Financial Crisis Management: Four Financial Crises in the 1980s (Staff
Study, 05/01/97, GAO/GGD-97-96).

GAO reviewed how federal financial agencies with responsibilities for
financial institutions and markets recognized, contained, and eventually
resolved four financial crises that occurred in the 1980's.

GAO noted that: (1) leadership was critical for effective management and
containment of each of the four financial crises; (2) Treasury and the
Federal Reserve led crisis containment efforts because of their
financial resources, access, and expertise, although each agency had its
own distinct and complementary leadership role; (3) as part of the
executive branch, Treasury was better positioned than the Federal
Reserve to provide the political leadership considered desirable in
containing a financial crisis; (4) at the same time, the Federal Reserve
had critical mechanisms and resources for providing temporary liquidity
in a crisis--currency swaps, discount window lending, and open market
operations; (5) Treasury also provided temporary liquidity during the
Mexican crisis through the Exchange Stabilization Fund; (6) successful
crisis response in each case depended greatly on swift and sometimes
innovative action, which appeared to help reduce in scope and intensity
the effect the crisis had on the financial system; (7) in addition, the
more effective the communication of the federal response the more it
appeared to help prevent a crisis from worsening, because it provided
clear and credible information that played a part in calming financial
markets; (8) several officials told GAO that contingency planning,
including interagency planning, helped facilitate federal preparedness
and response to a crisis; (9) they said that contingency planning helped
federal financial regulators identify resources to contain the crisis as
well as potentially vulnerable firms or markets; (10) GAO encountered
mixed views on the part of financial crisis managers concerning whether
or not contingency planning should be documented; (11) some officials
were reluctant to document their planning efforts due to fears of
triggering a panic or because circumstances of a crisis are never
identical to those in the plan; (12) coordination of crisis containment
efforts among key participants was important because rarely did one
agency have the necessary authority, jurisdiction, and resources to
contain the crisis; (13) reliable and timely information was important
to federal efforts to provide early warning of potential crises and to
help regulators decide whether and how to intervene; and (14) however,
several officials told GAO that the federal government's ability to
identify incipient financial crises or to monitor a crisis once it had *

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-97-96
     TITLE:  Financial Crisis Management: Four Financial Crises in the 
             1980s
      DATE:  05/01/97
   SUBJECT:  Financial institutions
             Financial management
             Financial management systems
             Stock exchanges
             Savings and loan associations
             Federal reserve banks
             International economic relations
             Bank failures
             Banking regulation
             Foreign exchange rates
IDENTIFIER:  Exchange Stabilization Fund
             Mexico
             International Monetary Fund
             Ohio
             Strategic Petroleum Reserve
             Savings Association Insurance Fund
             Ohio Deposit Guarantee Fund
             SAIF
             
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Cover
================================================================ COVER


Staff Study

May 1997

FINANCIAL CRISIS MANAGEMENT - FOUR
FINANCIAL CRISES IN THE 1980S

GAO/GGD-97-96

Financial Crises

(233391)


Abbreviations
=============================================================== ABBREV

  BIS - Bank for International Settlements
  CBOE - Chicago Board Options Exchange
  CFTC - Commodity Futures Trading Commission
  CME - Chicago Mercantile Exchange
  DJIA - Dow Jones Industrial Average
  ESF - Exchange Stabilization Fund
  FDIC - Federal Deposit Insurance Corporation
  FDICIA - Federal Deposit Insurance Corporation Improvement Act
  FHLBB - Federal Home Loan Bank Board
  FHLBC - Federal Home Loan Bank of Cincinnati
  FIRREA - Financial Institutions Reform, Recovery, and Enforcement
     Act
  FRS - Federal Reserve System
  FSLIC - Federal Savings and Loan Insurance Corporation
  IMF - International Monetary Fund
  NASD - National Association of Securities Dealers
  NYSE - New York Stock Exchange
  OCC - Office of the Comptroller of the Currency
  SEC - Securities and Exchange Commission
  SPR - Strategic Petroleum Reserve
  SRO - self-regulatory organization

PREFACE
============================================================ Chapter 0

The increasing interconnectedness of financial institutions and
markets has highlighted the need to ensure that diverse federal,
state, international, and private financial organizations work
together to effectively contain and resolve financial disruptions. 
The federal government's ability to manage financial crises
effectively is important to the stability of the U.S.  financial
system and economy as well as the worldwide financial system.  In
seeking to expand its current knowledge of financial crisis
management, GAO studied federal actions that successfully contained
four major financial crises of the turbulent 1980s--the Mexican debt
crisis of 1982; the near failure of the Continental Illinois National
Bank in 1984; the run on state-chartered, privately insured savings
and loan institutions in Ohio in 1985; and the stock market crash of
1987. 

On the basis of a review of emergency response literature, GAO
focused on three phases of financial crisis management.  The
preparedness phase included activities undertaken prior to the
occurrence of a crisis.  The containment phase included activities
undertaken in immediate response to a financial crisis to mitigate
the financial disruption and lessen ill effects on the financial
system.  The resolution phase included activities undertaken to
reduce the likelihood of the recurrence of the crisis or similar
financial crises. 

GAO observed that leadership was critical for effective management
and containment of each of the four financial crises.  Treasury and
the Federal Reserve led crisis containment efforts because of their
financial resources, access, and expertise, although each agency had
its own distinct and complementary leadership role.  As part of the
executive branch, Treasury was better positioned than the Federal
Reserve to provide the political leadership considered desirable in
containing a financial crisis.  At the same time, the Federal Reserve
had critical mechanisms and resources for providing temporary
liquidity in a crisis--currency swaps, discount window lending, and
open market operations.  Treasury also provided temporary liquidity
during the Mexican crisis through the Exchange Stabilization Fund. 

GAO observed that successful crisis response in each case depended
greatly on swift and sometimes innovative action, which appeared to
help reduce in scope and intensity the effect the crisis had on the
financial system.  In addition, the more effective the communication
of the federal response the more it appeared to help prevent a crisis
from worsening, because it provided clear and credible information
that played a part in calming financial markets. 

Several officials told GAO that contingency planning, including
interagency planning, helped facilitate federal preparedness and
response to a crisis.  They said that contingency planning helped
federal financial regulators identify resources to contain the crisis
as well as potentially vulnerable firms or markets.  GAO encountered
mixed views on the part of financial crisis managers concerning
whether or not contingency planning should be documented.  Some
officials were reluctant to document their planning efforts due to
fears of triggering a panic or because circumstances of a crisis are
never identical to those in the plan. 

GAO observed that coordination of crisis containment efforts among
key participants was important because rarely did one agency have the
necessary authority, jurisdiction, and resources to contain the
crisis.  The decentralized structure of financial regulation often
presented challenges to effective coordination in a crisis.  In
addition to coordinating with each other, federal regulatory
officials said that they often needed to coordinate with state
governments, international organizations, foreign governments, and
Congress.  Crisis containment also required coordination with the
private sector to determine whether the private sector could contain
the crisis without federal assistance, and to identify resources
available for crisis containment. 

Reliable and timely information was important to federal efforts to
provide early warning of potential crises and to help regulators
decide whether and how to intervene.  Federal financial agencies,
including the financial institution and market regulators, each
collected crisis-relevant information in their routine monitoring of
financial activity.  However, several officials told GAO that the
federal government's ability to identify incipient financial crises
or to monitor a crisis once it had occurred was sometimes limited by
the dispersed nature of the government's crisis surveillance
capability, along with limitations and gaps in the available
information. 

Financial crises are complex events often involving multiple markets
and institutions.  To fully explore all of the actions and viewpoints
involved would require a much lengthier discussion than this study
provides. 


However, because the information about each of the four crises GAO
reviewed has not been previously published in consolidated form, GAO
is publishing its results as a staff study to permit appropriate
archiving and retrieval of the information for future reference by
GAO staff and others who may have interest. 

Jean G.  Stromberg
Director, Financial Institutions and
 Markets Issues


INTRODUCTION
============================================================ Chapter 1

The federal government has faced many challenges in responding to
financial disruptions that threaten the stability of the U.S. 
financial system.\1 In the 1930s, the United States experienced one
of its most devastating financial crises.  Loss of public confidence
in banks caused disruptions in the financial system and, along with
other factors, ultimately led to the Great Depression.  In the 1980s,
the federal government was challenged by a series of financial
disruptions of considerable magnitude.\2 Some disruptions became
full-scale financial crises that cost taxpayers, firms, and
individuals collectively billions of dollars.  Others became crises
that had the potential to cause widespread damage but were
successfully contained.  The possibility of other such financial
crises can not be dismissed. 

This report presents our review of four financial crises of the
1980s:  the Mexican debt crisis of 1982, the near failure and rescue
of the Continental Illinois National Bank in 1984, the Ohio savings
and loan crisis of 1985, and the 1987 stock market crash.  These
crises, which varied in magnitude, were ultimately successfully
contained and resolved through joint efforts of federal agencies and
others.  By documenting these crises and the efforts to contain them,
this report seeks to expand current knowledge of financial crisis
management. 


--------------------
\1 Our nation's financial system is the collection of markets,
individuals, institutions, laws, regulations, and techniques through
which bonds, stocks, and other financial instruments are traded,
financial services produced and delivered, and interest rates
determined.  The financial system enables funds to be channeled from
savers to borrowers, payments to be made for goods and services, and
risks to be transferred from those less able or willing to manage
them to those who are more able or willing to do so. 

\2 Financial history offers many examples of financial crises.  See
Charles P.  Kindleberger, Manias, Panics and Crashes:  A History of
Financial Crises (New York:  Basic Books, 1989). 


   FINANCIAL SYSTEM ENVIRONMENT
   CHANGED
---------------------------------------------------------- Chapter 1:1

The financial crises of the 1980s were preceded by the abandonment of
the Bretton Woods system of fixed currency exchange rates, oil price
shocks, higher than normal annual rates of inflation, and
record-setting interest rates.  For almost two and a half decades
after World War II, western countries maintained a system linking the
prices of foreign currencies to U.S.  dollars and to gold.  This
arrangement, which the United States carried out with its allies, was
known as the Bretton Woods international monetary system.  External
imbalances, inflation, and other economic problems forced the
abandonment of the Bretton Woods system, which ended in August 1971
when the United States ceased to make dollars convertible into gold. 
In March 1973, a system of generalized floating exchange rates was
adopted for the major international currencies.  This followed an
18-month period during which an attempt was made to maintain a regime
of fixed exchange rates. 

The 1970s and early 1980s were characterized by protracted inflation,
record-setting interest rates, and higher than normal rates of market
volatility.  By early 1979 the annual rate of inflation in the United
States reached double digits.  The rise of oil prices in 1973 to 1974
and 1979 to 1980 helped generate an increase in the overall inflation
rate.  Commodity and real estate prices also soared in the 1970s.  To
combat inflation, the Federal Reserve launched a strong
anti-inflationary monetary policy in the period 1979 to 1982,
eventually raising nominal and real interest rates to unprecedented
levels for the postwar period.  The anti-inflation policy ultimately
succeeded in controlling inflation; however, it produced a massive
interest rate shock and was a prime factor in precipitating the
collapse of the savings and loan industry.\3 In the early 1980s, the
United States experienced its severest recession since the 1930s. 


--------------------
\3 See National Commission on Financial Institution Reform, Recovery,
and Enforcement, Origins and Causes of the S&L Debacle:  A Blueprint
for Reform (Washington, D.C.:  July 1993). 


      CRISES AFFECTED MANY SECTORS
      OF FINANCIAL SERVICES
      INDUSTRY
-------------------------------------------------------- Chapter 1:1.1

Throughout the 1970s, banks attempted to increase income by
aggressive lending.  Rising oil prices enriched oil exporting
countries.  These oil exporting countries were depositing their
foreign exchange holdings with large North American, European, and
Japanese banks with international experience.  With insufficient
demand for loans in the United States and encouragement from U.S. 
government officials, large U.S.  banks began to lend to newly
industrializing countries as an outlet for these funds.  Banks made
substantial investments in these countries and other specific
sectors, some of which had prospered from high commodity prices
during the inflationary period of the 1970s.  The sectors included
commercial real estate, energy, and farming. 

One of the first shocks to banks in the early 1980s came when the
Comptroller of the Currency closed Penn Square Bank of Oklahoma in
July 1982, a bank with easy lending policies and a large portfolio of
loans to oil firms.\4 It had deposits of $470 million.  Many oil and
gas explorers and producers were unable to repay their loans due to
failure to find oil and gas and declining oil prices.  OCC officials
told us that Penn Square's failure was mainly due to management
problems and criminal activity.  The failure of Penn Square had
rippling effects on the economy.  Banks experiencing losses included
Chase Manhattan, Continental Illinois National Bank, Michigan
National Bank, Northern Trust Company, and Seattle First National
Bank.  Continental had purchased loans worth $1 billion from Penn
Square.  After Penn Square's closure, Continental Illinois
experienced a run on its deposits and received assistance from the
Federal Reserve and FDIC. 

Another shock to the banking industry was the debt crisis of Mexico,
a major U.S.  trading partner, which spread to other newly
industrializing nations.  In August 1982, Mexico experienced a
financial collapse and was forced to suspend debt repayments to U.S. 
and foreign banks.  By the end of the 1970s and early 1980s, when oil
that Mexico exported commanded high prices, Mexico had about $100
million in foreign debt.  However, when the price of oil slid, so did
Mexico's foreign exchange earnings.  Higher dollar interest rates
meant larger borrowing costs on Mexico's sizable external debt. 
Following the Mexican debt crisis in August 1982, other developing
countries--including Argentina, Brazil, Chile, Peru, Venezuela, the
Philippines, and Yugoslavia-- also had debt servicing problems. 

The savings and loan industry was also hard-hit by high interest
rates, the maturity mismatch\5 of savings and loan balance sheets,
and deregulation.  During the inflationary 1970s, many savings and
loans became insolvent as home loan portfolio earnings were exceeded
by high interest costs needed to keep and attract new deposits.  By
the latter 1970s and the early 1980s, the industry's net worth was
virtually wiped out by record- setting interest rates and the
maturity mismatch of savings and loan balance sheets.  Deregulation
in 1982 permitted savings and loans to enter new lines of business
and led to increasingly risky asset choices.  Many in the industry
speculated aggressively with high-risk loans that eventually
defaulted, and the tide of insolvencies continued.  Institutions in
the Southwest, California, and Florida were hardest hit.\6

Commercial bank failures also increased in the 1980s.  When oil
prices fell sharply in 1986, many major banks in Texas failed, and
others were sold or merged with other banks.  Declining real estate
prices also contributed to bank failures.  Losses on loans to
less-developed countries eroded bank capital.  High-quality corporate
borrowers began to raise funds in capital markets through bonds and
commercial paper--driving banks to do more real estate lending. 
Banks lost low-cost sources of funds in savings and checking accounts
as investors sought investments paying higher rates of return.\7

The 1980s crises affected many U.S.  financial markets, including
equity, options, and futures markets.  The most significant event in
this sector was the market crash of 1987.  Although the stock market
declined during the recessionary period of 1981 through 1982, stock
prices rose to a then post-World War II high between 1983 and 1987 as
institutional and foreign investors poured money into the stock
market.  Some observers believed that concern about rising interest
rates at home and abroad and large budget and trade deficits led to
the crash of 1987.  Other observers attributed the crash to proposed
legislation that would have limited the merger and acquisition
activity that had contributed to a large part of the increase in
stock values during the 1980s.  Nearly all stocks suffered a massive
sell-off in the 1987 crash, which led to mechanical and liquidity
problems in trading and financial systems at exchanges and clearing
organizations. 


--------------------
\4 FDIC provided deposit insurance to Penn Square and served as
receiver for its assets by settling claims against the bank by
creditors--including the claims of insured depositors. 

\5 Matched maturities in bank asset-liability management is the
funding of loans with deposits of about equal duration and is
intended to minimize interest rate risk. 

\6 See Thrift Failures:  Costly Failures Resulted From Regulatory
Violations and Unsafe Practices (GAO/AFMD-89-62, June 16, 1989); and
Troubled Financial Institutions:  Solutions to the Thrift Industry
Problem (GAO/GGD-89-47 Feb.  21, 1989). 

\7 See Martin Feldstein, The Risk of Economic Crisis, Chicago: 
University of Chicago Press, 1991. 


   LINKAGES OF FINANCIAL MARKETS
   AFFECTED NATURE OF CRISES
---------------------------------------------------------- Chapter 1:2

Increasing financial linkages among domestic and global financial
markets--a product of new financial products, foreign investment in
capital markets, and advances in communications technology-- affected
the nature of financial crises during the 1980s.  These linkages also
introduced a new dimension to systemic risk\8 in the financial
system. 

During the 1980s, foreign investments in U.S.  capital markets
increased dramatically as did U.S.  investment in foreign markets,
especially equities.  For example, foreign purchases and sales of
U.S.  securities grew from about $198 billion in 1980 to almost $4.2
trillion in 1990.  During the same period, U.S.  purchases and sales
of foreign stocks and bonds grew from about $53 billion to about $904
billion.  Financial linkages increased for many reasons, including
the increased use of exchange-traded and over- the-counter derivative
products.\9 Derivative products, among other purposes, provide needed
protection against risks associated with fluctuations in currency
exchange rates, interest rates, and other prices and indexes. 
Beginning in the 1970s, private corporations--large commercial banks,
securities firms, and institutional investors--began using derivative
financial instruments on a wide scale, which helped foster linkages
among equities, debt, and futures markets. 

