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FEDERAL RESERVE BANK OF DALLAS
AUGUST 1997

FINANCIAL INDUSTRY

Are Capital Requirements Effective?
A Cautionary Tale from Pre-Depression Texas
Jeffery W. Gunther
Senior Economist and Policy Advisor
Linda M. Hooks
Assistant Professor
Washington and Lee University
Kenneth J. Robinson
Senior Economist and Policy Advisor

Mexican Payments System Reforms
Sujit "Bob" Chakravorti
Senior Economist

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Financial Industry Studies
Federal Reserve Bank of Dallas

Robert D. McTeer, Jr.
President and Chief Executive Officer

Helen E. Holcomb
First Vice President and Chief Operating Officer

Robert D. Hankins
Senior Vice President

Genie D. Short
Vice President

Economists
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Thomas F. Siems
Sujit "Bob" Chakravorti
Financial Analysts
Robert V. Bubel
Karen M. Couch
Kelly Klemme
Susan P. Tetley
Edward C. Skelton
Research Programmer Analyst
Olga N. Zograf
Graphic Designer
Lydia L. Smith
Editors
Anne L. Coursey
Monica Reeves
Lee Shenkman
Financial Industry Studies
Graphic Design
Gene Autry
Laura J. Bell

Financial Industry Studies is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy of the publication
containing the reprinted article is provided to the
Financial Industry Studies Department of the Federal
Reserve Bank of Dallas.
Financial Industry Studies is available free of
charge by writing the Public Affairs Department,
Federal Reserve Bank of Dallas, P.O. Box 655906,
Dallas, Texas 75265-5906, or by telephoning
(214) 922-5254 or (800) 333-4460, ext. 5254.

Contents
Are Capital
Requirements Effective?
A Cautionary Tale from
Pre-Depression Texas
Jeffery W. Gunther, Linda M. Hooks,
and Kenneth J. Robinson

Page 1

Mexican Payments
System Reforms
Sujit "Bob" Chakravorti

Page 12

Capital requirements are now a primary ingredient in efforts
to supervise and regulate the banking industry. Their main purpose is to protect the deposit insurance fund and to minimize
taxpayer exposure should financial difficulties occur. Capital
requirements are not new, however. Texas was one of the first
states to institute formal capital requirements when it introduced
a deposit insurance program early in the century. But this early
attempt at capital regulation proved ineffective in preventing a
complete breakdown of the deposit insurance system it was meant
to protect. Using recently discovered examination data for Texas
banks operating in the troubled 1920s, we show that the capital
requirements were unsuccessful largely due to a reliance on bookvalue capital measures that overstated the true financial condition
of banks. As some researchers have shown recently, the same
types of problems confront current efforts to rely on measures of
capital as the focus of banking supervision. This has led to recent
proposals to restructure bank capital regulation, such as the precommitment approach.

This article investigates the ongoing payments system
reforms begun by the Bank of Mexico in 1994. The goals of these
reforms are to reduce the amount of uncollateralized intraday
credit extended by the Bank of Mexico (previously unlimited), to
promote a market-based allocation of intraday credit for interbank
payments, and to move large-value paper-based payments to electronic form. The Bank of Mexico has been successful in achieving
all of these goals to some extent. But despite this progress, like
other central banks around the world, the Bank of Mexico still
faces the possibility that government guarantees may weaken
market discipline in the payments system.

Are Capital
Requirements
Effective?
A Cautionary
Tale from
Pre-Depression Texas

Capital regulation is now the cornerstone
of efforts to regulate hank risk taking. In 1988,
the Basle Accord was adopted by bank regulators in the United States, as well as in Japan,
Europe, and Canada. Under this agreement,
banks' minimum capital requirements depend
on the perceived credit risk exposure of their
assets and off-balance-sheet items. In the United
States, capital regulation was taken a step further when Congress enacted the Federal
Deposit Insurance Corporation Improvement
Act of 1991 (FDICIA). Under this legislation,
with its provisions for prompt corrective action
and early closure, banks face increasingly stringent supervision and regulation as their capital
levels decline, including the usual requirement
that regulators close the institution if the capitalto-asset ratio reaches 2 percent.

Jeffery W. Gunther
Senior Economist and Policy Advisor
Financial Industry Studies Department
Federal Reserve Bank of Dallas

According to many accounts, it was the
continued and relatively unfettered operation
Assistant Professor
of capital-impaired financial institutions that exWashington and Lee University
acerbated both the bank and thrift failures of
Kenneth J. Robinson
the past decade and the associated losses to the
Senior Economist and Policy Advisor
federal deposit insurance funds.1 Conceptually
Financial Industry Studies Department
speaking, the owners of thinly capitalized banks
Federal Reserve Bank of Dallas
may have the incentive to take on especially
risky ventures, as they have relatively little to
lose if the ventures should fail, but much to
gain if the ventures prosper. And with the
federal government guaranteeing the safety of
most deposits, depositors would have little
incentive to discipline bank owners against
mn this article, we explore how such risk taking.2 Similarly, the owners of thinly
capitalized banks may find it more profitable
this early attempt at capital to loot their institutions than to manage them
as going concerns. Again, with the safety of
regulation operated and why it deposits guaranteed, only bank regulators could
stand in the way of such deceitful strategies.3
Linda M. Hooks

ultimately proved unsatisfactory.

These factors may have played a significant role in the banking and thrift crises of the
1980s, as risky financial strategies turned out
poorly or fraudulent dealings created financial
losses. The goal of the new capital-based supervision is to protect the deposit insurance fund
(and ultimately the taxpayer) from the types
of risk taking, looting schemes, and financial
losses experienced during the banking and thrift
difficulties of the 1980s. This is accomplished by
preventing regulators from allowing capitalimpaired banks to continue to operate without
compensating restrictions on their financial
behavior and by not permitting insolvent banks
to remain open.
While the adoption of risk-based capital
requirements, prompt corrective action, and
early closure represent significant steps in the
implementation of capital regulation, they are

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIESDECEMBER1995

We are particularly grateful to Alan Barr
at the Texas Department of Banking for
providing data on failures of state chartered banks.
See Kane (1989) and Short and Gunther
(1988).
See Merton (1977) and Marcus (1984).
Akerlof and Romer (1993) describe in
detail how such looting can take place.

not the first attempts by federal regulators to
focus on capital as a key component of efforts
to regulate insured financial institutions. In
December 1981, the federal bank regulatory
agencies first jointly announced specific capital
requirements applicable to insured commercial
banks. Initially, these requirements were based
on the size of the institution, with larger organizations required to hold a smaller percentage of
their assets as capital. In 1985, bank regulators
decided to impose uniform capital-to-asset
requirements on all banks, regardless of size.4
Long before these requirements were implemented at the federal level, several states had
experimented with capital requirements for statechartered banks. Texas was one of the first
states to establish formal capital requirements.
The Texas capital requirements were part of an
overall package of increased regulation for
state-chartered banks that accompanied the
state deposit insurance system introduced in
the early part of the century. Similar to later
capital regulations at the federal level, Texas
instituted capital requirements in an effort to
protect its deposit insurance fund from financial
losses. However, in the 1920s, little more than
one decade after the capital requirements were
introduced, bank failures mounted and the
state-run deposit insurance program suffered
increasing losses—losses that proved severe
enough to cause the insurance program to close
down.

loan portfolios were propelling them toward
insolvency.
We can find no indication, though, that
banks were allowed to operate for any length of
time after they were classified by regulators as
insolvent. Still, while forbearance is not indicated in our examination data, we do find evidence that regulators allowed banks to operate
for several years after their adjusted capital was
designated as impaired.
We conclude that this early attempt at
capital regulation proved unsuccessful largely
because the capital requirements were based on
book-value measures that did not adequately
reflect the true financial strength of individual
banks, thereby allowing capital-impaired banks
to continue operating without fully compensating restrictions on their financial behavior.
The failure of capital regulation in preDepression Texas offers some parallels to the
financial-sector difficulties of the 1980s. The
capital regulations in place during the 1980s did
not prevent either the severe deterioration that
occurred in the financial strength of the Federal
Deposit Insurance Corporation or the meltdown
of the Federal Savings and Loan Insurance Corporation. In these relatively recent episodes of
financial failure, as in the collapse of the Texas
deposit insurance system in the 1920s, bookvalue accounting practices had the effect of
artificially boosting reported capital levels, and
capital-impaired institutions were allowed to
continue operating without fully compensating
restrictions on their financial behavior.

In this article, we explore how this early
attempt at capital regulation operated and why
it ultimately proved unsatisfactory. Using recently discovered examination data available
for a sample of state banks operating in Texas
in the 1920s, we are able to determine that
the book-value measures of capital applied to
individual banks were often grossly inflated.
Judging from entries on the examination
records, regulators recognized the shortcomings in the reported financial data and initiated
attempts to adjust reported capital levels downward to reflect estimates of the expected losses
embedded in bank loan portfolios. When estimated losses began to reduce the amount of a
bank's paid-in capital, regulators would then
classify its capital position as impaired. However, these adjustments were not included as
part of the banks' balance sheets that were
published by the state banking authorities. And
the formal capital requirements instituted in
Texas were based on reported capital, rather
than capital adjusted for loan losses. As a
4

see Keeiey (1988).

The Texas experience with capital regulation during the 1920s also has possible implications for the efficacy of capital regulation today,
even under the relatively rigorous capital-based
supervision implemented under Basle and
FDICIA. In the pre-Depression Texas experience, faulty book-value capital measures made
capital regulation ineffective. Similarly, the
effectiveness of today's capital-based supervision depends critically on the accuracy of
regulatory accounting procedures. Prompt corrective action and early closure are at the heart
of the new supervisory approach, but both are
based on book-value capital. To the extent that
book values overstate capital levels relative to
the risk of bank activities, the new capital-based
supervision is subject to the same criticisms that
have plagued capital regulation in the past. And
the task of assessing capital adequacy is becoming more rather than less difficult as the
complexity of bank activities, including derivatives trading, continues to grow. Hence, the
same types of problems that beset this early

result, it was possible for banks to satisfy the
capital requirements, even as losses in their

attempt at capital regulation in pre-Depression
Texas persist even today as a major challenge to
effective capital regulation.

deposits and the capital of a bank. With a
capital of $10,000, the deposits of a bank
are restricted to five times its capital and
surplus; from $10,000 to $20,000 to six

Capital requirements in pre-Depression Texas

times its capital and surplus; from $20,000

Texas was one of the first states to experiment with formal capital regulations. These
capital regulations were part of a broader package of increased supervision and regulation for
state-chartered banks that was implemented to
accompany the introduction of state deposit
insurance. Legislation that ushered in the Texas
deposit insurance system passed the state legislature in its second session in May 1909. The
law was referred to as Senate Bill 4 and became
effective January 1, 1910. All state-chartered
banks were required to join the system under
one of two plans—the depositors guaranty fund
or the depositors bond security system.

to $40,000 to seven times; from $40,000
to $75,000 to eight times; from $75,000
to $100,000, nine times; and if capital is
over $100,000, to ten times its capital and
surplus. 9

