Dismantling the economy’s legal infrastructure V-5-a: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail — Step 1: Eurodollar markets

In 1971 Nixon put an end to the Bretton Woods agreement by unilaterally terminating the US commitment to exchange dollars into gold. It was no coincidence that at about the same time US regulators began to ignore Walter Bagehot’s most basic advice: under no circumstances should a government give aid to a bad bank.[1] It was the desire to promote international financial stability and to protect the role of the dollar in the world economy that made it possible for a consensus in favor of bank bailouts to develop.

For fifteen years after the collapse of Bretton Woods the fundamental stability of the international financial system was being challenged every few years. The US supported financial stability by effectively guaranteeing that the creditors of a large international US bank would be protected whether or not the bank had engaged in fraud and was as a result insolvent. I argue here that the means by which the international financial system was stabilized involved a catastrophic mistake that has yet to be rectified. The foundations of the previous international order had been constructed on a tight-knit London money market where there was no question that one bank’s fraud was every bankers’ problem and prompt reporting of concerns about not just fraud, but even insufficient controls, at counterparty banks was both expected and understood as a moral imperative. The new international order left responsibility for both stopping fraud and ensuring that a high level of internal controls was being maintained entirely in the hands of US regulators who were in no way equipped for the task. These regulators ended up developing an ideology that imagined that both fraud and mismanagement would have the “natural” effect of extinguishing themselves. So here we are.

The development of the Eurodollar market in the early 1970s

The collapse of Bretton Woods is closely associated with the growth of both international banking and the Eurodollar market, that is, the market for dollar denominated bank accounts held in banks outside the United States. This growth took place in part because capital controls were lifted, but also because of the Federal Reserve’s commitment to support the market by standing ready to protect the offshore creditors of US banks that failed.[2] To understand why the Eurodollar market exists, we must look back to the early years of the Bretton Woods agreement.

In the years following the end of the Second World War, restrictions on the use of sterling in international trade led to a shift in favor of the dollar as the currency in which short-term trade credit was denominated (Strange 1976: 60). Since it was British banks that had expertise in the finance of international trade, the result was the birth of the Eurodollar market and dollar denominated accounts held in London. Because these accounts must clear through the US banking system, they are held either as deposits in foreign branches of US banks or in foreign banks that have access to the US clearing system through a US correspondent bank. US regulators chose to exercise little control over the Eurodollar market and thus allowed it to grow, relatively unregulated, until by 1973 it was $132 billion and equivalent to about 20% of US commercial bank deposits (Kapstein 1994: 35; St. Louis Federal Reserve Fred database). By 1980 it was $575 billion and a little less than half the amount of US commercial bank deposits (Kapstein 1994: 21).

In 1973 the US money center banks did not have the experience that British banks had in financing international trade. As a result, the US connection to international markets was managed through the Eurodollar market and relied heavily on the London interbank and foreign currency markets. When the Eurodollar market was disrupted, the whole of dollar-based international trade was threatened, because the US was not prepared to provide equivalent services in New York or any other domestic financial center. As a result, instability in the Eurodollar market threatened global trade and also, according to pessimists, a complete breakdown of the international financial order akin to the Depression (Spero 1980: 115). In the 1970s subsequent to the termination of the Bretton Woods agreement, US policymakers faced the challenge of proving to the world that they were competent to manage the new international financial order – and the first order of business was protecting the stability of the Eurodollar market.

While the first bailout of a large bank, the Bank of the Commonwealth, was mostly a domestic event,[3] it was triggered by the Federal Reserve’s decision not to let the bank in question open a foreign branch that would have given it access to Eurodollar funding.  (The following account derives from Sprague 1986: Ch 4.) Such decisions are public and in this case the decision was delivered with a very clear statement about the Fed’s concerns about the bank’s management and general condition.

Through the 1960s an enterprising bank lawyer at the Bank of the Commonwealth in Detroit had come up with a way to circumvent Michigan’s prohibition on bank holding companies and restrictions on bank branching: owning multiple banks through more than 100 interlocking partnerships run by just 18 general partners. The group’s activities were financed by Chase Manhattan Bank. The group’s management determined that in the high interest rate environment of the late 1960s punting on municipal bonds was a sure-fire way to make capital gains when interest rates fell. (Of course, they didn’t fall.) Management also deliberately created future tax deductions – and booked their value upfront as income. Regulators spent years trying and failing to “nudge” this network of banks into less disastrous behavior. Finally, in 1970 the Fed pulled the plug and forced the group to start selling off their banks. Chase Manhattan ended up taking over the biggest bank in the group, the Bank of the Commonwealth, but due to interstate banking restrictions could only own the bank for two years.

