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March/April 1993
Volume 78, Number 2
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federal Reserve
Bank of Atlanta
In This Issue:
The Rise of Electronic Payments Networks and the
Future Role of the Fed with Regard to Payment Finality
ß e y o n d Duration:
Measuring Interest Rate Exposure
FYI-The Use of Mitigating Factors in Bank Mergers
And Acquisitions: A Decade of Antitrust at the Fed
Policy Essay-New Tools for Regulators
In a High-Tech World
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March/April 1993, Volume 78, Number 2
JBßxmim
of Atlanta
President
R o b e r t P. Forrestal
S e n i o r Vice P r e s i d e n t a n d
Director of R e s e a r c h
Sheila L. T s c h i n k e l
Vice P r e s i d e n t a n d
A s s o c i a t e D i r e c t o r of R e s e a r c h
B. Frank K i n g
Research Department
William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham. Research Officer, Regional
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial
Public A f f a i r s
Bobbie H. McCrackin, Vice President
Joycelyn T. Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.
Material may be reprinted or abstracted if the Review and author are credited. Please provide the
Bank's Public Affairs Department with a copy of any publication containing reprinted material.
Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713
(404/521-8020). Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new
information. ISSN 0732-1813
JSditor's
Note
A n e w feature appears in this issue of the Economic Review. Essays
such as " N e w Tools for Regulators in a High-Tech World," presenting
analyses and insight of Atlanta Fed research staff m e m b e r s concerning
policy-related matters, will occasionally replace the review essay that
has been a regular feature of this publication.
(Contents
March/April 1993, Volume 78, Number 2
71ie Rise of Electronic
Payments Networks and the
Future Role of t h e Fed with
Regard to Payment Finality
William Roberds
b e y o n d Duration:
Measuring Interest
Rate Exposure
Hugh Cohen
This article argues that current payment practices on electronic
payments networks such as Fedwire and CHIPS amount to the creation of intraday money, by means of either an explicit or perceived
guarantee of payment finality. The author takes the position that recognizing certain forms of intraday "credit" as money is the key to
understanding and successfully regulating risk in the large-value
payments networks.
This discussion proposes that a major step toward containing the
systemic risk associated with electronic payments networks would be
the institution of some mechanism analogous to a reserve requirement
for all forms of electronic intraday money. The author suggests that a
sort of tradable electronic certificate could be created that would confer on its owner the right to create a limited amount of intraday money. In the author's view, this step would encourage the development
of an intraday money market—a pricing approach to containing risk—
that would lead to more efficient allocation of intraday funds than
would the continuing imposition of ad hoc limits on the volume of
such funds created.
The Federal Deposit Insurance Corporation Act of 1991 requires
regulators to account for interest rate risk in their risk-based capital
requirements. One technique regulators have relied on in their proposals is modified duration, which measures an asset's sensitivity to
interest rate fluctuations by making equal interest rate shifts to all
maturities of the current term structure and revaluing the asset under
the new term structure.
The author shows that for the beginning of the third quarter of
1992 modified duration failed to detect the true interest rate exposure of a very simple mock portfolio. Over that period the term
structure "twisted" significantly, a risk unmonitored by modified duration. The article illustrates other measures that do show this significant exposure.
The author warns that, as the example illustrates, overly simplistic models for measuring interest rate exposure may mislead users to
a sense of security at times when significant exposure actually exists.
32
The Use of Mitigating
Factors in Bank Mergers
And Acquisitions:
A Decade of Antitrust
At t h e Fed
FYI—
Christopher L. Holder
¿J ¿¡¡J Policy Essay—New Tools
For Regulators in a
High-Tech World
Stephen D. Smith and
Sheila L. Tschinkel
This article, the second in a two-part series, discusses how the
Federal Reserve has dealt with bank merger applications that had
potentially significant anticompetitive effects, according to the 1982
Department of Justice (DOJ) merger guidelines, over the last
decade. The Fed's Board of Governors approved most of the applications it reviewed during those years, citing a number of factors as
mitigating implied anticompetitive effects—competition from thrift
institutions, the likelihood of new entry into a market, the financial
health of the firm being acquired, and others. This discussion reviews these mitigating factors and provides insight into the Fed's
case-by-case approach to considering bank merger applications.
Traditionally, government subsidies have supported certain activities of financial institutions and regulations have limited others.
However, the authors argue, the technological advances that have
improved efficiency in trade have also made it possible to avoid
regulatory barriers at little cost, resulting in an expansion of trading
that may expand risk. They conclude that the existing quantitybased regulatory approach does not work as effectively in a lowtrading-cost environment and that a user fee-based system imposing
costs on financial transactions, rather than prohibiting trades outright, may more efficiently accomplish social goals.
2 / h e Rise of Electronic
Payments Networks and
The Future Role of the Fed
With Regard to
Payment Finality
William Roberds
/ I
/ I
/
I
/ M
ost participants in the U.S. e c o n o m y can identify with
/ M
G o e t h e ' s observation that " o n e goes through life with
/
m
more credit than money." There is a universal need to car/
m
ry out economic transactions without tapping scarce cash
—A»
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Mi,
reserves, a need that is met by various forms of credit from
credit cards to corporate bonds. Even most economists would agree that a
well-functioning credit market is essential for a successful market economy.
An equally important, though less discussed, aspect of credit concerns
the settlement of debt with minimum delay, inconvenience, and legal uncertainty. A successful system of credit clearly depends on the ability of debtors
and creditors to agree on terms under which debts are considered paid. Uncertainty surrounding payment finality could make potential lenders overly
cautious in their extension of credit.
The author is a research
officer and senior economist
in the macropolicy section of
the Atlanta Fed's research
department. He thanks the
many colleagues, both
within and outside the research
department, who have made
helpful and extensive
comments on earlier
drafts. The author is
solely responsible for
the contents.
Federal Reserve Bank of Atlanta
The settlement of credit-based transactions usually involves exchanging a
temporary form of payment (otherwise known as credit) for another, final
form of payment (money). In this sense, the issue of payment finality is inextricably linked to the larger issue of monetary policy. Consequently, the
Federal Reserve System has historically taken a leading role in formulating
the laws and regulations involving payment finality. This article considers
the Fed's role with respect to the finality or "moneyness" of a fairly new
form of payment, namely, large-value or wholesale electronic payments networks. In the United States, the two largest and best known of these netw o r k s are Fedwire, operated by the Federal R e s e r v e S y s t e m , and the
Clearing House Interbank Payments System (CHIPS), operated by the New
York Clearing House Association.'
Hco n o m ic Review
This discussion argues that the current payment
practices on Fedwire, CHIPS, and similar networks
amount to the creation of intraday money, by means of
either an explicit or perceived guarantee of payment finality. Though the intraday money created in this fashion is very short-lived, it is being produced in larger
and larger amounts, a phenomenon that has been of
much concern to researchers and regulators alike. The
position taken here is that the recognition of certain
forms of intraday "credit" as money is the key to successfully understanding and regulating the large-value
payments networks. The discussion includes a policy
proposal that would place an overall cap on the amount
of intraday money created via electronic payments
networks. Because it explicitly recognizes the monetary role of these networks, the proposal would be
likely to result in a more efficient electronic payments
environment than would alternative policy regimes.
M o n e y and Credit Defined
A useful first step toward analysis of any monetary
system is a precise definition of terms. The definition
of money that is used below is that proposed by Peter
M. Garber and Steven R. Weisbrod (1992). According
to their definition, money is "an asset that promises to
maintain its value in terms of the unit of account and
therefore becomes generally acceptable in market transactions." In the discussion below, credit will consist of
the transfer of some commodity (possibly including
money) from one economic agent to another, conditional on the promised future repayment of money.
7Tie Historical Development of Money
While there are many operational difficulties associated with monetary systems, one of the most persistent
of these has been the lack of any lasting agreement
about exactly what is generally acceptable as money.
From ancient times to the early twentieth century,
money was commonly defined as a certain amount of
a precious commodity, which was often but not always
gold. A system of pure c o m m o d i t y m o n e y suffers
from a number of problems, however, the most common being what happens to local economic activity in
areas where the monetary commodity is scarce. Peter
S p u f f o r d (1988), for example, documents how the
economies of medieval Europe, which were largely
2
Economic Kevieiu
based on the use of commodity money, repeatedly
spent t h e m s e l v e s into r e c e s s i o n by r u n n i n g trade
deficits with the Middle East. To settle their trade accounts, European countries were constantly exporting
precious metals. Despite all government efforts to the
contrary, this situation led to the reduction of the
stocks of precious metals to the point that monetary
exchange could not be sustained, barring the discovery
of new sources of gold or silver. 2
The economies of western Europe eventually managed to break out of this destructive pattern, thanks in
part to an influx of precious metal f r o m the N e w
World and in part to the d e v e l o p m e n t of institutions that could provide credit. Credit enabled a given
a m o u n t of c o m m o d i t y m o n e y to support a larger
m e a s u r e of economic activity. Two of these creditproviding means are especially relevant for the analysis of electronic payments networks: the banknote and
the c l e a r i n g h o u s e . T h e b a n k n o t e r e p r e s e n t e d the
promise of the issuing bank to pay, upon presentation,
a certain amount of the accepted commodity currency. 3
These notes, originally a form of credit, gradually became accepted as m o n e y (final payment) for most
transactions. With banknotes, payments often could be
effected without incurring the risks and costs of moving large amounts of precious metal. Banks were able
to economize further on the movements of precious
metal by establishing clearinghouses. 4 T h e role of
clearinghouses was to calculate, on a daily basis, each
member bank's net obligation vis-a-vis all other members. Net obligations would then be settled at the end
of the day, using gold or some other mutually acceptable form of payment.
In the United States, late-nineteenth-century restrictions on banknote issue accelerated the development
of yet another type of m o n e y — c h e c k a b l e bank deposits. 5 The widespread use of checks allowed banks
even greater economies on the use of precious metals
or banknotes. The m o v e m e n t toward check money
was assisted by the further development of private
clearinghouses, and later by the Fed's campaign to establish nationwide par (face-value) check clearing. 6
7Tie Economics of Electronic
Payments Networks
The evolution of money is a continuing process.
Today, the vast majority of transactions are still carried
out via the monetary "inventions" discussed above—
that is, by currency or check. Increasing numbers and
March/April 1993
amounts of transactions are taking place in pure electronic form, however, particularly on the large-value
or wholesale wire transfer networks. For example, the
overall transactions volume for large-value wire transfers in the United States (primarily Fedwire and CHIPS)
has been conservatively estimated at approximately
100 million transactions for 1990. While this number
represents only 0.1 percent of all transactions in the
United States for 1990, the total value of these transactions represents about $421 trillion—83.7 percent of
the value of noncash transactions for that year and
roughly thirty-five times the total value of U.S. gross
domestic product. 7 Most of the payments over these
systems are associated with either the domestic financial markets or markets for foreign exchange.
The emergence of electronic payments networks
poses both great opportunities for market participants
and great challenges to present or potential regulators.
The current state of computer technology is such that
the time between the initiation of a transaction and settlement could, from a purely technical viewpoint, be
reduced to a matter of minutes in most instances. However, this ongoing type of settlement (known as gross
settlement) has not become the accepted norm for payments networks, either domestically or abroad. Instead,
many electronic payments networks have opted for
once-a-day net settlement. Under such an agreement,
at the end of the business day a bank or another payments network participant pays to (receives from) the
network reserve funds equal to their total net debit
(credit) position vis-à-vis all other network participants.
This "clearinghouse" type of arrangement is often referred to as multilateral netting. 8
Strong economic incentives operate in favor of such
an arrangement. Suppose, for instance, that six banks
are organized into an electronic payments network. On
a certain day each bank wants to transfer $1 million to
each of the other five banks. Under gross settlement, a
total of thirty transactions would have to occur, and a
total of $30 million would change hands. Under a
multilateral netting scheme, no money would actually
be exchanged. At the end of the day, each bank's net
obligation to the other banks would be zero, and no
payments would be necessary. 9 Given this opportunity
to economize on transactions balances, it is hardly surprising that most electronic payments networks have
not tried to further reduce the interval between payment initiation and settlement.
In an era of electronic payments systems, a payments network with multilateral netting serves one of
the same functions that banknotes, clearinghouses, and
checks served in the pre-electronic era—that is, econ-
Federal Reserve Bank of Atlanta
omizing on costly transactions balances. In the uncertainty of the real world such multilateral netting arrangements also help to reduce the credit risk associated with the payments network. Risk is reduced because, other things being equal, the amount of funds
that each participant must "front" to settle is typically
smaller, thereby making it less likely that a participant
would not have access to sufficient funds to settle.
A potential disadvantage of multilateral netting is
that it requires a high degree of mutual trust and cooperation among participating institutions. In practice,
this problem is not insurmountable, however, because
a major purpose of electronic payments networks is to
facilitate payments among firms that are accustomed
to doing business with one another. And electronic
payments networks of any type require a high degree
of cooperation on matters such as computer formats,
security procedures, provisions for backups, and so
forth. The cooperation necessary for a multilateral netting agreement seems only a natural extension of that
already required for the existence of a given payments
network.
Both of the major large-value payments networks
in the United States—Fedwire and CHIPS—carry out
their operations under rules that, to some extent, embody
the multilateral netting principle discussed above.
However, the details are quite different across the two
systems. Fedwire is nominally a gross-settlement system: under Fedwire rules, payments made through the
Fedwire network are in almost all instances final and
irrevocable. Finality of payment is guaranteed by the
Fed, and reserve funds are made available immediately to the receiving institution. De facto multilateral
netting can still take place by m e a n s of "daylight
overdrafts." 1 0 A daylight overdraft occurs when an institution sends an amount of funds over the network
that exceeds its operating reserve balance plus the
sum of any incoming transfers. Fed regulations require that any such overdrafts must be repaid by the
end of the business day, either by additional incoming
transfers or deposits of additional reserve funds. Fedwire overdrafts are also subject to other restrictions,
which are discussed below."
In contrast to Fedwire, CHIPS operates on an explicit net-settlement basis. Payment messages sent
during the day are not final until end-of-the-day settlement occurs. Normally this settlement occurs around
6:00 P.M. via special Fedwire accounts at the Federal
Reserve Bank of New York. Because CHIPS is not a
bank and has no bank accounts, there are no daylight
overdrafts per se. The equivalent of daylight overdrafts
on CHIPS is the credit that participants are willing to
Hco n o m ic Review
extend to one another. As with Fedwire, the allocation
of such credit is subject to certain rules and limits. 12
Is It Really Money?
Are daylight overdrafts over Fedwire and intraday
"credit" over networks such as CHIPS really money or
simply a convenient form of credit? By sending payments orders over EFT networks, banks and their customers can de facto expand banks' intraday balance
sheets in a process that closely resembles the creation
of traditional, overnight bank deposits. The details of
this process are spelled out in Appendix 1.
Not every expansion of banks' balance sheets constitutes money creation, however. To qualify as money, a bank liability should pass a standard test of its
"moneyness." That is, how close an approximation is
this liability to final, irreversible payment? In the case
of Fedwire, the Fed's explicit guarantee of payment finality clearly qualifies daylight overdrafts as money.
For CHIPS and other private networks with multilateral netting, the money/credit question is more subtle.
The fact that finality of payment is not guaranteed
over CHIPS by the Fed or any other governmental entity raises the issue of systemic risk. 13 Over a payments network, systemic risk refers to the risk that
some network participants may not be able to settle
their net obligations at the end of the business day,
thereby forcing other participants to c o m e up with
funds to cover incoming transfers expected from the
failing participant. If this requirement, in turn, caused
other participants to fail to meet their obligations, the
integrity of the network or of other parts of the payments system could be compromised.
A l t h o u g h such a crisis has never occurred over
CHIPS, the CHIPS system has taken a number of steps
to limit its participants' exposure to systemic risk.
These include limiting the net credit and debit positions
of each participant (bilateral credit limits and overall
net debit caps, respectively) vis-à-vis other participants.
More recently, CHIPS has adopted a loss-sharing arrangement, which is backed by collateral requirements
and is designed to ensure that the losses from one
participant's failure are borne by more than one other
participant. The total amount of collateral required,
however, is small (estimated at $3 billion to $4 billion)
relative to the average amount of intraday credit extended via CHIPS (approximately $20 billion to $30 billion). Studies performed by CHIPS indicate that these
measures probably would cover losses induced by one
Economic Kevieiu
4
member's failure to settle but that the simultaneous failure of two or more members could easily exhaust these
provisions. As a last resort, CHIPS rules allow for its
governing committee to take any measures necessary
to complete the settlement process. However, the committee is limited in its ability to impose additional losssharing obligations on other CHIPS members. 14
Despite the fact that the Fed does not guarantee
payment finality over CHIPS, it can be argued that
for p u r p o s e s of e c o n o m i c analysis p a y m e n t s over
CHIPS and similar networks should be considered
"approximately" final and that CHIPS intraday credit
should be considered money. The first reason is that
the "settling" m e m b e r s of C H I P S and similar networks are U.S. banks, which would in most cases have
access to the Fed discount window. A second reason
to consider payments over many private networks de
facto final has been advanced by David L. Mengle
(1990), among others. Even though there is no guarantee of finality over these networks by the Fed, or by
any other regulatory agency, it can be in the best interests of participants in these networks to act as if
such a g u a r a n t e e were in place. By pursuing this
course of action, Mengle explains, network participants are in effect betting that the network will be
"bailed out" by some sort of governmental intervention should a crisis develop that could cause a settlement failure. The odds may favor this bet if regulators
have strong incentives to prevent settlement failures
and their negative consequences.
The viewpoint that CHIPS is too big to fail appears
to be widespread. Marcia Stigum quotes one bank officer who is responsible for his bank's CHIPS operation as saying, "If CHIPS fails to settle, I j u m p out of
my window. CHIPS cannot not settle because, if it
were to fail to do so, it would destroy confidence in
the money market internationally" (1990, 903). The view
that the Fed "stands behind" private payments systems is apparently shared by a large number of privatesector observers of the payments system, including officials of the American Banking Association (Philip S.
Corwin and Ian W. Macoy 1990, 11) and quite a few
academics (for example, Robert Eisenbeis 1987, 48;
Andrew F. Brimmer 1989, 15; Ben S. Bernanke 1990,
150; Hal S.Scott 1990, 187).
As long as this perception prevails in the private
sector, it makes little difference whether or not the
Fed explicitly guarantees payment finality. In other
words, the market has its own view of what policies the
Fed would pursue in the event of an impending systemic crisis, and such views are not under Fed control.
The bottom line is that payments over many private
March/April 1993
networks in effect constitute money because they are
perceived as such.
7Tie Policy Problem and Some
Real-World Complications
The above discussion shows that the process of netting payments over electronic networks represents a
rational private-sector response to the problem of how
to economize on costly transactions balances. By exchanging payments messages during the business day
and settling net positions at the end of the day, payments network participants economize on their need
for costly reserve balances. In the jargon of monetary
economics, these savings result from the substitution
of "inside" money (money created by the private sector, in this case the payments messages or daylight
overdrafts) for "outside" money (in this case, electronic reserve funds held with the Fed). 15
The ability to create this new form of inside money
has certainly been of benefit to the institutions that have
been able to do so, and its creation has likely been of net
benefit to society as a whole. At the same time, there is
evidently a limit to a good thing. The willingness of the
Fed to absorb systemic risk associated with electronic
payments systems is large but surely not infinite. As is
the case with traditional, overnight bank deposits, the
economy achieved by the private sector's substitution of
inside money for outside money should be offset by a
calculation of the costs of the Fed's guarantee of liquidity in the event of a systemic crisis. It is worth noting
that the Fed's total liability in the event of such a crisis
would not be bounded by the net amounts due to settle
but by the gross amount of payments messages entered
into the various networks (see Appendix 2). Maintaining
a credible (though perhaps implicit) guarantee against
systemic risk in electronic payments networks cannot be
consistent with unlimited growth in the number of such
networks or indefinite growth in the volume of potential
liabilities created via these networks.
Thus, the essential policy problem associated with
electronic payments networks is how to contain the
systemic risk associated with the creation of intraday
money via these networks without imposing undue
costs on the private sector. It needs emphasizing that
the scope of this particular problem goes beyond the
confines of domestic bank regulation. On the international front, several multicurrency payments systems
are currently in the planning stages. The advent of
cross-border payments networks poses some notewor-
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
thy complications for policy concerning electronic
payments networks. 16
The first potential complication lies in the sheer
size of the international currency markets, whose daily
volume is now close to $900 billion. 1 7 Because the
gains from netting arrangements are proportional to
the volume of payments over a given network, the incentives for netting cross-border payments are strong.
Also, for a given dollar volume of payments, crossborder payments networks can offer stronger incentives for netting than domestic networks, especially if
a substantial number of these obligations have to be
converted to another currency before settlement. In
other words, it is highly likely that a large volume of
inside money will be created over these networks and
that much of this money will be dollar-denominated.
A second potential problem is the temporal separation of markets in various currencies. This complication should be of particular concern to U.S. policym a k e r s , given that Western H e m i s p h e r e f i n a n c i a l
markets close (and settle) after Asian and European
markets have closed for the day. As a result, for certain
foreign exchange transactions there is a risk associated with the fact that payment in the foreign currency
will have been finalized before the offsetting payment
in dollars b e c o m e s final. 1 8 A c c o r d i n g to B r u c e J.
Summers (1991, 85), an average daily volume of as
much as $400 billion in foreign exchange transactions
is settled (on the dollar end of these transactions) by
CHIPS at the end of the U.S. East Coast business day.
The time delay between initiation and settlement for
some of these transactions can be as long as fourteen
hours.
On the domestic front, there are incentives for private, nonbank firms to organize themselves into payments networks, including those that allow for bilateral
or multilateral netting of obligations. Such networks,
known as delivery-versus-payments systems, already
exist for U.S. government securities, mortgage-backed
securities, and commercial paper. In principle, there is
no reason why such arrangements would not be extended to any heavily traded commodity. 19
The operation of domestic, nonbank payments networks raises policy concerns similar to those listed
above, and particularly the issue of ultimate responsibility for the integrity of the network. The settlement of
nonbank obligations will, in all probability, continue to
be effected via the banking system (that is, through Fedwire). If there is a market perception of a de facto Fed
guarantee against systemic risk in these networks, it
would be difficult not to recognize the intraday credit
extended over the nonbank networks as intraday money.
Hco n o m ic Review
Possible Policy Responses
The discussion to this point has attempted to show
that strong incentives exist for the extension of intraday credit, which in many cases is regarded as intraday money via electronic payments networks. Given
these incentives and continued technological improvements, the volume of such credit can be expected to
grow over time.
The intraday credit extended over these networks,
particularly over Fedwire and CHIPS, has hardly escaped the attention of U.S. policymakers. However,
the development of the legal and regulatory framework for electronic payments networks has proceeded
at a relatively slow pace. The measured pace of regulation in this area reflects a fundamental dilemma of
regulating p a y m e n t s systems. Because the critical
characteristic of a free-market economy is voluntary,
mutually beneficial exchange, policymakers are reluctant to burden payments networks with restrictions
that would unnecessarily hinder such exchanges.
