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FEDERAL RESERVE
BANK
OF NEW YORK

M ON TH LY R E V I E W
JULY

1976

Contents
The Business S itu a tio n ................................................ 179
The M oney and Bond Markets in June................... 183
A Probabilistic A p p ro a ch to Early W arn in g
o f Changes in Bank Financial C o n d itio n .......... 187

Volume 58




No. 7

FEDERAL RESERVE BANK OF NEW YORK

179

The Business Situation
The latest readings continue to suggest that the eco­
nomic expansion has slowed down somewhat in recent
months after an unusually sharp first-quarter increase.
Consumer spending, which provided a major impetus ear­
lier in the recovery, appears to have weakened for a period
during the spring, although the most recent figures suggest
that this weakness may well prove to have been temporary.
An additional source of slower growth in the second
quarter seems to have been a rough leveling-off in the rate
of inventory accumulation after this sector had provided
a sharp spur to overall growth in the first quarter. The
more moderate pace of activity in the second quarter was
reflected in a slower growth of industrial production and
in a leveling-off of nonfarm payroll employment in May
and June. In June, the unemployment rate edged up 0.2
percentage point to 7.5 percent after many months of
almost continuous decline. Despite the apparent slowdown
of economic growth in the second quarter, the available
information suggests that the expansion still has consid­
erable momentum behind it. Indeed, by settling down to a
more moderate pace, the expansion may well have im­
proved its prospects for longevity, as well as the prospects
for avoiding an early reemergence of capacity pressures in
critical industries and resulting upward pressures on prices.
The immediate price situation, to be sure, does not look
as good as it did a few months ago, when food and fuel
prices were undergoing temporary declines. With recent
advances in food prices and with some renewed upward
movements in prices of major fuels, the incoming data
look less favorable. Nevertheless, a careful reading of the
latest price figures does not, on balance, indicate that the
underlying rate of inflation has accelerated. F or example,
consumer prices excluding the volatile food and fuel com­
ponents rose at a bit over a 5 percent annual rate in
May, and wholesale industrial prices over the first half as
a whole rose at a surprisingly moderate 3.4 percent rate.
Moreover, while second-quarter labor cost data are still
incomplete, the rise in average hourly earnings continued
at well below the rapid 1974 and 1975 rates of increase.




INDUSTRIAL PRODUCTION, NEW ORDERS, AND
INVENTORIES

Industrial production increased in May for the four­
teenth consecutive month. The preliminary data indicate
that overall output of the nation’s mines, utilities, and
manufacturing plants rose 0.5 percent, with gains wide­
spread among industries. Nevertheless, this did represent
a slowdown from the earlier rate of recovery. Since the
trough of the recent business downturn, industrial produc­
tion has risen 15.8 percent, or more than 1 percent per
month according to newly revised data, thus indicating
that the recovery has been more robust than previously
believed. However, the recent recession was severe by
postwar standards, and the overall index has not com­
pletely regained its previous peak despite the duration
and strength of the recovery.
In May, a particularly strong gain was recorded in the
iron and steel industry, where output advanced 3.9 per­
cent. This continued the sharp rebound in steel making
that characterized the early months of 1976 and brought
the cumulative advance since last December to 15.5 per­
cent. To a large extent, the pickup in steel production is
related to the rebound in the production of automobiles.
Indeed, although demand for consumer-related flat-rolled
steel has been strong, demand from other sources—
notably the capital goods and construction industries— has
remained relatively depressed. The recent evidence sug­
gests that auto production will not cause steel shortages
to develop in the near term. The 1.1 percent increase in
output of the m otor vehicles and parts industry posted
during May was less than half the average increase re­
corded earlier in the year, and the preliminary data for
June show a similar percentage increase in assemblies
of domestic passenger cars to an 8.8 million unit annual
rate. Contrary to initial fears, the rubber industry strike
has not greatly affected auto assemblies, and the usual
plant shutdown for the model-year changeover will cur­
tail tire needs temporarily.

180

MONTHLY REVIEW, JULY 1976

Production of business equipment has also displayed
recent strength. In May, business equipment production
recorded a 1.1 percent gain, following healthy increases
in the earlier months of 1976. Despite these gains, how­
ever, output in this sector remains almost 7 percent
below its previous peak. Business equipment, which in­
cludes a wide variety of goods ranging from industrial
and farm machinery to equipment used in transport and
commercial enterprises, tends to lag in the recovery until
utilization of existing productive capacity reaches the point
that makes investment in new capital goods attractive.
The latest data on orders received by manufacturers
of durable goods suggest that further increases in the
output of business equipment are in the offing. According
to preliminary estimates, seasonally adjusted new orders
for machinery rose by nearly $300 million in May, m ark­
ing the fifth straight month of sizable growth. Overall,
durable goods orders have increased sharply in recent
months (see Chart I) , rising more than 16 percent in the
five months since December. This amounts to an average
rise of $1.4 billion per month, compared with $800 mil­
lion per month during the first nine months of the recovery.
The increase in total orders was greater than the rise in
shipments in May, the first sizable excess of orders over
shipments in nearly two years, resulting in a substantial
$1.5 billion increase in unfilled orders. The recent ad­
vances in new and unfilled orders augur well for continued
activity in the future.

C h a rt I

CHANGES IN DURABLES MANUFACTURERS’ ORDERS
S e a s o n a lly

a d ju s te d

B illio n s o f d o lla r s

Source-.




U n ite d S ta te s D e p a r tm e n t o f C o m m e rc e .

B illio n s o f d o lla r s

Businesses do, however, seem to be cautious in their
plans for expansion and their stockpiling of goods. The
data on inventories suggest that there has been some
flattening of inventory investment after the acceleration
in the winter months. April data on the book value of
wholesale and retail trade inventories show a rise of $800
million, about $300 million less than the average rate dur­
ing the first quarter. Data covering only manufacturing
firms show an average accumulation of $500 million per
month in April and May, the same rate as in the first
quarter of this year.
Some further indication of the course of activity in
coming months may be provided by the index of leading
indicators. The index rose 1.4 percent in May, the largest
increase since last July. Six of the eleven available
components advanced, while only three declined. The
most im portant positive factor was the large rise in new
orders. While the index is not considered an accurate
gauge of future rates of change in economic activity, it is
regarded as useful in showing the probable direction of
change. The results for May support expectations of
further increases in production and purchases.
PERSONAL INCOME, CONSUMER CONFIDENCE,
RETAIL. SALES, AND RESIDENTIAL CONSTRUCTION

According to preliminary estimates, personal income
rose $11 billion in May, equivalent to a 9.8 percent annual
growth rate. Total wage and salary disbursements grew at
a slightly greater annual rate of 10.3 percent during the
month, reflecting a sharp rise in average weekly earnings
in the private nonfarm sector. Although part of the May
increase was due to the artificially short workweek in April
and should be discounted, a substantial part did reflect an
improvement in workers’ hourly earnings. Over the past
year, advances in weekly earnings and in employment have
increased total wages and salaries by 10.7 percent. Be­
cause inflation has been more moderate, this represents
a sizable rise in the purchasing power of workers. Recip­
ients of other types of income have also gained in recent
months. For example, proprietors’ incomes grew strongly
in April and May, reflecting farm owners’ higher profits.
Despite the continued advance in personal income, the
spring surveys have indicated a weakening of consumer
confidence. The Conference Board survey of M arch-April
showed a sharp drop in consumer optimism, compared
with the poll two months earlier. After a year of fairly
steady improvement, the index dropped 11 points to 82.2
percent of the 1969-70 average level, and an even more
significant retrenchment of near-term buying plans was
reported at the same time. A later survey by the University

