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A review by the Federal Reserve Bank of Chicago Business Conditions 1968 June Contents Weaknesses in our financial system 2 Returns to labor and capital in agriculture 6 Bank credit cards: saturation in the Midwest? 12 Federal Reserve Bank of Chicago W eaknesses in our financial system Charles J. Scanlon* President, Federal Reserve Bank of Chicago TL excessive demands on our financial mechanism in recent years—caused largely by the need to finance tremendous Treasury deficits—highlight weaknesses in the nation’s financial system. A few changes, however, could go a long way toward improving the performance of the system and avoiding crises. Performance is limited by two types of weaknesses. One includes the whole array of institutional arrangements that tend to delay, and in some cases block the adjustments by which the market mechanism is supposed to realign the supply and demand for funds in a changing environment. These pose the problem of imperfect markets. The other is the problem of imperfect management. Included in this category are errors of judgment by managers of financial institutions often resulting from outmoded practices and attitudes and from “overreach ing” for profits. There are no pat solutions for either type of weakness. But efforts to perfect the nation’s financial markets and enlarge the role of the price mechanism would probably improve the adaptability of the system and increase its efficiency as an allocator of credit. Chan nels for the flow of funds between suppliers and users need to be improved, and the ca pacity of financial institutions to adjust to 2 *Summary of an address given before the annual convention of the Illinois Bankers Association in St. Louis, May 19-21, 1968. changing conditions needs to be increased. Actions increasing the flexibility of financial markets and enlarging the role of market prices would also strengthen competitive forces. R ig idity in m o rtg ag e s The choking effects of imperfections in a financial market were illustrated two years ago by the drying up of the mortgage market. The shortage of mortgage funds in 1966 can be traced largely to a complex of rigidities— including the traditional form of mortgage instrument and the legal impediments to price flexibility. Mortgage contracts as they are generally constituted put lenders in a bind when interest rates are rising. If a lender borrows short and lends long (as most financial intermedi aries do) and especially if he is thinly capi talized (as most intermediaries are) he is clearly pinched by long-term, fixed-interest contracts in a time of rising rates. The squeeze is made even tighter by the absence of an effective secondary market for mortgages, except possibly for those guaranteed by FHA and VA, and they are a small part of the total. Probably the most serious imperfection in the mortgage market results from efforts to control prices. Intended to protect homebuyers from high interest charges, both the usury laws in some states and the ceilings on interest rates on loans guaranteed by the Business Conditions, June 1968 government have severely restricted the flow of funds into mortgages when their yields were no longer competitive with other invest ments. In 1966 and again in 1968, such reg ulations clearly worked against the very people they were intended to protect. Weaknesses in management practices were also pointed up in the credit squeeze two years ago. The impact of the squeeze on sav ings and loan associations strongly suggests the need for changes in their loan commit ment practices, liquidity management, and policies regarding the prices and maturities of share accounts. Changes in these areas would increase the ability of associations to adjust to new market conditions. Homebuilding was sharply curbed in 1966 because funds were not available even to people prepared to pay the going price for mortgage credit—clear evidence of imper fections in the market mechanism and in management practices. Another example of market imperfection can be drawn from deficiencies in the private market for agricultural credit. These have included inadequate knowledge in central credit markets regarding the quality of paper generated by many small farm borrowers, lack of facilities for packaging such paper into marketable parcels at competitive rates, and failure to gear loan terms to farmers’ flow of funds. B a r r ie r s to co m p etitive p rices Part of the problem of imperfect markets results from government intervention. While aimed at imperfections in the market, or at counteracting their effects, government inter vention has often resulted in barriers to com petitive pricing. These barriers may be more common in financial markets than elsewhere. There is the fear, for example, that unrestrained com petition in banking will lead to unsound banking practices and too many bank failures. Competition must be restrained, it is said, because bank liabilities comprise most of the money supply. Tradition also identifies