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Workina Paper 9017 F A INSIDER'S VIEW O THE POLITICAL ECONOMY N O THE TOO BIG T FAIL DOCTRINE F O by Walker F. Todd and James B. Thomson Walker F. Todd i s a s s i s t a n t general counsel and research o f f i c e r a t the Federal Reserve Bank o f Cleveland and an adjunct instructor in the Cleveland-Marshall College o f Law, Cleveland S t a t e University. James B. Thomson i s an a s s i s t a n t v i c e president and economist a t the Federal Reserve Bank o f Cleveland and an adjunct i n s t r u c t o r i n the Department o f Economics, Cleveland S t a t e U n i v e r s i t y . W express our g r a t i t u d e t o Laura Davis f o r seemingly e endless r e t y p i n g and copying o f the manuscript and t o Stephen V . 0 . Clarke, Donald Hester, Tess Ferg, and an unnamed r e f e r e e f o r h e l p f u l suggestions on the manuscript i n various stages. Working papers o f the Federal Reserve Bank o f Cleveland a r e p r e l iminary m a t e r i a l s c i r c u l a t e d t o s t i m u l a t e discussion and c r i t i c a l comment. The views s t a t e d h e r e i n a r e those o f the authors and not necessari l y those o f the Federal Reserve Bank o f Cleveland o r the Board o f Governors o f the Federal Reserve System. Decembe r 1990 www.clevelandfed.org/research/workpaper/index.cfm CONTENTS Abs t rac t Prefatory Ouotat ions Origins of the Modern Too Big t o F a i l Doctrine W y the Too Big t o F a i l Doctrine Matters h Systemic Risk and Contagious Bank Runs Correspondent Banking and lnterbank Exposure lnterbank Exposure and Federal Deposit Insurance The H i s t o r i c a l Relationship Between Rising lnterbank Exposure and F i nanc i a l Distress A Measure o f lnterbank Exposure Conclusions and Policy Recommendations Foot no t es Appendix A References Tab l es Figures www.clevelandfed.org/research/workpaper/index.cfm ABSTRACT Understanding interbank exposure i s the key t o understanding the too b i g to fail doctrine. In p r i n c i p a l hypotheses: this paper, we present arguments supporting three h i g h l e v e l s o f interbank exposure reduce t h e s a f e t y and soundness o f the banking system; interbank exposure a f f e c t s t h e abi l i t y o f the Federal Deposit Insurance Corporation (FDIC) and bank r e g u l a t o r s t o use market d i s c i p l i n e as a c o n s t r a i n t interbank system. exposure is on banks' indicative of risk-taking; reduced and a stability rising of the level of financial I n a d d i t i o n , we p r o v i d e evidence t h a t interbank exposure does n o t , a t t h i s time, appear t o be a g e n e r a l i z e d problem f o r U.S. banks; however, some banks i n a l I c a t e g o r i e s o f asset s i z e s t i I l have comparatively h i g h r a t i o s o f interbank exposure t o c a p i t a l , d e s p i t e a general d e c l i n e i n these r a t i o s s i n c e the C o n t i n e n t a l I l l i n o i s f a i l u r e (1984). The FDIC alone i s not t o be c r e d i t e d o r blamed f o r the e v o l u t i o n o f the too b i g t o f a i l d o c t r i n e out o f the FDIC's " e s s e n t i a l i t y " "a bank t h a t cost." foreign The Federal Reserve, the Comptroller o f the Currency, large U.S. the and banks, and p o l i t i c i a n s a l s o deserve a share o f the c r e d i t o r blame. the Currency Todd Conover nation that i s , i s e s s e n t i a l c o u l d not be allowed t o f a i l no matter what D u r i n g Congressional testimony on the Continental f a i l u r e , of doctrine: were immune from "hinted failure." that former Comptroller the eleven l a r g e s t banks i n the One o f the principal justifications o f f e r e d by FDIC o f f i c i a l s f o r the Continental b a i l o u t was the a l l e g e d interbank exposure o f 2,300 o t h e r banks t h a t would have l o s t more than the insured amount o f t h e i r d e p o s i t s i f C o n t i n e n t a l had been closed w i t h o u t a f u l l www.clevelandfed.org/research/workpaper/index.cfm guarantee of repayment t o uninsured claimants. That, in brief, i s how the federal bank'supervisory a u t h o r i t i e s came t o f i n d themselves embroiled i n the "disparate treatment/too b i g t o f a i l " controversy that s t i l l i s unresolved. lnterbank exposure may arise from normal, correspondent banking a c t i v i t i e s that are not may become so i f not closely monitored. overnight or undertaken, term including institutions, repos), and indirect interbank sales purchases of of inherently dangerous but that The primary focus o f t h i s paper i s that is federal acceptances of directly funds, s e c u r i t i e s under purchases o f interbank exposure effic'iency-promoting loans agreements other and to to banks. deliberately depository resell Various exposure c e r t a i n l y are worth studying, but (reverse forms of information regarding such exposure i s d i f f i c u l t to capture from c a l l report data; thus, indirect interbank exposure i s mentioned only occasionally i n t h i s paper. However, a l l forms o f interbank exposure l i e a t the heart o f the too b i g t o f a i l doctrine. to force its lnterbank exposure acts as a constraint on the FDIC's a b i l i t y fellow regulators to close insolvent banks, which provides disconcerting guideposts as t o probable future experience w i t h cross-guarantee proposals that Market-oriented banks, strictly limits applied would corrective enforced toward to measures, p r i v a t e deposit such minimum c a p i t a l t o banks as well holdings of c a p i t a l long way be analogous as as market-value standards, nonbanks, insurance schemes. per accounting customer and n e t t i n g out for lending interbank instruments i n c a l c u l a t i n g c a p i t a l adequacy would go a reducing and c o n t r o l l i n g purported systemic failure a r i s i n g from interbank exposure. www.clevelandfed.org/research/workpaper/index.cfm risk P r e f a t o r y Quotations W e are l i v i n g amid the vestiges of old controversies, and we speak t h e i r language, though we a r e dealing w i t h d i f f e r e n t thoughts and different facts. -- Walter Bagehot, Lombard Street , p. 161 (1873). History i s a good inattentive pupils. -- teacher but there are George S t i g l e r , quoted i n Harold Lever and Christopher Huhne, Debt and Danaer, p. 31 (1986). [Former FDlC Chairman W i l l i a m M. Isaac] has doubts about the [Con t i nen t a l I rescue. I' I wonder i f we might not be b e t t e r o f f today i f we had decided t o l e t Continental f a i l , because many o f the large banks that I was concerned might f a i l have f a i l e d anyway," he s a i d . "And they probably are c o s t i n g the FDlC more money by being allowed t o continue several more years than they would have had they f a i led i n 1984." -- W i l l i a m Isaac, quoted i n Robert Trigaux, "Isaac Reassesses Continental B a i l o u t , " American Banker, p. 6 ( J u l y 31, 1989). www.clevelandfed.org/research/workpaper/index.cfm I . Oriains o f the Modern Too Bia t o F a i l Doctrine Former FDlC D i r e c t o r l r v i n e Sprague describes the o r i g i n s o f the too b i g t o f a i l d o c t r i n e i n banking as follows. FDlC press release The t e x t r e f e r s t o a May 17, 1984, l l l i n o i s National Bank and Trust regarding Continental Company o f Ch i cago ("Con t i nent a I" : The third paragraph caused more hassling among the regulators themselves and w i t h the banks than a l l the rest o f the press release put together. And well i t should have. I t was the essence o f the rescue. This paragraph granted 100 percent insurance t o a l l depositors, the uninsured, and a l l general c r e d i t o r s . I n view o f a l l Continental the circumstances surrounding Illinois assurance t h a t , I t read as follows: Bank, the FDIC provides i n any arrangements that may be necessary t o achieve a permanent s o l u t i o n , all depositors the and other general creditors of bank w i l l be f u l l y protected and service t o the bank's customers w i l l not be interrupted. www.clevelandfed.org/research/workpaper/index.cfm including I t s purpose, q u i t e b l u n t l y , was t o stop the run and prevent stability. recurrence. W e had to have The guarantee was extraordinary but not unprecedented. W had given s i m i l a r p u b l i c e assurances t o buy time for a permanent s o l u t i o n f o r Greenwich Savings Bank i n New York C i t y i n 1981 and Nashv i l l e , also for the United Tennessee, granted releases. 100 Only Southern i n 1983. percent the Bank in These two were insurance Continental by press guarantee, however, touched o f f a nationwide debate that t o this day continues generate controversy. to raise questions and (Sprague [19861, p. 162). Sprague added t h a t , under former 12 U.S.C. Section 1823(c)(2), the FDlC was authorized t o provide open-bank assistance to any f a i l i n g insured bank i f i t s continued operations were service i n i t s community." deemed "essential to provide adequate banking More I iberal a u t h o r i t y for the FDlC t o provide open-bank assistance was not enacted u n t i l the Competitive Equality Banking Act o f 1987. The f i r s t use o f the FDIC's " e s s e n t i a l i t y " doctrine occurred i n 1971, t o b a i l out Unity Bank, an $11.4 m i l l i o n , minority-owned bank i n Boston (Sprague [19861, pp. 36-44). The size o f banks rescued under the e s s e n t i a l i t y doctrine increased through the $8 b i l l ion F i r s t Pennsylvania case i n 1980 (Sprague [19861, pp. 86-92) and eventually the $41 b i l l i o n Continental case. Sprague notes that the FDIC's May 1984 assistance package for Continental was based on www.clevelandfed.org/research/workpaper/index.cfm the e s s e n t i a l i t y t e s t , "so presumably a bank that i s essential could not be (Sprague [19861, p. 162). allowed t o f a i l no matter what the cost." Later, during Congressional testimony on the Continental f a i lure, former Comptrol l e r o f the Currency Todd Conover "hinted that the eleven largest banks i n the nation were immune from f a i l u r e . " i s how the federal bank (Sprague [19861, p. 259). supervisory authorities came to That, i n b r i e f , find themselves embroi led i n the "disparate treatmentltoo b i g t o f a i I" controversy that s t i l l i s unresolved. I n t e r e s t i n g l y , t h i s modern evolution o f the FDIC's e s s e n t i a l i t y doctrine created a situation i n which the FDIC's statutory mandate was squarely contradicted: The pendulum has swung once again toward 100 percent p r o t e c t i o n o f depositors and c r e d i t o r s . Despite the fact that Congress made i t clear i n the 1950 Act that the FDlC was not created to insure a l l deposits since Congress insured amount regulators i n a l l banks, has gradually t o $100,000. i n the years increased the In addition, the have devised solutions that protect even the uninsured i n the preponderance o f cases. (Sprague [19861, p. 32; see also, C a l i g u i r e and ) Thomson [ 1987I and Penn ing [ 1968I . The FDlC alone i s not t o be credited or blamed f o r t h i s evolution of the too b i g to fail doctrine. During the F i r s t Pennsylvania rescue (1980), Sprague reports that "there was strong pressure from the beginning not t o l e t the bank f a i l ... [from] the other large banks, .. . the comptroller, www.clevelandfed.org/research/workpaper/index.cfm ... [and] frequently from the Fed." (Sprague 119861, p. 88). particularly regard telling in to how the The following passage i s "domino theory of banking" (precursor of too b i g t o f a i I ) f i r s t appeared i n policy-making c i r c l e s : I r e c a l l a t one session [ i n 1980, regarding F i r s t Pennsylvania], Fred Schultz, the Fed deputy chairman, argued i n an ever -- there were no a l t e r n a t i v e s bank. r i s i n g voice, that we had t o save the He said, "Quit wasting time t a l k i n g about anything else!" Paul Homan o f the Comptroller's o f f i c e was equally intense as he argued for any solution but a f a i lure. dominated the discussion went down, The -- domino theory i f F i r s t Pennsylvania i t s business connections w i t h other banks would entangle them also and touch o f f a crisis i n confidence that would snowball I t would other bank f a i l u r e s here and abroad. culminate The i n an international [domino] theory had (Sprague [ 19861, pp . 88-89 Foreign mid-1980s, observers (British, i n the aftermath of in financial never into been crisis. tested. . this case) the Continental clearly rescue, assumed, "that Reserve w i l l not allow one of the lynchpin banks t o f a i l . " , p. 22). Thus, the Federal Reserve's ever-looser by the the Federal (Lever and Huhne lender o f resort p o l i c i e s since the Franklin National Bank f a i l u r e (1974) last reasonably might be viewed as one of the p r i n c i p a l factors i n creating the too b i g to f a i l d o c t r i n e (Todd 11988aI; Schwartz [19871; Spero ). www.clevelandfed.org/research/workpaper/index.cfm Some o f those o r i g i n a l l y involved i n the creation o f t h i s doctrine have come t o repent i t , but too l a t e t o do the taxpayer much good. P o l i t i c s , not pure economics, i s now c l e a r l y the d r i v i n g factor i n preserving the doctrine, which i s generally acknowledged t o stand i n the way of both the expansion o f banks' powers and the reduction o f taxpayers1 costs. Former FDlC Chairman William lsaac has been quoted as saying that the regulators and p o l i t i c i a n s probably made a c o s t l y mistake i n t r y i n g t o save Continental, but lsaac also admits t h a t , i f he were Chairman now, he would be t r y i n g t o save everybody for p o l i t i c a l reasons, regardless o f cost, j u s t l i k e current FDlC Chairman William Seidman (Trigaux [19891). 