Unlike modern capital requirements, this
early attempt at capital regulation based its
requirements not on assets, but deposits.
Moreover, the bill was quite specific regarding
how banks were to rectify any shortcoming in
their capital. Banks were required to file a
sworn statement of their average daily deposits
for the year ending on the first day of
November. If average daily deposits for the year
amounted to more than the relevant multiple of
capital and surplus,

The most popular of the two plans was
the depositors guaranty fund.5 The guaranty
fund covered only noninterest bearing deposits
payable on demand, although there was no
limit on the amount of these deposits that was
covered by insurance. When banks joined the
system, they were required to pay a premium of
1 percent of their average daily deposits for the
previous year. Thereafter, each bank was
assessed one-fourth of 1 percent of its daily
average deposits annually until the fund
reached $2 million, after which additional
regular assessments were not required. However, if the guaranty fund fell below $2 million,
or in an emergency, banks would be subject to
a special assessment that was not to exceed
more than 2 percent of average daily deposits
for any one year.6

.. .then in any such case it shall be the duty
of the State Banking Board to require that
such state bank shall within sixty days

Under the second plan, known as the
depositors bond security system, a

thereafter increase its capital by 25 per

bank filed annually with the Commis-

cent thereof, and it shall be the duty of the

sioner of Insurance and Banking a pri-

commissioner to immediately furnish such

vate bond, or policy of insurance or
indemnity, equal to the amount of its

state bank with a certified copy of the

capital. This latter plan was not popular

order making such requirement, and upon

with the banks, as evidenced by the fact

receipt of such requisition the directors of

that less than 10 percent of banks
chose to be insured under this type of

such State Bank shall, within the time

plan when the deposit insurance system

required, cause such increase to be made

began operations. Moreover, until very
late in the operating life of the deposit

in its capital stock, and if the same is not

insurance system, banks were not

done within such time, it shall be unlaw-

allowed to switch between the two

ful for such bank to thereafter receive any
deposits at any time when its total demand

Recognizing that the existence of deposit
insurance might lead insured banks to increase
their risk profiles, more stringent regulations on
state-chartered banks accompanied the implementation of the guaranty fund. Senate Bill 4
specified that no state bank could own more
than 10 percent of the capital stock of another
bank; it instituted additional penalties for fraud;
and limits were placed on the indebtedness to a
bank of its directors and officers.7
Probably the most important regulatory
change accompanying the introduction of
deposit insurance was the implementation of
capital requirements.8 In his classic on the
history of deposit guarantees, Robb (1921, 151)
points out that

deposit insurance plans.
6

in the guaranty fund was increased to

amount to more than the limitation herein
placed upon deposits. 10

In response to mounting banking difficulties, the minimum amount required

and time deposits shall in the aggregate

$5 million in 1921.
' For some evidence that risk taking at
insured banks in Texas during the

Concerns about the propensity for insurance to increase bank risk, with potentially
adverse consequences for the guaranty fund,
seemed to be a motivating factor behind these
requirements. As Robb (1921, 151) points out,
"By these additional regulations the law
attempts to counteract any tendencies toward
reckless banking that the guaranty system may
engender." These capital requirements are summarized in Table 1.

1920s was greater than at uninsured
banks, see Hooks and Robinson (1996).
8

Section 27 of Senate Bill 4 contains the
capital requirements on Texas statechartered banks.

Robb points out that the Kansas deposit
insurance system, which passed the
state legislature on March 6,1909,
established a relationship between
deposits and capital. The Kansas law
stated, "It shall be unlawful for any
bank guaranteed under the provisions
of this act to receive deposits continuously for six months in excess of ten

The 1920s: A bad time for Texas banks
The early years of the Texas depositors
guaranty fund were relatively uneventful. By
1920, the fund had reached its required maxi-

Texas is credited with making the first
attempt in American history to establish
an arithmetical relationship between the

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIESDECEMBER1995

times its paid-up capital and surplus..."
(State of Kansas, 1909,103). Unlike
Texas, participation in the Kansas
system was voluntary.
10

See General Laws of Texas (1909, 423).

Table 1

Capital Requirements on Texas State-Chartered Banks
Capital

cash income. Texas produced about one-third
of the U.S. cotton crop and about one-fifth of
world output. It is no surprise then that the
sharp drop in cotton prices that occurred in the
early 1920s produced a severe regional recession. Cotton prices reached a high in March
1920 before falling almost 75 percent by April
1921. The index of prices received by Texas
farmers for all crops fell 71.4 percent over this
period. The economy recovered in 1922 and
into 1923, only to experience the effects of
another sharp decline in cotton prices from
1923 through 1926.12
These difficult economic times produced a
severe financial impact on Texas state banks,
most of which were located in rural areas. As
shown in Chart 1, the liquidation rate of statechartered banks in Texas rose sharply in the
1920s, peaking at 17 percent in 1925.13

Limit on deposits

$ 1 0 , 0 0 0 or less

< 5 x (capital + surplus)

over $ 1 0 , 0 0 0 but less than $ 2 0 , 0 0 0

< 6 x (capital + surplus)

$ 2 0 , 0 0 0 but less t h a n $ 4 0 , 0 0 0

< 7 x (capital + surplus)

$ 4 0 , 0 0 0 but less t h a n $ 7 5 , 0 0 0

< 8 x (capital + surplus)

$75,000 but less than $100,000

< 9 x (capital + surplus)

$ 1 0 0 , 0 0 0 or m o r e

< 10 x (capital + surplus)

N O T E : Deposits are b a s e d o n a v e r a g e daily d e p o s i t s for the y e a r e n d e d N o v e m b e r 1.
S O U R C E : General

Sessions,

Laws of Texas, Thirty-first
1909, 423.

See Warburton (1959).

See Grant and Crum (1978,125-26).

The liquidation rate includes both involuntary and voluntary liquidations. A
portion of the voluntary liquidations
involved banks switching to a national
charter to avoid the increasing costs
associated with membership in the
depositors guaranty fund. Also, Grant
and Crum (1978,155) point out that the
voluntary category included liquidations
undertaken in response to considerable
pressure from bank regulators for financially impaired banks to surrender their
charters: "...(M)ost of the banks that
entered 'voluntary' liquidation, except
for those that were nationalized, did so
because of financial difficulty."

As noted below, membership in the

Legislature,

Regular,

First, and Second

Called

mum of $2 million. From 1910 through 1920,
only twenty-four state banks failed in Texas,
compared with the more than 1,000 left operating at the period's end. According to Grant and
Crum (1978, 103), fifteen banks were closed
due to fraud, one bank was closed due to
losses on loans, one bank closed due to its
inability to meet a large withdrawal, and no
information is available about why the other
seven banks were closed. Only small disbursements from the guaranty fund were needed to
resolve these closed banks, and the withdrawals
were covered easily by special assessments that
returned the fund to its legislated minimum.
After allowing for recovery on the assets of the
failed banks, the special assessments averaged
about three-hundredths of 1 percent of the
deposits of participating banks.11

Failure of the guaranty fund
As bank failures mounted, special assessments on state banks were necessary to maintain the guaranty fund's designated balance.
Chart 2 shows how these special assessments
increased sharply in the early to mid-1920s,
both in dollar amounts and as a percent of total
deposits. In the early 1920s, these assessments
amounted to about 2 percent of banks' total
deposits. By 1927, assessments reached almost
2.5 percent of deposits.14 A total of $17 million
was raised through special assessments from
1910 through early 1927. Of course, recoveries
were made from the liquidations of the failed
banks. But, as shown in Chart 3, payments to
depositors far exceeded initial liquidation values
and subsequent recoveries from the failed
banks, resulting in large losses to the insurance

Beginning with a severe recession in 1920,
however, the Texas economy suffered a series
of setbacks that led to banking difficulties
throughout the decade. Cotton was king in
Texas, accounting for 70 percent of total crop
acreage and about the same percentage of farm
Chart 1

Chart 2

Liquidation Rate of
Texas State Banks, 1910-27

Special Assessments on
Texas State Banks, 1910-27

Percent

Percent of deposits

Millions of dollars
r 5

guaranty fund dropped considerably
after 1925. Thus, even though the dollar
amount of assessments had begun to
decline, the burden was spread over a
smaller number of banks. These calculations are based on total deposits as
recorded in Warburton (1959) rather
than on average daily deposits as stipulated in the law because data for this
latter deposit category were not available. Therefore, they should be considered an approximation of the actual
assessment burden. For comparison,
the maximum effective assessment rate
charged by the FDIC on insured banks
during the banking difficulties of the
1980s and early 1990s was one-fourth
of 1 percent of total deposits.

0
1910

1912

1914

1916

1918

1920

1922

1924

1910

1926

1912

1914

1916

1918

1920

-i

1
1922

S O U R C E S : W a r b u r t o n (1959); FDIC (1956).

S O U R C E : Grant a n d C r u m (1978).

1924

1926

Chart 3

solvency of the guaranty fund, the failure of the
fund in the mid-1920s suggests that the capital
regulations may have been seriously flawed. Of
course, other factors also contributed to the
fund's failure, such as the severity of the economic shocks that precipitated the crisis and
incompetent and dishonest bank management.
Nevertheless, an apparent paradox of the Texas
banking crisis of the 1920s is that reported capital levels remained fairly high, even though
banks were failing in increasing numbers.20
As shown in Chart 4, although the aggregate
capital-to-asset ratio for Texas state-chartered
banks fell during the 1910-27 period, even its
lowest point of 17 percent is remarkably high
by today's standards.21

Disposition of Insured Deposits at
Failed Texas State Banks, 1910-27
Millions of dollars

I I Losses to the fund
I

I Recoveries

Initial liquidations

T—r
1910

1912

1914

1916

1918

1920

1922

1924

Similar findings hold as well for individual
banks. The Annual Reports of the
Commissioner
of Insurance
and Banking are an important
source of information on the condition of state
banks in Texas. We were able to obtain some
of the reports that were produced from 1910
to 1922. Unfortunately, after 1922, with the
creation of a separate Department of Banking,
no annual reports were published. However,
during the 1910-22 period, the reports that
we obtained contained financial information on
fifty-eight failed banks at the time of their
closure.22 The reported capital-to-asset ratios of
these failed banks range from 7.1 percent to
37 percent, with an average of 20 percent,
which, by today's standards, is a remarkably
high capital position for failed banks.23

1926

SOURCES: Warburton (1959); FDIC (1956).

fund. Over the entire life of the guaranty fund,
accumulated losses totaled $11.6 million.15
As the assessment burden on banks began
to increase, state bankers began to question the
wisdom of membership in the guaranty fund.
But short of switching to a national charter, they
were not allowed to leave the plan.16 In response
to increased demands from bankers, the state
legislature in 1925 revised the original legislation
to allow banks to leave the guaranty fund and
join the depositors bond security system.17 Within
the first three months of this change in the law,
more than 300 of the approximately 900 state
banks in existence switched to the bond system.
By the end of 1926, approximately 800 state
banks were in the bond system, while only 75
banks remained in the guaranty fund. The percentage of eligible banks participating in the
guaranty fund fell from 96 percent in 1924 to 9
percent in 1926.18 Those banks that remained
in the guaranty fund faced increasingly heavy
assessment burdens. By August 1, 1926, the
maximum 2-percent assessment had already
been levied, collected, and paid out, amounting
to 8.5 percent of the capital of the remaining
127 banks in the guaranty fund. State bankers,
the Texas Bankers Association, and the state
Department of Banking all favored repeal of the
guaranty fund. On February 11, 1927, legislation
was signed that repealed both the depositors
guaranty fund and the depositors bond security
system. Liquidation of the guaranty fund
required another four years.19

Given these findings, the experience with
capital regulation in pre-Depression Texas
poses several interrelated questions. Why did
banks fail when their reported capital levels
were so high? And how could the insurance

188), during the last five years of the
existence of the guaranty fund, 126
state banks obtained national charters,
an average of twenty-five per year. Prior
to 1922, conversions averaged three
per year.
For a description of the depositors bond
security system, see footnote 5.
See Grant and Crum (1978,185). Not
only did the legislation allow banks to
switch insurance plans, but it also significantly watered down the requirements of the bond security system.
Henceforth, banks would be allowed to
count certain bonds already on their
books as sufficient to meet the requirements of the bond plan.
See Grant and Crum (1978,186,189).
As we discuss in a later section, it
appears likely that liquidity pressures
often were the factor that led bank

Chart 4

Capital Ratios at Texas State Banks, 1910-27

supervisors to close these institutions.
Capital is defined as the sum of paid-in
capital, surplus, and other capital

Percent of assets

accounts.

