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July/August 1991 Volume 76, Number 4 Federal Reserve Bank of Atlanta In This Issue: Globalization of Stock, Futures, and Options Markets 2?urope 1992: A Closer Look Commercial Bank Profitability Review Essay V, ». - • fe- 7- 7 • onomic mew July/August 1991, Volume 76, Number 4 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 R o s e n b a u m , Vice President, Macropolicy William R o b e r d s . Research O f f i c e r , Macropolicy G e n e D. Sullivan, Research O f f i c e r , Regional Larry D. Wall, Research O f f i c e r , Financial David D . W h i t e h e a d , Research O f f i c e r , Regional Public Affairs B o b b i e H. M c C r a c k i n , Vice President Joycelyn T . W o o l f o l k , Editor Lynn H . Foley, M a n a g i n g Editor Carole L. Starkey, Graphics Ellen Arth, Circulation T h e Economic Review of the Federal Reserve Bank of Atlanta presents analysis of e c o n o m i c and financial topics relevant to Federal Reserve policy. In a f o r m a t accessible to the nonspecialist, the publication reflects the w o r k of the Research D e p a r t m e n t . It is edited, d e s i g n e d , prod u c e d , and distributed through the Public A f f a i r s D e p a r t m e n t . V i e w s expressed in the Economic eral Reserve System. Review are not necessarily those of this Bank or of the Fed- Material may be reprinted or abstracted if the Review and author are credited. Please provide the B a n k ' s Public A f f a i r s Department with a copy of any publication containing reprinted material. Free subscriptions and limited additional copies are available f r o m the Public A f f a i r s Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N . W . , Atlanta, G e o r g i a 3 0 3 0 3 - 2 7 1 3 (404/521-8020). C h a n g e - o f - a d d r e s s notices and subscription cancellations should be sent directly to the Public A f f a i r s D e p a r t m e n t . Please include the current mailing label as well as any n e w information. (Contents July/August 1991, Volume 76, Number 4 Globalization of Stock, Futures, and Options Markets Peter A. Abken 23 Europe 1992: A Closer Look Janice L. Boucher 3 9 F F / — C o m m e r c i a l Bank Profitability: H a m p e r e d A g a i n by L a r g e B a n k s ' L o a n P r o b l e m s Robert E. Goudreau and B. Frank King §§ Review Essay Jerry J. Donovan In recent years the increasing volume of international financial transactions has pressured financial institutions to find more efficient ways of conducting business. To meet this challenge, the gradual automation of securities trading is transforming the industry. 'Electronic systems are displacing person-to-person methods of trading and are allowing around-the-clock trading throughout the world. This article examines automated trading systems for many of the world's principal organized exchanges for common stock, futures, and options contracts and for major over-the-counter markets for common stocks. The author also considers the problematic question of whether the increased trading promoted by automation generates volatility that has negative economic side effects. As of January 1993 a new economic order is expected to begin in Western Europe, bringing both gains and costs for the countries involved. In assessing the viability of the "Europe 1992" plan, the author of this article weighs the costs as well as the anticipated benefits. Several difficult parts of the program are still to be worked out. The potential costs could undermine the willingness of countries to cooperate to overcome remaining obstacles. In the industry as a whole, commercial bank profitability remained essentially stable in 1990. This article highlights some of the more interesting patterns of commercial banks' performance that emerged or continued in the nation and the Southeast last year. Extensive tables provide details about bank profitability from 1986 through 1990. International Trade and Finance Information A Guide to Periodical Literature Sources: (globalization of Stock, Futures, and Options Markets Peter A. Abken ,f the trendy buzzwords to emerge from the 1980s, "globalization" surely ranks high on the list of overused words in the business lexicon, but not without good reason. The word has become associated with financial markets' growing interconnections, facilitated largely by advances in communications and computer technology. Capital moves across national borders primarily as investment flows and secondarily as international trade financing. In dollar terms, global financial transactions today stand at a historically high multiple of world trade volume (John G. Heimann 1989). Record trade imbalances, however, have also contributed to financial interdependence, the most prominent example being the net current account surplus of Japan, leading to large overseas investments of the surplus, and the net deficit of the United States, necessitating borrowing from abroad. The author is a senior economist in the financial section of the Atlanta Fed's research department. He would especially like to thank Jim Shapiro of the New York Stock Exchange and Bruce Phelps of the Chicago Board of Trade for helpful comments. However, any errors are the author's responsibility. Reserve B a n k of Atlanta Digitized Federal for FRASER Financial transactions' increasing volume and their decreasing costs have put strong competitive pressures on financial institutions to change the ways in which they intermediate credit and other financial flows. The financial industry has turned to automated securities trading, which is transforming and displacing the face-to-face and mouth-to-telephone methods of making financial transactions and strengthening the globalization or internationalization of securities markets in the process. Automation of trading encompasses a number of innovations that have improved the efficiency of making financial transactions. The technologies range from quotation and communications systems that facilitate traditional trading methods to socalled screen trading systems that supplant them. Their operation can be confined to one organized financial exchange, as the New York Stock Exchange's SuperDot system is, or can link many organized exchanges, as the Chicago Mercantile Exchange's Globex system does. For convenience in this discussion Economic Review 1 of the gradual automation of securities trading, these innovations will be referred to generically as automated trading systems. This article examines currently running and proposed automated systems for many of the w o r l d ' s principal organized exchanges for common stock, futures, and option contracts. These exchanges are voluntary associations of members who come together to trade securities in auction markets, paying for the right to trade on an exchange—they buy a "seat" on the exchange. They generally trade for their own accounts and for outside customers. In contrast, participants in over-the-counter (OTC) markets, w h o are geographically dispersed, are brought together by t e l e p h o n e and c o m p u t e r l i n e s . O v e r - t h e - c o u n t e r trades go through dealers, who quote prices to buy and sell. The National Association of Securities Dealers (NASD) is one of several important OTC markets for common stocks in the United States that will be discussed below. creases in volatility of most financial markets, which has been attributed to causes ranging from deregulation of financial m a r k e t s , fiscal and trade imbalances, and so forth, to out-and-out irrationality and a gambling-casino mentality among traders. Some economists have recommended taxing securities transactions to alleviate the apparently unnecessary volatility. 1 On the other hand, there are substantive reasons for expecting that transactions volume will increase as uncertainty about " f u n d a m e n t a l s " rises. For one thing, trading securities is necessary to adjust portfolios optimally in response to changing expected securities' payoffs. 2 In addition, volatility is a prime factor motivating financial risk management, which has spawned a variety of derivative instrument markets. Options and futures markets, for example, deal in contracts that are valued on the basis of stock, bond, and other primary securities prices. A discussion of the growth of primary and derivative securities markets follows. T h e article concludes with a section on market performance and regulation that takes a broader perspective on globalization. The perceived impact of globalization is closely tied to one's view of market efficiency. Integrating m a r k e t s through electronic trading may reduce the magnitude of certain kinds of price shocks that propagate across markets because of a l a c k of i n f o r m a t i o n a b o u t the s o u r c e s of s u c h shocks. If m a r k e t s are e f f i c i e n t , t w e n t y - f o u r - h o u r t r a d i n g has the p o t e n t i a l to r e d u c e s u c h m a r k e t volatility. On the other hand, some market observers and participants, believing that markets are inefficient and excessively volatile, have proposed measures to curb speculative activity and the volatility they believe it engenders. The continuing reduction in transactions costs through technological innovation may only exacerbate market volatility. The final section considers this debate. Equities. Table 1 shows international equity market transactions, comparing activity for selected countries and r e g i o n s in 1980 with 1990. T h e sum of purchases and sales, referred to here as transactions volume, measures the total transactions in equity markets by foreigners in U.S. stock markets and by Americans in foreign stock markets. 3 The dollar volume of transactions in 1980 and in 1990 was greater for foreigners transacting in U.S. markets than for Americans dealing in foreign markets. However, the overall margin of foreign volume over domestic volume diminished from 321 percent in 1980 to 4 3 percent in 1990. 4 The absolute levels of dollar purchases and sales have increased markedly, well in excess of the dollar's inflation rate and twice as fast as the growth of transactions volume on domestic exchanges during this period (Joseph A. Grundfest 1990, 349). 71ie Growth of International Securities Trading Since the 1980s, securities markets of all kinds have been developing rapidly around the world. The volume of equity and bond market transactions has grown steadily, and both A m e r i c a n purchases and sales of foreign securities and foreign purchases and sales of U.S. securities have been expanding, as Table 1 shows. A useful indicator of market activity, the growth in transactions v o l u m e coincided with in- 2 Economic Review The compound annual growth rate for foreign transactions volume in U.S. securities was 17 percent, while the growth rate for U.S. transactions volume in foreign securities was 30 percent. Japanese transactions in U.S. stock markets grew at a 41 percent comp o u n d annual rate, f a s t e r than t h o s e of all other countries or regions. Japan's percentage share of the international transactions volume has correspondingly risen from 2.5 percent to 16 percent over the decade. T h e United K i n g d o m accounts for nearly half the 1990 European volume, up substantially from 1980. Much of its transactions volume probably stems from Middle Eastern and other non-United Kingdom buying and selling of U.S. stocks that occurs through Lond o n ' s markets, which are the preeminent financial July/August 1991 Table 1 Transactions Volume in Stocks U.S. Transactions in Foreign Securities Foreign Transactions in U.S. Securities Purchases* Sales 3 Percentage Aggregate Percentage Aggregate Purchases Share of Market Purchases Share a n d Sales3 of M a r k e t and Sales 3 Purchases 3 Sales 3 1990 France Germany United Kingdom Total Europe japan Canada Total W o r l d w i d e 5.82 5.90 44.94 84.95 27.47 19.52 173.04 12.83 7.01 6.05 3.55 5.90 11.95 4.72 14.14 6.27 12.17 3.37 6.69 48.07 93.01 25.74 44.80 7.45 45.52 90.32 5.58 35.64 93.53 178.47 49.39 74.53 78.40 152.94 60.36 30.38 18.63 57.85 38.14 16.01 30.89 4.78 31.52 4.92 62.41 24.63 9.70 122.49 130.89 253.38 3.83 100.00 0.47 0.67 1.14 6.36 0.24 0.22 0.46 2.57 1.38 3.16 1.36 3.62 2.75 6.78 15.38 37.97 15.10 361.37 188.34 10.56 100.00 1980 France Germany United Kingdom Total Europe Japan Canada Total W o r l d w i d e 2.24 4.97 2.75 7.44 2.56 4.94 5.30 12.38 6.60 7.05 16.44 24.62 0.87 21.55 46.16 61.32 1.90, 11.83 0.93 3.02 1.77 2.70 15.71 3.66 6.68 37.43 75.28 100.00 7.89 9.97 17.85 100.00 2.73 6.35 40.32 1.03 5.48 34.96 2.52 C o m p o u n d Annual G r o w t h Rate, 1980-90 (percent) Foreign U.S. 9.95 8.66 26.53 40.88 United Kingdom 22.35 41.81 Total Europe 14.48 Japan Canada 40.73 12.42 36.56 36.92 Total W o r l d w i d e 16.98 France Germany 3.80 30.38 a In billions of U.S. dollars. . ,, 1fin.. T Source: Derived by the Federal Reserve Bank of Atlanta from U.S. Department of the Treasury, U.S. Treasury Bulletin (Winter 1991), Table CM-V-5; (Winter 1981), Table CM-VI-10. Digitized Federal for FRASER Reserve Bank of Atlanta Economic Review 3 markets in Europe. From 1980 to 1990, both the United Kingdom and Japan were responsible for net inflows (cumulative excess of purchases over sales) into U.S. equity markets of about 17 billion dollars each. U.S. transactions volume in foreign equities also grew markedly during the decade, almost twice as fast as foreign volume. This growth rate reflects the low 1980 level of U.S. purchases and sales of foreign stocks relative to foreign participation in U.S. markets. The transactions volume shares in the United K i n g d o m and Japan realized significant increases f r o m 1980 to 1990, as did the corresponding compound annual growth rates. Though the share of overall volume was still relatively low in 1990, the growth rate for German stock market participation by U.S. investors was about as rapid as the rates for the United Kingdom and Japan. Chart 1 gives another view of world equity trading, showing the dollar trading volume in major world equity markets. Clearly, the New York and Tokyo markets surpass other world markets. Each of these will be discussed further in connection with automated trading systems. Bonds. The dollar transactions volume for bonds was approximately ten times as large as that for stocks in 1990; they were roughly comparable a decade earlier. The domestic and foreign bonds included in Table 2 exclude short-term bonds with remaining times to maturity of less than one year. Although there is considerable trading in these short-term securities, much of that trading includes government intervention in foreign e x c h a n g e markets, leading in turn to sizable purchases and sales of short-term government securities such as U.S. Treasury bills. Long-term securities better gauge the growth in private cross-border capital movements. The securities included in U.S. market t r a n s a c t i o n s are m a r k e t a b l e T r e a s u r y and federally sponsored agency bonds as well as corporate bonds. A l m o s t all b o n d s are traded o v e r - t h e - c o u n t e r , t h o u g h s o m e are traded on o r g a n i z e d e x c h a n g e s . Somewhat less than 10 percent of all U.S. corporate bonds are traded on organized exchanges (Jack Clark Francis 1991, 87). As seen in Table 2, most foreign transactions in U.S. bond m a r k e t s are in g o v e r n ment bonds. Although the bond market is primarily Chart 1 Dollar Trading Volume in Major World Equity Markets in 1990 a Billions New York a Tokyo London Frankfurt NASDAQ Osaka Annual trading volume is the sum of each issue's daily share volume multiplied trading days in the year. Source: NASDAQ (1991). 4 Economic Review Zurich Paris Toronto Amex by its closing price and aggregated over all issues and July/August 1991 Table 2 Transactions Volume in Long-Term Bonds 3 U.S. Transactions in Foreign Securities Foreign Transactions in U.S. Securities Aggregate Purchases Purchases' 5 Sales b a n d Sales b Percentage Aggregate Share Purchases Share a n d Sales b of M a r k e t Purchases' 3 of M a r k e t Sales b Percentage 1990 14.67 15.50 30.17 15.91 34.14 4.65 5.26 113.95 18.23 114.16 228.10 35.12 40.97 185.46 189.78 57.77 36.71 54.48 43.50 375.25 80.21 45.31 39.87 85.18 0.68 2.21 United Kingdom 564.62 555.67 1,120.29 29.08 Total Europe Japan 804.32 France Germany Canada Total W o r l d w i d e France Germany 26.24 12.78 13.47 1,578.17 1,476.04 773.85 744.96 649.50 100.00 2.50 66.81 69.46 136.26 1,906.80 3,851.99 100.00 313.58 0.71 0.45 1.16 0.94 0.66 0.62 6.31 34.60 49.37 0.45 6.07 0.43 1.28 0.88 6.16 9.59 12.23 34.97 18.68 53.39 11.44 2.54 5.21 United Kingdom 22.36 42.51 Total Europe Japan 30.29 20.15 30.37 Total W o r l d w i d e 12.35 17.15 1,945.19 7.75 Canada 111.39 38.32 3.54 731.08 2.59 0.96 4.21 66.61 56.25 60.65 6.81, 3.35 2.39 122.86 9.09 56.91 335.93 5.54 1.35 2.73 2.20 2.65 2.42 4.00 4.63 100.00 17.07 17.92 34.98 3.64 13.22 1 00.00 C o m p o u n d Annual G r o w t h Rate, 1980-90 (percent) Foreign U.S. France Germany 36.66 27.09 37.22 United Kingdom 38.70 33.99 Total Europe Japan 38.53 71.24 34.99 34.96 Canada 44.86 37.46 Total W o r l d w i d e 41.13 33.93 a Bonds having maturities of one year or greater. b In billions of U.S. dollars. 44.24 Source: Derived by the Federal Reserve Bank of Atlanta from U.S. Department of the Treasury, U.S. Treasury Bullet,n (Winter 1991), Table CM-V-5; (Winter 1981), Table CM-VI-10. Federal Reserve Bank of Atlanta Economic Review 5 over-the-counter (and thus not the point of interest in this discussion), the growing number of international transactions in bonds has stimulated derivative securities markets worldwide. Increasingly, derivative securities trade in one country on underlying securities originating in another. Several exa m p l e s — i n c l u d i n g the f u t u r e s c o n t r a c t s on U . S . Treasury bonds that trade on the Tokyo Stock Exchange (TSE) and the German government bond futures that trade at the London International Financial Futures Exchange (LIFFE, pronounced "life")—will be discussed below. The picture of globalization that emerged from the earlier consideration of equities trading comes into even sharper relief when cross-border bond trading is examined. Aside from the greater magnitude of dollar transactions volume mentioned earlier, the most striking feature is the uniformly high growth rates across countries and regions from 1980 to 1990. Equity market growth rates, particularly for French and German involvement in U.S. markets, do not show this evenness. All but one compound annual growth rate exceeds 30 percent. The transactions volume of Japanese investors in U.S. markets increased 71 percent annually! Similar to the equity data, the Japanese share in transactions volume rose over the decade from 5.5 percent to 38 percent, while the European share declined from 49 percent to 41 percent. U.S. investor participation in foreign bond markets mirrored the increased foreign activity in U.S. markets. Futures and Options. Exchange-traded f u t u r e s contracts have a long and—to some—notorious history. Commodity futures originated at the Chicago Board of Trade (CBOT) in the 1860s (see Chicago Board of Trade 1985, 1-4). Not until 1972 were the first financial futures introduced at the Chicago Mercantile Exchange (CME, or the "Merc"). The develo p m e n t of t h e s e c u r r e n c y f u t u r e s r e f l e c t e d the anticipated hedging needs stemming from the decision allowing the dollar and other major currencies to float against one a n o t h e r rather than to be m a i n tained at fixed parities. At the time agricultural contracts accounted for 97 percent of the C M E ' s volume (William J. Brodsky 1990). Many new financial futures and options soon followed. The C B O T established the Chicago Board Options Exchange (CBOE) in 1973 to trade options on listed stocks; they created the Ginnie Mae futures contract in 1975. 5 The C M E countered with its Treasury bill futures contract in 1976; the CBOT, with its Treasury bond futures contract in 1977. The latter is the most heavily traded futures contract in the world today. 6 Economic Review In the early 1980s, these exchanges developed futures and options contracts on equity indexes, such as the Standard and P o o r ' s (S&P) 500 futures ( C M E ) and S & P 100 options contracts (CBOE). At the time of the market crash of October 1987, the S&P 500 futures achieved a notoriety in the minds of many investors and stock exchange members that lingers to this day. While a number of factors had contributed to the crash, the use of index futures in conjunction with so-called program trading, which uses the automated order-routing system at the New York Stock Exchange, was widely blamed. (This subject will be considered further in a later section.) In any case, many exchanges, including the New York Stock Exchange, greatly expanded capacity through automation to handle future surges in volume. While volume in other futures contracts has remained generally flat during the 1980s, financial futures volume has grown steadily (see Robert W. Kolb 1991, 23). For e x a m p l e , by 1989 financial f u t u r e s volume made up 91 percent of the C M E ' s volume, with only the remaining 9 percent accounted for by commodity futures. At all U.S. futures exchanges in 1972, the total annual volume of futures trading measured by the number of contracts traded was 18.3 million. In 1990 this volume had risen to 276.5 million contracts, a compound annual growth rate of 16.3 percent. Though the U.S. exchanges are the world's most established, foreign futures markets are rapidly making inroads in the share of trading volume. For instance, since the opening of the London International Financial Futures Exchange in 1982, thirty options and futures exchanges have opened outside the United States (Brodsky 1991). The U.S. exchanges are still dominant in the world, but, as Table 3 shows, foreign options and futures markets that emerged in the 1980s are also well represented in the top-twenty ranks. In particular, the Osaka Securities Exchange's Nikkei 225 index futures contract and Tokyo International Financial Futures Exchange's Euroyen contract surged in volume during 1990. Automation of Equity Markets Individual stock exchanges everywhere have adopted some degree of automation, reflecting the exigencies of competitive pressures from domestic as well as foreign exchanges. Derivative securities markets have aggressively employed the new technologies to July/August 1991 Table 3 Most Heavily Traded Futures and Options Contracts Contract V o l u m e Rank 1990 1 1989 70,303,000 75,499,000 CBOE 58,845,000 58,371,000 CME 34,694,000 40,818,000 CBOT 27,315,000 20,784,000 C r u d e o i l (f) Nymex 23,687,000 20,535,000 Japanese g o v e r n m e n t b o n d (f) TSE 16,307,000 18,942,000 N o t i o n n e l g o v e r n m e n t b o n d (f) MATIF 15,996,000 15,005,000 TIFFE 1 4,414,000 4,495,000 5,443,000 10,560,000 3 4 T - b o n d (o) 5 5 6 1990 CBOT 3 2 Exchanges' 3 T - b o n d (f) 4 6 7 7 8 30 Euroyen (f) 9 25 N i k k e i 2 2 5 (f) Osaka 13,589,000 12,139,000 10 8 S&P 5 0 0 (f) CME 18 S&P 5 0 0 (o) CBOE 1 2,089,000 6,274,000 11 11 C o r n (f) CBOT 11,423,000 9,271,000 12 10 Soybeans (f) CBOT 9,635,000 13 10,302,000 G o l d (f) Comex 9,730,000 9,999,000 9,582,000 5,330,000 14 9 15 26 G e r m a n b o n d (f) LIFFE 17 N i k k e i 2 2 5 (o) Osaka 9,186,000 6,610,000 16 12 D e u t s c h e M a r k (f) CME 8,186,000 17 9,169,000 Short Sterling (f) LIFFE 8,355,000 7,131,000 Yen (f) CME 7,437,000 7,824,000 Notionnel government b o n d ( o ) MATIF 7,410,000 7,177,000 18 19 20 b 1 S&P 100 (o) E u r o d o l l a r (f) 2 a Contract 1989 3 16 13 15 (0 = futures contract; (o) = options contract. i5 the New York Mercantile Exchange; Comex is the Commodities Nymex Source: Futures and Options World: 1991 Annual Worldwide . Exchange (New York); other exchanges are described m the Directory and Review (Surrey, England: Metal Bulletin Journals Ltd., 1991), 9. Data used by permission of the publisher. link exchanges. The discussion below considers the movement toward automated trading in equity markets and derivative markets. New York Stock Exchange. U.S. equity markets are the largest and most liquid in the world. T h e biggest domestic exchange, the New York Stock Exc h a n g e ( N Y S E ) , is f a c i n g m o u n t i n g c o m p e t i t i v e p r e s s u r e s f r o m r e g i o n a l d o m e s t i c e x c h a n g e s and from foreign stock exchanges. The heart of the New York Stock Exchange is its specialists, charged by the exchange to maintain "fair and orderly" markets in the individual listed stocks assigned to them. The New York Stock Exchange is organized as a continuous two-sided auction market, with the specialist acting as auctioneer for incoming orders to buy or sell a particular stock. The specialist conducts an auction in the sense that he or she continually adjusts a stock's price to balance supply and demand throughout the Federal Reserve Bank of Atlanta trading day. She at times may also need to take the buy or sell side to keep prices f r o m fluctuating too greatly. Overall about 10 percent of share purchases and 10 percent of sales on the N Y S E result in specialists' staking their own capital in the trade (New York Stock Exchange 1991a, 17). This role is part of their obligation to the e x c h a n g e in performing the specialist's function. Also, the specialist has access to the computerized limit-order book, which displays orders to buy or sell if the market price reaches a specified level. Because of their knowledge, specialists have an informational advantage over traders off the exchange floor. 6 Although they may profit f r o m their inventory position, exchange rules constrain trading for their own accounts. On every trade the specialist also receives the difference between the sale price (the ask) and the purchase price (the bid). Other market participants are willing to Economic Review 7 incur these costs in order to gain the liquidity specialists provide. However, the specialist's role is being questioned with increasing frequency: How important is it? Is the provision of liquidity worth the price? Since the rise of institutional trading in the 1960s, the so-called upstairs market has developed, partly insulating the specialists from having to take positions in large blocks of 10,000 or more shares. Such blocks sent directly to the specialists may cause too much price fluctuation and be too risky for them to handle. Instead, block positioners match buyers and sellers and may also take positions in blocks themselves. Blocks are then sent to the specialist post for execution. Because of economies of scale, low commission rates are charged for block transactions. During the latter half of the 1980s, about half the N Y S E ' s volume was accounted for by institutional block trading (NASDAQ 1991, 39). Preferring new, automated mechanisms that are even cheaper, institutional investors are beginning to dispense altogether with using the exchange. More efficient handling of trading volume led to the development of the N Y S E ' s automated routing system in 1976 called the Super Designated Order T u r n a r o u n d S y s t e m ( S u p e r D o t ) . S u p e r D o t routes market orders of less than 2,099 shares to the specialist (or to a floor broker) for rapid execution, usually in less than a minute. 7 The system can also route large orders to the specialist. SuperDot is frequently used by program traders dealing in whole portfolios of stocks; they route lists of stocks through the system to appropriate specialists. T h e system handles market orders of as many as 30,099 shares and limit orders of as many as 99,999 shares of individual stocks, although the specialists are not obligated to execute these orders as rapidly as the New York Stock Exchange requires for smaller ones. Odd-lot orders of less than 100 shares are executed automatically by SuperDot at the prevailing price quote. About 75 percent of daily N Y S E orders are processed through the system (New York Stock Exchange 1991a, 21). Regionals. Regional e x c h a n g e s have developed their own versions of automated order-routing and execution systems for small trades. The Midwest Stock E x c h a n g e ( M S E ) , P a c i f i c Stock E x c h a n g e (PSE), Philadelphia Stock Exchange ( P H L X ) , and Boston Stock E x c h a n g e (BSE) use systems n a m e d M A X , SCOREX, PACE, and B E A C O N , respectively. 8 The Cincinnati Stock Exchange (CSE) is in fact an overthe-counter market with competing market makers. All trades on the CSE pass through the National Securities Trading System (NSTS), which is an order- 8 Economic Review matching system akin to the N A S D A Q system to be d i s c u s s e d shortly ( U . S . S e c u r i t i e s and E x c h a n g e Commission 1991,23-26). The Securities Act amendments of 1975 mandated the Securities and Exchange Commission (SEC) to establish a national market system with the objectives of increasing competition among market makers at different e x c h a n g e s and strengthening links among different exchanges (see Francis 1991, 13233). One major change was that negotiated commissions replaced fixed commissions on securities sales and purchases. Another consequence of the act was the establishment of the "Consolidated Tape," which continuously lists the trades at seven stock exchanges and two over-the-counter markets ( N A S D and Instinet). Since 1978 the regional exchanges, the American Stock E x c h a n g e ( A m e x ) , N A S D , and N Y S E have been linked by the Intermarket Trading System (ITS), which enables a broker or specialist at one exchange to send orders to buy or sell at another exchange showing a better price. Most of the stocks traded via the ITS communication system are N Y S E - l i s t e d s t o c k s , and a m u c h smaller number traded are Amex-listed and regionally listed stocks. At the broker's or specialist's discretion, orders are routed to the exchange showing the best bid or offer. Once a small order is received, the BEACON, MAX, and SCOREX systems "expose" it to the specialist for fifteen seconds during which he or she may better the bid or offer price; otherwise, the order is automatically executed at the specialist's quoted bid or offer. (PACE automatically executes all small orders.) The Amex has an order-routing system called Post Execution Reporting (PER) that is very similar to the N Y S E ' s SuperDot. Amex members can send orders for as many as 2,000 shares directly to the specialist using the system and receive an execution report for the trades (U.S. Congress 1990b, 49-50). T h e regional e x c h a n g e s and A m e x have only a small slice of the trading-volume pie. Table 4 shows where they stand in relation to the N Y S E and NASD, viewed both in terms of share volume and in terms of dollar volumes. N A S D A Q . N a t i o n a l A s s o c i a t i o n of S e c u r i t i e s Dealers runs a telecommunications network called N A S D A Q , for N A S D Automated Quotations. In this over-the-counter market NASD dealers compete with one another in m a k i n g bids and o f f e r s on stocks. 