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an e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f Chicago
The prime rate
Bank holding
companies— Part II
1
april
1975
The prime rate
3
The prim e rate m ade new s last year
when it rose to record-breaking levels.
B ut other, less dram atic develop
m ents have altered the very struc
ture of the prim e rate convention over
the past few years.
Bank holding companies— Part II
13
This article focuses on potential com
petition as a factor cited increasingly
by the Board o f Governors in orders
denying holding com pany acquisi
tions. A n article in B u s in e s s C o n
d itio n s , February 1975 exam ined the
issue of capital adequacy and its in
fluence on Board denial orders in re
cent years.
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3
Business Conditions, April 1975
■
< rate
u
Eh
The q.^ 1
Never in its 40-year history has the prime
rate— the interest rate charged by large
banks on business loans to their most
creditworthy customers—received more
publicity than in the past two years. In
July 1973 the prime rate was boosted above
the previous record high o f 8V percent. By
2
July 1974 the prime reached its current alltime high o f 1 2 percent and remained at
that level until late September 1974.
Because it is so widely viewed as a
barometer o f conditions in the nation’s
m oney and capital markets, the prime un
derstandably attracts considerable atten
tion when it rises to record high levels. In
recent years, however, there also have been
significant innovations in the structure o f
the prime rate convention itself. These
have resulted from the interaction of
m oney market forces, commercial banking
practices, and the actions o f the federal
government.
The introduction in the latter part o f
1971 o f a formula, or “ floating,” prime
rate— a rate explicitly linked to marketdetermined interest rates—added a new
dim ension to the prime rate concept.
Another significant m odification occurred
during the first h a lf o f 1973 with the adop
tion o f a “ dual” prime system composed o f
a “ large-business prime rate” and a
“ small-business prime rate.”
Other less dram atic developments also
have altered the longstanding prime rate
convention over the past few years.
Traditionally, prime rate changes were ini
tiated by one o f a few m ajor commercial
banks in New York City and prime rates at
large banks across the nation were
brought into line within a few hours or, at
most, days. A s prime rate adjustments oc
curred more frequently in the late 1960s
and early 1970s, the initiative shifted to
more banks in regional m oney centers. In
the same period a uniform prime was
replaced by different rates prevailing for a
week or more at a time at different banks.
T h e p rim e tr a d itio n
The modern prime rate has followed
the generally upward trend and major
cyclical fluctuations o f market rates ever
since it was first adjusted from IV2 percent
to 1 % percent in December 1947. However,
the prime rate has m oved much less fre
quently than market rates and has lagged
a month, a quarter, or even farther behind
those rates. The prime has been less
volatile than open market rates mainly
because o f its administered nature. Where
as market rates vary in direct response to
dem and/supply forces, the timing and the
magnitude o f changes in the prime rate are
at the discretion o f a relatively few large
com m ercial banks.
While temporary differentials between
the prime and other rates are partially ex
plained by its administered nature and
la g g e d b e h a v i o r , persistent spreads
between the prime and other rates reflect
primarily the differing characteristics o f
the various debt instruments—maturities,
risk factors, administrative and selling
4
Federal Reserve Bank of Chicago
costs, dollar denom inations, and methods
o f yield calculation (discount vs. bondyield basis), am ong others.
S e ttin g th e p rim e r a te
Determining its prime rate is one o f
m any decisions a large bank makes in the
continuous process o f m anaging its bal
ance sheet—i.e., its asset portfolio and
liability holdings. Three broad categories
o f market rates provide m ajor inputs into
these decisions: (1) rates on nonloan bank
assets, (2) rates on bank-acquired liabili
ties, and (3) rates on corporate debt claims
issued in lieu o f bank borrowing. Because
bank loan contracts remain in effect until
specified future dates, bankers’ expec
tations concerning the future course o f
market rates are more im portant than
current rates in the prime-setting decision.
Other important considerations are ex
pected growth in deposits—the m ajor
source o f bank funds—and expected loan
demand.
Several institutional characteristics o f
bank administration also have a profound
influence on the prime-setting process. A
decision to alter the prime rate involves ad
justments in a bank’s schedule o f business
loan rates. Nonprime rates typically are
determined by tying them directly and for-
The origin of the prime
The prime rate is a nom inal, or
{■stated, per dollar price o f bank credit.
Although quoted as a per annum rate, it
applies most frequently to short-term
loans with maturities o f less than one
year. Like other interest rates, its
econom ic function is to ration limited
supplies o f funds to a particular class o f
users—specifically, bank funds to those
business customers who are least likely
to default on repayment. The prime rate
also serves as a base for calculating
credit charges on loans carrying above
prime rates.
