FRBSF Economic Letter
97-32; October 31, 1997
The October '87 Crash Ten Years Later
This Economic Letter is adapted from remarks delivered by Robert
T. Parry, President and Chief Executive Officer of the Federal Reserve
Bank of San Francisco, at a conference sponsored by the Graduate School
of Management at the University of California, Davis, on October 17, 1997,
entitled "The October '87 Crash: What Have We Learned about the Causes
and Consequences of Large Market Movements?"
On October 19, 1987, "Black Monday," the Dow Jones Industrial
Average plunged 508 points--the largest one-day drop in history. The next
day, Tuesday, raised the spectre of a disintegration of the market and
with it a very serious threat to the functioning of the entire U.S. financial
system. While the "whys and wherefores" of this event remain
the subject of research and debate, this Economic Letter focuses
instead on the Fed's role in responding to the crisis. Specifically, it
discusses why the Fed intervened after the crash, what we did to help
stabilize the market, and what lessons we learned.
The Fed's role in financial
crises
A stock market crash raises a couple of interrelated policy issues for
a central bank: one has to do with our role as monetary policymaker, and
the other with our role in ensuring the safety and soundness of financial
markets and the payments system--that is, as "lender of last resort."
From the monetary policy point of view, we were concerned that the loss
of wealth due to the crash might cut consumer spending and lead to an
economic contraction. When the market bottomed out, the loss of wealth
owned by individuals amounted to nearly eight hundred billion dollars,
and in theory, this could have reduced people's spending on consumer goods.
It's true that the response of consumption to a given change in wealth
has always been estimated to be relatively small. But the size of this
crash meant that the wealth effect might have had an important impact
on overall economic activity.
As it turned out, the "wealth effect" wasn't a key
threat. Looking back, it appears to have had nearly imperceptible effects
on spending. One reason may have been that stock prices right after the
crash were actually above the levels of the previous year.
Fortunately, we didn't need to wait for the published data--which come
in with a substantial lag--to know that we weren't dealing with an overall
slowdown in economic activity. Through the District Banks and their branches,
the Fed has a nationwide network of contacts that includes current and
former Directors on our Boards as well as a number of Advisory Council
members. And the message from virtually all of them was that the crash
wasn't having a big effect on regional economic activity. Indeed, in the
year after the crash, GDP growth was quite strong.
Instead, the greater threat was to the viability of the exchanges and
brokerage firms, and, by extension, to the perfectly sound businesses
that might have failed if the exchanges had collapsed. Addressing this
threat has a lot in common with the Fed's historic role as lender of last
resort in preventing banking panics. Like banks, the various intermediaries
in the stock and bond markets held relatively small amounts of capital.
This made them vulnerable to sudden withdrawals by lenders.
When firms have problems because of their own business decisions, it's
clearly not the Fed's role to step in and help out. In fact,
doing so would only create a moral hazard, inducing firms to take excessive
risks and leading to instability in the financial system as a whole. But
when the effects of a bank run or a break in the stock market spread to
fundamentally sound firms and threaten the stability of the financial
system--that is, when there's systemic risk--then the Fed has
a clear and important role to play.
How systemic risk arose
in 1987
We usually think of stock exchanges as highly liquid markets, largely
because of the financial intermediaries in these markets who stand between
buyers and sellers by guaranteeing the execution of transactions. For
example, stock exchange specialists must buy into falling markets
in order to serve as a shock absorber. The system works very well to maintain
liquidity when buy and sell orders aren't too far out of balance. Ordinarily,
a small stock of inventories relative to gross trade flows is enough to
bridge the gap between buy and sell orders. Furthermore, clearinghouses
can guarantee the execution of trades in the face of any individual's
default risk.
