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January/February 1993
Volume 78, Number 1
Federal
Bank of
In This Issue:
Too -Big-to -Fail after FDICIA
banking Reform and the Transition to a Market
Economy in Bulgaria: Problems and Prospects
Competitive Considerations in Bank Mergers
And Acquisitions: Economic Theory, Legal
Foundations, and the Fed
/Review Essay
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January/February 1993, Volume 78, Number 1
Federal Reserve
Bank of Atlanta
President
Robert P. Forrestal
Senior Vice President and
Director of Research
Sheila L. Tschinkel
Vice President and
Associate Director of Research
B. Frank King
Research Department
William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
William Roberds, Research Officer. Macropolicy
Larry D. Wall, Research Officer, Financial
Public Affairs
Bobbie H. McCrackin, Vice President
Joycelyn T. Wool folk. Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.
Material may be reprinted or abstracted if the Review and author are credited. Please provide the
Bank's Public Affairs Department with a copy of any publication containing reprinted material.
Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713
(404/521-8020). Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new
information. ISSN 0732-1813
(Contents
January/February 1993, Volume 78, Number 1
7oo-Big-tO-Fail
After FDICIA
L a r r y D. W a l l
Jg
b a n k i n g Reform a n d the
Transition to a Market
Economy in Bulgaria:
Problems a n d Prospects
William C. Hunter
23
FYI—Competitive
Considerations in Bank Mergers a n d
Acquisitions: Economic
Theory, Legal Foundations,
And the Fed
Christopher L. Holder
3y
Review Essay
J e r r y J. Donovan
In
passing the Federal Deposit Insurance Corporation Improve-
m e n t Act of 1991 (FDICIA)
' Congress sought t0 reduce both the
potential for systemic problems in the banking system and bank
regulatory agencies' incentives to follow a too-big-to-fail policy.
FDICIA strictly controls regulators' ability to protect or extend the
lives of large banks while keeping other policy tools for dealing with
systemic risk. Some systemic risk issues remain, however, including
the effect of a large bank's failure on financial derivatives markets
and the effect of unexpected massive losses at one or more banks.
This article reviews these concerns as well as FDICIA's provisions
designed to reduce systemic risk.
To establish a market economy in the wake of Communism's
collapse, Bulgaria, like its East European neighbors, must revitalize
and privatize its banking and financial system. This article provides
the author's perspective, based on two extended visits to Bulgaria in
1992, on banking reforms now under way. After sketching the country's economic history and banking system structure, the author discusses problems plaguing its banking and financial sector, including
ineffective accounting and legal systems, a lack of information on
creditworthiness, and bad loans associated with inefficient stateowned enterprises. The author suggests some solutions to these
problems and briefly comments on the prospects for reform.
As the pace of bank consolidation has quickened during the last
decade, regulatory policy toward assessing competition in the banking industry has come under increased scrutiny. This article summarizes the Federal Reserve's general approach to antitrust analysis in
bank mergers and acquisitions since 1982. The author presents the
economic theory and legal framework behind the Fed's analysis and
cites empirical evidence regarding the Fed's approach.
Business Information Sources for Eastern Europe and the
Newly Independent States: A Guide to Periodical Literature
2oo-Big-to-Fail
After FDICIA
r
Larry D. Wall
he special treatment historically accorded large failing b a n k s —
judging them "too-big-to-fail"—is an important issue in reforming
deposit insurance. All unaffiliated depositors, and in some cases
all creditors, at large failing banks have received 100 percent cove r a g e of t h e i r f u n d s e v e n t h o u g h c o v e r a g e of o n l y t h e f i r s t
$100,000 deposited at domestic branches is guaranteed by law. 1 Following
this too-big-to-fail policy has been justified in part as necessary for preventing systemic problems that might grow f r o m a larger b a n k ' s difficulties.
However, the policy itself created problems. It tended to reduce the incentive for large depositors to exercise market discipline, and it tended to increase the cost of resolving large failing banks. 2 Further, operating under a
too-big-to-fail policy created a dilemma for bank regulatory agencies, which
had to either leave large depositors at small banks uninsured and create an
artificial incentive for large deposits to be shifted to too-big-to-fail banks or
cover all deposits at all banks, further reducing market discipline at small
banks and increasing the cost of resolving small bank failures.
The author is the research
officer in charge of the
financial section of the Atlanta
Fed's research
department.
He thanks Robert
Eisenbeis,
Frank King, Ellis Tollman,
Sheila Tschinkel, and Carolyn
Takedafor helpful
comments.
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
Congress addressed the too-big-to-fail issue as a part of its deposit insurance reform bill, the Federal Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA). Section 141 of the act generally requires the resolution of failed banks at the lowest cost to the FDIC, though it provides for an
exception that preserves the potential for banks to be considered too-big-tofail. T h e exception may be invoked if failure to do so would "have serious
adverse effects on economic conditions or financial stability" and providing
Kconom ic Review 7
additional F D I C coverage " w o u l d avoid or mitigate
such adverse e f f e c t s . " F D I C I A allows the exception
only with the agreement of a two-thirds majority of
the Board of Directors of the Federal Deposit Insurance Corporation, a two-thirds majority of the Board
of Governors of the Federal Reserve System, and the
Secretary of the Treasury ("in consultation with the
President").
T w o of the goals of F D I C I A are to reduce both the
potential for systemic problems and bank regulatory
agencies' incentives to follow a too-big-to-fail policy.
Having given a mandate to banking agencies to minimize F D I C losses, the act's prompt-corrective-action
provisions provide a structured way of addressing a
problem bank. A system of automatic review is set in
motion whenever a bank failure imposes material
costs on the F D I C or when the F D I C treats a bank as
too-big-to-fail. 3 Specific changes intended to limit systemic risk i n c l u d e requiring the Federal Reserve to
impose limits on interbank liabilities, authorizing the
F D I C to provide for a final net settlement to a failed
bank's creditors, and establishing statutory backing for
net settlement p r o v i s i o n s in bilateral and c l e a r i n g house payments agreements.
banking system and cause widespread bank failures,
adversely affecting bank customers and the real economy in a number of ways. However, not every run on
a large bank automatically generates systemic problems. A depositor run on any nonviable bank not 100
percent insured is rational and helps speed closure of
an institution that should be closed. Further, the argument that large bank creditors suffer losses in such a
closing is not, in and of itself, a legitimate systemic
concern. 5
Systemic risk arises when an institution's failure interferes with financial services c o n s u m e r s ' ability to
obtain important financial services in a timely manner
to such an extent that overall economic activity is reduced. 6 Systemic p r o b l e m s result if the failure of a
large bank causes contagious runs on viable banks,
thereby diminishing the overall availability of financial services. In addition, failure of a single institution
may generate systemic problems if it significantly impairs the payments system or financial markets. This
s e c t i o n h i g h l i g h t s t h e c h a n n e l s t h r o u g h w h i c h it
would be possible for systemic risk concerns to arise.
An analysis of the actual magnitude of these risks prior to F D I C I A is provided in the box on page 7.
F D I C I A also leaves in place the Federal Reserve's
d i s c o u n t w i n d o w , which is a p o w e r f u l tool for addressing systemic risk. Indeed, only the Federal Reserve is guaranteed to have the resources to be able to
address virtually all conceivable systemic risk situations b e c a u s e only the Fed has the p o w e r to create
money. However, F D I C I A discourages inappropriate
uses of the discount window by requiring the Federal
Reserve to share in the F D I C ' s losses if lengthy Fed
lending to a failing bank c a u s e s an i n c r e a s e in the
F D I C ' s losses. 4
R i s k s to O t h e r B a n k s . T h e f a i l u r e of o n e bank
poses a potential risk to other banks in a number of ways.
For example, other banks could suffer insolvency because of losses on interbank deposits and other forms
of credit. They risk illiquidity if access to interbank
deposits is delayed or if contagious deposit runs occur.
T h e extent of such risks is usually, but not always,
proportional to the size of the failing bank. Larger
banks have more interbank deposits likely to be at risk
if depositors are not covered, and large bank failures
are likely to be noticed by more depositors.
F D I C I A s u b s t a n t i a l l y r e d u c e s if not e l i m i n a t e s
most of the dangers associated with the failure of a
large bank. Some systemic risk issues remain, however, and the purpose of this article is to review those
concerns as well as FDICIA's provisions designed to
reduce such risks. Probably the biggest unresolved issue is what the effects of a large bank's failure would
be. According to some preliminary analysis, a too-bigto-fail policy may not be needed to protect financial
markets.
T h e m a g n i t u d e of the credit and direct liquidity
risks is also a function of whether the collapse of the
failed bank occurs over a long period of time or comes
as a surprise. If the failure is anticipated, other banks
will have had time to implement steps limiting their
exposure to the failing organization. In this vein, financially strong b a n k s h a v e recently been limiting
their exposure to banks with lower credit ratings in the
interest rate and currency swap markets.
5ystemic Risk
The concern about systemic risk stems from a fear
that a single bank failure could reverberate through the
2
Economic Review
Risks to the Nonbank Sector. Nonbank customers
and even third parties m a y also be hurt by a b a n k ' s
failure. Creditors, including large depositors, directly
risk default losses and reduced liquidity when a bank
fails. While these risks are analogous to those taken by
providers of interbank credit, they differ principally in
that nonbank customers, especially small businesses,
m a y h a v e less access to other s o u r c e s of liquidity.
January/February 1993
N o n b a n k firms can turn to the Federal Reserve discount window under certain situations if a substantial
liquidity problem arises, but the central bank has strongly preferred to avoid such lending. 7 Moreover, even if
the Federal Reserve chose to lend to nonbank customers,
the discount window is not structured to serve as a direct lender to a large number of small businesses. 8
The ability of bank customers to m a k e p a y m e n t s
depends not only on their bank's being solvent and liquid but also on the operation of various payments systems. The failure of a large correspondent bank, which
p r o v i d e s c h e c k - c l e a r i n g , A C H , and other o n g o i n g
payments services to certain small banks, could directly affect the small banks' access to certain parts of the
payments system. Moreover, such a failure could lead
to a loss of confidence in bilateral and clearinghouse
arrangements that handle a large fraction of the payments transactions. While the Federal Reserve is an
i m p o r t a n t supplier of m a n y p a y m e n t s services and
could help sustain confidence in its systems, private
arrangements play a critical role in some—especially
international—payments systems.
A n o t h e r p r o b l e m n o n b a n k c u s t o m e r s might f a c e
when a bank fails is a temporary reduction in credit
availability. Such a reduction might affect local economic conditions adversely. 9 However, implementing a
too-big-to-fail policy would protect b a n k borrowers
only to the extent that doing so would prevent contagious runs on viable banks. Borrowers are not necessarily protected by efforts to protect depositors because
whoever holds the loans after the bank's failure does
not have to extend any prefailure loans. Further, because the postfailure loanholder could demand repayment at the earliest time permitted by the loan contract,
protecting a failed bank's depositors would not protect
its borrowers.
This list of issues has recently been expanded by
increased concern about ways a bank failure would affect financial markets. Banks play an increasing role
as market makers in many financial contracts, especially for interest rate and foreign exchange contingent
c o n t r a c t s such as o p t i o n s , f o r w a r d c o n t r a c t s , c a p s ,
floors, and swaps. T h e failure of certain large banks
might significantly reduce this market-making capacity for some types of financial contracts. More generally, a bank's failure could result in a loss of confidence
in certain m a r k e t s , with the result that s o m e b a n k s
would be unable to maintain adequate hedges for their
existing exposure.
Systemic Risk. W h i l e certain p r o b l e m s plague a
too-big-to-fail policy, it is n o n e t h e l e s s an e f f e c t i v e
way to limit systemic risk. It prevents one bank's fail-
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
ure from creating any direct solvency or liquidity risk
for other banks or nonbank creditors. Its enactment also reduces the risk of contagious runs at other banks
by reassuring their depositors. A challenge F D I C I A
attempts to meet is establishing ways to eliminate the
too-big-to-fail doctrine while continuing to minimize
systemic risk.
incentive Changes
F D I C I A both provides regulators with various tools
for addressing problem banks and suggests changes in
regulatory procedures. 1 0 A simple reading of the act
may not disclose its real significance, however. Before
FDICIA, regulators already had the power to enforce
capital r e q u i r e m e n t s and to stop u n s a f e or u n s o u n d
banking practices. Thus, many of the tools the legislation specified were implicit in the agencies' existing
a u t h o r i t y . M o r e o v e r , m a n y of the m o s t i m p o r t a n t
suggested changes in regulatory procedure are simply
s u g g e s t i o n s (as R i c h a r d S c o t t C a r n e l l 1992 p o i n t s
out). The regulatory agencies retain substantial discretion in their treatment of p r o b l e m banks, especially
large ones.
The act's real significance is that it both provides
the banking agencies with a clear goal of minimizing
deposit insurance losses and sets up an incentive system to encourage compliance. T h e most important part
of the act in terms of setting the goal and incentive
system is section 131, which provides for prompt corrective action. That section begins by giving banking
agencies one goal: "to resolve the problems of insured
depository institutions at the least possible long-term
cost to the deposit insurance f u n d . " Toward that end,
regulators are encouraged to strengthen bank capital,
to respond to reduced capital levels by taking strong
action that will limit risk and encourage recapitalization, and to close failing banks before they e x h a u s t
their equity capital. The provisions for prompt corrective action outline a number of steps that bank regulators may take as an institution's capital ratios decline.
Although regulators generally retain the authority to tailor their actions to the specific circumstances, FDICIA
mandates action in two particular situations: (1) banks
that are undercapitalized must submit an acceptable
plan to restore their capital to a d e q u a t e levels, and
(2) b a n k i n g agencies must take action within ninety
days of a bank b e c o m i n g critically undercapitalized,
with the act containing a bias toward receivership or
conservatorship."
Kconom ic Review
3
Although the prompt-corrective-action guidelines
specify regulatory action, they include a mandatory ex
post review of any failure that imposes material costs
on the F D I C and thus provide an incentive for regulators to prevent costly bank failures. If a material loss
occurs, the inspector general of the appropriate banking agency must determine why and must make recommendations for preventing such a loss in the future.
This report must be made available to the Comptroller
General of the United States, to any m e m b e r of Congress upon request, and to the general public through
the Freedom of Information Act. Further, the General
Accounting Office must provide an annual review of
the reports and recommended improvements in supervision. T h e s e reporting and review requirements do
not force the banking agencies to make any substantive changes in their supervisory practices. However,
as discussed, these provisions supply strong political
incentives to prevent costly bank failures.
borrow at the discount window makes it possible for
uninsured deposits to be withdrawn prior to the resolution of a failing bank by providing the liquidity needed
to cover withdrawals. This section of F D I C I A limits
s u c h l e n d i n g to u n d e r c a p i t a l i z e d b a n k s to 60 d a y s
within any 120-day period unless the bank is certified
as viable by the Federal Reserve or its primary federal
bank regulator. 1 3 For banks that are critically undercapitalized the Federal R e s e r v e is instructed to demand repayment no later than at the end of five days.
If violation of the five-day limit occurs, the Fed is liable for part of the increased cost to the FDIC, and the
Board of Governors of the Federal Reserve must notify Congress of any payments to the F D I C under this
provision. U n d e r F D I C I A the Federal R e s e r v e disc o u n t w i n d o w retains substantial legal authority to
lend to problem banks, but failure to comply with the
intent of this portion of the act exposes the Fed to substantial ex post political pressure.
Two sections of FDICIA—sections 141 and 142—
change the legislative guidelines for deposit insurance
and discount window decisions on banks that might be
considered too-big-to-fail. Section 141 generally requires the F D I C to resolve bank failures at the least
possible cost to the deposit insurance fund. The agency m u s t d o c u m e n t its e v a l u a t i o n of the alternative
methods of resolving a failed bank, including the key
assumptions on which the evaluation is based.
F D I C I A c l e a r l y p r o v i d e s a m a n d a t e to b a n k i n g
agencies and seeks to create a system whereby there is
political incentive for the agencies to follow the mandate. The biggest changes to occur as a result of the
act will m o s t likely result f r o m the new c l i m a t e of
postfailure reviews and sanctions rather than f r o m formal changes in the agencies' legal powers.
While section 141 permits a systemic risk exception to least costly resolution, it also provides for increased accountability when this exception is invoked.
The FDIC, the Federal Reserve, and the U.S. Treasury
must all agree that an institution's ill-health poses a
s y s t e m i c risk. T h e Secretary of the Treasury is required to d o c u m e n t evidence indicating the need to
invoke the systemic risk exception. T h e G e n e r a l A c counting O f f i c e must review any actions taken, exa m i n i n g the basis for f i n d i n g action n e c e s s a r y and
a n a l y z i n g the i m p l i c a t i o n s f o r the actions of other
insured depositories and u n i n s u r e d depositors. T h e
rest of the banking industry, required to pay the cost
of a bailout through an emergency assessment to the
F D I C that is proportional to each b a n k ' s average total
tangible assets, is likely to act as a kind of watchdog. 1 2 T h e special assessment provides a strong incentive for the industry to question c o v e r i n g uninsured depositors, particularly when there is r o o m for
doubt about whether a failure would create systemic
risk.
Section 142 limits the Federal Reserve's ability to
provide through its discount window de facto too-bigto-fail treatment of a failing bank. Allowing a bank to
Economic
4
Review
Changes that Mitigate Systemic Risk
Along with supplying a mandate to minimize F D I C
losses, FDICIA addresses a number of systemic concerns raised by the banking agencies. The act aims to
reduce the systemic risk associated with ending a toobig-to-fail policy by enhancing the overall stability of
the banking system, by r e d u c i n g the losses w h e n a
bank fails, and through targeted reforms that address
specific potentially systemic problems. 1 4
Enhanced Stability and More Timely Closure. A
n u m b e r of r e f o r m s in FDICIA call for reducing the
l i k e l i h o o d of bank f a i l u r e . T h e p r o m p t - c o r r e c t i v e action provisions should result in higher bank capital
ratios and are intended to ensure more timely supervisory intervention. The act requires that regulators revise existing credit risk-based capital standards to take
account of interest rate risk, concentration of credit
risk, and the risks of nontraditional activities. In addition, banks must undergo an annual, full-scope, on-site
examination and an independent annual audit. These
measures should help prevent significant undetected
problems from arising at banks.
January/February 1993
T h e p r o m p t - c o r r e c t i v e - a c t i o n r e q u i r e m e n t s that
critically undercapitalized banks be placed in conserv a t o r s h i p or r e c e i v e r s h i p m e a n that b a n k s m a y b e
closed earlier with reduced losses to creditors. 15 Banks
may also be closed earlier with higher expected recove r i e s to t h e e x t e n t t h a t u n i n s u r e d d e p o s i t o r s b e c o m e m o r e likely to run on failing b a n k s b e c a u s e of
F D I C I A ' s provisions virtually eliminating coverage of
uninsured depositors.
Limits on Interbank Credit Exposure. The banking system relies heavily on interbank extensions of
credit for intraday, overnight, and longer-term purposes, but interbank credit is a potential source of systemic risk. F D I C I A directs the Board of Governors of
the Federal Reserve to develop a regulation limiting
interbank credit exposure. T h e Board has adopted a
new Regulation F on interbank liabilities to satisfy this
part of FDICIA. 1 6 T h e regulation restricts a bank's total exposure to its correspondent to 25 percent of the
r e s p o n d e n t ' s capital u n l e s s the c o r r e s p o n d e n t is at
least adequately capitalized. 1 7
Final Net Settlement. Without immediate access
to their funds at a failed bank, both bank and nonbank
creditors could face severe liquidity problems. FDICIA
a d d r e s s e s this p r o b l e m by authorizing the F D I C to
make a final settlement with creditors when it assumes
r e c e i v e r s h i p of a failed b a n k (section 4 1 6 ) . U n d e r
these provisions uninsured and unsecured creditors
may gain immediate access to their funds. The F D I C
pays a sum that is the product of the amount of uninsured and unsecured claims times a final settlement
rate. The final settlement rate is to be based on average F D I C receivership recovery experience so that the
F D I C receives no more and no less than it would have
as a general creditor standing in the place of the insured depositors. The F D I C ' s exercise of full powers
under the final settlement provision should substantially alleviate liquidity problems for bank creditors.
Netting of Interbank Payments. Many payments
systems result in banks' experiencing substantial intraday credit exposure to other financial institutions. This
exposure may arise both as a result of bilateral agreements and through p a y m e n t s clearing organizations.
F D I C I A seeks to reduce the risk in these p a y m e n t s
systems by explicitly recognizing contractual netting
a g r e e m e n t s and h o l d i n g t h e m l e g a l l y b i n d i n g if a
m e m b e r financial institution is closed. (Section 4 0 3
establishes that bilateral netting agreements are binding, and section 4 0 4 applies to clearing organization
netting.)