The prime can be viewed as a
wholesale credit price since it is official
ly posted only by the largest banks and
generally applies to corporate borrowers
o f the highest credit standing on largevolume loans, often in units o f $1 million
or more.
In the early Thirties the “ prime”
cred it c la s s ific a tio n w as already
fam iliar to investors who, for years, had
dealt in prime, or “ highest grade,” debt
instruments (e.g., A aa corporate bonds).
In fact, commercial banks posted
“ prime rates” prior to 1933, but these
were not publicized and varied from
region to region and from bank to bank.
(The Federal Reserve System prime rate
series includes data back to 1929.) By
contrast, the modern V /2 percent prime
was advertised by m ost m ajor banks.
With the contraction o f business ac
tivity, demand for business loans had
slackened by 1933. Large commercial
banks, replete with excess reserves
(funds available for immediate expan
sion o f bank lending), perceived a “ price
w a r ” developing from over-zealous
attempts to attract the few rem aining
low-risk loan customers. To avoid this
calamity for their earnings, large banks
introduced the IV2 percent prime, which
was considered the minimum profitable
return on lending after deducting ad
ministrative costs. Congress was eager
to revitalize commercial banking es
pecially by limiting “ excessive” com
petition in the industry. A s a result, the
bank-imposed floor on loan rates via the
prime rate convention soon becam e an
accepted feature o f bank lending.
Business Conditions, April 1975
m ally, or indirectly and informally, to the
prime. Thus, a bank must consider ex
pected dem and for nonprime loans in es
tablishing its prime rate.
A ban k’s “ customer relationships” —
the arrangements whereby a bank pro
vides a variety o f services to its longestablished clientele—also must be con
sidered in setting the prime. A banker must
be concerned with the long-run profi
tability o f the “ total customer” and,
therefore, is loath to make frequent rate ad
justments that m ight jeopardize customer
loyalty. The usual customer relationship
includes two features that are especially
r el e v a n t to p rim e rate decisions—
5
com pensating balance requirements and a
bank credit line.
Role of compensating balances
Com pensating balances are minimum
average checking account balances that
bank customers agree to maintain as par
tial remuneration for an array o f bank ser
vices. A lthough com pensating balances
earn no interest return, typically they do
qualify business customers for credit
lines—prearranged agreements whereby
banks extend credit on demand up to
specified amounts.
Com pensating balance requirements
Prime rate highlights
Late 1933 —A nationally uniform prime
rate o f IV2 percent is adopted.
December 15,194 7—The prime rate is in
creased from its original V/2 percent to
1% percent by Bankers Trust Company.
A ugust 20, 1956 —The initiative for
prime rate revisions moves outside New
York for the first time with a change by
the First N ational Bank o f Boston.
A ugust 6 , 1957 —The prime rate is in
creased by 50 basis points (V2 o f 1 per
cent) by Bankers Trust Company. All
previous changes had been in 25-basispoint steps.
December 6 , 1965 —The First National
Bank o f C hicago becomes the first nonE astern bank to initiate a prime rate
revision—the first change since August
23, 1960.
January 26, 1967 —The first “ split”
prime rate (i.e., different primes in effect
at v a r i o u s m oney market banks)
d ev e l o p s w h e n Chase M anhattan
Bank lowers its prime and other banks
do not follow. The split lasts two months.
June 9, 1969 —The prime rate is boosted
from 7 V to 8 V2 percent—the largest
2
single m ove in the history o f the rate.
October 2 1 , 1971 —First N ational City
Bank introduces a “ floating” prime
linked directly to market rates.
Late February 1973 —Use o f the floating
prime is suspended due to banks’ inabili
ty to reconcile the concept with rising
market rates and the desires o f the Com
mittee on Interest and Dividends (CID).
A pril 16, 1973 —The CID issues 14
guidelines w hich, am ong other things,
establish a “ dual” prime rate.
A pril 19, 1973 —First N ational City
Bank reinstates its formula prime.
Septem ber 13, 1973 — Wells Fargo Bank
in San Francisco posts the first double
digit prime, 10 percent.
December 3, 1973 —The First National
Bank o f C hicago adopts a decimal point
prime rate, 9.90 percent.
Ju ly 3, 1974 —Bankers Trust Company
m oves its prime to 12 percent, the
highest industry-wide rate to date.
6
Federal Reserve Bank of Chicago
also serve to raise “ effective” loan rates.