181

FEDERAL RESERVE BANK OF NEW YORK

of Michigan, however, suggested a much less pronounced
decline in consumer optimism. Any decline at a time when
income and employment growth has been strong is sur­
prising. One explanation offered by a few analysts was
uncertainty about inflation, perhaps stirred up by recent
food price increases. If price increases remain moderate
and personal incomes continue to advance, it seems likely
that the recent consumer pessimism will recede.
The spring slowdown in retail sales may have reflected
the consumers’ somewhat less optimistic mood. Seasonally
adjusted sales were little changed in April from the March
level and fell $1.1 billion in May. However, advance esti­
mates for June showed an increase of $1.4 billion.
Domestic-model auto sales also recovered in June, reaching
a 9.1 million unit annual rate after a moderate decline in
May. M arket observers attributed part of the sales increase
to price discounts offered on subcompact cars, reflecting
auto manufacturers’ attempts to reduce swollen inventories
before the end of the 1976-model year.
Residential construction activity has been relatively flat
this year, although the May data offer some signs of nearterm improvement. Permits issued to build new units
jumped in May, reaching the highest level in two years, and
there was also a slight rise in housing starts. Most of the
gain was concentrated in the depressed multifamily sector,
where construction had declined in January and February.
In May, housing starts of multifamily units increased 12.6
percent and permits issued for new units increased 19.5
percent. While it remains to be seen if the latest pickup in
multifamily construction activity presages continued gains,
the lower rental vacancy rate and the continued increases in
the volume of mortgage commitments at savings and loan
associations are conducive to further improvement. Recent
news on single-family housing starts has been less favor­
able than some experts had expected. About half of the
decline that occurred between the peak in the third quarter
of 1972 and the trough in early 1975 was made up by
last December, but there has since been little change.
RESOURCE UTILIZATION AND PRICES

Although the recovery is now into its second year,
the bulk of the economy continues to operate well below
productive capacity. M ost of the measures of capacity use,
as well as those of labor market tightness, suggest that
output expansion could proceed further in the near term
without causing an acceleration in price and wage inflation.
M cGraw-Hill reported that output stood at 77 percent
of capacity in May (see Chart II ). Although up more
than 7 percentage points from the trough level, utilization
as recorded by this survey is well below the 88 percent




Chart II

MEASURES OF CAPACITY UTILIZATION
Percent

S o u rce s:

Percent

M c G ra w -H ill, Inc. a n d B o a rd o f G o v e r n o rs o f th e

F e d e ra l R eserve S ystem .

level attained in the third quarter of 1973. M ore interest­
ing to those worried about production bottlenecks is the
situation in the industries that produce materials. The
Federal Reserve Board has compiled a new index of
capacity utilization in the materials industries that provides
further insight on this sector. The new index represents a
larger share of industrial production than the old major
materials series and thus offers a more comprehensive
view of cyclical movements in materials utilization.
According to the new index, utilization in May stood
at 80.4 percent of capacity, up 10 percentage points from
its low point in the second quarter of 1975. The current
rate of capacity use appears to be fairly comfortable by
historical standards. In the third quarter of 1973, when
capacity constraints generated shortages and production
delays, this index stood at 93 percent, 13 percentage
points above its May 1976 level. Although recent in­
creases in capacity utilization by materials producers have
been widespread, they have been somewhat larger in non­
durable materials industries, where the resurgence in de­
mand began earlier. Indeed, production facilities are re­
ported by some as being pressed in a few industries, such
as paper and textiles, though the pressure appears to be
limited to a few product lines and, at least in the near
term, should not create severe bottlenecks. Moreover, to
the extent that capacity additions are planned in these
areas and there are not long delays in the production of
capital goods, the possibility of substantial shortages is
reduced.
While the capacity utilization data appear encouraging
for the price picture, one should not rely too heavily upon

182

MONTHLY REVIEW, JULY 1976

them. Productive capacity is as much an economic as
an engineering concept, and the cost of using any particu­
lar unit depends on how obsolete it is. If part of existing
capacity either is old or reflects outmoded techniques,
there may be substantially higher production costs asso­
ciated with its use, and cost pressures could emerge before
utilization reaches historically high levels.
The information on labor market conditions indicates
that, despite substantial gains in employment since the
onset of the recovery, there are still large numbers of
persons available for work. Total civilian employment
has risen by 3.1 million in the year since the second quar­
ter of 1975, and 1.1 million of this increase occurred in
the second quarter of 1976. Continued growth of the
civilian labor force, however, has meant that employment
gains have not resulted in equivalent reductions in unem­
ployment. The unemployment rate, one measure of un­
utilized labor, averaged 7.4 percent in the second quarter,
down 0.2 percentage point from its value in the first quar­
ter. Although it is substantially below its peak of 8.7 per­
cent in the second quarter of 1975, the rate is still rela­
tively high. For example, in the 1970-74 period, which
included the major part of two recessions, the unemploy­
ment rate averaged less than 6 percent.
At current and recent rates of capacity and labor force
utilization, many economists would expect a gradual abate­
ment of inflationary pressures. Although the volatile
monthly changes do not show this very clearly, compari­
son of the average rate of price increase thus far in 1976
with that in the last half of 1975 does reveal some
easing. For example, consumer prices rose at an average
annual rate of 4.2 percent between December and May,
while the rate of increase averaged 7.2 percent in the last
six months of 1975. A significant deceleration in average
hourly earnings (adjusted to exclude interindustry em­
ployment shifts and overtime in manufacturing) was also
noticeable, as earnings increased at a 6.3 percent annual




rate in the first six months of 1976 as compared with a
7.4 percent rate in the last half of 1975.
Although the average rate of inflation has slowed some­
what, the recent price news has been less favorable than
it was earlier in 1976. However, many of the factors
that caused the sharp moderation in the winter months,
such as gasoline and food price declines, were expected
to reverse course and result in an acceleration later in
the year. Food prices at the consumer level moved up­
ward in April and posted a further hefty increase in
May, causing the overall index to rise at a 7.1 percent
annual rate. Excluding food and energy, however, the rate
of increase during May was 5.2 percent, consistent with
the widespread view on the underlying trend in the in­
flation rate. Some encouragement could also be found
in the behavior of prices of services, such as rent,
transportation, medical care, and consumer interest
rates. The services component rose at a 5.4 percent annual
rate in May, duplicating the moderate rate of April. In
the six months prior to April, the average rate of increase
had been a rapid 9.7 percent.
The seasonally adjusted wholesale price index rose in
June by 0.4 percent, which was somewhat faster than the
average increase of the preceding five months. Prices of
farm products and processed foods and feeds have added
upward pressure to the index since early spring, although
in June this component rose less sharply than in the
preceding two months. Prices of industrial commodities,
on the other hand, rose 0.5 percent in June, which was
considerably more rapid than the average rate of increase
during the preceding five months. From a longer term
perspective, however, the behavior of industrial commodi­
ties prices has been relatively favorable. During the first
six months of the year, prices of industrial commodities
increased at a moderate 3.4 percent annual rate, down
substantially from the 9.2 percent rate in the last half of
1975.

FEDERAL RESERVE BANK OF NEW YORK

183

The Money and Bond Markets in June
Interest rates in the money and bond markets declined
somewhat in June, after increasing in the previous month.
With Federal funds trading in a narrow range, rates on
money market instruments halted their upward move­
ment and edged slightly back toward lower levels. Bond
yields also retraced part of the increases that were reg­
istered in May.
The United States Treasury auctioned 24-, 49-, and
61-month notes during June, raising $5.0 billion in new
cash. Conversely, at the regular weekly auctions of
Treasury bills, net redemptions reduced the amount of
short-term debt outstanding. New bond financing in the
corporate market was heavy, as firms continued to use
bond sales as a major source of financing. Most new issues
sold well, although some aggressively priced issues met in­
vestor resistance at the month end.
Preliminary data indicate that the narrowly defined
money stock (M i) declined slightly in June after the
temporary spurt of late April and early May. Meanwhile,
the broadly defined money stock (M 2) grew at a modest
pace. In addition, for the first time in 1976, banks in­
creased the volume of outstanding large negotiable cer­
tificates of deposit (CDs) during June. This contributed
to substantial expansion in the bank credit proxy— total
member bank deposits subject to reserve requirements plus
certain nondeposit sources of funds— following rather
slow growth earlier in the year.
THE MONEY MARKET AND THE
MONETARY AGGREGATES

Interest rates on money market instruments declined
slightly in June, after having risen sharply since mid-April.
Yields on 90- to 119-day commercial paper ended the
month at 5.75 percent, nearly unchanged from rates
quoted at the opening of the period. Rates on ninety-day
bankers’ acceptances fell by 23 basis points in June to
close the month at 5.68 percent. The average yield in the
secondary market on ninety-day CDs declined sharply
during the first week of the month but traded at a nearly
constant level thereafter to end June at 5.73 percent, down
18 basis points from the rate at the end of May.




