Full text of Economic Policy Review (Federal Reserve Bank of New York) : Spring 1987, Vol. 12, No. 1

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Federal
fte6enfeBank of
ie irY o rk

Spring 1987

Volume 12 No. 1

A Perspective on the Globalization of Financial
Markets and Institutions

The Growth of the Financial Guarantee Market

The Household Demand for Money: Estimates
from C ross-sectional Data

Monetary Policy and Open M arket Operations
during 1986

57
64

Treasury and Federal Reserve
Foreign Exchange Operations
February-April 1987
November 1986-January 1987

This Quarterly Review is published by the
Research and Statistics Group of the
Federal Reserve Bank of New \brk.
Statement of E. GERALD CORRIGAN,
President of the Bank, on a perspective on
the globalization of financial markets and
institutions begins on page 1. Among the
members of the staff who contributed to
this issue are BEVERLY HIRTLE (on the
growth of the financial guarantee market,
page 10); and LAWRENCE J. RADECKI
and CECILY C. GARVER (on the
household demand for money: estimates
from cross-sectional data, page 29).
A report on monetary policy and open
market operations in 1986 begins on
page 35.
Two quarterly reports on Treasury and
Federal Reserve foreign exchange
operations for the periods February
through April 1987 and November 1986
through January 1987 begin on pages 57
and 64.

A Perspective on the
Globalization of Financial
Markets and Institutions
Mr. Chairman and members of the Committee: I am
pleased to be able to appear today in order to discuss
with the Committee recent and prospective develop
ments regarding the globalization of financial markets
and institutions, with particular emphasis on develop
ments in the three major financial centers of the world:
New York, London, and Tokyo. Within that broad
framework, I will devote particular attention to a series
of issues pertaining to access of U.S. firms to money
and securities markets in Japan.

Background
Legend has it that Willie Sutton once said that he
robbed banks because that’s where the money was. The
analogy is poor, but there can be no doubt that much
of the current interest in Japanese financial markets
stems from that same consideration: that’s where the
money is! Indeed, reflecting its very large domestic
savings rate and its massive current account surplus,
Japan has assumed a unique financial position in the
world’s community of nations. But Japan’s financial
position relative to the United States or to the rest of
the world did not develop in a vacuum. Thus, before
turning to the specific questions raised by the Com
mittee, allow me to comment briefly on the general
economic and financial environment within which we
must seek to address the points of stress and tension
which are so apparent.
Statement by E. Gerald Corrigan, President, Federal Reserve Bank
of New York, before the Committee on the Budget, United States
Senate, on Wednesday, May 6, 1987. The full testimony also
included four appendices which are available from the Public
Information Department of the Federal Reserve Bank of New York.

That broader perspective should include at least four
major points of reference, as follows:
First, the dramatic rise in Japan’s external surplus
over the decade of the 1980s and the corre
sponding increase in the external deficit of the
United States are primarily the result of macroe
conomic considerations, including (1) the per
sistent and very large domestic savings gap in the
United States—growing importantly out of the huge
budget deficits—coupled with Japan’s extraordi
narily high internal savings rate; and (2) consid
erably more rapid growth in domestic demand in
the U.S. economy, especially during the earlier
stages of the current expansion. There is also the
related issue of apparent differences in the ability
of U.S. firms, perhaps especially manufacturing
firms, to compete effectively in the external mar
ketplace or with external competitors. All three of
the factors, together with associated swings in
exchange rates—swings that in my view tend to
be exaggerated by the marketplace—lie at the
heart of the severe imbalances in the world
economy. The relative openness, or lack thereof,
of Japanese financial markets is at most a mar
ginal factor insofar as the underlying causes of
trade and current account imbalances are con
cerned.
Second, reversing the imbalances that have
developed over the past five years will not be easy
and will take time. Moreover, if that adjustment is
to take place in a context of growth rather than
in a framework of contraction, we must deal with
the fundamentals. More open external markets for

FRBNY Quarterly Review/Spring 1987

U.S. products and services are an important part
of the agenda for adjustment, but absent under
lying changes in economic policies and perform
ance here in the United States as well as else
where in the world, more open financial markets
simply will not materially help the adjustment
process along.
Third, under the best of circumstances, the United
States will be dependent on capital inflows from
abroad for several years to come. That is, and to
use a purely hypothetical example, even if our
budget and trade deficits move lower at roughly
the same speed as they increased, the United
States would still have relatively large— and
cumulating— current account deficits for the next
few years. This, of course, implies that our
external indebtedness will continue to grow, even
if at a slower rate, such that net capital inflows
will be needed. To the extent these necessary
capital flows are impeded— for whatever reason
—the implications for interest rates and exchange
rates, and therefore domestic economic activity,
are almost certain to be detrimental here and

...reversing the imbalances that have developed over
the past five years will not be easy and will take
time....More open external markets for U.S. products
and services are an important part of the agenda
for adjustment, but absent underlying changes in
economic policies and performances...more open
financial markets simply will not materially help the
adjustment process along.
elsewhere. To put it more directly, we must take
care to conduct our affairs in such a way that our
foreign creditors will be willing to acquire and hold
the needed amounts of dollar-denominated assets
at interest rates and exchange rates that are oth
erwise consistent with nonmflationary growth in the
U.S. and world economy.
Fourth, whether we like it or not, the globalization
of financial markets and institutions is a reality.
Since that reality has been brought about impor
tantly by technology and innovation, it cannot be
reversed in any material way by regulation or
legislation. Moreover, while this process of glob
alization and innovation is producing important
benefits to suppliers and users of financial serv
ices, it also produces anomalous results. To cite
an example or two, Japanese securities compa
nies—whether owned by Japanese or foreign
firm s—cannot generally engage in foreign
exchange trading and position-taking in Tokyo but

FRBNY Quarterly Review/Spring 1987
Digitized for2 FRASER

they do it in London and New York; U.S. banking
companies cannot underwrite corporate debt and
equity securities in the United States, but they do
it in London or elsewhere.
More generally, national systems of supervision
and regulation—to say nothing of tax and
accounting policies—that were created many years
ago were not designed for a marketplace of
worldwide dimensions in which firms with differing
charters and national origins compete head-tohead with each other around the clock and around

To put it more directly, we must take care to conduct
our affairs in such a way that our foreign creditors
will be willing to acquire and hold the needed
amounts of dollar-denominated assets at interest
rates and exchange rates that are otherwise con
sistent with noninflationary growth in the U.S. and
world economy.
the world. This situation is one of the reasons why
I believe the Congress must get on with the task
of fundamental reform of the structure of our
banking and financial system—a task that is
already well underway in several other countries.
A more rational structure at home—including a
structure that works in the direction of strength
ening the banking and financial system—would
help encourage a more rational structure inter
nationally. Both now and in the future, this is
probably more important to the prospects for U.S.
financial firms and U.S. national interests than are
the relatively narrow issues of immediate dispute
in particular markets.
In short, there are important and legitimate concerns
that must be dealt with pertaining to access of U.S.
firms to foreign financial markets. However, in seeking
constructive solutions to those problems, we must be
sensitive to the larger picture and we must recognize
that the solutions to these larger problems are not to
be found in the relatively narrow context of specific
equity and access issues pertaining to the activities of
U.S. financial firms abroad, as important as those issues
are for other reasons.

Major international financial markets: an overview
At the risk of injuring the sensitivities of our friends in
Frankfurt, Zurich, or Hong Kong—to say nothing of
Chicago or San Francisco—it is probably fair to say that
there are three dominant financial centers in the world
today: London, Tokyo, and New York. Accordingly, and
to provide some further perspective, Exhibit I attempts

to categorize the scope of activities available to various
classes of domestic and foreign institutions in each of
these markets.
As the exhibit indicates, there are important differ
ences from one market to the other, but as a general
m atter, these differences do not reflect strictly legal
distinctions based on the national origin of the firm in
question. To put it differently, all three markets have de
jure conditions of broad national treatm ent insofar as
the general range of banking and financial activities is
concerned even though there are important differences
between the centers and, as noted later, important de
facto distinctions in terms of competitiveness of foreign
versus dom estic concerns. For example:
• as mentioned earlier, banks, domestic or foreign,

cannot as a general m atter underwrite corporate
securities in New York or Tokyo but they may do
so in London.
• securities companies, domestic or foreign, may not
as a general m atter deal in foreign exchange in
Tokyo but they may in London and New York.
• in two instances, there is a small tilt in favor of U.S.
banks in that as of March of this year, U.S. banks
in Tokyo may have a securities affiliate whereas
domestic Japanese banks may not, and U.S. banks
were permitted in 1986 to own trust banks in Tokyo
whereas Japanese city banks may not. By the same
token, there are a number of foreign banks (none
of which is Japanese) which have grandfathered
securities subsidiaries in the United States.

Exhibit I

Permissible Activities by Type of Institution
US
Bank
Holding Co
NY
YES
LO
YES
YES
TO

Japanese
City
Bank
NY
YES
LO
YES
TO
YES

type of Institution
(3)
(4)
UK
US
Clearing
Securities
Bank
Firm
NY
NY
YES
S
LO
YES
LO
YES
TO
YES
TO
NO

Dealing in
Corporate
Securities

NY
LO
TO

NO
YES
S

NY
LO
TO

NO
YES
NO

NY
LO
TO

NO
YES
S

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

Foreign
Exchange
Dealing

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
NO

Dealing in
U.S.
Treasuries

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

Dealing in
UK Gilts

NY
LO
TO

NO
YES
NO

NY
LO
TO

NO
YES
NO

NY
LO
TO

NO
YES
NO

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

Dealing in
Japanese
Gov’t bonds

NY
LO
TO

NO
YES
YES

NY
LO
TO

NO
YES
YES

NY
LO
TO

NO
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

Trust
Bank

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
NO

NY
LO
TO

YES
YES
YES

NY
LO
TO

S
YES
NO

NY
LO
TO

S
YES
NO

NY
LO
TO

S
YES
NO

Account at
the Central
Bank

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

YES
YES
YES

NY
LO
TO

S
YES
YES

NY
LO
TO

S
YES
YES

NY
LO
TO

S
YES
YES

Activity
( 2)

( 1)

Banking
License

NY
LO
TO
YES
NO
S

=
=
=
=
=
=

(5)
Japanese
Securities
Firm
NY
S
YES
LO
TO
NO

(6)
UK
Merchant
Bank
NY
S
LO
YES
TO
NO

New York
London
Tokyo
Full license permitted.
Not generally permitted.
Permitted only through special purpose companies, such as a 50 percent owned affiliate or a nonbank bank.

FRBNY Quarterly Review/Spring 1987

in short, looking at broad classes of financial activities
in the three m ajor centers does not suggest that there
are systematic patterns of discrimination against foreign
participants in any of the centers that are rooted in law.
However, the simple “ yeses” and “ noes” in Exhibit I
do not even begin to tell the whole story. Thus, the
balance of this section will look at the individual markets
in somewhat greater detail.

...national systems of supervision and regulation—
to say nothing of tax and accounting policies—that
were created many years ago were not designed for
a marketplace of worldwide dimensions in which
firm s with differing charters and national origins
compete head-to-head with each other around the
clock and around the world.

Banking markets
For several decades, foreign banking institutions have
had a major presence in the United States. This reflects
several key factors, including: (1) the m ultinational
population base of the United States; (2) the size and
importance of U.S. markets; and (3) the role of the U.S.
d o lla r as a rese rve cu rre n cy and an in te rn a tio n a l
medium of exchange.
Typically, foreign banks operating in the U.S. market

concentrate th e ir a c tivitie s heavily on the so -called
w ho lesa le m arket. W h ile th e re are som e im p o rta n t
exceptions, foreign banks are generally not m ajor fa c
tors in retail banking m arkets. In addition, most of the
foreign banks that have a sizable presence in the United
S tates are a ffilia te d w ith w e ll-kn o w n m ajor banks
abroad, many of which have Triple-A credit ratings.
Needless to say, the prominent names of some of these
institutions, together with their credit ratings, give them
important recognition in their activities here in the United
States.
As of year-end 1986, there were more than 250 fo r
eign banks that had some kind of presence in the
United States. In the aggregate, the assets of such
foreign banks exceeded $500 billion (Exhibit II) at yearend 1986 and constituted almost 20 percent of total U.S.
banking assets. To an extent, this figure is inflated by
virtue of the fact that some foreign banks— notably the
Ja pa ne se — book m ost of th e ir W estern H em isphere
loans in U.S. offices. W hile not shown in the exhibit,
foreign banks also account for about 20 percent of all
commercial and industrial loans outstanding to United
States addressees. In both instances, Japanese banks
are by far the most dom inant group of foreign banks,
accounting for nearly half of the total assets and com
mercial loans outstanding at foreign banks in the U.S.
In certain markets, such as standby letters of credit and
standby’s associated with U.S. municipal bond offerings,

Exhibit II

Banking Operations of Foreign Banks in the United States
Total U.S. banking assets (In billions)* of major foreign countries as of December 31
Expressed as a percentage of total U.S. banking assets
1985
dollars percent
181.3
6.1
1.7
42.3
2.4
61.2
1.1
29.1
0.7
18.3
20.7
0.8
0.4
8.8
97.2
3.8

1986
dollars percent
8.7
245.4
42.4
1.5
40.6
1.5
36.4
1.4
24.5
0.9
22.4
0.8
0.4
11.0
3.8
103.9

Japan
Canada
United Kingdom
Italy
Switzerland
France
West Germany
All other countries
Total U.S. banking assets
of foreign banks

300.6

331.9

378.3

458.9

526.6

1,821.1

1,986.5

2,076.8

2,098.7

2,285.9

2,121.7

100

2,318.4

100

2,455.1

100

2,557.6

100

2,812.5

100

Total assets of
domestic banking
institutions-!Total U.S. banking
assetsf

1983
dollars percent
126.0
5.0
27.8
1.2
53.0
2.3
0.8
17.5
13.1
0.6
0.7
16.2
7.4
0.3
70.9
3.1

1984
dollars percent
151.3
6.1
38.1
1.5
51.4
2.0
23.9
0.9
15.3
0.6
0.7
18.3
7.6
0.3
72.4
2.9

1982
dollars percent
5.0
113.0
22.1
1.0
52.2
2.5
0.7
14.3
13.0
0.6
16.6
0.8
0.4
8.9
3.0
60.5

Countries

’Amounts for each country include the total U.S. banking assets of all banks from that country, namely the aggregate of the assets of their U.S. branches,
agencies, bank subsidiaries, Edge Act and Agreement corporations and New York State-chartered investment companies (called Article XII corporations),
flncludes the total consolidated assets (domestic and international) of all U.S. banks.

FRBNY Quarterly Review/Spring 1987

Japanese banks now account for between one-quarter
and one-half of the total U.S. market.
Measured in terms of numbers of institutions, the U.S.
banking presence in Japan is similar to that of Japanese
banks in the United States. However, in terms of asset
size, in either absolute or relative terms, U.S. banks are
much smaller in Japan than are Japanese banks here,
with total assets in Japan of something short of $20
billion. As in the United States, most foreign banking
activities in Japan are concentrated in the wholesale
markets and in activities such as foreign exchange
trading. In the recent past, however, at least one U.S.
bank has demonstrated some interest in selective
aspects of the Japanese retail banking markets.
The reasons for the relatively small U.S. banking
presence reflect a variety of factors. Historical and
strategic considerations probably play a role. It is also
true that U.S. banks find it more attractive to book Asian
loans in Hong Kong or Singapore rather than in Tokyo.
Finally, the historical rigidities of the local funding mar
kets in Japan make it difficult to build up a large
banking operation in Japan, especially in the face of

In short, looking at broad classes of financial
activities in the three major centers [London, New
York, Tokyo] does not suggest that there are sys
tematic patterns of discrimination against foreign
participants in any of the centers that are rooted in
law.
lingering uncertainties as to the receptivity of Japan to
a broad-based presence of major foreign banks.
While the size of the U.S. banking presence in Japan
is small, the same cannot be said for London. Indeed,
the U.S. banking presence in London is more than six
times the U. S. presence in Japan. And U.S. banking
assets in the United Kingdom are roughly three times
greater than U.K. banking assets in the United States.
To a considerable extent, the size of U.S. banking
operations in London reflects the long history of the
importance of the London market, its openness to for
eigners, and its association with the Eurocurrency
markets which are so important to U.S. companies—
financial and nonfinancial alike. In short, the London
market has, for many years, sought out and welcomed
foreign banks, in part by maintaining a “ friendly” reg
ulatory environment.
Securities markets
The comparative nature and scope of securities market
activities by foreign firms in the three major markets are
distorted somewhat because the U.K. does not require
strict separation of commercial and investment banking,

whereas both Japan and the United States make such
a distinction. In addition, data on relative size and
importance of securities market activities are not as
readily available as in banking. However, these limita
tions notwithstanding, some approximations of size and
importance are possible.
In terms of numbers of firms and employment levels,
U.S. securities firms’ presence in Japan and Japanese
securities firms’ presence in the United States are very
roughly equivalent and both have been growing quite
rapidly in recent years. The activities of U.S. securities
firms in Japan and Japanese firms in the United States
also tend to be quite similar in that both are concen
trated in trading-type activities. Both classes of insti
tutions are engaged in underwriting activities in each
other’s markets but, to date, virtually all such under
writing by the foreign participants in both markets takes
place as syndicate members, not as syndicate leaders
or managers. In the United States, four Japanese
securities houses (the "big four” ) are members of the
New York Stock Exchange while in Japan three U.S.
securities houses—and one securities company that is
owned by a U.S. bank through its London merchant
bank—are members of the Tokyo Stock Exchange.
In short, in many respects, the relative size and
importance of U.S. securities firms in Japan and Jap
anese securities companies in the U.S. are quite similar
and, as noted earlier, both are growing rapidly. However,
despite these broad similarities, there are particular

...there are particular points of tension regarding
the treatment of U.S. financial firms in Japan which
are not generally in evidence with regard to the
treatment of Japanese financial firms in the United
States.
points of tension regarding the treatment of U.S. finan
cial firms in Japan which are not generally in evidence
with regard to the treatment of Japanese financial firms
in the United States.

Japanese initiatives: financial deregulation and access
The post-war Japanese financial system was, in many
respects, modeled after the U.S. system. Not surpris
ingly, therefore, several features of the Japanese system
which are the subject of controversy today—including
interest rate ceilings on deposits and legal barriers
separating classes of financial institutions including
commercial and investment banks—are precisely the
same issues that have and continue to provoke con
troversy in the United States. In Japan, as in the United
States, pressures for sweeping change in the structure

FRBNY Quarterly Review/Spring 1987 5

and regulation of financial markets were largely muted
until the late 1970s and early 1980s. Similarly, while
U.S. financial firms have, for some time, had a minor
presence in Japan, it was not until fairly recently that
pressures for greater access built in a major way. These
mounting pressures for deregulation and more open
access reflected the interaction of a powerful set of
macroeconomic forces as well as the wave of change
and innovation that is rapidly transforming financial
markets and institutions around the world.
In response to these forces, the Japanese authori
ties—under prodding from the United States and other
governments—have over the past several years made
major changes in the structure and regulation of finan
cial markets, including important reductions in barriers
to foreign presence in the Tokyo markets. Taken as a
whole, the actions by the Japanese over the past sev
eral years are noteworthy, especially in the relatively
short time frame involved. Indeed, I believe a case can
be made that the Japanese record of the past several
years is better than some observers suggest and is
good enough to warrant confidence that further progress
will be made in the future.
Having said that, I would hasten to add that despite
this progress, the situation in Japan is still one in which
barriers— visible and invisible—to open and effective
competition between U.S. and Japanese financial firms
remain important factors limiting the activities and
competitive effectiveness of U.S. firms in Japan. It is
also true that as the strategic importance of the Tokyo
marketplace continues to grow and competitive pres
sures mount, concerns about those barriers have
received increasing attention. However, in a number of
important instances, specific issues raised by U.S. firms
have little or nothing to do with national treatment con
siderations.
At the risk of a great oversimplification, the points of
immediate concern to U.S. firms can be classified as
follows:
• Equal treatment issues: While purely legal barriers
to national treatment of U.S. firms in Japanese
markets have been eliminated, certain distinctions
between the treatment of U.S. and Japanese firms
are seen as having important competitive implica
tions even though the basis for the distinction is
not to be found in law. Concerns about practices
for issuing government debt and limitations on
seats on the Tokyo Stock Exchange would fit in this
category.
• Regulatory policies: There are several areas of
regulatory policy which are viewed by some U.S.
firms as especially troublesome. These would
include remaining regulatory and administrative
rigidities in the money market; prohibitions on cer

6 FRBNY Quarterly Review/Spring 1987

tain activities such as foreign exchange trading by
securities companies; and other miscellaneous
matters such as withholding taxes on interest
income to foreigners and limitations on the ability
to engage in short selling. While all of these poli
cies apply equally to U.S. and Japanese firms,
certain U.S. firms allege that, in practice, they are
more binding on U.S. firms since they impinge on
activities in which U.S. firms have special expertise.
There is, however, another important area of
regulatory policy which results in important differ
ences in treatment and that relates to capital ade
quacy standards for banks, a subject which is
covered in greater detail later in this statement.
• Limitations on acquisitions: In most foreign coun
tries, acquisitions of banks or other financial con
cerns by U.S. firms are either limited by law or
regulation or are very difficult to achieve as a
matter of practice. In Japan, the most significant
current barrier to acquisition may be price, but
whatever the reason, it is easier for foreign entities
to acquire U.S. banking and financial institutions
than is the reverse.
• Invisible barriers: There are a host of considera
tions ranging from language and custom to rela
tionships with bureaucrats which can be barriers to
market participants in any foreign center, and Japan
is certainly no exception. Indeed, some observers
would contend that so-called invisible barriers in
Japan are more of a problem than is the case in
other international financial centers.

The record of the past six months

Over the past several months, Japanese authorities
have implemented several important policy changes in
furtherance of the goal of more open and more com
petitive financial markets in Japan. These steps included
the following:
• Deposit deregulation: Effective April 6, 1987, the
Ministry of Finance (1) reduced the minimum size
of time deposits which are free of interest rate
ceilings from 300 million yen (about $2 million) to
100 million yen (about $700,000); and (2) reduced
the minimum size of money market certificates from
30
million yen (about $200,000) to 20 million yen
(about $150,000). Both the new and the old regu
lations apply equally to domestic and foreign insti
tutions.
In the area of deposit deregulation and greater
money market flexibility, national treatment con
siderations are not the central issue since Japanese
institutions operate under the same rules as foreign
institutions. Rather, the money market issues are
more a matter of greater market efficiencies in a

setting in which firms with special market exper
tise—Japanese or others—can take full advantage
of those skills. While the extent of money market
deregulation achieved is important, further steps are
needed. This area will be one of those considered
at the next round of so-called yen-dollar discussions
between the U.S. Treasury and Japanese authori
ties planned for the near future.
• Securities affiliates of U.S. banks: In March 1987,
the Ministry of Finance formally advised that it had
amended its regulations to permit U.S. banking
organizations to have securities affiliates in Japan,
subject to the same terms and conditions that apply
to securities affiliates of European universal banks.
What is particularly significant about this action is
that it provides access to Japanese securities
markets for U.S. banks even though such access
is not available to Japanese banks. It would also
permit these U.S. bank affiliates in Japan a wider
range of securities activities than is permissible
here in the United States.
At present, there are three U.S. banks with
securities affiliates in Japan through their U.K.
merchant banks and I know of four U.S. banking
organizations that are seeking to obtain licenses for
securities affiliates under the arrangements noted
above. The requests are in the advanced stage of
review such that formal applications will soon be
filed with final approvals expected in the near term.
Of course these arrangements would also be sub
ject to approval of U.S. bank regulatory authorities.
• Access to the government securities market: Prior
to 1978, all Japanese government debt was sold
by the so-called syndicate method whereby the
terms of such debt issues were negotiated by the
government and a syndicate of financial companies.
Each member of the syndicate, in turn, received a
predetermined share of the securities issue. The
syndicate method of issuing government debt is still
the dominant method of debt issuance in a number
of countries, including a few major industrial coun
tries. It is also the general procedure followed by
Federal government agencies here in the United
States as well as the prevailing method for issuing
most corporate and municipal debt.
Because most Japanese government debt was
issued in this fashion and because U.S. firms were
generally not part of the syndicate, U.S. firms did
not have meaningful direct access to new issues
of Japanese government securities. De facto limits
on access to new issues of government securities
placed U.S. firms at a competitive disadvantage not
just in the government market itself but in other
markets as well because of the important linkages

between government securities and other securities.
In response to this situation, the Japanese
authorities have taken several steps. First, for a
number of short- and intermediate-term issues, they
have fully adopted the auction method such that
about 35 percent of new issues in 1986 were auc
tioned. In addition, the Japanese authorities have
eliminated the requirement of having an account at
the Bank of Japan in order to be eligible to bid in
such auctions. However, the 10- and 20-year
m aturities are s till issued by the syndicate
method—a fact that is especially important in the
case of the 10-year bond which is the largest and
most important of the issues, especially in terms
of secondary market trading.
In these circumstances, effective April 1, 1987,
the syndicate has agreed to increase the total share
of the new issues available to foreign securities
firms from 1.19 percent to 5.725 percent of the
share available to securities houses and it has
raised the shares available to individual foreign
companies from 0.07 percent to a maximum of 1

...[the] latest initiatives by the Japanese strike me
as helpful and as reflective of continued good faith
efforts to move ahead with financial market liber
alization. To be sure, further effort on a variety of
fronts is needed.
percent. While still small, we understand that these
shares for the foreign group as a whole are com
mensurate with the overall size of foreign securities
firm secondary market trading in yen government
bonds. Finally, as discussed below, the Ministry of
Finance apparently is considering additional steps
which would further open the market for Japanese
government debt to foreign market participants.
Taken in the context of measures initiated by the
Japanese authorities over the past several years, and
taken in the context of further steps that may be under
consideration at the present (see below), these latest
initiatives by the Japanese strike me as helpful and as
reflective of continued good faith efforts to move ahead
with financial market liberalization. To be sure, further
effort on a variety of fronts is needed.

Looking to the future
In looking to the future, there is a clear need to reduce
both the specific points of friction referred to in this
statement and, more importantly, to deal with the
underlying problems which are at the heart of current
tensions in the international economic and financial
arena.

FRBNY Quarterly Review/Spring 1987 7

Insofar as particular problems relating to the activities
of U.S. banks and securities companies in Japan are
concerned, I would hope and expect that the Japanese
would continue to move forward with efforts to liberalize
their domestic financial markets, thereby providing
greater competitive opportunities for U.S. firms in the
Japanese marketplace. As I see it, there are four spe
cific areas that warrant particular attention:
• Greater access to the Japanese government
securities market: In this area, I believe that the
Japanese authorities may be considering one or
more possible further steps including: (1) the
offering through auction of new maturities of inter
mediate and longer term issues which would work
in the direction of increasing the percentage of
issues sold through auction; (2) shifting the 20-year
issue from a syndicate to an auction; and (3) the
use of something like the U.S. noncompetitive
tender system in the 10-year maturity which could
provide larger shares to U.S. market participants
while still preserving the syndicate framework for
that issue. Needless to say, I would welcome ini
tiatives along these lines which could pave the way
to the day in which the auction method of issuing
debt was the general practice. In turn, this would
be an important step in the direction of establishing
market practices in the Japanese government
securities markets that are more in line with prac
tices here and in London.

...the single item on which I place greatest emphasis
relates to bank capital adequacy standards and
specifically to the goal of moving Japanese bank
capital standards into closer alignment with
emerging international standards.
• Increased representation in the Tokyo Stock Ex
change: As I understand it, plans are now
underway to expand the number of seats—including
seats held by foreigners—on the Tokyo Stock
Exchange next spring when new facilities and
computer capabilities will be in place. Procedurally,
this will entail the establishment of a membership
committee within the exchange in the near term. I
am led to believe the committee’s deliberations
should be completed and its recommendations
made to the full exchange membership late this
year. Here too, I expect that the result of these
deliberations would be some added representation
of U.S. firms in the exchange. I would also hope
the time schedule for this process could be accel
erated, but I do understand the practical problems
involved.

8 FRBNY Quarterly Review/Spring 1987

• Money market liberalization: As noted earlier, the
next round of discussions between the Japanese
authorities and U.S. Treasury representatives are
scheduled to take place shortly. Those discussions
will, among other things, focus on. what further
steps might be taken to reduce rigidities in the
Japanese money market which, in turn, can make
it easier for U.S. institutions to compete in the
market and thereby more easily fund Japanesebased lending and securities market activities in the
local currency.

Taking a longer term view of the situation, Japan
faces many of the same problems in the financial
area that we are so conscious of here in the United
States. Namely, much of its overall banking and
financial structure—as well as the regulatory and
supervisory apparatus associated with that
structure—were not designed for the current inter
national market environment.
• Bank capital standards: While the areas mentioned
above are important, the single item on which I
place greatest emphasis relates to bank capital
adequacy standards and specifically to the goal of
moving Japanese bank capital standards into closer
alignment with emerging international standards.
Efforts to establish international standards for
bank capital adequacy have been underway within
the Bank for International Settlements (BIS) for
about three years. This effort was undertaken by
the G-10 central bank governors in recognition of
the fact that both competitive and prudential con
siderations pointed to the need for such standards
as the globalization of banking was proceeding very
rapidly. While efforts are proceeding in the BIS and
through other multinational channels, the United
States and the United Kingdom reached agreement
earlier this year on a joint approach to capital
standards in our respective countries. Such pro
posals were made available for public comment in
January and final rules are expected to be put in
place sometime later this year.
Senior officials of both the Bank of Japan and
the Ministry of Finance have indicated that they
agree in principle that Japanese bank capital
standards should, in due course, be brought into
broad alignment with international standards. And,
preliminary discussions between senior Federal
Reserve, Bank of England, and Japanese officials
have been held on the subject. Further discussions
are scheduled in the near term.
Achieving the needed degree of convergence in

this area will be much more difficult in the case of
Japan than was true with the United Kingdom
because the starting points with Japan are much
further removed from prevailing practices in the
United States and the United Kingdom. Moreover,
as we have seen with U.S. banks, even relatively
minor changes in this area can be controversial.
Thus, while achieving convergence with the Japa
nese will be a long and difficult task. Progress
along those lines is important.
As I see it, the four areas I have mentioned above
are the clear priorities. Given the progress that has
been made in the past, I am confident that efforts to
move ahead in these and other areas will prove fruitful

If we are to come full circle in restoring balanced
growth here at home and in the world more gener
ally, we must also avoid any renewed outburst of
inflation which would undermine prospects on all
fronts.
and mutually beneficial. Partly for this reason, I am
opposed to legislative efforts along the lines of the socalled "primary dealer” amendment that was incorpo
rated into the trade bill passed by the House or as
recently proposed by Senators Proxmire and Riegle. As
I see it, such legislation could have the effect of stalling
rather than accelerating discussions and negotiations,
while possibly producing unintended adverse side
effects—both in terms of general attitudes toward market
liberalization and attitudes regarding capital inflows to
the United States. It would be one thing to consider a
legislative approach in an environment in which progress
and good faith discussions were not taking place.
However, this is not the current situation.
Taking a longer term view of the situation, Japan faces
many of the same problems in the financial area that
we are so conscious of here in the United States.
Namely, much of its overall banking and financial
structure—as well as the regulatory and supervisory

apparatus associated with that structure—were not
designed for the current international market environ
ment. The Japanese will have to come to grips with
these issues just as we and others will have to do the
same. In the case of the Japanese, coming to grips with
these larger issues could also yield a situation in which
constructive change on the Japanese side is forth
coming at their initiative, as a part of that larger
process, rather than as a result of time-consuming and,
at times, difficult discussions of specific points of con
cern and friction. In this regard, the point should also
be stressed that problems of the nature discussed in
this statement—specific or generic—are by no means
limited to Japan.
In concluding, Mr. Chairman, let me return briefly to
where I started—with the economic fundamentals. If we
are to be successful in winding down our external
imbalances in an orderly way, we in the United States
must live up to our responsibilities—which means
learning to live within our means. To be sure, actions
abroad are needed and needed badly. But, as we call
on others to open their markets and stimulate their
economies, let us not lose sight of our end of the bar
gain. Our federal budgetary affairs—despite the efforts
of this committee and others—are still in a state of
disarray and must be put in order; the need for broadbased reform in our own financial structure must be
addressed; pressing questions as to the degree of
underlying competitiveness of our industrial sector must
be answered; and patterns of savings and investment
in our domestic economy must be brought into line with
the longer run needs of rising productivity and standards
of living. If we are to come full circle in restoring bal
anced growth here at home and in the world more
generally, we must also avoid any renewed outburst of
inflation which would undermine prospects on all fronts.
Moreover, balanced growth in the world economy will
also provide a much more constructive environment
within which legitimate issues regarding financial market
practices and evolution can be resolved here and
elsewhere.