At the same time, there is a widely recognized need
to provide safeguards for payments network participants against systemic risk. Some such protection is
afforded by the Fed discount window. However, there
are certain disadvantages associated with a reliance on
the discount window as a means of protection against
systemic crises. One potential drawback is that the
size of discount window loans necessary to avert a
systemic crisis could be quite large, potentially conflicting with m o n e t a r y policy objectives. A n o t h e r
drawback is the set of restrictions imposed on the use
of the discount window by the Federal Deposit Insurance
Corporation I m p r o v e m e n t Act of 1991 (FDICIA). 2 0
Section 142 of FDICIA limits discount window lending to undercapitalized banks to sixty days within any
120-day period unless the Fed or the undercapitalized
bank's primary federal bank regulator certifies that the
bank is viable. In the case of critically undercapitalized banks, FDICIA instructs the Fed to demand repayment of discount window loans within five days. If
the 5-day limit is violated, the Fed must share with the
FDIC in any resulting increase in costs, and Congress
must be notified of any payments to the FDIC under
this provision.
Larry D. Wall (1993) reports that a major objective of
FDICIA was to limit the extent of the too-big-to-fail
doctrine. Wall notes that although FDICIA allows for
"systemic risk" exceptions to its restrictions, invoking
this exception requires approval of the FDIC, the Fed,
and the U.S. Treasury (Section 142). Thus, while rec-
6
Economic Kevieiu
ognizing the importance of a lender of last resort in
averting systemic crises, Sections 141 and 142 of FDICIA mandate a clear set of incentives that discourage
excessive reliance on the discount window as protection against systemic risk.
Against this background, the Board of Governors of
the Federal Reserve System acted in 1990 to strengthen restrictions on daylight overdrafts incurred over
Fedwire. A major objective of these restrictions is to
limit the amount of systemic risk borne by the Fed in
its operation of Fedwire. The most substantive restrictions cap the intraday credit granted to any Fedwire
participant, limiting the amount of this credit to a fixed
percentage of the participant's risk-adjusted capital. 21
Beginning in 1994 the Fed will also start phasing in
interest charges for overdrafts that exceed a deductible,
which is also a fixed percentage of risk-adjusted capital. These charges will gradually rise to a level of 25
basis points at an annual rate. 22 These restrictions, together with the new regulations adopted by CHIPS
(discussed above), have no doubt helped to restrict the
potential for systemic crises in these two large-value
payments networks.
Given the increasingly diverse use of electronic payments networks, however, it is questionable whether
existing regulation of intraday netting over Fedwire,
or even domestic interbank payments networks more
generally, will be sufficient to eliminate the possibility
of systemic risk. Commenting on the 1990 changes in
the rules regarding Fedwire overdrafts, Corwin and
Macoy note that "fi]ronically, the result of . . . Federal Reserve policies seeking to limit the growth and
totals of daylight overdrafts on Fedwire is to shift
them to private wire systems" (1990, 10).23 In view of
the various reforms recently adopted on CHIPS, Corwin and Macoy's statements could probably be applied to some degree to that system as well. To be
effective over the longer term, any scheme for minimizing systemic risk over electronic payments networks will have to address the presence of this type of
risk on all networks that make use of intraday netting
of payments.
At one end of the policy spectrum, a suggested
remedy to this situation would be the elimination of
intraday netting in favor of real-time gross settlement,
that is, gross settlement without daylight overdrafts.
While this policy ignores the potential gains from netting arrangements, it has modern technology on its
side. That is, if technological improvements make it
possible for gross settlement to proceed on a virtually
real-time basis, the cost of a gross-settlement system
could be reduced vis-à-vis netting arrangements with
March/April 1993
daily settlement. A real-world approximation to such
a system is the Swiss Interbank Clearing (SIC) system.
Christian Vital and Mengle describe SIC as "a centralized gross settlement system created to process interbank payment transactions with no daylight overdrafts
and therefore no systemic risk" (1988, 23).. However,
even on this system, the time from initiation of a transaction to settlement often exceeds the technologically
feasible minimum of thirty seconds. Vital and Mengle
note that as of November 1988, 55 percent of transactions were executed within two hours of initiation, and
85 percent, within five hours.
Could such a system work in the United States? Certainly the introduction of gross settlement to U.S. payments networks would pose a larger, though hardly
insurmountable, technical challenge. In 1989, SIC had
163 members versus 139 for CHIPS and 11,435 for
Fedwire. (The total number of participants for Fedwire
is somewhat deceiving because only about 2,000 highv o l u m e p a r t i c i p a n t s maintain direct c o m p u t e r - t o computer links to the Federal Reserve Banks.) The
1989 average volume of transactions over SIC was comparable to that of Fedwire: daily averages were 223,000
for SIC versus 238,000 for Fedwire and 146,000 for
CHIPS. However, the average daily value of the transactions over SIC was much less than for the U.S. networks: $73 billion for SIC versus $730 billion for
Fedwire and $761 billion for CHIPS. 24 The higher value for the U.S. networks means that sustaining similar
volumes under a gross-settlement system would raise
the probability of a situation known as "payments gridlock," whereby numerous network participants would
each be waiting for other participants to make the first
payment. The elimination of net settlement could also
contribute to payments gridlock by encouraging network participants to wait until the last possible moment
to enter payments messages into the network so as to
economize on intraday reserve balances. Prevention of
payments gridlock would require installing additional
hardware to handle the last-minute volume or the introduction of peak-hour pricing of settlement services.
A constraint even more limiting than any operational difficulty associated with gross-settlement systems would be the r e l u c t a n c e of current users of
intraday netting to move to gross settlement. In fact,
history f a v o r s continued d e v e l o p m e n t of intraday
credit as a form of money. Once a form of credit—for
example, banknotes or checks—has become accepted
as a form of money, attempts to regulate that form out
of existence have ultimately been unsuccessful. And
in at least one case in which stringent regulation was
successfully introduced—a tax on banknotes by a con-
Federal Reserve Bank of Atlanta
gressional act of 1865—the ultimate effect of this regulation was the accelerated development of bank account money, an alternative form of inside money.
A Monetary Alternative
There have been numerous studies and proposed policy responses to the problem of "daylight overdrafts"
or "intraday credit." 25 Generally speaking, these studies
are of high quality, and most of the suggested policy
responses represent sensible approaches to this issue.
However, a common failing in this literature is a general reluctance to admit that the extension of intraday
credit via electronic payments networks is equivalent
to the creation of money. 26 The fact that "electronic intraday money" comes in a form different from currency or bank accounts does not affect the validity of this
generalization. Paper currency and check money both
developed as claims to a different, more widely accepted form of money. Electronic payments, which began as a form of claim on check money, are coming to
be more widely used as money. A reasonable first
premise of an effective policy on payments networks
would be that once something is used as money, it
should be viewed as such for purposes of policy.
A distinguishing feature of electronic intraday money, as it currently exists, is that it is all inside money. By
contrast, more traditional forms of money consist of a
combination of inside money (transactions accounts
at depository institutions) and outside money (currency plus bank reserves with the Fed). Traditionally, the
amount of inside money held by a depository institution is limited by reserve requirements to be no greater
than a fixed multiple of its holdings of outside money.
With electronic intraday money, no such requirements
exist. Abstracting from such restrictions as bilateral or
multilateral "caps," the sole restriction on the creation
of this kind of money is the requirement that it disappear by the end of the trading day. The second premise
of an effective payments system policy, in the framework of this proposal, would be the institution of
some mechanism analogous to a reserve requirement
for all forms of electronic intraday money.
In calling for the institution of a reserve-like requirement for intraday money, it should be pointed out
that the institution of such a requirement would not be
a panacea for all of the regulatory issues associated
with the operation of payments networks that allow
for netting of intraday payments. In particular, the
institution of reserve requirements is not seen as a
Hco n o m ic Review
substitute for risk-limiting measures such as capital
and/or collateral requirements, real-time monitoring of
net debit positions, and so forth. Rather, the establishment of a reserve-like mechanism for intraday money
creation would serve some of the same purposes as
imposing reserve requirements on ordinary, overnight
deposits in transactions accounts: delimiting the Fed's
liabilities as l e n d e r of last resort and s u p p l y i n g a
means of pricing the protection provided by the Fed
against systemic crises (which may currently be seen
as an implicit, rather than explicit, guarantee).
The third and final premise of an effective payments system policy would be recognition of the principle that the s u c c e s s f u l operation of a p a y m e n t s
system, particularly one with multilateral netting arrangements, requires the existence of an institution
analogous to a central bank. In the case of the U.S.
banking system, the function of a central bank is carried out by the Federal Reserve System; similar institutions exist in most countries today. Although in the
late nineteenth and early twentieth century no such
institution existed in the United States, many of the
present-day functions of the Fed were carried out by
private clearinghouse arrangements. Concerning the
role of these private clearinghouses, Gary Gorton has
noted that "by the early twentieth century clearinghouses looked much like central banks. They admitted, expelled, and fined members; they imposed price
ceilings, capital requirements, and reserve requirements; they audited members and required the regular
submission of balance sheet reports. . . . [T]hey issued money and provided a form of insurance during
panics" (1985, 283).
The fact that such institutions were created voluntarily suggests that some analogous regulatory organization, be it public or private, will inevitably be associated with any electronic payments network.
/teservable Electronic Intraday Money:
Some Details
How could reserve requirements be imposed on the
intraday money created by electronic payments networks? It seems that currently available payments
technology could be used to create a sort of tradable
electronic certificate, as follows.
T h e certificates would be called something like
"electronic intraday cash creation rights" (EICCR) and
could only be created by the Fed. An EICCR would
confer on its owner the right to create intraday money
8
Economic Kevieiu
via an electronic funds transfer system with a netting
arrangement, up to some prespecified limit. A network
participant placing a payments order over a certain
network would deposit the required EICCR "collateral" with the relevant network until settlement. Because
EICCR would be created in a limited amount, it would
have positive value. After its creation, EICCR would
be available for purchase by any depository institution
with its reserve funds. 2 7 EICCR not held as collateral
by a payments network could be resold to other depository institutions. Nonbank firms could buy EICCR
from a depository institution at which they maintained
a transactions account.
The term collateral as used here does not mean that
EICCR constitutes collateral in the usual sense of "an
item of sufficient value such that its liquidation would
provide funds necessary to cover any default on a particular debt." In practice, it would be highly unlikely
that EICCR liquidation would cover more than a fraction of the funds necessary to cover the obligations of
a failed network participant. EICCR might be better
described as proof of payment on an insurance policy,
under which the proof of payment could be traded
among different network participants provided that it
was not currently in use.
There are several details of the EICCR plan not described above that would need to be specified in practice. The first such detail would be a way to decide on
an initial allocation of EICCR—the amount of EICCR
to be created and who would be entitled to it. T h e
question of how much EICCR to create would pose
difficult but not insurmountable problems of the same
nature as those faced in determining the optimal rate of
growth for the Fed's open market portfolio. From a
standpoint of economic efficiency, the initial allocation
of EICCRs would be essentially irrelevant. One possible candidate for an initial allocation would be to
"grandfather in" participants in existing networks by
providing them with EICCRs equal to, say, their average maximum intraday exposure over some specified
time period.
Another detail that would have to be worked out
would be a mechanism for intraday transfer of EICCR.
An obvious candidate for such a mechanism would be
real-time delivery of EICCR against payment over Fedwire. To be effective, however, such a m e c h a n i s m
would require a "daylight overdrafts" policy of sufficient stringency so as to prevent the widespread substitution of Fedwire overdrafts for intraday m o n e y
creation over private networks.
Proposals such as the one described above have not
been given serious policy consideration in part because
March/April 1993
of the perception that a mechanism such as EICCR
would pose insurmountable technical difficulties. For
example, Edward C. Ettin states that "the sheer mechanics of calculating deposit and reserve balances
second by second make this approach impossible"
(1988, 290). It is not necessary to delve into the technical details to find such claims difficult to support,
given the current technological capabilities in the
banking industry. With the availability of debit cards
and point-of-sale (POS) terminals, consumers are able
to purchase electronically such items as gas and groceries on a real-time basis. 28 If everyday retail items
can be bought in such a fashion, then it seems reasonable to assume that currently available technology
could allow for the real-time purchase of the right to
create intraday money.
As a method of managing the aggregate amount of
systemic risk associated with the payments system, an
EICCR-based limit on the creation of electronic intraday money would have several advantages over more
direct regulation of electronic payments networks. A
requirement that intraday money creation be "collateralized" by EICCR would place an effective aggregate
limit on the amount of intraday electronic money outstanding at any given time. An a d v a n t a g e that an
E I C C R - b a s e d c o n s t r a i n t would h a v e o v e r s i m p l e
quantitative caps is that it would encourage the development of a market for intraday funds, particularly intraday EICCR. With such a market, an EICCR-based
constraint would be more efficient than quantitative
caps in the sense that electronic intraday money would
be created in the largest amounts in the networks associated with the highest demands for funds. An obvious
and beneficial side effect of the EICCR market would
be the availability of a market price for intraday "credit"—that is, a price reflecting the true value of the
Fed's safeguards against systemic risk in these markets. An operational difficulty associated with policies
that advocate the ad hoc pricing of daylight overdrafts
is that such policies provide no direct measure of the
appropriate price of intraday money. Incorrect pricing,
in turn, would amount to levying an unintended tax
on, or providing an unintended subsidy to, the creation
of intraday money.
The EICCR proposal outlined above bears a strong
resemblance to the idea of marketable emission permits in the area of environmental policy. Under such a
policy, firms emitting a harmful pollutant into the environment must purchase a permit to do so. The permit
allows for emission of the pollutant up to a specified
amount. By limiting the number of permits for a given
pollutant, the government can control its total emis-
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
sions. The permits can be freely traded between polluters at market prices. Although the available evidence
on the overall efficacy of such permits is mixed, there
is a good deal of evidence to suggest that the use of
permits represents a more cost-effective approach to
pollution control than does direct regulation (explicit
quantitative caps on emissions by each producer). 29
Under the EICCR proposal, the analog of "pollution" would be systemic risk. That is, in the course of
producing a desirable commodity—intraday money—
participants in electronic payments networks would
create an undesirable by-product, systemic risk, most
of which would be borne by the Fed as a lender of last
resort. As in the case of pollution permits, it is possible
to limit the amount of this risk outstanding by requiring
permits for creation of such risk (via the netting of payments) and limiting the total amount issued.
The pollution analogy is also useful for illustrating
the key difference between the EICCR proposal and
a system of explicit, fixed charges for daylight overdrafts or intraday credit. The equivalent of overdraft
charges in terms of environmental economics would
be a per-unit pollution tax. Overdraft charges attempt
to limit the extent of something undesirable—systemic risk—by fixing the price of the risk and letting
the m a r k e t d e t e r m i n e the quantity of the risk that
would be incurred, a policy that economists term price
rationing. In contrast, the EICCR proposal would limit
the quantity of risk and let the market determine the
price, an approach known as quantity rationing. In the
case of intraday money, quantity rationing (and the
systemic risk associated with creating intraday money)
would possess an important advantage over price rationing because the closest substitute for intraday
money—overnight reserves or federal funds—is already effectively price-rationed by the Fed by means of
daily interventions in this market. To fix prices successfully in the markets for two close substitutes (overnight
and intraday money), one would to have to possess
precise information on the relative price of the two
forms of money. Otherwise, one form of money would
be overpriced relative to the other, causing market imbalances as market participants try to convert their
funds from the more expensive to the cheaper form of
money. Under a quantity-rationing scheme for intraday money, the informational d e m a n d s on the Fed
would be less stringent. The Fed would simply set a
cap on the maximum amount of intraday money that
could be created on a given day. The market would
then decide the appropriate price for this money, a
price that would be consistent with the going rate of
federal funds.
Hco n o m ic Review
A proposal for reserve requirements on intraday
money, similar in some respects to the EICCR proposal
outlined above, has been advanced by E. Gerald Corrigan (1987) and put forth in more detail by Kausar
Hamdani and John A. Wenninger (1988). In the case
of Fedwire daylight overdrafts, Corrigan and Hamdani
and Wenninger propose that overdrafting banks hold
supplemental overnight reserves at a level that is the
average of these overdrafts. Supplemental balances
would earn interest at a rate lower than the overnight
fed funds rate. While the basic idea of the Corrigan
and Hamdani-Wenninger approach—making intraday
money reservable—is the same as that behind the present approach, there are some noteworthy differences.
The Hamdani-Wenninger proposal is limited to overdrafts on Fedwire, whereas this proposal suggests that
an EICCR-based "reserve requirement" be applied to
all electronic payments networks that allow for intraday netting of obligations (Corrigan also suggests that
reserve requirements be widely applied). For the reasons outlined above, imposition of a reserve ratio on
Fedwire, without imposing similar requirements on
private networks, would have the undesirable side effect of encouraging the creation of additional intraday
money and thereby additional systemic risk on the
private networks. 3 0 Both the Hamdani-Wenninger and
the Corrigan approaches also propose reserve requirements (clearing balances) based on average levels of
overdrafts, with the averaging taking place over some
specified period. On the other hand, an EICCR-based
reserve requirement would effectively place a continuously administered reserve requirement on the creation of intraday money. Because intraday money is
created on a continuous basis, a true reserve-based
market for such funds would have to reflect the continuous changes in the availability of reserves to be
held against such funds. A continuously applied reserve requirement would therefore seem preferable,
abstracting from technical difficulties, to reserve requirements based on a time average.
By serving as a uniform international standard for
electronic payments networks, an E I C C R - r e s e r v e based limitation on the creation of intraday money
could serve to lessen the risk associated with crossborder payments networks. Such limits could also help
to reduce Herstatt risk (see note 18), for example, by
means of a uniform international requirement that
cross-border payments network participants granting
credits to be settled in foreign currencies hold EICCR
reserves in the settling currency. Any such requirements would necessitate that EICCR for each currency
be made available on an around-the-clock basis.
10
Economic Kevieiu
Potential Problems
Aside from technical difficulties, one could foresee
other potential difficulties with the introduction of intraday reserve requirements, based on either EICCR
or more traditional reserve accounts. One of the most
troubling from a regulatory viewpoint would be the
blurring of the distinction between banking and commerce. Any statutory recognition of intraday electronic exchanges between nonbank firms as a reservable
form of payment would come close to conferring on
these firms the legal authority to create money, a right
currently reserved for depository institutions that are
regulated, examined, and insured by governmental
agencies. If nonbank firms are to be involved in the
production of intraday money, their involvement raises the question of what kind and degree of regulation
would be appropriate for these firms.
The inherent difficulty of such public policy issues
does not mean that an EICCR requirement or a similar limitation should not be placed on electronic intraday money. The unfortunate legacy of historical policy
toward intraday money has been the encouragement of
an unsustainable "bielectronic" monetary standard.
That is, current policies allow for a dual standard
whereby one form of money (transactions funds held
overnight at depository institutions) is reservable, yet
another form (electronic intraday payments) is not,
and the result is a situation reminiscent of the late
nineteenth-century U.S. experiments with bimetallism.
Theoretically, bimetallism was supposed to allow for
the simultaneous maintenance of gold and silver commodity standards, plus the maintenance of a strict mint
ratio of convertibility between the two metals. The
fate of such schemes is well known: in practice, because the mint ratio between the two metals rarely
equals their relative market prices, the cheaper of the
two metals circulates while the more expensive metal
is converted to a nonmonetary commodity. 31
In the present-day situation, the existence of reserve
requirements on overnight money means that inside
money created in the form of traditional checking accounts is more costly to produce than inside money
created via intraday credit over electronic payments
networks because the latter is currently nonreservable.
If there were a private market for the exchange of the
two forms of money, intraday money would probably
trade above par with overnight funds. 3 2 Yet par convertibility of electronic intraday money is maintained
by the daily settlement of electronic accounts via the
exchange of reserve funds—that is, via Fedwire. Par
March/April 1993
settlement of electronic intraday money in effect causes this money to be underpriced relative to the usual,
overnight bank funds. 3 3 The imposition of an EICCR
collateral requirement on intraday money could rectify
this situation while maintaining par valuation of intraday money in terms of overnight money.
The foregoing discussion assumes the continued existence of reserve requirements on transactions accounts
at depository institutions. However, many economists
question the need for reserve requirements, and any
policy designed to regulate the creation of intraday
money must contend with the possibility that these requirements could be abolished. 34 In the case of EICCR,
it can be argued that the efficacy of an EICCR collateral scheme need not depend on the existence of explicit
legal reserve requirements for overnight money.
For example, suppose that explicit reserve requirements for overnight f u n d s were abolished. Even in
this case, reserve accounts would still be of value for
the liquidity they provide. Most banks would almost
certainly continue to hold positive reserve balances
for clearing purposes. If these "clearing balances"
paid no interest or paid interest at a rate below the
market rate on overnight funds, 3 5 in the absence of
E I C C R or a s i m i l a r c o l l a t e r a l r e q u i r e m e n t t h e r e
would still exist a positive cost differential between
the cost of overnight and intraday money, a differential that would reflect the cost of holding liquid, but
low-yielding, reserve funds. Hence, the right to create
intraday money, which would be conferred by posting
of EICCR collateral, would still be of positive value.
The price of EICCR would reflect the value of intraday money in reducing the need for costly reserve
balances.
A more fundamental objection to placing reserve
requirements on electronic intraday money is implied
in, for example, the views expressed by Lawrence H.
White (1984, 1989). White argues that governmental
regulation of the money supply has been at best inefficient and that free market forces would, over time, deliver better monetary institutions. Those sharing White's
views might object to imposing reserve requirements
on electronic intraday money as precluding the development of efficient private-sector mechanisms for regulating the supply of intraday money.
This criticism is difficult to answer, given how little
the economics profession really knows about the workings of money. Because there is currently no widely
accepted theoretical framework for money, it is difficult
to rank systematically the "efficiency" of various monetary arrangements. Furthermore, the historical evidence concerning private banking systems is decidedly
Federal Reserve Bank of Atlanta
mixed. Richard H. Timberlake, Jr. (1984), Gorton (1985),
and Gorton and Donald J. Mullineaux (1987) have argued that the central-bank-like features of nineteenthcentury bank clearinghouses represented a spontaneous
private-sector response to the various risks typically associated with banking, including the sort of systemic
payment risk inherent in multilateral clearing arrangements. 36 Thus, one could argue that something akin to
reserve or collateral requirements would be imposed on
intraday money by the private sector.
There are several arguments that could be made in
favor of increased public-sector regulation of the electronic intraday money, however. The first is the argument made above concerning the CHIPS network—
that if participants in a given network expect the Fed
(and other central banks) to bear the systemic risk associated with intraday netting schemes, these participants may act as if the risk were covered, irrespective
of the Fed's actual policy stance on the issue. If these
expectations are backed by similar ones on the part
of the general public, there would be greater difficulty in dissociating Fed policy from any implied guarantee against systemic crises. In other words, simple
disclaimers of responsibility for systemic risk are not
likely to be credible if such disclaimers run against the
grain of public expectations. Any credible transfer of
the Fed's responsibility as lender of last resort to the
private sector would likely require an unambiguous
statutory backing and widespread political support.
A n o t h e r argument in f a v o r of g o v e r n m e n t a l , as
o p p o s e d to private, r e g u l a t i o n of these p a y m e n t s
networks concerns the allocation of regulatory responsibility. Under a system of private regulation, would one
payments network bear any responsibility for a systemic crisis on another network? In the historical example of the pre-Fed clearinghouses, it is well known
that these private clearinghouses provided effective
safety nets (from systemic liquidity crises) for their
member banks. During the 1907 panic, however, these
carefully planned private arrangements were unable to
prevent a systemic crisis from developing within the
closely allied but relatively unregulated trust companies. 37 If a similar "contagion" of systemic crises were
to develop over more than one private payments network, questions would certainly arise about how to allocate the responsibility for managing such a crisis. It
is conceivable that these allocations could be governed
by private contracts, but the scope and extent of such
arrangements would be unprecedented. In addition,
this approach would require a credible commitment on
the part of the U.S. government to limit the scope of
the Fed's control over the intraday money supply.
