Full text of Economic Review (Federal Reserve Bank of Atlanta) : May/June 1990, Volume 75, Number 3

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nEœnomic
^sM Review
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FEDERAL RESERVE BANK OF ATLANTA

Hedging Tools and Capital Guidelines

Commercial Bank Profitabili

THE PANIC OF 1907
How Trusts Tipped the Scales




MAY/jUNE 1990

Economic
Review
President
R o b e r t P. F o r r e s t a l

Senior Vice President and
Director of Research
S h e i l a L. T s c h i n k e l

Vice President and
Associate Director of Research
B. Frank King

Research Officers
W i l l i a m Curt Hunter, Basic Research
Mary Susan Rosenbaum, Macropolicy
G e n e D. S u l l i v a n , R e g i o n a l
L a r r y D. W a l l , F i n a n c i a l
D a v i d D. W h i t e h e a d , R e g i o n a l

Public Information Officer
B o b b i e H. M c C r a c k i n

Publications
l o y c e l y n T. W o o l f o l k , P u b l i c a t i o n s C o o r d i n a t o r
L y n n H. F o l e y , P r o d u c t i o n
C h e r y l B. B i r t h r o n g , G r a p h i c s a n d T y p e s e t t i n g
M i c h a e l J. C h r i s z t , C i r c u l a t i o n

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V O L U M E L X X V , N O . 3, M A Y / J U N E 1990, E C O N O M I C R E V I E W

Lessons from the
Panic of 1907
Ellis W. T a l l m a n a n d Jon R. M o e n

14

Capital Requirements for
Interest-Rate and
F o r e i g n - E x c h a n g e Hedges
L a r r y D. Wall, John J. P r i n g l e , a n d

T h e role of trusts in t h e 1907 Panic p o i n t s to
p o s s i b l e d i s a d v a n t a g e s of u n e v e n regulatory s t a n d a r d s a m o n g different t y p e s of financial institutions
that perform similar functions.

This study reviews recently a d o p t e d capital
regulations a n d p r o p o s e s a new p r o c e d u r e for
including i n t e r e s t - r a t e a n d f o r e i g n - e x c h a n g e risk
in t h e capital s t a n d a r d s .

J a m e s E. M c N u l t y

30
44

F.Y.I.

R e c o v e r i n g Bank Profitability:

R o b e r t E. G o u d r e a u a n d B. F r a n k King

S p o i l e d Again by Large Banks' Loan P r o b l e m s

Book Review

Presidential Economics: The Making of

Mary Susan R o s e n b a u m

Economic Policy from Roosevelt to Reagan and
by Herbert Stein

FEDERAL RESERVE BANK OF ATLANTA




Beyond

Lessons from the Panic
of 1907
Ellis W. T a l l m a n a n d Jon R. M o e n

The Bank Panic of 1907
was so serious that it became
a catalyst for the creation of America's
central bank. This study, which examines
the circumstances leading to and the intervention measures taken during the panic,
particularly focuses on trust companies'
function as a financial intermediary. Unequal
regulation among financial organizations, the
authors find, led to a concentration of riskier assets
in less regulated intermediaries, primarily trusts.
Trusts' riskier asset portfolios made them the focal
point from which the crisis spread to other segments of
the financial market. Allowing various types of institutions comparable access to all assets and investment
opportunities, the authors conclude, might reduce the
risk that the collapse of one type of asset would threaten
the solvency of an entire class of financial intermediary.

or t h e p a s t two c e n t u r i e s recurrent
crises have shaken the banking syst e m a n d f i n a n c i a l m a r k e t s in t h e
United S t a t e s . One s e v e r e crisis, the Bank
P a n i c of 1907, d i s r u p t e d financial m a r k e t s to
s u c h an e x t e n t t h a t it b e c a m e an i m p o r t a n t
c a t a l y s t for c r e a t i n g t h e F e d e r a l R e s e r v e a n d
t h e U.S. b a n k i n g s y s t e m as it o p e r a t e s today.
T h e p a n i c i n v o l v e d s e v e r a l t y p e s of financial
intermediaries, each distinct and playing a
u n i q u e r o l e in c a p i t a l m a r k e t s a t t h e s a m e
t i m e that e a c h o p e r a t e d u n d e r a different s e t
of r e g u l a t i o n s . This regulatory framework crea t e d c o n d i t i o n s that m a d e a panic m o r e likely
than if regulation h a d a l l o w e d uniform a c c e s s
to all i n v e s t m e n t o p p o r t u n i t i e s .

F

The authors are economists in the macropolicy and regional sections,
respectively, of the Atlanta Fed's research

 2


department.

What follows is a c a s e study of an individual f i n a n c i a l c r i s i s , a r e c o r d d e t a i l i n g e v e n t s
t h a t l e d up t o , a n d t h e m a n e u v e r s t h a t t o o k
p l a c e during, t h e P a n i c of 1907. T h e f o c u s is
on t h e c o n d i t i o n of New York City trust comp a n i e s , a financial i n t e r m e d i a r y t h a t had
grown rapidly in p r o m i n e n c e at t h e turn of t h e
century and e x p e r i e n c e d t h e m o s t s e v e r e d e p o s i t o r r u n s d u r i n g t h e B a n k P a n i c of 1907.
Their growth can b e a t t r i b u t e d largely to freer
i n v e s t m e n t o p p o r t u n i t i e s t h a t r e s u l t e d from
b e i n g l e s s s u b j e c t t o regulation t h a n s t a t e or
national banks. Although trust c o m p a n i e s
w e r e p r o f i t a b l e , t h e i r s p e c i a l i z a t i o n in collate r a l i z e d l o a n s , p e r c e i v e d a s risky l o a n s to
firms that c o u l d not o b t a i n c r e d i t through national or s t a t e b a n k s , a d d e d to t h e severity of
t h e panic.
T h i s r e s e a r c h h a s d i r e c t r e l e v a n c e for t h e
r e g u l a t i o n of i n t e r m e d i a r i e s . E x a m i n i n g t h e
role of t h e trust c o m p a n y a s a financial interE C O N O M I C REVIEW, MAY/JUNE 1990

m e d i a r y in t h e Panic of 1907 h e l p s to e x p o s e
t h e crucial role that u n e v e n regulation p l a y e d
in d e t e r m i n i n g t h e c o m p o s i t i o n of a s s e t portfolios of b a n k s a n d trusts. B e c a u s e trusts took
a d v a n t a g e of i n v e s t m e n t o p p o r t u n i t i e s t o
which b a n k s h a d l i m i t e d a c c e s s , t r u s t s h a d
relatively undiversified portfolios.

Economic Conditions
before the Panic
How d o e s a f i n a n c i a l c r i s i s b e g i n ? W h a t
prompts a panic? Most answers suggest that
f i n a n c i a l c a l a m i t i e s r e s u l t from an u n u s u a l
c o m b i n a t i o n of e c o n o m i c c o n d i t i o n s and
e v e n t s . In t h e c a s e of t h e 1907 Panic t h e coll a p s e of F. Augustus H e i n z e ' s a t t e m p t to corn e r t h e m a r k e t for c o p p e r s t o c k a p p a r e n t l y
t r i g g e r e d t h e c h a i n of e v e n t s , b u t i n f o r m e d
o b s e r v e r s a g r e e that t h e s a m e d e v e l o p m e n t s
p r o b a b l y would n o t h a v e l e d to a p a n i c in a
more benign e c o n o m i c environment.1 Oliver
M.W. S p r a g u e , writing for t h e National M o n e tary C o m m i s s i o n in 1910, d e s c r i b e s in d e t a i l
t h e e c o n o m i c c o n d i t i o n s a n d s p e c i a l circums t a n c e s t h a t r e s u l t e d in t h e P a n i c of 1 9 0 7 .
Unusually s e v e r e l i q u i d i t y p r o b l e m s in New
York City e m e r g e a s a b a c k d r o p in t h e crisis.
S e a s o n a l L i q u i d i t y F l u c t u a t i o n s . During
t h e National Banking Era t h e New York m o n e y
m a r k e t f a c e d s e a s o n a l v a r i a t i o n s in i n t e r e s t
r a t e s a n d l i q u i d i t y r e s u l t i n g from t h e t r a n s p o r t a t i o n of c r o p s from t h e i n t e r i o r of t h e
U n i t e d S t a t e s to New York a n d t h e n to
Europe. T h e outflow of capital n e c e s s a r y to fin a n c e c r o p s h i p m e n t s from t h e M i d w e s t t o
t h e E a s t C o a s t in S e p t e m b e r or O c t o b e r usually left New York City m o n e y m a r k e t s
s q u e e z e d for c a s h . As a r e s u l t , i n t e r e s t r a t e s
in New York City w e r e p r o n e t o s p i k e upward
in a u t u m n . S e a s o n a l i n c r e a s e s in e c o n o m i c
activity w e r e n o t m a t c h e d b y an i n c r e a s e in
t h e m o n e y s u p p l y b e c a u s e e x i s t i n g financial
structures t e n d e d to m a k e t h e m o n e y s u p p l y
"inelastic." The base money stock—gold,
g r e e n b a c k s , national bank n o t e s , and gold
and s i l v e r c e r t i f i c a t e s — w a s a l s o a f f e c t e d b y
unusual v a r i a t i o n s in g o l d flows t h r o u g h foreign e x c h a n g e m a r k e t s . R e c e n t r e s e a r c h b y
Fabio Canova offers e v i d e n c e that external

FEDERAL RESERVE B A N K O F ATLANTA




d i s r u p t i o n s t o t h e m o v e m e n t of g o l d w e r e
i m p o r t a n t d e t e r m i n a n t s of b a n k p a n i c s . 2
Atypical gold flows in 1907 s e e m to h a v e cont r i b u t e d to t h e e x t r e m e s e a s o n a l t i g h t n e s s in
New York City's m o n e y m a r k e t s in t h e fall.
T h e a b s e n c e of f i n a n c e b i l l s d u r i n g 1907
s u b s t a n t i a l l y a l t e r e d g o l d flows, c o n t r i b u t i n g
to the c o n d i t i o n s that framed the crisis.
Finance bills were contracts to e x t e n d credi t — e s s e n t i a l l y b o n d s i s s u e d to borrow overs e a s in h o p e o f p r o f i t f r o m a n t i c i p a t e d
exchange-rate fluctuations. The dollar's exc h a n g e rate v a r i e d o v e r t h e year, s t r e n g t h e n ing d u r i n g t h e h a r v e s t s e a s o n w h e n f o r e i g n
d e m a n d for d o l l a r s to p u r c h a s e c r o p s was
high a n d w e a k e n i n g t h e r e a f t e r . F i n a n c e b i l l s
w e r e m o s t f r e q u e n t l y drawn in t h e s u m m e r ,
two o r t h r e e m o n t h s b e f o r e c r o p m o v e m e n t ,
w h e n t h e d o l l a r p r i c e of s t e r l i n g w a s q u i t e
high (E.W. K e m m e r e r 1910). B a n k s a n d trust
c o m p a n i e s t h e n s o l d sterling n o t e s for dollars
when sterling was s t r o n g e r and repaid t h e
n o t e s w h e n t h e d o l l a r v a l u e of s t e r l i n g w a s
lower, t h u s m a k i n g a profit. I n c r e a s e d u s e of
finance bills s e e m s to have r e d u c e d t h e
volatility of e x c h a n g e rates a n d t h e v o l u m e of
g o l d s h i p m e n t s o v e r s e a s , e n h a n c i n g t h e effic i e n c y of t h e i n t e r n a t i o n a l e x c h a n g e m a r k e t ,
a c c o r d i n g t o C.A.E. G o o d h a r t a n d M a r g a r e t
Myers. F i n a n c e bills also p r o v i d e d a c r u d e futures o r forward market in foreign e x c h a n g e .
I n t e r n a t i o n a l Gold F l o w s . U n l i k e t h e foreign e x c h a n g e market, d o m e s t i c t r a d e offered
no such contractual provision to s m o o t h capital flows. T h e New York m o n e y m a r k e t t r a n s f e r r e d f u n d s to t h e i n t e r i o r of t h e U n i t e d
S t a t e s to f i n a n c e t r a n s p o r t of agricultural
g o o d s to New York City p o r t s . W i t h o u t a
m e c h a n i s m to arbitrage regional i n t e r e s t rates
o r i n c r e a s e l i q u i d i t y , i n t e r e s t r a t e s in N e w
York City g e n e r a l l y c l i m b e d d u r i n g t h e fall.
This regular pattern signaled the i n c r e a s e d
liquidity n e e d s of New York City b a n k s . Usually, h i g h e r i n t e r e s t r a t e s a t t r a c t e d s u f f i c i e n t
f u n d s t o o f f s e t t h e city's m o n e y s h o r t a g e . In
1 9 0 7 , h o w e v e r , a b e r r a t i o n s in i n t e r n a t i o n a l
gold flows c r e a t e d a d d i t i o n a l c r e d i t cons t r a i n t s in t h e f i n a n c i a l m a r k e t t h a t h e i g h t e n e d t h e probability of a panic.
In t h e s p r i n g o f 1 9 0 6 t h e U . S . T r e a s u r y
D e p a r t m e n t , u n d e r S e c r e t a r y L e s l i e Shaw, d e v i s e d p o l i c i e s to s t i m u l a t e g o l d i m p o r t s into
3

t h e U n i t e d S t a t e s to c o m b a t w h a t w a s p e r c e i v e d t o b e a s h o r t a g e of g o l d . S u b s i d i z i n g
g o l d i m p o r t s through t h e u s e of f i n a n c e bills,
t h e policy g e n e r a t e d a significant inflow of $50
million in a little m o r e than a month, b e t w e e n
April a n d May 1906. In t y p i c a l t r a d e , f i n a n c e
bills i s s u e d during t h e s u m m e r would have
p r e v e n t e d such substantial gold outflows
from England. As it was, l a r g e - s c a l e e x p o r t s of
g o l d from L o n d o n n e a r l y s p u r r e d a c r i s i s in
G r e a t Britain. To d e f e n d its d o m e s t i c financial m a r k e t s , t h e B a n k of E n g l a n d r a i s e d its
d i s c o u n t rate in l a t e 1906 a n d t h r e a t e n e d ano t h e r i n c r e a s e if A m e r i c a n f i n a n c e bills w e r e
not paid upon maturity without renewal
(Myers).

As H e i n z e ' s e x t e n s i v e i n v o l v e m e n t in
b a n k i n g b e c a m e a p p a r e n t , a l o n g with that of
a n o t h e r s p e c u l a t o r a s s o c i a t e d with t h e copp e r s c a m , C.F. M o r s e , d e p o s i t o r s ' f e a r s of ins o l v e n c y p r e c i p i t a t e d a s e r i e s of runs on t h e
b a n k s w h e r e t h e two m e n h e l d p r o m i n e n t positions. After t h e failure of his a t t e m p t to corn e r U n i t e d C o p p e r s t o c k , H e i n z e was f o r c e d
t o r e s i g n from t h e p r e s i d e n c y of M e r c a n t i l e
National, and worried d e p o s i t o r s b e g a n a run
on t h e b a n k . T h e New York C l e a r i n g h o u s e , a
c o n s o r t i u m of b a n k s in New York City, e x a m i n e d t h e bank's a s s e t s , a n n o u n c e d that it was
solvent, and stated that the clearinghouse
w o u l d s u p p o r t M e r c a n t i l e on t h e c o n d i t i o n
that Heinze and his b o a r d of directors resign.

T h u s f i n a n c e b i l l s w e r e s u s p e n d e d during
1907, s u b s t a n t i a l l y c o n s t r i c t i n g t h e s y s t e m of
a r b i t r a g e that m i n i m i z e d actual s h i p m e n t s of
g o l d . In 1907, d e s p i t e r e l a t i v e l y high U.S. interest rates, the United S t a t e s exported $30
million in gold to London during t h e s u m m e r .
As a r e s u l t , t h e New York m o n e y m a r k e t was
left with an uncharacteristically low v o l u m e of
g o l d u p o n e n t e r i n g t h e fall s e a s o n of c a s h
t i g h t n e s s . 3 New York f i n a n c i a l m a r k e t s w e r e
thus p r e s s e d b y e v e n l e s s liquidity than usual
at p r e c i s e l y t h e t i m e w h e n t h e n e e d for
m o n e y i n t e n s i f i e d . Any s h o c k to t h e financial
m a r k e t s could, a n d in 1907 did, spark a m a j o r
crisis.

D u r i n g t h e r e o r g a n i z a t i o n of M e r c a n t i l e
N a t i o n a l B a n k , t h e New York C l e a r i n g h o u s e
b e g a n e x a m i n i n g o t h e r b a n k s t h a t h a d int e r e s t s r e l a t e d to H e i n z e a n d t h a t h a d b e e n
raising suspicion for s o m e time. T h e restructuring of M e r c a n t i l e r e v e a l e d that Morse was o n e
of t h a t b a n k ' s d i r e c t o r s . S p r a g u e ( 1 9 1 0 , 248)
d e s c r i b e s M o r s e a s having "an e x t r e m e character, e v e n when j u d g e d b y American s p e c u lative s t a n d a r d s . "

The Onset of the Panic
Such a shock occurred on O c t o b e r 16, 1907,
w h e n F. Augustus H e i n z e ' s a t t e m p t to c o r n e r
t h e s t o c k of U n i t e d C o p p e r C o m p a n y f a i l e d .
Although U n i t e d C o p p e r was o n l y m o d e s t l y
s i g n i f i c a n t , t h e c o l l a p s e of H e i n z e ' s s c h e m e ,
which c a m e a t o p a slowing e c o n o m y , a declining s t o c k m a r k e t , a n d a tight m o n e y m a r k e t ,
s p a r k e d o n e of t h e m o s t s e v e r e b a n k p a n i c s
of t h e National B a n k i n g Era. I n v e s t i g a t i o n of
H e i n z e ' s i n t e r e s t s e x p o s e d an i n t r i c a t e n e t work of interlocking d i r e c t o r a t e s across b a n k s ,
b r o k e r a g e h o u s e s , a n d t r u s t c o m p a n i e s in
New York City. C o n t e m p o r a r y o b s e r v e r s like
S p r a g u e b e l i e v e d that t h e c l o s e a s s o c i a t i o n s
b e t w e e n b a n k e r s and b r o k e r s h e i g h t e n e d d e positors' anxiety.

 4


(

M o r s e w a s a d i r e c t o r of s e v e n New York
City b a n k s , t h r e e of which h e c o n t r o l l e d comp l e t e l y . H e was a l s o h e l d in low e s t e e m by
m o s t o t h e r b a n k e r s . H i s c o n n e c t i o n with
M e r c a n t i l e ' s difficulties worried d e p o s i t o r s at
h i s o t h e r b a n k s , a n d two c a l l e d for a i d from
t h e c l e a r i n g h o u s e on O c t o b e r 19 in r e s p o n s e
to large withdrawals of d e p o s i t s . T h e clearingh o u s e g r a n t e d a s s i s t a n c e on t h e c o n d i t i o n
that M o r s e retire c o m p l e t e l y from b a n k i n g in
New York. During t h e w e e k e n d , b o t h M o r s e ,
and E.R. T h o m a s , a n o t h e r of Heinze's cohorts,
w e r e r e l i e v e d of t h e i r r e m a i n i n g b a n k i n g int e r e s t s . T h e c l e a r i n g h o u s e p r o m i s e d to s u p port t h o s e b a n k s as well.
T h e a s s e t s of H e i n z e ' s b a n k s t o t a l e d $71
million, c o m p a r e d to o v e r $2 billion in all New
York City b a n k s a n d t r u s t s ( S p r a g u e 1910,
249). Although t h i s was a s i g n i f i c a n t a m o u n t ,
d e p o s i t o r s a p p a r e n t l y c o n s i d e r e d t h e cleari n g h o u s e ' s p r o m i s e of a $ 1 0 million f u n d to
aid former Heinze b a n k s sufficient b e c a u s e no
n o t a b l e run o c c u r r e d o n t h e b a n k s . On
M o n d a y , O c t o b e r 21, M e r c a n t i l e N a t i o n a l res u m e d b u s i n e s s with new m a n a g e m e n t , and
t h e run c e a s e d . S i m i l a r a c t i o n w a s t a k e n at

E C O N O M I C REVIEW, MAY/JUNE 1990

Heinze's C o p p e r C o r n e r A t t e m p t
F. A u g u s t u s H e i n z e , a k e y p l a y e r in t h e initial s t a g e of t h e p a n i c , r o s e r a p i d l y t o n o t o r i e t y
in t h e financial world a f t e r h e won a highly p u b licized legal battle against Amalgamated
C o p p e r in B u t t e , M o n t a n a . A m a l g a m a t e d h a d
b e e n o r g a n i z e d a few y e a r s e a r l i e r b y s e v e r a l
S t a n d a r d Oil C o m p a n y e x e c u t i v e s a n d financiers, including J a m e s Stillman of National
City B a n k of New York. T h e p u r c h a s e r s of
A m a l g a m a t e d r e p o r t e d l y e a r n e d a profit o f $ 3 6
m i l l i o n o n a n i n v e s t m e n t of $ 3 9 m i l l i o n , w h i c h
h a d g o n e primarily toward t h e a c q u i s i t i o n of t h e
A n a c o n d a m i n e s in M o n t a n a (New York
Times,
O c t o b e r 17, 1907).
Heinze, who owned a c o p p e r mine n e a r t h e
A m a l g a m a t e d M i n e s , c l a i m e d t h a t v e i n s of c o p p e r from h i s m i n e e x t e n d e d u n d e r l a n d o w n e d
by A m a l g a m a t e d and that a c c o r d i n g to t h e
" a p e x l a w " h e h a d a r i g h t t o m i n e it ( C a r o s s o
1970, 112). T h e m a t t e r was p u r s u e d in an e x t e n s i v e legal c o n f r o n t a t i o n t h a t was e v e n t u a l l y s e t t l e d o u t of c o u r t in F e b r u a r y 1906, w h e n H e i n z e
s o l d his c o p p e r i n t e r e s t t o A m a l g a m a t e d for a
r e p o r t e d $ 2 5 m i l l i o n , h a l f in c a s h a n d h a l f in
Amalgamated securities.
H e i n z e t o o k his g a i n s to New York City,
w h e r e h e b e c a m e i n v o l v e d in b a n k i n g ( A l l e n
1935). In January 1907 n e w s p a p e r a r t i c l e s h a d alr e a d y a s s o c i a t e d H e i n z e with E.R. T h o m a s a n d
C.F. M o r s e , b o t h New York b a n k e r s a n d o w n e r s
of t h e M e c h a n i c s a n d T r a d e r s S t a t e B a n k a n d
C o n s o l i d a t e d Bank. H e i n z e was p l a c e d on t h e
b o a r d of d i r e c t o r s of e i g h t b a n k s a n d t w o t r u s t
c o m p a n i e s . 1 E l e c t e d p r e s i d e n t of M e r c a n t i l e
National B a n k in F e b r u a r y 1907, h e i m m e d i a t e l y
r e p l a c e d t h e d i r e c t o r s h i p with h i s a s s o c i a t e s .
T h e H e i n z e g r o u p g a i n e d c o n t r o l of s e v e r a l
o t h e r b a n k s q u i t e quickly through "chain banking," an o r g a n i z a t i o n a l s t r a t e g y similar t o t o d a y ' s
b a n k holding company. T h e group would buy
s t o c k in a b a n k a n d u s e it a s c o l l a t e r a l t o b o r r o w
m o n e y , which was t h e n u s e d t o b u y s t o c k in a n o t h e r b a n k o r trust.
H e i n z e ' s a t t e m p t to c o r n e r t h e stock of
United Copper, a c o m p a n y of which he was
president, eventually triggered the Panic of
1907. T h e c o r n e r a t t e m p t , which p r o b a b l y exp l a i n s t h e s t e a d y a n d r e l a t i v e l y high p r i c e of
United Copper stock d e s p i t e a weak c o p p e r
m a r k e t during 1907, was not an unusual strategy.
However, unlike o t h e r market c o r n e r s c h e m e s ,
this o n e s e e m e d to b e public knowledge, as
s u g g e s t e d by several n e w s p a p e r articles referring to t h e i n t e n t of t h e H e i n z e g r o u p ( s e e
b e l o w ) . His r e p u t a t i o n a s a s p e c u l a t o r w a s further reinforced when the r e s p e c t e d investment

FEDERAL
BANK OF ATLANTA
Digitized
forRESERVE
FRASER


b a n k i n g h o u s e J.S. B a c h e w i t h d r e w from its b u s i n e s s r e l a t i o n s w i t h H e i n z e in F e b r u a r y 1 9 0 7
(New York Times, F e b r u a r y 15, 1907).
T h e a l l e g e d c o r n e r of U n i t e d C o p p e r s t o c k
c o l l a p s e d in O c t o b e r 1907. It w a s f o i l e d in p a r t
by a c t i o n s t a k e n b y an A m a l g a m a t e d s u b s i d i a r y ,
United M e t a l s Selling C o m p a n y , which a p p a r e n t l y h a d b e e n m a n i p u l a t i n g t h e m a r k e t for raw
copper. S u b s e q u e n t Pujo C o m m i t t e e investigations revealed that United Metals Selling
C o r p o r a t i o n s o l d o n l y 5 million p o u n d s of c o p p e r from April to August 1907 (U.S. C o n g r e s s , 734;
s e e also 717-40). The normal amount ranged
from 150 m i l l i o n t o 2 5 0 m i l l i o n p o u n d s . W h e n
Congressional Counsel Samuel Untermeyer
p r e s s e d a s s i s t a n t m a n a g e r T o b i a s Wolfson of
t h e U n i t e d M e t a l s S e l l i n g C o r p o r a t i o n for an e x planation, he s t a t e d that no b u y e r s could b e
found for copper. U n t e r m e y e r then q u i p p e d ,
" A n d all of a s u d d e n , in O c t o b e r , t h e y w e r e int e r e s t e d in 9 3 m i l l i o n p o u n d s in a s i n g l e
m o n t h ? " Wolfson r e s p o n d e d , "Yes. T h e y had
u s e d u p all t h a t t h e y h a d b o u g h t . " As a result of
t h e s e m a r k e t m a n i p u l a t i o n s , t h e p r i c e of raw
c o p p e r p l u m m e t e d , a n d t h e price of c o p p e r
m i n i n g s t o c k s b r o k e . H a v i n g r e a c h e d a high of
n e a r l y $ 1 2 1 a s h a r e in J a n u a r y 1 9 0 7 , A m a l g a m a t e d C o p p e r fell from $ 5 6 1/4 t o $ 4 1 3/4 in
O c t o b e r . Although U n i t e d C o p p e r m a i n t a i n e d a
s t e a d y p r i c e t h r o u g h o u t t h e first half of O c t o b e r ,
t h e following e v e n t s l e d t o t h e t o t a l c o l l a p s e of
the Heinze interests.
U n i t e d C o p p e r first r e a c h e d t h e h e a d l i n e s of
t h e New York Times o n T u e s d a y , O c t o b e r 15. O n
M o n d a y its s t o c k h a d r i s e n from $ 3 9 to $ 6 0 during t h e first 15 m i n u t e s of t r a d i n g o n t h e C u r b
Market.2 Buying was not d o n e through H e i n z e
brokers. Curb brokers e m p h a s i z e d that Heinze
b r o k e r s had b e e n taking g r e a t pains to k e e p
t r a c k o f all s h a r e s in U n i t e d C o p p e r t h a t h a d
c o m e o u t s i n c e t h e high p r i c e s o f January 1907,
in an a t t e m p t t o d i s t i n g u i s h s h o r t s e l l i n g . 3 S h o r t
p o s i t i o n s in U n i t e d C o p p e r w e r e t h u s known t o
b e d a n g e r o u s . H e i n z e was not i n t e r e s t e d in t h e
total n u m b e r of s h a r e s o u t s t a n d i n g b e c a u s e h e
b e l i e v e d m a n y s h a r e s w e r e h e l d in t h e w e s t e r n
U n i t e d S t a t e s , w h e r e , in t h o s e d a y s , t h e y c o u l d
t a k e a w e e k o r m o r e t o r e a c h New York for s a l e ;
rather, H e i n z e w a s c o n c e r n e d a b o u t how m a n y
s h a r e s were quickly a c c e s s i b l e to the market.
A p p a r e n t l y t h i n k i n g t h e t i m e w a s right for a
corner, H e i n z e p u r c h a s e d a large q u a n t i t y of
s h a r e s on M o n d a y through t h e b r o k e r a g e h o u s e
of his b r o t h e r , O t t o H e i n z e . M a n y s h a r e s of
United C o p p e r had a p p e a r e d on t h e market
d u r i n g t r a d i n g o n S a t u r d a y , O c t o b e r 12, a n d

5

Heinze s u s p e c t e d that brokerage h o u s e s were

ership

l e n d i n g out his s h a r e s of United C o p p e r to sup-

(Commercial

of

17,830 shares
and

Financial

of c o m m o n
Chronicle,

stock

J a n u a r y 4,

p o r t s h o r t s e l l i n g of t h e s t o c k . H e o r d e r e d G r o s s

1908). T h e a g e n c y c l a i m e d that t h e b l o c k was

a n d K l e e b e r g , a b r o k e r a g e h o u s e s t a r t e d in

h e l d in a j o i n t a c c o u n t a n d c o u l d n o t b e t r a n s -

1904, t o p u r c h a s e 6 , 0 0 0 s h a r e s of t h e s t o c k a t a s -

ferred unless both parties agreed. A newspaper

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

article reported that Heinze b e l i e v e d a "market

h i s own s h a r e s a g a i n from s h o r t s e l l e r s a t a h i g h -

p o o l " of U n i t e d C o p p e r s t o c k w a s b e i n g l e n t o u t

e r p r i c e t o a t t r a c t m o r e s h o r t s a l e s . Of c o u r s e ,

t o s h o r t s e l l e r s in v i o l a t i o n o f t h e a g r e e m e n t , al-

t h e s h o r t s e l l e r s d i d n o t r e a l i z e t h a t H e i n z e al-

t h o u g h H e i n z e d i d n o t i d e n t i f y w h o w a s in t h e

ready owned the shares that they had borrowed

p o o l (New York Times,

a n d t h a t h e w a s n o w b u y i n g from t h e m . T h i s a c -

p o o l b e e n unwilling t o c o o p e r a t e , B u c k i n g h a m ' s

tion, Heinze h o p e d , would force short sellers to

refusal of t h e transfer o r d e r might have p r e v e n t -

a s e t t l e m e n t in a t e c h n i q u e k n o w n a s a " b e a r

e d t h e m a r k e t p o o l from u p s e t t i n g t h e a t t e m p t -

s q u e e z e . " The s q u e e z e would result

ed

when

corner.

