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September/October 1991
Volume 76, Number 5
Federal Reserve
Bank of Atlanta
In This Issue:
.Recourse Risk i n Asset Sales
Are All Monetary Policy
Instruments Created Equal?
/European Monetary Union:
H o w Close Is It?
.Review Essay
•••'
•
>
'••
-
' V
-
Economic
jT^wiew
September/October 1991, Volume 76, Number 5
Äpinomic
Review
Atlanta
President
Robert P. Forrestal
S e n i o r Vice President a n d
Director o f R e s e a r c h
Sheila L. T s c h i n k e l
Vice P r e s i d e n t a n d
A s s o c i a t e D i r e c t o r of R e s e a r c h
B. Frank K i n g
Research Department
William Curt Hunter, Vice President, Basic Research
Mary Susan Rosenbaum, Vice President, Macropolicy
William Roberds, Research Officer, Macropolicy
Larry D. Wall. Research Officer, Financial
Public A f f a i r s
Bobbie H. McCrackin. Vice President
Joycelyn T. Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
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(Contents
September/October 1991, Volume 76, Number 5
R e c o u r s e R i s k in A s s e t S a l e s
Larry
J4
.
a
Are All Monetary Policy
Instruments Created Equal?
Marco Espinosa
J 1
FYI
European Monetary
* * U n i o n * H o w C l o s e Is I t ?
Michael J. Chriszt
Review Essay
Ellis W. Tailman
Since the early 1980s commercial banks, spurred by financial
market changes, improved technology, and tighter regulatory capital
standards, have greatly increased their sales of loans. Regulators are
concerned, however, about the risk banks retain by providing loan
buyers at least partial recourse if problems develop with a loan. Current capital regulations discourage providing recourse for credit risk
by including such loans' full value in banks' capital requirements.
This article reviews related literature and examines regulatory
problems posed by recourse risk. Some empirical evidence suggests
that providing recourse may not increase risk when indirect effects
of recourse through loan purchaser monitoring are taken into account. The author finds no reason to change capital standards until
further evidence is available about the gains from loan sales and
from market discipline.
Does monetary policy have real effects? Economists use economic models to examine this important question. Often, the answer
depends on the model chosen. In this study of selected models,
which highlight the interaction of fiscal and monetary policies, the
author explores the effects of monetary policy changes as embodied
in open market operations and changes in reserve requirements. The
author presents examples of how models can be used to address policy issues and argues that the internal consistency of a model is essential if it is to be used as a tool in policy analysis.
The European Community's goal of eventual monetary union
y t h e European Monetary System (EMS), established in 1979. This article provides a brief history of the evolution of the EMS, describes how its exchange rate mechanism works,
and reports on the European Community's recent progress toward
monetary union.
has been advanced b
The House of Morgan:
An American Banking Dynasty and the Rise of Modern Finance
by Ron Chemow
Correction
Table 6, page 45, of "Commercial Bank Profitability," in the July/August
1991 Economic Review, contains an error. Percentage return on assets in 1987
for banks with assets of $1 billion or more should read - 0 . 1 5 .
Recourse Risk
in Asset Sales
Larry D. Wall
C
The author is a research officer in charge of the financial
section of the Atlanta
Fed's
research department.
He
thanks George Bens ton for extensive comments and Steve
Smith for additional
helpful
comments. The opinions expressed in this study,
however,
are solely those of the author.
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
ommercial banks, especially small banks, have long sold participations in loans they originated. Until the 1980s loan sales
had been a very small fraction of loan originations for almost
all commercial banks in the United States, but during the past
decade loan sales have increased dramatically (Joseph G.
Haubrich 1989).
Changes in financial markets and in regulatory pressure are behind the
increase in loan sales. O n e significant long-run trend has been the growth in
the amount of information about a wide variety of loans. This i n f o r m a t i o n
a l l o w s loan sellers and b u y e r s to a g r e e m o r e readily on the f a i r v a l u e
of l o a n s . M o r e recently, a d v a n c e s in legal c o n t r a c t i n g and n e w dataprocessing technology have m a d e it possible for large groups of loans to be
pooled together and sold as a tradable security, a procedure called securitization. In addition, banks have increasingly m a d e a number of large loans
to support corporate restructurings, loans of amounts so large that holding
the entire loan would have exceeded the risk tolerances of even the biggest
U.S. banks. Besides these market developments, the key regulatory change
promoting loan sales has been the implementation and progressive tightening of capital standards since the early 1980s. In turn, many banks have
had to shrink their asset bases or increase their capital or both.
Bank supervisors generally see loan sales as an acceptable method by
which banks can reduce their total risk exposure to better match their existing capital levels. However, the implementation of a loan sales program
can raise a n u m b e r of potential supervisory questions related to a b a n k ' s
risk. For example, supervisors m a y be concerned that banks will sell their
highest-quality assets and retain their weakest, with the result that the decline in risk exposure will be less than proportionate to the decline in assets
Econ oinicRevieu>
1
(see Stuart I. Greenbaum and A n j a n V. Thakor 1987).
Supervisors also m a y anticipate that banks will bec o m e too reliant on loan sales as a source of funding.
This study focuses on one particular source of concern to regulators—that a bank will not transfer all
risk of loss when it sells a loan. This retained risk is
k n o w n as recourse risk. Regulators fear that a bank
will apparently reduce its capital needs by selling a
loan while in fact these needs would be unchanged because the bank has provided the buyer full recourse
should any problems emerge with the loan. Perhaps
the greatest concern is that, although the sales contract
will explicitly disavow any recourse, the seller will
n e v e r t h e l e s s provide it to maintain the institution's
reputation in financial markets. Such provision of implicit recourse troubles regulators because it impedes
accurately estimating the selling banks' risk.
T h i s study a l s o c o n s i d e r s a d d i t i o n a l r e g u l a t o r y
concerns raised by recourse risk, including accounting issues and limits on loans to a single borrower.
Following a review of reasons for which banks sell
loans and a discussion of the implications of recourse
for bank risk, the article e x a m i n e s regulatory problems posed by recourse risk. T h e analysis suggests
that no single answer satisfies questions about the appropriate regulatory treatment of recourse risk. The
regulations are structured to accomplish a variety of
goals, and their complexity precludes a simple solution. However, most of the problems associated with
recourse risk can be satisfactorily resolved in ways
that achieve the various regulations' goals.
Most loan sales are in fact m a d e without explicit
recourse for the full amount of the credit losses because otherwise regulators would refuse to recognize
these transactions as sales for regulatory accounting
p u r p o s e s . R e c o u r s e r e m a i n s an issue, h o w e v e r , because, a c c o r d i n g to theory, sellers will provide the
m a x i m u m recourse permitted in order to receive the
highest selling price.
W h y Banks Sell Loans
There is clearly a direct increase in risk when recourse is provided. However, this risk is offset somewhat as loan sales with recourse generate incentives
for a bank to acquire lower-risk assets to sell and to
hold in its p o r t f o l i o . E x i s t i n g e m p i r i c a l e v i d e n c e ,
w h i c h s u g g e s t s that t h e s e indirect risk r e d u c t i o n s
would approximate the direct increase in risk resulting f r o m selling loans with recourse, raises the question of w h e t h e r the c u r r e n t a p p r o a c h of i n c l u d i n g
loan sales with recourse in risk-based capital regulations is appropriate. The analysis below suggests that
accuracy of treatment hinges on the extent to which
the capital regulations capture the indirect effects of
recourse sales. If none of the indirect reductions are
c a p t u r e d , then i n c l u d i n g loan sales with r e c o u r s e
m a y be inappropriate. However, if the capital regulations fully capture the indirect influences so that an
accurate picture results, it is desirable to include the
asset sales in the capital regulations so that the direct
i n c r e a s e in risk is t a k e n into a c c o u n t . T h i s s t u d y
f o u n d that current r i s k - b a s e d capital s t a n d a r d s are
likely to capture the risk reductions only partially.
T h e current treatment of loans sales with recourse,
w h i c h i n c l u d e s t h e m in capital r e q u i r e m e n t s , m a y
therefore be justified as providing at least s o m e degree of protection to the Federal Deposit Insurance
Corporation (FDIC).
2
Economic Review
Analysts frequently point to deposit insurance subsidies and c a p i t a l r e g u l a t i o n s to j u s t i f y b a n k loan
sales. However, there are a number of other reasons a
bank might want to sell its loans. This section reviews
a variety of possible motivations.
Limitations on Bank Branching. The U.S. banking s y s t e m h a s long been f r a g m e n t e d by state and
f e d e r a l l a w s that r e s t r i c t i n t r a s t a t e and i n t e r s t a t e
branching. Because this fragmentation has limited the
size of individual banks, many institutions find themselves in the position of having opportunities to originate loans that w o u l d e x c e e d the a m o u n t they can
retain on their balance sheet given their own prudence
and regulatory requirements that banks diversify their
lending across customers. 1 Banks do not want to deny
loans to good customers, however, so small banks in
particular have sold part of the loans (a process called
using overlines) to their larger correspondent banks.
The current legal restrictions also encourage banks to
buy loans as a way of diversifying their loan portfolios outside their geographic markets.
The fragmentation of the U.S. banking system also
has affected banks' ability to obtain deposits at belowmarket rates. The situation that has resulted is an opportune environment for large banks to sell loans to
s m a l l e r b a n k s , a c c o r d i n g to G e o r g e G. P e n n a c c h i
(1988). Pennacchi suggests that smaller banks' lower
average cost of f u n d s combines with large banks' superior access to loans (arising from their presence in
international financial centers) to create loan sales opportunities. These opportunities are limited, however,
Pennacchi notes, because of a "moral-hazard" problem with loan monitoring. The moral-hazard problem
September/October 1991
is that the originating bank has less of an incentive to
monitor those loans it sells because it has less to lose
if the loans default, in turn, the price the purchaser is
willing to pay f o r the loans is r e d u c e d . P e n n a c c h i
c o n t e n d s that one way to r e d u c e the m o r a l - h a z a r d
problem is for the selling banks to provide recourse
on their loan sales.
Although branching law restriction seems to explain
the increase in loan sales, the fact that the trend is toward relaxing the intrastate branching restrictions raises
questions. 2 These changes in state laws have reduced
the pressure on banks to sell loans as a means of increasing diversification and obtaining lower-cost funding of loans. However, loan-origination opportunities at
money center banks—especially loans for corporate restructuring—have increased. This avenue, c o m b i n e d
with continuing legal and financial limitations on money center branching, may have created strong incentives
for loan sales from large to small banks.
Reserve Requirements. Christine Pavel and David
Phillis (1987) suggest that reserve requirements—the
p e r c e n t a g e of d e p o s i t s b a n k i n g institutions are required to hold on reserve with the F e d — r a i s e banks'
costs of f u n d s and e n c o u r a g e loan sales. A l t h o u g h
their assessment may have been accurate in the late
1980s, recent changes should reduce the importance
of reserve requirements in the future. Reserve requirements on nonpersonal time deposits and Eurocurrency
liabilities were eliminated on January 17, 1991. The
only remaining ones are on transactions accounts, and,
because of transactions accounts' low interest elasticity, banks do not rely on them to fund marginal loans.
Securitization as a Superior Technology. Lowell
L. Bryan (1988) and James A. Rosenthal and Juan M.
O c a m p o ( 1 9 8 8 a ) argue that securitized loans are a
more efficient way of garnering earnings than loans
that a bank originates and holds on its balance sheet.
S e c u r i t i z a t i o n can a l l o w b a n k s not only to r e d u c e
risks through diversification but also to reduce interest rate risk and to add reviewers, credit guarantors,
and poolers to the original analysis of the loan. The
net result, these authors argue, is that the cost of a securitized loan is, in general, significantly less than a
loan retained on a bank's balance sheet.
George G. Benston (forthcoming) agrees that securitization has some advantages but argues that Bryan
(1988) and Rosenthal and O c a m p o (1988a) overstate
the case. Securitization can provide opportunities for
greater asset diversification and interest rate risk reduction. However, securitization involves costly additional review of loans, and Benston points out that the
gain in credit quality m a y not offset the extra costs.
Federal
Reserve Bank of Atlanta
Benston also notes that securitization is unavoidably subject to costs arising f r o m adverse-selection
and moral-hazard risk. In particular, he singles out the
risk that the originating bank will sell loans of lower
quality than the information supplied would lead the
buyer to expect. Such problems have the potential to
cause a total breakdown in the loan-sales market (in a
manner similar to that observed in the used-car market by George A. Akerlof 1970). Buyers will demand
a discount in the selling price of the assets to c o m p e n sate for the risk that loans will be of lower quality
than promised. This reaction would prompt sellers of
the highest-quality assets to withdraw, in turn leading
buyers to demand an even larger discount. The ultimate result could be that the only loans that can be
sold are the highest-risk ones.
Adverse-selection and moral-hazard problems
are likely to be small w h e n the o r i g i n a t o r and the
purchaser have substantially the s a m e a m o u n t of information about the borrower. For example, securitization has been proved viable for standardized consumer
loans, such as h o m e mortgages and credit-card receiva b l e s , b e c a u s e the d e f a u l t c h a r a c t e r i s t i c s of large
pools of specific types of c o n s u m e r loans are fairly
well known. However, securitization has not worked
for s m a l l b u s i n e s s loans b e c a u s e e v a l u a t i n g these
loans depends on information available to the originating banks but not to a loan's purchaser.
The problems of adverse selection and moral hazard can be substantially reduced if the seller provides
recourse. Bryan (1988, 88-89) suggests that the seller
provide recourse for losses up to t w o or three times
the n o r m a l credit losses for the type of loan being
sold. 3 The problem with this approach, according to
Benston, is that it largely nullifies gains f r o m selling
the loans, except in the case of catastrophic losses.
The seller loses most of the benefits of diversification, and regulators will not reduce a b a n k ' s capital
requirements.
Differences in Risk Aversion and Underinvestment. Lawrence M. Benveniste and Allen N. Berger
(1987) and Christopher J a m e s (1988) provide m o r e
sophisticated versions of the argument that loan sales
may reduce a bank's cost of funding. Benveniste and
Berger's analysis is based on the assumption that investors have varying degrees of risk aversion. 4 If this
assumption holds, funding a group of risky assets with
a single class of liabilities is suboptimal. A bank can
reduce its cost of funding by issuing low-risk securities
to investors with high degrees of risk aversion and
high-risk securities to those more tolerant of risk. Benveniste and Berger show that loans sold with recourse
Econ oinicRevieu>
3
can provide a way of issuing low-risk securities to
risk-averse investors and that uninsured liabilities can
be obtained f r o m investors with less risk aversion in
order to f u n d marginal changes in those assets remaining on the bank's balance sheet.
J a m e s ' s (1988) analysis of loan sales with recourse
is based on prior studies by Stewart C. Myers (1977)
and René M . Stulz and Herb Johnson (1985). Myers
suggests that the presence of risky debt m a y lead a
firm to underinvest (in the sense that it m a y refuse to
invest in a positive net-present-value project) because
d e b t h o l d e r s ' gains f r o m risk reduction m a y e x c e e d
those f r o m undertaking the project. Stulz and Johnson
show that collateralized debt m a y counteract the incentive to underinvest by allowing the firm to sell a
portion of the cash flows associated with the new project. M o r e of the risk-reduction benefits are captured
by the equityholders because collateralizing the debt
r e d u c e s the interest rate required by the new b o n d h o l d e r s . J a m e s notes that loans sold s u b j e c t to recourse agreements have cash flow properties similar
to those of collateralized bonds and, hence, also tend
to reduce the incentive to underinvest.
Capital Costs. Rosenthal and O c a m p o (1988b) also suggest that funding a loan on the originator's bala n c e s h e e t m a y be m o r e c o s t l y b e c a u s e d o i n g so
involves higher capital costs. These authors compare
the direct costs of securitizing an asset with the costs
of holding it on the balance sheet. However, Benston
(forthcoming) notes a significant flaw in their argument: namely, that they recognize an equity capital
cost if the loan is funded on the balance sheet, but they
do not recognize any capital cost to the originator if
the loan is securitized, even though the originator provides limited r e c o u r s e . T h u s , their a n a l y s i s u n d e r states the capital cost of securitization by ignoring the
effect of recourse risk on the existing debt- and equityholders of the originator.
Although the Rosenthal and O c a m p o argument on
capital costs is flawed, more sophisticated arguments
also suggest that capital regulations encourage loan
sales. Current regulations rely on a combination of a
risk-based capital standard and a leverage standard.
T h e risk-based standards incorporate the credit risk of
on- and off-balance-sheet items, whereas the leverage
standards set a m i n i m u m tier one capital-to-total-asset
ratio. 5 The risk-based guidelines and the leverage standards are defined in book-value rather than marketvalue terms.
Banks that find capital regulations binding can raise
their capital ratios in three ways. They can (1) sell assets having market values in excess of book values to
4
Economic
Review
increase book capital, (2) reduce assets, or (3) issue
new capital. Mark J. Flannery (1989) notes that regulators can force banks to recognize asset-value losses
based on increased credit risk. However, historic cost
accounting does not permit recognition of increases in
the value of assets retained on a bank's books. Flannery suggests that banks m a y use securitization to capture gains in the value of existing bank assets. Such
sales would boost the seller's regulatory capital ratios
even if the bank did not use securitization to shrink its
asset base because the gains would cause an increase
in accounting capital that would otherwise go unrecognized in bank financial statements.
B a n k s that cannot m e e t regulatory r e q u i r e m e n t s
via gains f r o m asset sales must either reduce assets or
issue new capital. Loan sales provide a way of reducing assets at a cost that may be below that of issuing
new capital for several reasons. First, capital requirements unambiguously increase costs to the extent that
they reduce the F D I C subsidy. David H. Pyle (1985)
suggests that all noncapital liabilities are insured for
banks most likely to be engaged in off-balance-sheet
activities. Thus, increasing the volume of loans sold
with recourse would increase the value of the F D I C
subsidy, w h e r e a s increasing capital would decrease
the subsidy. 6 Existing regulations prevent sales with
explicit recourse f r o m reducing a b a n k ' s capital requirements, but banks may sell assets while retaining
substantial risk by supplying some indirect f o r m of
credit backing or by providing verbal assurances that
the seller will repurchase the loan if problems arise.