Hco n o m ic Review
A related problem with pre-Fed clearinghouse arrangements had to do with the distributional effects of
systemic crises. During pre-Fed money panics, clearinghouse member banks would often protect themselves from bank runs by resorting to suspensions of
payment (of specie or its equivalent). These suspensions constituted a reasonable (though, strictly speaking, illegal) mechanism for protecting the banking
system against liquidity crises. However, the suspensions also imposed significant costs on bank depositors who were unable to convert their bank deposits
into hard cash, effectively removing political support
for this mechanism. Similar considerations would afflict any private arrangement for dealing with systemic
crises over electronic payments networks. If it imposed large costs on a considerable segment of the
population, even an economically efficient mechanism
could prove politically untenable. 38
Conclusion
The history of money is one of ever-increasing sophistication in the technology for e c o n o m i z i n g on
transactions balances. The latest milestone in this historical trend is the advent of electronic intraday money. This money is in effect created by the extension of
intraday "credit" over electronic payments networks,
networks whose integrity is often seen as either de jure
or de facto guaranteed by the Fed or by foreign central
banks.
The development of electronic intraday money is a
natural outgrowth of the development of computer and
communications technology necessary for electronic
payment. These payments technologies offer the potential to economize on the use of scarce bank reserves
and to increase payments system efficiency. Unfortunately, the legal and regulatory framework of the paym e n t s s y s t e m has not kept pace with the rate of
technological innovation. In particular, current technologies allow for virtually c o n t i n u o u s p a y m e n t s
12
Economic Kevieiu
while the laws, regulations, and conventions regarding
settlement are still largely oriented toward settlement
on a once-a-day basis.
An unforeseen consequence of this disparity has
been the encouragement of a "bielectronic" monetary
standard. That is, money in overnight transactions acc o u n t s is r e s e r v a b l e while i n t r a d a y m o n e y is not
reservable but is convertible to overnight money at
par. As a result, the existing regulatory framework has
favored the creation of the less costly electronic intraday money in ever larger amounts. The creation of intraday m o n e y carries with it a certain a m o u n t of
systemic risk. A number of policy measures have been
aimed to limit the amount of such risk borne by the
Fed, and it is likely that the legal and r e g u l a t o r y
framework in this area will see additional changes.
This discussion has argued that a major step toward
containing the systemic risk associated with electronic
payments networks would be to eliminate the artificial
cost advantage associated with intraday money by creating tradable "intraday money creation rights." By
encouraging the development of an intraday money
market, this step would lead to more efficient allocations of intraday funds than would the continuing imposition of ad hoc limits on the creation of such funds.
The literature on electronic payments networks has
tended to focus on the very complex institutional and
technological characteristics of such systems. Without
minimizing the complexity of such issues, it is this author's opinion that such analyses have failed to emphasize the fundamental truth that electronic payments
are increasingly being used as an efficient form of
money. Conceptually, electronic payments are no more
innovative than were other devices that allowed for the
creation of inside money: banknotes in seventeenthcentury Sweden, clearinghouses in eighteenth-century
London, or checks in the nineteenth-century United
States. The introduction of marketable rights to the
creation of electronic intraday money would be a useful first step toward moving electronic payments systems away from the realm of technocracy and into the
mainstream of the marketplace.
March/April 1993
Appendix 1
T h e M e c h a n i c s of M o n e y C r e a t i o n : S o m e S i m p l e E x a m p l e s
The process by which banks can create money is covered in most college courses on m o n e y and banking.
H o w e v e r , the notion that banks can create m o n e y remains a foreign one to many people. The first example
describes how a theoretical banking system can create
traditional, overnight money.
Suppose that a small, closed economy has only two
banks. In this simple economy, banks hold liabilities in
the form of demand deposits and assets in the form of
loans to customers and reserves in an account held with a
central bank. There is a 10 percent reserve requirement,
meaning that each bank must end the banking day with a
ratio of reserves versus deposits of at least 10 percent.
N o interest is paid on reserves.
Suppose further that the two b a n k s ' initial balance
sheets are the following:
loan writes a check to a customer of Bank B. The Bank B
customer deposits the check in Bank B. Initially, assume
that the check clears instantaneously through a clearing
system run by the central bank. In the clearing process,
Bank A ' s balance sheet is contracted by $20, and Bank
B ' s b a l a n c e sheet is a u g m e n t e d by a c o r r e s p o n d i n g
amount. The new balance sheets for both banks are as
follows:
Bank A
Assets
Loans
Reserves
Liabilities
$920
$90
Deposits
Net Worth
$900
$110
Bank B
Liabilities
Assets
Bank A's Initial Balance Sheet
Assets
Loans
Reserves
Loans
Reserves
Liabilities
$900
$110
Deposits
Net Worth
$900
$110
Bank B's Initial Balance Sheet
Assets
Loans
Reserves
Liabilities
$900
$90
Deposits
Net Worth
$900
$90
Note that the aggregate M l money supply—the total demand deposits in the e c o n o m y — e q u a l s $1,800. Also
note that Bank B is "loaned up," that is, Bank B ' s reserve holdings equal exactly 10 percent of its deposits.
Bank A, however, holds an additional $20 in reserves
beyond its legal requirement, or $20 in excess
reserves.
Because these reserves earn no interest, Bank A decides
to loan the $20 to a creditworthy customer. When the
loan is m a d e , Bank A ' s assets and liabilities both expand. That is, its assets are increased by the addition of a
$20 loan, and its liabilities are increased by the amount
of additional funds made available to the borrowers' account, which is also $20. This means that Bank A ' s balance sheet can now be written as
Bank A
Assets
Loans
Reserves
Liabilities
$920
$ 110
Deposits
Net Worth
$920
$110
Note that the money supply has expanded to $1,820.
Suppose now that the Bank A customer who received the
Federal Reserve Bank of Atlanta
$900
$110
Deposits
Net Worth
$920
$90
Note that after clearing the check, the money supply has
remained constant at $ 1,820, and that both banks continue to meet their legal reserve requirements.
While the example is highly stylized, it is relevant because it demonstrates some salient features of banking
under a fractional (less than 100 percent) reserve requirement. First, it shows that the banking system can create
money in the form of demand deposits. Second, it can be
used to exemplify how reserve requirements place a constraint on the creation of such deposits. To illustrate, suppose that Bank B wishes to lend out its excess reserves
to a creditworthy customer. However, in contrast to the
earlier case with Bank A, there are only $18 of excess reserves available for Bank B to lend. If Bank B decides to
lend out the $18, then the M l money supply will expand
by $18. If the Bank B customer writes a check for $18 to
a Bank A customer, Bank B will lose its excess reserves
to Bank A after the check clears. After clearing, Bank A
can loan out its excess reserves, in the amount of 9 0 percent of $18, or $16.20. This process can be repealed over
and over again, but the total amount of m o n e y in the
economy is constrained by the reserve requirement and
by the amount of available reserves to be less than or
equal to $2,000, which is the amount of reserves available, or $200 divided by the reserve requirement of 10
percent or one-tenth.
N o w consider a second example that is exactly the
same as the first, except that the two banks decide to
eliminate checks and to exchange all payments via a private electronic payments network. The rules of the payments network are as follows.
Hco n o m ic Review
At the beginning of each business day, the network
assigns each member a net debit cap, which is a limit on
the a m o u n t of intraday net i n d e b t e d n e s s to the other
bank. For purposes of comparison with the first example,
suppose that this limit is given by each bank's initial excess reserves. At the end of the day, the two banks settle
by having the bank in the net debit position remit reserve
funds via a wire system run by the central bank. Further
suppose that it is also the custom of both banks to credit
their customers' accounts with good funds as soon as a
payment message to the customer's account is received
via the E F T network.
At the beginning of a certain business day, suppose that
each bank's initial balance sheet is as it was in the previous example. That is, both banks have $900 in loans and
deposits, Bank A has $100 in reserves, and Bank B has
$90 in reserves. According to the network rules, Bank A ' s
net debit cap is $20, and Bank B ' s net debit cap is zero.
Suppose that when the network opens for business,
each bank has twelve extremely creditworthy customers,
each of whom would like to send $20 to a customer of
the other bank. Suppose that the customers are named
C I , C2, C3, . . . , C24 and that o d d - n u m b e r e d customers use the payment services of Bank A and evenn u m b e r e d c u s t o m e r s u s e B a n k B. E a c h c u s t o m e r i
wishes to send customer / + 1 the sum of $20 (C24 wishes to send funds to C I ) . In this very predictable econom y , the s a m e set of p a y m e n t s are m a d e e v e r y day.
However, the order of payments is random.
Suppose that on a particular day, C1 is first in line at
Bank A and wishes to wire $20 to C2's account at Bank B.
Customer CI has no deposits at Bank A but has a $20
line of credit against some good collateral. Further, CI
expects a $20 payment sometime during the day f r o m
C24, who banks at Bank B. He taps his line of credit and
instructs Bank A to send a $20 payment message to C2,
after which the banks' balance sheets look like
below its net debit cap of zero, Bank B starts processing
its customers' payment orders. The first customer in line
is C14, who wants to send $20 to C I 5 , who banks with
Bank A. As was the case with C I and Bank A, C14 has
no deposits with Bank B but has a $20 line of credit with
Bank B that she taps and uses to send a payment message to C I 5 , knowing that the loan will be repaid sometime later in the day by C13. After C 1 4 ' s payment, the
balance sheets of the two banks and the money supply
have again expanded by $20, as shown below.
Bank A
Assets
Loans
$920
Reserves
$110
Due from B2 $20
Liabilities
Deposits
Due to B2
Net Worth
$920
$20
$110
Bank B
Assets
Loans
$920
Reserves
$90
Due from B1 $20
Liabilities
Deposits
Due t o B l
Net Worth
$920
$20
$90
Suppose that on this particular day, the remaining
customers in line at Bank A are customers C3, C 5 , . . . ,
C23 and that the remaining customers in line at Bank B
are C16, C18, . . . , C24, C2, C4, . . . , C12. None of
the customers had any funds on deposit with either bank
at the beginning of the day, but each had a line of credit
for $20. N o w consider the b a l a n c e sheets of the two
banks after C I , C3, . . . , CI 1 have sent payment messages to C2, . . . , C12; and C14, C 1 6 , . . . , C22 have
sent m e s s a g e s to C 1 5 , . . . , C23. T h e s e are as f o l lows:
Bank A
Bank A
Assets
Loans
Reserves
Assets
Liabilities
Liabilities
$920
$110
Deposits
Due to B2
Net Worth
$900
$20
$110
Loans
$1,020
Reserves
$110
Due from B2 $100
Deposits
Due to B2
Net Worth
$1,000
$120
$110
Bank B
Bank B
Assets
Loans
$900
Reserves
$90
Due from B1 $20
Assets
Deposits
Net Worth
$920
$90
Note that the M l money supply has expanded by $20.
Bank B ' s net debit position is now - $ 2 0 . Because it is
14
Economic Kevieiu
Liabilities
Liabilities
Loans
$1,000
Reserves
$90
Due from B1 $120
Deposits
Due to B1
Net Worth
$1,020
$100
At this point in the business day, the money supply
has expanded to $2,020, an amount exceeding the upper
limit of the first example by $20. As more customers
March/April 1993
send their payment messages, the intraday loans will start
to be paid off. (The example abstracts from the fees and
interest that would be charged for such loans in real life.)
At the close of the business day, both banks end up with
a net debit position of zero and their balance sheets look
exactly as they did at the start of the day.
While this second example also is highly stylized, it is
again a relevant one because it illustrates two salient features of a private electronic funds transfer system. First,
it shows that such an E F T system with a netting arrangement allows for an intraday expansion of balance sheets
that closely parallels the traditional process of inside
money creation. Second, it shows that this expansion of
balance sheets need not be constrained by traditional reserve requirements.
Some Real-World Complications
The simple examples above abstract from several important features of real-world payments systems. While
some of these features complicate the logic of the argument that intraday payments amount to money creation
unconstrained by reserve requirements, n o n e of them
renders the basic point invalid. S o m e of these complications are considered below.
The first complication is the existence of "check float."
Check float occurs when the f u n d s associated with a
check simultaneously appear as deposits on two banks'
balance sheets. Float occurs as a result of the time lag associated with the check-clearing process. In certain instances, this delay can result in a customer at a payee
bank having access to funds before the check for those
funds has been presented to the payor bank. In such instances an expansion of bank balance sheets and transactions deposits can occur, in a fashion analogous to that
described for the hypothetical wire transfer system in the
second example above. Check float is not counted in the
official monetary aggregates, however.
The existence of check float means that it is possible
for a banking system under a fractional reserve requirement to exceed the theoretical upper bound on inside
money creation (provided one is willing to include float
in the definition of "money"), at least on a short-term basis. This last fact, in turn, could be interpreted to mean
that the creation of intraday money via electronic payments networks is really n o more problematic than the
creation of check float.
There are at least two key distinctions, however, between the creation of money via check float and the creation of money via the netting of electronic payments. One
distinction is a technological one. That is, it is physically
much easier to run up a large net debit position on a wire
transfer network than it is systematically to write checks
Federal Reserve Bank of Atlanta
that will result in equally large amounts of check float.
This first distinction is a direct consequence of a second,
more fundamental distinction between intraday E F T netting and the purposeful management of check float—the
differing policy stance of the Fed and other regulatory
bodies toward these formally similar phenomena.
Simplistic attempts by individuals to exploit lags in
the check-clearing process are more popularly known as
"check kiting," and such activities carry a criminal penalty in most instances. M o r e subtle and s y s t e m a t i c attempts by larger organizations to exploit the lag in check
clearing are usually designated by a less ominous term,
" r e m o t e d i s b u r s e m e n t . " T h o u g h widely practiced, remote disbursement is officially discouraged by the Federal Reserve, and some of the more flagrant practices
associated with remote disbursement have been effectively prohibited. By contrast, the netting of intraday
payments has been generally tolerated (subject to certain
risk controls) as a means of introducing greater efficiency into the payments system. Thus, it seems that the exp a n s i o n of b a n k b a l a n c e s h e e t s , and the c o n s e q u e n t
creation of inside money, enjoys both technological and
regulatory a d v a n t a g e s when this activity occurs over
E F T networks as compared with its occurrence by means
of check float.
A second real-world c o m p l i c a t i o n is that r e s e r v e s
need not stay constant. As pointed out in Marvin Goodfriend and Monica Hargraves (1983), traditionally the
Fed has chosen to accommodate short-run fluctuations in
banks' demand for reserves rather than allow these dem a n d f l u c t u a t i o n s to a f f e c t s h o r t - t e r m interest rates.
Hence, reserve requirements have not historically posed
a barrier to b a n k s ' expansion of the m o n e y supply, at
least in the short run. For this reason, the first example
above exaggerates the constraining effect of reserve requirements on money creation. In real life, reserves can
be borrowed overnight in the Fed funds market at a rate
that changes little f r o m day to day.
It should be noted, however, that the Fed's accommodation of short-run fluctuations in reserve demand have
not reduced the marginal cost of adding further reserves
(and hence of creating additional reservable deposits) to
zero. Further, the real marginal cost of adding reserves—the
real Fed funds rate—fluctuates over the course of the business cycle and is typically highest near the business cycle
peak. In the case of intraday payments over E F T networks,
the marginal cost of additional payments is often negligible, given that preset caps on such payments and their associated net debit positions have not been breached. It
s e e m s unlikely, therefore, that such quantitative caps
would be as effective as the existence of reserve requirements in constraining the growth of banks' balance sheets.
A third complication is that bank customers may not
have free access to lines of credit, as the second example
Hco n o m ic Review
above supposes. However, the same aggregate expansion
of banks' balance sheets can be obtained by introducing
additional banks to the payments network. As long as
each participating bank is willing to credit its customers
immediately with funds sent over the network, the example goes through.
A final complication that could affect the validity of
these examples is that the electronic payments in the second example could presumably be sent over Fedwire,
which would change the accounting somewhat. Because
the finality of payment is guaranteed over Fedwire, any
overdrafts of banks' reserve accounts would become "due
to the Fed," and the "due f r o m ' s " would be actual increases in each bank's reserve account. These entries would
be exactly offset by new entries on the F e d ' s balance
sheet, which would consist of the p a y o r b a n k ' s " d u e
from's" on the asset side and increases in the payee bank's
reserve account on the liability side, as shown more formally in Appendix 2.
Appendix 2
T h e Algebra of Netting S c h e m e s
The properties of market clearing have been studied
extensively in economic theory (see, for example, Gerard
D e b r e u 1959). H o w e v e r , i m p l e m e n t a t i o n of m a r k e t
clearing has not been as thoroughly studied. One fairly
recent, systematic study is Alfred Lorn Norman (1987).
T h e following discussion uses a f r a m e w o r k similar to
N o r m a n ' s to analyze netting schemes.
E x a m p l e 1: A D o m e s t i c P a y m e n t s N e t w o r k
The first abstract setting to be considered is a domestic payments network. There are N + 1 participants in this
network, N participants ("banks") plus a network manager. In the jargon of equilibrium theory, there are N + 1
"commodities"—that is, things that will be traded. Each
c o m m o d i t y /, / = 1, . . . , N consists of (reserve account) funds to be held by bank i. The commodity N + 1
consists of funds in a settlement account with the network.
Assume that at the beginning of a business day, each
bank i knows the total amount of funds that all of its customers need to wire to all other banks j * i. Denote the
amount of this "excess d e m a n d " of bank i for commodity
j as Z . Note that Z . > 0 and Z . = 0. It is assumed that
transactions costs are negligible and that all banks' funds
are valued at par, which in this abstract setting means
that all c o m m o d i t i e s have a price equal to one. Each
bank has a large endowment of commodity i that is more
than sufficient to meet all demands for commodity i but
has no endowment of any other commodity. Three types
of clearing schemes can now be considered: gross settlement, settlement with bilateral netting, and settlement
with multilateral netting.
Case 0: gross settlement, meaning no netting. In this
case, the network manager does nothing other than to
v e r i f y that the transfers take place. E a c h bank i will
16
Economic Kevieiu
transfer a total of X ^ Z to other banks. The total funds
required to clear the market will be
' j*i
Under gross settlement, the maximum number of transfers necessary to settle is N(N - 1).
Case 1: settlement with bilateral netting. In this case,
the network manager still does not play an active role.
Instead, each bank i first determines its net debit (credit)
position vis-à-vis bank j, Z . - Zjr where 1 < i, j < N. All
banks in a net debit position then settle by paying IZ. - Z.\
to the bank in the net credit position. Under the assumptions of this analysis, half of the transactions that occ u r r e d u n d e r g r o s s s e t t l e m e n t need not o c c u r u n d e r
bilateral netting. Settlement thus requires a total amount
of funds equal to
FB = l l \ Z , j - Z j i \
> j<<
and involves at most N(N - 1 )/2 transfers.
Case 3: settlement with multilateral netting. In this
case, the network manager presents each bank i with its
net credit or debit position vis-à-vis all banks in the network, which will be X > ; ( Z - Z ) . Banks with a net debit
position will pay this amount to the network manager,
who will use these f u n d s to pay the amounts due net
creditors. The total amount of funds needed to clear the
market will be
Fm=(V
2)1I
j*'
fai-Zj,)
and settlement will involve, at most, N transactions—
that is, settling the network accounts of N banks.
The " e c o n o m y " of netting schemes derives from the
following results.
March/April 1993
Lemma 1. T h e n u m b e r of t r a n s a c t i o n s i n v o l v e d in
multilateral netting {<N) is no greater than the n u m b e r of
transactions for bilateral netting \<N{N - l)/2], which is
n o greater than the number of transactions for gross settlement [N(N - 1)].
Lemma 2. FXf < FB < FQ. (This equation represents just
the triangle inequality.)
In words, Lemma 1 means that f e w e r transactions are
needed as a result of netting, and Lemma 2 means that less
cash is needed. In this simple example, if clearing is instantaneous at the beginning of the business day and settlement
is made at the end of the day, the amount of daylight credit
extended is F(j for either type of netting scheme.
In the example above, the market is static, meaning
that money has no time value, and the excess demands Z .
are considered f i x e d quantities. In real-world networks,
m o n e y will have time value, and the granting of costless
or underpriced daylight credit will result in an increase in
the d e m a n d s f o r f u n d s at o t h e r b a n k s — t h e Z..'s. In a
network with bilateral or multilateral netting, a cap o n bilateral credit requires that t w o b a n k s i and j switch to
gross settlement when I Z - Z.l exceeds the cap value. In
a network with multilateral netting, a cap on overall credit requires that b a n k i m u s t switch to gross settlement
with all other banks j * i when bank f s overall net debit
position, Z, V ,(Z.. - Z j ) , exceeds the specified limit.
T h e example above also assumes that each bank i has
a sufficient endowment of (reserve account) funds to clear
exchanges under all settlement schemes. Conceivably, these
endowments could be so small as to make gross settlement
impossible with only bilateral e x c h a n g e s , even though
settlement could occur under a netting scheme. This situation corresponds to what is k n o w n as network "gridlock."
Arithmetic examples. Example 1 : A payments network
has eleven member banks. On a particular day, each bank
owes the other ten banks the gross amount of $10 million
each. In this example, E 0 = ($10 million • 10 recipients • 11
banks) = $1.1 billion, whereas FB = FM = $0. Under gross
settlement, there are 110 settling transactions, but no transactions are required to settle under either netting scheme.
Example 2: Each bank i owes bank i + 1 a sum of $10 million and owes bank i - l a sum of $5 million. In this case
F0 = ($5 million + $10 million) • 11 banks = $165 million,
F g = ($10 million - $5 billion) • 11 banks = $55 million, and
Fm = 0. Under gross settlement, 22 transactions are required
to settle; there are 11 transactions under bilateral netting;
under multilateral netting, no funds are required to settle.
E x a m p l e 2: A P a y m e n t s N e t w o r k w i t h
Different Currencies
N o w consider the case of an interbank payments network in which payment may be made in any of K differ-
Reserve Bank of Atlanta
Digitized forFederal
FRASER
ent currencies, where the Kih currency is the "dollar." Let
Pk represent the market-clearing dollar price of currency k,
where P 1 . In this network, there are K(N + 1) commodities—that is, accounts in K different currencies at N
different banks plus K settlement accounts with the network. Let Z(* denote bank /' s excess d e m a n d for the typical c o m m o d i t y — m o n e y in currency k in an account of
bank j. A s in the previous example, banks do not need to
transfer m o n e y to themselves, so Zf. = 0 for all / and k.
Associated with each bank i is a " h o m e currency" K(i).
Initially, consider the especially unrealistic case in which
each bank is well supplied with f u n d s in every currency.
One way to view the operation of the /^-currency payments
network would be to model this network as the simultaneous operation of K parallel domestic payments networks.
A m a x i m u m of KN(N - 1) transactions would occur under gross settlement, one-half that number under bilateral
netting, and, at most, KN transactions would occur under
simultaneous multilateral settlement in all currencies.