O c t o b e r 17, 1 9 0 7 ) . H a d t h e

Announcement

of

the

refusal

H e i n z e o w n e d a l a r g e p e r c e n t a g e of U n i t e d

s t r e n g t h e n e d United C o p p e r s t o c k on T u e s d a y ,

C o p p e r s t o c k , in w h i c h t h e m a j o r i t y o f a c t i v e l y

t h o u g h it still c l o s e d d o w n 16 from t h e p r e v i o u s

t r a d e d s h a r e s w e r e his o w n — s h a r e s t h a t h e h a d

day. W h e n legal a c t i o n w a s t h r e a t e n e d

p u r c h a s e d from b r o k e r s who allowed

t h e refusal of transfer, t h e o r d e r was r e s c i n d e d

large

short-sale positions. Then, even though he had

a n d t h e transfer went through.

bought shares at increasing prices, by d e m a n d ing d e l i v e r y of his s h a r e s H e i n z e i n t e n d e d t o
f o r c e s h o r t s e l l e r s t o c o m e u p with s h a r e s t h a t
t h e y did not p o s s e s s , and could not

possess,

u n l e s s t h e y b o u g h t t h e m from Heinze. T h u s t h e
settlement b e t w e e n Heinze and the short seller
c o u l d b e at a l m o s t a n y p r i c e a n d w o u l d c l e a r l y
p r o v i d e H e i n z e with a profit as long a s t h e r e
w a s n o o t h e r s o u r c e for U n i t e d C o p p e r s h a r e s .
To punish t h e e x c h a n g e h o u s e s that

had

g o n e s h o r t in U n i t e d C o p p e r s t o c k , H e i n z e p u t
o u t a n o r d e r c a l l i n g in a l l h i s U n i t e d

Copper

shares. However, Heinze's actions were

ill-

a d v i s e d b e c a u s e his s u s p i c i o n s of s h o r t s a l e s
turned

out

to

be

unfounded.

Gross

K l e e b e r g found many shares not owned

and
by

On W e d n e s d a y H e i n z e ' s c o r n e r a t t e m p t suff e r e d t h e final blow. G r o s s a n d K l e e b e r g w e r e
f o r c e d to sell U n i t e d C o p p e r s t o c k t o p a y for t h e
s h a r e s p u r c h a s e d earlier on margin.

p r i c e s p r e a d , s o t h e a n t i c i p a t e d t i m e lag b e t w e e n t h e i n c r e a s e in s t o c k p r i c e a n d t h e a d d i tional n u m b e r of s h a r e s for s a l e was insufficient
to s u p p o r t a corner.

United

C o p p e r fell from $ 3 6 t o $ 1 0 a s h a r e , a n d t h e firm
h a d to s u s p e n d o p e r a t i o n s . T h e s a m e day, t h e
brokerage house Otto Heinze and

Company

c l o s e d . It w a s s a i d a t t h e s t o c k m a r k e t t h a t H e i n z e
a n d his b r o k e r s w e r e " t a k e n t o t h e wall." T h e b r o k e r s h a d b o u g h t large a m o u n t s of U n i t e d C o p p e r
s t o c k o n m a r g i n a t i n c r e a s i n g p r i c e s r e s u l t i n g alm o s t e n t i r e l y from t h e i r own p u r c h a s e s . W h e n
t h e y s t o p p e d b u y i n g , t h e p r i c e fell, t h r e a t e n i n g
t h e i r f i n a n c i a l p o s i t i o n . As H e i n z e i n t e r e s t s w e r e
forced to sell t h e i r s h a r e s p u r c h a s e d on margin,
the stock price broke dramatically.

H e i n z e for s a l e at high p r i c e s . M o r e s h a r e s a p p e a r e d o n T u e s d a y a f t e r n e w s o f t h e high s t o c k

against

T h e n e w s p a p e r a t t r i b u t e d t h e failure of t h e
c o r n e r t o t h e m a r k e t pool of s t o c k h e l d by unknown individuals w h o s e transactions

Heinze

had a t t e m p t e d to b l o c k through t h e

transfer

agent. One c o m m e n t a t o r suggests that Amalg a m a t e d C o p p e r i n t e r e s t s , n a m e l y H.H. R o g e r s ,

Heinze's c o r n e r was further thwarted by what

Stillman, and other powerful financiers, were

a p p e a r e d t o b e t h e m a n e u v e r s of an u n k n o w n

" w a i t i n g in t h e w i n g s " t o d e n y H e i n z e a n o p p o r -

g r o u p of individuals d e t e r m i n e d to h i n d e r his

t u n i t y t o c o r n e r t h e m a r k e t in h i s s t o c k ( R o b e r t

s c h e m e by c o n t r o l l i n g a large b l o c k of U n i t e d

S o b e l ) . T h i s a n a l y s i s is f e a s i b l e . If t h e s t o c k w a s

C o p p e r stock. Newspaper sources reported that

traded infrequently, Heinze would not

on T u e s d a y t h e t r a n s f e r a g e n c y of

b e e n a w a r e o f h o w m u c h s t o c k e x i s t e d t o b e un-

United

C o p p e r , T. B u c k i n g h a m , r e f u s e d t o t r a n s f e r o w n -

l o a d e d d u r i n g his c o r n e r m a n e u v e r .

'Banks were Mercantile National, Consolidated

3

2

have

A short sale is a maneuver in which the seller, expect-

N a t i o n a l , M e c h a n i c s a n d T r a d e r s , U n i o n , Bank of

ing prices t o fall, offers stock he or she does not yet

Discount,

own t o b e d e l i v e r e d at a f u t u r e d a t e , t a k i n g p r o f i t s

Riverside,

Northern

National,

and

M e r c h a n t s Exchange N a t i o n a l ; trusts were H u d s o n

f r o m t h e d i f f e r e n c e b e t w e e n c u r r e n t (high) p r i c e s

and E m p i r e (New York Times, lanuary 21, 1907).

t h e y w o u l d be p a i d a n d t h e future (low) prices t h e y

T h e C u r b M a r k e t in t h o s e d a y s a c t u a l l y t o o k place

w o u l d face to acquire the stock.

o u t d o o r s on t h e curb of the street. It later m o v e d indoors and is now the American Stock Exchange.




8 E C O N O M I C REVIEW, MAY/JUNE 1990

s e v e r a l small b a n k s o p e r a t e d by a s s o c i a t e s of
t h e H e i n z e s , a n d b y O c t o b e r 21 r e o r g a n i z a tion of t h e national b a n k s was c o m p l e t e .

The Run on Trusts
By O c t o b e r 21, n o t h i n g r e s e m b l i n g a s y s t e m i c panic had yet stricken t h e banks, as
S p r a g u e p o i n t s out (1910, 250). D e p o s i t o r s at
Mercantile Bank withdrew funds but redep o s i t e d t h e m in o t h e r New York City b a n k s .
T h e c o n d i t i o n s of t h e e c o n o m y , however, w e r e
uncertain. T h e a p p a r a n t lack of liquidity in t h e
financial markets, as d i s c u s s e d a b o v e , s e t t h e
s t a g e for a m a j o r financial crisis to e r u p t from
c i r c u m s t a n c e s t h a t in o t h e r t i m e s m i g h t n o t
have sparked concern.
M a n y h i s t o r i c a l a c c o u n t s of t h e P a n i c of
1907 c i t e M o n d a y , O c t o b e r 21, a s t h e b e g i n ning of t h e crisis a m o n g t h e trust c o m p a n i e s .
On t h a t d a y t h e N a t i o n a l B a n k of C o m m e r c e
a n n o u n c e d that it would s t o p clearing c h e c k s
for t h e K n i c k e r b o c k e r T r u s t C o m p a n y , t h e
third l a r g e s t trust in New York City. However,
Vincent C a r o s s o (1987, 535) s u g g e s t s that t h e
run on K n i c k e r b o c k e r b e g a n O c t o b e r 18, when
Charles Barney, t h e K n i c k e r b o c k e r p r e s i d e n t ,
w a s r e p o r t e d t o h a v e b e e n i n v o l v e d in
H e i n z e ' s c o r n e r m a n e u v e r . Drawing from t h e
p r i v a t e p a p e r s of ).P. M o r g a n , C a r o s s o n o t e s
that t h e N a t i o n a l Bank of C o m m e r c e had
b e e n extending loans to the Knickerbocker
Trust to hold off d e p o s i t o r runs. National Bank
of C o m m e r c e ' s refusal to c o n t i n u e acting a s a
c l e a r i n g a g e n t for K n i c k e r b o c k e r w a s i n t e r p r e t e d a s a v o t e of no c o n f i d e n c e t h a t s e r i ously a l a r m e d K n i c k e r b o c k e r d e p o s i t o r s .
M o r g a n , a l o n g with j a m e s S t i l l m a n of
National City B a n k a n d G e o r g e B a k e r of First
N a t i o n a l B a n k , h a d o r g a n i z e d an i n f o r m a l
t e a m to o v e r s e e relief efforts during t h e panic
at t h e national b a n k s (Carosso 1970, 129; 1987,
538-39). Assisting t h e m w e r e s e v e r a l young financial e x p e r t s r e s p o n s i b l e for evaluating t h e
a s s e t s of t r o u b l e d i n s t i t u t i o n s a n d indicating
which o n e s w e r e worthy of aid. C h i e f a m o n g
t h e s e i n v e s t i g a t o r s was B e n j a m i n S t r o n g of
Banker's Trust C o m p a n y , who would later b e c o m e p r e s i d e n t of t h e F e d e r a l R e s e r v e B a n k
of New York. 4

FEDERAL RESERVE B A N K O F ATLANTA



On M o n d a y e v e n i n g , O c t o b e r 21, M o r g a n
had organized a m e e t i n g of trust c o m p a n y exe c u t i v e s to d i s c u s s ways to halt t h e panic.
Strong r e p o r t e d to Morgan that h e was u n a b l e
to e v a l u a t e Knickerbocker's financial condit i o n in t h e s h o r t t i m e b e f o r e f u n d s w o u l d
h a v e to b e c o m m i t t e d . Unwilling to act on limi t e d i n f o r m a t i o n , Morgan d e c i d e d n o t to aid
t h e trust; this d e c i s i o n k e p t o t h e r institutions
f r o m o f f e r i n g s u b s t a n t i a l a i d a s w e l l . On
O c t o b e r 22 K n i c k e r b o c k e r u n d e r w e n t a run for
t h r e e hours b e f o r e s u s p e n d i n g o p e r a t i o n s
just a f t e r n o o n , having p a i d out $ 8 million in
cash.
Ironically, next to t h e front-page article d e scribing t h e s u s p e n s i o n of t h e K n i c k e r b o c k e r
Trust in t h e W e d n e s d a y , O c t o b e r 23, e d i t i o n
of t h e New York Times was a h e a d l i n e d e s c r i b ing T r u s t C o m p a n y o f A m e r i c a , t h e s e c o n d
largest trust c o m p a n y in New York City, as t h e
current " s o r e point" in t h e panic. By attracting
a t t e n t i o n to T r u s t C o m p a n y , t h e n e w s p a p e r
article greatly e x a c e r b a t e d t h e s e r i o u s run on
it. B a r n e y , w h o w a s p r e s i d e n t o f K n i c k e r bocker, was a l s o a m e m b e r of t h e b o a r d of directors of Trust C o m p a n y of America.
It h a s b e e n a r g u e d t h a t t h e s t a t e m e n t in
t h e New York Times by G e o r g e W. Perkins, o n e
of M o r g a n ' s p a r t n e r s , c i t i n g Trust C o m p a n y ' s
p r o b l e m s a s t h e c u r r e n t " s o r e p o i n t " was an
a t t e m p t t o i s o l a t e t h e p a n i c at an i m p o r t a n t ,
fundamentally s o u n d institution that would
p r e s u m a b l y b e a i d e d through t h e run by t h e
m a j o r f i n a n c i e r s ( F r e d e r i c k Lewis Allen 1949,
2 4 8 - 4 9 ) . Trust C o m p a n y of A m e r i c a was n e a r
t h e Morgan a n d C o m p a n y offices, making it a
likely c a n d i d a t e for such a m a n e u v e r . During
t h e panic, t h e n e w s p a p e r s d e s c r i b e d f r e q u e n t
e x c h a n g e s of b i g l e a t h e r b o x e s b e t w e e n
Morgan offices a n d Trust C o m p a n y offices, signaling t h e e x c h a n g e of m o n e y a n d s e c u r i t i e s .
However, H.L. S a t t e r l e e , Morgan's son-in-law,
l a t e r e m p h a s i z e d t h a t n o b a n k e r would h a v e
p u r p o s e l y s t a r t e d a run on a n y b a n k for f e a r
that t h e panic might e v e n t u a l l y engulf his own
institution a s well (470).
On T u e s d a y , O c t o b e r 22, withdrawals from
Trust C o m p a n y of America w e r e a p p r o x i m a t e ly $ 1 . 5 m i l l i o n ; on t h e W e d n e s d a y w h e n t h e
i l l - t i m e d a r t i c l e was p u b l i s h e d d e p o s i t o r s
c l a i m e d a n o t h e r $13 million of nearly $60 million in total d e p o s i t s . Withdrawals from Trust

7

C o m p a n y of America on Thursday, O c t o b e r 24,
w e r e a further $ 8 million t o $ 9 million. During
t h e s p a n of t h e run, which l a s t e d two w e e k s ,
T r u s t C o m p a n y of A m e r i c a r e p o r t e d l y p a i d
out $47.5 million in d e p o s i t s . 5

Rescue Efforts
Realizing that t h e failure of Trust C o m p a n y
of America a n d Lincoln Trust, a n o t h e r institution w h o s e d i s t r e s s had b e e n p u b l i c i z e d ,
would e n d a n g e r t h e New York m o n e y market,
a c o m m i t t e e of five trust c o m p a n y p r e s i d e n t s
f o r m e d t o a s s i s t t r u s t s in t r o u b l e . N o t all
t r u s t s w e r e willing t o c o o p e r a t e , t h o u g h , s o
t h e c o m m i t t e e was not a b l e to c o l l e c t e n o u g h
m o n e y t o p r o v i d e r e l i a b l e r e l i e f for a t r u s t
c o m p a n y facing a s u d d e n run. T h e y p e t i t i o n e d Morgan for h e l p .
Morgan, Baker, a n d Stillman knew t h a t aid
for Trust C o m p a n y of America was not certain
a n d s a w t h a t t h e c o l l a p s e of s e v e r a l l a r g e
trusts would b e disastrous. Strong had arrived
at Trust C o m p a n y of A m e r i c a s o m e t i m e a f t e r
2:00 A.M. W e d n e s d a y a n d h a d b e g u n t o a p p r a i s e its a s s e t s . T h a t a f t e r n o o n h e r e p o r t e d
t o Morgan t h a t Trust C o m p a n y was b a s i c a l l y
s o u n d and d e s e r v e d a s s i s t a n c e . Morgan c h a n n e l e d a b o u t $ 3 million to Trust C o m p a n y just
b e f o r e c l o s i n g t i m e , w h i c h a l l o w e d it t o r e s u m e b u s i n e s s t h e next day.
Aid b e g a n to c o m e from s e v e r a l o t h e r
s o u r c e s . J.D. R o c k e f e l l e r d e p o s i t e d $10 million with t h e U n i o n T r u s t to h e l p t h e t r u s t s
and a n n o u n c e d his s u p p o r t for Morgan.
S e c r e t a r y of t h e T r e a s u r y G e o r g e C o r t e l y o u
a n d t h e m a j o r New York financiers m e t on t h e
e v e n i n g of W e d n e s d a y , O c t o b e r 23, a n d disc u s s e d p l a n s t o c o m b a t t h e crisis. C o r t e l y o u
d e p o s i t e d $ 2 5 million of t h e Treasury's funds
in n a t i o n a l b a n k s t h e f o l l o w i n g m o r n i n g .
B e t w e e n O c t o b e r 2 1 a n d O c t o b e r 3 1, t h e
Treasury d e p o s i t e d a total of $ 3 7 . 6 million in
New York n a t i o n a l b a n k s a n d p r o v i d e d $ 3 6
million in small bills to m e e t runs. By t h e midd l e of N o v e m b e r , however, t h e U.S. Treasury's
working capital had d w i n d l e d to $5 million.
Thus Treasury could not and did not cont r i b u t e m u c h m o r e aid during t h e r e s t of t h e
p a n i c (Timberlake, 173-78).

8


Crisis on the Stock E x c h a n g e
M e a n w h i l e , b y T h u r s d a y , O c t o b e r 24, call
m o n e y on t h e New York S t o c k E x c h a n g e was
n e a r l y u n o b t a i n a b l e . Call m o n e y was m o n e y
lent for t h e p u r c h a s e of s t o c k equity, with t h e
s t o c k s e r v i n g as c o l l a t e r a l for t h e l o a n s . Call
l o a n s c o u l d b e c a l l e d in a t a n y t i m e . T h e
o p e n i n g rate for call m o n e y was 6 p e r c e n t , but
e x c h a n g e p r e s i d e n t R a n s o n H. T h o m a s n o t i c e d a s e r i o u s scarcity of money. At o n e point
t h a t morning a bid of 6 0 p e r c e n t went out for
call m o n e y . Yet, e v e n at t h a t e x o r b i t a n t rate,
no m o n e y was o f f e r e d . T h e last r e c o r d e d
transaction of t h e day was at t h e o p e n i n g rate
of 6 p e r c e n t (U.S. C o n g r e s s , 3 5 5 ) . F e a r i n g a
t o t a l c o l l a p s e of t h e s t o c k m a r k e t , T h o m a s
c a l l e d S t i l l m a n for a i d . S t i l l m a n r e f e r r e d
T h o m a s to Morgan, who was in control of most
of t h e a v a i l a b l e funds. While T h o m a s t r a v e l e d
to Morgan's office, t h e call m o n e y rate on t h e
e x c h a n g e r e a c h e d 100 p e r c e n t .
In his t e s t i m o n y to t h e Pujo C o m m i t t e e , e s t a b l i s h e d in 1912 b y C o n g r e s s to i n v e s t i g a t e
t h e p o s s i b l e e x i s t e n c e of New York City
money cartels and their potential conspiracy
to p r e c i p i t a t e t h e panic, Morgan's p a r t n e r
Charles S t e e l e d e s c r i b e d efforts to provide
funds to t h e stock market during t h e crisis.
Morgan, who r e p o r t e d l y d i s c u s s e d t h e situation at t h e s t o c k e x c h a n g e with o t h e r b a n k e r s
b e f o r e his m e e t i n g with T h o m a s , told T h o m a s
to a n n o u n c e t h a t $ 2 5 million would b e availa b l e on t h e e x c h a n g e floor. After a short t i m e ,
S t e e l e a r r i v e d a t t h e e x c h a n g e with a list of
national b a n k s which, as a group, p r o m i s e d to
loan $25 million to t h e e x c h a n g e , including $4
million from First National and $8 million from
National City. T h e m a r k e t b o r r o w e d a total of
$ 1 8 . 9 5 million that day (U.S. C o n g r e s s , 457).
I n d i r e c t u s e of T r e a s u r y f u n d s t o f o r e s t a l l
c o l l a p s e of t h e m a r k e t during t h e p a n i c a l s o
c a m e u n d e r scrutiny during t h e Pujo i n v e s t i gation. Legally restricted to national banks,
Treasury d e p o s i t s w e r e c h a n n e l e d toward t h e
b a n k s that m o s t quickly p r e s e n t e d a c c e p t a b l e
c o l l a t e r a l , which for t h e m o s t p a r t m e a n t
T r e a s u r y b o n d s . D i r e c t u s e of T r e a s u r y d e p o s i t s in t h e s t o c k m a r k e t was p r o h i b i t e d . In
testifying to t h e Pujo C o m m i t t e e , however,
Treasury Secretary Cortelyou explained that

E C O N O M I C REVIEW, MAY/JUNE 1990

t h e u s e of T r e a s u r y f u n d s was n o t s p e c i f i e d
b e f o r e t h e y w e r e c r e d i t e d ; rather, t h e m a j o r financiers determined the most appropriate
a p p l i c a t i o n for t h e m o n e y (U.S. C o n g r e s s ,
439). Thus, in e f f e c t , nearly all t h e funds cont r i b u t e d to aid t h e p a n i c w e r e c o n t r o l l e d b y
Morgan, who d e c i d e d how much m o n e y
would b e u s e d a n d where.
Trying to d e t e r m i n e w h e t h e r g o v e r n m e n t
funds were u s e d directly to e a s e t h e credit
s t r a i n on t h e s t o c k m a r k e t , t h e c o u n s e l for
the Pujo C o m m i t t e e , Samuel Untermeyer,
p r e s s e d C o r t e l y o u for i n f o r m a t i o n a b o u t t h e
s p e c i f i c a m o u n t of g o v e r n m e n t d e p o s i t s r e c e i v e d b y e a c h n a t i o n a l b a n k from t h e t o t a l
$25 million a l l o c a t e d . Cortelyou had n o recoll e c t i o n of t h e t r a n s a c t i o n s a n d d i d n o t know
w h e t h e r t h e Treasury had r e c o r d s of t h e m .
E s t i m a t e s of a v a i l a b l e c a s h r e s e r v e s in
New York n a t i o n a l b a n k s i n d i c a t e t h e y w e r e
high e n o u g h t o p r o v i d e f u n d s t o t h e s t o c k
market had g o v e r n m e n t funds b e e n d e n i e d to
t h e e x c h a n g e . On August 22, 1907, New York
national b a n k s held $ 2 1 8 . 8 million. Cash res e r v e s in t h e " b i g s i x " n a t i o n a l b a n k s w e r e
$ 1 4 0 . 7 m i l l i o n . 6 On D e c e m b e r 3, 1 9 0 7 , r e s e r v e s h a d f a l l e n to $ 1 7 7 million for all New
York national b a n k s a n d $ 1 1 2 . 5 million for t h e
"big six." During t h e worst p e r i o d in t h e panic, r e s e r v e s w e r e p r o b a b l y lower. However, to
o f f e r t h e i r own f u n d s t o t h e s t o c k m a r k e t ,
b a n k s would h a v e had to d r o p b e l o w t h e legal
25 p e r c e n t r e s e r v e r e q u i r e m e n t . T h u s Untermeyer's c o n c e r n s w e r e not without a b a s i s d e s p i t e t h e a p p a r e n t a v a i l a b i l i t y of f u n d s from
banks. T h e congressional testimony suggests
that Morgan simply a l l o c a t e d t h e g o v e r n m e n t
d e p o s i t s in n a t i o n a l b a n k s t o t h e s t o c k e x c h a n g e in t h e s a m e a m o u n t s that t h e g o v e r n ment deposited them.
On O c t o b e r 25 a n o t h e r m o n e y pool was required. About $10 million c a m e from t h e Morgan group, $2 million from First National, a n d
$ 5 0 0 , 0 0 0 from Kuhn, L o e b , a n d Company. This
time, however, Morgan a l l o w e d t h e m a r k e t to
d e t e r m i n e t h e call m o n e y rate, which rem a i n e d at nearly 50 p e r c e n t m o s t of t h e day.
T h e Morgan f u n d s h a d r e s t r i c t i o n s d e s i g n e d
to s t i f l e s p e c u l a t i o n . First, n o m a r g i n s a l e s
were a l l o w e d — o n l y cash s a l e s for i n v e s t m e n t .
Also, t h e full a m o u n t of M o r g a n m o n e y was
not r e l e a s e d until a f t e r n o o n . Morgan's partner,

FEDERAL RESERVE B A N K O F ATLANTA



P e r k i n s , n o t e d t h a t t h e m o n e y c o l l e c t e d for
t h e Friday s t o c k e x c h a n g e pool was a b o u t t h e
m o s t that could b e c o l l e c t e d that day and y e t
was b a r e l y e n o u g h to k e e p t h e m a r k e t o p e n
(Allen 1 9 4 9 , 2 5 5 ) . T h r o u g h o u t t h e s t o c k e x c h a n g e crisis, b o t h Trust C o m p a n y of America
a n d Lincoln Trust w e r e s u p p o r t e d by Morgan's
efforts.

Actions of the New York
Clearinghouse Association
While financiers were working out t h e
c r i s e s with t h e trusts and t h e call loan market,
m o n e y a n d r e s e r v e s had b e c o m e increasingly
t i g h t a t b a n k s . On O c t o b e r 2 6 t h e c l e a r i n g h o u s e i s s u e d c l e a r i n g h o u s e loan c e r t i f i c a t e s
a s an artificial m e c h a n i s m to i n c r e a s e t h e s u p ply of currency a v a i l a b l e to t h e public, a tactic
it h a d u s e d in e a r l i e r financial c r i s e s in 1873
and 1893 ( s e e Richard Henry T i m b e r l a k e ,
Gary Gorton, or Ellis Tallman).
Although t h e n a t i o n a l b a n k i n g s y s t e m off e r e d no legal m e c h a n i s m to i n c r e a s e t h e s u p ply of c u r r e n c y quickly, loan c e r t i f i c a t e s
p r o v i d e d an informal (if unlawful) way to f r e e
up a s i z a b l e a m o u n t of c a s h . In normal b u s i ness banks used currency as reserve a s s e t s
a n d a s t h e m e d i u m t o c l e a r a c c o u n t s with
e a c h other. C l e a r i n g h o u s e loan certificates e n a b l e d banks to m o n e t i z e their noncurrency
a s s e t s during a crisis: b a n k s would s u b s t i t u t e
loan certificates for currency in t h e i r clearings,
t h u s r e l e a s i n g t h e currency to pay d e p o s i t o r s
who d e m a n d e d c a s h . Loan c e r t i f i c a t e s w e r e
not r e c o g n i z e d as currency b y t h e p u b l i c or by
d e p o s i t o r s , and t h e y w e r e s u p p o s e d to b e circ u l a t e d o n l y a m o n g b a n k s . However, A. Piatt
Andrew (1908) n o t e d that during t h e 1907
Panic, a n u m b e r of s u b s t i t u t e s for cash w e r e
e m p l o y e d in transactions.
F o l l o w i n g t h e first i s s u e of c l e a r i n g h o u s e
l o a n c e r t i f i c a t e s on O c t o b e r 2 6 d u r i n g t h e
1907 Panic, l o a n s initially i n c r e a s e d by a b o u t
$11 million. During t h e next t h r e e w e e k s m o r e
than $ 1 1 0 million in certificates w e r e i s s u e d in
New York City. Nearly $ 5 0 0 million in currency
s u b s t i t u t e s c i r c u l a t e d t h r o u g h o u t t h e country
as a "principal m e a n s of p a y m e n t , " a c c o r d i n g
to Andrew ( 1 9 1 0 , 515). S p r a g u e h a s criticized

9

t h e c l e a r i n g h o u s e for delaying t h e u s e of loan
c e r t i f i c a t e s until a f t e r t h e p a n i c was well
u n d e r way. H e b e l i e v e d t h a t i s s u i n g c e r t i f i c a t e s as soon as t h e crisis struck t h e trusts
would h a v e c a l m e d t h e market by allowing
b a n k s to a c c o m m o d a t e t h e i r d e p o s i t o r s m o r e
quickly. Aid would h a v e g o n e directly to troub l e d b a n k s a n d trusts, a n d t h e c u m b e r s o m e
d e v i c e of m o n e y p o o l s c o u l d h a v e b e e n
a v o i d e d . F e w e r loans would h a v e b e e n c a l l e d
in, t h u s r e d u c i n g t h e t e n s i o n at t h e s t o c k exc h a n g e ( S p r a g u e 1910, 257-58).
The clearinghouse also restricted the conv e r t i b i l i t y of d e p o s i t s i n t o c a s h — a n a c t i o n
which, like i s s u i n g loan c e r t i f i c a t e s , was illegal. T h e restriction, referred to as " s u s p e n s i o n
of p a y m e n t s , " i n c r e a s e d t r a n s a c t i o n c o s t s .
Nevertheless, banks continued other busin e s s activities such a s a c c e p t i n g d e p o s i t s and
clearing c h e c k s . T h e s u s p e n s i o n of p a y m e n t s
s p r e a d a c r o s s t h e country through t h e s y s t e m
of c o r r e s p o n d e n t b a n k s . Though convertibility
was w i d e l y r e s t o r e d by t h e b e g i n n i n g of
J a n u a r y , in a few i n s t a n c e s loan c e r t i f i c a t e s
a n d o t h e r s u b s t i t u t e s for c a s h c i r c u l a t e d a s
late a s March 1908.