9 These OTC securities tend to be smaller capitalization stocks that do not meet e x c h a n g e listing requirements; only a subset of them are also listed on organized exchanges. 1 0 To buy or sell a stock, an investor July/August 1991 Table 4 U.S. Equity Markets: 1990 Share and Dollar Volumes Share V o l u m e Dollar Volume Percent Millions 452,430 21.8 3.0 86,494 4.2 3,329 3.9 37,715 1.8 6,208 7.3 178,139 8.5 39,665 46.6 1,325,332 63.7 NYSE Totals 85,171 100.0 $2,080,110 100.0 33,380 39.2 2,589 Amex Regionals (BSE, CSE, MSE, PSE, a n d PHLX) NASDAQ N A S D A Q / O T C T r a d i n g in $ Listed Securities Source: NASDAQ (1991). calls a dealer, who checks N A S D A Q to find the best quotation from competing dealers in a particular stock at the lowest cost (that is, lowest bid-ask spread and commission). Unlike stock exchange specialists, dealers are not obligated to provide liquidity through their own position-taking. The OTC market instead relies on interdealer competition. About 13 percent of OTC transactions are handled by N A S D ' s Small Order Execution System (SOES), in operation since 1985. Public buy or sell orders of as many as 1,000 shares go through SOES to the dealer offering the best price quote. However, if there are currently better price quotes on N A S D A Q outside SOES, that dealer is required to fill the order at the better price." In 1990 SOES added the capacity to automatically execute matching limit orders entered into the system. Another N A S D A Q system is SelectNet, which allows N A S D A Q members to send buy or sell securities orders to other system members' terminals. SelectNet enables market makers to accept and execute orders partially or fully as well as to conduct price and quantity n e g o t i a t i o n s . S y s t e m users are t h e r e f o r e not anonymous. N A S D A Q securities orders must be for more than 1,000 shares. 12 N A S D A Q leads other domestic exchanges, most notably the New York Stock Exchange, in the indirect trading of foreign equities. This indirect trading is Digitized forFFRASER e d e r a l R e s e r v e B a n k of A t l a n t a through American Depository Receipts (ADRs). Foreign corporations have American commercial or investment banks buy their equity shares and place them in a trust account, against which ADR certificates are issued. These certificates are negotiable and can be traded on exchanges and through N A S D A Q . Investors find ADRs convenient because their purchase and sale and the distribution of dividend payments are entirely in dollars, not foreign currency. Foreign-currency denominated cash dividends are converted into dollars by the trustee, usually a commercial bank, and are passed on to the American Depository Receipts holders. The foreign corporation benefits by not having to comply with the SEC's disclosure requirements and other regulations enforced for domestic corporations (see Francis 1991,62, 806-7). In 1990 N A S D A Q reached new records in ADR trading with a trading volume of 2.2 billion shares of eighty-seven ADR issues. In comparison, the N Y S E had a 1.4 billion share volume for sixty-two ADR issues. N A S D A Q dollar volume was 21 billion, while the dollar volume in foreign securities directly listed on NASDAQ was 7 billion. 13 N A S D A Q is expanding in 1991 to offer an international quotation network based in the United Kingdom called NASDAQ International. Instinet. N A S D A Q dealers earn their livelihood from the difference in price between what they will pay for stock and their selling price, the bid-ask spread. Economic Review 9 That spread has come under pressure to narrow because of an electronic order-execution system called Instinet, owned by Reuters Holdings PLC. Instinet is a screen trading system in that it enables subscribers to trade a n o n y m o u s l y . T h e s e participants include not only O T C broker-dealers but also institutional investors. For example, N A S D A Q dealers can trade with other N A S D A Q dealers on Instinet to a d j u s t their inventory of stocks. T h e s e trades can be acc o m p l i s h e d w i t h i n the b i d - a s k s p r e a d q u o t e d on N A S D A Q so that N A S D A Q quotes would be unaffected. Institutional investors have also been trading a c t i v e l y on I n s t i n e t at m u c h l o w e r s p r e a d s than through N A S D A Q dealers or exchange specialists. To stay competitive, dealers h a v e had to cut their spreads. 14 stocks (Barbara Howard 1991, 16; William E. Sheeline 1990, 122). Crossing Networks. To reduce transactions costs, many institutional investors have turned to so-called crossing networks, such as Instinet's The Crossing Network and Posit (Portfolio System for Institutional Trading) of Jefferies & Company, a registered brokerdealer. Many institutional investors deal in indexed equity portfolios—for example, a portfolio mimicking the S & P 500 index. T h e s e " p a s s i v e " portfolio managers are not concerned about the precise timing of trade executions for individual stocks making up an index. For institutional investors seeking to trade in whole portfolios of stocks, crossing networks offer a low-cost alternative to transactions on organized stock exchanges. Most Instinet trades involve O T C and listed U.S. stocks, but an increasing number are in British, French, German, and other European stocks as well. The system, on-line an average of fourteen hours per day, can remain operational almost around-the-clock during periods of heavy trading. 15 The Crossing Network allows whole portfolios of stock to be bought or sold at primary markets' closing prices (for example, N Y S E closing prices) and the mean of the bid-ask O T C prices. Because the trades are based on the closing price, and hence passive, there is no "market impact" on the trades themselves—that is, large buy and sell orders are matched or crossed at that price, unaffected by the unfavorable price movement such a trade might ordinarily produce. The price does not adjust to balance supply and d e m a n d , so some orders will go unmatched in a single after-hours session. Anonymity is important to traders because a trader's identity can reveal how often and how much he or she is buying or selling, information that could move prices against the trader. For example, traders usually avoid selling large orders at once because doing so may prompt a stock's price to be bid down rapidly in the process of making the trade, on the assumption that some bad news is behind the sale. In that scenario, k n o w n as adverse selection risk, large orders will be put on the m a r k e t in smaller blocks. Instinet allows traders to poll each other almost instantaneously on a prospective trade. They can send anonymous messages over the system to particular traders to negotiate quantity or price. They can see all of the bids and offers on particular stocks at a given time on the Instinet "book." Madoff Investment Securities. This firm has set itself up in direct competition with N Y S E specialists. Madoff makes a market in 350 of the S&P 500 stocks by attracting mainly retail trades from brokers, paying them a penny per share for orders. These orders are executed at prices that match the best quoted on any exchange, as reported through ITS. Madoff operates through the Cincinnati Stock E x c h a n g e ' s National Securities Trading System, which is essentially an over-the-counter market. Because of low overhead costs, his commission costs are much lower than for trades carried out on an exchange floor. According to a recent estimate, this firm alone generates 2 percent of the daily trading volume in N Y S E listed 10 Economic Review Posit is a crossing network that operates during trading hours as well as off-hours. Portfolio trades can be executed at the primary markets' opening, at prespecified times of day after the opening, or at closing prices. This system has many options that users can select; their choices affect the cost of their trades. For example, trades not matched through Posit's computer can be canceled, held for matching at a later time, sent to the primary markets for execution, or "price-guaranteed" by Jefferies (that is, Jefferies takes the other side of the trade). These alternatives entail different commission costs. The amount of information about a prospective trade, like the size of the order or identity of the investor, may be revealed or hidden from other system users (U.S. Securities and Exchange Commission 1991, 83-86). Overseas Trading. The NYSE is also affected by the movement of institutional program trades overseas, particularly to London's over-the-counter market. A c o m m o n transaction involves a stock-index futures purchase or sale on a U.S. futures exchange with a subsequent exchange-for-physicals (EFP) transaction to unwind the futures position. 16 For example, a portfolio manager who wishes to buy an S & P 500- July/August 1991 indexed portfolio could buy the underlying stocks on the New York Stock Exchange or alternatively buy S & P 500 contracts on the Chicago Mercantile Exchange. In the latter case, the long futures position could then be offset through an EFP over the counter in London by finding a trader (or traders) short the S&P 500 futures who holds the underlying stock portfolio. The cash prices and futures price for the EFP transaction would be determined by negotiation but typically reflect the underlying stocks' closing prices on the New York Stock Exchange, Amex, and O T C markets as well as the futures on the transaction date. The parties have traded stocks outside of the N Y S E and have closed out their futures positions off the Chicago Mercantile Exchange exchange floor, saving commissions and market impact costs. 17 Similar overthe-counter program transactions also occur that do not involve index futures. About 10 to 15 million N Y S E shares currently trade after-hours in London every day (Kevin G. Salwen and Craig Torres 1991, C I ) . This exodus f r o m the exchange floor was spurred in part by a postcrash NYSE rule requiring immediate display of program trades' price and volume. SPAworks. A new system operated by R. Steven Wunsch takes after-hours trading a step further. He has designed a system, SPAworks, to trade stocks in an after-hours call market, which involves a single-price auction. This institutional arrangement was actually prevalent in the nineteenth century before the advent of continuous auction markets, and many relatively illiquid international exchanges still rely on it (see below). SPAworks has been operational since April 1991. The system works by allowing buy and sell orders to a c c u m u l a t e after the N Y S E closes at 4 : 0 0 P.M. (U.S. Securities and Exchange Commission 1991, 7377; Wunsch 1991). At a predetermined time before the next day's opening, a single computerized auction of each individual stock would be held, w h e r e b y trades would be consummated at the price resulting in the largest volume of trade. Participants entering bids above or below the auction price are able to execute their trades at the auction price. Other orders go unmatched. This system saves the cost of paying for the immediate liquidity provided on the exchange floor. O f f - H o u r s Trading. In response to the inroads these outside trading systems have made, the N Y S E announced in May 1991 that it would institute two afterhours sessions. "Crossing Session I" runs from 4:15 until 5:00 P.M. and allows investors to buy and sell at the 4:00 P.M. closing price. Once submitted by NYSE members through SuperDot, single-sided orders are Digitized for Federal FRASERR e s e r v e Bank of Atlanta matched against others based on the times they were submitted. Matched single-sided orders and paired (prearranged) orders are then executed through SuperDot at 5:00 P.M. "Crossing Session II," which operates f r o m 4:00 to 5:15 P.M., specifically accommodates program traders. After the close New York Stock Exchange m e m b e r firms place paired orders for programs that contain at least fifteen NYSE-listed stocks having a one-million-dollar market value or more. These coupled orders are executed as soon as they are received by the system. To make the new sessions attractive to program traders, the N Y S E has granted a Physical marketplaces (the trading floors) are becoming obsolete, marketplaces—networks computer terminals—are "site" for while "virtual" of computers and emerging as the transactions. nine-month exemption from being required to report price and volume information for individual program trades. Only the aggregate volume and dollar value of program trades are disseminated at 5:15 P.M. Singlesided and coupled order v o l u m e are each reported separately for Crossing Session I, beginning at 5:00 P.M. (Salwen and Torres 1991, C I ; U.S. Securities and Exchange Commission 1991, 36-39; New York Stock Exchange 1991b, 1-5). F o r e i g n E q u i t y M a r k e t s . M a n y f o r e i g n stock markets are considerably less liquid than U.S. stock markets, and their institutional arrangements reflect this fact. The Austrian and Norwegian stock markets simply hold a single daily call auction. Others use a mixed system of call auctions at some times of day and continuous trading at other times. Mixed auctions are prevalent in B e l g i u m , D e n m a r k , France, Italy, Spain, Sweden, and Switzerland. 1 8 T h e Australian, British, Canadian, French, and Japanese markets have automated trading systems. Four of the major automated exchanges are relatively well developed. T h e Toronto Stock Exchange uses the Computer Assisted Trading System (CATS), which functions as Economic Review 11 an electronic auction for less actively traded stocks and is being updated to handle more active stocks. Broker-dealers using the system can choose to have their trades executed by either a specialist or computer. CATS currently handles about 75 percent of trades on the exchange, a small volume compared with that of m a j o r A m e r i c a n e x c h a n g e s (Hansell 1989, 93; U.S. Congress 1990b, 63; Howard 1991, 15). CATS also displays the best five buy and sell limit orders along with the name of the broker making the order (Hansell 1989, 93; Howard 1991, 15). The Paris Bourse (stock exchange) relies on a licensed version of CATS, which is also under consideration for use at exchanges in Madrid, Brussels, and Sao Paulo (Hansell 1989, 93, 98; Ian Domowitz 1990, 170). The system used by the French exchange is named CAC, for Cotation Assistée Continu. This exchange, overshadowed by the London market, is much less liquid. In fact, exchange member firms hold a single daily auction in stocks c o m p l e m e n t e d by f o r w a r d trading in listed stocks using both continuous trading and call auctions in forward contracts (Richard Roll 1988,29). T h e London International Stock E x c h a n g e is a dealer market very similar in operation to N A S D A Q . The ISE is the most active world market in foreign (non-United Kingdom) stock trading, which makes up slightly more than half of the e x c h a n g e ' s volume. T h e average daily foreign issue volume was 1.3 billion p o u n d s sterling per day in 1990. I S E members have benefited from the migration of some U.S. program trading. The ISE's analog to the N A S D A Q quote-display system is the Stock Exchange Automated Quotation System (SEAQ); small orders of fewer than 5 , 0 0 0 shares are automatically executed on the Stock A u t o m a t e d E x c h a n g e Facility (SAEF). T h e Tokyo Stock Exchange (TSE) has a system similar to Toronto's CATS. Its Computer Assisted Order Routing and Execution System ( C O R E S ) now handles all but 150 of the exchange's most actively traded issues; however, the T S E is moving toward a fully automated system. Instead of specialists, the exchange has a group of overseers, called sait or i, who use computer screens to monitor the trades arranged by the computer and by floor traders and to approve the prices. The saitori can also allow CORES to generate trades automatically within a specified price range. In addition, they act as human circuit breakers on the e x c h a n g e f l o o r when trading b e c o m e s too volatile; they have the authority to suspend trading briefly (Hansell 1989,97). 12 Economic Review Futures and Options Markets Like prices of exchange-traded stocks, futures prices are established through an auction system, but one with no c o u n t e r p a r t to the single i n d i v i d u a l , the specialist, making a market in a stock. Instead, futures prices are determined by an auction known as the open-outcry system. Exchange m e m b e r s — f l o o r traders—congregate at designated trading pits and shout bids and offers at each other or use hand signals to indicate trading intentions. E x c h a n g e o f f i c i a l s record the price and amount of each transaction. Effective in providing liquidity, this system is also subject to error and even abuse. 19 As discussed above, international competition is forcing efficiency-enhancing automation. Many new overseas exchanges are fully or partially automated and trade many of the same contracts as American exchanges, although their volume levels are usually much lower. Systems emerging on futures and options m a r k e t s harbinger the internationalization soon to c o m e . In p a r t i c u l a r , the C h i c a g o M e r c a n t i l e E x change's Globex (Global Exchange) system is being designed to handle volumes that exceed current openoutcry volume levels at peak trading times. Globex. Globex, expected to be operable in early 1992, will automate and link participating exchanges. To date, the Chicago Board of Trade and Marché à T e r m e des I n s t r u m e n t s F i n a n c i e r s ( M A T I F ) , the F r e n c h f i n a n c i a l f u t u r e s m a r k e t , are m e m b e r s of Globex. Other exchanges in the Far East are considering joining Globex, including Australia's Sydney Futures Exchange (SFE) and possibly J a p a n ' s Osaka Securities Exchange, or OSE (Ginger Szala and Amy R o s e n b a u m 1990, 44). G l o b e x will operate afterh o u r s , b e g i n n i n g at 6 P.M. C h i c a g o t i m e , w h e n Japanese markets open. The genesis of Globex lay in efforts to extend the futures trading day. In 1984 the C M E established a relationship with the newly founded Singapore International Monetary Exchange ( S I M E X ) , a relationship based mainly on mutual advantages gained from trading compatible Eurodollar and foreign currency futures contracts. The two exchanges set up a mutual offset permitting contracts opened on one exchange to be closed on the other and vice versa. This link e f f e c t i v e l y l e n g t h e n e d the t r a d i n g day a l m o s t to twenty-four hours, helping the Chicago exchange to secure a foothold in booming East Asian financial markets. S I M E X enjoyed the benefits of the additional liquidity generated by the infusion of Chicago- July/August 1991 based trades. Also catering to growing interest from abroad, the Merc's Chicago rival, the Chicago Board of Trade, instituted nighttime trading of its Treasury bond futures contracts in April 1987. However, this insomniac trading, as one observer termed it, and the C M E ' s mutual offset arrangement were regarded as stopgap measures ("Futures M a r k e t s " 1988). More efficient and less error-prone electronic trading seems inevitable; the Chicago Board of Trade joined with the Chicago Mercantile Exchange as a Globex partner in 1990. Up to that point the C B O T had been developing its own after-hours system, called Aurora, that would electronically emulate open-outcry trading. (See the discussion below of LIFFE's Automated Pit Trading for a similar system). The mechanical heart of Globex is a network of computer screens. The system is a joint venture of the "partner exchanges" (CME, CBOT, and MAT1F) and Reuters Holdings PLC, which already has a large presence in over-the-counter spot foreign exchange markets. The Reuters network of computer terminals in banks and brokerage firms numbers about 180,000 worldwide. T h e C M E e m p h a s i z e s that trading via Globex is an alternate method of placing an order on its exchange or on partner exchanges (Brodsky 1990, 621). Because the exchanges do not view Globex as a new kind of futures exchange, they argue that regulatory approval of the system (particularly in Japan) should be straightforward. Globex automatically matches and executes orders entered into the system. The system first checks the credit standing of the member finn initiating a transaction and then matches orders based on the time an order was submitted and its price. Unlike standard open-outcry trading, Globex does not allow for orders to be executed at the prevailing market price (that is, there can be no market orders); all orders must be good-until-canceled limit orders (the order stays on the book until it is executed or canceled). 20 T r a d e s are c o n f i r m e d at p a r t i c i p a n t s ' s c r e e n s , prices and quantities are reported through the system, trades are cleared, and buyers' and sellers' accounts are adjusted. Traders on Globex deal anonymously with one another, an important consideration for most participants, as mentioned earlier. H o w e v e r , G l o b e x , like other a u t o m a t e d systems, does p r o d u c e a socalled electronic audit trail, which is regarded as an improvement over the open-outcry system's less accurate recording procedures. Electronic monitoring is expected to give traders more confidence in the trading p r o c e s s and m a k e s the r e g u l a t o r ' s j o b easier. Federal Reserve Bank of Atlanta Although trading has not yet begun on Globex, its relative performance compared with the open-outcry auction has been assessed by Domowitz (1991). Using s i m u l a t e d t r a d i n g e x p e r i m e n t s , he f i n d s that Globex is the more efficient trading mechanism according to a number of measures. Globex tends to result in lower price volatility and greater market liquidity, and the differences become more pronounced as the size of the market increases. In contrast, Merton H. Miller (1990) argues that screen trading systems, especially of the order-matching type like Globex, put traders (market makers) at a disadvantage because they cannot observe the order flow on a screen as they can from the trading pit. Traders with more current information can take advantage of previously posted traders' price quotes. For this reason Miller does not believe that electronic systems will ever attract sufficient competing market-maker participation to match the liquidity of the most active trading pits. To date, most screen trading systems have been used at low-volume exchanges or for low-volume contracts. Validation of Miller's or Domowitz's predictions will have to await actual trading t h r o u g h G l o b e x as w e l l as m o r e e x t e n s i v e deployment of other screen trading systems. Domestic Options Markets. A number of automated trading systems have been introduced to facilitate options trading. The most significant of these is the Chicago Board Options Exchange's Retail Automatic Execution System (RAES), which has been in operation since 1985. The system now handles both index options, including the heavily traded S & P 100 index option, and all C B O E equity options (on individual stocks). About 3.5 percent of contract volume is currently executed through RAES (U.S. Securities and Exchange Commission 1991, 19). The Amex uses a system called AUTO-EX for market and limit orders of as many as twenty equity contracts. The system is designed for use of Amex member firms and e x c h a n g e specialists. In addition, the A m e x has a m u t u a l - o f f s e t link with the E u r o p e a n Options Exchange in A m s t e r d a m for the stock index options contract on the Amex's Major Market Index, or MM I (U.S. Congress 1990b, 96). The Pacific Stock Exchange has a similar system for equity options called POETS (Pacific Options Exchange Trading System). The Philadelphia Stock Exchange uses A U T O M (Automated Options Market System) for equity options. The N Y S E ' s SuperDot also routes orders for trades on its equity and equity-index options. Delta Government Securities, a screen-based system for trading options on U.S. Treasury bills, notes, Economic Review 13 and bonds, is operated jointly by RMJ Securities and RMJ Options, which are a registered clearing agency and registered broker-dealer, respectively. Delta always stands as the intermediary between buyer and seller using the system. It effectively operates like an electronic options exchange, issuing any options traded through the system (U.S. Securities and Exchange Commission 1991,89). Foreign Derivatives Markets. There is stiff competition among European futures exchanges. Marché à Terme des Instruments Financiers vies with the L o n d o n International Financial Futures E x c h a n g e p r i m a r i l y o v e r the t h r e e - m o n t h E u r o - d e u t s c h e mark futures (a futures on the three-month rate on interbank deutsche mark-denominated deposits). MATIF, E u r o p e ' s most active futures exchange, joined Globex in November 1989 and plans to list its g o v e r n m e n t b o n d f u t u r e (the N o t i o n n e l ) a n d its short-term interest-rate future (on PIBOR—Paris Interbank Offered Rate) on the system. Part of the motivation behind MATIF's Globex membership was to b o o s t f o r e i g n p a r t i c i p a t i o n on the e x c h a n g e and lessen London's advantage of having the offices of almost 600 international banks and brokerage firms (Janet Lewis 1990, 130). dealers but by traders who post bids and offers for specified quantities. By the touch of a computer key, any trader can instantaneously accept bids and offers that appear on the screen. This system is the analog of the open-outcry method, in which bids and offers of floor traders are valid for "as long as the breath is warm." Because the futures exchanges deal in a limited set of futures contracts, liquidity is concentrated and rapid interactions between traders can be emulated on a screen. LIFFE expanded the system in 1990 to include a central limit-order book that enables purchases and sales of futures contracts if the market price reaches the posted limit price. In Japan financial futures were banned until 1985. Regulators and legislators have gradually been deregulating and expanding their financial and derivative markets, and the Japanese have become very active in developing futures exchanges. Japanese firms are eager to use the new contracts. They may now deal directly in securities on foreign exchanges, and foreign brokerage firms may be members of Japanese futures exchanges (see Szala and Rosenbaum 1990, 42). The fact that LIFFE also offers a futures contract on the l o n g - t e r m G e r m a n g o v e r n m e n t b o n d , the Bund, in part spurred the creation of the first German futures market, the Deutsche Terminbörse (DTB) in 1990. A consortium of fifty-three institutions, mostly large banks, belong to the DTB. The e x c h a n g e offers f u t u r e s contracts to compete with L I F F E ' s as well as stock options on German firms (Lewis 1990, 130). The first Japanese contracts were ten- and twentyyear yen bond futures, introduced on the Tokyo Stock Exchange in 1985. As of December 1989 the TSE offered U.S. Treasury bond futures equivalent to those of the C B O T . T h e J a p a n e s e Ministry of F i n a n c e , however, requires higher margins to be posted against Tokyo Stock Exchange futures contracts than does the Chicago Board of Trade for comparable positions. T h e higher margin levels apply even for Japanese firms taking positions in C B O T contracts, so these firms have little incentive to look abroad (Szala and Rosenbaum 1990,42). T h e Frankfurt-based exchange is organized as a c o m p u t e r n e t w o r k that m a t c h e s and p r o c e s s e s all trades electronically. The automated trading system employed is based on a similar system used by the Swiss Options and Financial Futures Exchange (SOFFEX), also an entirely automated order-matching system that allows member firms to be market makers, quoting bids and offers. Trades are entered anonymously, so large trades can be anonymously negotiated over the system (Hansell 1989, 93). Five fully automated futures and options exchanges now operate worldwide, as seen in Table 5. The TSE bond contracts, now the sixth most heavily traded future in the world (see Table 3), can all be traded through CORES. The TSE stock-index future on TOPIX (Tokyo Stock Price Index) is fully automated on C O R E S . F u l l y a u t o m a t e d t r a d i n g of a t h r e e m o n t h E u r o y e n contract is conducted on the new Tokyo International Financial Futures Exchange (TIFFE), which competes against S I M E X in Singapore. SIMEX is still dominant in a number of contracts, including yen-U.S. dollar futures and E u r o d o l l a r f u tures, but it lags in Euroyen. Unlike TIFFE, SIMEX is a traditional open-outcry exchange. L I F F E has a partially automated system, called Automated Pit Trading (APT), that mimics actual pittrading (London International Financial Futures Exchange 1991). The after-hours system operates from 4:30 to 6:00 P.M. local time, with access restricted to LIFFE members. APT is not driven by quote-making The Nikkei 225 futures, the highest-volume Japanese index futures contract, trades at the Osaka Securities E x c h a n g e ( O S E ) . T h e C M E has acquired the rights to offer a Nikkei 225 contract on its exchange, though it would prefer to link up with the OSE through Globex (Szala and Rosenbaum 1990, 14 Economic Review July/August 1991 Table 5 Automated Trading Systems System System Operator Equities American Stock Exchange Post Execution Reporting Amsterdam Stock Exchange System based on MSE's MAX Australian Association of Stock Exchanges Stock Exchange Automated Trading (SEAT) Boston Stock Exchange BSE Automated Communication and Order Routing Network (BEACON) Cincinnati Stock Exchange National Securities Trading System (NSTS) Insti net Corporation Instinet The Crossing Network Jefferies & Company, Inc. Portfolio System for Institutional Trading (Posit) London International Stock Exchange Stock Automated Exchange Facility (SAEF) Midwest Stock Exchange Midwest Automated Execution (MAX) National Association of Securities Dealers Small Order Execution Service (SOES) Select Net Private Offerings, Resales, and Trading through Automated Linkages (PORTAL) N e w York Stock Exchange Designated Order Turnaround system (SuperDot) Crossing Sessions I and II Pacific Stock Exchange Securities Communication Order Routing and Execution System (SCOREX) Paris Bourse Cotation Assistée en Continu (CAC) Philadelphia Stock Exchange Philadelphia Automated Communication and Execution System (PACE) Tokyo Stock Exchange Computer Assisted Order Routing and Execution System (CORES) Toronto Stock Exchange Computer Assisted Trading System (CATS) Wunsch Auction Systems, Inc. SPAworks Futures and Options American Stock Exchange (equity options) AUTO-EX Chicago Board Options Exchange Retail Automated Exchange System (RAES) Chicago Board of Trade Globex Chicago Mercantile Exchange Deutsche Terminbörse Globex Fully automated, integrated clearing Irish Futures and Options Exchange Fully automated, ATS-2 London International Financial Futures Exchange Automated Pit Trading (APT) Digitized forFederal FRASER Reserve Bank of Atlanta (table continues) Economic Review 15 Table 5 (continued) System System Operator Futures and Options London Traded Options Market Associated w i t h LIFFE Marché à Terme des Instruments Financiers GI obex New York Stock Exchange SuperDot N e w Zealand Futures and Options Exchange Fully automated ATS system Pacific Stock Exchange Pacific Options Exchange Trading System (POETS) Philadelphia Stock Exchange Automated Options Market System ( A U T O M ) Stockholm O p t i o n Market Integrated clearing facilities based on electronic trading and telephone brokering Sydney Futures Exchange Sydney Computerized Overnight Market (SYCOM) Swiss Options and Financial Futures Exchange Fully automated; integrated clearing Tokyo Stock Exchange Derivative markets fully automated CORES-F Sources: U.S. Securities and Exchange Commission (1991 ); Angrist (1991); U.S. Congress (1990b); Kang and Lawton (1990); Rosenbaum (1990); Hansell (1989). 