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review by the Federal Reserve Bank of Chicago Business Conditions April 1972 Contents The trend of business 2 Growing time deposits— at what cost to the small bank? 8 Federal Reserve Bank of Chicago OF BUSINESS Accumulating evidence indicates that the rise in general business activity that began in 1971 gathered momentum in the first quarter of 1972. Moreover, prospects are favorable that the uptrend will continue, at least through the remainder of the year. Most Midwest centers have shared in the national improvement, especially those that concentrate on the production of equip ment, both for consumers and producers. During the period of underutilization of resources in 1970 and 1971—the longest such period since before World War II— consumers and businesses accum ulated backlogs of deferred needs and wants. Ris ing incomes and profits, general availability of credit, and improving confidence now are helping to translate demand into current sales. The general improvement in the busi ness climate, in large part, reflects the cu mulative impact of stimulatory monetary and fiscal policy actions taken over a period of more than two years. Increases in employment, output, sales, and new orders in recent months have been broadly based. Revisions in data typically have shown larger gains than preliminary estimates—a common phenomena in a re covery, and a reversal of the typical experi ence of 1970 and 1971. Moreover, many businessmen and lenders have noted an im provement of market psychology or “tone.” At the turn of the year, many analysts sug gested that a restoration of confidence was required for a strong uptrend in 1972. Now it appears the missing ingredient has been supplied. Optimism as to business develop ments has been tempered, however, by growing fears that inflationary pressures are being rekindled. Residential construction activity, which ran far ahead of the general economy in 1971, moved to new highs, seasonally ad justed, in early 1972. Consumer purchases of autos and household durables, which strengthened substantially in the final third of last year, have continued at high levels in early 1972. Now strength in these con sumer sectors is being reinforced by a pick up in business investment. Increases in orders for producer equip ment and in contracts for nonresidential building tend to support a government sur vey released in mid-March that projected a rise of 11 percent in plant and equipment spending in 1972. Investment in business in ventories also promises to be a stimulating force in the months ahead. Inventories, overall, are at a low level relative to sales, and additional inventories at the manufac turing and trade levels probably will be needed to handle efficiently any further ex pansion in activity. Em p loym ent an d u n em p lo ym en t The overriding criterion for judging the Business Conditions, April 1972 performance of any economy is the effec tiveness with which it uses its human re sources. The unemployment rate is one measure of labor use. Others are labor force participation rates, turnover rates, average workweeks, and the quality of the match of jobs and skills. For almost two years, the U. S. labor force has been underutilized by any reason able standard. Throughout 1971, the overall unemployment rate averaged 5.9 percent (far above what policymakers consider de sirable). Moreover, the proportion of people of working age in the labor force was slight ly lower in 1971 than in either of the two previous years, and average workweeks in nonagricultural occupations were shorter. Hiring rates were down in 1971 and layoffs were up. Finally, many workers were forced to take jobs which did not fully utilize their training and experience. Since last summer, the labor picture has been clouded by such factors as the coal and Payroll employment has increased sharply since August million workers dock strikes and the liquidation of steel in ventories accumulated as strike hedges, but the underlying situation definitely has im proved. From August to March, non farm payroll employment increased 1.4 mil lion—3.5 percent on a seasonally adjusted annual rate basis. In the previous six months, employment had increased only 140,000. The unemployment rate remained at the 6 percent level through December, before declining in January and February. Average workweeks have increased moder ately in recent months, layoffs have de clined, and new hires have increased. There has been no significant rise in esti mates of job vacancies. Nevertheless, there are reports of increased demand for skilled workers and supervisory personnel, and college placement officers note a stronger market for graduates—at least those with technical training. The gradual improvement in the labor market has been reflected in improvements in the classifications assigned to major labor markets by the Department of Labor. Last September, 64 of 150 major labor markets were estimated to have a “substantial labor surplus”—6 percent or more unemploy ment. In March, 55 were in this category. The improvement was especially marked in the Seventh District, where the number of centers in the substantial labor surplus group dropped from 13 (of 24) in September to only six in March. The centers removed from the 6 percent or more unemployment group in this period were South Bend, Terre Haute, Flint, Kalamazoo, Saginaw, Rockford, and the Davenport-Rock IslandMoline area. On the other hand, no major Seventh District centers are estimated to have “low unemployment” (less than 3 per cent), while ten centers elsewhere in the nation are so classified. 