But on October 19, order flows were grossly out of balance--there were
virtually no other buyers. That left the specialists at the end of the
day with much larger inventories than usual. They had to pay for those
purchases within five business days and needed credit to do so. In addition,
investors had to meet margin calls as prices fell, and brokerage firms
extended credit to many of their customers to enable them to do so. Finally,
the solvency of the clearinghouses was in doubt, because the default risk
they were insuring was systemic. Although the clearinghouses were well
capitalized, they weren't able to bear this kind of risk, and on the morning
of October 20 there was a real possibility that they might fail.
At this point, then, all these players needed additional credit
to continue their functions. But banks were growing nervous and reluctant
to lend. And who can blame them? The drop in asset prices cast doubt on
the creditworthiness of all parties: investors, specialists, brokerages,
and clearinghouses. Furthermore, the reluctance of banks and other creditors
to issue further loans itself increased the risk of default. So there
was a genuine risk that expectations of a market meltdown would become
self-fulfilling.
How the Fed intervened
Before the market opened on October 20, the Fed issued the following
announcement: "The Federal Reserve System, consistent with its responsibilities
as the nation's central bank, affirmed today its readiness to serve as
a source of liquidity to support the financial and economic system."
This affirmation of the Fed's responsibilities to serve as lender of last
resort was intended to reverse the crisis psychology and to guarantee
the safety and soundness of the banking system.
The Fed backed up this announcement with a number of critical actions,
and I'll highlight four of the most important.
- First, we added substantially to reserves through open market operations.
The funds rate fell from 7-1/2 percent just before the crash to 6-1/2
percent in early November. This added liquidity helped prevent the crash
from spreading to bond prices.
- Second, we liberalized the rules governing the lending of securities
from our own portfolio to make more collateral available.
- Third, we used all of our contacts in the financial system to keep
the lines of communication clear and open. In talking with banks, for
example, we stressed the importance of ensuring adequate liquidity to
their customers, especially securities dealers, and at the same time
affirmed that they were responsible for making their own independent
credit judgments. We also were in close touch with participants and
regulators in the government securities market, officials at the various
exchanges and their regulators, and our colleagues at central banks
in other countries.
- Finally, as a means of gathering real-time information, we placed
examiners in major banking institutions to monitor developments--such
as currency shipments--to identify the potential for bank runs.
- To sum up, performing the lender-of-last-resort activity, and backing
it up with close monitoring and close communication, did what it was
supposed to do: it transferred the systemic risk from the market to
the banks and ultimately to the Fed, which is the only financial institution
with pockets deep enough to bear this risk. This allowed market intermediaries
to perform their usual functions and helped keep the market open.
What did we learn?
As our mothers sometimes tell us, we learn more from our mistakes than
from our successes, and the policy lesson here really comes from the Great
Depression, rather than from the October 1987 crash. During the Depression,
the Fed failed to avert the collapse of the banking system, and the loss
of intermediary services was one reason why the Depression was so deep
and so prolonged.
So the crash of 1987 and the Fed's swift and decisive response serves
to reaffirm our understanding of what we need to do. While this should
give confidence to the markets, I think it's worth repeating that it should
be used sparingly. Such Fed actions must be limited to crises marked by
systemic risk. Bailing out individual firms is not the job of
the Fed, nor is it in the public interest since it would induce excessive
risk-taking in the private sector.
Let me conclude with one last caveat that brings me back to monetary
policy concerns: once the critical stages have passed, the Fed needs to
be especially careful not to generate another set of problems--that
is, we must be careful not to overplay an easier policy stance.
That could create inflationary pressures that would menace the process
of healing in the financial system and possibly create future economic
crises.
I think it's fair to say that the Fed did not make this mistake following
the '87 crash. In the face of a strong economy, tight labor markets, and
an upward creep in inflation, monetary policy was tightened noticeably
between early 1988 and early 1989. The funds rate rose from a low of around
6-1/2 percent in late 1987 to just under 10 percent in early 1989. While
some people have debated about whether this action contributed to the
1990-1991 recession, I think it is clear that it helped set the stage
for the decline in inflation that has occurred in the 1990s.
Robert T. Parry
President and Chief Executive Officer
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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