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rev iew by th e Federal Reserve Bank of Chicago Business Conditions December 1971 Contents The 1970 amendments to the Bank Holding Company Act: One year later 2 Gold—Part II: Future without glitter 12 Federal Reserve Bank of Chicago The 1970 amendments to the Bank Holding Company Act: One year later An expansion of remarks made by Mr. Robert P. Mayo, President of the Federal Reserve Bank of Chicago, to the Chicago Chapter of the Bank Administration Institute on November 16, 1971 On December 31, 1970, following one of the most heated legislative battles in years, the Bank Holding Company Act Amendments of 1970 were signed into law. With only slight exaggeration, the amend ments have been called the most important banking legislation since the Federal Re serve Act. For what the amendments did was give concrete expression to congres sional concern about the nature of our bank ing system and its role in the American economy, not only for today and for the next few years, but well down the road into the foreseeable future. Though vague in certain respects, internally inconsistent in others, and not necessarily immutable in its particulars, the policy embodied in the amendments may well influence the char acter of banking into the next century. How did such an important piece of leg islation come into being? What does it say and, more to the point, what does it mean? What does it portend for banking and the American economy in the 1970s? It may assist bankers and others currently ponder ing these questions to review the events of the past several years, putting them in per spective and using them to illuminate sub sequent developments. Rise of the o n e-b an k holding co m p an y Prior to 1967, if the typical banker had been asked what a one-bank holding com pany was he would have responded with a blank stare. The existence of such an animal had simply never occurred to most people, and even within the small group of bankers, businessmen, and regulators who knew about it, the one-bank holding company was just on the verge of acquiring significance. As far back as the early 1950s, repre sentatives of the Federal Reserve had argued before congressional committees that the abuses at which regulation of bank holding companies was directed were not dependent on the number of banks owned by the hold ing company. Nevertheless, the Bank Hold ing Company Act of 1956 and its 1966 re vision limited Federal Reserve regulation to multibank holding companies — com panies owning or controlling 25 percent or more of the stock of two or more banks. Business Conditions, December 1971 The exemption of companies controlling only one bank reflected congressional pre occupation with the possibility that expan sion by large multibank holding companies within and across state lines might under mine state laws restricting branch banking and bring about a great inci'ease in the con centration of banking resources. As late as 1966, when the Bank Holding Company Act was revised, nothing had oc curred to make closing the one-bank loop hole an urgent matter of public concern. Although one-bank holding companies grew rapidly in number between 1955 and 1965 —from 117 to 550—most of them were small, and the fact that they combined banking with nonbanking activities often reflected nothing more than the availability of investment opportunities. Regulating such holding companies promised to be more bother than it was worth. Beginning in 1968, however, the onebank holding company movement—by this time it was accurate to describe it as such —took a turn that was sufficiently dramatic to catch the attention of many who, until then, had ignored it. The turning point was the formation by First National City Bank (Citibank) of New York of a holding com pany to own its own shares. This was the first time that a major money market bank had taken the initiative in forming a onebank holding company. More significantly, First National City Corporation, as the holding company was named, announced its intention to diversify into a variety of activities prohibited to banks as such. In large measure, this move reflected an attempt to circumvent legal obstacles en countered when First National City Bank previously had attempted to enter new activ ities directly. Citibank’s attempt to enter the credit card business by acquiring Carte Blanche ended in a consent judgment in 1968, under which its interest in the credit card company was sold to AVCO, a lead ing conglomerate. Here the issue was not bank entry into the credit card business per se—many banks were already in the busi ness—but simply that the manner of entry was deemed anticompetitive. Other efforts by Citibank to diversify its activities ran into more direct opposition. Its entry into the mutual fund business through the intro duction of the Commingled Managing Agency Account gave rise to lawsuits ini tiated by the Investment Company Institute and the National Association of Securities Dealers. After losing in the district court and winning in the Court of Appeals, Citi bank’s Managing Agency Account was de feated in a Supreme Court decision in 1971. Other banks had been encountering simi lar barriers to their efforts to diversify. The Association of Data Processors, whose legal standing to challenge a 1964 ruling by the Comptroller of the Currency permitting na tional banks to offer data processing ser vices had been questioned by the Comptrol ler, finally won its point in a decision by the Supreme Court in 1971. Still awaiting final disposition is a suit brought by an indepen dent travel agency to block banks from of fering general travel agency services. Long before the judicial system had pro vided even tentative answers to the issues raised by this litigation, other major banks jumped on the one-bank holding company bandwagon and began to enter nonbanking fields indirectly via the acquisition or es tablishment of holding company subsidiaries. By December 31, 1968, seven of the ten largest commercial banks in the United States had formed one-bank holding com panies. A year later, the list included 43 of the 100 largest banks. Although some bank- Federal Reserve Bank of Chicago ers continued to watch and wait, it was clear that many believed they had found the key which would unlock what, in their view, were unduly harsh restrictions on the activ ities of commercial banks. The movement gathered momentum, and by April 1, 1970, one-bank holding companies controlled 1,116 banks and 32.6 percent of the deposits of all commercial banks in the United States. R e a c t io n a n d r e s p o n s e 4 It was too much to expect that such a revo lutionary transformation of the organization of banking, and of the relationship between banking and other sectors of the economy, would go unchallenged. First to respond, of course, were those most directly affected— the firms in the industries being invaded by subsidiaries of bank holding companies. In addition to the lawsuits sponsored by trade as sociations, these industries fought back with some of the most intensive and sustained lob bying ever witnessed on Capitol Hill. But opposition to the holding companies had a much broader base than simply the pro tection of vested economic interests. Bankers and businessmen to whom memories of the holding company abuses of the 1920s were still vivid, as well as academicians and regula tors concerned about the potential implica tions of unbridled holding company expan sion for the safety, efficiency, and competi tiveness of the financial system, all expressed reservations about the one-bank holding com pany phenomenon. The ensuing debate was marked by extremes. A frequently heard prophecy was that arms-length bargaining between borrower and lender would even tually be replaced by the sort of community of financial and industrial interest typified by the Japanese Zaibatsu. The death of the free enterprise system was widely predicted, as were the demise of our democratic institu tions and their replacement by a quasi-fascist form of state capitalism. One need not endorse the more extreme of these flights of fancy to acknowledge the grain of truth that