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Is Low Unemployment
Inflationary?
R O B E R T O C H A N G
The author is a research officer in the macropolicy
section of the Atlanta Fed’s research department. He
thanks Robert Eisenbeis, Frank King, Mary Rosenbaum,
and Eric Leeper for useful comments and suggestions.
F
ROM A VARIETY OF PERSPECTIVES, THE MACROECONOMIC PERFORMANCE OF THE
U.S. ECONOMY
HAS BEEN VERY SATISFACTORY IN RECENT YEARS. IN PARTICULAR, BROAD-BASED MEASURES OF
INFLATION HAVE STABILIZED BETWEEN
BELOW
51⁄2
PERCENT.
HOWEVER,
21⁄ 2 AND 3 PERCENT WHILE UNEMPLOYMENT HAS FALLEN
MANY OBSERVERS REMAIN UNEASY, BELIEVING THAT THE CUR-
RENT SITUATION IS FRAGILE AND TEMPORARY.
THIS
THAT THE CURRENT RATE OF UNEMPLOYMENT IS
BELIEF IS, IN TURN, ROOTED IN A LESS OBVIOUS VIEW
“TOO
LOW” TO BE CONSISTENT WITH LOW AND STABLE
INFLATION.
This state of affairs becomes most visible on the first
Friday of every month, when the Bureau of Labor
Statistics releases the latest data on employment and
unemployment in the United States. Recently, these data
releases have often been followed by sharp changes in
financial markets. In particular, markets have taken
lower-than-expected unemployment rates to mean that
inflation is about to accelerate, resulting in falling stock
prices and increasing interest rates.
The average citizen would find this to be a rather
strange ritual. Isn’t low unemployment good for the country? And why is low unemployment supposed to lead to
higher inflation anyway? These are important and difficult questions. An influential economic theory, however,
argues that the answers are easy and widely found in
macroeconomics textbooks. Low unemployment, this theory implies, is unambiguously “good” only up to a point.
If unemployment falls below this point, known as
the nonaccelerating inflation rate of unemployment
(NAIRU), inflation tends to accelerate.1 Opinions about
the current location of the NAIRU vary, but many published estimates place it close to 6 percent.2 Since recent
unemployment figures have been consistently below that
4
range, adherents to this theory predict that inflation will
accelerate.
So far these predictions have turned out to be wrong.
That their failure should not be a surprise is one of the
themes of this article. More precisely, this article argues
that the concept of the NAIRU is of very limited use for predicting inflation, understanding its causes, or forming policy. There is both empirical and theoretical support for this
view. On the empirical side, the article discusses evidence
showing that the NAIRU is highly variable and that there is
a great deal of uncertainty about where it is at any particular point in time. These findings imply that, in practice, one
cannot know if unemployment is above or below that value
supposedly consistent with stable inflation. On the theoretical side, this article argues that even if such a value
became known, it would be irrelevant. Contemporary economic theory implies that movements of the unemployment
rate may be positively or negatively related to inflation,
depending on the nature of the fundamental shocks causing the unemployment changes. Identifying such shocks is
possible and helpful for predicting the inflation implications of unemployment changes; but given that these
shocks can be identified, whether current unemployment
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
is above or below the NAIRU provides no additional useful
information about prospective changes in inflation.
The Phillips Curve, the Natural Rate,
and the NAIRU
he idea that unemployment may be too low to be
consistent with stable inflation is of relatively
recent vintage. Its origins can be traced to the
1960s and 1970s discussion about how to interpret the
then recently discovered “Phillips curve,” an empirical
association between inflation and unemployment. Some
aspects of this debate are useful for the discussion that
comes later.
As some readers may recall, Phillips’s (1958) analysis of almost a century of U.K. data shocked the economics profession. Phillips focused on the relationship
between wages and unemployment and discovered the
striking fact that the rate of change in nominal wages had
a negative correlation with unemployment. Soon afterward, Samuelson and Solow (1960) showed that a similar
relation held in U.S. data. Moreover, Samuelson and
Solow argued that changes in nominal wages were positively related to overall inflation, thus recasting the wageunemployment relation discovered by Phillips into the
inverse relation between price inflation and unemployment commonly known as the Phillips curve.
The discovery of the Phillips curve generated a heated debate about its implications for economic policy. In
particular, research focused on whether a monetary
authority such as the Federal Reserve could “buy” less
unemployment at the cost of faster inflation. Some
argued that the existence of a Phillips curve implied that
unemployment could be permanently lowered if inflation
were kept at a permanently higher level. Others, in particular Friedman (1968) and Phelps (1968), argued that
there was an inflation-unemployment trade-off in the
short run but not in the long run. In justifying their thesis, Friedman and Phelps coined the term “natural rate of
unemployment.”
To understand Friedman and Phelps’s argument, consider first an economy without price surprises, so actual
inflation is always equal to previously expected inflation.
In such an economy, some workers would always be
observed to be unemployed and looking for a job. This
phenomenon may simply reflect the fact that, since workers and jobs are heterogeneous, unemployed workers and
T
firms may take time to search for adequate matches.
Hence, even if inflation were always perfectly foreseen,
the economy would experience a positive rate of unemployment that Friedman and Phelps called “natural.”
What if inflation were not perfectly foreseen?
Friedman and Phelps argued that unexpectedly high
inflation would make actual unemployment fall below its
natural rate, but only in the short run. This decline would
happen, in particular, if wage contracts had been negotiated on the basis of previously expected inflation, in which
case an inflation surprise would reduce real (inflationadjusted) wages and stimulate employment. One implication is that a
monetary authority
Contemporary economic
could indeed “buy”
lower unemployment
theory implies that
by inducing inflation
movements of the unto rise above previemployment rate may be
ously expected inflation. But this effect
positively or negatively
would be only temporelated to inflation,
rary because ecodepending on the nature
nomic agents would
eventually learn to
of the fundamental shocks
forecast inflation
causing the unemployment
correctly, and the
changes.
difference between
expected inflation
and actual inflation
would tend to disappear.3
Although unexpected accelerations in inflation,
engendered by monetary policy, may “cause” unemployment to fall below the natural rate, the converse need not
hold. Given monetary policy, the Friedman-Phelps theory
had no implications for whether movements in the unemployment rate have an independent effect on inflation.
In subsequent research, a subtly but clearly different
view on the relation between inflation and unemployment emerged. According to this view, inflation tends to
accelerate whenever unemployment falls below a particular number, which has come to be known as the “nonaccelerating inflation rate of unemployment,” or NAIRU.
The NAIRU concept was first proposed by Modigliani
and Papademos, who posited the existence of a rate of
unemployment “such that, as long as unemployment is
above it, inflation can be expected to decline” (1975, 142).
1. It is worth noting that several authors have also used the term natural rate to refer to the NAIRU. To avoid confusion, this article will make a distinction between the two concepts. The distinction is important because, as discussed below, the natural rate
concept developed by Friedman (1968) and Phelps (1968) is not the same as the NAIRU concept, although their values may
coincide.
2. For instance, the Congressional Budget Office (1996, 5) recently estimated that the NAIRU was 5.8 percent in 1995.
3. The Friedman-Phelps view further implies that the monetary authority can keep the unemployment rate permanently below
its natural rate only by perpetually engineering unexpected increases in inflation. If people’s expectations of inflation are relatively slow to adjust, ever-accelerating inflation is required. This implication does not hold true if expectations of inflation are
fully “rational,” as first demonstrated by the work of Lucas (1972) and Sargent and Wallace (1976).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
5
Ye a r - o v e r - Ye a r P e r c e n t C h a n g e
C H A R T 1 Inflation and Unemployment, 1955-96 (Monthly)
Unemployment
Consumer Price Index Inflation
12
8
4
0
1955
1965
The intuition is that low unemployment is likely to intensify wage pressures and consequently to result in a generalized wage increase. Assuming that firms manage to
pass this cost increase to consumers in the form of higher prices, a fall in unemployment is likely to be associated with an increase in inflation. Similarly, an increase in
unemployment must result in a fall in inflation. There
must therefore be a level of unemployment such that
inflation can be expected to remain constant; this level is
the NAIRU.
Readers may note that the Friedman-Phelps natural
rate and the NAIRU are different concepts. Friedman and
Phelps defined the natural rate as an equilibrium whose
value was determined by the characteristics of the labor
market. In contrast, the NAIRU is posited as an empirical
value rather than an equilibrium value. More importantly, the theory of the NAIRU implies that low unemployment may cause inflation to increase independently of
the causes of the low unemployment and, in particular, of
monetary policy; this is not an implication of the
Friedman-Phelps natural rate theory.
The NAIRU concept pervades current policy discussions and is the main concern of this article. Since
Modigliani and Papademos’s article numerous studies
have, not surprisingly, focused on the estimation of the
NAIRU. If there were in fact a strong, stable relation
between unemployment, a known NAIRU, and inflation,
then one could compare current unemployment with the
NAIRU to accurately predict future inflation. But this is
not the world we live in, as the discussion below will show.
A First Look at the NAIRU
o understand the details and some of the problems
associated with estimating the NAIRU, it is helpful
to have a broad idea of the historical behavior of
T
6
1975
1985
1995
unemployment and inflation. Chart 1 depicts the behavior of civilian unemployment and the inflation rate since
1955. The most notable aspect of this chart is the dramatic increase in inflation that started in the mid-sixties
and ended in the early eighties, and the subsequent disinflation. In 1965 inflation was less than 2 percent a year;
in 1980 it surpassed 13 percent. Much of the increase is
widely believed to have been caused by the oil shocks of
1973 and 1979, and in fact the chart shows a rapid
increase in inflation following each of these dates. It has
to be noted, though, that the increase in inflation actually started much earlier. The trend toward higher inflation
was broken around 1980, and the first half of the 1980s
witnessed a rapid decrease in inflation toward the 4 to 6
percent range. This change in inflation behavior has been
widely attributed to strongly contractionary monetary
policy starting in October 1979 and called, accordingly,
the “Volcker deflation.” Finally, inflation since 1991 has
been surprisingly stable at around 3 percent.
In Chart 1, unemployment shows a slightly upward
trend over the 1955-96 period but considerable variation
around its trend. Until the early seventies, unemployment
was about 5 percent on average. Its fluctuations were
much larger during the decade following the first oil
shock; average unemployment during that period was 7 1⁄ 2
percent, and it surpassed 10 percent in 1982, reflecting
the contractionary effects of the Volcker deflation. Since
1984 unemployment has been declining, averaging a little
less than 6 percent.
In Chart 1 it is not obvious that there may be a special level of the unemployment rate above which inflation
would be expected to decline. However, the ModiglianiPapademos definition of the NAIRU suggests a different
and more informative way to look at the same data. Their
definition implies that inflation is expected to decline
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
C H A R T 2 Unemployment versus Inflation Changes, 1955-96
1.6
1.2
Inflation
0.8
1955–73
0.4
1974–83
1984–96
0
–0.4
–0.8
–1.2
3.2
4.8
6.4
8.0
Unemployment
whenever unemployment is above the NAIRU. Hence
there should be a negative relation between expected
changes in inflation and the difference between unemployment and the NAIRU. If, in addition, this relation is
assumed to be linear, a plausible hypothesis for inflation,
unemployment, and the NAIRU is given by
Et[π(t + 1) – π(t)] = b[u(t) – u*],
(1)
where π(t) denotes the inflation rate in period t, u(t) the
unemployment rate in period t, u* the NAIRU, b a coefficient whose expected sign is negative, and Et[.] is short
notation for “expectation given information available up
to period t.” That is, provided that b is indeed negative,
an equation such as (1) implies that, if this month’s
unemployment is above the NAIRU u*, inflation should
be expected to decline next month. Neither b nor u* are
directly observable; instead, they must be inferred from
the data.
Versions of equation (1) are the basis of most
attempts to estimate the NAIRU. The intuition for work of
this kind, and some of the problems associated with it,
can be grasped from a scatter diagram of unemployment
against subsequent changes in inflation, such as Chart 2.
Each point in the chart represents a particular month’s
unemployment rate, measured against the horizontal
axis, and the subsequent month’s change in inflation,
measured against the vertical axis. In particular, observations above the horizontal axis represent months in which
inflation increased. If equation (1) were to hold in the
data, the observations depicted in Chart 2 would be distributed around a line of negative slope that intersects
the horizontal axis at precisely the NAIRU, u*.
At first glance the chart suggests that there is a negative relation between the unemployment rate and sub-
9.6
11.2
sequent changes in inflation, in particular for extreme
values of the unemployment rate. When unemployment
has been below 5 percent, inflation has historically
increased more often than decreased. Conversely, unemployment rates above 8 percent have been mostly associated with falling inflation rates. However, the
relationship in the middle range of unemployment rates
between 5 and 8 percent is much less clear: for each
value of unemployment in that range, the number of
observations above the horizontal axis is about the same
as the number of observations below it. Hence, if the
NAIRU is defined as “a rate of unemployment such that
inflation is as likely to increase as to decrease,” Chart 2
suggests that the data are not likely to yield a very precise
estimate of the NAIRU.
A closer look at Chart 2 should reveal a second
aspect of the data that is relevant for this discussion: the
relationship between changes in inflation and unemployment, and by inference the NAIRU, has moved significantly over time. To illustrate this behavior, observations
in Chart 2 are distinguished by different symbols corresponding to three different subperiods, 1955-73, 1974-83,
and 1984-96. Splitting the sample in this way is loosely
motivated by the fact that the oil shocks of 1973 and 1979
and the Volcker disinflation were large, unusual events
that affected both unemployment and inflation.
It is clear that the observations in Chart 2 are not
just randomly distributed across the three periods under
consideration. Observations before 1974, the squares in
the chart, appear mostly to the left, showing that unemployment was relatively low. Observations between 1974
and 1983, depicted as diamonds, appear to the right,
because unemployment in that period was relatively high.
Finally, observations from 1984 on, marked by triangles,
are in the middle part of the chart. Using these data to
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
7
look for a value of the unemployment rate at which inflation is “as likely to increase as to decrease,” it is hard to
deny that the value is different for each of the three periods considered. In other words, Chart 2 suggests that the
NAIRU has not been constant. It seems to have been
lower in the first period than in the second and to have
fallen after 1983 (although not to the pre-1974 level).
Chart 2 thus suggests that the NAIRU is an elusive number. Its precise location is difficult to infer from the data,
and it moves around over time. These conclusions,
obtained from the visual inspection of Chart 2, are confirmed by more formal statistical evidence, to which the
discussion now turns.
There Is No Reliable NAIRU Estimate
o understand the statistical estimation of the
NAIRU, start by supposing that equation (1) is
true. Estimating the NAIRU then amounts to estimating the parameters b and u* in (1),
which requires some
If there were a strong,
quick manipulations.
stable relation between
To simplify notation,
define the change
unemployment, a known
of the monthly inflaNAIRU, and inflation, then
tion rate, ∆π(t + 1) =
one could compare current
π(t + 1) – π(t). A
minor difficulty is
unemployment with the
that the left-hand
NAIRU to predict future
side of (1) is not the
inflation. But this is not
observed value of
∆π(t + 1) but its
the world we live in.
expected value conditional on information available up to
period t, which is unobservable. To handle this problem,
let e(t + 1) = ∆π(t + 1) – Et ∆π (t + 1) denote the error
in predicting ∆π(t + 1). One can now replace the lefthand side of (1) by the difference between the observed
change in inflation and the error in predicting it, ∆π
(t + 1) – e(t + 1). Finally, define c = bu*. Inserting these
definitions in (1), one obtains
T
∆π(t + 1) = –c + bu(t) + e(t + 1).
(2)
Equation (2) is very useful. It is a linear equation,
and its parameters b and c can be estimated using ordinary least squares.4 Since c is equal to bu*, an estimate
of u* is simply given by the estimate of c divided by the
estimate of b. This way of estimating the NAIRU is fairly
common in the literature.5
Once an equation such as (2) has been estimated,
standard statistical techniques allow assessment of the
precision of the estimated coefficients c and b and consequently the precision of the estimated NAIRU u*. The
degree of precision is usually summarized using confi8
dence intervals. A 95 percent confidence interval for u*,
in particular, provides upper and lower bounds for the
unemployment rate that should contain u* with 95 percent probability. Standard techniques are also available
for testing whether assuming that b, c, and the NAIRU
are constant, as is implicit in equations (1) and (2).
Recalling the discussion of Chart 2, it is clear that testing
for the stability of the NAIRU is particularly important
given that the data suggest that the NAIRU has changed
over time.
Equation (1) is unduly restrictive in that it restricts
the expected change in inflation to respond only to the
current value of unemployment relative to the NAIRU. It
may be more realistic to assume that the expected
change in inflation also responds to past unemployment,
as would be the case if increases in wages were translated only gradually to consumer prices. Similarly, people’s
expectations concerning the change in inflation may
depend on current and previous changes in inflation.
These considerations imply that lags of unemployment,
relative to NAIRU, and lags of inflation changes should be
included as explanatory variables in (1). Accordingly, the
following generalization of (1) was analyzed:
(3)
Et∆π (t + 1) = b0[u(t) – u*] + b1[u(t – 1)
– u*] + … + b11[u(t – 11) – u*
+ a0∆π(t) + … + a11 ∆π(t – 11).
The alphas and betas are coefficients to be estimated, in addition to the NAIRU, u*. In contrast to (1), equation (3) allows the expected change in inflation between
periods t and (t + 1) to be influenced by the deviations of
unemployment from the NAIRU in the previous twelve
months. Also, the expected change of inflation can be
influenced by the twelve previous changes in inflation.
The coefficients of (3) were estimated by ordinary
least squares. For brevity, details are omitted and only the
main findings are reported here. For the full 1955-96 sample displayed in Chart 1, NAIRU was estimated to be 6.14.
This estimate is close to others found previously.6 A second finding was that this estimate of NAIRU is rather
imprecise: a 95 percent confidence interval is given by
the range of unemployment rates between 5.38 and 6.90.
The wide range for the location of the NAIRU is consistent with the lack of precision found in previous work.
Indeed, the results presented here are on the optimistic
side. In a recent, convincing paper Staiger, Stock, and
Watson examined a large number of alternative procedures and concluded, “Our main finding is that the natural rate is measured quite imprecisely. For example, we
find that a typical value of the NAIRU in 1990 is 6.2 percent, with a 95 percent confidence interval for the NAIRU
in 1990 being 5.1 to 7.7 percent” (1996, 2).
Readers may note that Staiger, Stock, and Watson’s
“typical” confidence interval is much larger than the one
estimated here. In fact, for a specification very close to
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
(3), Staiger, Stock, and Watson argue that perhaps a better way to estimate a 95 percent confidence interval
yields an interval from 4.74 to 8.31.7
From the perspective of policy analysis, the main
implication of these findings is that the range of uncertainty about the location of the NAIRU is often too large
to be useful. Consider, in particular, the recent debate
about whether the unemployment rate signals increasing
inflation. Since unemployment has been in the 5.5 to 6.5
percent range for the last three years, there is no way to
tell, on the basis of observed data, whether current unemployment is above or below the NAIRU; it is well within
the confidence bands.
Returning to equation (3), further analysis shows
that the coefficients and hence the implied value of the
NAIRU have changed over time. One can test and easily
reject the hypothesis that the coefficients of (3) are constant over the three subperiods underlying the discussion
of Chart 2 above, namely 1955-73, 1974-83, and 1984present.8 Estimates of the NAIRU were at 5.91 for the first
subperiod, 7.44 for the second, and 6.04 for the most
recent subperiod. Hence the statistical analysis is consistent with the hypotheses obtained from the visual inspection of Chart 2. It also agrees with most of the literature.
The instability of the NAIRU raises further difficulties. Estimating a moving NAIRU requires specifying how
the NAIRU moves over time but, unfortunately, current
economic theory provides little guidance on the economic determinants of changes in the NAIRU. As a consequence, recent studies have focused on models in which
the u* is viewed as slowly varying over time but in a way
that has no relation with other economic events. This
strategy does imply that the NAIRU’s location at different
times can be estimated and its changes predicted.
However, there are at least two important problems with
it. The first is that the work of Staiger, Stock, and Watson
has shown that forecasts of the NAIRU obtained in this
manner are also subject to very wide confidence intervals. For example, when they estimated a version of (3)
allowing u* to be a smooth function of time, they found
the 95 percent confidence interval for u* in January 1990
to be 4.17 to 8.91.
The second problem is that the instability of the estimated NAIRU may be a symptom of a deeper problem,
namely, that equations such as (1) and (3) may be incorrectly specified. To illustrate this problem, assume in
equation (1) that the NAIRU is in fact constant. The
hypothesis expressed by that equation is that inflation
next month is expected to be the same as it is this month,
unless this month’s unemployment deviates from the
NAIRU. Intuition suggests that such a hypothesis is too
extreme: even if there is no such deviation, it may be the
case that inflation is not expected to stay the same. For
example, it is plausible that people’s expectations of
inflation would have increased following the oil shocks of
1973 and 1979 even if the unemployment rate had not
deviated from the NAIRU. Conversely, it is likely that
expectations of inflation decreased following the October
1979 Federal Reserve announcement of a change toward
money targets to fight accelerating inflation.
These considerations suggest that (1) should be
changed to something like
Etπ(t + 1) – π(t) = s(t) + b[u(t) – u*],
(4)
where s(t) represents the expected change in inflation
when unemployment is at the NAIRU. As shown by
Chart 1, s(t) was probably a positive number during the
subperiod from 1974 to 1983 in which inflation was accelerating. Suppose that s(t) was zero until 1973, a positive
number between 1974 and 1983, and a negative number
since 1984. Then it is not hard to show that the estimated NAIRU for the second subperiod would be higher than
that for the first or third subperiods, just as indicated
before.9 But this would just be the result of the incorrect
omission of s(t), for the earlier assumption was that the
NAIRU had stayed constant at u* for the whole 1955-96
period.
Some researchers have tried to deal with this specification problem by adding measures of supply shocks, or
4. A property of expectations conditional on an information set is that prediction errors are independent of any variable in the
information set (see Goldberger 1991, chap. 5). Since e (t + 1) is a prediction error and u(t) is assumed to be known by the public at t, e (t + 1) and u(t) must be independent. This condition guarantees that OLS estimates of b and c are at least consistent
(see Goldberger 1991, chap. 13.)
5. Recent examples include Weiner (1993), Tootell (1994), Fuhrer (1995), and Staiger, Stock, and Watson (1996).
6. See footnote 5 for published estimates.
7. Two reasons underlie the differences between the estimates given here and those of Staiger, Stock, and Watson. The first is that
they include in their regressions additional explanatory variables intended to control for supply shocks and Nixon-era price
controls. The second reason is that Staiger, Stock, and Watson assumed that the error term in the estimated equation is normally
distributed and derived exact confidence intervals based on that assumption. This study did not assume normality and derived
approximate intervals based on the so-called Delta method, which is valid in large samples. For a description of the Delta
method, see Goldberger (1991, 102).
