April 6, 1967
MONETARY POLICY BLUNDER CAUSED HOUSING CRISIS
By Leland J. Pritchard, Professor of Finance, the University of Kansas, Lawrence, Kansas.
The need for hikes in Reg. “Q” is challenged by a leading professor and writer in the field of money and banking. Prof. Pritchard faults the Federal Reserve for needlessly collapsing the home mortgage market in 1966 when, understandably adopting a tight money policy, it successively raised Reg. “Q” and caused an inequitable distribution of available credit. He calls for further reductions in member bank deposit interest rate ceilings than those belatedly lowered in July and September, 1966. Says this would further reduce the ratio of time deposits, reduce bank costs and increase profits, stimulate funds to S&L Associations., and Mutual Savings Associations, and obviate Governmental infusions to relieve the mortgage money shortage.
The sharp drop which occurred in residential construction in 1966 was almost entirely a credit phenomenon. It was the result of both a severely curtailed flow of credit into the housing industry and the sharply rising cost of credit. Both the reduced volume of funds, and the higher cost of mortgage credit, were the direct consequence of the Federal Reserves’ tight money policy.
By the third quarter of 1966 the impact of this policy had reduced housing starts, on a seasonally adjusted annual basis, approximately 50 percent from the level prevailing at the end of 1965.
The crisis thus created in the housing industry called for and brought forth massive infusions of government credit, and other emergency measures. The Federal Home Loan Banks (FHLB’s) relaxed the conditions for making advances to member savings and loan associations, and in mid-1966 Congress appropriated $1 billion to the Federal National Mortgage Association (FNMA) for purchases of certain private housing loans.
On July 1 the Board of Governors of the Federal Reserve System took the unprecedented action of authorizing the Federal Reserve banks to make their credit facilities available, through the member banks, to the mutual savings banks and the savings and loan associations. Fortunately it was never necessary to use this emergency measure.
It seems to be the general consensus that the housing industry must inevitably bear the major impact of a tight money policy. In the words of William McChesney Martin Jr., Chairman of the Board of Governors, “Home building was elbowed to the end of the line; residential construction activity was reduced for below the levels needed to meet our long-term housing needs.”
In fairness to Mr. Martin and the other member so the Board it should be said that it was neither their wish nor intention to “elbow the housing industry to the end of the line.” This unfortunate situation was simply the inevitable consequence of a severely restrictive monetary policy. It is with this fatalistic assumption that I wish to take issue.
NO NEED FOR INEQUITABLE BURDEN
No responsible person contends that the Reserve authorities were not correct in pursuing a restrictive monetary policy in 1966. Considering the lack of fiscal restraint exercised by the Federal Government, particularly after the first major escalation of the Vietnam War in June 1965, there was no alternative. But it was not necessary that the burden of monetary restraints be imposed so inequitably.
Federal Reserve credit policy in 1966 can be roughly divided into three periods. The period from January through March can be characterized as one of increasing though moderate restraint; from April through October as a period of severe restraint, and the remainder of the year, a period of rapid relaxation. It is with the April through October period that we are most concerned. During this period the Federal Reserve forced an actual reduction in member bank legal reserves, down about $1 billion from a level of approximately $24 billion. Since this reduction was accomplished through the open market operations of the System, we can logically assume that a proportionate decrease in the legal reserves of the non-member banks was also affected.
Combined with an intense demand for loans, the contraction of reserves forced the banks to operate with a large volume of net-borrowed reserves. The extreme point of stringency was reached during the first week in October when net-borrowed reserves position, to a net-free-position of approximately $500 million. The extent of the sharp reversal in monetary policy since October 1966 is revealed in the shift from this extreme net-borrowed reserve position to a net-free reserve position of nearly $200 million at the present time (March 1967). As a byproduct of the Reserves’ credit policies, the stock of money declined at an annual rate of 1.7 per cent during the April-October period.
The whole of 1976, however, the story is quite different. The Reserve authorities allowed bank credit to expand during 1966 by $19.7 billion, or at an annual rate of approximately 6 per cent. This compares to an annually compounded rate of increase of approximately 7 per cent in the preceding ten years, and a rate of about 5 percent for the entire period since World War II.
Since banks made a negligible change in their aggregate security holdings, decreasing only $200 million from the end of 1965 to the end of 1966, the entire increase in bank credit was available to finance loans.
During 1966 the commercial banks made a net addition of $5.5 billion to their aggregate holdings of nonfarm mortgages. This compares to a figure of $5.5 billion for 1965; $4.2 billion for 1964; $4.6 billion for 1963; and $3.8 billion for 1962.
BANK MORGAGES ROSE
In other words the commercial banks cannot be faulted for the dearth of new mortgage money in 1966. At the same time the banks were increasing mortgage lending above previous year levels, they were increasing their loans to business by approximately $14.2 billion. As many a businessman can now attest who has an excessive volume of inventories on hand, it would have been far better had the effects of the tight money policy been distributed more equitably – specifically by denying to him the funds he thought he needed in 1966.
The Savings & Loan industry on the other hand was able to expand its aggregate mortgage holdings by a net amount of only$3.8 billion in 1966. This figure compares with a net increase in 1965 of $8.9 billion in 1966. This figure compares with a net increase in 1965 of $8.9 billion; of $10.4 billion of 1964; and of $12.1 billion in 1963.
Those who have argued so vigorously that the lack of mortgage money was due to disintermediation (a shift by the public from indirect investment through financial intermediaries to direct investment), and who also insist that the commercial banks are only another type of financial intermediary, should ponder the above data.
WHAT SHOULD HAVE BEEN DONE
We may now consider the question; “How could the Federal Reserve have pursued a tighter money policy toward business and at the same time an easier money policy toward the housing industry?” And what is even more important to those who believe in the free enterprise system, how could such a segmented control of the credit market be accomplished through indirect, rather than direct controls?
The answer is: By reducing the volume of time deposits held by the commercial banks, and by reducing the over-all volume of bank credit.
The Board has the power to change the time deposit/demand deposit mix. Under its Regulation “Q” the Board has the power to fix the maximum interest rates member banks can pay on time deposits at any level the Board deems appropriate. By lowering the ceilings the Board can induce a shift from time deposits, to demand deposits and, since the Federal Deposit Insurance Corporation (FDIC) follows the lead of the Board of Governors, the effect of the Board’s action to virtually all commercial banks.
It is a fact that people choose to hold savings in the form of pass book savings account, or multiple-maturity non-negotiable certificates of deposit in commercial banks for about the same reasons they choose to hold share accounts or share certificates in Savings & Loan Associations or Savings Deposits in Mutual Savings Banks.
If time deposits are made less attractive fewer funds will be held in this form and more savings will flow through the Savings and Loan association and the Mutual Savings Banks, the principal institutional suppliers of nonfarm mortgage credit.
SHIFT, NOT A DECREASE, IN DEMAND DEPOSITS
A shift from time to demand deposits and the transfer of the ownership of these demand deposits to the Savings and Loan Associations and the Mutual Savings Banks does not force a reduction in the size of the banking system. These transactions simply involve a shift in the form of bank liabilities (from time to demand deposits) and a shift in the ownership of demand deposits (from savers to Savings and Loan Associations, et al).
The utilization of these demand deposits by the Savings and Loan Associations and the Mutual Savings banks also would not reduce the volume of demand deposits held by the commercial banks, or the volume of their earning assets. In the context of their lending operations it is only possible to reduce bank assets and demand deposits by retiring bank-held loans.
And in any event, a loan paid off can be replace irrespective of what is happening to time deposits, for the size of the banking system is not determined by the willingness of the public to save, and to entrust their savings to the commercial banks. The aggregate size of the banking system, and the volume of earning assets held by the banking system-given the opportunities to make “bankable” loans – is determined by the willingness of the Federal Reserve to supply legal reserves to the banking system.
A shift from time to demand deposits would not only increase the flow of funds through the Savings and Loan Associations and the Mutual Savings Banks, and thereby increase the funds available for mortgage financing; it would sharply reduce bank expenses, and increase bank profits.