The effective rate on Federal funds averaged 5.48 per­
cent in June (see Chart I) , an increase of 19 basis points
over the average for May but roughly unchanged from the
levels of the final week of that month. During June,
Federal Reserve open market operations were primarily
aimed at offsetting massive shifts in Treasury balances
between commercial banks and Federal Reserve Banks.
In recent years, the Treasury has been acting to minimize
the cash holdings in its Tax and Loan Accounts at com­
mercial banks. The Treasury typically transfers the re­
ceipts which flow into these deposits to its accounts at
Federal Reserve Banks. These transfers— Treasury calls—
drain reserves from the banking system. Conversely, when
Treasury expenditures exceed receipts and Treasury bal­
ances at Federal Reserve Banks decline, reserves are
released to the banking system. The amplitude of fluctu­
ations in Treasury balances at Federal Reserve Banks has
increased sharply since 1974, leading to the large impact of
Treasury operations on bank reserves reported in Table I.
The average absolute weekly impact of Treasury opera­
tions on commercial bank reserves was $2.09 billion,
computed on a daily average basis, in the first half of
this year as compared with only $0.45 billion in the first
half of 1973. The effect of these fluctuations on bank
reserves can be offset through Federal Reserve open
market operations, and Federal Reserve transactions for
the System Account have generally mirrored these swings.
This activity was particularly heavy in June. The Treasury
borrowed funds during the month, which will not be
needed until later in the year. In addition, Treasury de­
posits at Federal Reserve Banks typically rise after mid­
month tax dates, such as that of June 15.
In response to the increase in money market rates in
May, most banks raised their lending rate to prime cus­
tomers by Vi percentage point to IVx percent during the
first half of June. Business loan demand appeared to be
starting its long-awaited revival, as loans at weekly re­
porting banks rose in late May and early June. D ata in
subsequent weeks did not confirm the stronger loan activ­
ity, however. Commercial and industrial loans at all week­
ly reporting banks, including loans sold to affiliates, de­
clined on a seasonally adjusted basis by $275 million over

184

MONTHLY REVIEW, JULY 1976

Chart 1

SELECTED INTEREST RATES
Percent

MONEY MARKET RATES

A p ril

N o te :

M ay

April-June 1976

Ju n e

BOND MARKET YIELDS

A p ril

M ay

Percent

Ju ne

D a t a a r e s h o w n f o r b u s in e s s d a y s o n ly .

M O N E Y M A R K E T R ATES Q U O T E D :

s t a n d a r d A a a - r a t e d b o n d o f a t le a s t t w e n t y y e a r s ’ m a t u r i t y ; d a ily a v e r a g e s o f

P r im e c o m m e r c ia l lo a n r a te a t m o s t m a jo r b a n ks,-

o f f e r i n g r a t e s ( q u o te d in te rm s o f r a t e o f d is c o u n t) o n 9 0 - to 1 1 9 - d a y p r im e c o m m e r c ia l

y ie ld s o n s e a s o n e d A a a - r a t e d c o r p o r a t e b o n d s ; d a i l y a v e r a g e s o f y ie ld s o n

p a p e r q u o t e d b y th r e e o f th e fiv e d e a l e r s t h a t r e p o r t t h e ir r a te s , o r th e m id p o i n t o f

l o n g - te r m G o v e r n m e n t s e c u r it ie s ( b o n d s d u e o r c a l la b le in te n y e a r s o r m o re )

th e r a n g e q u o t e d i f n o c o n s e n s u s is a v a i l a b l e ; th e e f f e c t iv e r a t e o n F e d e r a l fu n d s

a n d o n G o v e r n m e n t s e c u r it ie s d u e in t h r e e to f iv e y e a r s , c o m p u te d o n th e b a s is

(th e r a t e m o s t r e p r e s e n t a t iv e o f th e tr a n s a c t io n s e x e c u t e d ) ; c lo s in g b id r a te s ( q u o te d
in t e r m s o f r a t e o f d is c o u n t) o n n e w e s t o u t s t a n d in g t h r e e - m o n t h T r e a s u r y b ills .

o f c lo s in g b i d p r ic e s ; T h u r s d a y a v e r a g e s o f y ie ld s o n t w e n t y s e a s o n e d t w e n t y -

B O N D M A R K E T Y IE LD S Q U O T E D : Y ie ld s o n n e w A a a - r a t e d p u b l ic u t i l i t y b o n d s a r e b a s e d
o n p r ic e s a s k e d b y u n d e r w r it i n g s y n d ic a t e s , a d ju s t e d to m a k e th e m e q u i v a le n t to a

the five statement weeks ended June 30.
Following the temporarily rapid growth rates of the
monetary aggregates observed in late April and early
May, M x declined slightly in June while M 2 posted a
modest increase. The pace of monetary growth over
longer horizons remained moderate, however. Averaged
over the four-week period ended June 30, seasonally
adjusted M i— private demand deposits adjusted plus cur­
rency outside banks— increased at an annual rate of 6.3
percent over its four-week average in the period ended thir­
teen weeks earlier (see Chart II ). This brought the Mi
growth rate of 4.0 percent over the four-week average
ended fifty-two weeks earlier. Averaged over the four-week
period ended June 30, M 2 M x plus commercial bank time
—




y e a r t a x - e x e m p t b o n d s ( c a r r y i n g M o o d y 's r a t in g s o f A a a , A a , A , a n d B a a ) .
S o u r c e s : F e d e r a l R e s e rv e B a n k o f N e w Y o r k , B o a r d o f G o v e r n o r s o f th e F e d e r a l
R e s e rv e S y s te m , M o o d y 's In v e s to r s S e r v ic e , In c ., a n d T h e B o n d B u y e r .

and savings deposits other than large negotiable CDs—
grew at an annual rate of 9.9 percent over its four-week
average ended thirteen weeks earlier and at 9.0 percent
over its four-week average ended fifty-two weeks earlier.
Combined with member bank deposit growth, the recent
increase in CDs pulled the bank credit proxy average to
5.2 percent and 3.2 percent at annual rates over average
levels thirteen and fifty-two weeks earlier, respectively.
THE GOVERNMENT SECURITIES MARKET

The Treasury redeemed part of its maturing bills and
borrowed new cash through coupon securities during June.
This reflected a continuation of its efforts to reduce its