they all contain. Indeed, I wish to make plain my strong disagreement with those who believe that the one-bank holding company movement should have been allowed to run its course unchallenged, undebated, and restrained only by the forces of the marketplace. Just as a free society can be maintained only within the framework of the rule of law, the preservation of a free competitive process presupposes some broad restraints on the behavior of market partici pants. This is an inescapable and well-known paradox, perhaps most familiar to us in the arguments for constitutional government or, more narrowly, in the generally acknowl edged need for antitrust legislation. In the case of banking, restrictions on entry, widely regarded as necessary to protect the integrity of the payments mechanism, and the uni versal need for credit by business give banks an unparalleled potential for influencing the allocation and distribution of resources. It may well be that the maintenance of a com petitive financial system that dispenses credit efficiently and without favoritism presup poses the separation of lender and borrower. This implies some limitations on the diversi fication of banks and bank holding companies into other activities. But simply to acknowledge the principle that restraints can be, and occasionally are, necessary and desirable, is to say little about their appropriate nature and extent in any given situation. It appears to be as easy, nay easier, for legislatures to err in the direction of overrestrictiveness than in the direction of excessive permissiveness. Given both the great room for legitimate disagreement about the effects of limiting banking diversification Business Conditions, December 1971 and the magnitude of the private interests at stake, it was inevitable that the battle over one-bank holding company legislation would be long and bitterly contested. The bills proposed to regulate one-bank holding companies covered the entire spec trum of attitudes toward the industry. Rep resentative Wright Patman’s bill, which was strongly supported by representatives of the insurance, travel agency, data processing, and mortgage and investment banking industries, spelled out a narrow “laundry list” of per missible activities for bank holding compa nies. With few exceptions, these were all ac tivities that banks had traditionally engaged in, or that were extremely limited extensions of their basic loan and deposit function. The Administration bill favored by the American Bankers Association—once that body had reconciled itself to the necessity of having any new legislation at all—did not mention any specific activities that would be permitted or prohibited to banks. Instead, it spelled out certain broad criteria for determining what would be permissible and assigned responsibility for making this determination to the Comptroller of the Cur rency, the Federal Reserve System, or the Federal Deposit Insurance Corporation, de pending on whether the bank controlled by the holding company was a national, state member, or insured nonmember bank. It was widely believed that this division of enforce ment responsibility would favor a liberal in terpretation of what was permissible. For more than two years, Senators and Congressmen had been besieged by represen tatives of the industries seeking to obtain slightly more favorable treatment than was being accorded others. If one may believe newspaper accounts, by the time the bills came to a vote, most members of the federal legislature were so weary of the issues that they would have voted for almost any bill just to be rid of the holding company ques tion. After several suspense-filled weeks dur ing which it appeared that the House and Senate conferees might never compromise their wide and strongly felt differences, the Conference Committee reported out the Bank Holding Company Act Amendments of 1970 on December 8. Within the month, the amendments were approved overwhelm ingly by both houses of Congress and signed into law by President Nixon. It is a measure of the genius of the Ameri can political system that the legislation finally adopted bore little resemblance to— indeed, was probably superior to— any one of the measures proposed by the contesting parties. The new law was much more than a crude compromise of opposing interests and, with the possible exception of the grandfather clause, reflected next to nothing of the ignoble sentiments that had pervaded the entire de bate. With but a few reservations, I believe the legislation to have been sound and in the best long-run interests of the banking system, the economy, and the nation. Although only time will tell, I believe that its basic principles and provisions will endure to have a profound effect on the evolution of the American fi nancial system over at least the next two or three decades. The n ew am en d m en ts The 1970 amendments to the Bank Hold ing Company Act contain many important exceptions, qualifications, and other details, but their essence is rather simply stated. First, they extend the coverage of the act to all bank holding companies, eliminating the onebank loophole. In contrast to a proposal fre quently heard during the hearings on the new legislation, the amended act makes no dis tinction in its treatment of one-bank and 5 Federal Reserve Bank of Chicago multibank holding companies. Second, the companies that were recognized as bank holding companies by virtue of the amend ments must register with the Federal Reserve, thereby providing some essential data not hitherto available on their number, size, and activities of such holding companies. This step should be completed within the next month or so. Third, and most important of all, Section 4 (c)(8 ) of the amended act lays down a revised set of criteria for determin ing the permissibility of individual nonbank ing activities of bank holding companies. The actual determinations, as under the old act, are left to the Board of Governors of the Federal Reserve System. The first test that such activities must meet is “to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.” The similarity of this to the wording of the old Section 4(c) (8), is not the result of an oversight. Rather, it reflects the refusal of Congress to adopt any of the proposed alternatives, such as “functionally related to banking.” On the basis of this refusal, it has been argued that Congress intended no change, and certainly no liberalization, in its criteria for determin ing the permissibility of holding company ac tivities.1 Such an interpretation would ap pear to be untenable, in view of Congress’ elimination of the stipulation that the activ ities of bank holding companies and their subsidiaries “be of a financial, fiduciary, or insurance nature . . ..” In any case, Congress added an entirely new standard to the act, which reads: In determining whether a particular activTThis viewpoint was recently reaffirmed by Chair man Wright Patman of the House Committee on Banking and Currency in a speech before the Ariz ona Chapter of Robert Morris Associates reprinted in The American Banker, November 29, 1971, p. 4. ity is a proper incident to banking or man aging or controlling banks the Board shall consider whether its performance by an affili ate of a bank holding company can reason ably be expected to produce benefits to the public, such as greater convenience, increased competition, or gains in efficiency, that out weigh possible adverse effects, such as un due concentration of resources, decreased or unfair competition, conflicts of interests, or unsound banking practices. The position and wording of this sentence suggest that it is simply an elaboration of the meaning of “a proper incident to bank ing.” In fact, the sentence that precedes it in the act implies that whether an activity is properly incidental depends primarily on whether it is “closely related to banking.” Actually— as a few minutes’ reflection should make clear—there is no obvious or unvarying relationship between an activity’s closeness to banking and the beneficial or adverse effect on the public of its performance by a holding company affiliate. As a general rule, or example, the