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Form F. R. 131 BOARD O F G O V E R N O R S /U OF THE FEDERAL RESERVE SYSTEM Office Correspondence •pQ p r Subject: Chairman Eccles i Lauchlin Currie —— Future T^nd of Ttank A i l t f ffp.i • In accordance with your suggestions I have considerably enlarged my previous note on the trend of bank assets in the next few years• I should be grateful for any further comments or criticisms. Do you think it would be a useful thing to send to the Board and, perhaps, Presidents of the Open Market Committee? I am now engaged on a memorandum on the monetary situation in relation to excess reserves, attempting among other things to work out a criterion of the "adequacy" or "excessiveness" of the money supply. LC: R & S. Confici ential Nov.11, 1956. THE TREND OF BANK ASSETS IN THE NEXT FEW YEARS Statement of the Problem Although it is not possible to be very explicit on this subject its importance in various connections justifies a consideration of the evidence bearing on it. Some people feel that in order to meet the demand for commercial loans on the part of their customers that is anticipated with further recovery, banks will dispose of their holdings of Governments and this will exert pressure on the Government bond market• Of even more importance, the rapidity and extent to which banks expand loans may determine in large part the rapidity and extent to which it may prove desirable to take action with regard to excess reserves. Conclusion A survey of the previous experience in this and other countries, and a consideration of the effect of more recent developments, suggests that ?/hile the probable increase in the demand for unsecured and secured loans may very well be in excess of the amount by which it is thought desirable to let total earning assets and, hence, deposits, expand, it wall probably not be greatly in excess. This view rests on the assumption that the recovery movement will continue to be orderly and will not be characterized by rapid advances in commodity prices* Even the anticipated excess in the demand for loans over the amount by which it is thought desirable to permit total earning assets to increase need not entail a liquidation of bank holdings of Government bonds because (a) a substantial portion of bank holdings is in notes and bills and (b) it is to be expected that the Government will retire and refund a portion of the short-term debt* Considerations Leading Up to the Conclusion It would appear, in the first place, that there will be little necessity or disposition to liquidate Governments in order to meet the demand for other types of loans so long as member banks possess an abundance of excess reserves. In view of the magnitude of the expansion of circulating deposits plus outside currency that has occurred since 1933, it is questionable whether it may not be thought desirable to prevent further expansion of the volume of money• If such should prove to be the case, action would have to be taken to return to the condition that prevailed up to 1932 of no excess reserves• The question would then arise as to whether and to what extent banks would liquidate their Governments in order to increase other types of earning assets» In addition to the expansion of other assets that is possible so long as banks possess excess reserves, there is the expansion that will be possible on the basis of reserves released by a shift from demand to time deposits and on the basis of additional capital and surplus. It is apparent, therefore, that considerable expansion of loans is possible before any necessity would arise for a liquidation of Governments. We may now look at the matter from the banks1 point of view. Banks are as a rule anxious to meet any requirements for loans of their customers which they consider safe. The rates are generally higher than on other assets and the goodwill and maintenance of the customer relationship is a factor. On the other hand, banks have always the problem of liquidity to bear in mind. They feel they need a substantial portion of assets they can realize on quickly without loss of principal or of goodwill. It is of interest to compare the proportion of earning assets of member banks represented by Governments, call loans to brokers in New York, and acceptances and commercial paper, of 18.6 percent in 1929 with 41 percent in 1956. If, on the latter date, Government guaranteed issues are included, the proportion becomes 47 percent. If only Government notes, bills and certificates are included in each case, the proportions were 10 percent in 1929 and 24 percent in 1956. Even