《货币银行学》课程教学资源（文献资料）The Decline of Traditional

The Decline of TraditionalBanking: Implications for FinancialStability and Regulatory PolicyFranklin R. Edwards and Frederic S. Mishkin The views expressed in this article are those of the authors and do not necessarily reflect the position of the FederalReserveBankofNewYorkortheFederalReserveSystem.The Federal Reserve Bank of New York provides no warranty, express or implied, as to the accuracy, timeliness, com-pleteness,merchantability,orfitness for any particularpurpose of any information contained in documents producedand provided by the Federal Reserve Bank of New York in any form or manner whatsoeverThe traditional banking business has been tonothing else,the prospect of a mass exodus from themake long-term loans and fund them by issu-banking industry (possibly via increased failures) coulding short-dated deposits, a process that iscause instability in the financial system. Of greater con-commonly described as “borrowing short andcern is that declining profitability could tip the incen-lending long.In recent years, fundamental economictives of bank managers toward assuming greater risk inforces have undercut the traditional role of banks in finan-an effort to maintain former profit levels.For example,cial intermediation.Asa sourceoffundsforfinancialinter-banks might make loans to less creditworthy borrowers ormediaries,deposits have steadily diminished in importance.engage in nontraditional financial activities that promiseIn addition, the profitability of traditional banking activi-higher returns but carry greater risk. A new activity thatties such as business lending has diminished in recenthas generated particular concern recently is the expand-years. As a result, banks have increasingly turned to new.ing role of banks as dealers in derivatives products. Therenontraditional financial activities as a way of maintainingis a fear that in seeking new sources of revenue in deriva-their position as financial intermediaries.2tives, banks may be taking risks that could ultimatelyThis article has two objectives: to examine theundermine their solvency and possibly the stability of theforces responsible for the declining role of traditionalbanking system.banking in the United States as well as in other countries,The challenge posed by the decline of traditionalandtoexploretheimplicationsofthisdeclineandbanksbanking is twofold:we need to maintain the soundness ofresponses to it for financial stability and regulatory polthebanking system whilerestructuring thebanking indus-icy. A key policy issue is whether the decline of bankingtry to achieve long-term financial stability. A sound regula-threatens to make the financial system more fragile. Iftory policy can encourage an orderly shrinkage of27FRBNYECONOMICPOLICYREVIEW/JULY1995

FRBNY ECONOMIC POLICY REVIEW / JULY 1995 27 The Decline of Traditional Banking: Implications for Financial Stability and Regulatory Policy Franklin R. Edwards and Frederic S. Mishkin 1 he traditional banking business has been to make long-term loans and fund them by issu￾ing short-dated deposits, a process that is commonly described as “borrowing short and lending long.” In recent years, fundamental economic forces have undercut the traditional role of banks in finan￾cial intermediation. As a source of funds for financial inter￾mediaries, deposits have steadily diminished in importance. In addition, the profitability of traditional banking activi￾ties such as business lending has diminished in recent years. As a result, banks have increasingly turned to new, nontraditional financial activities as a way of maintaining their position as financial intermediaries.2 This article has two objectives: to examine the forces responsible for the declining role of traditional banking in the United States as well as in other countries, and to explore the implications of this decline and banks’ responses to it for financial stability and regulatory pol￾icy. A key policy issue is whether the decline of banking threatens to make the financial system more fragile. If nothing else, the prospect of a mass exodus from the banking industry (possibly via increased failures) could cause instability in the financial system. Of greater con￾cern is that declining profitability could tip the incen￾tives of bank managers toward assuming greater risk in an effort to maintain former profit levels. For example, banks might make loans to less creditworthy borrowers or engage in nontraditional financial activities that promise higher returns but carry greater risk. A new activity that has generated particular concern recently is the expand￾ing role of banks as dealers in derivatives products. There is a fear that in seeking new sources of revenue in deriva￾tives, banks may be taking risks that could ultimately undermine their solvency and possibly the stability of the banking system. The challenge posed by the decline of traditional banking is twofold: we need to maintain the soundness of the banking system while restructuring the banking indus￾try to achieve long-term financial stability. A sound regula￾tory policy can encourage an orderly shrinkage of T The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the accuracy, timeliness, com￾pleteness, merchantability, or fitness for any particular purpose of any information contained in documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever

traditional banking while strengthening the competitiveThrift institutions (savings and loans, mutual savingsposition of banks,possibly by allowing them to expandbanks, and credit unions),which can be viewed as special-intomoreprofitable,nontraditionalactivities.Inthetran-ized banking institutions, have also suffered a decline insitional period, of course, regulators would have to con-market share, from more than 20 percent in the late 1970stinue to guard against excessive risk taking that couldtobelow10percent inthe1990s (Chart2)threaten financial stabilityAnother way of viewing the declining role ofThe first part of our article documents the declin-banking in traditional financial intermediation is to look ating financial intermediation role of traditional banks inthe United States.We discuss the economic forces drivingIn the United States, the importance ofthis decline, in both the United States and foreign coun-tries,and describe how banks have responded to thesecommercial banks as a source of funds topressures. Included in this discussion is an examina-nonfinancial borrowers has shrunktion of banks'activities in derivatives markets, a par-ticularly fast-growing area of their off-balance-sheetdramatically.In 1974 banks providedactivities.Finally,weexaminetheimplicationsof the35 percent of these funds; today theychanging nature of banking for financial fragility andregulatorypolicyprovide around 22 percent.THEDECLINE OF TRADITIONALBANKINGIN THE UNITED STATESthe size of banks'balance-sheet assets relative to those ofIn the United States,the importance ofcommercial banksotherfinancialintermediaries(Table1).Commercialbanksas a source of funds to nonfinancial borrowers has shrunkshare of total financial intermediary assets fell from arounddramatically. In 1974 banks provided 35 percent of thesethe 40 percent range in the 1960-80 period to belowfunds; today they provide around 22 percent (Chart 1)30percentbytheendof1994.Similarly,theshareoftotalfinancial intermediary assets held by thrift institutionsChart IChart 2CommercialBanks'ShareofTotalNonfinancialThrifts' Share of Total Nonfinancial BorrowingBorrowing1960-941960-94PercentPercent254035110255 LL120 LL70809196065707580859094196065759094Source: Board of Governors of the Federal Reserve System, Flow ofSource: Board of Governors of the Federal Reserve System, Flow ofFunds AccountsFunds Accounts.28FRBNYECONOMICPOLICYREVIEW/JULY1995