Under any rational system this would have been Chase’s problem to solve. But the Fed was concerned that the failure of a billion dollar bank could set off a banking crisis and so in 1972 the Fed put pressure on the FDIC to bail the bank out. The challenges of managing the dollar in the new environment with no tie to gold undoubtedly affected the Fed’s views. Under this pressure, the FDIC caved and provided its first bailout of any significance. According to Irvine Sprague, the FDIC chairman at the time, his eventual justification for the bailout was to avoid an increase in the significant concentration in the Detroit market – from 77% to 87% of deposits in just three banks – that would be created by a takeover of the Bank of the Commonwealth that complied with Michigan’s legal restrictions on branch banking. This explanation reads, however, like the veneer of conscience-soothing justification that any one of us is apt to adopt when forced to take a decision that is patently unjust.

While the FDIC was careful to structure the bailout as a loan and to force the Bank of the Commonwealth to book a loss on its investment portfolio, the loan paid a below market rate and the FDIC was forced to extend the loan multiple times, so that payment was not complete until 1995. From a banking theory perspective the extension of a loan that will be repeatedly rolled over is effectively an equity investment. Thus, the effect of this first bailout of a large bank was that the FDIC put de facto equity into a bad bank. Unsurprisingly the FDIC board had little desire to repeat this experiment. The spread of international banking would, however, affect the FDIC’s decision-making process.


The structure of the US regulatory system rendered extremely difficult the task of demonstrating to the world the competence of the United States in managing the new international monetary system. There were three federal bank regulators in the United States. Banks with a national charter were regulated by the Office of the Comptroller of the Currency (“OCC”), while state-chartered banks were regulated both by state banking authorities and either the Federal Reserve or the FDIC depending on whether the bank was a Federal Reserve member bank.[4] The OCC was (and is) funded by the assessment it imposes on national banks, and had a long history of attracting banks by offering more favorable regulation. In this era, the OCC was also notoriously uncooperative with its fellow regulators (Sprague 1986: 236).

While US banks were accustomed to navigating the regulatory turf battle and apparently knew when to be cautious about taking on exposure to an instrument approved by the OCC, but not the Fed or FDIC, foreign banks did not have this skill. With the massive growth of cross-border banking this had the natural effect of leaving foreign banks exposed to an instrument that the Fed and FDIC considered ultra vires, that is, beyond the limits of the activities permitted to a bank. Because national banks had been issuing these instruments – standby letters of credit – for a decade before the FDIC had the opportunity to challenge their validity in court in First Empire Bank v. FDIC,[5] foreign banks were “infuriated and embarrassed” when the FDIC did not immediately honor them (Spero 1980: 94).

This case arose in 1973, a year which opened with the de facto floating of exchange rates after the failure of efforts to peg rates subsequent to the collapse of Bretton Woods, and closed with the Iranian revolution and the first oil crisis. In short, 1973 was a year in which the bezzle[6] generated by a decade of lax financial conditions in the US was beginning to be revealed as fraudulent banks were exposed. The FDIC case associated with these arguably ultra vires instruments arose when the bank that issued them failed and was purchased, and the buyer refused to assume the standby letters of credit due to an underlying fraud. As a result, the instruments were transferred along with other bad assets to the FDIC. Ultimately, the FDIC in its lawsuit over the standby LOCs didn’t even raise its strongest legal argument, i.e. that the instruments were ultra vires, a fact that the adjudicating court commented on (Kettering 2008: 1669). It seems likely that the FDIC backed down in no small part, because having an apparently well-established instrument declared ultra vires would have threatened global confidence in the competence of the United States as a manager of the international financial system at a time when that system was already under a great deal of stress. It was by this far from carefully considered process that bank issuance of standby letters of credit became a generally accepted activity in the US.


The next bank to have its fraud exposed had been speculating on currencies and then covering up its losses (amongst other misdeeds). Franklin National had grown very quickly to become the 20th largest US bank, and in 1973 the size – and unprofitability – of the positions it was taking in the foreign exchange market made its lack of internal controls obvious to its counterparties who had shut it out of the market for forward contracts (Spero 1980: 83-84). By the end of 1973 Franklin had to pay a premium for the Eurodollar borrowings on which it relied heavily – and Spero (1980: 93) connects this premium to the FDIC’s treatment of the putatively ultra vires standby letters of credit discussed above which raised concerns in foreign markets about exposure to the failure of a US bank.