Second, capital regulations that set minimum equitycapital requirements may increase b a n k s ' taxes and
raise the cost of obtaining additional capital. 7 Recent
empirical e v i d e n c e f r o m J e f f r e y K . M a c K i e - M a s o n
(1990) for nonfinancial corporations and f r o m M y r o n
S. Scholes, G. Peter Wilson, and Mark A. W o l f s o n
(1990) suggests that corporate income taxes play an
important role in f i r m s ' financial decisions.
Third, c o m m o n stock issues h a v e generally been
associated with price declines for the issuing f i r m s '
c o m m o n stock w h e n new issues are announced. Although regulations do not explicitly mandate new issues of c o m m o n equity, their structure suggests that a
significant part of any new capital should ultimately
be obtained through a c o m m o n stock issue. During
the 1980s banks responded by sharply increasing their
issuance of all types of capital instruments, including
c o m m o n stock. 8
Larry D. Wall and P a m e l a P. Peterson (1991) ana l y z e d s t o c k m a r k e t r e s p o n s e s to b a n k i n g f i r m s '
announcements of new security issues and found evi-
September/October 1991
d e n c e that such a n n o u n c e m e n t s cause significantly
negative abnormal returns. After conducting several
tests they concluded that the hypothesis that best explains their results is the securities-overvaluation hyp o t h e s i s of M y e r s and N i c h o l a s S. M a j l u f ( 1 9 8 4 ) .
This hypothesis suggests that a f i r m ' s m a n a g e r s try
to m a x i m i z e the value of the existing c o m m o n shareholders' claims. If the f i r m m u s t issue new securities, it issues those that are most overvalued (or least
u n d e r v a l u e d ) b y the f i n a n c i a l m a r k e t s . F i n a n c i a l
m a r k e t s r e c o g n i z e this incentive and interpret new
c o ' m m o n s t o c k i s s u e s as a s i g n that m a n a g e m e n t
thinks that the residual claims on the f i r m ' s cash flow
are overvalued and therefore reduces the f i r m ' s c o m mon stock value. If Myers and M a j l u f ' s hypothesis is
correct, the dynamics they describe may lead banks to
reduce their assets instead of selling additional common stock.
Although capital regulations m a y have encouraged
banks to engage in loan sales, the regulations as written do not permit a reduction in capital requirements
for loans sold subject to recourse. T h e instructions for
bank call reports require that loan sales should not be
excluded from the balance sheet if the loans are "sold
in transactions in which risk of loss or obligation for
payment of principal or interest is retained by, or may
fall back upon, the seller." Exceptions are granted for
sale of loans in the G o v e r n m e n t National M o r t g a g e
Association, Federal National Mortgage Association,
and Federal H o m e Loan Mortgage Corporation. Special treatment is also provided to private certificates
of participation in pools of residential mortgages, acc o r d i n g to T h o m a s R. B o e m i o and G e r a l d A . E d wards, Jr. (1989). Boemio and Edwards also note that
banks have been allowed to sell loans that did not involve recourse to the selling bank but did provide recourse to a special pool funded by excess payments
from the underlying asset pool.
Empirical Evidence. The various theoretical studies of loan sales provide a wide variety of explanations about why banks sell loans. The theories are not
mutually exclusive. T h e issue of which ones have a
significant explanatory p o w e r is an empirical question
on which there is limited evidence.
In one significant study Pavel and Phillis (1987)
e x a m i n e l o a n s a l e s r e p o r t e d by 1 3 , 7 6 3 b a n k s f o r
1983, 1984, and 1985. The data are obtained f r o m the
Reports of Condition and Reports of Income filed by
the banks with federal regulators. According to Pavel
and Phillis these reports exclude loans sold with recourse "or with the reporting bank's endorsement or
g u a r a n t e e . " T h e results, w h i c h are c o n s i s t e n t w i t h
Reserve Bank of Atlanta
Digitized Federal
for FRASER
theory, suggest that banks with less diversified loan
portfolios are more likely to sell loans than firms with
highly diversified portfolios. T h e i r study also f i n d s
that large banks sell a greater dollar value of loans,
which suggests that most loan sales do not involve
small b a n k s selling l o a n s to t h e i r c o r r e s p o n d e n t s .
Banks that are more efficient loan generators (those
having low ratios of noninterest expense to the sum of
loans retained and loans sold) are m o r e likely to sell
loans. Pavel and Phillis's results also suggest that regulatory " t a x e s " in the f o r m of reserve requirements
and capital regulations encourage loan sales.
Implications of Recourse f o r Bank Risk
O n e view of recourse sales that is separate f r o m
the issue of capital requirements is that allowing such
sales would permit banks to evade regulatory capital
controls and thereby to increase F D I C subsidies. 9 A s
regards the question of whether recourse risk should
continue to b e included in the calculation of capital
requirements, if a large fraction of loan sales is motivated by wanting to increase the F D I C subsidy, the
i m p l i c a t i o n is that bank capital r e g u l a t i o n s should
continue to include it. However, if providing recourse
is not intended to exploit the F D I C and the combined
direct and indirect consequences of recourse do not in
fact increase bank risk, then the appropriateness of including loans sold with recourse in a b a n k ' s capital
requirements needs further consideration.
The argument that loan sales with recourse could
b e used to increase an F D I C subsidy for bank risk
taking is straightforward: if loans sold with recourse
are not included in the capital r e q u i r e m e n t s , b a n k s
have a m e c h a n i s m for taking on additional risk without h a v i n g to p r o v i d e a c o m m e n s u r a t e i n c r e a s e in
their capital level.
The counterargument to the F D I C exploitation hypothesis is that the indirect impact of loan sales will
substantially offset the direct increase in risk due to
recourse. O n e indirect offset can be seen in James's
(1988) model of loan sales. To the extent that banks
are selling low-risk loans that they would not otherwise have acquired, the direct increase in risk m a y be
minimal.
A second indirect effect is that recourse sales tend to
increase private-sector discipline of bank risk taking.
Although Pyle (1985) has argued that all noncapital liabilities have been protected at large banks, such prot e c t i o n is not g r a n t e d by law a n d d e p e n d s on the
Econ oinicRevieu>
5
F D I C ' s policies at the time a bank fails. Moreover,
since Pyle made his comments in 1985 the F D I C has
exposed nondeposit liabilityholders at large banks to
losses. Thus, purchasers of loans with recourse provisions probably are taking more risks than depositors
with f u n d s in excess of $ 1 0 0 , 0 0 0 in an account. In
valuing the recourse agreement, purchasers will discount it according to the selling bank's risk of failure
unless they k n o w with certainty that the F D I C will
p r o t e c t all n o n d e p o s i t c r e d i t o r s . 1 0 T h u s , a l t h o u g h
banks may be tempted to use loan sales with recourse
as a m e c h a n i s m for increasing F D I C subsidies, this
temptation will be partially offset by k n o w i n g that
prices attached to loan sales are an inverse function of
the bank's condition."
James (1988) provides indirect empirical evidence
on what the effect of loans sales with recourse would
be if recourse were not a factor in capital regulations.
H e u s e s r e g r e s s i o n a n a l y s i s to test the i m p a c t of
banks' standby letters of credit (SLCs) on their certificate of deposit (CD) rates as an indicator of perceived
credit risk, a safer bank being able to attract f u n d s to
CDs at lower rates. 12 An S L C is a bank's promise to
pay a third party in the event that a customer fails to
repay a loan or d e f a u l t s on some other o b l i g a t i o n .
SLCs that back loans create the same credit risk that
would have occurred had the bank originated the loans
for its own balance sheet and then sold them with full
recourse. Thus, while data on actual loan sales with rec o u r s e a r e l i m i t e d , a n a l y s i s of S L C s p r o v i d e s a
method of analyzing the effect of loan sales with full
recourse. If selling loans with recourse increases a
bank's risk, a statistically significant positive coefficient on S L C s w o u l d be e x p e c t e d , i n d i c a t i n g that
banks with higher levels of SLCs (which are similar,
in e f f e c t , to providing recourse) must pay m o r e on
their C D s to c o m p e n s a t e C D holders for the greater
risk. James finds that some risk variables, such as the
banks' capital level, have significant coefficients with
the correct sign, indicating that these factors are correlated directly or inversely, as expected with higher C D
rates; however, the coefficient on SLCs has the wrong
sign (a higher v o l u m e of S L C s was associated with
lower C D rates). Furthermore, this coefficient is statistically i n s i g n i f i c a n t . T h i s result s u g g e s t s that loan
sales with recourse are likely to have no significant
impact on the seller's risk exposure.
G.D. K o p p e n h a v e r and R o g e r D. Stover (1991a)
m o d e l e d the relationship b e t w e e n b a n k capital and
S L C issuance as a simultaneous-equations problem in
which changes in capital influence S L C issuance and
vice versa. U s i n g G r a n g e r causality tests (in which
6
Economic Review
causality is inferred when one variable is correlated
with another at an earlier period but the converse does
not hold) they found a positive relationship between
current S L C issuance and lagged capital but a negative
relationship between current capital and lagged S L C
issuance. They found a similar relationship between
contemporaneous values of the two variables in a twostage least squares regression model. In further work
Koppenhaver and Stover (1991b) added contemporan e o u s m e a s u r e s of capital and S L C issuance to the
Granger causality tests. They found that the contemporaneous relationship between the two variables was
s i g n i f i c a n t l y p o s i t i v e but that the r e l a t i o n s h i p to
lagged values was i n s i g n i f i c a n t . T h e y suggest that
banks were allocating capital to S L C issuance before
risk-based standards were imposed and that the riskbased guidelines could cause a decrease in issuance of
S L C s and the market discipline that arises from them.
/Regulatory Treatment of Risk
The provision of recourse on loan sales can influence a b a n k ' s market value and net income through
its i m p a c t on c r e d i t , interest rate, and f o r e i g n exc h a n g e rate risk. (The i m p l i c a t i o n s of r e c o u r s e f o r
banks' liquidity are discussed in the box.) The analysis below considers the way in which these risks are
and should be regulated. The discussion begins with a
conceptual review of how recourse risk would be analyzed in a comprehensive system if there were comp l e t e i n f o r m a t i o n a b o u t t h e d i s t r i b u t i o n of b a n k
returns. Unfortunately, the data required for the perfect r i s k - m e a s u r e m e n t system are not available, so
r e g u l a t o r s h a v e been r e q u i r e d to a d d r e s s d i f f e r e n t
risks p i e c e m e a l . T h u s , the c h a l l e n g e f a c i n g regulators is finding ways to incorporate recourse risk into
existing and future risk-analysis systems. The consideration of this problem first examines means of incorp o r a t i n g r e c o u r s e risk into the t w o m a j o r tools of
credit-risk measurement and control: risk-based capital regulation and limits on loans to a single borrower.
Following is an analysis of ways the interest rate and
foreign exchange rate risk could be incorporated into
the r i s k - b a s e d capital g u i d e l i n e s . T h e section concludes with a review of possible responses to banks'
attempts to frustrate the regulatory goals by providing
implicit rather than explicit recourse.
E x i s t i n g A p p r o a c h to R e g u l a t i n g B a n k Risk
Taking. The appropriate regulatory treatment of loans
sold with recourse depends on the goals of regulation.
September/October 1991
Liquidity Risk
A bank is s u b j e c t to liquidity risk w h e n it sells loans
the loan-sales m a r k e t by p r e v e n t i n g t r a n s a c t i o n s — a s
with r e c o u r s e in that it m u s t f i n d f u n d s to r e p u r c h a s e the
w h e n a bank cuts its l e n d i n g t o a b o r r o w e r if it c a n n o t
l o a n s if the r e c o u r s e p r o v i s i o n is i n v o k e d . H o w e v e r , an
sell the loan. A n o t h e r d i f f i c u l t y with such r e g u l a t i o n is
e v e n m o r e s i g n i f i c a n t f o r m of liquidity risk arises if a
that r e g u l a t o r s f r e q u e n t l y w o u l d not k n o w the b o r r o w -
bank sells l o a n s f o r less than the d e s i r e d maturity of the
e r s ' d e s i r e d loan maturity.
b o r r o w e r a n d the l o a n - s a l e s m a r k e t r e f u s e s to p u r c h a s e
Alternatively, regulators could address these prob-
the loan w h e n it is r e n e w e d o r " r o l l e d o v e r " — a s , for ex-
l e m s by e s t a b l i s h i n g p r o c e d u r e s that w o u l d p r e v e n t
a m p l e , w h e n a bank p e r s u a d e s a c o m m e r c i a l b o r r o w e r
banks from making replacement loans to cover matur-
that w a n t s t w o - y e a r f u n d i n g to a c c e p t f o u r c o n s e c u t i v e
i n g l o a n s t h e y h a v e sold if the latter h a v e s i g n i f i c a n t l y
s i x - m o n t h l o a n s in o r d e r to a c c o m m o d a t e the n e e d s of
i n c r e a s e d the b a n k ' s credit risk o r h a v e r e d u c e d liquidi-
the l o a n ' s u l t i m a t e p u r c h a s e r . A n o t h e r e x a m p l e of this
ty. F o r e x a m p l e , the r e g u l a t o r s c o u l d u s e ex p o s t m o n i -
situation involves a b a n k ' s agreement to begin early
t o r i n g f o r b a n k s that e x c e e d m i n i m u m s a f e t y s t a n d a r d s
p a y m e n t of the principal o n securitized credit card l o a n s
a n d are n o t f u n d i n g a m a t e r i a l a m o u n t of n e w l o a n s to
if credit losses o n the card p o r t f o l i o e x c e e d s o m e pre-
r e p l a c e loan s a l e s . In all o t h e r c a s e s b a n k s c o u l d b e re-
s p e c i f i e d level.
quired to obtain prior regulatory approval for new
T h e p r o b l e m a r i s e s in t h e s e e x a m p l e s n o t b e c a u s e
l o a n s . T h e k e y to m a k i n g this a l t e r n a t i v e w o r k is that
of the l o a n sale per se. T h e b a n k c o u l d r e f u s e to roll
r e g u l a t o r s w o u l d h a v e t o be p r e p a r e d to e n f o r c e s a f e t y
o v e r t h e c o r p o r a t e loan or c o u l d c u t its c r e d i t c a r d lines
s t a n d a r d s r e g a r d l e s s of c o n s e q u e n c e s f o r t h e b a n k a n d
as it p a s s e s t h r o u g h the loan r e p a y m e n t s . H o w e v e r , t h e
its b o r r o w e r . Strict, a c r o s s - t h e - b o a r d e n f o r c e m e n t m a y
b a n k m a y be u n w i l l i n g to r e f u s e n e w l o a n s t o its c u s -
a p p e a r t o b e s u b o p t i m a l in s o m e i n d i v i d u a l c a s e s . H o w -
t o m e r s , p a r t i c u l a r l y if t h e s e a r e l o n g - t i m e c u s t o m e r s
e v e r , a c a s e - b y - c a s e a p p r o a c h w o u l d i n v i t e a b u s e s in
w h o d o o t h e r t y p e s of p r o f i t a b l e b u s i n e s s with the
the f o r m of b a n k s s e l l i n g s h o r t - t e r m l o a n s w i t h the ex-
bank.
p e c t a t i o n that r e g u l a t o r s w o u l d a l l o w t h e m to f u n d n e w
A bank that rolls o v e r loans it c a n n o t sell in the loan-
l o a n s if t h o s e c o u l d n o t be r e s o l d . M o r e o v e r , if r e g u l a -
sales and securitized-credit m a r k e t s is e x p o s e d t o credit
t o r s r e t a i n c r e d i b i l i t y in their e n f o r c e m e n t the n u m b e r
risk if the quality of the b o r r o w e r s has deteriorated. T h e
of c a s e s r e q u i r i n g a c t i o n s h o u l d b e s m a l l . It is l i k e l y
b a n k is also s u b j e c t to the risk that it will be u n a b l e to
that b a n k s and their b o r r o w e r s w o u l d q u i c k l y learn that
f u n d additional l o a n s without a n u n a c c e p t a b l e deteriora-
the b o r r o w e r s ' ability t o o b t a i n c o n t i n u i n g f u n d i n g a f t e r
tion in its liquidity. O n e r e g u l a t o r y alternative for deal-
t h e i r l o a n s a r e sold d e p e n d s on the s t a t e of the l o a n -
i n g w i t h t h i s p r o b l e m w o u l d b e t o i n c l u d e in t h e
sales m a r k e t . W h e n b a n k s w a n t to c o n t r o l f u t u r e f u n d -
r i s k - b a s e d capital r e q u i r e m e n t s any loan sales in w h i c h
i n g d e c i s i o n s they d o n o t sell l o a n s , a n d b a n k b o r r o w e r s
the b o r r o w e r ' s d e s i r e d m a t u r i t y e x c e e d s that of t h e loan
will not p e r m i t loan sales that c r e a t e a s i g n i f i c a n t risk
sales contract. This approach may significantly affect
that early loan r e p a y m e n t will b e r e q u i r e d .
Two important objectives are protecting the real, or
nonfinancial, portion of the e c o n o m y f r o m shocks to
the financial sector and minimizing the F D I C ' s losses. Bank regulators also generally seek to avoid influencing the type and structure of bank loans as much
as is possible in line with the first two goals. 1 3 Often
the three g o a l s are not c o m p a t i b l e , and r e g u l a t o r s
must trade off greater progress toward one at the expense of another.
If regulators knew the true probability distribution
of a bank's future total returns given its existing portfolio, they c o u l d easily s p e c i f y a m i n i m u m capital
level that would set a m a x i m u m on the probability of
bankruptcy or expected F D I C losses arising f r o m the
b a n k ' s failure. Having three different goals in mind
would complicate the problem somewhat, but, if regulators both knew the true distribution of total returns
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and could specify their trade-off function between the
three goals, the problem could in fact be solved. Risk
a s s o c i a t e d w i t h s e l l i n g l o a n s s u b j e c t to r e c o u r s e
would only indirectly enter the p r o b l e m through its
effect on the distribution of total returns.