Advances in telecommunications and information technology had
furthered linkages among financial industries and markets and also
increased certain risks.  Advances in communications and computer
technology enhanced market participants' ability to quickly learn of
foreign market conditions and do business worldwide.  Cited as a
contributing factor to the 1987 market crash were complex,
technology-aided trading strategies.  Moreover, the volume of trading
during the crash challenged automated systems and created problems
for systems that cleared and settled transactions.\10

Many disruptions in the 1980s--beginning with the silver crisis of
1980\11 --heightened awareness that shocks could spread across
markets, institutions, and borders, thus enlarging the scope of
crises.  All the major foreign securities exchanges experienced
substantial increases in prices before the 1987 crash-- and during
the crash, sharp drops in value.  The disruption to the U.S. 
financial system could have been great if the 1987 stock market crash
had not ended when it did.  In 4 trading days in October 1987, the
Dow Jones Industrial Average lost about one- third of its total
value--almost $1 trillion.  Had the precipitous decline continued for
another day, massive disruptions to the U.S.  financial system and
the financial systems of other countries might have occurred.\12


--------------------
\8 Systemic risk is the possibility that failure of one or more
financial organizations or countries will trigger a chain reaction
and cause the collapse of other financial organizations or countries. 
A chain reaction of failures could take place because of linkages
between and among markets and due to participation by the same
institutions in several markets.  Systemic risk is the risk that a
disturbance could severely impair the workings of the financial
system and, at the extreme, cause a complete breakdown.  A breakdown
in capital markets could disrupt the process of savings and
investment, undermine the long-term confidence of private investors,
and cause turmoil in the normal course of economic transactions. 

\9 Derivative products are instruments that derive their value from a
reference rate, index, or the value of an underlying asset.  See
Financial Derivatives:  Actions Needed to Protect the Financial
System (GAO/GGD-94-133, May 18, 1994). 

\10 See Clearance and Settlement Reform:  The Stock, Options, and
Futures Markets Are Still at Risk (GAO/GGD-90-33, Apr.  11, 1990). 

\11 In March 1980, declining silver futures prices generated calls
for hundreds of millions of dollars more margin from Hunt family
members and related entities as well as calls for additional deposits
to maintain required collateralization for loans.  To fulfill these
cash needs, the Hunts borrowed heavily from broker- dealers, banks,
and others.  A concern existed that the Hunt default might lead to
the failure of one or more large broker- dealers and possibly
jeopardize futures clearing houses, broker- dealers, and banks. 

\12 See Financial Markets:  Preliminary Observations on the October
1987 Crash (GAO/GGD-88-38, Jan.  26, 1988). 


   PUBLIC SECTOR OFTEN HAS A
   CRISIS MANAGEMENT ROLE
---------------------------------------------------------- Chapter 1:3

In the 1980s, as today, federal financial agencies had
congressionally determined roles in financial crisis management. 
Table 1.1 highlights the major responsibilities of the federal
agencies.  The Federal Reserve and the Department of the Treasury,
the nation's finance ministry, had broad responsibilities for the
health of the financial system.  Three agencies--the Federal Reserve,
Office of the Comptroller of the Currency (OCC), and Federal Deposit
Insurance Corporation (FDIC)--were responsible for ensuring the
safety and soundness of federally chartered banks and state-chartered
banks that were federally insured.  The same responsibility for
federally insured savings associations was assigned to the Federal
Home Loan Bank Board (FHLBB).\13 The National Credit Union
Administration supervises insured credit unions.  Since Congress
permitted banks and savings and loans to operate under a state or
national charter, responsibility for supervisory oversight of those
institutions often involved federal and state regulators.  With many
self-regulatory organizations (SRO),\14 the Securities and Exchange
Commission (SEC) and Commodity Futures Trading Commission (CFTC) were
responsible for market integrity and investor protection in the
securities and futures markets, respectively.  State regulators were
responsible for oversight of insurance companies. 



                               Table 1.1
                
                  U.S. Federal Financial Organizations
                Involved in Responding to Four Financial
                          Crises in the 1980s

Federal agency      Responsibility
------------------  --------------------------------------------------
CFTC                Regulates the commodity futures and options
                    markets and seeks to ensure fairness and integrity
                    in the marketplace. Responsible for ensuring the
                    economic utility of futures markets--price
                    discovery and offsetting price risk--by
                    encouraging their integrity and protecting market
                    participants against manipulation, abusive trading
                    practices, and fraud. Oversight includes
                    exchanges, some off-exchange instruments, and
                    market participants.

FDIC                Promotes and preserves public confidence in banks
                    and protects the money supply by providing deposit
                    insurance to commercial banks, savings banks, and
                    savings and loan associations. FDIC's mission is
                    to maintain stability in the national financial
                    system by insuring bank depositors and reducing
                    the economic disruptions caused by bank failures.

FHLBB               Supervised the Federal Home Loan Bank System and
                    the Federal Savings and Loan Corporation (FSLIC)
                    and regulated federally chartered savings and loan
                    associations and federally chartered savings
                    banks, supervised savings and loan holding
                    companies, and shared with the states the
                    supervision of FSLIC-insured state-chartered
                    savings and loan associations.

Federal             As U.S. central bank, makes and administers policy
Reserve             for the nation's credit and monetary systems.
System              Through discount window operations and supervisory
                    and regulatory banking functions, helps to
                    maintain the banking industry in sound condition,
                    capable of responding to the nation's domestic and
                    international financial needs and objectives.
                    Regulates and supervises bank holding companies
                    and state-chartered banks that are Federal Reserve
                    members.

OCC                 Part of the Department of the Treasury that
                    regulates about 2,700 national banks. Approves
                    organizational charters, promulgates rules and
                    regulations, and supervises the operations of
                    national banks through examinations. Examinations
                    assess the financial condition of banks, the
                    soundness of their operations, the quality of
                    their management, and their compliance with laws,
                    rules, and regulations.

SEC                 Administers federal securities laws that seek to
                    provide protection for investors; ensures that
                    securities markets are fair and honest; and, when
                    necessary, provides the means to enforce
                    securities laws through sanctions.

Treasury            A major policy advisor to the president that
                    formulates and recommends domestic and
                    international economic, financial, tax, and fiscal
                    policies; serves as financial agent for the U.S.
                    government; and manufactures coins and currency.
----------------------------------------------------------------------
Source:  GAO. 

An international financial crisis may also involve foreign countries
and international organizations.  Three key international
organizations are the International Monetary Fund (IMF), the
International Bank for Reconstruction and Development (World Bank),
and the Bank for International Settlements (BIS).  Both IMF and the
World Bank were established following World War II and funded by
subscriptions or quota shares from the United States and other
members.  IMF, which was involved in one of the four crises we
discuss, was established to promote international monetary
cooperation and exchange rate stability and provide short-term
lending to members experiencing balance-of-payments difficulties. 
Originally, IMF was to make medium-term loans of 3 to 5 years'
duration for balance-of-payments support.  Its lending was to be
based on a country's fiscal and monetary policies, exchange rates,
and other macroeconomic factors.  The World Bank, on the other hand,
was to provide developing countries long-term loans for development
when private financing was unavailable.  Over the past several
decades, however, both IMF and the World Bank have provided longer
term financial assistance to countries involved in economic
adjustments.  BIS, a central bank for central banks, is both a
wholesale money market bank accepting deposits from central banks and
a forum promoting cooperation among central banks.  Established in
1930, BIS performs a variety of trustee and other banking functions,
mainly for central banks and international organizations.  With
encouragement and guarantees from leading central banks, BIS has
helped provide bridge financing\15 to a number of central banks in
Latin America and Eastern Europe pending disbursement of IMF and
World Bank credits. 


--------------------
\13 By authority of the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA), the Office of Thrift Supervision
replaced the Federal Home Loan Bank Board as primary regulator of
state and federally chartered savings institutions.  The Federal Home
Loan Bank Board was abolished. 

\14 SROs include such organizations as the Chicago Board Options
Exchange (CBOE), the Chicago Mercantile Exchange (CME), the National
Association of Securities Dealers (NASD), the New York Stock Exchange
(NYSE), and the Options Clearing Corporation (Options CC). 

\15 In the context of international finance, bridge financing is
short-term credit extended to countries in anticipation of longer
term financing. 


      POLICY TOOLS AVAILABLE TO
      CONTAIN CRISES
-------------------------------------------------------- Chapter 1:3.1

In a series of laws passed during this century, Congress gave federal
financial organizations responsible for the health of the financial
system a variety of policy tools to provide liquidity to help prevent
or contain a financial crisis.\16 These include open market
operations, access to the Federal Reserve's discount window, the
Exchange Stabilization Fund, and deposit insurance. 

Before the Federal Reserve was established in 1913, periodic
financial panics led to many bank failures, associated business
bankruptcies, and general economic contractions.  In establishing the
Federal Reserve, Congress gave it three important tools to carry out
responsibilities as lender of last resort and regulator of the supply
of money:  open market operations, foreign currency operations, and
discount window lending.  Open market operations enable the central
bank to buy and sell government securities, influencing the quantity
and growth of legal reserves and thereby enhancing or diminishing
liquidity to the overall banking system.  The Federal Reserve can
undertake foreign currency transactions to counter disorderly
conditions in exchange markets.  Discount window lending is a line of
credit facility provided by the Federal Reserve primarily to
depository institutions and occasionally to other institutions whose
financial distress might harm the economy.  The line of credit must
be secured by adequate collateral, which is determined by the Federal
Reserve. 

Another policy tool available for containing financial crises is the
Treasury Department's Exchange Stabilization Fund (ESF).\17

This fund provides the Treasury Secretary a means to (1) conduct
international monetary transactions for the purpose of stabilizing
the exchange value of the dollar, (2) counter disorderly market
conditions, or (3) extend short-term credit to foreign governments
when such credits are backed by assured sources of repayment. 
Congress has provided the Treasury Department wide latitude in its
operation of ESF.  The Secretary's decisions regarding the use of ESF
resources are subject to approval by the President but remain final
and unreviewable by any other government official. 

In the Banking Act of 1933, Congress created the federal deposit
insurance fund to better protect depositor savings and reduce the
number of runs on bank deposits.  At the time of the Continental bank
and Ohio savings and loan crises, federal deposit insurance was
administered by two separate entities, the Federal Deposit Insurance
Corporation (FDIC) and the Federal Savings and Loan Insurance
Corporation (FSLIC).  FDIC and FSLIC provided deposit insurance for
the nation's banks and savings and loans, respectively.  The
insurance funds of these entities were funded primarily through
assessments on members.  Both funds enjoyed the full faith and credit
of the U.S.  government.  In exchange, federally insured depository
institutions would be subject to strict regulatory supervision and
examination and limited in the types of activities they could
pursue.\18


--------------------
\16 See the Federal Reserve Act of 1913, the Banking Act of 1933, and
the Gold Reserve Act of 1934. 

\17 See 31 U.S.C.  ï¿½5302. 

\18 FSLIC was dissolved in 1989 by FIRREA.  A new fund, the Savings
Association Insurance Fund, was created and FDIC was designated as
its administrator. 


      U.S.  GOVERNMENT: 
      ULTIMATE LENDER OF LAST
      RESORT
-------------------------------------------------------- Chapter 1:3.2

Financial crises of the 1980s strained the basic regulatory framework
for protecting the nation's financial system.  Despite their deposit
insurance mechanisms, the savings and loan industry turned to the
federal government in the 1980s for assistance.  The nation's
experience with financial crises has increased public awareness that
the federal government, and therefore the American taxpayer, is the
ultimate lender of last resort.  This means providing liquid funds to
those financial institutions in need, especially when alternative
sources of funding have dried up.  That is, the federal government is
the entity the international financial community and financial
markets regard as a major source of funds to provide liquidity in a
crisis.  Ultimately, the U.S.  government bore the costs of several
crises. 

The experience of banks and savings and loans in the 1980s provided
ample evidence of the seriousness of the risks involved in
concentrations of certain types of financial exposure--particularly
when insufficient capital is held to protect against risk exposures. 
The failure of policymakers and regulators to effectively contain the
savings and loan crisis proved costly to American taxpayers.  Through
FIRREA, Congress created a new agency--the Resolution Trust
Corporation--to resolve failed savings and loans, liquidate their
assets, and pay off insured depositors.  The collapse of the savings
and loan industry resulted in taxpayers incurring a large expense
estimated, as of 1996, to be about $132 billion.\19


--------------------
\19 See Financial Audit:  Resolution Trust Corporation's 1995 and
1994 Financial Statements (GAO/GGD-96-123, July 2, 1996). 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:4

The objective of this study is to describe how federal financial
agencies with responsibilities for financial institutions and markets
recognized, contained, and eventually resolved four financial crises
that occurred in the 1980s. 


      SCOPE
-------------------------------------------------------- Chapter 1:4.1

During the survey phase of our work, we sought to identify all
financial disruptions in the 1970s and 1980s that had the potential,
if not quickly contained, to cause wide-ranging damage to the
financial system.  We decided that information on some events that
occurred during the 1970s--such as the Penn Central\20

commercial paper crisis and the failure of Franklin National Bank\21
and Bank I.D.  Herstatt\22 --as well as official recollections of
those events, were too dated to enable us to reconstruct an accurate
chronology and understanding of the crises.  These financial crises
also were too dated for us to determine the interactions among the
various agencies and officials involved in containing and resolving
them. 

We then considered the following financial disruptions that occurred
in the 1980s: 

  silver crisis of March 1980,

  Drysdale Government Securities failure of May 1982,

  Mexico debt crisis of August 1982,

  Continental Illinois Bank crisis of May 1984,

  Ohio savings and loan crisis of March 1985,

  market crash of October 1987, and

  Drexel Burnham Lambert failure of February 1990.\23

We selected the Mexico debt crisis, the Continental Illinois Bank
crisis, the Ohio savings and loan crisis, and the 1987 market crash
for further review and in-depth analysis on the basis of the
following criteria: 

  Decisions and actions had to be quickly made and implemented. 

  Diverse federal and nonfederal financial organizations were
     involved. 

  The disruption was significant, occurred quickly, and involved an
     abrupt and widespread reversal of expectations of market
     participants about the stability of particular institutions or
     markets that, if left unchecked, could have caused significant
     damage not only to affected markets or institutions but to other
     parts of the financial system and the economy. 

  Federal agencies could rely on their existing statutory and
     regulatory authorities and resources to deal with the problem. 
     Congressional action was not needed before federal agencies
     could respond to the crisis. 

  Senior officials were available to be interviewed. 

Taken as a whole, the crises we selected for our review sample
reflected diversity in (1) the nature of the problem, (2) the
financial institutions or markets affected, and (3) the types of
players involved.  We believe that the four cases selected cover a
wide-ranging set of experiences involving different markets and
participating decisionmakers from many sectors of government. 
Throughout, our primary interest was how federal organizations
exercised their existing authority to cope with sudden financial
distress. 


--------------------
\20 In June 1970, Penn Central--the largest railroad in the United
States and the sixth largest business enterprise in the
country--declared bankruptcy and threatened the commercial paper
market.  Penn Central had about $200 million in outstanding
commercial paper and after reporting losses, it was no longer able to
sell commercial paper nor roll over maturing issues.  Corporations
that relied heavily on commercial paper had to seek alternative
sources of funding.  Actions by the Federal Reserve--encouragement of
money center banks to lend to customers who were unable to roll over
commercial paper and discount window lending--provided liquidity,
enabling the commercial paper market to continue functioning.  This
prevented the crisis from developing into a full-scale panic. 

\21 In October 1974, the Franklin National Bank of New York--the 20th
largest bank in the United States--was declared insolvent by OCC.  At
the time, it was the largest bank failure in U.S.  history.  Nine
months before the collapse Franklin had $3.7 billion in deposits. 
Franklin had borrowed heavily in the Eurodollar interbank market and
had speculated unsuccessfully in foreign exchange and municipal
securities markets.  When Franklin was closed, it had borrowed $1,723
million from the Federal Reserve discount window.  This lending by
the Federal Reserve avoided instability in domestic and foreign
financial markets.  Losses from Franklin's failure totaled $59
million. 

\22 In June 1974, German banking authorities (Das Bundesaufsichtsamt
fur das Kreditwesen) closed Bankhaus I.D.  Herstatt in Cologne and
ordered its liquidation.  Herstatt was a large bank with
international operations and a reliance on profits from foreign
exchange and gold speculation.  It had assets of more than 2 billion
German marks.  Hundreds of large and small companies and public
authorities feared for their deposits.  Several U.S.  banks received
no foreign exchange settlement payments.  The total loss was $467
million. 

\23 Drexel's holding company declared bankruptcy in February 1990. 
In 1989, it had settled felony insider trading charges, suffered
decreased revenues as issuers in the high-yield bond market (upon
which Drexel relied for a substantial portion of its revenues) began
to default on payment obligations, and had severe short-term funding
problems when its commercial paper rating was lowered.  See pp. 
44-46 of Securities Firms:  Assessing the Need to Regulate Additional
Financial Activities (GAO/GGD-92-70, Apr.  21, 1992). 


      METHODOLOGY
-------------------------------------------------------- Chapter 1:4.2

In conducting our study, we first undertook an extensive literature
search of congressional testimony, books, journals, and newspaper
articles pertaining to financial crises.  This review enabled us to
chronologically describe the four events and identify the
participants involved in containing and resolving them and the
actions the participants took. 

