This Selected Issues paper examines the role of information and communication technology (ICT) in the recent acceleration of labor productivity growth in the United States. The analysis reveals that the increase of total factor productivity (TFP) growth is a broad phenomenon that encompasses non-ICT producing sectors, consistent with the view that ICT is a “general purpose technology.” The paper investigates whether the productivity boom may have dampened employment in recent years. It also assesses the contribution of immigrants to the United State economy.

Abstract

This Selected Issues paper examines the role of information and communication technology (ICT) in the recent acceleration of labor productivity growth in the United States. The analysis reveals that the increase of total factor productivity (TFP) growth is a broad phenomenon that encompasses non-ICT producing sectors, consistent with the view that ICT is a “general purpose technology.” The paper investigates whether the productivity boom may have dampened employment in recent years. It also assesses the contribution of immigrants to the United State economy.

VI. U.S. Large Complex Banking Groups: Business Strategies, Risks, and Surveillance Issues67

1. The growth of large U.S. bank holding companies (BHCs) has continued steadily in recent years, driven largely by mergers and acquisitions, advances in technology, and regulatory reforms. In particular, the Gramm–Leach–Bliley (GLB) Act of 1999 provided new opportunities for BHC expansion by allowing banks, securities firms, and insurance companies to affiliate under a financial holding company structure.68 At end-2003, total assets of the 20 largest BHCs amounted to $5.6 trillion, equivalent to 64 percent of the aggregate for all BHCs or about 50 percent of GDP.

2. This paper analyzes the implications for financial soundness and surveillance of the activities of the largest bank holding companies. The results are based on a review of business strategies and balance sheet data of the 20 largest BHCs—henceforth referred to as large complex banking groups (LCBGs).69 Notwithstanding recent record profitability, closer co-movements of financial soundness indicators, both among LCBGs and between LCBGs and other financial sectors, such as insurance, suggest that systemic exposure to common shocks may have increased over time. This finding supports the supervisory authorities’ ongoing efforts to complement risk-focused supervision of individual LCBGs and large nonbank groups with surveillance at a system level.

A. Evolving Business Strategies and Financial Outcomes

3. During 2000–03, the recession and wide swings in asset prices drove significant shifts in LCBG balance sheets, including a generalized switch from corporate to household exposure. With considerable household wealth flowing out of the stock market and into savings accounts, LCBGs were in a position to curtail, relative to total funding, their recourse to more costly market financing while still expanding their balance sheets at an average annual rate of 12 percent. At the same time, LCBGs’ stock of commercial and industrial (C&I) loans fell by 10 percentage points relative to total LCBG loans, driven by shrinking demand and some tightening of lending standards (Table 1). Much of the exposure was redirected to the market for mortgage-backed securities (MBS), in particular those issued by government-sponsored enterprises (GSEs) which confer particular advantages for computing risk-weighted capital adequacy (Box 1). By end-2003, LCBGs held nearly half of their investment account portfolios in MBSs issued by GSEs.70

Table 1.

Selected Indicators for Large Complex Banking Groups, 1999–2003

(Arithmetic means of ratios for individual LCBGs)

article image
Sources: Federal Reserve, Bank Holding Company Performance Reports.

Regulatory Implications of LCBG’s GSE Debt Holdings

The rapid growth of LCBG’s holdings of GSE securities has been driven by risk management considerations as well as regulatory incentives. LCBGs either swap conforming residential mortgages (which carry a 4 percent capital requirement) for the standardized mortgage pools issued and guaranteed by Fannie Mae and Freddie Mac (1.6 percent capital requirement) for a fee, or buy mortgage-backed securities (MBSs) outright. By accepting a marginal reduction in interest income, LCBGs replace claims on discrete households (mortgages) with possibly better diversified and more liquid instruments (MBSs), reducing risk and freeing up capital.

