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Federal
Reserve Bank of
New York
Quarterly Review
Spring 1991
1
Volume 16 Number 1
The Banking-Commerce Controversy Revisited
14
The Effect of Imports on U.S.
Manufacturing Wages
27
The Shifting Composition of U.S.
Manufactured Goods Trade
38
Factors Affecting the Com petitiveness of
Internationally Active Financial
Institutions
52
M onetary Policy and Open Market
Operations during 1990
79
In Brief: Japanese Banks’ Customers in the
United States
83
In Brief: Another View of the Underpricing
of Initial Public Offerings
Federal Reserve Bank of New York
Quarterly Review
Spring 1991 Volume 16 Num ber 1
Table of Contents
1
The Banking-Commerce Controversy Revisited
E. Gerald Corrigan
Statement by the President of the Federal Reserve Bank of New York before
the Subcommittee on Telecommunications and Finance of the House
Committee on Energy and Commerce, April 11,1991.
14
The Effect of Imports on U.S. Manufacturing Wages
David Brauer
U.S. imports of manufactured goods increased rapidly between 1975 and
1985. During the same period, real wages of U.S. manufacturing workers
stagnated. The author investigates whether the increased competition
from imports affected earnings within industries and contributed to the
sluggish growth of aggregate manufacturing wages.
27
The Shifting Composition of U.S. Manufactured Goods Trade
Susan H ickok
Finished goods are claiming an increasing share of U.S. imports, while
their share of U.S. exports has remained virtually unchanged in recent
years. These divergent developments may suggest some erosion of the
United States’ traditionally strong competitive position in the production of
finished goods. The author examines the factors underlying shifts in our
trade composition and the implications of recent trends for the nation’s
trade outlook and competitiveness.
38
Factors Affecting the Competitiveness of Internationally Active
Financial Institutions
Beverly Hirtle
The author identifies the characteristics of banks and securities firms that
appear to contribute to competitive success in the international arena. She
bases her findings on studies of several bank product markets and a
statistical analysis of the performance of fifty-one large financial institu
tions. Particular attention is given to the ways in which success in individual
product markets translates into overall profitability.
Table of Contents
52
Monetary Policy and Open Market Operations during 1990
Adapted from a report prepared by the Open Market Group of the Federal
Reserve Bank of New York and submitted to the Federal Open Market
Committee by Peter D. Sternlight, Manager for Domestic Operations of the
System Open Market Account.
79
In Brief: Japanese Banks’ Customers in the United States
Rama Seth and A licia Quijano
Foreign banks in the United States are often thought to specialize in
providing services to multinational firms from their home countries. This
article examines data on Japanese bank loans and the liabilities of
Japanese-owned firms to determine whether the increase in Japanese
bank assets in the United States during the 1984-89 period can be
attributed to growth in direct investment from Japan.
83
In Brief: Another View of the Underpricing of Initial Public Offerings
Judith S. Ruud
How should high average initial returns on new public offerings of common
stocks be interpreted? The usual view is that such offerings are inten
tionally underpriced. This study draws on previously neglected information
about return distributions and market practice to advance a different
explanation for the high average returns.
86
New Publications from the Federal Reserve Bank of New York
87
List of Recent Research Papers
The Banking-Commerce
Controversy Revisited
Mr. Chairman, members of the Subcommittee, I am
delighted to appear before you this morning to dis
cuss— in accordance with your request— the specific
features of the Administration’s proposals to modify the
current restrictions on the ability of commercial banks to
affiliate with both securities firms and commercial
entities. Because it is more controversial and because it
has more far-reaching implications, I shall concentrate
much of my prepared statement on the so-called banking-commerce question.
I should say at the outset that while I do have some
differences of view with the Treasury on a few specific
points— including the banking and commerce ques
tion— I enthusiastically applaud the efforts of Secretary
I very much share the view of the Treasury and
the President that these [financial system] issues
are a high priority on the national agenda for 1991,
and I support the thrust of the great bulk of the
approach suggested by the Treasury.
Brady and his associates at the Treasury to put before
the Congress and the nation a truly comprehensive
approach to reforming and modernizing the banking and
financial system in the United States. Unless this task is
successfully completed— and completed soon— I fear
we face renewed and more intense stress in our finanStatement by E. Gerald Corrigan, President of the Federal Reserve
Bank of New York, before the Subcommittee on Telecommunications
and Finance of the House Committee on Energy and Commerce,
April 11, 1991.
cial system, with all of its implications for strains in the
economy at large and a further deterioration in the
international competitive position of U.S. financial insti
tutions. Thus, I very much share the view of the Trea
sury and the President that these issues are a high
priority on the national agenda for 1991, and I support
the thrust of the great bulk of the approach suggested
by the Treasury.
In part I welcomed this invitation to appear before the
Subcommittee because it provided me with an opportu
nity to take a step back and reconsider my personal
views on whether the separation of banking and com
merce should be continued. In preparing this statement
I have gone to considerable lengths to give the benefit
of the doubt to the arguments for permitting commercial
firms to control banks. But the more I analyze the issue,
I have gone to considerable lengths to give the
benefit of the doubt to the arguments for
permitting commercial firms to control banks. But
the more I analyze the issue, the more I am sure
that it would be a huge mistake to eliminate the
barriers Congress has constructed between
banking and commerce.
the more I am sure that it would be a huge mistake to
elim inate the barriers Congress has constructed
between banking and commerce.
Basic reform of the system is needed and needed
badly. At the very least, we should put those reforms in
place and permit them to run their course before we
FRBNY Quarterly Review/Spring 1991
1
give any further consideration to permitting commercial
firms to own and control banking institutions having
access to the public safety net.
This statement is organized and presented in eight
sections as follows:
Definition of t e r m s .....................................................
2
International e xp erien c e ...........................................
4
A brief history of banking and
commerce ................................................................
4
The arguments for combining
banking and commerce .......................................
6
The risks associated with combining
banking and commerce .......................................
7
Balancing the risks and the b en e fits .....................
9
Combinations of banking and
securities fir m s ........................................................ 12
S u m m a ry ...................................................................... 13
The text of this statement is obviously very lengthy. I
apologize for that, but its length reflects the fact that the
mixing of banking and commerce raises many very
substantive questions, some of which are quite subtle.
Concern about these issues is reflected in the wide
spread present-dav prescriptions against such combi
nations in the international community as well as in a
long-standing Anglo-American caution about such
arrangements that reaches back some three hundred
years.
The bottom line of the statement is, however, quite
clear. I remain opposed to combinations of
commercial and banking organizations.
The bottom line of the statement is, however, quite
clear. I remain opposed to combinations of commercial
and banking organizations because (1) when firewalls
are needed most, they will not work; (2) it is inevitable
that at least parts of the supervisory system— if not the
safety net— will be extended to commercial owners of
banks; (3) the risks of concentration of economic
resources and power are great; and (4) the potential
benefits that might grow out of banking-commercial
combinations strike me as remote at best and illusory at
worst, at least under present circumstances.
Definition of terms
One of the immediate problems that must be confronted
in the debate on banking-commerce is the need for a
consistent definition of terms within which the debate
can be framed. The crucial issue is not whether a
manufacturing firm or a retail firm may own or control a
company that engages in financial services or even
2 FRBNY Quarterly Review/Spring 1991
whether an industrial company directly engages in the
provision of financial services. Rather, the core ques
tion— in the context of other problems associated with
banking-commercial combinations— is whether such a
business entity should be permitted to own and control
The core question ... is whether such a business
entity should be permitted to own and control
financial institutions that, in turn, have direct or
indirect access to the federal safety net
associated with banking institutions.
financial institutions that, in turn, have direct or indirect
access to the federal safety net associated with banking
institutions.
It follows, therefore, that we must have a clear con
ception of what we mean by the terms “control” and
“safety net.” The dictionary definition of “control” is a
useful starting point in that it stipulates that control
means the “power or authority to guide or manage.” But
even that definition is only a starting point because we
all know that in the day-to-day world of corporate affairs
it is not always easy to pinpoint the circumstances in
which financial or other arrangements produce the
result of “control.” Fortunately, however, there is a longestablished body of banking law and administrative rul
ings that helps clarify that ambiguity. That history tells
us that control is presum ed to exist when ownership
exceeds 24.9 percent and that control m ay exist when
ownership is far less than 24.9 percent. Control is
presumed not to exist when ownership is less than 4.9
percent. These parameters strike me as a very reason
able range within which the debate can be framed.
The definition of the safety net is rather straight
forward, even though the precise application of that
definition to particular cases can be difficult. For these
purposes, a financial firm may be said to have access to
the safety net if it, directly or indirectly, has deposit
insurance, has access to the discount window of the
central bank, has access to the account and payment
services of the central bank, and is subject to official
supervision. The ambiguity that can arise in the appli
cation of this definition centers on two main points: first,
whether the distinction between direct versus indirect
access to the safety net matters; second, whether con
cerns about access to the safety net apply equally to all
of its components or whether one or more elements,
such as deposit insurance and access to the discount
window, take on special significance in particular appli
cations of the definition.
While the specifics may vary from country to country,
the de facto presence of an official safety net for banks
is universal. The mere presence of a safety net implies
something of a covenant between those institutions that
are the beneficiaries of the safety net and the society at
large. Under the terms of that covenant, the affected
institutions agree to conduct their affairs in a safe and
impartial manner. As a part of that covenant, such
institutions are subject to official regulation, the burden
and costs of which are accepted in exchange for the
privileges and protections afforded by the safety net.
Looked at in this light, one of the key problems facing
banking and other financial institutions is that technol
ogy and other forces have fundamentally altered the
historic balance between the burdens of regulation and
One of the key problems facing banking and other
financial institutions is that technology and other
forces have fundamentally altered the historic
balance between the burdens of regulation and the
protections and privileges afforded by the safety
net. We see this quite vividly in the diminished
value of the banking franchise.
the protections and privileges afforded by the safety
net. We see this quite vividly in the diminished value of
the banking franchise.
All of this brings into sharp focus the question why all
nations have a safety net and regulated financial institu
tions in the first place. In other words, why don’t we
simply treat banks and other financial institutions the
same way we treat gas stations and furniture stores?
The fundamental answer to that question lies in the
essential functions that banking institutions perform.
That is, in the context of market economies, the tasks of
mobilizing savings, channeling those savings into the
most productive uses, and providing the means through
In the context of market economies, the tasks of
mobilizing savings, channeling those savings into
the most productive uses, and providing the
means through which payment is made are seen
as having such unique economic and fiduciary
importance as to justify both regulation and the
safety net.
which payment is made are seen as having such unique
economic and fiduciary importance as to justify both
regulation and the safety net. For example, since these
institutions can perform these functions only with some
one else’s money, and because the risks inherent in the
performance of these functions are so obvious, all
nations take at least some steps to protect depositors
and investors and to regulate some aspects of the credit
origination process.
But such protections, important as they are, cannot
fully explain the nature of the safety net arrangements
in this country, to say nothing of arrangements in other
countries that often go farther in protecting financial
institutions and their customers than is the case in the
United States. The missing link is, of course, what
central bankers and others call “systemic risk.” By sys
temic risk I mean the clear and present danger that
problems in financial institutions can quickly be trans
mitted to other institutions or markets, thereby inflicting
damage on those other institutions, their customers,
and ultimately the economy at large. More than anything
else, it is the systemic risk phenomenon associated
with banking and financial institutions that makes them
different from gas stations and furniture stores. It is this
More than anything else, it is the systemic risk
phenomenon associated with banking and
financial institutions that makes them different
from gas stations and furniture stores. It is this
factor— more than any other— that constitutes the
fundamental rationale for the safety net
arrangements that have evolved in this and other
countries.
factor— more than any other— that constitutes the fun
damental rationale for the safety net arrangements that
have evolved in this and other countries.
Looked at in this light, it seems to me very clear that
a society should care, and care a lot, about who it is
that controls financial institutions that have access to
the safety net. By the same token, I would concede that
those public policy concerns are not similarly present in
a situation in which an auto manufacturing company or
a retailer has a financial subsidiary, so long as neither
the auto company nor anyone else has any illusions
that it or the financial subsidiary has access to the
safety net. Admittedly, I can imagine circumstances in
which the sudden and uncontrolled failure of a major
financial subsidiary of a manufacturing company could
pose significant problems for financial markets and
financial institutions more generally. Similarly, I must
also admit that the competitive presence of financial
subsidiaries of commercial firms— even when operating
wholly outside the safety net— has been a factor in
undermining the value of the franchise of banks. This
may be especially true when the terms of credit or other
transactions with the financial subsidiary are heavily
subsidized by the parent company.
All of that notwithstanding, the banking-commerce
FRBNY Quarterly Review/Spring 1991
3
question does not stand or fall on whether commercial
firms can provide financial services; it does not even
stand or fall on the presence or absence of the Bank
Holding Company Act. The key question is whether we,
as a society, should care about who owns and controls
The banking-commerce question does not stand or
fall on whether commercial firms can provide
financial services__ The key question is whether
we, as a society, should care about who owns and
controls banking institutions that have access to
the safety net.
banking institutions that have access to the safety net
and the terms and conditions— if any— under which
such arrangements should be permitted.
International experience
Impressions to the contrary, examples in other major
countries in which commercial firms control banking
firms (recognizing that in most countries banking and
securities firms are one and the same) are very much
the exception rather than the rule. In fact, I am not
aware of a single example in which such a pattern of
ownership would apply to a major banking institution,
and I can think of only a limited number of cases in
which it would apply at all, even though there may very
well be some examples that I am not acquainted with.
Having said that, I will quickly state that (1) there are
cases abroad in which banks own large stakes in com
mercial firms; (2) there are many countries in which
banks have greater flexibility in the scope of their rela
tionships with commercial firms than is the case in the
United States; and (3) there are countries where, as a
general matter, ownership interests in banks and
corporations generally are not as widely distributed as
is the typical case in the United States. But commercial
control of banking institutions having access to the
safety net is by far the exception, not the rule, even
though in a number of countries, including the United
Kingdom and Germany, the absence of commercial
control of banks occurs by practice and tradition rather
than as a matter of strict legal prohibition.
While on this subject of statutory arrangements
abroad, I find it interesting that within the very recent
past we have had two important countries— Italy and
Mexico— that have had experience with commercial and
banking combinations, and have enacted sweeping new
legislation strictly precluding commercial firms from
controlling banks in the future. In the case of Italy,
ownership of banks in excess of 5 percent is subject to
approval by the Bank of Italy, and in no case can a
4 FRBNY Quarterly Review/Spring 1991
single owner’s holdings exceed an absolute ceiling of
15 percent. Mexico’s new law limits ownership to 5
percent, with an absolute ceiling of 10 percent.
The point of this, of course, is that if the United States
were to authorize commercial firms to control banking
institutions having access to the safety net, we would
be alone among the major countries of the world in
If the United States were to authorize commercial
firms to control banking institutions having access
to the safety net, we would be alone among the
major countries of the world in permitting such
arrangements.
permitting such arrangements. Perhaps being alone in
that regard should not bother us. But on the other hand,
perhaps experience around so much of the rest of the
world is telling us something.
A brief history of banking and commerce
Those who favor permitting banking-commercial combi
nations here in the United States often point out that
over the broad sweep of the financial history of the
United States we have had noteworthy examples of
commingling banking and commercial activities. How
ever, such examples are the exception, not the rule.
Moreover, the full history of banking in the Anglo-Ameri
can tradition seems quite clearly to point to a public
policy bias against such combinations.
The history of the banking-commerce issue over most
of the eighteenth and nineteenth centuries must be
Much of the earlier debate about the bankingcommerce issue did not center squarely on the
issue of who should be allowed to own banks.
Rather, it centered on the extent to which the
charter of banking corporations would permit such
an institution to engage in a broad range of
activities.
viewed in the context of prevailing legal and business
practices. For example, for most of that period, the
corporate form was in a state of evolution as a natural
outgrowth of the early and more mature stages of the
Industrial Revolution. Thus, most corporations were
chartered by some political jurisdiction to perform spec
ified functions. Partly for that reason, much of the ear
lier debate about the banking-commerce issue did not
center squarely on the issue of who should be
allowed to own banks. Rather, it centered on the extent
to which the charter of banking corporations would
permit such an institution to engage in a broad range of
activities, including activities that in today’s terminology
would fit squarely on the “commercial” side of the
ledger.
While there surely were examples in which banking
and commercial activities were authorized in the same
business entity, there is ample evidence that such com
binations were viewed with concern as a matter of broad
public policy. For example, when the Bank of England
was chartered by the British Parliament in 1694, the
chartering act contained a clear prohibition against the
bank engaging in commerce. Specifically, the act
provided:
And to the intent that their Majesties’ subjects
may not be oppressed by the said corporation by
their monopolizing or engrossing any sort of goods,
wares or merchandise, be it further declared ... that
the said corporation ... shall not at any time ... deal
or trade ... in the buying or selling of any goods,
wares or merchandise whatsoever.
Almost one hundred years later, Alexander Hamilton
drafted the chartering legislation of the Bank of the
United States, which was enacted on February 25,
1791. Hamilton’s model for the Bank of the United
States was influenced importantly by the charter of the
Bank of England, and it contained similar restrictions.
Specifically, Section 7, Article X reads:
The said corporation ... shall not be at liberty to
purchase any public debt whatsoever; nor shall it
directly or indirectly deal or trade in any thing,
except bills of exchange, gold or silver bullion, or in
the sale of goods really and truly pledged for money
lent and not redeemed in due time; or of goods
which shall be the produce of its lands.
Moreover, Section 8 states:
And be it further enacted, that if the said corpora
tion, or any person or persons for or to the use of
the same, shall deal or trade in buying or selling
any goods, wares, merchandise, or commodities
whatsoever, contrary to the provisions of this act,
all and every person and persons, by whom any
order or direction for so dealing or trading shall
have been given, and all and every person and
persons who shall have been concerned as parties
or agents therein, shall forfeit and lose treble the
value of the goods, wares, merchandises, and com
modities, in which such dealings and trade shall
have been.
In drafting the charters of each Bank of the United
States, Congress was sensitive to issues relating to
ownership of banks. No individual or partnership could
own more than 4 percent of the shares of the First
Bank. No individual, company, or corporation could hold
more than 0.875 percent of the shares of the Second
Bank.
In the period immediately after the chartering of the
Banks of the United States, there were some cases in
which banking and commercial entities or activities
were commingled. Yet, in a number of states and in the
charter of the Second Bank of the United States
enacted in 1816, the stipulations against such combina
tions of activities were retained.
Concerns about commingling banking and commer
cial activities were again recognized in the National
Banking Act of 1864, which stipulated that nationally
chartered banks would be limited to exercising “such
incidental powers as shall be necessary to carry on the
business of banking." Interpreting this phrase narrowly,
the courts subsequently ruled that it would be “ultra
vires” (beyond the proper scope or in excess of legal
authority) for a bank to carry on a mining, manufactur
ing, or trading business; to engage in the buying or
selling of cattle; or to operate a railway.
While the issues associated with the commingling
of banking and commercial activities were very
much a part of banking history in the last two
centuries, it was not until this century that the
question of commercial ownership of banks was
joined.
While the issues associated with the commingling of
banking and commercial activities were very much a
part of banking history in the last two centuries, it was
not until this century that the question of commercial
ownership of banks was joined. The ownership issue
began to surface in the legislative debate surrounding
the enactment of the Clayton Act. However, it was not
until the late 1930s that the debate in today's terms
really took shape. In that time frame, the Federal
Reserve Board, among others, began to call for legisla
tion that would curb the growing practice of commercial
firms owning banks— a trend that was (perhaps iron
ically) taking hold in part to save banks from the reper
cussions of the depression.
The efforts that began in the late 1930s culminated
with the passage of the Bank Holding Company Act of
1956. The 1956 act’s major restrictions applied only to
companies controlling two or more banks. However, in
response to the subsequent growing importance and
scope of the one-bank holding companies, the 1970
amendments to the act closed the so-called one-bank
loophole, although a similar loophole for so-called uni
tary thrifts was left in place and remains to this date.
Much of the legislative debate about the 1970 amend-
FRBNY Quarterly Review/Spring 1991
5
merits to the act centered on the distinction between
corporate “conglomerates” and “congeneric” corpora
tions. The result of the conglomerate/congeneric debate
was the adoption of a limited congeneric proposal—
bank holding companies could engage in activities
“closely related to banking.” Companies engaged in a
broader range of activities had a ten-year temporary
grandfather period to divest themselves of either their
For the greater part of this nation’s existence, the
fact that commercial firms did not own and control
banks, with some exceptions, was the generally
accepted state of affairs.
banks or their impermissible nonbanking activities.
To summarize briefly, for the greater part of this
nation’s existence, the fact that commercial firms did
not own and control banks, with some exceptions, was
the generally accepted state of affairs. Beginning in the
1930s, commercial firms began to acquire smaller
banks. This growing tendency was dealt with in federal
legislation in 1933, 1965, and 1970, but the matter was
not fully laid to rest. Now that we are at a watershed in
terms of the structure of our financial system, we once
again have an opportunity to get it right.
The arguments for combining banking and
commerce
While contemporary experience around much of the
industrial world and the history of banking in the AngloAmerican tradition would, taken by themselves, seem to
constitute sufficient grounds to go slowly in moving
toward permitting commercial firms to control banks,
neither that history nor those global practices constitute
necessary or sufficient reason to reject banking-com
mercial combinations out of hand.
Indeed, in a market economy— especially one such
as the United States that is so deeply rooted in the
tradition of freedom and entrepreneurial enterprise—
there is a strong philosophical bias toward permitting
any institution the right to go into any business, includ
ing banking. On the other hand, the very essence of
public policy has its roots in the central proposition that
the common good can dictate circumstances in which
individual prerogatives must be limited. It was precisely
this line of reasoning that led Adam Smith to the conclu
sion that banking had to be regulated when, in The
Wealth o f Nations, he wrote:
Such regulations may, no doubt, be considered
as in some respect a violation of natural liberty. But
those exertions of the natural liberty of a few indi
viduals, which might endanger the security of the
Digitized for
6 FRASER
FRBNY Quarterly Review/Spring 1991
whole society, are, and ought to be, restrained by
the laws of all governments; of the most free, as
well as of the most despotical. The obligation of
building party walls, in order to prevent the commu
nication of fire, is a violation of natural liberty,
exactly of the same kind with the regulations of the
banking trade which are here proposed.
Against this background I, for one, do not feel apolo
getic in taking the position that the case fo r permitting
commercial firms to control banking institutions should
be based on some affirmative public policy reasons to
I, for one, do not feel apologetic in taking the
position that the case for permitting commercial
firms to control banking institutions should be
based on some affirmative public policy reasons
to take this step.
take this step. In those circumstances, I think it only
reasonable to ask: first, why would commercials firms
want to control banking institutions; second, what public
policy ends would be served by such arrangements;
and third, how credible are the safeguards against
abuse, recognizing that even the most ardent of the
proponents accept the fact that such safeguards are
necessary?
As to the first of these questions, namely, why would
commercial firms want to control banking organizations,
I can see several possibilities: First, the commercial
firm may conclude that the rate of return on such invest
ments is greater than is available on alternative invest
ments. Second, the commercial firm may conclude that
such investments provide a vehicle to diversify its cash
flow and/or its profits. Third, the commercial firm may
see synergies between its basic business and one or
more aspects of the banking business. Fourth, the com
mercial firm may see advantages in having indirect
access to one or more elements of the safety net. While
it is never stated, I must confess that I wonder at times
if another motivation for such combinations might not be
a desire on the part of some firms to further leverage
their own capital position.
In considering the question why commercial concerns
might wish to make investments in banks, it is important
to keep in mind that any commercial firm can make
sizable passive investments in one or more banking
institutions under existing laws and regulations. Simi
larly, such passive investments could easily provide
major elements of income diversification. On the other
hand, if control is sought or achieved, or if the invest
ment is motivated by perceived synergies or by a desire
to gain indirect access to the safety net, then it must
follow that concerns about conflicts of interest, unfair
competition, concentration, and the extension of the
safety net m ust be present, even if differences of opin
ion exist as to the nature and depth of those concerns.
If control is sought or achieved, or if the
investment is motivated by perceived synergies or
by a desire to gain indirect access to the safety
net, then it must follow that concerns about
conflicts of interest, unfair competition,
concentration, and the extension of the safety net
must be present.
Indeed, to my knowledge, all of the proponents of
blending banking and commerce recognize that the
potential for such problems is present when control of
the bank exists. However, in the face of those concerns,
the argument is made that allowing such combinations
will provide important public benefits that— given appro
priate safeguards and firewalls— will more than com
pensate for the risks. The most important public benefit
that is cited in this regard is that such arrangements
would provide a needed source of fresh capital to the
banking system or to individual banks. It is also sug
gested— though not as forcefully— that commercial
ownership of banking organizations will provide, pre
sumably through synergies, greater innovations and
efficiencies that will lower costs for financial services to
their end users. Finally, it is suggested— drawing on the
experience in countries like Germany and Japan— that
close linkages between banks and commercial firms will
promote greater economic stability.
Regardless of how much weight one puts on the
potential benefits associated with permitting commer
cial firms to control banks, virtually everyone acknowl
edges that such arrangements must be accompanied
by strong regulatory safeguards to protect against
potential abuse. While the list of existing or suggested
safeguards or firewalls is long, in generic terms they fall
into three major categories: first, limits on which banks
can be acquired by which commercial firms; second,
various firewalls that limit transactions and/or interac
tion between the bank and its commercial owner; and
third, various arrangements whereby the authorities can
force a commercial owner of a bank to take certain
actions— including divestiture— in the event the bank is
in jeopardy.
In considering the merits of any or all firewalls, it is
important to keep several things in mind: First, firewalls
by their nature must limit synergies. Thus, the higher
and thicker the firewall, the less the synergy. Indeed, if
the firewalls are fail-safe, the synergies must all but
disappear. Second, firewalls by their nature seem incon
sistent with the essence of control. If, to use the diction
ary definition, the “power or authority to guide or man
age” is present, it is very hard to conceive of conditions
in which firewalls can be said to be fail-safe. Third, the
acid test of firewalls arises in the context of adversity
either to the banking institution itself, a cross-stream
affiliate, or the parent. That is, in the face of serious
problems, is it reasonable to conclude, based on experi
ence, that the m arketplace— here and abroad —
The acid test of firewalls arises in the context of
adversity either to the banking institution itself, a
cross-stream affiliate, or the parent— The
obvious danger is that in times of stress, firewalls
become walls of fire!
will distinguish one entity from another within the
framework of a business conglomerate with common
ownership of the component parts? Unless one can be
quite sure of that result, the obvious danger is that in
times of stress, firewalls become walls of fire!
The risks associated with combining banking and
commerce
From a public policy perspective there are three sets of
risks associated with permitting commercial firms to
control banks. The first is the historic concern about
conflicts of interest, unfair competition, and concentra
tion. The second is the contagion risk— or the dangers
that problems in one part of an overall entity cannot, in
market terms, be contained and isolated from other
parts of the firm. The third set of risks are those sur
rounding the potential extension of the safety net— or at
least parts of it— to the firms that control the banking
organizations.
I do not believe it is necessary to elaborate in any
detail on the nature of the risks regarding conflicts,
unfair competition, or excessive concentration that can
grow out of situations in which commercial firms control
banks. The nature of those potential sources of risk has
been recognized for centuries.
While those sources of potential concern have been
widely recognized, it should be stressed that they arise
because they constitute a threat to what I like to call the
impartiality of the credit decision-making process. As
such, they go right to the heart of one of the most
important functions of banking institutions in a market
economy.
It should also be stressed that in the contemporary
world of high-speed, high-complexity finance, practices
that cross the line between potential problems and
actual problems can be very difficult to detect until it is
FRBNY Quarterly Review/Spring 1991
7
too late. This is especially true if the entity that controls
the banking organization is not itself subject to direct
official supervision or oversight. This is an important
point since I suspect that none of the advocates of
commerce and banking combinations would favor the
extension of the kind of direct and continuing supervi-
Indeed, the nature of government involvement in
business that would seem to grow out of such
arrangements [banking-commerce combinations]
would in itself seem contrary to the role of
government in a market economy.
sion of bank holding companies we now have to com
mercial owners of banking institutions. Indeed, the
nature of government involvement in business that
would seem to grow out of such arrangements would in
itself seem contrary to the role of government in a
market economy.
The second set of risks associated with banking and
commercial combinations— namely the so-called con
tagion risks— pose even more difficult problems. By
contagion risks I mean, of course, the danger that
problems in any one part of a business will adversely
affect other parts of the business despite firewalls and/
or legal separations between particular business units
within the company as a whole.
The contagion problem is, of course, multifaceted.
That is, the concern does not simply center on the
relatively narrow question of what happens if the bank
ing entity itself gets into trouble. In fact, the contagion
problem can be more difficult to cope with in a situation
in which adversity at the level of the parent impairs the
well-being of the bank.
In any of these circumstances, the important question
relates to how the marketplace and how the owners
and managers of such institutions react to adver
sity. That is, faced with adversity, do the owners and
managers walk away from troubled affiliates or do they
conclude that reputational and other considerations
require that they make efforts to stabilize the troubled
affiliate in order to protect the well-being and the repu
tation of the entity as a whole? Similarly, and even more
important, what does experience tell us about the
manner in which the marketplace reacts to these cir
cumstances? That is, in the face of serious problems in
one part of a financial entity, does the marketplace
continue to deal with the other parts of the entity on a
business-as-usual basis or do market participants shy
away from the affiliated companies as well as the trou
bled entity?
On both of these points it seems to me that the
8 FRBNY Quarterly Review/Spring 1991
evidence is overwhelming that firewalls and corporate
separateness do not stand up well in the face of adver
sity and that the contagion risks are very real indeed. It
is noteworthy in this regard that in a recent ruling
regarding the relationship between Credit Suisse and
Credit-Suisse First Boston, the Swiss Federal Supreme
Court squarely acknowledged the existence of the con
tagion problem even in the face of legal separateness.
It seems to me that the evidence is overwhelming
that firewalls and corporate separateness do not
stand up well in the face of adversity and that the
contagion risks are very real indeed.
Specifically, the court said:
The Drexel affair has shown that isolating a com
pany that was in itself solvent could not protect it
from a loss of repute. Since the insolvency of one
member of a banking and financial group leads to a
loss of confidence in the other members, the Fed
eral Banking Commission is justified in requiring
evidence that sufficient own funds [capital] are
available within the group as a whole.
This ruling by the Swiss Federal Supreme Court is
important not only because it seems to be a common
sense affirmation of what experience suggests, but also
because it tends to reflect the widespread view outside
Even if we in the United States can convince
ourselves that firewalls and legal separations can
be made to stick in any circumstances, it will
accomplish little if the international financial
community does not accept that view.
of the United States that banking and financial firms are
a single entity. This is important because even if we in
the United States can convince ourselves that firewalls
and legal separations can be made to stick in any
circumstances, it will accomplish little if the interna
tional financial community does not accept that view.
This is particularly true in a context in which all major
U.S. financial firms— and therefore the well-being of the
financial system at large— are highly dependent on for
eign counterparties for a wide range of activities—
including funding.
As I look at experience in the United States and
around the world, it seems clear to me that Walter
Wriston had it exactly right when, a number of years
ago, he said:
For example, it is inconceivable that any major
bank would walk away from any subsidiary of its
holding company. If your name is on the door, all of
your capital funds are going to be behind it in the
real world. Lawyers can say you have separation,
but the marketplace is persuasive, and it would not
see it that way.
The realities of the contagion problem give rise to the
third set of risks associated with banking and com
merce combinations, and those risks include, of course,
the dangers that such combinations bring with them the
likelihood that at least some parts of the safety net willbe extended to the commercial owner of banking institu
tions, especially in times of stress.
certain extension of an element of the safety net is not
something we should take lightly since we must be
prepared to live with its consequences in foul weather
as well as in fair.
When the potential sources of risk associated with
commercial ownership of banks are considered, there
can be honest differences of judgment about how great
and how clear and present those dangers may be. That
is why these risks and potential risks must, in the end,
be carefully weighed and balanced against the potential
benefits of banking and commercial combinations. That
is the task of the next section of this statement.
Balancing the risks and the benefits
It seems clear to me that the mere fact of
permitting commercial firms to own and control
banking organizations carries with it at least the
implicit transfer of some elements of the safety
net to such firms.
However, fully aside from situations involving severe
financial strains, it seems clear to me that the mere fact
of permitting commercial firms to own and control bank
ing organizations carries with it at least the implicit
transfer of some elements of the safety net to such
firms, if in no other way than through the official sanc
tion of the particular combination in question. For exam
ple, I assume that even the proponents of merging
banking and commerce would agree that the acquisition
of a bank by a commercial company would be subject to
some sort of official approval process. I assume they
would also agree that a part of that application process
would have to focus on the financial strength of the
acquiring firm as well as the regulatory and managerial
firewalls that they agree should be constructed. I
assume they would further agree that some such appli
cations would be approved while others would be
denied and that some form of ongoing monitoring would
be necessary. In making this point, I should emphasize
that commercial firms wishing to own banks undoubt
edly will not be limited to a few “blue chip” companies.
To the contrary, the list of p o te n tia l acquirers will
include all comers— something I am convinced we
should be especially sensitive to in this era in which the
fate of seemingly very strong companies can fall on
difficult times so very quickly and irreversibly.
Therein, of course, lies the dilemma. That is, even the
official act of approving an application of a commercial
firm to acquire a bank seems to carry with it the exten
sion of at least some elements of official oversight to
the acquiring firm in a manner that brings with it— at
least by implication— an official blessing of the transac
tion and the relationship. As I see it, this subtle but
It is clear to me that in current circumstances the weight
of the arguments against permitting commercial firms to
own and control banking institutions is very powerful on
a number of counts. While any one of these factors
seems to me persuasive, it is the cumulative weight of
all the arguments that is truly compelling:
First, when firewalls are needed the most, they
will not work. This is important not only in its own
right but also because, as mentioned earlier, every
serious proposal to permit commercial firms to own
banks depends— either implicitly or explicitly— on
the premise that firewalls are fail-safe and will stand
up in the face of stress. Not only is that premise
inconsistent with experience, but it also seems to
me to be an outright contradiction since the con
cept of control is incompatible with the concept of
fail-safe firewalls. To put it differently, control seems
inescapably to entail responsibility. To make mat
ters worse, the very instant that synergies are
If the firewalls are fail-safe, the synergies must
disappear, and if the synergies disappear, the
central economic argument that public benefits
will flow from such combinations is rendered
moot.
stipulated— either explicitly or implicitly— the con
tradiction becomes glaring. If the firewalls are fail
safe, the synergies must disappear, and if the
synergies disappear, the central economic argu
ment that public benefits will flow from such combi
nations is rendered moot.
I am not suggesting that separately capitalized
subsidiaries and firewalls (or, better stated, Chinese
walls) may not serve a useful public policy purpose.
To the contrary, such arrangements can be a very
big help in minimizing problems of potential conflict
of interest and unfair competition. They can also be
very helpful in facilitating a sensible system of func
FRBNY Quarterly Review/Spring 1991
9
tional supervision. But it would be a serious mis
take to conclude or to assume that firewalls can
protect against the contagion problem.
The marketplace views these banking and finan
cial entities as a whole; indeed, that is how these
firms typically are managed, and in many cases
their integrated nature is a feature of their advertis
ing. To believe things would somehow be different
with commercial ownership of such firms seems to
me to strain common sense and experience to the
limit. Therefore, if we have commercial ownership,
there will be an entirely new dimension to the con
tagion problem— namely, the implication for the
banking entity should there be serious problems
It is worth pondering what would have occurred in
1980 had Chrysler owned a family of banking
institutions having access to the safety net.
Similarly, what might have happened if Texaco
were in a similar position at the time of the
Penzoil litigation?
with the parent. For example, it is worth pondering
what would have occurred in 1980 had Chrysler
owned a family of banking institutions having
access to the safety net. Similarly, what might have
happened if Texaco were in a similar position at the
time of the Penzoil litigation? It is also worth keep
ing in mind that the corporate landscape is cur
rently littered with dozens of “fallen angels,” many
of which might well have owned banks in happier
times. Finally, it is also worth noting that if we go
back twenty-five or thirty years we can find exam
ples of commercial companies that were seen as
financially invincible— and thus strong candidates
to own banks— that are today a mere shadow of
their earlier profile, if that.
In short, I draw very little comfort from the track
record of firewalls, especially their reliability in
times of stress. Given that the invincibility of fire
walls would be even more important in the case of
commercial ownership of banking institutions, the
risks associated with such arrangements seem to
me entirely too great.
Second, it is inevitable that at least parts of the
supervisory system— if not the safety net— will be
extended to commercial owners of banks. Partly
because it would be so very imprudent to rely on
firewalls, permitting commercial firms to control
banks would, of necessity, entail at least some
elements of the regulatory and supervisory appa
ratus being extended to the commercial owners of
10 FRBNY Quarterly Review/Spring 1991
banks. The application process itself guarantees
that result, as does even the most subtle imposition
of a source-of-strength doctrine. Similarly, with all or
most of the capital of the bank downstreamed from
the parent, the supervisor would have to look to the
Permitting commercial firms to control banks
would, of necessity, entail at least some elements
of the regulatory and supervisory apparatus being
extended to the commercial owners of banks.
parent to see what lies behind that capital. More
generally, the enforcement of firewalls— even those
governing transactions flows— would have to entail
at least some interaction between the supervisor
and the parent. At a minimum, all of this will compli
cate the already difficult moral hazard problem. At
worst, it could entail a greatly expanded role for the
government in the affairs of corporate America— a
result that I suspect few would welcome.
But the even larger question is whether, in the
face of adversity, such combinations might result in
the de facto extension of other aspects of the safety
net to the owner of the bank. As I said earlier, the
mere fact of official sanction of some such combi
nations and the denial of others seems to carry with
it some elements of that risk. How much further that
risk might be extended in the face of serious prob
lems is hard to judge, but it seems clear to me that
the best way to avoid that risk is to avoid creating
the preconditions under which it could arise.
If we were to permit commercial firms to control
banks, it is clear that the potential dangers in
terms of concentration of economic resources and
economic power— with all of the potential
implications for compromising the impartiality of
the credit decision-making process— could be
serious indeed.
Third, the risks of concentration of economic
resources and power are great. That is, if we were
to permit commercial firms to control banks, it is
clear that the potential dangers in terms of con
centration of economic resources and economic
power— with all of the potential implications for
compromising the impartiality of the credit decision
making process— could be serious indeed. Since
this is as much a social and political issue as it is
an economic issue, I tend to shy away from placing
too much emphasis on this factor. Even though I
choose to do that in recognition of the official posi
tion I hold, I would be less than candid if I did not
acknowledge that I, too, worry about the broad
socioeconomic— and perhaps even political— impli
cations of these arrangements that have been
raised by Henry Kaufman and others.
The potential benefits that might grow out of
banking-commercial combinations strike me as
remote at best and illusory at worst, at least under
present circumstances.
It is important to keep in mind that while these
concerns may seem remote today, once we start
down the very slippery slope of combining banking
and commerce we will, in practical terms, have
already passed the point of no return. Turning back
will not be easy or cheap.
Finally, the potential benefits that might grow out
of banking-commercial combinations strike me as
remote at best and illusory at worst, at least under
present circumstances. The one possible exception
to this is the source-of-capital argument, which is
discussed further below. However, that issue aside
for the moment, the two other economic arguments
(that is, the efficiency argument and the economic
stability argument) just do not strike me as very
convincing. For one thing, both depend on syn
ergies that, as outlined earlier, collide head-on with
the firewall problem. But even if we fully ignore the
firewall issue, it seems a major leap to conclude
that commercial-banking conglomerates would, in
fact, yield sizable efficiencies. Indeed, the history
of conglomerates generally is, at best, checkered.
