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Economic
Review
deral Reserve Bank
of San Francisco
Spring 1988

NUIl1ber 2

u.s. Bilateral Trade

Tomohiko Sakamoto

The Japan -

Barbara A. Bennett
and
Gary C. Zimmerman

U. S. Banks' Exposure to Developing
Countries: An Examination of Recent Trends

Bharat Trehan

The Practice of Monetary Targeting:
A Case Study of the West German Experience

Frederick T. Furlong

Changes in Bank Risk-Taking

1 Table of Contents
The Japan - U.S„ Bilateral T ra d e.................................................................................

3

Tomohiko Sakamoto

U.S. Banks9 Exposure to Developing Countries:
An Examination of Recent Trends .............................................................................

14

Barbara A. Bennett and Gary C. Zimmerman

The Practice of Monetary Targeting:
A Case Study of the West German Experience .......................................................

30

Bharat Trehan

Changes in Bank Risk-Taking....................................................................................

45

Frederick T. Furlong

Federal R eserve B ank o f San Francisco

1

Opinions expressed in the Economic Review do not neces­
sarily reflect the views of the management of the Federal
Reserve Bank of San Francisco, or of the Board of Governors
of the Federal Reserve System.
The Federal Reserve Bank of San Francisco’s Economic Review
is published quarterly by the Bank’s Research and Public Informa­
tion Department under the supervision of Jack H. Beebe, Senior Vice
President and Director of Research. The publication is edited by
Gregory J. Tong, with the assistance of Karen Rusk (editorial) and
William Rosenthal (graphics).
For free copies of this and other Federal Reserve publications, write
or phone the Public Information Department, Federal Reserve Bank
of San Francisco, P.O. Box 7702, San Francisco, California 94120.
Phone (415) 974-2163.

- u.s. Bilateral

Economist, Bank of Japan, and Asia Foundation VisitFellow at the Federal Reserve Bank of San Francisco.
The author appreciates comments from the editorial review
committee and participants of the FRBSF Research workshop. Research assistance by Mark Thomas, Janice Ferry,
and economists in the Bank of Japan is gratefully acknowledged. Editorial committee members were Barbara Bennett, Reuven Glick and Fred Furlong.

The bilateral trade imbalance between the United
States and Japan has already improved in real terms since
the exchange rate changes. However, the degree of
improvement has been moderate to date. This paper examinesfactors influencing the adjustment process ofthe trade
imbalance, focusing on relative price changes and structural factors.

Federal Reserve Bank of San Francisco

Since the meeting of the G-5 nations (France, Japan,
United Kingdom, United States, and West Germany) in
September 1985, a significant realignment of exchange
rates has taken place. Between September 1985 and
November 1987, the dollar fell against the Japanese yen
from 236.63 yen/dollar to 135.37 yenldollar- a depreciation of 42.8 percent. Against a basket of major currencies,
the dollar depreciated over this period an average of 34.3
percent. I In response, policymakers shifted their n""",',,-,,
concern from encouraging further depreciation
dollar to stabilizing its value near current levels.
Such a drastic change in exchange values was expected
to help correct international trade imbalances. In general,
a currency realignment influences real trade flows by
changing relative prices between domestic and foreign
tradables, thereby altering the quantities of domestic and
foreign goods demanded. If the adjustment in exchange
rates were sizable and sustained long enough to convince
people that the trend would not be reversed in the foreseeable future, it might also provoke supply responses.
Japan's trade surplus in real terms, in fact, has contracted markedly since the beginning of 1986, as import
quantities have risen and export quantities fallen (Table 1).
In addition, Japan's nominal trade surplus has started to
decline as well. With such changes in external trade
performance, the growth pattern of the Japanese economy
has experienced a rapid transformation from growth led by
external demand to growth led by domestic demand.
Since trade between Japan and the United States forms
the largest part of the two countries' respective external
imbalances, Japanese policyrnakers and their U .S. counterparts have paid keen attention to developments in
Japan's bilateral surplus with the U. S. A
understanding of the recent evolution of that trade therefore is
important. This paper seeks to contribute to that understanding by: 1) analyzing what actually has occurred to the
real bilateral merchandise trade since the currency realignment, and 2) examining the factors affecting the adjustment process of the bilateral trade imbalance.
With these two themes in mind, the remainder of this
paper is organized in the following manner. The first
section reviews the recent evolution of trade between Japan
and the United States. Sections Il and III discuss several
influences on the adjustment process in the bilateral trade
imbalance, focusing on the role of relative price changes
and structural factors, The last section offers a summary
and conclusions, as well as policy implications.
3

I. Exchange Rate Realignment and the Japan-U.S. Trade
In fiscal 1986 (from April 1986 to March 1987), Japan's
nominal trade surplus with the U.S. swelled by $8.7
billion and recorded an all-time high of$52.0billion. This
enormous bilateral trade surplus now accounts for more
than half (57.9 percent in fiscal 1986)of Japan's total trade
surplus. Viewed from the U.S. perspective, this surplus is
a trade deficit amounting to 34.5 percent of its total trade
deficit, and one that is far larger than its trade deficit with
any other single trading partner. Although Japan's nominal
surplus with the U.S. shows signs of flattening out or even
declining modestly in recent quarters (from $4.6 billion in
the fourth quarter of 1986 to $4.3 billion in the third
quarter of 1987, based on seasonally adjusted monthly
averages), the extent of improvement has remained moderate due to the so-called J-curve effect. The J-curve
describes the typical pattern of adjustment to changes in
the relative value of a currency. Specifically, as a currency
appreciates, export prices rise and lead at first to an
increase in the nominal value of exports even though the
real value (that is, the quantity) falls as higher prices lead
to reduced demand. With time, even the nominal value of
exports falls as demand fully adjusts to the higher prices.
To measure accurately the effectiveness of the currency
realignment in correcting trade imbalances, it is necessary
to examine the real bilateral trade balance.
An examination of Japan's real trade balance with
respect to the U.S., presented in Chart 1, 2 shows that
Japan's real exports to the U.S. began to fall around
mid-1986, while its real imports from the U.S. took an

upward turn with large fluctuations arising from imports of
nonmonetary gold.> Correspondingly, its real trade balance with respect to the U.S.4 has declined.
Two observations are in order, however. First, despite
the sharp appreciation of the yen against the dollar, Japan's
real exports to the U.S. have not diminished significantly.
In fact, Japan's real exports to the U.S. dropped only by
2.7 percent between the third quarter of 1985 and the first
quarter of 1987. Second, Japan's real imports from the
U.S. have not grown as quickly as those from other
regions. Japan's real imports from the U.S. recorded
growth of 9.7 percent during the period, compared to
growth rates of 48.9 percent and 22.3 percent, respectively, from the European Community and Asian countries.> These qualifications require further analysis.
Chart 2 shows that Japan's real exports to the U.S. have
been depressed by the rise in relative prices since 1986,
and that part of this effect has been offset by slow but
continued growth in the U.S. economy and the high
income elasticity of Japan's exports. These results come
from a regression equation including relative price and
U.S. income variables.
Since a variety of Japan's export items have been under
administrative or voluntary export/import restraints ,6 any

Chart 1
Japan's Real Trade
with the U.S.
1980=100
(seasonally adjusted)

250

Trade
Balance

200

Exports

150

100

Imports

1980

1981

1983

1985

1987

Source: Ministry of Finance

4

Economic Review / Spring 1988

P e rc e n t

Chart 2
C o n trib u tin g F a c to rs to the G ro w th of
J a p a n ’ s E x p o r t V o l u m e t o t h e U. S.

8 1

6

Q u a rte rly
G ro w th Rate
Dem and F a c to r

-

42

-

0

=

-2

-

-4 i

=6 -

8

Res duals

i
I

-

19 8 5
1. Contributing factors were estimated from the following real export equation:
In (real exports to the U.S.) = 3.46 * In (U.S. real domestic demand*)
(17.5)
+ 1.13 * In (relative price**)
(8.4)
- 12.38
(-1 3 .8 )
sample period: 1976/2Q - 1987/1Q
R2 = 0.9229

analysis based on this traditional specification of an export
equation may not capture price and income effects per­
fectly. Nevertheless, the reasonably good fit of the real
export equation estimated indicates that the yen’s steep
climb has been a dominant factor in limiting the growth of
Japan’s exports during the period under study. 7 The posi­
tive residuals, however, suggest that other factors must be
examined to help explain why Japan’s exports have not
responded even more. Likewise, it is important to analyze
the factors that have contributed to somewhat weak growth
in Japan’s imports of U.S. goods.I.

R e la tiv e P rice F a cto r
— — r —
~ t ' — ~ ~ r~ ------- t— —
II
III
IV
i
19 86
1987

i

2. Serial correlation corrected by a Cochrane-Orcutt adjustment (RHO = 0.74).
3. Independent variables are two-quarter moving averages of U.S. real domestic
demand and four-quarter moving averages of relative price.
* real GNP - real net exports
**weighted average of U.S. PPI and Japan’s competitors’ export prices / Japan’s
export prices

In the following two sections, we will look at some of
the factors that have been affecting the current adjustment
of the Japan-U.S. bilateral trade imbalance in more detail.
The analysis will focus on 1) whether the deterioration in
Japan’s relative export prices has, in fact, been restrained
relative to the depreciation of the dollar; 2 ) why and how
Japan’s exports to the U.S. have been so responsive to the
growth in U.S. demand; 3) whether the composition of
U.S. trade with Japan has influenced U.S. exports to
Japan; and 4) whether the improvement in U.S. relative
export prices fully reflects the dollar’s depreciation.

II. Factors A ffecting Ja p a n ’s Real E xports

Pricing Behavior Under the Strong Yen
Although Japan’s real exports to the U.S. have been
substantially depressed by a rise in relative export prices,
many analysts contend that Japanese exporters have lim­
ited increases in their export prices and, instead, have
squeezed their profits in yen terms to prevent a marked
decline in their market shares. In other words, adjustment
in the bilateral trade imbalance has been delayed by the
practice of restraining export price hikes.
To analyze this argument, it is useful to introduce the

Federal Reserve B ank of San Francisco

concept of “ cumulative pass-through.” The cumulative
pass-through is defined as the ratio of the cumulative
percent change in export prices to the cumulative percent
change in exchange rates during a given period. The pass­
through in the current “ yen-daka” (strong yen) phase is
much lower, hovering within a range of 50-55 percent, 8
compared to a ratio of 70-80 percent during the last strong
yen period in 1977-1978 (Chart 3). This lower pass­
through indicates that Japan’s export prices have been less
responsive to exchange rate movements in the more recent
period.
5

Since Japanese exporters' pricing strategies cannot be
independent of their competitors' prices in world markets,

it is useful to examine how Japan's export prices responded
to
in
To do so, we decomcumulative pass-through ratio into two
factors - "the world price inflation factor" and "the
Japanese exporters' adjustment factor" (Table 2). The first
factor measures the pass-through implicitly assuming that
Japan is a price-taker in the world export market. 9 The
second factor takes account of the extent to which Jappy,')",·tPl·'O may have been able to
their export
in response to various elements such as foreign
competition, foreign demand
and differences in
quality of products.
When we compare the value of each of these two
in the period 1985Q3-1987Q1 with their
values in the period 1977Q 1-1978Q4, it is clear that both
lower world-wide inflation and increased foreign competition at a time of slower foreign demand growth contributed
to the lower pass-through in the more recent period.
The more modest increases in foreign export prices in
the later period reflect the greater price stability worldwide
since the early 1980s. Many have argued that such price
has
the opportunities to pass currency
appreciation through to export prices. At the same time,
especially of raw materials, lowered the
domestic
costs of Japanese exporters and enabled
them to restrain the pass-through.

The reduced adjustment of Japan's export prices to
foreign export prices can be attributed mainly to stiff
competition from newly industrializing countries (NICs),
especially those in southeast Asia. For instance, Korea,
Hong Kong, and Singapore's combined share of U.S.
imports rose from only 3.7 percent in 1975 to 4.5 percent
in 1980; their share rose another 2.7 percentage points in
the following six years. Some of this increase in market
share may be ascribed to the fact that since 1985 the
exchange rates of their currencies have not appreciated
against the U. S. dollar as much as they have against the
yen.
In short, confronted with greater competition within a
stable price environment worldwide, Japanese firms were
unable to raise their export prices fully in response to the
rise in value of the yen. As a result, they accepted lower
unit sales (in terms of yen) from exports to avoid drastic
cutbacks in their production. to Thus, it is clear that
reduced pass-through has dampened the effect of the
currency appreciation on adjustments in export quantities.

Commodity Composition of Japan's Exports
In addition to the restrained adjustment in export prices,
another factor that has played a role in the moderate trade
adjustment to date is the commodity composition of

A ,-V"".""
Percent

1
Jan. 1977
Oct. 1978

1

1977

1 ~8~

I

!

I

I

i8e,'

1 19

1

iii

i

1978
iii
1987

Source: Ministry of Finance (Japan)
and Bank of Japan

(I

Economic Review / Spring 1988

unchanged since 1985 (the present level is about twice as
high as in 1980). These observations suggest that exports
of office machinery have played a major role in sustaining
Japan's overall exports despite the yen's rapid
appreciation.I?
The strong growth of office machinery exports is related
to changes in the structure of U.S. import demand. U.S.
private nonresidential fixed investment recovered quite
vigorously after 1983, fueled by tax reduction measures.
In the process, U.S. investment demand shifted toward
information processing
and related peripheral
equipment, partly because advances in electronic technology made such equipment considerably less expensive.
Office machinery and related equipment doubled its share
in total nonresidential equipment investment from 16.1
percent in the 1970s to 35.4 percent in 1985. The higher
relative price of U.S.-produced office equiprnent->
allowed imports of these items to flood in (more than a 30
percent increase at an annual rate). Its share in U. S. total
imports more than tripled in the last six years from 1.2
percent in 1980 to 3.9 percent in 1986.
A rapid response by Japan's exporters to changes in
foreign demand, supported by technological advances and
competitive prices, and Japan's subsequent penetration of
the U. S. market'< have kept the income elasticity of
Japan's exports at a fairly high level. This high income
elasticity, together with sustained U.S. growth, have partially offset the export quantity adjustment effect of the
yen's appreciation.

Japan's exports to the U. S. This section examines the role
of structural factors in Japan's exports.
The analysis presented here divides Japan's real exports
to the U.S. into several major commodity categories!! consumer goods, production goods, capital goods including office machinery, and capital goods excluding office
machinery. Chart 4 shows that real exports of consumer
goods to the U.S. have been falling since the beginning of
1986. This decline is primarily the result of the rise of
Japan's relative consumer goods export prices rather than
an overall decline in U. S. demand for consumer goods. In
fact, private consumption remained strong in the U.S.
while Japan's real exports of consumer goods dropped
20.2 percent between the first quarter of 1986 and the first
quarter of 1987.
Real exports of production goods, which ballooned in
1983 and 1984 in response to the pick-up in U.S. industrial output, began to decline in the first half of 1985 and
have continued to decline through the first part of 1987.
The decline was, to a certain extent, due to the stagnant
business climate surrounding the worldwide electronics
industry. It also may have been due to the voluntary export
restraint on steel and iron introduced in October 1984,
since the export quantity of production goods exclusive of
these commodities has followed a slightly upward trend.
Finally, real exports of capital goods including office
machinery have increased quite rapidly in spite of the yen's
steep rise (the current level is about seven times higher
than in 1980), while the export volume of capital goods
excluding office machinery has remained virtually

Chart 4
Japan's Real Exports to the U.S.
by Major Commodity Group

1980=100

300

1980=100

800

(Index seasonally adjusted)

700
250

600

Capital Goods Including
Office Machinery
(Right Scale)

200

500

~

400
150

Production Goods

300
200

100
50

Capltai Goods Excluding
Office Machinery
(Right Scale)

100

-f---,.--...,-----..--.....----.,----r---,---t1980
Source:

1981

1982

1983

1984

1985

1986

0

1987

Ministry of Finance (Japan), Department of Commerce

Federal Reserve Bank of San Francisco

7

III. Factors Affecting Japan's Real Imports
The Commodity Composition of Japan's Imports
As mentioned earlier, the growth in Japan's imports of
U. S. goods has been relatively moderate to date compared
with its imports from other trading partners. As a result,
the U.S. share of Japan's total imports, excluding those
from the Middle East, has fallen from 38.4 percent in 1960
to 26.9 percent in 1986, in sharp contrast to the sizable
gains by Asian NICs ( + 7.6 percent points in the 26 years)
and the European Community ( + 7.1 percent).
Japan's aggregate real imports recorded seasonally
adjusted growth of 12.8 percent between the third Quarter
of 1985 and the first quarter of 1987. This increase was
dominated by accelerated imports of manufactured goods
(an increase of 23.0 percent). During the same period,
Japan's real imports of raw materials showed practically no
gain (a meager increase of 1.8 percent) and imports of
foodstuffs did not increase as fast as those of manufactured
goods (an increase of 14.0 percent).
These developments reflect structural changes that have
been occurring in the Japanese economy. As illustrated in
Chart 5, imports of various kinds of industrial parts and
equipment (including those for general machinery, telecommunication equipment, electric household
appliances, automobiles, and computers) have been
increasing steadily, while the growth of domestic production of these final goods has been lackluster. Between

September 1985 and February 1987, the aggregate import
volume of these items increased by more than 20 percent
annually, while domestic industries' output increased only
slightly ( + 0.9 percent at an annual rate). Concurrently, in
materials-processing industries such as metals,
petroleum, chemicals, and textiles, a similar shift from
domestic production using imports of raw materials to
imports of semi-finished products is evident as a long-run
trend. Imports of semi-finished products increased by
about 50 percent between the end of 1979 and March
1987, while domestic production of those semi-finished
goods remained virtually unchanged, and imports of raw
materials gradually declined.
Thus, a steady increase in imports of intermediate
products generally has been evident in Japanese manufacturing industries. Moreover, imports of final products,
especially of consumer goods, also have grown rapidly as
a result of an increase in overseas production by Japanese
firms. 15 In this regard, it is significant to note that such
changes can be interpreted as a substitution of imports for
domestic production. This shift was encouraged not only
by changes in relative prices but also by technological
advances and increased supply capacity abroad.
With this structural shift in mind, a comparison of the
commodity composition of U. S. exports to Japan with that
of the European Community is useful. The combined

Chart 5
Japan's Imports of Industrial Parts and
Domestic Production of Final Goods

1980=100

220

(Volume Index seasonally adjusted)

200
180

Volume of Industrial
Parts Imports
,

160
140
~

120

Volume of Final Goods
Domestic Production

100
80
1983

1984

1985

1986

1987

Source: Ministry of Finance and Ministry of International Trade
and Industry (Japan)

1. Japan's import volume of industrial parts is a weighted sum of import quantities of 76
commodities (such as, parts of electric machinery and transportation machinery).
2. Domestic production of final goods is a weighted sum of production indices of electric
machinery, transportation machinery, and general machinery.