Distress S p r e a d s
New York City g o v e r n m e n t was a l s o n e a r ing a financial crisis of its own. It n e e d e d $ 3 0
million in new funds but had d e l a y e d a b o n d
i s s u e b e c a u s e of t h e situation in t h e financial
markets. T h e city had a t t e m p t e d to float a
b o n d i s s u e in t h e s u m m e r of 1907, b u t e v e n
t h e n t h e b o n d s had not found a m a r k e t .
Though no s o u r c e s p e c i f i e s how t h e New York
City C o m p t r o l l e r f i n a n c e d city e x p e n d i t u r e s
for t h e i n t e r i m , it s e e m s t h e city u s e d s h o r t t e r m l o a n s to p a y its e x p e n s e s until a n o t h e r
b o n d i s s u e could b e a t t e m p t e d . T h e Mayor of
New York, G e o r g e M c C l e l l a n , a p p r o a c h e d
Morgan on Monday, O c t o b e r 28, with t h e city's
financial p r o b l e m s . Short-term obligations
w e r e c o m i n g d u e , a n d t h e city h a d n o f u n d s
with which t o p a y t h e m . Morgan r e c o g n i z e d
that if t h e city d e f a u l t e d on its loans, t h e crisis
could b e c o m e c o m p l e t e l y u n m a n a g e a b l e .
Morgan, Stillman, and Baker thus a g r e e d
on O c t o b e r 2 9 to u n d e r w r i t e a $ 3 0 million, 6
 10


p e r c e n t b o n d i s s u e of New York City. Morgan
d e v i s e d a p l a n in w h i c h t h e m a j o r b a n k s
w o u l d t a k e p r o rata s h a r e s of t h e i s s u e a n d
d e p o s i t t h e m with t h e c l e a r i n g h o u s e . T h e
c l e a r i n g h o u s e would then i s s u e c l e a r i n g h o u s e
loan certificates in an e q u a l a m o u n t and credit t h e m to t h e city's a c c o u n t s at First National
a n d National City.
M e a n w h i l e , t h e l a c k of m o n e y t o t h e call
l o a n m a r k e t was t h r e a t e n i n g t h e b r o k e r a g e
h o u s e of M o o r e a n d Schley. T h e firm had borrowed $25 million from New York b a n k s , placing a large b l o c k of T e n n e s s e e Coal, Iron, and
Railroad C o m p a n y stock as collateral. The
loans w e r e a b o u t to c o m e d u e . To c o m p l i c a t e
m a t t e r s , t h e b r o k e r a g e was a l r e a d y using t h e
s a m e s t o c k as collateral on o t h e r l o a n s it had
g r a n t e d to its s e n i o r partner, Grant B. Schley,
Baker's brother-in-law.
If Moore and S c h l e y l i q u i d a t e d t h e s t o c k to
p a y off its l o a n , t h e p r i c e of t h e s t o c k would
h a v e t u m b l e d , causing t h e call loan market to
b e c o m e e v e n tighter. In t h e face of an already
weak stock market, such a disruption could
h a v e b e e n d i s a s t r o u s , u n d e r m i n i n g confid e n c e e v e n further.
Morgan e v e n t u a l l y s o l v e d t h e p r o b l e m by
giving his s u p p o r t t o a plan d e s i g n e d b y his
attorney and friend, Lewis Cass Ledyard.
L e d y a r d p r o p o s e d that U.S. S t e e l buy M o o r e
a n d S c h l e y ' s s h a r e s of T e n n e s s e e Coal, Iron,
a n d R a i l r o a d , p a y i n g for t h e m with its own
highly rated 5 p e r c e n t gold b o n d s . Carosso
( 1 9 7 0 ) h a s n o t e d t h a t t h i s m a n e u v e r was important for s e v e r a l r e a s o n s . M o o r e and S c h l e y
would b e s a v e d without d e p r e s s i n g t h e stock
m a r k e t , a n d U.S. S t e e l w o u l d b e a b l e t o a b s o r b a c o m p e t i t o r . T h e i n n o v a t i v e a s p e c t of
this a r r a n g e m e n t was that it i n v o l v e d no currency in a market that was a l r e a d y c a s h - s h o r t
from t h e runs on t h e trust c o m p a n i e s . T h e
d e a l w e n t through on M o n d a y , N o v e m b e r 4,
a f t e r P r e s i d e n t R o o s e v e l t a g r e e d n o t to o p p o s e it on antitrust grounds.
T h e crisis at t h e trust c o m p a n i e s c o n t i n u e d
during t h e M o o r e a n d S c h l e y e p i s o d e . Trust
C o m p a n y of A m e r i c a a n d L i n c o l n T r u s t r e quired further aid, and Morgan convinced
o t h e r trust p r e s i d e n t s to s u p p o r t a $25 million
loan for t h e t r o u b l e d i n s t i t u t i o n s . T h e funds
w e r e p r o v i d e d on N o v e m b e r 4 a f t e r s e v e r a l
nights of negotiation. T h e p a n i c b e g a n to e a s e

E C O N O M I C REVIEW, MAY/JUNE 1990

when t h e trust c o m p a n y p r e s i d e n t s organized
b y M o r g a n a g r e e d t o form a c o n s o r t i u m t o
support trust c o m p a n i e s facing runs.
T h e New York C l e a r i n g h o u s e had d e t a i l e d
k n o w l e d g e of t h e q u a l i t y of b a n k a s s e t s in
N e w York. A s i m i l a r , f o r m a l o r g a n i z a t i o n of
trust c o m p a n i e s would have had current
k n o w l e d g e of t h e a s s e t s a n d l i a b i l i t i e s of its
m e m b e r t r u s t s . S u c h an o r g a n i z a t i o n c o u l d
have m o r e readily a s s e s s e d the situation at
trust c o m p a n i e s facing runs t h a n t h e ad h o c
consortiums and m o n e y pools organized by
Morgan. As S p r a g u e h a s a r g u e d a n d e x p e r i e n c e s u p p o r t s , however, t h e l e g i s l a t i v e solut i o n t o a m a j o r c r i s i s is u s u a l l y m o r e
g o v e r n m e n t regulation r a t h e r than i m p r o v e d
industry self-supervision (1910, 273).

The Role of the Trusts
It is n o t s u r p r i s i n g t h a t t r u s t c o m p a n i e s
early on b e c a m e t h e focal p o i n t of t h e panic.
In New York, trust a s s e t s had grown p h e n o m e nally b e t w e e n 1890 a n d 1910, i n c r e a s i n g 2 4 4
p e r c e n t d u r i n g t h e 10 y e a r s e n d i n g in 1907,
from $ 3 9 6 . 7 million to $ 1 , 3 9 4 . 0 million. In c o n t r a s t , n a t i o n a l b a n k a s s e t s grew 9 7 p e r c e n t ,
from $ 9 1 5 . 2 million t o $ 1 , 8 0 0 . 0 million, while
s t a t e - c h a r t e r e d b a n k a s s e t s grew 82 p e r c e n t ,
from $ 2 9 7 million to $ 5 4 1 . 0 million ( B a r n e t t ,
2 3 4 - 3 5 ) . T h u s t h e m a n n e r in which trust c o m panies used their a s s e t s greatly affected the
New York m o n e y market. (For a m o r e d e t a i l e d
a n a l y s i s of t h e role of trusts in t h e panic, s e e
Moen and Tallman.)
Trust c o m p a n i e s w e r e much l e s s r e g u l a t e d
t h a n n a t i o n a l o r s t a t e b a n k s in N e w York. In
1906 New York S t a t e instituted a r e q u i r e m e n t
that trusts maintain r e s e r v e s at 15 p e r c e n t of
d e p o s i t s , but only 5 p e r c e n t of d e p o s i t s
n e e d e d t o b e k e p t a s c u r r e n c y in t h e vault.
B e f o r e t h a t t i m e trusts s i m p l y k e p t w h a t e v e r
r e s e r v e s t h e y felt n e c e s s a r y to c o n d u c t b u s i n e s s . National b a n k n o t e s w e r e a d e q u a t e a s
cash r e s e r v e s for t r u s t s while n a t i o n a l b a n k s
in central r e s e r v e c i t i e s like New York were req u i r e d t o k e e p a 2 5 p e r c e n t r e s e r v e in t h e
form of legal t e n d e r or s p e c i e .
T r u s t s w e r e originally r a t h e r c o n s e r v a t i v e
institutions, managing e s t a t e s , holding securi-

FEDERAL RESERVE B A N K O F ATLANTA 13




t i e s , a n d t a k i n g d e p o s i t s , b u t b y 1907 t r u s t s
w e r e p e r f o r m i n g m o s t of t h e f u n c t i o n s of
b a n k s e x c e p t issuing b a n k n o t e s . Many of t h e
larger trusts s p e c i a l i z e d in underwriting s e c u rity i s s u e s . O t h e r s wrote m o r t g a g e s or i n v e s t e d directly in real e s t a t e — a c t i v i t i e s b a r r e d or
l i m i t e d f o r n a t i o n a l b a n k s . N e w York C i t y
t r u s t s h a d a h i g h e r p r o p o r t i o n of c o l l a t e r a l i z e d l o a n s t h a n d i d N e w York City n a t i o n a l
banks. Conventional banking wisdom assoc i a t e d c o l l a t e r a l i z e d l o a n s with r i s k i e r inv e s t m e n t s and riskier borrowers. T h e trusts,
t h e r e f o r e , h a d an a s s e t p o r t f o l i o t h a t m a y
h a v e b e e n riskier than t h o s e of o t h e r i n t e r m e diaries.
N a t i o n a l a n d p r i v a t e b a n k s f o u n d t h e inv e s t m e n t b a n k i n g functions of trusts s o useful
t h a t m a n y of t h e m g a i n e d d i r e c t o r i n d i r e c t
control of a trust through h o l d i n g c o m p a n i e s
o r b y p l a c i n g t h e i r a s s o c i a t e s on a t r u s t ' s
b o a r d of d i r e c t o r s . In m a n y i n s t a n c e s a b a n k
a n d its a f f i l i a t e d trust o p e r a t e d in t h e s a m e
building.
Trusts a p p e a r to h a v e p r o v i d e d i n t e r m e d i ary f u n c t i o n s d i f f e r e n t from t h o s e of b a n k s .
A l t h o u g h t h e v o l u m e of d e p o s i t s s u b j e c t to
c h e c k a t t r u s t s was s i m i l a r to t h a t at b a n k s ,
trusts had much l e s s clearing activity than did
b a n k s , r e g i s t e r i n g c l e a r i n g s only a b o u t 7 perc e n t of t h e v o l u m e of t h o s e at b a n k s . T r u s t s
w e r e n o t t h e n like c o m m e r c i a l b a n k s , w h o s e
a s s e t s are u s e d as transactions b a l a n c e s by
individual d e p o s i t o r s or firms.
N a t i o n a l b a n k s w e r e p a r t of a n e t w o r k of
r e g i o n a l b a n k s t h a t h a d c o r r e s p o n d e n t relat i o n s h i p s to e x p e d i t e i n t e r r e g i o n a l t r a n s a c t i o n s ( J a m e s , 40). Trusts w e r e not p a r t of t h e
correspondent banking system, so their dep o s i t s w e r e m o r e local a n d l e s s d i r e c t l y s u b j e c t to t h e recurring s e a s o n a l strains on funds.
T h e m o s t s e v e r e r u n s in N e w Y o r k C i t y
w e r e l i m i t e d to t h e trust c o m p a n i e s , n o t t h e
s t a t e or national b a n k s (Moen and Tallman).
T r u s t s ' riskier a s s e t p o r t f o l i o s in c o n j u n c t i o n
with t h e i r a m b i g u o u s r e l a t i o n s h i p to t h e New
York C l e a r i n g h o u s e s i g n a l e d t o d e p o s i t o r s
that t h e trusts w e r e likely to b e c o m e insolv e n t during an e c o n o m i c a n d financial downturn.7 Runs forced trusts to l i q u i d a t e their
m o s t liquid a s s e t s , call l o a n s on t h e s t o c k
m a r k e t . L a r g e - s c a l e l i q u i d a t i o n of call l o a n s
d e p r e s s e d t h e value of stocks.

Given t h e p r e d o m i n a n c e of national b a n k s
in t h e call loan m a r k e t , e x t e n s i v e l i q u i d a t i o n
of call loans by trusts t h r e a t e n e d t h e a s s e t s of
n a t i o n a l b a n k s . Although t r u s t s a n d n a t i o n a l
b a n k s w e r e legally d i s t i n c t , b o t h i n t e r m e d i a r i e s o p e r a t i n g in t h e call m a r k e t w e r e e c o nomically i n t e g r a t e d . It was b e c a u s e national
b a n k s a n d t h e c l e a r i n g h o u s e w e r e aware that
t h e runs on t h e trusts could s p r e a d to t h e e n t i r e financial s y s t e m t h a t t h e y a c t e d d i r e c t l y
to s t o p t h e runs.

Conclusion
S o m e important policy lessons e m e r g e
from this c a s e s t u d y of t h e 1907 Panic.
Restriction of t h e t y p e s of i n v e s t m e n t s national b a n k s c o u l d m a k e in 1907 d i d n o t r e d u c e
t h e overall r i s k i n e s s of t h e financial s y s t e m ' s
a s s e t s ; rather, t h e u n e v e n regulation of trusts
and b a n k s c o n c e n t r a t e d riskier a s s e t s in a few
institutions, primarily t h e trusts. Negative
s h o c k s to trust a s s e t s , n o t a b l y c o l l a t e r a l i z e d
l o a n s , r a i s e d t h e s p e c t e r of t h e i r p o s s i b l e ins o l v e n c y . If r e g u l a t i o n s a l l o w e d i n t e r m e d i a r i e s c o m p a r a b l e a c c e s s t o all a s s e t s a n d
i n v e s t m e n t o p p o r t u n i t i e s , t h e p o t e n t i a l for

a d e q u a t e d i v e r s i f i c a t i o n of p o r t f o l i o s m i g h t
r e d u c e t h e risk t h a t t h e c o l l a p s e of o n e t y p e
of a s s e t would t h r e a t e n t h e s o l v e n c y of an entire class of intermediary.
Nor is it certain that a c c e s s t o t h e New York
Clearinghouse could have averted insolvency
a m o n g thrifts in 1907, given t h e high c o n c e n tration of risk in t h e i r portfolios. Although t h e
clearinghouse functioned to s o m e extent as a
central bank, lack of explicit legal authority to
i s s u e c l e a r i n g h o u s e loan c e r t i f i c a t e s k e p t t h e
c l e a r i n g h o u s e from fully exploiting t h e s e funct i o n s . It did maintain r e c o r d s on t h e financial
h e a l t h of p a r t i c i p a t i n g b a n k s a n d m a d e t h i s
information a v a i l a b l e to m e m b e r s . Thus,
when m e m b e r b a n k s r e q u e s t e d aid, t h e clearinghouse had the information n e c e s s a r y to
m a k e a d e c i s i o n quickly. Trusts' limited affiliation with t h e c l e a r i n g h o u s e m a d e information
a b o u t d i s t r e s s e d trusts h a r d e r to o b t a i n a n d
p r o b a b l y c o n t r i b u t e d to t h e d e s t a b i l i z i n g isolation of t h e K n i c k e r b o c k e r Trust.
Even with a c c e s s to a l e n d e r of last resort,
u n d e r c o n d i t i o n s of u n e v e n r e g u l a t i o n trust
c o m p a n i e s would h a v e had t h e i n c e n t i v e s to
m a i n t a i n p o r t f o l i o s with p r o f i t a b l e b u t risky
a s s e t s . T h e p o t e n t i a l for a f i n a n c i a l c r i s i s to
drive a c l a s s of i n t e r m e d i a r i e s into insolvency
would remain.

Notes
1

K i n d l e b e r g e r refers t o " c o p p e r s p e c u l a t i o n " that inv o l v e d m o r e t h a n j u s t H e i n z e ' s c o r n e r a t t e m p t as a
p r i m e c o n t r i b u t o r to t h e p a n i c . A n a l y s i s of t h e c o p p e r
m a r k e t d u r i n g 1907 is i n t e r e s t i n g (see t h e t e s t i m o n y of
W o l f s o n in U.S. C o n g r e s s ) , b u t t h e d i r e c t l i n k s t o t h e
panic are less clear. T h e c o n n e c t i o n is l e f t for further research.

2

F o r a d i s c u s s i o n o f t h e m o n e y s u p p l y p r o c e s s in t h e
N a t i o n a l B a n k i n g Era, s e e G o o d h a r t or, for a m o r e concise d e s c r i p t i o n , Tallman.
^The a b e r r a t i o n of g o l d flows e x a c e r b a t e d t h e a m o u n t of
g o l d s h i p m e n t s to t h e U n i t e d States w h e n European i m p o r t e r s p a i d for s h i p m e n t s of c o t t o n a n d cereal from t h e
U n i t e d States d u r i n g t h e panic.
4
T h e r e he was recognized as a d e c i s i v e l e a d e r d u r i n g t h e
e a r l y y e a r s of t h e c e n t r a l b a n k . H i s u n t i m e l y d e a t h in
1928, which left t h e y o u n g Federal Reserve System w i t h -

12



o u t f o c u s e d l e a d e r s h i p , has b e e n a r g u e d b y s o m e as
b e i n g t h e r e a s o n f o r t h e F e d ' s i n e p t h a n d l i n g of t h e
bank panics early in the Great D e p r e s s i o n (see
F r i e d m a n and Schwartz).
5

C a r o s s o (1987), c i t i n g f i g u r e s in J.P. M o r g a n ' s p r i v a t e
records. A run on Lincoln Trust, a s m a l l e r i n s t i t u t i o n ,
began w i t h w i t h d r a w a l s e x c e e d i n g $1 m i l l i o n .

6

S p r a g u e (1910, 234). Sprague notes that t h e six national
b a n k s ( N a t i o n a l City, N a t i o n a l Bank of C o m m e r c e , First
N a t i o n a l , Chase N a t i o n a l , Park N a t i o n a l , a n d H a n o v e r
National) had grown from 30 p e r c e n t to 60 p e r c e n t of t h e
t o t a l a s s e t s in N e w York n a t i o n a l b a n k s f r o m 1873 t o
1907.

7

K i n d l e b e r g e r suggests that t h e trusts w e r e r e s p o n s i b l e
for excessive c r e d i t e x p a n s i o n r e l a t e d to s p e c u l a t i v e act i v i t i e s p r i o r t o t h e Panic of 1907.

E C O N O M I C REVIEW, MAY/JUNE 1990

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B a n k i n g P a n i c s . " F e d e r a l R e s e r v e B a n k of A t l a n t a
Economic Review 73 ( N o v e m b e r / D e c e m b e r 1988): 2-21.
T i m b e r l a k e , Richard Henry. The Origins of Central Banking in
the United States. C a m b r i d g e , Mass.: Harvard University
Press, 1978.
U.S. C o n g r e s s . H o u s e . C o m m i t t e e o n U.S. B a n k i n g a n d
Currency. (Pujo C o m m i t t e e . ) Money Trust Investigation
Hearings on H.R. 429, 504. 6 2 d C o n g r e s s , 2 d a n d 3 d
sess., 1913. 3 Vols.

13

Capital Requirements for
Interest-Rate and
Foreign-Exchange Hedges
Larry D. Wall, John J. Pringle, a n d J a m e s E. McNulty

Though U.S. financial regulations have tried to keep pace with depository institutions' use of off-balance-sheet
ing the last 10 years, current regulatory standards governing banks' use of interest-rate and foreign-exchange

items durinstru-

ments focus only on credit risk. This article explains the treatment of the instruments under the current risk-based capital
guidelines. It also proposes an approach that would enable regulators to monitor risk exposure by basing capital requirements on internal risk standards.

D o m e s t i c d e p o s i t o r y institutions a r e p r i m e
p a r t i c i p a n t s in t h e m a r k e t s for i n t e r e s t - r a t e
and foreign-exchange-rate contracts. Com-

m e r e i a i b a n k s a n d s a v i n g s a n d loan a s s o c i a t i o n s can u s e t h e s e i n s t r u m e n t s n o t o n l y t o
c o n t r o l t h e i r own e x p o s u r e b u t a l s o , in large
part, to h e l p c o m m e r c i a l and institutional cust o m e r s m a n a g e t h e i r financial risk. However,
participation in t h e i n t e r e s t - r a t e a n d foreigne x c h a n g e - r a t e market can significantly a l t e r a
d e p o s i t o r y ' s r i s k i n e s s . An institution can u s e
such c o n t r a c t s not only to m i n i m i z e its e x p o s u r e to risk but a l s o to s p e c u l a t e a n d , h e n c e ,
i n c r e a s e its risk. Providing t h e s e i n s t r u m e n t s
to c u s t o m e r s m a y a l s o s u b j e c t an i n s t i t u t i o n
to g r e a t e r risk if t h e products a r e not properly
h e d g e d . M o r e o v e r , p r o d u c t s such as i n t e r e s t rate a n d c u r r e n c y s w a p s can g e n e r a t e c r e d i t
risk s i n c e t h e c o u n t e r p a r t y t o t h e c o n t r a c t
could default on its o b l i g a t i o n s .

Tfie authors are, respectively, a research officer in charge of the financial section of the Atlanta Fed's research department;
Professor
of Finance at the University of North Carolina at Chapel Hill and
visiting professor at the International
Institute for
Management
Development in Lausanne, Switzerland; and a faculty member in
the Department of Finance at Florida Atlantic University. This article is based in part on a chapter titled "interest-Rate Swap Credit
Exposure and Capital Requirements,"
by the same authors, in
I n t e r e s t Rate Swaps, edited by Carl R. Beidleman, to be published by Dow-\ones Irwin in August 1990. The authors
thank
Peter Abken for helpful comments.

B a n k a n d t h r i f t r e g u l a t o r s in t h e U n i t e d
S t a t e s are aware of t h e p o t e n t i a l of t h e s e offb a l a n c e - s h e e t i n s t r u m e n t s to a l t e r d e p o s i t o ries' risk e x p o s u r e s u b s t a n t i a l l y . C o m m e r c i a l
bank regulators have formally incorporated
t h e c r e d i t risk a s s o c i a t e d with i n t e r e s t - r a t e
a n d f o r e i g n - e x c h a n g e i n s t r u m e n t s into t h e i r
r i s k - b a s e d capital s t a n d a r d s . T h e s e s t a n d a r d s
f o c u s s o l e l y on c r e d i t risk, h o w e v e r : b a n k ' s
capital r e q u i r e m e n t s d o not explicitly c o n s i d e r t h e i m p a c t of i n t e r e s t - r a t e risk a n d foreign-

ver the past d e c a d e , off-balances h e e t financial i n s t r u m e n t s u s e d to
h e d g e risk a s s o c i a t e d with i n t e r e s t rate and foreign-exchange-rate fluctuations
h a v e p r o l i f e r a t e d . T h e g r o w t h in b o t h t h e
t y p e s of i n s t r u m e n t s a n d t h e i r s o p h i s t i c a t i o n
can b e t r a c e d to t h e i n c r e a s e d volatility of int e r e s t rates a n d foreign e x c h a n g e rates during
t h e late 1970s and early 1980s, and to t h e rise
in i n t e r n a t i o n a l f i n a n c i a l t r a n s a c t i o n s . N e w
t e c h n o l o g i e s have also b e e n an important catalyst, making it p o s s i b l e to c o m m u n i c a t e a n d
p r o c e s s t h e information n e c e s s a r y to m a n a g e
contracts and e v a l u a t e t h e instruments.

O

14


E C O N O M I C REVIEW, MAY/JUNE 1990

e x c h a n g e risk, a l t h o u g h r e g u l a t o r s h a v e e x p r e s s e d a d e s i r e to include t h e s e c o m p o n e n t s as soon as a practical m e t h o d can b e
determined.
Thrift r e g u l a t o r s , on t h e o t h e r h a n d , h a v e
explicitly i n c o r p o r a t e d i n t e r e s t - r a t e instrum e n t s in c a l c u l a t i n g i n t e r e s t - r a t e r i s k f o r
thrifts' capital r e q u i r e m e n t s . They do not
consider foreign-exchange instruments,
t h o u g h , primarily b e c a u s e very few thrifts
h a v e s i g n i f i c a n t e x p o s u r e in t h i s a r e a ; n o r
d o t h e y i n c l u d e c r e d i t risk a s s o c i a t e d with
i n t e r e s t - r a t e instruments. 1
A review of t h e capital r e q u i r e m e n t s now in
p l a c e surrounding t h e s e i n s t r u m e n t s s u g g e s t s
t h e a d v a n t a g e s of a c c o u n t i n g for t h e i r i m p a c t
on an i n s t i t u t i o n ' s r i s k i n e s s t h r o u g h c a p i t a l
s t a n d a r d s a n d n o t m e r e l y a s an a s p e c t of
credit risk. T h e impracticality of using off-site
m o n i t o r i n g a s a m e t h o d of e v a l u a t i o n s e e m s
t o b e a m a j o r o b s t a c l e t o linking an i n s t i t u tion's i n v o l v e m e n t in t h e s e m a r k e t s with capital r e q u i r e m e n t s . This article reviews existing
c a p i t a l r e q u i r e m e n t s for f o r e i g n - e x c h a n g e rate and i n t e r e s t - r a t e instruments and prop o s e s an a p p r o a c h t h a t is l e s s c u m b e r s o m e ,
more accurate, and potentially more cost effective. T h e discussion b e g i n s by summarizing

FEDERAL RESERVE B A N K O F A T L A N T A




k e y f e a t u r e s of t h e m o s t w i d e l y u s e d c o n tracts to control i n t e r e s t - r a t e and foreigne x c h a n g e - r a t e risk.

Interest-Rate and ForeignE x c h a n g e Instruments
A w i d e variety of i n t e r e s t - r a t e a n d foreigne x c h a n g e i n s t r u m e n t s h a s e m e r g e d to m e e t
risk m a n a g e m e n t n e e d s . In a d d i t i o n t o providing t h e usual kinds of c o n t r a c t s , c o m m e r cial b a n k s a n d o t h e r financial i n t e r m e d i a r i e s
h a v e b e e n i n g e n i o u s in customizing t h e s e ins t r u m e n t s to m e e t c l i e n t s ' p a r t i c u l a r n e e d s .
T h e following d i s c u s s i o n will o u t l i n e s o m e of
t h e key f e a t u r e s of c o m m o n c o n t r a c t s . 2
All i n t e r e s t - r a t e a n d f o r e i g n - e x c h a n g e ins t r u m e n t s are linked in that t h e v a l u e of t h e s e
c o n t r a c t s is a function of f o r e i g n - c u r r e n c y exc h a n g e r a t e s or i n t e r e s t r a t e s a n d t h u s o u t s i d e t h e c o n t r o l of t h e p a r t i c i p a n t s . F o r t h i s
reason they are s o m e t i m e s called derivative
a s s e t s . Another c o m m o n feature of all of t h e s e
i n s t r u m e n t s is t h a t t h e y a r e a z e r o - s u m
g a m e — t h a t is, t h e a m o u n t of p a y m e n t s r e c e i v e d b y o n e party m u s t e q u a l t h o s e m a d e
by t h e o t h e r party. 3

15

An important d i f f e r e n c e distinguishing vario u s c o n t r a c t s is t h a t s o m e a r e t r a d e d on e x changes whereas others are negotiated by the
two p a r t i c i p a n t s . E x c h a n g e - t r a d e d c o n t r a c t s
offer t h e a d v a n t a g e of minimal c r e d i t risk b e c a u s e t h e e x c h a n g e itself is a party to t h e c o n t r a c t . W h e n a firm b u y s , for e x a m p l e , a call
option on an e x c h a n g e , its contract is with t h e
exchange rather than the seller, and t h e exc h a n g e a s s u m e s r e s p o n s i b i l i t y for m a k i n g
p a y m e n t on t h e call. Partly b e c a u s e of t h e red u c t i o n in c r e d i t risk, e x c h a n g e - t r a d e d c o n tracts are also m o r e liquid, making it e a s i e r to
e n t e r into o r c l o s e out a position.
Exchange-traded contracts are, however,
l e s s flexible. T h e s e contracts' fixed maturities
may or may not b e a p p r o p r i a t e for controlling
a firm's e x p o s u r e . A f u r t h e r d i s a d v a n t a g e of
e x c h a n g e - t r a d e d contracts is that t h e y may req u i r e t h e p o s t i n g of m a r g i n — f u n d s s e t a s i d e
t o c o v e r p o t e n t i a l l o s s e s . In t h i s w a y e x c h a n g e s a r e a b l e to e l i m i n a t e t h e c r e d i t risk
of t h e i r c o n t r a c t s . C o n t r a c t s a r e " m a r k e d t o
m a r k e t " p e r i o d i c a l l y , in m o s t c a s e s a t l e a s t
o n c e e v e r y t r a d i n g day, b y transferring funds
from t h e margin to t h e o t h e r party w h e n e v e r
a d v e r s e m o v e s o c c u r in t h e m a r k e t p r i c e of
t h e c o n t r a c t . F o r m o s t ( b u t n o t all) n o n e x c h a n g e contracts no collateral is p o s t e d , nor is
t h e r e a n y t r a n s f e r of f u n d s b e f o r e t h e s e t t l e ment date.
Options, Futures, and F o r w a r d Cont r a c t s . Virtually all i n t e r e s t - r a t e a n d foreigne x c h a n g e - r a t e i n s t r u m e n t s can b e c r e a t e d
from s o m e c o m b i n a t i o n of p u t a n d call o p t i o n s . A c a l l o p t i o n g i v e s its p u r c h a s e r t h e
r i g h t — b u t n o t t h e o b l i g a t i o n — t o purchase a
g i v e n t y p e of a s s e t at a p r e s p e c i f i e d p r i c e
(the e x e r c i s e p r i c e ) at a p r e s p e c i f i e d d a t e in
t h e future (the expiration d a t e ) . 4 For e x a m p l e ,
an i n v e s t o r m a y own an o p t i o n to p u r c h a s e
J a p a n e s e yen at t h e rate of 155 yen p e r dollar
on o r b e f o r e O c t o b e r 1. If t h e y e n ' s m a r k e t
p r i c e on t h e expiration d a t e is 170 p e r dollar,
t h e o w n e r will e x e r c i s e t h e o p t i o n s i n c e t h e
market v a l u e of t h e yen is g r e a t e r than t h e exe r c i s e p r i c e on t h e o p t i o n . If, h o w e v e r , t h e
d o l l a r b u y s 135 yen on O c t o b e r 1, t h e h o l d e r
will not e x e r c i s e t h e o p t i o n b e c a u s e yen may
b e p u r c h a s e d at a lower p r i c e in t h e m a r k e t .
T h e b u y e r t y p i c a l l y p a y s t h e p r i c e of an o p tion (its p r e m i u m ) up front. A put o p t i o n , on

16



t h e o t h e r hand, gives its owner t h e right to sell
an a s s e t a t a f i x e d p r i c e on a p r e s p e c i f i e d
d a t e in t h e future. T h e put o p t i o n is otherwise
a n a l o g o u s to t h e call option. Both t y p e s of opt i o n s a r e t r a d e d on e x c h a n g e s a n d m a y b e
p u r c h a s e d from c e r t a i n f i n a n c i a l i n t e r m e d i a r i e s a s well if e x c h a n g e - t r a d e d o p t i o n s a r e
inadequate.
Another important off-balance-sheet hedging i n s t r u m e n t is t h e futures contract. T r a d e d
on an e x c h a n g e , f u t u r e s c o n t r a c t s o b l i g a t e
o n e party to p u r c h a s e an a s s e t at a fixed price
at a p r e s p e c i f i e d d a t e in t h e f u t u r e . F o r e x a m p l e , a Treasury bill futures contract may req u i r e o n e party to p u r c h a s e , on t h e
p r e s p e c i f i e d d a t e of N o v e m b e r I, for t h e pres p e c i f i e d a m o u n t of $ 9 2 0 , a $ 1,000 T r e a s u r y
bill t h a t m a t u r e s in 3 6 0 d a y s . T h e p a r t y t h a t
b u y s t h e T r e a s u r y bill is s a i d to h a v e " g o n e

"Virtually all interest-rate and foreignexchange-rate instruments can be created from some combination of put and
call options."

l o n g " in T r e a s u r y bill futures, while t h e party
which a g r e e s to s e l l is " s h o r t . " In c o n t r a s t to
o p t i o n s , which i n v o l v e n o o b l i g a t i o n t o t h e
b u y e r a f t e r t h e initial p u r c h a s e , f u t u r e s c o n tracts entail risk for both s i d e s .
A f u t u r e s c o n t r a c t c a n b e c r e a t e d from a
c o m b i n a t i o n of a call a n d put o p t i o n . Taking
t h e l o n g s i d e o f a f u t u r e m a t u r i n g on
S e p t e m b e r 15 with a current price of $ 9 0 5 , for
e x a m p l e , is identical to b u y i n g a call c o n t r a c t
a n d s e l l i n g a p u t c o n t r a c t in which b o t h o p t i o n s m a t u r e on S e p t e m b e r 15 a n d h a v e a
strike price of $905.
Closely r e l a t e d to t h e futures contract is t h e
forward c o n t r a c t . U n l i k e t h e f u t u r e s c o n t r a c t ,
however, t h e forward contract is not t r a d e d on
an e x c h a n g e , typically r e q u i r e s n o p o s t i n g of
margin, is not m a r k e d to market prior to maturity, a n d can b e t a i l o r e d to any maturity.