high interest rates as inherently bad, even though they may accurately reflect supply-demand conditions like any other price. Consequently, government regulation has restricted the organization of new banks, changes in bank locations and the types of business of existing banks, as well as invest ment policies and prices offered for deposits. These and other effects of regulation, while achieving stability, have also probably re duced the efficiency of the banking system in allocating credit. This, in turn, seems to have generated pressure for additional controls on credit flows, especially when it is necessary to limit the total supply of credit, in the in terest of economic stability. Few people would question that banking must be regulated. But wherever possible government involvement should be turned toward the perfecting of the market mechan ism and away from the substituting of regu lation for market forces. Price ceiling s an d ratio n in g The view that more flexible pricing in fi nancial markets would be beneficial throws into question the prescribed maximum rates financial institutions can pay on deposit and share liabilities. These ceilings and the pro hibition against interest payments on demand deposits were first imposed to help banks in sound condition forestall shifts to riskier assets—shifts, it was felt, that would result from price competition for deposits. Prescribed ceilings did not interfere sig nificantly with the performance of the market as long as they were well above the rates actually paid. But when market rates began 3 Federal Reserve Bank of Chicago pressing against ceiling rates, the flow of funds was redirected, with less flowing to banks and other financial intermediaries and more flowing directly into market invest ments. The result, in 1966, was a decline in bank deposits and savings and loan share accounts. While price controls in the form of in terest rate ceilings on the liabilities of finan cial institutions can prevent shifts of funds between different types of institutions, they cannot force funds to flow to those institu tions. Any kind of price control destroys the capacity of the market to strike equality be tween supply and demand, creating the ne cessity for a direct means of rationing if the commodity or service is to continue flowing through its normal channels. M an ag em en t— th e public side 4 Some steps have already been taken on the public side to strengthen market forces, or at least simulate more closely the results these forces would produce if they were operating perfectly. And other steps are under consideration. In residential mortgages, the Federal Na tional Mortgage Association has adopted the auction technique for establishing prices on commitments to purchase stated amounts of insured mortgages. In other action, the max imum rate lenders can charge for these mort gages has been raised to bring them more in line with effective market rates. In agricultural credit, the statutory re strictions on interest rates authorized for Federal Land Banks have been removed. And these banks have acquired some experience in writing mortgages that provide for some flexibility of interest rate. In a number of states, usury laws are being revamped to pro vide less interference with credit flows. Significant changes could result from the Federal Reserve System studies of the possi ble benefits of a redesigned discount window. While no decision has been reached, the cur rent thought is that this source of credit should be made more available to member banks and that the discount rate should play a larger role in determining the amount of credit provided from the discount window. Administrative surveillance would still need to play a part in the discount function, but hopefully a smaller one. Implied in such thinking is more frequent adjustment of the discount rate and a closer linkage between the discount rate and rates in financial markets. Another move under consideration is for malization of the current policy of providing credit through the discount window to help accommodate seasonal needs of individual banks. Such a move would supplement cur rent market flows of funds in response to seasonal pressures and, hopefully, help banks that do not have fully effective linkage with the national money market. M an ag e m e n t— th e p riv a te side The improvement of financial markets cannot rest with public agencies alone, how ever. Banks are making substantial contribu tions as they broaden their activities and respond to improvements in transportation, communication, business procedures, and fi nancing practices. These developments, which are most apparent among the large banks in large cities, are being extended grad ually to smaller banks in outlying areas. A faster pace in perfecting both markets and management will bring substantial benefits. Small banks in outlying areas, would benefit particularly from improvements in their link age with national markets and in their ability to attract funds and acquire desirable assets consistent