8

Economic Review / Spring 1988

share of foodstuffs and raw materials in U. S. exports to
Japan (39.2 percent) is more than twice as large as that in
EC exports (14.8 percent), whereas the share of manufactured goods in U. S. exports (60. 7 percent) is much smaller
than that in EC exports (85.5 percent). Thus, EC exports
have more of what Japan wants. This partly accounts for
the much faster growth in imports from the EC than from
the U.S. In sum, given the structural changes in the
Japanese economy, the countries whose exports comprise
more manufactured products have obvious advantages.
The structural composition of U. S. exports helps to
explain why overall U.S. exports to Japan have grown
more slowly. However, this alone cannot explain why the
growth in U.S. exports of individual commodity categories also has lagged behind the same commodities
exported by other nations. The data on commodity imports
in Table 3 implies that the primary cause of the slower
growth in U. S. exports does not lie in import barriers since
the barriers apply to all exporting countries in the same
way. In the next section, we examine another factor that
may account for the divergent behavior - the adjustment
of U.S. relative export prices.
Adjustment of U.S. Relative Export Prices
An historical comparison of United States producers'
pass-through ratios during the past three periods of dollar

Federal Reserve Bank of San Francisco

depreciation (Table 4) shows that the ratio of exchange rate
depreciation to a fall in foreign currency export prices (106
percent) in the present weak dollar phase is far higher than
those in previous periods. In other words, the prices of
U. S. exports in foreign currency terms have dropped by
more than the depreciation in the exchange value of the
dollar.
As a result of this change in U. S. exporters' pricing
behavior, U. S. export unit value in dollar terms in 1986
remained practically unchanged from the previous year
(+ 0.3 percent), and its unit value expressed in yen terms
declined by 29.2 percent. Although this improvement was
partially offset by more stable prices in Japan, U.S.
relative export prices declined by 25.6 percent against
Japan's domestic prices and returned to the pre-1980 level
(Table 5).
However, this improvement in the price competitiveness
of U.S. exports to Japan must be weighed against other
competing countries' export price behavior as well, since
U. S. exporters compete with other countries in the Japanese import market. An examination of major competitors' export prices relative to Japan's domestic prices
reveals that the improvement in U. S. relative export prices
is not all that dramatic. In fact, according to Table 5, U. S.
export prices relative to those of its major competitors still
are relatively unfavorable. Thus, the degree of the overall

9

Economic Review ! Spring 1988

improvement has been much smaller than the change in the
nominal dollar/yen exchange rate (29.4 percent in 1986
over the previous year) or the change in the dollar's real
bilateral exchange rate against the yen (25.6 percent).
In this connection, it is worth noting that U.S. export
prices relative to those of its competitors still are about 15
to 20 percentage points higher than they were in 1980
when the U. S. trade account was roughly in balance. In
other words, U. S. exporters have not yet restored their lost
price competitiveness following the dollar's appreciation
through 1985. It is also significant that the cumulative
change in relative export prices against Japan's domestic
prices since 1980 still is far more advantageous to other
countries.
These facts are important because the differences in the
levels of relative export prices may influence the growth in
each countries' exports to Japan, given the structural
changes in the Japanese economy. The growth of new
Japanese import demands likely alters the historical rela-

tionship between imports and other variables, such as
export prices and income growth.
As we have seen in Sections II and III, various factors
have influenced the
of the bilateral trade
imbalance between Japan and the U. S. The change in the
commodity composition of Japan's exports in response to
changes in U. S. demand and the structural features of
U. S. exports have played important roles in trade flows
between
two nations. In addition, the delayed
ment of Japan's export prices due to the restrained passthrough and the inadequate improvement of U. S.
prices relative to
exporters' prices have weakened adjustment to the currency realignment.
these factors cannot fully account for the relatively moderate correction of the trade imbalance. For instance, controversial microeconomic factors such as the effect of export
restraints on Japan's exports and the nonprice competitiveness of U. S. exports are not studied in this paper. These
points will have to be addressed in future studies.

IV. Summary and Conclusions
The currency realignment in foreign exchange markets
since the meeting of G-5 nations in September 1985 has
contributed appreciably to the adjustment of international
trade imbalances. The improvement of the bilateral
imbalance between Japan and the U .S. , however, has been
somewhat limited by structural factors and other elements
that have diminished the impact of the adjustment of
relative prices. Exchange rate changes alone are not sufficient to eliminate the bilateral trade imbalance. In addition, restructuring the Japanese economy for less dependence on external demand as well as restoring U. S.
competitiveness through heightened productivity growth
and restrained unit labor costs are both indispensable for
redressing the bilateral trade imbalance in the long run.
Japanese manufacturing industries are already moving
their production abroad through foreign direct investment
and by expanding imports of manufactured commodities
to substitute for domestic production. Moreover, many
Japanese industries such as iron and steel, chemicals, and
construction machinery are now placing more emphasis on
domestic business since domestic demand is robust and
domestic sales have become more profitable. Such
developments should make Japan's imports more responsive to growth in domestic demand and its exports less
elastic with respect to growth in foreign demand."? In the
meantime, improvement in such fundamental determinants of U. S. competitiveness as productivity growth and
Federal Reserve Bank of San Francisco

reduced unit labor costs has been observed along with
advantageous shifts in U. S. exporters' pricing behavior.
These trends suggest that the structural changes
required for further reductions in the bilateral trade
imbalance are emerging on both sides of the Pacific.
Structural changes will redress the imbalance in the long
run, not measures that focus on curbing Japan's exports
since these exports still have high income elasticities and
U.S. income still is growing. Even if it were possible to
reduce Japan's exports to the U.S. so steeply as to restore
balance, foreign economies would suffer from the impact
of this policy because of the resultant contraction in
Japan's import demand.
Accordingly, the best solution to the bilateral trade
imbalance should focus on durable growth in Japan's
imports from the U.S. In this regard, the most important
issue is whether the current strong growth in Japan's
manufactured imports can be sustained or not. The issue of
Japan's barriers to agricultural imports is secondary in the
sense that the effect of removing these barriers on bilateral
trade is fairly small in comparison to the effect of growth in
Japan's manufactured imports. IS
With a view to supporting the economic restructuring
process indirectly, Japanese policymakers have been
implementing measures to stimulate domestic demand and
stabilize exchange rates in cooperation with other major
developed countries. Correcting the current external

n

imbalance requires sustained growth in Japan's domestic
demand, not only because it induces more imports, but
also because it is conducive to minimizing the frictional
costs that accompany economic restructuring. Yet, it is
hardly possible to eliminate Japan's huge nominal trade
surplus in a year or two, because of the still-high income
elasticity of Japan's exports and the existing wide gap
between exports and imports. The conclusion that most
clearly emerges from this analysis is that Japanese policy
authorities have to achieve sustained growth in domestic
demand and maintain price stability over a fairly prolonged period.

The United States can contribute to reducing its trade
deficit by improving U.S. relative prices. As shown in the
text, this has been achieved so far by the dollar's decline
against major currencies. However, since the exchange
value of the dollar has already declined sharply, further
improvement of U.S. relative prices must be achieved
through productivity growth and reduced production
costs. At the same time, since inflationary pressure has
been mounting from the import side as a result of the
dollar's depreciation and there are some signs of tightening
supply/demand conditions in the U.S. economy, fiscal and
monetary policies aimed at future noninflationary economic growth also are needed.

FOOTNOTES
1. Weighted-average exchange value of the US. dollar
against the currencies of other G-1 countries plus Switzerland, published by the Federal Reserve Board. Weights
come from the 1972-1976 global trade of each country.
2. Japan's real exports and imports with the US. can be
obtained by deflating dollar values of exports to, and imports
from, the U.S. by export and import price indices. In this
paper, the export and import price indices with respect to the
U.S. have been calculated as follows:

°

a) Calculate the commodity composition of exports to,
and imports from, the U.S., using the "Summary of
Report, Trade of Japan," Japan Tariff Association.
b) Find the export (or import) price index in yen terms of
each goods category in the same data source.
c) Obtain the price index of total exports (or imports) with
respect to the U.S. by making a weighted average of the
price indices of goods, the weight being the share of
each goods category in total exports (or imports) with
respect to the U.S.
d) Translate the yen-denominated price indices thus calculated into those in dollar terms by the prevailing
dollar/yen exchange rate.
3. In fiscal 1986, Japan imported gold from the U.S, on
several occasions for the purpose of coining gold coins in
commemoration of the 60th anniversary of the current
emperor's reign,
4, Japan's real trade balance with its major trading partners,
includino the U,S., is measured by a ratio of Japan's real
exports to its real imports,
5, In 1986, U,S. exports of industrial supplies and materials
to the European Community (EC) and Asian countries
increased substantially (+ 9,5 percent and + 11,9 percent
over the previous year, respectively), Accordingly, there is
the possibility that some of these exports ultimately went to
Japan in the form of final products exported from the EC and
Asian countries to Japan,
6. Japanese exports currently subject to U,S,trade restraints
(in fiscal 1986) and their shares in Japan's total exports to the
U,S, are as follows:

12

Shares in Japan's Total Exports to the U.S.
(Percent)
Export Quantity Restraints
25,6
2,5
1.4
0,9

Passenger cars
Steel and iron
Textiles
Metalworking machinery
Subtotal
Export Price Restraints
Metalworking machinery
Integrated circuits
Cameras
Subtotal
Import Restraints

30.4
0,9
1,2
0,8

2,9
0,1
0,03
4,7
0,6

Cellular telephones
Pagers
Light trucks
Motor cycles
Subtotal

5.4

Grand total

37.8

7, It should be noted that the regression analysis employed
here implicitly assumes that income and price elasticities
have not changed over time,
8, Although the aggregated cumulative pass-through ratio
for Japan's exports between September 1985 and April 1987
was 54,9 percent, there is considerable variance among
individual commodities:
Foodstuffs
Textiles and textile products
Chemicals
Non-metallic mineral products
Metals and metal products
Machinery
Miscellaneous manufactures

34,7%
35,7
36,1
43.9
26,1
63,2
40,9

Economic Review / Spring 1988

9. Although such an assumption was introduced in this
paper for the sake of simplicity, it should be noted that in
reality Japan's export prices also affect its competitors'
export prices.
10. It should be borne in mind that the swollen profit margins
that had been attained during the last weak yen period
enabled Japanese exporters to squeeze their profits in this
process and, in this sense, cushioned the impact of the yen's
appreciation. The ratio of current profit to sales in principal
manufacturing industries climbed to 4.65 percent in the first
half of 1984 and stayed at that level through the first half of
1985. Subsequently, it declined sharply to the recent trough
of 2.85 percent in the first half of 1986, reflecting profitsqueezing in exports. The relationship between U.S import
prices and profit margins from the U.S. perspective has been
analyzed by Catherine L. Mann in "Prices, Profit Margins, and
Exchange Rates", Federal Reserve Bulletin, June 1986.
11. Japan's real exports to the U.S. of individual commodities can be obtained by deflating the dollar value of
exports of the commodity by its export price index. Real
exports of each commodity category (for example, consumer
goods) are calculated by aggregating real dollar values of
individual commodities in accordance with the definitions of
commodity categories given below:
a) Consumer goods
foodstuffs, television sets, automobiles, motor cycles,
cameras, watches, tape recorders, shoes, toys
b) Production goods
chemicals, textiles, metals, tires, integrated circuits,
non-metallic mineral products
c) Capital goods
power generating machinery, office machinery, metalworking machinery, electrical machinery
12. This viewpoint was first raised by Daniel E. Nolle and
Charles Pigott in the Quarterly Review, Federal Reserve Bank
of New York, Spring 1986.
13. Actually the U.S. producer price of office machinery rose
8.2 percent between 1980 and 1986 while Japan's export
price of office machinery in dollar terms fell by about 20
percent. Accordingly, U.S. relative prices deteriorated by
about 35 percent during the period.
14. "Import penetration" is defined as the ratio of imports of
manufactured goods to domestic absorption (namely,
GOP + imports exports). This ratio shows that Japan has

Federal Reserve Bank of San Francisco

rapidly penetrated the U.S. market in recent years (0.6 percent in 1970; 1.2 percent in 1980; 2.0 percent in 1986).
15. For instance, as a result of foreign direct investment, the
so-called "boomerang effect" is evident in Japan's imports of
household appliances from Asian NICs as depicted in the
table below. This effect may be partly responsible for a rapid
increase in Japan's manufactured imports from Asian
countries.
Import Volume by Commodity and by Region
(Percent change in fiscal 1986 over the previous year)

Portable stereos
Personal stereos
Electric fans
Refrigerators
Television sets
Calculators
Washing machines
Sewing machines

(Korea)
( " )
(
( " )
(Taiwan)
( " )
( " )
( " )
1/

)

+ 230

+ 230
+
+
+
+

330
230
650
250
+ 83.4
+59.9

16. In this paper, a variable weight export deflator was used
to calculate the pass-through ratio.
17. Although the extent to which the structural economic
changes have affected Japan's balance of payments cannot
be quantified exactly, an attempt was made by the Bank of
Japan to estimate changes in the income elasticities of
Japan's exports and imports by means of Kalman filtering
models. According to those estimates, the income elasticity
of Japan's exports has declined gradually while that of its
imports has risen sharply since early 1986 (see Special
Paper No. 155, "Quarterly Economic Outlook", Autumn
1987).
18. According to a paper by Dick K. Nanto (submitted to the
Subcommittee on Economic Goals and Intergovernmental
Policy of the Joint Economic Committee of the U.S. Congress
on December 9, 1985), Japan's liberalization of agricultural
imports will increase U.S. exports to Japan by $1.7 to $5.3
billion. However, the effect is of a once-and-for-all nature
and, once Japan's agricultural imports are liberalized, such
an increase cannot be expected to last. In contrast, the
increase in U.S. manufactured exports to Japan by $12.6
billion in 1986 does represent a trend given the structural
changes in the Japanese economy. Such exports may even
grow if U.S competitiveness improves further

13

u.s. Banks' Exposure to Developing Countries:
An Examination of Recent Trends

Barbara A. Bennett and
Gary C. Zimmerman
Economists, Federal Reserve Bank of San Francisco.
Outstanding research assistance provided by Alice Jacobson, John Nielsen, and Steven Dean. Special thanks to
Emily Kwok and Irene Tong for assistance with the
database. Editorial committee members were Hang-Sheng
Cheng, Chris James and Vivek Moorthy.

U.S. banks' total LDC loan exposure and exposure
relative to assets and capital have declined since the LDC
debt crisis began in 1982. The authors find, however, that
exposure to troubled LDCs has not fallen as much as
exposure to more creditworthy borrowers, and that
exposure has become increasingly concentrated at the
largest U.S. banks. They posit three possible explanations: involuntary lending, banks' relative advantages in
working with troubled borrowers, and the existence of
deposit insurance, which distorts lending decisions.

14

In February 1987, the government of Brazil announced
that it was suspending interest payments on its debts to
commercial banks. This debt-service moratorium came as
no surprise to the international financial community since
Brazil's ability to meet the regularly scheduled payments
of principal and interest on its obligations had been
deteriorating for some time. Nonetheless, Brazil's action
underscored the lingering concerns about a number of
lesser developed country (LDC) debtors following the
1982 debt crisis.
In view of renewed worries about the economic health of
LDC debtors and the continued high level of exposure to
those borrowers within the U. S. banking industry, a number of U. S. banks took action to increase their loan loss
reserves in June 1987. All told, these additions to loan loss
reserves amounted to over $15 billion. Bank stock values
responded favorably, but questions remain concerning the
adequacy of these actions.
Moreover, bank regulators remain concerned about
U.S. banks' exposure to developing countries. For example, as part of its risk-based capital proposal announced in
July 1987, the Federal Reserve Board suggested that all
banks with large exposures to high-risk countries be
required to maintain capital positions above the minimum
ratios.
This paper examines U. S. banks' exposure to international borrowers, with a particular emphasis on the subset
of troubled LDCs. It attempts to explain the pattern of
exposure that apparently concentrates international lending risk in the banking system. The paper is organized in
the following way. In the first and second sections, we
describe the events leading up to the debt crisis that
erupted in August 1982, when Mexico announced a moratorium on debt service, and how the debt crisis affected
bank lending to developing countries.
Readers who are familiar with this background material
may wish to tum directly to the third section where we take
a closer look at U.S. banks' exposure to developing
countries since the debt crisis. We find a number of
surprising and possibly disturbing developments, including an increase in U.S. banks' exposure to troubled LDCs
relative to their exposures to other international borrowers
and an increasing concentration of that total exposure at
the largest U.S. banks. In the fourth section, we attempt to
explain these developments. The paper concludes with a
discussion of policy implications.
Economic Review I Spring 1988

I. LDC Lending in Historical Perspective
Although several developing countries experienced debt
service problems during this period, in general, the high
inflation of the middle and late 1970s guaranteed that the
real, or inflation-adjusted, debt service burden was quite
low because loans were repaid in devalued dollars. Moreover, rapid growth of the economies of the industrial
countries generated strong demand for the exports of
developing countries. Consequently, very few LDCs experienced payment difficulties despite the rapid growth in the
nominal value of their indebtedness.
Beginning in the early 1980s, a number of factors
combined to increase LDC debtors' real debt burdens.
First, real interest rates rose dramatically as central banks
moved to reduce inflation by tightening credit. The rise in
real interest rates was translated immediately to LDCs'
borrowing costs since most of LDCs' debt was short- or
medium-term at floating rates tied to a market rate, such as
LIBOR (London Inter-Bank Offer Rate). Second, in 1982,
worldwide inflation unexpectedly abated. Long-term debt
obligations that were contracted on the assumption that
export prices would continue rising suddenly became
more costly in real terms. Worse yet, the decline in
inflation was not translated into lower nominal interest
rates.
Moreover, the value of the dollar, the currency in which
most loans to LDCs were denominated, rose relative to

Prior to the 1970s, longer term lending to developing
countries occurred primarily through official sources. The
bulk of private capital flows, to the extentthey occurred,
took the form of foreign direct investment. Private lenders
such as commercial banks tended to provide funds primarily to finance trade.
Even before the first oil crisis in 1973-74, however, the
role of private lenders began to change dramatically. Some
have suggested that the rapid rise in the U. S. money
supply in the early 1970s and the adoption of floating
exchange rates increased liquidity, particularly in the form
of Eurodollars, and led to a rise in international lending by
commercial banks. The first oil shock then generated
current account deficits for oil-importing countries and
equally large surpluses in the current accounts of the
Persian Gulf countries. Private lenders, most notably
commercial banks, facilitated the flow of funds between
lending and borrowing countries.
Chart 1 shows the growth in the external indebtedness of
Latin American countries to all countries from 1970
through 1984. It is clear that private lenders' (primarily
banks) share of the total funds advanced to those countries
increased significantly. Moreover, data on bank lending
suggests that U.S. banks took an active role in supplying
credit to LDCs generally, with exposure reaching a peak of
$166.2 billion in 1983.

