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Workina Paper 9017
AN INSIDER'S VIEW OF THE POLITICAL ECONOMY
OF THE TOO BIG TO FAIL DOCTRINE
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 .
We express our g r a t i t u d e t o Laura Davis f o r seemingly
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
Why the Too Big t o F a i l Doctrine Matters
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
We 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.
We
had
to
have
The guarantee was extraordinary but
not unprecedented.
We had given s i m i l a r p u b l i c
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.
Whv the Too Bia t o F a i l Doctrine Matters
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, we explain why the p o l i c y
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 we define a few key terms.
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
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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
a banker's bank
kept accounts
Of
course,
.
in
1933,
--
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
the
simply
did
FDIC
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) .
We believe t h a t ,
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 .
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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, we use the term "interbank exposure" to refer to such
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 we believe that interbank exposure could and should be reduced
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.
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*
*
*
'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.
We argue t h a t , up t o a given level o f exposure,
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 ,
we
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.
We present our conclusions and
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).
We
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
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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
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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
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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
We are unaware of any study that indicates that r i s i n g interbank exposure
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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.
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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 ....
...
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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.
We have already noted t h a t the
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,
we
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.
We have used Smith's
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 me
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.
We be l i eve that what Hoover meant i n that passage i s that Robinson was
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
me 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
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):
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Worse s t i I I , the Comptrol l e r informed me that these
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 me that
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
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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.
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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 my plan and
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 me that they
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. My nerves were perhaps overstrained when I
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, we selected f i v e categories o f interbank
risk:
CIPC, BDDI, LDI, AOB, and FFS.
We also looked a t measures o f i n t e r -
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 '
'
We also recognize that the
same c r i t i c i s m applies t o FOR, our measure o f exposure t o non-U.S.
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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 ) .
We construct the variables i n table 1 for
subsample
(except
for
FOR
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 we are concerned w i t h here i s the
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
$10 b i l l ion) from March 1984 to March 1990.
The individual bank s t a t i s t i c s
i n table 5 general l y confirm the aggregate p a t t e r n of exposure i n f i g u r e 2.
Overal l BDDl exposures are high enough a t a number o f banks i n each s i z e
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category to warrant further s c r u t i n y by bank supervisory a u t h o r i t i e s .
Figure 3 and table 6 show the p a t t e r n o f LDI exposure for U.S. banks.
Looking a t f i$ure 2, we 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
AOBC over
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,
AOBC
ratio
is a
AOB i s less than 10
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 AOBC i s generally an unimportant source o f
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,
in
may
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 FORC and ABRC, so they are omitted from these
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 FOR and ABR, because t h i s type of interbank exposure i s
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.
Figures 7 and 8 show that FORC and ABRC 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 ABRC have declined a t a s l i g h t l y
greater r a t e over the sample period.
of
Tables 10 and 11 confirm the results
the figures and indicate that FORC and ABRC may represent a p o t e n t i a l
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,
we must p o i n t out several caveats
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,
we
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 , we cannot determine
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
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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 we readi l y
, 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
On the other hand, i t i s clear from our study that there
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.
We
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
As the c r e d i t q u a l i t y o f nonbank borrowers decreases,
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 we noted i n section V I I ,
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, we suggest t h a t :
Banks be r e s t r i c t e d to having not more than 50 percent of
their
capital
(including
companies)
primary
at
risk
bank,
and
that
supervisor
to any s i n g l e
thrift,
they
any
and
be
financial
institution
ho(ding
nonbank-financial
required
combination of
to
report
direct
and
to
their
indirect
www.clevelandfed.org/research/workpaper/index.cfm
exposures t o any f i n a n c i a l i n s t i t u t i o n that exceeds 15 percent
o f t h e i r primary c a p i t a l .
- a l s o would
be
discipline.
financial
Public disclosure o f such exposures
helpful
For
in
asset
institutions
advancing
exposures
the
to
i n excess o f
cause
(claims
of
market
on)
other
15 percent o f
capital,
o f f s e t t i n g l i a b i l i t y exposure on the claimant bank's balance
sheet
could be deducted when determining
exposure t o any one f i n a n c i a l
institution.
i t s net
All
interbank
net, d i r e c t
interbank exposures that exceed 50 percent o f c a p i t a l ( i n the
aggregate)
should
scrutinized
by
be
publicly
examiners
as
disclosed
part
of
and
the
should
be
examinat ion
.-
process 131
Banks have aggregate
primary regulators.
then
publicly
Ii m i ts.)
interbank-exposure
(Alternative:
disclose
their
l i m i t s set by t h e i r
banks should determine and
own d i r e c t
These aggregate exposure
interbank-exposure
I i m i t s should
include a
r e s t r i c t i o n on exposure to banks w i t h i n the claimant bank's
local clearinghouse association and separate l i m i t s on t o t a l
exposure t o a l l banks i n the domestic banking system and to
all
foreign
Because
of
banks
for
regional,
each p a r t i c u l a r
country
concentration-of-risk
of
origin.
patterns
that
emerged i n the 1980s, i t also might be useful t o have banks
calculate
Federal
and
disclose
Reserve D i s t r i c t .
aggregate
Because
interbank
exposures
by
there
no
or
is
theory
evidence that t e l l s us how high to set the aggregate exposure
www.clevelandfed.org/research/workpaper/index.cfm
levels, we defer to banks' own p u b l i c l y disclosed judgments or
t o judgments o f the regulators on t h i s issue.
However, U.S.
bankers do have experience i n determining d i r e c t
interbank-
exposure l i m i t s , both under Federal Reserve-sponsored payments
system
risk-reduction
initiatives
and
on
their
i n i t i a t i v e s , even without Federal Reserve involvement
[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.
We believe that no domestic
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.
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-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, we believe) that the terminology we were using then (and
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):
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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.
www.clevelandfed.org/research/workpaper/index.cfm
10. There
i s a form o f
interbank exposure (some o f
l i a b i l i t y side o f banks1 ledgers,
other banks.
including,
i t offsetting)
f o r example,
on the
claims due t o
Such exposure, a l s o referred t o as "funding r i s k , " increases
the contagion r i s k
regarding banks'
funding sources.
For
the sake o f
s i m p l i c i t y and manageability, and because funding r i s k i s already a widely
f o r example, Wolfson [1986],
recognized and researched problem (see,
106-121),
we
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).
We base our
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 my [ 19831 paper. But
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?
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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.
AOBC = AOB/CAPITAL
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
+
AOB
+
FFS.
TOTEXPC = TOTEXP/CAPITAL
www.clevelandfed.org/research/workpaper/index.cfm
-
Tab1 e 1 ,. continued
FOR = Exposure t o f o r e i g n banks i n the U . S . and abroad.
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 , CA
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, OH ( o n l y )
26,514
22,972
. N a t l . C i t y , OH
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 & TX
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 . C i t y , OH
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
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
$1 t o $10
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
T O T E X P ~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
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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
OF COMMERCIAL BANKS. BY CLAS F E S ~
n n rr lllons of d o l l m ]
Demand deposiu
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
,-,
Certl-
Indl-
ctc.
tlons
F ~ ~ .
m c s t i c ~ etgn'
6.761
Tlmc dcposiu
---
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~alInstitutions Exam~natlonCouncil'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~tutionsExamination 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~onsExamination 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
1 2I , ~ ~
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~onsExamination 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
@FedFRASER