FRBNY Quarterly Review/Spring 1987 9

The Growth of the
Financial Guarantee Market

F inancial guarantees are instrum ents of credit
enhancement which insure security purchasers against
default and provide lower borrowing costs to issuers.
The issuer or underwriter of a security purchases a
financial guarantee to insure the timely payment of
principal and interest in the event of the issuer’s default.
In general, this guarantee is unconditional and irrevo
cable, contains no deductible and constitutes a legal
obligation of the insurer to the security holder. The
guarantee is written for the life of the security, which,
in the case of municipal bonds, can be as long as 30
years. Since the capital and resources of the insurer
are pledged to back the insured security, the financial
guarantee makes the security more marketable and
reduces interest cost to the issuer. The financial guar
antee, in effect, is a means for the insurer to "rent” its
superior credit rating to security issuers whose own
ratings are lower. The wedge that permits this trans
action is the interest cost saved by the issuer.
The first financial guarantee product, municipal bond
insurance, was developed in the early 1970s, and since
that time, the market has expanded to include guar
antees on a variety of instruments in both the municipal
and corporate debt markets. Until the late 1970s the
financial guarantee market consisted of just two firms
which wrote guarantees for municipal bonds. The rela
tionship among these firms, state insurance regulators,
professional associations and the major credit rating
agencies was straightforward and well established.
Since 1981, however, the market for municipal bond
insurance in particular and financial guarantees in
general has grown significantly. Financial guarantees are
now written for many different types of securities,

10FRASER
FRBNY Quarterly Review/Spring 1987
Digitized for

including limited partnership obligations, consumer
receivable-backed securities, mortgage-backed securi
ties, long-term and short-term corporate debt and tax
able industrial revenue bonds. Another class of financial
guarantees is being written to cover credit risk in such
transactions as interest rate and currency swaps.
The purpose of this paper is to decribe the cyclical
behavior of the financial guarantee market and to dis
cuss the factors which contributed to the market’s recent
growth. Like other property/casualty insurance lines,
financial guarantees are subject to an underwriting cycle
that is largely determined by changes in interest rates.
Interest rates affect the financial guarantee cycle by
influencing both the investment income of insurers and
the interest cost savings of debt issuers. As the theory
developed in this paper suggests, these influences
cause the quantity of financial guarantee insurance
underwritten to rise and fall with the level of interest
rates. Interest rates also affect the financial guarantee
market through their impact on the rest of the property/
casualty insurance industry. Periods of high interest
rates also tend to be periods of underwriting losses for
property/casualty insurers. Since high interest rate
environments correspond with the peak of the financial
guarantee underwriting cycle, property/casualty insurers
have incentive to redirect capital resources to the
financial guarantee market when interest rates are high.
Thus, the cyclical behavior of the property/casualty
industry reinforces the cyclical behavior of the financial
guarantee market.
While interest rates and the property/casualty under
writing cycle affect the cyclical pattern of the financial
guarantee market, some part of the growth in the market

in the 1980s can be attributed to other factors. These
fa c to rs inclu de a g en eral se cu la r expansion of the
market for credit enhancement services, changes in the
fe d e ra l tax code and the increa se in inn ova tion of
products and services in securities markets. The finan
cial guarantee market was also influenced by the growth
of markets for alternative credit enhancement devices
such as commercial bank letters of credit. The fact that
these longer term influences coincided with the upswing
of the underw riting cycle in the financial guarantee
market led to the trem endous expansion of the market
in the early 1980s. More recently, expansion in the
market has slowed, as the fall in interest rates has
moved the underw riting cycle into a relatively contrac
tionary phase. The behavior of the market during this
downswing, combined with regulatory proposals which
could constrain financial guarantee activity, is likely to
shape the nature of the market in its more mature stage.

Growth in premium volume
The growth of the financial guarantee market is best
illustrated by the sharp increase in financial guarantee
premiums in the 1980s. Unfortunately, comprehensive
m easures of fin a n c ia l g u a ra ntee prem ium s are not
readily available since insurers have not been required
to break out financial guarantee business from other
insurance lines in annual reports to state insurance
regulators. An estimate of financial guarantee premiums
can be derived, however, from data on surety bond
premiums. A surety bond is “ an agreement providing
for monetary com pensation in the event of a failure to
perform specified acts within a stated period.” 1 Financial
guarantees are technically a surety product and surety
'1985-86 Property/Casualty Fact Book (Insurance Information Institute,
New York, 1985).

Table 1

Premium Volume - Surety
Year
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985

Direct Written Premiums
(in thousands of dollars)*
589,568
696,350
835,919
902,552
1,000,732
1,088,848
1,216,634
1,488,641
1,911,182
2,454,556

Percent Change
—

18.1
20.0
8.0
10.9
8.8
11.7
22.4
28.4
28.4

premium data from reports to state insurance regulators
can be used to infer the growth in financial guarantee
premiums.2
Table 1 dem onstrates the growth of surety premiums
between 1976 and 1985. The rate of growth of surety
premiums accelerated between 1982 and 1985, aver
aging 26.4 percent a year, as opposed to 12.8 percent
a year during the period 1976 to 1982. Surety premiums
reached $2.5 billion in 1985, nearly five times their level
in 1976.
A second source of data about financial guarantee
p re m iu m s com es from the S u re ty A s s o c ia tio n of
America. The Surety Association collects surety pre
mium data by surety product from its member insurers.
Membership in the association is voluntary, however,
and financial guarantee insurers are underrepresented
in the membership. This underrepresentation, combined
with a tendency for financial guarantee business to be
classified under “ all other surety,” means that the Surety
A s s o c ia tio n ’s fin a n c ia l g ua ra ntee prem ium fig u re s
understate the actual volum e of financial guarantee
premiums. This underreporting is reflected by the fact
that total surety premiums as measured by the Surety
A sso ciatio n rose an average of only 12.5 percent
between 1980 and 1985 (Table 2). Reported premiums
for all financial guarantees rose considerably faster,
however, increasing an average of 70 percent a year.
Breaking the surety premium data down by product,
municipal bond insurance premiums grew by 60 percent
a year and premiums for other financial guarantees—
including those for commercial investment and corporate
debt enhancement— grew at over 80 percent a year, with
m ost of the increase com ing a fte r 1982. In 1980,
financial guarantee premiums accounted for just 3 per
cent of the total direct written premiums reported to the
Surety A ssociation. In 1985, they accounted fo r 24
percent.
The detailed Surety Association data can be used to
make an estimate of financial guarantee premiums for
all insurers. The surety premium data from reports to
state regulators reflect the surety activity— both financial
g u a ra n te e and tra d itio n a l s u re ty — of all in s u re rs .
Assuming that the Surety Association’s premium data
for traditional surety products is an accurate measure
of the activities of all insurers in this area, then the
Surety Association’s traditional surety premium data can
be subtracted from the state regulators’ total surety
prem ium s to provide a co m p re he nsive estim a te of
financial guarantee premiums.
These estimates are reported in Table 3. Total esti
m ated fin a n cia l g ua ra ntee prem ium s increased an

•Premiums paid by policy holders, 50 states and District of Columbia.
Source: A.M. Best Co., Executive Data Service

2These data are compiled from state insurance regulators’ reports by
the A.M. Best Company.

FRBNY Quarterly Review/Spring 1987

averag e of 47.3 p e rce n t betw een 1980 and 1985,
reaching a level of $1.3 billion. Although this is slower
than the 70 percent annual rate of increase implied by
the Surety A ssociation’s financial guarantee premium
data, the estimated premium data indicate a relatively
steady rate of growth through 1985. Financial guarantee
premiums increased by more than 50 percent in every
year between 1982 and 1985.

A model of the financial guarantee market
The growth in the financial guarantee market reflected
in these premium data can be attributed to both cyclical
and n oncyclical fa cto rs. In order to understand the
cyclical com ponent of the financial guarantee market,
it is necessary to understand how financial guarantees
are valued by security issuers and priced by insurers.
Clearly, the issuer of a security will be willing to pur
chase a financial guarantee only if the price of the
guarantee is less than the savings that result from the
purchase of the guarantee. Similarly, insurers will be
willing to sell a guarantee only if the premium received
is greater than the expected loss from the guarantee
plus a dm in istrative costs. This section discusses a
model of the financial guarantee market that incorpo
rates these decision rules.3
The central assum ption of the model is that financial
guarantee insurers are more effective credit analysts
than other capital m arket participants. When a security
is issued, m arket participants make an assessm ent of
its credit risk and the market yield on the security will
reflect this assessm ent. By shifting the ultimate liability
’ Details and further discussion of the model can be found in the
appendix.

for a security’s principal and interest payments from the
borrower to the insurer, a financial guarantee lowers the
security’s credit risk and reduces its required market
yield. The difference in total financing costs between
the uninsured and the insured security can be inter
preted as the market price of the security’s risk and
represents the maximum amount that a borrower would
be willing to pay for a financial guarantee. Clearly, this
interest cost reduction depends upon the credit market’s
initial assessment of the security’s risk. This assessment
may be inaccurate, however. If a financial guarantee
insurer can determine that the security’s true credit risk
is lower than the risk perceived by the capital market,
then the insurer will be willing to sell a financial guar
antee and assume the credit risk from the security
holder at less than the risk’s market price. It is this
wedge between the interest cost savings realized by the
borrower and the “ true ” price of the risk as discovered

Table 3

Estimated Financial Guarantee
Premium Volume (in thousands of dollars)

1980
1981
1982
1983
1984
1985

Total Surety
Premiums
1,000,732
1,088,848
1,216,634
1,488,641
1,911,182
2,454,556

Nonfinancial
Guarantee
Surety Premiums
813,585
890,841
887,124
966,933
1,054,046
1,156,561

Estimated Financial
Guarantee Premiums
187,147
198,007
329,510
521,708
857,136
1,297,995

Source Column 1: A.M. Best Co.
Column 2: Surety Association of America

Table 2

Surety Premiums by Product (in thousands of dollars)

1980
1981
1982
1983
1984
1985

Total
Financial
Guarantees
25,247
64,122
108,763
191,050
348,062
358,037

Financial Guarantees
Commercial
Investment
Loan
Guarantees,
All Other
Municipal
Corporate Debt Commercial
Bond
Credit
Loan
Guarantees
Enhancement Guarantees
N/A
N/A*
12,951
N/A
N/A
46,345
N/A
N/A
76,568
N/A
N/A
95,651
12,416
2,255
150,920
53,881
123,509
43,669

*N/A = not calculated, included in "All other financial guarantees.”
Note: All figures are direct premiums written.
Source: Surety Association of America

12 FRASER
FRBNY Quarterly Review/Spring 1987
Digitized for

Traditional Surety

All Other
Financial
Guarantees
12,296
17,777
32,195
95,399
182,471
136,978

All Contract
574,540
604,666
594,077
640,918
680,390
769,674

Worker’s
Compensation
+ Depository
12,416
14,664
16,804
18,081
25,985
16,830

All Other
Surety
226,629
271,511
276,243
307,934
347,671
370,057

Total
Surety
838,832
954,963
995,887
1,157,983
1,402,108
1,514,598

by the insurer that creates the market for financial
guarantees.
The interest savings associated with financial guar
antees can be substantial. In 1983, for example, a
Louisiana agency issued a student loan bond. Part of
the issue was insured by Fireman’s Fund Insurance
Company, received a AAA rating and yielded 7 percent.4
The remainder of the issue was backed by surplus
revenue, received an A rating and was priced at 7.4
percent.5 Such differences in yields translate into sig
nificant dollar savings. In 1985, the South Carolina
Public Service Authority saved an estimated $2.4 million
in interest costs over the life of a $135 million ten-year
electric revenue bond when it raised the bonds’ rating
from A to AAA with a guarantee from the Municipal
Bond Insurance Association.6
The demand for financial guarantees is based upon
the value of these credit enhancement services. A typ
ical security is composed of a series of coupon pay
ments and a principal payment that is due when the
security matures. A financial guarantee lowers the
security issuer’s cost of borrowing. If bonds are
assumed to sell at par and the yield curve is flat, then
this reduction can be thought of as a reduction in the
required coupon rate. The difference between the
coupon rate on an insured and uninsured bond is the
quality spread associated with that bond. The quality
spread reflects the compensation that investors require
to assume the additional risk associated with an unin
sured security. Clearly, then, the higher a security’s
perceived market risk, the larger its quality spread and
the greater the reduction in coupon payments associ
ated with a financial guarantee. Borrowers with high
perceived credit risk thus realize large interest cost
savings and place the greatest value on a financial
guarantee.
Just as the demand decisions of security issuers
involve comparing interest cost savings to the financial
4Two major credit rating agencies, Moody’s and Standard & Poor's,
assess the credit risk of various debt obligations and assign ratings
based on these assessments. Municipal and corporate bonds, for
instance, are rated from AAA (“ extremely strong” ) to CC (“ highly
speculative” ), with bonds rated BBB and above considered to be of
“ investment grade.” The two agencies have slightly different symbols
for their rating levels, but the investment grade categories are
analogous:
S&P_____ Moody’s
Credit Evaluation
AAA
Aaa
extremely strong
AA
Aa
very strong
A
A
strong
BBB
Baa
adequate
*The Bond Buyer, November 17, 1983.
•John W. Rindlaub, “ Municipal Bond Insurance” in Financial
Guarantee Insurance (Insurance Information Institute, New York,
1986), page 15.

guarantee premium paid, the supply decisions of
insurers involve comparing the expected losses from a
financial guarantee with the premium received. Recall
the central assumption of the model that financial
guarantee insurers are able to discover the true credit
risk of individual security issuers. Since insurers know
the true probability of default, they can make an accu
rate calculation of the expected losses associated with
any particular guarantee. The fact that they are able to
distinguish among borrowers of different risk types
means that there will be a separate financial guarantee
market for each true risk class. That is, insurers are
able to obtain information about the riskiness of indi
vidual borrowers that allows them to offer a different
schedule of premiums to borrowers of different risk
types.
If it is costly to obtain credit information, then the
supply decision of insurers will also incorporate infor
mation costs. Assuming that expected losses per dollar
of bond principal insured are the same within a risk
class, then insurers for whom information costs are low
will be willing to write guarantees at lower premium
rates than insurers for whom information costs are high.
Within a risk class, then, the upward slope of the supply
curve is determined by the distribution of information
costs among insurers.
Within a risk class, the supply of financial guarantees
is determined by the true default probability and the
demand for financial guarantees is determined by the
perceived default probability. This aspect of the model
highlights the importance of information about credit risk
in the financial guarantee market. In fact, in this analytic
framework, only borrowers whose perceived credit risk
is greater than their true credit risk will purchase a
guarantee. This result highlights the importance of
insurers’ ability to obtain superior credit information as
an essential element underlying the market for financial
guarantees.
The equilibrium price and quantity of financial guar
antee insurance are determined by the intersection of
the supply and demand curves in each risk class (Chart 1).
If the volume of financing is exogenous to the model, then
the equilibrium quantity of financial guarantees can also be
interpreted as the share of financing insured.
Both the equilibrium premium rate and the share of
financing insured in each risk class are affected by the
characteristics of borrowers and insurers in that risk
class. For instance, if the distribution of perceived credit
risk around the true degree of credit risk is the same
across risk classes, then the equilibrium price of a
guarantee will be higher in riskier credit classes. In this
case, average interest cost savings increase with the
degree of true credit risk, a result which implies that
demand increases. At the same time, since the

FRBNY Quarterly Review/Spring 1987

expected loss per dollar of insured principal increases
with the degree of credit risk, the supply of financial
guarantees decreases as the credit class becomes
riskie r. In cre a sin g dem and and d ecreasing supply
therefore imply an increase in the equilibrium price and
an indeterm inant change in the equilibrium quantity of
financial guarantees as the true degree of credit risk
increases. Similarly, when the costs of obtaining credit
inform ation increase, the equilibrium price of financial
g u a ra n te e co verag e incre a se s and the e q u ilib riu m
quantity declines.
The equilibrium quantity and price of financial guar
antees are also affected by the level of interest rates.
In fact, the effects of interest rates on the supply and
dem and fo r fin an cia l guarantees shape the cyclical
nature of the financial guarantee market. Interest rates
affect demand by altering the value of interest cost
savings realized by borrowers and affect supply by
a lte rin g the e xpe cted fin a n c ia l g ua ra ntee losses of
insurers.
The demand curve for financial guarantees is influ
enced by the factors that determine the value of a credit
upgrade. W ithin a risk class, the level of interest rates
affects the position of the demand curve by changing
the value of interest cost savings. The direction of the
effect of a change in interest rates on the value of a

Chart 1

The Financial Guarantee Market
P re m iu m

credit upgrade is not clear, however. On the one hand,
there is an observed tendency for quality spreads to
increase with the level of interest rates.7 The result of
this correlation is that interest cost savings tend to rise
when interest rates are high. This tendency is offset,
however, by the fact that higher interest rates reduce
the present value of the future stream of coupon pay
ment reductions. That is, holding the quality spread
fixed, an increase in interest rates reduces the present
value of the periodic interest cost savings because the
opportunity cost of money is greater.
An increase in interest rates thus has two opposing
effects on the value of interest cost savings: coupon
payment reductions increase but are discounted over
time at a higher rate. The sign of the net change in
the value of in te re s t cost sa vin gs thus ca n n o t be
determined a priori. Instead, the direction of change
depends upon the relative magnitude of the two interest
rate effects. If the increase in quality spreads is large
enough to offset the effects of discounting at a higher
rate, then the value of a credit upgrade will increase
when interest rates rise. If the reduction in coupon
payments is not sufficiently large, then interest cost
savings will decline.
Which of these two effects dom inates is an em pirical
question. In fact, it is quite possible that an increase
in interest rates will raise interest cost savings at some
tim es and low er them at others. C hart 2 p lo ts the
average ten-year Treasury bond yield against the implied
in te re s t cost sa vin gs on a 2 0-yea r m un icip al bond
resulting from an upgrade from a BBB rating to a AAA
rating. Although the interest cost savings measure is
considerably more volatile than the Treasury bond yield,
the two variables trend together. Average interest cost
savings and Treasury bond yields increased from 1978
to a peak during 1981 and 1982. The two measures
declined from that peak through the first quarter of
1987, despite diverging during 1984. Although during
some periods the interest cost savings measure and the
Treasury bond yield move in opposite directions, the
overall movement of the two series is positively corre
lated.8
If the value of interest cost savings rises with the level
of interest rates, then the demand for financial guar
antees will also increase with the level of interest rates.
That is, if an increase in interest rates raises the value
7One explanation for this correlation is that when interest rates
increase, credit becomes scarce and lower quality bonds become
significantly less liquid than higher quality bonds. Investors therefore
require a differentially higher yield on lower quality bonds when
interest rates are high.

insured in dollars

FRBNY Quarterly Review/Spring 1987

•The correlation coefficient of the monthly interest cost savings and
Treasury bill yield series is .20 for the period January 1978 to March
1987.

of a credit upgrade, then more borrowers will be willing
to purchase a financial guarantee at any given premium
rate. If the volume of financing is fixed, then the demand
curve for financial guarantees will shift to the right when
interest rates rise and shift to the left when rates fall.
This pattern suggests that demand for financial guar
antees moves pro-cyclically with changes in interest
rates.
The supply of financial guarantees is also affected by
the interest rate cycle. Like other insurance liabilities,
a financial guarantee is a future claim on the insurer.
In return for this future claim, the insurer receives a
premium payment at the time that the policy is written.
When interest rates are high, the premium payment
required to offset this liability falls because interest
income accrues more rapidly over the life of the guar
antee. To cover the same volume of future claims, then,
the insurer is able to charge lower premiums when
interest rates are high. The supply of financial guar
antees thus increases when interest rates rise and
decreases when interest rates fa ll.9
The effect of changing interest rates on supply may
be even greater for financial guarantees than for other

insurance lines. Changes in the level of nominal interest
rates are often due to changes in the expected rate of
inflation. Most p roperty/casualty lines insure against
events such as auto accidents and malpractice findings.
For this type of insurance, the dollar size of claims tends
to rise and fall with the general price level, and insurers’
loss reserve policies normally take this into account. For
many types of financial guarantees, however, potential
claims are fixed in nominal terms. Holding the probability
of default fixed, financial guarantee insurers’ expected
losses do not move with expected inflation.10 A con
traction in investm ent income is not offset by a corre
sponding reduction in loss lia b ilitie s when nom inal
interest rates fall. The cyclical effects of interest rates
are not damped by inflation-induced changes in liabili
ties, causing the supply of financial guarantees to be
more sensitive to nominal interest rate fluctuations than
other types of property/casualty insurance.
This description of the supply and demand for finan
cial guarantees suggests that the financial guarantee
m arket m oves c y c lic a lly w ith in te re s t rates. W hen
in te re s t rate s are high, both su p p ly and dem and
10Of course, the movement of inflation is, in general, part of the
cyclical behavior of the economy which may well affect default
rates. Mortgage guarantee insurance, for instance, is susceptible to
cyclical swings in default rates.

9See Robert T. McGee, “ The Cycle in Property/Casualty Insurance,”
this Quarterly Review (August 1986) for a detailed discussion of the
relationship between interest rates and the underwriting cycle.

Chart 2

In te re s t C o st S a ving s and In te re s t Rates
Percent/dollars

1978
Sources:

.1979

1980

1981

1982

1983

1984

1985

1986

1987

Federal Reserve Board and Federal Reserve Bank of New York staff estimates.

FRBNY Quarterly Review/Spring 1987

increase and the share of financing insured rises. When
interest rates fall, on the other hand, both supply and
demand contract and the equilibrium share of financing
insured declines. The effect of interest rates on the price
of financial guarantees is indeterminant, however, since
changes in premium rates depend upon the relative size
of movements in the supply and demand curves. This
analysis suggests that the financial guarantee under
writing cycle is characterized by large swings in the
equilibrium amount of insurance provided and by smaller
adjustments in price. This combination implies that
premium volume expands and contracts sharply over the
underwriting cycle.
The cyclicality of the financial guarantee market is
reinforced by its relationship with the rest of the prop
erty/casualty insurance industry. Many financial guar
antee insurers are divisions or subsidiaries of larger
property/casualty insurers. Like financial guarantee
insurers, these property/casualty insurers realize higher
investment income when interest rates are high and
therefore reduce premiums during high interest rate
periods. Since the demand for most types of property/
casualty insurance is not affected by the level of interest
rates, however, the premium cutting induced by an
increase in interest rates undercuts property/casualty
profitability. High interest rate environments tend to be
profitable for financial guarantee insurers, however,
since strong demand during these periods assures that
competitive pressures to reduce premium rates and
weaken underwriting standards do not become too
severe. Property/casualty insurers therefore have an
incentive to divert capital resources away from the
overly competitive property/casualty market and into
financial guarantees when interest rates are high. This
inflow of capital augments the increase in financial
guarantee supply that occurs when interest rates
increase, reinforcing the interest rate driven cyclical
nature of the market.

The financial guarantee market in the 1980s
This framework is useful for examining the experience
of the financial guarantee market in the 1980s. In the
early 1980s, both interest rates and quality spreads
reached a cyclical peak, and financial guarantee pre
mium volume began to increase rapidly (Table 3). This
premium growth is consistent with the upswing of the
financial guarantee underwriting cycle, as high interest
rates and quality spreads caused both supply and
demand to increase. Since 1982, however, both interest
rates and quality spreads have declined. In the munic
ipal bond market, for instance, the spread between AAA
rated and lower investment grade bonds has decreased
substantially (Table 4). The BBB-AAA spread declined
from a high of 160 basis points in 1982 to 81 basis

16 FRBNY Quarterly Review/Spring 1987

points in 1986. The yield on AAA-rated municipal bonds
also fell, declining from a high of 10.88 percent in 1982
to 6.13 percent in the first quarter of 1987. Although
quality spreads widened slightly at the beginning of
1987, this cyclical decrease in yields and spreads sig
nals the downswing of the underwriting cycle.
The effect of these declining interest rates and quality
spreads is evident in data from the municipal bond
market. The total face value of municipal bonds backed
by a financial guarantee fell from $47 billion in 1985 to
$26 billion in 1986, a drop of 44 percent (Table 5). The
share of municipal bonds insured dropped less sharply,
however, since the volume of new municipal bonds
issued declined from $204 billion in 1985 to $140 billion
in 1986. In 1985, financial guarantees backed 23 per
cent of all new municipal bonds issued, as opposed to
19 percent in 1986. The share of insured bonds rose
to 23.6 percent in the first quarter of 1987, although
the volume of insured bonds is approximately the same
as the 1986 volume at an annual rate.
Several factors aside from interest rates influenced
this growth and subsequent contraction of the financial
guarantee market during the 1980s. The increase in
demand for credit enhancement services following the
Washington Public Power Supply System (WPPSS)
default led to the continued expansion of the financial
guarantee market. The severity of the most recent
property/casualty underwriting cycle also promoted
capital investment in the financial guarantee market and
helped to sustain supply even in the face of declining
interest rates. The limited amount of high quality re
insurance available to financial guarantee insurers
constrained this expansion, however.
In the most recent financial guarantee cycle, these
idiosyncratic factors were dominant. When interest rates
and quality spreads were rising, these noncyclical fac
tors reinforced the upswing of the cycle. When interest
rates and spreads fell, however, these factors offset the
tendency for contraction in the market and sustained
the growth of both supply and demand. It was only
when interest rates leveled in 1986 that the influx of
capital and the increase in demand for credit enhance
ment were less able to sustain growth in the market.

Relationship to the property/casualty insurance
industry
One of the most important factors accounting for the
sustained growth in premium volume through the mid1980s was the relationship between the financial guar
antee market and the rest of the property/casualty
industry. Financial guarantee insurance is provided by
two types of insurers: monoline firms, which limit their
business to financial guarantees, and multiline firms,

which are involved in several different insurance lines.
In a multiline firm, financial guarantees are one of many
products which have a claim on the firm s’ capital and
reserves.
The interest rate driven property/casualty insurance
cycle has had a direct impact on the financial guarantee
market. In the early 1980s, the property/casualty market
experienced a sharp decline in underwriting profits as
a result of competitive pressure to drop premium rates.
This decline in profitability in traditional property/casualty
lines provided incentive for insurers to divert capital to
the increasingly profitable financial guarantee market in
the early 1980s. Between 1981 and 1985, 14 new major
insurers entered the financial guarantee market.11 While
some of the investors in these new entrants were from
outside of the insurance industry, major m ultiline prop11Rindlaub, op. cit. page 12.

Table 4

Interest Rates and Quality Spreads
Municipal Bonds
to |

1980
1981
1982
1983
1984
1985
1986
1987-1

v,'.

"fen-\fe3r
Treasury
Bond Yield
11.46
13.91
13.00
11.10
12.44
10.62
7.68
7.19

AAA
Municipal
Bond Yield
7.85
10.42
10.88
8.80
9.61
8.60
6.95
6,13

i 'V./>

Quality Spreads
AA-AAA
A-AAA BBB-AAA
.22
.60
1.16
.89
1.33
.46
.97
1.60
.43
.84
1.37
.40
.77
.27
.55
.33
.99
.59
.21
.81
.48
.97
.60
.15

Source: Moody’s Investors Service,
Municipal and Government Manual

Table 5

Municipal Bond Insurance

1980
1981
1982
1983
1984
1985
1986
1987-1
^

New Long-Term
Issues
(Billions of Dollars)
47.1
46.1
77.2
83.3
101.9
204.0
140.0
28.2
- ■•

Insured Issues
(Billions of Dollars)
1.4
2.9
7.6
12.1
20.9
46.9
26.2
6.6

Reinsurance
Percent Insured
3.0
6.5
9.8
14.5
20.5
23.0
19.0
23.6

Source: New Issues: Credit Markets
Insured Issues: Financial Security Assurance, Inc.
Comments before the S.E.C.
(March 16. 1987)

erty/casualty insurers such as Crum & Forster, Conti
nental Insurance, Firem an’s Fund, Traveler’s Indemnity,
and USF & G devoted capital and resources to writing
financial guarantee insurance.
The initial influence of the property/casualty under
writing cycle on the financial guarantee market was thus
to expand the amount of capital available to underwrite
financial guarantees. This su bstantial capital influx
caused a large increa se in the su pp ly of fin a n cia l
guarantees in the early 1980s.
In the mid-1980s, the influx of capital from m ultiline
insurers began to slow. Commercial property/casualty
lines experienced losses that forced some m ultiline
insurers to allocate strained capital resources away from
financial guarantees. An example of this is Industrial
Indem nity F inancial C o rp o ra tio n , a co rp o ra te debt
insurer, which was closed early in 1986 by its parent
organization, Crum & Forster, when that unit decided
to allocate its capital to other insurance lines.12 Along
sim ila r lines, USF & G, a m u ltilin e m un icip al bond
insurer, had its rating of insured bonds dropped from
AAA to AA because it suffered losses in the casualty
business.13 The drop in rating reduced USF & G’s ability
to write municipal bond guarantees even though it had
experienced no significant losses in this line.
This outflow of capital from m ultiline insurers was
offset to a large degree by the form ation of several
monoline financial guarantee insurers in 1985 and 1986.
These new monoline insurers include at least one AAA
rated m u n ic ip a l bond in s u re r (C a p ita l G u ara n te e
Investm ent C orporation) and two corporate financial
guarantee insurers (Financial Security Assurance and
Dryden Guaranty Trust). Although the municipal bond
insurer, CGIC, is a reorganization of USF & G’s previous
financial guarantee subsidiary, much of the remaining
investment in m onoline insurers represents new capital
in the market. This continued investm ent in the m unic
ipal bond and corporate financial guarantee sectors
o ffse t the w ith d ra w a l of m u ltilin e in su re rs from the
business and did much to sustain supply through 1986.

Although investm ent in primary capital has been main
tained in at least the major financial guarantee product
m arkets, these m arkets have been som ew hat c o n
strained by a shortage of high-quality reinsurance cap
ital. As in other lines of insurance, reinsurance in the
financial guarantee market spreads the risk of any par
ticular guarantee among several insurers. The issuer of
a financial guarantee (the ceding company) may transfer
12American Banker, January 22, 1986.
13John W. Milligan, "A One-Man Assault on the Municipal Guarantee
Business," Institutional Investor, June 1986, page 242.

FRBNY Quarterly Review/Spring 1987

some part of the liabilities of that guarantee to another
insurer (the reinsurer). This reinsurer may be a monoline
insurer that w rites only reinsurance or a financial guar
antee insurer that w rites both primary financial guar
antees and reinsurance on financial guarantees. In any
case, the ceding company pays the reinsurer a premium
for the reinsurance policy. The reinsurance premium is
in general a proportion of the premium received for the
fin a n c ia l g u a ra ntee by the ceding com pany m inus
comm ission expenses.14
The demand for financial guarantee reinsurance has
strained the capacity of the relatively few high quality
reinsurers. The limited number of reinsurers has been
further curtailed in reinsuring financial guarantees by
losses in property/casualty lines which have reduced
overall capacity. This contraction of capacity has been
offset to some degree by the entry of two monoline
m unicipal bond reinsurers, U.S. Capital Reinsurance
Company and Enhance Reinsurance Company. Both
insurers have a pproxim ately $100 m illion in capital.
Enhance is rated AAA by Standard & Poor’s.
The e xact e xte n t of re insu ran ce in the fin a n c ia l
g u a ra n te e m arket is d iffic u lt to m easure. A rough
measure of the amount of reinsurance of all surety
bonds is contained in Table 6. Direct written premiums
include all premiums received by an insurer for financial
guarantee business and for any reinsurance assumed
from other insurers. Net written premiums equal these
direct premiums minus any reinsurance ceded to other
insurers. The difference between direct and net pre
miums is thus net reinsurance premiums: the premiums
paid fo r re in s u ra n c e ce de d m inus the pre m iu m s
received fo r reinsurance assum ed. Net reinsurance
premiums measure the amount of reinsurance assumed
by reinsurers who are not prim arily financial guarantee
insurers. As a fraction of direct premiums, reinsurance
reached a peak of 19.4 percent in 1984 before falling
off to just 8.4 percent in 1985. Because only data on
net prem ium s are a va ila b le , it is im p ossib le to tell
whether this decline is a result of an absolute reduction
of reinsurance activity or whether it reflects a shift in
the p la cem e nt of re in su ra n ce away from m onoline
re in s u re rs and to w a rd s o th e r fin a n c ia l g u a ra n te e
insurers. Given the acknowledged strain on reinsurance
capacity, however, some real reduction in reinsurance
activity is probably indicated by these data. Such a
reduction implies a further constraint on the supply of
financial guarantees.