$ Billions

Chart 1
Growth in Latin American External Debts

300
250
200
150

Total
Creditors

~

100

~

Private
Creditors

50

1970
Source:

1972

1974

1976

1978

1980

1982

1984

The World Bank, World Bank Debt Tables

Federal Reserve Bank of San Francisco

IS

LDC currencies, making it more expensive for developing
countries to earn dollars with which to service their debts.
Ordinarily, the rise in the value of the dollar would have
stimulated demand for developing countries' exports,
enabling them to generate additional foreign exchange.
Instead, a worldwide recession reduced the demand for
developing countries' exports and made it extraordinarily
expensive for LDCs to obtain foreign exchange to service
their debt obligations.
These developments culminated in Mexico's announcement in August 1982 that it was imposing a moratorium on
the payment of interest on its debt obligations. A payments
"crisis" ensued. Mexico's creditors were able to negotiate
a "restructuring" of Mexico's debt to alleviate near-term
debt service problems, but by then a number of other
LDCs were experiencing similar difficulties.
At this point, default on LDC loans and the potential for
collapse of the international financial system became a real
concern. Official policymakers and private lenders
adopted similar approaches to managing the crisis for all

debtors experiencing difficulties. First, to obtain shortterm financing from the IMF (International Monetary
Fund), the debtor country had to reach an agreement with
the IMF concerning an economic reform program
designed to improve the longer term outlook for its debt
service capacity. Second, once an IMF agreement was
reached, banks had to reach an agreement with the debtor
to reschedule their loans. Initially, these reschedulings
established higher fees and spreads over the cost of funds
to compensate banks for lengthening loan maturities. In
subsequent reschedulings, spreads and fees were reduced
even as loan maturities were extended. (Actually, funds
provided by the IMF also were conditioned upon the
country reaching an agreement with its bank creditors.)
Finally, in a number of cases, banks also provided additional new funds at reduced interest rates primarily to
enable countries to cover their contractual interest payments. Typically, banks participated in these new loans in
proportion to their outstanding exposures to the borrower. 1

H. Bank Lending and Changing Risk Perceptions
As the crisis unfolded, investors abruptly changed their
assessment of the probability of default on LDC debt
obligations. This sort of change in perceived default probabilities can be inferred from the sharp decrease in the
value of outstanding claims on LDCs. The behavior of
prices in the bond, bank loan, and, indirectly, the bank
equities market is consistent with this view.
Articles by Edwards (1986), Folkerts-Landau (1985)
and Dornbusch (1986) examine the international bond and
bank loan markets' reactions to Mexico's announcement.
These articles compare yields on international and foreign
bonds issued by individual developing countries with
those issued by industrial countries. They find that the
yield spread increased dramatically in the third quarter of
1982, suggesting that investors required substantially
higher default risk premia for LDC debt than previously. It
is interesting to note, moreover, that default risk premia
increased for all the major non-OPEC LDC debtors,
suggesting an across-the-board reassessment of default
probabilities with respect to LDC debt. Edwards also finds
that the international bond market only anticipated the
debt crisis by a few weeks, and then only partially.
In addition to the evidence from the international bond
market, these articles find that risk premia on bank loans to
LDCs rose during the early 1980s, as well. Terrell (1984),
for example, notes that spreads over LIBOR for selected
major LDCs increased from an average of 125 basis points

16

through the first seven months of 1982 to 217 basis points
during 1983.
Additional evidence for the change in perceived default
risk is available from the secondary market for bank loans
to LDCs. This market has existed for some time but
became more prominent after the onset of the debt crisis.
For example, the financial press noted the emergence of
secondary market discounts of 10 to 25 percent relative to
the face value of LDC loans in 1983. 2 (Secondary market
discounts of 50 percent or more are not uncommon for
loans to certain LDCs today.) Since the trading volume in
this market was (and still is) quite thin, prices may not give
an accurate indication of the level of default risk, but the
change in those prices provides at least some indication
that investors' assessment of default risk changed for the
worse. 3
Other studies have focused on the stock market's reaction to the debt crisis. In general, these studies conclude
that investors tended to discount the market values of
banks that had large exposures to developing country debt.
Beebe (1985), for example, found that between 1982 and
the end of 1984, the sharp downward valuation of the
equities of the largest bank holding companies (those with
assets over $10 billion) can be explained in part by their
individual exposures to Latin American debtors, specifically Argentina, Brazil, Mexico, and Venezuela. Kyle and
Sachs (1984) likewise find evidence that the market tended
Economic Review / Spring 1988

to discount the share prices of banks with significant
exposures to Argentina, Brazil, Chile, Mexico, and Venezuela between September 1982 and June 1983. 4
Given the strong evidence for an increase in perceived
default risk following Mexico's actions, one would expect
to see a sharp decrease in the supply of loans to LDCs.
While it may be difficult to attribute patterns in LDC
lending to supply versus demand factors, the observed
decline in new lending is at least consistent with the view
that lenders became less willing to extend credit after the
debt crisis. According to data published by the Organization for Economic Cooperation and Development
(OECD), new medium- and long-term bank lending to
LDCs dropped from an average of $39.2 billion a year in
the period between 1978 and 1982 to $24. 1 billion after
1982. 5
Moreover, only a relatively small proportion of the
"new" lending to LDCs after the crisis actually represents
a net increase in the amount of borrowed funds available to
those countries. Instead, most of the new lending reported

by the OECD involves rollovers of maturing obligations
and/or reschedulings. Net new funds typically have been
provided only to enable the borrower to meet interest
payments coming due on outstanding obligations. In addition, most of the lending (whether on a net or a gross basis)
has been considered "involuntary" in the sense that it
takes place at below-market clearing rates and commercial
bank lending syndicates have had to invoke "fair-share"
rules with varying degrees of success as a means of
inducing members to continue to provide funds.
In fact, because commercial bank lending to LDCs
dropped off so dramatically, in October 1985, Treasury
Secretary Baker announced the so-called Baker Plan. The
Plan established modest goals for concerted net new
lending by commercial banks in conjunction with
increased official lending to the fifteen principal LDC
debtors. (For a list of the "Baker Fifteen," see Appendix
A.) Nonetheless, net new lending to these countries has
been meager at best. In 1986, loans outstanding actually
declined by nearly $3 billion."

III. Effect on U.S. Bank Portfolios
The increase in the perceived probability of default on
LDC loans lowered the value of the loans outstanding to
LDCs. As a result, U.S. banks suffered market value
capital losses even though they generally did not re-value
LDC loans on their books, or increase their loan loss
reserves significantly until the spring of 1987. Based on
data compiled from a variety of sources, U. S. banks
apparently wrote down only $2.2 billion, or approximately 1.7 percent, of their loans to non-OPEC LDCs
between 1982 and 1985. 7 Moreover, total provisions to
increase loan loss reserves likewise were modest, averaging approximately 0.51 percent of assets per year during
this period. 8
However, U. S. banks did take other steps to counter the
effects of the decline in the market values of their portfolios. For example, banks raised additional capital
through increased retained earnings, asset sales, and sales
of new equity and subordinated debt. They also curtailed
asset growth overall, and LDC loan growth particularly.
Terrell (1984) notes, for example, that banks raised frontend fees on LDC loans as a means of curtailing lending.
Outstanding loans to LDCs fell from a total of $152.6
billion in 1981 to $133.6 billion at the end of 1986. As a
result of these actions, exposure to LDC debtors steadily
fell between 1982 and 1986.
Charts 2 and 3 show the marked change in U. S. banks'
LDC debt exposure, in relation both to total assets and

Federal Reserve Bank of San Francisco

book value capital for those banks with significant international lending exposure." In the years preceding the debt
crisis, both total assets and book capital grew at roughly
the same annual rate (11.9 and 11.6 percent, respectively),
while loans to LDCs grew at a faster rate (14.9 percent, on
an annual basis). As a result, both measures of LDC loan
exposure rose between 1977 and 1982, the former reaching more than 13 percent of assets and the latter more than
243 percent of capital. Then, beginning in 1982, exposure
relative to capital, in particular, declined. By 1986, it was
about half the level of 1981.
Most of this decline is the result of banks' efforts to raise
book capital. Between 1982 and 1986, banks increased
capital at a 13.2 percent annual rate, while LDC loans
outstanding declined at only a 5.0 percent annual rate.
Most ofthese loans originally were short-term, and banks,
in theory, could have chosen not to refinance them upon
maturity. In practice, once the credit had been extended,
banks apparently were unable to force repayment of
principal.
Moreover, closer examination of the patterns of
exposure - among LDCs and other international borrowers, as well as exposure by size of bank - yields some
interesting and possibly disturbing observations. First,
exposure to all nations excluding LDCs, declined more
rapidly than total LDC exposure. For example, U. S.
banks' exposure to the major industrial nations, that is, the

17

G-lO countries plus Switzerland, declined 57.3 percent
from 210 percent of capital in 1981 to 90 percent in 1986.
Total international loan exposure relative to capital
declined by 55.2 percent. In contrast, LDC loan exposure
declined by 52.7 percent. Thus, the decline in LDC loan
exposure is not nearly as dramatic when one considers the
decline in lending to other, more creditworthy international borrowers.
Second, within the category of LDC borrowers, the
decline in U.S. bank exposure has varied, with more
dramatic declines reported for the LDCs that are not
experiencing debt problems. To analyze this development,
we grouped LDCs into two categories - "troubled" and
"not troubled". The troubled borrowers were selected
according to the following criteria: they received a rating
of worse than average by Institutional Investor, and/or
their outstanding bank loans were trading at a discount of
more than ten percent of face value in the secondary
market. Furthermore, in most cases, troubled countries
have a recent history of balance of payments difficulties,
economic instability, and actual defaults on their obligations. (Appendix A contains a list of the countries that fall
into the troubled category, as well as a list of the "Baker
Fifteen" countries.)
One way of measuring the change in banks' exposure to
these two groups that attempts to control for the common

factors that may have caused a general decline in international lending is to examine the change in these borrowers'
shares of U .S. banks' international loan portfolios. Thus,
Table 1 shows that exposure to what we have termed
troubled LDCs has risen from 26.1 percent of banks'
international loan portfolios in 1982 to 29.4 percent in
1986. Moreover, exposure to the Baker Fifteen has risen
from 25.9 to 31.3 percent of banks' international loan
portfolios. At the same time, loans to industrialized countries have fallen from 39.7 percent to 37.7 percent, and
loans to nontroubled LDCs have fallen from 12.0 percent
to 11.5 percent.
Thus, although borrowing by troubled LDCs has
declined in absolute terms, borrowing by more creditworborrowers has declined by more. As a result, banks'
relative exposure to troubled LDCs has risen. By implication, banks have tended to keep the worst risks in their
portfolios. Consequently, the decline in total LDC
exposure observed in Charts 2 and 3 overstates the decline
in U. S. banks' exposure to default risk associated with
lending to LDCs.
A third observation is that exposure by size of bank also
has varied, with the nine largest banks holding a larger
percentage of troubled LDC loans now than in 1981. As a
percentage of total loans outstanding to troubled borrowers, the nine money center banks reporting on the

Chart 2
International Lending Exposure as a Percent of Assets
Percent

30

,

Total

25
20

15

10
5

o
1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

Source: Country Exposure Lending Survey

18

Economic Review / Spring 1988

Chart 3
International lending Exposure as a Percent of Capital
Percent

550
500
450
400

,

Total

350

300
250

200
150
100
50

o
1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

Source: Country Exposure Lending Survey

CELS now hold 63 percent compared to a low of 56
percent in 1982. Table 2 shows that, in contrast, the other
two groups of banks - the next 14 largest and all other
international lenders - systematically reduced their proportional shares of the total U. S. bank exposure to troubled LDCs. To a certain extent, this reduction represented
a shift toward more creditworthy borrowers and a general
tendency to reduce international lending altogether.
In terms of absolute changes in exposure, the nine
money center banks reduced their troubled LDC loans
outstanding by only $1 billion, while the next 14 largest
banks and all other banks reduced theirs by $4 billion and

$6 billion, respectively, from 1982-1986. The latter two
groups tended to be more active sellers of loans in the
secondary markets. Also, the non-money center banks'
participation in involuntary new lending arrangements
associated with debt reschedulings has been relatively
limited. For example, Fortune Magazine reported in July
1983 that many of the nine largest banks provided more
than their proportional shares of the rescheduled loans to
Brazil because the other lenders, including many in the
next-largest category, provided substantially less than
their original shares. 10

IV. Explanations
Many observers now suggest that involuntary lending
provides an explanation for these patterns in U. S. banks'
exposure to LDCs. As noted earlier, LDC borrowers were
able to meet debt service obligations through additional
borrowing prior to the crisis. However, with the decline in
the market's perception of these borrowers' creditworthiness, new funds became scarce.
To induce existing lenders to provide some relief, a
number of debtors threatened to default. Lenders with
outstanding claims against these borrowers, then, were
faced with the choice of forbearing and/or rescheduling
those claims, selling the claims at a discount to other

20

creditors, or declaring the borrowers in default and
attempting to recover value through whatever remedies
might be available. The sale of such claims at a discount
would have involved the recognition of accounting losses,
and declaration of default probably would have entailed
even greater losses since the value of collateral generally
was less than the discounted value of the claim. Lenders
therefore may have been reluctant to pursue either of these
two options, particularly when the exposure to a given
borrower was large relative to the lender's capital. Consequently, lenders - particularly the largest ones with the
largest exposures and thus the most to lose in the event of

Economic Review / Spring 1988

default - may have"chosen" to reschedule existing loans
and even to extend new loans to cover interest payments on
existing obligations to avoid losses associated with
default.
However, because all existing lenders, whether they
participated or not, would have benefitted from the extension of new credit, LDC lending syndicates had to invoke
fair-share rules to ensure that adequate additional funds
were provided to prevent default. Nonetheless, lenders
with •relatively small outstanding exposures had little
incentive to participate in such lending. This may explain
the difference in the patterns of exposure among the three
size categories of U. S. banks. 1 1
While the involuntary lending explanation is consistent
with the patterns we have observed for banks, it is not
entirely satisfactory. A number of troubled LDCs also had
bonds outstanding prior to the crisis. In the absence of
distortions, one would expect, on the basis of the involuntary lending explanation, the two groups of lenders - the
bondholders and the banks - to respond similarly to the
debt crisis. Yet the two appear to have responded quite
differently.

Federal Reserve Bank of San Francisco

Nearly all accounts of the management of the debt crisis
suggest that it was the bank lenders and not the bondholders that were involved in debt reschedulings and
extensions of new credit. Moreover, data on funds raised in
international capital markets also suggest that unlike bank
loans, bond financing, at least for certain countries,
became nonexistent after the crisis.
This implies, in other words, that reliance on bank loans
increased relative to bonds as the credit rating of the
borrower declined. Moreover, nonbank creditors apparently became even more reluctant to supply funds to a
borrower with a given low credit rating after the crisis than
before.
To show the difference in the way bank lenders and
bondholders behaved, we regressed the ratio of bank loans
to total external funds raised (including bonded debt) in
international capital markets by a given country in a given
year on the credit rating of that country for that year.
Clearly, because of the way this ratio is defined, an
increase implies that reliance on bonded debt has
decreased. Bank loans were defined as the sum of international bank loans and foreign bank loans, but not floating

21

rate notes held by banks. For the credit rating, we used the
country ratings published annually by Institutional Investor as a proxy for creditworthiness. Ideally, some sort of
market measure like the actual market prices of loans
would be appropriate. However, the secondary market for
bank loans is thin and quotes prices for only a handful of
countries. A test of the extent to which the Institutional
Investor ratings are a good instrument for the secondary
market discounts revealed that at least for the few countries
for which discounts are quoted, the ratings are indeed a
good proxy. 12
To test for a change in LDCs' access to nonbank sources
of funds after the crisis (and controlling for changes in
creditworthiness), we included a dummy variable that
takes the value of zero prior to 1982 and the value of each
country's credit rating afterwards.
We used data compiled by the OECD for a sample of
approximately 62 countries between 1980 and 1986. 13
These countries represent the major international borrowers during this period and include 23 industrial countries, as well as 10 OPEC, 24 non-OPEC LDCs, and 5
Eastern Bloc countries. Table 3 presents the OECD data
grouped by type of borrower.
The results of our pooled cross-section time-series
regression are summarized in Table 4. The negative and
statistically significant coefficient on the credit rating

suggests that as LDCs' creditworthiness deteriorated,
bond financing "dried up" and they were forced to rely
increasingly on bank loans as a source of funds. Moreover,
the negative and significant coefficient on the credit rating
dummy variable suggests that for a given level of creditworthiness, access to alternative sources of funds diminished after the crisis.
These findings are consistent with the view that after the
debt crisis, a number of LDC borrowers were unable to
obtain funds from other sources and that it was the banks
that were "forced" to renew and reschedule existing loans
to avoid defaults and to protect their investments.
would explain the small decline in banks' exposure to
troubled borrowers relative to the decline in exposure to
more creditworthy borrowers.
Given that the banks appear to have responded differently to the debt crisis than did the bondholders, the
question remains as to why. The involuntary lending
explanation does not adequately address this issue.
Assuming that neither the bankers nor the bondholders
were willing to "throw good money after bad," bankers
must have had some inducements to continue lending that
bondholders did not have. Two explanations come to
mind. First, bankers may have had superior information on
the ability ofLDC debtors to repay, and/or superior ability
to obtain repayment. Second, bank lenders may have had
regulatory incentives to lend that were not available to
bondholders.
In the analysis that follows, these two alternatives are
examined as two different (but not necessarily mutually
exclusive) factors that may have played a significant role in
determining banks' willingness to lend to LDCs both
before and after the crisis. 14 The first one, the "efficiency
factor," has to do with advantages banks may have relative
to bondholders in assessing and monitoring riskier credits
and in handling problem loan workout situations. The
second factor, the "subsidy factor," relates to the effects
government subsidies (implicit or explicit) may have had
on banks' and investors' portfolio decisions.
Efficiency Factor
One factor that may account for the increase in banks'
exposure to LDCs throughout the 1970s, and, therefore,
may have had a bearing on banks' response to the debt
crisis is what we have termed the efficiency factor. This
explanation focuses on banks' relative advantages as
agents for investors in assessing the creditworthiness of
borrowers, monitoring borrowers, and working through
repayment problems. It draws on insights from models of
principal/agent problems in lending. 15
Broadly speaking, borrowers and investors (that is, the
ultimate lenders) may use two types of financial instru-