Legislative, regulatory, and credit rating actions affecting GSE securities might have important consequences for LCBG regulatory capital and could entail market risks. Although the indentures for Fannie Mae and Freddie Mac debt explicitly disclaim a sovereign guarantee, the issuers are unique in that they were created and chartered by Acts of Congress. Both direct obligations and MBSs issued by the two GSEs receive risk weightings of 20 percent, are exempt from concentration limits, and are supported by the Secretary of the Treasury’s legal authority to purchase up to $2.25 billion of each issuer’s bonds. If reforms were implemented to render the two issuers indistinguishable from other private corporations (including a reclassification of their securities for regulatory purposes), their direct obligations would become subject to a risk weight of 100 percent and a concentration limit of 10 percent of capital and surplus. In addition, if the debt ratings on MBSs issued by the two institutions were to be downgraded to below ‘AA-’ (while remaining in the investment grade range), these MBSs would become subject to a risk weight of 50 percent and a concentration limit of 25 percent. With LCBG holdings of GSE securities generally well in excess of such limits, the above scenario would require firms to hold additional capital and reduce their holdings of Fannie Mae and Freddie Mac securities.

LCBGs are slightly less sensitive to the regulatory treatment of GSEs than other deposit-takers. At end-2003, the 16 U.S.-based LCBGs held an average 37 percent of GSE direct debt relative to capital and surplus, and GSE-issued MBSs worth an average 94 percent. A re-weighting of GSE direct debt to 100 percent and GSE-issued MBSs to 50 percent would, ceteris paribus, reduce the weighted average risk-based capital ratio of these LCBGs by 56 basis points, compared with an estimated 87 basis point decline for all commercial banks and thrifts. Aggregate LCBG capital requirements would increase by $14 billion, equivalent to one-fifth of aggregate net income in 2003.

Sources: Board of Governors of the Federal Reserve System (2003) for regulations; Frame and White (2004) for general issues; Kulp (2004) for stress tests on commercial banks and thrifts; Fund staff estimates for LCBGs.

4. LCBGs have, however, pursued different business strategies in recent years, reinforcing the heterogeneous nature of this group. The most complex LCBGs—i.e., those most engaged in nontraditional banking activities—have become even more complex.71 For these firms, the switch to securities was most pronounced, as was the emphasis on trading and fee-generating activities. In contrast, medium-to-low complexity firms tended to focus more on core banking business, maintaining relatively large loan books and relying more heavily on retail deposits. However, while typically starting out with larger real estate exposures, some of these institutions have been even more aggressive in expanding their mortgage books and MBS portfolios than more complex LCBGs.

5. In particular, the dominance of the more complex institutions in the derivatives market has increased, including in the small but rapidly growing credit derivatives segment. The average ratio of derivatives contracts (measured by notional underlying values) to assets more than doubled in 2000–03, with most of the activity concentrated among eight market-making LCBGs. Reflecting in part the rapid growth of MBS holdings and the need to hedge the attendant interest rate risk, the average share of interest rate contracts rose at the expense of foreign exchange contracts. LCBGs also appear to have acquired some credit protection through a small but growing positive net position in credit default swaps and other credit derivatives.

6. The most complex LCBGs reported weaker financial results through the 2001 recession than their less complex peers. Reflecting a spate of bankruptcies at large firms, including Enron and WorldCom, noncurrent C&I loans more than doubled to 3.7 percent of total loans around the 2001 recession. Although the more complex LCBGs have held a smaller share of loans relative to other assets, they have maintained closer lending relationships with large corporate clients—including in the high-technology sector—and suffered larger asset quality deterioration as a consequence. With higher average operating costs to total income, returns on assets were typically lower at the most complex institutions, although the group of LCBGs as a whole maintained record profitability, outperforming most other large financial institutions in industrialized countries in the last five years.

7. This outcome would suggest that attempts at diversifying income and funding have not necessarily benefited the more complex institutions. Diversification at such institutions has come at the cost of a larger exposure to financial shocks, including from the equity market, explaining much of their weaker financial performance relative to less complex LCBGs.

B. Financial Soundness

8. The business strategies pursued by LCBGs have implications for the financial soundness of both individual institutions and the group as a whole. Diversification across business lines and regions, as pursued by LCBGs in recent years, in principle dilutes risks. However, if this comes at the expense of reduced profitability, increased earnings volatility, or a thinning out of capital, overall financial soundness can still deteriorate. With linkages to financial markets increasing, the performance of the more complex LCBGs during the recent downturn provides an example of a type of diversification, specifically into equity market exposure and special purpose vehicle-finance for large firms, that has failed to improve financial results relative to other business strategies. However, the implications for financial soundness need to be judged over a longer period.