8. The test is a standard one for stability of coefficients over time, as described by Harvey (1989, chap. 2).
9. For example, the assumption in the text is that s(t) is equal to some positive number, say n, for the 1974-83 subperiod. If one
estimates (2) the regression constant c is equal to bu* – n, and the true value of the NAIRU should be calculated to be (c – n)/b
and not c/b. Hence the standard procedure would overestimate the NAIRU for the 1974-83 subperiod.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
9
CHART 3
Effect of an Aggregate Demand Shock
P1
E0
P*
AD1
P r i c e
L e v e l
( P )
AS
E1
AD0
Y*
O u t p u t
Y1
( Y )
policy shocks that may shift inflationary expectations, to
(1) or (3). Also, some have examined specifications that
do not constrain expected inflation changes to be zero
when unemployment is at the NAIRU. But once these
changes are made, the NAIRU idea loses its simplicity
and, hence, much of its appeal. In addition, such procedures neglect an essential point: the bulk of the variation
of inflation may be due to changes in expected inflation
that are unrelated to the deviation of unemployment from
the NAIRU. Consequently, modeling efforts should be
directed toward understanding the other determinants of
expected inflation.
To summarize, statistical analysis confirms that the
value of the NAIRU is too elusive to be a reliable policy
concept. In addition, the estimated NAIRU seems to move
around, increasing uncertainty about its location and
raising questions about the statistical assumptions that
have to hold to estimate it.
Why Low Unemployment Is Not Always
Followed by Higher Inflation
erhaps the most compelling argument against
using estimates of the NAIRU to predict inflation is
a theoretical one. Most contemporary models of
actual economies treat both inflation and unemployment
as endogenous outcomes. These models treat movements
in inflation and unemployment as simultaneously determined responses to more basic forces or “shocks,” which
are typically modeled as random disturbances. In practice, shocks are of different kinds and hit actual
economies all the time. Inflation and unemployment will
move in opposite directions in response to some shocks
and in the same direction in response to others. Hence,
declines in unemployment will be associated with
increasing inflation in some cases but with decreasing
inflation in others. This relationship holds even if there is
a well-defined Friedman-Phelps natural rate to which
P
10
unemployment must return in the long run and even if a
NAIRU can be estimated. The relation between inflation,
unemployment, the natural rate, and the NAIRU is not
unambiguous but depends on the nature of the shocks
hitting the system. It also follows that predictions of inflation should be based, if possible, on an assessment of
these shocks rather than on unemployment movements
alone.
As a consequence, in contemporary economic models it is incorrect in general to assume that the probability of an increase in inflation has gone up just because the
unemployment rate has fallen below the estimated
NAIRU. The correct inference depends on the kind of
shock that has made the unemployment rate fall. It is
clearly possible for some shocks to cause a fall in unemployment and to raise the likelihood of a decrease in
inflation.
Is it possible to empirically identify the different
shocks that affect the economy? The answer is yes, as
shown recently by Sims (1986), Bernanke (1986),
Gordon and Leeper (1994), Leeper (1995), and Sims and
Zha (1996). These studies have shown how to identify the
underlying causes of low unemployment and thereby to
infer their expected effect on inflation. They present a
promising alternative concept for inflation forecasting
and policy formulation. If shocks can be identified, as this
line of research demonstrates, knowledge of the NAIRU
relative to the actual unemployment rate will add no new
information for predicting inflation.
It may be helpful to illustrate these ideas in a particular and perhaps familiar context. As described by
intermediate macroeconomic textbooks, the outcome of
many macroeconomic models can be summarized by the
intersection of two curves called aggregate demand (AD)
and aggregate supply (AS). The AD and AS curves are not
ordinary supply and demand curves. Rather, each summarizes the equilibriums of several markets, which can
be kept in the background for this discussion.
The aggregate supply (AS) curve summarizes the
combinations of output (Y) and price levels (P) such that
the market for labor is in equilibrium. In Chart 3, an AS
curve is shown with a positive slope, which is consistent
with the traditional view that nominal wages adjust sluggishly. Under that view, an increase in the price level (P)
reduces real wages and induces firms to increase hiring,
thus resulting in a reduction in unemployment and a consequent increase in output (Y); hence P and Y must be
positively related for labor market equilibrium. The
Friedman-Phelps natural rate hypothesis implies, in this
context, that the AS curve can only be upward-sloping in
the short run because eventually nominal wages will
adjust to fully incorporate the effect of unexpected inflation; hence the real wage, unemployment, and output will
eventually return to their original, so-called natural levels. Given that our emphasis is on the short run, the distinction between the short and the long run is not
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
CHART 4
Short-run Effect of an
Aggregate Supply Shock
L e v e l
( P )
AS0
E0
P*
E1
AS1
P1
AD
P r i c e
important for the purposes of this discussion.
Accordingly, in Chart 3, the output level associated with
the natural rate is denoted by Y*, and the AS curve can be
taken to be a short-run one.
The aggregate demand (AD) curve depicts combinations of output and price levels consistent with equilibriums in the markets for output and money, which, again,
need not be explicitly shown for the present purposes. It
is typically assumed that the AD curve is downward-sloping. Given the nominal supply of money, an increase in
the price level (P) causes a fall in the real quantity of
money. The resulting excess demand for money is usually
assumed to be eliminated by an increase in the interest
rate, which reduces the demand for output (Y). Hence
goods and money markets equilibriums require a higher P
to be associated with a larger Y or, in other words, the AD
curve to slope down.
The analysis of the effects of a particular shock to
the economy proceeds by comparing the outcomes before
and after the shock. In Chart 3, the aggregate supply
curve and the aggregate demand curve in the absence of
economic shocks are displayed as AS and AD0, respectively. The intersection of AS and AD0,, the point E0, gives
the outcome of this model in the absence of shocks: if
output is Y* and the price level is P*, all markets are in
equilibrium. Now, consider a shock in either the output
or the money market that displaces the aggregate
demand curve to the right, say, to AD1. An example of
such an “AD shock” is an unexpected decrease in the
demand for money. For any given price level P, and
assuming that the nominal supply of money has not
changed, the real supply of money must increase.
Equilibrium in the money market then requires a matching increase in the real demand for money. This increase
is brought about, in turn, by a fall in the interest rate and
an increase in income and output (Y). Hence Y must be
larger for each P, or the AD curve must shift to the right,
if the markets of money and goods are to be in equilibrium.
For all markets to be in equilibrium after the AD
shock, the new price level must be P1 and output Y1, as
given by the intersection of AD1 and AS. The upshot is
that prices and output both increase. The increase in output must be, in turn, associated with lower unemployment. Hence as a result of an AD shock unemployment
falls below the natural rate and inflation increases.
Chart 4 illustrates the effects of a different kind of
shock, one that affects supply. Initially, aggregate
demand and supply are given by AD and AS0, respectively.
Suppose there is a shock that shifts the aggregate supply
curve to the right, say, to AS1. An example is an unexpected increase in labor productivity that, given prices,
induces firms to increase employment and production.
Given all prices, and hence P, labor market equilibrium
thus requires increased output (Y), and the AS must
move to the right.
Y*
O u t p u t
Y1
( Y )
Chart 4 shows that after the AS shock, the model’s
equilibrium moves from E0 to E1. Since Y is above Y*,
unemployment must fall below the natural rate. On the
other hand, inflation must fall. Hence unemployment and
inflation respond in the same direction to an AS shock.
In this simple context it is possible that the natural
rate is such that “when unemployment is above it, inflation is expected to decline,” at least on average; in other
words, the natural rate and the NAIRU may coincide. This
would be the case if the economy were mostly affected by
AD shocks, which move unemployment and inflation in
the opposite direction. Note that, from this perspective,
the imprecision in the econometric estimation of equations such as (2) or (3) may be attributable to the existence of significant AS shocks.
Whether the estimation of the NAIRU yields precise
estimates is, however, beside the point. The reason to
estimate the NAIRU is, clearly, to forecast the direction of
prospective changes in inflation. But if the economy is
subject to AD and AS shocks, one should be able to make
better predictions by relying on all available information,
not only on the comparison between the NAIRU and
observed unemployment. To see why, suppose that one
observes prices only with a delay and observes that unemployment falls below the natural rate. Is it a good idea to
bet that inflation will increase? Clearly not, if one knows
that the fall in unemployment has been caused by an AS
shock. In such a case blind adherence to the concept that
“unemployment below the NAIRU is likely to be associated with increased inflation” would lead to a mistaken
inference.
These considerations are, of course, consequential
for economic policy. The effect of contractionary monetary policy changes, such as increases in the federal funds
rate, in the AD-AS model is to shift the AD curve toward
the origin. Suppose, as in the previous paragraph, that
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
11
unemployment falls below the natural rate. If the Federal
Reserve’s objective is to keep a stable price level, should
it adopt a contractionary monetary policy? The answer is
positive only if the cause of low unemployment is an AD
shock, as in Chart 3. If unemployment is instead low
because of a favorable AS shock, as in Chart 4, contractionary monetary policy will have the undesired effect of
exacerbating the fall in the price level.
Note that this simple example illustrates that it is
not necessary to deny the existence of a stable negative
correlation between unemployment and inflation to
assert that the NAIRU concept is of little use in predicting inflation. In the example, such a Phillips curve-type
correlation and perhaps even a stable NAIRU could be
observable if most shocks to the economy came from the
demand side. It is noteworthy that the NAIRU concept
was developed during an era in which it was widely
believed that demand shocks were responsible for the
bulk of economic fluctuations. Beliefs have since
changed due to two developments. The first is that since
1973 oil prices have become a main source of concern for
the U.S. economy. The second is the emergence of a
school of thought, called real business cycle theory, that
asserts that macroeconomic fluctuations are mostly
caused by shocks to the aggregate production function,
which affect the supply side. While many of the implications of real business cycle theory are controversial, it is
safe to say that the evidence presented by its proponents
has changed the beliefs of most macroeconomists toward
assigning supply shocks a more important role in explaining fluctuations.
It is not difficult to find examples of favorable aggregate supply shocks that may help explain why recent
unemployment has remained low without accelerating
inflation. Oil prices are one example: except for shortlived episodes mostly related to the U.S. conflict with
Iraq, the real price of oil has been surprisingly low for
many years. Another example is the furious pace of technological innovation in computers and communications.
While the quantitative effect of these shocks remains to
be determined, the point is that the recent performance
of the U.S. economy may be explained to a large extent by
good luck on the supply side.
This discussion has assumed that it is possible to
observe shocks to aggregate demand and aggregate supply or, more generally, the fundamental shocks that affect
actual economies. This is in fact a valid assumption in
view of the existence of a large literature devoted to identifying the sources of macroeconomic fluctuations.
Recent studies, in particular, have followed the lead of
Bernanke (1986) and Sims (1986) in trying to decompose the sources of fluctuations by imposing mild theoretical conditions on estimated vector autoregressions
(VARs).10 Using the Bernanke-Sims methodology, subsequent papers have analyzed the nature of the shocks that
12
ultimately cause fluctuations in the U.S. economy and
elsewhere. For example, Gali (1992) showed that an ADAS model similar to that described above can successfully explain the U.S. data. More recent studies have refined
estimates and proposed alternative models; a good exposition of technical details and recent developments is the
article by Leeper (1995). For present purposes, the point
to be noted is that isolating the fundamental shocks hitting actual economies is feasible and has been done in
practice.
The arguments just advanced can be summarized
and rephrased in a perhaps more appropriate way: concluding that inflation is likely to increase just because
the unemployment rate has fallen below the NAIRU
ignores useful and available information. Techniques are
available for identifying the different shocks that impinge
on the economy and cause unemployment to fall. Once
these shocks are identified, the deviation of the unemployment rate from the NAIRU provides no additional
information for the prediction of changes in inflation.
Conclusion: There Are Better Ways
his article has advanced theoretical and empirical
reasons to show that, in practice, the concept of a
noninflation accelerating rate of unemployment is
not useful for policy purposes. To make this point, the discussion has focused on three facts. First, the NAIRU
moves around. Second, uncertainty about where the
NAIRU is at any point of time is considerable. Third, even
if we knew where the NAIRU were, it would be suboptimal
to predict inflation solely on the basis of the comparison
of unemployment against the NAIRU.
It is not hard to find additional justification for the
views expressed here. A policy of raising the fed funds
rate when unemployment falls below the NAIRU may be
ineffective, for example, even if the NAIRU were constant, its location were known, and all shocks to the economy were to come from the demand side. Implementing
such policy would likely induce changes in the expectations and behavior of the private sector, a point made
forcefully many years ago by Lucas (1976). Because the
“Lucas critique” has been emphasized in past discussions
of the NAIRU and the Phillips curve, this article has not
elaborated on it. However, the Lucas critique is an important additional reason to be skeptical about using the
NAIRU for policy.
This article’s position has been critical of the NAIRU
concept, but economists remain divided about the policy
relevance of the NAIRU.11 The arguments discussed
above highlight the need to further develop models in
which the fundamental forces behind macroeconomic
fluctuations can be identified and analyzed. Fortunately,
a body of outstanding research in that direction is already
in progress.
T
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
R E F E R E N C E S
BERNANKE, BEN S. 1986. “Alternative Explanations of the
Money-Income Correlation.” Carnegie-Rochester Conference
Series on Public Policy 25:49-99.
CONGRESSIONAL BUDGET OFFICE. 1996. The Economic and Budget
Outlook: Fiscal Years 1997-2006. May.
FRIEDMAN, MILTON. 1968. “The Role of Monetary Policy.”
American Economic Review 58 (March): 1-17.
FUHRER, JEFFREY C. 1995. “The Phillips Curve Is Alive and Well.”
New England Economic Review (March/April): 41-46.
GALI, JORDI. 1992. “How Well Does the IS-LM Model Fit Postwar
U.S. Data?” Quarterly Journal of Economics 107 (May):
709-38.
GOLDBERGER, ARTHUR S. 1991. A Course in Econometrics.
Cambridge, Mass.: Harvard University Press.
GORDON, DAVID B., AND ERIC M. LEEPER. 1994. “The Dynamic
Impact of Monetary Policy: An Exercise in Tentative
Identification.” Journal of Political Economy 102
(December): 1228-47.
GORDON, ROBERT J. 1997. “The Time-Varying NAIRU and Its
Implications for Monetary Policy.” Journal of Economic
Perspectives 11 (Winter): 11-32.
HARVEY, A.C. 1989. The Econometric Analysis of Time Series.
Cambridge, Mass.: MIT Press.
LEEPER, ERIC M. 1995. “Reducing Our Ignorance about
Monetary Policy Effects.” Federal Reserve Bank of Atlanta
Economic Review 80 (July/August): 1-38.
LUCAS, ROBERT E. 1972. “Expectations and the Neutrality of
Money.” Journal of Economic Theory 4 (April): 103-24.
———. 1976. “Econometric Policy Evaluation: A Critique.”
Carnegie-Rochester Conference Series on Public Policy 1:19-46.
MODIGLIANI, FRANCO, AND LUCAS PAPADEMOS. 1975. “Targets for
Monetary Policy in the Coming Year.” Brookings Papers on
Economic Activity 1:141-63.
PHILLIPS, A. WILLIAM. 1958. “The Relation between
Unemployment and the Rate of Change of Money Wage
Rates in the United Kingdom, 1861-1957.” Economica 25
(November): 283-99.
ROGERSON, RICHARD. 1997. “Theory ahead of Language in the
Economics of Unemployment.” Journal of Economic
Perspectives 11 (Winter): 73-92.
SAMUELSON, PAUL A., AND ROBERT M. SOLOW. 1960. “Analytical
Aspects of Anti-Inflation Policy.” American Economic Review
40 (May): 177-94.
SARGENT, THOMAS J., AND NEIL WALLACE. 1976. “Rational
Expectations and the Theory of Economic Policy.” Journal of
Monetary Economics 2:169-83.
SIMS, CHRISTOPHER A. 1986. “Are Forecasting Models Usable for
Policy Analysis?” Federal Reserve Bank of Minneapolis
Quarterly Review 10 (Winter): 2-16.
SIMS, CHRISTOPHER A., AND TAO ZHA. 1996. “Does Monetary Policy
Generate Recessions?” Yale University. Photocopy.
STAIGER, DOUGLAS, JAMES H. STOCK, AND MARK W. WATSON. 1996.
“How Precise Are Estimates of the Natural Rate of
Unemployment?” National Bureau of Economic Research,
Working Paper 5477, March.
———. 1997. “The NAIRU, Unemployment, and Monetary
Policy.” Journal of Economic Perspectives 11 (Winter): 33-50.
STIGLITZ, JOSEPH. 1997. “Reflections on the Natural Rate
Hypothesis.” Journal of Economic Perspectives 11 (Winter):
3-10.
TOOTELL, GEOFFREY M.B. 1994. “Restructuring, the NAIRU, and
the Phillips Curve.” New England Economic Review (September/October): 31-44.
WEINER, STUART E. 1993. “New Estimates of the Natural Rate of
Unemployment.” Federal Reserve Bank of Kansas City
Economic Review (Fourth Quarter): 53-69.
PHELPS, EDMUND S. 1968. “Money Wage Dynamics and Labor
Market Equilibrium.” Journal of Political Economy 76
(July/August): 678-711.
10. As the name suggests, a VAR model is one in which a vector of variables is “regressed” against its own lags. Thus, for example,
one may define the vector x(t) to be the triple of output, inflation, and a short interest rate and estimate the system x(t) =
A(1) x(t – 1) + A(2) x(t – 2) + … + A(n)x(t – n) + e(t), where e(t) is a (three-dimensional) disturbance, n is the number
of lags, and A(1), … , A(n) are 3 x 3 matrices of coefficients to be estimated from the data. Typically, the estimates of the e(t)’s
will not directly yield the fundamental shocks hitting the economy but, rather, linear functions of such shocks. However,
Bernanke and Sims showed how one can recover the fundamental shocks by imposing a priori restrictions drawn from economic theory.
11. The curious reader is encouraged to read the Winter 1997 issue of the Journal of Economic Perspectives, which includes several recent papers on the subject. Of these, the studies by Staiger, Stock, and Watson (1997) and Rogerson (1997) are particularly critical of the NAIRU. More sympathetic views are developed by Stiglitz (1997) and Gordon (1997).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
13
Taking Note of the
Deposit Insurance Fund:
A Plan for the FDIC to
Issue Capital Notes
L A R R Y D . W A L L
The author is a research officer in the financial section of
the Atlanta Fed’s research department. He thanks George
Benston, Rob Bliss, Mark Carey, Jerry Dwyer, Bob
Eisenbeis, Mark Flannery, Ed Kane, Michael Gordy, Paul
Kupiec, Saikat Nandi, Will Roberds, Steve Smith, Ellis
Tallman, and workshop participants at the Board of
Governors of the Federal Reserve System and the Office of
the Comptroller of the Currency for helpful comments.
The views expressed are the author’s.
A
RE EXISTING REGULATORY POLICIES ADEQUATELY LIMITING TAXPAYERS’ EXPOSURE TO DEPOSIT
INSURANCE LOSSES?
LOOKING
TO THE PAST, IF THERE HAD BEEN A CREDIBLE, INDEPENDENT
ANSWER TO THIS QUESTION, THERE MIGHT HAVE BEEN FEWER LOSSES FROM THE THRIFT DEBACLE OF THE
1980S. BOTH
REGULATORS AND
CONGRESS
MIGHT HAVE RESPONDED MORE RIG-
OROUSLY TO THE THRIFT PROBLEM IF A MORE CREDIBLE SIGNAL HAD BEEN GIVEN ABOUT ITS SERIOUSNESS.
Looking to the future, although some subsequent
policy changes should help forestall such scenarios,
breakdowns that would expose the taxpayer to losses
remain possible. The likelihood that in the event of substantial bank failures taxpayer funds would have to bail
out the deposit insurance fund has been used as an argument for continuing regulatory controls on what activities
may be affiliated with banks.
This article argues that the interests of both taxpayers and banks may be best served by developing an independent monitor of the insurance fund and outlines a
proposal that would provide such a monitor. The proposal calls for the Federal Deposit Insurance Corporation
(FDIC) to issue securities for which the promise of payment is contingent on the state of the insurance fund.1
14
For example, if the fund required taxpayer contributions
to satisfy its deposit insurance obligations, then the securities would receive no payment. The notes would be
called capital notes because their promised payments
would depend on the level (or capital) in the deposit
insurance fund. Although capital noteholders would necessarily be subject to risk, the primary purpose of the
notes is not to substitute for bank-supplied funds in
absorbing the risk of loss but to produce information
about the risks facing the fund.
This proposal provides a way of tapping private
investors’ information.2 Private investors already gather a
substantial amount of information about the state of the
banking industry, and thus they are in a position to make
informed judgments about the state of the deposit insur-
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
ance fund. However, investors currently have no incentive to focus on the implications of their knowledge for
the insurance fund, nor do they have any organized vehicle for aggregating and expressing their views of the
fund’s health. The capital note proposal gives investors
both an incentive to examine the fund and a mechanism
for expressing their views. Capital notes would also help
regulators by providing an independent assessment of the
risks facing the fund and by enhancing the incentives of
senior regulators to protect the fund.3 Such supplemental
information might also be useful to Congress in evaluating both the condition of insured intermediaries and the
performance of the system for disciplining banks’ risk
taking.
The plan presented here is designed to produce useful information with little or no net cost to taxpayers and
banks. It imposes virtually no direct costs on the taxpayers because the sole source of funds for paying the notes
is the proceeds of deposit insurance premiums paid by
insured banks. Although the plan imposes costs on banks,
the net present value of this cost is likely to be near zero
because receipts from issuing notes would be used to offset banks’ current insurance payment obligations. In the
United States these receipts could be applied to payments on Financing Corporation (FICO) bonds.4 Indeed,
the plan would have a positive net present value to banks
to the extent that reducing policymakers’ concerns about
the insurance fund could result in more extensive deregulation.
A secondary rationale for this proposal is to encourage greater consideration of the use of carefully crafted
financial market contracts to reduce government exposure to deposit insurance losses. The government will
continue to bear some residual risk from the failure of
depositories as long as it provides deposit insurance.5
However, through thoughtfully designed financial contracts, the government could enlist private-sector help in
monitoring and perhaps even reducing its deposit insurance exposure.6
This recommendation is not presented as a substitute for mechanisms that monitor the riskiness of individual banks and limit losses at failed banks. It is
designed instead to provide information about the overall
state of the insurance fund, not about any individual
bank. The discussion
below focuses on the
United States and is
based on the current
system for monitorAs long as the governing and disciplining
ment is at risk of loss
banks as well as the
when depositories fail,
system for distributing losses at failed
some mechanism for
banks. Thus, the prosignaling the magnivisions of the Federal
tude of that exposure
Deposit Insurance
Corporation Imis desirable.
provement Act of
1991 (FDICIA), such
as those requiring
prompt corrective
action and least costly resolution, are assumed to remain
in force. However, the capital note proposal has the
potential for broader applications, as shown in Box 1,
which considers the benefits of incorporating capital
notes into alternative regulatory regimes such as crossguarantees and narrow banking.
