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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,
».
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•
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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 .
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(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
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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.
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"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"
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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 ,
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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
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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).
C a m b r i d g e U n i v e r s i t y P r e s s , 4 0 W e s t 20th Street,
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The Economist.
$70. Subscription Department, P O Box
58524, Boulder, C O 80322-8524.
Euromoney.
$226. Reed Publishing Group, 205 East
4 2 n d Street, Suite 1705, N e w York, N Y 10017.
European
Affairs.
$73. European Affairs, ElsevierB o n a v e n t u r a B.V., P O B o x 152, 1000 A D Amsterd a m , T h e Netherlands.
European Economy. $145. U N I P U B , 4 6 1 1 - F A s s e m b l y
Drive, L a n h a m , M D 20706.
European
Trends. $ 3 5 5 . T h e E c o n o m i s t I n t e l l i g e n c e
Unit, Business International, 2 1 5 Park A v e n u e South,
N e w York, N Y 10003.
Euroweek.
$1,107. Reed Publishing Group, 205 East
42nd Street, Suite 1705, N e w York, N Y 10017.
Far Eastern Economic Review. $138. Datamovers, Inc.,
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Money and Finance.
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Journals Fulfillment Department, Butterworth Heinem a n n , 8 0 Montvale A v e n u e , S t o n e h a m , M A 0 2 1 8 0 .
LatinFinance.
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Boulevard, Suite 505, Coral Gables, F L 33134.
Panorama
of EC Industry. $140. UNIPUB, 4611-F As-
sembly Drive, L a n h a m , M D 20706.
Risk. $ 3 3 6 . Risk M a g a z i n e Ltd., 104-112 M a r y l e b o n e
L a n e , London W I M 5 F U , England.
Selected Statistical Indicators of Caribbean
Countries.
Free. E c o n o m i c C o m m i s s i o n for Latin A m e r i c a and
t h e C a r i b b e a n , 2 2 - 2 4 St. V i n c e n t S t r e e t , S e c o n d
Floor, P O B o x 1113, Port of Spain, Trinidad.
The Semi-Annual Bulletin of the Clearinghouse of Pacific Basin Central Bank Economic Research. Free.
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Statistical Abstract of Latin America. $175. Regents of
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Weltwirtschaftliches
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JCB Mohr/Paul Siebeck, Postfach 2040, W-7400
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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
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The Inflationary Implications of Reducing
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Fiscal Policy and Trade Adjustment: Are the Deficits Really Twins?
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On the Sustainability of International
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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
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Forecasts
Janice L. Boucher
Stationary Representations, Cointegration, and Rational Expectations with an Application to the Forward
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