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Economic
Review
FEDERAL RESERVE BANK O F ATLANTA
NOVEMBER/DECEMBER 1988
Interest Rate Swaps
Europe, 1992
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WMm'&tlMV&i:-
BanLPamcs:
Some Unanswered Questions
Economic
Review
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ISSN 0732-1813
V O L U M E LXX1I1, N O . 6, N O V E M B E R / D E C E M B E R 1988, E C O N O M I C R E V I E W
2
Some Unanswered Questions
about Bank Panics
Ellis Tallman
22
Interest Rate Swaps:
A Review of the Issues
Larry D. Wall and John J. Pringle
42
52
56
58
F.Y.I.
What is the true cost of bank panics?
Current problems with deposit
insurance highlight the need to reexamine this question.
Since 1982, the interest rate swaps
market has grown at an extraordinary
pace. This article provides an overview
of this important financial innovation
and some of the issues that it places
before market participants and
regulators.
David D. Whitehead
Moving toward 1992:
A Common Financial Market for Europe?
Book Review
The Gathering
William Curt Hunter
by Edward J. Kane
Index for 1988
Statistical Pages
Finance, Employment, Construction, General
Crisis in Deposit
Insurance
Some Unanswered Questions
about Bank Panics
Ellis Tallman
Though
they
most economists
have been in terms
impact
of this financial
agree
of their
that bank
panics should
effect on macroeconomic
phenomenon
and suggests
Federal deposit guarantees distort the incentives of banks and depositors. In order to max-
The author is an economist
Fed's Research
2
in the macropol icy section of the
Department.
wide disagreement
performance.
a number
Recent experiences in the U.S. banking and
thrift industry have brought to the forefront issues
regarding the current extent of the government
regulatory framework for depository institutions.
Deposit guarantee legislation, beginning with
the 1933 establishment of the Federal Deposit
Insurance Corporation (FDIC), was enacted to
prevent bank system failures like those during
the Great Depression. Since deposits have
been guaranteed, no nationwide bank panics
have occurred. In that regard existing legislation
has been successful. Thus, for many years, the
federal deposit guarantee programs were perceived as inexpensive mechanisms to safeguard
the banking system against bank panics; current
experience, though, has altered the perceptions of deposit insurance costs. (For a related
article on deposit insurance, see this issue's
Book Review by William Curt Hunter on p. 52.)
Atlanta
be avoided,
In this article
of areas for further
exists over how
the author
costly
examines
the
analysis.
imize the value of their deposit insurance,
banks have an incentive to maintain an asset
portfolio with more risk than might otherwise be
assumed; depositors, meanwhile, have less incentive to monitor depository institutions, since
insurance has greatly reduced the risk of capital
loss on deposits. Thus, federal deposit insurance programs have produced "moral hazard"
problems that contribute, along with other factors, to the imposition of substantial costs upon
the intermediation system. These costs have become most apparent in the past several years.1
In light of possible federal insurance costs,
economists are focusing renewed attention on
the phenomena of bank runs and bank panics.
Some economists question whether the bank
panics that occurred from the National Banking
Era through the Depression substantially dampened macroeconomic activity, but existing
results from that period are ambiguous. Historically, major bank panics have been closely
associated with recessionary periods in business cycles. Disagreement exists, however, on
whether downturns in the business cycle created
poor economic conditions, thus sparking panECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
ics, or whether the occurrence of bank panics
spurred economic contractions. Even the more
moderate view, that panics exacerbated the
amplitude of recessions, is unproven because
no research has isolated the explicit economic
costs of bank panics.
This article addresses the issue of whether
bank panics have a large macroeconomic impact in addition to that caused by the contraction in the real economy. The macroeconomic
characteristics of the bank panics that took
place during the National Banking Era (18631914) are investigated to provide empirical
focus for analyzing the divergent views of banking crises and their economic impact. 2 This
study also examines the relationship between
bank panics and economic contractions and describes the similar economic properties of panic
periods, drawing from several studies that analyze these times. Data series of real economic
activity are scrutinized, as is banking activity in
general during the National Banking Era.
The measured macroeconomic impact of panics remains inseparable from the general economic downturn; thus, distinguishing clearly
FEDERAL RESERVE BANK OF ATLANTA
between the contraction effects of a panic and
those of a concurrent recession is difficult with
the present data set. The data reviewed in this
article, however, are consistent with the view
that bank panics themselves were not the cause
of economic downturns and thatthe disruptions
in the economy caused by these panics may
have been less severe than once believed. Many
discussions describe the Great Depression experiences as foremost examples of the cost and
deleterious effects of bank panics, in comparing
relevant economic measures of National Banking Era panics to those of the panics during the
Great Depression, the results suggest that the
events are not directly comparable. 3 A proper
comparison would address the institutional differences and the respective responses of these
institutions to the onset of panics. This paper
contends that economists must perform additional research to determine more clearly the
economic costs of bank panics. This research
should be directed explicitly at delineating the
costs incurred because of a bank panic from
those costs resulting from an existing contraction in the real economy.
3
Bank Panics Defined
Any discussion of bank panics must distinguish them from bank runs. In this article, a bank
run is characterized by depositors' attempting
to liquidate all their deposits at a particular
institution. A bank run does not necessarily
imply the removal of funds from the banking system ; since other banks may be perceived as solvent, the funds may be redeposited at another
bank. In this definition of a bank run, a number
of banks in a region can be affected simultaneously, but the run still does not extend to the
entire banking system.
Economists disagree about the costs and
benefits of bank runs. One perspective suggests
that runs impose a market discipline on banks
by threatening a large-scale removal of deposits
and prompt suspension of insolvent institutions.
Federal deposit insurance eliminates these
positive aspects of bank runs by reducing the
monitoring incentive of depositors. These economists advocate increased private market discipline for the banking industry primarily to
reduce the cost of bank failures and the time it
takes for them to run their course; runs provide
quick resolution to bank insolvency and, in this
view, subsequently improve the overall operation of the banking system.4 Implicitly, from this
perspective the social benefits of bank runs
exceed the associated costs.
In sharp contrast, a number of researchers
argue that bank runs are "contagious" and, as
such, dangerous to the entire financial system
because a run on an individual bankcan not only
spread to solvent banks but can threaten the
collapse of the entire banking system through a
bank panic. Thus, a'lowing bank runs to occur
may increase the risk of bank panics.
A bank panic can be described as a widespread desire on the part of depositors in all
banks to convert bank I iabil ities—their deposits—
into currency. A bank panic entails the removal
of bank deposits from the depository system,
thus threatening the intermediation process. In
contrast to bank runs, bank panics are basically
systemic problems and can b e viewed as systemic bank runs.
Throughout most of its history the U.S. banking system has operated on a fractional reserve
basis, which is designed so that the cash reserves
4
of banks are only a fraction of their outstanding
liabilities. In addition, a high proportion of bank
liabilities are demand deposits—that is, deposits that a bank is obligated to pay in cash on
demand to depositors. The exchange of deposits for currency at banks may appear initially as
equal reductions to both cash holdings and
deposits. Banks, however, keep cash reserves at
a reasonable percentage of outstanding liabilities. Thus, when a large amount of deposits are
converted to cash, banks may be forced to liquidate some of their interest-bearing assets to
increase their cash reserves. Bank panics are
dangerous to the banking system because, without a central bank, a large-scale conversion of
bank deposits into currency cannot be satisfied
in a fractional reserve system.
Historically, the fractional reserve banking
system in the United States has been subject to
panics. Given the possibility that bank assets
may not be liquid or may sell at less than face
value in a systemwide panic (in contrast to a
run), a bank panic can cause otherwise solvent
banks to fail. The definition of bank panics presented here, however, leaves unanswered the
question of how and why bank panics begin.
*
I
f
Crises during the
National Banking Era
Prior to the creation of the Federal Deposit
Insurance Corporation in 1933, bank panics
were a periodic occurrence. Several institutional features of the banking system during the
National Banking Era in particular make that
time interesting for the empirical investigation
of bank panics. First, the period from 1863 to
1914 preceded both the Federal Reserve System and the federal deposit insurance program.
Also, six major bank panics associated with
serious economic downturns occurred during
that era (in 1873, 1884, 1890, 1893, 1907, and
1914). The period also has an abundance of relevant data for study.
|*
y
In considering bank panics, the most notable
features of the National Banking System are
(I) the lack of a central bank, (2) the absence of
deposit insurance, and (3) the inability to increase quickly the supply of currency (or reserves) in periods of extreme consumer deECONOMIC REVIEW, NOVEMBER/DECEMBER 1988
f
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the supply
loan certificates,
of banks' available
artificially
reserves.
mand for currency in exchange for deposits.
Given the fractional reserve banking system and
the lack of a central authority to increase the
monetary base (bank reserves and currency),
the banking system suffered from chronic panics; the most notorious panics—in 1873, 1893,
and 1907—were associated with the most severe
business cycle contractions.
Bank panics during this period displayed
similar characteristics.5 In general, according to
Philip Cagan (1965), bank panics followed business cycle peaks. Often, panics occurred in
either spring or fall; this phenomenon can partly
b e explained by noting that, without a central
bank, the seasonal movement of funds between
the Midwest and financial centers in the East
put strains on bank reserve positions. The
failure of a large business or financial institution
usually preceded a panic.
In addition, the stock market would frequently
suffer substantial losses in the aggregate either
prior to or during the panic. These could signal
to depositors that bank assets might be riskier.6
The length of panics varied; the most intense
part of a panic typically took place in the span of
a few weeks, and the remnants usually subsided
within a few months.
FEDERAL RESERVE BANK OF ATLANTA
n q a a a n n q oniaflfl a n a a a n a i
such as this one from Atlanta, were used during the National Banking Era to expand
Other characteristics associated with panics
during the National Banking Era include the
mechanisms that private bankers employed to
survive the crises. Local clearinghouses provided the medium through which the mechanisms were instituted. Initially, the clearinghouse was a place where representatives of all
banks in a city met to settle accounts with all
associated banks by making or receiving payments, that is, "clearing" transactions. The
clearinghouse role, however, grew in operational
capacity. An insightful definition by James G.
Cannon (1910) provides a good description of
the fuller role of the clearinghouses:
A C l e a r i n g h o u s e , therefore, m a y b e d e f i n e d a s a
d e v i c e t o s i m p l i f y a n d facilitate t h e d a i l y exc h a n g e s of i t e m s a n d s e t t l e m e n t s of b a l a n c e s
a m o n g t h e ( m e m b e r ) b a n k s a n d a m e d i u m for
u n i t e d a c t i o n u p o n all q u e s t i o n s affecting t h e i r
m u t u a l welfare.
The two primary methods for responding to
bank panics during the National Banking Era
were (l) clearinghouse loan certificates (see
sample above) and (2) the restriction or suspension of bank deposits' convertibility into currency.7 (The box on page 18 provides more detail
5
on these mechanisms.) Clearinghouse loan certificates were extensions of loans for the purpose
of forming reserves. These certificates were written for clearinghouse association members and
were acceptable for settling clearinghouse accounts. Thus, the clearinghouse and its loan certificates offered the banking system an artificial
mechanism to expand the supply of available
reserves in order to prevent loan contraction.
When restricting the convertibility of deposits
into currency, banks limited the amount of cash
available or refused to pay cash in exchange for
deposits as they were legally bound to do. This
procedure reduced the outflow of bank reserves
by slowing down the liquidation of deposits.
Both mechanisms allowed banks to continue
other operations such as making loans and
clearing deposits, since restrictions applied
only to conversions of deposits into currency.
Transactions within the banking system were
supported.
Oliver M.W. Sprague (1910) provides an excellent analysis of the events before, during, and
after the bank panics of the National Banking
Era. Sprague's work describes in detail the
methods through which the banking system
maintained a functioning transactions mechanism in the midst of a systemwide drain of
deposits and reserves. Sprague is critical, though,
of convertibility restrictions, especially during
the panic of 1907 when, he felt, the severe strain
in the banking system spread to all business
sectors through this action. Yet, aside from increasing transactions costs, the ways in which restriction constrains business activity are unclear.8
The discussion in Sprague notes the degree
of bank failures, the contraction of loans, and the
general reduction in economic activity associated with the period of the panic. Sprague
does not, however, attribute the source of the
economic downturn to the panic; rather, the
panic is seen as an outcome of the economic
downturn. The banking crises arose from problems in other industries. Cagan supports the
view that panics did not cause recessions.
Theories of Bank Panics
The economics literature provides two main
approaches to bank panics and their causes;
6
these views differ most notably in their explanations of why depositors convert their deposits
into currency and exit the banking system. The
formal models of bank panics examine the issue
from a clearly d liferent set of assumptions about
the source of bank instability, and the relevant
conclusions about the cost of bank panics are
strongly influenced by the theoretical framework chosen.
One perspective on banking panics, referred
to as the "sunspot hypothesis" by Gary Gorton
(1988), suggests that the banking system is
inherently unstable. Douglas W. Diamond and
Philip H. Dybvig (1983) present this view in
detail. In this model, banks provide a liquidity
service by transforming illiquid financial assets
(loans) into more liquid ones by offering liabilities (deposits) with a smoother return path. In
effect, productive investments in the economy
may take time to mature and provide a return,
but depositors may require liquidity at different
and unpredictable times. In order to exploit the
opportunities created by this apparent discrepancy, banking intermediaries provide a
transformation service so that depositors can
have access to liquidity, since their liquidity
demands may vary. Though banks improve the
opportunities for the economy, theory suggests
that the potential exists for bank runs to take
place. Surprisingly, these bank runs occur despite the fact that bank assets in the model are
not risky; rather, they are just illiquid.
The risk in banking in this model, then, results
from the withdrawal behavior of depositors.
Banks are subject to runs because depositors
liquidate their deposits whenever they suspect
a bank run will occur, if the theory imposes a
first-come, first-serve rule for withdrawals. 9
Thus, according to this argument, no real economic information relevant to bank assets is
necessary to provoke a systemic bank panic.
Nonfundamental (noneconomic) causes may
spark a bank panic since "anything that causes
Idepositorsl to anticipate a run will lead to a
run." 10
In the sunspot theory, the bank run could
occur as a result of anything from a run on
another bank to a totally unrelated event like a
sunspot. It is rational for agents (individuals),
even those who prefer to leave deposits, to
withdraw their deposits in light of the potential
for capital loss if the bank fails. The inherent
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
instability in the banking system provides the
opportunity for panics to occur randomly without a fundamental economic basis for the event.
Bank runs are essentially random d u e to the
risky behavior of depositors.
In this view, a single bank run is costly because of its potential to spark a bank panic and
cause the collapse of the banking system. Bank
panics in turn are costly because even solvent
banks—those with loans to productive investment projects—can fail, thus causing the recall
of the loans and termination of investments.
Since the costs are imposed on the economy for
no underlying economic reason, a strong rationale exists, from this perspective, to prevent
banking panics and avoid these costly repercussions.
Sunspot theories provide a useful contrast to
other explanations of bank panics in which depositors rely on real economic information in
evaluating the financial condition of banks. In
this context "real" information refers to data on
the production sectors of the economy. Charles
J. Jacklin and Sudipto Bhattacharya (1988) provide a formal treatment of how interim information affects depositor assessment of the value of
risky bank assets. The information can lead to
bank panics if it signals a bad prospective outcome for bank investments and a negative outlook for the real economy. Under these conditions, panics can b e explained as rational
economic p h e n o m e n a within an economic
model in which information on the intrinsically
risky assets of banks may provoke depositors to
liquidate their deposits. Information on real
economic conditions is relevant insofar as it
reflects upon bank asset quality and thus shapes
depositor expectations.
In a similar vein, Gorton presents an economic model in which bank panics occur as a
rational response by depositors to the expectation of a recession. In this model, depositors
have incomplete information about the value of
bank assets, and so they use aggregate macroeconomic measures as indicators of bank asset
riskiness. Gorton shows that depositors choose
to liquidate bank deposits when the perceived
risk of bank assets exceeds a threshold level.
The model also suggests that panics are not
unique events, like sunspots. Rather, Gorton
presents data that are consistent with a rational
model in which economic agents form expecFEDERAL RESERVE BANK OF ATLANTA
tations of bank asset risk. A model explaining
consumer behavior in nonpanic times consequently also explains consumer behavior when
panics occur. However, such a model does not
address the extent to which panics affect the
severity of an economic contraction.
Several hypotheses regard real economic
variables as the fundamental causes of bank
panics." The costliness of bank panics in these
models, however, varies with assumptions about
the value of the loans recalled by banks. If some
of the recalled loans terminate an otherwise
productive investment, a bank panic may worsen an already-existing economic contraction. If,
on the other hand, a bank panic leads to prompt
liquidation of loans whose long-term prospects
are poor, the cost of bank panics may be minimal. Thus, even within a fundamental framework
for bank panics, their cost reflects assumptions
about the cost of loan contraction.
The theoretical explanations of bank panics
exemplify how the choice of theory influences
the conclusion about their cost. In the two
general views, sunspot and fundamental (or
"information-based") explanations appear to
have clear contrasts.12 The sunspot theories
suggest that bank panics have high economic
costs because they force banks to recall loans
that would otherwise increase economic welfare. As a result, bank panics should be avoided
if possible. The fundamental theories of bank
panics also focus on the recall of loans as the
main source of bank panic costs.13 However, a
variety of perspectives may be available on how
the loan contraction affects economic output.
Thus, the cost of loan contraction and the contribution of panics to contractions are central
elements in the theoretical analysis of bank panics and their impact on economic performance.
Business Cycles and Bank Panics:
Current Viewpoints
The previous overview of National Banking
Era bank panics concentrated on their common
characteristics and revealed two main features:
(1) a widespread desire to convert bank liabilities into currency and (2) an association with
serious economic contractions. In theoretical
models, when a banking system lacks a central
7
bank, depositors can cause a solvent bank to fail
by large-scale liquidation of deposits. Business
cycle research is interested in determining how
economic contractions relate to panics.
In the economics profession, the conventional view of bank panics is that they magnify
the steepness of a business downturn. 14 Milton
Friedman and Anna J. Schwartz (1963) (as well as
Cagan) portray panics as distinct events that
contribute separately to the severity of a business contraction. Friedman and Schwartz suggest that bank panics, by reducing the amount of
bank deposits, contract the aggregate money
supply. In their framework, reductions in the
money supply adversely affect output.
In a more recent work, Karl Brunner and Allan
H. Meltzer (1988) describe from a monetarist
perspective the interaction between the financial sector and the real economy. They maintain
that an increase in currency holdings relative to
deposits—a typical occurrence in bank panicsreduces both the money supply and bank credit;
the authors suggest that the relative reduction
in loans is greater than that of the money supply.
In their view, an unchecked run, that is, one
which is not alleviated by adequate central
bank provision of reserves, may lead to bank
failures, excess demand for reserves, increases
in interest rates, drops in asset values, and
further contraction of the money supply and
bank credit. Despite their belief that banking
crises are basically due to existing economic
conditions and the prevailing institutional framework rather than a catalyst of economic downturns, the authors ascribe a distinct economic
cost to bank panics because of the disruption of
credit markets and hence the exacerbation of
already adverse business cycle conditions.
Gorton suggests that, since banks fail most
frequently during a business cycle contraction,
macroeconomic information may signal the
severity of the downturn in the real economy to
depositors, who in turn attempt to liquidate
bank deposits before the worst of the recession.
Bank panics thus occur as a rational response to
exogenous economic conditions (factors "outside" the system like weather or the formation
of a cartel of oil-producing nations) and do not
represent unique events, that is, events that are
unexplainable within a rational economic model
consistent with "normal" time periods. This
model is consistent with the predictions of a
8
recent approach to business cycles referred to
as real business cycle theory.
Real business cycle theory presents an extreme view of how monetary and banking services relate to real economic phenomena. The
theory concentrates its analysis on real disturbances to the productive sectors of the economy,
which may explain a large proportion of observed
fluctuations in total output measures. From this
perspective, the role of monetary and banking
sectors in a theory of economic growth still
remains an open area for research. Robert G.
King and Charles I. Plosser (1984) present an
economic model in which technological shocks
directly affect only the real economy. A premise
of real business cycle theory is that the financial
sector is endogenous to innovations in the real
productive sector. The banking industry in King
"/n the economics profession, the conventional view of bank panics is that
they magnify the steepness of a business downturn."
and Plosser produces an intermediate good,
transactions services, which is an input into production and the purchase of final goods by
consumers. Thus, the researchers suggest that
the observed positive comovement of real production, credit, and transactions services reflects
exogenous shocks to the economy's real productive sectors. In essence, the movements of
bank transactions services and credit measures
result from movements in output. Banking services d o not initiate any costly shocks to the
real economy.
In this real business cycle view, the extent to
which panic costs add to those of a recession is
unclear. Bank loans, in this theory, should contract as a result of changes in expectations for
the outlook for the real economy. The contraction of loans surrounding panic periods is viewed
as a reflection of the altered prospects for the
aggregate economy and for these bank assets.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
From this perspective, the measurable costs of
banking panics are of primary interest since
such costs reveal whether panics exacerbate
economic downturns. In a full-information framework, one would expect panics to contribute
minimally to an economic contraction.
The factor which complicates the analysis is
that panics are often associated with business
cycle contractions, and disentangling the economic impacts of the two is difficult. From a
casual empirical view, the fact that the more
severe recessions are associated with bank panics suggests that bank panics are costly and
worsen contractions. The two views expressed
above, though, imply a different sequence of
events with respect to bank panics and business cycles. A simplified description of both
perspectives is provided below to help dis-
"¡n an alternative view... [tjhe recession in the real economy causes the
observed reduction in bans that occurs
when banks call in bad loans."
tinguish between the anticipated causal and
temporal relationships among financial and real
variables.
A version of the conventional view suggests
the following sequence: the bank panic occurs
near the onset of (and directly worsens) a recession, as depositors exchange large amounts of
deposits for cash. Banks attempt to satisfy consumer demand by paying currency, thereby reducing the aggregate money supply. In addition,
banks are forced to call in loans to maintain adequate reserves and satisfy depositors' liquidity
demands. Clearinghouses issue loan certificates
to prevent further loan contraction. They also
place restrictions on the convertibility of deposits into currency to stifle the liquidation of
deposits. These actions impose higher transactions costs on the economy. Thus, the panic
induces costs that lead to a more severe recession. The contraction of loans, then, should
FEDERAL RESERVE BANK OF ATLANTA
occur prior to a decl ine in output that is steeper
than the initial downturn.
In an alternative view, consumers see signs of
an oncoming severe recession and the associated loss in asset value. Currency has a higher
expected return than bank deposits, and consumers withdrawdeposits from the banking system. To prevent large-scale loan contraction and
slow the liquidation of bank deposits, the local
clearinghouse associations issue loan certificates and restrict convertibility at minimal costs
to the macroeconomy The recession in the real
economy causes the observed reduction in loans
that occurs when banks call in bad loans. Thus,
problems in the financial sector mirror those in
the real sector of the economy. In this case,
financial sector crises, with continued intermediation, do not add significantly to the severity
of real economic contraction. Temporally, advocates of this view expect to observe a real output decline prior to or simultaneous with the
contraction of loans. Since loans move passively in response to real economic movements,
this view does not expect loan movements to
initiate disturbances to the real economy.
The difficulty, however, has been to assess
the costs of reduced economic output caused
by bank panics, either directly (through recalling
loans) or indirectly (through lost loan opportunities or through the increased transactions
costs associated with restriction of payments). 15
Restrictions increase transactions costs, but
checks continue to be cleared, loans are made,
and the process of intermediation continues.
The degree to which these transactions costs
reduce aggregate output remains unclear. 16 The
source of the costs, however, is relevant only
after significant costs of panics have been established. As emphasized above, whether panics
worsened output declines remains ambiguous.
National Banking Era Panics:
Data Analysis
Empirical research has focused on the National Banking Era, a period without an explicit
central bank, to uncover evidence on the typical
effects of panics. General evidence indicates
that National Banking Era panics, in contrast to
the conventional view, may have had effects on
9
Table 1.
National Banking Era Panics
NBER Cycle
Peak to Trough1"
Panic
Date
Percentage Change in the
Ratio of Currency to
Deposits at Panic Date
to Previous Year's Average*
Percentage Change in
Pig Iron Production,
Measured From
Peak to Trough
Oct. 1873-Mar. 1879
Sept. 1873
14.5
-51.0
Mar. 1882-May 1885
June 1884
8.8
-14.0
Mar. 1887-Apr. 1888
No Panic
3.0
-9.0
Jul. 1890-May 1891
Nov. 1890
9.0
-34.0
Jan. 1893-Jun. 1894
May 1893
16.0
-29.0
Dec. 1895-Jun. 1897
Oct. 1896
14.3
-4.0
Jun. 1899-Dec. 1900
No Panic
2.8
-6.7
Sep. 1902-Aug. 1904
No Panic
-4.1
-8.7
May 1907-Jun. 1908
Oct. 1907
11.5
-46.5
Jan. 1910-Jan. 1912
No Panic
-2.6
-21.7
Jan. 1913-Dec. 1914
Aug. 1914
10.4
-47.1
*ln cycles
without
panics,
the percentage
change
is over
year
ending
at cycle
trough.
Measured
from
peak
to
trough.
f
The National
Bureau
of Economic
Research
(NBER)
determines
the dates
of business
cycles.
Source: Gorton (1988).
the banking system not dissimilar to the usual
effects that recessions themselves brought on
banking.
Table 1 summarizes the business cycle contractions experienced during the National Banking Era. The most severe bank panics were
accompanied by sizable increases in the ratio of
currency to deposits, evidence that bank deposits were liquidated for cash on a large scale.
Notably, the panic dates follow business cycle
peaks, and the recessions associated with panics
exhibit the largest reduction, from peak to
trough, in the production of pig iron, a proxy for
industrial output.
