1

27

3.1

Total

399

255

194

13

861

Percent

46.3

29.6

22.5

1.5

US
market
Euro­
market*

-

—
—

*The ECP sam ple contains only active program s. W here no
ECP rating was available, the U.S. CP rating was
substituted.
C om puted chi-square statistic: 119.4 (3 degrees of freedom ).
A statistic in excess of 11.341 allows the rejection of the null
hypothesis that the rating of the issuer and the market in
w hich it issues are inde pen den t factors with a p ro b a b ility of
error less than 0 .0 1 .
Sources: U.S.: S tandard & Poor’s C om m ercial Paper Ratings
Guide.
Euro: List of active program s was ob tained from
major m arket makers.

Motors Acceptance Corporation (GMAC) and Ford Motor
Credit only started selling ECP in 1986, and outstanding
ECP by each has not generally matched that of
Chrysler.
That some issuers sell paper without credit
enhancement in London but with a guarantee in New
York gives further evidence of the quality difference
between the markets. For example, buyers of the obli­
gations of the Australian natural resource companies
Comalco and CRA in London accept their credit risk,
but buyers of the same firms’ U.S. commercial paper
look to the banks that have written letters of credit as
the ultimate obligors.

Investor base
The role of central banks and commercial banks as
investors in ECP distinguishes the market from the U.S.
CP market. Central banks investing their dollar reserves
in a substitute for U.S. Treasury bills or bank CDs have
come to dominate one whole segment of the ECP
market. It is difficult to know precisely how much ECP
commercial banks buy for their own account, since they
also buy for their trust accounts and for distribution to
their institutional and individual clients. But it is clear
that banks take a considerable share of ECP onto their
books, although it is also clear that this share has fallen
in 1987. By contrast, banks in the United States buy
little CP for their own accounts. Also distinguishing the
European markets is the very small representation of
money funds in Europe; their U.S. counterparts are the
largest investors in U.S. CP.
The buyers of ECP differ among the four distinct ECP
issuer classes: sovereigns, top-quality corporates, prime
corporates and the rest. In the market for high-quality
sovereign paper, central banks account for most of the
demand, perhaps 80 percent. The rest is split between
fund managers and market makers.
Top quality corporate paper, rated A1+/P1, is bought
by fund managers and other corporations. Fund man­
agers include managers of pension funds, bank trusts,
and insurance companies. Prime quality paper, rated A1/
P1, is bought not only by fund managers and corpo­
rations but also by financial institutions, mostly banks.
The rest of investment grade paper, rated A2/P2, and
unrated paper are bought largely by banks.
The quality spectrum corresponds to the pricing
spectrum. Sovereign ECP yields the London Interbank
Bid Rate (LIBID) less 10 to 25 basis points; A1+/P1
corporate and bank paper yields a bit below LIBID, in
general, and rarely above it; A1/P1 paper yields range
from LIBID to midway between the interbank bid and
offer range rates (usually LIBID plus 6.25 basis points);
and A2/P2 paper and unrated paper yield from just




below the offered rate, LIBOR, to well above LIBOR.
Banks’ own funding costs incline them to buy the lessthan-prime ECP Since most banks can fund themselves
only at LIBID or perhaps a bit less, they cannot make
money holding A1 + /P1 paper. Of course, with overnight
or weekly rates lower than three- or six-month rates,
banks can add a funding spread to the slim interme­
diation spread by funding their purchases of longermaturity ECP with shorter-maturlty money, but thereby
they expose themselves to interest rate risk.

Maturity
Most ECP matures in 60 to 180 days; most U.S. CP
matures in less than 60 days. From the perspective of
the Euromarket, this difference may partly reflect the
emergence of ECP from the note issuance facility
market and, more generally, from syndicated loans.
Instead of borrowing from banks that in turn sell CDs
to fund loans, ECP issuers offer paper of like maturity
directly to investors. From the U.S. perspective, the
maturity difference reflects the fact that the U.S. market
caters to entities such as automobile finance companies
and credit card affiliates of banks that must manage
shorter, more predictable cash flow schedules. The welldeveloped secondary market in ECP makes it difficult
to explain the difference from the buyer’s side. Sec­
ondary market activity suggests that the average holding
period of ECP is roughly half of its maturity.
Secondary market
Partly as a result of the maturity difference, the ECP
market has an active secondary market, with weekly
turnover in a range of 40 to 60 percent of total ECP
turnover (Chart 2). As the market has matured, sec­
ondary trading has tended to fall in relation to primary
market turnover. Formerly, banks with little placing power
bid aggressively for paper to impress borrowers, only
to dump it into the secondary market. But such behavior
neither earned money nor, ultimately, won over issuers.
Many borrowers do not like the loss of control over
pricing that secondary market trading can bring. And so
great is competition in the market that dealers will
sometimes report to an issuer another dealer’s disposal
of recently issued paper in the secondary market.
There is some evidence that the secondary market
turnover increases in relative terms when interest rates
are falling (Chart 3). Most recently, as interest rates
have risen, the secondary market turnover has dropped.
Consistent with this pattern is the tendency of market
makers and bank treasuries that actively manage their
ECP portfolios to buy more paper when interest rates
decline and profits can be earned by funding threemonth paper with money borrowed overnight.

FRBNY Quarterly Review/Autumn 1987

29

Liquidity in the U.S. does not much depend on a
secondary market. Instead it is maintained by shorter
maturities, the undertaking of dealers to buy back paper
from customers, and very limited brokering of directlyplaced paper.

by arranging “ swinglines,” facilities for same-day funds
from banks in New York. But however quickly ECP set­
tles in the future, ECP issuance, clearing, and settle­
ment will continue to be spread out over different cities.

Issuance, clearing, and settlement
Differences in the complexity of issuance, clearing,
and payment between the U.S. and European markets
are likely to persist. The Euromarket locates issuance
and custody in London, most clearing in the clearing
houses in Belgium and Luxembourg, and ultimate dollar
settlement in New York. The entire process usually takes
two to three days. By contrast, U.S. CP is issued,
delivered, and settled the same day in New York.
CEDEL, one of the two m ajor European clearing
houses, offers same day settlement, but Euroclear, the
other major European clearing house, requires at least
two days to settle. Two-day settlement may suit Euro­
market investors whose other investments settle on this
basis. Nevertheless, as the number of issuers with
programs in both markets grows, same day settlement
of ECP may become more common, since borrowers
shifting from the U.S. CP market to the ECP market
require same-day funds to pay off maturing CP. Even
now, ECP issuers can circumvent the settlement delay

Temporary differences
Some of the differences between the markets are
clearly subject to change. Indeed, many observers
expect that market practices in various paper markets
will become more standardized.10 Those differences
between the ECP and U.S. CP markets that are likely
to narrow are discussed in detail below.
Concentration of dealers
The well-publicized and sharp competition among
dealers of ECP may well indicate the future of com­
petition in the CP market. As things stand, about half
or more of all dealer-placed paper in the United States
is sold by just two market leaders, Merrill Lynch and
10See S.L. Topping, “ Com m ercial Paper Markets,” Bank of England
Quarterly Bulletin, vol. 27 (February 1987), pp. 46-53.

C h a rt 3

C hart 2

Weekly Turnover in Primary and Secondary
Eurodollar Commercial Paper Market

Share of Weekly Eurocommercial Paper
Turnover in Secondary Market versus
Three-Month Eurodollar Rate
F o ur-W e ek M oving A ve ra g e fo r C om m ercia l P aper

F o u r-W e e k M oving A verage
B illio n s o f d o lla rs

1986
1986

1987

* B re a k ind ic a te s s ta rt o f CEDEL data.
S ources:

30

E u ro c le a r and CEDEL.

FRBNY Quarterly Review/Autumn 1987




1987

* B re a k in d ic a te s s ta rt o f CEDEL data.
S o u rc e s : E u ro c le a r, CEDEL, F e d e ra l R e s e rv e Bank
o f New Y ork.

Goldman Sachs.11 Merrill Lynch officials lay claim to
leadership among U.S. dealers, with a market share just
short of 30 percent.12 Merrill’s acquisition of A. G.
Becker from Paribas in 1984 put it into position to
overtake Goldman.
The degree of concentration is much lower in the
Euromarket. Estimates vary widely on market shares in
the amount of paper issued, but the consensus is that
the top six dealers place somewhere around 70 to 75
percent of ECP by value. No dealer can credibly claim
a market share much in excess of 20 percent. In terms
of number of dealerships for both ECP and Eurodollar
certificates of deposit, the top six dealers share less
than 50 percent of the market.13 By either measure,
ECP dealing is less concentrated than CP dealing.
The entry of U.S. banks into the U.S. CP market is
sharpening competition. Thus far they have acted only
as placing agents, finding buyers for CP without buying
the paper themselves. But despite their restricted role
as agents, banks are seeking to prove themselves reli­
able placers, at times offering paper to investors at a
favorable, slightly higher yield to ensure its sale. At the
same time, by charging a very modest placing fee, the
banks raise funds for the issuer at a favorable, slightly
lower net cost of funds. By early 1987, U.S. banks
served as exclusive placers of CP for 65 issuers with
over $7 billion in paper outstanding. They shared
placing in 70 other programs with over $19 billion out­
standing.14 While these figures indicate a market share
for all U.S. banks of about 5 percent or more, they do
suggest some measure of success in entry despite
ongoing legal restrictions on underwriting. Citicorp’s
purchase in November 1987 of Paine Webber’s CP
operation, with paper outstanding in the amount of about
$3 billion under about 40 programs, adds clout to an
already sizable placer.
"Moody’s S hort-Term M a rk e t R e c o rd ; Standard and Poor’s C om m e rcia l
P ap er R atin g G u id e. The Federal Reserve Board, noting the
concentration of dealerships in the U.S. CP market, adduced the
public benefit of fostering competition in explaining its decisions to
permit banks to place and to deal in U.S. CP See "Bankers Trust
New York Corporation," and “Citicorp, J.P. Morgan & Co,
Incorporated, Bankers Trust New York Corporation,” F e d e ra l R es erv e
B ulletin, vol. 73 (February 1987 and June 1987), pp. 148 and 490.
For a review of the Federal Reserve rulings, see Terrance W.
Schwab and Bernard J. Karol, “Underwriting by Bank Affiliates,”
R ev ie w o f F in a n c ia l S e rv ic e s R egulation, vol. 3 (May 20, 1987), pp.
93-100.
12ln computing Merrill's market share, the official excluded paper
issued by dealers on behalf of their own affiliates to eliminate the
effect of Merrill's sizable fund-raising. See Tom Herman, "Goldman
Sachs Abandons Policy It Says Hurt Growth in Commercial Paper
Field,” W all S tre e t J o u rn a l, October 2, 1987, p. 29.
13In te rn a tio n a l F in a n c in g R eview , July 4, 1987, p. 2202.
u Moody's Short-Term M a rk e t Record-, Standard and Poor’s C om m ercial
P a p e r R atin g G u id e.




