THE INFRASTRUCTURE of our nation's financial system proved to be vulnerable to the attacks of September 11. Key operations located at and near the World Trade Center included stock exchanges, clearing banks, several of the important dealers who made markets in federal government securities, traders who made markets in foreign exchange, and brokers who linked the banks that wanted to borrow and lend federal funds.

Following the attacks, all aircraft were grounded in U.S. airspace, except for military planes. The government bond market was closed and did not reopen until September 13. Equity markets were closed until September 17. The clearing of both wholesale payments and securities transactions was disrupted because of processing problems experienced by a major New York clearing bank, whose operations center was located near the World Trade Center. Communications were affected by the extensive damage suffered at a major telephone-switching center in Lower Manhattan. Also disrupted was our national system for clearing checks, a large share of which moves through air transport to the paying banks.

As severe as the interruption was, it is important to note that the vulnerability turned out to be the physical infrastructure of payments and trading systems, not the underlying strength of financial services firms. These firms and their suppliers proved to have the capital and the technical resources to restore damaged infrastructure. This fact is not a trivial one.

Developments during the first week after September 11 were especially important in limiting the impact of the attacks on our payments system and financial institutions. (See sidebar.) Although some components of the financial system had their operations shut down by the collapse of the Twin Towers, most continued to function normally. The depth of operational resources, the capacity to call on backup systems, and the role of the Federal Reserve in providing massive amounts of liquidity reflect the robustness of the U.S. financial system.

The electronic payment networks operated by the Federal Reserve System--Fedwire® and the Automated Clearing House (ACH)--hummed along without interruption. These systems facilitated the operation of other segments of the payments system and the settlement of transactions among financial institutions.

The attacks temporarily disrupted market mechanisms through which banks trade their reserves, including borrowing in the federal funds market or selling federal government securities held as secondary reserves. In response, the Federal Reserve made large loans through its discount window to provide liquidity to banks that could not raise adequate funds through normal mechanisms. Short-term discount window loans, which were $99 million on September 5, rose to more than $45 billion on September 12. By September 26, these loans dropped back to $20 million; the system had returned to normal.

Extra liquidity injected into the banking system flowed to where it was needed. Banks increased their loans to other banks substantially. Interbank loans increased from $300 billion on September 5 to $442 billion on September 12. By early October, interbank loans had returned to about $300 billion. The willingness of banks to increase their loans to one another by large amounts on short notice was based on the confidence that they were lending to banks that were strong financially. (See sidebar.) The solid capital positions enjoyed by most banks permitted them to make it through.

The credit card, debit card and ATM networks functioned normally after the terrorist attacks. The flow of data among participants in these systems, including banks and merchants, occurs over electronic communication networks. Participants in these systems settled their net positions over the Fed's electronic payment networks in the usual manner.

Operating the nation's check collection system was a greater challenge. Because banks could not collect checks through air transport, the Fed adopted a policy to minimize disruptions to the use of checks. The Reserve banks accepted checks from banks for deposit to their reserve accounts and credited these reserve accounts for the proceeds of the checks on the usual availability schedule. "Check float" increased substantially because the Fed could not collect the checks on the usual schedule. Such float jumped to $23 billion September 12. In comparison, it was only $2 billion a week earlier. The Fed's policy of accepting checks for deposit and crediting the accounts of collecting banks on the established availability schedule facilitated the relatively smooth operation of one important phase in check collection: banks accepting checks from their customers and crediting their accounts as usual.

Relatively few people withdrew more cash than usual from their accounts. The Fed was able to help banks meet this demand by providing additional cash from the vaults of the Reserve banks. Because the banks and the Fed made clear to the public that cash would remain readily available, an unusual demand for cash never materialized. What additional demand did surface quickly subsided.

Our nation's financial system returned to more normal operation during the week after September 11. Although stock market averages declined when the trading of equity shares resumed, the markets showed no signs of panic selling. Stock prices tended to change in a rational pattern, with the largest percentage declines in the share prices of companies that appeared most adversely affected by the attacks. Settlement of trades occurred in almost the usual orderly fashion. To provide extra time for processing in the Treasury securities market, trades conducted on September 13 and 14 were settled three days later, and five days after for trades made between September 17 and September 21; starting Monday, September 24, trades were settled on a normal next-day basis.

The large increases in bank reserves during the first days after September 11 were reversed during the following week, as more checks reached the paying banks and banks repaid their loans from the Fed's discount window. Interbank loans declined as the temporary disruptions in the operation of the financial markets ended.

Banks Were Prepared

One reason why payments systems worked in a crisis situation is that these systems contain arrangements that limit the risk assumed by each participant by extending credit to counterparties. In addition, banks have relatively high ratios of capital to total assets. Although large banks have experienced an increase in problem loans since 1997, bank capital ratios remain substantially higher than during the last period of major problems in the banking industry, in the late 1980s and early 1990s. One of the factors that could have adversely affected payments arrangements would have been an unwillingness of participants to extend credit to one another. There is no evidence that such credit restriction occurred.

The supervisory authorities in the United States are also committed to keeping our banking industry in sound condition. Banks that suffer losses that compromise their capital positions are closed or reorganized unless their shareholders inject additional equity. The experience of the U.S. savings and loan industry in the 1980s and of other nations, especially Japan, demonstrates the problems inherent in the supervisory policy of forbearance when losses deplete the capital of financial firms. An economy cannot grow if its major financial institutions remain in weak financial condition for an extended period of time. Moreover, such firms would not have the strength to withstand a shock of the magnitude of September 11.

Dealing with Future Crises

While we cannot know whether we will have more terrorist attacks in our future, the operation of our payments system and financial institutions after September 11 gives us a basis for optimism about our nation's ability to cope with future events. This capacity rests on a continuing commitment to two basic principles:

First, the Fed as the central bank must be prepared to inject additional reserves into the banking system temporarily during a financial crisis. This point is so well understood, certainly within the Fed, that there can be no doubt that liquidity would flow freely as needed.

Second, our government supervisory agencies must maintain a commitment to policies that promote the strength of our financial institutions. This strength includes sound capital positions and comprehensive contingency plans for maintaining or restoring operations. The Fed and financial firms across the country had prepared extensively for possible economic disruptions in advance of Y2K. Because of those preparations, the century rollover occurred with practically no problems whatsoever. On September 11, the contingency plans were taken off the shelf. In the days that followed, these plans paid off handsomely.

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