In terms of degree, the panics of 1873, 1893,
and 1907 are considered the most severe, especially because both clearinghouse toolspayments restrictions and clearinghouse loan
certificates—were implemented to quell the
crises. Also, the large contractions of pig iron
production in these panics exceed the contractions in most other panics. 17 The duration of the
recessions following the panics, however, were
10
quite different. Both the 1893 and the 1907 panics
were associated with brief yet severe recessions (one-and-a-half years and eleven months,
respectively). In contrast, the business contraction following the 1873 bank panic spanned six
years. In addition, most of the banking difficulties associated with the 1873 panic occurred
several years after the panic. Sprague notes that
few banks failed during the crisis of 1873 or during the subsequent months.
Measures of bank and real activity present the
aggregate impact of panics on an annual basis. For
some cycles, annual data fail to reflect adequately the extent of loan contractions—especially
the possibility of temporary loan reductions
during panics—that more frequently sampled
data may present. 18 However, annual measures
satisfactorily convey the long-term effects of
recessions associated with panics as compared
to business contractions without panics.
Chart 1 presents measures of intermediation,
total bank loans and total bank deposits (each
relative to "high-powered" money), from 1870 to
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Chart 1.
Total Bank Loans and Bank Deposits Relative to High-powered Money
(1870-1935)
Ratio
Ratio of D e p o s i t s t o
High-powered Money
R a t i o of L o a n s t o
High-powered Money
jcfva?8
O
1872
The vertical
1878
1884
lines in each chart
This chart shows
represent
1890
1896
the occurrences
1902
of bank
the ratio of total bank loans and bank deposits,
1935. High-powered
money
represents
the amount
of money
1908
panics.
each relative
to high-powered
that may be employed
money,
as bank
during
reserve
the period
1870-
assets.
Source for all charts: U.S. Bureau of the Census, Historical Statistics of The United States from Colonial Times to 1970. High-powered money
data are taken from Friedman and Schwartz (1963).
1935.19 (The vertical lines in Charts 1 through 6
denote years in which panics took place.) The
measure of loan contraction in Chart 1 suggests
that significant loan contraction of -10.3 percent
and -14.1 percent occurred in the years following the 1893 and 1907 panics. Nonetheless, loan
contractions of -1.4, -10.8, -9.6, and -7.8 percent,
respectively, during the years from 1877 to 1880
reflected the worst period for the banking industry in the National Banking Era and were not
directly associated with a panic.
FEDERAL RESERVE BANK OF ATLANTA
Chart 2 depicts the bank failure rate over the
period 1870 to 1932. The bank failure rate for
1893 (5.22 percent) was the highest in any year of
the period; on the other hand, the next two
highest rates, 4.34 percent in 1878 and 2.75 percent in 1877, occurred without a panic during the
aforementioned business cycle contraction. The
related panic was several years earlier, in 1873.
The degree of output contraction in the 1873
cycle as well as in both the 1893 and 1907 business cycles, from peak to trough, was very large.
11
Chart 2.
Bank Failure Rates
(1870-1932)
Percent
1872
This chart shows
sidered
changes
1881
the percentage
more reliable
in 1896.
1890
of banks
and not directly
1899
1917
1926
that failed from 1870 to 1932. The data for bank suspensions
comparable
Thus, the chart is most useful
to data of earlier
for detecting
One could argue that the severity of the associated recession was primarily responsible for
the reduction in the loan measures, although
the argument is inconclusive without further
research.
Chart 3 shows the percent change in total
loans relative to high-powered money in comparison to the growth rate of output from 1873 to
1914. The graph illustrates that the two measures follow similar paths over the business
cycle, especially in the period after the resumption of the gold standard in 1879. These data
suggest that the degree of loan contraction during the major National Banking Era panics was
not much greater (and, in fact, usually was less)
12
1908
periods.
periods
during
In addition,
which
the series
after 1921 were
on total number
large proportions
of banks
of
conbanks
failed.
than the reduction in measured output in related years. In addition, the data pattern in the
chart is consistent with the idea that the loan
contraction occurred as an outgrowth of diminished loan demand. Real business cycle theory
suggests that shocks to the real, or production,
economy reduce business demand for loans, and
that the financial measures contracted because
of real economic conditions, not as a result of
financial panic.
Chart 4 shows total loans relative to output
from 1870 to 1914. The chart suggests that the
level of loans relative to output increased prior
to panics (note especially the panics of 1873,
1893, and 1907). Declines in the ratio are less
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Chart 1.
Annual Percent Changes in the Ratio of Loans to High-powered Money
Percent
vs. Manufacturing Output
Change
(1873-1914)
Growth in Loans to
High-powered Money
•••••
Growth in
Manufacturing Output
Growth
in manufacturing
output
and loans
to high-powered
steep following panics than the conventional
view might anticipate; the largest declines
occur nearly two years following a panic. This
pattern is consistent with the real business
cycle view. That is, the ratio of loans to output
increases before the onset of a panic. As the
recession exerts an impact on the economy,
loans contract, causing a slight decline in the
measure. As the economy regains strength, output increases before loans increase, and the
ratio falls again.
This interpretation of the charts and data is
conjectural, of course. Yet it suggests no conclusive evidence in support of either view of the
cost of bank panics. Thus, the data and the
FEDERAL RESERVE BANK OF ATLANTA
money
follow
similar
patterns
over the business
cycle.
interpretation given above highlight the need
for further research into the degree of loan contraction during recessions caused either by
bank panics (that is, disintermediation effects)
or by economic conditions (that is, diminished
demand).
The Depression versus the National
Banking Era: Are the Panics Similar?
Bank panics threaten the banking system with
widespread bank failures, the collapse of intermediaries, and the contraction of mutually
13
Chart 4.
Total Bank Loans Relative to Output
(1870-1914)
Ratio
10
1872
This chart shows
prior
1876
1880
the movement
to a contraction
in business
1884
1888
of the ratio of loans
to output
1896
over the business
1900
cycle.
1904
The pattern
1908
suggests
1912
that output
falls
loans.
beneficial loans. A number of economists suggest that the panics during the Great Depression provide an example of how panics can
cause the banking system to collapse; the disintermediation during that period is the most frequently cited example of the cost of bank
panics. 20 (Another reason for studying the Depression is that popular thought associates the
term "bank panic" with the events of that period.)
Yet, as suggested below, some doubt exists as
to whether the panics of the Depression are
directly comparable to those of the National
Banking Era, especially with regard to the responses of the existing institutions to extreme
liquidity demands. While the Depression occurred during a period when a central bank was
14
1892
in place, that bank—the Fed—was inexperienced
in its role as lender of last resort and in dealing
with stresses on the banking system. Nonetheless, the existence of the Federal Reserve System during the Depression provides a distinction
between the institutional structures present in
the panics of the two periods. In fact, the financial crises during the National Banking Era, particularly the panic of 1907, gave impetus to the
establishment of the Fed in I914.
The central bank's primary role, according to
most economists at the time, was to provide an
"elastic" currency, that is, to accommodate
changes in depositors' liquidity preferences (as
exhibited in extreme form by bank panics). In
addition, central bank provision of funds to
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Chart 1.
Failure Rates of Nonfinancial Businesses
(1870-1933)
1872
The Depression-era
1881
increase
in nonfinancial
1890
business
1899
failures
establish an elastic currency would reduce the
observed seasonal fluctuations in domestic interest rates during the agricultural harvest and
planting seasons.21 In theory, adequate central
bank response to liquidity d e m a n d s should
quell panics. In fact, Friedman and Schwartz, in
addition to James D. Hamilton (1987), suggest that
during the Depression the Federal Reserve failed
to provide adequate liquidity to the banking
system.22 Thus, the Depression-era panics may
have caused a more dramatic contraction of
banking services than those of the National
Banking Era. Although the earlier period lacked
a central bank, the behavior of private clearinghouses, which resembled a central bank's, was
somewhat successful in stemming the dangers
of bank panics.
FEDERAL RESERVE BANK OF ATLANTA
1908
was not
1917
1926
unprecedented.
A reexamination of Chart 2, which depicts
bank failure rates, shows a significant increase
in the rate of bank failures in the 1930s relative
to the early 1920s. Most notably, Chart 1 shows
that the contraction in intermediation measures
during the Depression is far greater than any
contraction in the pre-Federal Reserve Era. The
Great Depression panics resulted in dramatically larger contractions in the banking system
than the prior panics.
Nonfinancial business failure rates, plotted in
Chart 5 for the period 1870 to 1933, show a
serious contraction from 1930 to 1933. The rates
during the Depression are comparable to those
of the National Banking Era; in particular, they
are quite similar to the rates during 1875-78, a
period of severe banking difficulties as well.
15
Chart 6.
Constant Dollar Value of the Liabilities of Failed Nonfinancial Businesses
(1870-1938)
Millions
1,000
—
1872
1881
The liabilities
of failed nonfinancial
Depression.
These liabilities
period
rrn
1890
businesses
have been deflated
used in this chart is 1910-14
(1910-14
1899
increased
prior to panics
by the wholesale
=
1917
and increased
1926
to an unprecedented
price index to reflect a real measure
1935
degree
of the liabilities.
during
The
the
base
100).
However, the repercussions of the business
failures, measured by the real liabilities of
failed nonfinancial businesses shown in Chart 6,
suggest that the real economic contraction during the Depression was far more serious than
the prior recessions. To compare with Table l,
output of pig iron, measured from peak to trough,
contracted 84.7 percent over 28 months. During
the worst contraction of the National Banking
Era, 1873-79, pig iron production contracted 51
percent. Thus, the data may be consistent with
the idea that the severity of the real contraction
led to the degree of failure in the banking system, suggested by Peter Temin ( 1976). This issue
may be the topic of further research.
16
1908
Thus, the Depression appears to present a
set of bank panics with effects on the banking
system much more serious than those of the
National Banking Era. The panics during the
time of the National Banking System do not
exhibit similar degrees of bank failure or loan
contraction. Despite the absence of the central
bank, the banking system appeared to avoid
collapse.
The discussion of the Depression suggests
that bank panics, when unchecked, may have
harrowing effects on the banking system that in
turn may lead to substantial repercussions on
the real economy. This implication, consistent
with the findings of Ben S. Bernanke (1983), may
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988
also be a topic for further research. However, the
National Banking Era panics show much smaller
effects on the banking system, which is likely the
result of actions by private clearinghouse organizations. Despite the lack of authorized public
policy tools, private bankers discovered mechanisms sufficient to maintain the operation of the
banking system under extreme conditions. The
main implication is that the bank panics in the
National Banking Era were quantitatively different from the Depression panics.
The question of explicit measurement of the
cost of these bank panics, though, also remains
open for research. The discussion above suggests that the costs of bank panics may d e p e n d
largely on the degree to which the panic "causes"
contractions in bank intermediation services.
The same approach to gauge the effect of bank
panics on economic recessions may be useful in
estimating the impact of Depression-era bank
panics on the real contraction in output during
that period. Empirical evidence on this issue
would go far toward resolving ongoing debates
regarding the Depression as well as bank panic
costs.
Bank Panics: Unresolved Issues
The cost of bank panics during the National
Banking Era remains a controversial subject in
economic research. Though panics are associated with the most severe recessions, the
extent to which panics reduce output needs to
be quantified before their actual costs can b e
determined. In particular, further work on bank
panics should analyze their costs apart from that
of economic contractions. 23
The evidence presented here suggests that
bank panics in the National Banking Era did not
approach the severity of those in the Depres-
FEDERAL RESERVE BANK OF ATLANTA
sion, especially with respect to the effects on
financial intermediation. During the National
Banking Era the macroeconomic impact of banking panics appears to have been minimized by
clearinghouses in support of their industry. The
National Banking Era panics may have threatened the intermediation system, but the private
market mechanisms were able to insulate the
banking system sufficiently to prevent its collapse. The intermediation process, though constrained, continued to operate throughout panic
periods. In contrast, panics during the Depression produced a more severe disruption in the
intermediation process; the dramatic reduction
in loans and the high rate of bank failures from
1930 to 1933 are unprecedented in United States
history since the Civil War.24 The National Banking Era panics d o not appear to have been
nearly as costly to either the banking system or
the real economy as were the Depression panics, despite the fact that no expl icit publ ic sector
institution to expand the money supply existed
during these prior panics. 25 From the experience of the pre-Federal Reserve panics, the
existing empirical evidence at least calls into
question current perceptions of the costs of
banking panics.
At the time of the National Monetary Commission (1910), experts believed that a central bank,
which would increase the supply of highpowered money in times of bank panics, could
reduce the severity of economic downturns by
removing the costs associated with bank panics.
However, the central-bank behavior of the
clearinghouses during panics appeared to minimize the effect of these events on the banking
system, given their limited formal central banklike powers. With reference to our present system, central bank provision of high-powered
money to extreme liquidity demands should
sufficiently insulate the banking system from
potential disintermediation.
17
Private Market Mechanisms In Response to Bank Panics
During the National Banking Era, private market
innovations developed both to assist the banking
system through panic-related liquidity difficulties
and to moderate the economic impact of bank
panics. The clearinghouses evolved as a private
collective entity to ensure the survival of the banking system.1
Clearinghouses executed actions to preserve
the continuity of the banking system and provided
protection to the system as a unified group. At the
onset of a systemic panic, the clearinghouse suppressed bank-specific information—that is, the
publication of individual bank balance sheets was
suspended. Instead, the balance sheet of the entire
clearinghouse association was published to signal
the clearinghouses' united effort to preserve the
banking system.
Clearinghouse Loan Certificates
Bank panics threatened the entire system in the
National Banking Era because, when one occurred,
the widespread desire to convert demand deposits intocurrency could not be satisfied in a fractional reserve system without a central bank. The
reserves of solvent banks could be depleted by
large-scale transformation of deposits into cash,
and banks could be forced to call in, or liquidate,
their loans. To prevent loan contraction, the clearinghouses issued loan certificates, which were
temporary loans to banks upon receipt of sufficient collateral. (See example from Atlanta on
page 5.) These certificates could be used to settle
clearinghouse balances, that is, to act as reserves.2 The clearinghouse loan certificates were
substituted for currency in clearinghouse settlements so that currency could be used to satisfy
depositor demands for cash or meeting other
obligations.
Such certificates were used extensively for settlement. For example, in June 1893, 78 percent of
all clearings in New York were settled with clearinghouse loan certificates; by August 1893, they
constituted 95 percent of clearings.3
The largest issue of clearinghouse loan certificates and other currency substitutes occurred
during the panic of 1907. At that time, these certificates and other substitutes for cash such as
certified checks made "payable through the clearinghouse" passed as forms of payment for transactions.4 The 1907 panic had approximately $500 million in monetized bank assets traded as currency,
18
nearly 4.5 percent of the measured money stock.
Like deposits, however, the cash substitutes
traded at a discount in comparison to currency.
If a bank failed and the collateral of that bank
was insufficient to cover its clearinghouse loans
outstanding, the loss was shared by all clearinghouse members in proportion to their capital.
Thus, members of a clearinghouse had a strong,
self-interested incentive to look carefully at collateral securities before issuing loan certificates,
which amounted to as much as 75 percent of the
collateral's value. Clearinghouses reserved the
right to require more collateral. Also, interest rates
on loans were set high enough to ensure that certificates were redeemed promptly after panics
subsided.
Restriction of Convertibility
of Deposits into Currency
Another mechanism employed by banks to
stem panic was the restriction of bank deposits'
convertibility into currency. This action impeded
the ability of depositors to withdraw their depositsfromthe banking system. Among area banks,
clearinghouses coordinated these general restrictions of convertibility, which tooktheiorm of dollar
limits on conversions and cash payments only for
wage disbursements, among other ways. Despite
the imposition of such convertibility restrictions,
the intermediation process continued in other
forms. Clearinghouses continued to settle deposit
accounts among banks, for example, and banks
were able to undertake loans. Thus, the banking
system remained operational, though in a restricted manner, to quell the threat of disintermediation.
Convertibility restrictions essentially allowed
the price of currency to increase relative to deposits, thus reducing currency demand during the
panic period. While the benefits of this mechanism are clear, the macroeconomic costs of convertibility restrictions remain an unsettled issue.
Sprague blames restriction, or "suspension of
payments" as he refers to it, for worsening economic downturns, particularly during the panic of
1907. Friedman and Schwartz note that the 1907
economic contraction appeared to worsen at about
the time of the restriction. However, they suggest
that the restriction of payments was a useful tool
which may have prevented widespread bank
failures.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
One noteworthy feature of clearinghouse loan
certificates and the restriction of payments is that
both were illegal.5 However, in only a few instances were these mechanisms opposed by
banks, courts, or depositors.6
Assessing the overall role of clearinghouses,
their efforts appear to have prevented serious dis-
intermediation and contained panics in terms of
costs to the banking system. The clearinghouses
had a direct interest in maintaining the smooth
operation of the banking system. Despite the
potential for collapse in the midst of bank panics,
the implementation of private market innovations
preserved the fractional reserve banking system.
Notes
1
2
Fora m o r e intensive e x a m i n a t i o n of clearinghouses s e e
e m p l o y e d as a transactions m e d i u m , like currency, a s
T h e e x t e n s i o n of c l e a r i n g h o u s e l o a n certificates is
they w e r e in 1907.
similar t o a federal o p e n m a r k e t p u r c h a s e of securities
5
C l e a r i n g h o u s e loan certificates were illegal if they were
G o r t o n (1985b) a n d T i m b e r l a k e (1984).
^ e e T i m b e r l a k e ( 1984) for a discussion of c l e a r i n g h o u s e
in that it increases "reserves" a v a i l a b l e for clearings.
loans; s e e G o r t o n (1985a) for a discussion of suspen-
Myers (1931): 415.
sion of p a y m e n t s .
" S e e A n d r e w (1908).
FEDERAL RESERVE BANK OF ATLANTA
19
Notes
'Currently, a s u b s t a n t i a l p r o p o r t i o n of thrifts in t h e savings
'^However, d e t e r m i n i n g w h e t h e r an e v e n t c r e d i t e d as a
a n d loan industry o p e r a t e with negative n e t worth, t h a t is,
p r o x i m a t e c a u s e of t h e p a n i c is c o n s i d e r e d a f u n d a m e n t a l
2
their liabilities exceed their assets. R o u g h e s t i m a t e s of
or n o n f u n d a m e n t a l source of t h e p a n i c is difficult. For
t h e cost for l i q u i d a t i o n or merger of t h e insolvent in-
e x a m p l e , S p r a g u e (1910) suggests t h a t t h e failure of cer-
stitutions is a p p r o x i m a t e l y $50 billion.
tain large b u s i n e s s c o n c e r n s triggered p a n i c s ; t h e s e
T h e National Banking Era is t h a t p e r i o d following t h e 1863
failures were v i e w e d a s f u n d a m e n t a l causes. In t h e case of
p a s s a g e of t h e National B a n k i n g Act, which e s t a b l i s h e d
a b a n k run, t h e failure of a large b a n k or financial b u s i n e s s
c o n d i t i o n s u n d e r which b a n k s c o u l d o b t a i n a federal char-
may signal a general e c o n o m i c d o w n t u r n since t h e size of
ter a n d issue currency. During this p e r i o d , a n d prior to
the concern itself suggests a well-diversified portfolio.
e s t a b l i s h m e n t of t h e Federal R e s e r v e S y s t e m in 1914,
Hence, their d e m i s e indicates a r e d u c t i o n in t h e v a l u e of
there was n o official central m o n e t a r y authority, a l t h o u g h
assets in t h e aggregate. An e c o n o m i s t w h o b e l i e v e s in
t h e I n d e p e n d e n t Treasury System actively p a r t i c i p a t e d in
s u n s p o t s m i g h t c o n s i d e r t h e a n n o u n c e m e n t of a large
t h e m o n e y m a r k e t o n occasion. For further information,
failure a s n o n f u n d a m e n t a l , in t h e s e n s e that it has no
s e e T i m b e r l a k e (1978).
u n a m b i g u o u s i m p a c t o n t h e e c o n o m y b e s i d e s shaking
depositors'
existence of an explicit central b a n k d u r i n g t h e De-
in t h e
banking
system.
n o m i c a g e n t s to s o m e external p h e n o m e n o n , c a p t u r e d
K a u f m a n (1987) p r e s e n t s an e c o n o m i c a r g u m e n t that b a n k
u n d e r t h e rubric of sunspots.
runs h e l p t h e b a n k i n g system t o o p e r a t e m o r e efficiently.
The research d o e s not d e a l explicitly with t h e macro-
l4
S e e n o t e 8.
e c o n o m i c effects of b a n k panics.
I5
S e e S p r a g u e (1910).
5
T a b l e 1 gives a q u a n t i t a t i v e d e s c r i p t i o n of the panics.
l6
T h e restriction of c o n v e r t i b i l i t y , h o w e v e r , h a s
6
T h e relationship b e t w e e n stock prices a n d depositors'
ing t h e m o s t severe panics so that t h e b e n e f i t s m i g h t have
prices reflect t h e p r e s e n t d i s c o u n t e d v a l u e of a business's
outweighed the u n m e a s u r e d costs. Friedman a n d Schwartz
future cash flows, a fall in stock prices indicates a per-
(1963) conjecture that, h a d a restriction b e e n i m p o s e d in
ceived r e d u c t i o n in t h e s e flows. D e p o s i t o r s may view the
1930, the severity of t h e contraction in 1929-33 m i g h t have
stock price d e c l i n e to i m p l y lower cash flows t o firms,
b e e n r e d u c e d . Restrictions, a s d e s c r i b e d above, d i d not
which m i g h t affect t h e ability of b a n k debtors, particularly
Thus, at a t i m e w h e n stock prices are declining, b a n k s '
occur d u r i n g t h e Depression.
' 7 The p a n i c in 1914 is less c o m p a r a b l e b e c a u s e of the issue
of emergency currency as p r o v i d e d by t h e Aldrich Vree-
o u t s t a n d i n g loans m a y b e v i e w e d a s riskier.
land Act of 1908. The institutional framework for this p a n i c
R e s t r i c t i o n s occurred in 1873, 1893, a n d 1907; clearing-
differed from t h e earlier o n e s as well as from Depression-
h o u s e l o a n certificates were u s e d in 1873,1884, 1890, 1893,
a n d 1907.
^he
era panics.
l8
conventional
m e a s u r e s at high frequency are necessary to discern t h e
b u s i n e s s d o w n t u r n b e c a m e a severe recession b e c a u s e of
t h e b a n k p a n i c a n d related costs. F r i e d m a n a n d Schwartz
i m p a c t of panics.
19
High-powered
(1963), Cagan (1965), Mitchell (1941), a n d G i l b e r t a n d W o o d
m o n e y as a way of highlighting the extent t o which loans
in a m a n n e r a d e q u a t e t o p r o v i d e conclusive evidence.
contracted ( a d j u s t e d for potentially available reserves).
20
B e r n a n k e (1983) argues that t h e c o l l a p s e of t h e b a n k i n g
system e x t e n d e d a n d d e e p e n e d t h e d e g r e e of e c o n o m i c
l n a first-come, first-serve framework, d e p o s i t s are con-
contraction from 1929 t o 1933.
verted t o currency a t par, o n e d e p o s i t o r at a time, until
b a n k assets are d e p l e t e d .
2l
M i r o n (1986) s h o w s t h a t t h e f o u n d i n g of t h e Federal
Reserve r e d u c e d significantly t h e seasonality of n o m i n a l
S e e D i a m o n d a n d Dybvig (1983). In theory, d e p o s i t o r s
w o u l d not o p e n an a c c o u n t at a b a n k if, prior t o their entry
interest rates; Clark (1986) p r e s e n t s a conflicting view-
into t h e b a n k , they a n t i c i p a t e d a run.
point.
" S e e G o r t o n (1988).
l2
represents t h e a m o u n t of m o n e y
a n d d e p o s i t s a r e m e a s u r e d relative t o h i g h - p o w e r e d
c o m p a r e d t h e costs of panics against t h o s e of a recession
b e particularly useful in resolving t h e issue.
money
which may b e e m p l o y e d a s b a n k reserve assets. Loans
(1986) reflect this view. However, research t o d a t e has not
E v i d e n c e o n t h e s e p a r a t e costs of t h e p a n i c in 1907 w o u l d
G i l b e r t (1988) m a k e s the p o i n t that t h e effects of b a n k
panics occur within a short t i m e frame. Accordingly, loan
view of t h e 1907 event is t h a t a m i l d
,0
been
c r e d i t e d with stifling t h e massive losses of d e p o s i t s dur-
p e r c e p t i o n s of a b a n k ' s risk is a s follows: since stock
corporate borrowers, t o p a y t h e i r d e b t s in a timely fashion.
9
Pro-
occurs d u r i n g p a n i c p e r i o d s , t h a t is, t h e reaction of eco-
t w e e n t h e s e eras' panics.
4
confidence
p o n e n t s of t h i s v i e w s u g g e s t t h a t s o m e t h i n g s p e c i a l
pression p r o v i d e s a m a j o r institutional difference be-
22
For a contrasting view, s e e Temin (1976). This article d o e s
C h a r i a n d l a g a n n a t h a n (1988) p r e s e n t a m o d e l in which
not a t t e m p t to assess the Fed's role; rather it e m p h a s i z e s
panics can occur as a result of either explanation. W h e n
only t h a t t h e 1930s panics were different from prior panics
in t h e effects o n t h e b a n k i n g system.
l o n g lines a p p e a r at banks, t h e u n i n f o r m e d agents in the
m o d e l are u n a b l e to distinguish b e t w e e n an information-
2 3
TO
d e t e r m i n e w h e t h e r loan r e d u c t i o n p r e c e d e d o u t p u t
b a s e d run a n d a substantial n u m b e r of agents requiring
d e c l i n e s , such research s h o u l d e m p l o y d a t a of h i g h e r
liquidity. Thus, d e p e n d i n g u p o n t h e true reason for long
frequency, that is, m o n t h l y observations, t o try t o dis-
lines at banks, b a n k p a n i c s m a y b e either information-
tinguish empirically between
b a s e d or a s u n s p o t o u t c o m e .
recession-related contractions of loans.