Demand for credit enhancement
The final factor responsible for the growth of the finan
14Michael R. Pinter, “ The Reinsurance of Financial Guarantee
Insurance” in Financial Guarantee Insurance (Insurance Information
Institute, New York, 1986), pages 54-56.

FRBNY Quarterly Review/Spring 1987

cial guarantee market was an increase in the general
demand for credit enhancement services. This increase
in demand was largely a result of the 1983 WPPSS
default. In 1983, WPPSS defaulted on $2.25 billion in
municipal revenue bonds issued to fund construction of
two nuclear power plants. Over 78,000 bondholders
were affected by the default, which received wide pub
licity. One of the outcomes of the WPPSS default was
an increased investor concern about credit risk and a
sh ift in p re fere nce s to w ards h ig h -q u a lity debt. The
demand for credit enhancement services increased as
part of this preference shift. The financial guarantee
market was particularly affected since a portion of the
WPPSS bonds was insured by the American Municipal
Bond A s s u ra n c e C o rp o ra tio n (A M B A C ). AM BAC
assumed responsibility for interest and principal pay
ments on the $23.6 million of WPPSS bonds it had
insured. The WPPSS default and AMBAC’s response
b ro u g h t a b o u t an in c re a s e in d e m a n d fo r c r e d it
enhancem ent, w hich helped to su stain dem and fo r
financial guarantees even as quality spreads narrowed.
The increase in the demand for credit enhancem ent
services was also a result of innovations in securities
markets which increased the importance of structured
financings and asset securitization. The structure of
these securities is more complicated than traditional
debt financings. For this reason, obtaining credit infor
mation and making an assessment of the default risk
of these securities is often difficult. The credit analysis
associated with a credit-enhanced security, however,
red uce s to o b ta in in g in fo rm a tio n a b o u t the c re d it
enhancer and the nature of the guarantee rather than
analyzing the entire structure of the underlying security.

Table 6

Reinsurance Of Surety (in thousands of dollars)

1981
1982
1983
1984
1985

Direct Premiums Net Premiums
Written
Written
1,112,925
970,498
1,247,829
1,094,117
1,512,741
1,272,198
1,564,934
1,941,130
2,473,103
2,264,435

Reinsurance
Premiums
Ceded
-Reinsurance
Premiums
Assumed

Percent
Of DPW

142,427
153,712
240,543
376,196
208,668

12.8
12.3
15.9
19.4
8.4

Note: Premium data include all business done by companies based
in the United States
Direct Written Premiums = financial guarantee premiums +
reinsurance assumed premiums
Net Written Premiums = Direct Written Premiums - reinsurance
ceded premiums
Source: A.M. Best’s Executive Data Services

Because of this simplified information requirement, credit
enhancement enables borrowers to have greater access
to public debt markets. In fact, many of these financings
would not be feasible were it not for the ability of a
credit enhancer to provide concise credit information to
the market. The use of financial guarantees in these
relatively com plicated structured financings has greatly
increased demand in the corporate financial guarantee
sector.

Competition from commercial banks
Financial guarantee insurers’ primary competitors in the
market for credit enhancement services are commercial
banks. Com m ercial banks compete with financial guar
antee insurers in the credit enhancement market through
Standby Letters of Credit (SLCs). A credit-enhancing
SLC is sim ilar to a financial guarantee in that the bank
agrees to provide funds for interest and principal pay
ments on a backed security in the event that the secu
rity issuer defaults. SLCs differ from financial guarantees
in that they have a fixed expiration date that does not
necessarily correspond to the m aturity of the backed
security. Although commercial bank SLCs are issued to
cover a variety of bank custom er activities, they are
used in the credit enhancement market primarily to back
commercial paper and tax-exem pt industrial revenue
bonds.
The overall use of SLCs has grown rapidly in the
1980s. Total outstanding SLCs were approximately $250
billion at the end of 1986, up from just $50 billion in
1980. Both dom estic and foreign com m ercial banks
participate in this m arket. In 1986, $453 million (5 per
cent) of tax-exempt housing bonds issued were backed
by SLCs, predom inantly from dom estic banks. Approx
imately 14 percent of tax-exem pt hospital bonds were
backed by SLCs, nearly three-quarters of which were
issued by foreign banks. Foreign bank SLCs also dom
inated the m arket for enhancem ent of pollution control

Table 7

Credit Enhancement in the Municipal Bond Market
Face Value of Bonds Insured
1984
1985
1986
Millions
Millions
Millions
of
of
of
Dollars Percent Dollars Percent Dollars Percent
Domestic Banks 11,418 32.7
12,113 14.9
4,637 10.7
Foreign Banks
6,959 19.9
25,043 30.9
10,530 24.3
Insurers
16,551 47.4
43,979 54.2
28,125 65.0
Total
34,928
81,135
43,292
Source: Financial Security Assurance, Inc. Comments before the
Security & Exchange Commission, March 16, 1987

bonds. Japanese and Swiss banks are particularly active
in this area.15
As with financial guarantees, securities backed by
SLCs receive a credit rating based upon the issuing
bank’s credit rating. Since very few dom estic banks
receive a AAA rating, SLCs from most dom estic banks
are at a competitive disadvantage to the relatively large
number of AAA-rated financial guarantee insurers. This
disadvantage is particularly acute in the municipal bond
enhancement market. Domestic bank letters of credit
accounted for only 10.7 percent of credit enhancement
in the municipal bond market in 1986, down from 32.7
percent in 1984 (Table 7). On the other hand, com
mercial bank SLCs have a competitive advantage in the
corporate credit enhancement market. Corporate secu
rities backed by SLCs from dom estic banks and the
domestic branches of foreign banks are exem pt from
SEC registration requirements. Similar securities backed
by financial guarantees do not qualify for this exemption.
Financial guarantee insurers claim that this disparity
places them at a com petitive disadvantage in the cor
porate market and are petitioning the SEC to extend
the registration exemption to securities backed by AAA
rated financial guarantees. This situation does not affect
enhancement of municipal bonds since all municipal
bonds are exempt from registration requirements.
There is at lea st one im p o rta n t resp ect in which
fin a n c ia l g ua ra ntee s and SLCs are co m p le m en tary
products. In many instances, insurers will require as part
of the financial guarantee contract that security issuers
obtain an SLC to absorb some part of the credit risk.
In these cases, the bank issuing the SLC assumes the
risk that the issuer will default, and the financial guar
antee in turn stands behind the bank and thus serves
mainly to give the guaranteed security a AAA rating.
T his stru ctu re d c re d it e nhancem ent is p a rtic u la rly
prevalent in the corporate financial guarantee market,
although it also occurs with municipal bond insurance.
Commercial banks are also involved in the financial
guarantee market through equity investments in financial
guarantee insurers. Citibank, Bankers Trust and J.P.
Morgan have each become major investors in AAA-rated
m u n ic ip a l bond in s u re rs (AM BAC , BIG and FG IC ,
respectively). This investment gives these banks a share
of the credit enhancement m arket for municipal bonds,
in which most dom estic comm ercial banks are at a
competitive disadvantage.

Segmentation in the financial guarantee market
The financial guarantee market is segmented both by
product and by type of insurer. Financial guarantee
insurers fall into one of two groups. The first group
15Cred/f Markets, February 23, 1987; March 9, 1987; March 16, 1987.

FRBNY Quarterly Review/Spring 1987

includes major insurers such as the American Municipal
Bond Insurance Corporation (AMBAC), the Municipal
Bond Investor’s Assurance Corporation (MBIA) and
Financial Security Assurance Inc. (FSA) that have
received a AAA claims paying ability rating from
Standard & Poor’s and/or Moody’s. The second tier of
the market is composed of various small non-AAA-rated
insurers. The major insurers are recognized by state
regulators and their actions are closely monitored by
the rating agencies. Some of these firms are monoline
insurers that are large participants in mature product
lines such as municipal bond insurance (AMBAC, Bond
Investors Guarantee Insurance, Financial Guarantee
Insurance Company) and corporate financial guarantees
(FSA). Others are large multiline property/casualty firms
that have entered these mature markets or are inno
vating new financial guarantee products (Prudential,
Continental, and until 1987, MBIA).
Firms in the second tier market, on the other hand,
are not rated by the two major credit rating agencies,
although they often receive a rating from the insurance
rating firm, A. M. Best Company. These insurers are for
the most part smaller multiline insurers that underwrite
a variety of products in addition to financial guarantees.
As such, their financial guarantee activity is not always
discernible in financial statements and in reports to
regulators and professional associations. Financial
guarantees are most commonly included as part of
surety business and occasionally reported in categories
such as miscellaneous casualty.
The end result of this reporting procedure is that the
activities of the second tier market are difficult to
quantify. Participants in this segment of the market are
often not known to regulators and professional asso
ciations until they are involved in some sort of default
or failure. Since these firms are not rated by Moody’s
and Standard & Poor’s, they for the most part do not
perform the same type of credit enhancement offered
by the major insurers. Instead, these smaller insurers
write products such as mortgage-backed bond guar
antees, limited partnership insurance and smaller cor
porate credit underwriting for small borrowers and
businesses.

Municipal bond insurance market
The financial guarantee market is also segmented by
type of product. One of the best understood financial
guarantee products is municipal bond insurance. The
first monoline municipal bond insurance company,
AMBAC, opened in 1971 and was joined in 1974 by
MBIA. Until the early 1980s, these two firms were the
primary providers of municipal bond insurance. In the
early 1980s, however, both the number of insurers
writing municipal bond guarantees and the percent of

FRBNY Quarterly Review/Spring 1987

municipal bonds insured grew significantly. In 1985, nine
major AAA-rated firms were engaged in writing munic
ipal bond guarantees for an estimated 23 percent of the
$204 billion of new municipal bond issues, up from 3
percent in 1980 and 9.8 percent in 1982. In 1986,
however, that percentage fell to 19 percent of the $140
billion of new issues (Table 5). According to the Surety
Association of America, municipal bond insurance gen
erated $150 million in premiums in 1984 and $124 mil
lion in 1985, as opposed to only $13 million in 1980
(Table 2). The total value of insured municipal bonds
outstanding was estimated to be $250 billion at the end
of 1986, up from $28 billion in 1975.
The major municipal bond insurers limit their coverage
to bonds which are of investment grade on their own
merit. For bonds at the lower end of the investment
grade classification, insurers may require additional
credit security. For instance, the issuing municipality
might be required to create a reserve fund equal to one
year’s interest payments on the bond. Such a fund both
reduces the insurer’s loss exposure and provides a
grace period for the issuer and insurer to restructure
in the event of a default. In other cases, the issuing
municipality might purchase a bank standby letter of
credit to absorb all or part of the primary credit risk. In
some instances, the letter of credit is used to raise the
bond to investment grade and make it eligible to receive
a financial guarantee.
The first major firm to offer financial guarantee
insurance was AMBAC. Founded in 1971, AMBAC is
now owned primarily by Citibank and an association of
AMBAC employees. AMBAC insures a wide range of
municipal bonds and related securities, including general
obligation and revenue bonds, industrial revenue bonds,
individual bond portfolios, municipal bond portfolios, unit
investment trusts and hospital bonds. AMBAC is a
monoline insurer with capital of $245 million.18 AMBAC
insures only investment grade securities and all issues
insured by AMBAC receive a AAA rating from Standard
& Poor’s.
The second major municipal bond insurer is MBIA.
MBIA was founded in 1974 as an association of mul
tiline property/casualty insurers, but in January 1987
became an independent monoline firm with $420 million
in capital. MBIA’s four investors are: Aetna Casualty and
Surety (48 percent); Fireman’s Fund Insurance (25
percent); CIGNA (17 percent); and Continental Insur
ance (10 percent). All issues insured by MBIA receive
a AAA rating from both Moody’s and Standard & Poor’s.
Two other municipal bond insurers also receive AAA
ratings from both Moody’s and Standard & Poor’s.
Financial Guarantee Insurance Company (FGIC) was
u Credit Markets, January 8, 1987.

fo u n d e d in 1983 w ith c a p ita l from fiv e in v e s to rs :
Shearson Lehm an/Am erican Express, M errill Lynch,
General Electric Credit Corporation, Kemper Corporation
and G e n e ra l R e in s u ra n c e C o rp o ra tio n . FGIC is a
m onoline insurer with $334 m illion in ca p ita l.17 The
founder of FGIC, Gerald Friedman, was also a founder
of AMBAC.
The Bond In v e s to r’s G uarantee Insurance (BIG)
company is the third firm to receive the “ double trip le ”
rating. Founded in 1984, BIG is owned by American
International Group, Inc., Bankers Trust New York Corp.,
Government Employees Insurance Co., Salomon Inc.,
and Xerox Credit Corp. BIG is a monoline insurer with
capital resources of $124 m illion.18
Participation in this market by other major, AAA-rated
firms has been m arginal. In October 1986, however, a
fifth m onoline municipal bond insurer, Capital Guaranty
Insurance C orporation, began operations in San Fran
cisco. CGIC is an offshoot of USF & G and will assume
the m unicipal bond guarantee business performed by
USF & G’s financial guarantee subsidiary. CGIC has an
initial capitalization of $100 m illion from six investors,
including C onstellation Investm ents, Fleet Financial
Group, N orstar Bancorp, Safeco C orporation, Sibag
Financial and USF & G.
Together AMBAC, MBIA, FGIC and BIG accounted for
over 95 percent of m unicipal bond insurance written in
1985 and 1986 (Table 8). The share of insured volume
w ritten by these firm s in the firs t q u a rte r of 1987
appears to have remained at this level. However, 1985
may have been a peak year for this line of business.
17Credit Markets, December 8, 1986.
1*Credit Marklets, September 8, 1986.

Table 8

Major Municipal Bond Insurers
Share Of Total Insured
Municipal Bonds (Percent)
MBIA*
FGIC
AMBACf
BIG*

1985
31.5
28.1
28.3
5.9

1986
35.9
28.5
24.5
8.3

1987-1
37.6
25.1
12.2
24.4

Net Premiums
Written
(Millions of Dollars)
1984
141.3
45.2
N/A§
N/A

1985
167.9
168.4
134.1
60.9

‘ Premium data for MBIA are for year ending November 30.
tPremium data for AMBAC are for following year ending June 30.
tBIG’s first year of operation was 1985.
§Not Available
Source: Premium data:
Business Insurance
October 20, 1986.
Distribution data: Securities Data Company, Inc.

The volume of new municipal bonds issued reached
only $140 billion in 1986, and the dollar volume of
insured issues fell to $26.2 billion from $46.9 billion in
1985. It appears that dollar volume remained at this
lower level in the first quarter of 1987, with new insured
volume running at a $26.6 billion annual rate.
This decline in the volume of municipal bond issues
insured can be attributed in part to a weakening of
demand for municipal bond guarantees. The spreads
b e tw e e n A A A -ra te d and lo w e r in v e s tm e n t g ra d e
municipal bonds fell by approxim ately 20 percent from
1985 and 50 percent from 1982 (Table 4), reducing the
value of a credit upgrade and undercutting the demand
for municipal bond insurance. In addition, changes in
the federal tax code that repeal tax exempt status for
some categories of revenue bonds and place a cap on
total tax exempt issues for private activity bonds are
likely to reduce total demand for guarantees by reducing
demand from this sector of the municipal bond market.
Municipal bond insurers are developing new products
to compensate for the decline in demand for traditional
m u n ic ip a l bond in s u ra n c e . S e v e ra l in s u re rs are
enlarging their activities in the taxable municipal bond
market. O thers are developing new applications for
already e xistin g fin a n c ia l gua ra ntee p ro du cts. For
instance, AMBAC has recently begun to market a form
of municipal liability insurance in conjunction with the
insurance broker Alexander and Alexander. The product
consists of a renewable line of credit issued by a local
bank and insured by AMBAC. In the event that a liability
claim forces the m unicipality to draw on the line of
credit, AMBAC guarantees that the loan will be repaid.
The line of credit may be from $2 million to $50 mil
lion.19 Similarly, BIG has developed a program in which
an insured letter of credit is substituted for the debt
service reserve fund for municipal bonds insured by
BIG. The substitution enables bond issuers to avoid the
costs associated w ith the new tax la w ’s a rb itra g e
restrictions on reserve fund income.
The loss record for municipal bond insurers remained
quite good through 1986 (Table 9). Since the market
developed in the early 1970s, the only m ajor loss suf
fered by these insurers has been the 1983 WPPSS
default. AMBAC had insured $23.6 m illion of the $2.25
billion defaulted WPPSS bonds and is responsible for
interest and principal payments on the bonds as long
as they are in default. In addition, in September of 1986,
AMBAC was forced to make interest payments on three
Chattanooga, Tennessee industrial developm ent bonds
when the developer who had received the funds from
the bonds defaulted on the September 1 payments. The
face value of the bonds is $55 m illion, but the total
19American Banker, January 2, 1987.

FRBNY Quarterly Review/Spring 1987

extent of AMBAC’s liability in this case is not yet clear.20

Corporate financial guarantee market
In contrast to the fairly uniform municipal bond insur
ance market, the corporate financial guarantee market
is com plex and diverse. The number of types of secu
rities and transactions for which financial guarantees are
written is large: commercial paper, limited partnerships,
leases, receivables, m ortgage-backed securities, con
sumer receivable backed securities and bank loans are
exam ples of the type of corporate instruments secured
by financial guarantees. Most corporate guarantees are
heavily collateralized so that insurers have recourse to
the assets underlying the debt in the event of default.
To date, there are relatively few monoline insurers of
corporate obligations, although a number of the major
AAA-rated m ultiline insurers write these sorts of guar
antees. The degree of participation in the corporate
market by non-AAA-rated insurers is uncertain, but the
rapid rate of product innovation and premium growth in
this market suggests that these sm aller insurers are
active in at least some product lines.
The dom inant m onoline participant in the corporate
financial guarantee market is Financial Security AssurwCredit Markets, September 15, 1986.

Table 9

Loss Rates By Financial Guarantee
Product (in thousands of dollars)
Direct Premiums
Earned
1980
1981
1982
1983
1984
1985

1984
1985

1984
1985
1980
1981
1982
1983
1984
1985

Direct Losses
Incurred

Loss
Ratio (percent)

Municipal Bond Guarantees
22.6
5,342
1,205
-.1
-1 5
10,150
3.0
636
21,009
100.0
38,727
38,712
10.7
55,626
5,938
-21.7
60,149
-13,054
Commercial Investment & Loan Guarantees,
Corporate Debt Credit Enhanced
0.0
0
165
157.0
10,002
6,351
All Other Commerical Investment
& Loan Guarantees
0.0
0
853
178.1
6,669
11,876
All Other Financial Guarantees
8.2
983
11,978
50.7
13,367
6,781
63.6
17,187
10,935
17.4
5,842
33,620
26.6
18,632
70,006
182.0
175,492
96,405

Source. Surety Association Of America

FRBNY Quarterly Review/Spring 1987

ance, Inc. (FSA). Founded in 1985 with $188 million in
capital invested by Ford Motor Credit, The Equitable,
John Hancock, Transamerica and New England Mutual
Life, FSA was the first monoline insurer of corporate
d e b t.21 FSA c u rre n tly has 25 fo re ig n and d om estic
investors and receives a AAA rating from both Moody’s
and Standard & Poor’s, as well as from Nippon Investors
Service, a Japanese credit rating agency.
FSA’s primary products are guarantees on structured
financings and securitized debt. Approxim ately 75 per
cent of FSA’s guarantees are written for asset-based
tra n s a c tio n s such as com m ercial m ortg ag e-ba cked
securities and bank-backed obligations. FSA also spe
cializes in guarantees of receivable-backed transactions
such as credit card-backed debt and auto loan-backed
debt.
Although FSA is the prim ary m onoline AAA-rated
insurer in the corporate guarantee market, several major
m u ltilin e com panies also w rite co rp o ra te fin a n c ia l
insurance. Prudential, GEICO, C ontinental, AIG and
CNA, among others, have units which have specialized
in various segments of the corporate market. Financial
Insurance Risk Management (FIRM), a subsidiary of
GEICO, insures smaller, privately-placed transactions
such as residual value insurance for lease contracts.
FIRM also assumes some reinsurance from FSA. C on
tinental Guaranty and Credit Corporation, a subsidiary
of Continental Insurance, also insures small corporate
transactions. In general, Continental Guaranty insures
transactions of less than $10 m illion, raising unrated
corporate securities to investm ent grade. Continental
g uarantees assets such as in d u s tria l d e ve lo p m e n t
bonds, corporate debt, municipal leases and educational
loans.
U nlike many co rp o ra te fin a n c ia l g ua ra ntee units,
D ryden G uaranty Trust is a m onoline s u b s id ia ry of
Prudential. Dryden, which was formed in 1986, is in the
process of applying for an independent credit rating.
This monoline structure is designed both to protect
Dryden from any change in Prudential’s rating and to
protect Prudential against any large losses suffered by
Dryden. Dryden’s primary product will be guarantees on
commercial bank portfolios of unrated corporate debt.
With such guarantees, banks will be able to market
pools of these loans, much as mortgage guarantees
permit mortgages to be pooled and securitized.
According to the SAA, the volume of direct premiums
written for corporate financial guarantees was nearly
$98 m illion in 1985 (Table 2). Losses in this line were

21Peter E. Hoey and Theodore V. Buerger, "Financial Guarantee
Insurance," Trusts and Estates (Insurance Information Institute, New
York, 1985).

severe in 1985, however (Table 9). The loss ratio (direct
losses incurred as a percent of direct premiums earned)
for commercial investment plus loan guarantees and
corporate debt credit enhancement was 157.0 in 1985.
For “ all other” commercial investment, losses were even
higher, representing 178 percent of premiums earned.
This record is unlikely to have improved, as defaults of
limited partnerships—categorized under “ all other”
commercial investment — have increased as a result
of the fall in oil prices and changes in the tax code.
The changes in the tax code which eliminate the tax
benefits of certain limited partnerships will sharply
decrease demand for this type of insurance in the
future. The Tax Reform Act of 1986 stipulates that only
income from passive activities such as limited partner
ship investments in real estate and oil and gas drilling
may be offset by losses from passive activities. Since
many of these partnerships purchased guarantees on
the bank loans that they assumed to fund investment,
the elimination of most of the tax shelter benefits of
these limited partnerships significantly reduces financial
guarantee demand in this area. On the other hand,
investor and borrower awareness of the value of finan
cial guarantees in corporate transactions is certainly on
the rise. Unlike the municipal bond insurance market,
the corporate financial guarantee market continues to
be supported by noncyclical factors which offset
declining interest rates and quality spreads. The demand
for corporate financial guarantees resulting from inno
vations in securitization and structured financings in both
domestic and foreign capital markets is likely to sustain
growth in this market even in the current low interest
rate environment.

Regulation
One of the most important issues facing the financial
guarantee market today is regulation. The primary
concern of state insurance regulators in reference to
financial guarantees is the integrity of the insurance
guaranty funds. Guaranty funds have been established
in every state in order to meet the obligations of insol
vent property/casualty insurers. Although procedures
vary from state to state, the basic structure is that sol
vent insurers in a state contribute to the fund on a
proportional basis after a failure has occurred. Both
regulators and insurers are therefore concerned about
the effects that a large financial guarantee claim would
have on a given guaranty fund. The total amount raised
by guaranty funds in all 50 states between 1969 and
1984 was $528 m illion.22 AMBAC’s losses on the
WPPSS bonds were $25.5 million in 1983 alone, nearly

5 percent of this total.23 The magnitude of losses such
as this has led to almost universal agreement among
insurance regulators that the direct claims of financial
guarantee policyholders should not be met from the
state guarantee funds.
Instead, the regulators’ concern is about the systemic
effects of insolvencies due to financial guarantees.
Under present regulations, property/casualty policy
holders from insolvent multiline insurers have access
to state guaranty funds regardless of the reason for the
insurer’s insolvency. A multiline firm that fails because
of losses from financial guarantees would still represent
a drain on guaranty fund resources even if financial
guarantee policyholders had no access to the fund. It
is this sort of resource drain that state agencies wish
to prevent through regulation.
The most direct approach to attaining this goal has
been proposed by the National Association of Insurance
Commissioners (NAIC). The NAIC proposal is that
financial guarantees be written only by monoline
insurers. Proponents of this view argue that if the
financial guarantee market is limited to monoline
insurers, both the state guaranty funds and other prop
erty/casualty policyholders will be protected from the
effects of large financial guarantee claims. In addition,
the monoline structure permits direct monitoring of
capital and reserve adequacy by regulators since all of
the insurer’s resources are devoted to financial guar
antees.
Because the NAIC proposal imposes minimum capital
requirements in addition to a monoline structure, it
would effectively restrict the financial guarantee market
to large insurers. New York State Superintendent of
Insurance James Corcoran supports NAIC model leg
islation being considered by the New York State
Assembly which would require that all new monoline
financial guarantee insurers have at least $50 million
in startup capital and surplus.24
Other regulators and industry participants dispute the
need to limit the market to monoline insurers. Propo
nents of this view argue that the monoline restriction is
unnecessary and disruptive. They contend that the
requirement to dedicate capital for financial guarantees
would serve to reduce capacity in other property/cas
ualty lines since a large amount of capital would have
to be diverted in order to form monoline subsidiaries.
Finally, opponents of the NAIC proposal argue that
requiring financial guarantees to be written by monoline
firms would eliminate the benefits of diversification.25
**W. James Lopp, Financial Security Assurance, Inc. Comments before
the Securities and Exchange Commission on March 16, 1987.
24New York State Assembly Bill No. 11347.

**7985-86 Property/Casualty Fact Book (Insurance Information Institute,
New York, 1985), page 41.

25American Insurance Association Statement of Position on Regulation
of Financial Guarantee Insurance (September 30, 1986), page 9.

FRBNY Quarterly Review/Spring 1987 23

Instead, the American Insurance Association and
others contend that risk limitations and capital and
reserve requirements are sufficient to prevent insol
vencies and protect the guaranty funds. Such require
ments are also a prominent feature of the NAIC model
legislation. In essence, these regulations limit the
exposure that insurers may assume from any one
source and impose mandatory contributions to contin
gency reserve funds based on the type of security
insured. In general, municipal bonds have the lowest
reserve contribution requirements and unrated corporate
securities have the highest.26 In New York State,
municipal bond insurers are already subject to reserve
requirements which stipulate that one-half of earned
premiums be reserved to cover losses. The legislation
adopted by New York State is likely to become the
standard for legislation elsewhere in the United States.
In terms of understanding and monitoring the financial
guarantee market, the most important contribution of
whatever legislation is adopted will be establishing a
legal definition of financial guarantees. By defining which
transactions constitute a financial guarantee and by
requiring these transactions to be reported, the pro
posed regulations will serve to uncover the activities of
the second tier financial guarantee market. The lasting
effects of the legislation, however, will depend upon the
ability of regulators and legislators to keep pace with
the rate of product innovation by insurers and the
investment community.

Outlook
The future of the financial guarantee market will be
shaped by this regulation as well as by other factors
involving both cyclical and noncyclical influences. In the
near term, the market is facing the downswing of the
underwriting cycle, as interest rates and quality spreads
have reached their lowest levels of the 1980s. The
combination of low interest rate levels and narrow
quality spreads means that the demand for financial
guarantees has fallen just at the point that insurers face
pressure to raise premiums to offset lower investment
income. At current interest rate levels, then, the financial
guarantee market is facing a period of contraction, with
insurers caught between the need to raise premiums
in order to be able to meet future liabilities and com
petitive pressures to accept lower premiums in order to
“ New York State Assembly bills Nos. 11347, 11348, 11349, (May 28,
1986).

FRBNY Quarterly Review/Spring 1987

generate new underwriting business.
The question that arises is whether insurers will be
adequately compensated for the risk that they assume
in writing financial guarantees in this low interest rate
environment. This is the first time that the fully-developed financial guarantee market has experienced the
downswing of the underwriting cycle. Competitive
pressures in the market are likely to be more severe
than in previous cyclical contractions because of the
large number of insurers that entered the market during
the underwriting cycle’s expansion in the first half of the
1980s. The large number of insurers competing for the
relatively small amount of financial guarantee business
could place pressure on insurers to lower underwriting
standards. With narrow quality spreads, only less
creditworthy borrowers will realize significant interest
cost savings through the purchase of a financial guar
antee. The pool of “ insurable” securities will therefore
be composed of a larger percentage of these borrowers,
and insurers will face pressure to guarantee these
securities in order to sustain premium income. These
pressures will be most severe for the most recent
entrants in the market since these insurers have a
smaller volume of outstanding business and therefore
smaller unearned premium reserves.27
It remains to be seen whether underwriting standards
will be maintained as the financial guarantee cycle runs
its course. Loss ratios for some types of corporate
guarantees are already quite high and a number of
small insurers have failed as a result of their financial
guarantees activities. This suggests that at least some
financial guarantee insurers are vulnerable to a down
turn in the underwriting cycle. Future losses in the
market will be determined by the degree to which
competition for underwriting business during this
downturn affects the credit decisions made by financial
guarantee underwriters.
^Although financial guarantee premiums are most generally paid in a
lump sum at the time that the security is issued, they are "earned"
in an accounting sense over the lifetime of the guarantee. For
instance, a $1 million premium on a ten-year bond guarantee might
be “ earned" by the insurer in ten annual installments of $100,000.
The remainder of the "unearned premium" is placed in a reserve
fund. Insurers with a large volume of outstanding insured securities
would thus be likely to have large unearned premium reserves and
therefore a source of accounting income that could sustain them
through a period of reduced current underwriting.

Beverly Hirtle

Appendix: A Model of the Financial Guarantee Market
This appendix develops in detail the model of the
financial guarantee market discussed in the text. The
model stresses the importance of interest rates in
determining the level of financial guarantee activity and
emphasizes the role of information about credit risk in
creating a market for financial guarantees. Comparative
static results derived from the model are used to
describe the cyclical nature of the financial guarantee
underwriting cycle. Finally, the relationship between credit
risk and the share of financing insured by financial
guarantees is explored.