Again, the financial capital issue aside, the two most
obvious sources of such gains in efficiency that are
not inherently objectionable would seem to lie in
the areas of technology and managerial expertise.
However, if better or different technology or man
agement is needed, it can be acquired directly.
With regard to the economic stability argument, it
must be acknowledged that in Germany and Japan
in particular, there are closer relationships between
banking and industry than is the case in the United
States. And it must also be acknowledged that in
recent years the overall economic performance of
those two countries has, by many standards, been
quite good. However, there are also other countries
where banking-commercial relationships are very
close but economic performance has been mixed or
worse. What that suggests, of course, is that eco
nomic performance is much more a function of the
fundamentals of macroeconomic policy than it is a
function of national preferences as to industrial
structure.
Moreover, even if we were to grant that there is
some marginal net benefit to economic perform
ance growing out of these arrangements, the ques
tion remains whether there may not be costs—
either economic or social— growing out of such
arrangements that would outweigh the potential
benefit. That is probably more a political question
than an economic one, so I must leave it to others
to consider the possible trade-offs involved.
There is one final aspect of this issue, and it relates to
the motivations for commercial ownership of banks. If
the motivation is either a desire to gain access to the
safety net or large-scale synergies, the problems are
obvious. If it is diversification of income, it is clear that
there are all kinds of ways commercial firms can diver
sify their income, including owning financial subsidi
aries that unambiguously do not have access to the
safety net. Finally, if the returns in banking are so
superior to returns available on alternate investments,
then it is clear that capital would flow to banking quite
freely and naturally with no need for the capital
resources of industrial firms to augment traditional
sources of capital.
However, as we all know very well, the current situa
tion in banking is not one in which relative returns
command that lofty position in the eyes of investors.
Indeed, the pattern of price-earnings ratios of even the
most successful banking organizations over recent
years tells us that in unmistakable terms; Thus, the
It is by no means clear to me that the banking
system is materially short of capital. The problem
may well be too much capital chasing too few
oood loans.
strains in the banking system and the associated pres
sures on the financial position of the deposit insurance
fund are the major factors that give rise to the sugges
tion that permitting commercial firms to own banks is
desirable on public policy grounds, in that such
arrangements will provide the needed fresh capital to
the banking industry.
While this argument deserves careful attention under
current circumstances, I find it unpersuasive. For one
thing, as I have said on earlier occasions, it is by no
means clear to me that the banking system is materially
short of capital. The problem may well be too much
capital chasing too few g oo d loans. Beyond that, there
is ample room for commercial firms to make passive
investments in banking institutions even under existing
FRBNY Quarterly Review/Spring 1991
11
rules. Finally, in a market economy, capital is attracted
by profits and returns. If an industry cannot compete—
especially because of outdated laws and regulations— it
will not, and should not, attract capital. On the other
hand, if the unnecessary and outdated structural
impediments to profitability are removed, capital should
flow quite naturally. At the very least, this says to me
am against banking-commercial combinations. Those
factors include the following:
I would not be allergic at all to providing some
greater flexibility regarding commercial firms’
ownership stakes in banks and vice versa, so long
as the control issue is not breached or threatened.
First, unlike banking ancLsommerce, combinations
of banking and securities firms are the rule, not the
exception, throughout the industrial world. In fact,
as things stand now, only J ap an and the
that before we as a nation take the essentially irrevers
ible step of permitting commercial firms to own and
control banking firms, we ought to put in place the kind
of basic reforms the Treasury and others have sug
gested and see what happens. I, for one, have little
doubt that where capital is needed and can serve its
purpose, it will be available from conventional sources.
As a part of that process, and as I have said on earlier
occasions, I would not be allergic at all to providing
some greater flexibility regarding commercial firms’
ownership stakes in banks and vice versa, so long as
Combinations of banking and securities
companies strike me as wholly in keeping with the
spirit of congeneric financial corporations. Indeed,
even within the narrowly defined limits of GlassSteagall, banks are actively engaged in a wide
range of securities activities.
The case for permitting commercial firms to own
and control banking institutions should rest on
some compelling and affirmative public policy
reason. In the current circumstances, I simply do
not see compelling public policy reasons to follow
that course of action.
the control issue is not breached or threatened.
To summarize, the position I have taken on the banking-commerce question is that, given the obvious risks,
the case for permitting commercial firms to own and
control banking institutions should rest on some com
pelling and affirmative public policy reason. In the cur
rent circumstances, I simply do not see compelling
public policy reasons to follow that course of action.
Thus, under present and foreseeable circumstances, I
remain opposed to such combinations.
Combinations of banking and securities firms
While I am strongly opposed to combinations of banking
and commercial firms, I have been, and remain, in favor
of authorizing combinations of banking and securities
firms— given, of course, appropriate corporate structure
and safeguards. The reasons that I favor such combina
tions are in many ways the mirror image of the reasons I
Digitized for
12FRASER
FRBNY Quarterly Review/Spring 1991
Unlike banking and commerce, combinations of
banking and securities firms are the rule, not the
exception, throughout the industrial world.
United States do not permit such combinations.
Moreover, in a number of important countries, secu
rities activities take place directly in the bank and
not in an affiliated company.
Second, combinations of banking and securities
companies strike me as wholly in keeping with the
spirit of congeneric financial corporations. Indeed,
even within the narrowly defined limits of GlassSteagall, banks are actively engaged in a wide
range of securities activities. More recently, and
reflecting the thrust of competitive and technologi
cal developments, banks and securities companies
alike have aggressively been moving into each
other’s traditional lines of business here and
abroad. Banking organizations now have securities
affiliates here and abroad, and securities compa
nies now have banks here and abroad. Moreover,
there is now a wide range of specific activities in
which banking organizations and securities firms
com pete directly. E x a m p le s in c lu d e foreig n
exchange; writing and brokering of interest rate and
currency swaps; underwriting and trading in a wide
range of Eurocurrency debt and equity instruments;
underwriting and dealing in a wide range of govern
mental securities, here and abroad; underwriting or
private placement of commercial paper; and, on a
limited scale, underwriting of debt and equity secu
rities here in the United States. Obviously, none of
these close parallels in business activities are to be
found among banking and commercial firms.
Third, bank holding companies— including such
companies that own securities subsidiaries— are
and should be subject to official supervision at the
level of the holding company. They are also subject
to functional supervision at the level of the bank or
securities affiliate of the holding company. This
means that the official supervisory process does
not have to reach into a new segment of corporate
America, as would be the case with banking and
commercial combinations.
More important, it also means that problems at
the level of the parent that might adversely affect
the bank should be easier to detect and remedy.
Indeed, the mere presence of officially promulgated
capital standards, consolidated reporting require
ments, and periodic inspections at the level of the
holding company provides some greater assurance
against contagion problems coming from any direc
tion. I might add in this regard that the principle of
consolidated supervision of banking institutions is
the norm throughout the industrial world. This prin
ciple is the basic line of reasoning that lies behind
the ruling of the Swiss court in the Credit Suisse
case that was cited earlier.
Fourth, because some elements of the safety
net— in this case, official supervision and regula-
While I am under no illusion about firewalls—
especially their ability to deal with the contagion
problems— I do believe that so-called Chinese walls
can play a very useful role in guarding against
conflicts of interest and unfair competition.
tion— apply to the holding company owners of
banks, it does not follow that all other elements of
the safety net need or should apply to the holding
company or to its nonbank subsidiaries. This is
surely the case with deposit insurance. On the
other hand, in Japan and the United Kingdom,
securities firms that are not affiliated with banks do
have account relationships with the central bank,
and in Japan such firms also have access to the
discount window at the Bank of Japan.
Fifth, while there is something to be said for the
so-called limited universal bank model, I believe
that securities activities (with some exceptions) of
banking firms should be conducted in a separately
capitalized subsidiary of the holding company, and
that the banking activities of securities firms should
be organized similarly. While I am under no illusion
about firewalls— especially their ability to deal with
the contagion problems— I do believe that so-called
Chinese walls can play a very useful role in guard
ing against conflicts of interest and unfair competi
tion. Such arrangements have, for example, worked
well over the years in relationships between trust
departments of banks and the bank as a whole. It is
also true, as noted earlier, that separately cap
italized entities can also facilitate functional super
vision. However, functional supervision is not good
enough. We also need consolidated supervision at
the level of the holding company.
Thus, combinations of banking and securities firms
should be permitted as long as appropriate supervisory
standards and policies are in place. However, such
arrangements can give rise to one major practical prob
lem: there will be a handful of securities firms owned by
commercial companies that would not be allowed to
own insured depository institutions. That is, securities
firms that are not controlled by commercial firms would
Prompt and comprehensive reform of the banking
and financial system is long overdue. Therefore, I
would urge the Congress to move as promptly as
possible toward the enactment of broad-based
progressive legislation this year.
be free to own insured depositories but those controlled
by commercial firms would not. This may seem arbi
trary, but it is a natural outgrowth of the argument
against the direct or indirect control of banking firms by
commercial entities. This would not, of course, preclude
commercial companies from owning and controlling
financial subsidiaries, as is now the case. But it would
put a halt to such firms owning and controlling banking
institutions with access to all elements of the safety net.
Summary
The long-term implications as to how the United States
should best reform and restructure its banking and
financial system cannot be anticipated with precision.
That, inevitably, points to the case for care and caution
in the process. The need for caution is at the heart of
the reasons that I oppose banking and commercial
combinations in the present circumstances.
However, the need for caution cannot be allowed to
result in paralysis. Prompt and comprehensive reform of
the banking and financial system is long overdue.
Therefore, I would urge the Congress to move as
promptly as possible toward the enactment of broadbased progressive legislation this year. Few items on
today’s national agenda strike me as having greater
importance, and even fewer will have greater impor
tance for the long-term well-being of not just the bank
ing and financial system but also the economy at large.
FRBNY Quarterly Review/Spring 1991
13
The Effect of Imports on U.S.
Manufacturing Wages
by David A . Brauer
The benefits of international trade have been recog
nized at least since Adam Smith emphasized them in
The Wealth o f Nations more than 200 years ago. Yet
while trade is advantageous for the economy as a
whole and exports help to support earnings and
employment, foreign imports may put downward pres
sure on earnings and employment in domestic importcompeting industries. In the United States, the ratio of
manufacturing imports to domestic supply doubled
between 1975 and 1985. During the same period, and in
the years since, the real hourly earnings of U.S. man
ufacturing workers have stagnated. This article exam
ines whether the increased penetration of imports has
been a major factor behind the sluggish growth of man
ufacturing wages in the United States.
In investigating the connection between import flows
and manufacturing wages, this article looks at both
aggregate and industry-level data, focusing particularly
on the period since 1975. The analysis reveals that
when other factors known to influence wages are taken
into account, increased exposure to imports has had a
very modest tendency to result in lower wages within
industries.1 Specifically, the increase in imports
1These results are consistent with those found in earlier research.
For instance, see Richard B. Freeman and Lawrence F. Katz,
“ Industrial Wage and Employment Determination in an Open
Economy,” in John M. Abowd and Richard B. Freeman, eds.,
Immigration, Trade, and the Labor Market (Chicago: University of
Chicago Press, 1991). John Abowd and Thomas Lemieux find that
increases in the import penetration ratio depressed union members'
real wages in the United States, though not in Canada ("The Effects
of International Competition on Collective Bargaining Outcomes: A
Comparison of the United States and Canada," National Bureau of
Economic Research, Working Paper no. 3352, May 1990).
14 FRBNY Quarterly Review/Spring 1991
appears to have reduced the level of a g g re g a te
manufacturing wages by Vz percent to 1 percent
between 1975 and 1985.
Although imports affected wages adversely, other fac
tors accounted for the bulk of aggregate wage move
ments. Productivity growth slowed sharply between
1973 and 1982, limiting employers’ ability to boost real
wages. Rapidly declining unionization rates, especially
after 1980, reduced the bargaining power of much of the
work force. Rapid labor force growth combined with
several recessions to increase the unemployment rate,
exerting downward pressure on wages. Export growth
was also slow during this period. Finally, many workers
were not fully compensated for the inflation arising from
energy shocks in 1973 and 1979.
While the aggregate impact of imports on wages has
been rather small, this study does find systematic evi
dence that the influence of imports on wage determina
tion has increased over time. In addition, it highlights
the importance of industry characteristics in determin
ing the direction and magnitude of this effect. In indus
tries producing nondurable goods, increases in imports
have been associated with significant reductions in
wages. By contrast, in industries producing durable
goods, increased import penetration does not appear to
have adversely affected wage movements, at least
through the mid-1980s. Indeed, if anything, the evi
dence suggests that in the most heavily unionized dura
ble goods industries, wages initially tended to increase
in response to import competition.
The first section of the article gives an overview of the
data. It is followed by a discussion of the possible
theoretical connections between an industry’s exposure
to com petition from im ports and the wages earned by
its workers, together with an analysis of changes in the
relationship between im ports and wages over tim e.
Next, the article presents results showing the impact of
a given increase in im ports on a typical worker’s wages.
A detailed comparison of the data at two points in
tim e— 1975 and 1985— is used to analyze the effect of
increases in imports on wages within industries.
An overview of the data
The United States m anufacturing sector has become
increasingly integrated with the international economy.
Chart 1 shows a clear upward trend in the import pen
etration ratio, defined as im ports divided by the sum of
im ports and dom estic shipments, between 1958 and
1989.2 This ratio increased from 5.4 percent in 1970 to
6.6 percent in 1975, 8.6 percent in 1980, and 13.1
percent in 1985, according to figures calculated from
the National Bureau of Economic Research (NBER)
Immigration, Trade, and Labor M arket Data Files.3 The
chart also shows that until 1980 the ratio of exports to
output exhibited a clear upward trend. In the early
1980s, however, the value of the dollar rose sharply,
encouraging imports and discouraging exports. Thus, in
the first half of the 1980s, the export ratio declined to a
level only slightly greater than that of the mid-1970s.
After the dollar’s value peaked in 1985, the import
penetration ratio stabilized, and the export-to-output
ratio resumed its upward trend.
The increase in the im port penetration ratio since the
early 1970s has been accompanied by stagnating real
wages and employm ent. Table 1 summarizes develop
ments in manufacturing wages since 1960, for all indus
tries as well as for durable and nondurable goods
sectors separately. The first two columns illustrate the
path of real hourly m anufacturing wages. After rising at
an annual rate of 1.5 percent from 1960 through 1973,
real wages were flat during the late 1970s and declined
throughout the 1980s. The stagnation in real wages
reflects in part a shift in compensation to nonwage
2Note that import penetration ratios represent just one way of
viewing foreign competitive pressures. They are not, for instance,
directly affected by foreign investment in domestic manufacturing
facilities. (In fact, other things being equal, a foreign producer’s
move to replace imports with goods produced at a U.S. facility
would reduce measured im port penetration.) Import penetration
ratios also do not capture possible differences in quality between
domestically produced and imported goods. These considerations,
along with others, could have consequences for wages and
employment beyond the results presented here.
3The NBER Data Files cover 428 manufacturing industries, each
observed annually between 1958 and 1985. For further details, see
the appendix to this article. In addition, see John M. Abowd, “ The
NBER Immigration, Trade, and Labor Markets Data Files,” National
Bureau of Economic Research, Working Paper no. 3351, May 1990.
forms such as medical and pension benefits and higher
payroll taxes. Nonetheless, the real hourly com pensa
tion received by manufacturing workers (columns 3 and
4) leveled off in the 1980s, after growing rapidly during
the 1960s and early 1970s and more slowly in the late
1970s. The last two colum ns suggest that the stagna
tion in real wages reflects factors other than a slowdown
in labor productivity growth, since productivity grew at a
healthy pace, particularly in durable goods m anufactur
ing, during the 1980s.
The downward trend in m anufacturing employm ent
since the late 1970s is documented in Table 2. Both the
average level of em ploym ent over the course of a busi
ness cycle (column 1) and the peak level of em ploym ent
during the cycle (column 2) were lower during the 1980s
than earlier. In addition, the average annual em ploy
ment growth rate (column 3), measured from trough to
peak, was much slower in the 1980s than in previous
expansions. Although other factors, such as labor-sav
ing technological change and declining dem and for
some goods, may be partially responsible, the weak
performance of manufacturing em ploym ent has coin
cided with the increase in im port penetration ratios and
therefore m erits exam ination along with the effect of
imports on wages.
Chart 1
Manufacturing Import Penetration and
Export-Output Ratios
Ratio
0 .1 4 -----------------------------------------------------------------
1958 60
65
70
75
80
85
89
Sources: Data for 1958-85 are from National Bureau of
Economic Research Immigration, Trade and Labor Market Data
Files; data for 1985-89 are based on U.S. Department of
Commerce official statistics.
FRBNY Q uarterly Review/Spring 1991
15
Table 1
M anufacturing Wages and Productivity, 1960-89
Real Hourly Wagesf
(2)
Average
Annual
increase
(t)
Level
(Percent)
All industries
1960-69
1970-73
1974-79
1980-89
Durable goods
1960-69
1970-73
1974-79
1980-89
Nondurable goods
1960-69
1970-73
1974-79
1980-89
Real Hourly Compensation
(4)
Average
(3)
Average
Annual
Index
Increase
(1982=100)
(Percent)
Productivity^
(5)
Average
Index
(1982=100)
(6)
Average
Annual
Increase
(Percent)
8.19
8.95
9.19
8.77
1.5
1.5
0.0
-0 .9
80.0
91.2
98.1
99.6
2.1
1.6
1.1
- 0 .0
66.8
80.8
91 1
114.2
2.9
3.8
1.6
4.0
8.72
9.50
9.79
9.28
1.3
1.6
0.0
-1 .0
80.0
91.2
98.2
99.2
2.0
16
1.1
-0.1
72 6
85.5
94.9
119.4
2.7
3.2
1.2
4.7
7.44
8.17
8.29
8.03
1.5
12
-0 .0
-0 .5
80.3
91.2
97.5
100.0
2.2
1.4
1.0
0.2
59.3
74.5
85.9
107.1
3.0
4.9
2.1
3.0
Sources: Bureau of Labor Statistics, Employment and Earnings and Handbook of Labor Statistics. Productivity figures for 1980 through 1989
are from Bureau of Labor Statistics, Productivity and Costs release, March 6, 1991.
f1982-84 dollars.
^Output per hour of all persons.
The growing influence of imports on
m anufacturing wages
T his se ction p re sen ts e vidence that im p orts have
become increasingly im portant determ inants of the
wages paid by m anufacturers. Before turning to the
evidence, however, it may be helpful to review the con
ceptual linkage between the two. In principle, increased
product m arket com petition should lead to lower wages,
lower employment, or both. (For a more detailed discus
sion, see the accompanying box.) Whether the com peti
tion stems from imports or any other source, it puts
downward pressure on the price of a product. From an
em ployer’s perspective, this effect diminishes the value
of any w orker’s contribution to output, and conse
quently fewer workers will be hired at the prevailing
wage rate. The decline in labor demand may in turn
exert downward pressure on the wage rate.
In an environm ent of unionized labor and less than
perfectly com petitive product markets, workers gener
ally receive “ rents,” or above-market wages and bene
fits. Employers are usually able to pass these costs on
to custom ers through their pricing policies. Increased
com petition from imports, however, can make it difficult
to co n tin u e passing wage costs through, because
demand for a firm ’s product becomes more sensitive to
price changes. N evertheless, the precise effect of
increased com petition on wages and employment will
16 FRBNY Q uarterly Review/Spring 1991
Table 2
M anufacturing Em ploym ent, 1960-89
(1)
Average
Employment
(Thousands)
All industries
1960-69
18.092
19,324
1970-73
1974-79
19,772
1980-89
19,307
Durable goods
1960-69
10,378
1970-73
11,175
1974-79
11,710
1980-89
11,410
Nondurable goods
1960-69
7,714
1970-73
8,159
1974-79
8,081
1980-89
7,900
(2)
End Year
Employment
(Thousands)
(3)
Average Annual
Growth Ratef
(Percent)
20,168
20,155
21,040
19,426
2.7
4.0
3.5
0.9
11,863
11,882
12,746
11,422
3.5
5.9
4.5
1.1
8,305
8,294
8,312
8,004
1.6
1.7
2.0
0.6
Source: Bureau of Labor Statistics, Employment and Earnings.
tTrough to the final year of each interval. Trough years—
1961, 1971, 1975, and 1983— represent the lowest overall
level of manufacturing employment during the interval.
Box: Conceptual Issues
Analyzing the effect of greater product market competi
tion on a fully competitive labor market with no hiring and
firing costs is a straightforward exercise. For any group
of workers possessing a particular set of attributes (skills
and abilities, experience, location, and so forth), employ
ers take the market-determined wage rate as given.+
They then hire up to the point where the marginal
worker’s contribution to output (which, in the absence of
increasing returns to scale, declines as additional work
ers are hired) equals the wage rate. Increased product
market competition, regardless of its source, will typ
ically result in a lower product price, which is equivalent
to a reduction in the value of the marginal worker’s
contribution to output. Consequently, with the wage rate
given, employers will respond by hiring fewer workers
than they had previously. Aside from the reduction in
employment, increased competition can result in a lower
wage rate if the reduction in demand for workers by all
employers is sufficiently large relative to the size of the
relevant labor market.
In reality, few of the assumptions of perfect labor mar
ket competition are satisfied. Modifying these assump
tions usually changes the results. One significant altera
tion, however, leaves the results unchanged. Workers
often earn more in their current jobs than they could in
the next-best alternative job for which they are qualified.
Employers may pay an above-market wage in order to
reduce the rate at which their current workers, especially
the most productive, quit, thus avoiding recruiting and
training costs.* Higher wages can also serve to attract
better quality workers or, according to the “efficiency
wage” hypothesis, to encourage greater effort.2 Under
these circumstances, employers will probably respond to
♦Strictly speaking, the wage rate should take into account
nonwage costs such as payroll taxes and employer
contributions to health insurance and retirement plans.
*See Steven C. Salop, "A Model of the Natural Rate of
Unemployment,” American Economic Review, vol. 69 (March
1979), pp. 117-25.
*For a formal model of the relationship between wages and
worker quality, see Andrew Weiss, “ Job Queues and Layoffs
in Labor Markets with Flexible Wages,” Journal of Political
Economy, vol. 88 (June 1980), pp. 526-38. Several theories
have been proposed to explain the effect of higher wages on
effort. Under the "shirking” hypothesis, high wages serve as
an extra incentive, prompting the employee to work harder in
order to avoid dismissal. See Carl Shapiro and Joseph E.
Stiglitz, "Equilibrium Unemployment as a Worker Discipline
Device," American Economic Review, vol. 74 (June 1984),
pp. 433-44. For an alternative explanation that emphasizes
sociological phenomena, see George A. Akerlof, "Labor
Contracts as Partial Gift Exchange," Quarterly Journal of
Economics, vol. 97 (November 1982), pp. 543-69.
increased competition by first reducing employment, just
as they did in the case of perfect markets. Industry
wages could also fall if the decline in employment causes
the industry’s demand for workers to fall.
A more interesting case involves industries where firms
and workers, the latter often represented by unions,
share the gains derived from market power. A union can
seek an above-market wage and benefits package
because it knows that increased labor costs can be
passed on to customers through higher prices." In these
circumstances, the introduction of competition is likely to
directly reduce demand for the firm’s product, resulting in
a downward shift in the associated demand curve for
labor. As in the case of perfect markets, this scenario will
lead to reduced wages, lower employment, or a combina
tion of the two.n The introduction of competition from
imports may also increase the responsiveness of product
demand to price changes, so that over time it will
become increasingly difficult for employers to pass
increases in labor costs through to their customers.
The relative effect of the new competition on wages
and employment depends on the specific objectives and
attributes of the employer, the industry, and, where pres
ent, the union. In an industry characterized by rapid
technological change and increasing product demand,
the effect of imports may not be obvious (although earn
ings and/or employment increases will be smaller than
they would have been had imports not increased). In
general, however, employers will attempt to reduce their
labor costs, either gradually through attrition and reduc
tions in the rate of increase in wages and benefits or
aggressively through large-scale layoffs, plant closings,
and demands for nominal wage concessions. Some
unions will offer such concessions to preserve employ
ment in the face of new competition; others will seek to
preserve existing wage levels at the risk of some mem
bers’ losing their jobs.
“Technically, the union members are earning "rents." Even in
firms without a union, employers may offer to share rents with
their employees in order to prevent unionization. Such
actions could be justified by the employer’s desire to
preserve the freedom to manage without interference from a
union.
ttThe experience of recently deregulated industries is
instructive in this context. One study suggests that when the
trucking industry was regulated, union drivers operating in
the regulated portion of the industry received substantial
rents. After five years of deregulation, however, these rents
were largely dissipated. See Nancy Rose, “ Labor Rent
Sharing and Regulation: Evidence from the Trucking
Industry,” Journal of Political Economy, vol. 95, no. 6
(December 1987), pp. 1146-78.
FRBNY Q uarterly Review/Spring 1991
Box: Conceptual Issues (Continued)
It is even conceivable that import competition could, in
certain declining industries, result in short-run wage
increases.** When a unionized industry with relatively
few dominant firms has long-lasting immobile or industryspecific facilities and equipment, a permanent decline in
demand resulting from imports will initially be met
entirely through reductions in hours and employment
because of the high cost of selling or shutting down
capacity. With import competition imposing an upper limit
on the industry’s productive capacity, any temporary
increase in demand will result in increased utilization of
labor. Because management has lost the option of
expanding capacity, it will be less able to resist union
wage demands, and consequently wages could rise in
the short run. In the long run, however, as the existing
capital stock wears out and plant closings become likely,
management’s bargaining power will be restored, result
ing in downward pressure on wages in addition to
employment losses.
These considerations suggest that in the short run,
increased import penetration, to the extent that it sig
nifies increased competition, should have a negative
impact on employment but an uncertain effect on aggre
gate or industry wages. Over time, however, we would
expect to observe an increasingly strong negative impact
on earnings. If unions at first perceive increased import
competition to be temporary, they may be unable to
#Colin Lawrence and Robert Z. Lawrence, “ Manufacturing
Wage Dispersion: An End Game interpretation,” Brookings
Papers on Economic Activity, 1:1985, pp. 47-116.
depend on the specific objectives of both unions and
employers. For instance, some unions, when faced with
d eclining dem and, will fig ht to preserve their wage
advantage at the expense of employment, while others
will offer wage concessions in order to save their mem
bers’ jobs. It has even been suggested that in some
industries, wages might initially increase in response to
increased im port com petition.4
The s h o rt-te rm im pact of im p ort co m p e titio n on
wages may therefore be weak or even perverse. Over
time, however, noncom petitive systems for wage deter
mination should be eroded by competitive forces. If
im p o rts e n ta il increased co m p e titio n , they should
become increasingly im portant determinants of wages.
One way to test this assertion is to examine the d istri
bution of wages by industry. If imports become more
4Lawrence and Lawrence, "Manufacturing Wage Dispersion: An End
Game Interpretation.” This argument is developed more completely
in the box.
Digitized for18
FRASER
FRBNY Q uarterly Review/Spring 1991
justify long-lasting wage concessions to their members.
But as it becomes clear that industries will continue to
face competition from imports, and that consequently
labor costs must be contained in order to preserve jobs,
concessions will become increasingly acceptable. Fur
thermore, in partially unionized industries, the high-wage
unionized firms will probably face greater employment
losses than nonunion firms even if imports have no effect
on wages at any firm; consequently, industry-wide aver
age wages will decline. Finally, if relatively high-wage
unionized industries suffer proportionally greater
employment losses as a result of imports, aggregate
average manufacturing wages will decline even if the
average wage within industries is unaffected.
This analysis of the conceptual issues assumes that
imports or other sources of product market competition
are determined independently of wages and employ
ment. Nonetheless, the existence of above-market
wages and profits in an industry may serve as a signal to
potential competitors (both foreign and domestic) that
entry can be profitable. The higher the wage, relative to a
competitive level, the more vulnerable the industry
becomes to competition. Under these circumstances, we
would expect to observe a positive correlation between
import penetration and wages.§§
ssFor evidence on this issue, see Lawrence F. Katz and
Lawrence H. Summers, “ Industry Rents: Evidence and
Implications," Brookings Papers on Economic Activity:
Microeconomics, 1989, pp. 209-75.
im portant in wage determ ination, the degree of im port
penetration within an industry should become more
closely associated with the wages paid by the industry.
Chart 2 summ arizes the evidence on this issue, using
data for 1958 to 1985 drawn from the NBER Data Files
for 125 m anufacturing industries identified by three d ig
its in the Standard Industrial C lassification (SIC) C ode.5
The solid line in C hart 2 illustrates the simple correla
tion, by industry, between hourly wages and the im port
penetration ratio for each year between 1958 and 1984.
It shows that during the 1960s the correlation coefficient
was negative but small (absolute value less than .1) and
not significantly different from zero. In the 1970s and
5The SIC code is a system of categorizing industries by type of
product. Industries are aggregated at levels ranging from the least
detailed (one-digit) to very detailed (seven-digit). These and all
subsequent calculations in this article are carried out at the threedigit level. Examples of three-digit industries include meat products
(201), logging (241), and household appliances (363).
early 1980s, however, the connection between high
im ports and low wages became much stronger, with the
absolute value of the correlation coefficient rising from
an average of .153 between 1970 and 1975 to .213
during 1976-82 and .298 in 1983-85.
In addition to the simple correlations, a series of
annual m ultiple regression equations are estim ated.
These relate production workers’ hourly earnings to the
im port penetration ratio while controlling for other fac
tors that can influence wages.6 The control variables
include the ratio of exports to output, value added per
hour worked (a measure of productivity), and the pro
duction w orkers’ unionization rate.7 The regression
coefficients for the im port penetration ratio are plotted
as the dotted line in Chart 2. They were uniformly
negative and over time tended to increase in magnitude.
In the latter half of the period, all else equal, every
percentage point increase in an industry’s import pen•Results of similar regressions using estimated compensation, which
includes nonwage labor costs as well as wages, can be found in
David Brauer, “ The Effect of Import Competition on Manufacturing
Wages," Federal Reserve Bank of New York, Research Paper
no. 9030, September 1990. They are generally similar to the results
shown here.
JThe export-to-output ratio is included in light of the observation that
export-intensive industries tend to offer high wages. See Lawrence
R Katz and Lawrence H. Summers, “ Industry Rents: Evidence and
Im plications,” Brookings Papers on Economic Activity:
Microeconomics 1989, pp. 209-75. The use of output per hour as
an alternative productivity measure does not materially affect the
results.
etration ratio was associated with a drop of about V«, to
Vfc of 1 percent in hourly wages. By contrast, before 1973
the relationship between im ports and wages was weak
and not statistically significant.
Aggregate effects
The results summ arized above suggest that im ports
have become more im portant in wage determ ination.
The next issue to be investigated is the specific impact
of a given increase in im port penetration on a typical
factory w orker’s wage. One way to examine this effect is
to estimate a single equation for hourly wages, using all
twenty-seven annual observations available for each
industry from 1958 through 1984.8 This approach is
used in Table 3, which shows a num ber of equations
designed to estimate the average effect of im ports on
wages in all m anufacturing industries (column 1), dura
ble goods producers (column 2), and nondurable goods
producers (column 3). In these equations, both wages
and value added are m easured in real (in fla tio n 8For a slightly different approach using the same data, see Freeman
and Katz, “ Industrial Wage and Employment Determination.” They
found that over time a 10 percent annual reduction in industry
revenues due to increased import penetration resulted in a modest
0.5 percent reduction in earnings for production workers, with
imports having a somewhat stronger impact in the early 1980s than
earlier. Their results also showed that the effect of imports on
earnings was strongest in highly unionized industries. This finding
suggests that when competition was less, unions were more
successful than nonunion workers in capturing a portion of
monopoly rents.
Table 3
Chart 2
Determinants of Real Wages
by Three-Digit Industry, 1958-84
Correlations of Industry Wages and Import
Penetration Ratios
Dependent variable: log production workers’ real hourly earnings
o
Intercept
Import
penetration
ratio
Exports/output
Percent unionized
Log value
added per hour
,04I i i I i i i i I i I i i I i I i i I I I i l I l I 1J
1958
60
65
70
75
80
84
Adjusted R2
(1)
All
Industries
(2)
Durable
Goods
(3)
Nondurable
Goods
1.004
(23.78)
1.471
(36.32)
.945
(29.33)
-.3 2 6
(14.35)
.130
(5.79)
.003
(9.39)
-.1 9 9
(5.88)
.040
(1.79)
.001
(1.62)
-.3 0 9
(9.18)
.231
(2.93)
.005
(18.05)
.245
(26.53)
.165
(12.01)
.267
(33.25)
.952
.944
.934
Notes: Regression equations also include year and three-digit
industry dummies. Absolute t statistics are given in parentheses.
FRBNY Q uarterly R eview/Spring 1991
19
adjusted) terms.9 The equations include a series of
dummy variables intended to capture unmeasured fixed
industry effects, such as the characteristics of indi
vidual workers, that are not related to the import pen
etration ratio or the other directly observed variables.
The equations also include a series of year dummy
variables intended to control for cyclical influences on
real earnings, long-term wage trends, and shocks
affecting consumer prices. Overall, with 125 industries
observed each year, the equation is based on 3,375
observations.
The equation including all industries (column 1) indi
cates that, all else equal, a 10 percentage point increase
in the import penetration ratio in a typical industry
during the 1958-85 period was associated with a wage
reduction of about 3.3 percent. A similar increase in the
ratio of exports to output resulted in an increase in real
wages of about 1.3 percent. As expected, both unioniza
tion and productivity had a positive impact on earnings.
The estimated effect of import penetration on wages
generally held up under a number of alternative specifi
cations.10 The inclusion of lagged export and import
penetration ratios yielded a long-run wage reduction of
about 4 percent in response to a 10 percentage point
increase in the import penetration ratio.
The significance of the regression results is best
understood through an example. The import penetration
ratio in the women’s clothing industry rose from around
10 percent in the mid-1970s to approximately 25 per
cent in the mid-1980s, while real hourly wages fell by
about 10 percent. The result in column 1 suggests that
the increase in imports was responsible for about half of
the real wage reductions observed in the industry. This
estimate assumes, however, that all other factors affect
ing wages paid by this industry were independent of the
increase in import penetration and that the relationship
between imports and wages was equal in all industries
and in all years.
Interestingly, the results were somewhat different
when the wage equation was estimated separately for
durable and nondurable goods. Results for the durable
•In both cases, nominal values are deflated by the consumer price
index. The use of other deflators common to all industries, such as
the GNP deflator or the producer price index for manufacturing, did
not affect the results. Unfortunately, it was impossible to construct
price series for the output of each industry.
10For further details, see Brauer, “ The Effect of Import Competition."
One alternative specification replaced the year dummies with the
manufacturing unemployment rate and a time trend in order to
separate cyclical effects from broad long-term trends. Another
substituted output per hour for value added per hour as the
productivity measure. In addition, estimated real hourly
compensation,' including nonwage benefits, replaced the real wage
as the dependent variable. None of these exercises materially
affected the estimates of the import effect.
20FRASER
FRBNY Quarterly Review/Spring 1991
Digitized for
goods sector, shown in column 2 of Table 3, indicate
that the response of wages to the import penetration
ratio was less than for manufacturing as a whole,
although it remained negative and statistically signifi
cant. By contrast, the results in the nondurable goods
sector, shown in column 3 of the same table, were quite
similar to those for overall manufacturing. In other
words, the relationship between imports and wages was
stronger for noQdurable than for durable goods pro
ducers. Some possible reasons for this divergence will
be discussed below.
Because the evidence presented in Chart 2 suggests
that imports are exerting a growing influence on wages,
one might question the reliability of estimates that
assume a stable import effect. An alternative way to
look at the effect of imports on wages (and employ
ment) is to compare the wage and employment changes
between two periods experienced by industries that
faced considerable competition from imports with the
changes experienced by industries that did not.11
The specific periods chosen for comparison are
1983-85 and 1975-77. The use of three-year periods
minimizes the effects of onetime events that may have
affected an industry in any particular year. The threeyear period also avoids difficulties associated with the
staggered expiration of union contracts. The periods
selected represent roughly comparable stages in the
business cycle. One major difference between them is
that during the latter period the dollar’s value was both
high and rising.12 According to the results illustrated in
Chart 2, the simple correlation between import penetra
tion and wages was stronger during the latter period
than in the former, but the regression coefficients were
similar. Table 4 shows that the overall manufacturing
import penetration ratio averaged 11.7 percent between
1983 and 1985, compared with 7.0 percent between
1975 and 1977. The export ratio also rose slightly
between the two periods. In 1983-85, average real earn
ings were 3.5 percent lower, and real compensation 1.5
percent lower, than in 1975-77. The unionization rate
"Previous work along these lines found no systematic effect of
imports on wages or employment. See Gene M. Grossman, “ The
Employment and Wage Effects of Import Competition in the United
States," Journal of International Economic Integration, vol. 2, no. 1
(Spring 1987), pp. 1-23. Grossman studied nine industries in which
imports increased significantly between 1967 and 1979. He found
that import competition had a significant negative impact on hourly
wages in only two industries (ball bearings, radio and television)
and caused a large loss of jobs only, in the radio and television
industry. Two other industries (nuts and bolts, hardware veneer)
experienced moderate employment losses.
12The real trade-weighted dollar, as measured by the Board of
Governors of the Federal Reserve System, averaged 94.7 (March
1973 = 100) between 1975 and 1977, and 125.8 between 1983 and
1985. Within periods, the dollar’s value fell from 93.9 in 1975 to
93.0 in 1977, but rose from 117.1 in 1983 to 131.9 in 1985.
also fell between the two periods.
Table 5 summ arizes regressions that relate the per
cent change in real wages by industry between the two
periods to the change in the im port penetration ratio
while controlling for changes in exports, changes in
productivity, and unionization.13 The coefficient on the
im p o rt ratio su g g e sts th a t a 10 p ercentage point
increase in an in d u s try ’s im p o rt p en etra tion ratio
yielded a reduction in hourly wages of about 0.9 percent
to 1.6 percent, the precise value depending on how
unionization was specified. Given the increase in the
average im port penetration ratio between the two peri
ods, this effect translates to a 0.4 percent to 0.8 per
cent reduction in aggregate earnings.14 The effect of
im ports on wages was statistically significant, however,
only in the equation shown in column 1. The evidence is
13Regressions and tabulations in this section apply to all 141 threedigit manufacturing industries (including the miscellaneous
categories) for which data on imports and exports exist.
14For an alternative approach to estimating the effect of imports on
aggregate wages, see Wayne Vroman and John M. Abowd,
"Disaggregated Wage Developments,” Brookings Papers on
Economic Activity, 1:1988, pp.313-38. Using data from the 1964-79
period, they found that a 10 percent increase in nonpetroleum
import prices yielded about a 1 percent increase in aggregate
earnings. Since higher import prices, all else equal, reduce the
vulnerability of U.S. industries to foreign competition, this result is
consistent with the findings presented here.
therefore somewhat inconclusive but suggests that
imports adversely affect earnings. The estimated effect
of changes in exports on wages was positive but very
small and statistically insignificant. Thus, while indus
tries in which a large fraction of output is exported tend
to pay higher wages, we cannot conclude that an
increase in the export-to-output ratio within an industry
will lead to increased wages. As expected, higher
unionization rates (in term s of both the initial level and
the change) had a positive impact on wages, as did
higher productivity.
To obtain a more precise measure of the impact of
increasing imports, the industries are divided into those
experiencing above-average, and those experiencing
below-average, increases in im port penetration.15 Table
6 illustrates the initial conditions within these groups,
with group averages weighted by employm ent. For m an
ufacturing as a whole, the differences between the
g ro u p s w ith a b o v e -a v e ra g e and b e lo w -a v e ra g e
increases in im ports were minor, with two notable
exceptions. Estimated labor costs per unit of value
added, shown in the next to last column, were som e
what higher in the group of industries that subsequently
faced significant increases in im ports. The high-im port
industries were also less capital intensive, as sug15For further detail, see Brauer, “ The Effect of Import Competition,"
especially Table 9.