W h i l e this e x a m p l e is easy to analyze, the assumption that each network participant has access to and wishe s to hold a " l a r g e " stock of f u n d s in e v e r y currency
seems particularly unrealistic. In a real-world situation,
each bank i would prefer to hold a specialized portfolio
of f u n d s in a f e w currencies. In an extreme e x a m p l e of
multilateral netting, each network participant / would only settle their net credit or debit position
7* _ 7K. {expressed in dollars}
k
by payment in their o w n domestic currency K(Z'). (Recall
that the prices Pk by assumption clear the currency market so that no one gets stuck with an unwanted currency.)
The total number of transactions involved in settlement
would be N while the total dollar value of funds needed
to settle would be
1/2)1
T h e total dollar v a l u e of f u n d s n e e d e d to clear u n d e r
gross settlement would be
^ = 1 x 1 ^ 4
i k
In such a situation, the overall reduction in the number of
transactions required for clearing, by going to multilateral netting f r o m gross settlement, would be f r o m a maxim u m of KN(Nl ) t o N.
Arithmetic example. Suppose, as in the previous exa m p l e , that there are eleven b a n k s in a p a y m e n t s netw o r k , only this t i m e it is s u p p o s e d that e a c h b a n k is
based in a different currency and that each bank wishes
to hold domestic money only at the beginning and end of
Hco n om ic Review
each trading day. As before, each bank i owes bank / + 1
an amount equivalent to $10 million, and bank / also
owes bank / - 1 an amount equivalent to $5 million. To
settle a debt with another bank, a given bank has to
make two transactions. First, it has to convert the required p a y m e n t to f o r e i g n c u r r e n c y ; s e c o n d , it discharges the debt in the required currency. Under a gross
settlement regime, settlement results in forty-four transactions having a total dollar value of F'Q = 2 • ($5 million
+ $10 million) • 11 banks = $330 million. Under bilateral netting, settlement requires twenty-two transactions
having a dollar value of F'R = 2 • ($10 million - $5 million) • 11 banks = $110 million. Under multilateral netting, no payments are needed to settle because F'M = 0.
E x a m p l e 3: A Generalized P a y m e n t s
N e t w o r k for K C o m m o d i t i e s
The framework for Example 2 can be adapted to payments for K different types of goods (for example, government bonds or mortgage-backed securities). The only
difference is that network participants may have endowments of any commodity, but that settlement is always in
the A"th commodity—that is, in dollars.
After settlement, bank Vs balance sheet will change as
follows:
Bank i
Assets
Liabilities
max { I ZJ. - X Z , J. , 0}
j
j
max {X Z . - X Zjr 0}
-
Net due from erased
Net due to erased
KZ.-Z.)
T
'J J<
Change in reserves
U n d e r a F e d w i r e - t y p e s y s t e m , bank / ' s p a y m e n t s
may be covered either by bank / ' s reserve balance or by
overdrawing this balance. Before settlement on such a
system, bank / ' s balance sheet would be
Bank i
Assets
Liabilities
+ max {1 - / ? . , Z Z . -Z..}
' j J' 'J
+ maxtSZ.-I
Change in reserve
account
Amount of daylight
overdraft, if any
Observational Equivalence of Multilateral Netting
(with G u a r a n t e e d Settlement) and Gross Settlem e n t with Daylight O v e r d r a f t s
-Xz„
Consider a domestic payments network, as in Example 1. Bank i wishes to send payment ZjJ to bank j,
and the payments will be settled by multilateral netting.
+ x zß
Before settlement bank /'s balance sheet looks like
the following (showing only intraday changes):
Debit senders' accounts
Credit receivers'
accounts
After settlement, the balance sheet of bank i would be
Bank i
Bank i
Assets
Liabilities
Assets
+ max {X Z1. - X Z.., 0 )
i
Zj-R.,0}
j
Due from network
18
Economic Kevieiu
Liabilities
+ max { X Z - X Z . , 0 }
max { X Z - X Z . - / ? , , 0 }
- max { X Z - X Z . - / ? ,0}
j u y j'
''
'
Cover daylight overdraft,
if necessary
Overdraft obligation
erased
Due to network
-
Xz
j 11
Debits to sending
customers' accounts
+ xz..
Credits to receiving
customers' accounts
T h e r e are t w o principal d i f f e r e n c e s b e t w e e n the
"multilateral netting" and " F e d w i r e " T-accounts. T h e
first is the presence of the initial reserve balance, Rp in
the Fedwire accounts. However, the historical incentives
of the Fedwire system have been such that banks would
try to m i n i m i z e Rr If it is assumed that tf is "fairly
small," then the remaining difference between the two
March/April 1993
systems is that under Fedwire, net creditors would be in
possession of the reserve funds "due t o " them from the
network, before settlement. By contrast, under an explicit multilateral net-settlement mechanism, net creditors
would not receive funds until after settlement. If settlement is guaranteed, however, this difference would be
inconsequential f o r the behavior of the network participants.
Notes
1. According to Junckcr, Summers, and Young (1991), the
Fed provides settlement for more than 160 private, smallvalue payments netting arrangements involving checks,
Automated Clearing House (ACH) transactions, and so
forth. To date, the relatively small amount of intraday credit
extended via these networks has not been a major policy
concern. Besides CHIPS, other domestic large-value payments networks include those operated by Participants
Trust Company (PTC) and by Depository Trust Company
(SFDS). See Juncker, Summers, and Young (1991) for
more details on the PTC and SFDS networks.
2. Of course, monetary exchange could have been carried out
with fiat money (legal tender), which was unknown in Europe at the time.
3. Clough and Cole (1941, 276-77) attribute the first widespread issue of banknotes to the Bank of Stockholm in
1661. The popularity of this note issue is at least partly explained by the fact that Sweden was on a copper standard at
the time.
4. Clough and Cole (1941, 493) and Braudel (1984, 606-607)
date the founding of the first clearinghouse for banks, the
London Clearing House, to 1773. As noted by Braudel,
nonbank clearing organizations were in existence centuries
before this date.
5. See for example, Timberlake (1978, 87).
6. Timberlake (1984), Gorton (1985), and Gorton and Mullineaux (1987) each provide descriptive accounts of the workings of nineteenth-century clearinghouses in the United
Stales. Duprey and Nelson (1986) describe the Fed's efforts
to introduce par checking.
7. Figures are from Bank for International Settlements (1991,
47).
8. Two excellent glossaries of terms commonly used in the literature on electronic payments are provided in Bank for International Settlements (1989) and Gilbert (1992).
9. Similar examples can be found for domestic clearinghouses in Juncker, Summers, and Young (1991) and for crossborder clearing arrangements in Gilbert (1992). Readers
interested in the mathematical details are referred to Appendix 2.
10. "De facto multilateral netting" means that the behavior of
Fedwire participants is essentially the same as if Fedwire
were a multilateral net settlement system, which it is not.
Garber and Weisbrod (1992, 300-302) discuss the behavioral
equivalence of "daylight overdrafts" and multilateral netting.
Federal Reserve Bank of Atlanta
A more formal discussion of this equivalence is given in
Appendix 2.
11. The vast majority of daylight overdrafts (on a value basis) arc
incurred by large banks in the business of clearing financialmarkets transactions. One recent estimate attributed 60
percent of daylight overdrafts to only three money-center
banks.
12. A useful summary of basic information on Fedwire and
CHIPS is provided in Bank for International Settlements
(1990a).
13. There are types of risk other than systemic risk associated
with private payments systems such as CHIPS. From a public policy point of view, however, systemic risk is the most
important for at least two reasons. First, a truly widespread
or "systemic" crisis would be the sort of risk that the private sector is least able to either control or insure against.
Second, existing rules covering EFT netting arrangements
typically do not provide a complete set of contingent rules
in the event of a systemic crisis. See, for example, Federal
Reserve Bank of New York (1991) for a more complete description of the CHIPS risk management procedures or
Stehm's (1992) description of risk management on the Participants Trust Company network.
14. See Federal Reserve Bank of New York (1991).
15. The classification of Fedwire overdrafts as inside or outside
money is somewhat problematic. The accepted definition of
outside (inside) money is money that does (does not) represent a net claim of the private sector against another party
outside the private sector (see, for example, Sargent 1987,
103, or Gurley and Shaw, 1960, 73). Any Fedwire payment
that is funded by a daylight overdraft causes the instantaneous creation of a claim by the payee bank against the public sector (the Fed). In this sense, Fedwire overdrafts
resemble more traditional forms of outside money such as
overnight reserves. Under normal circumstances, however,
the claim against the Fed caused by a daylight overdraft is
exactly offset by a claim of the Fed on the payor, a claim that
must be paid at par by the end of the business day. In this
"expectational" sense, no net liability has been created, and
daylight overdrafts more closely resemble inside money.
Another "inside" feature of daylight overdrafts is that they
are automatically created (up to the amount of any quantitative cap) at the behest of banks and their customers, at a
negligible marginal cost. By contrast, the more traditional
Fed liabilities commonly equated to "outside money," such
Hco n o m ic Review
as overnight bank reserves, are under explicit control of the
Fed. The Fed may choose to accommodate fluctuations in
the demand for overnight reserves, but it also exerts a high
degree of control over both the amount of the accommodation and the (typically nonnegligible) price charged. On balance, Fedwire daylight overdrafts seem more "inside" than
"outside."
16. More detailed treatments of the issues surrounding crossborder networks can be found in Bank for International Settlements (1989, 1990b) and Gilbert (1992).
17. Estimate by Bank for International Settlements (1993).
18. This risk is referred to as Herstatt risk, after the 1974 failure of a German firm, Bankhaus Herstatt. A detailed study
of Herstatt risk in the foreign exchange markets is presented in Kamata (1990).
19. McAndrews (1992) presents a more detailed treatment of
delivery-versus-payments systems.
20. The discussion of FDICIA below draws heavily on that of
Wall (1993).
21. For a summary of the restrictions enacted in 1990, see
Board of Governors of the Federal Reserve System (1991,
79-80).
22. For a summary of the pricing scheme for Fedwire daylight
overdrafts, see American Banker, October 1-2, 1992.
23. A very rough estimate of the magnitude of such a shift, provided in an unpublished Federal Reserve System study, is
calculated to be no more than one-third of the value of all
Fedwire transfers. More precise estimates must await full
implementation of pricing of daylight overdrafts.
24. Figures are from Bank for International Settlements (1990a).
25. Some representative studies from this rather large body of
literature include Board of Governors of the Federal Reserve System (1988), Faulhaber, Phillips, and Santomero
(1990), and Flannery (1988).
26. The "Angell" report notes that "systems for the binding
netting of . . . financial obligations provide a service that is
a very close substitute for the function of money as a medium of exchange" (Bank for International Settlements 1990,
7). The recognition of electronic payments as money is at
least implicit in the discussions of electronic payments systems by Corrigan (1987) and Flannery (1988). In a footnote,
Ettin (1988) characterizes electronic payments as money
and attributes this characterization to Jeffrey Marquardt.
27. Note that EICCRs as described here arc not "reserves" in
the traditional sense, nor do they confer a right to borrow at
the discount window. Rather, EICCRs confer on their owner the right to create intraday money, which is a close substitute for reserves.
28. Several readers of early drafts of the paper have correctly
pointed out that debit card and POS transactions are currently not settled on a real-time basis. It seems likely, however, that if the float associated with the settlement on these
transactions were appropriately priced, then real-time settlement would become the norm.
29. The idea of marketable emission permits was suggested by
Dale (1968). Baumol and Oates (1988, chap. 12) provide a
Economic Kevieiu
20
discussion of these permits and a survey of the literature
that analyzes them.
30. Note that this proposal does not claim that the imposition of
compensating balances on Fedwire would increase the aggregate level of systemic risk in the payments system. The
claim is that imposition of reserve requirements (via compensating balances) on Fedwire would shift such risk from
a network in which finality is explicitly guaranteed by the
Fed to other networks. As argued above, participants in
such systems may well see themselves as protected from
systemic risk by an implicit Fed guarantee.
31. See, for example, chapters 10 and 11 of Timberlake (1978)
for an account of the U.S. experiments with bimetallism. In
a nutshell, these experiments consisted of repeated, unsuccessful attempts by the U.S. government to circulate silver
coinage at a mint value above its market value. For a history of earlier experiments with bimetallism by various European countries, see Kindleberger (1984, chap. 4).
32. The validity of this statement does not require that the
(market) relative prices of the two types of money equal the
ratio of their production costs. As long as the market price
of each type of money increases as its production cost increases, intraday money would trade above par with overnight money.
33. A notable difference between the current situation and
ninetccnth-century bimetallism is the direction of the mispricing of the newer form of money. The introduction of
silver money was a flop because the mint, or official, value
of the new money was above its market price in terms of
gold. Presently, electronic intraday money has succeeded at
least partly because of its official valuation at par with ordinary overnight bank money. This value is below its market
price, which would be above par, as discussed above.
34. For example, Goodfriend and Hargraves (1983) offer an indepth assessment and critique of the performance of reserve
requirements as a component of monetary policy. For another treatment of the costs and benefits of reserve requirements, see chapter 13 of Garber and Weisbrod (1992).
35. Currently the Fed is required by law to pay interest on any
such balances on a quarterly basis, at a rate corresponding
to the average rate of return on the Fed's open market portfolio for the previous quarter. A reduction in this rate would
require statutory authorization.
36. It should be mentioned that the member banks of the
nineteenth-century clearinghouses were hardly unregulated
institutions. In other words, one does not have to endorse a
system of pure laissez-faire banking to believe that private
mechanisms could deal with some of the risk associated
with electronic payments networks.
37. See Tallman and Moen (1990) for an account of the trusts'
role in the 1907 panic.
38. For example, Donaldson (1992, 78) contends that a common pre-Fed mechanism for dealing with bank panics, that
is, suspension of payments and issue of clearinghouse certificates, often resulted in abnormally large profits for the
members of the clearinghouses.
March/April 1993
References
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Corrigan, E. Gerald. Financial Market Structure: A Longer
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Corwin, Philip S., and Ian W. Macoy. "A Comprehensive Look
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Donaldson, R. Glen. "Costly Liquidation, Interbank Trade,
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Duprey, James N., and Clarence W. Nelson. "A Visible Hand:
The Fed's Involvement in the Check Payments System."
Federal Reserve Bank of Minneapolis Quarterly Review
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Eisenbeis, Robert. "Eroding Market Imperfections: Implications for Financial Intermediaries, the Payments System,
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William S. Haraf, 288-95. Washington D.C.: American
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Faulhaber, Gerald R., Almarin Phillips, and Anthony M. Santomero. "Payment Risk, Network Risk, and the Role of
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Garber, Peter M., and Steven R. Weisbrod. The Economics of
Money, Banking, and Liquidity. Lexington, Mass.: D.C.
Heath, 1992.
Gilbert, R. Anton. "Implications of Netting Arrangements for
Bank Risk in Foreign Exchange Transactions." Federal
Reserve Bank of St. Louis Review 74 (January/February
1992): 3-16.
Goodfriend, Marvin, and Monica Hargraves. "A Historical Assessment of the Rationales and Functions of Reserve Requirements." Federal Reserve Bank of Richmond Economic
Review (March/April 1983): 3-21.
Gorton, Gary. "Clearinghouses and the Origin of Central
Banking in the United States." Journal of Economic History 45 (March 1985): 277-83.
Gorton, Gary, and Donald J. Mullineaux. "The Joint Production
of Confidence: Endogenous Regulation and Nineteenth
Century Commercial-Bank Clearinghouses." Journal of
Money, Credit and Banking 19 (November 1987): 457-68.
Gurley, John G., and Edward S. Shaw. Money in a Theory of
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Hamdani, Kausar, and John A. Wenninger. "The Macroeconomics of Supplemental Balances." Appendix to Controlling Risk in the Payments System. Washington, D.C.:
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1991): 847-58.
Kindleberger, Charles P. A Financial History of Western Europe. London: Allen and Unwin, 1984.
McAndrews, James J. "Where Has All the Paper Gone? BookEntry Delivery-against-Payments Systems." Federal Reserve
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Payments: An Evaluation of Payment Finality Rules." In
The U.S. Payments System: Efficiency, Risk and the Role
of the Federal Reserve, edited by David B. Humphrey,
145-80. Boston: Kluwer Academic Publishers, 1990.
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Sargent, Thomas J. Macroeconomic Theory. 2d ed. Orlando,
Fla.: Academic Press, 1987.
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System: Efficiency, Risk, and the Role of the Federal Reserve, edited by David B. Humphrey, 181-95. Boston:
Kluwer Academic Publishers, 1990.
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Spufford, Peter. Money and Its Use in Medieval Europe. Cambridge University Press, 1988.
Stehm, Jeff. "Clearance and Settlement of Mortgage-Backed
Securities through the Participants Trust Company." Federal Reserve Board Finance and Economics Discussion Series #214, November 1992.
Stigum, Marcia. The Money Market. 3d ed. Homewood, Illinois: Dow-Jones Irwin, 1990.
Summers, Bruce J. "Clearing and Payments Systems: The Role
of the Central Bank." Federal Reserve Bulletin 77 (February 1991): 81-91.
Tallman, Ellis W„ and Jon R. Moen. "Lessons from the Panic
of 1907." Federal Reserve Bank of Atlanta Economic Review 75 (May/June 1990): 2-13.
Timberlake, Richard H., Jr. The Origins of Central Banking in
the United States. Cambridge, Mass.: Harvard University
Press, 1978.
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22
. "The Central Banking Role of Clearinghouse Associations." Journal of Money, Credit and Banking 16 (February 1984): 1-15.
Vital, Christian, and David L. Mengle. "SIC: Switzerland's
New Electronic Interbank Payments system." Federal Reserve Bank of Richmond Economic Review 74 (November/December 1988): 12-27.
Wall, Larry D. "Too-Big-to-Fail after FDICIA." Federal Reserve Bank of Atlanta Economic Review 78 (January/
February 1993): 1-14.
White, Lawrence H. "Competitive Payments Systems and
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. "What Kinds of Monetary Institutions Would a Free
Market Deliver?" The Cato Journal 9 (Fall 1989): 367-91.
March/April 1993
¿beyond Duration:
Measuring Interest
Rate Exposure
Hugh Cohen
V
1
/
r
hile many factors contributed to the savings and loan in•
/
dustry's extensive losses in the 1980s, the biggest losses,
M
JB
/
those that brought on the savings and loan crisis, resulted
1 / 1 /
primarily from interest rate fluctuations during the late
f
y
1970s and early 1980s (see George J. Benston and George G.
Kaufman 1990). Those losses demonstrated the importance of calculating
and avoiding interest rate risk for financial practitioners who fund and
manage all sizes of portfolios. They also focused the attention of financial
regulators, the public, and, ultimately, Congress on potential losses from
interest rate risk. In the aftermath, hedging instruments and techniques
have been applied more broadly. 1 Congress, in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), has also instructed
federal bank regulators to account for interest rate risk in their risk-based
capital requirements.
The author is a senior
economist in the financial
section of the Atlanta Fed's
research department. He
thanks Peter Ahken, David
Heath, Frank King, Stephen
Smith, and Larry Wall for
helpful comments.
Federal Reserve Bank of Atlanta
A simple and potentially inadequate approximation of interest rate risk
exposure results from the use of a technique called "modified duration."
This technique is used to gauge the changes in the value of an asset or portfolio of assets that occur in response to a parallel shift in interest rates. It thus
measures the portfolio's sensitivity to interest rate fluctuations. Modified
duration gauges interest sensitivity by making equal interest rate shifts at all
maturities of the current term structure and revaluing a portfolio under the
new (parallel) term structure.
Acceptance of modified duration as a measure of interest rate exposure
can be seen in federal bank regulators' recent proposal of the method for the
purpose of integrating interest rate risk exposure into risk-based capital
Hco n o m ic Review
guidelines and in a modification of that proposal discussed by the Federal Reserve Board on March 31,
1993. The joint proposal seeks to approximate an institution's exposure to interest rate changes by measuring changes in its net economic value that would
result from 100 basis point parallel shifts in interest
rates over a three-month period. The change in net
economic value would be measured as the change in
the present value of its assets minus the change in the
present value of its liabilities and off-balance-sheet
positions. The more recent Federal Reserve proposal
adds 200 basis point shifts and a nonparallel shift
based on interest rate changes over the past five years
to the proposed exposure measures. 2
In addition, m o d i f i e d d u r a t i o n ' s simplicity has
made it a common topic in textbooks. As useful as the
method may be for teaching purposes, however, it is
an insufficient measure for hedging interest rate exposure in the real world. This article identifies two major
problems with using modified duration for this purpose. The discussion first presents the theory underlying modified duration and illustrates its benefits as a
hedging model. For the analysis a simple mock portfolio was constructed and revalued using simulated term
structures. The analysis points out some of the faults
of modified duration, which failed to capture major elements of interest rate exposure, and suggests more
accurate measures.
i / n d e r standing Duration
Duration is a term that is usually applied to bonds
but can be used in reference to any cash-flow stream.
The duration of a portfolio's cash flow may be thought
of as the weighted average maturity of its securities'
cash flows, where the weights are the proportion of
the cash f l o w s ' present value in the current period
over the total present value of the portfolio's future
cash flows.
For e x a m p l e , consider the prices in Table 1 for
$100.00 default-free securities to be paid off at a specified time in the future. The price of a zero-coupon,
$100.00 face-value bond maturing in two years would
be $89.96. The duration of the bond would be (2 •
89.96)/89.96 = 2.
Next, consider a $100.00 face-value bond that pays
5 percent c o u p o n s s e m i a n n u a l l y . (The bond pays
$5.00 [or .05 • $100.00] in six months, one year, and
one and one-half years. Additionally, the bond pays
$105.00 in two years, reflecting both interest and face-
24
Economic Kevieiu
value payments.) Assuming that the price of the bond
is the sum of its individual payments, the price of this
bond would be
Price = (.05 • 97.89) + (.05 • 95.56) + (.05 • 92.77)
+ (1.05 • 89.96)
= 4.8945 + 4.778 + 4.6385 + 94.458
= 108.769.
The duration of the bond would be
Duration = [(0.5 • 4.8945) + (1.0 • 4.778) + (1.5 • 4.6385)
+ (2.0 • 94.4586)]/108.769
= 1.87.
The duration of a two-year zero-coupon bond is two
years, and the duration of a two-year 10 percent coupon
bond (5 percent semiannually) is 1.87 years, illustrating that the duration of a zero-coupon bond is the maturity of the bond and that duration decreases as the
coupon rate increases. (Duration declines as the proportion of the total income stream paid early increases.) T h e box on page 30 shows that a cash f l o w ' s
duration is the sensitivity of its present value to a parallel shift in interest rates. The implication, therefore,
is that the price of the zero-coupon bond is more sensitive to parallel shifts in interest rates than the price of
the 10 percent bond is. This concept is important in
hedging interest rate exposure. Moreover, if the cash
flow's duration is zero, the cash flow will not change
value in response to a small parallel change in interest
rates. In other words, when the duration of a cash flow
is zero, the present value of the cash flow is hedged
against small parallel movements in the term structure.
(See the box for a more complete discussion of duration.)