9. This chapter’s analysis of financial soundness trends is based on a composite measure widely used in the literature. The so-called distance-to-default ratio (DD) is based on market measures of a company’s profitability and balance sheet structure.72 The DD varies positively with returns on assets and capitalization and negatively with the volatility of assets, and its level can be mapped into a proxy measure of probability of insolvency. Thus, any increase in DD indicates improved financial soundness—reflected in a lower probability of insolvency—resulting from higher expected profitability, better capitalization, lower asset volatility, or a combination of these factors. DD measures for the LCBGs are subject to large fluctuations, however, which tend to be associated with the business cycle and “expectation cycles” regarding future earnings prospects. Expectations can be influenced, for example, by merger events (many acquisitions occurred in the early to mid-1990s) or periods of market disturbance (such as the LTCM failure and liquidity squeeze in 1998).

10. The analysis also suggests that LCBGs’ business strategies, including diversification, have not translated into improved individual risk profiles over the last 15 years. For the 16 U.S.-based LCBGs, the (unweighted) average DD exhibits a slightly declining trend, indicating that risk reduction achieved through diversification has been offset by either higher risk-taking or lower risk-adjusted profitability (Figure 1).73 This finding is consistent with other studies that have failed to find net risk-diversification benefits among large financial institutions in the United States and other countries in the 1990s.74

Figure 1.
Figure 1.

LCBGs’ Average Distance-to-Default

Citation: IMF Staff Country Reports 2004, 228; 10.5089/9781451839562.002.A006

11. Nevertheless, the LCBGs weathered the 2001 recession better than the 1991 recession. Although the 2001 recession was milder than in 1991, it occurred against a background of severe financial shocks, including the stock market adjustment and a number of large corporate and sovereign defaults, all of which directly affected LCBGs. Despite this, the LCBGs’ average DD declined much less than it did around the time of the 1991 recession. Stronger capital positions going into the recession appear to have played a key role, as did improved risk management, including through better risk-based pricing and (possibly) increased recourse to credit derivatives.75

12. However, financial soundness indicators for the more complex LCBGs have on average been lower than for their less complex peers. For most of the last 15 years, the difference between LCBGs’ unweighted and complexity-weighted average DDs has been negative, indicating that financial soundness has been weaker among firms that are more complex (Figure 2). Moreover, the gap between the two measures widened whenever average financial soundness deteriorated, for example, during economic downswings. Firm-by-firm DDs also highlight that financial soundness of more complex firms tends to suffer more during recessions, notwithstanding the significant improvements made since the 1991 recession (Figure 3).

Figure 2.
Figure 2.

Risk Concentration by Complexity

Citation: IMF Staff Country Reports 2004, 228; 10.5089/9781451839562.002.A006

Figure 3.
Figure 3.

Average Distance-to-Default During Recessions

Citation: IMF Staff Country Reports 2004, 228; 10.5089/9781451839562.002.A006

Source: Fund staff calculations.1/ LCBGs are ordered by decreasing complexity.

13. The evidence also points out that LCBGs’ exposure to common shocks has increased. The “system” DD for the set of LCBGs, obtained as the DD of the portfolio composed by all LCBGs, captures the likelihood that a shock hits all firms contemporaneously. It has declined over the past 15 years, owing to a combination of lower DDs for some firms and closer co-movements of DDs (Figure 4, upper panel). The increasing co-movement of DDs is further illustrated by the clear downward trend in the difference between the system DD, which embeds all correlations among DDs, and the average of LCBGs’ individual DDs, which does not embed such correlations (Figure 4, lower panel). As a result, diversification of the LCBG group as a whole appears to have decreased.76

Figure 4.
Figure 4.

Distance-to-Default of the LCBG System

Citation: IMF Staff Country Reports 2004, 228; 10.5089/9781451839562.002.A006

Source: Fund staff calculations.

