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March/April 1994
Volume 79, Number 2

Federal Reserve
Bank of Atlanta

In This Issue:
Over-the-Counter Financial Derivatives:
Risky Business?
FYI—Comparing Dodge's Construction
Potentials Data and the Census Bureau's
Building Permits Series










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Review
March/April 1994, Volume 79, Number 2

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Federal Reserve
Bank of Atlanta

•^••••••••I^HH
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Federal Reserve Bank of Atlanta Economic Review
March/April 1994, Volume 79, Number 2

Over-the-Counter
F i n a n c i a l Derivatives:
Risky Business?
Peter A. Abken

23

FYI—Comparing
Dodge's
Construction Potentials Data
a n d t h e Census Bureau's
Building Permits Series
Cynthia Bansak and
Anne Toohey




In recent years over-the-counter (OTC) derivatives—such as interest rate and currency swaps—have grown in importance to become a mainstay of financial risk management. But concerns about
their perceived riskiness and their relatively unregulated status have
prompted increasing scrutiny of OTC derivatives markets. This article reviews the current structure of the OTC markets and outlines
the various types of risk, including systemic risk, present in these
markets.
In addition, the article summarizes the observations and recommendations of several comprehensive studies of derivatives markets
conducted by industry organizations and government regulators.
There seems to be a consensus among these studies that internal
controls and audit procedures at individual firms involved with
derivatives are the most important factors for reducing the chance
of firm-level losses as well as systemic risk. The author notes that
regulators have also expressed confidence in the ability of the current regulatory structure to supervise the OTC derivatives market.
The discussion concludes with a word of caution to policymakers
about changing regulatory structures, noting that such alterations
often bring unintended and unforeseen consequences.

Many consider construction, with its strong ripple effects on
local employment and business activity, an important sector of the
national economy. While numerous construction data series are
available for tracking national activity, at the local, state, and regional level, few data series comparable to other areas are available.
Two sources—the Census Bureau's building permits series and
F.W. Dodge's construction potentials data—provide data for states
and some metropolitan statistical areas. This article compares the
collection and reporting methodologies of the two series and illustrates data differences using annual figures to compare selected residential and nonresidential data series. The authors found that when
the sources used similar methodologies and reporting sources, as
for residential data, the data series were quite comparable over
time. However, when the methodologies differed as they did for the
nonresidential series, the Dodge and Census Bureau data series
were dissimilar and were generally not close substitutes.




(y/ver-the-Counter
Financial Derivatives:
Risky Business?

Peter A. Abken

r
The author is a senior
economist in the financial
section of the Atlanta Fed's
research department.

Federal Reserve Bank of Atlanta



heir continuing rapid g r o w t h — a n d some spectacular, wellpublicized losses by a few users—has gained financial derivatives a lot of attention in recent years. In late 1993 a U.S. subsidiary of the German conglomerate Metallgesellschaft AG lost
$1.8 billion in oil futures and forward contracts. Its poorly conceived derivatives hedges nearly bankrupted the company. In 1992 senior
managers at Showa Shell, the Japanese affiliate of Royal Dutch/Shell,
wiped out 82 percent of shareholders' equity by taking a $6 billion position in yen/dollar futures, effectively wagering five dollars for every dollar
they hedged. Their futures position turned out to be a disastrous bet when
the yen sharply appreciated against the dollar (Richard C. Breeden 1994
and William Falloon 1994). Several major so-called hedge funds, which
are private investment partnerships that leverage their investments using
derivatives of all kinds as well as bank loans, lost enormous sums through
derivatives positions. One lost $600 million speculating on the yen in two
days, and another, $1 billion—a quarter of the funds under its management—since the beginning of 1994 (Michael R. Sesit and Laura Jereski
1994; Brett D. Fromson 1994). (On the other side of the coin, these funds
made billions in 1992 speculating on European currencies.) The rapid,
huge sales of bonds in order to cover derivatives losses and reduce exposures reportedly roiled bond markets around the world, causing concern
about the disruption of financial markets from their trading. 1

Economic

Review 7

Also a source of anxiety are derivative instruments
more exotic than these examples generally involve. A
large consumer products firm recently announced a
$157 million pretax loss on some leveraged swaps designed to bet on the direction of change in U.S. and
German interest rates (Steven Lipin, Fred R. Bleakley,
and Barbara Donnelly Granito 1994). This and other
recently reported cases of losses have focused attention on the risks of these more complex derivatives.
Aside from their complexity, the largely unregulated
character of the over-the-counter (OTC) derivatives
markets sets them apart from other financial markets,
as has their extremely rapid growth and fast pace of
innovation. This article examines the current structure
of the OTC markets and recent recommendations for
improved monitoring and perhaps broader regulation
of their operation.
Over-the-counter derivatives are financial claims
that derive their value from the level of an underlying
price, price index, e x c h a n g e rate, or interest rate.
Some of the more common of these instruments include interest rate swaps, forward rate agreements,
caps, collars, floors, options, and their foreign exchange equivalents. In recent years OTC derivatives
have become a mainstay of financial risk management
and are expected to continue growing in importance as
more financial managers become more familiar with
their use.
Exchange-traded derivatives, such as futures contracts, are similar to OTC instruments in terms of their
risk management applications. They differ in a number
of important respects, however—a key difference being that OTC instruments are intermediated by financial institutions, which design or tailor an instrument to
the needs of the end user. OTC contracts are negotiated
bilaterally—between two counterparties—and thus are
essentially private transactions, unlike exchange-traded
instruments, which are arranged openly through an organized futures or options exchange. Another key distinction is the largely unregulated n a t u r e of O T C
derivatives trading, whereas exchange-traded derivatives are extensively regulated by federal government
agencies.
The history of derivatives in the United States is
long and checkered. Derivatives trace back to the founding
of the Chicago futures exchanges in the mid-nineteenth
century. The markets' modern history starts with the
trading of financial and foreign exchange futures on the
International Monetary Market of the Chicago Mercantile Exchange (CME) in 1972 and with standardized
stock option contracts on the Chicago Board Options
Exchange in 1973. With the emergence of the interest

2




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rate and currency swap market in the early 1980s, overthe-counter derivatives gained prominence.
Activity in derivatives markets is often characterized by a somewhat overly simplistic dichotomy between speculators and hedgers. Speculation and its
putative association with excess price volatility have
been a rationale for regulation both historically and
currently. 2 However, concerns about derivatives today
extend beyond price stability to market stability. In
particular, financial regulators want to minimize systemic risk—the possibility that the failure of one firm
as a result of derivatives trading would trigger the failures of other firms.
Most observers would agree that the use of derivatives carries risks, both to individual firms and to financial markets. From an economic perspective, it is
the proposition that the derivatives markets do not
internalize the social costs of their activities that
supports the case for (further) regulation. Even when
firms safeguard themselves individually in conducting derivatives operations, such measures may be inadequate to insulate the public from picking up the
costs of a systemic crisis that could spread from the
failure of one or more key derivatives players. The
threat of such a so-called market failure, in which private and social costs diverge, is a classic reason for
regulatory intervention (Stephen Schaefer 1992, 3).
For U.S. depository institutions engaged in derivatives
transactions, a further concern is that misuse of derivatives—for example, taking large speculative bets on
interest rates—could endanger the deposit insurance
safety net. Regulations span a wide array of actions
and costs. 3
Because of their perceived riskiness and their relatively unregulated status, the OTC derivatives markets
have been under increasing scrutiny. Industry organizations as well as government regulators have conducted several comprehensive studies of the markets.
T h e salient observations and r e c o m m e n d a t i o n s of
these studies are considered below.

An Overview of Derivatives Markets
Derivative instruments fall into four basic market
groups: interest rate contracts, foreign exchange contracts, commodity contracts, and equity contracts. The
first two groups are the dominant and older segments
of the market. The instruments themselves consist of
two basic types, those with linear payoffs and those
with nonlinear payoffs. 4

March/April 1994

Linear payoff contracts are those whose value at
maturity moves one-for-one with the level of the underlying price, price index, exchange rate, or interest
rate (hereafter simply referred to as price). Forward
contracts and swaps, which are sequences of forwards
with successively longer maturities, are the primary
linear payoff contracts. Forward contracts fix a price
on an asset for delivery at a specified future date.
These contracts are typically priced so that they cost
nothing to initiate, but as the underlying price fluctuates away from the price that prevailed at initiation,
they become assets or liabilities to the counterparty.
This one-for-one m o v e m e n t makes these contracts
well suited for hedging the underlying asset or liability
because the future appreciation of the derivative can
offset the loss on the asset or liability, or vice versa.
As an example, consider a simple, "plain vanilla"
interest rate swap. A typical use of such a swap is in
converting interest rate payments on floating-rate debt
into fixed-rate payments. The swap obligates a counterparty to pay a fixed interest rate payment, determined by the stipulated s w a p rate, at s e m i a n n u a l
intervals and simultaneously to receive a floating interest rate payment, typically indexed to LIBOR. 5 Only
the net difference between the fixed- and floating-rate
payments is exchanged. The combination of floatingrate debt and swap synthesizes a fixed-rate bond. As
LIBOR rises above the fixed swap rate, the net swap
payment offsets higher payments on the underlying
debt; conversely, as LIBOR falls below the swap rate,
interest saving on the debt is forgone as the counterparty makes a net swap payment to the other swap
counterparty. Thus, a swap locks in a fixed interest
rate, analogous to a forwards' fixing a price or exchange rate.
Nonlinear payoff contracts have payoffs that do
not move one-for-one with the underlying price at expiration. Option contracts have the simplest and most
common type of nonlinear payoff. For example, if the
price is above a call option's strike price (the price at
which the optionholder is entitled to purchase the asset), the payoff moves one-for-one, but if it is below
the price, the payoff is zero. Prior to expiration, the
value of an option is a smooth, convex function rather
than a kinked function of the underlying price. As another example, a digital or binary option—a type of
exotic option—has a payoff at expiration that jumps
from zero to a fixed amount if the underlying price
falls within a specified range. (In general, exotic options have relatively complicated contingencies that
determine their payoffs. See William C. Hunter and
David W. Stowe 1993a, 1993b.) The key point in the

Federal Reserve Bank of Atlanta



context of derivatives regulation is that nonlinear payoff contracts are more difficult to value than swaps
and forwards. Regardless of type, options are assets
to their purchasers and liabilities to their sellers or
writers.
Size of the Markets. The standard way to judge
the size of OTC derivatives markets is by reference to
the notional amount outstanding for particular types of
derivatives. The notional amount is the face value of
the principal of the underlying contract on which a
derivative instrument is based. (With the important exception of currency swaps, principal is usually not exchanged in a swap transaction.) Notional principal is a
misleading indicator of the size of derivatives transactions because most cash flows arising from such transactions are small compared with notional principal.
However, notional principal is useful as a measure of
the relative importance of one type of derivative compared with another or as a measure of the growth in
activity for one instrument.
One of the difficulties in studying OTC derivatives
markets is that data on market activity are somewhat
sketchy. Interest rate and currency swap activity has
been surveyed by a trade association, the International
Swaps and Derivatives Association, since the mid1980s. Chart 1 shows the worldwide growth in notional principal for interest rate and currency swaps from
1987 to 1992. Interest rate swaps denominated in a
single currency grew at a compound annual rate of
33.4 percent to a year-end 1992 notional amount of
$3.9 trillion; currency swaps grew at 29.4 percent to a
year-end notional amount of $860 billion over the
same period. During this period, the notional value of
exchange-traded interest rate and currency futures in
the United States rose at a 22.0 percent compound annual rate, reaching a year-end 1992 combined level of
$1.35 trillion (Commodity Futures Trading Commission [CFTCJ 1993a, 24).
With the exception of forward foreign exchange
contracts and forward rate agreements or FRAs (essentially one-period interest rate swaps), the other segments of the OTC derivatives markets are much smaller
than the swaps market. Year-end 1992 dollar and nondollar caps, collars, and floors were $468 billion, and
options on swaps (swaptions) were $ 108 billion.
The volume of new swaps originated during 1992,
in terms of notional principal, stood at $3.12 trillion
(105,000 contracts), whereas the volume in global
exchange-traded futures and options trading in 1992
totaled $140 trillion in notional value (600 million
contracts). 6 Clearly, the exchange-traded futures and
options are traded in more active markets in the sense

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3

that contract turnover is much higher. O n e reason for
this activity is that the average maturity of futures and
options contracts is less than one year; in fact, most
t r a d i n g i n v o l v e s c o n t r a c t s w i t h m a t u r i t i e s of o n e
month or less. On the other hand, roughly 60 percent
of interest rate swaps fall within a one- to three-year
maturity band, about 30 percent within three to seven
years, and 10 percent, more than seven years. Currency swaps are skewed toward even longer maturities.
The long maturities of swap contracts affect the riskiness of swap portfolios.
D e a l e r s . M o s t s w a p and other O T C derivatives
trading takes place through dealers, which are primarily the largest money-center banks, investment banks,
and insurance companies. 7 Worldwide, 150 dealers are
m e m b e r s of the International S w a p Dealers Association (ISDA). They run derivatives portfolios or " b o o k s "
that contain various swap and other derivatives positions they have with their customers, who may be end
users or other dealers. Dealers typically seek to hedge
their books against changes in interest rates (and other
market factors). M a t c h i n g a swap of a counterparty
that exchanges fixed-for-floating interest rate payments

with another counterparty that exchanges floating-forfixed payments is a standard method of insulating a
s w a p portfolio f r o m interest rate m o v e m e n t s . (This
risk is discussed more fully below.) Dealers also hedge
or "lay o f f " risk using exchange-traded f u t u r e s and
options contracts—for example, Eurodollar futures
contracts.
In addition to a commission, compensation for dealers' intermediation takes the f o r m of a spread between
the fixed rate they receive f r o m a counterparty to a
swap (the ask or offer rate) and the fixed rate they pay
to another (the bid rate). The swap ask rate is a few basis points (hundredths of a percentage point) higher
than the bid r a t e . D e a l e r s q u o t e d i f f e r e n t b i d - a s k
spreads for each instrument in which they "make markets." Less active markets—exotic options markets, for
i n s t a n c e — c o m m a n d larger d e a l e r s p r e a d s . D e a l e r s
b e a r m o r e risk a n d g r e a t e r c o s t s in h e d g i n g t h e s e
derivatives. Larger spreads may also represent economic rents for offering unique derivative instruments.
N o aggregate statistics on dealer activity are available. The dominant dealers in the United States are the
largest commercial banks. Federal Reserve statistics

Chart 1
Swaps Outstanding: Year-End Notional Amounts, 1987-92
Trillions of
Dollars
4.0

1987

1988

1989

1990

1991

1992

Source: C F T C , using data from the Bank for International Settlements and the International S w a p a n d Derivatives Association.

4



Economic

Review

March/April 1994

from the Consolidated Financial Statements for Bank
Holding Companies (FR Y-9C) give a glimpse of the
largest bank holding companies' (BHC) dealer activity. The top ten B H C s ' positions as of June 30, 1993,
are reported in Table 1. More than 90 percent of the
d e a l e r derivatives business is c o n c e n t r a t e d in these
largest institutions; relatively little is conducted in the
next 205 BHCs. The total size of derivatives positions
as measured by notional principal is typically a large
multiple of the total assets of each institution, but, as
mentioned earlier, this figure enormously exaggerates
the scale of this business and its risks. Forwards are
the m a i n areas of b a n k dealer activity, f o l l o w e d by
swaps and options.
In ten years of derivatives trading, trading revenues amounted to $35.9 billion, whereas cumulative
losses came to merely $19 million. M o o d y ' s and Standard and Poor's, which provide credit risk ratings for
corporate bonds, have never downgraded a firm strictly on the basis of its derivatives activities. Both firms
regard derivatives as sources of profit and income stability for commercial banks. 8 N o commercial bank has
failed because of derivatives activities. 9

T h e Risks of Derivatives
Derivatives risk stems f r o m a variety of sources.
This section discusses each of the following categories
of risk that arise in derivatives markets: market risk,
credit risk, legal risk, settlement risk, operating risk,
and systemic risk.
Market Risk. Market risk refers to any market-related
factor that changes the value of a derivatives position.
The relevant exposure is the u n h e d g e d portion of a
derivatives portfolio. Changes in the underlying price
cause a change in the current market value of a derivative. This change in value is referred to as delta risk.
For example, as the level of interest rates rises, the value of a plain vanilla swap falls for a counterparty that
receives a fixed rate of, say, 8 percent on a swap. If the
s w a p rate on a n e w l y o r i g i n a t e d f l o a t i n g - f o r - f i x e d
swap is now 9 percent, another counterparty would be
willing to take over the existing swap and receive 8
percent payments only if compensated for the lower
present value of the cash flows from that swap. 1 0 This
situation is analogous to the capital loss realized on a

Table 1
Ten Holding Companies with the Most Derivatives Contracts
(June 30, 1993, Notional Amounts, $ Millions)

Rank

Holding Company N a m e

State

Total

Total Futures

Total

Total

Assets

Derivatives

and Forwards

Swaps

Options

1

Chemical Banking Corporation

NY

145,522

2,117,385

1,245,500

554,257

2

Bankers Trust N e w York Corporation

NY

83,987

1,769,947

816,740

355,597

597,610

264,811

290,535

3

Citicorp

NY

216,285

1,762,478

1,207,132

4

J.P. Morgan & Co., Incorporated

NY

132,532

1,550,680

572,897

5

Chase Manhattan Corporation

NY

99,085

1,125,075

666,150

317,628

579,219

398,563

258,086

200,839

6

Bankamerica Corporation

CA

185,466

899,783

581,034

7

First Chicago Corporation

IL

49,936

452,780

229,926

88,823

8

75,324

IL

170,052

100,666

Continental Bank Corporation

22,352

276,790
61,058

9

36,205

56,041

Republic N e w York Corporation

NY

52,953

164,979

81,707

45,504

Bank of N e w York Company, Inc.