28 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 traditional banking while strengthening the competitive position of banks, possibly by allowing them to expand into more profitable, nontraditional activities. In the tran￾sitional period, of course, regulators would have to con￾tinue to guard against excessive risk taking that could threaten financial stability. The first part of our article documents the declin￾ing financial intermediation role of traditional banks in the United States. We discuss the economic forces driving this decline, in both the United States and foreign coun￾tries, and describe how banks have responded to these pressures. Included in this discussion is an examina￾tion of banks’ activities in derivatives markets, a par￾ticularly fast-growing area of their off-balance-sheet activities. Finally, we examine the implications of the changing nature of banking for financial fragility and regulatory policy. THE DECLINE OF TRADITIONAL BANKING IN THE UNITED STATES In the United States, the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically. In l974 banks provided 35 percent of these funds; today they provide around 22 percent (Chart 1). Thrift institutions (savings and loans, mutual savings banks, and credit unions), which can be viewed as special￾ized banking institutions, have also suffered a decline in market share, from more than 20 percent in the late 1970s to below 10 percent in the 1990s (Chart 2). Another way of viewing the declining role of banking in traditional financial intermediation is to look at the size of banks’ balance-sheet assets relative to those of other financial intermediaries (Table 1). Commercial banks’ share of total financial intermediary assets fell from around the 40 percent range in the 1960-80 period to below 30 percent by the end of 1994. Similarly, the share of total financial intermediary assets held by thrift institutions In the United States, the importance of commercial banks as a source of funds to nonfinancial borrowers has shrunk dramatically. In l974 banks provided 35 percent of these funds; today they provide around 22 percent. Chart 1 Percent 1960 65 70 75 80 85 90 94 20 25 30 35 40 Commercial Banks’ Share of Total Nonfinancial Borrowing 1960-94 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. Chart 2 Percent Thrifts’ Share of Total Nonfinancial Borrowing 1960-94 1960 65 70 75 80 85 90 94 5 10 15 20 25 Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts

Overallbankprofitability,however,isnotagoodTableRELATIVESHARES OFTOTALFINANCIALINTERMEDIARYindicatoroftheprofitabilityoftraditionalbankingbecauseASSETS,1960-94Percentitincludestheincreasinglyimportantnontraditional busi19601970198019901994nesses of banks. As a share of total bank income, noninter-Insurance companiesest income derived from off-balance-sheet activities, such12.519.615.311.513.0Life insurance4.44.9Property and casualty3.84.54.6as fee and trading income, averaged 19 percent in the Pension funds1960-80period(Chart4).By1994,thissourceofincome6.4Private8.412.514.916.2Public (state and localhad grown to about 35 percent of total bank income.3.34.64.96.78.4government)4.74.95.15.65.3Finance companiesAlthough some of this growth in fee and trading incomeMutual fundsmay be attributable to an expansion of traditional fee activ-2.93.61.75.910.8Stock and bond0.00.01.94.64.2Money marketities,much of it isnot.Depository institutions (banks)Commercial banks38.638.537.230.428.6Acrudemeasureof theprofitabilityof thetradi-Savings and loans andtional banking business is to excludenoninterest income19.019.419.612.57.0mutual savings1.11.41.62.02.0Credit unionsfrom total earnings, since much of this income comes fromTotal100.0100.0100.0100.0100.0nontraditional activities.By thismeasure,the pretax returnSource: Board of Governors of the Federal Reserve System, Flow of Fundson equity fell from more than 10 percent in 1960 to levelsAccounts.that approached negative 10percent in the late1980s andearly1990s(Chart5).Thismeasure,however,doesnotdeclined from around 20 percent in the 1960-80 period toadjustfortheexpensesassociatedwithgeneratingnonin-below10 percent by1994.3Boyd and Gertler (1994) and Kaufman and Mote(1994)correctlypoint outthatthedeclineintheshareofChart 3total financial intermediary assets held by banking institu-ReturnonAssetsandEquityforCommercialBanks1960-94tions does not necessarily indicatethat the banking indus-try is in decline.Because banks have been increasing theirPercentPercent222.0off-balance-sheetactivities (an issuewediscuss below),wemay understate their role in financial markets if we look1.820Return on equitysolely at the on-balance-sheet activities.However,theScale1.618decline in traditional banking,which isreflected in thedecline in banks' share of total financial intermediary1.416assets,raisesimportantpolicyissuesthatarethefocusof1.2-this article.There is also evidence of an erosion in traditional121.0banking profitability. Nevertheless, standard measures ofcommercial bank profitability such as pretax rates of0.810Return on assetsScalereturn on assets and equity (shown in Chart 3) do not pro-0.68vide a clear picture of the trend in bank profitabilityAlthough banks'before-tax rate of return on equity0.46declined from an average of 15 percent in the 1970-844 L0.2period to below 12 percent in the 1985-91 period, bank19606570758085.9094profits improved sharply beginning in 1992, and 1994Sources: Federal Deposit Insurance Corporation, Statistis an Banking andwasarecord yearforbankprofits.Quarterly Banking Profile29FRBNYECONOMICPOLICYREVIEW/JULY1995

FRBNY ECONOMIC POLICY REVIEW / JULY 1995 29 declined from around 20 percent in the 1960-80 period to below 10 percent by 1994.3 Boyd and Gertler (1994) and Kaufman and Mote (1994) correctly point out that the decline in the share of total financial intermediary assets held by banking institu￾tions does not necessarily indicate that the banking indus￾try is in decline. Because banks have been increasing their off-balance-sheet activities (an issue we discuss below), we may understate their role in financial markets if we look solely at the on-balance-sheet activities. However, the decline in traditional banking, which is reflected in the decline in banks’ share of total financial intermediary assets, raises important policy issues that are the focus of this article. There is also evidence of an erosion in traditional banking profitability. Nevertheless, standard measures of commercial bank profitability such as pretax rates of return on assets and equity (shown in Chart 3) do not pro￾vide a clear picture of the trend in bank profitability. Although banks’ before-tax rate of return on equity declined from an average of 15 percent in the 1970-84 period to below 12 percent in the 1985-91 period, bank profits improved sharply beginning in 1992, and 1994 was a record year for bank profits. Overall bank profitability, however, is not a good indicator of the profitability of traditional banking because it includes the increasingly important nontraditional busi￾nesses of banks. As a share of total bank income, noninter￾est income derived from off-balance-sheet activities, such as fee and trading income, averaged 19 percent in the 1960-80 period (Chart 4). By 1994, this source of income had grown to about 35 percent of total bank income. Although some of this growth in fee and trading income may be attributable to an expansion of traditional fee activ￾ities, much of it is not. A crude measure of the profitability of the tradi￾tional banking business is to exclude noninterest income from total earnings, since much of this income comes from nontraditional activities. By this measure, the pretax return on equity fell from more than 10 percent in 1960 to levels that approached negative 10 percent in the late 1980s and early 1990s (Chart 5). This measure, however, does not adjust for the expenses associated with generating nonin￾Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts. Table 1 RELATIVE SHARES OF TOTAL FINANCIAL INTERMEDIARY ASSETS, 1960-94 Percent 1960 1970 1980 1990 1994 Insurance companies Life insurance 19.6 15.3 11.5 12.5 13.0 Property and casualty 4.4 3.8 4.5 4.9 4.6 Pension funds Private 6.4 8.4 12.5 14.9 16.2 Public (state and local government) 3.3 4.6 4.9 6.7 8.4 Finance companies 4.7 4.9 5.1 5.6 5.3 Mutual funds Stock and bond 2.9 3.6 1.7 5.9 10.8 Money market 0.0 0.0 1.9 4.6 4.2 Depository institutions (banks) Commercial banks 38.6 38.5 37.2 30.4 28.6 Savings and loans and mutual savings 19.0 19.4 19.6 12.5 7.0 Credit unions 1.1 1.4 1.6 2.0 2.0 Total 100.0 100.0 100.0 100.0 100.0 Return on Assets and Equity for Commercial Banks 1960-94 Chart 3 Percent Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile. 4 6 8 10 12 14 16 18 20 22 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 1960 65 70 75 80 85 90 94 Percent Return on equity Scale Return on assets Scale