3 Federal Reserve Bank of Chicago O utput an d b ack lo g s Total manufacturing production, mea sured by the Federal Reserve index, rose almost continuously from August 1971 through March 1972. Total production was artificially depressed last August by sharp cutbacks in steel output following the negotiation of a new labor contract, but the steady rise in the index (which measures physical volume) is impressive, nonetheless. Manufacturing output was up 3.5 percent from the year-earlier level in March. How ever, it was still 4.0 percent below the peak reached in September 1969. Output of durable goods manufacturing industries has increased about as rapidly as total manufacturing output since last Au gust. But durable goods output in March was only slightly above a year earlier percent, 3Q 1969 =100 D 1969 M J 1970 S D M J S 1971 D M 1972 Note: FRB indexes of manufacturing output. 4 and was still 10 percent below the 1969 peak. Nondurable goods output, on the other hand, has been above the 1969 peak since the second quarter of 1971 and has increased substantially since then. In March 1972, nondurable goods output was 5.0 percent above the 1969 peak. Although favorable in comparison with durables, this growth rate for nondurable goods output is far below the long-term trend. In the tenyear period ending in 1969, nondurable goods output rose more than 5 percent an nually, and durable goods output rose al most 6 percent annually. The record of manufacturing activity since 1969 is much less favorable than that of the general economy. The total volume of goods and services produced in the first quarter of 1972 (gross national product ad justed for higher prices) was almost 5 per cent larger than in the third quarter of 1969, the cyclical high preceding the reces sion. A number of factors help account for the poor performance of manufacturing as compared with total economic activity. These factors include the growth of imports relative to exports; the continued rapid in crease in state and local government spend ing, largely for wages and salaries; the slow rate of inventory accumulation; and the sharp declines in output of business and defense equipment, which affected manu facturing output more, proportionately, than total activity. Increases in orders to manufacturers sug gest the recent rise in manufacturing output will continue. In February, manufacturers’ new orders exceeded shipments for the fifth straight month. Unfilled orders, therefore, have been increasing. Because shipments of nondurable goods, such as chemicals and paper products, move closely with new or ders, order backlogs of these firms are rela- Business Conditions, April 1972 of a firm’s inventory of purchased materials and components is closely related to the time required to obtain additional supplies. Steel in rebo und In early April, U. S. mills were turning out raw steel at an annual rate of more than 140 million tons, up from a 100 million ton rate at the start of the year. In the South Chicago-Gary area, which produces almost one-fourth of the nation’s steel, the rise in output in this period has been more rapid than in the rest of the nation. In 1971, the nation produced 120 million tons of raw steel, the smallest amount since 1963. (The record was 141 million tons in 1969.) Imports accounted for 17 percent of domestic steel usage last year, compared to only 7 percent in 1963. Moreover, domestic production of steel last year was concen trated in the seven months prior to the deadtively small. Changes in order backlogs, therefore, mainly reflect developments in the durable goods industries. Virtually all major durable goods industries, including iron and steel, machinery and equipment, and household furnishings, have reported in creases in order backlogs in recent months. Most industries continue to have substan tial unused capacity. But some industries, such as those producing materials for resi dential construction, motor trucks, and electrical apparatus, have been operating at effective capacity ceilings for several months. Promised delivery times on new orders for a variety of products, including steel, furniture, and equipment components, have lengthened. This phenomenon is usu ally apparent when a vigorous business up swing is underway. A trend toward longer lead times usually feeds on itself. This is because inventory investment is stimulated when deliveries take longer. The adequacy Federal Reserve Bank of Chicago line for a new management-labor contract on August 1. From January through July, output was at an annual rate of more than 140 million tons. In the August-December period, output was at a rate of only 92 mil lion tons as inventories accumulated against a strike possibility were liquidated. Manufacturers’ holdings of steel rose from 9.6 million tons in January 1971 to 15.9 million in July. By January 1972, these holdings had dropped back to 9.9 million tons. Steel orders have improved month by month this year on a broad front, and aver age delivery times have lengthened by about a week. Some steel analysts believe