NY

41,045

91,434

37,768

65,128

12,200

14,106

10,104,592

5,574,136

617,374

2,453,219

2,077,236

247,461

227,278

142,574

10,721,965

5,821,597

2,680,497

2,219,811

10

Top 10 Holding Companies
Other 205 Holding Companies
Total Notional Amount
for All Holding Companies
N o t e : Table includes

data for companies

with total assets of $150 million

or more or with more than one subsidiary

bank.

Source: U . S . Congress (1993), using data from the Board of G o v e r n o r s of the Federal Reserve System Consolidated Financial Statements for
Bank H o l d i n g C o m p a n i e s (FR Y-9C).

Federal Reserve Bank of Atlanta



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5

fixed-rate coupon bond when interest rates rise. Conversely, a counterparty paying an 8 percent fixed rate
would realize a capital gain on the swap upon closing
it out before maturity. The net cash flows from a swap
portfolio can be similarly analyzed.
The market risk of nonlinear payoff contracts—
options and other derivatives with option features—is
more difficult to assess. The entire "probability distribution" of the underlying price may be relevant to valuation. For example, as the volatility or dispersion of
the price increases, option prices rise because of the
greater likelihood that the contract will yield a payoff
at maturity. This characteristic is known in the market
jargon as volatility risk or vega risk. It is conceivable,
and in fact not uncommon, for the price of the underlying contract to remain unchanged while its volatility
shifts. Volatility risk is most effectively hedged using
other option contracts.
A payoff's nonlinearity implies that the sensitivity
of an option's price to changes in the underlying price
varies with the underlying price. For example, a call
option's price becomes increasingly sensitive to the underlying contract's price the farther in the money the
option becomes (that is, the higher the price moves
above the strike price). (In the extreme, the price of an
option that has no chance of finishing out of the money
moves one-for-one with the underlying price.) This risk,
known as convexity or gamma risk, though predictable
(unlike volatility shifts), complicates the hedging of options portfolios. Hedges need to be dynamic, meaning
frequently adjusted, rather than static, as in the hedging
of linear payoff contracts like swaps and forwards. 11
Credit Risk. Because OTC derivatives are entered
into bilaterally, performance on a contract depends on
the financial viability of the opposite counterparty.
Should the opposite counterparty become insolvent
and go bankrupt, a counterparty has to attempt to recover the value of a derivative contract in bankruptcy
court or, in the case of depository institutions, through
the institution's conservator or receiver (the Federal
Deposit Insurance Corporation for banks or the Resolution Trust Corporation for savings and loans). This position contrasts with exchange-traded derivatives that
have an exchange clearinghouse as the opposite counterparty. The credit exposure is to the clearinghouse—
effectively all clearing m e m b e r s of an e x c h a n g e —
rather than to an individual counterparty.
According to an ISDA survey conducted at the end
of 1991, the cumulative losses on derivative contracts
among participating ISDA members (representing 70
percent of the market) over a ten-year period was $358
million (Group of Thirty 1993b, 43). Somewhat more

6
Economic


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than half this amount was attributable to defaults triggered by a legal technicality, which will be discussed
in the next subsection. A recent survey of fourteen major
U.S. OTC derivatives dealers revealed that cumulative,
combined losses from 1990 through 1992 amounted to
$400 million (with $250 million occurring in 1992).
This loss represents only 0.14 percent of the dealers'
gross credit exposure, which is a worst-case measure
of losses if all contracts defaulted (U.S. General Accounting Office [GAOJ 1994, 55, and Appendix III).
Although actual losses experienced have been rather
small historically, derivatives dealers are clearly cognizant of the credit risks derivatives pose, and evolving
market practice continually refines safeguards against
credit losses.
The credit risks of linear payoff contracts are different from nonlinear payoff contracts because the
former can be either an asset or a liability to a counterparty, depending on the future evolution of the underlying price. A counterparty would not default on a
swap that is an asset. Unwinding that swap by marking it to market and closing it out would result in a
cash payment from the opposite counterparty. 1 2 Default occurs when the counterparty is insolvent and the
swap is a liability. In fact, conceptually the credit risk
of a swap or forward contract may be viewed and analyzed in terms of options. 13
The current exposure of a derivative is its mark-tomarket value or its replacement cost. The future exposure is the potential loss on a derivative as market rates
and prices change. This exposure is difficult to quantify and generally requires sophisticated simulation
analyses. The future exposure of an interest rate swap
traces a dome-shaped curve that rises and then falls
from the time of its origination to the time of its expiration. The reason is that early on there is relatively little uncertainty about movement in market rates. The
dispersion of rates or prices away from current levels
increases over time, elevating future exposure. On the
other hand, derivatives have fixed maturities, so the
number of remaining future payments falls with the
passage of time. These two effects offset each other.
By the last payment date there is no uncertainty and
no future exposure. In contrast, currency swaps have
future exposure profiles that rise steadily because the
final exchange of principal is the dominant cash flow,
which swamps the amortization effect of earlier periodic cash flows.
Converting derivatives exposures into expected losses requires an assessment of the probability that a
counterparty will default. Intuitively, the credit exposure to a counterparty may be large in the near term—

March/April 1994

so-called master agreements that provide for netting of
payments.
A related concept is close-out netting in the event of
counterparty bankruptcy. Through a master agreement,
the amount a defaulting counterparty owes upon termination of its outstanding contracts with another counterparty w o u l d be limited to the net a m o u n t of the
m a r k - t o - m a r k e t values. In the a b s e n c e of a m a s t e r
agreement, the sum of the gross amounts of contracts
with negative replacement value would be owed. The
credit exposure is generally much larger without netting arrangements in place. The practice of bilateral
netting and the use of master agreements are becoming
more widespread. Legal uncertainties pose the greatest
obstacles to broader application of bilateral netting.

say, three months—but the expected loss during this interval could be negligible for a financially strong counterparty because insolvency is highly unlikely. T h e
likelihood of default rises over progressively more distant time horizons as current information about a firm's
financial condition has less and less predictive value
and relevance. For example, currency swaps generally
have larger expected credit losses compared with interest rate swaps because the greatest probability of default coincides with the greatest total credit exposures,
both coming at the end of a currency swap's life.
The analysis of credit risk becomes more complex
in moving from considering the credit risk of individual derivatives to portfolios of derivatives. Simulation
analysis is again needed to handle the interrelationships of a portfolio's derivatives. One issue is the extent to which individual derivatives in a portfolio with
the same counterparty may be netted against one another. That is, a dealer or end user may owe payments
on s o m e derivatives while simultaneously receiving
payments on others, all with the same counterparty. If
only the net amount is paid, then the total cash flow is
generally much smaller. It is becoming increasingly
c o m m o n practice to bundle individual derivatives into

Chart 2 shows the gross replacement costs relative
to the book value of assets of commercial bank derivatives dealers from 1990 to 1992. These are disaggregated into interest rate and foreign exchange derivatives.
T h e g r o s s r e p l a c e m e n t c o s t s or c u r r e n t e x p o s u r e s
amount to less than 10 percent of assets. These measures
exaggerate exposures because they ignore the fact that
many derivatives contracts with a single counterparty
are included in bilateral netting arrangements, which

Chart 2
Commercial Bank Derivatives Positions—Dealers:
Replacement Costs Relative to Book Assets
Percent

1990

1991

1992

Source: C F T C , using data from the Board of G o v e r n o r s of the Federal Reserve System FR Y-9C Reports.

Federal Reserve Bank of Atlanta



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have been estimated to reduce counterparty exposures
by 40 percent to 60 percent (Group of Thirty 1993b,
135). Furthermore, all derivatives counterparties are
highly unlikely to default simultaneously—the expected loss is considerably smaller than the gross exposure—and recoveries in the event of default are likely
to be greater than zero. Chart 3 shows the corresponding gross replacement costs for bank nondealers, who
as a g r o u p have current exposures relative to assets
about a tenth the size of bank dealers'.
G r o s s credit e x p o s u r e s appear larger w h e n m e a sured against the equity capital of an institution. In a
recent survey conducted by the General Accounting
Office, the derivatives gross credit exposure of thirteen
m a j o r U.S. derivatives dealers in 1992 a m o u n t e d to
100 percent or more of equity capital for ten of the
thirteen dealers. However, another perspective emerges
in considering the s a m e e x p o s u r e s relative to loans
for seven of the dealers that are c o m m e r c i a l banks.
W h e r e a s the derivatives exposures ranged f r o m 100
percent to 500 percent of equity capital, the commercial loan exposures ranged from about 350 percent to
1200 percent (GAO 1994, 53-55), with loan exposures
being a multiple of the derivatives exposures at each
bank, except for one.

Legal Risk. The derivatives markets span industrialized nations all over the globe. Each nation of course
has different securities and bankruptcy laws, and uncertainty about how derivatives contracts are treated
in d i f f e r e n t legal j u r i s d i c t i o n s stands as one of the
m a j o r challenges to the derivatives business. Another
level of complexity is that many laws that affect O T C
derivatives were legislated before the advent of O T C
derivatives t r a d i n g . Derivatives c o u n t e r p a r t i e s risk
losses because of legal actions that render their contracts unenforceable.
The most notorious case is that of the London borough of Hammersmith and Fulham. In 1991 the U.K.
House of Lords nullified swap contracts that this Lond o n m u n i c i p a l i t y had e s t a b l i s h e d d u r i n g the m i d 1980s on the g r o u n d s that derivatives t r a n s a c t i o n s
were "beyond its capacity"—that is, the municipality
did not have the legal authority to enter into the contracts. This decision was far-reaching and voided contracts between 130 government entities and 75 of the
world's largest banks (Group of Thirty 1993b, 46). On
the basis of consultations with regulators and lawyers,
participants in these swaps had assumed prior to the
ruling that the municipalities had the right to engage in
swaps. Over half of the realized losses f r o m defaults

Chart 3
Commercial Bank Derivatives Positions—Nondealers:
Replacement Costs Relative to Book Assets

1990

1991

1992

Source: C F T C , using data from the Board of G o v e r n o r s of the Federal Reserve System FR Y-9C Reports.

8



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March/April 1994

(as of year-end 1991) stemmed from the Hammersmith and Fulham decision.
The question of capacity is also an issue in jurisdictions outside of the United Kingdom as well as for
other kinds of swap counterparties. A recent Group of
Thirty survey disclosed that, besides municipalities,
derivatives market participants are also concerned
about entering into contracts with sovereigns (that is,
national governments), pension funds, and, to a lesser
degree, with unit investment trusts and insurance companies (Group of Thirty 1993b, 47).

The classic case of settlement risk is the failure of
the Bank Herstatt, a German bank, on June 26, 1974.
As of the close of business that day, the German banking authorities permanently closed Herstatt, after it
had received marks from New York banks for its foreign exchange transactions but had not yet paid the
counterparty banks in dollars (R. Alton Gilbert 1992,
10). (The dollar payments were scheduled to be made
after the close of business in Germany.) Settlement
risk is now sometimes called Herstatt risk.

Another major area of concern regarding legal risks
is how derivatives are handled in the case of early termination as a result of the bankruptcy, insolvency, or
liquidation of a counterparty. Market participants have
serious doubts about how bankruptcy courts may treat
master agreements with bilateral close-out netting provisions. First, there is the risk that a particular bankruptcy proceeding could result in netting provisions
not being recognized, leaving a creditor counterparty
with a higher exposure than anticipated. Second, even
if respected, an automatic stay on terminating contracts (and transferring funds) that is typical in bankruptcy proceedings contributes to uncertainties about
exposures and the eventual recovery of funds from a
bankrupt counterparty.

Bilateral payments netting through master agreements is one mechanism that reduces settlement risk.
T h e fact that many contracts, such as interest rate
swaps, do not involve exchanges of principal also mitigates this risk. T h e greatest settlement risks lie in
cross-currency derivatives, for which notional amounts
are exchanged in different currencies. However, the
settlement risks of derivatives, excluding forward foreign e x c h a n g e contracts, are small c o m p a r e d with
those stemming f r o m spot and forward foreign exchange contracts. In 1992 worldwide average daily net
cash flows were $0.65 billion and $ 1.9 billion for interest rate and currency swaps, respectively, whereas the
net worldwide cash flows for spot and short-dated forward foreign exchange transactions were $400 billion
and $420 billion (Group of Thirty 1993a, 50). 15

The United States is ahead of many other jurisdictions in resolving these legal uncertainties because of
the general consistency among the Bankruptcy Code
(for nonfinancial entities) and the two laws governing
financial institutions—the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of
1989 and the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) of 1991. 14 Through its authority under FDICIA, the Federal Reserve Board in
February 1994 expanded the definition of a financial
institution to encompass all large-scale OTC derivatives dealers. In particular, certain affiliates of brokerdealers and insurance companies were not included in
the definition prior to the ruling, which now accords
legal certainty to netting arrangements that involve
these institutions. The Federal Reserve Board advocates developing a single standard regarding the netting of obligations (U.S. Congress 1993, 353-54).

Operating Risk. Operating risk is exposure to loss
as a result of inadequate risk management and internal
controls by firms using derivatives. This risk category
encompasses a wide variety of nuts and bolts operations that are central to the use of derivatives, either as
a dealer or as an end user. At the broadest level, lack
of involvement or understanding by a f i r m ' s senior
management or board of directors is an operating risk.
The example cited earlier—Showa Shell, a subsidiary
firm speculating on foreign currency—is an extreme
case in point. There is a consensus between derivatives
practitioners and regulators that an independent group
within a dealing firm be responsible for overseeing
risk m a n a g e m e n t . For e x a m p l e , the oversight of a
firm's derivatives positions needs to be uncolored by
pressures to generate trading profits or by other conflicting objectives. End users with extensive derivatives involvement should adopt similar practices.

Settlement Risk. Settlement risk is the risk of default during the period, usually less than twenty-four
hours, when one counterparty has fulfilled its obligation under a contract and awaits payment or delivery
of securities from the other counterparty. Owing to
differences in time zones and other factors, most exchanges are not made simultaneously (doing so would
eliminate settlement risk).