Chart 4terest incomeandthereforeoverstatesthedeclineintheShareofNoninterestIncomeinTotal Incomeprofitability of traditional banking.Another indicator offor Commercial Banksthedeclineintheprofitabilityoftraditional bankingisthe1960-94fall in the ratio of market value to book value of bank capi-Percenttal fromthemid-1960stotheearly1980s.Asnotedby35Keeley(1990),thisfall indicatesthatbankcharterswerebecoming less valuable in this period (Chart 6).The30decline in the value of bank charters in the years precedingthe sharp increase in nontraditional activities supports the25viewthattherewasa substantial decline intheprofitabilityoftraditional banking.Onlywiththeriseinnontraditional20activitiesthatbegins intheearly1980s(Chart4)doesthemarket value of banksbegintorise.15 L196094657075808590WHYISTRADITIONALBANKINGSources: Federal Deposit Insurance Corporation, Statistis an Banking andINDECLINE?Quarterly Banking ProfileFundamental economic forces have led to financial innova-tions that have increased competition in financial markets.Greater competition in turn has diminished the costadvantage banks have had in acquiring funds and hasundercut their position in loan markets. As a result, tradiChart5tional banking has lost profitability,and banks have begunReturnonAssetsandEquityforCommercialBankstodiversifyintonewactivitiesthatbringhigherreturns.ExcludingNoninterestIncome1960-94PercentPercent120.94Chart6Return on equityEquity-to-AssetRatios,MarketValuevs.BookValue30.6Scale1960-930.3Percent20Return on assetsScale00Market value of equity15-4-0.30-8-0.6-12-0.95Book value of equity-16-1.2o11196065707580938590-20 LL/L-1.51:1196065707580859094Source: Standard and Poor's Compustat.Sources:Federal Deposit Insurance Corporation, Statistics an Banking andNote: Chart presents equity-to-asset ratios for the top twenty-five bankQuarterlyBanking Profileholding companies in each year.30FRBNYECONOMICPOLICYREVIEW/JULY1995

30 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 terest income and therefore overstates the decline in the profitability of traditional banking. Another indicator of the decline in the profitability of traditional banking is the fall in the ratio of market value to book value of bank capi￾tal from the mid-1960s to the early 1980s. As noted by Keeley (1990), this fall indicates that bank charters were becoming less valuable in this period (Chart 6). The decline in the value of bank charters in the years preceding the sharp increase in nontraditional activities supports the view that there was a substantial decline in the profitability of traditional banking. Only with the rise in nontraditional activities that begins in the early 1980s (Chart 4) does the market value of banks begin to rise. WHY IS TRADITIONAL BANKING IN DECLINE? Fundamental economic forces have led to financial innova￾tions that have increased competition in financial markets. Greater competition in turn has diminished the cost advantage banks have had in acquiring funds and has undercut their position in loan markets. As a result, tradi￾tional banking has lost profitability, and banks have begun to diversify into new activities that bring higher returns. Chart 4 Percent 1960 65 70 75 80 85 90 94 15 20 25 30 35 Share of Noninterest Income in Total Income for Commercial Banks 1960-94 Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile. Chart 6 Percent 0 5 10 15 20 1960 65 70 75 80 85 90 93 Book value of equity Market value of equity Source: Standard and Poor’s Compustat. Note: Chart presents equity-to-asset ratios for the top twenty-five bank holding companies in each year. Equity-to-Asset Ratios, Market Value vs. Book Value 1960-93 Return on Assets and Equity for Commercial Banks Excluding Noninterest Income 1960-94 Chart 5 Percent Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile. -20 -16 -12 -8 -4 0 4 8 12 -1.5 -1.2 -0.9 -0.6 -0.3 0 0.3 0.6 0.9 1960 65 70 75 80 85 90 94 Percent Return on assets Scale Return on equity Scale

DIMINISHEDADVANTAGEINACQUIRINGFUNDScost of funds rose substantially.reducing the cost advan(LIABILITIES)tage they enjoyed.Until1980,deposits were a cheapsource offundsforU.Sbanking institutions (commercial banks, savings and loans,DIMINISHED INCOME (OR LOAN) ADVANTAGESmutual savings banks, and credit unions). Deposit rateBanks have also experienced a deterioration in the incomeceilings prevented banks from paying interest on checkableadvantages they once enjoyed on theasset side of their bal-deposits,and Regulation Q limited them to paying speci-ancesheets.Thegrowthof thecommercialpaperandjunkfied interest rate ceilings on savings and time deposits. Forbond markets and the increased securitization of assetsmany years, these restrictions worked to the advantage ofhave undercut banks' traditional advantage in providingcredit.banks because a major source of bank funds was checkableImprovements in information technology,whichdeposits (in 1960 and earlier years, these deposits consti-tuted more than 60 percent of total bank deposits).Thehave made it easier for households,corporations, and finan-zero interest cost on these deposits resulted in banks hav-cial institutions to evaluate the quality of securities, haveing a low average cost of funds.made it easier for business firms to borrow directly fromThis cost advantage did not last. The rise in inflathe public by issuing securities. In particular, instead oftion beginning in the late 1960s led to higher interestgoing to banks to finance short-term credit needs, manyratesandmadeinvestorsmoresensitivetoyielddifferen-businesscustomersnowborrowthroughthecommercialtials on different assets. The result was the so-called disin-paper market.Total nonfinancial commercial paper out-termediationprocess,in whichdepositors took theinstanding as a percentage of commercial and industrial bankmoney out of banks paying low interest rates on bothloanshas risen from5percent in1970 tomore than 20per-checkable and time deposits and purchased higher yield-cent today.ing assets. In addition, restrictive bank regulations cre-The rise of money market mutual funds has alsoated an opportunity for nonbank financial institutions toindirectly undercut banks by supporting the expansion ofinvent new ways to offer bank depositors higher rates.competing finance companies.The growth of assets inNonbank competitors were not subject to deposit ratemoney market mutual funds to more than S500 billionceilings and did not have the costs associated with havingcreated a ready market for commercial paper becauseto hold non-interest-bearing reserves and paying depositmoney market mutual funds must hold liquid, highinsurance premiums. Akey development was the creationquality, short-term assets.Further, the growth in theof money market mutual funds. which put banks at acommercial paper market has enabled finance companies,competitive disadvantage because money market mutualwhich depend on issuing commercial paper for much offund shareholders (or depositors) could obtain check-their funding, to expand their lending at the expense ofwriting services while earning a higher interest rate onbanks. Finance companies provide credit to many of thetheir funds. Not surprisingly, as a source of funds forsame businesses that bankshave traditionallyserved.Inbanks, low-cost checkable deposits declined dramatically.1980,financecompanyloanstobusinesses amountedtofallingfrom 60 percent ofbank liabilities in 1960 to underabout 30 percent of banks' commercial and industrial20 percent today.loans;today these loans constitutemorethan60percentofThe growing disadvantage of banks in raisingbanks'commercialandindustrial loans.funds led to their supporting legislation in the 1980s toThe junk bond market has also taken business awayeliminate Regulation Q ceilings on time deposits and tofrombanks.Inthepast,onlyFortune500companieswereallow checkable deposits that paid interest (NOWable to raise funds by selling their bonds directly to the pub-accounts).Although the ensuing changes helped to makelic,bypassingbanks.Now,evenlower quality corporatebor-banks more competitive in their quest forfunds,the banksrowers can readily raise funds through access to the junk31FRBNYECONOMICPOLICYREVIEW/JULY1995