Table 1
Prices of $ 1 0 0 . 0 0 D e f a u l t - F r e e S e c u r i t i e s
Years until
Maturity
Price of
$ 1 0 0 . 0 0 Bond
0.5
$97.59
1.0
$95.56
1.5
$92.77
2.0
$89.96
March/April 1993
flow that would hedge the portfolio's present value to this
shift? One hedging instrument would be a single cash
flow with a duration of 2.42 years (for simplicity approximated as 2.5 years) and a face value of $350.51. Because the duration of a single cash flow is the maturity
of the cash flow, this security would be one that would
mature on January 1, 1994. According to the term structure on July 1, 1992, a $398.81 face-value security maturing January 1, 1994, would be priced at $350.51. If
the term structure were shifted 1 basis point higher, the
new price of the cash flow would decrease to $350.43.
The two asset prices change by the same amount with
the shift in interest rates. Thus, the present value of the
cash flow of the four-year portfolio can be hedged for
small parallel movements of the term structure by shorting, or selling, the single cash-flow security that would
mature in two and one-half years. Table 3 illustrates
the benefits of using duration as a hedging tool.
/ / e d g i n g with Duration
A simple example will illustrate the process of hedging with duration. Consider a portfolio on July 1, 1992,
that consisted of receiving $100.00 on July 1 of each
year from 1993 through 1996 (face value: $400.00).
According to the term structure constructed from the
July 1, 1992, Wall Street Journal, this portfolio would
have the price and duration depicted in Table 2.
The first column shows the date of payment, and the
second column lists its present value. The sum of the
second column is the portfolio's price. The third column is the time (years) remaining until the payment
date. The fourth column weights the time into the future, multiplying it by the payment's price and dividing
that figure by the total portfolio price. The sum of the
weighted times is the duration of the portfolio. The
fifth column is the new price of the payments if the
term structure were shifted up by 1 basis point. 3
A second e x a m p l e of hedging with duration involves a portfolio with a greater duration. In the interest of simplicity the example analyzes only default-free,
fixed-income securities. A security is constructed to
Given that the portfolio's price changed with the
shift in interest rates, is it possible to find a single cash
Table 2
T h e Cash F l o w P o r t f o l i o of a Four-Year S e c u r i t y
Weighted Time
Adjusted Price
(+1 basis point)
1.0
0.27
$96.02
$90.87
2.0
0.52
$90.85
July 1995
$84.94
3.0
0.73
$84.92
July 1996
$78.67
4.0
0.90
$78.64
2.42
$350.43
Date of
Payment
Price
July 1993
$96.03
July 1994
Years until
Payment
$350.51
Total
The portfolio
receives
$100.00
on
each
July
1 from
1993
through
1996.
The
term
structure
is constructed
from
the July
1, 1992,
Wall
Street J o u r n a l .
Table 3
A P o r t f o l i o H e d g e d w i t h a Single Cash F l o w
Asset
Current Price
Adjusted Price
Difference
Long 4-Year Security
$350.51
$350.43
+$0.08
-$350.51
-$350.43
-$0.08
Short 2.5-Year Security
Combined Portfolio
Federal Reserve Bank of Atlanta
0.0
0.0
0.0
Hco n o m ic Review
resemble a thirty-year mortgage. However, again for
simplicity, the prepayment option and default risk are
not included and only biannual payments are considered. Specifically, at time July 1, 1992 (the beginning
of the third quarter), a cash flow is considered that
consists of $100.00 payments on January 1 and on July 1
in the years from 1993 through 2022 (a face value of
$6,000.00). Using a term structure of interest rates
constructed from the prices of stripped Treasury bonds
as reported in the Wall Street Journal on July 1, 1992,
this security had a market price of $2,316.38 and a duration of 9.54 years.
To hedge the price of this security, a bond with a single payment on January 1, 2002 (duration 9.5 years),
was selected. Using the same term structure, a face value of $4,714.52 maturing on January 1, 2002, was calculated as having a market price of $2,316.38. Thus,
this security was chosen as the hedging instrument.
Imagine a portfolio that is long the thirty-year security
and short the nine-and-one-half-year security. 4 Such a
portfolio would have a face value of zero and a duration of approximately zero. To demonstrate the usefulness of matching duration, a 1 basis point parallel shift
increase to the entire term structure was implemented,
and the securities were repriced. After the shift, the
thirty-year security has a market price of $2,314.17
and the nine-and-one-half-year security has a market
price of $2,314.17. Thus, even though the securities'
prices have changed by $2.21 (.1 percent), the price of
the portfolio is unchanged. Table 4 illustrates how
matching the duration of a portfolio can hedge the
portfolio to small parallel shifts of the term structure.
7esting Parallel Shift Simulations
Users of duration-based m o d e l s realize that the
models are useful only for small movements in the
term structure. However, interest rates in the United
States may become very volatile in relatively short periods of time. To capture a more realistic measure of
parallel movement interest rate exposure over three
months, many practitioners simulate larger parallel
shift movements. This study continues the previous example of a portfolio that is long the thirty-year security
and short the nine-and-one-half-year security, altering
the July 1 term structure by plus and minus 100 basis
points throughout the curve (as in the interagency proposal cited earlier), and revaluing the securities with
this new term structure. For a 100 basis point parallel
shift increase in interest rates the portfolio price was
+$4.99. For a 100 basis point decrease in rates the portfolio price was +$8.29. This analysis indicates that the
portfolio faces little interest rate exposure. In fact, for
any significant parallel shift in the term structure, the
price of the portfolio increases. Thus, modified duration indicates that there should be no concern about
losses from interest rate fluctuation.
As a test of this measure's accuracy, the portfolio
price was recalculated using the actual term structure
constructed from the stripped Treasury bond prices reported three months later, on October 1, 1992—and
the difference in the price of the portfolio was - $ 5 4 . 7 5
(see Table 5). Modified duration would have grossly
underestimated the actual interest rate exposure of the
simplest portfolio during the third quarter of 1992.
There are two important possible sources of such results: m i s m a t c h e d convexity and nonparallel term
structure movements.
Adjusting for Convexity. While duration is the
amount the price of a portfolio will change for small
parallel movements in the term structure, convexity is
how much duration will change for small parallel
shifts in the term structure. s Thus, if durations are
matched and convexities are not, the portfolio prices
are hedged only to small changes in the term structure.
After a small shift the durations would no longer be
Table 4
A Portfolio H e d g e d with Matching Durations
Asset
Current Price
Adjusted Price
Difference
Long 30-Year Security
$2,316.38
$2,314.17
+$2.21
Short 9.5-Year Security
-$2,316.38
-$2,314.17
-$2.21
Combined Portfolio
26
Economic Kevieiu
0.0
0.0
0.0
March/April 1993
matched, and in the event of a larger parallel shift the
portfolio prices would no longer be hedged.
The examples discussed demonstrate the results of
unmatched convexity. Recall that the portfolios were
perfectly hedged for a 1 basis point increase in the
term structure but that their prices d i f f e r e d for a
100 basis point shift. Unmatched convexity is clearly
evident in Table 6, in which the portfolio is priced for a
200 basis point shift. Compared with the price changes
for a 100 basis point shift (+$4.99 to +$8.27), the price
changes for a 200 basis point shift (+$19.21 to +$35.09)
seem to indicate a nonlinear increase in the magnitude
of the differences with the size of the parallel movement increases.
Eliminating convexity errors would be the first suggested improvement in simulating 100 basis point parallel shifts. This step is taken in the Federal Reserve's
revised proposal, where simulations of 200 basis point
shifts are included. Such shifts approximate two standard deviations of historical volatility. Because convexity errors can be large, at least two standard deviations should be simulated. 6
Incorporating convexity clearly improves the accuracy of duration-based models. However, in the example above convexity was not a problem. Movements
exceeding 100 basis points would have shown profits
in the portfolio. Recall that the portfolio had a large
positive price difference for both a 200 basis point increase and a 200 basis point decrease.
N o n p a r a l l e l S h i f t s in t h e T e r m S t r u c t u r e . T h e
biggest problem with using m o d i f i e d duration and
parallel shift simulations is that term structure movements historically have rarely been parallel. Unfortunately, portfolios hedged for parallel movements of
the term structure may have considerable exposure to
nonparallel movements. A statistical technique called
principal component analysis is a useful tool for illustrating this point. Principal component analysis breaks
down a sequence of random motions into its most
d o m i n a n t i n d e p e n d e n t c o m p o n e n t s , with the first
principal c o m p o n e n t being the m o s t d o m i n a n t , or
most often occurring, component in the random sequence. The second principal component is the next
d o m i n a n t c o m p o n e n t after removing the first one.
Chart 1 shows the two largest principal components
of historical forward interest rate volatility. 7 In the
chart the first principal component of forward interest
rate fluctuation is similar to a parallel shift in that the
entire curve moves in the same direction. Observe,
however, that short-term rates are more volatile than
long-term rates (a point missed by parallel shift simulation). This characteristic is similar to the nonparallel
Table 5
S i m u l a t i n g a P o r t f o l i o u n d e r a 1 0 0 Basis Point Shift
Simulation
Price of the
30-Year Security
Price of the
9.5-Year Security
Difference
+ 1 0 0 Basis Points
$2,111.24
$2,106.25
+$4.99
- 1 0 0 Basis Points
$2,555.74
$2,547.47
+$8.27
Actual O u t c o m e
$2,475.81
$2,530.56
-$54.75
Table 6
S i m u l a t i n g a P o r t f o l i o u n d e r a 2 0 0 Basis Point Shift
Price of the
30-Year Security
Price of the
9.5-Year Security
Difference
+ 2 0 0 Basis Points
$1,934.39
$1,915.18
+$19.21
- 2 0 0 Basis Points
$2,836.71
$2,801.62
+$35.09
Simulation
Federal Reserve Bank of Atlanta
Hco n o m ic Review
shift that the revised proposal discussed by the Federal Reserve Board uses for monitoring interest rate
risk. T h e second principal component of historical
forward rate m o v e m e n t is f u n d a m e n t a l l y different
from parallel shifts. It involves "twists" of the curve,
or short-term and long-term rates moving in different
directions. C o m b i n e d , these two principal components account for more than 98 percent of the historical
interest rate fluctuation (see Robert Litterman and
Jose Scheinkman 1991).
the first principal component.) The column number is
the number of standard deviations of the second principal component (so that +1 in the column means that
the term structure was steepened by one standard deviation of the second principal component and - 2 means
that it was flattened by two standard deviations of the
second principal component, assuming the curve was
initially steep). All standard deviations are for a threemonth period. For every simulated term structure the
profit/loss of the portfolio is calculated.
Given that historically the most likely changes in
the term structure are the independent movements of
its principal components, a useful measure of interest
rate exposure would be the change in the portfolio
price in relation to the movements resulting from possible combinations of historical principal components
of term structure fluctuation. Table 7 recalculates the
market price of the portfolio for simulated term structures. The term structures are the result of 0, 1, 2, and
3 standard deviation movements of the historical principal components. The row number is the number of
standard deviations of the first principal component.
(For example, +1 in the row means that the term structure was raised by one standard deviation of the first
principal c o m p o n e n t , and - 2 m e a n s that the term
structure was lowered by two standard deviations of
The greatest portfolio loss arising from the combinations of the first two historical principal components
is -$59.18. This simulated loss is close to the actual
loss of - $ 5 4 . 7 5 (see Table 5). Simulating more than
parallel shifts indicates that the actual loss should not
have been unexpected. Use of only parallel shift simulations was misleading as to the size of, and even the
existence of, possible losses. 8 It is important to note
that using historical interest rate fluctuations does not
require any reporting information about the securities
beyond what is required for modified duration; it simply requires the user to simulate more than parallel
shift scenarios. Thus, better information is available at
no additional cost.
In order to compare the different portfolios' exposure, the simulated portfolio values can be combined
Chart 1
Principal C o m p o n e n t s of Historical Volatility
Annual Volatility
3
5
7
10
20
30
Time
28
Economic Review
March/April 1993
Table 7
Simulated Portfolio Values
Standard Deviations
Of First Principal
Component
' In
Standard Deviations of Second Principal C o m p o n e n t
1
2
3
-1.54
-19.70
-37.69
-55.53
+ 10.82
-6.90
-24.47
-41.90
-59.18
+28.26
+11.07
-5.97
-22.89
-39.68
-56.35
+49.34
+32.77
+16.33
0.00
-16.22
-32.33
-48.35
1
+56.98
+41.20
+25.53
+9.95
-5.54
-20.94
-36.27
2
+67.63
+52.67
+37.79
+22.98
+8.25
-6.42
-21.03
3
+80.58
+66.44
+52.37
+38.35
+24.39
+10.47
-3.41
-3
-2
-1
-3
+53.99
+35.30
+16.79
-2
+46.73
+28.69
-1
+45.59
0
0
dollars.
into different test statistics. For example, the loss of
-$59.18—the worst-case scenario—would be a useful
statistic for determining margin (or capital) for the
portfolios. However, this method may still yield errors. First, although primary principal components
capture more than 98 percent of the historical movements, term structures do not move exactly as historical patterns predict. Thus, there is additional "noise"
that does not get simulated. Second, it is possible (although unlikely) for interest rates to move more than
three standard deviations during the three-month period. For this reason, some may argue that caution calls
for more than three standard deviations to be included
in the simulation. Third, any number of historical principal components can be used in the simulation. Clearly, including more components reduces the amount of
unmonitored interest rate risk. Performing simulations
with these dimensions in mind permits a more realistic
assessment of the portfolio's actual interest rate exposure and results in a statistic with a greater degree of
accuracy than modified duration. 9
In the example discussed, one may question why the
zero and one standard deviation movements were included in the simulations when the big gains and losses
occurred in the two and three standard deviation movements. The smaller movements were included because,
when options are part of a set of securities, portfolios
may exist that make money for all large movements of
the term structure but lose money when the term structure is relatively stable. It is, therefore, necessary to
simulate more than just the extreme outcomes. For in-
Federal
Reserve Bank of Atlanta
stance, consider a portfolio consisting of long positions
in a far, out-of-the-money call and put options on Treasury bond futures contracts. If interest rates fluctuate by
only small amounts, all options in this portfolio would
expire out-of-the-money and the original cost of the options would be lost. However, if interest rates fluctuate
by a large amount in either direction, the portfolio has
options that will finish in-the-money.
Conclusion
Both Hugh Cohen (1991) and James H. Gilkeson and
Stephen D. Smith (1992) show that the nature of cash
flows is important in evaluating prices and risks. This article shows that the evolution of interest rate movements
is also important in these evaluations. Modified duration
and parallel shift simulations give useful rough approximations of interest rate exposure. However, because of
the very simplicity that makes them attractive, these
models have restrictions that affect their accuracy, especially over long or volatile periods of time.
This article illustrates that at the beginning of the
third quarter of 1992, parallel shift simulations failed to
detect the possibility of any losses to a simple portfolio, which in actuality sustained significant losses over
the quarter. However, simulations based on historical
term structure fluctuations, requiring no additional reporting information, would have warned the user that
losses of the magnitude actually sustained were possible.
Hco n o m ic Review
Using Duration to H e d g e Interest Rate Exposure
H e d g i n g with C o n s t a n t Interest R a t e s
Consider at time 0 a default-free bond that pays $1.00
at time T in the future. Assuming a constant interest rate
and continuous compounding, the result is the relationship
(1)
b{T) = exp (-RT),
For example, i f / ( 3 0 ) = 8%, it is implied that the annualized interest rate on a default-free loan agreed upon today that will mature thirty years in the future and will be
instantaneously repaid is 8 percent. The forward interest
rate curve is the forward rate,/CD, for all T > 0. The forward interest rate curve can be used to price default-free
cash flows. Again, let b{T) be the time 0 price of a defaultfree bond that pays $ 1.00 at time T, and then
where R is the constant interest rate per unit of time, T is
the time in the future when the bond matures, and b{T) is
the price of the bond. For a coupon-paying bond,
i=n
Price of the bond = X CFexp(-RT),
i=\
(2)
Duration
1}CFj
For a coupon-paying bond,
'
where n is the total number of cash flows contained in
the bond and C F is the /th cash flow at time 7 . Duration,
a well-known function of a bond, is defined as
I
Price of the bond = X C F exp - f ' / ( / ) dt
i=i
(3)
i V ^
Duration
In words, duration is the weighted average maturity of
the cash flow of the bond. Differentiating the price of a
bond with respect to R finds that
dR
(7)
exp(-RTj)
£=1
of the bond)
I J"
Duration is similarly defined as the weighted average
maturity of the cash flows:
Price of the bond
d(Price
(6)
b(T) = exp | - J \ f ( t ) d t
'="
= X - TiCF; expi-RTi),
/=l
(4)
which leads to the well-known relationship
d {Price of the
dR
-Duration.
bond)
= Y^-TiCFj exp - f
,=i
L "0
'f{t)dt • (9)
(5)
Price of the bond
In words, the percent change in a bond's price in response to an infinitesimal positive change in the constant
interest rate is minus the duration. Thus, under the assumption of a flat term structure, the duration of a bond
is a single n u m b e r that indicates the sensitivity of the
bond price to a small change in interest rates. This result
can be extended for more than constant interest rates.
H e d g i n g with a T e r m Structure
Replace the assumption of a constant interest rate, R,
with a forward interest rate curve denoted by f{T). The
forward interest rate is the interest rate agreed upon now
at time 0 for an instantaneous default-free loan at time T.
30
Economic Kevieiu
If the price of the bond is differentiated with respect to a
parallel shift in the forward rate curve [substitute f{t) + R
for f(t) in equation 7 and differentiate with respect to R],
the result as R approaches 0 is
dR
=
(8)
Price of the bond
d {Price of the
bond)
exp[-£7(0^
=
Substituting,
d{ Price of the
bond)
dR
-Duration.
(10)
Price of the bond
This equation demonstrates the advantages of using duration as a measure of interest rate exposure. For any forward interest rate curve, the duration of a cash flow is the
sensitivity of that cash flow to a small parallel shift in the
term structure. The examples in the text illustrate the benefits and limitations of hedging with duration. For small
parallel fluctuations in the term structure, the portfolios are
well hedged. However, for larger parallel movements or
nonparallel movements, the portfolios may sustain severe
losses.
March/April 1993
T h e f a c t t h a t 100 a n d 2 0 0 b a s i s p o i n t p a r a l l e l s h i f t s
p l e x i t y of the p r o b l e m . T h e f a i l u r e to c a p t u r e t h e t r u e
f a i l e d to d e t e c t that t h e m o c k p o r t f o l i o c o u l d s u s t a i n
i n t e r e s t r a t e e x p o s u r e of t h i s r e l a t i v e l y s i m p l e m o c k
a n y loss o w i n g to interest rate e x p o s u r e , or that a single-
p o r t f o l i o illustrates that a large a m o u n t of i n t e r e s t r a t e
f a c t o r m o d e l d e t e c t e d only t h e possibility of s m a l l loss-
e x p o s u r e is u n d e t e c t e d b y t h e s e m e a s u r e s .
es, should be a l a r m i n g f o r those w h o d e p e n d solely
T h e f i n d i n g s r e p o r t e d h e r e s h o u l d s e r v e as a w a r n -
u p o n t h e s e m e a s u r e s to d e t e r m i n e t h e i r i n t e r e s t r a t e
i n g to b o t h i n v e s t o r s a n d r e g u l a t o r s i n t e r e s t e d in deter-
e x p o s u r e . F u r t h e r m o r e , the m o c k p o r t f o l i o c o n s t r u c t e d
m i n i n g interest rate e x p o s u r e . It is i m p o r t a n t to k n o w
is t h e m o s t s t r a i g h t f o r w a r d sort of p o r t f o l i o p o s s i b l e ,
t h a t o v e r s i m p l i f i e d a p p r o a c h e s to m e a s u r i n g i n t e r e s t
c o n s i s t i n g of o n l y d e t e r m i n i s t i c d e f a u l t - f r e e c a s h
rate exposure can be misleading, even for simple secu-
f l o w s . In c o n t r a s t , t h e set of s e c u r i t i e s a v a i l a b l e to in-
rities. G i v e n t h e c o m p l e x n a t u r e o f s e c u r i t i e s that are
v e s t o r s in i n t e r e s t r a t e c o n t i n g e n t c l a i m s c o n t a i n s e x -
c o m m o n w i t h i n interest r a t e c o n t i n g e n t c l a i m s , t h e re-
tremely c o m p l e x securities. Even a " s i m p l e " fixed-rate
s u l t s of p a r a l l e l s h i f t a n d s i n g l e - f a c t o r s i m u l a t i o n s
mortgage contains a complicated prepayment option.
s h o u l d n o t , by t h e m s e l v e s , b e v i e w e d as a c c u r a t e l y re-
In a d d i t i o n , c a p s , f l o o r s , s w a p s , f u t u r e s , o p t i o n s o n f u -
f l e c t i n g interest rate e x p o s u r e .
t u r e s , a n d c o u n t l e s s e m b e d d e d o p t i o n s a d d to t h e c o m -
Notes
1. One indication of this development has been the increase in
the open interest of the Treasury bond futures contract.
(Open interest is the number of futures contracts in existence.) Over the period from March 31, 1981, to March 31,
1993, the open interest of the nearest June futures contract
increased from 51,847 to 317,804.
2. See Docket R-0764, an interagency proposal of the Federal
Deposit Insurance Corporation, the Office of the Comptroller
of the Currency, and the Board of Governors of the Federal
Reserve System. The modified proposal presented to the
Federal Reserve Board was reported in the American Banker,
April 1, 1993, 1. It was not available in the Federal Register
at the time of publication.
3. A basis point is 1/100 of 1 percent. If interest rates were 3 percent, a 1 basis point increase would raise them to 3.01 percent.
4. Selling a security short is equivalent to borrowing the security and selling it at its current market price with the intention
of repurchasing the security at a future date and returning it
to its original owner. A short seller profits when the price of
the underlying security declines. Longing a security is equivalent to purchasing the security.
5. If duration is considered the first derivative of the portfolio
price with respect to parallel interest rate movements, convexity would be the second derivative. For a discussion of
the "convexity trap" in pricing mortgage portfolios see Gilkeson and Smith (1992).
6. The actual deviation of interest rates would lie within one
standard deviation approximately 65 percent of the time. It
would lie within two standard deviations approximately 95
percent of the time.
7. These components were supplied by a large financial institution in 1991.
8. Note that a one-factor historical model similar to the regulators' nonparallel shift would not have worked much better.
The 0 column in Table 7 simulates only the first historical
factor shifts, and the worst loss is -$6.90. Thus, two factors
are the minimum number necessary for an adequate measure
of this portfolio over this period.
9. If options were included in the portfolio, one would also
want to simulate the effects of changes in the market's implied volatility of interest rates to the term structure simulation.
References
Bcnston, George J., and George G. Kaufman. "Understanding
the Savings and Loan Debacle." Public Interest 99 (Spring
1990): 79-95.
Cohen, Hugh. "Evaluating Embedded Options." Federal Reserve Bank of Atlanta Economic Review 76 (November/December 1991): 9-16.
FDIC Improvement Act of December 19, 1991, Pub. Law 102242, 105 Stat. 2236.
Federal Reserve Bank of Atlanta
Gilkeson, James D „ and Stephen D. Smith. "The Convexity
Trap." Federal Reserve Bank of Atlanta Economic Review
11 (November/December 1992): 14-27.
Interagency proposal on revising risk-based capital standards as
prescribed by Section 305 of FDICIA (Docket R-0764),
Press release, Federal Register, July 31, 1992.
Litterman, Robert, and Jose Scheinkman. "Common Factors Affecting Bond Returns." Journal of Fixed Income (June 1991): 54-61.