E C O N O M I C REVIEW, MAY/JUNE 1990

C a p s , F l o o r s , a n d C o l l a r s . O p t i o n s , fut u r e s , a n d forward c o n t r a c t s all i n v o l v e a sing l e t r a n s a c t i o n a t s o m e p o i n t in t h e f u t u r e .
B o n d s a n d m a n y o t h e r c o n t r a c t s t h a t a firm
m i g h t wish to h e d g e , on t h e o t h e r h a n d , inv o l v e m u l t i p l e p a y m e n t s in t h e f u t u r e .
S e v e r a l i n s t r u m e n t s d e v e l o p e d in t h e 1980s
a r e d e s i g n e d t o r e d u c e t h e n u m b e r of c o n tracts r e q u i r e d to h e d g e m u l t i p l e p a y m e n t s .
O n e p o p u l a r c o n t r a c t is an i n t e r e s t - r a t e c a p . 5
In a c a p a g r e e m e n t , s h o u l d t h e m a r k e t r a t e
e x c e e d t h e c a p r a t e , t h e writer ( s e l l e r ) p a y s
t h e p u r c h a s e r an a m o u n t e q u a l to t h e m a r k e t
rate minus t h e c a p rate; in return, t h e borrowe r p a y s a o n e - t i m e f e e in a d v a n c e . T h e e f f e c t
of t h e c a p t h e n is t o s e t a m a x i m u m c o s t on
t h e firm's o u t s t a n d i n g d e b t .
S u p p o s e , for i n s t a n c e , a firm i s s u e s d e b t
with an i n t e r e s t r a t e of LIBOR ( L o n d o n Inter-

"Several instruments developed in the
1980s are designed to reduce the number of contracts required to hedge multiple payments. One popular contract is
an interest-rate cap."

b a n k Offer R a t e ) a n d b u y s a LIBOR c a p of 10
p e r c e n t with t h e notional principal of t h e c a p
e q u a l to t h e principal on t h e l o a n . 6 As long as
t h e LIBOR rate r e m a i n s b e l o w 10 p e r c e n t , t h e
b u s i n e s s will pay that rate on its d e b t a n d rec e i v e nothing from its c a p . S h o u l d t h e LIBOR
r a t e e x c e e d 10 p e r c e n t , t h e firm w o u l d r e c e i v e a p a y m e n t from t h e c a p d e a l e r . If LIBOR
is at 11 p e r c e n t , for e x a m p l e , t h e firm m u s t
pay i n t e r e s t e q u a l t o 11 p e r c e n t of t h e loan
principal to its d e b t h o l d e r s b u t will r e c e i v e a
p a y m e n t e q u a l t o 1 p e r c e n t of t h e n o t i o n a l
p r i n c i p a l . B e c a u s e t h e n e t v a l u e of t h e two
p a y m e n t s is 10 p e r c e n t , t h e b u s i n e s s ' s n e t int e r e s t p a y m e n t s a r e c a p p e d a t 10 p e r c e n t .
I n t e r e s t r a t e c a p s a r e " o v e r - t h e - c o u n t e r ins t r u m e n t s " ; t h a t is, t h e y are not t r a d e d on an
e x c h a n g e b u t m a y b e p u r c h a s e d from s o m e
large c o m m e r c i a l and i n v e s t m e n t b a n k s .

FEDE
R AFRASER
L RESERVE B A N K O F A T L A N T A
Digitized
for


C a p s r e s e m b l e o p t i o n s in two r e s p e c t s : t h e
b u y e r of t h e c a p m u s t m a k e an up-front paym e n t , a n d after t h e contract is s i g n e d only t h e
c a p w r i t e r is at risk. M a j o r d i f f e r e n c e s e x i s t
b e t w e e n t h e two c o n t r a c t s , n o n e t h e l e s s .
W h e r e a s an o p t i o n t y p i c a l l y e n t a i l s p u r c h a s ing an a s s e t a t a fixed p r i c e , a c a p i n v o l v e s
p a y i n g only an i n t e r e s t d i f f e r e n t i a l . A n o t h e r
d i s t i n c t i o n is t h a t t h e p a y m e n t s u n d e r a c a p
a r e l i n k e d ; if t h e s e l l e r of a c a p d e f a u l t s on
o n e p a y m e n t , t h e n t h e r e s t of t h e p a y m e n t s
under the cap are terminated, though the
b u y e r can still s u e for t h e n e t p r e s e n t v a l u e
(including t h e future i n t e r e s t e a r n i n g s ) of t h e
future p a y m e n t s .
A f l o o r is an o p t i o n - l i k e i n t e r e s t - r a t e risk
m a n a g e m e n t tool similar to a cap, e x c e p t that
a floor s e t s a minimum rather than a maximum
r a t e . T h u s in a f l o o r a g r e e m e n t , s h o u l d t h e
m a r k e t r a t e d r o p b e l o w t h e floor, t h e writer
( s e l l e r ) p a y s t h e p u r c h a s e r an a m o u n t e q u a l
to t h e floor rate m i n u s t h e m a r k e t rate. Floor
a g r e e m e n t s can b e particularly useful to t h o s e
i n v e s t i n g in f l o a t i n g - r a t e d e b t i n s t r u m e n t s
who n o n e t h e l e s s h a v e f i x e d - r a t e o b l i g a t i o n s .
C o n s i d e r , for e x a m p l e , an i n s u r a n c e c o m p a n y
that w a n t s to fund t h e p u r c h a s e of a floatingrate a s s e t with r e c e i p t s from t h e s a l e of fixedrate a n n u i t i e s . If t h e i n t e r e s t rate on its a s s e t
d r o p s b e l o w t h e rate on its a n n u i t i e s , t h e ins u r a n c e firm will incur a loss. A floor arrangem e n t , however, would a s s u r e t h e firm that t h e
c o m b i n e d return from t h e d e b t a n d t h e
a g r e e m e n t will e x c e e d its c o s t of its annuities.
F l o o r a g r e e m e n t s , like c a p s , a r e t r a d e d o v e r
t h e c o u n t e r rather than on e x c h a n g e s .
Collar a g r e e m e n t s c o m b i n e buying a cap
a n d writing a floor in which t h e c a p rate differs
from t h e floor rate. A collar is useful to contain
t h e e f f e c t i v e i n t e r e s t c o s t s of a f l o a t i n g - r a t e
d e b t i s s u e within a narrow b a n d . S u p p o s e a
firm i s s u e s d e b t with an i n t e r e s t rate of LIBOR
a n d e n t e r s into a collar, with t h e floor rate s e t
at 9 p e r c e n t and t h e c a p rate s e t at 11 p e r c e n t .
If LIBOR r a t e s d r o p b e l o w 9 p e r c e n t , t h e firm
will pay a total of 9 p e r c e n t : t h e d e b t h o l d e r s
will r e c e i v e LIBOR, a n d t h e o t h e r party to t h e
collar, 9 p e r c e n t m i n u s LIBOR. T h e b u s i n e s s
will p a y L I B O R , a n d n o p a y m e n t s will b e
made under the collar a g r e e m e n t should
L I B O R s t a n d b e t w e e n 9 a n d I 1 p e r c e n t . If
LIBOR e x c e e d s 11 p e r c e n t , t h e firm's n e t c o s t

17

will b e 11 p e r c e n t : t h e d e b t h o l d e r s will r e c e i v e LIBOR a n d t h e w r i t e r of t h e c o l l a r will
p a y t h e firm LIBOR m i n u s 1 1 p e r c e n t . F i r m s
wishing to c a p t h e i r i n t e r e s t p a y m e n t s without
paying an up-front f e e to c o v e r t h e c o s t of t h e
c a p may c h o o s e c o l l a r s ( b e c a u s e t h e c o s t of
purchasing a c a p can b e offset b y t h e i n c o m e
from writing a floor). 7 Collars are an o v e r - t h e c o u n t e r instrument.

p r i n c i p a l at t h e e n d of t h e loan. Currency
swaps, like i n t e r e s t - r a t e swaps, are not t r a d e d
on an e x c h a n g e .

S w a p s . I n t e r e s t - r a t e s w a p s , in which t w o
parties exchange interest-rate payments, are
a n o t h e r p o p u l a r risk m a n a g e m e n t t o o l . T h e
m o s t c o m m o n v e r s i o n of t h e i n t e r e s t - r a t e
swap r e q u i r e s o n e party to pay a fixed rate of
i n t e r e s t while receiving a floating i n t e r e s t rate
from t h e o t h e r party. A f i x e d - t o - f l o a t i n g - r a t e
i n t e r e s t - r a t e swap can effectively convert a
floating-rate o b l i g a t i o n to a f i x e d - r a t e obligation (or v i c e v e r s a ) . An i n t e r e s t - r a t e s w a p is
s i m i l a r t o a c o l l a r in which t h e f l o o r a n d c a p
r a t e s are e q u a l . A swap might a l s o b e viewed
as a l i n k e d s e t of forward c o n t r a c t s . I n t e r e s t rate swaps are usually arranged s o that n o upfront p a y m e n t is r e q u i r e d from e i t h e r party.

E x c h a n g e - t r a d e d i n t e r e s t - r a t e a n d foreignexchange instruments are regulated by the
e x c h a n g e s and, domestically, by t h e United
S t a t e s Commodity Futures Trading Commission. No U.S. g o v e r n m e n t organization directly r e g u l a t e s t r a n s a c t i o n s of i n s t r u m e n t s n o t
t r a d e d on an e x c h a n g e . A l t h o u g h b o t h c o m mercial b a n k and thrift regulators h a v e e s t a b l i s h e d r e g u l a t i o n s t o t e m p e r t h e i m p a c t of
t h e s e i n s t r u m e n t s on t h e s a f e t y a n d s o u n d n e s s of b a n k s , n o n e of t h e f e d e r a l r e g u l a t o r s
of d e p o s i t o r y i n s t i t u t i o n s h a v e r e s p o n s i b i l i t y
for t h e markets in t h e s e i n s t r u m e n t s .

I n t e r e s t - r a t e swap a g r e e m e n t s a r e not trade d on an e x c h a n g e . In o r d e r t o r e d u c e t h e
c r e d i t risk a s s o c i a t e d with a swap, t h e p a r t i e s
d o n o t actually e x c h a n g e t h e full v a l u e of t h e
i n t e r e s t p a y m e n t s . Instead, t h e d i f f e r e n c e b e t w e e n t h e fixed a n d floating r a t e s is calculate d , and a single n e t p a y m e n t is written by t h e
party owing t h e g r e a t e r a m o u n t of interest.
A n o t h e r t y p e o f s w a p is a c u r r e n c y e x c h a n g e in w h i c h two p a r t i e s a g r e e t o t r a d e
p a y m e n t s in d i f f e r e n t c u r r e n c i e s a t a p r e d e t e r m i n e d e x c h a n g e rate. For e x a m p l e ,
S o u t h e a s t M a n u f a c t u r i n g might borrow Swiss
francs in t h e E u r o b o n d market and u s e a currency swap to convert t h e obligation to dollars. In such an a g r e e m e n t t h e c o m p a n y could
pay an initial a m o u n t in Swiss francs e q u a l to
t h e principal on t h e loan, m a k e p e r i o d i c intere s t p a y m e n t s in U.S. d o l l a r s , a n d m a k e t h e
last p a y m e n t of i n t e r e s t a n d principal in U.S.
dollars. In return, t h e firm would r e c e i v e U.S.
dollars at t h e initial d a t e and r e c e i v e i n t e r e s t
a n d p r i n c i p a l in S w i s s f r a n c s . T h e s w a p n o t
only effectively changes the borrowed Swiss
francs to dollars but also provides a prea r r a n g e d e x c h a n g e rate for c o n v e r t i n g
S o u t h e a s t ' s d o l l a r s into francs. T h e s e in turn
will b e u s e d to p a y i n t e r e s t a n d r e p a y t h e

18


Regulation of Interest-Rate and
Foreign-Exchange Instruments

T h r i f t s a n d I n t e r e s t - R a t e Risk M a n a g e m e n t . Although thrifts h a v e t r a d i t i o n a l l y had
m i s m a t c h e d a s s e t and liability maturities that
call for m e a s u r e s to contain i n t e r e s t - r a t e risk,
most h e d g i n g t e c h n i q u e s w e r e n o t s p e c i f i c a l ly a u t h o r i z e d for thrifts by regulation until t h e
early 1980s. 8 In 1981, for t h e first t i m e , thrifts
were officially p e r m i t t e d to use futures
and o p t i o n s to control t h e i r interest-rate
risk. F u t u r e s , h o w e v e r , p r o v e d a p o o r h e d g i n g i n s t r u m e n t f o r m a n y t h r i f t s . A l o o k at
t h r i f t s ' e x p e r i e n c e with f u t u r e s i l l u s t r a t e s
why r e g u l a t o r s b e g a n t o e n c o u r a g e s w a p s as
an a l t e r n a t i v e way of m a n a g i n g i n t e r e s t - r a t e
risk.
Using f i n a n c i a l f u t u r e s to h e d g e i n t e r e s t rate risk r e q u i r e s a thrift to t a k e a short p o s i t i o n in t h e f u t u r e s m a r k e t . B e c a u s e m o s t
t h r i f t s s u f f e r l o s s e s w h e n i n t e r e s t r a t e s inc r e a s e ( s i n c e a large s h a r e of t h e i r a s s e t s are
at f i x e d , l o n g - t e r m r a t e s ) , t h e y n e e d an offb a l a n c e - s h e e t h e d g e that rises in v a l u e when
interest rates increase. Futures a g r e e m e n t s
p r o v i d e for t h e p u r c h a s e or s a l e of a d e b t s e curity, in which t h e value of t h e underlying s e curity d e c r e a s e s a s r a t e s go up. T h e o p t i m a l
futures h e d g e for a thrift t h e r e f o r e i n v o l v e s a
p r o m i s e to sell t h e a s s e t at a fixed price in t h e
future. This p l a c e s t h e thrift in a "short" position. What h a p p e n e d b e t w e e n 1982 a n d 1986,

E C O N O M I C REVIEW, MAY/JUNE 1990

of c o u r s e , was that i n t e r e s t r a t e s fell s u b s t a n tially s o that t h e v a l u e of t h e underlying a s s e t
i n c r e a s e d . As a r e s u l t , m a n y t h r i f t s e x p e r i e n c e d h u g e l o s s e s on t h e i r futures h e d g e p o sitions. E v e n t h e m o s t well c o n s t r u c t e d s h o r t
h e d g e in t h e financial futures market will prod u c e l o s s e s if i n t e r e s t r a t e s d r o p b e c a u s e t h e
h e d g e position h a s b e e n e s t a b l i s h e d p r e c i s e ly to p r o d u c e g a i n s that will p r o t e c t t h e institution if rates rise.
A n o t h e r d r a w b a c k of f u t u r e s p o s i t i o n s is
that, u n l i k e s w a p s , t h e y m u s t b e m a r k e d t o
market daily. Thrifts, like m o s t financial instit u t i o n s , follow a c c o u n t i n g p r a c t i c e s w h e r e b y
a s s e t s g e n e r a l l y are c o u n t e d at t h e i r b o o k
value rather than market value. However, mark e t l o s s e s on f u t u r e s p o s i t i o n s h a v e t o b e
r e c o r d e d as such i m m e d i a t e l y , although t h e i r
r e c o g n i t i o n in t h e i n c o m e s t a t e m e n t is n o r mally d e f e r r e d o v e r t h e t i m e remaining to mat u r i t y o f t h e i n s t r u m e n t b e i n g h e d g e d . In
a d d i t i o n , margin calls on futures c o n t r a c t s to
offset l o s s e s to t h e e x c h a n g e c r e a t e an i m m e diate cash outflow for t h e thrift.
T h e c o m b i n a t i o n of l a r g e d e f e r r e d l o s s e s
and cash outflows as a result of declining interest rates created t r e m e n d o u s psychological
p r o b l e m s for an industry that had just e x p e r i e n c e d huge s e t b a c k s b e c a u s e of rising i n t e r e s t
rates during t h e 1979-82 p e r i o d . T h e s e l o s s e s
c o n v i n c e d m a n y b o a r d s of d i r e c t o r s , a s well
as regulators, that futures a r e not a p p r o p r i a t e
h e d g i n g t o o l s for thrifts. 9 Nor d o many thrifts
p o s s e s s t h e l e v e l of e x p e r t i s e n e c e s s a r y t o
m a n a g e futures p o s i t i o n s . T h e fact t h a t T r e a sury b i l l f u t u r e s c o n t r a c t s e x t e n d o n l y t w o
years forward a l s o m a k e s t h e futures m a r k e t s
impractical for institutions that want to h e d g e
long-term liability c o s t s .
T h e i n t e r e s t - r a t e swap market, and to a less e r e x t e n t t h e market for c a p s and collars, b e c a m e a natural a l t e r n a t i v e for thrift f i n a n c i a l
managers seeking to avoid t h e s e problems.
Thrift regulators' e n d o r s e m e n t s of such " c a s h
market" hedging as interest-rate swaps and
i n t e r e s t - r a t e c a p s , in lieu of f u t u r e s h e d g i n g ,
p r o v i d e d t h r i f t s with a n o t h e r s t i m u l u s t o
switch to swaps as a way of managing i n t e r e s t rate risk. C a p s , collars, a n d s w a p s d o n o t e n tail margin calls, a n d o t h e r p r o b l e m s such as
b a s i s risk (arising from c h a n g e s in t h e s p r e a d
b e t w e e n rates) are more m a n a g e a b l e . Many

FEDERAL RESERVE B A N K O F A T L A N T A




thrift f i n a n c i a l m a n a g e r s t h u s b e c a m e m o r e
c o m f o r t a b l e with swaps than with o t h e r h e d g ing t e c h n i q u e s .
R e s e a r c h h a s c o n f i r m e d t h e s u i t a b i l i t y of
s w a p s for h e d g i n g m o r t g a g e portfolios. R o b e r t
C r a n e a n d P e t e r E l m e r s i m u l a t e d t h e perform a n c e of a n u m b e r of a s s e t a n d liability struct u r e s for a f i n a n c i a l i n s t i t u t i o n u n d e r 1 , 5 0 0
different i n t e r e s t - r a t e s c e n a r i o s . T h e s t r a t e g y
that p r o v e d b e s t on a risk-return b a s i s was to
fund f i x e d - r a t e a s s e t s (in t h i s c a s e , 1 5 - y e a r
m o r t g a g e s ) with d e p o s i t s t h a t h a d b e e n e x t e n d e d in m a t u r i t y t h r o u g h i n t e r e s t - r a t e
s w a p s . In f a c t , s w a p s p e r f o r m e d s o w e l l in
t h e s e s i m u l a t i o n s t h a t t h e y r e d u c e d t h e risk
of 1 5 - y e a r f i x e d - r a t e m o r t g a g e s b e l o w t h a t of
a strategy b a s e d on a d j u s t a b l e - r a t e lending.
M a t u r i t y M a t c h i n g C r e d i t . O n e regulatory
d e v e l o p m e n t t h a t s t i m u l a t e d t h e growth of
t h e s w a p m a r k e t was t h e m a t u r i t y m a t c h i n g
c r e d i t , o n e of t h e e a r l i e s t formal r i s k - b a s e d
capital r e q u i r e m e n t s , i n s t i t u t e d by t h e
F e d e r a l H o m e Loan Bank Board in 1987. T h e
maturity m a t c h i n g c r e d i t r e d u c e d t h e c a p i t a l
r e q u i r e m e n t for thrifts if t h e i r a s s e t - l i a b i l i t y
g a p ( t h e a m o u n t by which its l i a b i l i t i e s of a
given maturity e x c e e d a s s e t s of t h e s a m e maturity) r a n g e d b e t w e e n 15 a n d 25 p e r c e n t of
total a s s e t s . Institutions whose cumulative
o n e - and t h r e e - y e a r g a p s w e r e both b e l o w 15
p e r c e n t w o u l d q u a l i f y for a c r e d i t e q u a l t o 2
p e r c e n t of a s s e t s , while t h o s e with g a p s in t h e
15 to 25 p e r c e n t range would r e c e i v e credit on
a s l i d i n g s c a l e . T h u s a t h r i f t with g a p s l e s s
than 15 p e r c e n t , which would o t h e r w i s e h a v e
b e e n r e q u i r e d to hold c a p i t a l e q u a l to 5 p e r c e n t of a s s e t s , could lower its r e q u i r e m e n t to
3 p e r c e n t . T h e maturity m a t c h i n g c r e d i t prov i d e d u n d e r c a p i t a l i z e d thrifts with a strong inc e n t i v e to h e d g e , t h u s giving a further b o o s t
to participation in t h e swap market.
T a b l e 1 s h o w s how a s w a p would qualify a
thrift to r e c e i v e maturity matching credit. This
h y p o t h e t i c a l i n s t i t u t i o n h a s t o t a l a s s e t s of
$ 1 0 0 m i l l i o n , $ 7 0 million of which h a s a m a turity m o r e than t h r e e years. T h e thrift has $ 1 0
million in a s s e t s of o n e y e a r o r l e s s a n d $ 4 0
million in l i a b i l i t i e s of o n e y e a r o r l e s s . T h u s
its o n e - y e a r a s s e t - l i a b i l i t y g a p is a n e g a t i v e
$ 3 0 m i l l i o n — 3 0 p e r c e n t of its a s s e t s . Its c u mulative t h r e e - y e a r g a p is a n e g a t i v e $ 4 0 million, or 40 p e r c e n t of a s s e t s . B e c a u s e b o t h its

19

Table 1.
Gap Analysis
First Federal Savings and Loan Association
Maturity or Time to Repricing:
Under

One to

Over

O n e Year

Three Years

Three Years

Total

Before Hedging:
Assets

10

20

70

100

Liabilities a n d Net Worth

40

30

30

100

G A P (A - L)

-30

-10

40

Cumulative G A P

-30

-40

0

Assets

10

20

70

100

Liabilities a n d Net Worth

40

30

30

100

After Hedging:

Adjustment of
Liabilities for Hedging*

-25

0

25

0

Liabilities after Hedging

15

30

55

100

G A P (A - L)

-5

-10

15

Cumulative G A P

-5

-15

0

*The hedge is a $25 million interest-rate swap that converts variable-rate liabilities into fixed-rate liabilities.

o n e - a n d t h r e e - y e a r g a p s e x c e e d 25 p e r c e n t
of its a s s e t s , t h e institution would not qualify
for t h e m a t u r i t y m a t c h i n g c r e d i t a n d t h u s
would b e r e q u i r e d to hold capital at 5 p e r c e n t
of a s s e t s .
By e n t e r i n g into a $ 2 5 million i n t e r e s t - r a t e
swap as the fixed-rate payer, the institution
w o u l d b e a b l e t o r e d u c e b o t h its o n e - y e a r
a n d t h r e e - y e a r g a p s b e l o w 15 p e r c e n t s o that
it would q u a l i f y for t h e full 2 p e r c e n t c r e d i t .
T h i s a d j u s t m e n t occurs b e c a u s e t h e swap ext e n d s t h e maturity of t h e short-term liabilities
( m o s t likely d e p o s i t s or r e p u r c h a s e a g r e e m e n t s ) b e y o n d t h r e e years. T h e line " a d j u s t m e n t of l i a b i l i t i e s for h e d g i n g " in T a b l e 1
shows that short-term liabilities h a v e b e e n red u c e d by $ 2 5 million while l o n g - t e r m liabilities have i n c r e a s e d by t h e s a m e amount,
lowering t h e o n e - y e a r g a p to a n e g a t i v e 5 perc e n t a n d t h e t h r e e - y e a r g a p to a n e g a t i v e 15
p e r c e n t of a s s e t s .

20



A survey of s o u t h e a s t e r n thrifts in m i d - 1 9 8 9
b y Craig Ruff s h o w e d t h a t t h o s e m o s t likely
t o e n g a g e in h e d g i n g w e r e t h e o n e s with n e t
worth r a t i o s b e t w e e n 3 a n d 6 p e r c e n t of ass e t s — p r e c i s e l y t h e t y p e of thrift t h a t would
b e n e f i t from t h e maturity matching credit.
A d d i t i o n a l R e g u l a t o r y I n i t i a t i v e s . Two
1989 regulatory initiatives by t h e Federal Home
L o a n B a n k B o a r d will p r o b a b l y f u r t h e r e n c o u r a g e thrifts to u s e swaps. Thrift Bulletin 13,
which s e t out specific r e s p o n s i b i l i t i e s for mana g e m e n t and b o a r d s of directors in controlling
i n t e r e s t - r a t e risk, r e q u i r e s e a c h i n s u r e d
thrift's b o a r d of d i r e c t o r s to s e t s p e c i f i c limits
on t h e institution's e x p o s u r e to c h a n g e s in int e r e s t rates. T h e s e limits apply to b o t h the
p e r c e n t a g e c h a n g e in net i n t e r e s t i n c o m e and
t h e p e r c e n t a g e c h a n g e in t h e market v a l u e of
t h e n e t worth of t h e institution. Thrift Bulletin
13 also r e q u i r e s that e a c h institution with o v e r
$ 5 0 0 m i l l i o n in a s s e t s p e r f o r m a s i m u l a t i o n

E C O N O M I C REVIEW, MAY/JUNE 1990

a n a l y s i s to e s t i m a t e its e x p o s u r e t o c h a n g e s
in i n t e r e s t rates.
T h e r a t i o n a l e for t h i s r e g u l a t i o n was t h a t
b o a r d s of directors s h o u l d act as t h e first line
of d e f e n s e against e x c e s s i v e i n t e r e s t - r a t e risk.
Although it has d e c l i n e d s i n c e 1984 when t h e
F e d e r a l H o m e Loan Bank Board first b e g a n to
m e a s u r e it, m o s t t h r i f t s c o n t i n u e t o h a v e a
large a m o u n t of i n t e r e s t - r a t e e x p o s u r e .
R e g u l a t o r s e x p e c t d i r e c t o r s who s e e n u m e r ical e s t i m a t e s i n d i c a t i n g high i n t e r e s t - r a t e
e x p o s u r e at t h e i r institution to force m a n a g e m e n t to r e s t r u c t u r e t h e b a l a n c e s h e e t o r e n g a g e in o f f - b a l a n c e - s h e e t hedging.
A n o t h e r 1989 r e g u l a t i o n likely to p r o m o t e
h e d g i n g is t h e r i s k - b a s e d c a p i t a l p r o p o s a l ,
which c o n n e c t s thrifts' capital r e q u i r e m e n t s to
t h e i m p a c t c h a n g e s in i n t e r e s t r a t e s are likely
to h a v e on t h e m a r k e t v a l u e of t h e i n s t i t u t i o n ' s n e t w o r t h . S p e c i f i c a l l y , it s t a t e s t h a t
thrifts m u s t h o l d c a p i t a l e q u a l t o o n e - h a l f of
t h e c h a n g e in t h e m a r k e t v a l u e of n e t worth
that would result from a 2 0 0 - b a s i s - p o i n t (or 2
p e r c e n t a g e p o i n t ) c h a n g e in i n t e r e s t r a t e s . 1 0
institutions with large a m o u n t s of i n t e r e s t - r a t e
risk t h u s n e e d to h o l d m o r e c a p i t a l , a n d
h e d g i n g t h e i n t e r e s t - r a t e risk t h r o u g h c a p s ,
collars, or s w a p s b e c o m e s an a t t r a c t i v e a l t e r native.
Apart from 1989 risk-control initiatives, t h e
Financial I n s t i t u t i o n s R e f o r m , R e c o v e r y , a n d
E n f o r c e m e n t Act of 1989 (FIRREA) i n c l u d e s a
p r o v i s i o n r e q u i r i n g t h e Office of Thrift
Supervision (OTS) to e s t a b l i s h r i s k - b a s e d
c a p i t a l r e g u l a t i o n s no l e s s s t r i n g e n t than
t h o s e i m p o s e d on nationally c h a r t e r e d b a n k s
(Title III, S e c t i o n 5). Although t h e FIRREA provision d o e s not r e q u i r e OTS s t a n d a r d s to
e q u a l national b a n k s t a n d a r d s exactly, its e n forcement could mean that commercial bank
r e g u l a t i o n s for i n t e r e s t - r a t e a n d f o r e i g n - e x c h a n g e instruments might a l s o b e i m p o s e d on
thrifts.