COSTLY TIME DEPOSITS
Using differential cost figures prepared by the Federal Reserve Bank of Boston and income and other data on member banks from the Federal Reserve Bulletin, I have been able to prepare estimates on the relative cost of time and demand deposits and estimates on the relative cost of time and demand deposits and rates of earnings on loans for the year 1965, the last year for which adequate data are available. The average annual cost of maintaining a $1,000 time deposit came to $43, compared to an average cost of $14.30 per $1,000 of demand deposits. Thus for every shift of $1,000 from time to demand deposits bank costs are reduced by $27.70.
The differential is probably greater for 1966 as it appears that interest rates paid on time deposits have increased faster than the various other costs, involved in administering, either time of demand deposits.
Obviously, however, the overheated situation of the economy in 1966 required that if more funds were to be permitted to flow into the housing industry a compensating curtailment was required elsewhere. This could have been accomplished by reducing the rate of growth of bank credit to less than 6 percent.
The shift from time to demand deposits, b y reducing excess reserves, would have forced some credit contraction. Open market sales by the Federal Reserve would have provided any additional pressure for contraction if this were necessary.
EFFECT ON BANK PROFITS
Bank credit contraction means, of course, reduced loan volume and reduce bank earnings, but if this is accomplished by an even greater reduction in banks expenses, bank profits will obviously increase. And it is profits, not size, that is presumably the primary objective of bank managements.
Using the same source material referred to above, I estimated that member bank net earnings per $1,000 of loans outstanding was approximately $41.10 in 1965. This figure represents gross earnings, less those specific costs chargeable to the acquisition and administration of loans, plus an allocation of overhead costs.
If the net earnings per annum on $1,000 of loans is $41.10 and the net cost of acquiring, holding and service $1,000 of time deposits is $43 this would suggest that the banks should get out of the time deposit business altogether. This may be true, but, the reader should be cautioned that the direct comparison of return on assets, with cost of savings, is only valid for intermediary types of financial institutions; it is not valid to apply such a comparison to the commercial banks.
To determine whether time deposit banking is profitable from the standpoint of the banking system it is necessary to answer the following question: Does a given growth in time deposits induce the monetary authorities to follow a policy of greater ease, or less restraint, such as will enable the banking system to acquire an additional volume of reserves on the basis of which the banks can expand their earning assets, and thereby their net earnings, by an amount sufficient to more than offset the over-all increase in costs associated with the growth of time deposits?
Since in a net sense time deposits originate exclusively from shifts out of demand deposits (either directly or indirectly via the currency or undivided profits account routes), and sine time deposits are more expensive to maintain than are demand deposits; it is actually possible to increase the over-all profits of the banking system by inducing a return shift from time to demand deposits even though the net rate of return on loans is greater, dollar-for-dollar, than the cost of maintaining time deposits.
Assume for example, that the net annual return per $1,000 of loans was at the absurdly high level of $70, far above the rate of return than now prevails. The Federal Reserve would have to force a reduction of bank credit by more than $500 for every $1,000 shifted from time to demand deposits, before any reduction would take place, in over-all bank profits. The calculations are as follows: A shift of $1,000 from time to demand deposits, decreases expenses by $27.70. A further reduction of demand deposits by $500 (an inevitable consequence of reducing loans by $500) reduces expenses by $7.65, or a total reduction in expenses of $35.35. This is approximately the same as the loss in income ($35) resulting from the reduction in loans by $500. Any further reductions in loans, unless compensated for by additional shifts from time to demand deposits would, of course, reduce profits.
BELATED REMEDY
On July 20, 1966 the Reserve Authorities made the first reduction of interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multiple maturity non-negotiable certificates of deposit were reduce from 5 ½ to 5 percent on certificates maturing in 90 days or more, and from 5 ½ to 5 percent on certificates maturing in less than 90 days. These are the consumer-type credit instruments issued by commercial banks which are most competitive with the share accounts and share certificates of savings and loan associations and the savings deposits of mutual savings banks.
A second reduction was effected on September 26, 1966 when the maximum rates on single maturity negotiable and non-negotiable certificates of deposit of less than $100,000 denomination were reduced from 5 ½ to 5 percent. The FDIC of course extended all of these reductions to non-member insured banks.
Since banks are generally paying the maximums allowed these changes had a considerable effect on the relative attractiveness of time deposit, vis a’ vis accounts in Savings and Loan Associations, and savings deposits in Mutual Savings Banks. For example time deposits, which increased $8.3 billion during the first half of 1966 and stood at a figure of $156.8 billion in July grew by only $1.1 billion the remainder of the year, Share accounts in Savings and Loan Associations on the other hand had $2.9 billion of their total 1966 growth of $3.5 billion, in the last half of the year.
Furthermore, while the aggregate of time and demand deposits continued to increase after July, the proportion of time to demand deposits diminished. Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent. These were all desirable developments.
Not only was the flow of savings through the Savings and Loan Associations and the Mutual Savings Banks stimulated, and more funds made available for housing construction, but these developments had a favorable effect on bank profits.
Favorable as these developments were, they were nevertheless inadequate to counteract adequately the degree of stagnation and paralysis that had overtaken the housing industry.
The latest available seasonally adjusted annual figure for housing starts (February 1967) indicates that the industry is operating a level of about 1 million units, a very depressed level, both historically, and in terms of our current, and future housing needs.
What was called for was a much greater reduction in the interest ceilings on the consumer-type certificates of deposit. Since the Board uses the criterion, “equalization of competition for savings” in the fixing of rate ceilings, it is understandable why they would be loathe to lower the rate ceilings for commercial banks significantly below the rates paid by the FDIC for insured mutual savings banks and by the FHLB Board for member savings and loan associations.
BANKS DO NOT COMPETE FOR SAVINGS
While the action of the Board is understandable, it is nevertheless indefensible. It bears repeating that the commercial banks, from a system standpoint, do not acquire savings from outside the system. All savings held in the commercial banks originate within the system itself. Commercial banks are not therefore in any meaningful sense competing with Savings and Loan Associations and Mutual Savings Banks for the savings of the public.
Commercial banks are credit creating institutions. The aggregate lending capacity of the commercial banks is predicated upon the willingness of the Federal Reserve authorities to supply the banking system with legal reserves; it is not dependent upon the savings practices of the public, and the willingness of the public to hold time deposits in the banks. Commercial banks do not loan out time deposits, or the “proceeds” of time deposits; neither do they loan out existing demand deposits, or any type of existing asset, or liability. Commercial banks create new demand deposits when making loans to, or buying securites from, the nonbank public.
If the Board of Governors whishes to increase the lending capacity of the commercial banks they always have it within power to do so. All that is required are open market purchases by the Reserve Banks of an amount sufficient to cause a net additional in bank legal reserves. Since open market purchases are participated in by the customers of nonmember as well as member banks, these operations add to nonmember, as well as to member bank reserves.
Raising interest ceilings on time deposits, as the Board did on five successive occasions beginning January 1, 1957 and culminating in the disastrous increase to 5 ½ per cent on December 6, 1965, simply allowed the banks to increase their expenses with no concomitant increase in income. The earning assets held by the commercial banks, from a system standpoint, are not the result of the growth of time deposits.
The sequence is not from time deposits to earning assets, rather the sequence is from earning assets, and new demand deposits, these two come into being simultaneously, and from “old” demand deposits (which the public has saved) to time deposits.
CALLS FOR LOWER REG. “Q” CEILINGS
Proper public policy calls further reductions in the interest ceilings allowable under regulation “Q”. This would reduce further the proportion of time to demand deposits, reduce bank costs, increase bank profits; and stimulate an increased flow of funds through the Savings and Loan Associations and the Mutual Savings Banks.
There would then be no need of massive infusions of government credit to relive the shortage of mortgage money.
This course of action would not reduce the size of the banking system, the volume of earnings assets held by the banking system, the income received by the system, or the opportunities of the banks to make safe and profitable loans. Quite the contrary in fact. By promoting the welfare and health of such an important segment of the economy as is represented by the housing industry, the health and vitality of the whole national economy will improve. The aggregate demand for loan funds will expand, the volume of “bankable” loans will grow, and so will the banking system, - the Federal Reserve being willing.