competitive effects of acquiring a going concern would be more ad verse the closer were the activity in question to banking. Thus, the fact that both banks and mortgage companies make loans for residential construction suggests that mort gage company activities may be considered closely related to banking. But it also en hances the possibility that banks and mort gage companies may be in direct competition, so that their affiliation in a holding company might eliminate existing competition. In practice, the Board has interpreted Section 4 (c)(8 ) as embodying two distinct tests, both of which must be passed if a given activity is to be approved. Permissible activities must be both closely related to banking and in the public interest when per formed by a bank holding company affiliate. Moreover, even though the activity is con- Business Conditions, December 1971 sidered permissible, each specific proposal to engage in it, whether de novo or by acqui sition of a going concern, must pass the pub lic interest test. The words “closely related to banking” are so vague as to create some extremely dif ficult problems of interpretation. One basic problem is that the nature of banking itself is constantly changing rather than static. Over the past half century, banking has un dergone a fundamental transformation from a wholesale-oriented business, concentrating on short-term lending to business to a de partment store of financial services with an increasingly retail-oriented approach. Among the services introduced by banks in recent years—not always without opposition—have been data processing services, including pay rolls and tax return preparation; manage ment of a commingled investment fund; un derw riting revenue bonds; and leasing of personal property. Some of these have been disallowed by the courts; but those that re main represent major changes in what it is that constitutes “banking.” Hence, what is “closely related to banking” may be sub ject to evolution over time. But even if the definition of banking were clear and reasonably unchanging, there would still remain some extremely difficult problems in deciding what was closely re lated to it. There are many different ways in which nonbanking activities can be re lated to banking. The choice of which way is crucial. Some activities, such as mortgage banking, are closely related to banking in the sense that they provide similar services to an overlapping group of customers. Other activities, such as data processing, may be related technologically, in the sense that computer management of a customer’s checking account may produce much of the information necessary for processing his tax returns, etc. Some activities, such as armored car and messenger service, may stand in a vertical relationship to banks, in the sense that they constitute a necessary input into the banking business. Or activities may be related to banking in the more remote sense that they utilize a technology similar to that used by banks. The point is simply that there is no universally agreed-on procedure for classifying an activity as closely related to banking. The Board will have to make some more or less arbitrary judgments to give con crete meaning to this part of the act. In the process of implementing the public interest standard, the Federal Reserve finds itself having to blaze new paths of interpre tation and analysis. It is required, in effect, to measure all the costs and benefits of al lowing holding company affiliates to per form a given activity, to weigh them in some unspecified manner, and to decide on the basis of the result whether the activity should be permitted. Aside from the need to make a number of important value judg ments, the Board is handicapped by the fact that Federal Reserve staff personnel are only gradually becoming familiar with the tech nology, demand conditions, and state of competition in most fields of activity other than banking. Consequently, implementation of the provisions dealing with nonbanking activities is proceeding slowly and cautiously. Im plem en tin g th e am en d m en ts Even before the amendments were enact ed, the Board’s staff and those of the 12 Reserve banks were busy in anticipation of the hectic workload that was to follow. Early in 1971, the Board began to consider a list of activities proposed by the Association of Registered Bank Holding Companies. These were all activities that one or more members of the association had expressed some in- Federal Reserve Bank of Chicago terest in entering and which they believed to satisfy the requirements of the amended Section 4 (c)(8 ). The Board assigned the writing of background papers on each of these activities to research personnel within the System. On January 25, 1971, the Board proposed amendments to its Regulation Y, listing ten activities as permissible for bank holding companies under the new law. At the same time, it asked for comments and suggestions from interested parties to be received not later than February 26, 1971. Although the Board is empowered to ap prove activities either by the promulgation of general regulations or by order in indivi dual cases, it indicated its intention to pro ceed by regulation at first and to process individual applications under the new Sec tion 4(c)(8 ) only “in unusual and exigent circumstances.” The purpose of this defer ral of applications was obviously to give the Board time to consider some of the broader issues before getting bogged down in a heavy caseload of applications for the acquisition of companies engaged in activities that may not even be among those eventually declared to be permissible. In March, the Board announced its inten tion to hold hearings in April and May on the ten activities that it was considering. The first hearing, scheduled for April 14, was devoted to questions having to do with eight of the ten activities proposed as permissible. Hearings on data processing and acting as an insurance agent or broker were scheduled for April 16 and May 12, respectively. As expected, the hearings generated a great deal of heat and at least some light. It is perhaps not too unkind to remark that much of the testimony received was merely a restatement of arguments already familiar to the Board through the official transcripts of Senate and House Banking committee hearings. In any case, the Board was persuaded to postpone decisions regarding the permissi bility of acting as an insurance agent or broker, acting as an insurer, or providing data processing services. On May 27, it ap proved the other seven activities, with minor m odifications, effective June 15. In doing so, the Board indicated that it was not im posing any general limitation on the location of nonbanking activities, but might impose such limitations by order in individual cases.2 It also made clear that the activities of approved holding company subsidiaries were not to “be altered in any significant respect from those considered by the Board.” On June 15, effective July 1, the Board added an eighth activity to the approved list —data processing services. In approving the activity, the Board imposed fewer restric tions than expected—fewer even than in its original proposal—and thereby produced a great deal of disappointment in the data processing industry. The Board had con sidered but finally rejected provisions that would have limited data processing for par ties other than subsidiaries of the holding company or other financial institutions to some proportion of the holding company’s total data processing business. Aside from the obvious administrative difficulties such a provision would have presented, it was believed that an arbitrary quantitative limi tation on the ability of bank holding com panies to compete for data processing bus 2On December 6, Federal Reserve Board Gover nor George W. Mitchell made known his belief that geographical restrictions on bank holding company activities are “generally hostile to the public interest because they sequester competitive forces instead of releasing them.” If this is representative of the Board’s views, it suggests that geographical limita tions will be imposed sparingly and only where an