44). The C M E ' s first overtures to the Ministry of Finance, one of the chief regulators of Japanese exc h a n g e s , w e r e m a d e in A u g u s t 1988 and are still ongoing. The C B O T now lists a Japanese stock-index futures on the TOPTX and several Japanese government bond futures and options. Market Performance and Regulatory Issues R e g u l a t i o n of securities m a r k e t s in the United States is generally intended to ensure that securities trading is conducted openly and based on publicly available information. The Securities Act of 1933 and Securities Exchange Act of 1934 mandated extensive registration and disclosure requirements for firms issuing securities to the public. However, recent policy discussions have shifted regulators' sights to safe- 16 Economic Review guarding the performance and stability of financial markets. The Brady Commission's recommendations in the wake of the 1987 crash stand out as the most sweeping proposals for changing the ways financial markets operate and for reorganizing their regulators' responsibilities. 21 To the Brady Commission and to a large number of market observers, the crash was prima facie evidence that private financial markets can fail— spectacularly. Concerns about the flow of information and the ability of participants to act on it superseded traditional questions about fairness and honesty in the marketplace. 2 2 The crash underscored the potential systemic risk of market failure as trading disruptions spread from one market to another. The problems can engulf the banking system as credit demands mount, for example, because of timing differences between the receipt and disbursement of f u n d s by clearinghouses, straining liquidity and threatening widespread defaults. 23 July/August 1991 An important policy challenge is determining the appropriate mix of government and private-market actions to lessen the risk of securities market failure. It is feared that the electronic globalization of financial e x c h a n g e s might contribute to systemic risks. The 1987 crash broadened the concerns, touching off a debate about whether a crash in one country's markets can trigger shocks beyond domestic boundaries to other countries' markets. The desirability and feasibility of international regulatory cooperation to contain such potential problems is an open question just beginning to be addressed (see Grundfest 1990; Paul Guy 1990; and U.S. Congress 1990a). A survey of international regulatory issues is beyond the scope of this article. Rather, the following discussion focuses on the interconnections between markets and proposals to manage the international transmission of volatility. The basic issue to be considered has to do with the source of volatility and arguments for and against counteracting it. Since the stock market crash of October 1987, and even earlier in the decade, regulators and other market observers have become concerned about market volatility and cross-market spillovers. The increasing prevalence of cross-border trading as well as the opening of new exchanges and deepening of existing ones would seem to imply that world financial markets are b e c o m i n g unified. However, the evidence of such merging is not clear-cut. In fact, the Brady Commission concluded that through 1987 correlations of price movements from different world markets provide no evidence of closer links: "The correlations between the market in the U.S. and the markets in Germany and Japan appear to form totally random series. . . . [T]here is no evidence to suggest that the association is any closer today than it was a decade ago" (Nicolas F. Brady et al. 1988, II-6). Roll (1988) has observed that the only month in the 1980s in which all major world markets moved together was October 1987. A number of recent academic papers address the question of world financial market integration. Using a sophisticated model of global equity market equilibrium (an international capital asset pricing model with time-varying moments), Campbell R. Harvey (1991) found evidence of a lack of integration, particularly for Japanese markets with the rest of the world. The basic object of study is the reward-to-risk ratio on equities required by investors. In a world of integrated markets, the reward-to-risk ratio would be the same in every equity market. In fact, this ratio turned out to be twice as large in Japanese markets as in U.S. markets. Digitized forFederal FRASER Reserve Bank of Atlanta In other words, Japanese investors require expected returns on stocks to be double the magnitude expected by U.S. investors. C o m p l e t e integration across markets would equalize differences in the rewardto-risk ratio across countries because otherwise, for example, U.S. investors would skew their portfolios toward Japanese equities offering better trade-offs b e t w e e n r e t u r n and risk than d o m e s t i c e q u i t i e s . Increased U.S. purchases of Japanese stocks would bid up their prices and bid down U.S. stock prices, driving J a p a n e s e expected returns d o w n and U.S. expected returns up. There are many subtleties and qualifications in this analysis, but the preponderance of e v i d e n c e is against the simple h y p o t h e s i s that world markets have become integrated. The empirical work of David Neumark, P.A. Tinsley, and Suzanne Tosini reveals that price movements for U.S. stocks listed on New York, Tokyo, and London e x c h a n g e s are m o r e highly correlated during periods of high volatility than during times of low volatility because "only larger price changes pierce the transaction cost barriers between markets" (1991, 160). These authors noted that ordinarily the stock price volatility for this group of U.S. stocks (which are contained in the Dow Jones Industrial Average) is three times greater during N e w York trading hours than during London or Tokyo trading hours. In their view, this p h e n o m e n o n occurs because the largest share of news relevant to the determination of the stock prices is disseminated during New York trading hours. This pattern was disrupted in the aftermath of the October 1987 crash when, in the authors' judgm e n t , n e w s was m o r e globally dispersed and had mostly to do with "the volatile behavior of other investors" (176). Yasushi H a m a o , Ronald W. Masulis, and Victor Ng (1990) conducted another detailed study of intermarket linkages focusing on what they term price "volatility spillovers" among the New York, London, and Tokyo stock markets. For a subperiod that excludes the 1987 crash, they found that, while there was no significant transmission of volatility from Tokyo to either L o n d o n or N e w York, the latter two cities' volatility did spill over to trading in Tokyo. When the post-1987 period is included, evidence indicates that all three markets were shocked by "volatility surprises," although Tokyo markets still did not affect New York's. Mervyn A. King and Sushil Wadhwani (1990) have e x a m i n e d the m a r k e t events s u r r o u n d i n g O c t o b e r 1987 and offer a hypothesis about the worldwide scope of the market crash. To investigate the conundrum of Economic Review 17 what change in market fundamentals could explain a 23 percent drop in the Dow and similar gigantic declines in other markets around the globe, the authors developed a model in which rational traders in one m a r k e t h a v e less i n f o r m a t i o n a b o u t s t o c k s than traders in the home market and must infer information partly from stock price movements abroad. This situation leads to the possibility of price movement "contagion" f r o m one market to another, which will be particularly severe during periods of high m a r k e t volatility. A sharp decline in a foreign price index is a (noisy) signal of bad news, some of which home market traders may not know from other sources. While the authors' hypothesis does not shed light on the "news" that triggered the October 1987 crash, it does explain why the crash was so u n i f o r m around the world despite important differences in markets and economic circumstances. Gerard Gennotte and Hayne Leland (1990) have also developed a model in which rational traders' lack of information can precipitate a crash. Their concern is with informationless trading associated with hedging strategies like portfolio insurance. Formal portfolio i n s u r a n c e t e c h n i q u e s s y s t e m a t i c a l l y i n c r e a s e exposure to the market as stock prices rise and reduce it as stock prices fall (by shifting a portfolio's mix between index stocks and bonds or by adjusting the size of a short index futures hedge against a stock index portfolio). Although portfolio insurance-related selling is strictly passive, responding to declining stock prices, it could be mistaken for selling based on adverse information, and other traders look to prices and price changes as a way to glean information that they may lack. If nonpassive traders knew that they were taking the buy side of an informationless trade, they would m o r e likely be willing to do so and would thereby supply liquidity to the market. Gennotte and Leland's model shows how unobserved hedging programs, though only a small proportion of total trading, can destabilize a market. The disturbance may then propagate to other world markets. Their recommendation is that informationless trades should be preannounced and that "[electronic 'open books' should be a seriously considered reform [to show the buy and sell order flow], and other forms of market organization (such as single-price auctions) should be examined" (1990, 1016). Some recent institutional developments are consistent with the authors' r e c o m m e n d a t i o n s . T o r o n t o ' s C o m p u t e r Assisted Trading System displays limit orders to system users, and Wunsch's after-hours single-price auctions help concentrate market liquidity. Economic Review 18 The King and Wadhwani and Gennotte and Leland models explain how trading itself can generate intermarket volatility. Joseph E. Stiglitz (1989) and Lawrence H. Summers and Victoria P. Summers (1989), go further by asserting that financial markets are excessively volatile because of irrational traders' speculative activity. Decreasing transactions costs owing to technological innovation and derivative markets promotes this speculation. These authors recommend a transactions tax to "throw sand into the gears" of financial markets (Tobin 1984, cited in Summers and Summers 1989, 263). Each securities purchase or sale would be subject to a "small" tax—for example, 0.5 percent of the stock price. In fact, many governments around the world impose stock transaction taxes, although the trend abroad is toward eliminating such taxes (see Roll 1989, table 4). The gradual unification of world financial markets and continuing improvement in information flows will probably reduce the information asymmetry that produces contagion effects. However, in the view of those advocating transactions taxes these developments would just exacerbate irrational trading. At the core of their argument is the belief that financial markets are inefficient—that is, asset prices do not reflect "fundamentals." A growing list of so-called market anomalies seems to contradict efficient-markets theory. The apparent excess volatility analyzed by Robert J. Shiller (1989) stands as a challenge to efficientmarkets proponents. Nevertheless, the theory is only being challenged, not overturned. Transactions taxes and other remedies for supposed excess trading and excess volatility have been proposed and sometimes implemented with little regard for their efficacy or possible adverse consequences. Trading halts or circuit breakers, margin requirements, and price limits are also suggested as means of controlling trading. Of all these devices, margin requirements have been the most extensively studied and debated. In essence this work concludes that adjustments to margin requirements have no significant impact on stock market volatility (see David A. Hsieh and Miller 1990). Using data from twenty-three stock markets, Roll (1989) undertook a cross-market study of the effects of transactions taxes, margin requirements, and price limits on market volatility and found that none effectively reduce volatility. Circuit breakers shut down an entire market temporarily to give participants a "time-out," mainly to avoid a panic selling spree. Both the New York Stock Exchange and Chicago Mercantile Exchange have instituted such circuit breakers (see Franklin R. Ed- July/August 1991 wards 1988, 1989), although evidence is lacking concerning their u s e f u l n e s s . As Gennotte and Leland ( 1 9 9 0 ) point out, the w e e k e n d of O c t o b e r 17-18, 1987, was an extended trading halt for the market declines of the previous week, but participants were not inclined to stage a m a r k e t reversal the f o l l o w i n g Monday. It is not at all obvious that circuit breakers stabilize prices. To the contrary, they could induce traders to sell earlier and in larger quantities, fearing that a trading-halt price limit will soon be reached. This movement could destabilize prices. Sanford J. Grossman (1990) has argued persuasively that market equilibrium would be restored more quickly without halting trading. Rather than attempting to suppress m i s p r i c i n g s , G r o s s m a n c o n c l u d e s that the market would be better served by being informed of them, whether they arise from panic or any other source, because better-informed traders would recognize such occurrences as profit opportunities and thus reverse the price movements. Conclusion The globalization of financial markets simultaneously fragments traditional financial transactions marketplaces and integrates them via electronic means. Physical marketplaces (the trading floors) are becoming obsolete, while "virtual" marketplaces—networks of computers and computer terminals—are emerging as the "site" for transactions. The new technology is diminishing the role for human participants in the market m e c h a n i s m . Stock-exchange specialists are being displaced by the new systems, which by and large are designed to handle the demands of institutional investors, who increasingly dominate transactions. F u t u r e s and options f l o o r t r a d e r s also f a c e having their j o b s coded into c o m p u t e r algorithms, which automatically match orders and clear trades or emulate open-outcry trading itself. Federal Reserve Bank of Atlanta International capital flows and the trading volume associated with them have been expanding over time. The internationalization of financial markets implies that investment portfolios are becoming more homogenized and creates a demand for worldwide twenty-fourhour trading. Derivative markets also benefit from this trend as multinational corporations need financial services around the clock for hedging and other reasons. The competitive forces propelling changes in financial markets also compel changes in regulatory oversight of these markets. 2 4 Technology helps minimize some problems—for example, by making it possible to establish accurate audit trails of trades and thereby discouraging certain kinds of trading abuse s — w h i l e it creates others, such as business being drawn to markets with the most lenient regulatory standards. Nevertheless, financial marketplaces are perhaps closest to the textbook paradigm of voluntary exchanges for mutual benefit of transacting parties. Competition among the world's financial exchanges as well as among their regulators is likely to be the most efficient way to elicit the best mechanisms for conducting and regulating transactions. More problematic is the nature of trading and volatility associated with it. Does trading itself generate volatility that interferes with consumption, investment, and other economic decisions, in turn lowering social welfare? This article has given an overview of new automated trading systems and c o m m u n i c a t i o n s networks that are integrating markets. The technology discussed improves market mechanisms and information flows, but it may have the negative side effect of promoting "excess" trading. If markets are efficient, volatility per se is generally regarded as a neutral characteristic of markets. Derivative markets will continue developing to allow any desired degree of hedging against volatility. Only if markets are inefficient can a case can be made for curtailing volatility, but the evidence is ambiguous regarding market inefficiency. Even less clear is the efficacy of measures proposed to safeguard markets against volatility. Economic Review 19 Notes l . S e e Summers and Summers (1989) and the discussion of their proposal below. 2. Frequent trading will be necessary when the number of securities available to "complete markets" is smaller than the number of future "states." See Huang and Litzenberger (1988, chapter 7). This situation will be all the more likely if financial markets are incomplete. However, theory does not give an indication of how much trading is appropriate to allocate wealth over time efficiently. 16. See Kolb (1991, 17-18) for a general discussion of EFP transactions and Miller (1990) for EFPs in connection with the C M E ' s S&P 500 stock-index futures contract. 17. The futures exchange, however, would collect an additional fee for allowing the off-exchange or ex-pit EFP. The Commodity Exchange Act prohibits noncompetitive and prearranged transactions in futures, with the exception of EFPs. See B e h o f ( 1 9 9 0 , 2). 18. See Roll (1988, 29). Roll notes that the Spanish market trades groups of stocks continuously for ten minutes at a time. This article contains much interesting information about foreign stock markets. 19. See Kolb (1991, 59-61) for a succinct account of the FBI undercover sting operation at the C M E and CBOT, which began in early 1987 and resulted in indictments against forty-seven traders in January 1989. 3. The difference between purchases and sales represents the net capital flow, which is less relevant in considering the growth of securities trading and market liquidity. 4 . 3 2 1 % = [(75.28/17.85) - 1] * 100 and 43% = [(361.37/ 253.38) - 1] * 100. 5. See Smith (1991). Ginnie Mae stands for Government National Mortgage Association, a government-chartered agency that makes a secondary market in home mortgages and enhances the liquidity of that market by securitizing individual mortgages into "pass-through" certificates. The futures was on this underlying security. 20. Information on Globex came from 1991 C M E promotional literature. Domowitz (1990) provides a detailed description and analysis of the Globex trading algorithm as well as those for two other trading systems. 6. The N Y S E is in the process of instituting "A Look at the Book" program that permits public subscribers to the service to view the limit orders for 50 of the 2,370 NYSE-listed stocks. This service will be available through vendors and will show the limit-order book at three fixed times during the trading day. Currently, only the specialists and other N Y S E members, such as floor brokers, on the exchange floor have access to the specialists' books. 21. The Brady C o m m i s s i o n ' s basic recommendations were: (1) to have one agency be the overarching regulator of U.S. financial markets; (2) to have a unification of clearing systems of financial exchanges and OTC markets; (3) to have "consistent" margin requirements across different exchanges; (4) to institute coordinated "circuit breakers" across exchanges; and (5) to improve information systems to monitor trading activity in related markets. 7. Market orders specify quantity for trade at the current price. Limit orders specify price and quantity. 8. The meanings of the acronyms are given in Table 5. 9. The bid price is the price for which a dealer is willing to buy a stock, and the offer is the price for which he or she is willing to sell the stock. 10. See Bodie, Kane, and Marcus (1989) or Francis (1991) for further institutional details about organized exchanges and O T C markets and such details as listing requirements. 11. This account of SOES is based on Domowitz (1990). 12. See U.S. Securities and Exchange Commission (1991, 69); another N A S D A Q system described in this source is PORT A L (Private Offerings, Resales, and Trading through Automated Linkages), which is used in the secondary market for privately placed equity and debt. See note 24 below for further description. 22. The Securities and Exchange Act of 1934 authorized the Federal Reserve Board to established initial and maintenance margins to prevent excessive leveraging of securities purchases on securities exchanges. (In practice, the Board has set only minimum initial margin levels.) Part of the rationale for control over margins was to limit massive selling off of leveraged positions during market d o w n turns. 13. See N A S D A Q (1991, 14-15). Because of differences in accounting conventions, the N A S D A Q figures are inflated compared with the N Y S E figures. 14. See Hansell (1989, 102). The amount of institutional participation in N A S D A Q stocks as measured by the volume of block trading has been about 43 percent in recent years. See N A S D A Q (1991). 15. Instinet-sponsored section in Institutional 1991). Economic Review 20 Investor (January 23. See Brady et al. (1988, especially 51-52). Despite the potential dangers, no defaults occurred in the clearinghouse system during October 1987. 24. The S E C ' s April 1990 approval of Rule 144A is an instance of a c h a n g e in regulatory standards that reflect changes in the nature of financial transactions. This rule simplifies the S E C ' s disclosure requirements for private placement issuers (see Chu 1991). Foreign corporations are now able to raise capital in U.S. markets without having to meet the S E C ' s stringent financial disclosure req u i r e m e n t s as long as transactions are limited to large institutional investors. British financial authorities have instituted a similar relaxation of regulations for institutional investors (see Grundfest 1990). N A S D A Q ' s new P O R T A L system is used for communicating bids and offers on privately placed securities traded under the provisions of Rule 144A. July/August 1991 References Angrist, Stanley W . "Futures Trade on Screens—Except in U.S." Wall Street Journal, May 21, 1991, C I , C14. Behof, John P. " G l o b e x : A Global Automated Transaction System for Futures and Options." Study by the Federal Reserve Bank of Chicago, June 1990. Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments. Homewood, 111.: Irwin, 1989. Brady, Nicholas F., James C. Cotting, Robert G. Kirby, John R. Opel, and Howard M. Stein. Report of the Presidential Task Force on Market Mechanisms. Submitted to the President of the United States, the Secretary of the Treasury, and the Chairman of the Federal Reserve Board, January 1988. Brodsky, William J. " F u t u r e s in the Nineties: C o n f r o n t i n g Globalization." In Proceedings from a Conference on Bank Structure and Competition, 615-23. Federal Reserve Bank of Chicago, 1990. . "The Future Is N o w . " Institutional Investor 25 (Jan- uary 1991): 7. Chicago Board of Trade. Commodity Trading Manual. CBOT, 1985. Chu, Franklin J. "The U.S. Private Market for Foreign Securities." The Bankers Magazine 174 (January/February 1991): 55-60. Domowitz, Ian. "The Mechanics of Automated Trade' Execution S y s t e m s . " Journal of Financial Intermediation 1 (1990): 167-94. . "Equally Open and Competitive: Regulatory Approval of Automated Trade Execution in the Futures Markets." Center for the Study of Futures Markets Working Paper #214, forthcoming 1991. E d w a r d s , Franklin R. " S t u d i e s of the 1987 Stock M a r k e t Crash: Review and Appraisal." Journal of Financial Services Research 1 (1988): 231-51. . "Regulatory Reform of Securities and Futures Markets: T w o Years after the Crash." Center for the Study of Futures Markets Working Paper #189, June 1989. Francis, Jack Clark. Investments: Analysis and Management. 5th ed. New York: McGraw-Hill, Inc., 1991. "Futures Markets Will Let Their Fingers Do the Dealing." The Economist, March 19, 1988,77-78. G e n n o l t e , G e r a r d , and H a y n e L e l a n d . " M a r k e t L i q u i d i t y , Hedging, and C r a s h e s . " American Economic Review 80 (1990): 999-1021. Grossman, Sanford J. "Institutional Investing and New Trading Technologies." In Market Volatility and Investor Confidence: Report to the Board of Directors of the New York Stock Exchange, Inc., G2-1-17. June 7, 1990. Grundfest, Joseph A. "Internationalization of the World's Securities Markets: Economic Causes and Regulatory Consequences." Journal of Financial Services Research 4 (1990): 349-78. Guy, Paul. " I O S C O Moves Ahead." FI A Review (May/June Hamao, Yasushi, Ronald W. Masulis, and Victor Ng. "Correlations in Price Changes and Volatility across International Stock Markets." Review of Financial Studies 3 (1990): 281307. Hansell, Saul. " T h e Wild, Wired W o r l d of Electronic Exchanges." Institutional Investor (September 1989): 9 I f f . Harvey, Campbell R. "The World Price of Covariance Risk." Journal of Finance 4 6 (1991): 111-57. H e i m a n n , John G. Globalization of the Securities Markets. Statement in hearings before the Senate Subcommittee on Securities of the Committee on Banking, Housing, and Urban Affairs. June 14, 1989, 76. Howard, Barbara. "The Trade: Technology Aims to Take the Final Step." Institutional Investor 25 (January 1991): 1516. Hsieh, David A., and Merton H. Miller. "Margin Regulation and Stock Market Volatility." Journal of Finance 45 (1990): 3-29. Huang, Chi-fu, and Robert H. Litzenberger. Foundations for Financial Economics. New York: North-Holland, 1988. Kang, Jane C., and John C. Lawton. "Automated Futures Trading Systems." FIA Review (May/June 1990): 6-7. King, Mervyn A., and Sushil W a d h w a n i . "Transmission of Volatility between Stock Markets." Review of Financial Studies 3 (1990): 5-33. Kolb, Robert W. Understanding Futures Markets. 3d ed. Miami: Kolb Publishing Company, 1991. Lewis, Janet. "The Euro-Futures War." Institutional Investor 24 (March 1990): 129ff. 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Wall Street Journal, June 13, 1991, C I , C I 7 . Sheeline, William E. " W h o Needs the Stock Exchange?" Fortune, November 19, 1990, 119ff. 1990): 8-10. F e d e r a l Reserve B a n k of Atlanta Economic Review 21 Shiller, Robert J. Market Volatility. Cambridge, Mass.: MIT Press, 1989. Smith, Stephen D. "Analyzing Risk and Return for MortgageBacked Securities." Federal Reserve Bank of Atlanta Economic Review 76 (January/February 1991): 2-11. Stiglitz, Joseph E. " U s i n g Tax Policy to C u r b Speculative Short-Term Trading." Journal of Financial Services Research 3 (1989): 101-15. Summers, Lawrence H., and Victoria P. Summers. "When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax." Journal of Financial Services Research 3 (1989): 261-86. Szala, Ginger, and Amy Rosenbaum. "Deregulation in Japan M a y H a v e D i f f e r e n t M e a n i n g . " Futures 19 ( F e b r u a r y 1990): 42-44. 