At a more mundane level, inadequacies in documentation, credit controls, limits on positions, and types
of instruments approved for use can expose a firm to
risk of loss. Related to these considerations is the
functioning of the back-office operation, which handles trade confirmations, documentation, payments,
and accounting. Errors anywhere along the line of processing trades or maintaining positions are potentially

Federal Reserve Bank of Atlanta



Economic

Review

9

sources of loss. Systems have to be in place for allowing internal audits by the risk management group to
monitor derivatives activity within the firm. Computer
or communications hardware breakdowns could leave
an organization open to losses because of the inability
to conduct business": This danger is present for any
business, but particularly for derivatives, which require
frequent portfolio adjustments to hedge exposures and
so forth.
Backlogs in d o c u m e n t i n g transactions can be a
source of legal risk. During the beginning years of the
OTC derivatives markets, severe backlogs were not
uncommon and oral agreements were often the only
contract binding counterparties. Because of rapidly
changing rates and prices, it is standard practice in financial markets to make a transaction orally, followed
by a written contract. The risk is that if too much time
elapses, a counterparty holding a losing position could
deny the existence of an oral agreement or dispute the
terms of that agreement. Though a continuing concern,
derivatives documentation backlogs are reportedly
much less severe today (Group of Thirty 1993b, 45).
Personnel in derivatives operations are also sources
of risk. As in any business, human error can be costly if
not caught in time. The same is true of outright fraud.
A more subtle problem is the reliance on one or a few
highly specialized individuals. The loss of an individual or group of individuals could wreak havoc on an operation if no one else knows the specialists' jobs. For
example, if the manager of a derivatives portfolio were
to leave the firm for a better offer elsewhere, others
might be hard pressed to understand the composition
and risks of that portfolio or to be able to liquidate or
unwind the portfolio in the event of a crisis. 16
Systemic Risk. The influential Promisel Report of
the Group of Ten central banks defines systemic risk as
"the risk that a disruption (at a firm, in a market segment, to a settlement system, etc.) causes widespread
difficulties at other firms, in other market segments or
in the financial system as a whole" (Group of Thirty
1993a, 61). As noted earlier, defaults have been relatively rare occurrences in derivatives markets. There
has not been a systemic crisis. 17 However, the markets' global scope and interconnections as well as their
relatively unregulated structure have raised concerns
among regulators and legislators.
A major concern about derivatives markets is their
lack of transparency. Accounting and disclosure of
derivatives positions is widely regarded as inadequate.
Accounting standards lag well behind financial innovation. An April 1993 survey of derivatives dealers
and end users by the Group of Thirty revealed that on-

10



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ly 60 percent of dealers and 30 percent of end users
disclose their accounting policies for derivatives in
their public financial statements, and 40 percent of
dealers and 60 percent of end users have inconsistent
accounting policies for derivatives and underlying assets. Other pertinent information about the risks and
profitability, like credit exposures and unrealized gains
and losses, of derivatives activities was available publicly from only a fraction of the survey respondents
(Group of Thirty 1994, 80, 129). As of the survey date,
85 percent of dealers mark all derivatives positions
to market for internal management purposes while only 41 percent of end users do so. These percentages
are much lower for external financial statements—67
percent and 28 percent, respectively.
Even if these deficiencies in disclosure were remedied, the fast-changing nature of derivatives positions
would always create uncertainties for outsiders about
current positions and exposures. In times of hectic market conditions, there will be less agreement among
market participants about the equilibrium value of derivatives, particularly options and contracts containing
embedded options. Traders may be uncertain about the
appropriate volatility to use in pricing options. Furthermore, the financial condition of counterparties may be
difficult to evaluate. As a result, market liquidity may be
reduced so that buying or selling derivatives causes bigger price moves than during ordinary trading, reflecting
a reluctance to trade. If a major derivatives player were
suspected to be in difficulty, it might have problems
hedging its positions or obtaining funding to finance
them, which would tend to c o m p o u n d its solvency
problems. Under such conditions, should the institution
fail, the firm or its regulators could have a hard time
closing out or assigning its derivatives positions to other
counterparties. In fact, as a precautionary measure,
counterparties may reduce their exposure limits with
other counterparties in times of market turbulence.
Despite the relatively good—albeit brief—track record of the OTC derivatives practitioners, there is simply no way to guarantee that a systemic crisis will not
occur. Any of the previous sources of risk individually
or in combination could precipitate a systemic crisis.
Federal Reserve Bank of New York president William
J. McDonough states the regulator's perspective succinctly: "It may appear that central banks are unduly
preoccupied with low-probability scenarios of possible
systemic disruptions. However, it is precisely because
market participants may only take minimal precautions
for events in the tails of probability distributions that
central banks must be vigilant" (James A. Leach and
others 1993, 17). Implicit in this view is that the private

March/April 1994

sector may lack the incentive to internalize the costs of
safeguarding markets against systemic risk. In other
words, regulation may be necessary to compel participants to take additional measures to protect the stability
of derivatives (and other) markets. Few observers of
derivatives markets would deny that systemic risk is
potentially a concern; the controversy is over measures
to minimize that risk.

/Recommendations f o r Safeguarding t h e
Derivatives Markets
Derivatives markets have come under scrutiny by a
n u m b e r of derivatives industry groups and regulators—both in the United States and abroad. Each has
made recommendations for improving industry practice to reduce the chance of firm-level losses as well as
systemic risk. This section discusses the key recommendations of four of these groups whose views are
particularly influential. The purpose here is to highlight the salient points and not to give a comprehensive review.
The studies and proposals to be considered are the
following, in order of their publication: 18
1. B a s l e C o m m i t t e e on B a n k i n g S u p e r v i s i o n
(April 1993):
• "The Supervisory Recognition of Netting for
Capital Adequacy Purposes"
• " T h e S u p e r v i s o r y T r e a t m e n t of M a r k e t
Risks"
• "Measurement of Banks' Exposure to Interest Rate Risk"
2. G r o u p of Thirty (July 1993), "Derivatives:
Practices and Principles"
3. House Committee on Banking, Finance, and
U r b a n A f f a i r s M i n o r i t y Staff ( N o v e m b e r
1993), "Financial Derivatives"
4. U.S. General Accounting Office (May 1994),
"Financial Derivatives: Actions N e e d e d to
Protect the Financial System"
The Basle Committee on Banking Supervision, established in 1975, consists of senior representatives of
bank supervisory authorities and central banks from
the Group of Ten countries. 1 9 The Group of Thirty
comprises senior financial markets practitioners, regulators, and academics and largely corresponds to the
private sector's perspective. The Minority Staff report,
prepared under the direction of James Leach, the rank-

Federal Reserve Bank of Atlanta



ing minority m e m b e r of the H o u s e C o m m i t t e e on
Banking, Finance, and Urban Affairs, was submitted
as part of the proceedings related to the committee's
Hearings on Safety and Soundness Issues Related to
Bank Derivatives Activities (U.S. Congress 1993). The
U.S. General Accounting Office report was prepared
at the request of members of several House committees that frame legislation affecting financial markets.
A m o n g the o r g a n i z a t i o n s that h a v e e x a m i n e d
derivatives activity (see note 18 for other derivatives
studies), there is a general consensus that the first line
of d e f e n s e rests with senior m a n a g e m e n t and the
board of directors at individual firms involved with
derivatives. They need to establish internal controls
and audit procedures necessary to monitor a f i r m ' s
derivatives positions and exposures. This emphasis is
reflected in bank regulators' oversight of bank derivatives activity. The examination of bank holding companies and state member banks by the Federal Reserve
and of national banks by the Office of the Comptroller
of the Currency (OCC) has been aided by new guidelines and instructions for examiners in evaluating a
banking organization's derivatives operations. T h e
O C C issued Banking Circular 277, " R i s k Management of Financial Derivatives," in October 1993, and
the Federal Reserve implemented "Examining Risk
Management and Internal Controls for Trading Activities of Banking Organizations" in D e c e m b e r 1993.
These guidelines are largely consistent with the Group
of Thirty's recommendations. However, this kind of
regulatory oversight does not extend to all participants
in derivatives markets, such as unregistered securities
affiliates (like Drexel's derivatives affiliate mentioned
in note 17) and insurance companies. As a matter of
sound business practice, derivatives practitioners must
self-regulate their activities—the message that is the
tenor of the Group of Thirty's recommendations.
The Group of Thirty. In July 1993, the Group of
Thirty published a list of twenty recommendations for
dealers and end users that are intended as a "benchmark against which participants can measure their own
practices" (Group of Thirty 1993a, 7). The clear implication is that alternative practices may be equally effective or superior (and the Group of Thirty points out that
some of the recommendations were not unanimously
endorsed by all of its members). A fundamental criticism of the Group of Thirty report is that derivatives
dealers and end users may lack the incentive to adopt
the recommended practices, particularly because of the
costs of implementation. Of course, a powerful incentive in favor of heeding the recommendations is concern
about government regulatory efforts, which also impose

Economic

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11

costs. An additional four recommendations are expressly for the consideration of legislators, regulators, and
supervisors. Indeed, all of the recommendations have
proved useful in framing many of the issues that legislators, regulators, and supervisors have been deliberating.
The recommendations address each of the sources of
derivatives risk sketched in the previous section.
The first recommendation stresses the integral role
of senior management in understanding and controlling
derivatives operations. Even among derivatives dealers,
51 percent of respondents to the April 1993 Group of
Thirty survey rated the insufficient understanding of
derivatives by senior management as being of serious
concern (15 percent) or some concern (Group of Thirty
1994, 11). The next eight recommendations pertain to
valuation and market risk management. One of these
stresses the importance of having an independent group
within the firm monitor market risk. Another emphasizes the need for daily marking to market of derivatives positions, which, in fact, most m a j o r dealers
practice but less than half of end users do. A related
recommendation advocates using a portfolio valuation
approach known as value at risk. This statistical technique determines the change in the value of a derivatives portfolio resulting from adverse market movements (of any risk factor, such as price or volatility)
during a fixed time period. The Group of Thirty advises using one day as the time horizon, consistent with its
mark-to-market interval. The value at risk would be
computed for a given confidence interval—that is, the
probability of suffering a loss in excess of the value at
risk would be quantified as 2.5 percent or some other
small bound. (For a 2.5 percent probability, the actual
daily loss would be expected to exceed the daily value
at risk one trading day in every forty.) The Group of
Thirty also advocates the use of portfolio stress tests,
which focus on changes in portfolio value during periods of extreme volatility as well as illiquidity.
Although these last two are sound recommendations, both value-at-risk calculations and stress tests
are demanding exercises. They should be conducted
under conservative assumptions because there is little
consensus about the best valuation models for complex interest rate derivatives. For example, there is no
agreement about the best type of term structure model
in the current academic literature. Such a model is one
of the building blocks of simulation analyses. Current models generally fail to capture statistically the
episodic bursts of volatility that occur in actual markets (see, for example, Thomas F. Cooley 1993). Also,
in times of abnormal market conditions, liquidity is
usually substantially reduced (see the earlier discus-

12



Economic

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sion of systemic risk), which would have to be recognized in stress tests as well as in value-at-risk evaluations. The challenges of simulation are compounded
further when considering portfolios rather than individual instruments because of the need to estimate
correlations and other interdependencies among instruments, which are also likely to be less predictable
during periods of market stress. 20
Another five recommendations address credit risk
measurement and management. The Group of Thirty endorses using a probability analysis analogous to the one
for measuring market risk exposure. Credit exposure,
as mentioned earlier, is measured in terms of current
and potential exposures. The evaluation of potential exposure (future replacement costs) requires all of the
tools and sophistication that go into market risk calculations. In addition, the probability of counterparty default needs to be assessed. This is a much more challenging task because reliable statistical methods for
p r e d i c t i n g i n s o l v e n c y are not available and m o r e
judgmental approaches must be employed. Of course,
financial institutions—especially commercial banks—
are in the business of making credit evaluations and,
presumably, have the expertise to monitor their counterparties. The Group of Thirty stresses the need for an
independent group within the firm to evaluate credit
standards and risks and to set credit limits vis-à-vis individual counterparties.
Credit enhancements of several types can reduce
credit risks in derivatives transactions. The Group of
Thirty recommends that dealers and end users evaluate
the costs and benefits of such methods. One commonly used method is the posting of collateral, typically in
the form of government securities, if the counterparty
in a losing position has a mark-to-market value that
exceeds a specified threshold, such as $1 million. This
posting could be based on periodic marking-to-market
or on a net risk limit, beyond which collateral would
be transferred. Dealers generally resist being subject to
collateralization provisions, but recently collateral has
been requested in deals involving even triple-A banks.
In transactions between dealers, it is more common for
swap coupons to be reset so that credit exposures are
periodically reduced to near zero (Lillian Chew 1994,
36-37). (The dealers effectively transact a new swap at
current market rates.) Another method of credit enhancement is the establishing of separately capitalized
derivatives subsidiaries or the use of third-party credit
enhancements such as guarantees or letters of credit,
which are discussed below.
The Group of Thirty strongly encourages the use of
a single master agreement with each counterparty that

March/April 1994

provides for bilateral payments and close-out netting.
This position is combined with a call for continuing
efforts to ensure the legal enforceability of existing
and future derivative contracts. The success of netting
arrangements depends on the legal certainty of derivative contracts.
The remaining four recommendations to dealers
and end users pertain to the adequacy of back office
systems, to the high standards of expertise of derivatives professionals, to the line of authority for committing to derivative transactions, and finally to accounting and disclosure. The Group of Thirty seeks international harmonization of accounting standards and
particularly urges consistency in the way income is
recognized between derivatives and the assets or liabilities being hedged. With regard to public disclosures,
the "financial statements of dealers and end users
should contain sufficient information about their use
of derivatives to provide an understanding of the purposes for which transactions are undertaken, the extent
of the transactions, the degree of risk involved, and
how the transactions have been accounted for" (Group
of Thirty 1993a, 21). As noted earlier, the poor quality
of information in public financial disclosures is a major area for improved industry practice.
An additional four recommendations are directed
toward legislators, regulators, and supervisors. Two
urge the international recognition of bilateral payments and close-out netting arrangements as well as
efforts to resolve other legal and regulatory uncertainties, particularly issues concerning the legal enforceability of contracts. Many tax laws need amendment
so that better consistency can be achieved between the
taxation of gains and losses from derivative contracts
and t h o s e f r o m the u n d e r l y i n g i n s t r u m e n t s being
hedged. Uncertainties and inconsistencies about the
tax treatment of income flows impede wider use of
derivatives in risk management. Finally, authorities responsible for setting accounting standards need to
work to harmonize standards across jurisdictions and
m o d e r n i z e these standards in accord with current
derivative's risk management.
N o n e of the G r o u p of Thirty r e c o m m e n d a t i o n s
deals with capital adequacy. Capital is the cushion
against losses for a financial institution. Regulators
generally seek to establish minimum prudential standards, not optimal levels. Implicitly, however, the valueat-risk and credit e x p o s u r e a s s e s s m e n t s discussed
above are relevant to determining how much capital a
firm should hold to cover market and credit risks. The
provision of capital to support derivatives activities is
an issue properly included in a consideration of best

Federal Reserve Bank of Atlanta



practices and principles. Indeed, some major derivatives dealers have their own systems, similar to valueat-risk, for allocating capital internally to different
activities, such as swaps trading or government bond
trading (see "International Banking Survey" 1993).
As another example, unregistered broker-dealers of
U.S. securities firms fall outside the scope of capital
requirements imposed on registered broker-dealers by
the Securities and Exchange Commission. Most OTC
derivatives transactions of these firms are conducted
by unregistered broker-dealers, which deal in derivatives, especially interest rate and currency swaps, that
are not classified as securities by the SEC. One of the
reasons for this segregation of activities is that securities firms consider the SEC's net capital rule to be antiquated and excessive in its capital requirements. 2 1

Most observers would agree that the use of
derivatives carries risks, both to individual
firms and to financial markets.

(The net capital rule governs capital levels at the registered broker-dealers, and, in particular, requires that
100 percent of unrealized profits on derivatives positions be deducted from net capital.) As things stand
now, capital supporting unregistered securities affiliates is determined by the discretion of management,
not regulators. The determination of appropriate capital levels is not just a worry of the regulators.
Some of these unregistered securities dealers have
been restructured as "enhanced derivatives products
companies" (DPCs) that have capital segregated in the
subsidiary in order to gain the highest credit risk ratings (CFTC 1993b, Working Paper 6). The intention is
that counterparties would be more willing to enter into
derivatives transactions with the highly capitalized enhanced DPC than with the lower-rated parent company.
(The enhanced DPC is presumed to be insulated from
the bankruptcy of the parent company.) Some insurance companies have set up DPCs that are not separately capitalized but carry guarantees from the parent

Economic

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13

that confer a triple-A credit rating. These restructurings of the derivatives dealers are market-based responses to market participants' concerns about the
capital adequacy of their counterparties.
Minority Staff Report. T h e 900-page Minority
Staff report assembles a wealth of information about
derivatives markets. It reprints and summarizes much
that is contained in earlier studies and gives further
background information as well. In addition, the Minority Staff solicited responses from federal banking
and securities regulators on a range of issues, including
the Group of Thirty recommendations. (The regulators
are the Federal Deposit Insurance Corporation, the Of-

From an economic perspective, it is the
proposition that derivatives markets do
not internalize the social costs of their
activities that supports the case for
(further) regulation.

fice of Thrift Supervision, the Federal Reserve, the Office of the Comptroller of the Currency, the Securities
and Exchange Commission, and the Commodity Futures Trading Commission.) The Minority Staff gives
thirty recommendations of its own for stronger regulatory standards. Many of these recommendations reflect
the federal regulators' perspectives on the derivatives
markets, and many are consistent with those of the
Group of Thirty. The Minority Staff's recommendations are intended to "suggest areas where the regulators may take action to implement prudential safeguards
concerning derivatives activities." 22 They are presented
as points for regulators and legislators to consider
rather than as detailed suggestions.
Several recommendations deal with strengthening
capital requirements and protecting the deposit insurance safety net. "Bank and thrift regulators should retain a strong leverage capital standard to generally
guard against risks at insured financial institutions, including risks posed by derivative instruments" (Recommendation 1). The leverage capital standard is in
addition to risk-based measures for credit and market
risks. The leverage standard is based on the ratio of to-

14
Economic



Review

tal assets (not risk-adjusted) to capital and serves as a
backup for the risk-based standard. To the extent that
the latter may imperfectly measure risks, the leverage
ratio would place a ceiling on overall exposures. (For
example, a bank could have relatively conservative assets—like Treasury securities that currently receive no
capital c h a r g e — a n d consequently have a very low
capital cushion against interest rate shocks. In the absence of a leverage ratio, a bank with federally insured
deposits could expand its balance sheet by issuing liabilities and buying Treasuries and thereby raise its
exposure to interest rate risk.) Furthermore, the regulators should evaluate the need for increasing capital,
particularly for potential future credit exposures, above
the current standard (Recommendation 11). Then, regulators should "adopt capital, accounting and disclosure s t a n d a r d s b a s e d on a 9 9 p e r c e n t c o n f i d e n c e
interval (3 standard deviations)" (Recommendation
13), which is much more conservative than the 95 percent confidence interval commonly in use by derivatives dealers and end users.
There are two areas in which the Minority Staff's
recommendations go beyond previous proposals for
improved derivatives practice and regulation. The first
is greater coordination among federal banking and securities regulators. An interagency commission would
be "established by statute to consider comparable rules
related to capital, accounting, disclosure and suitability for dealers and end users of OTC derivative products" (Recommendation 4). One of the purposes of
this commission would be to bring uniform rules to all
participants, including those outside the oversight of
federal regulators, like insurance companies. The central thrust of this approach is that regulation would be
applied by product type rather than by institution, as in
the current system. (Recommendation 2 emphasizes
this point.) Consultations among federal regulators,
which are now less structured and informal, would be
formalized through the mechanism of an interagency
commission. (A less formal structure is the Working
Group on Financial Markets, which consists of the
heads of the Federal Reserve, Treasury, CFTC, and
SEC. The Working Group, formed in the wake of the
October 1987 stock market crash, was reconvened earlier this year to examine issues regarding derivatives.
In its report, the C F T C has proposed an interagency
council to improve communication among regulators
and to coordinate regulation. The OCC has a similar,
though narrower, proposal for an interagency task
force on U.S. bank activity in derivatives.) For the federal banking agencies, this coordination extends to
joint examinations of bank holding companies and

March/April 1994

banks involved in derivatives as well as coordinated
training programs for examiners.
The other area that gets particular attention in these
recommendations is the protection of "less sophisticated" participants. Derivatives dealers would be required
to judge the suitability of derivatives positions for their
customers. (OCC Banking Circular 277 includes such
a standard for its examiners in evaluating dealers affiliated with nationally chartered banks; the SEC requires
broker-dealers to consider suitability when dealing
with customers.) Counterparties, especially "less sophisticated" end users, would have to be informed
about the "specific costs and risks of derivative instruments in varying interest rate or other market change
scenarios" (Recommendation 23). Mutual funds that
hold derivatives or securities with embedded derivatives should be subject to enhanced disclosures of
risks for the benefit of their customers (Recommendation 26). Another recommendation directs regulators
to set minimum prudential practices for municipalities
and pension funds (Recommendation 25). The federal
bank regulators would design and run programs to educate end users about the risks and benefits of derivatives (Recommendation 24).