that the liquidation of inventories was carried too far by some users, and these customers are now seeking to rebuild their holdings. Industry sources now anticipate that U. S. steel output will exceed 135 million tons in 1972, mainly because of increased usage. Although imports continue at a high level, their proportion of domestic requirements is likely to decline this year—partly because of quotas negotiated with foreign producers, but also because of the reduced price dif ferential resulting from recent international currency realignments. C a rs an d tru cks strong 6 More than 10.2 million passenger cars were delivered to U. S. customers in 1971, including almost 1.6 million imports from Europe and Japan. Sales of “domestic” cars included about 450,000 net imports from Canada because of the auto trade pact with that country. With a strong finish in March, first-quar ter auto sales were at a seasonally adjusted annual rate somewhat in excess of the total for 1971. Auto sales were at a record level by a wide margin in 1971, with the carryover of sales from the General Motors strike in late 1970, the August-November price freeze, and the repeal of the excise tax all playing a role. Nevertheless, many ana lysts expect auto sales to set another record this year, totaling 10.5 million or more. Inventories of domestic-type cars at al most 1.8 million were relatively heavy at the end of March, but apparently not excessive. Auto producers have made numerous shifts in production schedules in recent months to keep inventories in good balance. Produc tion in the United States is scheduled at 2.42 million in the second quarter, the highest level for the period since 1968, when im ports from Canada and overseas were much less than they are now. While the auto sales picture has been favorable, the truck market has been boom ing. In the first quarter of 1972, 634,000 trucks were produced—up 23 percent from last year when a first-quarter record was set. Demand for all weights of trucks has been excellent in recent months, but de mand for heavy trucks has been especially strong. Production of heavy trucks has been limited by the capacity to produce such vital components as engines and axles. Shortages of components were intensified in March and early April by a strike that closed a major manufacturer of heavy duty truck engines. C a p ita l e x p e n d itu re s e x p a n d in g On the basis of a comprehensive survey of business plans, the Department of Com merce estimated in March that business firms would spend $90 billion on new plant and equipment in 1972. This projection, which includes only capital outlays for facili ties in the United States, indicates a rise of 10.5 percent this year from 1971, compared to a gain of only 2 percent last year. Busi ness firms have been raising their sights on Business Conditions, April 1972 capital outlays for several months. A sur vey of capital spending plans by foreign af filiates of U. S. corporations, on the other hand, indicates a rise of only 7 percent for 1972—the smallest gain in recent years. In contrast to domestic plans, intentions to spend on plant and equipment abroad have been scaled down in the past year. All major classes of business expect to increase capital spending in the United States in 1972, whereas in 1971 manufac turers, railroads, and airlines reduced spend ing. Manufacturers are expected to increase capital spending 9 percent in 1972, follow ing a 6 percent decline last year (despite rising prices). Plans of durable goods pro ducers, except for steel, are generally stronger than plans of nondurable goods producers. Large gains are expected for electric utilities and telephone companies, following the pattern of recent years. Production of business equipment, as measured by the FRB index, was up 4 per cent in February from the low point reached last May. But it was 11 percent below the record high of 1969. The situation is mixed by type of product, but the increase in total order backlogs for business equipment indi cates a further rise in production in the months ahead. By far the most vigorous elements in the equipment sector are highway trucks and trailers. Farm and construction machinery sales have been relatively strong in the first quarter, and orders for ships were sharply higher early in 1972. Even the hard hit machine tools industry has reported large gains in orders, although from a very low base last year. Expenditures for pollution control equipment continue to rise sharply and are accounting for a growing share of total capital outlays. In general, the em phasis on capital outlays in 1972, as in 1971, is on programs that will turn out better products more efficiently rather than on expansions of capacity. R eaching the g o als With a good first quarter under its belt, the economy has made a long stride toward the better state of health widely predicted at the start of the year. A $100 billion in crease in total spending for 1972, and a gain of 5 or 6 percent in real output, the strong est rise since 1966, now appear as realizable objectives. A solid gain in employment and a further decline in unemployment should accompany these developments. The very fact of the success of monetary and fiscal policies in revitalizing the econ omy, however, carries with it concern that price inflation may accelerate again. Nar rowing