11. W v the Too Bia t o F a i l Doctrine Matters h Imprecisely defined terms and p o l i c y conceptions that are not rooted i n practical reality regardless of economists' often determine the c l a r i t y (or official decisions lack thereof) of discussions o f banking theory. regarding the terms normally used i n Among our f a v o r i t e examples o f such vague or unnatural terms and conceptions are "lender o f "solvency," banking, l a s t resort," " l i q u i d i t y , " and the l i k e , a t least as those terms c u r r e n t l y are used i n the pol icy debate (Thomson 119901; Todd 11988al). C l a r i t y o f terms and p r e c i s i o n o f h i s t o r i c a l conceptions do matter, as does the legitimacy o f the l i n e o f descent o f the p o l i c y i n question. Otherwise, p o l i c y discussions regarding banking tend t o d e t e r i o r a t e i n t o the s i t u a t i o n described by Joseph Schumpeter (1950, p. 340), as f o l lows: www.clevelandfed.org/research/workpaper/index.cfm [Ilndividuals, as well know if where, as groups' o f t e n do not anywhere, they belong and, - sometimes from ignorance, a t other times from a correct perception of advantage, contradictory p r i n c i p l e s their All own. accounts for this the they mix up i n t o mongrel creeds o f confuses wide observers variety of and current interpretations. Reversing what some might consider normal procedure, w explain why the p o l i c y e discussion o f the too b i g t o f a i 1 doctrine matters a t both macroeconomic and rnicroeconomic levels, and then w define a few key terms. e The conception of interbank exposure encountered most frequently i n p o l i c y discussions i s the reduction o f private-sector payments networks. risk i n Federal Reserve-operated and some This r i s k arises from intraday or daylight overdrafts due to the posting o f debit and c r e d i t e n t r i e s for transfers o f funds and s e c u r i t i e s over those networks. transfers activities. over arises from government By far securities The volumes o f these transfers and the greater part of such foreign i n recent years, Fedwire (1989) and $32 t r i l l i o n over CHIPS (19881, relevant measures o f real economic a c t i v i t y exchange ($5.2 trading $183 t r i l l i o n have dwarfed the t r i l l i o n of U.S. gross n a t i o n a l product [I9891 and $2.7 t r i l l i o n o f gross world trade [I9881 for a l l countries). A variety of implemented i n recent years, credit risk-reduction measures have been proposed and including i n s t i t u t i o n - s p e c i f i c net debit and net l i m i t a t i o n s , or caps per sender, and the planned imposition o f a 25 www.clevelandfed.org/research/workpaper/index.cfm basis points per annum .fee f o r intraday overdrafts on Fedwire i n excess of 10 percent o f each sending payments network institution's transfers i n s t i t u t i o n s that are risk-adjusted initiated by or capital. Because most paid money to are c l e a r i n g or s e t t l i n g s e c u r i t i e s or center foreign exchange trades (Federal Reserve Bank o f New York 11987-8811, the 15 o r so largest U.S. banks probably w i l l account overdraft fees. has become 1970s. for nearly 90 percent o f the planned intraday However, t r a d i n g (and the magnitude o f intraday overdrafts) large enough t o create Federal Reserve concern only since the The f a i l u r e of Bankhaus I .G. Herstatt during the U.S. banking day i n 1974 also increased regulatory concern regarding intraday interbank exposure (Spero , pp. 108-114). Since intraday interbank exposure became a s i g n i f i c a n t Federal Reserve concern during the e a r l y 1980s, i t has become one o f the d r i v i n g factors behind the too b i g t o f a i l d o c t r i n e and has begun t o be addressed by s p e c i f i c p o l i c y i n i t i a t i v e s (Stevens ; Aspinwall and Scott [I9891 ; Spero [19801, pp. 108-114). Interbank exposure also may arise from normal, efficiency-promoting correspondent banking a c t i v i t i e s that are not inherently dangerous but that may become so if not c l o s e l y monitored. Clearing or other correspondent balances maintained by smal l e r banks a t large regional or money center banks, o r even by larger banks that are not members of the same clearinghouse, may g i v e r i s e t o unexpected c r e d i t r i s k exposure against the respondents. Thus, checks drawn on a large regional bank, accepted for deposit a t a small bank i n the same region, might c o n s t i t u t e a s i g n i f i c a n t r i s k with respect t o the c a p i t a l of the small bank i f the large respondent f a i l e d and were closed while i n possession o f the small bank's checks, before the f a i l e d respondent made f i n a l settlement for those checks. factor Such concerns were said t o have been a i n the FDIC's and Federal Reserve's decision t o rescue or b a i l out www.clevelandfed.org/research/workpaper/index.cfm Continental i n 1984. Reconstruction Finance correspondent bank count ry banks pp. Then, as during Continental's p r i o r rescue by the o l d ... 250-251). -- Corporation course, . 1933, -- a banker's bank kept accounts Of in i n which a large proportion of the Continen-tal was "a great (Jones [ 19511, pp . 47-49 ; Sp rague [ 19861, " correspondent banking runs downh i l l risk also: C i n c i n n a t i ' s commercial banks refused t o accept for deposit checks drawn on closed p r i v a t e l y insured t h r i f t i n s t i t u t i o n s during the March 1985 c r i s i s i n Ohio because recovery o f the f u l l value o f those checks was uncertain u n t i l the t h r i f t c r i s i s a c t u a l l y began to be resolved, about one week a f t e r (See Wolfson systemwide closing began. [19861, pp. 117-121; the Kane ; Federal Reserve Bank o f Cleveland Annual R e ~ o r t ,1985.) Neither intraday interbank exposure nor correspondent banking r i s k i s the p r i n c i p a l focus o f t h i s paper. The primary focus i s , term is interbank exposure that including sales of federal funds, directly and instead, overnight or deliberately undertaken, loans to depository i n s t i t u t i o n s , purchases of s e c u r i t i e s under agreements to r e s e l l (reverse repos), and purchases of acceptances o f other banks. I n addition, various forms of i n d i r e c t interbank exposure c e r t a i n l y are worth studying, but information regarding such exposure is difficult to capture thus, indirect interbank exposure i s mentioned only occasionally i n t h i s paper. Indirect interbank exposure purchased includes from c a l l loan report participations data; (often including shared national c r e d i t s ) , c r e d i t s extended against third-party guarantees (including bank-issued guarantees counterparties on or letters foreign agreements, interest-rate exposure also can of exchange swaps, credit), contracts, forward-rate arise and with risk foreign agreements, respect against bank exchange swap etc. Interbank to i n t raday www.clevelandfed.org/research/workpaper/index.cfm overdrafts or correspondent banking a c t i v i t i e s for the accounts o f banks, both i n the United States and abroad, because o f cross-border foreign transfer risk.. A l I these forms o f interbank exposure l i e a t the heart o f the too b i g to f a i l doctrine. banks are not Fears o f really r e t a i l depositors' the d r i v i n g factor protect the largest banks from f a i l u r e . "cash-over-the-counter" i n the runs on regulatorst decisions to 'That i s because i t takes a very long time to count and disburse large amounts o f cash. I n Ohio i n March 1985, i t was unusual for any one banking o f f i c e t o be a b l e t o pay out more than $1 m i l l ion to $2 m i l l ion o f cash to r e t a i l depositors i n a s i n g l e day. A t that rate, the $43 i t would take up t o 43,000 banking-office days t o pay o f f b i l l i o n o f domestic deposits o f Citibank (1989) i n cash t o r e t a i l customers. The real danger electronic that concerns runs on banks. When federal funds regulators is leave a bank a t $100,000 t o $5 m i l l i o n per e l e c t r o n i c t r a n s f e r , institutional the rate o f or from i t then becomes possible t o empty even a large bank l ike C i t ibank (which had about $115 b i l l ion of t o t a l deposits a t year-end 1989) i n only a day or two. Only banks normally have d i r e c t , on-line access t o e l e c t r o n i c transfers o f funds over Fedwire. a further incentive Banks that are not members o f the same clearinghouse have to remove funds e l e c t r o n i c a l l y at the trouble because Fedwire transfers are f i n a l when received, house settlements can be reversed. first sign o f while clearing- Thus, i n the l a s t 15 years or so, federal regulators r a t i o n a l l y have worried more about e l e c t r o n i c runs, almost always by other large banks (usually foreign banks, a t t h a t ) , that could empty b i g www.clevelandfed.org/research/workpaper/index.cfm banks i n a s i n g l e day. Regulators r a t i o n a l l y worry less about long lines of nervous r e t a i l claimants waiting for t h e i r money, as i n Ohio and Maryland i n 1985, but long l ines o f customers attempting withdrawals ( v i s i b l e runs) s t i l l worry bankers and p o l i t i c i a n s enough t o cause them t o pester regulators, nevertheless. Because Continental was the turning point a t which interbank exposure and the too b i g t o f a i l doctrine were linked so as t o become one and the same i n the minds of bank regulators, i t i s appropriate t o close t h i s section of the paper w i t h the following passage, again from Sprague's Bailout (1986, p. 248): ... Martin Mayer argued i n a Financier a r t i c l e i n l a t e 1985 that the FDI Act "almost c e r t a i n l y does not Continental. permit He what simply FDIC the did not attorney general's opinion that was l e g a l l y structured. did" at accept the the transaction Mayer observed c o r r e c t l y that the real d i f f i c u l t y was that foreign holders of debt s e c u r i t i e s and commercial paper holding company wou I d have yanked b i l l i o n i n Eurodeposits out of i n the thei r $17 the bank i f the s e c u r i t i e s holdings were not f u l l y protected i n the bailout. If the holding company was not saved, the bank cou Id not be rescued. www.clevelandfed.org/research/workpaper/index.cfm Thus, discussions discussions o f of interbank exposure rationally also must include interbank holdings o f bank holding company commercial paper, depos i t notes, and the l ike . Ill. Systemic Risk and Contagious Bank Runs The r i s k o f contagious bank runs o f t e n i s discussed as a p u b l i c p o l i c y concern and as a j u s t i f i c a t i o n for the too b i g t o fail doctrine. Most discussions apparently define t h i s r i s k as the s e n s i t i v i t y o f one bank t o the f a i l u r e o f another bank. Although that s e n s i t i v i t y may be i n d i r e c t ( i . e . , nervous depositors, noting the f a i l u r e o f one bank, run on another bank, even though the second bank s t i l l i s solvent), the p r i n c i p a l concern o f t h i s paper i s direct sensitivity (i.e., them from another bank). l i m i t e d number o f banks, one bank, fearing the loss o f i t s funds, removes The f a i l u r e or suspension o f one bank, or o f a arguably was an event that could have caused or contributed t o m u l t i p l e f a i l u r e s or suspensions i n the banking system i n the pre-1933 era. S i g n i f i c a n t contagion e f f e c t s o f that type would have p u b l i c p o l i c y implications today both for solvency o f federal deposit the way banks are regulated and f o r the insurance funds. Some federal regulators and academ i cs a l so ca l l t h i s phenomenon "sys tem i c r i sku (Cor r i gan [ 19901) . W believe t h a t , e for reasons explained below, the type o f i n d i r e c t and i r r a t i o n a l systemic r i s k u s u a l l y discussed by bank regulators today t o j u s t i f y increased regulatory d i s c r e t i o n i n applying the too b i g t o f a i l d o c t r i n e never actually existed i n the United States, Contraction o f 1929-1933. Instead, except possibly during the Great the type o f contagion or systemic r i s k that a c t u a l l y has existed and s t i l l e x i s t s i s both d i r e c t and r a t i o n a l . www.clevelandfed.org/research/workpaper/index.cfm That i s , banks providing funds t o a bank i n trouble r a t i o n a l l y might conclude that they were u n l i k e l y t o recover those monies and therefore might attempt to remove great quan t i t i es of those funds e l e c t ron i ca l l y (Thomson [ 19901; Kaufman ). I n t h i s paper, w use the term "interbank exposure" to refer to such e recognizing a l l the whi l e that d i r e c t , r a t i o n a l contagion or systemic r i s k , l i banks can f a i l for a v a r i e t y of reasons that do not necessarily have anything to do w i t h interbank exposure. Rather, our point here i s that i t i s interbank exposure that has become the p r i n c i p a l r a t i o n a l e for the too b i g to f a i l doctrine, while w believe that interbank exposure could and should be reduced e or controlled sufficient i n such a way justification that for i t no the longer could be construed as a doctrine. Market-oriented corrective measures, such as market-value accounting for banks, s t r i c t l y enforced minimum c a p i t a l standards, per customer nonbanks, and calculating netting capital lending l i m i t s applied to banks as well as out interbank adequacy would holdings go a long of capital way instruments toward reducing c o n t r o l l i n g alleged systemic f a i l u r e r i s k a r i s i n g from interbank exposure. the too b i g t o f a i l doctrine i s t o continue to be the guiding in and If l i g h t of regulators, then l e t i t f i n d something besides interbank exposure as i t s main reason for being. Interbank exposure o r d i n a r i l y i s thought t o r i s e to the' level of contagion r i s k because the f a i l u r e of one bank may be translated i n t o losses a t other banks whose asset p o r t f o l i o s include claims against the f a i l i n g i n s t i t u t i o n . These losses could be large enough t o exhaust the claimant bank's c a p i t a l , causing i t to f a i l . I t i s not d i f f i c u l t to imagine a s i t u a t i o n i n which the f a i l u r e o f one medium-to-large bank could r e s u l t i n a chain o f bank f a i l u r e s . The FDIC used t h i s very argument, after al I, to j u s t i f y the Continental b a i l o u t i n 1984. www.clevelandfed.org/research/workpaper/index.cfm * * * 'The remainder of t h i s paper . i s organized as follows. Section I V presents a b r i e f explanation as to why interbank claims e x i s t i n our banking system. W argue t h a t , up t o a given level o f exposure, e the e f f i c i e n c i e s gained by correspondent banking relationships usually outweigh the associated r i s k s . properly managed, the interbank exposures that a r i s e out o f If correspondent banking relationships do not represent a serious source of contagion i n the banking system. I n section V , w e look a t the implications o f interbank exposure for the continued solvency o f the FDIC's fund as a constraint on the FDIC's a b i l i t y t o close insolvent banks and as a guide t o probable future experience w i t h cross-guarantee provisions that would be analogous t o p r i v a t e deposit insurance schemes. Section V I presents the h i s t o r i c a l between r i s i n g interbank exposure and f i n a n c i a l c r i s e s . relationship Section V I I gives a rough p i c t u r e o f the d i r e c t i o n o f aggregate interbank exposure for U.S. banks since the f a i l u r e of Continental Illinois. W present our conclusions and e p o l i c y suggestions i n section V I I I . IV. Correspondent Banking and Interbank Exposure Interbank exposure i s defined q u a n t i t a t i v e l y , for the purposes of paper, as the assets one bank has a t r i s k w i t h respect t o another bank. this In t h i s study, the i nterbank-exposure i tems' include cash i tems i n the process of c o l l e c t i o n (CIPC), balances due from depository i n s t i t u t i o n s (BDDI), loans t o depos i t o r y i nst i t u t ions (LDI 1 , acceptances of other banks (AOB) , and federal funds sold and s e c u r i t i e s purchased w i t h agreements to resell (FFS). W e selected these items for our study because they are a v a i l a b l e from c a l l report data. Recent innovations i n banking may have created new categories of www.clevelandfed.org/research/workpaper/index.cfm interbank exposure innovations, that such as should be interest-rate included in future and currency studies, swaps, but are e i t h e r those poorly measured by pub1 i c l y avai l a b l e data ( e . a . , the data e x i s t only as measures o f u n d i f f e r e n t i a t e d aggregate exposure t o both banks and nonbanks) o r are not measured a t a l l . Tables f o l l o w i n g the paper present some o f the relevant data f o r correspondent balances and off-balance-sheet The first two interbank-exposure interbank exposures. items ClPC and BDDI, listed, which comprise v a r i a b l e cash and balances due, a r i s e out o f correspondent banking Indeed, i t i s l i k e l y that correspondent banking i s responsible relationships. for the l i o n ' s share o f the interbank exposure accounted f o r by ClPC and BDDl and a t least some o f the interbank exposure represented