allowing for some increase in liquidity requirements resulting from the experience in the depression, it is apparent that, judged by pre-depression standards, banks have a large portion of their earning assets in liquid form and could well afford to increase their customer loans at the expense of liquid earning assets. -4- It would appear, therefore, that the amount of expansion of customer loans to be expected becomes more largely a question of the probable demand for such loans than of reluctance of banks to make loans. In approaching this problem it will be helpful to compare the earning assets of member banks in 1955 with the earning assets in 1929. This is done in the following table: 1/ Member Bank Loans and Investments. June 1929-56.(In millions of dollars) 1929 Percent 1956 Percent Government Obligations Bills, Certificates 1,150 5,005 4*155 Total Guaranteed Total direct and guaranteed .28 5, 8. .58 ,86 11, 6 ,426 5 ,295 11 ,721 19. .97 16. ,46 56. .45 1 ,951 and Notes Bonds 6. .06 4.155 ,86 11. 15 ,672 42, 49 r Other Securities 5.898 16. .85 6 ,045 .79 18. Total Securities 10.055 28. .69 19 ,717 61. .28 2,025 7,754 9,759 5. .78 22, .07 .85 27, 1. ,079 ,150 5, ,209 4, 525 9 .75 15 .08 3,164 .05 9. ,540 2j 7 .27 447 1. .28 557 1 .75 All Other Loans 11,618 55. .16 ,555 5, 16 .64 Total Loans 24,988 .51 71. ,461 12, 58 .72 Total Loans & Investments 55,041 100,,00 ,178 52, 100 ,00 Loans on Securities To brokers in New York To others Total Loans on Real Estate Acceptances & commercial paper 1/ Exclusive of interbank loans. -5- This table serves the purpose of bringing out the absolute and percentage changes in the composition of the earning assets of member banks since 1929 and indicates the magnitude of changes the restoration of the 1929 composition would entail. The big changes, of course, have been the increase in Government direct and guaranteed issues and the declines in loans on securities and "All Other Loans". It is interesting, however, to note that Government bonds are only $2.5 billion in excess of 1929, although if guaranteed issues are included the increase is $4.2 billion. The big increase in Governments has been in bills and notes. Non-member insured banks on June 50, 1956, held approximately $500 million of Government bonds and $500 million of guaranteed issues. The figures would be still further increased by the inclusion of non-member non-insured banks. It is now proposed to examine separately the prospects of expansion in the various types of earning assets. We will then be in a better position to weigh the probabilities of a decline in bank holdings of Governments. Unsecured Loans 1. Movement of "All Other Loans". 1921-29* 1955-56. From June 1921 to June 1925 the index of production rose from 65 to 106. In the same period national bank loans other than on securities and real estate declined $607 million, and holdings of Government securities increased $570 million. -6- Froia June 1923 to June 1929 the index of production rose from 106 to 125. Loans other than on securities and real estate of national banks decreased by $714 million, or 9 percent. Their holdings of Government securities increased $110 million. In the same period the Government debt outstanding decreased by $5,369. In interpreting these facts a plausible explanation appears to be as follows: New loans were undoubtedly being made in the sharp recovery from 1921 to 1923. The total outstanding declined, however, as a result of the heavy liquidation of loans that had been carried over from the peak of 1920. Moreover, the price level stabilized at a considerably lower level than prevailed in 1919-20, and the requirements for working capital were lower on this account. From 1923 to 1929 unsecured los-ns continued to decline, although the index of production rose. This behavior appears to be in large part attributable to the lessening economic importance of those individuals and concerns that comprise the bulk of borrowing customers, and in part to the increasing ability to finance expansion in ways other than by bank loans. I may quote what I have said i/ elsewhere on this subject: !! Upon the basis of an investigation into the accounts of 729 companies, divided into 30 groups, for which comparable balance sheet© were available from 1922 to 1928 inclusive, the writer sought to explain the decline in bank loans as due to a recognition of the extent to which loans intensify the dangers 1/ The Supply and Control of Money in the United States, p. 41. -7- of a drastic decline in net earnings and of insolvency, should gross earnings decline.1/ Although only the larger