Demand
To begin, it is assumed that there are N risky borrowers,
each of whom wishes to borrow B dollars. Each bond
issuer belongs to one of K risk classes, where a risk
class is defined by the default probability of the bor
rowers in that class. In other words, each bond issuer
in a given risk class k has default probability pk. There
are Nk bond issuers in each class, where

cial guarantee. To calculate an explicit expression for the
total financing savings resulting from a guarantee, the
following assumptions about the structure and charac
teristics of bonds and the capital market are made. First,
the structure of all bonds in the market is assumed to
be identical, with bonds having principal B, a fixed
coupon rate c„ and maturity T. The yield curve is
assumed to be flat and all bonds are assumed to be
structured so that they sell at par. These last assump
tions imply that the coupon rate on each bond, cn, is
set to be equal to rn if the bond is uninsured and r if
the bond is insured. Under these assumptions, the
reduction in coupon payments when a guarantee is
purchased is
rnB - rB = qsnB
This result can be used to calculate the total value of
a guarantee to a bond issuer. This value, V„, is the
present value of all future interest cost savings:

Sk Nk = N
Each bond issuer knows his own risk class and “true”
default probability, pk, but the capital market does not
know the borrower’s true credit risk. Instead, the market
receives a noisy signal of the default probability of each
bond issuer, pn = pk + |xkn, where the index n desig
nates a specific borrower. |xk may vary by risk class and
is distributed over the interval [ - p k, 1 - p k] with contin
uous distribution function g(|xk;pk). The limits of the dis
tribution are determined by the fact that the market’s
perceived default probability, p„, is limited to the range
[0, 1].
The demand for financial guarantees is derived from
the interest cost savings that the guarantee provides to
the bond issuer. The model assumes that with a guar
antee, the bond issuer can borrow at the risk free rate, r.
Without the guarantee, however, the bond issuer can
borrow at rate rn, where ?„= r + qsn. qsn, the "quality
spread”, is assumed to be a function of the level of
interest rates as represented by the risk free rate, r, and
the market’s perception of the borrower’s credit risk, pn.
The quality spread is assumed to increase with the
perceived level of credit risk (8qs„/8pn > 0) and with the
level of interest rates (8qs„/8r > 0). This second
assumption reflects liquidity effects. When interest rates
rise, credit becomes scarce and lower quality bonds
become significantly less liquid than riskless debt.
Investors therefore require a differentially higher yield
on risky debt when interest rates rise.
This quality spread qsn represents the reduction in the
bond issuer’s cost of funds when he purchases a finan

T
Vn =

2
t =1

qsn

qs„

(1+fn)‘

^ S r,

[1 - (1 + r + qsn)~T]

where, without loss of generality, B is set equal to 1.
The uninsured borrowing rate r„ = r + qsn is used to
discount the flow of interest cost savings because this
rate represents the borrower’s opportunity cost of funds.
Taking derivatives,
8Vn

qs„

Sqsn

r + qsn
r
(r + qsn)2

8Vn
Sr

[T(1 + r + qsn)_(T+1>]

[1 - (1 + r + qsn) T] > 0

qsn
[T(1 + r +qsn)_{T+1)] [1 + - ^ - ]
r + qsn
8r
r(8qsn/5r) - qsn
(r + qsn)2

[1 - (1 + r + qsn)~T]

^ *qs,r = (8qsn/8r) (r/qs„) s* 1, then 8Vn/8r > 0
8V„
— f- 8T

as„
r + qsn

[(1 + r + qsn) ' T - (1 + r + qsn)-<T+dT>] > 0

Finally, since pn = pk + mn,
SVn/8fj,k= 8Vn/8pk= 8Vn/8pn= (8Vn/8qsn) (8qsn/8pn) > 0.

FRBNY Quarterly Review/Spring 1987

A p p e n d ix : A M odel o f th e F in a n cia l G uarantee M arket (continued)
These results are important in determining character
istics of the demand curve for financial guarantees. Each
bond issuer will be willing to purchase a guarantee if
the premium for that guarantee is less than or equal to
these total interest cost savings, Vn. Bond issuers are
indifferent between purchasing and not purchasing a
guarantee when Vn is exactly equal to the guarantee
premium, PR. This equality defines an implicit “ break
even” value for the random noise factor,
within each
risk class k. Terming this breakeven value ]Ik, the fol
lowing equation defines an implicit function for ]Ik.
F fa ; r,pk,T,PR) = V - PR = 0
= V(r,T,qsn(r,pk+ M.k)) - PR = 0
Within each risk class, ]Ik is a function of the risk-free
rate, r, the “ true” default probability, pk, the maturity of
the bond, T, and financial guarantee premium, PR. Using
the implicit function theorem, it can be demonstrated that
8£ k/8r = - F / F m = - (8Vn/8r)/(SVn/SfIk) < 0
(assuming eqsr > 1)

5TTk/8PR = —Fpr/ F = 1/(&Vn/8JTk) > 0
8jEk/8T -

- F T/F,xk = - (8Vn/ST)/(SVn/5jIk) < 0

5jlk/8pk = —Fpk/F(ik = - (SVn/Spk)/(SVn/STTk) = -1
where Fx denotes the derivative of F with respect to x.
Using the expression for Vn, it is straightforward to
demonstrate that total interest cost savings increase with
ixkn. Within a risk class, then, all bond issuers with jj.kn
greater than f lk will have interest cost savings greater
than the guarantee premium PR and will therefore be
willing to purchase a guarantee. Recalling that y.k has
distribution function g fa ;p k), the share of bond issuers
with M-kn greater than ]Ik is (1 - G fa p k)) where G fa p k)
is the cumulative distribution function of fi.k. Using this
result, the demand curve for financial guarantees in risk
class k can be written as:
Dk = (1 - G fa ; pk)) Nk
The slope of the demand curve equals

8Dk/8Nk = 1 - G fa ; pk) > 0
8Dk/8T - —(8G/8]Ik) (S^/STJN, > 0
BDk/8r = - (8G/8jEk) (8jIk/8r)Nk > 0 if eqs,r s* 1
8Dk/8pk = [8G/8jIk - 8G/8pk]Nk i! 0 ?
Note that in the special case when the distribution of
Hk is the same across risk classes—i.e., 8G/8pk = 0 —
demand increases in riskier credit classes— 8Dk/8pk >
0. In general, however, the change in demand resulting
from an increase in pk will depend upon the form of the
cumulative distribution function G fa ; pk).
Supply
The supply side of the model is determined by the
actions of insurers. The model assumes that there are
J insurers, each of whom can write up to Mk dollars of
coverage in each risk class k. This assumption is
equivalent to assuming that each insurer dedicates a
fixed amount of its capital to writing guarantees and
maintains a fixed exposure-to-capital ratio in each risk
class. The amount of capital dedicated to each risk class
is taken as given in this model; a more realistic
assumption would be that insurers profit-maximize by
optimizing the distribution of their capital across risk
classes.
Insurers are able to offer financial guarantees because
they are assumed to be more effective at assessing true
credit risk than other participants in the capital market.
Specifically, it is assumed that each insurer can learn
the true default probability of a bond issuer, pk, at some
cost q. This cost is a characteristic of the insurer that
is known to both insurers and bond issuers. For tractability, it is assumed that ct is distributed uniformly over
[0,C],
For a given default probability, pkI insurers are able
to calculate the expected loss associated with writing a
financial guarantee in that risk class. For this calcualtion,
pk is interpreted as the “ instantaneous” default proba
bility. That is, pk is the probabilty that the bond issuer
defaults in a given period. pk is assumed to be constant
and independent across periods. Under these assump
tions, the expected loss from a guarantee in risk class
k is:

- N k(8G/8jIk) (8]Ik/8PR).
The position of the demand curve is determined by
the four exogenous variables r, pk, T and Nk. Taking
derivatives, it can be shown that

Lk =

T —1
2 pk(1 - p k)‘(1 + r)-i B
j=0

Lk = pk(1+r)(pk+ r)-1 [1 - ( l - Pk)T(1 + r)~T]

FRBNY Quarterly Review/Spring 1987

Appendix: A Model of the Financial Guarantee Market (continued)
where it is assumed that the insurer discounts at the
risk free rate and B has been set equal to 1. Taking
derivatives,

&U = Pk(1 ~Pk) [ - 1
8r

(Pk + r)2

( 1 - P k) t

(1 + r)T

8Sk/8J = (Mk/C) (PR - Lk) > 0
SSk/8Mk = (J/C)(PR - Lk) > 0
8Sk/8C = - (JMk/C2) (PR - Lk) < 0

Equilibrium
[1 -T (p k+ r) (1 - Pk) - 1]) < 0

8Lk

Pk(1+0

T(1 - Pk)T

8pk

Pk + r

l ( 1 - p k) (1+r)TJ

Qk = Nk [1 -G (]Ik(PR:, r, pk, T); pk)]

r(1+r)
(1-pk)T
----- L_ f1 _ _v
---- H!sL.j > 0
(Pk + r)2
(1 + r)T

_8U

pk(1 +r) (1 - p k)T

(pk+ r) (1 + r)T

The equilibrium premium rate and quantity of insured
principal in each risk class can be derived from the
supply and demand curves described above. Equating
supply and demand, we have

(1 -P k )d 1 > 0.
(1 + r ) d1

Since insurers can distinguish among the true default
probabilities of the bond issuers, there will be a financial
guarantee supply curve and market equilibrium for each
risk class k. Each insurer will provide a guarantee if the
premium exceeds the expected loss plus the cost of
discovering the true pk. Insurers are indifferent between
writing and not writing a guarantee when the premium,
PR, is just equal to the expected loss, Lk, plus the
information cost, cr This equality defines a “ breakeven”
value of cf, c:
c = PR - Lk
All insurers with c, less than or equal to c will be willing
to write guarantees. Recalling that c} is distributed uni
formly over [0,C], the share of insurers with c, less than
or equal to c is (c/C). This share implies that the supply
curve for financial guarantees in risk class k is:
Sk = JMk(c/C) = JMk((PR - Lk)/C).
The slope of the supply curve, 8Sk/8PR, equals JMk/C.
Like the demand curve, the position of the supply
curve for each risk class is determined by the set of
exogenous variable r, pk, T, J, Mk and C. Taking deriv
atives,

and
PRk — QkC/JMk + L^r, pk, T)
where the two equations define implicit functions for the
equilibrium quantity, QJ, and premium rate, PRJ:
Qk " Qk(r> Pki T, Nk, J, Mk, C)
and
PR*k = PRJ(r, pk, T, Nk, J, Mk, C).
Using the implicit function theorem, it is possible to
derive comparative static results about QJ and PRJ. For
instance, defining the implicit function for QJ as
H(QJ; r, T, Nk, pk, J, Mk, C) = Q; - Nk[1 -G (ji;; pk)]
and noting that
H0- = 1 + (8G/8]Ik) (8p[k/8PR) (CNk/JMk) > 0
then the derivatives of Qk and PRJ are:
with respect to r:
8Q* _

8Sk/8pk = - (JMk/C) (8Lk/8pk) < 0
8Sk/8T = - (JMk/C) (8U/8T) < 0

Sm-k
8PR

8Lk
8r

8|Ik
-J > 0
8r

(assuming eqs,r > 1)
8PR*

8Sk/8r = - (JMk/C) (8Lk/8r) > 0

Hr
8G
— L- = - HQ.1Nk ----Hq.
8jlk

Hcr1[

8Lk

CNk

8]Ik

JMk

5»xk

if - (8Lk/8r) (JMk/C) < - N k(8G/8£k) (8]Ik/8r)
8Sk/8r < 8Dk/8r
then 8PR*/8r > 0

FRBNY Quarterly Review/Spring 1987

mmmmm
A p p e n d ix : A M odel o f th e F in a n cia l G uarantee M arket (continued)
With respect to J:

with respect to pk:
8Q*

Hr
8G
•= - H Q-1Nk [Hq.
8pk
8G 81Ik SLk

8pk

8Q*

8p.k

Ho-

----- -------- - ] £ 0 ?

Sm-k 8PR

8PR*

8pk

8PR*

CNk

8Pk

<JMk

8^ik

8pk

8Lk

---- —] § 0 ?
8pk
if 8G/8]Ik > 8G/8pk, then 8PR78pk > 0 and
8Q*/8pk 0 ?
if 8G/81Ik < 8G/8pk, then 8Q*/8pk < 0 and
8PR78pk ^ 0 ?
if 8G/8]Ik = 8G/8pk, then 8Q*/8pk < 0 and
8PR78pk > 0
With respect to Nk:
8Q

~ HNk

1 — G(m; pk)

8Nk

H q-

H q.

8PR*

8Q*

8Nk

JMk

■> 0

-> 0

- —

H q.

8PR*
-------- =
8C

8p.k

Q*Nk

8£k

8PR

JM k

Q*
H q.1--------> 0
JM k

8Q*

HMk

8Mk

Hq.

8PR*
8Mk

8]Ik

Q*CNk

8]Ik

8PR

J2Mk

= Hq.1--------- -------------> 0

Hq-.1 —

Q*CNk
>

J2Mk

The equilibrium premium volume, PM*, is the product
of the equilibrium premium rate and quantity of insur
ance:
PM* = Q*PR*
This volume moves with changes in the exogenous
variables according to:
8PM*

_
8Q*
^ 8PR*
PR*-------- + Q*
8x
8x

where x = Nk, r, pk, C, Mk, J, T
For most of the exogenous variables, this comparative
static is difficult to sign a priori since the derivatives of
Q* and PR* with respect to the variable in question have
opposite signs. However, under certain assumptions, it
can be shown that the equilibrium premium volume
moves procyclically with interest rates. That is, assuming
that
eqs.r

* 1

and

(2) 8Sk/8r < 8Dk/8r

then

8PM*
8Q*
8PR*
-------- = PR*-------- + Q* -------- > 0
8r
8r
8r

Note that these are sufficient (but not necessary) con
ditions for this result to hold.

With respect to Mk:

------ =

8jlk

— r z -----------^

8 |Ik 8PR

Q*C

( 1)

- Hq-1----------—-------- - < 0

8G
- z r

J2Mk

With respect to C:
8Q*

Hq.1 ----------- < 0

------- = Hq-1! ----- —[ —“ — --------- ] +

Q*C
---- < 0
JM2k

FRBNY Quarterly Review/Spring 1987
Digitized28for FRASER

The Household Demand for
Money: Estimates from
Cross-sectional Data
Virtually all quantitative research on the transactions
demand for money has used aggregate time-series data.
More specifically, the key variables comprising the
economic relationship — the dollar volume of M1, the
size of GNP, and interest rates — are measured at the
level of the national economy; and the data are aver
ages over periods of time, usually a quarter of the year.
The outcome of these research efforts has been rather
unsatisfactory in recent years: regression analysis often
shows marked instability in the demand for money, or
sometimes, improbable estimates of elasticities or
lagged effects.1 Economists have reacted to the break
down of the demand-for-money relationship by altering
the specification of the relationship, questioning the
econometric methods used, disputing the definition of
money, or accepting the instability as reflecting structural
changes in the economic and financial environment.
Our work reexamines the demand for money by taking
a different approach: we estimate the household sector’s
demand for money using cross-sectional data. That is,
the values of income, interest rates, and money pertain
to individual families at a single point in time. This may
be the first study to utilize this approach, since it was
not feasible until the introduction of interest payments
on some checking account deposits (e.g. negotiable
order of withdrawal accounts). Only when the oppor
tunity cost of these deposits varies across households
’ For a survey through 1982, see John P. Judd and John L. Scadding,
“ The Search for a Stable Money Demand Function: A Survey of the
Post-1973 Literature," Journal of Economic Literature (September
1982), pages 993-1023. Also, see numerous articles on this subject
in this Quarterly Review and in those of the other Federal Reserve
Banks, as well as papers written by the Board of Governors staff
economists.

at a point in time can regression analysis estimate the
impact of such costs on checking account balances.
Since some individuals hold a demand deposit account,
which cannot earn interest, and others a NOW account,
which typically earns 5 percent or more, the necessary
variation in opportunity cost is observed.
The data we use in this study were collected through
a sample survey conducted by the University of Mich
igan’s Survey Research Center specifically for the Board
of Governors of the Federal Reserve System. About
1,950 households nationwide were contacted in the
spring of 1984. The general purpose of this survey was
to provide basic information on the use of cash, bank
accounts, and credit cards as the means of payment
by American families. A more specific purpose was to
enable the Board staff to estimate the amount of cur
rency held by individuals for legitimate transactions.2
Fortunately, we obtained enough information from the
survey to do a credible job of estimating a cross-sec
tional demand-for-money equation and to test some
hypotheses, although more information on the banking
relationships and financial position of the sampled
households would have been useful.
The empirical results obtained here are broadly con
sistent with the standard approach to analyzing the
demand for M1. The estimated income and interest rate
elasticities of money demand are well within the gen
erally accepted range and are highly significant; and the
2"The Use of Cash and Transactions Accounts by American Families,”
Federal Reserve Bulletin (February 1986), pages 87-108. The survey
was repeated to check the results; "Changes in the Use of
Transactions Accounts and Cash from 1984 to 1986," Federal
Reserve Bulletin (March 1987), pages 179-96.

FRBNY Quarterly Review/Spring 1987 29

estim a te d c o e ffic ie n ts of several other e xp la n a to ry
variables in the regression are significant and have the
expected sign. These econom etric results bolster the
case for using the conventional approach to the demand
for money at the household level. But two problems
hinder the direct application of these results to money
demand at the economy-wide level: the lack of a con
sensus model for the business sector and the difficulty
of aggregating from the level of individual firm s and
households to the economy as a whole. Moreover, these
results, while relevant to monetary issues, do not pro
vide estimates of shifts in the demand for money during
the past ten years.

Model specification
The dem and-for-m oney equation is form ulated along
conventional lines. The underlying theory is that money
(M1) is held as an inventory in order to conduct trans
actions.3 Thus, observed checking account balances—
either with or without currency holdings added— are
3David E.W. Laidler, The Demand for Money: Theories and Evidence,
third edition (Harper and Row, New York, 1985), Chapter 6; William
J. Baumol, “ The Transactions Demand for Cash: An Inventory
Theoretic Approach", Quarterly Journal of Economics (November
1952), pages 545-56; and James Tobin, "The Interest Elasticity of
Transactions Demand for Cash," Review of Economics and Statistics
(August 1956), pages 241-47.

explained by income, serving as a proxy for the dollar
volume of transactions; by the (marginal) opportunity
cost of holding checking account balances; and by
several other factors affecting checking account usage
among fam ilies.4 We use dummy variables to incorpo
rate many of these other factors in the regression. (See
the box for a listing of the variables used.)
Notably absent from the regression equation is wealth;
this survey made no inquiry as to the financial wealth
of the individual households. We wanted to add wealth
as an explanatory variable because of its possible role
as a determinant of the demand for narrow money; and
because another survey of households, conducted by
a bank consulting firm, suggested that it does affect a
fam ily’s money holdings.5
The equation is estimated in log-linear form ; that is,
the n a tu ra l lo g a rith m s of th e d e p e n d e n t v a ria b le ,
income, and the opportunity cost are used instead of
their actual levels. Using the log of checking balances
as the dependent variable is more consistent with the
4The effects of fees and minimum balance requirements are very
important for determining average opportunity cost, but can
probably be ignored at the margin.
*Synergistics Research Corporation, Atlanta, Georgia. This survey
contacted about 1850 families nationwide in the spring of 1986.

Variables in the Regression Equation
Three alternative definitions of the dependent variable
were used in the first set of regressions (reported in
Table 1): (1) the household’s balance in its main
checking account, (2) its total balance across all its
checking accounts (if it owns more than one), and (3)
its total checking account balance plus the currency
holdings of the household member responding to the
survey (however they were obtained). All these variables
are measured as of the day of the survey. The inde
pendent variables include:
•total household annual income;
•the household’s marginal opportunity cost for
holding checking account balances (the national
average money-market deposit account rate shown
in the Bank Rate Monitor, less the rate of interest
earned on the household’s checking account bal
ance);
•the amount of currency held by that household
member responding to the survey (provided that it
was withdrawn out of a bank account);
•the total credit card balance of the household;
• a dummy variable taking the value of one for
households holding a demand deposit account and
normally paying a monthly service charge or other
fees, and taking the value zero otherwise;
• a dummy variable exactly like the aforementioned,

FRBNY Quarterly Review/Spring 1987

except in regard to NOW accounts;
• a dummy variable taking the value one for house
holds reporting that they paid for less than onequarter of their total expenditures from their main
checking account, and the value zero otherwise;
• a dummy variable taking the value one for house
holds reporting that their primary worker’s pay
period was shorter than a month, and zero other
wise;
• a dummy variable taking the value one for those
responding that there was more than one full-time
worker in the household, and zero otherwise;
• a dummy variable taking the value one for house
holds who transferred funds during the past month
into their main checking account from some other
bank account, and zero otherwise;
• a dummy variable taking the value one for those
households holding one or more secondary
checking accounts, and zero otherwise;
• a dummy variable taking the value one for house
holds also holding a money-market account (pro
vided by either a bank or an investment firm) with
checkwriting privileges, and zero otherwise; and
• a dummy variable taking the value one for those
households who preferred to carry extra currency
in the chance of an emergency, and zero otherwise.

basic assumptions of the classical regression model. If
the actual level of the checking account balance (not
its log) is specified as the dependent variable, the
regression equation’s disturbance term could not take
on a full range of values—a household’s checking
account balance can never be negative.6 Thus, the
disturbance term could not take on large, negative
values, a condition which violates a basic least squares
assumption. Instead, the log-linear functional form is
used. This specification leads to satisfactory least
squares estimates because a very large negative value
for the disturbance term implies that the household’s
checking account balance is close to, but not below
zero.7
One additional restriction is imposed: we have
included in the sample only those households whose
income exceeded $10,000. We decided to drop lowincome households because for such households
income is probably a poor proxy for the volume of
transactions. In many of these low-income households,
adults are either suffering extended unemployment or
have special circumstances and have voluntarily
dropped out of the full-time labor force (for example, a
student in graduate school). Many of these households
are running down their assets or are receiving assist
ance from the government, their families, or elsewhere.
In any case, their transactions volume and their
checking account balance may not correspond to their
income, and thus these respondents should be dropped
from the sample, even though doing so may introduce
a selection bias.8

Regression results
The regression results for household money demand are
statistically meaningful and reliable, and some particular
coefficient estimates agree neatly with the transaction
motive for holding money. The estimates of the income
elasticity (falling in a range of 0.60 to 0.86, depending
on the exact specification of the regression) are con
sistent with widely-held expectations; and they have
'Many households (almost one-third) do have overdraft privileges, but
an overdraft usually triggers credits of $100 or some even amount,
not an amount exactly equaling the overdraft.
7So, when using cross-sectional data, there is an a priori economic
rationale for the choice of functional form. In research on money
demand using time-series data, Zarembka developed an estimation
procedure that discriminated between linear and log functional
forms because of indecision between the two. See Paul Zarembka,
"Functional Form in the Demand for Money,” Journal of the
American Statistical Association (June 1968), pages 502-11.
'Although the income variable is defined to include unearned income,
in our judgment it is better to drop these households from the
sample. Another reason to do so is that they may not have sufficient
assets to justify a savings account, in which case our concept of
opportunity cost does not apply.

very high statistical significance (with t-statistics around
10). Money demand appears to have considerable
elasticity with respect to opportunity cost, with estimates
which are in the range of 0.37 to 0.49 and which are
highly significant. The estimated effect of a household’s
primary worker having a shorter period between pay
days is to reduce its checking account balance—the
effect predicted by the inventory model of money
demand.
Although there are many s ig n ifica n t variables
appearing in the equation, the explanatory power of the
regression equation may seem low, with the adjusted
R2 on the order of 0.24 to 0.36. Cross-sectional data,
however, usually produce regressions with lower
explanatory power than do time-series data. Moreover,
there is a particular reason for the low R2 in the case
of the cross-sectional equations we estimate—the
dependent variable relates to the balance in the main
checking account on the day of the survey. And natu
rally, there is substantial day-to-day variation in a
household’s account balance over the course of a
month, even though its monthly average balance may
be quite stable over an entire year. Had the survey
collected data on the household’s monthly average
balance, the explanatory power of the regression
equation would look much better. To convince ourselves
of this, we constructed artificial daily- and monthlyaverage balance data conforming to the inventory
model. On this basis, the R2 of the regression equation
would be expected to rise considerably if we had used
monthly-average data instead.
There were 922 observations used in the regressions.
While the survey contacted about 1,950 families, many
had to be dropped from the sample for any of several
reasons: the household did not own a checking account,
the respondent could not or would not answer a ques
tion, or the recorded response was implausible.

Coefficient estimates of the core model
The demand equation was initially estimated three
times, each time with a differently defined dependent
variable: main checking account balance, total balance
in all checking accounts, and total checking account
balance plus currency holdings. The same set of ten
independent variables—the “ core” model—was used.
These estimates are reported in Table 1.
•The estimated income elasticity is about 0.85,
within the limits of 0.5 to 1.0 implied by transac
tions models of money demand. It should be
noted, however, that this estimate is not signifi
cantly different from unitary elasticity at the 5
percent level.
•The estimated opportunity cost (interest rate)
elasticity is on the high side: 0.40 to almost 0.50.

FRBNY Quarterly Review/Spring 1987 31

These estimates indicate considerable sensitivity
of the level of checking balances to changes at
the margin in the amount of interest foregone in
order to hold those balances.9
• D 1: A household whose primary worker— or the
person who answered the survey, in the case of
•When the dependent variable is either total checking
balance or total balance plus cash, an inconsistency
opportunity cost variable refers to the main checking
main account is a NOW, then the opportunity cost of

account
creeps in. The
account. If the
holding cash

Table 1

Regression Results for the
Demand for Money by Households
Estimated Coefficients
(with t-statistics in parentheses)
Independent
Variables

Income
Opportunity
Cost
D1:
Pay Period Shorter
Than a Month
D2:
Two or More
Full-Time Workers
D3:
Usually Pays Fees
for Demand
Deposit Account
D4.
Usually Pays Fees
for NOW Account
D5:
Pays for Few
Expenditures out of
Main Checking
D6:
Made a Transfer
to Checking
during Past Month
D7:
Owns a Money-Market
Savings Account
D8:
Owns a Secondary
Checking Account
Intercept
Adj. R2

Dependent Variable
Currency
Holdings
plus
Main
Total of
Total of
Checking
Checking
Checking
Account
Account
Account
Balances
Balances
Balance
0.82
0.85
0.86
(10.8)
(11.2)
(10.5)
-0.42
-0.40
-0.49
(-4.2)
(-4.5)
(-4.0)
-0.52
(-4.8)

-0.49
(-4.6)

-0.43
(-4.3)

-0.32
(-3.3)

-0.34
(-3.6)

-0.33
(-3.9)

-0.40
(-4 1 ).

-0.41
(-4.2)

-0.39
(-4.5)

-0.53
(-3.3)

-0.48
(-3.0)

-0.49
(-3.3)

-0.49
(-2.5)

-0.37
(-2.0)

-0.25
(-1.4)

-0.30
(-2.5)

-0.24
(-2.1)

-0.28
(-2.6)

0.21
(2.0)

0.32
(3.1)

0.30
(3.1)

0.12
(1.2)
-1.02
(-1.2)
0.236

0.91
(95)
-1.21
(-1 5 )
0.325

0.81
(9.2)
-0.74
( -1 0 )
0.330

FRBNY Quarterly Review/Spring 1987

two or more full-tim e w orkers— is paid more often
th an once a m onth (a b o u t 91 p e rc e n t o f the
sample) tends to have lower money holdings, other
factors constant. So, households paid weekly or
b i-w e e kly have a low er average balance than
households paid monthly. This is precisely what
the inventory model of money demand would pre
dict.
• D2: A household with two or more full-time workers
(29 percent of the sample) also has lower money
holdings on average. So, having two w orkers in a
fam ily is in effect sim ilar to a shorter pay period.
If one of the fa m ily’s workers is paid at the begin
ning of the month and the other near the middle,
a tw o -w o rk e r h o u s e h o ld is c o m p a ra b le in its
deposit pattern to a household having one full-time
worker paid bi-weekly.
• D3 and D4: Paying fees on a demand deposit
account or NOW account correlates with lower
money balances. (In the sample, 42 percent of the
h o u s e h o ld s paid a fee on a dem an d d e p o s it
account, and 9 percent paid a fee on a NOW
account.) Our interpretation is that most house
holds who have free checking do so because they
m eet a m in im u m b a la n c e re q u ire m e n t in the
checking account itself, and meeting it in many
cases causes them to m aintain a higher average
balance than they would otherw ise.10
• D5: A household making relatively few payments
from its main checking account (6 percent of the
sample) holds a lower main account balance (or,
for one with m ultiple accounts, lower total bal
ance). A household in this group, however, does
not te nd to have lo w e r to ta l m oney h o ld in g s
(checking account balance p lu s currency). Appar
ently, in most of these cases, cash is used for
payments instead of check.
• D6: A h ousehold th a t d urin g the past m onth
transferred funds into its main checking account
from one of its other bank accounts (15 percent
of the sa m p le ) te n d s to hold le ss m oney. A
household falling in this category was thought to
be actively trying to maximize its interest income
by keeping funds longer in its savings account and
transferring them into the checking account only
Footnote 9 continued
will definitely be higher than the opportunity cost of holding
balances in the main checking account, and the opportunity cost of
holding balances in a secondary account may also be higher than in
the main account.
10Of course, some households have absolutely free checking (no fees
and no minimum balance requirement), can avoid fees by
maintaining a certain savings account balance, or do not find the
minimum balance requirement to be a binding constraint; but they
appear to be in the minority.

as needed; thus, the finding was expected.
• D7: A fa m ily h olding a m oney-m arket savings
account with checkwriting privileges (15 percent
of the sample) tends to hold more M1-type money.
On the one hand, this is surprising. Money-market
accounts are so convenient and useful that— other
th in g s e q u a l— a fa m ily w ith a m o n e y-m a rke t
account would be expected to maintain a lower
checking account balance, keeping more funds in
th e m o n e y -m a rk e t a c c o u n t in s te a d ; b u t we
observe the opposite. In light of the results from
another household survey, however, the finding is
much less surprising.11 This survey showed that
the ownership of a money-market savings account
is highly correlated with a fam ily’s wealth, which
is not measured in the survey used here. Own
ership of a money-market savings account may be
picking up the effect of wealth on money demand;
so, a positive coefficient for this variable is rea
sonable.
• D8: Holding a secondary checking account (26
p e rc e n t of the sa m p le ) has no im p a ct on a
h o u se h o ld ’s main a ccount balance, but has a
p ositive e ffe ct on its to ta l balance across all
checking accounts. A typical household, it seems,
does n o t s p lit the sam e to ta l balance among
however many accounts it happens to hold. If it
did, main account balance would be lower (and the
variable’s coefficient would be negative in the first
regression), and total account balance would not
be significantly higher (and the coefficient estimate
would be insignificant in the second).
V ariables re la tin g to a lte rn a tiv e p aym ent m eth od s
In addition to this core set of ten explanatory variables,
a few others, relating to cash and credit cards, were
tried. (In each of these regressions, total checking
a c c o u n t b a la n ce is the d e p e n d e n t v a ria b le .) The
regression results are presented in Table 2. First, the
am ount of cash on hand was added to the lis t of
explanatory variables; its coefficient is positive and
significant (first column of the table).12 One might have
thought that the sign would be negative, as cash and
checking account balances are natural substitutes. Our
estimate does not contradict this; instead, the positive
coefficient would seem to be an artifact of the survey’s

design. The cash and checking balance information was
collected, not as some average over the previous week
or month, but as of the day of the survey. If that day
happens to be soon after payday, cash holdings and
checking account balance are both likely to be high. If
that day is long after payday, they are both likely to be
low.

fable 2

Regression Results fo r the Augm ented
Versions of the Demand fo r Money by Households
Estimated Coefficients
(with t-statistics in parentheses)
Independent
Variables
Income
Opportunity
Cost
D1:
Pay Period Shorter
Than a Month
D2:
Two or More
Full-Time Workers
D3:
Usually Pays Fees
for Demand
Deposit Account
D4:
Usually Pays Fees
for NOW Account
D5:
Pays for Few
Expenditures out of
Main Checking
D6:
Made a Transfer
to Checking
during Past Month
D7:
Owns a Money-Market
Savings Account
D8:
Owns a Secondary
Checking Account
Cash
Credit Card
Balance-1*
Credit Card
Balance-2t
Intercept

11Synergistics Research Corporation.
12More precisely, cash on hand is the amount held by the household
member responding to the survey, providing it was obtained by a
withdrawal from a bank account. Earlier, in the regressions reported
in Table 1, cash was added to checking balances and the sum was
used as one form of the dependent variable. But the cash variable
was defined differently in that case; it was cash holdings—however
obtained.