margins of unused resources, length ening lead times, rising capital expenditures, and a higher rate of inventory investment— even the hoped for improvement in the international balance of trade—all carry in flationary connotations. The fact that the Pay Board was reconstituted in late March as a semi-public (rather than a tripartite) body because of the withdrawal of four labor leaders raised questions concerning the future of the price-wage stabilization pro gram. In recent months, prices of steel and most nonferrous metals have strengthened, a development that often precedes price increases for finished and semi-finished products. A renewal of inflationary pressures could hamper the business recovery. Similarly, strikes in major industries and unsettling developments on the international scene could alter favorable forecasts. Because of the broad base of the current uptrend in activity, however, the possibility of a gen eral slowdown appears remote. Federal Reserve Bank of Chicago Growing time depositsat what cost to the small bank? 8 FACT: Time deposits at all Federal Reserve member banks with total deposits of less than $50 million grew at an annual rate of 10 percent between 1966 and 1970. FACT: Demand deposits at these member banks grew at a 4 percent annual rate dur ing the same five-year period. The growth of time deposits over the fiveyear period 1966-70 continued the remark able upsurge in these deposits started in the early Fifties. For years, demand deposits constituted the major source of bank funds. In 1966, however, total time deposits at the typical Seventh District member bank ex ceeded total demand deposits for the first time in 30 years, and by 1970 time deposits constituted 57 percent of total deposits at district member banks. The extraordinary growth of time deposits relative to demand deposits, together with changes in the mix of time instruments and the sharp rise in interest rates paid on time and savings de posits, led to the emergence of interest on time deposits as the largest single expense of commercial banks. Among the many questions raised by the sharp increase in time deposit costs are the following: Have the increases in interest costs been offset by improved operating efficiency within the time deposit function? What effect has the change in the mix of time instruments had on total time deposit costs? Have time deposits remained profit able, in the sense that the gap between banks’ portfolio income and the cost of time deposit funds continues to be positive? In order to respond to these questions, it is necessary to determine which bank costs may reasonably be attributed to total time deposits and to the various time instruments that make up these deposits. The data used to make these measurements are provided by the Functional Cost Analy sis Program sponsored by the Federal Re serve System. The d a ta The Functional Cost Analysis (FCA) Pro gram is a bank-oriented, standardized cost accounting system designed primarily for small banks lacking the personnel and re sources to develop their own systems. The basic approach of FCA is to subdivide the bank for accounting purposes into a num ber of distinct “functions” and then to de termine the level and composition of the costs and revenues associated with each function. An important by-product of the FCA Program is a wealth of detailed data on each of the important bank functions. This article draws extensively on the FCA data collected for the time deposit function. An article on checking account costs, utiliz ing FCA data on the demand deposit func tion, appeared in the October 1971 issue of Business Conditions. Business Conditions, April 1972 Eighty-three Seventh District member banks with five-year deposit averages of less than $50 million participated in the FCA program of the Federal Reserve Bank of Chicago continuously from 1966 to 1970. All cost data used in this discussion are based on the experiences of these 83 banks. Although these banks do not constitute a random sample, in most respects their time deposit data are representative of national trends among banks in this size range. These 83 banks posted average annual growth rates of 11 percent for time deposits and 4 percent for demand deposits, about the same as growth rates for all similar size member banks in the nation. percent of total time deposits W h y tim e dep o sits g re w Prior to considering the effects of time deposit growth on bank profits, it is worth while to review some of the explanations for 1966 1967 1968 1969 1970 the rapid growth in time deposits generally. Some of the reasons given here may appear to be applicable only to larger commercial banks. But given the spillover effects of correspondent banking ties, multibank hold ing company affiliations, branch banking, and the mobility of time depositors, the same factors contributed indirectly to the rapid time deposit growth of small banks. Commercial banks have been prohibited from paying interest on demand deposits since 1933. This factor took on new im portance during the decade of the Sixties when the “opportunity costs,” or foregone earnings, of holding additional dollars in checking accounts reached the point where many firms were unwilling to hold any de mand deposits in excess of working bal ances. Rising interest rates led business firms to purchase open market instruments providing them not only with minimal or Federal Reserve Bank of Chicago near-zero risk and a high degree of liquidity, but also an attractive rate of return. Throughout the 1960s, but particularly during the five-year period under considera tion, banks were constrained in competing for time deposits by interest rate ceilings imposed by the Fed under Regulation Q. As market rates rose above the ceilings, banks lost funds to open market instru ments in a process that has come to be called “disintermediation.” 