Monday, January 24, 2011
Repeat of 1966 Policy Blunder
Unlikelihood of another 1966-type “credit crunch” is one of the findings made by Dr. Pritchard in his study of whether the Federal Reserve blundered in administering Reg. Q in 1966. He singles out the lack of mortgage funds, rather than their cost, for spawning the 1966 credit crisis and for collapsing the housing industry. Not until the damage was done, he points out, did the Federal Reserve change its indiscriminate increase in Reg. Q which had stopped the flow of funds into the housing industry. While he prefers lowering rather than rising Reg. Q during tight money, the monetary economist says that should an increase be decided it out to be selectively confined to large negotiable CDS.
The “credit crunch” of 1966 was not a general across-the-board credit crisis. It was on the contrary quite limited, its impact being largely confined to the residential-mortgage market. Business in fact obtained too much credit in 1966. During the first half of 1966 commercial and industrial loans of insured commercial banks increased at the abnormally high annual rate of 16.4 per cent. There was some slackening in the last half of the year but overall the commercial banks financed a 13 per cent net expansion of business loans in 1966.
Bank credit was the major source of financing that made possible an unattainable rate of inventory accumulation. Toward the end of 1968 a huge overhang of inventories developed and this was followed in the first six months of 1967 by the severest inventory adjustment on record. Inventory investment dropped from an annual rate of more than $18 billion to practically nothing.
In contrast to the plethora of credit being supplied business by the commercial banks, the housing industry was being starved for funds. Of the financial intermediaries providing the bulk of mortgage credit the savings and loans were hardest hit. Net inflows of funds virtually ceased during the first seven months of 1966. Since savings and loans supply about 45 per cent of residential mortgage financing a sharp contraction in new housing starts was inevitable. It was the unavailability rather than the cost of credit which forced a reduction in new housing starts from a level of 1,585,000 in January 1966 to a seasonally adjusted annual rate of only 848,900 in the fourth quarter of 1966, the lowest rate on record since the end of World War II.
The financial side-effects of the housing industry’s collapse involved wide-spread losses and bankruptcies among builders and contractors and threatened the solvency of many savings and loan associations. Bu July 1966 the financial crisis was so severe the Board of Governors of the Federal Reserve System took the unprecedented step of allowing savings and loans whose solvency was threatened to obtain credit assistance directly from the Federal Reserve banks. The Board’s judgment of the dimensions of the crisis is brought into sharper focus by pointing out that even nonmember banks are not allowed to borrow from the Federal Reserve banks except in an emergency, and then only if the advance is fully secured by United States Government obligations.
Tight money seems to be the accepted official (and unofficial) explanation of the mortgage credit crisis of 1966. The Present’s Council of Economic Advisers advances this explanation in the 1967 Economic Report of the President (p.60); and in the 1968 Report (p. 76) the Council reiterates that “Tight money was clearly the primary factor accounting for the sharp decline in homebuilding (in 1966)…”
If tight money is the correct explanation then we should be heading for another credit crisis in the residential mortgage market. Long-term interest rates including mortgage rates are now at higher levels compared with 1966; the Federal Reserve is currently following a monetary policy at least as restrictive as the period of greatest restraint in 1966; and; and the spread between the rates the savings and loan associations and the mutual savings banks are paying to savers and market rates of interest are greater than in 1966.
This spread in rates, the short-run accompaniment of a tight money policy, presumably leads to disintermediation – a shift by the public from indirect investment through financial intermediaries to direct investment. The mortgage markets suffer the sharpest effects of disintermediation since the intermediaries most affected (savings and loan associations and mutual savings banks) are major suppliers of mortgage credit. These effects are only slightly compensated by the subsequent direct investment. The mortgage markets suffer the sharpest effects of disintermediation since the intermediaries most affected (savings and loan associations and mutual savings banks) are major suppliers of mortgage credit. These effects are only slightly compensated by the subsequent direct investment.
Unfounded Fears of Another Credit Crunch
Suggestions that another “credit crunch” is in the offing have indeed appeared in the financial press. I think all such prognostications are not only premature – they are unfounded. Tight money was only a secondary cause of the 1966 mortgage credit crisis. The primary cause was the Board of Governors policy with respect to establishing the maximum interest rates commercial banks can pay on time and savings deposits (hereafter referred to as Regulation Q, its official designation). In the administration of its Regulation Q policy the Board allowed the commercial banks during the first seven months of 1966 to pay higher interest rates on certificates of deposit than savings and loan associations and the mutual savings banks could pay on share certificates and savings deposits. Such an interest rate differential has existed in no other period. It was this factor, unique to 1966, that triggered the residential mortgage credit crisis of that year. Data subsequently cited fully document this assertion.
Recent Monetary Policy and Interest Rates
From an extremely easy policy in 1967 the Federal Reserve has shifted toward a definitely tight money policy. From February 1967 to February 1968 the member banks were allowed to operate with net free reserves (free reserves are equal to the excess of excess reserves over member bank borrowings from the Federal Reserve banks). For most of 1967 net free reserves fell in the $150 - $250 million range. Allowing bank credit to expand at a rate of 11.1 per cent in 1967 provides further evidence of the extreme case that prevailed. This rate compares to a rate of 5.4 per cent in 1966 and an annually compounded rate of about 5 per cent for the whole period from 1946-1966.
Beginning in February of this year the Federal Reserve has veered sharply toward restraint. Net borrowed reserves (the excess of borrowings from the Federal Reserve banks over excess reserves) replaced net free reserves. Currently net borrowed reserves are falling in the $200 - $400 million range, a level comparable to the levels greatest credit restraint in 1966. Since the inception of the current tight money policy the Federal Reserve through its open market operations has kept total legal reserves of member banks moving virtually sidewise at a level of approximately $25.6 - $25.9 billion. If this policy were continued throughout 1968 (a highly unlikely possibility) there would be little if any net expansion of bank credit.
The near-term effect of this restrictive policy plus the inordinate volume of deficit financing requirements of the federal government and the reluctance of nonbank investors to “go long” in creditorship securities, except at premium rates that amply discount the present accelerated rate of inflation, has caused long-term interest rates to reach the highest levels in this century. Rates are significantly higher than in credit crisis year of 1966. For example, the current average AAA corporate bond rate is 6.2 per cent compared to 5.5 per cent, the highest level reached by this series in 1966. Similarly the current average yield on new FHA mortgages is 6.8 per cent compared to an average level in 1966 of 6.4 per cent.
Lack of Loan-Funds Rather Than the Cost of Loan-Funds the Cause
Obviously it was the lack of funds rather than the cost of funds that spawned the credit crisis of 1966.
The principal financial institutions that hold residential mortgages (savings and loan associations, mutual savings banks, life insurance companies and commercial banks) reduce their net acquisition of nonfarm residential mortgage debt from $18.5 billion in 1965 to $10.9 billion in 1966. Savings and loan associations alone accounted for $18.5 billion of this decline, while mutual savings banks accounted for another $1.4 billion.
These two financial intermediaries thus account ted for $6.4 billion or 84 per cent of the total decline – and these are the two financial intermediaries most affected by the Board of Governors Regulation Q policy. The nonnegotiable, multi-maturity time certificate of deposits of the commercial banks is to most savers apparently interchangeable with share certificates of savings and loan associations and savings deposits of mutual savings banks.
Regulation Q Policy and Effects
In December 1965 the Board of Governors raised the permissible interest ceiling on time certificates of deposit from 4 ½ to 5 ½ per cent for member banks. The Federal Deposit Insurance Corporation (FDIC), as it always does, made the Board’s ceilings applicable to all nonmember insured banks. Most commercial bankers on the basis of their evaluation of the competitive situation opted to pay rates at or near the ceilings. Although this was the fifth in a series of rate increases promulgated by the Board and the FDIC beginning in January 1957, it was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings than savings and loan s and the mutual savings banks could competitively meet.