We also reviewed the social science research literature in this area,
which deals with responses to natural and technological disasters,
for information relevant to our work on financial disruptions. 
Emergency situations have been the subject of social science research
for decades.\24 Although a comprehensive review of all such research
was not feasible, we reviewed the studies that disaster analysts
suggested were the most significant and relevant to financial crises. 
Our review of disaster literature led us to conceptualize financial
crisis management in terms of three primary phases, which we have
defined as follows: 

  Preparedness is the pre-crisis or pre-impact phase and includes the
     earliest sign of possible danger and any activities undertaken
     to prepare for managing a potential financial crisis before the
     crisis occurs. 

  Containment is the period when the crisis actually occurs and
     includes immediate activities undertaken in response to a
     financial crisis to mitigate the financial disruption and to
     prevent or lessen ill effects that could result due to financial
     linkages. 

  Resolution is the period of attempting to mitigate any long-term
     effects and includes activities undertaken to restore
     institutions and markets to normalcy and to reduce the
     likelihood that the crisis or similar crises will recur. 

We interviewed more than 70 federal, private sector, and state and
local officials involved in the four financial crises to determine
the nature of their involvement, interactions they had with other
participating officials, and the rationale for their actions. 
Generally, we asked the officials to draw on their experience in
these events and discuss the important lessons from that
experience--observations they would share with others who might go
through a similar experience in the future.  In addition to the
interviews, we reviewed books, journal articles, congressional
testimony, speeches, and newspaper articles.  We also reviewed agency
records, including letters, transcripts of meetings, memoranda,
notes, special studies, and other documents relating to each
organization's involvement in the four crises.  Such records were not
available for all crises. 

We received technical comments on this report from the Commodities
Futures Trading Commission, Federal Deposit Insurance Corporation,
Federal Reserve, Office of the Comptroller of the Currency,
Securities and Exchange Commission, and other officials involved in
these crises.  We incorporated the comments where appropriate. 


--------------------
\24 See Emergency Management:  Principles and Practices for Local
Government, Thomas Drabek and Gerald Hoetmer (Editors), International
City Management Association (Washington, D.C., 1990); Emergency
Management:  Strategies for Maintaining Organizational Integrity,
Thomas Drabek, Springer-Verlag (New York, 1990); Normal Accidents: 
Living With High Risk Technologies, Charles Perrow (New York, 1984). 


THE MEXICO DEBT CRISIS OF 1982
============================================================ Chapter 2

During the early 1980s, Mexico, a major U.S.  trading partner,
experienced a financial collapse precipitated in part by sharp
declines in oil prices, which reduced Mexico's foreign exchange
holdings from the sale of its oil.  The crisis began formally on
August 12, 1982, when Mexico's Secretary of Finance informed the
Federal Reserve Chairman, the Secretary of the Treasury, and the IMF
Managing Director that Mexico would be unable to meet its August 16
obligation to service $80 billion in mainly dollar-denominated debt
obligations to U.S.  and foreign banks.  The Mexico debt crisis
illustrated that growing ties between domestic and global capital
markets could trigger a domestic financial crisis. 


   SUMMARY OF CHRONOLOGY
---------------------------------------------------------- Chapter 2:1

By the time that Mexico was unable to meet debt obligations to U.S. 
and foreign banks, the Federal Reserve and Treasury had jointly
developed a strategy for U.S.  assistance to prevent a financial
crisis.  The strategy was to condition the granting to Mexico of
substantial extended credit on a commitment to an IMF economic reform
or stabilization program; at the same time, the United States would
provide short-term emergency credit and currency swaps\1 as
necessary.  When the crisis came in August 1982, the United States
took the lead in a multinational response and played a key role in
implementing the strategy.  Mexican governmental entities, European
and Japanese central banks and finance ministries, IMF, and
commercial banks in the United States and abroad were also involved
in crisis containment efforts.  The Federal Reserve played a key role
in organizing the responses of (1) U.S.  and foreign commercial
banks, which were asked to accept a moratorium on principal payments,
provide $5 billion in new loans, and restructure existing debt; and
(2) central banks in Europe and Japan, which were asked to provide
$925 million in liquidity support.  The Federal Reserve lent Mexico a
total of $1.05 billion.  The Department of the Treasury took the lead
in putting together the more immediate executive branch responses,
which involved a $1 billion ESF swap, a Department of Energy and
Department of Defense Strategic Petroleum Reserve prepayment of $1
billion for oil that the U.S.  purchased from Mexico, and a
Department of Agriculture $1 billion Commodity Credit Corporation
loan guarantee to Mexico to facilitate the import of grains and
fundamental foods.  Treasury also provided a $600 million longer term
swap in conjunction with the Federal Reserve and BIS.  IMF led
economic reform negotiations with Mexico and led an effort to obtain
$5 billion in new commercial bank loans for Mexico, and provided
close to $4 billion in medium-term credits. 


--------------------
\1 Foreign exchange swaps are bilateral agreements to exchange two
currencies at one date and to reverse the transaction at some future
date.  When a foreign central bank initiates the swap drawing, it
uses the dollars to finance sales of dollars to support its own
currency. 


   PREPAREDNESS:  INTERAGENCY
   CONTINGENCY PLANNING HELPED
   CONTAIN CRISIS
---------------------------------------------------------- Chapter 2:2

The Mexican debt crisis began on Thursday, August 12, 1982, when
Mexico's Secretary of Finance informed the Federal Reserve Chairman,
the Secretary of the Treasury, and the IMF Managing Director that
Mexico would be unable to meet its August 16 obligation to service
about $80 billion in mainly dollar-denominated debt obligations to
U.S.  and foreign banks.\2 Mexico owed $25 billion of this debt to
U.S.  banks.\3 The situation had the potential for upsetting the
financial stability of the industrialized world.  Because the private
sector was initially unwilling to lend additional money to Mexico,
the United States, IMF, and central banks of developed countries had
to step in and fill the vacuum. 

According to various U.S.  government officials, the Mexico debt
crisis, which developed visibly over several months, was not a
surprise.  The question, starting in March 1982, was not whether
Mexico was approaching crisis but what to do about it.  For months
before the start of the crisis, Federal Reserve and Treasury
officials had been watching changes in Mexico's foreign exchange
reserves, borrowing patterns, balance of trade, and domestic economic
and political situations.  Crisis management leadership was an issue,
but it was resolved before the crisis began.  Generally, leadership
in preparedness was shared by the Federal Reserve and Treasury, with
Treasury focusing on political aspects and the Federal Reserve on the
economic aspects of containment and resolution of the crisis.  Three
meetings between financial officials of the Mexican Ministry of
Finance, the Bank of Mexico, the Federal Reserve, and Treasury
concerning the deteriorating situation had already occurred before
the August 12 start of the crisis.  U.S.  officials said they had a
general understanding of a range of potential problems that Mexico's
inability to repay its debts would precipitate.  Federal Reserve and
Treasury officials said they had discussed and generally decided on
their respective agencies' responses to Mexico's expected requests
for assistance, but a single written interagency contingency plan was
not developed.  U.S.  officials said that, generally, the Federal
Reserve, Treasury, and other organizations were sharing available
information and communications were well coordinated. 


--------------------
\2 There were about 25 different kinds of Mexican debt.  Debtors
included the national oil company, the development bank, the
telephone company, and other government corporations.  A quarter of
the debt was accumulated by the Mexican state oil company. 

\3 At the time Mexico was the largest international borrower from
U.S.  commercial banks. 


      AGENCIES SHARED INFORMATION,
      PLANNED RESPONSE, AND
      RESOLVED LEADERSHIP ISSUES
      BEFORE THE CRISIS BEGAN
-------------------------------------------------------- Chapter 2:2.1

Fearful of a foreign currency crisis, Federal Reserve, Treasury, and
the Department of State (State) officials said they were monitoring
Mexico's borrowing, balance of trade, foreign exchange trends, and
domestic economic and political situations for months before the
start of the crisis.  Senior officials at the Federal Reserve and
Treasury said they met to discuss Mexico's likely request for
assistance and develop a U.S.  strategy.  These were more "when/how"
than "what if" discussions--that is, when Mexico asks for help, how
shall we respond?  The Federal Reserve and Treasury officials
identified the first opportunities to meet with Mexico's newly
appointed top financial officials at various multinational finance
meetings as well as during visits by these officials to Washington,
D.C. 

Federal Reserve officials had information about the exposure to
Mexican debt of most U.S.  banks.  They had determined, on the basis
of country lending data that the bank supervisory agencies--in
particular, OCC--maintained routinely,\4 that Mexican debt accounted
for 44 percent of the capital of the 9 largest U.S.  banks and 35
percent of the capital of the 15 biggest U.S.  regional banks.\5
Officials also knew that if payments ceased, bank capital positions
would rapidly deteriorate and threaten the banking system.  They also
understood that Mexico's debt servicing problems were likely to
spread to other developing countries. 

Preparedness planning took place before the crisis began.  On January
7, 1982--7 months before the crisis broke--State officials asked for
an interagency meeting on the Mexico debt situation.  Reports from
the Treasury attache in the U.S.  Embassy in Mexico City expressed
concern about Mexico's ability to finance its debt and access to U.S. 
financial markets.  Federal Reserve and Treasury officials said they
viewed State's requests as inappropriate because they saw the
potential crisis as one best addressed as an economic rather than as
a political problem.  They said they were concerned that State might
insist that terms of U.S.  assistance be softened for foreign policy
or diplomatic reasons.  That is, Treasury officials were concerned
that State would urge assistance even if the country was not taking
economic adjustment and reform measures.  The Federal Reserve and
Treasury initially resisted State's call for a meeting.  When the
meeting did occur on March 23, more than 2 months after the State
Department's request, Treasury officials said they asserted
themselves as leaders of the meeting.  Once State Department
officials understood that the Federal Reserve and Treasury officials
were alert to Mexico's debt problem, they stepped back. 

The initiative of top Mexican financial leaders played an important
role in U.S.  preparedness efforts.  Soon after their appointments,
Mexico's Secretary of Finance and Director General of the Bank of
Mexico requested separate meetings with the Federal Reserve, the
Department of the Treasury, and IMF--the three key organizations
whose support Mexico would need if a financial crisis developed. 
(See fig.  2.1.)

   Figure 2.1:  Selected Events in
   the Mexico Debt Crisis of 1982
   (May, June, July)

   (See figure in printed
   edition.)

Source:  GAO analysis. 


--------------------
\4 This information is maintained by the Interagency Country Exposure
Review Committee.  OCC develops and analyzes information on and
assesses risk in international lending, including the evaluation of
transfer risk associated with exposures to countries experiencing
difficulties servicing their external debt. 

\5 Banks are ranked according to size based on the amount of their
assets. 


      AGENCIES SHARED INFORMATION
      AND VIEWS BEFORE CRISIS
      BROKE
-------------------------------------------------------- Chapter 2:2.2

Mexican officials met with U.S.  officials on three separate
occasions before the crisis emerged in August.  Treasury and State
officials said they prepared for these meetings by developing and
agreeing on the positions they would take.  Treasury staff briefed
the Treasury Secretary on Mexico's situation, requests Mexico might
make, and proposed U.S.  responses.  The Treasury Secretary met with
the Federal Reserve Chairman to discuss requests and responses before
meetings with the Mexican officials.  As of early August, Mexico had
liquid reserves of less than $200 million, and the country was losing
dollars at the rate of $100 million a day.\6 Mexican capital was
being moved out of the country for a safe haven in the United States
and elsewhere.  Mexico appeared unable to generate export surpluses
and maintain confidence in its economy, which were essential for
Mexico to find the hard currency needed to service its loans. 

Treasury and the Federal Reserve had $1 billion in currency swap
arrangements with Mexico:  $300 million from Treasury's Exchange
Stabilization Fund and $700 million from the Federal Reserve's swap
line.\7 Overnight drawings on the Federal Reserve's swap arrangement
were used to bolster month-end figures for dollar reserves.\8
Treasury and Federal Reserve officials both told their Mexican
counterparts that before any substantial credit was granted to Mexico
on other than an overnight or short-term basis, Mexico should have a
convincing economic stabilization program to restore confidence in
the peso and the Mexican economy.  That is, Mexico should have an
IMF-approved economic adjustment or reform program.\9 IMF requires
that borrowing countries commit to reforms that improve the country's
economy and balance of payments.  Federal Reserve and Treasury
officials said they knew, however, that Mexico's current
president--who would soon be replaced by a successor--was unwilling
to adopt the policy measures that would be required for an IMF
program.  According to these officials, the president was in the last
year of a 6-year term and did not want to admit to having made any
economic policy errors. 


--------------------
\6 See Joseph Kraft.  The Mexican Rescue.  New York:  Group of
Thirty, 1984. 

\7 A major feature of foreign currency operations of the Federal
Reserve is the swap network, which consists of reciprocal short-term
credit arrangements with 13 foreign monetary authorities and with the
Bank for International Settlements.  These arrangements enable the
Federal Reserve to borrow the foreign currencies it needs for
intervention operations to support the dollar.  They also enable the
partner foreign central banks to borrow the dollars needed to support
their currencies.  See The Federal Reserve System:  Purposes and
Functions, Board of Governors of the Federal Reserve, Washington,
D.C.:  1984. 

\8 See Paul A.  Volcker and Toyoo Gyohten.  Changing Fortunes:  The
World's Money And The Threat To American Leadership.  New York: 
Times Books, 1992. 

\9 IMF seeks to maintain stability in the world economic and
financial system.  See Paul R.  Masson and Michael Mussa, The Role of
IMF:  Financing and Its Interactions with Adjustment and
Surveillance, Washington, D.C.:  1995. 


      BEFORE CRISIS, OFFICIALS
      COORDINATED TO AGREE ON
      STRATEGY
-------------------------------------------------------- Chapter 2:2.3

Federal Reserve and Treasury officials said they agreed on a two-part
strategy for dealing with Mexico:  (1) refuse to grant Mexico any
substantial credit unless Mexico committed to seeking an IMF
adjustment program; but (2) continue to support Mexico with advice
and overnight currency swaps until the December 1, 1982, installation
of Mexico's next president, who was expected to seek IMF help.  Any
longer term credits would have to be repaid from IMF medium-term
loans.  According to Federal Reserve officials, at the end of May,
Mexican officials asked the Federal Reserve to swap pesos for dollars
overnight so Mexico could meet its requirements for a certain level
of foreign reserves as backing for its currency.  The Federal Reserve
agreed to the overnight currency swap. 


      AGENCIES JOINTLY DEVELOPED
      CONTINGENCY PLANS
-------------------------------------------------------- Chapter 2:2.4

Over the next several months, U.S.  officials said this strategy was
challenged as Mexico's need for assistance escalated.  Mexican
officials asked the United States for an extended swap as a bridge
loan to a $2 to $3 billion jumbo loan they planned to arrange.  The
bridge loan was later obtained not through an extended swap, but
through a loan from U.S.  commercial banks.  U.S.  officials said
they explored contingency plans to address the possibility that
Mexico's President would not seek IMF help, but no such plans were
put into writing.  The outgoing President of Mexico had entered
office in 1976 while a tough and unpopular IMF program was in
progress.  Treasury, Federal Reserve, and State officials said they
discussed a variety of strategies and worked through their sometimes
differing assessments of those plans.  Among other ideas, they said
they discussed alternatives to IMF credits to assure repayment of
swaps if a crisis developed, including supplying dollars as
prepayment for oil.  The Federal Reserve could not approve an
extended swap without an assured means of repayment.  To have this
means of repayment, Federal Reserve staff drafted a letter from the
Secretary of the Treasury to the Chairman of the Federal Reserve in
which Treasury agreed to provide backing for the swaps by assuring
repayment of any drawings by Mexico. 

At the end of April, Mexico requested a $600 million overnight
currency swap with the Federal Reserve to satisfy international
reserve reporting requirements.  At the end of June, the Bank of
Mexico requested a swap on an extended basis, which the Federal
Reserve's Federal Open Market Committee approved.  The Federal
Reserve officials said they wanted such a swap contingent on Mexico
agreeing to an IMF stabilization program to repay the swaps.  When
the request from the Bank of Mexico was changed at the last minute to
an overnight swap for $200 million, the Federal Reserve Chairman
asked the Federal Open Market Committee to let its approval stand,
enabling him to make the swap available if needed to avert a
liquidity crisis and provided conditions were satisfied.  According
to Federal Reserve officials, the Federal Reserve deposited $200
million in dollars in Mexico's account at the Federal Reserve Bank of
New York, and the Bank of Mexico gave the Federal Reserve an
equivalent quantity of pesos at the going exchange rate, with a
promise to reexchange them when the swap expired.  U.S.  officials
agreed that swaps were temporary remedies and not the solution to the
much larger debt repayment problem. 

On July 23, Mexican finance officials again visited Treasury, the
Federal Reserve, and IMF in Washington, D.C.  Participants in the
meetings said that Mexico's situation was discussed at length,
particularly whether or not Mexico had the foreign currency reserves
needed to get through August.\10 U.S.  officials said they again
stressed that dollars would not be provided on an extended basis to
Mexico without that country's commitment to an IMF stabilization or
reform program.  Mexico's President reportedly would not seek IMF
help even though borrowing was increasingly difficult.  U.S. 
officials said they believed that the President of Mexico would not
be interested in an IMF program until Mexico had run out of foreign
reserves. 