companies were studied it is highly significant, in view of the apparent trend toward large scale enterprise, that the companies that were growing most rapidly and should on that account require larger loans, actually reduced them to a nominal figure, while companies whose earnings were low or declining were carrying heavy bank loans and in some cases actually increasing them. It appeared that the desire to liquidate loans pervaded all industry, since in those cases where loans were still relatively heavy in 1928 the ability to liquidate was lacking. It was inferred, moreover, from this study that the great bulk of commercial loans were being made to farmers and relatively small business concerns. If economic progress continues to be associated with the increasing importance of the larger corporations having access to the stock and bond markets, there is a strong probability that the commercial loan will continue to decline in the future.11 1/ The Decline of the Commercial Loan* Quarterly Journal of Economics, August, 1931, pp. 698-709. Our past experience appears to have some relevance to recent developments and future prospects. During the recovery from 19S5 to 1955, the volume of liquidation and write-offs of old loans of member banks exceeded the volume of new loans made, so that the total declined by $23 million despite an expansion of business activity. In 1935, however, new loans being made began to exceed old loans paid or written off, and the total for reporting member banks increased $693 million from October 1935 to October 1936. The fact that all other loans have begun to expand before full recovery is achieved, which was not true in 1921-23, is perhaps partly attributable to the extremely heavy liquidation that had already occurred -8- in the period 1929-33, and partly to the relatively more favorable recovery of agriculture in the present movement. The trend noticeable in the Twenties, where it appeared that broadly speaking only those industrial and commercial concerns that could not easily raise money elsewhere borrowed from banks, may be expected to continue. In fact the experience of the depression has served to emphasize anew the dangers associated with short-term indebtedness. From the point of view of this long-term trend, therefore, we would expect the proportion of other loans to total loans and investments to be less in the future than in the Twenties. 2. Bank Loans and the Recovery in Other Countries. The co-existence of increasing business activity and declining bank loans experienced in this country from 1921 to 1923 and from 1933 to 1955 is not peculiar to this country. As the following table indicates, the same divergent movements took place in the United Kingdom, Canada, and Sweden in recent years, though in the past year an upturn in loans has occurred in the United Kingdom. In interpreting these figures it should be borne in mind that the decline from 1929 was far less steep in England and Sweden, and hence that the percentage rate of decline and recovery in the United States is much greater. Another factor was the decline and subsequent increase in bank loans in the United States -9- attributable to bank closings and the subsequent taking over in part of loans from closed banks. We should, therefore, expect loans to decline more rapidly in the United States and show a greater degree of recovery. -10Bank Loans in United Kingdom, Canada, Sweden and the United States. 1929-56, and Yearly Average Index of Production. United Loans to customers (millioas of L) 1929. , 1950. , 1931. , 1952. , 1935. . 1936. . m 976 926 856 780 852 KingdomIndex of Production 100.0 92.5 83.8 83.5 88.2 115.1 1/ 1/ Second quarter. 2/ June. Canada Loans & disIndex of counts other than on secur. Produc(mill.of Canad.i tion 1,434 1,425 1,263 1,211 955 777 100.0 84.8 71.0 58.1 60.3 87.6 2/ Sweden Loans & overdrafts Index of (millions Producof kronor) tion 3,203 3,409 •5,392 3,031 2,763 100.0 99.3 95.4 90.1 126.9 135.8 2/ United States All other loans Index of (millions Producof dollars) tion 11,618 10,349 8,744 6,892 4,834 5,355 100.0 80.7 68.1 53.8 63.9 86.6 2/ -11- 5. Other Considerations Bearing on the Future Movement of 1 1 All Other Loans". American industry as a whole appears to have more cash and be in a more liquid position than in 1929. A considerable expansion of activity could, therefore, be financed without entailing the necessity of raising new money. Too much emphasis should not be put on this factor, however, since, for one thing, industry may prefer to remain more liquid than heretofore and, for another, a general condition of