There is evidence that the Boar’s primary objective in raising Regulation Q ceilings in December 1965 by a full percentage point was to “bail out” certain large New York city banks. These banks, beginning in 1961, stated issuing large denomination negotiable certificates of deposit (CD’s). This instrumentality has many of the marketability and liquidity qualities of Treasury bills. Its use enabled these large banks to draw funds out of banks all over the country and indeed the world. By late 1965 market interest rates had risen to levels that no longer made 4 ½ per cent CD’s attractive. Consequently as they matured they could not be replaced, the issuing banks had large outflows of funds and faced a liquidity crisis.
Assuming under the circumstances an increase in ceilings was justified it should have been a selective increase confined to the large denomination negotiable CD. The Board contends it did not have this selective power. If this explanation is accepted then the Board should have insisted from the beginning that large banks as well as small banks follow the old fashioned practice of storing their liquidity. They should not have been permitted to attempt to buy their liquidity through an open market instrument. Essentially the negotiable CD is a device for buying liquidity.
But it obviously cannot fulfill this function if the issuing banks do not have the option of raising the rates they pay to meet any market conditions that may prevail. In other words if the Board did not as it insisted have selective control powers over interest ceilings for the various types of CD’s issued by the banks,. It was, by allowing the banks to introduce the negotiable CD abdicating its Regulation Q power.
Major Policy Blunder
In any event the nonselective increase in Regulation Q ceilings proved to be a major policy blunder. The effect of the 5 ½ per cent ceiling was to dry up through the intermediaries, especially the savings and loan associations. Savers, instead of transferring the ownership of demand deposits which they had saved to the savings and loan associations and the mutual savings banks simply converted these demand deposits into time deposits. The higher rates paid by the banks also cause some disintermediation from the savings and loan associations and the mutual savings banks to the commercial banks.
In the seven months following the Board’s and the FDIC’s action, time deposits in commercial banks grew by $10.1 billion. Share accounts (and certificates) in savings and loan associations by contrast grew by only $0.5 billion, and savings deposits in mutual savings banks grew by only $1.1 billion. Annual rates of growth were respectively 7.0 per cent for commercial banks, 0.45 per cent for savings and loans, and 2.1 per cent for mutual savings banks.
As a consequence of the virtual stoppage in any net inflow of funds into the savings and loans, and the sharp decline in mutual savings bank deposits growth, the residential mortgage market collapsed. Mortgage money simply dried up, we had a “credit crunch.”
Thoroughly alarmed by the deteriorating situation the Board (and the FDIC) reversed their earlier actio0n and on July 20, 1966 made the first reduction in interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multi-maturity, nonnegotiable CD’s were reduced from 5 ½ to 5 per cent on certificates maturing in 90 days or more, and from 5 ½ to 4 per cent for certificates maturing in less than 90 days. These are the “consumer type” CD’s issued by the banks that are most competitive with the share accounts and share certificates issued by the savings and loans and the savings deposits offered by the mutual savings banks.
A second reduction in Regulation Q ceilings was effected on September 26, 1966 when the maximum rates payable on single maturity negotiable and nonnegotiable CD’s of less than $100,000 denomination were reduced from 5 ½ to 5 per cent.
Since banks were generally paying rates at or near the maximums allowed these changes had a considerable effect on the relative attractivene4ss of time deposits vies a vies share accounts in savings and loans and savings deposits in mutual savings banks.
Restored was some of the rate and the mutual savings banks had traditionally enjoyed. When the Federal Home Loan Bank Board (FHLBB) and the FDIC were given (September 1966) temporary emergency powers to fix dividend and interest rate ceilings for savings and loans and mutual saving banks they established ceilings which preserved to a small degree a rate differential advantageous to the intermediaries. Ceilings were fixed (with certain exceptions) at 4 ¾ per cent for share accounts and 5 ¼ per cent for share certificates of savings and loans, and 5 per cent for savings deposits of mutual savings banks.
The effects of restoring a rate differential in favor of the intermediaries is apparent in the reversal of the trends of the first seven months of 1966. Time deposits in commercial banks which had increased $10.1 billion in the first seven months and stood at a figure of $156.8 at the end of July grew by only $2.0 billion during the remainder of the year.
Share accounts in savings and loan associations by contrast which stood at a figure of $110.9 billion at the end of July had $3.1 billion of their total 1966 growth of $3.6 billion during the last five months of the year.
Mutual Savings banks were less affected but were able to post a gain of $1.5 billion in the last five months of 1966, compared with $1.1 in the preceding seven months; bringing total savings deposits tin these institutions to $55.0 billion by the end of 1966.
Almost immediately after the Board’s and the FDIC’s actions in reducing interest ceilings there was an easing in the mortgage markets and the near panic conditions that had prevailed were soon dissipated. But an industry with the long leads and lags of the construction industry and as demoralized as housing was in 1966 cannot quickly be turned around. It has only been recently that new housing starts have approached the levels prevailing in January 1966. The most recent available figures are (on a seasonally adjusted annual basis) 1,419,000 for January 1968 compared with 1,585,000 for January 1966
Misconceptions of the Role of the Commercial Banks in the Savings-Investment Process
If, as here contended the primary cause of the 1966 crisis in the residential mortgage market was the Board’s Regulation Q policy, some inquiry into the Board’s concept of the role of the commercial banks in the savings-investment process seems in order. Certainly the Board would not precipitate a general credit crisis in the mortgage markets in order to accommodate a few New York city banks however big. Nor can we question the Board’s motives. Certainly it was not the Board’s objective to “elbow home-building to the end of the line.” Quite the contrary in fact William McChesney Martin, Jr. Chairman of the Board of Governors in evaluating the Board’s December 1965 action in raising Regulation Q ceilings made the following reassuring statement “I expect a continued ample flow of funds into residential construction.” (Federal Reserve Bulletin, December 1965, p. 1673)
Why did this forecast go awry? I think the explanation is to be found in the Board’s basic misconceptions concerning the role of the commercial banks in the savings-investment process. On the same page from which the above quote is taken Chairman Martin makes this statement: “Now I’d like to add something about our increase in maximum rates on time deposits. This part of the action was designed to permit the banking system as whole (boldface added)…to expand their resources sufficiently to provide the economy with additional credit…” And on page 1675 Chairman Martin explains that the time deposit rate ceiling was raised “…to allow the economy to use more efficiently the funds already (boldface added) available…”
There is the clear implication in these statements that commercial banks are financial intermediaries, that they loan out time deposits and that a growth of time deposits will increase the volume of loans the banks can make. This is made even more explicit in his “Statement to Congress” (Federal Reserve Bulletin, February 1967, p. 213) “Viewing credit flows in broader perspective, all financial intermediaries – banks (boldface added) as well as thrift institutions – were falling behind in the competition for savings flows:…”
Commercial Banks From a System Standpoint Do Not Loan Out the Public’s Savings
If the banks do not loan out the public’s savings what do they loan out? And the answer is” when the commercial banks make loans to or buy securities from the nonbank public they acquire these earning assets by creating new money. This new money almost invariably takes the form of demand deposits (our check-book money).
From a system standpoint the commercial banks do not loan any existing deposits, demand or time; nor do they loan out the equity of their owners, nor the proceeds from the sale of capital notes or debentures or any other type of security. It is absolutely false to speak of the commercial banks as financial intermediaries not only because they are capable of “creating credit” but also because all savings held in the commercial banks originate within the banking system. The source of time deposits is demand deposits, either directly or indirectly via the currency and undivided profits accounts of the banks. It is of course possible for currency hoards (a form of monetary savings) to be returned to the banks in exchange for time deposits. But this can never be a net source of time deposit growth since all currency held by the nonbank public was at some prior time withdrawn from the commercial banks and involved the cashing of demand and/or time deposits.
Only on a short-term seasonal basis could currency flows result in a growth of time deposits. On a net annual basis currency flows are out of, not into, the banking system.