The G A O would have all m a j o r derivatives dealers
adopt these provisions.
Even for the banking system, where regulation is
now most comprehensive, much more could be done to
improve the risks of derivatives. These steps would include "(1) gathering consistent information on large
counterparty credit exposures and sources and amounts
of derivatives-related income, and maintaining the information in a centralized location accessible to all regulators; (2) revising capital requirements to ensure that
all derivatives risks are covered and that legally enforceable netting agreements are recognized; and (3)
increasing emphasis on the identification and testing of
key internal controls over derivatives activities" (GAO,
124). The GAO does not believe that the April 1994
proposal by the Federal Financial Institutions Examinations Council for expanded bank reporting of derivatives activity goes far enough to be useful to regulators.
The GAO wants more information on the sources of income by activity, whether from executing customer orders or from proprietary trading, and by derivative
product. The proposed reporting requirements contain
information that is still too aggregated to reveal potential future problems at individual banks.

GAO Report. The GAO report echoes the Minority
Staff report's call for congressional legislative action
to improve uniformity of federal regulation and, in
particular, to make insurance company derivatives affiliates and unregistered broker-dealers subject to federal regulation. They go further and also recommend
that Congress reconsider the entire structure of the
federal financial regulatory system, with the aim of
modernizing it. However, the immediate need is to
broaden federal regulatory authority. The banking system currently has the most stringent federal oversight
because of its access to federal deposit insurance and
the Federal Reserve's discount window, but the GAO
argues that the failure of a nonbank derivatives dealer
could also require federal involvement to stem systemic repercussions. "Existing differences in the regulation of derivatives dealers limit the ability of the
federal government to anticipate or respond to a crisis
started by or involving one of these institutions [securities and insurance affiliates]" (GAO 1994, 124).

Two areas that the GAO examines in some depth
are accounting principals for derivatives and the state of
international regulatory cooperation. As other groups
have noted, accounting and disclosure practices for
derivatives have many deficiencies. This shortcoming
is particularly true for end users, which typically do
not mark derivatives positions to market but rather account for positions at historical cost. These users can
often apply so-called hedge accounting rules, which
the GAO faults as being inconsistent and contradictory. Deferral hedge accounting allows the gains and
losses on a derivative to be deferred and reported at
the same time as the income from the instrument being
hedged. A potential for manipulation of financial reports exists because hedge accounting can mask wide
swings in values of derivatives that, after the fact, may
prove not to have correlated well with the value of the
hedged position and would not have qualified for this
accounting treatment if the actual low correlation had
been known (GAO, 98). Another area of concern is
the use of hedge accounting in situations in which anticipated positions in an instrument are being hedged
by derivatives, such as an anticipated purchase of a
mortgage-backed security.

The GAO report covers much of the same ground
surveyed in earlier studies. Its accent is on a stronger
hand of government regulators on derivatives users.
The GAO endorses the Group of Thirty recommendations but sees the need for regulations to compel compliance with best practices standards. Currently, large
insured depository institutions have to follow the corporate governance provisions mandated by FDICIA. 2 3

Federal Reserve Bank of Atlanta



T h e Financial A c c o u n t i n g Standards Board has
been i m p r o v i n g d i s c l o s u r e r e q u i r e m e n t s in financial statements through the adoption of several Statements of Financial Accounting Standards related to

Economic

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15

off-balance-sheet positions, but the current standard
still leaves f i r m s with m u c h d i s c r e t i o n about the
amount of detail to reveal regarding derivatives positions. The solution, according to the GAO, is to move
to a market-value accounting standard. Derivatives
dealers have to apply market-value accounting to their
trading positions. If all derivatives users were subject
to this standard, the transparency of derivatives activity would be substantially improved.
The GAO report gives a thorough overview of the
state of international regulatory coordination. T h e
most successful area of international cooperation is in
the regulation of bank capital, which is taken up in the
next section. There is less agreement on capital adequacy for international securities firms. Wide differences in accounting and disclosure standards exist
internationally. As noted above, laws regarding derivatives activity, especially netting, also vary considerably from one country to another.
The G A O has identified clear weaknesses in the
oversight of derivatives activities within the management of f i r m s and within the regulatory structure.
Many of these problems were also cited in the earlier
Group of Thirty report. The most serious shortcoming
of the GAO's assessment of the OTC derivatives markets is a failure to weigh the costs and benefits of increased regulation and disclosure requirements. The
GAO's argument for further regulation rests largely on
the presumed need to eliminate the risk of failure of a
major derivatives dealer. The benefit of avoiding that
risk evidently outweighs the explicit costs imposed by
more regulation and the implicit costs of less hedging
(less risk-sharing) by intermediaries and end users because of the higher costs of such transactions. This issue deserves closer and more careful examination. The
vulnerability of the financial system has not been established, despite the hundreds of pages of studies that
have recently been devoted to the topic.
As part of its two-year study, the GAO conducted a
survey of fifteen major U.S. OTC derivatives dealers
and received fourteen responses (from seven banks,
five securities firms, and two insurance company affiliates). Given the concern about "global involvement,
concentration, and linkages" in this report (page 7), a
surprising fact is that the weighted-average net credit
exposure of the derivative dealer respondents to other
U.S. dealers was 11 percent at year-end 1992 (GAO,
157). This exposure is slightly lower than it had been
in the 1990 and 1991 GAO surveys. The exposure to
non-U.S. dealers was 27 percent. (For the responding
dealers, about 75 percent of their contracts were subject to netting agreements [GAO, 58].) Furthermore,

16



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among the world's largest derivatives dealers, none had
more than a 10 percent market share of any particular derivative product (GAO, 41). Eight of the dealers
who responded derived an average of 15 percent of their
pretax income from derivatives activity (GAO, 73).
This and other information from the survey indicates
that derivatives activity is not the dominant source of
income; the major dealers appear to be well diversified. On balance, a convincing case has not been made
that derivatives markets dangerously concentrate risks
among a small number of participants.
Basle Committee Proposals. The Basle Committee
proposals of April 1993 would incorporate market risks
into a risk-based capital standard for banks. For banks
with international dealings, the Basle Capital Accord
of 1988 established minimum capital adequacy standards that were fully implemented in the G-10 countries and many other countries by year-end 1992. The
basic procedure entails weighting both on- and offbalance-sheet items by credit riskiness, using weights
prescribed by the capital accord, and then maintaining
capital against these risk-weighted balance sheet items
at or above mandated levels. The minimum core capital
ratio is 4 percent of core capital to risk-weighted balance sheet items, and the total capital ratio is 8 percent
of core plus supplementary capital. 24
The proposal on netting is intended to amend the
1988 capital standard to permit bilateral netting of
credit risks under well-specified conditions. The market risk proposal would assess specific capital charges
on open positions (that is, unhedged positions) for
debt and equity trading portfolios as well as foreign
exchange positions. Derivative securities are included
in the coverage of all these portfolios. The proposal
f o c u s e s on trading p o r t f o l i o s , in which p o s i t i o n s
change rapidly, as opposed to investment portfolios,
in which positions are l o n g e r - t e r m and relatively
static. The trading portfolio contains proprietary positions taken to execute trades with c u s t o m e r s , to
speculate on short-term security price movements and
arbitrage security price discrepancies, and to hedge
other positions in the trading account. The investment
portfolios would continue to be subject to the provisions of the 1988 Capital Accord. The interest rate
risk proposal would cover the entire bank, but at its
current stage of development, the proposal is advancing a measurement system rather than a procedure for
assessing capital charges. Derivatives, including those
outside of trading accounts, figure into the measurement scheme.
The Basle Committee proposes a new class of capital to help satisfy the capital charges against market

March/April 1994

risks in trading portfolios: "Capital requirements for
market risk . . . tend to be far more volatile than those
for eredit risk and a more flexible source of capital
may be considered appropriate" (Basle Committee
1993c, 9). (The other types of capital would also have
to be allocated to back the trading portfolio activities.)
Banks will be able to issue short-term subordinated
debt for the sole purpose of meeting this capital requirement. Among other stipulations, the debt would
have a lock-in feature that prevents the payment of
principal or interest in the event a bank falls below 120
percent of the required market risk-based capital.
Under the capital accord, the only type of netting
recognized is netting by novation, which is highly restrictive. Netting by novation entails combining contracts that are denominated in the same currency and
have the same value dates (dates on which repricing
occurs) into a new contract with a counterparty. The
capital accord uses two methods to calculate credit
equivalent amounts for off-balance-sheet items: current exposure and original exposure. 25 Capital requirements are based on risk weights applied to positions in
on-balance-sheet items, like loans and government securities, and to credit-equivalent off-balance-sheet positions. Using the current exposure method, the total
credit exposure for a derivative is its current replacement cost and a so-called add-on that represents the future exposure of the instrument, determined by a schedule of scale factors applied to the notional amount of
the security. This schedule depends on the type of instrument and its time to maturity. (For example, currency swaps have higher add-ons than interest rate
swaps, and longer-dated instruments have higher factors than shorter-dated ones.) The computation is perf o r m e d f o r all c o n t r a c t s with positive current replacement value for which counterparty default would
cause a credit loss, and then all of these credit equivalent amounts are totaled. This procedure is very conservative b e c a u s e any o f f s e t t i n g cash o u t f l o w s f r o m
negative value contracts with the same counterparty reduce credit exposure but are ignored in determining the
current exposure.
The netting proposal would base the current replacement cost on the net amount of the current exposure to a counterparty. T h e conditions under which
this procedure would be permitted are restrictive. For
example, the enforceability of the netting scheme must
be clearly established in all relevant jurisdictions, and
derivative contracts cannot contain "walkaway clauses" (discussed in note 12). The add-on amount, however, would be computed without considering netting,
as it has been under the 1988 Capital Accord. The

Federal Reserve Bank of Atlanta



Basle Committee "has not yet identified any evidence
suggesting that the need for add-ons declines appreciably in [a netting] e n v i r o n m e n t " (Basle C o m m i t t e e
1993a, 4). They estimate that the capital charge would
drop by 25 percent to 40 percent using the new procedure. However, some in the industry believe that the
add-on treatment is excessive, but no satisfactory alternative method consistent with this framework has been
proposed (Chew 1994, 38-39).
The proposal on market risks sets forth an elaborate system for measuring market risks of on- and offbalance-sheet items. Only interest rate derivatives
positions will be considered here. For the purpose of

The central policy issue in derivatives
regulation is whether further federal
regulation is appropriate or whether the
existing structure can oversee these
markets.

capital determination, derivatives positions are converted into notional security positions. These positions
are then grouped into thirteen maturity time bands,
each of which has its own risk weight. The risk weight
represents the sensitivity of that notional position at a
given maturity to a given change in the interest rate
risk factor. (The size of the change is a two-standarddeviation shift in interest rates. Separate factors are assigned to specific risks and general risks, for which
only the latter usually apply to interest rate and foreign
exchange derivatives. Specific risk reflects credit-related
and liquidity risks of the underlying security.)
The conversion of a fixed-for-floating interest rate
swap is relatively straightforward. The swap is viewed
as a combination of fixed- and floating-rate government securities with coupon payment dates and maturities matching the value dates and maturity of the
swap. Receiving a fixed rate from a swap is equivalent
to receiving a fixed coupon from a bond. The notional
fixed-rate bond is slotted into the appropriate maturity
time band in the capital calculation. Paying a floating
rate on a swap is equivalent to having issued (or being
s h o r t ) a s h o r t - t e r m b o n d that gets r o l l e d over or

Economic

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17

repriced at the next value date. This bond gets slotted
as a short-term instrument, say a three-month maturity.
Interest rate options and forward contracts are more
complicated. Interest rate forward contracts are treated
as combined long and short notional positions in government securities. 26 Options are similar but require
conversion to notional amounts using delta equivalent
values. (Delta is the sensitivity of the option price to a
small change in the underlying security price and is
evaluated using a particular option pricing model. Options can be hedged against small changes in the underlying price by taking an opposite position in the
underlying price adjusted by [multiplied by] the delta
value.) The separate long and short notional securities
get slotted into the time bands.
The proposal then allows for further adjustments
that reflect the offsetting impacts of different types of
positions. Perfectly matched positions drop out from
further consideration and do not affect capital. For example, a swap in a portfolio to pay fixed and receive
floating together with an identical swap with the same
counterparty, swap rate, and currency to receive fixed
and pay floating would be exempt from inclusion in
the capital charge computation. Full offsetting is also
permitted for closely matched positions that meet a
number of specified conditions.
Consolidated long and short positions within each
maturity band are multiplied by risk weights, and then
the weighted positions are offset to give a net weighted
position. Because the included securities do not actually fully offset each other—there are differences in
maturity within each band as well as differences in
instruments of the same maturity—a vertical disallowance factor is introduced to compensate for the socalled basis risks. The disallowance, which is added to
the net weighted position, is 10 percent of the smaller
of the weighted gross long or short positions. A horizontal disallowance serves a similar purpose in adjusting for offsetting positions across different time bands.
This calculation adjusts for the imperfect correlation of
interest rate movements across maturity time bands.
(Initially offsetting long and short positions across time
bands will not change in value by perfectly offsetting
amounts as the term structure of interest rates shifts
and twists.) The overall net weighted open position
plus the vertical and horizontal disallowances would
constitute the net open position against which a market
risk-based capital charge would be assessed.
Public comments on the Basle Committee proposals were extremely critical of the market risk-based
capital standard. The fundamental problem is that the
procedure for measuring market risks is at variance

18




Economic

Review

with industry practice. Derivatives dealers expressed
doubts about the regulatory treatment of market risks
in the April 1993 Group of Thirty survey. In response
to the issue of "inappropriate treatment or proposed
treatment by regulators of market risk in derivatives,"
33 percent indicated serious concern and another 48
percent, some concern. This survey slightly predated
the public release of the Basle proposals, but the general regulatory approach involving capital based on riskadjusted balance sheet values is well known. Many
comments on the market risk capital standard stressed
that a portfolio approach is the appropriate way to
measure risk. A basic deficiency in the regulators'
approach is that risk is treated as though it can be
evaluated separately by security type and maturity and
then aggregated to give a portfolio exposure. Stephen
Schaefer observes that "the connection between this
and a modern portfolio theory approach is, at best, tenuous since it is well known that risk does not aggregate in the linear manner implied by [the regulators'
approach]" (Schaefer 1992, 12). Hugh Cohen (1994)
demonstrates that the error in measuring interest rate
risk exposures using the regulators' approach, even for
balance sheets consisting of nothing but easily valued
government bonds, is unacceptably large.
ISDA argues that the Basle Committee market risk
proposal would actually increase systemic risk because it could create perverse risk management incentives. The proposal penalizes some standard hedging
m e t h o d s by assessing horizontal or vertical disallowances for standard hedging methods. For example,
it discourages hedging a swap with an offsetting position in a Treasury security or Treasury bond futures
contract. This combination would be subject to a horizontal disallowance. The disallowance seems excessive in view of the small basis risk (that is, imperfect
correlation). As another example, so-called durationbased bond hedges would be subject to a vertical disallowance. 27
ISDA offers an alternative portfolio-based approach
that recognizes the risk reduction possible through diversification of securities that have "imperfectly correlated
risk factor subcategories" (Joseph Bauman 1993, 6). The
subcategories they propose are parallel shift risk, term
structure risk, basis risk, volatility risk, and convexity
risk. The risk factors to which the subcategories apply
include interest rates, foreign exchange spot rates, equity indexes, commodity prices, and others. The riskfactor sensitivity approach is akin to the value-at-risk
measurement advocated by the Group of Thirty.
Needless to say, this is a demanding procedure. It is
probably within the means of large derivative dealers