The problem in regulating recourse risk is that in
reality the true distribution of a b a n k ' s future returns
is not known. The historic return pattern for a limited
set of assets can be determined most c o m m o n l y by
estimating the variances of returns associated with individual assets and the covariances of returns among
assets. H o w e v e r , historic variances and c o v a r i a n c e s
m a y not be very accurate predictors of future values.
Moreover, the use of historic values as proxies f o r
expected future values is especially problematic when
banks know more about the distribution of future asset returns than the regulators do (a condition that
Econ oinicRevieu>
7
should generally hold if a bank is competently managed). Banks can deliberately avoid the intent of regu l a t i o n b y o v e r i n v e s t i n g in a s s e t s f o r w h i c h t h e
historic data underestimate risk and underinvesting in
assets for which the data overestimate the risk.
In practice regulators split the types of risk into
categories, such as credit risk, interest rate risk, and
foreign exchange risk. They then proceed to simplify
their analysis of the d i f f e r e n t categories. A l t h o u g h
this a p p r o a c h m a k e s the a n a l y s i s easier, it ignores
correlations a m o n g different types of risks.
Risk-based capital standards take into account only
the credit risk associated with an individual asset and
ignore the correlation of credit losses a m o n g assets.
Only in a crude fashion do bank regulations take correlations into a c c o u n t — b y establishing that a bank
may not lend m o r e than 15 percent of its capital to
any single b o r r o w e r or g r o u p of related borrowers.
M o r e o v e r , these standards use broad categories f o r
c l a s s i f y i n g a s s e t s . F o r e x a m p l e , all n o n m o r t g a g e
loans to private individuals and corporations carry the
same risk weighting under the standards.
R e g u l a t o r s m o n i t o r interest rate and f o r e i g n exchange rate risk as well as a bank's liquidity. These
risks are not explicitly captured by either capital standard but are included in a rough manner in the leverage standard. For example, the total leverage standard
is a control for interest rate risk in that it would require a m i n i m u m capital level of a bank that invested
solely in Treasury securities (which require no capital
under the risk-based standards) but which could be
taking significant interest rate risk.
Risk-Based Capital Guidelines. O n e concern regarding the current regulatory treatment of loan sales
with recourse is raised by theoretical and empirical
evidence suggesting that the combined direct and indirect risk changes would not necessarily materially
increase the b a n k ' s total risk exposure. Another concern is that f o r c i n g b a n k s to c a r r y the e n t i r e loan
amount on their books, even though their m a x i m u m
loss may be a fraction of that amount, could create inconsistencies with other risk-based capital standards.
Measuring the Impact of Recourse on Banks' Total
Risk. O n e way in which loans could be sold with rec o u r s e w i t h o u t i n c r e a s i n g a b a n k ' s risk e x p o s u r e
would be for the loans to be of such low risk that the
bank w o u l d not o t h e r w i s e h a v e m a d e the loans, as
s u g g e s t e d by J a m e s ( 1 9 8 8 ) . In this c a s e the small
amount of credit risk could be more than offset by the
profitability the loans contribute through the reduction in the bank's risk of failure. The risk-based capital standards are unlikely to capture this risk reduction
Economic
8
Review
fully because of the broadness of the asset risk categories. H o w e v e r , even if J a m e s ' s m o d e l explains a
substantial portion of b a n k loan sales, the case for
l o w e r i n g the risk w e i g h t i n g on loans sold with recourse is weak. Other models of loan sales imply that a
bank may sell loans with recourse to increase its risk
exposure. Unfortunately, in view of the fact that all
p r i v a t e - s e c t o r , n o n m o r t g a g e loans are g i v e n equal
w e i g h t u n d e r the r i s k - b a s e d s t a n d a r d s , l o w - r i s k
private-sector loan sales cannot be distinguished f r o m
high-risk loan sales in a manner consistent with other
s t a n d a r d s . 1 4 M o r e o v e r , m a n y low-risk loans that a
b a n k m a y choose to sell with recourse m a y also be
profitable to m a k e and sell without recourse. If so,
regulations that discourage selling loans with recourse
may not significantly reduce the volume of loan sales.
A second way for banks to sell with recourse while
not increasing their risk of failure would be to m a k e
o f f s e t t i n g a d j u s t m e n t s in their other b a l a n c e - s h e e t
and off-balance-sheet items. That is, the F D I C risksubsidy increase because of recourse sales is at least
partially o f f s e t by l o a n s ' l o w e r selling p r i c e s if a
bank becomes riskier. A bank could offset any higher
risk due to recourse by reducing the variability of returns in the rest of its portfolio or by increasing its
capital level. Risk-based capital guidelines are likely
to capture at least partially the reductions in the variability of returns from the rest of the bank's portfolio,
particularly given that the risk-based standards have
built in an incentive for banks to reduce risk in ways
the regulations can capture. For example, a bank that
increases its holdings of Treasury securities and reduces its holdings of commercial loans as part of its
decision to sell loans with recourse would experience
a decrease in its risk-based capital requirements.
The risk-based standards would not pick up all reductions in variability, however, because some could
grow out of portfolio changes involving shifts in assets within the same risk-weighting category. For instance, a b a n k ' s capital r e q u i r e m e n t s w o u l d not b e
lowered if it increased its loans to AAA-rated corporations while decreasing its holdings of loans to highly l e v e r a g e d t r a n s a c t i o n s . ( T h i s t y p e of p o r t f o l i o
change is not easily incorporated in the weighting of
loan sales with r e c o u r s e , t h o u g h . ) R e g u l a t o r s a l s o
could not attribute shifts within asset risk categories
to loan sales with recourse. Moreover, it would not be
fair to recognize shifts in portfolio risk for banks that
sell loans with recourse without doing the s a m e for
banks that do not sell loans. Because of these conditions, a good case can be made for not amending the
risk-based standards to take into account the potential
September/October 1991
for banks that sell loans with recourse to reduce their
remaining portfolio's risk.
A bank may also increase its capital level to offset
the increased risk due to recourse. Because risk-based
g u i d e l i n e s already f u l l y c a p t u r e c h a n g e s in capital
levels, there is no need to change the guidelines to reflect higher capital levels resulting f r o m sale of loans
with recourse.
A third a r g u m e n t in f a v o r of treating loan sales
with recourse differently f r o m loans kept on the
books is that loans sold with recourse should reduce
the F D I C payout if a bank were to fail. That is, if the
b a n k f a i l s and the loan b u y e r s try to e x e r c i s e r e c o u r s e , they will b e c o m e g e n e r a l c r e d i t o r s of the
failed bank and share the losses proportionately with
other uninsured creditors, including the F D I C . T h e
strengths of this argument depend on placing greater
i m p o r t a n c e o n l i m i t i n g the F D I C ' s l o s s e s w h e n a
bank fails than on preventing b a n k failures. If preventing failures is the dominant concern, the smaller
losses to the F D I C may not seem an important benefit
of loan sales with recourse. If protecting the F D I C is
the principal goal, the risk sharing m a y be important.
H o w e v e r , for the standards to be consistent, adjustments to the capital standards would be necessary for
all credit-risky off-balance-sheet items because th$y
all involve some risk sharing. If capital standards are
to be reduced when a private party shares the risk of
failure with the F D I C , p e r h a p s the risk-based standards should be modified to include all nondeposit liabilities as a (secondary) element of capital.1"1
Selling loans with recourse generates m o r e direct
risk than selling without recourse, but, as pointed out
earlier, indirect offsets may render the total change in
risk insignificant. However, the empirical finding that
recourse has no material impact on a b a n k ' s total risk
does not necessarily imply that risk-based standards
should give loan sales with recourse a lower weight.
Capital standards may already incorporate some risk
reduction indirectly resulting f r o m recourse sales, and
m e a s u r i n g the u n c a p t u r e d risk r e d u c t i o n w o u l d be
difficult, if not impossible.
One could argue that loan sales may improve the
b a n k i n g s y s t e m ' s e f f i c i e n c y and that private-sector
discipline would limit a bank's risk taken on through
sales with r e c o u r s e . For e x a m p l e , J a y a n t R. K a l e ,
T h o m a s H. Noe, and Stephen G. T i m m e (1990) found
that initial bank announcements of plans to securitize
loans generated positive abnormal returns for the selling banks' shareholders. Moreover, the current structure of risk-based capital standards does not permit an
accurate accounting for the full impact on a b a n k ' s
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Reserve Bank of Atlanta
risk of l o a n s sold w i t h r e c o u r s e , so the s t a n d a r d s
would inevitably be biased either for or against loan
sales w i t h r e c o u r s e . T h e r e f o r e , to e n c o u r a g e l o a n
sales the best approach would be to establish a lower
weight on loan sales with recourse than on loans held
in a bank's portfolio.
Evidence regarding the results of biasing standards
in f a v o r of loan sales p i n p o i n t s several p r o b l e m s .
First, there is little solid empirical evidence that loan
sales generate economies of scope with bank's other
activities. 1 6 Indeed, Loretta J. Mester (1991) finds the
o p p o s i t e — t h a t loan sales generate d i s e c o n o m i e s of
Existing capital regulations
discourage
loan sales with recourse by including the
full value of such loans in banks' capital
requirements.
scope. Second, although loan sales with recourse generate s o m e m a r k e t discipline, theory does not give
clear indications as to whether the additional market
discipline would outweigh the deposit insurance subsidy to b a n k risk taking. Third, the results of Kale,
N o e , and T i m m e ' s (1990) study could be explained
by a variety of hypotheses, not all of which imply a
net social gain to s e c u r i t i z a t i o n . For e x a m p l e , the
stock m a r k e t m a y view the loan sales as a way for
banks to avoid an anticipated issue of new equity. In
light of this research, keeping the current standards
seems called for unless there is additional evidence
that (1) the standards overestimate the net impact of
loan sales with r e c o u r s e on b a n k s ' risk or (2) loan
sales generate gains to society relative to loans funded
by the originator.
Potential Inconsistencies
in the Risk-Based
Standards. A s alluded to above, risk-based standards contain an inconsistency in the way loan sales with partial
recourse are treated relative to loans with identical risk
exposure held on the book. A bank that makes a loan
sale with partial recourse is required to carry 100 percent of the loan on its books if it retains a significant
Econ oinicRevieu>
9
risk of loss. For example, a bank would have to retain the entire loan amount if it sells a loan with rec o u r s e on the first 9 percent of the losses and the
expected loss was 3 percent. However, the bank
would need to include only the first 9 percent if the
transaction were structured so that the borrower obtained the same amount of f u n d s through a subordinated loan equal to 9 percent of the borrowing and a
senior loan (a loan repaid b e f o r e the s u b o r d i n a t e d
loans) equal to 91 percent of the borrowing and if the
bank p u r c h a s e d the s u b o r d i n a t e d part without ever
owning the senior loan.
Unfortunately, this inconsistency is inherent in the
r i s k - b a s e d s t a n d a r d s . All n o n m o r t g a g e l o a n s to
private-sector borrowers carry the same risk weighting regardless of the b o r r o w e r ' s riskiness or the sen i o r i t y of t h e d e b t o b l i g a t i o n . T h e t h e o r e t i c a l l y
correct approach to measuring a bank's risk accurately would be to use weightings that fully reflect the
riskiness of each loan. 1 7 U n d e r this method, subordinated debt to any given borrower would carry a higher risk w e i g h t i n g t h a n s e n i o r d e b t f r o m the s a m e
borrower. However, this approach would not automatically weight all subordinated debt more heavily than
all senior debt because the subordinated debt of some
borrowers is less risky than the senior debt of certain
other b o r r o w e r s . A n accurate m e a s u r e m e n t s y s t e m
would require evaluation of individual borrowers as
well as of the seniority of the loan contract. Regulators are reluctant to rate individual borrowers, though,
because doing so could easily lead to politically motivated credit rationing.
Moreover, senior and subordinated debt are merely
the t w o end points of a continuum of debt contracts
having varying seniority. Any rules designed to favor
senior debt over subordinated debt would encourage
banks to design contracts that meet the formal requirements of senior debt but are, in fact, as risky as some
junior issues by equally risky borrowers. Thus, a completely accurate risk rating system would require that
regulators examine individual debt contracts to determine their seniority level. At this point the direct cost
(that is, the financial cost to the regulatory system) of
imposing completely accurate risk-based standards
clearly would exceed any possible gain, and the longrun indirect costs of such government micromanagement of banks likely would be enormous.
Regulators must choose between encouraging and
discouraging loan sales with recourse relative to subordinated debt, assuming that some level of inconsistency is unavoidable in the risk-based standards. The
current policy takes the more conservative approach.
Economic Review
10
Single-Borrower Lending Limit. T h e limit on a
b a n k ' s loans to a single b o r r o w e r e n f o r c e s at least
some diversification of bank portfolios. If the recourse
risk were ignored, loans sold with recourse could be
used to avoid the intent of the single-borrower limits.
Including recourse risk raises a question of how much
of a loan sold with recourse should count against the
limit. If the purchaser has recourse for the entire loan,
it is clear that the entire loan should count. But what
if the selling bank is liable for only a fraction of the
l o a n — f o r example, 10 percent? The answer lies in the
aim of the single-borrower lending limit, which is to
enforce diversification by limiting a bank's m a x i m u m
exposure to any single borrower. In this example the
m a x i m u m exposure is 10 percent, and it follows that
only 10 percent of the loan should count against its
borrowing limit.
Recourse for Interest Rate or Foreign Exchange
Contingencies. Recourse agreements need not be restricted to credit contingencies. Loan sales contracts
can require the seller to repurchase assets based on
interest rate or foreign exchange rate contingencies.
These contingencies can be explicitly stated, or they
can be implicit f u n c t i o n s of interest or f o r e i g n exchange rates, such as in contracts that m a k e the rep u r c h a s e contingent on the b o r r o w e r ' s p r e p a y m e n t
pattern. T h e total leverage standards provide s o m e
c o n t r o l s on the m a x i m u m e x p o s u r e to interest rate
and foreign exchange rate risk by requiring a bank to
hold some capital even if its credit risk is minimal.
Any added interest rate or foreign exchange risk due
to recourse could be partially captured by the leverage standards and thereby generate some additional
capital requirements if the risk-based standards were
not already binding. However, this approach to regulating interest rate and f o r e i g n e x c h a n g e risk provides at best only a very crude measure of a b a n k ' s
risk exposure.
An a l t e r n a t i v e a p p r o a c h that takes g r e a t e r c o g nizance of those risks is suggested by Wall, John J.
Pringle, and James E. McNulty (1990). They suggest
that each bank set a m a x i m u m exposure level to interest rate and foreign exchange rate risk, establish systems adequate to ensure that actual exposure does not
exceed the internal guideline, and keep their exposure
within their i n t e r n a l g u i d e l i n e s . R e g u l a t o r s w o u l d
then create an interest rate and foreign exchange rate
component to the risk-based capital standards and use
b a n k s ' internal guidelines in setting capital requirements. Recourse risk under this system could be treated
like any other interest rate or foreign exchange rate
option sold by the bank, such as the prepayment op-
September/October 1991
tion given to b o r r o w e r s under fixed-rate residential
mortgage contracts.
Implicit Recourse Arrangements. A s mentioned
earlier, one concern of regulators is that banks will
sell loans under contracts explicitly disavowing any
recourse but will provide verbal or implicit promises
to repurchase the loan if problems arise. Banks may
grant implicit recourse in order to maximize the price
received on a loan sale. These agreements, which are
generally honored in the interest of the seller's reputation, increase future loan sale prices. Implicit recourse
limits both regulatory and market discipline of bank
risk taking.
It is h a r d to m e a s u r e e m p i r i c a l l y the d e g r e e to
which implicit recourse is involved in loan sales. A
study by Gary Gorton and Pennacchi (1989) suggests
that its use m a y be c o m m o n enough that the selling
b a n k ' s rating significantly a f f e c t s the rate of return
loan buyers require. However, subsequent research by
the same authors (1991) found that implicit recourse
is not a significant factor in the loan-sales market for
at least some of one bank's loan sales. Regardless of
the s i g n i f i c a n c e of i m p l i c i t r e c o u r s e to the overall
loan-sales market, implicit recourse could have a significant effect on the riskiness of individual banks.
Providing implicit recourse could be discouraged if
regulators would take strong measures against banks
that provide it. Banning all repurchases of loans sold
without explicit recourse m a y not be necessary. Such
a ban should in fact be avoided, if possible, to maintain liquidity in the loan-sales market. Rather, banks
should not be allowed to repurchase loans that have
e x p e r i e n c e d a s i g n i f i c a n t decline in credit quality.
This prohibition can be enforced after the fact for financially strong banks that are not repurchasing a material a m o u n t of l o a n s . All other loan r e p u r c h a s e s
could r e q u i r e prior regulatory a p p r o v a l . M o r e o v e r ,
any bank discovered to have engaged in a pattern of
providing implicit recourse on loans that have experienced a significant decline in credit quality should be
required to treat all outstanding loan sales as sales
with full recourse for the purposes of the risk-based
standards and the limits on loans to a single borrower.
While it could be costlier in some individual cases to
e n f o r c e this policy strictly than to provide forbearance, refraining f r o m full enforcement of such regulations would only encourage banks to sell additional
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loans with implicit recourse in the expectation that they
will also receive forbearance if the need arises. T h e
strict enforcement of limitations on implicit recourse
would teach banks and their customers not to be parties to loan sales with implicit recourse if the bank
wishes to retain a relationship with the borrower.
Conclusion
In the past d e c a d e b a n k s h a v e s i g n i f i c a n t l y inc r e a s e d their sales of l o a n s . T h e o r y s u g g e s t s that
banks would sell loans with recourse if permitted to
do so by regulators. However, existing capital regulations discourage loan sales with recourse by including
the full value of such loans in b a n k s ' capital requirements. By limiting possible solutions to moral-hazard
and adverse-selection risks to loan purchasers, capital
regulations probably hamper market development and
reduce the prices banks receive for loans sold.