1 Banks also faced severe competition for funds from other financial institutions, i.e., life insurance companies, credit unions, in vestment companies, pension funds, mutual savings banks (MSBs), and savings and loan associations (S&Ls). Nonbank competitors offering savings instruments that are espe cially close substitutes for commercial bank time deposits are MSB and S&Ls, of which only S&Ls are of significant importance in the Seventh District.1 2 10 1Most severely affected were those large money market banks borrowing highly interest-sensitive funds through the issuance of certificates of de posit (CDs) in denominations of $100,000 and over. The banks under consideration in this article were too small to attract many deposits of this size. In October 1970, CDs and time open accounts in denominations of $100,000 and over constituted, on average, only 5.6 percent of the total dollar volume of CDs and time open accounts of the 83 FCA banks. According to the Survey of Time and Savings Deposits at the close of business on Octo ber 31, 1970, CDs and time open accounts in de nominations of $100,000 and over as a proportion of total CDs and time open accounts were 25 or more percent for three banks, 20-25 percent for three banks, 10-20 percent for six banks, and 0-10 percent for 46 banks. The remaining 25 banks had no time deposits in denominations of $100,000 or more. Nevertheless, even these banks came under increasing restraint as interest rates rose to the highest levels in decades, as occurred in 1966 and 1969. 2Since there are only a handful of MSBs in the Seventh District, none of which compares in size with the larger institutions on the East Coast, MSB data are not included in this discussion. During the 1960s, savings grew absolutely at both commercial banks and savings and loan associations. Only since 1964, however, have commercial banks been successful in increasing their share of the total. One im portant explanation for the more rapid growth of savings at commercial banks has been the narrowing of the spread between average yields on time and savings accounts at commercial banks and S&Ls. The nar rowing of the spread in average yields re flects primarily a change in the mix of com mercial bank time deposits rather than a narrowing of spreads on similar types of ac counts at banks and S&Ls. Increases in yields on existing types of accounts were largely precluded by interest rate regula tion, which was extended to S&Ls in 1966, and which has been applied in such a man ner as to minimize the disruptive effects of rising interest rates on mortgage lending institutions and, hence, the housing market. Increasingly profitable investment oppor tunities, the prohibition of interest payments on demand deposits, the ceilings on time deposit interest, and competition from non bank institutions all motivated banks to de velop alternative methods of attracting and retaining the public’s funds. The strong demand for bank credit that marked the decade of the Sixties further intensified banks’ efforts in this direction. By making broader use of certificates of deposit and other time instruments (such as time open accounts, golden passbook accounts, etc.), and by liberalizing terms on various time accounts, it was possible for banks to in crease the interest paid to the saver. An important result was the gradual displace ment over the decade of the Sixties of regu lar passbook savings as the dominant com ponent of commercial bank time deposits. Banks moved aggressively on several Business Conditions, April 1972 other fronts. They lifted or eliminated ceil ings on account size and extended the days of “grace” for deposits made after the be ginning of the interest period and with drawals made before the end. They began to compute interest on a short-period basis —even daily—and waived penalty charges on excessive withdrawals. Banks also went from passive acceptance of time deposits to active solicitation of firms to establish time accounts—certainly a conspicuous change from their traditional posture. These and other changes enabled commercial banks to compete effectively for the public’s funds. In the process, banks themselves became par ties to the extraordinary growth in time de posits in recent years. On the whole, time deposits contributed an increasing proportion of bank funds for holding in reserve and for making loans and investments in each year between 1966 and 1970. In 1970, time deposits supplied more Time deposit costs increased as proportion of total bank costs percent of total cost 60 r 1966 1967 1968 1969 1970 than 57 percent of funds available for in vestment in bank portfolios for the 83 Sev enth District FCA banks, as compared to 53 percent in 1966. H igher costs a p p e a r Associated with the rapid increase in time deposits has been an increase in