This upward trend in the public’s holdings of currency has been consistent and it has been large. Currency holdings of the nonbank public which stood at a figure of $6.4 billion at the end of 1939 now are in excess of $39 billion. During the same period the commercial banks have expanded their earning assets from $40.7 billion to approximately $357 billion. The commercial banks acquired this vast increment of $316 billion in their earning assets by creating an approximately equal volume of new demand deposits.
In the normal course of being transferred a small fraction of demand deposits is saved. Since 1939 the public has chosen to make a net transfer amounting to $170 billion of these saved demand deposits into time deposits. This raise the total volume of time deposits held in the commercial banking system from the miniscule level of $15.3 billion at the end of 1939 to the present vas sum of $186 billion.
Most of this growth ($135 billion) has been since the Board inaugurated its policy of higher and higher Regulation Q ceilings.
‘The Board has thus been an indispensable accessory in erecting an institutional savings structure (time deposit banking) the effect of which is to block the flow of a vast volume of monetary savings into investment – into job creating activities.
The following simple illustrations are designed to portray the principles involved in bank “credit creation,” and the roles of the commercial banks in the savings-investment process
The first “T” account illustrates the effect on the consolidated balance sheet of the banking system when a loan of $10,000 is made to the nonbank public:
Commercial banks
Loans $10,000 Demand deposits $10,000
As a consequence of a “meeting of minds,” and because demand deposits are acceptable as a means-of-payment by the public, the banks are able to write up their earnings assets by $10,000 giving the borrower in exchange for his note a net addition to his checking account of $10,000. And note this: There will be no effect on prices, production, employment or any Gross National product (GNP) item until the borrower of these newly created deposits spends them and spends them in such a way as to increase the demand for goods and services.
Spending the newly created demand deposits will have no effect on the size of the banking system:
Commercial banks
Loans $10,000 Demand Deposits $10,000
(-)Demand deposits $10,000
(+)Demand deposits $10,000
Limits on this expansion process must be, and are, built into the structure o the banking system. This is accomplished by require the banks to hold asses called legal reserves. Legal reserves must be held in at least a minimal relationship to the volume of demand and time deposits, e.g., 12 per cent of demand deposits and 5 per cent of time deposits. The aggregate of bank legal reserves held by the banks, both member and nonmember, is in turn controlled by the Federal Reserve System through its so-called open-market operations.
Assume that after a number of transfers the recipients of demand deposits are able to save $1,000. How is this illustrated on the consolidated balance sheet? The answer is: it cannot be illustrated, for monetary savings, from the standpoint of the banking system is a function of velocity or rate of turnover of deposits, it is not a function of volume. The growth of bank held savings thus results in no alteration of the “footings” of the consolidated balance sheet. And as long as monetary savings are held in the commercial banks either in the form of demand or time deposits the rate of turnover of these deposits is zero.
Unfortunately the impact on the economy is not zero, it is decidedly negative. Monetary savings involve a prior cost of production to business and when the funds are not returned to the marketplace a depressing effed5t is exerted on the economy.
Savers have four principal options at their disposal: (1) leave the savings in the form of demand deposits – and lose any explicitly return: (2) transfer the saved demand deposits to some financial intermediary in exchange for earning assets: (3) invest the funds directly; and (4) shift the demand deposits into time deposits.
No matter which alternative is selected there will be no effect, per se, on the size of the banking system or the volume of earning assets held by the system. The fourth alternative will of course alter the “mix of bank’s liabilities.
Loans $10,000 Demand deposits $10,000
(-)Demand deposits $1,000
(+)Time deposits $1,000
Of the four alternatives only (2) and (3) are a “use” of savings from the standpoint of the economy. Only (2) and (3) enable monetary savings to be used in such a way as to finance GDP items. In neither (1) nor (4) are the savings being used to finance investment. Both in reality are a form of stagnant money.
The fact that the earning assets held by the commercial banks are approximately equal to their demand and time deposits liabilities is often cited to prove that demand and time deposits are actually being invested. It bears reiteration that no investment can take place unless money is turning over. The turnover of money involves the transfer in the ownership of demand deposits and this is the exclusive prerogative of the nonbank owners of these deposits.
The earning assets held by the commercial banks are not therefore investment or even evidence of consumption. Their existence provides only presumptive evidence that investment (or consumption) has taken place; on the assumption that the recipients of the banks newly created demand deposits have transferred the ownership of these deposits to the producers of goods and services.
In contrast to the commercial banks the earning assets held by the savings and loans mutual savings banks and other financial intermediaries, are positive proof that expenditures have been made, that money “changed hands” – for it is impossible for the financial intermediaries to acquire earning assets without expending the money balances put at their disposal by savers, or acquired through the retention of earnings
Time Deposits and the Lending Capacity of the Commercial Banks
Since time deposits originate within the banking system, there cannot be an “inflow” of time deposits and the growth of time deposits cannot per se increase the size of the banking system.
However, due to the lower reserve ratios applicable to time deposits a shift from demand to time deposits will, other things being equal, increase the excess legal reserves in the system and will to that extent add to the system’s incremental lending capacity. Holding other things equal however ignores the dynamics of monetary policy execution. In the short term the Manger of the Open Market Account, following the general directives of the Federal Open Market Committee (FOMC), seeks a certain level of net free or net borrowed reserves. Any increase in excess reserves will of course increase the volume of net free reserves, or reduce the volume of net borrowed reserves. If the change is at all substantial ($50) million or so) the Manger of the Open Market Account will react by ordering open market sales sufficient to offset the increase.
IN the longer-term the bank credit proxy” (the sum of demand and time deposits) is the criterion relied on to determine whether the level and rate of change of bank credit (earning assets) conforms to the objectives of monetary authorities.
Since the monetary authorities make their determinations on the basis of the size and not the “mix” or the bank credit proxy, there is no a priori reason to assume that an expansion of time deposits will alter the FOMC’s consensus as to the proper volume and rate of change in bank credit.
Monetary policy is conditioned by many diverse elements in the economy; the level and rate of increase of prices; the level and expected level of deficits in the international accounts of the country: the rate and expected rate of unemployment; Treasury debt management requirements, etc.
To the extent that the growth of time deposits reduces inflationary pressures, reduces deficits in the balance of payments, increases unemployment, and in general dampens down the economy, to that extent will the FOMC be induced to follow an easier or less restrictive monetary policy. Since time deposits do in fact exert a depressing influence on the economy, it is quite probable that the growth of time deposits does induce (in the indirect way noted) the Federal Reserve to supply a larger volume of legal reserves to the banking system than otherwise would be provided. Assuming the bank system exploits this larger lending capacity it can then be said that the growth of time deposits does bring about through these indirect effects on monetary policy an increase in bank earnings assets and a larger banking system. How much larger? No one can give an answer to that question.
Size however is not synonymous with profitability. Sine time deposits are much more expensive to maintain than are demand deposits (about $43 per $1,000 per year for time deposits on the average compared to about $15 for demand deposits), any shift from demand to time deposits will, from a system standpoint, increase bank costs. J Profits will be reduced since this transfer results in no increase in bank earnings.
If these adverse effects on costs and profits are to be overcome it is necessary to assume that the expansion of time deposits induces the monetary authorities to follow an easier (or less restrictive) monetary policy.
Furthermore, this change in monetary policy results in the monetary authorities supplying the banking system with an additional volume of reserves sufficient to enable the banks to expand their earnings assets, and there by their net earnings, by an amount which will more than offset the overall increase in costs associated with the growth of time deposits and the incremental demand deposits resulting from the expansion of bank credit.
It is indeed a moot question that these conditions have ever been fulfilled.
Conclusion
A further reduction in Regulation Q ceilings is highly desirable. A reduction in Regulation Q ceilings would benefit the banks, the financial intermediaries, homeowners and home builders, and in fact the whole economy.
Bank profits would rise because a lowering of rate ceilings would reduce the ratio of time to demand deposits. All studies show (see list below) that the lower the ratio of time to demand deposits the higher the ratio of profits to the net worth of banks irrespective of the size of the bank.
The larger flow of funds through the financial intermediaries that would result from such a reduction would ease mortgage interest rates thereby stimulating residential construction.