The situation then sharply deteriorated.  Mexico officially asked for
the full $700 million Federal Reserve swap at the end of July. 
Planning efforts ensured that everything was in place.  According to
Federal Reserve officials, the Federal Open Market Committee had
given its approval the prior month, and officials were able to use
the instrument that had been drafted to limit the length of time that
Federal Reserve swap funds were in use.  The swap drawing was
provided August 4 and was supposed to last while Mexico began
discussions with IMF.  The funds were quickly depleted, setting the
stage for the full-blown Mexican debt crisis.  (See fig.  2.2.)

   Figure 2.2:  Selected Events in
   the Mexico Debt Crisis of 1982
   (August)

   (See figure in printed
   edition.)

Source:  GAO analysis. 


--------------------
\10 Foreign currency reserves are the stock of official assets
denominated in foreign currencies that can be used to meet external
payment obligations.  In most cases, reserves are managed by the
central bank and are part of its balance sheet. 


   CONTAINMENT:  SWIFT AND
   COLLABORATIVE ACTION TAKEN TO
   AVOID IMMEDIATE DEFAULT
---------------------------------------------------------- Chapter 2:3

The crisis formally began on Thursday, August 12, 1982, when Mexico's
Finance Secretary informed the Treasury Secretary and the Federal
Reserve Chairman that Mexico had almost run out of foreign exchange
reserves and would not be able to meet its obligations to foreign
banks on August 16.  Money that was supposed to last a month or two
drained out of Mexico's foreign exchange reserves in a flight of
money abroad.  Federal Reserve and Treasury officials said they knew
immediately that the crisis had come.  They said that outright
default would have ruined Mexico's credit rating and shut off the
further lending that was essential to the operation of its economy. 
Creditor banks would suffer losses, and the solvency of some banks
could be threatened.  U.S.  and foreign officials said that they were
concerned because the world's largest commercial banks had heavy
exposure to Mexico as well as other developing countries.  The
potential for worldwide financial system instability could not be
discounted. 

The next day, Mexican financial officials flew to the United States
to meet with Treasury, Federal Reserve, and IMF officials to discuss
a plan of action.  U.S.  officials said they encouraged accelerated
negotiations with IMF for a reform program.  According to U.S. 
officials, Mexican officials agreed, but they also said the country
would need additional help until the IMF financing could become
available. 


      AGENCIES USED CONTINGENCY
      PLANS TO AVOID IMMEDIATE
      DEFAULT
-------------------------------------------------------- Chapter 2:3.1

According to U.S.  officials, the most urgent problem facing the
government was to avoid Mexico's default on August 16, which could
threaten the capital positions of the world's largest commercial
banks.  The Treasury Secretary assigned the Deputy Secretary of the
Treasury the task of organizing the assistance effort.  Treasury
agreed that Monday morning it would provide Mexico with a $1 billion
swap from its Exchange Stabilization Fund (ESF) for 1 week.\11
However, the swap would have to be secured, and Mexico had little
undedicated cash flow.  Various federal officials said they turned to
one of the possibilities they had discussed during preparedness
planning--namely, supplying dollars as prepayment for a U.S. 
purchase of oil from Mexico.  Mexico's 1981 contract to supply oil to
the Department of Defense's Strategic Petroleum Reserve provided a
precedent for this possibility. 

U.S.  officials told us that arranging a U.S.  government oil
purchase from the Mexican government, with the proceeds of the sale
to secure the loan, was difficult and required considerable effort by
the Treasury Deputy Secretary and cooperation from the Departments of
Defense and Energy, the Office of Management and Budget, and other
U.S.  government agencies.  Negotiations with the Mexican government
were challenging, as both the United States and Mexico were concerned
about the domestic political implications of the price for the oil. 
The difficulty was essentially avoided by obscuring the price.  The
United States would pay Mexico $1 billion from ESF for oil for the
Strategic Petroleum Reserve valued at $1.2 billion.  The oil would be
delivered over the course of 15 months, and Mexico would pay a $50
million negotiating fee for the advance from the Treasury ESF.\12 The
Commodity Credit Corporation would also provide Mexico with a $1
billion credit for the purchase of U.S.  agricultural products by
October 1.  Some U.S.  officials thought the price paid for the oil
was too high, but they said that the Secretary of the Treasury
overruled their objections.  The agreement enabled Treasury to
activate the $1 billion swap on August 16, 1982.  According to U.S. 
officials, $1 billion dollars was credited to the Bank of Mexico
account at the Federal Reserve Bank of New York.  The Bank of Mexico
subsequently used the funds from the Strategic Petroleum arrangement
with the Energy Department to repay Treasury's $1 billion ESF swap. 


--------------------
\11 ESF was originally established to provide the Secretary of the
Treasury with funds to conduct international monetary transactions to
stabilize the dollar's exchange value.  The Secretary of the Treasury
may use ESF consistent with U.S.  obligations in IMF regarding
orderly exchange arrangements and a stable system of exchange rates. 
Financing is considered on a case-by-case basis on the basis of a
demonstrated need for liquidity, evidence of an appropriate economic
adjustment program in cooperation with IMF, and an assured source of
repayment.  For a more detailed discussion of ESF see pp.  114-117
and 148-152 of Mexico's Financial Crisis:  Origins, Awareness,
Assistance, and Initial Efforts to Recover (GAO-GGD-96-56, February
23, 1996). 

\12 Treasury advanced payment to the Bank of Mexico for $1 billion. 
The Department of Defense, which actually received the oil, then paid
Treasury $1 billion. 


      FEDERAL RESERVE CHAIRMAN
      SOUGHT HELP FROM CENTRAL
      BANKERS
-------------------------------------------------------- Chapter 2:3.2

As Treasury Department officials worked to avoid an immediate
default, the Federal Reserve Chairman said he focused on providing
somewhat longer term funding for Mexico.  The Federal Reserve
Chairman telephoned central bankers in other countries to discuss
Mexico's financial difficulties.  Mexico's Secretary of Finance made
similar calls to other central bankers and finance ministries.  At
the Federal Reserve Chairman's request, the Bank for International
Settlements (BIS) in Basle, Switzerland, called a meeting of central
bankers for August 18 to discuss Mexico's situation.\13

According to U.S.  officials, the central bankers agreed that the
central banks of industrialized countries would loan Mexico $1.5
billion as a credit bridge to IMF assistance, contingent on assurance
of repayment if an IMF agreement was not reached.\14

The United States would advance half and the rest would be split
among central banks in Europe and Canada and the Bank of Japan. 
Spain and the United States added an additional $350 million at the
last moment, bringing the total to $1.85 billion.  The funds were
made contingent upon Mexico showing it could put up adequate
collateral if IMF negotiations for a long-term economic stabilization
program fell through.  The U.S.  share of the $1.85 billion was $925
million and consisted of a new Treasury ESF $600 million swap with
the Bank of Mexico and a new Federal Reserve swap line of $325
million.  According to U.S.  officials, these funds were to provide
Mexico with adequate financing until a larger package could be
arranged. 


--------------------
\13 BIS is the principal forum for consultation, cooperation, and
information exchange among central bankers.  In recent years it has
mobilized supplementary resources for IMF and arranged bridge
financing for heavily indebted developing countries.  BIS was
established in 1930--and is the oldest functioning international
financial organization--to manage Germany's World War I reparations
payments.  After World War II, BIS evolved into a clearinghouse for
the main European central banks.  See "The Bank for International
Settlements and the Federal Reserve," Charles Siegman, Federal
Reserve Bulletin October 1994. 

\14 The countries participating in this agreement were Belgium,
Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the
United Kingdom, and the United States.  Spain and Switzerland
cooperated with the agreement. 


      FEDERAL RESERVE FACILITATED
      PRINCIPAL PAYMENT MORATORIUM
      AGREEMENT
-------------------------------------------------------- Chapter 2:3.3

U.S.  officials said that to provide time for IMF to negotiate a
program with Mexico, Mexico sought an agreement with U.S.  commercial
banks that would provide for a 90-day postponement of principal
payments on Mexico's debt.  The heads of about 100 leading commercial
banks attended a meeting on August 20 in New York at the Federal
Reserve Bank of New York to discuss the Mexican debt situation.\15
According to Federal Reserve officials, on August 21, Mexico's
Finance Secretary met with an advisory group of U.S.  commercial bank
representatives.\16

Emphasizing at the August 20 meeting that any agreements reached were
between Mexico's Ministry of Finance and the banks, according to
meeting participants, the president of the Federal Reserve Bank of
New York described the funding provided by the U.S.  government to
Mexico as well as multilateral negotiations for the $1.5 billion,
later raised to $1.85 billion.  The Finance Secretary of Mexico told
the bankers that Mexico would seek an IMF program, and he asked the
banks to accept postponement of Mexico's principal payments for 90
days.  With the support of this bank advisory group, headed by three
Co-Chairmen, the Mexican government identified all the banks with
loans outstanding and requested that they postpone payments due for
the 90 days.  No bank specifically objected to the request for a
standstill on payments, and central bank and Mexican officials
interpreted this to mean that commercial banks agreed to the terms
proposed by Mexico's Finance Secretary.  The advisory group also
developed information on maturing debts. 


--------------------
\15 Because the large banks had sought participation of other smaller
banks in foreign loans, estimates of the number of banks that
actively participated in loans to Mexico ranged from 500 to over
1,000. 

\16 The advisory group banks were Citicorp, Chase, Chemical, Morgan
Guaranty, Bank of America, Bankers Trust, Manufacturers Hanover, Bank
of Tokyo, Lloyds, Societï¿½ Gï¿½nï¿½rale of Belgium, Bank of Montreal,
Swiss Bank, Deutsche Bank, and Banamex. 


      CONTAINMENT WAS SLOWED BY
      UNEXPECTED ACTIONS OF
      MEXICAN PRESIDENT
-------------------------------------------------------- Chapter 2:3.4

On September 1, unexpected actions by the President of Mexico slowed
negotiations related to the IMF austerity program.  In his last
annual address, the President nationalized all Mexican banks because,
he said, they had provoked and aided the capital flight.  The
President also imposed foreign exchange controls and denounced wage
and spending restraints.  These actions caused confusion about the
Mexican government's willingness to reform its economy. 

According to Federal Reserve officials, the announcement resulted in
a surge of requests for repayments of dollar deposits in the foreign
offices of Mexican banks, which brought the international foreign
exchange clearing system to the edge of breakdown.  Mexican banks
could not honor demand for dollar deposits, and it was feared that
all the foreign currency assistance provided might be used up in
honoring these claims.  A bank advisory group pressured banks with
claims to roll over debts.  On September 7, 1982, the Federal Reserve
Bank of New York deposited $70 million from money advanced to Mexico
by BIS in the Bank of Mexico's account.  According to Federal Reserve
officials, a standstill was arranged so that the foreign branches of
Mexican banks received reduced requests to honor demands for
repayment. 

According to Federal Reserve officials, in September IMF provided
Mexico's Finance Secretary with a carefully worded memo setting forth
conditions for negotiations.  The Finance Secretary informed IMF that
the negotiations could continue.  When Mexico requested access to the
second part of the BIS and U.S.  swap lines, however, the central
banks were reluctant to provide access because Mexico's progress
toward an IMF agreement seemed slow.  (See fig.  2.3.)

   Figure 2.3:  Selected Events in
   the Mexico Debt Crisis of 1982
   (September, November, December)

   (See figure in printed
   edition.)

Source:  GAO analysis. 


      FEDERAL RESERVE CHAIRMAN
      ENCOURAGED SOLUTION
-------------------------------------------------------- Chapter 2:3.5

The Mexican government agreed to the terms of an IMF program on
October 23.  The Federal Reserve Chairman acted quickly to encourage
the containment of the crisis.  Two days later, on the 25th, he
informed BIS that the United States was prepared to permit limited
drawdowns of its portion of the funds to Mexico, on the basis of the
progress of the Mexico-IMF agreement. 

The Finance Secretary of Mexico announced the agreement's terms on
November 10.  The announcement stated that Mexico would cut its
budget deficit from 16.5 percent of gross national product to 8.5
percent to encourage private investment, reduce its foreign
borrowings in 1983 to $5 billion from $20 billion in 1981, cut back
the growth of the money supply to deal with inflation, hold inflation
to 55 percent in 1983, reduce subsidies, limit wage increases, and
increase exports.  Taxes were to be raised.  The details of the
agreement were laid out in an attached memorandum on economic
policies. 

With this agreement in hand, the Managing Director of IMF informed
the U.S.  and foreign banks they would have to provide written
commitments for an additional $5 billion in loans to Mexico by
December 15 before the IMF assistance plan could be implemented;
Mexico needed the additional loans to repay BIS and Federal Reserve
loans and to build reserves.  Unless the banks came up with the
money, the Managing Director of IMF reportedly said that he would not
recommend that the Executive Directors of IMF accept the Mexican
program. 

Once again, the Federal Reserve Chairman encouraged action on the
resolution.  He quickly announced his support for the new loans.  He
also indicated that new loans U.S.  banks made to Mexico as part of a
resolution package to service that country's international debt in an
orderly manner should not be subject to supervisory criticism as
imprudent.  With this reassurance, the banks agreed to extend more
loans to Mexico and began to negotiate terms and reschedule the $20
billion in loans coming due in 1983 and 1984.  The banks also
accepted a second 90-day moratorium.  The banks launched lengthy
negotiations among themselves about fairly sharing the new loans to
Mexico. 


      PACE OF CONTAINMENT
      QUICKENED UNDER NEW
      PRESIDENT OF MEXICO
-------------------------------------------------------- Chapter 2:3.6

Once Mexico's new President took office on December 1, 1982, the pace
of containment quickened.  Steps in the restructuring program--eased
exchange controls and increased fuel prices and interest rates--were
announced within a week by Mexican government officials, and Mexican
finance officials and the bankers agreed to terms on December 8.  On
December 22, with a commitment of $4.3 billion in new lending from
the banks, the IMF Managing Director announced that a critical mass
of new lending had enabled the IMF program to move forward. 
Throughout this period and in the weeks following, U.S.  officials
said that the United States and foreign central banks encouraged
regional and smaller banks to give full consideration to making loans
to Mexico sufficient to reach the previously announced goal of $5
billion.  In the end, 526 banks participated in the lending to
Mexico. 

By the end of 1983, the containment effort could be called a success. 
According to U.S.  officials, Mexico had repaid the interest arrears
on its loans as well as emergency loans and currency swaps,
established economic reforms, and restructured its debt through 1984. 
Mexico had not defaulted.  Large U.S.  and foreign banks had not
failed, and financial system collapse had been avoided. 


   RESOLUTION:  EXECUTIVE AND
   LEGISLATIVE INITIATIVES
---------------------------------------------------------- Chapter 2:4

To encourage more critical assessments of the risk of lending to
foreign countries and more prudent U.S.  bank international lending,
Congress passed the International Lending Supervision Act of 1983.\17
Generally, the act sought to balance the interest of debtor countries
in maintaining access to private credit markets against the need for
maintaining a safe and sound banking system.  The act required OCC,
FDIC, FHLBB, and the Federal Reserve to establish uniform systems of
supervision and ensure that, among other things,

  agency assessments of the adequacy of bank capital include country
     risk,

  banks achieve and maintain special reserves for foreign loans as
     required by the agencies,\18

  banks provide quarterly data on international banking activities to
     the agencies,

  banks publicly disclose information about their exposure in foreign
     countries that is material to bank assets and capital, and

  banks amortize fees from loans over the life of loans. 

The act significantly increased the oversight responsibilities of the
Federal Reserve and other banking agencies with respect to foreign
lending.  The act directed federal banking agencies to consult with
supervisory authorities of other countries to reach understandings
aimed at achieving effective and consistent supervisory policies and
practices with respect to international lending.  The act also
required federal banking agencies to establish regulations for
accounting for fees on international loans. 


--------------------
\17 Pub.  L.  No.  98-181, Title IX, as amended, 12 U.S.C.  
3901-3912. 

\18 The act provides for the maintenance of special reserves when the
appropriate federal regulator determines that the quality of an
institution's assets has been impaired by an inability of public or
private borrowers in a foreign country to make payments on their
external indebtedness for reasons that include a failure by the
country to, for example, move toward implementing sound economic
policies that can restore growth and enhance creditworthiness.  Such
reserves are not required for countries that are maintaining debt
service and are working with international institutions to develop
and implement sound economic policies.  The act was amended in 1989
to provide for additional agency review of risk exposures, and
appropriate additions to general reserves, of institutions with
medium- and long-term loans outstanding to any highly indebted
country.  A highly indebted country is any country designated as such
in the World Bank's annual world debt tables.  See Foreign Debt
Reserving Act of 1989, Pub.  L.  No.  101-240, ï¿½ 402. 