March/April 1994

to perform this kind of analysis, but it is less likely to
be easily implemented by smaller participants. Still
more demanding—and more accurate—are simulation
approaches, also endorsed by ISDA. The evaluation of
the precision of such analyses would come under the
purview of the independent risk management group.
For establishing capital levels, ISDA would have
the regulators specify the performance guidelines for
each firm's internal risk model. For example, the regulators would decide the size of the confidence interval
that applies to potential trading losses. The regulators
would also have the discretion to evaluate the suitability of the internal risk model.
Following the requirements of FDICIA, the Federal
Reserve, the OCC, and the FDIC issued a proposal (a
"Notice of Proposed Rulemaking") for public comment in September 1993 that would establish a riskbased capital standard for interest rate risk, including
derivatives positions, as well as fuller disclosures of
o f f - b a l a n c e - s h e e t items. T h e proposed m e t h o d for
measuring is very similar to that in the earlier Basle
Committee proposal and shares many of its defects. 28
However, the Fed-OCC-FDIC proposal stipulates that
examiners from the U.S. banking agencies could require firms to use their own internal models rather
than the supervisory model of the proposal.

of supervising the OTC derivatives markets. Policymakers need to be cautious about changing regulatory
structures because such alterations often bring unintended and u n f o r e s e e n c o n s e q u e n c e s . Indeed, one
leading academic observer argues that government
regulation is "the sand in the oyster" that stimulates
much financial innovation (Merton H. Miller 1986,
470). It is by now a truism that financial innovation
outpaces the regulatory and legislative process.
Regulations that are deemed too onerous drive business into unregulated entities or offshore. An example
of the former is the SEC's net capital rule for brokerdealers, which is currently under review for amendment. As noted above, this rule, in place long before
the advent of OTC derivatives, was a principal reason
that securities firms set up unregistered dealers to conduct most types of OTC derivatives transactions. As
another example, because of uncertainties about the legality of commodity swaps (which the CFTC almost
ruled to be illegal off-exchange commodity futures
contracts), much of this business was transacted in
London in its early years, until the passage of the Futures Trading Practices Act of 1992. (This act exempted swaps from the provisions of the Commodity Exchange Act of 1936 and its later amendments.) There
are many other examples.

Conclusion

The regulation of capital is a specific area where illdesigned rules can be counterproductive. Different
kinds of institutions are likely to have different requirements and thus a uniform standard may be inappropriate. Different institutions, such as banks and
securities firms, may pose different systemic risks and
therefore ought to face different capital requirements
(Schaefer 1992). As pointed out above, risk-based
capital standards, though an improvement over simpler
standards, may mismeasure risk exposures. Consequently, firms may manage risks in suboptimal ways if
better means are rendered too costly by additional capital charges. These sorts of considerations imply that
rigid standards ought to be avoided because they may
actually increase systemic risk by changing behavior
to circumvent regulations or even by actions that comply with regulations. The current system of on-site examination, in which a degree of examiner discretion
comes into play, coupled with m i n i m u m prudential
standards mitigates the problems associated with fixed
rules.

The central policy issue in derivatives regulation is
whether further federal regulation is appropriate or
whether the existing structure can oversee these markets. The six federal banking and securities regulators
believe that the current regulatory structure is capable

Systemic risk is the largest risk posed by O T C
derivatives and at the same time the most ill-defined
one. Diffuse fears of derivatives market calamities are
shaky grounds for broader regulation. The key intermediaries in these markets are well diversified and

Clearly, the task of measuring capital and establishing capital requirements is one of the most challenging
issues facing private sector participants and government regulators. The regulators have attempted to develop procedures that will set m i n i m u m prudential
standards for capital without making the costs of compliance excessive. Another challenge is inconsistency
in standards from one country to another—the lack of
a level playing field for similar institutions. The Basle
Committee seeks to achieve "regulatory convergence"
across jurisdictions and expects that supervisors of
other types of financial institutions will adopt its standards. However, since the release of the Basle proposals, international regulators have been unable to agree
in their consultations on prudent capital standards
(U.S. Congress 1993, 457). 29

Federal Reserve Bank of Atlanta



Economic

Review

19

h i g h l y c a p i t a l i z e d . It is a l s o i m p o r t a n t t o n o t e t h a t

Federal Reserve S y s t e m , the F D I C , and the O C C :

t h o s e i n t e r m e d i a r i e s not u n d e r f e d e r a l r e g u l a t i o n still

" T h e markets for s o m e derivative instruments report-

f a c e m a r k e t d i s c i p l i n e , as d o o t h e r i n t e r m e d i a r i e s . T h e

edly experienced reduced liquidity during the E u r o -

r e c e n t c r e a t i o n of s e p a r a t e l y c a p i t a l i z e d d e r i v a t i v e s

pean currency crisis. This complicated

p r o d u c t c o m p a n i e s is e v i d e n c e of m a r k e t p r e s s u r e s to

s t r a t e g i e s a n d h e i g h t e n e d m a r k e t risks f o r s o m e inter-

hedging

limit c r e d i t r i s k s . C o l l a t e r a l i z a t i o n a n d c o u p o n r e s e t -

m e d i a r i e s d u r i n g this p e r i o d . N e v e r t h e l e s s , it is u n l i k e -

t i n g of s w a p s a r e o t h e r c o m m o n l y u s e d m e t h o d s o f

ly that the u n d e r l y i n g m a r k e t s w o u l d h a v e p e r f o r m e d

r e i n i n g in credit

as t h e y did in S e p t e m b e r w i t h o u t t h e e x i s t e n c e of re-

risks.

A n i s s u e to c o n s i d e r is that r e g u l a t o r y a c t i o n s that

l a t e d d e r i v a t i v e s m a r k e t s that e n a b l e d c u r r e n c y p o s i -

m i g h t c o n s t r a i n d e r i v a t i v e s activity m i g h t a l s o e x a c e r -

t i o n s t o b e m a n a g e d , a l b e i t w i t h s o m e d i f f i c u l t y in

b a t e s y s t e m i c p r o b l e m s e l s e w h e r e . H e d g i n g s h o u l d re-

s o m e i n s t r u m e n t s " ( 1 9 9 3 a , 18). T h e c o l o r f u l d e s c r i p -

d u c e the risk of f a i l u r e . T h e b r e a k d o w n in S e p t e m b e r

t i o n s of d e r i v a t i v e s activity in the p o p u l a r p r e s s t e n d to

1 9 9 2 of t h e E u r o p e a n E x c h a n g e R a t e

o v e r l o o k t h e m a r k e t ' s s t a b i l i z i n g i n f l u e n c e . T h e r e is

Mechanism,

which had narrowly aligned m a j o r European exchange

little a r g u i n g w i t h the c o n t e n t i o n that d e r i v a t i v e s a r e

r a t e s , is a r e c e n t e x a m p l e o f h o w d e r i v a t i v e s p e r -

risky

f o r m e d under turbulent conditions. T h e following as-

intermediaries and end users.

b u s i n e s s , but so are t h e u n d e r l y i n g p o s i t i o n s of

s e s s m e n t c o m e s f r o m t h e B o a r d of G o v e r n o r s of the

Notes
1. Regulators subsequently testified that hedge fund activity
was not a major cause of volatility (Harlan 1994).
2. Gramm and Gay (1994) point out that from the advent of
futures trading through 1920, at least 160 bills were introduced in Congress to restrain or eliminate futures trading.
Much of the impetus for such bills came from agricultural
price declines attributed to futures trading. For the same
reason, trading in commodity options was banned in 1934
by the Code of Fair Competition for Grain Exchanges under
the National Industrial Recovery Act. Trade in onion futures was banned by Congress in 1958 (see Gray 1983).
Hedge funds are now being considered for tougher regulation (Fromson 1994).
3. A broad overview of U.S. and international regulatory
frameworks is given in Commodity Futures Trading Commission (1993b, Working Paper 3).
4. Financial Derivatives: New Instruments and Their Uses
(1993) contains articles that discuss and analyze many
derivatives contracts in detail. The dichotomy in terms of
linear versus nonlinear payoffs is somewhat arbitrary because some linear payoff contracts, such as swaps, may
contain embedded options. However, the basic distinction is
useful.
5. LIBOR is the acronym for the London Interbank Offered
Rate, which is the rate received by large banks for shortterm time deposits in the interbank market. The fixed swap
rate is determined by the term structure of LIBOR rates
(and extrapolated to longer maturities using government securities).
6. These figures imply that the average swap contract size has
a notional value 127 times larger than the average futures
and options contract.
7. Two U.S. insurance companies act as dealers in the derivatives markets (U.S Congress 1993).

20



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8. See U.S. Congress (1993, 670-71). The trading revenue and
losses data derive from Keefe, Bruyette & Woods, Inc. No
dates are indicated for the period of the survey. However,
the losses figure has probably risen somewhat after the market turbulence of early 1994.
9. To put trading losses in perspective, consider that the fifty
largest commercial banks incurred cumulative loan chargeoffs (losses) of almost $90 billion from 1985 to 1991 (Corrigan 1992, 12).
10. More precisely, the up-front payment would be equal to the
present discounted value of the difference between the
stream of 9 percent payments and the 8 percent payments.
11. A comprehensive list of risks that require hedging appears
in Group of Thirty (1993a), 43-45.
12. Some swap agreements contain a so-called walkaway or
limited two-way payment clause that gives a counterparty
who owes a payment on a swap the right to terminate the
agreement in the event the opposite counterparty becomes
bankrupt. This is a case in which a solvent counterparty
may withhold payment on a swap that has positive value to
a bankrupt counterparty. Limited two-way payments were
intended to give creditors extra leverage in negotiating with
failed counterparties (specifically on other contracts with
the failed counterparty with positive replacement value to
the creditor). The ISDA and others have been advocating
swap agreements with full two-way payments in the interest
of establishing smooth-functioning netting agreements.
13. Abken (1993) and Hull (1989) take this approach to modeling default-risky derivatives.
14. See U.S. Congress (1993, especially 698 and 793-96), for
further detail on the legal aspects of netting arrangements.
Other areas of legal concern are discussed in depth in
Group of Thirty (1993b, Section 3), as well as in U.S.
Congress (1993, 695-700).

March/April 1994

15. The text does not clarify whether the swap cash flows are
gross or net. Presumably they are net to be comparable with
the foreign exchange cash flows.
16. See Strauss (1993) for an example of extraordinary efforts
by senior management to understand the risks being taken
by a derivatives subsidiary.
17. The bankruptcies of Drexel Burnham Lambert in 1990 and
the Bank of New England (BNE) in 1991 both required unwinding of the derivatives books of these institutions. These
failures had the potential to have systemic repercussions,
but both were closely managed by regulators. Reportedly,
swap and other contracts were closed out or assigned to other counterparties smoothly, without significant losses to any
counterparties. The FDIC took over BNE and temporarily
acted as counterparty for the bank's derivatives. Similarly,
the SEC unwound Drexel's derivatives portfolios, except
for its swap book, which was under control of Drexel's unregistered broker-dealer affiliate. Nonetheless, the swap
book was also closed out in an orderly fashion, without
market disruption. Each of these institutions had derivatives
books that were large, about S30 billion in notional size, but
not of the size of major derivatives dealers. See U.S. Congress (1993, 798-800).
18. Two other major studies made at the request of Congress
are Board of Governors (1993a) and CFTC (1993a). Other
studies and recommendations have been made by the Institute of International Finance, the Bank of England, and the
International Monetary Fund. See U.S. Congress (1993,
802-9) for summaries. The U.S. securities and banking regulators also have a number of narrower proposals, which
are listed in U.S. Congress (1993, 53-54).
19. The Basle Committee members come from Belgium, Canada, France, G e r m a n y , Italy, Japan, L u x e m b o u r g , the
Netherlands, Sweden, Switzerland, the United Kingdom,
and the United States. The group usually meets at the Bank

for International Settlements in Basle, Switzerland, to frame
common prudential standards for member countries.
20. See Odier and Solnik (1993) for evidence about the instability of correlations, particularly during market downturns.
Asset price movements tend to become more synchronized
internationally during volatile periods, reducing the benefits
of diversification.
21. The SEC has proposed modifications to the net capital rule.
See U.S. Congress (1993, 771-77).
22. See James A. Leach, letter to the House Committee on
Banking, Finance, and Urban Affairs, November 22, 1993,
8, of U.S. Congress (1993).
23. FDICIA was enacted to protect the deposit insurance safety
net and to limit systemic risk in the banking system. It contains so-called prompt-corrective-action provisions that enable regulators to intervene in problem banks before problems threaten the Bank Insurance Fund (see Wall 1993).
24. See Wall, Pringle, and McNulty (1993) for the definitions
of core and supplementary capital.
25. Wall, Pringle, and McNulty (1993) give a detailed discussion and examples of the Basle Accord and example computations.
26. A security held in a long position is one that is purchased,
often in the expectation of price appreciation. One in a short
position is borrowed and sold in the expectation that an
identical security can be purchased at a lower price.
27. A duration-based hedge insulates a bond portfolio from
changes in value from interest rate fluctuations.
28. In particular, see Cohen (1994), for a critique of the measuring scheme in the Fed-OCC-FDIC proposal.
29. The CFTC and the SEC recently concluded an agreement
with their U.K. counterpart, the Securities and Investments
Board (SIB), to coordinate information sharing and promote improved industry practice in many of the areas cited
by the Group of Thirty and others (Reed 1994).

References
Abken, Peter A. "Valuation of Default-Risky Interest-Rate
Swaps." In Advances in Futures and Options
Research,
edited by Don M. Chance and Robert R. Trippi, vol. 6.
Greenwich, Conn.: JAI Press, Inc., 1993.
Basle Committee on Banking Supervision. "The Prudential Supervision of Netting, Market Risks, and Interest Rate Risk."
Preface to Consultative Proposal, April 1993a.
. "The Supervisory Recognition of Netting for Capital
Adequacy Purposes." Consultative Proposal, April 1993b.
. "The Supervisory Treatment of Market Risks." Consultative Proposal, April 1993c.
. "Measurement of Banks' Exposure to Interest Rate
Risk." Consultative Proposal, April 1993d.
Bauman, Joseph. "Comment on 'Consultative Proposal by the
Basle Committee: Capital Adequacy for Market Risk.' " International Swaps and Derivatives Association, Inc., December 28, 1993.

Federal Reserve Bank of Atlanta



Board of Governors of the Federal Reserve System, Federal
Deposit Insurance Corporation, and Office of the Comptroller
of the Currency. "Derivative Product Activities of Commercial Banks." January 27, 1993a.
. "Examining Risk Management and Internal Controls for
Trading Activities of Banking Organizations." SR 93-69,
December 20, 1993b.
Breeden, Richard C. "Directors, Control Your Derivatives."
Wall Street Journal, March 7, 1994, A14.
Chew, Lillian. "Protect and Survive." Risk 7 (March 1994):
36-42.
Cohen, Hugh. "Data Aggregation and the Problem in Measuring a Bank's Interest Rate Exposure." Federal Reserve Bank
of Atlanta working paper, forthcoming 1994.
Commodity Futures Trading Commission. "OTC Derivative
Markets and Their Regulation." October 1993a.