by LDI, AOB, and FFS. Correspondent banking evolved i n the e a r l i e s t stages o f the U.S. and U.K. banking .systems and inefficiency a unit important Canada. of in large, has the effect banking of arbitraging system.2' away- Correspondent nationwide branching systems (See Kryzanowsk i and Roberts [ 19891 . like much of the banking is less that of post-1920s I n a cor respondent bank i ng r e l a t i o n s h i p there are two types o f i n s t i t u t i o n s : correspondent banks (usually sma I I banks) and respondent banks (usua I I y allows a correspondent bank large banks). t o o b t a i n services, such as The r e l a t ionsh i p check clearing, secu r i t i es safekeeping , and computer services , from i t s respondent bank a t a lower cost than would be incurred i f i t performed those functions itself. Federal Reserve Banks compete w i t h large regional and money center banks f o r such correspondent provide its banking business. correspondent diversification through bank loan In addition, with a source participations. a of respondent bank can increased portfolio Correspondents often www.clevelandfed.org/research/workpaper/index.cfm place surplus funds w i t h respondents (or use respondents as intermediaries for the onward placement o f surplus repos. I n - r e t u r n for correspondent bank as a funds) v i a sales o f federal the services provided by the funds and reverse respondent bank, normally keeps noninterest-bearing balances a t form - o f implicit payment for the services the i t s respondent that it receives. Correspondent banks also keep cash balances a t respondent banks that provide their check-clearing respondent bank services as a reserve account against can debit (credit) checks drawn on ( t o ) which the (payable to) the correspondent bank. To the extent that interbank exposure arises from normal correspondent relationships, most economists assume that the b e n e f i t s associated w i t h the increased e f f i c i e n c y of the banking system outweigh the r i s k s associated w i t h interbank exposure. Indeed, if properly managed, much of the interbank-exposure r i s k faced by a correspondent bank can be d i v e r s i f i e d away by the establishment of m u l t i p l e correspondent banking relationships, although i n actual p r a c t i c e such d i v e r s i f i c a t i o n of more than one of the r i s k might prove i n s u f f i c i e n t i f respondents were members of D i v e r s i f i c a t i o n can l i m i t the same clearinghouse. the exposure of a correspondent respondent bank and can reduce the replacement costs o f bank t o any one establishing new correspondent banking relationships i f one of the respondent banks f a i l s . V. lnterbank Exposure and Federal Deposit Insurance lnterbank exposure can increase the r i s k exposure o f the FDIC i n a t least two ways. First, it reduces the independence of bank f a i l u r e s . That is, interbank exposure increases the probabi l i t y that the f a i l u r e of a bank A w i l l www.clevelandfed.org/research/workpaper/index.cfm be accompan i ed by the f a i l u r e o f banks B , C, and D. Second, i t reduces the a b i l i t y o f the FDlC t o close and dispose of insolvent banks i n a manner that does not protect shareholders claimants have greater $100,000 of perceived amounts a t federal deposit high levels and of uninsured creditors. Most interbank r i s k than those covered by the nominal insurance. interbank As i n the Continental exposure can create case (1984), pol i t i c a l and regulatory pressures that would force the FDlC t o adopt a pol icy of f u l l or partial forbearance stockholders, thereby toward a failing removing bank's depositors' uninsured discipline creditors as a and/or significant component of market d i s c i p l i n e on the bank's behavior (Thomson ). I f bank f a i l u r e s were t r u l y independent events, the r i s k exposure of the FDIC's insurance fund from any s i n g l e bank f a i l u r e would be the expected value of losses should the bank f a i l , m u l t i p l i e d by the p r o b a b i l i t y that the bank would f a i l . That i s , the FDIC's r i s k exposure t o the bank would be a function of the riskiness of the bank. However, i f contagion or systemic r i s k e f f e c t s (such as interbank exposure) caused bank f a i l u r e t o be a nonindependent event, then the r i s k exposure of the FDIC's insurance fund w i t h respect t o any s i n g l e bank would be a function of both the riskiness of the bank's assets and the degree of interbank sensitivity within the banking system. I n such a scenario, the cost t o the FDlC of bank A's f a i l u r e would have t o include any losses that i t would incur from banks that went under as a r e s u l t of bank A's f a i lure. 3/ I t i s clear that interbank exposure increases the r i s k t o the FDIC from a s i n g l e bank f a i l u r e . Because contagion e f f e c t s a r i s i n g from d i r e c t interbank exposure are one form of r i s k that the FDlC cannot d i v e r s i f y away i n i t s own p o r t f o l i o ( i t necessarily i s exposed t o r i s k s from the f a i l u r e of any insured bank), interbank exposure may increase the t o t a l r i s k exposure of the www.clevelandfed.org/research/workpaper/index.cfm FDIC t o the banking i n d u s t r y by c r e a t i n g a s i t u a t i o n i n which the troubles o f one bank necessari l y and d i r e c t l y a r e transmitted t o other banks.4' The second undesirable consequence o f d i r e c t effect on the FDIC's capacity t o dispose o f interbank exposure f a i led is its i n s t i t u t i o n s without extending forbearances t o uninsured c r e d i t o r s and stockholders. Kane (1989) presents a set o f four c o n s t r a i n t s that o f t e n prevent the FDlC from c l o s i n g an insolvent bank: explicit information constraints, s t a f f constraints, reserves constraints. in the FDIC's insurance fund, the i m p l i c i t and and p o l i t i c a l and legal I t i s c l e a r that an increase i n d i r e c t interbank exposure would increase the s e v e r i t y o f each o f these c o n s t r a i n t s . levels o f d i r e c t For example, w i t h h i g h interbank exposure, the i n f o r m a t i o n the FDlC would need t o c l o s e an insolvent i n s t i t u t i o n would have t o include the c o n d i t i o n o f the i n s t i t u t i o n and the impact o f i t s f a i l u r e on other banks. As the passages from Sprague (1986) i n the f i r s t sect ion o f t h i s paper i n d i c a t e , Continental (1984) was and probably s t i l l i s the leading example o f how interbank exposure a f f e c t e d the way a f a i l i n g bank was handled by the bank regulators. Financial I n testimony before the House Banking Committee's Subcommittee on Institutions, Supervision, Regulation, and Insurance, then FDlC Chairman W i l l iam lsaac s t a t e d that one f a c t o r t h a t prompted the b a i l o u t was the FDIC's concern over the impact C o n t i n e n t a l ' s f a i l u r e would have on small banks w i t h interbank exposure t o Regarding t h i s concern, it. that: Hundreds of small banks p a r t i c u l a r l y hard h i t . banks had nearly $6 would have Almost 2,300 billion at been small risk in www.clevelandfed.org/research/workpaper/index.cfm lsaac s t a t e s Continental; 66 of them had more than t h e i r capital on the l i n e and. another between 50 and 100 percent But was 113 had .s' Isaac's statement correct? Later analysis showed that i t was u n l i k e l y that more than a dozen or so banks ( a l l of them small) would have f a i l e d as a r e s u l t of allowing Continental t o f a i l . Banking, I n a report t o the House Finance and Urban A f f a i r s Subcommittee on Financial Supervision, Regulation, and Insurance, Congressional staff Institutions, found that, if Continental had been allowed t o f a i l without government assistance, and even if Continental's losses totaled 60 percent of payment t o uninsured claimants), assets (only a 40 percent then only 27 banks would have f a i l e d , and only 56 banks would have experienced losses between 50 and 100 percent of their capital. Using a more r e a l i s t i c (but s t i l l higher than apparently i s expected) loss r a t e of 30 percent of Continental's assets, the Congressional staff found that only s i x banks would have f a i l e d , experienced Nevertheless, from our losses between 50 and 100 percent and only 22 would have of their c a p i t a l .6' i t i s clear from the passages c i t e d from Sprague (as well as personal interbank-exposure memories) that the regulators' perception of r i s k reduced t h e i r capacity t o dispose of Continental i n a manner that would have protected only the 10 percent of a l l depositors who were insured. V I . The H i s t o r i c a l Relationshit) Between Risina Interbank Exposure and Financial Distress W are unaware of any study that indicates that r i s i n g interbank exposure e www.clevelandfed.org/research/workpaper/index.cfm causes f i n a n c i a l d i s t r e s s , which this might although Adam Smith describes some s i t u a t i o n s i n be so. However, the historical interbank exposure i s a leading indicator o f overlending perhaps "overtrading"). (what Not a l l Adam evidence suggests financial distress, Smith and Walter that a sign o f Bagehot called f i n a n c i a l panics necessarily have been preceded by r i s i n g levels o f d i r e c t interbank exposure, but several notable instances o f increased interbank exposure were followed by f i n a n c i a l panics. The l i v e l i e s t sources t o read on t h i s point include studies by Adam Smith (1976 ed.), Walter Bagehot (1873), Charles P. Kindleberger (1978), and, o f a l l people, Herbert Hoover (1952). Kindleberger, Stephen V.O. among other recent w r i t e r s , (asset) funding or Clarke (1983), and Joan Edelman Spero (1980), consistently have i d e n t i f i e d e i t h e r (liability) risk of direct, the c r e d i t international, interbank exposure ( o r both) as concerns for monetary and bank supervisory a u t h o r i t i e s . Clarke's study o f prescient the international regarding both interbank funds market. the interbank market efficiencies and (1983, pp. 43-48) myopic tendencies of was the He proposed the creation o f a r i s k - r e l a t e d p r i v a t e insurance pool, funded by banks, that would replace the i n i t i a l involvement o f central banks as difficulties. lenders o f last resort i n periods o f interbank payment Active involvement of the central banks would be reserved for t r u l y disastrous, not merely d i f f i c u l t or inconvenient, periods o f d i s t r e s s i n the interbank market. described direct transmission of Adam Smith, Hoover, Kindleberger, Spero, and Clarke a l l interbank financial exposure distress as a device from one bank for propagation t o another or f i n a n c i a l center t o another. www.clevelandfed.org/research/workpaper/index.cfm or from one Guttentag and Herring (1986) noted the myopic tendencies of international lenders regarding the sustainabi l i t y o f debt service capacities o f debtors as a exp l ana t ion poss i b l e of over lend i ng f requen t and econom ic subsequent defaults i n contexts analogous t o the developing-country debt problems o f the 1980s. Lever and Huhne (1986, pp. 31-55), among others, noted this same myopic Kaletsky (1985), and Todd (19891, and amnesiac quality regarding international lending, w i t h p a r t i c u l a r a t t e n t i o n t o d i r e c t interbank exposure during the 1920s i n Todd (1989). Chernow (1990, pp. 636-652) describes i n d e t a i l the i n t e r e s t i n g cases of Morgan Guaranty Trust Company, Bankers Trust Company, and Citibank, a l l o f New York, i n the r o l l i n g over and rescheduling of b i l l i o n s of d o l l a r s of c r e d i t s for B r a z i l (including interbank or "Project IV" c r e d i t s ) a f t e r 1982. Those r o l l o v e r s and reschedulings were intended to keep a l i v e the f i c t i o n s that U.S. banks could ignore lessons of the past, i n both Europe and L a t i n America (which the New York banks p a r t i c u l a r l y should have remembered), developing clouded ). and countries future that with repayment commercial unstable banks legal prospects and (Chernow could make "good political [19901, loans" environments pp. 636-639; to and Todd Wolfson (1986, pp. 102-105) analyzes the emergency measures taken regarding Mexican c r e d i t s i n August 1982; a smaller proportion o f those c r e d i t s were interbank claims than i n the case of B r a z i l . I n the pre-Wor Id War I I era, one of the r i s k i e r forms of d i r e c t interbank exposure identified i n the h i s t o r i c a l l i t e r a t u r e was accommodation paper. Accommodation b i l I s of exchange are refinancing d r a f t s drawn by one bank upon another t o enable the f i r s t bank to share the c r e d i t r i s k o f i t s customer (account p a r t y ) w i t h another bank (the drawee or accepting bank). I n the more arcane forms of accomnodation or refinancing d r a f t s , the drawing www.clevelandfed.org/research/workpaper/index.cfm bank's underlying customer (account p a r t y ) may also be a bank, so that long chains of accommodation or unusual refinancing paper can be established. t o - f i n d proposals i n the accommodation b i l l s w i t h a t least accountability bank exposures between the interbank.market three banks with the i n the United States ( t h e U.S. I t was not a t a l l i n the 1980s regarding linked i n a chain o f ultimate liability and legal asset accepting bank) and the o r i g i n a l underlying nonbank customer ( i f any) i n some foreign country (Todd [1988b]). Fortunately, such proposals s t i l l are the exceptions, not the r u l e , i n the U.S. b i l l s o f exchange (bankers' acceptances) market. While most i n t e r n a t i o n a l , interbank claims were concentrated i n London and offshore banking havens during the 1970s and e a r l y 1980s (Clarke ), U.S. banking o f f i c e s increased t h e i r d i r e c t , international interbank exposures for both assets and l i a b i l i t i e s i n recent years. Ieve I s for the 34 largest U .S. ho Iders o f However, mid-year correspondent 1989 exposure balances (demand deposits), f o r example, were $9.3 b i l l i o n , down about 12 percent from mid-year 1988 levels (American Banker ). types on U.S. International interbank claims o f a l l banks by u n a f f i l i a t e d foreign banks rose from $120 b i l l i o n a t year-end 1988 t o $135 b i l l i o n a t year-end 1989 (Federal Reserve B u l l e t i n , May 1990, table 3.17). From the perspective o f borrowers of interbank c r e d i t , the amounts involved can become q u i t e large: Interbank claims o f a l l types and o f a l l countries on B r a z i l just before the February 1987 one-year moratorium on Brazi 1's external debt were reported as approximately $35 b i l l i o n , then about one-third o f B r a z i l ' s t o t a l foreign debt and about 12 percent o f domestic product ( B a t i s t a 119881, pp. 39, 191). www.clevelandfed.org/research/workpaper/index.cfm i t s gross Adam Smith (1976 ed., Book l l , chapter 2, pp. 327-337) describes the operations o f chains o f accommodation paper i n the a f f a i r s o f 'Scottish banks, p a r t i c u l a r l y the Bank o f Ayr, which f a i l e d i n 1772 a f t e r two years o f such practices. Essentially, t o meet demands upon them that could not be met from Scott i sh e x i s t i ng resources, bankers. When the Scottish banks no longer could pay o r r o l l over maturing accommodation d r a f t s , banks drew a c c o m d a t ion the scheme became