FRBNY ECONOMIC POLICY REVIEW / JULY 1995 31 DIMINISHED ADVANTAGE IN ACQUIRING FUNDS (LIABILITIES) Until 1980, deposits were a cheap source of funds for U.S. banking institutions (commercial banks, savings and loans, mutual savings banks, and credit unions). Deposit rate ceilings prevented banks from paying interest on checkable deposits, and Regulation Q limited them to paying speci- fied interest rate ceilings on savings and time deposits. For many years, these restrictions worked to the advantage of banks because a major source of bank funds was checkable deposits (in l960 and earlier years, these deposits consti￾tuted more than 60 percent of total bank deposits). The zero interest cost on these deposits resulted in banks hav￾ing a low average cost of funds. This cost advantage did not last. The rise in infla￾tion beginning in the late 1960s led to higher interest rates and made investors more sensitive to yield differen￾tials on different assets. The result was the so-called disin￾termediation process, in which depositors took their money out of banks paying low interest rates on both checkable and time deposits and purchased higher yield￾ing assets. In addition, restrictive bank regulations cre￾ated an opportunity for nonbank financial institutions to invent new ways to offer bank depositors higher rates. Nonbank competitors were not subject to deposit rate ceilings and did not have the costs associated with having to hold non-interest-bearing reserves and paying deposit insurance premiums. A key development was the creation of money market mutual funds, which put banks at a competitive disadvantage because money market mutual fund shareholders (or depositors) could obtain check￾writing services while earning a higher interest rate on their funds. Not surprisingly, as a source of funds for banks, low-cost checkable deposits declined dramatically, falling from 60 percent of bank liabilities in l960 to under 20 percent today. The growing disadvantage of banks in raising funds led to their supporting legislation in the 1980s to eliminate Regulation Q ceilings on time deposits and to allow checkable deposits that paid interest (NOW accounts). Although the ensuing changes helped to make banks more competitive in their quest for funds, the banks’ cost of funds rose substantially, reducing the cost advan￾tage they enjoyed. DIMINISHED INCOME (OR LOAN) ADVANTAGES Banks have also experienced a deterioration in the income advantages they once enjoyed on the asset side of their bal￾ance sheets. The growth of the commercial paper and junk bond markets and the increased securitization of assets have undercut banks’ traditional advantage in providing credit. Improvements in information technology, which have made it easier for households, corporations, and finan￾cial institutions to evaluate the quality of securities, have made it easier for business firms to borrow directly from the public by issuing securities. In particular, instead of going to banks to finance short-term credit needs, many business customers now borrow through the commercial paper market. Total nonfinancial commercial paper out￾standing as a percentage of commercial and industrial bank loans has risen from 5 percent in l970 to more than 20 per￾cent today. The rise of money market mutual funds has also indirectly undercut banks by supporting the expansion of competing finance companies. The growth of assets in money market mutual funds to more than $500 billion created a ready market for commercial paper because money market mutual funds must hold liquid, high￾quality, short-term assets. Further, the growth in the commercial paper market has enabled finance companies, which depend on issuing commercial paper for much of their funding, to expand their lending at the expense of banks. Finance companies provide credit to many of the same businesses that banks have traditionally served. In 1980, finance company loans to businesses amounted to about 30 percent of banks’ commercial and industrial loans; today these loans constitute more than 60 percent of banks’ commercial and industrial loans. The junk bond market has also taken business away from banks. In the past, only Fortune 500 companies were able to raise funds by selling their bonds directly to the pub￾lic, bypassing banks. Now, even lower quality corporate bor￾rowers can readily raise funds through access to the junk

bond market.Despitepredictions of the demise of the junkBefore1980,twoU.S.banks,Citicorp and BankAmericabond market after the Michael Milken embarrassment, it isCorporation,werethelargest banks in theworld.Intheclear that the junk bond market is here to stay. Although1990s,neither ofthese banksranks amongthetop twenty.sales of new junk bonds slid to $2.9 billion by 1990, theyAlthough some of this loss in market share may be due toreboundedtoS16.9billionin1991,S42billionin1992,the depreciation of the dollar, most of it is not.and $60 billion in 1993.Similarforces are working to undermine the tradiThe ability to securitize assets has made nonbanktional role of banks in other countries. The U.S. banks arefinancial institutions evenmoreformidable competitors fornot alone in losing their monopoly power over depositors.banks. Advances in information and data processing tech-Financial innovation and deregulation are occurring world-nology have enabled nonbank competitors to originatewideand have created attractive alternatives forboth deposloans,transformtheseintomarketablesecurities,and sellitors and borrowers.In Japan,for example, deregulation hasthem to obtain more funding with which to make moreopened a wide array of new financial instruments to theloans.Computer technology has eroded the competitivepublic, causing a disintermediation process similar to theone that has taken place in the United States.In Europeancountries, innovations have steadily eroded the barriers thathave traditionally protected banks from competition.U.S. banks are not alone in losing theirInothercountries,bankshavealsofacedincreasedmonopoly power over depositors. Financialcompetition from the expansion of securities markets.Both financial deregulation and fundamental economicinnovation and deregulation are occurringforces abroad have improved the availability of informationworldwide.in securities markets,making it easier and less costly forbusiness firms to finance their activities by issuing securi-ties rather than going to banks. Further, even in countriesadvantage of banks by lowering transactions costs andwhere securities markets have not grown, banks have stillenabling nonbank financial institutions to evaluate creditlost loan business because their best corporate customersrisk efficiently throughthe use of statistical methodshave had increasing access to foreign and offshore capitalWhen credit risk can be evaluated using statistical tech-markets such as the Eurobond market.In smaller econo-niques, as in the case of consumer and mortgage lending,mies, such as Australia, which still do not have well-banks no longer have an advantage in making loans.4 Andeveloped corporate bond or commercial paper markets.effort is being made in the United States to develop a mar-banks have lost loan business to international securitiesket for securitized small business loans as well.markets.In addition,the sameforces that drove the securi-U.S. banks have also been beset by increased for-tization process in the United States are at work in othereigncompetition,particularlyfromJapaneseandEuropeancountriesand will undercuttheprofitabilityof traditionalbanks.The success of the Japanese economy and Japan'sbanking there. Thus, although the decline of traditionalhigh savings rate gave Japanese banks access to cheaperbanking has occurred earlier in the United States than infundsthan wereavailableto American banks.This costother countries,we can expect a diminishedrolefor tradi-advantagepermitted Japanese banks to seek out loan busi-tional banking in these countries as well.ness in the United States more aggressively, eroding U.S.banksmarket share. In addition, banks from all majorHOWHAVEBANKSRESPONDED?countries followed their corporate customers to the UnitedIn any industry, a decline in profitability usually results inStates and often enjoyed a competitive advantage becauseexit from the industry (often by widespread bankruptcies)and a shrinkage of market share. This occurred in theof less burdensome regulation in their own countries.32FRBNYECONOMIC POLICY REVIEW/JULY1995