14. Finally, an analysis of sectoral financial soundness measures suggests that risk profiles of LCBGs and the insurance sector have become more similar, but remain distinct from those of investment banks. Between 1994–2003, the system DDs of the insurance and investment bank sectors exhibit a declining trend, similar to the group of LCBGs, although all sectors show improvements beginning in 2003 (Figure 5). Recently, the co-movement between the DDs of the LCBG system and the insurance sector appears to have become stronger, with the contemporaneous correlation increasing to 0.92 in 1999–2003 from 0.77 in 1994–98. By contrast, the co-movement between the DDs of the LCBG system and the investment bank sector appears to have become weaker, given the decline in their contemporaneous correlation to 0.36 in 1999–2003 from 0.44 in 1994–98. This finding points to greater exposure to common sources of risk for LCBGs and insurers, as well as some risk transfer from these sectors to investment banks.

Figure 5.
Figure 5.

Sectoral System Distance-to-Default

Citation: IMF Staff Country Reports 2004, 228; 10.5089/9781451839562.002.A006

Source: Fund staff calculations.

15. In sum, although capital strength and improved risk management have served LCBGs well over the current cycle, systemic risks do not appear to have necessarily declined. Greater exposure to common shocks and changing interdependencies in financial soundness across sectors are potential sources of vulnerability that require supervisors to take a broader view of the financial system.

C. Surveillance Issues and Supervisory Responses

16. The foregoing analysis supports intensified financial surveillance of LCBGs and systemically important nonbank groups at a system level. Supervisory assessments would need to include efforts to understand the systemic implications of risk management systems and instruments, and to identify critical factors for the liquidity of markets in which hedging instruments are traded.77 Financial surveillance of systemically important institutions, such as LCBGs and large nonbank groups, the continuous monitoring of the functioning of the markets in which they operate, and market discipline are likely to become even more important as financial innovation progresses and conglomeration intensifies.

17. Encouragingly, financial system surveillance has strengthened in recent years. Greater emphasis is being placed on studies of key market segments and risk transfer systems. Large bankruptcies such as that of Enron have brought structured-finance practices into focus, with the Federal Reserve, the Securities and Exchange Commission (SEC), and the Office of the Comptroller of the Currency (OCC) launching a joint study of the 11 most active structured-finance firms (five investment bank holding companies, three U.S.-based BHCs, and three foreign-controlled BHCs), culminating in the recent issuance of structured-finance guidance for banking and securities firms. The Federal Reserve is also studying liquidity issues in the derivatives market, which it regards as central to efficient risk management. Such work is likely to inform policy responses in potential episodes of market instability such as the one associated with the collapse of LTCM in 1998. Importantly, the implementation of Basel II is being used as a key vehicle to strengthen banks’ risk management systems and improve market discipline.

18. Traditional efforts by U.S. regulators to ring-fence insured depository institutions have increasingly given way to a new emphasis on risk-focused supervision of BHCs. The stated objective of risk-focused supervision is to ensure that the holding company does not threaten the viability of its insured depository institution subsidiaries or affiliates. There has been a gradual policy shift away from the dependence on legal protection provided by the holding company structure toward emphasis on internal risk management and market discipline (Box 2). The move away from a reliance on “firewalls” between the subsidiaries and affiliates of a holding company and toward “umbrella” supervision of BHCs by the Federal Reserve—a key provision of the GLB Act—as well as recent proposals by the SEC for the consolidated supervision of investment banking groups are motivated precisely by the increasing interdependency between financial soundness profiles of financial firms of the type documented above.78

The U.S. Regulatory Structure: A Bird’s-Eye View

The U.S. regulatory structure is unique in that it offers a great deal of choice to the financial firm as to how, and by whom, it is being supervised. Commercial banks may opt to be chartered and regulated at the national or state level—and in the latter case may choose whether to become a member of the Federal Reserve System or not—and can opt to change their charter. For nationally-chartered banks, the primary supervisor is the OCC; for insured state-chartered banks that are members of the Federal Reserve System, it is the Federal Reserve and the respective state; and for insured state-chartered banks that are not members of the Federal Reserve System, it is the Federal Deposit Insurance Corporation (FDIC) and the respective state. States retain exclusive purview over insurance companies and some supervisory rights over investment firms (few states other than New York exercise the latter). There has also been a traditional functional split in the regulation of bank and nonbank financial intermediaries, and an absence of regulation of those sectors not considered to pose risks for depositors and retail investors. Most securities firms that trade on recognized exchanges are regulated by the SEC which, in turn, delegates much of the day-to-day responsibility to recognized exchanges that act as self-regulating organizations.