In addition, foreign securities firms are entering the
U.S. CP market as dealers for foreign issuers. In late
1986, U.S. affiliates of foreign securities firms, mostly
Canadian and Japanese, shared placing in 25 programs
with approximately $5 billion outstanding. The foreignbased securities firms uniformly deal in paper of bor­
rowers from their home country, probably because long­
standing relations incline the borrowers to give their
dealers an opening. It should be noted, however, that
none of the foreign securities dealers serves as a sole
placer of U.S. CP.
The competitive challenge in U.S. CP has led a
market leader to change a long-held business policy in
favor of practice typical of the ECP market. Heretofore
Goldman Sachs insisted on a company’s sole use of
Goldman to place the company’s CP. Now, Goldman is
prepared to play co-dealer, particularly on large paper
programs where the firm has not played a role to date.15
Although the previous policy might have spurred the
dealer to win wide acceptance of an issuer’s paper in
order to capture all the business so generated, issuers
now seem keen to encourage more direct competition.
While U.S. banks have entered the business of
placing CP in New York, a U.S. bank ranks among the
top ECP dealers in London. It is generally acknowledged
that Citicorp Investment Bank, Limited leads its com­
petitors in the amount of paper placed, although the
market share it claims is much disputed. Other leaders
are the affiliates of U.S. securities firms—Merrill Lynch,
Morgan Stanley, and Shearson Lehman—Swiss Banking
Corporation International, and the U.S.-Swiss hybrid
Credit Suisse First Boston. Each of these six probably
enjoys a market share between 10 and 20 percent. All
are trying to secure their positions before Japanese
institutions enter the market.
The superior performance of Citicorp Investment
Bank, Limited in the ECP market is attributable in part
to its strength in a traditional banking activity. Most
observers credit its leadership to its mixing dollar paper
with forward sales of dollars against a variety of cur­
rencies to create “cocktail” paper. In effect, buyers of
such mixtures get CP in their currency of choice,
although they also expose themselves to Citicorp on the
forward transaction.
Other U.S. banks are making serious, if less suc­
cessful, efforts to compete in ECP dealing. U.S. banks
represent no less than 8 of the 20 top dealers of ECP
and Euro-CDs. Taken together, U.S. banks probably
have carved out a market share of a quarter or more.
The resources devoted by U.S. banks to the ECP
market must be understood in light of their overall
investment banking strategies and, in particular, their
15Tom Herman, “Goldman Sachs Abandons Policy."

FRBNY Quarterly Review/Autumn 1987

31

interest in demonstrating the inappropriateness of GlassSteagall restrictions.
Greater competition among dealers in the ECP market
brings lower prices for their services. U.S. CP dealers
used to collect a fee of one-eighth of a percent for
buying paper from the issuer and reselling it or, failing
that, taking any unsold paper into position. This fee
works out to $3.47 per million dollars per day until
maturity at issue.16 More recently, fees have fallen to
around ten basis points or even lower. In the Euro­
market, the spread between what dealers pay for ECP
and sell it for averages three basis points. This spread
works out to only $75 for placing $1 million of 90-day
paper. When working as agents for some high-quality
issuers who do not want anyone but end-investors to
own their paper, ECP placers also make a commission
of less than five basis points. Little money is being
made at these rates. And some dealers have accepted
paper at rates lower than they can place it, to gain
market share.
Such intense competition for market share may sug­
gest that a great deal of money is at stake. It appears,
however, that dealing dollar CP in New York and London
produces only modest revenues. If dealing in the U.S.
fetches ten basis points per year on placements of $180
billion, only $180 million is earned. If dealing generates
three basis points on the roughly $50 billion outstanding
in London, only $15 million is at stake, matched, per­
haps, by another $10 million in the secondary market.
These are estimates of gross revenue out of which
overhead and expense must be paid. Only very rapid
growth of these markets can justify the resources that
financial firms are devoting to them.
The entry of foreign securities firms and U.S. banks
as dealers will make the U.S. CP market increasingly
competitive. It was this prospect that prompted the exit
in October 1987 of Salomon Brothers from the U.S. CP
market, where it had achieved a market share in excess
of 10 percent. The outlook for the rapidly growing ECP
market is less certain: the current competitiveness of
the market may continue if heavier future volume is
spread out over the current dealing capacity, or it may
end in a shake-out that would remove some capacity.
Already in 1987, J.H. Shroder Wagg and Salomon
Brothers have withdrawn from the ECP market. The
more heterogeneous investor base in the ECP market
may leave room for more players. In any case, it is
likely that the U.S. CP and ECP markets will converge
somewhat in the competitive structure of dealing.

the two markets may reduce another market difference:
the fact that no Europaper issuer issues directly. In the
United States, finance companies, representing a sub­
stantial share of the market, place their own paper
directly with investors (Chart 4); in the smaller, less
developed Euromarket, no issuer has yet found it
worthwhile to bypass the dealers.
Note that foreign issuers in the U.S. CP market, even
those with large and long-standing programs, do not
directly place paper. It appears that U.S. buyers demand
that dealers sell them the paper. The reason usually
given is the desire for the monitoring of the more remote
borrower’s credit standing by the dealer. For direct
issuance to take hold in the Euromarket, the buyer of
the paper must not make a similar demand for dealers
to monitor the credit of foreign borrowers.
A direct issuer of CP in the U.S. essentially replaces
the dealer on commission with in-house dealers. Dealer
fees of about one-eighth of a percent can exceed the
cost of hiring a full-time staff to manage a program,
provided that outstandings are sufficiently large, nor­
mally in the $200-250 million range. Thus the concen­
tration of dealers in U.S. CP does not necessarily mean
that they have a hold on the business and can exact

C hart 4

U.S. Com m ercial Paper Outstanding:
Dealer Placed versus D irectly Issued
B illio n s of d o lla rs
4 0 0 ---------------------------------------------------------------------------------

Direct issuance
Changes in the degree of concentration of dealers in
S ource: F e deral R eserve Bank of New Y o rk .
16Stigum,

32

p. 639.

FRBNY Quarterly Review/Autumn 1987




oligopolistic returns. CP dealers face a potential com­
petitor in each customer.
The U.S. CP market looks much less concentrated if
the relevant market is taken to be the CP market as a
whole rather than dealer-placed CP. Merrill Lynch and
Goldman Sachs together place little more than a quarter
of all U.S. CP. The fourth-ranked placer is the firstranked direct issuer, GMAC, with about a 10 percent
market share. As a group the top four placers share
well less than half the market. On this showing, the U.S.
CP market looks much more competitive.
It is reasonable to take the whole CP market as the
relevant market for the assessment of concentration
even though direct issuance cannot substitute perfectly
for hiring a dealer. A direct issuer performs most of the
functions that a dealer performs: making arrangements
with buyers, assessing the market, posting rates, and
closing sales. The direct issuer must set up dealers in
a dealing room and buy telephones and screens. The
direct issuer cannot, however, free himself of the risk
that paper may not be sold in the desired quantity at
the posted rates. Still, the direct issuer may fund the
shortfall in much the same way that the dealer would
fund an overnight CP position, with repos or same-day
bank credit. On balance, direct issuance substitutes
closely for hiring a dealer; therefore, it makes sense to
measure concentration in terms of the CP market as a
whole.
Sharpened competition that drives down dealers’ fees
may over time shift the composition of U.S. CP to more
dealer-placed paper. With lower fees, the threshold
amount that an issuer must sell regularly before it can
break even issuing directly should rise. Over time, one
would expect the share of paper directly placed to fall.
Since dealer fees in Europe are currently less than
half those in the United States, outstandings of perhaps
$1 billion would be required before savings on dealer
fees would outweigh direct issuance costs. At this point,
even Chrysler generally has less than that amount of
ECP outstanding. Again, the more heterogeneous nature
of the investor base for ECP may raise the threshold
for an issuer to internalize the dealing function. But as
the market grows, it seems safe to anticipate the
appearance of direct placement in the Euromarket,
especially if the exit of current dealers or other factors
should cause dealer fees to rise.
Importance of credit ratings
Euromarket practice should converge to U.S. market
practice in requiring paper to be rated. Only about 45
percent of active ECP issuers at end-1986 were rated,
while credit ratings are ubiquitous in the United States.
There are two plausible explanations for this difference.
First, Euromarket investors generally have not relied on




credit agencies and their ratings. This year, an agency
called EuroRatings was set up by Fitch Investors
Service and Compagnie Beige d’Assurance Credit to
serve the Euromarket exclusively. As of September,
1987, EuroRatings advertises 67 short-term ratios, of
which 9 are for U.S. firms. By contrast, buyers of U.S.
corporate debt have consulted credit ratings for gen­
erations. In the United States, regulation has reinforced
tradition: prime quality paper, distinguished by a high
rating, need not be registered with the Securities and
Exchange Commission.17 Second, borrowers in the
Euromarket have not encountered severe liquidity
problems or defaulted on their paper. It was only in the
wake of the largest shock to the U.S. CP market, Penn
Central’s default on $82 million of outstanding paper,
that multiple ratings became as widespread in the
United States as they are today.18 But even though
Europe has not witnessed such an episode, ratings are
becoming more important there as well, as investors
become accustomed to the concept.
Tough competition among paper dealers is paralleled
by competition among raters. While the third-ranked
U.S. CP rater, Fitch, has teamed up with a European
partner, the two major raters in the United States have
both adopted strategies to establish their position in the
Euromarket. Standard and Poor charges an entity with
a U.S. rating only $5000 for an ECP rating on top of
the $25,000 annual U.S. fee. Moody’s has gone a step
further by making its CP ratings global paper ratings,
applicable in any market or currency.
Increasing reliance by Euromarket investors on ratings
will undermine the distinction between ECP and
Euronotes. Euronotes are said to be underwritten,
meaning that the contract governing their issuance also
contains an undertaking by a group .of banks to buy the
paper in the event that it cannot be sold at a yield less
than LIBOR plus an agreed spread. For years, however,
the U.S. rating firms have required that an issuer of
commercial paper have sufficient access to bank credit
to repay maturing paper in the event that new paper
could not be sold. So rated issuers of ECP must have
access to bank credit, even if that access is not con­
tractually bundled with the paper issuance. A rating thus
substitutes for an announced, “underwritten” program
of paper issuance, and ratings have gained in Europe
even as the announcement of Euronote programs has
fallen off.
17Low-rated paper is issued under the private placement exemption
that restricts sales to a limited number of sophisticated investors, at
the cost of market width and higher yields. See Darrow and Grusen,
"Establishing a U.S. Commercial Paper Programme," pp. 10-11.
1,See Thomas M. Timlen, “Commercial Paper—Penn Central and
Others,” in Edward I. Altman and Arnold W. Sametz, eds., Financial
C rises: Institutions a n d M arkets in a Fragile E nvironm ent (New York:
John Wiley, 1977), pp. 220-25.

FRBNY Quarterly Review/Autumn 1987

33

Pricing base
Pricing differences between the two markets persist
but are showing signs of erosion. CP dealers in the U.S.
market post absolute rates, while the Euromarket has
traditionally based pricing on LIBID or LIBOR, plus or
minus a spread. Specifically, a rise in the yield spread
between U.S. Treasury bills and Eurodollars would lead
ECP rates to rise with the Eurodollar rates one-for-one.
U.S. CP rates, by contrast, vary with respect to both
Treasury bill rates and Eurodollar rates and generally
split the difference when the latter two diverge.19
But yields on some ECP, that issued by sovereigns,
have developed in 1987 a noticeable independence from
bank deposit rates. At the beginning of the year, dollar
paper for Sweden and Spain gave a return to investors
generally 0-10 basis points below the bid rate for
Eurodollar deposits with banks (Chart 5). In the spring
the Treasury cut back on its issuance of Treasury bills
in response to unanticipated tax revenue and recurring
approaches to the legislated debt limit. Reduced supply
met an increased demand, as central banks sought to
invest reserves acquired in support of the dollar, and,
consequently, Treasury bill rates hardly rose as threemonth Eurodollar rates rose through 7 percent in April.
Sovereign ECP rates, however, did not quite rise in step
with bank deposit rates. In late April and early May,
sovereign ECP offered investors 10-20 basis points less
than Eurodollar deposits in banks. When Treasury bill
rates rose in late July and Eurodollar rates remained
steady, the difference between the yields of sovereign
ECP and bank deposits narrowed again.
Sovereign ECP yields thus stray from Eurodollar
deposit rates to stay closer to Treasury bill rates when
the Treasury and Eurodollar rates diverge; ECP yields
approach Eurodollar deposit rates when Treasury and
Eurodollar rates converge. When the Treasury-Eurodollar
spread has been less than 100 basis points this year
through September, the Kingdom of Sweden’s ECP has
yielded an average of about 5 basis points less than
LIBID; when the Treasury-Eurodollar spread has reached
over 100 basis points, Sweden’s ECP has yielded an
average of 14 basis points less.
The investment behavior of central banks lies behind
these changing rate relations. Formerly, U.S. CP sold
by either French state corporations or banks with a
government guarantee competed with U.S. Treasury bills
in offering sovereign risk on dollar paper. Now central
banks can spread their dollars across paper issued by
or guaranteed by most of the governments of Western
Europe. By investing in sovereign ECP, central banks
can pick up more than 100 basis points while sacrificing

liquidity only modestly: for this reason, such investments
are becoming increasingly common.
The pricing of other ECP has not similarly diverged
from interbank rates. The ECP yield index that the Bank
of England has published just since late August 1987
shows little independence of ECP rates. In particular,
the rates published for three-month ECP prime corpo­
rate and bank holding company borrowers range nar­
rowly from 0-3 basis points above the London Interbank
Bid Rate.
Convergence of rates in the two markets would
require ECP rates to fall relative to Eurodollar bank
deposit rates. Alternatively, U.S. CP rates could rise
relative to domestic bank CD rates. Indeed, with heavy

C hart 5

Rates on Sovereign E u rocom m ercial Paper
of Sweden and Spain and
on E urodolla r D e p o sits*
B asis p o in ts
30 0

S p re a d s v e rs u s E u ro d o lla r B id R ates

.