Regulation of Commercial Banks'
Use of Hedging Tools
B e c a u s e c o m m e r c i a l b a n k s have historically
b e e n far l e s s e x p o s e d to i n t e r e s t - r a t e c h a n g e s
than m o s t thrifts, regulation of b a n k participa-

FEDERAL RESERVE B A N K O F A T L A N T A




tion in t h e i n t e r e s t - r a t e a n d f o r e i g n - e x c h a n g e
instruments market has followed a different
c o u r s e . Although large c o m m e r c i a l b a n k s routinely t a k e f o r e i g n - e x c h a n g e risks, l o s s e s from
such i n v o l v e m e n t h a v e not b e e n a significant
f a c t o r u n d e r m i n i n g t h e f i n a n c i a l s t a b i l i t y of
any m a j o r b a n k in r e c e n t y e a r s . Bank regulators h a v e b e e n c o n c e r n e d primarily with c r e d it risk. T h o u g h t h e y h a v e b e e n i n c r e a s i n g l y
s e n s i t i v e t o o f f - b a l a n c e - s h e e t i t e m s , U.S.
b a n k r e g u l a t o r s d i d n o t c o n s i d e r t h e m formally until 1986. Capital r e g u l a t i o n s a d o p t e d
in t h e United S t a t e s in 1981 a n d still in e f f e c t
through 1989, for e x a m p l e , a p p l i e d only to onb a l a n c e - s h e e t a s s e t s . In 1988, h o w e v e r , t h e
G r o u p of T e n countries, plus L u x e m b o u r g and
S w i t z e r l a n d , r e a c h e d an a c c o r d , c a l l e d t h e
B a s l e A g r e e m e n t , on new p r o c e d u r e s for evaluating c a p i t a l . " T h e new s t a n d a r d s e x t e n d to
o f f - b a l a n c e - s h e e t activities and weight both
on- a n d o f f - b a l a n c e - s h e e t activities according
to t h e i r c r e d i t r i s k i n e s s . 1 2 I n t e r e s t - r a t e a n d
f o r e i g n - e x c h a n g e - r a t e risk a r e not, h o w e v e r ,
explicitly i n c o r p o r a t e d into t h e capital g u i d e lines.
Although t h e B a s l e A g r e e m e n t a p p l i e d only
t o l a r g e b a n k i n g o r g a n i z a t i o n s with i n t e r n a tional o p e r a t i o n s r e g u l a t e d by t h e signatories,
U.S. r e g u l a t o r s h a v e d e c i d e d to i m p o s e t h e
r e q u i r e m e n t s on all d o m e s t i c c o m m e r c i a l
b a n k s as well. T h e s e s t a n d a r d s have s i n c e
b e e n further e x t e n d e d to c o v e r t h e E u r o p e a n
C o m m u n i t y (EC) a n d t h e E u r o p e a n F r e e
Trade Association (EFTA).13 One important
limitation of t h e a g r e e m e n t is t h a t t h e capital
s t a n d a r d s d o n o t n e c e s s a r i l y a p p l y t o firms
not r e g u l a t e d b y central b a n k s o r o t h e r c o m m e r c i a l b a n k o v e r s e e r s . U.S. i n v e s t m e n t
b a n k i n g a n d i n s u r a n c e c o m p a n i e s , for e x a m p l e , a r e n o t r e g u l a t e d b y U.S. f e d e r a l b a n k
regulatory agencies and, hence, are not
b o u n d by t h e capital regulations governing
s w a p s — a situation with p o t e n t i a l l y significant
c o m p e t i t i v e implications (joanna Pitman).
T h e new capital g u i d e l i n e s , which are to b e c o m e fully e f f e c t i v e at t h e e n d of 1992, will req u i r e b a n k s t o m a i n t a i n a ratio of at l e a s t 8
p e r c e n t total capital t o risk-weighted on- and
o f f - b a l a n c e - s h e e t i t e m s . By t h e e n d of 1992,
b a n k s will a l s o h a v e to maintain a c o r e capital
ratio of at l e a s t 4 p e r c e n t . Core (tier I) capital,
as d e f i n e d b y t h e B a s l e A g r e e m e n t , c o n s i s t s
21

of t h e b o o k v a l u e of c o m m o n a n d p e r p e t u a l
p r e f e r r e d e q u i t y , m i n o r i t y e q u i t y i n t e r e s t in
consolidated subsidiaries, and retained earni n g s l e s s g o o d w i l l . S u p p l e m e n t a r y ( t i e r 2)
c a p i t a l i n c l u d e s i t e m s like g e n e r a l loan l o s s
reserves, mandatory convertible debt, perp e t u a l d e b t , s u b o r d i n a t e d d e b t , a n d limitedlife p r e f e r r e d stock. Total capital is t h e sum of
core and supplementary capital. Transitional
a r r a n g e m e n t s p r o v i d e for b a n k s t o arrive at a
t o t a l c a p i t a l ratio of at l e a s t 7 . 2 5 p e r c e n t b y
t h e e n d of 1990, with c o r e capital e l e m e n t s totaling at l e a s t 3.25 p e r c e n t .
Risk W e i g h t i n g . O n - b a l a n c e - s h e e t a s s e t s
are a s s i g n e d to various risk c a t e g o r i e s that are
w e i g h t e d t o r e f l e c t t h e e x t e n t of u n c e r t a i n t y .
A s s e t s with v i r t u a l l y n o c r e d i t risk, s u c h a s
c a s h a n d c e n t r a l g o v e r n m e n t s e c u r i t i e s from
t h e i n d u s t r i a l i z e d c o u n t r i e s b e l o n g i n g to t h e
O r g a n i z a t i o n for E c o n o m i c C o o p e r a t i o n a n d
D e v e l o p m e n t , a r e a s s i g n e d a weight of z e r o
a n d t h u s r e q u i r e no c a p i t a l . O t h e r a s s e t s , inc l u d i n g m o s t b a n k c e r t i f i c a t e s of d e p o s i t ,
r e c e i v e a 20 p e r c e n t weight, while h o m e mortg a g e s r e c e i v e a 50 p e r c e n t w e i g h t . A s s e t s of
n o r m a l c r e d i t risk, such as c l a i m s on t h e priv a t e s e c t o r , fixed a s s e t s , and real e s t a t e , a r e
a s s i g n e d a 100 p e r c e n t weight.
O f f - b a l a n c e - s h e e t i t e m s are first c o n v e r t e d
i n t o c r e d i t - r i s k e q u i v a l e n t v a l u e s b a s e d on
t h e t y p e of i n s t r u m e n t . For e x a m p l e , a c r e d i t
c o n v e r s i o n factor of 100 p e r c e n t is a p p l i e d to
d i r e c t c r e d i t s u b s t i t u t e s such as s t a n d b y lett e r s of c r e d i t , which o b l i g a t e b a n k s to s u p p l y
c r e d i t at s o m e u n s p e c i f i e d future time. T h e s e
a r e t h e n g e n e r a l l y m u l t i p l i e d by t h e risk
w e i g h t s a p p l i c a b l e t o t h e c o u n t e r p a r t y for an
o n - b a l a n c e - s h e e t transaction.
B e c a u s e off-balance-sheet activities are
c o n v e r t e d into risk e q u i v a l e n t s of o n - b a l a n c e s h e e t i t e m s e x c l u s i v e l y on t h e b a s i s of c r e d i t
risk, no c a p i t a l r e q u i r e m e n t s are i m p o s e d on
e x c h a n g e - t r a d e d options and futures that
c o n t a i n r i s k for t h e e x c h a n g e b y r e q u i r i n g
d a i l y p a y m e n t of v a r i a t i o n m a r g i n . A l s o e x c l u d e d from t h e c a l c u l a t i o n s are o p t i o n s ,
c a p s , a n d floors written b y a b a n k . T h e s e ins t r u m e n t s i n v o l v e n o c r e d i t risk to t h e b a n k
s i n c e t h e p u r c h a s e r ' s part of t h e a g r e e m e n t is
c o m p l e t e d with t h e initial p a y m e n t a n d e n tails n o f u r t h e r o b l i g a t i o n t h a t c o u l d l e a d to
default.

22


T h e c r e d i t risk involved in i n t e r e s t - r a t e and
f o r e i g n - e x c h a n g e i n s t r u m e n t s can b e calculate d in o n e of two ways: t h e c u r r e n t e x p o s u r e
m e t h o d p l a c e s most of t h e weight on t h e pres e n t m a r k e t v a l u e of t h e i n t e r e s t - r a t e or
foreign-exchange instrument, whereas the
original e x p o s u r e m e t h o d a s s i g n s risk b a s e d
on t h e s w a p s ' maturity a n d d o e s not a c c o u n t
f o r s u b s e q u e n t c h a n g e s in m a r k e t v a l u e .
Though m o s t of t h e G r o u p of T e n b a n k supervisors favored the current e x p o s u r e method,
t h e B a s l e A g r e e m e n t a l l o w s s u p e r v i s o r s to
c h o o s e e i t h e r p r o c e d u r e . According to the
a g r e e m e n t , b a n k regulators may p e r m i t individual b a n k s to a d o p t e i t h e r m e t h o d , with t h e
understanding that o n c e a bank c h o o s e s the
c u r r e n t e x p o s u r e m e t h o d it c a n n o t s w i t c h
b a c k to t h e original e x p o s u r e m e t h o d .
The current exposure approach divides
c r e d i t risk r e l a t e d t o an i n t e r e s t - r a t e o r a
f o r e i g n - e x c h a n g e i n s t r u m e n t i n t o two p a r t s :
t h e actual current e x p o s u r e and t h e p o t e n t i a l
for an i n c r e a s e in e x p o s u r e , d e p e n d i n g on
c h a n g e s in i n t e r e s t r a t e s or f o r e i g n - e x c h a n g e
r a t e s . B e c a u s e t h e b a n k would incur l o s s e s if
t h e counterparty d e f a u l t e d and t h e net pres e n t v a l u e of t h e n e t i n s t r u m e n t p a y m e n t s
would h a v e p o s i t i v e value to t h e bank, t h e act u a l c u r r e n t c r e d i t e x p o s u r e is v i e w e d a s
e q u a l to t h e m a r k e d - t o - m a r k e t v a l u e of t h e
i n t e r e s t - r a t e and f o r e i g n - e x c h a n g e instrum e n t . If t h e i n t e r e s t - r a t e or f o r e i g n - e x c h a n g e
instrument has negative value to the bank,
t h e n t h e b a n k is not currently s u b j e c t to credit risk s i n c e counterparty default would not result in b a n k l o s s e s . T h e r e f o r e , t h e v a l u e of t h e
current e x p o s u r e is s e t at zero. T h e p o t e n t i a l
i n c r e a s e in c r e d i t e x p o s u r e d u e to i n t e r e s t r a t e c h a n g e s is e q u a l t o 0 . 5 p e r c e n t of t h e
n o t i o n a l p r i n c i p a l of an i n t e r e s t - r a t e i n s t r u m e n t for i n s t r u m e n t s that mature in m o r e than
o n e y e a r . If t h e i n t e r e s t - r a t e i n s t r u m e n t mat u r e s in o n e y e a r o r l e s s , t h e p o t e n t i a l inc r e a s e in e x p o s u r e is s e t e q u a l to zero.
B e c a u s e b a n k regulators view foreigne x c h a n g e r a t e s as p o t e n t i a l l y m o r e v o l a t i l e
than interest rates, a higher capital requirem e n t is i m p o s e d on e x c h a n g e - r a t e i n s t r u m e n t s . 1 4 For t h o s e t h a t m a t u r e in l e s s t h a n
o n e y e a r t h e p o t e n t i a l i n c r e a s e in e x p o s u r e is
s e t at 1 p e r c e n t of t h e i n s t r u m e n t ' s n o t i o n a l
p r i n c i p a l . Foreign e x c h a n g e i n s t r u m e n t s ma-

E C O N O M I C REVIEW, MAY/JUNE 1990

Table 2.
Calculation of Credit-Equivalent Amounts for Interest-Rate Swaps
under Risk-Based Capital Guidelines,
Current Exposure Method

Type of Contract and
Remaining Maturity

Potential Exposure
Notional
Principal
(Dollars)

X

+

Potential
Potential
Exposure Conversion = Exposure
Factor
(Dollars)

Current Exposure

Replacement
Cost*

Credit
Equivalent
Amount
(Dollars)

Current
Exposure
(Dollars)*

1 ) 120-day forward
foreign exchange

5,000,000

2) Fixed/floating interestrate swap, single
currency, 7 months

5,000,000

3) Fixed/floating interestrate swap, single
currency, 4 years

10,000,000

.005

50,000

-200,000

4) Fixed/floating interestrate swap, single
currency, 4 years

10,000,000

.005

50,000

150,000

150,000

200,000

5) Fixed/floating interestrate swap, single
currency, 7 years

5,000,000

.005

25,000

325,000

325,000

350,000

6) Cross-currency,
floating/floating
foreign-exchange swap,
7 years

5,000,000

.05

250,000

350,000

350,000

600,000

.01

50,000

10,000

10,000

60,000

-5,000

50,000

'These numbers are purely for illustration.
"The larger of zero or positive mark-to-market value.

turing in m o r e t h a n o n e y e a r r e q u i r e a p o t e n -

p o s u r e is s e t a t z e r o a n d o n l y t h e c u r r e n t e x -

tial i n c r e a s e in c r e d i t e x p o s u r e e q u a l t o 5 p e r -

p o s u r e is c o n s i d e r e d . T h e s e v e n - m o n t h s w a p

c e n t of t h e i n s t r u m e n t ' s n o t i o n a l p r i n c i p a l . 1 5

has a negative replacement cost b e c a u s e the

An e x a m p l e of t h e c o m p u t a t i o n of t h e c r e d -

b a n k w o u l d r e c e i v e a p a y m e n t for e n t e r i n g

it e q u i v a l e n t a m o u n t is p r o v i d e d in T a b l e 2.

i n t o such a s w a p . S i n c e t h e r e g u l a t i o n s d o n o t

T h e first c o n t r a c t is a 1 2 0 - d a y forward f o r e i g n

count negative r e p l a c e m e n t cost, this swap

exchange a g r e e m e n t . Since the contract ma-

h a s a c r e d i t e q u i v a l e n t e x p o s u r e of z e r o .

t u r e s in u n d e r o n e y e a r , t h e p o t e n t i a l e x p o sure

is e q u a l

to the

notional

T h e third t r a n s a c t i o n i l l u s t r a t e s c a l c u l a t i o n

principal

of c r e d i t e q u i v a l e n t e x p o s u r e for an i n t e r e s t -

( a s s u m e d to b e $5 million) multiplied by a

r a t e s w a p with n e g a t i v e r e p l a c e m e n t c o s t b u t

c r e d i t c o n v e r s i o n f a c t o r of 0 . 0 1 , r e s u l t i n g in an

m o r e t h a n o n e y e a r t o m a t u r i t y . In t h i s c a s e

e x p o s u r e of $ 5 0 , 0 0 0 . T h e c o n t r a c t is a l s o a s -

t h e c r e d i t e q u i v a l e n t a m o u n t is e q u a l t o t h e

s u m e d t o h a v e a c u r r e n t r e p l a c e m e n t c o s t of

p o t e n t i a l e x p o s u r e of t h e s w a p . T h e n e x t two

$ 1 0 , 0 0 0 . T h e s e c o n d c o n t r a c t is a s i n g l e -

f i x e d - t o - f l o a t i n g i n t e r e s t - r a t e s w a p s (4 a n d 5)

currency, fixed-to-floating interest-rate swap

illustrate that t h e potential conversion factor

t h a t m a t u r e s in s e v e n m o n t h s . T h e s w a p m a -

r e m a i n s at 0 . 0 0 5 r e g a r d l e s s of t h e r e m a i n i n g

t u r e s in l e s s t h a n o n e y e a r , s o its p o t e n t i a l e x -

maturity on a s w a p . R e m a i n i n g m a t u r i t y is l e s s

FEDERAL RESERVE B A N K O F A T L A N T A




23

i m p o r t a n t for s w a p s u n d e r t h e c u r r e n t e x p o s u r e m e t h o d b e c a u s e any i n c r e a s e in r e p l a c e m e n t c o s t will b e r e f l e c t e d t h r o u g h t h e
calculation's current exposure c o m p o n e n t
w h e n t h e s w a p is n e x t v a l u e d f o r c a p i t a l
a d e q u a c y p u r p o s e s . T h e l a s t c o n t r a c t is a
cross-currency, floating-rate-to-floating-rate
c u r r e n c y s w a p t h a t m a t u r e s in s e v e n y e a r s .
B e c a u s e t h i s c o n t r a c t ' s p o t e n t i a l e x p o s u r e is
far larger than on t h e s e v e n - y e a r i n t e r e s t - r a t e
swap, t h e credit conversion factor is 0.05 rather
than the 0.005 factor applied to interestrate swaps.
Although it is l e s s a c c u r a t e , t h e original exp o s u r e m e t h o d is c o m p u t a t i o n a l l y e a s i e r . It
m a y a l s o b e m o r e c o n s i s t e n t with t h e o t h e r
r i s k - b a s e d s t a n d a r d s in t h a t it a v o i d s t h e
n e e d to mark to market. T h e original e x p o s u r e
m e t h o d s e t s t h e c r e d i t e x p o s u r e e q u a l to t h e
notional principal of t h e swap multiplied by a
c o n v e r s i o n f a c t o r t h a t d e p e n d s on e a c h
swap's maturity. T h e a g r e e m e n t p e r m i t s e a c h
regulator to c h o o s e whether the conversion
factors will b e b a s e d on t h e original maturity
of t h e s w a p o r i t s r e m a i n i n g m a t u r i t y . T h e
c o n v e r s i o n f a c t o r for s w a p s m a t u r i n g in l e s s
than o n e y e a r is 0.5 p e r c e n t . An additional 1.0
p e r c e n t is a d d e d to t h e c o n v e r s i o n factor for
e a c h additional year. T h e capital r e q u i r e m e n t
for contracts c o n t i n g e n t on foreign e x c h a n g e is
2 p e r c e n t for t h o s e m a t u r i n g in o n e y e a r o r
l e s s , with a n o t h e r 4 p e r c e n t a d d e d for e a c h
additional year.
O n c e a c r e d i t - e q u i v a l e n t a m o u n t is c a l c u lated, interest-rate and foreign-exchange
c o n t r a c t s a r e t r e a t e d d i f f e r e n t l y from o t h e r
off-balance-sheet activities. The credite q u i v a l e n t a m o u n t s of such c o n t r a c t s a r e all
m u l t i p l i e d by a 50 p e r c e n t credit-risk weighting, r e g a r d l e s s of t h e c o u n t e r p a r t y ' s c r e d i t
risk, reflecting regulators' j u d g m e n t that m o s t
p a r t i c i p a n t s in t h e s w a p m a r k e t a r e r e l i a b l e .
T h e B a s l e A g r e e m e n t n o t e s , however, that t h e
c r e d i t risk weighting on swaps could b e raised
if t h e a v e r a g e c r e d i t q u a l i t y of swap c o u n t e r parties d e t e r i o r a t e s or if swap l o s s e s i n c r e a s e .
N e t t i n g of S w a p P a y m e n t s . An i m p o r t a n t
e l e m e n t in d e t e r m i n i n g capital r e q u i r e m e n t s
for a b a n k ' s s w a p p o r t f o l i o is t h e c o n t r a c t u a l
a g r e e m e n t to n e t swap p a y m e n t s a c r o s s mult i p l e s w a p s b e t w e e n two p a r t i e s . Each party
d o e s not p r e s e n t p a y m e n t s ; i n s t e a d , t h e
24



party that o w e s p r e s e n t s t h e n e t a m o u n t d u e
after t h e various t r a n s a c t i o n s a r e t a l l i e d . This
s y s t e m l e s s e n s t h e l i k e l i h o o d t h a t o n e party
will default after receiving a full p a y m e n t from
t h e counterparty. T h e B a s l e a g r e e m e n t g e n e r ally p e r m i t s b a n k s to n e t c o n t r a c t s s u b j e c t to
n o v a t i o n , an a r r a n g e m e n t t h a t a u t o m a t i c a l l y
a m a l g a m a t e s s w a p s p a y a b l e in t h e s a m e
currency at t h e s a m e t i m e into a single net
p a y m e n t . Netting by novation may b e i m p l e m e n t e d in s t a g e s in t h o s e c o u n t r i e s w h e r e nat i o n a l b a n k r u p t c y laws a l l o w l i q u i d a t o r s to
u n b u n d l e t r a n s a c t i o n s within a given p e r i o d
u n d e r a c h a r g e of f r a u d u l e n t p r e f e r e n c e . 1 6
T h e B a s l e A g r e e m e n t d o e s not p e r m i t netting
w h e r e t h e c o n t r a c t s are m e r e l y s u b j e c t to
c l o s e - o u t c l a u s e s , in which o u t s t a n d i n g o b l i g a t i o n s on all s w a p s are a c c e l e r a t e d a n d nett e d t o d e t e r m i n e a s i n g l e e x p o s u r e in t h e
e v e n t of b a n k r u p t c y , for e x a m p l e . T h e s u p e r visors a p p r o v e of b o t h novation and c l o s e - o u t
c l a u s e s but c o n t e n d that t h e s e have not yet
b e e n a d e q u a t e l y t e s t e d in t h e courts. Netting
of c o n t r a c t s u n d e r c l o s e - o u t c l a u s e s may b e
p e r m i t t e d in t h e future in j u r i s d i c t i o n s where
it is u p h e l d in t h e courts.
Regulation of I n t e r e s t - R a t e Risk. Although
c a p i t a l r e g u l a t i o n s for b a n k s d o not explicitly
i n c o r p o r a t e t h e i m p a c t of i n t e r e s t - r a t e risk,
regulators are n e v e r t h e l e s s c o n c e r n e d a b o u t
this s o u r c e of risk. G u i d e l i n e s for large b a n k s
g e n e r a t e d by t h e Office of t h e C o m p t r o l l e r of
t h e Currency (OCC) s t r e s s four c o m p o n e n t s of
risk m a n a g e m e n t , according to t h e analysis of
David S c o t t : a policy on i n t e r e s t - r a t e risk app r o v e d by each b a n k ' s b o a r d of directors; limits on total risk e x p o s u r e , p r e f e r a b l y s t a t e d in
t e r m s of i n c o m e at risk from an i n t e r e s t - r a t e
m o v e m e n t of s p e c i f i e d s i z e ; a m e a s u r e m e n t
s y s t e m that a d e q u a t e l y c a p t u r e s t h e riskiness
of a b a n k ' s p o r t f o l i o ; a n d d e v e l o p m e n t a n d
u s e of g o o d m a n a g e m e n t r e p o r t s , j a m e s
H o u p t ( s e e e s p e c i a l l y p. 9) e x p r e s s e d similar
views a b o u t F e d e r a l R e s e r v e regulatory polic i e s . N e i t h e r Houpt nor S c o t t s e e m s i n c l i n e d
to r e q u i r e all b a n k s to a s s e s s t h e sensitivity of
t h e e q u i t y v a l u e to c h a n g e s in i n t e r e s t r a t e s .
I n d e e d , Houpt a r g u e s that "in many c a s e s liquid a n d o t h e r w i s e s o l v e n t i n s t i t u t i o n s c a n
'ride out' market fluctuations without ever
f e e l i n g t h e e f f e c t of s i z e a b l e rate c h a n g e s on
t h e i r b o t t o m lines" (9). Both also s u g g e s t that

E C O N O M I C REVIEW, MAY/JUNE 1990

it would b e difficult a n d p r o b a b l y t o o c o s t l y
for r e g u l a t o r s t o g a t h e r s u f f i c i e n t information
for a c c u r a t e off-site analysis of b a n k s ' i n t e r e s t rate risk.

Proposals for Interest-Rate Risk
and Capital Guidelines
Making e x p o s u r e to i n t e r e s t - r a t e c h a n g e s a
formal part of t h e r i s k - b a s e d c a p i t a l s y s t e m
w o u l d b e d e s i r a b l e for t h r e e r e a s o n s . First,
U.S. r e g u l a t o r s h a v e m a d e a c o n s i d e r a b l e effort t o s e c u r e i n t e r n a t i o n a l a g r e e m e n t o n
s t a n d a r d s in o r d e r t o a s s u r e a l e v e l p l a y i n g
field for o r g a n i z a t i o n s o p e r a t i n g in m o r e than
o n e country. A c c o u n t i n g for i n t e r e s t - r a t e risk
in c a p i t a l r e q u i r e m e n t s w o u l d f u r t h e r p r o mote equality across various countries.
S e c o n d , formal g u i d e l i n e s should h e l p organizations plan for t h e future. Third, a p p r o p r i a t e
s t a n d a r d s c o u l d d i s c o u r a g e b a n k s from e x p o s u r e to e x c e s s i v e i n t e r e s t - r a t e a n d f o r e i g n e x c h a n g e risk.
In d e v e l o p i n g an i n t e r e s t - r a t e risk c o m p o nent to capital s t a n d a r d s , regulators must d e t e r m i n e which risk m e a s u r e t o u s e . S e v e r a l
c o n s i d e r a t i o n s s u g g e s t t h e focus s h o u l d b e on
market v a l u e s r a t h e r t h a n a c c o u n t i n g v a l u e s .
Economically insolvent organizations have a
great i n c e n t i v e to t a k e large risks: such a b a n k
will c a p t u r e m o s t of t h e g a i n s while t h e FDIC
incurs m o s t of t h e l o s s e s if a v e n t u r e fails. In
a d d i t i o n , t h e a r g u m e n t t h a t b a n k s can " r i d e
o u t " a c h a n g e in r a t e s is m i s t a k e n . C o n s i d e r ,
for e x a m p l e , a b a n k that h a s b e c o m e e c o n o m ically i n s o l v e n t b e c a u s e r a t e s h a v e risen.
M a n a g e r s of s u c h an i n s t i t u t i o n a l m o s t c e r t a i n l y will t e l l r e g u l a t o r s t h a t t h e y e x p e c t
r a t e s t o fall, r e t u r n i n g t h e b a n k t o s o l v e n c y .
I n t e r e s t r a t e s might i n d e e d fall, b u t t h e y
might just a s well i n c r e a s e , in which c a s e t h e
b a n k w o u l d l o s e e v e n m o r e v a l u e . No e v i d e n c e s u g g e s t s that b a n k s u p e r v i s o r s or managers can o u t - g u e s s t h e c o n s e n s u s f o r e c a s t of
t h e m a r k e t r e f l e c t e d in c u r r e n t i n t e r e s t
rates.17
Two a l t e r n a t i v e s are a v a i l a b l e for analyzing
t h e effect of rate c h a n g e s on b a n k e q u i t y valu e s : (1) d u r a t i o n a n a l y s i s a n d (2) s i m u l a t i o n
analysis. Duration analysis in its s i m p l e s t form

FEDERAL RESERVE B A N K O F A T L A N T A



c o n d e n s e s a bank's e x p o s u r e into a single
n u m b e r . A w e a k n e s s of this a p p r o a c h is that it
d o e s n o t e a s i l y i n c o r p o r a t e t h e o p t i o n s imp l i c i t in m a n y b a n k c o n t r a c t s (such a s m o r t g a g e l o a n s with p r e p a y m e n t p r i v i l e g e s ) nor
d o e s it a d d r e s s t h e i r r e g u l a r i t i e s i n t r o d u c e d
b y c a p s , floors, a n d o t h e r o f f - b a l a n c e - s h e e t
c o n t r a c t s . S i m u l a t i o n a n a l y s i s , on t h e o t h e r
h a n d , r e q u i r e s r e g u l a t o r s to s p e c i f y t h e r a t e
c h a n g e s t h a t will b e a n a l y z e d . For e x a m p l e ,
regulators may require a bank to a s s e s s t h e
e f f e c t s of a 1 0 0 - b a s i s - p o i n t i n c r e a s e in r a t e s
and t h e e f f e c t s of a 1 0 0 - b a s i s - p o i n t d e c r e a s e .
T h e p r o b l e m of o f f - s i t e m o n i t o r i n g m u s t
a l s o b e a d d r e s s e d in d e v e l o p i n g an i n t e r e s t r a t e risk c o m p o n e n t . T h e O f f i c e of Thrift
Supervision r e q u i r e s thrifts to report o v e r 6 0 0
i t e m s d e a l i n g with maturity a n d y i e l d s of ass e t s , liabilities, and o f f - b a l a n c e - s h e e t i t e m s in
o r d e r to m o n i t o r thrifts' i n t e r e s t - r a t e e x p o s u r e
(Houpt). Bank regulators would d o u b t l e s s req u i r e at l e a s t this l e v e l of d e t a i l in r e p o r t i n g
a n d p o s s i b l y m o r e t o a n a l y z e s o m e of t h e
larger banks' interest-rate e x p o s u r e accurately.
S c o t t and Houpt argue with s o m e merit that
t h e c o s t s of s u c h d e t a i l e d r e p o r t i n g a r e likely t o e x c e e d t h e b e n e f i t s in m a n y c a s e s .
Moreover, e v e n if regulators could o b t a i n suff i c i e n t d e t a i l on a q u a r t e r l y b a s i s a t r e a s o n a b l e cost, it is not c l e a r that t h e figures would
adequately reflect a bank's interest-rate exposure between quarterly statements. The
e a s e of b u y i n g a n d s e l l i n g m a n y a s s e t s , such
a s s e c u r i t i z e d m o r t g a g e s , c o m b i n e d with t h e
low c o s t of e n t e r i n g i n t o o f f - b a l a n c e - s h e e t
t r a n s a c t i o n s , m a k e s it p o s s i b l e for an institut i o n ' s e x p o s u r e t o c h a n g e d r a m a t i c a l l y in a
very short t i m e . I n d e e d , a large b a n k that act i v e l y " s u p p l i e s " i n t e r e s t - r a t e risk m a n a g e ment products to corporations could easily
c h a n g e t h e m a g n i t u d e and e v e n t h e direction
of its e x p o s u r e to i n t e r e s t rates within d a y s (if
not hours) after quarterly financial records a r e
c l o s e d . T h u s , q u a r t e r l y f i n a n c i a l filings m a y
not only b e e x c e s s i v e l y costly but may also
fail to m e a s u r e risk accurately.
O n e a l t e r n a t i v e t o o f f - s i t e risk e v a l u a t i o n
b a s e d on q u a r t e r l y financial s t a t e m e n t s
would b e s t a n d a r d s g r o u n d e d in e a c h institut i o n ' s i n t e r n a l risk l i m i t s . T h i s p r o c e d u r e
w o u l d b e in k e e p i n g with c u r r e n t r e g u l a t o r y
policies that require institutions to set and
25

follow internal risk s t a n d a r d s . T h e first s t e p in
using internal risk criteria would b e to e s t a b lish a t r a d e - o f f b e t w e e n e x p o s u r e to i n t e r e s t rate fluctuations and capital r e q u i r e m e n t s . In
such a s y s t e m , c h a n g e s in e q u i t y v a l u e would
i n c l u d e t h e e f f e c t of i n t e r e s t - r a t e fluctuations
on t h e market value of a b a n k ' s a s s e t s , liabilit i e s , a n d o f f - b a l a n c e - s h e e t i t e m s . Each b a n k
would t h e n s p e c i f y its m a x i m u m e x p o s u r e to
an i n t e r e s t - r a t e c h a n g e a n d s e t up i n f o r m a tion reporting s y s t e m s to e n s u r e against accid e n t a l l y e x c e e d i n g t h e s e l i m i t s . Of c o u r s e ,
t h e b a n k w o u l d a l s o b e r e q u i r e d to c o n d u c t
its o p e r a t i o n s in s u c h a way t h a t it d i d n o t
i n t e n t i o n a l l y v i o l a t e its own g u i d e l i n e s for
interest-rate exposure.
If capital s t a n d a r d s w e r e b a s e d on an instit u t i o n ' s internal risk limits, internal reporting
r e q u i r e m e n t s could b e tailored to t h e s o p h i s tication of e a c h b a n k ' s activities. While b a n k s
relying on s h o r t - t e r m funding and l o a n s with
m i n i m a l o f f - b a l a n c e - s h e e t i t e m s might n e e d
very little information a b o u t e x p o s u r e , m o n e y c e n t e r b a n k s might r e q u i r e highly refined reporting s y s t e m s . This approach would also
offer b a n k s s o m e trade-off b e t w e e n t h e i r capital r e q u i r e m e n t s and t h e c o m p l e x i t y of t h e i r
i n f o r m a t i o n - g a t h e r i n g t o o l s . B a n k s with lower
internal t o l e r a n c e s for risk e x p o s u r e could e n s u r e c o m p l i a n c e through s o p h i s t i c a t e d rep o r t i n g p r o c e d u r e s while o t h e r b a n k s m i g h t
c h o o s e to s e t higher t o l e r a n c e s that could b e
m o n i t o r e d with l e s s refined s y s t e m s .
T h e e f f e c t i v e n e s s of this a p p r o a c h , which is
similar to Thrift Bulletin 13, would d e p e n d on
careful b a n k e x a m i n a t i o n . Bank s u p e r v i s o r s
would h a v e to e v a l u a t e an individual b a n k ' s
information s y s t e m in relation to its i n t e r e s t r a t e risk m o d e l to e n s u r e a g a i n s t a c c i d e n t a l
v i o l a t i o n s of t h e e x p o s u r e limit, a n d d e t e r m i n e t h a t t h e b a n k h a s in fact c o m p l i e d with
its own risk g u i d e l i n e s . T h e c a p i t a l r e q u i r e m e n t s c o u l d levy an a u t o m a t i c p e n a l t y (highe r capital or fines) for a c c i d e n t a l b r e a c h e s and
a m o r e s e v e r e o n e for d e l i b e r a t e infractions.
R e l i a n c e on internal s t a n d a r d s would k e e p
o r g a n i z a t i o n s from i n c r e a s i n g t h e i r i n t e r e s t r a t e risk b e t w e e n q u a r t e r l y f i n a n c i a l s t a t e m e n t s to e v a d e capital r e q u i r e m e n t s since
i n t e r n a l g u i d e l i n e s would a p p l y at all t i m e s .
O n e p o t e n t i a l p r o b l e m with t h i s s t r a t e g y is
t h a t a b a n k ' s p r e f e r r e d risk p o s i t i o n s m i g h t
 26


c h a n g e o v e r t i m e . T h i s shift c o u l d b e a c c o m m o d a t e d , however, by letting organizations
c h a n g e t h e i r s t a n d a r d s . To d e c r e a s e i n t e r e s t r a t e risk, a b a n k w o u l d n e e d o n l y t o notify
r e g u l a t o r s t h a t it p l a n n e d to r e d u c e its level
of p e r m i t t e d risk. Raising t h e internal risk criteria would r e q u i r e c o m p l i a n c e with t h e capital g u i d e l i n e s for t h e higher risk level.
T h e a p p r o a c h o u t l i n e d h e r e for linking
i n t e r e s t - r a t e risk t o c a p i t a l s t a n d a r d s is a l s o
a p p r o p r i a t e for f o r e i g n - e x c h a n g e e x p o s u r e .
Since a bank's foreign-exchange-rate exposure can c h a n g e significantly, a s y s t e m not
s o l e l y reliant on q u a r t e r l y financial s t a t e m e n t s is d e s i r a b l e . C a p i t a l r e q u i r e m e n t s
b a s e d on a b a n k ' s i n t e r n a l r i s k s t a n d a r d s
would c o m p e l institutions to maintain pres p e c i f i e d limits for f o r e i g n - e x c h a n g e risk at all
times.