Economic

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. "OTC Derivative Markets and Their Regulation: Working Papers." October 1993b.
Cooley, Thomas F. "Comment on an Equilibrium Model of
Nominal Bond Prices with Inflation-Output Correlation and
Stochastic Volatility." Journal of Money, Credit, and Banking 25 (1993): 666-72.
Corrigan, E. Gerald. "Painful Period Has Set Stage for Banking
Rebound." American Banker, February 3, 1992, 12-13.
Falloon, William. "From Bad to Worse." Risk 7 (April 1994):
7-8.
Financial Derivatives: New Instruments and Their Uses. Research Division, Federal Reserve Bank of Atlanta, 1993.
Fromson, Brett D. "Tougher Rules on Hedge Funds Sought."
Washington Post, March 15, 1994, D l .
Gilbert, R. Alton. "Implications of Netting Arrangements for
Bank Risk in Foreign Exchange Transactions." Federal Reserve Bank of St. Louis Review 74 (January/February 1992):
3-16.
Gramm, Wendy L., and Gerald D. Gay. "Scams, Scoundrels and
Scapegoats: A Taxonomy of CEA Regulation over Derivative Instruments." Journal of Derivatives 1 (1994): 6-24.
Gray, Roger W. "Onions Revisited." In Selected Writings on
Futures Markets: Basic Research in Commodity
Markets,
edited by Anne E. Peck, vol. 2, 319-22. Chicago: Board of
Trade, 1983.
Group of Thirty, Global Derivatives Study Group. "Derivatives: Practices and Principles." July 1993a.
. "Derivatives: Practices and Principles, Appendix I:
Working Papers." July 1993b.
. "Derivatives: Practices and Principles, Appendix III:
Survey of Industry Practice." March 1994.
Harlan, Christi. "Regulators Believe Hedge-Fund Activity
Wasn't Major Cause of Market Volatility." Wall Street
Journal, April 14, 1994, A2.
Hull, John. "Assessing Credit Risk in a Financial Institution's
Off-Balance Sheet Commitments." Journal of Financial
and Quantitative Analysis 24 (1989): 489-501.
Hunter, William C., and David W. Stowe. "Path-Dependent
Options." In Financial Derivatives: New Instruments and
Their Uses, 167-72. 1993a. (First published in Federal Reserve Bank of Atlanta Economic Review 77 [March/April
1992]: 29-34.)
. "Path-Dependent Options: Valuation and Applications."
In Financial Derivatives: New Instruments and Their Uses,
173-86. 1993b. (First published in Federal Reserve Bank of
Atlanta Economic Review 77 [July/August 1992]: 30-43.)

Economic
22


Review

"International Banking Survey." The Economist, April 10,
1993, 3-38.
Leach, James A., William J. McDonough, David W. Mullins,
and Brian Quinn. "Global Derivatives: Public Sector Responses." Group of Thirty, Occasional Paper 44, Washington, 1993.
Lipin, Steven, Fred R. Bleakley, and Barbara Donnelly Granito.
"Just What Firms Do With 'Derivatives' Is Suddenly a Hot
Issue." Wall Street Journal, April 14, 1994, A l , A7.
Miller, Merton H. "Financial Innovation: The Last Twenty
Years and the Next." Journal of Financial and Quantitative
Economics 21 (1986): 459-71.
Odier, Patrick, and Bruno Solnik. "Lessons for International Asset Allocation." Financial Analysts Journal 49 (March/April
1993): 63-77.
Office of the Comptroller of the Currency. "Risk Management
of Financial Derivatives." Banking Circular 277, October 27,
1993.
Reed, Nick. "Connect and Survive." Risk 7 (April 1994): 10,
12.
Schaefer, Stephen. "Financial Regulation: The Contribution of
the Theory of Finance." London Business School, IFA
Working Paper 157-92, 1992.
Sesit, Michael R., and Laura Jereski. "Hedge Funds Face Review of Practices." Wall Street Journal, February 28, 1994,
Cl.Cll.
Strauss, Cheryl Beth. "The Shadow War at AIG." Investment
Dealer's Digest, September 6, 1993, 14-18.
U.S. Congress. House. Committee on Banking, Finance, and Urban Affairs. Hearings on Safety and Soundness Issues Related to Bank Derivatives Activities. Part 3 (Minority Report).
103d Cong., 1st sess., October 28,1993. Serial 103-88.
U.S. General Accounting Office. "Financial Derivatives: Actions Needed to Protect the Financial System." GAO/GGD94-133, May 1994.
Wall, Larry D. "Too-Big-to-Fail after FDICIA." Federal Reserve Bank of Atlanta Economic Review 78 (January/February 1993): 1-14.
Wall, Larry D., John J. Pringle, and James E. McNulty. "Capital Requirements for Interest Rate and Foreign Exchange
Hedges." In Financial Derivatives: New Instruments and
Their Uses, 226-38. 1993. (First published in Federal Reserve Bank of Atlanta Economic Review 75 [May/June
1990]: 14-28.)

March/April 1994

FYI
Comparing Dodge's
Construction Potentials Data
and the Census Bureau's
Building Permits Series
Cynthia Bansak and Anne Toohey

y l
JW
/ I
/ M
/ I
/
m
/
mf
m
A

The authors are economic analysts in the macropolicy and
regional sections,
respectively,
of the Atlanta Fed's research
department. They thank Mark
Coleman and Anita Gryan
from F.W. Dodge Division/
McGraw-Hill, Inc., for their
invaluable input, Linda Hoyle
and Donald Luery from the
Census Bureau for their thorough review, and especially
Frank King, Mary Rosenbaum, Tom Cunningham, and
Mark Rogers for helpful comments on early drafts.

Federal Reserve Bank of Atlanta



any economists and analysts consider construction an important sector of the national economy. Total residential and
nonresidential spending accounted for approximately 7 percent of overall U.S. gross domestic product (GDP) in 1993.

r
M
In addition, construction has strong ripple effects on local
employment and business activity, not only creating jobs in construction and
building materials manufacturing but also boosting employment for furniture
manufacturers, financing agencies, and building maintenance companies.
At the national level, numerous construction data series—such as permits,
starts, outlays, and completions—are available for tracking U.S. economic
activity. Because insufficient sample sizes prohibit estimation for starts, outlays, and completions at the local and regional level, alternative measures,
such as permits, must be used to monitor building activity at the local level.
The construction industry is unique in that it provides its own measure of future economic activity as a by-product of the permitting process.
Two sources provide data for tracking planned construction at the state
and metropolitan statistical area (MSA) levels, in addition to providing aggregates of national activity. The U.S. Census Bureau reports detailed unit
and value data for residential and nonresidential building permits, and F.W.
Dodge releases data on what it calls construction potentials (contracts that
reflect work to begin within sixty days) at the local level. Although both

Economic

Review

23

sources report construction trends, considerable differences in data methodologies set them apart from each
other. Users should evaluate these differences before
deciding which measure is most suitable for a particular purpose. Whereas the Census Bureau's data are
largely designed for economic analysis and policymaking, Dodge's more detailed data are better suited
for use by firms in the construction industry. For example, the Census Bureau offers various residential and
nonresidential data series on a monthly, year-to-date,
and annual basis at relatively low cost (see Table 1); on
the other hand, Dodge can tailor a report for a specific
user's needs according to a variety of criteria such as location, project type, and value—but at a considerably
higher price.
This article compares the collection and reporting
methodologies of the Census Bureau's building permit
series with F.W. Dodge's construction potentials data.
In addition, selected residential and nonresidential data
series are compared using annual figures to illustrate
data differences. The article also examines the state
and local estimates in terms of the extent to which the
Census Bureau and F.W. Dodge estimates may be substituted for one another.

C e n s u s Bureau Building P e r m i t Data
The Census Bureau collects residential and nonresidential permit data directly from local permit-issuing
offices, which collect and tabulate applications for future building work in their jurisdictions. Jurisdictions
are defined as municipalities, counties, townships, or
unincorporated towns. The permit values are based on
estimates of the costs of future construction work, not
on actual costs of the completed project.
The local permit-issuing agencies provide the Census Bureau with tallies of the number of units and of
their dollar value as submitted on permits issued for
numerous categories of residential and nonresidential
construction and several categories of additions and
renovation work (see Table 1 for classifications). Permits are not counted for mobile homes, landscaping,
moved or relocated buildings, maintenance and repair,
installations (such as plumbing, electrical, and mechanical work), placement of manufactured items, or
heavy construction (such as highways and streets and
earthmoving).
Respondents from local permit-issuing offices are
also asked to classify whether the permit is intended
for privately owned or publicly owned construction

24




Economic

Review

because the Census Bureau tabulates and reports only
privately owned construction. Privately owned construction is defined as buildings owned by private
companies during the construction period, even if the
structures ultimately will be owned by the public sector. For some categories, such as single-family resid e n t i a l , the d i f f e r e n c e b e t w e e n total p e r m i t s and
permits for privately owned construction is negligible.
Methodology. Building permit data are collected
through a mail survey, missing data are estimated, and
the aggregates are reported on a monthly, year-to-date,
and annual basis for local and state areas. For the
monthly series, data are collected from a sample of
8,300 permit-issuing locations out of the more than
17,000 local permit-issuing jurisdictions that account
for over 95 percent of all new, private residential construction in the United States. The remaining 5 percent of private residential construction is built without
formal permits and is therefore not included in Census
Bureau estimates. Permit-issuing agencies are asked to
complete a form reporting permit activity for both residential and nonresidential construction by category. 1
On average, the Census Bureau estimates a response
rate of 75 percent to 80 percent for both the monthly
survey and the annual tally.
Specific large permit-issuing locations are always
included in the monthly survey, forming a constant
sample. Census has selected with certainty 116 MS As
and primary metropolitan statistical areas (PMSAs) as
well as other large areas identified according to a variety of criteria to make up this constant sample. 2 Permit
issuers f r o m these d e s i g n a t e d areas represent the
largest portion of the total 8,300 surveyed each month.
For permit offices in large areas not responding to the
survey, the Census Bureau extrapolates data from what
is reported. The remainder of the monthly survey—
approximately 800 reporting places—is a sample of
smaller jurisdictions selected at a rate of one in ten.
These responses are therefore weighted by ten and are
also extrapolated to cover missing survey responses.
The Census Bureau then sums the data from responses
collected with certainty and the weighted responses.
Each month, the Census Bureau reports monthly
building permit data along with a cumulative year-todate estimate. The cumulative year-to-date estimate includes revisions made for monthly reports submitted
after the cut-off date in the monthly processing cycle
and for any corrections in previously reported data.
These revisions may be for the most recent month or
for any of the previous months in the year-to-date total. However, state- and MSA-level revised monthly
data are not released, and cumulative data do not

March/April 1994

Table 1
Census Structure Groups
Number
101

Structure Group Classification and Description
Single-Family Houses—Includes all detached one-family houses. Also includes all attached one-family
houses separated by a w a l l that extends from ground to roof with no c o m m o n heating systems or interstructural public utilities. Includes prefabricated, sectionalized, panelized, and modular homes w h i c h are manufactured partially off-site but w h i c h are transported and assembled at the construction site. Excludes mobile
homes.

103

Two-Family Buildings—Includes all buildings containing two housing units, w h i c h may be one above the
other or side-by-side. If built side-by-side, they (1) do not have a w a l l that extends from ground to roof, or
(2) share a heating system, or (3) have interstructural public utilities such as water supply/sewage disposal.

104

Three- and Four-Family Buildings—Includes all buildings containing three or four housing units. If built
side-by-side, they (1) do not have a w a l l that extends from ground to roof, or (2) share a heating system, or
(3) have interstructural public utilities such as water supply/sewage disposal.

105

Five-or-More-Family Buildings—Includes all buildings containing five or more housing units. If built side-byside, they (1) do not have a wall that extends from ground to roof, or (2) share a heating system, or (3) have
interstructural public utilities such as water supply/sewage disposal.

109
213

Total—A summarization of items 101 through 105.
Hotels, Motels, and Tourist Cabins Intended for Transient Accommodations—Includes hotels, motels, tourist
cabins, and apartment hotels intended for transient accommodations.

214

Other Nonhousekeeping Shelter—Includes lodge associations or club buildings with bedrooms, rooming
houses, dormitories, fraternity houses, and similar nonhousekeeping residential buildings.

318

Amusements, Social, and Recreational Buildings—Includes buildings designed to provide amusement or
recreation, such as theaters, radio and T V studios, auditoriums, athletic and social clubs, Y M C A buildings
used primarily for recreation, arenas, bowling alleys, skating rinks, bathhouses, and gymnasiums.

319
320

Churches and Other Religious Buildings—Includes churches, temples, synagogues, parish halls, Sunday
school rooms, monasteries, and convents.
Industrial Buildings—Includes plants producing, processing, or assembling goods and materials, such as
factories, machine shops, paper mills, beverage plants, manufacturing plants, and printing plants.

321

Parking Garages (Buildings and O p e n Decks)—Includes garage buildings and open-deck parking structures
to be used primarily for transient parking. Does not include storage garages, w h i c h are reported in 328.

322
323

Service Stations and Repair Garages—Includes service stations and repair garages.
Hospitals and Institutional Buildings—Includes hospitals, convalescent homes, rest homes, homes for the
aged, nursing homes, orphanages, and similar establishments for prolonged institutional care. Does not include doctors' offices, w h i c h are included in item 324, or staff houses and apartments, w h i c h are included
in items 101 through 105.

324
325

Office, Bank, and Professional Buildings—Includes offices, banks, professional buildings, financial institutions, administration buildings, and medical office buildings.
Public W o r k s and Utilities Buildings—Includes buildings providing public services such as transportation,
communications, power, light, heat, sewage and garbage disposal, trash incineration, and water supply.

326

Schools and Other Educational Buildings—Includes buildings such as schools, libraries, museums, observatories, universities, and academies. Does not include faculty and student apartments, w h i c h are included in
items 101 through 105.

327

Stores and Customer Services—Includes buildings used in buying, selling, distributing, or storing of merchandise and materials or performing customer services such as stores, auto and other showrooms, warehouses,

Continued

Federal Reserve Bank of Atlanta



Economic

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on page 26

25

Table 1 (Continued)

grain elevators, restaurants, taverns, night clubs, bakery shops, laundry and dry c l e a n i n g shops, laundromats,
beauty and barber shops, a n d kennels.
328

O t h e r Nonresidential B u i l d i n g s — I n c l u d e s buildings such as sheds, boat houses, barns, silos, d o g pounds,
post offices, storage garages, a n i m a l hospitals, jails, and reformatories.

329

Structures O t h e r T h a n B u i l d i n g s — I n c l u d e s n o n b u i l d i n g recreational facility construction a n d harbor a n d
port facility construction such as outdoor s w i m m i n g pools, marinas, outdoor stadiums, parks, outdoor theaters, boardwalks, w h a r v e s , a n d docks.

437

Additions, Alterations, and C o n v e r s i o n s — N o n r e s i d e n t i a l and N o n h o u s e k e e p i n g — Includes additions, alterations, a n d conversions to nonresidential and n o n h o u s e k e e p i n g residential buildings and conversions of
housekeeping buildings to nonresidential or nonhousekeeping residential buildings. D o e s not include special "installation" permits issued to c o v e r electrical, plumbing, heating, air-conditioning, or similar mechanical w o r k . A l s o excludes the installation of fire escapes, elevators, signs, etc., a n d conversions to residential
housekeeping buildings.

438

Additions of Residential G a r a g e s a n d C a r p o r t s — I n c l u d e s additions of n e w residential garages and carports,
w h e t h e r attached or detached. D o e s not include those included in items 101 through 105. Item number
4 3 6 w a s used through 1985.

Source: U.S. Bureau of the Census.

match the sum of unrevised monthly data. In addition,
differencing the monthly cumulative figures does not
produce actual revised monthly figures. The monthly
report with unrevised data and the revised cumulative
year-to-date data offer different advantages, and the
data user interested in current analysis must decide
which series is more relevant.
Annual summary data for the previous calendar
year are released in May of each year. Rather than a
survey, this annual report is essentially a tally of the
data submitted from the approximately 17,000 permitissuing jurisdictions in the United States. The Census
Bureau uses previously collected and revised data
from the 8,300 monthly respondents and canvasses the
remaining jurisdictions, asking them to report total
building permits for the year. Again, the Census Bureau estimates data for nonreporting places using a
complex model based on the previous year's permit
level.
Reporting. The Census Bureau's residential permit
d a t a are w i d e l y r e p o r t e d t h r o u g h the m e d i a and
newswire services at the census regional and national
levels. For state, M S A , and local levels, residential
permit data are published in the Current Construction
Report Series C-40, produced by the Construction
Statistics Division of the Census Bureau.

26




Economic

Review

Nonresidential data do not typically receive much
media attention and are not published in the C-40 report. Only the International Trade Administration of
the Commerce Department publishes the nonresidential data in their bimonthly periodical, Construction
Review, reporting major building category detail (categories 318 through 325 in Table 1) at the large MSA,
regional, and national levels. However, for states this
publication reports only total private nonresidential
construction, including renovations and alterations.
In addition to the C - 4 0 report, the Construction
Statistics Division of the Census Bureau releases both
residential and nonresidential building permit data details on diskette or as printouts, typically with a fourweek lag time. These reports provide monthly and
cumulative year-to-date data. A national total is not
provided on the state data diskette but can be obtained by summing the fifty states plus the District of
Columbia. Each May, the annual summary data are released. Annual diskettes and printouts are similar to
monthly diskettes but include only annual summaries
for activity in the various classifications.
T h e C o m m e r c e Department Bulletin Board also
provides select series on a monthly basis. Residential
detailed permit data, such as whether permits are for
one-unit or five-unit construction, are available at only

March/April 1994

the state and national levels, not the M S A level.
Nonresidential detailed permit data—distinguishing
between industrial, office, or retail permits—are provided at only the MSA level. However, total nonresidential permits are released at the state and national
levels.