S pain

S w eden

-60

L J ___ I___ I___ I___ I___ I___ I____ I___ I____ L _ l
Jan Feb M ar A pr M ay Jun Jul
1987

Aug

Sep

* London Interbank O ffe re d Rate.
1®See N ancy J. Kim m elm an and Gioia M. Parente, "The TED S pread—
O utlook and Im plications," Salomon Brothers Bond Market Research
M em orandum , July 15, 1987.

FRBNY Quarterly Review/Autumn 1987
Digitized34
for FRASER


S ources: F e d e ra l R e se rve Bank of New Y ork,
M e rrill Lynch.

O ct

Nov

issuance of CP, CP rates have approached and some­
times have exceeded domestic CD rates. But since a
domestic reserve requirement and a Federal Deposit
Insurance Corporation insurance premium drive a wedge
of 30 basis points or so between domestic bank rates
and Eurodollar deposit rates, considerable distance still
generally separates pricing in the two markets, espe­
cially for direct issuers in the U.S. market.20 The expe­
rience of GMAC, which has not been able to maintain
$1 billion of ECP outstanding at prices no higher than
at home, underscores this point. Along the way to con­
vergence, foreign issuers could be expected to exit from
the U.S. market, given the foreign premium. Thus,
convergence of rates might well be associated with
greater specialization by nationality of issuance in the
two markets.

Conclusion
This article argues that the Eurocommercial paper
market and the U.S. commercial paper market are likely
to continue to differ in some important respects. In
particular, the U.S. market will probably remain less
cosmopolitan than the ECP market, requiring foreign
issuers to pay a higher interest rate than U.S. issuers
of like quality. As a consequence of the diminished but
persistent foreign premium in the U.S. market, the U.S.
market funds a prime selection of foreign credits. Con­
versely, the less quality-conscious ECP market offers
funds to a distribution of U.S. borrowers of lower quality
than the general run of U.S. issuers of CP. In addition,
the ECP market is likely to remain a market for longermaturity paper with much greater reliance on secondary
market trading to provide liquidity. Issuance, clearance
*°See Lawrence L. Kreicher, "Eurodollar Arbitrage," this Q uarterly
R eview , Summer 1982, pp.10-21.




and settlement of ECP span half the globe and take
two days while these same processes in the U.S. CP
market are carried out in one city in the course of a
day.
Other differences are likely to prove transitory.
Although dealing in ECP appears much more compet­
itive than dealing in U.S. CP, the entry of U.S. banks
serving as placing agents and of foreign securities firms
is increasing competition among U.S. dealers in New
York. And if direct issuers are recognized as competitors
of U.S. securities firms, the market appears even more
competitive. In addition, ratings are likely to become as
necessary in Europe as they are in the United States.
Finally, both pricing methods and levels are likely to
converge in the two markets, although this convergence
may coincide with greater segmentation by nationality
of issuers in the two markets.
Out of these differences come three useful points for
the ongoing debate over banks’ underwriting in the U.S.
CP market. First, dealing in the U.S. CP market is less
competitive than dealing in ECP, but the difference is
both easy to overstate and already narrowing. Second,
foreign issuers of U.S. CP and smaller U.S. firms that
do not have programs large enough to warrant direct
issuance would be the principal beneficiaries of further
competition and lower dealing rates in the United States.
Third, since the total revenues at stake, particularly in
the competitive circumstances characteristic of the ECP
market, do not seem large, only explosive growth of CP
issuance would make the policy question at hand deci­
sive for commercial bank revenues or profitability.

Robert N. McCauley
Lauren A. Hargraves

FRBNY Quarterly Review/Autumn 1987

35

Current Labor Market Ttends
and Inflation

The rapid drop in the unemployment rate to 6 percent
has caught almost all analysts by surprise. As recently
as a year and a half ago, such a low level of unem­
ployment seemed almost unattainable in the foreseeable
future. Lawrence Summers’ account of unemployment
trends is representative of the expectations of that time:1
Even forecasts that call for steady growth over the
next five years do not foresee unemployment rates
dipping below 6 percent__ Where Kennedy-Johnson
economists set 4 percent as an interim fuIIemployment target, contemporary policy makers
would regard even the temporary achievement of
6 percent unemployment as a great success.
The decline in the unemployment rate to 6 percent
was unusual for two reasons. First, it coincided with
much weaker GNP growth than would have been
expected on the basis of past relationships. Second, it
has not been accompanied by upward pressure on
wages or an acceleration in inflation more generally.
When the unemployment rate fell to 6 percent in the
late 1970s, a rather pronounced upward spiral in wage
and price inflation occurred, a sequence of events that
makes the current situation quite remarkable in contrast.
In this article, we will explore in more detail the cir­
cumstances that have made the current drop in the
unemployment rate less inflationary than it would have
’ Lawrence H. Summers, “Why Is the Unemployment Rate So Very
High near Full Employment?” B rookings P apers on Econom ic
A ctivity, vol. 2 (1986), pp. 339-83.

36FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


been by the standards of the late 1970s.2
The first section reviews the relationship between real
GNP and the unemployment rate. This relationship is
often referred to as Okun’s Law—an econometric esti­
mate of the sensitivity of the unemployment rate to
changes in GNP growth. Okun’s Law has also been
used to calculate the growth of potential GNP consistent
with maintaining a given unemployment rate. The prin­
cipal findings from this section are as follows:
• The extent to which the decline in the unemploy­
ment rate over the past year might be inflationary
is uncertain because the decline has occurred with
considerably weaker GNP growth than past rela­
tionships would suggest.
• Nonetheless, potential GNP calculations based on
Okun’s Law, as well as simple scatter diagrams
showing changes in the inflation rate and the
potential GNP gap (the difference between potential
and actual GNP), suggest that we could be
approaching a point where inflationary pressures
could emerge.
In the second section of this article, we compare
current labor market conditions to those in the late
1970s in an effort to understand why the current drop
in unemployment has not induced a significant accel­
eration in wage inflation. We explore this question by
using the concept of the NAIRU (“nonaccelerating
inflation rate of unemployment”), the level of unem2Throughout this analysis, we have assumed that recent stock market
turbulence and related developments will have only a relatively
small, short effect on nonfinancial business activity.

ployment that is consistent with a stable rate of inflation.
More specifically, we review the changes in the labor
market over the past 10 years that could have shifted
the NAIRU upward or downward at both the aggregate
and disaggregated levels. At the same time, we examine
whether there are any special factors at the disaggre­
gated level that could account for the large error from
Okun’s Law. Our analysis in this section points to the
following conclusions:
• Measures of overall labor market tightness other
than the unemployment rate generally confirm that
the demand for labor is stronger now than it was
in 1977. Since wage inflation has not accelerated,
these indicators suggest that the NAIRU may be
lower than it was in 1977.
• The recent decline in the unemployment rate has
been widespread across regions, industries and
demographic groups, suggesting that the large error
over the past year from the empirical estimates of
Okun’s Law cannot be easily explained by unusual
developm ents in some segm ents of the labor
market.
• At the disaggregated level, some factors imply that
the NAIRU currently might be lower now than in
1977, while others suggest that it could be higher.
Our impressionistic review of both the aggregate
and disaggregated statistics suggests to us that the
NAIRU is lower than in 1977, possibly as much as
a full percentage point lower.
Okun’s Law and unemployment
The decline in the unemployment rate to 6 percent
already in 1987 appears to run counter to Okun’s Law.3
Although the first formulation of this rule of thumb stated
that about 4 percent real GNP growth was necessary
to achieve a stable unemployment rate, most analysts
have subsequently reduced the estimate of necessary
GNP growth to around 2.5 percent to allow for the
changes in productivity, labor force growth and work­
week that have taken place. Over the past year (the
second quarter of 1986 to the second quarter of 1987),
however, the unemployment rate has fallen almost a full
percentage point while GNP has increased at slightly
less than this break-even rate of 2.5 percent. These
developments raise the question whether Okun’s Law—
even in its revised state— has broken down in some
fundamental sense.
The problem can be seen more clearly from Chart 1,
which compares the Congressional Budget Office (CBO)
macroeconomic forecast of August 1986 to the forecast
3A rthur M. Okun, “ Potential GNP: Its M easurem ents and S ignifican ce,”
in Joseph Peckman, ed., Econom ics P olicym aking (C am bridge: MIT
Press, 1983).




made in August 1987.4 Even with the outlook for real
GNP somewhat weaker than the CBO projection of
August 1986, the unemployment rate has already fallen
to 6 percent, attaining that level some three to four
years ahead of the schedule originally predicted by the
CBO.
To quantify the amount of this unexpected decline in
unemployment, we estimated a version of Okun’s
eq u a tio n , draw ing on the w ork of D ouglas M.
Woodham.5 The equation we used, estimated over the
1960-87 period, is shown below:
AU = 0.401 - 0.226Y - 0.159Y (t-1) - 0.0018 time.
(7.8)
(10.0)
(7.1)
(2.6)
R2 = 0.65, D.W. = 1.7, S.E = 0.23,
where AU is the change in the unemployment rate and
Y is the quarterly percent change in real GNP.
♦Congressional B udget O ffice, “ The Econom ic and B udget Outlook:
An U pdate," August 1986 and August 1987.
5Douglas M. Woodham, “ Potential O utput Growth and the Long-Term
Inflation O utlook," this Q uarterly Review, Summer 1984. The theory
behind O kun’s Law is quite straightforw ard. The grow th rate of GNP

C hart 1

C ongressional Budget O ffice Long-Run
Forecasts*
For C alendar Y ears 1986 to 1991
Percent
3 . 5 0 ---------------------------------------------------------------Real GNP
As of
A ugust 1986

1985

1986

1987

1988

1989

1990

1991

♦ C o n g re ssio n a l B u d g e t O ffic e , The E cono m ic and B u d g et
O utlo ok: An U p d a te , A u g u st 1986 and A ugu st 1987.