Adj. R2

Dependent Variable:
Total of Checking Account Balances
0.77
(97)
-0.37
(-3.6)

0.72
(8.7)
-0.37
(-3.6)

0.60
(6.2)
-0.38
(-3.2)

-0.45
(-4.3)

-0.44
(-4.2)

-0.40
(-3.1)

-0.25
(-2.7)

-0.24
(-2.6)

-0.15
(-1.4)

-0.39
(-4.2)

-0.30
(-2.7)

-0.38
(-2.5)

-0.40
(-2.6)

-0.30
(-1.7)

-0.35
(-1.9)

-0.33
(-1.8)

-0.48
(-1 8 )

-0.21
(-1 9 )

-0.21
(-1.9)

-0.16
(-1 3 )

0.27
(2.6)

0.26
(2.5)

0.31
(2.7)

0.92
(9.8)
0.15
(6.5)

0.90
(96)
0.15
(6.5)
0.00017
(2.1)

0.94
(9.0)
0.15
(5.2)

—
—
—

—

—
-0.86
(-1.1)
0.354

—
-0.41
(-0.5)
0.357

—
—

0.90
(2.1)
0.27
(0.3)
0.339

‘Credit Card Balance-1: the actual level of the balance.
fCredit Card Balance-2: the natural logarithm of the balance if the
balance is positive; otherwise, the
respondent is dropped from the sample

FRBNY Quarterly Review/Spring 1987

The next step was to add to this augmented equation
a variable representing attitude toward cash. This vari
able took the value one for those respondents who
agreed with the statement, “ I prefer to carry extra cur
rency for emergencies because it is difficult to obtain
currency on short notice.” The variable took the value
zero if the respondent disagreed. Its coefficient estimate
(not shown in the table) falls far short of statistical sig
nificance; apparently attitude does not translate into
identifiable extra checking account balances.13
The last step was to add total credit card balances
to the equation. This is the sum of balances on all types
of credit cards—store, gasoline company, travel and
entertainment, and bank. This variable was added to
the equation in three ways, with mixed and somewhat
puzzling results.
• The level of the total balance (balance-1 in Table
2): This specification is asymmetric with respect
to the income and opportunity cost variables
(which enter the equation as their natural logs, not
their levels), but it circumvents the problem of
dealing with those households having no credit
cards or a zero balance. High credit card balance
corresponds with higher-than-average checking
account balance (middle column of Table 2). Our
interpretation is simply that credit card charges
preserve checking account balances, or if the
credit card balance is due, checking account bal
ance must be built up in advance in order to pay
the bill.
• The natural log of credit card balances (not shown
in the table): To avoid the problem created by the
fact that the log of zero is undefined, a balance
of one dollar is arbitrarily attributed to those
reporting a balance of zero. In this case, credit
card balances are not correlated with money
holdings.
•The natural log of credit card balances, but with
those reporting a zero balance or not owning credit
cards (297 households) dropped from the sample
(balance-2 in Table 2): There are 625 households
reporting a credit card balance in this reduced
sample. For this equation, credit card balances
have a significant effect, but by dropping one-third
of the sample, the coefficient estimates for the
other variables change somewhat and the signif
icance of a few variables drops below the 5 per
cent level.
In sum, adding these variables somewhat improved
the fit of the regression equation. We have provided our
13This dummy was also added to the equation explaining total M1
balances; its estimate is insignificant there as well.

34 FRBNY Quarterly Review/Spring 1987

interpretation of the results, but admittedly, the con
nections between a household’s cash on hand, credit
card balances, and checking account balances are
indirect, complex, and difficult to determine a priori.

Summary and conclusions
This paper reports estimates of the household sector’s
demand for money obtained from regression analysis
of cross-sectional survey data. In general, the estimates
agree with the transactions motive for holding money
and support the use of the conventional approach to
the demand for M1. In the context of recent experience,
these results suggest that the inability of econometric
models to track the short-term movements of M1 sat
isfactorily is likely to have been the product of structural
shifts in the demand for money, precipitated by various
factors, including regulatory changes. The observed
instability and unpredictability of money demand appear
not to have been the fault of just the estimation methods
or the definition of money. But the regression results
reported here neither provide quantitative estimates of
the suspected structural shifts nor identify the causes;
they are only suggestive on these matters.
The empirical analysis, while important because it
provides estimates of the household sector’s money
demand, cannot be directly applied to the setting of
monetary targets. The estimates of the demand elas
ticities cannot be used to project the sensitivity of M1
to a change in money-market conditions. We do not
know how to translate the elasticities derived from dif
ferences among individuals at a point in time into elas
ticities pertaining to changes over time. This is a
problem parallel to converting estimates of the marginal
propensity to consume derived from budgets of indi
vidual families into the marginal propensity to consume
out of next year’s GNP. Hence, the cross-sectional
estimates cannot be used to make projections of the
effect that a change in interest rates will have on the
growth of M1 over a period of time, say one year.
These limitations aside, this study has the virtue of
using a fresh approach to the research on money
demand. In addition, the regression estimates indicate
that the interest rate elasticity of the household sector’s
demand for money may currently be much greater than
was estimated from pre-1974 aggregate time-series
data. Indeed, the short- and medium-term sensitivity of
M1 to interest rates may be substantially greater than
economists and policymakers have thought it to be.

Lawrence J. Radecki
Cecily C. Garver

Monetary Policy and Open
Market Operations During 1986
Monetary policy in 1986 sought to sustain the ongoing
economic expansion against a background that included
restrained and often uneven economic growth and
declining inflation. Indeed, as measured by the implicit
gross national product (GNP) deflator, prices rose at their
slowest pace since 1964, thanks in good part to the col
lapse of oil prices, a factor that many regarded as tem
porary. The monetary aggregates grew rapidly, lifting M1
well above its target range and taking the broader
measures to the upper ends of their ranges, but the
growth did not seem to have the same interpretation as
it had in earlier times. In this instance, the increases
seemed less likely to foster excessive economic growth
or inflation. Hence, the Federal Open Market Committee
(FOMC) accommodated the rapid M1 expansion and
judged appropriate policy in the context of the growth of
the broader aggregates, economic activity, inflation,
financial market developments, and the foreign exchange
value of the dollar. Total reserves grew a record 20 per
cent over the year, reflecting the unprecedented expansion
of transactions balances. The relatively generous provision
of reserves in combination with a series of discount rate
Adapted from a report submitted to the Federal Open Market
Committee by Peter D. Sternlight, Executive Vice President of the
Bank and Manager for Domestic Operations of the System Open
Market Account. Ann-Marie Meulendyke, Manager, Open Market
Operations Department, and Sandra Krieger, Chief, Open Market
Analysis Division, were primarily responsible for preparation of this
report. Other members of the Open Market Analysis Division
assisting in the preparation were Jeremy Gluck, Economist; Connie
Raffaele and Robert Van Wicklen, Senior Statisticians; and Debra
Chrapaty and Martin Gonzalez, Assistant Economists. Barbara
Walter, Assistant Vice President, and Samuel Foxman, Special
Assistant, Dealer Surveillance Department, alse participated in
preparing the report.

cuts accomplished a gradual reduction in the degree of
pressure on reserve positions.
The financial markets responded with falling interest
rates to the combination of modest economic expansion,
low rates of inflation, and adjustments to the stance of
monetary policy. Long-term rates fell sharply near the
start of the year, and the rally extended to the short
term sector once the discount rate was cut in March.
Interest rate movements were mixed later in the year,
but (ates, nonetheless, finished substantially lower.
M2 and M3 grew slowly near the start of the year, but
accelerated during the spring, and each was generally
near the 9 percent top of its annual range during the
latter months of the year. Nominal income expanded just
over 4 percent over the four quarters of 1986, which
meant that M2 and M3 velocity—the ratio of nominal
GNP to money—declined significantly. The declines in
market interest rates apparently contributed to the
increased demand for the broader aggregates by
attracting some funds that might otherwise have been
held in market instruments. In these circumstances, the
FOMC judged growth near the upper ends of their
ranges to be acceptable.
M1 grew a record 15 percent between the fourth
quarter of 1985 and the fourth quarter of 1986, far
exceeding the range that had been set at the February
meeting. As the year proceeded, it became increasingly
apparent that the demand for M1 was rising sharply and
that its movements had become more interest-rate
sensitive. The declines in interest rates made NOW
account rates reasonably competitive with market rates
when interest-rate ceilings on these deposits were
phased out at the beginning of the year.

FRBNY Quarterly Review/Spring 1987 35

A number of factors outside direct Federal Reserve
control continued to serve as background to the policy
process. Among the most important of these were the
ongoing Federal budget and international current
account deficits. The Gramm-Rudman (GR) deficit
reduction process encouraged some steps to shrink
future deficits but, in fiscal 1986, the deficit grew. Like
wise, the current account deficit widened, even though
the exchange value of the dollar had dropped substan
tially since its peak level in February 1985. Further
declines in the value of the dollar in 1986 were viewed
as acceptable. However, there were concerns at times
that the dollar could fall too sharply with the declines
feeding upon themselves, thereby promoting domestic
inflationary pressures. In that context, the Federal
Reserve was aware that it needed to be sensitive to
the consequences of its monetary policy actions for the
foreign currency markets.
The Trading Desk continued to take a flexible
approach to implementing policy in the face of the
uncertainties about the behavior of the monetary
aggregates as the year went along. With the reserve
pressures being generally maintained at relatively low
levels, it met reserve needs promptly during much of
the year. Reserve pressures were lowered near the end
of 1985 and early in 1986 through reductions in the
expected amount of discount window borrowing to $300
million, an amount considered to be only modestly
above frictional levels. Thereafter, further easing of
reserve pressure was accomplished with four one-halfpercentage-point cuts in the discount rate, which low
ered the rate to 51/2 percent by August.

The monetary aggregates
The broader monetary aggregates behaved about in line
with the objectives during 1986 while M1 once again
grew much more rapidly than anticipated. M1 velocity
declined very sharply during 1986, making its behavior
difficult to interpret. The FOMC was cautious in its
reading of the growth of this measure and moved to
deemphasize it as a policy indicator. The Committee
tended to place its emphasis on the broader aggregates,
economic expansion, inflation, domestic and interna
tional financial market conditions, and the exchange
value of the dollar.
At its February meeting, the FOMC set growth rate
ranges for fourth quarter 1985 to fourth quarter 1986.
The ranges for the broader aggregates, M2 and M3,
were left at 6 to 9 percent, the same as the tentative
ranges set the preceding July. The Committee noted that
growth in 1985 had been generally in line with expec
tations and that the behavior of M2 and M3 seemed to
have been less affected than M1 by institutional and
interest rate changes. The broader aggregates include

36 FRBNY Quarterly Review/Spring 1987

an array of deposit and money market instruments that
have often exhibited offsetting movements. The range
for M1 growth was widened by 2 percentage points to
3 to 8 percent to reflect the uncertainties already
apparent in February about the appropriate behavior of
that aggregate. The 1986 range for M1 was well below
the actual 12 percent increase in 1985.
In evaluating the prospective growth of M1, the Com
mittee assumed that its velocity would not decline so
substantially as it had in 1985, when it had dropped 5
percent. The Committee recognized the possibility that
velocity could decline rapidly in 1986 if there were a
continuation of the recent trends, which might make it
appropriate for M1 to run above its annual range. Of
particular concern were factors shifting the public’s allo
cation of savings, including the deregulation of interestbearing NOW accounts. The Committee believed that it
was appropriate to continue to be guided by all three
monetary measures, as collectively they seemed to have
more significance than they did individually.
Against a backdrop of low inflation and declining shortand long-term interest rates, M1 did not return to its tra
ditional relationship to economic activity or to the broader
aggregates. M1 appeared to have become more interestsensitive than it had been when market rates were far
above the regulated rates on M1 deposits. M1 grew 15.3
percent from the fourth quarter of 1985 to the fourth
quarter of 1986, substantially above the upper end of its
range (Chart 1).1 M1 growth started out slowly, barely
rising in January after rapid expansion in the last few
months of 1985. Growth accelerated and M1 moved
above the upper limit of its cone in March. Once short
term rates dropped in the wake of discount rate cuts in
March and April, M1 growth accelerated further. By May,
M1 exceeded the upper end of its parallel band. The
above-path growth continued without pause for the rest
of the year, with a further acceleration in December.
Both of the broader aggregates closed the year just
about at the tops of their target ranges, with M2 growth
of 9.1 percent, on a fourth quarter to fourth quarter basis,
and M3 growth of 8.9 percent (Charts 2 and 3). M2
started 1986 somewhat below the lower bound of its cone,
but soon quickened, and during the latter half
'All money growth rates cited in this report are based on the data
available before the benchmark and seasonal revisions in February
1987. The earlier data were used because they more closely represent
the information available to the FOMC members at the time that their
decisions were being made. The revisions were generally small for
1986 and had M1 growth at 15.2 percent over the four quarters. The
fourth quarter to fourth quarter growth of M2 was lowered 0.2
percentage points to 8.9 percent. Growth of M3 was lowered from 8.9
percent to 8.8 percent. The quarterly growth patterns of the
aggregates were modified slightly by the revisions. In particular,
growth rates for M1 and M2 early in the year were raised modestly,
while growth rates for subsequent months were lowered very slightly
on balance.

Chart 1

Chart 2

M1:

M2:

L e v e ls and T a rg e t R anges

Cones and tunnels

Billions of dollars
2850

Billions of dollars
740

9.0%

2800

2750
Actual
2700

6.0 %

2650

2600

2550

2500
1985

O N D J
1985

1986

---------------------------------------------- -----------F M A M J
J A S O N D
1986

Chart 3

Chart 4

M3:

T o ta l D o m e s tic N o n fin a n c ia l D eb t
L e v e ls and M o n ito rin g R anges

L e v e ls and T a rg e t R anges

Cones and tunnels

Billions of dollars
3550

Billions of dollars
7800

3500

11. 0 %
7600

3450
3400

7400

3350

7200

3300

7000

3250
6800
3200
6600

3150
3100

N D
1985

J A
1986

6400 I-----1-----1---------- 1-----1-----1-----1-----1-----1----- 1-----1-----1-----1-----1-----1
O N D J F M A M J J A S O N D
1985
1986

FRBNY Quarterly Review/Spring 1987

of the year was generally around the upper end of its
designated cone range. M3, meanwhile, showed a pat
tern of moderate growth and remained comfortably
within its cone until the summer. It moved slightly above
it for a time in late summer although it stayed within
the parallel bands. The expansion of domestic nonfinancial debt continued to outpace the growth of GNP,
registering a 13.2 percent increase over the four quar
ters and running above the Committee’s 8 to 11 percent
monitoring range for the year (Chart 4).
The FOMC confronted the question of how to handle
the M1 overshoot at the May meeting. It decided to
accept the rapid growth that had already occurred, but
it set a range for the March-to-June period that antici
pated a deceleration in money growth over the balance
of the quarter. While the desired slowing in M1 did not
occur, the pace of economic activity seemed to be
slowing, giving further evidence that the relationship
between M1 and GNP had changed.
By the time the Committee met in July, it took account
of the mounting evidence that the relationship of M1 to
income had been significantly altered by changes in the
composition of the aggregate, making it very difficult to
assess or predict the implications of M1 growth for the
future course of economic activity and the rate of infla
tion. It believed that the operational significance of M1
could only be judged in the perspective of concurrent
economic and financial developments, including the
behavior of the broader aggregates. The Committee
decided to retain the annual range for M1 for its con
tinued information value for policy, even ifethe range
were used only as a benchmark for measuring devia
tions. It rejected raising or rebasing the range, since
such an adjustment might imply greater certainty about
the future performance of the measure than in practice
existed. The FOMC indicated that growth above the
existing range would be acceptable for the year.
Both of the broader aggregates were well within their
ranges at the time of the July review. The growth ranges
set near the beginning of the year continued to be seen
as consistent with the Committee’s overall policy
objectives, so those ranges were retained. Growth rates
for both measures accelerated somewhat over the bal
ance of the year. They, nonetheless, ended near the
upper ends of their annual target ranges, despite the
explosive growth in the M1 component, reflecting the
slow growth or declines in some of the less liquid non
transactions components.
All three measures outpaced GNP growth during the
year, resulting in velocity declines. From the fourth
quarter of 1985 to the fourth quarter of 1986, M2
velocity fell 4.5 percent while M3 velocity fell 4.3 per
cent. The velocity declines in the broader aggregates
held them below their long-term trends (Charts 5 and

FRBNY Quarterly Review/Spring 1987

6), but the distortion was far less than that to M1. Much
of the below-trend performance reflected the weakness
in M1 velocity. To some extent, the declining velocity
may have reflected shifts from market instruments to
liquid nontransactions components of M2 and M3. As
spreads of market rates over those available on more
liquid nontransactions M2 components narrowed,
increased inflows to these accounts became apparent.
There was also a shift in the composition among the
nontransactions components within M2, as interest rates
on various components were adjusted at different
speeds, creating incentives for customers to change the
mix of their deposit holdings. Interest-rate ceilings on
passbook savings accounts were eliminated April 1, by
which point market rates had fallen enough that the
ceilings were no longer binding. As market rates fell
further, bank and thrift institutions were reluctant to
lower their passbook savings rates below previous
interest-rate ceilings since rates had been at the ceiling
level for so many years. There was concern that any
bank that led such a move could lose previously loyal
customers and market share. Rates on time deposits,
meanwhile, were adjusted more promptly as market
rates fell, leading to a decline in the spread of the rates
on small time deposits over those on passbook
accounts. These changes were associated with a surge
in savings deposits and a net runoff in small time
deposits (Chart 8). Some of the dropoff in small time
deposits may have been associated with inflows to
money market deposit accounts (MMDAs) which were
sought for their liquidity (minimum balances on these
accounts were eliminated at the start of the year).
MMDAs showed a more modest narrowing of the yield
spread to Treasury issues as compared to time deposits
over the course of the year.
M3 velocity fell more than it had in 1985 when it was
only slightly below its declining trend. Growth of its nonM2 components was mixed, with large time deposits
decelerating while term Eurodollar deposits, RPs, and
institutional money market mutual funds were acceler
ating. Inflows into institution-only money market mutual
funds (MMMFs) increased at times when declines in
short-term market interest rates outpaced those on the
MMMFs and periodically made yields on these invest
ments relatively more attractive (offering rates on insti
tution-only MMMFs leveled off and moved into alignment
with market yields in September).
M1 velocity declined about 91/2 percent during 1986,
more steeply than it had in 1985 (Chart 7). The decline
during 1986 was again attributed to the interaction of
lower interest rates with the changed composition of M1.
As market rates fell, the opportunity cost of holding
wealth in transactions form declined, which caused
increases in consumer holdings of checkable deposits.

Chart 5

M1 V e lo c ity G ro w th *

♦Data from four quarters earlier.
Shaded areas represent periods of recession, as
defined by the National Bureau of Economic Research.

Corporate treasurers also had less incentive to keep
demand deposits at minimal levels since the interest
foregone was reduced. Furthermore, many banks raised
compensating balances required to pay for bank ser
vices to offset the impact of earnings lost from lower
rates.
The e ffe c t of d e c lin in g rates on flo w s into NOW
accounts w as even m ore pro no un ced than in 1985
because m arket rates fell below the previous ceilings
on these accounts. These ceilings and the minimum
balance requirem ents on Super NOW accounts were
elim inated at the start of 1986. Depository institutions
were slow to reduce NOW account interest rates below
these ceilings for fear of an adverse customer reaction.
The lower levels of m arket rates made NOW account
rates competitive with other short-term instruments. This
minimized the incentive for the public to separate sav
ings from transactions balances and inspired transfers
from time and savings accounts and money market
instruments into NOW accounts.

The economy and financial markets
Economy
Economic growth continued at a modest pace in 1986,
the fourth year of an expansion that is now one of the

Chart 6

Chart 7

M2 V e lo c ity G r o w th *

M3 V e lo c ity G r o w th *

Percent
8 --------------------------------------------

.qLllI li i ! i 1111 i i l i i 111i il i i il.iiil.i il 1i.i i .Lli i I i i i l.m 1u ll 1111111
1970
72
74
76
78
80
82
84
86
*Data from four quarters earlier.
Shaded areas represent periods of recession, as
defined by the National Bureau of Economic Research.

Percent

-8

1970

* Data from four quarters earlier.
Shaded areas represent periods of recession as
defined by the National Bureau of Economic Research.

FRBNY Quarterly Review/Spring 1987

longest in peacetime. From the fourth quarter of 1985
to the fourth quarter of 1986, real GNP expanded 2.0
percent, somewhat below the 2.9 percent growth rate
in 1985. For the year as a whole, growth was spurred
by person al consum ption e xpe n d itu re s, re sid e n tia l
construction, and inventory investment. But as in 1985,
the more rapid growth of imports than exports was a
drag on the economy, as was weak business fixed
investment. Growth was uneven both over the year and
across different sectors of the economy.
In the first quarter, strong private construction, inventory
accumulation, and a temporary pick-up in net exports
helped the econom y grow at a robust 3.8 p ercen t

Chart 8

C on sum e r D e p o s it R ates ve rsu s
T re a s u ry B ill Rates
Percent
8.0

C h a n g e s in S e le c te d C o n s u m e r
D e p o s its in M2
Billions of dollars

1985

1986

FRBNY Quarterly Review/Spring 1987

rate,2 considerably ahead of the 1985 fourth-quarter pace.
Real GNP growth slowed to an almost negligible 0.6
percent rate in the second quarter of 1986, as the dra
matic plunge in the price of oil led to a contraction in
energy-related industries. The slowdown occurred despite
an increase in consumer spending and continued strong
residential construction. Having absorbed much of the
negative impact on the energy sector of falling oil prices,
economic activity rebounded in the third quarter of 1986,
expanding at a 2.8 percent rate. This growth was sup
ported by particularly strong consumer spending that was
partly attributable to automobile sales incentive programs.
Growth in the final quarter decelerated to a 1.1 percent
rate, inhibited by the termination of automobile incentive
programs and weak inventory investment.
Civilian employment rose by 2.3 percent from December
1985 to D ecem ber 1986, som ew hat above the 1985
growth rate. In absolute terms, employment grew most
rapidly in the retail trade and se rvice sectors, w hile
manufacturing and mining saw declining employment until
late in the year. Employment in agriculture also fell as the
problems of the farm sector continued. Unemployment
receded only slightly during 1986 as labor force expansion
nearly kept pace with job creation. The unemployment
rate hovered around the 7.0 percent mark for most of the
year, dropping to 6.7 percent in December.
The inflation picture continued to improve in 1986 as
falling energy costs restrained the growth of both con
sumer and producer prices. Measured by the broad
im plicit GNP deflator, prices increased by 2.1 percent
in 1986 (1985-IV to 1986-IV), compared to a 3.3 percent
increase in 1985. Measured by the consum er price
index (CPI), the inflation rate fell even more dramatically
from 3.7 p e rc e n t in 1985 to 1.1 p e rc e n t in 1986
(D ecem ber to D ecem ber). However, e x c lu d in g the
energy component, 1986 consum er prices rose by 3.8
percent, just below the 4.0 percent increase in 1985.
Little progress was made towards reducing the Fed
eral budget deficit. It came in at $221 billion for fiscal
1986, up $9 billion from fiscal 1985 (including both onand off-budget item s). The year began w ith doubts
about the constitutionality of the Gramm-Rudman (GR)
budget reduction measure that was signed in December
1985. Indeed in February, a key provision of GR that
gave the C om ptroller General budget-cutting authority
was struck down in a Federal court. The decision was
later upheld by the Supreme Court. In October, C on
gress approved a fiscal year 1987 budget that nominally
met the GR-prescribed deficit of $144 billion. W hile
achievement of the target relied on a variety of one-time
revenue-raising and bookkeeping measures, it should be
2AII monthly and quarterly data referred to in this section, with the
exception of foreign trade figures, are seasonally adjusted. The data
reflect revisions made through mid-April 1987.

noted that in the first quarter of the new fiscal year,
O c to b e r-D e c e m b e r 1986, the d e fic it w as ru n n in g
appreciably below the year-earlier level. This partly
reflected tem porary tax law effects, but it encouraged
some observers to expect a noticeably sm aller deficit
for fiscal year 1987.
The foreign trade deficit also remained high in 1986.
Despite a 15.3 percent decline in the trade-weighted dollar
over the year, following a 15.7 percent decline in the
previous year, the merchandise trade deficit swelled to
$166 billion from $140 billion in 1985.3 While the value
of exports increased by $3.8 billion over the 1985 level,
growth in demand for U.S. exports was limited by sluggish
economic growth abroad. Signs of a reduction in imports
that emerged in the spring were contradicted by a sharp
deterioration in July, leading to a record third-quarter trade
deficit. Though the nominal fourth-quarter trade deficit was
little changed from that of the third quarter, real net
exports picked up substantially, offering some hope of a
turnaround in the trade picture.
Dom estic financial markets
Both long- and short-term interest rates fell substantially
in 1986. The rally in the long-term oond m arket that
began in 1984 continued until April (Chart 9). Long-term
Treasury bond rates declined by about 250 basis points
from mid-January until mid-April, while corporate yields
fell less sharply. From mid-April until the end of the year,
long-term yields changed little, on balance. A springtime
run-up in coupon rates was reversed by the end of
June. For the year as a whole, long-term Treasury rates
eased by roughly 180 basis points.
Although short-term yields fell as well, the patterns
were a little different. Short-term rates fell in March-April
and again in June-August in association with discount
rate cuts (Chart 9). For the year, the decline in short
term yields was less abrupt than long-term yield decline.
Three- and six-m onth Treasury bill rates fell by about
145 basis points in 1986. Hence the Treasury yield
curve became flatter than in 1985 (Chart 10). Interest
rates on short-term private securities showed sim ilar
patterns to Treasury bills for much of the year, but rose
sharply at year-end in the face of extraordinary credit
demands.
The spectacular decline in oil prices was the dominant
market influence in early 1986 and, on and off, through
much of the year; from the beginning of the year until
April, the spot price of Texas crude oil fell from more than
$25 per barrel to less than $10 per barrel (Chart 11). The
drop in energy prices contributed to the bond market rally
by diminishing inflationary expectations and increasing the
3The reported dollar depreciation (December to December) is based on
the Federal Reserve Board’s trade-weighted index. The merchandise
trade figure is on a revised Census basis.

i
FRBNY Quarterly Review/Spring 1987

perceived likelihood of discount rate cuts. However, the
rally was tempered by concern over the falling value of
the U.S. dollar in the exchange markets, signs of an
economic pick-up that could be inflationary once oil prices
stopped falling, and the fate of the GR budget reduction
measure. Short-term issues did not participate in the rally
until early March when a coordinated discount rate cut
by the United States, Japan, and West Germany was
announced. Before the discount rate reduction, the 200basis-point spread between 10-year Treasury issues and
three-m onth Treasury bills that had prevailed at the
beginning of the year was roughly halved.
The increase in yields between mid-April and early
June was prom pted by a te m p o ra ry back-up in oil
prices, indications of stronger economic growth, and
renewed concerns about inflation and the sagging dollar.
In particular, a reported 3.7 percent growth rate of firstquarter GNP (as of mid-May) was surprisingly large and
was followed by reports of stronger production and sales
in April. The Treasury announced the suspension of 20year bond sales in late April, which meant the 30-year
bond auctions held at m idquarter would provide the
Treasury’s only new long-term debt. There were fears
that Japanese investors would limit their participation in
the Treasury’s May refunding in the face of the large
yield d e clin e s since February. However, Japanese
demand for 10- and 30-year issues was reported to be
quite strong. Moreover, Japanese and other holders did
not sell the February 30-year issue to finance purchases
of the new 30-year bond to the extent that was expected
by dealers; hence a “ short squeeze” developed in which
dealers found it difficult to deliver the February issue

Chart 10

Y ie ld C u rve s fo r S e le c te d
U.S. T re a s u ry S e c u ritie s
Percent
1 0 .00

9.50
9.00
8.50

—

7.00
6.50

6.00

-I

—

—
—

8.00

7.50

January 2, 1986 1

—

-I
April 2, 1986

September 17, 1986

—

1
L)<?ce nbe r 3 , iy 8b

-As

l
—

—j

-1

5.50
5.00 □ - - L

JL JL X JL J j - L I I
5

JL -L -L - X ]

|
10
15
20
Number of years to maturity

FRBNY Quarterly Review/Spring 1987
Digitized42
for FRASER

and some market participants experienced delivery fails
and significant losses.
The decline in rates resumed in early June as new
data contradicted the view that econom ic activity was
h e a tin g up. T h e se in c lu d e d re p o rts o f w e a k M ay
employment growth and a downward revision of firstquarter GNP growth announced in m id-June. Although
first-quarter GNP was revised back upwards in July, very
slow second-quarter growth reported in late July reaf
firmed the impression of econom ic sluggishness. W hile
two discount rate cuts helped short-term rates to con
tinue falling until the end of August, yield changes on
longer term securities were mixed. M arket participants
were initially hopeful that debt-ceiling lim itations would
reduce the size of the Treasury's August refunding and
then disappointed when the issue size was not cut.
Concern over the w illingness of Japanese investors to
continue buying Treasury issues in view of the d ollar’s
weakness and a bottoming out of oil prices in July also
led to uneasiness among investors.
From the beginning of September until the end of the
year, lon g-te rm rates w ere n ea rly u nchanged w h ile
short-term rates rose moderately. Coupon rates rose
somewhat through mid-October after evidence of faster
growth emerged, especially the broad-based em ploy
ment gains in August. The soaring price of gold and

moderate increases in other commodity prices aroused
greater inflationary concern. Long-term rates drifted a
bit lower near year-end after the Bank of Japan lowered
its discount rate and economic data pointed to a slug
gish economy. Price movements often reflected oil price
changes, particularly as the December OPEC agreement
to limit production approached, which helped lift prices
from the $15-per-barrel area to around $18 per barrel
by year-end. The dollar also staggered in the second
half of December in thin trading. It fell sharply on
December 31 following the report of a record trade
deficit for November.
Short-term rates drifted higher from October until yearend.as strong credit demands emerged. Lower 1986
capital gains taxes encouraged sales of appreciated
assets and stimulated corporate mergers and acquisi
tions and leveraged buyouts before 1987. The new tax
law also prompted automobile purchases in 1986 before
the elimination of sales tax deductibility. Except for
Treasury bills, which were heavily in demand for
dressing up balance sheets, short-term rates rose quite
sharply in December in response to these pressures.
Private foreign investors modestly expanded net pur
chases of U.S. financial instruments in 1986 above the
1985 level. However, the pattern of investment changed.
Private foreigners cut back on net investment in U.S.
Treasury issues and sharply increased acquisitions of
equities; net purchases of corporate bonds and U.S.
Government agency securities were slightly ahead of
1985 levels.4
The current account deficit grew more than private
foreign capital inflows, contributing to the dollar weak
ness. When dollar declines became excessive in the
eyes of official foreign institutions, they intervened to
buy dollars, placing the proceeds in a mix of Treasury
securities and bank deposits. Mostly in connection with
foreign exchange market intervention, official foreign
investors acquired at least a net of $36 billion of
Treasury bills and coupon issues.
In the Federally sponsored agency market, the Federal
Farm Credit Banks System (FFCB) continued to suffer
losses as a result of weakness in the agricultural sector. In
the second and third quarters of 1986, losses exceeded
earlier estimates, but did not significantly affect spreads of
FFCB issues over Treasury issues. As demand for the
FFCB’s longer term issues waned, the agency reduced the
average maturity of its offerings; the FFCB has not offered
bonds with maturities exceeding one year since July 1986.
According to Treasury data, private foreigners stepped up net purchases
of U.S. corporate and municipal securities from $40 billion in 1985 to $44
billion in 1986 and more than tripled net equity investments to reach a
level of $19 billion. Private foreigners reduced their net acquisition of
marketable Treasury issues from $17 billion in 1985 to $9 billion in 1986.
Other sources suggest that the Treasury data understate net purchases
by foreigners.

