The Impact on the Financial and Banking Sector

from the U.S. Perspective

WILLIAM W. LANG*

It is an honor to talk to you today and to be with this distinguished panel. I am particularly
honored to share the panel with such a distinguished alumni of my alma mater the City
College of New York. I should begin by saying that my remarks today represent my own
views. They do not necessarily reflect the views of the Office of the Comptroller of the
Currency.
It is of course difficult, given the short period of time that has elapsed, to talk about the
events of September 11 other than in its human dimension. Nevertheless, the subject of this
panel is a very important one. It is undoubtably true, as evidenced from public statements by
terrorists groups before and after the event, that one of the goals of the attacks, particularly
the attack in New Yorks financial district, was to damage the U.S. economy, particularly its
banking and financial sectors. It is with that in mind that I will focus my talk this morning
on the effect of September 11 on the banking sector.
Before I turn to the substance of my remarks, John Virgo suggested that I provide some
background about the Office of the Comptroller of the Currency (OCC) since many of you
from outside the U.S. may not be familiar with the agency. Despite its name, the OCC no
longer plays any role related to the currency. The OCC is the regulator of national banks. In
the United States, national banks are those banks chartered by the federal government, and
state banks are banks chartered by individual states. For the most part, a bank customer
would not be able to tell the difference between a national and state bank since they
essentially perform the same functions. Most of the larger institutions tend to be national
banks, but some of the very largest banks are state chartered.
Given my current position, it seemed to me that my comparative advantage on this panel
would be to discuss the impact of September 11 on the banking industry. To a certain extent,
my task today is easier than the other speakers, since much of my discussion will be about
some important immediate effects of the terrorist attacks, rather than exclusively discussing
what will happen in the future. My remarks will cover three topics.
1. How did the events affect the overall condition of the banking industry and its future
prospects? This, of course, will depend critically on the health of the U.S. economy, but
there is certainly a back-and-forth here. The health of the banking industry plays an
important role in the health of the U.S. economy.
2. What was the immediate or near-term reaction of banking customers, businesses, and
households to the events of September 11? Was there any evidence of financial panic in
the immediate aftermath of the attack?

Deputy Director for Policy Analysis, Office of the Comptroller of the CurrencyU.S.A.

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3. How did the payments, clearing, and settlements system in the U.S. economy, which to a
large extent means the world economy, hold up under the stress of September 11? The
terrorist attacks of September 11 created a horrible stress test for the payments system.
It is worthwhile to take stock and see how the system functioned under the strain. While
a full assessment will take some time, we can make some preliminary comments on the
functioning of the payments system in the days and weeks following the attack.
Let me go through these issues one by one. First, how did the events affect the health of
the banking system? There are two counterbalancing factors affecting the present state of the
U.S. banking system. As everyone here knows, the U.S. economy had been weakening for
some time prior to September 11. Professor Baumol made some important and insightful
remarks on the possible positive long-run effects on the economy as a results of September
11. Nevertheless, it is likely that the economy will be weaker in the short run.
The economys weakness can be seen in a number of ways. Household debt is near record
levels, reaching levels not seen since the mid-1980's. Business and personal bankruptcies
have been rising. There is significant weakness in the manufacturing sector that is leading
to increased levels of noncurrent commercial loans. Loan growth has slowed considerably,
with commercial and industrial loans showing negative growth in the second quarter of this
year. This is the first time in a very long time that we have seen actual declines in commercial
loans. The attacks on September 11 will exacerbate these existing weakness in the short term,
and I will leave it to others on this panel to forecast the magnitude and duration of these
effects.
The other side of this story is that the banking sector is by historic standards in relatively
good position to take some negative economic hits. Bank capital is at very high levels. Risk
base capital ratios at large banks, that is banks with over $1 billion in assets, were around 12
percent as of the second quarter of this year. At a similar period just prior to the 1990's
recession, risk-based capital ratios were under 8 percent. Even with the relatively weak
economy, return on equity for banks were slightly above 14 percent in the second quarter.
That compares to less than 7 percent just prior to the 1990's recession. In summary, the
banking sector is in a better position to absorb negative shocks to the economy as compared
to many prior recessions. Of course, there is some level of economic distress that would
threaten the health of the banking sector.
Let us turn quickly to the reaction of the banking public, business, and consumer
customers. The main point here is that there was no story. Of course, we would expect
deposit insurance to protect the system against general bank runs of the type seen during
banking panics prior to the establishment of federal deposit insurance. But one might have
expected the events of September 11 to generate anxiety among uninsured depositors and
other uninsured bank creditors. In fact, while there was a blip in withdrawals from the
banking system, it was very minor. Business customers who had lines of credit might also be
expected to draw down their lines of credit quickly. A business customer might rationally
worry that credit availability might shrink in the future and that a prudent course would be
to rapidly draw down existing lines before banks reassess their willingness to lend. Was there
a huge rush to draw down lines of credit? While we did see some of that in industries most
directly affected by the attacks, this again was a relatively minor event. The attacks of
September 11 did not cause any significant financial panic among banks business customers.