FRBNY Quarterly Review/Autumn 1987

37

Chart 2 contains the recent errors from this equation
on a four-quarter moving sum basis. Over the past year,
the unem ploym ent rate has declined almost 1 per­
centage point more than would be expected from this
equation. Although this is one of the larger errors for
this equation, it is not totally unprecedented. In 1983,
for example, the unemployment rate declined 2.1 per-

centage points, while the equation predicted a fall of
1.3 percentage points. In a sense, however, a negative
error at this stage of the business cycle (fifth year of
the expansion) should not be all that surprising if one
assumes that the most productive workers are reem­
ployed first, leaving less productive workers to be
employed later in the expansion. This reasoning implies
that a given GNP growth rate would be associated with
larger declines in unemployment as the expansion
continued. It would also suggest (as has been the case
over the past year) that the more rapid decline in the
unemployment rate would be associated with slower
growth in productivity.
In any case, it appears that over time the errors in
this equation, w hether positive or negative, have
become larger, thus limiting the applicability of the
equation to short-run forecasts. Equations relating the
unemployment rate to GNP growth can still be used,
however, to make rough calculations of the long-run
trend in the potential growth rate of GNP.6 The results
of such a calculation are shown in the top panel of

Footnote 5 c on tinued
(Y) is equal to the grow th rates of the labor force (L), the w orkweek
(W), p ro d u c tiv ity (P), and the em ploym ent rate (E). Or, in equation
form : (Y) = (L + W + P) + E. (L + W + P) is usually view ed as
d e term in ing the long-run trend in GNP grow th, often called potential
GNP (PY). E in contrast is view ed as the cyc lic a l com ponent of Y,
and since analysts are often interested in how sensitive the labor
m arket is to changes in GNP grow th, the equation is rewritten as:
E = Y - ( L + W + P). If it is assum ed that L + W + P grows at a fairly
constant rate, L + W + P can be subsum ed into the constant term in
a regression equation. In ad dition, since most analysts tend to focus
more on the unem ploym ent rate (U = 1 - em ploym ent rate) than the
em ploym ent rate, the change in U(a U) is usually substituted for E,
y ieldin g the follow in g regression equation: A U = constant term aY, w here the con stant term is equal to (L + W + P) and the
c o e fficie n t “ a " m easures the sen sitivity of A U to Y. If (L + W + P)
tends to be increasing or d e creasin g over time, then a time trend
w ould also need to be in clud ed, an ap proach we have follow ed in
this article. O ther researchers have allow ed (L + W + P) to shift in
value from c y c le to cycle. To c alcula te potential GNP grow th (PY),
we set the c y c lic a l com pone nt A U equal to zero. The regression
equation is then solved for Y, w hich is the same as PY since the
c yclica l com ponent has been set equal to zero, and we obtain: PY
= 1/a (L + W + P) + b/a (tim e trend), w here " b ” is the estim ated
co e fficie n t on the tim e trend. In the equation we estim ated above, a
lagg ed value of Y was also inclu d e d because the effect on a U from
Y ap peared to be spread over two quarters. In this case, the
calcula tion of PY requires the a d ditiona l step of setting Y = Y ( - 1 ) .

•O ur method of obtaining potential grow th rate estim ates is de scrib e d
in footnote 5. For other ap proa ches to estim ating potential GNR see
C ongressional Budget O ffice, "The Econom ic and B udget Outlook:
An U pdate," August 1987; and Frank de Leeuw and Thomas
Holloway, "The M easurement and S ignificance of the C yclica llyAdjusted Federal B udget and D eficit,” Jo u rn a l o f Money, C redit and
Banking, May 1983, pp. 232-42. For a de tailed analytical
de scription, see Peter K. Clark, "P otential GNP in the U nited States,
1948-80,” Review o f Incom e and Wealth, June 1979, pp. 141-65. For
a brief international com parison that takes the same approa ch used

C hart 2

Errors from Equation Relating Unem ploym ent to GNP
F o u r-Q u a rte r M oving Sum
P e rc e n ta g e po in ts

A

■/ \ I

I \
/ \

I n

_1

A

A

A
\ A
i/

\

/

1

A

\j

\ / v l

i

y

v

11

yvvw

j

It

L
\ n

s
u

V .

\

\n
111111111111111111111111.1.11ii 11111111JjjllJ i u LlllLi i i 1i i i 1Ill hul l ii In ill nl m iii 11in ,Li u lii i lii ill nl nil
1961

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

S haded are a s re p re s e n t p e rio d s of re c e s s io n , as d e fin e d by the N ational B ureau o f E cono m ic R esearch.

38FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


83

84

85

86

87

Chart 3 (see footnote 5 for more details on this cal­
culation) both on a trend basis and a cyclical average
basis. It appears from these rough estim ates that
potential GNP has fallen from around 4 percent in the
early 1960s to around 2.5 percent in the 1980s,
although the process was probably not as smooth as
the trend line in the chart suggests.7 The table in the
lower left corner of the upper part of Chart 3 shows
Footnote 6 c on tinued
here, see Robert S. Gay, "L e a rn in g to Live with ‘Slow ’ Growth,"
E conom ic P erspectives, M organ Stanley, A pril 12,1987.
H 'hese results are ge nera lly consistent w ith other estim ates of
potential GNP grow th. The C ongressional Budget O ffice in the
January 1987 E conom ic a n d B u d g e t Outlook estim ates that potential

Footnote 7 con tinued
GNP has fallen from about 3.5 percent in the 1960s to 2.5 percent
in the 1980s. Data R esources Incorporated in its Summer 1987 issue
of U.S. Long-Term Review puts potential GNP grow th at around
2.3 percent for the 1986-2012 period, down from 3.2 percent over
the 1960-73 period. Robert S. Gay in "Le arn ing to Live with 'Slow'
G row th” estim ates potential GNP grow th at 2.4 percent in the 1980s,
com pared with 3.4 percent over the 1965-73 period. As noted
above, however, the slow dow n in the grow th rate of potential GNP
was probably not as uniform as the sim ulation in this article
suggests; a significa nt part of it probab ly took place in the mid1970s. See W oodham, "P otential O utput G row th"; and Frank de
Leeuw and others, "The H igh-Em ploym ent B udget: New Estimates,
1955 to 1980,” Survey o f C urrent Business, Novem ber 1980,
pp. 13-43. The ap proach used here, w hich estim ates the long-run
trend in potential GNP from an econom etric equation, is very slow to
recognize shorter-run shifts in the trend, p a rticularly any
im provem ent in potential GNP grow th. Hence, these estim ates
should only be view ed as a rough sum m ary of past trends, not as a
good indica tor of future, longer-run developm ents.

C hart 3

Growth in P otential GNP
T rend and C y c lic a l A v e ra g e s *
P erce nt
4.5
C yclica l ave rage
from co m p o n e n ts
o f po te n tia l GNP '

Trend from e q uation

/

4.0

C y c lic a l ave rage
from equation

3.5

3.0

2.5

C om ponents

1961-69

L a bor fo rc e
P ro d u c tiv ity
W o rk w e e k

1.8

P oten tial GNP

%

1970-79
2.5%

1980-87
1.7%

2.4
-0 .3

1.1

1.1

-0 .5

-0 .3

3.7

3.1

2.4

2.0
1960
B illio ns o f 1982 do lla rs
4000
Ratio scale
3500
3000

P otential GNP c y c lic a l
a ve rage fro m com ponents
\
'''" ^ A c tu a l GNP

2500
\
P otential GNP Jrend
fro m equation

2000

1500 l i u l m l m l i i i l 11 1 1 1 1 1 1 1 1 1 1 1 1 1 1 m l m l 111 l l i l L u i l i i l l l l J J , J L l i l U 1 L U 11 i i ! LI 11 11±
1960 61 62 63 64 65 6 6
67 6 8 69 70 71 72 73 74 75 76 77 78 79 80
* T h e tw o re c e s s io n s o f the 1980s w ere c om bined fo r purpose s o f the ca lcu la tio n .
re ce s s io n , as d e fin e d by the N ational Bureau o f E co n o m ic R esearch.




1,1111 11. i i . l i

81

82

83

i h , i ! m i l n i ii.li J
84 85 8 6
87

S haded a reas re p re s e n t p e rio d s of

FRBNY Quarterly Review/Autumn 1987

39

another calculation of potential GNP based on the trend
growth rates of the labor force, the workweek, and
productivity. These calculations are roughly in line with
the results from the equation, suggesting that the
equation can be used to obtain some very general idea
of long-run trends in potential GNP growth.8 Other
researchers have found similar evidence. If we consider
all the evidence (see footnote 7), it appears that the
longer-run growth rate of GNP consistent with stable
prices is about 2.5 percent at this time.
In assessing the outlook for inflation, we still need to
investigate where the economy currently stands relative
to potential output. The bottom panel of Chart 3 com­
pares the actual level of GNP to the potential GNP
shown in the previous chart. It shows the economy
running well above capacity in the mid- to late 1960s
and exceeding its potential once more around 1973,
before the mid-1970s recession brought GNP below
potential again. By the late 1970s, the economy was
at potential; then the two recessions of the early 1980s
brought GNP growth well below capacity. Finally, the
results from the equation suggest that the economy is
now beginning to approach capacity once again. Thus,
it appears that the current situation parallels that of
1977, when the economy was also nearing its potential.
However, at the present time, no acceleration in com­
pensation is apparent.
These observations raise the question, how well has
the difference between potential and actual GNP pre­
dicted the tendency for the inflation rate to accelerate
or decelerate in the past? The upper part of Chart 4
shows a simple scatter diagram linking changes in the
CPI inflation rate to the difference between potential and
actual GNP. Although large errors have occurred, par­
ticularly when wage and price controls were imposed
and removed in the early 1970s, there does appear to
be a loose relationship. Somewhat more interesting is
the result for 1987, which suggests not only that 1987
is turning out more or less as expected, but also that
the economy is just about at the level of operation
where inflation, excluding any special shocks, would be
expected to hold fairly steady, neither accelerating nor
slowing. The lower part of Chart 4 shows that more or
less the same conclusion could be reached by using
the growth of compensation in place of the CPI. (Com­
pensation in 1987 has been increasing less rapidly than
generally expected, but the current operating level of
the economy is quite close to that threshold where wage
pressures could emerge unless the economy operates
at or below the potential rate.) Overall, the results we
•Any rough measure, such as potential GNP, should be used
cautiously. For a detailed explanation, see William Fellner, "The
High-Employment Budget and Potential Output,” S u rv e y o f C urrent
B usiness, November 1982, pp. 26-33.

FRBNY Quarterly Review/Autumn 1987
Digitized40
for FRASER


obtained using potential GNP suggest that further sig­
nificant declines in the unemployment rate or sustained
growth in real GNP considerably above the likely growth
in potential GNP of about 2.5 percent could add to
inflationary pressures.9

Unemployment and inflation
With the economy currently operating at its highest level
relative to potential since the late 1970s (Chart 3), it
is also an appropriate time to compare current labor
market conditions to those in the late 1970s to see
whether the NAIRU has changed appreciably since then.
In other words, if at this point in time, growth in the
economy at about the potential rate would be consistent
with stable inflation, then the current unemployment rate
is probably close to the NAIRU. Establishing a precise
benchmark for the NAIRU in the late 1970s, however,
is not easy, even when econometric techniques are
used, and analysts have produced a wide range of
estimates.
Nevertheless, even an impressionistic appraisal of the
current situation in relation to that of the late 1970s
would suggest the NAIRU has fallen.10 Thus far in the
current cycle, wage growth has not accelerated sub­
stantially since the unemployment rate fell to 6 percent.
When the unemployment rate fell to 6 percent over the
1977-78 period, nonfarm compensation growth accel­
erated sharply (from a cyclical low on a fourth-quarterto-fourth-quarter basis of 7.75 in 1977 to 8.75 percent
in 1978). This suggests that since 1977 the NAIRU may
have fallen from a range of 6.5 to 7 percent to around
6 percent.11 Hence, in this section we will try to identify
•When we checked this result against the simulations from more
formal econometric models of the trade-off between inflation and
unemployment, we reached similar conclusions. The models we
used can be found in A.Stephen Englander and Cornelis A. Los,
"The Stability of the Phillips Curve and Its Implications for the
1980s," Federal Reserve Bank of New York Research Paper 8303,
February 1983; and Flint Brayton and Eileen Mauskopf, "The Federal
Reserve Board MPS Quarterly Model of the U.S. Economy,” in
Econom ic M o d e llin g (Butterworth and Co., July 1985). For an
extensive review of econometric "Phillips Curve” equations, see
Robert J. Gordon, “Inflation, Flexible Exchange Rates, and the
Natural Rate of Unemployment,” in Martin Neil Baily, ed., Workers,
Jobs, a n d Inflation (Washington, DC: Brookings Institute, 1982).
’•Economists have studied the relationship between inflation and the
amount of slack in the labor market for many years without general
agreement on what the exact relationship is or what level of
unemployment is consistent with price stability. For a general
introduction to this issue, see Stuart E. Weiner, “The Natural Rate of
Unemployment: Concepts and Issues,” Federal Reserve Bank of
Kansas City Review, January 1986, pp. 11-24.
11The rapid drop in the unemployment rate from 7.5 percent in the
first quarter of 1977 to 6 percent in the second quarter of 1978
makes it difficult to estimate the NAIRU precisely during that period
because it is likely that not only the level of unemployment matters
for wage pressures but also whether the unemployment rate is
changing gradually or rapidly. Most empirical studies put the NAIRU
in the late 1970s in the 6 to 7 percent range. Similar conclusions