      THE BAKER AND BRADY PLANS
-------------------------------------------------------- Chapter 2:4.1

As the decade of the 1980s proceeded, other less-developed
countries--principally Latin American countries--went through debt
crises.  The approach used to contain the Mexican debt crisis in 1982
was used with these other countries.  Two successive U.S.  government
initiatives were undertaken to readdress developing country debt. 
Since each initiative was launched by the Secretary of the Treasury,
the plans bore the Secretary's last name.  In 1985 the Baker plan
tried to revive economic growth in developing countries by insisting
that the heavily indebted middle income developing countries
undertake economic reform programs designed to promote growth with
the support of private banks and multilateral development banks.  But
the Baker plan did not succeed in restoring growth in these
countries, and concerns grew about the monetary burden of the debt. 
In 1989, the Brady plan recognized that some of the troubled debtors
might not be able to fully service their debts and restore growth at
the same time.  The Brady plan sought permanent reductions in the
debtors' existing debt-servicing obligations in countries with
commitments to economic reform plans.  Mexico reduced its
debt-servicing burden under the Brady plan in 1990 by reducing its
stock of debt, lengthening maturity, and lowering interest payments. 


THE CONTINENTAL ILLINOIS BANK
CRISIS
============================================================ Chapter 3

The Continental Bank crisis began on May 8, 1984, when Continental
Illinois National Bank, then a major money center bank ranked the
sixth-largest U.S.  bank in terms of assets, experienced the
beginning of a sudden run on its deposits.  Beset by rumors about its
difficulties, Continental faced a liquidity crisis of major
proportions.  Federal agencies agreed that Continental's failure
would threaten the immediate health of many smaller banks whose
deposits it held.  This crisis illustrated that a financial crisis
could develop as a result of a major financial institution having a
high loan concentration in a few business sectors, such as oil or
real estate. 


   SUMMARY OF CHRONOLOGY
---------------------------------------------------------- Chapter 3:1

On May 8, 1984, the Continental Illinois National Bank (Continental),
which held a large amount of nonperforming loans,\1

experienced the beginning of a sudden run on its deposits. 
Initially, the Federal Reserve encouraged bank lending and provided
massive amounts of liquidity support.  Federal banking agencies
crafted a multipart strategy to (1) stop the run and (2) sell or
arrange to recapitalize the bank.  They announced that FDIC would
place a temporary $2 billion subordinated note in the bank, that the
ultimate resolution of Continental's problems would not subject
depositors or general creditors to loss, and that the Federal Reserve
would continue to provide liquidity support through the discount
window.  Other money center banks participated by taking $500 million
of the subordinated note.  This successfully slowed the run.  Unable
to sell the bank, FDIC permanently resolved Continental's problems
several months later with a capital infusion of $1 billion into
Continental's holding company and the purchase of $5.1 billion of its
poor-quality loans.  Treasury resolved a disagreement among the bank
agencies about the treatment of shareholders.  In consultation with
the Department of Justice, Treasury settled disagreements regarding
the treatment of bondholders. 


--------------------
\1 Nonperforming loans are those not paying principal and interest
according to the original terms of the loan agreement.  When the
principal and interest payments on a loan are past due by 90 days or
more, the loan is considered in default. 


   PREPAREDNESS:  SURVEILLANCE AND
   PLANNING PREPARED REGULATORS
---------------------------------------------------------- Chapter 3:2

On May 8, 1984, when the crisis began, Continental was a major money
center bank.  In 1981 it was ranked as the sixth-largest U.S.  bank
in terms of assets.  Continental was also the nation's leading
commercial and industrial lender and was considered a preeminent
money center wholesale bank.\2 Continental had hundreds of
correspondent banks and over $30 billion in deposits, 90 percent of
which were uninsured foreign deposits or large certificates
substantially exceeding the $100,000 deposit insurance limit. 
Continental was the largest provider of correspondent banking
services in the country.  At the time of the crisis, according to
U.S.  government documents, Continental held a large amount of
nonperforming energy and real estate loans that resulted from
inadequate management controls.  Due to these nonperforming loans,
Continental's credit rating was downgraded in July of 1982.  As a
result of the downgraded credit rating, the federal funds and
certificate of deposit markets began to dry up as the bank lost the
confidence of domestic money markets.  Continental turned to foreign
money markets for funding.  Throughout 1982, 1983, and the first part
of 1984, Continental regularly required $8 billion in overnight
funds.  In the first months of 1984 the Vice-Chairman, President, and
Chief Financial Officer resigned from Continental.  As rumors spread
about the bank's ill health, maturities on Continental notes began to
shorten, and the bank had to offer higher rates of interest to
attract lenders.  Continental was relying heavily on volatile
European funding sources.  In response to rumors about the bank's
financial difficulties, large uninsured depositors--particularly
foreign banks--were removing funds to avoid losses in case the bank
failed.\3 The bank lost about $9 billion in funding, and the prospect
was for the total to reach the $15 to $20 billion range of lost
funding.  (See fig.  3.1.)

   Figure 3.1:  Selected Events in
   the Continental Bank Crisis
   (May)

   (See figure in printed
   edition.)

Source:  GAO analysis. 

As uncertainty about the bank's health continued in May 1984, the
bank was unable to meet its funding requirements.  Beset by rumors
about its difficulties, Continental faced a liquidity crisis of major
proportions.  According to FDIC documents, federal agencies agreed
that Continental's failure would threaten the immediate health of
many smaller banks whose deposits it held and would have severe
consequences for the entire economy.  It would also, they agreed,
generate flights to quality throughout the financial markets--that
is, investors and depositors in money center banks would seek more
profitable investments and safer places for their funds,
respectively--and create severe funding problems for other large,
highly leveraged money center banks suspected of weakness because of
poor-quality loans in their portfolios.  The FDIC Chairman said that
something had to be done quickly to stabilize the situation.  By May
11, 1984, when other funding sources were unavailable, the Federal
Reserve loaned Continental $2.8 billion at the discount window. 

According to an FDIC official, the timing of the run on Continental
was the only aspect of the crisis that surprised regulatory
officials.  According to the Comptroller of the Currency, through its
routine monitoring and surveillance of Continental's financial
condition, OCC was aware of Continental's problems, which had
developed over several years.  In the 2 years before the run, OCC had
provided nearly constant supervision with bank examiners located
on-site in the bank.  After a 1982 bank examination, OCC sought
corrective measures and took enforcement action. 

Regulatory officials said they had not met to jointly develop
contingency plans to address a possible run on the bank.  However,
OCC, Federal Reserve, and FDIC officials said they had informal
relationships and had taken steps individually that prepared them to
manage the crisis.  In addition, federal officials involved in
managing this crisis had previously worked together.  For example,
staff of the Federal Reserve, FDIC, OCC, and Treasury had
communicated and coordinated on the resolution of the Penn Square
Bank in 1982. 


--------------------
\2 Continental had 57 offices in 14 states and 29 foreign countries
with $34 billion in assets, about 12,000 employees, and about 21,000
shareholders. 

\3 Continental lost about $15 billion in funding in the 10-day period
prior to May 17, 1984. 


      AGENCIES WERE AWARE OF
      CONTINENTAL'S CONDITION
      THROUGH ROUTINELY COLLECTED
      INFORMATION
-------------------------------------------------------- Chapter 3:2.1

Continental's funding difficulties began in July 1982, when the
failure of Penn Square--one of its correspondent banks--revealed that
Continental had more than $1 billion in problem energy loans.\4
Problems in Continental's loan portfolio grew in the years following
the Penn Square failure.  Continental owned nearly $1 billion in
shipping loans of questionable quality and also had loan exposure to
the Mexican and Argentine debt crises.  Continental's lenders were
increasingly concerned about the bank's creditworthiness. 

Although regulatory agency officials said they were aware of
Continental's problems, they said that no interagency meetings were
held to discuss Continental's financial condition or federal
responses to a possible run on the bank.  Before the run in May 1984,
OCC was monitoring the development of the bank's funding problems and
reporting to the Federal Reserve Bank of Chicago and FDIC.  In fact,
for months before the run, OCC and Federal Reserve Bank of Chicago
officials told us that they had tried to contain Continental's
problems by urging the bank to improve the quality of its loan
portfolio, retain earnings to rebuild capital, and investigate ways
of writing off bad loans. 

OCC routinely collected considerable documentary information about
Continental's condition, including the quality of Continental's loan
portfolio and the stability of its funding.\5

This information, and the agencies' attention to it, increased
federal agency preparedness for the crisis that later occurred.  Once
the run was under way, regulators said they made a special effort to
collect information on correspondent bank exposures to Continental
for a detailed determination of the systemic risk associated with a
Continental failure.  However, the Federal Reserve, FDIC, OCC, and
Treasury officials said they understood the general magnitude of the
crisis without having details on correspondent bank exposures. 


--------------------
\4 Penn Square was a small bank in Oklahoma City that made energy
exploration loans to many companies who failed to find oil and gas
and faced sharp drops in energy prices.  Penn Square sold these loans
to other banks for a fee.  Continental purchased $1.1 billion of
these loans.  Penn Square had more than 24,000 accounts with $250
million in insured deposits. 

\5 On April 2, 1984, OCC determined that Continental had no
significant additional domestic liquidity available, excluding the
Federal Reserve discount window, and that major sources of
international funding were drying up.  Even so, OCC did not declare
Continental insolvent. 


      FEDERAL RESERVE AND FDIC
      WERE STRATEGICALLY PREPARED
      IN SOME WAYS
-------------------------------------------------------- Chapter 3:2.2

The Federal Reserve and FDIC had already taken steps that prepared
them for the crisis.  The Federal Reserve Bank of Chicago had
developed documents describing its response to a run on a "major"
money center bank--with the unwritten understanding that the unnamed
bank was Continental.  The Federal Reserve Bank of Chicago had
planned to arrange extraordinary levels of collateral to secure
discount window lending and, if needed, quick possession of more
collateral.\6 Although FDIC had not developed a specific response to
a run on Continental, the agency had prepared legal documentation for
the placement of subordinated debt in a large bank.  FDIC had
originally developed this documentation to respond to another
possible crisis, but it was adaptable for use in responding to the
Continental crisis. 


--------------------
\6 The discount window is a line of credit facility maintained by the
Federal Reserve for direct loans to a financial institution.  All
institutions that hold required reserves with the Federal Reserve are
eligible to borrow at the discount window. 


   CONTAINMENT:  JOINT
   DISCUSSIONS LED TO CONTAINMENT
   STRATEGY
---------------------------------------------------------- Chapter 3:3

Generally, federal agencies shared the leadership in containing the
Continental crisis as each agency exercised its statutory authority. 
Agency officials said they agreed readily on some containment and
resolution strategies and less readily on others.  If the federal
agencies had met to make contingency plans before the crisis
occurred, as was done in the case of the Mexican debt crisis, they
might have avoided having to resolve their differing views in a
crisis setting. 


      OFFICIALS AGREED ON
      INTERVENTION AND CONTAINMENT
      STRATEGY
-------------------------------------------------------- Chapter 3:3.1

Top officials of OCC, FDIC, and the Federal Reserve had the first of
many joint discussions about the Continental crisis on the morning of
May 11, 1984, at Federal Reserve headquarters in Washington, D.C.\7
They immediately agreed that the government should intervene to
prevent the bank's failure.  They believed Continental's failure
would seriously threaten the banking system.  They also agreed that
FDIC would not pay off depositors by liquidating the bank and meeting
its obligations from the proceeds.  Regulators thought that a pay-off
would be disruptive to the financial system and FDIC, could cause a
run on other money center banks, and could disrupt relations between
U.S.  banks and foreign creditors.  At this time federal banking
regulatory agencies generally wanted the management and shareholders
of Continental to be accountable for mistakes they made, and OCC
communicated this to Continental officials.  An interim financial
assistance program was to ensure that Continental would have the
capital resources, liquidity, and the time it needed to end the
crisis of confidence and resolve problems in an orderly and permanent
manner.  Agency officials also agreed that FDIC should purchase $2
billion in subordinated debt from Continental, and the Federal
Reserve should provide loans to Continental through its discount
window as long as FDIC was involved in providing capital to
Continental.\8 The subordinated debt note was viewed as a short-term
funding solution--that is, a mechanism to stabilize Continental's
funding sources.\9

Other elements of the strategy emerged in discussions among Treasury
and the other money center banks.  On Monday, May 14, the Secretary
of the Treasury said he suggested, and bank regulators agreed, that
other banks should participate in the FDIC-subordinated note to
demonstrate the banking system's confidence in Continental.  After
discussions revealed that the other banks had concerns about the
riskiness of this participation, the FDIC Chairman suggested that
FDIC assure the banks and all depositors and lenders that the
resolution of the bank would not result in any losses in dealings
with Continental.  After some discussion, the other regulators agreed
to this, and the banks participated by taking $500 million of the
note. 

The discount window loans to Continental--which quickly exceeded any
previous bank loan from any Federal Reserve Bank--gave Continental
the funding it needed to pay off maturing notes.  However, this
Federal Reserve assistance did not mitigate the market's distrust of
Continental's financial strength, and normal funding was impossible. 


--------------------
\7 See Irvine H.  Sprague.  Bailout:  An Insider's Account of Bank
Failures and Rescues.  New York:  Basic Books, 1986. 

\8 Federal Reserve discount window borrowing reached a daily high of
$7.6 billion in August 1984. 

\9 The note was conditioned on Continental's accepting certain
restrictions related to hiring, promotions, and other factors.  FDIC
could replace senior management; remove members of the Board of
Directors; and, in principle, control the bank. 


      JOINT AGENCY ANNOUNCEMENT OF
      RESCUE PACKAGE SLOWS RUN
-------------------------------------------------------- Chapter 3:3.2

With the hope of ending the run and restoring confidence in
Continental, FDIC, OCC, and the Federal Reserve jointly announced on
May 17th the placement by FDIC of the $2 billion subordinated debt
note.  As subordinated debt, the note would be the last debt repaid
in the event of a failure.  Therefore, all current creditors would be
repaid before FDIC.  This was by far the largest commercial bank
bailout in FDIC history.  FDIC provided $1.5 billion of the
subordinated debt, and a group of seven major U.S.  banks provided
the balance.  In addition, a consortium of 28 banks provided
Continental with a $5.3 billion funded line of credit, which was
later replaced by a $4.5 billion standby line of credit.  The
agencies also announced that the resolution of the bank would not
impose losses on anyone.  This meant that FDIC would not pay off
depositors by liquidating the bank and meeting its obligations from
the proceeds--which could fall short and would take a considerable
period of time.  Instead, FDIC would support a takeover, find a
merger partner, or recapitalize the bank; in any event, all
Continental obligations would be honored.  The Federal Reserve would
continue to meet the bank's liquidity requirements. 

This announcement did not completely end the run.  Withdrawals from
Continental slowed considerably after the announcement, but they
continued.  However, the announced intervention bought regulators
some limited time to explore alternatives. 


      SECRETARY OF THE TREASURY
      MEDIATES AGENCIES'
      DISAGREEMENT OVER RESCUE
      METHODS
-------------------------------------------------------- Chapter 3:3.3

In keeping with its statutory authority, FDIC officials said it
developed the solution to Continental's problem in consultation with
the other regulatory agencies.  FDIC first allowed the bank to look
for a merger partner or a buyer.  When Chemical, Citicorp, and First
Chicago banks reviewed Continental's loan files, they decided that
Continental was in worse shape than they expected and declined to
participate in a merger or purchase.  Regulators said they were
concerned that Continental could worsen the financial condition of an
acquiring institution.  The regulators said they believed that any
merger or purchase would likely require massive FDIC assistance. 
FDIC developed a plan to place capital in the bank and resolve the
difficulties through open bank assistance.  The continuing
withdrawals from the bank limited the amount of time available for
the resolution effort. 

Regulatory officials said they resolved several disputes in the
development of the resolution.  Concerned that the bank's
shareholders would not support a package that left them entirely at
risk, FDIC proposed that the resolution leave the shareholders with
15 percent of the bank's stock free and clear so that the
shareholders would not be at risk to absorb further losses.  FDIC
would hold 85 percent of the stock.  OCC and the Federal Reserve said
they objected strongly, arguing that the government should not bail
out stockholders of the bank or its holding company, who should risk
a complete loss on their investment.  The agencies brought the
dispute to the Secretary of the Treasury, who agreed with OCC and
Federal Reserve officials that stockholders should be at risk.  FDIC
agreed that the final package would leave the stockholders at risk of
losing their entire investments. 

A similar dispute arose over the treatment of the bank holding
company's bondholders.\10 All agencies agreed that the holding
company bondholders should be at risk--but their bonds had indenture
covenants\11 preventing infusions of capital into the bank from
outside the holding company by sales to others of bank securities
without the approval of debt holders.  Placing capital directly into
the bank without waivers from bondholders, which would not help the
holding company, could provoke a lawsuit.  Placing the capital in the
holding company to be downstreamed into the bank avoided legal
complications but left the holding company solvent and the
bondholders whole. 

Treasury officials said they believed that the holding company
bondholders should not be bailed out and the assistance should be
placed directly in the bank.  As the primary regulator of bank
holding companies, Federal Reserve officials said they argued that
the holding company should be bailed out to avoid major financial and
confidence problems in other bank holding companies.  FDIC officials
said they argued that Continental could not afford the legal battles
involved with a direct placement of capital in the bank; they also
said that placing subordinated debt that does not count as
capital--and that does not have legal complications--would not
adequately reassure the public that the bank was properly
capitalized.  Treasury officials said they continued to insist on the
placement of subordinated debt.  The head of FDIC eventually took the
issue to the Secretary of the Treasury, who indicated that FDIC
should use its legal authority to press ahead with its plan to
downstream assistance from the holding company to the bank.  FDIC's
version of the assistance package was supported by a legal opinion
from the Department of Justice. 