185

FEDERAL RESERVE BANK OF NEW YORK

short-term debt and to increase its longer term debt. For
example, at auctions held between April 1 and June 30,
the Treasury permitted a net $4.4 billion decline in threeand six-month bills while its outstanding debt rose by $0.6
billion.
Treasury bill rates declined somewhat during June, as
investors came to believe that further firming in short­
term credit markets was unlikely in the near future. At
the regular weekly auction on June 28, three- and sixmonth bills were issued at average rates of 5.37 percent
and 5.75 percent, respectively (see Table II ), down
about 20 basis points below the final auction of the pre­
vious month. On June 23, 52-week bills were sold at an
average return of 6.08 percent, 23 basis points below the
average issuing rate on May 26. Rates on most bill issues
ended the month about 10 to 25 basis points below levels
prevailing at the end of May.
In the market for coupon-bearing Government obliga­
tions, the Treasury borrowed additional funds, totaling
$5 billion in three separate note auctions. On June 3,
$2 billion of new cash was obtained through 49-month
notes at an average issuing yield of 7.71 percent. On
June 21, two-year notes with an average return of
6.99 percent were sold to refund $2 billion of maturing
notes and to borrow $500 million of new cash. On June 29,
an average issuing rate of 7.63 percent resulted from
the auction of $2.5 billion of five-year notes for new
money.
Some price improvements on seasoned issues were
recorded in the Federal agency market, where new issue
activity was light. On June 8, the Government National
Mortgage Association auctioned $285.5 million of
IVa percent and IV 2 percent mortgage-backed securities
for new cash. The thirty-year issues were aggressively
priced to yield 8.43 percent and 8.48 percent, respec­
tively, on a corporate bond equivalent basis. On June 23,
the Federal National Mortgage Association issued $300
million of ten-year debentures priced at par to yield 7.95
percent. The Farm Credit System placed $1.4 billion
of securities on June 17 to raise $292 million in new
cash. The issue was composed of $615 million of 6.15
percent Banks for Cooperatives bonds due January 1977
and $789 million of 6.50 percent Federal Intermediate
Credit Bank bonds due April 1977. Government-backed
tax-exempt urban renewal and public housing notes total­
ing $580 million were sold through the Department of
Housing and Urban Development on June 16. These
short-term notes of eighty-six local public housing agen­
cies were placed at an average yield of 3.28 percent, com­
pared with a 3.47 percent rate in a similar offering on
May 18.




Table 1
FACTORS TENDING TO INCREASE OR DECREASE
MEMBER BANK RESERVES, JU NE 1976
In millions of dollars; (+ ) denotes increase
and (—) decrease in excess reserves

Changes in daily averages— week ended
Net
changes

Factors
June
16

June
9

June
2

June
30

June
23

“ Market” factors
M em ber b an k requ ired reserves . .

4-

151

+

165

—

199

—

365

—

562

—

810

O p eratin g tr a n s a c tio n s
+ 1 ,0 0 3

+ 4 ,8 5 9

— 2,419

— 4,058

F ed er a l R eserve float ...................

+

40

+ 1 ,0 4 0

—

+

T reasu ry o p eration s* ......................

— 1,287
(—

+ 3 ,8 4 5

— 1,092

— 4,280

— 3,434

— 3,674

G old a n d fo r eig n a cc o u n t ..........

—

44

20

—

6

+

32

+

92

+

94

Currency o u ts id e b a n k s ..............

—

162

—

450

—

422

+

21

+

586

—

427

_

121

+

407

—

491

+

162

—

175

—

218

+

409

8

— 3,214
—

283

i— 3,829

+

396

O ther F e d e r a l R eserve
.................

lia b ilitie s a n d c a p ita l

T o ta l “ m a r k e t” fa c to rs ..............

+ 1 ,1 5 4

+ 5 ,0 2 4

— 2,618

— 4,423

— 3,776

— 4,639

— 1,077

— 5,334

+ 2 ,8 6 5

+ 3 ,7 0 0

+ 4 ,3 3 5

+ 4 ,4 8 9

+ 2 ,7 3 4

Direct Federal Reserve credit
transactions
Open m ark et op era tio n s
(s u b to ta l)

................................................

O u trigh t h o ld in g s :
T reasu ry s ec u r ities

........................

—

881

...................

—

13

F e d e r a l agen cy o b lig a tio n s . . . .

—

14

B a n k er s' a cc ep ta n ces

— 2,941

+ 2 ,5 8 0

+ 2 ,1 3 2

+ 1 ,8 4 4

—

—

17

—

—

—

—

22

+

276

292 i +

40

12

_

17

—

77

—

18

—

36

R e p u rc h a se a g r e e m e n ts :
T reasu ry se c u r itie s

........................

—

68

— 1,995

...................

—

72

—

F e d e r a l a gen cy o b lig a tio n s -----

—

29

—

94

+

M em ber b ank b o r r o w in g s .................

-f

107

—

149

—

—

5

+

+

4

+

B a n k er s' a cc ep ta n ces

8
45

4

+ 1 ,0 9 3

+ 2 ,2 4 2

+ 1 ,5 4 8

+

370

+

210

+

+

123

+

56

+

64

+

116

+

2

+

31

e +
l

256

S e a so n a l b orrow in gs- ...................
!-

+

6

O ther F e d e r a l R eserve a s s e t s ! . . . .

+

55

.......................................................

—

915

— 5,479

+ 3 ,2 7 1

+ 3 ,6 5 7

+ 4 ,3 9 3

+ 4 ,9 2 7

Excess reservest§ .........................

-f

239

—

+

—

+

+

T o ta l

455

451

653

-f
—

159

766

^

+

18

56

+

+

407

617

288

Monthly
averages|l

Daily average levels

Member bank:
T o ta l reserves, in c lu d in g
...........................................

33,777

33,155

34,011

33,610

34,789

33,868

R e q u ired reserves .................................

v a u lt cash £§

33,363

33,198

33,397

33,762

34,324

33,609

E x c e s s reserves § ....................................

414

152

465

260

T o ta l borrow in gs

143

43

614

242

93

48

164

166

...................

17

12

16

22

29

19

N on b orrow ed reserves ........................

33,535

33,062

33,963-

33,446

34,623

33,726

56

197

36

220

.................................

S e a s o n a l b o rro w in g sf

—

—

N e t ca rry-over, ex c ess or
d eficit

( — )U ...........................................

—

N o te : B e c a u s e o f rou n d in g, figu res do n o t n ece ssa rily ad d to to ta ls .
* In clu d es ch a n g es in T reasu ry cu rren cy a n d ca sh ,
t In clu d ed in to ta l m em ber b ank borrow in gs.
I n clu d es a s s e ts d en o m in a ted in foreign cu rren cies.
§ A d ju sted to in c lu d e w aivers o f p e n a ltie s for reserve d e ficie n c ie s in
acc o rd a n c e w ith th e R e g u la tio n D ch an ge effective N ovem b er 19, 1975.
|| A verage for five w eeks en d ed J u n e 30, 1976.
1 N o t reflected in d a ta above.
1

t

12

99

MONTHLY REVIEW, JULY 1976

186

Table II

OTHER SECURITIES MARKETS

Yields in the corporate and municipal bond markets also
halted the upward movement of the previous month and
partly retraced their earlier increases. Sentiment was
buoyed by the stabilization in short-term money market
conditions. While a substantial volume of new corporate
issues, including obligations of many finance companies,
was distributed easily during June, aggressive pricing on
large issues late in the month met strong investor resis­
tance. After a relatively heavy schedule of new state and
local issues through the first half of June, the calendar of
tax-exempt financings diminished considerably, taking
some pressure off that sector.
In corporate underwriting, the largest industrial offer­
ing was $125 million of thirty-year debentures at mid­
month. The Aa-rated debt was well received at a yield of
8.57 percent. Mixed receptions were accorded to a num ­
ber of new utility issues during the month. Investors
quickly purchased $200 million of Aaa-rated telephone

C h a r t II

GROW TH OF SELECTED M O N E Y STOCK MEASURES
S e a s o n a lly a d ju s t e d a n n u a l r a te s
P e rc e n t

P e rc e n t

N ote-. G r o w th r a te s a r e c o m p u te d o n th e b a s is o f fo u r - w e e k a v e r a g e s o f d a ily
fig u r e s fo r p e r io d s e n d e d in th e s ta te m e n t w e e k p lo tte d , 13 w e e k s e a r lie r a n d
5 2 w e e k s e a r lie r . The la te s t s ta te m e n t w e e k p lo tt e d is Jun e 30, 1976.
M l - C u rre n c y p lu s a d ju s te d d e m a n d d e p o s its h e ld b y th e p u b lic .
M 2 = M l p lu s c o m m e rc ia l b a n k tim e a n d s a v in g s d e p o s its h e ld b y th e p u b lic , le ss
n e g o tia b le c e r tific a te s o f d e p o s it is s u e d in d e n o m in a tio n s o f $ 1 0 0 ,0 0 0 o r m ore.

S o u rc e :

B o a rd o f G o v e rn o rs o f th e F e d e ra l R es e rv e S ystem .