Conclusion
T h e m a r k e t for i n t e r e s t - r a t e a n d f o r e i g n e x c h a n g e i n s t r u m e n t s e v o l v e d rapidly during
t h e 1980s in r e s p o n s e to t h e n e e d s of c o m m e r cial b a n k s , thrifts, a n d t h e i r c u s t o m e r s . Regulators' a w a r e n e s s that t h e p o t e n t i a l of t h e s e
i n s t r u m e n t s t o i n c r e a s e as well a s d e c r e a s e
t h e risk e x p o s u r e of insured d e p o s i t o r i e s has
a l s o grown. R e c o g n i z i n g t h a t t h e s e h e d g i n g
t o o l s c a n a d v e r s e l y a l t e r i n t e r e s t - r a t e risk,
thrift r e g u l a t o r s h a v e i n c o r p o r a t e d i n t e r e s t r a t e i n s t r u m e n t s in t h e i r c a p i t a l s t a n d a r d s .
Bank regulators have r e s p o n d e d by conside r i n g t h e c r e d i t risk t h a t is a s s o c i a t e d with
interest-rate and foreign-exchange contracts
in r i s k - b a s e d capital g u i d e l i n e s .
Though bank regulators are d e v e l o p i n g
g u i d e l i n e s t h a t will e n a b l e b a n k s t o s e l f m a n a g e t h e i r risk e x p o s u r e , t h e y have not yet
e v o l v e d a m e t h o d for i n c l u d i n g i n t e r e s t - r a t e
a n d f o r e i g n - e x c h a n g e e x p o s u r e in t h e i r riskb a s e d capital g u i d e l i n e s . A p r o c e d u r e such as
t h e o n e p r o p o s e d h e r e , which u s e s a b a n k ' s
internal risk limits to e s t a b l i s h links b e t w e e n
this kind of risk e x p o s u r e a n d capital criteria,
has two i m p o r t a n t a d v a n t a g e s : first, it would
r e d u c e t h e c o s t s of complying with t h e capital
r e q u i r e m e n t s by allowing b a n k s a c h o i c e b e t w e e n t h e e x p e n s e of d e v e l o p i n g m o r e s o -

E C O N O M I C REVIEW, MAY/JUNE 1990

phisticated information-gathering systems
a n d maintaining higher capital levels; s e c o n d ,
it offers a m o r e r e l i a b l e b a s i s for a b a n k ' s cap-

ital r e q u i r e m e n t s by a c c o u n t i n g for an institu
tion's e x p o s u r e at all t i m e s , not just as it is re
p o r t e d in quarterly financial s t a t e m e n t s .

Notes
' T h e n e e d to measure interest-rate a n d foreign-exchange
risk is not u n i q u e , and e v e n s o m e of t h e p r o p o s a l s to increase m a r k e t d i s c i p l i n e w o u l d b e n e f i t from i n c o r p o r a t i n g e s t i m a t e s of i n t e r e s t - r a t e a n d f o r e i g n - e x c h a n g e
r i s k . For e x a m p l e , t h e S h a d o w F i n a n c i a l R e g u l a t o r y
C o m m i t t e e p r o p o s e s that banks b e r e q u i r e d t o m a i n t a i n
h i g h e r l e v e l s of t o t a l c a p i t a l , a n d W a l l w o u l d r e q u i r e
b a n k s t o i s s u e p u t t a b l e s u b o r d i n a t e d d e b t . B o t h of
t h e s e plans r e q u i r e a sufficiently large c a p i t a l cushion to
ensure that losses by a b a n k o v e r a short p e r i o d of t i m e
cannot exceed a depository's e q u i t y a n d s u b o r d i n a t e d
d e b t . N e i t h e r of t h e s e p r o p o s a l s e x p l i c i t l y a d d r e s s e s
t h e issue of i n t e r e s t - r a t e a n d foreign-exchange-rate risk
measurement.
2

N e i t h e r a c o m p l e t e r e v i e w of t h e features of t h e s e cont r a c t s n o r a c o m p r e h e n s i v e d i s c u s s i o n of t h e v a r i o u s
t y p e s of contracts is w i t h i n t h e s c o p e of t h i s s t u d y . See
Smith, Smithson, a n d W i l f o r d (especially c h a p t e r 3) for a
m o r e t h o r o u g h d i s c u s s i o n of i n t e r e s t - r a t e a n d f o r e i g n exchange c o n t i n g e n t contracts.

3

T h e fact t h a t t h e e x c h a n g e of cash f l o w s is a z e r o - s u m
game d o e s not necessarily i m p l y that t h e i n s t r u m e n t s
d o n o t c r e a t e v a l u e f o r t h e i r users. For e x a m p l e , s e e
Wall and Pringle (1988) for a r e v i e w of p o s s i b l e gains to
interest-rate swap users.
4
A n o p t i o n that can b e excercised o n l y on a specific d a t e
is r e f e r r e d to as a E u r o p e a n o p t i o n . A m e r i c a n o p t i o n s
m a y b e e x c e r c i s e d any t i m e t h r o u g h a s p e c i f i c d a t e in
the f u t u r e . E x c h a n g e - t r a d e d o p t i o n s are g e n e r a l l y
American o p t i o n s . However, M e r t o n has p r o v e n that t h e
v a l u e of an o p t i o n is m a x i m i z e d b y d e f e r r i n g e x e r c i s e
u n t i l t h e last d a y if t h e u n d e r l y i n g asset d o e s n o t m a k e
any p a y m e n t prior t o t h e expiration date. T h e discussion
b e l o w focuses o n E u r o p e a n o p t i o n s since t h e c o n d i t i o n s
for d e f e r r i n g e x e r c i s e f r e q u e n t l y h o l d for i n t e r e s t - r a t e
and foreign-exchange-rate o p t i o n s .
5
See A b k e n for a m o r e d e t a i l e d discussion of caps, floors,
a n d collars.
6

T h e n o t i o n a l p r i n c i p a l is u s e d for c e r t a i n i n t e r e s t - r a t e
c o n t i n g e n t a g r e e m e n t s t o d e t e r m i n e t h e d o l l a r value of
t h e p a y m e n t . T h e r o l e of t h e n o t i o n a l p r i n c i p a l in d e t e r m i n i n g t h e p a y m e n t u n d e r a cap a g r e e m e n t is analogous to t h e use of t h e p r i n c i p a l a m o u n t of a loan in t h e
c a l c u l a t i o n of i n t e r e s t p a y m e n t s o n t h e l o a n . T h e p r i -

F E D E R A L RESERVE B A N K O F A T L A N T A




m a r y d i f f e r e n c e b e t w e e n t h e p r i n c i p a l o n a loan a n d
t h e n o t i o n a l p r i n c i p a l of a c a p i s t h a t t h e n o t i o n a l
p r i n c i p a l never changes hands. T h e t e r m n o t i o n a l princ i p a l is u s e d in a s i m i l a r m a n n e r for f l o o r , c o l l a r , a n d
interest-rate swap agreements.
7
Abken provides examples.
8

T h e d i s c u s s i o n of t h r i f t r e g u l a t i o n is b a s e d in p a r t o n
McNulty.

9

W h i l e t h e official regulatory a t t i t u d e t o w a r d futures has
n o t c h a n g e d since t h e early 1980s, m a n y , if n o t m o s t ,
regional t h r i f t regulatory officials t a k e a d i m v i e w of futures for t h e reasons m e n t i o n e d here.
l0
T h i s is o n e part of a t h r e e - p a r t capital r e q u i r e m e n t that
i n c l u d e s a c r e d i t - r i s k c o m p o n e n t s i m i l a r to t h a t u s e d
for c o m m e r c i a l banks a n d a c o l l a t e r a l i z e d b o r r o w i n g requirement.
1

' T h e G r o u p of Ten consists of Belgium, Canada, France,
t h e Federal R e p u b l i c of G e r m a n y , Italy, lapan, t h e
Netherlands, Sweden, the United Kingdom, and the
U n i t e d States of America.
l2
S e e K e e t o n f o r an a n a l y s i s o f t h e e f f e c t o f t h e r i s k b a s e d capital g u i d e l i n e s on b a n k i n g organizations' capital r e q u i r e m e n t s .
l3
T h e E u r o p e a n C o m m u n i t y consists of B e l g i u m , France,
Italy, Luxembourg, the Netherlands, the Federal
R e p u b l i c of G e r m a n y , D e n m a r k , I r e l a n d , t h e U n i t e d
K i n g d o m , G r e e c e , S p a i n , a n d Portugal. T h e E u r o p e a n
Free Trade Association i n c l u d e s Austria, Norway,
Sweden, Switzerland, Finland, a n d Iceland.
l4
S e e Board of Governors of t h e Federal Reserve System
a n d Bank of England and M u f f e t t .
F o r a c r i t i q u e of a d r a f t v e r s i o n of t h e s w a p r e q u i r e m e n t s see Smith, Smithson, a n d Wakeman.
l6
F r a u d u l e n t p r e f e r e n c e e x i s t s if a d e b t o r f a v o r s o n e
c r e d i t o r o v e r o t h e r s in s e t t l i n g b a n k r u p t c y claims, thus
t r a n s f e r r i n g p r o p e r t y w i t h o u t a fair c o n s i d e r a t i o n in exchange. For an e x t e n s i v e discussion of swap n e t t i n g see
Shirreff.
15

17

M o r e o v e r , e v e n if s o m e g r o u p of s u p e r v i s o r s c o u l d
d e m o n s t r a t e a s u p e r i o r a b i l i t y to p r e d i c t i n t e r e s t rates,
this edge w o u l d not necessarily help the regulatory
agencies. Private investors w o u l d h a p p i l y b i d away any
regulator w h o can c o n s i s t e n t l y out-guess t h e m a r k e t on
future rate changes.

27

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Secondary Mortgage Markets 3 (Fall 1986): 2-7.
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P r i c e s . " New England
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D e c e m b e r 1987): 22-32.
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U.S. a n d English Insolvency Laws." In Swap Finance, vol.
2, e d i t e d b y Boris A n t l , 91-102. L o n d o n : E u r o m o n e y
Publications L i m i t e d , 1986.
H o u p t , ( a m e s V. "A R e g u l a t o r y P e r s p e c t i v e o n I n t e r e s t
Rate Risk: A Fed View." Issues in Bank Regulation 13 (Fall

S m i t h , C l i f f o r d W „ Jr., Charles W. S m i t h s o n , a n d D. Sykes
Wilford. Managing Financial Risk. New York: Ballinger Publ i s h i n g C o m p a n y , 1990.
S m i t h s o n , C h a r l e s W. "A L E G O ® A p p r o a c h t o F i n a n c i a l
E n g i n e e r i n g : An I n t r o d u c t i o n to Forwards, Future,
Swaps, a n d O p t i o n s . " Midland Corporate Finance Review 4
(Winter 1987): 16-28.
Wakeman, Lee M a c d o n a l d . "The Portfolio A p p r o a c h to
Swaps M a n a g e m e n t . " C h e m i c a l Bank C a p i t a l M a r k e t s
G r o u p s u n p u b l i s h e d w o r k i n g p a p e r , May 1986.
W a l l , L a r r y D. "A P l a n f o r R e d u c i n g F u t u r e D e p o s i t
Insurance Losses: Puttable S u b o r d i n a t e d Debt."
F e d e r a l R e s e r v e B a n k of A t l a n t a Economic Review 74
(July/August 1989): 2-17.
Wall, Larry D., a n d K w u n - W i n g C. Fung1. " E v a l u a t i n g t h e
C r e d i t E x p o s u r e of I n t e r e s t R a t e S w a p P o r t f o l i o s . "
F e d e r a l Reserve Bank of A t l a n t a W o r k i n g Paper 87-8,
D e c e m b e r 1987.
Wall, Larry D., a n d lohn ). Pringle. "Interest Rate Swaps: A
Review of t h e Issues." Federal Reserve Bank of Atlanta
Economic Review 73 ( N o v e m b e r / D e c e m b e r 1988): 22-40.

1989): 7-10.
l a c k s o n , D o m i n i q u e . " S w a p s K e e p in S t e p w i t h t h e
Regulators." Financial Times, August 10, 1988, 22.
K e e t o n , W i l l i a m R. "The New Risk-Based Capital Plan for
C o m m e r c i a l Banks." F e d e r a l Reserve Bank of Kansas
City Economic Review 74 ( D e c e m b e r 1989): 40-60.
M c N u l t y , l a m e s E. " I n t e r e s t Rate Risk: Lessons L e a r n e d
a n d Q u e s t i o n s U n a n s w e r e d . " journal of Retail Banking 9
(Fall 1987): 29-34.
M e r t o n , R o b e r t C. " T h e T h e o r y o f R a t i o n a l O p t i o n
Pricing." Bell journal of Economics and Management Science 4
(Spring 1973): 141-83.

28



. " A l t e r n a t i v e Explanations of Interest Rate Swaps: A
Theoretical and Empirical Analysis."
Management 18 (Summer 1989): 59-73.

Financial

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J o s e p h A. Whitt, Jr.
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Jon R. M o e n a n d Ellis W. Tallman
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Lucy F. Ackert a n d William C. Hunter
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Charles H. W h i t e m a n and William R o b e r d s
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Recovering Bank Profitability:
Spoiled Again by Large Banks'
Loan Problems
R o b e r t E. G o u d r e a u a n d B. Frank King

n c r e a s e d l o a n - l o s s provisions at t h e
nation's largest b a n k s sharply r e d u c e d
t h e a v e r a g e p r o f i t a b i l i t y of U.S. c o m mercial b a n k s in 1989. O t h e r b a n k s i n c r e a s e d
p r o f i t a b i l i t y , with t h e l e a s t p r o f i t a b l e c a t e g o r i e s in 1 9 8 8 p o s t i n g t h e l a r g e s t g a i n s . For
b a n k s in m o s t s i z e c a t e g o r i e s , 1989 was t h e
third s u c c e s s i v e y e a r of gains. 1 However, t h e
s m a l l e s t b a n k s , e v e n with i n c r e a s e d p r o f itability, did not perform as well as t h e i r larger
counterparts.

I

S o u t h e a s t e r n b a n k s d i f f e r e d from t h e nat i o n a l p a t t e r n in two s i g n i f i c a n t w a y s . 2 First,
profitability of t h e largest b a n k s d e c l i n e d l e s s
in t h e r e g i o n t h a n in t h e n a t i o n as a w h o l e .
Also in contrast to t h e national picture, t h e regions' b a n k s with a s s e t s l e s s than $ 2 5 million
a n d t h o s e in t h e $ 5 0 0 b i l ! i o n - t o - $ I b i l l i o n

The authors are, respectively, an assistant economist in the financial
section of the Atlanta Fed's Research Department and the department's associate director of research. They thank Sherley Wilson for
her valuable research assistance.

30



asset size class suffered s o m e decline. T h e s e
r e d u c t i o n s r e s u l t e d primarily from c o n t i n u i n g
t r o u b l e s at b a n k s in L o u i s i a n a a n d d e v e l o p ing p r o b l e m s at s o m e Florida b a n k s .
T h e p a t t e r n of 1989's p r o f i t a b i l i t y c h a n g e s
at t h e largest b a n k s is c o n s i s t e n t with y e a r s of
f o r e c a s t s that i n t e r e s t e a r n i n g s a n d e x p e n s e s
would influence b a n k s ' i n c o m e l e s s as d e p e n d e n c e on f e e i n c o m e a n d n o n i n t e r e s t exp e n s e s grew. I n t e r e s t e a r n i n g s s e e m to h a v e
b e c o m e l e s s i m p o r t a n t at t h e l a r g e s t b a n k s .
Had t h e s e b a n k s not r e p l a c e d i n t e r e s t inc o m e with f e e i n c o m e during t h e p a s t s e v e r a l
y e a r s , t h e y would h a v e b e e n e v e n l e s s profi t a b l e in 1989. T h e s m a l l e s t b a n k s c o n t i n u e d
to show u n i m p r e s s i v e overall profitability, on
t h e o t h e r hand, mostly b e c a u s e of higher noni n t e r e s t c o s t s than t h o s e of t h e i r larger c o u n terparts.
T h e 26 t a b l e s at t h e e n d of this a r t i c l e tell
s e v e r a l s t o r i e s a b o u t b a n k p r o f i t a b i l i t y in
1989 a n d p r e c e d i n g y e a r s . T h e r e m a i n d e r of
this p r e s e n t a t i o n highlights s o m e of t h e m o r e
interesting patterns that e m e r g e d or continued during 1989.

E C O N O M I C REVIEW, MAY/JUNE 1990

Profitability a t the Nation's Banks
P r o f i t a b i l i t y M e a s u r e s . Bank profitability
can h a v e different m e a n i n g s . For t h e p u r p o s e s
of this report t h e focus is on t h r e e profitability
measures and their c o m p o n e n t s : net interest
margin, return on a s s e t s (ROA), a n d return on
e q u i t y (ROE). 3 T h e s e m e a s u r e s are d e s c r i b e d
in d e t a i l in t h e a p p e n d i x . Briefly, n e t i n t e r e s t
margin i n d i c a t e s a b a n k ' s i n t e r e s t r e v e n u e s
less i n t e r e s t c o s t s a s a proportion of i n t e r e s t earning a s s e t s . For this analysis, r e v e n u e s are
a d j u s t e d t o t a k e into a c c o u n t d i f f e r e n t p r o portions of tax-free i n t e r e s t i n c o m e e a r n e d b y
various banks. R e v e n u e s are a l s o a d j u s t e d for
c r e d i t risk. T h e a d j u s t m e n t for c r e d i t risk is
c a l c u l a t e d by subtracting a bank's annual provisions for loan l o s s e s , which a p p r o x i m a t e exp e c t e d l o s s e s , from i n t e r e s t e a r n i n g s . Net
interest margin is similar to a b u s i n e s s ' s gross
profit margin, d i f f e r i n g a m o n g o t h e r w a y s in
t h a t it o m i t s e a r n i n g s from f e e s for s e r v i c e s
p r o v i d e d , an increasingly i m p o r t a n t s o u r c e of
r e v e n u e for t h e largest b a n k s .
Return on a s s e t s a n d return on e q u i t y a r e
m o r e g e n e r a l m e a s u r e s of a b a n k ' s a b i l i t y to
earn from its total o p e r a t i o n . A m e a s u r e of n e t
i n c o m e a s a p r o p o r t i o n of t o t a l a s s e t s , ROA
g a u g e s how effectively a bank u s e s ail of its financial and real i n v e s t m e n t s . ROE r e f l e c t s
how much a b a n k is e a r n i n g on s h a r e h o l d e r s '
investments.
P r o f i t a b i l i t y P a t t e r n s . R e v e r s i n g t h e upward m o v e m e n t of 1 9 8 8 f i g u r e s , o v e r a l l a d j u s t e d n e t i n t e r e s t margin d r o p p e d to 3.13
p e r c e n t in 1 9 8 9 f r o m 3 . 7 5 p e r c e n t in 1 9 8 8 .
( S e e T a b l e 1 for d a t a on n e t i n t e r e s t m a r g i n s
b y s i z e c l a s s f o r t h e y e a r s 1 9 8 5 - 8 9 . ) As in
1987, l o a n - l o s s provisions of b a n k s with a s s e t s
e x c e e d i n g $1 billion a c c o u n t e d for t h e s h a r p
d e c l i n e . T h e s e p r o v i s i o n s w e r e primarily related to loans to less d e v e l o p e d countries;
however, t r o u b l e d real e s t a t e l o a n s a l s o c o n t r i b u t e d . In o t h e r s i z e c l a s s e s , m a r g i n s inc r e a s e d o r w e r e s t a b l e . B a n k s with l e s s t h a n
$ 5 0 0 million in a s s e t s r e c o r d e d margins n e a r
or a b o v e t h e h i g h e s t m a r g i n s e a r n e d s i n c e
1985.
While b a n k s ' n e t interest margin, particularly when a d j u s t e d for c r e d i t risk, c o n t i n u e s to
b e t h e d o m i n a n t f a c t o r a f f e c t i n g b a n k prof-

F E D E R A L RESERVE B A N K O F ATLANTA




i t a b i l i t y , t h e r e is e v i d e n c e t h a t t h e l a r g e s t
b a n k s h a v e r e d u c e d t h e i r d e p e n d e n c e on int e r e s t e a r n i n g s d u r i n g t h e last d e c a d e . T h i s
reduction may have l e s s e n e d t h e n e g a t i v e imp a c t of sharply h i g h e r l o a n - l o s s p r o v i s i o n s on
t h e s e b a n k s ' profitability in 1989.
M e a s u r i n g t h e e x t e n t t o which b a n k s h a v e
r e d u c e d t h e i r d e p e n d e n c e on i n t e r e s t e a r n ings is difficult b e c a u s e m o v e m e n t s in intere s t r a t e s t h e m s e l v e s affect t h e significance of
i n t e r e s t e a r n i n g s . During t h e 1980s market int e r e s t r a t e s d e c l i n e d s u b s t a n t i a l l y , a n d lower
figures for i n t e r e s t earnings would have resulte d e v e n in t h e a b s e n c e of c h a n g e s in b a n k s '
s t r a t e g i e s . To g a u g e t h e r e d u c e d i m p o r t a n c e
of i n t e r e s t earnings at larger b a n k s , it h e l p s to
c o m p a r e t h e i r r e l a t i v e c o n t r i b u t i o n s to t o t a l
r e v e n u e in 1985 a n d 1989, y e a r s w h e n m e a s u r e s of i n t e r e s t e a r n i n g s p e r dollar of a s s e t s
w e r e s i m i l a r at t h e s e b a n k s ( s e e T a b l e 2).
T h o u g h i n t e r e s t e a r n i n g s p e r d o l l a r of a s s e t s
w e r e s o m e w h a t h i g h e r in 1989 t h a n in 1 9 8 5 ,
t h e y a c c o u n t e d for 84.6 p e r c e n t of total e a r n ings, c o m p a r e d with an 87.1 p e r c e n t s h a r e in
1985. At b a n k s in s m a l l e r s i z e c l a s s e s , t h e r e is
no e v i d e n c e of similar r e d u c t i o n s .
T h e m o s t s i g n i f i c a n t v a r i a t i o n in m a r g i n
c o m p o n e n t s ( s h o w n in T a b l e s 3 t h r o u g h 5)
a m o n g s i z e g r o u p s lay b e t w e e n t h e l a r g e s t
b a n k s a n d t h o s e in o t h e r c a t e g o r i e s . In 1989
b a n k s h a v i n g a s s e t s e x c e e d i n g $1 b i l l i o n
r e c o r d e d much higher interest earnings and
interest c o s t s p e r dollar of i n t e r e s t - e a r n i n g ass e t s than did b a n k s in any o t h e r size category.
But e v e n without c o n s i d e r i n g l o a n - l o s s provis i o n s of t h e larger b a n k s , their i n t e r e s t margin
was lower. As m e n t i o n e d earlier, t h e s e b a n k s
a l s o r e c o r d e d much larger a d d i t i o n s t o l o a n l o s s r e s e r v e s . R e m a r k a b l y l i t t l e v a r i a t i o n in
i n t e r e s t e a r n i n g s , i n t e r e s t e x p e n s e , a n d provisions a p p e a r e d among small and m e d i u m s i z e d b a n k s in 1989; t h e i n t e r e s t c o m p o n e n t s
i n c r e a s e d while l o a n - l o s s provisions d e c l i n e d
in all size c a t e g o r i e s e x c e p t t h e largest.
Banks' p e r f o r m a n c e on n e t i n t e r e s t margins
was n o t t r a n s l a t e d d i r e c t l y i n t o c o m m e n s u r a t e l y lower r e t u r n s on a s s e t s a n d e q u i t y for
t h e nation's b a n k s , h o w e v e r ( s e e T a b l e s 6 and
7). D e v i a t i o n s a p p e a r e d at b o t h e n d s of t h e
s i z e s p e c t r u m . T h o u g h r e t u r n s i m p r o v e d for
all b u t t h e largest b a n k s , t h e g r e a t e s t relative
i m p r o v e m e n t was r e c o r d e d b y t h e u n d e r - $ 2 5
31

million and the $500 million-to-$ 1 billion
a s s e t size groups. D e s p i t e t h e i r i m p r o v e m e n t ,
profitability l e v e l s in b a n k s with a s s e t s of l e s s
than $ 2 5 million r e m a i n e d well b e l o w t h o s e of
their larger counterparts (other than the
largest b a n k s ) for t h e fifth c o n s e c u t i v e year.
Prior to 1989 larger loan l o s s e s at t h e smalle s t b a n k s a c c o u n t e d for p a r t of t h e i r lagging
returns on a s s e t s a n d equity. In contrast, t h e i r
a d d i t i o n s to l o a n - l o s s r e s e r v e s during 1989
w e r e g e n e r a l l y in line with o t h e r b a n k s ' , l e a d ing t o t h e c o n c l u s i o n t h a t t h e i r low r e l a t i v e
return on a s s e t s a r o s e s o l e l y from h i g h e r
n o n i n t e r e s t e x p e n s e s ( s e e T a b l e 8). T h e s e
e x p e n s e s , which h a v e a v e r a g e d 3 . 8 p e r c e n t
of a s s e t s for t h e s m a l l e s t s i z e c l a s s d u r i n g
t h e p a s t five y e a r s , c o n t i n u e d to e x c e e d
n o n i n t e r e s t e x p e n s e - t o - a s s e t s ratios in all size
c l a s s e s e x c e p t t h e largest.
T h e g e n e r a l p a t t e r n of return on e q u i t y foll o w e d t h a t o f ROA e x c e p t t h a t t h e l a r g e r
banks' lower equity capital ratios allowed
t h e m t o return m o r e on b o o k v a l u e of e q u i t y
f o r e v e r y d o l l a r of ROA. L i k e ROA, R O E inc r e a s e d in 1989 for all b u t t h e l a r g e s t b a n k s ,
a n d R O E was l o w e s t in t h e two s m a l l e s t s i z e
c l a s s e s as well as t h e largest.

Southeastern Banks
As a w h o l e , b a n k s in t h e S o u t h e a s t r e c o r d e d profitability similar to t h e i r national c o u n t e r p a r t s ' l e v e l s in 1989, with t h e e x c e p t i o n s
n o t e d e a r l i e r . ( D a t a on s o u t h e a s t e r n b a n k s '
profitability are in T a b l e s 9-14.) Loan-loss prov i s i o n s d i d n o t hit t h e r e g i o n ' s l a r g e s t b a n k s
as hard. T h e i r l o a n - l o s s i n c r e a s e was 22 b a s i s
p o i n t s c o m p a r e d with an i n c r e a s e of 65 b a s i s
p o i n t s for b a n k s in t h e n a t i o n o v e r a l l . T h i s
b e t t e r performance carried over into southe a s t e r n b a n k s ' ROA a n d ROE.
O t h e r e x c e p t i o n s a p p e a r in two s i z e c a t e gories. Specifically, interest margins were
lower in t h e $ 5 0 0 million-to-$l billion size cate g o r i e s as a result of higher a d d i t i o n s to loanloss provisions.4 Lower adjusted interest
margins t r a n s l a t e d t o lower ROA a n d ROE for
t h e r e g i o n ' s b a n k s in t h i s g r o u p . L i k e t h e i r
c o u n t e r p a r t s nationally, s o u t h e a s t e r n b a n k s in
t h e s m a l l e s t size c l a s s r e p o r t e d l e s s prof32


i t a b i l i t y on an ROA a n d R O E b a s i s t h a n d i d
b i g g e r institutions. Though higher loan l o s s e s
in t h e s m a l l e s t c l a s s a c c o u n t for a s m a l l portion of this distinction, higher n o n i n t e r e s t exp e n s e s as a p e r c e n t a g e of total a s s e t s p l a y e d
a m a j o r part in t h e s e b a n k s ' c o n t i n u i n g lackluster p e r f o r m a n c e .
Among t h e region's s t a t e s , profitability followed t h e s a m e patterns o b s e r v e d over the
p a s t s e v e r a l years. (Data on b a n k profitability
b y s t a t e a r e f o u n d in T a b l e s 15-20.) B a n k s in
Georgia, w h o s e i n t e r e s t margins a r e much
h i g h e r t h a n o t h e r s t a t e s in t h e r e g i o n , p e r f o r m e d b e s t b y all m e a s u r e s , a n d t h o s e in
Louisiana brought up t h e rear. In line with t h e
nation, n e t i n t e r e s t margin, ROE, and ROA fell
to s o m e e x t e n t in e a c h s t a t e .