unraveled. drafts Smith says on that London Itthe operations o f t h i s bank [ A y r l increased the real d i s t r e s s i t meant t o relieveff and t h a t , even had i t succeeded, the operation "would only have transferred a great part o f [the c a p i t a l o f the country] from prudent and p r o f i t a b l e , to imprudent and u n p r o f i t a b l e undertakings." Kindleberger (1978, pp. 53-63) describes the evolution o f accomnodation paper (or finance b i l l s ) i n the eighteenth century as follows, and h i s account i s worth restatement here in extensa for our purposes: Bi l I s o f exchange were not necessarily drawn each time a consignment o f goods took place, covering the exact amount o f the transaction. I n 1763, i n Sweden, Carlos and Claes Gri l l b i l I s on Lindegren i n London could not be i d e n t i f i e d w i t h p a r t i c u l a r shipments, which were o f t e n made i n rapid succession, but were drawn when the f i rm needed money, general l y for remi t tances t o creditors. This would seem t o be the evolution o f accommodation paper, i n which the c r e d i t o f a house or individual i s gradually separated from that o f p a r t i c u l a r transactions. I n the end, the accommodation b i l l was nothing more than an IOU or promissory note. Real b i l l s partisans, l i k e H. Parker W i l l i s were f i r m l y opposed t o accommodation paper and regarded trade as [properly] commercial b i l I s based on s e l f - l i q u i d a t i n g .... ... www.clevelandfed.org/research/workpaper/index.cfm The problem a r i s e s where the r a t i o o f the debt represented by the b i l l t o the d e b t o r ' s wealth g e t s o u t o f hand, as may happen i n p e r i o d s o f euphoria. Drawing o f - b i l l s i n chains i s e v i d e n t l y i n f e c t i o u s . Described by Adam Smith as a normal business p r a c t i c e [ i n The Wealth o f Nations, Book I I , chapter 2, pp. 327-3371 i t can e a s i l y be overdone. A draws on B, B on C, C on D, and so on; a l l increase the amount o f c r e d i t a v a i l a b l e f o r use. The v i c e o f the accommodation o r f i n a n c e b i l l , according t o [ R . G.1 Hawtrey, I T h e A r t o f C e n t r a l Bankinq (1932)1, i s i t s use " f o r c o n s t r u c t i o n o f f i x e d c a p i t a l when t h e necessary supply o f bonafide long-run savings cannot be obtained from the investment market." [Thus, the equivalent p r a c t i c e today would be the use o f short-term interbank borrowings t o support long-term lending p r a c t i c e s . ] He c l a i m s the system was p a r t i c u l a r l y abused i n the London c r i s i s o f 1866 [ t h e c o l l a p s e o f Overend Gurney] and the New York c r i s i s o f 1907. W have already noted t h a t the e spectacular f a i l u r e o f the de Neufvi l les i n 1763, which produced panic i n Hamburg, B e r l i n , and ( t o a lesser e x t e n t ) London as we1 l as Amsterdam, was the r e s u l t o f the u n r a v e l i n g o f a p a r t i c u l a r l y impressive c h a i n o f discounts. I f one house f a i l s , the chain c o l l a p s e s and may b r i n g down good names, those w i t h a reasonable r a t i o o f debt t o c a p i t a l , as w e l l as bad. With accommodation b i l l s , t r a d e r s w i t h l i m i t e d c a p i t a l o f t h e i r own a r e a b l e t o acquire the use, a t l e a s t t e m p o r a r i l y , o f l a r g e volumes o f borrowed funds, a use they may t r y t o s t r e t c h i n t o longer-term .... I n 1857, John B a l l , a London accountant, reported knowing f i r m s w i t h a c a p i t a l o f under 10,000 pounds and o b l i g a t i o n s i t was a fair of 900,000 pounds, and claimed illustration [of accommodation f i n a n c i n g used t o support longer-term lending] . . . . When they were abused, finance or accommodation b i l l s gave r i s e t o excessive c r e d i t expansion. At all stages, f i c t i t i o u s names were introduced i n t o the chain from time t o time, t o improve the appearance o f c r e d i t w o r t h i n e s s . From time t o time, a l s o , such b i l I s were w r i t t e n f o r odd amounts, t o suggest an u n d e r l y i n g commercial t r a n s a c t i o n . And when t h i s was done, claims were sometimes made . . . t h a t the banks abroad knew i t was finance paper d i s g u i s e d as commercial b i l l s [and thus should not be heard t o complain' when the p r a c t i c e co l lapsed]. www.clevelandfed.org/research/workpaper/index.cfm Hawtrey (1932, p. 129) made the following t e l l i n g p o i n t about accomodation "The real p o i n t i s that the accommodation b i l l i s a sign or finance b i l Is: I t i s not drawn t o supply funds for of distress-. asset, but to make good a deficiency of the a c q u i s i t i o n o f an cash due to disappointed expectat ions." Reviewing the theory o f accommodation financing Hawtrey's, and Kindleberger's accounts, w e see i n l i g h t o f Smith's, that it may become a dangerous p r a c t i c e for banks i n expansionary times to extend c r e d i t to other banks, believing themselves t o have behaved i n a safe and prudent manner because the extensions o f c r e d i t are e n t i r e l y short-term Clarke .) A funding gap develops because the borrowing banks, turn, finance longer-term drawings. bad, If i n nature. (See in loans and investments w i t h the proceeds of t h e i r large c r e d i t s extended by the u l t i m a t e l y borrowing banks go as happened w i t h the loans p a r t i c i p a t e d out to other banks by Penn Square i n 1982, the p a r t i c i p a t i n g banks, such as S e a f i r s t and Continental i n that case, may be dragged i n t o severe c a p i t a l impairment or even insolvency by the collapse o f interbank c r e d i t s ( i n d i r e c t , i n that case) that they have extended.2' Accordingly, i t would be nothing more than good comon sense for bankers and bank regulators to be aware of the nature and extent of interbank commitments, both d i r e c t and i n d i r e c t , as well as the extent t o which banks r e l y on interbank borrowings as s i g n i f i c a n t sources of funds. W have used Smith's e p e r i l s of paper. the v a r i e t y of and Kindleberger's examples interbank exposure that to illustrate the comprises accomnodation However, i t should be obvious that the same p e r i l s may e x i s t for any form of interbank extensions of c r e d i t . www.clevelandfed.org/research/workpaper/index.cfm The most i n c i s i v e recent explanation o f the p o t e n t i a l p i t f a l l s for U.S. banks i n the i n t e r n a t i o n a l interbank market i s i n Clarke (1983). However, f o r the u l t i i n a t e h i s t o r i c a l i l l u s t r a t i o n o f what could happen t o the U.S. banking system i f i t became too exposed t o foreign interbank c r e d i t s , necessary t o t u r n t o the Memoirs o f Herbert Hoover. it is Hoover's account o f the international payments c r i s i s during the summer o f 1931 shows the important r o l e played by accommodation paper and, by extension, by d i r e c t c r e d i t exposure i n p u t t i n g the international financial interbank dominoes so close together that they a l l had t o topple a f t e r C r e d i t a n s t a l t o f Vienna suspended foreign payments i n the spring o f 1931. Hoover's account o f begins, i n relevant p a r t , as follows (Hoover , the c r i s i s 1 1 1 , p. 73): With these bank closings i n central Europe, I n a t u r a l l y wanted t o know i f American banks had any loans t o or deposits i n the banks o f t h i s c r i s i s area. I first telephoned Henry Robinson, chairman of a large C a l i f o r n i a bank [ F i r s t National Bank o f Los Angeles, an ancestral component o f Security P a c i f i c ] , who had had much experience i n international banking. He t o l d m e that many of our banks had bought German trade b i l l s The and bank acceptances, both 60 and 90-day paper. trade b i l l s were supposed t o be secured by b i l l s of lading covering goods shipped, and t o be payable on d e l i v e r y o f the goods. The bank acceptances were simply " k i t e d " b i l l s without any c o l l a t e r a l . Robinson expressed great alarm. W be l i eve that what Hoover meant i n that passage i s that Robinson was e expressing discomfort because U.S. credit without t o German and other verifying banks had been extending d i r e c t central independently interbank European banks v i a accomnodation paper the European banks1 assumption that there r e a l l y were underlying trade transactions t o support the volume of refinancing www.clevelandfed.org/research/workpaper/index.cfm -27acceptances or finance b i l l s that the banks o f central Europe were drawing on U.K. and U.S. banks. As Hoover's account l a t e r shows, the volume of refinancing b i l l s drawn g r e a t l y exceeded the actual volume of underlying The drawing banks, trade transact ions. Kindleberger, i n the fashion described above by resorted t o accomnodation paper whenever they needed funds, even though 'there were no trade transactions t o support While i t would have been i l l e g a l under U.S. t h e i r drawings. law f o r drawing banks t o f a i l t o disclose that t h e i r d r a f t s were not a c t u a l l y connected to p a r t i c u l a r trade transactions, crisis if t h i s p r a c t i c e would not necessarily have created a financial the central European banks had had the capacity gradually to reduce and u l t i m a t e l y t o repay the refinancing b i l l s they drew, or i f there had been no p r e c i p i t a t i n g factor causing extensive presentment for payment of finance renewal. bills drawn by central European banks instead of routine Regrettably, neither s o l u t i o n was v i a b l e because the volume o f b i l I s drawn so accounts far exceeded receivable that the i t was value of al l central inconceivable that European export the eventual, normal operations of international trade would have enabled the finance b i l l s t o be repaid. For example, German gross exports during a l l o f 1931 were only $1.9 b i l l i o n , and the export surplus was only $650 m i l l i o n (Schuker , 45). The p r e c i p i t a t i n g factor causing presentment French banks, a c t i n g w i t h the encouragement o f domestic political accomnodat ion paper for p. payment was that the French government for holdings of issued by German and Austrian banks to protest the reasons, began to redeem all their formation of a German-Austrian customs union i n the spring of 1931. Thus, with there the central banking resources available at the time, www.clevelandfed.org/research/workpaper/index.cfm was no way to international avoid the crisis interbank market. Continuing h i s account o f through the (See C l a r k e normal , operations pp. of 177-201; the Clay the 1931 c r i s i s , Hoover w r i t e s as f o l l o w s I a t once i n q u i r e d o f Federal Reserve o f f i c i a l s what amounts o f these b i l I s [ t h e k i t e d o r interbank accommodation acceptances] were h e l d by American banks and business houses. A f t e r some i n q u i r y , they informed m t h a t our banks h e l d o n l y $400 m i I l i o n o r $500 e m i l l i o n o f them and t h a t they could be e a s i l y handled. [No tw i t hs tand i ng the assurances o f Federa l Reserve o f f i c i a l s , those amounts were r e a l money i n those days, approximately one-half o f one percent o f gross n a t i o n a l product]. Worrying over the matter d u r i n g t h a t n i g h t , I was somehow not s a t i s f i e d w i t h t h i s r e p o r t , and i n the morning I d i r e c t e d the Comptrol l e r o f the Currency t o secure an accurate report on such American h o l d i n g s d i r e c t from the banks. Twenty-four hours l a t e r I received the a p p a l l i n g news t h a t the t o t a l American bank h o l d i n g s probably exceeded $1.7 b i l l i o n ; that c e r t a i n banks having over one b i l l i o n d o l l a r s o f d e p o s i t s h e l d amounts o f these b i l l s , which, i n case o f loss, might a f f e c t t h e i r c a p i t a l o r surplus and c r e a t e great p u b l i c fears. [Without h i s naming them, we assume t h a t President Hoover was r e f e r r i n g t o the New York C l e a r i n g House banks.] Here was one consequence o f the Reserve Board m a i n t a i n i n g a r t i f i c i a l l y low i n t e r e s t rates and expanded c r e d i t i n the U.S. from mid-1927 t o mid-1929 a t the u r g i n g o f European bankers. Some o f our bankers had been y i e l d i n g t o sheer greed f o r the s i x or seven percent i n t e r e s t o f f e r e d by banks i n the European panic area. New York r a t e s f o r commercial loans rose from 4.5 t o 6 percent d u r i n g those two years. Hoover means t h a t , u s i n g the rationales usually offered for expanded d i r e c t interbank c r e d i t s , bankers seeking a higher r a t e o f r e t u r n than i s a v a i l a b l e through normal domestic extensions o f c r e d i t t o nonbank customers may r e s o r t to direct f o r e i g n interbank c r e d i t s . interbank extensions o f credit, including Hoover continues as f o l l o w s (1952, 1 1 1 , p . 74): www.clevelandfed.org/research/workpaper/index.cfm Worse s t i I I , the Comptrol l e r informed m that these e European banks were a l ready i n d e f a u l t on many bank acceptances and were f r a n t i c a l l y endeavoring t o secure renewals. He thought the acceptances comprised a major p a r t o f American bank holdings and informed m that e some o f the "trade b i l Is" d i d not have the c o l l a t e r a l documents attached. One o f the con t ro I dev i ces for prevent i ng naked accommodat ion acceptances o r finance b i l l s from entering the market i s t o require the attachment of b i l l s o f lading or d e t a i l e d descriptions o f the underlying trade transactions that support the drawing of the drafts. This has been traditional market p r a c t i c e f o r centuries,B1 but i n periods o f euphoria, not u n l i k e the 1980s. sound market p r a c t i c e i s abandoned, and i t becomes not a t a l l unusual to f i n d U.S. banks accepting d r a f t s drawn on them by foreign banks, ostensibly t o support underlying trade transactions on the books o f those foreign banks -- transactions that are not disclosed i n f u l l t o the credit-extending U.S. banks. Similarly, interbank c r e d i t extensions i n other forms (such as Eurodollar placements) might be obtained by borrowing banks ostensibly f o r the purpose o f , supporting t h e i r own extensions of should be apparent that trade c r e d i t , such borrowings could be used merely but it to cover funding s h o r t f a l l s that otherwise would cause the closing o f the borrowing insolvent foreign i n s t i t u t i o n s . Hoover continues (1952, 1 1 1 , p. 74): When the Comptroller's information began to come i n , I sent for [Under] Secretary [of the Treasury Ogdenl M i l l s who was also f e a r f u l , and requested him t o ask h i s friends i n the Bank o f England by telephone what they knew about the volume o f these b i l l s . I n a day or two they replied, i n alarm, that there might be $2 b i l l i o n i n the banks of B r i t a i n and the Dominions, w it h Sweden, Norway , Sw i t ze r Iand, and together Denmark. They also stated that there were q u a n t i t i e s i n L a t i n American and Asian banks. They said the German and other eastern European banks were f r a n t i c a l l y t r y i n g to renew the bank acceptances and were being refused. www.clevelandfed.org/research/workpaper/index.cfm I t looked a t t h i s time as i f Germany, A u s t r i a , Hungary and o t h e r eastern