In May 1974 when Franklin finally lost access to Eurodollar funding, the Federal Reserve decided that it was in the interests of financial stability to support the bank. The Fed’s lending policies in support of Franklin National would shatter precedents as the $4.7 billion bank saw $2 billion in funding flow out over the course of two months (Spero 1980: 126-27).

This outflow was undoubtedly aggravated by the June 26, 1974 closure of a German bank, Bankhaus I.D. Herstatt of Cologne, also due to losses on currency speculation.[7] (This section relies on Spero 1980 and Kapstein 1994.) In this case, not only did the German Bundesbank choose not to support the bank, but the bank was closed while both the London and New York markets were open – and while a significant intraday balance was outstanding in both the foreign currency spot market and the interbank market. That is, the failure disrupted the settlement process in both markets causing losses and frozen funds. As the London interbank and foreign currency markets froze up, small and medium-sized banks were either shut out of them or forced to pay a premium. Only in September 1974, after the G-10 central bankers issued a joint statement that “the means are available … for the provision of temporary liquidity” to the Eurodollar market, did interest rates on the market fall (Schenk 2014: 1141).[8] The tiered rate structure in interbank markets would continue into early 1975. In many cases, small banks were unable to execute foreign currency trades for their clients. To revive the foreign exchange spot market the New York Clearinghouse created a temporary emergency rule allowing banks to recall payments one day after they were made. It would remain in place for almost six months. As Herstatt’s foreign exchange trading book was only one-tenth the size of Franklin National’s, there was good reason to believe that a disorderly failure of Franklin could have had a devastating effect on the nascent Eurodollar markets and would have – at a minimum – created major complications for the program of establishing a post-Bretton Woods international monetary system (Spero 1980: 113-14).[9]

Before Franklin National was finally sold in October 1974, the Federal Reserve had lent it almost $1.8 billion allowing unlimited outflows to foreign branches abroad that would ultimately amount to nearly half a billion dollars. As Franklin National ran out of collateral in the US, the Federal Reserve arranged for the Bank of England to act as the Federal Reserve’s agent maintaining physical possession of collateral in London.[10] The loan to Franklin National was of such long duration that the Fed altered its regulations in order to charge an interest rate above the official discount rate – and closer to the market rate – in cases of “protracted assistance where there are exceptional circumstances or practices involving only a particular member bank” (Spero 1980: 204n19).[11] Finally, because Franklin was shut out of participation in the London foreign exchange market due to settlement risk, and no buyer was willing to take on Franklin’s foreign exchange book due to its reputation for unauthorized and illegal trading, the Federal Reserve Bank of New York had to purchase the trading book and operate it until all the outstanding contracts were filled (Spero 1980: 132-35).[12]

Finally, on October 8, 1974 the bank now just $3.7 billion in size was declared insolvent, after the Fed and FDIC had managed to arrange a government-assisted sale of the bank. Franklin’s deposits were assumed by the purchaser which was permitted to select $1.5 billion in assets to form a “good” bank. The remaining “bad” bank assets along with the loan from the Federal Reserve were transferred to the FDIC for liquidation. The liquidation was complex and involved substantial litigation. Ultimately, in 1989 the FDIC returned $23 million to the shareholders of Franklin National (FDIC 1997a: 262).

It is easy to underestimate the enormity of the decision to take such extraordinary action to ensure that Franklin National’s creditors were made whole. The Federal Reserve because of its vast holdings of US government debt remits its surplus profits to the US Treasury every year – and the FDIC which was also put at risk by this policy has access to a line of credit from the Treasury. The Fed effectively committed the full faith and credit of the US government to stand behind the liabilities of US banks with significant exposure on the Eurodollar markets – whether or not they were engaged in fraud (which Franklin National most definitely was). There is no question that this provided significant support to the dollar’s role in international finance subsequent to the collapse of Bretton Woods – which was both the intent of the policy and a rather obvious effect of it. The policy is, however, euphemistically referred to in the literature as that of a “lender of last resort” or provision of liquidity to international markets (e.g. Kapstein 1994: 20, 42. See also Gourinchas, Rey & Sauzet 2019). Of course, since it is in practice a credit guarantee – which is why the FDIC is involved – it really has nothing to do with liquidity at all. The likely reason this is referred as “liquidity” support is that the Federal Reserve does not have legal authority to provide a credit guarantee to a bank. I will discuss below how this fairly direct government support of the US money center banks represented a complete transformation of the nature of the international monetary system. For now, however, let us continue with our history.