affirmative need for them has been demonstrated. Business Conditions, December 1971 iness made no sense. If, indeed, it is in the public interest for them to offer such ser vices, they should be encouraged to do so. What the Board did was to specify that the information processed should be “banking, financial, or related economic data . . ..” In general, the Board has not seen its role as rubber-stamping decisions made by other agencies regarding appropriate activities for banks. Thus, the fact that the Comptroller of the Currency had ruled that a national bank might offer a given service would not be taken as conclusive in determining whether the same service would be permissible for bank holding companies. This could lead to a situation in which a Board refusal to au thorize an activity for bank holding compan ies could be nullified by the bank’s carrying on the activity directly. A possible deviation from this general policy was the Board’s ac tion, effective September 1, adding insurance agency and broker functions to the list of permissible activities. That such activities traditionally had been performed by state banks where permitted by state law and by national banks in communities with popula tions not exceeding 5,000 probably was not totally ignored by the Board in its decision. This was the ninth of the ten activities orig inally proposed to be approved by the Board, leaving only “acting as an insurer” to be acted upon. The nine activities that have been approved are:12 (1) making or acquiring, for its own ac count or for the account of others, loans and other extensions of credit (including issuing letters of credit and accepting drafts), such as would be made, for example, by a m ort gage, finance, credit card, or factoring com pany; (2) operating as an industrial bank, Morris Plan bank, or industrial loan company, in the manner authorized by State law so long as the institution does not both accept demand deposits and make commercial loans; (3) servicing loans and other extensions of credit for any person; (4) performing or carrying on any one or more of the functions or activities that may be performed or carried on by a trust com pany (including activities of a fiduciary, agency, or custodian nature), in the manner authorized by State law so long as the institu tion does not both accept demand deposits and make commercial loans; (5) acting as investment or financial ad viser, including (i) serving as the advisory company for a mortgage or a real estate in vestment trust and (ii) furnishing economic or financial information; (6) leasing personal property and equip ment, or acting as agent, broker, or adviser in leasing of such property, where at the in ception of the initial lease the expectation is that the effect of the transaction and reason ably anticipated future transactions with the same lessee as to the same property will be to compensate the lessor for not less than the lessor’s full investment in the property; (7) making equity and debt investments in corporations or projects designed primarily to promote community welfare, such as the economic rehabilitation and development of low-income areas; (8) (i) providing bookkeeping or data pro cessing services for the internal operations of the holding company and its subsidiaries and (ii) storing and processing other banking, financial, or related economic data, such as performing payroll, accounts receivable or payable, or billing services; and (9) acting as insurance agent or broker in offices at which the holding company or its subsidiaries are otherwise engaged in busi ness (or in an office adjacent thereto) with respect to the following types of insurance: (i) Any insurance for the holding com pany and its subsidiaries; (ii) Any insurance that (a) is directly related to an extension of credit by a bank Federal Reserve Bank of Chicago or a bank-related firm of the kind de scribed in this regulation, or (b) is di rectly related to the provision of other financial services by a bank or such a bank-related firm, or (c) is otherwise sold as a m atter of convenience to the purchaser, so long as the premium income from sales within this subdivision (ii) (c) does not constitute a significant portion of the aggregate insurance premium income of the holding company from insurance sold pursuant to this subdivision (ii); (iii) Any insurance sold in a commu nity that (a) has a population not ex ceeding 5,000 or (b) the holding company demonstrates has inadequate insurance agency facilities. Recently, the Board has issued proposals that serving as an investment adviser to mutual funds and performing property man agement services be added to the list of per missible activities. In October, it received a letter from Richard W. McLaren, Assistant Attorney General in charge of the Antitrust Division, questioning the legality of bank holding companies acting as advisers to mu tual funds. Though acknowledging the prob able procompetitive consequences of holding company entry into the activity, McLaren suggested that it might constitute a violation of the Glass-Steagall Act separating com mercial and investment banking. The Board held hearings on several questions related to factoring and serving as investment adviser to a mutual fund on November 12. The first ap p licatio n s 10 A Board press release on May 27 an nounced that applications to engage in non banking activities subject to Section 4 (c)(8 ) were being accepted. Since then the number of such applications has gradually risen, as the principles governing the Board’s actions have become clearer. As expected, applica tions for de novo entry by bank holding com panies into activities already included on the approved list have received liberal treat ment. Indeed, most such applications are deemed automatically approved unless ob jections are raised by the Reserve bank. In the area of acquisitions, mortgage com panies have produced the greatest activity and raised some of the most difficult prob lems, especially with regard to competitive effects. As of late October, the Board had under consideration seven applications to acquire mortgage companies, many involv ing extremely large banks and leading mort gage companies in the same city. Because both banks and mortgage companies make real estate loans, there is considerable com petitive overlap between the activities of the two types of institutions. Consequently, there is some question whether bank holding com panies should be allowed to acquire mort gage companies located within the same local geographic area served by the holding com pany’s bank or banks. Indeed, a speech in April by Donald Baker, acting director of Policy Planning in the Antitrust Division, in dicated that the Justice Department would scrutinize such cases very closely and urged holding companies to look to distant markets for nonbanking acquisitions. The Board held hearings on these and other issues in mort gage company cases on November 8. The hearings on mortgage companies and the actions taken by the Board on the first several applications involving mortgage com panies warrant your closest consideration. In addition to setting precedents for subsequent cases, the actions taken by the Board in these cases will serve as a useful indicator of its attitudes toward the competitive and other issues in holding company expansion into nonbanking areas generally. To paraphrase an old quotation usually applied to the Su- Business Conditions, December 1971 preme Court’s interpretation of the Consti tution, the Bank Holding Company Act Amendments of 1970 mean what the Board says they mean—at least until new litigation or legislation changes the rules. The am en d m en ts in p ersp ective Domestic nonbanking activities of bank holding companies have been only one con cern of the Board in its task of implementing the Bank Holding Company Act Amend ments of 1970. A number of other questions have had to be cleared up before those af fected by the amendments could be certain of their status. For example, on September 20, the Board announced the types of foreign business activities that would be permissible for domestic bank holding companies. On the same day, the Board