35 -i

These closures represent true failures in
the sense that they do not include any

banks that liquidated solely to convert
to a national charter.

In an effort to ensure consistency with
the capital measures reported in Chart 4,

capital is defined from the items in the
Annual Reports as the sum of paid-in

capital, surplus, and undivided profits.
Surplus represents the part of bank

capital that was accumulated from net
earnings to serve as an additional safe-

Why was capital regulation ineffective?

guard against losses. Texas state banks
were required to set aside 10 percent of

Given that the primary goal of the capital
regulations accompanying the introduction of
deposit insurance in Texas was to protect the

FEDERAL RESERVE BANK OF DALLAS

See Warburton (1959) and FDIC (1956).
According to Grant and Crum (1978,

net earnings to surplus until the surplus
account equaled 50 percent of paid-in

S O U R C E : All-Bank

Statistics,

United States

1896-1955,

B o a r d of

Governors of the Federal Reserve System (1959).

FINANCIAL INDUSTRY STUDIESDECEMBER1995

capital. Undivided profits are, in today's
terminology, retained earnings.

Chart 5

failure.25 This procedure results in a sample of
thirty-two banks.26
To gauge the extent of the losses estimated by examiners, we compare the reported
or unadjusted capital-to-asset ratios for our
sample of failed banks, as recorded in their
examination records, with what we call adjusted
capital-to-asset ratios that incorporate the losses
estimated by examiners. We divide the banks
into five groups of nearly equal size based on
their unadjusted capital-to-asset ratios. Chart 5
shows the average unadjusted and adjusted
capital-to-asset ratio for each of the five groups.
Consistent with the data found in the various
Annual Reports of the Commissioner
of Insurance and Banking, these banks reported high
levels of capital relative to total assets, even
near the time of their failure. The group of
banks with the highest capital reported an average capital-to-asset ratio of 35 percent, while the
group with the lowest capital had an average
capital ratio of 11 percent. However, once the
estimated losses are deducted, the average capital ratio for each of the groups falls considerably, often to about half its unadjusted level.
These findings indicate that the book-value
capital ratios reported by the Texas banks were
grossly overstated and thereby help to explain
the apparent paradox of how the banks could
have failed even as their reported capital levels
remained fairly high.

Distribution of Capital Ratios of
Texas State Banks at Failure
Percent of a s s e t s
40
Unadjusted

Adjusted

Rank b a s e d o n ratio of u n a d j u s t e d capital to assets
N O T E : Bars represent the m e a n values for e a c h group.
S O U R C E : Examiner's

Report

of Condition,

Federal R e s e r v e B a n k

of Dallas.

fund have suffered such large losses, given that
banks failed with such high levels of capital
remaining on their books? An alternative source
of data regarding the financial condition of the
banks at their time of failure might help answer
these questions.

Book-value capital overstated,

There is no indication in the examination records of what is entailed in
classifying a bank's capital as impaired.
However, in most cases this occurred
when the potential losses estimated
during the examination process exceeded the level of surplus plus undivided profits, so that the potential
losses began to erode the amount of
paid-in capital contributed to a bank.
We use as our definition of failure those
banks whose charter surrender was
characterized as either "involuntary" or
"voluntary" because, as noted in footnote 13, this distinction was largely
meaningless. We do not include those
voluntary surrenders for purposes of
switching to a national charter, though,
since this would not represent closure
due to financial difficulties. We also
exclude two banks that were sold voluntarily and were not in financial difficulty.
These failures occurred between 1924
and 1928.

in the

Federal Reserve Bank of Dallas' archives are examination records on almost two hundred statechartered banks in Texas from 1919-27, which
coincides with the turbulence of the state banking system and its deposit insurance fund.
These records contain bank balance-sheet information, including the capital positions of the
banks. Further, these examination records also
include estimates of the losses likely to be
incurred by individual banks. These losses are
mostly from the banks' loan portfolios but could
also include estimated losses on securities, real
estate, and cash items. Judging from handwritten entries in these examination reports,
bank examiners would deduct the amount of
these estimated losses from bank capital. This
adjustment would result in the examiner indicating on the reports for a number of banks that
their capital was "impaired."24

The relationship between the unadjusted
and adjusted capital-to-asset ratios for our bank
sample is shown in Chart 6. For most levels of

Chart 6

Capital Versus Adjusted Capital at
Failed Texas Banks
(Percent of assets)
A d j u s t e d capital
55 -.

By investigating those examination records
that are available for banks close to the time of
their failure, and by deducting from capital the
losses estimated by examiners, we are able to
obtain somewhat more meaningful measures
of the financial condition of failed banks. To
accomplish this, we pool together the data on
all the banks for which we have an examination
report dated one year or less before the time of

• • *

Capital
S O U R C E : Examiner's
of Dallas.

Report

of Condition,

Federal R e s e r v e B a n k

Chart 7

bank's adjusted capital is compared with its
level of deposits, now seventeen banks are in
violation of the capital requirement, and three
of these are insolvent. These results indicate
that the adjustments by examiners to bank capital to reflect likely losses give a more accurate
picture of the financial health of individual
banks. Chart 8 also shows which of these banks
were classified as capital-impaired by examiners.29 Interestingly, of the thirty-two failed banks,
twenty-four were deemed either to be capital
impaired, as assessed by examiners, or to have
had adjusted capital ratios below the statutory
minimum. While the capital regulations themselves were largely ineffective, regulators did
attempt to take into account the prevalent
overstatement of book-value capital levels by
forming their own estimate of potential losses.
However, given that (1) almost half of the banks
in our sample were not in violation of capital
requirements near the time of their failure, even
after adjusting for estimated losses, (2) only three
out of the thirty-two banks' capital fell below
zero after accounting for estimated losses, and
(3) the depositors guaranty fund suffered large
losses that ultimately resulted in its liquidation,
even the regulatory adjustments to bank capital
contained in the examination reports did not
provide a very accurate picture of the economic
value of Texas state banks.30

Capital Levels of Texas Banks at
Time of Failure
Capital-to-deposit ratio
80 -,
70 60

50
40 -I
30

$100,000
ormore

$75,000100,000

$40,00075,000

$20,00040,000

B a n k s ' capital z o n e s
N O T E : T h e horizontal lines represent the inverse of the limit
o n deposits f o u n d in Table 1. T h e r e q u i r e m e n t for b a n k s
with capital of $ 1 0 0 , 0 0 0 or m o r e is 10 percent; with
capital of $ 7 5 , 0 0 0 - 1 0 0 , 0 0 0 , 11.1 percent; with capital
of $ 4 0 , 0 0 0 - 7 5 , 0 0 0 , 12.5 percent; with capital of
$ 2 0 , 0 0 0 - 4 0 , 0 0 0 , 14.3 percent.
S O U R C E : Examiner's

Report

of Condition,

Federal R e s e r v e B a n k

of Dallas.

adjusted capital, reported or unadjusted capital
ratios tend to fall in a fairly wide range of about
20 percentage points, as indicated by the
dashed lines.27 Of particular note is how wide
the range of reported capital becomes for banks
approaching insolvency on an adjusted-capital
basis, with reported capital ratios reaching as
high as 30 percent.
Because the formal capital requirements
instituted in Texas were based on reported
book-value capital, and given the abundance of
evidence presented above indicating that
reported capital was grossly overstated, it is
difficult to see how the capital regulations in
place could have been effective in their intended purpose of preventing "reckless" banking
and protecting the guaranty fund. In Chart 7, the
statutory required minimum amount of capital
relative to deposits, which, as shown in Table 1,
is based on banks' capital zones, is depicted by
the horizontal lines, while each of our thirty-two
individual banks' reported or unadjusted capitalto-deposit ratio, as stated in the last examination
report available prior to failure, is shown by the
vertical bars.28 Reported capital fell short of its
statutory level relative to deposits for only four
of the thirty-two banks, even near the time of
failure, suggesting that the capital requirements
probably had little constraining effect on bank
behavior. In contrast, in Chart 8, when each

FEDERAL RESERVE BANK OF DALLAS

Was forbearance a problem? One reason
why these adjustments to capital, while an
improvement, are still suspect is that regulators
may have delayed recognition of problems in
The correlation between these two
measures of capital is 63 percent.

Chart 8

We convert the representation of capital

Adjusted Capital Levels of Texas
Banks at Time of Failure

requirements from a deposits-tocapital to a capital-to-deposits ratio
for ease of exposition. The capital-to-

A d j u s t e d capital-to-deposit ratio

deposit ratios shown here are calculated

80 -,

as paid-in capital and capital surplus
99.35

Capital unimpaired

Capital impaired

relative to total deposits. These calculations are based on total deposits from
bank examination records rather than
on average daily deposits as stipulated
in the law because data for this latter
deposit category were not available.

.ill

i f ] _-•.!» i l l

llllllll
$20,00040,000

decline in deposits. See footnote 24.

might overstate the extent of the banks'
insolvency if the banks possessed a
value as a going concern that was lost
unlikely that such factors can account

of Condition,

of Dallas.

deposits, if the bank had suffered a large

in the resolution process. But it is

N O T E : S e e note to C h a r t 7.

Report

paired, as judged by examiners, even
when its capital is fairly high relative to

It is possible that losses incurred by the

B a n k s ' capital z o n e s

S O U R C E : Examiner's

a bank to be designated as capital im-

insurance fund in resolving failed banks

$40,00075,000

$100,000 $75,000ormore
100,000

We should note that it is possible for

FINANCIAL INDUSTRY STUDIESDECEMBER1995

Federal R e s e r v e B a n k

for the large losses suffered by the
insurance fund.

Table 2

Measures of Bank Financial Distress Prior to Failure
on banks, then, may have forced the regulators' hand in triggering the decision to close a
failing bank.32
However, even though our limited data,
represented by examination reports on thirtytwo state bank failures, do not allow us to determine definitively whether or to what extent
forbearance was widespread, we can use the
available examination reports to at least shed
some light on this issue. Most of the records
contain a question that asks if the examiner
considers the bank to be solvent. Of the thirtytwo failures, only four examination reports indicated that the bank was not solvent when close
to failure. Several more banks were classified as
either questionably solvent or "barely" solvent
when approaching failure. In only one case was
a bank classified as insolvent more than one
year prior to failure. However, as stated earlier,
the data on the increasing assessment burdens
and ultimate depletion of the deposit insurance
fund are consistent with the view that the condition of troubled banks was substantially worse
than examiners' assessments would indicate.
In this sense, forbearance was still practiced,
though unintentionally.