20
panic-initiated
versus
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
24
T h e nearest e q u i v a l e n t is t h e three successive years of
25
T h e I n d e p e n d e n t Treasury S y s t e m w a s e v o l v i n g as a
loan contraction from 1878 t o 1880, as t h e U n i t e d States
m o n e t a r y a u t h o r i t y over t h i s p e r i o d . S e e T i m b e r l a k e
r e s u m e d t h e gold standard, t h o u g h t h e s e years were not
(1978) a n d F r i e d m a n a n d Schwartz (1963).
associated with a panic.
References
. " C l e a r i n g h o u s e s a n d t h e Origins of Central
Andrew, A. Piatt. " S u b s t i t u t e s for Cash in t h e Panic of 1907."
Quarterly
Journal of Economics
23 (August 1908): 497-516.
Bernanke, Ben S. " N o n m o n e t a r y Effects of the Financial
Crisis in t h e P r o p a g a t i o n of t h e G r e a t
American
Economic
vey of t h e Literature." Explorations
in Economic
History
Brunner, Karl, a n d Allan H. Meitzer. " M o n e y a n d Credit in the
Transmission Process." American
Economic
Review
78
and Effects
1865-1960.
of Changes
in
the
National Bureau of E c o n o m i c
Research. N e w York: C o l u m b i a University Press, 1965.
C a n n o n , J a m e s G . Clearing-Houses.
H a m i l t o n , James D. "Monetary Factors in t h e G r e a t Depression." Journal
National
Monetary
Office, 1910.
tion a n d Rational Expectations." Journal
of Finance
43
(July 1988): 749-61.
Clark, Truman A. "Interest Rate S e a s o n a l s a n d the Federal
Economy
94 (February 1986):
76-125.
D e p o s i t Insurance, a n d Liquidity." Journal
of
Political
91 (June 19831:401-19.
Corporation
Annual
Report
Deposit
1940. Washington,
D.C., 1941.
Reserve Bank of Chicago Staff M e m o r a n d a 87-3, April
1987.
United
States:
1867-1960.
History
Princeton: Princeton
University Press, 1963.
King, R o b e r t G., a n d Charles I. Plosser. "Money, Credit, a n d
Prices in a Real Business Cycle M o d e l . " American
Review
Failures, Contagion, a n d Banking Panics." Paper presented
at t h e Federal Reserve Bank of Chicago C o n f e r e n c e o n
Bank Structure a n d C o m p e t i t i o n , May 11, 1988.
Miron, Jeffrey A. "Financial Panics, t h e Seasonality of t h e
N o m i n a l Interest Rate, a n d t h e F o u n d i n g of t h e Fed."
Economic
Review
Mitchell, W e s l e y C. Business
76 (March 1986): 125-40.
Cycles
and
Their
Causes.
Berkeley a n d Los Angeles.- University of California Press,
Myers, Margaret G. The New York Money
Origins
Market
Volume
I:
N e w York: C o l u m b i a Univer-
and Development.
Neal, Larry. "Trust C o m p a n i e s a n d Financial
1897-1914." Business
Failures: S o m e Lessons from the United States a n d t h e
United K i n g d o m . " Federal Reserve Bank of St. Louis
form." Cato Journal
Review
Innovation,
45 (Spring 1971):
68 ( D e c e m b e r 1986): 5-14.
7 (Winter 1988): 589-94.
Sprague, Oliver M.W. History
System.
sion?
United
ulation, Monetary Policy, a n d Central Banking." Federal
1978.
Reserve Bank of R i c h m o n d Working Paper 88-1 (April
15 (March 1985a): 177-93.
Journal
FEDERAL RESERVE BANK OF ATLANTA
National
Forces Cause the Great
Depres-
States.
Origins of Central
Banking
in the
C a m b r i d g e : Harvard University Press,
"The Central Banking Role of C l e a r i n g h o u s e
of Money,
Credit
and Banking
41
(February 1984): 1-15.
U.S. Bureau of t h e Census. Historical
States:
the
N e w York: W.W. Norton, 1976.
Associations." Journal
Gorton, Gary. "Bank S u s p e n s i o n s of Convertibility."
Under
ington, D.C.: U.S. G o v e r n m e n t Printing Office, 1910.
Timberlake, Richard H.The
1988).
of Crises
National Monetary C o m m i s s i o n . Wash-
Tem in, Peter. Did Monetary
Goodfriend, Marvin, a n d Robert G. King. "Financial Dereg-
Economics
History
Schwartz, Anna J. "Bank R u n s a n d D e p o s i t Insurance Re-
Banking
Gilbert, R. Alton, a n d Geoffrey E. W o o d . " C o p i n g with Bank
of Monetary
Eco-
74 (June 1984): 363-80.
35-51.
Gilbert, R. Alton. "A Re-examination of the History of Bank
Review
. " B a n k Runs: Causes, Benefits, a n d Costs." Cato
7 (Winter 1988): 559-87.
sity Press, 1931.
Friedman, Milton, a n d A n n a J. Schwartz. A Monetary
of the
96
1941.
Federal D e p o s i t Insurance Corporation. Federal
Insurance
Economy
Kaufman, G e o r g e G. "The Truth A b o u t Bank Runs." Federal
American
D i a m o n d , Douglas W., a n d Philip H. Dybvig. "Bank Runs,
of Political
(June 1988): 568-92.
nomic
of Political
19 (March 1987):
Economics
ing Panics a n d Information-Based Bank Runs.- Welfare
Journal
Chari, V.V., a n d Ravi Jagannathan. " B a n k i n g Panics, Informa-
Economy
of Monetary
Jacklin, Charles J., a n d S u d i p t o Bhattacharya. "Distinguish-
C o m m i s s i o n . Washington, D.C.: U.S. G o v e r n m e n t Printing
Reserve." lournal
Oxford
(forthcoming, 1988).
Papers
a n d Policy Implications." Journal
(May 1988): 446-51.
Cagan, Philip. Determinants
His-
145-69.
23 (October 1986): 339-415.
Stock of Money
" B a n k Panics a n d Business Cycles."
Economic
Bordo, Michael D. " E x p l a n a t i o n s in Monetary History: A Sur-
of Economic
tory 45, no. 2 (1985b): 277-84.
Depression."
73 (June 1983): 257-76.
Review
Banking in t h e United States." Journal
Colonial
Times
Statistics
of the
United
to 1970. Washington, D.C., 1975.
21
Interest Rate Swaps:
A Review of the Issues
Larry D. Wall and John J. Pringle
Interest
rate swaps have gained
introduced.
presents
This article
information
questions
considerable
importance
some of the conventional
on swaps' pricing,
risks, and
The interest rate swap market began in 1982.
By 1988 the outstanding portfolios of 49 leading
swap dealers totaled $889.5 billion in principal,
of which $473.6 billion represented new business in 1987.2 Reflecting their rapid growth,
swaps have gained considerable importance in
the capital markets. Thomas Jasper, the head of
Salomon Brothers' swap department, has estimated that 30 to 40 percent of all capital market
transactions involve an interest rate, foreignexchange, or some other type of swap.3
The authors are, respectively, a senior economist in the
financial section of the Atlanta Fed's Research
Department
and a professor of finance at the University of North Carolina
at Chapel Hill. They wish to thank William Curt Hunter and
Peter Abken for their
comments.
markets
views regarding
in the six years
the use of interest
since they
were
rate swaps
and
regulation.
In the last two decades a myriad of new
instruments and transactions have brought about
significantchanges in financial markets. Some of
these innovations have attracted considerable
publicity; stock index futures and options, for
example, were an important element in the
studies of the October 19, 1987, stock market
crash.1 However, not all of these new developments are well-known to the public. One recent
innovation that is quietly transforming credit
markets is interest rate swaps—an agreement
between two parties to exchange interest payments for a predetermined period of time.
22
in capital
Their rapid growth is one reason swaps have
generated considerable interest among academics, regulators, accountants, and market
participants alike. Paramount among the questions surrounding swaps are the reasons for
their use and the basis of their pricing. Regulators are also keenly concerned with the risks
swaps pose to financial firms, while accountants
are debating appropriate reporting. This article
reviews the current literature and presents some
new research on interest rate swaps. Among the
issues addressed are the workings of interest
rate swaps, the reasons that firms use such
swaps, the risks associated with interest rate
swaps, the pricing of these swaps, the regulation
of participants in the swap market, and the disclosure of swaps on firms' financial statements.
What Is an Interest Rate Swap?
Interest rate swaps serve to transform the
effective maturity (or, more accurately, the repricing interval) of two firms' assets or I iabil ities.
This type of swap enables firms to choose from a
wider variety of asset and liability markets without having to incur additional interest rate risk,
that is, risk that arises because of changes in
market interest rates. For instance, a firm that
traditionally invests in short-term assets, whose
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
returns naturally fluctuate as the yield on each
new issue changes, may instead invest in a longterm, fixed-rate instrument and then use an
interest rate swap to obtain floating-rate receipts. In this situation, one firm agrees to pay a
fixed interest rate to another in return for receiving a floating rate.
Interest rate swaps have fixed termination
dates and typically provide for semiannual payments. Either interest rate in a swap may be
fixed or floating. 4 The amount of interest paid is
based on some agreed-upon principal amount,
which is called the "notional" principal because
it never actually changes hands. Moreover, the
two parties d o not exchange the full amounts of
the interest payments. Rather, at each payment
a single amount is transferred to cover the net
difference in the promised interest payments.
An example of an interest rate swap is provided in Chart I. Atlanta HiTech agrees to pay
Heartland Manufacturing a floating rate of interest equal to the London Interbank Offered
Rate (LIBOR), which is commonly used in international loan agreements. 5 In return, Heartland
Manufacturing promises to pay Atlanta HiTech a
fixed 9.18 percent rate of interest. The swap
transaction is ordinarily arranged at current
market rates in order for the net present value of
payments to equal zero. That is, the fixed rate on
a typical interest rate swap is set so that the
market value of the net floating-rate payments
FEDERAL RESERVE BANK OF ATLANTA
exactly equals the market value of the net fixedrate payments. If the swap is not arranged as a
zero-net-present-value exchange, one party
pays to the other an amount equal to the difference in the payments' net present value when
the swap is arranged.
Chart 2 demonstrates three aspects of the
swaps market: converting floating-rate debt to
fixed-rate debt, converting a floating-rate asset
to a fixed-rate asset, and using an intermediary
in the swap transaction. In Chart 2, Widgets
Unlimited can issue short-term debt but is averse
to the risk that market interest rates will increase. To avoid this risk, Widgets enters into a
swap in which it agrees to pay the counterparty a
fixed rate of interest and receive a floating rate.
This arrangement resembles long-term, fixedrate debt in that Widgets' promised payments
are independent of market interest rate changes.
If market interest rates rise, Widgets will receive
payments under the swap that will offset the
higher cost of its short-term debt. Should market rates fall, though, under the terms of the
swap Widgets will have to pay its counterparty
money.
The combination of short-term debt and swaps
is not identical to the use of long-term debt.
One difference is that Widgets' interest payments are not truly fixed. The company is protected from an increase in market rates but not
from changes in its own risk premium. The swap
23
Chart 1.
An Interest Rate Swap without a Dealer
LIBOR
Atlanta
HiTech
Heartland
Manufacturing
9.18%
In this example,
bank Offered
not actually
Atlanta
HiTech agrees
Rate. In return,
exchange
the net difference
Heartland
the full amounts
in the promised
to pay Heartland
agrees
of the interest
interest
Manufacturing
to pay Atlanta
payments,
The other swap user in this example illustrates a swap's potential to convert a floating
rate asset to one in which the rate is fixed. OneState Insurance, a small life insurance company,
has long-term, fixed-rate obligations but would
like to invest part of its portfolio in short-term
debt securities. OneState Insurance can invest
in short-term securities without incurring interest rate risk by agreeing to a swap in which
the insurer pays a floating rate of interest and
receives a fixed rate of interest. This combination provides the insurance company with a
stream of income that does not fluctuate with
changes in short-term market interest rates.
This example also demonstrates the usefulness of an intermediary in a swap. Although
Widgets and OneState Insurance could have
entered into a swap agreement with each other,
in this example (see Chart 2), both Widgets
Unlimited and OneState Insurance actually have
rate of interest
but at each payment,
rate of interest.
equal
to the London
These two companies
a single amount
is transferred
to
Interdo
cover
payments.
would not compensate Widgets if its own cost
of short-term debt increased from LIBOR-plus0.5 percent to LIBOR-plus-O.75 percent. If the
cost of short-term debt to Widgets decreased to
LIBOR-plus-0.30 percent, however, the cost of
the debt issue would fall by 0.20 percent. In
addition, the counterparty to the combination
generally does not provide the corporation with
the interest rate option implicit in many bonds
issued in the United States, whereby they can
be called in at a fixed price regardless of current
market rates. Call options allow issuers to
exploit large changes in market interest rates.6
In contrast, standard interest rate swap contracts may be unwound or canceled only at prevailing market interest rates.
24
a floating
HiTech a fixed 9.18%
a swap agreement with DomBank. Numerous
large commercial and investment banks as well
as insurance companies have entered into the
swap market as intermediaries. DomBank is
compensated in an amount equal to the difference between what is received on one swap
and what is paid under the other one. In this
example, the fee is equal to 10 basis points.
Using DomBank is advantageous to Widgets
and OneState Insurance for two reasons. First,
the use of an intermediary reduces search time
in establishing a swap agreement. DomBank is
will ing to enter into a swap at any time, whereas
Widgets and OneState Insurance might take
several days to discover each other, even with a
broker's help. Second, an intermediary can reduce the costs of credit evaluation. Either of the
participants in an interest rate swap may become bankrupt and unable to fulfill their side of
the contract. Thus, each swap participant should
understand the credit quality of the other party.
In this example, Widgets and OneState are not
familiar with each other, and each would need to
undertake costly credit analysis on the other
before agreeing to deal directly. However, total
credit analysis costs are significantly reduced
since both parties know the quality of DomBank
and DomBank knows their respective credit
standings.
Reasons for Interest Rate Swaps
Why d o two firms agree to swap interest
payments? They could either acquire assets or
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Chart 2.
An Interest Rate Swap with a Dealer
LIBOR
Widgets
Unlimited
LIBOR
Onestate
Insurance
DomBank
9.5%
LIBOR
+
9.4%
Debt
Principal
0.5%
Credit
Markets
This chart
three aspects
of the swaps
(1) Converting
floating-rate
debt to fixed-rate
(2) Converting
floating-rate
assets
an intermediary
Quality Spread Differential. The cost savings
explanation of swaps claims that swaps allow
corporations to arbitrage quality spread differentials. A quality spread is the difference
between the interest rate paid for funds of a
given maturity by a high-quality firm—that is,
one with low credit risk—and that required of a
lower-quality firm. The quality spread differential is the difference in quality spreads at two
different maturities. Table l provides the calculation of the quality spread differential based
on the example provided in Chart I. Atlanta
market:
debt (Widgets
to fixed-rate
(DomBank)
issue liabilities with their desired repricing
interval (or maturity) and eliminate the need to
undertake a swap. An early explanation for
swaps was that they reduce corporations' funding costs by allowing firms to exploit market
inefficiencies.7 Although this explanation remains popular with some market participants,
academic analysis has questioned the ability of
market inefficiencies to explain the existence
and growth of the swap market. Several other
explanations for the swap market's popularity
that do not rely on market inefficiency have also
been provided. The next section of this article
presents both original research and a review of
recent literature to determine alternative reasons for the surge in use of interest rate swaps.
FEDERAL RESERVE BANK OF ATLANTA
0.25%
Credit
Markets
demonstrates
(3) Using
LIBOR
+
Debt
Principal
to facilitate
assets
the
(Onestate
Unlimited)
Insurance)
swap
HiTech, which has a AAA rating, can obtain shortterm financing at six-month LlBOR-plus-0.20 percent or fixed-rate financing at 9.00 percent.
Heartland Manufacturing can obtain floatingrate funding at six-month LlBOR-plus-OJO or
fixed-rate funds at 10.20 percent. For floatingrate funding, the quality spread, or difference in
rates, between the two firms is 50 basis points,
but it widens to 120 basis points for fixed-rate
funding. The difference in quality spread, or the
quality spread differential, in this example is 70
basis points.
The quality spread differential may be exploitable if Atlanta HiTech desires floating-rate
funds and Heartland Manufacturing seeks a
fixed rate. Table 2 shows how the qual ity spread
differential is exploited through an interest rate
swap. Atlanta HiTech issues fixed-rate debt, and
Heartland issues floating-rate debt. Then the
two firms enter into an interest rate swap. The
net result is that Atlanta HiTech obtains funds
at LIBOR minus 18 basis points and Heartland
obtains fixed-rate funds at 9.88 percent. Compared with their cost of funds had they not used
the interest rate swap strategy, this result represents a 38 basis point savings for Atlanta
HiTech and a 32 basis point savings for Heartland. Note that the division of the gain in this
25
Table 1.
Numerical Example of a Quality Spread Differential
Credit rating
Cost of Raising
Fixed-Rate Funding
Cost of Raising
Floating-Rate Funding
Atlanta
HiTech
Heartland
Manufacturing
AAA
BBB
Quality
Spread
9.00%
10.20%
1.20%
6-month LIBOR
plus 0.20%
6-month LIBOR
plus 0.70%
0.50%
Quality Spread
Differential
example is arbitrary and that the two parties
could split the gains differently. However, the
total gains to the swapping parties will always
equal the quality spread differential—70 basis
points in this example.
Table 2 clearly demonstrates the ability of
swaps to help exploit apparent arbitrage opportunities. However, some observers question
whether arbitrage opportunities actually exist.
Stuart Turnbull (1987) argues that swaps are
zero-sum games in the absence of market imperfections and swap externalities. He also suggests that quality spread differentials may arise
for reasons that are not subject to arbitrage. Clifford W. Smith, Charles W. Smithson, and Lee
Macdonald Wakeman (1986) note that, even if
quality spread differential arbitrage were possible, such activity by itself would not explain
swap market growth. In fact, the annual volume
of new swaps should be declining as arbitrage
becomes more effective.
0.70%
risk is shifted from creditors to shareholders.
Creditors have the option of refusing to roll over
their debt if the firm appears to b e riskier than
when the debt was incurred, and short-term
creditors have more opportunities to exercise
this option. Thus, the creditors of a firm that
issues short-term debt bear less risk than the
creditors of a firm that issues long-term debt. If
the creditors of firms that issue short-term debt
bear less risk, the equity holders and long-term
creditors necessarily bear more risk.
If the qual ity spread differential is not entirely
the result of market inefficiencies, why does it
exist? In a 1987 research paper, the authors of
this article point out that quality spread differentials could arise for a number of reasons,
including differences in expected bankruptcy
costs. Because the expected discounted value
of bankruptcy-related losses increases at a faster pace for lower-rated corporations than for
higher-rated ones, quality spreads increase
with maturity. In this case, the lower initial cost
of swap financing is offset by higher costs later.
A third possible explanation for the quality
spread differential involves differences in shortand long-term debt contracts. Long-term contracts frequently include a variety of restrictive
covenants and may incorporate a call option
that is typically not present in short-term debt
contracts. The differences in these contract provisions may be reflected in the interest rates
charged on various debt contracts. For example,
Smith, Smithson, and Wakeman point out that
the long-term corporate debt contracts issued
by U.S. firms in domestic markets typically have
a call provision that is not adjusted for changes
in market interest rates. However, long-term
debt contracts issued in the Eurobond markets
frequently have call provisions that adjust call
prices for market rate changes. Thus, quality
spread differentials will reflect differences in
contract terms if they are calculated using
domestic U.S. market rates for lower-quality
firms and Eurobond rates for higher-quality
firms.
Alternatively, Jan G. Loeys (1985) suggests
that quality spread differentials could arise as
In a forthcoming paper, one of the authors of
this article suggests that the quality spread dif-
26
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Table 2.
Numerical Example of a Swap's Ability to Reduce a Firm's Cost of Funding
Atlanta
HiTech
Heartland
Manufacturing
Direct Funding Cost
Fixed-rate funds raised directly by Atlanta HiTech
(9.00%)
(6-month
LIBOR + 0.70%)
Floating-rate funds raised directly by Heartland
Swap Payments
Atlanta HiTech pays Heartland floating rate
Heartland pays Atlanta HiTech fixed rate
(LIBOR)
LIBOR
9.18%
(9.18%)
All-in cost of funding
LIBOR - 0.18%
9.88%
Comparable cost of equivalent direct funding
LIBOR + 0.20%
10.20%
Savings
38 basis points
32 basis points
ferential may reflect differences in the agency
costs associated with short- and long-term debt.
Agency costs arise because managers, owners,
and creditors have different interests, and managers or owners may take actions that benefit
themselves at the expense of the other parties
and at the expense of total firm value. In particular, Larry D. Wall notes that the owners of
firms that issue long-term, noncallable d e b t
create an incentive to underinvest and to shift
investments from low-risk to high-risk projects. 8
A firm may underinvest in new projects because
most of the benefit of some projects is received
by creditors in the form of a reduced probability
that the firm will default. Owners will prefer a
high-risk project to a low-risk project because
they receive the gains on successful high-risk
projects while creditors may suffer most of the
losses if the projects fail. Creditors recognize
the incentives created by long-term d e b t and
demand a higher risk premium in compensation. The problems created by long-term d e b t
may b e reduced or eliminated by short-term
debt, that is, d e b t which matures shortly after
the investment decision. 9 An interest rate swap
allows lower-quality firms to issue short-term
debt while avoiding exposure to changes in
market interest rates. Thus, the combination of
short-term d e b t and swaps may b e less costly
than long-term debt.
FEDERAL RESERVE BANK OF ATLANTA
In their 1987 paper, the authors also point to
another agency cost—that of liquidating insolvent firms—which may b e reduced by using
short-term debt. Insolvent firms have an incentive to underinvest because, according to David
Mayers and Clifford W. Smith (1987), creditors
receive almost all of the benefit. Creditors of
these firms can reduce the costs associated with
underinvestment by taking control of the firm as
soon as possible after the firm becomes insolvent. However, creditors may not gain control of
a firm until it fails to make a promised d e b t payment. Short-term d e b t may hasten creditors'
gaining control when a firm has adequate funds
to pay interest but lacks the resources to pay
interest on its d e b t and repay the principal.
According to Wall and John J. Pringle, the
quality spread differential is not exploitable to
the extent that it arises from differences in the
expected costs of bankruptcy, shifts in risk from
creditors to equityholders, or actual differences
in contract terms. However, the quality spread
differential can b e exploited to the extent that it
arises from agency costs. Moreover, arbitrage
may eliminate differentials that arise from market inefficiencies, whereas one firm's swap does
not reduce the potential agency cost savings to
another firm. Thus, agency cost explanations
could provide at least a partial explanation for
the continuing growth of the swap market.
27
An important question facing the quality
spread differential-based explanations is the
extent to which the differential reflects exploitable factors. The authors note that the various
explanations of the quality spread differential
are not mutually exclusive. For example, if the
differential is 70 basis points, then perhaps only
30 basis points may b e exploitable.
One empirical study that has some bearing on
the quality spread differential is by Robert E.
Chatfield and R. Charles Moyer (1986). This
study examines the risk premium on 90 longterm puttable bonds issued between July 24,
1974, and August 2,1984, and a control sample of
174 nonputtable bonds. The put option on longterm, floating-rate d e b t gives creditors the
option to force the firm to repay its debt if the
firm becomes riskier.10 The study finds that the
put feature reduces the rate that the market
requires on long-term debt by 89 basis points
for the bonds in the sample. Chatfield and
Moyer provide strong evidence that at least part
of the quality spread differential does not arise
due to inefficiencies in the markets for shortand long-term debt. However, the observed
savings arising from the put feature may b e
attributable to some of the factors discussed
earlier, including bankruptcy costs, risk shifting
from creditors to equityholders, and agency
costs. Thus, the Chatfield and Moyer results cannot be used to determine the magnitude of
agency-cost savings available through interest
rate swaps.
Other Explanations. Several explanations for
the increased use of the interest rate swap
market which do not depend on exploiting the
quality spread differential are available. One is
that swaps may be used to adjust the repricing
interval (or maturity) of a firm's assets or liabilities in order to reduce interest rate risk. For
example, a firm may start a period with an acceptable degree of exposure to changes in
market interest rates. Subsequently, though, it
desires a change in its exposure because of
shifts in its product environment or in the
volatility of interest rates. Swaps provide a lowcost method of making immediate changes in
exposure to market interest rates. For example,
suppose that a firm is initially fully hedged with
respect to interest rate changes but that a subsequent change in its product markets increases
its revenues' sensitivity to interest rates. This
28
company may be able to offset the increased
sensitivity by entering into a swap whereby it
agrees to pay a floating rate of interest, which
better matches revenues, and receives a fixed
rate of interest to cover payments on its outstanding debt. 11
Smith, Smithson, and Wakeman (1987a) suggest that swaps may allow firms greater flexibility in choosing the amount of their outstanding debt obligations. In particular, reducing debt levels may be a problem if swaps are
not used. To reduce its outstanding long-term
debt, a firm may need to pay a premium (that is,
the call price may exceed the current market
value of the debt). On the other hand, if it issues
short-term debt without a swap, it may be exposed to adverse changes in market interest
rates. However, by issuing a combination of
"Swaps provide a low-cost method of
making immediate changes in exposure to market interest rates."
short-term debt and swaps, the firm avoids the
need to pay a premium to retire debt and simultaneously eliminates its exposure to changes in
market interest rates.