Table 4
Summ ary Statistics for Manufacturing
1975-77 and 1983-85
Average hourly
earnings (nominal)
Average hourly
earnings (real)
Average hourly
compensation
(nominal)
Average hourly
compensation
(real)
Total employment
(thousands)
Import penetration
ratio (percent)
Export ratio
(percent)
Unionization rate
1983-85
Average
1975
1976
1977
1975-77
Average
1983
1984
1985
5.03
5.42
5.89
5.45
9.00
9.41
9.94
9.45
9.29
9.47
9.67
9.48
9.02
9.11
9.30
9.14
6.00
6.53
7.16
6.56
11.12
11.61
12.17
11.63
11.09
11.41
11.75
11.42
11.14
11.24
11.38
11.25
16,706
17,211
17,997
17,305
17,002
17,419
17,050
17,157
6.6
7.1
7.4
7.0
10.0
11.9
13.1
11.7
8.4
47.7
8.1
47.0
7.6
46,3
8.0
47.0
9.0
37.2
8.5
35.6
8.6
n.a.
36.4 f
8.7
Source: All nominal figures are based on the National Bureau of Economic Research Immigration, Trade, and Labor Market Data Files.
Notes: Hourly earnings, compensation, and unionization rates are for production workers. Employment refers to all workers. Real earnings
and compensation are in 1982-84 dollars, deflated using the consumer price index,
t 1983-84 average.
FRBNY Q uarterly Review/Spring 1991
21
gested by the capita l-p er-w o rke r figures in the last
column.
Sim ilar breakdowns within the durable and nondura
ble sectors are revealing. They show that in the durable
goods sector, im port penetration increased sharply in
relatively high-wage, heavily unionized, and ca pita lintensive industries such as autom obiles, steel, and
construction equipm ent.16 By contrast, in the nondura
ble goods sector, the industries most heavily affected
by imports were characterized by low wages, low union
ization rates, and strongly labor-intensive production.
Table 7 shows changes in wages, unit labor costs,
unionization, and the ratio of capital to labor, calculated
on the assumption that the em ploym ent distribution
across industries was unchanged within each group.
Thus, these figures abstract from changes in group
averages caused by shifts in employm ent. Real wages
and unit labor costs declined in all categories, but for
manufacturing as a whole the decline was only slightly
greater in industries facing more than a 5 percentage
point increase in the im port penetration ratio than in
Table 5
Determ inants of Real Wage Change
Dependent variable: percent change in real wages, by industry
1983-85 versus 1975-77
Intercept
Change in import
penetration ratio
Change in
export ratio
Change in
percent union
(1)
(2)
(3)
-2.8 8 3
(1.77)
-12.780
(6.17)
-10.641
(5.63)
-0 .1 6 0
(2.23)
-0.0 9 3
(138)
-0.0 9 8
(1.48)
0.082
(0.44)
0.010
(0.05)
0.013
(0.07)
0.177
(1.83)
Percent union,
1975-77
Percent change in
value added per hour
Adjusted Rz
0.239
(2.71)
0.168
(5.08)
0.179
(5.50)
0.178
(5.41)
0.200
(6.69)
0.186
(6.27)
.228
.335
.364
Notes: Equations are based on 141 observations. Absolute t
statistics are given in parentheses.
16The computer and electronic components industries, which thrived
despite the increase in imports, are important exceptions to the
overall pattern.
Table 6
C haracteristics of Industries
1975-77
(1)
Employ
ment
(Thousands)
(2)
Real
Hourly
Waget
(3)
Percentage
Unionized
(4)
Import
Penetration
Ratio
(5)
Estimated
Unit Labor
C ostt
(6)
Capital
to Labor
Ratio§
All industries
Change in import penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
17,205
9.44
47.0
.068
.5429
21.9
10,759
6,446
9.54
9.30
46.1
48.3
.042
.108
.5260
.5687
24.0
18 3
Durable goods
Change in im port penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
10,007
10.23
51.2
.073
.5722
19.4
5,512
4,495
9.61
10.99
47.4
55.9
.045
.108
.5720
.5725
16.6
22.9
Nondurable goods
Change in import penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
7,197
8.36
41.0
.060
.5025
25.2
5,247
1,950
9.46
6.02
44.6
33.5
.037
.108
.4749
.5612
31.8
7.7
Note: Employment refers to all workers; hourly wage and percentage unionized, to production workers only.
f1982-84 dollars, deflated by consumer price index.
£Ratio of estimated compensation to value added.
§Capital stock, in constant dollars, divided by total employment.
Digitized22
for FRASER
FRBNY Q uarterly Review/Spring 1991
a a n H W
l
th o s e e x p e rie n c in g a b e lo w -a ve ra g e in cre a se in
im ports.17
The differences in the response of wages to changes
in im ports for durable and nondurable goods are strik
ing. For durable goods, real wages actually fell by only
2.1 percent in the high-im port group, while they dropped
2.9 percent in the low -im port group. In nondurable
goods, by contrast, real wages fell by over 7 percent in
those industries facing above-average increases in
imports, compared with a decline of only 2.4 percent in
the low-im port group.
As noted, these figures are based on fixed employ
ment weights and ignore shifts in the employment mix
between the two periods. Column 6 of Table 7 shows
that total employment rose in industries with belowaverage increases in imports but declined sharply in
industries with more than a 5 point increase in the
import penetration ratio. The data in column 1 suggest
that im p o rts a p p a re n tly had little direct downward
impact on average wages paid by industries producing
durable goods. Average wages earned by workers in
this sector, however, could have been further reduced
through the elim ination of jobs in high-wage industries
with strong im port growth.
17Part of the decline in aggregate wages is probably due to the
weakening of unions, but industries that experienced import growth
and those that did not were equally affected by falling unionization
rates. See Richard B. Freeman and James L. Medoff, What Do
Unions Do? (New York: Basic Books, 1984).
Evidence on this point is provided in Table 7. Column
7 computes the change in simple average wages in
each sector w ithout correcting for the shifting of jobs
between industries over time. For m anufacturing as a
whole, actual average real wages fell by 3.7 percent,
compared with the 2.9 percent decline shown in column
1. The difference between these figures im plies that
employment shifts were apparently responsible for a
fu rth e r 0.8 p e rce n t red uctio n in a g g re g a te w ages.
Employment shifts had their greatest impact in the highim p o rt in d u s trie s p ro d u c in g d u ra b le g o o d s . W ith
em ploym ent shifts taken into account, average real
wages in this group declined by 5.2 percent, compared
with the decline of just 2.1 percent under constant
employment shares. In the nondurable goods sector, by
contrast, employment shifts had virtua lly no effect on
average wages in the high-im port group, despite the
pronounced loss of jobs.
The data using constant em ploym ent shares shown in
column 1 are consistent with the Table 3 regressions,
which suggested a stronger and more significant rela
tionship between industry wages and im port penetra
tion for nondurable than for durable m anufacturing. As
a further test, Table 8 repeats the regressions per
formed in columns 1 and 2 of Table 5, separating the
sample into durable and nondurable goods industries.18
18The column 3 specification, with both the initial unionization rate
and its change included, yields results very similar to those in
which only the initial unionization rate is included.
Table 7
Wage Changes Assuming Constant Employment Distribution, 1975-77 to 1983-85
(3)
Import
Penetration
Ratio
(5)
Capital
to Labor
Ratio
5.2
- 2 .8
27.4
- 0 .9
- 3 .7
-1 0 .8
- 9 .6
1.8
10.3
- 2 .6
-3 .1
20.5
41.1
3.2
- 7 .9
- 3 .2
- 4 .7
-2 .5
-1 1 .0
5.1
- 0 .8
32.5
0.3
- 4 .2
-2 .9
-2 .1
-1 1 .4
-1 0 .4
1.8
8.4
- 0 .5
- 1 .0
17.8
45.3
4.1
- 4 .4
- 2 .8
- 5 .2
-3 .5
- 9 .4
5.2
- 5 .9
21.6
- 2 .6
- 2 .8
-2 .4
-7 .1
-10.1
- 8 .0
1.1
13.9
- 5 .3
-7 .1
22.1
17.0
2.3
-1 5 .9
- 3 .6
- 7 .2
(2)
Percentage
Unionized
All industries
Change in import penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
- 2 .9
-1 0 .3
-2 .6
-3 .2
Durable goods
Change in import penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
Nondurable goods
Change in import penetration ratio,
1975-77 to 1983-85
Less than 5 percentage points
Greater than 5 percentage points
(6)
Memo:
Employment
Change
(7)
Wage Change
Including
Employment Shifts
(4)
Estimated
Unit Labor
Cost
(1)
Real
Wage
Notes: Columns 1, 4, 5, 6, and 7 show percent changes; columns 2 and 3 show percentage point changes.
FRBNY Q uarterly Review/Spring 1991
23
Table 8
Determ inants of Real Wage Change
Dependent variable: percent change in real wages,
1983-85 versus 1975-77
Durable
Goods
(1)
Intercept
Change in
import ratio
Change in
export ratio
Change in
percent unionized
-8.701
(4.51)
0.228
(2.21)
0.021
(0.12)
Adjusted R2
(3)
(2)
(4)
-13 .2 9 5 -0 .9 6 4 -1 2 .6 2 5
(7.23)
(052)
(4.23)
0.236 -0 .3 2 5
(2.55)
(3.51)
-0 .0 3 6
(0.23)
0.233
(0.60)
-0 .2 3 2
(2.40)
0.104
(0.27)
0.362
(2.88)
-0 .2 0 9
(1.40)
Percent unionized,
1975-77
Percent change in
value added per hour
Nondurable
Goods
0.145
(4.34)
For nondurable goods the impact of changes in im ports
on industry wages was negative and significant: a 10
percentage point increase in the im port penetration
ratio yielded an estimated 2.3 percent to 3.2 percent
reduction in wages. For durable goods, however, a sim
ilar increase in im ports would have resulted in a wage
increase of approxim ately 2.3 percent.
The latter result is somewhat puzzling and contrasts
with some other results in the literature.19 It is, however,
consistent with the hypothesis discussed in the box that
increasing im port penetration can, at least initially, be
associated with increasing wages in industries that are
highly unionized, concentrated, and declining. One sim-
0.169
(2.89)
0.202
(4.63)
0.213
(5.42)
0.160
(3.60)
0.200
(4.62)
.242
.391
.361
.361
Notes: Equations (1) and (2) are based on 72 observations.
Equations (3) and (4) are based on 69 observations.
Absolute t statistics are given in parentheses.
19Freeman and Katz, “ Industrial Wage and Employment
Determination," found that over time wages fell more in response to
imports in highly unionized industries than in industries with low
unionization rates. Contrasting results can be found in David A.
Macpherson arid James B. Stewart, “ The Effect of International
Competition on Union and Nonunion Wages," Industrial and Labor
Relations Review, vol. 43, no. 4 (April 1990). Macpherson and
Stewart, using data on individual workers between 1975 and 1981,
found that wages were less sensitive to imports in highly unionized
industries than in industries with lower unionization rates. These
authors did find that increases in the im port penetration ratio
reduced union members’ relative wage advantage within industries.
Abowd and Lemieux, “ The Effects of International Competition,"
reported similar findings for the United States, but found that
increases in imports had no significant im pact on union wages in
Canada.
Table 9
Determ inants of Real Wage Change
Dependent Variable: Percent Change in Real Wage 1983-85 versus 1975-77
All Manufacturing
(1)
(2)
Intercept
Change in import
penetration ratio
Change in
export ratio
Change in
percent unionized
Percent change in
value added per hour
Adjusted R2
Nondurable Goods
(5)
(6)
-3.149
(242)
-11.262
(5.58)
-8.3 5 5
(4.85)
-10.765
(4.90)
-0 .9 6 5
(0.52)
-13 .0 8 4
(3.90)
-0.908
(4.92)
-0.4 2 3
(1.84)
-0.651
(2.89)
-0.3 3 9
(113)
-0 .6 3 6
(1.94)
-0.1 1 7
(0.30)
0.009
(0.05)
-0.0 0 7
(0.04)
-0.0 8 5
(0.55)
-0.0 7 9
(0.51)
0.208
(0.53)
0.108
(0.27)
0.206
(2.26)
Percent unionized,
1975-77
Change in imports times
percent unionized in 1975-77
Durable Goods
(3)
(4)
-0.0 7 5
(0.57)
0.130
(3.15)
0.358
(2.85)
0.179
(2.68)
0.077
(1.63)
2.021
(4.36)
0.856
(1.50)
2.113
(4.27)
1.373
(2.01)
0.888
(0.99)
-0 .3 1 3
(0.31)
0.189
(6.13)
0.203
(6.80)
0.251
(6.18)
0.239
(5.89)
0.157
(3.52)
0.201
(4.59)
.318
.341
.397
.417
.361
.352
Notes: Equations (1) and (2) are based on 141 observations. Equations (3) and (4) are based on 72 observations. Equations (5) and (6) are
based on 69 observations. Absolute t statistics are given in parentheses.
Digitized for24
FRASER
FRBNY Q uarterly Review/Spring 1991
pie way to test this effect is to include the interaction
between the increase in the import penetration ratio and
the initial unionization rate in the wage change regres
sions. The term for the import penetration ratio could be
interpreted as the hypothetical effect of imports on
wages in the absence of unionization. A positive coeffi
cient on the interaction term, if combined with a nega
tive coefficient on the pure import penetration term,
would indicate that the downward pressure on wages
stemming from increased competition from imports
could, for a time, be resisted or offset by unions.
Results shown in Table 9 lend support to this conjec
ture. For all manufacturing, the interaction term was
positive and, in one case, statistically significant, with
the pure import penetration term magnified relative to
the results of Table 5. Consequently, the 4.7 point
increase in the import penetration ratio would appar
ently, in the absence of union resistance, have led to a 2
percent to 4 percent decline in aggregate wages. For
durable goods, the interaction term was positive and
significant, and more importantly, the pure import pen
etration term was now negative and, in one case, statis
tically significant. Thus, it appears that even among
durable goods producers, increasing imports would, in
the absence of unions, have exerted downward pres
sure on wages. Such pressure, however, was offset by
the tendency of unions to resist wage cutting in the face
of declining demand. This tendency appears to explain
import competition’s weak impact on wages in indus
tries producing durable goods. For nondurable goods,
by contrast, the interaction term was not statistically
significant and its inclusion added nothing to the
explanatory power of the equation. In these industries,
union resistance to downward pressure on wages from
import competition has been less evident.
Conclusions
There appears to be a statistically significant and grow
ing inverse relationship between import penetration and
earnings, both across industries at a point in time and
within industries over time. The effect of imports on aggre
gate manufacturing wages, however, appears to be small.
The doubling in the overall import penetration ratio be
tween 1975 and 1985 reduced average hourly earnings
in manufacturing by only about 1/2 percent to 1 percent.
The effect of imports on wages differs sharply by
industry. In the durable goods sector, which tends to be
high-wage, capital-intensive, and heavily unionized, wage
losses in industries experiencing high import growth
were no greater than in other industries. This finding
suggests that on the whole unions in these industries
resisted wage reductions. Still, employment losses suf
fered by these generally high-wage industries appear to
have put downward pressure on overall average man
ufacturing earnings. In the nondurable goods sector,
low-wage, labor-intensive industries that experienced
increased import penetration saw severe wage losses.
Nonetheless, the bulk of the decline in real wages
since the early 1970s should be attributed to factors
other than increased imports. Real wages declined
even in industries that did not experience significant
increases in imports. Most notably, from the mid-1970s
to the mid-1980s, wage growth was depressed by slow
productivity growth, declining unionization rates, the
upward trend in unemployment, and stagnant exports,
while energy shocks boosted prices.
Finally, the adverse effects of import penetration must
be balanced against benefits to the overall economy from
international trade. Increased competition from imports
contributed to the reduction of costs to consumers. The
increase in the overall import penetration ratio generally
occurred in the context of expanding international trade,
with export ratios resuming their rise in the late 1980s.
And although the issue is not discussed in detail in this
study, results presented here suggest that increased
exports may be associated with higher wages.
FRBNY Quarterly Review/Spring 1991
25
Data Appendix
Much of the analysis in this article is based on the
National Bureau of Economic Research (N B ER ) Trade,
Immigration, and Labor M arkets Data Files, which pro
vide information on 428 manufacturing industries by four
digit Standard Industrial Classification code. This infor
mation includes wages and employment (both for pro
duction workers and for all workers), industry trade flows,
unionization rates, and value added per worker. The data
set covers 1958 through 1986, although import and
export data are only available through 1985 and union
ization data through 1984. Because of questions con
cerning the reliability of four-digit classifications, the data
have been aggregated to the three-digit level. This step
yields 143 observations for each year, two of which (SIC
214, tobacco stemming and redrying; SIC 347, metal
coatings and engravings) lack information on imports or
exports and are not used further. The data set does not
include information on the individual characteristics of
workers.
Hourly earnings are calculated by dividing the total
annual payroll for production workers by total hours, then
deflating to 1982-84 dollars using the consumer price
index. Both the payroll and hours variables in the NBER
data set are based on the Annual Survey of Manufactur
ers. Hourly com pensation is estimated by multiplying
FRBNY Q uarterly Review/Spring 1991
Digitized for 26
FRASER
hourly earnings by the ratio of total com pensation to total
wages as reported in the National Income and Product
Accounts. Because the figures in the National Income
and Product Accounts are only reported at the two-digit
level, with the exception of the motor vehicle industry
(S IC 371), it is assumed that the ratio of com pensation to
wages is constant across three-digit industries within any
two-digit classification.
Import and export data for 1 972-85 com e from the
Bureau of Labor Statistics trade monitoring system . For
1958-71 the NBER obtained raw data from the Census
Bureau publication “US Commodity Exports and Imports
as Related to Output,” then adjusted the data using the
Bureau of Labor Statistics method for import and export
classification. The import penetration ratio is defined as
imports divided by the sum of imports plus output. O ut
put refers to the value of industry shipments, in millions
of dollars, as reported in the Annual Survey of M anufac
turers. The export ratio is defined as the ratio of exports
to output. The unionization rate is for production workers
and is based on observations from the M ay Current
Population Survey in 1974, 1980, and 1984, with linear
interpolation to obtain estim ates for other years. Produc
tivity is defined as value added per production worker
hour, with value added taken from the Annual Survey of
Manufacturers.
The Shifting Composition of
U.S. Manufactured Goods Trade
by Susan Hickok
Finished goods are claiming an increasing share of U.S.
imports while their share of U.S. exports has remained
virtually unchanged in recent years. An examination of
these divergent developments in the role of finished
goods in U.S. trade suggests that U.S. comparative
advantage may be moving away from finished goods
and toward industrial supplies. This shift is somewhat
disturbing since demand for finished goods appears to
be growing rapidly while the outlook for industrial sup
plies is less dynamic. A declining U.S. comparative
advantage in the finished goods sector is also of con
cern because a strong competitive position in this
sector is a sign of an economy’s technological sophis
tication and, to some extent, its market power in the
world economy.
This article examines a number of factors that might
explain the recent trends in U.S. trade composition. It
finds that weak U.S. investment, as measured against
the investment performance of U.S. trade partners, has
lowered the relative supply of capital to U.S. industry,
eroding the traditionally strong competitive position of
the United States in the production of finished goods. To
a lesser degree, wage restraint in the U.S. steel indus
try and U.S. steel import restrictions have encouraged
shifts in the composition of U.S. trade more favorable to
the U.S. industrial supplies sector than to the U.S.
finished goods sector. Finally, demand developments
have also supported a slightly greater rise in finished
goods as a share of U.S. imports than as a share of
U.S. exports. But because the differential impact of
demand developments on the import and export sides
has been small, these developments have contributed
only modestly to the divergence in U.S. import and
export composition trends.
The first section of this study details the trends in
U.S. import and export composition during the 1980s. In
the second section, the various potential determinants
of changes in U.S. import and export composition are
introduced and analyzed. The concluding sections dis
cuss the implications of the analysis for the future
course of the U.S. trade balance and U.S. competi
tiveness over time.
The changing composition of U.S. trade
Developments in the composition of U.S. manufactured
goods trade during the last decade are fairly straightfor
ward.1 On the import side, U.S. purchases of both
foreign finished goods and foreign industrial supplies
have risen sharply, but purchases of foreign finished
goods have risen much faster. In consequence, finished
goods increased from slightly more than 66 percent to
slightly more than 77 percent as a share of total U.S.
manufactured goods imports between 1978 and 1989
(Chart 1).2 The counterpart to this rise was an 11 per
centage point fall in the import share of industrial sup
plies. These changes in import shares are traceable
mainly to developments in the machinery and metals
’ Manufactured goods are defined as Standard Industrial Trade
Classification (SITC) categories 5 through 8, with industrial supplies
making up categories 5 (chemicals) and 6 (leather, rubber, cork,
wood, paper, textiles, and minerals) and finished goods categories
7 (machinery and transport equipment) and 8 (furniture, clothing,
footwear, instruments, and other manufactured goods). This
definition excludes processed food and fuels.
2Because unusual silver bullion sales raised the share of industrial
supplies in U.S. exports in 1979 and 1980, 1978 is used as the
base year in this study.
FRBNY Quarterly Review/Spring 1991
27
industries.3 M achinery accounted for almost all of the
gain in finished goods’ import share; prim ary and fabri
cated metals suffered most of the share loss for indus
trial supplies (Table 1).
While the com position of U.S. imports has been sh ift
ing, the com position of U.S. exports has remained sta
ble. Finished goods were about 74 percent of total U.S.
3Automotive products fell somewhat as a share of both U.S. imports
and U.S. exports between 1978 and 1989 because of relatively slow
growth in shipments by U.S. automobile companies across the U.S.Canadian border. U.S. automobile plants operate on both sides of
the border under a free trade arrangement.
FRBNY Q uarterly Review/Spring 1991
Digitized28
for FRASER
manufactured goods exports in both 1978 and 1989.
F u rth e rm o re , little c o m p o s itio n c h a n g e has been
observable within either the finished goods or industrial
supplies export category. In particular, the m achinery
and metals industries have shown only m inor share
movements.
The distinct difference in im port and export com posi
tion trends appears to have been even slightly larger in
real terms than in nominal terms. Although it is true that
finished goods rose as a share of both real im ports and
real exports between 1978 and 1989, the rise in share
was about 13 percentage points greater on the im port
side.4 This finding suggests that the difference in the
evolution of U.S. im port and U.S. export composition
has resulted from factors affecting real trade flows
rather than just relative trade prices.
The tendency for finished goods to represent a rising
share of U.S. im ports while remaining static as a share
of U.S. exports over the last decade has generally held
across geographic areas (Table 2).5 For every major
trade partner except Germany, finished goods sales to
the United States have increased substantially as a
share of U.S. manufactured imports. At the same time,
for all areas except Germany and the rest of Western
Europe, U.S. sales of finished goods have shown no
4Trade price indexes are not available for manufactured goods alone.
The estimate of real changes in the text is derived by deflating
nominal U.S. imports and exports of finished goods plus raw
materials excluding petroleum by comparable trade price indexes.
sData here and in the rest of the text are in nominal terms because
data in real terms are not available.
Table 1
Subcom ponents of U.S. Manufactured Goods
Trade Com position
(Percent Share)
Imports
Exports
1978 1989
Finished Goods (SITC 7 + 8)
66.6
Machinery and transport
equipment excluding automotive
(SITC 70-77, 79)
25.3
Automotive products (SITC 78)
22.6
Other manufactured goods,
primarily consumer goods
18.7
(SITC 8)
33.4
Industrial supplies (SITC 5 + 6)
15.6
Metals {SITC 67-69)
Other industrial supplies
(SITC 5 + 6, excluding 67-69)
17.8
significant increase as a share of U.S. manufactured
exports. In fact, Germ any stands alone as the only
major U.S. trade partner for which finished goods have
gained more in U.S. export share than they gained in
U.S. im port share.
The broad sim ilarity across regions in U.S. im port and
U.S. export com position trends— that is, the substantial
rise in import share for finished goods and the lack of
significant change in export share for these same cate
gories of goods — suggests that these trends are more
closely tied to developm ents in the United States than
to developments abroad. In other words, their evolution
appears to be linked to shifts in the ability of the United
States to compete in different industries rather than to
shifts in the com petitiveness of foreign countries.
To be sure, the U.S. im port share of finished goods
has leveled off during the last three years. N everthe
less, it remains at the elevated level it reached in 1986,
indicating that the 1980s developm ents marked a dura
ble change in U.S. im port com position. Overall, U.S.
trade composition changes during the 1978-89 period
suggest a significant shift in U.S. comparative advan
tage from finished goods, notably machinery, toward in
dustrial supplies, especially manufactured metals prod
ucts. This shift appears fundam ental and widespread
since it is evident in both nominal and real trade flows
and in trade flows with alm ost every foreign country.
1978
1989
77.3
73.7
74.0
35.9
20.4
48.6
13.7
50.3
10.4
21.0
22.7
8.3
11.4
26.3
6.2
13.3
26.0
5.1
14.4
20.1
20.9
Explaining developments in U.S. trade composition
Four factors are generally identified as affecting the
composition of an econom y’s international trade. They
are 1) changes in the com position of dom estic and
foreign demand, 2) changes in the supply of dom estic
and foreign production inputs (capital and labor), 3)
differences across countries in inter-industry labor and
other cost developm ents not directly related to changes
in input supply, and 4) government trade policies restrict
ing the import of certain products. These four factors
appear to explain fairly well the evolution of U.S. import
and export com position during the 1978-89 period.
The impact of these four factors may be summarized
Table 2
Shift in Composition of U.S. Trade toward Finished Goods by Region: 1978-89
(Percentage Point Increase in Finished Goods as a Share of Total U.S. Manufactured Goods Imports and Exports)
Latin
America
U.S. imports
U.S. exports
15
2
Asian
NICSt
Japan
5
-1
12
1
Other
Asia
30
-5
Germany
Other
Western
Europe
Canada
Rest of
World
World
1
4
9
7
5
1
-2
-9
11
0
fH ong Kong, Singapore, South Korea, and Taiwan.
FRBNY Q uarterly R eview/Spring 1991
29
briefly. Demand developments in the United States con
tributed the most to the shift in the composition of U.S.
imports toward finished goods. Foreign demand devel
opments also favored a substantial shift in U.S. exports
toward finished goods. Finished goods, however, did not
gain in U.S. export share, an inconsistency explained
by supply factors. Although changes in production
inputs tended to boost the share of finished goods in
U.S. imports, they tended to reduce the share of such
goods in U.S. exports. In fact, production input develop
ments were probably the single most important factor
behind the lack of change in finished goods’ share of
U.S. exports. They also explain to some extent why
finished goods rose more rapidly in U.S. import share
than demand developments alone would have sug
gested. The remaining two factors, changes in produc
tion costs and trade restrictions, contributed further to
the rise in finished goods import share by cutting im
ports of industrial supplies. Consequently, they also ex
plain some of the divergence in U.S. import and export
developments, although their overall impact was signifi
cantly smaller than that of changes in production inputs.
S h ifting dem and patterns
Changes in the composition of U.S. and foreign demand
are an obvious factor affecting the composition of U.S.
trade. As economies grow, demand for finished goods
generally rises faster than demand for industrial sup
plies.6 Unfortunately, because data are not available on
the composition of world demand, it is impossible to
calibrate directly the extent to which this expected shift
occurred worldwide during the 1978-89 period. Never
theless, since the comparative advantage positions of
individual countries do not affect the composition of
world exports in aggregate, the shift in the composition
of world exports may be taken as a proxy for the shift in
the composition of world output and world aggregate
demand.7 Between the years 1979 and 1987 (the ear*lf industrial supplies consisted solely of intermediate products used
in the production of finished goods, the only reasons for an
observable difference between the growth in demand for industrial
supplies and the growth in demand for finished goods would be
that a country’s degree of vertical integration in manufacturing
changed or that intermediate products accounted for a declining
share of the total value of finished goods. But in the product
classification used here, "industrial supplies” includes
pharmaceuticals, construction materials, paper products, fertilizers,
floor coverings, glassware, metal containers, and other products
that are not direct inputs into finished manufactured goods
production.
d iffe re n c e s in transport costs across products and similar factors
could cause differences between world trade composition and world
demand composition. However, these differences are unlikely to
have caused the change in world trade composition to differ
significantly from the change in world demand composition, the
focus of the analysis above, during the 1978-89 period.
30 FRBNY Quarterly Review/Spring 1991
liest and latest years, respectively, for which data is
available on a consistent basis), world exports of fin
ished goods grew 96 percent while world exports of
industrial supplies rose only 55 percent. Given initial
share levels in 1978, this difference in growth translates
into a 5 percentage point rise in finished goods (from 63
percent to 68 percent) and a concomitant 5 percentage
point decline in industrial supplies as shares of world
manufactured goods exports over the course of this
period.
On the U.S. side, shifts in the composition of U.S.
demand mirrored shifts in the composition of world
demand. U.S. demand for finished goods grew about 40
percentage points faster than U.S. demand for indus
trial supplies, a difference roughly equivalent to that
between these same components in world demand. The
difference in U.S. demand growth rates translates into a
7 percentage point rise (from 56 percent to 63 percent)
in finished goods and a 7 percentage point fall in indus
trial supplies as shares of total U.S. manufactured
goods purchases.
The roughly similar world and U.S. demand develop
ments could be expected to result in commensurate
shifts of about 5 percentage points and 7 percentage
points in favor of finished goods in the composition of
U.S. exports and imports, respectively.8 On the import
side, U.S. demand shifts would thus appear to explain
in aggregate somewhat more than half of the 11 per
centage point increase in finished goods as a share of
total U.S. manufactured goods imports. On the export
side, in contrast, foreign demand shifts raise the ques
tion why there was no rise in the share of finished
goods.
Changes in in p u t su p p ly
Changes in supply factors help explain this puzzle.
They also offer some understanding of why the com
position of U.S. imports shifted more toward finished
goods than did the composition of total U.S. demand.
The most obvious change in supply factors has been
the much stronger growth in capital investment abroad
than in the United States over the last two decades.
Stronger foreign investment resulted in a significantly
faster rise in the average foreign capital/labor ratio than
in the U.S. capital/labor ratio during this period.
Capital investment and capital/labor ratio develop•Technically, U.S. demand developments should be excluded from
world demand developments to calculate the impact of foreign
demand shifts on U.S. exports. Moreover, U.S. and world demand
shifts should be weighted by the initial U.S. import and export
compositions to assess the impact of the shifts on U.S. trade. If
these two corrections were made and the results extrapolated to
1989, the results would still suggest that demand developments
alone boosted finished goods roughly 5 percentage points as a
share of U.S. exports and 7 percentage points as a share of U.S.
imports.
merits are particularly relevant to the change in share of
industrial supplies and finished goods in U.S. trade
since finished goods generally require a higher level of
capital input per employee for their production than do
industrial supplies. Unfortunately, reliable capital/labor
ratio estimates are not available internationally for dif
ferent industries w ithin the m anufacturing sector to
illustrate this point.9 However, input/output measures
showing the contributions of capital goods and value
added (a measure of labor input) to production may be
used to judge the amount of capital per employee in
each industry. Based on the U.S. input/output table for
1983, a middle year in the period under consideration,
the ratio of capital input to value added for the industrial
supplies category was 0.07, or only about half of the
0.16 ratio for the finished goods category (Table 3).10
9U.S. capital stock data are available by industry. However, these
data are distorted because they include some factories that are no
longer in operation. Industries such as steel that have many closed
factories included in their capital stock have unrealistically high
capital/labor ratios since no labor is employed in these factories.
Using input/output flow measures as a substitute for capital/labor
stock measures does implicitly assume that the average life of
capital is the same across all industries.
10These ratios reflect the composition of U.S. industrial supplies and
finished goods output. They give relatively low weight to the
consumer goods sector of finished goods production compared with
the weight consumer goods would receive in a global input/output
table. Consumer goods generally have a lower capital/labor ratio
than other finished goods. Relying on a U.S. input/output table
rather than a (nonexistent) global input/output table does not
seriously affect the analysis because U.S. trade in the most laborintensive consumer goods category, apparel, is conducted under
the Multi-Fiber Arrangement. The impact of the Multi-Fiber
Arrangement on U.S. trade composition is discussed later in the
Table 3
C apital/Labor Ratios by Industry
Industrial supplies
Metals
Finished goodsf
Machinery and transport equipm ent
(excluding automotive)
Automotive products
Other manufactured goods
(primarily consumer goods)
0.07
0.10
0.16
0.17
0.21
0.09
Source: Annual input/output accounts of the U.S. economy,
1983, Survey of Current Business, Bureau of Economic
Analysis, February 1989.
Notes: Capital goods input is measured as the sum of lines
43 to 63 in the input/output table, excluding line 53
(electronic components and accessories). Line 12 (repair
and maintenance construction) is also included as a capital
input.
fT h is ratio excludes capital goods that are inputs in their
own industry's output.
During the 1977-87 period,11 the U.S. investm ent
performance was weak relative to that of the rest of the
world. The net manufacturing sector capital/labor ratios
of the major foreign industrialized countries grew on
average about 1 1/2 tim es as fast as the U.S. capital/
labor ratio during these years (Table 4). Germ any was
the only m ajor foreign ind ustria lize d co un try whose
ratio grew more slowly than the U.S. ratio. Although
available data do not perm it easy com parisons of the
U.S. ratio with the manufacturing sector capital/labor
ratios of developing countries, rough estim ates based
on econom y-w ide investm ent flow s and population
growth suggest that here, too, the U.S. ratio generally
grew more slowly than it did abroad. In fact, the average
developing country ratio appears to have risen almost
1% times as much as the U.S. ratio. All told, with an
adjustment for the rise in the developing country cap
ital/labor ratio in manufacturing that would be consis
tent with econom y-w ide investm ent and population
changes, the trade-weighted average foreign capital/
labor ratio in m anufacturing for both industrial and
developing countries is likely to have risen about 40
percent since 1977, or about 1% tim es faster than the
25 percent rise in the U.S. ratio.
How im portant has this difference in foreign and U.S.
capital/labor ratio growth been to the com position of
U.S. trade? The existence of a link between the relative
size of capital/labor ratios and trade com position is a
basic tenet of international trade theory. Unfortunately,
however, there is no satisfactory means to gauge accu
rately the quantitative impact of a change in relative
capital/labor ratios on the com position of trade flows.
One tool from the discipline of international econom
ics that could provide some quantitative insight into this
problem is the Rybcyznski theorem .12 The Rybcyznski
theorem links output growth rates across product sec
tors in a given country with the growth rates for that
country’s capital and labor supplies. However, the Ryb
cyznski theorem relies on some very strong underlying
assum ptions— namely, that prices remain constant and
that resources are fully em ployed— to establish its link.
Consequently, estimated effects based on this theorem
Footnote 10 continued
text. Excluding clothing from the capital/labor ratio shown for other
manufactured goods on Table 3 would raise this ratio to 0.12.
11These calculations are for 1977-87 rather than 1978-89 to allow
some time for investment to be put in place and for labor
adjustment to occur before the effect on trade composition is
measured. Using the other time frames shown on Table 5 does not
significantly change the results.
12T.M. Rybcyznski first laid out his findings in “ Factor Endowment and
Relative Commodity Prices,” Economica, vol. 22, no. 84 (November
1955), pp. 336-41.
FRBNY Q uarterly Review/Spring 1991
31
are at best illustrative of what changing relative capital/
labor ratios might mean for U.S. trade composition.
A rough application of the Rybcyznski theorem sug
gests that the 15 percentage point faster growth in
foreign capital/labor ratios relative to growth in the U.S.
capital/labor ratio could have led to growth in the ratio
of foreign finished goods output to foreign industrial
supplies output that would have been about 15 percent
age points faster than growth in the ratio of U.S. fin
ished goods output to U.S. industrial supplies output, if
all other factors remained unchanged.13 This relative
change in output ratios may be traced through to the
changes it implies for the growth rates of U.S. finished
goods im ports and U.S. finished goods exports and,
13A detailed discussion of the Rybcyznski theorem and the
calculations presented above is not provided in this article because
of the tenuous nature of the results. However, such a discussion is
available in Susan Hickok, “ Factors behind the Shifting Composition
of U.S. Manufactured Goods Trade," Federal Reserve Bank of New
York Research Paper no. 9036, December 1990. The research paper
presents estimates based on the Rybcyznski theorem that suggest
that stronger foreign investment relative to U.S. investment has led
to an increase of 2 percentage points to 4 percentage points in
finished goods as a share of U.S. imports and a decrease of 2
percentage points to 4 percentage points in their share of U.S.
exports. These estimates are judged to be fairly plausible,
particularly because they are robust to moderate changes in the
strict assumptions underlying the Rybcyznski theorem.
subsequently, for changes in finished goods as a share
of total U.S. manufactured im ports and exports. The
end result of these calculations would indicate ttiat the
more rapid growth observed in foreign ca p ita l/la b o r
ratios compared with the U.S. ratio m ight have raised
the share of finished goods in U.S. im ports by roughly 3
percentage points. In contrast, the more rapid growth in
foreign ca pita l/la bo r ratios m ight have low ered the
share of finished goods in U.S. exports by roughly 3
percentage points. Combining these figures suggests
that roughly 6 percentage points of the 11 percentage
point difference between the evolution of U.S. im port
composition and U.S. export com position— that is, the
11 percentage point gain in finished goods as a share of
U.S. imports compared with the absence of any gain in
finished goods as a share of U.S. exports— m ight be
due to much stronger capital stock growth abroad rela
tive to the United States.
Given the problems associated with use of the Ryb
cyznski theorem, however, it is useful to examine other
evidence suggesting that changes in relative capital/
labor ratios played a significant role in shaping the
divergent trends in U.S. im port and U.S. export com
position. This evidence comes from a com parison of
capital/labor ratio developm ents and trade com position
Table 4
Relative Growth in C apital/Labor Ratios by Region
(Cumulative Percent Growth; Ratio to U.S. Growth in Parentheses)
Manufacturing Capital/Labor Ratios for Industrial Economies
United
Japan
Germany
France
Kingdom
United
States
Canada
1977-87
25
32
53
18
41
43
1975-85
21
37
45
19
39
43
1970-80
32
28
86
34
45
39
United
States
Foreign TradeWeighted Average
37
(1.48)
37
(1.76)
46
(1.44)
Economy-wide Capital/Labor Ratios for Developing Economies
Other
Asian
Latin
Foreign TradeAsia
NtCsf
America
Weighted Average
1977-87
151
400
250
152
1975-85
163
400
336
222
1970-80
153
815
302
296
259
(1.72)
355
(218)
469
(3.07)
Sources: Organization for Economic Cooperation and Development, "Flows and Stocks of Fixed Capital, 1962-87,’' 1989; International
Monetary Fund, International Financial Statistics, various issues.
Notes: Industrial country data are calculated from OECD estimates of real net capital stocks in manufacturing and the countries’ own
reported manufacturing employment levels. Developing country data and the comparable U.S. series are based on the assumption that
capital has a ten-year life span. Capital growth is calculated as the sum of nominal gross fixed capital formation economy-wide for the
period shown, divided by the sum of nominal gross fixed capital formation for the preceding ten-year period. The growth in each
economy’s population over the period shown is then subtracted from this estimated growth in the nominal economy-wide capital stock,
f Hong Kong, Singapore, South Korea, and Taiwan.
Digitized for
32 FRASER
FRBNY Q uarterly Review/Spring 1991
shifts on both a region-by-region basis and a product
subcategory-by-subcategory basis within the finished
goods and industrial supplies categories. If weak U.S.
investm ent relative to that abroad was a substantial
factor in the com position changes in U.S. trade over the
last decade, regions with faster growing capital/labor
ratios would be expected to have experienced larger
gains in finished goods as a share of their sales to the
United States than regions with slower growing capital/
labor ratios during this period. Similarly, if the issue is
investigated at a more disaggregated product level, the
goods requiring a larger capital/labor ratio for their
production would be expected to have gained more in
U.S. im port share since 1978 than the goods requiring a
lower ratio.