Although requirements usually are stated
as percentages o f dollar amounts o f credit
lines, m any arrangements require the
deposit o f additional balances when credit
lines are activated or used. N om inal loan
rates at banks are quoted in terms o f the
dollar size, or principal, o f the loan. If a
borrower uses part o f the loan proceeds to
meet com pensating balance requirements,
the “ effective” loan rate on the funds ac
tually available for the borrowers’ use will
exceed the stated rate because the bor
rower is paying loan interest on funds com
mitted to remain in his deposit account. By
in crea sin g com pensating balance re
quirements, banks can raise “ effective”
loan rates and thereby ration credit
without changing prime rate quotations.
Other methods whereby banks can
trim the flow o f credit without altering loan
rate schedules include reclassifying bor
rowers from lower- to higher-risk classes
(ones carrying higher loan rates) and vary
ing one or more nonprice loan terms—
maturities, collateral requirements, or
even loan sizes. Because o f these practices,
coupled with the ongoing uncertainty that
su rrou n d s future events—specifically,
future credit conditions and market in
terest rates—the prime rate has tended to
be more inflexible, or “ sticky,” than most
other short-term interest rates. A s a conse
quence, most banks have been satisfied
simply to follow prime rate adjustments in
itiated by a few “ leader banks.”
Managing bank liabilities
During the late 1940s and throughout
the 1950s, large commercial banks were
able to accom m odate the growth in
The prime rate closely followed other
short-term rates in the postwar era
percent
‘ New series: e a rlie r data n o t s tric tly co m p a ra b le .
Source: Prim e rate and rates on CD s, E u ro d o lla rs and c o m m e rcia l pa p er
(A u g u s t 1 9 6 1 -N o v e m b e r 1971) fro m S a lo m o n B ro th ers, A n A n a ly tic a l
R e c o rd o f Y ie ld s a n d Y ie ld S p re a d s , M ay 1974.
Business Conditions, April 1975
7
business loan demand by reducing their
large stock o f liquid assets—mainly, short
term U.S. Government securities ac
cumulated during the war. Because o f the
favorable earnings potential o f loans vis-avis these securities, banks found it advan
tageous to reduce their U.S. Government
security holdings in order to finance more
business credit. Because o f banks’ highly
liquid positions, there was little pressure
for increases in the prime rate and ad
justments occurred only infrequently.
Faced with reduced liquidity in the ear
ly 1960s, large banks began to direct more
attention to the liability side o f their
balance sheets. In their competition for
funds to meet expanding credit demands,
large banks began to rely relatively less on
such traditional sources as demand de
posits and regular time and savings de
posits and to rely more on marginal
percent
sources o f funds, including large-denomi
nation negotiable certificates o f deposit
(CDs), federal funds, and Eurodollars.
N egotiable certificates o f deposit are bank
tim e d e p o sits w i t h v a ri o u s stated
maturities, and federal funds are over
night loans between banks made in im
mediately available funds. Eurodollars for
domestic bank lending m ainly are funds
acquired by U.S. banks from their foreign
branches.
During the 1960-65 period favorable
m argins between loan returns and costs o f
market-sensitive funds enabled large com
mercial banks to meet expanding credit
demands while holding the prime rate at
4 V2 percent. A s markets for CDs, federal
funds, and Eurodollars matured and com
petition intensified, however, spreads
between the prime rate and rates on bank
liabilities narrowed. By December 1965 the
Eurodollar rate had risen above the prime
rate, and the 90-day CD rate and the
federal funds rate had climbed to within
less than V2 o f 1 percent o f the prime.
Beginning in the 1960s, large banks
becam e increasingly sensitive to competi
tion from com m ercial paper—unsecured
prom issory notes issued by large cor
porations either directly or through dealers
and sold to large-volume investors, in
cluding other large corporations. Competi
tion from the com m ercial paper market
placed unusual pressures on banks in the
acquisition and use o f funds. During the
1960s the volume o f commercial paper out
standing nearly tripled and the number of
participants in the market grew con
siderably. Historically, the prime rate had
exceeded the 90-day commercial paper rate
by one percentage point or more. This
differential narrowed in the early 1960s, as
more and more corporations came to view
commercial paper as a close substitute for
bank credit.
Commercial paper began to compete
strongly for investment funds with com
mercial bank CDs. Top-quality corporate
Federal Reserve Bank of Chicago
8
paper and bank-issued CDs were sold in
large denom inations and short maturities,
and each type o f claim carried m inim al
default risk. Because o f these similar
characteristics, the same groups o f in
vestors—m ainly large corporations—con
stituted the m ajor markets for both com
mercial paper and CDs. Over time large in
vestors grew increasingly sensitive to in
terest rate differentials; w idening and
narrowing spreads between CD and com
mercial paper rates prompted large quan
tities o f funds to shift between these
markets. As a result o f this high degree o f
substitutability, the rate on 90-day com
mercial paper m oved in close harm ony
with the 90-day CD rate during the 1960s.