liquidity is quite compatible with the existence of a shortage of working capital on the part of small manufacturers, merchants, and farmers, who make up so large a proportion of the borrowers from banks. The requirements of farmers, on the other hand, are likely to be met more largely by agencies other than commercial banks than was true formerly. It is reasonable to assume that the future character of the recovery movement will have an important influence on the demand for commercial loans. If the movement is steady and orderly in character and is not accompanied by any marked rise in prices, working capital requirements will be less than they would be if the movement assumes the proportions of a boom and rapid increases in prices occur. This reasoning receives some confirmation from a contrast of the 1917-20 experience, which was a commodity and general business boom, with that of 1923-29. Loans of national -12- banks other than on securities increased #3.8 billion, or 59 percent, in the earlier period as contrasted with a decrease of $714, or 9 percent in the period 1923-29 in such loans. To this point most of the considerations mentioned appear to suggest that on balance a moderate expansion only of "All Other Loans" is to be anticipated if the recovery movement continues orderly and rapid price advances are avoided. There are two considerations, however, which point in the opposite direction. One is an increase in "All Other Loans" of reporting member banks in the past year. If the same amount of expansion took place in the next four years this would mean an increase of $2.8 billion. If, however, the same rate of increase occurs, the expansion would be $4.5 billion. It would be very helpful if more were known of the nature of the increase that has occurred. It may in part represent the taking over of existing loans by member banks, in part an expansion in installment selling, and in part loans for capital purposes which are expected to be refunded. The trend in the next six months in comparison with the trend in the previous year should afford some clue as to the permanence and strength of the recent movement. -13- A factor which is now present but which was lacking in the Twenties is a tax on undistributed earnings. While it is not expected to induce the larger companies having access to the stock and bond markets to borrow from banks, it may very well have this effect on the intermediate-sized corporationswhich have no access to the capital markets and which may experience some difficulty in getting some two or three hundred shareholders to take up rights to subscribe for new stock. In such cases there is an added inducement to distribute earnings in dividends ana finance working capital requirements by means of bank loans. Eespite the increase that has occurred in the past year and the uncertain effect of the new tax on undistributed earnings, previous experience in this and other countries would appear to suggest that "All Other Loans" will not regain the proportion of total loans and investments they represented in 1929 and that it is doubtful if they will regain the absolute level then prevailing. In other words, assuming the absence of rapid price advances, it seems more likely that "All Other Loans" will expand some $3 or $4 billion, rather than by the $6 billion necessary to restore the 1929 level. Security Loans» The only comparable series of loans on securities covering the post-war decade is that for national banks. This type of loan increased from $2.7 billion in 1921 to $5.5 billion in 1929, -14- or by $2.8 billion. In 1921 they comprised 17 percent of national bank loans and investments, in 1925 eighteen percent and in 1929 twenty-five and a half percent. It appears improbable that security loans will increase as rapidly in the next few years. For one thing, many people of this generation have had a disastrous experience with margin trading and the caution thus engendered may be expected to last for some time. Of more importance, however, is the requirement for higher margins than prevailed in the Twenties. It is perhaps not unreasonable to expect that any tendency toward a rapid increase in security loans will be checked by higher margin requirements. On the other hand, there may be more of a tendency for commercial loans to be backed by collateral. Loans on Seal Estate. Although the increase in residential building has not as yet been reflected in any increase in bank loans, this is probably owing to the continuance of liquidation of old loans. It is to be anticipated, however, that loans on real estate will experience