It may be objected that this would further accentuate inflationary pressures in the economy and worsen our balance of payments situation. Both inflationary pressures in the economy and our chronic deficits in the balance of payments are primarily the result of excessive federal expenditures abroad on our far-flung military establishment.
Let us cure these ills by attacking the source, not by starving the domestic economy. In fact no amount of domestic unemployment will cure our balance of payments problem and reserve the dollar as the premier reserve currency of the world.
The “credit crunch” of 1966 was not a general across-the-board credit crisis. It was on the contrary quite limited, its impact being largely confined to the residential-mortgage market. Business in fact obtained too much credit in 1966. During the first half of 1966 commercial and industrial loans of insured commercial banks increased at the abnormally high annual rate of 16.4 per cent. There was some slackening in the last half of the year but overall the commercial banks financed a 13 per cent net expansion of business loans in 1966.
Bank credit was the major source of financing that made possible an unattainable rate of inventory accumulation. Toward the end of 1968 a huge overhang of inventories developed and this was followed in the first six months of 1967 by the severest inventory adjustment on record. Inventory investment dropped from an annual rate of more than $18 billion to practically nothing.
In contrast to the plethora of credit being supplied business by the commercial banks, the housing industry was being starved for funds. Of the financial intermediaries providing the bulk of mortgage credit the savings and loans were hardest hit. Net inflows of funds virtually ceased during the first seven months of 1966. Since savings and loans supply about 45 per cent of residential mortgage financing a sharp contraction in new housing starts was inevitable. It was the unavailability rather than the cost of credit which forced a reduction in new housing starts from a level of 1,585,000 in January 1966 to a seasonally adjusted annual rate of only 848,900 in the fourth quarter of 1966, the lowest rate on record since the end of World War II.
The financial side-effects of the housing industry’s collapse involved wide-spread losses and bankruptcies among builders and contractors and threatened the solvency of many savings and loan associations. Bu July 1966 the financial crisis was so severe the Board of Governors of the Federal Reserve System took the unprecedented step of allowing savings and loans whose solvency was threatened to obtain credit assistance directly from the Federal Reserve banks. The Board’s judgment of the dimensions of the crisis is brought into sharper focus by pointing out that even nonmember banks are not allowed to borrow from the Federal Reserve banks except in an emergency, and then only if the advance is fully secured by United States Government obligations.
Tight money seems to be the accepted official (and unofficial) explanation of the mortgage credit crisis of 1966. The Present’s Council of Economic Advisers advances this explanation in the 1967 Economic Report of the President (p.60); and in the 1968 Report (p. 76) the Council reiterates that “Tight money was clearly the primary factor accounting for the sharp decline in homebuilding (in 1966)…”
If tight money is the correct explanation then we should be heading for another credit crisis in the residential mortgage market. Long-term interest rates including mortgage rates are now at higher levels compared with 1966; the Federal Reserve is currently following a monetary policy at least as restrictive as the period of greatest restraint in 1966; and; and the spread between the rates the savings and loan associations and the mutual savings banks are paying to savers and market rates of interest are greater than in 1966.
This spread in rates, the short-run accompaniment of a tight money policy, presumably leads to disintermediation – a shift by the public from indirect investment through financial intermediaries to direct investment. The mortgage markets suffer the sharpest effects of disintermediation since the intermediaries most affected (savings and loan associations and mutual savings banks) are major suppliers of mortgage credit. These effects are only slightly compensated by the subsequent direct investment. The mortgage markets suffer the sharpest effects of disintermediation since the intermediaries most affected (savings and loan associations and mutual savings banks) are major suppliers of mortgage credit. These effects are only slightly compensated by the subsequent direct investment.
Unfounded Fears of Another Credit Crunch
Suggestions that another “credit crunch” is in the offing have indeed appeared in the financial press. I think all such prognostications are not only premature – they are unfounded. Tight money was only a secondary cause of the 1966 mortgage credit crisis. The primary cause was the Board of Governors policy with respect to establishing the maximum interest rates commercial banks can pay on time and savings deposits (hereafter referred to as Regulation Q, its official designation). In the administration of its Regulation Q policy the Board allowed the commercial banks during the first seven months of 1966 to pay higher interest rates on certificates of deposit than savings and loan associations and the mutual savings banks could pay on share certificates and savings deposits. Such an interest rate differential has existed in no other period. It was this factor, unique to 1966, that triggered the residential mortgage credit crisis of that year. Data subsequently cited fully document this assertion.
Recent Monetary Policy and Interest Rates
From an extremely easy policy in 1967 the Federal Reserve has shifted toward a definitely tight money policy. From February 1967 to February 1968 the member banks were allowed to operate with net free reserves (free reserves are equal to the excess of excess reserves over member bank borrowings from the Federal Reserve banks). For most of 1967 net free reserves fell in the $150 - $250 million range. Allowing bank credit to expand at a rate of 11.1 per cent in 1967 provides further evidence of the extreme case that prevailed. This rate compares to a rate of 5.4 per cent in 1966 and an annually compounded rate of about 5 per cent for the whole period from 1946-1966.
Beginning in February of this year the Federal Reserve has veered sharply toward restraint. Net borrowed reserves (the excess of borrowings from the Federal Reserve banks over excess reserves) replaced net free reserves. Currently net borrowed reserves are falling in the $200 - $400 million range, a level comparable to the levels greatest credit restraint in 1966. Since the inception of the current tight money policy the Federal Reserve through its open market operations has kept total legal reserves of member banks moving virtually sidewise at a level of approximately $25.6 - $25.9 billion. If this policy were continued throughout 1968 (a highly unlikely possibility) there would be little if any net expansion of bank credit.
The near-term effect of this restrictive policy plus the inordinate volume of deficit financing requirements of the federal government and the reluctance of nonbank investors to “go long” in creditorship securities, except at premium rates that amply discount the present accelerated rate of inflation, has caused long-term interest rates to reach the highest levels in this century. Rates are significantly higher than in credit crisis year of 1966. For example, the current average AAA corporate bond rate is 6.2 per cent compared to 5.5 per cent, the highest level reached by this series in 1966. Similarly the current average yield on new FHA mortgages is 6.8 per cent compared to an average level in 1966 of 6.4 per cent.
Lack of Loan-Funds Rather Than the Cost of Loan-Funds the Cause
Obviously it was the lack of funds rather than the cost of funds that spawned the credit crisis of 1966.
The principal financial institutions that hold residential mortgages (savings and loan associations, mutual savings banks, life insurance companies and commercial banks) reduce their net acquisition of nonfarm residential mortgage debt from $18.5 billion in 1965 to $10.9 billion in 1966. Savings and loan associations alone accounted for $18.5 billion of this decline, while mutual savings banks accounted for another $1.4 billion.
These two financial intermediaries thus account ted for $6.4 billion or 84 per cent of the total decline – and these are the two financial intermediaries most affected by the Board of Governors Regulation Q policy. The nonnegotiable, multi-maturity time certificate of deposits of the commercial banks is to most savers apparently interchangeable with share certificates of savings and loan associations and savings deposits of mutual savings banks.
Regulation Q Policy and Effects
In December 1965 the Board of Governors raised the permissible interest ceiling on time certificates of deposit from 4 ½ to 5 ½ per cent for member banks. The Federal Deposit Insurance Corporation (FDIC), as it always does, made the Board’s ceilings applicable to all nonmember insured banks. Most commercial bankers on the basis of their evaluation of the competitive situation opted to pay rates at or near the ceilings. Although this was the fifth in a series of rate increases promulgated by the Board and the FDIC beginning in January 1957, it was unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings than savings and loan s and the mutual savings banks could competitively meet.
There is evidence that the Boar’s primary objective in raising Regulation Q ceilings in December 1965 by a full percentage point was to “bail out” certain large New York city banks. These banks, beginning in 1961, stated issuing large denomination negotiable certificates of deposit (CD’s). This instrumentality has many of the marketability and liquidity qualities of Treasury bills. Its use enabled these large banks to draw funds out of banks all over the country and indeed the world. By late 1965 market interest rates had risen to levels that no longer made 4 ½ per cent CD’s attractive. Consequently as they matured they could not be replaced, the issuing banks had large outflows of funds and faced a liquidity crisis.