GC tenure

Personnel changes in the Fed Board’s General Counsel’s office may help explain the extraordinary nature of the Fed’s support of Franklin National: just when the bailout took place the average level of experience as staff in the Federal Reserve General Counsel’s Office of the attorneys in the Office fell below two years, down from 8 years in 1969.[13] In short, the attorneys making these decisions had probably barely begun to understand the basic operations of the Fed, much less the most appropriate way to handle a crisis. The reasons for this are unclear. Was this the beginning of the “revolving door” where banks offered huge paychecks to Fed lawyers that were not matched by the salaries paid by the Federal Reserve? Was General Counsel Thomas O’Connell a catastrophically bad manager, or was he the only attorney with such a strong sense of public service that he stayed at the Fed despite strong financial incentives to leave? Was the exodus of attorneys somehow associated with the new role of the Fed created by inflation and Nixon’s decision to end Bretton Woods? We do not know.

One of the most remarkable events of 1974 that took place within the Fed was the Board’s appointment of Thomas O’Connell, the only attorney with significant experience in the General Counsel’s office to a new position, Counsel to the Chairman. This took place on July 10 after it was clear that Franklin National was insolvent and that any sale of the bank would require government assistance (Spero 1980: 137). At the same time, Andrew Oehmann was made Acting General Counsel (Fed Bulletin July 1974). Oehmann, who had served in the Kennedy Administration but had little banking experience, had been hired in 1973 as Special Assistant to the General Counsel. At the time the only attorney remaining in the General Counsel’s office who had been hired before 1972 was Pauline Heller, and she had been brought in as a specialist in bank holding companies in 1969. A very high level of staff turnover continued through the 1970s. As a consequence, the only Fed attorney with long experience in the General Counsel’s office continued to be Thomas O’Connell who would serve not as General Counsel, but as Counsel to the Chairman until his death in January 1979 at 53 years of age.

The decision to move O’Connell out of the General Counsel’s office and into a position advising the Chairman is remarkable, especially when one takes the timing of the decision into account. As General Counsel to the Board of Governors, an attorney must treat the Board itself as its client and may not advise the Chairman as an individual, except to the degree that the Chairman’s interests are closely aligned with those of the Board. In particular, if the Chairman were to insist on acting in a manner that was clearly illegal the Board’s attorney would have a duty to report the Chairman to the Board and/or the White House. On the other hand, the Counsel to the Chairman does not need to put the Board’s interests first, but can advise the Chairman as to how best to achieve his goals – and for the most part it would be unethical for an attorney to report on his client based on confidential attorney client communications. In short, moving the General Counsel into the role of Counsel for the Chairman in the midst of an unprecedented bailout of financial markets gives the appearance that the Fed Board at this time was preparing to act in a way that did not just push to the limits of the Fed’s statutory authority but also exceeded them. In this situation, O’Connell could have chosen to resign, but that would have left the Fed Board without a single attorney with significant General Counsel experience. It is easy to imagine that an attorney placed in this situation might conclude that the interests of the public as well as the Fed would be better served if he did not resign. It is perhaps telling that O’Connell died of health problems at 53. In any event, the General Counsel’s office was left with no one with any depth of experience in the job though the Franklin National bailout, and this makes it somewhat less surprising that the Fed was setting new precedents in 1974 rather than following old ones.

The implications of the remarkable rescue of the Eurodollar market from the consequences of Franklin National’s failure were not ignored by the members of the Board. Two weeks after the assisted sale of the bank, Federal Reserve Chairman Arthur Burns gave a speech addressing the fact that “for the first time since the Great Depression, the availability of liquidity from the central bank has become … an essential ingredient in maintaining confidence in the commercial banking system.” First, he analyzed why this had taken place and then discussed what needed to be done to ensure “a free enterprise system.”