European count r i e s had as much as $5 b i l l i o n o f these short-term b i l l s a f l o a t . The- Germans had a l s o , over the years s i n c e the war, f l o a t e d many long-term loans by their government, their m u n i c i p a l i t i e s , and t h e i r business houses. I t looked as i f the German t o t a l e x t e r n a l debt ' a l o n e , e x c l u d i n g reparations but including long-term debt, might p o s s i b l y exceed $5 b i l l i o n . They not o n l y had p a i d a l l t h e i r r e p a r a t i o n i n s t a l l m e n t s t o the a l l i e s out o f t h i s borrowed money, but had p a i d f o r r e c o n s t r u c t i o n o f German i n d u s t r y and t h e i r budget d e f i c i t s . I t was obvious t h a t they and the o t h e r s could not meet t h e i r short-term o b l i g a t i o n s , a t l e a s t f o r the present. For reference, $5 b i l l i o n i n 1931 would have represented more than 5 percent of U.S. one-half would gross national product, would have been approximately times t o t a l federal budget o u t l a y s , and, have surpluses represented p l u s net borrowings, at capital least seven inflows, r e p a r a t i o n s payments, and years i n the case o f Germany, of that excluding debt capital one-and country's trade s e r v i c e on o f f i c i a l flight. Hoover Thus, the e x p l o s i v e mine which underlay the economic system o f the world was now coming c l e a r l y i n t o view. I t was now evident why the European c r i s i s had been so long delayed. They had k i t e d b i l l s t o A i n order pay B and t h e i r i n t e r n a l d e f i c i t s . I d o n ' t know t h a t I have ever received a worse shock. The haunting prospect o f wholesale bank f a i l u r e s and the n e c e s s i t y o f saying not a word t o the American people as t o the cause and danger, l e s t I p r e c i p i t a t e runs on our banks, l e f t me l i t t l e sleep. The s i t u a t i o n was no longer one o f h e l p i n g c o u n t r i e s t o the i n d i r e c t b e n e f i t o f everybody. now a question o f saving ourselves . . . . foreign I t was I cabled S e c r e t a r i e s [Henry] St imson [ S t a t e ] and [Andrew] Me1 Ion [Treasury] my p l a n , which was f o r a among a l I banks everywhere s tand-s t i I I agreement holding German and central European short-term obligations. As my cable o u t l i n i n g the p l a n might www.clevelandfed.org/research/workpaper/index.cfm continues become p u b l i c , i t had t o be c a r e f u l l y phrased so as n o t t o f i r e f u r t h e r alarms as t o the already tense c e n t r a l European s i t u a t i o n . Hoover's cable, as he put i t , was f a r more o p t i m i s t i c about Germany's abi l i t y t o pay than Hoover's p r i v a t e b e l i e f indicated. Hoover says t h a t S e c r e t a r i e s Stimson and Mellon were more p e s s i m i s t i c than he. However, Stimson and Mellon a l s o urged Hoover t o agree t o a French proposal f o r a $500 m i l l i o n emergency loan t o Germany from the western governments. r e p l i e d as f o l l o w s (1952, 1 1 1 , pp. 77-78): I r e p l i e d t h a t t h i s was a banker made c r i s i s , and t h a t the bankers must shoulder the burden . o f the s o l u t i o n , not our taxpayers; moreover, t h a t the amount proposed would not be a drop i n the bucket [compared t o the amount a c t u a l l y needed t o refund the e n t i r e t y o f the I t was merely a p a r t i a l re1 i e f German e x t e r n a l d e b t ] . o f banks a t government expense. Or even i f a loan t o Germany was provided by American, B r i t i s h , and French and other banks themselves, i t [ s t i l l ] would be a w h o l l y inadequate s o l u t i o n . 1 again informed them [Stimson and Mel Ion] by telephone i n d e t a i l o f the s i t u a t i o n as t o German and other c e n t r a l European I also short-term o b l i g a t i o n s i n the U.S. and abroad. s t a t e d t h a t such a loan would not even take care o f the American s i t u a t i o n alone [ t h a t i s , m a i n t a i n i n g c u r r e n t payment s t a t u s on German o b l i g a t i o n s t o U.S. banks]. A t t h i s p o i n t I i n s t r u c t e d Mr. M i l I s t o ask a f r i e n d i n the Bank o f England by telephone what t h e i r idea was o f the French proposal. He q u i c k l y learned t h a t the Bank o f England d i d n o t approve o f such a loan. Also, the B r i t i s h treasury o f f i c i a l s had no f a i t h t h a t i t would meet the c r i s i s . The a f f a i r began t o take the c o l o r o f the usual attempt o f European p o l i t i c a l o f f i c i a l s t o make us the f i r s t t o refuse t o do something and t h e r e f o r e the scapegoat f o r anything t h a t happened. Indeed, one reason given t o me by Messrs. Stimson and Mellon f o r American governmental support o f a loan was fear o f just that. I finally telephoned them emphatically t h a t we would not p a r t i c i p a t e i n such a loan and t h a t I was p u b l i s h i n g the g i s t o f the s t a n d - s t i l l proposal t o the world t h a t very minute. They protested against the publication as undiplomatic. I issued i t nevertheless. www.clevelandfed.org/research/workpaper/index.cfm Hoover 'The next day, the [ I n t e r n a t i o n a l Monetary Conference, meeting i n London], w i t h the now p u b l i c proposal i n f r o n t o f i t , adopted the essence o f m plan and y delegated the Bank for lnternat ional Sett lements a t Berne t o carry i t o u t . I t s success depended on bankers o f a l l countries holding the b i l l s [ t h e frozen interbank or refinancing b i l l s drawn by the c e n t r a l European banks] and agreeing f u r t h e r that they would accept p a r i passu payments on unsecured b i l l s when payment could be extracted by the Bank for International Settlements. A group o f ou'r New York banks informed m that they e could not agree t o the s t a n d - s t i l l plan and that the only s o l u t i o n was f o r our government to p a r t i c i p a t e i n a large i n t e r n a t i o n a l loan to Germany and other countries. M nerves were perhaps overstrained when I y r e p l i e d t h a t , i f they d i d not accept w i t h i n 24 hours I would expose t h e i r banking conduct t o the American peop l e . They ag reed. Strange behavior for an unquestionably conservative Republican president from California iterations! toward Hoover the says New further York banks that, a in year light later, of more the recent Bank for International Settlements ( B I S ) made a retrospective study of the central European b i l I s of exchange problems and estimated that the t o t a l problem was f a r larger even than Hoover had imagined i t . Hoover, said that the total amount o f The BIS study, as described by short-term international private indebtedness that existed a t the beginning o f 1931 was more than $10 b i l l i o n . ~t time the magnitude o f indebtedness was not At known . cent ra l banks began to real i ze . . a danger and they endeavored ... to strengthen t h e i r reserves of foreign exchange. . . . The menace . . . d i d not appear as self-evident as i t does today. ... I t was ... almost c e r t a i n t o break the s i t u a t i o n a t some p o i n t . The l i q u i d a t i o n i n a s i n g l e year [was] o f more than s i x b i l l i o n of short-term indebtedness ... of the balance . . s t i l l outstanding, a substantial amount has i n fact become b locked . (Omissions in original). .. . . www.clevelandfed.org/research/workpaper/index.cfm Hoover concluded that " i t i s also obvious that I w a s r i g h t when I maintained that a h a l f a b i l l i o n o f government money [ f o r the proposed o f f i c i a l loan to Germany] would have been only a drop i n [ t h i s $10 b i l l i o n ] bucket." (1952, I l l , p . 79). Despite h i s understanding o f interbank exposure to the the dangers o f American increased banking system, Hoover international nevertheless approved two large p r i v a t e bank loans t o support the p a r i t y o f the pound s t e r l i n g a t or near $4.86 i n the summer o f 1931. On August 1, Hoover approved a $250 m i l l ion loan, and on August 26, U.S. banks lent another $400 m i l l i o n t o the Bank o f England (Hoover 119521, I l l , pp. 81-82). Hoover should have learned h i s lesson from the central European experience e a r l i e r that summer. Ultimately, the Bank of England suspended international payments o f gold on September 21, 1931. redemption o f Thus, on top of the central European interbank c r e d i t problem, Hoover's acquiescence i n p r i v a t e bank lending to the Bank o f England resulted i n an additional $650 m i l l i o n do1 l a r s of credit exposure (about 0.7 percent of U.S. product) that had l i t t l e or no value for enabling U.S. gross national banks ( p r i n c i p a l l y the money center banks) t o meet claims on them from domestic sources. I n the f a l l o f 1931, following the suspension o f gold payments by the Bank o f England, industries in congressional Association. Hoover gathered Washington, leaders, leaders o f together with the banking and some cabinet and proposed the creation o f . insurance officials and the National Credit The Association, which was s i m i l a r i n concept t o the c u r r e n t l y discussed cross-guarantee or p r i v a t e deposit funded w i t h an initial capital insurance schemes, was t o be contribution of $500 m i l l i o n from U.S. www.clevelandfed.org/research/workpaper/index.cfm banks. The banks were t o use that c a p i t a l pool, together w i t h p o t e n t i a l borrowing a u t h o r i t y f o r the Association o f $1 b i l l i o n more, t o make loans t o support troubled , I l l , pp. 84-88). 107-Ill), financial institutions in the United States (Hoover However, as Hoover l a t e r notes (1952, I l l , pp. the banking s i t u a t i o n i n t h i s 'country became so f e a r f u l winter of 1931-32 t h a t , a f t e r a few weeks o f e f f o r t , Association died, and bankers asked for d i r e c t 1932, Hoover requested creation of the Corporation t o take over, under federal auspices, support" role of the National Credit federal help. new I n January Reconstruction the "extended the National Credit Association. i n the (See Jones Finance liquidity .) There s t i l l was no solvency or c a p i t a l support lender a t the federal level (Todd [ 1988a1) . The h i s t o r i c a l record shows us that d i r e c t interbank lending can perform a useful function i n channeling funds more e f f i c i e n t l y from areas o f low loan demand t o areas o f high loan demand, when such a system i s managed prudently. The record also shows t h a t , i n periods o f monetary and c r e d i t i t becomes increasingly d i f f i c u l t for bankers to r e s t r a i n t h e i r expansion, enthusiasm f o r lending, including d i r e c t interbank lending, so as t o remain w i t h i n the l i m i t s o f prudence and common sense. to direct Upon occasion, overexposure interbank c r e d i t s arises, and then disaster follows inevitably, a l b e i t w i t h the delay necessary for the discovery o f the nature and extent o f the problem (two years i n the case described by Smith, up t o four years a f t e r the onset o f expanded d i r e c t by Hoover). Increasing interbank lending i n the case described interbank exposure probably i s an e a r l y warning www.clevelandfed.org/research/workpaper/index.cfm signal of impending trouble for the banking system and might, i n some circumstances, be a p r i n c i p a l cause o f the kinds o f contagion or systemic r i s k that many bank regulators c i t e as j u s t i f i c a t i o n f o r creation o f the too b i g to f a i l doctrine. The point those regulators conveniently ignore i s t h a t , without d i r e c t interbank lending, i t usually i s d i f f i c u l t for any bank t o become, or t o long remain, too b i g t o f a i l . VII. A Measure o f Interbank Exposure The measures o f interbank exposure that can be constructed from p u b l i c l y avai lable data are flawed i n many ways. construct measures o f Currently, interbank exposure that sources o f such exposure. I n addition, for i t i s not possible t o include a l l o f the relevant the interbank-exposure items that can be constructed, the data are highly aggregated, thereby making i t impossible t o derive an accurate measure o f Therefore, t h i s exercise i n measuring interbank exposure i s performed w i t h three purposes i n mind: an individual bank's risk. 1) t o demonstrate how' one would go about measuring interbank-exposure r i s k , 2) to obtain an o v e r a l l impression o f the level and d i r e c t i o n of aggregate interbank exposure for U.S. banks, and 3) t o point out the g l a r i n g deficiencies i n the data a v a i l a b l e t o construct measures o f interbank-exposure r i s k . The data used in the study are taken from the Federal Financial I n s t i t u t i o n s Examination Council's (FFIEC's) Reports o f Condition and Income ( c a l l reports) from March 1984 through March 1990. chosen for two reasons: in March 1984 This sample period was 1) there was a major r e v i s i o n o f the c a l l reports and 2) because interbank exposu re www.clevelandfed.org/research/workpaper/index.cfm was a factor i n the decision t o b a i l out Continental i n July 1984, we are interested i n the d i r e c t i o n o f aggregate interbank claims since that time. After all, i t would hardly be a triumph o f l o g i c a l consistency for the a u t h o r i t i e s t o have breached precedent by b a i l i n g out Continental due t o i t s interbank exposure and then to do nothing about discouraging or interbank exposure generally i n the aftermath o f the bai lout -- reducing but we fear that such inaction and inconsistency i s exactly what i s s t i l l happening. The banks i n the sample are grouped i n t o f i v e subsamples on the basis o f size, as measured by t o t a l assets: banks w i t h less than $100 m i l l i o n ; banks w i t h a t least $100 m i l l ion but less than $300 m i l l i o n ; banks w i t h a t least $300 m i l l i o n but less than $1 b i l l i o n ; banks w i t h a t least $1 b i I1ion but less than $10 b i I l ion; and banks w i t h more than $10 b i l l ion. To measure interbank exposure, w selected f i v e categories o f interbank e risk: CIPC, BDDI, LDI, AOB, and FFS. W also looked a t measures o f i n t e r e bank exposure t o foreign banks (FOR) and t o banks domiciled countries (ABR). A b r i e f description o f table 1. Our measure o f total these variables interbank exposure, i n foreign i s presented i n TOTEXP, i s not a l l - i n c l u s i v e measure and omits p o t e n t i a l l y important sources o f exposure, such as stock and subordinated debt participations sold with recourse. of These other and interbank banks and other an loan possible interbank-exposure items were omitted because they are not r e a d i l y a v a i l a b l e to us from our interbank-exposure data ' source. 