with the growth of their trade Business Conditions, June 1968 areas. New rural demands for fairly large amounts of funds in rural areas require that many small banks develop procedures for handling larger volumes of credit. To meet these demands, small banks must grow and must develop more effective linkage with financial resources outside of their areas. There are a number of possibilities for strengthening the ability of small banks to serve the growing needs of their communi ties. One involves the clothing of certain assets with liquidity they do not ordinarily have. For example, there might be ways of pooling the notes of farmers or small busi nesses in marketable packages or of having these notes serve as the basis for issuing mar ketable securities. Another applies the same technique to the marketing of liabilities issued by small banks, such as CDs, debentures, and notes. Conversely, credit surplus areas might obtain higher income on their savings by de veloping more effective means of participa ting in credits generated elsewhere. While many small banks could benefit sub stantially from efforts to develop new secon dary market instruments based on business, agricultural, and mortgage paper, the growth route is an even more challenging possibility, and harder to evaluate. S tru ctu re o f b a n k in g Not all small banks can grow to optimum size for efficient operation relative to the growing needs of their customers. Yet, changes in the technology of banking, like changes in other fields, promise increased benefits from size. Recent developments in credit cards and the increased reliance on computer facilities are cases in point. There is no intention here to propose a solution to the issue of branch and holding company banking in Illinois. Nevertheless, it is important to point out that the economic pressures flowing from technological im provements will intensify further. The variety and quality of services demanded will also rise further. And the structure of banking will continue to change. What form banking will take in Illinois is not clear. But further thought should be given to the possible array of financial institutions that will provide the best services most effi ciently. Attention should center on ways the financial mechanism can better meet the requirements of a rapidly changing economy. R e stra in ts on cre d it While better financial markets could set the stage for less interference from regulatory authorities and strengthen free enterprise in banking, more self-reliance and self-discipline on the part of banks is also needed. In efforts to maximize profits and the mistaken belief that all problems of achieving economic sta bility have been solved, some banks and other establishments (financial and nonfinancial) have become accustomed to operating with very low margins of liquidity and limited abil ity to adjust to unexpected changes. These establishments have become more vulnerable both to normal economic fluctuations and to changes in monetary and fiscal policy. Con cern about the impact of policy changes on such institutions may under some conditions restrain proper execution of policy. Although the Federal Reserve System is committed unequivocally to providing ulti mate liquidity in times of stress, the central bank was never intended as a substitute for the prudent management of individual banks. Moves to perfect financial markets will make it easier for managements of soundly man aged banks to adjust to changes in the supply and demand for funds. That could be of great benefit to their communities and, in times of stress, to the nation. 5 Federal Reserve Bank of Chicago Returns to labor and capital in agriculture 6 T h e government’s farm commodity pro grams are intended to give farmers operating essentially full-time businesses about as much income as their labor, capital, and manage ment skill would bring in another activity. After years of such programs— and billions of dollars of government subsidies—the goal of parity for most farmers is about as remote as ever. There are, however, substantial dif ferences within agriculture itself. Many farm ers manage too few resources to achieve re turns comparable to nonfarmers, while others appear to be earning incomes quite com parable with nonfarm incomes. Incomes have increased faster for farmers than for others in recent years, but the gap is still wide. The Department of Commerce estimated the median income for farm fam ilies at $4,841 in 1966, as compared with $7,582 for other families. Estimates by the Department of Agricul ture show a similar picture. In 1967, for example, income per person living on farms averaged just under $1,700— about 60 per cent of the $2,800 averaged by other people. Both estimates tend to understate the real income of farm families. The Department of Commerce estimated only money income, making no allowance for the value of home produced food or the rental value of farm dwellings. The Department of Agriculture tried to allow for non-money income by in cluding