If allowance is made for some outside factors, both of
these expectations are, in fact, borne out. More specifi
cally, if one allows for the impact of a sharp fall in U.S.
nonferrous metals demand on the composition of U.S.
im p o rts from the Latin A m e rican and o the r Asian
regions and for the impact of clothing import restrictions
on U.S. imports from the Asian newly industrialized
countries (NICs), the regions with the strongest invest
ment performances did show the largest gains in fin
ished goods as a share of their exports to the United
States. Furthermore, if one allows for the impact of the
special U.S.-Canadian automobile free trade zone on
automobile trade and the impact of clothing import
restrictions on consum er goods trade, com position
changes within the finished goods and industrial sup
plies categories indicate a strong correlation between a
product’s capital-intensity and that product’s gain in
U.S. im port share.14
There is, consequently, fairly clear evidence that the
relatively weak U.S. investment performance of the 1970s
and 1980s contributed to the diverse evolution of U.S.
import and U.S. export composition since 1978. Although
a reliable quantitative estimate is not available, both
theory and observation suggest that the impact was
probably substantial. In particular, region-by-region and
product subcategory-by-subcategory matches between
U.S. trade com position shifts and capital/labor ratio
factors strongly suggest that relative capital/labor ratio
developments explain, to a substantial degree, why
finished goods claimed an increasing share of U.S.
imports while stagnating as a share of exports.
Other supply developm ents
A third factor affecting the composition of trade consists
of those developments in the cost of production inputs
across industries that are not directly related to changes
14A detailed discussion of the regional and product subcategory
comparisons is provided in Hickok, “ Factors."
in input supply. No available data suggest that the
pattern of relative capital costs across U.S. industries
has evolved substantially differently from the pattern of
relative capital costs across foreign industries over the
last decade.15 However, data suggest such a distinction
on the labor cost side. This distinction is the product of
the restructuring in the U.S. metals industry or, more
specifically, a reduction in the wage premium earned by
employees of U.S. steel firms resulting from the indus
try ’s financial problems in the last decade.16
Analysts have estimated that workers in the heavily
unionized U.S. steel industry earned a substantial wage
premium, on the order of 40 percent, in the 1970s.17
This premium was measured by com paring the ratio of
U.S. steel wages to average U.S. m anufacturing wages
with the ratio of foreign steel wages to average foreign
manufacturing wages. Although premium estim ates are
not available for the 1980s, a cross-country comparison
of wage developm ents in the prim ary m etals industry
with wage developm ents in m anufacturing in general
suggests that the U.S. steel wage premium fell signifi
cantly during the 1979-89 period (Table 5). Neverthe1sThe impact of U.S. and foreign subsidies and industrial targeting is
judged to be insignificant in Hickok, "Factors.”
16A wage premium is generally associated with the U.S. automobile
industry as well as the U.S. steel industry. However, U.S. automobile
wages grew in line with average U.S. manufacturing wages between
1978 and 1989, suggesting that automobile wage developments had
no significant independent effect on the evolution of U.S. trade
composition.
17See Robert W. Crandall, The U.S. Steel Industry in Recurrent Crisis
(Washington, D.C.: Brookings Institution, 1981); and the General
Accounting Office, Report to the Congress, New Strategy Required
for Aiding the Distressed Steel Industry, Washington, D.C., January 8, 1981.
Table 5
Primary Metals Com pensation as a
Percentage of Average M anufacturing
Com pensation
United States
Foreign averaget
Canada
Japan
France
Germany
Italy
United Kingdom
1979
1988
Change from
1979 to 1988
143
123
128
145
116
111
116
119
135
125
134
147
119
110
122
117
-8
+2
+6
+2
+3
-1
+6
-2
Source: Unpublished data provided by the U.S. Bureau of
Labor Statistics.
t Simple average of foreign countries listed.
FRBNY Q uarterly R eview/Spring 1991
33
less, the U.S. steel wage premium appears to have
remained positive in 1989. Consequently, its fall would
not in itself have caused labor to shift away from the
metals sector, and any impact on the composition of
U.S. trade would depend on the extent to which the
reduction was passed on to U.S. steel prices.
It is convenient to analyze the effect on trade com
position of the reduction in the U.S. steel wage premium
by e xam in ing trad e price m ovem ents. Once these
movements are clearly identified, trade elasticities may
be used to judge the impact on import and export
com position. Although data on U.S. steel import and
export prices do not go back to 1978, data on U.S.
im port and export prices for industrial supplies as a
group are available for the entire 1978-89 period. Devel
opm ents in the price indexes for industrial supplies may
be traced fairly directly to developments in their steel
price components.
U.S. export prices for all industrial supplies declined
about 6 percent relative to U.S. import prices for all
industrial supplies during the 1978-89 period (Chart 2).
For finished goods products, in contrast, U.S. export
prices on average rose relative to U.S. import prices
over these years. The decline in the U.S. export price/
im port price ratio for industrial supplies of over 6 per
cent from the level it would have reached had it tracked
the rising U.S. export price/im port price ratio for fin
ished goods matches fairly closely the difference in
U.S. wage developm ents in these two sectors relative to
wage developm ents abroad. Available data suggest that
foreign wages in the finished goods sector in general
(com puted as the simple average of wage develop
ments for eight m ajor U.S. trade partners) rose about
40 percent relative to U.S. wages over the last decade
(Table 6). Foreign wages in the industrial supplies sec
tor, however, rose almost 50 percent relative to U.S.
wages. The more rapid foreign wage increase in the
industrial supplies sector was due entirely to an even
sharper rise in foreign metals wages relative to U.S.
m etals wages. Foreign wages in other industrial sup
plies industries rose at just about the same rate relative
to U.S. wages as did foreign wages in the finished
goods sector. Taken together, these developments sug
gest that the fall in the U.S. steel wage premium was
probably the ultim ate source of the 6 percent decline in
U.S. export prices for industrial supplies relative to U.S.
im port prices for industrial supplies during the 1978-89
period, a period when U.S. export prices were rising
relative to U.S. im port prices for most other products.
How have th ese wage and price deve lo pm e nts
affected the com position of U.S. trade? On the U.S.
im port side, the declining price of competing U.S. prod
ucts has reduced the U.S. demand for industrial sup
plies purchases from abroad. A rough quantitative
Digitized for
34FRASER
FRBNY Q uarterly R eview/Spring 1991
estimate of this reduction may be made by assum ing a
price elasticity of demand for im ports of - 1 . 18 This
elasticity would imply that the declining relative price of
competing U.S. industrial supplies cut the growth in
demand for industrial supplies im ports by over 6 per
centage points from what it would have been if the
prices of U.S. industrial supplies had risen at the same
rate as the prices of U.S. finished goods. Given the
initial share of industrial supplies in total U.S. m anufac
tured goods imports, a cut in demand of slightly more
than 6 percent would account for a fall of approxim ately
2 percentage points in the industrial supplies im port
share by the end of the 1978-89 period.
On the U.S. export side, the relative fall in U.S.
industrial supplies price would increase the volum e
growth but reduce the price per unit of industrial sup
plies exports from what it otherwise would have been. If
18Estimates are not available for the individual price elasticities of
demand for U.S. imports and exports of industrial supplies or
finished goods. Overall U.S. trade price elasticity estimates are
generally on the order of - 1 . The assumption of any price elasticity
from a reasonable range centered around - 1 would result in a
trade composition impact not significantly different from that derived
above.
Chart 2
Change in U.S. Export Prices as a Percentage of
U.S. Import Prices
Difference between 1978 and 1989
Percent
10----------------------------------------------------------
5
-5 -
Industrial
supplies
Capital
goods
Automobiles
and parts
Consumer
goods
a price elasticity of - 1 is assumed, the volume and
price effects would cancel each other out, suggesting
that the relative fall in U.S. industrial supplies export
price did not have a significant impact on the com posi
tion of U.S. manufactured goods exports measured in
nominal terms. That the fall in the U.S. steel wage
premium differs in its im pact on nominal and real
exports is consistent with the observation that the differ
ence in the evolution of U.S. im port and export com
position was greater in real than in nominal terms.
Overall, the fall in the U.S. steel wage premium
appears to have had a measurable impact on the com
position of U.S. im ports over the 1978-89 period, reduc
ing the share held by industrial supplies by about 2
percentage points. However, with no measurable impact
on nominal export com position, this 2 percentage point
im port change alone explains only a small part of the
divergence over the last decade in U.S. import and U.S.
export com position trends.
Trade restrictions
U.S. and foreign trade restrictions are another factor
likely to affect the com position of U.S. manufactured
goods im ports and exports. The most im portant U.S.
trade restrictions in this regard are the voluntary export
re s tra in ts on Ja pa ne se a uto m o b ile sh ip m e n ts, the
M ulti-Fiber A rrangem ent restricting clothing im ports,
and the voluntary export restraints on foreign steel
shipments to the United States. On the U.S. export
side, im portant foreign trade restrictions have been
placed on U.S. automobiles, telecom m unications equip
ment, and wood products (particularly plywood).
The U.S. im port restrictions have had surprisingly
little measurable impact on U.S. import composition
over the 1978-89 period. R estrictions on Japanese
automobile shipments to the United States were, in fact,
not binding during the April 1989-March 1990 autom o
bile agreement year (although this may to some extent
be due to the transplantation of Japanese autom obile
production to the United States, itself in part a reaction
to U.S. im port restrictions). Moreover, the fact that Jap
anese automobile sales to the United States grew sig
nificantly faster than overall Japanese manufactured
goods sales between 1978 and 1989 suggests that U.S.
im p o rt re s tric tio n s p ro b a b ly d id not s u b s ta n tia lly
depress autom obiles as a share of total Japanese
sales. The rise in price and the quality upgrading of the
automobile models that Japan did send to the United
States in response to the restrictions may explain the
strong nominal perform ance of Japanese automobile
export sales.19
U.S. clothing restraints also do not appear to have led
to a significant fall in the share of clothing in total U.S.
manufactured goods im port purchases between 1978
and 1989.20 Clothing im ports doubled (rising from 7
percent to 14 percent) as a share of U.S. clothing
19Fred Mannering and Clifford Winston estimate that for these reasons
restrictions actually raised the nominal value of Japanese
automobile shipments to the United States in 1984 by $3 billion
(“ Economic Effects of Voluntary Export Restrictions," in Clifford
Winston et al., Blind Intersection? Policy and the Automobile
Industry [Washington, D C.: Brookings Institution, 1987]).
^W ithin the context of the Multi-Fiber Arrangement, the United States
has negotiated agreements with the major world clothing producers
limiting the growth rate of clothing imports into the United States.
U.S. clothing restrictions have varied across trade partners, causing
composition shifts in individual regions' trade flows. In particular,
restrictions cut clothing sales from the Asian NICs, while the "other
Asia" region benefited from the restricted NIC sales by sharply
increasing its own clothing shipments to the United States.
Table 6
Change in Foreign Wage Rates Relative to U.S. Wage Rates: 1978-88
(Cumulative Percent Change)
Finished goods
Capital equipment
Industrial supplies
Primary and fabricated metals
Western
Europe
Canada
Japan
Asian
NICs
Average
22
23
27
33
8
6
14
21
40
32
44
46
90
109
115
125
40
43
49
56
Notes: Figures are derived from unpublished data provided by the U.S. Bureau of Labor Statistics. The finished goods category is a
weighted average of nonelectrical machinery, electric and electronic equipment, precision instruments, apparel and other textile products,
and automotive products, based on 1978 U.S. import shares as a proxy for the relative size of each industry. Capital equipment includes
the finished goods industries except apparel and other textile products and automotive products. The industrial supplies category is a
weighted average of primary metals: fabricated metals; stone, clay, and glass products; chemicals and allied products; and paper
products. The Western Europe column shows the simple average of changes in France, Germany, Italy, and the United Kingdom. The
Asian NICs column shows the simple average of changes in Taiwan and South Korea. The average column at the right shows the simple
average for the eight economies considered.
FRBNY Q uarterly Review/Spring 1991
35
consumption over these years. Consum er goods
imports in general also about doubled (rising from 6
percent to 10 percent) as a share of U.S. consumer
goods consumption during the 1978-89 period. This
similar change in import penetration ratios suggests
that clothing import restrictions, although binding in
both 1978 and 1989, did not cause a significant change
in clothing’s import share. In fact, the restrictions may
have prevented clothing’s import share from falling
because they probably kept out a larger share of poten
tial clothing imports in 1978 than in 1989. That is, if
there had been no import restrictions, clothing may well
have declined in import share over the course of the
1980s as foreign manufacturers moved increasingly
toward more capital-intensive production. (Clothing pro
duction is one of the least capital-intensive manufactur
ing sectors.)
The third major U.S. restriction, limits on steel
imports, had only a minor impact on U.S. import com
position developm ents. U .S. restrictions on steel
imports were not binding on many foreign suppliers in
1989. Only the European countries came within 5 per
cent of their maximum allowable market share in the
United States. It is plausible that European steel sales
to the United States would have been higher last year if
there were no U.S. steel restraints. U.S. purchases of
European steel grew more slowly than U.S. purchases
of other European products. If European steel sales to
the United States had grown as fast as overall Euro
pean manufactured goods sales to the United States,
industrial supplies as a share of U.S. manufactured
goods imports from all sources would have been about
1 percentage point higher than they actually were in 1989.
Foreign restrictions on U.S. manufactured goods
exports do not appear to have had any significant
impact on the evolution of U.S. export composition. The
automobile, telecommunication, and wood product pur
chases of the econom ies with significant trade
re stric tio n s a g a in s t U .S . products would have
accounted for too small a share of total U.S. manufac
tured goods exports to have had a measurable impact
on U.S. export composition even if those purchases had
substantially increased. In fact, major changes in Jap
anese telecommunications policy and Taiwanese and
South Korean automobile policies increased U.S. sales
of these products to these economies about eightfold
during the 1978-89 period but did not raise the overall
share of telecommunications equipment or automotive
products in U.S. exports.
Overall, trade restrictions appear to have had a rela
tively small impact on shifts in the composition of U.S.
trade. Only U.S. restrictions on European steel seem to
show any significant effect, pushing U.S. imports
slightly in the direction of finished goods.
Digitized for
36FRASER
FRBNY Quarterly Review/Spring 1991
The four factors together
Demand developments appear to have strongly favored
a shift in both U.S. manufactured goods import and
export flows toward finished goods and away from
industrial supplies, although the impact on the import
side was slightly greater. The shift in U.S. imports
toward finished goods was also supported by a strong
foreign investment performance relative to that of the
United States. A declining U.S. steel wage premium and
U.S. steel import restrictions restrained imports of this
important industrial material and indirectly furthered the
increase in finished goods import share. On the export
side, the strong foreign investm ent perform ance
appears to have cut significantly into finished goods as
a share of U.S. export sales. In fact, since reductions in
the U .S. steel wage premium and foreign trade
restrictions seem to have had no discernible impact on
nominal U.S. manufactured goods export composition,
strong foreign investment appears to be the main rea
son that finished goods gained no share in U.S. man
ufactured goods exports during the 1978-89 period.21
Impact of shifts in trade composition on the U.S.
trade outlook
The shifting composition of U.S. manufactured goods
imports toward finished products, unaccompanied by a
comparable shift in the composition of U.S. manufac
tured goods exports, is likely to have significant implica
tions for the outlook for the U.S. trade balance. The
apparent durability of the import shift, with finished
goods imports maintaining over the last three years the
sharp gain in share achieved earlier in the 1980s, sug
gests that U.S. demand for imports may grow at a faster
rate in the future. The lack of a shift in U.S. export
composition means that there would be no offsetting
increase in foreign demand for U.S. exports, assuming
other economic factors remain unchanged. This
assymetric situation arises because demand for fin
ished goods generally increases faster than demand for
industrial supplies as economies mature. Indeed, world
demand for finished goods appears to have grown
almost twice as fast as world demand for industrial
supplies since 1979.
Put more formally, an economy’s income elasticity of
demand for imported finished goods is generally greater
than its income elasticity of demand for imported indus21Hickok, “ Factors,” considers the possible impact on U.S. trade
composition of scale economies in certain trade sectors, trade
hysteresis resulting from large exchange rate movements in the
1980s, and shifts in U.S. trade flows between different trade
partners. Only the last of these three factors appears to have
played a role, and that role modest, in shaping the 1978-89
evolution of U.S. trade composition. Of course, shifting trade flows
across trade partners could in part be a reaction to the demand,
supply, and trade restriction developments discussed in this
section.
trial supplies.22 Consequently, the shift in U.S. import
composition in favor of finished goods is likely to have
raised the aggregate U.S. income elasticity of demand
for imports above what it otherwise would have been,
leading to higher U.S. import purchases as the U.S.
economy grows. With no apparent significant shift in the
composition of U.S. exports, sales of U.S. exports
would receive no comparable boost in response to eco
nomic growth abroad, again assuming other factors
remain unchanged.
The increased sensitivity of U.S. import demand to
income growth without a corresponding change on the
export side implies that, in coming years, overall U.S.
economic growth may have to be slower or U.S. prices
lower relative to foreign prices than would otherwise be
the case in order for the United States to maintain a
given trade balance level. Trade adjustment through
lower U.S. prices relative to foreign prices is, however,
likely to be harder to achieve than in the past because
of the change in U.S. import composition over the
1978-89 period. The demand for differentiated finished
goods responds to significant nonprice factors and con
sequently tends to be less sensitive to relative price
changes than does the demand for homogeneous
industrial supplies. Therefore, the U.S. price elasticity
of demand for imports may have decreased as U.S.
import composition shifted toward finished goods and
away from industrial supplies.
Several other characteristics of international trade
suggest that recent U.S. trade composition develop
ments could lead to market dynamics even more
unfavorable to the U.S. trade outlook than these elas
ticity considerations alone suggest. Finished goods are
typically differentiated products; brandname recognition
and purchaser loyalty are important. For capital goods,
moreover, design specification and compatibility with
related equipment are also key considerations. For
these reasons, foreign exporters who have moved more
into finished goods have altered market dynamics in
“ Income elasticities of demand for imports are not available
separately for the finished goods and industrial supplies categories
within the manufactured goods sector. However, elasticities have
been separately estimated for raw materials and for total
manufactured goods. Morris Goldstein and Mohsin S. Khan present
estimates of these elasticities drawn from eight different studies in
“ Income and Price Effects in Foreign Trade," Handbook of
International Economics, vol. 2, chap. 20 (New York: Elsevier
Science Publishers, 1984), p. 1086. The manufactured goods
elasticity was higher than the raw materials elasticity in every study.
The average of the estimated manufactured goods elasticities was
1.5; the average of the estimated raw materials elasticities, 0.8. It is
reasonable to expect that the elasticity for the industrial supplies
component of manufactured goods would be similar to the raw
materials elasticity while the elasticity for finished goods would be
higher than the overall manufactured goods elasticity.
their favor: they are likely not only to retain their
increased market share but also perhaps to make fur
ther gains in that share. They have consequently
affected the outlook for trade composition as well as the
actual trade composition developments of the 1978-89
period.
A more conjectural dynamic impact of the U.S. trade
composition shift that has occurred since 1978 is the
likely effect it has had on perceptions of the quality of
foreign products. As foreign producers, especially those
in countries relatively new to the international trade
arena, demonstrate that they can produce sophisticated
finished goods, they enhance the perceived quality of
all their products. An improved foreign quality reputation
further increases U.S. demand for imports, particularly
in the finished goods category where quality character
istics are important.
Conclusion
Finished goods climbed 11 percentage points as a
share of U.S. manufactured goods imports between
1978 and 1989. They showed no increase as a share of
U.S. manufactured goods exports during this period.
Since finished goods have been growing more rapidly
than industrial supplies in both U.S. and world demand,
this 11 percentage point difference in U.S. import and
U.S. export developments is not an encouraging sign
for U.S. competitiveness. Weak U.S. investment relative
to investment abroad appears to be the most important
factor behind the difference. A reduction in the U.S.
steel wage premium, U.S. restrictions on steel imports,
and slight differences between foreign demand develop
ments and those in the United States have also contrib
uted, but these three factors together seem to account
for at most only half of the 11 percentage point diver
gence. Changes in relative capital supplies probably
account for the other half. In fact, only changes in
relative capital supplies appear to explain adequately
why the decline in U.S. competitiveness in the finished
goods sector has been so widespread across trade
partners.
As for developments affecting the future, investment
abroad appears to continue to outpace investment in
the United States. Western Europe, where investment
was less buoyant than that of other regions through the
mid 1980s, in particular appears to have increased its
investment effort in recent years. Given the dynamics
underlying the U.S. trade composition developments of
the past decade, unless the pattern of relatively weak
U.S. investment is reversed, the United States may well
face a more challenging international trade environment
in coming years.
FRBNY Quarterly Review/Spring 1991
37
Factors Affecting the
Competitiveness of
Internationally Active Financial
Institutions
by Beverly Hirtle
Large internationally active banks and securities firms
have responded to the opportunities and challenges of
an increasingly competitive global market environment
with a wide range of strategies and approaches. A
variety of factors— including the development of global
financial markets operating across national boundaries,
the increased access of foreign competitors to domestic
financial markets, and the expanding availability of tra
ditional banking services from nontraditional sources—
have acted to alter the competitive environment in
which these financial institutions operate. These devel
opments have both changed the character of markets
for existing bank products and services and introduced
new markets in which banks and securities firms must
compete both domestically and internationally. Conse
quently, the factors that determine competitive success
for large financial institutions now reflect the greater
degree of international integration characterizing the
various markets for bank products and services.
This article examines the factors that appear to affect
the competitive position of large, internationally active
banks and securities firms. It synthesizes the results of
seven studies of bank product markets and a study
assessing the competitive performance of banks and
securities firms on the basis of conventional quantitative
measures. These eight papers were prepared as one
part of a Federal Reserve Bank of New York research
project evaluating the international competitive position
of U.S. financial institutions.1
’ The papers are available in Federal Reserve Bank of New York,
International Competitiveness of U.S. Financial Firms: Products,
Markets and Conventional Performance Measures, May 1991. They
are cited individually in the footnotes that follow.
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FRBNY Quarterly Review/Spring 1991
The first half of the article reviews the performance of
major financial institutions in the seven separate prod
uct markets. Three of these markets— the Eurocredit,
swaps, and foreign exchange markets— are essentially
international in nature; product attributes and prices
differ little across national trading centers. In contrast,
the remaining four markets— commercial lending, retail
banking, government bonds, and equities— are largely
national in character. Analyzing the ability of foreign
banks and securities firms to compete successfully in
these national markets not only suggests how institu
tions are able to establish themselves in overseas mar
kets but also provides a measure of the strength of local
institutions’ domestic franchise.
The review of the seven product markets offers a
fairly com prehensive picture of the com petitive
strengths of banks and securities firms along national
and institutional lines. While this approach provides
insights about those banks and securities firms that
tend to be successful competitors in particular markets,
it does not establish a sense of the overall competitive
position of institutions across all of their market activi
ties. To meet this last objective, the article evaluates the
performance of fifty-one large, internationally active
financial institutions by measuring the institutions’
return on equity and assets, capitalization, and asset
size from the mid-to-late 1980s. This more quantitative
approach sheds light on the competitiveness of banks
and securities firms as integrated institutions. In addi
tion, it highlights the strengths and weaknesses of the
conventional measures of performance on which it
relies.
The final section of the article draws on this examina
tion of consolidated competitive performance as well as
the review of the seven product markets to identify the
characteristics that appear to be associated with com
petitive success for banks and securities firms. The
major finding of this section is the suggestion that
banks and securities firms compete most successfully
in international markets by building on traditional
domestic market strengths. These traditional strengths
include the existence of an established customer base,
technical expertise and innovative ability resulting from
specialization in particular domestic markets, and famil
iarity with home-country financial and currency mar
kets. The ability of individual financial institutions to
translate these attributes into success in the interna
tional arena is in turn affected by several conventional
factors: the size of the institution may help to determine
whether it can take advantage of economies of scale,
particularly in information gathering and processing;
capitalization may affect the institutions’s credit stand
ing; the cost of capital may influence a bank’s ability to
offer competitive prices for its products and services;
and the existence of links across product markets may
allow banks to exploit economies of scope in producing
a variety of products and services.
The competitive performance of internationally
active banks and securities firms
This section reviews competitive conditions in seven
product markets to clarify which financial institutions
are successful competitors on an international scale.
The review primarily focuses on banks and securities
firms grouped by national affiliation, but it also consid
ers the competitive strategies taken by different firms in
the various markets. The seven product markets dis
cussed are not an exhaustive list of the activities in
which internationally active financial institutions partici
pate; rather, they are meant to provide general insights
about the characteristics making for competitive suc
cess across various international banking markets. The
final part of this section takes a more integrated view of
these institutions by reviewing a range of conventional
quantitative measures of competitive success.
International p ro d u c t m arkets
In each of the international product markets— the
Eurocredit, swaps, and foreign exchange markets—
market activities are highly integrated across national
trading centers, resulting in little if any differentiation in
product attributes or price along national lines. The
national affiliation of financial institutions participating
in these markets is thus potentially less important than
other firm-specific characteristics. These markets come
closest to constituting a “level playing field” for institu
tions from different countries and, as such, provide a
means of highlighting the factors associated with com
petitiveness in a truly international setting.
Eurocredit m arket2
At first glance, the Eurocredit market appears to be a
leading example of a truly global financial market. Con
sisting of the markets for international loans and bonds
originated and sold outside of the country of both the
borrower and the currency of the issue, the Eurocredit
market serves a diverse group of multinational cus
tomers conducting transactions in a wide variety of
currencies. Borrowers can escape domestic market reg
ulations, restrictions, and taxation; at the same time,
international banking competitors can operate on a rel
atively level playing field. Financial intermediaries are
generally free to help any borrower raise capital through
bonds or loans denominated in any currency.
Despite the potential for banks and securities firms to
participate equally in most sectors of the Eurocredit
market, a high degree of segmentation is evident. Dif
ferent financial institutions specialize in and dominate
different sectors of the market, which are often related
to their classification (for example, “bank” or “security
firm”) and nationality.
Nationality appears to be an especially strong factor
in the Eurobond sector of the market. In the nondollar
bond sector, the nationality of the lead underwriter
tends to be strongly correlated with the nationality of
the currency, reflecting the importance of ties to homecountry investors in placing nondollar issues. In the
dollar-denominated bond sector, however, the nation
ality of the intermediary and that of the bond issuer are
strongly correlated. The greater international accep
tance of the dollar and the greater ease in placing
dollar-denominated issues mean that borrower rather
than investor relations are the key to competitiveness in
this sector.
Nationality appears to be less important in the
Euroloan sector, as reflected in the weaker association
between the home-country of the currency and the
nationality of both borrowers and lenders. This weaker
correlation suggests that it may be easier for an inter
mediary to overcome national currency preferences
among banks when forming an investor base in the
Euroloan market. Nevertheless, existing customer rela
tionships appear to play an important role in bringing
new borrowers to the market and winning loan man
dates. All these links together suggest that a firm can
use the comparative advantage of its domestic cus
tomer base to gain market share.
In addition to the specialization in various sectors of
2The material in this section is based on John M. Balder, Jose A.
Lopez, and Lawrence M. Sweet, "Competitiveness in the Eurocredit
Market."
FRBNY Quarterly Review/Spring 1991
39
the Eurocredit market associated with nationality, there
is specialization along institutional lines. Commercial
banks dominate the Euroloan market while investment
banks and universal banks tend to dominate Euro
bonds. This observed segmentation, in spite of the
relative freedom of any intermediary to offer any finan
cial service in the Eurocredit market, points to a ten
dency for firms to rely on their traditional domestic
market strengths in the face of intense competition.
This competition has resulted in low profitability.
Although little reliable data exist regarding the prof
itability of a firm’s Eurocredit market operations, market
withdrawals and reports of losses support the notion of
a low-profit market. U.S. securities firms are among the
most successful competitors in the Eurobond market,
but the market share of U.S. intermediaries has
declined since 1983, in part reflecting the decline in
issues by U.S. borrowers. An increase in Japanese
issues, particularly in the equity-warrant sector, has
helped foster a significant increase in the market share
of Japanese intermediaries. U.S. and Japanese banks
also command the largest market shares in the
Euroloan sector.
Swap m arket3
Like the Eurocredit market, the swap market has a
strong international focus. The rapid growth of the mar
ket during the 1980s has been driven in large part by
the expansion of international financial flows and a
more volatile interest rate environment. Interest rate
and currency swaps are important financial tools used
by firms both to reduce the costs of borrowing in over
seas and domestic capital markets and to manage the
interest rate and currency risk exposures generated by
international economic and financial market activity. As
such, swaps are denominated in a wide variety of cur
rencies to meet the financing needs of a diverse, multi
national customer base.
Although the customer base and product attributes of
the swap market underscore its international character,
the segregation among swap dealers along both
national and institutional lines is significant. The prin
cipal swap-dealing firms are commercial banks and
securities firms. Institutional and regulatory struc
tures— particularly in the United States, Japan, and, to
a lesser extent, the United Kingdom— have traditionally
induced securities firms and commercial banks to focus
on businesses that give them natural strengths in differ
ent types of swaps. The underwriting activity of securi
ties firms, for instance, tends to generate a natural flow
of swaps related to bond market financings. In contrast,
3The material in this section is based on Robert Aderhold, Ethan
Heisler, Ricardo Klainbaum, and Robert Mackintosh,
“ Competitiveness in the Global Swap Market."
Digitized40
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FRBNY Quarterly Review/Spring 1991
the strength of commercial banks in the area of interest
rate risk management tends to give those institutions an
advantage in transactions relating to balance sheet
management. As a counterpart to specialization along
institutional lines, there is also a tendency for swap
dealers to specialize in swaps denominated in their
home-country currency, particularly in the nondollar
sector. These trends together suggest that competitive
success in the swap market continues to be influenced
by domestic market factors.
Overall, the strongest competitors in the swap market
are large global financial institutions, including U.S.
money center banks, U.S. diversified securities firms,
and European universal banks. Although virtually all
major international commercial banks and securities
firms participate in the swap market to some degree,
the number that are important competitors is limited.
Market share data and surveys of market participants
suggest that major competitors number no more than
twenty-five.
A study of these major competitors suggests that a
variety of firm-specific factors influence competitive suc
cess in the swap market. For instance, the size and
breadth of an institution’s financial market activities
appear to be important to the efficient management of
risks associated with swap market transactions. Swap
portfolio size is important, both because it can reduce
the costs of managing interest rate and currency risks
and because large market share can put firms in a
position to gain superior knowledge of market order
flow. Similarly, a presence in a variety of related mar
kets gives dealers access to order flow information and
lower transaction costs for instruments used in swap
portfolio management. Finally, strong credit standing is
essential in the swap market because both parties to a
swap are exposed to credit risk.
Foreign exchange m arket4
The foreign exchange market is one of the most impor
tant international links between national financial mar
kets. Consisting primarily of the buying and selling of
demand deposits in different currencies, the foreign
exchange market has grown rapidly and changed signif
icantly during the past few decades. The growth in the
market has been spurred by economic developments
that have led to large trade imbalances among major
economies and thus to significant increases in interna
tional capital flows. The impact of these economic
developments has in turn been reinforced by advances
in technology and the liberalization of financial markets,
4The material in this section is based on Peter S. Holmes, Paul
DiLeo, Thaddeus Russell, John R. Dacey, and Kimberly Reynolds,
"Competitiveness in the Global Market for Foreign Exchange.”
forces that have led to tighter integration of national
money and capital markets.
Financial institutions have pursued a variety of strat
egies in their approach to foreign exchange trading. A
number of large dealers, primarily commercial banks,
provide a diversified range of foreign exchange services
and make markets in many currencies. In contrast,
other foreign exchange dealers specialize in transac
tions involving particular currencies and instruments,
offering a more limited range of services. This speciali
zation frequently reflects the institution’s overall market
strengths, especially the information and experience
acquired by participation in both domestic and overseas
financial markets. In particular, many dealers are led by
their familiarity with both domestic financial markets
and the direction of domestic monetary policy to spe
cialize in transactions involving their home-country
currency.
Judged by the success of overseas branches and
affiliates, U.S. institutions appear to hold a dominant,
but perhaps diminishing, position in foreign exchange
trading. The trading operations of U.S. multinational
banks appear to be among the most profitable relative
to other international institutions, both in terms of abso
lute foreign exchange income and in terms of the share
of total operating income derived from foreign exchange
activities. U.S. institutions are also rated highly in sur
veys assessing the global performance of foreign
exchange market participants. The overall strong show
ing of U.S. institutions largely reflects the importance of
the dollar as an international reserve currency. Among
non-U.S. institutions, Swiss banks are strong perform
ers in terms of the profitability and income derived from
their foreign exchange operations, while U.K. institu
tions are rated highly in foreign exchange market sur
veys assessing the quality of foreign exchange
services.
N ational p ro d u c t m arkets
The four national markets for banking products and
services— commercial lending, retail banking, govern
ment bonds, and equities— are largely independent
across national boundaries. Although markets in differ
ent countries may offer similar products and services,
differences in regulatory structure, financial market
sophistication, and traditions governing the relationship
between banks and their customers may create signifi
cant national differences in the way that the markets
function. These national differences can represent a
barrier to foreign financial institutions wishing to
become successful competitors in overseas financial
markets.
The discussion that follows focuses primarily on
national markets in the United States, Japan, Germany,
and the United Kingdom, although other national mar
kets are also considered. Markets in these four coun
tries reflect a range of market structures, regulatory
environments, and customer affiliations that have
resulted in domestic banking franchises of varying
strengths. Evaluating the ability of foreign banks and
securities firms to compete successfully in these mar
kets thus not only helps identify factors that may enable
institutions to establish themselves in overseas mar
kets, but also provides a measure of the strength of
local institutions’ domestic franchise.
Com m ercial lending m arkets5
Commercial credit, consisting of credit extended by
banks to nonfinancial business customers, has histor
ically been the most important component of lending by
commercial banks. Commercial credit is used for a
variety of purposes, including the financing of working
capital, new plant and equipment, and corporate
restructurings such as mergers and acquisitions. In
recent years, however, alternative sources of nonbank
commercial credit such as public debt and credit
extended by nonbank financial institutions have become
increasingly important in commercial lending markets,
particularly in the United States. The existence of these
alternative credit sources has changed the competitive
environment of several of the national commercial lend
ing markets.
A number of factors affect the competitive position of
banks in the U.S., U.K., German, and Japanese com
mercial lending markets. For instance, the ability of a
bank to sustain competitive advantage in loan pricing is
strongly influenced by its cost of capital, which includes
the cost of debt and equity and takes into account tax
effects. A bank with a lower cost of capital can price
more aggressively while still earning an acceptable rate
of return on the loans in its portfolio. The credit stand
ing of a bank is also an important factor, largely
because it affects the institution’s ability to serve as a
reliable source of standby liquidity. The ability of a bank
to continue to extend credit during tight credit periods
appears to figure prominently in firms’ choice of lender.
In general, aggressive pricing and strong customer
relationships seem to be the leading sources of compet
itive advantage in commercial lending, but their precise
importance appears to vary with the national market.
Aggressive pricing strategies have been most influential
in the United States, where customers are more price
sensitive and relationships between banks and corpora
tions appear to be weaker. Customer relationships
seem particularly important in the German and Jap5The material in this section is based on Jonathan T.B. Howe,
George Budzeika, Gina G. Riela, and Paula Worthington,
"Competitiveness in Commercial Lending Markets.”
FRBNY Quarterly Review/Spring 1991
41
anese corporate lending markets, in part because of the
traditional links between banking and commerce in
these economies.
Foreign banks, particularly Japanese banks, have
enjoyed considerable success in penetrating the U.S.
commercial lending market. The large volume of trade
with the United States and the growing presence of
foreign-owned firms have provided ample opportunities
and a strong customer base for foreign banks operating
in the U.S. commercial lending market. In addition,
Japanese banks in particular appear to have broad
customer bases that include U.S. as well as foreignaffiliated borrowers. Foreign bank penetration in the
U.K. commercial lending market is also fairly extensive.
In the United Kingdom, the fairly significant degree of
foreign penetration into the broader U.K. economy may
partly explain the success of foreign banks.
Foreign banks have experienced much less success
in the domestic commercial lending markets of Germany
and Japan. In these countries, customer relationships
with domestic firms are long-established and reinforced
by interlocking directorships and mutual ownership. Fur
thermore, especially in the Japanese market, the pres
ence of foreign-owned businesses is relatively small,
limiting the ability of foreign banks to capitalize on
home-country customer ties. In addition, with very few
exceptions, foreign banks in both the Japanese and
German markets have been unable to establish the
branch networks that appear to provide domestic banks
with lower cost sources of funding. All of these factors
have tended to limit the extent to which foreign banks
are able to be successful competitors in the German
and Japanese commercial lending markets.
Retail banking m arkets6
Retail banking includes the deposit-taking and lending
activities that commercial banks conduct for individuals
and small businesses. In the retail banking markets of
the United States, Japan, the United Kingdom, and
Canada, the intensity of competition has increased dur
ing the 1980s, furthered by interest rate deregulation
and the increased price sensitivity shown by consum
ers. Technological advances in data processing and
electronic equipment have been associated with a con
tinuing reorganization of the production of banking ser
vices. The ability of banks to process and deliver
multiple retail services on increasingly larger scales
appears to be driving this reorganization.
Despite the increased competition in retail banking
markets, domestic banks dominate in each of the four
countries because of the advantage that domestic
«The material in this section is based on M. Ellen Gaske, Michele S.
Godfrey, Edward J. Rooney, Annaliese J. Schneider, and Paula R.
Worthington, “ Competitiveness in Retail Banking Markets."
Digitized for
42 FRASER
FRBNY Quarterly Review/Spring 1991
banks continue to have over foreign banks in providing
retail services. For instance, a strong physical presence
appears to be important for full-scale deposit-taking
activities. Domestic institutions that have already
invested in a substantial branch network thus have an
advantage; the “bricks and mortar” costs of achieving
such a presence present a significant barrier to new
banks, including new foreign banks, seeking to enter a
local retail market. In addition, in most markets, it
appears that national preference continues to matter,
with consumers preferring to transact their retail bank
ing business with domestic institutions.
For foreign banks wishing to enter overseas retail
banking markets, niche banking has emerged as a
leading competitive strategy. As in other national bank
ing markets, niche strategy in retail banking is fre
quently designed to capitalize on foreign institutions’
domestic market strengths. For instance, some foreign
banks pursue a “population niche” strategy and choose
to meet the retail banking needs of an identified ethnic
or regional customer base— most often, customers with
ties to their home-country markets. Alternatively, for
eign banks may use a “product niche” strategy by
opting to specialize in a limited range of products or
attempting to use a single product to create name
recognition. The “product niche” strategy has been par
ticularly common among U .S. banks, which have
attempted to apply technological advances in the pro
duction of retail banking services in the U.S. market to
overseas retail markets, with some limited success.
While a strong domestic retail franchise is evident in
each of these four national markets, the degree to
which domestic banks are able to dominate the local
retail market may be weakest in the United States.
Restrictive interstate banking rules have hindered U.S.
banks from building the national, full-service franchises
that have served as deterrents to foreign entry in other
national markets. A second factor is the diversity and
geographic dispersion of the U.S. population. The exis
tence of immigrant populations yields entry opportuni
ties for foreign banks in certain regional markets,
particularly on the east and west coasts. Foreign banks,
especially from the United Kingdom and Japan, appear
to have identified and targeted certain customer bases
and products and filled those niches profitably, although
their share of the total U.S. retail banking market is
fairly limited.