22

Economic Review / Spring 1988

rnents to transfer savings. These can be characterized as
bonds (direct finance) on the one hand, and bank loans
(intermediated finance) on the other. The choice between
the two will depend on the one that provides borrowers
with the cheapest source of funds and investors with the
highest return net of the costs associated with administering their investment. Among the usual costs associated
with administering an investment are the costs of collecting and maintaining records of scheduled principal and
interest payments, but they also include the cost of more or
less continuously monitoring the borrower's financial condition. This sort of monitoring is necessary to prevent
borrowers from engaging in activities that reduce the value
of the lenders' claims.
For some borrowers, the costs of such monitoring are
relatively modest since publicly available information
conveys an accurate picture of their true net worth and,
therefore, the likelihood of default. Since investors can
readily determine when action is needed to protect the
value of their claims, these borrowers generally will prefer
bond finance because the standard covenants contained in
bond indentures will provide adequate protection for
investors at the lowest cost. 16. 17
For other borrowers, however, monitoring may be costly
because their assets are not traded and are therefore
difficult to evaluate. In these cases, the standard financial
ratios on which bond covenants rely will not convey
accurate information about the borrower's true condition.
In fact, if these borrowers were to use bond finance, it is
possible that they might violate standard bond covenants
and therefore be forced to seek new sources of credit or
even be forced into liquidation, even though better information would have indicated that such actions were
unnecessary and costly to both borrower and investor.
These borrowers therefore will prefer bank loans
because banks typically have access to information about
their condition that is not readily available to investors
directly. For example, banks may have information about a
borrower's payments activity and transactions balances
that investors do not. Consequently, banks will be able to
monitor the condition of these borrowers more cheaply
than could the individual investors, making bank loans the
cheaper source of funds. In a sense, then, the obligations
of these borrowers could be worth more to investors when
held in bank portfolios.
This analysis is applicable to international lending,
although solvency may not always be the proper measure
of default risk. Instead, a more general approach would be
to treat default risk as a function of the cost of default. In
cases where actual insolvency is not at issue, default risk
would be defined as the value of unrestricted future access
to external borrowed funds plus the value of seizable
Federal Reserve Bank of San Francisco

assets, to the extent such assets exist. 18 Thus, a sovereign
borrower will not default as long as the cost of doing so
exceeds the value of its external obligations.
Assuming investors can readily determine the value of a
given borrower's external obligations relative to the cost of
defaulting on those obligations, bonds will be the preferred
financing vehicle. Presumably, most industrial countries as
well as those LDCs with relatively small amounts of debt
outstanding, significant wealth, and high returns to capital
investment will be the countries that can tap the bond
markets.
In contrast, LDCs that have high amounts of debt
outstanding relative to GNP or other measures of capacity,
or have unstable political regimes such that default through
repudiation is a possibility, have found their ability to raise
external funds through bond finance severely limited, and
thus have had to rely chiefly on bank loans. To the extent
that investors are willing to hold these obligations at all,
they appear to prefer to hold them indirectly because banks
can monitor and work with problem borrowers more
cheaply, and because banks have better access to assets
that may be seized than do individual investors.
Banks' apparent advantage in providing credit to higher
risk borrowers suggests that, given the increase in demand
for external funds on the part of LDCs in the 1970s, banks
would have been the logical ones to supply most of the
needed funds. Moreover, this analysis suggests that once
the debt crisis erupted and investors became less certain of
the chances of being repaid, the value of banks' ability to
gauge solvency risk and to handle workout situations
would have increased. Therefore, one would expect to see
banks holding proportionately more of troubled LDCs'
debt than before the crisis. One might also expect the
banks' share of the outstanding obligations of nontroubled
borrowers to fall as the debt crisis changed the relative
values of these obligations as well.
This theory is .consistent with the results of our regression findings that banks and not bondholders were
involved in continued lending to troubled LDCs. Moreover, it helps to explain why banks continued to lend to the
smaller borrowers even though, according to the involuntary lending explanation, there may have been less incentive to do so because exposure to these borrowers was
small. A recent study by Gluck (1987) supports this view.
He found that as the creditworthiness of selected LDCs
improved in the years after the debt crisis, they were able to
obtain bond financing and forego bank loans as a source of
funds.
Folkerts-Landau (1985) and Edwards (1986) also
provide some interesting evidence that is consistent with
the relative advantage argument. They suggest that
because banks are in a better position to reschedule and

23

renegotiate a borrower's obligations than are bondholders,
whose primary recourse is declaring default on the obligation, risk premia on the two types of instruments should
reflect these differences. Consistent with this hypothesis,
they observe that default risk premia rose by substantially
more on bonds than on bank loans after the onset of the
debt crisis.
The relative advantage argument, then, suggests that
once the debt crisis erupted and investors became more
concerned about the probability of default on the part of at
least some of the LDC debtors, one would expect to see an
even greater preference for bank loans as opposed to bonds
in those countries. As default risk increased, banks' superior ability to work with troubled debtors and ultimately, to
seize assets, would have become more valuable to investors. This would explain why U.S. banks' exposure to
troubled LDCs rose relative to their exposure to more
creditworthy international borrowers. It also would
explain why exposure became more concentrated at the
nine largest banks. Since those banks are the ones most
actively involved in the international payments network
and in trade finance, they are also the banks best able to
monitor and seize assets if necessary.
Moreover, in workout situations, lenders need to act
cohesively and the fewer lenders there are, the easier it
would be to achieve consensus. This view suggests first
that bond finance is particularly unsuited to workout
situations since it is unlikely that the myriad bondholders
could be forced to work cohesively. It also suggests that the
banks with the largest exposures to begin with (that is, the
nine money center banks) would have had the greatest
incentive to work cohesively and to continue lending to the
troubled debtors.

Subsidy Factor
A second and possibly more important factor that may
have induced banks to continue lending to troubled LDCs
is the existence of regulatory incentives or subsidies. In
general, government subsidies, either of the lender's
assets or its liabilities, will distort decisions regarding
risk. If the government were to underwrite at least a
portion of the increased risk, lenders would have an
incentive to make and hold riskier loans than they otherwise would.
These subsidies can arise in two ways. First, the government (or a multilateral official institution such as the IMF)
may subsidize exposure to LDCs directly by providing a
guarantee of the loans to LDCs. With a guarantee of this
sort, the guarantor would repay the lender up to the face
value of the guarantee in the event of default by the LDC
debtor. Clearly, such guarantees will encourage banks to
make and hold LDC debt because some or all of the
24

increased risk is borne by the guarantor (that is, the
government) and not the lender.
Of course, there have been no public pronouncements
that provide unequivocal evidence of the existence of such
guarantees. Sachs (1987), however, maintains that loan
guarantees were an explicit part of the negotiations involving rescheduled debt. 19 Moreover, a number of other
studies have argued that bank managers and investors
behaved as if implicit guarantees existed, in part because
there are clear public policy goals served by lending to
LDCs. For example, Folkerts-Landau (1985) argues that
the governments of the major industrial countries informally encouraged banks to lend to developing countries on
the implicit understanding that the central banks would
fulfill a lender-of-last-resort function if necessary. 20 Likewise, Guttentag and Herring (1985) suggest that one
reason that banks allowed exposure to LDCs to become so
high may be the existence of official international support
for developing countries through such programs as the
IMP's adjustment assistance programs. 21
In contrast, there is little evidence that direct guarantees, whether explicit or implicit, were available for
bonded debt. If guarantees were to apply only to bank
loans, this would explain the willingness of bank lenders
to continue lending while bondholders became more
reluctant after the crisis.
A second way that the government could have subsidized lending to LDCs is indirectly - through (underpriced) guarantees of banks' liabilities. Of course, such
subsidies are not available to bondholders. This sort of
deposit insurance subsidy increases banks' willingness to
hold risky assets generally. Since lending to LDCs was
considered riskier than lending to industrial countries even
prior to the debt crisis, banks would have had incentives to
increase their exposure to LDC borrowers, particularly as
the demand for external funds apparently increased
throughout the 1970s. This could explain why a very large
share of the private lending to LDCs even prior to the crisis
took the form of bank loans as opposed to bonds.
Once the debt crisis erupted, the response of bank share
prices and of new bank lending to troubled LDCs would
have depended on the nature of the subsidy. Direct subsidies in the form of loan guarantees likely would have had
less impact on stock prices and lending behavior than
indirect subsidies. Specifically, with direct subsidies, one
would not expect bank share values nor secondary market
values of outstanding LDC loans to decline since the
guarantor would have been the one to bear the losses.
The actual decline in share values and secondary market
prices after the crisis suggests either that direct subsidies
were not a significant factor in banks' international lending
decisions, or that investors and bank managers were
Economic Review / Spring 1988

unsure of the strength of such implicit subsidies. The fact
that banks tended to view IMF assistance and involvement
in the rescheduling of a troubled country's debt as a
prerequisite for providing new funds to that country may
be a reflection of this uncertainty. Alternatively, Sachs has
argued that banks have been willing to continue lending as
a quid pro quo for IMF protection with respect to outstanding obligations. 22
Regardless of the significance of direct subsidies in
banks' lending decisions, indirect subsidies (that is, subsidies associated with deposit insurance protection) almost
certainly played an important role. There is a large and
growing body of evidence on the so-called deposit insurance problem which suggests that indirect subsidies exert
a strong influence on banks' domestic lending. Foreign
lending should be no different in this regard. Moreover, the
declines in bank share prices and secondary market prices
for LDC loans are both consistent with this type of subsidy.
Unlike direct subsidies, in the event of default, bank
shareholders do bear the risk ofloss with indirect subsidies
even though insured depositors do not.
Also, banks' willingness to continue lending to troubled
LDCs after the crisis is consistent with the view that
indirect subsidies were a significant factor in lending
decisions. For example, one could argue, as Furlong and
Keeley (1987) have, that a lender's incentive to hold risky
assets increases the closer the lender is to insolvency.
Thus, the decline in the market value of banks' net worth
following the debt crisis probably provided banks with an
additional incentive to maintain their exposure to the
riskier LDCs.
Finally, the regulatory accounting treatment of
rescheduled and nonaccruing LDC debt also is consistent
with the existence of indirect subsidies. Regulators have
allowed banks to record most LDC loans at book value as
long as there is some "reasonable" prospect that the bank
will be repaid at least its principal investment. As a result,
banks have not had to record capital losses for LDC loans
even though the market value of LDC loans declined
precipitously following the 1982 crisis. By allowing this
sort of indirect subsidy through "capital forbearance,"
bank regulators may have provided some additional
inducements to continue lending. (Of course, regulators
have required banks to improve their book value capital-toassets ratios since then, so the forbearance may not have
been as great as it might have first appeared.)
In sum, subsidies of various sorts probably help to
explain why U. S. banks' exposure to developing countries
reached such a high level in the 1970s. Once the debt crisis
erupted, uncertainty over how the regulators would
respond to the increased possibility of default probably
also helps to explain why bank share values subsequently
Federal Reserve Bank of San Francisco

declined and why banks reduced their new lending to
troubled LDCs. Moreover, the apparent tendency for
banks to keep the riskiest debt may be consistent with this
view, particularly if the regulators' actions over time could
be interpreted as providing assurances of willingness to
forbear.
However, the existence of subsidies does not necessarily
explain why seemingly only the nine largest banks could
take advantage of them, unless the subsidies were directed
at a group of banks considered, by both the regulators and
the market, as too large to be allowed to fail. Otherwise,
subsidies would have been perceived to extend to other
large banks as well, if not also to the smaller banks.

Assessment
The available evidence on lending to LDCs cannot
clearly distinguish among the three explanations: the
involuntary lending argument, the efficiency factor, and
the subsidy factor. More sophisticated tests might shed
some light and, in fact, work in progress by James suggests
that indirect deposit subsidies have had a lot to do with
LDC lending.
However, it is likely that all three influences have been
operating since they are not mutually exclusive and may
even be complementary. For example, part of the reason
that the governments of industrial countries may have
chosen to provide protection for bank loans to LDCs may
have been that, in the event of a crisis, bank lenders have a
relative advantage in monitoring the borrower and in
handling a problem loan workout. Moreover, multilateral
organizations like the IMF may have encouraged continued lending and helped to enforce fair-share rules
because the amount of funds provided otherwise would
have been inadequate. Thus, the three influences could
have been and probably were mutually reinforcing.

25

v. Summary and Policy Implications
Mexico's announcement in August 1982 had a profound
impact on the market's assessment of the default probabilities associated with lending to developing countries.
Specifically, default risk premia increased and the holders
of existing debt suffered large market value capital losses.
As a result, lenders have become less willing to extend
new loans to the countries perceived as most risky. Moreover, the outstanding exposure of U.S. banks has declined
through actual write-offs, repayments, and, primarily,
through growth in capital accounts.
The decline in exposure to troubled LDCs, however, is
not very dramatic when compared to the declines in
exposure to more creditworthy international borrowers.
Likewise, the largest U.S. banks now have a larger share of
troubled LDC exposure than when the debt crisis erupted.
This paper has posited a number of possible explanations,
all of which imply that after 1982 investors developed a
decided preference for holding the obligations of troubled

26

LDCs in the form of bank loans as opposed to bonds.
Previously cited work by James suggests that indirect
subsidies have played a significant role in keeping U. S.
banks' exposure to the riskiest developing countries high.
Consequently, bank regulators must continue to monitor
these exposures carefully and encourage banks to continue
to raise capital to prevent further distortions in international lending decisions.
At the same time, however, bank lending to troubled
monitoring
LDCs also may be a reflection of the
capabilities banks have in working with problem debtors.
As a result, the true value of these loans on banks' books
may lie somewhere between their book values and their
values to nonbank investors on the secondary market.
Such considerations are important to proposals that would
require banks either to mark their LDC loan portfolios to
market and/or to hold substantially more book capital.

Economic Review / Spring 1988

APPENDIX A
International Banking

List of Country Groups
G-10 Plus Switzerland

Switzerland
Italy
Belgium-Luxembourg

Germany
United States
Japan

Canada
France
Netherlands

Sweden
United Kingdom

Non-G-10 Developed Countries

Australia
Austria
Finland

Ireland
Spain
Greece

Bahrain
Oman
Algeria
Gabon
Iran

Kuwait
Nigeria
Saudi Arabia
Venezuela

New Zealand
Denmark
Iceland

Norway
Portugal
Turkey

OPEC LDCs

Brunei
Trinidad & Tobago
Ecuador
Indonesia

Iraq
Libya
Oatar
United Arab Emirates

Non-OPEC Developing Countries, Troubled Debtors

Argentina
Barbados
Bolivia
Chile
Costa Rica
Dominican Republic
Guatemala
Haiti
Ivory Coast

Liberia
Malawi
Morocco
Panama
Peru
Senegal
Uruguay
Zambia

Angola
Botswana
Burundi
China PR
Cyprus
Ethiopia
Ghana
Hong Kong
Israel
Kenya
Lesotho
Malaysia

Mauritius
Nauru
North Korea
Pakistan
Puerto Rico
Solomon Islands
Sri Lanka
Syria
Tanzania
Vietnam
Yugoslavia

Bahamas
Bermuda
Brazil
Columbia
Cuba
EI Salvador
Guyana
Honduras

Jamaica
Madagascar
Mexico
Nicaragua
Paraguay
Philippines
Sudan
Zaire

Non-OPEC Developing Countries, Nontroubled Debtors

Antigua
Burma
Cameroon
Congo
Egypt
Fiji
Guinea
India
Jordan
Lebanon
Macao
Mauritania

Mozambique
Nepal
Netherlands-Antilles
Papua New Guinea
Singapore
South Korea
Swaziland
Taiwan
Upper Volta
Yemen
Zimbabwe

Baker's List of 15 Largest LDCs with Debt Servicing Problems

Brazil
Mexico
Argentina
Venezuela

Philippines
Chile
Yugoslavia
Nigeria

Federal Reserve Bank of San Francisco

Morocco
Colombia
Peru
Ecuador

Ivory Coast
Uruguay
Bolivia

27

FOOTNOTES
1. See Sachs (1987) for a more complete description of the
rescheduling arrangements.
2. Cited in Kyle and Sachs (1984).
3. In addition, the average (for all rated countries) country
risk rating published by Institutional Investor fell from 52.3 to
41.0 between 1980 and 1983.
4. There are a number of other studies on the impact of lDC
exposure on bank share prices. See, for example, Smirlock
and Kaufold (1987) and Cornell and Shapiro (1986).
5. The data on external funds raised in international markets
come from the OECD's Financial Statistics Monthly. All data
are reported in U.S. dollars and are converted on the basis of
the average spot rate for the month the bonds or loans were
reported. For this paper, we use year-end figures that reflect
the sum of all new lending, including bond financing over the
year. It should be noted, however, that these figures represent total funds raised, including rescnedulinqs and retinancings, as opposed to net new funds raised.
6. Morgan Guaranty Trust Company, World Financial Markets, June/July 1987.
7. Rodney Mills, "Foreign lending by Banks: A Guide to
International and U.S. Statistics," Federal Reserve Bulletin,
October 1986.
8. It should be noted, however, that this increase in loan loss
reserves also is the result of anticipated loan losses arising
from banks' domestic loan portfolios at this time.
9. Data on U.S. banks' international loan exposure come
from the Federal Reserve Board's Country Exposure Lending
Survey (CElS). This survey was first conducted in 1977 in
response to a perceived need for better data on the crossborder claims of consolidated banking organizations
domiciled in the U.S. with foreign branches and majorityowned foreign subsidiaries. The data are now collected on a
quarterly basis. US bank exposure to over one hundred
countries and a number of international organizations are
reported by type of borrower and time remaining to maturity,
with adjustments for loan guarantees that shift exposure
across countries.
CElS data are reported for three subsets of banks: the nine
money center banks, the next 14 largest banks, and the
remaining banks with at least $30 million in consolidated
claims on non-U.S. residents and that have at least one
foreign branch or foreign subsidiary (about 160 in number).
The major drawbacks of these data are that they do not
cover the claims held by all U.S. banks and the country-bycountry breakdown only covers exposures that exceed
three-fourths of one percent of a reporting bank's capital.
Also, CElS data do not cover local-currency-denominated
claims.

28

10. Reported in Sachs (1987), cited above.
11. Krugman (1985) and Sachs (1984) have developed
models that show once a sovereign borrower has run into
debt problems, it may be in the interests of all the lenders
involved to reschedule the outstanding obligation and
extend additional funds to reduce the borrower's near-term
debt burden and enhance long-term repayment prospects.
However. because there is a public good aspect to new
lending i~ that the value of any given lender's outstanding
exposure will be enhanced whether or not that lender participates in providing new funds, the lenders with the smallest
exposures will have an incentive to "free ride" on the new
lending of the others.
12. The Spearman Rank Test showed that correlation
between the Institutional Investor rating and the loan discount for a given country was 0.843, at a significance level of
0.0001.
13. OECD, Financial Statistics Monthly.
14. There may be other factors, as well. For example, Guttentag and Herring (1985) argue that bank lending to
developing countries can be explained by a concept drawn
from current research in cognitive psychology called "disaster myopia." However, because this view has not gained wide
acceptance in the literature, it is not addressed In this article.
15. Berlin and loeys (1986), James (forthcoming) and
implicit in Folkerts-landau (1985).
16. These covenants typically require the borrower to meet
certain readily observed conditions which, presumably, are
good indicators of the borrower's true net worth. These
conditions include among other things, restrictions on the
types of assets the borrower may invest in, the maintenance
of certain financial ratios, and the maintenance of a minimum
level of capital adequacy. Violations of these covenants
imply that the borrower is close to insolvency, giving bondholders the right to accelerate the maturity of their claim even
to the point of forcing liquidation of the borrower's assets in
bankruptcy.
17. For example, the growth in the commercial paper market
largely is due to the ability of larger, well-established borrowers to raise funds directly at a lower cost than through
bank loans.
18. See Niehans (1985) and Glick (1986).
19. Sachs (1987), p. 21.
20. Folkerts-landau (1985), p. 324.
21. Guttentag and Herring (1985), p. 136.
22. Sachs (1987), p. 21.