This study reviews related literature and analyzes
the impact of loan sales on banks' riskiness. Findings
indicate that the direct impact of loan sales is to increase risk, but the direct results are at least partially
offset by indirect effects. For example, some degree
of market discipline would be exercised as purchasers
of loans sold with recourse would be willing to pay
less for w e a k b a n k s ' loans sold with r e c o u r s e than
they would pay for loans sold by strong banks. Moreover, empirical evidence confirms that the net direct
and indirect effect of loan sales with recourse is that
risk m a y not be s i g n i f i c a n t l y i n c r e a s e d . H o w e v e r ,
risk-based capital standards may to some degree incorporate risk reduction resulting f r o m market discipline. As for the uncaptured risk reduction, there is as
yet no evidence on whether it would exceed the direct
increase in risk resulting f r o m recourse. 1 8 A n additional issue is that, although there is some theoretical
evidence about gains f r o m loan sales, there is no clear
empirical evidence that loan sales have produced any
gains other than perhaps providing banks a way to def e r n e w c a p i t a l issues. F u r t h e r e v i d e n c e a b o u t the
gains f r o m loan sales and about risk reduction arising
f r o m market discipline is needed before there would
be reason to change the treatment of recourse risk under risk-based capital standards.
Econ oinicRevieu>
11
Notes
1. Regulators require that a b a n k ' s m a x i m u m credit exposure
to any one borrower, or group of related borrowers, not exceed 15 percent.
2. Relaxation of interstate b a n k i n g laws could increase reported loan sales b e c a u s e loans sold to affiliated banks
should be subject to far fewer moral-hazard problems.
10. An e x a m p l e of the effectiveness of market discipline on
b a n k ' s off-balance-sheet risk taking may be found in the
interest rate swap market, where s o m e banks that had been
dealers are being effectively prevented f r o m competing in
parts of the swap market because of increases in the banks'
perceived risk of failure.
3. Loan buyers may also be protected by outside credit enhancements, such as guarantees purchased f r o m insurance
c o m p a n i e s . H o w e v e r , outside credit e n h a n c e m e n t s only
s h i f t the a d v e r s e - s e l e c t i o n and m o r a l - h a z a r d p r o b l e m s
f r o m loan buyers to the providers of the credit enhancements.
11. See Boot and Thakor (1991) for an application of this argument to bank loan commitments.
4. Benveniste and Berger include deposit insurance in their
formal model, but their general argument for the advantage
of debt sales with recourse also could be made in environments without deposit insurance.
5. Tier o n e capital consists of c o m m o n and perpetual preferred equity, paid-in-capital in excess of par, and retained
earnings.
6. Barham and Lefebvre (1990) have developed a model in
which capital regulation is assumed to be a costly tax, and
they h a v e a n a l y z e d the o p t i m a l c o n t r a c t a s s u m i n g an
a s y m m e t r i c i n f o r m a t i o n p r o b l e m . B a n k s in their m o d e l
have access to an ex ante loan-analysis technology that allows them to separate " g o o d " f r o m " b a d " loans but that an
insurer of securitized loans can use to perform an ex post
analysis of failed loans to determine their quality. Barham
and Lefebvre suggest that the optimal contract would be
one in which the bank forfeits its entire capital if it is found
to have misrepresented the quality of the loan. Bank regulators are unlikely to approve such draconian punishment.
7. If true, the tax explanation for sales would be a contributing factor in all loan sales. However, taxes alone could not
explain loan sales unless the seller of the loans were required by the regulators to hold more capital than would be
held by the purchaser of the loans.
8. Lehman Brothers (1990) reports that total capital issues increased f r o m less than $0.5 billion per year between 1976
and 1981 to n o less than $2.5 billion per y e a r b e t w e e n
1982 and 1989. C o m m o n stock issues totaled over $2 billion in three years: 1986, 1987, and 1989.
9. Several of the theoretical models discussed provide both a
rationale f o r loan sales that is i n d e p e n d e n t of e x i s t i n g
safety and soundness regulations and a reason for loans to
be sold with recourse that does not involve exploiting the
government safety net. Moreover, the models that do not
consider recourse also ignore moral-hazard and adverseselection risk. Had these risks been considered, the other
models of loan sales would likely have found the provision
of recourse to be an important element.
Economic
12
Review
12. J a m e s (1988) and Pavel (1988) also look directly at the
risk i m p l i c a t i o n s of loan s a l e s . H o w e v e r , P a v e l ' s data
source on loan sales explicitly excludes loans sold with recourse, and J a m e s ' s data appear to have the same limitation.
13. T h e s e are the t h r e e p r i m a r y g o a l s of b a n k s a f e t y and
s o u n d n e s s regulation. C o m m e r c i a l bank regulators have
been assigned other responsibilities, such as consumer protection. This discussion focuses on the regulators' safety
and soundness responsibilities because recourse risk does
not raise significant issues for other responsibilities.
14. T h e risk-based standards could be m o d i f i e d to accord a
lower weight to private-sector loans that satisfy some prespecified criteria. However, any simple criteria are likely
to lead to significant inaccuracies. For example, standards
based on conventional financial ratios will not yield accurate risk measures across industries. Regulators could undoubtedly develop standards for different industries that
would be far more accurate than the current system, even
though the revised standards would still contain errors. The
problem is that regulators could more easily be placed under strong political pressure to manipulate more complicated s t a n d a r d s to a l l o c a t e c r e d i t t o p o l i t i c a l l y p o w e r f u l
industries.
15. A case could also be made for including all noninsured liabilities, including uninsured deposits. H o w e v e r , deposits
that lack de jure insurance frequently receive 100 percent
de facto coverage by the FDIC. Thus, uninsured deposits
should not be included in the capital regulations unless the
FDIC eliminates all coverage of uninsured deposits.
16. Economies of scope exist when the cost of conducting two
or more activities in the same firm is less than the total cost
of conducting the activities in separate firms.
17. The approach to measuring risk would be theoretically correct in the sense that the portfolio weightings accurately reflected the variance of individual loans. The ideal system
would analyze the risk of the entire portfolio rather than
the risk of individual assets, as noted above.
18. The lack of empirical evidence may be due in part to the
fact that the risk-based standards did not take effect until
the end of 1990 and the full capital requirements will not
be in place until the end of 1992.
September/October 1991
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Economics 84 (August 1970): 488-500.
Barham, Vicky, and Olivier Lefebvre. "Bank Loans Securitization with Asymmetric Information: A Principal-Agent Solution." Center for Operations Research and Econometrics,
Université Catholique de Louvain, Discussion Paper N u m ber 9072, N o v e m b e r 1990.
Benston, George G. " T h e Securitization of Credit: T h e Benefits and Costs of Breaking U p the B a n k . " Journal of Applied Corporate Finance (forthcoming).
Benveniste, Lawrence M., and Allen N. Berger. "Securitization with Recourse: An Investment that O f f e r s Uninsured
Bank Depositors Sequential C l a i m s . " Journal of Banking
and Finance 11 (September 1987): 403-24.
Boemio, T h o m a s R., and Gerald A. Edwards, Jr. "Asset Securitization: A S u p e r v i s o r y P e r s p e c t i v e . " Federal
Reserve
Bulletin 75 (October 1989): 659-69.
Boot, Arnoud W.A., and Anjan V. Thakor. "Off-Balance Sheet
L i a b i l i t i e s , D e p o s i t I n s u r a n c e and C a p i t a l R e g u l a t i o n . "
Journal of Banking and Finance 15 ( S e p t e m b e r 1991):
825-46.
Bryan, Lowell L. Breaking Up the Bank: Rethinking an Industry under Siege. H o m e w o o d , 111.: D o w Jones-Irwin, 1988.
F l a n n e r y , M a r k J. " C a p i t a l R e g u l a t i o n and Insured B a n k s '
Choice of Individual Loan Default Risks." Journal of Monetary Economics 24 (September 1989): 235-58.
Gorton, Gary, and George Pennacchi. "Are Loan Sales Really
Auditing and
O f f - B a l a n c e Sheet?" Journal of Accounting,
Finance 4 (Spring 1989): 125-45.
. "Bank and Loan Sales: Marketing Non-Marketable Assets." Paper presented at the Western Finance Association
meetings in Jackson Hole, Wyoming, 1991.
G r e e n b a u m , Stuart I., and A n j a n V. Thakor. "Bank Funding
Modes: Securitization versus Deposits." Journal of Banking and Finance 11 (September 1987): 379-401.
Haubrich, Joseph G . " A n O v e r v i e w of the Market for Loan
Sales." Commercial Lending Review 4 (Spring 1989): 39-47.
James, Christopher. " T h e Use of Loan Sales and Standby Letters of Credit by Commercial Banks." Journal of Banking
and Finance 22 (November 1988): 395-422.
Kale, Jayant R., T h o m a s H. Noe, and Stephen G. T i m m e . " T h e
Impact of Loan Sales and Securitization on Bank Shareholder's Wealth." Paper presented at the Financial Management Association meetings in Orlando, Florida, 1990.
Koppenhaver, G.D., and Roger D. Stover. "Standby Letters of
Credit and Large Bank Capital: An Empirical Analysis."
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. "Standby Letters of Credit and Bank Capital: Evidence
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L e h m a n B r o t h e r s . Financings
by United States Banks and
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L e h m a n Brothers, 1990.
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1990): 1471-93.
Mester, Loretta J. "Traditional and Nontraditional Banking:
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Myers, Stewart C. " D e t e r m i n a n t s of Corporate B o r r o w i n g . "
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Myers, Stewart C., and Nicholas S. Majluf. "Corporate Financing and Investment Decisions When F i n n s Have Information That Investors D o Not H a v e . " Journal of
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Pavel, Christine A. " L o a n Sales H a v e Little Effect on Bank
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Stulz, René M „ and Herb Johnson. " A n Analysis of Secured
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Wall, Larry D „ and Pamela P. Peterson. "Valuation Effects of
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77-87.
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Review 75 (May/June 1990): 14-28.
Econ oinicRevieu>
13
re All Monetary
Policy Instruments
Created Equal?
Marco Espinosa
n November 1987 the New Yorker devoted parts of three issues to analyzing the workings of the Federal Reserve System. The author of these
articles wrote, "The financial system, usually portrayed as a static balance sheet, actually is dynamic, like a p u m p house, and functions according to physical laws that a hydraulic engineer might understand. It
is like a fantastic labyrinth of pipes, storage tanks, and pressure valves. . . .
The Federal Reserve Board stands alongside the system like a supervising
engineer who has the power to alter the flows inside the plumbing." 1
This type of journalism responds to the growing public interest in better
understanding the monetary authority's role in the economy. It recognizes
that this role should be examined in a dynamic framework. It also embodies
the belief that monetary policy can alter the course of the economy.
But d o e s the f i n a n c i a l system really work like a p u m p h o u s e ? C a n
monetary policy change the course of the e c o n o m y ? 2 On what basis do
economists m a k e monetary policy recommendations? As is discussed below, the analogy to a smoothly operating system like that of a p u m p house
is not in fact particularly accurate.
The author is an economist
in the macropolicy section of
the Atlanta Fed's
research
department. He thanks Eric
Leeper, Mary
Rosenbaum,
and Steve Russell for very
helpful comments.
However,
any errors are the author's
responsibility.
Economic
14
Review
In a physical science like chemistry, a researcher can conduct a laboratory experiment to learn the effects of, for example, mixing magnesium and
lithium. In economics, when one wants to know the consequences of, for
instance, lowering reserve requirements, there is no research lab available,
and no controlled experiment is possible. Instead, economists build econ o m i c m o d e l s — s i m p l i f i e d versions of h o w real-world e c o n o m i e s work.
Economic models are sets of assumptions and the rules that m a k e the assumptions consistent with each other. Implicitly or explicitly, whether they
recognize it or not, economists always have models in mind when they analyze problems. Any prediction of, for example, the effect of lowering reserve
September/October 1991
requirements on the inflation rate or the rate of interest in the eeonomy depends critically on the particular
m o d e l applied. A b e n e f i t of using these s i m p l i f i e d
versions of real economies w h e n addressing policy issues is that, a m o n g other things, using a model reduces the n u m b e r of variables in the economy being
analyzed at a given time, making it possible to examine particular problems more effectively and to verify
the internal consistency of policy recommendations.
This article highlights some of the issues arising in a
selection of models that attempt to analyze, in a formal
setting, the consequences of some hypothetical monetary policies. In these models fiscal and monetary policy are constrained by the requirements of financing
government expenditures, and the choice of ways to finance such expenditures affects the real interest rate
(that is, the interest rate adjusted for inflation). They
were chosen because policymakers generally seem to
have such economies in mind when they explore alternative policy options. The models highlight the interaction of f i s c a l and m o n e t a r y policies. T h e article
provides examples of how these models can be used to
address some monetary policy issues.
Although monetary policy is usually studied in isolation f r o m fiscal policy, and vice versa, these types of
government economic policies are necessarily linked
to each other. Consider the following stylized description of fiscal policy. W h e n the government decides on
a level of expenditures to be financed domestically, it
must also decide on h o w much of those expenditures
will be financed by taxes and how much by the issue
of debt such as Treasury bills and bonds (hereafter, for
the sake of simplicity, debt is referred to as bonds).
Because government expenditures minus taxes are def i n e d as d e f i c i t s , d e f i c i t s i m p l i c i t l y d e t e r m i n e the
amount of bonds to be issued.
Given the amount of government bonds outstanding, a decision must be m a d e as to whether or not to
monetize those bonds—that is, whether to buy them
with newly created currency. This decision, which determines the composition of the government's liability portfolio, is made by the monetary authority and is
therefore identified by many economists as monetary
policy.
It is true that most analysts study monetary and fiscal policies separately. H o w e v e r , it should be clear
from the above description of these policies' interrelationship that analysts are implicitly making assumptions about one when studying the other.
T h e I m p a c t of Fiscal a n d M o n e t a r y P o l i c i e s .
A m o n g the m o s t controversial issues in m a c r o e c o nomics is whether fiscal and monetary policies have
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real e f f e c t s . B e c a u s e m o s t m a c r o e c o n o m i c m o d e l s
conclude that policy can affect macroeconomic activity only if it changes the real rate of interest, a policy is
said to have real effects if it influences the real rate of
interest in the economy.
A ground-breaking paper by Robert Barro (1974)
looks at the choice between using taxes or government
bonds to finance a given level of government expenditures. Barro shows that changes in the mixture of taxes
and bonds chosen by the policy authority can have no
real effects—that is, that the different mixes may have
equivalent implications for the real economy. He labeled this situation "Ricardian equivalence."
The basic assumptions behind Barro's finding are
that in the long run the government budget has to be
balanced and that private savers will buy bonds only if
they know the bonds will eventually be paid off. Barro
also assumes that the government's financing choices
are limited to bonds and taxes. If, for example, the government were to reduce nondistorting taxes and issue
more bonds to finance its expenditures, private savers
would increase their savings in anticipation of the higher future taxes that would have to be levied to repay the
new bonds. The increased savings could be channeled
toward the purchase of the new bonds, allowing real
interest rates to remain unchanged. This mechanism illustrates h o w the government financing scheme m a y
affect the timing of savings but not the total amount of
consumption or investment in the economy.
Barro's (1974) paper was seminal for formally presenting, in a dynamic setting (a framework that recognizes the intertemporal nature of e c o n o m i c decision
making), a set of conditions under which the governm e n t ' s choice of bonds or taxes to finance expendit u r e s is i r r e l e v a n t (has n o real e f f e c t s ) . H o w e v e r ,
Barro's analysis failed to include n e w currency creation as a financing alternative. Stated differently, he
did not analyze the choices available to the government regarding its liability portfolio (its holdings of
g o v e r n m e n t securities and currency). This portfolio
can be modified through open market operations. In
particular, the monetary authority can purchase bonds
with newly created currency in an open market purchase, or it can sell b o n d s through an open market
sale. Implicitly, Barro assumes that monetary policy
does not depend on the state of the government debt.
S. Rao Aiyagari and Mark Gertler (1985) looked at
budget financing schemes involving different combinations of taxes, currency, and government bonds. When
they examined the economic implications of retiring
government obligations by either currency creation or
future taxes, they considered three cases. O n e was the
Econ oinicRevieu>
15
polar Ricardian case, in which all government obligations were retired via (backed by) future taxes. The other w a s t h e p o l a r n o n - R i c a r d i a n c a s e , in w h i c h all
government debt was retired by issuing currency. Between these was the situation in which government exp e n d i t u r e s a r e f i n a n c e d w i t h a m i x of t a x e s a n d
currency issues. Aiyagari and Gertler found that open
market operations have real effects except when current
issues of bonds are backed 100 percent by future taxes.
T h e q u e s t i o n of w h a t b a c k s the d e b t e x p l i c i t l y
highlights the links between fiscal and monetary policies. In Aiyagari and Gertler's words, "The backing of
the g o v e r n m e n t bonds is a m e a s u r e of the extent to
which fiscal policy a c c o m m o d a t e s monetary policy,
and vice versa" (1985, 38).
7Tie Effects of Open Market Operations
T h e I r r e l e v a n c e of O p e n M a r k e t O p e r a t i o n s :
T h e M o d i g l i a n i - M i l l e r T h e o r e m . M o n e t a r y policy
involves changes in the composition of the government's portfolio of assets and liabilities. This portfolio
is analogous in some ways to the liability portfolio of
a private f i r m . A c c o r d i n g to the M o d i g l i a n i - M i l l e r
theorem (discussed in Neil Wallace 1981), when markets are complete a firm's value is the same regardless
of h o w its liabilities are divided between equity and
debt; in other words, the composition of a firm's liability portfolio is irrelevant in determining a firm's value.
O n e w a y in w h i c h the c o m p o s i t i o n of the g o v e r n m e n t ' s liability portfolio can be changed is via open
market operations. Just as swaps of debt and equity
may not matter to the value of a private firm, swaps of
bonds and currency m a y not change real interest rates
in the economy.
A p p l y i n g the M o d i g l i a n i - M i l l e r tradition to the
g o v e r n m e n t ' s liability structure, Wallace (1981) concentrates on monetary policy experiments. His work
emphasizes the microeconomic foundations of macroeconomic policy prescriptions. In Wallace's model the
g o v e r n m e n t ' s asset portfolio consists of physical assets and its liability portfolio is composed of currency.