Percentage of banks that
Years
before
failure

Are
capital
impaired

Do not meet capital
requirement
(adjusted)

Do not meet capital
requirement
(book value)

0-1
1-2
2-3
3-4

72
59
46
27

53
19
15
9

12
7
4
4

SOURCE: Examiner's Report of Condition, Federal Reserve Bank of Dallas.

the hopes that banks' financial health would
recover. Grant and Crum (1978, 157) report
several cases in which insolvent banks were
allowed to continue operating.31 They quote
Banking Commissioner Charles Austin in 1925
Most of these failures were banks known
to this department to be absolutely insolvent for a long time, but which appear to
have been kept open with the hope that
they might work out their own salvation.
Bank failures do not develop overnight,
but are usually the result of conditions
well known and fully recognized for a

In almost every case, however, while the
majority of banks were classified as solvent at or
before failure, most of the descriptions of their
financial condition indicated serious financial
difficulties occurring several years prior to failure. The extent of banks' financial weakness in
the years prior to failure depends on the particular measure of capital difficulties, as shown
in Table 2. The least restrictive measure is the
reported, or book-value capital ratio. By this
measure, only 12 percent of the banks in our
sample did not meet the minimum capital-todeposit requirement when close to failure, compared with 53 percent of banks when using the
adjusted-capital measure. Almost three-fourths
of the banks that failed were classified as capital impaired one year or less prior to failure. The
proportion of banks operating in financial difficulty trails off as the failure date recedes. In
every case, the least restrictive measure is the
reported book-value capital ratio, while the
designation of capital impairment captures the
largest percentage of subsequent failures.33 If
restraints had been set in place for capitalimpaired banks similar to those legislated for
banks not meeting the formal capital requirements, then perhaps the regulatory apparatus
would have been more successful in limiting
losses to the insurance fund.

long time before the crisis develops. None
of the failures which have occurred so far
this year should have been any surprise to
any person having access to the bank examiner's reports, and most of them should
have been no surprise to the public at
large for the reason that the banks have
been notoriously insolvent and generally
discussed in the communities where they
existed for many months prior to their
closing.

Warburton (1959) also cites forbearance as a problem in Texas during the
1920s.
Weaver (1926, 62) points out that the
commissioner had the authority to close
institutions where "the interests of the
depositors are jeopardized" by fraud or
heavy deposit withdrawals. Friedman
and Schwartz (1963, Chapter 7) also
note the importance of liquidity pressures on bank failures during the
1930s.
Data for all thirty-two bank failures are
not available for up to four years prior
to failure. The number of banks for
which we have examination data in the
years before failure are as follows:
twenty-seven banks one to two years
before failure, twenty-six banks two to
three years before failure, and twentytwo banks three to four years before
failure.

These words highlight the important distinction between bank insolvency and bank
failure or closure. Banks are insolvent when the
market value of their assets is less than the
market value of their liabilities. Here, failure or
closure refers to a decision by the chartering
authority that effectively terminates the operations of the bank. Wc do not have a definitive
answer as to what ultimately triggered closures
of Texas banks during the 1920s. It appears
likely, however, that regulatory assessments of
capital strength were not the primary factor in
determining when a failing bank was ultimately
closed. Warburton (1959, Table 10, 46) provides evidence that incompetent management
and associated heavy depositor withdrawals
were the primary causes of Texas bank failures
over the period 1921-30. Liquidity pressures

Assessment. Overall, the available evidence indicates that this early attempt to imple-

Table 3

Losses to Bank Insurance Fund from Bank Failures, 1985-94

ment capital standards on banks produced
mixed results, at best. Unlike seven other state
deposit insurance systems in place at the time,
no insured depositor suffered any losses under
the Texas system.34 However, though reported
capital levels were quite high, even at the time
of failure, they were largely fictitious, and the
depositors guaranty fund suffered such heavy
losses that its cost proved too great for its
members. We surmise that a primary reason
for the failure of capital regulation in preDepression Texas was that the capital requirements were based on book-value measures
that did not adequately reflect the true financial strength of individual banks. As a result,
capital-impaired banks were allowed to continue operating without fully compensating
restrictions on their behavior, since specific
restrictions were legislated only for banks that
failed the capital requirement on a book-value
basis.35 The lesson we take from this early
attempt at capital regulation is: Without meaningful measures of capitalization that provide
at least a close approximation of the net economic value of an institution relative to the
size and risk of its activities, together with
appropriate compensating restrictions on the
financial behavior of capital-impaired institutions, capital regulation will tend not to provide
an adequate level of protection to the deposit
insurance fund.

Year

related to

$1,008
1,725
2,021
6,872
6,123
2,813
6,269
3,960
584
139

above analysis is whether the current regulatory accounting standards supporting Basle and
FDICIA provide an adequate measure of bank
capital relative to the size and riskiness of bank
activities. Several recent analyses have questioned whether the current capital-based supervisory system in place will make a difference,
should banking difficulties develop in the
future. Jones and King (1995) estimate that most
of the banks exhibiting a high risk of insolvency
from 1984 to 1989 would not have been classified as undercapitalized had the FDICIA guidelines been in place. In fact, more than one-third
of the banks would have been classified as well
capitalized. Interestingly, Jones and King suggest a modification to the calculation of loan
loss reserves based on examination results as
one possible adjustment to the risk-based capital requirements. It was also an adjustment to
capital based primarily on estimated loan losses
that Texas examiners in the 1920s used in an
apparent attempt to derive more meaningful
capital measures. Along these same lines, Peek
and Rosengren (1996) question whether the
prompt corrective action provisions of FDICIA
would have made a difference during recent
banking difficulties in New England.
This evidence from the past decade, plus
our analysis of the Texas banking difficulties of
the 1920s, highlights how problematic bookvalue accounting measures can be. Market-value
accounting was part of the original proposal
that eventually became FDICIA, but the objections of regulators and bankers caused it to be
dropped from the final bill.38 It should be emphasized that the estimation of the economic or
market value of banks' assets and liabilities,
many of which are not publicly traded, presents
a number of formidable difficulties.39 As a result,
the same types of measurement problems that
have plagued traditional forms of capital regula-

the

FEDERAL RESERVE BANK OF DALLAS

120
145
203
221
207
169
127
122
41
13

SOURCE: United States General Accounting Office (1996).

Capital regulation is probably more important today than it was in pre-Depression Texas.
This reflects the aftermath of the bank and thrift
difficulties of the 1980s and early 1990s. The
collapse of many savings and loans has been
estimated to have cost taxpayers between $150
billion and $175 billion.36 Banking difficulties of
the 1980s and early 1990s were not as severe,
but did result in the Federal Deposit Insurance
Corporation reporting a negative balance of $7
billion for the first time in 1991.37 Despite a system of formal capital requirements in place,
bank failures generated substantial losses, as
indicated in Table 3. The more recent Basle
risk-based capital requirements, along with
the prompt corrective action and early closure
features of FDICIA, were implemented to avoid
a replay of these difficulties. And the prompt
corrective action and early closure provisions of
FDICIA are specifically designed to prevent
banks from pursuing any risk-taking or looting
incentives that may arise if their capital should
become impaired.
immediately

Estimated loss
(in millions)

1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

What about today?

However,

Number of failed banks

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

Seven other states experimented with
deposit insurance systems around this
time, including Oklahoma, Kansas,
Nebraska, Mississippi, South Dakota,
North Dakota, and Washington. All of
these state-run plans experienced financial difficulties and ultimately collapsed.
See FDIC (1956), American Bankers
Association (1933), and Calomiris
(1989) for descriptions of these various
deposit insurance systems. While no
insured depositors suffered any losses
in Texas, in the other states losses on
insured deposits ranged from $1.2
million to $33.7 million.
Grant and Crum (1978,158-59) report
that the actions available to regulators
included: (1) stockholder assessments
to restore capital, which were largely
unsuccessful due to the fact that the
principle stockholders were often
officers of the bank who had depleted
their own resources in an attempt to
save their business, (2) "overnight
reorganizations" with new stockholders
and a new charter quickly arranged,
and (3) liquidations.
See National Commission on Financial
Institution Reform, Recovery and
Enforcement (1993).
See FDIC Annual Report (1991). One
likely reason why the thrift industry's
difficulties were much more severe was
the less stringent supervision and regulation of savings and loans. While thrifts
were subject to capital requirements in
the 1980s administered by the Federal
Home Loan Bank Board, the amounts
required were substantially reduced
throughout the 1980s, while the definition of regulatory capital was watered
down. See Barth (1991) and Kane
(1989).
See Benston and Kaufman (1994).
See Berger, King, and O'Brien (1991).

Reforming

Corporation Improvement Act of 1991," in

tion since the Texas banking crisis of the 1920s
are likely to remain a source of concern, even if
attempts were made to implement market-value
accounting.
In fact, the measurement problems associated with capital regulation may have increased
as banks have moved beyond their traditional
role of taking deposits and making loans into
new forms of financial intermediation. In this regard, many have argued that traditional methods
of assessing capital adequacy are not applicable
to these new lines of business, particularly the
trading of financial derivatives, because measurement of the size and risk potential of derivatives portfolios is exceedingly difficult.
In response to these developments, several
new approaches to capital regulation have been
advanced.40 A prominent example is the socalled precommitment approach, whereby banks
determine their maximum precommitted trading
losses and set aside sufficient capital based on
these estimates.41 Under this approach, penalties
would be assessed on banks if their trading
losses exceeded their maximum expected losses.
This approach addresses the measurement
problem squarely, since regulators are required
to know only the actual losses, leaving the
measurement of the size and riskiness of trading
activities to the banks themselves. Unfortunately, to the extent that this approach has
merit, its primary application is to portions of a
bank's overall activities, rather than the bank as
a whole.

Financial Institutions and Markets in the United

States,

ed. George G. Kaufman (Boston: Kluwer Academic
Publishers), 1-17.
Berger, Alan N., Kathleen Kuester King, and James M.
O'Brien (1991), "The Limitations of Market Value
Accounting and a More Realistic Alternative," Journal of

Banking and Finance 15 (September): 7 5 3 - 8 3 .
Bliss, Robert R. (1995), "Risk-based Capital: Issues and
Solutions," Federal Reserve Bank of Atlanta

Economic

Review, September/October, 3 2 - 4 0 .
Board of Governors of the Federal Reserve System
(1959), All-Bank Statistics,

United States

1896-1955

(Washington, D.C.: Board of Governors of the Federal
Reserve System).
Calomiris, Charles W. (1989), "Deposit Insurance:
Lessons from the Record," Federal Reserve Bank of
Chicago Economic

Perspectives,

Examiner's Report of Condition,

May/June, 1 0 - 3 0 .
Federal Reserve Bank

of Dallas, unpublished examination reports (Dallas,
1919-1928).
Federal Deposit Insurance Corporation (1991), Annual

Report (Washington, D.C.: Federal Deposit Insurance
Corporation).
(1956), Annual Report (Washington, D.C.: Federal
Deposit Insurance Corporation).