the relative importance of time deposit costs. Total costs generated by time deposits comprised 54 percent of total bank costs in 1970, com pared to 47 percent in 1966. The primary cost associated with time de posits is the interest paid, accounting for approximately 90 percent of total time de posit costs over the period. Interest rates on all time instruments rose an average of 1.3 percentage points, or about one-third, during the five-year period 1966-70. Non interest costs increased at about the same rate, so that the percentage of total time deposit costs accounted for by interest paid remained virtually constant. Thus, increased operating efficiency did not prove to be a significant offset to rising interest costs. Noninterest costs associated with time deposits may be divided into those, like in terest costs, which are required to attract deposits, and those which are required to process accounts. Costs incurred to attract time deposits include advertising and pub licity, and some portion of net occupancy costs. Advertising and publicity costs per dollar of deposit showed their greatest gains between 1968 and 1970, but increased, on average, about 14 percent per year. Net oc cupancy costs, which consist of rent or de preciation, taxes, and maintenance on bank premises less rental income, nearly doubled per dollar of deposits between 1966 and 1970. Most of the increased occupancy costs associated with time deposits resulted from efforts to improve the accessibility of time 11 Federal Reserve Bank of Chicago Composition of noninterest costs 1966 1967 1968 1969 1970 (p e rc e n t) Labor costs 49 50 48 42 42 Capital costs 6 8 8 11 12 Material costs 7 7 8 7 7 12 7 19 11 7 17 12 7 14 9 15 9 17 17 15 100 100 100 100 100 Publicity and advertising Net occupancy Other* Total ‘ Includes legal and investment fees, FDIC and other insurance, directors' fees, outside exams and audits, travel, memberships and dues, donations, and gifts. 12 deposit services to bank customers. These improvements include the addition of space and facilities or, where state law permits, the building of additional branches. Processing costs per dollar of time de posits rose slightly over the period for the 83 FCA banks under discussion. These costs arise from opening the account, recording deposits and withdrawals, posting interest, and closing the account. These “production line” activities generate the need for tellers, bookkeepers, and supervisory personnel. Almost half of the total noninterest costs associated with time deposits are labor costs. However, because of the smaller amount of activity generated by time de posits compared to demand deposits, the number of employees required to handle time deposits is only a fraction of the num ber needed to administer the demand de posit function. In 1970, for example, rough ly 10 percent of total bank personnel were involved in the time deposit function, com pared with approximately 50 percent in the demand deposit function. During the five years 1966-70, labor costs held rather constant per dollar of time deposits, as increases in both the price of labor services and the average deposit balance reflected the inflationary tendencies preva lent during the period. Annual labor costs per account increased from $2.66 to $3.70 over the five-year period. Reflecting primarily the adoption of new technology, capital costs increased three fold per dollar of time deposits, and nearly fourfold per time account. Each year from 1966 to 1970, capital costs comprised a growing proportion of total noninterest costs, although their most rapid gains came between 1968 and 1970. Much of the in crease in capital costs was due to the com puterization of time deposit accounting dur ing the period. In 1966, only five of the 83 FCA banks had computerized the time de posit service. By 1970, the number had risen to 63. M easu rin g e fficien cy Although cost per account and cost per dollar of time deposits are of interest, they are not the best measures of efficiency. A better measure is one that relates time de posit costs to the total activity generated by such accounts. In a very real sense this activity—the processing of deposits and withdrawals, the opening and closing of ac counts, and the posting of interest—can be considered the “output” produced by the time deposit function of the bank. To overcome the lack of homogeneity of these different activities, the volume of each type of activity must be weighted by some measure of its relative value to the depositor and cost to the bank. In an unregulated, fully competitive banking system charac terized by perfect knowledge, the appropri ate weights would be the “prices” of the various activities. These charges could then be used to weight the units of various types of activity to obtain an overall dollars-and- Business Conditions, April 1972 cents measure of the “output” of the time deposit function. Lacking an explicit mar ket valuation of the various types of activity, weights reflecting the relative handling costs per item relative to the cost of handling a deposit have been used. For regular sav ings accounts and CDs and “other” time ac counts, they are as follows: Activity Deposits Withdrawals Accounts opened Accounts closed Interest posting (regular savings only) Weight 1.00 1.10 3.10 2.35 2.25 To arrive at the total “units of