Dodge tracks all public and private construction
projects costing more than $50,000. Dodge construction potentials data cover not only construction work
that is competitively bid but also negotiated contracts
and design/build arrangements, in which a project is
planned and constructed by a single firm.

Caveats. As an indicator of future construction activity, the Census Bureau's building permits series has
several limitations. First, data collection is imperfect.
The value of permits is based on estimates of future
construction work, not on actual building costs. Value
estimation criteria differ somewhat among local building permit offices so that data are not completely consistent when different geographic areas are compared
on a month-to-month basis. In addition, not all work
granted a permit is built, not all construction is permitted, and not all areas, particularly rural regions, require
permits for construction work. N o adjustments are
made to account for any of these limitations.

There are some building costs and construction projects that Dodge does not include. Like Census data,
Dodge estimates reflect only "hard" construction costs
and do not include development costs, land, or "soft"
costs such as fee profits and interest or architectural
and engineering services. Contracts exclude minor additions and alterations. In addition, like the Census
Bureau's series, Dodge construction potentials do not
cover farm construction, some small projects, or most
"force account" work, a type of work done by fulltime workers of industrial firms, utilities, and local
governments for their employers. Again like the Census series, Dodge's single-family potentials do not include mobile homes. See Table 2 for a list of the major
Dodge structure groups.

Furthermore, the data include only privately owned
construction. Therefore, all categories exclude public
expenditures, which for such categories as schools,
hospitals, and infrastructure may be sizable. In addition, the series do not provide land costs or estimates
of planned square footage.
Finally, the Census Bureau's monthly revision procedures create discontinuities between monthly and
year-to-date statistics. Monthly revisions are not provided separately but are first included in the yeart o - d a t e f i g u r e s , with f u r t h e r revisions m a d e after
publication of the December year-to-date totals included in the annual figures. The data user must decide how to reconcile the fact that the annual total
will equal neither the twelve-month summation of initial monthly data nor the December cumulative yearto-date figure.

F.W. Dodge Construction Potentials Data
F.W. Dodge collects data on planned activity at the
local level. Dodge's construction potentials (contracts)
data are conceptually similar to permit data. Dodge
defines a contract award as a project that is within sixty days of groundbreaking, the traditional beginning of
the physical construction process. When an individual
project reaches the awards stage, it is entered into the
Dodge construction potentials (DCP) statistical data
base. Potentials data are compiled by individual project and are aggregated to the county, MSA, state, regional, and national levels.

Federal Reserve Bank of Atlanta



Methodology. Dodge's data collection method is
based on a system of construction news reporters and
correspondents. Dodge attempts to conduct a virtual
census of all ongoing building activity throughout the
United States. However, Dodge samples single- and
two-family housing by conducting a survey of about
5,000 permit-issuing jurisdictions. For n o n r e s p o n dents and permit areas outside the sample, Dodge estimates the level of activity on the basis of a variety of
available measures, such as reports from architectural
firms, engineering firms, and other sources in the planning and construction process. Single- and two-family
residential data are the only data Dodge develops from
survey-based estimates. This residential survey is similar to the Census survey, but the Census Bureau uses a
larger sample size. All other Dodge data, including
multifamily housing, are based on individual project
reports.
Individual project reports are compiled by approximately 450 full-time reporters, and another 850 people
conduct various newsgathering activities. In a typical
year, these reporters and correspondents make about
two million calls to obtain information on construction
at various stages of development. The reporters also
review newspapers and check with permit offices to
obtain data for estimating construction contract values.
Each of the more than 3,200 counties in the United
States is the explicit responsibility of at least one of
the full-time reporters.
Through the Dodge reporters' network, long-term
relationships are developed with architects, engineers,

Economic

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Table 2
Dodge Structure Group Mapping
Number

Structure Group Classification

1

Stores and Food Service

2

Warehouses (ex. Manufacturer O w n )

3

Office and Bank Buildings

4

Garages/Service Stations

5

Manufacturing Plants

6

Warehouses (Manufacturer O w n )

7

Laboratories (Manufacturer O w n )

8

Schools and Colleges

9

Laboratories (ex. Manufacturer O w n )

10

Libraries, Museums, etc.

11

Hospitals/Health Treatment

12

Government Administration

13

Other Government Service

14

Places of W o r s h i p

15

Religious

16

Amusement

17

Miscellaneous Nonresidential

18

One-Family Houses

19

Two-Family Houses

20

Apartment Buildings

21

Hotels and Motels

22

Dormitories

24

Streets and Highways

25

Bridges

26

Dams and Reservoirs

27

River/Harbor Development

28

SewerageA^aste Disposal

29

W a t e r Supply Systems

30

Electric Power/Heating Systems

31

G a s Systems

32

Communications Systems

34

Airport/Space Facilities

35

Miscellaneous Non-Building

Source: F . W . Dodge.

contractors, and others in the construction process. A
key reason for the cooperation among these sources is
that these firms are generally the agents of building
owners, who encourage competitive bidding in the interest of minimizing development costs.
Reporters collect data on project value, total square
footage, the project's designation as new building or
additions or alterations, public or private ownership,
and information on individuals and firms related to the
project. Reporters follow construction from the earliest planning phases through the bidding and negotiation stage to the contract award, or the construction

28



Economic

Review

starts, stage. In addition, for some projects, Dodge reports a f t e r the award into the c o n s t r u c t i o n b i d d i n g
phase for some subcontractor specialties. Dodge publ i s h e s this i n f o r m a t i o n in i n d i v i d u a l p r o j e c t s u m maries, titled Dodge Reports, which provide detailed
information about construction projects, including
names, phone numbers, and addresses for owners, architects, engineers, bidders, and contractors. The sale
of these reports and related project news is D o d g e ' s
primary business. Building p r o d u c t s m a n u f a c t u r e r s ,
suppliers, contractors, and s u b c o n t r a c t o r s p u r c h a s e
these reports to develop sales leads.
Revisions. Dodge revises its monthly construction
potentials reports as m u c h as three years back each
month. The large majority of revisions are made to the
most recent months, but the window of revision is a
rolling thirty-six months. After three years, the data become final. In addition, if a project is abandoned or deferred, even in the start stage, Dodge removes it from
the D o d g e construction potentials data base. The revised year-to-date totals include monthly revisions. To
expedite the revision process, Dodge systematically audits all projects exceeding $3 million in value through
an independent statistical validation and auditing function.
Reporting. Dodge releases numerous construction
reports in addition to preparing individual requests for
customers. For example, Dodge publishes a monthly
Construction and Housing Review, maintains a market
area construction forecast data base, and offers an online service called Dodge Dataline. Dodge's most popular releases are the Dodge Reports, described earlier.
This study, however, considers only the D o d g e construction potentials because they are most comparable
to the Census Bureau's building permit series.
Dodge construction potentials are published monthly in hard copy form in the Dodge Construction Potentials Bulletin, w h i c h is p r o d u c e d in n i n e r e g i o n a l
editions. Dodge's regions, which correspond closely to
C e n s u s regions, include N e w E n g l a n d , M i d d l e Atlantic, East North Central, West North Central, South
Atlantic, East South Central, West South Central, Pacific Northwest, and Pacific Southwest. 3 Each Bulletin
contains building contracts data for the current month
and cumulative year-to-date figures for nonresidential,
residential, and nonbuilding categories, and, unlike the
Census Bureau, D o d g e also provides public construction d a t a f o r s o m e series. For e a c h c l a s s i f i c a t i o n ,
Dodge reports the number of projects, square footage,
and the total valuation. Within a Bulletin, data are provided by county, M S A , and state and are totaled by region.

March/April 1994

However, the level of detail of data published at the
r e g i o n a l , state, M S A , and c o u n t y level varies. T h e
most highly detailed data (such as that for categories
of nonresidential building) are published only at the
regional level in the Bulletin. For states, data are reported for total nonresidential, residential, and nonbuilding categories, but detail within these categories
is not provided. For the M S A s and counties within the
states, only total nonresidential and residential categories are reported; neither the nonbuilding category
nor nonresidential and residential subcategories are reported for M S A s and counties.
In addition, because the Bulletin publishes only one
month of data and the data are revised each month for
three years back, the monthly reports, like the Census
reports, do not contain sufficient information to construct a continuous time series of revised data. However, D o d g e can provide monthly and annual revised
series and additional categories of construction work
f r o m their D o d g e construction potentials data base.
By special request, D o d g e offers 209 categories and
subcategories of construction and any combination of
county, M S A , state, or regional data that a data user
might require. Table 3 provides a brief comparison of
s o m e of the m a j o r s i m i l a r i t i e s and d i f f e r e n c e s be-

tween D o d g e and C e n s u s Bureau m e t h o d o l o g y and
reporting.
Caveats. Unlike the Census Bureau, which reports
all private renovations, D o d g e reports only additions
and alterations defined as major. A m a j o r renovation
consists of three or more alterations on one structure.
Although nonresidential renovations generally m e e t
these criteria, a large portion of residential improvement may not be included under the Dodge additions
and alterations classifications.
A d d i t i o n a l l y , p u b l i c c o n s t r u c t i o n is d e f i n e d as
buildings that will eventually be occupied by government workers, a definition differing from that of the
Census Bureau's more limited one of public construction as structures that are owned by public agencies.
Finally, like the Census Bureau's, Dodge's data collection is imperfect.

/Research Methodology a n d
General Results
To assist analysts in choosing between Dodge and
Census Bureau data, this study attempted to determine

Table 3
Dodge and Census Comparison
Dodge
Permits not counted for mobile homes
Reports private construction
Reports public construction
Releases revised monthly data
Estimates for unpermitted work
Annual data compiled from 17,000 reporting places
Cumulative year-to-date equals sum of released revised monthly data
Residential building data collected primarily from permit issuing offices
Nonresidential building data collected primarily from permit issuing offices
Nonresidential data collected primarily from building contractors and architects
Data provide estimates of value of future construction work
Data available at national, state, and local level
Both major and minor addition and alterations included within category
Does not cover farm construction
Removes from estimates work that is intended but not built
Residential monthly data published in bulletins
Nonresidential monthly data published in bulletins
Provides customized series and hundreds of levels of detail

Census

X

X

X

X

X
X
X
X
X
X

X
X

X
X

X

X

X
X

X

X

X
X

X

X
X
X

Low cost

Federal Reserve Bank of Atlanta



Economic

Review

29

if the s e r i e s w e r e f a i r l y c l o s e s u b s t i t u t e s . S i m i l a r
movement between the two series over time would indicate that they could be fairly i n t e r c h a n g e a b l e f o r
tracking trends in construction spending. For determining the actual level of construction spending, however, a consistent ratio between comparable series of
the two data sources would be a better measure for determining substitutability.
For this project, annual totals of construction contracts and permits f r o m 1980 to 1991 were used for
the six states that in whole or part make up the Federal
Reserve's Sixth District (Alabama, Florida, Georgia,
L o u i s i a n a , Mississippi, and T e n n e s s e e ) and for six
M S A s in the district ( A t l a n t a , B i r m i n g h a m , J a c k sonville, M i a m i , N a s h v i l l e , and N e w O r l e a n s ) . To
c o m p a r e h o w well F.W. D o d g e and C e n s u s B u r e a u
construction data track together, this study matched
c o m p a r a b l e categories of construction activity f r o m
the two sources (see Table 4). Although some classifications such as single-family and total nonresidential
building were relatively comparable, specific building
structure categories were m o r e difficult to match. In
addition, some categories were more detailed for one
source than for the other. As a result, some series were
aggregated to provide a m o r e accurate m a p p i n g between the two sources. For example, Dodge maintains
two categories of multifamily residential construction
while the Census Bureau maintains three. In this case,
the Dodge and Census categories were aggregated to
provide a total multifamily category for each source.
However, certain types of building activity were defined differently by the two sources and were not altogether comparable.

Table 4
Dodge and Census Structure Group Matchings
Census

Dodge
Group Number(s)
(From Table 2)
Residential:
Single-family

18

Multifamily

(1 through 17)

(318 through 328)

(1 +2)

Office, Bank, and Professional

 30


3
(5+6+7)

Economic

101
(103+104+105)

Stores and Customer Service
Industrial

(From Table 1)

(19+20)

Nonresidential:
Total Nonresidential

Group Number(s)

Review

327
324
320

After matching the building classifications, the various c o m p a r a b l e building structure categories were
compared. To better reveal the movement across building structure categories, the data for the six states and
six M S A s were pooled into two panels, D o d g e and
Census, for each building category. Each panel contained seventy-two data points, resulting from twelve
annual observations for each of the six states or M S A s .
Correlation coefficients were calculated on first differences for these panels of data. Correlations were also
run for each category in each state and MSA. All of
these used data based on first differences (the current
period less previous period values). Essentially, yearover-year changes in dollar levels were compared. The
first differences represented the cyclical annual changes
in the variables, but using first differences eliminated
most of the trend caused by inflation and long-term real growth from the correlation coefficients. The correlation coefficients measured how well the data moved
together.
Correlation coefficients were generally positive and
rather high for most structure categories in the combined panels as well as the state and M S A correlations
(see Tables 5, 6, and 7). However, in a few state and
M S A categories con-elation coefficients were negative,
indicating an inverse relationship in the movement between the two series. This outcome is probably the result of timing differences in reporting contracts and
permits, though. It is likely that in some cases Dodge
may have reported a new contract near the end of one
year that the Census Bureau did not report until early
in the next year when the permit was issued. As a result, Dodge's total would be larger one year, and the
Census Bureau's, the next, with such a timing discrepancy resulting in a negative correlation coefficient.
To provide a relative measure of conformity of levels
of permit values over time, annual ratios of the elements
of the two series were also formulated and averaged for
the states and M S A s in each building structure category
(Dodge/Census). An annual ratio near one indicated
very similar values for a particular category of the two
sources. An average ratio greater than one demonstrated
higher estimates for the Dodge series than for the Census Bureau series; conversely, a ratio less than one indicated higher Census Bureau estimates. It was expected
that similar methodologies and definitions would yield
ratios generally close to one. However, in some instances, such as single-family building, for which Dodge
i n c l u d e s e s t i m a t e s f o r n o n p e r m i t t e d w o r k and the
Census Bureau does not, a ratio consistently above one
was expected, an expectation borne out by the ratio of
single-family contracts to permits.