O p e n market operations are defined as purchases of
real assets with currency or vice versa. 3 By engaging
in open market operations, the monetary authority can
affect the aggregate budget deficit, the distribution of
future taxes, and the budget constraints to which the
e c o n o m i c agents, like the g o v e r n m e n t , are subject.
Only if policies have no net effect on the budget constraints of economic agents would one expect to ob-
Economic
16
Review
serve unchanged purchasing power and consumption
patterns. In Wallace's analysis, fiscal p o l i c y — w h i c h
he identifies as the budget deficit, net of interest paym e n t s — i s t a k e n as g i v e n . A u x i l i a r y r e d i s t r i b u t i v e
m e c h a n i s m s keep agents' budget constraints unchanged across different government portfolio choices. U n d e r t h e s e a s s u m p t i o n s , his m o d e l g e n e r a t e s
irrelevance of open market operations. 4
Should it be inferred from this type of model that
open market operations do not matter and, if monetary
policy is identified with open market operations, that
monetary policy does not matter? O n e feature these
m o d e l s share is their a s s u m p t i o n that c u r r e n c y and
g o v e r n m e n t b o n d s , the t w o t y p e s of liabilities that
constitute the government's portfolio, yield the same
real rate of return to the holder. In economists' terms,
the models assume that bonds do not dominate currency in rate of return. This assumption is clearly at odds
with the facts. Would a $100 bill stored in a drawer for
three m o n t h s yield the s a m e real rate of return as a
three-month Treasury bill that costs $100?
The value of these models rests on the fact that they
provide a b e n c h m a r k — a benchmark that indicates that
under some conditions, however unrealistic, open
market operations are irrelevant. It is then important to
inquire what role these conditions play and why they
may not hold.
W h e n O p e n M a r k e t O p e r a t i o n s M a t t e r . In a
1985 paper, Wallace examines the effects of Barro's
(1983) definition of open market operations. Barro describes the exchange of government bonds for currency
as a combination of two policies. The first policy involves issuing currency and reducing current taxes by
the same magnitude. T h e second policy involves raising taxes by the same amount and buying government
bonds with the additional tax revenues. These policies
leave the level of taxes unchanged but cause the quantities of currency and bonds to m o v e in opposite directions. Wallace notes that these two policies constitute a
pair of offsetting Ricardian experiments. In each case,
Wallace's model would predict that the change in the
government deficit has no real effects, so this sort of
open market operation is irrelevant. Wallace also notes
that in Barro's setting, without any further assumptions
about transactions frictions (assumptions that might
help explain rate-of-return dominance), currency and
bonds must yield the same rate of return.
Wallace discusses open market operations in t w o
alternative settings that provide such friction. In the
first, currency has intrinsic value: it provides services
similar to the commodities consumed. Taken literally,
this is of course an inadequate description of currency's
September/October 1991
use. However, it is a convenient way to try to capture
the notion that currency provides a stream of consumable services. T h i s d e v i c e helps to e x p l a i n the o b served rate-of-return dominance; although bonds offer
a higher rate of return, people will still choose to hold
some currency. The other setting imposes a transaction
restriction that requires the use of currency in each
transaction involving savings. This version is also an
extreme characterization of the role of currency in society, but it nonetheless may be a useful device to obtain r a t e - o f - r e t u r n d o m i n a n c e . W a l l a c e s h o w s that
these models deliver both Ricardian equivalence and
irrelevance of Barro-style open market operations.
Wallace also describes some alternative models in
which legal restrictions on private intermediation (for
example, the imposition of reserve requirements on
commercial banks) generate rate-of-return dominance.
In these models, Ricardian equivalence does not hold,
and open market operations have real effects. Because
Wallace views legal restrictions as the best vehicle for
modeling rate-of-return dominance, he concludes that,
in general, Ricardian equivalence is not c o m p a t i b l e
with rate-of-return dominance.
Stylized Policy Problems
This section explores models that constitute a relatively new approach to monetary policy and in which
alternative policy experiments can be p e r f o r m e d . In
these models open market operations matter, and the
u n d e r l y i n g a s s u m p t i o n is that t h e r e is a c o n s t a n t
deficit to be financed forever. Not all issues of bonds
are assumed to be "backed" by future taxes. In Aiyagari and G e r t l e r ' s terminology, m o n e t a r y policy accommodates fiscal policy.
Inflationary Implications of a Tight M o n e t a r y
Policy. T h o m a s J. Sargent and Wallace's (1981) work
is a m o n g the most controversial in the literature because of its policy implications. T h e authors analyzed
the c o n s e q u e n c e s of f i n a n c i n g a g i v e n g o v e r n m e n t
deficit exclusively with u n b a c k e d bonds. T h e basic
conclusion of their research is that in an economy in
w h i c h the real rate of i n t e r e s t e x c e e d s t h e rate of
growth of the economy, the monetary authority's apparent choice about whether or not to monetize a given government deficit is not in fact a real one; the real
choice is when to monetize, not whether to do so. T h e
logic behind this conclusion rests on the fact that when
the real rate of interest exceeds the rate of growth in
the economy, bonds cannot be rolled over indefinitely;
Reserve Bank of Atlanta
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eventually the size of the debt will outstrip the econom y ' s ability to pay off the rolled-over debt. W h e n taxes are not part of the menu of alternative government
financing sources, monetizing later rather than earlier
increases the cost of debt service and thus the amount
by which the monetary authority will have to monetize
in the future. Therefore, the longer monetization is delayed, the m o r e inflationary it becomes. Sargent and
Wallace's assumption that the real rate of interest exceeds the rate of growth of the U.S. economy has been
challenged as unrealistic (see Michael R. Darby 1984).
Welfare Implications of S o m e Alternative Monetary Policies. M a n y analyses of monetary policy have
sought to find the " o p t i m a l " policy. As Wallace has
observed, " T h e presumption seems to be that there is a
unique best policy for the Fed to follow and the Fed's
problem is to find it" (1984, 15). Wallace explores that
association in a model that captures some basic features of real economies.
W h a t elements are desirable for a model that will
examine the question of what the effects of alternative
monetary policies would be among different groups of
agents? Implicit in W a l l a c e ' s (1984) description of
what is expected f r o m the monetary authority is the
notion that monetary policy is not irrelevant—that is,
the monetary authority's actions have real effects. The
discussion above illustrates that under some assumptions open market operations, the basic instrument of
monetary policy, have real effects. A particular case in
which real effects are likely to occur in this specific
type of model is w h e n monetary policy is at least partly subordinated to fiscal p o l i c y — w h e n the fiscal authority does not back its debt 100 percent with future
taxes but expects the monetary authority to monetize
part of its debt.
W a l l a c e is also interested in g e n e r a t i n g r a t e - o f return dominance, so his choices lie a m o n g models in
which currency has intrinsic value, models in which
its use is enforced in every economic transaction, and
models in which it is held because of some legal restriction. As discussed above, Wallace views legal restrictions as the natural choice among these options. 5
Finally, in Wallace's model some agents are "savers,"
others are "borrowers," and others are endowed with
currency or bonds denominated in currency. Borrowers in this model borrow f r o m private intermediaries,
and savers hold deposits of these reserve-holding intermediaries.
In Wallace's model, all borrowing and lending is
assumed to be intermediated by commercial banks that
o p e r a t e competitively. T h e s e b a n k s are required t o
hold currency reserves equal, at a m i n i m u m , to a fixed
Econ oinicRevieu>
17
positive fraction of their total liabilities (deposits). The
banks lend to borrowers or the government at the market rate of interest and accept deposits from savers to
w h o m they pay the weighted average of the rate of return on loans and the rate of return to currency.
It is a s s u m e d that g o v e r n m e n t bonds and private
loans compete on equal footing in the credit market.
While it can be argued that private loans do not compete on the same basis because, for example, bonds
are risk-free and private loans are not, it is feasible to
think in terms of a kind of mutual f u n d that could put
together a virtually risk-free portfolio for private
loans. In any event, Wallace's interest here is in highlighting the fact that the government, like many other
borrowers, competes for savings in the market. 6
W a l l a c e s h o w e d that a t i g h t e r m o n e t a r y p o l i c y
hurts borrowers, who end up facing a higher real rate
of interest, and benefits the initial holders of currency
or bonds by enhancing the purchasing power of their
assets. Its impact on savers is ambiguous: the return
on their deposits is the weighted average of the rate of
return on currency and bonds, and these rates m o v e in
opposite directions. Clearly, monetary policy cannot
be designed to make everybody happy.
I n f l a t i o n a r y I m p l i c a t i o n s of S o m e A l t e r n a t i v e
M o n e t a r y Policies. T h e M o n e t a r y C o n t r o l Act of
1980 gave the Federal Reserve System responsibility
for e s t a b l i s h i n g required reserve ratios f o r a broad
range of transactions deposits issued by all depository
institutions. In addition, in 1984 the System returned
to something very close to contemporaneous reserve
accounting. 7 A l t h o u g h in recent history reserve requirements—the requirement that commercial banks
h o l d a f r a c t i o n of t h e i r c u s t o m e r s ' d e p o s i t s in a
noninterest-bearing account at the central b a n k — h a v e
not been used as a monetary policy instrument, legislative and regulatory changes have created conditions u n d e r w h i c h the required r e s e r v e ratio could
acquire a more active monetary policy instrument role.
M a r c o E s p i n o s a and S t e v e n R u s s e l l ( 1 9 9 1 ) u s e
Wallace's model to analyze a situation in which the
monetary authority can choose between two policy instruments: the required reserve ratio, which can b e
c h a n g e d directly, and the ratio of nominal bonds to
nominal currency, which can be changed through
open market operations. Because in practice the m o n etary authority is also concerned about inflation, the
a u t h o r s s e e k to c o m p a r e t h e i n f l a t i o n a r y c o n s e quences of reducing real interest rates via these two
instruments. 8 It is assumed that the monetary authorities view the initial level of real interest rates as "too
high" and target a lower real interest rate. Policy ex-
Economic Review
18
periments involving simultaneous changes in both instruments are not examined.
Like Wallace (1984), Espinosa and Russell (1991)
want to capture rate-of-return dominance. The model
should also be one in which open market operations
matter and reserve r e q u i r e m e n t s can play an active
role. W a l l a c e ' s (1984) m o d e l is f l e x i b l e e n o u g h to
i n c o r p o r a t e all these f e a t u r e s in a d d i t i o n to b e i n g
tractable. Also, although Wallace introduces reserve
requirements, he does not look at them as a policy instrument. Espinosa and Russell examine the implications of using the required reserve ratio as an active
policy instrument.
In his analysis, Wallace concentrated on cases in
which the real interest rate is greater than the growth
rate of the economy. At the time Wallace was writing,
the United States had just experienced a period during
w h i c h real interest rates consistently e x c e e d e d real
growth rates. Wallace found that the effects of open
market operations were often perverse, in the sense
that open market purchases reduce both the real rate of
interest and the rate of inflation. Historically, real interest rates have been lower than the real growth rates.
T h e r e f o r e , a n o t h e r c h a r a c t e r i s t i c d e s i r e d is for the
model to be capable of delivering an equilibrium real
rate of interest lower than the rate of growth in the
e c o n o m y . T h e assumption underlying E s p i n o s a and
Russell's research is that the monetary authority does
not face perverse circumstances. It is their view that
the relationship between interest rates and inflation envisioned by many policymakers and economists is a
trade-off between lower interest rates and higher inflation rates. Any m o v e to ease credit conditions creates
inflationary pressures. T h e y label this trade-off the
"conventional wisdom." They therefore need to identif y specifications of Wallace's model that are consistent with this position.
In E s p i n o s a and R u s s e l l ' s m o d e l , as long as the
monetary authority permanently issues currency, the
inflation rate will be positive. The real rate of interest,
on the o t h e r h a n d , m a y be less t h a n , e q u a l to, or
greater than zero, depending on the state of the credit
market. The real value of the revenues the government
o b t a i n s f r o m c u r r e n c y g r o w t h is c a l l e d c u r r e n c y
"seignorage." Similarly, in this research the real value
of r e v e n u e s o b t a i n e d f r o m issuing b o n d s is called
bond seignorage. If the real rate of interest exceeds the
rate of growth in the economy, no seignorage revenue
can be extracted from the government bonds; in fact,
the bonds represent an extra financing burden.
It follows from the discussion above that real currency and real bond balances can be thought of as a
September/October 1991
" t a x " base. T h e difference between the rate of growth
in the economy and the rate of return to currency, and
the rate of growth in the economy and the gross real
rate of interest can be considered tax rates.
Given the fixed deficit, which it cannot modify, the
m o n e t a r y authority c h o o s e s the ratio of reserve requirements to be imposed on commercial banks and
chooses between currency and bonds (the bonds/currency ratio) for the composition of its portfolio. The
settings of these t w o variables describe monetary policy. Associated with each monetary policy are a real
rate of inflation and a real rate of interest in the economy. These adjust to clear the currency and credit markets and to allow the government to finance its deficit.
It is s u p p o s e d that the m o n e t a r y a u t h o r i t y a t tempts to reduce the real interest rate by reducing the
bonds/currency ratio (conducting an open market purchase), holding the required reserve ratio fixed. T h e
monetary authority can target a lower real rate of interest through open market purchases. However, the
effect on the inflation rate in the economy depends on
whether the case considered is perverse or conventional. W h e n the conventional wisdom holds—that is, under the set of conditions identified by Espinosa and
Russell—the inflation rate rises. If, on the other hand,
the e c o n o m y ' s state resembles that assumed by Wallace—a rate of interest higher than the rate of growth
in the e c o n o m y — t h e rate of inflation in the economy
will be lower.
T h e intuition b e h i n d these results is as f o l l o w s :
open market purchases have two effects, and these effects act in opposite directions. On one hand, an open
market purchase causes the rate paid on government
bonds to decline. On the other hand, the bond seignorage tax base—the real value of the government bonds
present in the e c o n o m y — i s reduced. W h e n the interest
rate in the economy is already low, the tax base effect
outweighs the tax rate effect. The resulting loss of income has to be made up from the alternative financing
s o u r c e — t h a t is, f r o m currency seignorage. It is the
need for higher currency seignorage that explains the
higher rate of inflation in the conventional case. In the
perverse case, the need for less currency seignorage
explains the deflationary result.
Espinosa and Russell show that under the assumptions of their model a lower reserve ratio always leads
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to a lower real rate of interest. If in addition the conventional wisdom holds, a lower required reserve ratio
leads to a higher rate of inflation. T h e model thus allows comparison of the inflationary e f f e c t s of open
market operations and reserve requirements.
Because their goal is to compare the magnitudes of
inflation rate increases that are associated with using
different monetary policy instruments to peg interest
rates at levels below their current ones, Espinosa and
Russell must ensure that each of the two rate-pegging
experiments whose results are compared begins at the
same position. Under these conditions they establish
that, w h e n the conventional wisdom holds, reducing
the real interest rate to a particular level by cutting the
required reserve ratio is always m o r e inflationary than
reducing the rate of interest to the same level via open
market purchases.
The basic intuition behind this result is as follows:
whenever the conventional wisdom holds, both conducting open market purchases and lowering reserve
requirements produce a net loss of revenue f r o m currency seignorage. However, because reducing the reserve ratio lowers the currency seignorage tax base,
the loss of revenue it produces is larger than the loss
produced by conducting an open market purchase.
Conclusion
Do monetary policies have real effects? The answer
to this question depends critically on the definitions of
monetary policy and of "money," and on assumptions
about the nature of the interaction of fiscal and monetary policies. The small sample of the monetary policy
literature examined here highlights these issues. T h e
examples of monetary policy analysis presented illustrate a m e t h o d o l o g y that f o r m a l l y s p e c i f i e s the ass u m p t i o n s p o s t u l a t e d w h e n a policy issue is u n d e r
c o n s i d e r a t i o n . A l t h o u g h the a s s u m p t i o n s m a d e by
these researchers can perhaps be challenged on any
n u m b e r of g r o u n d s , the model is at least internally
consistent. The fact that such consistency often cannot
be found in many informal policy recommendations
points to the value of formal modeling in the process
of policy analysis.
Econ oinicRevieu>
19
Notes
1. See Greider (1987, 60).
2. It is, of course, possible to envision e n v i r o n m e n t s in which
m o n e t a r y p o l i c y h a s n o real e f f e c t s . M a n y e c o n o m i s t s
think that monetary policy has e f f e c t s only in the short run
or no e f f e c t s at all. See, for e x a m p l e , Linden (1991) and
the section on the irrelevance of open market operations in
this article.
3. The reader will notice that this definition of open market operations differs f r o m the definition provided above. However, it can be shown that a government intermediation of the
kind described in Wallace is irrelevant, so open market operations as conventionally defined will be irrelevant. See Sargent (1987, chapter 8) for details.
4. Chamley and Polemarchakis (1984) m o d i f y some of Wallace's auxiliary redistributive mechanisms and show that under weaker assumptions a similar irrelevance result occurs.
This and other related papers display different versions of irrelevance in the Modigliani-Miller tradition. W h a t varies
among the versions is the particular consumption allocation
and price sequences held fixed across alternative financing
schemes and the set of auxiliary redistribution assumptions.
5. See Wallace (1986) for a detailed explanation.
6. Note that the aggregate dissavings ( c o n s u m p t i o n that exceeds current income) of private borrowers at any given date
depends on the interest rate paid in the credit market while
the aggregate savings function of private savers at any given
date depends on the rate paid on deposits.
7. See, for example, Rosenbaum (1984) for a detailed description.
8. Espinosa and Russell (1991) also deal with the case in which
the monetary authority is interested in targeting the nominal
interest rate.
References
Aiyagari, S. Rao, and Mark Gertler. " T h e Backing of Government Bonds and Monetarism." Journal of Monetary
Economics 16(1985): 19-44.
Barro, Robert. "Are Government Bonds Net Wealth?" Journal
of Political Economy 82, no. 6 (1974): 1095-1117.
. Macroeconomics.
N e w York: John Wiley and Sons,
1983.
C h a m l e y , Christophe, and Herakles Polemarchakis. "Assets,
General Equilibrium and the Neutrality of Money." Review
of Economic Studies 51 (January 1984): 129-38.