I m p l i c a t i o n s of the C h a n g e s . T h e net e f f e c t of
F D I C I A should be to reduce interbank risk substanDigitized Federal
for FRASER
Reserve Bank of Atlanta
tially. The prompt-corrective-action provisions and the
increase in market discipline are expected to constrain
bank risk taking and increase the F D I C ' s rate of recovery f r o m failed banks. In combination, these factors
should almost eliminate the risk that one bank's failure
would cause insolvency at other banks. 1 8
The final settlement procedure provides the F D I C
with a m e c h a n i s m f o r r e s o l v i n g potential liquidity
problems at creditor banks or nonbanks. The netting
procedures under F D I C I A further reduce the risk associated with payments systems. Any remaining credit risk is likely to be small as long as banks comply
with the limits on interbank credit exposure. 1 9 The final settlement procedures and p a y m e n t s system netting together should eliminate m o s t of the liquidity
risk associated with the p a y m e n t s s y s t e m . A n y remaining liquidity problems could be addressed by the
Federal Reserve discount window. Although F D I C I A
places increased limits on the discount w i n d o w , as
mentioned earlier, the Fed may still lend to adequately capitalized b a n k s and to u n d e r c a p i t a l i z e d b a n k s
that the Fed (or the bank's primary federal supervisor)
certifies as viable.
t/nresolved Issues
F D I C I A addresses a n u m b e r of issues associated
with large bank failure. However, at least two possible
areas of concern remain: the effect of a large bank's
failure on financial markets and the effect of sudden
massive losses at one or more banks.
F i n a n c i a l M a r k e t s . A b a n k ' s f a i l u r e c o u l d adversely affect selected financial markets by forcing the
immediate u n w i n d i n g of a large n u m b e r of hedging
transactions, by weakening c o n f i d e n c e in derivative
products that create credit exposure, and by causing
the loss of one market maker. 2 0 These relatively new
issues have received less attention than many others
related to systemic risk. Nonetheless, some preliminary analysis is possible. 2 1
Knowledge of the implications of large bank failures is most limited in the area of o v e r - t h e - c o u n t e r
derivative products such as interest rate, foreign exchange, and commodity swaps. Available insight has
been derived primarily f r o m the failures of a few large
financial institutions, including Drexel, Burnham, Lambert and the B a n k of N e w England. T h e s e p r o d u c t s
seem to have several difficulties, but the biggest ones appear unrelated to systemic risk issues. The problems include (1) contract language in many swap agreements
Kconom ic Review
5
that m a y yield a windfall profit to counterparties of the
failed b a n k , (2) the o c c a s i o n a l inability to u n w i n d
derivative contracts at market prices after the institutions' financial problems have become apparent, and
(3) increased cost of or inability to maintain adequate
hedges at the failed institution while it is unwinding its
derivatives book. 2 2
The failure of a bank with a large over-the-counter
derivatives book poses two risks to its counterparties:
credit risk and the risk that the derivatives contract
will be closed and the counterparty will lose its hedge.
Evaluation of the credit risk is complicated by the nature of most derivatives. Although the size of many
markets for over-the-counter derivatives, such as interest rate swaps, is measured by the notional principal of
the underlying contracts, this measure generally overstates risks for two reasons. Actual payments on many
types of derivatives are a small fraction of the notional
principal. 23 Further, at any given time a bank is likely
to be winning on some contracts and losing on others.
Credit losses to a failed bank's counterparties arise only on those contracts under which the failed bank owes
money. 2 4
However, the measure that is the obvious alternative to the notional principal, the current credit exposure of the derivatives book (mark-to-market value of
those contracts that have positive value to the bank),
may understate exposure for many banks affected by
systemic risk. The credit exposure on derivative contracts varies with changes in the value of the underlying commodity (interest rates, foreign exchange rates,
and so forth). In a systemic risk situation, there m a y
be sharp price m o v e m e n t s in the underlying c o m m o d ity and large c h a n g e s in the v a l u e , and h e n c e credit
exposure, of banks' over-the-counter derivatives book.
Current U.S. regulatory practice at least partially compensates for the increased risk by requiring banks to
maintain capital proportionate to the amount of potential increases in credit exposure. 2 5 The potential losses
to derivative counterparties are limited in two ways:
expected credit losses f r o m failed organizations will
likely be a small fraction of exposure, and liquidity
problems may be addressed by final settlement procedures or the discount window.
A potentially serious problem related to over-thec o u n t e r d e r i v a t i v e s is the e f f e c t of f a i l u r e on the
hedging position of counterparties. These derivatives
purchased f r o m large c o m m e r c i a l b a n k dealers are
used by corporations and institutions to hedge exposure to interest rate, foreign exchange, and commodity
price changes. The failure of the bank dealer may result in early termination of the contracts, raising con-
6
Economic Review
cerns in t w o areas. First, the b a n k ' s c o u n t e r p a r t i e s
need to know when the contract will be terminated so
that they can arrange for a substitute hedge. 2 6
The second consideration is that the counterparties
affected by early termination of derivatives contracts
will need to reestablish their hedge positions in the
over-the-counter derivatives market as quickly as possible to minimize their risk exposure. Most financially
strong corporate and institutional users would be unlikely to have problems doing so, given the number of
dealers in most markets. However, users whose financial condition had weakened may face greater costs in
arranging a hedge. 2 7
There may also be systemic implications in the failure of a large bank that results in the immediate termination of all over-the-counter derivatives contracts.
Such a failure on the part of a m a j o r bank dealer could
significantly, if only temporarily, r e d u c e dealer capacity in some derivatives markets. Further, even if remaining dealers have the capacity to service the additional d e m a n d , individual dealers m a y f a c e binding
bilateral credit limits that restrict their ability to deal
with specific counterparties. 2 8 A l t h o u g h these limits
are most likely to be binding on interdealer hedging
trades, that dynamic could reduce dealers' ability to
arrange hedges for end-users. 2 9 Credit limits may also
pose a problem in another way: new information that
enters the market through a bank failure may cause a
réévaluation and possible reduction of selected credit
lines by some dealers. There is, therefore, at least the
potential for some users to face significant problems
r e e s t a b l i s h i n g their h e d g e s in the w a k e of a m a j o r
bank dealer's failure.
It is important, however, in evaluating the use of
the too-big-to-fail doctrine to protect financial markets, to recognize that w h a t e v e r p r o b l e m s arise are
rooted in a bank's failure, not its treatment of creditors. Providing the protection for uninsured creditors is
s i g n i f i c a n t only in that p r e v e n t i n g runs m a y allow
more time for the development of new market makers
and expanded capacity at existing firms. Even this significance is limited, though, because a bank will come
under prompt-corrective-action provisions as its capital position declines, and market participants will be
warned about the possible restrictions facing a large
market maker. Further, if the loss of market-making
capacity through an institution's closing would pose
a serious problem, then supervisors should consider
encouraging the bank to begin phasing out its m a r k e t m a k i n g activities before it b e c o m e s critically undercapitalized so that the market may gradually adjust to
the reduced capacity.
January/February 1993
S y s t e m i c Risk b e f o r e F D I C I A
An important issue in evaluating whether FDICIA is
contributing significantly to reducing systemic risk is determining the baseline likelihood of a financial system
collapse among generally viable banks before FDICIA.
Three commonly expressed concerns about large bank
failure need to be considered: The first is the idea that interbank liabilities could generate credit losses leading to
widespread insolvency or that delays in access to interbank liabilities could cause widespread illiquidity. The
second concern is that the failure of a large bank might
spark runs on viable banks. The third, and farther-reaching,
fear is that payments systems may collapse in the wake
of a large bank's failure.
The analysis below seeks to address two questions
central to evaluating FDICIA's merit: (1) What are the
odds that one of these three problems would in fact emerge,
and (2) how do the banking agencies' pre-FDICIA tools
for mitigating a problem at a large bank compare with
the tools post-FDICIA?
Interbank Liabilities
The most direct risk a large bank's failure poses for
other banks is that they will lose part or all of their investment in that bank. A sudden failure incurring massive
losses could threaten the financial stability of respondent
banks. However, determining the level of systemic risk
should include distinguishing maximum possible losses
from expected losses. Expected losses for a bank closed
when it first becomes insolvent are likely to be a small
fraction of possible losses. For example, total interbank
exposure to Continental Illinois greatly overstated other
banks' likely losses when Continental was rescued by
the FDIC. There were 65 banks with uninsured balances
in Continental exceeding 100 percent of their capital,
and another 101 banks had uninsured balances equal to
between 50 percent and 100 percent of their capital.
However, if a recovery rate of 90 percent is assumed for
Continental's assets, no banks would have had losses in
excess of their capital and only 2 banks would have had
losses equal to between 50 percent and 100 percent of
their capital.' George G. Kaufman (1990) states that the
FDIC's estimated recoveries at the time of failure of
Continental were 97 percent to 98 percent and that the
current estimate is 96 percent.
Even when a failure would not result in substantial
credit losses on interbank deposits, theoretically it might
still place other banks at risk if they could not obtain immediate access to their funds or if they were to experience a run by depositors fearing insolvency or illiquidity.
However, the danger is not as great as it sounds. Even if
Federal
Reserve Bank of Atlanta
the FDIC did not provide immediate access to interbank
deposits, other banks would not necessarily fail because
of illiquidity. A bank widely recognized as viable despite
temporary illiquidity could probably borrow from other
banks or the Federal Reserve discount window.
Contagious Bank Runs
One bank's failure may lead to withdrawals at other
banks if customers lose confidence that their deposits
will be fully redeemed. Depositors may also lose confidence because the failure discloses new information on
the value of other banks' assets.2
The likelihood that financial markets will mistakenly
run on solvent banks is important in evaluating the risk
of bank runs. Empirical evidence suggests that financial
markets generally are able to assess the implications of
new information accurately. For example, analysis of the
Mexican debt crisis revealed that the stock market responded to individual bank stocks in proportion to each
bank's loan exposure even though such information had
not been publicly released. 3 Studies of five major domestic failures also found no substantial evidence of contagion risk. 4 Further, when a misleading television story
prompted a run on Old Stone, the thrift was able to stop
the run within two days by convincing investors it was
solvent.5
There are also some puzzling examples of possible
market mistakes, however. The failure of the Overseas
Trust Bank in Hong Kong and that of Penn Square Bank
in the United States are two such cases. Gerald D. Gay,
Stephen G. Timme, and Kenneth Yung (1991) found evidence that the failure of the Hong Kong bank had a significant negative impact on other banks in the city. This
result is surprising because the Overseas Trust Bank's
failure resulted from fraud, and such conditions would
generally not be expected to provide significant information about other banks. In the case of the Penn Square
Bank, Robert E. Lamy and G. Rodney Thompson (1986)
and John W. Peavy III and George H. Hempel (1988)
discovered that banks with no direct connections to the
organization nevertheless suffered significant losses in
stock market valuation after that bank failed. Lamy and
Thompson suggest that the drop in market value reflected the fact that Penn Square was liquidated with losses
to depositors, and this action could have raised doubts
about coverage afforded other banks. Another explanation, by Peavy and Hempel, is that the market may have
overreacted to the news of Penn Square's failure. Supporting that hypothesis, their findings indicate that losses suffered immediately after the failure by banks not
Kconom ic Review
7
directly connected to Penn Square were subsequently
offset by significant positive abnormal returns for institutions.
Another study supplies weak evidence that there may
be reason for concern about contagious runs. Randall J.
Pozdena (1991) found that similarities in stock returns
for firms in the same industry were much greater in
banking than in other industries, suggesting that bank
values may be more dependent on a common set of factors than those of many other industries. Pozdena also
found that similarities in returns were fewer among
banks with higher capital ratios.
Thus, there seems to be a risk that the failure of a
large bank could spark contagious runs on viable banks
if the markets fail to distinguish viable from nonviable
banks. Studies of financial market performance generally
suggest that markets tend to assess the implications of
new information accurately. Some evidence of occasional errors has been found, however. Thus, at least a small
potential for contagious runs apparently exists. The risk
is minimized, though, by the Federal Reserve's option to
provide funding to any viable bank experiencing a run.
Payments Systems
Other banks and the financial system may be exposed
to a failed bank through their joint connections to the
payments system. 6 The risk may occur through one of
several mechanisms—the bilateral provision of services
from the failed bank to its respondent, securities positions taken by the failed bank that need to be unwound,
or a failure's effect on payments clearinghouses. The
discussion that follows focuses on the potential for a
bank failure to disrupt the processes by which payments
are made in the banking system.7
Many small banks are dependent on correspondent
banks for services such as check clearing, automated
clearinghouse services and access to international payments systems. Loss of access to these services could
create significant problems for some respondent banks,
especially those that are too small to participate directly
in certain payments systems. If a failing bank deteriorates gradually, respondents may reduce their risk by
shifting their payments system business to other banks
that are still financially strong or by making contingency
plans. However, respondents that are still dependent at
the time of failure would not necessarily lose access to
the payments system. In the case of a troubled institution
large enough to be an important supplier of correspondent services, the FDIC, under FDICIA, would likely try
to sell the bank and could otherwise be expected to create and operate a bridge bank. Because the FDIC has
these powers, invoking a too-big-to-fail policy is not es-
8
Economic Review
sential for preserving respondent banks' access to the
payments system.
Another bilateral issue that can affect payments systems concerns exchanging cash and various securities.
The problem is that the exchange of value does not always occur simultaneously. Solvent parties arc reluctant
to surrender their part of the transaction before receiving
value from the bankrupt party for fear that prompt and
full payment will not be forthcoming. William S. Haraf
(1991) noted that this situation occurred with the failure
of the securities firm of Drexel, Burnham, Lambert in
1990 and that third parties were affected by the disruption.8 Haraf also notes, however, that changes, some of
which are being implemented, to the payments and settlement systems designed to shorten or eliminate lags in
payments would be more efficient than resorting to
declaring certain institutions too-big-to-fail. (He further
notes that, despite some delays in winding up Drexel's
affairs, their positions were ultimately liquidated.)
Multilateral clearinghouse arrangements may also be
strained by the failure of a bank. These arrangements allow their bank members to make payments to each other
with a single net payment at the end of each day to cover
any net credit balances. 9 Transactions through clearinghouses may generate significant bilateral credit between
banks. If the clearinghouse lacks a binding netting agreement and one bank fails to make a required payment, the
failed banks are converted to bilateral agreements and
the net positions of all other banks are recalculated. The
danger is that banks that could have met their net position with the failed bank included may be unable to do so
if the failed bank's position is excluded. 10 Thus, the potential exists for a single bank's failure to cascade through
a payments system, forcing a number of banks to become illiquid and causing a loss of confidence in the entire netting arrangement.
The Federal Reserve has worked to reduce this risk
by requiring banks to monitor and establish caps on their
intraday liabilities and credit exposure to other banks. In
addition, as a continuation of pre-FDICIA efforts to contain payments system risk, the Federal Reserve is imposing interest charges on banks that run large intraday
overdrafts on Fedwire." If a problem arises despite these
restrictions the Federal Reserve retains adequate power
under FDICIA to provide discount window loans to viable banks that temporarily lack liquidity.
Summary
Two common themes run throughout this review of
the risk of systemic problems in the absence of a toobig-to-fail policy prior to FDICIA. First, although some
risk of losses on interbank liabilities, contagious runs,
January/February 1993
ity p r o b l e m s . Furthermore, the Federal Reserve has historically had detailed, timely information on b a n k s as a
result of its supervision and regulation, and on the payments system as a c o n s e q u e n c e of its role as a provider
of p a y m e n t s services. T h u s , t h e Fed h a s h a d both t h e
tools and the k n o w l e d g e required to effectively address
systemic risk situations arising f r o m temporary liquidity
problems.
and failures in the p a y m e n t s system existed, that risk f r e quently has been overstated. Second, the Federal R e s e r v e
could have contained most systemic risk situations
through the discount window. 1 2 T h e most likely system
risk s c e n a r i o s w o u l d h a v e i n v o l v e d t e m p o r a r y , w i d e s p r e a d liquidity p r o b l e m s b u t l i m i t e d actual s o l v e n c y
problems. T h e Federal R e s e r v e ' s discount w i n d o w had,
as it does n o w , the resources to resolve temporary liquid-
Notes
1. These figures on other banks' exposure to Continental
Illinois came from U.S. Congress (1984, 16-18).
2. Finance theory provides a third reason for depositors to
lose confidence: they could b e c o m e concerned about
their bank's inability to meet an increase in demand for liquidity by other depositors. Diamond and Dybvig (1983)
have developed a model in which banks are solvent at
the beginning of the period but are subject to a random
amount of withdrawal by depositors. The bank must
prematurely liquidate projects at a loss if deposit withdrawals are too high. If too many projects are liquidated,
the bank may b e c o m e insolvent. Empirical examples
that correspond exactly to the D i a m o n d and Dybvig
model are hard to find. However, the U.S. banking system in the late 1800s and early 1900s was subject to
periodic liquidity crises during and shortly after harvest season, and some evidence suggests that the crises
were due entirely to liquidity concerns about individual
banks. A model of inelastic currency supply developed
by Champ, Smith, and Williamson (1991) suggests the
potential for periodic liquidity crisis and provides some
evidence on the problem. However, Calomiris and Gorton (1991) raise questions about this history of panics in
the period prior to the formation of the Fed. In any case,
such random withdrawal models are not closely examined here because there is no evidence to suggest that
such a problem has occurred since the Fed's creation or
that the Fed could not fully resolve any liquidity-based
runs with its existing authority. The Federal Reserve can
and does provide an elastic supply of currency and liquidity.
3. See Cornell and Shapiro (1986) and Smirlock and Kaufold (1987).
4. Aharony and Swary (1983) found that no significant abnormal bank stock returns occurred around the failures
of the United States National Bank of San Diego in
1973 and Hamilton National Bank in 1976. They did
find significant negative abnormal returns associated
with the failure of Franklin National Bank in 1974, but
they suggest that this result could be based on a revaluation of t h e risks a s s o c i a t e d with f o r e i g n e x c h a n g e
trading. Aharony and Swary further note that some Eur o p e a n b a n k s w e r e taking f o r e i g n e x c h a n g e l o s s e s
a r o u n d this time. F o r m e r F D I C D i r e c t o r Irvine H.
Federal
Reserve Bank of Atlanta
Sprague (1986) argued that regulators were concerned
about the potential failure of other large banks if Continental Illinois failed in 1984 with losses to depositors.
Saunders (1987), Swary (1986), and Wall and Peterson
(1990) failed to find clear-cut evidence to support the
regulators' concerns. Dickinson, Peterson, and Christiansen (1991) also failed to find evidence of contagion
around the time of the failure of the First RepublicBank
in 1988.
5. The story of how the run was stopped is provided by Leander (1991).
6. Haraf (1991) has noted that the failure of a nonbank institution can also impose strains on various payments
mechanisms. For example, Fedwire and the Clearing
House for Interbank Payments (CHIPS) were forced to
remain open longer than usual to accommodate problems arising from the failure of Drexel, Burnham, Lambert.
7. See Baer and Evanoff (1990) for a review and analysis
of the issues associated with large dollar value payments
systems. Roberds (forthcoming, 1993) discusses ways
of further controlling the risks of those systems.
8. Moen and Tallman (1992) found that the failure of nonbank firms also disrupted the payments system in the
Panic of 1907.
9. For an example of such a system, see the discussion of
CHIPS provided by the Group of Experts on Payments
Systems (1990, 131-42).
10. Given that the failed bank was presumably financially
weak immediately prior to failure, there is a high probability that depositors were, on net, withdrawing substantial a m o u n t s of m o n e y f r o m the failing bank. T h e s e
withdrawals would likely be transferred to other banks,
with a substantial part of the withdrawals going through
clearinghouses. Thus, odds are relatively high that, if a
bank fails, it will be a large net payer to various clearinghouses.
11. See Cummins (1992) for a discussion of the Federal Reserve's decision to charge for intraday overdrafts.
12. See Smith and Wall (1992) for a discussion of how discount window and deposit insurance operations could
address systemic risk issues without reliance on a toobig-to-fail policy.
Kconom ic Review
9
Financial markets are also likely to take actions that
would reduce their costs associated with the loss of a
market m a k e r if the problem bank's financial condition deteriorates gradually. Market participants m a y
shift business to other market makers as a hedge against
the institution's possible failure. Moreover, the troubled bank may find that its trading operations are m o r e
valuable if sold than if forced to operate as part of a financially weak organization. 30 Alternatively, there may
be market adjustment through the individuals whose
trading and technical expertise are at the heart of any
securities trading operation. T h e s e key p e o p l e m a y
seek to leave the ailing bank or may be bid away by an
organization having the resources to support and expand their trading operations.
Overall, there are some risks to financial securities
markets when a large bank fails. Although the problems are likely to be temporary, some users m a y very
well have problems arranging substitute hedges in a
timely manner. Further research is needed on several
issues: (1) the rate at which lost market-making capacity is replaced, (2) the likelihood that credit limits restrict dealers' ability to service users and engage in
interdealer hedging, (3) the significance of the costs
associated with a temporary reduction in liquidity, and
(4) the significance of a large bank's exposure to risk
if it lost access to derivative markets for several days.