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So the main story was that there was no story. I think that the reaction of bank customers to
the attacks is evidence of a significant degree of public confidence in the soundness of our
banking system.
The last issue I will address, the functioning of the payments system in the aftermath of
September 11, is perhaps the most relevant for this panel discussion. Over the past 10 years,
there has been increasing interest among economists in the area of payments system risk.
Until then, the functioning of the payments system was largely ignored by the economics
profession. In the modern payments system, extremely large amounts of funds are transferred
around the globe in a blink of an eye. The risks associated with the functioning of this global
payments system has been of considerable concern for two main reasons. First, there are risks
associated with the technical operations of these systemstheir security and reliability. The
second concern is how easy is it for these systems to break down economically. What do I
mean by, break down economically? When large payment transfers are made, if the two
parties' accounts are not debited and credited instantaneously and at the same time, then some
party is at risk that a payment will not be made. In essence, this represents a short-term credit
exposure with associated short-term credit risks.
The major economic concern is that there is the potential for cascade effects. Failure to
make a payment by one party, either because of technical disruptions or lack of available
funds, may create a liquidity problem for those who were to receive payment. If they then
have difficulty obtaining the liquid funds to meet their obligations, they in turn might not
make payment. The fear is that such a chain reaction can lead to a liquidity crisis and
financial meltdown.
To limit potential losses, parties to large scale payments transactions and clearing systems
will set limits on their maximum exposure to a particular counter-party. An event like the
September 11 attacks raises the question of what happens if there are operational problems,
e.g., the computers break down or the communications system breaks down.
So, how did the system hold up in the wake of the September 11 attack? First, the extent
of operational problems, at least in my view, while severe and significant were less than one
might have expected. This is somewhat of a half-empty, half-full analysis in that very
significant operational problems did arise. Over the last 20 years or so, there has been a
considerable effort to improve disaster contingency plans for payments systems operations.
While unintended consequences are never a good ex post justification for governmental
action, one of the side benefits of the large scale government effort to prepare for Y2K was
the increased disaster preparedness of our payments system in the aftermath of the attacks
on September 11. For the most part, despite significant glitches most back-up systems did
ultimately function. The problems that did arise were not all problems of machinery. It was
very difficult for people, particular those working in the New York area, to go to work the
next day and to operate efficiently given the emotional and psychological trauma generated
by the attacks. Nevertheless, while operating at less than normal levels of efficiency, people
and machines generally did continue to function and the payments system continued to
operate.
However, in some instances the system did not function adequately and back-up systems
did not work. The result was that credit limits and exposures had to be extended beyond
normal limits and the Federal Reserve had to pump in a tremendous amount of liquidity into
the system. Despite these very significant stresses, at the end of the day the system held. I

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think many lessons will be learned, positive and negative lessons, as a result of the payments
systems reaction to the real world stress test generated by the events of September 11.
Understanding exactly why some things worked and some things did not will turn out to be
a tremendous boon for contingency planning, and I believe it will result in important
improvements in the system's ability to withstand extreme stress. Atlantic Econ. J., 29(4): pp.
360-363, Dec. 01. All Rights Reserved