Darby, Michael R. " S o m e Pleasant Monetarist A r i t h m e t i c . "
Federal Reserve Bank of Minneapolis Quarterly Review 8
(Spring 1984): 15-19.
Espinosa, Marco, and Steven Russell. "The Inflationary Implications of Reducing Market Interest Rates via Alternative
Monetary Policy Instruments." Federal Reserve Bank of Atlanta Working Paper 91-1, February 1991.
G r e i d e r , W i l l i a m . " T h e Price of M o n e y . " The New
Yorker,
November 9, 1987,54-112.
L i n d e n , D a n a W e c h s l e r . " A T o u c h of the Invisible H a n d . "
Forbes, May 27, 1991, 136-37.
Economic Review
20
R o s e n b a u m , M a r y . " C o n t e m p o r a n e o u s Reserve Accounting:
The New System and Its Implication for Monetary Policy."
F e d e r a l R e s e r v e B a n k of A t l a n t a Economic
Review 69
(April 1984): 46-57.
Sargent, T h o m a s J. Dynamic Macroeconomic
Theory. C a m bridge, Mass.: Harvard University Press, 1987.
Sargent, Thomas J., and Neil Wallace. " S o m e Unpleasant Monetarist Arithmetic." Federal Reserve Bank of Minneapolis
Quarterly Review 5 (Fall 1981): 1-17.
Wallace, Neil. " A Modigliani-Miller Theorem for Open-Market
Operations." American Economic Review 71 (June 1981):
267-74.
. " S o m e of the Choices for Monetary Policy." Federal
Reserve Bank of Minneapolis Quarterly Review 8 (Winter
1984): 15-24.
. "Ricardian Equivalence and Money Dominated in Return: A r e They Mutually Consistent G e n e r a l l y ? " Federal
Reserve Bank of Minneapolis, Staff Report 99, 1985.
. " T h e Relevance of Legal Restrictions T h e o r y . " Cato
Journal
6 (Fall 1986): 613-16.
September/October 1991
1FÏÏÏÏ
Monetary Union:
How Close Is It?
Michael J. Chriszt
The author is an economic
analyst in the
macropolicy
section of the Atlanta
Fed's
research department. He is
grateful to Jan Boucher
and Mary Rosenhaum
for
guidance and to Mary
Mathewes-Kassis
and Jeff
Watson for
assistance.
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
any attempts to establish m o n e t a r y unions across national
borders have failed, but a f e w successful unions still exist today. 1 A m o n e t a r y union is a f o r m a l a r r a n g e m e n t in which
t w o or m o r e i n d e p e n d e n t c o u n t r i e s a g r e e to fix their e x change rates or to employ only one currency to carry out all
transactions. One of the most ambitious efforts to date is now under way in
the European Community (EC, or the Community), whose twelve m e m b e r
countries are striving toward European Monetary Union (EMU). 2 W h e n
full union is achieved, these nations, which account for nearly 4 0 percent
of world trade, will carry out transactions with one currency through one
central bank and will be subject to one monetary policy. 3 O n e big obstacle
to European Monetary Union is that it will require E C m e m b e r states to
f o r g o national m o n e t a r y policies, instead subordinating t h e m s e l v e s to a
single monetary policy concerned with the interests of the European C o m munity at large.
The E C ' s readiness to establish monetary union owes m u c h to the European Monetary System ( E M S ) and, in particular, its exchange rate mechanism ( E R M ) . Established in 1979, the E M S has provided e x c h a n g e rate
stability and the d e g r e e of e c o n o m i c c o n v e r g e n c e a m o n g E C m e m b e r
states necessary as a foundation for full monetary union. The purpose of
this article is to explain the development of the European Monetary System, describe h o w its exchange rate m e c h a n i s m works, and recount the
E C ' s recent moves in the direction of monetary union.
Econ oinicRevieu>
21
A Rationale for Fixed Exchange
Rates and Monetary Union
.Evolution of the European
Monetary System
From a nation's point of view, there are economic
and political reasons both f o r and against p u r s u i n g
monetary union. O n e widely held explanation of why
independent nations w o u l d c h o o s e to adopt a fixed
exchange rate regime is that doing so has a n u m b e r of
positive w e l f a r e e f f e c t s . 4 A currency union can increase and stabilize the income level within a country
by r e d u c i n g uncertainty s u r r o u n d i n g its c u r r e n c y ' s
value. The fact that the zone of fixed exchange rates
can be considered as one entity for purposes of producing goods and services allows resources to be allocated
more efficiently. In addition, fixed rates may promote
price stability because r a n d o m shocks can be better
absorbed by a group of countries with a broader, more
diverse p r o d u c t i o n base (natural r e s o u r c e s , capital,
and labor) than by a single country's economy. Moreover, eliminating individual countries' potential use of
exchange rate management as a nontariff trade barrier
should increase economic efficiency over the longer
run. The fact that the need for foreign exchange transactions is reduced in a currency union also helps its
m e m b e r countries save the resources they would otherwise use for foreign exchange market transactions.
The concept of economic and monetary union is inherent in the Treaty of R o m e , establishing the European Economic Community in 1957. The treaty states
that "the Community shall have as its task, by establishing a c o m m o n market and progressively approximating the economic policies of m e m b e r states, . . . a
h a r m o n i o u s d e v e l o p m e n t of e c o n o m i c a c t i v i t i e s "
("Treaty Establishing the European E c o n o m i c C o m m u n i t y " 1987, 125). This idea was expanded in the
Single European Act of 1987, which states that to "ensure the convergence of economic and monetary policies which is necessary for the further development of
the Community, m e m b e r states shall . . . take account
of the experience acquired in cooperation within the
f r a m e w o r k of the European Monetary System" ("Single European A c t " 1987, 549). E c o n o m i c " c o n v e r gence" has been identified with the improvement and
cooperation necessary to harmonize living and working conditions in all E C m e m b e r states (Horst Ungerer
et al. 1990). The European Monetary System and the
Exchange Rate Mechanism can be viewed as a means
to achieve convergence, which is a necessary condition for economic and monetary union.
Countries may use monetary union or steps toward
it to f u r t h e r p o l i t i c a l g o a l s . E s t a b l i s h i n g a u n i o n
w o u l d o f f s e t the i n f l u e n c e of a larger c o u n t r y that
might be b r o u g h t into the g r o u p , in e f f e c t diluting
the larger n a t i o n ' s e c o n o m i c p o w e r through the coll e c t i v e p o l i t i c a l p o w e r of the u n i o n p a r t i c i p a n t s '
shared e c o n o m i c objectives, in addition, each of the
m e m b e r nations, even the more d o m i n a n t ones,
w o u l d gain e c o n o m i c i n f l u e n c e vis-a-vis c o u n t r i e s
outside the union merely by being part of a f e d e r a tion that is s t r o n g e r than any o n e m e m b e r n a t i o n .
Formal bonds a m o n g union m e m b e r s would also reduce the likelihood of a large outside state's d o m i n a t i n g e i t h e r t h e u n i o n as a w h o l e or any s i n g l e
m e m b e r country.
At the E C ' s inception, monetary unification was
not an issue: the international monetary system was
w o r k i n g well in 1958. During the 1960s, h o w e v e r ,
dollar and international payments crises led E C leaders to give serious consideration to formal monetary
integration. Large fluctuations in m e m b e r states' exchange rates were beginning to jeopardize gains f r o m
earlier progress toward more efficient and profitable
commercial transactions a m o n g m e m b e r s ; monetary
cooperation and integration began to seem essential if
the economic benefits of being an E C m e m b e r were
to be preserved and fostered.
However, monetary union also carries costs for its
members. The most fundamental potential cost has to
do with agreeing to a fixed exchange rate. By floating
its exchange rate, a country can use its currency's value as a policy instrument, actively influencing or pass i v e l y a l l o w i n g a p p r e c i a t i o n or d e p r e c i a t i o n . A s
mentioned earlier, monetary union requires that an individual country relinquish control over its exchange
rate, thereby abandoning an important tool for maintaining economic and political sovereignty.
Economic
22
Review
Community heads of state initiated efforts to establish a monetary union in 1969, asking the E C C o m mission to prepare a plan for economic and monetary
union. The resulting blueprint, known as the Werner
Report (after L u x e m b o u r g ' s Prime Minister Manfred
Werner), concluded that the first step would be to reduce e x c h a n g e rate fluctuations a m o n g m e m b e r
states. Complete monetary union was scheduled to be
in effect by 1980.
The E C ' s initial approach to exchange rate stabilization was structured within the Bretton Woods system (established by delegates f r o m m a n y nations in
1945 at Bretton Woods, N e w Hampshire, at a confer-
September/October 1991
ence to plan postwar economic arrangements). Bretton Woods required participating countries to maintain their c u r r e n c i e s ' e x c h a n g e rates within a 1
percent range against the U.S. dollar, w h o s e v a l u e
was fixed to gold at $35 per o u n c e . U n d e r this arrangement, E C currencies were held within 2 percent
of each other. The Bretton Woods system collapsed in
1971, however. A new international monetary agreem e n t — t h e S m i t h s o n i a n A c c o r d — e m e r g e d later the
s a m e year, a l l o w i n g c u r r e n c i e s to vary 4.5 percent
against the dollar. T h i s arrangement meant that E C
currencies could m o v e as much as 9 percent against
other m e m b e r s ' monies.
This range was considered by some E C countries
to be too wide and unstable. To regain exchange rate
stability, B e l g i u m , L u x e m b o u r g , F r a n c e , Italy, the
Netherlands, and West Germany devised the European
Joint Float A g r e e m e n t in April 1972. This arrangement involved maintaining 2.25 percent fluctuation
margins around established rates for E C currencies,
while permitting the 4.5 percent margins against the
U.S. dollar established by the Smithsonian Accord.
The Joint Float is better k n o w n as "the snake in the
tunnel." If the exchange rates between each E C curr e n c y and the U.S. d o l l a r were c h a r t e d o v e r time
and the charts o v e r l a i d e a c h other, the i m a g e of a
snake w o u l d appear: the e x c h a n g e rates a m o n g E C
m e m b e r s would fluctuate within a narrow band (the
snake's body) that would never exceed 2.25 percent
in width, while the body would squirm up and down
in relation to the dollar within a 4.5 percent band (the
tunnel) (Richard W. E d w a r d s 1985, 537). When the
S m i t h s o n i a n a g r e e m e n t w a s a b a n d o n e d in M a r c h
1973 and e x c h a n g e rates were allowed to float, the
snake lost its tunnel; the 2.25 percent margins were
maintained, however, among E C currencies.
T h e Joint Float was meant to e n c o m p a s s all E C
currencies, but within two years of its inception five
of the E C ' s m e m b e r s — D e n m a r k , F r a n c e , I r e l a n d ,
Italy, and the United K i n g d o m — h a d withdrawn for a
variety of reasons. The e c o n o m i c turbulence of the
1970s and the limited progress toward economic and
monetary convergence m a d e keeping these m e m b e r s '
currencies within the 2.25 percent b a n d unfeasible.
T h e r e were various unsuccessful attempts to restore
these parameters throughout the decade, but E C leaders realized that the Joint Float guidelines could not
a c h i e v e e x c h a n g e rate s t a b i l i t y . F o r the m o m e n t ,
plans to establish a monetary union were shelved.
T w o m a i n f a c t o r s m a y explain w h y m o v e m e n t s
toward European Monetary Union failed at first. O n e
significant development was the introduction of the
Federal
Reserve Bank of Atlanta
a m b i t i o u s Werner Plan at a time of turmoil for the
w o r l d ' s e c o n o m i e s . T h e collapse of Bretton W o o d s
and the oil crisis of 1973 created t r e m e n d o u s pressures—strains that could not be addressed without affecting exchange rates. Besides these external forces,
among themselves m e m b e r states failed to coordinate
domestic macroeconomic policies to the extent necessary to bring about e c o n o m i c c o n v e r g e n c e ( D e n n i s
S w a n n 1984).
Establishment of the
European Monetary System
T h e E u r o p e a n M o n e t a r y S y s t e m s u c c e e d e d the
Joint Float as a monetary plan in 1978 but did not
begin f o r m a l operations until M a r c h 1979. All E C
c o u n t r i e s at t h e t i m e b e c a m e p a r t i c i p a n t s in the
E M S , although the Italian lire was allowed a wider
fluctuation margin; Britain c h o s e not to participate
in any of the arrangements, apart f r o m actual m e m bership, largely because of fears about losing monetary sovereignty.
The goal of the European Monetary System was to
establish a greater measure of monetary and exchange
rate stability in the Community. Its designers regarded
the E M S as a central ingredient of a more complete
strategy aimed at lasting economic growth and stability, a return to full employment, the harmonization of
living standards, and a lessening of the E C ' s regional
disparities ( " E u r o p e a n C o u n c i l R e s o l u t i o n " 1978).
Community leaders saw the E M S as a route to an effective long-term program for close economic cooperation and a zone of monetary stability—requirements
for monetary union.
The E M S included an exchange rate mechanism to
stabilize movements among E C currencies. The system
also established financing arrangements to fund intervention in the currency markets as well as consultation
procedures to ensure cooperation and clarity a m o n g
E C states' m o n e t a r y policies. Finally, the European
Currency Unit ( E C U ) was installed as the exchange
rate m e c h a n i s m ' s denominator, or " b e n c h m a r k . "
All E C m e m b e r states embrace the European M o n etary System, but not all participate in its exchange
rate m e c h a n i s m . For instance, Portugal and G r e e c e
have access to the ECU and its benefits because they
belong to the E M S , but neither country fixes its exchange rate to the E C U — a requirement for E R M participation. The United Kingdom remained outside the
E R M until October 1990.
Econ o in ic Revieu>
23
How t h e Exchange Rate
Mechanism Works
The European Currency Unit serves as the basis for
determining e x c h a n g e rate parities, or central rates,
a m o n g E M S m e m b e r s . T h e E C U c a n b e s t be d e scribed as a basket m a d e up of fixed amounts of all
E C currencies. Each currency's weight is decided by
the relative importance of that country's G N P in total
C o m m u n i t y o u t p u t and t h e o v e r a l l s h a r e of e a c h
state's intra-EC trade. Weights are normally revised
every five years. See Table 1 for the current composition of the ECU.
Table 1
Composition of the E C U
Weight
(percent)
Currency
Belgian/Luxembourg Franc
French Franc
Lira
Guilder
Mark
Danish Krone
Punt
Peseta
Drachma
Pound Sterling
Escudo
8.1
19.3
9.7
9.6
30.4
2.5
1.1
5.2
0.7
12.6
0.8
Source: Commission of the European Community.
In a d d i t i o n to p o s s e s s i n g b i l a t e r a l c e n t r a l r a t e s
against each other, every E M S currency has a central
r a t e a g a i n s t t h e E C U . F o r e x a m p l e , the d e u t s c h e
mark's central rate against the French franc is F F 3.35,
and its E C U central rate is E C U 2.06. Table 2 shows
official cross and E C U rates used to track currency
fluctuations in the E M S .
M a x i m u m d e v i a t i o n s f r o m b i l a t e r a l p a r i t y grid
rates permitted in the E M S agreement are defined by
i n t e r v e n t i o n p o i n t s that are 2 . 2 5 p e r c e n t a b o v e or
b e l o w e a c h bilateral central rate. 5 For e x a m p l e , if
the mark strengthens against the f r a n c , its upper limit in relation to the French currency would be roughly
F F 3.43 [(3.35 x .0225) + 3.35]. Should the mark depreciate against the f r a n c , the lower limit would be
F F 3.27 [3.35 - (3.35 x .0225)1.
Economic
24
Review
T h e European Council Resolution establishing the
E M S states, "Intervention in participating currencies is
compulsory when the intervention points defined by the
fluctuation margins are reached" ("European Council
Resolution" 1978, 10). W h e n this occurs, the central
banks involved must engage in reciprocal buying and
selling of their currencies on the exchange markets. For
example, if the mark appreciates to a standing at FF 3.43,
the Bundesbank must sell marks in exchange for francs
and the Banque de France must buy francs for marks.
A l t h o u g h central b a n k s usually m a k e f o r e i g n exc h a n g e market interventions in participating currencies, early i n t e r v e n t i o n s — b e f o r e c o m p u l s o r y intervention limits are reached—are often made using third
currencies, especially the U.S. dollar. Rather than letting their currencies fluctuate within the entire allowable range, the authorities in some E M S countries try
to maintain their currencies' position within a narrower band. Carrying out the more frequent interventions
necessary to remain within these self-imposed margins
using E M S currencies would be a c u m b e r s o m e process for the central bank of the country maintaining its
narrow margins; each intervention would require consulting with the central banks whose currencies would
be involved in the transaction. B e c a u s e the U n i t e d
States has not required any such concurrence involving foreign exchange intervention, a large part of intramarginal E M S interventions are made in dollars. In
addition, because the dollar is a leading reserve currency, E M S central banks usually have ample dollar
reserves with which to carry out interventions.
The E M S includes a device to ensure that one currency's strength or weakness does not put unmanageable strain on the system. This "divergence indicator"
measures a currency's deviation f r o m all parity grid
rates by comparing the currency's exchange rate with
its E C U central rate. If a currency deviates from the
central rate by three-fourths of its permitted fluctuation range, it has crossed a "threshold of divergence"
("European Council Resolution" 1978, 10). According to the European Council Resolution,
W h e n a c u r r e n c y c r o s s e s its " t h r e s h o l d o f d i v e r g e n c e , " this results in a p r e s u m p t i o n that the a u t h o r i ties c o n c e r n e d will correct the situation by a d e q u a t e
measures, namely:
(a) d i v e r s i f i e d intervention;
(b) m e a s u r e s of d o m e s t i c m o n e t a r y policy;
(c) c h a n g e s in central rates; 6
(d) o t h e r m e a s u r e s of e c o n o m i c policy.
( " E u r o p e a n C o u n c i l R e s o l u t i o n " 1978, 10)
September/October 1991
W h e n a c u r r e n c y r e a c h e s its threshold of divergence against its E C U rate, only the issuer of that currency must take corrective action. (The E M S provides
credit facilities for m e m b e r s with insufficient foreign
reserves.) The divergence indicator is a signal for policy action to c o m m e n c e . If the central bank in question refuses to take adequate measures, it must give
reasons for its inaction to other E M S central banks.