Marcelle Arak and others (1988) present a
general model in which firms will choose the
combination of short-term debt and interest
rate swaps over short-term debt; long-term,
fixed-rate debt; and long-term, variable-rate
debt. The model suggests that the combination
will b e preferred if the firm expects higher riskfree interest rates than does the market, the firm
is more risk-averse than the market with respect
to changes in risk-free rates, the firm expects its
own credit spread to be lower than that expected by the market, and the borrower is less riskaverse to changes in its credit spread than is the
market. The researchers also note that not all
four conditions need to be met at the same
time.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Arak and her colleagues' model is very broad
and could include the agency cost models as
subsets. An additional implication of their
model is that firms may use swaps to exploit
information asymmetries. Suppose that a company desires fixed-rate financing to fund a
project. It could issue long-term debt, but, if
management thought that the company would
soon receive a better credit rating, issuing longterm debt would force the firm to pay an excessive risk premium. By issuing short-term debt,
the firm could obtain a lower cost of long-term
funds in the future when its credit rating improved. However, this strategy would expose
the firm to interest rate risk. By instead issuing a
combination of short-term debt and interest
rate swaps the firm's managers can exploit their
information about the true credit risk of the firm
"One limitation of the nonarbitrage
explanation of swaps is that they provide only one reason for floating-rate
payers to enter into swaps, namely; the
ability to change the maturity structure
of the firm's assets and liabilities."
without exposing the organization to changes in
market interest rates.12 When the good news
comes, the firm's floating rate payments to outside creditors falls while its payments under the
swap remain the same, thus reducing the firm's
total financing costs. One important limitation
of this explanation is that it appl ies only to firms
that expect improved credit ratings in the near
future.
In yet another alternative to the quality
spread differential explanation, Loeys points
out that swaps may allow firms to exploit differences in regulation. He notes that Securities
and Exchange Commission (SEC) registration
requirements raise the cost of issuing bonds in
the United States by approximately 80 basis
points above the cost of issuing bonds in the
Eurobond markets. However, not all firms have
access to the Eurobond market. Thus, the costs
of obtaining fixed-rate funding may be reduced
FEDERAL RESERVE BANK OF ATLANTA
by having companies with access to the Eurobond market issue long-term debt and then
enter into a swap with firms that lack access to
but prefer fixed-rate funding. Smith, Smithson,
and Wakeman, observi ng that a variety of regulations differ across countries in ways that can b e
exploited, refer to this explanation as tax and
regulatory arbitrage.
A Review of the Explanations. The various
explanations of interest rate swaps discussed
above are not mutually exclusive, since different
firms may use swaps for different reasons. One
of the most popular explanations of interest
rate swaps—that they allow arbitrage of the
quality spread differential—is also the explanation with the weakest theoretical support. The
other explanations are all theoretically plausible. Unfortunately, published empirical evidence on the reasons for using swaps is almost
nonexistent. Linda T. Rudnick (1987) provides
anecdotal evidence that reductions in financing
costs are one of the primary reasons that firms
enter into interest rate swaps. In research currently in progress, the authors of this article are
examining the financial characteristics of firms
that reported the use of swaps in the notes to
their 1986 financial statements.
One limitation of the nonarbitrage explanations of swaps is that they provide only one
reason for floating-rate payers to enter into
swaps, namely, the ability to change the maturity structure of the firm's assets and liabilities.
Moreover, this single explanation fails to provide a sound reason for a firm to issue long-term,
fixed-rate d e b t and then enter into a swap
agreement. If a company does issue long-term
debt and then enters into a swap agreement as
a floating-rate payer, either fixed-rate payers
are sharing part of their gains with the floatingrate payer or floating-rate payers obtain some
as yet undiscovered benefit from swaps.
Risks Associated with Swaps
Interest rate swap contracts are subject to
several types of risk. Among the more important
are interest rate, or position, risk and credit risk.
Interest rate risk arises because changes in
market interest rates cause a change in a swap's
value. Credit risk occurs because either party
29
may default on a swap contract. Both participants in a swap are subject to each type of risk.
Interest Rate Risk. As market interest rates
change, interest rate swaps generate gains or
losses that are equal to the change in the
replacement cost of the swap. These gains and
losses allow swaps to serve as a hedge which a
company can use to reduce its risk or to serve as
a speculative tool that increases the firm's total
risk. A swap represents a hedge if gains or losses
generated by the swap offset changes in the
market values of a company's assets, liabilities,
and off-balance sheet activities such as interest
rate futures and options. However, a swap is
speculative to the extent that the firm deliberately increases its risk position to profit from
predicted changes in interest rates.
The determination of whether and howto use
a swap is straightforward for a firm that is a user,
one which enters into a swap agreement solely
to adjust its own financial position. 13 First, the
company evaluates its own exposure to future
changes in interest rates, including any planned
investments and new financings. Then, its views
on the future levels and volatility of interest
rates are ascertained. Firms wishing greater
exposure to market rate changes enter into
swaps as speculators. Alternatively, if less exposure is desired, the company enters into a
swap as a hedge.
The problem facing a dealer—a firm that
enters into a swap to earn fee income—is more
complicated. A dealer may enter into a swap to
hedge changes in market rates or to speculate in
a manner similar to users. However, a dealer
may also enter a swap to satisfy a customer's
request even when the dealer wants no change
in its interest rate exposure. 14 In this case, the
dealer must find some way of hedging the
swap transaction.
The simplest hedge for one swap transaction
by a dealer is another swap transaction whose
terms mirror the first swap. An example of this
arrangement is given in Chart 2, in which the
dealer's promised floating-rate payments of
LIBOR to Widgets Unlimited is exactly offset by
OneState's promise to pay LIBOR. Similarly, the
fixed payments to OneState Insurance are
covered by Widgets' promised fixed payments,
and DomBank is left with a small spread. This
combination of swaps is referred to as a matched
pair. One problem with relying on matched
30
pairs to eliminate interest rate risk is that the
dealer is exposed to interest rate changes during the time needed to find another party interested in a matching swap. Another problem is
that the dealer may b e relatively better at
arranging swaps with fixed-rate payers and,
thus, have problems finding floating-rate payers
to execute the matching swap (or vice versa).
An alternative to hedging one swap with
another swap is to rely on debt securities, or on
futures or options on debt securities, to provide
a hedge. Steven T. Felgran (1987) gives an example whereby a dealer agrees to pay a fixed rate
and receive a floating rate from a customer. The
dealer uses the floating-rate receipts to support
a bank loan, which is then used to purchase a
Treasury security of the same maturity and value
as the swap. Any gains or losses on the swap are
"One problem with relying on matched
pairs to eliminate interest rate risk is
that the dealer is exposed to interest
rate changes during the time needed
to find another party interested in a
matching swap. "
subsequently offset by losses or gains on the
Treasury security. Felgran does note one problem with using Treasury securities to hedge a
swap: the spread between them and interest
rate swaps may vary over time. 15 According to
Felgran, dealers are unable to hedge floatingrate payments perfectly. Sources of risk include
differences in payment dates and floating-rate
reset days, disparities in maturity and principal,
and "basis risk," that is, the risk associated with
hedging floating payments based on one index
with floating payments from another index.
Using the futures market to hedge swaps also
entails certain drawbacks. Wakeman points to
the "additional risk created by the cash/futures
basis volatility." He also notes that matching the
fixed-rate payments from a swap with the Treasury security of the closest maturity may not be
optimal when the Treasury security is thinly
traded. As an alternative he suggests that "onECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
the-run" (highly liquid) Treasury issues be used
for hedging. The investment amount and type of
issues to be used may be determined applying
a duration matching strategy. Still, this approach
is unlikely to eliminate interest rate risk for the
swap dealer since duration matching provides
a perfect hedge only under very restrictive assumptions.
Credit Risk. Aside from interest rate and
basis risk, both interest rate swap participants
are subject to the risk that the other party will
default, causing credit losses. The maximum
amount of the loss associated with this credit
risk is measured by the swap's replacement
cost, which is essentially the cost of entering
into a new swap under current market conditions with rates equal to those on the swap
being replaced.
"Aside from interest rate and basis
risk; both interest rate swap participants are subject to the risk that the
other party will default, causing credit losses. "
A simple example can demonstrate the credit
risk of swaps. Suppose that Widgets Unlimited
agrees to pay a fixed rate of 9.5 percent to DomBank, and in return Widgets will receive LIBOR
on a semiannual basis through January 1994. If
the market rate on new swaps maturing in January 1994 falls to 8 percent, the swap has positive value to DomBank—that is, DomBankwould
have to pay an up-front fee to entice a third party
to enter into a swap whereby DomBank receives
a fixed rate of 9.5 percent. DomBank will suffer a
credit loss if Widgets becomes bankrupt while
the rate is 8 percent and pays only a fraction of
its obligations to creditors. On the other hand, if
the rate on swaps maturing in January 1994 rises
to 10.5 percent and DomBank defaults, Widgets
may suffer a credit loss.
This example demonstrates that both of the
parties to an interest rate swap may b e subject
to credit risk at some time during the life of a
FEDERAL RESERVE BANK OF ATLANTA
swap contract. However, only one party at a time
may be subject to credit risk. If rates in the
above example fall to 8 percent, DomBank can
suffer credit losses, but Widgets is not exposed
to credit risk. That is, the swap has negative
value to Widgets when the market rate is 8 percent; Widgets would be happy to drop the swap
agreement if DomBank were to go bankrupt. In
practice, though, Widgets is unlikely to receive a
windfall from DomBank's failure. The swap contracts may provide for Widgets to continue making payments to DomBank or, if the contract is
canceled, provide for Widgets to pay DomBank
the replacement cost of the swap. 16
One way of reducing the cred it risk associated
with swaps is for the party to whom the swap has
negative value to post collateral equal to the
swap's replacement cost. Some swaps provide
for collateral but most d o not. According to
Felgran, swap collateralization is of uncertain
value because such documentation has yet to
b e adequately tested in court. Moreover, some
parties that would be happy to receive collateral are themselves reluctant to post it when
swap rates move against them. Certain commercial banks in particular have a strong incentive to
avoid collateral ization. Such institutions take
credit risks in the ordinary course of business
and are comfortable with assuming credit risk
on interest rate swaps. Investment bankers, on
the other hand, are typically at risk for only short
periods of time with their nonswap transactions
and are not as experienced in evaluating credit
risk. Thus, the continued presence of credit risk
in the swap market strengthens the relative
competitive position of commercial banks.
Several simulation studies have explored the
magnitude of the credit risk associated with
individual swaps or matched pairs of swaps.
Arak, Laurie S. Goodman, and Arthur Rones
(1986) examine the credit exposure—or maximum credit loss—of a single interest rate swap
to determine the amount of a firm's credit line
that is used by a swap. 17 They assume that shortterm rates follow a random walk with no drift; in
other words, the change in short-term rates does
not depend on the current level of or on past
changes in short-term rates. After the swap
begins, the floating-rate component of the swap
is assumed to move one standard deviation
each year in the direction of maximum credit
exposure. The standard deviation of interest
31
rates is calculated using 1985 data on Treasury
issues. Their results suggest that until the swap
matures, maximum annual credit loss on swaps
is likely to b e between 1 and 2 percent of
notional principal.
J. Gregg Whittaker (1987b) investigates the
credit exposure of interest rate swaps in order
to develop a formula for swap pricing. Using an
options pricing formula to value swaps and assuming that interest rates follow a log-normal
distribution and volatility amounts to one standard deviation, Whittaker finds that the maximum exposure for a 10-year matched pair of
swaps does not exceed 8 percent of the notional
principal.
The Federal Reserve Board and the Bank of
England studied the potential increase in credit
exposure of a matched pair of swaps. 18 The
study's purpose is to develop a measure of the
credit exposure associated with a matched pair
of swaps that is comparable to the credit exposure of on-balance sheet loans. The results
are used to determine regulatory capital requirements for interest rate swaps. The joint
central bank research assumes that for regulatory purposes the swaps' credit exposure should
be equal to its current exposure, that is, the
replacement cost plus some surcharge to capture potential increases in credit exposure. The
investigation uses a Monte Carlo simulation
technique to evaluate the probabilities associated with different potential increases in
cred it exposure. 19 Interest rates are assumed to
follow a log-normal, random-walk distribution
with the volatility measure equal to the 90th
percentile value of changes in interest rates
over six-month intervals from 1981 to mid-1986.
The credit exposure of each matched pair is
calculated every six months and the resulting
exposures are averaged over the life of the
swap. The study concludes with 70 percent confidence that the average potential increase in
credit exposure will be no greater than 0.5 percent of the notional principal of the swap per
complete year; at the 95 percent confidence
level it finds the average credit risk exposure to
be no greater than 1 percent of the notional
principal.
Terrence M. Belton (1987) follows this line of
research in analyzing the potential increase in
swap credit exposure, but he uses a different
method of simulating interest rates. Belton
32
estimates a vector autoregressive model over
the period from January 1970 to November 1986
to estimate seven different Treasury rates. (Vector autoregressive models estimate current
values of some dependent variables, in this
case interest rates at various maturities, as a
function of current and past values of selected
variables. Belton uses current and past interest
rates as explanatory variables.) Changes in the
term structure are then simulated by drawing a
set of random errors from the joint distribution
of rates and solving for future values at each
maturity. In effect, Belton's procedure allows
the historical shape in the yield curve and historical changes in its level and shape to determine the value of various interest rates in his
simulations. Belton's analysis differs from prior
studies in that he uses stochastic, or random,
'[SJeveral ways of estimating the increased credit exposure
associated
with matched pairs of swaps... might
not be applicable to swap portfolios."
default rates rather than focusing exclusively on
maximum credit exposure. His results imply
that the potential increase in credit exposure of
swaps caused by rate changes can be covered
by adding a surcharge of I percent to 5 percent
of the notional principal to the current exposure
for swaps with a maturity of 2 to 12 years.
While the foregoing analyses suggest several
ways of estimating the increased credit exposure associated with matched pairs of swaps,
these approaches might not be applicable to
swap portfolios. Starting with the assumption
that dealers use matched pairs of swaps and
that the swaps are entered into at market interest rates, Wall and Kwun-Wing C. Fung (1987)
note that the fixed rate on the matched pairs will
change over time as interest rates move up and
down. Wall and Fung point out that if rates have
fluctuated over a certain range, a bank may have
credit exposure on some swaps in which it pays
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
a fixed rate and on others in which it pays a floating rate. In this case, an increase in rates generates an increase in the credit exposure of
swaps in which the dealer pays a fixed rate but
also causes a decrease in the exposure of swaps
in which the dealer pays a floating rate. Similarly, a decrease in rates will increase the exposure on the swaps in which the dealer pays a
floating rate and decrease exposure on those in
which the dealer pays a fixed rate. 20
In a more empirical vein, Kathleen Neal and
Katerina Simons (1988) simulate the total credit
exposure of a portfolio of 20 matched pairs of
interest rate swaps. The initial portfolio is
generated by originating one pair of five-year
swaps per quarter from the fourth quarter of
1981 through the fourth quarter of 1986 at the
prevailing interest rate. For the period 1987
"[Tjhe maximum
exposure
on a
matched pair of swaps is unlikely to
exceed a small fraction of the swap's
notional principal."
through 1991, the interest rates are generated
randomly based on the volatility observed in
historical rates.21 The maturing matched pair is
dropped each quarter from the sample and a
new five-year swap is added to the portfolio at
the simulated interest rates. After running
"several thousand" simulations and assuming a
portfolio of interest rate swaps with a notional
principal of $10 million, Neal and Simons find
the average maximum credit loss to b e $ 185,000
and the 90th percentile exposure, $289,000.
No single correct approach is available to
determine the expected credit exposure on an
interest rate swap. The results may be influenced by the assumptions that are made about
the distribution of future interest rates. However, several studies using different methodologies have reached the conclusion that the
maximum exposure on a matched pair of swaps
is unlikely to exceed a small fraction of the
FEDERAL RESERVE BANK OF ATLANTA
swap's notional principal. Moreover, the analysis of a single matched pair may overstate the
expected exposure of a swap portfolio. Therefore, additional simulations of portfolio analysis
risk may be appropriate to determine the risk
exposure of swap dealers. Dominique Jackson
( 1988) reports that a survey of 71 dealers showed
that 11 firms had experienced losses with "total
write-offs accounting for $33 million on portfolios which totaled a notional (principal) of
$283 billion."
How Should Swaps Be Priced?
In addition to considering the reasons for
engaging in swaps and the attendant risks, the
literature on interest rate swaps addresses two
important pricing questions: (1) how should
the overall value of a swap be established, and
(2) what spread between higher-rated and lowerrated firms is appropriate to cover swap credit
risk? James Bickslerand Andrew H. Chen (1986)
provide an analysis of a swap's overall value.
They suggest that an interest rate swap b e
treated as an exchange of a fixed-rate bond for a
floating-rate bond. According to this approach,
the fixed-rate payer has in effect sold a fixedrate bond and purchased a floating-rate bond.
Bicksler and Chen suggest that pricing an interest rate swap is essentially the same as pricing a floating-rate bond.
Insight into the appropriate spreads between
high- and lower-rated firms can be obtained by
comparing the qual ity spreads on bonds versus
those on swaps. Patrick de Saint-Aignan, the
chairman of the International Swap Dealers
Association and a managing director at Morgan
Stanley, remarks that, "There's a credit spread
of 150 basis points in the loan market but of only
5 to 10 basis points in swaps." 22 However, Smith,
Smithson, and Wakeman (1987a) note that the
risk exposure, as a proportion of notional principal for swaps, is far less than the exposure on
loans. Lenders have credit exposure for all principal and interest payments promised on the
loan, whereas a swap participant's credit exposure is limited to the difference between two interest rates. Thus, the credit risk borne by swap
dealers is a far smaller proportion of the (notional) principal than that assumed by lenders.
33
Belton also addresses the question of appropriate spreads to compensate for swaps' credit
risk by considering the default premium required to compensate one party for the expected value of the default losses from the other. For
low-risk firms—companies with a 0.5 percent
probability of default in one year and zero payment on default—the required premium is 0.70
basis points for a two-year swap and 3.02 basis
points for a ten-year swap. For below-investmentgrade firms—with a 2 percent probability of
default per year and zero payment on default—
the required premium ranges from 2.83 basis
points for a two-year swap to 14.24 basis points
for a ten-year swap. The differences in default
premium of 2 to 14 basis points found by Belton
for swaps is approximately in the 5 to 10 basis
point range of the credit spread charged in
swaps markets.
Whittaker (1987b) applies his options pricing
method for calculating swaps' credit risk to the
issue of swap pricing. He views a swap as a set of
options to buy and sell a fixed-rate bond and a
floating-rate bond. In his model default by the
fixed-rate payer is analogous to a decision to
exercise jointly a call option to purchase the
fixed-rate bond and a put option to sell a floatingrate security. From this perspective, the decision to exercise one option is not independent
of the decision to exercise another. Thus, one
option may b e exercised even though it is unprofitable to do so, provided that it is sufficiently profitable to exercise the other option. He
then estimates the value of these options and
suggests that "the market does not adequately
take account of the exposure and pricing differentials across varying maturities." However,
Whittaker claims that his results may not necessarily imply that the market is on average underpricing swap credit risk.
One limitation of the above studies is that
they fail to combine into an integrated framework the distribution of interest rates and the
credit risk associated with swaps. A conceptually superior approach to interest rate swap
valuation begins by separating the payments.
The result looks like a series of forward contracts
in which the floating-rate payer agrees to buy a
zero-coupon Treasury security from the fixedrate payer. This forward contract may then be
decomposed into two options, one in which the
floating-rate payer buys a call from the fixed34
rate payer on the zero-coupon Treasury security
and one in which the floating-rate payer sells a
put on the security to the fixed-rate payer.
Unfortunately, the options derived from this
analysis cannot be valued using standard options pricing formulas because both options are
subject to credit risk. Herb Johnson and René
Stulz (1987) analyze the problem of pricing a
single option subject to default risk. However,
swaps are a series of linked options whose payments in one period are contingent on the terms
of the swap contract being fulfilled in prior
periods. Thus, as Smith, Smithson, and Wakeman (1987b) suggest, to derive an optimal default strategy for swaps requires analysis of
compound option issues similar to those discussed by Robert Geske (1977) for corporate
coupon bonds.
"ITJhe interest rate swap market is
subject to remarkably little regulation
and does not have a central exchange or
even a central clearing mechanism."
The theoretical and pedagogical advantages
of splitting a swap into a series of default-risky
options are that the decomposition clearly illustrates the primary determinants of swap value:
the distribution of the price of default-risk free
bonds (interest rates), the possibility of default
by either participant, and the linked nature of
the options through time. The practical problem
with the decomposition is that developing a
pricing formula is not straightforward.
Requirements Imposed on Swaps
Regulation. In contrast to most other financial
markets in the United States, the interest rate
swap market is subject to remarkably little
regulation and does not have a central exchange
or even a central clearing mechanism. The terms
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
of a swap agreement are determined by the parties to the contract and need not be disclosed.
Nor does the existence of a swap need to be disclosed at the time the agreement is executed.
(The financial statements' disclosure requirements for individual firms are discussed later in
this article.) While certain regulators have a
general responsibility for the financial soundness of some participants in the swap market,
no public or private organization has overall responsibility for its regulation.
In general, this lack of regulation has not
resulted in any major problems. Legislatures
could make one potentially valuable contribution, though, by providing specific statutory
language on the treatment of swap contracts
when one party defaults. Market participants
are currently waiting for the courts to determine
"Like regulatory requirements, accounting standards for swaps are minimal at best, owing largely to their
rapid development "
if default procedures will follow the language of
the swap contract or if the courts will impose
some other settlement procedure. For example,
many swaps are arranged under a master contract between two parties that provides for the
netting of payments across swaps. This clause is
desirable because it reduces the credit risk
borne by both parties. However, the risk exists
that a bankruptcy court will ignore this clause
and treat each swap separately.
Even though the swap market is not subject to
regulation, individual participants are. In particular, federal banking regulators in the United
States are including interest rate swaps in the
recently adopted risk-based capital standards.
These standards are designed to preserve and
enhance the safety and soundness of commercial banks by requiring them to maintain capital
commensurate with the levels of credit risk
they incur.23
FEDERAL RESERVE BANK OF ATLANTA
Banks' capital standards first translate credit
exposure on swaps into an amount comparable
to on-balance sheet loans. The loan equivalent
amount for swaps is equal to the replacement
cost of the swap plus 0.5 percent of the notional
principal. This loan equivalent amount is then
multiplied by 50 percent to determine a riskadjusted asset equivalent. Banks are required
to maintain tier-one (or core) capital equal to
4 percent of risk-adjusted assets and total capital equal to 8 percent by 1992.24
The central banks of 12 major industrial powers
have agreed to apply similar risk-based capital
requirements to their countries' financial firms.25
However, these standards d o not apply to U.S.
investment banks or insurance companies. Thus,
capital requirements are not being applied to
all swap dealers. Some market participants are
concerned that the standards will place dealers
that are subject to capital regulation at a competitive disadvantage. 26
Accounting. Like regulatory requirements,
accounting standards for swaps are minimal at
best, owing largely to their rapid development.
Existing accounting standards provide a general
requirement that a firm disclose all material
matters but do not require a company to disclose its participation in the interest rate swap
market. Different firms appear to be following
many of the same rules in accounting for the
gains and losses under swap contracts, but
some important discrepancies exist in practice.
Keith Wishon and Lorin S. Chevalier (1985)
note that swap market participants generally do
not recognize the existence of swaps on their
balance sheets, a practice which is consistent
with the treatment of futures agreements. However, they aver that the notes to the firm's financial statements should disclose the existence of
material swap agreements and discuss the
swap's impact on the repricing interval of the
firm's d e b t obligations. Harold Bierman, Jr.
(1987) recommends that firms also disclose the
transaction's effects on their risk position.
Another issue at the inception of some swap
contracts is accounting for up-front payments.
Wishon and Chevalier believe that any up-front
payments that reflect yield adjustments should
b e deferred and amortized over the life of the
swap. While acknowledging that payers appear
to be following this policy, the researchers note
that some recipients have taken the position
35
that all up-front fees are arrangement fees and
may b e immediately recognized in income.
Bierman argues that yield-adjusting fees cannot
b e distinguished from others. Thus, all fees
should be treated in the same manner. He further
maintains that the most appropriate treatment
is to defer recognition and amortize the payments over the life of the contract.
According to Wishon and Chevalier, regular
payments and receipts under a swap agreement
are frequently recorded as an adjustment to
interest income when the swap is related to a
particular debt issue. Though the receipts and
payments are technically not interest, this
approach is informative, especially if footnote
disclosure is adequate. They report, nonetheless, that changes in the market value of the
swap are generally not recognized in the income
statement if gains and losses are not recognized
on the security hedged by the swap. This treatment parallels that of futures, which meets the
hedge criteria in the Financial Accounting Standards Board's Statement Number 80, "Accounting for Futures Contracts."
Another issue arising during the life of an
interest rate swap is the presentation of the
credit risk. For a nondealer, credit risk may not
be material and, therefore, need not be reported. However, Wishon and Chevalier argue that
the credit risk taken by a dealer is likely to be
material and should b e disclosed.
Some firms may enter into swaps as a speculative investment. Wishon and Chevalier contend that speculative swaps should b e accounted for in the same manner as other speculative investments. Among the alternatives they
discuss are using either the lower of cost or
market method of valuation, with writedowns
only for losses that are not "temporary," and the
lower of cost or market in all cases. Both approaches are flawed. The treatment of some
swap losses as "temporary" is inappropriate
because objective and verifiable predictions of
changes in interest rates are impossible. 27 Yet
using the lower-of-cost-or-market method of
valuation in all cases will always result in a
swap's being valued at its historical low, an excessively conservative position. Probably the
best approach is to report the swap's replacement cost and to recognize any gains or losses in
the current period.