issued a list of rules and presumptions that would guide it in de termining when a company exercises control over a bank or other company. These rules were designed to simplify implementation of the provisions in the 1970 amendments that broaden the Board’s ability to find control in situations when a company owns less than 25 percent of a bank’s stock. Many other minor issues, including a great number of purely procedural questions, have been dealt with along the way since the amendments were enacted at the end of last year. But the fact remains that the key issue in the implementation of the amendments is the treatment to be accorded holding company plans for expansion into nonbanking areas. Although Congress originally set out to set tle just this question— and succeeded, in the sense of specifying the broad criteria that should govern such expansion—the buck has now passed to the Board of Governors. It is, of course, too early to speculate about the minute details of the Board’s ultimate policy. But several principles have already become clear. The Board is on record as being sympathetic to the banks’ reasons for wanting to expand their horizons. There is no obvious reason why arbitrary restrictions should limit commercial bank participation —whether directly or via the holding com pany route—in the great expansion of the financial service industry expected over the next several decades. At the same time, the Board supports the clear mandate of Con gress that the separation between banking and commerce be preserved. It is willing to see the wall between the two displaced only to the extent that the holding company form of organization offers some insulation from the possible adverse effects that might ac com pany the banks’ entry into certain ac tivities directly. Regarding acquisitions of companies in lines of business already included on the ap proved list, final conclusions must await the Board’s action in the first cases under Sec tion 4 (c)(8 ). My own strongly felt belief is that the Board will apply essentially the same strict competitive standards that have marked its decisions on applications to ac quire banks under Section 3 (a )(3 ), modi fied only to the extent necessary to take into account the additional criteria included in the public interest test of Section 4 (c)(8 ). Beyond that, I am unwilling to hazard any guesses, other than to suggest that the next year or so should be every bit as interesting as the last year in the area of bank holding company expansion. 11 Federal Reserve Bank of Chicago Gold Part II: Future without glitter The article “Gold—An historical perspec tive” in the last issue of Business Conditions traced the role of gold in monetary arrange ments from its rise to the center of the world’s payments system at the turn of this century through its lingering demise through the Thirties and the postwar period. This article focuses on issues involved in recent negotiations leading to the restructuring of the international monetary system. S everin g the gold link 12 The suspension of the convertibility of the dollar into gold on August 15, 1971 inactivated the last operational link of world currencies with gold. In a sense, the action of the President of the United States last summer marked the end of an era. But more fundamentally, it merely formalized a situation that existed for years. In the late 1960s, foreign monetary officials largely re frained from demanding gold from the U. S. Treasury in tacit recognition that the U. S. “gold window” would be closed at any time that the United States was confronted with large volumes of foreign-held dollars for con version into gold. For all practical purposes, the dollar was not “exchangeable” into gold. Yet during this period, the international monetary system performed well its basic function—facilitating flows of goods, ser vices, and productive capital among nations on a scale never before realized. The de facto absence of a link between the currencies of major trading countries and gold had little influence on the functioning of the system. The myth of gold—its ability to bestow value on currencies and viability on a mone tary system—has long been dead. What made the international monetary system function as long as it did was a cooperative, international effort to make it function. What ultimately made the system break down was the inability or unwillingness of the coun tries that benefited from the system to ren der enough cooperation to undertake either the internal or external adjustments that would have eliminated disruptive deficits and surpluses in their balance-of-payments accounts. This reality formed a backdrop in the negotiations for the reform of the system. R eestab lish in g fix e d e x ch an g e rate s The primary responsibility of monetary officials has been to come up with a pay ments system that will serve the needs of international trade and commerce and be compatible with national desires for domestic full employment, price stability, and econom ic growth. “Floating” currencies, adopted by major countries following the suspension of the gold convertibility of the dollar, were viewed widely as merely temporary arrange ments. While “floating” freed the monetary authorities of individual countries from the Business Conditions, December 1971 necessity of supporting the exchange rate of their currency relative to the dollar (which used to entail sales and purchases of dollars with domestic currency in domestic mar kets), it also introduced an element of un certainty as to the future values of interna tional contracts. This uncertainty was considered by many to be a serious impedi ment to international commerce. The consensus among monetary experts throughout the current negotiations had been that a regime of relatively fixed—but somewhat less rigid—exchange rates, simi lar to the one in existence prior to August 15, should be readopted as the basis for any new system. But it was clear that relative exchange rates must be at new levels. The exchange rates of many countries were established years ago and were main tained, with few exceptions, despite fun damental changes in the productivity and relative economic developments that had taken place in individual countries. Misalign ment of the rates at which currencies ex changed for each other was the underlying cause of the persistent surpluses and deficits in the international accounts of individual countries. And these surpluses and deficits —and the unwillingness or inability of in dividual countries to eliminate them—were the source of the difficulties in the func tioning of the international monetary sys tem in recent years. Internal policies adopted by individual countries in their pursuit of domestic objectives of full employment and economic growth were traditionally either inadequate or, in some instances, in direct conflict with international objectives of elim inating deficits and surpluses. It was clear, therefore, that the elimination of the disrup tive imbalances must be achieved through external measures—the realignment of the rates of exchange. R e alig n in g th e ra te s Since August 15, when official mainte nance of fixed exchange rates stopped, and until mid-December, when agreement was reached by the ten leading trading countries of the noncommunist world, the exchange rates of currencies of major surplus countries “floated” upward relative to the currency of the major deficit country, the United States. In principle, this occurred for the following reasons. Prices (i.e., the exchange rates) of individual currencies in terms of each other were determined in a free, dayto-day market just like the prices of any other commodity—by supply and demand. The supply of any particular currency on the for eign exchange market in any one country was generated as residents disposed of the pro ceeds of their individual transactions in that particular currency. Demand was generated as the residents attempted to acquire that particular currency to make payments abroad in settlement of their individual trans actions. A surplus in a country’s balance of payments meant that in the aggregate the residents of that country were receiving