Further consultations will, if necessary, take place in
the appropriate European Community bodies in order
to alleviate the situation.
.Recent Moves toward
European Monetary Union
Although economic and monetary cooperation and
union were alluded to in the E C ' s establishing treaty,
m e m b e r states were unwilling to embrace any m a j o r
c o m m i t m e n t to this goal before the late 1980s. The
M a d r i d s u m m i t in June 1989 u n a n i m o u s l y adopted
the first phase of a three-phase plan by Jacques Delors, President of the European Commission, to push
the E C toward economic and monetary union.
The first phase calls for closer cooperation between
m e m b e r state governments in economic and monetary
policy. Phase Two foresees the establishment of new
Community institutions, including the European System of Central Banks (see the box on page 6 for a detailed look at the envisioned E C central bank), and
Phase T h r e e would institute a single currency and a
single monetary policy decided and implemented by
the E C central bank.
T h e C o m m u n i t y is in P h a s e O n e n o w ; c o n f l i c t
over timing and implementation has impeded
progress on Phases T w o and Three. At the October
1990 summit in R o m e , however, eleven of twelve E C
heads of state approved a text establishing a timetable
for the final phase, with only Britain's Prime Minister Margaret Thatcher dissenting. T h e text states that
on January 1, 1994, the agreed-upon start for the second phase, a new C o m m u n i t y institution will be established to strengthen the coordination of monetary
policies, to d e v e l o p the instruments and procedures
needed for the f u t u r e conduct of a single m o n e t a r y
p o l i c y , a n d to o v e r s e e d e v e l o p m e n t of t h e E C U .
Within three years f r o m the start of the second phase,
the European C o m m i s s i o n and the council of the new
monetary institution will report on progress m a d e so
that provisions can be arranged for the start of the
third phase.
Federal
Reserve Bank of Atlanta
Table 2
European M o n e t a r y System Rates as of July 1 , 1 9 9 1 *
Spot
ECU
Position versus
Weakest ERM Currency
(percent)
128.490
114.02
Peseta
42.0674
37.33
Belgian Franc
1528.08
1356.00
Lira
2.3175
2.0565
Guilder
0.6976
1.6155
Pound Sterling
2.0583
1.8265
Mark
0.7692
1.4650
Punt
7.8923
7.0035
Danish Krone
6.9705
6.1855
French Franc
5.14
1.90
1.77
1.05
1.00
0.97
0.86
0.45
0.00
* Comparisons of individual currencies within the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). The first two
columns of figures show conversion rates per dollar (except the pound
sterling, which is expressed in dollars per pound) and the European Currency Unit (ECU), respectively. Column three shows the position of each
against the weakest ERM currency.
Source: Reuters News Service.
R e c e n t d e v e l o p m e n t s m a y h a v e m a d e the R o m e
summit's timetable appear too ambitious. The
p a i n f u l e c o n o m i c a d j u s t m e n t s r e q u i r e d by the f o r mer East G e r m a n y f o l l o w i n g G e r m a n e c o n o m i c and
monetary union h a v e shown C o m m u n i t y leaders that
a European-wide monetary union may have some
perils, e s p e c i a l l y f o r the c o u n t r i e s that are not as
economically well-off. T h e initial impact of the Persian Gulf crisis and its e f f e c t on oil prices also rem i n d e d E C m e m b e r s that c o o r d i n a t i o n is d i f f i c u l t
during times of e c o n o m i c distress, when it is tempting to use sovereign discretionary policies to address
domestic conditions. The current work of E C leaders
forging E M U is now focused m o r e on fostering economic and monetary convergence within the C o m m u nity, rather than establishing schedules for eventual
union.
T h e o u t c o m e of the J u n e 1991 E u r o p e a n C o u n c i l
s u m m i t leaves the t w e l v e E C m e m b e r s f a c i n g d i f f i cult n e g o t i a t i o n s on e c o n o m i c and m o n e t a r y union.
T h e m e m b e r s h a v e not r e a c h e d a g r e e m e n t on the
f u t u r e s h a p e of the E u r o p e a n C o m m u n i t y and o n
h o w m u c h s o v e r e i g n t y they should h a v e to r e l i n quish to a c h i e v e m o n e t a r y union. T h e E C s u m m i t ' s
o f f i c i a l c o m m u n i q u é said that at the next E u r o p e a n
C o u n c i l s u m m i t , in D e c e m b e r 1991, the d r a f t texts,
Econ oinicRevieu>
25
The Proposed European Central Bank
A c o m m o n central bank has been d e e m e d crucial f o r
p o l i c y will be c a r r i e d out w i t h o u t r e g a r d to o t h e r C o m -
the E u r o p e a n C o m m u n i t y to a c h i e v e its established goal
m u n i t y e c o n o m i c p o l i c y o b j e c t i v e s . T h e s y s t e m will
of m o n e t a r y union. T o this e n d , a c o m m i t t e e of E C c e n -
also support the C o m m u n i t y ' s general e c o n o m i c pol-
tral bank g o v e r n o r s — t h e c o u n t e r p a r t s to the c h a i r m a n of
icy as e s t a b l i s h e d by the relevant E C institutions.
the F e d e r a l R e s e r v e S y s t e m — d r a f t e d statutes in N o v e m -
The statutes' authors hope to ensure the E C B ' s
ber 1990 f o r the E u r o p e a n S y s t e m of Central B a n k s and
d e m o c r a t i c l e g i t i m a c y a n d a c c o u n t a b i l i t y t h r o u g h its
the E u r o p e a n Central B a n k ( E C B ) . T h e E C ' s present In-
formation process and reporting requirements. D e m o -
t e r g o v e r n m e n t a l C o n f e r e n c e on M o n e t a r y U n i o n is ex-
cratic l e g i t i m a c y is c o n f e r r e d by the s t a t u t e ' s r e q u i r e -
pected to finalize the plan by the end of 1991.
ment that m e m b e r states' g o v e r n m e n t s a p p r o v e the
statute b e f o r e it m a y be i m p l e m e n t e d . A c c o u n t a b i l i t y is
Organizational Features
a d d r e s s e d t h r o u g h the s t a t u t e ' s calls f o r a n a n n u a l report
A c c o r d i n g to the plan, the E u r o p e a n System of Central
t o be p r e s e n t e d to E C h e a d s of state, t h e C o u n c i l of the
B a n k s will consist of the E C B and the central banks of the
E u r o p e a n C o m m u n i t y , and the E u r o p e a n P a r l i a m e n t . In
m e m b e r states. E C m e m b e r s are obliged to ensure that na-
addition, the E C B will report regularly o n the s y s t e m ' s
tional laws, including the statutes of their national central
activities and must publish their financial statements.
b a n k s , are c o m p a t i b l e with E C B legislation and existing
Further a c c o u n t a b i l i t y is e s t a b l i s h e d by a u t h o r i z i n g the
E C treaties.
p r e s i d e n t of t h e C o u n c i l of t h e E u r o p e a n
T h e decision-making bodies of the E C B will be its executive board and council. T h e board will c o m p r i s e a president, a vice president, and f o u r other m e m b e r s , all chosen
by E C heads of state after consultation with the European
P a r l i a m e n t , while the council will incorporate the board
and the twelve member-state central bank governors.
Community
a n d a C o m m i s s i o n m e m b e r to attend E C B C o u n c i l
meetings.
More Work Ahead
A l t h o u g h the d r a f t s t a t u t e f o r t h e E u r o p e a n S y s t e m
of Central B a n k s and the E C B deals fully with organi-
T h e e x e c u t i o n of r o u t i n e o p e r a t i o n s will be h a n d l e d
z a t i o n a l p r o v i s i o n s , the s t a t u t e still n e e d s w o r k in t w o
t h r o u g h the central b a n k s y s t e m ' s f e d e r a t i v e s t r u c t u r e .
m a j o r a r e a s . F i r s t , the p l a n d o e s n o t yet a d d r e s s t r a n s i -
T h e s t r u c t u r e is m o d e l e d o n the p r i n c i p l e of subsidiari-
tional a r r a n g e m e n t s : the decisions on the necessary
ty, w h i c h h o l d s that f u n c t i o n s s h o u l d b e p e r f o r m e d by
s t e p s t o b e i m p l e m e n t e d in S t a g e T w o , the t r a n s i t i o n
the a g e n c y that can m o s t e f f e c t i v e l y h a n d l e t h e m , at a
t o S t a g e T h r e e , t h e E C B ' s s t a r t - u p p r o c e d u r e s , a n d the
p o s i t i o n a s l o w w i t h i n the h i e r a r c h y a s p o s s i b l e a n d
i m p l i c a t i o n s o f f u l l p a r t i c i p a t i o n in t h e s y s t e m b y
t h u s n e a r e s t to the c o n s t i t u e n c y a f f e c t e d b y such f u n c -
s o m e m e m b e r s t a t e s at d i f f e r e n t d a t e s t h a n o t h e r s —
tions. National central b a n k s will be used as o p e r a t i o n a l
t h e s o - c a l l e d " t w o - s p e e d " E u r o p e , in w h i c h p o o r e r E C
a r m s of the s y s t e m , w h i l e the e x e c u t i v e b o a r d will ad-
s t a t e s d o n o t i m m e d i a t e l y p a r t i c i p a t e in m o n e t a r y
d r e s s m a t t e r s of p o l i c y .
u n i o n b e c a u s e of e c o n o m i c d i f f e r e n c e s . S e c o n d , c e r -
T h e s y s t e m ' s structure m e e t s t w o important r e q u i r e -
tain t e c h n i c a l q u e s t i o n s — e s p e c i a l l y t h o s e r e l a t i n g t o
ments for m a k i n g policy with C o m m u n i t y - w i d e goals. Be-
i n c o m e d i s t r i b u t i o n — s o m e legal q u e s t i o n s , a n d t h e lo-
c a u s e m o n e t a r y p o l i c y d e c i s i o n s will b e p l a c e d in the
c a t i o n of t h e E C B ' s h e a d q u a r t e r s are still u n d e r c o n -
hands of the central decision-making bodies, national self-
sideration.
interests are likely to be subordinated to E C B goals. Yet
Also unresolved are questions c o n c e r n i n g the re-
m e m b e r states will continue to play an important role in
s p o n s i b i l i t y f o r e x c h a n g e rate p o l i c y , the e x a c t p r o c e -
executing the s y s t e m ' s day-to-day tasks through both the
dure f o r giving operational p o w e r s to the e x e c u t i v e
E C B and the individual central banks.
b o a r d , a n d the n e e d f o r collateral in l e n d i n g t o credit
The Basic Principles
c o m p l e t e w o r k in t h e s e a r e a s in the c o u r s e of the o n g o -
i n s t i t u t i o n s . T h e C o m m i t t e e of G o v e r n o r s i n t e n d s t o
P r i c e s t a b i l i t y will b e t h e s y s t e m ' s p r i m a r y o b j e c -
ing I n t e r g o v e r n m e n t a l C o n f e r e n c e .
t i v e . H o w e v e r , t h i s g o a l d o e s n o t m e a n that m o n e t a r y
which contain all the necessary factors for the implem e n t a t i o n of E M U , s h o u l d b e f i n a l i z e d . A p h r a s e
was added indicating that Britain maintained its res e r v e o n the g o a l a n d t i m e t a b l e of t h e m o n e t a r y
union. T h e remainder of the report stressed the need
f o r s a t i s f a c t o r y and lasting p r o g r e s s on e c o n o m i c
Economic
26
Review
convergence beginning immediately, during the first
stage of E M U .
Although most m e m b e r s agree on the E M U goal,
they are still at odds on whether to set up a European
central bank in 1994 or 1996 and on h o w independent
it should be from political influence. Britain's posi-
September/October 1991
tion a p p e a r s to be t h a t a s i n g l e c u r r e n c y s h o u l d
emerge when and if the e c o n o m i c s of such a m o v e
permit it and not through imposed timetables (Ralph
Atkins and David Marsh 1991). An alternative plan
under consideration would create a two-tiered m o n e tary union: a core g r o u p — G e r m a n y , France, and the
L o w C o u n t r i e s — w o u l d proceed rapidly to union, to
be j o i n e d by other European C o m m u n i t y m e m b e r s
w h e n their e c o n o m i e s h a d d e v e l o p e d s u f f i c i e n t l y ,
thus avoiding a p a i n f u l a d j u s t m e n t process. Alt h o u g h t h i s t w o - t i e r e d plan has all but b e e n dism i s s e d , it n o n e t h e l e s s r e f l e c t s t h e m u l t i f a c e t e d
nature of the o n g o i n g European Monetary Union negotiations.
1. See Graboyes (1990) for a detailed discussion of past and
present monetary unions.
2. E u r o p e a n C o m m u n i t y m e m b e r s are B e l g i u m , D e n m a r k ,
France, Germany, Greece, Ireland, Italy, L u x e m b o u r g , the
Netherlands, Portugal, Spain, and the United Kingdom.
3. Statistics on world trade (in 1989) were f o u n d in International Monetary Fund (1990).
4. For a m o r e d e t a i l e d d i s c u s s i o n of this e x p l a n a t i o n , sec
Grubel (1981, 512-27, 641-63).
5. The upper and lower rates are actually 2.2753 percent and
2.2247 percent, respectively. These bands ensure that the
buying rate for central bank A of currency B is equal to
central bank B ' s selling rate of currency A because they
represent the exact arithmetical inverse. As the total allowable fluctuation remains 4.5 percent (2.25 + 2.25 = 2.2753 +
2.2247), the difference is insignificant.
Conclusion
The European Monetary System and its exchange
rate mechanism are operating as planned, even though
m e m b e r s have not entirely agreed on the timing or
characteristics of a monetary union. 7 The E C ' s Single
Market P r o g r a m — E C 1992—is likely to e n c o u r a g e
continued economic convergence, which would ease
the progress toward union. In addition, relaxing the
timetable for E M U should allow m e m b e r countries to
plan f o r and apply the m a r k e t f o r c e s n e c e s s a r y t o
bring economies closer together as a prelude to concentrating their efforts on monetary integration.
Great Britain and Spain maintain fluctuation bands of
+/—6 percent, however. T h e s e wide bands are temporary
arrangements, and both countries are expected to reduce the
margins as economic conditions permit ("European Council
Resolution" 1978, 10).
6. A c h a n g e in central rates, or a parity grid r e a l i g n m e n t ,
which means currency revaluation or devaluation, is considered a drastic solution to exchange rate digressions. Central
rate changes are infrequent, and none have been m a d e since
1987. (See issues of Financial Times for a table that shows
parity grid realignments).
7. See lingerer et al. (1990, tables 17-24) for a detailed look at
competitiveness and convergence measures.
References
Atkins, Ralph, and David Marsh. "Kohl, Major in EMU Accord." Financial Times, June 10, 1991, 1.
Edwards, Richard W. International
Monetary
Collaboration.
"Single European Act." In Treaties Establishing the European
Communities, abridged ed., 523-76. Luxembourg: Office for
Official Publications of the European Communities, 1987.
Dobbs Ferry, N.Y.: Transnational Publishers, Inc., 1985.
" E u r o p e a n C o u n c i l R e s o l u t i o n . " Bulletin of the
European
Communities no. 12 (1978).
Graboyes, Robert F. "The E M U : Forerunners and Durability."
Federal Reserve Bank of Richmond Economic Review 76
(July/August 1990): 8-17.
Grubel, Herbert G. InternationaI Economics. H o m e w o o d , 111.:
S w a n n , Dennis. The Economics of the Common Market. 5th
ed. New York: Penguin Books, 1984.
"Treaty Establishing the European Economic C o m m u n i t y . " In
Treaties Establishing the European Communities,
abridged
ed., 115-383. Luxembourg: Office for Official Publications
of the European Communities, 1987.
Richard D. Irwin, Inc., 1981.
International M o n e t a r y F u n d . Direction of Trade
1990 Yearbook. Washington, D.C.: IMF, 1990.
Federal
Reserve Bank of Atlanta
Statistics
Ungerer, Horst, J o u k o J. Hauvonen, A u g u s t o L o p e z - C l a r o s ,
and T h o m a s Mayer. The European Monetary System: Developments and Perspectives. Occasional Paper 73, International Monetary Fund, November 1990.
Econ oinicRevieu>
27
JRfeview Essay
The House of Morgan:
An American Banking Dynasty
and the Rise of Modern Finance
by Ron Chernow.
New York: Atlantic Monthly Press, 1990.
812 Pages. $24.95.
Ellis W. Tallman
I ooks more than two inches thick often intimidate the casual reader. Keeping facts in mind and maintaining reading m o m e n t u m
through several hundred pages can be difficult. Ron Chernow's
The House of Morgan, a National Book Award winner, manages,
despite its m o r e than 800 pages, to avoid the pitfalls of many
books of similar ambition. A n y o n e even slightly interested in its subject
should find the book highly rewarding reading.
At its simplest level, The House of Morgan is a historical chronicle of a
financial institution and the personalities associated with it. It is more, however. The book provides an overview of the evolution of the financial intermediation industry using the Morgan b a n k s as a f o c a l point. C h e r n o w
combines m a j o r episodes in the history of the Morgan institutions with an
informed view of the development of U.S. financial markets. In Chernow's
words, the story "holds up a mirror in which we can study the changes in
the style, ethics, and etiquette" of the financial intermediation industry.
The reviewer is an
economist in the
macropolicy
section of the Atlanta
Fed's
research
department.
Economic Review
28
Other books that have examined the Morgans (notably Morgans:
Private
International Bankers, by Vincent P. Carosso) are informative and useful,
but often such financial histories are geared toward specialists and include
extensive and cumbersome footnotes and financial data. Other, more popularized treatments may be sensationalistic and loosely documented, concentrating on issues attracting the press. The House of Morgan: An American
Banking Dynasty and the Rise of Modern Finance defies the dichotomy of
popular versus scholarly historical texts.
September/October 1991
Chernow presents a generally rigorous treatment of
the Morgan institutions as players in the evolving financial industry. While maintaining historical accuracy, h e also successfully conveys the excitement and
intrigue of major incidents like the Panic of 1907. His
candid portraits of the Morgan bankers not only depict
these men as influential financial decision makers but
also describe their human qualities, allowing the reader
to identify with these individuals who have rarely been
viewed as sympathetic.