Early in the fall, Congress passed a bill that liberalized the
FFCB’s accounting rules with respect to amortization of loan
losses and costs of outstanding high coupon debt. Despite
the FFCB’s troubles, its issues continued to attract enough
demand to retain fairly narrow spreads against Treasury
issues. This was partly because the FFCB reduced out
standing debt by $6.5 billion over the year, and partly
because investors largely retained confidence that
“something would be done,” perhaps through direct Fed
eral assistance, to keep the entity solvent.
Corporate bonds
A record volume of corporate bonds was issued in 1986.
According to the Federal Reserve Board, gross issuance
in the United States totaled $232 billion, nearly double
the 1985 figure. But as interest rates fell to the lowest
levels since 1979, some of the gross volume repre
sented the refinancing of outstanding debt; net issuance
was nearly $100 billion below gross. Because of the
increased risk to investors of bond calls, the spread
between high-grade corporate securities and Treasury
bonds (which offer better call protection) increased in
1986. Investors also grew wary of potential downgrad
ings of outstanding debt should a firm announce take
over plans to be financed by additional bond sales.
Of the more than $130 billion net corporate volume in
1986, a substantial proportion consisted of below-investment-grade “high-yield” or “junk” bonds. Many of these
issues arose from merger and acquisition (M&A) and
leveraged buyout activity; companies that financed take
overs by issuing debt often found that their outstanding
debt issues were downgraded. The high-yield bond market
suffered two major shocks in 1986. The first was the filing
for Chapter 11 bankruptcy by the LTV Corporation in midJuly. The filing, which resulted from weaknesses in the
energy and steel industries rather than M&A activity,
caused a sharp decline in high-yield bond prices. Rising
oil prices led to a partial reversal of the decline. The
second major shock was the insider-trading scandal in
November involving Ivan Boesky. The episode threatened
to curtail M&As in general and brought into question the
ability of a major underwriter of high-yield bonds to con
tinue its active market-making role. After a plunge in highyield bond prices, the market recovered some of its losses
and activity picked up a bit. Still, some of the year-end
financing of M&As that was supplied by banks would
probably have been supplied by bond investors if the
Boesky affair had not occurred.
The trend towards asset securitization continued in
1986. According to market estimates, new asset-backed
issues totaled nearly $70 billion in the year, about twothirds of them collateralized by mortgages. But as falling
long-term rates encouraged mortgage prepayments and
the retirement of mortgage-backed securities, the

FRBNY Quarterly Review/Spring 1987 43

spreads between mortgage-backed issues and Trea
suries widened to more than 200 basis points. After
rates leveled off and substantial mortgage refinancing
had already taken place, apparent prepayment risk
diminished and spreads over Treasuries declined. The
first security collateralized by credit card receivables
appeared in 1986, and securities backed by automobile
loan receivables were issued in substantial volume. In
fact, the largest corporate offering of the year was a
$4.0 billion issue secured by General Motors Accep
tance Corporation automobile and truck loans.
Municipal bonds
Changing perceptions of the impact of tax-reform leg
islation dominated the municipal bond market in 1986.
This uncertainty and ultimate restrictions on municipal
issuance contributed to the roughly 30 percent decline
in the 1986 volume of new tax-exempt issues from the
1985 level, to perhaps $160 billion; however, the rush
of issues at the end of 1985 in advance of potential tax
law changes made the slowdown look particularly dra
matic. Until the tax reform bill took shape in August and
September, uncertainty about the status of tax-exempt
bonds weighed heavily on the market. In the first half
of the year, the call risk that resulted from falling long
term interest rates added to investor uneasiness. Early
in the year, a spread developed between bonds issued
before January 1, 1986, and those issued afterwards
since it appeared that post-January 1 issues might ret
roactively be subject to the alternative minimum tax.
This spread disappeared in March as the Treasury and
Congress dropped the notion of differential treatment.
Late in July, it appeared likely that bank investors would
face restrictions on their ability to deduct the interest cost
of financing municipal bond purchases. In the tax legis
lation that finally emerged, banks did indeed lose the
deductibility of carrying costs. In addition, the legislation
established three classes of municipal bonds: “ public
purpose” issues that remain tax-exempt, “private activity”
(or industrial development) issues that are subject to the
alternative minimum tax and volume limitations based on
state population, and fully taxable securities. Shortly after
the tax bill was passed, the first “stripped” municipal bond
appeared in the market. Prior to the passage of the bill,
tax-exempt issues could not be stripped without effectively
losing their tax-exempt status.
Both tax-exempt bond mutual funds and property/
casualty insurance firms stepped up their net purchases
of municipal securities, particularly late in the year.
According to Federal Reserve data, the bond funds
increased their holdings by about $60 billion over the
year as few alternative tax shelters remained for
household investors. Property/casualty insurance com
panies returned to the municipal bond market as major

FRBNY Quarterly Review/Spring 1987
Digitized 44
for FRASER

investors for the first time in this decade; these firms
increased their holdings of tax-exempt securities when
improved profit performance gave rise to a need to
shelter income.

Policy implementation
Open market operations
The FOMC prescribed essentially the same approach
to implementing policy in 1986 as it had since 1983
(modified in February 1984 with the implementation of
contemporaneous reserve requirements). The Desk
targeted levels of nonborrowed reserves over two-week
reserve maintenance periods that were believed to be
consistent with achieving the degree of reserve pressure
sought by the FOMC. Specifically, an indicated level of
adjustment plus seasonal borrowing at the discount
window was estimated to be associated with the degree
of reserve pressure sought by the Committee. A
reduction in the borrowing level would mean that banks
would be able to meet an enlarged share of their
reserve needs away from the discount window. Since
access to the window has been restricted by frequency,
amount, and reason for borrowing, declines in the
pressure for banks to use the window have tended to
lower money market rates.
For each maintenance period, nonborrowed reserve
objectives were constructed by estim ating bank
demands for total reserves to meet requirements and
to provide a cushion of excess reserves. From that
demand for total reserves, the intended amount of
borrowing was subtracted. What remained was the
nonborrowed reserve objective. The Desk received daily
estimates of what nonborrowed reserves would be for
the period in the absence of any additional open market
operations beyond those already undertaken. The dif
ference between these estimates and the nonborrowed
reserve objective was an indication of the reserves to
be added or absorbed during the period.
In formulating the strategy for achieving the nonbor
rowed reserve objective during a maintenance period,
the Desk took account not only of the overall direction
and size of reserve adjustments, but also the estimated
distribution of reserves within the maintenance period
and the likelihood of revisions to the estimates. These
latter considerations encouraged the relatively heavy
use of short-term self-reversing reserve transactions.
To meet the objective, the Desk chose an approach
that tried to assure that reserves were not so scarce
on any given day that banks would have great difficulty
in avoiding overdrafts. Such days occurred even in
periods when reserves were sufficient, on average, for
banks to meet their requirements easily. If reserves
were not provided on those days, the efforts of banks
to avoid running overdrafts would introduce unusual

upward pressures on the Federal funds rate and unusual
demands for accommodation at the discount window. On
the other side, if reserves were exceptionally high rel
ative to requirem ents on particular days, there was a
risk that banks would try to get rid of unwanted reserves
and w ould push down the Federal funds rate in a
manner that could be misleading as to the general intent
of policy. While there were no restrictions on holding
excess reserves, a bank’s ability to work them off on
other days was limited by the need to maintain a posi
tive daily balance in its Federal Reserve account.
Usually, the reserve variation within a period was
modest enough that the Desk did not have to plan to
both add and drain reserves in the same period. Gen
erally, it was able to meet a period’s reserve need by
adding reserves on those days when they were espe
cially deficient while taking no actions on the other days.
Similarly, in periods of overabundant reserves, the Desk
sought to drain reserves on those days when reserves
were particularly plentiful. On occasion, however, it was
necessary to both add and drain reserves within a
period in response to very large swings in market fac
tors or major revisions to projected reserve needs.
Another consideration in planning a reserve strategy
was the likelihood of revisions to staff estimates of
reserve demands and supplies during the period. The
staff made estimates of required reserves, the largest
factor underlying reserve demand, by estimating levels
of transactions deposits subject to reserve requirements
and applying a rese rve ratio. E stim ating required
reserves proved to be particularly difficult because of
the unexpected strength in transactions deposits. The
errors in required reserve forecasts grew on an absolute
basis during 1986, and on average the forecasts tended
to underpredict the final number for required reserves.
Comparing the path estimate at the start of the m ain
tenance period to the actual level showed an average
absolute miss of $400 m illion, well above the $260
million absolute error in 1985. An unusually large $1.8
billion underestimate in the period ended December 31,
1986, contributed to the m iss.5 Excluding that period
would reduce the average absolute error to $340 million.
On average there was an underprediction in 1986 of
$200 m illion , or $135 m illion if the fin a l period is
excluded. While maintenance periods were in progress,
the forecasts were revised as new data became avail
able. The average absolute error in the required reserve
estimates made on the final day of the maintenance
period, the last time open m arket operations would be
possible, was $110 m illion, a bit higher than the $70
million average in 1985.

Forecasting excess reserves, the other component of
demand, continued to be a challenge in 1986. Average
excess reserves, which had been increasing annually
since 1980, rose somewhat further in 1986, showing a
rise of $100 m illion, or $75 m illion excluding the m ain
tenance periods with m idyear or year-end statem ent
dates. A variety of factors apparently played a role in
the increase. The volume of reserve transactions con
tinued to expand as shown by the growing volume of
clearing over Fedwire (Chart 12). The increased volume
probably added to the banks’ uncertainty about closing
reserve positions and prompted them to hold higher
reserve balances to avoid overdrafts.
The demand for excess reserves was probably raised
very little if at all during the initial phase of the Federal
Reserve’s new policy to reduce “ daylight” overdrafts,
Footnote 5 continued
predetermined based upon holdings two periods earlier and is
known at the start of the period. However, for banks that have
excess vault cash, applied vault cash is equal to their requirements.
For those institutions, revisions to required reserves, which change
the nonborrowed reserve objective, result in revisions to applied
vault cash, which change the volume of reserves available to meet
the objective. Hence, such revisions to required reserves do not
change the amount of reserves needed to meet the objective. For
the final maintenance period of 1986, applied vault cash turned out
to be $300 million higher than the initial estimate, providing some
offset to the large miss in the required reserve forecast.

Chart 12

G ro w th o f F e d w ire A c tiv ity and
E xcess R eserve L e v e ls
Daily averages
Millions of dollars

Billions of dollars

1 0 00 ------------------------------------------------------------------------------------------------ 5 5 0

5Some revisions to required reserves at small institutions are matched
by revisions to applied vault cash— that portion of vault cash that
meets requirements. For the larger institutions, vault cash is

FRBNY Quarterly Review/Spring 1987

which began in March 1986. “ Daylight” overdrafts occur
when more funds are sent out over Fedwire than the
institution has in its account at the Federal Reserve.6
The new policy encouraged participants to establish
debit caps or limits on the amount of funds they could
send to other banks in excess of funds received. These
caps, based upon a self-evaluation of creditworthiness,
were expressed as a multiple of capital, ranging up to
three times capital for a single day. Institutions which
did not follow the self-evaluation procedure were not
allowed to incur overdrafts on Fedwire. Concern about
incurring outsize overdrafts could have influenced
behavior even though the incidence of such overdrafts
was minimal. All but a handful of banks had no difficulty
staying well within the initial relatively generous guide
lines. The few banks that ran close to their limits did
not increase their excess reserves.
The Monetary Control Act of 1980 (MCA) and the
Garn-St Germain Act of 1982 had contributed to the rise
in excess reserves in earlier years but probably played
only a limited additional role in 1986.7 Both the MCA
and the Garn-St Germain Act provide for annual upward
indexing of the zero and low reserve tranches for all
institutions.8 The automatic rises in these limits are, in
effect, reserve requirement reductions, which have
tended to result in higher excess reserves.
Between 1980 and 1984, the MCA gradually reduced
reserve requirements of member banks. It also imposed
reserve requirements on nonmember institutions which
have risen in annual increments. The process is to be
completed in September 1987. The initial impact of the
phase-up of reserve requirements for nonmember banks
and thrifts was to raise excess reserves. Before the
MCA, these institutions’ reserves had not been held in
the form of deposits at the Federal Reserve so they had
not been counted in the total. Initial requirements were
low, and only the larger institutions had requirements
that exceeded their holdings of vault cash.9 Each step
in the phasing up of reserve requirements on non
member institutions brought a new group of banks’
•Daylight overdrafts can also arise on the Clearing House Interbank
Payments System (C.H.I.P.S.) if a bank sends more funds over
C.H.I.P.S. than it has received.
7For greater detail on these developments see “ Monetary Policy and
Open Market Operations in 1985,” this Quarterly Review
(Spring 1986), and other sources cited there.
•The MCA imposes a reserve requirement of 3 percent on
transactions deposits up to a size limit (and 12 percent over that
limit). The Garn-St Germain act exempts from reserve requirements
reservable liabilities up to a lower size limit. Both of these limits are
linked to deposit growth. The 3 percent tranche under the MCA rose
from $29.8 million in 1985 to $31.7 million in 1986, while the exempt
level under the Garn-St Germain Act rose from $2.4 to $2.6 million.
•Vault cash in excess of requirements is not treated as part of total
or excess reserves.

FRBNY Quarterly Review/Spring 1987

requirements above their normal vault cash holdings so
that they had to begin holding balances with the Federal
Reserve. As they opened reserve accounts and used
them for clearing purposes, they became candidates to
hold excess reserves. Initially, they often needed more
balances for clearing than to meet requirements. How
ever, with the phase-in well along, some of the larger
nonmember institutions that had been maintaining
reserve accounts for some time found that reserves
needed to avoid overdrafts no longer exceeded
requirements by a wide margin. Thus, they were able
to reduce excess reserves.
The variability and uncertainties affecting the demand
for reserves have been mirrored on the supply side.
Factors other than open-market operations that affect
the supply of nonborrowed reserves, often called
“market factors,” have varied both from day to day and
from period to period. The average absolute period-toperiod change in the sum of all market factors in 1986
came to $1.9 billion. At times market factors have been
difficult to forecast. In 1986, overall forecast accuracy
improved, with about a $510 million average absolute
error in the estimates made the first day of maintenance
periods, compared to $770 million in 1985. By the final
day it had been reduced to $90 million, similar to 1985.
As in past years, the Treasury balance at the Federal
Reserve was responsible for a sizable share of both the
overall market factor variation and the forecast errors.
In 1986, the period-to-period absolute changes in the
Treasury balance averaged $1.7 billion, and the average
absolute forecast error on the first day of the mainte
nance period was $510 million. The forecast error for
the first day was substantially smaller than the $760
million figure for 1985, even though variability increased
by about $300 million. Forecasting in 1985 had been
hampered by disruptions to the regular patterns of
Treasury cash flows during the protracted Congressional
impasse over the debt ceiling which extended through
the debate on GR legislation.
Currency in circulation also was subject to sizable
period-to-period variation with absolute first differences
averaging $1.2 billion in 1986. Nonetheless, currency
was easier to forecast than the Treasury balance, as
recurring seasonal patterns played a dominant role. The
average absolute miss in the first day’s forecast was
$225 million, similar to the previous year.
The first-day forecasts of float and extended credit
borrowing also improved from 1985, making more
modest contributions to the reduced overall error. Float
predictability was aided by improved communications
between Federal Reserve Banks and the Desk as to the
timing of reserve adjustments to offset previous floatdistorted reserve transfers. Extended credit borrowing
(which is treated as a market factor) became less

variable, making forecasting easier. Other factors
showed minor net offsetting changes.
To accomplish the desired reserve adjustments while
taking account of both the variability and uncertainties
in the reserve estimates, the Desk made heavy use of
temporary transactions, arranging $202 billion of System
repurchase agreements and passing through to the
market $160 billion of customer-related RPs, both rep
resenting significant increases over the previous year’s
totals. In contrast, the Desk made limited use of
matched sale-purchase agreements, arranging only $21
billion in the market.
The Committee made only one policy adjustment to
the assumed level for adjustment plus seasonal bor
rowing during the year, lowering it from $350 million to
$300 million following the February FOMC meeting,
which brought it more into line with recent experience.
Planned borrowing was then only modestly above what
was considered to be frictional levels,10 so there was
little room to cut it further. Instead, when additional
changes were contemplated, the Committee planned its
reserve strategies on the expectation that reductions in
reserve pressures would be accomplished with cuts in
the discount rate. The rate was cut one-half percentage
point on each of four occasions, in March (in the context
of a coordinated move with other central banks), April,
July, and August. This means of reducing reserve
pressures was viewed as more feasible than lowering
the path level of borrowing to the frictional range.
Operating with a borrowing assumption around frictional
levels could have presented some difficulties. A one-day
spike in borrowing could make it impossible to achieve
the desired average borrowing level because borrowing
on other days of a maintenance period could never go
below zero. When there is not much room within the
reserve specifications for borrowing to vary from day to
day, the banks are effectively prevented from reducing
aggregate reserve availability. That situation can make the
Federal funds rate sensitive to very small misses either
of the nonborrowed reserve objective or of estimates of
the demand for reserves. A small overabundance could
introduce unwanted excess reserves which, collectively,
the banks could not eliminate. Their attempts to do so
would tend to drive the Federal funds rate close to zero.
On the other hand, a small shortfall of reserves relative
to the desired level would require banks to step up their
1#Frictional borrowing is defined as the borrowing that would occur even
if the Federal funds rate were generally at or below the discount rate.
Borrowing takes place in such circumstances because individual
banks make miscalculations of their reserve positions and because
reserve transfer systems are subject to periodic disruptions that may
leave reserves poorly distributed. It is difficult to estimate exactly how
much borrowing would occur on a routine basis if the Federal funds
rate were below the discount rate. It would probably vary over the
year and might depend upon how long the banks expected the rate
relationship to last.

borrowing, and would lift the funds rate above the dis
count rate. Thus, relatively small misses in reserve
availability could lead the funds rate to bounce around
within a relatively wide range.
Even with the borrowing objective around $300 million,
the Desk occasionally faced a situation where banks
overborrowed early in the period, precluding achievement
of the intended borrowing level. Sometimes the Desk did
see an abundance of excess reserves drive down the
funds rate, while at other times it chose to miss the non
borrowed reserve objective to avoid that outcome.
Actual borrowing ran below path more often than not
in the first half of the year. However, there was one
large overshoot in February, reflecting weekend wire
problems at large banks. Borrowing ran above path over
most of the summer and fall. It was boosted in the
summer by technical adjustments as banks in regions
dependent on oil encountered difficulties and turned to
the discount window. Informally this “ special situation”
borrowing was thought of as nonborrowed reserves (at
first only partly but later entirely). In late August, such
borrowing was formally classified as extended credit
borrowing and treated as nonborrowed reserves. The
above-path borrowing in the fall reflected either higherthan-intended borrowing before the settlement day that
could not be reduced to the path average or reserve
shortfalls on the settlement day. Exceptionally strong
reserve demands on and before the year-end statement
date led to very high borrowing in the final period.
With policy generally accommodative of the bulges in
M1 and required reserves during 1986, the Desk tended
to be in a reserve-adding posture. Excluding brief
periods in May and again in early September, when a
combination of strong growth in the broader monetary
aggregates and signs of a strengthening in economic
activity led to a more cautious approach, the Desk was
generally prompt in meeting estimated reserve needs
and cautious in accomplishing drains. It was often willing
to permit overshoots of the nonborrowed reserve
objective if it appeared that the demand for excess or
required reserves might be exceeding the estimates
used to build the path.
Nonborrowed reserves ran well above the final day’s
objective in 10 of the 26 maintenance periods. The
overshoots reflected mostly a tendency for the Desk to
meet excess reserve demands when they seemed to be
running above the formal path allowance or to provide
more reserves when the money market suggested
reserves were less plentiful than forecast. Late in the
year in particular, these decisions were vindicated by
sizable upward revisions to required reserves after the
period ended. Significant reserve misses on the low side
of the objective occurred in six periods scattered around
spring and summer. At those times, there tended to be

FRBNY Quarterly Review/Spring 1987 47

downward revisions to required reserves, below path
excess reserves, and shortfalls in reserve estimates.
With discount window borrowing generally low and the
demand for total reserves growing dramatically to sup
port the rapid expansion of M1, nonborrowed reserves
expanded an unprecedented $12.5 billion in 1986,
slightly outpacing the $11.7 billion increase in required
reserves (measured between year-end statement period
averages). To support the increase in nonborrowed
reserves and a $14.1 billion increase in currency, the
System’s portfolio of Treasury and agency securities
rose by a record $20.2 billion. The remaining supply of
reserves came from several sources. The RPs arranged
during the last maintenance period of 1986 provided
$3.5 billion more reserves on average than those
arranged in the corresponding period the year before.
Over the year, growth in applied vault cash provided
$1.8 billion. Foreign currencies provided most of the
balance. The revaluation of the Federal Reserve’s for
eign currency holdings provided $1.9 billion while
holdings themselves rose by about $500 million, over
half of which represented interest earned on the cur
rencies. The biggest offset was the foreign RP pool
which drained an additional $900 million in the last
period of 1986 compared to the previous year.
The net increase in the System portfolio was accom
plished by adding $19.1 billion of Treasury bills and $1.5
billion of coupon issues, while running off $400 million
of maturing Federally sponsored agency issues. In
adjusting its portfolio, the Desk leaned toward shorter
maturities during the year, thus tending to assure the
ample liquidity of the portfolio. It bought coupon issues
in the market only once, compared with two or three
market entries in recent years. When rolling over
maturing coupon issues, it weighted its tenders for the
new issues more heavily than in the recent past toward
the shorter maturities while cutting back in its takings
of longer term issues.
This emphasis on increasing the liquidity of the port
folio continued a tendency already under way in the last
few years, which saw the average maturity of the Sys
tem’s portfolio of Treasury issues decline from 55
months at the end of 1980 to 49 months at the end of
1985. During 1986 there was a further shortening to 46
months. At the end of 1986, $109 billion of the System’s
$202 billion portfolio of Treasury and Federally spon
sored agency securities was in Treasury bills.

Dealer surveillance developments
The major developments in 1986 were the significant
changes to the list of primary dealers, including the
addition of several new foreign-owned firms, and the
passage of the Government Securities Act of 1986

48 FRASER
FRBNY Quarterly Review/Spring 1987
Digitized for

(GSA) that will result in federal regulation of all brokers
and dealers in government securities.
During 1986, five new firms were added to the list of
primary dealer firms. This represented the largest
addition to the list since 1976. These firms report daily
to the Federal Reserve Bank of New York. The group
of firms with which the Bank conducts business on
behalf of the System Open Market Account is drawn
from the primary dealer list. Among the 40 primary
dealer firms, about half are diversified securities firms
or affiliated with such securities firms, seventeen are
banks or are affiliated with banks, and others are firms
that specialize in government securities. Thirty-two are
controlled by U.S. interests and eight are foreign owned.
Five different countries are represented by the foreignowned firms, reflecting the increased international char
acter of the market and increased importance of foreign
investors as holders of dollar-denominated assets in
general, and U.S. Government securities in particular.
In October, Congress enacted the GSA to provide for
the first time federal regulation of all government
securities brokers and dealers. Congress designated the
Treasury Department as the rulemaker for government
securities brokers and dealers, in consultation with the
Federal Reserve Board and the S ecurities and
Exchange Commission. The Act provided that the
Treasury rely on existing SEC or depository institution
regulations where appropriate and assigned enforcement
and examination responsibilities to existing depository
institution supervisors and to the SEC and self-regulatory organizations for securities firms. The Treasury
published proposed rules for comment on February 24,
1987; the final rules will become effective July 25, 1987.

Conducting open market operations
January to late August
Monetary policy over the first eight months of the year
generally accommodated the strong demand for reserves
associated with the growth in the demand for transactions
balances. The degree of pressure on bank reserve posi
tions was eased gradually in view of apparently sluggish
economic growth, well-contained price pressures and
moderate growth in the broader monetary aggregates
within the Committee’s desired long-run ranges. The initial
move toward easing began in late December 1985 with
a $100 million decrease in the path allowance for sea
sonal plus adjustment borrowing and was followed by an
additional $50 million downward adjustment in mid-Feb
ruary 1986. Subsequent adjustments to the stance of
monetary policy took the form of four 50-basis-point cuts
in the discount rate in early March, late April, mid-July,
and late August. However, in late Mayi the Desk met
reserve needs a bit more cautiously as money growth

exceeded expectations and data suggested that eco
nomic growth was accelerating.
At its December 1985 meeting, the FOMC directed
the Desk to decrease somewhat the degree of pressure
on reserve positions. Specifications from the FOMC
directives, including guidelines for intermeeting period
adjustments to the reserve posture, are presented in
Table 1. The allowance for adjustment and seasonal
borrowing used in construction of the nonborrow ed
reserve path was lowered to $350 million from $450

m illio n . D uring th a t in te rm e e tin g perio d , the usual
allowance for excess reserves was raised from $700
m illion to $800 m illion to reflect recent actual levels. In
addition, the allowance was raised tem porarily in the
maintenance period ended January 1 to accommodate
year-end pressures.
Overnight borrowing declined to fairly low levels rel
ative to the path allowances in January and the first
part of February. At times, against a background that
included light borrowing, very firm conditions in the

Table 1

Specifications from Directives of the Federal Open Market Committee and Related Information
Short-term Annualized Rate of Growth
Specified for Period Indicated
Date
of
Meeting

(percent)

Initial
Borrowing Assumption
for Deriving
Nonborrowed
Reserve Path

Discount
Rate

(millions of dollars)

(percent)

12/16 to
12/17/85

7 to 9*

November to March
6 to 8

6 to 8

350

71/2

2/11 to
2/12/86

November to March
6

300

71/2
7 on
March 7f

7 to 8*

March to June
7

300

7
6V2 on
April 181-

4/1/86

Notes

The Committee sought to decrease
somewhat the existing degree of
pressure on reserve positions.
Somewhat greater reserve restraint
might, and somewhat lesser reserve
restraint would, be acceptable
depending on the behavior of the
aggregates, the strength of the busi
ness expansion, developments in
foreign exchange markets, progress
against inflation, and conditions in
domestic and international credit
markets.
The Committee sought to maintain
the existing degree of pressure on
reserve positions. Somewhat greater
or somewhat lesser reserve restraint
might be acceptable depending on
behavior of the aggregates, the
strength of the business expansion,
developments in foreign exchange
markets, progress against inflation,
and conditions in domestic and
international credit markets.
The Committee sought to maintain
the existing degree of pressure on
reserve positions. Somewhat greater
or somewhat lesser reserve restraint
might be acceptable depending on
behavior of the aggregates, the
strength of the business expansion,
developments in foreign exchange
markets, progress against inflation,
and conditions in domestic and
international credit markets.

*lt was noted that the behavior of M1 continued to be subject to unusual uncertainty,
fAnnouncement date.

FRBNY Quarterly Review/Spring 1987

money market, uncertainties in the reserve projections,
and indications that the demand for excess reserves
would be higher than form ally allowed for, the Desk
provided more nonborrowed reserves than suggested by
the p ath s. Such p ro v is io n w as d e sign ed to a void
excessive pressures in the money market and to alle
viate the need for borrowing to bulge on settlem ent
days. As a result, in two of the first three periods of
the year, nonborrowed reserves averaged above the
formal objectives while borrowing averaged below path.

Table 2 presents period average levels of the reserve
components.
The y e a r began w ith a p ro je c te d need to d ra in
reserves as the year-end bulge in money unwound.
However, the seasonal need to absorb reserves was
delayed until early February, mostly because of unusu
ally high levels of the Treasury’s balance. The balance
rose beyond the capacity of the Treasury tax and loan
accounts when January tax revenues were added to
balances already swollen by year-end sales of securities

Table 1

Specifications from Directives of the Federal Open Market Committee and Related Inform ation (continued)
Short-term Annualized Rate of Growth
Specified for Period Indicated
Date
of
Meeting

Initial
Borrowing Assumption
for Deriving
Nonborrowed
Reserve Path

Discount
Rate

(millions of dollars)

(percent)

8 to 10

300

6V2

7 to 9

300

(percent)
12 to 14*

March to June
8 to 10

n.s.t

June to September
7 to 9

5/20/86

7/8 to
7/9/86

6V2
6 on
July 10f

Notes

The Committee sought to maintain
the existing degree of pressure on
reserve positions. This action was
expected to be consistent with a
deceleration in money growth over
the balance of the quarter. If the
anticipated slowing in monetary
growth did not develop, somewhat
greater reserve restraint would be
acceptable in the context of a
pickup in growth of the economy,
taking account of conditions in
domestic and international financial
markets and the behavior of the
dollar in foreign exchange markets.
Somewhat lesser reserve restraint
might be acceptable in the context
of a marked slowing in money
growth and pronounced sluggish
ness in economic performance.
The Committee sought to decrease
somewhat the existing degree of
pressure on reserve positions, taking
account of the possibility of a
change in the discount rate. Some
what greater or lesser reserve
restraint might be acceptable
depending on the behavior of the
aggregates, the strength of the busi
ness expansion, developments in
foreign exchange markets, progress
against inflation, and conditions in
domestic and international credit
markets.

*lt was noted that the behavior of M1 continued to be subject to unusual uncertainty.
fAnnouncement date.
tit was noted that while growth in M1 was expected to moderate from the exceptionally large increase during recent months, that growth would
continue to be judged in light of the behavior of M2 and M3 and other factors,
n.s. Not specified.

50FRASER
FRBNY Quarterly Review/Spring 1987
Digitized for

Table 1

Specifications from Directives of the Federal Open Market Committee and Related Information
Short-term Annualized Rate of Growth
Specified for Period Indicated
Date
of
Meeting

(percent)

Discount
Rate

(millions of dollars)

(percent)

n.s4

June to September
7 to 9

7 to 9

300

n.s.t

August to December
7 to 9

7 to 9

300

5’/2

September to December
7 to 9
7 to 9

300

5’/2

300

5V2

8/19/86

9/23/86

11/5/86
n.s.t

12/15 to
12/16/86

Initial
Borrowing Assumption
for Deriving
Nonborrowed
Reserve Path

n.s.
Growth in M1 will
continue to be
appraised in light
of the behavior of
M2 and M3 and
other factors in
the directive.

November to March
7

6
5'/2 on
August 20f

(continued)

Notes

The Committee sought to decrease
slightly the existing degree of pressure on reserve positions. Somewhat
greater or lesser reserve restraint
might be acceptable depending on
the behavior of the aggregates, the
strength of the business expansion,
developments in foreign exchange
markets, progress against inflation,
and conditions in domestic and
international credit markets.
The Committee sought to maintain the
existing degree of pressure on
reserve positions. Slightly greater
reserve restraint would, or slightly
lesser reserve restraint might, be
acceptable depending on the
behavior of the aggregates, taking
into account the strength of the busi
ness expansion, developments in for
eign exchange markets, progress
against inflation, and conditions in
domestic and international credit
markets.
The Committee sought to maintain the
existing degree of pressure on
reserve positions. Slightly greater or
slightly lesser reserve restraint might
be acceptable depending on the
behavior of the aggregates, taking
into account the strength of the busi
ness expansion, developments in for
eign exchange markets, progress
against inflation, and conditions in
domestic and international credit
markets.
The Committee sought to maintain
the existing degree of pressure on
reserve positions. Slightly greater
reserve restraint or somewhat lesser
reserve restraint would be accept
able depending on the behavior of
the aggregates, taking into account
the strength of the business expan
sion, developments in foreign
exchange markets, progress against
inflation, and conditions in domestic
and international credit markets.

fAnnouncement date.
jit was noted that while growth in M1 was expected to moderate from the exceptionally large increase during recent months, that growth would
continue to be judged in light of the behavior of M2 and M3 and other factors,
n.s. Not specified.