In the latter part o f the decade banks
themselves came to view commercial paper
as a ready source o f loanable funds. They
began to borrow extensively in the paper
market by having their affiliates (i.e.,
holding com panies and subsidiaries) issue
bank-related paper, and then channel the
acquired funds into the bank via loan
sales. By December 1969 the vd u m e o f
bank-related commercial paper outstand
ing amounted to more than $4 billion and
accounted for over 13 percent o f the total
volume o f commercial paper. After reach
ing $7.8 billion in July 1970, however, the
volume o f bank-related paper fell sharply,
primarily because o f the Federal Reserve’s
imposition o f reserve requirements on this
type o f paper. By October 1971, when the
formula prime was introduced, bankrelated paper totaled $1.9 billion and ac
counted for less than 6 percent o f all com
mercial paper outstanding.
The formula prime
On October 20,1971 a few large banks
announced that they were considering the
feasibility o f a formula, or “ floating,”
prime rate—i.e., prime rate quotations ad
justed in direct response to variations in
the rates on one or more m oney market in
struments. Although the prime rate and
market rates always had been related and
generally moved together over time, banks
had never attempted to explain in detail
the connection between them.
The next day, October 21, First
N ational City Bank (Citibank), the largest
bank in New York, announced the first
Prime rates could not keep pace with the commercial
paper rate, given CID guidelines
percent
S o u rc e : Data fo r N o ve m b e r 1971 th ro u g h J u ly 1973 fro m S a lom on
B ro th e rs , A n A n a ly tic a l R e c o rd o f Y ie ld s a n d Y ie ld S p re a d s , M ay 1974;
o th e r p rim e rate d a ta fro m Federal Reserve Bank o f C h ica g o .
Business Conditions, April 1975
9
placed market to use—the rate charged
issuers or the rate offered investors. Some
banks chose longer intervals than a week
for appraising prime rate adjustments,
and some selected V\ percentage point
rather than Vs percentage point as the
minimum step for prime rate adjustments.
One New York bank based its formula rate
on two alternative money-market cri
teria—the issuer rate on 90-day commer
cial paper (plus .50 o f 1 percent) or the 90day CD rate (plus .65 o f 1 percent).
prime rate formula. The essence o f the for
mula was that the prime rate was to be
reviewed weekly, adjusted by minimum
steps o f Vs percentage point, and kept ap
proxim ately 50 basis points above the
average rate on 90-day commercial paper
placed through dealers. The choice o f the
com m ercial paper rate reflected the high
degree o f substitutability between bank
loans and com m ercial paper. Moreover,
because o f its relatively large volume, com
mercial paper was considered fairly well
insulated from unusual disruptive in
fluences on both domestic and foreign
credit markets, resulting in a reliable in
dicator o f the “ free market rate” for short
term business credit.
By the end o f 1971 a few other commer
cial banks had introduced their own for
mulas. While differing from Citibank’s for
mula in m inor respects, these other for
mulas followed it in relating prime rate
quotations to average rates on top-quality
90-day com m ercial paper. Banks differed
in their choices o f w hich side o f the dealer-
Why a formula prime?
Although its adoption by some o f the
largest banks was an important event, the
idea o f a formula, or a “ floating,” prime
rate for business loans was not a new one.
Bankers had searched for a long time for
some means o f insulating prime rate
changes from political criticism. And two
m ajor political incidents were fresh in the
minds o f com m ercial bankers when the for
mula prime was introduced.
percent
13
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----- formula prime rate
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----- commercial paper (90-day)
9
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formula prime “split”
5
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4
j overlap of formula and nonformula prime
‘ F o rm u la rate te m p o ra rily a b a nd o n e d .
_____ I_____ I_____ I_____ l_____ --------- 1
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1974
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1975
T
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10
• In December 1964 several banks
boosted the prime rate from 4V6 to 4% per
cent. Although this w as the first prime
rate m ovement since August 1960,
banks began to rescind their rate hikes
two days later, follow ing Presidential
urging that rates be held down.
• In June 1969 the prime rate again
came under close political scrutiny
when banks undertook a full percentage
point increase, from IV 2 to 8V percent, at
2
that time a record high. This m ove
kindled immediate Congressional re
sponse, and ten days later hearings were
convened by the House Committee on
Banking and Currency for the specific
purpose o f investigating prime rate in
creases. On this occasion, however,
banks did not rescind their increases,
and the 8V2 percent rate remained in
effect until M arch 1970 when it was
lowered to 8 percent.