If policymakers were to conclude that a too-big-tofail policy is necessary to protect banks that are financial market makers, there would be implications for
securities firms that have a similar presence in many
financial markets. Securities firms not affiliated with
bank holding companies currently have neither insurance like that provided banks by the F D I C or a mandate to comply with safety and soundness regulations
like those imposed on banks. Although securities firms
are partially regulated by the Securities and Exchange
Commission (SEC), the agency regulates only some
subsidiaries, and in any case, its historical mandate is
consumer protection rather than maintaining financial
system stability. If certain banks are considered toobig-to-fail in order to protect the securities markets,
logic would suggest that securities f i r m s should receive similar coverage and that the provider of liquidity or solvency guarantees should b e able to protect
itself via banklike safety and soundness regulations.
Unexpected Massive Losses. The mechanisms that
may soften the impact of failure on the financial system are most effective in dealing with slow deterioration of o n e or m o r e b a n k s . In a variety of w a y s
regulators and markets can gradually disengage troubled b a n k s f r o m the financial system and limit the
Economic
10
Review
damage of failure. However, a sudden massive loss at
one or more banks could create a situation in which the
m a r k e t ' s e x p o s u r e to a failing bank would be at its
maximum, and regulators would be in a weak position
to i m p l e m e n t their full array of crisis m a n a g e m e n t
tools.
Fortunately, such economic losses appear to be exceptional. Sudden losses greater than a bank's capital
are possible only if a bank has a very large concentration of risk to a single factor such as interest rate risk,
foreign exchange rate risk, or having borrowers from a
single geographic area that is devastated. Rather than
truly being sudden, large losses may only appear to be
so because banks and bank regulators have failed to
provide for the timely recognition of reductions in asset values. Most often private sector parties will have
begun reducing their exposure as soon as e c o n o m i c
capital is significantly impaired, even though delays in
accounting recognition m a y have slowed regulatory
action.
Notwithstanding the extremely low probability of
an unexpected failure of a previously well capitalized
large bank that is engaged in a number of complex activities, such a failure would create a big problem for
the regulators. The F D I C may be able to avoid invoking the systemic risk exception but only if it and the
failed bank were exceptionally prepared for such a
c o n t i n g e n c y . T h e F D I C w o u l d h a v e to identify the
bank's insured and uninsured creditors and calculate
appropriate payouts for each of them. The Federal Reserve could buy a little time for the F D I C by exercising its discount window power to lend to a critically
undercapitalized bank for five days. However, the failed
bank would be crippled prior to its closure with a massive outflow of uninsured deposits, severe limits on its
access to the p a y m e n t s s y s t e m , and an inability to
f u n c t i o n in the over-the-counter derivatives market.
E v e n with the a d d i t i o n a l time, the F D I C p r o b a b l y
would be forced to establish a bridge bank while it
evaluated alternative methods of resolving the failure.
Further, the F D I C probably would not have time for
careful review of the b a n k ' s books to determine the
amount and type of each of the institution's liabilities
( i n c l u d i n g o f f - b a l a n c e - s h e e t activities). T h e F D I C
could readily evaluate all liabilities only if the bank
had organized its financial records in a way that permitted quick access.
Although it might be possible to manage a single
bank's unexpected failure, the situation would probably be unmanageable in the even more unlikely case
that the viability of a number of large banks became
questionable. With several large banks in trouble, de-
January/February 1993
positors would b e likely to demand immediate withdrawal of their f u n d s , refraining only if the government were providing 100 percent deposit insurance.
Because regulators have limited operational resources
(such as p e o p l e ) and m a y also f a c e f i n a n c i a l c o n straints that restrict the number of bank closings they
can handle at one time, they may want to provide 100
percent coverage as a means to avoid closing too many
banks in a short period.
The risk of sudden large losses to individual banks
or groups of banks is remote and can be f u r t h e r reduced, but it cannot be eliminated. T h e key to reducing the risk is for institutions to m i n i m i z e c o n c e n trations of exposure to specific events that could cause
a sharp drop in their value.
Conclusion
F D I C I A h a s m a n d a t e d that r e g u l a t o r s v i r t u a l l y
eliminate deposit insurance losses. T h e act provides
for a systemic exception to its requirement that problem banks must be resolved at the lowest cost to the
insurance funds. However, F D I C I A also creates some
significant political incentives to avoid using the systemic risk exception. Moreover, it is clear f r o m the series of measures to address specific systemic issues
that the intent of Congress was virtually to eliminate
the practice of the too-big-to-fail doctrine. Congress,
having been told that interbank credit created systemic
risk, m a n d a t e d limits on interbank credit. C o n g r e s s
1. "Too-big-to-fail" does not literally mean that a bank cannot
fail. The shareholders in large banks have lost their investment, and the managers have been fired. A bank is considered too-big-to-fail when it is thought to be too large to
close in a way that imposes losses on uninsured depositors
and certain other creditors.
2. Large depositors are not protected when a bank is liquidated, but they have frequently been covered when a failed
bank has been sold as a part of a purchase and assumption
transaction or when the FDIC assumed ownership of the
failed organization and operated it as a bridge bank. The
FDIC generally has sought to avoid liquidating a bank in
order to preserve any franchise value remaining in the organization. However, the FDIC can preserve the franchise
value without providing 100 percent coverage to all depositors by transferring only the insured deposits to the successor organization.
Federal Reserve B a n k of Atlanta
learned that delayed access to funds could pose a systemic problem, so it authorized the F D I C to use final
net settlement. In response to reports that the shock
w a v e s f r o m a large b a n k failure could be amplified
through the payments system, Congress m a d e contractual n e t t i n g a g r e e m e n t s b i n d i n g . I n d e e d , C a r n e l l
(1992) has noted that the original bill passed by the
House and the bill introduced to the Senate did not allow for a systemic risk exception to least-cost resolution and that the exception was added after regulators
and the Bush A d m i n i s t r a t i o n asked f o r the c h a n g e .
T h e earlier versions of F D I C I A relied solely on the
Federal R e s e r v e ' s d i s c o u n t w i n d o w to a d d r e s s any
systemic problems.
Although F D I C I A does not ban the too-big-to-fail
doctrine, it has substantially reduced the likelihood of
future large bank bailouts. Bankers and bank depositors should not casually assume that any given bank
would be considered too-big-to-fail. Regulators would
be well advised to look for ways to close a large failing b a n k w i t h o u t p r o t e c t i n g u n i n s u r e d creditors. If
conditions were such that a large fraction of the banking system was potentially not viable, regulators m a y
have no choice but to protect uninsured depositors. 3 1
However, for most other systemic risk situations, including financial market risk, the potential still exists
for identifying and developing solutions. A careful review of FDICIA's provisions makes it clear that Cong r e s s is l o o k i n g f o r an e n d to o p e r a t i n g u n d e r a
too-big-to-fail policy and not for m o r e explanations as
to why too-big-to-fail treatment is essential.
3. The act defines a material loss as one exceeding the greater
of $25 million or 2 percent of the institution's total assets,
whichever is greater.
4. The exact restrictions on Fed lending are discussed in the
section titled "Incentive Changes."
5. Indeed, if a bank is closed by regulatory or market pressure
before it wipes out its capital, losses to creditors should be
small to nonexistent.
6. Gorton (1988) and Tallman (1988) challenge the view that
bank panics caused declines in real e c o n o m i c activity.
However, this debate is beyond the scope of this paper. It
suffices to note that policymakers in the United States have
believed that systemic problems could adversely affect the
real economy.
7. One reason for the Federal Reserve to be reluctant to lend
to nonbank firms is that, because discount window lending
must be fully collateralized, such lending could imperil the
Kconom ic Review
11
position of the firm's creditors. Thus, if the Fed lends to
nonviable nonbank firms it may be transferring wealth
away from creditors that cannot or do not withdraw their
investment. The Federal Reserve is also not generally in a
position to judge the viability of nonbank firms because the
agency does not examine and rarely monitors the financial
condition of specific nonfinancial firms.
8. For further discussion of the historic operation of the discount window see the Board of Governors of the Federal
Reserve System (1985, chap. 4) and Garcia and Plautz
(1988).
9. Calomiris, Hubbard, and Stock (1986) and Gilbert and
Kochin (1989) have found that the failure of one or more
banks may have negative effects on its regional economy.
In Gilbert and Kochin's research the effects are largest in
two of the three states in their sample if a bank is closed
rather than merged with another institution.
10. Many provisions of FDICIA, including the general promptcorrective-action provisions and the definition of material
loss, have delayed effective dates or phase-in clauses. This
article focuses on the effects of FDICIA after all parts of
the act have taken full effect.
11. FDICIA creates five categories based on capital levels:
well-capitalized, adequately capitalized, undercapitalized,
significantly undercapitalized, and critically undercapitalized banks. Any bank having a tangible equity-capital-to-totalassets ratio of less than 2 percent is classified as critically
undercapitalized. The act also provides that bank regulators
may place a bank in receivership or conservatorship on a
number of other grounds, including violation of a ceaseand-desist order, concealment of records or assets, inability
to cover deposit w i t h d r a w a l s , and an u n d e r c a p i t a l i z e d
bank's failure to develop a plan that would raise its capital
or its material noncompliance with a plan to raise capital.
12. Normal FDIC premiums are calculated on the basis of a
b a n k ' s total domestic deposits. The expanded premium
base provided in FDICIA for emergency assessments will
tend to increase the relative proposition of costs borne by
banks with foreign deposits and substantial nondeposit liabilities. Because banks with foreign deposits and substantial nondeposit liabilities lend to be larger and to affect the
financial system more significantly, the effect of FDICIA
may be to shift more of the costs to the banks most likely to
receive too-big-to-fail treatment.
13. A critically undercapitalized bank is not viable according to
the definition in the act.
14. An argument may also be made that the net effect of FDICIA
will be to weaken banks. The act will increase the number
of regulatory requirements imposed on banks (including
some requirements such as Truth in Savings that are unrelated to bank safety) and will also increase bank reporting
requirements. It does nothing to enhance banks' ability to
compete with nonbank financial firms, which continue to
take market share in many of the b a n k ' s most profitable
markets while remaining free from most of the costly safety
and consumer regulations imposed on banks. Moreover, the
act was passed in an environment in which deposit insurance premiums had been substantially increased on healthy
banks to rebuild the insurance fund.
12
Economic
Review
T h i s a r g u m e n t that FDICIA will weaken banks has
some merit but probably misjudges the impact of what is
and is not in the act. FDICIA probably will strengthen the
financial condition of individual banks and reduce the risk
of bank failures that impose significant costs on the banking system. Banks that cannot strengthen their financial position will likely be forced to merge. Instead, the effect of
higher regulatory costs will be that banks will continue to
concede market share to nonbank firms in markets in which
the law has made banks less competitive.
15. No losses need occur if a bank is closed before its losses become too large. However, closing a bank before its capital
reaches zero does not guarantee that losses will be avoided
unless bank assets are valued at liquidation prices. See
Berger, King, and O'Brien (1991) for a discussion of the
alternative definitions of "market value" and their limitations.
16. See the press release from the Board of Governors of the
Federal Reserve System dated July 14, 1992, Docket No.
R-0769.
17. The regulation on interbank liabilities uses a definition of
"adequately capitalized" that is similar but not identical to
that used to fulfill the prompt-correclive-action sections of
FDICIA.
18. The only case in which the failure of one bank could cause
insolvency at other banks would be that of a well-capitalized
bank failing suddenly and its remaining assets providing
creditors with a low recovery rate. These unexpected losses
would have to be massive under the currently proposed
capital requirements for prompt corrective action because a
well-capitalized bank must maintain a total capital-to-riskassets ratio of at least 10 percent.
19. The limits on interbank credit extension may not be effective at preventing insolvency if a group of related banks fail.
For example, if a set of international banks from a foreign
country were ordered by its government to stop payments,
limits on exposure to any single bank might not be effective.
20. See Holland (1992) for a discussion of some of the risks in
the swaps market. That analysis focuses on the credit risks
posed by the interbank market for swaps. However, the issues raised by interbank credit exposure to swaps are not
fundamentally different from the issues raised by other
types of interbank credit exposure.
21. For a general discussion of the risks posed by over-thecounter derivatives to banking organizations see Hansell
and Muehring (1992).
22. See Shirreff (1991) and Torres (1991) for discussion of
some of the problems encountered in unwinding the derivatives books of some large financial firms. Shirreff (1992)
discusses some of the regulators' general concerns about
the swap market.
23. For example, consider an interest rate swap with a notional
principal of $100 million. One party agrees to pay a fixed
rate of 8 percent and the other party agrees to pay the London interbank offered rate (LIBOR) for five years. The
$100 million notional principal will never change hands.
The party that owes the larger interest payment will pay
an amount to the other party equal to the absolute value of
LIBOR minus 8 percent.
J a n u a r y / F e b r u a r y 1993
24. Further, many master derivatives contracts between two
parties provide for netting across contracts so that gains on
one contract may be offset by losses on other contracts.
25. See Wall, Pringle, and McNulty (1990) for a discussion of
the (credit) risk-based capital guidelines as applied to overthe-counter interest rate and foreign exchange derivatives.
26. This issue may require some sensitivity on the part of the
FDIC to the needs of the bank's counterparties. For example, the FDIC ordinarily likes to close a bank on a Friday
after the U.S. financial markets close. If all over-the-counter
derivatives are terminated at this point, those users that lack
access to foreign markets may have problems arranging
substitute hedges before Monday morning and would therefore be exposed to any changes in market prices during the
weekend. A possible solution would be for swap contracts
to provide that if a bank should fail at the start of a weekend the contract would be terminated at a fixed time on
Monday morning and the remaining obligations of the two
parties would be based on market prices at the time of termination. The FDIC may have to agree to this arrangement.
The one risk in such an arrangement would be that some
dealers may try to manipulate market prices around the termination time, but doing so is likely to be difficult in a
market with a large number of users trying to arrange substitute hedges.
27. Many derivatives products involve two-sided credit risk. If
a user's credit quality has deteriorated sufficiently, dealers
may not be willing to take the credit risk ordinarily involved with products like forward contracts and swaps.
Some derivatives contracts contain clauses to protect the
parties against material adverse changes in the financial
condition of their counterparties, and such contracts would
force the parties to recognize deterioration in the user's
condition prior to its failure. However, financially weakened users may need to provide additional protection to the
dealer in order to reestablish their hedge if the derivatives
contract contains no such clause. For example, rather than
using an ordinary interest rate swap without collateral to
protect against an increase in market interest rates, the user
may be required to post collateral with the dealer or buy an
interest rate cap.
28. Virtually all dealers impose a limit on their maximum credit to any given counterparty. The limit is established according to the counterparty's size and financial strength.
The maximum exposure limits aggregate exposure from all
types of credit risk, including any loans. See Arak, Goodman, and Rones (1986) for an example of ways a dealer
could calculate its credit exposure on an interest rate swap
and Chew (1992) for a recent discussion of a banks' management of derivatives credit risk.
29. The clientele of some dealers tends to be weighted toward
one side of the derivatives market. For example, the customer bases of some commercial banks may be weighted
toward firms that wish to pay a fixed rate of interest on
their interest rate swaps. The bank ends up having a concentration of floating rate contracts. One common way for
these commercial banks to hedge their transactions is to arrange offsetting swaps in which the bank pays a fixed rate
with a dealer that has a different clientele. If credit lines became exhausted in the interdealer market, dealers could
have more problems hedging deals with their natural clientele
and, thus, be less willing to offer over-the-counter derivatives
to their usual customers.
30. Financially weak banks may handicap trading operations in
a number of ways. Their presence may bring the general
credibility of the trading operations into question with customers.
31. The policy mistakes, if any, that led to the questionable viability of a large fraction of the banking system would have
occurred prior to any decision to exercise the systemic risk
exception.
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Chew, Lillian. "A Bit of a Jam." Risk 5 (September 1992): 82ff.
Cornell, Bradford, and Alan C. Shapiro. "The Reaction of Bank
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Haraf, William S. "The Collapse of Drexel, Burnham, Lambert:
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American Banker, August 4, 1992, 1, 10.
Kaufman, George G. " A r e S o m e Banks T o o Large to Fail?
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Leander, Tom. "Old Stone's Theodore Barnes Stopped a Run
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Pozdena, Randall J. "Is Banking Really Prone to Panics?" Federal Reserve Bank of San Francisco Weekly Letter (Octobcr 11,
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J a n u a r y / F e b r u a r y 1993
M;anking Reform and the
Transition to a Market
Economy in Bulgaria:
Problems and Prospects
r
The author is vice president
and senior economist in charge
of basic research in the Atlanta
Fed's research department. The
views expressed in this article
are the author's and not necessarily those of the Federal
Reserve Bank of Atlanta, the
Federal Reserve System, the
U.S. Treasury, the Bulgarian
National Bank and its Bank
Consolidation Company, or
other international
agencies.
Federal
Reserve B a n k of Atlanta
William C. Hunter
he Bulgarian banking and financial system changed dramatically
in 1989 when the C o m m u n i s t Party lost its ruling monopoly and
Bulgaria, like most of its East European neighbors, started down
the road to political and economic democratization. The enthusiasm a c c o m p a n y i n g the breakdown of C o m m u n i s t control m a d e
the obstacles to a smooth transition to a market economy seem relatively
minor. However, the pervasiveness of these stumbling blocks (internal budget deficits, massive external debt, inefficient state-owned enterprises, and a
banking system mired in nonperforming assets, to n a m e a few) has n o w bec o m e painfully apparent. These problems, intensified by the recent collapse
of the ruling political coalition on October 28, 1992, m a k e the task of restructuring the financial system monumental indeed.
Despite the magnitude of the difficulties confronting Bulgaria, it is important that the country persist in efforts already under way to revitalize and
privatize its banking and financial system, which will play a vital role in the
transition to a market economy. T h i s article presents an overview of the
banking reform taking place in Bulgaria, discussing the lack of information
on creditworthiness, the lack of effective accounting and legal systems, and
the p r o b l e m s associated with bad loans within the b a n k i n g s y s t e m and
among state-owned enterprises. 1 In Bulgaria, as in other transition economies
of Eastern Europe, the banking system's ability to fulfill its role in stimulating economic growth depends directly on h o w it handles the deadweight
Kconom ic Review
15
losses associated with failed state-owned firms, which
have been transformed into bad loans on commercial
banks' balance sheets.
The nature of the reforms being undertaken in Bulgaria parallel those occurring in other East European
countries such as Hungary, Romania, the independent
states of the former Soviet Union, and the Czech and
Slovak Republics. Thus, while this article focuses on the
Bulgarian case, the problems, prospects, and proposed
solutions are also relevant to these other e c o n o m i e s
in transition. To begin, a brief overview of the economic history of Bulgaria provides the necessary background for describing the particulars of the Bulgarian
banking system.
A Brief Economic History of Bulgaria 2
Situated on the northeastern section of the Balkan
Peninsula, the Republic of Bulgaria has a population
of about 9 million people. T h e Bulgarian standard of
living, while low, is above that of Romania and Albania, t w o of its neighbors. The average Bulgarian worker earns about $90.00 (U.S.) per month. Blessed with a
w a r m climate and fertile soil, the country has a natural
comparative advantage in the production of agricultural commodities.
T h e c o n t e m p o r a r y B u l g a r i a n state dates back to
681, when the Bulgarian Kingdom was founded after
the B y z a n t i n e E m p i r e f o r m a l l y r e c o g n i z e d B u l g a r
control of the region between the Balkan Mountains
and the Danube River. For the next seven centuries the
Bulgarian state was controlled by a succession of various ruling factions, and the Bulgars were gradually ass i m i l a t e d i n t o the r e g i o n ' s m o r e n u m e r o u s S l a v i c
population. In the latter half of the fourteenth century
Bulgaria was invaded by the O t t o m a n T u r k s and in
1396 lost its independence for the next five centuries.
After the Russian-Turkish War in 1878 Bulgaria was
liberated from Turkish domination and became an independent state.
Until well into the twentieth century Bulgaria's economy was dominated by agricultural production. Between 1920 and 1944 the Bulgarian economy showed
signs of resilience despite the worldwide depression
during the early 1930s. For e x a m p l e , f r o m 1929 to
1939 the average annual growth rate in industrial output in Bulgaria was 4.8 percent, compared with only
1.1 percent for Europe as a whole. This economic resilience c a m e at a price, h o w e v e r . T h e c o n s t r a i n t s
i m p o s e d b y t h e d e p r e s s e d w o r l d e c o n o m y and a
Economic
1 6
Review
s h r i n k i n g export m a r k e t in E u r o p e led B u l g a r i a to
seek alternative trade arrangements, including bilateral
trade agreements with Germany. W h i l e these agreements, which covered an estimated 88 percent of the
country's agricultural output, guaranteed the sale of
Bulgarian agricultural products to Germany, they also
tied the Bulgarian economy closely to Germany's. As
a result, m u c h of Bulgarian industry was e x c l u d e d
f r o m the European free trade zone, isolating the country f r o m market forces governing the European and
world e c o n o m i e s and leading to its a l i g n m e n t with
Germany during World War II.
Following the war, Bulgaria came under the Soviet
U n i o n ' s i n f l u e n c e , and e c o n o m i c d e v e l o p m e n t w a s
subjected to the Communist Party's doctrine. The government gradually assumed direct control of the entire
e c o n o m y , nationalizing agriculture, financial industries, and virtually all private industry and determining
the allocation of resources and output at all levels of
production.