22 Economic Review Tobin, James. "On the Efficiency of the Financial System." Lloyds Bank Review, no. 153 (July 1984): 1-15. U.S. Congress. O f f i c e of Technology Assessment. Trading Around the Clock: Global Securities Markets and Information Technology—Background Paper. O T A - B P - C I T - 6 6 . Washington, D.C.: U.S. Government Printing Office, July 1990a. . Electronic Bulls and Bears: U.S. Securities Markets and Information Technology. OTA-C1T-469. Washington, D.C.: U.S. Government Printing Office, September 1990b. U.S. Securities and Exchange Commission. Questionnaire of the Working Party on Regulation of Secondary Markets. May 29, 1991. Wunsch, R. Steven. "Single-Price Auctions." Institutional vestor 25 (January 1991): 20. In- July/August 1991 .Europe 1992: A Closer Look Janice L. Boucher / The author is a visiting scholar at the Federal Reserve Bank of Atlanta and an assistant professor of economics at the University of South Carolina. She is grateful to Marco Espinosa, Mary Rosenbaum, and Larry Schulz for helpful comments and to Mike Chriszt for data collection. Digitized for Federal FRASERReserve Bank of Atlanta marine that it is January 1, 1993. The start of a new year, it is also the beginning of a new economic order in much of Europe. The agenda of the Europe 1992 program, begun in July 1985, will be fully in place, and its operation will begin. Goods and services will pass freely between, for example, France and Germany; no longer will truckers have to stop at border checkposts to fill out countless legal documents. Goods from Spain destined for Italy will not have to meet Italian product standards for admittance; as long as they have passed Spanish standards, the goods may not be denied entry into Italy. A Belgian purchasing a British certificate of deposit will not have to pay a tax for investing outside her own country. A Dutchman can open a bank account with a German bank. Welcome to Europe post-1992. This vision of the new European Community (EC) may be achieved. However, the actual outcome of the 1992 program may be more or less than this goal. Many—and the most difficult—directives are still to be determined. Monetary and political union remain longer-term questions. The changing state of the world political and economic environment must be taken into account as well. There are no guarantees for what is ahead. The purpose of this article is to review the Europe 1992 program critically. Following a brief history of the program's evolution and a comparison of the United States' historical experience and current EC attempts to form a union, the often-cited benefits anticipated with the advent of Europe 1992 are examined, along with the implicit assumptions on which these expectations are based. In a later section potential costs of the 1992 program are considered. These cost factors, which are not always quantifiable and have not received much attention, are an important aspect of assessing the plan's viability. The remaining sections consider the obstacles and issues Economic Review 23 still to be faced. The box below provides some facts and figures about the European Community. 71ie Evolution of Europe 1992 The concept of Europe 1992 is not really new. It is but one development in a dynamic process set in motion in the 1950s. Throughout its history—and still today—progress to realize a unified Europe has occurred in fits and starts. The History. Europe 1992 had its inception in the 1957 Treaty of Rome, which established the EC with six founding members: Belgium, France, Italy, West Germany, Luxembourg, and the Netherlands. Eventually, the United Kingdom, Ireland, Denmark, Greece, Spain, and Portugal applied for and received membership into the EC. The original signers of the treaty envisioned an integrated Europe that would allow free EC Facts and Figures T h e E C m e m b e r states (see table) c o v e r a geograph- 1985-89 period. A s c a n be seen, u n e m p l o y m e n t rate i c a r e a of 9 1 2 , 0 0 0 s q u a r e m i l e s , a n d , s i n c e t h e u n i f i c a - d i f f e r e n c e s o n t h e o r d e r o f 12 p e r c e n t a n d i n f l a t i o n r a t e t i o n o f G e r m a n y , h a v e a b o u t 3 4 1 m i l l i o n p e o p l e . In a n d i f f e r e n c e s of a p p r o x i m a t e l y 10 p e r c e n t h a v e p e r s i s t e d . area less than one-fourth the size of the United States, C r o s s - m e m b e r d i f f e r e n c e s in i n t e r e s t r a t e s a l s o r e m a i n , the E C has almost one and one-half times the United w h i c h lifting of capital controls and the b a n k i n g direc- States' population, with 3 7 4 persons per square mile t i v e s h o u l d m i n i m i z e . It is a l s o i m p o r t a n t t o n o t e that c o m p a r e d w i t h 6 6 in t h e U n i t e d S t a t e s ( C o m m i s s i o n of the disparities have shrunk s o m e w h a t since 1985. the European C o m m u n i t i e s 1989). Significant regional C o n v e r g e n c e of t h e s e r e g i o n a l e c o n o m i c d i s p a r i t i e s d i s p a r i t i e s in i n f l a t i o n r a t e s , u n e m p l o y m e n t r a t e s , g r o w t h is c e r t a i n l y a g o a l o f t h e 1992 p r o g r a m . M o r e i m m i n e n t r a t e s , interest r a t e s , a n d tax rates still e x i s t t h r o u g h o u t t h e a r e q u e s t i o n s c o n c e r n i n g h o w t o a c h i e v e it. D i a l o g u e is E C , a l t h o u g h it is h o p e d that t h e 1992 p r o g r a m w i l l at ongoing about what measures might support the E C ' s least reduce these disparities. T h e table c o m p a r e s s o m e less-developed regions without infringing on the c o m - descriptive figures for the twelve m e m b e r states for the p e t i t i v e spirit o f t h e 1 9 9 2 p r o g r a m . Comparative Statistics for the Twelve E C Members 1985 Country 1986 1988 1989 1.6 4.0 3.3 0.2 16.4 3.1 4.7 -0.1 -0.7 9.4 5.3 4.1 1.2 4.6 2.7 1.3 13.5 2.2 5.0 1.5 0.7 9.6 4.8 4.9 3.1 4.8 3.5 2.8 13.7 4.1 6.2 3.4 1.1 12.6 6.8 7.8 11.1 10.5 6.2 11.8 9.5 6.5 20.1 10.3 9.7 10.0 6.2 11.0 9.2 5.7 19,1 8.5 8.1 9.4 5.6 10.9 8.3 5.0 16.9 6.9 1987 Consumer Price Index Inflation Rates Belgium Denmark France West Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain United Kingdom 4.9 4.7 5.8 2.2 19.3 5.4 9.2 4.1 2.2 19.3 8.8 6.1 1.3 3.7 2.5 -0.1 23.0 3.9 5.9 0.3 0.1 11.7 8.8 3.4 Unemployment Rates3 Belgium France West Germany Italy Netherlands Portugal Spain United Kingdom 24 Economic Review 11.4 10.2 7.1 10.2 10.6 8.6 21.5 11.2 11.2 10.4 6.4 10.9 9.9 8.0 21.0 11.5 J u l y / A u g u s t 1991 Real G D P Growth Rates Belgium Denmark France West Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain 0.9 4.3 1-8 3.6 2.0 -0.6 1.9 2.0 2.3 2.6 3.9 2.6 3.3 3.5 2.3 2.3 0.8 -0.3 2.6 3.4 2.0 4.3 2.7 2.4 1.8 -0.1 4.9 3.0 3.7 3.0 4.7 5.6 United Kingdom 3.8 3.0 3.5 3.1 4.3 -0.2 1.1 3.9 3.7 3.9 3.7 4.2 3.7 4.2 3.2 5.2 4.6 4.9 3.0 3.2 Deposit Ratesb Belgium Denmark France West Germany Greece Ireland Italy Netherlands Portugal Spain United Kingdom 6.69 8.21 6.80 4.44 15.50 6.98 8.09 4.10 25.08 10.53 8.87 ' 5.33 6.58 5.32 3.71 15.50 6.50 8.89 3.93 17.13 9.00 6.92 5.00 7.07 5.31 3.20 15.33 6.21 7.01 3.55 14.46 8.97 5.11 4.54 7.75 5.01 3.29 17.33 3.63 6.69 3.48 13.21 9.06 4.27 5.13 8.27 5.92 3.50 17.14 4.54 6.93 3.49 13.00 9.55 6.07 Lending Rates'3 Belgium Denmark France West Germany Greece Ireland Italy Netherlands Portugal Spain United Kingdom 12.54 14.65 17.77 9.53 20.50 12.44 13.36 9.25 27.29 13.52 12.29 10.44 12.98 16.38 8.75 20.50 12.23 15.93 8.63 19.63 12.19 10.83 9.33 13.62 15.82 8.36 21.82 11-15 13-58 8.15 18.92 16.36 9.63 8.92 12.59 15.65 8.33 22.89 8.29 13.57 7.77 17.53 12.43 10.29 11.08 13.44 16.01 9.94 23.26 9.42 14.21 10.75 19.59 15.84 13.92 - No comparable data were available for Denmark, Greece, Ireland, or Luxembourg. b \in data were available for Luxembourg. , _ . Sources: Unernptoyment rates are from Ma/n Economic Indicators, Organisation for Economic Coopérât,on and Development Paris (published twelve times yearly; various issues from 1985-89). All other data are from International Fmancal Statistics Yearbook (Washington, D.C.: International Monetary Fund, 1985-89). Federal Reserve Bank of Atlanta Economic Review 31 trade of goods, services, capital, and labor—the "four f r e e d o m s " — a n d would adopt a common policy toward nonmember trading partners and on agriculture and transport. Of course, the ultimate goals, explicitly stated in Article 2 of the Treaty of Rome, were for all member states to realize higher living standards, economic stability, and closer relations. Unfortunately, progress in line with these principles faltered in the 1970s and early 1980s. Hit by an oil price shock in 1973 and again in 1979, and facing worldwide recession at the close of the 1970s and e c o n o m i c stagnation at home, the E C ' s m e m ber states tried to insulate themselves against competition f r o m each other. T h e y devised e l a b o r a t e schemes for constructing a protective wall that may not have broken the letter of the laws set out in the Treaty of R o m e but surely broke the spirit. Countryspecific regulations and standards covered everything from the noise level emitted by lawn mowers to the wheat content of pasta, effectively limiting the entry of goods from neighboring states. "Local-content" rules specified a required amount of local goods in a finished product, and " d o m e s t i c - o r i g i n " rules det e r m i n e d the e x t e n t to w h i c h a s s e m b l y m u s t be completed in a country for it to be considered the p r o d u c t ' s c o u n t r y of o r i g i n . In a d d i t i o n , d i f f e r ences in border and value-added taxes, programs of state aid and public procurement, and other nontariff barriers implicitly constituted protectionism, whether intended or not. In July 1985, prompted by the economic malaise that had settled over Europe for almost a decade, the EC produced a White Paper titled "Completing the Internal Market," which suggested approximately 300 directives or trade reforms within the EC. 1 The White Paper forged renewed cooperation among the member states and outlined guidelines for pursuing economic reorganization. T h e directives dealt mostly with dismantling the nontariff barriers to trade that had cropped up to replace tariffs removed in the mid1960s. In 1987 the EC legislated the Single European Act, amending the Treaty of Rome to include as proposals 282 of the White Paper's 300 directives and changing the voting rule from "unanimity" to "qualified majority rule." 2 The change in the voting rule, which made it easier and quicker to put into action any directives brought before the Council of Ministers, is a key element in hastening completion of the 1992 program. The following box outlines the E C ' s organizational structure, and the appendix lists the key provisions of the Single European Act. F o r m i n g a U n i o n : P a r a l l e l s w i t h the U n i t e d States. To be sure, the 1992 plan has carried with it Organizational Structure of the European Community Several institutions share responsibility f o r shaping and ultimately enacting t h e ideals of an integrated Europe. Six bodies carry out various legislative and advisory f u n c t i o n s . The E u r o p e a n C o m m i s s i o n has the task of ensuring that the Single European Act is carried out. T h e c o m m i s s i o n m a y m a k e its o w n p r o p o s a l s and acts as t h e c l e a r i n g h o u s e for proposals m a d e by other E C institutions. T h e c o m m i s s i o n e r s are a p p o i n t e d by their gove r n m e n t s but are to act independently of t h e m . J a c q u e s Delors is the current c o m m i s s i o n president. T h e E u r o p e a n Council, s o m e t i m e s referred to as the E C S u m m i t , consists of the h e a d s of state of the m e m b e r g o v e r n m e n t s , their foreign ministers, and the president and vice president of the c o m m i s s i o n . T h e council is r e s p o n s i b l e f o r e s t a b l i s h i n g g e n e r a l g u i d e l i n e s on b r o a d policy issues like m o n e t a r y c o o p e r a t i o n , fiscal harmonization, and n e w m e m b e r s h i p . T h e C o u n c i l of M i n i s t e r s h a s d e c i s i o n - m a k i n g a u thority. T h e council passes p r o p o s a l s by "qualified m a j o r i t y . " A t least f i f t y - f o u r of t h e s e v e n t y - s i x p o s s i b l e votes must be cast for a proposal to b e c o m e a directive. H o w e v e r , responsibility for enacting the directive into national law rests with t h e m e m b e r states. T h e European Parliament is an elected body of 518 m e m b e r s . It does not retain any legislative p o w e r within the E C but instead acts as an advisory board through t h e p o w e r of o p i n i o n . P a r l i a m e n t v o t e s on p o s i t i o n s taken by t h e Council of Ministers. H o w e v e r , the C o u n cil of Ministers is f r e e to reject the o u t c o m e of the Parl i a m e n t ' s vote. T h e E u r o p e a n C o u r t of J u s t i c e l i t i g a t e s d i s p u t e s a m o n g m e m b e r states and private parties that fall within the c o n s t i t u t i o n of the T r e a t y of R o m e . D e c i s i o n s reached by the Court of Justice are binding on all m e m b e r states. Finally, t h e E c o n o m i c and Social C o m m i t t e e c o m prises representatives f r o m various trade organizations and p r o f e s s i o n a l a s s o c i a t i o n s . T h e c o m m i t t e e , w h o s e function is advisory, discusses items such as labor laws, e n v i r o n m e n t a l s t a n d a r d s , p r o f e s s i o n a l ethics, and culture in relation to proposals or directives. Source: Adapted from Hufbauer (1990). 26 Economic Review July/August 1991 the image of creating a "United States of Europe." The analogy is more fitting than not and provides a useful construct in thinking about the 1992 vision. Indeed, many of the anticipated benefits, costs, and obstacles to the 1992 plan can be seen in the experience of the U n i t e d States f r o m its f e d e r a t i o n in 1787 through the Civil War and up to today. Admittedly, the United States' and the European Community's experiences differ greatly. For whatever reasons—perhaps because briefer histories as independent entities gave them less time to grow accustomed to exercising their own authority—states in the United States willingly ceded some of their powers to the new federal government in 1789. External trade, for example, and foreign relations and issuance of currency became federal matters when the Constitution replaced the Articles of Confederation. More significantly, the external threat of European countries' expansionist designs provided a strong incentive for the states to join in political union. Fighting together for the same ideal in the American Revolution fostered their sense of unity. Despite vivid economic and political differences that continue to characterize individual states and regions in the United States and despite periods of heated and, in the case of the Civil War, violent disagreement, the states remain united, as evidenced by their electing a single president to represent them ("If You Sincerely Want" 1991). What makes Europe different? First, each member state has a history rich with a distinctive heritage, language, culture, and currency. For these countries, many of which have operated independently for centuries, ceding authority to an EC institution is still viewed with reluctance. The idea of an EC head of state comparable in powers to the president of the United States is beyond most current debate (see "If You Sincerely Want" 1991). As will be discussed in this article, the issue of sovereignty is central to many of the 1992 agenda's directives. However, while the EC m e m b e r s ' separate and distinct identities may make their union more difficult, it should not be impossible. It is interesting to note that in the United States political union preceded economic union, and monetary union was based on a common currency, though different regions were permitted to initiate their own "monetary policy." In the early years of the Federal Reserve System, f o u n d e d in 1913, Reserve Banks could set different discount rates depending on local economic and financial conditions. In contrast, the EC, prompted by the growing economic superiority of Japan and the United States, has sought economic Federal Reserve Bank of Atlanta integration before monetary and political union. As in the United States, the reality of a threat—in the EC's case e c o n o m i c — m a y serve to strengthen the ties among the member states. Anticipated Benefits of the Europe 1992 Program: The Cecchini Report C o m m i s s i o n e d by the EC, the Cecchini Report (directed by Paolo Cecchini) is the most often cited analysis of the benefits and costs anticipated from European economic integration. 3 The report has much more to say about the benefits than it does the costs, projecting a one-time increase of 4.3 percent to 6.4 percent of the E C ' s 1988 gross d o m e s t i c product (GDP), about $3,240 for a family of four. Prices are expected to fall approximately 6 percent. From two to f i v e million j o b s will be created. According to the report, these gains should be achieved over the "medium term"; no specific date is attached. 4 The Methodology. The report is a compilation of broad and c o o r d i n a t e d research e f f o r t s c o n c e r n e d with the 1992 program's impact, in terms of total expected net gains, on thirty-six d i f f e r e n t industries throughout the EC. Inherently, the task of predicting meant relying extensively on extrapolation and simulation. Gaps in data sometimes required that numbers for certain industries or member states be projected or that estimates f r o m business surveys be used. For some industries, elasticities of d e m a n d and supply were based on previous empirical work or were extrapolated. Moreover, the study covers only seven of the twelve EC members: France, Germany, Italy, and the United K i n g d o m , as well as Belgium, L u x e m bourg, and the N e t h e r l a n d s , the latter three being treated as one group. Cecchini himself notes that "the research is unprecedented for various reasons—first for the sheer size of its scope, but also because of the novelty of the subject-matter and the methodological difficulties. . . . A further problem was the unevenness of the empirical data on European market fragmentation. Yet despite these fragilities, the results that emerge tell an unmistakable story" (Cecchini 1988, xviii). Table 1 shows the Cecchini Report's projection of gains after nontariff barriers have been removed. The benefits are expected to come in four stages: the gains (or cost reductions) for intra-EC trade resulting from the removal of border controls and excess paperwork; the gains (or cost reductions) to production realized Economic Review 27 Table 1 Potential Gains in Economic Welfare for the EC Resulting from Completion of the Internal Market Billions of Percent of U.S. Dollars 3 1988 EC G D P Step 1 Gains f r o m removal of barriers affecting trade 9.4 - 10.6 0.2 - 0.3 Step 2 Gains f r o m r e m o v a l of barriers affecting overall p r o d u c t i o n 67.3 - 83.8 2.0 - 2.4 Gains f r o m r e m o v i n g barriers (subtotal) 76.7 - 9 4 . 4 2.2 - 2.7 Step 3 Gains f r o m e x p l o i t i n g e c o n o m i e s of scale m o r e f u l l y 72 2.1 54.3 1.6 Step 4 Gains f r o m intensified c o m p e t i t i o n , r e d u c i n g business inefficiencies and m o n o p o l y profits Gains f r o m market integration (subtotal) 73.2b - 126.3 2.1b - 3.7 205.3 - 3 0 4 . 4 4.3 - 6.4 Total For t w e l v e m e m b e r states at 1988 prices M i d p o i n t of a b o v e 255 5.3 a The numbers reported were converted to dollars at the 1988 average $/ECU rate. b The lower estimates for the sum of stages 3 and 4 were generated together and cannot be broken down. Source: Adapted from Cecchini (1989, 84; originally in Commission of EC, Directorate General for Economic and Financial Affairs, The Economics of Europe 1992—An Assessment of the Potential Effects of Completing the Internal Market [Brussels, 1988]). by o p e n i n g up public procurement and by mutual recognition of standards and regulations for goods and services; the unit-cost reductions arising from restructuring businesses and expanding output (that is, achieving economies of scale); and the gains from more efficient production stemming from increased competition. However, there may be factors that interfere with full development of these benefits. Merton J. Peck (1989) notes that 60 percent of the gains are expected to be concentrated in seven of the t h i r t y - s i x i n d u s t r i e s s t u d i e d : m o t o r v e h i c l e s and other transport; electrical goods; mechanical engineering; food, edibles, and tobacco; credit and insurance; c h e m i c a l s ; and o f f i c e machinery. Peck also notes that most of the gains occur in the third and fourth stages when economies of scale are exploited; for motor vehicles, 87 percent of the gains are attributed to these two stages. In reference to auto manufacturing specifically, a significant question is how likely the industry is to reach the latter two stages. Alasdair Smith and Anthony J. Venables (1990) show Economic Review 28 that the automobile industry is highly nationalistic in that automakers tend to dominate their home markets. Table 2 illustrates the pervasiveness of this tendency. For example, the two French automakers, Renault and Peugeot, capture 63 percent of the French market. While it must be acknowledged that nontariff barriers may also come into play, there seems some merit to considering Smith and Venables's view that such a national bias exists. If so, economies of scale arising f r o m e x p a n d i n g p r o d u c t i o n to f u r n i s h newly tapped markets may be more difficult to achieve— and, hence, the gains more elusive—than the Cecchini Report presumes. National favoritism—and the fact that it cannot be legislated a w a y — i s also d e m o n s t r a t e d in sales of electrical equipment. Although the industry expects to extract a substantial share of its gains from opening up public procurement, the reality is that designs to open up public procurement have been on the books since the early 1970s and, to date, only 2 percent of such contracts have been awarded to nonnationals. July/August 1991 Table 2 European Car Market Shares, 1988 (percent) European West Community France Fiat 16 7 5 Ford 12 6 10 General Motors 10 5 15 Japanese g r o u p 9 3 15 14 34 4 11 29 3 Volkswagen group 15 9 29 Specialists 12 6 18 2 1 1 Automakers Peugeot g r o u p Renault Others Germany Source: A d a p t e d f r o m Smith a n d V e n a b l e s ( 1 9 9 0 , 1 2 1 ; originally in A u t o m o b i l e Industry D a t a Ltd., 1989 Car Yearbook). (Transport, energy, telecommunications, and water supply were exempted until recently.) As Peck has observed, "This history . . . does not augur well for other kinds of national preference" (1989, 293), On a related point, the evolution of divergent regulations and standards within the EC was a protectionist reaction to the c o m p l e t e elimination of tariffs during a time of general economic lethargy. The indep e n d e n t m i n d - s e t that led to raising the nontariff barriers remains a loose thread in knitting together the economies of the twelve member states. In fact, as recently as February 20 of this year, European Commission President Jacques Delors remarked that another such decline in economic growth might impede progress toward the 1992 target (Knight-Ridder News Network). T h e s e d y n a m i c s could k e e p actual g a i n s f r o m equaling the Cecchini Report's projections. In another sense it is quite possible that the Cecchini Report grossly underestimates the gains to be had. The report recognizes that the estimated gains are "static" that is, they are generated without considering additional positive side effects that may arise in an economic environment of increased competitiveness motivating innovation and industry reorganization over time. In fact, a "virtuous circle" in which increased competition leads to innovation promoting further competition and so on is anticipated. Richard E. Baldwin (1989) has found that such "dynamic effects" could produce an additional 1.7 percent to 2.6 Digitized for FFRASER e d e r a l R e s e r v e B a n k of Atlanta percent increase in G D P beyond that estimated in the Cecchini Report. U n d e r l y i n g A s s u m p t i o n s . T h e popularity and press accorded the Cecchini Report does not guarantee the 1992 figures. In fact, the estimates are based on some very specific and narrow assumptions that may be misleading. For instance, two key assumptions maintained throughout the study were full employment and unchanged wages. The Cecchini Report does entertain alternative assumptions about pricing and output behavior that in some cases produce substantially disparate results. For example, different assumptions about the pricing and output decisions of firms in the auto industry lead to widely differing estimates of the gains to be realized. Estimated gains for the auto industry range f r o m 0.02 percent to 0.30 percent above 1988 EC GDP, depending on the pricing behavior assumed for the industry. Peck (1989) has pointed out that the estimate used in the final analysis is the latter figure. Another assertion f u n d a m e n t a l to the projections is that the f i v e m e m b e r s not expressly included in t h e e m p i r i c a l a n a l y s i s — D e n m a r k , G r e e c e , Ireland, Portugal, and S p a i n — w o u l d achieve the same percentage gains in G D P as those included. H o w ever, the i n d u s t r i a l m i x e s of e a c h m e m b e r state vary widely and would seem to indicate distributional differences in the percentages. It is not a certainty that the omitted countries—the less developed economies of the EC, for whom agriculture plays a dominant role—will share equally in the anticipated gains. There has also been concern that these countries are likely to bear burdensome adjustment costs during the transitional stages of the 1992 program, which perhaps, along with questions about their share in the anticipated gains, account for the southern-rim countries' reluctance to legislate EC directives. Additional, implicit assumptions include the following: (1) that all 282 directives would be legislated by the member states; (2) that there will be no change in the relations among the m e m b e r states; (3) that there will be no change in each m e m b e r ' s and the EC's trade relations with the rest of the world; and (4) that there will be no change in the social or political environment within the EC. Insofar as these assumptions do not prove valid, the anticipated gains stemm i n g f r o m the c o o r d i n a t e d r e m o v a l of n o n t a r i f f barriers could be reduced. With regard to the first assumption, the EC is well on its way to having the legislation to adopt the 282 directives passed by the Council of Ministers. To date, 184 have been enacted at the EC level. Unfortunately, Economic Review 29 many of the member states have been reluctant to legislate them at the national level. The northern-rim members have enacted about 55 percent of the directives, and the southern-rim countries have legislated only 4 0 percent ( " E u r o p e ' s R h e t o r i c " 1989; Peter Brimelow 1990). In fact, only twenty-four of the directives have been legislated by all twelve members. Implementation of EC legislation in the food and consumer protection areas is lagging most. An EC vote in f a v o r of removing a barrier is only as good as the willingness of the member states to enforce it. The assumed stasis of the member states' relations with each other surrounding the 1992 agenda is currently being tested by major changes in leadership and structure. With a new prime minister at the helm, Great Britain's position vis-a-vis the 1992 agenda and the related topic of monetary union is expected to be more harmonious. German reunification does not appear to have altered attitudes toward 1992, nor does the demise of the communist states of Eastern Europe. The strength of Commission President Jacques Delors is thought to be a significant factor in maintaining cohesiveness. In addition, the recent decision to double the budget of the EC Structural F u n d — a fund supported by tax contributions from each member state and used for agricultural policy, regional dev e l o p m e n t , and social p o l i c y — m a y help maintain cohesiveness by offering assistance to those countries that experience the roughest transitional pains and may therefore be most likely to break the envisioned unity over the longer run. On the other hand, the currently discussed reform of the Common Agricultural Policy (CAP)—which accounts for 60 percent of the Structural Fund's budget—is potentially divisive. Farms in southern-rim and northern-rim states tend to operate differently and to have different interests at stake under the CAP. Northern farms are often larger and more efficient than those in the south. More importantly, some countries receive lower support prices than others, and countries receiving less financial aid are willing to concede more in the GATT talks about national f a n n ing policy. 5 The resulting contention over C A P reform among the member states is an element to watch for possible spillover effects on cooperation about other 1992 items. As for the assumed unchanged trade relations with the rest of the world, the recent scuffle over the United States-European Community agricultural policy raises questions. The problem is how to resolve differences in the systems of agricultural subsidies ingrained in the national policies of the United States 30 Economic Review and the EC members. The United States desires coordinated cuts in agricultural subsidies of 75 percent to 90 percent, while the EC has offered more modest cuts on a smaller range of goods. The concern for the 1992 agenda is that the disagreements might hamper trade negotiations in other areas. For example, the United States objects to the decision last year to deny its hormone-treated beef into the EC on the grounds that it does not meet health standards. In addition, the European Commission has recently issued a report on discriminatory U.S. trade policy practices, cond e m n i n g , a m o n g other things, the U.S. Super 301 Trade Bill, which allows the United States to retaliate against countries that it deems are not trading fairly with the United States (Knight-Ridder N e w s Network, April 18, 1991). The United States is the EC's second-largest trading partner, based on exports plus imports (the largest if the European Free Trade Association [EFTA1 countries—Austria, Finland, Iceland, Norway, Sweden, and Switzerland—are not grouped; see Table 3). 6 Because of this relationship, any change in United S t a t e s - E u r o p e a n C o m m u n i t y trade relations could substantially alter the manner in which the benefits to different sectors of the EC cited in the Cecchini Report actually play out. Finally, the social and political environment can hardly avoid change. In fact, the Single European Act explicitly includes amendments in the area of social policy, and a treaty on political union is being discussed. Further discussion of these topics follows in a later section. Other Estimates and Considerations. The Cecchini Report is one of several studies that project gains from the 1992 program. Peck, for instance, believes a reasonable figure is double the 1 percent of G D P realized from the removal of all tariffs in 1968. T h e r e are other, m o r e positive, c o n s i d e r a t i o n s that the Cecchini Report and similar studies do not take into account. For example, because European Monetary Union is not technically part of the Single European Act, Cecchini's and others' estimates do not allow for any benefits that monetary union may yield. 