Economic Review / Spring 1988

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Federal Reserve Bank of San Francisco

29

Monetary Targeting:
the West German Experience
Rising inflation over the 1970s led to the adoption of
monetary targets as a guide to
in a
number of industrialized countries. The West '-''-,' n
Central Bank (the Bundesbank) was the first central bank
to announce a target
money
Since
the
rates of inflation that have prevailed in West
have
been lower than those in most other industrialized nations.
This paper examines the extent to which the Bundesbank
has relied upon monetary targets to keep inflation under
control as well as to achieve its other policy objectives.
Our analysis focuses upon two key questions. We ask
whether the West German central bank's choice of a target
variable has the properties required of such an aggregate.
This question is especially interesting because from 1975
to 1987 the Bundesbank targeted a rather unusual monetary aggregate called Central Bank Money (CBM), which
is a weighted average of the components of the broad
monetary aggregate M3. Thus, we ask whether a stable
relationship exists between CBM and key macroeconomic
variables such as output, interest rates, and the price level.
Our answer is yes.
We ask the same question for M3, which is the aggregate that the Bundesbank has announced it will target over
1988. Once again, the data is consistent with the existence
of a stable relationship between key macroeconomic variables and this aggregate. In fact, the data suggests that
CBM and M3 are rather similar.
We then look at the performance of the Bundesbank
since the time that it began to target CBM. Despite the
Bundesbank's success in keeping inflation low, it turns out
that the Bundesbank's target variable has been outside the
pre-announced range nearly as often as it has been within
it. Furthermore, movements in the dollar-deutschemark
exchange rate appear to be an important determinant of
where the Central Bank Money Stock ends up relative to
its target range. Clearly, the Bundesbank retains a considerable amount of discretion in its implementation of
policy.
The rest of the paper is organized as follows. Section I
presents a brief description of the institutional environment in which the Bundesbank operates. Section II
describes the Bank's original target variable, CBM, as well
as the factors that led to its choice. Section III continues the
examination of CBM in a more formal way and also
examines the properties of the more conventional monetary aggregates M 1, M2, and M3.
H ...

h

".,. .... ".,.1-

Trehan

Economist, Federal Reserve Bank of San Francisco.
Editorial committee members were Reuven Glick, Fred
Furlong and Ramon Moreno.

Since the Bundesbank
targeting in
it has used two target variables - Central Bank
Money and M3. Wefind both choices to have the properties
required
monetary target. However, the Bundesbank
has not adhered strictly to its targets, retaining considerable discretion in its implementation of monetary targetChanges in the dollar-deutschemark
exchange rate have a significant impact on where the
target variable ends up relative to the pre-announced
range.

30

Economic Review / Spring 1988

Section IV looks at the conduct of monetary policy
since the Bundesbank first announced a monetary target in
1975. It contains a brief description of the economic
developments and some statistical analysis of the factors
that have influenced monetary policy in the interim. A

more detailed description of West German monetary policy since 1975 is presented in the Appendix. Section V
presents the conclusions and discusses the implications of
our analysis for the United States.

I. The Bundesbank and its Monetary Policy Objectives
The organization of the Bundesbank is similar to that of
the Federal Reserve. The Central Bank Council is the
policymaking body of the bank and is composed of the
members of the directorate and the presidents of the eleven
land central (that is, regional) banks. The directorate is the
central executive organ, whose members are nominated by
the federal government and appointed by the president of
Germany after consultation with the Central Bank
Council. I
The Bundesbank Act of 1957 emphasizes the Bank's
role in ensuring the stability of the currency, which has

n.

Choosing an Intermediate Target

Two criteria govern the choice of an intermediate target
variable. The first is that the target variable be controllable
by the central bank given the available instruments. The
second is that its control should lead to stable and predictable effects on the economy.

Opposite

been interpreted to include both a stable price level and a
stable foreign exchange value for the deutschemark.
The Act allows the Central Bank a considerable degree
of autonomy. While the Bundesbank is required to support
the general economic policy of the government, it does not
have to do so if such support were to threaten the stability
of the currency. Members of the federal government are
allowed to attend the policy deliberations of the Bundesbank. While they cannot vote, they can place items on
the agenda and suggest that a policy decision be postponed
for two weeks.

The monetary aggregate called Central Bank Money
(CBM) is a weighted average of the components of the
broad monetary aggregate, M3. Currency is included and
receives a weight of 1. The weights are .166 for demand
deposits, .124 for savings deposits, and .081 for time

Chart 1
o vement s in German M1 and

2*

1978

1986

Percent

16
12

8
4
0
-4
1975

*

1976

1980

1982

1984

Growth rate is measured over the previous four quarters.

Economic Review / Spring 1988

31

deposits. The weights on the various deposit accounts are
actually the reserve requirements that were in effect in
January 1974 and the weights have remained unchanged
since then (although the actual reserve requirements have
varied over time). CBM differs somewhat from the monetary base since it excludes excess reserves and includes
only residents' holdings of deposit accounts. To understand why the Bank chose to target CBM rather than a
more conventional aggregate, such as M1 or M2, it is
useful to examine the circumstances leading up to its
choice.
Prior to 1973, the Bundesbank paid close attention to
"free liquid reserves," which consisted of excess reserves
of commercial banks, short-term foreign assets, and
unused rediscount quotas. However, the relationship
between this aggregate and bank lending weakened in the
early 1970s. In particular, bank lending continued to grow
significantly even when free liquid reserves were close to
zero. Faced with this shift in behavior, the Bundesbank was
forced to find alternative aggregates.
M1 was not a particularly attractive candidate because
experience over the 1960s had shown that changes in
policy did not have predictable effects on MI. Furthermore, the decontrol of interest rates over the 1965-67
period led to an increase in the degree of substitution
between demand deposits and short-term deposits. As a
consequence, the Bundesbank began to look at a somewhat broader concept of the money stock consisting of M 1

plus time deposits of less than six months maturity. Underlying this step was the belief that demand deposits and
short-term deposits had become close substitutes due to
interest rate decontrol. This aggregate was later modified
by including time deposits with maturities up to 3 months
only, and was called MIa.
Unfortunately, sharp interest rate movements in the
early 1970s demonstrated that MIa was an unstable indicator. For one thing, it turned out to have a positive interest
rate elasticity. Consequently, a broader aggregate called
M2 was introduced that contained MI plus time deposits
of up to 4 years maturity.2
However, MI and M2 often moved in opposite directions, making it difficult to interpret what their movements
really meant. Chart I illustrates that the high degree of
substitution between M1 and M2 has continued over time.
There is general agreement that these deposit swings are
interest rate-induced. However, the problem for monetary
policy has been the difficulty of predicting the extent of
these movements.
Another margin of substitution that came to light as a
result of the sharp interest rate swings of the early 1970s
was that between savings and time deposits. As a consequence, the monetary authorities defined a new aggregate
called M3 which consisted of M2 plus savings deposits.
Although M3 was perceived to internalize the deposit
shifts plaguing M1 and M2, the Bundesbank chose not to
target this aggregate at that time, apparently on the

Chart 2
Similar Growth Rates for CBM and M3 *

Percent

12
10
8
6

4
Central Bank
1975

*

32

1976

1978

1980

1982

1984

1986

Growth rate is measured over the previous four quarters.

Economic Review / Spring 1988

grounds that assigning equal weights to demand, time, and
savings deposits would exaggerate the "moneyness" of
the latter two. 3
Thus, the choice of CBM was motivated by the Bundesbank's belief that none of the existing monetary aggregates
was likely to be useful as a target variable. Narrower
aggregates such as Ml and M2 were likely to be afflicted
by portfolio substitution, which would make it difficult to
interpret movements in them, and the broad aggregate M3
was too imprecise a measure of transactions balances. A
broad aggregate with more appropriate weights was, therefore, seen as the solution. This broad aggregate was
expected to share some ofthe characteristics ofM3 and, at
the same time, reflect movements in transactions aggregates to a greater extent than M3.

The Bundesbank has mentioned this as the rationale for
choosing CBM on several occasions:
The various types of deposits within the minimum
reserve component of the central bank money stock
(that is, savings, time and demand deposits) are
consequently in a relation of roughly 4:3:2 to each
other. This could approximate the varying degrees of
moneyness or liquidity which the different categories
of deposits are regarded as having,"
Chart 2 plots the growth fiites of Central Bank Money
and M3 for the period 1975-1986. The growth rates of the
two aggregates are close, suggesting that they do indeed
have similar characteristics. We tum now to an examination of the relationship between these aggregates and
various macroeconomic variables.

III. Analyzing the Monetary Aggregates
For an aggregate to be useful as a monetary target, there
should exist some sort of equilibrium relationship between
it and macroeconomic variables such as output, the price
level, and the rate of interest. However, this requirement is
more properly imposed upon the long-run behavior of the
aggregate, since it would be unnecessarily stringent to
require that equilibrium exist in every single period.
Nevertheless the short-run behavior of the aggregate is not
irrelevant. For policymakers, the usefulness of a long-run
relationship between a particular monetary aggregate and
key macroeconomic variables is likely to be severely
impaired if short-run movements in the aggregate are
largely uncorrelated with movements in those variables of
policy concern.
This section presents an analysis of the properties of
four alternative monetary aggregates - CBM, Ml, M2
and M3. We begin by examining the nature of long-run
movements in the various monetary aggregates and
whether these movements are related to long-run movements in output, prices, and the interest rate. It turns out
that there is no stable, long-run relationship between
output, interest rates, and the real value of either Ml or
M2.
We then go on to estimate money demand functions for
the remaining two aggregates, CBM and M3. These
demand functions allow for adjustment towards long-run
equilibrium and also for the effects of short-run changes in
the independent variables. The properties of the estimated
demand functions provide essential information about the
usefulness of these aggregates as target variables. For
instance, a significant interest rate elasticity implies that
the aggregate is subject to control through policy-induced

Federal Reserve Bank of San Francisco

interest rate movements. In addition, a stable demand
function ensures that policy-induced variations in the
target variable would have predictable effects on the
economy.

Long-run Behavior
Recent work in econometrics has shown that it is
important to determine correctly the nature of the longterm movements of a variable before attempting to carry
out any estimation. Specifically, it is necessary to determine whether random disturbances have permanent
effects on the level of the variable. A variable that exhibits
no tendency to return to its original value following a
disturbance it said to be nonstationary. Conversely, if the
effects of the random disturbance were to die out over time,
the variable would be said to be stationary. Of course, the
variable still could be growing around a trend, in which
case the series is said to be trend-stationary. 5
The point is that conventional econometric techniques
require stationarity. For example, if output, interest rates,
and the monetary aggregates were stationary, then we
could estimate money demand functions directly. Things
are not as straightforward if some (or all) of these variables
were nonstationary. We return to these issues below.
To determine whether the variables that are of interest to
us are stationary (or trend-stationary, as the case may be),
we use the Dickey-Fuller test for unit roots, which is
described in Fuller (1976). The test consists of regressing
the first difference of the variable in question on its own
lagged level plus a constant, a time trend, and lagged first
differences as appropriate. The null hypothesis that the

33

series contains a unit root (in other words, that random
disturbances permanently alter the level of the series)
implies that the coefficient on the lagged level should be
zero. The test statistic is just' the ratio of the estimated
coefficient to its standard error, except that under the nun
hypothesis this statistic does not have the usual t-distribution. Critical values for this statistic are tabulated in Fuller.
Table I presents the results of this test for the levels and
differences of the logs of real GNP, the real values of the
four monetary aggregates," and the interest rate variable
(which is the rate on three-month bank loans), The sample
period is 1975Ql to 1986Q4, In each case, we have
included two lags of the first difference of the dependent
variable to capture the short -run dynamics. The first half of
the table shows that we cannot reject the hypothesis of
nonstationarity (or nontrend-stationarity, as the case may
be) at even the 10 percent level for any of the series. By
contrast, we can reject the hypothesis of nonstationarity at
the 5 percent level for the first difference of all the series in
the table,

34

Our findings suggest that the levels of all the variables in
question contain unit roots. A variable that contains a unit
root has no tendency to return to any
value over
time (or to return to any trend
for an
equilibrium relationship to exist between a particular
aggregate and variables such as output, interest rates, etc.,
the disturbances that cause nonstationary behavior in the
monetary aggregate must also influence the latter set of
variables. If the
in the
does
arise from the same sources as the nonstationarity in
output, etc., the monetary aggregate will tend to drift away
from the other variables.
Recent developments in econometrics
a means
of determining whether there is a long-run reranonsrup
between variables that contain unit roots. It turns out that
we can test for the existence of a long-run relationship
between such variables by estimating an ordinary least
squares regression and examining the residuals from this
regression for stationarity. A finding that the residuals are
stationary means that even though the variables included

Economic Review / Spring 1988

in the regression are nonstationary, there exists a linear
combination of the variables that is stationary. Put differently, the variables will not drift away from each other.
Such variables are said to be cointegrated. (See Granger
and Engle, 1987.)
Table 2 presents the results of regressing the logs of the
real values of each of the monetary aggregates on the logs
of real GNP and the interest rate. We present two alternative test statistics. The row labelled "Dickey-Fuller Test"
presents the results of the Dickey-Fuller test for stationarity of the residuals. As discussed, this test involves
regressing the first difference of the residual series from
the regression on its lagged level. The test statistic is the
ratio of the estimated coefficient to its standard error, as
before. The Durbin-Watson statistic for the original equation also can be used to test the hypothesis that the
variables are cointegrated, If the variables were not cointegrated, the residuals would be nonstationary and the
Durbin- Watson statistic would be close to zero. Thus, the
null hypothesis of no cointegration (or alternatively, that
the residuals are nonstationary) would be rejected if the
Durbin- Watson statistic were large enough. Critical values
for both tests are reported in Engle and Yoo (1987). Note,
however, that the critical values of the Durbin-Watson
statistic reported there are for cointegration in the bivariate
case only.?

Federal Reserve Bank of San Francisco

The results in Table 2 show that we can reject the
hypothesis of no cointegration between CBM, real GNP,
and interest rates at the 5 percent level on the basis of the
Dickey-Fuller test. The Durbin-Watson statistic is also
reasonably large. The Dickey-Fuller test does not allow us
to reject the hypothesis of no cointegration between M3
and the other two variables at even the 10 percent level.
However, the Durbin-Watson statistic for this regression is
significant at the 10 percent level. For
and M 1, we
cannot reject the null of no cointegration on the basis of
either test.
Although none of the more conventional monetary
aggregates (Ml , M2 or M3) is cointegrated with income
and interest rates taken together, it is possible for them to
be cointegrated with income alone. The results of the tests
for cointegration between each of these aggregates and real
GNP are presented in Table 3. We can reject the null
hypothesis of no cointegration between M3 and real GNP
at the 10 percent significance level using either the DickeyFuller test or the Durbin-Watson statistic. However, we
cannot reject the null of no cointegration either between
MI and real GNP or between M2 and real GNP.
These results have important implications for the choice
of target variable. Our evidence suggests that the real
values of both M 1 and M2 are subject to random disturbances that permanently alter the levels of these aggre-

35

gates but that do not have similar effects on either income
or interest rates. This makes it undesirable to use M I and
M2 for monetary targeting, since they exhibit no tendency
toward a stable relationship with key macroeconomic
variables. One implication of this finding is that if a money
demand function were estimated for either of these aggregates, the absence of an equilibrium relationship likely
would show up as permanent "shifts" in the estimated
function.
By contrast, our results show that permanent disturbances to the real value of CBM are related to permanent
disturbances to output and interest rates. The finding that
CBM is cointegrated with real GNP and interest rates has
an intuitive interpretation. It implies that even though
these three series are subject to random disturbances that
have permanent effects, these disturbances are not independent. Thus, long-run movements in the real value of
CBM will tend to be closely associated with movements in
output and interest rates. We also find that permanent
disturbances to the real value of M3 are related to permanent disturbances to output (although the evidence here is
weaker). Thus, long-run movements in M3 will mirror
movements in output.

Estimating Demand Functions
The existence of a cointegrating regression is not sufficient to ensure that either CBM or M3 will be useful as
monetary aggregates since it tells us only about long-run
relationships. We need to examine the behavior of these
two aggregates over the short-run as well. It is tempting to
do so by estimating money demand functions in the first
differences ofthe variables, since first differencing purges
the data of long-run movements. However, such a step is
inappropriate when the variables are cointegrated because
it means ignoring the long-run relationship that exists
between them.
The appropriate way to proceed is to estimate an error
correction model which forces gradual adjustment of the
dependent variable toward some long-run value while
explicitly allowing for short-run dynamics. 8 For example,
our finding of cointegration implies that the difference
between the actual value ofCBM and that suggested by the
cointegrating regression will tend to move back towards
zero following a random disturbance. This suggests that
the discrepancy between the actual and equilibrium value
of CBM is likely to be one of the factors that determines
the growth ofCBM at any time. Of course, the growth rate
of CBM also is likely to be influenced by various temporary disturbances to the other variables in the regression.
These considerations suggest that the equation to be
estimated should be of the form:
CBM t = a

+ b, I

a Real GNP

t - i

1

+

Cj

I

a INT

t

j

+ d EC t

J

i

where

a denotes the first difference,
INT is the interest rate, and,
EC t = CBM t + 4.22 1.28RGNPt
is the error-correction term.

+ O.02INT t

The error-correction term is constructed using the
coefficients from the cointegrating regression shown in
Table 2. The first differenced terms capture the effects of
short-run disturbances to output and interest rates while
the error correction term captures the adjustment towards
long-run equilibrium. A similar equation is estimated for
M3, with the error-correction term obtained from the
cointegrating regression shown in Table 3.
The estimated demand functions for CBM and M3 are
shown in Table 4. The functions were first estimated with 8
lags of both the first difference of real GNP and the interest
rate. Lags that were insignificant were then eliminated,
taking care that this did not induce residual autocorrelation. The coefficient on the error-correction term in the
CBM equation reveals that approximately one-fourth of
36

Economic Review / Spring 1988

the previous quarter's discrepancy between the actual and
equilibrium value of CBM is corrected each quarter. Shortrun movements in real GNP and interest rates also have a
significant impact on CBM growth.
The equation for M3 reveals that the previous period's
discrepancy between actual and equilibrium values is a
significant factor in explaining M3 growth as well. Further,
while there is no long-run relationship between M3 and the

Federal Reserve Bank of San Francisco

rate of interest, the growth rate of M3 is temporarily
affected by interest rate movements.
A Chow test was carried out to test the stability of each
of the estimated demand functions. The sample was
divided. into two subsamples, the first extending over
1975Ql-1979Q4 and the second extending over
I980Q 1-1986Q4. The breakpoint was chosen on the basis
of the dollar-mark exchange rate: the dollar reached its low
point against the mark in 1979Q4 and began to appreciate
after that. For CBM, the computed value of the F(9,28)
statistic is 1.48, which has a marginal significance level of
.20. The computed value of the F(5,38) statistic for the M3
equation was 0.68, which has a marginal significance level
of .64. 9 Thus, neither the demand function for M3 nor that
for CBM exhibits any evidence of instability over the
1975Ql-1986Q4 period.
To summarize, the evidence presented in this section
suggests that the real value of CBM has had a stable
relationship with real income and interest rates over the
period that the Bundesbank has been targeting CBM. Real
output and the real value of M3 also appear to be similarly
related. However, no stable, long-nm relationship exists
for either Ml or M2.
These results are consistent with the argument that the
narrower aggregates are subject to random portfolio disturbances that prevent them from having a stable relationship
with output. These disturbances appear to be internalized
within the broader aggregate M3 to an extent that interest
rate fluctuations do not appear to have any long term
impact on it. The evidence also suggests that aggregate
CBM has characteristics more like those of the broad
monetary aggregate M3 than the relatively narrow aggregates M1 and M2. This implies that the weights attached to
savings and time deposits in CBM are sufficient to offset
the impact of portfolio disturbances that afflict M 1 and M2
and to ensure a stable relationship between real output, the
interest rate, and the real value ofCBM. Thus, our analysis
suggests that both CBM and M3 possess the characteristics required of a target variable. 10
We now tum to the second issue that is of interest,
namely, an examination of the actual conduct of policy
since the Bundesbank began to target CBM.