D u r i n g the period of C o m m u n i s t domination the
Bulgarian government's main economic objective was to
create new industries—engineering, metallurgy, chemicals, electricity generation, and appliances, a m o n g
others. This emphasis virtually reversed the comparative contributions of industry and agriculture to aggregate production or output, resulting in a massive shift
in occupations and in migration of the population from
rural to urban areas.
Bulgaria's East European neighbors, including Czechoslovakia, East Germany, Hungary, Poland, and R o m a nia, w e r e also b r o u g h t into the Soviet sphere after
World War II. Given the similarity of their economic
institutions and policy objectives and their c o m m o n
concern for fostering industrialization, income redistribution, and social equality, these countries, along with
the Soviet Union and others with centrally planned
economies, f o r m e d an economic union—the Council
for Mutual E c o n o m i c Assistance ( C M E A ) — i n Janu a r y 1949. A n e s s e n t i a l c o m p o n e n t of the S o v i e t
g r o w t h strategy, the council p r o v i d e d a f r a m e w o r k
within which its m e m b e r s could p r o m o t e their own
(and the Soviet Union's) national objectives. 3
T h e Bulgarian e c o n o m y showed significant signs
of weakness as early as the late 1950s, and the government's five-year economic plans issued following
the nationalization of industry were rarely achieved.
In recognition of this failure, the government introduced several economic reform programs during the
1960s and 1970s. At the end of the 1970s, the socalled N e w E c o n o m i c M e c h a n i s m w a s i n t r o d u c e d
with the aim of creating s e l f - f i n a n c i n g f i r m s at all
January/February 1993
levels of industry and thereby enhancing productivity
and efficiency. These r e f o r m s were d e e m e d ineffective. Indeed, the rate of economic development actually s l o w e d in the years f o l l o w i n g a d o p t i o n of the
program.
Attempts at economic reform continued through the
1980s. H o w e v e r , as late as 1988 state-owned enterprises and cooperatives still dominated the Bulgarian
economy, producing virtually all of the country's output and employing almost all of the work force. With
the downfall of the Communist Party in 1989, Bulgaria took its most important steps toward economic ref o r m by d i s c o n t i n u i n g the central p l a n n i n g of f i r m
management and developing the mechanisms to establish private ownership and property rights.
The country began the process of economic reform
with a parliament controlled by a fragile democratic
c o a l i t i o n . T h i s c o a l i t i o n c o l l a p s e d in late O c t o b e r
1992, and it is not yet clear h o w this d e v e l o p m e n t
will affect the speed with which r e f o r m s are implemented. In addition, the country has an external debt
of approximately $12 billion (U.S.) owed primarily to
the F e d e r a l R e p u b l i c of G e r m a n y , J a p a n , a n d t h e
United Kingdom. The government also faces the difficulties of managing an internal budget deficit estimated to be approximately 9 billion Bulgarian leva
(approximately $500 million [U.S.] at the current official exchange rate of about 23 leva to $1 [U.S.]) for
fiscal 1992.
7Tie Structure of t h e
Bulgarian Banking System
The modern era in Bulgarian banking and finance
began with the passage of the Banking L a w of Dec e m b e r 27, 1947, which effectively nationalized the
system. From 1948 until 1981, this system, similar to
those of other East European countries, comprised three
distinct banks. T h e Bulgarian National Bank, m u c h
like the Gosbank in the classic Soviet economic model
of centralized planning, m o n i t o r e d the financial aspects and financed the investments of the central government's annual economic plan. It also monitored the
payments of enterprises, received their deposits, and
extended credit in the domestic currency. The Bulgarian Foreign Trade Bank had sole responsibility for foreign exchange operations (payments associated with
imports and exports, foreign credits, and management
of foreign currency reserves). The State Savings Bank
was limited to serving the household sector, receiving
Federal
Reserve Bank of Atlanta
their savings deposits and financing housing credits
much as savings and loan associations do in the United States.
Bulgaria's three-bank system ended in 1981 when
t h e g o v e r n m e n t c r e a t e d a s p e c i a l b a n k to f i n a n c e
business activities that were not included in its official e c o n o m i c plan or that exceeded the plan's target
budget. Further c h a n g e occurred in 1987, w h e n the
g o v e r n m e n t set u p s e v e n s p e c i a l i z e d c o m m e r c i a l
banks, each restricted to lending in a particular econ o m i c sector, such as transportation, electronics, construction, or chemicals. T h e seven banks operated as
full-service universal banks, able to provide loans in
the domestic or foreign currency and to take equity
positions in other f i r m s , c o m p a n i e s , and joint v e n tures in their respective sectors. In 1989 the government created fifty-nine new commercial banks out of
the f o r m e r branches of the Bulgarian National Bank
and simultaneously eliminated the r e q u i r e m e n t that
certain banks engage in specialized lending. 4 This action allowed all banks to function as universal banks.
Since 1989 several new banks have been granted charters by the Bulgarian National Bank, including at least
four private banks (as of late 1992). As of July 1991
there were a total of s e v e n t y - f o u r b a n k s (excluding
the Bulgarian National Bank and the Bulgarian Foreign Trade Bank) with a total of 4,033 offices operating in the country.
Most Bulgarian banks are organized as joint stock
companies. Until late 1991 the shares of all banks except the four recently created private banks were owned
principally by the Bulgarian National Bank, the Bulgarian Foreign Trade Bank, and a f e w large state enterprises in the nonfinancial sector. A s of July 1991
the Bulgarian National Bank owned approximately 32
percent of the shares of the older commercial banks
(the seven created in 1987 and the Bulgarian Foreign
Trade Bank) and about 65 percent of the shares of the
f i f t y - n i n e b a n k s c r e a t e d in 1989 out of its f o r m e r
branches. The Bulgarian Foreign Trade Bank and the
seven specialized banks created in 1987 also o w n a
significant percentage of the shares of these fifty-nine
banks.
In conjunction with the World Bank, the Bulgarian
National Bank has designed a merger and privatization
program to consolidate Bulgaria's commercial banks
into eight to ten institutions with shares held by private domestic and international investors. The shares
of the commercial banks owned by the Bulgarian National Bank and the state-owned enterprises were recently transferred to the Bank Consolidation Company,
a wholly owned subsidiary of the Bulgarian National
Kconom ic Review
17
Bank established to manage and oversee the consolidation effort.
b a n k i n g and Financial System
Obstacles to the Bulgarian Transition
Of the m a n y problems confronting the Bulgarian
and other East European economies, the lack of wellfunctioning m o n e y and capital markets is especially
critical. T h e existing m a r k e t s in these countries are
less diverse and stable than those of Western economies
primarily because they lack the complex information
required to assess risks and the c r e d i t w o r t h i n e s s of
borrowers. This dearth of information is understandable given that central planning regimes offered f e w
incentives to accumulate such data.
Before 1987 the governments of centrally planned
economies like Bulgaria served as the lender of last resort, automatically financing the losses of state-owned
enterprises. These governments essentially provided a
f o r m of c o m p r e h e n s i v e i n s u r a n c e to f i r m s w i t h o u t
charging the appropriate premiums, and this practice
led, in most cases, to the overextension of credit between state-owned enterprises and by commercial banks
to these firms. In Bulgaria, where most commercial
banks' balance sheets are dominated by such loans, an
estimated 54 percent of all bank credits, equaling 34.4
percent of the country's gross domestic product, were
nonperforming. For the specialized commercial banks
created in 1987, n o n p e r f o r m i n g loans accounted for
65 percent of the loans held on their balance sheets. 5
Currently, Bulgarian state-owned enterprises have
an estimated total outstanding debt of about 100 billion leva. Of this total, m o r e than a quarter is owed to
other state-owned enterprises and about half is owed
to Bulgarian commercial banks. This interdependence
of the balance sheets of state-owned enterprises and
commercial banks impedes the operation of the Bulgarian money and capital markets because it makes it
difficult to distinguish efficient and economically or
financially viable firms f r o m those that are inefficient
and nonviable. This situation, in turn, makes it almost
impossible for banks or other investors to make rational credit decisions, creating negative spillover effects
for consumers.
T h e overall uncertainty in the Bulgarian economy
adversely affects the profitability of business enterprises in general and reduces the market value of their
installed capital, thereby limiting their c a p a c i t y to
borrow against this capital. This atmosphere of uncer-
Economic
18
Review
tainty, overlying a complex system of interfirm credits that links the fortunes of well-run firms to the poorly run o n e s , is s l o w i n g the t r a n s i t i o n to a m a r k e t
economy.
The narrowness of the capital markets in the evolving e c o n o m i e s of Bulgaria and other East European
countries exposes investors and creditors to excessive
degrees of systemic risk because they cannot diversify.
This inability to diversify leads to large risk premiums
and overly expensive credit, and, coupled with the interdependence of state-owned enterprises' and c o m mercial b a n k s ' balance sheets, allows small shocks
incurred by a particular firm or sector to be transmitted to other f i r m s and sectors and eventually to the
c o m m e r c i a l banks and the entire economy. To limit
their exposure to such risks, lenders and investors will
tend to shorten their investment and lending horizons.
From a social viewpoint the domination of short-term
q u i c k - p a y b a c k i n v e s t m e n t s m a y not be optimal because they may squeeze out more desirable (and m o r e
profitable) longer-term investments.
.Removing the Obstacles
T h e factors identified above represent m a j o r impediments to Bulgaria's successful shift to a market
economy. It is clear that the Bulgarian banking and financial system would be made more efficient by the
implementation of policies that would ( 1 ) improve the
f i n a n c i a l i n f o r m a t i o n s y s t e m and the legal instruments available to lenders, investors, and borrowers;
(2) cleanse commercial banks' and state-owned enterprises' balance sheets of their bad loans; and (3) enhance Bulgarian policymakers' credibility.
Financial Information. An improved financial inf o r m a t i o n system in Bulgaria and similar transition
economies would provide for a better assessment of
individual f i r m s ' creditworthiness, thereby encouraging more lending and investment. Developing a framework of legal i n s t r u m e n t s to e n f o r c e contracts and
protect both lenders' and b o r r o w e r s ' property rights
would also improve the lending environment.
A uniform set of transparent accounting standards,
including rules for public disclosure of nonproprietary
financial information, is critical to the further liberalization of Bulgaria's banking and financial sectors. Accounting standards form part of the resource allocation
process, allowing banks to compare the merits of one
borrower over another. Similarly, bank supervisors, investors, depositors, and m a n a g e r s need d e p e n d a b l e
January/February 1993
bank financial statements to make informed judgments
about bank financial health and performance.
For banks, a vital component of the accounting system is a set of rules relating to valuation of assets and
capital. Without such rules, accounting systems bec o m e relatively worthless and the value of banks' equity capital m a y be called into question. Assets need
to be valued on a bank's books at their true worth, particularly w h e n this value is less than the price paid for
t h e m . C o n s i d e r i n g the scope of the n o n p e r f o r m i n g
loan problem among Bulgarian commercial banks, the
application of accounting standards would require that
such assets be written d o w n or written off, depending
on their status, before the banks will be free to function as true financial intermediaries.
Cleansing Balance Sheets. Finding appropriate
ways to clean up commercial banks' and state-owned
firms' balance sheets f r o m bad loans would uncouple
the fortunes of f i r m s that should continue operating
f r o m those that ought to be shut down, restructured, or
reorganized. A m a j o r challenge in Bulgaria and other
former Soviet Bloc countries is to achieve this objective without imposing excessive costs on the national
budget or f u r t h e r h a m p e r i n g the incentive structure
faced by market participants.
A n u m b e r of m e t h o d s for c l e a n s i n g the b a l a n c e
sheets of commercial banks and state-owned enterprises
are being debated in the transition economies of Eastern Europe: the simple cancellation of state-owned enterprises' debts, socialization or nationalization of bad
debts, privatization of bad debts through specialized
asset liquidation or carve-out companies, or liquidation and restructuring of banks and state-owned enterprises through a specialized government restructuring
agency or company.
The simple cancellation of all debts of state-owned
enterprises is not advisable for several reasons. First,
such a step would reduce the working capital of creditor firms and banks; it also carries the risk of driving
good firms whose cash-flow requirements depend critically on debt service receipts into bankruptcy. Similarly, cancellation of only the acknowledged bad debts
of s t a t e - o w n e d e n t e r p r i s e s is ill-advised b e c a u s e it
could give rise to serious moral hazard or other incentive problems. Such a plan of debt forgiveness or cancellation might lead suppliers of inputs to the stateo w n e d c o m p a n i e s (both good and bad) to withhold
financing in fear of further debt cancellation by the
government or the outright repudiation of these obligations by state-owned enterprises in hopes of receiving f u r t h e r g o v e r n m e n t protection. To the contrary,
the East European g o v e r n m e n t s should consider ex-
Federal
Reserve Bank of Atlanta
t e n d i n g the credit of p r o f i t a b l e s t a t e - o w n e d e n t e r prises to minimize disruptions to the financial sector
as b a n k s ' and state-owned f i r m s ' balance sheets are
cleansed. 6
Separating the future prospects of the debtor and
creditor enterprises and banks through the nationalization, socialization, or absorption of bad debts by the
government is a feasible alternative to a simple debt
cancellation policy. Such actions would transform the
nature of these debts and alter their risk characteristics
without changing their magnitude.
Tn nationalizing the debt, the government can engage in debt-for-debt swaps, exchanging its o w n debt
(bonds or bills) for the bad loans that creditor f i r m s
and banks hold against other enterprises. In essence
the transaction would recapitalize the firms and banks
by replacing bad loans with g o v e r n m e n t obligations
and transforming debtor f i r m s ' liabilities to other enterprises and b a n k s into g o v e r n m e n t liabilities. B y
acting as a financial intermediary, the government essentially transfers the cost of the restructuring to Bulgarian taxpayers. 7
B y servicing its o w n debt the g o v e r n m e n t w o u l d
ensure that the creditor enterprises and banks are paid
off. However, to secure its capacity to service its debt,
the government must have at its disposal a functional
tax system capable of collecting the needed revenues
without resorting to inflationary finance. This need for
revenue points out the urgency for quick development
of an efficient tax and collection system.
The Bulgarian government has, in principle, adopted
this bad-debt nationalization plan for a portion of commercial banks' bad loans granted before 1990. However,
given Bulgaria's internal budget deficit, its tax system
will h a v e difficulty coping with the debt-service requirements on the government bonds used in this plan,
as acknowledged by the existence of a five-year moratorium on the payment of interest on this debt. 8
The presence of the internal budget deficit calls for
other, innovative solutions to the country's bad debt
problem. In addition to the debt s w a p p r o g r a m , the
Bulgarian government has established the Bank Consolidation C o m p a n y — s i m i l a r in some respects to the
Resolution Trust C o r p o r a t i o n in the U n i t e d States,
which is charged with liquidating financially failed
savings and loan associations—to oversee the restructuring, consolidation, and privatization of the banking
system. 9 A similar agency is being formed to handle
this process for state-owned enterprises. T h e use of
government entities to carry out the restructuring reflects the general lack of information on asset values,
a shortage of private risk capital, and the absence of
Kconom ic Review
19
established markets for asset liquidation. Thus, unlike
the United States in recent cases, Bulgaria cannot rely
on the formation of private companies to purchase and
liquidate the failed companies.
In short, cleansing the balance sheets of the c o m mercial b a n k s and viable state-owned enterprises is
critical to the success of the ongoing Bulgarian transition. O n c e these balance sheets are cleaned up and
better valuation of assets is possible, the economy can
be further opened up and the benefits associated with
foreign capital investment can be realized. These benefits include financial and managerial assistance and
better access to international capital markets. Foreign
investors and managers can bring the know-how, contacts, information, and other skills needed to augment
the country's existing expertise and improve the functioning of domestic money and capital markets.
E n h a n c i n g Credibility. A m o n g the countries of
Eastern E u r o p e , a n o t h e r o b s t a c l e to the s u c c e s s f u l
t r a n s f o r m a t i o n to a market e c o n o m y is g o v e r n m e n t
policymakers' lack of credibility, which adds to the
uncertainty faced by economic agents and results in
i n e f f i c i e n t d e c i s i o n m a k i n g a m o n g m a r k e t particip a n t s b e c a u s e they d o not k n o w the " r u l e s of the
g a m e " in the newly liberalized markets. To enhance
their credibility, policymakers must demonstrate that
they are willing to introduce f u n d a m e n t a l change in
the m a n n e r in which policy is conducted and to be
consistent in their policy choices. The adoption of a
rule-based policy f r a m e w o r k rather than one based on
discretion represents one way of gaining credibility. A
rule-based f r a m e w o r k tends to reduce the perception
of arbitrariness and thereby strengthens confidence in
the policy-making process. However, a system devoid
of some discretionary leeway is not advisable because
it may not allow policymakers to respond to e c o n o m ic shocks or political crises in a timely and appropriate fashion.
Regardless of the degree of discretion allowed policymakers in these transition economies, at least two
elements of policy credibility are crucial to the success
of the changes. First, the economic reform program itself must be credible. It should be feasible, stand up to
the test of professional scrutiny, and reflect the experiences and lessons f r o m similar episodes in other countries. Second, policy c o m m i t m e n t s must be credible.
They must not be changed in midcourse to take advantage of private sector agents' response to the initially
announced policies. This practice can only result in
policy i n e f f e c t i v e n e s s as e c o n o m i c d e c i s i o n m a k e r s
learn not to trust their policymakers and react to policy
pronouncements in perverse and undesirable ways that
20
Economic Review
neutralize the policies' intended effects. Clearly, policymakers must find ways to guarantee to market participants that policy will not be used to their disadvantage
after they have altered their behavior in response to
policy pronouncements.
There are many ways of achieving consistency and
credibility in policy making in Bulgaria and the other
f o r m e r Soviet Bloc countries. A m o n g these are political constraints like those imposed by constitutions
( s u c h as b a l a n c e d b u d g e t p r o v i s i o n s ) ; l e g a l c o n straints set forth by parliaments, congresses, and other official governing bodies; and external constraints
of the t y p e i m p o s e d by international o r g a n i z a t i o n s
such as the Basle C o m m i t t e e on B a n k i n g S u p e r v i sion, the G e n e r a l A g r e e m e n t on T a r i f f s and T r a d e
(GATT), the International M o n e t a r y F u n d , and the
World Bank.
T h e n e w l y f o r m e d d e m o c r a t i c g o v e r n m e n t s of
Eastern E u r o p e face e n o r m o u s political pressures as
they attempt to implement reforms. In such an envir o n m e n t , the v a l u e of e c o n o m i c policy c o n s t r a i n t s
imposed by international agencies should not be underestimated. In most cases these restrictions, in addition to fostering a smooth transition, also contribute
much in the way of binding policymakers to credible
and consistent economic policies.
The Bulgarian Banking Industry's Future
The short-run prospects of the Bulgarian banking industry hinge directly on the ability of the Bank Consolidation Company to carry out its task of restructuring,
consolidation, and privatization. Given the banking sect o r ' s key role in the economic development process,
the future of the Bulgarian economic transition is seen
to depend critically on developments in this sector.
T h e B a n k C o n s o l i d a t i o n C o m p a n y ' s initial goal
was to reduce the number of commercial banks f r o m
about seventy-four to around eight or ten through a judicious merger and consolidation program beginning
in October 1991 and ending in February 1992. For numerous reasons, this ambitious goal was not achieved.
As of September 1992 one merger involving twentytwo commercial banks was formalized with the voluntary signing of a merger agreement, spearheaded by
the B a n k Consolidation C o m p a n y and approved by
the Bulgarian National Bank, that resulted in the formation of the United Bulgarian Bank (formerly named
the Bulgarian Credit Bank). This bank anticipates receiving equity investments and technical assistance
January/February 1993
diversified. In addition, the bank management must be
of high quality, and the bank must have positive earnings potential and excellent liquidity on its balance
sheet. A s for most Western banks, the merged institution must also have f o r m a l written policies covering
all aspects of its operations.
from the European Bank for Reconstruction and Development and other foreign organizations. Currently,
it is anticipated that two or three mergers involving
other commercial banks will be formalized during the
winter of 1993.
Considering the magnitude of its task, it is not surprising that the Bank Consolidation C o m p a n y failed to
meet its initial consolidation goals. Clearly, the consolidation effort cannot be effectively carried out without proper attention to the problems discussed in this
article. In trying to achieve consolidation, the B a n k
Consolidation Company faces a banking industry
characterized by n u m e r o u s banks of inefficient size
(too small to exploit economies of scale) with undiversified loan portfolios, poor-quality assets and excessive bad debts, inadequate equity capital, and a labor
force generally lacking in modern banking and financial skills.
Conclusion
A natural function for banks in the transition from a
c o m m a n d to a market e c o n o m y is to replace central
plans for financial intermediation and economic development in such a way as to bring market forces to bear
on the process of transferring savings into investment.
This process is the key to both the failure of the system of central planning in pre-1989 Bulgaria and to
the country's prospects for future economic reform.