The remainder of this article reviews the need for a
way to monitor the health of the fund, and lays out the
capital note plan in greater detail, explaining how capital
1. For simplicity, the proposal assumes the existence of only one fund, but the plan could easily be extended to each of the two
existing funds in the United States, the Bank Insurance Fund and the Savings Associations Insurance Fund.
2. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) provides for ex post monitoring of the fund’s
condition via studies of excessively expensive bank resolutions and through its requirement for higher insurance premiums if
the systemic risk exception is invoked. In contrast, the capital note proposal allows for ex ante information production by private market participants.
3. The federal bank regulatory agencies in the United States are the FDIC, the Federal Reserve System, the Office of the Comptroller
of the Currency (OCC), and the Office of Thrift Supervision (OTS).
4. FICO was created by Congress to help finance the resolution of failed thrifts. Its obligations are to be met by the collection of
insurance premiums from thrifts and banks.
5. Box 1 notes that the removal of de jure deposit insurance does not imply the end of de facto insurance.
6. Two casual suggestions proposed in a seminar as alternatives to the capital notes plan call for contracts that could produce the
same information as capital notes. One suggestion was that the United States issue option contracts that are payable only if the
deposit insurance fund requires a taxpayer bailout. The capital note proposal seems preferable to issuing options contracts
because Congress could have a very difficult time understanding why it should make payments to optionholders when it also
has to appropriate taxpayer money to bail out the insurance fund. Paul Kupiec suggested that the FDIC issue contracts that
would require payments to the agency in the event the insurance fund needed additional funding. The capital note proposal
also seems to have an advantage over Kupiec’s suggestion for issuing reinsurance contracts because the capital note plan would
obtain the investors’ funds before a crisis rather than try to obtain the money after a crisis. However, while the capital note
arguably offers distinct advantages, both of these alternative proposals seem capable of providing independent information
about the state of the insurance fund and hence could result in a significant improvement over the current system of monitoring the fund.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
15
B O X
1
The Usefulness of Capital Notes under
Alternative Regulatory Systems
he capital note proposal for monitoring the health of the
FDIC fund is set in the context of existing U.S. banking
supervision and closure policies. A number of alternative
approaches to bank supervision and closure have been proposed over the years. However, the attractiveness of the capital note proposal hinges on whether the government is at
risk from bank failures. As long as the government is at risk
of loss when depositories fail, some mechanism for signaling
the magnitude of that exposure is desirable. The analysis
that follows argues that none of the existing proposals for
bank supervision and closure would eliminate the government’s exposure to loss, and some of the proposals may actually increase the government’s risk by shifting its exposure to
unregulated entities. Thus, the benefits of implementing the
capital note proposal are independent of the system of bank
supervision and closure. However, the capital note proposal
would be feasible only in systems that explicitly recognize a
contingent government liability.
T
Proposals That Recognize Contingent
Government Liability
The capital note proposal would be both desirable and
feasible with reform proposals that explicitly permit government deposit insurance as a backup to private-sector systems for monitoring banks and absorbing losses from failed
banks.
Cross-Guarantees. A deposit insurance reform proposal from Ely (1994) is based on cross-guarantees among
banks. The idea behind this proposal is that the parties in
the best position to evaluate a depository’s risk exposure are
other depositories managing similar risks. The proposal has
some historical support in the work of Calomiris (1990) on
state-run deposit insurance systems in the 1800s. If Ely’s
proposal worked as intended, then government guarantees
would be unnecessary because no bank would fail with large
losses to depositors. However, banks in such a system could
collectively choose to take on risk, knowing that if enough of
them failed the government would probably step in to protect depositors. Indeed, by tying the fortunes of many banks
together, a cross-guarantee system could force systemic concerns and a government bailout if a subset of the depositories suffered sufficiently large losses.
While the cross-guarantee system would not eliminate
the government’s exposure to loss, this approach is not
16
inherently inconsistent with a government backup insurance fund that issues capital notes. Under such a system, the
losses at failed banks would first be the responsibility of the
other banks in the cross-guarantee system and would
become a government problem only if the losses exceeded
the capacity of the cross-guarantee system to absorb them.
The backup government insurance scheme, including the
capital note issue, could be funded by the individual crossguarantee funds. The note price and interest rate would
then serve as a signal about the financial condition of the
cross-guarantee systems.
Specialized Guarantors and Puttable Subordinated
Debt. The idea of shifting monitoring responsibility and the
risk of loss to private parties unaffiliated with banks is
shared by proposals by Kane, Hickman, and Burger (1993)
and Wall (1989). The Kane-Hickman-Burger proposal shifts
the risk of loss and responsibility for monitoring to a private
surety. Wall’s proposal requires banks to either maintain a
minimum amount of subordinated debt in a form that could
be withdrawn or face automatic closure. Both of these proposals avoid some of the conflict of incentives facing crossguarantees by placing the responsibility and risk outside the
banking system. Both systems would provide for marketdetermined early closure of depositories should their equity
values erode gradually over time. However, both are vulnerable to the possibility that a sudden, very large drop in asset
prices could change the incentive of the private monitors.1
Should the sudden loss exceed the value of a depository’s
equity, the risk arises that private monitors’ claims will
become more like equity than debt. That is, the value of the
private monitor’s claim may be greater if it forbears from
closing an institution in the hope that the depository will
recover its financial strength.
Both the Kane, Hickman, and Burger proposal and the
Wall proposal give market participants an incentive to monitor banks and signal when individual banks are financially
distressed; thus, both are similar in spirit to the capital note
proposal. Neither plan would necessarily be operationally
inconsistent with the capital note plan. The guarantors
under the Kane-Hickman-Burger proposal could contribute
to a government backup insurance fund in a manner similar
to that suggested for the cross-guarantee system. Under the
puttable debt proposal, the banks themselves would contribute to the government insurance fund.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
Proposals That Claim to Eliminate Contingent
Government Liability
Proposals designed to eliminate the government’s contingent liability are unlikely to accomplish their intended
goal, as Benston (1995) notes. In any event, they would complicate the use of capital notes because of questions about
which institutions are likely to receive de facto insurance
coverage.
Eliminate Deposit Insurance. Proposals to eliminate
deposit insurance seem to obviate the use of capital notes. If
the government is not at risk, then monitoring systems seem
unnecessary. The problem with this approach is that eliminating statutory provisions for deposit insurance is not the
same as eliminating either the expectation or reality that
deposit insurance will be provided at failed depositories.
Neither the states of Ohio or Maryland explicitly backed
their deposit insurance systems, but when the funds went
bankrupt the states bailed out the depositors. Similarly,
banks have failed in numerous countries around the world
and depositors were ultimately bailed out, despite the
absence of deposit insurance or tight limits on the extent of
de jure insurance coverage. The bottom line is that democratic governments in the later part of this century have
often been unwilling to let depositors suffer.
While eliminating deposit insurance statutes is not
necessarily a feasible way of eliminating deposit insurance,
it would nevertheless render the capital note plan unworkable. First, the existence of capital notes based on government deposit insurance liabilities would further undercut
the market’s perception that deposit insurance had truly
been eliminated. Second, it is not clear who would pay the
interest on the notes. Without an insurance fund, nobody
would pay insurance premiums that could go toward paying
off the noteholders. Third, it would be less clear what set of
government bailouts might place the noteholders at risk.
Safe Bank Proposals. Another proposal that seems to
eliminate risk to the FDIC is some version of the safe bank
or narrow bank proposal (see, for example, Litan 1987 and
Pierce 1991). Such a proposal would limit deposit insurance
to accounts backed by short-term, highly liquid securities
with low credit and market risk. These securities could be
marked to market on a daily basis so that the exposure of the
insurance fund to losses would be minimal. If such a proposal worked as intended, it too could eliminate the advantages of preferred stock in the insurance fund.
The problem with safe bank proposals is their implicit
assumption that the combination of making short-term,
information-intensive loans and issuing short-term, highly
liquid deposits in banks is a historical accident with no
economic basis for its continued existence. However, the
widespread combination of these functions in banklike institutions around the world suggests that there is some economic benefit in combining the two functions. Flannery
(1994) argues that this combination is an efficient way of
dealing with the agency costs associated with making shortterm, information-intensive loans. Rajan (1996) argues that
businesses’ demand for large loans at short notice makes it
desirable to have lending concentrated in institutions that
specialize in managing liquidity, which is what deposittaking banks must do. Whether or not Flannery or Rajan are
correct, or whether the loan-deposit combination exists for
some other reason, the weight of banking practice worldwide
suggests that banks cannot be neatly divided into a deposittaking function and a lending function. Yet, if this division is
not possible, then limiting deposit insurance to narrow
banks only means that banking problems currently troubling
policymakers will reappear outside the narrow banks. Thus,
while adopting the narrow bank proposal seems unlikely to
make deposit insurance irrelevant, it nevertheless has the
effect of eliminating regulation of those institutions for
which it is relevant.
The narrow bank proposal creates the same sort of
operational problems for the capital note proposal as the
elimination of deposit insurance—namely, that those institutions most likely to require government support are not
formally covered by the system.
1. This vulnerability is less than it may appear based on a review of banks’ financial statements. Often, what appears, from the perspective of the financial statements, to be a sudden loss is actually a series of losses accumulated over a longer period. The losses only seem
to have occurred suddenly because the bank deferred recognition of the losses until delay either no longer benefited the bank or release
became unavoidable. For example, many banks deferred recognizing losses on loans to Latin American borrowers in the 1980s for a
long period of time until the banks decided that recognition would be desirable.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
17
notes would reduce taxpayers’ risk in the event of deposit
insurance losses. The discussion includes a consideration
of some possible disadvantages.
The Need for Monitoring
rior to the creation of the Federal Deposit
Insurance Corporation in 1933, both depositors and
the government monitored the condition of individual banks. Depositors monitored banks because they were
exposed to losses should the bank fail.7 The government
played an important role by examining banks’ confidential
records and certifying that the records did not contain
adverse information. However, the creation of the FDIC,
combined with the agency’s historic policy of seeking to
protect all depositors, resulted in less depositor discipline, especially in
weaker financial institutions. This relaxing of depositor monitoring shifted the
An alternative to
burden of disciplinenhanced government
ing banks’ risk taking
discipline of banks is
to federal bank regulators.
to shift risk back to
Federal bank regthe private sector in
ulators provided an
an attempt to enlist
adequate level of discipline over most of
market discipline.
the period from the
mid-1930s through
the mid-1970s, helped
in no small part by
restrictive regulations that boosted banks’ charter values
and simplified banks’ operations by limiting their activities largely to gathering deposits and making short-term
loans.8 However, regulators’ ability to maintain restrictive regulations has been eroding continually since the
1970s. Bank charter values have declined as the combination of improving technology (communication, data
processing, and financial), increases in the level and
volatility of interest rates, and changes in regulation has
increased competition among banks and between banks
and nonbank firms. The complexity of banks, especially
the largest banks, has increased dramatically with the
use of technology to provide a wide variety of financial
services.
As the task of supervising banks became more difficult, two supervisory problems surfaced. The first was that
of conflicts in supervisory incentives, revealed during the
thrift debacle of the 1980s.9 Kane (1989a, 1989b) points
out that although bank supervisors are in effect agents for
the taxpayers, their personal objectives often include
other goals that are inconsistent with reducing taxpayer
exposure to failed depositories.10 Congress sought to
mitigate this conflict in incentives through passage of
the FDIC Improvement Act of 1991. In particular, the act
P
18
provides for prompt corrective action that prescribes a
series of mandatory and optional regulatory responses to
falling capital ratios.11 However, prompt corrective action
depends in large part on the accurate measurement of
banks’ financial condition, and such accurate measurement is not always feasible. A large fraction of a depository’s
assets are either not traded at all or are traded in very illiquid markets where prices may vary from full-information
value (Berger, King, and O’Brien 1991). The determination
of the economic value of these assets is necessarily subject to potentially large measurement error. Thus, regulators still have room to exercise discretion so that, as Kane
(1995) points out, incentive problems have not been eliminated by FDICIA.12
The second problem is how to supervise banking
organizations effectively, given that changing technology
has made these organizations far more complex. The
banking, securities, and insurance industries have each
used advances in technology and innovative legal
approaches to offer products that are functionally similar
to products offered by the other two industries but that
have a very different regulatory status; for example,
money market mutual funds are substituted for bank
deposits. As a consequence, current systems of regulation
that designate separate regulatory bodies for each of the
different types of financial services are being made obsolete by developments in the financial marketplace.
Whether regulators could adequately limit the risk to the
FDIC fund in the emerging complex, highly competitive
financial marketplace is an open question.13 Some analysts, such as Pierce (1991, 98-100), advocate severely
restricting insured banks’ choice of assets, in part
because they are pessimistic about regulators’ ability to
monitor sophisticated financial services firms.14
An alternative to enhanced government discipline of
banks is to shift risk back to the private sector in an
attempt to enlist market discipline. FDICIA has sought to
enlist depositor discipline through adoption of least costly resolution.15 This provision retains deposit insurance
coverage up to the de jure coverage level of $100,000;
however, the FDIC absorbs losses from larger deposits
only if doing so reduces the overall cost of resolution to
the agency. If this stipulation is enforced for all bank failures, it should substantially increase depositor monitoring, especially at the largest banks, which tend to be the
most complex. However, FDICIA also provides for the suspension of least costly resolution in systemic risk situations, thus tending to reduce depositor monitoring,
particularly at large banks. The ultimate effectiveness of
least costly resolution in providing depositor discipline at
large banks therefore remains an open question, in part
because no very large bank has failed since the adoption
of FDICIA.16
Even if systemic risk considerations (real or imagined) limit the potential effectiveness of depositor discipline, other opportunities for increasing market
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
discipline remain. One set of options would be to shift
more of the losses to the private sector without giving
market participants direct authority to force troubled
banks to close. Examples of such options include
increased issuance of subordinated debt, as proposed by
Benston and others (1986, 192-96), and the use of private
coinsurance to help set insurance premiums for individual banks. Market discipline in these instances arises
from the risk premiums that financial markets would
charge individual banks. The limitation of these proposals is that, while they give government regulators more
time to close failing banks before the FDIC absorbs any
losses, they do not directly address the problems of conflicting regulatory incentives or the problems of supervising very complex financial firms.
Another set of options for increasing market discipline would give private parties both a larger fraction of
the risk of loss in bank failure and the ability to close a
failing bank. Examples of such proposals (which are discussed in Box 1) include those of Kane, Hickman, and
Burger (1993) for private sureties and Wall (1989) for
puttable subordinated debt. These strategies, which give
private participants the authority to close any institution
that cannot demonstrate its solvency or reasonable risktaking policies, go further to address the regulatory problems of conflicting incentives and the difficulty of
supervising complex organizations. However, these proposals are limited in that sudden, very large losses can
effectively force the conversion of the private monitors
into de facto equityholders in a failed depository. Thus, in
some circumstances the health of the FDIC would ultimately depend on government supervisors, even under
the provisions of these proposals.
Ultimately, then, although the primary system for
protecting taxpayers from losses at financial intermediaries has been improved, and perhaps could be further
7. This monitoring occurred for all national banks and those state-chartered banks that did not have state-sponsored deposit
insurance.
8. Charter or franchise value is the net present value of the economic profits resulting from owning a bank charter. Keeley (1990)
provides evidence of a decline in franchise value. Demsetz, Saidenberg, and Strahan (1996) provide evidence that banks with
higher franchise values take less risk.
9. See Kane and Yu (1995) for evidence that the U.S. Federal Home Loan Bank Board (FHLBB) dramatically understated the true
reserves of the Federal Savings and Loan Insurance Fund for the period 1985-88. They further argue that the misinformation
supplied by the FHLBB played an important role in actions taken by Congress in 1987. Cole and Eisenbeis (1996) provide evidence that delays in closure increased the cost to taxpayers. Other discussions that suggest that regulatory problems have contributed to actual or potential taxpayer losses include Kane and Kaufman (1993) on problems in Australia; De Krivoy (1995)
on Venezuela; Cargill, Hutchison, and Ito (1995) on Japan; and Gall (1996) on Brazil.
10. Several theoretical models reach varying conclusions about optimal closure policies. Examples of these studies include
Acharya and Dreyfus (1989), Davies and McManus (1991), Kumar and Morgan (1994), Mailath and Mester (1994), and Noe,
Rebello, and Wall (1996). However, the previously cited empirical work appears to suggest that Kane’s model better explains
most past regulatory forbearance than do these models.
11. For a presentation of the structured early intervention and resolution proposal that formed the basis for prompt corrective
action provisions of FDICIA, see Benston and Kaufman (1988). For a discussion of FDICIA’s key safety and soundness provisions, see Wall (1993).
12. Jones and King (1995) and Peek and Rosengren (1996) show that a large fraction of the banks with high insolvency risk in
their respective samples would not have come under prompt corrective action requirements given existing capital standards.
13. Chan, Greenbaum, and Thakor (1992) question whether fairly priced deposit insurance is feasible in a competitive marketplace. Their results may be put in more general terms by recognizing that in order to own a bank charter in the United States,
a firm must generally participate in the deposit insurance system and accept other regulatory requirements. When restated
in this manner, their results imply that an intermediary will prefer to be chartered as a bank only if the rents from owning a
charter (including any government subsidy through deposit insurance) exceed the regulatory costs (both safety and soundness costs and social regulation costs) of owning a charter. As the government reduces or eliminates the deposit insurance subsidy, the ratio of rents to taxes from owning a bank charter will become less favorable and less intermediation will take place
through the banking system. However, even if one believes that the ratio of rents to taxes from owning a bank charter should
be increased to encourage charter ownership, it is not obvious that the most efficient way to do so is by subsidizing bank risk
taking.
14. Box 1 discusses the narrow bank approach in greater detail but reaches the conclusion that the approach is unlikely to reduce
FDIC’s exposure to the degree suggested by its proponent.
15. Another legislative change is a depositor preference provision, which states that domestic depositors (including the FDIC,
which stands in the depositor’s place when it makes an insurance payment) in a failed depository are entitled to full repayment before nondeposit creditors receive any payment. In theory this provision should lead to an increase in monitoring by
nondeposit creditors, at least in those states that did not previously follow depositor preference. In practice, the increased risk
to nondeposit creditors can be substantially reduced by having the bank put up collateral to back the nondeposit liability. See
Osterberg (1996) for a review and empirical analysis of depositor preference laws.
16. FDICIA also provides regulators with various powers, such as final net settlement, designed to enhance their ability to implement least costly resolution. The credibility of least costly resolution could be enhanced if regulators developed and advertised
plans to implement least costly resolution in a way that was unlikely to generate systemic risk.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
19
improved, it remains vulnerable to failure. Drawing on an
engineering analogy, when the failure of a primary system
could have catastrophic consequences, backups must be
incorporated into the design to reduce the risk of damage. Given the potentially high stakes from a failure of
the system to limit banks’ risk to the fund, Kane (1995)
argues that it would be desirable to monitor the condition
of the FDIC. He contends that information about the
FDIC’s condition would help taxpayers assess their exposure as well as assist labor markets in evaluating the performance of top government officials. In particular, Kane
recommends implementing some mechanism that would
encourage production and dissemination of private information about the performance of the deposit insurer. He
argues that “the trick would be to make sure that projected cash flows respond to loss exposures occasioned by
inadequacies in federal loss-control and pricing policies”
(1995, 454). However, while his specific proposals would
produce direct information on individual banks or subsets of banks, they would produce only indirect information on the fund per se. These proposals are essentially
substitutes for FDICIA’s approach to dealing with individual bank risk and do not constitute backups.17 The proposal that follows is a low-cost backup system.
A Plan for a Low-Cost Backup System
he plan outlined here calls upon the deposit insurer to issue capital notes as a mechanism for signaling taxpayers about the riskiness of the deposit
insurance fund. Subsequent discussion explains the reason for the plan’s structure, shows how the plan will meet
its goals, and analyzes some potential problems.
1. The FDIC’s insurance fund would issue coupon notes
that pay interest and principal except in circumstances stipulated below. These notes would vary in
maturity from one to five years. New note issues
would occur at least semiannually.
2. Interest payments would be suspended if the fund
received a loan from the government to finance the
resolution of failing banks. If such a suspension
occurred then insurance premiums would automatically increase to a historically high level (such as a
minimum premium of $0.25 per $100 of deposits).
3. The capital notes’ right to interest (future and
cumulative unpaid interest from prior periods)
would be terminated when the fund reaches zero,
and any source of funds other than depository insurance premiums would be appropriated by Congress
to absorb deposit insurance losses.
4. The quantity of capital notes would be determined
by the FDIC, based on the goal of maximizing the
information content of the notes about the health of
the insurance fund. Depositories, their affiliates,
and the accounts they manage for other parties
(such as trust accounts and mutual funds) would
not be permitted to hold the notes as an investment.
T
20
Small inventories of the notes for securities affiliates that act as market makers would be permitted.
5. Every time the FDIC issued new notes it would
report on the status of the fund and the risks facing
the banking system. The report would also contain
an estimate of the distribution of potential losses to
the insurance fund (under at least three sets of economic assumptions) and a description of the methods used to estimate losses. Further, if the yield to
maturity at the time of issue of a note exceeded that
of comparable maturity investment-grade securities,
then three reports would be required.18 First, the
FDIC would be obligated to report to Congress on the
risk that the insurance fund would become inadequate, on any steps the agency planned on taking to
reduce the risk, and on any additional legislation
that would be helpful in reducing the risk to the
insurance fund. Second, the Secretary of the
Treasury would be required to report on the budget
implications of the risk to the fund. Finally, the
General Accounting Office (GAO) would be required
to review the problems, regulatory responses, and
any appropriate congressional responses.
6. Part of the pension plan provided for the FDIC directors would be invested in capital notes while the
directors were in office; for example, one-quarter of
a director’s contribution to the pension fund during
his or her term would be automatically invested in
the notes. A director would be able to sell the notes
over some time period after retiring from office.19 In
order to reduce the exposure to banks not directly
under its regulation, the FDIC would have the
authority to examine any insured bank at its sole discretion.
7. The proceeds from the capital note issue would go to
repaying FICO bonds.20 The premiums levied on
banks to pay the interest and principal on FICO
bonds would be proportionately reduced.
The plan outlined here relies on signals from market
pricing to indicate when the insurance fund is likely to be
under stress. The reason for requiring the FDIC to return
to the financial markets at least every six months to issue
new securities is that an issue of long-term capital notes
could have an illiquid secondary market so that signals
obtained from note prices could contain considerable
noise. The provision forcing the FDIC to sell notes regularly gives the financial markets a periodic opportunity to
provide information about the quality of the insurance
fund.