The House of Morgan covers more than 150 years
in the evolution of banking institutions associated with
the name of Morgan, starting in the 1830s in London
with George Peabody and Junius Spencer M o r g a n ' s
wholesale bank, which dealt primarily in raising capital f r o m large-scale investors in Britain and then funding U.S. state g o v e r n m e n t s . B y beginning the story
b e f o r e the a d v e n t of the great J. P i e r p o n t M o r g a n ,
Chernow gives the reader a perspective on the development of the House of Morgan in an economy that itself continues to evolve.
Most images of Pierpont Morgan, considered the
epitome of the private banker, present him as a remote
figure, grimacing in front of unwanted photographers
or organizing relief for the financial markets during
the Panic of 1907. C h e r n o w ' s portrait reveals a man^
with such financial power and will that he essentially
designed the structure of numerous manufacturing and
transportation industries. For example, he orchestrated
the formation of General Electric and U.S. Steel, as
well as m a n y railroad mergers, in the midst of "the
first great wave of financial mergers in U.S. history."
According to Chernow, Morgan viewed the displacement and n u m e r o u s bankruptcies resulting f r o m the
railroad industry's bitter price wars in the late 1800s as
evidence of the " c h a o s " of competition. In sharp contrast to the competitive free market thinking of today's
dominant capitalists, Pierpont M o r g a n believed that
the controlled oversight of consolidated enterprises
created order and prevented the disruptions that free
competition could produce, like the railroads' initial
overbuilding and subsequent bankruptcies.
A s a provider of capital to burgeoning industries,
Morgan was in an enviable position. Because obtaining
capital was difficult in the 1890-1910 period, bankers
could command high rates and fees for their services.
Like bankers at other large institutions of the time, financiers at Morgan banks parlayed their gains by exerting i n f l u e n c e o v e r t h e f i r m s they h e l p e d f i n a n c e .
Morgan bankers were usually on the board of directors
of client firms and actively participated in their management. Chernow refers to this period as the Baronial
Federal
Reserve Bank of Atlanta
Age. During this era the Morgan bank apparently held
a high code of banker ethics, proving loyal to its clients
even while maintaining control over them.
P i e r p o n t M o r g a n p r e f e r r e d d e a l i n g in p r i m a r y
claims to firms' cash flows (that is, debt claims); thus,
bonds collateralized by firms' assets were the Morgan
banks' main financial assets. Through their active involvement in management, Morgan bankers played the
monitoring role for firms that debtholders are expected
to play. On the other hand, Pierpont Morgan considered
the market for stock equity (secondary, or residual,
payment promises) to be speculative and volatile. His
conservative view of equity markets, however, did not
prevent him f r o m amassing wealth and power.
Bankers were a m o n g the m o s t influential m e n in
the country at this time because they provided a scarce
resource—capital. Pierpont Morgan was perhaps the
most powerful man of his time, exercising control of
the o r g a n i z a t i o n of industry while gaining prestige
a m o n g bankers and g o v e r n m e n t officials alike. His
role as private central banker during the Panic of 1907
remains an impressive act of personal authority likely
never to be duplicated. 1 Despite this power, he was
not nearly the richest m a n of his day; industrialists
like Andrew Carnegie or John D. Rockefeller were far
wealthier.
From the time of its founding, the Morgan Empire,
m a d e up of private institutions with associated banks
in Philadelphia, London, and Paris, has had an international perspective; the links between Great Britain and
the United States have been especially strong. Chernow highlights this international aspect in the section
of the book dealing with the period he dubs the Diplomatic A g e (1914-48). He suggests that bankers were at
their most powerful at the outbreak of World War I.
D u r i n g the w a r they f i n a n c e d the f i g h t i n g n a t i o n s
rather than individual firms. T h r o u g h o u t the Diplomatic Age, the role of sovereign debt was the most notable financing activity of the large banking houses.
Chernow candidly describes financial maneuverings to
arrange sovereign debt for less than admirable
regimes, including the provision of investment capital
for fascist Italy, imperialist Japan, and post-1930 Germany. However, bankers had much less influence on
the nations they dealt with than they had held over
firms during the Baronial Age. Thus, the bankers had
little recourse in response to the numerous defaults on
sovereign debt. For example, Latin American countries defaulted on loans during the 1930s (only Argentina under Peron eventually repaid its loans).
A n o t h e r m a j o r s h a p e r of the M o r g a n institution
during the Diplomatic A g e was the Great Depression
Econ oinicRevieu>
29
and its aftershocks. Chernow helps put to rest a variety
of m y t h s that were p r o p a g a t e d a m o n g the p o p u l a r
press. For example, he suggests that the Federal Reserve Bank of New York acted appropriately following the 1929 stock market crash by providing adequate
liquidity. Although it has become generally recognized
in the e c o n o m i c s literature that the Federal Reserve
m a d e mistakes later in the D e p r e s s i o n , the popular
press often (incorrectly) suggests that the Fed acted
improperly following the stock market crash.
On the other hand, the accuracy of Chernow's analysis of the failure of the Bank of the United States in
1930 is questionable. The fourth-largest deposit bank
in N e w York, the Bank of the United States catered to
Chernow fails to emphasize effectively a
number of the regulatory changes that set
up bank risk-taking behavior later in the
period following the Great Depression.
immigrants, primarily Jewish. Unsuccessful in its attempt to get a $30 million loan from private bankers,
the bank failed. Its customers lost nearly 30 percent of
their deposits, and the managers of the bank were imprisoned for fraud. Some analysts, including Chernow,
interpret the lack of support for the failed institution,
with its largely ethnic depositors, as evidence of antiSemitism. However, such explicit concern for the dep o s i t o r s a f f e c t e d b y b a n k f a i l u r e s is a m o d e r n
perspective—evolving since federal deposit insurance
was established—and it seems misguided to project it
onto bankers in 1930.
In the era b e f o r e d e p o s i t i n s u r a n c e , b a n k e r s attempting to quell bank runs simply assessed the balance sheets of a failing bank to determine whether the
bank was merely short in liquidity or was inherently
insolvent. During the Panic of 1907, Pierpont Morgan
allowed a bank run to close the Knickerbocker Trust
when he was unable to determine its condition in time
to decide to take action that would have prevented a
run. Soon after, however, he provided liquidity to the
Trust C o m p a n y of A m e r i c a d u r i n g its run b e c a u s e
Economic Review
30
B e n j a m i n S t r o n g , later to b e c o m e N e w York F e d
Governor, examined its books and d e e m e d it solvent.
In the case of the Bank of the United States, it is likely that the bank was d e t e r m i n e d insolvent and not
w o r t h r i s k i n g $ 3 0 million to s a v e . T h e author, by
c o n c e r n i n g himself with the d e p o s i t o r s h i p , i n f u s e s
post-Depression concern about systemic risk into preDepression bankers. If in fact the institution had been
bailed out, it would have been the first instance of the
" t o o big to f a i l " d o c t r i n e i m p l e m e n t e d in the U.S.
banking system.
The massive number of bank failures and the recurrent b a n k p a n i c s d u r i n g the early 1930s f u e l e d the
public's growing distrust of financial institutions, esp e c i a l l y t h o s e o n Wall S t r e e t . C h e r n o w d e s c r i b e s
Congress as a lightning rod for popular attacks on fin a n c i a l i n s t i t u t i o n s as the p e r c e i v e d s o u r c e of the
problems. In response, Congress organized an investigation into banking practices. These Pecora hearings
(named after Ferdinand Pecora, counsel for the Senate
Banking and Currency Committee) presented the inside n e t w o r k of Wall Street to a v e r a g e c i t i z e n s in
1933. Chernow argues that these revelations of the financial elite's business practices further aggravated
c i t i z e n s ' o u t r a g e and p o p u l i s t o p p o s i t i o n t o Wall
Street.
A m o n g the targets of anti-Wall Street forces was J.P.
"Jack" Morgan, Jr., who proved easy prey to attack for
political ends. Portrayed as much less formidable than
his father, Jack Morgan nonetheless found his experience in front of the Senate committee similar to his father's during the 1913 Pujo Committee investigation
into the existence of a " M o n e y Trust." The two generations of M o r g a n s were on the front lines d e f e n d i n g
Wall Street in Congressional hearings. The combative
experiences, Chernow suggests, left both men personally scarred. The 1913 hearings came on the eve of the
establishment of the Federal Reserve System; a central
bank was already a topic of interest for Congress. In
1933, the Pecora hearings and populist fervor led to
legislation constraining Wall Street's power.
Chernow depicts the Glass-Steagall Act of 1933 as
a political maneuver, led mainly by populist forces, to
punish the powerful financiers. He provides additional
u s e f u l i n f o r m a t i o n a b o u t the u n d e r l y i n g c a u s e s of
Glass-Steagall, defusing the idea that securities affiliates of banks caused insolvencies and the m a j o r bank
runs. The act, by separating investment and commercial banking activities, forced the House of Morgan to
choose between the two. Morgan chose the latter but
soon created Morgan Stanley (a spin-off company) as
an investment bank.
September/October 1991
The Morgan banks changed substantially after the
separation of Morgan Bank and Morgan Stanley. Initially, the two firms carried on business with the traditional M o r g a n discretion and d i s c r i m i n a t i o n . T h e y
continued to engage in relationship banking, in which
the banker performed financial services for a single
client and would rarely also serve a m a j o r competitor
in that client's industry. Chernow emphasizes the Morgan b a n k s ' exclusivity; to have accounts with t h e m
was a mark of prestige.
the Morgan banks in this rapidly changing financial
market environment, he suggests that a developed capital market and deregulation altered the playing field
for both traditional and investment banking. Had he
sufficiently examined the post-Depression regulatory
changes such as those discussed above, his analysis of
deregulation would have been more effective. The author fails to link the most relevant determinants f o r
bank risk-taking behavior, and thus the discussion of
deregulation and banking practices remains incomplete.
The Morgan banks maintained their stature despite
the limited activities they engaged in. Morgan Stanley,
for e x a m p l e , did not initially have a sales force. In
fact, it did not sell, distribute, or trade securities but
instead concentrated on underwriting. Shifts in the industrial structure later forced Morgan Stanley to alter
its business perspective, Morgan B a n k concentrated
on providing financing to businesses. The institution
was significantly affected as financial markets developed and the industry grew to a point at which the
largest blue-chip firms could negotiate financing directly f r o m the c a p i t a l m a r k e t m o r e c h e a p l y t h a n
through a bank. In 1959, Morgan Bank merged with
Guaranty Trust, forming Morgan Guaranty Trust and
shifting its focus toward trading Treasury securities,
municipal securities, and Federal funds.
In general, banking and securities industry deregu l a t i o n r e d u c e d t h e p r o f i t m a r g i n on t r a d i t i o n a l
b a n k loans and underwriting and even reduced the
commission on stock sales and purchases. By doing
so, deregulation reintroduced competition for deposits,
uncommon for post-Depression banks. In order to survive these changes, the Morgan banks, along with the
financial industry in general, had to adapt or become
extinct.
The period following the Great Depression involved
enormous regulatory changes for banking and financial
institutions and the evolving market structure. In his
discussion of the Morgan banks and the financial industry they were part of, Chernow fails to emphasize
effectively a number of the regulatory changes that set
up bank risk-taking behavior later in the period. For example, deposit insurance, which subsidized banks' risk
taking, was instituted. Regulation Q was imposed, limiting the interest rate that banks could pay on deposits
and e f f e c t i v e l y restricting competition for deposits.
The regulatory changes insulated banks from competition and supported overpopulation in the banking industry. Gradually, bank regulations were relaxed—but
t h e r e was no r e d u c t i o n of d e p o s i t i n s u r a n c e — a n d
banks were competing for business among themselves
and other financial institutions. Although a discussion
of the regulatory changes and their side effects is not
directly r e l a t e d to the M o r g a n b a n k s , p r o v i d i n g it
would have given the reader a fuller understanding of
the U.S. banking industry's evolution and the relevant
adaptations of the Morgan banks.
The book's final section, titled "the Casino Age," reveals something of C h e r n o w ' s o w n attitudes toward
modern financial markets and recent activities involving mergers and acquisitions. Tracing the evolution of
Federal
Reserve Bank of Atlanta
Through his dramatic chronicle of the 1980s, Chern o w presents a financial environment changing at a
pace that was out of control. Once mutually loyal and
long-lasting, banking relationships have become whate v e r c o m b i n a t i o n of client and b a n k is e x p e d i e n t .
Bankers, notably investment bankers, are no longer
controllers of capital but "hired guns" at the bidding of
industrialists. This turning of the tables does not mean
that the industrialists now run the banks. Rather, highly
d e v e l o p e d industrial structures in c o n j u n c t i o n with
more efficient primary and secondary markets in financial assets have decreased the need for relationship
banking.
In such a competitive financial market the returns
to traditional b a n k i n g services are low; the lack of
lasting b a n k e r - f i r m r e l a t i o n s h i p s m a k e s even such
low-profit activities somewhat uncertain. Investment
bankers turned to alternative methods to make a profit.
A s the 1980s progressed, investment banks were generating a larger share of their profits f r o m taking positions in risky f i n a n c i a l d e a l s — t h a t is, risking their
own capital. Chernow notes, for example, that Morgan
Stanley established a fund for and took positions in
leveraged buyouts (LBOs).
M o r g a n Stanley had o n e of the m o s t s u c c e s s f u l
mergers and acquisitions groups a m o n g investment
banks. Providing insight into the kinds of maneuvers
and deal making involved in mergers and acquisitions,
Chernow describes the strategies that changed Morgan
Stanley's image: once an esteemed and exclusive private club, it became a cudgel bearer, pounding target
firms into submission. The details of a select number
of hostile takeovers illustrate how the banker code of
Econ oinicRevieu>
31
ethics operative in the Baronial Age disappeared. In its
wake is an impersonal environment in which an investment bank's client or f o r m e r client is vulnerable to
a h o s t i l e t a k e o v e r by a n o t h e r of t h e s a m e b a n k ' s
clients. The descriptions of the insider trading scandals
that occurred during the 1980s at Morgan Stanley and
at Morgan Grenfell, the associated London bank, represent the banker's equivalent of a "fall from grace."
In particular, the Guinness scandal at Morgan Grenfell
in 1986, in which the i n v e s t m e n t bank e n g a g e d in
stock price manipulation, sullied the hallowed name of
Morgan.
Morgan Guaranty Trust made a high proportion of
its profits during the 1980s from trading securities and
taking risky positions. The general impression Chernow
creates is that bank intermediaries are doing less intermediation and more risk taking with their own capital—
whether through real estate investment trusts, Latin
American loans, or commercial real estate investments,
and despite opportunities limited by Glass-Steagall and
other regulation. A recurring theme is that these risktaking practices developed over time as the market for
provision of capital became more competitive. Deregulation has sped up the process, but the existence of deposit insurance clearly raises "moral hazard" problems
for banks as risks are essentially subsidized.
profit. In contrast, mergers and takeovers in the 1980s,
the a u t h o r argues, were o f t e n r e c o m m e n d e d to the
firms by investment bankers, w h o received fees from
such deals. Chernow suggests that under this system
s o m e f i r m s b e c a m e involved in deals that m a y not
have been in their best interests. However, Chernow
does not acknowledge that a firm's board of directors
ultimately must be held responsible for the f i r m ' s important business decisions regardless of the sales tactics employed by investment bankers. He also fails to
emphasize the crucial role played by the tax l a w s —
namely, the tax deductibility of f i r m s ' interest paym e n t s — a s a factor motivating f i r m s to increase the
leverage on their balance sheets.
The Morgan banks, once an elite institution dominated by individual personalities, have gradually bec o m e o n e of m a n y f a c e l e s s f i n a n c i a l f i r m s in an
increasingly impersonal financial market. The banker
will likely never again be as enigmatic or powerful as
Pierpont Morgan, so Morgan's role in financial history
will remain legend. Despite the challenges the Morgan
b a n k s h a v e f a c e d o v e r t h e i r l o n g h i s t o r y and the
tremendous competition they face in today's financial
markets, the Morgan banks in the United States, Morgan Stanley and Morgan Guaranty, remain preeminent
institutions.
The verdict on whether the mergers and acquisitions, L B O s , and the assorted financial activities of the
1980s have been successful must wait for time to produce further evidence. Proponents of such activities
argue that the potential for hostile takeover keeps a
f i r m ' s m a n a g e m e n t working to maximize the f i r m ' s
value. Detractors—and Chernow seems to be among
them—consider such practices too costly in the long
t e r m , citing the f a i l u r e of s o m e h i g h l y p u b l i c i z e d
takeovers and the misuse of massive amounts of resources to cover exorbitant debt payments.
T o d a y ' s relatively m o r e efficient capital m a r k e t s
provide more readily available financing for firms so
that the marketplace can be the determining factor for
success or failure of technological innovations. Along
with benefits from greater efficiency, competition in financial markets has eroded profit margins on traditional banking services, leading to increased risk taking by
investment and commercials banks. Well-run firms will
likely survive, if not thrive, under changing regulatory
structures, and financial industries will continue to pursue new markets and methods to earn profits.
Chernow contrasts modern mergers and takeovers
with the earlier merger wave under Pierpont Morgan's
leadership. The wave of mergers at the turn of the century was part of M o r g a n ' s grand design, intended to
keep business activity controlled. Chernow notes that
in the 1970s the firms' directors or management initiated mergers, which were seen as opportunities for
Not surprisingly, The House of Morgan ends inconclusively. Chernow's thoroughly researched and wellwritten chronicle shows how financial intermediaries,
notably the Morgan banks, came to be the kinds of institutions they are today. Given the financial industry's
continuing evolution, the future of the industry and the
Morgan banks remains unknown.
Note
1. For additional discussion of M o r g a n ' s role in the Panic of
1907, see Ellis W. Tallman and Jon R. Moen, "Lessons from
Economic
32
Review
the Panic of 1907," Federal Reserve Bank of Atlanta Economic Review (May/June 1990): 2-13.
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