Despite its lack of resources, the Bank Consolidation C o m p a n y has made important strides in establishing a f r a m e w o r k f o r m e r g i n g B u l g a r i a ' s b a n k s . A
uniform accounting system and an analysis system for
appraising b a n k s ' financial health h a v e been established. The analysis system r e s e m b l e s the C A M E L
rating system used by commercial bank regulators in
the United States, which appraises bank capital, asset
quality, m a n a g e m e n t , earnings potential, and liquidity f o r all c o m m e r c i a l b a n k s as well as for m e r g e r
candidates. Under the Bank Consolidation C o m p a n y ' s
g u i d e l i n e s , the b a n k r e s u l t i n g f r o m a m e r g e r m u s t
have sufficient equity capital in accordance with the
existing international capital regulations (8 percent of
total assets), must not contain excessive bad debts in
its loan portfolio (nonperforming assets must be written down, written off, or reserved), and must be well
Unfortunately, as this article suggests, the Bulgarian banking and financial system is currently incapable
of carrying out this function effectively. The problems
in the Bulgarian banking and financial system are both
b r o a d - b a s e d and d e e p - r o o t e d and will p r o b a b l y be
eliminated only through a slow and difficult process of
economic transition. Despite this pessimistic outlook,
however, there are several positive developments taking
place in the banking system. Bulgarian policymakers
seem to understand the need for further banking system reform and are taking steps to restructure the industry to put it on a sound e c o n o m i c footing. A s these
system reforms are carried out, they should generate
positive external e f f e c t s f o r price r e f o r m , m o n e t a r y
policy, trade liberalization, and other key elements in
the economic transition process.
Notes
1. During the spring of 1992 the author was on special assignment
in Bulgaria working with the University of Delaware-Bulgarian
Coalition and with the Bulgarian National Bank and its Bank
Consolidation Company. More recently, he visited Bulgaria as
part of a Federal Reserve' Bank of Atlanta-U.S. Treasury shortterm technical assistance mission at the Bank Consolidation
Company. Much of this article is based on information obtained during these visits, such as unpublished memoranda and
conversations with officials of the Bulgarian National Bank,
the Bulgarian Bank Consolidation Company, the International
Monetary Fund, the World Bank, the University of Delaware-
Reserve B a n k of Atlanta
Digitized Federal
for FRASER
Bulgarian Coalition, and the managements of several Bulgarian
commercial banks.
2. This description draws heavily on documents of the Bulgarian National Bank, including its 1990 Annual Report.
3. Approximately 90 percent of Bulgaria's foreign trade was
c o n d u c t e d with C M E A c o u n t r i e s until 1989, w h e n the
CMEA relationships began to disintegrate.
4. Although sector-specific lending by commercial banks is no
longer mandatory, many still lend to only a few firms in designated sectors. This behavior, combined with the fact that
many of the newly created commercial banks were allocated
Kconom ic Review
21
the loans accumulated by state-owned enterprises under the
old Gosbank-type financial system, has resulted in a banking
system characterized by inadequate loan portfolio diversification. Inadequate diversification exacerbates other problems
in Bulgaria's banks, including small capital bases and inexperienced managements, that are discussed elsewhere in the
article.
5. Given the accounting principles employed in Bulgarian banks,
these estimates are extremely conservative by Western standards.
6. Identifying which state-owned enterprises are profitable requires the adoption of meaningful accounting conventions,
as discussed earlier.
7. It should be kept in mind that, unlike bad loans that resulted
from the savings and loan debacle in the United States, the
bad loans of the Bulgarian commercial banks have always
been government obligations. These loans were made by the
government's monobank and assigned to the newly created
commercial banks once the two-tiered banking system was
22
Economic
Review
adopted. However, as in the U.S. savings and loan crisis, the
Bulgarian government should commit not to engage in future
bailouts of banks if it is to avoid the problems of excessive
risk taking associated with the moral hazard dilemma.
8. However it is financed, any plan to nationalize debt hinges
on the question of government credibility; government bonds
swapped for bad loans must be marketable if the plan is to
be effective. By substituting public debt for private or quasiprivate debt, the government is merely making explicit an
existing obligation. The point is that it must commit itself to
raise taxes or earmark revenues (for example, cut future
spending) to service this newly issued debt. If the governm e n t c a n n o t credibly c o m m i t , its debt will not be marketable. An alternative to the issue of g o v e r n m e n t debt
would be obligations of the central bank serviced by earmarked taxes (fees) collected from the banking system.
9. The activities of the Bank Consolidation Company are discussed in more detail in the section that follows.
J a n u a r y / F e b r u a r y 1993
Competitive Considerations in
Bank Mergers and Acquisitions:
Economic Theory, Legal
Foundations, and the Fed
Christopher L. Holder
The author is an analyst in the
financial section of the Atlanta
Fed's research
department.
He gratefully
acknowledges
comments from D wight
Blackwood, Jim Burke,
Angela Dirr, Frank King,
AI Martin, Bobbie
McCrackin,
Steve Rhoades, Aruna Srinivasan. Sheila
Tschinkel,
and Larry Wall.
Digitized Federal
for FRASER
Reserve Bank of Atlanta
n the past decade the U.S. banking industry has experienced m a j o r
structural changes, including a significant reduction in the n u m b e r of
independent banking organizations. This change is partly the result of
the increased pace of bank m e r g e r s and acquisitions. 1 D u r i n g the
twenty-year period from 1960 to 1979, mergers averaged 170 per year,
with an average of $4.9 billion in total bank assets being acquired each year.
In contrast, from 1980 to 1989 there was a yearly average of 498 mergers
and $64.4 billion in total bank assets acquired. 2 Whatever dynamics underlie this industry consolidation, the overall result at the national level has
been the increased concentration of banking resources a m o n g f e w e r banks.
At the same time, local market share concentration levels have remained
virtually unchanged during the eighties, a particularly important factor because local banking markets are the arena in which banking agencies measure competition between banks in considering antitrust issues. 3
Consolidation in the banking industry has been a hot media topic in part
because one alternative means of exit open to banks—failure—carries such
negative force. 4 Ordinarily, stockholders and creditors operating in a market
economy accept the risk of failure as a normal part of their investment, but in
the banking system the deposit guarantees of the federal government put public funds at risk. Because any funds lost are drawn from insurance premiums
Kconom ic Review
23
paid by the insured institutions, they in fact come only
indirectly from taxpayers and consumers of bank products. N o n e t h e l e s s , the s a v i n g s and loan crisis h a s
made a direct taxpayer bailout of the banking system
all too conceivable. To the extent that consolidation
is necessary for the U.S. banking system to remain
strong and globally competitive, mergers and acquisitions are clearly preferable, as a means to this end, to
large numbers of bank failures.
The Federal Reserve System, created by the F e d e r al Reserve Act in 1913 to provide for a safer and more
flexible banking and monetary system, shares responsibility for b a n k i n g s u p e r v i s i o n with other f e d e r a l
b a n k i n g agencies. Part of the F e d ' s responsibilities
includes administration of the laws that regulate bank
holding companies and supervision of state-chartered
member banks. These institutions are required to obtain
approval f r o m the Federal Reserve Board of Governors prior to c o m p l e t i n g a b a n k m e r g e r or acquisition. 5
The Fed does not automatically grant approval of
applications for merger. Several factors are taken into
account—the likely effects of the acquisition on banking competition, financial and managerial resources
and p r o s p e c t s f o r the a c q u i r e r ' s f u t u r e , the c o n v e nience and needs of the community to be served, and
any other legal issues related to a particular application. In considering the competitive aspects of a proposed merger, the Fed determines the extent to which
existing competition would be adversely affected by
the acquisition if an acquiring bank or bank holding
company already has one or more banking offices in
the market in which it seeks to acquire a bank. The
Fed also examines the likely effects of the acquisition
on probable future, or potential, competition if the acq u i r e r is not already r e p r e s e n t e d in the m a r k e t s in
which the bank to be acquired operates.
To e n s u r e that safety and s o u n d n e s s criteria are
met, the Fed considers the financial and managerial resources and the expected future of both the acquirer
and the bank to be acquired. Some of the m a j o r factors
taken into account include (1) the present and future
capital position, asset quality, income, liquidity, and
riskiness of the acquirer, (2) the means by which the
acquirer intends to finance the merger and its level of
debt and ability to service that debt, and (3) the quality
of the acquirer's m a n a g e m e n t and any plans for improving it.
The effect of the acquisition on banking products
and services in the relevant banking markets is another
concern examined by the System. If new or better services or lower prices for bank services are likely to re-
24
Economic Review
sult from an acquisition, the merger is more likely to
win a p p r o v a l . T h e Fed also e x a m i n e s an a c q u i r e r ' s
record under the Community Reinvestment Act, such as
its performance in meeting the credit needs of its community, including low- and moderate-income areas.
T h e d y n a m i c nature of the U.S. b a n k i n g system,
the several purposes of bank regulation, and the num e r o u s v a r i a b l e s to be c o n s i d e r e d in e a c h m e r g e r
t r a n s a c t i o n — s u c h as d i f f e r e n t s u p p l y and d e m a n d
conditions and the unique characteristics of different
geographic markets—necessitate examining mergers
on a case-by-case basis. It is the purpose of this article
to focus on one aspect of the Fed's analysis of bank
acquisitions over the last decade: the likely effect of
mergers on competition. 6 T h e discussion summarizes
the Federal Reserve's general approach to antitrust issues over the last decade. The economic factors and
legal precedents that serve as the Fed's foundation for
c o m p e t i t i v e a n a l y s i s and c h a n g e s in t h o s e c r i t e r i a
over the last decade are also considered. 7 For example, regulators have taken into account that banks have
faced increased competition not only f r o m within the
banking industry but also f r o m thrifts and other financial institutions as they have experienced deregulation.
Antitrust Issues
Antitrust regulation seeks to fulfill several objectives for bank customers and the general public. O n e
goal is to prevent m o n o p o l y prices (excess profits) in
the banking industry. Another is maintaining public
access to b a n k products and services, an issue that
can be especially problematic in small markets. 8 Antitrust laws seek to avoid static (noninnovating) markets
and to allow efficiency-increasing, s e r v i c e - e n h a n c i n g
mergers. In addition, antitrust regulations are connected with safety and soundness issues, including limiting Federal Deposit I n s u r a n c e C o r p o r a t i o n ( F D I C )
losses.
The Federal Reserve keeps the objectives and concerns of antitrust regulation in mind in analyzing the
c o n s e q u e n c e s of b a n k m e r g e r s and acquisitions on
market competition. Although few deals are actually
denied by regulators on competitive grounds, antitrust
issues play an important role in structuring mergers
and acquisitions. M a n y deals are restructured to include divestiture, and an u n k n o w n n u m b e r of banks
are deterred from even filing a merger application because of anticipated antitrust concerns. 9
January/February 1993
E c o n o m i c s of Market Structure
One of the main purposes of antitrust regulations in
mergers is to prevent acquirers from earning abnormal
profits at the expense of consumers within the market
w h e r e the m e r g e r occurred. 1 0 D e f i n i n g the relevant
market, in terms of both product and geographic area,
is crucial for analyzing the economic effects of a proposed merger. Simply defined, a market is a group of
buyers and sellers that significantly influence prices,
quality, and quantity of specific products and services
and the g e o g r a p h i c area in which these buyers and
sellers interact. A market can also be defined as an area
in which the prices of all similar (substitute) goods are
dependent on each other but are unaffected by prices
for goods outside of the area.
For example, consider the case of t w o merchants
w h o sell essentially the same product at similar, but
not necessarily identical, prices (as b a n k s do). O n e
m e r c h a n t is located on the north side of t o w n and
draws customers entirely from that area while the other merchant, located on the south side of town, draws
customers exclusively f r o m the south side. B e c a u s e
these merchants have no c o m m o n customers, it might
seem that they operate in separate markets. That assumption is not necessarily correct, however. To determine whether they are operating in the same market it
is necessary to observe buyers' responses to a nontrivial and nontransitory price change in the good being
sold. Suppose that one of the merchants—the one on
the north side of town—raised the price of the product
being offered. If this price change did not affect demand for the comparable good offered by the southside m e r c h a n t , w h o did not c h a n g e prices, the t w o
would be functioning in separate markets. However, if
some customers were willing to switch the store f r o m
which they buy, the merchants would be in the same
market and would be direct competitors, even though
they previously had currently d r a w n their c u s t o m e r
base f r o m separate areas.
Besides direct competition, the potential for competition is an important factor in determining markets. A
potential competitor is one who would have to make
an entry decision, and thus incur entry costs, before
c o m p e t i n g in a particular market. Because potential
competitors help deter the exercise of market power (a
single buyer's or seller's ability to influence the price
of its product or service) within a market, their presence enhances competition. The degree to which they
can forestall anticompetitive behavior is directly related to the proportions of obstacles—the size of entry
Federal Reserve Bank of Atlanta
costs and the existence of legal barriers to e n t r y —
standing between the potential competitors and entry.
The lower the entry costs, or the fewer the legal restrictions on entry, the more potential competition contributes to sustaining c o m p e t i t i o n within a m a r k e t .
Unfortunately, the importance of potential competition
c a n n o t b e a s s e s s e d n u m e r i c a l l y with the c u r r e n t l y
available empirical data.
In measuring the effects of either direct or potential
competition in markets, it is necessary to determine
the degree of substitutability between p r o d u c t s — i n
e c o n o m i c terms, the cross-elasticities of supply and
d e m a n d . T h e cross-elasticity of supply indicates the
r e l a t i o n s h i p b e t w e e n the p r o d u c e d q u a n t i t y of o n e
good and a change in the price of another. The crosselasticity of demand indicates the relationship between
the d e m a n d e d quantity of one product and a change
in the price of another. The more responsive the quantity of o n e p r o d u c t p r o d u c e d or d e m a n d e d is to a
change in price of another product, the higher the crosselasticities and the more those products are viewed as
substitutes (see Frederic M . Scherer 1990 or Jean Tirole 1988).
However, cross-elasticities alone cannot precisely
determine markets. For one thing, cross-elasticities are
difficult to estimate, and current theory does not define specific numerical levels at which a product becomes an adequate substitute for another product and
would be included in the market. Another issue is that
of the time f r a m e in which customers and suppliers
m i g h t switch p r o d u c t s — t h a t is, s w i t c h i n g p r o d u c t s
m a y not be possible in the short term. In addition, the
price changes that would induce buyers or sellers to
substitute must take into account the relative prices of
products and transactions costs. In practice, only those
producers that might have a direct and immediate effect on competition are included in the market. T h e
manner in which markets are currently defined by the
Fed is discussed later.
O n c e the r e l e v a n t m a r k e t has b e e n d e t e r m i n e d ,
competition within the market must be assessed. To do
so, federal banking agencies apply theories developed
in the field of industrial organization, the area of applied economics that seeks to explain the behavior of
firms in a market. In particular, the agencies rely heavily on the concept k n o w n as the structure-conductperformance (SCP) paradigm, which contends that the
structure of a market indicates the amount of competition among firms in that market. 11 In this view, market
structure is considered to be affected by the basic conditions underlying an industry, such as d e m a n d and
supply functions and legal constraints. In turn, market
Kconom ic Review
25
Box 1
Determination of Geographic Markets
T h e S u p r e m e C o u r t ' s decision in the 1963 Philadelphia National Bank c a s e — t o consider a b a n k ' s geographic market to be its local area—remains the foundation of
the F e d ' s delineation of geographic markets. T h e Fed attempts to define markets in terms of the area in which
buyers and sellers can interact without significant transaction costs. B e c a u s e the market is the basis for calculating t h e s t r u c t u r a l e f f e c t s of a p r o p o s e d m e r g e r , t h i s
market definition is often crucial in deciding whether a
m e r g e r is permissible under antitrust laws. 1
The j o b of determining local banking market definitions at the Fed falls to the twelve Federal Reserve Banks,
with p r o c e d u r e s and g u i d a n c e f r o m the Board. Recent
national studies of c o n s u m e r and business behavior and
local market surveys by various Reserve B a n k s confirm
that the B o a r d ' s definition of a market as a local banking
market is still current (see G r e g o r y E. Elliehausen and
John D. W o l k e n 1990, 1992). T h e following discussion
r e v i e w s s o m e of the factors considered by the Reserve
Banks in defining banking markets. W h i l e their general
a p p r o a c h is s i m i l a r , s o m e R e s e r v e B a n k s m a y g i v e
greater or less emphasis to certain factors. T h e B o a r d ' s
staff coordinates general consistency a m o n g Reserve
B a n k d e f i n i t i o n s . T h e a p p r o a c h d i s c u s s e d h e r e is that
used by the Federal Reserve B a n k of Atlanta.
Empirical e v i d e n c e indicates that convenience is an
important determinant in an individual's selection of a financial institution and that m a n y people maintain their
p r i m a r y b a n k i n g relationships near w h e r e they live or
work. 2 C o m m u t i n g patterns are therefore important for
identifying an integrated market area. Metropolitan Statistical A r e a s ( M S A s ) or Ranally Metro Areas ( R M A s )
are generally used as a first approximation in delineating
urban markets, and county boundaries help define rural
markets. M S A s are areas consisting of a central city (or
Census B u r e a u - d e f i n e d urbanized area) and its dependent
fringes. R M A s are similar, made up of areas that contain
at least seventy people per square mile and have at least
2 0 percent of the labor force c o m m u t i n g into the R M A ' s
central city for employment. R M A s are not, however, restricted to following county borders, as are MSAs. 3
Although R M A s and county boundaries form a g o o d
first a p p r o x i m a t i o n of market boundaries, other factors
also help determine a final market definition. O n e of the
m o s t i m p o r t a n t is the actual b a n k i n g patterns of b a n k
customers. T h i s information is obtained partly through
interviewing bank and thrift m a n a g e r s , w h o s e detailed
k n o w l e d g e of the customer base can sometimes provide
unique insights into market dynamics. In addition, banks
often keep detailed records of c u s t o m e r d e m o g r a p h i c s ,
Economic
2 6
Review
such as c u s t o m e r addresses analyzed by zip code. Surveys of c o n s u m e r s and small businesses a r e also c o n ducted to identify actual banking patterns.
Another important question to address in delineating
markets is whether there is a continuous chain of develo p m e n t between t w o areas. For instance, consider three
banks, A, B, and C. B a n k A does not c o m p e t e directly
with B a n k C, but both B a n k A and Bank C c o m p e t e with
B a n k B. B e c a u s e Bank A ' s pricing policies directly influence those of Bank B and indirectly influence those of
B a n k C, all three banks are considered to b e in o n e market. T h e fact that prices tend toward equalization within a
market m a k e s evidence of pricing discrepancies useful in
determining a market's boundaries. T w o areas are viewed
as b e c o m i n g m o r e integrated if there are indicators like
road construction between the areas and n e w residential
subdivisions and p l a n n e d c o m m e r c i a l d e v e l o p m e n t involving both areas. In addition, natural or political barriers that m a y prohibit integration of t w o areas are considered in defining markets.
I n f o r m a t i o n regarding the c a s e with which c u s t o m e r s
can shift b a n k i n g relationships is also important for determining markets. U.S. Census Bureau data are used to
t r a c k c o m m u t i n g b e t w e e n c o u n t i e s . O t h e r i t e m s that
m a y b e h e l p f u l are traffic counts, transportation routes
( n u m b e r , condition, a p p r o x i m a t e c o m m u t i n g t i m e and
d i s t a n c e , e x i s t e n c e of c o n t r o l l e d a c c e s s r o a d s , and so
forth), m a j o r e m p l o y e r s in the area and information on
where their e m p l o y e e s live, and the growth of population c o m p a r e d with e m p l o y m e n t and public transportation routes.
In a d d i t i o n to e x a m i n i n g c o m m u t i n g p a t t e r n s f o r
w h a t t h e y i n d i c a t e a b o u t c u s t o m e r s ' e a s e in s h i f t i n g
b a n k i n g relationships, it is helpful to consider the extent
to which residents and businesses in o n e area rely on another area for goods, services, and entertainment. T h i s
a s s e s s m e n t is b a s e d on s e v e r a l i n d i c a t o r s , i n c l u d i n g
(1) location of m a j o r retailers, (2) location of m a j o r service providers (hospitals, airports, colleges, and universities), (3) media coverage patterns (newspaper circulation
patterns, radio and television coverage patterns) and
bank and thrift advertising patterns, (4) mall surveys showing where customers live, and (5) local (toll-free) calling
areas.
Market definition in antitrust analysis is not an exact
science. Each market has a unique set of economic, legal,
and political conditions. In practice, market delineation
must rely on secondary and anecdotal evidence. Markets
are not static, and changes in d e m a n d and supply factors
cause the shifting of market boundaries over time.
J a n u a r y / F e b r u a r y 1993
Notes
1. For a review of the economic literature on geographic
market delineation, see Wolken (1984).
2. For a bibliography and further details, see King (1982) or
Wolken (1984).