7 For example, the issuance of a single currency can be expected to eliminate currency fluctuations that may deter business decisions and cut into profits. 8 Secondly, to reiterate an earlier point, the estimated gains do not take the "virtuous circle" into account. Finally, the E C ' s heightened sense of c o m p e t i t i v e n e s s with l a r g e r e c o n o m i e s l i k e the United States and Japan may be enough to override conflicts and solidify cooperation to put the Europe 1992 program in place. July/August 1991 Table 3 Trade Statistics for the ECa (in millions Country 1985 of U.S. 1986 U n i t e d States Exports Imports Exports - Imports EFTA b Exports 48,993.8 71,617.4 -22,623.6 Imports 58,145.5 63,875.2 Exports - Imports -5,729.7 Japan Exports Imports Exports - Imports NICs c Exports Imports Exports - Imports dollars) 1989 1987 86,570.0 88,820.9 60,169.2 75,430.9 -26,365.6 84,876.0 -24,706.8 88,844.3 -13,413.4 71,578.1 88,485.1 83,728.7 -12,150.6 102,895.3 -14,410.2 99,191.8 110,434.1 -11,242.2 47,172.1 24,162.7 23,009.4 47.986.3 28,136.9 53,154.5 79,520.1 -2,250.9 105,681.2 115,856.2 -9,995.0 9,370.5 31,122.1 14,173.3 1 1,757.7 16,948.8 38,305.2 17,861.8 20,443.4 12,101.7 11,452.2 649.5 16.292.2 24,676.1 31,989.0 24,348.9 13.087.3 3,204.8 18,128.1 23,886.9 19,882.4 6,548.1 8,102.1 4,466.5 21,128.2 19.849.4 - Figures indicate exports and imports of the countries listed to and from the EC . , » The EFTA (European Free Trade Association) countries are Austria, Finland, Iceland, Norway, Sweden, and Switzerland. c The NK;s (newly industrialized countries) include Hong Kong, South Korea, Singapore, and Taiwan. Source: International Monetary Fund, Direction of Trade Statistics, database, 1991. Potential Costs of Europe 1992 T h e Cecchini Report recognizes that, while the Europe 1992 program offers a number of potential benefits, there are also costs involved. The study portrays the costs as to be wholly borne by firms that, in the wake of fiercer competition, will see their profit margins squeezed through downward price pressure. This squeeze on profits should be balanced by downward pressure on costs as production inefficiencies are eliminated and economies of scale are realized so that on net, over the medium term, firms will enjoy gains. Adjustment Costs. Unavoidably, as the European economy transforms from a market characterized by considerable segmentation and varieties of barriers into one that is more free and open, certain sectors, peoples, or member states are likely to experience some pain. The Cecchini Report expects these adjustment Federal Reserve Bank of Atlanta costs to come in the form of unemployment, especially as firms respond to the newly integrated market by eliminating waste built in during many years of the old regime. Sectors largely protected by public procurement initiatives will probably also suffer. T h e concern is that concessions intended to offset negative effects encountered during the adjustment phase may be made and may compromise the envisioned outcome of the 1992 plan. Unfortunately, the nature of the Cecchini study precluded actually measuring the costs to be incurred during this transition. Generally, initial increases in unemployment in certain regions or sectors of the EC are to be expected as competition forces businesses to restructure or streamline. However, there seems no reason to believe that when the transition is complete u n e m p l o y m e n t will be higher than before. In fact, competition, restructuring (through new entrants), and innovation will be likely to create more job opportunities in the long term. Economic Review 31 Implementing Mutual Recognition. The Cecchini Report anticipates that the profit squeeze on businesses will be balanced by reduced production costs and greater efficiencies. However, it does not consider the possibility that, when products meeting the standards of one country can no longer be denied entry to any other member state, the result may be a rise in consumer demand for quality excellence that will force product standards upward. As in the case of the U.S. auto industry when Japanese autos entered the U.S. market, an EC-wide move to the highest product standard would entail additional costs for all firms in m e m b e r states currently m e e t i n g lower standards, thus raising production costs to a level beyond what the Cecchini Report assumes. However, consumers may be willing to pay for these costs if they reflect better quality. Achieving Economies of Scale. The extent of the economies of scale expected to emerge from the singlemarket initiative is also questionable. Originally, the plan called f o r applying E C - w i d e standards to all products. Obvious e c o n o m i e s of scale would have been reaped as all firms converted production facilities to meet a single standard. However, the task of unifying the more than 100,000 existing standards was seen as i n s u r m o u n t a b l e , and the c o m m i s s i o n a g r e e d on the " p r i n c i p l e of mutual r e c o g n i t i o n , " which may or may not result in economies of scale. If, for example, intermediate goods produced according to German standards are not coordinated with the standards of French goods in which they are components, no benefits may be realized. A German company supplying headlights to both German and British a u t o p r o d u c e r s m a y f i n d that the h e a d l i g h t s f o r British producers still have to meet British wiring standards; two standards—requiring two smaller scales of operation—must still be met. 9 The existence of market niches that prevent mass production and mass marketing may also interfere with achieving economies of scale. On the other hand, as businesses in each industry across the EC begin to compete with one another, an eye will be kept on the standards of products that sell the best. More than likely, businesses will adopt similar standards as they did in the United States when liquid detergent and tartar-control toothpaste proved their appeal. Mutual self-interest in having one industry standard, such as in the computer industry, may also prompt quicker harmonization of standards. Unanticipated Administrative Costs. The Cecchini Report explicitly recognizes the cost savings that will result from the elimination of border controls and Economic Review 32 the associated paperwork and staff. However, expenditures for personnel to implement the Europe 1992 program have not been considered and will naturally offset some of the anticipated reductions. For example, the offices of the Directorate Generals (DG)—in particular the DG-4, which is responsible for monitoring, investigating, and pursuing competition policy—apparently lack sufficient staff to ensure m e m b e r - b y - m e m b e r compliance with all aspects of the 1992 program (Douglas Rosenthal 1990). Expenditure for the necessary personnel for this and other EC agencies, such as an environmental agency or a trademark office, will require financing by the member states. Government Procurement, Regulation, and Taxation. The most challenging issues facing the EC are probably public procurement, regulation, and taxation, not only because their resolution will require unanimous approval but also because they ultimately infringe on state law. Related cost reductions envisioned in the Cecchini Report are not in fact likely to be realized until long after the border controls are removed and mutual recognition is practiced. For example, 0.5 percent gains over 1988 G D P are anticipated from opening public procurement. However, as mentioned earlier, there is no clear indication that public contract bids will actually be awarded without national biases. With respect to regulation, the newly adopted unified environmental, health, and safety standards are stricter than some member states had enforced and are therefore costlier than before. These potential costs were not considered in the Cecchini Report. Furthermore, enforcement will add costs. For instance, the EC Commission has taken the United Kingdom, France, and Belgium to court for failure to meet EC standards for water denitrification. A c c o r d i n g to s o m e , this move is only the beginning; the commission is expected to investigate compliance regarding pesticides in drinking water, river quality, and sewage contamination of beaches ("British Spat" 1989). Finally, harmonization of value-added and excise taxes may impose an additional financial burden on s o m e m e m b e r states. C u r r e n t l y , v a l u e - a d d e d tax (VAT) rates range from 0 percent to 38 percent across the twelve member states, as Table 4 indicates. There are three categories of rates: reduced, standard, and higher. All member states do not necessarily apply the same rates to the same good. Recently, a two-tiered system has been proposed that sets a m i n i m u m reduced rate of 5 percent and a minimum standard rate of 14 percent (rather than bands of 4 percent to 9 percent and 14 percent to 20 percent, as had been previ- July/August 1991 ously proposed). M e m b e r states are free to set the rates higher but may go no lower. Support for the new proposal looks p r o m i s i n g , a l t h o u g h nine m e m b e r states would prefer a m i n i m u m standard rate of 15 percent and the United Kingdom prefers unenforced convergence of rates through cross-border free trade and competition (The Economist Intelligence Unit 1991,14). On paper, the new proposal solves the problem for some countries that, under the old proposal, would have had to reduce their rates and incur a loss in VAT revenue. However, as the 1992 plan becomes fully operational ( p e r h a p s well a f t e r J a n u a r y 1, 1993), those member states that have VAT rates well above the minimum, or even average, rates may find it necessary to lower their own rates, push for reconsideration of the minimum rates, or even reopen dialogue on which rates, reduced or standard, apply to various goods. The larger income base and corresponding tax revenue the 1992 initiative is expected to precipitate may ease disagreement somewhat about VAT rates. However, because the issue goes beyond pure monetary cost and touches on the issue of sovereignty (discussed more fully in the next section), it may take some time and effort beyond 1992 to reach an agreement that is passed into legislation. Obstacles and Remaining Issues Remaining issues and additional obstacles to fulfillment of the 1992 agenda can also be viewed as potential costs, for they threaten completion of the program and realization of the gains. In part, the measure of how beneficial or costly the plan turns out to be for each member state will be reflected by how much backsliding goes on once the directives are adopted and put into practice. Moreover, obstacles still standing on the road to 1992 may indicate that some members perceive a lower-than-expected s h a r e of t h e g a i n s a n d p e r h a p s e v e n t o o m a n y costs—not in the f o r m of economic burden or directly through the 1992 agenda but rather through related social and political d e v e l o p m e n t s , particularly having to do with the issue of sovereignty. In fact, several of the remaining issues for the EC lie outside the 1992 program set forth in the Single European Act. European monetary union and political union are examples. These issues are discussed below, along with some of the current o b s t a c l e s to "completing the internal market." These stumbling Digitized forFederal FRASERReserve Bank of Atlanta Table 4 Value-Added Tax Rates in the ECa (percent) Standard Higher 1, 6 17, 19 Denmark None 22 25, 33 None France Germany 2.1, 5.5, 13 18.6 28 7 14 None 3, 6 18 25 Country Belgium Greece Reduced 36 19 None 38 3, 6 12 None 6 18.5 Portugal Spain 8 6 17 None 30 United Kingdom 0 12 17.5 None Ireland Italy Luxembourg Netherlands 1.4, 5, 10 4, 9 33 a The reduced rates apply to "necessity items," the higher rates to "luxury items," and the standard rates to most other goods. All countries do not necessarily categorize the same goods under the same rate. Sources: EC Commission and Knight-Ridder News Network, various recent releases. blocks arise f r o m d i s a g r e e m e n t s over specifics of the Single European Act but may have their roots in concerns beyond the details of the 1992 plan. Moreover, these obstacles may be even more difficult to o v e r c o m e b e c a u s e , like tax law c h a n g e s , most of t h e r e m a i n i n g d i r e c t i v e s r e q u i r e u n a n i m o u s approval. Harmonization of Standards and Taxes. Mutual recognition applies to most standards except when the e n v i r o n m e n t , health, or s a f e t y — s o - c a l l e d " e s s e n t i a l s " _ a r e concerned. For these, the EC has endorsed adopting a unified or EC-wide set of standards, product by product. Unanimous agreement is required and has yet to be accomplished. For example, EC regulations on the cross-border transport of animals have not been determined, and, as one EC official grumbled, "If we have to check every box, crate or trainload of goods that crosses a border to make sure they don't contain any rabid dogs, then the single market will be a farce" ("Sticking Points" 1990). Ongoing disagreement about such issues could jeopardize completion of the internal market. As discussed above, harmonization of social security taxes, labor taxes, and corporate taxes (perhaps using some EC-wide average) remains another obstacle, one that cuts deeply into the issue of sovereignty, besides potentially imposing heavy costs on businesses Economic Review 33 in countries with low tax rates and on governments in countries with high tax rates. In the words of the EC Commissioner of Taxation Policy, "Taxation is one of the thorniest issues, precisely because it has to do with both s o v e r e i g n t y and m o n e y " ( " S t i c k i n g P o i n t s " 1990). Debate about the subject tends to break down to debate over whether public budget control should be exercised at the EC level or allowed to evolve through competition and the move toward monetary union. Already the EC has decided that member states receiving assistance from the EC Structural Fund must match 50 percent of the aid f r o m their own public funds. The complexity of the issues involved can be seen in the fact that for countries like Greece, Portu- In the United States political union preceded economic union. In contrast, the EC . . . has sought economic integration monetary and political before union. gal, and Ireland, such a demand restricts the f u n d s available for other public programs (Jorgen Mortensen 1990, 38). Quotas and Local-Content and Domestic-Origin Rules. Agreement on the handling of national quotas and the interpretation of local-content rules still has to be worked out. At present, unified positions on these seem near. Once goods are permitted to move freely among the member states, distinct national quotas will cease to be effective. Some countries want to retain quotas on Japanese autos, for example, and object to an EC-wide quota. The solution being pursued is an export agreement between Japan and the EC in which Japan voluntarily agrees to restrict its auto exports to the EC. Member states except France and Italy have agreed to phase out the voluntary restriction over six years. Local-content and domestic-origin rules also pose difficult problems. Rules must still be outlined regarding goods produced by nonmember affiliates in m e m b e r countries or by plants located in m e m b e r states but owned partly by nonmembers. For example, Economic Review 34 France recently sought to deny entry of an auto, the Bluebird, produced in the United K i n g d o m by the Japanese company Nissan. The French claimed that only 70 percent of the auto was "local content" while 80 percent was required for admittance. The United Kingdom rebutted, saying that because the auto satisfied British local-content rules, by mutual recognition the car could not be denied entry. The case, eventually dropped by the French, illustrates the complexities of interpreting and implementing the directives of the Single European Act. Social Harmonization. One of the issues probably least publicized and potentially most harmful to the competitive spirit of the 1992 plan is what Paul Craig Roberts (1990) calls "social harmonization." Under the EC Social Charter or Labor Policy, social harmonization would legally bind all member states to enforce the same set of "workers' rights." These include the right to adequate health care, unemployment compensation, worker safety, and the like. Recalcitrant companies would be punished by having duties imposed on their products. As Roberts sees it, the concept of social harmonization runs completely counter to the idea of completing the internal market by unleashing market forces. Instead, he claims, it actually "reintroduces protectionism in the guise of harmonization." As it stands, the Social Charter divides the EC members into two camps: those fearing that without unified labor policy the L D C s , as it were, of the E C , with their lower labor costs and less restrictive policies, will export unemployment to the more industrial r e g i o n s of the E C ; a n d t h o s e a f r a i d that a unified labor policy itself will lead to unemployment throughout the EC by raising the cost of doing business. The southern-rim countries in particular fear that e m p l o y m e n t will be redistributed toward the Golden Triangle between Germany, France, and the United Kingdom. In essence, the debate focuses on the question of whether free trade exists not only in labor but in goods, services, and capital when there are country-by-country distortions in the labor market that carry over to price distortions in these other markets. A lack of resolution on this one, very difficult issue could undermine successes in other areas. To subvert whatever labor policy is instituted, agreed-upon guidelines for industrial policy and open public procurement could be abused. Mutual recognition may be disregarded, and economies of scale may be harder to come by. Fortunately, it is not likely that progress on the timely removal of border controls or standardization of essentials will be set back or that tariffs or even capital controls will be reintroduced. July/August 1991 There has been some progress on the free mobility of labor: five EC members—France, Germany, and the Benelux countries—have agreed on immigration policy ("Five EC Nations" 1990). Previously, discord arose over concerns about how such potential problems as immigration, drug trafficking, and the movement of criminals and terrorists would be handled. The agreement reached is that a shared crime-intelligence data network will be used to monitor cross-border criminal activity. Participation by the other EC members is anticipated, although progress is expected to be slow. According to Ambassador van Agt, free mobility of labor will probably be the last of the "four f r e e d o m s " to be realized (speech at the Federal Reserve Bank of Atlanta, February 11, 1991). Industrial Policy, Strategic Trade Policy, and National Security. What issues outside those raised by the Single European Act threaten attaining the four freedoms? For one, agreement on which forms of industrial policy will be acceptable in light of the Single European Act will be hard to secure. In many instances, it is not clear at what points state initiatives overstep the bounds of competition embraced by the Single E u r o p e a n Act (Rosenthal 1990). In fact, the degree of control over national expenditure that will be ceded to the supranational EC has,yet to be decided. At present, the EC has control over public expenditures at the national level on research and technological development, environment, subsidies, debt write-offs, and below-market loans to industry (Rosenthal 1990). Industrial policy encompasses more than these, however. At the national level, tax reductions, tax deferrals, worker retraining, or the creation of enterprise zones can each be used to target a particular industry a government has an interest in aiding. The EC has energetically disciplined states that have given aid suspected to impede competition. O f t e n , these governments are forced to reclaim their gifts. In one well-known case, the EC forced the French government to reclaim a large portion of aid given to Boussac, a textile manufacturer. To enforce some degree of preventive control, the EC has written into its books that state aid valued at more than $15 million must receive prior clearance by the European Commission. Such disciplinary measures are meant to insure against infringement of the competition policy under the Single European Act. State aid in the name of national defense, however, is exempted from any of these measures. If the Directorate General's current posture on competition policy is any guide to the way protectionist industrial policy will be handled, then it is likely that more cases will be investigated and prosecuted. Federal Reserve Bank of Atlanta Strategic trade policy also falls under the rubric of industrial policy and may be still another obstacle to completing the internal market and realizing its benefits. Critics of strategic trade policy (and, in fact, some growth policies) argue that the defense industry, being research-and-development intensive, creates positive spillovers into other industries. These externalities come in the form of innovations useful for consumer and industrial products and thereby give a country a competitive edge. Reliance on strategic trade policy to foster national growth interferes with the competitive spirit of the 1992 program, and such national benefits may come at the expense of EC-wide growth. On the other hand, the use of strategic alliances— those in which companies from the same or different member states but within the same industry join together (without ceding corporate control)—may overc o m e any nationalistic tendencies. Alliances have already been formed in the auto, semiconductor, financial services, t e l e c o m m u n i c a t i o n s , electronics, civil aviation, aerospace, defense, communications, computer, chemical, and pharmaceutical industries. 10 At the same time, the EC's views on the competitive effects of strategic alliances have yet to be shaped (Rosenthal 1990). It is too early to tell whether these alliances will help or hinder competition. A more insidious f o r m of industrial policy that may be employed to protect domestic interests involves use of "national security" as an argument to shut out nonnational companies not only in the defense industry but also in other industries such as the airline industry, e l e c t r o n i c s , t e l e c o m m u n i c a t i o n s , computers, and even textiles or footwear. Clearly, reliance on national security arguments offers a loophole allowing the appearance of compliance with free trade directives while in reality the directives are being circumvented. European Monetary and Political Union. Outside the 1992 program, other distinct but related issues—such as monetary and political union—threaten completion of the internal market. Although European monetary union and political union are neither part of the Single European Act, treaties outlining EC positions on these issues are expected to be produced. In the meantime, the act can be fully carried out with or without monetary or political union. The threat to success lies in the possibility that m e m b e r states d i s s a t i s f i e d with E C g u i d e l i n e s on p o l i t i c a l and monetary union could exert pressure by not fully implementing the internal market directives. As for monetary union, the benefits of a single European currency in terms of eliminating transactions Economic Review 35 costs of currency conversion and associated uncertainty about exchange rate movements seem clear. Not so certain is what monetary union would mean for monetary and even fiscal sovereignty. According to Delors's plan, the ultimate issuance of a single currency would require transferral of monetary authority to a European System of Central Banks (ESCB). 11 Considerable progress has already been made toward coordinating monetary policy under the E u r o p e a n Monetary System; however, if monetary policy is not available to any degree as an instrument for conducting national e c o n o m i c policy, m e m b e r c o u n t r i e s ' control over interest rates, exchange rates, inflation, unemployment, and related variables will be m o r e difficult. A related concern is the impact that monetary union, through requiring limits on each m e m ber's government finance, would have on the taxing and spending authority of each member state. There is currently no outline for political union like the Delors plan for monetary union. Political union inside the E C m e a n s m o r e than adopting a common foreign policy. For countries like Italy, Holland, D e n m a r k , and Greece, it means d r a f t i n g EC s t a n c e s on t o u r i s m , the e n v i r o n m e n t , c o n s u m e r rights, and culture. For others, particularly the United Kingdom and France, such discussion is alarming bec a u s e it f o r e b o d e s m a n a g e m e n t e m a n a t i n g f r o m Brussels and not from the capitals of each member state. Most likely, the principle of "subsidiarity"— whereby items are delegated to either the EC level or the state level, whichever can most effectively handle t h e m — w i l l be m a n d a t e d , offering some insurance against the movement of national discretion to Brussels. Requiring a unanimous vote to confirm foreign policy decisions would also help limit a transfer of powers from the member states to Brussels. Political union requires institutionalizing democratic and legislative procedures as well as representation and voice. Items like unanimous or majority voting, equal or weighted representation, the status of the EC Parliament, and powers of the European Court of Justice—currently determined by national bodies—all lie in the purview of political union. Revamping at both the national and EC levels is not likely to be as swift nor as consensual as the development of the Single European Act. The eventual outcome of monetary and political union, and perhaps fiscal union, will be an amalgam of quid pro quo negotiations on each. The three are intimately tied because they all address the same fundamental issue: how much national sovereignty are the member states willing to cede to the EC? " H o w Economic Review 36 much" depends on the economic, social, and political costs and benefits each member expects. Conclusion The 1992 plan has certainly brought with it more than was originally laid out in the White Paper of 1985 when the resolve to complete full economic integration took shape. The plan has served not only as the m a p toward e c o n o m i c integration but has also pointed in the direction of monetary and political union. To be sure, Europe has been and is undergoing a metamorphosis. Since the writing of the 1985 White Paper, EC members have taken a serious look at their ways of doing business with each other. Almost all aspects of the European economic, legal, social, and political environment have been touched. Everything from border and customs controls, banking regulation and health and safety standards to foreign policy and the penal system has been reevaluated. Full or even partial completion of the 1992 agenda rests entirely on each member state's perceptions of the benefits and costs—economic, legal, social, and political. Anticipation of the benefits projected by the C e c c h i n i R e p o r t m u s t be c o u n t e r b a l a n c e d by the probability that unexpected costs and obstacles may arise as the 1992 program is implemented. The ceding of sovereignty is probably the largest cost that each of the member states has to consider. Unfortunately, it is at the heart of contention over many of the remaining directives. While some of the directives of the 1992 agenda are easy to keep separate from the sovereignty issue, others are more entwined. The removal of administrative and border controls, mutual recognition of product standards, and harmonization of trade policies with respect to n o n m e m b e r s h a v e proceeded w i t h o u t m u c h d i s c u s s i o n o v e r s o v e r e i g n t y . Not surprisingly, these points are the ones on which the m o s t progress has been made. Those items in which sovereignty is at issue—particularly industrial and national security policy, labor laws, taxation, and, outside the 1992 plan, European monetary and political u n i o n — c o u l d become big stumbling blocks to completing the internal market, especially if concessions on completing the internal market are made in return for agreement on the substance of monetary and political union. Requiring unanimous approval on the directives before they become EC law as well July/August 1991 as foot-dragging by the members in enacting them into national legislation will also make continued progress on the 1992 agenda more tedious and slow-moving. Some of the benefits and costs spelled out here and in other places will not be evident until the countries have begun participation in the plans. The very fact that EC law must be written into national law gives the member states time to react to the 1992 plan and then decide whether participation is worthwhile. Furthermore, participation by each member will continue to depend on what that country considers its alternatives. It is worth remembering that each country is traveling an unknown road that is not "one way." The final destination for each member and thus for the EC as a whole may be different in its specifics than originally envisioned but no less desirable. Appendix Key Provisions of the Single European Act, Effective July 1,1987 Research and technological development: Institutional Provisions • n e w goals f o r competitiveness, c o m m o n stan- C h a n g e s in l e g i s l a t i v e p r o c e s s : • q u a l i f i e d m a j o r i t y v o t i n g in C o u n c i l of M i n i s t e r s • " c o o p e r a t i o n p r o c e d u r e " t o i n c r e a s e r o l e of work programs" Environmental policy: European Parliament • assent procedure for new E C membership • environmental, health, and natural resource objectives applications • p r i n c i p l e s f o r legislative a c t i o n a n d f o r liability • i m p l e m e n t i n g p o w e r s f o r rule m a k i n g by • a c t i o n at C o m m u n i t y l e v e l s e c o n d a r y t o a c t i o n Commission E s t a b l i s h m e n t o f C o u r t of First I n s t a n c e u n d e r E u ropean Court of Justice dards, and research and development " f r a m e - / Internal Market Provisions 1 9 9 2 d e a d l i n e f o r c o m p l e t i o n of i n t e r n a l m a r k e t Qualified majority voting for most " 1 9 9 2 " measures, replacing Luxembourg Compromise requirement of unanimity; e x c e p t i o n s f o r m e a s u r e s affecting taxes, free m o v e m e n t of persons, rights of e m ployed persons at m e m b e r - s t a t e l e v e l Foreign Policy Provisions E u r o p e a n Political C o o p e r a t i o n ( E P C ) outside ins t i t u t i o n a l f r a m e w o r k of E C Undertakings: • m e m b e r states' e n d e a v o r to achieve joint formulation and implementation of E u r o p e a n foreign policy • p r i o r c o n s u l t a t i o n a n d c o n s i d e r a t i o n of o t h e r member-state views Other Amendments to EC Treaties Economic and monetary policy: • i n c r e a s e in c o o p e r a t i o n e f f o r t s • m e m b e r state c o n f e r e n c e required for institutional c h a n g e s Social policy: • regular meetings; i n v o l v e m e n t of C o m m i s s i o n and Parliament • c o n s i s t e n c y o f e x t e r n a l p o l i c i e s of E C a n d EPC; cooperation between E C and E P C delegations to third countries and internal organizations • n e w m e a s u r e s f o r h e a l t h a n d s a f e t y of w o r k e r s • possible coordination o n national security issues • C o m m i s s i o n r o l e in l a b o r r e l a t i o n s • e s t a b l i s h m e n t of f o r e i g n p o l i c y s e c r e t a r i a t in • e m p h a s i s on reduction of regional disparities Brussels a n d i n c r e a s e in s t r u c t u r a l f u n d s f o r s o c i a l a n d r e g i o n a l aid Source: Adapted f r o m Powers (1989). Digitized forF eFRASER d e r a l R e s e r v e B a n k o f Atlanta Economic Review 37 Notes 1. A White Paper is an official government report that typically recommends changes for the topic under investigation. 