March/April 1994

Table 5
Correlation Coefficients by Structure Category for Panels of State and MSA Data
States

MSAs

Single-family

.960

.942

Multifamily

.919

.794

Total Nonresidential

.647

.563

Retail Building

.695

.580

Office Building

.718

.610

Industrial Building

.505

.174

Table 6
Correlation Coefficients by Structure Category for Individual States
Alabama

Florida

.767

Single-family
Multifamily
Total Nonresidential
Retail Building
Office Building

Louisiana

Mississippi

Tennessee

.885

.975

.953

.684

.818

.857

.921

.892

.938

.718

.878

.606

.728

.691

.650

-.399

.360

.788

.708

.738

.736

-.387

.513

.934

.610

.646

.306

.505

.452

.681

.796

-.408

.115

-.009
.790

Industrial Building

Georgia

Table 7
Correlation Coefficients by Structure Category for Individual MSAs
Atlanta
Single-family

.958

Multifamily

.813

Total Nonresidential
Retail Building
Office Building
Industrial Building

.714
.800
.692
.527

Miami

Nashville

N e w Orleans

.944

.845

.972

.776

.893

.651

.851

.827

.302

-.039

.531

.584

.687

-.108

.760

.635

.098

.474

.306

.787

.727

.384

.119

-753

-.316

-.612

Birmingham
.859
.796
.471
.304

Standard deviations were calculated to measure the
variation of these ratios. A l t h o u g h an average ratio
near one indicated that over time the two sources had
very similar dollar value estimates on average, this
t e c h n i q u e did not m e a s u r e the similarity of m o v e ments over time. A low standard deviation for each ratio indicated that there was little annual variation for
these ratios; that is, the relationship between D o d g e

Federal Reserve Bank of Atlanta




Jacksonville

and Census data was relatively constant over time. For
example, in Atlanta the average ratio for single-family
contracts to permits was just slightly over one, and the
standard deviation was less than 0.05, indicating that
the D o d g e and Census estimates were quite similar,
with little variation over the sample period. However,
the industrial building category in Nashville had an average ratio near one (1.125) but a standard deviation

Economic Review

31

g r e a t e r than 1.5. A l t h o u g h in this case D o d g e and
Census data averaged out to be similar estimates, the
annual ratios demonstrated a great deal of variability.
T h e annual ratios and standard deviations did not
demonstrate consistent patterns (see Table 8). With the
exception of some residential series and the total nonresidential series, the annual average ratios and standard deviations for most structure categories varied
widely. Unlike the other measures of comparison used
in this study, the annual ratios did not confirm that the
residential series were significantly more comparable
than the nonresidential series.
An additional step involved running regressions using the panels of seventy-two observations and dumm y variables for each state to see if there were any
geographic effects on the relationship between Dodge
and Census data (see Tables 9 and 10). For each building structure group, the Dodge data panel was used as
the dependent variable and the Census panel data as
the independent variable. B e c a u s e the t w o variables
were relatively interchangeable, specifying the Census
data as the independent variable produced adjusted R2s
fairly s i m i l a r to the c o r r e l a t i o n c o e f f i c i e n t s . O n c e
again, first differences were used to focus on cyclical
movement.
N o n e of the d u m m y variables for states was significant in explaining external influences; however, other

regression results were consistent with the other statistical analyses. The coefficients for the Census variables were generally statistically significant at high
levels of confidence for the residential series. (It is important to note that for this study the f-statistics tested
w h e t h e r the c o e f f i c i e n t s were statistically d i f f e r e n t
f r o m one rather than the usual null hypothesis of a
m e a n equal to zero.) However, all nonresidential series, except state level industrial building, were rejected as being statistically different f r o m one. Like the
means of the ratios created, the coefficients for the regressions on the Census data were expected to be near
one. The expected result was confirmed for the residential series, but the nonresidential results were much
less conclusive. T h e a d j u s t e d R2s for each building
s t r u c t u r e g r o u p i n d i c a t e d that variation w i t h i n the
Census data was associated with most of the variation
within the D o d g e data for the residential series but
was associated with considerably less variation of the
nonresidential series.
The various summary statistics for first differences
and levels indicated that the t w o residential series
tracked each other better than did the nonresidential
s e r i e s . T h i s r e s u l t w a s not s u r p r i s i n g b e c a u s e the
methodologies for the residential data are quite similar
for the two data sources. The results for nonresidential
construction were not as clear. In some cases, series

Table 8
Average Annual Dodge to Census Ratios and Standard Deviations

Alabama
Florida

Total

Retail

Single-family

Multifamily

Nonresidential

Building

2.501/.853

1.358/.336

1 -038/.247

1.094/.031

1.225/. 109

.962/. 123

1.288/. 105

1.1 72/. 1 70

1,832/.234

1.441/.5 72

2.35Ó/.69 7

1.207/.548

Tennessee

1,735/.478

1.214/.138

Atlanta

1.097/.049

Birmingham

1.391/.335

Jacksonville

Georgia
Louisiana
Mississippi

1.063/.225

1.240/.908

1.212/.672

1.272/.125

1.036/. 116

.892/. 116

1.147/.302

.906/.213

.579/. 131

1.191/.347

1.097/. 195

,633/.35 7

3.364/3.359

1.196/.696

.986/.474

.817/.385

3.679/5.958

1.207/.254

1.081/.355

.898/.668
.397/. 159

1.228/.212

.930/.135

1.310/.489

.984/. 260

1.957/1.787

1.054/.375

1,365/.422

1.723/2.262

.809/.480

1.038/.292

1.386/.471

1.149/.978

.487/.308

1.104/.1 78

1.030/.074

1.239/.241

1,339/.453

2.014/.715

Nashville

1.190/.196

1.203/.269

1.255/.313

1.424/.398

32



Economic

Review

.422/.097

1.095/.214

1.142/.033

1.395/.343

Industrial
Building

Miami
N e w Orleans

Office
Building

1.976/2.355

1.010/.241

1.275/.326

1 -477/.841

.267/.387

1.206/.344

1.125/1.555

.707/.670

2.255/3.764

March/April 1994

Table 9
State Regression Coefficients/f-Statistics
(Panels of Dodge and Census Data with State Dummy Variables)

Single-family

Louisiana

Mississippi

R2

Constant

Census

Alabama

Florida

Georgia

17652/.433

1.053/1.307

—11931 /—.207

-16028/-.277

17496/304

-35703/-.620

-26778/-.465

.915

-1732/-.037

4120/089

5379/116

.829

-599/-.018

.901 /—1.905

3493/075

-17623/372

Nonresidential

-3593/-.052

.647/-3.606

2984/.031

67655/691

-99/-.001

14861/152

32416/332

.367

Retail Building

-2991/-.127

,724/-2.826

3020/.091

8901/268

-1185/-.036

1093/033

2709/082

.432

-461 3/-. 158

.767/-2.405

2444/059

-12420/-.301

-2341/-.057

2156/052

8182/199

.469

19017/371

1935/038

17682/346

33228/650

.188

Multifamily

Office Building
Industrial Building

-5839/-. 162

.771 /—1.341

7188/141

Table 10
MSA Regression Coefficients/f-Statistics
(Panels of Dodge and Census Data with MSA Dummy Variables)
Census

Atlanta

Birmingham

Jacksonville

Miami

Nashville

R2

-8347/-.513

1.035/707

19772/839

7326/318

12543/544

4478/194

10372/450

.878

Constant
Single-family

968/055

.896/—1.148

- 2 382/-.096

-1066/-.043

669/027

4916/196

-2373/-.096

.594

Nonresidential

-541/-.015

.615/-3.275

5620/110

-2826/-.055

311/006

-4650/-.091

7272/142

.249

Retail Building

-2018/-. 164

.643/-3.018

2685/154

1630/094

2543/146

-6167/-.354

3089/177

.274

4877/139

2341/067

-1411/-.040

5944/170

.309

474/_. 145

-1219/-. 120

-2838/-.280

-.067

Multi-family

Office Building
Industrial Building




-5451/-.220

.654/—3.121

-29/-.001

1699/237

.1 33/-8.900

-1841/-. 182

- 1 567/-.1 55

did not have high correlation coefficients although the
average of the annual ratios was near one. This result
indicates a possible discrepancy in the timing of the
reporting of the construction activity. In other cases,
such as industrial building, both the correlation coefficients and the ratios are low. This outcome could well
result from different classification criteria and mismatched series or from differences in sampling and
coverage of actual activity.
When state and MSA data were compared, data aggregated to the state level were found generally to perform better than at the M S A level: that is, the state
data tended to have higher correlation coefficients than
the MSA data, but the two were similar for the ratios
and their standard deviations. This result may be attributed largely to the effects of aggregation rather
than to similarities in methodologies.

Data Comparisons
The following section compares the D o d g e and
Census data using the outlined comparison methodology. The discussion focuses on the following structure
categories: single and multifamily residential, total
nonresidential, retail, office, and industrial building.
Residential Construction. Dodge and Census data
for single-family and multifamily construction tended
to move together much more than the total nonresidential construction data and specific nonresidential
series. Tables 5, 6, and 7 show the correlation coefficients for panels of state and MSA data and for the individual states and MSAs, respectively. Relative to
nonresidential categories, correlation coefficients for
single-family construction and multifamily construction for the southeastern states and MSAs were quite
high.
However, analysis of the ratio of the total dollar value of single-family contracts for Dodge to the total dollar value of permits for Census reveals a different
picture. The mean values for these ratios varied widely,
as seen in Table 8. For example, in Florida for every
dollar of single-family construction activity reported
by Census, Dodge reported $1.09; but in Alabama for
every dollar estimated by Census, Dodge estimated
$2.50. Such differences are consistent with a ratio
greater than one for more rural states because Dodge
estimates residential building in areas where permits
are not required, and rural states generally have more
nonpermitted construction. Therefore, it is not surprising that more rural states such as Alabama, Louisiana,

Economic
34


Review

Mississippi, and Tennessee have average ratios well
above one, and, in the case of Alabama and Mississippi, above two. Consistent with this conclusion, in the
M S A s — w h e r e most construction is permitted—the
Dodge and Census estimates for single-family construction were similar and the means of the ratios were
near one.
With the exception of Alabama and Mississippi, the
standard deviations for single-family building intentions were quite small, indicating that regardless of
whether Dodge had higher value estimates than Census for single-family permits, the relationship between
the annual estimates did not vary greatly from year to
year.
For multifamily construction, the means for the ratios were higher than one for all states and MSAs (see
Table 8). For states, the mean ratios varied modestly,
with Louisiana and Alabama the highest. These upperend ratios were probably pulled up by the ratios for
New Orleans and Birmingham, which had means near
two. For the MSAs, there seemed to be no consistent
relationship between the Dodge and Census estimates.
In addition, standard deviations for both states and
MSAs showed much more volatility for multifamily
permits than for single-family permits.
In order to eliminate value estimation discrepancies, residential ratios were also calculated using unit
data (see Table 11). The ratio of single-family units as
reported by Dodge to the number reported by Census
was greater than one for all states except Florida. In
the more populated states, such as Georgia and Florida, the ratios were very close to one. As was the case
with the ratios of the value estimates, the more rural
states had ratios much greater than one. Again, this result was expected since Dodge makes estimates for
unpermitted work. For M S A s , where almost all the
work is permitted, the means of the ratios were consistently near one. In state and MSA comparisons based
on value per unit, the Dodge estimates for single-family
permits were consistently larger than the Census estimates, but the ratios were still relatively near one (see
Table 11).
For multifamily contracts, the ratios for unit data
were consistently closer to one than they were for the
value of multifamily construction ratios. It is reasonable to expect these categories to be relatively similar
because most multifamily building takes place in urban areas and is permitted, so both sources would be
likely to have similar methods for estimation. However, D o d g e potential estimates for multifamily construction include not only actual permits but also
construction contract awards that may not yet be per-

March/April 1994

Table 11
Average Annual Dodge to Census Ratios and Standard Deviations
(Units and Per Unit $ Values)

Alabama
Florida
Georgia

Single-family

Multifamily

Single-family

(Units)

(Units)

(Per Unit $ Value)

1,923/.562

1.087/.222

1.287/.067

.951/.027

1.092/.068

1.151/.038

1 -079/.080

1.025/.181

1.194/.056

Louisiana

1.470/. 181

1.207/.470

1.248/.085

Mississippi

2.070/.468

1.010/.349

1.124/.082

Tennessee
Atlanta

1,459/.328
.938/.070

Birmingham

1,265/.246

Jacksonville

.981/.030

Miami
Nashville
N e w Orleans

1.01 7/.089

.982/. 164
1.085/. 173
1.715/1.550

1.207/. 1 71
1.1 74/. 1 56
1.2 56/. 170
1.1 34/.119

1.173/.063
1.165/.023
1.016/.058

1.05 3/. 100

1.050/.260

1.124/.081

1.042/. 193

1.343/.902

1.327/. 1 50

Federal Reserve Bank of Atlanta



1.121/.057
1.1 57/.160

1.126/.324

1.095/.070

.912/. 180

Interestingly, the means of the ratios for the aggregated values were near one for both states and M S A s
(see Table 8). Despite not moving together particularly
well on an annual basis, the average values for the estimates of nonresidential construction are fairly similar
over time. Once again, differences in the timing of reported data may be responsible for this outcome.

1.254/.212

1.178/.062

1.073/.151

mitted. Like the single-family category, on a value per
unit b a s i s D o d g e v a l u e d m u l t i f a m i l y c o n s t r u c t i o n
work consistently higher than Census.
Nonresidential Construction Comparisons. When
all categories of nonresidential construction were aggregated into one total series, values for the Dodge construction potentials and Census construction permits did
not track as well as the residential series. Correlation
coefficients for panels of aggregate state and M S A data
were considerably lower than for the residential series
(see Table 5). In addition, correlation coefficients for individual states and M S A s indicated even greater variation between the series (see Tables 6 and 7). In a few
cases, such as that of Mississippi, some correlation coefficients were actually negative. As explained earlier,
this negative correlation probably resulted from timing
differences in Dodge and Census reporting. These differences are more apparent in the smaller states, with
less nonresidential building, than in the larger states, for
which the volume of building tends to mute the effects
of timing differences.

Multifamily
(Per Unit $ Value)

1.267/.417
1.1 53/.164
1.1 67/. 1 72
1.358/.518

Retail. W h e n data for nonresidential construction
were separated into the specific categories, the results
varied greatly a m o n g building categories. For retail
buildings, the correlation between the panels of data
was still fairly strong for both states and M S A s . H o w ever, the results for the individual states and M S A s
varied widely and in some cases were even negative
(see Tables 6 and 7).
W h e n the m e a n s of the ratios f o r retail building
were analyzed, the results for states and M S A s varied.
At the state level, the ratios p e r f o r m e d particularly
well. Even states with low correlation coefficients had
means near one. However, at the M S A level, for which
all the ratios were above one, the results were not as
strong. This finding supports the previous conclusion
that data at the M S A level do not track as well as the
state data because M S A data have less aggregation.
Office. The correlation coefficients for office construction were strong for the panels of state and M S A
data (see Table 5). As before, when the data were disaggregated into series for each state and M S A , correlation coefficients generally fell. For the states, results
varied widely, but M S A correlation coefficients were
somewhat higher than those of the states. This result
contrasts with previous results, in which data aggregated to the state level showed less variation between
the series. O n e contributor to this contrasting result
may be the fact that, because almost all office building

Economic

Review

35

is done within M S A s , aggregating to the state level
provides relatively little additional information.
Industrial. For industrial building, the sources did
not correspond well. The correlation coefficients for
the panels of state and MSA data were the lowest of
all the building group categories (see Table 5). The results further deteriorated when tests were run on the
individual states and MSAs. Except for a few states
and one MSA, the series demonstrated almost no correlation.
The means of the ratios of Dodge data to Census data for industrial buildings for states and MSAs varied
widely, demonstrating the greatest range of mean values of any of the series (see Table 8). Means for states
and MSAs were not consistently greater or less than
one. Although definitional differences would seem to
affect states in a similar manner, it is possible that differences in categorization of buildings affect states
with varying industrial compositions differently. For
e x a m p l e , d i f f e r e n c e s in w a r e h o u s e c l a s s i f i c a t i o n s
should have a greater effect on a state with a relatively
large proportion of distributional facilities, such as
Georgia, than on a state like Mississippi, which is not a
major distribution center. Consistent with this assumption, Alabama and Tennessee—which have diversified
industrial facilities—had means fairly close to one.

Dodge and the Census Bureau. Statistical results indicated that in many cases the residential series were almost interchangeable. These series had generally high
correlation coefficients and average annual ratios near
one. Single-family contracts and permits demonstrated
the greatest similarities, but the multifamily results
were also strong.
T h e c l a s s i f i c a t i o n s and m e t h o d o l o g i e s used by
Dodge and the Census Bureau for nonresidential series
were not as similar as for the residential series, and the
nonresidential series showed less correspondence in
statistical tests. Correlation coefficients were much
lower, and the annual ratios differed to a much greater
extent. Within the nonresidential category, the office
building series were the most comparable, and the industrial building series demonstrated the fewest similarities. Unlike the residential series, the various nonresidential series from each data source were generally
not close substitutes. Individual researchers should
question which set is most useful for a particular purpose.
In addition, potential users should note that regional
data are generally more highly variable than are national data, and, as the data are disaggregated, findings
become more subject to error. Consequently, researchers should explore the developments that cause variation in the local economy when analyzing the data,
rather than placing emphasis on the actual changes in
permit levels.

Conclusion

Although this study is a preliminary examination of
the data sources, it provides a basis for comparison of
Dodge and Census data on construction permits. The
specific needs of individual researchers will determine
which is the most relevant data source; it is not the intention of the authors to recommend one or the other.
Finally, the findings of this study suggest that a valuable next step would be a more thorough examination
of monthly Dodge and Census estimates and revisions.

When F.W. Dodge and the Census Bureau used similar methodologies and reporting sources, their data series were quite comparable over time. However, when
the methodologies differed, the data series were dissimilar.
The methodologies used in calculating residential
contracts and permits created very similar series for

Notes
1. A copy and description of form C-404, "Report of Building
or Zoning Permits Issued and Local Public Construction,"
can be found in the back of the annual Current Construction
Report Series C-40.
2. In addition to the selected MSAs and PMSAs, large areas are
defined as "all places that authorized housing units during

36



Economic

Review

the period greater than or equal to a predetermined number
of units" (Current Construction Report Series C-40 Appendix).
3. The latter two correspond to the Census Bureau's Mountain
and Pacific regions, respectively.

March/April 1994

References
Bansak, Cynthia. "Nonresidential Construction Data Available." Federal Reserve Bank of Atlanta Regional Update 5
(July-September 1992): 5-6.
Doan, Thomas A. RATS User's Manual. Evanston, 111.: Estima,
1992.
F.W. Dodge Division/McGraw-Hill, Inc. Dodge Construction
Potentials Bulletin. Published monthly in nine regional editions.
. "Two Measures of the Construction Market Compared."
June 1992.

Federal Reserve Bank of Atlanta



Greene, William H. Econometric Analysis. New York: Macmillan Publishing Company, 1990.
U.S. Bureau of the Census. Current Construction
Reports—
Housing Units Authorized by Building Permits:
Annual
1992. Washington, D.C.: U.S. Government Printing Office,
1993.
. Current Construction Reports—Housing
Units Authorized by Building Permits: April ¡994. Washington, D.C.:
U.S. Government Printing Office, 1994.

Economic

Review

37




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