36
Bierman suggests that, when a speculative
swap is terminated prior to maturity, the gain or
loss should be recognized immediately. However, no consensus exists on the treatment if the
swap is a hedge. Wishon and Chevalier report
widespread disagreement on the appropriate
treatment of a swap's termination. One common
approach would defer and amortize any gains or
losses on the swap over the life of the underlying financial instrument. The other calls for
immediate recognition of any gains or losses.
The treatment of gains or losses on futures
hedges suggests that the deferral and amortization of early swaps termination is appropriate.
Eugene E. Comiskey, Charles W. Mulford, and
Deborah H. Turner (1987-88), surveying the financial statements of the 100 largest domestic
banks in 1986, discovered that some banks are
deferring gains or losses in accordance with
hedge accounting treatment even though hedge
accounting would not be permitted in similar
circumstances for futures. 28 They also found
that five banks disclosed their maximum potential credit loss in the extremely unlikely event
that every counterparty defaulted on all swaps
that were favorable to the bank.
The Financial Accounting Standards Board
issued an Exposure Draft of a proposed Statement of Financial Accounting Standards titled
"Disclosures about Financial Instruments." The
statement proposes disclosing a variety of new
information about financial instruments, including the maximum credit risk; the reasonably
possible credit loss; probable credit loss; the
amount subject to repricing within one year, one
to five years, and over five years; and the market
value of each class of financial instrument. This
statement specifically includes interest rate
swaps in its definition of financial instruments.
If, when, and in what form this proposal will be
adopted is unclear.
Commercial banks in the United States are
currently required to disclose the notional principal on their outstanding interest rate swap
portfolio to the federal bank regulators. 29 It
would seem that regulators should also consider requiring disclosure of the replacement
cost of outstanding swaps given that replacement cost is an element of the risk-based capital standards.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Conclusion
This article surveys the literature and some
research in progress on interest rate swaps. The
extremely rapid growth of the market has left
academics trying to explain the existence of the
market and the pricing of these instruments,
FEDERAL RESERVE BANK OF ATLANTA
regulators attempting to determine what risks
these instruments pose to financial firms, and
accountants endeavoring to determine how institutions should report their use of swaps.
Evidence is beginning to accumulate to dispel
some of the early misconceptions about this
market, but far more analysis remains before
interest rate swaps can b e fully understood.
37
Notes
1
S e e A b k e n (1988) for a review of t h e s t u d i e s of t h e stock
a b l e b o n d s may fail t o p r o v i d e a separating e q u i l i b r i u m if
m a r k e t crash.
2
seemingly small c h a n g e s are m a d e to their e x a m p l e .
The size of t h e interest rate s w a p m a r k e t is typically s t a t e d
13
in t e r m s of t h e n o t i o n a l p r i n c i p a l of t h e o u t s t a n d i n g
ward, a n d o p t i o n s markets. S e e S m i t h s o n (1987) for a dis-
swaps. S e e the explanation of interest rate s w a p transac-
cussion of t h e various financial i n s t r u m e n t s t h a t may b e
tions for a discussion of t h e role of t h e notional principal.
Refer to Jackson (1988) for a discussion of t h e size of t h e
3
u s e d t o control interest rate risk.
l4
T h e d e a l e r may e n t e r into a s w a p for a c u s t o m e r even
interest rate a n d currency s w a p markets.
though t h e d e a l e r desires a c h a n g e in exposure in a direc-
S e e Celarier (1987): 17. This e s t i m a t i n g a p p e a r s t o encom-
tion o p p o s i t e to the swap.
p a s s t h e effect of b o t h interest rate s w a p s a n d a related
i n s t r u m e n t c a l l e d a currency swap. A currency
15
since the Treasury yield curve incorporates c o u p o n in-
arrangement b e t w e e n two organizations to exchange
terest p a y m e n t s a n d principal r e p a y m e n t s at t h e maturity
principal a n d interest p a y m e n t s in two different curren-
of t h e s w a p whereas t h e s w a p contract provides only for
cies a t prearranged exchange rates. For e x a m p l e , o n e cor-
p e r i o d i c interest p a y m e n t s .
poration agrees t o pay a fixed a m o u n t of dollars in return
' f i d g e t s w o u l d p r o b a b l y prefer t o cancel t h e contract a n d
enter into a new swap contract with a different party.
corporation. This article focuses o n interest rate swaps,
Otherwise, market rates c o u l d increase a b o v e 9.5 p e r c e n t
a n d hereafter t h e term swaps will b e u s e d as a synonym
a n d t h e n D o m B a n k m i g h t b e u n a b l e to m a k e t h e prom-
for interest rate swaps. Beckstrom (1986) offers a discus-
ised p a y m e n t s . S e e H e n d e r s o n a n d Cates (1986) for a dis-
sion of different types of swaps.
cussion of t e r m i n a t i n g a swap u n d e r t h e insolvency laws of
6
7
the United States a n d t h e U n i t e d K i n g d o m .
Both fixed-rate interest p a y m e n t to floating-rate p a y m e n t
swaps a n d floating-rate to floating-rate swaps whereby,
5
17
O n e way that b a n k s typically limit their risk t o individual
for e x a m p l e , o n e party pays t h e L o n d o n Interbank Offered
borrowers is to establish a m a x i m u m a m o u n t that t h e
Rate (LIBOR) w h i l e t h e other party pays the commercial
organization is willing to l e n d t o t h e borrower, called the
p a p e r rate, are o b s e r v e d in t h e market.
borrower's credit line. The a m o u n t of a credit line u s e d by
L I B O R is the m o s t c o m m o n floating rate in interest rate
a loan is t h e principal of t h e loan; however, t h e a m o u n t of
swap agreements, according t o H a m m o n d (1987).
the line u s e d by a s w a p is less clear since a swap's max-
However, t h e call o p t i o n is n o t a free gift p r o v i d e d by t h e
i m u m credit loss is a function of market interest rates.
b o n d market t o corporations. Corporations p a y for this call
l8
S e e also Muffet (1987).
o p t i o n by paying a higher rate of interest on their b o n d s .
19
The M o n t e Carlo t e c h n i q u e involves r e p e a t e d simula-
S e e B i c k s l e r a n d C h e n (1986) as well a s W h i t t a k e r (1987a)
tions wherein a key value, in this case an interest rate, is
a n d H a m m o n d (1987) for further discussion.
drawn from a r a n d o m s a m p l e .
% e e Myers (1977); B o d i e a n d Taggart (1978); a n d Barnea,
20
H a u g e n , a n d S e n b e t (1980).
9
l n d e e d , s o m e variation in t h e s p r e a d s h o u l d b e e x p e c t e d
swap is an
for receiving a fixed n u m b e r of J a p a n e s e yen from a n o t h e r
4
This analysis d o e s n o t c o n s i d e r t h e use of t h e futures, for-
p a i r t h e b a n k a g r e e s t o two swaps: 1) t h e b a n k pays a fixed
Long-term, c a l l a b l e d e b t m a y a l s o r e d u c e t h e agency
rate of 1! p e r c e n t a n d receives LIBOR on t h e first swap,
p r o b l e m s of u n d e r i n v e s t m e n t a n d risk shifting p r o b l e m s .
a n d 2) t h e b a n k pays LIBOR a n d receives 11 percent. For
However, Barnea, H a u g e n , a n d S e n b e t p o i n t o u t that call-
t h e s e c o n d m a t c h e d p a i r t h e b a n k p a y s a n d receives a
a b l e d e b t d o e s not e l i m i n a t e t h e u n d e r i n v e s t m e n t probl e m . Wall (forthcoming) s u g g e s t s t h a t c a l l a b l e
C o n s i d e r two m a t c h e d pairs of swaps. For the first m a t c h e d
9 percent fixed rate for LIBOR. A s s u m e that t h e notional
bonds
principal, maturity, a n d repricing interval of all swaps are
may not solve t h e risk shifting p r o b l e m in all cases a n d
e q u a l . If t h e current m a r k e t rate for swaps of t h e s a m e
also n o t e s that short-term d e b t will solve b o t h p r o b l e m s if
maturity is 10 percent, t h e b a n k has cred it e x p o s u r e o n t h e
it m a t u r e s shortly after the firm m a k e s its i n v e s t m e n t
9 p e r c e n t fixed-rate s w a p in which it pays a fixed rate of
decision.
interest a n d has credit e x p o s u r e on t h e 11 p e r c e n t fixed-
^ I n v e s t o r s may also have an incentive t o exercise t h e p u t
rate s w a p in which it pays a floating rate of interest. If t h e
o p t i o n o n fixed-rate b o n d s w h e n interest rates increase.
market rate o n c o m p a r a b l e swaps increases t o 10.5 per-
An easy way t o control for this feature is to focus ex-
cent, credit exposure increases o n t h e 9 p e r c e n t s w a p in
clusively o n floating-rate b o n d s . However, Chatfield a n d
which t h e d e a l e r p a y s a fixed rate a n d d e c r e a s e s o n t h e
Moyers' s t u d y c o n t a i n e d fixed-rate, p u t t a b l e b o n d s . Their
11 p e r c e n t s w a p in which t h e d e a l e r pays a floating rate.
research controlled for t h e interest rate feature of t h e p u t
G i v e n the a s s u m p t i o n s of this e x a m p l e , the c h a n g e in
o p t i o n o n t h e s e b o n d s by i n c l u d i n g a variable for t h e num-
exposure is a l m o s t zero w h e n t h e market rate m o v e s from
ber of t i m e s per year t h e c o u p o n rate on a b o n d a d j u s t s
a n d a m e a s u r e of interest rate uncertainty.
10 p e r c e n t t o 10.5 percent.
21
The p a p e r d o e s not explain how s w a p r e p l a c e m e n t v a l u e s
swaps for controlling interest rate exposure by savings
22
D a v i d Shirreff (1985): 253.
institutions.
23
T h e s t a n d a r d s d o not i n c l u d e any framework for evaluat-
" B e n n e t t , C o h e n , a n d McNulty (1984) discuss the use of
l2
a n d interest rate volatility were calculated.
R o b b i n s a n d S c h a t z b e r g (1986) s u g g e s t t h a t c a l l a b l e
ing t h e overall interest rate risk b e i n g taken by b a n k i n g
b o n d s are superior to short-term d e b t in t h a t they p e r m i t
organizations.
firms to signal their lower risk a n d t o r e d u c e t h e risk b o r n e
24
T h e s t a n d a r d s effective in 1992 d e f i n e core (tier-one)
by e q u i t y h o l d e r s . However, their results d e p e n d on a
capital as c o m m o n stockholders equity, minority interest
specific e x a m p l e . Wall (1988) d e m o n s t r a t e s that t h e call-
in t h e c o m m o n stockholders' e q u i t y accounts of con-
38
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
solidated subsidiaries, and perpetual, noncumulative
27
If the p r e d i c t e d c h a n g e s in interest rates were subject t o
preferred stock. (The Federal Reserve will a l s o allow b a n k
objective verification, t h a t w o u l d suggest that arbitrage
h o l d i n g c o m p a n i e s to c o u n t p e r p e t u a l , c u m u l a t i v e pre-
o p p o r t u n i t i e s exist. That is, investors may b e a b l e t o earn
ferred stock.) Total capital consists of core capital p l u s
a profit with no net investment (financing t h e p u r c h a s e of
s u p p l e m e n t a r y (tier-two) capital. S u p p l e m e n t a r y capital
o n e d e b t security with t h e s a l e of another) a n d without
includes the allowance for loan a n d lease losses; per-
a s s u m i n g any risk (since objective verification proved t h a t
petual, c u m u l a t i v e preferred stock; long-term preferred
i n t e r e s t rates will m o v e in t h e p r e d i c t e d
stock, h y b r i d c a p i t a l i n s t r u m e n t s i n c l u d i n g p e r p e t u a l
However, efficient markets theory i m p l i e s t h a t the market
d e b t , a n d m a n d a t o r y convertible securities; a n d subor-
will i m m e d i a t e l y c o m p e t e away any arbitrage opportu-
d i n a t e d d e b t a n d intermediate-term preferred stock.
25
nities.
The framework for risk-based capital s t a n d a r d s has b e e n
28
Deferral of gains or losses on futures is p e r m i t t e d only if
approved by t h e G r o u p of Ten countries (Belgium, Canada,
t h e future is d e s i g n a t e d as a h e d g e for an "existing asset,
France, the Federal R e p u b l i c of Germany, Italy, lapan, the
liability, firm c o m m i t m e n t or a n t i c i p a t e d transactions,"
Netherlands, Sweden, the United Kingdom, a n d the United
according t o Comiskey, Mulford, a n d Turner, 4, 9.
29
States) together with Switzerland a n d Luxembourg.
26
direction).
P i t m a n (1988) discusses t h e capital s t a n d a r d s ' implica-
S e e Felgran (1987) for a listing of t h e t o p 25 U.S. b a n k s by
notional principal of swaps outstanding.
tions for various swap m a r k e t participants.
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(forthcoming).
. "Alternative Financing Strategies: Notes Ver-
1987, 206-13.
and Competition,
Shirreff, David. "The Fearsome Growth of S w a p s . "
Finance
M o d e l with Uncertain Interest Rates ."lournal
E x p o s u r e of Interest R a t e S w a p Portfolios." Federal
Rate Swaps." Federal Reserve Bank of Chicago,
Corporate
Wall, Larry D. "Interest Rate Swaps in an Agency Theoretic
lournal
41 ( S e p t e m b e r 1986): 935-49.
Rudnick, Linda T. " D i s c u s s i o n of Practical Aspects of Interest
money
S w a p s M a n a g e m e n t . " Chemical Bank Capital Markets
G r o u p u n p u b l i s h e d working paper, May 1986.
sus C a l l a b l e Bonds." lournal
on Bank Structure
Financial
16 (Spring 1987): 15-21.
Management
(January
1988): 68-80.
ference
14 ( D e c e m b e r
Economics
Turnbull, Stuart M. "Swaps: A Zero S u m G a m e ? "
and Finance
(Spring 1988): 26-29.
of Finance
of Financial
W a k e m a n , L e e M a c d o n a l d . " T h e Portfolio A p p r o a c h To
1987, 473-96.
ture and Competition,
D e b t . " lournal
1985): 501-21.
54 (March 1987): 45-54.
Insurance
Financial M a n a g e m e n t Association Meetings, Las Vegas,
O c t o b e r 1987b.
Wishon, Keith, a n d Lorin S. Chevalier. "Interest Rate Swaps—
Your Rate or M i n e ? " lournal
of Accountancy
(September
1985): 63-84.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
IK OF ATLANTA
dustry:
t Decade
F
December 7-8, 1988
Banks face numerous challenges as this decade of unprecedented change in financial services draws to a
close. To address banking's future, the Atlanta Fed will host a conference on December 7 and 8 that will
bring together an impressive range of speakers from industry, academia, and government, including
Manuel Johnson, William Isaac, Doug Barnard, Robert Litan, and George Vojta.
Topics to be covered include:
New Market Strategies for a Changing Environment
Problems of Risk in the Financial System
What the Next Session of Congress Promises for the Industry
Developments in Consumer and Community Regulations
The lively exchange of information among business, government, and Fed leaders will help you determine your business and banking strategies for the coming decade and beyond.
For more information on the conference, please contact Linda Donaldson, Conference Coordinator, at
(404| 521 -8747. You can also register for the conference using the form below. Hotel arrangements must be
made directly with the Hyatt Regency Atlanta at (404) 577- ! 234. Discount airfare is available from Osborne
Travel at 1 (800) 334-2087.
I
1
REGISTRATION FORM
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The Banking Industry: Preparing for the Next Decade
December 7-8, 1988
Hyatt Regency Atlanta
Atlanta, Georgia
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L
Moving toward 1992:
A Common Financial Market
for Europe?
David D. Whitehead
All the credit institutions, bankers' associations
and supervisory authorities of the countries
of the European Community are now fully convinced that 1992 is a real deadline
Deputy
Director
Tommaso
General
Padoa-Schioppa
October
1987
Until a couple of years ago most observers
believed the concept of a truly common market
for Europe was little more than a dream. A common European market would require 12 widely
disparate nations to agree on and pass legislation designed to ensure the free flow of goods,
services, people, and capital across mutual borders, essentially molding into one the economies of a dozen sovereign states. More recently,
however, steps have been taken that render the
realization of greater economic integration far
more likely.
The author
is research
tion of the Atlanta
like to thank
42
Sharon
officer
in charge
Fed's Research
Fleming
of the financial
Department.
for research
He
assistance.
secwould
This development has far-reaching ramifications. A single European market with a population larger than that of the United States would
carry significant competitive implications for
the conduct of business throughout the world.
Consolidations that are occurring in Europe are
creating firms with the resources to compete
even more effectively in global markets. For
example, 22 of the world's 50 largest banks are
already housed in the common market countries.
This article reviews the progress Europe is making toward the formation of a common market.
Special attention is given to the movement
toward an integrated European banking market
and a summary of its implications for the American banking industry.
The dream of mutual economic cooperation
among the nations of Europe grew out of a
devastated post-World War II environment and
was viewed as a way to help guarantee peace
and economic prosperity for the continent. Formal agreement on this goal was set forth in the
Treaty of Rome in 1957, but, as the years passed
and 1 ittle progress was reaI ized, most observers
doubted that a common market would emerge.
The skepticism was founded primarily on the
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Background on the European Economic Community
In 1946, following the end of World War II, British
Prime Minister Winston Churchill painted a picture of his dream of a united Europe enjoying the
peace and economic prosperity associated with
political unity and free trade. Five years later, the
Treaty of Paris was signed, creating the European
Coal and Steel Community, which was the first
step toward a European common market. The success of the European Coal and Steel Community
encouraged community members to ratify the
Treaty of Rome in 1957, which established the
European Economic Community (EEC) with the
goal of a unified internal market encompassing
the entire economies of six European countries:
France, West Germany, Italy, the Netherlands,
Belgium, and Luxembourg. The United Kingdom,
Denmark, and Ireland entered in 1973; Greece
became a member in 1981; and Portugal and
Spain followed suit in 1986. The European Economic Community is but a part of a larger international organization, the European Community,
the basic structure and institutions of which are
described in the box on page 50.
difficulty of harmonizing the commercial trade
laws of 12 nations. Enthusiasm, however, has
now replaced skepticism as a result of the
Single European Act, which streamlined the
process of melding the member states'laws and
set a deadline of 1992 for the establishment of
the common market.
The original push for a European common
market was based on a keen realization of the
potential economic benefits from free trade and
expanded geographic competition. Free trade
would reduce distribution costs and encourage
efficiencies through the specialization and division of labor associated with increased competition and the principle of comparative advantage. In addition, an expanded geographic
market encompassing over 320 million people
would allow for increased production efficiencies through economies of scale. The arguments
for a common market basically revolved around
Europe's potential for competing on a more
equal footing with the United States and Japan.
FEDERAL RESERVE BANK OF ATLANTA
Six additional countries belong to the European
Free Trade Association, which shares in the benefits of duty-free access for industrial goods within
the EEC, but are not members of the common
market. These six—Switzerland, Austria, Sweden,
Norway, Finland, and Iceland—do not participate
in the EEC's farm subsidy and agricultural trade
programs. Upon realization of the 1992 goal, they
will not share in its associated benefits such as tax
and regulatory harmony and freer trade and capital flows.
To promote these benefits, the preamble and
general clauses of the treaty called for implementation of common policies and rules in almost
every economic and social area across all member
states. In addition to the treaty's specific articles, a
general article empowered the European Economic Community to set up any common policy
necessary to attain the general objectives of the
treaty. This latter article gave the European Community the power to structure policies dealing
with industrial, social, and environmental problems not originally foreseen.
The Development of
a Common Market
A common market is an economic objective
that necessarily carries social and political consequences. To establish a European common
market or free trade area, all trade barriers
among the 12 member states must first b e removed. To date the European Community has
been successful in removing tariff barriers, or
taxes that each country had charged on imported goods. This first step is perhaps the easiest
in establishing a free trade area. Nontariff barriers are harder to break down because they are
intertwined into the economic, legal, social, and
political fabric of each nation.
Nontariff barriers include any politically controllable measures that impede the free movement of goods and services across borders and
thus benefit a producer in one country to the
detriment of producers in other countries. The
43
community has identified eight general types
of nontariff barriers and produced approximately 300 proposals for removing them. The
basic suggestions for eliminating nontariff
barriers are: (1) abolishing frontier controls on
goods; (2) achieving the free movement of people; (3) harmonizing technical standards for
motor vehicles, tractors, and agricultural machinery, food laws, pharmaceutical and high
technology medicine, chemical products, and
other industrial output; (4) opening up public
procurement markets; (5) coordinating services,
including financial services and transportation;
(6) liberalizing the laws regarding capital movement; (7) creating suitable conditions for industrial cooperation, company law and taxation,
and intellectual and industrial property rights;
and (8) removing fiscal frontiers, such as indirect
value-added taxes associated with intracommunity purchases. As of March 1988, 75 specific
proposals had been adopted, a joint position
had been reached on 14 others, and 126 had gone
to the Council of Ministers. Although significant
headway has been made, the process is slower
than expected.
Observers should not be surprised that the
path toward economic integration is a long one.
After all, as the 12 member states build a legal
foundation for the new economic order, they are
at the same time giving up a degree of autonomy. For example, every time they agree on
common technical and environmental standards for a product, each individually gives up
the right to establish its own standards. Similarly, agreement on a common tax policy reduces each nation's autonomy with respect to
taxation. For instance, the dozen member states
currently have substantially differentvalue-added
tax rates that affect costs to producers. These
taxes represent barriers to free competition,
and the community realizes these should b e
eliminated before a truly competitive combined market can be realized. Yet eliminating
these taxes requires another loss of autonomy
for the member states.
European economic integration would also
b e facilitated by a common currency unit or stable exchange rates. A European Monetary System has been established in an attempt to
create a stable system of currency exchange
rates, but only eight of the twelve EEC member
states, comprising seven currencies, are cur44
rently members of the exchange-rate mechanism. Even within the European Monetary
System, exchange rates are not pegged but are
allowed to vary within a given range. In addition,
the exchange value of a currency may be realigned to reflect changing economic conditions
such as a persistent differential in inflation rates
between a given country and others in the system. The fact that realignment took place seven
times between 1983 and 1987 indicates that each
of these countries maintains its sovereignty with
respect to monetary and fiscal policies.
The creation of the European Currency Unit
(ECU) as a common unit of account has given the
European Community a standard of value for
setting prices but does not decrease the autonomy of any nation. 1 To some degree the ECU
acts as an official unit of exchange and has been
used by the private sector to establish value in
commercial dealings across national borders.
The value of an ECU is defined in terms of
specific amounts of each of 10 currencies. In
terms of any single currency, an ECU's value
varies with changes in the exchange rates of
each currency. Again, since exchange rates are
not pegged, each country maintains its autonomy with respect to internal economic decisions. The European Community is currently
studying and debating the merits of a common
currency and central bank, but no quick resolution appears likely. Prospects for a rather competitive free trade area for Europe appear likely
by 1992, but complete integration that encompasses fiscal and monetary policy will take longer, if it occurs at all.
Harmonization:
Two Decades of Struggle
Over its first two-and-a-half decades, from
1958 to 1985, the European Community attempted to establish a common market by harmonizing and centralizing all laws pertaining to trade
and commerce in each member state. One key
attempt was in the area of agriculture, but finding a simple yet universal formula for farm price
supports and agricultural policies proved extremely complicated and inefficient. The process that the European Community's central
governing body must go through to pass direcECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
tives and regulations is laborious and in itself
has tended to restrict progress. This process,
described in the box on page 50, requires
extensive time and effort within both the structure of the European Community and the legislative bodies of each member state. Centralizing and harmonizing the member states' trade
and commercial laws proved to b e so timeconsuming that most observers questioned
whether a common market would ever emerge.
Some proposals recommended by the Commission in 1985 had been under consideration for
more than a decade.
A Change in Direction: Minimal Harmonization. In 1985 the European Parliament passed
the Single European Act, which was ratified by
the parliaments of member states in 1986 and
1987. The act marked three fundamental changes
that should facilitate the decision-making process in the m e m b e r states. First, the Single
European Act replaced the requirement for
unanimity with qualified majority voting in four
fields: the creation of a real internal market by
1992, technological research and development,
economic and social cohesion, and improvement of working conditions.
Second, the act endorsed the European Commission's 1985 legislative timetable. At that
time, a European Commission White Paper
identified barriers to the free movement of
goods, people, services, and capital in the EEC
and constructed a legislative agenda for removing them by December 31, 1992. The Commission also called for the drafting of almost 300
proposals that would help integrate the European Community. Approximately 20 of these are
directly concerned with banking and security
trading, which will b e discussed later in this article. Each individual country must eventually
change its domestic legislation to conform to
the directives, and a grace period of one to two
years has been granted to allow countries time
to conform. The timetable calls for all of the
Commission's proposals to b e completed by
the end of 1989, which gives the Council time to
adopt them and the member countries' legislative bodies time to comply before the December 31, 1992, deadline.
Third and perhaps most important, the Single
European Act marked a shift in the European
Community's philosophy from the originally
desired "harmonization and centralization" to
FEDERAL RESERVE BANK OF ATLANTA
the new goals of "minimal harmonization" and
"mutual recognition." The principle of mutual
recognition basically holds that firms or products approved and regulated by one member
state should b e free to operate or be sold
throughout all 12. In this way a firm chartered in
one state may offer the same array of products in
a host state that it offers in its home state. Host
states must agree to recognize that the firm is
regulated by its home state's regulatory framework. If certain firms in the host state find themselves at a competitive disadvantage, they may
put pressure on their domestic legislative
bodies to "level the playing field." Competition
thus becomes the key element in integrating
the 12 states into a unified market.
The Community did recognize the potential
adverse effects of such regulatory competition.
By passing more liberal regulation, any of the
dozen member states could create a more advantageous competitive environment for its
home producers throughout the common market but in so doing expose the public to unacceptably high risk or actually undermine the
essential objectives of the common market. To
eliminate this incentive, the community specified a level of "minimal harmonization." Still,
the principle of competitive market forces predominates in most cases.
