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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

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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

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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

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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.

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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).

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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.

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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

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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,

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...

[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 . "
[1986],

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 [1980]).
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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:

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[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
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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

[1980],

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 [1989]; 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 [1988];

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

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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
[1988]).

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 [1990]).
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
[1989]).

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 [1983]), 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 [1990]).
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 [1983].)

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 [1952],

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 [1988],
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
[1967],

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.
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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).

..

.

.

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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.

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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

[1952],

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
[1951].)

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

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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

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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

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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

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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

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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

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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

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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
[1983], 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,

[1985],

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 [1932]).

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.

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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 [1986],

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:

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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 [1989];

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

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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:

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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
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www.clevelandfed.org/research/workpaper/index.cfm
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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

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www.clevelandfed.org/research/workpaper/index.cfm
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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


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102