32 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 bond market. Despite predictions of the demise of the junk bond market after the Michael Milken embarrassment, it is clear that the junk bond market is here to stay. Although sales of new junk bonds slid to $2.9 billion by 1990, they rebounded to $16.9 billion in 1991, $42 billion in 1992, and $60 billion in 1993. The ability to securitize assets has made nonbank financial institutions even more formidable competitors for banks. Advances in information and data processing tech￾nology have enabled nonbank competitors to originate loans, transform these into marketable securities, and sell them to obtain more funding with which to make more loans. Computer technology has eroded the competitive advantage of banks by lowering transactions costs and enabling nonbank financial institutions to evaluate credit risk efficiently through the use of statistical methods. When credit risk can be evaluated using statistical tech￾niques, as in the case of consumer and mortgage lending, banks no longer have an advantage in making loans.4 An effort is being made in the United States to develop a mar￾ket for securitized small business loans as well. U.S. banks have also been beset by increased for￾eign competition, particularly from Japanese and European banks. The success of the Japanese economy and Japan’s high savings rate gave Japanese banks access to cheaper funds than were available to American banks. This cost advantage permitted Japanese banks to seek out loan busi￾ness in the United States more aggressively, eroding U.S. banks’ market share. In addition, banks from all major countries followed their corporate customers to the United States and often enjoyed a competitive advantage because of less burdensome regulation in their own countries. Before 1980, two U.S. banks, Citicorp and BankAmerica Corporation, were the largest banks in the world. In the 1990s, neither of these banks ranks among the top twenty. Although some of this loss in market share may be due to the depreciation of the dollar, most of it is not. Similar forces are working to undermine the tradi￾tional role of banks in other countries. The U.S. banks are not alone in losing their monopoly power over depositors. Financial innovation and deregulation are occurring world￾wide and have created attractive alternatives for both depos￾itors and borrowers. In Japan, for example, deregulation has opened a wide array of new financial instruments to the public, causing a disintermediation process similar to the one that has taken place in the United States. In European countries, innovations have steadily eroded the barriers that have traditionally protected banks from competition. In other countries, banks have also faced increased competition from the expansion of securities markets. Both financial deregulation and fundamental economic forces abroad have improved the availability of information in securities markets, making it easier and less costly for business firms to finance their activities by issuing securi￾ties rather than going to banks. Further, even in countries where securities markets have not grown, banks have still lost loan business because their best corporate customers have had increasing access to foreign and offshore capital markets such as the Eurobond market. In smaller econo￾mies, such as Australia, which still do not have well￾developed corporate bond or commercial paper markets, banks have lost loan business to international securities markets. In addition, the same forces that drove the securi￾tization process in the United States are at work in other countries and will undercut the profitability of traditional banking there. Thus, although the decline of traditional banking has occurred earlier in the United States than in other countries, we can expect a diminished role for tradi￾tional banking in these countries as well. HOW HAVE BANKS RESPONDED? In any industry, a decline in profitability usually results in exit from the industry (often by widespread bankruptcies) and a shrinkage of market share. This occurred in the U.S. banks are not alone in losing their monopoly power over depositors. Financial innovation and deregulation are occurring worldwide

banking industry in the United States during the 1980sChart8through consolidations and bank failures.From 1960 toCommercial Real Estate Loans as a Percentage of TotalCommercialBankAssets1980, bank failures in the United States averaged less than1960-94Percent12To survive and maintain adequate profit levels10many U.s. banks are facing two alternatives.8First, they can attempt to maintain their6traditional lending activity by expanding intonew, riskier areas of lending. .. [Second, theycan pursue new,off-balance-sheet activitiesn2 657075808590941960that are more profitable.Sources: Board of Governors of the Federal Reserve System, Federal ReerveBulletin and Flow of Funds Accounts.ten per year, but during the 1980s, bank failures soared, ris-estate loans, traditionally a riskier type of loan (Chart 8).Ining to more than 200 a year in the late 1980s (Chart 7).addition, they have increased lending for corporate take-To survive and maintain adequate profit levels,oversandleveragedbuyouts,whicharehighlyleveragedmany U.S. banks are facing two alternatives. First, they cantransactions.Thereisevidencethat bankshaveinfactattempt to maintain their traditional lending activity byincreased their lending to less creditworthy borrowers.expanding into new,riskier areas of lending.For example,During the 1980s, banks loan loss provisions relative toU.S. banks have increased their risk taking by placing aassets climbed substantially, reaching a peak of 1.25 per-greater percentage of their total funds in commercial realChart9Chart 7Loan Loss Provisions Relative to AssetsBankFailuresforCommercialBanks1960-941960-94NumberPercent2501.52001.01501000.5500 LOL1196065707580S949019608707580859094Sources: Federal Deposit Insurance Corporation, 1993 Ammual Report andSources: Federal Deposit Insurance Corporation, Statistics on Banking andQuarterly Banking ProfileQuarterly Banking Profile33FRBNYECONOMICPOLICYREVIEW/JULY1995

FRBNY ECONOMIC POLICY REVIEW / JULY 1995 33 banking industry in the United States during the l980s through consolidations and bank failures. From 1960 to 1980, bank failures in the United States averaged less than ten per year, but during the l980s, bank failures soared, ris￾ing to more than 200 a year in the late l980s (Chart 7). To survive and maintain adequate profit levels, many U.S. banks are facing two alternatives. First, they can attempt to maintain their traditional lending activity by expanding into new, riskier areas of lending. For example, U.S. banks have increased their risk taking by placing a greater percentage of their total funds in commercial real estate loans, traditionally a riskier type of loan (Chart 8). In addition, they have increased lending for corporate take￾overs and leveraged buyouts, which are highly leveraged transactions. There is evidence that banks have in fact increased their lending to less creditworthy borrowers. During the l980s, banks’ loan loss provisions relative to assets climbed substantially, reaching a peak of 1.25 per￾To survive and maintain adequate profit levels, many U.S. banks are facing two alternatives. First, they can attempt to maintain their traditional lending activity by expanding into new, riskier areas of lending. . . . [Second, they can] pursue new, off-balance-sheet activities that are more profitable. Chart 7 Number 1960 65 70 75 80 85 90 94 0 50 100 150 200 250 Bank Failures 1960-94 Sources: Federal Deposit Insurance Corporation, 1993 Annual Report and Quarterly Banking Profile. Chart 8 Percent Sources: Board of Governors of the Federal Reserve System, Federal Reserve Bulletin and Flow of Funds Accounts. Commercial Real Estate Loans as a Percentage of Total Commercial Bank Assets 1960-94 1960 65 70 75 80 85 90 94 2 4 6 8 10 12 Chart 9 Percent 1960 65 70 75 80 85 90 94 0 0.5 1.0 1.5 Loan Loss Provisions Relative to Assets for Commercial Banks 1960-94 Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile

cent in 1987.Only with the strong economy in 1994 havebanks should be permitted to engage in unlimited deriva-loan loss provisions fallen to levelsfound in the worst yearstives activities, including serving as off-exchange or over-the-counter (OTC) derivatives dealers. Some feel that suchof the 1970s (Chart 9). Recent evidence suggests that largebankshavetakenevenmoreriskthanhavesmallerbanksactivities are riskier than traditional banking and couldlargebanks havesuffered thelargestloanlosses (Boydandthreaten the stability of the entire banking system. (WeGertler 1993).Thus, banks appear to have maintaineddiscuss this issue more fully later in the paper.)The United States is not the only countryto expe-theirprofitability(andtheirnetinterestmargins-interestincome minus interest expense divided by total assets) byrience increased risk taking by banks. Large losses andtaking greater risk (Chart 10).5 Using stock market mea-suresofrisk,DemsetzandStrahan(1995)alsofindthatbefore1991 largebankholding companies took on moreMuch of the controversy surrounding bankssystematicrisk than smallerbank holding companies.efforts to diversify into off-balance-sheetThe second way banks have sought to maintainformer profit levels is to pursue new, off-balance-sheetactivities has centered on the increasing roleactivities that are more profitable.As Chart 4 shows, U.S.of banks in derivatives markets.commercial banks did this during the early 1980s, dou-blingtheshareoftheirincomecomingfromoff-balance-sheet, noninterest-income activities.6 This strategy. how-ever,has generated concernsaboutwhat activities arebank failures have occurred in other countries. Banks inproper for banks and whether nontraditional activitiesNorway, Sweden,and Finland responded to deregulationmight be riskier and result in banks'taking excessive risk.by dramatically increasing their real estate lending, a moveAlthough banks have increased fee-based activities, thefollowed by a boom and bust in real estate sectors thatarea of expanding activities in nontraditional banking thatresulted in the insolvency of many large banking institu-has raised the greatest concern is banks' derivatives activi-tions.Indeed, banks'loan losses in these countries as a fracties.Great controversy surrounds the issue of whethertion of GNP exceeded losses inboththebanking and thesavings and loans industries in the United States. TheInternational MonetaryFund (1993) reports that govern-Chart 10ment (or taxpayer) support to shore up the banking systemNet Interest Margins for Commercial Banksin Scandinaviancountries isestimatedtorangefrom2.8to1960-944.0 percent of GDP.This support is comparable to the sav-Percentings and loan bailout in the United States,which4.0amounted to 3.2percent of GDP.Japanesebankshavealsosufferedlargelossesfrom3.5riskier lending, particularly to the real estate sector. Thecollapse of real estate values in Japan left many banks with30huge losses.Ministry of Finance estimates in June 1995indicated that Japanese banks were holding 40trillion yen(S470 billion) of nonperforming loans—loans on whichinterest payments had not been made for more than six2.01months-but many private analysts think that the actual8019606570758590amountof nonperformingloans maybe substantiallySources: Federal Deposit Insuraln, Statistics on Banking andlarger.Quarterly Banking Profile34FRBNYECONOMICPOLICYREVIEW/JULY1995

34 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 cent in 1987. Only with the strong economy in 1994 have loan loss provisions fallen to levels found in the worst years of the 1970s (Chart 9). Recent evidence suggests that large banks have taken even more risk than have smaller banks: large banks have suffered the largest loan losses (Boyd and Gertler 1993). Thus, banks appear to have maintained their profitability (and their net interest margins—interest income minus interest expense divided by total assets) by taking greater risk (Chart 10).5 Using stock market mea￾sures of risk, Demsetz and Strahan (1995) also find that before 1991 large bank holding companies took on more systematic risk than smaller bank holding companies. The second way banks have sought to maintain former profit levels is to pursue new, off-balance-sheet activities that are more profitable. As Chart 4 shows, U.S. commercial banks did this during the early 1980s, dou￾bling the share of their income coming from off-balance￾sheet, noninterest-income activities.6 This strategy, how￾ever, has generated concerns about what activities are proper for banks and whether nontraditional activities might be riskier and result in banks’ taking excessive risk. Although banks have increased fee-based activities, the area of expanding activities in nontraditional banking that has raised the greatest concern is banks’ derivatives activi￾ties. Great controversy surrounds the issue of whether banks should be permitted to engage in unlimited deriva￾tives activities, including serving as off-exchange or over￾the-counter (OTC) derivatives dealers. Some feel that such activities are riskier than traditional banking and could threaten the stability of the entire banking system. (We discuss this issue more fully later in the paper.) The United States is not the only country to expe￾rience increased risk taking by banks. Large losses and bank failures have occurred in other countries. Banks in Norway, Sweden, and Finland responded to deregulation by dramatically increasing their real estate lending, a move followed by a boom and bust in real estate sectors that resulted in the insolvency of many large banking institu￾tions. Indeed, banks’ loan losses in these countries as a frac￾tion of GNP exceeded losses in both the banking and the savings and loans industries in the United States. The International Monetary Fund (1993) reports that govern￾ment (or taxpayer) support to shore up the banking system in Scandinavian countries is estimated to range from 2.8 to 4.0 percent of GDP. This support is comparable to the sav￾ings and loan bailout in the United States, which amounted to 3.2 percent of GDP. Japanese banks have also suffered large losses from riskier lending, particularly to the real estate sector. The collapse of real estate values in Japan left many banks with huge losses. Ministry of Finance estimates in June 1995 indicated that Japanese banks were holding 40 trillion yen ($470 billion) of nonperforming loans—loans on which interest payments had not been made for more than six months—but many private analysts think that the actual amount of nonperforming loans may be substantially larger. Much of the controversy surrounding banks’ efforts to diversify into off-balance-sheet activities has centered on the increasing role of banks in derivatives markets. Chart 10 Percent Sources: Federal Deposit Insurance Corporation, Statistics on Banking and Quarterly Banking Profile. Net Interest Margins for Commercial Banks 1960-94 1960 65 70 75 80 85 90 94 2.0 2.5 3.0 3.5 4.0