Before we consider the labor market changes that
may have contributed to such a decline, however, we
review some measures of labor market tightness at the
aggregate level to see how their current values compare
with those in 1977. Besides the unemployment rate
(which is about a percentage point lower), the four other
commonly used indicators of labor market tightness
(initial claims for unemployment insurance, discouraged
workers, help wanted advertising, and the length of the
workweek in m anufacturing) suggest that the labor
market now is somewhat tighter than it was in 1977.
Nevertheless, one less commonly used indicator—
involuntary part-time workers as a percent of the labor
force—does suggest some additional slack in the labor
market in 1987 as compared to 1977 (top panel of

those factors responsible for the apparent decline in the
NAIRU.
Footnote 11 con tin u e d
about the NAIRU in the late 1970s were reached in the 1983
E conom ic R eport o f the P resident (pp. 37-38):
W hile it is not easy to p inp oint the threshold unem ploym ent rate
precisely, it p ro b a b ly lies betw een 6 and 7 percent. Econom etric
studies of histo rical data sug gest that when unem ploym ent
is close to 6 pe rcent the rate of inflation tends to accelerate.
For exam ple, du ring 1978 when the unem ploym ent rate was
6 .1 percent, inflation as m easured by percent change in the
gross national p ro d u c t (GNP) d e flator rose to 7.4 percent from
5.8 pe rcent in 1977. An even larg er increase o ccu rred in 1979
w hen the unem ploym ent rate averaged 5.8 percent.
For an e m pirical study that argues NAIRU could have been
7 pe rcent or even som ew hat higher in the late 1970s, see Steven
Braun, “ P rod uctivity and the NIIRU (And Other P hillips Curve
Issues)," W orking Paper N um ber 34, Board of G overnors of Federal
Reserve System, February 1984.

C hart 4

Potential GNP, Inflatio n , and Com pensation
Q ll to Qll of Each Y ear
C hange in the inflatio n r a te *

------__

75
' 7 4 _______ ___

2

79

Hfct
73 8 Q— ____
R egression line plus
1 --------------------------------------------------------------------------------------------------- ~—- — — ______________________ one sta n d a rd e r r o r ________________

7°66

_
®

69

—

64

■--------- ---

----------__ __

81

/_ _ _

■
Dc586

65

~ 8 4 -----R egression line

77
- 85

- 2 -------------------------------------------------------------------------------------------------------- R egression line m in u s -------------------- 7 8 ------ —
________________
one sta n d a rd e rro r
J72_________ |___________ |___________ |___________ |___________ I
83
-

4

-

3

-

2

1
0
1
2
3
4
P o te n tia l less actual GNP as a -percent o f po tentia l (tw o -y e a r ave rage )

C hange in c o m p e n s a tio n g row th rate +

2 ____ 6 8 ------- —

66
—

__________ _________

fL
^

1

7 4 ---------— _____
fi4
7<,
79--------------- _____
80

O'
67
-1 — 6 9 -------------------------------------------------------- —

71

72

7C.

co
78

—___

R e g re ssio n line plus
one bidnu
sta n d a rd e r r o r -

Q0
85

' 8 6 -------

R e g re ssio n line

77

----------------- 63 ---------------------------------- - ===

" 8 7 — 81__ _

82

------ -------

-2

------------------------------------------------------------------------------------------------------------------------------------ -----------------------_ _ _ 7 6 --------------

_3

____________________________________________________________________ R egression line m inus.
one standard e rro r

83 |

- 4 I___________ I___________ I___________ I___________ I___________ I___________ I___________ I___________ I___________ I___________ I___________ I
“ 4
-3
-2
-1
0
1
2
3
4
5
6
7
P o te n tia l less actual GNP as a p e rc e n t of po tentia l (tw o -y e a r ave rage )
* CPI e xclud ing food and e n e rg y .
"I” Nonfarm bu sin ess se cto r.




FRBNY Quarterly Review/Autumn 1987

41

Chart 5). It is not possible to know, however, how much
slack this high level of involuntary part-time workers
represents because the category includes any worker
working less than 35 hours who would like any addi­
tional employment. Many of the part-time employment
opportunities exist in the service industry, and as the
bottom panel of Chart 5 indicates, average weekly hours
in the service sector have been declining, reflecting an
increased use of part-time workers in that sector. This
suggests that the service sector may have the capacity
to grow if weekly working hours are expanded, even if
demographic forces limit the growth of the labor force
groups (women and young people) who traditionally
have been employed in this sector.
A rough measure of the importance of this relatively
high level of involuntary part-time employment can be
calculated by assuming that these additional involuntary
part-time workers are currently employed about one-half
of a normal workweek. Then, if the involuntary part-time
employment was to fall back to its 1977 level as these
workers took full-time jobs, it would be equivalent to
expanding total hours by about one-half of 1 percent.
Hence, effective employment and output could rise
without lowering the unemployment rate or creating

C hart 5

Involuntary Part-Tim e Employment as a
Share of the Civilian Labor Force and
Average W eekly Hours in Service Sector
P e rc e n t

Involuntary p a rt-tim e em ploym e nt
as a sha re of the c iv ilia n la b o r fo rc e

r\
/

r

\

^

llT r t ^ r r r r m illllllllllllllllllllllllllllllllllllllllllll l l l l ll l l l l l l ll l l l l l l l ll l l l
1967 69
71
73
75
77
79
81
83
85
87
A vera ge w e e k ly h o urs
A verage w eekly ho urs in s e rv ic e se cto r
3 5 --------------------------------------------------------------------34

33-----------------

------------------

inflationary pressures. The assumptions behind this
calculation are, of course, quite tenuous, and require
that the involuntary part-time employed workers would
in fact work more hours at the current wage rates.
Overall, the aggregate labor market statistics suggest
that the demand for labor is stronger than in 1977.
These statistics also appear to indicate that the NAIRU
has shifted down, because wages have not accelerated
significantly as they did when the unemployment rate
fell to 6 percent in the late 1970s.
In the remainder of this section we make various
comparisons of 1977 and 1987 at the disaggregated
level to see if we can identify the reasons for the
apparent downward shift in the NAIRU from a range of
6.5 to 7 percent in the late 1970s to around 6 percent
currently. We also investigate whether special devel­
opments in any segment of the labor market may help
to account for the recent instability in Okun’s Law.
In exploring these questions, we focus on demo­
graphic, industrial and regional statistics. Developments
in these labor markets could potentially affect the
NAIRU in many different ways. For example, members
of different age and sex cohorts experience different
frictional unemployment rates because they differ in their
turnover frequencies and in their average unemployment
durations. Or, from another perspective, changes in the
composition of aggregate demand, and hence in the
sources of the demand for labor, can affect the level of
structural unemployment if workers have relatively lim­
ited mobility across industries and regions.12
Demographic trends
Changes in demographics since 1977 have both favor­
able and unfavorable implications for the inflation out­
look. Unemployment rates for young people are quite
low and labor force participation rates both overall and
for women in particular are very high compared to the
situation prevailing in 1977. Both developments suggest
possible wage pressures, especially at the entry level
and in the service sector. On the other hand, the labor
force is growing older, suggesting that the average
worker is experiencing less turnover and higher pro­
ductivity. Moreover, prime-age males are experiencing
relatively high unemployment for this stage of the cycle.
These factors could help contain inflationary pressures,
particularly if employment growth becomes more bal­
anced over time as the manufacturing sector grows
more rapidly and service-sector growth slows. In what

n r l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l l i i l l l [ l l l l l l l llllll,lllJ

1967

69

71

73

75

77

79

81

83

S ource: Bureau o f L a bor S ta tis tic s .

FRBNY Quarterly Review/Autumn 1987
Digitized 42
for FRASER


85

87

12For a general overview of the theoretical and em pirical evidence
relating to the NAIRU, see David Laidler and J. Michael Parkin,
"In flation: A Survey,” Econom ic Journal, vol. 85 (D ecem ber 1975),
pp. 741-809.

follows, we briefly review these trends and determine
how pervasive the recent decline in unemployment has
been across demographic categories.
The breakdown of unemployment rates by age in
Table 1 reveals that, for almost all age cohorts, unem­
ployment rates have declined over the past year and
are now below their 1977 levels. Because the decline
in unemployment over the past year is widespread
across all groups, we cannot point to any specific
developments in age categories that would account for
the unexpected sharpness of the drop in the aggregate
unemployment rate. This conclusion also holds when the
unemployment rate is disaggregated by sex.
The disaggregation by gender also shows that the
burden of unemployment is today more evenly distrib­
uted across gender. The aggregate unemployment rate
for men is only slightly below the level prevailing in
1977, and the unemployment rate for prime-age men
remains above its 1977 level. The unemployment rates
for females in every age category are considerably
lower than in 1977. The first development may reflect
the slow growth of manufacturing jobs—jobs which men
have tra d itio n a lly held; the second re fle c ts the
increasing strength of the service sector, which employs
many women. In addition, the teenage labor market has
become increasingly tight, with unemployment rates
dropping to cyclical lows, the teenage labor force
growing slowly, and teenage workers constituting an
increasingly smaller portion of the labor force as a
whole (Tables 1 and 2). These developments, combined
with the lower unemployment rates for women, suggest
that wage pressures could emerge for workers at the

Table 2

Labor Force Trends
Percent of Labor Force by Age and Sex
Age

1970

1977

8.8

9.5
15.0
45.7
29.8

45.2
35.5

1970

1977

1987*

60.4
79.7
43.4

62.3
77.6
48.4

65.3
76.3
55.9

1970-75

1975-80

1980-86

Both sexes, 16 and over

2.5

2.7

1 .6

Men
16 to 24
25 to 54
55 and over

1.9
4.9
1.7

1 .8

1.1

1.9
2 .0

0 .8

0.4

-1 .7
2.3
-0 .7

3.5
4.8
3.7

4.0
2.7
5.0
1.9

Both sexes, 16 to 19
Both sexes, 20 to 24
Men, 25 and over
Women, 25 and over

12.8

50.2
28.3

1987*
6.7
12.6

Civilian Labor-Force Participation Ratea

Both sexes
Men
Women

Civilian Labor Force by Age and Sex
(Average Annual Rate of Change)

-

Women
16 to 24
25 to 54
55 and over

0 .6

2.4
-

0 .8

3.9
0.7

•January-S eptem ber average
Source: Bureau of Labor S tatistics

Table 1

Unemployment Rates by Age and Sex
(In Percent)