Hco n o m ic Review
FYI
7Tie Use of Mitigating
Factors in Bank Mergers
And Acquisitions:
A Decade of Antitrust
At the Fed
Christopher L. Holder
n important aspect of the industry consolidation experienced
over the past decade by the U.S. banking system is the increased
pace of bank mergers and acquisitions. 1 From an average of 170
mergers per year from 1960 to 1979, the yearly average grew to
498 during the period from 1980 to 1989 (see Stephen A. Rhoades
1985a and John P. La Ware 1991). The increased number and size of bank
mergers in recent years, as well as the relatively large number of bank failures, have renewed interest in how antitrust enforcement is pursued by the
federal banking agencies. The federal authorities having primary responsibility for the aspects of bank mergers related to competitiveness are the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Office
of the Comptroller of the Currency (OCC), and the Department of Justice
(DOJ). 2
The author is an analyst in the
financial section of the Atlanta
Fed's research department.
He gratefully
acknowledges
comments from Jim Burke,
Frank King, Bobbie McCrackin, Steve Rhoades,
Aruna Srinivasan, Sheila
Tschinkel, and Larry Wall.
32
Economic Kevieiu
The purpose of antitrust regulation in mergers is to prevent an acquirer
from being able to exercise market power, thereby earning abnormal profits
at the expense of customers within the market where the merger occurred.
From a policy standpoint, a proposed merger may be denied if it carries with
it the possibility of significant anticompetitive effects on prices and consumer and business welfare. The Fed's guidelines help anticipate a bank
merger's effects on competition. However, a mechanical application of these
guidelines, because they provide only approximations, can be misleading,
and it may be appropriate to consider additional factors.
March/April 1993
There are substantive, positive reasons for regulators
to refrain from interfering in the market for corporate
control. For example, mergers may eliminate inefficiencies or poor management. They also provide diversification and reduce excess capacity in local markets.
There is a strong argument that industry consolidation
is a healthy and even necessary development for U.S.
banks to become stronger and remain globally competitive. With these things in mind, the Fed's approach is
generally to approve mergers unless competitive effects
are significantly adverse. In merger applications that apparently pose problems with regard to competitiveness
the Fed looks for factors that might mitigate the anticompetitiveness implicit in a breach of its guidelines.
The essential elements in antitrust analysis of bank
mergers are specification of the correct geographic and
product markets, determination of all the direct and
potential competitors, and the analysis of the merger's
effects on the structure of individual markets. The
Federal Reserve reviews these factors in a two-stage
process, determining first whether a competitive problem potentially exists and, if so, whether the merger
could in fact significantly affect competition adversely. The Fed's approach to identifying potential competitive problems is discussed in detail in an article in
the January/February 1993 issue of this Review. That
article examines the Fed's initial screening of proposed transactions for those that could have a significantly adverse effect on competition.
This article, the second in a two-part series detailing how the Fed deals with antitrust issues, deals with
the other stage of the Fed's competitive analysis. If a
proposed merger's effects exceed the Fed's structural
benchmarks and the application goes to the Board of
Governors of the Federal Reserve System, the Fed then
seeks to determine to what extent the merger might be
anticompetitive. 3 During the last decade, the Board
has approved most bank merger applications it has reviewed, citing a number of mitigating factors such as
competition from thrift institutions, the likelihood of
new entry given the market's attractiveness, and the financial health of the firm being acquired. These and
other mitigating factors cited by the Board will be the
focus of this article.
7Tie Data
Bank merger applications dating f r o m N o v e m ber 19, 1982, through December 1992 were examined
in order to identify those that presented possible an-
Federal
Reserve Bank of Atlanta
titrust concerns and went to the Board of Governors
for review. 4 The applications considered were filed by
bank holding companies or state member banks to acquire another bank or bank holding company. (Applications from institutions that had a primary regulator
other than the Fed and applications involving acquisitions of thrift institutions were not examined.) Acquisitions were judged to pose potential antitrust problems
on the basis of the Board's rules regarding delegation
of authority to the Reserve Banks that were applicable
at the time the merger application was filed.
T h e D e p a r t m e n t of Justice guidelines issued in
June 1982 are the foundation for the Fed's initial screening of applications. 5 The guidelines discussed market
concentration in terms of the Herfindahl-Hirschman
Index (HHI) and established three postmerger H H I
concentration ranges for considering the likelihood
that a particular acquisition would have significant anticompetitive effects. A postmerger HHI below 1,000
is c o n s i d e r e d u n c o n c e n t r a t e d ; b e t w e e n 1,000 and
1,800, m o d e r a t e l y c o n c e n t r a t e d ; and h i g h e r than
1,800, highly concentrated. (For a discussion on the
calculation and use of the HHI see Christopher L.
Holder 1993, 28-30.) The Department of Justice stated
that it was more likely than not to challenge transactions with a change in the HHI greater than 100 points
in a moderately concentrated market or in a highly
concentrated market. A change between 50 points and
100 points in a highly concentrated market might be
challenged, depending on the postmerger market concentration, the size of the resulting increase in concentration, and the presence or absence of several other
market-specific factors.
For the purposes of this article, these Department of
Justice criteria were applied as stipulated in the Fed's
Delegation of Authority guidelines for three distinct
subperiods over the decade studied: (1) November 19,
1982, to December 1985, (2) January 1986 to June 1987,
and (3) July 1987 to December 1992. 6
A total of 155 merger applications were identified
as posing potential competitive problems. Of these,
sixteen involved issues of "prior common control" not
relevant in most applications and were dropped from
the data set. Of the remaining 139 applications, involving 297 local banking markets, applicants in 86 of
these markets proposed totally divesting all of either
their own or the target's branches, ensuring that the
p o s t m e r g e r market share of the applicant was not
higher than either its or the target's premerger market
share. 7 These 86 markets were dropped from the data
set, leaving a total of 211 local banking markets for
which competitive issues potentially remained.
Hco n o m ic Review
Mitigating Factors
A majority of the applications involving the remaining 211 markets were approved. In j u s t i f y i n g
these approvals, the Board cited a number of factors
that mitigated the potential anticompetitive effects of
these transactions as indicated solely by the structural,
or HH1, numbers. The following discussion examines
the fifteen mitigating factors cited by the Board in reference to applications reviewed between November
1982 and December 1992. The factors are grouped
here into five categories: strong remaining competition, misleading HHI, potential competition, conve-
nience and needs considerations, and procompetitive
effects on the market. Individual markets could, and
often did, involve multiple mitigating factors as identified in the Board's decision. 8 (Table 1 presents a summ a r y of the m i t i g a t i n g f a c t o r s cited over the last
decade, and Table 2 presents the results of this analysis summarized by year.)
.Strong Remaining Competition
Each of the mitigating factors cited in this category
was used to indicate significant competition that was
Table 1
Factors Cited during t h e Last D e c a d e as
Mitigating Potential A n t i c o m p e t i t i v e Effects o f Bank M e r g e r s
Mitigating Factor
Number of
Percentage
Markets
of Markets
113
107
10
230
53.6
50.7
4.7
76
4
3
3
3
89
36.0
1.9
1.4
1.4
1.4
34
16.1
1
0.5
Strong Remaining Competition
Thrift Competition
Numerous Remaining Competitors
Nonbank and Out-of-Market Competition
Total
Misleading H H I
Partial Divestiture
Deposit Runoff
Total Deposits Incorrect
Passive Investment
Limited Competition
Total
Potential Competition
Likelihood of Entry
Expected D e N o v o Entry
Total
35
Convenience and Needs Considerations
Financial Health of Target Firm
N o Less Anticompetitive Solution
Total
30
3
33
14.2
1.4
7
3
3.3
1.4
0.5
Procompetitive Effects on Market
Benefits to Acquiring Bank
Market Share of Dominant Firm(s)
Applicant's Small Size in the Market
1
11
Total
Denials
r
Five
merger
34
6*
applications,
involving
Economic Kevieiu
competition
in six banking
markets,
were
denied
for competitive
reasons.
March/April 1993
a
Table 2
Factors Mitigating Potential
ft)
V
I
n
Anticompetitive
Effects of Bank Mergers, S u m m a r i z e d by Year
(Number
re
of
Markets)
03
M
3
7?
Mitigating Factor
>
Strong Remaining Competition
Dec. 1982
1983
1984
1985
1986
1987
Thrift Competition
1
9
22
29
20
18
1
Numerous Remaining Competitors
0
8
9
17
16
19
5
Nonbank and Out-of-Market
0
0
0
0
0
3
0
1
17
31
46
36
40
6
Partial Divestiture
0
4
3
2
5
0
9
Deposit Runoff
0
1
0
0
0
0
0
Total Deposits Incorrect
0
0
1
0
0
0
1
Passive Investment
0
0
0
1
0
0
Limited Competition
0
0
0
1
0
0
5
4
4
'1989
1992
1990
1991
3
1
7
2
113
3
8
8
14
107
0
2
4
1
10
6
11
19
17
230
1
3
6
43
76
0
0
0
3
4
0
0
1
3
0
0
2
0
0
0
1
0
1
3
0
0
0
3
5
1
10
1
6
6
47
89
34
Competition
Total
1988
Total
H H I Misleading
Total
Potential Competition
Likelihood of Entry
0
1
1
3
0
4
2
4
6
2
11
Expected D e N o v o Entry
0
0
0
0
0
0
0
0
1
1
1
3
0
4
0
4
1
0
0
2
7
2
11
35
Financial Health of Target Firm
0
5
6
3
0
6
2
1
1
0
2
1
0
0
0
0
5
1
N o Less Anticompetitive Solution
0
0
0
0
3
0
7
7
3
0
6
2
1
1
5
1
33
Total
Convenience and Needs Considerations
Total
30
Procompetitive Effects on Market
Benefits to Acquiring Bank
0
1
0
0
0
5
0
0
0
0
0
1
0
0
0
0
0
1
7
Market Share of Dominant Firm(s)
0
0
0
0
0
1
1
Applicant's Small Size
0
0
0
0
1
3
0
0
0
1
0
1
1
0
0
6
0
0
1
0
2
11
0
1
1
2
0
1
0
0
0
0
0'1
in the Market
Total
Denials
;'Thc
b
Five
Federal
merger
Reserve
denied
applications,
UJ
lui
two applications
involving
in 1992 in which
competition
in six banking
a bank
markets,
holding
were
company
denied
sought
to acquire
for competitive
a thrift institution
reasons.
(see the box on page
41).
6b
not captured by bank deposit market share data and
would remain an important aspect of competition in
the postmerger banking market.
Thrift Competition. The Board cited competition
from thrift institutions more frequently than any other
mitigating factor (see Holder 1993, 31). 9 The Board
considered such measures as the number, size, and
share of deposits held by thrifts in a market, as well as
how the thrifts ranked in size within a market. The
higher these measures, the m o r e likely it was that
thrifts were included as a mitigating factor. In addition, the Board also looked for evidence that thrifts
were actually competing with banks by offering the
full cluster of traditional banking services. Types of
business and consumer transaction accounts (for example, N O W accounts), commercial and industrial
loan ratios, the existence of a commercial lending department or commercial lending officers, and active
advertisements for business customers were all used as
evidence that thrifts were actively competing with
banks.
Nonbank and Out-of-Market Competition. Nonbank, nonthrift financial institutions were cited as a
source of competition that did not show up in the
structural numbers. These financial institutions were
viewed as competing with banks in a broad array of financial services, and their presence was considered a
mitigating factor if they provided significant competition within a local banking market. In all, the Board referred to this mitigating factor ten times over the period
under study: three times in 1987, twice in 1990, four
times in 1991, and once in 1992. 16 The appearance of
this mitigating factor in decisions in only the latter half
of the decade is consistent with, and largely the result
of, the increased competition and institutional deregulation generally experienced by the financial services
industry during this period.
From November 1982 through June 1987, thrifts
were generally not explicitly included in HHI calculations but were considered a mitigating factor in 98 out
of 116 markets, or 87.7 percent of the markets with
competitive issues. 10 After June 1987 the Board automatically assigned thrifts a 50 percent weight in calculating HHIs and gave them an even higher weighting
in 15 out of 95 markets."
The most common nonbank, nonthrift competitor
mentioned was credit unions—with presences specifically mentioned in six out of the ten markets. Competition from credit unions was assessed by reviewing
membership requirements (liberal requirements would
attract many more customers), relative and absolute
size, loan-to-total-asset ratios, and business accounts
offered.
Numerous Remaining Competitors. The second
most often-cited mitigating factor was the Board's
recognition that the number of competitors remaining
in a particular market after a merger was a signal
about the likelihood of monopoly power developing. 12
The expectation was that remaining competitors would
rise to the occasion in the event that an acquirer attempted to exercise market p o w e r through prices.
(This potential is not adequately captured in the HHI
because the index is a static measure of competitive
structure.) Although the Board has not specified the
number of competitors necessary for their presence to
be considered a mitigating factor, the type of market
(rural or urban, small or large deposit base) apparently
played a role in this determination. 13 It appears, though,
that while the existence of numerous remaining competitors was often cited as a mitigating factor, it did
not play a major role in decisions regarding the transactions studied. 1 4 In addition, the Board sometimes
noted that large statewide or regional banks having a
small market share in a particular market may exert a
stronger competitive influence than their small market
share indicates because of their significant financial
Other nondepository institutions were also cited as
providing significant competition for banks—including
consumer and commercial finance companies, industrial loan companies, and securities brokerage firms. 1 7
For one market Mexican financial institutions were
cited, and savings and credit union societies (in Puerto
Rico) were cited in two markets. 18 Decisions on two
applications acknowledged significant competition for
financial services from institutions that solicited business from within a market even though they maintained no offices in the market. 19
36
Economic Kevieiu
and m a n a g e r i a l resources. Implicit in the B o a r d ' s
opinion is the assumption that large banks can price
independently of market leaders in a particular local
market because they can operate with financial support from the home office. 15
Misleading HHI
Mitigating factors in this category were used when
a mechanical interpretation of the structural numbers
might be misleading. The issues raised relate to the
accuracy of using the market share of total bank deposits as the sole indicator of competitive influence
in a particular market, a data problem. T h e factors
cited were partial divestiture, deposit runoff (with-
March/April 1993
drawal of monies because of recent acquisitions), total
deposits incorrect, passive investment, and limited
competition.
Partial Divestiture. Partial divestiture, reducing
an acquirer's new market share by selling some of
the deposits and loans of either the applicant or bank
involved, was considered a mitigating factor. In such
instances, concentration numbers based on the assumption that all the deposits and loans of a target
institution would be acquired misrepresented a merger's effects on competition. To compensate, the Board
adjusted the HHI for the divestitures by calculating
new concentration numbers reflecting the proposed
sale of a bank's branches. While the divestiture was
sometimes deemed adequate to correct any potential
problems, in other cases additional factors played a
role.
Deposit Runoff. Deposit runoff was a mitigating
factor in two applications (four markets). Because
branch-level deposit data are collected annually and as
a result often do not reflect an institution's current
holdings, this factor can be important. In the first market, the Board noted that the applicant had recently acquired a failed bank in the market and projected that
significant deposit and loan losses would result from
that acquisition, reducing the applicant's market share.
The Board agreed with the applicant's contention that
its competitive position as measured by deposits was
overstated. 20
A single application accounted for each of the three
remaining instances of deposit runoff cited as a mitigating factor. The applicant had acquired all of its offices in the three markets by acquiring failed or failing
thrifts from the Resolution Trust Corporation (RTC).
Since these acquisitions, the applicant had experienced significant deposit runoff that other competitors
in these markets had not been subject to. The Board
concluded that the latest branch-level deposit data
available overstated the competitive influence of the
applicant in these markets. 21
Total D e p o s i t s I n c o r r e c t . Total d e p o s i t s m a y not b e
a perfect measure of competitive influence. Recognizing that fact the Board has, in two merger applications, stated that the deposits of individuals, partnerships, and corporations (IPC deposits) can be the
better measure to use when calculating market concentration. 2 2 The Board's position is that " I P C deposits may be the proper focus of the competitive
analysis in mergers and acquisitions in markets, such
as those including state capitals, in which government deposits constitute a relatively large share of total d e p o s i t s . " 2 3 B e c a u s e g o v e r n m e n t d e p o s i t s are
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
o f t e n short-term (monies f r o m tax collections) or
must be invested in lower-yielding, relatively safe assets, they can inflate total deposit figures and be misleading.
In a third merger decision, the Board found that
commercial banks in the relevant market had a substantial portion of their deposits in amounts greater
than $100,000 that were predominantly short-term in
nature. The applicant was cited as having almost 50
percent of its deposits in such accounts. The Board
stated that these types of deposits "do not serve as a
base for significant lending by banks in this market,
and tend to overstate the competitive influence of
banks in the market." 2 4 As above, the Board's conclusion was that total deposits were not the best measure
of competition within this market.
Passive Investment. The Board has also cited the
fact that in three applications the acquirer was investing passively in a bank and was not seeking control of
the institution. 2 5 Thus, the structural changes as reflected in the HHI overstated the transaction's actual
effects on competition. The Board noted that if these
proposals had involved acquiring control of the bank,
competition most likely would have been substantially
diminished in the relevant markets. Relying on commitments that applicants would not seek to influence
the bank's independent activities, the Board concluded
that control of the bank would not be acquired by the
applicant.
The Board pointed out, however, that one company
did not need to acquire control of another to reduce
competition between them. Partial ownership could dilute independence of action and encourage collusive
activities. In approving the applications, therefore, the
Board also noted that there would be no director interlocks among applicants and banks and that stock ownership was meant strictly as a passive investment. In
two of the applications, the Board also pointed out that
the bank was under the firm and active management of
a family that collectively owned more than 50 percent
of the outstanding stock, the implication being that the
applicant's likely influence over the bank's actions
would be limited.
Limited Competition. In some cases competition
between an applicant and a target bank was already limited by their having common principals or ownership.
Thus, the amount of competition actually eliminated
would have been less than the HHI indicated. The
Board noted in one application that the applicant's principals had formed the target bank de novo (as a newly
chartered bank) in 1965 and that the applicant's shareholders already owned 77 percent of the bank. 2 6 In a
Hco n o m ic Review
second application, a principal of the applicant was also
a management official of the target bank. 27 In another
application, it was noted that brothers owned both the
applicant and the bank. Each owned stock in the other's
institution in addition to having numerous other business relationships. 28 In all of these cases, the Board approved the merger.
relatively high ratio of population per bank or banking
office, and a relatively high ratio of deposits per bank
or banking office (with high ratios tending to indicate
that the market is underbanked or that the population
and deposits are e n o u g h to support new entrants).
Higher-than-average per capita income indicates that a
market is attractive as does recent de novo entry into
the market. Rapid growth is especially important,
making it easier for entrants to attract an adequate customer base.
Potential Competition
In the extreme case of an unattractive, declining
market, a case can be made that an institution's exit
from the market is a necessary adjustment because the
market can no longer support the existing number of
independent institutions. This factor is generally cited when the bank is in danger of failing. In addition,
declining markets are often unattractive for expansion by o u t - o f - m a r k e t f i r m s so that an i n - m a r k e t
merger may be the only means of preventing a bank's
failure.
In this category the Board cited likelihood of new
entry into the relevant market and expected de novo
entry as mitigating factors. The expectation was that
future competitors could at least partially offset any
current anticompetitive effects of a proposed merger.
Likelihood of Entry. In line with market theory,
the Board has tried to assess the likelihood of new entry and its effect on competition within the market of a
proposed merger. The relaxation of legal barriers to
entry in a large number of states in recent years has
significantly increased the pool of potential entrants
into most banking markets. Recent empirical evidence
supports the hypothesis that an increase in laws permitting interstate banking and statewide branching has
made potential competition a more important factor in
banking markets (see Dean F. Amel and J. Nellie Liang
1991). Correspondingly, the Board has cited the likelihood of new entry as a mitigating factor much more
frequently in recent years. Twenty-seven of the thirtyfour occasions in which potential new entry was cited
as a mitigating factor occurred after July 1987, with
eleven occurring in 1992.
If a market is considered attractive for entry and
has few or no legal barriers (restricting branching
or prohibiting entry by out-of-state bank holding companies), then new entry can be expected to lessen the possible anticompetitive effects of a merger. The Board
reasons that if a bank (or banks) within a market implements noncompetitive pricing and earns greaterthan-normal profits, other firms could be expected to
enter the market to capture some of this excess profit,
forcing more intramarket competition and a return to
competitive pricing. A market is attractive for entry if
(1) it can easily support a new bank or banks, (2) there
are banks that are likely to expand quickly into the
market, and (3) the market has certain characteristics
associated with market attractiveness.
The Board delineated several characteristics that
add to a market's attractiveness—large market size,
urban location, rapid population and deposit growth, a
Economic Kevieiu
3 8
Empirical evidence supports considering the likelihood of entry as a mitigating factor in merger decisions. Studies have developed a fairly consistent set of
variables that are positively related to the entry of
firms into banking markets, either by acquisition—the
more common means—or de novo. These variables
include market size, market concentration, profitability, rate of growth, and the number of customers per
bank, all of which have been cited by the Board. In
addition, urban markets have been found to be significantly more likely to experience entry than rural
markets (see Amel 1989).
A high likelihood of entry because of a market's
attractiveness was cited as a mitigating factor in applications involving twenty-one markets over the sample period; twelve markets were determined to be unattractive or declining. Legal issues affecting entry
played a role in nine markets, and statewide branching or permissible interstate mergers and acquisitions were cited as mitigating factors in eight of those.
In one market there were legal barriers preventing
branching or interstate mergers or acquisitions, and
this factor weighed against approval of the proposed
merger.
Expected De Novo Entry. The Board cited the expected de novo entry of a new competitor as a factor
that mitigated any potentially anticompetitive effects
in one market. 29 No further explanation of the use of
this factor was given. It seems obvious, however, that
the Board expected the new entrant to provide enough
competition to offset at least partially any anticompetitive effects of the merger.
March/April 1993
Convenience and Needs Considerations
Section 3(c) of the Bank Holding Company Act
(1956) specifies that in supervising bank mergers and
acquisitions federal agencies must consider the convenience and needs of the community to be served. If a
merger would result in a favorable impact on the convenience and needs of the community, that consideration may outweigh concerns about anticompetitive
effects. In Board decisions, two factors fall into this
category: the target firm's financial health and the lack
of a less-anticompetitive solution.
Financial Health of the Target Firm. The Board
cited the financial health of the target firm as a mitigating factor in a total of thirty markets. In eight of
these markets, the Board was relatively certain that the
bank would fail. The decision indicated that serving
the convenience and needs of the c o m m u n i t y outweighed the anticompetitive effects of allowing the
merger. Specific public benefits cited included uninterrupted banking service, continued operation of conveniently located offices, and maintaining employment
within the community.
In the remaining twenty-two markets, the Board
concluded that the bank had proven to be a weak competitor with a possibility of failing in the future and
that this fact lent some weight toward approval. Citing
a particular bank as a weak competitor is based on the
hypothesis that deposit-share data probably overstate
the firm's competitive influence in its market and thus
misrepresent the anticipated anticompetitive effects of
the merger. The Board cited several factors it considered in reaching its conclusion: regulatory exam results, deteriorating capital levels, past and projected
earnings records, declining market share, a low loanto-deposit ratio, small bank size, and the failure to offer the full range of banking services. Often, the failure
of a weak bank to provide a full range of services to its
customers is addressed in an acquiring institution's application, with the acquirer promising to improve the
range and quality of the services provided to the community.