The advantage of this trade-off is its practicability—it is much easier to achieve. The new
strategy of minimal harmonization and mutual
recognition also allows the home country to
maintain regulatory control and responsibility
for domestic firms, including their activities in
other states, but mandates only minimal agreement on the scope of permissible activities. The
difference in approach between the First and
Second Banking Directives, which are discussed
in the next section of this article, reflects this
dramatic shift in philosophy.
The Banking Coordination Directives
"Host country rule" characterized the First
Banking Directive, which was adopted in 1977
and established a basic set of rules under which
financial institutions could establish branches
across national boundaries. This directive,
which is in force today, permits branching by a
45
Table 1.
Core Banking Activities of the
European Economic Community
The Second Banking Directive provides that, subject
to prohibitions in its home country, a credit institution
may undertake any of the following activities:
• deposit-taking and other forms of borrowing;
• lending (including participation in consumer credit,
mortgage lending, trade finance, as well as factoring
and invoice discounting);
• financial leasing;
• money transmission sen/ices;
• issuing and administering means of payments (credit
cards, travelers' checks, and bankers' drafts);
• guarantees and commitments;
• trading for the institution's own account or for the
account of its customers in money market instruments (such as checks, bills, and certificates of
deposit), foreign exchange, financial futures and
options, exchange and interest rate instruments,
and securities;
• participation in share issues and the provisions of
sen/ices related to such issues;
• money brokering;
• portfolio management and advice;
• safekeeping of securities;
• credit reference service; and
• safe custody services.
credit institution, considered to be an entity
whose business is to receive deposits or other
repayable funds from the public and to grant
cred it for its own account. In order to establ ish a
branch, authorization by the appropriate supervisor in the host country must be acquired. The
branch then falls under the supervisory authority of the host country. The activities a branch
may perform in a host country must conform to
those approved for similar types of credit institutions headquartered there. In addition, a
branch in a host country is required to have its
own dedicated capital—that is, its own funds
separate from its parent.
The Second Directive shifts the emphasis
from host country rule to home country rule and
applies a principle which involves the mutual
recognition by all member states of the authorization and supervisory systems within each
member state. This directive acknowledges that
prior harmonization of certain essential supervisory rules throughout the EEC will be neces46
sary. Areas that these rules affect include initial
capital requirements, supervision of credit institutions' major shareholders, limitations on
the size of participations in nonfinancial undertakings, and harmonization of solvency ratios.
Once the essential supervisory rules are in
place, though, the directive provides for cooperation among supervisory authorities in the
different member states.
Any credit institution that is duly authorized
in one member country may branch throughout
the EEC without host country authorization.
Subject to prohibitions in its home country, a
credit institution may undertake any or all ofthe
core banking activities commonly agreed to in
the directive. These core banking activities are
presented in Table I.
Agreement on these core activities does not
preclude a home country from prohibiting one
or more of these activities to its own financial
organizations. However, once a home country
authorizes the offering of a core product or service, a financial institution headquartered in
that country may engage in that activity throughout the EEC regardless of host country prohibitions. For example, a branch of a financial
institution operating in a host country may offer
financial services prohibited to a counterpart
headquartered in the host country. If this situation places the domestic counterpart at a competitive disadvantage, pressure will probably
develop to change the host country prohibitions. Over time these competitive pressures
should lead to common offerings by similar
types of financial institutions throughout the
EEC, thus resulting in a common market for
financial services.
The Second Directive has not yet been adopted. The timetable calls for an opinion by the
European Parliament by June 30, 1988; an opinion by the Economic and Social Committee by
June 30, 1988; the Council's common position by
December 31, 1988; a second reading by the
European Parliament by March 31, 1989; and
adoption by the Council of Ministers by June 30,
1989. As of August 1988, the last month for which
information was available at press time, the
opinion by the European Parliament and by the
Economic and Social Committee had not been
reported.
Obviously, the Second Directive is not on
schedule, but prospects for adopting it appear
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
good. A number of major problems, though, still
need to be resolved. In addition to obtaining
agreement on the various provisions in the
Second Banking Directive concerning the limits
on financial institutions' activities and the
degree to which banks may own equity stakes in
commercial businesses (which, at present,
varies greatly among member states and complicates mergers among banks in different EEC
nations), the remaining problems involve determining the minimum levels for deposit insurance along with the manner in which it should
be provided and setting forth a method for handling financial institution failures. With regard to
capital standards, the European Commission
has proposed directives based on the framework developed by the Basel Committee on
Banking Regulations and Supervisory Practices,
which is composed of representatives from the
Group of Ten (Belgium, Canada, France, West
Germany, Italy, Japan, the Netherlands, Sweden,
the United Kingdom, and the United States),
Switzerland, and Luxembourg.
Though the problems pertaining to types of
financial services offered, deposit insurance,
and the means of handling failures appear to b e
well on the way to a common agreement, the
other two problem areas are more complex.
Bank ownership of significant equity shares of
commercial business creates major political
issues when mergers or acquisitions of these
banks by foreign entities is proposed. Not only
would the foreign entity gain control of the bank,
but, in countries like Germany where banks own
significant shares of commercial businesses, by
so doing it may gain control of large firms in the
host country. To date, this issue is unresolved.
Moreover, even the issue of bank activities is not
problem-free. A wide disparity in bank powers
currently exists. The problem of allowing banks
based in other member countries to engage in
activities not permitted in the host country is
exacerbated by the fact that some banks are
partly owned by their governments, thus posing
obvious problems in merger and acquisition
cases. Finally, adjusting to freer capital flows
may prove difficult for the less developed common market countries. Greece, for example, now
limits outflows of domestic capital.
The process of internal deregulation creates a
subsidiary problem of how to deal with entry
into the community by banks external to the
FEDERAL RESERVE BANK OF ATLANTA
community. The question is whether the community should take an open or a protectionist
position. The proposed Second Banking Directive contains a provision that would establish a
communitywide principle of reciprocity for
non-Economic Community banks. These issues
are complex and are currently being debated.
The Status of Banking and Capital Flow Proposals. The 1985 White Paper's legislative initiatives specified 22 proposals in the financial
services sector, 17 of which had been submitted
by March 1988. The remaining five are scheduled for completion by the Commission no
later than the end of this year. Two of the key elements in these proposals are that (I) each
state agrees to recognize mutually the way standards are applied by other member states and
(2) home country supervision and control of
financial institutions operating in each member
state is recognized. Three proposals involving
banking and capital flows have been adopted,
six have been submitted to the Commission for
adoption, and one proposal remains to be submitted. Table 2 briefly describes the Commission's proposals or recommendations in the
financial services sector and their status with
respect to adoption as of March 1988.
Conclusion
The European goal of el iminating the maze of
nontariff barriers that impede the flow of goods,
services, and capital among a dozen member
states is approaching reality after more than
30 years of fits and starts. The new philosophical approach of mutual recognition and minimal
harmonization has resulted in so much progress
in the last few months that the goal of achieving
a truly common market at last seems probable.
The process in which the European Community is engaged is probably one of the most
important economic and political events of the
late twentieth century. The Community would
encompass a population of some 323 million, 80
million larger than the current U.S. population. It
would merge the economies of 12 nations that
collectively have a gross national product roughly
equal to that of the United States.
While advances have been made on a number of fronts, the movement toward a common
47
Table 2.
Proposals and Recommendations for the EEC's Financial Services Sector
Status:
Proposals that have been adopted:
Banking:
• Bank accounting—Harmonization of bank accounting systems.
Adopted 12/8/86—Implementation is required by
12/31 /90 and must be applied in member states for the
first time beginning with the 1993 financial year.
• Deposit insurance—Recommendation for a deposit
guarantee system.
Adopted 12/22/86—Implementation is not required
since it is only a recommendation.
• Control of large exposures—Harmonizes the control
of large exposures by credit institutions.
Adopted 12/22/86—Implementation is not required
since it is only a recommendation.
• European Code of Conduct relating to electronic
payment between financial institutions, traders, and
service establishments and consumers.
Adopted 12/8/87—Implementation is not required since
it is only a recommendation.
Capital
Flows:
• Liberalization of units in collective investment undertakings for transferable securities. Provides for free
circulation of units in collective investment undertakings such as unit trusts.
Adopted 12/20/85—Member states must comply with
the directive by 10/1/89. Derogation, that is, the partial
repeal of the directive, for Portugal has been extended to
12/31/90.
• Liberalization of operations such as transactions in
securities not dealt on stock exchanges, admission
of securities on the capital market, and long-term
commercial credit.
Adopted 11 /17/86—Compliance with the directive was
required by 2/28/87. Greece, Italy, and Ireland have
derogations, and Spain and Portugal may postpone
liberalization until 10/1/89 and 12/31/90, respectively.
Proposals submitted to Council but not yet adopted:
Banking:
• Mortgage banking—Freedom of establishment and freedom to supply services across borders in the field of
mortgage credit.
• Reorganization of credit institutions—Specific procedures involving the reorganization or closing of financially
troubled credit institutions.
• Foreign branch publication of accounting documents—Eliminates the need for foreign branch offices of banks
headquartered in a member state to publish separate accounts for those branches.
• Own funds—Harmonizes the concept of "own funds" which basically defines capital.
• Second directive on coordination of credit institutions.
Capital
Flows:
• Liberalization of capital movements.
Commission proposals still to be presented to the Council:
• Directive on solvency ratios.
par-
a n d t h e e s t a b l i s h m e n t of a p p r o p r i a t e stan-
ticularly impressive. From 1958 to 1985 only a
d a r d s for capital ratios a n d d e p o s i t insurance t o
market for financial
services has b e e n
few relatively u n i m p o r t a n t directives concern-
safeguard p u b l i c c o n f i d e n c e in financial institu-
ing b a n k i n g were a p p r o v e d . Since 1985 substan-
tions. The E u r o p e a n C o m m u n i t y will very likely
tial progress has b e e n achieved on a w i d e range
have a c o m m o n financial services market within
of q u e s t i o n s i n c l u d i n g specifications of allow-
t h e t i m e f r a m e originally targeted.
a b l e activities for credit institutions, t h e choice
T h e i m p o r t a n c e of reaching this objective is
b e t w e e n s p e c i a l i z e d a n d universal b a n k i n g ,
twofold. First, as t h e E u r o p e a n C o m m i s s i o n ' s
48
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
1985 White Paper acknowledged, financial services play a critical role in the Community's
economy. The efficiency and competitiveness of
the financial sector directly affect the costs of
services provided to the economy's other sectors, from manufacturers to consumers. Deregulation, along with new technology and global
capital markets, will allow the European banking community to achieve the efficiencies associated with geographic and product expansion. These efficiencies should provide benefits
that will radiate throughout the entire economy.
Second, realization of a common European banking arena will expand the home market for deposits. This enlarged internal deposit and
capital base should give European banks a further
FEDERAL RESERVE BANK OF ATLANTA
competitive advantage in world financial markets. Consolidations or simple working agreements among these European institutions are
likely to have a significant competitive impact
that will be felt throughout the world.
Implications for U.S. banks of a common European banking arena are two-pronged. First, they
will likely face larger competitors both in domestic and foreign markets. Second, U.S. banks
may find themselves at a competitive disadvantage depending on how extensive European
product deregulation is relative to the United
States. This disparity could increase pressures
on the American financial services industry at a
time when it is undergoing substantial stresses
of its own.
49
The Organization of the European Community
The European Community (EC) is an international organization comprising a dozen member states that have agreed to share a measure of
sovereignty in order to create—through the adoption of common policies—joint benefits for all 12
nations.
The objectives of the Community include:
• a closer union of the people of Europe;
•ongoing improvement of living and working conditions;
• concerted action to guarantee steady expansion, balanced trade, and fair competition;
• reduction in the economic differences between regions;
• progressive abolition of restrictions on international trade;
• increased overseas development; and
• pooling of resources to preserve and strengthen peace and liberty.
The Constitution of the European Community is
based on the Rome Treaties, which established
the European Economic Community (EEC) and the
European Atomic Energy Community, as well as
the Paris Treaty, which established the European
Coal and Steel Community. Thus, the EC consists
of three separate legal entities: the European
Coal and Steel Community, the EEC, and the European Atomic Energy Community. All three entities
are controlled by common institutions: the European Parliament, the Council of Ministers, the
European Commission, the Court of Justice, the
Court of Auditors, and an Economic and Social
Committee that acts in an advisory capacity.
The European Commission, which houses the
executive powers of the European Community, is
responsible for the functioning and development
of the common market. This commission is mandated to initiate and implement cross-European
legislation, and in 1985 it sent 694 proposals to the
Council of Ministers. The Commission also has
investigative powers and may impose fines for
breaching community rules.
The Council of Ministers, which includes 76
ministers delegated by the various governments
of the member states, is the legislative body. The
Council makes major policy decisions for the
Community.
The European Parliament, unlike national parliaments, does not have legislative powers. Instead,
it supervises the Commission and Council of
Ministers by debating their programs and reports.
This body is also invited to give an opinion on
50
Commission proposals before the Council makes
a decision. Parliament does have the power to dismiss the Commission by a two-thirds vote, and it
makes final decisions on Community expenditures by approving or rejecting the draft budget
drawn up by the Commission and agreed to by the
Council. Its 518 members are elected by universal
suffrage. Delegates represent political parties
and are not national representatives.
The Economic and Social Committee and the
Advisory Committee constitute a consultative
body with 189 members representing employers,
trade unions, and other interest groups such as
farmers and consumers. Before some proposals
may be adopted, opinion must be sought from the
Economic and Social Committee.
The Court of Justice ensures that the European
Community's laws are observed. Its judges, from
all the Community countries, pass judgment on
disputes concerning the appl ication or interpretation of Community laws.
The Court of Auditors has extensive power to
examine the legality and regularity of Community
receipts and expenditures and the sound financial management of the Community's budget. The
Community generates revenues from customs
duties and agricultural levies on imports from the
rest of the world and a value-added tax collected
in member states. Almost three-fourths of these
expenditures are applied toward the support of
farm prices and the modernization of agriculture
and the fishing industry.
Unlike many international organizations, the
European Community and its institutions have
powers that carry the force of law. In fact, the European Community was founded on a system of laws
that are separate from and which transcend the
national laws of the member states.
The Treaty of Rome specifies the process that is
to be followed in adopting EC laws. The Council of
Ministers makes decisions only on proposals submitted by the European Commission. Amendments by the Council of Ministers to Commission
proposals require unanimity of its members. The
Commission, on the other hand, may change a proposal at any time during the Council's period of
consideration, a provision which gives the Commission a good deal of bargaining power. When
the Council receives a proposal, it is referred to a
Permanent Representatives Committee for examination and preparation of a decision.
The Council of Ministers is empowered to pass
five different types of acts that affect the legisla-
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
tive autonomy of member states in different ways.
The Council's Recommendations and Opinions
are nonbinding and are intended to serve as a
general guideline for member states. Council
Directives set forth the objective to be attained
but leave to the member states the procedures to
be followed. Directives are binding and may be
addressed to selected member states, to selected enterprises, or even to individuals. On varied
questions the Council may adopt resolutions that
are applied on a case-by-case basis. Finally, the
Council may also pass regulations that supersede
national legislation and establish European law
that is binding on all member states. This process
is obviously very cumbersome, requiring consideration and agreement on the part of groups
dispersed across 12 nations that represent the
interest of affected parties.
Note
'The ECU was originally created by t h e E u r o p e a n Payments
rected in 1975 as the E u r o p e a n Unit of Account (EUA). T h e
Union in 1950 as t h e c o m m u n i t y ' s unit of account a n d was
EUA was m o d e l e d after t h e International Monetary Fund's
used for internal b u d g e t a r y purposes. Conversion
unit of account, the SDR, which was d e f i n e d in t e r m s of a
into
national currencies was b a s e d o n official central rates for
b a s k e t of 16 currencies in specified quantities. W h e n t h e
m e m b e r states' currencies fixed at international levels
E u r o p e a n Monetary System was e s t a b l i s h e d in 1979, t h e
established by t h e Bretton W o o d s a g r e e m e n t . As t h e Bret-
EUA was r e n a m e d t h e ECU, b u t the original formulas for
ton W o o d s system of fixed exchange rates d i s i n t e g r a t e d ,
the b a s k e t of currencies were u n c h a n g e d .
so d i d t h e c o m m u n i t y ' s unit of account, b u t it was resur-
References
Commission of the E u r o p e a n C o m m u n i t i e s . The
of the European
Community.
Institutions
Brussels, 1986.
Court of Justice of t h e E u r o p e a n C o m m u n i t i e s . The Court
Justice of the European
Communities.
E c o n o m i c a n d Social C o m m i t t e e of t h e E u r o p e a n Communities. The Other
of
Luxembourg, 1983.
European
Assembly.
Brussels, 1985.
Padoa-Schioppa, Tommaso. "Towards a E u r o p e a n Banking
Regulatory Framework." Banca D'ltalia Economic
Bulletin
(February 1988): 49-53.
FEDERAL RESERVE BANK OF ATLANTA
51
Book Review
The Gathering Crisis in Deposit Insurance
by Edward J. Kane
Cambridge, Mass.: MIT Press, 1985.
176 pages. $14.95.
Originally published in 1985, Edward J. Kane's
The Gathering Crisis in Deposit Insurance takes
on additional importance given the current
emergency in our nation's deposit insurance programs. When the book was written, the reserves
in U.S. deposit insurance funds were just beginning to show signs of decline. Since 1985, however, the rapid deterioration of the reserves of
the Federal Savings and Loan Insurance Corporation (FSLIC) has resulted in that fund's
insolvency and the need for a massive infusion
of federal aid.
What caused this crisis, and what are some
possible long-term solutions? The reader of
The Gathering Crisis in Deposit Insurance will
find the answers to these questions and much
more. Professor Kane, who holds the Reese
Chair of Banking at Ohio State University and is
an internationally acclaimed banking scholar,
provides a comprehensive overview and detailed economic analysis of the problems surrounding the nation's federal deposit insurance
programs. The fact that Kane first began writing
this book in early 1983-almost three years
before the FSLIC was officially declared insolvent—only confirms the depth of Professor
Kane's insight into the structure and workings of
this nation's deposit insurance system. This
insight is even more remarkable in light of the
52
recent actions of the Federal Home Loan Bank
Board. To appreciate properly, then, the author's understanding of the deposit insurance
dilemma, an overview of the current status of
this crisis is in order.
Deposit Insurance: How the Problem
of Zombie Thrifts Evolved
On Friday, August 19, 1988, the Federal Home
Loan Bank Board, overseer of the nation's
federally chartered savings and loan associations and savings banks, announced a stunning
multibillion-dollar FSLIC bailout of eight insolvent Texas thrift institutions. At that time the
bailout, estimated to cost the FSLIC between
$2.5 billion and $5.5 billion, represented the
most costly multiple rescue ever undertaken by
the fund. The bailout may have also signaled an
end to the era of high-risk investment strategies
which have been pursued by many of the nation's now-troubled thrift institutions.
The beginning of the problem thrift period
can b e traced back to the late 1970s when rising
interest rates shrank the spread between the
rates thrifts earned on their long-term asset
portfolios, principally mortgages, and the rate
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
they paid on their primarily short-term deposit
liabilities. As the 1980s arrived and profit margins
continued to b e squeezed, many alreadyweakened thrifts tried to improve their earnings
performance by undertaking speculative highrisk investment strategies. Needless to say,
many of these weak institutions suffered equityeroding losses as the high-risk investments
proved unsuccessful. Certain institutions were
in such dire financial condition that Kane coined
the now-popular phrase "zombie thrifts," referring to institutions that are still operating but
financially moribund.
The term " z o m b i e " has most often been
applied to problem thrifts in Texas. These
institutions are also the ones that pursued the
most speculative investment strategies and
that were devastated by the collapse of the oil
economy. In Texas, the thrift problem is so
severe that an estimated 100-plus thrifts are
currently in need of rescue. Although the crisis is
concentrated in the so-called oil patch—Texas,
Oklahoma, and Louisiana—zombie thrifts are by
no means located only in this geographic area.
On August 10, 1987, President Reagan signed
legislation that provided $10.8 billion for the
insolvent FSLIC. This assistance package is part
of the Competitive Equality Banking Act of 1987,
which allowed the Federal Home Loan Bank
Board to create a new entity, the Financing Corporation, which serves as the vehicle for replenishing the thrift insurance fund.1 Funds to
recapitalize the FSLIC will come from bonds
sold in the capital markets. Interest payments
on the debt will be m a d e from assessments on
FSLIC-insured thrifts, while the principal will be
backed by zero-coupon long-term Treasury
bonds bought with the proceeds of the bond
issues.
This recapitalization plan is not without its
own risks, however. First, the $10.8 billion capital infusion approved by Congress for thrift rescues nationwide is significantly less than the
$15.2 billion that Home Loan Bank Board Chairman M. Danny Wall estimates will be required to
clean u p the thrift problem in Texas alone. The
likelihood of such a shortfall is very real for the
insurance fund, which former Home Loan Chairman Edwin J. Gray in early 1987 told Congress
was losing $10 million per day. Even if one takes
the approximate $20 billion available to the
FEDERAL RESERVE BANK OF ATLANTA
FSLIC through the year 1990, estimates of the
total cost of liquidating insolvent thrifts nationwide range from $45 billion to a staggering $65
billion. 2 Second, given that they will in effect be
subsidizing insolvent and perhaps poorly managed zombie institutions, many healthy, wellmanaged thrifts may actually withdraw from the
FSLIC after a one-year moratorium. Finally, the
weakest institutions may not even be able to
meet the assessments required to service the
bonds.
One often-proposed solution to the current
thrift crisis is to merge the FSLIC with the much
healthier Federal Deposit Insurance Corporation (FDIC), which insures the deposits at the
nation's commercial banks and, like the FSLIC,
has prime responsibility for handling insolvent
institutions. The rationale underlying this proposal derives from the fact that the FDIC began
1988 with roughly $ 18 bill ion in reserves in add ition to an annual income from premium assessments of roughly $3.3 billion.
Though a merger between the nation's two
most important deposit insurers seems plausible, according to noted financial consultant
Dan Brumbaugh, Jr., and banking law scholar
Robert Litan, the FDIC may soon b e unable to
fund the cost of closing all insolvent commercial
banks and may itself be headed towards a fate
similar to the FSLIC's.3 Brumbaugh and Litan
base their conjecture on an analysis of the capital base of the nation's commercial banks with
over $50 million in total assets. This analysis,
which is conducted relative to the cushion available to the FDIC in the event of bank failures,
focuses on the growth of insolvent commercial
banks during the 1986-87 period.
Although many analysts will no doubt disagree with the Brumbaugh-Litan conjecture,
their analysis does raise questions about the
financial strength of the FDIC. Factors that
Brumbaugh and Litan cite as contributing to the
overvaluation of the deposit insurer's financial
strength include the use of generally accepted
accounting principles that tend to overstate the
true value of bank capital and understate insolvency risk, the presence of inadequate loan
loss reserves for the Third World loans being
carried on bank balance sheets, and the overstating of the value of domestic real estate
owned by banks.
53
Kane's Analysis: Deposit Insurance
Problems and Solutions
In analyzing U.S. deposit insurance programs—
that is, the programs of the FSLIC, the FDIC, and
the National Credit Union Share Insurance FundProfessor Kane provides a masterful analysis of
the incentive problems that arise in deposit
insurance relationships. These problems occur
(1) when the insurance premiums charged to
institutions are actuarially unfounded—in other
words, not related to the underlying riskiness of
the insured institution-and (2) when regulatory
policy further retards market discipline from
operating to keep risk-return relationships in
balance.
The presence of risk-insensitive premiums
leads to the insurance problems of moral hazard
and adverse selection. Moral hazard arises
when the presence and structure of insurance
change the incentives of the insured to exercise
proper care under the insurance contract. The
problem of adverse selection exists when the
insured presents more of a risk to the insurer
than the insurer can detect from the information
provided. Both problems result in insured parties' taking excessive risks since the insurance
premiums d o not cover the insurer's expected
losses.
With fixed-rate deposit insurance, one can
understand why Kane's zombie thrifts pursue
high-risk investment strategies. By bidding for
deposits at premium rates, these institutions
are actually issuing contingent claims on the
insurance funds. If the high-risk, high-return projects financed by these deposits pay off, then the
institution makes handsome returns. On the
other hand, if these projects fail, the management can basically walk away, leaving the problem on the insurance agency's doorstep. Thus,
their behavior can be likened to a Ponzi scheme
or a game of "heads I win, tails you lose."
Kane's exposition is divided into six chapters.
Chapter 1 introduces the reader to the general
regulatory environment of financial institutions
and reviews the nature of the incentive problems along with suggestions for reform of the
deposit insurance system. Chapter 2 examines
the preferred procedures that federal regulators use for handling insolvent depository institutions. Professor Kane discusses how delayed
54
closings and the preference of the insurance
agencies for purchases and assumptions of
insolvent institutions by solvent ones actually
dull the market's ability to discipline management, thus allowing further risk-taking on the
part of banks and thrifts. These actions lead to a
significant weakening of the deposit insurance
funds. Professor Kane provides statistical support for this claim with data based on FDIC- and
FSLIC-assisted mergers that occurred during
the early 1980s.
Chapter 3 describes in some detail the major
types of risk that bank and thrift managements
have assumed as a result of an inefficient deposit insurance program. The author presents
numerical estimates on the exposure of the
insurance funds along with their loss experience
over the 15 years prior to 1985. The interested
reader should compare Professor Kane's estimates with those cited in the introduction of this
review. Clearly, regulatory policy has not kept
pace with the ability of institution managers to
add risk to their portfolios.
Interest-rate risk is covered in chapter 4.