The supervisory philosophy places considerable emphasis on internal risk management and focuses increasingly on market discipline. Weak banks, including fairly large regional banks, tend to be absorbed by healthy banks or are allowed to fail—a key disciplining factor. Four private credit rating agencies that are classified by the SEC as “nationally recognized statistical rating organizations” play prominent roles, including by providing ratings benchmarks for regulatory capital requirements. They also serve as key sources for the analysis of large structured-finance transactions, which have surged in volume and complexity in recent years. Partly to counter too-big-to-fail or too-complex-to-fail perceptions, the Federal Reserve in early 1999 initiated a large complex banking organization (LCBO) program, which provides continuous supervision of large domestic or foreign BHCs that have particularly complex operations and dynamic risk profiles, focusing on both firm-specific and common risks. As discussed by DeFerrari and Palmer (2001), the LCBO program, which includes daily information exchanges between the Federal Reserve, the OCC, and other agencies, has served as the principal vehicle for consolidated supervision of BHCs in the United States, and has adapted and evolved with experience and changing circumstances.

19. Although risk-focused supervision of BHCs involves a large number of agencies, there is little evidence that supervisory procedures are more effective when implemented under more centralized structures.79 In the aftermath of the GLB Act, the Federal Reserve led the formation of a cross-sectoral group of BHC supervisors, including the OCC, the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision, the state banking supervisors, the SEC, and the National Association of Insurance Commissioners. Convening roughly twice a year, the group has entered into a number of information-sharing protocols.

20. SEC supervision of investment banks until recently remained confined to registered broker-dealers as opposed to holding companies and unregistered affiliates. While the GLB Act lays down the supervisory ground rules for any group that includes a commercial bank, an important gap in the consolidated supervision of investment bank holding companies has recently been filled. In an effort to meet EU requirements that all large complex financial institutions operating in the EU be subject to consolidated supervision, the SEC is proposing a measure of capital relief for securities firms in exchange for agreement to submit to consolidated supervision, including inspections of holding companies and the imposition of a consolidated capital requirement. Similar to that planned for commercial banks under Basel II, the capital regime would afford large securities firms the option of using a model-based alternative to the traditional net capital rule, subject to SEC approval of internal risk management processes. Business penalized by the traditional net capital rule would likely migrate from unregulated affiliates to registered broker-dealers as a result. Details remain to be clarified, however, on the extent to which the SEC’s approach will be consistent with that of the Federal Reserve with respect to BHCs.80

21. Overall, the U.S. supervisory approach appears well advanced, with future reforms likely to focus on continuing adaptation and evolution rather than radical change. The interagency model with the Federal Reserve as lead supervisor of BHCs appears generally effective, although coordination and wind-down procedures have yet to be tested in a stress period. It is too early to assess whether the SEC will be effective in applying a similar degree of oversight to the investment banking groups. Although the Federal Reserve has not taken a position on the need for a federal insurance supervisor, the dispersion across states of insurance regulatory standards is an issue that may warrant attention, especially given additional evidence that the insurance sector has taken on some risk from other sectors (IMF, 2004). As financial innovation and interdependencies across institutions and markets progress, similarly important may be the task of exploring ways to strengthen and clarify the power and scope of the lead supervisors.

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67

Prepared by Gianni De Nicoló, Peter Hayward, and Ashok Vir Bhatia (MFD), with research assistance from Marianne El-Khoury. This paper greatly benefited from authorities’ comments.