estimates for the value of produce and rental of the farm dwelling. But it did not allow for other factors, such as differences in the purchasing power of money income and income tax provisions for farm and nonfarm families. These factors also affect the level of real income. Professor Dale Hathaway of Michigan State University has estimated that farm fam ilies need about 86 percent as much money income as nonfarm families to maintain com parable levels of consumption. Even so, es timates by both the departments of Agri culture and Commerce suggest that average farm incomes would have to be substantially higher to be on a par with average nonfarm incomes. Hathaway points out, however, that not all people living on farms operate the farm for a living and not all people operating farms Income per person living on farms well under that for nonfarm population thousand dollars 5 ~ 0 1950 I I I I I I I I I 1 I I I I I I I. I ’52 '54 '56 '58 '60 '62 '64 '66 68 Business Conditions, Ju n e 1968 live on them. Farmers often have other sources of income, and many who are not farmers have large farm interests. Yet, when people are categorized by broad occupation or industry group, agriculture still comes off poorly in the figures. According to estimates by the Department of Commerce, money income of full-time, year-round farmers, farm managers, or farm laborers is substantially less than any other occupational group. The median income for farmers and farm managers was $3,547 in 1966, for example, compared with $6,856 for all male workers. Industry groups show much the same pattern. Median incomes for people working full-time in agriculture, for estry, and fisheries in 1966 were about 57 percent of the median for the next higher group (personal services) and 48 percent of the median for all groups. Money incomes* in agriculture relatively low, whether workers grouped by: industry . . . thousand dollars 0 1 2 I 3 I 4 I 5 I 6 I 7 I 8 ~T— 9 1---------1 transportation, com m unication, and other public u tilitie s mining manufacturing construction retail trade personal services agriculture, forestry, R e tu rn s to a g ricu ltu ra l re so u rce s Farmers, unlike most other occupations, often have substantial financial investment in their business—mostly in real estate. Numerous studies have been made on the rate of return from farm real estate, compared with other investments. Such studies neces sarily involve some fairly arbitrary estimates, since farmers’ incomes do not come in neat packages that separate “returns to capital,” “returns to labor,” and “returns to manage ment.” The usual estimation process starts with gross income, including non-money in come. When estimated production costs are subtracted, the remaining net income con stitutes the farmer’s current return on his capital and the labor and management (sup plied by him and other members of his fam ily). Returns to capital are usually derived as the residual left after deducting estimated charges for labor and management from net income. ond fisheries or occupation thousand dollars 0 1 2 3 4 5 6 7 8 9 professional and technical craftsm en and foremen operatives nonfarm laborers farmers and farm managers farm laborers ^Median money income, full-time male worker, 1966. Federal Reserve Bank of Chicago Despite their many shortcomings, such estimates can provide a basis for rough com parisons of returns on capital invested in agriculture with returns on other types of in vestments. Such comparisons indicate lower returns to capital in agriculture than in other investments. Rates of return to farm real estate trended downward after the late 1940s, according to Department of Agriculture es timates—from a fairly high 8 percent then to around 3 percent in the late 1950s. The average so far in the 1960s has been between 3 and 4 percent. Over the same period, rates of return from other equity investments, such as common stocks, have averaged higher. The average earnings-price ratio for 500 stocks, while also trending downward until recently, has fluctuated between 6 and 7 percent since the late 1950s. With the boom in business activity and rising interest rates, the differ ence has become even greater since 1965. U n d erp a id but w e a lth y 8 Yet, despite the apparent disparity be tween incomes of farmers and people in other pursuits, many farm people acquired sub stantial net worths. In 1962, the Board of Governors of the Federal Reserve System conducted a survey of the financial charac teristics of different groups. Farm operators and their families were found to have net worths twice that of other families— $44,000 on the average, compared with $22,600. Part of farmers’ higher net worth can be attributed to lower levels of consumption by farm fam ilies and their tendency to invest higher pro portions of income in productive assets. But a larger part can no doubt be attributed to sharp increases in the prices of physical assets owned by farmers—especially land. The value of farm real estate is estimated to have increased about $100 billion