In the fall o f 1971 signs pointed toward
a renewed round o f political concern.
Phase I o f the wage-price control program
had been unveiled two m onths earlier and
Phase II was due in about a month. The
Committee on Interest and Dividends
(CID), organized under the Econom ic
Stabilization Program, had taken initial
steps to m onitor interest rate develop
ments. On October 20, 1971, just one day
before Citibank announced its formula
rate, the CID requested that all lending in
stitutions keep records o f their loan rate
schedules, retroactive to August 15, 1971.
This CID action suggested to commercial
banks that closer scrutiny o f prime rate
revisions m ight be approaching.
How precise were the “ formulas” ?
The nonform ula prime rate had been
m oving steadily downward for several
weeks prior to introduction o f the formula
rate. Soon after the form ula rate was in
augurated, it, too, began to follow a declin
ing pattern, falling from 5% percent in
Federal Reserve Bank of Chicago
November 1971 to a low in M arch 1972 o f
4% percent—the lowest level in over a
decade.
Beginning in April 1972, the formula
rate reversed direction and began to m ove
steadily upward. By early October 1972 it
had climbed to 5% percent—the level that
prevailed just prior to the introduction o f
the formula concept one year earlier. On
October 12,1972 the Committee on Interest
and Dividends released a statement ex
pressing concern over prime rate develop
ments and giving notice that it would
review the earnings o f financial in
stitutions in the course o f m onitoring in
terest rate movements. Nevertheless, the
formula prime continued to rise, m oving
from 5% to 5% percent in mid-October and
then to 6 percent late in December.
The rate remained at 6 percent during
January 1973 as the conflict between CID
objectives and formula rates—tied to a
sharply rising 90-day com m ercial paper
rate—began to intensify. On February 2
four banks announced increases in their
prime rates from 6 to 6V4 percent. On
February 4 the CID requested that the
banks justify the increases by supplying
information on operating costs and earn
ings. Shortly thereafter, the four banks
rescinded their increases.
This incident was follow ed by a CID
statement, released on February 23, outlin
ing acceptable conditions for prime rate in
creases: (1 ) they should be much smaller
than changes in “ related open market in
terest rates,” (2 ) they should be delayed to
assure that open market increases are not
temporary, and (3) they should not prompt
large increases in rates on small business
loans. Considering that the commercial
paper rate was rising rapidly during this
period, the first two o f these conditions un
dermined the floating rate concept as
defined at that time. A s a result, floating
prime rates were abandoned industry-wide
near the end o f February 1973.
On April 16 a set o f 14 CID guidelines
11
Business Conditions, April 1975
The dual prime
Included in the Committee on In
terest and D ividends (CID) guidelines o f
April 16,1973 were instructions for com
mercial banks to establish a “ dual
prim e” system. The dual prime was to
consist o f a “ large-business prime rate”
(the conventional prime rate) and a
“ small-business prime rate” applicable
to a com m ercial bank’s least risky local
borrowers. Banks were expected to show
special restraint in raising the smallbusiness prime, increases being deemed
justifiable only when rising costs o f
funds were not offset by increasing
revenues from large-borrower loans and
other loans and investments. As a con
sequence, the small-business prime was
expected to change less frequently and
in smaller steps than the large-business
rate.
The CID defined a “ small business”
as any domestic business establishment
(including farms) with (1 ) total indebted
ness, excluding long-term real estate
debt, o f $350,000 or less for the preceding
1 2 -month period, and (2 ) total assets o f
not more than $ 1 million. As long as a
particular loan did not place a business
firm over the $350,000 debt limit,
qualifications for the small-business
prime were independent o f the dollar
amount o f individual loans.
M onthly data on the small-business
prime indicate that the m ajor objective
o f the dual rate structure was achieved:
the small-business prime increased
much more gradually than its largebusiness counterpart. Greater risks
and higher per-dollar costs o f lending to
smaller firm s suggested that the smallfor com m ercial bank loan rates became
effective. Included were provisions for
commercial banks to establish a “ dual
prim e” system consisting o f a “ largebusiness prime rate” and a “ small-
business prime would exceed the largebusiness rate. When the dual rate was
initiated in April 1973, however, many
banks pegged the small-business prime
at or near the level o f their regular prime
quotations, 6V percent. As a result of
2
relatively steeper increases in the largebusiness prime in subsequent months,
the large-borrower rate soon surpassed
the small-borrower rate and has remain
ed above it until recently. Some banks
have continued reporting a smallbusiness prime even though the CID
was dismantled on April 30, 1974.