Notes are issued at several maturities to provide a
time profile of the risks facing the insurance fund. For
example, suppose investors thought banks were taking
excessive risks but believed these risks would not become
apparent until the next recession. In this case, notes
maturing in one year may show very little, if any, risk premium, but notes maturing in five years would trade at
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
substantially higher yields than comparable Treasury
securities, reflecting concerns about future losses.
Not only would requiring the FDIC to provide an
evaluation of the fund’s status with each new issue help
noteholders and independent analysts in assessing the
adequacy of the fund; it would also provide a way to
review the regulatory agencies’ outlook on the current
condition of the banking system and suggest how they
might handle problem banks.
The capital notes are intended to measure the insurance fund’s solvency, but payment of interest on the notes
would be suspended if the fund had to turn to the
Treasury to obtain sufficient liquidity.21 Suspension of
interest payments is designed to ensure that solvency
problems are not hidden by the FDIC under the pretense
that the only issue is the liquidity of the fund. The
Treasury, as supplier of these funds, should charge interest for providing the required liquidity. However, capital
noteholders would retain their claim to future interest in
this case so long as Congress did not appropriate taxpayer funds to cover failed banks’ losses.22
Stipulating that directors of the FDIC invest in the
capital notes would give them an added incentive to follow
market signals.23 The optimal amount of investment for
directors would balance their incentive to protect the taxpayers from deposit insurance losses with not giving them
such a stake that they would avoid using the fund when
failure to do so would have adverse consequences for the
overall economy.24 This part of the proposal would expose
the directors of the FDIC to the risk of loss and thereby
reduce the expected value of their compensation. This
reduction should be offset with higher salary or benefits
unless some evidence indicates that FDIC directors are
currently overcompensated.
How the Proposal Would Reduce Taxpayers’ Risk
key concern in issuing capital notes is whether
they would actually reduce the risk that the
deposit insurance fund would require taxpayer
support. Three aspects of this question will be considered
in the following discussion: First, how would the notes
contribute to better decisions by the regulatory agencies?
Second, how would the notes increase the probability
that Congress would take appropriate oversight actions if
the need arose? Finally, what limitations might adversely
impact the informativeness of the pricing signal?
Capital Notes and the Regulatory Agencies. Because
the capital note plan lacks a mechanism to compel
changes at the regulatory agencies, to what extent would
the plan, in practice, change regulators’ actions? If regulators always use their discretion in a manner contrary to
the interests of taxpayers, then a plan that fails to force
changes in regulators’ behavior cannot help protect the
taxpayers. However, existing theory does not indicate
that regulatory agencies must always act contrary to taxpayers’ interests; theory merely states that conflicting
incentives will sometimes produce suboptimal results.
Regulators’ preferred policies will in many cases be optimal, especially if timely information allows them to prevent a problem from occurring. In other cases, while the
A
17. Kane discusses two specific alternatives: “marketing cash flows from uninsured funding instruments [for example, subordinated debt] or FDIC coinsurance agreements” (1995, 454). These alternatives would provide information about the performance of the various individual banks or groups of banks that constitute the portfolio of exposures facing the deposit insurer.
As such, they would require changes in the way losses are currently distributed when a bank fails and might entail changes
in the way the closure decision itself is made.
18. This provision could be strengthened by including a stipulation that would automatically increase deposit insurance premiums when capital note rates exceeded those of investment grade notes. An increase in insurance premiums might not be the
most efficient way to reduce the risk that taxpayer funds would be used to resolve bank failures. However, the prospect of higher premiums could help regulators and banks reach a consensus on which measures (such as higher capital requirements or
implementation of least-costly resolution) would best reduce risk to the fund.
19. For example, the directors could sell the notes evenly over a four-year period, with 25 percent of the notes eligible for sale after
one year, 50 percent eligible after two years, 75 percent after three years, and the entire investment eligible after four years.
20. Alternatively, the funds could be used to bolster the insurance fund if the plan were adopted in a country other than the United
States.
21. The FDIC currently has the authority to borrow from the U.S. Treasury, but the insurance fund is obligated to repay the loans.
A congressional appropriation is required for the FDIC to obtain funds from the Treasury that the insurance fund would not
be obligated to repay.
22. For example, suppose the fund had $20 billion in assets and faced immediate liquidity needs from the failure of some depositories of $40 billion but would also acquire a claim on the failed institutions’ assets with a current market value of $35 billion.
In this case the fund might need a loan of approximately $20 billion to resolve the depositories, but, after selling off the assets
the fund should have approximately $15 billion.
23. The use of the regulators’ pension fund as a mechanism for generating financial accountability follows a recommendation by
Kane (1996).
24. The claim that failures in the financial sector could spill over with adverse consequences for the real economy is controversial.
For example, Benston (1995) and Kaufman (1996) argue that deposit insurance is not needed to protect against systemic risk.
The link between FDIC directors’ compensation and note values could be strengthened if one did not believe such a spillover is
possible.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
21
personal benefit of pursuing a suboptimal strategy will
dominate under the current incentive system, it will be
less likely to dominate under some other incentive structures. Capital notes are likely to influence regulatory
actions both by providing the agencies with additional
information and by changing their incentives.
Risk premiums on the notes would serve as signal
about a number of different problems that could be
addressed by the regulatory agencies.25 An increase in
risk premiums (a decrease in note prices) could be a signal that the riskiness of the banking system has
increased. For example, changes in regulation or technology could allow banks to expand their product offerings into riskier financial activities. In this case
regulators could seek to insulate the fund more effectively from the additional risk, or they could
limit banks’ ability to
take the additional
The capital note proposal
risk. The risk premiwould prompt investors to
um might also increase in response to
scrutinize the underlying
a reduction in the
economic realities facing
market’s confidence
the fund and ignore disinthat the FDIC would
follow least costly
formation proffered by
resolution. In this
those with a stake in a
case, the regulatory
misinformed public.
agencies might wish
to review the feasibility of their strategies
to implement least
costly resolution and then better advertise their plans to
financial markets. A third possibility is that deposit insurance premiums or the insurance fund have become inadequate in relation to the level of risks facing banks. In
this case, the FDIC could choose to increase its insurance
premiums or, if the fund has reached its maximum permissible level (as has recently been the case), could seek
permission from Congress to increase the fund’s size.
Admittedly, these market signals to the regulatory
agencies about problems facing the fund are unlikely to
alert regulators to completely unrecognized problems.
However, an increase in the risk premium would provide
independent information about the severity of a threat to
the insurance fund. This independent information could
be useful both for setting priorities within the regulatory
agencies and for helping to overcome political opposition
to measures the regulators deem necessary to protect the
fund.
The plan changes the FDIC directors’ incentives to
engage in forbearance in several ways. First, the proposal imposes costs on regulators while they are in office,
especially FDIC administrators, by requiring reports from
the FDIC and an examination by the GAO if the yield on
notes exceeds that of comparable maturity investment22
grade securities. Few administrators like to be forced to
discuss publicly possible problems that are occurring on
their watch, and even fewer would want the GAO to
second-guess their past policies and their plans for future
action.
Second, senior regulators, including FDIC directors,
could not expect to be able to hide their mistakes until
either they had found new employment, leaving their successors to clean up the problem, or banks had become
healthy as a result of taking large gambles. The price or
rate on capital notes would serve as a clear signal to
Congress and potential employers of significant problems
facing the insurance fund while the regulators were still
in office, as suggested by Kane (1995). Thus, senior regulators who engaged in forbearance could not count on
leaving their regulatory agency with their good reputations intact.
Third, requiring directors of the FDIC to own capital
notes would put part of their own wealth at risk if the
FDIC engaged in forbearance. As noted above, the
amount of notes held by the FDIC’s directors might be
restricted to serve the social goal of not excessively discouraging the FDIC from invoking the systemic risk
exception in severe cases, even if that action bankrupts
the fund. Another limitation of this advantage is that the
FDIC shares regulatory responsibility over banks with the
OCC and the Federal Reserve. The FDIC has the unconditional right to enter any bank it insures and is thus
able to protect the fund from forbearance by these other
agencies.
Further, the proposal creates subtle changes in regulators’ incentives to deal with emerging problems before
they threaten to impose significant losses on the fund.
The potential cost to regulators if notes should start trading at a substantially lower level becomes an incentive to
prevent note prices from falling. One way regulators
might address this incentive would be to deal more
aggressively with potential threats to the insurance fund
before economic losses occur. They might also try to
reduce the risk premiums on the notes by assuaging market uncertainty about the state of the fund with more
information. This impetus to disseminate information
would be reinforced by the requirement that the FDIC
report on the state of the insurance fund each time it
issues new notes. The process of providing additional
information will further encourage timely action by regulators: not only will it force them to recognize potential
threats at an earlier stage, but it will also help Congress
and taxpayers to monitor the regulatory process.
Capital Notes and Congress. Issuing capital notes
would give voters and their representatives a clear signal
about the health of the deposit insurance fund. Banks in
weak financial condition have a strong incentive to produce accounting numbers that give a misleading impression of good health. Bank auditors have mixed incentives
but they are hired by the banks, so they have a strong
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
motivation to approve the rosiest picture possible of
opaque financial information as long as the analysis is
consistent with the legal standards for auditors’ performance. The three federal bank regulatory agencies also
face conflicting incentives, but experience around the
world shows that when serious financial problems arise,
regulators often look for ways to defer taking action. In
contrast, this capital note proposal would prompt
investors to scrutinize the underlying economic realities
facing the fund and ignore disinformation proffered by
those with a stake in a misinformed public. Potential
investors in the notes stand to suffer substantial losses if
they underestimate the likelihood that payments will be
deferred or eliminated. Thus, the price or rates set on
these notes could serve as a more accurate signal about
the true condition of the fund than reports from banking
and regulatory systems might provide.
The capital note proposal would encourage timely
oversight and legislation by Congress because it would
lower the cost of obtaining information and thus reduce
congressional members’ incentive to remain uninformed
(or underinformed) about the state of the deposit insurance fund. Members may choose to remain underinformed if obtaining information about the true condition
of the fund is costly and the likely political benefit from
obtaining the information is small.26 Capital notes could
serve as a low-cost warning signal that would allow legislators to focus attention on the fund primarily during
periods when gains from legislative changes would be the
largest. The benefits to Congress from note price signaling are reinforced by the stipulation that would require
mandatory reports by the FDIC, the Treasury, and the
GAO should the notes be issued at rates exceeding those
of comparable investment-grade securities.
Congressional members’ incentives to monitor the
condition of the deposit insurance fund is affected by the
capital note plan in two ways. First, by reducing the cost
of recognizing when the fund poses a threat to the taxpayers, the proposal makes it harder for legislators to
plausibly deny their responsibility to take action to
reduce the threat. The rates charged on capital notes
send a signal that may be more easily understood by the
electorate than the conflicting testimony of “experts.” In
this way the rates may be used in political campaigns by
challengers to bolster their chances of defeating members who shirk their obligations to taxpayers.
Second, capital noteholders could also provide a
political counterweight to lobbying depositories. In the
early stage of a threat to the insurance fund, noteholders
would have an incentive to lobby for more aggressive regulatory action to preserve the value of their claims. While
appealing in principle, this advantage of the plan is only
of second-order importance because banks would probably retain greater political clout and, if the insurance
fund becomes sufficiently weak, noteholders’ primary aim
becomes persuading Congress to bail them out along with
the fund.
The Pricing of Capital Notes. All of the arguments
for the advantages of the capital note proposal depend on
the prices of the notes sending a clear signal about the
condition of the fund. But both the FDIC and Congress
could take steps that would reduce the information content in the notes’ prices. The FDIC could mislead capital
noteholders by withholding information to prevent the
notes from signaling most potential problems. This scenario is unlikely, however. Regulators collect and publish
a substantial volume of data on banks’ financial condition,
and most of the banking system’s assets are in publicly
traded banks that are already closely watched by stock
analysts. Further, bond rating agencies currently evaluate
the credit quality of many bank debt issues, including
those of virtually all of the very large banking organizations, and this knowledge could be applied to rating notes
issued by the bank insurer. Thus, the FDIC would have a
very difficult time concealing unrealized losses to the
banking system that would threaten the fund’s solvency.27
A more serious threat to the effectiveness of the plan
is the potential for Congress to bail out the capital noteholders along with the deposit insurance fund. There is
no way to prevent noteholders from petitioning for a
bailout or to bind the hands of future Congresses.
However, capital noteholders are being paid specifically
to accept the risk that the FDIC fund could become
impaired, and, in general, these noteholders would be
capable of bearing that risk. Thus, as a group, the capital
noteholders would not have a strong case for a bailout.
Even given the potential for a bailout of noteholders, the
price of the notes would remain depressed until the
bailout became a certainty, so prices could still be used as
a signal that problems remained. The primary limitation
of such signals would be in interpreting changes in capital note prices and rates when the value of deposit insurance claims has a substantial probability of exceeding the
fund’s assets. These changes could reflect variations both
in the fundamental condition of the fund and in the probability of a bailout.
25. For a survey of the evidence that various market signals contain information about banks’ financial condition, see Gilbert
(1990) as well as a more recent study by Flannery and Sorescu (1996). For a contrary opinion, see Simons and Cross (1991)
and Randall (1993).
26. For example, in those states where no congressional action is appropriate, the political benefit of obtaining additional information about the state of the fund may be close to zero.
27. An example (perhaps the only example) of such a deception would be a large bank taking very substantial losses from undisclosed fraud or unauthorized risk taking that was recognized by the examiners but not the bank’s auditors.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
23
Potential Disadvantages of
the Capital Note Proposal
robably the biggest disadvantage of the plan outlined here is that the FDIC would bear a continuing
responsibility to pay interest on the capital notes,
implying a need for higher deposit insurance premiums
for depositories. However, even if higher premiums were
a pure loss to depositories, it could be argued that the
gains to taxpayers from better regulatory decisions and
improved congressional oversight would exceed the loss
if banks passed the higher premiums to their customers.
Moreover, the net cost to depositories from the issuance
of capital notes is likely to be small. The proceeds from
the note issue would go to pay down the FICO note issue
and reduce insurance premiums on those notes. What
cost, if any, the plan would impose on banks depends on
the amount and timing of lower insurance premiums
stemming from reduced FICO obligations, the amount
and timing of payments by the capital notes, and the discount rate applied to those future payments (which
should reflect banks’ marginal cost of funds). (Rates likely to be paid on capital notes are discussed in Box 2.)
Another possible disadvantage of the capital note
plan, it might be argued, is that if the notes indicated a
high degree of risk to the deposit insurance fund, the
public’s confidence in the deposit insurance fund could
erode, thereby precipitating a systemic problem.
However, the FDIC has a $30 billion line of credit at the
U.S. Treasury, and Congress may appropriate additional
funds as a loan or as a grant to resolve failed banks; thus,
plunging capital note values would not necessarily indicate that the insurance fund would be unable to honor its
obligations to insured depositors. Any public misperception that the note values measure the fund’s ability to
honor its claims could be corrected, providing a low-cost
solution to the problem. The capital notes are a only signal about whether the insurance fund is likely to need
government help, not an indication of its ability to pay off
insured depositors.
P
24
Conclusion
ank regulators and deposit insurers around the
world have repeatedly failed to resolve foundering
depositories in a timely manner. In the United
States the risk that a financial breakdown could lead to a
taxpayer bailout of the deposit insurance fund has been
cited to justify current regulatory controls and the imposition of inefficient taxes for social welfare purposes.
Despite some regulatory changes in the 1990s to protect
taxpayers from future debacles, however, widespread failures could still expose taxpayers to losses.
The proposal outlined in this article provides a way
to monitor the deposit insurance fund—through capital
notes issued by the FDIC—that would better serve the
interests of both taxpayers and banks. Because the interest paid on capital notes would be suspended if the fund
required a loan from the Treasury or eliminated if taxpayer funds were contributed to offset deposit insurance
losses, noteholders would have more incentive to take
action should the risk of loss to the taxpayers become
substantial. Capital notes would provide taxpayers and
their congressional representatives clear signals about
the health of the fund and would change the incentive
structure facing senior regulators.
Banks should benefit under the capital note proposal because the receipts from issuing the notes could be
used to reduce banks’ insurance payment obligations. In
addition, by relieving some of the concerns policymakers
have about the insurance fund, the capital note plan
could lead to a more deregulated environment for banks.
Finally, both regulators and Congress may profit
from a better method for assessing the status of the
insurance fund as they struggle to cope with safety and
soundness questions arising from the integration of the
banking industry with other finance-related industries.
B
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
B O X
2
A Rough Calculation of the
Likely Interest Rate on Capital Notes
he capital notes proposed in this article are intended to
be an effective, low-cost signal of the condition of the
FDIC fund. Potential investors in capital notes, however, are
concerned about more than the risk that the FDIC will have
insufficient funds to honor its promises to the noteholders.
Investors will demand that the note’s pricing reflect the current value of the default-free term structure. Investors will
also demand compensation for risks other than economic
default, such as the possibility that notes could become illiquid or the risk that payments could be suspended or terminated for political reasons rather than because of the FDIC’s
inability to make timely payments. If the notes are to be an
effective signal of the state of the FDIC fund, analysts need
to be able to filter out most of the changes in the status of
the fund from other reasons for rate changes. Further, if the
notes are to be low-cost signals, then the nondefault risk
premiums attached to the notes should be small.
No one can say with certainty exactly how the notes will
be priced because they currently do not exist. However, varieties of notes already in the market, such as municipal revenue notes and bonds as well as corporate notes and bonds,
share many of the same characteristics as capital notes. This
box compares the features of capital notes with those of
other types of debt securities to obtain a rough estimate of
likely prices if capital notes were to be issued.
T
Determinants of the Prices of Capital Notes
The rate on capital notes may be reasonably approximated by the following function:
Rate on notes = f{default-free term structure, tax status,
default risk premium, premium for the risk
of interest deferral, information cost premium, liquidity premium, risk of political
interference}.
Default-Free Term Structure. The default-free term
structure represents the payment to investors for deferring
consumption; it is an important element in the pricing of all
fixed-income securities. The default-free term structure for
obligations denominated in U.S. dollars is usually approximated by the term structure of U.S. Treasury securities.
Capital notes and corporate notes of the same default risk
would be expected to respond in a similar fashion to movements in Treasury securities. Municipal revenue notes also
respond to movements in the Treasury rate, but their rate
movements are dampened because they are not subject to
federal taxation.
Tax Status. Income from ordinary corporate notes and
capital notes is subject to federal income tax. However,
interest on municipal notes, which are obligations of state
and local governments, are not subject to federal tax. This
tax break allows municipal notes to trade at lower yields,
imuni, than otherwise identical corporate notes and capital
notes, itax. The formula for determining the lower yield is
imuni = itax(1 – t),
where t is the federal income tax rate of the marginal
investor.
Default Risk Premium. Municipal revenue debt issues,
corporate debt issues, and capital notes are all subject to
default risk, and numerous studies show that this risk is
priced in the debt markets.1 Municipal revenue securities are
used to finance a specific project and are backed solely by the
revenue from that project. The debt issues are expected to
default if the revenues are insufficient to repay the noteholders. Corporate debt is typically backed by the cash flow of the
entire corporation, but these cash flows must pay the firm’s
operating costs and its other debt issues. Corporate notes will
default if the firm’s cash flow is insufficient.
One difference among the three types of debt obligations is the potential for noteholders to hedge changes in
credit risk. In theory, a corporate debtholder could perfectly
hedge her exposure to changes in a firm’s credit risk by taking a short position in the firm’s stock. In practice such a
hedge is unlikely to be perfect for a variety of reasons; for
example, payments to the noteholders may depend on the
decisions of a bankruptcy court (especially if the firm has
multiple classes of debt outstanding), or the market value of
the firm’s assets may be subject to discontinuous movements. Nevertheless, a large fraction of the risk could be
hedged by taking appropriate short positions in the firm’s
stock.
1. For example, Altman (1989) shows that bond ratings are generally negatively correlated with default probabilities and yields.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
25
B O X
2
( C O N T I N U E D )
The default risk on capital notes depends on the magnitude of losses to the deposit insurer and on the insurer’s ability to recover those losses via higher premiums, both of which
in turn depend on the performance of a portfolio of banks.
Not all banks have publicly traded stock, but the FDIC’s
biggest exposures are concentrated in banks with traded
stocks. Thus, investors could hedge a significant portion of
the default risk on capital notes. However, the fraction of risk
covered by such a hedge would almost certainly be less than
that for a typical corporate note of comparable risk.
Most municipal projects tend to be specialized with a
high degree of idiosyncratic risk. Some revenue bonds and
notes, such as those associated with hospitals or power facilities, may be somewhat correlated with the stocks of firms in
the same industry, but other revenue debt issues (such as
those associated with toll roads and university dormitories)
may have few, if any, natural hedges. In general, the proportion of municipal revenue note default risk that can be
hedged is likely to be substantially lower than either corporate notes or capital notes.
Risk of Deferral of Interest Payments. Even if
investors ultimately receive full payment of interest and
principal, these payments may be delayed if the issuer is in
financial distress. The capital note proposal provides for a
suspension of payments if the FDIC obtains a loan from the
Treasury. Payments on a corporate note may be suspended if
the firm enters bankruptcy proceedings. The bankruptcy
court will typically place a stay on payments to the firm’s
noteholders, at least until either an acceptable restructuring plan has been approved by the court or the firm is liquidated. Municipal revenue note payments are also subject to
holds if the project enters bankruptcy.
Information Cost Premium. Investors rarely, if ever,
know the true probability of default on a debt security.
Instead, they form their best estimate based on publicly
available information and on the private information they
collect. Each investor then determines the risk premium
required to cover her private individual estimate of default.
If the investor believes that other market participants (the
issuer or other investors) have superior information, then
she will demand a premium to cover the risk that she is
being sold an overpriced security. If the competition among
unaffiliated investors to produce information helps in accurately pricing debt obligations, those investors that have
superior information will, at least in the long run, be the
marginal buyers of an issue. However, the possibility that the
issuer is acting on superior information may make prices
less accurate measures of actual default risk. Issuers with
26
superior information may sell notes when debt markets overvalue them and defer selling notes when the market undervalues the securities. Investors recognize that issuers are
likely to have superior information and will demand higher
prices if they believe issuers are using their information
advantage to sell overvalued notes.