The Distribution of
Bank Profitability
A n a l y z i n g t h e c h a n g e s in b a n k s ' o v e r a l l
profitability l e v e l s r e v e a l s certain c l u e s a b o u t
how b a n k s h a v e r e s p o n d e d t o difficulties und e r l y i n g t h e l a r g e n u m b e r of b a n k f a i l u r e s
during r e c e n t years. For e x a m p l e , m o d e r a t e
o n e - y e a r d e c l i n e s in profitability of t h e m o s t
p r o f i t a b l e b a n k s would n o t n e c e s s a r i l y indic a t e significant difficulty for t h e b a n k i n g s y s t e m . On t h e o t h e r hand, if t h e l e a s t p r o f i t a b l e
banks have suffered reduced profitability,
t h e r e is c a u s e t o s u s p e c t c o n t i n u i n g p r o b lems.
O n e way to a n a l y z e t h e distribution of b a n k
profitability within a given a s s e t - s i z e category
is to rank all b a n k s in that category in a s c e n d ing o r d e r of profitability, divide t h e group into
quartiles, a n d d e s c r i b e t h e profitability of t h e
m o s t p r o f i t a b l e b a n k in e a c h q u a r t i l e . For e x a m p l e , t h e b a n k s with t h e b e s t ROA in t h e
first ( l o w e s t ) q u a r t i l e w o u l d b e t h o s e a t t h e
2 5 t h p e r c e n t i l e ; t h a t is, 25 p e r c e n t of t h e
b a n k s in a p a r t i c u l a r s i z e c a t e g o r y a r e l e s s
p r o f i t a b l e t h a n t h e b a n k at t h e 2 5 t h p e r c e n t i l e . C o m p a r i n g t h e p r o f i t a b i l i t y of t h e
b a n k a t t h e 25th p e r c e n t i l e o v e r t i m e w o u l d
i n d i c a t e t h e d e g r e e t o which t h e l e a s t profi t a b l e b a n k s in that a s s e t category are e x p e r i e n c i n g i m p r o v e m e n t o r d e t e r i o r a t i o n in
earnings. Likewise, comparing t h e ROA for t h e

E C O N O M I C REVIEW, MAY/JUNE 1990

b a n k s at t h e 75th p e r c e n t i l e o v e r t i m e would
i n d i c a t e c h a n g e s in t h e e a r n i n g s of t h e m o r e
profitable b a n k s in that s i z e category. (A 75thp e r c e n t i l e bank would b e more profitable
than 75 p e r c e n t of t h e b a n k s in its size c a t e g o ry.) A r i s e in p r o f i t a b i l i t y o v e r t i m e a t t h e
various p e r c e n t i l e s s u g g e s t s i m p r o v e d conditions; downward m o v e m e n t s i n d i c a t e d e t e r i o r a t i o n . T a b l e s 21 t h r o u g h 2 6 p r e s e n t t h e
p r o f i t a b i l i t y d i s t r i b u t i o n for e a c h of t h e six
a s s e t - s i z e c a t e g o r i e s during t h e past five
years.
Last y e a r t h e ROA of all t h r e e p r o f i t a b i l i t y
p e r c e n t i l e s of b a n k s in all s i z e c l a s s e s e x c e p t
t h e largest i m p r o v e d . For t h e l e a s t p r o f i t a b l e
b a n k s in e a c h c l a s s u n d e r $ 5 0 0 million in a s s e t s , 1989 was t h e t h i r d c o n s e c u t i v e y e a r of
i m p r o v e m e n t . ROA h a s i m p r o v e d d u r i n g at
l e a s t t h e last two y e a r s for b o t h t h e m e d i a n
b a n k a n d t h e 7 5 t h - p e r c e n t i l e b a n k s in e a c h
size class b u t t h e largest.
In e a c h of t h e last t h r e e years, t h e g r e a t e s t
profitability improvement has occurred
a m o n g t h e l e a s t p r o f i t a b l e b a n k s . Last y e a r ' s
m o d e r a t e ROA g a i n for t h e n a t i o n ' s l o w e s t quartile s m a l l e s t b a n k s is a w e l c o m e improvem e n t over t h e a n e m i c or n e g a t i v e returns
r e c o r d e d by t h e s e b a n k s for t h e previous four
y e a r s . As in 1 9 8 8 , p e r h a p s s o m e , b u t b y n o
m e a n s all, of last year's i m p r o v e m e n t in small
b a n k p r o f i t a b i l i t y can b e a s c r i b e d to t h e fact
t h a t a n u m b e r of t h e l e a s t p r o f i t a b l e s m a l l
b a n k s in t h e United S t a t e s d i s c o n t i n u e d o p e r ations. C l o s e to o n e - h a l f of t h e failed b a n k s in
r e c e n t y e a r s had a s s e t s u n d e r $ 2 5 million. In
t h e o t h e r two q u a r t i l e s for t h e s m a l l e s t b a n k s
ROA has b e e n much m o r e s t a b l e .

e d to loan loss, in 1989. In t h e i r c a s e t h e p o o r
got poorer, a s b a n k s with t h e lowest ROA lost
a b o u t o n e - f o u r t h of t h e i r r e t u r n on a s s e t s
w h i l e m o r e p r o f i t a b l e $1 b i l l i o n - p l u s b a n k s '
ROA d e c l i n e d l e s s than 5 p e r c e n t .

Conclusion
T h e nations' largest b a n k s suffered profi t a b i l i t y d e c l i n e s in 1 9 8 9 a s t h e y d o u b l e d
t h e i r p r o v i s i o n s for loan l o s s e s from 1988 additions. E x c e p t for t h e largest, however, b a n k s '
1989 p r o f i t a b i l i t y c o n t i n u e d a slow r e c o v e r y
from 1986 lows. T h e l e a s t p r o f i t a b l e b a n k s
c o n t i n u e d to r e c o v e r most, while t h e most
p r o f i t a b l e m a i n t a i n e d or m o d e s t l y i m p r o v e d
their returns. D e s p i t e ongoing recovery and
t h e failure of m a n y of t h e worst p e r f o r m e r s in
t h e i r s i z e class, though, t h e s m a l l e s t b a n k s —
t h o s e with a s s e t s of l e s s t h a n $ 2 5 m i l l i o n —
c o n t i n u e d to record ROAs a n d R O E s that w e r e
well b e l o w t h o s e of t h e i r larger c o u n t e r p a r t s .
H i g h e r o p e r a t i n g e x p e n s e s p e r d o l l a r of a s s e t s a c c o u n t e d for t h e g a p in 1989.
E x c e p t for s o m e b a n k s ' high o r i n c r e a s i n g
loan l o s s e s , c o n c e n t r a t e d in Louisiana a n d to
a l e s s e r d e g r e e in F l o r i d a a n d T e n n e s s e e ,
s o u t h e a s t e r n b a n k s followed t h e national patt e r n c l o s e l y . L a r g e r b a n k s in t h e r e g i o n s u f f e r e d l e s s from loan l o s s e s . L o u i s i a n a b a n k s
g e n e r a l l y d i d n o t perform as well as b a n k s in
o t h e r regional s t a t e s , continuing a p a t t e r n e s t a b l i s h e d in t h e early 1980s, and t r o u b l e s surf a c e d a t F l o r i d a b a n k s with a s s e t s o f $ 5 0 0
million to $1 billion.

ROA of t h e l a r g e s t b a n k s d e c l i n e d a l o n g
with t h e i r overall profitability, which was relat-

Appendix
Profitability M e a s u r e s

i n c o m e a n d e x p e n s e s a n d is roughly s i m i l a r t o a
b u s i n e s s ' s g r o s s profit m a r g i n . Gross profit is t h e

T h r e e different m e a s u r e s have b e e n used to

a m o u n t r e c e i v e d from s a l e s minus t h e c o s t of

p r o v i d e information on b a n k p e r f o r m a n c e : ad-

g o o d s or s e r v i c e s sold; o t h e r e x p e n s e s such as

j u s t e d n e t i n t e r e s t margin, return o n a s s e t s , a n d

sales, advertising, salaries, and rent have not

return on equity. A d j u s t e d net i n t e r e s t margin

b e e n d e d u c t e d . For b a n k s , t h i s i n d i c a t o r is c a l -

gauges t h e difference b e t w e e n a bank's interest

c u l a t e d b y s u b t r a c t i n g i n t e r e s t e x p e n s e from

F E D E R A L RESERVE B A N K O F ATLANTA




33

t a x - a d j u s t e d i n t e r e s t r e v e n u e ( n e t of l o a n - l o s s

focus on r e t u r n s t o s h a r e h o l d e r s l o o k at ROE.

provisions) and dividing that result by net

Highly c a p i t a l i z e d b a n k s t h a t p o s t t h e s a m e r e -

i n t e r e s t - e a r n i n g a s s e t s . F o r t h i s c a l c u l a t i o n , in-

turn o n a s s e t s a s l e s s well c a p i t a l i z e d c o m p e t i -

t e r e s t r e v e n u e from t a x - e x e m p t s e c u r i t i e s is a d -

t o r s will r e c o r d a l o w e r r e t u r n on e q u i t y . S i n c e

j u s t e d upward by t h e b a n k ' s marginal tax r a t e t o

r e t u r n o n e q u i t y is c o m p u t e d b y d i v i d i n g a

avoid penalizing institutions that hold substan-

b a n k ' s n e t i n c o m e b y its e q u i t y c a p i t a l , a b a n k ' s

tial s t a t e a n d l o c a l s e c u r i t i e s p o r t f o l i o s , w h i c h

return o n e q u i t y will d e c l i n e a s its e q u i t y c a p i t a l

r e d u c e tax b u r d e n s .

i n c r e a s e s , a s s u m i n g n e t i n c o m e r e m a i n s fixed.

L o a n - l o s s e x p e n s e s a r e s u b t r a c t e d f r o m int e r e s t r e v e n u e t o p l a c e b a n k s t h a t m a k e lower-

Profitability D a t a a n d C a l c u l a t i o n s

risk l o a n s at l o w e r i n t e r e s t r a t e s on a m o r e
e q u a l f o o t i n g with c o m m e r c i a l b a n k s t h a t m a k e

T h e d a t a in t h i s a r t i c l e a r e t a k e n from r e p o r t s

higher-risk l o a n s , which can g e n e r a t e g r e a t e r in-

of c o n d i t i o n a n d i n c o m e filed with f e d e r a l b a n k

t e r e s t i n c o m e . F o r e x a m p l e , i n t e r e s t r a t e s on

regulators by insured commercial banks. The

credit cards have b e e n substantially higher than

s a m p l e c o n s i s t s of all b a n k s t h a t h a d t h e s a m e

r a t e s on p r i m e c o m m e r c i a l l o a n s , b u t loan l o s s -

identification n u m b e r at t h e beginning and e n d

e s o n c r e d i t c a r d s h a v e a l s o b e e n larger. L o a n

of e a c h y e a r . T h e n u m b e r of b a n k s in t h e

l o s s e s o n c r e d i t c a r d s w e r e 3.1 p e r c e n t of t o t a l

national s a m p l e is 12,493.

c r e d i t c a r d v o l u m e in 1 9 8 8 for t h e n a t i o n ' s t o p
100 b a n k s in c r e d i t card o p e r a t i o n s , a c c o r d i n g t o
" T o p 100 B a n k s in C r e d i t Card O p e r a t i o n s . "
B a n k s a l s o b r i n g in n o n i n t e r e s t r e v e n u e in
t h e form of loan origination f e e s ; d e p o s i t s e r v i c e
c h a r g e s ; c h a r g e s for l e t t e r s of c r e d i t , l o a n c o m mitments, and other off-balance-sheet services;
a n d g a i n s from t h e s a l e of s e c u r i t i e s , t o n a m e a
few. In a d d i t i o n , t h e y incur n o n i n t e r e s t e x p e n s e s such as e x p e n d i t u r e s on e m p l o y e e salaries,
computer

equipment,

and

maintenance.

T h e t h r e e p r o f i t a b i l i t y m e a s u r e s u s e d in t h i s
s t u d y a r e d e f i n e d a s follows:
A d j u s t e d N e t I n t e r e s t Margin =
Expected Interest Revenues Interest Expense
Average I n t e r e s t - E a r n i n g A s s e t s
Return o n A s s e t s =

T h e r e f o r e , B a n k X with a c o m p a r a t i v e l y low a d j u s t e d i n t e r e s t margin m a y a c h i e v e a h i g h e r r e t u r n o n a s s e t s t h a n B a n k Y, w h i c h a t t a i n e d a
larger margin. T h a t is, Bank X may r e c o r d a highe r return on a s s e t s by realizing h i g h e r n o n i n t e r e s t r e v e n u e s or lower noninterest e x p e n s e s .
T h e r e t u r n on a s s e t s (ROA) r a t i o — t h e r e s u l t

1989

Net Income
Average Consolidated Assets
Return on E q u i t y =
Net Income
Average E q u i t y C a p i t a l

of d i v i d i n g a b a n k ' s n e t i n c o m e b y its a v e r a g e
a s s e t s — g a u g e s how well a b a n k ' s m a n a g e m e n t

Average interest-earning a s s e t s and a v e r a g e e q -

is u s i n g t h e firm's a s s e t s . T h e r e t u r n o n e q u i t y

uity capital a r e d e r i v e d by averaging b e g i n n i n g - ,

(ROE) figure t e l l s a bank's s h a r e h o l d e r s how

m i d d l e - , a n d e n d - o f - y e a r b a l a n c e s h e e t figures.

m u c h t h e i n s t i t u t i o n is e a r n i n g o n t h e

book

The e x p e c t e d interest income component to net

v a l u e of t h e i r i n v e s t m e n t s . R O E is c a l c u l a t e d by

i n t e r e s t margin i n c o r p o r a t e s two s i g n i f i c a n t a d -

d i v i d i n g a b a n k ' s n e t i n c o m e b y its total e q u i t y .

j u s t m e n t s from o r d i n a r y i n t e r e s t i n c o m e . If prof-

T h e r a t i o of ROA to R O E falls a s t h e

bank's

its b e f o r e tax a r e g r e a t e r than zero, t h e l e s s e r of

c a p i t a l - t o - a s s e t s ratio r i s e s . S m a l l e r b a n k s t y p -

r e v e n u e from s t a t e a n d local s e c u r i t i e s e x e m p t

ically h a v e h i g h e r c a p i t a l - t o - a s s e t ratios.

from f e d e r a l tax o r t h e b a n k ' s p r o f i t s b e f o r e tax

Analysts who want to c o m p a r e

profitability

w h i l e i g n o r i n g d i f f e r e n c e s in e q u i t y c a p i t a l rat i o s t e n d t o f o c u s o n ROA. P e o p l e w i s h i n g t o

34



is d i v i d e d b y 1 m i n u s t h e b a n k ' s

marginal

f e d e r a l tax rate. L o a n - l o s s e x p e n s e s a r e s u b t r a c t e d from i n t e r e s t r e v e n u e .

E C O N O M I C REVIEW, MAY/JUNE 1990

Table 12.
Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets
(Insured commercial banks by consolidated

Year

assets)

All

0-$25

$25-$50

$50-$100

$100-$500

$500 million-

Banks

million

million

million

million

$1 billion

$1 billion+

1985

3.57

3.77

3.78

3.77

4.31

4.22

3.30

1986

3.34

3.54

3.74

3.90

3.93

3.98

3.06

1987

2.71

3.82

3.95

4.12

4.21

3.91

2.03

1988

3.75

4.05

4.17

4.27

4.29

4.00

3.54

1989

3.13

4.20

4.24

4.24

4.27

4.05

2.65

Source: Figures in all tables have been computed by the Federal Reserve Bank of Atlanta from data in "Consolidated Reports of
Condition for Insured Commercial Banks" and "Consolidated Reports of Income for Insured Commercial Banks," 19851989, filed with each bank's respective regulator.

Table 2.
Tax-Equivalent Interest Earnings as
a Percentage of Interest-Earning
Assets and Total Revenue
(Insured commercial banks with over
$1 billion in assets)
Tax-Equivalent
Interest Earnings

Tax-Equivalent

as Percent of

Interest Earnings

Interest-Earning

as Percent of

Year

Assets

Total Revenue

1980

14.45

92.6

1981

17.04

93.1

1982

15.25

91.9

1983

12.38

89.0

1984

12.85

89.7

1985

11.33

87.1

1986

9.93

83.9

1987

9.83

83.0

1988

10.83

84.0

1989

11.89

84.6

4l
F E D E R A L RESERVE B A N K O F ATLANTA




Table 15.
Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets
(Insured commercial banks by consolidated assets)

Year

All
Banks

1985

11.41

11.80

11.57

11.39

11.58

11.59

1986

10.18

10.78

10.74

10.69

10.53

10.73

9.93

1987

9.90

9.95

10.00

10.00

10.06

10.04

9.83

1988

10.66

10.13

10.19

10.25

10.36

10.46

10.83

1989

11.59

10.68

10.78

10.76

11.01

11.15

11.89

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 millionS i billion

$1 billion+
11.33

Table 4.
Loan-Loss Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks by consolidated assets)

Year

All
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 millionSi billion

$1 billion+

1985

.79

1.25

1.00

.93

.70

.80

1986

.92

1.33

1.10

.96

.90

1.02

.88

1987

1.48

.94

.82

.68

.69

.90

1.84

.76

1988

.64

.72

.63

.56

.58

.79

.65

1989

1.08

.57

.53

.48

.56

.68

1.30

Table 5.
Interest Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks by consolidated assets)

36

Year

All
Banks

0-S25
million

S25-S50
million

$50-$100
million

$100-$500
million

$500 millionS i billion

1985

7.04

6.79

6.79

6.69

6.57

6.57

7.26

1986

5.92

5.90

5.91

5.83

5.70

5.73

5.99

$1 billion+

1987

5.71

5.19

5.23

5.19

5.16

5.23

5.96

1988

6.27

5.36

5.39

5.42

5.48

5.67

6.63

1989

7.38

5.91

6.01

6.04

6.18

6.42

7.93




E C O N O M I C REVIEW, MAY/JUNE 1990

Table 6.
Percentage Return on Assets
(Insured commercial banks by consolidated assets)

Year

All
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 millionS i billion

$1 billion+

1985

.70

.36

.69

.75

.87

.72

.67

1986

.63

.09

.46

.62

.68

.61

.65

1987

.10

.26

.46

.66

.75

.51

-.15

1988

.84

.37

.62

.78

.81

.58

.89

1989

.52

.63

.77

.91

.94

.91

.37

Table 7.
Percentage Return on Equity
(Insured commercial banks by consolidated assets)

Year

All
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 million$1 billion

$1 billion+

1985

11.31

3,67

8.00

9.30

11.96

10.29

12.53

1986

10.10

.91

5.34

7.72

9.43

9.00

11.84

1987

1.63

2.75

5.39

8.02

10.08

7.51

-2.80

1988

13.56

3.88

7.03

9.24

10.66

8.70

16.47

1989

8.21

6.45

8.52

10.43

12.15

13.10

6.49

Table 8.
Total Noninterest Expenses as a Percentage of Total Assets
(Insured commercial banks by consolidated assets)

Year

All
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 million$1 billion

$1 billion+

1985

3.5

3.7

3.2

3.2

3.2

3.4

3.6

1986

3.5

3.7

3.3

3.2

3.2

3.4

3.6

1987

3.7

3.8

3.3

3.2

3.2

3.4

4.0

1988

3.7

3.8

3.3

3.2

3.2

3.4

3.9

1989

3.7

3.8

3.3

3.2

3.2

3.2

3.9

FEDERAL RESERVE B A N K O F ATLANTA




37

Table 15.
Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by consolidated assets)

Year

AHSE
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 million$1 billion

$1 billion+

1985

4.42

4.47

4.21

3.95

4.65

3.91

4.56

1986

4.25

4.19

4.19

4.25

4.25

3.88

4.32

4.29

4.42

4.54

3.69

4.23

1987

4.28

4.20

1988

4.34

4.30

4.26

4.36

4.45

4.18

4.33

1989

3.81

4.16

4.30

4.18

4.23

3.48

3.60

Table 10.
Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by consolidated assets)

Year

ANSE
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100~$500
million

$500 millionSi billion

$1 billion+

1985

11.74

12.04

11.86

11.64

11.86

11.90

11.63

1986

10.74

11.16

11.12

11.05

10.89

10.94

10.51

1987

10.28

10.35

10.43

10.33

10.30

10.12

10.26

1988

10.64

10.54

10.59

10.53

10.50

10.50

10.73

1989

11.06

11.18

11.21

11.00

10.99

10.97

11.09

Table 11.
Loan-Loss Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by consolidated assets)

38

Year

ANSE
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 million$1 billion

$1 billion+

1985

.75

.90

.87

.96

.71

1.16

.60

1986

.86

1.13

1.02

.92

1.00

1.24

.70

1987

.80

.98

.88

.69

.68

1.22

.80

1988

.64

.71

.69

.57

.60

.56

.66

1989

.78

.79

.58

.51

.57

.96

.88




E C O N O M I C REVIEW, MAY/JUNE 1990

Table 12.
Interest Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by consolidated assets)

Year

AHSE
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 millionS i billion

$1 billion+

1985

6.56

6.67

6.78

6.73

6.50

6.83

6.46

1986

5.63

5.84

5.90

5.89

5.64

5.81

5.49

1987

5.20

5.18

5.26

5.22

5.09

5.21

5.23

5.45

5.76

5.73

6.18

6.53

6.61

1988

5.66

5.53

5.59

5.60

1989

6.48

6.23

6.34

6.32

Table 13.
Percentage Return on Assets
(Insured commercial banks in the Southeast by consolidated assets)

Year

All SE
Banks

0-$25
million

$25-$50
million

$50-$100
million

$100-$500
million

$500 million$1 billion

1985

.91

.75

.90

.80

.98

.50

.99

1986

.82

.33

.63

.74

.74

.55

.94

1987

.78

.31

.52

.73

.80

.45

.86

1988

.82

.30

.51

.82

.81

.86

.87

1989

.69

.28

.68

.90

.90

.55

.62

$1 billion+

Table 14.
Percentage Return on Equity
(Insured commercial banks in the Southeast by consolidated assets)

Year

All SE
Banks

0-$25
million

$25-$50
million

1985

13.09

7.27

10.00

9.70

13.31

7.64

1986

11.87

3.25

7.01

8.83

10.00

8.68

15.78

1987

11.18

2.82

5.70

8.61

10.56

6.90

13.99

1988

11.65

2.78

5.49

9.45

10.58

12.85

13.69

10.13

11.43

8.28

9.81

1989

9.71

FEDERAL RESERVE B A N K O F ATLANTA



2.46

7.15

$50-$100
million

$100-$500
million

$500 million$1 billion

$1 billion+
16.74

4l

Table 15.
Adjusted Net Interest Margin as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by state)
AUSE
Banks

Alabama

Florida

Georgia

Louisiana

Mississippi

1985

4.42

4.71

4.61

5.03

3.51

4.26

4.10

1986

4.25

4.72

4.56

4.75

2.47

4.15

4.36

1987

4.28

4.50

4.30

4.98

3.04

4.35

4.21

1988

4.34

4.47

4.36

4.98

3.43

4.28

4.11

1989

3.81

3.92

3.79

4.60

2.81

3.84

3.48

Year

Tennessee

Table 16.
Tax-Equivalent Interest Revenue as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by state)
AUSE
Banks

Alabama

Florida

Georgia

Louisiana

Mississippi

Tennessee

1985

11.74

11.79

11.80

12.14

11.53

11.52

11.40

1986

10.74

10.83

10.78

11.01

10.39

10.51

10.69

1987

10.28

10.11

10.14

11.10

9.97

10.30

10.03

1988

10.64

10.61

10.40

11.27

10.63

10.36

10.62

1989

11.06

10.95

10.91

11.77

10.67

10.76

11.06

Year

Table 17.
Loan-Loss Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by state)

Year

40

All SE
Banks

Alabama

Florida

Georgia

Louisiana

Mississippi

Tennessee

1985

.75

.60

.66

.57

1.36

.61

.71

1986

.86

.45

.68

.67

2.14

.67

.66

1987

.80

.45

.77

.72

1.61

.61

.64

1988

.64

.32

.59

.54

1.29

.46

.73

1989

.78

.41

.77

.59

1.44

.49

.95




E C O N O M I C REVIEW, MAY/JUNE 1990

Table 12.
Interest Expense as a Percentage of Interest-Earning Assets
(Insured commercial banks in the Southeast by state)

Year

All SE
Banks

Alabama

Florida

Georgia

Louisiana

Mississippi

1985

6.56

6.48

6.53

6.54

6.67

6.65

Tennessee
6.59

1986

5.63

5.65

5.54

5.60

5.78

5.69

5.68

1987

5.20

5.16

5.06

5.39

5.32

5.34

5.18

1988

5.66

5.82

5.45

5.75

5.91

5.67

5.77

6.62

6.35

6.58

6.42

6.44

6.63

1989

6.48

Table 19.
Percentage Return on Assets
(Insured commercial banks in the Southeast by state)

Year

AUSE
Banks

Alabama

Florida

Georgia

1985

.91

1.20

.86

1.20

1986

.82

1.22

.87

1.09

1987

.78

1.08

.75

1.13

1988

.82

1.16

.78

1989

.69

1.01

.62

Mississippi

Tennessee

.38

1.03

.95

-.22

1.00

.98

-.07

.88

.89

1.15

.03

.85

.84

1.12

-.09

.81

.61

Louisiana

Table 20.
Percentage Return on Equity
(Insured commercial banks in the Southeast by state)

Year

AUSE
Banks

Alabama

Florida

1985

13.09

14.95

13.68

18.38

4.73

14.14

13.85

-2.91

13.50

13.74

1986

Georgia

11.87

15.15

14.21

16.41

Louisiana

Mississippi

Tennessi

1987

11.18

13.27

12.06

16.02

-.93

11.49

12.33

1988

11.65

14.38

12.21

15.77

.44

10.92

11.55

1989

9.71

12.55

9.65

14.64

-1.25

10.22

8.39

FEDERAL RESERVE B A N K O F ATLANTA




4 l

Table 21.
Percentage Return on Assets

Table 22.
Percentage Return on Assets

(Insured commercial banks with assets
below $25 million)

(Insured commercial banks with assets
of $25 million to $50 million)
Percentile According to Profitability

Percentile According to Profitability
Year

75%

50%

25%

Year

75%

50%

1985

1.29

.82

.07

1985

1.34

.97

.50

1986

1.12

.65

-.26

1986

1.23

.83

.29

1987

1.09

.67

-.03

1987

1.18

.84

.35

1988

1.14

.78

.20

1988

1.24

.93

.53

.39

1989

1.30

1.00

.60

1989

1.20

.85

Table 23.
Percentage Return on Assets

Table 24.
Percentage Return on Assets

(Insured commercial banks with assets
of $50 million to $100 million)

(Insured commercial banks with assets
of $100 million to $500 million)

Percentile According to Profitability

Percentile According to Profitability

Year

75%

50%

25%

Year

75%

50%

25%

1985

1.34

1.02

.60

1985

1.32

1.03

.74

1986

1.28

.94

.45

1986

1.27

.97

.57

1987

1.25

.92

.52

1987

1.25

.97

.60

1988

1.28

.98

.65

1988

1.33

1.04

.72

1989

1.34

1.04

.71

1989

1.37

1.08

.78

Table 25.
Percentage Return on Assets

Table 26.
Percentage Return on Assets

(Insured commercial banks with assets
of $500 million to $1 billion)

(Insured commercial banks with assets
over $1 billion)

Percentile According to Profitability

42

25%

Year

75%

50%

1985

1.19

1986

Percentile According to Profitability

25%

Year

75%

50%

.92

.65

1985

1.11

.89

1.19

.92

.55

1986

1.11

.90

.60

1987

1.20

.94

.47

1987

1.08

.86

.30

1988

1.29

.99

.57

1988

1.21

1.02

.72

1989

1.32

1.07

.66

1989

1.20

.97

.52




25%
.59

E C O N O M I C REVIEW, MAY/JUNE 1990

Notes
'Six size c a t e g o r i e s of c o m m e r c i a l b a n k s are a n a l y z e d in
this study. They are ( I ) banks w i t h t o t a l assets u n d e r $25
million, (2) banks w i t h t o t a l assets of at least $25 m i l l i o n
and less than $50 m i l l i o n , (3) banks w i t h t o t a l assets of at
least $50 m i l l i o n a n d less t h a n $100 m i l l i o n , (4) b a n k s
with t o t a l a s s e t s of at l e a s t $100 m i l l i o n a n d less t h a n
$500 m i l l i o n , (5) b a n k s w i t h t o t a l assets of at least $500
m i l l i o n a n d less than $1 b i l l i o n , a n d (6) b a n k s w i t h t o t a l
assets of at least $ I b i l l i o n .
De n o v o banks are n o t i n c l u d e d in this s t u d y . T h e ratios d i s p l a y e d are full-year p r o f i t a b i l i t y figures b a s e d on
beginning-, middle-, and end-of-year balance sheets
and i n c o m e s t a t e m e n t s . Banks t h a t c o m m e n c e o p e r a tions d u r i n g any particular year will b e missing, at a m i n imum, beginning-of-year data. Commercial banks with
assets u n d e r $50 m i l l i o n a c c o u n t e d f o r 54.4 p e r c e n t
(6,790) of t h e t o t a l n u m b e r of banks n a t i o n w i d e (12,493)
that were i n c l u d e d in t h e 1989 s a m p l e , b u t o n l y 5.3 p e r cent of U.S. banks' t o t a l assets.
2

In t h i s s t u d y t h e S o u t h e a s t refers to t h e six s t a t e s t h a t
are e n t i r e l y or p a r t i a l l y w i t h i n t h e Sixth Federal Reserve
District: Alabama, Florida, Georgia, Louisiana, Mississippi, and Tennessee.
See Wall (1983) for a review of southeastern banks' returns on assets a n d e q u i t y for t h e 1972-82 p e r i o d .