French andBritishbankssufferedfromthereplace some of their lost"banking" revenue with theworldwide collapse of real estate prices and from majorattractive returns that can be earned in derivatives markets.failures of risky real estate projects funded by banks.Banks haveincreased theirparticipation in deriv-Olympia and York's collapse is a prominent example.Theativesmarketsdramaticallyinthelastfewyears.In1994loan-loss provisions of Britishand French banks,likeU.S.banks held derivatives contracts totalingmorethanthose of U.S.banks,have risen in the1990s.Oneresults16trillion in notional value.8Ofthesecontracts,63perhas been the massive bailout of Credit Lyonnais by thecent were interest rate derivatives,35 percent were foreignFrenchgovernmentinMarch1995.Evenincountriesexchange derivatives, and the remainder were equity andwith healthy banking systems, such as Switzerland andcommodityderivatives.9In addition,most of thesederiv-Germany,some banks have run into trouble.Regionalatives wereheld bylargebanks,and wereheld primarilybanks in Switzerland failed, and Germany's BfG Bankto facilitate the banks'dealer and trading operationssufferedhugelosses(DM1.1billion)in1992andneeded(Table 2).10 In 1994, the seven largest U.S.-bank derivaa capital infusion from its parent company, Credit Lyon-tivesdealersaccounted formorethan90 percentof thenais.Thus,fundamentalforces not limitedtotheUnitednotional value of all derivatives contractsheldbyU.S.banks (Table 3).11 The profitability of derivatives activitiesStateshave causedadeclineintheprofitabilityof traditional banking throughout the world and have created anhas clearly encouraged banks to step up their involvementin 1994, derivatives accounted for between 15 and 65 per-incentiveforbankstoexpandintonewactivitiesandtakeadditional risks.cent of the total trading income of four of the largest bankdealers (Table 4).12The increased participation of banks in derivativesBANKS' OFF-BALANCE-SHEET DERIVATIVESACTIVITIESmarkets has been aconcernto both regulatorsand legislaMuch of the controversy surrounding banks'efforts totors because they fear that derivatives may enable banks todiversify into off-balance-sheet activities has centered ontake morerisk than is prudent.Therecanbe little doubtthe increasing role of banks in derivatives markets. Largethat derivatives can be used to increase risk substantiallybanks, in particular,have moved aggressively to becomeworldwide dealers in off-exchange or OTC derivatives,Table3such as swaps.Their motivation, clearly,has been toNOTIONAL/CONTRACT DERIVATIVES AMOUNTS OF FIFTEENMAJORU.S.OVER-THE-COUNTERDERIVATIVESDEALERSMillions of DollarsBanksTable2Chemical Banking Corporation3,177.600DERIVATIVES CONTRACTS2,664,600CiticorpDecember 31,1994J.P. Morgan & Co., Inc.2,472,500Bankers Trust New York Corporation2,025.736Asset/LiabilityBankAmerica Corporation1,400.707TradingTotalPercentagee Management PercentageThe Chase Manhattan Corporation1,360,000(S Billions)ofTotal(S Billions)ofTotal(S Billions)First Chicago Corporation622,100BankAmerica951,3336851,401Securities firms00N10045Bank One1,509.000Salomon, Inc984421,9822,026Bankers Trust1,326.000Merrill Lynch&Co..Inc67595Chase1,2931.3601,143.091Lehman Brothers, Inc.973109Chemical3,0693.178The Goldman Sachs Group, LP.995,2759221682,4492,665CiticorpMorgan Stanley Group, Inc.843.00088122,180292J.P. Morgan2,472Insurance companies54859526511NationsBankAmerican International Group, Inc.376,86969486713.658Total/averagea12,791306,159General Re Corporation102,.102The Prudential Insurance Co. of AmericaSources:Annual reports for 1994Total17,852,239oals,eressed inbillions ofllar,appear incolums3, and5.Aera.expressed as percentages, appear in columns 2 and 4.Sources: Annual reports for 1994.35FRBNYECONOMICPOLICYREVIEW/JULY1995

FRBNY ECONOMIC POLICY REVIEW / JULY 1995 35 French and British banks suffered from the worldwide collapse of real estate prices and from major failures of risky real estate projects funded by banks. Olympia and York’s collapse is a prominent example. The loan-loss provisions of British and French banks, like those of U.S. banks, have risen in the l990s. One result has been the massive bailout of Credit Lyonnais by the French government in March 1995. Even in countries with healthy banking systems, such as Switzerland and Germany, some banks have run into trouble. Regional banks in Switzerland failed, and Germany’s BfG Bank suffered huge losses (DM 1.1 billion) in l992 and needed a capital infusion from its parent company, Credit Lyon￾nais. Thus, fundamental forces not limited to the United States have caused a decline in the profitability of tradi￾tional banking throughout the world and have created an incentive for banks to expand into new activities and take additional risks. BANKS’ OFF-BALANCE-SHEET DERIVATIVES ACTIVITIES Much of the controversy surrounding banks’ efforts to diversify into off-balance-sheet activities has centered on the increasing role of banks in derivatives markets. Large banks, in particular, have moved aggressively to become worldwide dealers in off-exchange or OTC derivatives, such as swaps.7 Their motivation, clearly, has been to replace some of their lost “banking” revenue with the attractive returns that can be earned in derivatives markets. Banks have increased their participation in deriv￾atives markets dramatically in the last few years. In l994, U.S. banks held derivatives contracts totaling more than $16 trillion in notional value.8 Of these contracts, 63 per￾cent were interest rate derivatives, 35 percent were foreign exchange derivatives, and the remainder were equity and commodity derivatives.9 In addition, most of these deriv￾atives were held by large banks, and were held primarily to facilitate the banks’ dealer and trading operations (Table 2).10 In l994, the seven largest U.S.-bank deriva￾tives dealers accounted for more than 90 percent of the notional value of all derivatives contracts held by U.S. banks (Table 3).11 The profitability of derivatives activities has clearly encouraged banks to step up their involvement: in 1994, derivatives accounted for between 15 and 65 per￾cent of the total trading income of four of the largest bank dealers (Table 4).12 The increased participation of banks in derivatives markets has been a concern to both regulators and legisla￾tors because they fear that derivatives may enable banks to take more risk than is prudent. There can be little doubt that derivatives can be used to increase risk substantially, Sources: Annual reports for 1994. Table 3 NOTIONAL/CONTRACT DERIVATIVES AMOUNTS OF FIFTEEN MAJOR U.S. OVER-THE-COUNTER DERIVATIVES DEALERS Millions of Dollars Banks Chemical Banking Corporation 3,177,600 Citicorp 2,664,600 J.P. Morgan & Co., Inc. 2,472,500 Bankers Trust New York Corporation 2,025,736 BankAmerica Corporation 1,400,707 The Chase Manhattan Corporation 1,360,000 First Chicago Corporation 622,100 Securities firms Salomon, Inc. 1,509,000 Merrill Lynch & Co., Inc. 1,326,000 Lehman Brothers, Inc. 1,143,091 The Goldman Sachs Group, L.P. 995,275 Morgan Stanley Group, Inc. 843,000 Insurance companies American International Group, Inc. 376,869 General Re Corporation 306,159 The Prudential Insurance Co. of America 102,102 Total 17,852,239 Sources: Annual reports for 1994. a Totals, expressed in billions of dollars, appear in columns 1, 3, and 5. Averages, expressed as percentages, appear in columns 2 and 4. Table 2 DERIVATIVES CONTRACTS December 31, 1994 Trading ($ Billions) Percentage of Total Asset/ Liability Management ($ Billions) Percentage of Total Total ($ Billions) BankAmerica 1,333 95 68 5 1,401 Bank One 0 0 45 100 45 Bankers Trust 1,982 98 44 2 2,026 Chase 1,293 95 67 5 1,360 Chemical 3,069 97 109 3 3,178 Citicorp 2,449 92 216 8 2,665 J.P. Morgan 2,180 88 292 12 2,472 NationsBank 485 95 26 5 511 Total/averagea 12,791 94 867 6 13,658