2. The unanimity rule is still operative in cases in which legal issues arise regarding turnover taxes, consumer taxes, indirect taxes, health, safety and environment, and the free movement and rights and interests of workers. 9. EC standards organizations like the European Committee lor Standardization (CEN) and the European Committee for E l e c t r o t e c h n i c a l S t a n d a r d i z a t i o n ( C E N E L E C ) a r e working to agree on EC-wide standards for some industrial products. Adherence to the standards, however, will not be compulsory. 3. For an expanded treatment of the European Commission's expectations for the 1992 program, see Emerson (1989). 4. For a chart that illustrates the propagation of these gains, see Cecchini (1988, 100). 5. A c o m p l e x s c h e m e of " m o n e t a r y c o m p e n s a t o r y a d j u s t m e n t s " is used to prevent e x p l o i t i n g c r o s s - c o u n t r y support-price differentials. 6. The estimated gains are contingent upon assumed reductions in import prices. 7. A n d r e a s van A g t , a m b a s s a d o r of the EC to the United States, contends that monetary union will not be achieved until the late 1990s (speech given at the Federal Reserve Bank of Atlanta, February 11, 1991). 10. Along similar lines, the pan-European initiative known as Eureka encourages industries and universities from across Europe to collaborate in research and development for commercial application in areas ranging from medicine and b i o t e c h n o l o g y to c o m m u n i c a t i o n s to l a s e r s a n d robotics. 8. Even though the EC members fix rates against each other, allowance of a ± 2 . 2 5 percent c h a n g e ( ± 6 . 0 percent for Spain and the United Kingdom) is permitted and realignments do occur. Currency changes of this magnitude, although small, can cut into profit margins in the single digits. 11. The Delors plan for monetary union follows three stages. The first stage calls for convergence of economic performance and cooperation in monetary and fiscal policy. All restrictions to capital mobility are to be removed. In the second stage, the ESCB would be set up and gradually begin operation. Policy-making would gradually be transferred from the members' central banks to the European Central Bank. The exchange rate banks would also be narrowed. In the third stage, there would be an irrevocable locking of exchange rates (no realignments possible) and ultimately the issuance of a single currency controlled by the ESCB. References Baldwin, Richard E. "The Growth Effects of 1992." Economic Policy 4, no. 2 (1989): 277-89. B r i m e l o w , Peter. " T h e Dark Side of 1992." Forbes, January 22, 1990, 88. "British Spat with EC over Pollution Shows What 1992 May Bring." Wall Street Journal, December 14, 1989, A I , A16. Cecchini, Paolo. The European Challenge 1992: The Benefits of a Single Market. With Michel Catinat and Alexis Jacquemin. Translated by John Robinson. Aldershot, England: Wildwood House, 1988. Commission of the European Communities. "A Community of Twelve: Key Figures." European File no. 3-4/89. March 1989. The Economist Intelligence Unit. European Trends: Key Issues and Developments in the EC, EFT A, and Single Market, no. 2, 1991. Emerson, Michael. The Economics of Nineteen Ninety-Two: The E.C. Commission's Assessment of the Economic Effects of Completing the Internal Market. New York: Oxford University Press, 1989. " E u r o p e ' s Rhetoric and Reality." The Economist, September 23, 1989, 64. "Five EC Nations Agree to End Controls on Immigration, Travel Among Them." Wall Street Journal, June 14, 1990, A l l . Hufbauer, Gary Clyde. "An Overview." In Europe 1992: An American Perspective, edited by Gary Clyde Hulbauer, 5354. Washington, D.C.: Brookings Institution, 1990. Economic Review 38 "If You Sincerely Want to be United States " The Economist, March 23, 1991,21-24. Morlenson, Jorgen. "Federalism vs. Co-ordination: Macroeconomic Policy in the European Community." Center for European Policy Studies, Brussels, Working Paper no. 47, 1990. Peck, Merton J. "Industrial Organization and the Gains f r o m Europe 1992." Brookings Papers on Economic Activity 2 (1989): 277-99. Powers, Linda F. "The Single European Act and ' 1 9 9 2 ' . " In 1992—New Opportunities for U.S. Banks and Business in Europe, 15-16. New Y o r k : A m e r i c a n Bar Association, 1989. R o b e r t s , Paul C r a i g . " E u r o p e 1992: Free M a r k e t or Free Lunch?" Business Week, June 4, 1990, 26. R o s e n t h a l , D o u g l a s E. " C o m p e t i t i o n P o l i c y . " In Europe 1992: An American Perspective, edited by Gary Clyde Hufbauer, 293-344. Washington, D.C.: Brookings Institution, 1990. Smith, Alasdair, and Anthony J. Venables. "Automobiles." In Europe 1992: An American Perspective, edited by Gary Clyde Hufbauer, 119-58. Washington, D.C.: Brookings Institution, 1990. "Sticking Points: Is the 1992 Timetable for European Integration Too Optimistic?" Wall Street Journal, September 21, 1990, R 3 7 . R 3 8 . July/August 1991 Commercial Bank Profitability: Hampered Again by Large Banks' Loan Problems Robert E. Goudreau and B. Frank King Z arge U.S. commercial banks recorded exceptionally high loan-loss provisions for the second year in a row in 1990. The losses flattened large banks' margins and rates of return at levels well below those of their smaller counterparts. Profitability of the smaller banks, which had improved every year since 1987, held relatively steady in 1990. 1 In the industry as a whole profitability therefore remained essentially stable, with slight declines in interest margins and return on equity and steady return on assets. After three years of increase, profit ratios for the smallest banks (those with assets below $25 million) held steady, continuing to be below figures recorded by their most consistently profitable competitors, which during the 1986-90 period were banks with assets between $50 million and $500 million. The smallest banks' primary disadvantage was again higher noninterest costs than other banks. In each bank size group except the largest two, profitability growth stalled at the most and least profitable institutions, breaking a two-year pattern of increase. However, the least profitable of the banks with assets of more than $500 million reported sharply diminished profitability. The authors are, respectively, an assistant economist in the financial section of the Atlanta Fed's research department and the department's associate director of research. They thank Sherley Wilson for her valuable research assistance. Digitized Federal for FRASER Reserve Bank of Atlanta Southeastern banks' profitability followed the national pattern in 1990 with two notable exceptions. 2 At the largest banks, interest margins and returns on assets and equity dropped from levels well above their national counterparts in 1989 to quite similar levels. Rising provisions for loan losses, which had plagued large banks in other parts of the nation in previous years, seriously affected the regions' largest banks in 1990. The smallest banks also stood out. As profitability measures for the nation's banks with assets totaling less than $25 million leveled off, return on assets and equity for the smallest banks in the Southeast deteriorated for the fifth year in a Economic Review 39 row, closely approaching zero. New banks in Florida and G e o r g i a — w h i c h have grown slowly yet incur considerable noninterest operating expenses—along with some high-loss, low-asset trust c o m p a n i e s in Florida were primarily responsible for the poor record of the smallest banks. The extensive tables at the end of this article contain a substantial amount of information about bank profitability in 1990 and preceding years. The remainder of this presentation highlights some of the more interesting patterns that emerged or continued last year. Profitability at the Nation's Banks Profitability M e a s u r e s . Bank profitability can have different meanings. For the purposes of this report the focus is on three profitability measures and their components: net interest margin, return on assets (ROA), and return on equity (ROE). 3 These measures are described in detail in the appendix. Briefly, net interest margin indicates a bank's interest revenues less interest costs as a proportion of interest-earning assets. For this analysis, revenues are adjusted to take into account different proportions of tax-free interest income earned by various banks and for estimated credit risk. The credit risk adjustment is calculated by subtracting a bank's annual additions to reserves for loan losses, which are assumed to approximate expected losses, from interest earnings. Net interest margin is similar to a business's gross profit margin, differing among other ways in that it omits earnings from fees for services provided, an increasingly important source of revenue for the nation's largest banks. Return on assets (ROA) and return on equity (ROE) are more general measures of a bank's ability to earn from its total operation. A measure of net income as a proportion of total assets, ROA gauges a bank's effectiveness in using all of its financial and real investments to earn interest and fees. ROE reflects how well a bank is using shareholders' investments. Profitability Patterns. The adjusted net interest margin of 3.07 percent for U.S. commercial banks last year was about the same as 1989's 3.13 percent margin. Large banks again depressed overall profitability. Their large-scale additions to loan-loss provisions held their interest margin adjusted for both risk and taxexempt income to a level well below that of other banks. 4 interest revenue declined more than interest expense in most size classes as well, resulting in slight margin declines for other banks as well. (See Tables 1 40 Economic Review and 3 for data on net interest margins and loan-loss expenses by size class for the years 1986-90.) The nation's commercial banks with more than $1 billion in assets maintained 1989's relatively high additions to loan-loss reserves, and banks with assets between $500 million and $1 billion significantly increased their additions. These additions primarily reflected rising delinquencies on commercial and industrial and commercial real estate loans. 5 Adjusted margins for most other size classifications were only slightly below the levels r e c o r d e d in 1989, while banks with assets less than $25 million continued a rebound begun in 1986 to record the highest margin of any size group. As in past years, declining loan losses accounted for most of their improvement. The most significant variation in margin components (shown in Tables 2 through 4) among size groups lay between the largest banks and those in other categories. In recent years, commercial banks with assets greater than $1 billion experienced somewhat better interest earnings but markedly higher interest expenses per dollar of interest-earning assets than did banks in any other asset classification. These largest banks, which raise greater proportions of their funds in the money markets than other banks, paid interest expenses 25 percent above the average interest expense faced by smaller banks. Accordingly, interest margins for banks with more than $1 billion in assets have been substantially lower relative to other asset classes. This pattern continued in 1990. The pattern is evident even if occasionally dramatic changes in the largest banks' loan-loss reserves are ignored. (The difference between interest revenues and interest expenses, excluding additions to loanloss provisions, for different size U.S. banks over the 1986-90 period are displayed in Table 5.) The difference between interest revenue (unadjusted for addit i o n s to p r o v i s i o n s f o r loan l o s s e s ) and i n t e r e s t expense margins has been quite similar over time and across all size categories of banks except the largest during the past five years. Lower interest revenues minus interest-expense margins have restrained profitability for the largest banks in recent years, while abrupt changes in loan-loss provisions h a v e m a d e yearly profitability for this class quite variable. Moreover, changing profitability for the nation's largest banks, which account for an overwhelming majority of banking assets, has played a major role in determining annual profitability for the entire industry. Excluding the smallest banks, which recorded stable R O A of 0.61 last year, and the largest banks, which reported an incremental increase of 4 basis July/August 1991 points to 0.39 percent, moderate declines in adjusted interest margins for the other bank categories generally translated into moderately lower returns on assets (see Table 6). A m o n g the various categories, under-$25 million banks showed the highest adjusted margin and the lowest increase in loan-loss provisions, yet the aggregate R O A for these banks rem a i n e d below the returns for all but their largest competitors. These under-$25 million banks seem to have earned lower returns principally as a result of higher noninterest expenses (see Table 7). Noninterest expenses for the smallest U.S. banks averaged 3.8 percent of total assets during the 1986-90 period, noticeably surpassing noninterest expense-to-assets ratios for other asset classifications. 6 The pattern for return-on-equity changes nationwide was a magnified version of ROA changes (see Table 8). 7 ROE was down in each size class but the largest, for which it rose about 11 percent. The larger banks, which typically maintain lower equity ratios, returned more on book value of equity per every dollar of ROA. 8 The ROE for the country's smallest and largest b a n k s r e m a i n e d well b e l o w that of o t h e r banks, casting some doubt on the longer-term vitality of both groups of banks as they are now structured. Southeastern Banks Unlike 1989, when provisions for less developed country (LDC) loans contributed to increased loan losses nationally but had only a modest impact on the Southeast's banks, additions to loan-loss reserves hit the region's largest banks as hard as they did the nation's in 1990. 9 (Data on southeastern b a n k s ' profitability are in Tables 9-15.) Consequently, last year's adjusted interest margin for the region's largest banks fell from 3.71 percent to 3.16 percent, return on assets dropped from 0.62 to 0.42 percent, and return on equity declined from 9.79 percent to 6.54 percent. Loanloss provisions for southeastern banks with assets exceeding $1 billion jumped from 0.87 to 1.30 percent of interest-earning assets. N o n p e r f o r m i n g real estate loans b e c a m e m u c h m o r e p r e v a l e n t in the Southeast and had a major effect on the region's large banks. Among the other banks, margins were generally steady; however, an increase in adjusted interest earnings for the $500 million-to-$l billion category raised its margin sharply. 10 While profitability for the nation's smallest banks has advanced to more respectable levels since 1986, Digitized forFederal FRASER Reserve Bank of Atlanta earnings performance for the region's under-$25 million banks stalled at half the national level in 1989 and fell drastically in 1990. These banks returned a slim 0.07 percent on assets last year compared with 0.61 percent for national counterparts. Poor returns on assets and equity for the region's smallest banks can be traced to two sources: a concentration of small new banks in Florida and Georgia and relatively high additions to loan-loss provisions at small banks in Florida and Tennessee. Banks established during the past five years in the Southeast are concentrated in Florida and Georgia. Many of these banks have grown slowly and are recording high noninterest expenses relative to their size. Hence their return on assets is quite low or negative. In Florida, for instance, forty-three of the seventyf i v e s m a l l e s t b a n k s r e c o r d e d n e g a t i v e r e t u r n s on assets in 1990. Of these forty-three banks, twentyseven had been e s t a b l i s h e d since 1986. F l o r i d a ' s smallest banks' R O A measures were further reduced by a small group of newer banks specializing in trust business. This group recorded the high noninterest expenses associated with trust management, reported overall losses, and, because assets on their own books were low, showed unusually high negative ROAs. Poor loan-loss e x p e r i e n c e also depressed profitability of the smallest banks in Florida and in Tenn e s s e e . A l t h o u g h the u n d e r - $ 2 5 m i l l i o n b a n k s in neither of the two states matched the loan-loss reserve additions of the largest banks in their states, the increase in their provisions averaged more than 0.90 percent of total assets, almost twice that of their national counterparts and other small banks in the region. Despite low returns at the smallest banks, southeastern banks as a group attained a 0.54 percent return on assets versus 0.51 percent nationwide. T h e region's advantage was considerably larger in 1989, but 1990 returns deteriorated sharply at banks in the $50$100 million asset size category as well as the largest and smallest categories in the region. Profitability patterns for the region's states changed in several ways (see Tables 16-21). Georgia banks' problems allowed Alabama banks to climb to the top in ROA and ROE after vying for several years with each other for the region's best profitability. Alabama banks as a group returned 1.03 percent on assets versus a 0.94 percent ROA for Georgia banks and only 0.54 for the region. Returns on assets for the remaining southeastern states, except Louisiana, declined in 1990. In particular, last y e a r ' s loan-loss provisions for Florida and Tennessee banks rose markedly because of now-sour Economic Review 41 real estate loans that were made in overbuilt areas of these states. Heightened loan-loss provisions drove Florida banks' net interest margin to 3.19 percent, only a bit above Louisiana's. Florida banks' return on assets dropped to a meager 0.29 percent, again just slightly ahead of Louisiana's improved earnings. Louisiana banks, which have struggled for years in a weak, energy-based economy, reduced statewide additions to loan-loss provisions to achieve their 0.24 percent ROA. Although this return is still modest, it r e p r e s e n t s an i m p r o v e m e n t f o r L o u i s i a n a b a n k s , which as a group had not recorded discernibly positive profitability since 1985, the year before oil prices fell from previously robust levels. TTie Distribution of Bank Profitability A n a l y z i n g c h a n g e s in o v e r a l l p r o f i t a b i l i t y f o r banks of differing profitability levels can help evaluate the degree to which banks have been successful in responding to difficulties facing financial institutions during the 1980s. One way to analyze the distribution of bank profitability within a given asset-size category is to rank all banks in that category in ascending order of profitability, divide the group into quartiles, and describe the profitability of the most profitable bank in each quartile. For example, the banks with the best ROA in the first (lowest) quartile would be those at the 25th percentile; that is, 25 percent of the banks in a particular size category are less profitable than the bank at the 25th percentile. Comparing the profitability of the bank at the 25th percentile over time would indicate the degree to which the least profitable banks in that asset category are e x p e r i e n c i n g imp r o v e m e n t or deterioration in e a r n i n g s . L i k e w i s e , c o m p a r i n g the R O A for the bank at the 75th percentile over time would indicate changes in the earnings of the more profitable banks in that size category. A rise in profitability over time at the various percentiles suggests improved conditions; d o w n w a r d movements indicate deterioration. Tables 22 through 27 present the national profitability distribution for each of the six asset-size categories during the past five years. Last year the three smallest categories of 25th percentile banks, those with assets under $100 million, logged returns on assets equal to or slightly below 1989 ratios. The weakest banks in the three larger asset classes experienced more clearly decreased profitability. The greatest decline occurred for the least 42 Economic Review profitable $1 billion-plus banks, for which last year's return on assets plunged to 0.10 percent, only onefifth of the preceding year's ROA. Reversing a twoyear i m p r o v e m e n t , profitability for nearly all size classes of 50th and 75th percentile banks diminished modestly in 1990. For banks in size classes with asset holdings less than $1 billion, the declines ranged from 1.0 to 9.4 percent; however, the ROA for the median $1 billion-plus bank declined by one-fourth. Conclusion Loan losses and thin interest margins continued to plague the largest banks in the nation and the region. The largest commercial banks in the nation recorded returns on assets less than half that of banks in the $50 million-to-$l billion size range for the second year in a row, primarily because of continued largescale additions to loan-loss provisions. Troubled commercial real estate loans in several regions of the country m a d e increased provisions necessary and sharply affected large banks in the Southeast. Last year's profitability for banks in other asset categories in the nation as a whole was comparable to 1989's. Improvements in returns on assets for the two smallest bank classes stalled and still stand some 10 to 20 basis points below the returns for m i d s i z e banks, which were the most consistently profitable throughout the 1986-90 period. Weaker banks in the small size categories held their own during 1990, while earnings of the weakest large banks moved down. The nation's least profitable $1 billion-plus banks suffered the worst decline. In fact, profitability for at least a majority of the nation's largest banks narrowed last year as the ROA for this category's 50th percentile bank fell by one-fourth. Profitability for southeastern banks was basically the same as the nation's with two exceptions. Unlike their national c o u n t e r p a r t s , the smallest size regional banks continued to experience falling profit ratios, for the fifth year in a row. A concentration of small new banks in Florida and Georgia was responsible for much of this poor performance. In contrast to their better-than-national 1989 performance, the region's largest banks sharply increased their loan-loss provisions. Return on assets for these banks last year approximately equaled the return for national counterparts. Alabama banks were the region's most profitable during 1990, with Georgia banks a close second. In- July/August 1991 creased provisions for anticipated loan losses crimped profitability for Florida, Louisiana, and Tennessee banks. However, after a lengthy, difficult workout of poorly performing loans, Louisiana banks appear to be back on track. Their combined profitability was discernibly positive for the first time in five years. Appendix Profitability Measures Three different measures have been used to provide information on bank performance: adjusted net interest margin, return on assets, and return on equity. Adjusted net interest margin gauges the difference between a bank's interest income and expenses and is roughly similar to a busin e s s ' s gross p r o f i t m a r g i n . Gross profit is the a m o u n t received from sales minus the cost of goods or services sold; other expenses such as sales, advertising, salaries, and rent have not been deducted. For banks, this indicator is calculated by subtracting interest expense from tax-adjusted interest revenue (net of loan-loss provisions) and dividing that result by net interest-earning assets. For this calculation, interest revenue from tax-exempt securities is adjusted upward by the b a n k ' s marginal tax rate to avoid penalizing institutions that hold substantial state and local securities portfolios, which reduce tax burdens. Loan-loss expenses are subtracted from interest revenue to place banks that make lower-risk loans at lower interest rates on a more equal footing with commercial banks that make higher-risk loans, which can generate greater interest income. For example, interest rates on credit cards have been substantially higher than rates on prime commercial loans, but loan losses on credit cards have also been larger. Charge-offs on credit cards were 2.9 percent of total credit card volume in 1989 for the nation's top 100 banks in credit card operations, according to "Top 100 Banks in Credit Card Operations." Banks also bring in noninterest revenue in the f o r m of loan origination fees; deposit service charges; charges for letters of credit, loan commitments, and other off-balancesheet services; and gains f r o m the sale of securities, to name a few. In addition, they incur noninterest expenses such as e x p e n d i t u r e s on e m p l o y e e s a l a r i e s , c o m p u t e r equipment, and maintenance. Therefore, Bank X with a comparatively low adjusted interest margin may achieve a higher return on assets than Bank Y, which attained a larger margin. That is, Bank X may record a higher return on assets by realizing higher noninterest revenues or lower noninterest expenses. The return on assets (ROA) ratio—the result of dividing a b a n k ' s net income by its average assets—gauges how well a bank's management is using the f i r m ' s assets. The return on equity (ROE) figure tells a b a n k ' s shareholders how much the institution is earning on the book value of their investments. R O E is calculated by dividing a bank's net income by its total equity. The ratio of ROA to ROE Federal Reserve Bank of Atlanta falls as the b a n k ' s capital-to-assets ratio rises. S m a l l e r banks typically have higher capital-to-asset ratios. Analysts who want to compare profitability while ignoring differences in equity capital ratios tend to focus on R O A . Those wishing to focus on returns to shareholders look at ROE. Highly capitalized banks that post the same return on assets as less well capitalized competitors will record a lower return on equity. Because return on equity is computed by dividing a bank's net income by its capital reserve, a bank's return on equity will decline as its capital reserve increases, assuming net income remains fixed. Profitability Data and Calculations The data in this article are taken from reports of condition and income filed with federal bank regulators by insured commercial banks. The sample consists of all banks that had the same identification number at the beginning and end of each year. The number of banks in the 1990 sample is 12,149. The three profitability measures used in this study are defined as follows: Adjusted Net Interest Margin = Expected Interest Revenues - Interest Expense Average Interest-Earning Assets Return on Assets = Net Income Average Consolidated Assets Return on Equity = Net Income Average Equity Capital A v e r a g e interest-earning assets, consolidated assets, and equity capital are derived by averaging beginning-, middle-, and end-of-year balance sheet figures. The expected interest income component to net interest margin incorporates two significant adjustments from ordinary interest income. If profits before tax are greater than zero, the lesser of revenue from state and local securities exempt from federal tax or the b a n k ' s profits before tax is divided by 1 minus the b a n k ' s marginal federal tax rate. Loan-loss expenses are subtracted from interest revenue. Economic Review 43 Table 1 Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets (Insured commercial banks by consolidated assets) Year All Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$500 million $500 millionSi b i l l i o n $1 b i l l i o n + 1986 3.33 3.54 3.73 3.89 3.91 3.96 3.05 1987 2.67 3.81 3.95 4.11 4.19 3.86 1.98 1988 3.74 4.04 4.15 4.25 4.28 3.84 3.53 1989 3.13 4.23 4.31 4.36 4.37 4.16 2.61 1990 3.07 4.29 4.27 4.27 4.16 3.97 2.60 Source: Figures in all tables have been computed by the Federal Reserve Bank of Atlanta from data in "Consolidated Reports of Condition for Insured Commercial Banks" and "Consolidated Reports of Income for Insured Commercial Banks," 1986-90, filed with each bank's respective regulator. Table 2 Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets (Insured commercial banks by consolidated Year All Banks $0-$25 million $25-$50 million $50-$ 100 million 1986 10.17 10.77 10.73 10.68 1987 9.85 9.94 10.00 1988 10.65 10.12 1989 11.62 1990 11.26 assets) $100-$ 500 million $500 millionSi billion $1 b i l l i o n + 10.51 