9 Despite the fact that we missed some items, we believe that TOTEXP picks up the m a j o r i t y o f interbank exposure i n the asset p o r t f o l i o . m ' ' W also recognize that the e same c r i t i c i s m applies t o FOR, our measure o f exposure t o non-U.S. www.clevelandfed.org/research/workpaper/index.cfm banks (both domestic and foreign o f f i c e s ) , and ABR, our measure o f exposure to banks domiciled i n foreign countries (both U.S. and non-U.S. o f f i c e s ) . W construct the variables i n table 1 for e subsample (except for FR O and ABR) because requirements for d i f f e r e n t s i z e banks. constructed only for of different reporting These variables generally can be banks w i t h more than $100 m i l l i o n i n assets. variables are constructed i n two ways: the group l e v e l . the e n t i r e sample and each The 1) a t the individual level and 2) a t The f i n a l variables are constructed as r a t i o s o f exposure to c a p i t a l because the u l t i m a t e r i s k that w are concerned w i t h here i s the e r i s k of c a p i t a l impairment due to interbank exposure. The group aggregate interbank-exposure r a t i o s are p l o t t e d out over the sample period i n figures 1 through 8. The individual interbank-exposure r a t i o s are used to construct tables 4 through 11. Figure 1 shows that the ClPCC exposure o f U.S. banks has been r e l a t i v e l y f l a t since the Continental I l l i n o i s c r i s i s . U 1 a t the individual bank level i n table 4. These r e s u l t s are confirmed For example, i n March 1984, 22.07 (11.66) percent o f U.S. banks had ClPCC exposure exceeding 50 (100) percent of c a p i t a l , w h i l e i n March 1990, 23.92 (11.18) percent o f U.S. banks had ClPCC exposure exceeding 50 (100) percent o f c a p i t a l . Figure 2 shows that the BDDlC exposure o f U.S. banks w i t h more than $10 b i l l i o n i n assets f e l l from March 1984 through December 1986. Then BDDIC for these banks increased dramatically, w i t h a general decline thereafter. BDDlC generally declined for a l l other banks (those w i t h assets of less than $10 b i l l ion) from March 1984 to March 1990. The individual bank s t a t i s t i c s i n table 5 general l y confirm the aggregate p a t t e r n of exposure i n f i g u r e 2. Overal l BDDl exposures are high enough a t a number o f banks i n each s i z e www.clevelandfed.org/research/workpaper/index.cfm category to warrant further s c r u t i n y by bank supervisory a u t h o r i t i e s . Figure 3 and table 6 show the p a t t e r n o f LDI exposure for U.S. banks. e Looking a t f i$ure 2, w can see that LDlC i s highest f o r the largest banks From March 1984 u n t i l March 1990, LDlC and lowest f o r the smal lest banks. has remained f a i r l y constant for banks w i t h assets less than $1 b i l l ion and has fa1 len for banks w i t h assets greater than $1 b i l l ion. Figure 4 and table 7 show the changes i n the interbank-exposure A B over OC the sample period. For r e l a t i v e l y unimportant source o f all of the bank interbank exposure. groups, AB OC ratio is a A B i s less than 10 O percent o f c a p i t a l for every aggregate group i n every quarter and was lower i n March 1990 than i t was i n March 1984 f o r each group. However, table 7 shows that although A B i s generally an unimportant source o f OC exposure for U.S. banks as a whole, interbank i t may be an important source o f such exposure f o r a few U.S. banks. FFSC is plotted reported i n table 8 . of a l l our in figure 5, and the individual bank numbers are As one might expect, FFSC shows the greatest v a r i a t i o n interbank-exposure ratios. The seemingly e r r a t i c behavior o f FFSC may be due i n part to the short maturity o f FFS assets and the way the FFS i s recorded on the c a l l reports. position of the variable on the day the c a l l average q u a r t e r l y p o s i t i o n . the numbers representative Although The data from the reports r e f l e c t the reported of the as i s made and not an Because FFS tend to be very short-term assets, of true t h i s problem may report the day of FFS p o s i t i o n the of call the report banks influence the numbers reported, may in not be the sample. i t should not dominate the trends for the groups or for individual banks over time. I t is more l i k e l y than not that the movements i n the FFSC over time are driven by www.clevelandfed.org/research/workpaper/index.cfm i n t e r e s t rates and the a v a i l a b i l i t y o f p r o f i t a b l e investment opportunities i n s e c u r i t i e s and in the banks' home markets. The o s c i l l a t i o n o f the exposures around a r e l a t i v e l y f l a t trend l i n e over time i s consistent w i t h market factors d r i v i n g FFSC over time. TOTEXPC, the sum of the s p e c i f i c interbank-exposure i n f i g u r e 6 and reported i n table 9. ratios, i s plotted TOTEXPC follows the same p a t t e r n as BDDlC for a l l our aggregate bank groups. Overall, TOTEXPC has f a l l e n most for the banks w i t h more than $1 b i l l i o n i n assets and has exhibited a s l i g h t decline or stayed the same f o r the remainder o f the banks. Thedecrease i n TOTEXPC f o r the large banks tends t o r e f l e c t a decrease i n the BDDIC and LDlC over the sample period. The behavior o f TOTEXPC for the individual banks i n each group i n table 9 confirms the r e s u l t s i n f i g u r e 6. Figures 7 and 8 present the degree o f interbank exposure o f U.S. banks to foreign banks (non-U.S. banks i n the United States and abroad) and banks domiciled i n foreign countries (both U.S. and non-U.S. banks). Banks w i t h less than $ 1 0 0 m i l l i o n i n assets do not report the l i n e items i n the c a l l report required t o compute F R and ABRC, so they are omitted from these OC tables and figures. However, because i t i s u n l i k e l y that small banks have much o f t h i s type of interbank exposure, t h i s omission should not a f f e c t the analysis. It is interesting to look at measures o f foreign banking exposure, such as F R and ABR, because t h i s type of interbank exposure i s O subject t o sovereign r i s k . 'That i s , the claimant bank i s subject not only t o the r i s k of f a i l u r e of the banks whose assets i t holds, but also t o the risks associated w i t h political decisions made by foreign governments. BC Figures 7 and 8 show that FORC and A R decline s l i g h t l y over the sample period for banks w i t h less than $10 b i l l i o n i n assets. For banks w i t h www.clevelandfed.org/research/workpaper/index.cfm assets greater than $10 b i l l i o n , FORC and A R have declined a t a s l i g h t l y BC greater r a t e over the sample period. of Tables 10 and 11 confirm the results the figures and indicate that F R and A R may represent a p o t e n t i a l OC BC problem for only a few U.S. banks. I n addition, anecdotal evidence, which recent interbank claims data (Federal Reserve B u l l e t i n , t a b l e 3.17) tend t o confirm, suggests that these exposures may be increasing f o r money center banks. Before one reads too much i n t o the relationships tables, w must p o i n t out several caveats e for the i n the figures and results. First, the numbers r e f l e c t the aggregate interbank exposure f o r each bank (group) and do not take i n t o account possible d i v e r s i f i c a t i o n o f the bank's (group's) exposure. A bank could have a very high exposure t o other banks i n the banking system but very l i t t l e exposure t o any one bank. Such a bank would have less interbank-exposure r i s k than a comparable bank w i t h less exposure t o the banking system but a high level o f exposure t o one bank (or a small group of banks). Second, with currently determine riskiness o f the interbank claims. available data, w e cannot There i s less reason t o be concerned about a bank's interbank exposure t o a sound and conservatively managed bank than the same level of exposure t o one of the " h i g h - f l i e r s " of the banking or t h r i f t industries. Third, there are interbank claims on the l i a b i l i t y side of the balance sheet that o f f s e t some of the asset exposure. Fourth, t o the extent that domestic geographic d i s t r i b u t i o n o f interbank exposure matters ( @ . a L , exposure w i t h i n the same clearinghouse or w i t h i n the same Federal Reserve D i s t r i c t ) , such d i s t r i b u t i o n cannot be determined from F i n a l l y , w cannot determine e the c u r r e n t l y available data. (See table 1 2 . ) the duration of the exposure. Banks w i t h a high level o f interbank exposure www.clevelandfed.org/research/workpaper/index.cfm concentrated i n assets w i t h very short m a t u r i t i e s have less interbank-exposure risk, by duration, than banks w i t h the same level o f interbank exposure concentrated i n assets w i t h longer m a t u r i t i e s . Overal I , interbank exposure, as defined in this study (with a l l inherent l i m i t a t i o n s ) , does not seem to be a problem f o r U.S. the periods investigated. Aggregate exposure r a t i o s and its banks during the majority o f individual bank-exposure r a t i o s do not appear to be a t levels that are high enough f o r concern, and there i s a general f l a t o r d e c l i n i n g trend i n our measures o f interbank exposure for banks as a whole. admi t However, as w readi l y e , the measures that we are able- t o construct from c a l l report data are so crude that our i n t e r p r e t a t i o n s o f the r e s u l t s are based more on i n s t i n c t than on hard evidence. are a O the other hand, i t i s clear from our study that there n few banks w i t h aggregate interbank exposure high enough t o warrant closer scrutiny by t h e i r managements, shareholders, and other investors, and, a t the time o f t h e i r next supervisory examination, by the regulators. VIII . Conclusions and Policv Recomnendations Interbank exposure i s a form o f s e n s i t i v i t y that need not (but i n the eyes of some influential authorities, at least, potentially does) constitute contagion or systemic r i s k that has s i g n i f i c a n t p u b l i c p o l i c y implications for the safety and soundness o f the banking system. W e present hypotheses. arguments and anecdotal evidence supporting three basic The f i r s t i s that high levels o f interbank exposure reduce the s a f e t y and soundness o f the banking system. This contagion r i s k increases the www.clevelandfed.org/research/workpaper/index.cfm probabi l i t y that a s i n g l e bank f a i lure, or the f a i l u r e o f a l i m i t e d number o f banks, would r e s u l t i n a s e r i e s o f bank f a i l u r e s . that interbank discipline as exposure a affects constraint on abi l i t y the banks' of Our second hypothesis i s the FDIC t o A risk-taking. use market reduction in the independence o f bank f a i l u r e s increases the constraints on the FDIC's a b i l i t y t o dispose o f insolvent banks without extending forbearances t o the bank's uninsured depositors, hypothesis i s that a general creditors, level o f rising and stockholders. interbank exposure reduced s t a b i l i t y o f the f i n a n c i a l system. is The third indicative o f lnterbank claims tend t o r i s e as banks see reduced investment opportunities i n t h e i r t r a d i t i o n a l markets and as entry i n t o new markets factors. increase other or competitive A the c r e d i t q u a l i t y o f nonbank borrowers decreases, s banks w i l l indirect banks is precluded by e i t h e r Iending to as a these and other supposedly safer regulatory comparable borrowers alternative to direct through Iending. Unfortunately, the h i s t o r i c a l accounts indicate that the perceived safety o f increased interbank lending may be a delusion that chains a greater number o f financial death. i n s t i t u t i o n s together Interbank lenders and borrowers become chained prosper together as but they also i n a 1980s version o f the medieval dance o f t o each other and long as r e a l , nonfinancial economic a c t i v i t y perish together if real, nonfinancial economic decreases without appropriate adjustments i n lenderst behavior. recent experience about " c r e d i t real economic political i n northeastern real estate markets crunches" appear activity, and pressure t o "ease increases, activity Worse y e t , as illustrates, stories i n the f i n a n c i a l press . f o l l o w i n g declines i n these up" might so as constitute t o deter a signal regulators of enough from pursuing necessary reforms, such as d i s c 10s i ng and reducing d i rect interbank exposures. www.clevelandfed.org/research/workpaper/index.cfm To remedy problems associated w i t h d i r e c t interbank exposure, useful solutions might include the following measures: 1) ÿ he construction o f a data c o l l e c t i o n system geared to measuring d i rect and some forms o f i n d i r e c t interbank exposure. be done by modifying the e x i s t i n g c a l l separate reporting schedule. This could reports or s e t t i n g up a data on As w noted i n section V I I , e interbank claims are not collected now i n a manner that allows us t o properly measure and evaluate interbank-exposure the remainder of our policy recomnendations assumption that interbank-exposure i n the future i f not a t present. d i r e c t i o n already risk. are I n fact, based on the r i s k can be accurately measured, Some supervisory movement i n t h i s i s underway; beginning w i t h the June 30, 1987, cal l reports, commercial banks have had to report aggregate amounts of loans purchased from other depository i n s t i t u t i o n s , as well as Obviously, much more s t i l l institutions.=' loans sold t o other has to be done t o improve c o l l e c t i o n of data on interbank exposure, but c o l l e c t i o n of data on loan p a r t i c i p a t i o n s purchased and sold i s an important f i r s t step. 2) Excluding ClPC and insured interbank deposit balances from the measures, w suggest t h a t : e Banks be r e s t r i c t e d to having not more than 50 percent of their capital (including companies) primary at risk bank, and that supervisor to any s i n g l e thrift, they any and be financial institution ho(ding nonbank-financial required combination of to report direct and to their indirect www.clevelandfed.org/research/workpaper/index.cfm exposures t o any f i n a n c i a l i n s t i t u t i o n that exceeds 15 percent o f t h e i r primary c a p i t a l . - a l s o would be discipline. financial Public disclosure o f such exposures helpful For in asset institutions advancing exposures the to i n excess o f cause of on) (claims market other 15 percent o f capital, o f f s e t t i n g l i a b i l i t y exposure on the claimant bank's balance sheet could be deducted when determining exposure t o any one f i n a n c i a l institution. i t s net All interbank net, d i r e c t interbank exposures that exceed 50 percent o f c a p i t a l ( i n the aggregate) should scrutinized by be publicly examiners as disclosed part of and the should be examinat ion .