activity” generated by each bank’s time deposit func tion, the products obtained by multiplying the quantity of each activity by its corre sponding weight are summed. The result is the total number of weight units or “units of activity” for the time deposit function. posit balances during the period resulted largely from attempts by depositors to keep pace with inflation, although growth in real income also played a role. It is not surpris ing that time deposit activity per account, which depends primarily on transaction be havior and is, therefore, largely independ ent of price level changes, showed little tendency to increase. Also tending to hold down activity was the greater emphasis on certificates of deposit and “other” time ac counts, which normally carry fixed maturi ties and/or a notification period for with drawal and, consequently, require less servicing. It is this combination of higher balances and lower activity that suggests the possibility that the higher interest costs attributable to the switch from passbook savings to CDs and “other” time accounts may have been offset to some degree by lower operational costs—i.e., labor, capital, material, etc. C h an g e in the m ix Costs p e r u n it of a c tiv ity Labor cost per unit of activity increased only 5.5 percent—actually, a decline in terms of constant dollars—over the fiveyear period 1966-70, while capital costs per unit of activity increased threefold. The great difference in these increases—which cannot be accounted for by differences in the rate at which the prices of the two cate gories of productive agents advanced—indi cates that a major substitution of capital for labor took place during the period. Since activity per account was fairly con stant over the five-year period, while aver age account size increased $300, costs per unit of activity reflect more fully than cost per dollar of deposit the increases in prices of productive services used in servicing time deposits. Increases in nominal average de Because the change in composition of time deposits at commercial banks was largely responsible for the increase in aver age interest costs, an initial impression may be that it costs more to raise an additional dollar through the issuance of a CD or golden passbook account than by inducing depositors to add to their regular savings accounts. Previous studies indicate, how ever, that some savings accounts—in particu lar, those characterized by small balances, high activity, and short life—contribute little or nothing to profit and, in fact, may be maintained at a loss. CDs and “other” time accounts, on the other hand, are char acterized by large balances and little activity per account. This suggests that CDs and “other” time accounts should have lower op erational costs than regular savings accounts. 13 Federal Reserve Bank of Chicago The experience of the 83 small banks shows that while regular savings accounts and CDs and “other” time accounts have all grown absolutely over the five-year period 1966-70, their relative shares of total time deposits have nearly reversed themselves. In 1966, for example, 62 percent of the total time deposits of the 83 banks was in regular savings accounts and 37 percent was in CDs and “other” time accounts. By 1970, the share of total time deposits accounted for by regular savings accounts had declined to 42 percent, while that of CDs and “other” time accounts had risen to 57 percent. The effects on costs The extent to which the increased interest costs associated with CDs and “other” time accounts were offset by lower operational costs due to larger average balances, re duced activity per account, and advancing technology, varied greatly for the 83 FCA banks over the five-year period. In 1970, the average annual interest cost of CDs and “other” time accounts was 5.2 cents per dollar and the average interest cost of regular savings accounts was 4.0 cents per dollar, a difference of 1.2 cents per dollar. On the other hand, the operat ing costs of CDs and “other” time accounts were .07 cents per dollar, while the operat ing costs of regular passbook savings ac counts were 1.09 cents per dollar. In each case, these costs were estimated by allocat ing total time deposit costs according to the total weight units of activity for each type of account. The total cost of CDs and “other” time accounts was 5.27 cents per dollar, and the total cost of regular pass book savings accounts was 5.09 cents per dollar. The difference of .18 cents per dol lar is rather negligible, and it would appear that the higher interest cost of CDs and “other” time accounts is largely offset by lower actual operating costs and larger aver age balances. The measured total cost per Business Conditions, April 1972 dollar for CDs and “other” time accounts was not significantly greater than for regu lar passbook savings accounts during any of the other four years. P ro fita b ility There are two other questions that must be resolved before one can judge the rela tive profitability of regular savings and CDs and “other” time accounts, or the extent to which the higher interest costs associated with CDs and “other” time deposits are offset by lower operating costs. One ques tion concerns the cost differences in the physical facilities required to service the two Increasing portfolio income4 ' kept time deposits profitable