FRBNY Quarterly Review/Spring 1987

to state and local government entities. The Treasury
balance ran as high as $19.1 billion on January 22,
creating massive reserve needs in a period that nor
mally would involve seasonal draining. Uncertainties
about reserve levels were compounded by wide swings
in the size of the foreign investm ent pool. Against this
background, the Desk provided reserves in January
mostly through a combination of overnight and term
System repurchase agreements and custom er-related
repurchase agreements. On occasion, the Desk prean
nounced a System RP to enlarge the feasible size. The
Desk also arranged one 15-day RP operation for a
custom er to keep the order from unduly inflating the
daily foreign investm ent pool.
The seasonal need to absorb reserves m aterialized
in February and was accomplished prim arily with sales
of Treasury bills to foreign accounts totaling $2.5 billion
and redemptions of $1 billion. The net decline in System
holdings over the month of February was about $3.5
b illio n . M atched s a le -p u rc h a s e tra n s a c tio n s w ere

arranged on a number of occasions to reduce temporary
rese rve overag es. The Federal fu nd s rate hovered
around 8 percent over much of January but moved into
a range of 72U to 77/s percent in early February as the
heavy absorptions from m arket factors lessened.
In accordance with the decision of the Committee, Desk
operations in February and March sought to maintain
reserve conditions similar to those that prevailed in the
weeks immediately preceding the February 11-12 meeting.
At that meeting, there was concern that short-term rates
had shown little tendency to decline and the Federal funds
rate remained significantly above the discount rate despite
the more accommodative policy stance since the previous
meeting. With this in mind, it was noted that the discount
rate might need to be reduced to permit or accommodate
a market tendency toward lower rates and that such a
move would be a desirable complement to open market
operations, depending on evolving economic and financial
circumstances; in light of the risks for the dollar in foreign
exchange markets, there was particular concern that any

Table 2

1986 Reserve Levels
In millions of dollars, not seasonally adjusted

Period
Ended

RR
current

RR first
published

ER
current

ER first
published

Adj. &
Seas. BR

Jan.

47,644
48,294
45,743
45,629
45,408
46,142
46,187
47,479
48,703
47,612
47,554
47,600
49,627
48,755
50,871
49,528
50,592
50,279
51,268
52,964
53,287
54,170
53,947
55,599
55,865
57,511
59,369

47,620
48,489
45,873
45,701
45,399
46,241
46,412
47,571
48,646
47,548
47,481
47,558
49,482
48,733
50,882
49,472
50,557
50,351
51,343
53,001
53,140
54,122
53,827
55,468
55,758
57,366
59,292

1,307
1,276
921
1,187
1,038
976
926
622
873
888
688
1,014
636
1,247
679
1,117
585
867
793
706
660
751
814
916
1,130
740
2,048

1,306
1,252
792
1,186
1,003
909
804
621
956
928
739
1,074
707
1,324
599
1,182
589
790
752
649
849
775
908
1,067
1,330
823
2,345

48,950
49,570
46,663
46,815
46,445
47,118
47,113
48,101
49,575
48,500
48,241
48,613
50,262
50,002
51,550
50,644
51,177
51,146
52,061
53,670
53,946
54,921
54,761
56,515
56,995
58,251
61,417

866
143
374
182
594
229
234
298
190
344
256
305
193
354
316
408
386
395
519
412
364
283
423
374
242
204
904

Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.

1
15
29
12
26
12
26
9
23
7
21
4
18
2
16
30f
13t
27110
24
8
22
5
19
3
17
31

NBR plus
Extended
Credit BR
current

NBR plus
Extended
Credit Br
first
published

NBR
Interim
Objective*

Extended
Credit
BR

48,084
49,427
46,289
46,633
45,851
46,889
46,879
47,803
49,386
48,156
47,985
48,308
50,070
49,648
51,234
50,236
50,791
50,751
51,542
53,258
53,583
54,638
54,338
56,141
56,753
58,048
60,513

48,060
49,598
46,291
46,706
45,808
46,921
46,981
47,894
49,413
48,131
47,964
48,327
49,997
49,703
51,166
50,246
50,760
50,747
51,576
53,238
53,626
54,615
54,313
56,161
56,846
57,985
60,733

48,252
48,875
46,306
46,216
45,917
46,861
47,007
48,145
49,134
48,148
48,060
48,123
50,087
49,465
51,539
50,085
51,149
50,896
51,966
53,537
53,708
54,689
54,365
55,959
56,255
57,865
60,314

472
471
529
480
506
475
535
576
671
637
571
566
526
525
442
294
373
515
592
569
538
488
476
437
368
310
282

*As of final Wednesday of reserve period.
fSpecial situation borrowing raised average adjustment borrowing in the July 30, August 13, and August 27 periods by about $120 million, $175
million, and $102 million, respectively. It was classified as extended credit borrowing beginning August 21.

52 FRASER
FRBNY Quarterly Review/Spring 1987
Digitized for

such measure be taken in the context of similar action
by other important industrial countries to avoid a decline
in the dollar that might feed upon itself. On March 7,
following discount rate cuts in West Germany and
Japan, and sizable declines in most market interest
rates in recent weeks, the discount rate was reduced
to 7 percent from 71/2 percent.
Consistent with the February directive and the lower
average level of borrowing after year-end, the nonbor
rowed reserve paths were built with an allowance for
$300 million of adjustment plus seasonal borrowing
subsequent to the February meeting. Borrowing was
inflated by technical factors associated with wire transfer
problems in the period following the meeting but was
light in the two periods in March. The usual allowance
for excess reserves was raised by $100 million to $900
million in late February to reflect recent experience.
Reserve availability in March fluctuated within a
moderate range. Reserves were managed with relatively
few temporary transactions and small purchases of bills
from foreign accounts at the end of the month. The
Federal funds rate generally ran close to expectations,
occasionally drifting to the firm side, especially when
there were wire problems. The funds rate eased at other
times, including when the March discount rate cut was
anticipated and when reserves were temporarily quite
abundant. Over the first half of the February-March
intermeeting period, Federal funds traded mostly in a
range of 73/4 to 8 percent; following the discount rate
reduction in early March, the rate moved into a range
around 73/a percent.
At its April 1 meeting, the Committee voted to maintain,
at least initially, the existing degree of pressure on reserve
positions. On April 21, after the announcement of a
reduction of the discount rate to 6V2 percent, the Com
mittee held a telephone conference and agreed to main
tain this directive. Recognizing that partial data suggested
a strengthening in all monetary aggregates in recent
weeks, it was understood that in carrying out open market
operations within the framework of the directive, a degree
of caution should be exercised to avoid an impression that
a further change in the discount rate was sought over the
period immediately ahead.
The Desk faced generally large needs to add reserves
over A pril and May reflecting, at various times,
increases in required reserves, currency, the foreign RP
pool, and the Treasury balance. The Treasury balance
was subject to wide swings and proved difficult to pre
dict. Mindful of the Committee directive and against the
background of a frequently soft money market, weak
ness in the dollar in the foreign exchange markets, and
uncertainty regarding the Treasury’s balance, the Desk
at times adopted a particularly cautious approach to
timing its reserve injections.

The Desk addressed these reserve needs through a
combination of Treasury bill purchases and repurchase
agreements. Treasury bill purchases included purchases
in the market in early April of $1.95 billion and pur
chases from foreign accounts over April and May
totaling $1.7 billion. Both System and customer-related
repurchase agreements were arranged to increase
reserve supplies temporarily and were particularly large
over a brief period between late April and May 1 when
both the Treasury balance and foreign RP pools swelled
to very high levels. On one occasion early in the first
maintenance period, a round of matched sale-purchase
agreements was arranged in the market when reserve
injections proved to have been overdone.
Borrowing mostly averaged close to the path allow
ance in April and May, but was somewhat below the
allowance in the April 23 period, in part because of
exceptionally light use of the discount window around
midperiod when the market anticipated a discount rate
reduction. Also in that period, reserve needs were sat
isfied on the final day by an unanticipated bulge in float
and a large shortfall in the Treasury balance. The
Treasury ended with an unplanned overdraft of about
$300 million, despite having substantial cash in the tax
and loan accounts. The balance was brought back
above zero using cash inflows the next day. Excess
reserves fell to low levels in early April and mid-May
but were otherwise close to the path allowances.
Expectations of a discount rate cut caused the funds
rate to move erratically around mid-April and the rate
dropped sharply prior to the actual announcement of a
rate reduction. Overall, the funds rate declined about
one-half percentage point from the rate prevailing
around the time of the previous meeting and funds
generally traded in a range of 63/4 to 7 percent between
late April and late May.
At the May 20 FOMC meeting, the Committee voted
to maintain the prevailing degree of reserve restraint
but, against a background of greater than anticipated
growth in all of the aggregates, a majority of the mem
bers felt that policy implementation over the intermeeting
period should be alert to the potential need for some
firming of reserve conditions, especially if business
indicators gave a clear signal of a pickup in the rate of
economic expansion and monetary growth did not slow
in line with expectations. Shortly after the meeting, in
the face of stronger growth in both M1 and M2 than had
been anticipated, the Desk was a bit cautious in the way
it met reserve needs. However, in June, as economic
data indicated that business activity was growing at a
slower pace rather than picking up, the Desk moved to
meet reserve needs a bit more promptly.
Borrowing averaged close to the path allowance over
the May-July intermeeting period with occasional

FRBNY Quarterly Review/Spring 1987 53

misses. Borrowing was somewhat below the path in
mid-June when the need to borrow was reduced by a
much lower than normal demand for excess reserves.
In the July 2 period, borrowing averaged above path as
a result of a pickup near the close associated with wire
problems and the quarter-end statement date. The Desk
deliberately overshot the nonborrowed reserve objective
to alleviate undesirably firm conditions in the money
market. As a result, the excess reserve allowance,
which had been temporarily raised to $1.1 billion to
accommodate heavy quarter-end and statement date
demands, was also exceeded in that period.
The Desk continued to face sizable reserve needs in
June. Required reserves showed more than seasonal
strength reflecting the strong growth in checkable
deposits. Currency demand was seasonally strong
throughout the interval. Also absorbing reserves were
higher than normal levels of the foreign overnight
investment pool.
The Desk met the reserve needs by purchasing Treasury
bills and arranging repurchase transactions. It bought $2.5
billion of bills in the market in late May and another $1.9
billion from foreign accounts gradually over the period. Desk
plans for additional market purchases of bills were post
poned as persistent shortfalls in the Treasury’s balance
reduced the projected reserve needs for late June and July.
The Federal funds market was often on the comfortable
side, with funds trading in a narrow range around 67/s per
cent, although conditions were occasionally firmer when
statement and Treasury note settlement date pressures or
wire problems developed.
At the July meeting, against the background of a
sluggish expansion in economic activity and a subdued
rate of inflation, most Committee members believed that
some easing was desirable. Taking account of the like
lihood that the discount rate would be reduced within
a few days after the meeting, a majority indicated a
preference for implementing the easing, at least initially,
through a lower discount rate rather than through open
market operations. The discount rate was reduced to 6
percent shortly after the meeting.
In the periods between late July and mid-August,
borrowing averaged about $100 million above the $300
million path allowance, in part as a result of special
situation borrowing by banks experiencing problems
related to oil industry loans. The special situation bor
rowing not classified as extended credit averaged about
$120 million in the late July maintenance period and
about $175 million in the next period. Nonborrowed
reserves also diverged from path levels, reflecting
informal adjustments for swings in the demand for
excess reserves as well as unanticipated movements
in market factors late in each period. However, in the
mid-August period, most of the reserve miss was
Digitized for54
FRASER
FRBNY Quarterly Review/Spring 1987

deliberate, after taking into consideration the special
borrowing and expected low excess reserve demand.
Excess reserves were either moderately above or below
the path allowance in each maintenance period,
reflecting unusually large swings in reserve carryover
positions as well as the nonborrowed reserve misses.
The seasonal need to add reserves tapered to a
moderate size in the second half of July. The Desk
addressed the reserve needs primarily by arranging
customer-related repurchase agreements in the market,
although System repurchase agreements were arranged
early in the intermeeting period when the need was still
considerable. In addition, the Desk purchased a total
of $1.4 billion of bills from foreign accounts as oppor
tunities developed. Federal funds generally traded in the
61/4 to 63/e percent area after the July 10 announcement
of the discount rate cut, down from 67/s percent at the
time of the July meeting.
Late August to year-end
Open market operations over the final four months of
the year were generally directed toward implementing
the slightly more accommodative stance adopted at the
August FOMC meeting and embodied in the 50-basispoint reduction in the discount rate that closely followed
that meeting. While average borrowing exceeded the
path allowances in September and early October, the
desired easing was reflected in the money market,
where Federal funds traded mostly around 57/s percent
or a shade lower. The borrowing overages generally
reflected reserve needs that did not show through to
the market until late on settlement day, or a clearing
need resulting from an unexpected late-day outflow.
However, over November and much of December, while
nonborrowed reserve objectives were mostly achieved
or even exceeded and borrowing averaged close to the
$300 million allowance, the Federal funds rate tended
to firm. Desk efforts to alleviate the unusual money
market pressure and keep pace with reserve needs
were repeatedly frustrated by relentless upward revi
sions to required reserves, a lessened use of the dis
count window, and unpredictably high demands for
excess reserves.
At the August FOMC meeting, the Committee issued
a directive that called for a slight decrease in reserve
pressure, taking account of the possibility of a change
in the discount rate. The reduction in the discount rate
to 51/2 percent shortly thereafter accomplished the
desired easing and the Desk operations continued to
aim for $300 million of seasonal plus adjustment bor
rowing and $900 million of excess reserves. However,
in early September, the Desk was a shade more cau
tious in injecting reserves to meet projected needs
against a background that included continuing strength

in the monetary aggregates, scattered indications of a
pickup in economic growth, and increased market con
cern about inflation.
Borrowing tended to exceed the formal path allowance
between late August and late September. In the August 27
period, special situation borrowing raised daily borrowing
above path until the second week when it was reclassified
as extended credit borrowing. Excluding the special bor
rowing, borrowing was very close to the path objective.
Average borrowing in the next period was lifted about $200
million above path, largely because an upward revision to
required reserves of $400 million on the last day of the
period introduced a need that could not be completely met
(total propositions for the Desk’s RP operation that day fell
short of the desired injection), and the demand for excess
reserves exceeded expectations. In the September 24
period, unexpected late-day outflows caused a bulge in
borrowing which contributed to another borrowing overage.
In allowing for excess reserves over the August-September intermeeting period, the Desk took into account
the likelihood that demand would fall below path. The
lower demand was suggested by money market condi
tions, the distribution of excess reserves as the mainte
nance periods progressed and, in the September 24
period, the phase-up of reserve requirements at non
member institutions. However, downward revisions to
required reserves after the periods ended lifted excess
reserves somewhat closer to path allowances.
The Desk faced fairly sizable reserve needs in Sep
tember as first currency, and then the Treasury balance,
rose. A large portion of the reserve needs was met by
the Desk’s purchase of $2.1 billion of Treasury bills in
the market in late August and purchases from foreign
accounts totaling about $900 million. Temporary trans
actions supplemented these reserve injections.
With the Desk making informal allowance for low excess
reserve demand, nonborrowed reserves fell somewhat
short of path in the periods between late August and late
September. On a number of occasions, nonborrowed
reserves averaged somewhat below the level expected
on the final day, partly as a result of reserve shortfalls.
Federal funds generally traded in a narrow range around
57/s percent following the August 20 announcement of the
discount rate cut to 5V2 percent.
At the September FOMC meeting, the Committee
adopted a directive that called for maintaining the pre
vailing degree of pressure on reserve positions but
indicated that it would be more likely to move toward
slightly greater rather than lesser reserve restraint
depending on monetary, economic, and foreign
exchange conditions. In the absence of further devel
opments calling for adjustment of reserve positions, no
changes were made to the path allowance for bor
rowing. The typical allowance for excess reserves was

lowered by $50 million to $850 million on October 22
to reflect the recent behavior of excess reserves.
Over the September-November intermeeting period,
borrowing frequently averaged higher, and excess
reserves lower than expected, in part because under
estimates of required reserves repeatedly understated
reserve needs. Nonborrowed reserves averaged mod
estly below the objectives, mostly as a result of the
lower than anticipated levels on the last day of the
maintenance periods.
Overnight borrowing ran above path in late September
but then tapered down to very low levels in October,
except on settlement days, as small banks made less
use of the window and as seasonal borrowing worked
lower. Heavy settlement day use of the discount window
raised average borrowing considerably above its
objective in the early October and November periods.
Upward revisions to required reserves after the main
tenance periods ended more than offset the effects of
these unexpected borrowings on the level of excess
reserves and reduced average excess reserves below
expected levels. The comfortable tone in the money
market until very near the periods’ ends suggested that
the level of reserve needs may have been underesti
mated by bank reserve managers as well.
High levels of the Treasury’s balance continued into
early October, which, together with an increase in the
foreign investment pool, created a sizable need.
Reserve needs were more moderate later in the month.
Over the intermeeting period, guided by the size and
duration of the reserve needs, the Desk arranged both
System and customer-related repurchase agreements,
with a number of the former extending over multiple
days. The Desk also purchased a total of $1.3 billion
of Treasury bills from foreign accounts. Federal funds
generally traded close to 57/s percent although the range
of trading was quite broad at the quarter-end and on
most settlement days.
Over the fall, economic activity continued to show
signs of moderate growth while growth of the broader
aggregates tempered somewhat. Against this back
ground, at its November and December meetings, the
Committee voted to maintain the existing degree of
reserve restraint. However, in December, economic data
suggested a greater possibility for slower rather than
faster growth over the near term. With this in mind,
while the Committee called for no immediate change in
reserve pressure, it expressed a slightly greater will
ingness to move toward lesser rather than greater
restraint, depending on the behavior of the monetary
aggregates, taking account of the strength of the
economy, developments in the foreign exchange mar
kets, domestic and international financial market con
ditions, and the outlook for inflation.

FRBNY Quarterly Review/Spring 1987 55

Policy was implemented over the final two months of
the year against a background of persistently stronger
than expected demands for reserves. Hence, while
nonborrowed reserve supplies on average were about
in line with or above the objectives, the pressures on
reserve positions were sometimes greater than
intended. Extraordinarily strong credit demands and
accelerating growth in deposits subject to reserve
requirements helped push overnight and other short
term interest rates far above normal levels earlier and
more persistently than in recent years. The strong credit
demands, particularly for commercial, industrial, and real
estate loans from large banks, added to the volume of
flows through reserve accounts and to the uncertainty
about reserve levels. These developments may have
made banks a little hesitant to use up their access to
the discount window, especially those banks that had
borrowed in recent periods. Aggressive foreign agency
bank buying of term Federal funds to cover year-end
needs, which were enlarged by strong credit demands,
may have contributed to the firmness as early as midNovember. During November, Federal funds traded
mostly in a range around 515/ie percent. December
trading conditions were generally firmer with the funds
rate most frequently between 6 and 6V2 percent.
The demand for bank loans soared over the final
weeks of 1986 as businesses and investors rushed to
complete transactions which would receive less favor
able tax treatment beginning in 1987. The loans may
have been the dominant factor underlying the unusual
acceleration in deposit growth as some loans were
taken in the form of demand deposits. The higher bal
ances may have been retained to handle the increased
transactions volume and to meet increased compen
sating balance requirements.
The extraordinary growth of bank loans and reservable deposits made it very difficult to estimate reserve
demands. Often, upward revisions to required reserve
levels were as big as $500 million during a period and
pushed another $100 million to $150 million higher after
the period ended. The required reserve revisions in the
year-end period cumulated to $1.6 billion during the
period, and to $1.8 billion when final reserve require
ments were known shortly thereafter. It was also difficult
to project the desired levels of excess reserves because
banks, uncertain of their needs, became more cautious
about releasing funds.
Between mid-November and year-end, nonborrowed
reserves exceeded the formal objectives, but most of
the overages were intended. Against the background of
special seasonal and technical factors, the Desk made
frequent allowances for higher excess reserve demands.

FRBNY Quarterly Review/Spring 1987
Digitized for56
FRASER

In the December 17 period, the Desk provided more
reserves than formally called for because of a string of
shortfalls during the period and a taut money market
which suggested the need might be greater than pro
jected. Borrowing until the final day averaged only $90
million, and the Desk was willing to mitigate the bulge
in settlement day borrowing that would have been
needed to attain the path objective.
In the year-end period, although the nonborrowed
reserve objective allowed for $1.4 billion of excess
reserves ($10 0 million more than occurred in the
equivalent period a year earlier), the Desk provided
more reserves than formally indicated in light of the
extreme money market pressures. While the very gen
erous overage was reduced somewhat by a much higher
than anticipated Treasury balance on the final day,
reserve supplies more than met the banks’ needs and
the funds rate plunged from 38 to 0 percent over the
course of the final day. Some banks actually paid a
brokerage fee to have the excess reserves, an obvious
nonearning asset on their year-end balance sheets,
taken off their books, even though the funds had value
on January 1, 1987, the first day of a new maintenance
period.
While excess reserves initially appeared to end most
periods substantially over the levels anticipated on the
final day, later upward revisions to required reserves
placed excess reserve levels more in line with those
expectations. However, in the year-end period, even
after taking account of subsequent upward revisions to
required reserves, excess reserves averaged $2.0 bil
lion, far above the expected level. A number of banks
turned to the discount window in that period to satisfy
these extraordinary demands, particularly near year-end,
raising the average level of borrowing in that period to
slightly over $900 million.
The large reserve needs over the final two months
of the year were addressed with a combination of out
right and temporary transactions. On an outright basis,
the Desk purchased about $10.2 billion of Treasury
securities, including about $6.2 billion of bills and $1.5
billion of coupon issues in the market, and $2.5 billion
of bills from foreign accounts. The coupon purchase was
the first in almost a year and tended to emphasize the
short and intermediate maturity range more than past
coupon issue purchases, reflecting the Committee’s
preference for portfolio liquidity. Temporary transactions
were also used to provide reserves. Large System RP
operations were necessary on a number of occasions.
At the close of the year, a record $16.0 billion of System
RPs was on the books, including $9.2 billion of RPs
arranged that day.

(This report was released to Congress
and to the press on May 29, 1987)

Treasury and Federal Reserve
Foreign Exchange Operations
February—April 1987

The dollar traded rather steadily in February and early
March, and then moved lower through the end of April.
It closed the period down more than 8 percent against
both the Japanese yen and the British pound, down
roughly 2 percent against the German mark and most
other continental currencies, and unchanged on balance
against the Canadian dollar. The U.S. authorities inter
vened in the market at various times during the threemonth period under review.
After declining almost continuously for nearly two
years (Chart 1), the dollar steadied as the period
opened. Market participants were reassured by a coor
dinated U.S.-Japanese intervention operation under
taken in late January following a joint statement by
Secretary Baker and Finance Minister Miyazawa in
which they reaffirmed their willingness to cooperate on
exchange rate issues. Talk that the financial authorities
of the major industrial countries would soon meet
encouraged expectations that multilateral efforts might
be forthcoming to prevent the dollar from declining fur
ther. In addition, reports of extensive Japanese partic
ipation in the February refunding operations of the U.S.
Treasury reassured the exchange markets by seeming
to suggest that Japanese investors would continue to
make substantial investments in dollar-denominated
assets.
Meanwhile, economic statistics being released sug
gested that the underlying economic fundamentals were
A report 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.

clearly moving in directions that would lead to adjust
ment of external imbalances. To be sure, there were still
few signs that the dollar’s two-year decline had reduced
the nominal U.S. trade deficit. However, GNP data for
the fourth quarter of 1986, together with information
becoming available on export and import volumes,
showed that the nation’s trade deficit was declining in
volume terms and that the nation’s external sector was
beginning to contribute to economic growth (Chart 2).
Japan’s trade surplus, though still high in nominal terms,
had been declining in volume terms since the beginning
of 1986. As for Germany, weak export volumes and
strong import volume gains carried a similar indication
that earlier exchange rate movements were working to
reduce external imbalances. In these circumstances, the
dollar rose from its lows of late January to trade within
a narrow range through mid-February against both the
yen and the mark, around ¥153 and DM1.82, respec
tively.
Then on February 22, following meetings held at the
Louvre in Paris, finance ministers and central bank
governors of six major industrial countries stated that,
given the economic policy commitments they were
making, their currencies were now “ within ranges
broadly consistent with underlying economic funda
mentals.” In the announcement, the authorities of Ger
many and Japan stated that they would provide greater
stimulus to their economies, and the U.S. government
said that it would resist protectionism and substantially
reduce the budget deficit for the fiscal year 1988. The
statement noted that “further substantial exchange rate
shifts among their currencies could damage growth and
adjustment prospects in their countries.” The officials

FRBNY Quarterly Review/Spring 1987 57

of the six major industrial countries also announced that
they had agreed “ in current circumstances to cooperate
closely to foster sta bility of exchange rates around
c u rre n t le ve ls.” A lthough m any m arket p a rticip a n ts
regarded previous promises of domestic policy actions
by the m ajor industrial nations with skepticism , the
prospect of increased cooperation and the more explicit
association of the U.S. Treasury with a call for greater
exchange rate stability reassured the market about the
near-term outlook for the dollar. Remarks by some fo r
eign officials attending the Paris meeting suggested that
th ere had also been an agreem ent fo r co ordin ate d
intervention in the exchange market.
During the first several weeks following the Paris
agreement, the dollar strengthened, especially against
the German mark and other continental currencies.
Although many market professionals expressed doubt,
given the continuing pressures of large international
trade imbalances, that further declines in the dollar
could be avoided over time, there was less sense of
downside risk in holding dollars in the near-term. As a
resu lt, som e c o rp o ra tio n s began to unw ind co stly
hedges against their dollar positions. This commercial
demand gave the dollar a buoyancy which some market
professionals suspected was the result of central bank
intervention, an impression which added to the dollar’s
firmness.
The dollar continued to trade narrowly against the yen
a ro u n d =¥153 a fte r th e P a ris m e e tin g . J a p a n e s e

exporters took advantage of any firm ing of the dollar
against yen to convert export proceeds into yen— an
activity that accelerated ahead of Japan’s fiscal yearend in March. Japanese investors took advantage of any
easing of the dollar against the yen to increase their
holdings of U.S. and other foreign assets. They per
ceived relatively little near-term exchange rate risk in
investing abroad, expecting the authorities to prevent
any significant further appreciation of the yen against

Chart 2

The U.S. tra d e p e rfo rm a n c e c o n tin u e d to
im p ro v e in re a l te rm s and c o n tr ib u te d to
U.S. e c o n o m ic g ro w th . . .
Billions of 1982 dollars
20
Change in net exports in constant dollars

------------------------ .---------

Chart 1

1986

T he d o lla r has d e c lin e d a g a in s t m ost m a jo r
fo re ig n c u rre n c ie s fo r m ore th a n tw o years.
Percent *

1987

b u t th e a d ju s tm e n t of the tra d e d e fic it in
n o m in a l te rm s la g g e d as the p ric e e ffe c ts
o f th e d o lla r’s d e c lin e m asked th e ch a n g e s
in v o lu m e s .
Billions of dollars

5 ----------------------------------------------- --------Monthly U.S. trade deficits

1985

1986

1987

♦Percentage change of monthly average rates for dollars
from the average for the month of February 1985.
’
All figures are calculated from New York noon quotations.

FRBNY Quarterly Review/Spring 1987
Digitized for58
FRASER

Apr May Jun

Jul

- -

>
1 i

'//A

- p.

Aug Sep Oct Nov Dec Jan Feb
1986
1987

The charts show Department of Commerce data
released through April.

the dollar.
Meanwhile, greater stability in dollar exchange rates
in February, together with the subsequent Paris com
mitment to foster exchange rate stability, was seen in
the market as reducing exchange rate risk more gen
erally and thereby enhancing the relative attractiveness
of assets denominated in currencies with relatively high
interest rates. Sterling, which also benefited from a
number of other economic and political developments,
rose strongly against all m ajor currencies in February
and early March, amid reports of strong demand by
foreign investors. There were also signs of increased
investor interest in the Australian and Canadian dollars,
the Swedish krone, the French franc, and the Italian lira
to take advantage of the high interest rates available
in those currencies.
In that environment, investors found that a number
of currencies offered more attractive investment oppor
tunities than the German mark. Traders viewed eco
nom ic a c tivity as som ew hat stron ge r in the United
States and somewhat weaker in Germany than previ
ously thought. Also, expectations persisted that short
term interest rate differentials would continue to favor
the dollar relative to the mark. Moreover, market par
ticipants were aware that there remained outstanding
large positions, long of marks and short of dollars; any
generalized move to trim these positions was expected
to result in considerable bidding for dollars. In these
circum stances, the dollar continued to rise gradually
against the mark in late February and early March.
Around mid-March, speculative buying started to push
the dollar up more rapidly against the mark. A number
of stop-loss orders to buy dollars and sell marks were
triggered, and the resulting bidding for dollars in oth
erwise thin trading propelled the dollar rate up as high
as DM1.8745 on March 11 in New York. Under these
circumstances, the Desk entered the exchange market,
se lling $30 m illion a ga in st m arks. The in te rve n tio n
o pe ra tion , w hich was u ndertaken to fo ste r g re a te r
e xcha ng e rate s ta b ility as e n visa g e d in the Paris
agreement was quickly talked about in the markets.
Dealers imagined that the Desk had sold a much larger
amount and interpreted the action as signaling that
major countries would seek to limit any significant rise
in the dollar, as well as any significant decline. As a
result, market participants calculated that there was little
need to protect them selves against the possibility that
the dollar might continue to advance. In view of their
long-standing expectation that the dollar would decline
over time, bidding for dollars quickly subsided, and
dollar rates started to drift down (Chart 3).
As the dollar started to decline after mid-March, the
focus of m arket attention shifted from the mark to the
yen. The expectation that short-term interest rate d if

ferentials would move in favor of the dollar against the
mark and fear of central bank intervention limited the
dollar’s decline against the mark. But against the yen,
the dollar was trading only slightly above the ¥150 level
that many m arket p articipants, espe cia lly in Japan,
believed represented at least an important psychological
benchmark and perhaps constituted the lower limit of
the yen-dollar exchange rate range they thought had
been agreed to in conjunction with the Paris agreement.
Although Japanese econom ic growth was weaker than
it had been in many years, market participants evidently
judged that the Japanese government, embroiled in a
debate concerning tax reform, would not take early and
significant policy actions to spur dom estic demand and
reduce its trad e su rp lu s as p rom ised in the Paris
agreement. Moreover, the announcement that the United
States would impose trade sanctions on selected Jap
anese products following a dispute over sem iconductor
products fueled fears of protectionism . In Europe, con-

Chart 3

The d o lla r tra d e d s te a d ily a g a in s t m ost
m a jo r fo re ig n c u rre n c ie s d u rin g F ebruary
and e a rly M arch b u t s u b s e q u e n tly
d e c lin e d s h a rp ly , e s p e c ia lly a g a in s t
th e J a p a n e s e yen.
Percent *

_161. I I I I I I I I I I I I I I I I I I I I I I I I I l' I
Nov

Dec
1986

Jan

Feb

Mar

Apr

1987

♦Percentage change of weekly average rates from the
week ending October 31, 1986. All figures are calculated
from New York noon quotations.