Assuming under the circumstances an increase in ceilings was justified it should have been a selective increase confined to the large denomination negotiable CD. The Board contends it did not have this selective power. If this explanation is accepted then the Board should have insisted from the beginning that large banks as well as small banks follow the old fashioned practice of storing their liquidity. They should not have been permitted to attempt to buy their liquidity through an open market instrument. Essentially the negotiable CD is a device for buying liquidity.
But it obviously cannot fulfill this function if the issuing banks do not have the option of raising the rates they pay to meet any market conditions that may prevail. In other words if the Board did not as it insisted have selective control powers over interest ceilings for the various types of CD’s issued by the banks,. It was, by allowing the banks to introduce the negotiable CD abdicating its Regulation Q power.
Major Policy Blunder
In any event the nonselective increase in Regulation Q ceilings proved to be a major policy blunder. The effect of the 5 ½ per cent ceiling was to dry up through the intermediaries, especially the savings and loan associations. Savers, instead of transferring the ownership of demand deposits which they had saved to the savings and loan associations and the mutual savings banks simply converted these demand deposits into time deposits. The higher rates paid by the banks also cause some disintermediation from the savings and loan associations and the mutual savings banks to the commercial banks.
In the seven months following the Board’s and the FDIC’s action, time deposits in commercial banks grew by $10.1 billion. Share accounts (and certificates) in savings and loan associations by contrast grew by only $0.5 billion, and savings deposits in mutual savings banks grew by only $1.1 billion. Annual rates of growth were respectively 7.0 per cent for commercial banks, 0.45 per cent for savings and loans, and 2.1 per cent for mutual savings banks.
As a consequence of the virtual stoppage in any net inflow of funds into the savings and loans, and the sharp decline in mutual savings bank deposits growth, the residential mortgage market collapsed. Mortgage money simply dried up, we had a “credit crunch.”
Thoroughly alarmed by the deteriorating situation the Board (and the FDIC) reversed their earlier actio0n and on July 20, 1966 made the first reduction in interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multi-maturity, nonnegotiable CD’s were reduced from 5 ½ to 5 per cent on certificates maturing in 90 days or more, and from 5 ½ to 4 per cent for certificates maturing in less than 90 days. These are the “consumer type” CD’s issued by the banks that are most competitive with the share accounts and share certificates issued by the savings and loans and the savings deposits offered by the mutual savings banks.
A second reduction in Regulation Q ceilings was effected on September 26, 1966 when the maximum rates payable on single maturity negotiable and nonnegotiable CD’s of less than $100,000 denomination were reduced from 5 ½ to 5 per cent.
Since banks were generally paying rates at or near the maximums allowed these changes had a considerable effect on the relative attractivene4ss of time deposits vies a vies share accounts in savings and loans and savings deposits in mutual savings banks.
Restored was some of the rate and the mutual savings banks had traditionally enjoyed. When the Federal Home Loan Bank Board (FHLBB) and the FDIC were given (September 1966) temporary emergency powers to fix dividend and interest rate ceilings for savings and loans and mutual saving banks they established ceilings which preserved to a small degree a rate differential advantageous to the intermediaries. Ceilings were fixed (with certain exceptions) at 4 ¾ per cent for share accounts and 5 ¼ per cent for share certificates of savings and loans, and 5 per cent for savings deposits of mutual savings banks.
The effects of restoring a rate differential in favor of the intermediaries is apparent in the reversal of the trends of the first seven months of 1966. Time deposits in commercial banks which had increased $10.1 billion in the first seven months and stood at a figure of $156.8 at the end of July grew by only $2.0 billion during the remainder of the year.
Share accounts in savings and loan associations by contrast which stood at a figure of $110.9 billion at the end of July had $3.1 billion of their total 1966 growth of $3.6 billion during the last five months of the year.
Mutual Savings banks were less affected but were able to post a gain of $1.5 billion in the last five months of 1966, compared with $1.1 in the preceding seven months; bringing total savings deposits tin these institutions to $55.0 billion by the end of 1966.
Almost immediately after the Board’s and the FDIC’s actions in reducing interest ceilings there was an easing in the mortgage markets and the near panic conditions that had prevailed were soon dissipated. But an industry with the long leads and lags of the construction industry and as demoralized as housing was in 1966 cannot quickly be turned around. It has only been recently that new housing starts have approached the levels prevailing in January 1966. The most recent available figures are (on a seasonally adjusted annual basis) 1,419,000 for January 1968 compared with 1,585,000 for January 1966
Misconceptions of the Role of the Commercial Banks in the Savings-Investment Process
If, as here contended the primary cause of the 1966 crisis in the residential mortgage market was the Board’s Regulation Q policy, some inquiry into the Board’s concept of the role of the commercial banks in the savings-investment process seems in order. Certainly the Board would not precipitate a general credit crisis in the mortgage markets in order to accommodate a few New York city banks however big. Nor can we question the Board’s motives. Certainly it was not the Board’s objective to “elbow home-building to the end of the line.” Quite the contrary in fact William McChesney Martin, Jr. Chairman of the Board of Governors in evaluating the Board’s December 1965 action in raising Regulation Q ceilings made the following reassuring statement “I expect a continued ample flow of funds into residential construction.” (Federal Reserve Bulletin, December 1965, p. 1673)
Why did this forecast go awry? I think the explanation is to be found in the Board’s basic misconceptions concerning the role of the commercial banks in the savings-investment process. On the same page from which the above quote is taken Chairman Martin makes this statement: “Now I’d like to add something about our increase in maximum rates on time deposits. This part of the action was designed to permit the banking system as whole (boldface added)…to expand their resources sufficiently to provide the economy with additional credit…” And on page 1675 Chairman Martin explains that the time deposit rate ceiling was raised “…to allow the economy to use more efficiently the funds already (boldface added) available…”
There is the clear implication in these statements that commercial banks are financial intermediaries, that they loan out time deposits and that a growth of time deposits will increase the volume of loans the banks can make. This is made even more explicit in his “Statement to Congress” (Federal Reserve Bulletin, February 1967, p. 213) “Viewing credit flows in broader perspective, all financial intermediaries – banks (boldface added) as well as thrift institutions – were falling behind in the competition for savings flows:…”
Commercial Banks From a System Standpoint Do Not Loan Out the Public’s Savings
If the banks do not loan out the public’s savings what do they loan out? And the answer is” when the commercial banks make loans to or buy securities from the nonbank public they acquire these earning assets by creating new money. This new money almost invariably takes the form of demand deposits (our check-book money).
From a system standpoint the commercial banks do not loan any existing deposits, demand or time; nor do they loan out the equity of their owners, nor the proceeds from the sale of capital notes or debentures or any other type of security. It is absolutely false to speak of the commercial banks as financial intermediaries not only because they are capable of “creating credit” but also because all savings held in the commercial banks originate within the banking system. The source of time deposits is demand deposits, either directly or indirectly via the currency and undivided profits accounts of the banks. It is of course possible for currency hoards (a form of monetary savings) to be returned to the banks in exchange for time deposits. But this can never be a net source of time deposit growth since all currency held by the nonbank public was at some prior time withdrawn from the commercial banks and involved the cashing of demand and/or time deposits.
Only on a short-term seasonal basis could currency flows result in a growth of time deposits. On a net annual basis currency flows are out of, not into, the banking system.
This upward trend in the public’s holdings of currency has been consistent and it has been large. Currency holdings of the nonbank public which stood at a figure of $6.4 billion at the end of 1939 now are in excess of $39 billion. During the same period the commercial banks have expanded their earning assets from $40.7 billion to approximately $357 billion. The commercial banks acquired this vast increment of $316 billion in their earning assets by creating an approximately equal volume of new demand deposits.
In the normal course of being transferred a small fraction of demand deposits is saved. Since 1939 the public has chosen to make a net transfer amounting to $170 billion of these saved demand deposits into time deposits. This raise the total volume of time deposits held in the commercial banking system from the miniscule level of $15.3 billion at the end of 1939 to the present vas sum of $186 billion.