Unexpectedly, the small-business
prime remained below the largebusiness rate until recently
percent
1973
1974
1975
*Small-business prime rate loses its of
ficial status.
Note: The small-business prime rate is the
simple unweighted average of the rates in effect on
the last business day of the first full calendarweek
of the month at 370 commercial banks; the range
of variation of these rates is considerable. The
large-business prime rate is the rate most com
monly quoted by large banks on that date.
business prime rate.” The CID guidelines
permitted com m ercial banks to adjust
their “ large-borrower prime rate” (the con
ventional prime rate) in accordance with
“ . . . costs o f borrow ing from alternative
12
market sources. . .
This particular
guideline was fundam ental to formula rate
calculations and permitted the reinstate
ment o f the form ula concept.
On April 19 Citibank announced that
it would return to a form ula rate. Although
its formula called for a IV 2 percent prime,
Citibank did not adhere to its formula.
Citibank’s actual prime rate was revised
from 6V to 6% percent on April 19—the
2
same rate initiated a day earlier by nonfor
mula banks. Although other banks ex
pressed some interest in returning to for
mulas, the First N ational Bank o f Chicago
was the only other large bank to endorse
the concept. The form ula announced by the
Chicago-based bank on M ay 7 set the
prime at 1.08 times (i.e., 108 percent) the
three-week average rate on 90-day commer
cial paper. The C hicago bank posted an ini
tial rate o f 7 percent, despite the fact that
its new formula called for a rate in the IV 2 to
7% percent range.
In subsequent m onths, as the prime
continued to rise, the two formula-prime
banks posted rates from V2 to 3A o f a percen
tage point below their formula-derived
rates. Although these banks were anxious
to reconcile actual rates with the floating
concept, the sensitive political situation
prevented them from doing so in the face o f
steady increases in the rate on 90-day com
mercial paper. Both banks had started the
CID-guideline period with prime rates well
below their form ula rates. The CID
guidelines o f April 16 called for increases
in the rate to be taken in “ moderate steps,”
and the CID had requested that rate in
creases be undertaken with relative in
frequency. Com pliance with these guide
lines effectively precluded the formula-rate
banks from fully implementing their for
mulas in the face o f a rapidly rising com
mercial paper rate.
The paper rate began falling in late
September for the first time in 1973, and
formula banks were finally in a position to
adjust actual rates to their formulas. In the
Federal Reserve Bank of Chicago
fourth quarter o f 1973 the commercial
paper rate dropped below both the nonfor
mula and formula prime rates for the first
time since the first quarter o f that year,
a n d fo r m u la r e l a t i o n s h i p s w e re
reestablished.
When the prime rate was increased to
10 percent in mid-September 1973, finan
cial observers suggested that, m ainly
because o f political considerations, an up
per limit had been reached. This view gain
ed support when large banks, after lower
ing their prime rates slightly in the fourth
quarter o f 1973, closed out the year with
rate quotations at or near (but not above)
the 10 percent mark.
The idea o f a “ ceiling” on the prime
rate, however, was short-lived. Although
the prime fell as low as 8 V2 percent at some
banks during the first quarter o f 1974, by
mid-April the rate was again at 10 percent
and a few banks already had moved to
quotations above 10 percent. Subse
quently, over a dozen record-breaking
highs were recorded and, by mid-July 1974,
most commercial banks were posting a 12
percent prime rate. In the weeks after the
12 percent prime rate was initiated,
floating-rate banks again began holding
their posted rates below the rates called for
by their formulas. A t times during the
almost three-month reign o f the 1 2 percent
prime, formula-rate calculations were oneh a lf o f a percentage point or more above
the posted rate.
Since late September 1974, the prime
rate declined from its 1 2 percent high and
stood at less than 8 percent in late March
1975. Both First N ational City Bank and
The First N ational Bank o f C hicago have
announced that, while not abandoning the
formula concept, they would use it as an in
dicator o f the direction o f prime rate
changes rather than as a precision instru
ment. A s a result, posted rates have de
clined at these banks but not as rapidly as
the formula-based figures.
R andall C. M erris
Business Conditions, April 1975
13
Bank holding companies-P a rt n
Under the Bank Holding Com pany A ct o f
1956 the Board o f Governors m ay not ap
prove a holding com pany acquisition that
m ay substantially lessen competition un
less the anticom petitive effects are clearly
outweighed by such factors as the con
venience and needs o f the community or
financial and m anagerial considerations.