The final rescue package was announced at a joint OCC, FDIC, and
Federal Reserve news conference by the FDIC Chairman on July 26,
1984.  The permanent assistance program was designed to prevent the
failure of Continental and enable the bank to restore its position as
a viable self-financing entity.  FDIC placed $1 billion in the
holding company in exchange for holding company stock.  This $1
billion was immediately downstreamed to the bank as equity capital. 
FDIC also purchased troubled loans with a face value of $5.1 billion
for $3.5 billion.  FDIC paid for the troubled loans by assuming
Continental's debt to the Federal Reserve Bank of Chicago.  Final
accounting of cost to FDIC was $1.6 billion. 

Key management changes were also announced.  FDIC had the right to
convert up to 80 percent of the preferred stock.  Stockholders were
left with a 20-percent stake in the bank, but losses on the bad loan
portfolio were charged against that stake and eventually wiped it
out.  FDIC sold its remaining interest in Continental in June 1991. 
Continental continued to operate, but as a much different
institution.  (See fig.  3.2.)

   Figure 3.2:  Selected Events in
   the Continental Bank Crisis
   (July, September)

   (See figure in printed
   edition.)

Source:  GAO analysis. 


--------------------
\10 Continental's parent holding company was Continental Illinois
Corporation. 

\11 Indenture covenants are formal agreements between bond issuers
and bondholders specifying the terms and conditions of bonds.  The
indenture covenants may include such considerations as, for example,
amount of issue, interest to be paid, maturity date, repayment
schedule, call provisions, collateral pledged, appointment of a
trustee, and other items. 


   RESOLUTION:  FDIC STRENGTHENED
   OVERSIGHT OF NATIONALLY
   CHARTERED BANKS
---------------------------------------------------------- Chapter 3:4

FDIC officials told us that the Continental failure led to some
changes in procedures at FDIC.  For example, before the Continental
failure, FDIC examined only state-chartered banks that were not
members of the Federal Reserve System.  After Continental, FDIC
conducted examinations of state-chartered banks that were members of
the Federal Reserve System as well as nationally chartered banks like
Continental.  Also, FDIC officials said they began to meet weekly
with senior officials of other federal bank supervisory agencies to
exchange information about emerging bank problems. 

Hearings on the failure of Continental were held in September and
October 1984 by the House Committee on Banking, Finance, and Urban
Affairs.  Senate hearings were not held.  The failure of Continental
raised questions for the Committee about

  whether regulators had created a two-tier system for large and
     small banks, with large banks being considered "too big to
     fail";

  whether Congress should have a voice in rescue plans created by
     bank regulators;

  whether the decades-old system of deposit insurance needed to be
     reformed; and

  whether Congress should further deregulate banks. 


      LEGISLATIVE INITIATIVES TO
      LIMIT "TOO BIG TO FAIL"
      POLICY
-------------------------------------------------------- Chapter 3:4.1

Although Congress considered several banking bills in 1984 through
1986 that contemplated a wide variety of banking topics, bank reform
legislation did not pass during this period.  In 1987, Congress
passed the Competitive Equality Banking Act of 1987 (P.L.  100-86). 
Among other things, the act gave FDIC bridge bank authority to
facilitate FDIC's disposition of failed banks.  The bridge bank is to
assume the assets and liabilities and carry on the business of the
failed bank for a limited time until the bank is acquired or merged. 
Bridge bank authority essentially buys FDIC time to arrange an
orderly merger or acquisition and enables the agency to delay
resolution of holding company issues until other issues are resolved. 

The Federal Deposit Insurance Improvement Act of 1991 (FDICIA)\12

established cost constraints for regulators resolving financial
difficulties of banks.  Before the passage of FDICIA, FDIC could
fully protect all bank depositors and creditors, regardless of cost,
if the bank was deemed essential to its community.  The new act
narrowed the circumstances under which FDIC could act in this way. 
The least-cost provision of the act sought to limit the circumstances
under which uninsured deposits are fully protected by preventing FDIC
from incurring a loss when it protects them.\13 Only when a large
bank failure is determined to pose a systemic risk to the nation's
financial system may FDIC protect all deposits and nondeposit
liabilities in a failing depository institution and sustain a loss. 
FDICIA also required that such action be approved in advance by
FDIC's Board of Directors, the Board of Governors of the Federal
Reserve, and the Secretary of the Treasury in consultation with the
president.  Absent such approval, FDIC must resolve the problems of a
failing institution using the resolution method that is least costly
to the insurance fund--which can be a liquidation in which only
insured deposits are protected.  Other legal changes would also
influence how FDIC would handle a failure like Continental's today. 
Also, the Resolution Trust Corporation Completion Act of 1988\14
prohibited the use of federal deposit insurance funds to benefit
shareholders in connection with a resolution. 


--------------------
\12 P.L.  102-242. 

\13 1992 Thrift Resolutions:  RTC Policies and Practices Did Not
Fully Comply With Least-Cost Provisions (GAO/GGD-94-110, June 17,
1994). 

\14 P.L.  103-204. 


THE OHIO SAVINGS AND LOAN CRISIS
============================================================ Chapter 4

The Ohio savings and loan crisis began on March 5, 1985, when the
most widespread run on depository institutions since the Great
Depression began.  The run was set off by the collapse in March of
Home State Savings Bank, the largest of Ohio's 71 privately insured
savings and loan institutions.  About $4 billion in deposits of a
half-million depositors were threatened at 71 institutions.  This
crisis showed that a financial crisis occurring in a financial
institution that is not federally insured could involve the federal
government in a financial rescue.  This case also illustrated the
linkage that had developed between securities markets and financial
institutions.  Factors that helped contain the Ohio savings and loan
crisis included the joint leadership of the Ohio Governor's Office
and the Federal Reserve, provision of liquidity by the Federal
Reserve Cleveland Bank, innovative action by the state of Ohio and
federal regulators, and collaboration between federal and state
regulators. 


   SUMMARY OF CHRONOLOGY
---------------------------------------------------------- Chapter 4:1

The 1985 Ohio savings and loan crisis was the most widespread run on
depository institutions since the Great Depression.  The run was set
off by the collapse in March of Home State Savings Bank, the largest
of Ohio's 71 privately insured savings and loan institutions.  A
concern of the Federal Reserve was that the run could spread to other
states with private insurance funds and ultimately to federally
insured savings and loans.  Because the 71 thrifts were not federally
regulated, federal agency officials said they lacked immediate access
to important crisis-related information.  At the Ohio Governor's
request, the Federal Reserve provided liquidity support to qualified
thrifts experiencing heavy withdrawals.  Federal Reserve officials
and staff also worked closely with the Ohio Governor, sometimes
engaging in nonroutine activities.  Federal Reserve officials helped
the state monitor the run, collect information, respond to questions
from the public, and find a permanent solution to the instability. 
Ultimately, the run was contained through a state-declared bank
holiday, temporary limits on withdrawals, and state-mandated
conversion of most of Ohio's privately insured thrifts to federally
insured status.  The Federal Home Loan Bank of Cincinnati provided
the thrifts with federal deposit insurance.  By the middle of June
1985, most thrifts had reopened with federal insurance, and
confidence had been restored in nearly all of the institutions. 

Figure 4.1 lists a chronology of events in the Ohio savings and loan
crisis. 

   Figure 4.1:  Selected Events in
   Ohio Savings and Loan Crisis of
   1985 (March)

   (See figure in printed
   edition.)



   (See figure in printed
   edition.)

Source:  GAO analysis. 


   PREPAREDNESS:  LIMITED
   INFORMATION AND AUTHORITY MADE
   PLANNING DIFFICULT
---------------------------------------------------------- Chapter 4:2

In 1985, savings and loan institutions in Ohio experienced the most
widespread run on depository institutions since the Great Depression. 
About $4.3 billion in deposits of a half-million depositors were
threatened at 71 institutions.  The run, which began on March 5,
resulted from publicized losses of $150 million from Home State
Savings Bank (Home State), Ohio's largest privately insured savings
and loan institution.\1 The run continued despite efforts by Ohio and
Ohio Deposit Guarantee Fund officials to reassure the public.  State
officials said that depositor funds were safe, and officials of the
private Guarantee Fund said that depositors would not lose their
money.  The Ohio Deposit Guarantee Fund was a private,
state-chartered insurance system that guaranteed 100 percent of all
deposits.  After questions were raised on a radio talk show about the
ability of the Guarantee Fund to meet the needs of Home State
depositors, withdrawals began at other thrift institutions. 

Home State's losses were due to the failure on March 4, 1985, of a
largely unregulated government securities dealer, ESM Government
Securities, following a massive fraud involving false audit reports. 
ESM was missing about $300 million in customer funds.  Home State was
heavily exposed to this failed securities dealer through repurchase
agreement transactions.\2 Lax supervision had allowed Home State to
borrow almost 50 percent of its funds through ESM.  As the result of
ESM's failure, Home State and American Savings and Loan Association
in Florida, which were part-owned by the same person, sustained
substantial losses.  Home State estimated losses at $150 million or
more. 

Home State's deposits, like those of the other state-chartered and
privately insured Ohio thrifts, were insured by the Ohio Deposit
Guarantee Fund.  Immediately before the run on Home State, the
Guarantee Fund had total assets of $130 million to guarantee about
$4.3 billion in deposits for about 500,000 depositors.  According to
Federal Reserve officials, the thrifts had chosen private deposit
insurance because such insurance was less expensive and burdensome
compared to federal deposit insurance.  The Guarantee Fund had no
legal power to ensure compliance by its members and had no cease and
desist power.  According to a Guarantee Fund official, the privately
insured Ohio thrifts were regulated by the Ohio Department of
Commerce's Division of Savings and Loan Associations. 


--------------------
\1 On March 6, 1985, the Cincinnati Enquirer reported that Home State
might suffer large losses in connection with the failure of ESM. 

\2 Repurchase agreements are contracts to sell and subsequently
repurchase securities at a specified date and price. 


      FEDERAL AGENCIES HAD LIMITED
      INFORMATION ABOUT HOME STATE
-------------------------------------------------------- Chapter 4:2.1

When the run on privately insured thrifts began, federal agencies had
little information about the Guarantee Fund or thrifts it insured. 
The Federal Reserve Bank of Cleveland had been concerned for some
time about the condition of the fund and its insured thrifts. 
However, the fund had not honored the Reserve Bank's 1982 requests
for information.\3 FHLBB, which had failed in its attempts to bring
the privately insured institutions under Federal Savings and Loan
Insurance Corporation (FSLIC) coverage, also lacked information about
the condition of the thrifts.\4 The Guarantee Fund had collected
information on the financial condition of the thrifts it insured, but
it did not share this information with the Federal Reserve. 

Although Ohio state banking regulators and officials of the guarantee
fund were aware of the exposure of Home State to ESM Government
Securities, they said they had not initiated any interagency meetings
with federal officials to prepare for a possible crisis resulting
from the failure of Home State.  Ohio state regulators had initiated
interagency meetings, but those meetings had not involved federal
officials.  About 5 months before the run--in October 1984--the Ohio
Superintendent of Savings and Loans met with officials of ESM
Government Securities, Home State, and the Guarantee Fund to caution
them on Home State's exposure to ESM.  However, according to a state
official, state banking officials were reluctant to issue cease and
desist orders because state judges would not support them.  In
addition, the Guarantee Fund had no authority to issue or enforce a
cease and desist order. 


--------------------
\3 The Federal Reserve Bank of Cleveland was aware of financial
problems at at least one privately insured thrift as a result of its
discount window transactions. 

\4 FSLIC was established by Congress in 1934 to insure deposits in
savings and loan institutions and savings banks.  The Financial
Institutions Reform, Recovery, and Enforcement (FIRREA) Act of 1989
transferred the assets and liabilities of the Corporation to a new
deposit insurance fund called the Savings Association Insurance Fund. 
This fund is operated by the Federal Deposit Insurance Corporation. 


   CONTAINMENT:  OHIO
   GOVERNOR AND FEDERAL RESERVE
   LED CRISIS CONTAINMENT EFFORTS
---------------------------------------------------------- Chapter 4:3

A lack of information about the scope of the crisis and the financial
condition of the 71 Ohio thrifts complicated and slowed federal and
state responses to the crisis, which took about 3 months to resolve. 
State and federal officials said the State of Ohio and the Federal
Reserve intervened after it was clear that Home State and many of the
other Ohio thrifts were in poor financial shape and unable to stop
the runs on their deposits, and the private Guarantee Fund was
insufficient to cover depositor withdrawals. 

Among other things, the containment and resolution efforts involved
discount window borrowing to satisfy deposit withdrawals, intensive
information gathering to monitor the run, carefully managed
communications with the public, the declaration of a bank holiday for
the thrifts, emergency state legislation, and an intensive effort to
bring Guarantee Fund-insured thrifts under federal deposit insurance. 

According to Federal Reserve and Federal Home Loan Bank officials,
leadership during the Ohio savings and loan crisis came primarily
from the Governor of Ohio and officials of the Federal Reserve.  The
legal authority necessary to contain and resolve the crisis rested
with the Governor of Ohio.  Federal Reserve officials--including the
president and staff of the Federal Reserve Bank of Cleveland and the
Federal Reserve Board Chairman--facilitated decisions and actions of
the Ohio Governor.  According to the Governor of Ohio, the Federal
Reserve also provided liquidity support to the privately insured
thrifts, supplied bank examiners to monitor the run and conduct
federal deposit insurance examinations, and assisted in other ways. 


      FEDERAL AGENCIES DID NOT
      AGREE ON NECESSITY OF
      INVOLVEMENT
-------------------------------------------------------- Chapter 4:3.1

Federal financial officials said they disagreed about the necessity
to become involved in the Ohio savings and loan situation.  The top
FHLBB official told us that he was responsible for regulation and
oversight of federally chartered thrifts and the operation of FSLIC
and was not inclined to involve FHLBB in crisis management efforts,
since the thrifts had elected private rather than federal deposit
insurance.  A Federal Reserve official told us that the Federal
Reserve Board Chairman was instrumental in encouraging Federal Home
Loan Bank officials to provide federal deposit insurance for
qualified Ohio thrifts.  According to Federal Reserve and Ohio
officials, FDIC officials were also reluctant to be involved; they
considered the crisis a state problem. 


      FEDERAL RESERVE OPENED
      DISCOUNT WINDOW AS RUN
      CONTINUED
-------------------------------------------------------- Chapter 4:3.2

On March 4--the same day that ESM failed--the Federal Reserve Bank of
Cleveland received a request from Home State for information about
discount window borrowing.  After reviewing Home State's application,
the Federal Reserve Bank of Cleveland judged Home State's collateral
acceptable and began discount window lending.\5 During the week of
March 5 through 9, the Federal Reserve Bank of Cleveland followed
routine procedures to make cash shipments to various Home State
offices.  Federal Reserve officials told us they were increasingly
concerned that Home State's problems could spread to other privately
insured Ohio savings and loans. 

By the end of the first week of the run, Home State depositors had
withdrawn an estimated $155 million, and the Guarantee Fund had
advanced $45 million to satisfy deposit demands, according to a
Guarantee Fund official.  On March 10, 1985, the Federal Reserve
emphasized in a public statement that privately insured,
state-chartered depository institutions could be eligible for
discount window assistance. 


--------------------
\5 The Depository Institutions Deregulation and Monetary Control Act
of 1980 (P.L.  No.  96-221) gave nonmember depository institutions,
including the state-chartered thrifts in Ohio, eligibility for
discount window borrowing. 


      FEDERAL RESERVE BELIEVED
      RISK OF CONTAGION MADE
      CONTAINMENT EFFORTS
      NECESSARY
-------------------------------------------------------- Chapter 4:3.3

During the week of March 4 through 9, the Federal Reserve Bank of
Cleveland officials said they worked to determine Home State's
financial condition and the likelihood that the run would threaten
other institutions in Ohio and other parts of the country.\6 They
were also concerned about the payment system, since Guarantee Fund
thrifts had correspondent clearing relationships with commercial
banks.  In addition, the Federal Reserve Bank of Cleveland helped
educate some members of the Ohio Governor's staff about banking
issues, including possible approaches to solving the Home State
problem.  On March 6, a senior Federal Reserve examiner who had
reviewed Home State's books told the president of the Federal Reserve
Bank of Cleveland that the financial condition of Home State was as
bad as any he had seen. 

Federal Reserve Bank of Cleveland officials said they conferred with
other Federal Reserve officials in Washington, D.C., and New York
about possible effects of the run on other thrifts and banks. 
Federal Reserve officials decided that the Federal Reserve was
compelled to act to contain the crisis because of the possibility of
contagion and possible effects on the dollar in international foreign
exchange markets.  The decision was difficult because of the lack of
reliable information on the financial condition of the privately
insured institutions. 


--------------------
\6 Georgia, Maryland, North Carolina, Pennsylvania, Rhode Island, and
Utah also had privately insured savings and loans. 


      FEDERAL RESERVE LED EFFORTS
      TO OBTAIN RELIABLE
      INFORMATION
-------------------------------------------------------- Chapter 4:3.4

Federal Reserve officials said the lack of information on the
financial condition of Guarantee Fund thrifts delayed decisive action
by the state of Ohio and the Federal Reserve and prompted debates
about the existence of risk to the financial system.  When Home
State's problems were first disclosed, little information was
available to state and federal agencies.  The Federal Home Loan Bank
of Cincinnati had quarterly and annual reports of the Guarantee Fund
insured thrifts, but these were considered of little value because
they had not been verified by on-site federal examinations and did
not provide information about financial linkages, such as creditor
relationships. 