Burns described five destabilizing and interconnected trends that had been generated by the new policy of promoting competition in the banking sector: declining capital, increasing reliance on volatile market-based funding, expansion of off-balance-sheet commitments, declining asset quality, and for the largest banks increased exposure to foreign currency risk. He then explained that these trends had raised questions about bank solvency and found that “while faith in our banks is fully justified, it now rests unduly on the fact that troubled banks can turn to a governmental lender of last resort. … In a free enterprise system, the basic strength of the banking system should rest on the resources of individual banks.” After listing the ways in which the Fed was restraining the banking system, he concluded that it is time to set aside the tacit assumption that “the sweeping financial reforms of the 1930’s had laid the problem of soundness and stability to rest” and that “a substantial reorganization [of our bank regulatory system] will be required” to avoid the problem of “competition in laxity” and a complete failure to address the demands of this new environment.  He emphasized that it was important to end the system whereby banks were free to choose their regulator (Burns 1974). Burns’ colleagues on the Board of Governors expressed similar concerns, and one of them went so far as to conclude that if banking was going to be a “no failure industry”, then public “control” would probably be necessary (Coldwell 1976. See also Holland 1975). Reforms promoted by Burns were adopted into law in the Financial Institutions Regulatory Act of 1978.

Dismantling the economy’s legal infrastructure V-5: The collapse of Bretton Woods and the entrenchment of Too-Big-to-Fail posts:
Step 1: The Eurodollar Market
Step 2: The Growth of LDC Loans
Step 3: The First Pennsylvania bailout
Step 4: The LDC Crisis
Step 5: The Growth of Leveraged Buyout Loans
Step 6: Continental Illinois


[1] “If the banks are bad, they will certainly continue bad and will probably become worse if the Government sustains and encourages them. The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.” (Lombard St, Ch IV ¶ 4.)

[2] Some have argued that the deposit of “petrodollars” by oil-exporting countries also played a large role in the growth of the Eurodollar market, but that growth was in fact much faster than can be accounted for by OPEC countries (Spiro 1999: 60-62).

[3] Note, however, that the first FDIC bailout was of a tiny minority-owned bank in Boston that the FDIC sought to support in hopes of fostering banking services in a disadvantaged community (Sprague 1986). The experiment was not a success, and there have been virtually no bailouts of small banks since.

[4] The Federal Reserve had two forms of additional authority over banks. All national banks were required to be members of the Federal Reserve, and the Fed was the regulator of all bank holding companies, which typically were the owners of the national banks.

[5] First Empire Bank v. FDIC, 572 F.2d 1361 (9th Cir. 1978).

[6] Galbraith (1955): “At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars.”

[7] While employees of Herstatt were later convicted for hiding their losses using improper accounting entries, the criminal convictions associated with the Franklin National failure were much more extensive.

[8] The Federal Reserve’s stance on the Eurodollar market increased the attractiveness of depositing Eurodollars in US bank foreign branches, but caused some consternation amongst certain European central bankers who were unwilling to provide similar encouragement to offshore banking (Kapstein 1994: 42).

[9] As the OPEC oil exporting countries were important beneficiaries of the smooth operation of the international monetary system, the counterfactual of a collapse in that system raises the possibility that oil prices would have been forced down due to a collapse in trade – and thus that the world would have been sent down a very different historical path.

[10] In addition, to avoid publicity the Federal Reserve typically does not “perfect” its liens in the collateral it takes because doing so requires providing public notice of the lien. This practice leaves it open to third party claims on the collateral. In order to ensure that Franklin National’s London assets would actually be transferred into the US liquidation, the Bank of England arranged to transfer the collateral to the FDIC immediately upon the formal declaration of insolvency of the bank, effectively spiriting the collateral away from any of Franklin’s creditors in London who might have a claim to it (Spero 1980: 152).

[11] In the event, Franklin was only charged the special rate starting in late September, and thus only paid it for 11 days.

[12] The contract of sale for the foreign exchange book required Franklin to indemnify the New York Fed for any losses in excess of those estimated – and when Franklin was finally declared insolvent a month later the FDIC assumed the contract and therefore indemnified the New York Fed for any excess losses (Sper0 1980: 135).

[13] Through most of the 1960s the office had been staffed with a stable team of five to six attorneys, who had many dozens of years of Federal Reserve General Counsel experience between them and were led by General Counsel Howard Hackley who had been a law clerk in the office in the 1930s. When Hackley departed in 1968 things changed. The next General Counsel served only three years and by 1970 when Thomas O’Connell, who had joined the General Counsel’s office in 1956, took the helm, all the other experienced attorneys had left.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s