10.71 9.93 9.99 10.04 9.99 9.78 10.18 10.24 10.35 10.30 10.83 10.72 10.86 10.89 11.14 11.28 11.87 10.61 10.72 10.72 10.84 11.15 11.44 Table 3 Loan-Loss Expense as a Percentage of Interest-Earning Assets (Insured commercial Year All Banks $0-$25 million 1986 0.92 1.33 1987 1.48 1988 $25-$50 million banks by consolidated assets) $50-$ 100 million $100-$500 million $500 millionSi billion $1 b i l l i o n + 1.10 0.96 0.90 1.02 0.88 0.94 0.83 0.68 0.69 0.90 1.84 0.65 0.72 0.63 0.57 0.59 0.79 0.66 1989 1.10 0.58 0.55 0.49 0.58 0.69 1.33 1990 1.10 0.48 0.49 0.49 0.64 0.98 1.30 44 Economic Review J u l y / A u g u s t 1991 Table 16 Interest Expense as a Percentage of Interest-Earning Assets (Insured commercial banks by consolidated assets) Year All Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$ 5 0 0 million $500 millionSi billion $1 b i l l i o n + 1986 5.92 5.91 5.91 5.83 5.70 5.73 5.99 1987 5.71 5.19 5.23 5.19 5.16 5.23 5.96 1988 6.27 5.36 5.39 5.42 5.48 5.67 6.63 1989 7.38 5.91 6.01 6.04 6.18 6.42 7.93 1990 7.09 5.85 5.96 5.96 6.03 6.19 7.55 Table 5 Tax Equivalent Interest Earnings Less Interest Expense as a Percentage of Interest-Earning Assets (Insured commercial banks by consolidated assets) $50-$ 100 million $100-$500 million $500 millionSi billion $1 b i l l i o n + 4.85 4.82 4.98 3.93 4.77 4.79 4.88 4.76 3.81 4.76 4.78 4.82 4.87 4.63 4.19 4.23 4.81 4.86 4.86 4.95 4.85 3.93 4.17 4.76 4.77 4.76 4.80 4.95 3.89 Year All Banks $0-$25 million $25-$50 million 1986 4.25 4.86 4.82 1987 4.15 4.75 1988 4.39 1989 1990 1 Table 6 Percentage Return on Assets (Insured commercial banks by consolidated assets) Year All Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$ 5 0 0 million $500 million$1 b i l l i o n $1 b i l l i o n + 1986 0.63 0.09 0.46 0.62 0.68 0.61 0.65 1987 0.99 0.26 0.46 0.66 0.75 0.51 20.15 1988 0.84 0.36 0.61 0.77 0.81 0.58 0.89 1989 0.51 0.61 0.74 0.88 0.92 0.88 0.35 1990 0.51 0.61 0.72 0.82 0.81 0.77 0.39 Digitized for F eFRASER d e r a l R e s e r v e B a n k of A t l a n t a Economic Review 45 Table 7 Total Noninterest Expense as a Percentage of Total Assets (Insured commercial All Banks Year banks by consolidated $0-$25 million $25-$50 million $50-$ 100 million assets) $100-$500 million $500 millionSi billion $1 bill ion-H 1986 3.1 3.7 3.3 3.1 3.2 3.4 3.0 1987 3.2 3.8 3.3 3.2 3.2 3.4 3.2 1988 3.3 3.7 3.3 3.2 3.2 3.3 3.3 1989 3.3 3.8 3.3 3.2 3.2 3.2 3.3 1990 3.5 3.9 3.4 3.3 3.3 3.5 3.5 Table 8 Percentage Return on Equity (Insured commercial banks by consolidated assets) Year All Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$500 million $500 millionSi billion $1 b i l l i o n + 1986 10.10 0.91 5.34 7.72 9.43 9.00 11.84 1987 1.63 2.75 5.39 8.02 10.09 7.51 -2.80 1988 13.50 3.79 6.96 9.15 10.67 8.67 16.40 1989 7.94 6.30 8.22 10.20 11.95 12.72 6.20 1990 7.91 6.17 7.96 9.41 10.37 10.40 6.89 Table 9 Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets (Insured commercial 46 banks in the Southeast by consolidated assets) Year A l l SE Banks $0-$25 million $25-$50 million $50-$100 million $100-$ 5 0 0 million $500 millionSi billion $1 bill ion-t- 1986 4.24 4.18 4.19 4.24 4.24 3.78 4.30 1987 4.26 4.19 4.29 4.41 4.52 3.61 4.23 1988 4.34 4.30 4.27 4.35 4.44 4.17 4.34 1989 3.91 4.20 4.35 4.29 4.32 3.59 3.71 1990 3.58 4.19 4.35 4.19 4.18 4.07 3.16 Economic Review J u l y / A u g u s t 1991 Table 10 Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by consolidated assets) $500 million$1 b i l l i o n $1 b i l l i o n + 10.88 10.84 10.50 10.32 10.28 10.04 10.26 10.55 10.53 10.49 10.49 10.73 11.24 11.31 11.14 11.11 11.08 11.20 11.00 11.09 10.98 10.87 11.47 10.83 Year A l l SE Banks $0-$25 million $25-$50 million $50-$ 100 million 1986 10.72 11.15 11.11 11.05 1987 10.27 10.34 10.43 1988 10.64 10.54 1989 11.18 1990 10.91 $100-$ 500 million Table 11 Loan-Loss Expense as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by consolidated assets) $50-$ 100 million $100-$ 5 0 0 million $500 million$1 b i l l i o n $1 b i l l i o n + 0.92 1.00 1.24 0.70 0.88 0.69 0.68 1.22 0.80 0.71 0.69 0.58 0.61 0.56 0.66 0.79 0.81 0.62 0.53 0.60 0.96 0.87 1.06 0.74 0.54 0.62 0.63 1.05 1.30 $25-$50 million Year A l l SE Banks $0-$25 million 1986 0.86 1.13 1.02 1987 0.80 0.98 1988 0.64 1989 1990 i Table 12 Interest Expense as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by consolidated assets) Year A l l SE Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$ 5 0 0 million $500 millionSi b i l l i o n $1 b i l l i o n + 1986 5.63 5.84 5.90 5.89 5.64 5.81 5.49 1987 5.20 5.18 5.26 5.22 5.09 5.21 5.23 1988 5.66 5.53 5.59 5.60 5.45 5.76 5.73 1989 6.48 6.23 6.34 6.32 6.19 6.53 6.62 1990 6.28 6.07 6.20 6.17 6.06 6.34 6.36 Digitized forFFRASER e d e r a l R e s e r v e B a n k of A t l a n t a Economic Review 47 Table 13 Percentage Return on Assets (Insured commercial banks in (he Southeast by consolidated assets) Year A l l SE Banks $0-$25 million $25-$50 million $50-$ 100 million $100-$ 5 0 0 million $500 millionSi billion $1 b i l l i o n + 1986 0.82 0.33 0.63 0.74 0.74 0.55 0.94 1987 0.78 0.31 0.52 0.73 0.80 0.45 0.86 1988 0.82 0.30 0.51 0.81 0.81 0.86 0.87 1989 0.68 0.26 0.64 0.89 0.87 0.55 0.62 1990 0.54 0.07 0.67 0.71 0.84 0.65 0.42 Table 14 Total Noninterest Expense as a Percentage of Total Assets (Insured commercial A l l SE Banks Year banks in the Southeast by consolidated $0-$25 million $25-$50 million $50-$ 100 million $100-$ 5 0 0 million assets) $500 millionSi billion $1 bill ion-t- 1986 3.4 4.1 3.4 3.3 3.3 3.9 3.3 1987 3.4 4.9 3.5 3.3 3.4 3.6 3.4 1988 3.4 4.3 3.5 3.4 3.4 3.4 3.4 1989 3.3 4.4 3.5 3.3 3.3 3.4 3.3 1990 3.5 4.8 3.7 3.6 3.5 3.7 3.5 Table 15 Percentage Return on Equity (Insured commercial 48 banks in the Southeast by consolidated Year A l l SE Banks $0-$25 million $25-$50 million $50-$ 100 million 1986 11.87 3.25 7.01 8.83 1987 11.18 2.82 5.70 1988 11.64 2.80 1989 9.57 1990 7.48 $500 millionSi billion $1 b i l l i o n + 10.00 8.68 15.78 8.61 10.56 6.90 13.99 5.48 9.41 10.56 12.85 13.69 2.24 6.73 9.93 11.09 8.25 9.79 0.55 7.04 8.03 10.69 7.65 6.54 Economic Review $100-$ 5 0 0 million assets) J u l y / A u g u s t 1991 Table 16 Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by state) A l l SE Banks Alabama Florida Georgia Louisiana Mississippi Tennessee Year 4.24 4.73 4.56 4.71 2.40 4.12 4.37 1986 1987 4.26 4.50 4.30 4.95 2.98 4.39 4.21 4.34 4.47 4.37 4.98 3.41 4.21 4.11 1988 3.91 4.14 3.83 4.71 2.87 3.96 3.64 1989 3.58 4.11 3.19 4.32 3.12 3.87 3.38 1990 Table 17 Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by state) Year A l l SE Banks Alabama Florida Georgia 1986 10.72 10.83 10.77 10.98 1987 10.27 10.11 10.13 1988 10.64 10.60 1989 11.18 1990 10.91 Mississippi Tennessee 10.32 10.48 10.70 11.06 9.91 10.33 10.04 10.41 11.27 10.62 10.35 10.61 11.18 10.96 11.90 10.77 10.91 11.22 10.84 10.66 11.47 10.57 10.67 11.28 Louisiana Table 18 Loan-Loss Expense as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by state) A l l SE Banks Alabama Florida Georgia Louisiana Mississippi Tennessee Year 0.86 0.45 0.68 0.67 2.14 0.67 0.66 1986 0.80 0.45 0.77 0.72 1.61 0.61 0.64 1987 0.64 0.32 0.59 0.54 1.30 0.46 0.74 1988 0.79 0.41 0.78 0.58 1.48 0.51 0.95 1989 1.06 0.47 1.20 0.98 1.22 0.60 1.33 1990 Digitized forFFRASER e d e r a l R e s e r v e B a n k of Atlanta Economic Review 49 Table 19 Interest Expense as a Percentage of Interest-Earning Assets (Insured commercial banks in the Southeast by state) Year A l l SE Banks Alabama Florida Georgia Louisiana Mississippi Tennessee 1986 5.63 5.65 5.54 5.60 5.78 5.69 5.68 1987 5.20 5.16 5.06 5.39 5.32 5.36 5.18 1988 5.66 5.82 5.45 5.75 5.91 5.67 5.77 1989 6.48 6.62 6.35 6.61 6.42 6.44 6.63 1990 6.28 6.25 6.27 6.16 6.24 6.21 6.57 Table 20 Percentage Return on Assets (Insured commercial banks in the Southeast by state) Year A l l SE Banks Alabama Florida Georgia 1986 0.82 1.22 0.87 1.09 1987 0.78 1.08 0.75 1988 0.82 1.16 1989 0.68 1990 0.54 Louisiana Mississippi Tennessee -0.22 1.00 0.98 1.13 -0.07 0.88 0.89 0.78 1.15 0.03 0.85 0.84 1.01 0.62 1.10 -0.12 0.79 0.61 1.03 0.29 0.94 0.24 0.76 0.43 Table 21 Percentage Return on Equity (Insured commercial 50 banks in the Southeast by state) Year A l l SE Banks Alabama Florida Georgia 1986 11.87 15.15 14.21 16.41 1987 11.18 13.27 12.06 1988 11.64 14.39 1989 9.57 1990 7.48 Mississippi Tennessee -2.91 13.50 13.74 16.02 -0.93 11.49 12.33 12.20 15.76 0.41 10.91 11.54 12.55 9.56 14.41 -1.70 9.97 8.30 13.01 4.38 11.40 3.55 9.77 5.92 Economic Review Louisiana J u l y / A u g u s t 1991 Table 23 Percentage Return on Assets Table 22 Percentage Return on Assets (Insured commercial assets below banks $25 (Insured commercial with $25 million million) banks with assets of to $50 million) Percentile A c c o r d i n g t o Profitability Percentile A c c o r d i n g to Profitability Year 75% 50% 25% -0.26 1986 1.23 0.83 0.29 0.67 -0.03 1987 1.18 0.84 0.35 1.14 0.78 0.20 1988 1.24 0.93 0.53 1.20 0.84 0.38 1989 1.29 0.99 0.58 1989 1.16 0.83 0.38 1990 1.23 0.93 0.55 1990 Year 75% 50% 25% 1986 1.12 0.65 1987 1.09 1988 Table 25 Percentage Return on Assets Table 24 Percentage Return on Assets (Insured commercial $50 million banks with assets of (Insured commercial $100 million to $100 million) banks with assets of to $500 million) Percentile A c c o r d i n g t o Profitability Percentile A c c o r d i n g to Profitability 75% 50% 25% Year 75% 50% 25% Year 1986 1.28 0.94 0.45 1986 1.27 0.97 0.57 1987 1.25 0.92 0.52 1987 1.25 0.97 0.60 1988 1.28 0.98 0.64 1988 1.33 1.04 0.71 1.34 1.04 0.70 1989 1.37 1.07 0.77 1989 1990 1.26 0.99 0.65 1990 1.28 1.02 0.66 Table 27 Percentage Return on Assets Table 26 Percentage Return on Assets (Insured commercial $500 million (Insured commercial banks with assets of to $ 1 assets over $ 1 billion) banks with billion) Percentile A c c o r d i n g to Profitability Percentile A c c o r d i n g to ProfjtabHjty 75% 50% 25% Year 75% 50% 25% Year 1.19 0.92 0.55 1986 1.10 0.90 0.60 1986 1.20 0.94 0.47 1987 1.08 0.86 0.30 1987 1.29 1.00 0.56 1988 1.21 1.01 0.71 1988 1.30 1.06 0.64 1989 1.20 0.96 0.50 1989 1.30 0.96 0.41 1990 1.12 0.74 0.10 1990 Digitized for F e dFRASER e r a l R e s e r v e B a n k of Atlanta Economic Review 51 Notes 1. Six size categories of commercial banks are analyzed in this study. They are (1) banks with total assets of no more than $25 million, (2) banks with total assets exceeding $25 million and at most $50 million, (3) banks with total assets greater than $50 million and no more than $100 million, (4) banks with total assets exceeding $100 million, up to $500 million, (5) banks with total assets exceeding $500 million and at most $1 billion, and (6) banks with total assets greater than $1 billion. De novo banks are not included in this study. The ratios displayed are full-year profitability figures based on beginning-, middle-, and end-of-year balance sheets and income statements. Banks that commence operations during any particular year will be missing beginning-of-year data and perhaps more. See Table A on the following page. 2. In this study Southeast refers to the six states entirely or partially within the Sixth Federal Reserve District: Alabam a , Florida, Georgia, Louisiana, Mississippi, and Tennessee. 3. The revenue, expense, and profitability figures presented are generally similar to those displayed in prior bank profitability studies published in the Economic Review (see Goudreau and King 1990 for the most recent study). The figures may not be identical because the data have been corrected for reporting errors. Additionally, the interest revenue as a percentage of interest-earning assets ratio and adjusted net interest margins may differ from figures reported in previous studies because of corrections in the treatment of tax-exempt interest income. 4. The term loan-loss reserves is used interchangeably with loan-loss provisions in this article and should not be read mistakenly to mean that a bank sets aside funds (cash) in reserve to cover its loan losses. An increase in the loanloss account does not directly cause any change in the allocation of a bank's assets. An increase in loan-loss provisions reduces the net value of the bank's loans on its accounting records and its net income. Increases in provisions will also have a negative 52 Economic Review impact on a b a n k ' s equity capital as reported in its accounting records (additions to loan-loss provisions are subtracted f r o m bank e q u i t y ) and m a y trigger r e g u l a t o r y demands for additional equity. See Wall (1988, 39-41). 5. Loan problems worsened in 1990, with the bulk of troubled loans shifting generally from sour commercial real estate lending in the Southwest. The proportion of noncurrenl real estate loans at the end of 1990 was the highest since banks began reporting troubled loans in 1982. The 1990 deterioration was greatest in commercial real estate loans. Although most regions' commercial real estate loans deteriorated, larger banks in the Northeast region were hardest hit ("Commercial Banking Performance" 1990, 2). 6. There are three main components of total noninterest expense. They are (1) salaries and employee benefits, (2) expenses for premises and fixed assets, and (3) other noninterest expenses. The proportion of total noninterest expense was stable for under-$25 million banks, as well as other asset classes, during the 1986-90 period. Salaries and employee benefits account for almost half the total, expenses for premises and fixed assets absorb approximately 15 percent, and other noninterest costs equal about 40 percent of the total. 7. Equity-to-assets ratios for U.S. banks as a whole from 1986 to 1990 were 6.2, 6.1, 6.2, 6.4, and 6.4 percent, respectively. For southeastern banks, respective capital-toassets ratios were higher—6.9, 7.0, 7.1, 7.1, and 7.3 percent from 1986 to 1990, respectively. 8. Equity-to-assets ratios for banks in the six asset classifications in 1990 are shown in Table B. Equity-to-asset ratios for the different size banks took on a similar distribution during the preceding four years, but these equity ratios have risen moderately for each class over the 1986-90 period. 9. See Table C. See " C o m m e r c i a l Banking P e r f o r m a n c e " (1990, 2) for troubled real estate rates for other states and regions. 10. See Table D. July/August 1991 Table A U.S Commercial Banks, 1990 $100-$500 Million $50-$ 100 Million $500 million$1 Billion $0-$25 Million $25-$50 Million 3,204 3,134 2,741 2,449 250 371 Percent of U.S. Banks 26.4 25.8 22.6 20.2 2.1 3.1 49.0 109.7 184.7 458.4 163.8 2,327.1 Total Assets ($ billions) 1.5 3.3 5.6 13.9 5.0 70.7 Number of Banks Percent of U.S. Total Assets $1 Bill ion-f- Table B Equity-to-Assets Ratio U.S. C o m m e r c i a l Banks, 1990 Equity-to-Total Assets (Percent) $0-$25 Million $25-$50 Million $50-$ 100 Million $100-$500 Million 9.96 9.07 8.75 7.83 $500 Million$1 Billion $1 Billion+ .„ 7.48 r7n 5.70 Mississippi Tennessee 7 Table C Troubled Real Estate Asset Rates'1 (December 31 1990) Alabama Florida Georgia Louisiana 2.96 5.99 4.10 11.59 Percent real estate loans (plus other real estate owned) as a percent 4.09 of total real estate loans (plus other 5.71 real Table D Southeastern C o m m e r c i a l Banks, 1990 $25-$50 Million $50-$100 Million $100-$500 Million $500 million$1 Billion Number of Banks 279 494 421 334 37 50 Percent of S.E. Banks 17.3 30.6 26.1 20.7 2.3 3.1 4.5 17.1 28.3 59.4 23.9 203.7 Total Assets ($ billions) Percent of S.E. Total Assets 1.3 5.1 8.4 17.6 7.1 60.5 Digitized for F e FRASER deral Reserve B a n k of Atlanta Economic Review 53 References "Commercial Banking Performance—Fourth Quarter, 1990." FDIC Quarterly Banking Profile. Federal Deposit Insurance Corporation, Washington, D.C. Goudreau, Robert E., and B. Frank King. "Recovering Bank Profitability: Spoiled Again by Large Banks' Loan Problems." Federal Reserve Bank of Atlanta Economic Review 75 (May/June 1990): 30-43. 54 Economic Review "Top 100 Banks in Credit Card Operations." American Banker (September 17, 1990): 21 A. Wall, Larry D. " C o m m e r c i a l Bank P r o f i t s : Still W e a k in 1987." Federal Reserve Bank of Atlanta Economic Review 73 (July/August 1988): 28-42. July/August 1991 /Review Essay International Trade and Finance Information Sources: A Guide to Periodical literature Jerry J. Donovan n response to the growing importance of worldwide trade and capital flows,« literature about major international trade and finance areas—like the Pacific Rim, the European Community, and Latin America—is proliferating. To meet the needs of those active in foreign commerce, as well as economists and academicians interested in public policy on an international scale, a wide array of publications has appeared, disseminating theoretical, technical, and practical information. Among these are a number of periodicals that provide current information on trade and finance activity in The reviewer is the research librarian in the Atlanta Fed's research library. He is grateful to a number of people in the research department— particularly Jan Boucher, Peter Abken, Mary Rosenbaum, Curt Hunter, Tom Cunningham, Aruna Srinivasan, and Larry Wall—for assistance in evaluating the publications reviewed in this article. Reserve B a n k of Atlanta DigitizedFederal for FRASER particular world regions. This review is focused on a selection of these international journals and m a g a z i n e s , m a n y of which, though certainly not all, are relatively new. Almost half the periodicals included began publication within the last four years. Some of the titles, because of their narrow focus and relatively small readership, may be little known. (See the box on page 63 for subscription information.) Most of the publications reviewed fall into four categories: (1) "serious" general interest magazines like Asiaweek, a Hong Kong publication intended to help readers develop understanding of Asia; (2) "academic" or "research" journals, like The Journal of International Money and Finance, containing exposition and empirical analysis of economic theory relevant to monetary and other aspects of economic policy; (3) "quasi-theoretical" publications, such as Risk: Managing Risk in the World's Financial Markets, that bridge the gap between the academician and the practitioner; and (4) statistical sources like The Semi-Annual Bulletin of the Clearinghouse of the Pacific Basin Central Bank Economic Research and the Statistical Abstract of Latin America, offering short facts and citations of references that provide greater detail on a topic. Economic Review 55 A m o d i f i e d v e r s i o n of the " S t r u c t u r e of W o r l d Trade, 1980-87" developed by the European Community has been adopted as a handy, if somewhat arbitrary, system for c l a s s i f y i n g the p e r i o d i c a l s in this review: 1 • • • • • Global (for many world trade areas) North America (Canada, Mexico) Latin America (excludes Mexico) Western Europe (includes European Community) Far East/Asia 2 A s with any system, classification by geography does not result in absolute consistency. An inadvertent byproduct of this approach is a somewhat uneven distribution of p u b l i c a t i o n s a m o n g the g e o g r a p h i c regions, resulting from the fact that certain areas comm a n d f e w e r known periodical titles focusing on the area. This discussion of periodicals is the second part of a two-part review. Part 1, in the M a y / J u n e Economic Review, looked at seasoned reference directories and statistical c o m p e n d i u m s of worldwide information. Together, selections of works from these two articles would form a useful reference collection on international trade and finance. Global (Multicountry) To keep abreast of current developments in international finance and trade, whether for a specific trade area or the world at large, newspapers like The Financial Times of L o n d o n (daily), the Asian Wall Street Journal of Hong Kong (weekly), the Wall Street Journal/Europe of B r u s s e l s (daily, text in E n g l i s h ) , Le Monde of Paris (daily, text in French), or Frankfurter Allgemeine of Frankfurt (daily, text in German) offer a broad range of business and e c o n o m i c information. For those interested in more in-depth coverage, a variety of periodicals is available. The p u b l i c a t i o n s of T h e E c o n o m i s t Intelligence Unit of L o n d o n (EIU), which merged in 1987 with B u s i n e s s I n t e r n a t i o n a l ( N e w York), p r o v i d e a farreaching information network. The Economist, the oldest of E I U ' s publications (begun in 1843), is widely respected for its weekly review of economic developments as well as politics and general news in the United Kingdom and around the world. Although less well known, other EIU publications provide sound international economic analysis and forecasts. Notable among these are the 165 Country Reports that monitor politi- 56 Economic Review cal, e c o n o m i c , and business conditions within each country, a c c o m p a n i e d by annual Country Profiles',3 European Trends, a quarterly publication analyzing key issues and developments in the European Communities, the European Free Trade Area (EFTA), and the Single Market; and the EIU occasional studies, published as monographs. How to Win in Emerging Stock Markets: Profitable Investment Strategies for the 1990s, for example, a monograph published in collaboration with the I n t e r n a t i o n a l F i n a n c e C o r p o r a t i o n (IFC), discusses trends in developing-country equity markets, the barrage of new country funds, and analytic tools intended to support more informed deliberation about investing in emerging markets. A number of periodicals published elsewhere also offer perspectives on the global financial scene. Several of these are discussed below. Economic Policy: A European Forum (Cambridge, England; semiannually; began 1985) offers articles on topics ranging from the workings of individual markets to broad interactions throughout the world economy. All articles are commissioned from "leading e c o n o m i s t s (whose) brief is to demonstrate how live policy issues can be i l l u m i n a t e d by the insights of m o d e r n economics and by the most recent evidence." The journal's aim is to provide incisive articles written in plain language for the wide audience that participates in policy debates. T h e April 1991 issue ( n u m b e r 12), f o r example, contains five diverse policy articles: "Mexico and the Brady Plan," "Reputation and Credibility in the European Monetary System," "Aging Population: P r o b l e m s and P o l i c y O p t i o n s in the U.S. and G e r many," "Effective Demand, Enterprise R e f o r m s and Public Finance in China," and "The British Electricity Experiment." Prior to publication the contents of each issue are discussed by an e c o n o m i c policy panel, m a d e up of distinguished economists from Europe and elsewhere w h o rotate memberships annually. Highlights of the panel discussions printed in each issue give the reader alternative interpretations of evidence and a sense of the liveliness of the panel's interchanges. Although the journal's contributing authors are well known for their rigorous academic research, articles in Economic Policy are targeted more toward a lay audie n c e . T h i s " p l a i n l a n g u a g e " a p p r o a c h l e a v e s out econometric evidence, and researchers or a c a d e m i cians must search for the statistical evidence elsewhere in the author's more scholarly work. Economic Policy offers a strictly European perspective on global developments. Unfortunately, an outgrowth of that view- July/August 1991 point is a rather limited scope of issues, confined to those that are salient to Europeans. Nevertheless, the journal is recommended to researchers concerned with public policy as it affects international commerce and trade. Euromoney (London; monthly, with monthly supplements; began 1969) enjoys wide readership in the world's financial community because of its general but detailed coverage of developments in principal world financial markets. The magazine from time to time carries substantive articles that offer fresh insights into Europe's integrated financial markets. While the focus is broadly international, the emphasis is on European finance. The magazine includes individual country and instit u t i o n a l s u r v e y s , b i o g r a p h i c a l a c c o u n t s of w o r l d f i n a n c i e r s and b a n k e r s , f i n a n c i n g t e c h n i q u e s , and statistics on bond markets, such as international interest rates and comparative data on swaps. Although regular (one or more) monthly supplements are sometimes a valuable bonus, they frequently seem to be vehicles for advertising the efforts of national economic development agencies. A supplement of some interest was the March 1991 "Banking in the New Europe," which dealt with topics like the establishment of a banking presence in idiosyncratic national markets of Europe; a roundtable discussion of m a j o r French, German, and Italian bankers spelling out their new-era priorities for coping with the C o m m o n Market environment; and strategies for cross-border mergers and acquisitions. Euromoney is essential for practitioners tracking current world capital and money markets. In addition, the publication has merit for academics who need to stay broadly conversant with developments in these areas. The Institutional Investor International Edition: The Magazine for International Finance and Investment (New York; monthly; began 1976) is a practical journal designed for international money managers. It contains some of the material found in its sister publication, the Institutional Investor, which covers U.S. money markets, but it concentrates on international topics. Because it is heavily weighted toward the practitioner, the magazine merely reports current financial e v e n t s r a t h e r than p r o v i d i n g a t h o r o u g h a n a l y s i s grounded in extensive research. Such articles may be based on rumor in the financial marketplace, and it is up to the reader to sort out the substance of a story. T h e m a g a z i n e d o e s not p r o v i d e c u r r e n t data on money markets but instead offers such special statistical features as the annual summary and analysis of the DigitizedFederal for FRASER Reserve Bank of Atlanta y e a r ' s leaders in the international bond market that appears in the February 1991 issue. Occasional special f e a t u r e s deal with m a t t e r s like the s c o r e b o a r d of notable international transactions during the 1980s or a forum about national regulation of global, cross-border trading (both in the January 1991 issue). The Institutional Investor International Edition is recommended for readers who wish to keep informed about forces in the international money markets—the investment banking houses and the personalities who move them. The International Economy: The Magazine of International Economic Policy ( W a s h i n g t o n , D . C . , six issues per year; began 1987) o f f e r s t h o u g h t f u l , indepth articles, often by public figures rather than journalists. Its issues tend to be thematically organized around important, but not necessarily obvious, topics. Especially useful among the regular features of The International Economy are the "Country Risk-Watch" tables. These tables give an evaluation of risk factors for fifteen developing national economies by relative comparison over time as well as the current year's projected external debt position and domestic indicators (see Figure 1). The International Economy does not eschew controversy in probing economic topics of worldwide concern. T h e J a n u a r y / F e b r u a r y 1991 issue i n c l u d e s a cover story discussing U.S. Treasury Secretary Nicholas Brady's work at home and abroad on matters like the savings and loan industry bailout and Third World debt. This issue also contains four articles on American banking; a consideration of three scenarios for the Soviet Union o v e r the next three years; and "The International Economy Power Tree," a four-page diagram that portrays the relationships among national and international finance agencies and lists the names and phone numbers of these agencies' officials. International Reports (New York; weekly, fifty-one issues per year; began 1947) always covers developm e n t s in f i n a n c i a l and f i s c a l i s s u e s in the U n i t e d States, Canada, Japan, Germany, and the United Kingdom. Other nations of Eastern and Western Europe, Latin America, the Pacific Rim, and the Middle East are examined with regularity according to emerging considerations. These reports follow a terse, "executive s u m m a r y " f o r m a t , comprehensive and o f f e r i n g solid, n o n s p e c u l a t i v e i n f o r m a t i o n . A r e c e n t i s s u e included editorial comment on the departure of KarlOtto Pohl from the Bundesbank, as well as a discussion that sheds light on the changing support for a hard Economic Review 57 lu» oc Figure 1 The International Economy COUNTRY RISK-WATCH T E VIE C O M P RISON ARGENTINA BOLIVIA Projattd Trade Bilance Current Account To GNP Extend! M» loGDP Annui] DeW-Sovice ToGDP Rama Monto Of Imports Total Bener Beitel +S7.0b +$0.8% 30% 5% 6.0 Same CHILE Beller COLOMBIA Same ECUADOR Same IVORY COACT MEXICO Worse Beller MOROCCO Beder NIGERIA Betler PERU Same PHILIPPINES Better URUGUAY Beller VENEZUELA Betler YUGOSLAVIA EXTERNAL ECONOMIC INDICATORS Outlook For 6 Mo« From Now Same BRAZIL 1 9 9 1 PROJECTED Situation Compircd TolYrAjo Worse Same Same Same Same Same Worse Better Better Same Same Same Betler Better Same +$60m +S15b +$1.0b +SlJb +$800m +$1.5b -$10.0b -$2.0b -2.2% 84% <0.4% 30% -1.0% +1.0% -3.0% -10% -2.8% -3.0% 63% 46% 107% 190% 40% 89% > c CTQ c Hurst'iii'd Creditors: Wiirscnrd S45.0b $29.7b $3.0b 7% 1.0 4.3b 0.3b 3m 3.6% 4.0 U6b 65.2b 105b 11% 6.0 19b 8.5b 8% 6.0 18b 6.6b 11% 3.0 4.Cte 4.2b 20% 0 18b 3.0b 5% 4.0 105b 10% 2.0 526b +1.5% 100% 15% 4.0 28b +S1.0b -1.5% 30% 3% 2.0 22b -$3.5% 67% +$350m +1.0% 77% +S6-0b +3.5% 60% -$5.0b -2.0% 25% 8.5% 15 8% 3.5 5% 6% 8.0 lj GLOBAL DEBT CLIMATE: IH'IHnrs: Detf Debt ToU.S. Banki" +$5.0b —$3.5b EXTERNAL POSITION Debt To BIS Banks' Source: "Country Risk-Watch," The International 31b 75b 33b 19b 55.0b 5.2b 6.8b 3.8b 9.3b 2.0b 17.5b 7.0b 2.8b 1.7b 0.6b 7!m lZ3b 575m 263m 81m 2.8b Commercial Bank Credit Official Credit Statuì MF Program St IBB Laige arrears Sane a m a n Pending Arrean Rescheduling Program Large aneais Airean Pending Cumul Cumnl None Curnnl Cunent None Anean Rescheduling Pending Arrears Aman Program Cumul Cumnl Program Cuiront Current None Amars Cumnl Program Anean Current None Current Current Program Cunent Cumnl Program Current Current