Government bond m arkets7
The government bond markets in the United States,
Japan, and Germany are largely dominated by domestic
TThe material in this section is based on John J. Ruocco, Maureen
LeBlanc, and Patrick Dignan, “ Competitiveness in Government Bond
Markets.”
financial institutions. While the dominance of domestic
firms may be somewhat less in the United States than in
Germany and Japan, the strong position of domestic
institutions in all three markets is in part an outgrowth
of historical practices that limited participation in gov
ernment bond underwriting to a specified group of
domestic banks and securities firms. Although foreign
firms currently face the same general regulatory
requirements as domestic financial institutions, their
penetration into most national government bond mar*
kets has been limited.
The limited role of foreign banks and securities firms
in the U.S., Japanese, and German government bond
markets primarily reflects the competitive advantages
accruing to large, established domestic institutions.
First, there appear to be significant advantages to oper
ating on a large scale in government bond markets,
particularly in gathering and processing information. A
large customer base helps ensure that the dealer is
active and receiving supply, demand, and price informa
tion from all sectors of the market, so that the traders
and salespeople are both more knowledgeable and
more effective. Even in the most liquid government
bond markets, this type of information appears to be
critical to success. Second, firms participating in a wide
range of financial market activities also appear to have
a competitive advantage in government bond markets.
Information about financial market conditions and inter
est rate movements derived from transactions in other
markets often can be applied to government bond mar
ket activities, generating economies of scope in infor
mation processing.
In addition to facing these information-related com
petitive disadvantages, foreign financial institutions
must cope with the difficulties arising from their lack of
a natural distribution network and local customer base
for the securities. Many foreign firms have attempted to
overcome this disadvantage by targeting as likely cus
tomers affiliates of firms from their home countries.
Foreign institutions also attempt to distribute govern
ment bonds to clients located in their home country and
to those located in other foreign countries. The ability of
foreign firms to market government securities interna
tionally, however, may be constrained by investor reluc
tance to purchase foreign government securities. In this
sense, then, foreign competitors wishing to enter the
U.S. government bond market may face less of a com
petitive disadvantage than foreign competitors in other
markets because of the wider acceptance of dollardenominated securities outside of the United States.
To offset their inherent disadvantage in government
securities distribution, foreign institutions often attempt
to attract business by offering better services, a wider
array of products, or more innovative products than their
domestic counterparts. In some markets, foreign firms
may have an advantage in providingjnnovative products
and implementing sophisticated trading strategies origi
nally developed in their home-country government bond
markets. The ability of foreign institutions to capitalize
on a competitive advantage in these “leading edge”
areas, however, is sometimes restrained by the char
acter of the various domestic markets. For example, the
absence of a repurchase agreement market or the lack
of hedging vehicles and^of the ability to sell securities
short can hinder the efforts of foreign financial institu
tions to develop a niche in innovative product offerings.
Equity m arkets8
The national equity markets in the United States, Ger
many, Japan, and the United Kingdom have distinctive
market structures that affect the competitive environ
ment facing both foreign and domestic financial institu
tions. In the U.S. and U.K. markets, underwriting and
brokerage fees are negotiated, leading to stiff competi
tion and a sharp narrowing of intermediary profits in
these activities in recent years. In contrast, the Jap
anese and German equity markets are still charac
terized by fixed brokerage commissions and strong
relationships between customers and individual banks,
features that have limited the ability of foreign institu
tions to gain significant market share.
In each of the four markets, demand for equity ser
vices is concentrated among domestic institutional
investors, giving large and sophisticated domestic
financial institutions a decisive competitive advantage.
A study of these firms suggests that large financial
institutions may benefit from economies of scale in
providing “plain vanilla” equity trading and underwrit
ing. In addition, institutions able to provide a range of
sophisticated equity products and services may have an
advantage because they can absorb the lack of prof
itability in “core” underwriting and brokerage areas by
engaging in more profitable corollary activities such as
derivative products and proprietary trading. As a conse
quence of these scale and scope economies, a handful
of domestic firms dominate trading and underwriting in
each of these four markets.
Faced with these circumstances, most foreign institu
tions attempting to enter local equity markets have
pursued one of two alternative strategies, although typ
ically with quite limited success. The first strategy
involves establishing market share in a particular popu
lation or product niche, most often by trying to build on
competitive strengths developed in home-country equity
markets. For instance, foreign institutions may cap•The material in this section is based on Martin Mair, Michael
Kaufman, and Steven Saegar, “ Competitiveness in Equity Markets.”
FRBNY Quarterly Review/Spring 1991
43
italize on their existing customer base by specializing in
serving investors from their home-country. Alternatively,
foreign banks and securities firms may build on tech
nical expertise acquired in domestic markets by provid
ing leading edge products such as derivatives, block
and basket trading, trading in overseas markets, merg
ers and acquisitions, and fund management. For this
product niche strategy to succeed, however, foreign
entrants must be more expert in these leading edge
techniques than domestic institutions, and, in addition,
the legal/regulatory environment must permit firms to
engage actively in these techniques. Foreign firms mak
ing the greatest competitive inroads using this strategy
are largely from the United States, with U.K. firms also
making a strong showing.
The second strategy used by foreign firms endeavor
ing to enter a local equity market is to purchase a
domestic institution active in that market. This strategy
enables foreign firms to buy market share by purchas
ing existing customer bases and to gain expertise in
more sophisticated markets, such as the United States
and United Kingdom, where domestic institutions are
already using leading edge trading techniques.
Conventional com petitive perform ance m easures9
This section summarizes the results of a study that
uses conventional quantitative performance measures
to assess the performance of fifty-one large, interna
tionally active banks and securities firms. The study
augments the more descriptive review of the seven
product markets by examining the performance of these
large financial institutions on a consolidated basis, that
is, across all the markets and activities in which they
participate. This approach yields insights into the
aggregate effects of the competitive strategies pursued
by these institutions in individual banking markets.
The study focuses primarily on the performance of
seven national groups of institutions across four broad
categories: size, profitability, productivity, and cap
italization.10 The study employs return on assets and
return on equity as measures of profitability, the levels
and growth rates of total assets and revenue as indica
tors of size, the shareholders’ equity and price earnings
ratios as measures of capitalization, and the ratio of
total revenue to non-interest expense as a gauge of
productivity. The data analyzed consist primarily of
information from the financial statements of the sample
•The material in this section is based on J. Andrew Spindler,
Jonathan T.B. Howe, Amil K. Petrin, David F. Dedyo, and Brian J.
Brown, “ The Performance of Internationally Active Banks and
Securities Firms Based on Conventional Measures of
Competitiveness."
10The seven countries are Canada, France, Germany, Japan,
Switzerland, the United Kingdom, and the United States.
FRBNY Quarterly Review/Spring 1991
Digitized44
for FRASER
firms for the 1985-89 period. Table 1 lists the fifty-one
firms arranged by country, and Table 2 presents a sum
mary of the findings.
As Table 2 indicates, the Japanese bank group’s
performance appears formidable across most m ea
sures, notably those relating to size, growth, and pro
ductivity. The Swiss bank group also appears strong,
especially in capitalization and profitability. The German
bank group turned in a solid performance in many
categories, showing strength in growth and profitability.
These measures may actually understate the perform
ance of German and Swiss banks, since unreported
earnings and hidden reserves at these institutions tend
to conceal additional underlying strength in profitability
and capitalization. The U.K. banks also showed
strength in a few criteria.
The performance of the sample of U.S. banks as a
group was uneven, although a few of these firms
showed considerable overall strength. By measures
such as the shareholders’ equity ratio, the U.S. banks
performed relatively well, although their showing was
only fair in terms of other criteria, including return on
assets and return on equity. Large provisions against
LDC loans in 1987 and 1989 weakened the performance
of U.S. banks across most measures and help explain
their mixed performance during the overall 1985-89
period. Although it must be recognized that losses on
LDC loans are in fact real losses, the core profitability of
U.S. institutions appears to be stronger than indicated
by the published numbers for the period under study.
The sample U.S. securities firms as a group generally
did not perform as well as their principal overseas
counterparts, the “Big Four” Japanese securities
houses. The four Japanese firms grew faster than the
U.S. firms and also appeared more profitable and better
capitalized, although no clear national pattern emerged
with regard to size. Again, however, individual U.S.
securities firms turned in results that by certain mea
sures rivaled or surpassed those of the Japanese
houses.
While this analysis gives a sense of the performance
of internationally active banks and securities firms
along national lines, any conclusions about the relative
performance of national institutions should be drawn
with caution. Differences in national accounting prac
tices and standards limit the accuracy of performance
comparisons based on reported data. The problem of
cross-national comparability of data may be especially
acute for German and Swiss banks, but it affects Jap
anese financial data also. Accounting conventions in
some of these countries may have resulted in an under
statement of the actual financial strength of financial
institutions over the mid-to-late 1980s.
Even if we assume that the data are comparable,
additional difficulties arise in assessing the implications
of the analysis for the overall competitive position of
individual firms and national groups. The particular sta
tistics chosen to represent the four aspects of com peti
tive perform ance— size, profitability, productivity, and
capitalization— may not be accurate measures in some
important respects. For instance, use of total assets as
a measure of size ignores off-balance sheet activities,
Table 1
Banking O rganizations and Securities Firms in Sample
Country
Canada
France
Germany
Japan
Switzerland
United Kingdom
United States
Japan
United States
Total Assets
Year-End 1989
(In Millions of Dollars)
Banks
1 Royal Bank of Canada
2 Canadian Imperial Bank of Commerce
3 Bank of Montreal
4 Bank of Nova Scotia
1 Banque Nationale de Paris
2 Credit Lyonnais
3 Society G6n6rale
4 Banque Paribas
5 Banque Indosuez
1 Deutsche Bank
2 Dresdner Bank
3 Commerzbank
1 Dai-lchi Kangyo Bank Ltd.
2 Sumitomo Bank Ltd.
3 Fuji Bank Ltd.
4 Mitsubishi Bank Ltd.
5 Sanwa Bank Ltd.
6 Industrial Bank of Japan Ltd.
7 Bank of Tokyo Ltd.
8 Long-Term Credit Bank of Japan Ltd.
9 Mitsubishi Trust and Banking Corp.
10 Sumitomo Trust and Banking Co. Ltd.
11 Mitsui Trust and Banking Co. Ltd.
1 Union Bank of Switzerland
2 Swiss Bank Corp.
3 Credit Suisse
1 Barclays PLC
2 National Westminster Bank PLC
3 Midland Bank PLC
4 Lloyds Bank PLC
5 S.G. Warburg Group PLC
6 Kleinwort Benson Group PLC
1 Citicorp
2 Chase Manhattan Corp.
3 BankAmerica Corp.
4 J.P Morgan and Co. Inc.
5 Security Pacific Corp.
6 Chemical Banking Corp.
7 Manufacturers Hanover Corp.
8 Bankers Trust New York Corp.
9 First Chicago Corp.
1
2
3
4
1
2
3
4
5
6
Securities firms
Daiwa Securities Co., Ltd.
Nomura Securities Co., Ltd.
Nikko Securities Co., Ltd.
Yamaichi Securities Co., Ltd.
Salomon Brothers Inc.
Merrill Lynch
Shearson Lehman
Goldman Sachs and Co.
Morgan Stanley and Co.
First Boston Corp.
88,446
78,398
64,780
62,251
231,463
210,727
175,787
82,164
55,316
198,254
143,866
111,277
389,134
370,516
364,888
362,256
339,490
248,730
201,827
175,351
174,961
152,330
142,097
112,503
104,487
75,885
204,874
186,529
100,303
92,378
21,640
14,234
230,643
107,369
98,764
88,964
83,943
71,513
60,479
55,659
47,907
44,924
38,989
29,674
29,547
118,250
63,942
63,548
61,298
53,276
46,313
Note: Assets of Canadian firms are as of October 31, 1989, and assets of Japanese firms are as of March 31, 1990.
FRBNY Q uarterly R eview/Spring 1991
45
which are an im portant component of the activities of
large financial institutions. More importantly, perform
ance in the four categories selected may not tell the full
story about firm-level competitiveness. Factors such as
te chnological soph istica tion and innovative capacity,
potentially critical to a firm ’s future success, have not
been taken into account in this analysis because they
generally cannot be quantified using standard mea
sures. Failing to consider such “ human capital” ele
ments may understate the competitive standing of some
firms, particularly those whose competitive strategies are
formed around providing technically sophisticated prod
ucts and services. In addition, the balance sheet data
used in the study are for the most part retrospective. In
many cases, the past performance of these institutions
may not be a good indicator of future success.
Determ inants of com petitive success among
internationally active banks and securities firms
This section draws on the examination of the consoli
dated performance of the fifty-one internationally active
financial institutions and the review of the seven product
markets to identify the characteristics of banks and
securities firms that appear to be associated with com
petitive success. As a point of departure, the experi
ence of U.S. financial institutions over the mid-to-late
1980s will illustrate the ways that success in individual
product markets translates into overall profitability. The
factors common to effective com petitors in these indi
vidual markets can then be identified, providing insight
into some of the important qualities that appear to influ
ence competitive success on an international scale.11
The perform ance of U.S. financial institutions
To some extent, the fairly weak perform ance of U.S.
banks and securities firms as gauged by the conven
tional quantitative measures conflicts with the im pres
sion left by the review of the seven product markets.
That review suggested that U.S. banks and securities
firms are among the most prom inent com petitors in
in te rn a tio n a l m a rk e ts such as fo re ig n e xc h a n g e ,
Eurocredit, and swaps, and among the most successful
entrants in overseas national markets such as govern
ment bonds and equities. At first glance, this evidence
seems hard to reconcile with the reported perform ance
of U.S. banks and securities firms as aggregate finan
cial institutions.
Closer consideration of the product m arket review
"M a n y of these same issues are addressed— with a somewhat
different focus— in "International Competitiveness of U.S. Financial
Firms: The Dynamics of Change in the Financial Services Industry,"
a forthcoming Federal Reserve Bank of New York study. This study
examines the dynamic forces influencing key sectors and services
in financial markets and gives particular attention to economic and
technological change.
Table 2
Performance Summ ary of Sample Banks and Securities Firms by C ountry Group (1985-89)
Securities
Banks
Performance
Measure
Size
Total assets*
Real asset growth*
Total revenue?
Real revenue growth*
Profitability
Real return on assets*
Real return on equity*
Productivity
Total revenue/
Non-interest expense
Capitalization
Shareholders'
equity ratio*
Price-earnings
multiple
Firms
United
States
Canada
France
Germany
Japan
Switzerland
United
Kingdom
United
States
1 of top 10
2.2 (6)
3 of top 10
4.3 (7)
0 of top 10
0.5 (7)
0 of top 10
6.1 (2)
2 of top 10
3.1 (4)
2 of top 10
4.3 (6)
0 of top 10
5.5 (2)
1 of top 10
5.6 (4)
6 of top 10
12.6 (1)
0 of top 10
16.0 (1)
0 of top 10
3.1 (5)
0 of top 10
4.9 (5)
1 of top 10
3.6 (3)
4 of top 10
5.7 (3)
0.08 (7)
1.6 (7)
0.17 (6)
3.5 (6)
0.21 (4)
9.7 (2)
0.24 (3)
6.8 (3)
0.27 (2)
11.5 (1)
0.32 (1)
5.3 (4)
0.20 (5)
4.2 (5)
0.33
9.7
1.83
19.6
1.51 (4)
1.74 (2)
1.46 (5)
1.44 (6)
2.06 (1)
1.36 (7)
1 52 (3)
1.12
2.16
4.8 (4)
4.9 (3)
2 2 (7)
3.6 (5)
2.5 (6)
6 2 (1)
5.1 (2)
3.4
9.6
8# (4)
8» (5)
No data
19 (3)
74 (1)
21 (2)
6# (6)
9
21
Japan
Comparable
37.1
7.0
Comparable
11.7
22.1
Notes: Except where noted, all figures are country group averages for the period 1985-89. Ordinal ranking among the seven national
groupings of banks appears in parentheses where appropriate
■[Figures are based on ranking of individual banks by total assets at fiscal year-end 1989.
t in percent.
§Figures are based on ranking of individual banks by average revenue, 1985-89.
||Average price-earnings multiples of the U.S., Canadian, and U K bank groups are calculated from their 1985 and 1986 results only.
Digitized
FRASER Q uarterly Review/Spring 1991
46 for FRBNY
provides some insight into the aggregate performance
of U.S. banks and securities firms, however. Although
U.S. institutions are strong competitors in a number of
markets, their strength is most evident in the three
international markets— swaps, foreign exchange, and
Eurocredit. Each of these markets is characterized by a
high degree of competition, particularly in the core
product activities such as basic interest rate and cur
rency swaps, spot currency transactions, and basic
Eurocredit facilities, all of which have taken on a com
modity-like aspect. The low profitability resulting from
this intense competition has led participants in these
markets to rely on innovation and product niches in
specialized or technically complex instruments.
This strategy has become increasingly difficult to pur
sue, however. The very intensity of competition that has
compelled participants in these markets to adopt a
product niche strategy has also resulted in increasingly
shorter periods during which any particular bank can
realize the gains of an innovative or specialized prod
uct. These intense competitive conditions have made it
difficult for financial institutions to participate profitably
in these markets. Thus, even for those institutions that
remain, sizable market share in these activities does not
necessarily translate into a high degree of profitability.
This conclusion suggests that the ability of financial
institutions to establish and maintain profitability on an
aggregate basis may depend in large part on their
performance in home-country financial markets. The
effectiveness of both foreign banks and securities firms
and domestic nonbank competitors in a number of U.S.
national banking markets is consistent with the some
what lackluster consolidated performance of U.S. insti
tutions as gauged by conventional competitiveness
measures. The product market review suggests that the
domestic franchise of U.S. commercial banks is per
haps the weakest among the national groups consid
ered, an assessment that is borne out by the significant
foreign bank presence in U.S. national markets, particu
larly commercial lending. For a variety of reasons, U.S.
bank customers appear to be more price sensitive and
less dependent on established banking relationships
than customers in many other countries. Thus U.S.
commercial banks have been open to competition from
nonbank financial institutions as well as foreign banks
and securities firms. At the same time, the greater
international acceptance of dollar-denominated securi
ties provides foreign financial institutions with a natural
customer base, both inside and outside the United
States, for activities in U.S. financial markets. Overall,
then, U.S. banks and securities firms appear to have a
less reliable source of profitability from participation in
domestic banking markets than do many institutions
from other countries. The relative weakness of the
domestic franchise of U.S. institutions may therefore
underlie their uneven performance as gauged by con
ventional quantitative measures of competitiveness.
B uilding on traditional institutio na l strengths
The factors that appear to affect the strength of the
domestic banking franchise for U.S. commercial banks
demonstrate how conditions in home-country national
banking markets can shape the international competi
tive standing of financial institutions. The review of the
individual product markets suggests that banks and
securities firms compete successfully in international
and overseas domestic markets primarily by building on
traditional strengths developed in their home-country
domestic banking markets. These strengths include
particular knowledge of home-country capital and cur
rency markets; specialization in certain categories of
financial products and techniques, sometimes as a
result of regulation limiting participation in domestic
markets to certain types of institutions; and, perhaps
most important, the existence of an established cus
tomer base, which can both provide access to new
markets and serve as a deterrent to competitors wish
ing to enter existing markets.
Specialization based on dom estic m arket a ctivities
Perhaps the most common means of exploiting a
domestic market strength to gain competitive advantage
in international and overseas markets is through spe
cialization in international products that are closely
related to domestic market activities. For instance,
among U.S. financial institutions, participation in the
swap market is heavily segmented by institution type:
U.S. commercial banks have specialized in swaps
related to balance sheet management because of their
existing expertise in interest rate risk management,
while U.S. investment banks have been more prevalent
in the market for swaps related to new security issues.
This segmentation clearly mirrors the areas of domestic
market specialization that have resulted from regulatory
restrictions on financial market participation. Similarly,
product specialization in the Eurocredit market has
occurred along institutional lines, with commercial
banks tending to be the strongest competitors in the
Euroloan sector and securities firms tending to be domi
nant in the Eurobond sector.
There is also a broader sense in which financial
institutions have sought competitive advantage in over
seas and international markets through product special
ization that mirrors strength in domestic m arkets.
Financial institutions from certain countries, most nota
bly the United States and the United Kingdom, have
developed a high degree of technical expertise in con
structing, managing, and marketing complex financial
FRBNY Quarterly Review/Spring 1991
47
products and services. This expertise involves both the
development of physical capital— primarily computer
systems and software— and the development of trained
professionals and support staff with both technical and
market knowledge.
Banks and securities firms from the United States and
the United Kingdom have frequently attempted to
exploit these domestic market strengths when entering
international and overseas national markets. The tech
nical ability to introduce and develop complex derivative
products has given these institutions profitable product
niches in markets such as swaps and foreign exchange,
where competition in core products and services has
greatly reduced profitability. Specialization in complex
financial products has also provided a potential entry
niche into overseas banking markets such as those in
Germany and Japan, where domestic institutions have
not traditionally focused on products and services
requiring significant technical innovation. Successful
utilization of domestic technical strength in overseas
markets has been dependent, however, on the ability to
develop both customer demand and regulatory approval
for complex products and services.
weakness. On the one hand, the strong demand for
transactions in the dollar and dollar-denom inated
instruments creates a natural advantage for U.S. finan
cial institutions possessing a presumably greater knowl
edge of the factors affecting dollar movements and
interest rate fluctuations. U.S. institutions have used
this advantage to establish strong competitive positions
in international m arkets such as swaps, foreign
exchange, and Eurocredit.
On the other hand, the same conditions that give U.S.
financial institutions an advantage in international mar
kets may create a relative disadvantage in domestic
markets. The wide acceptance of dollar-denominated
securities outside of the United States means that for
eign institutions wishing to enter U.S. securities mar
kets such as government bonds and equities have a
relatively extensive natural distribution base in the form
of existing overseas customers. The existence of this
distribution base may make it easier for foreign financial
institutions to establish themselves in U.S. national
markets. To some extent, then, the status of the dollar
in international markets may have resulted in a weaken
ing of the domestic franchise of U.S. financial institutions.
S pecialization b ased on know ledge of hom e-country
m arkets
The ability to derive a competitive advantage in interna
tional m arkets from knowledge of hom e-country
markets and conditions is perhaps most evident in the
foreign exchange and swap markets. Institutions par
ticipating in both of these markets show a clear ten
dency to specialize along home-country currency lines,
most likely because of more intimate knowledge of
domestic capital markets and economic conditions.
This knowledge may give domestic financial institutions
an advantage in assessing the factors affecting homecountry currency movements and interest rates and
thereby create profit opportunities through dealings with
customers. Alternatively, specialization in currency by
national affiliation may simply arise because customers
associate financial institutions with their home-country
currencies and turn to those institutions to meet their
needs to transact in various currencies.
In either case, specialization along home-currency
lines is an effective competitive strategy only to the
extent that there is a significant market for transactions
in an institution’s home currency. Banks and securities
firms from a nation whose currency has wider interna
tional acceptance may therefore have greater potential
to exploit this strategy.
For U.S. banks and securities firms, the status of the
dollar as an international reserve currency is thus a
source of competitive strength, although closer exam
ination suggests that it may also be a possible cause of
B uilding on an existing custom er base
The existence of an established customer base can be
an extremely important competitive advantage for finan
cial institutions in both international and overseas
domestic markets. On the one hand, strong customer
ties can provide a natural clientele for a bank or secu
rity firm wishing to enter new markets, enabling the
institution to establish a market presence through trans
actions with existing customers from other markets. On
the other hand, an established and secure customer
base can also serve to deter potential competitors, both
foreign and domestic, from entering existing bank mar
kets. From many perspectives, then, the existence of
strong customer ties is a crucial determinant of compet
itive success.
Banks and securities firms trying to enter both inter
national and overseas national bank markets have
looked to their established customers as a ready-made
client base for their new activities, with some degree of
success. For instance, in the Eurobond market the
strong segmentation along national lines results fairly
directly from financial institutions’ use of existing cus
tomer ties to establish a competitive position. In the
nondollar sector of the market, banks and securities
firms appear to have extended customer ties in homecountry markets to form distribution bases for Eurobond
issues denominated in their national currencies. In the
dollar sector, by contrast, it appears that ties between
bond issuers and financial institutions may be key;
since dollar-denominated securities have a greater
Digitized
FRASERQuarterly Review/Spring 1991
48 forFRBNY
acceptance outside of the United States, the insight and
experience gained by banks and securities firms in
dealing with borrowers from their home countries seem
to be more pivotal than the ability to distribute the
bonds. In both cases, however, it is clear that links to
existing customers are important determinants of the
ability to compete in the Eurobond market.
The importance of ties between financial institutions
and their customers is equally clear in the Euroloan
market. The history of the Euroloan market during the
1980s indicates that two discrete waves of borrowers
have dominated the market— sovereign borrowers in the
early 1980s, followed by corporate borrowers seeking
merger and acquisition funding in the late 1980s. These
developments suggest that the Euroloan market is in
some sense a residual credit market, because the abil
ity of intermediaries to “bring” customers to this market
appears to be an important determinant of the level of
borrowing. In this sense, the association between
banks and their borrowing customers is vital, and the
ability of a bank to transform existing domestic cus
tomers into potential Euroloan borrowers is key to its
becoming a successful competitor in this market.
Relationships with domestic customers have also
shaped the strategies used by foreign banks and secu
rities firms seeking to enter overseas national markets.
In one common approach, institutions adopt a popula
tion niche strategy to establish an initial market pres
ence. Frequently, they will target the overseas affiliates
of businesses and organizations from their home coun
tries as potential customers. In this situation, strong ties
with domestic customers can carry over, giving foreign
banks and securities firms a natural, if necessarily lim
ited, clientele in overseas markets.
In a somewhat different sense, a secure customer
base can also affect the competitive strategy of banks
and securities firms by serving as a deterrent to poten
tial competitors, both foreign and domestic. As noted
earlier, when the ties between domestic customers and
financial institutions are particularly strong, it can be
extremely difficult for competitors to establish a pres
ence in the market. Foreign firms in such an environ
ment face the addition al problem of attracting
customers who, in the face of custom or through lack of
familiarity, may be reluctant to deal with foreign institu
tions. In this situation, foreign banks and securities
firms may be limited, at least in the short run, to dealing
exclusively with customers who are themselves affili
ated with the financial institution’s home country.
A comparison of the commercial lending markets in
the United States and the United Kingdom with those in
Germany and Japan dramatically illustrates how strong
customer ties can affect the ability of foreign financial
institutions to establish themselves in overseas national
markets. In the U.S. and U.K. markets, the wide range
of alternative borrowing sources has left ties between
domestic borrowers and lenders relatively weak. Bor
rowers in these markets appear to be significantly more
price sensitive than borrowers in many other national
markets. In this environment, foreign banks have had a
great deal of success in establishing themselves as
significant competitors to domestic institutions.
In the German and Japanese markets, on the other
hand, ties between borrowers and lenders are much
stronger. Domestic corporate customers and banks typ
ically have extensive and extremely stable financial
relationships in which lending plays a central role. The
strong customer ties that characterize these relation
ships have made it very difficult for foreign banks to
gain a significant share of commercial lending activity in
the Japanese and German markets.
As these examples indicate, a strong and diversified
domestic customer base can be a key competitive
advantage in both national and international banking
markets. Just as financial institutions tend to compete
successfully by specializing in particular products
based on traditional strengths developed in domestic
banking markets, they also appear to compete success
fully by cultivating particular domestic customer clien
teles. The ability of institutions to parlay the experience
and relationships gained in domestic banking markets
into a significant presence in overseas and international
markets thus appears to be an important criterion for
competitive success in the international arena.
Institution-specific ch aracte ristics and com petitive
success
The domestic market strengths that banks and securi
ties firms attempt to exploit in forming competitive strat
egies are often common to different institutions within
the same country. In addition to such national charac
teristics, however, a variety of institution-specific factors
appear to be associated with competitive success. Spe
cifically, the ability of financial institutions to build on
domestic market attributes appears to be most strongly
associated with factors such as institution size, cap
italization, and the cost of capital. The ability to develop
and exploit links across product markets also appears
to be associated with competitive success for at least
some banks and securities firms.
Scale o f m arket operations
In many banking markets, the scale on which financial
institutions operate appears to be an important compet
itive factor. Specifically, in many national and interna
tional product markets, banks and securities firms oper
ating on a large scale may be able to produce more
efficiently than smaller institutions, particularly in the
FRBNY Quarterly Review/Spring 1991
49
management of large portfolios of financial instruments
and in the gathering and processing of information.
Although smaller firms may operate profitably in partic
ular niches of the various bank product markets, these
scale economies tend to result in banking markets that
are dominated by a relatively few large competitors.
Large-scale operations can contribute to the effi
ciency of information management in different ways. On
a technological level, the fixed costs of maintaining
computer systems and developing specialized software
and data management techniques will be distributed
across a wider base. While such scale economies in
“back office” operations may be important, scale econ
omies in information gathering that result from specific
market activities, particularly trading and underwriting
of various financial instruments, appear to have a more
direct link to profitable participation in various banking
markets. In markets such as equities, government
bonds, Eurocredit, swaps, and foreign exchange, insti
tutions with a large market presence and a broad cus
tomer base may be able to assemble information about
market conditions more efficiently because they are
exposed to a wider range of proposed transactions.
Institutions with a smaller market presence, by contrast,
may not be able to manage their market activities as
profitably because they must invest more time and effort
in obtaining this information. Such size-related efficien
cies may represent an important strategic advantage,
particularly in highly competitive banking markets in
which profitability in core activities is minimal.
C apitalization
A second institution-specific element that appears to
affect the ability of banks and securities firms to com
pete in national and international banking markets is
capitalization. More strongly capitalized banks may
have an advantage because they are viewed as being
better able to withstand financial adversity. The credit
standing of a financial institution affects its ability to
compete in markets for financial products and services
primarily by affecting the willingness of potential cus
tomers to accept the institution as a counterparty. This
effect is particularly prevalent in the swap market,
where participants are exposed to large amounts of
credit risk. Banks and securities firms that lack strong
credit ratings can find it difficult to participate fully in
this market because other financial institutions may be
reluctant to accept them as counterparties in swaps
transactions. This is particularly true for long-dated
swaps, where the credit exposure is more significant
because of its much longer duration. Thus, strongly
capitalized banks and securities firms with high credit
ratings have a competitive advantage over those institu
tions with a less secure capital standing.
50 FRBNY Quarterly Review/Spring 1991
Capitalization may also affect the ability of financial
institutions to compete in markets where continuity of
service is important. For instance, corporate borrowers
appear to prefer to borrow from strongly capitalized
banks because these institutions are more likely to have
continued access to funding sources and thus to be
able to lend during tight credit periods. In addition, a
relatively weak credit rating can be a substantial disad
vantage in competing for large corporate customers,
particularly if these customers have higher credit rat
ings than the banks themselves. In this situation, com
mercial banks may not be able to offer better assurance
of continued funding than the corporate customer can
obtain on its own. Strongly capitalized financial institu
tions thus appear to have a competitive advantage in
commercial lending markets, particularly during periods
when tight credit conditions are widely anticipated.
Cost o f ca pita l
The ability of banks and securities firms to be effective
competitors is affected not only by the amount of capital
held by specific institutions, but also by the cost of
obtaining that capital. In some sense, of course, the two
factors are related: individual institutions that are per
ceived to be more risky will tend to face higher costs of
acquiring capital. At a more fundamental level, however,
the cost of capital reflects macroeconomic factors such
as household savings behavior, the stability of the mac
roeconomy, the pattern of relationships among banks,
corporations, and government, and to some extent, the
corporate tax structure.12 These macroeconomic factors
are in general beyond the control of specific institutions
or groups of institutions within a national economy.
Thus, to a large extent, the cost of capital facing indi
vidual financial institutions is a competitive attribute
that reflects conditions in their home-country markets.
The cost of capital affects the ability of financial
institutions to offer competitive prices on their products
and services. The spreads that banks and securities
firms earn on their banking activities must be sufficient
to generate the required rate of return on the capital
used to support those activities. Institutions with high
capital costs are therefore at a competitive disadvan
tage, particularly in markets where acting as a low cost
provider of core products and services is an important
competitive strategy. The importance of this effect is
especially evident in markets such as the U.S. commer
cial lending market. Japanese financial institutions have
been able to penetrate this market and to obtain a
12See Steven A. Zimmer and Robert N. McCauley, "Bank Cost of
Capital and International Competition,” Federal Reserve Bank of
New York Quarterly Review, vol. 15, no. 3-4 (Winter 1991), pp. 33-59.
for a full discussion of the determinants of the cost of capital for
banks in six major industrial economies.
significant market share largely because their low cap
ital costs have enabled them to extend credit at lower
rates than many U.S. commercial banks facing a signifi
cantly higher cost of capital. A cost of capital advantage
is thus an important factor in the ability of financial
institutions to maintain a continuing presence in highly
competitive global and national product markets.
Links across p ro d u c t m arkets
Banks and securities firms that participate in a range of
financial markets may sometimes have a competitive
advantage over those institutions that operate in a more
limited set of markets. Much of this potential advantage
stems from greater efficiency in obtaining and process
ing information. In much the same way that operation on
a large scale within a single market appears to allow
banks and securities firms to realize economies of scale
in information handling, participation in a range of prod
uct markets may enhance the ability of some financial
institutions to manage large and diverse portfolios of
financial instruments efficiently.
For instance, the profitability of transactions in the
swap and Eurocredit markets is determined, at least in
part, by accurate knowledge of conditions and move
ments in a variety of other markets such as foreign
exchange and the various national money and credit
markets. To the extent that a financial institution is
actively involved in these various markets— because of
internal foreign exchange operations or through partici
pation in overseas government and corporate bond mar
kets— it may have greater access to the information
necessary to price transactions correctly in the swap
and Eurocredit markets. Similar advantages may accrue
when portfolio positions taken from participation in one
market offset positions derived from activities in
another market, possibly reducing the expense of hedg
ing the overall position of the institution.
Conclusion
The principal finding of the study is that financial institu
tions compete internationally primarily by building on
the strengths developed in their domestic banking mar
kets. In large measure, banks and securities firms appear
to succeed in international and overseas national
markets by capitalizing on advantages that reflect the
inherent characteristics of their domestic markets.
The characteristics of an institution’s home-country
market thus appear to be a critical determinant of its
overall competitive success. The strength of the domes
tic banking franchise not only shapes the competitive
strategies adopted by banks and securities firms in
international and overseas markets, but also appears to
anchor the overall financial performance of these insti
tutions. Financial institutions from countries with a
strong domestic banking franchise may benefit from a
stable source of profitability that appears to sustain
their aggregate financial position.
The importance of the domestic franchise is clearly
illustrated in the experience of U.S. financial institu
tions. Although U.S. banks and securities firms have
had a great deal of success in obtaining market share in
international and overseas financial markets, conven
tional quantitative measures of aggregate performance
show these institutions to be only moderately success
ful com petitors. These two som ewhat conflicting
assessments can be reconciled by noting that both
nonbank firms and foreign banking institutions have
made significant inroads in a number of U.S. national
financial markets, a development that points to the
weakness of the U.S. domestic banking franchise rela
tive to that in other countries. This weakness may in
turn underlie the uneven performance of U.S. financial
institutions as aggregate entities.
The finding that home-country market conditions con
tinue to play a critical role in the competitive success of
large, internationally active financial institutions sug
gests that the true internationalization of financial and
banking markets is incomplete. This impression is even
more strongly reinforced by the continued domination of
national banking markets by a few large domestic com
petitors, despite the fact that, in most cases, there is
little regulatory or legal differentiation between domes
tic and foreign financial institutions. Although interna
tional markets in particular present many opportunities
for competition on a “level playing field,” segregation
along national and institutional boundaries remains an
important force in the competitive environment.
FRBNY Quarterly Review/Spring 1991
51
Monetary Policy and Open
Market Operations during 1990
Overview
During 1990, the Federal Open Market Committee
responded to signs of weakening economic activity and
financial market fragility by shifting toward a more
accommodative policy. The Committee relaxed reserve
pressures several times in the second half of the year to
alleviate financial market strains and, in the final
months, to counter contractionary influences on the
economy.
Over the first half of the year, policy was essentially
on hold following a move to ease reserve pressures in
mid-December 1989. The risks of inflation and of eco
nomic weakness were seen as being about evenly bal
anced; higher food and fuel costs helped lift prices
early in the year while the economy experienced only
slow growth. In mid-July, the Federal Open Market
Committee (FOMC) acted to ease reserve conditions to
offset a degree of credit restraint on the part of lending
institutions that was deemed “greater than anticipated
or appropriate.” Policy then held steady in the immedi
ate aftermath of the Iraqi invasion of Kuwait in August.
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. Cheryl Edwards, Senior Economist, Open Market
Analysis Division, and R. Spence Hilton, Senior Economist, Open
Market Analysis Division, were primarily responsible for the
preparation of this report under the guidance of Ann-Marie
Meulendyke, Manager, Open Market Department. Other members of
the Open Market Analysis Division assisting in the preparation were
Robert Van Wicklen, Theodore Tulpan, John Krafcheck, and John
Phelan. Judy Cohen, from the Domestic Research Department, also
assisted.
52 FRBNV Quarterly Review/Spring 1991
Surging petroleum prices threatened simultaneously to
worsen inflation and to plunge an already sluggish
economy into a downturn, and a period of some turmoil
ensued in many financial markets. In late October the
FOMC eased reserve pressures amid growing evidence
of softening economic activity and after the conclusion
of a budget agreement involving a large reduction in the
federal deficit over the next several years. Over the final
months of 1990, the economy weakened considerably,
concerns about the condition of the financial system in
creased, the monetary aggregates expanded anemically,
and underlying inflation pressures appeared to ebb. The
Committee responded by stepping up the pace of
accommodation through three more easing moves.
Prompted by similar concerns, the Board of Governors
of the Federal Reserve System approved a reduction in
the discount rate in December. The Board also elimi
nated reserve requirements on nontransactions depos
its, in part to counter the contractionary effects of
banks’ tightening credit standards and lerfding terms.
The onset of the recession in the second half of the
year ended eight years of economic growth, the longest
recorded peacetime expansion in U.S. history. With
GNP declining in the final quarter, the economy
expanded a mere 0.5 percent (fourth quarter over fourth
quarter) over the year as a whole, and most major
spending components of GNP either slowed in growth
or fell. The downturn was at least exacerbated, and
perhaps brought on, by the Persian Gulf crisis. Mean
while, rising energy costs generated by developments
in the Middle East helped lift most broad inflation mea
sures to their highest levels since the early 1980s. For
the year as a whole, consumer price inflation excluding
the volatile food and fuel components edged up on
balance, although by other measures, underlying infla
tion and labor cost pressures did not intensify.
Yields on investment grade fixed-income securities
responded to changes in the outlook for economic
growth and inflation and to prospective and actual mon
etary policy developments. Through the first four
months of the year, yields trended up because of rising
food and energy costs, an apparent pickup in economic
activity, higher interest rates abroad, and prospects of
much heavier Treasury borrowing. Most rates changed
direction and moved lower over the next few months in
response to accumulating evidence of economic weak
ness and speculation that the System would ease mon
etary policy. At the onset of the Persian Gulf crisis in
August, longer term yields jumped and rates on shorter
dated instruments posted lesser increases as sky
rocketing energy prices fanned inflation fears. During
the final months of the year, most yields moved steadily
lower as oil prices eased off their highs, a federal
budget accord was reached, and the Federal Reserve
took a series Of measures intended to help revive the
faltering economy. On balance, the yield curve for
Treasury securities steepened over the course of the
year.
A slumping economy coming atop a high level of
financial indebtedness contributed to growing strains in
many financial markets in 1990. Borrowing became
more difficult for less than top-rated borrowers. Some
degree of dislocation was evident at times in many
financial markets, especially during the second half of
the year. The market for below-investment-grade secu
rities, which had already been buffeted by a series of
developments late in 1989, deteriorated dramatically in
1990. Meanwhile, the financial position of many bank
holding companies deteriorated, posing potentially seri
ous consequences for the financial system as a whole.