FRBNY Quarterly Review/Spring 1987

cern was growing that the Japanese were diverting their
exports from other markets to Europe. With the weak
ness of the German economy seemingly confirmed by
figures then becoming available, market participants
w ere se n sitive to the p o s s ib ility th at trad e fric tio n
b etw een Japan and Europe was also in te n sify in g .
Market concerns increased that there might be renewed
calls for a lower dollar as a response to these trade
problems. A clear bearish sentiment reemerged towards
the dollar against the yen.
On March 23, the dollar moved below ¥150. Japanese
investm ent houses, insurance companies, and corpo
rations sold dollars aggressively, stop-loss orders were
activated, and the dollar began to move down sharply.
To restrain the dollar’s decline, the Desk made daily
purchases of dollars against yen in a series of opera
tions between March 23 and April 6, purchasing a total
of $3,007.7 m illion. The operations by the U.S. author
ities were coordinated with operations by the Bank of
Japan and several European central banks.
By the end of March, the dollar appeared to be set
tling in a range around ¥147. But concern over the
s ta b ility of the d o lla r had spread from the fo re ign
e xch a n g e to o th e r fin a n c ia l m arkets. The d o lla r ’s
depreciation precipitated sharp declines in prices of U.S.
bonds and equities. It contributed to sharp increases
in the prices of gold and silver. And as investors sought
alternatives to dollar-denom inated assets, the prices of

C hart 4

In te re s t ra te s rose in th e U n ite d S ta te s
and d e c lin e d a b ro a d . . .
Percent
12

Japan

3l M I I I I I .1 I I I I I I I M I I I l I I I I I I
F M A M J J A S O N D J F M A M J J A S O N DJ F M A
1985
1986
1987

so th a t in te re s t d iffe re n tia ls m o v e d
s h a rp ly in fa v o r o f th e d o lla r.
Percent
5

Table 1

Federal Reserve
Reciprocal Currency Arrangements
In millions of dollars
Institution
Austrian National Bank
National Bank of Belgium
Bank of Canada
National Bank of Denmark
Bank of England
Bank of France
German Federal Bank
Bank of Italy
Bank of Japan
Bank of Mexico
Netherlands Bank
Bank of Norway
Bank of Sweden
Swiss National Bank
Bank for International Settlements:
Dollars against Swiss francs
Dollars against other
authorized European currencies

Amount of Facility
April 30, 1987
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,(XX)
700
500
250
300
4,000

Total

FRBNY Quarterly Review/Spring 1987
Digitized for60
FRASER

600
1,250
30,100

'Germany

-Y

4 FMAMJJ AS ONDJ
1985

United Kingdom

F M A M J J A S O N D J F MA
1986
1987

The top chart shows long-term government bond yields
and the bottom chart shows the differentials between
U.S. Treasury bonds and foreign government securities.

bonds denominated in other currencies rose. As a result
of the divergent forces in the w orld’s bond markets,
long-term interest rate differentials moved strongly in
favor of the dollar (Chart 4).
Meanwhile, market participants came to believe that
new incentives would be needed to maintain the cred
ibility of official efforts to stabilize exchange rates and
halt the dollar’s decline. As a result, they looked forward
to a scheduled meeting of the G-7 finance ministers and
central bank governors in Washington on April 8 for
evidence that the authorities were firm ly committed to
exchange rate stability.
The G-7 m inisters and governors welcomed the pro
posals announced by the governing party in Japan for
substantial measures to stimulate Japan’s economy. But
market participants were disappointed that additional
new initiatives were not announced. Also, U.S trade
statistics for February, released on April 14, left the
im pression that the adjustm ent in the w o rld ’s trade
imbalances, at least in nominal terms, was still disap
pointingly small. Under these circumstances, sentiment
towards the dollar remained bearish. Market participants
questioned whether interest differentials favoring the
dollar were su fficien t to m aintain foreign inve sto rs’
appetite for dollar-denominated assets. As a result, the
dollar was again heavily offered in early April, especially
against the yen but also against other currencies that
provided attractive capital m arket outlets for foreign
investors. The U.S. authorities continued to intervene

on occasion, buying dollars at times to foster exchange
rate stability. They operated on three of the nine busi
ness days between April 7 and April 17, buying $532
million against yen. As before, these operations in yen
were closely coordinated with those undertaken by the
Bank of Japan and several European central banks.
Statements by U.S. and Japanese officials in mid-April
were interpreted as indicating that the officials were
genuinely concerned about the risks of further sharp
downward m ovements in dollar rates and that other
action might be forthcom ing to enhance efforts to sta
bilize exchange rates. Comments by Bank of Japan
Governor Sumita and other Japanese officials suggested
that new arrangem ents were under consideration to
finance concerted intervention operations. In a speech
before the Japan Society in New York, Treasury Sec
retary Baker, making specific reference to the dollar-yen
rate, said that U.S. and other authorities intended to
co op erate clo s e ly to fo s te r exchange rate s ta b ility
despite trade difficulties and that a further decline of
the d o lla r a g a in st o the r m ajor c u rre n c ie s could be
counter-productive. Also around m id-April, U.S. short
term interest rates firmed, and this was taken by some
market participants as an indication that U.S. monetary
policy might be tightening somewhat to ease the pres
sures on the dollar.
Even so, many in the m arket continued to doubt that
the authorities were sufficiently comm itted to exchange
rate stability to make m ajor adjustm ents to dom estic

Table 2

Drawings and Repayments by Foreign Central Banks under Regular Reciprocal Currency Arrangements
In millions of dollars; drawings (+ ) or repayments ( - )
Outstanding as of
February 1, 1987
61.4

Central Bank Drawing on the
Federal Reserve System
Bank of Mexico

February
-61.4

March
0

April
0

Outstanding as of
April 30, 1987
0

Data are on a value-date basis

Table 3

Drawings and Repayments by Foreign Central Banks under Special Swap Arrangement with
the U.S. Treasury
In millions of dollars; drawings (+ ) or repayments ( - )

-61.6

March
*

April
*

Outstanding as of
April 30, 1987
*

+ 225.0

225.0

Amount of
Facility

Outstanding as of
February 1, 1987

February

Bank of Mexico

273.0

61.6

Central Bank of Argentina

225.0

Central Bank Drawing
on the U.S. Treasury

Data are on a value-date basis
*No facility

FRBNY Quarterly Review/Spring 1987

economic policies. Thus, the dollar again came under
strong selling pressure during the last full week of April
as hopes of more economic policy convergence faded.
In Japan, official comments suggested that there would
be no further easing of credit policy, and there seemed
to be little e vid e n ce of m ovem ent to w a rd a m ore
expansionary budget. Doubts developed that the Federal
Reserve had much scope to tighten monetary policy,
given the decline in U.S. final domestic demand as
reported in the first quarter GNP data. Moreover, reports
emerged from U.S.-Japanese trade negotiations indi
cating little progress, and, towards the end of the month,
the U.S. House of Representatives added to its trade
bill a provision calling for mandatory restrictions on U.S.
imports from countries with large trade surpluses.
Thus, the dollar was again subject to episodes of
intense se llin g p ressure in the third w eek of A pril.
Against the yen it declined below ¥140, reaching a 40ye a r low of ¥ 1 3 7 .2 5 on A p ril 27. The d o lla r also
declined against the European currencies, easing below
DM 1.80 to trade as low as D M 1.7710 a ga in st the
Germ an mark. The Desk interven ed on three more
occasions in late April, both in yen and marks, pur
chasing $424.9 m illion against yen and $99 m illion
against marks.
In the final days of April, comments by Chairman
Volcker and by Prime Minister Nakasone during his visit
to Washington indicated that the central banks of the
two countries were making more adjustments in their
monetary policies. Mr. Nakasone announced that the
Bank of Japan would act to ease short-term market
rates, and Mr. Volcker stated that the Federal Reserve
had “ snugged up ” m onetary policy in lig h t of the
exchange rate pressure. With the market perceiving that

Table 4

Net Profits ( + ) or Losses ( - ) on
United States Treasury and Federal Reserve
Current Foreign Exchange Operations

monetary authorities were acting to widen interest rate
differentials in favor of the dollar, the currency recovered
from its lows against the yen and the mark to close the
period at ¥140.85 and DM1.7925, respectively. At these
levels, the dollar was down 8 3/8 percent against the
yen from both its opening in February and its level in
m id-M arch. Against the m ark, the d ollar closed the
period down 2 1/8 percent from its opening in February
and down 4 3/8 percent from its highs in mid-March.
On a trade-weighted basis as measured by the Federal
Reserve Board index, the dollar declined 3 7/8 percent
against all G-10 currencies between the opening in
February and the end of April.
For the three month period as a whole, intervention
d o lla r p urcha ses by the U.S. m on eta ry a u th o ritie s
totalled $4,063.6 m illion, while dollar sales totalled $30
m illion. All interven tion was financed out of foreign
currency balances. The bulk of the authorities’ dollar
purchases, or $3,964.6 million, was against sales of
yen, of which $1,962.3 m illion equivalent was drawn
from the T re a sury’s b alan ces and $ 2 ,0 0 2 .3 m illio n
equivalent was drawn from the Federal Reserve. In
addition, the Federal Reserve and the Treasury each
sold $49.5 million equivalent of German marks. On one
occasion in the period, as indicated above, the Federal
Reserve and the Treasury each sold dollars by pur
chasing $15 m illion equivalent of German marks.
During the three-m onth period, foreign central banks
also bought dollars in extraordinary amounts in the
exchange markets. In part, these purchases reflected
operations of the Bank of Japan, the Bundesbank, and
several other European central banks which purchased
dollars against yen and other currencies in accordance
with the understandings of the Paris Accord and the
April G-7 statement to foster exchange rate stability. But
in part, these reflected the purchases of a number of
European central banks that took advantage of the rel
ative firm ness of their currencies against the mark, the
dollar, or both, to replenish official reserves by pur
chasing dollars.

In millions of dollars

Period
February 1, 1987 April 30, 1987
Valuation profits and losses on out
standing
assets and liabilities
as of April 30, 1987

Federal
Reserve
+ 688.1

United States
Treasury
Exchange
Stabilization
Fund
+ 571.9

+ 1,981.3

+1,809.8

Data are on a value-date basis.

Digitized for62
FRASER
FRBNY Quarterly Review/Spring 1987

During the three-m onth period, the Treasury D epart
ment through the Exchange Stabilization Fund (ESF)
joined with other central banks to provide a m ultilateral
short-term credit facility totalling $500 m illion for the
Central Bank of the Argentine Republic in support of
Argentina’s econom ic program to achieve sustainable
growth and a viable balance of paym ents position. The
ESF’s portion of the facility was $225 million. The facility
was established on March 5, and the full amount was
drawn by the Central Bank of the Argentine Republic
on March 9.

Meanwhile, Mexico fully repaid on February 13 the
$61,6 million drawing on the ESF and $61.4 million
drawing on the Federal Reserve that were outstanding
under a two-tranche $1.1 billion multilateral near-term
contingency support facility provided jointly by the U.S.
monetary authorities, the Bank for International Settle
ments (acting for certain central banks), and the central
banks of Argentina, Brazil, Colombia, and Uruguay. The
facility has now lapsed. As noted in previous reports,
the first tranche of $850 million had been made avail
able to Mexico on August 29, 1986, with the Federal
Reserve providing $210.2 million and the ESF providing
$211.0 million. On December 8, after Mexico had
become eligible to draw the second tranche of $250.0
million, Mexico had drawn $61.8 million from the Federal
Reserve and $62.0 million from the ESF. Drawings on
the first tranche were fully repaid in the previous
reporting period.
In the period from February 1 through April 30, the
Federal Reserve and ESF realized profits of $688.1
million and $571.9 million, respectively, on sales of

foreign currency balances. As of April 30, cumulative
bookkeeping or valuation gains on outstanding foreign
currency balances were $1,981.3 million for the Federal
Reserve and $1,809.8 million for the Treasury's ESF.
These valuation gains represent the increase in the
dollar value of outstanding currency assets valued at
end-of-period exchange rates, compared with the rates
prevailing at the time the foreign currencies were
acquired.
The Federal Reserve and the ESF invest foreign
currency balances acquired in the market as a result
of their foreign operations in a variety of instruments
that yield market-related rates of return and that have
a high degree of quality and liquidity. As of April 30,
1987, under the authority provided by the Monetary
Control Act of 1980, the Federal Reserve held invest
ments totalling $1,091.1 million equivalent of its foreign
currency holdings in securities issued by foreign gov
ernments. In addition, as of the same date, the Treasury
held the equivalent of $2,566.1 million in such securities.

FRBNY Quarterly Review/Spring 1987 63

(This report was released to Congress
and to the press on March 9, 1987)

Treasury and Federal Reserve
Foreign Exchange Operations
November 1986 - January 1987

After trading fairly steadily throughout November and the
first half of December, the dollar moved sharply lower
until the end of January. It closed the period down more
than 11 percent against the German mark and most
other Continental currencies, about 7 percent against
the Japanese yen and the British pound, and almost 4
percent against the Canadian dollar. There were large
dollar purchases by foreign central banks during the
period. The U.S. authorities intervened on one occasion
in late January.
As the period opened, the dollar had moved up from
the lowest levels reached against the yen and the mark
in the third quarter. Many market participants were
beginning to believe that the dollar, after a long decline,
was entering a stage of greater near-term stability
(Chart 1). There were some indications that the favor
able side of depreciation was starting to show through
in the U.S. economy. The trade deficit seemed to have
stabilized at last, though remaining large at $14 billion
a month. Output growth in the third quarter also
appeared to have been a little stronger than many
market participants had previously expected, suggesting
some strengthening of export demand.
Meanwhile, the cumulative effects of the dollar’s pro
longed depreciation were seen in financial markets to
be exerting pressures in other countries for more
exchange rate stability. Although Japan’s trade surplus
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.

Digitized for
64FRASER
FRBNY Quarterly Review/Spring 1987

remained high in nominal terms, the yen’s sharp
appreciation was eroding competitive positions, resulting
in some production cutbacks for overseas markets, and
contributing to a rise of unemployment rates. Questions
arose whether Japanese domestic demand would
remain strong enough to sustain the modest rate of
economic growth forecast for the current year. In late
October, there had been an announcement of a 1/2
percentage point cut in the Bank of Japan’s discount
rate and of an economic policy accord between U.S.
Treasury Secretary Baker and Japanese Finance Min
ister Miyazawa. The monetary policy action, together
with the accord’s assurances with respect to Japanese
and U.S. fiscal policies, was seen as supportive of more
favorable prospects for the Japanese economy and for
a reduction in the two nations’ external imbalances. At
the same time, understandings reached in the BakerMiyazawa agreement—that the exchange-rate realign
ment already accomplished between the two currencies
was “now broadly consistent with the present underlying
fundamentals” and that the two nations were reaffirming
their willingness to cooperate on exchange rate issues—
took pressure off the yen in the exchange market. The
accord seemed to imply agreement that the yen’s
appreciation was sufficient, at least for the time being.
Many market participants also believed that, henceforth,
official intervention—perhaps on a coordinated basis—
would be used if necessary to counter a new rise in
the yen.
In the case of Germany, the mark’s appreciation was
seen in the market as increasing pressure on German
authorities to take steps to ease currency strains within

C h a rt 1

The d o lla r ’s e ig h te e n m o n th d e c lin e
pau se d d u rin g th e a u tu m n o f 1986.
Percent*

-------------------------------- 1-----------------------------------Canadian dollar

Japanese yen

V__ \

\
\\
\
\ N^ ' \ v

Swiss
franc

British pound
German
■V-^S^mark

I I I I II

I I

I I I I I I I II

F M A M J J A S O N D J F M A M J J
1985

1986

ASONDJ

1987

* Percentage change of monthly average rates for dollars
from the average for the month of February 1985. All
figures are calculated from New York noon quotations.

the European Monetary System (EMS). Since the midS eptem ber Econom ic C om m unity (EC) m eeting in
Gleneagles, Scotland, central banks participating in the
EMS m o n e ta ry a rra n g e m e n ts had used e xcha ng e
market intervention to try to protect the EMS from ten
sions associated, in part, with the decline in the dollar.
Although there was little e vidence that G e rm a ny’s
internal economy was suffering heavily from the effects
of the m ark’s appreciation, many market participants
e x p e c te d th e B u n d e s b a n k to buy d o lla rs in th e
exchange market if the dollar resumed a significant
downward movement.
Under these circum stances, m arket professionals
moved in early November to cover short dollar positions
assumed earlier. This bidding for dollars helped push
up dollar rates to their highs of the three-month period,
around DM 2.08 against the mark and Y 165 against
the yen. The dollar continued for a time to be reason
ably well bid, especially against the Japanese yen as
institutional investors from Japan bought a broad variety
of dollar-denominated assets, including equities and real
estate investments. The continuing firmness of the dollar
vis-^-vis the yen took on a self-reinforcing character;
with the dollar standing well above Y 160 after announce
ment of the Baker-Miyazawa accord, confidence grew that
the dollar would stay around these levels. Consequently,

Japanese investors not only bought new dollar-denom inated securities, they also repaid loans used to finance
previous investm ents. In early December, when dollar
interest rates began to rise, largely for seasonal and
ta x -re la te d reasons, the co sts of d o lla r-b o rro w in g s
in c re a s e d and J a p a n e s e in v e s to rs u nw ou nd th e ir
hedges further.
The dollar was not as strong against the European
currencies as it was against the yen. After the dollar
reached its high against the mark in early November,
m arket p ro fe s s io n a ls began to build up th e ir m ark
positions, and many European-based investors who had
hedged th e ir d o lla r assets e a rlie r in the ye ar w ere
content to retain their protection against a renewed
dollar decline. In addition, market participants came to
the view that the agreement between Secretary Baker
and M inister M iyazawa was not relevant for the dollar/
mark exchange rate. In these circum stances, the dollar
eased back against the mark in November and early
December. It subsequently rose against the mark in midDecember, however, when reports of a trip by Secretary
B a ker to E urope g e n e ra te d e x p e c ta tio n s th a t the
Germ an a u th o ritie s w ould jo in in an a gree m e nt on
exchange rate stability sim ilar to the Baker-Miyazawa
accord. By the middle of December, the dollar was
trading near DM 2.03, down a modest 11/2 percent
against the mark since the end of October; it was v ir
tually unchanged against the yen at about Y 163.

Table 1

Amount of Facility
January 30, 1987
250
1,000
2,000
250
3,000
2,000
6,000
3,000
5,000
700
500
250
300
4,000
600
1,250
30,100

FRBNY Quarterly Review/Spring 1987

While the view that the dollar was in a period of sta
bility dominated trading until mid-December, a number
of developm ents were taking place at the same time
that gradually undermined the m arket’s confidence in
that view. Many m arket participants were becoming
convinced that U.S. domestic demand was slowing and
th a t any signs of stren gth w ould prove tem porary,
reflecting shifts in the timing of transactions before new

Chart 2

The re le a s e o f p re lim in a ry tra d e s ta tis tic s
fo r N o ve m b e r a t th e end o f th e year
d is p e lle d th e vie w th a t th e U.S. tra d e
d e fic it had s to p p e d d e te rio ra tin g .
Billions
of U.S. dollars
5--------------------------------------------------------Trade balance*
|

2qL

Nov-Jan
1985-86

Revised

Feb-Apr

| Preliminary

May-Jul
1986

Aug-Oct

Nov

♦Census data. Three-month averages for periods
indicated, monthly value for November.

tax laws took effect at the start of the year. The pros
pects for 1987 were increasingly seen as dependent on
a turnaround in the U.S. trade position.
At the sam e tim e, U.S. C o n g re s s io n a l e le c tio n s
resulted in a Republican loss of the Senate majority.
T his outcom e was in te rp re te d as c o m p lic a tin g the
Adm inistration’s efforts to maintain control of econom ic
policy, most especially to resist pressure for protectionist
legislation or calls for a lower dollar. Political uncer
tainties intensified following revelations that some U.S.
officials had participated in controversial arms sales.
M eanw hile, developm ents in G erm any and Japan
indicated that the m ajor industrial countries m ight be
moving away from the econom ic conditions needed for
greater exchange rate stability. In Germany, short-term
in te r e s t ra te s ro s e m a rk e d ly in N o v e m b e r and
December. W hile some of the tightness was attributed
to seasonal factors, there was concern in the m arket
that the German central bank m ight have adopted a
more restrictive monetary stance to curb above-target
expansion in central bank money. Com m ents by some
German officials seemed to support this view. In Japan,
the governm ent adopted a budget late in December for
the fiscal year beginning in April 1987 that did not
appear to provide the degree of fiscal support to the
economy expected after the Baker-M iyazawa accord.
Although the dollar started to soften during the second
half of December in response to these developm ents,
market forces did not turn decidedly against the dollar
until year-end. On December 31, preliminary U.S. trade
statistics were released showing a m assive deficit for
November of $19.2 billion (Chart 2). Several days later,
S e creta ry B aker and o th e r A d m in is tra tio n o ffic ia ls
commented that special and temporary factors distorted
the figures for November and that some of these factors
could also influence December trade flows, which might
show a sim ilarly large gap.
The preliminary November trade figures were a severe
disappointm ent to the market. They dispelled the belief
that a favorable shift in U.S. trade perform ance had
begun and cast an even more pessim istic shadow on

Table 2

Drawings and Repayments by Foreign Central Banks under Regular Reciprocal Currency Arrangements
In millions of dollars; drawings ( + ) or repayments ( - )
Central Bank Drawing on the
Federal Reserve System
Bank of Mexico

Outstanding as of
November 1, 1986

November

December

January

Outstanding as of
January 30, 1987

143.4

- 66.8

-39.6
+ 61.8

-37.4

61.4

Data are on a value-date basis.

FRBNY Quarterly Review/Spring 1987
Digitized for66
FRASER

the o u tlo o k fo r econom ic grow th in the new year.
Moreover, the figures enhanced the position of those
arguing th at the U nited S tates needed to take an
aggressive approach to improving its trade position. The
debate on trade policy gained new attention with the
reopening of Congress early in January. Against this
background, statem ents attributed to several U.S. o ffi
cials were interpreted by m arket participants as being
consistent with the view that the United States now wel
comed a lower dollar. By the start of the new year, market
sentiment towards the dollar had turned clearly bearish, and
dollar rates moved sharply lower—to DM 1.92 and Y 158,
down more than 5 percent and 3 percent since midDecember against the mark and the yen, respectively.
In early January, the selling of dollars against the
mark subsided tem porarily as the market focused its
attention on a rapidly changing situation within the EMS
(Chart 3). As the mark was rising against the dollar and
emerging at its top intervention lim it within the EMS
arrangement, some other EMS currencies were being
weakened by concerns about underlying com petitive
ness and the s u sta in a b ility of balance of paym ents
p o s itio n s . E a rlie r, m a rk e t p a rtic ip a n ts had w id e ly
assumed that no adjustment of EMS parities would take
place before national elections in Germany in late Jan
uary. But as pressures within the EMS intensified and
intervention to preserve existing parities ballooned, the
prospect of an earlier realignment developed. During the
first weekend in January, press comm entary suggested
that the German authorities would accept an immediate
realignm ent rather than face several weeks of massive
intervention which might undermine the Bundesbank’s
efforts to maintain control over m onetary growth. The
next week, the EMS currencies were caught up in a
speculative whirlwind as residents of EMS countries
other than Germany sought to hedge their mark com
m itm e n ts . The EMS e x c h a n g e rate s tru c tu re w as
maintained by intervention until the January 10 weekend

Chart 3

T e n s io n s w ith in th e EMS in c re a s e d in
N o v e m b e r and D e c e m b e r, p ro m p tin g a
re a lig n m e n t o v e r th e Ja n u a ry 10 w e e k e n d .
Percent*

14 21 28 5
Nov
1986

12 19
Dec

16 23
Jan
1987

Weekly averages of 9 a.m. rates in New York for the
weeks ending on dates shown.
* Percentage deviation of each currency from its ECU
central rate. Dotted lines correspond to the System’s
2'/4 percent limit on movement from bilateral central
exchange rates for all participating currencies except
the Italian lira. The lira may fluctuate 6 percent from
its central rates against other EMS currencies.
"f"The bilateral central rates of the German mark and
Netherlands guilder were revalued by 3 percent
and those of the Belgian franc by 2 percent against
the other participating currencies.

Table 3

Drawings and Repayments by Foreign Central Banks under Special Swap Arrangement with
the U.S. Treasury
In millions of dollars; drawings ( + ) or repayments ( - )
Central Bank Drawing
on the U.S. Treasury
Bank of Mexico
Central Bank of Nigeria

Amount of
Facility

Outstanding as of
November 1, 1986

November

December

January

Outstanding as of
January 30, 1987

273.0

144.0

-67 .0

-39 .8
+ 62.0

-3 7 .6

61.6

37.0

22.2

-14 .8

7.4

Data are on a value-date basis.
*No facility.

FRBNY Quarterly Review/Spring 1987

w hen a re a lig n m e n t w as agreed upon. A fte r the
realignment, reflows out of marks back into other EMS
currencies were slow to m aterialize.
Once the EMS realignm ent was over, traders per
ceived the Bundesbank as unlikely to intervene in dol
lars to prevent movements in dollar exchange rates from
aggravating EMS strains. Thus, the dollar came under
sharp selling pressure when trading resumed following
the realignment, pressure that was to continue for most
of the rest of the month (Chart 4).
Selling of dollars against yen also built up rapidly.
With the dollar below Y 160 against the yen, market
participants questioned whether the Baker-Miyazawa
accord would indeed assure exchange market stability.
Finance Minister Miyazawa and Bank of Japan Governor
Sumita were reported to have made it known, in order
to reassure the markets, that the Japanese central bank
would intervene to prevent the dollar from depreciating
further, almost regardless of cost. At the same time,
m arket p a rticip a n ts com m ented that th ere w ere no
similar statements by U.S. officials. On January 13, after
the dollar broke through Y 158, Japanese exporters
rushed to sell dollars, and Japanese investment houses
and pension funds flooded the market with forward sales
to hedge their dollar exposures. The dollar declined by
more than 1 percent against the yen that day in heavy
trading. The Japanese press reported that the Bank of
Japan had bought huge amounts of dollars. Traders
interpreted the report as indicating that the pressure on
the dollar was so strong that official intervention without
the participation of the U.S. authorities would fail.
Against this background, a news report on January
14, citing an unidentified U.S. official as stating that the
U.S. Administration wanted the dollar to decline further,
unleashed new selling of dollars against both the mark
and the yen. The dollar fell by more than 3 percent
against both currencies in a few hours of extrem ely
nervous trading.
The dollar’s decline continued throughout most of
January as strong selling pressure mounted on three
additional occasions. Each occurred in response to
various statements, attributed to Administration officials,
that m arket participants believed reflected a continuing
lack of official concern about the dollar’s decline. The
dollar hit a post-World War II low of Y 149.98 against
the yen on January 19, and a seven-year low of DM
1.7675 against the mark on January 28.
On January 21, a consultation between Secretary
Baker and Finance Minister Miyazawa resulted in a joint
statement that, among other things, reaffirmed their
willingness to cooperate on exchange rate issues. When
the dollar moved down on the morning of January 28,
after the President’s State of the Union Message, U.S.
authorities intervened in yen, in a manner consistent

FRBNY Quarterly Review/Spring 1987

C h a rt 4

D u rin g th e s e c o n d h a lf o f th e p e rio d
u n d e r re v ie w , th e d o lla r m o ve d
s h a rp ly lo w e r.
Percent *

Percentage change of weekly average rates from the
week ending August 1, 1986. All figures are calculated
from New York noon quotations.

Table 4

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

Period
November 1, 1986January 30, 1987
Valuation profits and losses on
outstanding assets and liabilities
as of January 30, 1987
Data are on a value-date basis.

Federal
Reserve

United States
Treasury
Exchange
Stabilization
Fund

+ 8.0

+ 6.6

+ 2,322.8

+ 1,975.0

other countries were, by contrast, below late November
levels, especially in Germany after the Bundesbank
announced on January 22 cuts of 1/2 percentage point
in its discount and Lombard rates to 3 percent and 5
percent, respectively, effective January 23, in conjunc
tion with other monetary policy measures.
Thus, the dollar firmed from its lows against both the mark
and the yen to close the period at DM 1.8320 against
the mark and Y 153.70 against the yen. As measured
by the Federal Reserve Board’s trade-w eighted index,

Chart 6

In te re s t d iffe r e n tia ls fa v o r in g th e d o lla r
have te n d e d to n a rro w th ro u g h m o s t o f
th e p e rio d s in c e e a rly 1 9 8 5 . . .
Percent
1

U.S.
-----

with the joint statement. Operating in coordination with
th e J a p a n e s e m o n e ta ry a u th o r itie s , th e F o re ig n
Exchange Trading Desk purchased $50 million against
the sale of yen, financed equally by the Federal Reserve
and the U.S. Treasury.
During the final days of the month, pressures against
the d o lla r su bside d. R eports of the U .S .-Ja pa ne se
intervention operation and talk of an upcoming meeting
of financial authorities of the m ajor industrial countries
encouraged expectations for broader cooperation on
e xchange rate and econom ic policy m atters. Also,
release of prelim inary U.S. trade data for December,
showing a much sm aller deficit of $10.7 billion, and a
substantial downward adjustment in the revised data for
November revived the view that the U.S. trade deficit
had stabilized (Chart 5).
Moreover, doubts had developed about the future
course of U.S. interest rates. The swift decline in dollar
exchange rates raised questions in the market whether
the Federal Reserve would let short-term rates ease.
Market participants also noted that U.S. market interest
rates had not co m p le te ly fa lle n back to the levels
prevailing before year-end (Chart 6). Interest rates in

Japanese y e n ^ y

ollars

Chart 5
^*-*G e rm a n marks

>■
LLI

\
V
\

1 1.1 1 I I

FMAMJ J ASO NDJ
1985

Billions of U.S. dollars

5 --------------------------------------------------------------

"*Vs*

A t th e end o f Ja n u a ry, th e tra d e d e fic it
re p o rte d fo r D e c e m b e r w as n a rro w e r
th a n e x p e c te d and th e re v is e d N o ve m b e r
s h o rtfa ll w as re d u c e d .

i r r r r f n

11 r

* i

F M A M J J A S O N D J
1986
1987

Trade balance*
^ Revised

O - i ----------------------- ---------------- ------- ---------------- —

. . . b u t h a ve w id e n e d d u rin g th e p e rio d
u n d e r re v ie w .

| Preliminary
---------------- —

-----------------p

Percent
7.0-------------------------------------------------------------------- ---------------U.S. dollars
6.5

-5

6.0
-

10-

5.5
5.0

-15
4.5

Aug Aug

Sep

♦ Census data.

Oct
1986

Nov

Dec

Sep

Oct
1986

Nov

Dec

Jan
1987

The two panels show interest rates for three-month
Eurocurrency deposits, monthly averages on the top
and weekly averages on the bottom.

FRBNY Quarterly Review/Spring 1987

it had declined 9 percent since the beginning of the
three-month period.
*

At the beginning of the three-month period, Mexico
and Nigeria had drawings outstanding on short-term
financing facilities of the U.S. Monetary Authorities.
Mexico. As noted in the previous report, $850 million
of a $1.1 billion multilateral near-term contingency
support facility for Mexico’s international reserves was
made available jointly by the U.S. Monetary Authorities,
the Bank for International Settlements (acting for certain
central banks), and the central banks of Argentina,
Brazil, Colombia, and Uruguay on August 29. On that
date, the Central Bank of Mexico drew $211 million from
the U.S. Treasury through the Exchange Stabilization
Fund (ESF) and $210.2 million from the Federal
Reserve through its regular swap facility with the Bank
of Mexico. As of November 1, $144 million was out
standing from the drawings on the ESF and $143.4
million was outstanding from the drawings on the Fed
eral Reserve. The Central Bank of Mexico repaid its
August 29 drawings from the ESF and the Federal
Reserve in three installments starting on November 26,
liquidating them by January 5.
On December 8, after Mexico received disbursements
under loans from the International Bank for Recon
struction and Development, the Central Bank of Mexico
became eligible to draw the remaining $250 million
under the multilateral facility. On this date, Mexico drew
$62 million from the ESF and $61.8 million from the
Federal Reserve. On January 5, the Central Bank of
Mexico repaid the ESF and the Federal Reserve each
$0.4 million in connection with its other repayments,
leaving $61.6 million outstanding on its December

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FRBNY Quarterly Review/Spring 1987

drawing from the ESF and $61.4 million outstanding on
its drawing from the Federal Reserve at the end of the
period. After the period closed, Mexico fully liquidated
these outstanding commitments.
Nigeria. At the beginning of the period, Nigeria had
a $22.2 million swap drawing outstanding from a $37
million short-term facility provided by the ESF. This
facility was part of a $250 million short-term credit
facility organized under the leadership of the Bank of
England. The Central Bank of Nigeria repaid $7.4 million
on November 28 and the remaining $14.8 million on
December 10.
*

In the period from November 1 through January 30,
the Federal Reserve and ESF realized profits of $8
million and $6.6 million, respectively. As of January 30,
cumulative bookkeeping or valuation gains on out
standing foreign currency balances were $2,322.8 mil
lion for the Federal Reserve and $1,975 million for the
Treasury’s ESF. These valuation gains represent the
increase in the dollar value of outstanding currency
assets valued at end-of-period exchange rates, com
pared with the rates prevailing at the time the foreign
currencies were acquired.
The Federal Reserve and the ESF invest foreign
currency balances acquired in the market as a result
of their foreign operations in a variety of instruments
that yield market-related rates of return and that have
a high degree of quality and liquidity. Under the authority
provided by the Monetary Control Act of 1980, as of
January 30, the Federal Reserve held $3,103.6 million
equivalent in securities issued by foreign governments.
As of the same date, the Treasury held the equivalent
of $4,265.5 million in such securities.

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FRBNY Quarterly Review/Spring 1987