Basically, the author shows how interest-rate
risk—the loss of market value of assets as a
result of changes in market interest rates—can
be considered equivalent to the default of part
of an institution's mortgage portfolio. Using this
equivalence relationship, Kane examines
pseudodefault rates on the mortgage holdings
of insured thrifts, savings and loans, and mutual
savings banks over several years. This chapter
also includes several methods for estimating
the value of deposit insurance to insured institutions. These methods range from a simple
percentage of insured deposits to the use of the
rather sophisticated option pricing models of
modern financial economics.
Chapter 5 of the book concentrates on the risk
associated with lending to less developed
countries (LDCs). The magnitude of the LDC
debt crisis is related to the magnitude of federal
default guarantees. Professor Kane argues that
the establishment of a secondary market for this
debt would help resolve the crisis by establishing market values for the debt. These could then
b e used to restructure the loans on the institutions' books. However, this approach may be
unacceptable as it would require substantial
reductions in the book equity of the institutions affected.
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
The final chapter presents Professor Kane's
broad-based proposals for deposit insurance
reform. For example, the use of market value
measures, as opposed to historical valuation, is
proposed. In addition, risk-based deposit insurance premiums are suggested as another way
to alleviate the incentive problems associated
with the current deposit insurance program.
Finally, Kane recommends implementing statutory restrictions on the ability of regulatory
bodies to keep insolvent institutions operating.
Finally, such litigation might require a significant expenditure of resources by the insurers or
the thrift owners, resources that could be better
used in other capacities.
In today's environment Kane's proposals represent only modest changes for a system that
needs major restructuring. If Professor Kane
were writing this monograph today, he would
likely offer sweeping changes in the overall form
and structure of the nation's deposit insurance
program, including a discussion of how the transition to the new structure should be managed.
This transition issue will certainly be a key component in any major reform proposal.
A 1988 Perspective on Kane's Analysis
The Gathering Crisis in Deposit Insurance is
an important volume for academic scholars,
policymakers, practitioners, and others interested in the overall safety and soundness of our
financial system. If the finance community is
lucky, Professor Kane will publish a new volume
dealing with the question of where we go from
here.
Taken as a whole or separately, the author's
proposals are certainly steps in the right direction and could form part of the basis for serious
reform of the deposit insurance system. However, the presence of measurement error, a
practical certainty in any attempt to report thrift
assets and liabilities at their market values, will
inhibit the judicious closing of thrifts when their
net worth is zero. In addition, such closings are
certain to be challenged in the courts by thrift
owners and other stakeholders in an effort to
preserve their property rights, and the courts
will not necessarily agree with the insurers.
William Curt Hunter
The
reviewer
Research
is a research
officer
in the Atlanta
Fed's
Department.
Notes
n a d d i t i o n t o p r o v i d i n g m u c h - n e e d e d assistance t o the
2
t h r i f t insurance fund, t h e law a l s o requires b a n k s to clear
customers' checks m o r e quickly, b a n s t h e creation of n e w
W i l l i a m Proxmire, " C o m m e n t , " American
Banker,
Septem-
ber 23, 1988, 4.
3
R. D a n B r u m b a u g h , Jr., a n d Robert E. Litan, "Insuring t h e
limited-service (nonbank) banks, a n d i m p o s e s a morato-
Insurers: The Banks Are in Big Trouble, Too," The New
rium on granting b a n k s authority to e x p a n d into such areas
Times,
York
Sunday, August 21, 1988, sec. 3.
as insurance, real estate, a n d securities underwriting.
FEDERAL RESERVE BANK OF ATLANTA
55
Economic
Review
AGRICULTURE
ECONOMIC POLICY
"Crop Costs and Farm Survival"
Gene D. Sullivan and W. Gene Wilson, March/
April, 8
Book Review: Hard Heads, Soft Hearts
by Alan S. Blinder
Mary Susan Rosenbaum, July/August, 43
BOOK REVIEWS
"Forecast Accuracy and the Performance
of Economic Policy: Is There a Connection?"
William Roberds, September/October, 20
Buying into America by Martin and Susan Tolchin
(New York: Times Books, 1988)
William J. Kahley, September/October, 52
The Gathering Crisis in Deposit Insurance by
Edward j. Kane (Cambridge, Mass.: MIT Press, 1985)
William Curt Hunter, November/December, 52
Hard Heads, Soft Hearts by Alan S. Blinder
(Reading, Mass.: Addison-Wesley Publishing, 1987)
Mary Susan Rosenbaum, July/August, 43
Hot Money and the Politics of Debt by R.T. Naylor
(New York: Simon and Schuster, 1987)
Thomas J. Cunningham, March/April, 34
"Stock Market Activity in October 1987:
The Brady, CFTC, and SEC Reports"
Peter A. Abken, May/june, 36
CORPORATE FINANCE
"Assessing the Fairness
of Investment Bankers' Fees"
William Curt Hunter and Mary Beth Walker,
March/April, 2
"Leverage Ratios of
Domestic Nonfinancial Corporations"
Larry D. Wall, May/June, 12
"interest Rate Swaps: A Review of the Issues"
Larry D. Wall and John J. Pringle, November/
December, 22
EMPLOYMENT
"Past and Current Trends in Retirement.
American Men from 1860 to 1980"
Jon R. Moen, July/August, 16
FINANCIAL INSTITUTIONS
Book Review: The Gathering Crisis
in Deposit Insurance by Edward J. Kane
William Curt Hunter, November/December, 52
"F.Y.L—Commercial Bank Profitability:
Still Weak in 1987"
Larry D. Wall, July/August, 28
"Some Unanswered Questions about Bank Panics'
Ellis Tallman, November/December, 2
FORECASTING
"F.Y.I.—Improving Monthly Models
for Economic Indicators: The Example of
an Improved CPI Model"
R. Mark Rogers, September/October, 34
FOREIGN EXCHANGE
"F.Y.I.—Disaggregating the Dollar Index:
Trade in Textiles and Apparel"
Shannon B. Mudd, March/April, 28
"The U.S. Dollar and the "Delayed J-Curve' "
Jeffrey A Rosensweig and Paul D. Koch, July/
August, 2
56
ECONOMIC REVIEW, NOVEMBER/DECEMBER 1988 f
Index for 1988
FOREIGN INVESTMENT IN
THE UNITED STATES
Book Review: Buying into America
by Martin and Susan Tolchin
William J. Kahley, September/October, 52
INTERNATIONAL FINANCE
"F.Y.I.—The Southeastern Forest Industry after
the Tax Reform Act of 1986"
W. Gene Wilson, May/June, 30
"The Lasting Role of Natural Resources
in Alabama's Economy"
W. Gene Wilson, January/February, 6
"Louisiana: Prospects for a Diversified Economy"
Gene D. Sullivan, January/February, 36
Book Review: Hot Money and the Politics of Debt
by R.T. Naylor
Thomas J. Cunningham, March/April, 34
"Mississippi: A Dual Economy"
Aruna Srinivasan, January/February, 50
INTERNATIONAL TRADE
"Overview—Long-Term Prospects for
the Southeastern States"
William J. Kahley, January/February, 2
'F.Y.I.—Disaggregating the Dollar Index:
rade in Textiles and Apparel"
Shannon B. Mudd, March/April, 28
'' F.Y.I.—Moving toward 1992:
\ Common Financial Market for Europe?"
David D. Whitehead, November/December, 42
The U.S. Dollar and the Delayed J-Curve' "
Jeffrey A. Rosensweig and Paul D. Koch, July/
August, 2
INVESTMENT BANKING
Assessing the Fairness of
'nvestment Bankers' Fees"
William Curt Hunter and Mary Beth Walker,
March/April, 2
REGIONAL ECONOMICS
Diversity and Balanced Growth:
ennessee Stays on Track"
Jon R. Moen, January/February, 58
Florida's Challenge: Managing Growth"
William J. Kahley, January/February, 14
"A Tale of Two Georgias"
B. Frank King and David Avery, January/
February, 24
STOCK MARKET
Book Review: "Stock Market Activity in 1987:
The Brady, CFTC, and SEC Reports"
Peter A. Abken, May/June, 36
"The Effect of the 'Triple Witching Hour
on Stock Market Volatility"
Steven P. Feinstein and William N. Goetzmann,
September/October, 2
"The Relationship between the S&P 500 Index
and S&P 500 Index Futures Prices"
Ira G. Kawaller, Paul D. Koch, and
Timothy W. Koch, May/June, 2
TEXTILE INDUSTRY
"F.Y.I.—Disaggregating the Dollar Index:
Trade in Textiles and Apparel"
Shannon B. Mudd, March/April, 28
UNDERGROUND ECONOMY
Book Review: Hot Money and the Politics of Debt
by R.T. Naylor
Thomas J. Cunningham, March/April, 34
FEDERAL RESERVE BANK OF ATLANTA
57
FINANCE
ANN
$ millions
Coronerei al Bank Deposits
Demand
NOW
Savings
Time
SEPT
1988
AUG
1988
JUL
1988
1,836,700 1 ,818,206 1 ,818,838
361,559
360,813
380,672
176,020
171,569
172,739
519,728
522,585
524,239
822,969
806,118
794,253
SEPT
1987
AUG
1987
JUL
1987
1,698,632 1 ,677,766 1,694,997
358,242
354,979
369,381
160,086
153,372
155,256
510,573
511,382
508,633
703,841
697,147
691,733
t
CHG ('
+ 8
+ 1
+10
+ 2
+17
Commercial Bank Deposits
Demand
NOW
Savings
Time
221,807
40,461
24,330
58,406
102,808
220,039
40,659
23,834
58,408
101,211
219,005
41,635
24,005
58,503
99,751
205,131
40,951
22,227
57,488
88,574
200,839
39,435
21,384
57,385
86,512
201,150
40,767
21,785
57,326
84,934
+ 8
- 1
+ 9
+ 2
+16
Coronerei al Bank Deposits
Demand
NOW
Savings
Time
23,006
4,127
2,630
4,779
11,997
22,606
4,003
2,619
4,828
11,628
22,486
4,099
2,609
4,840
11,474
20,909
4,149
2,231
4,695
10,264
20,200
3,923
2,131
4,582
9,926
20,405
4,041
2,146
4,606
9,978
+10
- 1
+18
+ 2
+17
Corrmerclal Bank Deposits
Demand
NOW
Savings
Time
87,412
15,549
10,830
26,943
35 , 528
86,558
15,563
10,596
27,175
34,787
86,737
16,163
10,734
27,266
34,264
80,498
15,604
10,026
27,221
29,144
78,889
15,134
9,681
27,232
28,373
78,403
15,824
9,860
26,933
27,327
+ 9
- 0
+ 8
- 1
+22
Commercial Bank Deposits
Demand
NOW
Savings
Time
37 , 025
8,447
3,521
9,657
16,914
36,614
8,879
3,407
9,344
16,563
35,986
9,013
3,419
9,370
15,993
33,179
8,799
3,208
8,847
13,900
32,157
8,481
3,021
8,790
13,328
32,403
8,568
3,088
8,873
13,246
+12
- 4
+10
+ 9
+22
Commercial Bank Deposits
Demand
NOW
Savings
Time
27,995
4,953
2,405
7,929
13,132
28,087
4,953
2,391
8,087
13,125
28,089
5,008
2,389
8,090
13,070
27,139
4,837
2,209
7,899
12,536
26,986
4,738
2,176
7,887
12,556
27,187
4,961
2,218
7,898
12,475
+
+
+
+
+
Commercial Bank Deposits
Demand
NOW
Savings
Time
15,172
2,335
1,575
2,974
8,592
15,168
2,320
1,560
2,972
8,578
15,175
2,429
1,568
2,990
8,520
14,306
2,374
1,465
2,981
7,727
14,014
2,279
1,400
3,013
7,553
13,973
2,338
1,400
3,028
7,426
+ 6
- 2
+ 8
- 0
+11
Commercial Bank Deposits
Demand
NOW
Savings
Time
31,197
5,050
3,369
6,124
16,645
30,827
4,941
3,261
6,002
16,530
30,711
5,032
3,294
5,947
16,430
29,100
5,188
3,088
5,845
15,003
28,593
4,880
2,975
5,881
14,776
28,779
5,035
3,073
5,988
14,482
+ 7
- 3
+ 9
+ 5
+11
NOTES:
3
2
9
0
5
All deposit data are extracted from the Federal Reserve Report o f Transaction A c c o u n t s , other D e p o s i t s
and V a u l t Cash ( F R 2 9 0 0 ) , and are reported for the average o f the week ending the first M o n d a y o f the
month.
M o s t recent d a t a , reported institutions w i t h over $40 million in d e p o s i t s and $3.2 m i l l i o n o f
reserve requirements as o f September 1 9 8 8 , represents 95 percent o f deposits in the six-state a r e a .
The m a j o r d i f f e r e n c e s between this report and the "call report" are s i z e , the treatment o f interbank
d e p o s i t s , and the treatment o f f l o a t . The total deposit data generated from the R e p o r t o f Transaction
Accounts e l i m i n a t e s interbank deposits b y reporting the net o f deposits "due to" and "due from" other
depository institutions.
The Report o f Transaction Accounts subtracts cash in process o f collection
from demand d e p o s i t s , while the call report does n o t . T h e S o u t h e a s t data represent the total o f the
six s t a t e s . Subcategories w e r e chosen on a selective basis and do not add to t o t a l . P = p r e l i m i n a r y .
* = M o s t recent m o n t h v s . y e a r - a g o m o n t h .
FINANCE
OCT
1988
$ millions
Commercial Bank Deposits
Demand
NOW
Savings
Time
SEPT
1988
AUG
1988
1,798,554 1,836,700 1,818,206
358,778
361,559
360,813
168,970
176,020
171,569
506,112
519,728
522,585
814,269
822,969
806,118
polimeri, m i Dann ueposiis
Dema nd
NOW
Savings
Time
ci. / , 1DO
39,702
23,979
56,635
101,895
Lomraerciai D a n e ueposits
Demand
NOW
Savings
Time
3,943
2,516
4,653
11,809
Bank Deposits
¿¿i,mi
OCT
1987
SEPT
1987
AUG
1987
1,652,890 1 ,698,632 1,677,766
342,013
358,242
354,979
152,389
160,086
153,372
495,345
511,382
508,633
693,320
703,841
697,147
ANN
X
CHG (*)
+ 9
+ 5
+11
+ 2
+17
¿vu.ujy
40,659
23,834
58,408
101,211
199,734
38,870
21,437
55,770
87,109
205,131
40,951
22,227
57,488
88,574
200,839
39,435
21,384
57,385
86,512
+ 9
+ 2
+12
+ 2
+17
¿J.UUb
4,127
2,630
4,779
11,997
¿¿,bUb
4,003
2,619
4,828
11,628
20,081
3,954
2,145
4,488
9,887
20,909
4,149
2,231
4,695
10,264
20,200
3,923
2,131
4,582
9,926
+12
- 0
+17
+ 4
+19
86,640
15,353
10,639
26,326
36,075
87,412
15,549
10,830
26,943
35,528
86,558
15,563
10,596
27,175
34,787
80,476
15,096
9,969
26,786
29,938
80,498
15,604
10,026
27,221
29,144
78,889
15,134
9,681
27,232
28,373
+ 8
+ 2
+ 7
- 2
+20
eanK Deposits
Jb.UJ/
8,559
3,393
9,078
16,657
3/,OZb
8,447
3,521
9,657
16,914
36,614
8,879
3,407
9,344
16,563
31,549
8,154
2,969
8,432
13,267
33,179
8,799
3,208
8,847
13,900
32,157
8,481
3,021
8,790
13,328
+14
+ 5
+14
+ 8
+26
Coirmercial Bank Deposits
Demand
NOW
Savings
Time
267538
4,653
2,245
7,609
12,495
27,995
4,953
2,405
7,929
13,132
28,087
4,953
2,391
8,087
13,125
25,697
4,584
2,050
7,547
11,806
2?,135
4,837
2,209
7,899
12,536
26,986
4,738
2,176
7,887
12,556
+ 4
+ 2
+10
+ 1
+ 6
Commerclai Bank Deposi ts
Demand
NOW
Savings
Time
14,927
2,264
1,544
2,896
8,479
15,172
2,335
1,575
2,974
8,592
15,168
2,320
1,560
2,972
8,578
13,646
2,277
1,356
2,856
7,456
14,306
2,374
1,465
2,981
7,727
14,014
2,279
1,400
3,013
7,553
+ 9
- 1
+14
+ 1
+14
Commercial Sank Deposits
Demand
NOW
Savings
Time
30,492
4,930
3,642
6,073
16,380
31,f97^
5,050
3,369
6,124
16,645
30,827
4,941
3,261
6,002
16,530
28,285
4,805
2,948
5,661
14,755
297!ö ü ~
5,188
3,088
5,845
15,003
4,880
2,975
5,881
14,776
+ 8
+ 3
+24
+ 7
+11
Demand
NOW
Savings
Time
Demand
NOW
Savings
Time
NOTES:
40,461
24,330
58,406
102,808
All deposit data are extracted from the Federal Reserve Report o f Transaction A c c o u n t s , other Deposits
and V a u l t Cash ( F R 2 9 0 0 ) , and are reported for the average o f the week ending the first Monday o f the
m o n t h . H o s t recent d a t a , reported institutions with over $40 million in deposits and $3.2 m i l l i o n o f
reserve requirements as o f September 1 9 8 8 , represents 95 percent o f deposits in the six-state a r e a .
The m a j o r d i f f e r e n c e s between this report and the "call report" are s i z e , the treatment o f interbank
d e p o s i t s , and the treatment o f f l o a t . The total deposit data generated from the R e p o r t o f Transaction
Accounts eliminates interbank deposits by reporting the net o f deposits "due to" and "due from" other
depository institutions.
The R e p o r t o f Transaction Accounts subtracts cash in process o f collection
from demand d e p o s i t s , while the call report does n o t .
The Southeast data represent the total o f the
six s t a t e s . Subcategories w e r e chosen on a selective basis and do not add to t o t a l . P = p r e l i m i n a r y .
* = Most recent month v s . y e a r - a g o m o n t h .
EMPLOYMENT
ANN
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
JUL
1988
JUN
1988
123,888
117,066.
6,823
123,028
116,209
6,819
JUL
1987
122,105
114,652
7,453
X
+1
+2
- 8
Unemployment Rate - % SA
5.4
5.3
6.0
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
41.2
414
41.2
419
40.6
401
+ 0
+ 3
16,690
15,553
1,087
16,591
15,543
1,048
16,448
15,247
1,189
+1
+ 2
- 9
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
6.0
6.1
6.2
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
41.0
369
41.6
373
40.9
360
+0
+3
1,882
1,751
131
1,875
1,746
129
1,913
1,764
149
- 2
- 1
-12
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
6.5
7.0
7.3
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
40.9
369
41.5
373
41.3
362
- 1
+ 2
6,199
5,886
313
6,142
5,847
295
5,985
5,630
356
+ 4
+ 5
-12
4.3
4.6
5.2
40.1
338
41.0
343
40.2
328
- 1
+ 3
3,181
2,973
208
3,150
2,948
202
3,075
2,900
175
+ 3
+ 3
+19
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment R a t e - % SA
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
6.1
6.1
5.3
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
41.4
359
41.5
359
42.1
357
- 2
+ 1
1,938
1,738
200
1,916
1,712
204
1,956
1,723
233
- 1
+ 1
-14
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
9.9
10.2
11.5
42.4
470
42.9
474
41.1
451
+ 3
+ 4
1,146
1,055
91
1,144
1,054
90
1,155
1,032
122
- 1
+ 2
-25
Unemployment Rate - % SA
7.5
7.4
10.0
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
40.0
310
40.7
318
39.9
301
+ 0
+ 3
2,343
2,199
144
2,364
2,236
128
2,352
2,198
154
0
0
6
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment R a t e - t SA
5.8
5.4
6.2
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
41.2
370
41.9
374
40.8
363
NOTES:
JUL
1988
CHG
1
1
JUL
1987
ANN
I
CHG
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . X Real E s t .
Trans., Com. & Pub. Util.
106,055
19,500
5,634
25,569
16,450
25,781
6,779
5,597
106,882
19,651
5,507
25,545
17,423
25,663
6,740
5,611
102,212
18,982
5,628
24,544
16,156
24,479
6,660
5,377
+
+
+
+
+
+
+
+
4
3
0
4
2
5
2
4
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . X Real E s t .
Trans., Com. X Pub. Util.
13,779
2,369
804
3,454
2,312
3,136
829
769
13,877
2,393
796
3,457
2,400
3,136
827
768
13,156
2,343
793
3,369
2,245
2,994
816
752
+
+
+
+
+
+
+
+
5
1
1
3
3
5
2
2
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
Trans., Com. 8 Pub. Util.
1,537
376
77
339
305
283
71
74
1,541
378
77
339
309
283
71
73
1,510
370
76
333
297
277
72
73
+
+
+
+
+
+
+
2
2
1
2
3
2
1
1
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
Trans., Com. X Pub. Util.
5,022
535
353
1,375
724
1,393
372
261
5,083
540
351
1,384
771
1,395
371
262
4,802
527
345
1,304
692
1,305
364
256
+
+
+
+
+
+
+
+
5
2
2
6
5
7
2
2
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . X Real E s t .
Trans., Com. X Pub. Util.
2,794
567
152
697
475
558
158
178
2,802
571
150
695
487
556
157
178
2,770
569
154
697
466
541
158
176
+
+
+
+
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . X Real E s t .
Trans., Com. X Pub. Util.
1,495
168
84
364
306
329
84
105
1,498
169
82
363
311
329
85
104
1,477
163
80
365
306
318
85
105
+
+
+
-
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
Trans., Com. 8 Pub. Util.
877
233
35
191
184
144
39
43
884
235
35
191
189
145
39
43
851
221
36
185
179
141
39
42
+
+
+
+
+
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . X Real E s t .
Trans., Com. X Pub. Util.
2,052
497
103
488
318
428
104
108
2,068
502
102
353
333
428
104
107
1,998
493
102
482
305
410
98
99
+
+
+
+
+
+
+
+
All labor force data are from Bureau o f Labor S t a t i s t i c s reports supplied b y state a g e n c i e s .
seasonally a d j u s t e d . The Southeast data represent the total o f the six s t a t e s .
JUN
1988
1
0
1
0
2
3
0
+ 1
1
4
4
0
0
+ 3
- 1
0
3
5
3
2
3
2
0
+ 2
3
1
1
1
4
4
6
9
O n l y the unemployment rate data are
EMPLOYMENT
AUG
1988
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
123,396
116,737
6,659
JUL
1988
123,888
117,066
6,823
AUG
1987
121,614
114,527
7,088
ANN
Ï
CHG
+ 1
+ 2
- 6
Unemployment Rate - % SA
5.6
5.4
6.0
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
41.3
412
41.2
414
41.3
403
0
+ 2
16,685
15,268
1,057
16,690
15,553
1,087
16,318
15,204
1,171
+ 2
+ 0
-10
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
M f g . A v g . W k l y . Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
Qfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
6.3
6.0
6.9
41.3
371
41.0
369
41.1
360
+ 0
+ 3
1,885
1,752
132
1,882
1,751
131
1,904
1,763
141
- 1
- 1
- 6
7.2
6.5
7.6
41.5
372
40.9
369
41.5
363
0
+ 2
6,235
5,921
314
6,199
5,886
313
5,925
5,589
336
+ 5
+ 6
- 7
4.9
4.3
5.5
40.6
341
40.1
338
40.3
329
+ 1
+ 4
3,197
3,001
196
3,181
2,973
208
3,067
2,905
162
+ 4
+ 3
+21
6.3
6.1
5.2
41.3
356
41.4
359
41.6
352
- 1
+ 1
1,919
1,727
192
1,938
1,738
200
1,941
1,723
218
- 1
+ 1
-12
Unemployment Rate - % SA
10.1
9.9
11.3
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
42.9
470
42.4
470
41.4
450
+ 4
+ 4
1,134
1,046
89
1,146
1,055
91
1,142
1,029
113
- 1
+ 2
-21
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment Rate - % SA
M f g . A v g . W k l y . Hours
Mfg. Avg. Wkly. Earn. - $
Civilian Labor Force - t h o u s .
Total Employed - t h o u s .
Total Unemployed - t h o u s .
Unemployment R a t e - % SA
M f g . A v g . W k l y . Hours
MfG. Avg. Wkly. Earn. - $
"
0 T E S :
»11 l«co„ri°1TJlt.c^i;e
are s e a s o n a l l y a d j u s t e d .
7.8
7.5
9.9
40.4
318
40.0
310
40.4
306
0
+ 4
2,314
2,180
133
2,343
2,199
144
2,198
141
- 1
- 6
6.3
5.8
6.7
41.2
368
41.2
370
41.3
362
- 0
+ 2
ANN
AUG
1988
JUL
1988
AUG
1987
I
CHG
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , C o m . 8 P u b . Util,
106,287
19,668
5,690
25,650
16,343
25,802
6,778
5,614
106,055
19,500
5,634
22,569
16,450
25,781
6,779
5,597
102,471
19,198
5,352
24,620
15,993
24,515
6,661
5,398
+
+
+
+
+
+
+
+
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . S Real E s t .
T r a n s . , C o m . 8 P u b . Util.
13,767
2,378
804
3,460
2,291
3,140
827
770
13,779
2,369
804
3,454
2,312
3,136
829
769
13,421
2,358
797
3,369
2,232
3,000
816
753
+ 3
+1
+ 1
+ 3
+3
+ 5
+ 1
+2
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , C o m . 8 P u b . Util.
1,527
376
76
341
294
284
71
74
1,537
376
77
339
305
283
71
74
1,510
372
77
334
294
278
71
73
1
1
1
2
0
+ 2
0
+ 1
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , C o m . 8 P u b . Util.