The profitability of a large number of banks suffered as
the value of their loan portfolios declined, especially for
real estate-related activities. During the year, the out
standing debt of many banking institutions was down
graded, and market yields on much of this debt soared.
At the same time, there were growing indications that
banks were cutting back on the availability of credit,
even for creditworthy customers, although the magni
tude of this credit squeeze remained uncertain. Mone
tary policy moves during the latter half of the year were
intended in part to relieve the effects of the credit
restrictions.
Growth of the broader monetary aggregates in 1990
fell below the previous year’s pace. M2 advanced 3.9
percent (fourth quarter over fourth quarter), while M3
rose just 1.7 percent.1 Both measures expanded much
more slowly in the second half of the year and finished
well down in their respective growth cones. A soft econ
omy, retrenchment in bank lending, and a quickened
pace of thrift resolutions all helped to restrain the
growth of these aggregates. Nonfinancial debt also
increased more slowly in 1990; it rose 6.8 percent and
finished well within its monitoring range. Meanwhile,
growth in M1 rebounded in 1990 after posting a meager
gain in the previous year; boosted by rapid growth in
currency (much of which apparently went overseas), M1
advanced 4.2 percent.
Implementation of monetary policy continued to be
complicated by the strong reluctance of many depos
itory institutions to borrow from the discount window
under the adjustment credit program. The Desk’s formal
operating procedures continued to make use of an
assumption for borrowing that presumes a reasonably
stable relationship between the amount of borrowing
and the spread between the federal funds and discount
rates. Instances of unusual reluctance to use the dis
count window, which have hampered the Desk’s opera
tions for several years, multiplied in 1990; many
depository institutions feared that their presence at the
window might be misconstrued as a symptom of funda
mental financial difficulty. On occasions when borrowing
had to rise to make up a shortfall in nonborrowed
reserves, the funds rate often increased to excep
tionally high levels. In light of the continued imprecision
in the borrowing relationship, the Desk pursued its bor
rowing objectives flexibly. When formulating its program
for daily operations, it often emphasized current trading
conditions in the federal funds market over estimated
reserve needs associated with the borrowing allowance.
Extraordinary year-end funding pressures and reduc
tions to reserve requirements had a significant impact
on money markets and the D esk’s operations in
December. In an atmosphere of heightened financial
fragility, and in keeping with ongoing efforts to improve
capital positions, many banks strove to rein in the vol
ume of lending that would be on their books on the endof-year reporting date. At the same time, demands for
funds spanning the turn of the year were high. Disloca
tions occasionally emerged in the money markets as
many institutions refrained from their custom ary
arbitrage activities. Short-term interest rates, including
the federal funds rate, were prone to considerable vol
atility. The reserve requirement reduction indirectly
tMoney and debt growth rates cited in this report are based on data
available on April 4, 1991. The money data incorporate the February
1991 benchmark and seasonal revisions, as well as subsequent
revisions. The benchmark revisions raised the growth rates of each
of the three monetary aggregates by 0.2 percentage point over the
four quarters of 1990.
FRBNY Quarterly Review/Spring 1991
53
added to this volatility. Many banks, unaccustomed to
working with such low reserve balances at the Fed,
tended to manage their reserve positions very cau
tiously so as to reduce the risk of incurring overnight
overdrafts or having to bid aggressively for funds late in
the day. Demands for excess reserves in this climate
ran high, although banks would sometimes seek to
unload their reserve holdings in late-day trading once
they felt confident of meeting their clearing needs. The
volatility of the funds rate, resulting both from more
cautious reserve management and from year-end fund
ing needs, made it very difficult to gauge the underlying
demands for reserves. Toward the end of the year, the
Desk sought to alleviate these pressures in the federal
funds market by exceptionally aggressive provisions of
reserves through open market operations.
The economy and interest rates
The pace of economic activity slowed dram atically in
1990, as a modest rebound in the rate of expansion
early in the year gave way first to a period of generally
sluggish growth and then to an economic contraction.
Over the four quarters of the year, real GNP expanded
just 0.5 percent, down from 1.8 percent in 1989 (Table
1). Growth in most sectors of the economy weakened to
some degree during the year, while manufacturing and
construction activity declined. Meanwhile, rapidly rising
petroleum prices helped to lift overall inflation to levels
not seen since 1981. Inflation excluding food and energy
prices, or “ core” inflation, was somewhat higher at the
consumer level, but some other measures of underlying
price and labor cost pressures showed no acceleration
or decelerated over the year. Yields on investmentgrade securities responded to the changing outlook for
econom ic growth and inflation and the accompanying
prospects for monetary policy. Interest rates rose and
then fell over the first half of 1990 as early indications of
strengthening economic growth and heightened infla
tion gave way to signs of sluggish growth and more
m oderate price pressures. S urging energy prices
pushed yields back up in late summer, especially for
longer dated issues, but rates subsequently fell in the
face of growing signs of a significant economic down
turn and several steps to ease monetary policy. On
balance, yields on Treasury coupon securities ended
mixed, with shorter yields down as much as 70 basis
points and the long bond yield about 25 basis points
higher. Meanwhile, key bill rates ended the year about
100 basis points lower (Charts 1 and 2).
S lu g g is h g ro w th a nd in fla tio n w o rrie s—January
th ro u g h Ju ly
Early in 1990, the ongoing economic expansion, then
entering its eighth year, appeared to be resilient. Fueled
Digitized
FRASER Q uarterly Review/Spring 1991
54for FRBNY
by a m odest rebound in final goods dem and and
boosted by a w eather-related spurt in co nstructio n
activity, real GNP in the first quarter rose 1.7 percent
(annual rate), up from the sluggish 0.3 percent pace in
the preceding quarter. At the same time, inflation was
a c ce le ra tin g , a ltho ug h much of th is p ressure was
expected to be short-lived because it resulted from the
severe winter weather in December 1989 that pushed
up the cost of fuel and some foods. As measured by the
fixed-weight price deflator, the inflation rate jum ped to
6.6 percent in the first quarter from 3.8 percent in the
previous quarter.
Signs that econom ic activity was picking up while
inflation was gaining some momentum helped push
yields on many long-term Treasury issues to levels just
over 9 percent by the end of April, up more than 100
basis points since the start of the year. Bill rates rose by
lesser amounts to their highest levels for the year.
Unexpectedly strong nonfarm payroll em ploym ent sta
tistics were released in February and March, and other
economic reports pointed to somewhat greater strength
Table 1
Changes in Key Economic Statistics
(Percent, Unless O therw ise Ind icated )
Fourth quarter to fourth quarter
Real GNP
Final dem and
D isposable personal incom e
C onsum er expenditures
Business fixed investm ent
Residential construction
1990
1989
0.5
1.8
1.5
- 0 .4
1.6
1.7
0.1
1.2
2.2
4.5
-7 .1
Government purchases
-1 0 .2
3.4
Nonfarm inventories (b illion s of dollars)
-4 3 .8
-1 1 .9
39.1
27.8
4.8
4.0
C onsumer price index, total
6.2
4.7
C onsum er price index, exclu d in g food and
fuel
5.2
4.4
Producer price index, total
5.7
4.9
Producer price index, exclud ing food and
fuel
3.5
4.2
Employm ent cost index
4.9
5.0
Average hourly earnings
3.7
4.1
Net exports (b illion s of do lla rs)
Fixed-w eight GNP deflator
0.6
December to December
Industrial production
Nonfarm payroll em ploym ent, total
Employment, m anufacturing
-1 .3
1.1
0.6
2.2
-3 .1
- 1 .0
Notes: GNP com ponents and personal incom e are m easured in
constant do lla r terms. Final dem and and governm ent purchases
are net of C om m odity C redit C orporation purchases, w hich are
treated as akin to changes in farm inventories.
in the m anufacturing sector than had previously been
perceived.2 Meanwhile, investors became more con
cerned about inflation prospects as price data began to
reflect rising food and fuel costs and as the core compo
nent of the consumer price index (CPI) crept up. These
statistics helped to dispel expectations that the System
would soon follow its December move with another
easing step. This perception was reinforced in late Jan
uary by Chairman Greenspan, who expressed the view
E m p lo y m e n t data during the year were disto rted by the tem porary
hiring of census workers. C haracterizations of the job data in this
report are net of the im pa ct of these workers.
in congressional testim ony that the current inflation rate
was unacceptably high and that the recent slowdown in
economic activity appeared to be only a “ tem porary
hesitation.” With the release in m id-April of the March
CPI, which showed a disturbingly large jum p in the
index’s core component, investor psychology shifted
further and yields surged.
Rising interest rates abroad, p articularly in Japan and
Germany, added to the upward pressure on dom estic
yields early in 1990 by substantially narrowing the d if
ferential between foreign and dom estic rates and by
curbing the foreign appetite for U.S. securities. Higher
yields abroad were largely the product of foreign coun
tries’ deteriorating inflation outlooks and tighter m one
tary policies, which, in the case of West Germany, were
linked in part to the potential inflationary consequences
of union with East Germany. Sharp declines in Jap
anese equity prices early in the year also helped to
push U.S. interest rates higher as foreign investors
reportedly sold U.S. securities to m itigate their losses;
however, some “ fligh t-to-q ua lity” demand for dom estic
securities was seen at tim es when foreign equity mar
kets came under strong downward pressure.
Increased borrow ing by the Treasury and sharply
higher estimates of its future funding needs added to a
negative market sentim ent early in the year. A progres
sive deterioration in official deficit forecasts occurred
throughout the year, in large measure reflecting a scal
ing back of projected econom ic growth and revised
Chart 2
Yield Curves for Selected
U.S. Treasury Securities
Percent
May 2, 1990
Notes: Treasury bill yields are on a bond-equivalent basis.
Coupon yields are constant maturity values.
FRBNY Q uarterly Review/Spring 1991
55
estimates of the costs of the savings and loan bailout.3
Official projections of the final costs of the thrift bailout
escalated to a range of $90 billion to $130 billion (in
present value terms), well above the $50 billion origi
nally allocated by the Congress for this task. Estimates
of the “working capital” needs of the Resolution Trust
Corporation (RTC), the agency charged with disposing
of failed thrifts, also grew, and in February the agency
began to raise funds by borrowing from the Federal
Financing Bank, a move that resulted in increased
Treasury borrowing from the public. In a related devel
o p m e n t, th e R e s o lu tio n Funding C o rp o ra tio n
(REFCORP), the borrowing agency authorized to raise
a total of $30 billion to pay for thrift losses, borrowed
$81/2 billion in auctions of forty-year bonds in January
and in April, and both auctions fared poorly. (Later
auctions of thirty-year REFCORP bonds were better
received.)
During the middle of the year, economic growth was
uneven, but slower on balance than in the early months
of 1990. The real economy expanded at about a 1
percent annual rate during the middle two quarters,
with somewhat slower growth coming in the second
quarter. Inflation moderated in the spring and early
summer as food and fuel cost pressures eased, and
there was little evidence that the upsurge in these costs
earlier in the year was having an impact on core
inflation.
Accumulating evidence of lower growth and slower
inflation put interest rates on a declining trend, and by
the end of July many longer term rates were just a bit
above, and shorter term rates somewhat below, the
levels prevailing at the start of the year. Yields had
moved sharply lower following the release of an unex
pectedly weak jobs report in early May, and smaller
than expected changes in the producer price index
(PPI) reported soon afterwards alleviated inflation wor
ries. Subsequent economic reports confirmed that a
slowdown was underway and virtually eliminated any
speculation that monetary policy would be tightened in
the near future. Another weak employment report
released in June encouraged talk of a possible reces
sion, stirred expectations of a Fed easing, and pushed
yields even lower; however, later economic reports pro
vided a more mixed assessment of the pace of the
expansion, and the core inflation rates in the PPI and
3The ultimate implications of growing deficits for interest rates are
complex. Extra Treasury borrowing brought on by slowing economic
growth normally is accompanied by reduced credit demands from
other sources. Moreover, if funds borrowed to pay for deposit
insurance losses and the Resolution Trust Corporation’s working
capital needs are recirculated in financial markets, as is generally
assumed, then the funds available to other borrowers would not be
reduced and there would be little impact on interest rates apart
from dislocations brought on by new funding patterns.
56 FRBNY Quarterly Review/Spring 1991
CPI reports released in June were seen as too high to
permit an easing move.4
Accordingly, many investors were surprised when
Chairman Greenspan intimated in congressional testi
mony on July 12 that the Fed would relax reserve
pressures, a step that was implemented by the Desk on
the following day. Some were unconvinced by the rea
son given for the move— to help offset a recent modest
tightening of credit availability. Chairman Greenspan’s
Humphrey-Hawkins testimony, delivered the following
week on the same morning that an unexpectedly big
jump in the CPI was announced, did not dispel these
doubts and left many participants concerned that mone
tary policy was moving toward further ease just when
inflation appeared to be gaining momentum. Conse
quently, while rates on many shorter maturity issues
moved lower on the easing move, longer term yields
held steady or moved a bit higher.
Budgetary developments continued to affect financial
markets during the spring and early summer. Growth in
Treasury borrowing, in part to finance an accelerated
pace of RTC activity, underscored a deteriorating bud
get outlook. Formal negotiations for a multiyear budget
package began in mid-May, and in June President Bush
announced that tax hikes would be part of any credible
budget package. Hopes were raised that significant
deficit cuts could be realized, lowering the Treasury’s
prospective borrowing needs and possibly paving the
way for an easing move by the Fed to offset fiscal
restraint. Chairman Greenspan directly linked a mone
tary policy move to a budget pact in his July HumphreyHawkins testimony when he indicated that the System
might reduce reserve pressures if “major, substantive,
credible cuts in the budget deficit” were achieved. Inter
est rates, especially those on short-term Treasury secu
rities, eased on these developments; however, little
progress was made in budget negotiations before the
summer recess, and most investors remained skeptical
of the prospects for significant deficit reductions.
Persian Gulf crisis and declining economic
activity—August through December
The surge in oil prices that followed the Iraqi invasion of
Kuwait in August raised the prospect of rapidly escalat
ing inflation and generally clouded the economic out
look. Yields on longer term securities shot up quickly,
and the Treasury yield curve steepened dramatically, in
part because many participants sought the relative
safety of shorter term securities. Moreover, in the aftermath of the invasion, trading conditions were quite vol4Several payroll employment reports, including some released in the
spring and summer, showed large revisions to previously released
data. These revisions sometimes altered perceptions formed by the
initial release.
atile, with prices for oil and long-term securities often
moving sharply on rumors or reported developments
relating to the Persian Gulf crisis. This volatility, and the
close association between movements in oil prices and
long-term rates, eventually moderated but remained a
feature of trading for the rest of the year. Petroleum
prices peaked in October around $40 per barrel for
some grades of oil, but prices soon fell back as fears of
an immediate outbreak of hostilities abated and as
investors became assured that the shortfall left by the
embargo on Iraqi and Kuwaiti oil would be filled by
higher output elsewhere (Chart 3).
In the weeks following the invasion, financial market
participants were uncertain about the course of mone
tary policy. Accum ulating evidence that economic activ
ity was slowing and concerns over the impact of a
sustained rise in oil prices on consumer spending and
business investm ent generated speculation that an
easing of policy could occur in the not too distant future.
This perception helped limit the upward movement in
rates on shorter term instruments. At the same time,
however, the System was seen as being constrained by
the rapid run-up in oil prices and as preferring to wait
until the turm oil in financial markets abated before mak
ing any policy move. Other price data available in
August and Septem ber added modestly to a deteriorat
ing inflation outlook, and in September, a stronger than
expected employm ent report largely dispelled the view
Chart 3
Petroleum Prices
Dollars per barrel
1990
that policy would soon be eased to spur growth.
Investors monitored the course of budget talks in late
summer and early fall, and interest rates often moved
inversely with the degree of optim ism about the course
of negotiations. In early September, President Bush
reiterated his goal of achieving significant cuts in a
m ultiyear package and Chairm an Greenspan again tied
a possible easing in policy in part to the adoption of a
credible and enforceable agreem ent, but hopes for
achieving such an agreement dimmed as budget nego
tiations dragged on. On Septem ber 30, budget nego
tiators reached an accord on a plan to cut future deficits
by a cumulative $500 bilJion over five years and to
provide several new enforcem ent m echanisms, and the
plan was termed “ credible” by Chairm an Greenspan.
On October 4, however, the House of Representatives
rejected the proposal. A reformulated accord, which was
sim ilar in many respects to the earlier agreement, was
reached on October 27. It was soon ratified by the
Congress and followed by an easing move by the Fed.
The economy began to turn down in the second half
of the year, a contraction brought on to an indeterm inate
degree by the rise in oil prices and the uncertainty over
the future course of events in the Middle East. Real
GNP in the final quarter dropped 1.6 percent (annual
rate). The m anufacturing sector— particularly auto pro
d uction— was hard hit, but many se rvice industries
weakened as well. Businesses, however, were keeping
their inventories trim (final demand actually posted a
slight gain in the final quarter). Exports also remained a
bright spot. Pressures on core prices showed some
tendency toward moderation in the fourth quarter, but
total inflation rem ained elevated because of higher
energy prices.
Interest rates moved steadily lower during the final
two m onths of the year as in v e s to rs in c re a s in g ly
accepted the view that the U.S. econom y had entered
into a recession and as the System took several steps
to spur growth. Many long-term yields again fell to
levels not far above those prevailing at the start of 1990,
while shorter term yields dropped to their lows for the
year. A weak em ploym ent report in early November was
soon followed by a move to ease policy. Yields fell
dram atically on December 7 on news of huge job losses
in the previous month and big downward revisions to
October’s employm ent levels, and the Fed eased later
that day. Meanwhile, evidence of some m oderation of
core inflation was seen in the m onthly PPI and CPI
reports released in November. Actions by the Board of
Governors in D ecem ber to elim inate some reserve
requirements and to lower the discount rate, as well as
another easing move by the FOMC, added momentum
to the downward move in rates and convinced most
investors that the System was prepared to act aggres
FRBNY Q uarterly R eview/Spring 1991
57
sively to support a faltering economy.
Debt issuance
The Treasury’s financing needs continued to grow in the
latter part of the year. The size of its regular weekly bill
auctions rose steadily to a record $20 billion in the final
quarter— a rise that was only briefly interrupted in Octo
ber when the Treasury exhausted its remaining borrow
ing authority under a temporary debt ceiling. The size
of the midquarter refunding also reached a record level
of $34 billion in November. For the year as a whole, the
Treasury issued a net $232 billion in new marketable
debt (including over $50 billion to raise RTC “working
capital”), compared with $123 billion in 1989.5 Mean
while, REFCORP borrowed $ 181/2 billion during the year,
exhausting all but $7 billion of its remaining borrowing
authority (which it used up in January 1991).
In other markets, public debt offered by U.S. corpora
tions in the domestic bond market rose 3.6 percent,
reversing a three-year decline, as a large jump in assetbacked issuance helped offset the virtual disap
pearance of new speculative grade offerings .6 With
many municipalities struggling to cover budget gaps
brought on by a slowing economy, borrowing by state
and local governments picked up 5.9 percent. Borrow
ing in both the corporate and tax-exempt markets was
concentrated in the middle and the end of the year,
when interest rates were at their lowest. Yields on toprated corporate and tax-exempt offerings generally
moved in line with those on comparable Treasury secu
rities, although often with some lag.
Financial market strains
Monetary policy in 1990 was conducted amid a height
ened sense of financial fragility. A worsening economic
climate and higher energy costs directly undermined
the financial health of many companies, but in the view
of many analysts, a root cause of the financial difficul
ties that surfaced or intensified in 1990 was the buildup
in debt over the past decade that had left firms increas
ingly vulnerable to an economic downturn.7 One of the
clearest overall indications of mounting pressures dur
ing the year was the sharply increased number of com
panies whose debt was downgraded. According to
*These figures are for calendar years. The federal government’s
budget deficit in fiscal year 1990 was $220 billion, up from $153
billion in the previous year and just shy of the record $221 billion
deficit in fiscal year 1986.
•Data on corporate and municipal debt issuance were supplied by
the Board of Governors of the Federal Reserve System.
7Between 1979 and 1989, the ratio of outstanding debt of all
domestic nonfinancial sectors to the level of GNP rose from 1.35
to 1.82.
58 FRBNY Quarterly Review/Spring 1991
Moody’s Investor Service, total corporate downgrades
outnumbered upgrades by nearly 4.5 to 1, up from a
ratio of 2.5 to 1 in 1989.8 (In 1982, during the last
recession, this ratio was 2.8 to 1). The “quality spread,”
or difference in yields paid by the highest and lowest
rated investment grade corporate issuers, also trended
up (Chart 4). Hardest hit were financial institutions;
downgrades in this sector by Moody’s outnumbered
upgrades by more than 8 to 1 in 1990.9 The savings and
loan industry continued to shrink as a result of problems
that had come to light years earlier; during 1990 over
400 thrifts closed or merged. Meanwhile, difficulties
emerged elsewhere in the financial system, particularly
among bank holding companies.
Developments in the market for speculative debt
The problems that in 1989 beset the market for belowinvestment-grade securities, sometimes called “highyield” or “junk” bonds, intensified in 1990. As the year
began, this market was already under pressure from a
sluggish economy that aggravated the interest payment
burden of many highly leveraged issuers of junk debt.
Pressures grew in late January when Allied Stores and
Federated D epartm ent Stores, two subsidiaries of
Campeau Corporation whose difficulties had sparked a
general sell-off in the high-yield market in September
1989, filed for bankruptcy protection. That same month,
ratings were lowered on almost $20 billion of outstand
ing high-yield debt issued by RJR Nabisco, a company
whose debt had been viewed relatively favorably.10
Then, in February, the Drexel Burnham Lambert Group,
a major underwriter and holder of junk debt, filed for
bankruptcy. This action came after the firm began to
face difficulties attracting funding for its operations .11
Although rumors of Drexel’s impending demise had
been circulating for some time, many junk bond yields
still rose upon the announcement. Investors were con-
•The totals include ratings changes for industrial and financial
companies and for investor-owned public utilities. Total downgrades
numbered nearly 450 in 1990, up from nearly 350 in the previous
year.
•The financial sector includes banks, thrifts, insurance companies,
and other financial institutions. There were about 150 downgrades
by Moody’s in 1990 and under 20 upgrades.
10This move by Moody’s followed a similar step taken by Standard
and Poor’s the previous July.
11The Federal Reserve Bank of New York was heavily involved in
coordinating an orderly winding down of the operations of Drexel’s
government securities subsidiary, a primary dealer. Additional
information on the System's response to the collapse of Drexel is
contained in the testimony of Chairman Greenspan before the
Subcommittee on Economic and Commercial Law of the House
Committee on the Judiciary on March 1, 1990, reprinted in the
Federal Reserve Bulletin, May 1990.
cerned not only about the impact of disposing of
Drexel’s considerable holdings of junk bonds but also
about the functioning of the m arket for high-yield debt
following the collapse of its biggest market-maker. The
prospect of large divestitures of junk bond holdings by
thrifts attempting to restructure and by the RTC, which
acquired its holdings from seized thrifts, also weighed
on the m arket over the first half of the year.
Despite these developments, a number of factors
helped to calm the m arket for junk bonds over the next
several months. New issuance was nil. Several com pa
nies announced plans to recapitalize or restructure their
outstanding high-yield debt through corporate “ buy
backs,” further alleviating supply pressures and gener
ally helping to restore investor confidence. Furthermore,
the RTC reassured investors that it would pursue an
orderly, long-term liquidation of its high-yield holdings.
Finally, the growing popularity of collateralized bond
obligations— in this case, securities derived from pools
of junk bonds that diversify risk— added liquidity to the
Chart 4
Yield Spreads
Basis points
* Provided by Donaldson, Lufkin and Jenrette.
FRBNY Q uarterly R eview/Spring 1991
59
market. According to one measure, the spread between
yields on junk bonds and those on Treasury securities
widened modestly in February but, on balance, was
about unchanged during the first half of the year
(Chart 4).12
The market for high-yield debt deteriorated dramat
ically following the Iraqi invasion of Kuwait. Rising fuel
costs were expected to depress earnings of transporta
tion-related companies, especially airlines, many of
which had large amounts of junk bonds outstanding.
Growing concerns over an economic downturn pushed
yields sharply higher on bonds issued by firms in
cyclically sensitive sectors of the economy, notably
some retailers and casino operators. Some of the big
gest jumps in junk bond yields came amid eroding
equity prices and extremely illiquid trading conditions. A
number of affected companies filed for bankruptcy dur
ing the last few months of the year, and more saw their
outstanding debt downgraded. The spread between the
index of yields on junk bonds and corresponding Trea
sury securities about doubled over the year, after hav
ing doubled in 1989. According to the Bond Investors
Association, eighty-nine issuers defaulted on about $25
billion of speculative debt in 1990; in the previous year,
fifty-seven issuers defaulted on about $12 billion, and in
1988 thirty-seven issuers defaulted on under $5 billion.
Credit developments in the banking system
The financial position of many bank holding companies
deteriorated markedly in 1990 as a soft economy jeop
ardized the value of assets carried on the balance
sheets of their bank subsidiaries. In particular, a
depressed real estate market in parts of the country
placed tremendous strains on the many banks that had
aggressively extended credit for construction activity
and related commercial projects over the past several
years. Loans granted to companies that were highly
leveraged with below-investment-grade debt also came
under pressure as junk bond prices plummeted. These
developments compounded the difficulties of some
banking institutions burdened with problem loans
extended years earlier to less developed countries.
As 1990 began, the problems of bank holding compa
nies were most apparent in the Northeast, particularly
in New England, a region that had seen some of the
most spectacular growth in property prices in the 1980s
but was now experiencing a depressed real estate mar
ket. Several of the larger regional banks in the area
reported sizable losses and additions to loan-loss
reserves, for the most part stemming from soured con
struction-related loans. The credit ratings on the debt of
12The spread is based on indexes provided by Donaldson, Lufkin and
Jenrette.
60 FRBNY Quarterly Review/Spring 1991
many bank holding companies in the region were down
graded during the year, and yield spreads on their
outstanding debt widened significantly, in some casds
reaching “distressed” levels. In January, one of the
most seriously affected, and largest, banks in the
region, Bank of New England, began to borrow from the
discount window. After it became clear that the bank’s
difficulties would not be quickly resolved, its borrowing
was classified under the extended credit program. Soon
afterwards, federal regulators issued orders requiring
the holding company’s main banking subsidiary to
improve its capital position, and the bank embarked on
a major effort to shed a sizable portion of its asset
holdings.13
Problems confronting banks throughout the country
worsened as the year progressed, most visibly for many
of the nation’s money center banks. Banks’ profitability
during the year suffered from deteriorating loan port
folios. Partly as a result, ratings on the outstanding debt
of many bank holding companies were lowered. The
downgradings mostly affected longer term debt, but
ratings on some commercial paper and other short-term
liabilities were lowered as well. Yield spreads on much
of this debt widened considerably in expectation of or
soon after these moves. Bank stock prices were on a
downward course during most of the year.14
Negative sentiment toward the banking sector inten
sified in late summer. In September, two government
agencies issued reports highlighting the fragility of the
banking system. About the same time, Chase Manhat
tan Corporation encountered a much higher than
expected rate on the auction repricing of some of its
outstanding notes. Shortly thereafter, Chase announced
far-reaching cost-cutting efforts, a reduction in the stock
dividend, and a sizable addition to the bank’s loan-loss
reserves. These events were seen as symptomatic of
industry-wide difficulties, and in fact they were soon
repeated at several other large holding companies. In
this environment, yields on much bank holding com
pany debt soared— with spreads over com parable
Treasury issues widening as much as 200 basis points
in a matter of days for some of the most affected
institutions. Demand for Treasury bills as a safe haven
materialized when concerns over the health of the
banking system were greatest. The pressures on many
banks moderated a bit towards the end of the year, but
investors remained uncertain about the financial posi
tion of many banks. Consequently, some banks report13The bank's extended credit borrowing ended in June. The bank was
eventually seized by the Federal Deposit Insurance Corporation in
January 1991.
14The unweighted average of stock price changes for thirteen of the
nation’s largest bank holding companies fell 40 percent for all of
1990.
edly had greater difficulty attracting deposits.
Banks responded to the increased financial strains
they faced with some retrenchment in their loan activity.
The volume of lending typically slows when an economy
turns down because the demand for credit dries up and
banks become more cautious in lending to borrowers
whose ability to repay has fallen. However, in 1990,
indications gradually accumulated suggesting that
many banks had cut back on the availability of credit
even to creditworthy borrowers, a development that was
popularly characterized as a “credit crunch.”15 To some
degree this retrenchment was evidenced by commercial
banks’ reluctance to assume all the lending activity left
by a shrinking savings and loan industry. Although the
extent to which banks had deliberately reduced their
willingness to supply credit remained unclear, the possi
ble impact of such a cutback on the economy was a
growing consideration in the Federal Reserve’s for
mulation of monetary policy during the year.
Early in the year, evidence that banks had become
more cautious in extending or renewing credit was
mostly anecdotal. Highly leveraged borrowers and nonresidential real estate developers in areas with signifi
cant inventories of unsold properties were said to be
particularly affected. Also mentioned were many smalland medium-sized businesses— most of which lacked
direct access to credit markets. Banks reportedly were
responding to the growing uncertainties associated with
lending for certain types of activities and to what they
perceived as a greater stringency on the part of banking
examiners in the evaluation of loan portfolios. Further
more, many banks felt constrained in granting new
loans by the scheduled application of tighter capital
standards, especially at a time when problems with
their existing loan portfolios were spreading. In this
environment, many banks reportedly discouraged all
but their most creditworthy customers from borrowing,
either by directly limiting access to funds or by charging
higher rates. The higher funding costs that banks them
selves faced as the year progressed exacerbated this
trend. Although direct evidence of a squeeze on credit
remained fragmentary, from midsummer through the
rest of the year the pervasive sluggishness in the mone
tary aggregates and the results of various lending sur
veys increasingly suggested that banks had become
more reluctant to lend. Partly because of a reduced
desire to extend new credit, as well as concerns about
their year-end balance sheets, banks held off lowering
their prime lending rates— despite generally declining
market yields— until early 1991.
,5The term "credit crunch” has often been used to describe a
situation in which binding interest rate ceilings on deposits reduce
banks’ ability to attract funds and thus their capacity to lend, a
situation which did not exist in 1990.
The money markets and year-end
In an atmosphere of increased credit concern, many
borrowers encountered growing difficulties obtaining
short-term financing in the commercial paper market.
The downgrading of Chrysler Financial Corporation’s
commercial paper in June— to A3 by Standard and
Poor’s and to P3 by Moody’s— served as a catalyst in
focusing investor attention on the credit risks in this
market in a slowing economy. Many financial compa
nies found it more difficult to place their paper as their
financial problems received increased attention. The
exposure of money market mutual funds as major hold
ers of commercial paper came under some scrutiny
during the year, and the Securities and Exchange Com
mission put forth a proposal to limit these funds’ hold
ings of less than top-rated paper.16 In this environment,
quality spreads— yield differences between issues with
different ratings— widened, and some borrowers were
forced to seek alternative, sometimes more costly,
sources of short-term financing.
The funding pressures that typically arise in money
markets towards the year-end as institutions adjust their
balance sheets for that important reporting date were
aggravated in 1990 by these financial market strains.
Corporate borrowers, cut off from alternative sources of
short-term financing, increasingly turned to their com
mitted credit facilities at banks. At the same time, how
ever, many of these banks were discouraging new
borrowing as they sought to improve their capital posi
tions before the year-end statement date by constrain
ing their balance sheets. In addition, with credit
concerns rising, many lenders were pulling back on
their credit lines to certain borrowers, including credit
lines to many domestic banks; and some institutions
were refraining from their customary arbitrage activities,
creating some dislocation in the money market. Mean
while, many banks were wary of borrowing at the dis
count window even for routine adjustment credit lest
their borrowing somehow become known to the public
and be misinterpreted as a sign of fundamental prob
lems. Thus, adjustment credit borrowing from the dis
count window lost some of its value as a safety valve
when pressures intensified.
The high demands of many branches and agencies of
Japanese banks operating in the United States added
to the year-end distortions. Like their U.S. counterparts,
many Japanese banks faced growing strains in 1990 as
plummeting equity prices and a sagging real estate
market at home depressed their asset holdings just as
they were struggling to comply with tighter capital
16This proposal was adopted with some modifications in February
1991, but most money funds had begun to adjust their portfolios to
conform to its provisions before then.
FRBNY Quarterly Review/Spring 1991
61
standards. During the year, credit ratings of many Jap
anese banks were reduced by the U.S. ratings agen
cies. Larger Japanese banks that traditionally provided
credit to regional Japanese banks cut back on this
lending, forcing some borrowers out of the yen-denominated market in search of alternative funding for the
year-end. At the same time, credit-sensitive U.S. lend
ers, particularly regional institutions that were less
familiar with Japanese institutions, cut their own credit
lines to these borrowers. Other lenders often declined
to fill this funding gap, despite the profitable opportuni
ties that occasionally emerged, because they wished to
keep their balance sheets from expanding or to avoid
carrying Japanese names on their books over the yearend.
In these circumstances, demand for funds covering
the year-end emerged sooner than usual. Japanese
institutions in particular were early, active borrowers of
both term monies and forward two-day Eurodollars and
federal funds. The dislocation in normal funding pat
terns also contributed to an upsurge in volatility of the
federal funds rate, which swung from elevated levels to
extreme lows on some days .17 The Desk acted aggres
sively to alleviate these pressures— particularly in late
December— by providing reserves through open market
operations. Relative calm returned to the money mar
kets with the passing of the year-end, but many of the
elements that contributed to these extraordinary fund
ing pressures remained.
The monetary aggregates
Growth of the broader monetary aggregates, M2 and
M3, decelerated in 1990 (Chart 5). Early in the year, M2
and M3 continued to advance in line with growth in the
latter half of 1989. In the spring, however, a pervasive
weakness emerged that was to last for the remainder of
the year, except for a spurt of growth in late summer.
Overall, M2 and M3 increased 3.9 percent and 1.7
percent, respectively, from the fourth quarter of 1989 to
the final quarter of 1990. These rates of expansion left
both aggregates in the lowest quarter of the FOMC’s
annual target growth cones at the end of the year.
Growth of total domestic nonfinancial debt in 1990 was
somewhat below the previous year’s pace. Total debt
expanded fairly steadily throughout the year, supported
by a high rate of expansion in federal government bor
rowing. It rose 6.8 percent overall and finished slightly
below the midpoint of its monitoring range. Meanwhile,
after growing anemically in 1989, M1 grew a modest 4.2
percent in 1990. Boosted by exceptionally strong cur
rency growth, M1 growth was in line with the pace of
17The cut in reserve requirements made late in the year also
contributed to an increase in the volatility of the federal funds rate.
(See the discussion of the Desk’s December operations below.)
Digitized for
62FRASER
FRBNY Quarterly Review/Spring 1991
expansion set in the second half of 1989.
The ongoing restructuring of the savings and loan
industry depressed growth of the broader aggregates,
and especially M3, to a greater extent than had been
anticipated at the start of the year because of the
unexpectedly strong pace of the RTC’s restructuring
activity. Much of this activity came in the late spring and
early autumn. The downsizing of the savings and loan
industry resulted primarily in a switching of deposits—
out of thrifts and into other depositories— which by
itself has no impact on the aggregates; however, some
of the deposits of dissolved thrifts, especially managed
liabilities, were reinvested in instruments not included in
the monetary aggregates.
At the same time, commercial banks’ funding require
ments fell as their lending diminished. A slumping econ
omy and more cautious lending behavior on the part of
banks whose financial positions had deteriorated con
tributed to this decline in lending activity. The resulting
weakening of the broader aggregates was viewed by the
Committee with increasing concern. As banks cut back
on their asset expansion, the gap between market inter
est rates and yields on banks’ retail deposits widened
beyond the average that had prevailed in the mid-to-late
1980s. The slowdown in M3 was more pronounced than
that for M2 because many banks substituted cheaper
and more stable retail deposits, which are included in
M2, for more expensive and volatile time deposits and
other managed liabilities found in M3. The strength of
noncompetitive tenders at Treasury auctions during the
year suggested that some of the funds leaving both
banks and thrifts found their way into the government
securities market.
In February, the FOMC reaffirmed the 1990 target
range for M2 that had been tentatively established the
previous July and that called for growth of 3 percent to 7
percent— the same range that had been set for 1989.
The Committee lowered the target range for M3 to allow
for the anticipated shrinkage of the thrift industry. The
new range encompassed growth of 2 Vz percent to 61/2
percent for M3 in 1990, compared with the tentative
range established the previous July (and the 1989
range) of 31/2 percent to 71/2 percent. The 1990 ranges
were considered consistent with sustained economic
growth and the FOMC’s continued commitment to price
stability. The Committee maintained the width of its
ranges for M2 and M3 at 4 percentage points, as it had
done since 1988, because the rate of monetary growth
associated with an acceptable economic performance
remained subject to considerable uncertainty. In addi
tion, the behavior of M3, and to a lesser degree M2, was
rendered less predictable because of the uncertainty
about the effects of thrift restructurings. These ranges
were also expected to provide the Committee with
Chart 5A
Chart 5B
M2: Levels and Target Ranges
M3: Levels and Target Ranges
Cones and Tunnels
Cones and Tunnels
Billions of dollars
3450
Billions of dollars
4300
5.0%
7.5%
3400
V
4200
3350
//
/ /
/ /
/ /
/ /
3300
4100
3250
/
/
/
A
\
3200
4000
/
3150
/
/
3100
/
/
V ^ / / 3.5% x
s '
3900
3050
/
3000
3800
/
/
C
/
/
.....
s'
V
Actual
/ /
S
s'
'
1.0%
i I i i
Ii i I
s
s'
s
/
/
/
/
/
_
/
/ / // /
/
/ X
//
/
/
\
/
/
s '
// /
Ii
i i
I M ...1., I 1 I J I 1 1 1 I I
O N D J F M A M J J A S O N D J F M A M J J A S O N D
1988
1989
1990
Chart 5D
Chart 5C
Total Domestic Nonfinancial Debt: Levels and
Monitoring Ranges
Cones and Tunnels
M1: Levels and Growth Rates
Billions of dollars
880
10.0% /
/
/
/
/
Billions of dollars
860
/
/
/
840
/
5.0%
5.0%
/
s'
820
s'
s'
s'
/
/
/
/
/
s 'jr ^
/ / * • / Actual
800
J
S
o%
780
\
760
\
^
\
\
\
-5.0%
\ ^
740
1988
1989
1990
I I I I I I I I I I I
I I
m
I i i I i i I i Is
ONDJ FMAMJJ ASONDJ FMAMJJ ASOND
1988
1989
1990
FRBNY Q uarterly R eview/Spring 1991
63
ample leeway to pursue a more aggressive policy to
restrain inflation should price pressures intensify. The
Committee continued to evaluate money growth in light
of progress towards price stability, movements in
velocity, and developments in the economy and finan
cial markets.
The FOMC set a monitoring range for total domestic
financial debt growth of 5 percent to 9 percent, below
the tentative 6V2 percent to 101/2 percent range estab
lished the previous July and the range for 1989. The
range was lowered because corporate merger and
acquisition activity and household debt growth were
expected to diminish— prospective developments wel
comed by the Committee in light of existing debt bur
dens. Meanwhile, for the fourth consecutive year no
growth range was set for M1 because the relation
between that aggregate and nominal GNP remained
very uncertain.
During the first half of 1990, M2 growth decelerated a
bit from the pace maintained late in the previous year.