Corporate debt issuers have an incentive to issue overpriced notes because mispricing gains accrue to the shareholders. Furthermore, these issuers often have some
discretion in the timing of their issues that would permit
them to exploit mispricings. However, the value of most new
corporate bonds and notes is relatively insensitive to inside
information because the notes involve very low risk. Hence,
the maximum possible mispricing gains are usually small.2
Municipal project managers may also gain some operational
flexibility by issuing mispriced debt issues that have too low
a promised interest payment given their risk; hence, they
have some incentive to time their issues to coincide with
market mispricings. However, the incentive for municipal
projects to issue mispriced notes is likely to be lower since
the persons responsible for the issue are in a weaker position to capture part of the mispricing gains. Further, municipal projects often require some legislative approval, a
stipulation that could sharply reduce the managers’ scope
for timing an issue. Investors in capital notes, by contrast,
should have minimal concern about the FDIC manipulating
the timing of its note issues, given that the proposal leaves
little discretion about timing. The FDIC may have some discretion over the amount of each issue, but the directors of
the FDIC have very little ability to capture any rents associated with mispriced notes.
Liquidity Premium. An important component of note
pricing is investors’ beliefs about their ability to sell the
notes in the secondary market at a price that fairly approximates the notes’ true value. While some investors buy notes
with an intention of holding them until maturity, others plan
on selling their holdings before the note matures. Further,
even those investors that plan on holding notes until maturity will place positive value on the option of being able to
sell their holdings before they mature. Thus, if two notes differ by only their expected liquidity in the secondary market,
the note that promises a more active secondary market will
require lower yield.
Notes and bonds tend to have far less active secondary
markets than comparable stock issues, in large part because
many investors follow a “buy and hold” strategy. The lack of
a secondary market may be less important in short-term
issues than in the longer ten- to thirty-year bonds. Shorter
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
maturity issues, such as with capital notes, allow “buy and
hold” investors who want to cash out of the notes to receive
their investment back from the issuer on a shorter time
scale. Thus, the liquidity of capital notes is likely to be less
important to their pricing than the liquidity of longer term
securities would be.
When financial economists are analyzing the pricing of
various bonds, a common proxy for the probable depth of the
secondary market for a bond is its issue size. Corporate
issues generally range from tens of millions of dollars to over
$1 billion (in rare cases involving longer-term bonds), with
larger corporations often issuing amounts exceeding $100
million. The size of some municipal revenue bonds exceeds
$100 million, but many revenue bonds have a par value
under $10 million.3 The amount of capital notes to be issued
will be determined by the FDIC, in large part based on liquidity considerations. The ability to issue up to $8 billion will
give the FDIC considerable flexibility; for example, if the
agency issued the full $8 billion, sold notes every six months
with each sale consisting of five issues maturing annually
over the next five years, then each issue could be over $250
million.4 Thus, based on the issue’s size, the liquidity premium on capital notes may not be any larger than on comparable corporate or revenue notes (after tax adjustment).
Risks about the Amount and Timing of Payments. In
most cases, payments received by noteholders fairly reflect
borrowers’ ability to make full and timely payments in accordance with their debt contract. However, under certain circumstances, noteholders may not receive full and timely
payments even though the note issuer has the economic
capacity to make the payments. Conversely, in rare cases
noteholders may receive larger and more timely payments
than the economic capacity of the issuer would permit.
Investors will demand a risk premium to cover the potential
that the issuer will default for reasons other than economic
capacity, and they will accept a lower rate to the extent that
they anticipate a bailout should the note issuer become
unable to pay. Both types of distortions will reduce analysts’
ability to use note rates to identify the changes in a note
issuer’s economic ability to pay.
Corporate notes have limited exposure to both distortions. Corporations have used bankruptcy proceedings to
avoid honoring burdensome obligations (usually labor contracts or obligations arising from civil suits). Corporations
also have a very small possibility of receiving a government
(national or local) bailout if the political authorities are
unwilling to accept the consequences of a bailout. However,
the main source of distortion may be unpredictable deviations from the absolute priority rule in bankruptcy proceedings. Corporate obligations typically provide for varying
degrees of seniority if the firm should fail, but this seniority
is often not followed strictly; for example, equityholders may
receive a payment even though the junior creditors are not
fully repaid.5 Some deviations from absolute priority are
likely to be anticipated ex ante by noteholders, but certain
classes of creditors may receive unexpected gains or losses
due to unexpected deviations from absolute priority.
Municipal revenue bonds and notes may also suffer
from both types of distortions. Local political authorities
may change the ground rules that govern a project’s operation in a way that reduces the revenues (for example, by
allowing more competition) or increases the expenses associated with a project. Conversely, they may bail the project
out by using other sources of revenue.
Capital notes are subject to both possible risks. The
FDIC could suspend payments on the notes by borrowing
from the U.S. Treasury when other resolution methods may
have reduced the FDIC’s outlays for failed bank resolutions.
Similarly, Congress could appropriate taxpayer money to
cover FDIC losses even though the losses could have been
covered by current and future bank insurance premiums.
The one important difference between capital notes
and the other two types of notes is that a suspension of payments on the other notes may trigger a loss of managerial
control. The bankruptcy court will assume control over the
major decisions made by a corporation or municipal project
in bankruptcy, and the owners and managers of a corporation may lose total control of the firm in bankruptcy proceedings. Hence, the managers of corporations and
municipal projects face potentially large costs if they enter
2. See Smith (1986) for a survey of empirical studies of corporate security issuance.
3. In a study of municipal general obligation bonds, Kidwell, Koch, and Stock (1987) examine the reoffering yield on bonds issued
between 1978 and 1980. They find that the reoffering yield on issues of less than $15 million is influenced by state-specific factors but
that larger issues seemed to be sold into a national market.
4. The total number of issues outstanding at any given time would be thirty. At any given time five issues would mature in six months,
five issues in one year, four issues in one and a half years, four issues in two years, three issues in two and a half years, three issues in
three years, two issues in three and a half years, two issues in four years, one issue in four and a half years, and one issue in five years.
5. For a recent analysis of absolute priority rule violations see Longhofer and Carlstrom (1995).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
27
B O X
2
( C O N T I N U E D )
into bankruptcy to defer, reduce, or eliminate payments to
noteholders. The FDIC loses no control rights over the insurance fund if it borrows from the Treasury or receives a congressional appropriation to cover losses under the capital
notes proposal. If the FDIC did borrow from the Treasury, it
would be subject to some costs, and the automatic increase in
bank insurance premiums would probably generate political
heat for the FDIC; however, these costs are likely to be less
than those faced by corporate and municipal note issuers.
Similarly, Congress may face political opposition to an “unnecessary appropriation” of funds to cover FDIC losses.
Thus, the odds of note payments being adjusted for
noneconomic reasons appears to be greatest for capital
notes. However, these risks would seem less likely to be
priced in to the notes if the FDIC fund appears to be very
strong and shows little probability of default for economic
reasons. If the insurance fund faces minimal resolution costs
relative to its existing fund, then the FDIC and Congress
would have to manufacture a situation that would justify
suspension or termination. However, as the cost of resolving
failures rises relative to the size of the insurance fund, so
does the ability of the FDIC and Congress to justify suspensions and terminations of note payments. If the fund is in
sufficient financial distress, relatively small changes in the
assumptions about liquidity needs and resolution costs may
be sufficient to justify suspension or termination of interest
payments. Thus, if default for noneconomic reasons has any
significant impact on capital note pricing, it is most likely to
be at a point when the probability of the FDIC needing a loan
or congressional appropriation has become significant but
such actions are not yet a certainty. The implication of this
analysis is that if a significant premium is required for these
nondefault risks, it will tend to accentuate the notes’ sensitivity to economic default risks.6
Expected Pricing of Capital Notes
The above analysis suggests that the pricing of capital
notes would probably be similar to that of similar corporate
and municipal revenue notes after adjusting for tax differences, with comparable default risk ratings. According to
this analysis, corporate notes seemed least subject to various nondefault risks. Corporate notes may have slightly
higher risk premiums because of the risk that their issuers
have superior information, but otherwise corporate notes
have equal or lower risk levels (for any given note rating
class). Capital notes may have more political risk than
municipal revenue notes in some cases, but otherwise their
risk premiums would appear to be equal or lower than comparably rated revenue notes. Thus, this analysis indicates
that, to a first approximation, capital notes with low default
risk ought to trade at rates somewhere between comparably
rated corporate notes and revenue notes, after adjusting for
their varying tax status.
6. An offsetting influence would be the potential for a congressional bailout of the capital noteholders. However, the noteholders’ case for
a bailout is weakened by the fact that they are being paid to bear this risk. Further, noteholders’ prospects for a bailout are likely to be
unclear until the need for a congressional appropriation to cover FDIC losses becomes apparent. Thus, if noneconomic risks are significant, the risk that noteholders will get less than they deserve will probably dominate when the FDIC fund’s condition first starts to
deteriorate. This situation implies that capital notes will be sending the desired signal while there may still be time to reduce the fund’s
losses. However, changes in the note rate may be a less reliable indicator of the FDIC fund’s condition in the later stages of financial
deterioration when the fund becomes very weak.
28
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
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Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
What’s Really New about
the New Forms of
Retail Payment?
W I L L I A M R O B E R D S
The author is a research officer and senior economist in
charge of basic research in the Atlanta Fed’s research
department. He thanks Gerald Dwyer, Robert Eisenbeis,
Charles Kahn, Frank King, Bruce Smith, and Larry
Wall for helpful conversations and comments on earlier
drafts.
T
O MOST
AMERICAN
CHARGE.”
THIS
CONSUMERS, THE WORD PAYMENT IS SYNONYMOUS WITH “CASH, CHECK, OR
FAMILIAR TRIAD IS NOW BEING AUGMENTED, HOWEVER, WITH A VARIETY OF
ALTERNATIVE PAYMENT METHODS, INCLUDING DEBIT CARDS, REMOTE BANKING, STORED-VALUE
OR “SMART” CARDS, AND “ELECTRONIC CASH.”
There is much that is new about these alternative
methods of payment, which have come about through the
widespread availability of technologies that were unavailable even a decade ago. The apparent novelty of some of
these new forms of payment has led some observers to
conclude that the new forms will be different from the old
not only in a technological but also in an economic sense.
For example, one recent analysis offered readers the following warning: “Don’t think the differences between traditional currency and the coming electronic versions are
as superficial as updating our economic lexicon. The
changes underway in our monetary system will fundamentally alter how consumers interact with businesses
and how businesses interact with one another” (Flohr
1996, 74).
While such a prediction may hold true in some limited respects, it would be difficult to believe that the costly
lessons of economic history are not relevant for electronic
payments. This article examines the question of whether,
from the standpoint of economic theory, there is or will
likely be anything new about these new forms of payment.
The discussion begins with a description of some of the
conflicts of interest that confront all types of payment sys-
32
tems in market economies. The article then considers in
some detail why traditional forms of payment, such as
checks and banknotes, represent reasonable solutions to
these conflicts of interest and outlines some shortcomings
of the traditional forms. The article also analyzes the economic characteristics of the new forms of payment and
explains why they differ little and in some cases not at all
from more traditional forms. Finally, the article briefly
considers some of the policy issues raised by the introduction of the new payment methods.
The Conflict of Interest between
Buyers and Sellers
arious forms of payment have evolved as a means of
resolving the natural conflict of interest between
buyers and sellers of goods (or services). In developed economies, a buyer of a given commodity only rarely
possesses a commodity that a seller wishes to consume.
In the absence of a double coincidence of wants, a buyer
must offer a seller a good that the seller believes can be
used to purchase other goods.
In market exchanges the natural self-interest of the
seller is to provide goods to the buyer in exchange for
V
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
something of equal or greater value. Since the seller is not
directly consuming the good offered in payment, however,
he or she may often have difficulty discerning the quality
of this good. For example, a check written on insufficient
funds looks exactly like a check written on good funds.
This sort of problem, known by the term adverse selection,
has been studied extensively by economists.
Compounding the problem of adverse selection is
the problem of moral hazard. In market exchanges moral
hazard can occur when buyers undertake deliberate
actions, unobservable by the seller, that would undermine
the value of goods the buyer offers in exchange. For
example, a buyer could have sufficient funds to cover a
check written for a certain purchase but then remove the
funds from the account before the check clears.
In market settings the incentive problems of adverse
selection and moral hazard are not necessarily one-sided.
Buyers do not always know the quality of goods and services they are purchasing, and sellers can in many cases
undertake unobservable actions to lessen the value of the
items or services being sold. While these problems are
quite serious in some markets (real estate, for instance),
it can be argued that in most cases such problems are
probably less severe for the buyer than for the seller. It is
inherently easier to judge the quality of groceries, for
example, than to judge the quality of the check used to
pay for the groceries. For this reason, the discussion
below will concentrate on the incentive problems faced
by the seller and not the buyer.
All payment systems must address such incentive
problems by providing timely, accurate information concerning the value of the goods offered in payment. To the
extent that modern electronic technology can improve
the speed and accuracy of communication, such technology can provide less costly solutions to these incentive
problems. The use of technology is unlikely to provide an
automatic solution to these problems, however. For
example, a company offering a news service over a computer network such as the Internet might require payment by some sort of funds sent over the Internet. The
company needs to send the product (news) to its customers immediately in order for the product to have
value. However, even if the customers can send electronic “checks” very quickly over the Internet, the company
still needs to know with a reasonably high probability
whether the checks are good.
The presence of incentive problems leads sellers to
prefer means of payment that provide them maximum
assurance concerning the value of the assets received in
exchange, even in cases where such assurance can be
costly or inconvenient for the buyer. In some cases, the
seller can gain such assurance by withholding delivery of
the good until the value of the payment is verified. In
other cases, such delays are either not feasible (as in the
case of the hypothetical news service described above) or
are uneconomical (as in the case of goods that have a
very small value).
Buyers’ preferences are in many ways opposed to
sellers’. Buyers naturally prefer immediate use of the
goods they have purchased with a minimum of cost and
inconvenience to themselves. Dishonest buyers (those
intentionally offering to pay with something worth less
than the value of
the purchased good)
would prefer that the
The presence of incentive
seller know as little
problems leads sellers to
as possible about the
value of the good
prefer means of payment
offered in exchange,
that provide them maxiand in many cases,
mum assurance concernas little as possible
about their own idening the value of the assets
tity and financial conreceived in exchange, even
dition. Honest buyers
in cases where such assur(those offering something worth at least
ance can be costly or
the value of the purinconvenient for the buyer.
chased good) would
prefer that sellers
have access to enough information (but generally no
more)to distinguish them from dishonest buyers.
Cash, which today means government-issued currency, provides a time-honored if somewhat imperfect solution
to the buyer-seller conflict. From the buyer’s perspective,
cash is desirable because it is relatively convenient and
almost perfectly anonymous.1 From the seller’s perspective, cash is desirable because it eliminates the need to
evaluate the true worth of assets offered by the buyer.
Despite its time-honored popularity as a transactions medium, cash carries with it its own disadvantages.
Since cash does not bear interest it loses value over time
as long as inflation rates are positive. Holders of cash also
forgo the interest that would accrue if the cash were held
as an interest-bearing asset. Hence, people using cash
pay an implicit tax on their cash holdings as long as interest rates are positive. There are also substantial costs
associated with handling large amounts of cash, and the
anonymous nature of cash encourages theft, counterfeiting, and its use in illegal activities.
Payment by Check Solves One Problem with Another. Since the Civil War, checks have been the principal
alternative to cash for retail payments in the United
1. See, for example, Townsend (1989) or Williamson and Wright (1994) for a formal discussion of the informational role of cash
in anonymous transactions. Cash also serves as a numeraire, that is, a good whose price is always equal to one and therefore
can be used to determine the relative prices of other goods.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
33
States. While checks have been a successful payment
mechanism, the use of checks to resolve the buyer-seller
conflict of interest is in itself somewhat paradoxical.
When paying for a good or service by check, a buyer
transfers a claim on the assets of a bank or similar institution to the seller.2 The check itself represents the transfer of a fixed-value debt claim (deposits) on the assets
of the bank on which the check is drawn. In most cases,
the writer of the check does not know the “true” or market value of the bank’s assets. Thus, payment by check
apparently compounds one adverse-selection/moralhazard problem (that between the buyer and the seller)
with another (that between the depositor and the bank).
The paradox of payment by check is resolved when a
check is presented to the bank on which it is drawn and
settled by transfer of
some reserve commodity (cash or the
Alternative forms of payment
equivalent) from the
bear their own costs resultbuyer’s bank to the
ing from factors such as
seller or the seller’s
bank. The act of setrisks associated with delayed
tlement is proof to
settlement, the physical and
the seller that the
interest costs of clearing and
buyer does have ownership of sufficient
settlement, the costs of onvalue to pay for the
line verification systems, and
purchase and is proof
the risks associated with
to the buyer that the
assets of the bank are
counterfeiting.
“good,” or sufficient
to fund settlement.
Under current U.S. banking law, the value of virtually all deposits of less than $100,000 is guaranteed by
deposit insurance, so a bank’s ability to exchange a dollar
in deposits for a dollar in cash is effectively guaranteed
for small depositors. For these depositors the act of settlement carries with it no information concerning the liquidity of their own deposit claims. However, checkable
deposits evolved before the establishment of the governmental banking safety net. One can argue that the informational value of settlement was more important prior to
the advent of governmental guarantees. Also, the fact
that many of the (proposed) new forms of payment
involve exchanging uninsured claims on relatively unregulated institutions makes the informational value of settlement potentially critical for these new forms. The
following discussion considers some of the informational
aspects of check-based payment in more detail.
Advantages of Payment by Check. Why should
banks and similar financial intermediaries issue primarily short-term (demandable or zero-maturity) debt in the
form of deposits, and why should people pay for goods and
services by transferring these debt claims? Modern financial theory suggests a number of answers to the first question but has less to say on the second.
34
On the first question, Diamond (1991) offers one
possible explanation. Diamond examines the effect of
debt maturity on the adverse selection problem faced by
the bondholders of a generic firm, who may have difficulty discerning the true worth of the firm’s assets. He
argues that firms holding high-quality (higher-yielding)
assets may wish to restrict their debt issue to short maturities. By showing a willingness to roll over its debt, a firm
can signal its belief that future news about the firm’s
earnings will be good. In some cases, however, Diamond
suggests that the use of short-term debt as a signaling
device can be too costly. If bondholders have difficulty
obtaining accurate information concerning the quality of
a firm’s assets, then the cost of rolling over short-term
debt may force a firm into liquidation, even if the firm is
fundamentally solvent.3
Despite this disadvantage, Flannery (1994) argues
that the issue of short-term debt makes sense for highly leveraged financial firms (those with a high
debt/equity ratio) such as banks. Flannery points out
that a high degree of leverage can induce a sharp conflict of interest between a firm’s debt- and equityholders, even when debtholders (such as depositors) have
good information concerning the quality of the firm’s
assets. The issuance of short-term debt can help to
ameliorate this conflict of interest, from the viewpoint
of the debtholders, by limiting the firm’s ability to
acquire assets that are too risky. In the case of financial
firms, this feature of short-term debt is especially useful because financial firms’ assets (for example, bank
loans) are subject to many risks that cannot be controlled by contracts or covenants.
Another justification for banks’ issuance of shortterm debt is described by Calomiris and Kahn (1991),
who emphasize the role of short-term debt in controlling
the moral hazard risk faced by depositors in the absence
of deposit insurance. In the event that a bank becomes
insolvent and has to be liquidated, holders of bank debt
face (again, absent deposit insurance) the risk that the
bank’s management will undertake actions to dilute the
value of the debtholders’ claims.4 By issuing debt that is
redeemable in cash on demand at par (at some prespecified value), Calomiris and Kahn argue that banks give
debtholders the option of forcing the bank into liquidation early, before the value of the debtholders’ claims can
be diluted. This “put option” feature of bank deposits
increases people’s willingness to hold bank debt in the
presence of moral hazard risk.
In summary, each of the analyses cited above provides a strong rationale for banks’ issuance of primarily
short-maturity or puttable (demandable at par) debt.
Issuance of demandable or short-maturity debt helps to
ameliorate the conflicts between bank debtholders
(including depositors) and equityholders (or bank management) resulting from leverage, adverse selection, and
moral hazard. Other things being equal, these conflicts
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
can be minimized if depositors know they can walk into
their bank at any time and exchange their deposit claims
for a fixed amount of cash.5
In modern banking systems depositors do not have to
rely solely on the demandable nature of bank debt for protection of their interests. Banks in most developed countries are supervised and regulated by governmental
agencies, whose mission is to limit banks’ risk-taking
behavior. While the par demandability of most bank
deposits is required by law, the deposits themselves are
usually backed by a governmental safety net of deposit
insurance and, if necessary, by banks’ direct access to
central bank credit via a discount window or a similar
lending facility. It is worth noting, however, that, despite
these more recent developments, the nominal form of the
deposit contract has not changed for hundreds of years.
This fact suggests that par demandability of deposits continues to be important in reassuring depositors that their
interests are being protected.6
On the second question—why people pay for goods
and services by transferring short-term debt claims—
Calomiris and Kahn (1991, 509) suggest that the puttable
feature of bank debt makes it a natural choice for use in
transactions. For the reasons outlined above, bank debt
must be essentially demandable at par. It would then
seem there is little to be lost, and much to be gained, if
bank debt claims are transferred from buyer to seller and
then immediately redeemed. In other words, the convention of payment by transfer of bank debt that is demandable at par simultaneously solves two information
problems by providing a high degree of assurance to
depositors concerning the quality of bank assets and to
sellers concerning the value of claims (for example,
checks) they have received in exchange.
Payment by transfer of bank debt therefore constitutes a “natural” solution to the two-dimensional conflict
of interest between banks and depositors and between
buyers and sellers. In this sense it is not surprising that
the U.S. payments system historically evolved so as to
emphasize transfers of claims on banks (such as checks)
as an alternative to cash payment. However, the term
natural in this instance does not mean inevitable. There
are many examples, both historical and contemporary, in
which leveraged financial firms have issued large
amounts of par demandable debt without such debt being
used as a transactions medium. Calomiris and Kahn
(1991, 509) note that the debt of Roman banks was
demandable but not accepted as a form of payment. Wall
(1989) and Flannery (1994, 321) point out that the debt
of modern finance companies is often puttable or contains put-option-like features designed to protect
debtholders. However, such debt is not commonly accepted as a transactions medium.
Economic history also provides many examples in
which debt used as a medium of exchange was not shortmaturity or demandable. Longer-maturity notes known
as bills of exchange were widely used as a form of payment among merchants until the twentieth century (see,
for example, Braudel 1982, 138-48, or Cuadras-Morató
and Rosés 1995). There were certain difficulties associated with this practice, however. The most critical problem was that, in the event of a default by the party on
which the bill was drawn, the legal recourse of those parties who had accepted the bill as payment was in many
cases quite limited. Consequently, in cases in which the
bill issuer defaulted, parties (other than the issuer)
using the bill as a means of payment were expected to
provide payment by some other means. In practice this
drawback led to such bills being used for payments only
between parties who had long-standing business relationships or other grounds to trust one another’s ability
to pay.7
2. Throughout the article the term bank will be used to indicate both banks and other depository institutions (such as thrifts and
credit unions) that offer similar services.
3. In some cases, however, such liquidity problems can be overcome via a lender-of-last-resort arrangement. See, for example,
Kahn and Roberds (1996).