5,023
537
354
1,377
717
1,398
371
261
5,022
535
353
1,375
724
1,393
372
261
4,796
528
345
1,305
682
1,307
364
256
+
+
+
+
+
+
+
+
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
Trans., Com. 8 Pub. Util.
2,794
563
152
699
478
558
158
178
2,794
567
152
697
475
558
158
178
2,777
571
155
696
468
543
158
176
+
+
+
+
1
1
2
1
?
3
0
+ 1
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , C o m . 8 P u b . Util,
1,496
169
85
365
303
330
84
105
1,495
168
84
364
306
329
84
105
1,478
164
82
365
303
320
85
104
+ 1
+ 3
+ 4
0
0
+ 3
- 1
+ 1
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , C o m . 8 P u b . Util.
875
234
35
191
185
141
39
43
877
233
35
191
184
144
39
43
858
230
36
187
179
137
39
43
Nonfarm Employment - t h o u s .
Manufacturing
Construction
Trade
Government
Services
F i n . , I n s . 8 Real E s t .
T r a n s . , Cora. 8 P u b . U t i l .
2,052
500
103
488
314
429
104
108
2,052
497
103
488
318
428
104
108
2,007
498
103
481
307
413
98
100
S t
c U r ^ U °r ^
# s t i " r e P ° r t s supplied b y state a g e n c i e s .
The Southeast data represent the total o f the six s t a t e s .
Only the unemployment r a t e data
4
2
6
4
?
5
2
4
+
+
+
+
+
+
+
+
5
2
3
6
5
7
2
2
2
2
3
2
3
3
0
0
+ 2
+ 0
0
+ 1
+ 2
+ 4
+ 6
+ 8
CONSTRUCTION
ANN
JUL
1987
CHG
U N I T E D STATES
Nonresidential Building Permits - $ Mil .
Total Nonresidential
50,250
Industrial B l d g s .
7,249
Offices
12,717
Stores
13,562
Hospitals
2,228
Schools
1,078
50,613
7,323
12,773
13,679
2,315
1,079
47,615
8,183
13,974
12,237
2,488
1,170
+ 6
-11
- 9
+11
-10
- 8
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
M u l t i f a m i l y units
Total Building Permits
Value - $ M i l .
SOUTHEAST
Nonresidential Building Permits - $ Mil .
Total Nonresidential
7,745
Industrial B l d g s .
781
Offices
1,872
Stores
2,435
Hospitals
499
Schools
229
7,743
777
1,891
2,468
484
237
7,802
1,001
1,855
2,465
432
182
- 1
-22
+ 1
- 1
+16
+26
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
ALABAMA
Nonresidential Building Permits - $ M i l .
Total Nonresidential
517
Industrial B l d g s .
27
Offices
179
Stores
173
Hospitals
13
Schools
25
508
22
175
177
14
18
530
53
159
184
16
27
- 2
-49
+13
- 6
-19
- 7
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i l .
Total Nonresidential
3,691
Industrial B l d g s .
328
Offices
803
Stores
1,082
Hospitals
174
Schools
96
3,689
333
816
1,062
173
97
3,791
391
851
1,157
307
37
- 3
-16
- 6
- 6
-43
+159
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
GEORGIA
Nonresidential Building Permits - $ M i l .
Total Nonresidential
1,916
Industrial B l d g s .
251
Offices
559
Stores
603
Hospitals
128
Schools
70
1,916
252
551
613
124
83
1,769
574
464
559
21
72
+ 8
-56
+20
+ 8
+510
- 3
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i l .
Total Nonresidential
322
21
Industrial B l d g s .
Offices
56
Stores
106
Hospitals
117
Schools
9
354
22
60
146
105
9
464
37
89
176
22
28
-31
-43
+37
-40
+432
-68
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
M u l t i f a m i l y units
Total B u i l d i n g Permits
Value - $ M i l .
-15
-26
-17
-14
-18
+10
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
M u l t i f a m i l y units
Total Building Permits
Value - $ M i l .
MISSISSIPPI
JUL
1988
t
JUN
1988
12-month c u m u l a t i v e rate
TENNESSEE
Nonresidential B u i l d i n g Permits - $ Mil .
1,094
Total Nonresidential
Industrial B l d g s .
129
Offices
227
Stores
410
Hospitals
49
Schools
18
Data supplied
Nonresidential
six s t a t e s .
JUN
1988
JUL
1987
ANN
X
CHG
93,789
94,377
96,425
- 3
982.5
452.8
992.1
462.5
1,059.3
557.1
- 7
-19
140,702
141,697
144,084
- 2
15,613
15,692
15,805
- 1
198.9
104.3
200.5
106.0
206.0
109.6
- 3
- 5
23,330
23,406
23,455
- 1
575
588
689
-17
9.6
2.8
9.9
2.8
11.0
5.7
-13
-51
1,092
1,097
1,241
-12
8,985
9,008
8,914
+ 1
112.4
73.2
112.7
74.9
111.1
69.8
+ 1
+ 5
12,676
12,698
12,705
- 0
3,650
3,682
3,577
+ 2
44.9
18.0
45.3
18.6
48.3
20.3
- 7
-11
5,566
5,599
5,346
+ 4
377
385
461
-18
5.8
0.9
5.9
0.9
7.1
15.2
-18
-94
699
739
886
-21
' M**
Nonresidential B u i l d i n g Permits - $ M i l .
Total Nonresidential
206
Industrial B l d g s .
23
Offices
48
Stores
63
Hospitals
18
Schools
11
NOTES:
JUL
1988
'
219
23
54
64
19
13
242
31
58
73
22
10
'
1,057
124
235
407
50
17
287
293
311
- 8
4.6
1.7
4.7
1.8
5.2
1.3
-12
+31
493
512
552
-11
'
983
215
233
316
44
8
+11
-40
- 3
+30
+11
+125
Residential B u i l d i n g Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units.
M u l t i f a m i l y units
Total Building Permits
Value - $ M i l .
"v- v-v v
1,739
1,735
1,854
- 6
21.6
7.7
22.1
7.1
23.1
12.1
- 7
-36
2,804
2,762
2,725
+ 3
by the U . S . Bureau o f the C e n s u s , Housing Units Authorized B y Building Permits and Public C o n t r a c t s , C - 4 0 .
data exclude the c o s t o f construction for publicly owned b u i l d i n g s . The Southeast data represent the total o f the
CONSTRUCTION
AUG
1987
ANN
J
CHG
93,789
96,711
- 2
982.5
452.8
1,057.2
543.2
- 6
-17
142,722
140,702
143,976
- 1
15,758
15,613
15,909
- 1
200.3
94.2
198.9
104.3
206.2
116.7
- 3
-19
23,565
23,359
23,631
- 0
585
575
656
-11
9.6
2.9
9.6
2.8
10.9
4.5
-11
-36
1,119
1,092
1,200
- 7
9,070
8,985
9,073
- 0
113.9
62.2
112.4
73.2
111.6
80.2
+ 2
-22
12,814
12,676
12,813
+ 0
3,690
3,650
3,573
+ 3
45.1
18.3
44.9
18.0
48.3
19.0
- 7
- 4
5,644
5,566
5,321
+ 6
374
377
454
-18
5.7
0.9
5.8
0.9
7.0
1.4
-19
-36
702
699
920
-24
374
287
308
+21
4.6
1.8
4.6
1.7
5.1
1.2
-10
+50
494
493
546
-10
1,745
1,739
1,845
- 5
21.4
8.1
21.6
7.7
23.3
10.4
- 8
-22
2,792
2,833
2,831
- 1
ANN
JUL
1988
AUG
1987
Nonresidential Building Permits - $ M i l .
50,960
Total Nonresidential
Industrial B l d g s .
7,393
Offices
12,979
Stores
13,610
Hospitals
2,377
Schools
1,133
50,250
7,249
12,717
13,562
2,228
1,078
47,265
8,032
13,715
12,450
2,425
1,070
Nonresidential Building Permits - $ M i l .
Total Nonresidential
7,838
Industrial B l d g s .
782
1,867
Offices
2,454
Stores
Hospitals
534
224
Schools
7,745
781
1,872
2,435
499
229
Nonresidential Building Permits - $ M i l .
Total Nonresidential
536
Industrial B l d g s .
29
174
Offices
174
Stores
Hospitals
25
24
Schools
12-month c u m u l a t i v e rate
AUG
1988
t
CHG
8
8
5
9
2
6
Residential BuiYdTmj Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multifamily units
Total Building Permits
Value - $ M i l .
7,222
993
1,871
2,474
397
174
+ 8
-21
- 0
- 1
+34
+29
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
Single-family units
Multi family units
Total Building Permits
Value - $ M i l .
517
27
179
173
13
25
545
52
164
180
16
26
- 2
-44
+ 6
- 3
+56
- 8
Residential B u i l d i n g Permits
Value - $ M i l .
Residential Permits - T h o u s .
Single-family units
M u l t i f a m i l y units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i l .
3,743
Total Nonresidential
321
Industrial B l d g s .
815
Offices
1,086
Stores
Hospitals
191
Schools
95
3,691
328
803
1,082
174
96
3,740
390
837
1,147
289
39
+ 0
- 8
- 3
- 5
-34
+144
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
Single-family units
Multi family units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i K
1,953
Total Nonresidential
263
Industrial B l d g s .
Offices
577
Stores
605
130
Hospitals
Schools
70
1,916
251
559
603
128
70
1,748
267
496
568
17
65
+12
- 2
+16
+ 7
+665
+ 8
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i l .
327
Total Nonresidential
21
Industrial B l d g s .
45
Offices
103
Stores
116
Hospitals
Schools
8
322
21
56
106
117
9
465
40
94
179
15
26
-30
-48
-52
-42
+673
-70
^Resi^n^ai^Buifding^rmU
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total B u i l d i n g Permits
Value - $ M i l .
Nonresidential B u i l d i n g Permits - $ M i l .
200
Total Nonresidential
Industrial B l d g s .
23
42
Offices
62
Stores
21
Hospitals
12
Schools
206
23
48
63
18
11
238
29
61
75
17
7
-16
-21
-31
-17
+23
+71
Residential Building Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
Multi family units
Total Building Permits
Value - $ M i l .
Nonresidential Building Permits - $ M i l .
1,077
Total Nonresidential
124
Industrial B l d g s .
214
Offices
Stores
424
51
Hospi tals
15
Schools
1,094
129
227
410
49
18
986
209
219
325
42
11
+ 9
-41
- 2
+30
+21
+36
Residential B u i l d i n g Permits
Value - $ M i l .
Residential Permits - T h o u s .
S i n g l e - f a m i l y units
M u l t i f a m i l y units
Total Building Permits
Value - $ M i l .
NOTES:
+
+
+
AUG
1988
JUL
1988
95,099
991.4
453.1
Data supplied by the U . S . Bureau o f the C e n s u s , Housing Units Authorized By Building Permits and Public C o n t r a c t s , C - 4 0 .
Nonresidential data exclude the c o s t o f construction for publicly owned b u i l d i n g s . The Southeast data represent the total o f the
six s t a t e s .
GENERAL
LATEST
DATA
U N I T E D STATES
Personal Income
($ b i l . - SAAR)
Plane P a s s . A r r . (thous.)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
SOUTHEAST
Personal Income
($ b i l . - SAAR)
.
CURR
PERIOD
PREV
PERIOD
'-¿ Â n ^
YEAR
AGO
m ^ M M m ^ .
:
Q2
4,003.5
3,923.7
3,721.7
+ 8
JULY
N.A.
N.A.
8 , 1 0 7 . 0 . 8,185.0
N.A.
8,203.5
- 1
342.7
207.8
+ 4
+ 2
AUG
JUNE
356.6
211.4
Q2
493.4
482.9
459.4
+ 7
354.9
190.8
:
•
.: - r ^ - v .
vi
Plane Pass. A r r . (thous.)
Petroleum P r o d , (thous.)
C o n s u m e r Price Index
1967=100
Kilowatt Hours - m i l s .
JULY
JULY
5,988.8
1,286.0
5,710.9
1,303.0
6,115.8
1,421.0
- 2
-10
JUNE
N.A.
35.1
N.A.
31.4
N.A.
35.1
0
ALABAMA
Personal Income
($ b i l . - SAAR)
Q2
51.1
50.1
48.1
+ 6
JULY
JULY
183.1
56.0
180.0
56.0
195.2
56.0
- 6
0
JUNE
N.A.
4.9
N.A.
4.4
N.A.
4.9
0
201.0
195.5
184.6
+ 9
2,990.1
21.0
SEPT
191.5
11.1
2,731.9
22.0
JULY
188.3
9.6
2,929.9
22.0
SEPT
181.3
10.9
93.7
92.4
87.8
2,101.0
N.A.
2,092.3
N.A.
2,229.8
N.A.
Plane P a s s . A r r . (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($ b i l . - SAAR)
Plane P a s s . A r r . (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1977=100
MIAMI
Kilowatt Hours - m i l s .
Personal income
($ b i l . - SAAR)
Q2
JULY
JULY
JUNE
Q2
+ 2
- 5
+ 6
+2
+ 7
- 6
Plane Pass. A r r . (thous.)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
JUNE
N.A.
6.4
N.A.
5.5
N.A.
6.3
+ 2
LOUISIANA
Personal Income
($ b i l . - SAAR)
Q2
53.2
52.2
50.6
+ 5
JULY
JULY
316.4
1,136.0
305.1
1,151.0
329.3
1,265.0
- 4
-10
JUNE
N.A.
5.1
N.A.
4.5
N.A.
5.4
- 6
Q2
28.4
27.7
26.7
+ 6
JULY
JULY
43.873.0
42.7
74.0
50.7
78.0
-14
N.A.
2.3
N.A.
JUNE
2.1
N.A.
2.4
- 4
Q2
66.0
65.0
61.6
+ 7
354.4
N.A.
358.9
N.A.
380.9
N.A.
- 7
N.A.
5.3
N.A.
5.3
N.A.
5.2
Plane Pass. A r r . (thous.)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
MISSISSIPPI
Personal Income
($ b i l . - SAAR)
Plane P a s s . A r r . (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
TENNESSEE
Personalincome
($ b i l . - SAAR)
Plane Pass. A r r . (thous.)
Petroleum P r o d , (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
NOTES:
JULY
AUG
1988
t
CHG
JULY
1988
AUG
1987
X
CHG
• MSIlÉtlIif "
• '." i l l i f r - I
Agriculture
Prices Rec'd b y Farmers
Index (1977=100)
144
141
127 +13
Broiler Placements (thous.)
96,828
92,563
93,199 + 4
90.30
85.00
Calf Prices ($ per c w t . )
82.30 +10
Broiler Prices U per lb.)
41.90
42.10
31.60 +33
Soybean Prices ($ per bu.)
8.40
8.87
5.02 +67
(Q2)181
(Q3 Ì193 +28
Broiler Feed Cost ($ per ton) (Q3)248
'ïïrmiWiMV
vmm:.•••„^Mv. ï i & ï S I I ^ s l l S i ^ i
Agriculture
Prices Rec'd by Farmers
Index (1977=100)
130
129
111
Broiler Placements (thous.)
39,972
39,638
36,789
Calf Prices ($ per c w t . )
90.84
85.28
81.39
Broiler Prices {t per lb.)
41.46
42.15
30.30
Soybean Prices ($ per bu.)
8.52
9.06
5.28
Broiler Feed Cost ($ per ton) (Q3)226
(Q2)163
(Q3)181
m
+17
+ 9
+12
+37
+61
+25
Agriculture
Farm Cash Receipts - $ mil
Dates: J U N E , JUNE
Broiler Placements (thous.)
Calf Prices ($ per c w t . )
Broiler Prices (tf per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
1,145
14,428
91.90
42.00
8.55
216
14,177
82.70
40.00
9.45
158
862
12,802
79.40
31.00
5.38
185
+33
+13
+14
+35
+59
+17
3,410
2,388
96.00
41.50
8.55
216
2,409
95.80
42.40
9.45
158
3,219
2,233
84.70
30.50
5.05
185
+ 6
+ 7
+13
+36
+69
+17
^rTcufture
Farm Cash Receipts - $ m i l .
Dates: J U N E , JUNE
1,263
Broiler Placements (thous.)
15,798
Calf Prices ($ per c w t . )
85.00
Broiler Prices (tf per lb.)
41.00
Soybean Prices ($ per bu.)
8.65
Broiler Feed Cost ($ per ton)
216
15,780
76.90
42.50
9.02
158
1,178
14,800
77.30
29.00
4.92
185
+ 7
+ 7
+10
+41
+76
+17
Agriculture
Farm Cash Receipts - $ m i l .
Dates: J U N E , JUNE
Broiler Placements (thous.)
Calf Prices ($ per c w t . )
Broiler Prices (<t per lb.)
Soybean Prices ($ per b u . )
Broiler Feed Cost ($ per ton)
M s m m m m m m m m
JULY
JUNE
+ 2
Agriculture
Farm Cash Receipts - $ m i l .
Dates: JUNE, JUNE
559
Broiler Placements (thous.)
N.A.
Calf Prices ($ per c w t . )
94.00
8roiler Prices (< per lb.)
N.A.
Soybean Prices ($ per bu.)
8.65
Broiler Feed Cost ($ per ton)
266
N.A.
91.00
N.A.
8.90
185
446
N.A.
83.40
N.A.
5.49
165
Agriculture
Farm Cash Receipts - $ m i l .
Dates: J U N E , JUNE
Broiler Placements (thous.)
Calf Prices ($ per c w t . )
Broiler Prices U per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
833
7,358
95.00
41.50
8.29
266
7,272
82.90
44.70
8.84
185
600
6,951
84.60
31.50
5.31
165
+39
+ 6
+12
+32
+56
+61
AgrTcuTture
Farm Cash Receipts - $ m i l .
Dates: J U N E , JUNE
Broiler Placements (thous.)
Calf Prices ($ per c w t . )
Broiler Prices (4 per lb.)
Soybean Prices ($ per b u . )
Broiler Feed Cost ($ per ton)
885
N.A.
85.30
N.A.
8.59
261
801
N.A.
78.60
N.A.
5.18
208
+10
N.A.
82.50
N.A.
9.27
197
+25
+13
+58
+61
+ 9
+66
+25
Personal Income data supplied by U . S . Department o f C o m m e r c e .
Taxable Sales are reported as a 12-month c u m u l a t i v e t o t a l .
Plane
Passenger Arrivals are collected from 26 a i r p o r t s .
Petroleum Production data supplied by U . S . Bureau o f M i n e s .
Consumer Price
Index data supplied by Bureau o f Labor S t a t i s t i c s . Agriculture data supplied b y U . S . Department o f A g r i c u l t u r e . Farm Cash Receipts
data are reported as cumulative for the calendar year through the month s h o w n . Broiler placements are an average w e e k l y r a t e . The
Southeast data represent the total o f the six s t a t e s . N . A . = not a v a i l a b l e . The annual percent change calculation is based on most
recent data over prior y e a r .
R = revised.
ü
GENERAL
Personal income
($ bil. - SAAR)
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($ bil. - SAAR)
Plane Pass. A r r . (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($ bil. - SAAR)
ANN
LATEST
DATA
CURR
PERIOD
PREV
PERIOD
Q2
4,003.5
3,923.7
3 ,721.7
+ 8
AUG
N.A.
8,141.0
N.A.
8,107.0
N.A.
8 ,155.3
- 0
AUG
JUNE
356.6
211.4
354.9
190.8
342.7
207.8
+ 4
+ 2
Q2
493.4
482.9
459.4
+ 7
6,059.5
1,285.0
5,988.8
1,286.0
5 ,998.9
1 ,411.0
+ 1
- 9
JUNE
N.A.
35.1
N.A.
31.4
N.A.
35.1
0
Q2
51.1
50.1
48.1
+ 6
AUG
AUG
187.6
56.0
183.1
56.0
186.5
56.0
+ 1
0
N.A.
4.9
N.A.
4.4
N.A.
4.9
0
201.0
195.5
184.6
+ 9
3,012.6
20.0
SEPT
191.5
11.1
2,990.1
21.0
JULY
188.3
9.6
2 ,959.4
22.0
SEPT
181.3
10.9
+ 2
- 9
93.7
92.4
87.8
+ 7
2,129.5
N.A.
2,101.0
N.A.
2,,092.5
N.A.
+ 2
JUNE
N.A.
6.4
N.A.
5.5
N.A.
6.3
+ 2
Q2
53.2
52.2
50.6
+ 5
326.1
1,136.0
316.4
1,136.0
342.1
1,,255.0
- 5
- 9
JUNE
N.A.
5.1
N.A.
4.5
N.A.
5.4
- 6
Q2
28.4
27.7
26.7
+ 6
AUG
AUG
46.2
73.0
43.8
73.0
47.8
78.0
- 3
- 6
JUNE
N.A.
2.3
N.A.
2.1
N.A.
2.4
- 4
Q2
66.0
65.0
61.6
+ 7
AUG
357.5
N.A.
354.4
N.A.
370.6
N.A.
- 4
N.A.
5.3
N.A.
5.3
N.A.
5.2
AUG
AUG
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
JUNE
personal income
($ bil. - SAAR)
Q2
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1977=100
MIAMI
Kilowatt Hours - m i l s .
personal income
($ bil. - SAAR)
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Incomt
{$ bil. - SAAR)
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($ bil. - SAAR)
Plane Pass. Arr. (thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
Personal Income
($ b i l . - SAAR)
Plane Pass. Arr. {thous.)
Petroleum Prod, (thous.)
Consumer Price Index
1967=100
Kilowatt Hours - m i l s .
NOTES:
AUG
AUG
JUNE
Q2
AUG
AUG
AUG
JUNE
YEAR
AGO
ANN
I
SEPT
1988
CHG
+ 6
+ 2
AUG
1988
SEPT
1987
X
CHG
Agriculture
Prices Rec'd by Farmers
Index (1977=100)
145
Broiler Placements (thous.)
96,738
Calf Prices ($ per cwt.)
89.10
Broiler Prices (4 per lb.)
39.20
Soybean Prices ($ per bu.)
8.42
Broiler Feed Cost ($ per ton) (Q3)248
144
96,828
90.30
41.90
8.40
(Q2)181
129
92,045
86.00
28.50
5.00
(Q3)193
+12
+ 5
+ 4
+38
+68
+28
Agriculture
Prices Rec'd by Farmers
Index (1977=100)
138
Broiler Placements (thous.)
39,700
Calf Prices {$ per cwt.)
83.87
Broiler Prices U per lb.)
38.79
Soybean Prices ($ per bu.)
8.63
Broiler Feed Cost ($ per ton) (Q3)226
130
39,972
90.84
41.46
8.52
(Q2)163
124
36,117
84.13
27.27
5.20
(Q3)181
+11
+10
- 0
+42
+66
+25
Agriculture
Farm Cash Receipts - $ m i l .
Dates: JULY, JULY
1,350
Broiler Placements (thous.)
14,320
Calf Prices ($ per cwt.)
81.80
Broiler Prices (4 per lb.)
36.70
Soybean Prices ($ per bu.)
8.56
Broiler Feed Cost ($ per ton)
216
14,428
91.90
42.00
8.55
158
1,005
12,260
83.10
26.50
5.24
185
+34
+17
- 2
+38
+63
+17
3,703
2,452
90.20
39.10
8.56
216
2,388
96.00
41.50
8.55
158
3,470
2,296
84.90
27.50
5.24
185
+ 7
+ 7
+ 6
+42
+63
+17
Agriculture
Farm Cash Receipts - $ m i l .
Dates: JULY, JULY
1,519
Broiler Placements (thous.)
15,675
Calf Prices ($ per cwt.)
81.40
Broiler Prices (4 per lb.)
39.00
Soybean Prices ($ per bu.)
8.46
Broiler Feed Cost ($ per ton)
216
15,798
85.00
41.00
8.65
158
1,360
14,686
81.30
27.00
5.05
185
+12
+ 2
+ 0
+44
+68
+17
Agriculture
Farm Cash Receipts - $ m i l .
Dates: JULY, JULY
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (4 per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
Agriculture
Farm Cash Receipts - $ mil
Dates: JULY, JULY
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (4 per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
663
N.A.
90.00
N.A.
8.81
266
535
N.A.
87.50
N.A.
5.31
165
+24
N.A.
94.00
N.A.
8.65
185
Agriculture
Farm Cash Receipts - $ m i l .
Dates: JULY, JULY
Broiler Placements (thous.)
Calf Prices {$ per cwt.)
Broiler Prices (4 per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
980
7,253
85.00
41.50
8.63
266
7,358
95.00
41.50
8.29
185
703
6,876
88.00
28.90
5.21
165
+39
+ 5
- 3
+44
+66
+61
Agri cui ture
Farm Cash Receipts - $ m i l .
Dates: JULY, JULY
Broiler Placements (thous.)
Calf Prices ($ per cwt.)
Broiler Prices (4 per lb.)
Soybean Prices ($ per bu.)
Broiler Feed Cost ($ per ton)
1,039
N.A.
78.60
N.A.
8.62
261
N.A.
85.30
N.A.
8.59
197
936
N.A.
82.40
N.A.
5.17
208
+ 3
+66
+61
+11
- 5
+67
+25
Personal Income data supplied by U . S . Department o f Commerce. Taxable Sales are reported as a 12-month cumulative total.
Plane
Passenger Arrivals are collected from 26 airports.
Petroleum Production data supplied by U . S . Bureau of M i n e s . Consumer Price
Index data supplied by Bureau of Labor Statistics. Agriculture data supplied by U . S . Department o f Agriculture. Farm Cash Receipts
data are reported as cumulative for the calendar year through the month shown. Broiler placements are an average weekly r a t e . The
Southeast data represent the total of the six states. N.A. = not available. The annual percent change calculation is based on m o s t
recent data over prior y e a r .
R = revised.
m Economic
^ Review
Federal Reserve Bank of Atlanta
104 Marietta St, N.W.
Atlanta, Georgia 30303-2713
Address Correction Requested
@FedFRASER