Both sexes, 16 and over
Men,
16
20
25
55

16 and over
to 19
to 24
to 54
and over

Women, 16 and over
16 to 19
20 to 24
25 to 54
55 and over

1977

1982-IV

1986-11

1987-111

C hange
since 1982-IV

7.1

10.7

7.1

6 .0

-4 .7

-

5.9
16.9
9.5
4.8
3.3

-5 .2
-8 .5
-8 .4
-4 .4
-2 .5

- 1.1
-3 .3
- 1.8
- 0 .8
-0 .7

6 .1

-4 .1
-7 .4
-4 .9
-3 .6
- 2 .0

- 1 .2
-3 .3
- 1 .2
- 1 .0
-0 .5

6.3
17.3

1 1. 1

7.0

25.4
17.8
9.2
5.9

20.2

8 .2

10.1

18.3
10.9
6.4
4.6

22.3
14.2
8.5
5.0

7.2
18.3
10.5

10.8

4.3
3.9

11.3
5.6
4.0

6.0

3.5

14.9
9.3
5.0
3.1

C hange
since 1986-11

1.2

Source: Bureau of Labor S tatistics




FRBNY Quarterly Review/Autumn 1987

43

entry level and in the service sector.
Other demographic trends that might put upward
pressure on wages are evident in Table 2. The center
panel shows that the total labor force participation rate
and the participation rate for women are at very high
levels by historical standards. Hence, labor force growth
generally is not expected to be nearly as rapid as in
the 1970s when a large number of people entered the
labor market. As a result, further increases in labor
supply, particularly in the service sector, are likely to
occur only if higher wages are offered.
Currently, young people who entered the labor force
in the 1970s are moving into their most productive years
(top panel of Table 2). Over 80 percent of the labor
force is currently over age 25, as compared to around
75 percent in 1977. Their higher productivity potential
and lower turnover rates could offset at least in part
the inflationary consequences of the slower labor force
growth cited above. In addition, one potentially highproductivity cohort—prime-age men—still has a relatively
high unem ploym ent rate (Table 1). If future labor
demand is concentrated in manufacturing and other
sectors that employ this cohort, wage inflation will be
less severe than if those sectors that primarily employ
women and young people grow more rapidly.
The unemployment rate for prime-age men (currently
4.8 percent) could perhaps fall to around its 1977 level
(4.3 percent) without creating additional wage pressure.
Since this cohort constitutes two-fifths of the total labor
force, such a decline in this group’s unemployment
might reduce the aggregate unemployment rate by
0.2 percentage point without additional inflationary
pressures.
In general, the implications of many of these demo­
graphic factors for the NAIRU cannot be precisely cal­
culated. In the past, economists have tried to control
for a limited number of demographic influences on the
unemployment rate by constructing the hypothetical
unemployment rates that would have been observed if
the relative labor force shares of different population
subgroups (with different frictional unemployment rates)
had remained constant at some given point in time.13
In Chart 6, we constructed a weighted unemployment
rate using the labor market shares as of 1967.14
The actual rate rose above the weighted rate during
the 1970s. This increase was due to the rising teenage
13This notion was first introduce d by G eorge L. Perry, "C ha nging
Labor Markets and Inflation," Brookings Papers on Econom ic
A ctivity , vol. 3 (1970), pp. 411-41. For recent estim ates that are
based on the same approa ch as the one used in this article, see
Mark Zandi, "W age Inflation: Myth or Reality,” U.S. Econom ic
Outlook, W harton E conom etric Forecasting Services, Novem ber
1987.
14The labor force was separated by sex and by the follow ing age
groups: 16-19, 20-24, 25-54, and 55 and over.

44FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


ana female shares of the labor force at a time when
these cohorts experienced relatively high unemployment
rates. In the 1980s, the actual rate and the weighted
rate have been about the same because of the reduced
numbers of young workers and the lower unemployment
rate for women. The recent convergence of the female
and male unemployment rates implies that further
increases in the female labor force share should no
longer necessarily raise the actual unemployment rate
relative to the weighted rate. In the 1970s, the obser­
vation that the measured unemployment rate had risen
above the weighted rate formed the basis of the argu­
ment that the NAIRU was higher than what it was in
the 1960s. The same logic today would suggest that,
all other things equal, the NAIRU has returned to the
same level as in the 1960s.15 By our calculations, it
appears that demographic factors could have reduced
the NAIRU from its 1977 level by as much as 0.5 per­
centage point.16
15For more detail along these d e m ograph ic lines, see C ongressional
B udget O ffice, "E conom ic and B udget O utlo ok” ; see also Lawrence
H. Summers, “ Why is the U nem ploym ent Rate So Very H igh?" for
estim ates of the im pacts other attribute s of the labor force m ight
have on the unem ploym ent rate.
16Using a sim ilar ap proach, the C ongressional B udget O ffice estim ates
that the NAIRU has fallen 0.3 percentage point since 1977. For more
detail, see "The Econom ic and B udget Outlook: An U pdate,” A ugust
1987.

C hart

6

A ctual versus "1 9 6 7 -w e ig h te d ”
Unem ploym ent R a te s *
P erce nt
12

10

A
U \

A ctual
Av

/}

\

8

J\

6

£

■

A

r

^

19 67-w e ighte d

/

o lllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllllll
1967

69

71

73

75

77

79

81

83

85

87

* The w eig h te d unem ploym ent rate is the un em plo ym en t ra te
that w ould have re s u lte d if ea ch age and g e n d e r g ro u p had
m aintained the sam e sha re of th e labor fo rc e as in 1967.

Industry trends
Recent unemployment rates disaggregated by industry
are shown in Table 3. As was the case with the demo­
graphic breakdowns, the recent decline in the unem­
ployment rate has been widespread across industries,
again ruling out unusual sectoral reasons for the decline
in the aggregate unemployment rate.17 This breakdown
of the labor market statistics also shows that all indus­
tries have unemployment rates less than their 1977
levels. The rates for finance, insurance and real estate
(FIRE) and services, government, and nondurable
manufacturing have even gone below their cyclical lows,
attained in 1978.
The low unemployment in FIRE and services reflects
in part the rapid growth in jobs in those sectors. Since
1979, employment in FIRE and services has increased
at an average rate of 4.5 percent. In contrast, employ­
ment in durable and nondurable manufacturing has
declined at average rates of 1.6 and 0.6 percent,
respectively. These variations suggest that the ability of
the economy to expand further without inflation now
depends in part upon the industrial composition of future
growth. Imbalanced employment growth across indus­
tries will raise structural unemployment because workers
have only limited ability to move from one industry to
another. Although most of the job creation during the
current expansion has been in the service sector,
manufacturing employment has been quite strong thus
far this year. Moreover, many analysts predict that the
weaker dollar will further stim ulate manufacturing
17An unem ployed w orker's “ in d u s try ” refers to the industry in w hich
the w orker was m ost recently em ployed, even if that worker had
been em ployed in a d iffe ren t indu stry for a longer period of time.

exports. If the manufacturing sector should expand more
rapidly while the service sector slows, the more bal­
anced growth could be a factor contributing to a lower
NAIRU. Up to this point in the expansion, however, the
imbalanced growth across sectors has probably raised
the NAIRU.18
The NAIRU could also be affected by the pattern of
real wages in recent years. Since 1977 real wages have
fallen in all industries except FIRE and services, where
they rose on average 0.4 percent per year. Real wages
in manufacturing have fallen 6.7 percent since 1977,
after rising 8.2 percent over the 1970-78 period. Simi­
larly, the real minimum wage has fallen 22 percent since
1979, and the differential between manufacturing and
service sector wages has narrowed 24 percent since
1978.
These trends in wages could put both upward and
downward pressure on the NAIRU, but we suspect that
the net effect has been downward. The decline in real
wages in manufacturing should lower the NAIRU, all
other things equal, because it should increase the
number of workers that can be employed without raising
product prices. At the same time, a long period of
losses in real wages could make manufacturing workers
more militant if they try to recover previous wage losses
as the labor market tightens. However, awareness of
increased foreign competition and concern about job
18The em pirical relationship between structural unem ploym ent and the
dispersion of em ploym ent grow th across industries has been
explored by David Lilien, ‘‘Sectoral Shifts and Structural
Unem ploym ent,” Jou rnal o f P olitical Economy, August 1982, pp. 77793; and by Katherine A braham and Lawrence Katz, "C yclica l
Unem ploym ent: Sectoral Shifts or A ggregate D isturbances,” Jou rnal
o f P olitical Economy, June 1986, pp. 507-22.

Table 3

Unemployment Rates by Industry
(In Percent)

C onstruction
M anufacturing
D urables
N ondurables
Transportation and
p u b lic utilities
W holesale and retail
FIRE* and services
G overnm ent
A gricultu re

1977

1982-IV

1986-11

1987-111

Change
since 1982-IV

C hange
since 1986-11

12.5
6.7

21.9
14.2
16.1
11.4

12.6

11.3
5.7
5.7
5.8

- 1 0.6
- 8.5
- 1 0 .4
- 5.6

- 1 .2
-1 .4
-1 .3
-1 .5

4.7

7.9

8 .0

10.6

6 .0

7.6
5.1
4.8

5.4
7.8
5.6
3.6
14.0

-

- 1 .2
- 1.1
-0 .7

6 .2

7.4

4.2
11.2

7.2
7.1
7.3

4.2
6.7
4.9
3.6
10.1

3.7
3.9
2.7
1.5
4.9

0 .0

-3 .8

‘ Finance, Insurance, and Real Estate
Source: Bureau of Labor S tatistics




FRBNY Quarterly Review/Autumn 1987

45

security may reduce the wage demands of workers even
in a tight labor market. The decline in union represen­
tation since 1977 (from 23.5 percent of the labor force
to 16.5 percent) might also play a moderating role. The
fall in the real minimum wage should help lower the
NAIRU because it gives employers more flexibility in
hiring marginal workers. Finally, the narrowing of the
spread between m anufacturing and service sector
wages should also reduce the NAIRU because it is likely
to increase labor mobility across industries.
Some implications of these changes in real wages for
the NAIRU can be roughly measured. The decline in
the real minimum wage could have reduced the NAIRU
by about 0.2 percentage point, while the decline in
unionization could have reduced it by roughly 1 per­
centage point.19 But we were unable to find previous
1#The estim ated effe ct on the total NAIRU for the de clin e in the

Footnote 19 continued
minimum wage is based on estim ates of how much teenage
unem ploym ent w ould be affected by changes in minim um w age. The
effect on the total NAIRU is small, of course, because teenagers are
a small fraction of the labor force. For more detail, see Howard
Wachtel, Labor an d the Econom y (Orlando, Florida: A cade m ic Press,
1984), p. 470. We are not aware of any em pirical studies of the
im pact of unionization on the total unem ploym ent rate or on the
NAIRU. Workers in the relatively high-paying union sector are more
likely to remain unem ployed longer because they hope to be
recalled to their form er jobs or because they search longer for other
union jobs— such behavior would raise the NAIRU as unionization
increases. We based our estim ates on results derived from interstate
com parisons. For more detail, see Summers, “ Why is the
Unem ploym ent Rate So Very H igh?"; and Robert T. McGee, "S tate
U nem ploym ent Rates: What Explains the D ifferences," this Q uarterly
Review, S pring 1985, pp. 28-35. There are some d ifficu ltie s in using
interstate estim ates to calcula te w hat the effects m ight be at the
a g gregate level, and these results should be interpreted cautiously.
For exam ple, interstate estim ates are likely to cap ture not only the
effects of unionization on the NAIRU m entioned above but also the
effects of unionization on the location decisions of em ployers. At the
a g gregate level, of course, the effects of location decisio ns on
unem ploym ent would cancel out. H ence, the 1 percentage point
estim ate presented here should be view ed as an u p per limit.