AVERAGE ISSUING RATES
AT REGULAR TREASURY BILL AUCTIONS*
In percent
Weekly auction dates— June 1976
Maturity
June
7

June
14

June
21

June
28

5.459

5.380

5 .356

5 .368

5 .768

5 .695

5 .7 2 2

5.754

Monthly auction dates— April-June 1976
April
29
F ifty - tw o w eek s .........................................

May
26

June
23

5 .6 4 5

6.309

6 .081

* In ter est ra tes on b ills are q u oted in term s o f a 3 6 0 -d a y year, w ith th e d is c o u n ts from
par a s th e retu rn on th e face a m o u n t o f th e b ills p a y a b le a t m a tu r ity . B o n d y ield
eq u iv a le n ts, re la ted to th e am o u n t a c tu a lly in v e sted , w ou ld be s lig h tly h igh er.

debentures due in forty years at an 8.68 percent yield.
However, an A aa/A A -rated (Moody’s/Standard & Poor’s)
telephone issue met stiff resistance when the $300 mil­
lion 39-year debentures were priced to return 8.85 per­
cent, a somewhat lower rate than had been expected. The
return required on electric utility bonds was indicated by
two thirty-year financings during the month. An Aa-rated
$80 million issue carried a 9.00 percent yield, while an
A-rated $125 million offering provided investors with a
9.22 percent return. In recent months, yield differentials
on utilities with different ratings have continued to narrow.
At the beginning of June, the result of increases in
municipal rates over the previous month required the
State of Maryland to provide yields of from 4.25 percent
in 1979 to 6.00 percent in 1991 on $175 million of Aaarated securities, 25 to 40 basis points higher than those
attached to a comparably rated issue sold a month earlier.
Later in June, the State of Wisconsin offered $120 million
of Aaa-rated bonds, returning from 3.20 percent in 1977
to 6.00 percent in 2006. These bonds, offered at consider­
ably lower yields on comparable maturities, were success­
fully distributed after some initial investor resistance. Rate
declines over the m onth were similarly indicated by The
Bond Buyer index of twenty bond yields on twenty-year
tax-exempt bonds, which closed the month at 6.87 percent,
down 16 basis points over the period. The Blue List of
dealers’ advertised inventories rose by $35 million to close
the month at $860 million, reflecting the heavy volume of
municipal financing.

FEDERAL RESERVE BANK OF NEW YORK

187

A Probabilistic Approach to Early Warning
of Changes in Bank Financial Condition
By L e o n K o r o b o w , D a v id P. S t u h r ,

The subject of early warning is one that challenges our
understanding of the nation’s financial system. In the
perspective of the strains imposed on banks by virulent
inflation and severe recession during the past few years,
it is clear that improved methods of early detection of
financial weaknesses in our banking system could help
bank regulatory authorities to anticipate and mitigate
future problems. An effective early warning system could
make a substantial contribution to a more smoothly func­
tioning financial system.
The Federal Reserve Bank of New York has for some
years had under study statistical techniques to assist in the
supervision of banks in the Second Federal Reserve Dis­
trict. This research has been aimed at the development
of early warning indicators from financial reports that
banks file routinely with regulatory agencies. The
results thus far strongly suggest that substantial im­
provements in the allocation of supervisory resources
could be achieved by focusing attention primarily on banks
designated vulnerable by the criteria set forth in the early
warning procedures. These procedures also can provide
estimates of the probability that any single bank will, under
varying economic circumstances, develop severe financial
weakness at some future date. Earlier investigations have
been described in the September 1974 and July 1975

* This article has been adapted from an address to a Conference
on Financial Crises at the Salomon Brothers Center for the Study
of Financial Institutions, New York University Graduate School of
Business Administration, on May 20, 1976. Leon Korobow is an
Assistant Vice President in the Bank Supervision and Relations
Function of the Federal Reserve Bank of New York. David P.
Stuhr is an economist in the Banking Studies Department and
Associate Professor of Finance at Rutgers University. Daniel
Martin is a senior banking research analyst in the Banking Studies
Department. The authors acknowledge the many helpful com­
ments made by their colleagues at the Bank but accept full respon­
sibility for this paper.




and

D a n ie l M a r t i n *

issues of the Federal Reserve Bank of New York M onthly
Review. This article brings those reports up to date and
comments more broadly on the role that early warning
research can play in improving bank supervision.
EARLY WARNING AS AN AID TO SUPERVISION

The financial turbulence of the 1970’s clearly high­
lighted an im portant new dimension of the problems of
bank supervision. The failure of the United States National
Bank of San Diego, the Franklin National Bank, and the
Security National Bank dramatized the consequences of
high risks and imprudent management, if not fraud, even
for large institutions. Each of these banks had assets in
excess of $1 billion. While failures on this scale have been
relatively few, the general problems that have surfaced
in banking in recent years clearly indicate that large banks
are not immune to failure and that improved techniques
of spotting financial deterioration at an early stage could
make an im portant contribution to the stability of our
financial system.
Many of the problems that have affected banks in
recent years are the direct result of the twin shocks of
severe inflation and recession. In some cases, a willingness
to extend the normal limits of risk taking for the sake of
enhanced profits during the 1960’s and early 1970’s con­
tributed to a degree of risk exposure which, in retrospect,
proved to be unwise. Clearly, banks must be prepared to
take risks if they are to serve the financial needs of the
nation’s economy, but these risks must be tempered by the
public’s interest in a sound and stable banking system,
since the potential costs of widespread instability in bank­
ing extend far beyond the banks directly concerned.
The achievement of an appropriate balance between
risk taking and the preservation of comfortable margins
of safety with respect to earnings, capital, and liquidity
is a goal that both bankers and bank supervisors have a
vital stake in pursuing. From this point of view, it is

MONTHLY REVIEW, JULY 1976

188

im portant to recognize what bank supervisors have always
known: that on-site examinations provide accurate insight
into developing, as well as actual, financial problems at
banks. The experience of supervisors and the results of
financial research indicate that financial deterioration
typically does not occur overnight. A decline in earnings,
capital, liquidity, and asset quality and inadequate man­
agement, as reflected in poor internal controls and audit­
ing procedures, usually develop over a period of time.
Thus, regularly scheduled bank examinations normally
would uncover these adverse developments.
Regular examinations not only probe a bank’s finan­
cial condition but also provide valuable information on
whether banks are complying with regulatory policies and
procedures. An on-site examination has strong precaution­
ary and psychological influences on a bank and is the
m ajor cutting edge of supervisory policy.
There are, nonetheless, a number of factors that make
an effective statistical early warning system important foi
responsive and efficient bank supervision. First, significant
changes in a bank’s management policies and financial
condition can occur between examinations. Second, an
on-site examination is a lengthy and expensive process
and not always the most cost-effective method of tracking
small, but important, changes in a bank’s financial
condition. Third, although examiners generally are sen­
sitive to developing trends that indicate potential future
management or financial problems and normally comment
on such matters in their reports, they must necessarily
emphasize their findings concerning the actual condition
of the bank rather than the estimated impact of potential
problems. Fourth, an examiner’s findings are part of the
official record and could provide the basis for enforce­
ment or other supervisory actions. In contrast, statistical
early warning measures can be informal, affording
the opportunity for experiments with techniques to
uncover financial weakness at its earliest stages.
In short, early warning analysis can be a valuable ad­
junct to the process of bank examination and supervision.
By providing accurate and timely information on changes
in bank financial condition between examinations, it could
make possible a more efficient use of supervisory re­
sources. Moreover, an efficient early warning system can
be a useful tool of analysis in the ongoing appraisal of
bank financial condition.
DETECTING POTENTIAL. DETERIORATION