With assistance from Ohio thrift regulators, the Federal Home Loan
Bank of Cincinnati, the Office of the Comptroller of the Currency,
and FDIC, the Federal Reserve said it initiated a large effort to
quickly determine the financial condition of the privately insured
Ohio thrifts and how many would qualify for liquidity assistance
through the discount window.\7 On March 6, 1985, several senior
members of the Federal Reserve Bank of Cleveland's Division of Bank
Supervision and Regulation reviewed records at Home State.  On March
8, 1985, the Federal Reserve received the available examination
reports from the state on thrifts with deposits insured by the
Guarantee Fund.  Next, about 200 examiners--most of them Federal
Reserve examiners--were deployed throughout the state on March 11 to
collect operational and financial information on those thrifts.  The
Federal Reserve Bank of Cleveland and the Federal Home Loan Bank of
Cincinnati began assessing the condition of Guarantee Fund thrifts. 
On this basis, the Federal Reserve Bank of Cleveland decided which
thrifts could survive with liquidity assistance from the discount
window until a permanent solution could be devised. 


--------------------
\7 The discount window loans would be made by the Federal Reserve
Bank of Cleveland and secured by government and agency securities,
commercial loans, and residential mortgages. 


      OHIO GOVERNOR DEVELOPED
      BASIC STRATEGY
-------------------------------------------------------- Chapter 4:3.5

The then-Governor of Ohio told us that on March 6, 1985, he received
a telephone call from the owner of Home State, who told him that the
failure of ESM Government Securities had caused his thrift problems. 
The Governor asked his chief of staff to define the problems,
ascertain the causes of the problems, and determine whether other
thrifts were threatened.  The Governor received assurances from his
staff that there were no problems.  Federal Reserve officials
initially had difficulty convincing the Governor of Ohio that the
situation could prove serious.  The Governor also discussed the Home
State situation with state legislative leaders.  He and they agreed
that Ohio had to act to protect depositors and thrifts; they also
agreed, however, that the state would not put money into Home State,
although it should do something to protect other institutions.  One
of the Governor's objectives was to quickly find a buyer for Home
State. 


      STATE AND FEDERAL OFFICIALS
      DISCUSS OBJECTIVES AND
      STRATEGIES
-------------------------------------------------------- Chapter 4:3.6

The weekend of March 9 and 10, the Governor met with advisors to
discuss options; he also formally requested help from the president
of the Federal Reserve Bank of Cleveland.  Federal Reserve officials
and the Governor's staff discussed the possibility of bringing the
privately insured thrifts under federal deposit insurance.  The
president of the Federal Reserve Bank of Cleveland told us that on
March 10, 1985, the Federal Reserve invited several large Ohio bank
holding companies to discuss purchasing Home State.  Similar meetings
with out-of-state institutions concerning Home State and other
privately insured thrifts that would not qualify for federal
insurance took place on March 16 and 17.  The potential buyers, which
were unable to determine the financial condition of Home State,
wanted the state to provide indemnification or compensation for
losses.  The Governor said he believed this would be unacceptable to
the legislature and voters. 

Federal Reserve and Ohio state officials said they worked closely
together, despite the differences in their primary goals.  Federal
Reserve officials were most concerned about stopping the run and
preventing it from spreading to other states.  State officials were
most concerned about limiting the financial exposure of the state of
Ohio and minimizing losses to individual depositors.  Officials of
the Federal Reserve Bank of Cleveland and the Ohio Governor's Office
had not worked together before, and neither group fully understood at
first the other's responsibilities, concerns, and resources,
according to officials we interviewed.  Officials said that
educational efforts required considerable time. 

During the weekend of March 9 and 10, Federal Reserve officials said
they discussed the objectives of the Federal Reserve's involvement;
possible future events; and operational and logistical actions,
including ways to improve operations for monitoring the run.  Federal
Reserve officials focused on promoting cooperative efforts among the
various parties involved in managing the crisis. 


      TO ENHANCE COORDINATION AND
      COMMUNICATION, FEDERAL
      RESERVE ENGAGED IN
      NONROUTINE ACTIVITIES
-------------------------------------------------------- Chapter 4:3.7

Federal Reserve officials anticipated problems communicating and
coordinating with their examiners in the field who were monitoring
the run.  The Federal Reserve Bank of Cleveland said it set up a
situation room to facilitate communication and coordination during
crisis containment efforts.  The room, which was near the offices of
senior officials, was equipped with 20 telephones, maps, televisions,
and radios to monitor the crisis, including media reports.  Examiners
were briefed about events, provided with the latest financial
information on thrifts insured by the Guarantee Fund and packages of
documents necessary for discount window borrowing for the thrifts,
and equipped with cellular telephones or pagers. 

Federal Reserve officials said, and Federal Reserve documents
demonstrate, that they engaged in other nonroutine activities to
facilitate crisis containment efforts.  On March 11, 1985, Federal
Reserve examiners were positioned throughout Ohio near Guarantee Fund
thrifts to unobtrusively survey levels of depositor traffic in thrift
lobbies and parking lots.  Examiners were to report activity back to
the situation room.  The examiners were instructed to avoid doing
anything that would alarm thrift employees or their customers. 
Examiners were also to deliver documents for borrowing at the
discount window and establish secure warehouses for collateral. 
Situation room personnel began to contact the thrifts to advise them
of the availability of the discount window, inquire about
withdrawals, and offer to send an examiner to deliver borrowing
documents and secure collateral. 


      FEDERAL RESERVE COMMUNICATED
      CAREFULLY WITH THE PUBLIC
      AND MEDIA
-------------------------------------------------------- Chapter 4:3.8

Communications with the public were carefully managed by the Federal
Reserve Bank of Cleveland.  Officials of the Ohio Superintendent of
Savings and Loans, the conservator of Home State, and the Guarantee
Fund were not answering questions from the public.  According to
Federal Reserve documentation, the Public Information Department at
the Federal Reserve Bank of Cleveland took calls from depositors,
bank officers and directors, municipal officials, congressional
offices, and the print and broadcast media.  Questions concerned when
deposits would be available, deposit insurance, why thrifts had been
closed, and how depositors were supposed to pay their bills.  The
most difficult task was explaining that the thrift crisis was the
responsibility of the state of Ohio and not the federal government
and that the Federal Reserve was acting as a facilitator. 

To ensure consistency and minimize confusion in communications with
the media, two officials were assigned the task of communicating with
media representatives.  The Federal Reserve publicly restated its
policy that state-chartered institutions were eligible for liquidity
assistance through the discount window under normal terms and
conditions. 


      AS RUNS SPREAD, OHIO
      GOVERNOR CLOSED HOME STATE
      AND LEGISLATURE ACTED
-------------------------------------------------------- Chapter 4:3.9

The runs on deposits intensified, spreading to other institutions
insured by the Guarantee Fund, despite continued assurances from
officials of the State of Ohio and the Guarantee Fund that depositor
money was safe.  About $23.4 million in withdrawals occurred on March
13 and $63.9 million on March 14.  According to Federal Reserve
documentation, six Guarantee Fund-insured thrifts were particularly
hard-hit.  At the drive-in windows of some Cincinnati institutions,
examiners observed some lines as long as 100 cars. 

The Governor of Ohio and the state legislature took several actions
to reduce the widening depositor withdrawals.  The Governor told us
that he announced that Home State would not reopen for business; he
also appointed a conservator to wind up the thrift's affairs.  At the
time of its failure, Home State had $1.4 billion in assets and 92,000
accounts at 33 offices.  Home State's problems would clearly exhaust
the $130 million Guarantee Fund. 

On March 13, 1985, the Ohio legislature passed a bill that
appropriated $50 million for a new fund to back the remaining
Guarantee Fund thrifts--excluding Home State--and provided for thrift
contributions of $40 million.  On March 14, the Chairman of the
Federal Home Loan Bank Board met with members of Ohio's congressional
delegation in Washington, D.C.  The Chairman of the Federal Home Loan
Bank told us that the subject of the meeting was expedited approval
of federal deposit insurance for the thrifts insured by the Guarantee
Fund.  Also on March 13, 1985, Federal Home Loan Bank officials began
examining state reports on thrifts to estimate the number eligible
for federal deposit insurance. 


      GOVERNOR DECLARED BANK
      HOLIDAY AND ESTABLISHED
      PUBLIC COMMUNICATIONS CENTER
------------------------------------------------------- Chapter 4:3.10

The then-Governor of Ohio told us that on March 14, 1985, officials
of some of the privately insured thrifts told him that they were
unable to stay open through the end of the next day and lacked
adequate collateral for discount window borrowing to meet depositor
demands.  The Governor considered several options:  doing nothing,
imposing limits on withdrawals, or closing the thrifts.  He decided
to close the privately insured thrifts for 72 hours to stop the runs
and buy time to devise a permanent solution to the problem. 

The then-Governor of Ohio said that on March 15, 1985, he and the
president of the Federal Reserve Bank of Cleveland held a news
conference announcing a Guarantee Fund thrift holiday for the
remaining 70 thrifts.\8 The president of the Federal Reserve Bank of
Cleveland also announced that liquidity help would be available when
thrifts reopened.  That same day, the state of Ohio opened a
telephone bank staffed by 300 people to handle inquiries from the
public concerning the state's actions and the safety of deposits. 
The day before the closed thrifts were due to reopen, on March 17,
the Governor met with over 100 thrift executives, who told him they
were concerned about additional runs on deposits.  After the
discussion, the Governor decided to extend the bank holiday by 2
days.\9


--------------------
\8 Executive Order 85-7. 

\9 Executive order 85-8. 


      GOVERNOR AND FEDERAL
      OFFICIALS PUSHED FOR FEDERAL
      INSURANCE
------------------------------------------------------- Chapter 4:3.11

The Governor's strategy was to restore depositor confidence by (1)
completing emergency legislation requiring federal deposit insurance
for the Guarantee Fund-insured thrifts, (2) pursuing expedited
approval of federal deposit insurance from the federal government for
those thrifts by March 19, and (3) reopening those thrifts by March
19.  According to Federal Reserve documents, on March 19 and 20
Federal Reserve examiners examined closed thrifts to determine which
would be eligible for federal deposit insurance.  Some thrifts were
well managed, in sound financial condition, and would qualify for
federal insurance; others were not likely to qualify.  On March 18
and 19, the Federal Home Loan Bank of Cincinnati telephoned the
privately insured thrifts to determine their plans to seek federal
deposit insurance.  Over 200 examiners were sent to expedite the
application process for thrifts that indicated they would apply for
federal deposit insurance. 


      STATE LEGISLATURE LIMITED
      WITHDRAWALS, REQUIRED
      FEDERAL DEPOSIT INSURANCE
------------------------------------------------------- Chapter 4:3.12

The then-Governor of Ohio told us that on March 20, the Ohio state
legislature enacted a law that provided for the reopening of the
closed thrifts--on a limited basis in some cases and on a
full-service basis in others.  The law limited thrifts to no more
than $750 in withdrawals per month per customer and required thrifts
to have federal deposit insurance before opening on a full-service
basis.  On March 29, 1985, 26 of the former 71 Guarantee Fund
institutions had reopened with a full range of banking
activities--most with federal insurance.  By the 24th of April, 51 of
the 71 thrifts had opened, 31 with federal deposit insurance and 19
without, as approved by the Ohio Superintendent of Savings and Loans. 
As of June 14, 1985, all but 8 of the original 71 privately insured
thrifts had opened on a full-service basis. 

Home State, acquired by Hunter Savings and Loan of Cincinnati,
reopened on June 14, 1985.  The state of Ohio had contributed a total
of $129 million, in addition to the resources provided by the
Guarantee Fund, to reopen Home State.  The state of Ohio received
$134 million from lawsuits. 


   RESOLUTION:  LEGISLATION
   ENACTED TO ADDRESS GOVERNMENT
   SECURITIES FRAUD AND IMPROVE
   DISCLOSURE
---------------------------------------------------------- Chapter 4:4

Following the containment of the Ohio savings and loan crisis, two
federal laws were enacted to address problems that surfaced during
the crisis--fraudulent sales activities of government securities and
disclosure to depositors about their depository institution's
insurance coverage.  The Government Securities Act of 1986 (P.L. 
99-571) created tighter regulation of government securities brokers
and dealers like ESM Government Securities.  The act focused on
secondary brokers and dealers that sell government securities by
requiring the dealers to register with SEC.  It also required new
regulations designed to prevent fraudulent and manipulative practices
and protect the integrity, liquidity, and efficiency of the market
for government securities.  Previously, such government securities
brokers and dealers were not regulated.  The act required government
securities brokers and dealers to file independently audited balance
sheets and income statements at least once a year.  Dealers were to
meet regulatory standards showing they had adequate cash reserves and
properly managed customer accounts and securities.  Newly regulated
members were required to join a stock exchange, which made them
subject to exchange regulation. 

The Federal Deposit Insurance Corporation Improvement Act of 1991
(P.L.  102-242) required all state-chartered banks, thrifts, and
credit unions without federal deposit insurance to conspicuously
disclose that fact to existing and prospective customers.  These
institutions were also required to disclose that depositors are not
guaranteed return of their money if the institution fails.  The
provision also applied to any other institution, as determined by the
Federal Trade Commission, that might be mistaken for a bank. 


THE STOCK MARKET CRISIS OF 1987
============================================================ Chapter 5

The stock market crisis began on October 19, 1987, when a large and
rapid sell-off of equity securities led to mechanical and liquidity
problems in trading and financial systems at stock, options, and
futures exchanges and associated clearing organizations.  Credit
relationships between financial firms and banks were also strained. 
The market break was extraordinary in terms of the speed and extent
of falling prices and skyrocketing trading volume.  This crisis
showed that the size and potential impact of increased linkages
between the equities markets and futures markets could change the
character of a financial crisis.  Factors that contributed to
containing the crisis included the complementary leadership of the
financial exchanges, the Treasury Department, and the Federal
Reserve; the early offer of liquidity by the Federal Reserve to keep
the markets functioning; swift and innovative action by federal
financial regulators; and the collaboration of the private and public
sectors. 


   SUMMARY OF CHRONOLOGY
---------------------------------------------------------- Chapter 5:1

On October 19th, 1987, an accelerated and massive sell-off of equity
securities and futures and options contracts led to automation and
liquidity problems in U.S.  financial markets and institutions. 
Difficulties also occurred in the clearance and settlement system and
in bank extensions of credit to securities firms.  European and
Pacific rim financial centers experienced similar declines.  Federal
officials were most concerned that the U.S.  system for allocating
credit would be halted.  To keep markets open and functioning as they
should, federal officials and agencies took various actions in
accordance with their individual authorities and responsibilities. 
For example, the White House and Treasury collaborated in making
public announcements to foster confidence in the markets.  Treasury
discussed with finance ministries in London and Tokyo and other
financial centers the importance of providing liquidity support to
their markets.  The Federal Reserve also discussed with other central
banks the importance of providing liquidity support.  The Federal
Reserve provided prompt and sizable liquidity through open market
operations.  Around noon on October 20th, the market was plummeting
and uncertainty existed about whether NYSE could remain open. 
However, buying activity in one stock index futures contract around
noon signalled the turnaround of the markets.  By the end of the
week, markets were calmer, but some officials involved in trying to
manage the crisis believed that luck played a major role in the
recovery. 


   PREPAREDNESS:  ROUTINE MARKET
   MONITORING AND EXISTING
   NETWORKS HELPED PREPARE
   REGULATORS
---------------------------------------------------------- Chapter 5:2

On October 19 and 20, 1987, a large and rapid sell-off of equity
securities led to automation and liquidity problems in trading and
financial systems at stock, options, and futures exchanges and
associated clearing organizations.  Credit relationships between
financial firms and banks were also strained.  The crash was
extraordinary in terms of the speed and extent of falling prices and
skyrocketing trading volume.  From the close of trading Tuesday,
October 13, to the close of trading Monday, October 19, the Dow Jones
Industrial Average (DJIA) declined by almost one-third, representing
about a $1 trillion loss in value of all outstanding U.S.  stocks.\1
On October 19, the DJIA plunged 508 points (23 percent).\2 NYSE
volume was 604 million shares, more than twice the average daily
volume for the year. 

The individual markets experienced a variety of difficulties on the
19th and 20th of October.  NYSE specialists faced large order
imbalances throughout both days.  NYSE's automated order entry system
was overloaded because of insufficient capacity.  Due to reduced
over-the-counter market-maker\3 participation, investors had
difficulty getting timely price information, and NASD transaction
reports were delayed.  A proliferation of option transactions within
the same underlying securities at CBOE in response to rapid price
changes slowed trading.  CBOE stopped offering some options on
individual stocks that were not trading and did not trade one stock
index option contract for over 1 hour.  CME's clearing department
received late payments\4 and delayed some of its payments, and CME
suspended trading in the S&P 500 index futures contract for about an
hour on October 20, 1987.  Derivatives option and futures markets
became disconnected from equity markets.  Some securities firms said
that their banks were refusing to lend them additional funds.  Many
firms were overwhelmed with customer orders, and some firms were
pressuring NYSE and NASD to stop trading so that they could catch up
with customer order flows. 