4. In the vernacular, such actions are described by the phrase “take the money and run.”
5. A downside of par demandability of bank deposits is that it can lead to bank runs. However, in Calomiris and Kahn’s view, in
the absence of regulation runs may be necessary in order to control moral hazard risk.
Various other rationales have been offered for demand deposits. For example, Jacklin (1987) suggests that demand deposits
can work as a sort of insurance contract against the risk of depositors having to consume earlier rather than later. Gorton and
Pennacchi (1990) hypothesize that the demandable nature of deposit contracts may help to insulate depositors from adverse
fluctuations in the market value of banks’ assets when such fluctuations result from inaccurate information about banks’
future earnings. However, in contrast to the theories described in the text, these theories do not suggest why bank debt would
have a natural role as a transactions medium.
6. The idea that deposit contracts naturally tend to take the form of demandable debt is reinforced by recent experience with
money market mutual funds, as described in Collins and Mack (1994). In theory, these funds differ fundamentally from banks
because (1) they are required to hold a narrow class of short-term, liquid assets and (2), in contrast to bank deposits, the value
of each share in the fund is marked daily to the market value of the fund’s assets. In practice, certain funds’ stated share
values have at times diverged from the market value of their assets, causing their shares to be viewed more like debt deposit
contracts.
7. Prepaid phone cards represent a modern-day example of a transactable debt instrument that cannot be converted to cash on
demand. Naik (1996) recounts various problems that have been associated with the use of these cards.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
35
Traditional Alternatives to
Cash and Check Payments
ayment by check has many drawbacks, some of
which are described below. Attempts to circumvent
these difficulties have led to the use of other forms
of payment. This section will describe some traditional
alternatives to check payment.
Credit Transfers. An obvious drawback to check
payment is that checks do not constitute “good funds”
unless they have been cleared and settled. The gap
between payment and settlement poses a risk to a seller
if the seller delivers goods or services before a check payment becomes final. In some countries this drawback of
checks has contributed to the disuse of checks and the
predominance of giro or credit transfers.8
In giro transactions the buyer of a good or service
initiates payment by instructing her bank to arrange for
the appropriate sum to be debited from her own account
and credited to the seller’s bank account. Provided that
the seller does not deliver a good or service until payment
has been made, this form of transaction eliminates some
of the risk the seller faces at a cost of less convenience to
the buyer. Historically, giro transactions have not been
widely employed at the retail level in the United States.9
Banknotes. Another disadvantage of payment by
check is that the clearing and settling of checks entails
substantial costs such as physical costs of clearing and settlement and costs associated with the use of non-interestbearing reserves in settlement. If each check transaction
had to be settled one-for-one by transfer of non-interestbearing reserves, checks would bear the same implicit tax
as cash. If some checks can be settled on a net basis or
through correspondent arrangements, then the use of
checks can economize on the use of reserves. However,
the requirement that every check transaction be cleared
and settled means that payment by check still imposes
some implicit tax, though obviously less than if the same
payments were made with cash.10
Some of the costs associated with clearing and settling checks can be abated by the use of privately issued
banknotes. Although such banknotes are no longer used
today, they were widely used in the United States during
earlier periods. The term banknotes refers to bank-issued
debt that is issued in circulating or “bearer” form and is
convertible on demand into cash.11 From the standpoint
of a seller of goods and services, the key distinction
between checks and banknotes is that the latter is a debt
claim issued directly by the bank and not a transfer of a
debt claim initiated by a buyer. Banknotes also differ from
government-issued fiat currency because their value
derives from the value of the private issuer’s assets and
not from the monetary authority of a sovereign government. As long as a banknote cannot be counterfeited and
as long as a seller believes that the note-issuing bank is
willing to exchange its notes on demand for cash, then
banknotes can resolve the conflict between buyer and
P
36
seller by making the buyer’s creditworthiness essentially
identical to that of the issuing bank. And as long as other
people are willing to accept a banknote in exchange at its
par value, there is no need for each transaction to be settled by exchange of cash. This feature of banknotes
makes them particularly useful for transactions in which
the time or money cost of clearing and settlement makes
payments by check impractical.
In theory, banknotes can circumvent the conflict
between buyer and seller by creating a form of deposit
that does not have to be cleared and settled through the
banking system in order to be useful for transactions. In
practice, however, the use of banknotes as a transactions
medium has been associated with at least two serious
problems.
First, the issue of banknotes does not in and of itself
resolve the conflict (discussed in the previous section)
between holders of the issuing institution’s debt (for
example, noteholders and depositors) and the institution’s equityholders or managers. If banking laws, regulations, and customs insufficiently restrain the ability of
equityholders and/or management to dilute the value of
debtholders’ claims, then a payments system based on
banknotes can be ineffective. However, history suggests
that it is possible to create systems of banking practices,
laws, and regulations that would provide noteholders
with a high degree of confidence in the value of the banknotes.12 The effect of these restrictions has often been to
place strict restraints on the types of assets that can be
used to back banknote issues.13
Second, the relatively anonymous nature of banknotes also introduces a new dimension of risk into market
transactions—the moral hazard associated with counterfeiting activities. If banknotes are issued in untraceable
bearer form, then this anonymity provides strong incentives for counterfeiting.14 If counterfeit notes are accepted by sellers and presented to the issuing institution,
then the institution faces a difficult choice. If the issuer
fails to redeem the counterfeit notes, then it may undermine public confidence in the value of its legitimate
notes. On the other hand, if the issuer redeems the counterfeit notes it must absorb the resulting loss, again possibly undermining public confidence in its notes.
As is the case with cash, the anonymity of banknotes
carries with it certain other advantages and disadvantages. The advantages include convenience and privacy
during transactions, and the disadvantages include
encouragement of theft and illicit activity.
In the United States, banknotes circulated widely
until the Civil War and continued to circulate until 1935.
During the Civil War, banknotes issued by institutions
other than national (federally chartered) banks were
essentially taxed out of existence, and stringent regulations were placed on the issue of notes by national banks
(see Timberlake 1993, 86-88; Friedman and Schwartz
1963, 20-23). The legal authority for issue of banknotes by
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
national banks expired in 1935 (Friedman and Schwartz
1963, 422).15
Debit Cards and Credit Cards. Credit cards and
debit cards represent more recent alternatives to the use
of checks and cash.16 Debit card transactions are functionally similar to check transactions.17 When a buyer
pays for a good or service using a debit card, the buyer
authorizes the seller to transfer funds from the buyer’s
account to the seller. There is an important distinction,
however, when debit card transactions take place on-line.
In on-line transactions, funds are immediately deducted
from the buyer’s account. This immediacy provides sellers with almost complete assurance against the moral
hazard and adverse selection risks associated with check
clearing and settlement.18
However, this assurance comes at a cost. The costs of
constructing and maintaining a dedicated on-line verification system makes this form of payment inefficient for
some small-value transactions. Caskey and Sellon (1994,
90) report that the direct cost of on-line debit card payments for small-value (grocery store) transactions is
slightly less than the cost of check payments but still substantially greater than the cost of cash payments. And,
because the on-line system directly accesses buyers’ bank
accounts, each on-line debit card transaction has to be
authorized by the buyer, typically by entering a PIN (personal identification number) at a retail terminal.
Credit card transactions superficially resemble debit
card transactions but are different in terms of their eco-
nomic function. As with on-line debit cards, sellers of
goods and services usually accept credit cards in payment
only after the transaction has been authorized by an online verification system. The distinguishing feature of credit card transactions is that they do not represent a direct
transfer of funds between buyer and seller. Rather, funds
flow from the card-issuing institution to the seller. The
card issuer is then responsible for collecting the debt
incurred by the buyer. The problem of judging the creditworthiness of the buyer is thus transferred from the seller
to the card issuer. While credit cards are a convenient and
relatively secure means of payment, Caskey and Sellon
(1994, 90) report that using a credit card is by far the most
expensive method of payment for small-value transactions.
New Forms of Payment
he foregoing discussion suggests that there is much
room for improvement in the area of retail payments. Cash is convenient and anonymous, but it
bears an implicit tax and is subject to theft and illicit use.
Various alternative forms of payment bear their own costs
resulting from factors such as risks associated with
delayed settlement, the physical and interest costs of
clearing and settlement, the costs of dedicated on-line
verification systems, and the risks associated with counterfeiting. These problems, combined with the advent of
new computer and communications technologies, provide economic incentives for the creation of new methods
of payment.
T
8. This practice has been most notable in Germany. See, for example, Bank for International Settlements (1993, 161-62).
9. In recent years electronic credit transfers have been widely used for certain other types of payments, however, such as direct
deposits of payrolls, government benefit payments, and corporate payments to vendors and contractors. See Bank for
International Settlements (1993, 442).
10. Checkable accounts in the United States have also been subject to a legal reserve requirement. See Feinman (1993) for a historical summary of reserve requirements in the United States. Prior to the Federal Reserve System’s involvement in the check
payments system, it was common for banks to pass along the costs of check clearing and settlement by discounting the value
of checks drawn on other banks. Duprey and Nelson (1986) present a detailed description of this practice, known as nonpar
banking.
11. In this article the term banknotes will refer only to circulating notes issued by commercial banks or other private institutions.
Currency issued or backed by governments or central banks will be referred to as cash.
12. See, for example, Dwyer (1996) for examples of both types of regime from the U.S. Free Banking Period (1837-65).
13. White (1995) traces the pre-Civil War history of various devices employed by state governments to protect the interests of banknote holders, including restrictions on minimum denominations, state-sponsored insurance plans, and restrictions on asset
holdings. Broadly speaking, placing restrictions on asset holdings seems to have been the most efficient mechanism.
Williamson (1989) and Champ, Smith, and Williamson (1996) point out that the Canadian experience with banknote issue
was quite different from the U.S. experience. In Canada, banks were historically able to issue banknotes against general assets.
The value of these notes was backed by cooperative agreements among banks that would have been difficult to implement
under U.S. banking laws.
14. The incentive to counterfeit also exists with government-issued currency. However, the likelihood of successful counterfeiting
is greater if there a large number of private issuers of banknotes.
15. According to Lacker (1996), however, most of the Civil-War-era legal restrictions on banknote issue have been repealed by
recent banking legislation.
16. In this section, the term debit card does not apply to “stored-value” or “smart” cards, which are discussed below.
17. That is, both checks and debit cards represent debit transactions as defined in the glossary.
18. Not all debit card transactions are on-line. See Caskey and Sellon (1994) for a discussion of different types of debit card transactions. On-line verification systems can also be used to guard against check fraud and reduce the risks associated with check
payments.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
37
It is impossible to predict exactly which of the various new and proposed forms of payment will be successful in the marketplace. A combination of economic theory
and historical experience suggests, however, that whatever the operational features of the new forms, these forms
will function similarly to either checks or banknotes or
perhaps some combination of these. The key economic
attributes of these two traditional forms of payment are
described below and summarized in Table 1.19
The Check Model for Retail Payments. First, the
check model requires that the payment itself be a transfer from the buyer to the seller of a zero-maturity, parvalued debt claim on a financial institution’s assets. As
discussed above, there are numerous theoretical reasons
for payments to take this form.
Second, as is the case with checkable bank deposits,
the institution against which the payment is drawn holds
a diversified portfolio of both short-term, liquid assets
and at least some longer-term, illiquid assets.20
Third, the transactions instrument (check) is considered a liability of the buyer and not the institution on
which it is drawn; the instrument is easily reproducible,
relative to currency.
Fourth, the value of the payment is verified as quickly as possible by clearing and settlement through the
banking system. As discussed above, this step is necessary if claims can be easily reproduced.
Fifth, the payment is not anonymous in the sense
that the act of clearing and settlement reveals the identity of the buyer to both the seller and/or the bank against
which the check is drawn.
The Banknote Model. As with the check model, in
the banknote model the payment itself consists of a
transfer from the buyer to the seller of a zero-maturity,
par-valued debt claim on a financial institution’s assets.
However, the banknote model differs from the check
model in the following ways.
First, the historical experience in the United States
has been that the composition of assets against which
banknotes can be issued has been more tightly regulated
than the assets that are used to back checkable deposits.
For example, during the U.S. Free Banking Period, notes
were generally issued only against certain types of bonds
(see, for example, White 1995 or Dwyer 1996).21
Second, the transactions instrument is considered to
be a liability of the issuing institution and is relatively difficult to counterfeit.
Third, the seller receiving the payment has the
option of verifying its value by presenting it to the issuing
institution for redemption in cash.
Fourth, the payment itself need not reveal the identity of the buyer to either the seller or the issuing bank.
Charts 1 and 2 depict highly stylized examples of
transactions under the two models.22 In Chart 1 a buyer
has funds on deposit at bank A. The buyer purchases
goods from the seller and pays by check. The seller
deposits the check in an account at bank B. B presents
the check to A, which debits the buyer’s account and
transfers reserve funds to B. Finally, B credits the seller’s
account for the amount of the purchase. In Chart 2 a
buyer deposits funds with a bank A, which in turn issues
banknotes. The buyer uses the notes to purchase goods
from another party, the buyer/seller. This process is
repeated potentially many times until a buyer/seller buys
goods from a seller who wishes to exchange the notes for
some other form of money. The seller does this by depositing the notes at bank B. B presents the notes to A, and
receives reserve funds in settlement.
T A B L E 1 Two “Model” Forms of Payment
38
Model Characteristics
Check Model
Banknote Model
Form of Payment
Transfer of zero-maturity,
par-valued debt issued
by a financial institution
Transfer of zero-maturity,
par-valued debt issued
by a financial institution
Backing Assets
Historically,
diversified asset portfolio
Historically,
less diversified, more
liquid asset portfolio
Liability of
Check writer (buyer)
Issuing institution
Immediate Clearing
and Settlement
Required
At the option of the seller
Anonymity
No
Yes, at least for
some transactions
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
The key differences between the two models are easily
seen from the charts. The check model favors security over
anonymity and convenience by involving the banking system
in each transaction. The banknote model offers potential
cost savings because not every transaction has to be routed
through the banking system for clearing and settlement.
Under the banknote model, transactions outside the banking system (for example, those depicted with dashed lines in
Chart 2) are also potentially anonymous, with attendant
advantages and disadvantages. Finally, the fact that not all
transactions are cleared and settled potentially raises the
risks associated with each unsettled transaction.23
The next section analyzes two of the most widely discussed new forms of payment using the two formal models as benchmarks.
Payment with Stored-Value Cards. A stored-value
card is a relatively new form of payment card.24 Storedvalue cards differ from traditional debit cards in the
sense that the card does not provide access to the buyer’s
bank account. Instead, the buyer purchases stored value
with cash or bank funds, and the appropriate amount of
stored value is placed on a card in the form of data on a
magnetic strip or electronic chip. When the card is used
to make a purchase, the amount of the purchase is
deducted from the balance on the card, not from the
buyer’s checking account. Merchants and other receivers
(or their banks) of these stored-value claims then present the claims to the issuing bank (or other institution)
for settlement. Stored-value cards thus can offer potential cost savings over on-line debit and credit card systems to the extent that they eliminate the need for costly
on-line verification of each transaction.
Stored-value cards resemble both checks and banknotes in the sense that the transfer of stored value repre-
sents the transfer of a demandable, par-value debt claim
from buyer to seller. Do these cards more closely resemble electronic checks or electronic banknotes? The
answer depends on the manner in which the stored value
is created and on what happens after the stored value is
transferred from buyer to seller.
If the stored value represents claims on bank assets,
that is, on funds in a bank account, then in this respect
the value placed on stored-value cards represents something closer to traditional checkable deposits than it does
banknote claims. On the other hand, if the stored value
represents a claim on a firm outside the safety net of the
traditional banking system, then it is likely that a special
pool of liquid assets will be maintained in order to back
the stored value. In such cases, stored-value cards would
more closely resemble banknotes.25
Stored-value cards also resemble banknotes to the
extent that the stored value placed on the card represents a liability of the issuing institution. As discussed
above, this feature of stored-value cards is advantageous
in the sense that it can eliminate the need for on-line verification. However, this banknote-like feature of storedvalue cards makes them potentially subject to risks from
counterfeiting.26
Various issuers of stored-value cards have proposed
different rules for clearing and settlement of stored-value
transactions. Some stored-value card systems require
that each stored-value transaction be cleared and settled
through the banking system. This first type of system
more closely adheres to the check model in this respect.
In other stored-value systems, stored value can be transferred from one card to another without clearing and settlement of the transaction; such transactions are known
as peer-to-peer transactions. This second type of system
19. The “check model” and the “banknote model” correspond in a very rough way to the “account-based/notational” and “tokenbased” models of electronic money that have been discussed in the computer science literature. See the discussions in Wayner
(1996, 210-11) or Camp, Sirbu, and Tygar (1995, 1-2).
20. In the history of economic thought there have been numerous theoretical arguments both for and against such maturity mismatches between assets and liabilities. This debate dates back at least to the “currency” and “banking” schools of early nineteenth century Britain. For some more recent contributions see, for example, Flannery (1994, 323-26), who argues that in the
case of banks, such mismatches are likely to occur because of a combination of the effects of leverage and noncontractable risks
associated with bank assets. On the other side, Gorton and Pennacchi (1992) argue that maturity mismatches are unnecessary
for transactions accounts and that short-term transactions liabilities can be backed by short-maturity, liquid assets.
21. Again, it should be noted that in other countries banknotes have historically been issued without such restrictions.
22. The transactions shown in Charts 1 and 2 are meant to serve as examples. Other patterns of transactions are possible in
each case.
23. Absent a reserve requirement, the ability to issue circulating banknotes could lead to an indeterminate increase in the aggregate quantity of outstanding bank liabilities. For a formal discussion of this effect, see, for example, Wallace (1983).
24. For an introduction to the economics of stored-value cards see Congressional Budget Office (1996). See Allen and Barr (1997)
or Zoreda and Otón (1994) for an introduction to the operational aspects of stored-value cards. Stored-value cards that contain an electronic chip (as opposed to a magnetic strip) are commonly called smart cards.
25. McAndrews (1996, 22) argues that the most likely issuers of stored-value cards will be joint ventures involving both banks and
nonbanks. McAndrews argues that one problem that will have to be resolved by such joint ventures is the question of exactly
whose liability is represented by the stored value.
26. The need for protection against counterfeit risk has been underscored by recent experience with stored-value cards in Japan.
There, widespread counterfeiting of stored-value cards led to losses reported to be as great as $500 million. See Glain and
Shirouzu (1996) or Pollack (1996).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
39
C H A R T 1 The Check Model of Payments
Settles
Bank A
Bank B
Presents
Check
Deposits
Funds
Debits
Account
Deposits
Check
Credits
Account
Pays by Check
Seller
Buyer
Provides Goods
or Services
more closely approximates the hand-to-hand transfer of
banknotes from buyer to seller.
There is also a wide range of possibilities concerning
the anonymity of transactions with stored-value cards. If
buyers can purchase stored-value cards anonymously,
then in this respect stored-value cards more closely resemble banknotes. However, this anonymity is compromised
somewhat if each transaction made with a stored-value
card can be traced back to an individual card or to a particular seller. Likewise, if each stored-value transaction
has to be cleared and settled through the banking system,
then this requirement limits the anonymity of stored-value
transactions. On the other hand, if stored-value transactions can take place without the involvement of the banking system, these transactions could be almost completely
anonymous, even if the original purchase of value can be
traced back to a specific issuer or location.
In summary, payment by means of stored-value cards
mimics the banknote model in the sense that the payment instrument represents a liability of the issuing institution and not that of the buyer using the stored-value
card. In other respects, payment by stored-value card can
follow either the check or the banknote models, depending on exactly how the stored value is issued, transferred,
and settled. If the stored-value claim is issued in a
nonanonymous way against bank assets and each storedvalue transfer has to be cleared and settled through the
banking system, then payment by stored-value card
comes close to the check model.27 If stored value is issued
anonymously against a specific pool of backing assets and
can be transferred anonymously without the involvement
of the banking system, then payment by stored-value card
almost perfectly matches the banknote model. Other
types of stored-value systems would probably fall somewhere between these two extremes.
40
Payment with Electronic Cash. A limitation of
stored-value payment systems is their requirement for
specialized cards, computers, and electronic networks in
order to hold and transfer stored value. Another variation
on the stored-value idea would go a step further and eliminate the need for such specialized equipment. Instead,
stored value would be held on nonspecialized computers
and transferred via widely accessible computer networks
such as the Internet. This method of payment has been
given a variety of names, such as electronic cash, digital
cash, electronic currency, electronic coins, and electronic scrip.28 The discussion will use the term electronic
cash, which seems to be the most commonly used. The
term may be somewhat misleading, however, since electronic cash represents claims on the assets of private
institutions and, unlike the paper cash in common use
today, does not have governmental backing.
As is the case with smart cards, electronic cash
resembles traditional, privately issued banknotes in the
sense that it represents a liability of the issuer and not of
the buyer using the electronic cash to make a purchase.
However, in other respects, payment via electronic cash
may conform more closely to the check model than to the
banknote model. For example, electronic cash issued as a
claim on a firm outside the traditional banking system
could be issued either against a specific pool of backing
assets (as in the banknote model) or as a claim on bank
assets (as in the check model).
There are also at least two areas in which technological constraints pose significant challenges to the
ability of electronic cash to conform to the banknote
model. The first is anonymity. Transferring stored value
from one computer to another ultimately involves transferring data from one computer to another. Since data
on computers are readily copied and manipulated, some
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
C H A R T 2 The Banknote Model of Payments
Settles
Bank A
Bank B
Presents Notes
Deposits
Funds
Issues
Notes
Deposits
Notes
Notes
Buyer
Goods
Buyer/
Seller
verification procedure is necessary in order to ascertain
that the transferred data represent a legitimate claim to
stored value. If the verification process involves a third
party (other than the buyer and seller), anonymity
could be compromised. Some innovative techniques
have been proposed to circumvent this problem.29 At
least in theory, these techniques should allow almost
complete anonymity of electronic cash transactions
while simultaneously providing verification of the
stored-value claim.
A second problem with electronic cash has to do with
the issue of clearing and settlement. To perfectly emulate
the banknote model, electronic cash should allow for
peer-to-peer transactions between buyer and seller that
do not require clearing and settlement through the banking system. If, however, the security of electronic cash is
such that a seller cannot discern the legitimacy of an
electronic cash transfer, then mandatory clearing and
settlement of each transaction through the banking system may be necessary.
As with stored-value cards, the bottom line for electronic cash payments is that they can follow the banknote model, come close to approximating the check
model, or fall somewhere between these two extremes. It
seems clear, however, that in economic terms neither
Credits
Account
Notes
Seller
Goods
stored-value cards nor electronic cash represent radical
departures from traditional modes of payment.