No Less-Anticompetitive Solution. Another issue
considered in such cases is whether a failing bank has
potential buyers other than the anticompetitive applicant.
The presence of bidders promising less-anticompetitive
effects who could also satisfy the convenience and
needs considerations of the community is likely to
weigh against approval of the merger. On the other
hand, the lack of other potential acquirers tends to
weigh heavily toward approval of the merger.
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
In two cases involving acquisition of either a failing
bank or one that was a very weak competitor unlikely
to survive on its own, the Board recognized that the
merger would have some negative effects on competition but cited as a mitigating factor the absence of a
better solution. In these markets, the target bank was
either offered to or had attracted some interest from investors outside the market or institutions other than the
applicant. However, in both applications only the applicant actually agreed to purchase the bank. 30 In a third
application, the Board cited the FDIC's conclusion that
no less-anticompetitive solution was available. 3 1
Procompetitive Effects o n a Market
The Board has indicated that factors enhancing
competition within a market work in favor of a merger
application's approval. Three mitigating factors of this
sort have been cited: benefits to the acquiring bank,
the market share of dominant firm(s), and an applicant's small size in the market.
Benefits to the Acquiring Bank. The benefits expected to accrue to an acquiring bank were cited in
two applications as a mitigating factor supporting approval of the application. In the four markets affected,
the regional economy encompassing both the acquirer
and the target was suffering an economic downturn,
reflected in the operating results of the institutions involved. The Board concluded that the cost savings resulting f r o m the m e r g e r would better position the
applicants to survive this downturn. 32
A third application citing benefits to the applicant as
a mitigating factor involved an opinion by the Board
that the applicant's management could gain financial
and operating efficiencies through elimination of duplicate boards of directors and through the pooling of capital accounts, thus positioning itself to be a stronger
competitor in the future. 33 In a fourth application, the
Board concluded that because both the applicant and
the target bank were small in absolute size, they might
derive some economies of scale from consolidation. 34
In the final application involving this mitigating factor,
the Board found that the acquisition would not disturb
the competitive balance within the market, noting that
after the merger five of the remaining seven institutions
would have market shares greater than 10 percent. The
Board concluded that the merger would result in a viable, but not dominant, competitor. 35
Market Share of Dominant Firm(s). If a high HHI
for a market was caused exclusively by the large market
Hco n o m ic Review
share of one or two firms, this factor worked in favor of
mergers that involved other institutions in the market
and against approval for transactions involving the
dominant firm(s). 36 The implication is that the Board is
more willing to approve mergers that result in a market
of more nearly equal-sized competitors, thereby reducing the market power of the dominant firm(s). 37
Several mitigating factors were considered in these
five denials, but they were not seen as overcoming the
significantly adverse effects of these proposals. (Citing competitive issues, the Board has also recently denied two bank holding company applications in which
those institutions were trying to acquire thrifts. For a
discussion of these two denials see the box on page 41).
Applicant's Small Size in the Market. In one application the Board cited the relatively small size of an applicant as a mitigating factor, noting that the applicant
had not increased its market share in recent years despite a significant increase in the market's deposits
generally. 38 The Board also pointed out that the merger
would result in only a modest increase in market concentration relative to the market's overall competitive
structure. (The change in the HHI would be 265 points,
which would not greatly exceed the applicable guidelines.) While the Board did not express its reasoning, one
possible explanation for its decision is that the acquisition presumably would enable the acquirer to become a
more effective competitor in the market. The underlying assumption would be that more evenly sized banks
would increase competition within a market.
In all five bank acquisition denials the Board considered competition from thrifts. Including thrifts at
100 percent weight produced the structural changes
shown in columns 5 and 6 of Table 3. Even after including thrifts at 100 percent weight, each merger exceeded guidelines. In addition, the Board noted in
three of the cases—Pikeville National, Saver's Bancorp, and Sun west—that the facts of the cases did not
warrant 100 percent thrift inclusion.
The Board noted in three of the applications (Pennbancorp, Pikeville National, and Saver's Bancoip) that the
acquirer proposed to expand the services currently being provided by the target bank. While these improvements in services apparently lent some weight toward
approval, they were not enough to outweigh the potential adverse effects on competition.
The Board noted several factors working against
approval of the mergers. In one denial, Pikeville National, the Board noted that significant legal barriers to
entry in the market made it unlikely that new competition would mitigate the anticompetitive effects of the
transaction. In another case, Saver's Bancorp, the number of competitors in the market was limited, and the
Board noted that consummation of the proposal would
further reduce that number. The Board also considered
financial and managerial factors in the Saver's Bancorp application. Although the bank to be acquired had
Denials
During the past decade, the Board has denied five
applications for which competitive issues were a factor
in p r o p o s e d state m e m b e r bank and bank holding
company acquisitions of another bank or bank holding
company. 3 9 Those applications would have involved
the structural changes depicted in Table 3.
Table 3
M e r g e r A p p l i c a t i o n s D e n i e d o n t h e Basis of
C o m p e t i t i v e Issues d u r i n g t h e Last D e c a d e
Postmerger
Applicant
Date
Pennbancorp
1983
Dacotah B H C
Pikeville National
Saver's Bancorp
Thrift
Reserve
weighting
Board
40
2,573
526
5,338
658
is only
for this
Economic Kevieiu
50 percent.
with
461
2,405
490
3,481
287
1,915
752
numbers
435
2,016
868
5,092
Change in H H I
(Thrifts at 1 0 0 % )
2,024
526
3,738
The structural
Postmerger H H I
(Thrifts at 1 0 0 % )
741
1985
1987
in this market
of Governors
3,058
2,251
1987
(Market #2)
Change
in H H I
1984
1985
Sunwest (Market #1)
HHI
388
3,642*
100 percent
thrift inclusion
513
were
not given
by the
Federal
market.
March/April 1993
Thrift Acquisition Denials
In addition to denying five bank mergers for competitive reasons since November 1982, the Board has recently denied two acquisitions of thrifts by bank holding
companies. The first, an application from Norwest Corporation, was denied on April 3, 1992. 1 It involved a
change in the HHI, with thrifts accorded half weight, of
565 points, to a postmerger level of 2,727. (The deposits
of the thrift being acquired are accorded 100 percent
weight in the calculation of the postmerger HHI.) The
Board noted four decisive factors: (1) market structure,
(2) potential competition, (3) financial health of the target firm, and (4) competition from credit unions. In this
case, the structure of the market weighed against approval. Norwest controlled more than twice the share of
the market's second-largest competitor. In addition, after
c o n s u m m a t i o n , N o r w e s t w o u l d control twenty of the
forty-eight branches in the market, with only one other depository institution controlling more than three branches.
The Board also noted that most of the remaining depository institutions were small.
The Board also found that the market was unattractive for entry and that the merger's negative effects on
competition were unlikely to be offset by new entry. The
market's small size, the fact that it had not experienced a
high growth rate, and the fact that no new competitors
had entered the market during the previous five years
were all noted by the Board in reaching its conclusion.
The Board found that, owing to the financial condition
of the thrift, there were public benefits to the merger,
but these benefits did not clearly outweigh the likely adverse effects on competition. It also noted that the R T C
had received qualified bids f r o m prospective purchasers
that did not have a significant presence in the market. In
addition, although the Board considered N o r w e s t ' s argument that the measures of market share did not adequately take into account competition from credit unions
in the market and overstated the competitive effects of
the merger, this point was not addressed in detail. The
Board's decision makes it eleeir that this factor did not
overcome the likely anticompetitive effects of the proposal.
The Board also denied an application from SouthTrust Corporation to acquire a thrift institution on July 9,
1992. 2 The proposed acquisition would have produced a
change in the HHI of 672 points, to a postmerger level
of 2,488, with thrifts given 50 percent weight (again, in
the postmerger HHI the target thrift was accorded a 100
percent weight). Several competitive factors were important in the decision: (1) the structure of the market,
(2) potential competition, (3) S o u t h T r u s t ' s contention
that the structural numbers overstated the anticompetitive e f f e c t s b e c a u s e the t h r i f t did not c o m p e t e with
Federal
Reserve Bank of Atlanta
SouthTrust in several banking product lines, and (4) convenience and needs considerations.
SouthTrust contended that the large number of competitors remaining mitigated the potential anticompetitive effects of the proposed merger. However, the Board
concluded that other structural factors weighed against
approval. These included the fact that upon consummation SouthTrust would become the market's largest c o m petitor with a market share more than 50 percent greater
than the second-largest competitor. In addition, SouthTrust would control eight of the market's twenty-two depository institution o f f i c e s with only o n e other f i r m
controlling more than two offices. Most of the remaining
eleven institutions would be small ones, with seven of
them having market shares of less than 5 percent.
SouthTrust also suggested that recent entry made the
market attractive to potential competitors. However, the
Board disagreed, noting that the market was rural, small,
and poor by Florida norms and had experienced slow
population growth and deposit growth below the state
average for rural counties. In addition, population and
deposits per bank and banking office were below comparable rural markets in Florida. The Board also stated that
while there had been several indirect acquisitions of branch
offices in the market, there had been n o de novo entry
since before 1987.
SouthTrust contended that the thrift was not a competitor in several product lines, including commercial
lending. SouthTrust's approach differed, however, f r o m
the traditional concept of a cluster of banking products,
and the Board reaffirmed its position that the cluster concept introduced by the Supreme Court in the Philadelphia
National Bank case is still the appropriate f r a m e w o r k
for analyzing the competitive effects of bank mergers. 3
The Board also noted that potential convenience and
needs benefits to the c o m m u n i t y to be served did not
outweigh the expected anticompetitive effects of the proposed acquisition. The decision pointed out that the thrift
was in satisfactory financial condition and was an important provider of services in the market, having, for example, an i m p o r t a n t role as a lender in the m a r k e t for
one-to-four-unit residential mortgages .
Notes
1. "Letter to Norwest Corporation, April 3, 1992," Federal
Reserve Bulletin 78 (1992): 452.
2. "SouthTrust Corporation," Federal Reserve Bulletin 78
(1992): 710.
3. U.S. v. Philadelphia National Bank, 374 U.S. 321 (1963).
Hco n o m ic Review
previously suffered losses, it had improved markedly
over the last few years, and the Board concluded that
its prospects were favorable and that it had demonstrated its ability to remain an effective competitor.
In the first market in the Sunwest application, the
Board a c k n o w l e d g e d S u n w e s t ' s claim that various
nonbank financial institutions existed in the market
but concluded that the record did not clarify the extent
to which other institutions competed with banks in the
market. The Board noted that it would be "willing to
consider any additional facts or information that Applicant may be able to submit regarding this issue." 4 0
In the second market involved in this application, the
Board disagreed with Sunwest that the market was declining and therefore that its decline mitigated the anticompetitive effects within the market.
Each of the above denials involved some question
about the correct definition of the relevant geographic
market affected by the transaction, and the applicants
disagreed with their Reserve Bank's market definitions. The Board noted in detail the points considered
in deriving the market definitions used by the Fed in
each of the above applications.
be. The Fed's analysis over the last decade cites several factors that can mitigate a merger's potentially harmful effects on competition as indicated by the HHI.
The deregulation and innovations of nonbank financial institutions—especially thrifts—in recent years
have allowed many firms to compete more directly
with banks in providing financial services. The Fed
now generally gives thrifts an automatic weighting of
50 percent when considering potential competitive effects from bank mergers. In addition, the removal of
many legal restrictions on statewide branching and
out-of-state acquisitions has decreased the anticompetitive effects of mergers in many markets by substantially increasing the likelihood of new entry. The
current financial health and competitiveness of the target firm, partial divestitures, and any procompetitive
effects on the market were also considered by the
Board as important factors mitigating the potential anticompetitive effects of some mergers.
Most bank merger applications that fail the Fed's initial screening for potential anticompetitive effects are
eventually approved by the Board. While the Fed has
denied only five applications for reasons related to competition over the last decade (plus two denials of thrift
institution acquisitions in 1992), antitrust considerations
still play an important role in the industry's approach to
consolidation. The Fed's consistent use of its guidelines
in antitrust enforcement has lead to self-screening on
the part of potential acquirers who can proceed with relative certainty about the Fed's reaction to a specificmerger proposal. Many proposals are initially structured
to include divestiture that addresses likely antitrust concerns, and an unknown number of banks are deterred
from even attempting certain acquisitions. The Fed has
shown that it examines transactions on a case-by-case
basis and is willing to give consideration to mitigating
factors unique to specific markets.
Conclusion
The Federal Reserve analyzes the competitive effects of bank mergers in a two-stage process. First, the
Fed conducts an initial screening, based largely on the
Department of Justice's 1982 merger guidelines, to
identify the proposed mergers that may threaten competition. Then, if a proposed merger seems to involve
potential competitive issues, the Board and the Reserve Banks conduct an in-depth analysis to determine
what the merger's actual effects on competition would
Notes
1. Throughout this article the terms merger and acquisition are
used synonymously.
2. The Federal Reserve has primary jurisdiction over mergers
of state member banks and mergers and acquisitions by
bank holding companies. The OCC has primary responsibility for national banks, and the FDIC oversees insured
state nonmember banks. In addition, Section 18(c) of the
Federal Deposit Insurance Act provides that "before acting
on any application for approval of a merger transaction, the
responsible agency . . . shall request reports on the competitive factors involved from the Attorney General and the
42
Economic Kevieiu
other two banking agencies." Once a merger or acquisition
has been approved by the appropriate federal banking agency, the DOJ, by law, has thirty days in which to file suit if it
feels the transaction would violate antitrust statutes. If the
DOJ does file suit, the merger is automatically stopped
pending resolution of legal action.
3. Applications for mergers that seem to involve no issues of
competitiveness are "delegated" to the appropriate Federal
Reserve Banks for handling. If a particular transaction has
potentially significant issues (competitive, legal, financial,
and so forth) it is subject to extensive Board review. Au-
March/April 1993
thority to deny an application rests solely with the Board.
The criteria used to determine whether an application is delegated (processed by the Reserve Banks) or nondelegated
(processed by the Board) is given in the Fed's "Rules Regarding Delegation of Authority." See Holder (1993).
4. November 19, 1982, is the date the Board first referred
to the 1982 DOJ merger guidelines and the HerfindahlHirschman Index (HHI). See "First Bancorp of New Hampshire, Inc.," Federal Reserve Bulletin 78 (1982): 769. The
Board's actions on applications discussed in this article that
potentially posed significant competitive issues are available in the Federal Reserve Bulletin.
5. U.S. Department of Justice Merger Guidelines, June 14, 1982.
6. Bank-specific antitrust guidelines differed in these three
subperiods. See Holder (1993, 31, 33).
7. Divestiture is considered by the federal agencies as an acceptable means of reducing potential anticompetitive effects of a proposed merger (see Holder 1993).
8. For a previous treatment of the use of mitigating factors by
the Board, see Loeys (1985).
9. Academic research generally supports the inclusion of
thrifts as competitors of commercial banks. See Burke,
Rhoades, and Wolkcn (1987) and Watro (1983).
10. In eleven of these markets the Board gave thrifts 100 percent weight; in seventy-two markets, 50 percent weight; in
two markets, 25 percent weight; and in one market, 15 percent weight. A thrift weighting was not specified in the remaining twelve markets.
11. In thirteen of these markets the Board gave thrifts 100 percent weight, and in two markets, 75 percent weight.
12. The Board usually cited this factor in a simple statement
saying that despite elimination of a competitor, numerous
banking alternatives would remain in the market.
13. In applications involving divestitures to an out-of-market
competitor, the Board cited as a mitigating factor the fact
that the number of independent competitors within the market would remain the same after the merger. Because the
number of competitors within a market is already reflected
in weighting in the calculation of the market HHI, it is not
clear why the Board has considered this factor as mitigating
the anticompetitive effects indicated by the market's structural numbers.
14. In 103 of the 107 applications in which the presence of numerous remaining competitors was used as a mitigating factor, other mitigating factors were also cited in the Board's
decision. Only four applications that exceeded guidelines
were approved with numerous remaining competitors cited
as the sole mitigating factor. In each of these cases the postmerger HHI and the change in HHI did not greatly exceed
applicable guidelines:
Year
Change in HHI
Postmerger HHI
1983
1985
1987
1987
149
101
212
269
1,138
1,474
2,220
1,930
See "1st Source Bank," Federal Reserve Bulletin 69 (1983):
311; "The Marine Corporation," Federal Reserve Bulletin
Federal Reserve Bank of Atlanta
71 (1985): 262; "Houghton Financial, Inc.," Federal Reserve Bulletin 73 (1987): 870; and "U.S. Bancorp," Federal
Reserve Bulletin 73 ( 1987): 941.
15. This mitigating factor is similar to one cited by the OCC in a
November 1984 merger decision. In this transaction, the
OCC argued that market shares understate the competitive
influence of finns that are in the market but have most of their
resources elsewhere, and "these market shares would not reflect the capacity of such firms to divert resources from the
external market in response to an attempt to exercise market
power in the relevant market." "Decision of the Comptroller of the Currency on the Application to merger Farmers
Community Bank, State College, Pennsylvania, into Peoples
National Bank of Central Pennsylvania, State College, Pennsylvania," November 5, 1984, Press Release. This argument
is sometimes referred to as the "deep pockets" hypothesis.
16. "AmSouth Bancorporation," Federal Reserve Bulletin 73
(1987): 351; "Sunwest Financial Services, Inc.," Federal
Reserve Bulletin 73 (1987): 463; "Hartford National Corporation," Federal Reserve Bulletin 73 (1987): 720; "First
Union Corporation," Federal Reserve Bulletin 76 (1990):
83; "WM Bancorp," Federal Reserve Bulletin 76 (1990):
788; "BanPonce Corporation," Federal Reserve Bulletin 77
(1991): 43; "First Hawaiian, Inc.," Federal Reserve Bulletin
11 (1991): 52; and "Laredo National Bancshares, Inc.,"
Federal Reserve Bulletin 78 (1992): 139.
17. "AmSouth Bancorporation," Federal Reserve Bulletin 73
(1987): 351; "Sunwest Financial Services, Inc.," Federal
Reserve Bulletin 73 (1987) 463; "Hartford National Corporation," Federal Reserve Bulletin 73 (1987): 720; "First
Union Corporation," Federal Reserve Bulletin 76 (1990):
83; "WM Bancorp," Federal Reserve Bulletin 76 (1990):
788; "First Hawaiian, Inc.," Federal Reserve Bulletin 11
(1991): 52.
18. "Laredo National Bancshares, Inc.," Federal Reserve Bulletin 78 (1992): 139; and "BanPonce Corporation," Federal
Reserve Bulletin 77 (1991): 43, respectively.
19. "Hartford National Corporation," Federal Reserve Bulletin
73 (1987): 720; and "Laredo National Bancshares, Inc.,"
Federal Reserve Bulletin 78 (1992): 139.
20. "First Tennessee National Corporation," Federal Reserve
Bulletin 69 (1983): 298.
21. "BankAmerica Corporation," Federal Reserve Bulletin 78
(1992): 338.
22. "Norstar Bancorp, Inc.," Federal Reserve Bulletin 70
(1984): 164; and "Valley Bank of Nevada," Federal Reserve Bulletin 74 (1988): 67.
23. "United Bank Corporation of New York," Federal Resen'e
Bulletin 66 (1980): 61.
24. "Laredo National Bancshares, Inc.," Federal Reserve Bulletin 78 (1992): 139.
25. "Sun Banks, Inc.," Federal Reserve Bulletin 71 (1985):
243; "First State Corporation," Federal Reserve Bulletin 76
(1990): 376; and "SunTrust Banks, Inc.," Federal Reserve
Bulletin 76 (1990): 542. The percentage ownerships involved in the three applications were 15 percent, 24.9 percent, and 24.99 percent, respectively.
26. "Central Wisconsin Bankshares, Inc.," Federal
Bulletin 71 (1985): 895.
Hco n o m ic Review
Reserve
27. "Fairfax Bancshares, Inc.," Federal Reserve Bulletin 73
(1987): 923.
28. "Lisco State C o m p a n y , " Federal Reserve Bulletin 76
(1990): 31.
29. "Centura Banks, Inc.," Federal Reserve Bulletin 76 ( 1990): 869.
30. "Van Buren Bancorporation," Federal Reserve Bulletin 69
(1983): 811; and "First National Bankshares of Sheridan,"
Federal Reserve Bulletin 70 (1984): 832.
31. "Indiana Bancorp," Federal Reserve Bulletin 69 (1983):
913.
32. "RepublicBank Corporation," Federal Reserve Bulletin 73
(1987): 510; and "Alaska Mutual Bancorporation," Federal
Reserve Bulletin 73 (1987): 921. In addition to a proposal
by the applicant to raise additional capital in the Alaska
Mutual Bancorporation transaction, the FD1C agreed to
make a significant capital contribution to the applicant.
33. "F.S.B., Inc.," Federal Reserve Bulletin 78 (1992): 550.
34. "Fairfax Bancshares, Inc.," Federal Reserve Bulletin 73
(1987): 923. In drawing this conclusion, the Board relied on
a body of empirical work indicating that there are economies of scale in banking. Academic research suggests that
banks have a U-shaped cost curve that implies some scale
economies. However, the scale-efficient bank size is disputed (see Bauer. Berger, and Humphrey 1992; Evanoff and Is-
35.
36.
37.
38.
39.
railevich 1991; Humphrey 1990; Hunter, Timme, and Yang
1990; and Ferrier and Lovell 1990). In addition, the efficiency gains are usually small (see Berger and Humphrey 1991).
Similar results have been found for thrifts (see Mester 1987).
"Old Kent Financial Corporation," Federal Reserve Bulletin 69 (1983): 102.
"Community Bancshares, Inc.," Federal Reserve Bulletin
70 (1984): 770; "Norwest Corporation," Federal Reserve
Bulletin 76 (1990): 873; and "CB&T Financial Corporation," Federal Reserve Bulletin 78 (1992): 704.
For an empirical analysis of the results of increasing the
size of fringe firms in a market see Rhoades (1985b).
"AmSouth Bancorporation," Federal Reserve Bulletin 66
(1987): 351.
"Pennbancorp," Federal Reserve Bulletin 69 (1983): 548;
"Dacotah Bank Holding Company," Federal Reserve Bulletin 70 (1984): 347; "Pikeville National Corporation,"
Federal Reserve Bulletin 71 (1985): 240; "Saver's Bancorp,
Inc.," Federal Reseiye Bulletin 71 (1985): 579; and "Sunwest Financial Services, Inc.," Federal Reserve Bulletin 73
(1987): 463.
40. "Sunwest Financial Services, Inc.," Federal Reserve
letin 73 (1987): 463.
Bul-
References
Amel, Dean F. "An Empirical Investigation of Potential Competition: Evidence from the Banking Industry." In Bank
Mergers: Current Issues and Perspectives, edited by Benton
E. Gup, 29-68. Norwell: Kluwer Academic Publishers, 1989.
Amel, Dean F., and J. Nellie Liang. "The Relationship between
Entry into Banking Markets and Changes in Legal Restrictions on Entry." Board of Governors of the Federal Reserve
System unpublished paper, 1991.
Bauer, Paul W., Allen N. Berger, and David B. Humphrey. "Efficiency and Productivity Growth in U.S. Banking." In The
Measurement of Productive Efficiency: Techniques and Applications, edited by H.O. Fried, C.A.K. Lovell, and S.S.