M any o f the Board’s early denials o f
bank holding com pany applications were
based on existing com petition ; that is, a
holding com pany was seeking to acquire a
bank with which one o f its subsidiaries
w as in direct competition. Because o f the
difficulty o f gaining Board approval to ac
quire a direct competitor, m any holding
com panies found it necessary to acquire
banks in cities far removed from the
markets served by their subsidiary banks.
However, an acquisition which eliminates
no existing com petition m ay be potentially
anticom petitive if it would foreclose the
possibility that the holding com pany’s
subsidiary banks and the bank to be ac
quired m ight compete in the reasonably
foreseeable future.
The potential competition concept
The concept o f potential competition is
concerned with the possible anticom
petitive consequences that could flow from
the com bining o f two business enterprises
w hich do not compete with one another
because they do business in separate
geographic or product markets.
The Board has applied the term
“ potential com petition” to at least four
situations. In its purest sense the concept
posits that the conduct o f established
sellers in a market m ay be influenced by
the existence o f one or more likely potential
entrants. But because o f the difficulty o f
proving that a bank holding company
located in New York City can influence the
pricing and services o f a bank in, say, Buf
falo, the concept o f potential competition
did not win widespread acceptance until
very recently.
The Board has applied the term
“ probable future com petition” (sometimes
interchangeably with the term “ potential
com petition” ) to situations where, in its
judgment, an alternative means of entry
m ight be more conducive to increasing
competition. That is, it would be preferable
from the standpoint o f the public if a
holding com pany entered a market by es
tablishing a new firm (de novo entry) or ac
quired a small firm already in the market
(a so-called “ foothold acquisition” ) rather
than acquiring one o f the leading firms in
that market. Both de novo and foothold en
try add to the number o f firms offering
significant competition to the leading
firms in a market and m ay be expected to
lessen future levels o f market concentra
tion. Thus, im plicit in the Board’s use o f
the term “ probable future com petition” is
the expectation o f procompetitive effects
follow ing actual de novo or foothold entry
by the applicant holding com pany.1
Recently, the Board has broadened the
concept o f potential competition to reflect
its concern with two other situations. One
is the case where a holding com pany seeks
to acquire a fairly sizable bank outside the
holding com pany’s market, thereby fore
closing the possibility that the bank could
ever form its own holding com pany and ex-
'The distinction between potential competition
and probable future competition has been provided by
Stephen A. Rhoades. See “Some Observations on
Potential Competition in Banking,” in Proceedings of
a Conference on Bank Structure and Competition,
Federal Reserve Bank of Chicago, 1972. In this article
potential competition is used to refer to both concepts.
Federal Reserve Bank of Chicago
14
pand into the market(s) o f the acquiring
holding com pany. The other concerns the
situation o f a holding com pany acquiring
two banks in the same market that have
some affiliation with one another. This
type o f acquisition not only forecloses the
possibility o f the two banks com peting in
the future, but also the possibility that one
o f them m ight be acquired by a banking
organization not presently in the market.
Analysis of Board denials
The Board’s negative attitude toward
situations involving potential competition
is by no means new; indeed, potential com
petition was first cited as an important fa c
tor in denying a holding com pany applica
tion in 1960. Since that time, the Board has
used potential competition more and more
Analysis of potential
competition denial orders
Denials of
holding company
applications1
Denials involving
potential
competition
Major Minor
factor2 factor3
4
0
26
11
17
8
3
4(0)
io ( iy
3(1)
7(4)
28( 9)
4(1)
7(2) 10(3)
26(10)
8(2)
43(10)
11(3)
33(7) 43(9)
150(30)
'Includes only denials of applications: to acquire
banks under Sections 3(a)(1), 3(a)(3), and 3(a)(5) of the
Bank Holding Company Act; and to acquire nonbank
companies under Section 4(c)(8) during the 1971-74
period.
2Means potential competition alone was suf
ficient to outweigh factors favoring approval. In such
cases existing competition was insignificant.
'Means potential competition, though an impor
tant factor favoring denial, could not by itself sustain
a denial recommendation.
4The numbers in parentheses represent denials of
nonbank acquisitions under Section 4(c)(8). Prior to
1971, all denials shown in the table involved acquisi
tion of banks. The number to the left of the
parentheses includes the 4(c)(8) denials.
1957-66
1967-70
1971
1972
1973
1974
frequently as a factor in disapproving
holding com pany applications.
To gain a better understanding o f the
evolving use o f the potential competition
concept as it relates to the Board’s ad
ministration o f the Bank H olding Com
pany Act, all Board denial orders issued
under the act during the 1957-74 period
were analyzed. The analysis reveals that
in these 18 years, the Board issued a total
o f 150 denial orders. O f these, more than
h a lf (76) cited potential competition as
either a m ajor or m inor factor in the deci
sion to deny the applications. Further, o f
the 76 denial orders involving potential
competition, almost h a lf (36) were issued in
1973 and 1974.