At mid-day on October 20, the securities markets and the financial
system approached breakdown.  The ability of stock, options, and
futures markets to price equities was in question, and those markets
were described as disconnected.  Many individual stocks ceased to
trade because few buyers were in the market, and trading in many
individual options was halted.  Stock index futures were selling at a
large discount, and investors were questioning the value of equity
assets.  Rumors circulated that several major market participants,
including a clearinghouse, were about to fail.  The financial system
was close to gridlock, and a widespread credit breakdown seemed
possible.  The primary concern of federal officials was that the U.S. 
system for allocating credit would be halted, and the financial
system would stop functioning. 


--------------------
\1 The DJIA, a price-weighted index of 30 stocks listed on NYSE, is
the most widely followed indicator of U.S.  stock market movements. 

\2 Since the 1920s, only the drop of 12.8 in the DJIA on October 28,
1929, and the fall of 11.7 percent the following day, which together
constituted the Crash of 1929, have approached the October 19 decline
in magnitude. 

\3 Market makers are professional securities dealers who have an
obligation to buy when there is an excess of sell orders and to sell
when there is an excess of buy orders. 

\4 These late payments were not rule violations, and CME took no
action to declare the firm making the late payments in default. 


      AGENCIES DEPENDED LARGELY
      UPON INFORMATION AND
      EXISTING COMMUNICATION
      NETWORKS
-------------------------------------------------------- Chapter 5:2.1

Although the Federal Reserve had developed a written plan that
outlined potential responses to a range of financial crises, no
interagency meetings had been held before October 1987 to prepare for
a market crash like the one that occurred.  However, an SEC official
told us that a joint SEC-CFTC effort in 1986 to monitor expiration
day effects--so-called triple-witching days--helped prepare them to
handle the market crash.\5 The readiness of federal officials and
agencies to manage the market crash largely depended upon the
availability of information that federal agencies had routinely
collected, the existing communication networks among the agencies,
and the ability of the agencies to influence the behavior of market
participants and their creditors. 

At the time of the crash, federal regulators, exchanges, and clearing
organizations routinely collected information on the financial health
of firms, the trading of financial instruments, and payments. 
Federal regulators received quarterly detailed reports of firm
capital levels.  These reports provided information on the likely
resilience of firms to market volatility.  Exchanges and some federal
regulators collected information on the trading of financial
instruments, such as customer identity, the number of shares or
contracts, price, and other trading information.  CFTC collected
trading data through its large trader reporting system.  Exchanges
and the over-the-counter securities market also collected information
about the performance of their specialists or market makers.  CME's
clearing department had a system that provided information about
payments in the futures clearance and settlement system. 

Many of the federal agencies involved in responding to the market
crash had established interagency communication networks before the
market crash occurred.  SEC, CFTC, and the exchanges had jointly
developed a telephone list of public and private sector market
officials that included both office and home phone numbers.  Also,
CFTC had routinely invited SEC officials to market surveillance
meetings focusing on volatility in stock or options futures
contracts, including a special surveillance meeting called for the
afternoon of Monday, October 19, on the basis of the previous
Friday's 120-point drop.  Many officials at SEC and CFTC had worked
with exchange and firm officials and understood their
responsibilities, concerns, and organizational resources.  However,
Federal Reserve and Treasury officials had limited working experience
with SEC and CFTC officials.\6 Also, the SEC Chairman, who was new to
his position, had little working experience with other senior federal
financial officials. 


--------------------
\5 The term "triple-witching days" refers to the third Friday of
March, June, September, and December, when options and futures on
stock indices expire concurrently and trading on index futures, index
options, and underlying stocks has been characterized by increased
volume and price volatility. 

\6 After the silver market crisis of 1979-1980, CFTC established
quarterly interagency financial futures surveillance meetings
involving staff from CFTC, the Federal Reserve, and Treasury.  SEC
was invited to participate after initiation of stock futures trading
in 1982. 


   CONTAINMENT:  LEADERSHIP, SWIFT
   ACTION, AND COLLABORATIVE
   EFFORTS HELPED CONTAIN CRISIS
---------------------------------------------------------- Chapter 5:3

Generally, federal officials and agencies acted within their
respective authorities in responding to the market crash.  Officials
and agencies shared information willingly, although some information
was simply unavailable.  Interagency and public communications were
occasionally problematic.  The most significant policy decisions,
especially the decision on whether or not to close NYSE, were made
collaboratively.  The NYSE Chairman consulted on this matter with
officials at other exchanges, federal regulatory agencies, Treasury,
the Federal Reserve, and the White House. 


      FEDERAL OFFICIALS ACTED
      WITHIN THEIR AGENCIES'
      AUTHORITY
-------------------------------------------------------- Chapter 5:3.1

Federal officials and agencies responded to the market crash in
accordance with their respective authorities and responsibilities. 
Treasury's objective was to keep markets open and encourage investor
confidence in the markets.  To this end, according to the Secretary
of the Treasury, Treasury officials (1) consulted with and encouraged
the Federal Reserve to provide liquidity with open market operations;
(2) prepared a message for the president to encourage investor
confidence in the financial markets, including a call for a budget
summit agreement to reassure credit markets about the direction of
long-term interest rates; and (3) discussed with finance ministries
in London, Germany, and Tokyo the importance of providing liquidity
support to their markets. 

SEC and CFTC objectives were to preserve the integrity and economic
utility of securities and futures markets.  To do this, SEC expedited
various rule reviews, and both SEC and CFTC consulted with exchanges
and clearing organizations to ensure that these organizations were
fulfilling their responsibilities.  One expedited rule review allowed
additional issuer stock buy-back programs so that companies could
purchase their own securities as long as they did not engage in
manipulative activities.\7 SEC and CFTC also collected and
disseminated information to federal officials on the financial
condition of member firms.  The exchanges and NASD were directly
responsible for keeping their markets liquid and their trading
systems open and for monitoring firm capital.  The NYSE Chairman
consulted with other officials--especially those at SEC and the White
House--concerning conditions at NYSE and the implications of closing
it.  Clearing organizations were to keep payments flowing by ensuring
timely payments. 

The Federal Reserve's primary objective was to provide financial
system liquidity, mainly through system repurchase agreements in open
market operations.  To that end, and to reassure the markets, the
Federal Reserve issued a public statement of its readiness to serve
as a source of liquidity to support the economic and financial
system.  The Federal Reserve also maintained a highly visible
presence through open market operations in arranging system
repurchase agreements.  One Federal Reserve official was concerned
that the liquidity put into the financial system would not be working
liquidity, i.e., would not be used for its intended purpose. 
Finally, Federal Reserve officials discussed with officials of major
banks the importance of meeting unusually large customer financing
needs. 


--------------------
\7 SEC regulations include a rule designed to prevent an issuer from
dominating the market for its securities; the rule pertains to
volume, timing, price, and the manner of purchases.  See 17 C.F.R. 
Sec.  240.10b-18. 


      MANY ACTIVITIES OF FEDERAL
      AGENCIES WERE ROUTINE
-------------------------------------------------------- Chapter 5:3.2

In responding to the market crash, federal agencies performed many
well-defined, routine tasks.  Exchanges and clearinghouses generally
used existing operational procedures to ensure that individual
financial instruments were trading and that payments were timely. 
NYSE operations procedures followed existing rules that allowed
specialists additional time to open securities and to halt trading. 
SEC and CFTC monitored volatility through procedures already
developed to oversee expiration day effects.  SEC followed a drill to
monitor the capital of the 25 largest firms.  CFTC used the large
trader reporting system to analyze trading for the effects of
portfolio insurance and index arbitrage.  The Federal Reserve's
arrangements of system repurchase agreements were also a matter of
routine. 


      AGENCIES SHARED INFORMATION
      BUT SOME INFORMATION WAS NOT
      AVAILABLE
-------------------------------------------------------- Chapter 5:3.3

In the market crash case, agencies effectively shared crisis-
relevant information--data related to the financial health of firms,
the functioning of trading systems, and payments in clearance and
settlement systems.  Generally, such information went quickly and
directly to senior decisionmakers both inside and outside the federal
government.  However, federal regulators and some exchanges did not
have all the information they wanted. 

Some of the desired information was available with some difficulty or
after some delay.  For example, derivatives markets had difficulty
pricing options and futures because of an inability to get price data
from NYSE.  CBOE had to request information from NYSE on which stocks
were trading.  SEC and CFTC had to request additional information
from firms on trading strategies.  The Federal Reserve and SEC had to
collect information about credit relationships between firms and
banks. 

Other information was simply unavailable.  According to a Federal
Reserve official we interviewed, no one knew whether capital
calculations were correct because equity prices were changing so
rapidly.  This complicated the task of reassuring banks of the
solidity of a firm's capital.  The largest unknown during the crisis,
of course, was the market sentiment of participants and when and how
much they would buy and sell. 


      COMMUNICATIONS WERE
      SOMETIMES PROBLEMATIC
-------------------------------------------------------- Chapter 5:3.4

The federal response to the market crash included some significant
communications problems.  A message regarding the possible closure of
NYSE that the NYSE Chairman intended to give differed from the
message some heard.  The NYSE Chairman said he told others that NYSE
was having problems, and if the decline continued there would be
further problems.  Federal regulators and exchanges said that they
were told that NYSE was about to close.  The NYSE Chairman called SEC
and, according to SEC officials, told them that NYSE was about to
close.  SEC called CFTC, NASD, CBOE, and other exchanges and told
them that NYSE was about to close.  According to an SEC official, the
NYSE Chairman called SEC back about 10 minutes later and said that
buyers were coming into the market and that NYSE would stay open. 

Miscommunication on this point also occurred between the SEC Chairman
and the print media.  On the morning of October 19, 1987, at about
11:15 a.m., the SEC Chairman told reporters that he had discussed
market conditions with the NYSE Chairman and that a trading halt had
been among the items covered.  He stressed that if the market fell
too rapidly a trading halt was an option.  The wire services reported
that SEC was considering a trading halt, and SEC officials said that
the SEC Chairman was misquoted.  About 1 p.m., SEC announced that no
such trading halt was under consideration.  The NYSE Chairman
announced that NYSE did not intend to close unless required to do so
by the President.  CFTC told reporters that no halt in trading of
index futures was under consideration.  According to a NYSE official,
although the comments attributed to the SEC Chairman appeared to some
to have spooked the markets and led to further price declines, the
sell-off of equity securities actually had nothing to do with what
the SEC chairman said. 


      AGENCIES DECIDED SOME
      MULTIJURISDICTIONAL ISSUES
      COLLABORATIVELY
-------------------------------------------------------- Chapter 5:3.5

In the market crash case, the heads of federal financial
organizations and exchanges and their senior staff collaboratively
decided multijurisdictional issues.  One example of this was the
decision to keep NYSE open even though specialists were overwhelmed
and automated systems were malfunctioning.  Because this decision had
implications beyond equities markets, the NYSE Chairman consulted on
this matter with officials at other exchanges, federal regulatory
agencies, Treasury, the Federal Reserve, and the White House. 

Another example of collective leadership was in the case of the near
failure of First Options of Chicago Inc.  (First Options).  Federal
Reserve, the Comptroller of the Currency, CBOE, and Options CC
officials decided how to keep First Options solvent, although this
action was not well coordinated according to OCC officials.  First
Options, the options clearing firm with the largest number of option
market makers, had severe liquidity problems and required an infusion
of $312 million from its holding company, Continental Illinois
Corporation.  Continental bank, the parent company, initially infused
cash into First Options but took back the advance at the instructions
of OCC officials.  These actions violated OCC restrictions on the
amount of money a bank can advance to an operational subsidiary. 
Instead, First Options was made a subsidiary of the holding company
and received a cash infusion from the holding company. 


      TREASURY AND FEDERAL RESERVE
      LED EFFORTS TO CALM MARKETS
-------------------------------------------------------- Chapter 5:3.6

In the market crash case, the Federal Reserve and Treasury played
significant leadership roles in helping to restore confidence in the
markets.  Actions of the Federal Reserve that helped restore
confidence in the market included the agency's statement of readiness
to provide liquidity, its support of keeping NYSE open and First
Options solvent, and its encouragement of extensions of credit during
the market crash. 

Treasury's successful effort to reassure institutional and individual
investors through statements from the President was especially
important.  One exchange official we interviewed pointed out that in
times of financial panic, the most effective reassurance is likely to
come from the White House, especially because elected officials can
be held accountable for their words and actions. 


   RESOLUTION:  CRISIS STUDIES
   ACCOMPANIED BY REGULATORY AND
   LEGISLATIVE INITIATIVES
---------------------------------------------------------- Chapter 5:4

Immediately after the market crash, various studies sought to
describe and explain the market crash and recommend actions to
prevent such a crash from occurring again. 

One study commissioned by the President said that the precipitous
market decline of mid-October was triggered by (1) an unexpectedly
high merchandise trade deficit that pushed interest rates to new high
levels and (2) proposed tax legislation that led to the collapse of
the stocks of a number of takeover candidates.  According to this
study, the initial decline ignited mechanical selling by a number of
institutions employing portfolio insurance strategies and mutual fund
groups reacting to requests from investors to exit the fund and
receive cash.\8 This study concluded the following: 

  One agency should coordinate regulatory issues that have an impact
     across related market segments and throughout the financial
     system. 

  Clearing systems should be unified across marketplaces to reduce
     financial risk. 

  Margins should be made consistent across marketplaces to control
     speculation and financial leverage. 

  Circuit breaker mechanisms should be formulated and implemented to
     protect the market system. 

  Information systems should be established to monitor transactions
     and conditions in related markets. 

SEC, CFTC, GAO, and exchanges also conducted studies that identified
various issues and set forth recommendations.\9 Our study found two
areas needing immediate attention to help restore confidence in the
markets and alleviate concerns that the markets could crash again. 
Specifically, we found that (1) problems with the New York Stock
Exchange's systems adversely affected trade executions and pricing
information both in New York and in other markets, and (2) decisions
of federal and self-regulators were made without benefit of any
formal intermarket contingency planning.\10

In March 1988, a Working Group on Financial Markets was appointed by
the President to consider the major issues raised by numerous studies
and their recommendations.\11 The members of the Working Group were
the senior officials of Treasury, the Federal Reserve, SEC, and CFTC,
with the Under Secretary for Finance of the Treasury serving as
Chairman.  The Working Group made conclusions and recommendations in
the areas of circuit breakers,\12 clearance and settlement, margin
payments, contingency planning, capital adequacy, and trade
processing systems.\13 The Working Group has continued to provide a
forum for high-level discussion of interagency financial regulatory
issues. 

The Market Reform Act of 1990 included provisions responsive to the
market crash experience.\14 These provisions granted SEC additional
authority to suspend trading on a temporary basis in any nonexempt
security and at securities exchanges, subject to a presidential
disapproval.  The act also gives SEC emergency authority to take
steps to restore order to securities markets, which can be
accomplished through altering rules on hours of trading, position
limits, and clearance and settlement. 

SEC, CFTC, and securities and futures exchanges implemented
coordinated circuit breaker mechanisms that provide for a 30-minute
trading halt of all securities and all derivative instruments after a
350-point DJIA decline in a day and a 1-hour halt after a 550-point
DJIA decline.  Stock, options, and futures markets also implemented a
teleconferencing system linking financial markets and regulators. 
Computer capacity has been increased at exchanges and at
broker-dealers.  A 3-business-day settlement period has also become
standard for securities markets, which eliminates 2 days of potential
participant default. 

The Federal Deposit Insurance Corporation Improvement Act of 1991
clarified that in extraordinary circumstances, the Federal Reserve
could lend from its discount window to anyone without legal
constraints on the use to which the credit was being put.  As before,
however, all borrowers were required to show that they needed the
Federal Reserve's cash to remain in business, could not borrow
elsewhere, and had secure collateral to back up the loans. 


--------------------
\8 Presidential Task Force on Market Mechanisms, Report, Washington,
D.C.:  January 8, 1988. 

\9 See Commodity Futures Trading Commission, Division of Economic
Analysis.  Division of Trading and Markets, Final Report On Stock
Index Futures And Cash Market Activity During October 1987,
Washington, D.C.:  Jan.  1988; and Securities and Exchange
Commission, Division of Market Regulation, The October 1987 Market
Break, Washington, D.C.:  Feb.  1988. 

\10 See Financial Markets:  Preliminary Observations on the October
1987 Crash (GAO/GGD-88-38, Jan.  26, 1988). 

\11 Executive Order 12631. 

\12 Circuit breakers are intended to deal with large and rapid market
declines.  When a particular price has fallen by a specified amount
over a specific time period, exchanges temporarily halt trading. 

\13 Working Group on Financial Markets, Interim Report, Washington,
D.C.:  May 16, 1988. 

\14 Public Law 101-432. 


MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix I


   GENERAL GOVERNMENT DIVISION,
   WASHINGTON, D.C. 
--------------------------------------------------------- Appendix I:1

Thomas J.  McCool, Associate Director, Financial Institutions and
Markets Issues
Craig A.  Simmons, Director (Retired)
Alison Kern, Assistant Director (Retired)
Patrick S.  Dynes, Project Manager
Gordon Agress, Evaluator
Desiree W.  Whipple, Reports Analyst


   OFFICE OF THE CHIEF ECONOMIST,
   WASHINGTON, D.C. 
--------------------------------------------------------- Appendix I:2

James L.  Bothwell, Chief Economist


   OFFICE OF CONGRESSIONAL
   RELATIONS, WASHINGTON, D.C. 
--------------------------------------------------------- Appendix I:3

Helen H.  Hsing, Director


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