As the banking industry continues to
evolve in response to market pressures, the
implementation of capital regulation most likely
will continue to adapt as well. However, despite
all this change, measurement problems akin to
the inflated book values that plagued an early
attempt at capital regulation that occurred some
eighty years ago in the state of Texas are likely
to remain as a significant challenge to effective
capital regulation.

Forty-Seventh
Insurance

Annual Report of the Commissioner

and Banking

Forty-Sixth Annual Report of the Commissioner
Insurance

(Austin: Von Boeckmann-Jones).

and Banking (Austin: Von Boeckmann-Jones).

Friedman, Milton, and Anna Jacobson Schwartz (1963),

A Monetary History of the United States 1867-1960
(Princeton: Princeton University Press).

References

General Laws of Texas, Thirty-first Legislature,

Akerlof, George A., and Paul M. Romer (1993), "Looting:

First, and Second Called Sessions,

The Economic Underworld of Bankruptcy for Profit,"

Boeckmann-Jones), Chapter 15, 4 0 6 - 2 9 .

Brookings

Papers on Economic

Regular,

1909 (Austin: Von

Activity, no. 2: 1 - 7 3 .
Grant, Joseph M., and Lawrence L. Crum (1978), The

American Bankers Association (1933), The Guaranty of

Development

Bank Deposits (New York: American Bankers Association).

(Austin: Bureau of Business Research, University of

of State-Chartered

Banking in Texas

Texas at Austin).
Barth, James R. (1991), The Great Savings and Loan
40

For more on these approaches to

Debacle

Hooks, Linda M., and Kenneth J. Robinson (1996),

(Washington, D.C.: The AEI Press).

"Moral Hazard and Texas Banking in the 1920s," Federal

determining capital, as well as some

shortcomings, see Bliss (1995).
41

See Kupiec and O'Brien (1995).

Reserve Bank of Dallas, Financial Industry Studies

Benston, George J., and George G. Kaufman (1994),

Working Paper no. 1 - 9 6 (Dallas, October).

"The Intellectual History of the Federal Deposit Insurance

Jones, David S., and Kathleen Kuester King (1995),

Peek, Joe, and Eric S. Rosengren (1996), "Will Legis-

"Implementation of Prompt Corrective Action: An

lated Early Intervention Prevent the Next Banking Crisis?"

Assessment," Journal of Banking and Finance 19

Federal Reserve Bank of Boston Working Paper no. 9 6 - 5

(June): 4 9 1 - 5 1 0 .

(Boston, September).

Kane, Edward J. (1989), The S&L

How Did It Happen?

Insurance

Mess:

Robb, Thomas Bruce (1921), The Guaranty of Bank

(Washington, D.C.: The Urban

Deposits

(Boston: Houghton and Mifflin Company).

Institute Press).
Short, Genie D., and Jeffery W. Gunther (1988), "The
Keeley, Michael C. (1988), "Bank Capital Regulation in

Texas Thrift Situation: Implications for the Texas Financial

the Early 1980s," Federal Reserve Bank of San Francisco

Industry," Federal Reserve Bank of Dallas Financial

Weekly Letter (San Francisco, January 22).

Industry Studies (Dallas, September).

Kupiec, Paul, and James O'Brien (1995), "A Pre-commit-

State of Kansas (1909), Session Laws of Kansas

ment Approach to Capital Requirements for Market Risk,"

(Kansas: Official State Paper, March 10, 1909).

Federal Reserve Board of Governors Working Paper no.
9 5 - 3 6 (Washington, D.C., July).

U.S. General Accounting Office (1996), "Bank and Thrift

Marcus, Alan J. (1984), "Deregulation and Bank Financial

tory Action Provisions," Report to Congressional

Policy," Journal of Banking and Finance 8: 5 5 7 - 6 5 .

mittees (Washington, D.C.: U.S. Government Printing

Regulation: Implementation of FDICIA's Prompt Regula-

Com-

Office, November).
Merton, Robert C. (1977), "An Analytical Derivation of
the Cost of Deposit Insurance and Loan Guarantees:

Warburton, Clark (1959), Deposit Insurance

An Application of Modern Option Pricing Theory," Journal

States During the Period 1908-1930

of Banking and Finance 3: 3 - 1 1 .

Federal Deposit Insurance Corporation).

National Commission on Financial Institution Reform,
Recovery and Enforcement (1993), Origins and

Weaver, Findley (1926), "State Banking In Texas,"

Causes

unpublished Master of Arts Thesis, University of Texas,

of the S&L Debacle: A Blueprint for Reform (Washington

Austin (June).

D.C.: U.S. Government Printing Office, July).

FEDERAL RESERVE BANK OF DALLAS

in Eight

(Washington, D.C.:

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

Mexican Payments
System Reforms

Since the late 1980s, Mexico has engaged
in a series of far-reaching financial and economic reforms. These reforms include the privatization of its banks and other state-owned
enterprises, interest rate deregulation, an easing
of reserve requirements, reductions in restrictions on trade and foreign bank entry, and an
overhaul of the payments systems.1 This article
investigates the ongoing payments system
reforms that Mexico began in 1994.
The safe and efficient transfer of monetary
value in exchange for goods, services, and
financial assets is vital to any market economy.
The apparatus used to transfer monetary value
is the payments system. For the purpose of
analysis, the payments system as a whole can
be divided into large-value and small-value
systems. Large-value, or wholesale, payments
systems are primarily used to transfer funds
between banks, and the average value of each
transfer is relatively large. Folkerts-Landau,
Garber, and Lane (1994) list the important functions of large-value systems: to provide the
necessary infrastructure for the intermediation
of household and business payments, to enable
more efficient liquidity management by banks,
to assist the development of security markets,
and to allow for more effective implementation
of monetary policy. The primary thrust of payments system reform in Mexico thus far has
concentrated on large-value systems.

Sujit "Bob" Chakravorti
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

A
Kms

with the other major

financial reforms initiated
since the late 1980s, Mexico's
recent efforts to enhance the role
of market-based decisions in
the payments system represent
a significant step in the
right direction.

Small-value, or retail, payments systems
process relatively small payments among consumers and businesses. Retail payment instruments include cash, checks, automated
clearinghouse payments, credit and debit cards,
and, more recently, electronic money.2 Pingitzer
and Summers (1994) state that "the efficient
operation of a market economy depends on
the availability of a smoothly functioning smallvalue transfer system that connects all economic
agents."
Although financial analysts agree that
large-value payments systems should be safe
and efficient, there is little consensus on their
optimal design and operation. Major differences
exist in the types of large-value payments systems employed in developed countries.3 As a
result, developing countries seeking to enhance
their integration with international capital markets face difficulty in identifying the most
appropriate blueprint for strengthening their
own large-value systems.4 Mexico provides an
interesting example of the recent push to enhance the safety and efficiency of large-value
payments systems in emerging financial markets.
In early 1994, the Bank of Mexico, the

Most of my understanding of the
Mexican payments systems is based on
interviews and written correspondence
with the major players in the Mexican
financial markets. I benefited from conversations with Juan Antonia, Giiberto
Calvillo, Abdon Sanchez-Arroyo, and
Francisco Soli's at the Bank of Mexico,
H6ctor Perez Galindo and Carlos H.
Garza at INDEVAL, and individuals at
other institutions that are major players
in the payments systems described. In
addition, I would like to thank Alton
Gilbert, Jeff Gunther, Genie Short, Ed
Stevens, Bruce Summers, and Jim
Thomson for comments on previous
drafts.
' For a discussion of Mexican financial
system reforms, see Welch and Gruben
(1993) and Gruben, Welch, and Gunther
(1993).
2

For a description of these systems, see
Chakravorti (1997).

For a comparison of large-value payments systems, see Horii and Summers
(1994) and Bank for International
Settlements (1997).

For an overview of payments system
issues in developing countries, see
Listfield and Montes-Negret (1994) and
Sato and Humphrey (1995).

Glossary of Terms
Clearing/Clearance "Clearing is the process of transmitting, reconciling and in
some cases confirming payment orders or security transfer instructions prior to
settlement, possibly including netting of instructions and the establishment of final
positions for settlement" (Bank for international Settlements 1993).

central bank of Mexico, proposed reforming its
payments system. The goals of these reforms
are to decrease the amount of unsecured intraday credit it extends to banks over the largevalue interbank payments system, to promote
market discipline in the determination of credit
exposures related to the payments system, and
to move large-value transactions away from
checks to electronic systems. The first two
goals are designed to reduce payments system
risk, while the last one is aimed at increasing
efficiency.

Clearing House for Interbank Payments System (CHIPS) CHIPS is the primary
electronic large-value funds transfer system for the dollar component of foreign exchange and cross-border transactions. CHIPS, established in 1970, is operated by
the New York Clearing House Association.
Delivery Versus Payment (DVP) DVP describes transactions in which delivery of
an asset occurs if and only if payment occurs. Participants need not deliver good
funds but only a payment instrument with the underlying value.
Fedwire Fedwire, the U.S. large-value gross settlement system operated by the
Federal Reserve, is used for the transfer of funds and government securities.
L i q u i d i t y Risk The risk that a participant does not have good funds at the time of
settlement, but can provide them at a later time.

Progress has been made on each of these
fronts. Except under certain circumstances, the
Bank of Mexico no longer extends uncollateralized intraday credit to settle payments on its
large-value payments system.5 Instead, to maintain adequate liquidity while imposing market
discipline, the Bank of Mexico implemented a
net large-value payments system, in which
participants send payments based on intraday
lines of credit they extend to one another.
In addition, the Bank of Mexico has successfully promoted this system as an alternative to
high-value checks. However, some challenges
remain for the Bank of Mexico in implementing
the desired market discipline in the intraday
credit market.

Settlement "An act that discharges obligations in respect of funds or securities
transfers between two or more parties" (Bank for International Settlements 1993).
Settlement Risk The risk that one party to a transaction does not deliver the underlying asset in its entirety at the specified settlement time. This asset could be good
funds, another financial asset, or a physical asset.

Sistema de Atencion a Cuentahabientes de Banco de Mexico (SIAC) SIAC is
the large-value gross settlement system that transfers funds between reserve
accounts at the Bank of Mexico.
Sistema de I n f o r m a c i o n de D e p o s i t o de Valores (SIDV) SIDV is the large-value
securities transfer system. SIDV is operated by the Instituto de Deposito de Valores
(INDEVAL).
Sistema de Pagos E l e c t r o n i c o de Uso A m p l i a d o (SPEUA) SPEUA is the largevalue funds transfer system that nets payments and settles over SIAC. SPEUA is
operated by the Bank of Mexico.
S y s t e m i c Risk "The risk that the inability of one institution to meet its obligations
when due will cause other institutions to be unable to meet their obligations when
due" (Bank for International Settlements 1992). This definition applies in the context
of payments systems.