considerable rise in the next few years. Various factors should contribute to this end. In the first place, there are the new provisions of the Banking Act of 1955, and the new opportunities to assure against loss afforded by the Federal Housing Administration. The latter are of particular importance in the case of -15- thinly-margined mortgages* Secondly, the probable continuance of low yields on securities, acceptances, commercial paper and call loans, and the present strong liquid position of banks will combine to enhance the attractiveness of real estate loans. Thirdly, there appears to be a strong likelihood of a very heavy volume of building construction in the next few years. While, therefore, it is to be expected that the bulk of mortgage lending will continue to be handled by agencies other than commercial banks, there is a possibility that loans on real estate by commercial banks may double in the next few years. With reference to our main problem, however, it may be pointed out that this would mean an increase of only two billions. Acceptances and Commercial Paper. It appears unlikely that the growth on these types of loans will be of quantitative significance. Even if the total of acceptances rises to the level of the late Twenties, this would mean a net expansion of only some $700 million. Other Securities. Member banks hold slightly more other securities than they did in 1929 and the proportion of earning assets represented by other securities has increased from 17 percent to 19 percent. It seems probable, therefore, that banks will be somewhat reluctant to increase their holdings by any substantial amount -16- unless they have excess reserves which they can utilize in no other manner. The more stringent definition of investment securities may also be a factor. Government Securities Total holdings of Government securities, direct and guaranteed, increased from 12 percent of member bank loans and investments in 1929 to 42§ percent on June 50, 1956. Long-term Governments, direct and guaranteed, showed a much less rapid increase. They amounted to 22§ percent of member bank earning assets on June 30, 1936, as compared with percent in 1929. In view of the magnitude of the increase, the prospects of little additional increase in the Federal debt, and the signs of an upturn in the demand for bank loans, it is likely that member bank holdings of Government securities are now at or near their peak. If they do not increase further, the proportion they represent of member bank loans and investments will decline as other earning assets increase. Whether bank holdings of Governments will experience an absolute decline and if so, by what amount, appears to depend more largely on the rapidity of debt retirement by the Government and the policy with regard to funding short-term issues than on the pressure to liquidate arising from the expansion in the demand for other types of loans. This conclusion is based on (a) the probable moderate expansion in the demand for other types -17- of loans, (b) the possibility of increasing total earning assets and (c) the scarcity of other types of liquid earning assets. While the probable increase in the demand for unsecured and secured loans may be in excess of the amount by which it is thought desirable to permit total earning assets and, hence, deposits to expand, it will probably not be greatly in excess. In the meantime it is to be expected that a portion of bank holdings of short-term Governments will be retired and refunded, so that the total bank holdings of all Governments will decline. In other words, there appears little likelihood that banks will be under the necessity of liquidating their holdings of Government bonds in order to satisfy local requirements for loans. If the expansion in the demand for loans is less than anticipated, if substantial debt retirements by the Federal Government are not effected and if a substantial part of the short-term debt is not converted into long-term issues, it is quite possible that banks will retain the bulk of their present holdings of Governments. This may even prove to be the case if some 20 or 30 percent of the notes are retired or converted into long-term issues* All insured banks now hold only 46 percent of the total of notes outstanding and even including the Federal Reserve Banks they hold less than 60 percent. The liquid character of such notes may lead banks -18- to increase the proportion of the total outstanding they now hold. A table showing the proportions of the total of various classes of Government direct and guaranteed issues held by the member