- process 131 Banks have aggregate primary regulators. then publicly Ii m i ts.) interbank-exposure (Alternative: disclose their l i m i t s set by t h e i r banks should determine and own d i r e c t These aggregate exposure interbank-exposure I i m i t s should include a r e s t r i c t i o n on exposure to banks w i t h i n the claimant bank's local clearinghouse association and separate l i m i t s on t o t a l exposure t o a l l banks i n the domestic banking system and to all foreign Because of banks for regional, each p a r t i c u l a r country concentration-of-risk of origin. patterns that emerged i n the 1980s, i t also might be useful t o have banks calculate Federal and disclose Reserve D i s t r i c t . aggregate Because interbank exposures by there no or is theory evidence that t e l l s us how high to set the aggregate exposure www.clevelandfed.org/research/workpaper/index.cfm levels, we defer to banks' own p u b l i c l y disclosed judgments or t o judgments o f the regulators on t h i s issue. However, U.S. bankers do have experience i n determining d i r e c t interbank- exposure l i m i t s , both under Federal Reserve-sponsored payments system risk-reduction initiatives and on their i n i t i a t i v e s , even without Federal Reserve involvement , pp. 27-32). own (Clarke Thus, the only t r u l y novel aspect o f t h i s proposal would be e i t h e r regulatori l y administered or pub1 i c l y disclosed interbank-exposure l i m i t s . Because of sovereign credit systems and cross-border risk for nationalized currency transfer banking r i s k i n general, a l i m i t should be set on the t o t a l interbank claims o f each U.S. bank on a l l f i n a n c i a l Limits also exposure should t o any i n s t i t u t i o n s from each foreign country. be set single region o f America or Eastern Europe). on international or too on a bank's aggregate the world interbank (such as H i s t o r i c a l l y , self-imposed Latin limits interbank exposure have proved t o be too weak inconsistently enforced to be of practical l i m i t i n g loss when payment flows have been interrupted use in (Clarke 119831, pp. 27-32). Because of the h i s t o r i c a l interplay between banks' lending and foreign p o l i c y considerations cross-border (see Tolchin [19901; Chernow [19901), any regulatory l i m i t s on such regional lending might have t o be set i n consultation w i t h the Treasury and State Departments. W believe that no domestic e bank's aggregate net interbank claims on s p e c i f i c countries and www.clevelandfed.org/research/workpaper/index.cfm regions o f the world should be allowed t o exceed the level set for the claimant next-largest) bank's institution exposure in its to own the largest local (or clearinghouse association. limit Such measures would the alleged ripple effects of irrational, contagious bank f a i l u r e s and would increase the safety and soundness o f our banking system. They should allow exercise discipline market interlocked smaller banks) fully to be either avoided or in deciding to the d e f i n i t i o n o f include off-balance-sheet as holdings o f allow large banks (or Thus, the regulators' Continental dilemna significantly diminished. meaningful system o f supervision or regulation o f implemented, bank regulators t o f a i I as a consequence o f e i t h e r supervisory intervention o r r a t i o n a l bank runs. would the FDIC and other However, before a interbank exposure can be interbank exposure needs t o be expanded t o exposures and other relevant asset exposures, such stock and subordinated debt of other banks, that are not c u r r e n t l y a v a i l a b l e from c a l l report data. This paper presents a measure o f interbank exposure f o r U.S. March 1984 u n t i l March 1990. data indicate that t h i s period. conclusion. the o v e r a l l Interbank-exposure level o f banks from r a t i o s formed on aggregated interbank exposure declined during The same r a t i o s formed on an individual-bank basis support t h i s Overall, the evidence suggests that interbank exposure i s not a serious problem. However, a l i m i t e d number o f banks have exposure r a t i o s that are high enough t o warrant f u r t h e r investigation by t h e i r regulators. www.clevelandfed.org/research/workpaper/index.cfm -47FOOTNOTES Commenting on an e a r l i e r d r a f t o f t h i s paper, Hester (1987) observed (accurately, w believe) that the terminology w were using then (and e e that still confused. prevails i n academic and p o l i c y discussions) i s somewhat Hester wrote that "contagion and systemic r i s k s are medical terms w i t h meanings which are q u i t e d i f f e r e n t . Contagion refers t o the spread o f disease and systemic r i s k r e f e r s t o a simultaneous collapse o f d i f f e r e n t elements or organs. which [ i s ] ... Neither i s equivalent to sensitivity, the p a r t i a l d e r i v a t i v e of one v a r i a b l e w i t h respect t o another ." 2. One explanation for Bens ton, enables the lack o f scale economies i n banking found by ( 1982) Hanweck, and Humphrey small banks t o capture is some of that bank i ng correspondent the e f f i c i e n c i e s of larger banking organizations. 3. The c l a s s i c recommendation regarding t h i s type of problem would be for the Federal Reserve, the FDIC, or another lender of l a s t resort t o lend f r e e l y to banks w i t h exposure t o bank A but not the market-determined itself. Humphrey (1989); 197). f a i l u r e of Todd (1988a); bank A Clarke (1983); t o lend so as t o prevent See, for example, and Bagehot (1873, Clarke's observations on the c l a s s i c lender-of-last-resort are worth restatement here (1983, p. 45): www.clevelandfed.org/research/workpaper/index.cfm p. theory - A l though ar rangement s l i nk i ng [depos i t 1 i nsu rance assessments w i t h r i s k would contribute t o prudent bank i ng , they do not assure i t . So long as banks -especial l y b i g banks -- have reason t o assume that the monetary a u t h o r i t i e s w i I I not l e t them f a i I , moral hazard remains a problem. Banks that adopt go-for-broke s t r a t e g i e s can b i d up deposit rates s u f f i c i e n t l y not only t o o f f s e t the increases i n insurance premia but also t o a t t r a c t investors who are w i l l i n g t o gamble. To be sure, a dynamic economy requires a willingness t o take r i s k s but whether t h i s willingness should be found i n banks may be doubted, especially i f the cost o f f a u l t y business judgment i s borne by the p u b l i c . I n order t o provide assurance that they would bear the f u l l cost o f risk-taking, banks should therefore be required not only t o pay r i s k - r e l a t e d insurance premia but also to understand c l e a r l y that support from the lender of l a s t resort w i l l be provided only t o solvent i n s t i t u t i o n s . I n recent years the Federal Reserve has paid l i p service t o t h i s i n j u n c t i o n . . . but uncertainty about the precise p o s i t i o n of troubled banks has led t o slippage i n p r a c t i c e . I n a s i g n i f i c a n t number o f cases, market reports o f difficulties at an i n s t i t u t i o n have led to heavy outflows of uninsured deposits and to a p p l i c a t i o n for c r e d i t from the Discount Window. More o f t e n than n o t , the Fed has responded i n the s p i r i t of "Treat the patient f i r s t and ask questions about solvency l a t e r . " Even then the question was n o t , " I s the i n s t i t u t i o n solvent now?" but rather -- "With reformed management and, perhaps, some c a p i t a l infusion, does the bank stand a f a i r chance of becoming solvent a t some point i n the not-too-distant future?" See Shaffer (1989) regarding the e f f e c t of "pooling" on j o i n t failure risks. 5. See William M. Isaac's testimony before the House o f Representatives, Committee on Banking, Finance and Urban A f f a i r s , Subcommittee on Financial Institutions, [Hearings] Supervision, , Regulation pp. 457-491). and Insurance (U.S. Congress See also Wolfson (1986, p. 111) for a comparable statement regarding Continental by Comptrol l e r o f the Currency Todd Conover. www.clevelandfed.org/research/workpaper/index.cfm 6, S t a f f report, U.S. Congress [Hearings] (1985), pp. 418-445. See Zweig (1985). Continental may I n the have Penn Square relied lending substantially on frenzy, Penn Seafirst Square's and credit evaluations of the loans i n which they p a r t i c i p a t e d , thereby creating what can be termed " i n d i r e c t interbank exposure." I n d i r e c t interbank exposure represents a form o f agency problem i n the s p i r i t o f Jensen and Me'ckling (1976). However, our study i s concerned p r i m a r i l y w i t h d i r e c t interbank exposure. See also Wolfson (1986, pp. 99-102, 106-113) regarding the legacy o f Penn Square. 8. Regardless o f one's views on the "real b i l l s t 1 doctrine i n monetary p o l i c y , a macroeconomi~ issue, i t remains a bedrock p r i n c i p l e o f safe and sound banking, a microeconomi~ issue, that only "real b i l l s 1 ' should be treated as "prime1' bankers' acceptances of the types normally eligible for discount or purchase by a central bank (Todd [1988b]; Hawtrey ). 9. Off-balance-sheet sources captured, of risks, such as interbank-exposure interest-rate risk in the swaps, banking are system additional that are i n aggregate form only, by the reporting schedules that banks c u r r e n t l y f i l e w i t h t h e i r regulators. Also, w i t h i n the Federal Reserve System, on-line access t o complete c a l l report data across d i s t r i c t l i n e s i s not as readily a v a i l a b l e as persons outside the System might suppose. Some measures o f off-balance-sheet r i s k s are summarized i n table 2. www.clevelandfed.org/research/workpaper/index.cfm 10. There i s a form o f interbank exposure (some o f l i a b i l i t y side o f banks1 ledgers, other banks. including, i t offsetting) f o r example, on the claims due t o Such exposure, a l s o referred t o as "funding r i s k , " increases the contagion r i s k regarding banks' funding sources. For the sake o f s i m p l i c i t y and manageability, and because funding r i s k i s already a widely f o r example, Wolfson , recognized and researched problem (see, 106-121), w e usually excluded liability items and concentrated pp. on interbank asset exposures instead. 11. Anecdotal Reserve center evidence (which recent data in aggregated form i n Federal B u l l e t i n t a b l e 3.17 tend t o confirm) suggests t h a t , among money institutions, interbank f a i l u r e o f Continental . exposure may have increased since the See table 3 for a l i s t o f correspondent balances and interbank deposits held by selected large banks. 12. See Fraust (1987). W base our e interbank suggested 50 percent o f exposures on impairment as one o f the FDIC's capital citation i t s standard measures o f I i m i t on n e t , of 50 aggregate, percent capital the purported impact o f Continental's f a i l u r e (1984) on i t s correspondent banks (see footnote 5 ) . The 15 percent reporting or disclosure l i m i t a t i o n i s not based on any r u l e or evidence, but i t matches the 15 percent o f c a p i t a l per customer lending limit that generally applies unpublished l e t t e r (June 20, to bank customers. Clarke, in an 1990) commenting on a d r a f t o f t h i s paper, o f f e r e d the following observations: www.clevelandfed.org/research/workpaper/index.cfm I ' m not a t a l l confident i n the e f f i c a c y o f Ii m i t s . Recent such . [voluntary, sel f-imposed] experience i n the real estate market i n the [Northeast] ... suggests that the banks have already forgotten the lessons o f t h e i r disastrous L a t i n American loans. So, i n the absence o f anything b e t t e r , I ' m inclined t o s t i c k w i t h the p roposa l s on pp . 43-48 o f m [ 19831 paper. But y what can you do i f you get regulators l i k e those i n the FSLlC during the '80s and senators l i k e the wicked f i v e and a president and Congress that think the market can do no wrong? www.clevelandfed.org/research/workpaper/index.cfm bpendix 4 by James B. Thomson Markets and Bankina System S t a b i l i t v Although i t i s w i d e l y accepted t h a t a free-market of f a i l i n g banks would be the most e f f i c i e n t one, s o l u t i o n t o the problem t h e r e a r e some who would d i s p u t e the c l a i m t h a t the market s o l u t i o n i s s t a b l e a t a l l , most s t a b l e s o l u t i o n . l e t alone the (See Campbell and Minsky [19871; Corrigan ; Guttentag and H e r r i n g [1986, 19881.) and Such r e s e r v a t i o n s about the s t a b i l i t y o f markets ( a t l e a s t o f f i n a n c i a l markets) may be traced t o t h e c l a i m t h a t market solutions solutions. runs on result i n more s h o r t - r u n volatility than r e g u l a t o r i l y determined I n the case o f banking, bank f a i l u r e r a t e s and the frequency o f insolvent i n s t i t u t i o n s a r e proxies for volatility. Thus, as the argument goes, the more v o l a t i l e a banking system i s , the less s t a b l e i t i s . One flaw i n such arguments systemic s t a b i l i t y aspects. rather -- i s that they r e l y too h e a v i l y on one aspect o f short-run v o l a t i l i t y -- and ignore other more important A second flaw i s t h a t such arguments focus on short-run phenomena than on long-run evidence, even though s t a b i l i t y t r u l y has meaning o n l y i n a long-run c o n t e x t . flows o f funds, o r i s a concept that I n o t h e r words, v o l a t i l i t y o f l i q u i d i t y , draws more academic and supervisory a t t e n t i o n (wrongly, I t h i n k ) than s u s t a i n a b i l i t y and s t a b i l i t y o f outcomes ( f o r example, maintenance o f solvency, o r p o s i t i v e net worth on a market-value b a s i s ) , which a r e c a p i t a l - s t o c k concepts. www.clevelandfed.org/research/workpaper/index.cfm Economists use the term "stability" to refer to a specific properties that a market or an economic system possesses. set of I n the simplest terms, one can think o f the financial system as a b a l l r o l l i n g down a path. The f i r s t condition f o r s t a b i l i t y i s directed momentum: Yhen there are no outside forces operating on the b a l l , i t follows i t s e q u i l i b r i u m path. an exogenous force, When f o r example, new information a r r i v i n g i n the market, acts on the b a l l , i t deviates from i t s path. How f a r the b a l l deviates and how quickly i t returns t o the equi l ibrium path are also factors that a f f e c t the stability of conditions: the system.* that i s , Volatility is related to only one o f these i t i s a measurement o f how f a r and how o f t e n the b a l l deviates from some path. Measures of v o l a t i l i t y give us no information on how quickly the b a l l returns t o the equilibrium path and, indeed, cannot t e l l us whether the b a l l returns to i t s path a t a l l . Market systems n a t u r a l l y e x h i b i t more short-run v o l a t i l i t y than regulated ones because market forces continually make c o r r e c t i v e adjustments i n order t o return t h e i r bal l t o i t s equi l ibrium path. I n regulated systems, c o r r e c t i v e actions tend t o be deferred (supervisors pretend that the b a l l has not r e a l l y deviated from substantial ball interim. path), periods occasionally. the its of creating an nonadjustment, environment with substantial Large-scale adjustments o f t e n occur a t deviate farther and farther from in its which there adjustments are made the expense o f having equilibrium path in the Hence, the b a l l might stray from i t s equilibr,ium path more o f t e n and f o r longer periods o f time. *For s i m p l i c i t y , the discussion here t r e a t s the path o f the r o l l i n g b a l l as though i t were fixed. However, the analysis also i s v a l i d when the path i s allowed to evolve over time and to be a f f e c t e d by. the same forces as those a c t i n g on the b a l l . www.clevelandfed.org/research/workpaper/index.cfm The d i f f e r e n c e between the market and regulatory adjustment processes i s equivalent t o the d i f f e r e n c e i n exchange-rate adjustments under f l o a t i n g and fixed exchange-rate regimes. Under a f l o a t i n g exchange-rate regime, and demand factors i n markets cause nearly continuous adjustments o f exchange r a t e and, a t times, a high level o f short-run v o l a t i l i t y . f i x e d exchange-rate periods, with supply the Under a regime, the o f f i c i a l exchange r a t e i s maintained f o r long large adjustments made p e r i o d i c a l l y . Short-run volatility measured by movements i n exchange rates t y p i c a l l y would be low i n a fixed-rate regime, while actual v o l a t i l i t y i n the foreign exchange markets might be q u i t e high. Hence, regulated systems e x h i b i t less short-run v o l a t i l i t y than market systems, but conclusions about based s o l e l y on "measured" the relative s t a b i l i t y of short-run comparisons of apples and oranges and, volatility, the two systems, may be as misleading as i n any case, are subject t o the same "flows o f funds versus c a p i t a l stock" c r i t i c i s m mentioned above. To the extent that regulated systems achieve less short-run v o l a t i l i t y by suppressing the c o r r e c t i v e forces p r o b a b i l i t y that, over time, inherent i n markets, the greater a major adjustment would be needed. i s the This is analogous to the absence o f small earthquakes along a f a u l t l i n e , which allows stress to b u i l d up and thereby increases the p r o b a b i l i t y that a major quake eventually w i l l occur. Small quakes, l i k e self-correcting r e l i e v e the pressures that accumulate over time. market forces, Suppression o f these forces through regulatory interference allows the pressure t o r i s e and increases the magnitude and violence o f the r e s u l t i n g adjustment. Therefore, over the long run, regulated f i n a n c i a l systems tend to display more v o l a t i l i t y and t o stray farther from and adjust less quickly to the equilibrium market-oriented f i n a n c i a l systems. www.clevelandfed.org/research/workpaper/index.cfm path than References American Banker. 