Early in the year, however, strength in transaction and
other liquid accounts and a surge in currency— much of
it apparently destined to go overseas— helped push this
aggregate close to the top of its growth cone. Then,
during the spring, M2 growth was gradually curbed by
the rising opportunity costs of holding M2 balances,
particularly money market mutual funds (MMMFs). A
steeper yield curve reduced the attractiveness of rates
on these funds compared with yields on competing
Treasury securities of som ewhat longer maturity.
(Weakness in MMMFs may also have been a reaction to
a rallying stock market, as evidenced by strong flows
into equity mutual funds.) Rates on retail deposits,
particularly certificates of deposit (CDs), were unusually
slow to respond to the rise in market interest rates
through April, further depressing M2 in the first half of
the year. Still, M2 advanced at an average rate of 5.1
percent over the first two quarters.
Growth in M3 over the first half of the year came
solely from M2; its non-M2 component fell dramatically.
Declines were most evident in large time deposits. The
fall in thrift time deposits had been expected; however,
the declines seen at commercial banks were unantici
pated because banks had been expected to pick up
enough of the thrifts’ loan business to have sought
additional financing through large time deposit issu
ance. The weakness at commercial banks was attrib
uted to the slackening pace of economic expansion
and, increasingly, to banks’ growing reluctance to lend.
M3 expanded at a 2.1 percent annual rate over the first
two quarters of 1990. Meanwhile, M1 grew at a 4.8
percent pace during this time, partly as a result of the
strong currency growth; and debt rose at a 6.8 percent
rate, buoyed by growing Treasury borrowing, some of
Digitized
FRASER Quarterly Review/Spring 1991
64for FRBNY
which was used to fund the RTC’s activities.18
At its midyear review of the growth ranges for the
broader monetary aggregates and debt, the FOMC set
a new, lower range for M3 in 1990 of 1 percent to 5
percent. This move reflected the weakness in M3 to
date, as well as expectations of continuing thrift resolu
tion activity by the RTC and moderate expansion of
commercial bank credit. These factors were expected to
affect M2 to a much lesser degree, and the growth
range for this aggregate was retained in July, as was the
monitoring range for debt.
Growth in the broader aggregates tapered off even
further in the second half of the year, despite a brief
jump in the aftermath of the Iraqi invasion of Kuwait. At
that time, MMMFs surged as investors fled the uncer
tainty and volatility of equity and bond markets, and
currency sharply increased, in large part because of
demands from the Middle East. Growth in currency and
MMMFs decelerated by November, however, and the
earlier weakness in the broader aggregates reemerged.
The accelerated slippage in the economy, and perhaps
to some degree, growing difficulties of banks in attract
ing funds as anxieties about their financial health deep
ened, aggravated the weakness in M2 and M3. Growth
in small time and savings deposits remained sluggish
late in the year despite declines in the opportunity costs
of holding these deposits. The weakness in M2 was
fairly broad-based, and the managed liability compo
nent of M3 shrank. Meanwhile, M1 growth remained
robust in the second half of the year as a result of the
late summer surge in currency growth.
The drop in deposit liabilities associated with the
restructuring of the thrift industry and with banks’
restrained lending behavior contributed to a significant
2.7 percent advance in the income velocity of M3 that
extended the recent pattern of increases but ran coun
ter to the declining long-run trend (Chart 6). The drop in
liabilities also helped bring about a lesser, 0.6 percent,
rise in the velocity of M2. Both increases were well above
the aggregates’ respective average rates of velocity
growth for the period 1982-90 but not much different
from the gains registered in 1989. Meanwhile, the in
come velocity of M1 was up a scant 0.3 percent in 1990,
an increase well below the previous year’s rapid 5.0
percent advance. The velocity for domestic nonfinancial
debt fell 2.1 percent, in line with recent yearly declines.
The course of policy
During 1990, the FOMC responded to economic and
«Growth rates of M1 and M2 in the first half of the year were revised
upward modestly by the benchmark and seasonal factor revisions.
For the second half of the year, these revisions led to minimal
changes in the growth rates of both aggregates, but M3 growth was
raised modestly.
Chart 6C
Chart 6D
Total Domestic Nonfinancial Debt Velocity Growth
Percent
M1 Velocity Growth
Percent
8
-------
Notes: Velocity growth is measured from four quarters earlier. Shaded areas represent periods of recession as defined by the N ational Bureau
of Econom ic Research.
FRBNY Q uarterly R eview/Spring 1991
65
financial developments by continuing the gradual
easing of reserve pressures it had initiated in mid-1989.
Following a move to ease reserve pressures in midDecember of 1989, the Committee’s policy stance
remained unchanged for nearly seven months because
the risks of inflation and an economic softening were
seen as about evenly balanced.
By mid-July, however, the risks appeared to be
weighted in the direction of weakness in economic
activity. Although the trend rate of inflation had shown
no signs of improvement, progress toward reducing this
rate was anticipated because the monetary aggregates
had grown at moderate rates for an extended period
and economic expansion was expected to continue at a
pace below its potential. Meanwhile, indications such
as a marked slowing in monetary growth in the second
quarter suggested that credit conditions had become
tighter than appropriate. To offset this unintended
degree of restraint, reserve pressures were eased
slightly on July 13.
The outlook for the economy and prices was not much
changed just prior to the Iraqi invasion of Kuwait; how
ever, the invasion and subsequent surge in oil prices
introduced considerable uncertainty into the longer
term prospects for both economic activity and inflation.
In these circumstances, the Committee felt that it could
best contribute to the nation’s economic goals by foster
ing a stable policy environment. It therefore left reserve
pressures unchanged following its August meeting, but
it remained disposed toward ease.
The Committee took its second accommodative step
in late October. When it met early in the month, evi
dence pointed to a significant risk of a much weaker
economy, and protracted federal budget negotiations
had recently produced a tentative accord that incorpo
rated a significant degree of fiscal restraint. Chairman
Greenspan was on record as declaring the agreement
“credible,” an assessment he had identified as a pre
condition to easing policy. In view of widespread market
expectations that an easing would follow a budget pact,
Committee members thought that an immediate easing
could give rise to expectations of a further move once
the package was enacted. Consequently, the FOMC
decided to delay implementing its accommodative move
until the budget agreement was approved. At that point,
the enactment of a budget was thought to be imminent;
however, the Congress rejected the original budget
agreement. The easing did not occur until October 29,
after a somewhat revised package was passed.
The Committee stepped up its pace of accommoda
tion in November and December, easing its policy
stance three times. Evidence received during this
period indicated that a downturn in economic activity
had begun and that financial conditions remained frag
66 FRBNY Quarterly Review/Spring 1991
ile. While the contraction was expected to be mild and
brief, the uncertain condition of many financial institu
tions and a curtailed supply of credit to many borrowers
contributed to a risk that the downturn might be more
severe or prolonged. Moreover, money growth slowed
further, and underlying inflatio n pressures were
expected to moderate somewhat. In these circum
stances, the Committee eased reserve pressures fol
lowing its November meeting and carefully monitored
the incoming information for signs that additional
accommodation would be appropriate. Data received in
early December confirmed that additional easing steps
were called for, and the Committee acted at that time
and again following its December meeting.
In December, the accommodative moves were not
confined to reserve pressures but were extended to
other policy tools. On December 4, the Board of Gover
nors announced that it would eliminate reserve require
m ents on n o n p e rs o n a l tim e d e p o s its and on
Eurocurrency liabilities by cutting the reserve require
ment ratios on these deposits in two steps beginning in
mid-December.19 The timing coincided with a normal
seasonal rise in reserve needs and therefore limited the
size of the open market operations called for to absorb
the reserves released by the cuts. Lower requirements
were expected to reduce costs for depository institu
tions holding more reserves to meet requirements than
necessary for clearing purposes, because institutions
do not earn interest on reserve balances. The Board
anticipated that the action would provide an added
incentive for these institutions to lend to creditworthy
borrowers and thus would counter, to some extent, the
observed tightening in credit terms.
Soon after, on December 18, the Board of Governors
approved a cut in the discount rate to 6Vz percent from
the 7 percent rate that had prevailed since February
1989. It took the step in response to the weakness in
the economy, constraints on credit, and anemic money
growth.
Policy implementation
Behavior of discount window borrowing
Implementation of open market policy in 1990 was com
p licated by the c o n tin u ed d e te rio ra tio n of the
relationship between discount window borrowing and
the federal funds rate. The FOMC specifies its policy
objectives in terms of desired degrees of reserve pres
sure, a concept associated with attaining a specified
19The Board reduced the reserve requirement ratio for nonpersonal
time deposits with an original maturity of less than eighteen months
to 1V& percent, from 3 percent, for the reserve maintenance period
running from December 13 to December 26 and then eliminated the
requirement in the following maintenance period. Time deposits
maturing in eighteen months or more have been exempt from
reserve requirements since 1983.
mix of nonborrowed and borrowed reserves.20 By man
aging nonborrowed reserves, the Desk seeks to achieve
a chosen level of borrowed reserves, which are supplied
by the discount window under the adjustment and sea
sonal program s.21 The portion of required reserves not
“ See A nn-M arie M eulendyke, U.S. M onetary Policy an d Financial
M arkets (Federal Reserve Bank of New York, 1990), chap. 6, for a
com plete discussio n of the borrowed reserve operating procedure.
21Reserves can also be borrowed under the extended credit program.
This fa cility is used by de p o sito ry institutions in financial difficulty.
Institutions borrow ing under this program are expected to
con centrate on resolving their basic problem s instead of seeking
funds to repay the loan; thus, their borrowing is more likely to be
for extended pe riods than for the short intervals of adjustm ent
provided as nonborrowed reserves must be borrowed
from the discount window if reserve deficiencies are to
be avoided. As long as there is a predictable degree of
reluctance to borrow, a specified level of borrowing is
expected to be consistent with a particular degree of
money market pressure, as measured by the spread
between the federal funds rate and the discount rate. In
recent years, however, d ep osito ry in stitu tio n s have
become less willing to borrow from the discount w in
dow; thus, a larger spread between the federal funds
Footnote 21 con tinued
borrowing. Institutions borrow ing under the extended cre dit program
may be cha rged an above-m arket rate that exceeds the basic
discount rate.
Table 2
Specifications from Directives of the Federal Open Market Committee and Related Inform ation
Date of
Meeting
Specified Short-Term
Growth Rates
M2
M3
Borrowing
Assumption
for Deriving
NBR Path
Associated
Federal
Funds Rate*
Committee
Preference
for Degree
of Reserve
Pressure
Prospective Reserve Restraint Modifications
Guidelines for
Modifying
Reserve
Pressure
Factors to Consider for Modifications
(In Order Listed)
1
3
4
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
A slightly
greater or
slightly lesser
degree would
be acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Maintain
A slightly
greater or
slightly lesser
degree would
be acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Maintain
A slightly
greater degree
might be
acceptable.
A slightly
lesser degree
would be
acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
(Percent)
(Millions of
Dollars)
(Percent)
12/18 to
12/19/89
November to March
8V6
5Vfe
150
125 on 12/20*
8.50
8.25 on
12/20
Decrease
slightly
A slightly
greater or
slightly lesser
degree would
be acceptable
Progress
toward price
stability
2/6 to
2/7/90
December to March
7
3V6
125
150 on 2/8§
8.25
Maintain
A slightly
greater or
slightly lesser
degree would
be acceptable
March to June
4
150
200 on 4/26§
300 on 5/3§
8.25
Maintain
6
March to June
3
300
350 on 5/17§
400 on 6/14S
450 on 6/28§
8.25
4
June to September
3
1
450
400 on 7/13*
450 on 7/26§
500 on 8/2§
8.25
8 00 on 7/13
3/27/90
5/15/90
7/2 to
7/3/90
2
fT he middle of the federal funds rate trading area that is expected to be consistent with the borrowing assumption. The discount rate remained at 7 percent from the
beginning of the year until December 19, when it was reduced to 6 50 percent.
^Change in borrowing assumption reflects change in reserve pressures.
§Change in borrowing assumption reflects technical adjustment.
FRBNY Q uarterly Review/Spring 1991
67
rate and the discount rate has been needed to induce
institutions (in the aggregate) to borrow the amount
assumed by the Committee. (Notes on the FOMC direc
tives, the expected degree of money market firmness,
and the borrowing assum ptions used to construct the
reserve paths are in Table 2.)
During 1990, the reluctance to borrow from the d is
count window became even more pronounced. Against
the backdrop of the savings and loan associations’
ongoing difficulties, developments in leveraged buyout
and real estate lending raised public concerns about
the financial health of depository institutions. The Bank
of New England was a focus of attention early in the
year. Then, between Septem ber and year-end, con
cerns about a number of large banks intensified as a
result of reports of large losses, dividend reductions,
anti m ounting evidence of an econom ic dow nturn.
Moreover, throughout this period there was heavy media
coverage of those institutions considered to be under
earnings stress.
This intense scrutiny by the press tended to reinforce
the perception that depository institutions borrowing
from the discount window were in financial straits.22
“ Attention has focused on adjustm ent borrow ing. Seasonal borrow ing,
used prim arily by small a g ricu ltu ra l banks du ring the growing
season when their loan dem and is seasonally strong, has not been
affected.
The Federal Reserve does not release data on individ ual bank
Table 2
Specifications from Directives of the Federal Open Market Committee and Related Inform ation
(Continued)
Date of
Meeting
Specified Short-Term
Growth Rates
M2
M3
Borrowing
Assumption
for Deriving
NBR Path
Associated
Federal
Funds Rate*
Committee
Preference
for Degree
of Reserve
Pressure
2
3
4
A slightly
greater degree
might be
acceptable.
A somewhat
lesser degree
would be
acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Maintain
A slightly
greater degree
might be
acceptable.
A somewhat
lesser degree
would be
acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Decrease
slightly
A slightly
greater degree
might be
acceptable.
A somewhat
lesser degree
would be
acceptable
Progress
toward price
stability
Strength of
the business
expansion
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
Decrease
slightly
A slightly
greater degree
might be
acceptable.
A somewhat
lesser degree
would be
acceptable
Progress
toward price
stability
Trends in
economic
activity
Behavior of
the monetary
aggregates
Developments
in foreign
exchange and
domestic
financial
markets
(Millions of
Dollars)
(Percent)
8/21/90
June to September
4
2V&
500
8.00
Maintain
10/2/90
September to December
4
2
500
450 on 10/45
400 on 10/18§
350 on 10/29"
300 on 11/8§
8.00
12/18/90
September to December
1-2
1-2
November to March
4
1
7.75 on 10/29
300
225 on 11/14"
200 on 11/235
150 on 12/6«
125 on 12/7*
100 on 12/135
7.75
7.50 on 11/14
100
125 on
12/19+t
7.25
7.00 on 12/19
Factors to Consider for Modifications
(In Order Listed)
1
(Percent)
11/13/90
Prospective Reserve Restraint Modifications
Guidelines for
Modifying
Reserve
Pressure
7.25 on 12/7
tThe middle of the federal funds rate trading area that is expected to be consistent with the borrowing assumption. The discount rate remained at 7 percent from the
beginning of the year until December 19, when it was reduced to 6.50 percent.
^Change in borrowing assumption reflects change in reserve pressures.
§Change in borrowing assumption reflects technical adjustment.
•Change in borrowing assumption reflects technical adjustment and a change in reserve pressures.
ttThe borrowing assumption was increased so that only part of the accom m odation from the cut in the discount rate would show through to the market.
68 FRBNY Q uarterly Review/Spring 1991
This perception is, in fact, not consistent with long
standing practices or with the periodic needs of the
banking system. From time to time, healthy institutions
find them selves unexpectedly short of reserves late in
the day, perhaps because reserve position managers
were not informed of a large deposit outpayment or
because an expected inflow of funds did not m aterialize.
In such circum stances, the institutions generally turn
first to the federal funds market and other money mar
kets, but they may not be able to obtain enough funds
at reasonable rates to meet their needs if reserves are
Footnote 22 c on tinued
borrow ing. However, it may occa sio nally be possible for other banks
to infer the probab le iden tity of a borrower from their observation of
the in stitu tio n ’s behavior in the funds m arket or from the d istrict-byd istrict Federal Reserve data pu blished for W ednesdays.
scarce for the banking system as a whole. Previously,
when such system w ide shortages prevailed, banks
would bid for funds in the market until rates rose to a
level sufficiently high above the discount rate to induce
institutions short of reserves to come to the window for
adjustment credit.23 The additional reserves thus intro
duced would relieve the institutions’ own reserve defi
ciencies and, with them , the system w ide shortage.
Recently, with the heightened reluctance on the part of
many institutions to borrow, banks have been bidding
the funds rate to very high levels as they seek to avoid
borrow ing. N onetheless, when the entire system is
23The Federal Reserve extends such cre d it for a lim ited tim e period,
usually one day to two weeks, de p e n d in g on the size and nature of
the institution involved.
Table 3
1990 Reserve Levels
(M illions of Dollars, Not Seasonally A djuste d)
Period
Ended
Jan.
Feb.
Mar.
Apr.
May
June
July
Aug.
Sept.
Oct.
Nov.
Dec.
10
24
7
21
7
21
4
18
2
16
30
13
27
11
25
8
22
5
19
3
17
31
14
28
12
26
Required
Reserves
(Current)
Required
Reserves
(First
Published)
63,844
61,627
59,735
59,585
59,633
59,997
59,633
62,675
61,040
59,657
58,526
60,709
60,046
60,944
59,609
59,599
60,367
59,304
61,546
59,832
61,021
59,471
61,132
61,006
61,513
56,113
63,962
61,668
59,774
59,599
59,643
60,020
59,640
62,600
61,081
59,865
58,603
60,801
60,042
60,957
59,611
59,617
60,292
59,365
61,577
59,739
61,099
59,534
61,249
61,034
61,618
56,017
Excess
Reserves
(Current)
Excess
Reserves
(First
P ublished)
Total
Reserves
1,117
841
1,220
968
797
737
1,078
665
1,105
927
1,011
479
1,020
898
875
764
910
893
746
1,122
984
650
982
966
561
1,922
1,020
958
1,217
992
816
832
1,120
782
1,138
862
1,014
348
1,072
841
837
709
1,019
848
733
1,243
956
635
915
1,055
497
2,111
64,961
62,468
60,955
60,553
60,430
60,734
60,711
63,341
62,145
60,584
59,537
61,188
61,066
61,842
60,484
60,363
61,277
60,197
62,292
60,954
62,004
60,121
62,114
61,972
62,073
58,034
Adjustm ent
and
Seasonal
Borrowed
Reserves
320
2 7 3*
832§
1,348"
126
184
192
206
257
303
625
732
383
399
534
489
1,086
631
701
507
388
372
257
169
106
482
Nonborrow ed
Reserves
plus
Extended
C redit
Borrowed
Reserves
(Current)
N onborrow ed
Reserves
plus
E xtended
C redit
Borrowed
Reserves
(First
P ublished)
64,641
62,195
60,123
59,205
60,304
60,551
60,519
63,135
61,889
60,281
58,912
60,456
60,683
61,443
59,950
59,874
60,192
59,566
61,591
60,447
61,616
59,749
61,857
61,804
61,968
57,552
64,661
62,355
60,159
59,245
60,333
60,669
60,568
63,176
61,963
60,423
58,992
60,417
60,731
61,399
59,914
59,836
60,225
59,582
61,610
60,474
61,668
59,798
61,907
61,921
62,010
57,646
N onborrow ed Extended
C redit
Reserves
Interim
Borrowed
O bjective* Reserves
65,042
62,520
60,573
60,430
60,443
60,820
60,440
63,448
61,844
60,514
59,220
61,432
60,574
61,522
60,172
60,024
60,790
59,688
62,027
60,115
61,658
60,145
61,947
61,785
62,431
57,569
19
27
33
133
1,841
1,995
1,965
1,676
899
673
1,098
559
183
182
298
419
38
8
5
9
13
26
25
25
25
22
Note: The allow ance for excess reserves generally was $950 million. In the period ended January 10, it was $1.2 billion, in the period ended
D ecem ber 26, it was set at $1.5 billion initially and then raised to $1.7 billion to reflect both year-end dem ands and increased dem ands
du ring the phase-in of the reserve requirem ent cut.
TAs of the final W ednesday of the reserve period.
in c lu d e s $111 m illion of spe cia l situation adjustm ent borrowing, w hich was treated as nonborrow ed reserves.
§lncludes $665 m illion of s pe cia l situation adjustm ent borrowing.
"In c lu d e s $1,096 m illion of spe cia l situation adjustm ent borrowing.
FRBNY Q uarterly Review/Spring 1991
69
short of reserves, the borrowing must occur because
there is no other way for the banking system as a whole
to obtain reserves late in the day.
In part reflecting the reluctance to borrow, adjustment
borrowing was typically very light in 1990, as it had
been in the latter half of 1989. (Actual reserve levels
appear in Table 3.) Contributing to the light borrowing
were the generally narrower spreads of the funds rate
over the discount rate. Narrower spreads emerged as
policy became more accommodative and the discount
rate was held at 7 percent for most of the year. During
many maintenance periods, adjustment credit was very
low until the final day, when borrowing sometimes rose
in the face of settlem ent day pressures. The low point
fo r a d ju stm e n t b orrow ing in 1990 occurred in the
Decem ber 12 m aintenance period, when borrowing
averaged a minimal $19 million at a time when the
average funds rate exceeded the discount rate by 43
basis points (Chart 7). This average for adjustment
Chart 7
Borrowing and the Spread between the Federal Funds Rate and the Discount Rate
Millions of dollars
1600
Borrowing
Excludes special situation borrowing
1400
1200
I
I
I
I
I
1
I
1
I
I
seasonal borrowing
/\
\
*\
ii
I
i
A \jI'M
1— / V - » '
1
1 \
1 \
V J \' v >
. M
i Vx A
wT
/ \
/
\\
/
\
A
y \ / \
\) \
/
/ \ V
* ^
'
---------------------- -
1 1 111 1 1 1 1 1 11
Percent
4
.
\
Adjustment
borrowing
A—
V
m
i n
i u m
ii
^\ A
/' I /\
/
/)
A - / — \ —l i l l
' J
i n ' l l ii*! i l l
/
/
/
\
j 1! /i
_______________________________________________________________________________
borrowing was the lowest since July 1980, a period
when the funds rate was considerably lower than the
discount rate.
For the year, adjustm ent credit averaged $231 million,
while the spread between the funds rate and the d is
count rate averaged 112 basis points. Early in the year,
however, the Bank of New England borrowed steadily
for about a month under the adjustm ent credit program.
This special situation borrowing was treated as akin to
extended credit borrowing, and the Desk disregarded it
in assessing how adjustm ent borrowing was behaving.
Later borrowing by the institution was form ally classified
as extended credit borrowing. Excluding the special
situation borrowing, average adjustm ent credit was $159
million. Com parable figures for 1989 and 1988 were
$243 million and $293 m illion per day, w hile spreads
averaged 228 basis p oints and 137 b asis p o in ts,
respectively.
Seasonal borrowing followed its typical pattern of
*
r \
\
\
1\
\
111
I
i
Federal Funds Rate less Discount Rate
______________ __ ____ __
LLLLLU 111 1 11.1 1 11 1111 1 111 I 111 1 1 111 1 11 1 1 1 11 111 1 11 11 1 11 11 1 1 1111 11 111.1. 11,11 11 1LU
1988
Digitized for
70 FRASER
FRBNY Q uarterly Review/Spring 1991
1989
1990
rising in the spring and declining in the fall (Chart 8).
The rise in seasonal borrowing was accommodated
through eight increases in the borrowing allowance from
February through August, while its decline was reflected
in six reductions in the allowance from October through
the year-end. On tw o o cca sio n s, O ctober 29 and
November 14, reductions were made both to reflect
routine decreases in seasonal borrowing and to reduce
reserve pressures. Seasonal borrowing peaked in the
August 22 maintenance period at an average $432
m illion per day.24 For the year as a whole, seasonal
borrowing averaged $223 m illion, compared with $274
million in 1989 and $235 million in 1988.
O p e ra tin g p ro c e d u re s
The Com m ittee form ally followed a borrowed reserve
operating procedure in 1990; however, it took account of
the uncertain relationship between borrowing and the
federal funds rate, as it had in the previous two years.
The Desk treated the intended levels of borrowing flexi
bly in order to achieve the desired policy stance,
designed so that federal funds generally traded in a
24Peak period averages in 1989 and 1988, respectively, were $509
m illion (July 26 period) and $433 million (O ctober 5 period).
narrow range around the C om m ittee’s expected rate.
The Desk continued to evaluate estimated needs to add
or drain reserves when planning the nature and size of
its daily operations, but it was also guided by the funds
rate prevailing before its typ ical m arket entry tim e,
around 11:30 a.m. to 11:40 a.m., when determ ining
whether to perform an operation. Market participants
focused on the federal funds rate as an indicator of the
Federal Reserve’s policy stance, even though the Fed
eral Reserve does not have com plete control over this
rate.
One com plication of paying greater heed to the funds
rate was that federal funds at tim es traded at rates that
were not consistent with reserve projections made by
the staffs of the New York Reserve Bank and the Board
of Governors. Such inconsistencies often occurred
when market participants expected an im m inent shift in
the Federal R eserve’s policy setting. At these tim es, the
funds rate som etim es reflected the expected policy
move instead of the current reserve picture. In these
circum stances, the Desk usually deferred addressing
the reserve situation rather than risk m isleading m arket
participants about the stance of policy. Indeed, after the
experience of late November 1989, the Trading Desk
sought to signal policy moves more clearly in 1990 in an
effort to m inimize the possibility of m isunderstanding.25
Open m a rk e t o p e ra tio n s a nd rese rve m a n a g e m e n t
In 1990, the System ’s portfolio of securities grew by $12
billion, somewhat below the average annual increase of
$14.3 billion registered over the 1981-88 period. In the
first eleven months of the year, the portfolio showed an
increase of $18.7 billion, the bulk of which was in Trea
sury bills. In December, however, the Desk reduced the
portfolio by $6.7 billion to absorb part of the reserves
released by the cuts in reserve requirem ent ratios. This
contraction was accom plished through sales of Treasury
securities to foreign accounts and redem ptions of bills
at auctions.
As usual, the prim ary m otivation for growth in the
portfolio during the year was to offset reserve drains
from currency issuance. Currency rose at an excep
tionally rapid pace, prim arily because of a dram atic
surge in shipments to foreign countries. The $26.1 b il
lion growth in currency was the largest ever and about
twice that recorded in the previous year. Other factors
that can affect the supply of reserves were m ostly
trendless in 1990, although holdings of foreign currency
and special drawing rights increased reserve levels
modestly over the year. In contrast, foreign currency
acquisitions added considerably to reserve levels in
25See "M onetary Policy and Open M arket O perations d u ring 1989,”
Federal Reserve Bank of New York Q uarterly Review, vol. 15, no. 1
(S pring 1990), p. 63.
FRBNY Q uarterly Review/Spring 1991
71
1989 and led the Desk to reduce its portfolio of U.S.
Treasury securities.
Weakness in total reserve demand restrained some
what the need to expand the portfolio over the first
eleven months of the year. Required reserves fell by
$2.3 billion between the reserve maintenance period
ended January 10 (which included year-end 1989) and
that ended December 12 because reservable deposit
growth was slow and deposits were at their seasonal
peak at the start of the year. Required reserves then
declined by $10 billion in the next two reserve mainte
nance periods— less than the $131/2 billion released by
the reserve ratio reduction because of the seasonal
increase in transactions deposits. Meanwhile, the drop
in reserve demand related to the cut in requirements
was p artially offset by elevated excess reserve
demands (described below).
Desk operations: January through November
The Desk made outright purchases of Treasury bills in
the market on five occasions when reserve projections
suggested large, sustained needs to add reserves.26
(The appendix gives details of portfolio changes.) The
pattern of purchases in 1990, as in most years, gener
ally reflected seasonal variation in currency growth and
Treasury balances. A purchase on October 31 was in
part necessitated by the reserve drain created from the
unwinding of a warehousing transaction involving
deutsche marks. Later, a transaction on November 28
was smaller than usual in anticipation of the cut in
reserve requirements announced six days later.
In April, the Desk usually adds to the System portfolio
because required reserves rise as taxpayers build
transactions deposit balances to handle tax payments
and because high tax receipts swell the Treasury’s
balance at the Federal Reserve. In April 1990, the Desk
expanded the portfolio by nearly $6 billion, somewhat
less than the average increase of recent years because
the Treasury balance was far below its usual late April
levels. In 1990, an unusually large $38 billion of cash
management bills matured soon after the tax payment
date. Paying off these bills depressed the Treasury’s
balance at the Federal Reserve relative to its typical
late April levels. Furthermore, tax receipts were lower
than normal.
Desk operations: D ecem ber
The reserve requirement cut had a profound impact on
the reserve management strategies of depository insti
tutions and the Trading Desk. Total required reserves on
nontransactions deposits had been met by about $11%
“ The Desk sold bills in the market on one occasion early in the year
when required reserves and currency were declining seasonally.
Digitized72
for FRASER
FRBNY Quarterly Review/Spring 1991
billion of deposits at the Federal Reserve and about
$13/4 billion of vault cash. The reduction in requirements
enabled additional institutions to meet their reserve
requirements entirely with vault cash, while others found
that the level of balances that they were required to hold
at the Federal Reserve fell sharply. At the same time,
many depository institutions found that they needed to
hold reserves for clearing purposes in excess of their
new lower requirements. Depository institutions’ reserve
accounts are used to process hundreds, or perhaps
even thousands, of transactions each day, and their
reserve balances swing sharply during the course of the
day. Institutions can project these swings to some
extent but also face late day surprise inflows and out
flows. As a result, they try to hold positive balances in
their accounts to guard against being inadvertently
overdrawn at the end of the day. In many cases, the
balances needed to avoid such overdrafts are close to
or exceed those needed to meet requirements.
The Trading Desk recognized that, following the cut in
reserve requirements, demands for excess reserves
would probably far exceed typical levels, but it could not
quantify with any precision how much depository insti
tutions would want to hold and for what length of time.
The cut in requirements was expected to lift perma
nently the banking system ’s dem and for excess
reserves because many depository institutions would
need to hold such reserves to help meet their clearing
needs. Moreover, it was anticipated that excess reserve
demand would temporarily run above this new, perma
nently higher range while institutions adjusted to their
new levels of requirements. Past experience was not a
good guide in helping to determine either the size or the
persistence of the elevated demands because the mag
nitude of the reductions for Federal Reserve member
banks was unprecedented and because neither non
member nor foreign institutions had ever had their
requirements reduced.
Gauging excess reserve demands in future mainte
nance periods was also complicated by uncertainty
about the volume of required clearing balances. A
depository institution can establish such a balance by
specifying an average level of reserves that it will hold
on deposit at the Federal Reserve for clearing purposes
in addition to any balances that it must hold to meet
reserve requirements. In exchange, it receives credits
on its required clearing balance that it can use to pay
for priced services from the Federal Reserve, such as
check processing. Thus it earns implicit interest on its
required clearing balances. These balances are an
attractive way for institutions that use priced services to
obtain some cushion against unexpected reserve out
flows from their reserve accounts and consequently to
reduce their excess reserves, which by law pay no
interest. The Desk knows required clearing balances for
a given maintenance period at the beginning of that
period, but not those for future periods. Thus, the Desk
anticipated that future demands for excess reserves
would be relieved to some extent by the opening of
required clearing balances, but it could only make
rough estimates about the extent to which depository
institutions would choose such balances.27
The reserve requirement reductions made it neces
sary to drain reserves to avoid leaving the banking
system with excess reserve levels far more massive
than it could want; however, the magnitudes of the
reserve drains were highly tentative because the extent
of the increase in excess reserve demand was uncer
tain. Consequently, the Desk drained reserves cau
tiously because it did not want to withdraw too many
reserves and thus create undesired firmness in the
money market, especially around the year-end when
demands for liquidity were high. The Desk therefore
eschewed an outright market transaction in December.
Instead, it opted to reduce the portfolio gradually by
running off $1 billion of maturing bills at the Treasury bill
auctions each week for four weeks and by selling about
$2.7 billion of securities to foreign accounts.
Unusually high demands for year-end funding com pli
cated the D esk’s ability to drain reserves in late 1990.
Year-end funding demands were greatest in late Novem
ber and again in m id -to -la te December. Japanese
banks, in particular, were early aggressive borrowers of
both term m onies and forward tw o-day funding for
December 31 and January 1.
Depository institutions managed their reserve posi
tions cautiously during the December 26 maintenance
period, which contained the first phasedown of require
ments. The funds rate was often firm in the morning,
especially in the second week. The Desk responded
with what it estimated were generous reserve provi
sions, so that a sizable cushion of excess reserves had
been built up by the settlem ent day. Indeed, funds
trading touched a low of Vie of 1 percent late on Decem
ber 24. On the December 26 settlem ent day, the Desk
refrained from market action to affect reserves because
federal funds were trading on the soft side, projections
suggested that reserve supplies were ample, and the
cushion of excess reserves was sizable. But an unex
pected shortfall in reserve supplies, a maldistribution of
reserves, and sharply higher than anticipated demands
for excess reserves all contributed to a late day spike in
the federal funds rate, which reached a record high of
100 p ercen t before clo sin g at a lo fty 80 percent.
27Required clearing balances rose from $1.8 billion in the
m aintenance period ended D ecem ber 12 to nearly $2 billion in the
period ended January 9, 1991. They continued to rise in early 1991.
Reserve market pressures were aggravated that day by
demands from foreign and regional banks, some of
which apparently had little or no collateral on deposit
with the Federal Reserve to pledge against a loan from
the discount window. In the end, a number of institu
tions borrowed; adjustm ent and seasonal borrowing
soared to nearly $5 billion, w hile excess reserves,
which had averaged about $900 m illion in the first
twenty-five m aintenance periods of the year, rose to
$1.9 billion.
The true extent of the demand for excess reserves
was especially difficult to measure during the following
maintenance period, which ended January 9, 1991. The
demand for excess reserves is generally high around
the year-end because d e p o s ito ry in s titu tio n s face
uncertain reserve flows in view of the massive shifting
of funds that occurs as entities dress up their balance
sheets. In 1990, excess reserve demand was expected
to be sharply above even this elevated level because of
the cut in requirements. On December 27, the first day
of the period, a firm funds rate reflected nervousness
about funding over the year-end, in part because of the
tight market at the close on the previous day. The Desk
sought to assure market participants that it was pre
pared to provide ample liquidity; it entered the m arket
early to arrange a sizable round of overnight System
repurchase agreements (RPs) for that day ($6 billion),
and it took the unprecedented step of making com m it
ments for a two-day System RP on Monday, December
Chart 9
Daily Trading Ranges for Federal Funds
Percent
2o— ------------------------------------------
15 —
Daily high
- • Effective rate
Daily low
10
+ + ++
TTtt"
■"I’ -f 4 + - ■
5 -
Ql I I I I ...............I I I I I I I I i l l I I I l l l l I III 1
28 30 4
November
1990
6
10 12 14 18 20
December
1990
24 26 28
1
3 7
January
1991
9
Notes: Shaded areas represent settlement days. Federal funds
rate reached a high of 100 percent on December 26.
FRBNY Q uarterly Review/Spring 1991
73
31, that would span the New Year’s Day holiday. It
arranged $15.7 billion of System RPs on this basis—
one of the largest volumes ever arranged— out of
requests for nearly $34 billion. Nonetheless, depository
institutions bid up the funds rate in early trading on
Friday and Monday, December 28 and 31, despite large
cushions of accumulated excess. The Desk again
entered the market early on Friday and arranged $11
billion o f over-the-weekend System RPs. On Monday, it
added another $2.7 billion of reserves with a two-day
operation, supplementing the substantial volume of pre
arranged transactions. The reserve additions wound up
exceeding demand; funds closed at zero at one broker
on that day.
The Desk’s generous reserve provision in the face of
large demands from the banking system created
roughly $10 billion of excess reserves during the first
week of the period. Once the year-end passed, depos
itory institutions sought to pare their excess reserve
holdings. In order to do so, they had to hold reserve
balances that were likely to be insufficient for clearing
purposes. Since their reserve needs for clearing pur
poses were uncertain until late on most days, they held
onto their reserves for much of the day, thus keeping
the funds rate on the firm side. Then, late in the day,
they released the reserves into the federal funds mar
ket, and the funds rate plunged. Consequently, the
funds rate showed unusually large intraday swings
(Chart 9).
Forecasting reserves and operating factors
As the Desk formulated a strategy for meeting reserve
needs, it took account of potential revisions to the
estimated demand for and supply of reserves. On the
demand side, these revisions could take the form of
74 FRBNY Quarterly Review/Spring 1991
changes in estimated required reserve levels or in the
banking system’s desired excess reserve balances. On
the supply side, revisions to operating factors could
change the reserve outlook. In both cases, revisions
late in the maintenance period were especially difficult
to deal with since they could necessitate very large
reserve operations.
Staff forecasts of reserve levels in 1990 were about as
accurate as those in 1989. Forecasts of required
reserves and excess reserves improved modestly, on
average, while forecasts of operating factors were com
parable in accuracy to those made in the previous year.
As usual, forecasts of both the demand for and the
supply of reserves improved as the maintenance period
progressed because additional information became
available. Mean absolute forecast errors were cut
roughly in half by midperiod and reduced substantially
by the final day of the period. (See appendix for
details.)
The two operating factors that proved hardest to fore
cast in 1990 were the Treasury’s balance at the Federal
Reserve and currency growth. Large forecast errors for
the Treasury balance were made in April and Septem
ber, two months with major tax dates. In April, tax flows
fell below expectations and differed substantially from
typical historical patterns. In late September, tax
receipts exceeded initial forecast levels, while expendi
tures were lower than expected. Meantime, forecasts of
currency generally fell short of actual levels over the
first three quarters of the year. The underpredictions
were especially large following the Iraqi invasion of
Kuwait, when shipments of U .S. currency abroad
surged. In the fourth quarter, when the strong growth of
currency abated somewhat, forecasts generally over
estimated currency growth.
A ppendix: Reserve Management and the System Open Market A ccount
This appendix summarizes outright and temporary trans
actions conducted by the Trading Desk in 1990 and the
factors that prompted them. A final section reviews the
accuracy of staff estimates of the supply of and demand
for reserves, estimates that help to determine the Desk’s
reserve management strategy.
Outright changes in the System portfolio
Total System holdings of U.S. government securities
rose $12.0 billion in 1990 to end the year at $247.6 billion
(Table A1).f This rise contrasted sharply with the record
$10.2 billion decline in 1989, but it was somewhat below
the average increase recorded over the 1985-88 period.
In the first eleven months of 1990, when the full increase
for the year occurred, the $18.7 billion net expansion
exceeded the pace set over the corresponding period in
1988, when the portfolio expanded by $13.1 billion. The
pre-December expansion in 1990 offset reserve drains
from operating factors.* In December, however, the port
folio was reduced by $6.7 billion in response to the cuts
in reserve requirement ratios. For the entire year, the
System portfolio grew at less than half the pace of total
tT his level is re ported on a so-called com m itm ent basis. It
reflects the com m itm ent made on D ecem ber 28 to sell $20
m illion of Treasury bills to foreign accounts for delivery on
January 2, 1991, and the com m itm ent, made on the final
business day of 1990, to redeem $1 billion of Treasury bills
on January 3, 1991. It exclud es the tem porary changes in
the po rtfo lio from the execution and repaym ent of MSP
tra nsactio ns with foreign acco unts because the sales include
com m itm ents to repurchase the securities. It also excludes
RP operatio ns be cause they are tem porary in nature and are
arranged for the Federal Reserve Bank of New York account
rather than the System account.
♦O perating factors are sources and uses of nonborrowed
reserves other than D esk-initiated open m arket operations in
governm ent securities. O pe ratin g factors include the
Treasury’s Federal Reserve balance and the System ’s foreign
currency assets.