From 1957 through 1965 only ten
denials o f holding com pany applications
involved potential competition; in none o f
these was the concept a m ajor issue. Not
until April 1967 w as a holding com pany
application denied primarily on potential
competition grounds.2
On a relative frequency basis potential
competition was far more im portant as a
cause for denials in the 1967-70 period than
at any time before or since. From 1967
through 1970, 65 percent o f all denial
orders involved potential competition, and
in 47 percent o f these potential competition
alone was sufficient cause for denial. In the
previous ten years (1957-66) potential com
petition played only a m inor role in 42 per
cent o f all Board denial orders. In 1973 and
1974 the Board issued 69 denial orders and
52 percent o f these (36) involved potential
competition; however, potential com peti
tion w as the major factor in only 26 percent
o f these denials.
Why the change?
There are several reasons for the re
cent increase in the number o f denials in
volving potential competition. Possibly
2In 1962 the Board denied a bank merger pri
marily on the basis of potential competition.
Business Conditions, April 1975
the m ost im portant reason is the increased
number o f applications from holding com
panies in states where multibank holding
com panies have been particularly active in
acquiring banks. A s holding companies
have exhausted the expansion possibilities
in their own markets, they have had to
resort to the acquisition o f banks located in
markets progressively more distant from
their subsidiary banks. Attempts by one o f
a state’s larger holding companies to ac
quire leading banks in distant markets are
likely to be denied on the basis o f potential
competition. This is particularly likely if
the markets are highly concentrated.
A n o th e r reason for more Board
denials based on potential competition is
the increased activity o f bank holding com
panies in acquisitions o f nonbank busi
nesses as a result o f the 1970 amendments
to the act. M ost o f these involved appli
cations to acquire consumer finance and
m ortgage banking companies, two ac
tivities that m any holding companies are
well-equipped to enter de novo. Attempts to
acquire leading firms in these industries,
particularly where there was geographic
(but not product) market overlap between
the nonbank com pany and the holding
com pan y’s subsidiary bank(s), have been
struck down by the Board because o f the
adverse effects such acquisitions would
have on potential competition.
The reasons for the recent decline in
the percentage o f denials involving poten
tial com petition are twofold. First, the
capital adequacy o f banks and bank
holding com panies becam e an increasing
ly prevalent reason for denying appli
cations (see B usiness Conditions, Febru
ary 1975). In the 1973-74 period capital ade
quacy w as an adverse element in almost 33
percent o f Board denials compared to less
than 6 percent in the 1967-70 period and 24
percent in 1971-72. Second, as the record on
denials has developed, holding companies
have gained insights into Board attitudes
toward the evolution o f the financial struc
15
tures within their states. One or more
denials on grounds o f potential competi
tion usually suffice to give holding com
panies a clear idea o f the type o f acquisi
tion that is likely to be denied. A s ac
quisitions with little likelihood o f approval
are eschewed, the B oard’s denial rate falls.
Judicial precedents
Between 1967 and 1974, the Board
den ied 33 b a n k h o ld in g com p a n y
applications primarily on the basis of
potential competition. During all but six
m onths o f this period judicial attitudes
toward the application o f the potential
competition concept to banking were in
doubt.3 The potential competition concept
as applied to banking was first given
credence in the U.S. Supreme Court deci
sion in United States v. M arine Bancorporation on June 26, 1974.4 Although rul
ing against the Justice Department with
respect to the specific case, the Court up
held the Justice Department’s use o f poten
tial competition with the proviso that “ the
application o f the doctrine to commercial
banking must take into account the exten
sive and unique federal and state regu
latory restraints on entry into that line o f
commerce . . .”
In view o f its denial record dating back
to 1962, the Board w as 12 years ahead o f
the courts in applying the concept o f poten
tial competition to banking. These denials
arrested or considerably slowed, in its incipiency, a trend toward increased concen
tration in banking w hich had been emerg
ing in m any states.
H arvey Rosenblum
’The U.S. Department of Justice had repeatedly
been frustrated in attempts to block bank mergers in
volving potential competition, having lost eight Dis
trict Court cases between 1967 and 1973.
4The legal precedent for denying acquisitions of
nonbank companies on potential competition
grounds was clearer. See FTC v. Proctor & Gamble,
386 U.S. 568 (1967), and United States v. Continental
Can Co., 378 U.S. 441 (1964).
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