Trade-offs in payments system design
The details of the recent payments system
reforms in Mexico are best understood in the
context of the policy alternatives facing payments system operators in general. To provide a
framework for an analysis of Mexico's reforms,
this section discusses some of the major issues
associated with the operation of large-value
payments systems.
A safe payments system minimizes the
risks involved in the transfer of monetary value.
From a public policy perspective, a safe payments system can prevent the costly disturbances that result from the stoppage of clearing
and settlement caused by a failure of one or
more participants to settle. An example of such
a stoppage occurred in the Hong Kong futures
market during October 1987, when the market
was closed for four days to sort out its settlement problems. The Hong Kong government,
along with leading banks and brokerage firms,
helped the various parties meet their obligations by extending credit totaling HK$2 billion
(US$256 million).6

risk, and systemic risk. (See the box entitled
"Glossary of Terms.") Liquidity risk is the risk
that a participant does not have good funds at
the time of settlement but can provide them at
a later time. Settlement risk is the risk that one
party to a transaction does not deliver the
underlying asset in its entirety at the specified
settlement time. This asset could be good funds,
another financial asset, or a physical asset.7
Systemic risk, as defined by the Bank for
International Settlements (1992), is "the risk that
the inability of one institution to meet its obligations when due will cause other institutions to
be unable to meet their obligations when due." 8
However, safety is not the only factor
influencing the economic benefits provided by
a payments system. An efficient payments system also promotes an efficient allocation of
financial resources. At the level of individual
market participants, this efficiency results in
lower transactions costs. For example, a comparison of the cost differentials between securities clearing and settlement systems used in
emerging markets and the United States illus-

The risks that safe payments systems
attempt to minimize are often collectively
referred to as payments system risk. Payments
system risk includes liquidity risk, settlement

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

I discuss these circumstances below.

This conversion is based on the prevailing exchange rate of 7.81 HK
dollar—U.S. dollar in October 1987.
For a description of this event, see
Folkerts-Landau et al. (1995).

When discussing large-value payments
systems, good funds are usually
reserves held at the central bank by
financial institutions.

Bank for International Settlements
(1992), A2-7. In the broader banking
literature, systemic risk is often defined
as the failure of a financial institution
leading to the failure of one or more
financial institutions, with adverse consequences to both the financial system
and the economy as a whole.

trates the potential cost savings to participants.
According to Stehm (1996), the average cost to
process and settle a securities trade in emerging
markets is probably between ten and one hundred times greater than in the United States.
When designing payments systems, operators can choose between gross settlement
systems and net settlement systems. In gross
settlement systems, each transaction is settled
individually; in net settlement systems, participants settle the net of their incoming and outgoing payments at the end of a specified period
of time, usually a day. (For a comparison of
gross and net settlement systems, see the box
entitled "Gross Versus Net Settlement.") Gross
settlement offers participants the immediacy of
using the underlying funds and reduced settlement risk because each transaction is settled
with good funds.9 However, these systems are
more expensive for participants to use than netting systems because of the need for greater
quantities of good funds to settle. Operators of
payments systems must weigh the safer gross
settlement system against the more efficient net
settlement system.

Financial institutions usually do not
earn interest on these reserves, so
they attempt to minimize their reserve
holdings.

For a description of Swiss Interbank
Clearing, see Vital and Mengle (1988).

For a discussion of these issues, see
Hancock and Wilcox (1996) and
Richards (1995).

The risk and efficiency trade-offs of
payments systems that net are modeled
in Chakravorti (1996).

extend unlimited and uncollateralized intraday
credit to its banks to make payment over its
large-value gross settlement system. As part of
the recent reforms, however, the Bank of
Mexico has replaced most unsecured intraday
credit with fully collateralized credit.
Central banks are faced with a trade-off
when deciding to extend intraday credit. By not
providing intraday credit, they eliminate credit
risks associated with direct intraday lending.
However, such a policy may result in payment
gridlock, especially in financial systems without
well-developed interbank funds markets. Payment gridlock occurs when the flow of payments stops because participants are waiting
to receive payments before sending them. By
providing intraday credit, central banks increase
intraday liquidity and prevent payment gridlock.
A central bank's major concern about such a
policy is the credit risk associated with intraday
lending, especially if this credit is not properly
priced. In addition, the reliance on central bank
credit by payments system participants may distort the market allocation of intraday credit.
Another way to reduce payment gridlock
that does not rely on central bank credit is to
net payments instead of settling each payment
individually. In net settlement systems, participants extend each other credit during the
day and settle their positions with good funds
at the end of the day. An example of such
a system is the Clearing House Interbank
Payments System (CHIPS), the large-value
payments system used primarily to settle international dollar payments and dollar components of foreign exchange transactions.12
However, such systems do not usually guarantee the immediacy of funds. In other words,
good funds are not usually available until the
end of the day for further transactions.

Payments system operators often adopt
policies to increase the efficiency of gross
settlement systems or decrease the settlement
risk of netting systems. To decrease cost to
participants, gross settlement system operators
may extend free intraday credit. To decrease
settlement risk to participants, net settlement
system operators may impose market-based
debit caps and/or loss-sharing arrangements
among participants. Market-based debit caps
restrict the amount a participant can owe at
any time during the day. Loss-sharing rules distribute the losses associated with the failure of
one or more participants to settle among the
remaining participants.
One area in which central banks' gross
settlement systems differ is the quantity of intraday credit they extend. In this context, intraday
credit is used to facilitate payment flows during
the day. Payments system participants are
expected to end the day with a zero balance. At
one extreme is Swiss Interbank Clearing, where
the Swiss National Bank, the central bank of
Switzerland, extends no intraday credit.10 At the
other extreme, until recently some central banks
extended unlimited daylight credit. Until the
mid-1980s, the Federal Reserve extended nearly
unlimited daylight credit to Fedwire participants. Since then, the Federal Reserve has
imposed limits on intraday credit and also
charges fees based on the quantity of credit
extended.11 The Bank of Mexico also used to

In its reform of the payments systems, the
Bank of Mexico reduced its direct exposure to
intraday credit risk, while maintaining sufficient
liquidity. The Bank of Mexico implemented
parallel gross and net settlement systems. The
two net settlement systems settle over the gross
settlement system at the end of the day. To
decrease its exposure to credit risk, the Bank of
Mexico eliminated the extension of daylight
credit to banks except under certain limited
circumstances. Although the Bank of Mexico
eliminated direct unsecured intraday credit, it
guaranteed payment of end-of-day net clearing
balances arising from the two parallel netting
systems. However, these guarantees may still
expose the Bank of Mexico to undesired levels
of credit risks.

Gross Versus Net Settlement
To illustrate the difference between gross
and net settlement systems, consider the following
six individual payments between institutions A, B,
and C:
B

Chart 2

Bilateral Net Settlement

$400
$400
$300

$600
B

$500
$400

In gross settlement systems, each institution
settles each payment individually ( Chart 1). If we
assume that the central bank does not grant intraday credit, each participant would either have to
wait until it is paid, borrow funds in the interbank
funds market, or hold assets in the form of central
bank reserves to make payment. If each bank
waited until it was paid, there is a possibility that

(Chart 3). In this case, institution A reduces its
holdings of central bank reserves from $100 in the
bilateral netting system to $0 in the multilateral
netting system; institution B reduces its holdings
of central bank reserves from $200 to $100; and
institution C reduces its holdings of good funds
from $100 to $0. The cost of holding reserves to A
and C is zero and to B is $1. Multilateral settlement
systems require the least amount of central bank
reserves to settle and are also the least costly to
participants.

Chart 1

Gross Settlement

However, settlement of payments is not final
in net settlement systems. Settlement only becomes
final at the end of the day when good funds are
transferred. One way to increase the efficiency of
the payments system and to ensure settlement
at the time of payment is for the central bank to
extend free intraday credit and guarantee payment.
In such systems, participants enjoy the benefits of
netting, since they settle at the end of the day and
also benefit from immediacy of funds due to the
guarantee. But by extending free intraday credit,
central banks are exposed to settlement risk, and
the guarantee distorts the payments system participant's credit assessments of other participants.

no one would send a payment, resulting in payment gridlock. Let us assume that institutions do
not wait for incoming payments before sending an
outgoing payment. In such a system, one cost of
participation is the cost of holding or borrowing
central bank reserves. For illustrative purposes,
assume there is a 1 percent cost for holding or
borrowing reserves. In this example, institution A
uses $800, institution B uses $900, and institution
C uses $900. The cost for A would be $8; for B, $9;
and for C, $9.

Chart 3

Multilateral Net Settlement

Alternatively, these participants could bilaterally net payments during the day and settle at the
end of the day. By bilaterally netting, an institution
nets payments between itself and each of the other
institutions, resulting in only one transaction with
each of the other participants (Chart 2). In such a
system, institution A only needs $100 of central
bank reserves, reduced from $800; institution B
only needs $200, reduced from $900; and institution C only needs $100, reduced from $900.
The cost for A is $1, reduced from $8; for B, $2,
reduced from $9; and for C, $1, reduced from $9.

J II 1!£

Multilateral netting would further reduce
holdings of central bank reserves by the institutions

FEDERAL RESERVE BANK OF DALLAS

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

The Mexican payments system reforms

be processed over SIAC. Brokers, for example,
send payments via SIAC since they are not
allowed to participate in SPEUA directly.15
If a SIAC participant does not have adequate collateral for a payment and the payment
is used to settle an end-of-day clearing obligation from another system, such as SPEUA, the
Bank of Mexico will extend unsecured credit to
the bank to allow the payment to be made.
Although the Bank of Mexico thus extends
unsecured credit, it charges penalty rates on
such overdrafts and strongly encourages participants to avoid them. In addition to penalties
for each unsecured overdraft, the Bank of
Mexico imposes sanctions based on a participant's unsecured overdrafts during a given
month. The Bank of Mexico may also increase
collateral requirements for a participant that
sends uncollateralized nonrejectable payments
too often. Because the Bank of Mexico is willing to allow such payments, the receiving participant of a SPEUA payment bears no same-day
liquidity risk. However, that participant does
face credit risk based on its share of the losssharing arrangement should the sending participant be unable to meet its obligation after three
days.16

Before the proposed reforms in 1994,
the Bank of Mexico operated the Sistema de
Atencion a Cuentahabientes de Banco de
Mexico (SIAC-BANXICO, or SIAC), which was
Mexico's only electronic large-value interbank
payments system.13 SIAC was introduced in
1986, replacing the electronic system known as
Sistema de Informacion Contable. Participants
used SIAC to transfer Mexican pesos, U.S. dollars, and government securities. Each participant
had three SIAC accounts: a peso account, a
U.S. dollar account, and a securities account.
The Bank of Mexico guaranteed every payment
and granted free unlimited and unsecured daylight peso overdrafts to banks. However, the
Bank of Mexico did charge penalty rates for
overnight borrowing resulting from daylight
overdraft positions.

For a description of the Mexican payments systems prior to 1994, see
Sanchez-Arroyo (1996).

In addition to SPEUA and SIDV end-ofday positions, SIAC also settles positions from the check clearinghouses.

The Bank of Mexico does not regulate

A bank that has defaulted on settlement

or supervise brokers.
has three days to meet its shortage of
funds and faces penalties for the length
of time it takes to settle. If the bank
cannot settle at the end of three days,
the loss-sharing arrangements are used.
At this point, the banks that granted the
defaulting bank credit share in the loss.
This loss-sharing arrangement is
described in the box entitled "SPEUA
Loss-Sharing Arrangements." Failure to
meet its overdraft within the three-day
time frame is not sufficient for the Bank
of Mexico to close the bank.
17

Diaz (1996).