3. The Office of Management and Budget (OMB) establishes the official requirements for defining MSAs; see "Revised Standards for Defining Metropolitan Areas in the
structure, consisting of the number, size distribution,
and market shares of firms, influences the conduct of
firms. This c o n d u c t — f o r example, the degree of competition or collusion between f i r m s — d e t e r m i n e s the
firms' performance, measured by profits or prices. The
S C P paradigm implies that the f e w e r the n u m b e r of
f i r m s and the greater their m a r k e t shares, the m o r e
likely it is that those firms have the potential to earn
abnormal profits (defined as profits greater than those
that would be earned in a perfectly competitive market
or as profits exceeding those commensurate to the level of the f i r m ' s risk). Banks' abnormal profits imply
costs to the public that antitrust regulation seeks to
avoid. Estimation of the S C P model for the U.S. banking industry has generally shown that a statistically
s i g n i f i c a n t and positive r e l a t i o n s h i p d o e s exist between market concentration and profitability. 12
Legal Framework
The standards by which the Fed assesses the competitive e f f e c t s of m e r g e r s and a c q u i s i t i o n s c o m e s
from the Bank Holding C o m p a n y Act (1956) and the
B a n k M e r g e r Act ( 1 9 6 0 ) and their a m e n d m e n t s in
1966. These acts require federal banking agencies to
consider the probable effects on competition of proposed mergers. If a merger is expected to have a substantially adverse impact on competition, the application is
to be denied unless the anticompetitive e f f e c t s of a
merger are clearly outweighed by its favorable impact
on t h e c o n v e n i e n c e a n d n e e d s of the c o m m u n i t y .
However, neither piece of legislation specifies precise
standards for ensuring market competitiveness. In addition, once a merger or acquisition is approved by the
appropriate federal banking agency, the Department of
Justice has thirty days in which to file suit if it believes the transaction would violate antitrust statutes.
If a suit is filed, the merger is automatically stopped
pending resolution of legal action.
Digitized Federal
for FRASER
Reserve B a n k of Atlanta
1990's," Federal Register 55 (March 30, 1990). See also
Jerry J. Donovan, "A Primer on MSAs," Federal Reserve
Bank of Atlanta Regional
Update 5 ( J a n u a r y - M a r c h
1992). RMAs are Rand McNally and Company's definitions of the metropolitan areas of the n a t i o n ' s m a j o r
cities. For m o r e information see Rand McNally:
1992
Commercial Atlas and Marketing
Guide.
In a case involving the Philadelphia National Bank
in 1963, the S u p r e m e Court clarified the m e a n s by
which regulators should m e a s u r e competition. 1 3 This
ruling established three m a j o r legal p r e c e d e n t s still
used by the Federal Reserve. First, the court confirmed
that the Sherman and Clayton Antitrust Acts apply to
banking, and the court used market structure (as defined above) as an indicator of competition within the
market. Secondly, the ruling determined that the "cluster
of products (various kinds of credit) and services (such
as checking accounts and trust administration) denoted
by the term 'commercial b a n k i n g ' . . . composes a distinct line of c o m m e r c e " f o r C l a y t o n Act p u r p o s e s .
Third, the sections of the country affected by an acquisition (the geographic market) must b e taken into account. The court opined that "in banking, as in m o s t
service industries, convenience of location is essential
to effective competition. Individuals and corporations
typically confer the bulk of their patronage on banks
in their local community; they find it impractical to conduct their banking business at a distance."
Product Market. In determining the relevant product market in which to assess the probable competitive
effects of a bank acquisition or merger, the Supreme
Court, in the Philadelphia National Bank case, determined that commercial banking is the appropriate line
of c o m m e r c e . T h e c o u r t stated that " t h e c l u s t e r of
p r o d u c t s . . . and s e r v i c e s " p r o v i d e d by c o m m e r c i a l
banks is unique relative to other institutions, including
thrifts. This conclusion was based partially on the fact
that, by law, only commercial banks could offer dem a n d deposits at the time. In addition, it was recognized that the availability of a package of products and
services at a single institution p r o v i d e d a c u s t o m e r
c o n v e n i e n c e and value that surpasses the e c o n o m i c
significance of these products and services individually. In measuring this cluster of services, the court used
deposits as a proxy for estimating market share. 1 4
Geographic Market. Once the appropriate product
market has been determined, the relevant geographic
market in which competition occurs must be defined. 1 5
Kconom ic Review
27
In the Philadelphia National Bank case the Supreme
Court ruled that the market consisted of that area "in
which the seller operates, and to which the purchaser
can practicably turn for supplies." 16 The Court also concluded that convenience factors tended to localize markets in banking. Accepting that at least some consumers
and small businesses are limited to their communities
for banking services, the standard has been that local
markets are the correct area in which to measure the effects of competition between depository institutions. 17
HieFed
In his 1991 t e s t i m o n y b e f o r e the C o m m i t t e e on
Banking, Finance, and Urban Affairs, John P. La Ware,
a m e m b e r of the Board of Governors of the Federal
Reserve System, stated that the "primary objectives of
public policy in this area [antitrust] should be to help
manage the evolution of the banking industry in ways
that preserve the benefits of competition for the cons u m e r s of b a n k i n g s e r v i c e s , and to e n s u r e a s a f e ,
sound and profitable banking system" (LaWare 1991).
With this objective in mind, and given current antitrust
laws and judicial precedents, the Federal Reserve analyzes competition, using market structure (concentration) as an important measure of competition and using
the concept of a cluster of banking products in a local
geographic market. 1 8
T h e F e d ' s process of analyzing a b a n k m e r g e r ' s
e f f e c t s on c o m p e t i t i o n begins at one of the t w e l v e
Federal Reserve Banks, which are delegated most analysis, data-gathering, and r e c o m m e n d a t i o n f u n c t i o n s
because of the unique information they can access. A s
a result of t h e i r f u n c t i o n s , the R e s e r v e B a n k s are
aware of local factors in their districts that might serve
to integrate or separate market areas. In addition, the
Reserve Banks have, or can acquire from local sources,
k n o w l e d g e of special f a c t o r s that m a y r e i n f o r c e or
mitigate public losses through anticompetitive impacts
of a proposed merger. For example, information on
subtle issues, such as mortgage market concentration,
is readily available to the Reserve Banks, which can
m a k e use of banker contacts and surveys of local businesses and consumers. 1 9
In this process the Reserve Bank first identifies the
relevant geographic market and then conducts an initial structural screening, including calculation of market shares and the m a r k e t ' s H e r f i n d a h l - H i r s c h m a n
Index (HHI). (See the box on page 26 for a discussion
of the factors considered by the Federal Reserve Bank
of Atlanta in defining banking markets.) The H H I is
calculated by summing the squares of each firm's market shares. (See the box below for a practical example
of h o w the HHI is calculated.) If no serious issues are
raised—that is, if the HHI and market shares are within acceptable limits—the Reserve Bank generally approves the application for merger. However, if structural
measures exceed benchmark levels, the transaction is
deemed to have possible anticompetitive effects. Reserve Bank and Board staff findings and recommendat i o n s are t h e n s u b j e c t t o r e v i e w by the B o a r d of
Governors, which makes the final decision based on
all factors laid out in the governing laws. 2 0
In deciding if a merger potentially involves significant anticompetitive issues and t h e r e f o r e cannot be
delegated to the Reserve Bank, the Board uses guidelines similar to those established by the Department of
Justice. 21 (See the box on page 32 for a brief discussion of the Department of Justice's activity in recent
years.) Although the numerical guidelines the Board
uses are admittedly somewhat arbitrary, they do provide a consistent approach to antitrust e n f o r c e m e n t ,
reducing the costs of uncertainty associated with applying antitrust laws.
Box 2
Calculation of the Herfindahl-Hirschman Index
T h e Fed currently relies extensively on a m e a s u r e of
m a r k e t c o n c e n t r a t i o n — t h e H e r f i n d a h l - H i r s c h m a n Ind e x — s p e c i f i e d by the D e p a r t m e n t of Justice in its 1982
m e r g e r guidelines. 1 T h e H H I is calculated by s u m m i n g
t h e s q u a r e s of t h e m a r k e t s h a r e of e a c h f i r m : H H I =
X [ x ( i ) / x ] 2 , w h e r e x(/') is t h e total deposits of firm i, and x
is the total deposits of all f i r m s in the market.
The HHI is generally considered to b e better than other concentration measures (such as market-share c o n c e n -
Economic
28
Review
tration ratios) because it captures both the n u m b e r and
size distribution of all f i r m s in t h e market. 2 T h e calculation of HHIs in practice is illustrated by analyzing t w o
markets in a recently approved Board case in which Barnett B a n k s , Inc. (Bamett) proposed to acquire First Florida Banks, Inc. (First Florida). 3
T h e first market to be considered is the North L a k e /
S u m t e r banking market, defined by the Federal Reserve
B a n k of Atlanta as S u m t e r C o u n t y , F l o r i d a , plus that
J a n u a r y / F e b r u a r y 1993
portion of L a k e C o u n t y north of the Florida Turnpike. A
total of eight banks with $1.58 billion in deposits c o m peted in this market. In addition, there w e r e f o u r thrift
institutions holding $405 million in deposits (see Table 1).
T o c o m p u t e the H H I , first calculate the market shares of
each firm, using bank deposits only (column 4) and
bank-plus-thrift deposits at half weight (column 5). 4 For
i n s t a n c e , B a r n e t t h a s a b a n k s - o n l y m a r k e t s h a r e of
24.09 percent and a t h r i f t s - a t - h a l f - w e i g h t m a r k e t share
of 2 1 . 3 6 p e r c e n t { 3 8 1 , 5 8 9 / [ 1 , 5 8 4 , 0 1 9 + (0.5 •
405,215)1). These market shares squared indicate
e a c h f i r m ' s c o n t r i b u t i o n to the m a r k e t ' s H H I ( c o l u m n s
6 and 7). F o r e x a m p l e , B a r n e t t Bank adds 5 8 0 points
(24.09 • 24.09) to the m a r k e t ' s banks-only H H I and 4 5 6
p o i n t s ( 2 1 . 3 6 • 2 1 . 3 6 ) to the m a r k e t ' s t h r i f t s - a t - h a l f weight H H I . T o calculate the H H I for the market, sum
each f i r m ' s contribution to the HHI. In Table 1 the mark e t ' s b a n k s - o n l y H H I is 1,801 and its t h r i f t s - a t - h a l f weight H H I is 1,468. 5
ket share of 23.58 percent ¡(381,589 + 39,707)/[ 1,584,019 +
(0.5 • 405,215)]}. Barnett's contribution to the banks-only
H H I b e c o m e s 708 points (26.60 • 26.60), increasing the
m a r k e t ' s banks-only H H I by 121 points to 1,922. Barn e t t ' s contribution to the thrifts-at-half-weight H H I bec o m e s 5 5 6 points (23.58 • 23.58), increasing the m a r k e t ' s
thrifts-at-half-weight H H I by 95 points to 1,563.
B e c a u s e the applicable guidelines (the 1,800/200 rule
with thrifts at 50 percent weight) were not breached, the
Fed w o u l d g e n e r a l l y c o n c l u d e that this m e r g e r w o u l d
h a v e no significant anticompetitive e f f e c t in the North
Lake/Sumter banking market.
T o illustrate what h a p p e n s w h e n c o m p e t i t i v e guidelines are breached, consider another market in which Barnett and First Florida c o m p e t e d , the H i g h l a n d s C o u n t y
banking market. Delineated by the c o u n t y ' s borders, this
market had a total of six banks competing for $691.4 million in total deposits. In addition, five thrifts operated in
the market, holding $366.9 million in total deposits (see
Table 2). Again calculate the market share of each institution, first with b a n k s - o n l y d e p o s i t s , then a d d i n g thrift
deposits at half weight. Then calculate each f i r m ' s contribution to the m a r k e t ' s H H I , s u m m i n g to get a total premerger H H I of 2,359 (with thrifts at half weight). Next,
add First F l o r i d a ' s deposits to Barnett's and recalculate
the market shares and HHIs. This market would h a v e a
T o calculate the structural c h a n g e s that would occur
after a m e r g e r , add First F l o r i d a ' s $ 3 9 . 7 million in deposits to B a r n e t t ' s $ 3 8 1 . 6 million in deposits to get the
total a m o u n t of d e p o s i t s f o r t h e c o m b i n e d institution.
T h i s n e w deposit total of $ 4 2 1 million represents a n e w
banks-only m a r k e t share of 26.60 percent [(381,589 +
3 9 , 7 0 7 ) / l , 5 8 4 , 0 1 9 ] and a n e w thrifts-at-half-weight mar-
Table 1
North Lake/Sumter Banking Market
(Deposits
as of June 30,
Total Deposits
($000)
Depository Institution
Barnett Banks, Inc.
First Union C o r p o r a t i o n
SunTrust Banks, Inc.
Citi-Bancshares, Inc.
First FS&LA of Lake C o u n t y
First Family FS&LA
UniSouth, Inc.
First National Bank of Mt. Dora
BankFirst
First Florida Banks, Inc.
Banks
381,589
321,203
312,120
286,550
Reserve B a n k of Atlanta
DigitizedFederal
for FRASER
Market S h a r e
114,593
82,314
45,943
39,707
Thrifts
Banks
Thrifts
Only
50%
Only
50%
24.09
20.28
19.70
18.09
21.36
17.98
17.47
16.04
5.75
4.31
6.41
4.61
2.57
2.22
0.68
0.60
7.23
5.20
2.90
2.51
24,198
21,555
1,584,019
405,215
HHI
Banks
205,305
154,157
Mid-State Federal Savings Bank
Citizens Federal Savings Bank
TOTAL
Premerger HHI
Postmerger HHI
C h a n g e in HHI
Thrifts
1991)
100
580
411
388
327
0
0
52
27
8
6
0
0
456
323
305
257
33
19
41
21
7
5
0
0
1,801
1,922
121
1,468
1,563
95
100
Kconom ic Review
29
Table 2
Highlands County Banking Market
(Deposits
as of June 30,
Total Deposits
Market Share
($000)
Banks
Depository institution
Barnett Banks, Inc.
Thrifts
383,714
H u n t i n g t o n FSB
First U n i o n C o r p o r a t i o n
SunTrust Banks, Inc.
BancFlorida, FSB
H o m e Savings Bank, FSB
1991)
Thrifts
Banks
Thrifts
Only
50%
Only
50%
55.50
43.86
9.97
11.09
10.21
4.20
4.19
6.58
3.76
3.53
1.65
0.96
3,080
1,924
99
123
104
18
18
43
14
12
3
1
174,365
97,053
89,298
14.04
12.92
73,437
73,385
First Florida Banks, Inc.
57,525
32,927
30,883
H i g h l a n d s I n d e p e n d e n t Bank
NationsBank C o r p o r a t i o n
G o l d o m e FSB
H a r b o r FS&LA
8.32
4.76
4.47
28,918
16,777
TOTAL
Premerger HHI
Postmerger HHI
C h a n g e in HHI
691,400
366,882
HHI _
Banks
100
197
167
69
23
20
100
3,556
4,479
923
postmerger thrifts-at-half-weight H H I of 2,936, producing
a change in the H H I of 577 points.
T h i s c h a n g e of 5 7 7 points in a highly concentrated
market exceeds the applicable 1,800/200 rule with thrifts
at half weight, and the Reserve Bank would have had to notify Board staff that applicable guidelines were breached
and that the merger was potentially anticompetitive. A t
2,359
2,936
577
this point, both Reserve B a n k staff and the Board staff
would have conducted an in-depth analysis of the likely
effect of the merger within the market. 6 Such an analysis
would involve considering a variety of factors such as
market attractiveness, potential competition, the financial
strength of the target firm, and so forth.
Notes
1 . T h e H H I was d e v e l o p e d i n d e p e n d e n t l y by Orris C.
Herfindahl, "Concentration in the U.S. Steel Industry,"
Ph.D. diss., Columbia University, 1950, and by Albert
O. Hirschman, National Power and the Structure of Foreign Trade (Berkeley and Los Angeles: University of
California Press, 1945).
2. The three- or four-firm concentration ratio, which was
used extensively by the Department of Justice and federal banking agencies in the past, ignored the competitive
influence of banks not ranked in the top three or four of
the market. For an empirical justification of why the
HHI might be preferred to firm concentration ratios, see
Rhoades (1985b).
3. " B a r n e t t B a n k s , I n c . " Federal
(1993): 44.
30
Economic Review
Reserve
Bulletin
4. The Board's use of thrifts at half weight is discussed on
page 31.
5. Notice the substantial difference the inclusion of thrift
deposits makes. The market is highly concentrated using
bank-only deposits but only moderately concentrated
with thrift deposits at 50 percent weight.
6. In the above merger, Barnett committed to divest the only First Florida branch in the market in order to mitigate
potentially adverse competitive effects. In light of this
divestiture the Board concluded that consummation of
the proposed merger would not affect competition in the
Highlands County market.
79
J a n u a r y / F e b r u a r y 1993
Criteria f o r j u d g i n g Potential
Anticompetitive Effects
This article examines all bank merger applications
considered by the Federal Reserve System for potentially significant competitive issues during the decade
from D e c e m b e r 1982 until December 1992. It does not
examine applications in which a thrift was to be acquired or merger proposals filed with another federal
regulator. In determining whether a particular application entailed potentially significant competitive issues,
both D e p a r t m e n t of Justice m e r g e r g u i d e l i n e s and
Board rules regarding delegation of authority to the
Reserve Banks that were in effect when the application was filed were considered. Consequently, the data were divided into three periods ( D e c e m b e r 1982D e c e m b e r 1985, January 1986-June 1987, and July
1987-December 1992) in which different benchmarks
were used to determine a transaction's potential anticompetitive effects.
In June 1982 the Department of Justice issued new
merger guidelines applicable to the enforcement of antitrust laws in all industries. T h e Board first referred to
these guidelines, and specifically to the H H I as a measure of concentration, in a merger decision on N o v e m ber 19, 1982. The Board's publication of this decision
in the Federal Reserve Bulletin in D e c e m b e r 1982
marks the beginning of the data period reviewed in
this article. 22
T h e D e p a r t m e n t of Justice guidelines established
three postmerger concentration ranges to consider in
determining whether a particular transaction is likely to
pose a significant anticompetitive threat and thus be
subject to in-depth e c o n o m i c analysis and possible
challenge by the Justice Department. The Fed continues to make decisions in terms of these three ranges. A
market with a postmerger HHI below 1,000 is considered unconcentrated, a market with a postmerger HHI
between 1,000 and 1,800 is moderately concentrated,
and a market with a postmerger HHI greater than 1,800
is a highly concentrated market. The Department of
Justice stated that it was more likely than not to challenge transactions that would result in a change greater
than 100 points in a moderately concentrated market
and was also likely to challenge mergers producing a
change greater than 100 points in a highly concentrated
market. Depending on the postmerger concentration of
the market, the size of the resulting increase in concentration, and the presence or absence of several other
factors relating to the market, the Department of Justice might decide to challenge an approval on the basis
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
of a change between 50 and 100 points in a highly concentrated market.
F o r t h e p u r p o s e s of t h i s a r t i c l e , a m e r g e r w a s
flagged as potentially raising competitive issues unless
it fell clearly in a category the Department of Justice
was unlikely to challenge. For the data sample from
D e c e m b e r 1982 to D e c e m b e r 1985, this set includes
mergers in markets that were moderately concentrated
(as defined above) and resulted in a c h a n g e greater
than 100 points and mergers in a highly concentrated
market effecting a change of at least 50 points.
In F e b r u a r y 1985 the D e p a r t m e n t of J u s t i c e informed the Office of the Comptroller of the Currency
( O C C ) that it would not, ordinarily, challenge a bank
merger unless there was an H H I change of at least 200
points in a highly concentrated market. 2 3 This increase
in concentration benchmarks was intended explicitly
to recognize competition f r o m nondepository institutions, a factor not captured in deposit market-share data. Although the Board referred to this new rule in six
applications in 1985, the new benchmark was not used
consistently until 1986, as r e f l e c t e d in the B o a r d ' s
amended "Rules Regarding Delegation of Authority"
to the Reserve Banks on D e c e m b e r 17, 1985. 24 In examining data f r o m the beginning of January 1986 until
D e c e m b e r 1992, this so-called 1,800/200 rule is the
benchmark that was used to identify applications for
mergers that might be significantly anticompetitive.