68

As shown in a joint paper by the Federal Reserve and the U.S. Treasury (2003), BHCs have gradually expanded their securities underwriting, broker-dealing, and insurance agency activities, although concentration in the nonbank financial sector has remained broadly stable during 1999–2003. For a comparative perspective on consolidation in the U.S. banking industry, see Group of Ten (2001).

69

The 20 largest BHCs comprise 16 U.S. firms and four subsidiaries of European banks. At end-2003, they accounted for 73 percent of BHC nonbank assets and virtually all BHC derivatives activity.

70

For analysis of recent supply and demand developments in C&I credit, see Bassett and Zakrajšek (2003). For an evaluation of vulnerabilities arising from current exposures to residential and commercial real estate, see Collier, Forbush, and Nuxoll (2003).

71

Asset measures may not adequately capture the actual size of financial institutions’ activities. Therefore, for the purpose of this chapter, each institution’s complexity ranking is calculated as a simple average of its rank order according to six measures of nontraditional banking activity (as a share of total assets unless otherwise indicated): assets associated with nonbank activities; notional value of derivatives contracts; the sum of private investment securities and all trading securities; noninterest income (as a share of gross interest and noninterest income); net loans and leases (ranked in inverse order); and core deposits (inverse order). For analytical purposes, the seven highest-ranked institutions are referred to as LCBGs of “high complexity”, the next six as “medium complexity”, and the last seven as “low complexity”. The complexity ranking is only partially correlated with a ranking by asset size, with a rank correlation coefficient of 0.63 in 1999 and 0.55 in 2003. For a review of measures of financial institutions’ size, see Samolyk (2004).

72

The distance-to-default ratio is computed as the sum of the return on the estimated market value of assets and the capital-to-assets ratio at market prices, divided by the volatility of assets. Estimates of the market value of assets are based on the structural valuation model of Black and Scholes (1973) and Merton (1974), and were computed using the estimation procedure described in Vassalou and Xing (2004) using daily market and annual accounting data. Although distance-to-default-type measures are sensitive to variations in the underlying assumptions, they have been shown to predict supervisory ratings, bond spreads, and rating agencies’ downgrades (Krainer and Lopez, 2001; Gropp, Vesala, and Vulpes, 2002; Chan-Lau, Jobert, and Kong, 2004).

73

Market and accounting data for the 16 U.S.-based LCBGs for the period 1989–2003 cover only those institutions that were in existence at end-2003.

75

DD ratios may suffer from a downward bias caused by the asymmetric accounting treatment of credit derivatives. Because credit derivative gains and losses flow through trading income, they tend to make trading results more volatile, leading to wider swings in stock prices and, ceteris paribus, a smaller DD. Credit derivative results do not flow through to allowances for loan and lease losses.

76

These results are consistent with those obtained by De Nicoló and Kwast (2002). It should be noted that increased diversification of individual institutions in a group does not mechanically imply lower diversification of the group as a whole. As is clearly pointed out by Haubrich (1998), banks diversify by growing—i.e., by adding risks—which is very different from the subdivision of risk typical of a portfolio choice.

77

With reference to the burgeoning credit derivative market, Duffie (2004) has stressed that financial institutions “managing portfolios of credit risk need an integrated model, one that reflects correlations of defaults and changes in market spreads. Yet, no such model exists…. This is one area of finance where our ability to structure financial products may be running ahead of our understanding of the implications.”

78

Within an LCBG, for instance, although the deposit-taking subsidiary may be protected in a balance sheet and legal sense, it may not be immune to reputational and operational risks emanating from a distressed nonbank financial affiliate, nor to the potential for conflicts of interest. For this and other reasons, the Federal Reserve insisted upon, and won, consolidated supervisory powers over any financial group that includes a U.S.-chartered commercial bank.

79

In recent years, several countries have moved toward more centralized supervisory systems. Yet, there is no consensus on a uniform best model; most models have not been tested in stress periods; and even apparently similar centralized supervisory systems conceal important differences—as exemplified by the comparison of the United Kingdom and the Dutch models conducted by Kremers, Shoenmaker and Wierts (2003).

80

For example, the SEC does not intend to apply a leverage ratio, which the Federal Reserve still uses for the LCBGs.

United States: Selected Issues
Author: International Monetary Fund