37

IV. West German Monetary Policy since the mid-1970s
In this section, we examine West German monetary
policy since the Bundesbank began to target CBM in
1975. We begin by describing the factors that the Bundesbank takes into account in setting the target range each
year, and then look at how the CBM target has varied over
the years. Finally, we look at how successful the Bundesbank has been at achieving these ranges and the factors
that have played a role in determining where CBM ended
up relative to its target range.
By announcing a CBM
for 1975, the Bundesbank
became the first central bank to announce a money growth
target. In the beginning, the Bundesbank's discussion of a
desirable rate of CBM growth was couched in terms of the
expected growth of capacity, the desired change in capacity utilization, and the expected development of the
"velocity of circulation." 11 The Bundesbank also made an
allowance for the "unavoidable" rate of inflation, which
was defined as "price rises which have already entered into
decisions and arrangements in the economy." However,
the Bundesbank stopped using the term unavoidable in
1985, explaining that "Given the large measure of price
stability achieved, it would have been difficult to explain
credibly why this concept should be retained." 12
Recent discussions of the target range for CBM have
been cast in terms of the growth rate of the nominal
"production potential" , which is further broken down into
the growth rate of real production potential and a "tolerated" rate of inflation. The rate of inflation that the Bank
allows for has been declining over time. For example, it
was between 4 to 5 percent in 1976, between 3.5 to 4
percent in 1981, and 2 percent in 1986. The Bundesbank
also retains the option of revising targets at mid-year, but
has not done so until now.
Table 5 presents the target ranges as well as actual
growth of CBM since 1975. The Bank announced singlevalued targets for the first four years, but (convinced
perhaps by the size of the errors) has been expressing its
targets as ranges since 1979. It is notable that the upper
bound of the target range decreased steadily from a high of
9 percent in 1979 to 5 percent in 1985. However, it went up
by a half-percentage point in both 1986 and 1987. The
width of the range also was narrowed to 2 percentage
points beginning in the target year 1984, but was widened
back to 3 percentage points for 1987. We discuss the
significance of these changes below.
The Bundesbank's record in achieving its target ranges
has been mixed. CBM growth was above target from 1975
to 1978- the four years for which the target consisted of a
single number. However, for two of those years the discrepancy was only around one percentage point. CBM

38

growth did not exceed the upper bound of its target range
for the next six years, actually ending up below the lower
bound in 1980 and 1981. However, the target was overshot
in both 1986 and 1987.
An examination of the conduct of monetary policy since
1975 provides interesting insights into how the Bundesbank reacts to different economic developments and
helps explain the Bank's record of monetary targeting. (A
description is contained in the Appendix.) It is quite
that the Bundesbank attaches a
deal of
importance to price level stability. But
rate
stability - especially the stability of the mark-dollar rate
- has always been an extremely important consideration.
While the exchange rate is important because Germany's
foreign trade comprises a significant proportion of its
GNP, the focus on the dollar is probably the result of the
fact that the mark is one of the most important reserve
currencies in the world after the dollar. Consequently, the
least sign of instability in the value of the dollar sets up

Economic Review ! Spring 1988

speculative movements in the mark. In addition, a significant amount of world trade is invoiced in dollars.
The strong correlation between movements in the markdollar rate and how well the Bundesbank performed relative to its target range, in fact, allows us to divide the
period under review into three sub-periods. The first
covers the years immediately following the adoption of the
CBM target, that is, approximately 1975 to 1979. The
dollar tended to depreciate over this period and the Bundesbank generally allowed CBM to exceed its target.
The mark fell relative to the dollar over the first half of
the 1980s. Over that period, CBM ended the year below
the lower bound of its target range twice and was below the
midpoint once. It never ended the year above the upper
bound of its target range.
The last two years or so constitute the final sub-period,
where the mark has been appreciating against the dollar
again. And in both 1986 and 1987, CBM has grown above
the target range. Thus, the target has been exceeded
despite the fact that the Bundesbank increased the upper
bound of the target range half a percentage point each year.
This is not to say that the Bundesbank cares only about
stabilizing the exchange rate. As mentioned above (and
described in the Appendix), the Bank is extremely concerned about price level stability. And the Bundesbank has
from time to time, adjusted its policy stance to take the
level of real activity directly into account. To obtain a more
accurate idea of the importance that the Bundesbank
attaches to various objectives, a monetary policy reaction
function was estimated for the years 1975-1986.
The reaction function was estimated in terms of the
deviation of CBM from the midpoint of the announced
target path.t ' This variable - denoted by CBMDEV
below - is preferable to using (either the level or the
growth rate of) CBM directly, since using CBM may result
in confounding the demand function for the aggregate with
the Bundesbank's reaction function. The explanatory variables in the regression are the growth rate of real GNP
(RGNP), the rate of inflation (GNPDEF), and the growth
rate of the deutschemark-dollar exchange rate
(DM$RATE), which is expressed in dollars per mark. 14

Federal Reserve Bank of San Francisco

The estimated equation is:
CBMDEV t =

1.52
(2.96)

+

.01 RGNPt
(.39)

.01 RGNPt
.32)
.03 RGNPt
( - 1.32)

R2/R

2

+ .05 RGNP t _ 2

I

(l.58)
3

(

.19 GNPDEF t
(-3.32)

I

+

.004 DM$RATE t _
(.62)

I

+

.005 DM$RATEt 2
(.93)

= .65/.53;

.18 GNPDEFt
3.02)

+ .006 DM$RATE t
(.96)

D.W. = 1.75;

+

.02 DM$RATEt _
(3.19)

3

Rho = .58 (3.88)

From the test statistics, we can reject the null hypothesis
that the coefficients on the current and lagged values of
real GNP growth are zero at the 5 percent level of significance. However, the sum of the coefficients on real GNP is
.02, and has a marginal significance level of .84. The
coefficients on the inflation rate are significant at the 1
.37, which also is
percent level, and their sum is
significant at the 1 percent level. We can reject the
hypothesis that the coefficients of the current and lagged
values of the exchange rate are zero at the 5 percent level of
significance. The sum of these coefficients is .03 and is
significantly different from zero at the 5 percent level as
well.
These results are consistent with our earlier discussion.
The estimates suggest that the Bundesbank responds
immediately to changes in inflation. An increase in inflation leads to a contemporaneous reduction in CBM growth
relative to the mid-point of its target range as well as a
reduction in CBM growth over the next quarter. When the
mark appreciates against the dollar, policymakers respond
by pushing CBM above the midpoint of its target range.
However, this response is slower than the response to
inflation. Finally, the measured response to GNP is ambiguous. Thus, the Bundesbank apparently attaches the greatest importance to the rate of inflation and to stabilizing the
exchange rate. IS
We have examined how the Bundesbank sets its monetary targets and how successful it has been in attaining
these targets. We saw that the target is missed fairly often,
and that large misses are associated with variations in the
dollar-mark exchange rate. These casual observations are
supported by the results from the estimated reaction
function.

39

However, the fact that the Bundesbank often gives up on
its monetary target in pursuit of exchange rate stability has
not called into question its commitment to price level
stability. This appears to be the result of the relatively low
rates of inflation that have prevailed in West Germany over
the period. For example, Germany's GNP deflator
increased by approximately 3 percent over 1986, after
increases of approximately 2 percent over each of the
previous two years. While the rate of inflation did go up

v.

Conclusions

This paper has focused on two aspects of the process of
monetary targeting in Germany since 1975. The first
concerns the choice of a target variable. Our results
suggest that CBM has characteristics similar to the broad
aggregate M3, and that neither is susceptible to the portfolio disturbances afflicting Ml and M2. We found evidence that the real value of CBM is cointegrated with real
output and interest rates and (weaker evidence) that M3 is
cointegrated with output. Cointegration between these
variables allowed us to employ an error-correction specification to estimate demand functions for CBM and M3.
These demand functions were robust to a simple test for
nonstability. These results imply that both CBM and M3
satisfy the requirements for a target variable.
The finding regarding the nature ofCBM has potentially
important implications for the U. S. as well. Until recently,
U. S. monetary policy has placed the most emphasis on the
narrow monetary aggregate, MI. However, the behavior of
Ml over the past few years has been largely at odds with
the behavior of output and inflation. In fact, U. S. policymakers today are faced with a dilemma that is similar to
that faced by West German policymakers during the
mid-1970s. The policy of targeting the narrow aggregate
Ml has been rendered infeasible by the increased substitutability between various types of deposit accounts
both inside and outside MI. 17 While the broad aggregates
M2 and M3 do not appear to have been as susceptible to the
random portfolio disturbances that have afflicted Ml in
recent years, movements in them are not likely to be

40

following the 1979 oil price increase, the highest annual
increase in the GNP deflator recorded since 1979 was the
4.8 percent inflation rate during 1981. 16 These relatively
low rates of inflation imply that the Bundesbank's practice
of giving up on its monetary target to focus on stabilizing
the deutschemark has not imposed large costs in terms of
price level stability. As a consequence, the Bank's antiinflation stance remains credible.

closely related to movements in macroeconomic variables
that are of interest to policymakers. As such, it may be
useful to examine the relationship between output, inflation, and some aggregate similar to the West German
Central Bank Money Stock with a view to obtaining a
more suitable monetary target.
The second part of the paper examined the conduct of
monetary policy in Germany since the Bundesbank began
to target a monetary aggregate. The Bundesbank
obviously places a great deal of emphasis on inflation.
This is reflected in the estimated reaction function. It is
also evident in the low rates of inflation in Germany over
this period, rates that clearly have been lower than those
that prevailed in most industrialized nations.
Germany's concern over inflation has not bound it to
strict adherence to monetary targets, since the target has
been missed frequently. Our finding of a stable CBM
demand function suggests that the deviations from target
are not due to "shifts" in the demand for CBM. Instead,
the deviations demonstrate that the Bundesbank has
retained a considerable level of discretion in the implementation of monetary targeting. Our examination of
episodes of deviation from target shows that fluctuations in
the exchange rate were a major determinant of where CBM
ended up relative to its target. This practice has not had
adverse effects on inflation because the Bundesbank has
reacted symmetrically to increases and decreases in the
value of the mark - easing when the mark tended to
appreciate and tightening when it tended to depreciate.

Economic Review / Spring 1988

APPENDIX
German Monetary Policy Since 1975
To provide greater insight into the discussion and conclusions in Section III, this appendix provides a brief
description of German monetary policy since the Bundesbank began to target CBM. *
December 1974-December 1975
Monetary policy relaxed substantially in 1975, the first
year that a target was announced. Real GNP had begun to
contract in mid-l 974 and fell by approximately 5 percent
over the next four quarters. The Bundesbank's tendency to
ease was reinforced early in the year by the falling dollar,
which fell to the then-postwar low of2.28 marks in March.
When economic activity showed no sign of picking up by
mid-1975, the Bundesbank eased policy even further. The
discount rate stood at 3 Yz percent in September - half the
level in September 1974. **
The monetary easing had the expected impact on CBM
growth. The level of CBM in December 1975 was 10
percent above that in December 1974, or 2 percent above
target. The Bundesbank responded to this overshooting by
redefining the target year. The CBM target growth rate
would henceforth be measured on a year-over-year basis,
instead of December-over-December. The justification for
dropping the old method was that it exaggerated the role of
temporary factors. The targeted growth rate of CBM was
set at 8 percent for 1976.
1976-1977
The economy rebounded over the next couple of years,
while the rate of inflation declined. Domestic demand
grew strongly in 1976 and real GNP increased by around
5.5 percent. The rate of inflation fell to 4 percent per year.
Real GNP grew at a 2.5 percent rate the following year
although unemployment did not fall much. Although the
cost of living index for 1977 was 3.9 percent above 1976
levels, inflation was clearly slowing down over the course
of the year.
The dollar, after recovering over mid-1975 and staying
relatively stable over the first half of 1976, started falling
against the mark in the second half. It fell throughout
1977, with the rate of depreciation accelerating consider-

ably after October. On March 1, 1978 the dollar stood at
1.99 marks, having fallen 19 percent over the previous 14
months. The Bundesbank eased substantially over 1977,
causing CBM to grow rapidly. CBM grew at a 12 percent
annual rate over the second half of the year, but the 9
percent rate of growth for the year as a whole was just 1
percent above the target.
1978
The depreciating dollar was perhaps the most important
reason behind the Bundesbank's maintaining its easy
policy stance over 1978. Real GNP grew by 3.5 percent
over the year and the rate of unemployment fell to 3.7
percent. Thus, the level of domestic activity suggested no
need to ease. However, the mark was appreciating significantly against the dollar, so that by October 1978, the
dollar stood at 1.78 marks. The attempt to stabilize the
mark caused policy to remain accommodative, with the
discount rate held at 3 percent over the year. This stance
was facilitated by a still-declining rate of inflation - the
2.6 percent increase in consumer prices over 1978 was the
lowest since the end of the 1960s. Easy policy did lead to a
surge in CBM growth, with CBM growing 11 percent over
the year, while the target rate was 8 percent.
The size of the miss appears to have been responsible for
a redefinition of the target year once again, as the Bundesbank decided to target CBM growth on a fourth quarter
over fourth quarter basis from the following year.
1979
The dollar-mark exchange rate was relatively stable over
1979. Accordingly, the Bundesbank focused on domestic
conditions. Inflation was picking up gradually: while the
cost of living index in 1979 was just 4.1 percent above
1978, its value in December 1979 was approximately 5.5
percent above year-ago levels. Economic activity was
strong, with real GNP rising at a 4.5 percent rate and the
unemployment rate averaging 3.3 percent.
The Bundesbank therefore tightened policy. The discount rate was raised to 4 percent in March and to 5 percent
in July. CBM remained above target till May. At mid-year

*

This description is not meant to be exhaustive. For a detailed discussion. see various issues ofthe GEeD's Economic Surveys on Germany and the
Bundesbank's Annual Reports.

**

In Germany, the discount rate is not a penalty rate as it is in the U.S. Instead it is the rate at which commercial banks borrow against rediscount
quotas established by the Bundesbank. For a description ofpolicy instruments and operating procedures, see Deutsche Bundesbank (1982).

Federal Reserve Bank of San Francisco

41

the Bank decided to aim for the lower half of the CBM
target range and policy was tightened further over the
second half of 1979.

tion in interest rates towards the end of the year allowed
German monetary authorities to ease domestic rates. The
discount rate stood at 5 percent in December.

1980

1983

A depreciating mark and rising inflation came together
to determine the tight monetary policy stance that prevailed over 1980. Consumer prices were approximately
5 Y2 percent above 1979 levels, while the mark fell by
around 13 percent against the dollar. Although real GNP
grew
nearly 2
over the year, this
almost entirely in the first quarter, with output actually
declining over the second half of the year. In February, the
Bundesbank announced that it would keep CBM around
the middle or perhaps in the lower half of its target range.
Attempts to revive CBM growth, and thereby to increase
real activity, during the summer were dropped when the
mark began to depreciate. Signalling a continuation of-its
tight monetary policy stance, the Bundesbank reduced the
target range for the next year by 1 percent.

The mark was relatively stable in early 1983 and the rate
of inflation declined, allowing policymakers to focus on
output growth. The Bundesbank indicated
under
these conditions, it would allow CBM growth in the upper
half of its 4-7 percent target range over the year. Policy
remained easy in the
but the mark's depreciation later in the year led to a
of
the unemployment rate went up during 1983, the rate of
output growth picked up over the course of the year. Real
GNP increased by 1.5 percent over the year as a whole
the first increase since 1980.

1981
1981 was a year of contracting output and rising inflation. Real GNP fell 0.3 percent over the year, while the
cost of living index rose by nearly 6 percent. The mark fell
sharply against the dollar early in the year. By midFebruary, it had fallen by about as much again as it did over
all of 1980.
The Bundesbank reacted with a severe tightening of
policy. The mark recovered in response and began to
appreciate against the dollar in the latter half of the year.
As a consequence, interest rates began to decline in late
1981. CBM growth was on target until mid-year but then
slowed and actually declined for a while towards the end of
the year.

1982
The worldwide recession in 1982 and the consequent
decrease in German exports combined with stagnant
domestic demand to cause a decline in real GNP of over
1.5 percent, while the unemployment rate rose from 5 to
6.5 percent. Although consumer prices increased by 5.3
percent during 1982, the pace of inflation was clearly
slowing over the year. When the mark stabilized in early
1982, the Bank announced that CBM growth around the
middle or in the upper half of the target range would be
acceptable.
Monetary easing paused at mid-year as the mark fell
against the dollar again. However, the worldwide reduc-

42

1984
Real GNP grew by 2.5 percent in 1984, despite severe
production losses due to strikes. Strong foreign demand
contributed significantly to this increase. However, the
unemployment rate stayed at 8. 1 percent of the total labor
force. Inflation continued on its downward trend as the cost
of living index rose 2.4 percent compared to 3.3 percent in
1983. However, the mark fell by approximately 13.5
percent against the dollar over 1984, and this fall appears
to have been largely responsible for halting the downward
drift in interest rates.

1985
Interest rates actually increased around the time that the
dollar peaked in February 1985. But the decrease in U. S.
interest rates that followed triggered a marked decline in
German interest rates as well. The upswing in real activity
continued, with output growing at a 2.5 percent rate.
Inflation slowed down further, with consumer prices
increasing at a 2.2 percent rate over the year.
The upper bound of the CBM target range for 1984 had
already been lowered to 6 percent on the grounds that the
level of uncertainty about the economic environment had
gone down. For 1985, the Bundesbank cited the prevailing
low levels of inflation as the reason for lowering both the
upper and lower bounds of the target range by I percent.