Most of this growth ($135 billion) has been since the Board inaugurated its policy of higher and higher Regulation Q ceilings.
‘The Board has thus been an indispensable accessory in erecting an institutional savings structure (time deposit banking) the effect of which is to block the flow of a vast volume of monetary savings into investment – into job creating activities.
The following simple illustrations are designed to portray the principles involved in bank “credit creation,” and the roles of the commercial banks in the savings-investment process
The first “T” account illustrates the effect on the consolidated balance sheet of the banking system when a loan of $10,000 is made to the nonbank public:
Commercial banks
Loans $10,000 Demand deposits $10,000
As a consequence of a “meeting of minds,” and because demand deposits are acceptable as a means-of-payment by the public, the banks are able to write up their earnings assets by $10,000 giving the borrower in exchange for his note a net addition to his checking account of $10,000. And note this: There will be no effect on prices, production, employment or any Gross National product (GNP) item until the borrower of these newly created deposits spends them and spends them in such a way as to increase the demand for goods and services.
Spending the newly created demand deposits will have no effect on the size of the banking system:
Commercial banks
Loans $10,000 Demand Deposits $10,000
(-)Demand deposits $10,000
(+)Demand deposits $10,000
Limits on this expansion process must be, and are, built into the structure o the banking system. This is accomplished by require the banks to hold asses called legal reserves. Legal reserves must be held in at least a minimal relationship to the volume of demand and time deposits, e.g., 12 per cent of demand deposits and 5 per cent of time deposits. The aggregate of bank legal reserves held by the banks, both member and nonmember, is in turn controlled by the Federal Reserve System through its so-called open-market operations.
Assume that after a number of transfers the recipients of demand deposits are able to save $1,000. How is this illustrated on the consolidated balance sheet? The answer is: it cannot be illustrated, for monetary savings, from the standpoint of the banking system is a function of velocity or rate of turnover of deposits, it is not a function of volume. The growth of bank held savings thus results in no alteration of the “footings” of the consolidated balance sheet. And as long as monetary savings are held in the commercial banks either in the form of demand or time deposits the rate of turnover of these deposits is zero.
Unfortunately the impact on the economy is not zero, it is decidedly negative. Monetary savings involve a prior cost of production to business and when the funds are not returned to the marketplace a depressing effed5t is exerted on the economy.
Savers have four principal options at their disposal: (1) leave the savings in the form of demand deposits – and lose any explicitly return: (2) transfer the saved demand deposits to some financial intermediary in exchange for earning assets: (3) invest the funds directly; and (4) shift the demand deposits into time deposits.
No matter which alternative is selected there will be no effect, per se, on the size of the banking system or the volume of earning assets held by the system. The fourth alternative will of course alter the “mix of bank’s liabilities.
Loans $10,000 Demand deposits $10,000
(-)Demand deposits $1,000
(+)Time deposits $1,000
Of the four alternatives only (2) and (3) are a “use” of savings from the standpoint of the economy. Only (2) and (3) enable monetary savings to be used in such a way as to finance GDP items. In neither (1) nor (4) are the savings being used to finance investment. Both in reality are a form of stagnant money.
The fact that the earning assets held by the commercial banks are approximately equal to their demand and time deposits liabilities is often cited to prove that demand and time deposits are actually being invested. It bears reiteration that no investment can take place unless money is turning over. The turnover of money involves the transfer in the ownership of demand deposits and this is the exclusive prerogative of the nonbank owners of these deposits.
The earning assets held by the commercial banks are not therefore investment or even evidence of consumption. Their existence provides only presumptive evidence that investment (or consumption) has taken place; on the assumption that the recipients of the banks newly created demand deposits have transferred the ownership of these deposits to the producers of goods and services.
In contrast to the commercial banks the earning assets held by the savings and loans mutual savings banks and other financial intermediaries, are positive proof that expenditures have been made, that money “changed hands” – for it is impossible for the financial intermediaries to acquire earning assets without expending the money balances put at their disposal by savers, or acquired through the retention of earnings
Time Deposits and the Lending Capacity of the Commercial Banks
Since time deposits originate within the banking system, there cannot be an “inflow” of time deposits and the growth of time deposits cannot per se increase the size of the banking system.
However, due to the lower reserve ratios applicable to time deposits a shift from demand to time deposits will, other things being equal, increase the excess legal reserves in the system and will to that extent add to the system’s incremental lending capacity. Holding other things equal however ignores the dynamics of monetary policy execution. In the short term the Manger of the Open Market Account, following the general directives of the Federal Open Market Committee (FOMC), seeks a certain level of net free or net borrowed reserves. Any increase in excess reserves will of course increase the volume of net free reserves, or reduce the volume of net borrowed reserves. If the change is at all substantial ($50) million or so) the Manger of the Open Market Account will react by ordering open market sales sufficient to offset the increase.
IN the longer-term the bank credit proxy” (the sum of demand and time deposits) is the criterion relied on to determine whether the level and rate of change of bank credit (earning assets) conforms to the objectives of monetary authorities.
Since the monetary authorities make their determinations on the basis of the size and not the “mix” or the bank credit proxy, there is no a priori reason to assume that an expansion of time deposits will alter the FOMC’s consensus as to the proper volume and rate of change in bank credit.
Monetary policy is conditioned by many diverse elements in the economy; the level and rate of increase of prices; the level and expected level of deficits in the international accounts of the country: the rate and expected rate of unemployment; Treasury debt management requirements, etc.
To the extent that the growth of time deposits reduces inflationary pressures, reduces deficits in the balance of payments, increases unemployment, and in general dampens down the economy, to that extent will the FOMC be induced to follow an easier or less restrictive monetary policy. Since time deposits do in fact exert a depressing influence on the economy, it is quite probable that the growth of time deposits does induce (in the indirect way noted) the Federal Reserve to supply a larger volume of legal reserves to the banking system than otherwise would be provided. Assuming the bank system exploits this larger lending capacity it can then be said that the growth of time deposits does bring about through these indirect effects on monetary policy an increase in bank earnings assets and a larger banking system. How much larger? No one can give an answer to that question.
Size however is not synonymous with profitability. Sine time deposits are much more expensive to maintain than are demand deposits (about $43 per $1,000 per year for time deposits on the average compared to about $15 for demand deposits), any shift from demand to time deposits will, from a system standpoint, increase bank costs. J Profits will be reduced since this transfer results in no increase in bank earnings.
If these adverse effects on costs and profits are to be overcome it is necessary to assume that the expansion of time deposits induces the monetary authorities to follow an easier (or less restrictive) monetary policy.
Furthermore, this change in monetary policy results in the monetary authorities supplying the banking system with an additional volume of reserves sufficient to enable the banks to expand their earnings assets, and there by their net earnings, by an amount which will more than offset the overall increase in costs associated with the growth of time deposits and the incremental demand deposits resulting from the expansion of bank credit.
It is indeed a moot question that these conditions have ever been fulfilled.
Conclusion
A further reduction in Regulation Q ceilings is highly desirable. A reduction in Regulation Q ceilings would benefit the banks, the financial intermediaries, homeowners and home builders, and in fact the whole economy.
Bank profits would rise because a lowering of rate ceilings would reduce the ratio of time to demand deposits. All studies show (see list below) that the lower the ratio of time to demand deposits the higher the ratio of profits to the net worth of banks irrespective of the size of the bank.
The larger flow of funds through the financial intermediaries that would result from such a reduction would ease mortgage interest rates thereby stimulating residential construction.
It may be objected that this would further accentuate inflationary pressures in the economy and worsen our balance of payments situation. Both inflationary pressures in the economy and our chronic deficits in the balance of payments are primarily the result of excessive federal expenditures abroad on our far-flung military establishment.
Let us cure these ills by attacking the source, not by starving the domestic economy. In fact no amount of domestic unemployment will cure our balance of payments problem and reserve the dollar as the premier reserve currency of the world.
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