In the Connecticut National Bank case in 1974, the
Supreme Court recognized thrifts as significant c o m petitors f o r a b r o a d r a n g e of c o n s u m e r s e r v i c e s . 2 5
However, the court concluded that thrifts should not,
at that time, be a factor in assessing the competitive
effects of bank mergers because thrifts were not competitive in the area of commercial lending. With the
passage of the Depository Institutions D e r e g u l a t i o n
and M o n e t a r y C o n t r o l A c t (1980) and the G a r n - S t
Germain Act (1982), which effectively deregulated the
thrift industry, thrifts were authorized to compete with
banks in providing the cluster of products previously
unique to b a n k i n g . In r e c o g n i t i o n of this increased
competition, the Board began including thrifts as competitors in specific applications. By March 27, 1987,
competition f r o m thrifts had grown to such a point that
the Board c h a n g e d its rules regarding delegation of
authority to the Reserve Banks to give thrifts a weight
of 50 percent w h e n calculating concentration numbers,
to reflect both actual and potential competition f r o m
thrifts. 2 6 Beginning with the June 1987 decisions (published in the July 1987 Federal Reserve Bulletin), determinations made regarding the competitive effects of
mergers were based on this assumption of 50 percent
Kconom ic Review
31
Box 3
Department of Justice Antitrust Activities in Recent Years
T h e Department of Justice held a relatively relaxed
v i e w of antitrust in b a n k i n g t h r o u g h o u t m u c h of the
1980s. M e r g e r g u i d e l i n e s a d o p t e d in 1982, b a s e d o n
permissible m a r k e t shares, generally w e r e less restrictive than standards used previously and thus e n l a r g e d
the pool of potentially valid mergers. T h e 1982 guidelines also established factors that could b e used to justify
m e r g e r s that f a i l e d the m a r k e t c o n c e n t r a t i o n test. In
1985, recognizing the increasing importance of n o n b a n k
competitors, the D e p a r t m e n t of Justice established the
1,800/200 rule (with thrifts generally given 2 0 percent
weight), which w a s quickly adopted by the other federal
banking agencies (which generally give thrifts 5 0 percent weight). Importantly, until 1991 the Department of
J u s t i c e did not c h a l l e n g e any m e r g e r that p a s s e d t h e
1,800/200 rule with thrifts at 5 0 percent and w a s approved by o n e of the federal agencies, even if it failed
the 1,800/200 rule with thrifts at the Department of Justice's standard of 2 0 percent.
In 1989 the D e p a r t m e n t of J u s t i c e b e g a n taking a
m o r e aggressive approach t o w a r d bank m e r g e r s . Four
large transactions since 1990 demonstrate the c h a n g e s .
In the first of these, late in 1990, the Federal Reserve
B o a r d a p p r o v e d First H a w a i i a n , I n c . ' s a c q u i s i t i o n of
First Interstate of Hawaii, Inc. 1 The D e p a r t m e n t of Justice sued to block the transaction, citing adverse market
effects for small and medium-sized businesses. T h e n in
1991, the Department of Justice raised strong objections
to Fleet/Norstar's acquisition of the failed B a n k of N e w
England, citing concentration in three banking markets.
In a d d i t i o n , the D e p a r t m e n t of J u s t i c e stated that t h e
"failing f i r m " d e f e n s e did not apply to Fleet/Norstar bec a u s e t h e r e w e r e o t h e r b i d d e r s f o r t h e B a n k of N e w
England that did not pose any competitive concerns. In a
third t r a n s a c t i o n , o n F e b r u a r y 13, 1992, the F e d a p p r o v e d t h e a c q u i s i t i o n of A m e r i t r u s t C o r p o r a t i o n by
Society C o r p o r a t i o n despite D e p a r t m e n t of Justice objections that the proposed branches to b e divested were
weak. 2 The D e p a r t m e n t of Justice filed suit, citing adverse competitive effects on the availability of loans to
small businesses in t w o counties in Ohio. T h e agency
eventually dropped its opposition to each of these mergers after negotiating divestitures beyond those required
by the Fed. In a separate case in 1992, the Department
of J u s t i c e h e l d talks w i t h B a n k A m e r i c a C o r p o r a t i o n
over its proposed acquisition of Security Pacific Corporation. H o w e v e r , after B a n k A m e r i c a a m e n d e d its appli-
cation to include additional divestitures, the D e p a r t m e n t
of Justice did not file to block this merger.
T h e n e w m e r g e r guidelines published in 1992 spotlight the approach the Department of Justice is n o w taking with respect to mergers. 3 T h e guidelines describe the
d e p a r t m e n t ' s five-step process currently conducted with
r e s p e c t to e a c h p r o p o s e d m e r g e r . F i r s t , t h e r e l e v a n t
product and geographical markets are identified, and the
structural impacts within these m a r k e t s arc calculated.
S e c o n d , specific characteristics of the market are then
considered to determine whether there are antitrust c o n cerns. Third, the timeliness, likelihood, and sufficiency
of entry into the market as it relates to anticompetitive
behavior are forecast. Any efficiency gains expected
f r o m the merger are calculated, and, as the last step, if
the continued existence of either party is doubtful, the
expected results of the failure are analyzed.
While this process sounds very similar to the F e d ' s ,
t h e r e a r e s e v e r a l i m p o r t a n t d i f f e r e n c e s . F i r s t , in the
transactions cited the Department of Justice did not use
the cluster of services provided by commercial banks as
the relevant product market but instead segregated vario u s f i n a n c i a l services into s e p a r a t e p r o d u c t m a r k e t s . 4
Within these separate product markets, the D e p a r t m e n t
of Justice's emphasis was on the market for commercial
loans, especially to small and medium-sized businesses,
d e s i g n a t e d a c c o r d i n g to v a r i o u s size d e f i n i t i o n s . Alt h o u g h this c a s e - b y - c a s e a p p r o a c h m a y b e t t e r r e f l e c t
m a r k e t r e a l i t i e s , it a l s o i n c r e a s e s u n c e r t a i n t y a m o n g
merging parties concerning the D e p a r t m e n t of Justice's
likely response to a m e r g e r proposal. 5 T h e Department
of Justice also indicated that its 1,800/200 rule applied
only to the initial screening of a particular merger and
that a transaction failing that b e n c h m a r k w a s subject to
closer investigation using the m o r e restrictive 1,800/50
rule. 6 In addition, although the weighting of thrifts will
continue to be determined on a case-by-case basis, the
D e p a r t m e n t of J u s t i c e h a s i n d i c a t e d t h a t it b e l i e v e s
thrifts have substantially retreated from business banking and, t h e r e f o r e , d e s e r v e n o w e i g h t in this p r o d u c t
market. 7 T h e D e p a r t m e n t of Justice has also indicated
that divestitures must introduce n e w and viable competitors into the market. In this regard, the agency has taken
a direct hand in choosing which branches are to be divested, as opposed to the F e d ' s practice of allowing the
applicant to select the branches for divestiture.
Notes
1. See "First Hawaiian, Inc.," Federal Reserve Bulletin 77
(1991): 52.
3 2
Economic Review
2. See "Society Corporation," Federal Reserve Bulletin
(1992): 302.
78
J a n u a r y / F e b r u a r y 1993
3. See "Department of Justice and Federal Trade Commission Horizontal Merger Guidelines," April 2, 1992.
4. This was not the Department of Justice's first attempt at
breaking up the "Philadelphia National" cluster. In 1985
the agency appealed a transaction that had been approved
by the appropriate federal regulators, arguing that transaction accounts and small business loans were separate
product lines. The Court of Appeals held that the District
Court did not err when it "concluded that the government
failed to factually support its claim that existing circumstances in this case warranted a departure from the definition of the relevant product market as the cluster of
banking services traditionally offered in the commercial
banking industry adopted by the Supreme Court in U.S.
v. Philadelphia National Bank." See U.S. v. Central State
Bank, 817 F.2d 22 (6th Cir. 1987).
5. In Society's acquisition of Ameritrust, the Department of
Justice concluded that businesses with more than $10 million in annual sales "appear to be able to obtain loans
from institutions in Detroit and Pittsburgh as well as lo-
weighting f o r all thrifts, the so-called 1,800/200/50
rule. This rule was the selection criterion used in analyzing the sample data f r o m July 1987 through December 1992. 27
A total of 155 applications in the sample were identified as mergers that might have significant anticompetitive effects. Of these applications, sixteen involved
"prior c o m m o n control," that is, an attempt to restructure ownership of t w o or more banks f r o m individuals
to a corporation owned by the same individuals. 2 8 Because none of these mergers were denied and such
a p p l i c a t i o n s raise issues not relevant to m o s t b a n k
merger transactions, the applications involving prior
c o m m o n control appearing in the sample period were
dropped f r o m the data set.
Total Divestiture. The 139 remaining applications
f o r m e r g e r s p r e s e n t i n g potentially s i g n i f i c a n t anticompetitive problems involved a total of 297 banking
markets that exceeded the structural criteria described
above. ( M a n y bank mergers involved multiple markets, s o m e but not all of w h i c h p o s e d c o m p e t i t i v e
problems.) In eighty-six of these markets, an applicant
agreed to divest (sell) all of either its own or its target's branches in the market.
The Board (as well as other federal banking agencies and the Department of Justice) considers divestiture to be an effective way for applicants to address
areas of competitive concern to regulators while al-
Federal Reserve Bank of Atlanta
cally" (Society Corporation Competitive Factor Report).
In First H a w a i i a n ' s acquisition of First Interstate of
Hawaii, the Department of Justice determined that the
"unique geography" of Hawaii limited businesses with
less than $50 million in annual sales in obtaining loans
from nonlocal institutions (First Hawaiian, Inc., Competitive Factor Report). In BankAmerica's acquisition of Security Pacific, the Department of Justice concluded that
businesses with annual sales of less than $100 million
were locally limited (BankAmerica Corporation Competitive Factor Report). See Letzler and Mierzewski (1992).
6. See Report of the Department of Justice on the Likely
Competitive Effects of the Proposed Acquisition by First
Hawaiian, Inc. of First Interstate of Hawaii, Inc. (1990).
7. Letter from James F. Rill, Assistant Attorney General,
Antitrust Division, to Hon. Alan Greenspan, Chairman,
Board of Governors of the Federal Reserve System, on
the application of BankAmerica Corporation to acquire
Security Pacific Corporation, March 12, 1992.
lowing the nonobjectionable portion of the transaction
to proceed. Generally, it is preferred that these divestitures be made to institutions not currently operating in
the m a r k e t , t h e r e b y i n s u r i n g that the c o m p e t i t i v e
structure of the market remains unchanged. However,
divestiture to an in-market competitor is permissible,
provided that the market's resultant structural changes
are not too severe. Because total divestiture usually
addresses the competitive issues involved in a market
and no further factors are generally considered by the
Board, these eighty-six m a r k e t s were also e x c l u d e d
f r o m the sample studied.
Mitigating Factors. In the remaining 211 markets
the Board approved the vast majority of applications
for mergers that exceeded the criteria for delegation
of authority and were likely to be challenged by the
D e p a r t m e n t of J u s t i c e a c c o r d i n g to its p u b l i s h e d
merger guidelines. T h e Board cited a n u m b e r of factors that mitigated the potentially significant anticompetitive effects of these transactions, as indicated by
the structural numbers (HHI). Relevant issues included competition f r o m thrifts, market attractiveness, and
the financial health of the target firm. As noted earlier, the second part of this discussion, in the next issue
of the Economic Review, will examine all of the mitig a t i n g f a c t o r s d i s c u s s e d by the B o a r d in a p p l i c a tions dating f r o m D e c e m b e r 1982 through D e c e m b e r
1992.
Kconom ic Review
33
Conclusion
T h e increased n u m b e r and size of b a n k mergers
over the last few years, as well as the larger number of
bank failures, has renewed interest in antitrust enforcement by federal authorities. The Fed, considering the
public-interest protections of antitrust regulations, has
adopted a two-stage approach to competitive issues
in bank mergers, first determining whether a competitive problem might exist and then, if so, determining
whether the proposed acquisition would have a significantly a d v e r s e a n t i c o m p e t i t i v e e f f e c t . T h i s article
s u m m a r i z e s the F e d ' s general a p p r o a c h to antitrust
1. Throughout this article the terms merger and acquisition
are used synonymously.
2. See Rhoades (1985a) and LaWare (1991). Numbers do not
include acquisitions of failed banks. Numbers for 1988 and
1989 are estimated.
3. See LaWare (1991), who states that "over the last decade,
the average proportion of bank deposits accounted for by
the largest three firms in urban markets has increased by
only one percentage point, and has remained virtually unchanged in rural markets. These ratios have actually declined in both types of markets since the mid-1970s."
4. Firm shrinkage is an alternative vehicle for consolidation
that BankAmerica Corporation has shown can work.
5. The Federal Reserve has jurisdiction over mergers of state
member banks and mergers or acquisitions by bank holding
companies. The Comptroller of the Currency has primary
responsibility for national banks. The Federal Deposit Insurance Corporation oversees insured state n o n m e m b e r
banks. In addition, section 18(c) of the Federal Deposit Insurance Act provides that "before acting on any application
for approval of a merger transaction, the responsible agency
. . . shall request reports on the competitive factors involved
from the Attorney General and the other two banking agencies."
6. A second article, in the next issue of the Atlanta Fed's Economic Review, will examine all merger applications filed by
state member banks or bank holding companies (applications to acquire another bank or bank holding company)
that involved potentially significant competitive issues since
the Board first began applying the 1982 Department of Justice merger guidelines to bank mergers in November of that
year. The discussion will specifically consider mitigating
factors the Board referred to in these applications.
7. The Fed's approach to antitrust issues is not the only accepted view. For instance, the Department of Justice may
i m p l e m e n t antitrust regulation slightly differently (see
Guerin-Calvert and Ordover 1992). Others are critical of
3 4
Economic Review
analysis over the last decade. It presents the economic
theory and legal f r a m e w o r k behind the Fed's analysis
and cites empirical evidence both for and against the
Fed's approach.
Certain elements are essential for each evaluation:
specification of the correct g e o g r a p h i c and product
markets in which competitive effects take place, determination of direct and potential competitors, and analy s i s of the e f f e c t s of m e r g e r s o n the s t r u c t u r e of
individual markets. While all merger applications are
examined in light of the same criteria, the dynamic aspects of the U.S. banking industry and the several objectives of antitrust laws are such that bank merger
analysis must be done on a case-by-case basis.
the application of antitrust standards to the banking industry, arguing that the current approach of regulators is antiquated and fails to r e c o g n i z e much of the competition
currently faced by banks (see, for example, Bove 1991 and
Demsetz 1973). A comprehensive analysis of the various
approaches concerning antitrust issues is beyond the scope
of this paper.
8. See, for example, "SouthTrust Corporation," Federal Reserve Bulletin 78 (1992): 769.
9. Federal agencies consider divestiture an acceptable means
of reducing the anticompetitive effects of a proposed merger. Reducing the resultant market share of the acquiring
bank in turn reduces the ability to exercise anticompetitive
behavior in the market. Divestiture as a solution for competitive problems has become increasingly more important
over the last decade because of the proliferation of large
mergers, in which divestitures are small relative to the size
of the entire transaction. For the Federal Reserve Board of
Governor's position on the timing of divestitures see "BankAmerica Corporation," Federal Reserve Bulletin 78 (1992):
338.
10. For a thorough discussion of the e c o n o m i c s of market
structure see Scherer (1990) or Tirole (1988).
11. For an overview of the SCP paradigm and a review of the
empirical literature, see Rhoades (1977, 1982).
12. See, for e x a m p l e , H a n n a n (1991), Berger and H a n n a n
(1989), and Rhoades (1982). For alternative explanations of
the profit-concentration relationship in banking, such as the
efficiency-structure hypothesis, see Smirlock (1985), Berger (1991a, 1991b), and Hasan and Smith (1992).
13. U.S. v. Philadelphia National Bank, 374 U.S. 321 (1963).
14. Recent empirical evidence supports the use of this cluster
concept in commercial banking. For instance, studies indicate that businesses and consumers tend to purchase additional products and services from the institution at which
they maintain their p r i m a r y c h e c k i n g account (see Elliehausen and Wolken 1990, 1992).
J a n u a r y / F e b r u a r y 1993
15. For a review of the economic literature on geographic market definition see Wolken (1984).
16. U.S. v. Philadelphia National Bank, 374 U.S. 321 (1963).
17. Recent empirical evidence supports the idea that banking
markets, at least for some consumers and small businesses,
are still local in nature (see Elliehausen and Wolken 1990,
1992; Hannan 1991). For another viewpoint see Dunham
(1986).
18. While the courts are willing to hear arguments that the appropriate product or geographic markets have changed, it
requires that this claim be factually supported, which has
not yet been demonstrated in Court. See U.S. v. Central
State Bank, 817 F.2d 22 (6th Cir. 1987). In addition, some
products offered by banks and bank holding companies
have regional, national, or even international markets. Although the Board considers nonbanking activities, only
rarely are there any significant anticompetitive effects owing to the large number of competitors within these markets
and their small market shares.
19. See "SouthTrust Corporation," Federal Reserve Bulletin 78
(1992): 769.
20. The Reserve Banks have been delegated authority to approve transactions that present no significant concerns. If a
particular transaction does involve significant competitive,
legal, or other issues, the application becomes nondelegated
and is subject to Board review. Authority to deny a transaction rests solely with the Board. The Fed's "Rules Regarding Delegation of Authority" spell out the criteria used to
determine whether an application is delegated and can be
approved by the Reserve Banks or nondelegated and must
be acted upon by the Board. The Fed does not structure acceptable deals, such as by adding divestitures to an applicant's original application. However, Fed staff will consult
with an applicant on how to structure the application to
maximize the chances of approval.
21. See U.S. Department of Justice Merger Guidelines, June
14, 1982. The Department of Justice assumed an important
role in bank mergers and acquisitions when the Bank Holding Company Act (1956) and the Bank Merger Act (1960)
applied the antitrust provisions of the Clayton Act to the
banking industry.
Comptroller of the Currency, on the application of First National Bank of Jackson, Jackson, Mississippi, to acquire
Brookhaven Bank and Trust Company, Brookhaven, Mississippi, February 8, 1985.
24. The six 1985 application decisions in which the Board referred to the new rule were: "United Banks of Colorado,
Inc.," Federal Reserve Bulletin 71 (1985): 647; "Marshall
& Ilsley Corporation," Federal Reserve Bulletin 71 (1985):
663; "The Marine Corporation," Federal Reserve
Bulletin
71 (1985): 795; "Central W i s c o n s i n Bankshares, Inc.,"
Federal Reserve Bulletin 71 (1985): 895; "First Security
Corporation of Kentucky," Federal Reserve Bulletin 71
(1985): 898; and "First Railroad & Banking Company of
Georgia," Federal Reserve Bulletin 71 (1985): 963.
25. U.S. v. Connecticut National Bank, 418 U.S. 656 (1974).
26. Letter from Don E. Kline, Associate Director, Board of
Governors of the Federal Reserve System, to all officers in
charge of supervision at all Federal Reserve Banks, March 27,
1987.
27. The Board continues generally to use 50 percent weight for
thrifts in calculating structural numbers. It may give 100
percent weight to thrifts in cases in which thrift behavior
suggests that it is appropriate to do so—when thrifts are
substantially exercising their banklike powers.
28. In 1978 the Change in Bank Control Act was passed requiring
regulators to assess the competitive effects when an individual purchases a bank. In examining such an application,
if the c o m m o n control was established before 1978, the
Board considers the competitive effects of the transaction(s)
at that time rather than current market conditions. A traditional structural analysis based on deposit data at the time
of affiliation is conducted. Other factors considered include
the absolute size of the banks at the time of affiliation, the
number of years that the institutions have been affiliated,
and whether the affiliation existed before antitrust laws were
applied to bank mergers. (Prior to the Bank Merger Act of
1960, the banking laws did not refer to competitive effects.)
In addition, the Board considers any other issues that would
mitigate potential anticompetitive effects of the merger.
In denying approval of a prior common control application, the Board recognizes that any existing anticompetitive
effects of the institution's affiliation cannot be reversed. A
denial would, however, preserve the possibility of a reversal at some point in the future, whereas approval could perpetuate anticompetitive possibilities.
22. "First Bancorp of New Hampshire, Inc.," Federal Reserve
Bulletin 68 (1982): 769.
23. Letter from Charles F. Rule, Acting Assistant Attorney
General, Antitrust Division, to Hon. C. T o d d Conover,
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Households." Federal Reserve Bulletin 78 (March 1992):
169-81.
Guerin-Calvert, Margaret E., and Janusz A. Ordover. "The
1992 Agency Horizontal Merger Guidelines and the Department of Justice's Approach to Bank Merger Analysis." In
Proceedings:
Annua! Conference on Bank Structure
and
Competition, 1992, 545-60. Chicago: Federal Reserve Bank
of Chicago, 1992.
. "Structure-Performance Studies in Banking: An Updated
Summary and Evaluation." Board of Governors of the Federal Reserve System, Staff Study 119, August 1982.
. "Mergers and Acquisitions by Commercial Banks, 196083." Board of Governors of the Federal Reserve System,
Staff Study 142, January 1985a.
. "Market Performance and the Nature of a Competitive
Fringe." Journal of Economics and Business 37 (February
1985b): 141-57.
Scherer, Frederic M. Industrial Market Structure and Economic
Performance. 3d ed. Chicago: Rand McNally, 1990.
Smirlock, Michael. "Evidence on the (Non)Relationship between Concentration and Profitability in Banking." Journal
of Money, Credit, and Banking 17 (February 1985): 69-83.
Hannan, Timothy H. "Bank Commercial Loan Markets and the
Role of Market Structure: Evidence from Surveys of Commercial L e n d i n g . " Journal of Banking and Finance 15
(February 1991): 133-49.