and can potentially be quite dangerous.13 In the last year,In May1994,RepresentativeGonzalez andRepre-many banks sustained substantial losses on interest ratesentative Jim Leach introduced the Derivatives Safety andSoundness Act of 1994. This bill directs the federal bank-derivatives instruments when interestrates continued torise.Because of the leverage that is possible, derivativesing agencies to establish common principles and standardsenablebankstoplacesizable"bets"on interestrate andforcapital,accounting.disclosure,andexaminationofcurrency movements, whichif wrong—can result in siz-financial institutions using derivatives. In addition, the billable losses. In addition,as dealers in OTC derivatives mar-requires the Federal Reserve and the U.S. Comptroller ofkets,banks maybe exposed to substantial counterpartythe Currency to work with other central banks to developcredit risk. Unlike organized futures exchanges, the OTCcomparable international supervisorystandardsforfinan-market offers no clearinghouse guarantee to mitigate thecial institutions using derivatives.In discussing the needcredit risk involved in derivatives trading. Finally, becausefor derivatives legislation,Representative Leach said,"onederivatives are often complex instruments, sophisticatedof the ironies of the development of [derivatives markets] isthat while [individual firm] risk can be reduced . . : sys-risk-control systems may be necessary to measure and tracka bank's potential exposure.Questions have been raisedtematic risk can be increased."A second problem,Leachabout whether banks are currently capable of managingnoted, is that inmanycases derivativesinstruments"arethese risks.too sophisticated for financial managers."15 Afurther indi-Concern about the growing participation of bankscation of these concerns is the plethora of recent studiesinderivativesmarketsisexemplifiedbytheremarksofthathaveexaminedtheactivitiesoffinancial institutions inRepresentative Henry Gonzalez,Chairman of the Bankingderivativesmarkets.Studies have been conducted by theBank for International Settlements(the“PromiselCommitteeof the House of Representatives:Report"), the Bank of England, the Group of Thirty, theI have long believed that growing bankOffice of the U.S. Comptroller of the Currency, the Com-involvement in derivative products is, as I say andmodityFutures Trading Commission,and,most recentlyrepeat, like a tinderbox waiting to explode. In thetheU.S.GovernmentAccountingOffice(GAO)caseofmanymarketinnovations,regulationlagsThe GAO released its report,"Financial Deriva-behind until the crisis comes, as it has happenedtives: Actions Needed to Protect the Financial System,"inin our case with S&L's and banks..We must work to avoid a crisis related toMay 1994.The report concluded that there is some reasonderivative products before, once again,..thetax-to believe that derivatives do pose a threat to financial sta-payer is left holding the bag.14bility. It raises the prospect that a default by a major OTCderivatives dealer-and in particular by a major bank-could result in spillover effects that could "close down"OTC derivatives markets, with potentially serious ramifi-cationsfortheentirefinancial system.TheGAOrecom+ohaCONTRIBUTION OF DERIVATIVES TRADING TO TOTALmends that a number ofmeasures be taken to strengthenTRADINGINCOMEgovernment regulation and supervision of all participants19931994PercentPercent(S Millions)(S Millions)in OTC derivatives markets, including banks.Chase108201518The fear of a major bank failure because of OTC391453Chemical2740029800Citicorpderivatives activities appears to stem from two sources.6636539797J.P. MorganFirst, the sheer size of banks OTC derivatives activities4234Total/averagea1,5622,251suggests that they may be exposed to substantial marketSources: Company annual reports.and creditrisk because oftheir derivatives positions.Ina Totals, expressed in millions of dollars, appear in columns 1 and 3. Averagesexpressed as percentages,appearincolumns 2and 4particular, there is concern that as OTC derivatives deal-36FRBNYECONOMICPOLICYREVIEW/JULY1995

36 FRBNY ECONOMIC POLICY REVIEW / JULY 1995 and can potentially be quite dangerous.13 In the last year, many banks sustained substantial losses on interest rate derivatives instruments when interest rates continued to rise. Because of the leverage that is possible, derivatives enable banks to place sizable “bets” on interest rate and currency movements, which—if wrong—can result in siz￾able losses. In addition, as dealers in OTC derivatives mar￾kets, banks may be exposed to substantial counterparty credit risk. Unlike organized futures exchanges, the OTC market offers no clearinghouse guarantee to mitigate the credit risk involved in derivatives trading. Finally, because derivatives are often complex instruments, sophisticated risk-control systems may be necessary to measure and track a bank’s potential exposure. Questions have been raised about whether banks are currently capable of managing these risks. Concern about the growing participation of banks in derivatives markets is exemplified by the remarks of Representative Henry Gonzalez, Chairman of the Banking Committee of the House of Representatives: I have long believed that growing bank involvement in derivative products is, as I say and repeat, like a tinderbox waiting to explode. In the case of many market innovations, regulation lags behind until the crisis comes, as it has happened in our case with S&L’s and banks. . . . We must work to avoid a crisis related to derivative products before, once again, . . . the tax￾payer is left holding the bag.14 In May 1994, Representative Gonzalez and Repre￾sentative Jim Leach introduced the Derivatives Safety and Soundness Act of l994. This bill directs the federal bank￾ing agencies to establish common principles and standards for capital, accounting, disclosure, and examination of financial institutions using derivatives. In addition, the bill requires the Federal Reserve and the U.S. Comptroller of the Currency to work with other central banks to develop comparable international supervisory standards for finan￾cial institutions using derivatives. In discussing the need for derivatives legislation, Representative Leach said, “one of the ironies of the development of [derivatives markets] is that while [individual firm] risk can be reduced . . . sys￾tematic risk can be increased.” A second problem, Leach noted, is that in many cases derivatives instruments “are too sophisticated for financial managers.”15 A further indi￾cation of these concerns is the plethora of recent studies that have examined the activities of financial institutions in derivatives markets. Studies have been conducted by the Bank for International Settlements (the “Promisel Report”), the Bank of England, the Group of Thirty, the Office of the U.S. Comptroller of the Currency, the Com￾modity Futures Trading Commission, and, most recently, the U.S. Government Accounting Office (GAO). The GAO released its report, “Financial Deriva￾tives: Actions Needed to Protect the Financial System,” in May 1994. The report concluded that there is some reason to believe that derivatives do pose a threat to financial sta￾bility. It raises the prospect that a default by a major OTC derivatives dealer—and in particular by a major bank— could result in spillover effects that could “close down” OTC derivatives markets, with potentially serious ramifi- cations for the entire financial system. The GAO recom￾mends that a number of measures be taken to strengthen government regulation and supervision of all participants in OTC derivatives markets, including banks. The fear of a major bank failure because of OTC derivatives activities appears to stem from two sources. First, the sheer size of banks’ OTC derivatives activities suggests that they may be exposed to substantial market and credit risk because of their derivatives positions. In particular, there is concern that as OTC derivatives deal￾Sources: Company annual reports. a Totals, expressed in millions of dollars, appear in columns 1 and 3. Averages, expressed as percentages, appear in columns 2 and 4. Table 4 CONTRIBUTION OF DERIVATIVES TRADING TO TOTAL TRADING INCOME 1994 ($ Millions) Percent 1993 ($ Millions) Percent Chase 108 15 201 28 Chemical 391 61 453 42 Citicorp 400 29 800 27 J.P. Morgan 663 65 797 39 Total/averagea 1,562 42 2,251 34