3

The revenue, e x p e n s e , a n d p r o f i t a b i l i t y figures p r e s e n t ed are g e n e r a l l y similar to those d i s p l a y e d in prior bank
p r o f i t a b i l i t y s t u d i e s p u b l i s h e d in t h e Economic Review (see
G o u d r e a u a n d W h i t e h e a d for t h e m o s t r e c e n t s t u d y ) .
The figures are not i d e n t i c a l because r e p o r t i n g errors by
banks are c o n t i n u a l l y b e i n g f o u n d a n d c o r r e c t e d .

A d d i t i o n a l l y , t h e i n t e r e s t r e v e n u e as a p e r c e n t a g e of
i n t e r e s t - e a r n i n g assets r a t i o a n d a d j u s t e d n e t i n t e r e s t
margins may d i f f e r from figures r e p o r t e d in p r e v i o u s
s t u d i e s b e c a u s e of c o r r e c t i o n s in t h e t r e a t m e n t of taxe x e m p t interest income.
4

Size categories I t h r o u g h 6 last year c o n t a i n e d 304, 489,
400, 326, 33, a n d 47 s o u t h e a s t e r n b a n k i n g i n s t i t u t i o n s ,
r e s p e c t i v e l y . That is, t h e n u m b e r of r e g i o n a l b a n k s w i t h
t o t a l assets b e t w e e n $500 m i l l i o n a n d $1 b i l l i o n e q u a l e d
33 i n 1989 c o m p a r e d w i t h a t o t a l of 47 s o u t h e a s t e r n
banks w i t h assets of at least $1 b i l l i o n . T h e n u m b e r of ins t i t u t i o n s i n e a c h of t h e r e m a i n i n g size c l a s s i f i c a t i o n s
was much higher.
T h e u n e v e n p e r f o r m a n c e of southeastern banks in t h i s
$500 m i l l i o n - t o - $ l b i l l i o n asset category can b e t r a c e d to
a c q u i s i t i o n a n d merger activity, a b r o a d p r o f i t a b i l i t y imp r o v e m e n t in 1988, and a d i s c e r n i b l e clustering of poorly p e r f o r m i n g larger r e g i o n a l b a n k s in 1989. N u m e r o u s
i n s t i t u t i o n s w i t h i n this size category e x p e r i e n c e d d e c l i n ing profits in 1985, 1986, and 1987. A n u m b e r of these ina d e q u a t e l y p e r f o r m i n g banks, m o s t of w h i c h w e r e
l o c a t e d in L o u i s i a n a a n d F l o r i d a , e v e n t u a l l y w e r e acq u i r e d b y or m e r g e d i n t o larger, m o r e p r o f i t a b l e entities.
The banks that r e m a i n e d in this asset class generally rep o r t e d i m p r o v e d p r o f i t a b i l i t y in 1988. A l t h o u g h a majority of southeastern banks in t h e $500 m i l l i o n - t o - $ l b i l l i o n
s i z e c l a s s r e g i s t e r e d r e s p e c t a b l e e a r n i n g s in 1989,
b e l o w - s t a n d a r d p r o f i t p e r f o r m a n c e b y s o m e of t h e $500
m i l l i o n - t o - $ l b i l l i o n b a n k s again h e l d d o w n last year's
a v e r a g e p r o f i t r a t i o s f o r t h i s c a t e g o r y of s o u t h e a s t e r n
bank.

References
G o u d r e a u , R o b e r t E., a n d D a v i d D. W h i t e h e a d . " C o m -

W a l l , Larry D. " C o m m e r c i a l Bank Profits: S o u t h e a s t e r n

mercial Bank Profitability: I m p r o v e d in 1988." Federal

Banks Fare W e l l . " F e d e r a l R e s e r v e B a n k of A t l a n t a

Reserve Bank of Atlanta Economic Review 74 duly/August

Economic Review 68 (July 1983): 22-35.
. " C o m m e r c i a l Bank Profitability: Still Weak in 1987."

1989): 34-47.
"Top 100 B a n k s i n C r e d i t C a r d O p e r a t i o n s . "
Banker, S e p t e m b e r 18, 1989, 30.

FEDERAL RESERVE B A N K O F ATLANTA




American

F e d e r a l R e s e r v e B a n k of A t l a n t a Economic

Review 73

(July/August 1988): 28-42.

43

Book Review
Presidential Economics: The Making of Economic Policy from
Roosevelt to Reagan and Beyond,

2d revised edition.

by Herbert Stein.
Washington, D.C.: American Enterprise Institute for Public Policy Research, 1988.
450 pages. $12.75.

u b l i c d i s c u s s i o n of e c o n o m i c p o l i c y
is b e d e v i l e d b y t h e f a i l u r e t o d i s tinguish b e t w e e n q u e s t i o n s of logic
( w h e t h e r or not t h e federal deficit must fall, for
e x a m p l e ) , f o r e c a s t s (whether or not t h e deficit
will fall or, s i m i l a r l y , t h e l i k e l i h o o d o f t h e
deficit's b e i n g cut), a n d policy r e c o m m e n d a t i o n s (how t o cut t h e d e f i c i t ) . H e r b e r t S t e i n
h a s s p e n t his c a r e e r i l l u m i n a t i n g t h e s e d i s tinctions. In t h e m i d s t of t h e d e b a t e o v e r t h e
t r a d e d e f i c i t , for i n s t a n c e , w i t h j u s t a f e w
words h e was a b l e to clarify t h e discussion on
t h e feasibility of large t r a d e deficits w h e r e s o
m a n y o t h e r a n a l y s e s h a d f a i l e d : " D o e s anyo n e know an o p t i m u m rate of t h e t r a d e deficit
o t h e r t h a n w h a t e m e r g e s in t h e m a r k e t ? I
t h i n k not. C e r t a i n l y t h e o p t i m u m r a t e is n o t
z e r o . A c l i c h é of t h e s e d a y s is t h a t a t r a d e
deficit of t h e p r e s e n t s i z e c a n n o t go on forever. T h i s is n o t a x i o m a t i c a l l y t r u e , b u t it is
p r o b a b l y t r u e . T h a t d o e s not, h o w e v e r , g i v e
any g u i d a n c e . . . . (I]f s o m e t h i n g c a n n o t go on
forever, it will s t o p . " 1

P

S t e i n , A. Willis R o b e r t s o n P r o f e s s o r of Econ o m i c s E m e r i t u s at t h e University of Virginia
a n d f o r m e r C h a i r m a n of t h e P r e s i d e n t ' s
Council of E c o n o m i c Advisors, is an acknowle d g e d v i r t u o s o at f o c u s i n g a t t e n t i o n on t h e
44



heart of e c o n o m i c i s s u e s , cutting away t h e political a n d cultural b a g g a g e a n d o t h e r effluvia
that e n c u m b e r policy d e b a t e . His m o s t r e c e n t
b o o k , Presidential Economics, is an e x t e n d e d exe r c i s e in c l a r i f i c a t i o n a n d d e b u n k i n g . S u b titled The Making of Economic Policy from Roosevelt
to Reagan and Beyond, t h e b o o k t r a c e s t h e policymaking p r o c e s s from t h e o r y to formulation,
implementation, outcome, and evaluation.
T h e narrative, which b e g i n s in t h e 1920s, e s t a b l i s h e s a historical b a s i s for e x a m i n i n g t h e
e c o n o m i c p o l i c i e s of t h e R e a g a n a d m i n i s t r a t i o n s , e s p e c i a l l y t h e tax cuts early in t h e first
t e r m . S t e i n ' s d e s c r i p t i o n a n d e v a l u a t i o n of
d i f f e r e n t s c h o o l s of t h o u g h t and r e c e i v e d (or
d i s c a r d e d ) t h e o r y during e a r l i e r a d m i n i s t r a t i o n s s e t s up t h e d i s c u s s i o n of t h e R e a g a n
years.
S t e i n ' s review of t h e r e c o r d r e v e a l s a g o o d
d e a l of c o n t i n u i t y in U.S. e c o n o m i c p o l i c y making, a l b e i t m o r e in t e r m s of p r o c e s s (the
making) than of i d e a s (the policy). He m a k e s
t h i s d i s t i n c t i o n e a r l y on in Presidential
Economics. In t h e U n i t e d S t a t e s a history of rising
living s t a n d a r d s , along with faith in t e c h n o l o g ical a n d social p r o g r e s s , h a s e n c o u r a g e d t h e
b e l i e f t h a t t h e r e is a u n i q u e , c o r r e c t p o l i c y
s o l u t i o n to e v e r y p r o b l e m — r a n g i n g from

E C O N O M I C REVIEW, MAY/JUNE 1990

p o v e r t y a n d low p r o d u c t i v i t y growth to e n v i r o n m e n t a l d e g r a d a t i o n a n d inflation.
W h e n t h e e l e c t o r a t e p e r c e i v e s that current
p o l i c y is " n o t working," a c c o r d i n g t o c r i t e r i a
that m a y b e a r b i t r a r y , it c r e a t e s s u p p o r t for
c h a n g e , b u t it rarely i d e n t i f i e s an a l t e r n a t i v e
policy. This s e q u e n c e has occurred r e p e a t e d ly in t h e United S t a t e s . T h e initial s u p p o r t for
P r e s i d e n t s R o o s e v e l t , K e n n e d y , Nixon, Carter, a n d Reagan was m o r e a r e j e c t i o n of t h e n standard e c o n o m i c policies than a s e n t i e n t
e m b r a c e of a s p e c i f i c alternative program.
Recognizing this pattern, Stein d i s c u s s e s
c r i t e r i a for j u d g i n g b o t h t h e s u c c e s s of e c o nomic policy a n d t h e validity of s t a n d a r d e c o n o m i c t h e o r y . S t e i n o b s e r v e s a b i a s in t h e
United S t a t e s toward a c c e p t i n g t h e efficacy of
current policy: any e c o n o m i c c o n d i t i o n s t h a t
are n o t i n c o n s i s t e n t with a policy's e x p e c t e d
s u c c e s s f u l o u t c o m e a r e t y p i c a l l y v i e w e d as
e v i d e n c e of t h e policy's e f f e c t i v e n e s s . As long
as g e n e r a l c i r c u m s t a n c e s a r e a c c e p t a b l e (for
e x a m p l e , i n f l a t i o n is low a n d e m p l o y m e n t
growth is s t r o n g ) , t h e b u r d e n of p r o o f is on
c o m p e t i n g p o l i c i e s . If c o n d i t i o n s a r e n o t
good, o r not g o o d e n o u g h , this s t a t e of affairs
is b l a m e d on c u r r e n t p o l i c y , a n d t h e p u b l i c
bias shifts to e m b r a c e an a l t e r n a t i v e , e v e n if
unproven, policy.
Unfortunately, t h e real world is a p o o r l a b o ratory for evaluating e c o n o m i c policy b e c a u s e
it is difficult to distinguish t h e e f f e c t s of policy
from t h e i m p a c t of m y r i a d o t h e r i n f l u e n c e s .
For t h i s r e a s o n S t e i n s u g g e s t s t h a t all e c o nomic policy is e x p e r i m e n t a l . E c o n o m i c t h e o ry m a y s u g g e s t a p p r o p r i a t e p o l i c y in t h e
s e n s e that it is not i l l - e q u i p p e d to g u i d e policy, b u t t h e o r y customarily f o c u s e s on t h e rel a t i o n s h i p a m o n g o n l y a few v a r i a b l e s , n o t
hundreds. T h e risk is that o n e or m a n y of t h e
u n s p e c i f i e d v a r i a b l e s m a y b e h a v e in a way
that s u b v e r t s t h e "surface" v a r i a b l e s ' relationship.
Considering his views, then, S t e i n is not b e ing d i s m i s s i v e w h e n h e d e s c r i b e s P r e s i d e n t
Franklin R o o s e v e l t ' s fiscal policy as e x t e m p o rized. Each s u c c e e d i n g p r e s i d e n t h a s f a c e d
the s a m e c h a l l e n g e s t h a t c o n f r o n t e d his p r e decessors and contemporary policymakers:
How c a n o n e t e l l if p o l i c y is w o r k i n g , a n d
when d o e s o n e d e c i d e if it is n o t e f f e c t i v e ?
D o e s t h e policy's failure yield any information

FEDERAL RESERVE B A N K O F ATLANTA




a b o u t w h i c h p o l i c y m i g h t work n e x t t i m e ?
T h a t is, d o e s t h e e x p e r i e n c e l e a d t o a r e v i sion of b e l i e f a b o u t t h e way t h e world works?
As an e x a m p l e of how difficult such distinct i o n s may b e t o j u d g e , Stern c i t e s t h e c a s e of
p e r s o n a l i n c o m e t a x c u t s . In r e c e n t h i s t o r y
t h e r e h a v e b e e n two p e r s o n a l tax cut programs. T h e r e a s o n i n g s u p p o r t i n g e a c h tax cut
was e n t i r e l y d i f f e r e n t , and t h e m e a n s by
which e a c h was e x p e c t e d t o s t i m u l a t e g r o s s
n a t i o n a l p r o d u c t (GNP) w e r e m u t u a l l y e x c l u s i v e . T h e e v i d e n c e , however, which s u g g e s t s
t h a t e a c h p r o g r a m was s u c c e s s f u l , is c o n s i s t e n t with b o t h t h e o r i e s . B e c a u s e t h e r e is not
e n o u g h information to distinguish clearly b e t w e e n t h e e f f e c t s of t h e two p o l i c i e s , t h e
available data are not sufficient to support
o n e t o t h e e x c l u s i o n of t h e o t h e r . In o t h e r
words, t h e d a t a d o not allow a rigorous t e s t of
t h e underlying truth.
R e c e n t history's b e s t e x a m p l e of this o b s e r v a t i o n a l e q u i v a l e n c e is t h e t a x c u t s d u r i n g
t h e a d m i n i s t r a t i o n s of P r e s i d e n t s K e n n e d y
a n d R e a g a n . B e f o r e e a c h t a x r e d u c t i o n was
p a s s e d , its p r o p o n e n t s c o n t e n d e d t h a t t h e
cut would "raise national i n c o m e , i n c r e a s e
i n c o m e growth, b o o s t total o u t p u t and r e d u c e
t h e u n e m p l o y m e n t r a t e . " In t h e e a r l y 1 9 6 0 s
e c o n o m i s t s s u p p o r t i n g a tax cut had o n e pred o m i n a n t v i e w of h o w t h e t a x c u t w o r k e d .
L o w e r t a x e s w o u l d y i e l d h i g h e r a f t e r - t a x inc o m e for any level of gross i n c o m e . Higher inc o m e s would b o o s t s p e n d i n g b y h o u s e h o l d s
and b u s i n e s s e s ; this increased spending
would raise r e s o u r c e u s e ( e m p l o y m e n t and
factory utilization) at existing p r i c e l e v e l s b e c a u s e t h e e c o n o m y was t h e n o p e r a t i n g at l e s s
than full e m p l o y m e n t . As a c o n s e q u e n c e , add i t i o n a l r e s o u r c e s c o u l d b e e m p l o y e d without b i d d i n g up prices. Although few d i s p u t e d
that t h e higher level of activity might b r o a d e n
t h e tax b a s e s o as to o f f s e t t h e l o s s t o t h e
Treasury r e l a t e d to t h e tax rate cut, S t e i n e m p h a s i z e s that this c o n t e n t i o n was not central
to t h e policy.
During t h e 1 9 8 0 p r e s i d e n t i a l c a m p a i g n it
was a r g u e d that a tax cut would s t i m u l a t e
more activity and quickly r e p l a c e r e v e n u e ,
b u t t h i s r e s u l t was a t t r i b u t e d t o a d i f f e r e n t
c h a n n e l of i n f l u e n c e than that a c k n o w l e d g e d
a g e n e r a t i o n b e f o r e . T h i s s u p p l y - s i d e view,
like t h e 1960s policy, a s s u m e d t h e e x i s t e n c e
45

of u n e m p l o y e d r e s o u r c e s . However, t h e s e res o u r c e s r e p u t e d l y w e r e i d l e n o t b e c a u s e of
i n a d e q u a t e d e m a n d but b e c a u s e t h e after-tax
return to working or investing was insufficient
i n c e n t i v e . R e d u c i n g t a x r a t e s , e s p e c i a l l y at
t h e margin, would r a i s e t h e after-tax return to
labor and capital and so elicit a greater supply of r e s o u r c e s . In this way t o t a l o u t p u t and
i n c o m e s would b e raised by a tax cut. Several
additional t e n e t s characterized the supplys i d e v i e w of t h e e a r l y 1 9 8 0 s , m o s t n o t a b l y
that a tax cut would e n l a r g e t h e tax b a s e b y s o
much and so quickly that t h e cut actually
would raise total r e v e n u e and lower t h e
f e d e r a l b u d g e t deficit.
T h e d e s i g n e r s of t h e 1 9 6 4 t a x cut d i d n o t
e x c l u d e s u p p l y - s i d e e f f e c t s from t h e i r s c e n a r i o , b u t t h e i r s u p p o r t w a s n o t b a s e d on
t h e s e i m p a c t s , w h i c h w e r e j u d g e d to b e of
s e c o n d a r y i m p o r t a n c e and d i s c e r n i b l e only
o v e r t h e l o n g e r run. T h e lion's s h a r e of t h e tax
cut e f f e c t (and all t h e i m m e d i a t e impact) was
e x p e c t e d t o c o m e from i n c r e a s e d e x p e n d i tures.
In t h e w a k e of b o t h tax cut p r o g r a m s , t o t a l
s p e n d i n g a n d t o t a l o u t p u t r o s e a n d t h e une m p l o y m e n t rate fell. T h e e c o n o m y e x p a n d e d from 1961 to 1966, a n d an e v e n l o n g e r a n d
still-continuing e x p a n s i o n s t a r t e d in late 1982.
Each t a x cut was d e e m e d a s u c c e s s from t h e
point of view of m a c r o e c o n o m i c p e r f o r m a n c e ,
a l t h o u g h t h e tax r e v e n u e e f f e c t s w e r e l e s s
clear. S t e i n s t r e s s e s t h a t given t h e n u m e r o u s
o t h e r e v e n t s during t h e years surrounding
t h e s e tax cuts, many q u e s t i o n s a b o u t t h e connection b e t w e e n e c o n o m i c policies and econ o m i c p e r f o r m a n c e remain m y s t e r i e s . In fact,
a g o o d d e a l of t h e a n a l y s i s of t h e s e tax cuts'
i m p a c t is s p e c u l a t i v e , which is not to say uninformed.
In t h e m i d - 1 9 6 0 s t h e g r o w t h r a t e o f t h e
m o n e y supply a c c e l e r a t e d , providing m o n e tary as well as fiscal policy stimulus as t h e tax
cut c a m e on line. T h e s e p o l i c y c h a n g e s w e r e
not s y n c h r o n o u s . However, t h e timing, lags in
impacts, and c h a n n e l s of i n f l u e n c e of t h e polic i e s w e r e n o t s o p r e c i s e a s t o a l l o w o n e to
d i s e n t a n g l e t h e i r s e p a r a t e e f f e c t s . Similarly,
t h e tax cuts of t h e early 1980s were e n a c t e d at
a t i m e w h e n financial m a r k e t i n n o v a t i o n arid
d e r e g u l a t i o n m a d e it d i f f i c u l t t o g a u g e t h e
e x a c t s t a n c e of m o n e t a r y p o l i c y . S t a r t i n g
46



around 1982, moreover, t h e rise in t h e dollar's
e x c h a n g e v a l u e s l o w e d inflation. W h a t influe n c e s w e r e r e s p o n s i b l e for t h e lower inflation
a n d e c o n o m i c r e b o u n d in t h e 1 9 8 0 s ? T h e
point S t e i n m a k e s s o convincingly is that it is
rarely p o s s i b l e to distinguish t h e net individual c o n t r i b u t i o n s of various e c o n o m i c policies
from e a c h o t h e r , let a l o n e from t h e unc o u n t a b l e small a n d large forces acting on t h e
e c o n o m y at e v e r y m o m e n t .
C o n c e d i n g t h e f o r e g o i n g p o i n t s is n o t to
argue that o n e cannot distinguish good policy from b a d b e f o r e it is i m p l e m e n t e d . Stein's
p r e s c r i p t i o n for d i s c e r n i n g a p p r o p r i a t e m e a sures is a b r o a d approach, not a specific agenda. (Unfortunately, t h e fact that it is also b a s e d
on c o m m o n s e n s e s u g g e s t s that its probability of a d o p t i o n is r a t h e r low, given S t e i n ' s d e -

"(IJt is rarely possible to distinguish the
net individual contributions of various
economic policies from each other, let
alone from the uncountable small and
large forces acting on the economy at
every moment."

piction of U.S. p o l i c y m a k e r s ' a n d t h e public's
b i a s toward i m p r o b a b l e s c h e m e s . ) " T h e imp o r t a n t t h i n g is to find p o l i c i e s t h a t h a v e a
r e a s o n a b l e c h a n c e of i m p r o v i n g t h e p e r f o r m a n c e of t h e e c o n o m y a n d a l s o of b e i n g acc e p t a b l e to a sufficient range of i n t e r e s t s and
o p i n i o n s . . . . It is n o t s u f f i c i e n t or e v e n very
helpful to lay o u t ' i d e a l ' p r o g r a m s as if t h e i r
ideal character could b e objectively demons t r a t e d a n d as if t h e i r i m p l e m e n t a t i o n c o u l d
b e c o n f i d e n t l y e x p e c t e d o n c e t h e y had b e e n
promulgated." Repeatedly, Stein e x p o s e s the
i m p o r t a n c e of s e p a r a t i n g b o t h s e n t i m e n t and
f o r e c a s t s from logic. Many e c o n o m i c p o l i c i e s
h a v e b e e n o v e r s o l d by a failure to m a k e
t h o s e distinctions. Inevitably, such policies
a r e j u d g e d to b e d i s a p p o i n t m e n t s or failures
b e c a u s e a d i s p a s s i o n a t e a s s e s s m e n t was
never provided.

E C O N O M I C REVIEW, MAY/JUNE 1990

T h e c h a l l e n g e of a c h i e v i n g c o n t i n u e d e c o nomic growth in t h e United S t a t e s is an i s s u e
that S t e i n a d d r e s s e s t h r o u g h o u t t h e b o o k ,
s i n c e m o s t new p r e s i d e n t i a l a d m i n i s t r a t i o n s
e n t e r office with a plan to i m p r o v e e c o n o m i c
p e r f o r m a n c e . S t e i n c o n c l u d e s his d i s c u s s i o n
of t h e Ford-Carter stagflation y e a r s by disting u i s h i n g b e t w e e n p o l i c i e s f o c u s e d on t h e
short run, which usually d e f i n e t h e c h a l l e n g e
of improving e c o n o m i c p e r f o r m a n c e as raising
actual o u t p u t to p o t e n t i a l , from p o l i c i e s foc u s e d on t h e l o n g e r run, which a d d r e s s t h e
task of raising p o t e n t i a l . This i s s u e can b e d e fined in t e r m s of growth v e r s u s d e v e l o p m e n t .
If t h e l o n g e r run is n o m o r e than a s u c c e s sion of short runs, t h e r e is nothing wrong with
policies d e s i g n e d to e n s u r e b e t t e r short-run
p e r f o r m a n c e . However, t h e e x p e r i e n c e of t h e

"The initial success of some short-run
policies tempted policymakers to repeat
them. Given the brief history of active
countercyclical
economic policy, there
were few reasons to expect that shortterm policies could not work indefinitely."

1970s s h o w e d t h a t t r a d e - o f f s s u c h a s t h o s e
b e t w e e n e m p l o y m e n t a n d inflation which
may e x i s t o v e r t h e short term a r e n e i t h e r e x p l o i t a b l e nor s t a b l e o v e r l o n g e r p e r i o d s , in
fact, s o m e short-run p o l i c i e s may d a m a g e t h e
e c o n o m y ' s ability to a c h i e v e b e t t e r results in
the long run. Policies d e s i g n e d to s u p p o r t t h e
u n e m p l o y e d , for e x a m p l e , m a y h a v e d i s i n c e n t i v e e f f e c t s that m a k e t h e l a b o r force l e s s
m o b i l e and m o r e p r o n e to e x t e n d e d p e r i o d s
of u n e m p l o y m e n t . S i m i l a r l y , w h i l e p o l i c y
s t i m u l u s m i g h t l o w e r u n e m p l o y m e n t at t h e
cost of m o r e rapid i n c r e a s e s in p r i c e s , a c c e l e r a t i n g inflation h a s b e e n r e q u i r e d t o k e e p
u n e m p l o y m e n t lower. Clearly, t h i s s i t u a t i o n
too is u n t e n a b l e o v e r t h e longer t e r m .
T h e initial s u c c e s s of s o m e short-run polic i e s t e m p t e d p o l i c y m a k e r s to r e p e a t t h e m .
Given t h e b r i e f history of a c t i v e c o u n t e r c y c l i -

FEDERAL RESERVE B A N K O F ATLANTA




cal e c o n o m i c policy, t h e r e w e r e few r e a s o n s
to e x p e c t t h a t s h o r t - t e r m p o l i c i e s c o u l d n o t
work i n d e f i n i t e l y . T h e long t e r m was s e l d o m
c o n s i d e r e d , a n d , when it was, it was not c o n s i d e r e d t o b e d i f f e r e n t in n a t u r e from t h e
short run.
D i s a p p o i n t m e n t with t h e failure of s h o r t run p o l i c i e s led to s o m e very s o b e r i n g b e n e f i t / c o s t a n a l y s i s . S t e i n s u g g e s t s t h a t ex p o s t
a n a l y s i s of t h e s e p o l i c i e s is a l w a y s l e s s b i a s e d than ex a n t e a s s e s s m e n t s . He a r g u e s
t h a t e x a n t e e v a l u a t i o n s a r e flawed b e c a u s e
b e n e f i t s a r e s e e n as d i r e c t a n d m e a s u r a b l e ,
while t h e c o s t s a r e r e g a r d e d a s indirect, or at
l e a s t diffuse. This view l e a d s to a t e n d e n c y
toward o v e r e s t i m a t i n g b e n e f i t s and u n d e r e s t i m a t i n g c o s t s a n d s o toward e x c e s s g o v e r n ment spending and regulatory programs.
However, S t e i n d o e s not distinguish i m m e d i a t e and long-run c o s t s and b e n e f i t s . For many
p r o g r a m s like H e a d S t a r t , b e n e f i t s a r e slow,
indirect, and cumulative, w h e r e a s costs are
i m m e d i a t e , direct, and recurring. Still, he
s t r e s s e s that t h e d i s i n c e n t i v e e f f e c t s on s o m e
i n c o m e m a i n t e n a n c e p r o g r a m s c a n n o t b e ign o r e d w h e n e v a l u a t i n g e c o n o m i c p o l i c i e s of
t h e 1960s and 1970s.
In his afterword, S t e i n a s s e s s e s both m o n e tary and fiscal policy in r e c e n t years. He faults
m o n e t a r y policy for t h e inflation of t h e 1970s
and early 1980s. However, this conclusion
g i v e s m o n e t a r y p o l i c y m o r e i n f l u e n c e than it
can c l a i m . High real i n t e r e s t r a t e s , s t a g n a n t
productivity growth, a stifling regulatory structure, a large t r a d e deficit, and intransigent inflation a r e all s y m p t o m s of a b a d policy mix.
M o n e t a r y policy a l o n e c a n n o t b e s o d e s t r u c tive. Interestingly, m o n e t a r y policy e m b r a c e d
a l o n g e r - r u n f o c u s (in l a t e 1979) w h e n fiscal
policy lost such a p e r s p e c t i v e .
On t h e e x p e r i e n c e of r e c e n t fiscal p o l i c y ,
Stein concludes: "Probably the outstanding
l e s s o n of t h e e p i s o d e [federal b u d g e t deficits
o v e r $ 2 0 0 b i l l i o n ] was t h a t t h e U.S. d i d n o t
h a v e a n y fiscal p o l i c y . " S t e i n d e f i n e s fiscal
policy as that "which d e t e r m i n e s an appropria t e s i z e for t h e deficit or surplus to which d e cisions about expenditures and revenues are
t h e n a d a p t e d . " He c o n t i n u e s , " T h e distinctive
f e a t u r e of a fiscal policy is that t h e r e is a rule
or p r i n c i p l e which d e t e r m i n e s t h e s i z e of t h e
deficit o r surplus first a n d which r e q u i r e s ex-

47

p e n d i t u r e s a n d r e v e n u e s to conform t o t h a t . "
T h e G r a m m - R u d m a n r e q u i r e m e n t s p r o v e d to
b e insufficiently punitive to force fiscal policy
i n t o s h a p e . S t e i n f a i l s t o r e c o g n i z e t h a t in
such a s e t t i n g it was i m p o s s i b l e for m o n e t a r y
policy to c o m p e n s a t e for fiscal policy's flaws.
By in e f f e c t a b s o l v i n g fiscal p o l i c y of any res p o n s i b i l i t y for e c o n o m i c c o n d i t i o n s , h e shifts
t h e e n t i r e load to m o n e t a r y policy. If e v a l u a t e d on this b a s i s , m o n e t a r y p o l i c y will always
b e found wanting.
Presidential Economics is p o w e r f u l l y p e r s u a sive in its a r g u m e n t s for b e t t e r policymaking,
providing a s it d o e s a rich history of s u c c e s s e s
and pitfalls. Essentially, Stein's a d v i c e e m phasizes consensus and pragmatism over
ideology. T h e United S t a t e s has a mixed e c o n omy in which few m a r k e t s are c o m p l e t e l y un-

48



r e g u l a t e d a n d few a r e e n t i r e l y r e g u l a t e d . In
t h i s s e t t i n g , p o l i c i e s b a s e d on e x t r e m e s are
unlikely to p r o m o t e t h e g e n e r a l welfare. Stein
a r g u e s that pragmatism d o e s n o t i n d i c a t e the
failure of i d e o l o g y b u t rather a familiarity with
t h e facts; it is not s o much a c o m p r o m i s e b e t w e e n o p p o s i n g i d e a l s a s it is an i d e a l in its
own right. As such, it r e q u i r e s no apology.
Mary Susan Rosenbaum

The reviewer is research officer in charge of the macropolicy
of the Atlanta Fed's research

section

department.

Note
1

H e r b e r t Stein, "Leave t h e Trade Deficit Alone," Wall Street
Iournal, March 11, 1987.

E C O N O M I C REVIEW, MAY/JUNE 1990













•

-

In

Memoriam

J. Edward Rooks
For his contributions as a graphic designer and typesetter
to the Economic Review and other publications of the
Federal Reserve Bank of Atlanta




June 22, 1958 - J u n e 24, 1990

V

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