Early warning research at the Federal Reserve Bank
of New York has recently focused on the problem of
detecting potential financial deterioration in banks rather




than on studying the characteristics of banks that have
already undergone severe deterioration. This approach
required a substantial modification of the methodology
employed in the earliest stages of the project.1
Measures of vulnerability were investigated, using
financial data that are reported routinely to bank regu­
latory agencies, so that the condition of banks could be
closely m onitored in periods between scheduled on-site
examinations. A num ber of financial variables were se­
lected for testing. These were variables that past experience
had indicated were closely associated with financial
strength or weakness. The objective was to find the
smallest set of variables that could be used to detect early
signs of financial deterioration. Since overall economic
conditions can have a substantial impact on a bank’s
ability to withstand unexpected shocks or strains, the
analysis was structured to take into account the external
environment.
For each variable employed, a standardized deviation
was computed for every bank. The values of the variables
were compared with the averages for all member banks
in the District, and the differences were divided by the
respective standard deviations of each of the variables. The
resulting standardized deviations were added algebraically
to form an overall bank score in which the component
variables were weighted equally. A score was obtained for
each member bank from financial data for an appropriate
base year. We expected that the higher the bank score
the more resistant the institution would be to adverse
economic or financial developments while the lower the
score the greater its vulnerability.
The performance measure thus obtained for any given
base year promised to provide a stable indication of finan­
cial strength or weakness for all member banks in the
Second Federal Reserve District. The 350 or so member

1 See Leon Korobow and David P. Stuhr, ‘“Toward Early Warn­
ing of Changes in Banks’ Financial Condition: A Progress Re­
port”, Monthly Review (Federal Reserve Bank of New York,
July 1975), pages 157-65. See also David P. Stuhr and Robert Van
Wicklen, “Rating the Financial Condition of Banks: A Statistical
Approach to Aid Bank Supervision”, Monthly Review (Federal
Reserve Bank of New York, September 1974), pages 233-38;
Joseph F. Sinkey, Jr., and David A. Walker, “Problem Banks:
Identification and Characteristics”, Journal of Bank Research
(Bank Administration Institute, Winter 1975); Joseph F. Sinkey,
Jr., “A Multivariate Statistical Analysis of the Character of Prob­
lem Banks”, The Journal of Finance (American Finance Associa­
tion, March 1975); Joseph F. Sinkey, Jr., “Early-Warning System:
Some Preliminary Predictions of Problem Commercial Banks”,
Proceedings of a Conference on Bank Structure and Competition
(Federal Reserve Bank of Chicago, May 1975), pages 85-91.

FEDERAL RESERVE BANK OF NEW YORK

banks comprising this group included banks which varied
widely in size, scope of banking business, and propensity
for taking risks. Among these banks were a large number
whose management policies were known to be conservative
and whose balance sheets and income statements would
lead most observers to conclude that they had a low
tolerance for risk. The overall group also included a
number of large banks, as well as many that were active
practitioners of liability management.
We rejected performance comparisons based on banks
that are similar in size and scope of banking activities.
The risk exposure in a group of similarly situated banks
might be uniformly high or low, and thus be misleading
as a basis for determining the degree to which a particular
bank might be vulnerable to economic and financial strains.
The scoring approach provides a means for comparing
and tracking bank financial performance over varying
periods of time. However, one of the main problems in
applying these procedures to the supervisory process is the
need for a link between the bank scores and an inde­
pendent measure of a bank’s soundness. In other words,
it is important to know the significance of a low score
and the degree of vulnerability indicated by progressively
lower standings in the list of scores.
MEASURING EFFICIENCY

One measure of the effectiveness of the procedures is
suggested by the role of the bank score as an aid to bank
supervision. That measure is the extent to which the bank
scores in a base year provide an accurate indication of
those banks that deteriorated seriously in subsequent
years, as evidenced by receipt of a low rating from super­
visory personnel.
The scoring procedure made it possible to divide
Second District member banks into two groups— i.e., re­
sistant and vulnerable. This division suggested that the
efficiency of supervision could be improved by allocating
resources primarily to the banks designated vulnerable.
The dividing line, in terms of bank scores, between the
banks designated vulnerable and those designated resistant
was drawn with the aid of a cost function that minimized
the costs of two types of error— i.e., drawing the line too
high and examining more banks than necessary, and draw­
ing the line too low, thus failing to identify banks that were
likely to deteriorate or fail.
The cost of the first type of error for a given bank is
based on its size, since the cost of examining a large bank
usually far exceeds the cost of examining a small bank.
The cost of the second type of error is assumed to be a
large multiple of the cost of examining the bank and




189

reflects the high social costs of failing to identify and
to examine a bank that subsequently undergoes substan­
tial deterioration.2 The optimal dividing line between
resistant and vulnerable banks is the one that minimized
these costs.3
The gain in efficiency represents the reduction in exam­
ination expenses, less the cost of failing to identify
correctly banks that subsequently deteriorated. In this
article, the gain is expressed as the percentage reduction
in costs from examining only banks designated vulnerable,
compared with the costs of examining all banks annually,
as at present. In the comparison, total costs are comprised
of the costs of the two types of errors described above.
AN EARLY WARNING FUNCTION

Using the cost function, it was possible to compare
alternative sets of variables in terms of their value in
identifying as vulnerable banks that would be given a low
supervisory rating in a subsequent period. The set of
variables that yielded the most efficient allocation of super­
visory resources was selected after experimentation with
many different combinations. The set of six variables dis­
cussed below was more efficient than any other combina­
tion tested thus far, including the twelve-variable combina­
tion employed in the July 1975 report. The six variables
are shown in Table I, where the contributions to resistance
and vulnerability are indicated by plus and minus signs,
respectively.
The first variable, total operating expenses/total operat­
ing revenues, is a measure of a bank’s ability to generate

2 We assumed that the cost of correct classification is zero.
This implies that the examination costs associated with designating
as vulnerable and, therefore, examining banks that deteriorated
seriously is matched by the benefits of identifying the source of,
and possibly arresting, the deterioration. See Korobow and Stuhr,
op cit., pages 160-63.
3 The total cost of the two types of errors can be expressed as
follows:
m
n
TC = 2 (cost r:w )i + 2 (cost v:s)j
i= 1
j= 1
where:
TC = Total cost
m = Number of banks receiving low summary ratings
classified as resistant
(cost r:w)i = Cost of classifying as resistant the ith bank when
it receives a low summary rating
n = Number of banks with high or intermediate sum­
mary ratings classified as vulnerable
(cost v:s)j = Cost of classifying as vulnerable the jth bank
when it retains a high or intermediate summary
rating

190

MONTHLY REVIEW, JULY 1976
Table I
THE SIX EARLY W ARNING VARIABLES
Variable

Sign*

Total operating expenses/total operating revenues ............................
Total loans /to tal assets ..............................................................................
Commercial and industrial loans /total loans ......................................
Provision for loss /to tal loans and investments ....................................
Net liquid assets /to tal assetsf ................................................................

+

Gross capital /risk assetsj ........................................................................
* A plus sign means that an increase in the value of the variable is indicative
of resistance, a minus sign means that an increase in the variable is in­
dicative of vulnerability,
f Net liquid assets are defined as United States Treasury securities maturing
in less than one year plus Federal funds sold plus loans to brokers and
dealers minus Federal funds purchased minus other liabilities for bor­
rowed money.
t Gross capital = Equity capital plus capital notes and debentures plus loss
reserves.
Risk assets = Total assets minus cash and due from banks minus United
States Treasury securities.