Old versus New Forms of Payments:
Some Caveats
hile most traditional forms of payment evolved
in relatively unregulated environments, the contemporary use of these forms is governed by a
large and well-established body of laws and regulations.
The purpose of these laws and regulations is to protect
the public interest, more generally, and often the rights of
consumers and small depositors, more specifically. While
in some cases these laws and regulations apply to some of
the new forms of payment, in other cases their applicability is at best ambiguous. A complete discussion of
potentially applicable banking laws and regulations is
beyond the scope of this article. But the potentially large
impact of banking laws and regulations on the new payment forms merits a brief survey of some of the relevant
legal and regulatory issues.30
The first and perhaps most crucial question is
whether entities other than banks have the legal right to
issue transferable liabilities in the form of, say, storedvalue cards or electronic cash. Current U.S. law limits the
ability of nonbanks to offer deposits and limits the ability
W
27. Formally, such stored-value cards most closely resemble traditional travelers checks or cashier’s checks, which in contrast to
ordinary checks are considered liabilities of the institution on which they are drawn.
28. On the details of various existing and proposed forms of electronic cash, see, for example, Chaum (1992), Congressional Budget
Office (1996), Flohr (1996), and Wayner (1996).
29. The most prominent of these innovations is Chaum’s (1992) technique, based on the idea of “blind signatures.” Digital blind
signatures allow both a buyer and an electronic-cash issuer to “sign” electronic cash in a way that is verifiable to the signer
and to other designated parties but is unobservable and irreproducible by other parties.
30. The discussion below borrows heavily from U.S. Department of the Treasury (1996, apps. 14) and Congressional Budget Office
(1996, chap. 4). The reader is referred there for more detailed discussions of legal and regulatory issues.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
41
of nonbank depository institutions to make commercial
loans. If new forms of transactions liabilities were to be
seen as deposits, these laws would also apply to nonbank
firms offering these new types of liabilities. Whether or
not various new forms of payment legally constitute
deposits is not entirely resolved, although the Federal
Deposit Insurance Corporation recently ruled that most
types of stored-value cards are not deposits for insurance
purposes (see FDIC 1996).
From a regulatory viewpoint, the distinction
between bank and nonbank issuers of new forms of transactions liabilities is also important. Banks and bank holding companies are subject to both specialized laws and
regulatory oversight designed to limit their risk exposures. In return, banks and their depositors are protected
from potential losses by the safety net afforded by federal deposit insurance and by banks’ access to the Fed’s discount window. In the case of bank-issued transactions
liabilities, at least some of these restrictions and assurances could carry over to the newer forms. Transactions
deposits at banks are also subject to a legal reserve
requirement, which mandates that banks maintain a certain percentage of their transactions deposits as either
cash or non-interest-bearing accounts at the Fed. As of
this writing, it appears likely that balances on storedvalue cards issued by banks will be subject to reserve
requirements (see Blinder 1995).
By contrast, nonbank issuers of new types of transactions liabilities could or could not largely be free of the
restrictions and oversight required by state and federal
laws. Some exceptions to this statement might occur if a
nonbank issuer were owned by a bank or bank holding
company. It is also unlikely that the coverage of the federal safety net would extend completely to nonbankissued transactions liabilities.
Another important question has to do with applicability of the rules governing the validity of electronic
funds transfers. For retail payments, these rules are provided by the Electronic Funds Transfer Act of 1978 and
the Federal Reserve System’s corresponding Regulation E.
Regulation E also requires extensive disclosure of information to consumers regarding their rights and obligations when using various forms of electronic funds
transfer. Currently, the applicability of Regulation E to
various new forms of payment is uncertain. In the case of
stored-value cards, for example, the Fed has proposed
exempting from Regulation E all cards containing no
more than $100 as well as all stored-value cards that are
off-line and that do not track individual transactions (see
Board of Governors 1996).
A final area of regulatory ambiguity results from
potential conflicts between the putative anonymity of
42
some of the new forms of payment and the reporting
requirements of federal anti-money-laundering laws.
These laws currently impose extensive record-keeping
requirements on financial institutions for certain types of
transactions, especially those that involve exchanging
cash for other types of liabilities. The general applicability of these laws to the new forms of transactions liabilities is again uncertain.
Conclusion: The More Things
Stay (Virtually) the Same
he advent of various new electronic forms of payment cannot be described as revolutionary. The
new types of payments are better described as evolutionary adaptations of some older forms of payment—
checks and banknotes—to modern communications
technology.
Since the new forms of payment do not really represent anything particularly new from the standpoint of
economic theory, it seems likely that the same policy
issues that apply to the creation of checkable deposits
and to the issue of banknotes will apply to the creation of
the new forms of payment liabilities. Among the most
critical open policy questions are the following:
First, should institutions not regulated as banks be
able to offer the same types of transaction services as
banks—that is, should there be “free” electronic banking?
Second, if the answer to the first question is yes,
what are the rights and responsibilities of nonbank
providers of transactions services? In particular, to what
extent should existing banking laws apply to these nonbank providers? And what should be the responsibility of
the public sector toward these nonbank providers, particularly in the case of a failure of a provider or a more widespread liquidity crisis?
Third, should banks and other providers of transactions services be allowed to create electronic liabilities
with some characteristics of circulating banknotes? And
what restrictions, if any, should apply to these liabilities?
Fourth, is it necessary to impose a non-interestbearing reserve requirement on all transactions liabilities
in order to maintain a stable overall level of prices?31
Aside from the occasional interjection of the word
electronic, these are classical questions of monetary economics. These questions were widely debated in the nineteenth and early twentieth centuries, but by the
mid-twentieth century they had been resolved, at least in
a policy sense, in favor of the regulated form of banking
that we are familiar with today. If the new types of payments become popular enough to force these same questions to be asked again, it will be interesting to see if the
same answers emerge.
T
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
Glossary
Adverse selection: a condition that exists in economic situations when a meaningful attribute of one party (say, the
creditworthiness of a borrower) is unobservable by another
party (say, a lender).
Banknote: for the purposes of this article, a debt obligation
issued by a bank (or some other private institution) that the
issuer promises to redeem in a prespecified amount of cash
on demand and that is intended to circulate in bearer form.
Bill of exchange: an order from one party (for example, a
buyer of a good or service) to another party (often a bank)
to pay a certain amount of money to a third party (often a
seller of a good or service) on a certain date. In contrast to
checks, bills of exchange are not demandable at par value.
Cash: for the purposes of this article, either (a) governmentissued fiat money, as circulates in virtually all countries
today, or (b) specie or government-backed claims to specie,
as circulated in many countries prior to the 1930s.
Check: an order from one party (for example, a buyer of a
good or service) to another party (usually a bank) to pay a
certain amount of money to a third party (often a seller of a
good or service) on demand.
Clearing: the process by which a payment order (such as a
check) moves to the bank on which it is drawn, prior to settlement.
Credit card: a card that indicates that the holder has access
to a line of credit with a bank or other institution. The line
of credit can be used to make transactions up to a limit; the
balance on these transactions is then paid off by the card
holder.
Credit transaction or giro transaction: a transaction in
which the order to pay moves from the bank of the buyer of
a good or service to the bank of the seller. Examples of credit transactions include the giro transactions that are commonly used in many European countries and direct payroll
deposits in the United States.
Debit card: a card that allows the holder to make transactions by accessing funds on her account with a bank or sim-
ilar institution. Differs from a credit card on which funds are
first spent down and then paid off.
Debit transaction: a transaction in which the order to pay
moves from the bank of the seller of a good or service to the
bank of the buyer. Examples of debit transactions include
payments by check or by debit card.
Demandable at par: a condition of debt claims that are puttable at any time at par (face) value. For example, today virtually all checks are demandable at par.
Electronic cash: a par-valued debt claim on a bank or other
institution designed to be used as a means of payment over
the Internet or other nonspecialized computer network. Also
called electronic scrip, electronic currency, and electronic
coins.
Moral hazard: a condition that exists in economic situations in which one person can undertake actions to her own
benefit and to the detriment of other people without such
actions being observed.
Put option: an option contract that entitles its holder to sell
or “put” an asset at a prespecified price.
Puttable debt: debt that can be resold to its issuer at a prespecified price.
Smart card: a type of stored-value card on which the relevant account information is stored on a computer chip.
Stored-value card: a type of payment card on which the relevant account information is accessible from the card itself
in the form of data stored on a magnetic strip or computer
chip.
Settlement: an act that discharges obligations between two
parties. For example, when one bank presents another bank
with a check drawn on a depositor’s account, the latter bank
can settle this obligation by transferring an equal amount of
reserve funds to the former.
——————————————
Adapted from Bank for International Settlements (1993) and
Congressional Budget Office (1996).
31. This issue has been raised by numerous theoretical studies—for example, Wallace (1983), Woodford (1990), and Smith
(1991)—that suggest that some sort of non-interest-bearing requirement may be necessary. By contrast, Goodhart (1993)
argues that non-interest-bearing reserve requirements are not necessary for the conduct of monetary policy, essentially
because of private-sector demand for central bank liabilities as a transactions medium. The Federal Reserve System has strongly endorsed the latter viewpoint; see, for example, Blinder (1995) and Greenspan (1996). For an extended discussion of this
issue, see Roberds (1994).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
43
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45
The Buck Stops Where?
The Role of Limited
Liability in Economics
T H O M A S H . N O E A N D
S T E P H E N D . S M I T H
Noe is an associate professor and Smith holds the
H. Talmage Dobbs Jr. Chair of Finance in the College
of Business Administration at Georgia State University.
Both authors are also visiting scholars in the Atlanta
Fed’s research department.
If you come to grief, and creditors are craving
(for nothing planned by mortal head is certain in this
Vale of Sorrow—saving that one’s liability is limited),
do you suppose that signifies perdition?
If so, you’re but a monetary dunce;
you merely file a winding-up petition,
and start another company at once!
—Gilbert and Sullivan, Utopia Limited
L
IABILITY, OR THE LACK THEREOF, HAS LONG PLAYED AN INTERESTING ROLE IN THE FIELDS OF
ECONOMICS, FINANCE, AND LAW.
FROM EARLY TIMES SOCIETIES HAVE DEBATED WHEN TO SHARE
LOSSES ARISING FROM BAD ECONOMIC OUTCOMES, WHETHER THESE OUTCOMES ARE DUE TO BAD
DECISIONS ON THE PART OF INDIVIDUALS, EVENTS INDEPENDENT OF INDIVIDUAL ACTIONS, OR
SOME COMBINATION OF THE TWO.
In modern societies personal limited liability is the
norm, given such conditions as finite wealth and the
elimination of debtors’ prisons. In fact, over the last few
centuries, many societies have taken this principle further by passing laws that allow investors in banks and
other business enterprises to limit their losses to either
their initial investment (pure corporate limited liability)
or some multiple of their initial capital contribution. This
latter liability structure might call for an additional infusion of funds on the part of investors up to some maximum (say, two times the investment) should an enterprise fail to meet its obligations from available resources.
Bank shareholders, for example, were once routinely
46
required to post at least some additional funds in the
event of a bank failure. This practice ceased only after
the substitution of public capital, in the form of government deposit insurance, for the private capital formerly
used to support the system.1 Overall, changes in liability
provisions, by many accounts, have been among the major
influences on both the level and distribution of contemporary economic output as well as the allocation of financial resources in today’s financial markets.
This article reviews a large and growing literature on
the role of personal and corporate limited liability in the
economy. As early as Adam Smith’s ([1776] 1994) criticism of the emerging joint stock corporations of the eigh-
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
teenth century and Walter Bagehot’s ([1873] 1991) analysis of the reasons for and consequences of the incorporation of the Bank of England in the seventeenth century,
economists have been aware that liability structures,
almost by definition, influence decisions made by households, businesses, and government agencies. This review
attempts to provide a more thorough understanding of
incentive structures under alternative liability regimes
and, in doing so, should help policymakers better understand the possibly unintended effects of certain policies
and programs.
Workers, investors, managers, and policymakers confront limited liability considerations every day. It is therefore useful to look at examples that cover the import of
limited liability on activities ranging from investment,
labor, and financing decisions made by individuals and
corporations to the implementation of discretionary government policies that are intended to promote growth or
redistribution of wealth in the economy. This examination begins with an illustration of some conflicts that may
arise in labor markets because of certain rights, such as
personal limited liability, held by providers of human capital, or the fact that the floor of zero wealth generally
associated with personal limited liability may not be sufficient to sustain productive work. Next is a discussion of
how liability rules influence the incentives of debtors and
creditors at the level of individual corporations and of
how liability structures are important in the investment
and financing decisions of managers, acting as agents for
shareholders. An outline of the role of limited liability in
the relationship between government and private institutions as it relates to economic growth and the provision of
liquidity to the banking system rounds out the article.
Labor Contracting, Limited Liability, and
Subsistence Levels
otential problems arise in labor contracting when
individuals have limited liability and cannot be
forced to work. Another factor to consider with
regard to labor contracting is that the “real” lower bound
for labor income might not be zero but some positive subsistence level.
Limited Liability and the Inalienability of Human
Capital. Limited liability, combined with other basic
rights, can provide those who supply labor an incentive to
“hold up” the owners of a firm. Consider, for example, an
individual whose only wealth exists in the form of human
capital, in particular an idea that may generate future
P
cash flows if he or she expends the required labor input.
This “entrepreneur” might choose to sell the right to
future cash flows generated by this idea to individuals
with current wealth. Since the price of a security represents the present value of potential future cash flows, an
“idea person” needed to make an ongoing contribution
may well have an incentive to attempt to negotiate an
additional share of future output after starting a project
even after having sold the rights to all future cash flows
at the outset. Leverage in such a situation is based on the
facts that a person cannot be forced to work and that he
or she possesses limited liability.2 Furthermore, any
threat by disgruntled shareholders to confiscate assets
may be met with a “take the money and run” response on
the part of the entrepreneur.3
Hart and Moore
Changes in liability provi(1994) and Noe and
sions have been among
Smith (1994) argue
the major influences on
that these problems
can to some extent be
both the level and distrimitigated by simply
bution of contemporary
arranging financial
economic output as well
transactions that do
not transfer the total
as the allocation of finanvalue of a project to
cial resources in today’s
an idea person immefinancial markets.
diately. This arrangement seriously blunts
entrepreneurs’ incentives to hold up other
claimants for a larger share of output. If the amount held
back is large enough, the negative incentive effects of
“no-forced” work and limited liability can be eliminated.
In other words, investors can solve a potential hold-up
problem by holding up the transfer of part of the value of
a project to the entrepreneur. This idea is very much in
the spirit of venture capital arrangements and certain
relationships with builders, whereby compensation is
passed along in a piecemeal fashion, conditional on the
completion of certain measurable outcomes. Such a
“carrot-and-stick” approach can be used to induce “good”
behavior. In fact, in some cases a simple labor contract—
whereby an entrepreneur is paid a fixed wage immediately and, conditional on performance, a fixed wage in the
future—will solve the hold-up problem.
Destitution and Positive Limited Liability. This discussion has so far been based on the premise that the
1. For a discussion of the history of multiple liability provisions and a rationale for their application to U.S. banking, see Wilson
and Kane (1996).
2. Hart and Moore (1994) define the inability to force labor as the “inalienability of human capital.”
3. One might think that in a world of repeated contacts the loss of reputation on the part of the idea person would be sufficient
incentive to “behave” (put forth effort). However, there is an end-game problem here. For example, if there are a finite number
of times the idea person needs funds, he or she may well deliver as promised at the beginning of a relationship but have no
incentive to produce after a certain point.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
47
worst that can happen to an individual is that he or she
will “go broke,” that is, reach zero income or wealth.
Realistically, however, a very low (or zero) level of income
may be insufficient to allow a worker to produce in the
future. Dasgupta (1993) argues, for example, that a certain level of caloric intake is necessary if a laborer is to
have the physical strength necessary to engage in agricultural or other economic production. This argument suggests that, for purposes of relevance to economic output,
there is a strictly positive subsistence level below which
certain economic resources such as food cannot fall.4
While the cost of a minimally nutritious diet is relatively trivial to most households in the more developed
world, the need for positive subsistence levels is a large
factor in the functioning of many economies throughout
the less developed world. Moreover, the lack of serious
consideration of these constraints might have important
implications for economic theory, particularly so-called
general equilibrium approaches that purport to model an
entire economic system, albeit in an abstract and simplified setting. Dasgupta and others have argued that these
fixed costs arising in the theory of consumer demand
raise important questions regarding employment, wages,
and the distribution of nonhuman capital, such as land.
Consider, for example, a situation in which $400
worth of calories per year is needed in order for a human
to be productive in some economic activity (see footnote
4). This cost is fixed, and it can be assumed that individuals who have sources of wealth that allow them to
achieve this intake will be extremely efficient relative to
workers without this level of wealth. In particular, their
production will, at some levels, display increasing returns
to scale (that is, a small increase in labor input will produce a more than proportional increase in output once
the fixed cost of $400 has been covered). Those unable to
clear this nutritional hurdle will simply not be able to
compete in the labor market; they may be able to survive,
but they will not be productive in the conventional sense
of the term. Thus, the distribution of nonhuman capital
sources of production, such as land, becomes important.
Even if there is sufficient aggregate wealth (and Becker
1993 notes that most countries have per capita incomes
far exceeding subsistence levels) the distribution of that
wealth may be such that it simply does not benefit individuals with wealth to hire workers who have access to no
capital other than their own labor. Hiring an already
healthy worker, even at a slightly higher wage, is simply
more efficient than paying the fixed nutritional cost of
hiring a malnourished one.
In a more developed economy, even someone who
goes bankrupt will typically have access to income sufficient to cover his or her basic needs, either through labor
or through a social safety net. However, since, conservatively, 300 million to 600 million people worldwide are in
economic circumstances below the subsistence level, it is
not meaningful to speak of personal limited liability as
48
being simply a non-negative wealth position. It is in this
sense that subsistence, and not zero, levels of income are
the relevant ones for some of the analyses in the area of
economic theory and practice.
Liability Rules and the Incentives of Debtors,
Creditors, and Managers
here is a large body of work that seeks to analyze
the importance of liability rules at the individual
firm level in terms of the relationship between borrowers and creditors as well as potential conflicts
between stockholders and managers. Major focal points
in this area include investment and financing decisions of
firms and the distortionary bargaining power generated
by liability provisions in bankruptcy. Here, this liability
structure will be examined in light of what conflicts
induced by limited liability may arise with outside
claimants, even when managers and owners have nonconflicting goals, and problems that arise when managers
have their own, potentially separate, objectives and possess liability protection.
Creditors versus Owners. Consider the problem
faced by creditors with multiple potential borrowers,
some with relatively lower-risk ventures available for
investment and others offering higher-risk projects. As
noted by Stiglitz and Weiss (1981), a creditor is going to
be unable, without further analysis, to distinguish among
these potential borrowers and their associated projects.
The borrowers, on the other hand, know that, should a
lender grant them a loan, their payoff will be the larger of
the difference between the value of the project less what
they owe on the loan or zero. This limited liability associated with being the residual claimant, or equityholder, is
well known.
A creditor faces the problem of choosing between
(1) simply setting a loan rate that reflects what potential
borrowers believe to be the average risk, based on, say,
previous experience in the field for such a group of projects; (2) asking that potential borrowers post collateral
(which they may or may not have); or (3) expending
money on further investigation of potential projects
(credit analysis). In all cases, the lender faces a problem
brought on in large measure by the personal or corporate
limited liability of borrowers. If simply setting a loan rate,
a lender could charge a relatively low rate, in which event
almost all potential borrowers would seek funds. But
lender profits would be low or negative in this case, providing lenders the incentive to charge higher loan rates.
Eventually, lower-risk borrowers, offering lower-risk
investments, will find it unprofitable to seek bank financing, leaving banks with a relatively higher-risk pool of
potential applicants.
As an extreme example, consider two potential borrowers, one with a project offering a certain 10 percent
rate of return and the other with a project with an equal
chance of paying 20 percent or 0 percent. If the lender
T
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
charges 5 percent, both borrowers will seek funds, while
at 11 percent the borrower with the lower-risk project will
obviously be unable to make a profit and will drop out.
However, the borrower proposing the higher-risk project
will, precisely because she has limited liability, continue
to seek funds, since the best she can do is 9 percent (20 –
11 percent), while the worst is no profit (the project pays
0 percent and the borrower cannot pay off the loan).
This so-called adverse selection problem (at higher
prices for credit, only the risky apply) may lead lenders to
limit the supply of credit below that demanded by borrowers. Indeed, in this simple example there is no interest rate at which the creditor can expect to make a profit. As a result, the supply of credit will be zero while the
demand for credit will be positive for any interest rate
between 0 percent and 20 percent.
Another option open to lenders to help mitigate the
“heads I win, tails you lose” advantage of the borrower is
to require all potential borrowers to post collateral. But
this solution poses its own problems. Requiring full collateral is likely unrealistic since, if borrowers could
finance their own projects, they probably would not seek
outside funding in the first place. And while partial collateral may alleviate the net effect of borrower-limited
liability, the essential conflict between borrowers and
creditors remains.
Obviously, lenders also engage in credit analysis.
However, as long as risk assessment is less than a perfect
science, there may remain groups of borrowers to whom
banks are unwilling to lend at any interest rate. Clearly,
none of the three proposed options is generally sufficient
to eliminate the incentive problems associated with limited liability.
A problem closely related to the adverse selection
issue involves the fact that limited liability provides,
holding other factors constant, an incentive for a borrower to choose a relatively higher-risk project as opposed to
a lower-risk project. Consider again the extreme numerical example, now supposing that a single entrepreneur
has a choice between undertaking one or the other of the
two projects. Since the expected return on the two projects is the same—that is, 10 percent = (0.5)(20 percent)
+ (0.5)(0)—the expected return to the borrower is actually higher for the riskier project. That is, the borrower is
better off (in terms of the expected pecuniary reward) by
taking the higher-risk and not the lower-risk project
because, and in this case only because, the borrower has
limited liability. For example, at an interest rate of 15
percent, the borrower would expect to receive either
5 percent (20 – 15 percent) or no profit by taking on the
higher-risk project and nothing for taking on the lowerrisk project.
This story would be different, however, if it were possible to impose a large enough nonpecuniary cost on the
borrower in the event that she failed to repay the loan.
Debtors prisons in earlier centuries exemplify such a
cost. But of course this approach essentially begs the
question since, for all intents and purposes, borrowers
would no longer have limited liability.
It is sometimes argued that borrowers will not
exploit the default option in repeated contacts in order to
avoid reducing their reputation. Still, unless individuals
derive some nonmonetary benefit from being thought
well of in terms of meeting their obligations, entrepreneurs may continue to have an incentive to exploit their
limited liability by taking on higher-risk projects.