more payments from abroad than they were send ing abroad. The supply of foreign currencies in that country exceeded the demand. In the face of excess supply, the price continued to drop until it reached the point where the “cheapness” attracted enough buyers on the demand side to take the available supply off the market. The values of foreign currencies in terms of the U. S. dollar rose on the foreign exchange markets as the market forces gen erated by the U. S. balance-of-payments defi cit and European balance-of-payments sur pluses were permitted to exert their influence on the relative value of these currencies. There were some who suggested that these “market-determined” exchange rates should be adopted as the base for the future 13 Federal Reserve Bank of Chicago system of fixed exchange rates. But the ex tent of appreciation and depreciation result ing from this process was distorted by two factors: unusual speculative conditions in the world’s exchange markets; and efforts on the part of some countries to limit the mar ket-induced appreciation of their currencies either by the imposition of restrictions on international transactions of their residents or by direct governmental intervention in foreign exchange markets. Because of these, floating exchange rates failed to produce a structure sufficiently changed to eliminate past disequilibria. A more equitable struc ture had to be determined by negotiations. The prime task confronting monetary of ficials of the ten major noncommunist trading countries engaged in international negotia tions had been to determine where the ex change values should be pegged once the sys tem reverted to the fixed exchange rates Productivity abroad increased faster than in the United States percent, 1963 =100 regime. This was a difficult process. The ex tent of the relative change in the external values of individual currencies directly in fluences the competitiveness of a nation’s products on world markets, its ability to sell its products, and its ability to provide do mestic employment. These, clearly, were very sensitive areas of decision for any govern ment. It was no wonder that the negotiations were prolonged. A chieving the re alig n m e n t The controversy over the realignment of currency values was not limited merely to the question of extent of relative revalua tion and devaluation. Equally controversial was the question of the means of achieving it. The issue had been: should the surplus countries revalue their currencies relative to the dollar, or should the deficit country (i.e., the United States) devalue the dollar in terms of gold? In purely technical terms of what was expected of the realignment, a uniform 10 percent upward revaluation of surplus countries’ currencies relative to the dollar would be approximately equal to a 10 percent devaluation of the dollar relative to gold. This would hold provided that in the latter case the surplus countries in question main tained the gold value of their currencies un changed, and all other countries, as was gen erally assumed, maintained the same external value of their currencies relative to the dollar. Straightforward as this proposition is in economic terms, it generated a great deal of controversy in the negotiations. Some coun tries preferred that the adjustments be ef fected, at least in part, through the devalua tion of the dollar (i.e., through an increase in the dollar-price of gold). Their argument seems to have been based largely on the proposition that the deficit country, the United States, must bear much of the burden Business Conditions, December 1971 of the adjustment. Initially, there was oppo sition to this measure largely on the grounds that an official action increasing the dollarprice of gold might tend to perpetuate the myth of the importance of gold in monetary arrangements. But eventually the United States withdrew its opposition to devaluation as the view became more widespread that unless an early compromise was agreed upon, world com merce would suffer irreparable damage from the continuation of the unsettlements in the exchange markets. On November 13, Presi dent Nixon announced that the United States would devalue the dollar as part of the gen eral realignment of currencies. The announced willingness of the United States to devalue the dollar provided a basis for an agreement at the meeting of the fi nance ministers and central bank governors of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzer land, the United Kingdom, the United States, and representatives of the International Monetary Fund (IMF) on December 17 and 18. The exchange value of the major currencies were redefined, and the United States agreed to devalue the dollar in terms of gold by increasing the dollar-price of gold to $38 per ounce.1 The m ean in g of the realig n m en ts . . . The fundamental issue in the current in ternational monetary crisis—and indeed for many years preceding the crisis stage—was ^ h e devaluation of the dollar, although already effective in the exchange markets, will become “legal” only after approval of the measure by the U. S. Congress. In a similar vein, many countries declared new “central values” of their currencies in terms of the dollar rather than new “par values.” Central values need not be officially approved by the IMF and are considered temporary, pending final U. S. action. Foreign reserves soared billion dollars N o te : R e serve s in c lu d e g o ld , f o r e ig n s e rv e p o s itio n in th e IM F , a n d SDRs. c u rre n c ie s , re the misalignment of the relative exchange values of major currencies. Reaching an agreement on this issue overshadows in im mediate significance any other issues. The redefinition of the values of individual cur rencies in terms of gold has been the means toward that end. In itself, redefining values in terms of gold was of little practical signifi cance. Since the cessation of the official con vertibility of foreign currencies into gold in the Thirties, and of the dollar on August 15 of this year, the valuation of currencies in terms of gold has been largely an account ing convenience. Gold provided—and con tinues to provide—a fixed point, a “numer aire,” against which the exchange rates of in dividual currencies can be defined. Beyond that, because at this time no sales or pur chases of monetary gold are undertaken, the redefinition of the value of gold in terms of individual currencies merely changes the book 15 Federal Reserve Bank of Chicago value of the existing monetary gold. A coun try that has revalued its currency in terms of gold will have the book value of its official gold stock (as well as its holdings of other for eign currencies that were devalued relative to gold, that held steady, or were revalued less than that particular currency) reduced in terms of its own currency. For the United States as the devaluing country, the dollar value of the U. S. gold stock as well as other foreign assets will increase, and the govern ment will record a “bookkeeping profit” once the devaluation becomes official.2 Should the convertibility of the dollar into gold be re sumed, and at that time, should any country choose to sell some of its gold to the U. S. Treasury, the new, higher price of gold in terms of the dollar would become economi cally relevant. The selling country would re ceive more dollars for a given amount of gold than it would have received prior to the de valuation of the dollar. But until the time the United States, or any other country, is pre pared for unlimited official trading in gold, gold will remain an illiquid asset for official holders, somewhat inferior to SDRs, the dol lar, or any other convertible foreign currency in official reserves in its immediate usefulness in meeting, on a large scale, the purposes for which official reserves are held.3 16 2During the 1934 devaluation, most of the result ing “bookkeeping profit” was transferred to the Ex change Stabilization Fund of the U. S. Treasury. The bulk of this amount was later used to finance the U. S. quota subscription in the IMF. The “prof its” from the currently pending revaluation will be offset by the automatic rise in certain U. S. dollar liabilities (e.g., currency subscriptions in the IMF). 