Program Cunent Current Program 0.7b 5.8b 2.4b DOMESTIC INDICATORS Eligible RxEx-bn Credit Yes No Short-Term Yes Pari. Club Reschedg Dale Of Neil "PoliticalSocial Index ExchangeRate 12-89 May 1995 2 Debatable Pending May 1993 3 Yes BOLIVIA 7-88 Nov 1994 2 Debatable BRAZIL 044)2-87 Dec 1993 3 Yes CHILE M a y 1994 2 Yes COLOMBIA Pending May 1992 2 Debatable ECUADOR Pending Nov 1994 3 No 9-86 1994 2 Debatable 9-90 1992 2 Yes MOROCCO 1-91 1992 2 Yes NIGERIA 6-84 1995 1 No PERL' 5-89 1992 1 Yes PHILIPPINES - Nov 1994 3 Yes URUGUAY - Dec 1992 3 Yes VENEZUELA Seeking Umcbedukd 2 Yes YUGOSLAVIA Yes No Yes Yes Yes Short-Temi No Yes Yes Yes Yes ARGENTINA IVORY COAST MEXICO Noie: Ccuntry Riik-Watch is compiled by The liuernaiional Economy cn ihc bui* of interviews wilh severa! country risk specialisti. In some cuci, numben tre rounded and miy noi add up precisely. Some itemi involve jidgement calli. Assejsmcnt compietfd aboux one raonth before publicalion date. ••Political-social index 1 — Prtential for severe political unrest 2 — Political situation noi conducive to sound 3 — Adequate Economy 5, no. 4 (July/August 1991): 52-53. Reprinted by permission of the publisher. European Currency Unit (ECU) and the success of the European Monetary Union (EMU). Each number offers an array of regular features like "The Market Report" (foreign exchange outlook and credit market outlook), "Export Credit Conditions and Collections Experiences," "Secondary Market Prices for Commonly Traded L D C Debt," the "IR Statistical Market L e t t e r " (including interest rates on external currency f u n d s , Euro-interest rate differentials, and export credit and collection data). International Reports should probably not be used alone; its purpose is to provide prompt, insightful coverage of emerging conditions and events, inevitably at the e x p e n s e of f u l l b a c k g r o u n d t r e a t m e n t . H e n c e , International Reports' (individual) subscription price of $1,075 a year will appear steep except to those who value the magazine's cogently organized coverage of current factors in worldwide finance and trade. The Journal of International Money and Finance (Oxford, England; quarterly; began 1982) is an academic journal with editorial offices at Fordham University at Lincoln Center, New York City. The journal specializes in empirically oriented studies of exchange rates, financial market aspects of G-7 and G-10 country issues, and other topics related to international markets and finance. T h e supplement to the March 1991 issue (volume 10, number 1), which contains the proceedings of the "Conference on Political Influences in International Economic Models," is representative of the intellectual interaction between politics and economics found in this publication. The journal, less than ten years old, suffers from the uneven quality often seen in relatively young scholarly journals. Nonetheless, it is recommended for its treatment of economic theory subjected to thorough statistical analysis. Risk: Managing Risk in the World's Financial Markets (London; ten issues per year; began 1987) is a relative newcomer to the literature on the world's financial markets. It strikes a middle ground between theoretical and a p p l i e d articles a b o u t s w a p s and other f i n a n cial i n s t r u m e n t s . B e c a u s e Risk is t a r g e t e d t o w a r d senior-level m o n e y m a n a g e r s , it f r e q u e n t l y features interviews with sellers of r i s k - m a n a g e m e n t i n s t r u ments. The magazine might be likened to a specialized version of Euromoney, requiring greater depth of knowledge, particularly of technical terminology. Quasi-academic articles with abundant modeling lure the reader toward the journals or papers f r o m which the articles derive. Risk focuses primarily on the Lon- DigitizedFederal for FRASER Reserve Bank of Atlanta don, Paris, and Frankfurt markets, but it does not omit the United States. Risk regularly presents analyses of the savings and loan situation and discussions of such topics as f o r e i g n - e x c h a n g e r i s k - m a n a g e m e n t techniques used by U.S. firms and the challenges of risk management in dealings with less developed countries. The mainstay of Risk is the continuing coverage of swaps, valuation methods (including models), market data, defaults, legal developments, forward rates, and pricing in d i f f e r e n t currencies. " T h e Debty D o z e n " table (Figure 2), which illustrates turnover in the L D C debt market and leading traders, ranked by volume, is an example of the useful topical analysis found in this publication. Risk is an essential tool for participants in international derivative securities markets, and it is helpful for academics and others interested in following developments in those markets. Other researchers will probably find Risk too technical. Weltwirtschaftliches ArchivlReview of World Economics ( T u e b i n g e n , G e r m a n y ; q u a r t e r l y ; text and summaries in several languages; began 1914) emphasizes empirical research, although it is somewhat less technical than the Journal of International Economics. Monetary policy receives much attention in this scholarly j o u r n a l ' s international c o v e r a g e . Its E u r o p e a n perspective offers Americans an expanded view. Of p a r t i c u l a r interest in the f o r e i g n trade and f i n a n c e area is 1989's Band 125, Heft 3, whose principal articles comprise nine papers presented and discussed at the first International Seminar in International Trade, held August 24-25, 1988, at St. Catherine's College, Oxford, jointly organized by the Centre for Economic Policy Research, London, and the National Bureau of E c o n o m i c Research, C a m b r i d g e , Massachusetts. This c o n f e r e n c e emphasized e x c h a n g e rates and trade policy. L e n g t h y scholarly articles typically c o n s u m e the most space in an issue, but studies and surveys appear from time to time. For example, 1990's Band 126, Heft 4 included "Post-Soviet-Type E c o n o m i e s in Transition: What Have We Learned from the Polish Transition Programme in the First Year?" Shorter papers and comments always follow the full-length articles. While longer articles are accompanied by a summary in German, French, and Spanish, respectively, shorter papers a n d c o m m e n t s a n d b o o k r e v i e w s m a y a p p e a r in E n g l i s h or G e r m a n . Weltwirtschaftliches Archiv is strongly recommended for researchers seeking technical treatment of m o n e t a r y and other e c o n o m i c and financial policy. Economic Review 59 Figure 2 THE DEBTY DOZEN Turnover in the LDC debt market, and leading traders, ranked by volume Rank Trading house Turnover ($bn) 1990 1989 Estimate of total market ($bn) 1990 1989 Number of traders 1 1990 1989 JP Morgan 1 (1) 16.0 14.0 75-100 70-80 25 Manufacturers Hanover 2 (7) 14.5 8.0 130-150 100 20 (4) 14.3 9.8 90-100 70-80 12 13.4 70-80 60-70 15 80 60 11 80-85 16 Chase Manhattan 3 NMB 4 (2) 12.5 Citibank 5 (5) 10.5 8.5 Bankers Trust 6 (5) 10.1 8-92 100 Chartered WestLB 7 H 9.4 5.3 100 80 5 First Chicago 8 (-) 9.0 4.7 100 50-60 8 3 9 (-) 8.8 4.2 125 80 11 Salomon Bros 10 (8) 8.5 7.52 90 80-85 12 6 Midland Montagu Banco Santander 11 (11) 7.5 5.5 80 50 Chemical Bank 12= (11) 7.0 5.5 — — Morgan Grenfell 12= 1 2 3 4 5 (~)5 7.04 5 100-120 80-100 7 6 Often includes activities other than straight trading, such as distribution and corporate structural financing; all traders worldwide Rough estimate Mid-range of market estimates ($11.5 billion—13.5 billion). No figures available from NMB Last six months of 1990 only Took over Libra team in mid-1990. In 1989, Libra's $11.5 billion turnover placed it third Source: RISK market survey, February 1991: trading houses' calculations of their own turnover, and estimates of the market Source: Risk 4 , no. 3 (March 1991): 4 3 . Reprinted by permission of the publisher. TVorth America (Canada-Mexico) The Canadian Journal of Economics/Revue Canadienne d'Economie (sponsored by the Canadian Economics Association, Ontario; quarterly; text in English and French; began 1968) offers a useful blend of articles on theoretical as well as applied aspects of econ o m i c s and f i n a n c e . T h i s h y b r i d q u a r t e r l y c o v e r s a broad range of topics, including the economics of the environment. For example, Canadian natural resources n o w threatened by industrial civilization, such as fisheries, receive considerable attention. In addition to articles of practical application, the Canadian Journal of Economics often contains distinguished theoretical articles. The journal also includes obituaries (biographical sketches) of prominent Canadian economists, book reviews, and announcements of conferences, prizes, and the like. 60 Economic Review C a n a d a ' s position as one of the United States' prim a r y t r a d i n g p a r t n e r s l e n d s a d d e d i m p o r t a n c e to Canadian perspectives on trade and finance addressed in the Canadian Journal of Economics. This journal is recommended to academicians as well as practitioners with significant interest in trade and finance involving Canada. Business Mexico: A Eook at Mexico and Its Economic, Investment and Trade Prospects (The American C h a m b e r of C o m m e r c e of M e x i c o , M e x i c o City; q u a r t e r l y ; b e g a n 1983; p r e v i o u s l y p u b l i s h e d u n d e r t h e t i t l e s Mex-Am Review a n d Mexican American Review) f u r n i s h e s a c o m p r e h e n s i v e v i e w of M e x i c o ' s e c o n o m i c , i n v e s t m e n t , and trade p r o s p e c t s . Its articles are g r o u p e d u n d e r broad topics listed in the t a b l e of c o n t e n t s : t r a d e , a g r i c u l t u r e , g o v e r n m e n t , e n v i r o n m e n t , e c o n o m i c analysis, and special f e a t u r e reports. July/August 1991 Because the United States is Mexico's largest trading partner and M e x i c o is the United S t a t e s ' thirdlargest trading partner, Business Mexico is particularly i m p o r t a n t f o r its t r e a t m e n t of both A m e r i c a n and Mexican business interests. Recent issues emphasize several aspects of the Mexican economy that could be affected by the U.S.-Mexico Free Trade Agreement— the maquiladoras (border-area manufacturing facilities w h o s e p r o d u c t s are e x e m p t f r o m t a r i f f s ) , the computer and software industries, and direct foreign investment in Mexican agriculture. L atiii America (Excluding Mexico) LatinFinance (Coral Gables, Florida; ten issues per year, plus supplements; began 1989) contains facts and a r r a y s of n u m e r i c a l d a t a h a v i n g to do with S o u t h American finance. Its contents routinely e n c o m p a s s developments in equity, other financial markets, and current events in the corporate marketplace. Features include such topics as "The Enterprise for the Americas," a survey of debt traders, and Japan's Latin lending. Each issue contains a concise index to the contents of the charts and tables throughout that issue. From time to time LatinFinance produces a supplement, an example of which is the March 1991 "Privatization in Latin America." This publication is highly recommended to those engaged in finance in the Latin countries and to researchers. Selected Statistical Indicators of Caribbean Countries (Port of Spain, Republic of Trinidad and Tobago; irregularly; began 1987), an official publication of the United N a t i o n s ' E c o n o m i c C o m m i s s i o n f o r L a t i n America and the Caribbean ( E C L A C ) , Subregional H e a d q u a r t e r s for the C a r i b b e a n , p r e s e n t s s e l e c t e d authoritative statistics available to the agency. T h e p u b l i c a t i o n c o v e r s m o r e than t w e n t y i n d i c a t o r s — including national accounts (current and constant), balance of payments, main domestic exports, agricultural production, money supply, government revenues, retail price index, and measures of tourism—for twenty-one C a r i b b e a n c o u n t r i e s . D a t a are p r o v i d e d f o r 1980 through 1989 in the current edition (volume 3, 1990). The publication uses single and consistent sources of information in an effort to minimize inconsistencies in data presentation from country to country. There is a table of contents, but no index; researchers, however, should find the format easy to understand. This handy compendium is recommended to those who need back- Reserve Bank of Atlanta DigitizedFederal for FRASER ground statistics on Caribbean countries and w h o s e budget may be limited. Statistical Abstract of Latin America (UCLA Latin American Center, Los Angeles; annually; began 1955) covers the twenty "standard definition" Latin American countries. 4 It is a well-organized compendium of data on geography and land tenure; transportation and c o m m u n i c a t i o n ; population, health, education, and crime; church and state; working conditions, migration, and housing; industry, mining, and energy; sea and land harvests; foreign trade; financial flows; and national accounts, government policy and finance, and p r i c e s . All t a b l e s g i v e d e t a i l e d s o u r c e s so t h a t a researcher can conveniently seek the primary data in fuller detail. There is a subject index at the end of the volume. Comprehensive and detailed, this one-volume statistical reference is highly recommended for both business people and researchers interested in Latin America. Western Europe European Affairs: The European Magazine (Amsterdam; bimonthly; text in English; began in 1987) is a journal with an insider's, often quite cerebral, view of a broad spectrum of public affairs. Contributing authors are likely to be world-renowned figures: for instance, Helmut Schmidt in the Summer 1990 issue; Z b i g n i e w Brzezinski and T h e o S o m m e r (editor-inchief of Die Zeit) in the February/March 1991 issue. A t y p i c a l i s s u e c o n s i s t s of a r t i c l e s o n a c o v e r t h e m e , c o l u m n s , i n t e r v i e w s , c o u n t r y r e p o r t s , and departments (including book reviews). Subject matter tends toward political science, e c o n o m i c s , m o d e r n history, and the p h i l o s o p h i c a l . F o r e x a m p l e , in an interview titled " G e r m a n y : United, But Not a World Power," Sommer discusses the determinants and consequences of the German reunification. In an article in the April/May 1991 issue, Lester C. Thurow (Dean of M I T ' s Sloan School of M a n a g e m e n t ) considers the transformation from an economic world centered on the U n i t e d States to o n e with a tripolar l e a d e r s h i p structure including the United States, Japan, and the EEC, and how, in new "Bretton Woods" negotiations, this time in Brussels, "the European Community will effectively be writing the rules of trade for the 21st century" (page 33). European Affairs o f f e r s e x t e n s i v e b a c k g r o u n d information on political and economic developments Economic Review 61 in Europe and is recommended for practitioners, business economists, and academicians. European Economy (Luxembourg; quarterly; began 1978) contains important reports and communications from the Commission of the European Communities to the Council of Ministers of the European Communities and to the European Parliament on the economic situation and developments, as well as on the borrowing and lending activities of the European Community. European Economy a l s o p r e s e n t s r e p o r t s a n d studies on problems concerning economic policy. Two supplements accompany the main periodical: Series A, " E c o n o m i c T r e n d s , " d e s c r i b e s , with the aid of tables and graphs, the most recent trends in industrial production, consumer prices, unemployment, the balance of trade, e x c h a n g e rates, and other indicators; Series B, "Business and Consumer Survey Results," gives results of o p i n i o n surveys of industrial chief executives (for orders, stocks, production, outlook, and the like) and of EC consumers (on such topics as the economic and financial outlook), as well as other business cycle indicators. This package of publications is a must for information to support forecasting and business planning. Euroweek: Incorporating the International Bond and Equities Letter (London; weekly; began 1987) a E u r o m o n e y P u b l i c a t i o n s title, f e a t u r e s articles and statistics on bonds, equities, and derivatives around the world. In addition to tables of comprehensive statistical data, the regular format consists of news and analysis of f a c t o r s a f f e c t i n g w o r l d m a r k e t s , a d i a r y of forthcoming events, new and emerging issues, ratings, call alerts, foreign-exchange forecasts, and summaries of syndicated loans arranged by country. It is recommended to both business people and researchers for its e x h a u s t i v e a r r a y of i n f o r m a t i o n on capital issues, including ratings and prices. Panorama of EC Industry (Luxembourg; annually; began 1989) provides a description of industry across the European Community comparable to coverage the U.S. Industrial Outlook gives to U.S. industry. This reference work will be useful to those interested in the current situation and the future outlook for m a n u f a c turing and service industries in the EC. The publication considers specific sectors and the implications of topical issues on E u r o p e a n industry. T w o m a i n sources for data cited in the Panorama are Eurostat and industry associations. Although data are generally thought to be reliable, those for m o r e recent periods 62 Economic Review are still being revised and should be regarded with caution. Data for all twelve member states are usually i n c l u d e d . W h e r e d a t a are not a v a i l a b l e f o r E C 12, country coverage is indicated in footnotes appearing below each table. Production figures for Japan and the United States, derived from their censuses of manufacturers, are also included. After introductory discussions, the main body of text consists of industry reviews and forecasts, arranged in chapters, for industry sectors by NACE classification. 5 Each chapter contains a summary of recent developments in the industrial sector, consumption, trade, and employment as well as a review of structural changes and a discussion of the outlook. As a handy compendium of European Community information, Panorama of EC Industry is highly recommended. Asi'A and the Far East (Including Pacific Rim and Newly Industrialized Economies) The Semi-Annual Bulletin of the Clearinghouse of Pacific Basin Central Bank Economic Research (San Francisco; began 1976) is published by the Federal Reserve Bank of San Francisco as part of its Pacific Basin program, begun in 1974, to promote cooperation among central banks of the region and enhance public understanding of economic policy issues. The bulletin is a descriptive list of central banks' research publications and working papers, received over a sixmonth period, in accordance with participating institutions' agreement to send research products regularly to the center. 6 The center, in turn, compiles the list and disseminates it to enhance contacts among the participants through the regular e x c h a n g e of information. Examples of items in the June 1990 Bulletin include an article from the (Bank of Thailand) Quarterly Bulletin, " F i n a n c i n g of T h a i l a n d ' s C u r r e n t A c c o u n t Deficit during 1970-1988," and "Proceedings of the E i g h t P a c i f i c B a s i n C e n t r a l B a n k s C o n f e r e n c e on Economic Modelling." W h i l e the r e s e a r c h e f f o r t s listed in the bulletin speak explicitly to concerns of the institutional memb e r s h i p of t h e c l e a r i n g h o u s e , t h e y a l s o r e w a r d researchers seeking publications, official and otherwise, covering smaller economies. The listings appeal primarily to economists and academicians, although practitioners will also find the financial research contacts within participating countries useful. The publication is highly recommended for those doing research on the Pacific Basin. July/August 1991 Abstracts of Recent Research by Center Associates (San Francisco; semiannually; began 1991) is p u b lished by the Center for Pacific Basin Monetary and Economic Studies, established in July 1990 by the San Francisco Federal Reserve Bank under the auspices of the bank's Economic Research Department. It disseminates information, in the form of titles, with abstracts, of current research done by Associates of the Center for Pacific Basin M o n e t a r y and E c o n o m i c Studies. T h e research m a y take the f o r m of w o r k i n g papers sponsored by organizations not necessarily e n j o y i n g widespread recognition or articles appearing in narrowly focused journals with small circulation (such as ASEAN Economic Bulletin or Asian-Pacific Economic Literature). The center hopes this publication will build a community of scholars—a network spanning America, Asia, and Europe—sharing a c o m m o n interest in P a c i f i c Basin m o n e t a r y and e c o n o m i c i s s u e s . T h e authors' mailing addresses are provided to facilitate requesting papers and providing comments. Presenting Subscription Information" Abstracts of Recent Research by Center Associates. Free. Institutional Investor International Edition. $295. Insti- C e n t e r f o r P a c i f i c B a s i n M o n e t a r y and E c o n o m i c Studies, Federal Reserve Bank of San Francisco, P O B o x 7 7 0 2 , San Francisco, C A 94120. Asiamoney. $195. Reed Publishing Group, 205 East 42nd Street, Suite 1705, N e w York, N Y 10017. Asiaweek. $130. Asiaweek Ltd., 13th Floor South, Somerset House, 28 T o n g Chong, Quarry Bay, H o n g Kong. tutional Investor, 4 8 8 M a d i s o n A v e n u e , N e w York, N Y 10022. The International Economy. $72 (add $15 first class Business Mexico. $65. A m e r i c a n C h a m b e r of C o m m e r c e of M e x i c o , Lucerna 78, M e x i c o D F 0 6 6 0 0 , Mexico. p o s t a g e ) . T h e International E c o n o m y P u b l i c a t i o n s , I n c . , 1050 C o n n e c t i c u t A v e n u e , N W , S u i t e 1 2 2 0 , W a s h i n g t o n , D C 20036. International Reports. $ 5 3 5 ( s c h o o l s and universities), $ 1 , 0 7 5 (regular). International Reports, Inc., 114 East 32nd Street, Suite 602, N e w York, N Y 10016-5506. The Canadian Journal of Economics. $65. University of Journal of International T o r o n t o Press, J o u r n a l s D e p a r t m e n t , 5 2 0 1 D u f f e r i n Street, D o w n s v i e w , Ontario M 3 H 5T8, Canada. Country Reports; Country Profiles. $255/package. The E c o n o m i s t Intelligence Unit, Business International, 215 Park A v e n u e South, N e w York, N Y 10003. Economic Policy. $43 (institutions), $22 (individuals). 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Regents of the University of California, U C L A Latin American Center, 405 Hilgard Avenue, Los Angeles, C A 90024-1447. Weltwirtschaftliches Archiv. D M 1 4 8 (deutsche m a r k s ) . JCB Mohr/Paul Siebeck, Postfach 2040, W-7400 Tuebingen, Germany. *Prices and addresses shown are current as of July 1991. 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 Economic Review 63 papers that tend to be highly technical or theoretical in nature, the publication is recommended primarily for research economists and other academicians. Asiamoney (Hong Kong; monthly except July/ August and D e c e m b e r / J a n u a r y ; began 1989 as Billion) is one of the Euromoney Publications periodicals. Its format resembles the design of Euromoney, i n c l u d i n g special s u p p l e m e n t s f r o m t i m e to t i m e . The contents of each issue of Asiamoney offer a consistent protocol of "Spot R e p o r t s , " " F e a t u r e s , " and " D a t a b a s e , " p r o v i d i n g u n i f o r m c o v e r a g e of topics ranging from chatty, anecdotal reports on swap activity to serious comparative economic forecasts for the eleven countries in its specific purview. 7 Special studies each month prove useful as reference information on such topics as the largest mergers and acquisitions in Asia in 1990, ranked in various ways. Also included is an overview of the equity and debt m a r k e t s , a l o n g with an a n a l y s i s of the y e a r ' s worst deals. The " D a t a b a s e " section is a systematic tabulation of " A s i a n Syndicated Loans Signed and New Equity Listings" for the previous two months. Asiaweek (Hong Kong; weekly; began 1975) offers not only broad coverage of both political and economic news but also an "almanac" replete with economic indicators (GNP per capita, G N P growth, exports, the current a c c o u n t , foreign debt, and the c o n s u m e r price index) for forty-four countries. 8 The almanac makes it 1. D e l i n e a t i n g a s y s t e m a t i c g e o g r a p h i c structure f o r world trade and finance regions is a complex task. Geographical and political considerations like proximity or national tariff and trade restrictions define different spheres for analysis. 2. Modified structure taken from Panorama of EC Industry 1990, 53. Far East/Asia includes the Pacific Rim countries (Japan, Australia, and New Zealand) and such newly industrialized economies (NIEs) as Hong Kong, Taiwan, and South Korea. 3. Together, the EIU Country Report and Country Profile provide an annual p a c k a g e c o m p a r a b l e to, but p o s s e s s e d of greater detail than, the well-known OECD Economic Surveys published annually for each of the O E C D ' s member nations. 4. The countries are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Cuba, Dominican Republic, Ecuador, El Salv a d o r , G u a t e m a l a , Haiti, H o n d u r a s , M e x i c o , N i c a r a g u a , Panama, Paraguay, Peru, Uruguay, and Venezuela. This standard definition evolved by way of events like the creation of the Pan American Union of 1910 (of which the United States was a member); the Organization of American States (OAS), since 1948; the expulsion of Cuba in 1962; and some other Economic Review 6 4 possible, for instance, for a researcher to obtain indicators for such small nations as Bhutan and to compare them with consistently configured data for the United States and Germany by consulting a one-page table. Additional tables include statistics on social indicators (population, population growth rate, infant mortality, l i t e r a c y , p e o p l e per d o c t o r , a n d p e o p l e per telephone); commodity prices given in U.S. dollars for the previous week, six months ago, and one, three, and five years ago; market trends for featured items like the cost of private hospital rooms; lending rates; and currency trends. Occasional special features list information such as public holidays throughout Asia for the upcoming month; this calendar item can be valuable f o r planning business i n t e r a c t i o n s . Asiaweek, dense with factual reporting and useful statistics, is valuable for monitoring Asian trade and finance. Far Eastern Economic Review (Hong Kong; weekly; began 1946) is the D o w Jones publication for the Far East, providing coverage of topics similar to those in The Wall Street Journal. Typically the contents are in four sections: "Regional Affairs," "Arts and Society," "Business Affairs," and "Regular Features" (like book reviews, letters to the editor, and comparisons of s t o c k m a r k e t a c t i o n in l e s s p u b l i c i z e d c i t i e s l i k e Bangkok, Kuala Lumpur, Manila, Taipei, and Bombay). The Far Eastern Economic Review is essential reading f o r all people w i s h i n g to stay current with economic and political events in the Far East. changes involving former European colonies. All "standard definition" countries are sovereign nations. 5. N A C E stands for Normalisation des Activités Industrielles des Communautés Européennes—in English, the General Industrial Classification of Economic Activities within the European Community. 6. Participating institutions are the Reserve Bank of Australia, Bank of Canada, P e o p l e ' s Bank of China (Beijing), Hong Kong Government Secretariat, Bank of Indonesia, Bank of Japan, Bank of Korea (Seoul), Bank Negara Malaysia, the Reserve Bank of New Zealand, Central Bank of the Philippines, The Monetary Authority of Singapore, Bank of Thailand, and the Federal R e s e r v e Bank of New York and the Board of Governors of the Federal Reserve System. 7. The countries Asiamoney covers are Australia, Hong Kong, Indonesia, Japan, Korea, Malaysia, New Zealand, Singapore, Taiwan, Thailand, and the Philippines. 8. Asiaweek keeps correspondents in twenty-two nations worldwide, including the Pacific Rim, the NIEs, Canada, the Soviet Union, Europe, and the United States. July/August 1991 Working Paper Series Available T h e Research Department of the Federal Reserve Bank of Atlanta publishes a working paper series to stimulate professional discussion and exploration of economic subjects. We welcome readers of the Economic Review to complete and return the form below in order to receive our recently released working papers. If you would like a copy of any of the current papers, simply check the box next to the paper's number and return the form to the Public Affairs Department, Federal Reserve Bank of Atlanta. 91-1 Marco Espinosa and Steven Russell The Inflationary Implications of Reducing Market Interest Rates via Alternative Monetary Policy Instruments 91-2 Jeffrey A. Rosensweig and Ellis W. Tallman Fiscal Policy and Trade Adjustment: Are the Deficits Really Twins? 91 -3 Marco Espinosa and Chong K. Yip On the Sustainability of International 91-4 Coordination Peter A. Abken Valuation of Default-Risky Interest-Rate 91 -5 Swaps William C. Hunter and Stephen G. Timme A Stochastic Dom inance Approach to the Evaluation of Foreign Exchange 91-6 Forecasts Janice L. Boucher Stationary Representations, Cointegration, and Rational Expectations with an Application to the Forward Foreign Exchange Market Previous working papers are also available. For more information contact the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713 (404/521-8020). • Please start my subscription to the Working Paper Series. • Please send me a copy of the following working papers: • 91-1 • 91-2 • 91-3 • 91-4 • 91-5 • 91-6 Name — Address City — State ZIP Return to the Public A f f a i r s Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713. 1 Bulk Rate U.S. Postage F e BERÄL PAID R e s e r v e Atlanta, GA Permit 292 Bank-of A i " L A N TA Public Affairs Department 104 Marietta Street, N.W. Atlanta, Georgia 30303-2713 ( 4 0 4 ) 5 2 1 - 8 0 2 0 printed on recycled paper