banks, insured banks, and Federal Reserve banks is appended. Another factor that has a bearing on this subject is the possible liquidation of a substantial amount of notes and bills held by the Federal Reserve banks. Member banks may be expected to absorb a portion of such notes and bills and this would tend to keep up their total holdings of Governments. Still another factor of uncertain effect would be a rise in long-term interest yields and a fall in bond prices. This might induce a certain amount of liquidation of bonds by banks. It is interesting to note, however, that banks maintained their holdings of Governments in 1928-29 despite the rise in interest rates and the active demand for loans that prevailed at that time. The preceding discussion serves, among other things, to indicate the important bearing of refunding operations on monetary policy. If, for example, it is found that the conversion of notes and bills into long-term issues leads to a substantial decline in the total holdings of Government securities of banks, such operations would serve to offset an expansion of loans which would otherwise result in an expansion of total deposits. On the other hand, in so far as banks decline to convert short into -19- long-term issues, the rate of interest at which the short-term debt can be converted into long-term debt will be higher than it otherwise would be. Individuals and agencies other than banks must be induced to increase their total holdings of Governments and this will absorb financial deposits otherwise available for investment elsewhere. A table showing the holdings of Government securities, other securities, and loans of commercial banks in England, Canada and Sweden, is also appended. This table indicates that to date there has been no reduction in the commercial bank holdings of Government securities in these countries. AMOUNT AND PROPORTIONS OF VARIOUS CLASSES OF THE PUBLIC DEBT HELD BY VARIOUS CLASSES OF BANKS. 1954-1956. Jane 50 1955 Total direct outstanding 27.645 Member banks 9,871 Percent 35.7 Insured banks 10,470 Percent 37.9 Federal Reserve banks 2,432 Percent 8.8 1956 28^989 11,721 35.5 12,515 37.9 2,430 7.4 Bonds Member banks Percent Insured banks Percent Federal Reserve banks Percent 16,510 4,838 29.3 5,210 31.6 468 2.8 14.936 4,458 29.8 4,889 32.7 317 2.1 18.628 5,295 28.4 5,817 31.2 316 1.7 Notes Member banks Percent Insured banks Percent Federal Reserve banks Percent 6.932 2,871 41.4 3,047 44.0 605 8.7 10.501 4,313 41.1 4,476 42.6 1,511 14.4 11.861 5,160 43.5 5,428 45.8 1,494 12.6 Certificates Member banks Percent Insured banks Percent Federal Reserve banks Percent l t 635 637 39.0 656 40.1 265 16.2 156 146 Bills Member banks Percent Insured banks Percent Fed.Reserve bks .bills & certificates 1934 Percent 1.404 791 56.3 794 56.6 2.053 1,099 53.5 1,105 53.8 2.354 1,266 53.8 1,270 54.0 477 34.0 604 29.4 620 26.3 681 276 40.5 298 43.8 4.123 1,558 37.8 1,882 45.6 4.718 1,950 41.3 2,257 47.8 Lly guaranteed outstanding Member banks Percent Insured banks Percent - — - — — — — — — — - - COM^ICIAL BANKS' EARNING ASSETS. CANADA. SWEDEN. UNITED KINGDOM. Canada ff 1929. lP£5-55. (Money figures in millions of Canadian dollars) Year June 30 1929 1933 1934 1935 Dominion & Provincial Government Securities % to Amount Total 13 552 28 639 29 654 56 839 Other Securities % to Amount Total 175 6 222 10 185 8 8 179 Other loans & discounts % to Amount Total 1,434 51 1,057 46 1,018 45 954 41 Other earning assets % to Total Amount 861 31 383 17 398 18 356 15 Total % to Total Amount 100 2,820 100 2,301 100 2,253 100 2,508 — Sweden (Money figures in millions of kronor) Year Dec. 31 1929 1933 1934 1955 Total Securities % to Total Amount 9 595 462 10 640 14 648 14 Loans outstanding & overdrafts _ _ % to Total Amount 5,203 69 65 2,803 2,750 61 2,765 61 Other earning assets % to Total Amount 25 1,047 26 1,166 25 1,117 25 1,140 Total Amount 4,645 4,431 4,507 4,551 % to Total 100 100 100 100 United Kingdom (Money figures in millions of t) Other earning Other Loans to Govt. Secur.& Securities Treas.Notes 1/ Total assets customers 2/ Year % to % to % to % to % to June Total Total Amount Amount Total Amount Total Amount Total 30 Amount ,278 1,625 61 100 17 513 19 2 996 1929 58 -255 14 1,776 44 100 35 2 779 1933 707 40 1954 625 57 46 3 45 761 245 15 1,677 100 41 1955 727 44 53 3 231 779 15 1,790 100 1/ Includes British Government bonds and Treasury bills, estimated for the 10 London clearing banks* 2/ Advances & items in transit, of data from the banks making such reports. The estimates for ! S3 & f 34 are less reliable than !35,tho all estimates t^nt^tlve