3According to Article V Section 6 of the Articles of Agreement of the International Monetary Fund, countries may sell gold to the IMF for other foreign currencies. However, the capacity of the IMF, in effect, to underwrite the official gold market is limited. Thus, large-scale purchases of gold by that institution would no doubt require some special agreements among member countries. The realignment of currencies in terms of gold has not altered the declining signifi cance of gold in the international monetary arrangements. The real, immediate signifi cance of the measures rests in the realign ment of the value of the currencies. Here is how the realignment is expected to work. In principle, devaluation of a currency reduces the amount of other currencies that can be bought with a given amount of a currency that is devalued. Revaluation, of course, is the “other side of the coin”; larger amounts of foreign currencies can be purchased with a given amount of a revalued currency. Neither devaluation nor revaluation, as such, has any direct impact on the domestic internal value or the purchasing power of the home currency. There is only the indi rect domestic impact arising from the effect of devaluation or revaluation on prices of imported goods and services; these prices tend to go up in the country that devalues, down in the country that revalues. But it is these indirect impacts that are expected to bring about changes in the flows of trade and capital among countries, and thereby eliminate longstanding disequilibria. In addition to increasing prices of im ported goods, a devaluation reduces the prices of domestically-produced goods and services that are purchased by foreigners. Take, for example, a tractor that costs $5,000 in the United States. Before the changes in the relative values of the cur rencies, a prospective Japanese buyer would have needed 1,800,000 yen (i.e., 5,000 x 360, given the previous exchange rate of $1.00=360 yen) to purchase it. After the dollar was devalued and the yen revalued, the tractor still costs $5,000 in the United States. But it will now take only about 1,540,000 yen, given the new exchange rate of $1.00=308 yen. To the Japanese buyer Business Conditions, December 1971 using yen, the price of the U. S.Devaluation of the dollar made tractor has been reduced is expected to bolster by about 260,000 yen.4 U. S. foreign trade . . . Similar reductions, proportion billion dollars al to the extent of the relative 50 revaluation, will confront pro spective buyers of U. S. goods in 45 all countries whose currency values have risen relative to the 40 dollar. Such price reductions are expected to stimulate demand for 35 U. S. goods abroad, and lead to increases in U. S. exports. This, 35 in turn, is expected to increase production and employment at 25 home. imports What is just as important is 20 that devaluation of the dollar is expected to have the opposite ef fect on U. S. imports because of trade balance its impact on the prices of for eign-made goods purchased by U. S. residents. Let us take as an example a German automobile that costs 7,320 marks in Ger many and sold in the United States last year for $2,000 plus transportation cost from Ger seasonally adjusted many. After the German mark quarterly data rose in value relative to the dol lar, nothing basically changed for Germans as far as the price of 1964 '6 5 '6 6 '6 7 '6 8 '6 9 '7 0 '71 the car was concerned, as ex pressed in terms of German prospective U. S. buyer will need $2,271 marks. But with the mark revalued, plus transportation cost to purchase the car. 4This and the following examples abstract from Since the prices of domestically-produced certain effects that may follow the change in the cars will remain essentially unchanged, they exchange rates. For example, to the extent that the will become more attractive to prospective U. S.-produced tractor contains imported compo nents or material, its dollar-price may be increased buyers, and some will choose these in pref as the producer passes on his increased costs. Also, erence to foreign-made cars. Imports will be profit margins at various levels of distribution may reduced and U. S. production—and employ be changed, or costs of production increased as vol ume rises. All these will influence the price outcome. ment—increased. - 17 Federal Reserve Bank of Chicago The combination of reduced imports and increased exports are expected to help im prove the U. S. foreign trade balance. The improvement will be aided by the impact of foreign revaluation on the competitiveness of these countries in world markets. Not only will their sales in the United States be damp ened and their purchases from the United States increased, but also the competitive price superiority of foreign business firms over U. S. producers in “third-country” mar kets will be reduced as a result of the ap preciation of the value of their currencies relative to the value of other currencies. But not all effects will be advantageous to U. S. residents—nor will only disadvan tages accrue to residents of countries abroad. The realignment will mean higher prices on goods imported into the United States. Al though finished imported goods represent a relatively small portion of total consumption . . . and improve U. S. balance of payments billion dollars expenditures by U. S. residents, the effect of dollar devaluation will be felt by many who came to rely on cheap foreign-produced goods to provide greater variety— and larger amounts of buying power—to their budgets. Those traveling abroad will find that their dollars will buy less. Also, increases in prices of imported raw materials and components used in the production of U. S. goods may result in some price increases that will affect nearly everyone. At the same time, consumers in the reval uing countries abroad will find their budgets “buying more.” Imported goods—Americanmade goods—will cost less, and consumers will be able to substitute cheaper foreign goods for relatively more expensive domes tically-produced goods. Other things equal, their standard of living will increase—while that of the Americans will be reduced some what. In this sense, the realignment of cur rencies will reward residents of revaluing countries for their past frugality, and for the productivity that enabled their economies to grow and gain competitively in world mar kets. At the same time, devaluation for most Americans will mean a collective payment on the bill for the Vietnam war, wage in creases in excess of productivity gains—in short, for the things that over the past sev eral years have contributed to inflationary pressures in this country and thus under mined the external value of the dollar, mak ing the change in parity essential. . . . and of o ther m e asu re s 18 In addition to realigning the exchange parities of currencies, or establishing new central values, representatives of the major countries and the officials of the Interna tional Monetary Fund, meeting in Washing ton, agreed to widen the “band” of per missible deviation from parity of the “fixed” Business Conditions, December 1971 exchange rates. Under the old system, the exchange rate of the currency of any one country relative to the dollar was permitted to deviate by not more than one percentage point either below or above the officially declared par value, or a total “band” of 2 percent. As the limit was approached, the authorities were obliged to enter the market to support the fixed rate. In the opinion of many observers, this relative rigidity of exchange rates was con ducive to speculation in the foreign exchange markets under certain conditions, and was often too confining for national authorities in their pursuit of domestic policy objectives. Speculative activity—that is, transferring funds, say, from dollars to another currency in anticipation of a quick profit from changes in the par value—was made rela tively “safe” under the 2 percent band. A speculator stood to lose, at a maximum, 2 percent on his speculative transfer if his expectations were not realized. On the other hand, speculators could gain several times