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nEœnomic ^sM Review mmamummmu • 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 The Economic Review seeks to inform the public about Federal Reserve policies and t h e economic environment and, in particular, to narrow the gap between specialists and concerned laypersons Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System Material may be reprinted or abstracted if the Review and author are credited Please provide the Bank's Public I n f o r m a t i o n Department w i t h a copy of any p u b l i c a t i o n containing reprinted material Free s u b s c r i p t i o n s a n d l i m i t e d a d d i t i o n a l c o p i e s are available from the Public Information Department, Federal Reserve Bank of Atlanta. 104 Marietta Street. N W . Atlanta, Georgia 30303-2713 (404/521-8788) Change-of-address notices and subscription cancellat i o n s s h o u l d be sent d i r e c t l y t o the Public I n f o r m a t i o n Department Please include the current m a i l i n g label as well as any new information ISSN 0 7 3 2 - 1 8 1 3 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 References A l l e n , F r e d e r i c k L e w i s . The Lords of Creation. Harper a n d Brothers Publishers, 1935. . The Great Pierpont Morgan. Brothers Publishers, 1949. New York: N e w York: H a r p e r a n d A n d r e w , A. P i a t t . " S u b s t i t u t e s f o r Cash i n t h e Panic of 1907." Quarterly journal of Economics 23 ( A u g u s t 1908): 497-516. . 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Seasonal Variations in the Relative Demand for Money and Capital in the United States-. A Statistical Study. FEDERAL RESERVE B A N K O F ATLANTA W a s h i n g t o n , D C.: U.S. G o v e r n m e n t P r i n t i n g O f f i c e , 1910. . "Seasonal V a r i a t i o n s in t h e N e w York M o n e y Mark e t . " Quarterly journal of Economics 25 (March 1911): 3349. K i n d l e b e r g e r , C h a r l e s P. Manias, Crashes, and Panics: A History of Financial Crises. N e w York: Basic Books, 1989. K i n l e y , D a v i d . The Independent Treasury System of the United States and Its Relations to the Banks of the Country. W a s h i n g t o n , D C.: U.S. G o v e r n m e n t P r i n t i n g O f f i c e , 1911. M o e n , |on, a n d Ellis W. Tallman. "The Bank Panic of 1907: T h e R o l e of t h e T r u s t C o m p a n i e s . " F e d e r a l R e s e r v e Bank of Atlanta W o r k i n g Paper 90-3, May 1990. M y e r s , M a r g a r e t . The New York Money Market: Origins and Development. N e w Y o r k : C o l u m b i a U n i v e r s i t y Press, 1931. N e a l , Larry. "Trust C o m p a n i e s a n d F i n a n c i a l I n n o v a t i o n , 1897-1914." Business History Review 45 (Spring 1971): 3551. The New York Times, lanuary 21-October 17, 1907. Noyes, A l e x a n d e r Dana. Forty Years of American Finance. New York: G.P Putnam and Sons, 1909. S a t t e r l e e , H e r b e r t L. ). Pierpont Morgan: An Intimate Portrait. New York: M a c m i l l a n a n d Company, 1939. S o b e l , R o b e r t . Panic on Wall Street. N e w York: M a c m i l l a n , 1968. Sprague, O l i v e r M.W. "The A m e r i c a n Crisis of 1907." The Economic journal ( S e p t e m b e r 1908): 353-72. . History of Crises Under the National Banking System. N a t i o n a l M o n e t a r y C o m m i s s i o n . W a s h i n g t o n , D.C.: U.S. G o v e r n m e n t Printing Office, 1910. T a l l m a n , E l l i s W. " S o m e U n a n s w e r e d Q u e s t i o n s a b o u t 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 References A b k e n , Peter A. "Interest-Rate Caps, Collars, a n d Floors." 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 ( N o v e m b e r / D e c e m b e r 1989): 2-23. A l f r i e n d , M a l c o l m C. " I n t e r e s t R i s k - B a s e d C a p i t a l S t a n d a r d : H i s t o r y a n d E x p l a n a t i o n . " F e d e r a l Reserve B a n k o f R i c h m o n d Economic Review 74 ( N o v e m b e r / D e c e m b e r 1988): 28-34. A r a k , M a r c e l l e , L a u r i e S. G o o d m a n , a n d A r t h u r Rones. " C r e d i t L i n e s for N e w I n s t r u m e n t s : Swaps, O v e r - t h e Counter Options, Forwards and Floor-Ceiling A g r e e m e n t s . " F e d e r a l Reserve Bank of Chicago, Conference on Bank Structure and Competition, 1986, 437-56. B e l t o n , Terrence M. 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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 E C O N O M I C REVIEW, MAY/JUNE 1990 Working Paper Series Available R e s e a r c h D e p a r t m 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 A t l a n t a p u b l i s h e s a w o r k i n g p a p e r s e r i e s t o s t i m u l a t e professional discussion and exploration of e c o n o m i c s u b j e c t s . We w e l c o m e r e a d e r s of t h e Economic Review t o c o m p l e t e a n d r e t u r n t h e form b e l o w in o r d e r t o r e c e i v e o u r r e c e n t l y r e l e a s e d working p a p e r s . If y o u would like a c o p y of any of t h e c u r r e n t p a p e r s , s i m p l y c h e c k t h e b o x n e x t t o t h e p a p e r ' s n u m b e r a n d return t h e form t o t h e P u b l i c Information D e p a r t m e n t , F e d e r a l R e s e r v e B a n k of Atlanta. 90-1 T h o m a s J. Cunningham Some Real Evidence on the Real Bills Doctrine Versus the Quantity 90-2 Theory J o s e p h A. Whitt, Jr. The Long-Run 90-3 Behavior of the Real Exchange Rate: A Reconsideration Jon R. M o e n a n d Ellis W. Tallman The Bank Panic of 1907: The Ro/e of Trust 90-4 Companies Lucy F. Ackert a n d William C. Hunter A Sequential Test Methodology Margin Management 90-5 for Detecting Futures Market Disruptions with Applications to Futures P e t e r A. Abken Valuing Default-Risky 90-6 interest-Rate Caps: A Monte Carlo Approach P e t e r A. Zadrozny Estimating a Multivariate ARMA Model with Mixed-Frequency U.S. GNP at Monthly Intervals 90-7 Data: An Application to Forecasting Charles H. W h i t e m a n and William R o b e r d s Monetary Aggregates as Monetary Targets: A Statistical Investigation Previous working p a p e r s are also a v a i l a b l e . For m o r e information c o n t a c t t h e Public Information D e p a r t m e n t , 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 , 104 M a r i e t t a S t r e e t , N.W., A t l a n t a , G e o r g i a 3 0 3 0 3 - 2 7 1 3 (404/521-8788). • P l e a s e start my s u b s c r i p t i o n t o t h e Working P a p e r S e r i e s . • P l e a s e s e n d m e a c o p y of t h e following working p a p e r s : •90-1 Q90-2 090-3 Q90-4 Q90-5 a90-6 Q90-7 Name Address City State ZIP Return to the Public Information Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713. 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 I Economic Review Federal Reserve Bank of Atlanta 104 Marietta S t , N.W. Atlanta, Georgia 3 0 3 0 3 - 2 7 1 3 Address Correction Requested Bulk Rate U.S. Postage PAID Atlanta, Ga. Permit 292