since 1950—an annual average increase of $6 bil lion. That is equal to 46 percent of the aver age annual net farm income during the same period. In eight of those 18 years, the aver age annual capital gain was equal to at least half the income from farming. The rising value of farm assets constitute only “paperprofits” for most farmers—profits that would quickly disappear if farmland prices dropped. But land prices have declined only one year out of the last 18. O th e r e v id e n ce Average or aggregate figures on farm in come obscure the wide range of incomes and wealth within agriculture. Sizes and types of farms are, of course, important factors af fecting levels of income. Large farms often use new technology more efficiently than small farms, with the result that production costs per unit of output tend to be lower and incomes higher. The range of incomes from farms of dif ferent sizes and types is even greater when total incomes are compared—including im puted capital gains and income of farm fam ilies from sources other than their farm. The effect of rapidly rising land prices and the resulting steep rise in the net worth of farm owners increases, of course, with in creases in size of farm. A recent study by the Department of Agri culture sheds new light on the levels of in come of farm people. In the study, the actual incomes of farmers (including net income from farming and net gain in worth) were arrayed by size of farming operations. The returns to labor and capital were then com pared with what equivalent resources might have earned elsewhere in the economy. Farm operators were assumed to have taken non farm jobs requiring comparable education and experience and 1 ) leased their real estate and became landlords or 2 ) sold their farms Business Conditions, Ju n e 1968 and invested the equity in common stock. L a b o r e a rn in g s an d re tu rn s on cap ital A person’s earnings from labor are gen erally associated with age, education, and sex. In this study, such relationships were established for use in estimating wage-equiv alents for farmers operating different size farms and for other unpaid members of the family, compared with urban workers. Oper ators of farms with sales grossing more than $20,00 0 were estimated to have a wage rate about 5 percent higher than the average wage of manufacturing workers. Operators with farms at the other end of the scale, grossing less than $5,000, were estimated to command a wage about 20 percent less than the aver age manufacturing employee. The difference was attributed mainly to the lower education and older age of farmers on the smaller or less productive farms. Returns to farm operators’ capital were related to what similar equity could earn if the farms were leased or equivalent capital was invested in stocks. Both comparisons in cluded provision for capital gains. For the landlord comparison, rent was established at about 6 percent of recent land values and the annual rate of capital gain was estimated at 5 per cent. Hence, the total return on invested capital to landlords ranged from 11.1 percent in 1959 to 11.8 percent in 1966. For the stockholder, dividends were estimated at an average of a little more than 3 percent. Es timates of capital gain of common stocks varied widely for individual years—from 7 to 13 percent—with the result that estimated total returns to stockholders ranged from 16.6 percent in 1959 to 11.0 percent in 1966. Viewed in this way, the estimates show a disparity between incomes from agricultural and nonagricultural pursuits similar to earlier studies. In 1959, for example, returns to Returns to larger farm ers comparable to those in other occupations returns to form ing as percent of those earned by landlords or stockholders, 1964 0 25 50 75 100 125 150 175 farming were roughly half what farmers could have earned by working full time off the farm and investing their capital either as landlords or stockholders. In 1966, which was an exceptionally good year for farmers, some of them did consid erably better than they could have as land lords or stockholders, even though farm earn ings in the aggregate were still about a fifth below the earnings estimated for the landlord and stockholder comparisons. The differences were due to size of farm. Size of fa rm s A breakdown of farms by size shows sub stantial differences between farms that may be considered “commercial” and those con sidered marginal or part time. In 1964 and Federal Reserve Bank of Chicago 10 1966, for example, farmers with operations Their net incomes were only about a third grossing sales of more than $2 0 ,000 —an av those of landlords and stockholders with sim erage of about $60,000— had total net earn ilar resources. Many of the people operating these small ings (including capital gains) averaging farms are, of course, grossly underemployed. around $20,000. In most instances, that was considerably more than they could have The resources under their control are usually far less than needed to keep one person fully earned, according