revenues from normal banking operations and to control
total expenses in an efficient manner. Operating expenses
include all costs except securities losses or extraordinary
items. The importance of this variable in relation to vari­
ous measures of income or rate of return, which had
proved less efficient, is that it reflects the limits on bank
revenues imposed by market competition. Thus, internal
cost control is an especially critical means of maintaining
or increasing operating efficiency.
The next two variables— total loans/total assets and
commercial and industrial loans/total loans— measure the
risk of loss inherent in business lending. The inclusion of
both variables is, in effect, a means of emphasizing dif­
ferent aspects of the bank’s loan portfolio. Two of the six
— provision for loss/total loans and investments and net
liquid assets/total assets— are new variables. The former
represents a measure of prospective losses envisioned by
bank management in relation to the bank’s overall loans
and investments; the latter measures the bank’s ability to
meet unexpected deposit or other drains. Finally, the ratio
of gross capital/risk assets is a modified version of an
earlier measure of bank capital, the main function of
which is to cushion losses.
The efficiency of the six variables in classifying banks
as resistant or vulnerable is indicated in Table II.
Two separate periods are shown: (1) base year 1969,
identifying vulnerable banks in 1970-72, and (2 ) base
year 1971, identifying vulnerable banks in 1972-74. In
the first period, the inflationary boom in the economy




generated a high level of loan activity and sustained many
borrowers whose underlying financial position was not
strong. Many banks, therefore, showed good financial
results. In the latter period, severe financial strain and
recession presented a stringent test of financial staying
power for borrowers and lenders alike.
In each estimation period, the calculation to determine
the most efficient cutoff score involved the comparison of
each bank’s score in the base year with its supervisory
rating in the subsequent three-year period. A comparison
was made of the gains and losses at various cutoff points.4
At the optimal cutoff point, which gives the highest gain in
efficiency, the six-variable early warning function pro­
duced a 47 percent increase in efficiency in the 1970-72
period and 42 percent in 1972-74. Moreover, about 87
percent of the banks that received low supervisory ratings
in 1970-72 and 93 percent in 1972-74 were correctly
identified as vulnerable in the respective base years.
These gains are well in excess of those that could be
expected from following several naive decision rules for
allocating supervisory resources. F or example, Naive fore­
cast 1 in Table II is based on the assumption that bank
supervisory ratings will not change over the estimation
period. This assumption gives rise to a decision rule that
banks with high or intermediate supervisory ratings would
not be examined annually. Only low-rated banks in the
base year would be subject to annual examinations. This
rule yielded a small gain in efficiency in 1970-72 and a
substantial loss in 1972-74.
Naive forecast 2 is a broader rule that would exempt
from annual on-site examination banks having the highest
supervisory ratings. All banks with intermediate or low
supervisory ratings in the base year would be examined
annually. In this case, the gain in efficiency was much
lower than the gain achieved using the optimal decision
rule of the early warning function estimated over the
period 1970-72 and was negligible over the period 197274. Thus, the early warning function developed from the
six variables possesses a significantly greater capacity to
isolate vulnerable banks than any simple rule based on the
tendency of supervisory ratings to remain unchanged over
time. The function is also more efficient than the simple
assumption that severe deterioration among banks would

4 A bank was considered to have had a low supervisory rating
if it received a low rating in at least one of the three years subse­
quent to the base year, although it may not have received a low
rating in all three years. In general, approximately three quarters
of the banks that received low supervisory ratings during the
periods studied had high or intermediate ratings in the base years.

191

FEDERAL RESERVE BANK OF NEW YORK

be confined in subsequent periods to those banks with
intermediate and low supervisory ratings in any base
year. Of course, the value of early warning procedures
in improving the efficiency of bank supervision depends
on the applicability of the cutoff points, developed from
past estimation periods, to the economic conditions ex­
pected in the future. Research conducted thus far indi­
cates a good degree of stability.
A PROBABILITY INTERPRETATION
OF THE SCORING PROCEDURE

While the division of banks into resistant and vulnerable
groups was useful in appraising the efficiency of alterna­
tive early warning functions, it made no distinction as
to the likelihood that individual banks would deteriorate or
fail in each group. A study of the bank scores for various
base years indicated that many of the banks at the low
range of scores subsequently deteriorated, although some
did not, and a few that ranked high did meet difficulty.
The outcome owed much to the composition of each
bank’s loan portfolio, the economic influences affecting
the bank’s borrowers, as well as its investments, and the
capacity of bank management to adjust its financial posi­
tion quickly and effectively to a changing economic
environment. While these factors are reflected in the
indicators of financial vulnerability that were employed,
it must be emphasized that we are dealing with probabi­
listic events in the sense that many of the management
initiatives that can strongly affect the soundness and
future condition of both resistant and vulnerable banks
cannot be forecast reliably.

Nonetheless, study of the bank scores and the location
in the listing of banks that received low supervisory
ratings in the period subsequent to the base year clearly
indicates a high concentration of low-rated banks at
the bottom of the list. This observation suggests that vul­
nerability increases with diminished financial performance
as measured by the early warning indicators we employed.
It also suggests that the bank scores can be translated into
a probability estimate using regression methods.
In estimating the probability of banks receiving a low
supervisory rating as a function of their scores, we con­
structed an “observed probability” for each member bank
in the Second District. These probabilities were obtained
by determining for banks whose scores were within a
selected interval in the base year the proportion of banks
that received low supervisory ratings over the estimation
period subsequent to the base year.5 That proportion was
taken to be a proxy for the given bank’s probability of
receiving a low supervisory rating. The observed probabil­
ities were then used as the dependent variable of a
regression equation.
The purpose of the regression was to estimate the rela­
tionship between the bank scores and the observed
probabilities. This relationship was assumed to be a
continuous function, approaching zero for large positive
scores and approaching one for large negative scores. F ur­
thermore, the function was assumed to be monotonic, that

5 The interval was one bank score unit on either side of each
bank’s score.

Table II
ANALYSIS OF GAINS IN EFFICIENCY FROM CLASSIFICATION OF BANKS INTO RESISTANT
AND VULNERABLE GROUPS ON THE BASIS OF THE SCORING PROCEDURE
In percent
Base year 1969: estimation period 1970-72
Cutoff
bank score
based on:

Percentage of banks having
low supervisory ratings
correctly identified

Gain in
efficiency

Base year 1971: estimation period 1972-74
Percentage of banks having
low supervisory ratings
correctly identified

Gain in
efficiency

Optimal cutoff point ................................

86.8

47.2

92.9

42.2

Naive forecast: 1* ......................................

26.3

11.9

26.8

-7 5 .4

Naive forecast: 2 t ......................................

89.5

31.7

75.0

7.6

♦All banks with low supervisory ratings in the base years of 1969 or 1971 are assumed to retain these ratings
in the subsequent three years, with no other banks receiving low ratings,
f All banks with low or intermediate supervisory ratings as of 1969 or 1971 are assumed to be vulnerable in
the next three years. Banks with high ratings in 1969 or 1971 are assumed to be resistant.




MONTHLY REVIEW, JULY 1976

192
Table III

ESTIMATED COEFFICIENTS OF THE ARCTANGENT REGRESSIONS
Coefficients
Estimation
period

Base year

Ra
ao*

a if

1969

1970-72

- 2 .7

- .6 2

.94

1971

1972-74

-1 .9

-.6 0

.91

♦Coefficents ao are constant terms.
tCoefficients ai relate changes in bank scores to changes in probabilities.

is, for any two banks the one with the lower score (m ean­
ing that it is more vulnerable) should have a higher proba­
bility of receiving a low supervisory rating subsequent to
the base year.
A conveniently available trigonometric function having
the required properties is:
Pi = 0.5 +

- arctan (a0 + a i Si),
7T

where Pi is the probability that each bank will receive
a low supervisory rating, a0 and ax are the coefficients
to be estimated from the regression, and Si is each bank’s
score. A simple transformation yields an equation that
can be estimated using linear regression techniques:
tan (7r(Pi— 0 .5 )) = a0+ a i Si

oration in 1970-72) and the base year 1971 (estimating
probabilities of deterioration in 1972-74) are shown in
Table III. The fit is good in both periods, as indicated by
values of R 2 in excess of .90. While the ai coefficients,
which relate changes in bank scores to changes in proba­
bility, are not significantly different, the constant terms, a0,
do differ significantly between the two base years. The
shift appears to reflect overall changes in banking prac­
tices as well as differences in the external economic en­
vironment: during those years. The lower negative value of
a0 in the later period suggests that banks faced a higher
risk of deterioration or failure for any given level of bank
score as a result of the generally more difficult economic
and financial conditions at the time. The chart illustrates
the relationship between bank scores and the probability
of receiving a low supervisory rating, given the bank
scores in the base year 1971 and the supervisory ratings
assigned to these banks over the subsequent three years.
The probability function can be related to the earlier
efficiency measurement in which banks were designated
either as resistant or vulnerable, and supervisory resources
were allocated primarily to the vulnerable group. Essen­
tially what was done was to classify as vulnerable all
banks whose probability of receiving a low supervisory
rating was greater than a certain cutoff probability level.
If these optimal cutoff points are translated into the
probability of a bank receiving a low supervisory rating
subsequent to the base year, then all banks with a
probability of about 15 percent or greater would be