A full assessment of the Bank of
Mexico's success in reducing the level
of intraday credit would require a
comparison of the aggregate bilateral
SPEUA credit granted as a percentage
of the total value of payments to the
aggregate overdrafts on SIAC as a
percentage of total value of payments
before the reforms.

As part of the reforms, the Bank of Mexico
reorganized SIAC into three linked payments
systems: a new SIAC, the Sistema de Pagos
Electronico de Uso Ampliado (SPEUA), and the
Sistema de Informacion de Deposito de Valores
(SIDV). SIAC, still operated by the Bank of
Mexico, is now used primarily to settle positions
from the other two systems. The Bank of
Mexico replaced unlimited and unsecured overdrafts with 100 percent collateralized overdrafts.
In addition, the Bank of Mexico placed limits on
the size of the fully collateralized overdrafts
based on bank size. SPEUA, also operated by
the Bank of Mexico, is another electronic largevalue funds transfer system. Unlike SIAC,
SPEUA participants use uncollateralized intraday
credit to make payment. However, participants
face credit limits based on the credit lines they
extend to one another. SIDV, operated by
Instituto de Deposito de Valores (INDEVAL), a
private firm, clears and settles government- and
bank-issued securities and equities. Each of
these systems is discussed in more detail below.

After these changes were implemented in
March 1995, SIAC participants learned to manage their SIAC accounts better and reduce their
reliance on Bank of Mexico unsecured intraday
and overnight credit. SIAC participants significantly reduced their reliance on Bank of
Mexico unsecured credit after the first three
months following the adoption of these policies.
Of the penalties imposed for SIAC unsecured
overdrafts in the first nine months after the
adoption of these policies, 92 percent occurred
in the first three months, whereas only 8 percent
of the penalties occurred in the next six
months.17 Thus, early indications suggest that
the Bank of Mexico has been successful in
reducing the amount of uncollateralized credit it
grants to SIAC participants.18

SIAC. CLirrently, SIAC participants hold
only peso accounts at the Bank of Mexico, and
payments are irrevocable. As mentioned above,
most payments over SIAC must be collateralized
or made with good funds, which limits the Bank
of Mexico's exposure to unlimited and uncollateralized intraday credit. Most analysts agree that
this policy has reduced the Bank of Mexico's
risk because the value of unsecured intraday
credit extended by the Bank of Mexico has
decreased. SIAC's major function is to settle
payments resulting from end-of-day positions
from the other systems.14 These types of SIAC
payments are called nonrejectable payments. In
addition, some individual payments continue to

SPEUA. SPEUA was developed to increase
intraday liquidity and to decrease the risk
absorbed by the Bank of Mexico. Unlike SIAC,
SPEUA participants are limited to banks. In
SPEUA, the participants determine the levels of
intraday credit through bilateral credit lines that
they extend to each other. Further, each bank
has an aggregate credit limit that is the sum of
the bilateral credit limits. Like SIAC payments,
SPEUA payments are irrevocable, except if payments are queued.
For example, if a sending bank exceeds its
credit limit, payment messages are placed in a

SPEUA Loss-Sharing Arrangement
These loss-sharing arrangements are used after a bank has failed to settle its SPEUA obligations for
three consecutive days. The additional settlement obligation (obligacion adicional de liquidacion—OAL) for
institutions that grant credit to the defaulting institution is1

LER:

(B.1)

OALP

(B.2)

OALjjz - Cj2

(B.3)

OAL i j z - Cj3

C,
-71

ZLER kj 1
k=1
LERij2-

OAL ij1

K l e r <kj2 ~ OALkji)
,
k=1

LER/j3 - OALii0 - OAL
'72
-'71
I

Ar=1

(LERkj3-

OALkj2 - OALkn)

where

OAL ijt = The additional settlement obligation of participant /' as a result of the default of participant j on
day f. Equation B.1 calculates the additional settlement obligation for day 1, equation B.2 for day
2, and equation B.3 for day 3.
Cjt

= The overdraft of defaulting bank j at day t. For days 2 and 3, Cjt measures the difference between
the overdraft position on day t and the overdraft position from the preceding day, or day t - 1.
If the difference is negative, the overdraft position for the preceding day will be recalculated.

LER,jt

= The amount of the credit line extended to participant j by participant i at day t.

LERkjt

= The amount of the credit line extended to participant j by participant k at day t.

= The bank for which the additional settlement obligation is being calculated.

= The overdraft bank.

= All banks except overdraft bank j.

= The total number of SPEUA participants.

The Bank of Mexico has considered
allowing participants to decrease their

In period 1, the additional settlement obligation of a participant is equal to the product of the participant's share of the total credit extended to the overdraft participant and the total amount of the overdraft. 2
In periods 2 and 3, the calculation of the additional settlement obligation is similar, except that it is based on
any additional credit extended to the overdraft bank. The total additional settlement obligation of a participant is equal to the sum of the obligations in days 1 through 3. If there is a shortfall between the defaulting
participant's overdraft and the sum of the additional settlement obligations of the remaining participants, the
Bank of Mexico absorbs the loss.

credit lines during the day. However,
such a change would further complicate
the loss-sharing rules. The Bank of
Mexico is considering the adoption of
less complex loss-sharing arrangements in conjunction with the introduction of collateral requirements. If such
changes are adopted, the Bank of
Mexico may consider allowing partici-

' Bank of Mexico (1997). The description of loss-sharing arrangement did not appear in the original version but appeared as an update.
2

pants to decrease their credit lines.

Loss-sharing rules are often based on the credit line and not the actual credit extended. For example, CHIPS' loss-sharing arrangements are
also based on credit lines extended (see New York Clearing House Association 1996).

The effectiveness of the loss-sharing
provision is critically dependent on how
the Bank of Mexico settles insolvent
banks. If banks are not allowed to fail,

queLie. Payments that are queued can be canceled before they are sent. When the participant
is again sufficiently below the credit limit, the
queued payment message is sent if it has not
previously been canceled. However, due to the
high credit lines extended to participants, few
payments are queued. In addition, participants
usually stop sending payments when their
credit limit is reached. The Bank of Mexico
restricts them from reducing credit lines during
the day.19 At the end of the day, each bank must
meet any debit positions and send payments via
SIAC. As part of the reforms, the Bank of
Mexico also established loss-sharing rules to distribute losses in the event of the failure of a
SPEUA participant. (For a description of this

FEDERAL RESERVE BANK OF DALLAS

arrangement, see the box entitled "SPEUA LossSharing Arrangement.") According to these
rules, SPEUA participants that grant intraday
credit to a failed participant share in the loss
based on a loss-sharing formula.20 In addition,
the Bank of Mexico plans to impose collateral
requirements in the future.
In reforming its payments systems, the
Bank of Mexico also wanted to move high-value
payments away from checks to electronic form.
Several studies have shown that electronic alternatives are significantly less costly to process
and use than checks. 21 This savings increases the
efficiency of a country's payments system. To
provide an incentive to use SPEUA instead of
checks, the Bank of Mexico changed the value

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

or if interbank placements are not subject to loss even in the event of failure,
SPEUA participants extending credit
would discount the costs associated
with the loss-sharing provision in their
interbank lending decisions.
2'

See Robinson and Flatraaker (1995) and
Humphrey and Berger (1990) for cost
comparisons of electronic forms and
checks or paper giros. Giro payments
are credit transfers between the payor
and the payee that may be used for
recurring or nonrecurring payments.
The payor instructs the Giro, an organizational structure that receives and
makes payment, to debit his or her
account and credit the payee's account.
Giro payments are a dominant form of
payment in many European countries.
Giro payments can be either electronic
or paper based.

In May 1996, the Bank of Mexico further
reduced the minimum value per transaction to 100,000 pesos. However, there
was no significant change in the value
or volume of check payments.

The figures for check value and volume
are from Diaz (1996) and correspondence with Bank of Mexico staff.

Named after the German bank that was
closed in 1974 before it could make
payment on its dollar obligations,
Herstatt risk is the risk in a foreign
exchange transaction that one party
delivers one currency but the counterparty does not deliver the other. In the
case of Herstatt, the time zone difference between Germany and New York
was largely to blame for the dollar
defaults. Although this type of settlement risk is named Herstatt risk, it is
not necessarily eliminated if there is
little or no time zone difference between
the currencies being settled. The difference in settlement times of the two
underlying currencies in a foreign
exchange transaction leads to Herstatt
risk. For a discussion of foreign exchange settlement risk, see Chakravorti
(1995) and Bank for International
Settlements (1996).

For a general overview of clearance and
settlement of securities in emerging
markets, see Stehm (1996).

Based on a survey of various DVP
systems, the Bank for International
Settlements (1992) categorized DVP
systems into three models. Model 2
DVP systems settle the securities part
of the transaction on a gross basis
during the day and settle the funds side
on a net basis at the end of the day.
Model 1 DVP systems settle both the
securities and funds side on a gross
basis. Although model 1 systems have
less settlement risk than model 2
systems, such systems require greater
amounts of good funds to settle and as
a result are more expensive for participants to use. Model 3 DVP systems
settle both the securities and funds side
on a net basis.

The adoption of delivery-versus-payment
arrangements does not eliminate payments system risk completely. There
could still be a failure to settle the payment. In non-DVP transactions, there
is the potential for one party to never
deliver its asset after receiving the
counterparty's asset.

Most stock transactions occur on the
stock exchange because of tax benefits
associated with exchange traded stocks.

For SIAC transfers, nonbank participants may transfer funds themselves if
they are SIAC participants. However, for
SPEUA transfers, nonbank SIDV participants must have correspondent relationships with a SPEUA participant.

firmed the seller's possession of the security and
that the buyer has adequate funds or overdraft
facilities, the transaction cannot be reversed. If
the seller does not have the underlying security
or the buyer does not have the funds or sufficient overdraft facilities, the transaction is
placed in a queue and settled when each party
has the necessary funds and securities to settle.
If the queued transaction involves government
or bank securities, the trade can be canceled.
However, if the transaction is an equity transaction, it cannot be canceled while in the
queue because of stock exchange rules regarding trades.28

date on checks to next day from same day in
January 1996. The Bank of Mexico also reduced
the minimum value for SPEUA transactions from
500,000 pesos to 150,000 pesos in December
1995.22 The Bank of Mexico believes that these
policies were responsible for the reduction of
the average daily value of checks from 55 billion pesos in 1995 to 6 billion pesos in 1996.23
Although the value of check transactions
decreased significantly, the number of checks
processed did not decrease significantly because the number of checks with values of
150,000 pesos and above was and continues to
be fairly small. The average daily number of
checks decreased from 782,000 in 1995 to
684,000 in 1996.
Most Mexican peso components of largevalue foreign exchange transactions are settled
via SPEUA. Most foreign exchange peso transactions are for U.S. dollars, and the dollar components of each transaction are settled primarily
via New York-based CHIPS. In most cases, if a
nondollar-peso foreign exchange transaction is
requested by a client, the trader would first
make a dollar trade and then trade dollars for
the desired currency. Herstatt risk exists for
peso-dollar transactions using SPEUA and
CHIPS, since the settlement of the dollar and
peso components of the transaction may not
occur simultaneously, even though SPEUA and
CHIPS operate roughly during the same time.24
For large-bank-to-large-bank transactions, the
peso and dollar transactions are not settled in
any specific order. However, for transactions
involving a small participant and a large bank,
the large bank will often require the delivery of
one currency before releasing the other.