that much if the currency in which funds were placed was revalued. The widening of the band of permissible fluctuation, from 2 percent to 4.5 percent (i.e., from 1 percent on each side of the par value to 2.25 per cent), increases the extent of a possible loss and, thus, is expected to discourage disrup tive speculation. Moreover, wider move ment of the exchange rates will permit a bet ter accommodation of the exchange rates to changing economic conditions in individual countries. It will make formal, relatively large changes in parities less likely, while at the same time, small and more frequent formal changes can be undertaken more readily. This, too, is expected to reduce speculation. The wider band of fluctuation also should permit greater divergence in monetary con ditions without giving rise to disruptive short-term capital flows. For example, a higher level of interest rates, maintained by monetary authorities in an effort to restrain domestic economic activities, could be bet ter sustained without attracting negating in flows of foreign capital. The reason: with a wider band for exchange rate movement, foreign investors stand to lose more through possible movements in exchange rates than they stand to gain on the interest rate dif ferential in the different national markets. Conclusion Just as it is the function of a national monetary system to facilitate domestic com merce, so the primary function of the inter national monetary system is to facilitate ex change of goods, services, and productive capital across national boundaries among nations of differing internal monetary sys tems. Over time, monetary systems of indi vidual countries evolved and changed in response to the changing nature of economic activity so as to continue to best perform their basic functions. The international monetary system, too, has been undergoing many changes. At times, however, the inertia arising from divergent national interests has meant that desirable changes have been slow in coming. Pressures accumulated and dis ruptions ensued. Over the past several years, the trading nations of the world have been confronted with such a situation. But they have risen to the challenge, and have em barked on a collective effort to resolve the accumulated problems. In the background of these negotiations were and are real economic issues: how to assure smooth flows of trade and capital, on which virtually all nations rely for their economic well-being within the framework of a noninflationary world that assures full employment and a rising standard of living to all. Negotiations 19 Federal Reserve Bank of Chicago still continue and many issues remain to be resolved. Gold, its price in terms of various world currencies, has been one of the issues. But against the background of the real economic issues that have formed the frame work of negotiations, the gold issue has been largely stripped of its mysticism. The ques tion has not been: What price gold? The question has been: What will be the price of European cars, American steel, Canadian wheat, Japanese television sets, and Hong Kong textiles in world markets that will maximize production and employment, and economic well-being, for all? Over the centuries, gold has performed a useful, indeed a vital, function in the evolu tion of both national and international mone tary systems. But as the complexities of ec onomic relationships increased, the practical usefulness of gold diminished. Many years ago, close links between gold and national monies became too confining to permit full realization of economic opportunities within individual economies. Acting individually, all nations have freed themselves from this confinement by cutting the link between gold and their domestic monetary systems, and by successfully substituting monetary manage ment unencumbered by the vagaries of gold. In the international monetary area, the demise of gold has been far slower in com ing than it has in individual economies. While diminished in relative importance, gold con tinues as a significant portion of the interna tional reserves of many countries. For nations, just as for individuals, any thing widely acceptable as a medium of ex change, as a claim on real goods and services, is money. Gold continues as international money among official institutions because it has been accepted by a majority of nations as such. It is so accepted because govern ments that in the past, have used their na tion’s energies in securing their gold hoards have a vested interest in insuring that these hoards continue to command real resources. Because of this, gold will play a role in the international payments arrangements for many years, perhaps until nations, through mutual trust and international discipline, are prepared to accept “credit” money—and the advantages that such money offers— as readily and universally as individual citizens within individual nations have accepted it for many years. When that time comes, official gold hoards can be put to good uses. That time may be far away—but cer tainly much closer than it appeared only a few years ago. The foundations for a more rational system have been laid by the ac ceptance in principle of the new interna tional money—the Special Drawing Rights (SDRs). Building on these foundations progresses. Gold is no longer dug out of the earth so that it can be buried at heavily guarded underground vaults at another loca tion as official reserves. The broad accept ance of the SDRs so far, and the continued ongoing search among nations to reconcile their differences for the common good, hold great promise for the future— and dull the glitter of gold. BU SIN ESS C O N D IT IO N S is p u b lish ed m o n th ly b y the F e d e ra l R eserve B a n k of C h ic a g o . Jo sep h G . K v a s n ic k a w a s p r im a rily resp o n sib le fo r the a rtic le " G o ld —Part II: Future w ith o u t g litte r." 20 Su 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 Research D e p a rtm e n t, F e d e ra l 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 . Index for the year 1971 Month Pages October April June 12-16 March 10-20 A g ricu ltu re an d fa rm fin an ce Farmers’ off-farm incomes exceed farm earnings. . . Food prices higher in 1971............................................. Food programs—increased emphasis....................... 2-5 2-8 B an kin g an d credit The challenges for small banks.................................... Checking account costs— Trends and composition among small banks, 1966-70.................................. Commentary on central bank activities....................... Congress and the Fed view bank taxation................. Interest rates—the volatile price of credit................. Rebuilding America’s liquidity.................................. The 1970 amendments to the Bank Holding Company Act: One year later.................................. Time deposit growth—back on track?....................... October April September August February 2-11 6-11 9-15 7-12 2-8 December July 2-11 7-12 Month Pages Economic co nd itio n s, g e n e ra l Review and outlook— 1970-71........................... The trend of business— Housing leads construction rise..................... The trend of business— Postwar business cycles compared................... The trend of business—The freeze and after........ 2-28 May 2-12 March September 2-9 2-8 July November 2-11 May November December August February 12-20 12-19 12-20 2-6 9-12 April 12-16 9-15 Em ploym ent Colleges and jobs............................................ .......... The coming upsurge in employment............... ........... 2-7 In tern a tio n a l econom ic trends Anatomy of an international monetary crisis............. Gold—Part I : An historical perspective..................... Gold—Part I I : Future without glitter......................... Trends in U. S. foreign trade...................................... The value added tax in Europe.................................... M oney an d m o n ey su p p ly The growing appetite for cash................... ............... What is money?..........................................
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