This situation is
not unique to the
borrower/creditor
As well as a direct effect
relationship. While
on investment policy, corpersonal limited liaporate limited liability has
bility alone is an
important factor in
an indirect effect on corrisk-taking decisions,
porate capital structure
the existence of cordecisions because shareporate limited liability creates an addiholder gambling incentives
tional layer of incenare anticipated by rational
tive problems in the
creditors and priced into
relationship between
equityholders in cordebt contracts.
porations and bondholders (debtholders
in the firm).
One striking illustration of shareholders attempting
to exploit limited liability occurred when the owners of
Tri-State Paving, a small California contracting firm,
responded to the threat of imminent bankruptcy by driving to Las Vegas to gamble with the company’s liquid
assets. A good day at the tables could yield a payoff sufficient to let the owners retain control of the firm; a bad
day would lead to financial ruin—a situation no worse
than it already faced. From the perspective of the owners,
the Las Vegas investment was a no-lose proposition. The
firm’s creditors, of course, felt differently, as evidenced by
the legal actions they took in response to Tri-State’s innovative investment strategy.
Fortunately, most financially distressed firms do not
gamble as blatantly as Tri-State did. In fact, debt
covenants frequently preclude such blatant speculation.
The problem in establishing such covenants is that often
the outcomes of decisions made by firms are nonverifiable in that they are difficult or impossible for third parties to monitor. For example, a firm may decide to save
4. For example, Stigler (1945) estimates that a diet primarily consisting of dried beans, cabbage, and rice, at a cost of $400 per
year in 1993 dollars (Becker 1993), is the least-cost diet consistent with the nutritional needs of the typical person.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
49
money now by hiring a mediocre team of risk managers
who can handle routine situations but may not be able to
cope with complex problems that may arise. In most situations, this strategy will increase firm profits, but it
increases the potential of generating huge losses when
exceptional circumstances occur. Thus, this hiring policy
increases risk. However, since employment policies are
notoriously hard for third parties to second-guess, it
would be very difficult to write debt covenants precluding
such actions.
Corporate limited liability gives the shareholders of
financially weak firms an incentive to gamble to the
potential detriment of societal welfare. In the classical
economic paradigm, the total value of a project includes
all the benefits and costs associated with the project.
Introducing a consideration other than total value (in
this case, the riskiness of project returns) into the stockholders’ investment calculus serves only to distract them
from the objective of value maximization, a result that is
socially harmful. As pointed out by John, John, and
Senbet (1991), a consequence of this relationship is that
even fairly priced deposit insurance for banks will not
eliminate the incentive of banks to gamble.
At the same time, the incentive to gamble may actually counter other distortions related to investment externalities. For example, risky projects frequently are more
innovative than safe projects. However, because of externalities (such as insufficient enforcement of patent laws)
firms may underinvest in innovative projects. In such
cases, then, corporate limited liability, by providing a
countervailing incentive to choose more innovative risky
projects, may actually increase social welfare. Indeed,
Zha (1995) has shown that providing exceptions in bankruptcy can, in some circumstances, increase social welfare precisely by encouraging risk-averse entrepreneurs
to invest in risky but socially valuable projects.
As well as a direct effect on investment policy, corporate limited liability has an indirect effect on corporate
capital structure decisions because shareholder gambling
incentives are anticipated by rational creditors and
priced into debt contracts. This pricing effect can lead
firms either to eschew debt financing in favor of equity or
to reject profitable investment options altogether.
Box 1 provides a numerical analysis of this problem
that can be summarized as follows: fully informed, rational potential bondholders recognize that equityholders
can switch investment policies in a way that is detrimental to bondholders’ interests in a manner analogous to the
borrower/bank example already mentioned. These potential bondholders will incorporate this factor into their
decision regarding the promised payments they demand
from equityholders or, equivalently, the yields they
require in order to hold the bonds. While equityholders
may pledge personal assets as collateral, residual incentive problems, analogous to the borrower/banker case,
may remain a problem. Thus, equityholders may be forced
50
to forgo new debt financing even though the combined
wealth of bond and stockholders may have been
increased by an investment on the part of the firm.
An even bigger problem arises if shareholders have
better information than bondholders do. This asymmetry
of information creates a classic “lemons” problem.
Issuers of new securities with bad information have an
incentive to flood the market with overvalued securities.
The profits from this strategy are proportional to the
informational sensitivity to the claim being offered.
Financial market participants recognize this fact and
therefore react skeptically to the prospect of the issuance
of information-sensitive securities such as equity. This reaction drives firms toward issuing information-insensitive
securities to outsiders. The most informationally insensitive claim is, of course, a claim that pays a fixed
amount regardless of the firm’s value. However, given
corporate limited liability, such a claim is not feasible
when firm value is less than the minimum stipulated
payment on the claim required to finance the investment. Thus, limited liability on the part of corporate
investors increases the mispricing of corporate securities. When mispricing becomes large relative to the
potential profits from the new investments funded by the
security issuance, firms may, in fact, forgo profitable
investment opportunities when forced to finance them
on the capital market. Because, absent limited liability,
firms can issue informationally invariant claims on firm
cash flows and such claims entail no mispricing costs,
corporate limited liability restrictions are necessary for
informational asymmetries to lead to the mispricing of
claims or underinvestment. Nachman and Noe (1994)
provide a formal treatment of these issues.
Limited liability also affects the incentives of the
financially distressed firm through its effect on bankruptcy negotiation. The key to this relationship is that bankruptcy is costly. For example, bankruptcy entails large
legal and administrative expenses and may make it more
difficult for a firm to market its product line.5 Thus, both
debtors and creditors can gain from avoiding bankruptcy.
The division between both stockholders and creditors of
the gains from avoiding bankruptcy will depend on their
respective bargaining power.
In the United States, bankruptcy law grants stockholders a number of clear advantages. Perhaps the most
important of these is the exclusionary period, a 180-day
period after the filing for bankruptcy (which can be
extended by the court) in which only shareholders can
file reorganization plans. Because of corporate limited
liability and the fact that corporate value is less than
promised debt payments, all costs associated with
remaining in bankruptcy during the exclusionary period
are borne by creditors.
The upshot of this legal arrangement is that, even if
after the exclusionary period ends and creditors can
finally obtain the most favorable settlement possible from
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
B O X
1
Liability and Financing Decisions
he effect of corporate limited liability on financing decisions is illustrated by the example of Gamblers-Dream
Enterprises, a company with a very simple structure of corporate cash flows and liabilities. All of its cash flows and
debt obligations will accrue in the next period, called “time
1.” The possible time 1 cash flows under its current operating policies are as follows:
T
Calculating the firm value and the value of the debt,
under the new cash flow distribution the value of the firm is
100(0.4) + 500(0.3) + 900(0.3) = $460,
while the value of the debt is
100(0.4) + 500(0.3) + 700(0.3) = $400.
Cash Flow
$100
$500
$900
Probability
.20
.60
.20
To simplify calculating values, assume that market values are synonymous with expected cash flows. Under current
operating polices, the value of Gamblers-Dream is
100(0.2) + 500(0.6) + 900(0.2) = $500.
Suppose that Gamblers-Dream has debt outstanding
with a promised payment of $700. The market value of this
debt at time 0, under the current operating policies, is
460 = min{F, 100}(0.4) + min{F, 500}(0.3)
+ min{F, 900}(0.3),
100(0.2) + 500(0.6) + 700(0.2) = $460.
The value of the equity is the difference between total firm
value and the debt value
$500 – $460 = $40.
This firm appears to be in financial distress since the
promised payment exceeds the firm’s market value.
Suppose that Gamblers-Dream can change its operating policies to produce the following distribution of time 1
cash flows.
Cash Flow
$100
$500
$900
Probability
0.40
0.30
0.30
Hence the value of equity is $60. It is clear that it is in the
shareholders’ interest to undertake this shift since their
equity claim increases in value by $20, even though the value
of the firm declines by $40. The decline in value of creditors’
claims of $60 exceeds the decline in firm value by $20, which
is the shareholders’ gain.
Suppose that instead of having debt outstanding
Gamblers-Dream needs to issue debt in order to finance its
operating policies. In this case the $40 loss in market value
is factored into the pricing of the debt. For example, suppose
that the firm needs to raise $460 in external financing to
undertake the project. If the firm borrows the $460, the
promised payment, F, will have to satisfy the equation
where min(x, g) denotes the minimum of x and g.
This equation reflects the fact that the firm will choose
the riskier operating policy. Guessing that a solution would
have to be such that F > 700, this equation reduces to
$460 = 190 + 0.3F.
Solving this gives F = 900. Thus, the only way the firm can
obtain debt financing is to promise its entire cash flow to
debtholders. Therefore, the shareholders would no doubt
either switch to equity financing or eschew investing in the
project entirely.
5. An interesting example of this effect is the problem that Wang Computers faced in trying to market its word processors to corporations when it faced financial distress. Corporations were understandably reluctant to commit to computer systems produced by a firm that might soon be defunct and unable to support its product line.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
51
their perspective (absolute creditor priority), they still
must bear the costs of the bankruptcy process. Limited
liability protects the penurious shareholders from these
costs, allowing them to use the threat of dumping the
costs of bankruptcy on bondholders to force concessions
in prebankruptcy negotiations. Shareholders may thus be
able to negotiate a settlement in which the costs of bankruptcy are avoided and debt is written down sufficiently
to ensure that they receive a fraction of firm value proportional to the costs of bankruptcy. Therefore, corporate
limited liability, in the presence of costly bankruptcy
options, not only protects shareholders from contributing
their private capital in the event of financial exigency but
also provides them with a cushion of residual value proportional to the costs of the bankruptcy reorganization.
While rational potential claimants may factor this option
to equityholders into their required returns, limited liability may result in actions like those described above
once the firm is in financial distress. Box 2 provides a
graphic example of this phenomena.
Owners versus Managers. For the purpose of this
discussion, managers so far have been treated as agents
acting in the best interest of shareholders. However, in
almost all cases, save that of the sole proprietor who also
manages the enterprise, there is an important potential
conflict, fueled in part by the personal limited liability of
the manager, between residual stakeholders (owners)
and agents (managers), who actually implement policies
and procedures. Indeed, Anderson and Tollison (1982)
argue that this agency problem was the primary concern
motivating Adam Smith in his much-discussed critique of
the then relatively new limited liability corporations.6
B O X
2
Limited Liability and Bankruptcy
he following example illustrates the use of the exclusionary period to hold up creditors. Consider a firm that
currently owes $1.4 million to creditors: $0.8 million on a
senior debt issue and $0.6 million on a junior issue. The current value of the firm is $1.3 million. If the firm enters bankruptcy, the costs of bankruptcy and financial distress will eat
up $0.3 million in firm value. If the shareholders’ initial formal offer made after filing for bankruptcy is rejected, the
delay caused by shareholders drawing out the automatic stay
period will result in an additional $0.1 million loss.
The actions taken by shareholders and creditors will
depend upon what these agents predict about what will
occur in the next stage of the reorganization. For this reason, it is useful to first consider what will happen if the final
stage of negotiations is reached—the stage after the exclusionary period has elapsed, when creditors can make a proposal. At this point, firm value is
T
1.3 – 0.3 – 0.1 = $0.9 million.
At this stage, creditors can force a division based on absolute
priority. The payoffs would be
Shareholders:
Junior debt:
Senior debt:
52
$0
$0.1 million
$0.8 million
Thus, before the final court-ordered disposition of assets,
shareholders might prefer to offer an acceptable alternative.
Shareholders:
Junior debt:
Senior debt:
$0.05 million
$0.15 million
$0.8 million
If shareholders declare bankruptcy without delay, they will
obtain $0.05 million, senior debt will be unimpaired receiving $0.8 million, and junior debt will lose $0.45 million. The
cost of bankruptcy gives shareholders bargaining power.
Also, in lieu of declaring bankruptcy, shareholders can
make a first and final offer to restructure debt by lowering
the promised payment to junior debt to $0.15 million and
threaten bankruptcy if the offer is rejected. Junior debt, if it
finds the threat credible, will accept the offer. The threat of
forcing bankruptcy is credible because of corporate limited
liability. Absent renegotiations, the shareholders have nothing to lose.
From this example we see that corporate limited liability exerts an effect upon the allocation of value, even in
firms that have failed. Limited liability comes into play
because shareholders can threaten to use limited liability in
bankruptcy negotiations.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
A manager has every incentive to engage in activities
that maximize his or her welfare so long as it is costly for
shareholders to monitor the effort put forth or output
produced by the manager. Much of this compensation
may take the form of perquisites such as limousines,
deluxe furnishings, and extra staff. Personal limited liability limits the damages that owners can extract from
their agents, absent criminal plundering of the firm, so
the efficacy of shareholders’ monitoring of management
becomes a key determinant of corporate efficiency.
However, since corporate limited liability also limits the
losses of shareholders to their initial investment, it clearly attenuates the incentives of shareholders to monitor
managers. For this reason, firms where monitoring is particularly important, such as Lloyds of London, might not
provide owners with limited liability protection.
Given the adverse effect of limited shareholder liability on owner monitoring of managers and creditor monitoring of owners, it would appear, at first glance, that
unlimited shareholder liability would generate welfare
improvements relative to limited liability. However, as
Winton (1993) shows, this conclusion does not hold uniformly. Unlimited liability, combined with the transferability of shareholdings, means that the expected payoff
from holding shares depends on the identity of their
owner. A wealthy investor knows that he will be forced to
pay when a firm incurs large losses. A poor investor, on the
other hand, knows he is protected by personal limited liability from being forced to make large payments to the
firm. Because the expected payoffs on shares are higher
for poor shareholders than they are for rich shareholders,
this disparity generates an incentive, other things held
constant, for rich shareholders to sell to poor shareholders. Thus, in a situation with unlimited corporate liability,
the rich may end up owning bonds while the poor own
stock. The result can be a decline in efficiency: since the
poor have small liquid balances to finance unexpected
capital needs of the firm in the event that investment
opportunities look particularly rewarding, external funds
may have to be raised to finance growth. The resulting
need for new investors implies increased flotation and
other related costs that may more than offset the reduced
monitoring engendered by granting shareholders the protections of limited liability.
Governments, Intermediaries, and the Structure
of Financial Markets
s previously shown, limited liability has the potential to distort investment and financing decisions
at the individual firm level. Moreover, it has been
argued that increasing liability beyond initial investments creates socially inefficient risk sharing because,
A
under these circumstances, the value of shares will be
inversely related to investors’ private wealth. A solution
to this problem would be to allow outside claimants to
seize the assets of a firm while it is still “alive,” although
it is notoriously difficult to determine the market value of
many assets, particularly those that are not actively traded in financial markets.
Given such measurement problems, alternative contracts have evolved that specify that shareholders must
either have sufficient liquid assets on hand to meet current obligations or be able to borrow the necessary funds
from an outside entity. Under these circumstances, the
ability to access liquidity works as a signal (albeit an
imperfect one) that a firm is economically solvent.
Moreover, in modern times, central banks have emerged
as the ultimate providers of liquidity (that is, the lender
of last resort). It is therefore useful to review the role of
corporate limited liability in the context of central bank
provision of liquidity through the banking system and
other government insurance programs.
Bank Charters and Limited Liability. It is generally thought that the first institution to be granted corporate limited liability status was the Bank of England
(BOE), then a private institution. The monarchy, in need
of financing, struck a deal with the BOE and, in the
process, granted it sole authority to act as an agent to the
government in terms of the circulation of currency.
Included in this arrangement was a provision that BOE
“shareholders” would not be held personally liable for any
debts incurred by the new corporation (Bagehot [1873]
1991). Before long, any number of commercial firms were
appealing to the crown for similar liability protection and
monopoly rights to trade either certain goods or in certain areas of the world.
Historically there has been a great deal of variation
in the liability rules regarding individuals engaged in the
business of brokering money and credit. In Europe, financial institutions other than central banks were often
denied corporate limited liability long after this status
(often accompanied by monopoly trading and governing
rights) was allowed to commercial firms. Even after the advent of essentially universal access to corporate limited
liability, financial institutions, including twentieth-century
investment banks as well as accountants and lawyers, continued to operate under the partnership structure, that is,
without the protection of limited liability.
Banking, as much or more than almost any other
industry, has been the subject of extensive debate and
policy discussions concerning liability rules. For example,
Evans and Quigley (1995) provide a lively and insightful
discussion of shareholder liability regimes as well as an
analysis of some data from nineteenth-century Scottish
6. The manager/owner conflict can be viewed as a special case of the principal/agent problem discussed by Adam Smith and formalized by more recent writers such as Ross (1973).
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
53
banking, where corporate limited liability and unlimited
liability (personal limited liability only) institutions competed for deposits and investors. They suggest that the
dominance of one liability structure over another will
depend on whether it is cheaper to monitor the quality of
the assets or the personal wealth of the investors providing guarantees. If the former is less costly, corporate limited liability organizations will dominate, and vice versa if
asset values are more costly to verify than personal
wealth. This argument is consistent with the proposal
that, should a banker be able to post sufficient personal
collateral, the value of which is verifiable, depositors
could eliminate the potentially negative influences of
limited liability. It is also consistent with the idea that as
a sophisticated system of “monitoring the monitors” (the
professional auditing industry) emerged, the other
advantages associated with corporate limited liability
caused this organizational structure to become dominant
in banking in the twentieth century. These advantages
primarily involved the easing of risks associated with
transferring ownership (Woodward 1985).
Indeed, it is difficult to imagine the set of advanced
financial markets and contracts that have developed over
the past two centuries without some restrictions on the
seizure of the personal assets of existing and potential
shareholders. Interestingly, however, multiple liability
provisions, requiring some additional capital infusions by
shareholders in bankruptcy, were not eliminated in the
United States until around the time the Federal Deposit
Insurance Corporation (FDIC) was formed in 1933. In
essence, at least for small depositors, the FDIC substituted a guarantee from the government for private guarantees by bank shareholders.7
Limited Liability and the Lender of Last Resort.
Other governmental or quasi-governmental agencies
established by efforts to improve the functions of the
economy may cause liability-induced behavioral changes
in many areas of commerce and the delivery of financial
services as well. Consider, for example, the development
of the central bank. The central bank, acting as a lender
of last resort, works through a subset of financial institutions in order to provide for an elastic currency.
Practically, this means it provides liquidity to the financial system during times of stress. These times of need
arise in situations when market participants, because of
less than full information, have trouble distinguishing
economically solvent from insolvent firms. In times when
there is great uncertainty investors often seek liquidity.
Absent a central bank, “corners” on the provision of liquidity might arise where its provision is left solely to private institutions (Donaldson 1988). Thus, the existence
of a lender of last resort allows private institutions of all
types, to some degree or another, to hold fewer liquid
assets and increase investments in riskier but, on average, more profitable ventures.
54
In the United States, banks and thrift institutions
pay a positive tax for privileged access to the discount
window by, among other things, holding zero-interestbearing accounts at the Federal Reserve. At the same
time, other firms also tend to benefit from the lender of
last resort actions by being able to draw their short-term
liquidity directly or indirectly through the banking system. To the extent that not all claims on these corporations or partnerships are counteractable (Grossman
1995), there may be welfare effects as these other institutions hold less liquidity than they would in the absence
of a lender of last resort (Calomiris 1989; Smith 1993).
Limited liability plays a role in this situation because,
with less than a full array of contracts to cover all contingencies, managers of these institutions, acting in the
interests of shareholders, rationally have an incentive to
exploit the optionlike characteristic of their residual
claim on the cash flows from production.
Of course, a similar argument can be made for institutions with explicit or implicit government guarantees.
They too may have an incentive to hold less liquid positions than they would in the absence of backing by the
government. In short, the brute force of limited liability
can potentially tend to exacerbate the risks faced by policymakers concerned with stabilizing financial markets
during times when, for whatever reason, liquidity is in
short supply.
There is also a potentially positive view of this provision of emergency liquidity. Bernanke (1983), for example, has provided evidence to support the idea that much
of the economic damage in the Great Depression was
caused by the failure of banks and their customers, eliminating valuable information concerning whether firms
were fundamentally solvent but in financial distress or
essentially bankrupt. In this sense, bankruptcies can be
viewed as socially costly and the public provision of liquidity through the central banking system can be viewed
as a way of minimizing these costs, particularly during
times of stress in markets and the banking system
(Holmstrom and Tirole 1996). That is, if the social costs
of bankruptcies are high, then the provision of liquidity to
temporarily weak but fundamentally sound economic
units may actually improve the welfare of the society
despite the partially offsetting effects of limited liability.
Conclusion
his article has reviewed some of the effects of liability structure on the actions of individuals in
financial and labor markets. With roots stretching
back at least to the early days of the Bank of England,
corporate limited liability has had a strong influence
on the development of modern capitalism. Resulting
improvements regarding transferability of ownership
have greatly enhanced the flow of financial capital and
encouraged riskier ventures than might have been taken
T
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
if stockholders were personally liable for more of an
endeavor. However, these same risk-taking incentives
may cause conflicts of interest at both the macro- and
microeconomic level. From central banks providing an
elastic supply of liquidity in times of financial crises to
government guarantees, limitations of liability have at
times resulted in risks taken at the firm level that may
not be socially optimal. Policymakers, in their quest to
balance social goals with excessive risk taking, should be
aware that decisions made in the name of safety and
soundness may result in unintended consequences.
Corporate liability risks can even drive a wedge
between contracting parties in the sense that the rational
reaction by outsiders to the option value of limited liability held by stockholders may result in investment, financing, and security design decisions that would not be optimal if liability provisions were less generous. Even in
bankruptcy negotiations, the limited liability option is
potentially valuable to stockholders who may hold up
creditors with the threat that they can walk away, leaving
claimants to pay the bankruptcy costs associated with
dissolving a firm. Limited liability has also proven to be
an important factor in the adverse selection (only the
risky apply) and moral hazard (taking on riskier ven-
tures) problems often encountered in borrower/bank
relationships. Absent nonpecuniary costs (such as
debtors prison), complications due to limited liability
may be sufficiently severe to cause some or even all borrowers to be credit rationed.
Personal limited liability may also act as an incentive
in labor contracting arrangements, whereby individuals
sell their ideas and then hold up outside claimants for
additional compensation for their needed labor efforts.
Or, given the fact that, realistically, a positive amount of
income is needed in order to engage in productive effort,
the assumption that personal limited liability is zero, and
not a subsistence value, may result in a cycle of unemployment and malnutrition for at least a portion of a population.
Although this article has covered but a portion of the
issues arising from the existence of corporate and/or personal liability, these and other examples are sufficient to
show that alterations in liability provisions have changed
the nature of contracting in ways that require us to
remember that the buck does stop somewhere, and where
it stops is not irrelevant from either a private or public
perspective.
7. While the system of public insurance has been established in the United States for more than sixty years, it is not surprising that
many of the problem financial institutions in the 1980s were those that were allowed to remain open even though their liabilities exceeded their assets. With limited liability and, for all intents and purposes, no investment in the firm, managers of these
institutions had every incentive to take on high-risk projects in the hopes of growing out of their problems.
Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 1997
55
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