Changes in the value of a0 shift the curve to the left or
right, without changing the function’s shape, while a larger
absolute value of ai increases the steepness of the curve
(see c h a rt).6
The estimated coefficients of the arctangent regressions
for the base year 1969 (estimating probabilities of deteri­

RELATIONSHIP BETWEEN BAN K SCORES IN 1971
A N D THE PROBABILITY OF RECEIVING A LOW
SUPERVISORY RATING IN THE PERIOD 1972 TO 1974
P r o b a b ilit y o f r e c e iv in g a lo w s u p e r v is o r y
r a t in g in th e p e r io d 1 9 7 2 t o 1 9 7 4

6 The choice o f the arctangent function is arbitrary and was
heavily influenced by convenience for programming the regres­
sions. Other estimating procedures are being explored and will be
reported on in subsequent papers. Of particular interest is logit
analysis, a technique that treats the actual occurrence or non­
occurrence of an event as a dependent variable without the con­
struction of observed probabilities. It also dispenses with the inter­
mediate step of combining the independent variables into a single
bank score; the relative weights of the variables in the estimated
probability function are computed within the regression itself.
The technique is described by Strother H. Walker and David
Duncan, “Estimation of the Probability of an Event as a Func­
tion of Several Independent Variables”, Biometrika (1967), and
is applied to credit analysis in The Journal of Commercial Bank
Lending (August 1974) by Delton L. Chesser.




193

FEDERAL RESERVE BANK OF NEW YORK
Table IV
ANALYSIS OF GAINS IN EFFICIENCY FROM CLASSIFICATION
OF BANKS INTO RESISTANT AND VULNERABLE GROUPS
ON THE BASIS OF VARIOUS PROBABILITY LEVELS
In percent
1972-74

1970-72
Cutoff
probability
level

Percentage of
banks having low
supervisory ratings
correctly identified

Gain in
efficiency

Percentage of
banks having low
supervisory ratings
correctly identified

Gain in
efficiency

10 .....................

94.7

34.3

96.4

14.1

Optimal* .........

86.8

47.2

92.9

42.2

20 ....................

55.3

34.7

75.0

25.6

30 ....................

39.5

19.5

58.9

6.6

40 ....................

21.1

3.4

41.1

—41.1

50 .....................

15.8

60 ....................

13.2

3.2
-

26.8

-7 4 .8

1.5

21.4

-8 9 .6
t

70 .....................

5.3

-13.9

16.1

80 ....................

2.6

—15.9

10.7

t

90 .....................

0

-1 5 .6

3.6

t

* For 1970-72 the optimal cutoff probability level was 13 percent; for 1972-74
it was 16 percent,
t Large loss.

considered vulnerable. As shown on Table IV, the effi­
ciency of other specific probability levels can be
determined. For example, the first line on the table
indicates that, if banks with a 10 percent or higher prob­
ability of receiving a low supervisory rating were ex­
amined, the gain in efficiency relative to annual examina­
tions would have been 34 percent in the 1970-72 period
and 14 percent in 1972-74.
FORECASTING SUPERVISORY RATINGS

of banks that actually received low' supervisory ratings in
1975 would increase as the range of estimated probability
increased to higher levels. Table V shows that this is in
general what happened, although 1975 represented only
one third of the forecast period. Only 2.2 percent of the
banks with probability estimates of 20 percent or less re­
ceived low ratings in 1975, but 41.5 percent of banks with
probability estimates of 80 percent or more had low ratings.
Since this test included some banks that had low super­
visory ratings not only in 1975, but also in earlier years
on which the function was originally estimated, a further
test was conducted. In this test, low-rated banks in each
probability range were included only if they had received
low supervisory ratings for the first time in 1975. These
are the banks that, on the basis of a naive decision rule
employed in 1974, might have been expected to continue
to receive high or intermediate supervisory ratings in 1975.
The third column of Table V shows that only 0.7 percent
of the banks in the probability range of 20 percent or less
received low supervisory ratings for the first time in 1975,
compared with 19.5 percent for those with probabilities of
over 80 percent. More than half the banks that received
low supervisory ratings for the first time in 1975 were in
the highest probability range in 1974. This test, while
rough and based on the relatively small number of banks
that received low supervisory ratings in 1975, suggests that
the early warning function has a significant capability for
identifying vulnerable banks in years subsequent to the
estimation period.

Table V
PERFORMANCE OF AN EARLY W ARNING FUNCTION
IN PREDICTING BANKS LIKELY TO RECEIVE
LOW SUPERVISORY RATINGS IN 1975
In percent

The forecasting ability of the early warning function
must be tested in periods that extend beyond those
used to estimate the function. This test is not yet possible
for the function estimated over the 1972-74 period, since
the data for a comparable three-year period are not yet
available. Nonetheless, we conducted preliminary tests,
assuming economic conditions similar to those of 1972-74,
and the results are encouraging. The results of one
test are shown in Table V. Using the function computed
over the period 1971-74, the estimated probability of a
bank receiving a low supervisory rating in 1975-77 was
obtained for each Second District member bank, based on
1974 financial reports. The banks were classified into five
ranges of probabilities. We expected that the proportion




Estimated probability
of receiving a
low rating as of 1974*

Percentage of the banks in various
probability ranges as of 1974, which:
Had a low supervisory
rating in 1975t

Received a low rating
for the first time in 1975t

0.7

0 to 20 ............................

2.2

20 to 40 ............................

10.2

1.5

40 to 60 ............................

17.3

6.9

60 to 80 ............................

16.1

6.5

80 to 100 ............................

41.5

19.5

* Assumes an economic environment similar to that of 1971-74. Probability
estimates are derived from 1974 financial statements of Second District
member banks.
f All banks with low supervisory ratings in 1975, regardless of previous ratings.
J Banks with low supervisory ratings in 1975 that did not have low ratings in
1974.

MONTHLY REVIEW, JULY 1976

194

CONCLUDING REMARKS

The probability approach shows considerable promise
as a useful guide to the degree and intensity of supervision
appropriate for banks within an overall group designated
vulnerable in any base year. Those banks with relatively
high probabilities of deterioration could be considered
candidates for the most immediate and intensive super­
visory attention. However, to achieve substantial overall
gains in efficiency, supervisory resources must also be
allocated to banks with relatively low probabilities of
deterioration subsequent to the base period. While the
precision and efficiency of the forecasts can be expected
to improve with more sensitive measures to detect finan­
cial weakness at an early stage, some uncertainty is bound
to remain in view of the probabilistic nature of financial
early warning systems.
New approaches are in process of development. For
example, we are exploring methods to estimate the proba­
bilities of failure or a low supervisory rating directly from




the early warning variables involved without the inter­
mediate step of the bank score. This change involves a
specific weighting of variables and may lead to improve­
ments in the sensitivity of the probability functions. A
great deal more must be done to sharpen the measures
employed as early warning indicators, thus ensuring that
future areas of weakness do not escape unnoticed.
There is also a need in early warning research for a
far more thorough analysis of the structure of bank loan
portfolios than has been available thus far. In particular,
the consequences of industry or geographic concentrations
of loans and investments during a period of adverse eco­
nomic or financial developments are areas that deserve
careful study. The balance-sheet and income data which
banks are now providing in greater detail and frequency
should prove valuable in future early warning research.
We are optimistic, however, that the approaches outlined
here can do much to assist bank supervisors in spotting
potentially vulnerable banks before the problems of these
institutions threaten their viability.