to these estimates, if they occupied. According to the Department of had used their capital as landlords or stock Agriculture, farms with sales under $5,000 holders and obtained off-farm employment. require only about 23 manhours of labor a Farmers selling products in this volume week—little more than half-time. This is accounted for slightly more than 16 percent against about 109 hours—more than two of all farms but nearly 70 percent of all farm and a half manweeks—for farms with gross production and government payments to sales of more than $2 0 ,0 0 0 . farmers. Farmers with gross sales between $ 10,000 and $20 ,0 0 0 accounted for 16 per N o n farm e a rn in g s cent of the farms and 17 percent of the cash Although nonfarm sources of earnings receipts and government payments. Their were not considered — the study being in total incomes ranged from $6,600 to $9,000 tended to compare only returns to farm re in those years— about three-fourths as much sources—these earnings must be included in as landlords and stockholders with similar an evaluation of the well-being of people livinvestments in 1964 and slightly more than four-fifths as much in 1966. These retu rn s are within the range Capital gains and off-farm income Hathaway estimated as help boost total income needed for farm fam R eturns fro m fa rm in g ilies to live at levels O ff- fa r m T o tal N et C a p ita l comparable to those of incom e incom e incom e g a in s N u m b e r o f fa rm s G ro s s rece ip ts nonfarm families. (d o lla rs p er fa rm ) (th o u sa n d s) (p e rcen t) (d o lla rs ) Farmers grossing 2 0 ,0 0 0 a n d o v e r 17,9 0 9 1 ,91 4 4 ,4 8 9 11,5 0 6 8 325 1959 less than $ 10,000 in 2 ,2 5 2 2 3 ,8 3 7 6 ,2 9 8 17,5 3 9 527 16 1966 sales did not fare 1 0 ,0 0 0 - 1 9,999 nearly so well. Even in 7 ,9 3 4 1 ,322 1,521 12 5,091 1959 503 the fairly good year of 2 ,1 7 3 1 ,59 4 1 0 ,6 3 6 6 ,8 6 9 510 16 1966 1966, farm s in the 5 ,0 0 0 - 9 ,9 9 9 1 ,545 5 ,7 6 6 693 17 1,061 1959 3 ,1 6 0 $5,000 to $9,999 class 7 ,4 2 9 14 3 ,9 8 9 1 ,527 1,913 1966 446 had incomes equal to U n d e r 5 ,0 0 0 only about two-thirds 1959 63 1 ,114 509 2 ,3 7 8 2 ,5 7 6 4,001 those of the landlord 1966 1 ,769 55 1,071 813 3,421 5 ,3 0 5 and stockholder com A ll fa rm s parisons. Farmers with 1959 4 ,0 9 7 2 ,7 7 3 1 ,042 2,071 100 5 ,8 8 6 1966 3 ,2 5 2 100 5 ,0 4 9 2 ,0 1 3 2 ,7 3 8 9 ,8 0 0 sales less than $5,000 did even less well. S O U R C E : U S D A , ''P a r it y R eturns Position o f F a rm e rs, " 1967. Business Conditions, June 1968 ing on farms. Many farm people derive large parts of their income from sources other than their farm. More than a third of the total income of farm families was earned from offthe-farm sources in 1966. Like farm income, off-farm income varies widely with the size of the farm operation. Farmers with more than $20,000 in gross sales had off-farm incomes of about $2,200 in 1966—roughly 11 percent of their total net income. At the other end of the scale, off-farm income accounted for more than three-fourths of the earnings of farmers with gross sales less than $5,000. This lower-income group had off-farm incomes averaging more than $3,400. These smaller operations accounted for more than half the number of farms but less than 7 percent of the farm products. The low level of productivity on these farms hardly qualifies them as bonafide farm operations. Many are properties on which retired people live. Yet, because this group is usually in cluded in statistics describing agriculture, commercial farms often have features attrib uted to them that distort the picture. To say this is not to dismiss the problem of low agricultural income by defining it away. Certainly, programs to benefit low-income groups are needed. But for bonafide opera tors with strong managerial skills operating farms large enough to use new technology effectively, farming appears to provide re turns comparable—or nearly comparable— to those acheived in other pursuits. Returns in agriculture clearly have been high enough to cause farmers to bid up the price of farm land and greatly increase their new invest ment in farming. Contrary to popular opinion, commercial agriculture is growing rapidly. Even though the total number of farms has declined in recent years—from more than 4 million in 1959 to around 3.2 million today—the num ber of larger commercial farms has increased sharply. There were, for example, 60 percent more farms grossing $20,000 or more in 1966 than in 1959. However, farms grossing between $10,000 and $19,000 increased slightly, from 503,000 to 510,000 over the same period. Farms grossing under $10,000 declined a third, to 2.2 million. 11 Federal Reserve Bank of Chicago Bank credit cards: saturation in the Midwest? 