Table 4

Unemployment Rates by Region
(In Percent)

CLF*

1977

1982-IV

1986-11

1987-111

C hange
since 1982-IV

C hange
since 1986-11

5.7

7.7

7.2

4.2

2.9

- 4 .3

-1 .3

15.2

8.7

9.9

6.5

4.7

-5 .2

-

17.4

6.5

13.5

8 .0

6 .6

-6 .9

-1 .4

7.5

4.8

8 .1

5.6

4.9

-3 .2

-0 .7

17.0

7.0

9.2

5.7

5.7

-3 .5

0 .0

6 .0

6.4

13.0

9.4

7.6

-5 .4

10.9

5.7

8.5

9.9

8.5

0 .0

5.4

6.7

9.3

7.7

6.5

-2 .7

-

1 .2

15.0

8 .2

10.9
10.7

6 .8

5.7

-5 .2

-

1 .1

7.1

5.9

-4 .8

-

1 .2

New England
(C onnecticut, Maine, M assachusetts,
New H am pshire, Rhode Island, Vermont)

Middle Atlantic
(New Jersey, New York, Pennsylvania)

1 .8

East North Central
(Illinois, Indiana, M ichigan, Ohio,
W isconsin)

West North Central
(Iowa, Kansas, M innesota, M issouri,
N ebraska, North Dakota, South Dakota)

South Atlantic
(Delaw are, Florida, G eorgia, M aryland,
North C arolina, South C arolina, V irginia,
West V irginia, D istrict of C olum bia)

East South Central
(A labam a, Kentucky, M ississippi,
Tennessee)

-

1 .8

West South Central
(Arkansas, Louisiana, O klahom a, Texas)

-1 .4

Mountain
(Arizona, C olorado, Idaho, Montana,
N evada, New M exico, Utah, W yom ing)

Pacific
(Alaska, C alifornia, H awaii, O regon,
W ashington)

National unemployment rate
'P ercen t of U.S. C ivilian Labor Force.
Source: Bureau of Labor S tatistics

46FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


7.1

studies that would provide a basis for estimating how
much the fall in real manufacturing wages might affect
the NAIRU or how much shrinking wage differentials
across sectors might increase labor mobility.
Regional trends
Like the demographic and industrial unemployment
rates, the regional unemployment rates (Table 4) sug­
gest that the decline in unemployment over the past
year at the national level has been widespread. There­
fore, none of the disaggregated data can help to explain
the large error that emerges in tracking the total
unemployment rate with a conventional econometric
estimate of Okun’s Law. In other words, the recent
decline in the unemployment rate has not been con­
centrated in one or two specific components.
Over the longer run, the regional data also capture
the imbalanced nature of the current recovery that we
noted earlier for industries. The New England, Middle
Atlantic and Pacific regions are experiencing unem­
ployment rates below the 6 percent national average.
These regions have almost half the U.S. labor force.
In 1977, all the regional unemployment rates were
contained in a spread from 4.8 to 8.7 percent. Currently,
the range is about o n e -th ird larger, from 2.9 to
8.5 percent.
This disparity could have some implications for the
NAIRU. The level of structural unemployment is likely
to increase with the amount of regional imbalance
because workers cannot readily move from one geo­
graphic area to another.20 Examining the highest and
lowest rates—the procedure we followed earlier— is
clearly not an entirely adequate way of judging the
overall regional imbalance in unemployment. A more
comprehensive measure of imbalance is shown in
Chart 7. This variable is the weighted standard deviation
of annual state unemployment rates, in which each
unemployment rate is weighted by each state’s annual
share of the U.S. labor force. It appears from this
measure that the current recovery has been quite
imbalanced, and regional imbalance could, therefore, be
a factor increasing the NAIRU.21 The effect relative to
1977 could be fairly large because the current level of
“ For a discussion of the theoretical relationship between regional
unem ploym ent and aggreg ate unem ploym ent, supplem ented with
em pirical evidence for the United Kingdom , see G. C. A rchibald,
“ The P hillips Curve and the D istribution of Unem ploym ent,”
Am erican E conom ic Review, May 1969 (Papers and P roceedings of
the 1968 Annual Meeting of the Am erican Economic A ssociation),
pp. 124-34.
21Katherine Abraham suggests that the upward drift in regional
unem ploym ent dispersion between 1960 and 1985 may explain the
increase over that period in the ratio of job vacancies to
unem ploym ent. For more detail see Katherine Abraham , “ Help
Wanted A dvertising, Job Vacancies, and Unem ploym ent,” B rookings
Papers on Econom ic A ctivity, vol. 1 (1987), pp. 207-43.




unemployment rate dispersion is about 25 percent
above the 1977 level and has been increasing over the
last two years.
Conclusion
We have reviewed several factors that could be affecting
the trade-off between unemployment and inflation. Most
of our comparisons have been relative to 1977, a year
when compensation growth reached a cyclical low and
began to accelerate. It appears that since 1977 some
developments have taken place that could have raised
the NAIRU—the unemployment rate at which inflation
tends to remain stable— as well as some that could have
lowered the NAIRU. We were able to quantify certain
factors that could have lowered the NAIRU by as much
as 2 percentage points (demographics, minimum wage,
and unionization). However, it was not possible to
quantify the impacts of some other factors that could
have raised the NAIRU, such as regional and industrial
imbalance in the current expansion. Overall, our findings
suggest that the NAIRU has shifted downward from the
6.5 to 7.0 percent range in the late 1970s to about
6 percent at present, although we will not know with
confidence what the NAIRU is in the current cycle until
we actually see firm evidence of upward movements in

C hart 7

Unem ploym ent Rate Dispersion
across S ta te s *
P erce ntag e p o in ts
2 . 4 ---------------------------------------------------------------------

1971

73

75

77

79

81

83

85

87

* T h e d isp e rsio n m easure is the w e ig h te d standard
de via tio n o f annual s ta te unem ploym ent ra tes, in w hich
ea ch unem ploym ent rate is w eig h te d by each s ta te ’s
annual s h a re o f the U.S. labo r fo rce .

FRBNY Quarterly Review/Autumn 1987

47

wages.22 The various factors affecting the NAIRU that
we have analyzed here will, of course, continue to
change over time, and NAIRU will also change as a
result.
Interpreting the NAIRU in the current environment is
also complicated by the consideration that wage pres­
sures are likely to develop differently than in the past.
**ln looking at this question, some analysts have reached more
optimistic conclusions; others, more pessimistic conclusions. For a
more optimistic point of view, see "Economic Watch; A Shift Towards
Strength?” M o rg a n E co nom ic Q u arterly, September 1987. A more
pessimistic outlook is presented in Richard Berner and Jerry
Pedgen, “Inflation Prospects for 1987-88,” Salomon Brothers,
July 29, 1987.

Digitized for
48 FRASER
FRBNY Quarterly Review/Autumn 1987


Historically, wage pressures emerged first in the man­
ufacturing sector and subsequently spread throughout
the economy. Now, however, with the demand for labor
in the manufacturing sector remaining quite low until
recently, wages are more likely to begin moving grad­
ually upward in response to very tight labor markets in
some regions and in many service-producing industries.
Such a process will most likely make it more difficult
to detect emerging inflationary pressures.

Richard Cantor
John Wenninger

(This report was released to Congress
and to the press on September 3, 1987)

Treasury and Federal Reserve
Foreign Exchange Operations
M a y - J u ly

1 9 8 7

Early in May, the dollar moved down against major for­
eign currencies, continuing a trend that had prevailed
throughout the year. But during the rest of the threemonth period ending in July, the dollar first stabilized
and then advanced modestly to close up 6 V2 percent
against the Japanese yen and roughly 4 percent against
the German mark and other European currencies. The
U.S. authorities intervened in the market during three
episodes in the period.
As the May-July period opened, many market partic­
ipants were not yet convinced that the authorities of the
major industrialized countries were committed to
exchange rate stability. To be sure, statements by both
U.S. and Japanese officials during preceding weeks had
been interpreted as indicating a genuine concern about
the effects of further sharp downward movements in
dollar rates and a willingness to cooperate closely to
foster exchange rate stability. Nevertheless, traders were
disappointed that, after the dollar’s 21/ 2-year decline,
progress in diminishing the world’s external imbalances
was so slow. They were mindful of the intense political
pressure in the United States over trade issues and
wary that there might be new calls for a lower dollar.
They were concerned that any further exchange rate
decline might add to domestic inflation. They noted, as
well, that a decline in U.S. final domestic demand was
reported in the first quarter GNP data. Consequently,
many market participants remained skeptical that the
A report presented by Sam Y. Cross, Executive Vice President in
charge of the Foreign Group at the Federal Reserve Bank of New
York and Manager of Foreign Operations for the System Open
Market Account. Christopher Rude was primarily responsible for
preparation of the report.




authorities would attach a high enough priority to
exchange rate stability to alter domestic economic pol­
icies if necessary.
Thus, traders retained their bearish attitude toward the
dollar, even though they were aware that the authorities
of the Group of Seven (G-7) industrial nations had
intervened to purchase dollars in substantial amounts
since late March. There was skepticism that private
investors, already experiencing substantial exchange
rate losses on their dollar portfolios, would continue to
place funds in the United States. Although long-term
interest rate differentials favoring dollar assets were at
their highest levels since the dollar was at its peak in
1985, market participants questioned whether this
interest rate advantage would prove sufficient to induce
heavy participation by Japanese and other investors in
the U.S. Treasury’s refunding operation early in May.
The dollar, therefore, continued to decline during the first
week of May. It moved down to DM 1.7590, its lowest
level against the mark in nearly seven years. Against
the yen, it eased back to Y 137.95, not far above the
40-year low touched just weeks before.
In these circumstances, the U.S. authorities entered
the market in early May, in keeping with the February
Paris and April Washington agreements, to contain the
intense selling pressure on the dollar. On the first
two business days of May, the Desk purchased $140
million against marks and $20 million against yen in
the first intervention episode of the period under
review.
Meanwhile, market participants had taken note of
comments made by Chairman Volcker and by Japanese
Prime Minister Nakasone in late April, indicating that

FRBNY Quarterly Review/Autumn 1987

49

the central banks of the two countries were willing to
adjust their monetary policies in a way that would lend
support to the dollar. Mr. Nakasone announced that the
Bank of Japan would act to ease short-term interest
rates. Mr. Volcker stated that the Federal Reserve had
“ snugged up” monetary policy in light of the exchange
rate pressure. Short-term interest rate differentials had
already widened in favor of the dollar even before these
comments, as U.S. market rates responded to growing
inflation concerns. But when U.S. interest rates con­
tinued to firm and these differentials continued to
expand in May, market participants came increasingly
to see the industrialized countries as committed to
exchange rate stability.
At the same time, some of the markets’ worst fears
proved to be unfounded. It soon became clear that
Japanese institutions had, in fact, made sizable bond
purchases at the May Treasury refunding. Reports that
the U.S. unemployment rate had fallen to 6.3 percent
in April and that producer prices had increased sharply
by 0.7 percent for the same month were seen as giving
the U.S. monetary authorities both more room and a
greater need to tighten policy. Meanwhile, officials in
Japan indicated that they were willing to guide money
market rates lower. Also, the Bundesbank lowered the
minimum rate on its repurchase agreem ents and

reduced the lower limit for money market rates by cut­
ting the rate at which it stood ready to sell three-day
Treasury bills. These actions were interpreted by the
markets as indicating that the German authorities were
willing to join the Japanese and U.S. central banks in
adjusting monetary policies to foster exchange rate
stability.
Other developments also helped to reduce selling
pressures against the dollar. After Japanese authorities
urged financial institutions in Japan to refrain from
speculative dollar sales and required these institutions
to report their foreign exchange positions much more
frequently, traders in Tokyo became reluctant to make
sizable dollar sales. Later in May, the prospect for
greater economic policy convergence improved when
Japan’s Parliament finally approved the budget for the
fiscal year ending March 1988, paving the way for an
extraordinary parliamentary session during the summer
to draw up a supplementary budget aimed at expanding
domestic demand. Then, following reports of an attack
on a U.S. naval vessel in the Persian Gulf, the dollar
also began to derive some benefit from the view that
a disruption in oil supplies would be relatively less det­
rim ental to the United States than to many other
developed countries. In response to these develop­
ments, the dollar gradually moved up from its early May

C hart 1-A

C hart 1-B

Dollar exchange rates stabilized after
mid May . . .

to close the three-m onth period under
review up m oderately.

P e rc e n t*
10

P e rc e n t*
— -------------------------------

4 _—

-1 0

-20

Ja p a n e se yenj

\

/

/Pound s te r lin g -----------

w

-4 0

--------------------------------------------- \ — >

1985

1986

1987

-1 0 L

l

I

I

Feb

I

I

I

I

M ar

I

I

I

I

I

I

I

A pr

I

I

M ay

I

I

I

I

Jun

I

I

I

I

I

I

Jul

1987
* P e rc e n ta g e change of m onthly average rates fo r dollars
from the ave rage fo r the month of February 1985. All
fig u re s are calculated from New Y ork noon quotations.