1990. Top Numbers 199Q (cumulative f o l i o publication). New York. Aspinwall, Richard, and Scott, Kenneth. 1989. "Federal Reserve Proposals t o Modify the Payments System Risk Reduction Program." Statement No. 45. Shadow Financial Regulatory Comnittee (September 18, 1989). Mid America I n s t i t u t e , Chicago, I l l i n o i s . Bagehot, Walter. New York: 1873. Scribner, Armstrong and Co. B a t i s t a , Paulo Nogueira, J r . Brasileira, A Description o f the Monev Market. Lombard Street: 1988. Da Crise lnternacional a Moratoria Rio de Janeiro, B r a z i l : Benston, George J., Hanweck, Gerald A . , "Scale Economies i n Banking: Paz e Terra. 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Committee on Banking, Finance and Urban A f f a i r s , Subcommittee on Financial Institutions, Supervision, Regulation and Insurance. Inquiry i n t ~ Continental I l l i n o i s Corp. and Continental I l l i n o i s National Bank. October 4. 1984 (98th Congress, Printing Office. 2nd Session). Washington, D.C.: S t a f f report c i t e d above i s a t pp. 418-445; Government testimony o f William M. lsaac i s a t pp. 457-491. Wolfson, Martin H. 1986. Experience. Armonk, New York: Zweig, P h i l l i p L. 1985. New York: Financial Crises: Bel l v Up: Understandina the Postwar U.S. M.E. Sharpe, Inc. The Collapse of the Penn Sauare Bank. Crown Publishers. www.clevelandfed.org/research/workpaper/index.cfm Table 1: D e f i n i t i o n s o f Variables CAPITAL = Total e q u i t y c a p i t a l . ClPC = Cash items i n the process o f c o l l e c t i o n and balances due from depository i n s t i t u t i o n s . ClPCC = CIPC/CAPITAL BDDl = Balances due from depository i n s t i t u t i o n s . BDDIC = BDDI/CAPITAL LDI = Loans t o depository i n s t i t u t i o n s . LDlC = LDI/CAPITAL A00 = Acceptances o f other banks. A B = AOB/CAPITAL OC FFS = Federal funds sold and s e c u r i t i e s purchased under agreements t o r e s e l l . FFSC = FFS/CAPITAL TOTEXP = CBDl + LDI + AB O + FFS. TOTEXPC = TOTEXP/CAPITAL www.clevelandfed.org/research/workpaper/index.cfm - Tab1 e 1 ,. continued F R = Exposure t o f o r e i g n banks i n the U . S . and abroad. O FOR c o n s i s t s o f balances due from f o r e i g n . banks, loans t o f o r e i g n banks, and acceptances o f f o r e i g n banks. FORC = FOR/CAPITAL ABR = Exposure t o U . S . and non-U.S. banks d o m i c i l e d i n f o r e i g n c o u n t r i e s . ABR c o n s i s t s o f balances due from banks abroad, loans t o banks abroad, and acceptances o f banks abroad. ABRC = ABWCAPITAL Source: Authors. www.clevelandfed.org/research/workpaper/index.cfm www.clevelandfed.org/research/workpaper/index.cfm assets Source: . commitments- Loan Standby letters of credit Commercial letters of F e d e r a l R e s e r v e Y-9 r e p o r t s a n d p u b l i s h e d f i n a n c i a l s t a t e m e n t s . B a n k e r s T r u s t , NY 55,658 C i t i c o r p , NY 230,643 C h a s e M a n h a t t a n , NY 107,369 M a n u f a c t u r e r s H a n o v e r , NY 60,479 48,857 Bank o f N . Y . , NY J P . Morgan, NY 88,964 M a r i n e M i d l a n d , NY 27,067 C h e m i c a l , NY 71,513 F i r s t Chicago, IL 47,907 Bank o f A m e r i c a , C A 98,764 31,467 M e l l o n Bank, PA PNC F i n a n c i a l , PA 45,661 BancOne, O ( o n l y ) H 26,514 22,972 .Natl. City, O H co , T o t a1 contracts Foreign exchange I t e m s o f S e l e c t e d L a r g e Bank H o l d i n g Companies (As o f December 31, 1 9 8 9 ) (Amounts i n m i l l i o n s o f d o l l a r s ) T a b l e 2 : Off-Balance-Sheet sJ!m= Interestrate www.clevelandfed.org/research/workpaper/index.cfm zLluZmh Time a n d savings deposits due t o N.A. N.A. N.A. 1,151 1,603 1,144 679 1,063 523 210 57 201 411 88 Source : ers 1 9 9 0 . N.A. N.A. N.A. 0 18 29 58 4 51 22 74 28 59 0 Demand Time a n d s a v i n g s d e p o s i t s due t o d e p o s i t s due t o foreign banks f o r e i g n banks M u l t i s t a t e bank h o l d i n g companiest t o t a l s might be o v e r s t a t e d due t o double-counting o f intra-company c l a i m s . 2,230 2,256 1,924 1,689 1,371 1,043 366 8 66 63 1 1,410 533 3 93 439 82 B a n k e r s T r u s t , NY C i t i b a n k , NY C h a s e M a n h a t t a n , NY M a n u f a c t u r e r s Hanover, MY Bank o f N . Y . , NY & DE Morgan G u a r a n t y , NY M a r i n e M i d l a n d , NY C h e m i c a l , NY & T X F i r s t Chicago, IL Bank o f America, CA M e l l o n Bank, PA P i t t s b u r g h N a t l . , PA & KY Bank One, OH, I N , TX, & W I N a t l . City, O H Note: a l l Demand deposits due t o ( A s o f J u n e 30, 1 9 8 9 ) (Amounts i n m i l l i o n s o f d o l l a r s ) 8.9 2.2 3.4 4.6 5.0 3.1 5.1 2.5 3.6 2.1 3.3 4.8 7.6 1.5 (est . ) (est.) (est.) (est . ) (est.) Interbank deposit: as a p e r c e n t of t o t a l deposits C o r r e s p o n d e n t B a l a n c e s a n d I n t e r b a n k D e p o s i t s o f S e l e c t e d L a r g e Banks Bank Table 3: www.clevelandfed.org/research/workpaper/index.cfm w m m m ; 'P. 1 a 2 3 2 X (D I1 0 O 0 W O N O 0 r O < 4 O t ° O W O * t r d N W n I W o W * I N I o O * 0 N W 0 I 8 s 0 S 5' 5 E & - h -. E e 3 E- 3' 3 z . 2 -. In m rt 3 * 5 s m % Y 0 2: 5. rt 0 D : S n - 'P. % rt 3 R n g: a -. 7 0r www.clevelandfed.org/research/workpaper/index.cfm z7.- ; I R ? = ? p W O W ( P m g ID z rr 0 m C 1 > : -4 0 -4 I - II i$- z-&.= m z!?: 8 * w N = rr w g W g W o o N rr 0 r r . o O oW W " N rr 0 w o w 0 rr 0 " w Z m w 2 B -B 1 m r r z m 5 - m u 7 % cl : -. e - v 0 % 2 $ m. . z w A & %D c j I: 2 6 m -* m K 7 -- K - n o pz EF d N - A n n 0 - n 4 Y O * n m Y z W n ? - n n n n 2 * 'at r. 8 -. n r W w o - n z n - u * n ?&?*P"?-O m A r W O " N - , z O Y C n n N N N Y P",P,Y,IU~ y w * - N * Z ' O- * F o y W m ~ Y c. n ?z 0, 0 4 . w $-EW%W:N w L%LSL2Lm&hE owSosmervso$E Y - n 0 ?'I ~ o * O e r r m-a - 0 5 ? ga w 5 7 rr 0 n n 2 ID 0 n m ?.a % d . = i!; m : E2 W,N,W,,~ W - 2 z ., 8 0 0'z g . o 0 \ O Y n S 0 n A n " 0 0 Y h n ? n - n N O . * 0.0 a Y C I d . 0 4 n n . N I n - r n W N * z N s O n u n 4 U . ~ N N $ 0 - n N N a n d ) ~ W _ * * f Y W U W w D rr C 7 4 0 = m m 0 0 W *_gg u Y" I - 0 0 n d P W _ i ~ . t ~ w 3 - 4 n - " & ' . . o"wm n U 4 d 0 0.0 Y n n 4 4 0 ? O W 0, Y Y S Y 3 p W " ,W F F g %O S 7 W 4 0 7 n Fzf -, 0 d . n n d ~ o g n n n n . O N N N Z C m W O W u ~ m ~ @ , O = N W 0 0 0 O n N N , . . ,zWzWZQaC* * -N,,W,OO;a;s 0 0 0 d . " ?dIU,.c'W L U ~ O O " , s G ; a z Y w " Z m z t = 3 2 - I -* n 0 d 5 a W ~ o N a ~ ) ~ * " Y O " - O n d - 4 W = . o \ W 0 0 Y n Y 3 O 0 n m . y r 3 0 p N N Y t - 0 7 o o * n 3 0 " 5 0 n A N n d n - N F 2 -8 -.- 0 W ? 0 W 0 3 0 I V Y ? ' ? - " . % U E s ~ m ~ 8Y ~ ~ " Y Y n d O d n . Y n n n - C N I n N N ",.c'"?Y'&Pf'E! ? f s g W F gygaEspgg5e Y n d 0 4 O W n - n n - n Y = z % n W N W F W F IUU - Y - *w. - - * . W O W Z *A 2 * O N m N y N q Y y C y L-R 0, Y r V) 3 Y www.clevelandfed.org/research/workpaper/index.cfm 2171 (100.00) $100 t o $300 mi lli o n 3/84 3/90 12184 9723 1574 (100.00) (100.00) (100.00) Under S 100 million 3/84 3/90 449 (100.00) Source: ALL BANKS 3/84 3/90 22 45 14466 13025 (100.00) (100.00) (100.00) (100.00) Over $10 billion 3/84 3/90 Federal Deposit Insurance Corporation's Reports o f Condition and Income f o r March 1984 and March 1590. . $1 t o $10 b i lli o n 3/84 3/90 709 237 377 (100.00) (100.00) (100.00) Assets $300 t o $1000 million 3/84 3/90 a. LO1 = Loans t o depository i n s t i t u t i o n s . b. C a p i t a l i s defined as t o t a l e q u i t y c a p i t a l (book value). c. Percent o f banks ( ) TOTAL Over 300% 200 t o 300% 100 t o 200% 50 t o 100% 25 t o 50% 0 t o 25% a percent of capitalb L O I ~as Nunber o f Banks Table 6: Cross-Sectional D i s t r i b u t i o n o f LDlC www.clevelandfed.org/research/workpaper/index.cfm O Z N O o* W 0 0 O 0m * 0 U O o C a a n A N U o 1 4 O * oN u u S S O W 8N 0 A n n * ? ? ? ;',!"NPS 2 4 s u O W % g , ' ~ s ~ s A A Y Y Y A A A A p p p * ; E Z N g e g + eO w W A A Y Y ? 0 U - ? ' g , Y " 4 . o * , w L O Y A ! Y Y Y N W U A P . ? ? N % , * Y Y . n n Y Y A A P 0 O N 0 o o 0 o P ~ N W U - * U - u 4 ~ ~ ~ Y pPJ 9 p , w ~ 0 A P P 0 0 0 0 0 A P 0 0 0 - f 0 f ? U U ' Q N 0 u - W 4 - 0 Y Y Y A www.clevelandfed.org/research/workpaper/index.cfm h C1 u O 7 o g 0 s o g ) ° o A u - - C u o I g : 8 S w A A 3 C , A w u I o O O 0 C1 s h ) w A A u N y y p h ) . Ww - r U ' IU m k c L $ * g g E g g - N ~ 0 Y Q - l ~ W m Y n A A A N ESIY A h ) A A h ) A h ) Y A A - ?' F A ) h A i? - ? N ? ' W ? h ) . rwoyW-lzo 0 C 4 - u W h)myWLIg Y ~ - Y Y h A A l N - n ) O A W W A ?' ?' ? W ? g g $" L R J c J 2 .2 g u Y W y W A Y W N Y ? .NAY - N A A A W s5zgrxJ ? U A a A A ?' A A A W Y-Np,?, Q u N W u ~ Y ~ ~ ~ C G J E , , N Y A A y 3 3 A A N y A A y W m p N - Q u m u ~ * W . , y ~ O ~ N Y W m y O ~ N Y A A A N A d U . A N ' d ? A S " ! I " , % = I : ' E E 2 g $ 3 % Y Y Y A A N m A Y A . - -. Y Y g n - i Y ) h - Y A h " I A h ) ? P N .U,f G) I A z Y A A A h ) 0 h ) f W -l u * , u r u y W Z j o z -R w ~ o ~ h , Y www.clevelandfed.org/research/workpaper/index.cfm 3/90 3/84 3/90 million $100 t o 3300 = Total measured interbank exposure. 3/84 Under S 100 million Source: 3/84 3/90 mi 11i o n 3/84 3/90 b i Ili o n $ t o $10 1 3/84 3/90 Over $10 billion 3/90 ALL BANKS 3/84 Federal Deposit Insurance Corporation's Reports o f Condition and Income f o r Harch 1984 and March 1990. c. Percent o f . banks ( ). Assets $300 t o $1000 b. C a p i t a l i s d e f i n e d as t o t a l e q u i t y c a p i t a l (book value). a. TOTEXP TOTAL Over 300% a percent o f capitalb TOTEXP~ as Nunber of Banks Table 9: Cross-Sectional D i s t r i b u t i o n o f TOTEXPC www.clevelandfed.org/research/workpaper/index.cfm o A p p A p A p A 3 A s RN=ozNzNs*~N 0 0 0 - 4 0 Y W Z c 2. - i$ -. n ? ? ? ? a s * A A A A eNzaz-ew~Ng: Y Y Y 7 W w o \ 3 g 0 0 Y www.clevelandfed.org/research/workpaper/index.cfm Y Y n 0 n 0 n ? n : ' n 0 n 0 ,YN, zW:Wz=sRsEgG Y .. - o a 4 - o . 0 p N w u 0 W W -- m 0 Y Y ~ Y T a b l e 12: What t h e F e d e r a l R e s e r v e Used t o P u b l i s h COMMERCIAL DANICS 1435 RESERVES AND LIA I L ~ E S COMMERCIAL BANKS. BY CLAS F E S ~ OF n n rr lllons of d o l l m ] Demand deposiu Tlmc dcposiu Certl- Reserve Dank8 call date Mrnlhcr. total 194 1 -Dec. 1945-Dec. 1947-ncc. I95R-llec. 1959-Dec. 1960-ncc. 1961-Jcino Scpt. 27 ....I 16,038) 2;932I .... .. K r - . York C1lv:S mestlc adbanks. iurted7 ,, - ctc. tlons F ~ ~ . m c s t i c ~ etgn' 6.761 Indl- --- I 1941-Dcc. 31 1 9 4 s - ~ C C . 31.. 1947-Dcc. 31. I9SR-ncc. 31 1959-kc. 31 . 1960-Dcc. 31 1961-Junc 30 .... Scot. 27.. 1.1 ... .... ... .... 8 llrcakdowns of loan. Investment. and denorlt cla*rlllc available prior to 1947: aummary h g u r u for earlier dater preceding table. P o r a d~rcusslonof rcvlslon In loan schedule. see the v r m l o r Juruary 1960. p. 12. 1 G n t r a l reserve city banks. Dcginning w i ~ h1942. excludu reciprocal bank balancer. YThrouph 1960. demand dcpositr othcr than Interharc and J.S. Government. lers cash items reported u in process of collcctic I: begin ~ n g * Source: F e d e r a l R e s e r v e B u l l e t i n -47 (December 1961) , p. '1435. www.clevelandfed.org/research/workpaper/index.cfm Figure 1: Cash Items in the Process of Collection Percent of capital All banks - - - Assets < $100 million - - - - Assets $100 to $300 million - - Assets $300 million to $1 billion ,,, ,, , ................. Assets $1 to $10 billion -. .- Assets > $10 billion SOURCE: Federal Financ~al Institutions Exam~natlon Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 2: Balances Due from Depository lnstitutio'ns All banks - - - Assets < $100 million -- - - Assets $100 to $300 million - - - - - - - - Assets $300 million to $1 billion ................. Assets $1 to $10 billion -. .- Assets > $10 billion SOURCE: Federal Financial lnstitutlons Examination Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 3: Loans to Depository Institutions Percent of capital 140 All banks - - - Assets < $100 million - - - - Assets $100 to $300 million - - - - - - - - Assets $300 million to $1 billion ..,...-. ........Assets $1 to $10 billion . .-Assets > $10 billion -. SOURCE: Federal Financial lnst~tutions Examination Council's Reports of Condition & Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 4: Acceptances of Other Banks Percent of cap~tal 11 10- \ \ 8- \ 6- 4- 2 - All banks - - - Assets < $100 million -- - - Assets $100 to $300 million - - - - - - - - Assets $300 million to $1 billion ................. Assets $1 to $10 billion -. .- Assets > $10 billion SOURCE: Federal Financial lnst~tut~ons Examination Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 5: Federal Funds Sold and Repurchase Agreements Purchased All banks - - - Assets < $100 million - - - - Assets $100 to $300 million - - - - - - - - Assets $300 million to $1 billion .................Assets $1 to $10 billion -. .-Assets > $10 billion SOURCE: Federal Financial lnstitut~ons Examination Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 6: Total Measured Exposure Percent of c a ~ i t a l All banks - - - Assets < $100 million - - - - Assets $100 to $300 million - - - - - - - Assets $300 million to $1 billion , .................Assets $1 to $10 billion .- Assets > $10 billion -. SOURCE: Federal Financial Institutions Examination Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 7: Exposure to Foreign Banks Abroad and Their U.S. Branches Percent of capltal 325 "O- \. 250 200 L. - - \ -1 . 150- 100 .............. .. .....-...-.... ...... I 50 ' - \ ------_ - - - ----0 ...-.. --. .. -. I 12 9 3 3 a4 I 1 2 , ~ ~ I 12/85 I 12.86 72/87 12188 12/89 3/90 6 ' w All banks - - - - Assets $100 to $300 million - - - - - Assets $300 million to $1 billion , ,, ................. Assets $1 to $10 billion .- Assets > $10 billion -. SOURCE: Federal Financial lnstitut~ons Examination Council's Reports of Condition 8 Income. www.clevelandfed.org/research/workpaper/index.cfm Figure 8: Exposure to U.S. and Non-U.S. Banks Domiciled in Foreign Countries Percent of c a ~ i t a l All banks - - - - Assets $100 to $300 million - - - - - - - - Assets $300 million to $1 billion ................. Assets $1 to $10 billion -. .- Assets > $10 billion SOURCE: Federal Financial Institutions Examination Council's Reports of Condition & Income. www.clevelandfed.org/research/workpaper/index.cfm