cents per dollar 1966 1967 1968 1969 1970 * Portfolio income equals total revenue from the investment of time deposit funds, less the costs of lending and investing these funds. **N et earnings before taxes equals portfolio in come from time deposit funds, less total time de posit costs, including interest paid. types of time deposit accounts. The sale of CDs requires merely a desk, plus a minimal amount of personnel and bookkeeping ser vices to handle the opening, transferring, and closing of accounts, and recording of interest. In contrast, regular savings ac counts require not only a desk and person nel to open the account, but also tellers, bookkeepers, additional prime floor space, etc., to handle subsequent deposits, interest postings, and withdrawals. It seems reason ably clear that more physical capital is needed to service regular passbook savings accounts than CDs and “other” time ac counts, though such a distinction is not made in the FCA data. If adequate recogni tion were given to this imputed differential in the cost of capital, the gap between the costs of the two types of time deposits would narrow. Of course, given the exis tence of regulatory ceilings on the interest payable on passbook savings, it may be reasonable for banks to promote the higher cost CDs and “other” time deposits even if they are, in fact, more expensive. The second question concerns possible differences in portfolio strategy associated with the mix of time deposit accounts. It is generally acknowledged that the portfolio policy followed by a given bank depends not only on regulatory constraints, attitudes toward risk, market opportunities, and fore casts of future events, but also on the struc ture of the bank’s liabilities. Previous studies have shown that regular savings accounts are less volatile sources of funds than de mand deposits. Hence, a deposit structure heavily weighted toward regular savings re quires less liquidity in the asset portfolio. Certificates of deposit tend to be some what more volatile than regular savings ac counts as sources of funds. They are a par ticularly unreliable source of funds when 15 Federal Reserve Bank of Chicago interest rates on such time instruments ap proach regulatory ceilings while other mar ket interest rates are soaring upwards. A liability structure characterized by a large proportion of demand deposits and CDs dictates a shorter-term asset structure than would be required if liabilities were more heavily weighted toward regular passbook savings accounts. The difficulty of measur ing the influence of liability structure on banks’ portfolios precludes any definite conclusion as to which type of time ac counts is most profitable.3 Conclusion Following the general rise in interest 3To judge whether bankers have acted wisely in their asset and liability policies, it is necessary to look at the marginal, or additional, revenue re ceived from that portion of an additional dollar of deposits invested in the portfolio, and the mar ginal, or extra, cost incurred by the bank in at tracting that additional dollar. When the extra cost exceeds the extra revenue, each additional time deposit dollar obtained will lower total bank profits. Although average revenue exceeded aver age cost for all earning assets and deposit liabilities taken together during the period, it cannot be de termined with certainty from the data at hand whether the banks’ emphasis on CDs and “other” time deposits was justified in terms of profitability. BU SIN ESS C O N D IT IO N S is p u b lish ed rates, yields on earning assets for the 83 FCA small banks increased over the fiveyear period 1966-70. These higher yields on earning assets furnished the driving force which caused banks to promote time de posits. The higher yields also provided the incentive to promote the higher interestbearing CDs and “other” time accounts, which displaced regular passbook savings accounts as the primary source of time de posit funds. Although CDs and “other” time accounts required higher interest payments than regular passbook savings accounts, these in terest costs were offset to a considerable degree by the lower operating costs of CDs. If differences in required physical capital were considered, the remaining gap in total cost between the two types of deposits would probably disappear. But even if banks did not pursue optimal strategies with respect to the composition of their time deposit lia bilities, perhaps because of the constraining effects of Regulation Q, it is nonetheless clear that, overall, over the period 1966-70 the returns on the 83 FCA banks’ portfolios increased sufficiently rapidly to remain above the rising costs of time deposits. m o n th ly b y the F e d e ra l R eserve B a n k o f C h ic a g o . G eo rg e W . C loos w a s p r im a rily resp o n sib le fo r the a rtic le "T h e trend of b u sin e ss" a n d D a vid E . U p d e g ra ff fo r " G ro w in g tim e d e p o sits—at w h a t cost to the sm a ll b a n k ? " S u b scrip tio n s to Business Conditions a re a v a ila b le to the p u b lic w ith o u t c h a rg e . For in fo r m atio n co ncern ing b u lk m a ilin g s , a d d re ss in q u irie s to the R esearch D e p a rtm e n t, Fe d e ra l 16 R eserve B a n k of C h ic a g o , B o x 8 3 4 , C h ic a g o , Illin o is 6 0 6 9 0 .
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