Schmidt. Oxford: Oxford University Press, 1992.
Berger, Allen N., and David B. Humphrey. "The Dominance of
Inefficiencies over Scale and Product Mix Economies in
Banking." Journal of Monetary Economics 28 (August
1991): 117-48.
Burke, Jim, Stephen A. Rhoades, and John Wolken. "Thrift Institutions and Their New Powers." Journal of Commercial
Bank Lending 69 (June 1987): 43-54.
Evanoff, Douglas D., and Philip R. Israilevich. "Scale Elasticity
and Efficiency for U.S. Banks." Federal Reserve Bank of
Chicago Working Paper 91 -15, 1991.
Ferrier, Gary D., and C.A. Knox Lovell. "Measuring Cost Efficiency in Banking: Econometric and Linear Programming
Evidence." Journal of Econometrics 46 (October/November
1990): 229-45.
Holder, Christopher L. "Competitive Considerations in Bank
Mergers and Acquisitions: Economic Theory, Legal Foun-
44
Economic Kevieiu
dations, and the Fed." Federal Reserve Bank of Atlanta Economic Review IS (January/February 1993): 23-36.
Humphrey, David B. "Why Do Estimates of Bank Scale Economies Differ?" Federal Reserve Bank of Richmond Economic Review 76 (September/October 1990): 38-50.
Hunter, William C., Stephen G. Timme, and Won Kuen Yang.
"An Examination of Cost Subadditivity and Multiproduct
Production in Large U.S. Banks." Journal of Money, Credit
and Banking 22 (November 1990): 504-25.
La Ware, John P. Testimony before the Committee on Banking,
Finance and Urban Affairs of the U.S. House of Representatives. September 24, 1991. Reprinted in Federal Reserve
Bulletin 11 (November 1991): 932-48.
Loeys, Jan G. "The Fed's Use of Mitigating Competitive Factors in Bank Merger Cases." Federal Reserve Bank of Philadelphia Working Paper 85-8, August 1985.
Mester, Loretta J. "Efficient Production of Financial Services:
Scale and Scope Economies." Federal Reserve Bank of Philadelphia Business Review (January/February 1987): 15-25.
Rhoades, Stephen A. "Mergers and Acquisitions by Commercial Banks, 1960-83." Board of Governors of the Federal
Reserve System, Staff Study 142, January 1985a.
. "Market Performance and the Nature of a Competitive
Fringe." Journal of Economics and Business 37 (February
1985b): 141-57.
Watro, Paul R. "Thrifts and the Competitive Analysis of Bank
Mergers." Federal Reserve Bank of Cleveland Economic
Review (Winter 1983): 13-22.
March/April 1993
olicy Essay
iVew Tools for Regulators
In a High-Tech World
Stephen D. Smith and Sheila L. Tschinkel
Smith holds the H. Talmage
Dobhs, Jr., Chair of Finance
in the College of Business at
Georgia State University and
is a visiting scholar at the
Federal Reserve Bank of
Atlanta. Tschinkel is Senior
Vice President and Director of
Research at the Atlanta Fed.
The authors thank Curt
Hunter, Frank King', Bobbie
McCrackin, Joycelyn
Woolfolk, and especially Will
Roberds and Larry Wall for
comments that have substantially improved the essay.
Reserve Bank of Atlanta
Digitized Federal
for FRASER
71
i m ^ any people believe that the deregulation of financial institu/ I
/ M
tions in the 1980s has caused substantial losses to the public.
/ I
/
È
At the same time, there are feelings in some quarters that the
m /
È
continued subsidization of particular financial institutions,
/
r
M
along with appropriate restrictions, would enable these firms
to remain viable and to continue providing low-cost credit to certain sectors
of the economy. After all, when a system that seemed to work for many
years was dismantled, the public faced disasters like the losses at savings
and loans (which are still being paid for). While the correlation of events—
the lifting of regulations and the losses that followed—appears to suggest
cause and effect, it is important to look behind this relationship if we want
to improve the system that delivers financial services.
This article argues that much of what has seemingly resulted from deregulation is actually caused by technological change that is outside the control
of a traditional regulatory system. The resulting ability to avoid regulatory
barriers at little cost generates an expansion of trading that may also expand
risk. In this case, price regulation of transactions may work better than quantity regulation in achieving public policy objectives.
Traditionally, the government has designed systems that subsidize certain
activities of financial institutions or has developed regulations that limit others. These policy instruments may be viewed as opposite sides of the same
coin. Subsidization may be seen as establishing a very low, or zero, price for a
good or service while regulation increases the price, perhaps at times to infinity.
Technology's ability to break down this type of regulatory system has
been demonstrated in the savings and loan industry's massive losses in the
Hco n o m ic Review
early 1980s. At that time, the value of mortgage portfolios at thrift institutions plunged as interest rates
soared to double-digit levels. Within the traditional
framework, thrift portfolios were restricted primarily
to mortgages (to encourage housing). The reasoning
was that any losses on these assets could be offset by
gains from paying below-market rates of interest on
deposits. However, depositors soon learned about an
alternative to holding low-interest bank and thrift accounts. Developments in computer and communications technology had allowed money market mutual
f u n d s to be created and to expand rapidly, and the
money flooded out of regulated depositories into unregulated money funds. The government was left with
a choice: (1) it could do nothing and thereby preserve
some low-cost deposits at troubled thrifts but cripple
the ability of many depositories to make new loans, or
(2) it could deregulate deposit interest rates, a move
that would allow viable depositories to compete in the
market. 1 The eventual decision was to decontrol deposit interest rates. However, in a very real sense this
deregulation did not result from ideological beliefs in
the benefits of free markets. Rather, it was generated
by financial markets that exploited low-cost technologies. In fact, technological advances developed in the
marketplace can and almost always will be able to circumvent so-called direct regulation, which relies on
regulators' ability to know the feasible set of alternative strategies available.
In the discussion that follows, we begin by providing a general discussion of transactions costs as they
relate to existing regulations. To illustrate, we focus on
two situations created by advances in technology that
undercut regulatory attempts to control the production
of a socially desirable good. The first example demonstrates the role of organized financial exchanges in
"producing" the prices of financial instruments. For
our purposes, an exchange is defined as an organized
trading system requiring the payment of fixed costs.
This definition includes physical entities (such as the
New York Stock Exchange) but also incorporates overthe-counter transactions. The National Association of
Securities Dealers (through the NASDAQ system) is,
rather obviously, in the business of producing prices, as
is the very large over-the-counter market in government securities. We argue that the franchise value of
this socially useful function has been eroded by lowcost technology that allows traders to use the product
(prices) without paying for it.
Our second example covers deposit insurance guarantees, which are a form of subsidization that prevents
bank runs. Historically, the high cost of technology
Economic Kevieiu
4 6
helped regulation contain the amount of the subsidy
by limiting the movement of deposits.
Our goal is not to debate the merits of the myriad
government subsidy programs. Rather, we argue that
existing regulations no longer work in a low-tradingcost environment. Simply stated, private benefits that
arise from circumventing these restrictions depend directly on the cost of technology. As the technological
cost of trading drops to near zero, the number of privately beneficial trades soars, and traditional regulation can no longer limit potential public losses. We
suggest, therefore, that consideration should be given
to replacing the subsidy/prohibition regulatory paradigm with a user fee-based system that may more efficiently accomplish social goals. Such a system would
replace direct intervention with indirect intervention.
A fee is suggested as a preferable alternative to regulation seeking to limit quantities because a fee would
likely cause less loss of efficiency. In international
trade, for example, tariffs can in many instances be
shown to be more efficient than quotas. Moreover, other examples, such as seignorage in monetary theory,
suggest that a user fee may lead to fewer distortions.
Imposing a user fee would not shut down markets, as
direct intervention may, and therefore it would not
eliminate privately beneficial sharing arrangements. It
is important to note that any fee would need to be
levied against particular transactions as opposed to institutions. 2
Transactions Costs and
Effective Regulation
In most economic settings, reducing transactions
costs improves social welfare. Economists generally
believe that the volume of trade in a security tends to
increase when there exists an easily accessible, lowcost market in which new and existing holdings can be
traded. To the extent that the initial holders of such
claims have the option to transfer them to someone
w h o values them more highly, this concept m a k e s
sense. When transfer costs are high, there is little effort put forth to make a "secondary" market in the asset. Conversely, as technology improves and lowers
the cost of transactions, there is an ever greater incentive to create a secondary market. The transfers that
result benefit the initial parties and others.
While improved efficiency in trade may be helpful
when no social goods are involved, it may undermine
regulatory attempts to limit access to scarce social
March/April 1993
goods like insurance on deposits. Enhanced efficiency
in trade, by definition, makes it easier to (a) avoid
prohibitions on activities (that is, it makes "tax avoidance" easier) and (b) expand the growth of valuable
subsidies. 3 As a result, unregulated secondary markets
develop whereby private benefits are maximized and
public well-being minimized in what amounts to a
zero-sum game. Direct prohibitions will never be effective in this case if perfect, or nearly perfect, financial substitutes can be derived quickly in response to
new regulatory guidelines.
changes produce, can be used by swap participants at
essentially no cost. Moreover, to the extent that swaps
are unregulated, the default risk engendered by these
contracts is not subject to oversight by any private or
public regulatory agency. 5
The solution to the free-riding problem suggested
by Ronald Coase (1960) would rely on side payments
between participants to generate a socially optimal
level of the activity. The " w i n n e r s " in some senses
would compensate the "losers" so that the latter continue to play the game. However, as Rafael Rob (1989)
and others have pointed out, there is no guarantee that
this "gains to trade" model assumed by Coase will
work in a noncooperative framework.
Private Use of Prices Obtained f r o m
Public Exchanges
The availability of publicly observable prices that aggregate the information of all traders promotes the efficient allocation of resources by agents throughout the
economy. This function of prices is a critical one in a
free market system, as described by F.A. Hayek (1945),
but it is not a costless process. When transactions costs
are high, additional trading in secondary markets is not
worthwhile and the producers (exchanges) can recover
costs. However, low-cost trading technology fosters
growth in secondary market transactions, pulling trading away from the primary market and thereby threatening the quality of information generated because
exchanges have less and less incentive to create prices. 4
A purely "private-party" example of technology's
role in the cost of such "tax" avoidance relates to the
so-called gray market in listed equities. In this market
traders use the information provided by organized exchanges to determine a "fair" price for the security but
then avoid the exchange's trading tax (higher transactions costs) by trading off-market. The growing availability of programs that allow strategies to be formulated quickly permits traders to act on price information
as it becomes available, typically through services or
media organizations that broadcast the data in real
time. While the exchanges may charge these organizations a fee for accessing the data, they are unable to
obtain revenues from all users.
Such "free-riding" is certainly not restricted to private markets for equity securities. Swap markets, for
example, have experienced tremendous growth by using costly price information generated in exchanges to
create new securities. The prices that participants are
willing to pay to swap interest payments, for instance,
are based in large part on interest rates that prevail on
the original securities. This information, which the ex-
Federal Reserve Bank of Atlanta
Trading o n Government Guarantees
The government subsidizes a number of activities
thought to be socially useful. One common means of
subsidization is to provide guarantees to purchasers of
selected financial instruments in order to encourage an
activity deemed to be socially desirable, such as home
ownership. Alternatively, guarantees may be used to
discourage undesirable activities like bank panics.
Whatever the rationale, an important part of the "guarantee package" involves the use of regulation to limit
the government's risk exposure to manageable levels.
However, the guarantees have true market values, and,
if trading costs are low enough, holders will be willing
to sell some of them to capture the value for their
shareholders.
A specific example that touches the pocketbooks of
all taxpayers involves the recent trend toward the securitization of assets originally held by depository intermediaries. 6 As regulators moved to impose higher
capital requirements, institutions had two options available to them. The first involved issuing more capital
against existing assets. The potential dilution suffered
by shareholders made this alternative unattractive for
many institutions. The other option, which in the past
would have been prohibitively costly, involved the
transfer of certain assets to third parties by creating a
new security, whose promised repayments are backed
by the original assets. The current low cost of such "financial engineering" makes it worthwhile for banks or
thrifts that might otherwise have raised capital to instead sell high-quality assets to insurance companies
and other institutions in order to meet capital requirements. Unfortunately, this process reduces the average
quality of assets on the institutions' books, and these
Hco n o m ic Review
are financed by insured deposits. The windfall from
these transactions goes, of course, to the institutions'
shareholders.
It will always be possible, as long as transactions
costs are low enough, to create secondary market trading in a subsidy and avoid a quantity regulation. Securitization has legitimate benefits, such as added liquidity
and reduced cost of diversification for banks (see, for
example, Gary Gorton and George Pennacchi 1992).
However, it seems that much of the bank activity in
this area has been undertaken to avoid the capital tax
and thus more of this financial engineering takes place
than is socially optimal.
It has been argued that risk-based deposit insurance
could solve this problem, although it may be difficult
to specify the premium, which varies by risk, ex ante.
In any case, deposit insurance premia may be viewed
as user fees. Both are a form of price, as opposed to
quantity, regulation.
Some Thoughts o n a User Fee Proposal
It should by now be clear that regulations designed
to restrict the volume (or quantity) of particular assets
or subsidies are not effective when such inexpensive
trading strategies exist. Unfortunately, blanket prohibition of large classes of securities may cause more
harm than good. What, then, are the options available
to the public and private exchanges? It seems logical
to seek the answer in price-based regulation. Growth
could be limited by removing most traditional regulations and instead imposing a positive cost on selected
transactions through a user fee.
While it is true, as many authors have argued (see,
for example, Paul Kupiec 1992), that transactions fees,
or taxes, impede the efficiency of markets, impeding
various types of free-riding transactions is desirable
from a social welfare point of view. An imposed cost
would indeed limit the volume of, for example, offbalance-sheet securitization, thereby making it worthwhile for institutions to raise capital instead. From a
taxpayer's point of view, this result is precisely the
goal. A positive cost for trading in securities would inhibit the wealth-transferring trades without prohibiting
asset transfers outright. 7 As noted earlier, unlike an
outright prohibition this a p p r o a c h would not shut
down markets completely. Rather, it would result in
m a n a g e d growth, whereby only the most efficient
firms in the industry would be able to produce privately beneficial contracts. It is true that market partici-
48
Economic Kevieiu
pants could still use low-cost technology to avoid fees
by moving transactions to places where fees do not apply, such as outside the United States. However, besides the fact that customer demand is likely to limit
such moves, international coordination of a fee system
could benefit both the United States and other countries likely to have similar problems. Although such
coordination could prove difficult to accomplish—because individual countries may want to attract activity
to their domestic m a r k e t s — i n the long run an unbounded expansion of trading could prove costly.
On the other hand, tax evasion is always a possibility. It would be less likely, however, if penalties were
attached to the statute enacting the user fee. Under
these conditions most transactors would comply in the
same way that most people pay their taxes. Furthermore, evasion would be discouraged by the fact that
avoiding the taxes would require collusion among at
least two participants. Finally, provisions could be implemented that would tie a financial transaction's U.S.
legal standing to payment of the fee.
Many prominent economists, including Nobel
Prize-winner James Tobin, have long called for a tax
on securities transactions. They argue that excessive
resources are being used in financial m a r k e t s that
could more productively be employed elsewhere in the
economy. While it may not be possible to determine
whether there are too many financial transactions in
total, it seems clear that limiting the growth in freeriding transactions could enhance public welfare.
To be sure, a user fee would be expected to impede
the growth of transactions, including those that are
viewed as socially beneficial. However, the costs of
this approach may, on balance, be lower than those
generated under the current system. In short, it seems
that price regulation of the sort accomplished through
a form of user fee may work better than traditional
quantity regulation in effectively limiting public losses. This argument is an application of the theory that
examines whether price regulation is better than quantity regulation. There is general agreement among
theorists that, in many situations, price regulation is
superior from a social point of view. 8 In the area of financial regulation, it is a topic worth further investigation by both researchers and public policy specialists.
Conclusion
The idea of imposing a volume-based fee on financial transactions is not to be considered lightly. We are
March/April 1993
all t o o f a m i l i a r w i t h r e g u l a t o r y s t r a t e g i e s t h a t o f t e n
t r e m e n d o u s v o l u m e of t r a n s a c t i o n s s u g g e s t s that e v e n
h a v e u n i n t e n d e d a n d c o s t l y e f f e c t s . A t the s a m e t i m e ,
a r e l a t i v e l y i n s i g n i f i c a n t f e e ( f o r e x a m p l e , f r a c t i o n s of
the o b s e r v e d c o s t s to t a x p a y e r s of u n i n h i b i t e d p r i v a t e
a b a s i s p o i n t ) c o u l d c r e a t e a s u b s t a n t i a l p o o l of f u n d s .
transactions appear substantial. Indeed, the realized
T h e s e f u n d s c o u l d p r o v e u s e f u l in the e v e n t of u n a n -
c o n t i n g e n t l i a b i l i t y of g o v e r n m e n t a g e n c i e s a l o n e is
t i c i p a t e d f i n a n c i a l stress o r e m e r g e n c y .
e n o u g h to m a k e the public take notice. A user fee,
I m p o s i n g costs on f i n a n c i a l t r a n s a c t i o n s , r a t h e r
w h i c h w o u l d b e a t y p e of t a x a n a l o g o u s t o a toll p a i d
t h a n p r o h i b i t i n g t r a d e s o u t r i g h t , is n o t p r o p o s e d as a
when a vehicle crosses a bridge, would generate rev-
p a n a c e a f o r l i m i t i n g r i s k s to t a x p a y e r s or p r o t e c t i n g
e n u e that could be passed through to the institutions
t h e r i g h t s of p r i v a t e p r o d u c e r s of f i n a n c i a l i n f o r m a -
that are threatened by free-riding. T h e pass-through
tion. T h i n k i n g a b o u t this a l t e r n a t i v e s c h e m e is, h o w e v -
m a y i n v o l v e p r i v a t e e x c h a n g e s o r a c e n t r a l p o o l of
er, a start in t h e d i r e c t i o n of r e c o g n i z i n g that m o d e r n
g o v e r n m e n t f u n d s s u c h as t h e F D I C i n s u r a n c e f u n d .
t e c h n o l o g y , c o m b i n e d w i t h l i m i t e d liability, h a s b e l i e d
To the extent that Congress has authorized a national
t h e o l d a d a g e t h a t " t h e r e is n o s u c h t h i n g as a f r e e
m a r k e t f o r s e c u r i t i e s , s o m e of t h e s e f u n d s c o u l d b e
l u n c h " f o r t r a d e r s in m a n y f i n a n c i a l m a r k e t s . U n f o r t u -
e m p l o y e d to c r e a t e s u c h an e x c h a n g e . Finally, the
nately, their l u n c h e s m u s t b e p a i d f o r b y t h e r e s t of u s .
Notes
1. A third choice, placing rate controls on money market mutual funds, was not politically viable. Many small depositors
did not see any reason why they should subsidize banks and
thrifts by accepting below-market rates on deposits. Some of
these depositors, including groups such as the gray panthers,
became politically active in efforts to prevent Congress from
extending interest controls to money funds.
2. While this proposal has theoretical appeal, considerable
study is needed to assess its practical effects. The design of a
user fee or how much revenue it could generate is also beyond the scope of this article.
3. Kane (1981) has made a similar point in terms of a regulatory "dialectic." His idea, that institutions find ways to circumvent regulation and that regulators then respond by imposing
new constraints, is similar to the argument here. He contends
that improvements in technology help institutions in the "cat
and mouse" game. The argument here is that while technology has now made the tool kit used by regulators obsolete in
the current environment, a substitute one may be possible.
4. This is an example of the so-called Grossman-Stiglitz (1980)
paradox. If the returns to producing information are zero (or
close to zero), traders will have no incentive to collect information, and, in turn, the informational role of prices is destroyed. Because no transactor has incentive to pay for the
socially beneficial component of price information, and if
there is no way to prevent free-riding, charges by exchanges
will not recover costs.
5. Private exchanges, like government, try to limit, through various devices, the risk exposure of participants. Mulherin,
Netter, and Overdahl (1991) provide an excellent discussion
of this point.
6. There are many other examples as well. For e x a m p l e ,
Roberds (in this Economic Review) discusses the free-riding
of private clearinghouses on the central bank. Smith (forthcoming, 1993) has brought out similar points with regard to
the securities firms and the central bank.
7. To be sure, financial innovation might indeed create situations in which a fee could be avoided. While it may be possible, in theory, to generate substitutes for securities, the cost
in terms of transactions or liquidity would likely be higher
than paying a fee. This argument suggests that because the
cost of substitution between securities is low, a fee should be
broadly based as opposed to levied against a subset of securities, such as options and futures.
8. See, for example, Bhagwati (1965) for an analysis of this choice
in terms of quotas versus tariffs in international trade theory.
He shows that under imperfect competition a tariff system may
provide superior "welfare" when compared with a quota system. His setting is, however, static, and Rotemberg and Saloner
(1989) have argued that the results may be reversed in a dynamic setting. In other situations it might be socially harmful to
have any fixed quota. For example, in a liquidity crisis the central bank, if limited to a quota system, might find it in everyone's interest to ignore it. (See also note 6.)
References
Bhagwati, Jagdish. "On the Equivalence of Tariffs and Quotas." In Trade Growth and the Balance of Payments: Essays
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
in Honor of Gottfried Haberler, edited by R.E. Balduring et
al. Amsterdam: North Holland, 1965.
Hco n o m ic Review
Coase, Ronald H. "The Problem of Social Cost." Journal of
Law and Economics 3 (October 1960): 1-44.
Gorton, Gary, and George Pennacchi. "The Opening of New
Markets for Bank Assets." In The Changing Market in Financial Services, edited by R. Alton Gilbert. Norwell,
Mass.: Kluwer Academic Publishers, 1992.
Grossman, Sanford J., and Joseph E. Stiglitz. "On the Impossibility of Informationally Efficient Markets." American
Economic Review 70 (June 1980): 393-408.
Hayek, F.A. "The Use of Knowledge in Society." American
Economic Review 35 (September 1945): 519-30.
Kane, Edward. "Accelerating Inflation, Technological Innovation, and the Decreasing Effectiveness of Banking Regulation." Journal of Finance 36, no. 2 (1981): 355-67.
Kupiec, Paul. "On the Ramifications of a Securities Transaction
Tax for the Function and Efficiency of Capital Markets."
Board of Governors of the Federal Reserve System, Finance
and Economics Discussion Series, 212, October 1992.
50
Economic Kevieiu
Mulherin. J. Harold, Jeffry M. Netter, and James A. Overdahl.
"Prices Are Property: The Organization of Financial Exchanges from a Transaction Cost Perspective." Journal of
Law and Economics 34 (October 1991, part 2): 591-644.
Rob, Rafael. "Pollution Claim Settlements under Private Information." Journal of Economic Theory (1989): 307-33.
Roberds, William. "The Rise of Electronic Payment Networks
and the Future Role of the Fed with Regard to Payment Finality." Federal Reserve Bank of Atlanta Economic Review
78 (March/April 1993): 1-22.
Rotemberg, Julio, and Garth Saloner. "Tariffs versus Quotas
with Implicit Collusion." Canadian Journal of Economics
22, no. 2 (1989): 237-44.
Smith, Stephen D. "Private versus Public Efficiency in Securities Markets." Journal of Banking and Finance (forthcoming, 1993).
March/April 1993
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