Hasan, Iftekhar, and Stephen D. Smith. "A Note on Competition, Fixed Costs, and the Profitability of Depository Intermediaries." Federal Reserve Bank of Atlanta Working Paper
92-12, October 1992.
King, B. Frank. "Review of Empirical Literature." Federal Reserve
Bank of Atlanta Economic Review 67 (April 1982): 35-40.
Economic
3 6
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Letzler, Kenneth A., and Michael B. Mierzewski. "Antitrust
Policy Poses Greater Burdens for Bank Merger and Acquisitions." Banking Policy Report 11 (April 20, 1992): 1, 14-18.
Rhoades, Stephen A. "Structure-Performance Studies in Banking: A Summary and Evaluation." Board of Governors of
the Federal Reserve System, Staff Economic Study 92, Fall
1977.
Tirole, Jean. The Theory of Industrial Organization.
Cambridge, Mass.: MIT Press, 1988.
Wolken, John D. "Geographic Market Delineation: A Review
of the Literature." Board of Governors of the Federal Reserve System, Staff Study 140, November 1984.
J a n u a r y / F e b r u a r y 1993
R e v i e w Essay
Business Information Sources
For Eastern Europe and the
Newly Independent States:
A Guide to Periodical literature
r
Jerry J. Donovan
he c o l l a p s e in late 1989 and early 1990 of the E a s t e r n B l o c ' s
seemingly impenetrable wall of socialism has opened up new markets for the United States and other industrialized nations. 1 For the
industrial West the immense area of Eastern Europe and the countries that formerly made up the Soviet Union represents some 400
million potential consumers as well as a pent-up need for investment capital,
up-to-date technology, new management skills, and an orientation toward
capitalist marketing and sales techniques.
The reviewer is the research
librarian in the Atlanta Fed's
research library. He is
grateful to a number of people
who assisted in evaluating the
publications
reviewed,
especially Molly Molloy,
Slavic reference librarian at
the Hoover Institution
Library
at Stanford University, and
Julie Pfeffer,
publications
manager at FY1 Information
Resources, Washington, D.C.
Federal
Reserve B a n k of Atlanta
Businesspeople and investors who seek opportunities in the former Eastern
Bloc countries need to understand not only the economies of these countries
but also the democratization and privatization processes that are occurring
in t h e m . A n u m b e r of f a c t o r s — c o l l e c t i v e l y r e f e r r e d to as " c o u n t r y (or
sovereign) risk"—must be evaluated, including countries' political stability
and their policies toward foreign loans and investments. The latter determine the presence or absence of such barriers as wage-price controls, profit
controls, tariffs, and expropriation of foreigners' assets.
The urgent demand for this type of information has spawned a rapidly
growing body of periodical literature designed to help businesspeople and
investors evaluate the opportunities available in East E u r o p e a n markets.
Policymakers, analysts, and academics should also find many of these publications of interest. T h i s essay r e v i e w s several periodicals f o c u s i n g on
Eastern Europe and the newly independent states. (See the box on page 39
for prices and subscription information for the periodicals reviewed here.)
Most of these publications were inaugurated since 1990, reflecting the critical need for information about this area. This review is one of t w o parts;
part 1, in the November/December 1992 Economic Review, focused on U.S.
Kconom ic Review
37
government sources, general reference works, and directories providing information about foreign investment and trade with the former Soviet Bloc countries.
While the majority of works discussed in part 1 provide background information, the periodicals reviewed
here give m o r e u p - t o - t h e - m i n u t e i n f o r m a t i o n a b o u t
developments. Taken together, the works examined in
these t w o essays provide investors, businesspeople,
and policymakers with unprecedented access to information about this dramatically c h a n g i n g part of the
world.
ABSEES: Soviet and East European Abstracts
Series (Oxford, England; quarterly; began July 1970) is
an English-language indexing and abstracting service
that scans articles originally published in eleven languages of the nine East European countries and the
f o r m e r Soviet Union. Articles are gleaned f r o m fifty
newspapers, general interest magazines, and trade journals published throughout the area. T h e articles cover
a wide range of subjects—from agriculture to economic planning, from labor and wages to science and techn o l o g y — a n d the a b s t r a c t s a l w a y s i n c l u d e a literal
English translation of their headline or title. 2
ABSEES issues are arranged in three parts: (1) introductory material with definitions; (2) a country/subject index, with each entry including a one- or two-line
English s u m m a r y that points the user to the desired
abstract entry; and (3) the abstracts, also arranged by
country/subject. Each year's final issue also contains a
cumulative index, by country/subject, for that year.
ABSEES abstracts can be an important first step in
the research process for businesspeople and investors.
Of c o u r s e , the articles abstracted should a l w a y s be
scrutinized for exaggerated claims and unreliable statistics that may have been promulgated by the defunct socialist governments. In addition to this obvious caveat,
however, users should also be aware that the weighting
of titles included in ABSEES does not necessarily reflect the size of the respective national economies represented nor their degree of economic liberation. (The
newspapers and periodicals abstracted by ABSEES are
heavily weighted toward the Russian language (thirteen), followed by Bulgarian (eight), Serbo-Croatian
(seven), and Czech (six). The remaining sixteen are divided among Albanian, German, Hungarian, Lithuanian, Polish, Romanian, and Slovak.)
Another deterrent to using ABSEES may be the general unavailability of the publications abstracted. Few
libraries in the United States subscribe to all fifty titles
covered, although research collections in major universities or population centers will likely have a majority.
38
Economic Review
The technical translators that m a y be needed to deal
with the original-text languages are most likely to be
available in or near research and population centers.
Arguments and Facts International
(San Francisco:
AFI, Ltd.; monthly; began 1990), as the title suggests,
presents a blend of editorial opinion ("arguments" on
political, social, and economic issues) with news coverage ("facts" about business conditions arranged by
industrial sector, topic, and location). The Russianlanguage version, published in Moscow, boasts a circulation recently reported as m o r e than 26 million.
T h e publication's success is built on factors like the
high caliber of informed contributors to its editorial
o p i n i o n pages. In the June/July 1991 issue, for instance, American and Russian intellectuals contributed
eleven pages of discussion on such matters as U.S. and
Russian views on the political and economic foment
occurring in the Soviet Union just before the attempted coup d'état in late s u m m e r 1991.
N e w s i t e m s in t h e J u n e / J u l y 1991 i s s u e c o v e r
macro- and microeconomic conditions, regional news
of the Socialist Republics, legislation, and trade and
commercial developments, including emphasis on industrial sectors. Abundant detail in the form of names,
addresses, and telephone, fax, and Telex numbers provides great convenience to the reader.
Arguments
and Facts International
is expensive,
but the informed thought of the editorial opinions and
the scope and detail of its reporting make it a worthwhile investment.
T h e Business International/Economist Intelligence
Unit provides country and industry coverage for business and academicians. Country Reports (quarterly)
and Country Profiles (annual), mentioned previously
in this Economic Review (July/August 1991, 56), monitor political, economic, and business conditions within each country. Both publications are available for the
C o m m o n w e a l t h of Independent States as well as all
East European countries except Albania. The quarterly
European Trends: Key Issues and Developments
in the
EC, EFT A, and the Single Market, also reviewed in
the July/August 1991 Economic Review (56), warrants
mention again because of its strong emphasis on governmental and economic events in Eastern Europe and
the newly independent states. Political and economic
developments require serious scrutiny and insightful
interpretation by the European Community. European
Trends provides articles to these ends. For instance, issues in the past two years have featured articles like
" F i n a n c i n g E u r o p e ' s R e g i o n s in the 1 9 9 0 ' s , " which
January/February 1993
discusses f u n d i n g the e c o n o m i c restructuring of the
five Länder of f o r m e r East Germany, and " T h e Comm o n w e a l t h of Independent States: T h e Crossroads,"
w h i c h e x a m i n e s the evolution of the f o r m e r Soviet
Union's search for an optimum balance between full
independence of each state and a coordinating center
as a central government.
Business International/Economist Intelligence Unit
recently developed an East European Risk Service to
i n c o r p o r a t e into the broader, existing Country
Risk
Service. T h i s s e r v i c e p r o v i d e s f u l l i n t e r n a t i o n a l l y
comparable, macroeconomic country risk analysis, updated quarterly, on the newly independent states and
all the East European countries except Albania. T h e
service's format stresses the essential matter of external
financing forecasts along with other external finance
indicators like reserve cover, as well as m e d i u m - t e r m
lending risk, political and policy risk, and short-term
trade risk. T h e service is available on diskette, tailored
to the subscriber's specific requirements. It reflects, as
d o e s the array of B u s i n e s s I n t e r n a t i o n a l / E c o n o m i c
Intelligence Unit publications, solid, t h o r o u g h g o i n g
analysis by a research staff that frequently works on
site in the subject countries. A l t h o u g h the p u b l i c a tions are expensive, the information can be quite useful.
Central European: Finance and Business in Central
and Eastern Europe ( L o n d o n : E u r o m o n e y P u b l i c a tions; monthly; began 1991) continues the Euromoney
Publications tradition—begun in 1969 in
Euromoney
(see t h e r e v i e w in Economic
Review,
July/August
1991, 57)—of general but detailed coverage of important financial market developments. T h e May 1992 issue of Central European, for instance, offers a six-page
discussion of the internal squabbling in the Yugoslav
state of Slovenia that has impeded privatization and
r e f o r m of the banking system. A n o t h e r seven pages
are devoted to problems with obtaining Western bank
financing for a desperately needed n e w Central and
East European infrastructure. The issue also contains
feature sections, of varying length, on deals, privatization, joint venture alerts, a bank profile ( M e g a b a n k
in Poland), secondary markets, and regulation. This
new publication shares the principal attributes of Euromoney—solid
information for practitioners tracking
current capital and m o n e y markets and a vehicle to
keep academicians broadly conversant with those developments.
The English-language edition of Commersant:
The
Russian Business Weekly ( M o s c o w ; English edition
published jointly with R e f c o G r o u p , Ltd., Chicago;
Subscription Information*
AB SEES: Soviet and East European
Abstracts
Series.
$695. A B S E E S Limited, 7 6 c Roupell Street, London,
S E I 8SS, England.
Arguments and Facts International.
$600. AFI, Limited,
2 4 3 Kearny Street, San Francisco, C A 94108.
Central European: Finance and Business in Central and
Eastern Europe. $435. R e e d Publishing G r o u p , 205
East 4 2 n d Street, Suite 1705, N e w York, N Y 10017.
Commersant:
The Russian Business Weekly. $265. R e quest order f o r m by mail for English (or Russian) edition f r o m R e f c o G r o u p L i m i t e d ( U S A ) , 111 W e s t
J a c k s o n B o u l e v a r d , C h i c a g o , IL 6 0 6 0 4 , or b y s f a x ,
(312) 930-6534.
Country Reports; Country Profiles. $ 2 9 5 / p a c k a g e (per
country). T h e Economist Intelligence Unit, Business
International, 215 Park A v e n u e South, N e w York,
N Y 10003.
Dateline: Russia. $360. Dateline International, Inc., P O
B o x 1270, M i n d e n , N V 89423-1270.
European
Trends. $ 3 7 5 . T h e E c o n o m i s t I n t e l l i g e n c e
Unit, Business International, 215 P a r k A v e n u e South,
N e w York, N Y 10003.
Finance International.
$ 1 5 0 . T o set u p a s u b s c r i p t i o n
and be billed for it, fax an order letter to 4 4 - 7 1 - 8 2 3 1001 (Subscription Department, Springfleet Publishing Limited, 4 and 5 G r o s v e n o r Place, L o n d o n S W 1 X
7HJ, England).
Global Finance. $120. Global Finance Joint Venture, 11
W e s t 19th S t r e e t , S e c o n d F l o o r , N e w Y o r k , N Y
10011.
Perspectives.
$ 2 2 5 . International F r e e d o m F o u n d a t i o n ,
2 0 0 G Street, N E , Washington, D C 20002.
Russian Business Monitor. $ 8 per issue. For subscription
instructions, write R B M E u r o k o s m o s , P O B o x 2 3 3 ,
103051 M o s c o w , Russia, or t e l e p h o n e (7-095) 20812-88.
'Prices and addresses shown are current as of December 1992. Prices are annual subscription rates (in U.S. dollars) for individuals
in the United States, unless otherwise specified; postage may be extra. Addresses are for subscriptions only and may differ from
place of publication.
Reserve B a n k of Atlanta
DigitizedFederal
for FRASER
Kconom ic Review
39
weekly; began 1908, suspended 1917, resumed January 1990), straightforwardly organized and written in
smoothly idiomatic A m e r i c a n English, is decidedly
pitched t o w a r d the A m e r i c a n business market. T h e
current format, c o m m e n c i n g with the September 15,
1992, issue, reflects the responses to a survey that asked
its readers to help create a publication they would like
to read. This issue includes articles on top stories of
the week, investment, banking, and defense spending,
as well as reproductions of selected d o c u m e n t s like
the Russian Federation Resolution " O n Information
a b o u t Gold M i n i n g and P r o d u c t i o n " and a detailed
presentation of economic indicators.
Exporters may find useful the explication of the list
of i m p o r t c o m m o d i t i e s eligible f o r s u b s i d y by the
Russian Federation and the coefficients for converting
these commodities' foreign trade contract prices.
Economists may appreciate the emphasis given to tables of economic indicators and the statistical analyses
of various kinds of e c o n o m i c activity (for example,
e x c h a n g e rates, c o m m o d i t y p r i c e s , and the central
bank and commercial banking system). However, researchers will doubtless balk at the omission of references for data sources.
Dateline:
Russia ( M i n d e n , N e v . [ U . S . A . ] , a n d
Moscow, Russia; monthly; began October 1992) presents a wide selection of topics—about twenty, ranging
(alphabetically) f r o m aerospace to transportation—offering "information, understanding, [and] opportunity," for the American businessperson and investor. The
subject of most articles in the table of contents is selfevident, although some need amplification. "Conversion," for example, refers to the transformation of
economic activity formerly associated with the militaryindustrial complex to civilian activities. Given the significant part of R u s s i a ' s gross national product represented by the military, this topic is, of course, one of
the most important issues in Russia today. The article
discusses the ways in which enterprises whose defense
contracts have been reduced or canceled can convert
their capacities, scientific and technical potential, and
manpower. N e w laws governing the situation are discussed, as are plans for the then-impending International C o n f e r e n c e on C o n v e r s i o n held in M o s c o w ,
October 14-16, 1992. One suggested conversion activity is the plan u n d e r w h i c h ballistic missiles withdrawn from service would be used as delivery vehicles
to launch commercial space probes.
Dateline: Russia includes some lighter features such
as a table of daily rates (in U.S. dollars) in state-run
Moscow hotels for single, double, half-suite, and suite
4 0
Economic Review
accommodations. A " H o w To" column takes up learning the Russian language, with a beginning lesson in
the Cyrillic alphabet that includes some basic English
words translated into the Russian.
Finance International
( L o n d o n : Springfleet P u b lishing Limited; quarterly; began 1992) consists of clusters of articles pulled together a r o u n d geographical
area or banking/finance topics. Contributing authors
often are prominent national figures and authorities in
the international financial field. A twelve-page study
on Eastern E u r o p e f o c u s i n g on H u n g a r y ( M a r c h
1992), for example, featured articles by the Minister
of Finance, the chairman and C E O of the Budapest
B a n k , and the M i n i s t e r of I n d u s t r y and T r a d e discussing, respectively, the H u n g a r i a n e c o n o m i c program of structural adjustment and d e v e l o p m e n t , the
state's role in privatization, and Hungary's progress toward a market economy that makes it one of the more
attractive c o u n t r i e s f o r Western i n v e s t m e n t . In the
same issue three sections on global custody have general interest for securities investors around the world.
The discussion in the three sections centers on trends
toward concentration in custody services, technology's
effects on competition for clients, and establishing and
managing an agent network. The authors of these sections are seasoned executive practitioners with varied
custody experience at firms in N e w York and Boston.
Finance International is geared to the financial executive interested primarily in area-specific studies, but it
also includes some topical articles. Although not limited
to Eastern E u r o p e and the newly independent states,
this new publication informs financiers of significant
issues affecting trade with that part of the world.
Global Finance (New York: Global Finance Joint
Venture; monthly; began 1987) offers sophisticated insight into investment and finance around the world, including places until recently considered off-beat for
Western purposes, such as China, Hungary, Poland,
Sri Lanka, and Peru. For some months the publication
has placed increasing emphasis on Eastern Europe and
the newly independent states, representative of which
is the a r t i c l e (in t h e M a r c h 1992 i s s u e ) " R u s s i a n
Roulette," delineating specific problems of resolving
legal disputes in Russia. The article discusses such obstacles as unclear law, big gaps in the law, defining
what income is for the purpose of levying new income
taxes (which are payable in hard currency), ill-qualified
j u d g e s , ambiguities surrounding authority to sign a
contract, and disputes over contracts signed b e f o r e
the breakup of the Soviet Union. The M a y 1992 issue
January/February 1993
includes a substantial article about "Bulgaria's Slow
Trek to the Market," investigating the 90 percent devaluation of the currency, which has a uniquely managed float among East European currencies; favorable
changes in the laws governing restitution of private
property; reform of the banking system; and liberalization of a foreign investment act. All issues include departments that deal regularly with features like risk
management, global trends, futures and options, and a
central European roundtable.
Global Finance's growing focus on Eastern Europe
and the newly independent states makes it a worthwhile publication for investors and creditors seeking
opportunities in those areas, as well as for academicians scanning the horizon. The publication's attractive format and exceptionally creative artwork do not
vitiate a serious approach to the subject matter.
Perspectives (formerly Soviet Perspectives)
(Washington: International Freedom Foundation; monthly; began March 1991) guides the reader through principal
issues in the continuing maze of economic reform and
the panorama of joint venture business opportunities in
the former Soviet Union. The style is terse, and the selection of news and feature topics targets information useful to U.S. business and investment interests vis-à-vis
the newly independent states. For example, the lead article in the August 10, 1992, issue examines the M u nich G - S e v e n S u m m i t , w h i c h called f o r billions of
dollars in aid to the former Soviet republics. The article
highlights particular sectors that will likely be m o s t
enhanced by the aid—personnel and other management
training, nuclear safety, and oil and gas. The issue also
contains a calendar of upcoming trade shows and conferences on opportunities in the newly independent states
as well as articles on notable privatization events in the
republics, significant newly agreed-upon joint ventures,
and U.S. and Canadian government offices created to
facilitate trade with the newly independent states.
The publication is available electronically on the
NewsNet on-line service; information on this service is
available (in the United States) at 800-345-1301.
Russian Business
Monitor ( M o s c o w : R B M Eur o k o s m o s ; f i v e i s s u e s p e r year; b e g a n A p r i l 1992)
p r o m i s e s to provide needed i n f o r m a t i o n f o r investment and business with Russia and the other newly independent states. The first issue presents a balanced
array of expository and factual articles. An essay on political and economic reform from August 1990 through
February 1992, complete with tables, graphs, charts,
and other illustrations explicating Russian e c o n o m i c
f u n d a m e n t a l s , occupies almost half the issue. Other
useful features of this issue include a section that discusses steps being taken to bring R u s s i a n financial
statements into accord with the "world standard" and
the "British and American Model" and a section listing contacts for business opportunities in Russia.
The Russian Business Monitor editorial board and
the staff are economists, lawyers, political scientists,
and other professionals, many of w h o m are affiliated
with the Russian A c a d e m y of Sciences, the A c a d e m y
of National Economy, and other governmental and independent organizations.
A Western reader, particularly one not already versed
in Russian background, m a y find that a lack of systematic definition of terms slows c o m p r e h e n s i o n of
technical economic discussions (for example, the interchangeable use of " R u s s i a " and "Russian Federation"). Moreover, the English translation of the text is
at times awkward and not smoothly idiomatic. Nevertheless, the Russian Business
Monitor h a s m a d e a
good beginning in providing businesspeople and investors with a broad range of information.
Notes
1. The Eastern Bloc comprised East Germany and the other
countries of Eastern Europe—Albania, Bulgaria, Czechoslovakia, Hungary, Poland, Romania, and Yugoslavia—and the
Soviet Union (Armenia, Azerbaijan, Byelarus, Estonia, Georgia, Kazakhstan, Kyrgyzstan, Latvia, Lithuania, Moldova,
Russia, Tajikistan, Ukraine, and Uzbekistan, sometimes referred to as the newly independent states). There is at present
no broadly accepted alternative name for the states of the former Soviet Union. Commonwealth of Independent States encompasses only some of those nations. The people of the area
object to the term States of the Former Soviet Union. Hence,
Federal Reserve B a n k of Atlanta
following the lead of the U.S. Department of Commerce International Trade Administration, this article will use the
term newly independent states, where appropriate, to designate the former Soviet Union.
2. The informed reader may wonder whether the Current Digest
of the Post-Soviet Press (formerly Current Digest of the Soviet Press) is an alternative to ABSEES. The former concentrates on the political arena within the former Soviet Union
with neither particular emphasis on the East European nations nor the subjects that are the special concern of ABSEES.
Kconom ic Review
41
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