1986
The target range for 1986 was increased by half a
percentage point on the grounds that the potential real
output growth rate had increased. Prices were stable over
the year, with some indices actually declining. Monetary

Economic Review / Spring 1988

policy was dominated by the exchange rate again. The
mark continued to appreciate against the dollar, and the
Bundesbank responded with an accommodative policy.
The discount rate was cut to 3.5 percent in March.
The accommodative policy stance was continued even
when clear signs that CBM was overshooting its target
emerged at mid-year. Thus, CBM growth for the 1986
target year was 7.7 percent, or more than 2 percentage
above the upper bound of the target range.
Uncertainty over the future course of exchange rates
("special uncertainties" in the Bundesbank's language)
to a widening of the 1987 target range by 1 percentage
point.
Real output increased by 2.5 percent in 1986 due largely
to an increase in consumption. However, growth began to
slow from the middle of 1986, with production stagnating

Federal Reserve Bank of San Francisco

in the last quarter of 1986 and declining in the early
months of 1987. The rapid deterioration was a surprise,
being a consequence of sluggish exports and sharply
increased import penetration. The volume of exports fell
for only the third time in post-war history.
1987 on
Available data suggest that monetary policy continued
to focus on the exchange rate over 1987. CBM grew 8.1
percent from the fourth quarter of 1986 to the fourth
rm"rtp,. of 1987, 2.1
above the 3
target range. In
1988, the Bundesbank announced
a 3-6 percent range for M3, citing the relatively large
impact of (difficult to explain) currency movements on
CBM as the reason for dropping that aggregate.

43

FOOTNOTES
1. Willms (1983) points out that the role played by the Central
Bank Council in appointing new members has diminished
over time, and that some members were appointed over the
Central Bank's objections.
2. The West Germany definition of M2 is thus different from
the U.S. definition. In the U.S., M2 contains M1, savings
deposits, Money Market Deposit Accounts, Small Time
Deposits (that is, time deposits containing up to $100,000),
and some money market mutual funds.

14. Since the explanatory variables are in growth rates,
CBMDEV for a given quarter is actually measured as a
percentage of the target level of CBM for that quarter. The
estimated equation also contains a constant dummy for the
second quarter of 1978 that is not shown below.
15. It should be pointed out that concern about the
exchange rate ultimately does reflect concern about real
GNP.

4. Deutsche Bundesbank, Special Series No.7, p. 78.

16. Since Germany is not an oil producer, the GNP deflator is
not directly affected by oil prices. An alternative is to look at
the Consumer Price Index. This index increased by 6.8
percent in 1981. The average rate over 1979-81 was 5.9
percent, while that over 1983-85 was 2.2 percent. The CPI fell
by 1.1 percent over 1986.

5. Technically, we will be concerned with the existence of a
"unit root." The simplest example of a process that contains a
unit root is given by

17. See Judd and Trehan (1987) for a discussion of the
recent changes in the behavior of various monetary aggregates in the U.S.

3. See the discussion on pp. 71-82 of Deutsche
Bundesbank, Special Series NO.7.

Yt=Yt-1 +u t
where u, is a stationary disturbance term. Such a process is
called a random walk. This is a special case of a nonstationary process. For instance, the process

Yt = 2Yt_1 + u,

REFERENCES
Courakis, A.S. "On Unicorns and Other Such Creatures: The
Case of the German Central Bank Money Stock,"
Zeitschrift fur die gesamte Staatswissenschaft, 136
(1980).

is nonstationary although it does not contain a unit root.

Deutsche Bundesbank. Annual Report, 1975 to 1986.

6. We look at the real values of the monetary aggregates
because the objective is to estimate money demand functions in real terms. The GNP deflator has been used to
convert nominal to real values.

_ _ _ _, The Deutsche Bundesbank: Its Monetary Policy
Instruments and Functions, Deutsche Bundesbank Special Series, No.7, 1982.

7. Granger and Engle also present alternative tests for the
null of no cointegration. One of these is the Augmented
Dickey-Fuller test, which adds the lagged differences of the
residual as additional right-hand-side variables to the regression used for the Dickey-Fuller test. The test statistic is the
same as before. Results of this test are not reported here
because the lagged differences of the residual were found to
be insignificant.
8. For an earlier example of the use of an error-correction
model to estimate a money demand function, see Hendry
(1980). See also Motley (1988).
9. Splitting the sample into two equal sub-samples also does
not suggest instability. For CBM, the computed F-statistic of
1.27 has a marginal significance level of .30. For M3, the
F-statistic is .53, and has a marginal significance level of .75.
10. Needless to say, the Bundesbank's choice of CBM as the
target variable has not been free from criticism. See, for
example, Courakis (1980).
11. The following description is based on the discussions
contained in various issues of the Annual Report of the
Deutsche Bundesbank.

Engle, R.F. and CW.J. Granger. "Cointegration and Error
Correction: Representation, Estimation and Testing,"
Econometrica, March 1987.
Engle, R.F. and B.S. Yoo. "Forecasting and Testing in CoIntegrated Systems," Journal of Econometrics, 1987.
Francke, H. and M. Hudson. Banking and Finance in West
Germany, St. Martin's Press, New York, 1984.
Fuller, Wayne A. Introduction to Statistical Time Series, John
Wiley & Sons, 1976.
Hendry, OF "Predictive Failure and Econometric Modelling
in Macro-Economics: The Transactions Demand for
Money," in P. Omerod (ed.) Economic Modelling,
London: Heinemann Educational Books, 1980.
Judd, John and B. Trehan. "Portfolio Substitution and the
Reliability of M1, M2 and M3 as Monetary Policy Indicators," Federal Reserve Bank of San Francisco, Economic
Review, Summer 1987.
Motley, B. "Should M2 be Redefined?" Federal Reserve Bank
of San Francisco, Economic Review, Winter 1988.

12. See the Bundesbank Annual Report for 1985.

OECD, Monetary Targets and Inflation Control, 1979.
_ _ _ _ , Economic Surveys: Germany, 1979 to
1986/1987.

13. Because the reaction function does not take into account
the factors that go into setting the target ranges themselves,
the results below are perhaps more appropriately interpreted
as measuring the Bundesbank's response to unanticipated
movements in output, the price level, and the exchange rate.

Willms, M. "The Monetary Policy Decision Process in the
Federal Republic," in The Political Economy of Monetary
Policy: National and International Aspects, edited by
D.R. Hodgman, Federal Reserve Bank of Boston, Conference Series, No. 26, 1983.

44

Economic Review / Spring 1988

Changes in Bank Risk-Taking

Frederick T. Furlong
Research Officer, Federal Reserve Bank of San Francisco. Comments by Christopher James, James O'Brien
and Michael Keely on earlier drafts are appreciated.
Research assistance provided by John Nielsen and Janice
Ferry. Editorial committee members were Hang-Sheng
Cheng, Christopher James and Ramon Moreno.

In the 1980s, two countervailing developments are
evident among large bank holding companies - improvements in capital positions and increases in asset risk.
Empirical evidence presented in this paper indicates that
the net effect has been to increase the default risk oflarge
bank holding companies and to raise the risk exposure of
the deposit insurance system. The findings, however, do
not support the view that the requirement to raise capital
to meet minimum capital standards in the 1980s contributed to greater risk-taking among large BllCs.

Capital positions among large bank holding companies
improved dramatically during the 1980s. Chart 1 shows
that the average ratio of book value, primary capital to
assets for 98 of the largest publicly traded bank holding
companies (BHCs) rose from about 4% percent in 1980 to
about 6Y2 percent in 1986 1 The rise in capital ratios was
even more remarkable when measured in terms of market
values. 2
From a regulatory perspective, this decrease in bank
leverage represents a positive development since it should
serve to reduce default risk among the banking institutions
and to protect the deposit insurance system, everything
else equal. Default risk and the liability of the insurance
system, however, also depend on the degree of asset risk
assumed by banking organizations. This is relevant, since
in the 1980s, the problems associated with energy loans,
real estate loans, and lending to lesser developed countries, as well as higher volatility in financial markets likely
have contributed to greater asset risk for banks. Thus,
greater asset risk may have offset part or all of the beneficial effects of the higher levels of bank capital.

Chart 1
Primary Capital
to Total Assets

Ratio

.08

.07
Book Value

.06

.05
.04
.03

~
Market Value

.02
1975

Federal Reserve Bank of San Francisco

1979

1983

1986

45

Changes in capital
in the 1980s also may
have raised bank asset risk
In December 1981,
the bank regulatory authorities announced the imposmon
of the first
minimum
ratios for
banks and BHCs. These requirements, which became
effective in mid-1982, were amended in 1983 and again in
effects
1985. 3 The new capital requirements had
making the
requirements uniform for
all banks and
and of increasing regulatory
requirements for those BHCs with
low camtaito-asset ratios at the
the decade.
The shift to uniform minimum
standards has
raised the concern that
may have had the unintended
side-effect of allowing more asset risk for
in general. This worry was
the
Reserve in
its 1986 proposal for new risk -based
standards,
which were said to be needed "to
the disincentives
relainherent in the existing guidelines to hold
tively liquid assets."
Another concern is that the BHCs that were
to
raise their capital ratios to meet higher
standards
may have reacted by increasing asset risk." This view of
the effect of capital regulation can be found in a number of
academic studies as wen as in the
press
Furlong and Keeley, 1987a, for a
of the articles
maintaining this
Their
is that BHCs
forced by regulation to raise
would be
to
increase asset risk relative to the other BHCs.
\l1rlll"'''\!

I.

The purposes of this paper are to examine empmcally
the change in asset risk among the
BHCs in the
1980s, and to evaluate the net effects of the improvements
in capital positions and changes in asset risk on the default
risk of large BHCs and on the risk
pose to the deposit
insurance system. The paper also
whether
changes in asset
default
and the value of the
deposit insurance subsidy were
for those BHCs
required to increase capital ratios to
the new ICli:Ul,~the
atreadv met the minimum standards
decade.
The rest of the paper is organized
presents opposing views on how
requirements would be related to the mcentives
to take risk. Section II presents empirical
asset risk rose among large bank
between 1981 and 1986. That section also offers evidence
suggesting that the rise in bank asset
has more than
offset the benefits from
capital
in a
rise in default risk among the large
and an increase
in the risk they present to the deposit insurance
Section III provides a summary and conclusions.

on Bank Asset Risk

In recent years,
focused on how a
decisions regarding asset risk are affected
the current
system of fixed-rate deposit insurance
Several
studies have shown that, with fixed-rate deposit insurance,
the value of a bank's equity is
related to the
riskiness of its assets as wen as its
of leverage. 5 That
is, the value of a bank increases as the bank shifts to more
risky assets and as it increases leverage (reduces its capitalto-assets ratio). Under these circumstances, if leverage
were constrained by regulators, a
bank
would be expected to hold the most risky asset portfolio
permitted under bank regulation.
With underpriced deposit insurance,
much of
the burden of constraining asset risk among value-maximizing banks would fall on the
authorities. In
principle, for asset-risk regulation to be effective, regulators must impose costs on a bank that violates the regulations that are at least equal to the gains the bank realizes
from increasing asset risk. Thus, developments that mute

46

Purposes

the regulatory response to
would tend to foster
more asset risk.
One such development may have
the
of
uniform minimum capital standards for banks and BHCs
uniform
in the 1980s. The application of
ratios could have hindered the process
which
judgmental adjustments are made
bank examiners as to
the amount of capital required of
and BHCs with
different asset portfolios. That
the exphcit
ratio may have limited the extent to
ratios have been adjusted upward to compensate for
asset risk.
As stated earlier, one reason given
the regulatory
authorities for wanting to switch from
current uniform
minimums to risk-based capital
is that the
latter standards, in principle at least, would vary automatically among banking institutions according to the degree
of asset risk. Without such systematic adjustments, it is
possible that a bank meeting the capital standards now

Federal Reserve Bank of San Francisco

may be able to hold a riskier portfolio than it previously
could at the same degree of leverage. Under these circumstances, and with the system of fixed-rate deposit insurance
asset risk in banking can be expected to
rise.
Another critical question in the regulation of asset risk
in banking is how a bank's incentives to take on asset risk
are affected by changes in the stringency of capital requirements. The traditional argument is that higher capital
standards lead to more asset risk because banks that are
required to increase capital will shift to higher yielding,
riskier assets to increase the rate-of-return on equity. For
example, Kahane (1977) and Koehn and Santomero
(1980) claim to show that, within a two-parameter Mark, more stringent capital requirements
would cause a utility-maximizing bank to increase asset
risk. Unfortunately, their models do not hold for valuemaximizing banks, for which the liability exposure of the
deposit insurance system is especially relevant. Moreover,
it has been shown in a previous issue of this Review
(Furlong and Keeley, 1987a),6 that these studies have
internally inconsistent models and that their results cannot
be used to support their claims.
There are other arguments, however, that suggest that
higher capital requirements could lead to banks holding
more risky combinations of assets." James (1987), for
example, shows that higher capital requirements on new
investments can exacerbate an underinvestment problem.
That is, an institution faced with raising relatively more

capital to fund new projects would tend to forego certain
low risk ventures in which it might otherwise invest. The
implication is that the resulting asset portfolio would tend
to be smaller and include relatively more risky assets than
if capital requirements were lower.
While the possibility that higher capital requirements
can lead to greater asset risk cannot be ruled out, it
certainly can be shown that increases in regulatory capital
requirements do not have to lead banks to take on more
asset risk. Given that a bank has incentives to increase
asset risk owing to the
of mispriced deposit
insurance, Furlong and Keeley (1987b) show
the
effect of a given change in asset risk on the value of a bank
is negatively related to a bank's capital-to-asset ratio. That
is, with underpriced deposit insurance, the marginal gain
to a bank from increasing asset risk declines as its capital
position increases. 8
This finding implies that regulatory constraints on asset
risk sufficient to restrain a bank at a given level of leverage
also would be sufficient at any lower level of leverage. The
conclusion to be drawn from this view of banks and bank
regulation is that higher capital requirements should not
lead to greater asset risk.
The validity of the last statement depends on the
assumption that regulatory constraints are not eased. This
is an important qualification since, as stated earlier, the
issue is whether, for a given level of leverage, a bank
meeting capital standards now may be able to hold a riskier
portfolio.

II. Empirical Results
This section empirically investigates changes in risktaking in banking between 1981 and 1986. Evidence is
presented first on how asset risk among a sample of large
BHCs changed over this period. Then, changes in default
risk, which is related to both the asset risk and the leverage
of an institution, among the sample of large BHCs is
examined along with the change in the risk these BHCs
pose for the deposit insurance system. This section also
studies whether the requirement for a BHC to raise its
capital-to-asset ratios to meet the new regulatory requirements in the 1980s was related to the BHC's changes in
asset risk and default risk.
BHC Sample
The basic sample of institutions considered consists of
98 large, publicly traded BHCs with financial data available on the Compustat tapes for the years 1975 to 1986.
Among this set of institutions, about one-fourth had book

Economic Review / Spring 1988

value, primary capital-to-asset ratios that were below the
minimum standards announced by the regulatory
authorities in December 1981. The minimum primary
capital standard announced in 1981 for most BHCs with
$1 billion or more in assets was 5 percent. 9
When the minimum
ratios were set in 1981 the
majority (two-thirds) of the large BHCs with primary
capital ratios below the minimum were multinational
holding companies. Technically, the minimum standards
did not apply to the multinational institutions. Nevertheless, the multinational BHCs were under regulatory pressure to increase capital ratios, and it is reasonable to
assume that the BHCs anticipated that they eventually
would be subject to the formal minimum standards.
Indeed, by June 1983, the multinationals were subject to
the same minimum capital standards that applied to other
holding companies with assets of $1 billion or more. In
1985, the minimum primary capital ratio for all BHCs was
set at a uniform 5 Y2 percent. 10

47

Since one of the issues to be investigated is whether
being required to increase its capital ratio after 1981
affected the risk assumed by a BHC, the institutions not
meeting the 1985 minimum primary capital requirements
on average during 1981 are identified as the BHCs that
should have been most directly influenced by the higher
capital standards. In the basic sample of 98 institutions
considered, 24 are classified as not meeting the capital
requirements. For convenience of presentation, these 24
institutions are referred to as the "capital-deficient
BHCs," and the other institutions in the sample are
referred to as either "capital-sufficient BHCs" or "other
BHCs."

Given that most, if not all, bank debt is either explicitly
or implicitly federally insured to some degree, the deposit
insurance system is in effect the primary creditor of banks.
For this reason and for simplicity, we assume that the
maturity of the equity call option is related to the renewal
period of the insurance guarantee, which is assumed to be
once a year, at a known date.
With this simplification, the Black-Scholes option pricing formula applied to the equity of a BHC is

and
Changes in Asset Risk
In finance theory, asset risk commonly is represented by
the variation in the economic rate-of-return on assets.
Specifically, asset risk is assumed to be positively related
to the variability of the return on assets. Following this
approach, the analysis of asset risk in this paper focuses on
the standard deviation of the return on assets as the
appropriate measure of risk. In addition, since the regulatory authorities have expressed specific concern over a
shift by institutions away from low-risk, liquid assets,
changes in the relative holdings of such assets among the
sample of large BHCs also are reviewed.
The problem posed by using the standard deviation of
the return on assets in an empirical analysis of changes in
risk is that the variation in the economic (market value)
rate-of-return on assets is not observable. Fortunately, it
can be estimated from other "observable" variables. This
is done in another study related to risk in banking, by Ronn
and Verma (1986).
Using the results from Black and Scholes (1973), Ronn
and Verma represent the equity value of a banking organization as a call option on the value of its assets. The
argument for doing so is that the debtholders can be
thought of as effectively owning the assets of a firm and
giving the stockholders the option to buy the assets back at
maturity (under the assumption the maturities of assets and
liabilities are equal). At maturity, the value of the equity
(the option) would be the difference between the value of
the assets and the face value of the liabilities if that
difference were positive, and zero otherwise.
In this model, the exercise price is equal to the face
value of the bank's debt at maturity, and the option would
be exercised by the stockholders only if the value of the
assets were to exceed that of the liabilities. If the value of
the liabilities were to exceed the value of the assets at
maturity, the stockholders would not exercise the option
and,
, in effect, would allow the debtholders to keep the
assets.

48

E

SA

m:m)

SE

ANc

(2)

where
E

market equity,

A

market assets,

D

the current face value of the bank's debt,

SA

standard deviation of the rate-of-return on
market assets,

SE

standard deviation of the rate-of-return on
market equity, and

N(x)

the standard normal cumulative density
function evaluated at x.