Table A1
System Portfolio: Summ ary of Holdings
(B illions of D ollars)
________ Change from:________
Year-End
1989 to
Year-End
1990
Year-End
1988 to
Year-End
1989
Year-End
1987 to
Year-End
1988
247.6
12.0
-1 0 .2
14.5
118.7
122.6
6.3
11.8
0.4
-0 .2
-11.1
1.3
-0 .4
5.4
9.7
-0 .6
Year-End
1990
__________________ H oldin gs
Total holdings
Bills
C oupons
A gency issues
Notes: H oldings are reported on a com m itm ent basis. Totals
may not ad d be cause of rounding.
marketable Treasury debt, and the System’s share of
such debt fell nearly 1 percentage point to 11.1 percent.
Composition of the System portfolio
The increase in the System portfolio was almost all in
Treasury bills. The System’s bill holdings expanded
slightly more than they had shrunk in 1989. Coupon
holdings rose modestly in 1990. Meanwhile, Federal
agency holdings edged down about $200 million
because all but a small part of such holdings were rolled
over at maturity. With the preference for bills, the
weighted average maturity of the portfolio fell by 2.2
months, to 40.5 months.
Bank reserve behavior
The expansion of the System portfolio over the year was
prompted by the reserve drains from currency issuance.
Currency issuance drained over $26 billion of reserves
between the reserve maintenance period ended January
10, 1990, and that ended January 9, 1991 (Table A2).
Currency growth in 1990 was boosted by a dramatic
surge in currency shipments to foreign countries.
Operating factors other than domestic currency, on net,
added about $21/2 billion to reserve levels over the year,
compared with the substantial $26 billion injected in
1989. The difference is largely explained by the behavior
of foreign currency holdings. In 1989, foreign currency
accounted for a $22 billion increase in reserve levels,
primarily reflecting dollar sales in foreign exchange mar
kets and the Treasury’s warehousing of foreign currency
with the Federal Reserve System. This substantial vol
ume of reserves more than covered the reserve drain
from domestic currency growth and prompted the Desk
to reduce the System’s portfolio of U.S. government
securities. In contrast, foreign currency added only about
$13/4 billion to reserve levels over 1990, in part because
net warehousing activity reduced foreign currency hold
ings and intervention was only modest.§ Meanwhile,
interest earnings lifted foreign currency holdings by over
$2!£ billion. The net depreciation of the dollar provided
reserves because it raised the dollar value of the Sys
tem’s foreign currency portfolio.
Total reserve demand contracted in 1990, reflecting a
drop in required reserves. Required reserves fell $2.3
billion between the maintenance period ended January
10 and that ended December 12, largely because of weak
sin order to com plete one “ de -w are hou sin g" tra nsactio n, the
Federal Reserve m onetized $1'/2 billio n of sp e cia l draw ing
rights for the E xchange S tabilization Fund, a move that
added to reserves. The E xchange S tabilizatio n Fund used
the proceeds to repurchase a po rtio n of its w arehoused
foreign currency.
FRBNY Q uarterly R eview/Spring 1991
A ppendix: Reserve Management and the System Open Market A ccount (Continued)
growth in reservable deposits. In the next two mainte
nance periods, required reserves fell about $10 billion.
This drop was less than the $131/2 billion released by the
reserve requirement cut because transactions deposits
rose to their seasonal highs. Excess reserves were
sharply higher in these two maintenance periods, reflect
ing adjustments by depository institutions to the new
requirements and year-end funding pressures.
The supply of total reserves fell markedly during the
Table A2
Bank Reserves
(M illions of Dollars)
Change from:
Period
Ended
1/10/90
to Period
Ended
1/9/91
Period
Ended
1/11/89
to Period
Ended
1/10/90
54779
54800
-9 8 4 4
-9 8 4 1
1245
57
22
3
-1 1 8 9
295
274
233
41
-4 4
-4 7
-3 0
-1 7
-1 7 0 9
-5 2 1
-4 8 5
-3 6
51481
3592
-1 2 3 6 3
2475
-4 1 2
-5 2
M aintenance
Period
Ended
1/9/91
N onborrow ed reserves
Excluding extended credit
In clu ding extended cre dit
Extended cre dit borrow ing
Borrowed reserves
Inclu ding extended cre dit
A djustm ent plus seasonal*
A djustm ent*
Seasonal
R equired reserves*
Excess reserves
System portfolio and operating factors
(B illions of dollars)
System p o rtfolio
247.6
12.0
- 1 0 .2
O pe ratin g factors:
Foreign currency^
U.S. currency
Treasury balance
Float
SDRs
G old deposits
Foreign deposits
A p p lie d vault cash
O ther items
Foreign RP pool11
33.0
286.5
7.4
2.7
10.0
11.1
0.3
28.9
15.7
6.7
1.7
-2 6 .7
-1 .6
1.5
1.5
22.1
- 1 3 .0
1.5
-0 .3
3.5
—
0.1
0.6
0.3
-1 .2
—
- 0 .1
1.7
-2 .4
-0 .2
Notes: Figures may not add because of rounding. Signs on
cha nges in System p o rtfolio and operating factors indicate
im pa ct on bank reserves.
^A djustm ent borrow ing includes $85 million of special situation
borrow ing in the pe riod ended January 9, 1991.
*Not ad ju sted for cha nges in required reserve ratios.
§Market value.
in c lu d e s custom er-related repurchase agreem ents.
76 FRBNY Q uarterly Review/Spring 1991
year. When required reserves fell, nonborrowed reserves
also declined, although to a lesser extent, while borrow
ing fell modestly and excess reserves rose. The decline
in borrowing was concentrated in the adjustment credit
component. Borrowings under both the seasonal and the
extended credit programs were roughly unchanged, on
balance, over the year.
O utright transactions
The Desk conducted outright operations when reserve
projections suggested large, sustained needs to add or
drain reserves. The total volume of outright activity was
$38.4 billion, somewhat smaller than in 1989, although
much larger than in 1988. Virtually all of the Desk’s
outright activity took place in Treasury bills. Purchases
totaled $25.2 billion. Sales and redemptions, which
made up the balance of outright activity, were larger than
those in most other reserve-adding years, mainly
because of the need to drain reserves in December.
Roughly half of the Desk’s outright activity was con
ducted in the market and about one-third was carried out
with foreign accounts. Redemptions of maturing securi
ties, which totaled $5.6 billion, accounted for the
remainder. The Desk entered the market on six occa
sions to conduct outright transactions, all of which were
in Treasury bills. It sold $3 billion on January 31. It then
bought $4.4 billion on April 4, $3.2 billion on May 30,
$2.8 billion on August 29, $3.3 billion on October 31, and
$2.9 billion on November 28. Net purchases from foreign
accounts w ere $3.9 billion.
Temporary transactions
The Desk also met reserve needs through self-reversing
transactions— RPs to add reserves and MSP transac
tions in the market to drain reserves. Such transactions
help to smooth the uneven pattern of reserve availability
that arises from the daily movements in operating fac
tors. MSP transactions are also arranged each day with
foreign official accounts to meet their demand for an
overnight investment facility.11 On occasions when the
Desk desires to make a reserve injection, some of these
orders can be arranged in the market, as customerrelated RPs. These RPs routinely mature on the next
business day because participation in the foreign invest
ment pool varies daily.
System RPs accounted for about two-thirds of the total
volume of temporary reserve additions, with the
remainder provided by customer-related RPs. The Desk
arranged sixty-three System RP operations for a total of
BSee M eulendyke, U.S. M onetary P olicy a n d Fin ancial
Markets, p. 146, for a com plete discu ssio n of the reserve
im pa ct of the overnight investm ent facility.
Appendix: Reserve Management and the System Open Market A ccount (Continued)
$262 billion, and sixty-seven customer RP operations for
$128 billion. The Desk entered the market before its
normal intervention time on two occasions in 1990 to
combat unusually strong year-end funding pressures. It
also conducted its first forward RP, as described in the
text. The highest balance of outstanding RPs was $18.3
billion on December 31.
Thirty-four of the System RP operations had terms
exceeding one business day. Most of these operations
allowed early withdrawals, an option that appeals to
dealers but can complicate the Desk’s planning by leav
ing the amount of added reserves uncertain. To facilitate
the planning of open market operations when multiday
System RPs are outstanding, the Desk on June 14
changed the deadline for withdrawing collateral for such
RPs from 1:00 p.m. to 11:00 a.m. The earlier deadline
ensured that the Desk knew the magnitude of with
drawals before conducting its operations.
Roughly 10 percent of the temporary transactions
arranged in the market drained reserves. Most of these
MSP transactions were executed early in the year, when
currency and required reserves fell seasonally. The Desk
also drained reserves temporarily in December and early
January 1991 following the cut in reserve requirements,
but it was predominantly adding reserves on a temporary
basis at this time to counter year-end funding demands.
Over the year, the Desk arranged twenty-one rounds of
MSP transactions in the market for a total of $48 billion.
Ten of these rounds spanned more than one business
day.
Forecasting reserves and operating factors
When the Desk formulated a strategy for meeting reserve
needs, it took account of potential revisions to the esti
mated demand for and supply of reserves. Large revi
sions late in the maintenance period were especially
troublesome because they could necessitate very large
reserve operations. In 1990, staff forecasts of reserve
demand improved modestly, while the accuracy of fore
casts of operating factors was similar to that of the
preceding year’s forecasts (Table A3).ft
The accuracy of required reserve forecasts at the
beginning of reserve periods was slightly better in 1990
than in 1989, while the mid- and late period estimates
were of similar accuracy in the two years. The improve
ment in beginning-of-period forecasts was accomplished
despite a $150 million increase in the mean absolute
period-to-period change in required reserves. When pre
paring these forecasts, the staff faced some challenges,
including dealing with uncertainty about deposit levels
following large tax payment dates and deciphering distorttT h e Trading Desk uses forecasts of required reserves, excess
reserves, and operating factors m ade by staffs at the Federal
Reserve Bank of New York and the Board of G overnors. The
Desk also considers a forecast of the Treasury's Federal
Reserve balance, an op eratin g factor, m ade by Treasury staff.
Table A3
Approximate Mean Absolute Forecast Errors for Various Reserves and Operating Factors
(Millions of Dollars)
_____________________ First Day___________Midperiod__________ Final Day__________ First Day__________ M idperiod__________ Final Day
Reserves
Required
Excess*
300-320
125-150
195
115-135
70
—
330
135-150
195-215
130
70-90
—
Factors
Treasury
Currency
Float
Pool
1010-1030
630-670
500
190-225
260
530-570
380-430
210-280
140-170
120
70-95
45
30
35-40
10
890-1080
730-810
350-390
200-230
275
440-460
390-420
160-200
130-175
110
70-90
40
25
30-40
10
Note: Forecast errors are expressed as a range to indicate the varying degrees of success achieved by the staffs of the Federal Reserve
Bank of New York and the Board of Governors.
*The reported forecast errors overstate the degree of uncertainty about excess reserves. The Desk supplem ents beginning-of-period and
m idperiod forecasts with informal adjustments that are based on the observed pattern of estimated excess reserve holdings as each
maintenance period unfolds. Federal Reserve staffs make no formal model forecasts of excess reserves on the final day of the
maintenance period.
FRBNY Q uarterly Review/Spring 1991
77
A ppendix: Reserve Management and the System Open Market A ccount (Continued)
tions in deposit flows during the power failure in New
York in mid-August. As maintenance periods progressed,
forecasts became more accurate as additional deposit
information became available. The mean absolute pre
diction error was over one-third smaller at midperiod and
was sharply lower on the final day.
The excess reserve forecasting performance also
improved slightly in 1990, despite the uncertainties about
excess reserve demand in the December 26 mainte
nance period. The mean absolute period-to-period
change in excess reserves was about the same as in
1989. Until the December 26 period, the largest predic
tion errors occurred at times when large banks ran siz
able deficiencies in order to make use of their large
carryovers. Actual excess reserves, which were relatively
low during these periods, were at first substantially
overpredicted.**
The accuracy of the forecasts of operating factors in
1990 was roughly in line with that in 1989. As usual, the
forecast errors shrank as the maintenance period pro
gressed. Overall, there was a tendency to overestimate
the supply of reserves from operating factors. This ten
dency was especially apparent over the last six periods
of the year, when forecasts made on the final day of the
period overpredicted the supply of reserves by an aver
age $100 million to $135 million (on a period-average
basis), errors equivalent to final day misses of about $1.4
billion to $1.9 billion. These misses at times aggravated
settlement day pressures in the funds market.
The forecast errors for the Treasury’s balance at the
Federal Reserve were slightly smaller than in 1989. The
largest error occurred in the period ended May 2. Indi
vidual income tax receipts, which were forecast to be
quite large, were expected to fill the Treasury’s accounts
in the banking system to capacity, thus causing large
«T h e carryover privile g e perm its de pository institutions to
a p p ly a lim ited am ount of their excess or de ficie nt reserve
position in one period to their requirem ents in the following
period. Large banks m onitor their reserve balances closely.
Before the cut in reserve requirem ents in Decem ber, they
were reasonably successful in keeping non-interest-bearing
excess reserves w ithin the carryover allowances, so that their
average holdings of excess reserves over a year typ ic a lly
were clo se to zero. Carryovers therefore tended to produce a
sawtooth pattern of excess reserve holdings at large banks.
This pattern at tim es showed through to aggregate excess
reserve holdings. The Desk does not receive much
inform ation about "c a rry ins" until m idperiod.
78 FRBNY Q uarterly Review/Spring 1991
remittances that would swell the Fed balance.^ However,
tax receipts fell short of projections. Sizable errors
began to appear in mid-April, but they were first attrib
uted to timing problems. Later in the year, large forecast
errors in the October 3 period drained reserves when
taxes came in higher, and spending came in lower, than
expected. For the year as a whole, the Treasury’s Fed
balance was less volatile than in previous years. Capac
ity limitations drove the balance above the $5 billion
target level on only about fifteen business days, com
pared with about fifty-five business days in 1989.
An additional feature that contributed to forecast errors
in 1990 was a change in tax remittance regulations.
Previously, employers remitted all withheld taxes to the
Treasury according to fixed schedules. Beginning in
August, employers were required to remit these taxes as
soon as withholdings reached $100,000. For large firms,
this change resulted in a considerable speedup in tax
remittances. For a time, it became more difficult to pre
dict daily flows to the Treasury because the historical
patterns used by the forecast staffs were based on the
earlier withholding schedules. After several months of
observing the data flows, the staffs discerned a new tax
remittance pattern; by year-end, major forecast misses
due to the change were largely eliminated.
Forecasting U.S. currency in circulation proved to be
more demanding than usual in 1990, while the forecast
ing performance for other reserve factors was similar to
that in previous years. Growth in currency was unusually
strong throughout the first three quarters of 1990, and
initial estimates fairly consistently underpredicted this
strength. In the fourth quarter, after the volume of cur
rency shipped abroad subsided somewhat, initial fore
casts of currency in circulation tended to overpredict
currency growth.
ssDepository institutions m ust fully colla te ra lize and pay
interest on funds held w ith them in so-called Treasury tax
and loan (TT&L) accounts. The am ount of funds that the
institutions will acce p t d e pend s on their ab ility to use the
funds profitably and on the availability of collate ral. An
institution that receives funds in excess of its colla te ra l lim it
remits the excess to the Treasury’s Federal Reserve balance.
(The excess funds com e eith er from the taxes co lle c te d by
the institution on behalf of the Treasury or from investm ents
made directly by the Treasury.) Large rem ittances ty p ic a lly
occu r around m ajor tax dates, w hen the volum e of funds
flowing into TT&L acco unts su b stantia lly exce eds capacity.
In Brief
Economic Capsules
Japanese Banks’ Customers in the United States
by Rama Seth and Alicia Quijano
Some recent studies attribute the growth of foreign
banks in the United States to the increase in foreign
direct investment in this country. Foreign banks are said
to specialize in providing services to multinational firms
from their home countries.1 This interpretation of the
importance of foreign bank lending is applied in particu
lar to Japanese banks, which accounted for over 16
percent of U.S. commercial and industrial loans in 1989,
well over half of such loans made by foreign banks.
Available data on Japanese banks, however, provide
little support for the view that foreign bank lending
growth essentially reflects increased foreign investment
in the United States. While Japanese banks’ branch and
agency lending in the United States increased more
than sixfold in the period between 1984 and 1989,
borrowing by U.S. nonbank affiliates of Japanese firms
less than quadrupled during the same period.2 As a
result, loans to Japanese-ow ned firms may have
accounted for more than three-quarters of Japanese
branch lending in this country in 1984, but no more than
two-fifths in 1989. Japanese banks may initially have set
up shop to service Japanese customers, but in the later
1980s the banks significantly expanded their strictly
U.S. market share.
tSee, for example, George Bentson, "U.S. Banking in an Increasingly
Competitive World Economy,” Journal of Financial Services
Research, vol. 4 (1990), pp. 311-39; and Charles W. Hultman and
L. Randolph McGee, "Factors Affecting the Foreign Banking
Presence in the U.S.," Journal of Banking and Finance, vol. 13
(1989), pp. 383-96.
2A U.S. affiliate is a U.S. firm in which a foreign investor owns or
controls 10 percent or more of the voting securities of the firm.
Inferences from data on liabilities and loans
We calculate the share of Japanese bank lending to
U.S. nonbank affiliates of Japanese companies by com
paring data on affiliate liabilities and data on loans by
U.S. branches and agencies of Japanese banks. (See
the appendix for a discussion of data sources and
details of the methodology.) Our estimates of the share
of borrowing by Japanese firms are based on the
extreme assumption that all of the bank debt of Jap
anese multinationals in the United States was owed to
Japanese banks’ branches and agencies. To the extent
that such affiliates borrowed from non-Japanese banks,
claims of Japanese branches and agencies on firms
without Japanese ownership would be even higher.3
Our findings, presented in the chart, show the
decreased relative importance of Japanese firms in
branch and agency lending in the United States. Loans
to these firms in all sectors taken together accounted
for at most two-fifths of Japanese lending in this country
by 1989, as opposed to more than three-fourths of the
lending in 1984. Although only data for 1984 and 1989
are actually plotted in the chart, the intervening years
3The overstatement of the affiliate share may be offset by any
underreporting by U.S. affiliates of Japanese firms that is
attributable in part to the rapid growth in direct foreign investment.
The degree of offset, however, cannot be measured. Some bias is
also introduced in the estimates because the data sources are not
fully synchronized: the bank data are reported on a calendar-year
basis, while affiliate data are reported on a fiscal-year basis. The
direction of the bias introduced by this inconsistency is not clear
since the fiscal year varies across affiliates. This difference in
reporting may not be of much consequence, however, since the
fiscal year matches the calendar year for roughly three-quarters of
affiliates from all countries.
FRBNY Quarterly Review/Spring 1991
79
confirm the pattern of decline.4 A breakdown of loans by
category, moreover, underscores the decreasing share
of lending to affiliates in the fastest growing categories
of loans.
The nonfinance sectors, commerce and industry and
real estate, offer clear-cut evidence of the diminished
role of U.S. affiliates of Japanese firms as a customer
base. At the beginning of the period under study, Jap
anese banks may well have relied on Japanese cus
tom ers fo r a ready-m ade cu stom er base in these
sectors. In 1984, U.S. borrowing by Japanese-owned
firms accounted for as much as three-quarters of the
comm ercial and industrial loans made by Japanese
banks’ branches and agencies. Japanese-owned real
estate firms and partnerships could have accounted for
all real estate loans by the branches and agencies until
1986. But in more recent years, a different pattern
emerged. Our estimates suggest that in 1988 and 1989,
“ See Rama Seth and A licia Quijano, “ Growth in Japanese Lending
and in Investm ent in the United States: Are They R elated?” Federal
Reserve Bank of New York, Research Paper no. 9101, January 1991.
U.S. borrowing by Japanese-owned com m ercial and
industrial firms and by real estate firms could account
for less than tw o-fifths of total credit by Japanese banks’
branches and agencies to each of these sectors.
This shift in the custom er base did not affect one area
of lending. In both 1984 and 1989, loans to nonbank
fin an ce a ffilia te s of Ja pa ne se firm s co uld e n tire ly
account for this category of lending by branches and
agencies of Japanese banks. Such loans, however,
amounted to a relatively small part of overall lending by
branches and agencies: about 3 percent of their total
portfolio in 1984 and 1989. Thus it appears that Jap
anese banks, in e xpanding th e ir U.S. o p e ra tio n s ,
increasingly directed their credit to U.S.-owned com
mercial, industrial, and real estate firms.
Nonfinance affiliates of Japanese firms do not dom i
nate Japanese bank len din g in the U nited S tate s
despite their heavy reliance on bank financing. Roughly
half of the U.S. liabilities of these nonfinance affiliates
have been, and continue to be, owed to banks (see
table). This financing pattern m irrors that of nonfinancial
U.S. Loans Made by U.S. Branches and Agencies of Japanese Banks
Billions of dollars
*120 --------------------------------------------------
-----------------------------------------------------------------1984 loans
1989 loans
Possible loans to
U.S. affiliates of
Japanese firms
100%
U.S. commercial and
industrial loans
100%
/ / / 36% . . . .
/////// //// /
Real estate loans
100%
Loans to nonbank
financial institutions
Sources: U.S. Department of Commerce; Federal Financial Institutions Examination Council, Reports of Condition; Federal Reserve Bank of
New York staff estimates.
Notes: Chart shows bank debt of U.S. nonbank affiliates of Japanese firms as a share of loans to U.S. addressees by branches and agencies
of Japanese banks. If bank debt is greater than loans, 100 percent of branch and agency lending in the category is assumed to be made to
affiliates. Affiliate borrowing for 1989 is estimated.
80 FRBNY Q uarterly Review/Spring 1991
Bank Share of Affiliate Debt
(Percent)
All sectors
Finance and insurance (nonbank only)
N onfinance
Real estate
O ther industries
1984
1989
50
23
57
78
56
16
5
55
80
50
Sources: U.S. D epartm ent of Com m erce; Federal Reserve
Bank of New York staff estim ates.
Notes: Table reflects U.S. lia b ilitie s of U.S. nonbank affiliates of
Japanese firms. Figures for 1989 are estim ates.
firms in Japan, which owed an estimated 53 percent of
their debt to banks in 1985.5 U.S.-owned nonfinancial
corporate business, by contrast, owed only between
one-fifth to one-quarter of its liabilities to banks during
the same period.6
An interesting sidelight to this finding is the fact that
nonbank financial firms affiliated with Japanese firms
rely hardly at all on bank financing. Acquisition-led
tripling of the balance sheets of these affiliates— pre
dom inantly securities firm s— probably explains why
their liability structure so closely resembles that of U.S.
securities firms in general.7 In both cases, only a minor
5Bank for International Settlem ents, 59th Annual Report, June 1989,
p. 87.
6Board of Governors of the Federal Reserve System, Flow of Funds
A ccounts, F inancial Assets an d Liab ilitie s, Year-end 1966-89,
S eptem ber 1990, p. 10.
7The sim ilarity in the liab ility structure of U.S.-owned and Japaneseowned firm s em erged when Yasuda Life Insurance acquired an 18
pe rcent interest in Paine W ebber and N ippon Life Insurance
part of the firms’ liabilities is owed to banks. Seven
percent of the Japanese finance affiliates’ liabilities has
been to banks in recent years, and 4 percent to 6
percent of the liabilities of the largest U.S. securities
firms was owed to banks between 1984 and 1989.8
Conclusion
In conclusion, recent growth in Japanese banks’ assets
in the United States cannot be solely or even largely
attributed to growth in direct investm ent from Japan.
Japanese banks may initially have followed their Jap
anese customers to the United States, at least in order
to lend to firms in commerce, in d u stry and real estate.
Home-country relationships, however, cannot explain
the recent expanded presence of the Japanese in the
U.S. lending market. Although Japanese nonfinance
affiliates rely more heavily than their U.S. counterparts
on bank loans, they do not account for the bulk of U.S.
lending by Japanese banks’ branches and agencies.
Rather, loans to U.S.-owned firms now appear to pre
dominate in the U.S. loan books of Japanese banks.
This finding suggests that any slowdown in foreign
asset growth stemming from Japanese banks’ difficulty
in meeting capital requirem ents could have a broader
impact than often thought. Specifically, U .S.-owned
firms could find them selves vulnerable to a tightening of
credit by Japanese banks.
Footnote 7 continued
acquired a 13 percent interest in Shearson Lehman Brothers in
1987. In spite of the m inority ownership, the U.S. C om m erce
D epartm ent classifies all of the acq uired lia b ilities as those of the
new affiliate. Before these a cq uisitions, the bank share in affiliate
financing was roughly 20 percent.
8John R. Dacey and Jackie Bazel-H orow itz, “ L iab ility M a nage m en t,’
Funding and Liq u id ity: Recent Changes in L iq u id ity M anagem ent
P ractices at C om m ercial Banks an d S ecurities Firms, Federal
Reserve Bank of New York, July 1990, p. 80.
Appendix: Data Sources
Data on U.S. nonbank affiliates of Japanese companies
are from the Commerce Department series on foreign
direct investment, and data on U.S. branches and agen
cies of Japanese banks are from the Federal Financial
Institutions Examination Council (FFIEC) call reports.
The broad sectoral classification in the two data sets
allows us to compare each category of loans with the
borrowings of affiliates in the same sector. For example,
U.S. borrowings of affiliates in commerce and industry,
estimated at $29 billion, are compared with the $77
billion in commercial and industrial loans to U.S.
addressees made by branches and agencies (see table
below). On the basis of this comparison, we estimate that
affiliates could account for a maximum of 38 percent of
branch and agency loans in this category (see chart).
The maximum could only apply in the extreme case in
which all affiliate local borrowings are from Japanese
banks’ branches and agencies in the United States.
The Commerce Department’s annual surveys of direct
investment and the 1987 benchmark survey identify
FRBNY Q uarterly Review/Spring 1991
81
Appendix: Data Sources (Continued)
external sources of funds for affiliates in the United
States.f These sources of funds are decomposed into
the liabilities of affiliates owed to the foreign parent, to
other foreigners, and until 1987, to U.S. banks and non
banks. The 1988 and 1989 U.S. bank liabilities are esti
mated on the basis of the distribution of bank and
nonbank liabilities and the average growth rates by sec
tor in previous years. For this study, only data on affiliate
debt to U.S. banks and to U.S. nonbanks are used
because they are the most comparable with the FFIEC
call report data.
The FFIEC call report data on Japanese banks'
branches and agencies decompose lending by obligor:
commercial and industrial (both U.S. and foreign resi-
dents), real estate, nonbank financial institutions, foreign
governments, and purchasers of securities. We exclude
Japanese banks’ subsidiaries from our study because of
their greater independence from the parent, wider scope
of activities, and acquisition-related growth, all of which
point to a weaker link with Japanese firms in the United
States. Were the subsidiary data to be included and the
assumption that affiliates borrow only from Japaneseowned banks retained, we would find the link between
Japanese banking and Japanese direct investment in the
United States to be even weaker than is suggested here.
Since the Commerce Department data do not reveal
the ownership of the banks providing credit to the foreign-owned firms in the United States and the call report
data do not identify loans made to U.S. affiliates of
Japanese firms, we juxtapose the two sets of data. By
assuming that all affiliate bank debt is with Japanese
banks, we can infer a ceiling on the share of affiliate
borrowing in Japanese bank lending.
tFor an explanation of C om m erce D epartm ent data, see A licia
M. Quijano, “A G uide to BEA S tatistics on Foreign Direct
Investm ent in the U nited S tates,” Survey o f Current Business,
February 1990, pp. 29-37.
Juxtaposition of Two Data Sources
(B illions of Dollars)
Affiliate Debt*
Total
Commerce and industry^
Finance and insurance
Real estate
1984
1989
14
49
12
29
1
1
12
8
Branch and Agency Lending*
Total
1984
1989
38
130
To com mercial and industrial firms
28
U.S.
Foreign
To financial institutions
To real estate firms
Other
To foreign governments
For purchasing and carrying securities
16
12
1
0
9
8
1
90
77
12
6
22
12
10
2
Sources: U.S. Department of Commerce: Federal Financial Institutions Examination Council, Reports of Condition; Federal Reserve Bank
of New York staff estimates.
Note: 1989 figures for affiliate debt are estimates.
f Consists of U.S. bank liabilities of Japanese firms' U.S. nonbank affiliates.
* Consists of nonbank loans of Japanese banks’ U.S. branches and agencies.
§ Includes all industries other than finance, insurance, and real estate. Insurance affiliates account for less than 0.5 percent of the bank
debt of finance affiliates, most of which are securities firms.
FRBNY Q uarterly Review/Spring 1991
Another View of the Underpricing
of Initial Public Offerings
by Judith S. Ruud
Over the past two decades several studies have
reported that initial public offerings on average achieve
sizable returns over very short periods.1 In the parlance
of investment bankers, firms going public appear to
“leave money on the table” in significant amounts.
While hardly a cause for complaint from investors, such
underpricing might hurt emerging firms trying to raise
capital for expansion. The high average initial returns
on new issue shares is therefore an anomaly that
invites further study.
Most current academic theories hold that initial public
offering (IPO) underpricing is undertaken deliberately.2
Proponents of this view offer different rationales for
intentional underpricing. For example, underwriters may
recommend low offering prices to reduce the effort
required to sell new issues, or issuers may purposely
underprice their IPOs in order to cash in on a reputation
for good performance later.3 The findings presented
’ See, for example, Roger Ibbotson, “Price Performance of Common
Stock New Issues,” Journal of Financial Economics, vol. 2 (1975),
pp. 235-72; Roger Ibbotson and Jeffrey Jaffe, “Hot Issue Markets,”
Journal of Finance, vol. 30 (1975), pp. 1027-42; and Jay Ritter, “The
'Hot Issue’ Market of 1980," Journal of Business, vol. 57 (1984),
pp. 215-40.
*See, for example, David Baron, “A Model of the Demand for
Investment Banking Advising and Distribution Services for New
Issues,” Journal of Finance, vol. 37 (1982), pp. 955-76; Kevin Rock,
"Why New Issues Are Underpriced,” Journal of Financial
Economics, vol. 15 (1986), pp. 187-212; Seha Tinic, "Anatomy of
Initial Public Offerings of Common Stock," Journal of Finance,
vol. 43 (1988), pp. 789-822; Franklin Allen and Gerald Faulhaber,
"Signaling by Underpricing in the IPO Market,” Journal of Financial
Economics, vol. 23 (1989), pp. 303-23; Mark Grinblatt and Chuan
Yang Hwang, “Signalling and the Pricing of New Issues," Journal of
Finance, vol. 44 (1989), pp. 393-420; and Ivo Welch, "Seasoned
Offerings, Imitation Costs, and the Underpricing of Initial Public
Offerings,” Journal of Finance, vol. 44 (1989), pp. 421-49.
3For evidence against the latter hypothesis see Judith S. Ruud,
"Underpricing of Initial Public Offerings; Goodwill, Price Shaving or
Price Support?” Ph.D. diss., Harvard University, 1990. Chapter 4
finds little evidence of any future benefit from IPO underpricing.
here, however, suggest that the apparent underpricing
(that is, high average initial returns) may be Jargely
attributed to a different source— the frequent market
practice of underwriter price support or stabilization.4
Underwriter price support involves transactions that
serve the specific purpose of keeping the market price
from falling too far below the fixed selling price of the
offering. Although price support may tie up underwrit
ers’ capital in the short run, it is often thought that the
practice ultimately enhances underwriters’ reputations
with issuers and investors. T h e S e cu rities and
Exchange Commission generally prohibits security
price manipulation, but it has permitted price support on
the grounds that it mitigates underwriter losses stem
ming from temporary downward price pressure during
the selling period.5 The Commission has taken the
position that stabilization is not manipulative as long as
the possibility of stabilization is disclosed in the offering
prospectus.6
Statistical analysis provides a means of evaluating
whether IPO underpricing is a deliberate strategy or
a consequence of underwriter price support. Specifi
cally, if IPO underpricing were done deliberately across
the board, the distribution of a sample of IPO initial
returns might approximate a bell-shaped curve, with the
♦For a detailed presentation of this argument and methodology, see
Judith S. Ruud, “Underwriter Price Support and the IPO
Underpricing Puzzle,” Federal Reserve Bank of New York, Research
Paper no. 9117, May 1991.
5See Securities Exchange Act Release no. 2446 (March 18, 1940).
The Securities Act of 1934, 15 USC §10(b) and 17 CFR §240.10b-7,
permits stabilization.
•To preserve the option of stabilization, most offering prospectuses
contain the following legend: “In connection with this offering, the
underwriters may effect transactions which stabilize or maintain the
market price of the common stock of the company at a level above
that which might otherwise prevail in the open market. Such
stabilization, if commenced, may be discontinued at any tim e.”
FRBNY Quarterly Review/Spring 1991
83
Initial Public Offering Returns for Different Intervals
Occurrences
250-
One-Day Returns
200
150
100
50
0I
I
I
I
I
1
I
lr----,1 41
1
im
H
1
1
1
1
150
One-Week Returns
100
50
0I
I
I
I
I
,—
I
-,nn
i
il
1i
in— ii,— ,i
iH
ll
11 J11__11r
i_
i .—
.
150
Two-Week Returns
100
50
O'I
I
I
I
I
I.----■i— 111 11
i
1 11
1 11— 111—
i r---- ,1___1
150
Four-Week Returns
100
50
I
I___ I
-60
to
-55
-55
to
-50
I — ■11—n m
I
-50
to
-45
-45
to
-40
-40
to
-35
-35
to
-30
-30
to
-25
m
-25
to
-20
i
, i
-20
to
-15
-15
to
-10
-10
-5
0
5
to
to
to
to
-5
0
5
10
Percent returns*
\ m
10
to
15
a
1
15
to
20
20
to
25
25
to
30
1— 1
f]lC Z llE = ]ln = ll.n = 1lc ^
30
to
35
35
to
40
40
to
45
45
to
50
50
to
55
55
to
60
60
to
65
65
to
70
Sources: Securities Data Company; Investment Dealers’ Digest: and Standard and Poor’s Daily Stock Price Record.
Note: Returns are measured as the natural logarithm of the ratio of the market price at the end of the indicated period to the original offering price.
* Each range starts at the first indicated value and continues to, but does not include, the second. For example, the range 0 to 5 includes returns
of 0 through 4.99 percent.
Digitized for84
FRASER
FRBNY Q uarterly Review/Spring 1991
peak of the distribution centered on a return greater
than zero. In fact, however, relatively few IPOs sink
much below their offering price immediately. Instead of
tracing a bell-shaped curve with a positive mean, the
distribution of one-day returns peaks steeply around
zero and the negative tail of the distribution is signifi
cantly curtailed.
Underwriter price support affords a plausible explana
tion for the positively skewed distribution of initial IPO
returns. The effect of such price support would be to
reduce the number of negative initial returns from what
would otherwise be observed. If investment bankers are
actively supporting price in the aftermarket, observa
tions that would have been in the left tail of the distribu
tion (that is, negative returns) may be propped up to
zero or a small negative return by a standing purchase
order at or slightly below the offer price. The statistical
term for this effect is censoring.7 Initial returns of zero
are observed in instances that would have yielded neg
ative returns in the absence of underwriter price sup
port. Thus, systematic price support would allow the
right tail (positive returns) to be observed, but not the
“true” left tail. This previously overlooked censoring of
the negative tail of the distribution of initial returns could
produce a positive mean initial return even if offering
prices were set at their true expected market value.
The observed distributions of initial returns of 469
IPOs occurring in 1982 and 1983 are consistent with the
hypothesis that positive mean initial returns are largely
due to underwriter price support. The four panels of the
chart— the cross-sectional distributions of one-day
returns, one-week returns, two-week returns and fourweek returns— illustrate the initial effect and gradual
withdrawal of price support. The distribution of initial
one-day returns peaks steeply around the zero percent
return range and appears to have a partially censored
left tail.8 Fifty-nine percent of the one-day initial returns
7A sample is said to be censored if there is some threshold level
below which actual values are not observed. In this case the
threshold value is zero.
•In statistical terms, the distribution exhibits considerable
leptokurtosis and positive skewness.
fall between the range of - 5 percent to 5 percent. In
fully 25 percent of the one-day initial return observa
tions, the closing price is the same as the offering price.
The concentration of the observed distribution of initial
one-day returns around zero indicates the potentially
strong influence of price support.
The tendency for most of those stocks with one-day
returns in the zero return range to fall in price, thus
yielding negative one- and two-week returns, is also
consistent with the gradual withdrawal of price support.
Of those IPOs in the modal one-day return range of
zero percent to & percent, only 8 percent increase in
price, while 47 percent report negative one-week
returns and the remaining 45 percent report one-week
returns in the same distribution range. The overall oneweek mean return is less than the overall one-day mean
return. Successively smaller mean returns over time
suggest that reports of positive mean initial returns are
not primarily the result of systematic underpricing, but
rather the result of temporary underwriter price support
of new issues. As price support is withdrawn, the mean
initial return decreases.
Even stronger indications of the influence of price
support are found for the subset of IPOs underwritten
by top-tier investment banks.9 Because price support
requires a commitment of capital, larger and wealthier
investment banks would be more likely to engage in
the practice.
In sum, investigation of the distribu tio n of initial IPO
returns shows that positive mean initial returns result in
some measure from a partially censored left (negative)
tail. Underwriter price support or stabilization can readi
ly account for this censoring of the distribution of initial
returns: stock prices are allowed to rise, but are pre
vented from falling significantly until the issue is fully
sold. This interpretation, which incorporates neglected
information on return distributions and on market prac
tice, stands in contrast to the view that positive average
initial IPO returns result from deliberate underpricing of
most offerings.
9Details can be found in Ruud, “Underwriter Price Support."
FRBNY Quarterly Review/Spring 1991
85
NEW FROM THE FEDERAL RESERVE BANK OF NEW YORK
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implem enting m onetary policy. Interm ediate Targets and Indicators for M onetary Policy:
A C ritica l Survey evaluates the usefulness of various policy guides adopted or proposed
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of policy rules that may have implications for the role of interm ediate targets. Postpaid
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tion and U.S. M onetary Policy, the proceedings of a colloquium held at the Federal
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members examine the conceptual and practical issues confronting m onetary authorities
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The book also places m onetary policy in broader historical and operational contexts. It
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FRBNY Q uarterly Review/Spring 1991
RECENT FRBNY UNPUBLISHED RESEARCH PAPERSf
9108.
M ullin, John J. “ The Speculative Effects of Anticipated Trade Policy under
Dual Exchange Rates.” February 1991.
9109.
Remolona, Eli M. “ Global Stock Markets and Links in Real Activity.” March
1991.
9110.
Akhtar, M.A., and Howard Howe. “ The Political and Institutional Indepen
dence of U.S. Monetary Policy.” March 1391.
9111.
Hung, Juann. “ Noise Trading and the Effectiveness of Sterilized Foreign
Exchange Intervention.” March 1991.
9112.
Budzeika, George. “ Determinants of the Growth of Foreign Banking Assets
in the United States.” May 1991.
9113.
Charrette, Susan M. “A Theoretical Analysis of Capital Flight from Debtor
Nations.” May 1991.
9114.
Peristiani, Stavros. “An Empirical Analysis of the D eterm inants of Discount
W indow Borrowing: A Disaggregate Analysis.” May 1991.
9115.
Peristiani, Stavros. “ Permanent and Transient Influences on the Reluctance
to Borrow at the Discount Window.” May 1991.
9116.
Uctum, Merih. “A Critical Evaluation of Exchange Rate Policy in Turkey.”
With Yaman Asikoglu. Revised April 1991.
9117.
Ruud, Judith S. “ Underwriter Price Support and the IPO Underpricing
Puzzle.” May 1991.
fS in g le copies of these papers are available upon request. Write Research Papers,
Room 901, Research Function, Federal Reserve Bank of New York, 33 Liberty Street,
New York, N.Y. 10045.
FRBNY Q uarterly Review/Spring 1991
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