The buyer's overdraft facility is the lesser
of the fully collateralized credit line or buyer's
bank credit line. Collateral can be in the form of
bank or government securities. When used for
collateral, government securities receive a lesser
discount than bank securities.
In addition to the collateralized credit
lines, participants are granted credit lines that
are a component of their overdraft facility from
banks. Every morning, the Bank of Mexico
extends credit lines to banks for the purpose of
making SIDV payments. In turn, banks allocate
these credit lines to SIDV participants. Although
there is not a set policy for the amount of
credit each bank is granted by the Bank of
Mexico, in most cases banks receive credit lines
of around 60 percent of their aggregate SPEUA
credit line to allocate to SIDV participants. In
addition to the collateralized and bank credit
lines, buyers can transfer funds from SPEUA
or SIAC to use for payment.29 However, participants use the overdraft facility most of
the time.

SIDV. Operated by INDEVAL, SIDV is used
to clear and settle bank and government securities, and equities.25 SIDV participants are required to have two types of SIDV accounts—a
funds account and a securities account. All SIDV
transactions follow the Bank for International
Settlements' Delivery Versus Payment (DVP)
model 2.26 In a DVP transaction, the underlying
security and the payment for that security are
exchanged at the same time, thereby reducing
settlement risk.27 In October 1994, DVP was
implemented for bank securities transactions. In
July 1996, the DVP process was extended to
government securities, and in April 1997, the
DVP process was extended to equities.
For a DVP SIDV settlement to occur, the
buyer must have a positive balance in its SIDV
funds account or have access to overdraft
facilities, and the seller must have the security in
its securities account. Once INDEVAL has con-

SIDV is linked to SPEUA and SIAC. These
links enable participants to transfer funds in real
time between these systems either directly, if
they are banks, or through their correspondent
bank. A participant, for example, can sell a
security using SIDV and transfer the funds to
SIAC and then use the funds to offset some
other obligation, all within minutes.
The Group of Thirty in 1989 made recommendations for the clearance and settlement of
securities.-30 (See the box entitled "Group of
Thirty Recommendations for Securities Clearing
and Settlement" for a complete list.) These
recommendations have been accepted as a
standard that securities markets around the
world should strive to meet, and, in 1992, the
Group of Thirty produced status reports on various countries, including Mexico. At that time,
Mexico did not satisfy two of the recommendations. First, Mexico did not satisfy recom-

Group of Thirty Recommendations for
Securities Clearing and Settlement
mendation 5, which states that each country
should use DVP to settle all securities transactions. Today, all transactions cleared and
settled by INDEVAL use DVP.
Second, Mexico did not meet recommendation 9, which states that each country should
adopt the international message standard developed by the International Organisation for
Standardisation (ISO Standard 7775). Use of one
standard for numbering and identifying securities facilitates greater ease in cross-border transactions. In 1993, INDEVAL implemented the
International Securities Identification Number
CISIN) code.31
Some market participants are concerned
about the funds-netting component of SIDV's
DVP system, especially if participants are
allowed in the future to sell securities short or
act as market makers. They fear that the risk of
open positions taken by participants may affect
end-of-day settlement. In a netting system, the
default of one participant may affect others,
even if they did not deal directly with the
defaulting participant. However, other participants argue that, by allowing participants to
make the market or sell short, the liquidity of
these markets should improve. Greater liquidity
in the market should enable participants to have
greater ease in buying and selling securities,
thereby reducing the settlement risk associated
with open positions in general.

The recommendations made by the Group of Thirty (1989) are:

Recommendation 1: Trade Comparison
By 1990, all comparisons of trades between direct market participants (that is,
brokers, broker/dealers, and other exchange members) should be accomplished
by T + 1.

Recommendation 2: Trade Affirmation
Indirect market participants (such as institutional investors, or any trading counterparties which are not broker/dealers) should, by 1992, be members of a trade
comparison system which achieves positive affirmation of trade details.

Recommendation 3: Central Securities Depository
Each country should have an effective and fully developed central securities
depository, organized and managed to encourage the broadest possible industry
participation (directly and indirectly), in place by 1992.

Recommendation 4: Trade Netting System
Each country should study its market volumes and participation to determine
whether a trade netting system would be beneficial in terms of reducing risk and
promoting efficiency. If a netting system would be appropriate, it should be implemented by 1992.

Recommendation 5: Delivery Versus Payment
Delivery versus payment (DVP) should be employed as the method for settling all
securities transactions. A DVP system should be in place by 1992.

Recommendation 6: Same Day Funds
Payments associated with the settlement of securities transactions and the
servicing of securities portfolios should be made consistent across all instruments and markets by adopting the "same day" funds convention.

Recommendation 7: T + 3 Settlement
A "Rolling Settlement" system should be adopted by all markets. Final settlement
should occur on T + 3 by 1992. As an interim target, final settlement should
occur on T + 5 by 1990 at the latest, except where it hinders the achievement
o f T + 3 by 1992.

Recommendation 8: Securities Lending
Securities lending and borrowing should be encouraged as a method of expediting the settlement of securities transactions. Existing regulatory and taxation
barriers that inhibit the practice of lending securities should be removed by 1990.

Remaining challenges

Recommendation 9: Common Message Standard
Each country should adopt the standard for securities messages developed
by the International Organisation for Standardisation [ISO Standard 7775].
In particular, countries should adopt the ISIN [International Securities Identification Number] numbering system for securities issues as defined in the ISO
Standard 6166, at least for cross-border transactions. These standards should
be universally applied by 1992.

As part of its payments system reforms,
the Bank of Mexico attempted to implement a
market-based allocation of intraday credit. By
eliminating unsecured daylight overdrafts on
SIAC and simultaneously developing SPEUA,
the Bank of Mexico attempted to shift most of
the credit risk associated with the extension of
intraday credit from itself to payments system
participants. Furthermore, by implementing
explicit loss-sharing rules for SPEUA settlement
failures, the Bank of Mexico attempted to
increase market discipline by imposing losses
on creditors.
However, concerned about maintaining
adequate liquidity to avoid payment gridlock
and keeping the cost to participants relatively
low, the Bank of Mexico has implemented policies that may have the unintended effect of distorting the market-based allocation of intraday
credit. For example, the Bank of Mexico's
restriction on participants' decreasing their
credit lines during the day may also increase the
availability of interbank funds to troubled participants, which, in turn, could increase the risk

FEDERAL RESERVE BANK OF DALLAS

of financial loss from a settlement default. In
addition, the previously mentioned practice of
granting immediacy of payment for SIAC transactions used to meet end-of-day settlement
may distort the credit assessments made among
interbank participants.
Banks evaluate their daily credit line
extensions knowing that the Bank of Mexico
will make payment at the end of the day. As
long as the Bank of Mexico allows nonrejectable payments to exist on SIAC, marketbased risk assessments may be distorted by the
guaranteed end-of-day extension of liquidity
by the central bank. Although the SPEUA losssharing rules can allocate losses to SPEUA
creditors, even if the defaulting bank is not

FINANCIAL INDUSTRY STUDIESSEPTEMBER1998

The Group of Thirty, established in
1978, is a private-sector nonprofit
organization concerned with the working of international financial markets.
In 1989, the Group of Thirty published
its recommendations to reduce risk
and improve efficiency of securities
markets around the world.
S. D. INDEVAL (1995).

declared failed, other considerations might
make the Bank of Mexico reluctant to impose
these loss-sharing rules as a first step. To the
extent that banks feel that the Bank of Mexico
will deal with insolvent banks without creditors
absorbing losses, its efforts to induce participants to monitor risk and allocate their exposures based on the establishment of interbank
SPEUA credit lines with loss-sharing provisions
will not impose the degree of market discipline
that would exist if market participants anticipated the potential for interbank losses.
In this regard, the Bank of Mexico has
revised its policies governing the liquidation
of failed banks, with the purpose of promoting market discipline. In 1995, the Bank of
Mexico established — through an amendment
to Fondo Bancario de Proteccion al Ahorro
(FOBAPROA) 32 —explicit rules identifying categories of bank liabilities that it will not guarantee. The 1995 FOBAPROA amendment states
that

ing. In addition, with the implementation of
DVP for all securities transactions and 100
percent collateral requirements for the funds
component of securities transactions, credit
risk in securities transactions has been significantly reduced. However, to maintain adequate
liquidity at a relatively low cost for participants,
the Bank of Mexico established the large-value
interbank funds payments system, SPEUA, and
the securities clearing and settlement system,
SIDV. Participants do not use good funds to
settle each SPEUA or SIDV transaction but must
settle their net positions at the end of the day.
In addition, the Bank of Mexico extends unsecured credit to allow banks lacking reserves
to settle over SIAC their end-of-day clearing
balances from the other systems, although the
Bank of Mexico strongly discourages banks
from relying on such credit.
Payments system reforms are still being
implemented, and further changes may be
necessary for the Bank of Mexico to meet its
stated objectives. Market participants seem generally pleased with the payments system
reforms implemented to date. However, the
Bank of Mexico may find that some of the
policies designed to increase liquidity in the
payments system, such as the inability of SPEUA
participants to decrease their credit lines during
the day and the guarantee of payment for nonrejectable SIAC payments, unintentionally work
against the goal of promoting market-based
intraday credit decisions. The need for some of
these policies in Mexico may diminish over time
with renewed strength in the banking system
and a continued deepening of financial markets.

FOBAPROA shall guarantee all liabilities
contracted by participating financial institutions, as long as said liabilities stem
from their normal business operations,
excluding:
1) subordinated debentures they might
issue,
2) liabilities resulting from illicit or
anomalous acts or acts of bad faith,
and
3) liabilities stemming from credit contracted between banks in order to
guarantee liabilities payable in favor
of the Bank of Mexico, provided the
said banks participate in the fund
transfer systems administered by the
central bank.33

Finally, the SPEUA loss-sharing rules designed to help promote market discipline in the
payments system will not be fully effective if
participants feel that the Bank of Mexico will
resolve insolvent banks without imposing
losses. However, this struggle to offset the possibility that government guarantees may weaken
market discipline in the payments system is not
unique to Mexico; it is, in fact, common to
developing countries in general and even to
developed countries. As with the other major
financial reforms initiated since the late 1980s,
Mexico's recent efforts to enhance the role of
market-based decisions in the payments system
represent a significant step in the right direction.

Exception three of this amendment specifically
addresses SPEUA credit lines. However, this
amendment applies only when the bank is in
the process of being liquidated. To date, none
of these exclusions has been imposed.

Conclusion

FOBAPROA is the Mexican deposit
insurance fund.

Bank of Mexico (1996).

The 1994 large-value payments system
reforms implemented by the Bank of Mexico,
including the introduction of parallel intraday
large-value payments systems for funds and
securities, have reduced payments system risk
while keeping transaction costs relatively low.
By eliminating free and unsecured daylight
overdrafts, the Bank of Mexico has reduced its
credit risk associated with direct intraday lend-

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