Of the variables in equations 1 and 2, only equity can be
observed directly. To reduce further the number of
unknown variables in the system, it is assumed that the
market's evaluation of SE, which in the context of the
model is made ex ante and assumed to be constant over the
one-year life of the option contract, is based on the past
value of the standard deviation of the return on equity. The
specific assumption used is that the option contract is set
just prior to the beginning of a calendar year, and the value
of SE is equal to the standard deviation of the return on
equity for the previous twelve months. With this assumption, E and SE can be treated as known parameters in the
equation system. 11 That leaves a system of two equations
and two unknowns, A and SA' that can be solved simultaneously using a numerical approximation technique.
This approach was followed to derive two sets of estimates for SA and A for each BHC using data for the years
1981 and 1986. The year 1981 is the year before the new
capital standards were imposed and before the general rise
Federal Reserve Bank of San Francisco

in bank capital positions, while 1986 is the last full year for
which data are available. Equity, E, is estimated using the
sum of the market value of common stock and the par
value of preferred stock at the end of each year. The
estimate of the standard deviation of the return on equity,
SE' is derived using the monthly stock price data for each
year.
The top row of Table 1 presents the average of the
standard deviations of the rates-of-return on assets for all
the BHCs in the sample for each year, as well as the change
in the averages. From 1981 to 1986, the increase in the
average standard deviation is statistically and economically significant. Over that period, the measure of asset
risk doubled. 12
The bottom portion of Table 1 presents evidence on the
change in asset risk for the two subgroups, the capitaldeficient and the capital-sufficient BHCs (other BHCs).
For both groups, the increase in asset risk was substantial
and highly significant. However, the change in the average
of the standard deviations of the rates-of-return on assets
for the two groups is not statistically significant. That is,
the increase in asset risk was not greater for the BHCs with
low capital-to-asset ratios that were forced by regulatory
authorities to raise their capital ratios after 1981, compared to the BHCs that satisfied the requirements in 1981.
While the variation in the return on assets is an appropriate measure of asset risk, as pointed out earlier, regulatory

Economic Review / Spring 1988

authorities have expressed specific concern over banks
shifting away from low-risk, liquid (or marketable) assets
- that is, they have been concerned with a decline in such
assets relative to total assets. From the Compustat data, the
items that might be included in the category of low-risk,
liquid assets include vault cash, interbank deposits (due
from banks), and reserves held with the Federal Reserve as
well as Treasury and agency securities.
The argument for focusing on these assets is that, all
else equal, the lower the relative holdings of assets with
or no
the
the overall risk of assets.
This line of reasoning, however, is not necessarily valid.
The net impact on an institution from increasing or
decreasing a given type of investment has to be evaluated
in terms ofthe composition of the institution's overall asset
portfolio - that is, it has to take into account the
covariances in the returns on assets, as does the variation
of the return on total assets.
Recognizing the limitations of using the relative holdings of liquid assets as an indicator of asset risk, Chart 2
shows that the average of the ratios of these assets to total
assets declined markedly for both groups of BHCs after
1981. This evidence is consistent with the finding of an
increase in asset risk in Table 1. It also tends to support the
regulatory authorities' concern that banks have shifted
away from assets with low default risk under the capital
standard adopted in 1981.

49

However, other factors could account for this decline in
the ratios of low-risk, liquid assets to total assets. Other
causes seem likely because it is evident from Chart 2 that
the decline in the average ratio for the capital-deficient
BHCs was under way
to 1981.
Another observation from Chart 2 is that the decline in
the average ratio between 1981 and 1986 is larger for the
capital-deficient BHCs than for the other BHCs. A separate comparison of the changes in the ratios reveals that the
difference is statistically significant. However, based on
the evidence in Table 1, the
the relative
noknngs of
assets with
or no
risk does
not seem to have resulted in a larger increase in overall
asset risk for the capital-deficient BHCs.13 The last observation points up the potential danger of evaluating the risk
of an institution based on a subset of its assets in isolation
from the rest of its portfolio.

Default Risk
The preceding evidence indicates that asset risk has
increased substantially since 1981. However, over this
same period, the capital positions of the BHCs in the
sample also increased sharply (Chart I). The greater asset
risk and the reduced leverage would have opposite effects
on the overall risk or default risk of the BHCs. From a

regulatory perspective, an important question is: what has
been the net effect on the default risk among the BHCs and
the liability they impose on the federal deposit insurance
system? To answer this question, we first
evidence
on the change in default risk and then tum to the related
issue of the change in the risk exposure of the deposit
insurance system.
One approach to evaluating the default risk of an institution is presented in Boyd and Graham (1986) and Wall
(1985). This approach uses an indicator that is related to
the
of
which in tum is a
of the
variation in income and the
an institution. Specifically, an institution fails when losses exceed
capital. That is,
Probability of failure = Probability (profits <

E).

Dividing both terms of the inequality in the parentheses by
E, the probability of failure can be expressed as being
equal to the probability that the rate-of-return on equity, r E'
is less than negative one,
Probabilityu.;«. - 1).

Assuming that the return on equity is distributed as a
normal random variable, and standardizing the terms in
statement 4, the probability of failure is equal to
Probabilitytrj, - fE)/SE)<Z)

.325

z= (-1 -fE)/SE'

Capital-Deficient

SHes

.300

.275
.250
.225
.200
.175
.150
1975

50

1979

1983

(5)

where f E is the expected rate-of-return on equity and

Chart 2
low-Risk, liquid Assets
To Total Assets

Ratio

(4)

1986

(6)

The variable z then is the standard normal variate, representing the number of standard deviations the rate-ofreturn would have to fall below its expected value for the
bank to fail. To be consistent with the other studies that
have used this measure of default risk, we will use the
negative of z and denote it as Z. Thus, higher Z-values
indicate a lower probability of failure. 14
To test for changes in default risk, Z-values were estimated for each bank in the
for
two years I 1
and 1986. One difference between the Z-values derived in
this study and those calculated in other studies is that in
this study the Z-values are based on estimates of the
market values of the returns on equity and the standard
deviations of the returns on market equity, rather than on
book value measures. IS The expected return on equity was
estimated using the average market return on equity in
each year for each institution. The standard deviations of
the returns on equity are the same as those used in the
calculations for Table 1.
The top portion of Table 2 shows that the mean value of
Z for the overall sample of BHCs was significantly lower in
1986 than in 1981. The lower value of Z indicates a higher

Federal Reserve Bank of San Francisco

probabilitv of failure. This means that the increase in asset
risk more than offset the decrease in leverage, and thus led
to higher default risk on average.
The bottom
of Table 2 reveals
on average,
the default risk did increase for the capital-deficient BHCs.
However, for that group BHCs, the change in Z was not
zero. For the other BHCs, the
value of Z did decline on average and the decline is
risk,
did not increase more
among the BHCs that were required to increase capital
after 1981 than among the other BHCs. In fact, as reflected
the
in the
the default risk was not
significantly lower for the capital-deficient group comto the other BHCs in 1986, whereas the difference
between the two groups of institutions was not significant
in 1981.
SYstem Risk
As a
to the evidence on the changes in
estimates of the change in the risk exposure of
the deposit insurance system between 1981 and 1986 can
be used to evaluate the net effect of the rise in asset risk and
the decrease in leverage. Merton (1977) shows that the
deposit insurance zuarantee can be modeled as a put
Building on Merton's model of a Black-Scholes
and
an examination interval of one
JLl'~;IJ'IJ'~n In~:nr!Clln.'g>

Economic Review I Spring 1988

year, Ronn and Verma (1986) express the value of the
as
insurance guarantee per dollar of

I=N

-----+

-d

With the exception of I, which is the per dollar of
deposit value of
and
which is one minus the
dividend rate relative to assets, all the other variables in
equation 7 are found in equations 1 and 2.
In
the face value of the debt at
maturity represents the exercise
16 The bank can be
thought of as choosing to exercise the put option (sell the
assets to the insurance system) if, at the end of the
insurance guarantee period (assumed to be one year), the
face value of the debt were greater than the value of the
assets. Whereas, if the value of assets were higher- that is,
equity were positive, the bank can be thought of as not
exercising the
option and
on to the assets.
Using the estimates for the unobservable variables, A
equations 1 and 2, and the estimates
and SA' from
for the other variables from the Compustat data, equation 7
using data for
was
each BHC in the
1981 and 1986. In using the calculations from equation 7
to estimate the value of deposit insurance, certain assump-

51

tions are being made. It is implicitly assumed that regulators applied the same closure or insurance renewal rule in
both time periods: to close institutions found to have
negative market capital at the scheduled examination.
Different closure rules would generate different estimates
of the value of deposit insurance, and, more important for
the purposes of this paper, affect the estimates of the
changes in the value of deposit insurance.
Given these restrictive assumptions concerning the closure rule, the results in Table 3 should be viewed with
caution, particularly with regard to the estimates of the
levels of the value of the insurance guarantee. As it stands,
the evidence concerning the changes in I is roughly
consistent with that on default risk. The mean value of I for
all BHCs in the sample is significantly higher using the
data for 1986 than that based on the data for 1981. Using
the maximum statutory deposit insurance premium for

banks, $.0008 per dollar of deposit, as a benchmark, the
estimates in the top portion of Table 3 indicate that, on
average, deposit insurance was overpriced in 1981 under
the assumed closure rule. Likewise, the estimates based on
the data for 1986 indicate that, on average, deposit insurance was overpriced for the sample of BHCs.17
These results are consistent with the idea that the
increase in asset risk more than offset the benefits from the
decline in leverage among the BHCs, and left the deposit
insurance at greater risk at the end of 1986 than at the end
of 1981.
like the results in Table
the
findings reported in the bottom portion of Table 3 do not
allow us to reject the hypothesis that the increase in the
mean value of I was the same for both groups of BHCs,
since the difference between changes for the two groups is
not significantly different from zero.

III. Summary and Conclusions
This paper examines changes in asset risk, default risk,
and the liability of the deposit insurance system for a
sample of large BHCs between 1981 and 1986. For the
sample, asset risk increased substantially. This increase in
asset risk appears to have been large enough to offset the
effects of improved capital positions among the sample
institutions between 1981 and 1986. On average, the

52

estimates of default risk among the sample institutions and
the risk the institutions present to the deposit insurance
system increased significantly. These findings tend to
justify concerns that there has been an easing of combined
capital and asset risk standards in banking. That is, institutions appear to be holding riskier assets relative to
leverage.

Federal Reserve Bank of San Francisco

The paper also considers the issue of whether BHCs
forced to raise capital to meet the new minimum capital
standards increased asset risk and default risk by more than
other bank holding companies. The capital-deficient
BHCs did tend to make larger cuts between 1981 and 1986
in their relative holdings of liquid asset with little or no
default risk and (as discussed in the Appendix) showed
somewhat bigger increases in loan loss reserves ratios.
Despite this development, however, the evidence on the
change in the variation of the return on assets indicates

that, on average, the BHCs required to raise primary
capital did not increase asset risk by more than the BHCs
that were relatively well capitalized in 1981. In addition,
between 1981 and 1986, there was no significant difference in the change in the estimates of the per dollar of
deposit value of the deposit insurance for the capitaldeficient BHCs compared to that for the other BHCs. The
results in this paper, then, do not support the view that
increases in regulatory capital standards lead banks to
increase asset risk.

APPENDIX

Loan Loss Ratios as Measures of Asset Risk
Another risk measure often employed in empirical studies focuses on the "quality" of an institution's loan portfolio. That measure of loan risk is the ratio of loan loss
reserves to total loans (LLR). The usual justification for
using this measure is that an institution with higher risk
loans would be expected to have a higher value of LLR 1
To the extent that loan loss reserve ratios can be compared among banks, the plots in the chart point to a general
deterioration in the quality of loans among the sample of
BHCs. Moreover, after 1984, it is evident that the rise in
LLR was noticeably larger for the capital-deficient BHCs.
Separate computations show that the difference in the
changes in the ratios for the two groups between 1981 and
1986 is statistically significant, suggesting a greater
increase in asset risk among the capital-deficient BHCs.
However, as discussed in the text in connection with
Table 1, the evidence on the change in the variation in the
return on market assets does not show a significant difference in the increase in overall asset risk for the two
groups of BHCs. A possible explanation for the difference
in the behavior of LLR for the two groups in the sample in
recent years is that the ratios have been affected by offbalance sheet credit extensions or loan sales, and, thus,
may not accurately reflect the differences in risk associated
with the lending activities of the BHC's. One reason this
seems possible is that the greater rise in LLR for the
capital-deficient BHCs in the 1980s was due to much
slower growth in on-balance sheet loans among those
BHCs than among the other BHCs, and not to a more
pronounced pick-up in the growth of loan loss reserves.
Whether the loan loss reserve ratios adequately reflect
differences in the quality of assets connected with credit
extensions depends in part on what accounts for the
slowdown in the accumulation of loans at the capitaldeficient BHCs. Take the most relevant off-balance sheet
activity, standby letters of credit (SLCs), for example. To

Economic Review / Spring 1988

the extent that a bank uses SLCs as an alternative to direct
lending, its volume of on-balance sheet loans would be
less. Since SLCs generally are issued to higher quality
bank borrowers (see James, 1987), the quality of the
remaining on-balance sheet loans for a bank issuing SLCs
should be lower on average. When compared only to onbalance sheet credits, then, the loan loss reserve ratio
should be higher the greater the use of SLCs by a bank.
However, the quality of the on-balance sheet loans are not
representative of the bank's credit exposure via SLCs, and,
thus, as SLCs grow, the loan loss reserve ratio can overstate the deterioration in quality of a bank's effective credit
extensions.
The problem presented by SLCs is that they tend to lead
to an overstatement of a bank's book value capital position. This is because the minimum capital standards are
expressed only in terms of on-balance sheet assets and
capital, and the enforcement of capital regulation does not
always fully compensate for SLCs. A bank then could use
SLCs effectively to increase leverage and overall risk, even
if the risk of its combined on- and off-balance sheet assets
were unchanged.
In contrast, if a slowing in loan growth at a bank were
related to loan sales, a rise in loan loss reserve ratios would
not necessarily be a distortion. Once again, the sales of
loans would be expected to involve higher quality bank
loans.? With loans sold without recourse not included on a
bank's balances, the average quality of the bank's credit
extensions could fall. Thus, a higher loan loss reserve ratio
would be indicative of the difference in the quality of the
bank's loan portfolio, everything else the same. However,
while the bank's assets might be riskier, the sale of loans
could lead to a reduction in leverage, which would tend to
offset the adverse effects of higher asset risk.
It is not certain, then, what a higher loan loss reserve
ratio that stems from slower loan growth means for the risk

53

of a bank's combined on- and off-balance sheet assets.
And, the implications for the default risk of an institution
are blurred since slower loan growth can have implications
for
as wen as for loan loss reserve ratios. With
SLCs present, loan loss reserve ratios tend to overstate
asset risk but understate book value leverage. In contrast,
loan sales lead to higher loan loss ratios but can be used to
reduce leverage, and, thereby, default risk.

Loan Loss Reserve
To Total
ans

Ratio

.020
.019

Capital-Deficient

.018

SHes

.017
.016
.015
.014

Other SHes

.013
.012
.011
.010
1975

1979

1983

One complication encountered when relating this measure of risk to capital requirements is that loan loss reserves are themselves included in
regulatory capital. Given that there are tax advantages from allocating earnings to loan loss reserves, a bank attempting to build up capital through
retaining earnings would be expected to make the maximum possible contributions to loan loss reserves.
2 See James, 1987.

54

Federal Reserve Bank of San Francisco

FOOTNOTES
1. For regulatory purposes, primary capital for BHC's
includes common
loan loss reserves, minority interests in
accounts of consolidated subsidiaries, net
mandatory convertible securities, perpetual preferred stock,
and perpetual debt subordinated to the interests of depositors.
2. Market value of primary capital is estimated by the sum of
the market value of common
and the book value of
preferred equity.
3. For a description of the change in capital requirements,
see
Stone and
(1
4.
(1
shows that capital positions among large
BHCs improved appreciably on a book value as well as on a
market value basis in the 1980s. The results of that study also
"U'jI...lCO"1 that the imposition of the new capital requirements
contributed to the general improvement in bank capital positions by raising capital-to-asset ratios at those BHCs with
relatively low ratios at the beginning of the 1980s.
5. See for example Dothan and Williams (1980), Sharpe
(1978), Kareken and Wallace (1978), Merton (1977), Pyle
(1984), and Furlong and Keeley (1987a, b).
6. See also Keeley and Furlong, 1987.
7. Outside the academic literature, a common argument for
why capital regulation will affect the asset risk of a bank
assumes that bank managers are constrained to meet a
target rate-of-return on equity. In this instance, a bank reacts
to capital regulation by shifting to investments with higher
expected yields to maintain a predetermined rate-of-return
on equity. Such behavior would imply a shift to a more risky
asset portfolio, given the usual tradeoff between asset yields
and risk.
Although apparently widely held, this view of the reaction of
banks to capital requirements implicitly assumes that banks
do not engage in optimizing behavior because, on the margin, banks ignore the tradeoff between asset risk and return
on equity.
8. This result can be shown formally by adapting a BlackScholes put option formula to the deposit insuranceguarantee along the lines of Merton (1977). This is done in Furlong
and Keeley (1987b), which shows that the second derivative
of the option value of deposit insurance with respect to asset
risk with
to
is positive. For a graphic presentation of the effects of leverage on the gains from risk-taking,
see
and
(1987a).
9. For BHCs with less than $1 billion in assets, the minimum
primary capital ratio was set at 6 percent in 1981. Minimum
ratios for total capital were set at 5% percent for SHCs with $1
billion or more in assets (excluding 17 multinational BHCs)
and a 6V2 percent for the smaller SHCs. (See Gilbert, Stone,
and Trebling, 1985).
the minimum total capital ratio was set at 6
10. In 1
percent for all SHCs.
11. Ronn and Verma also attempt to include in their model a
regulatory closure policy in which a bank with a deficiency in
capital equal to or less than a certain fraction of total debt is

Economic Review / Spring 1988

given financial assistance and not closed. For the estimates
in this paper, it is assumed that a bank discovered to have
negative capital upon examination is closed without financial
assistance to the stockholders.
12. In the context ofthe model, the values of SA derived using
the data for 1981 and 1986 represent estimates of the market's ex ante evaluation of the standard deviations of the
return on assets of the SHCs for the years 1982 and 1987
respectively.
13. The Appendix discusses another commonly used
indicator of asset risk, the ratio of loan loss reserves to total
loans. The change in this indicator between 1981 and 1986
for the sample of SHCs in this study points to a general rise in
loan risk. Tile change in the loan loss reserve ratio was larger
for the capital-deficient SHCs. However, from the evidence in
Table 1, this does not appear to have led to a relatively longer
increase in overall asset risk. The Appendix discusses how
difference in off-balance sheet credit extension could possibly account for the difference in the changes in loan loss
reserve ratios for the capital-deficient and the capital-sufficient SHCs.
14. In computing the Z-values, it is assumed that regulators
always close a bank when the bank is found to have negative
net worth upon examination. To the extent that banking
organizations are allowed to operate with negative market
net worth, the Z-values would tend to overstate the chances
an institution would be closed by regulators.
15. Under this approach the observed equity is assumed to
represent the true measure of protection to liability holders. In
general, this is not the case with book value measures of
capital.
16. The exercise price is X = De", the face value of the
organization's debt at the time of the examination, which is
assumed to be one year - that is, t = 1. The term r is the rate
paid on bank debt, which is assumed to be the risk-free
interest rate.
17. Estimates from Marcus and Shaked (1984) for a smaller
sample of BHCs show that deposit insurance was overpriced, on average, in 1979 and 1980. Ronn and Verma show
that the value of the insurance guarantee depends on the
closure rule applied by regulators. Using a less stringent
closure rule than the one assumed in this paper, Ronn and
Verma report results for which the average per dollar of
deposit value of the insurance guarantee was about equal to
.0008 in1983. This would imply that, using the rule of closing
banks when equity is discovered to be zero upon examination, the Ronn and Verma results would show deposit insurance to be overpriced on average. As in these other studies,
the estimates used in this paper for the value of the insurance
guarantee show that it varies considerably among the institutions in the sample.

55

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Federal Reserve Bank of San Francisco