50FRASER
FRBNY Quarterly Review/Autumn 1987
Digitized for


^P e rc e n ta g e change of w e e k ly a ve ra g e rates fo r d o lla rs
from th e w e e k en ding Ja n u a ry 30. All fig u re s are
c a lc u la te d fro m New Y ork noon q u o ta tio n s.

I

lows to trade at DM 1.7830 and at Y 140.40 on May 18.
The underlying market sentiment toward the dollar
remained cautious, however, and the dollar was still
vulnerable to potentially adverse news. In fact, two
episodes did occur between mid-May and early June
that temporarily precipitated renewed bouts of selling
pressure against the dollar. The first occurred on May
19 when a major U.S. money-center bank announced
a restructuring of its capital and loan-loss reserves that
would imply a substantial reported loss for the second
quarter. The second episode occurred on June 2 fol­
lowing the announcement that Paul Volcker would not
serve a third term as Chairman of the Federal Reserve.
In both episodes the U.S. authorities intervened to blunt
the selling pressures. In the first, the Desk purchased
a total of $133 million against the mark, partly in New
York and partly in Pacific markets in coordination with
the Bank of Japan. In the second, the Desk purchased
a total of $410 million against marks along with $103
million against yen in New York and the Far East. This
latter operation was undertaken in cooperation with the
Bundesbank, the Bank of France, the Bank of Italy, and
the Bank of Japan. In both episodes, the intervention
operations helped reassure market participants, and the
dollar promptly moved up to levels higher than had
prevailed beforehand. Market participants began to feel
that the dollar was regaining notable resiliency.

In m id-June, at the tim e of the Venice sum m it
meeting, the leaders of the G-7 industrial nations reaf­
firmed the earlier Paris and Washington agreements with
respect to exchange rates. Moreover, the communique
announced a plan for enhanced multilateral surveillance,
including more extensive use of medium-term economic
objectives and interim performance indicators. The call
for im proved surve illa n ce , though seen by some
observers as a sign that international economic policy
cooperation would increase in the future, left market
participants initially disappointed that no concrete ini­
tiatives to support the dollar were forthcoming. But the
dollar softened only temporarily during the meeting,
subsequently reversing the decline without intervention
support.
By late June, traders were becoming increasingly
impressed with the resilience that the dollar had shown
to adverse news in the preceding weeks. In addition,
the dollar began to benefit from the release of several
economic statistics and other evidence suggesting a
better-than-expected performance for the U.S. economy.
During the course of the summer, anecdotal reports of
rising export volumes gave market participants a basis
for seeing the external sector as a growing source of
demand. Preliminary estimates of the GNP data for the
second quarter released in mid-July, indicating that the

C hart 2

Short-term interest rates moved higher in
the United States in May while declining
somewhat further abroad.

Table 1

Federal Reserve Reciprocal Currency
Arrangements

P erce nt

In M illions of D ollars

8 --------Am ount of Facility

Institution
A ustrian N ational Bank
National Bank of B elgium
Bank of C anada
National Bank of D enm ark
Bank of England
Bank of France
G erm an Federal Bank
Bank of Italy
Bank of Japan
Bank of M exico
N etherlands Bank
Bank of Norway
Bank of Sweden
Swiss N ational Bank
Bank fo r International Settlem ents:
Dollars against Swiss francs
Dollars against other
authorized European currencie s
Total




July 31, 1987
250
1 ,0 0 0
2 ,0 0 0

250
3,000
2 ,0 0 0
6 ,0 0 0

3,000
5,000
700
500
250
300
4,000
600
1,250
30,100

3I—L. I l I I I I I I I I I I I I l I I I I I .1 .1 .1—1 U
Feb

M ar

A pr

May

Jun

Jul

1987
The cha rt show s w e e kly a ve rage rates on three-m onth
E u ro -d e p o s its denom inated in dollars, German m arks, and
Japanese yen.

FRBNY Quarterly Review/Autumn 1987

51

change in the level of net exports was positive for the
third consecutive quarter, seemed to confirm this view.
Under these circumstances, the market showed only
short-lived disappointment when, in the middle of July,
the U.S. trade figures showed a modest widening in the
deficit to $14.4 billion in May after having declined in
March and April. Indeed, this was yet another occasion
when selling pressure against the dollar was quickly
shaken off.
By contrast, market participants were becoming dis­
appointed about the economic outlook for many of the
United States’ trading partners. Although there were
some indications that the Japanese economy was
beginning to recover from the depressing effects of the
yen’s earlier rise, news in Germany that manufacturing
orders and retail sales had declined in May and that
unemployment remained high underscored market views
about the underlying weakness of the economy there.
Even in the United Kingdom, the European country with
the most optimistic outlook just a few months before,
a series of disappointing statistics tended to suggest
that the economy was beginning to overheat and raised
questions in the market about the near-term outlook for
sterling-denominated bonds and stocks.
Against this background, market participants began
to buy back dollars previously sold. Reports of increased
corporate demand ahead of the quarter end, buying by
Japanese investors to reduce hedges on U.S. invest­
ments, and renewed investor interest in U.S. securities
circulated in the market. Meanwhile, rising tensions in
the Persian Gulf and talk of large dollar purchases from
the Middle East tended to strengthen the dollar’s role
as a store of value and currency of choice for flight
capital at times of political uncertainty.
Thus, the dollar moved up steadily for several weeks
after mid-June and then firmed within a fairly narrow
range for the rest of the period under review. The more
stable dollar, together with the receding of inflationary
fears following a report of a slowdown in producer price

inflation for May, gave a lift to U.S. bond prices and
led to an easing of market interest rates generally. At
the same time, some of the bullish sentiment that had
prevailed in the Japanese and German bond markets
faded, so that interest rate differentials favoring the
dollar narrowed somewhat.
As the dollar firm ed, market participants came
increasingly to expect the G-7 central banks to intervene
at some point to sell dollars in an effort to restrain the
dollar’s rise. Traders assumed that the U.S. authorities
would try to retain the favorable trade effects of the
dollar’s depreciation of the past two years and noted
that the U.S. authorities had sold dollars in early March

The U.S. trade performance continued to
contribute to U.S. economic growth.
B illions o f do lla rs

25 ---------------------------------------------------------,-------------------------------------Change in net exports in constant dollars

20 --------------------------------------------------------------------15
10
5 —

0—
-5 -1 0

-

-1 5 -

-20

-

Q -ll

Q -lll
1986

Q-IV

Q -l

Q -ll
1987

Table 2

Drawings and Repayments by Foreign Central Banks under Special Swap Arrangement
with the U.S. Treasury
In M illions of D ollars; D raw ings ( + ) or Repayments ( - )
C entral Bank Draw ing
on the U.S. Treasury
C entral Bank of the
A rgentine R epublic

Amount of
Facility

Outstanding as of
May 1. 1987

May

June

July

Outstanding as of
July 31, 1987

225.0

225.0

0

0

- 2 2 5 .0

*

Data are on a value-date basis.
*No fa c ility

52

FRBNY Quarterly Review/Autumn 1987




C hart 4

C hart 5

The upward trend in long-term U.S. interest
rates slowed while rates abroad
rebounded . . .

D ollar purchases by the U.S. authorities
were far sm aller during the current
three-m onth period . . .

P ercent

B illio n s of do lla rs eq uivalen t
3.0

r

Dollar purchases
X

"" lA g a in s t Japanese yen

1I n i t o r t Kingrthm

\
\

/

AV
\

N

r

\

'
v

^
/ \

U nited S tat es

Germ any

/
/

I * ’' " - X/

V
\

W
Japan

V

'v

\

-0.5

\
1 1 1 1 1 1 1 1 1 1

1 1 I 1 1 1 1 1 I 1 1

Mar

A pr

May

Jun

Jul

1987

/

1 1 IV ^ I

1 1

1987

1986

1985

Feb

j

and the foreign exchange reserves of
other G-7 countries stopped rising.
B illio ns of d o lla rs e q u iv a le n t
16

so that interest differentials favorable
to dollar assets narrowed.
P ercent

r\

---[•"•Vi
\

r

t

i

'd \
\V

/

/1

\

^--S^Japan ^ ^ / V *
Germany

I i,l

11

~ \

l i i
1985

1 1 1

\

< !

\j

U nited K ingdom

V
,

\

, V

1 1 1 1 1 1 1 1 1 1 1

1986

/

//

/

A pr
i i

i i
1987

1

The top cha rt show s long -term go vernm ent bond yields
and the bottom c h a rt s ho w s the d iffe re n tia ls betw een
U.S. Treasu ry bonds and fo re ig n governm ent se cu ritie s.




'

1 1

May
1987

The bottom c h a rt sho w s monthly cha nges in fo re ig n
e xch ange re serves of the G-7 in d u stria l cou ntries,
e xclu d in g the U nited States, as re p o rte d in the
Interna tiona l M onetary Fund’s Interna tiona l Financial
S ta tistics, vario us issues.

FRBNY Quarterly Review/Autumn 1987

53

Table 3

Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations
In M illions of Dollars

United States Treasury
Period
May 1, 1987 July 31, 1987
Valuation profits and
losses on ou tstand ing
assets and lia b ilitie s
as of July 31, 1987

Federal
Reserve

Exchange
S tabilization
Fund

+ 103.2

+ 109.7

+ 1,580.2

+ 1,422.8

D ata are on a value -da te basis.

at around DM 1.87 against the mark. They were also
aware that, with central bank money in Germany
growing more rapidly than targeted by the Bundesbank
for the year, the German central bank might try to
absorb liquidity once the dollar strengthened— either
through domestic monetary operations or by selling
dollars in the exchange market. As the rate approached
DM 1.87, rumors circulated in the market at various
times that the Federal Reserve or the Bundesbank were
selling dollars. As long as some market participants
believed the central banks would effectively contain any
significant upward pressure against the dollar, there was
little incentive for them to build up speculative long
positions in the dollar.
Consequently, the dollar fluctuated generally in a
narrow range through the end of July. It closed the
three-month reporting period at DM 1.8600, up 53/4
percent against the mark, and at Y 150.05, up 83A»
percent against the yen, from its lows in early May. On
a trade-weighted basis in terms of the other G-10 cur­

Digitized for
54FRASER
FRBNY Quarterly Review/Autumn 1987


rencies, as measured by the index developed by the
staff of the Federal Reserve Board, the dollar had risen
by nearly 4 percent during the three-month period.
During the period, the U.S. authorities sold a total of
$806 million equivalent of foreign exchange— $683
million equivalent of marks and $123 million equivalent
of yen. These operations were financed equally from
Federal Reserve and U.S. Treasury balances.
*

*

*

*

On July 15, the Central Bank of the A rgentine
Republic fully repaid a $500 million multilateral short­
term credit facility provided by the U.S. Treasury through
the Exchange Stabilization Fund (ESF) and the central
banks of a number of other countries. As noted in the
previous report, the full amount was drawn on March
9. The ESF’s portion of the facility was $225 million.
In the period from May 1 through July 31, the Federal
Reserve and ESF realized profits of $103.2 million and
$109.7 million, respectively, on sales of foreign currency.
As of July 31, cumulative bookkeeping or valuation
gains on outstanding foreign currency balances were
$1,580.2 million for the Federal Reserve and $1,422.8
million for Treasury’s ESF. These valuation gains rep­
resent the increase in the dollar value of outstanding
fo re ig n cu rre n cy assets valued at e n d -o f-p e rio d
exchange rates, compared with the rates prevailing at
the time the currencies were acquired.
The Federal Reserve and the ESF regularly invest
foreign currency balances acquired in the market as a
result of their foreign exchange operations in a variety
of instruments that yield market rates of return and that
have a high degree of quality and liquidity. A portion of
the Federal Reserve’s invested balances— $953.6 mil­
lion equivalent as of July 31, 1987— were held in
securities issued by foreign governments under the
authority provided by the Monetary Control Act of 1980.
The Treasury also held some of its invested balances—
$2,537.2 million equivalent as of the same date— in
such securities.

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for FRASER
Quarterly Review/Autumn 1987





33 Liberty S treet

Federal Reserve Bank of New York

New York, N.Y. 10045