12 I n less than two years, bank credit cards have become a common banking service throughout much of the Seventh Federal Re serve District—Iowa being the major excep tion. Almost 1,000 banks—half the insured banks in district portions of Illinois, Indiana, Michigan, and Wisconsin—offer credit card services. Because of ceilings on interest charges in Iowa, bankers there say credit card plans cannot be developed profitably. Although bank credit card plans have been used in the district since 1952, only a hand ful of banks in Indiana, Michigan, and Wis consin offered the service before 1966. In the mid-1960s, banks searching for ways to expand their services began exploring the opportunities afforded by credit cards. With the widening acceptance of credit cards gen erally, the growing availability of efficient processing equipment, the increasing evi dence that credit cards could be profitably provided, and the rise in competition from sources both in and outside the district, banks entered the credit card field in force in 1966 and 1967. In their drive to establish credit cards as a convenient means of financing consumer purchases, banks in the district have taken on more than 4,250,000 credit card accounts. More than 84,000 merchants accept one or more bank cards issued in the district. Nevertheless, in March, district banks were carrying only $145 million of credit out standing on credit card plans. Of this total, more than $75 million was held by Illinois banks, $42 million by Michigan banks, and the remaining $28 million shared by banks in Indiana and Wisconsin. The amounts outstanding under credit cards are small compared with other forms of bank loans to individuals. Of the $5.3 billion of single payment and instalment loans out standing in March to individuals at member banks in district states where credit cards are offered, less than 2.7 percent was loaned on credit cards. More than $2 billion was out standing on automobile loans, and more than $1.7 billion on other types of instalment loans to individuals. V a r ie t y in b a n k card s Three types of credit card plans are used in the district. Some banks operate their own; some are affiliated with such travel and enter tainment plans as American Express and Carte Blanche; and some are affiliated with other banks having their own credit cards. Many factors influence a bank’s choice of plan: the objectives of its management, the market it wants to serve, and the cost of initi ating and operating different types of plans. Choices are affected by the competition in the area and whether the state allows branching and banking by holding companies. Only 25 district banks are affiliated with travel and entertainment cards. Under these plans, banks extend credit to cardholders for the amount of their purchases on the card. These plans are the least costly for banks to introduce and operate, but the market is limited both by the cards being issued usually to only higher income groups and by their Business Conditions, June 1968 being accepted at only a few types of stores. Even fewer banks—eight in the district last December—operate independent credit card plans. Under these plans, a bank solicits cardholder and merchant accounts, operates an authorization center controlling large pur chases and overuse of cards, processes the sales slips received from merchants, and bills the cardholder monthly. The bank accepts only sales slips generated by its cardholders, and the card can be used only with merchants that have signed up with the bank. Most of these independent plans were de veloped in areas with no direct competition from other credit cards. Many are offshoots of an earlier era when credit cards were in tended primarily to improve methods of handling local merchants’ accounts receiv able. With the development of competition and the resulting fragmentation of their mar kets, some independents sought affiliation with other credit card systems. While the re maining independents have strong positions in some communities, there are probably few opportunities in the district today for the successful introduction of new independent card plans. Most district banks offering credit card service are affiliated with plans sponsored by other banks. Three credit card systems are widely used in the Seventh District—Midwest Bank Card in Illinois and Indiana, and First Wisconsin Charge Card and Michigan Bankard, respectively, in those states. Although each developed along slightly different lines, they are generally typical of the credit card systems in operation elsewhere in the United States. The la rg e system s The major credit card systems in the dis trict differ from independent credit card operations mainly in providing for the par ticipation of many affiliated banks. Under the First Wisconsin Charge Card and Michigan Bankard plans, affiliate banks sign up merchants in their trade areas, furnish the sponsoring bank with names of customers to be issued credit cards, and serve as initial banks of deposit for sales slips coming in for collection. The sponsoring bank—First Wis consin National in Milwaukee or Michigan National in Lansing — issues credit cards, operates the authorization center, processes sales slips, and bills cardholders. This arrangement allows affiliate banks to offer credit cards without incurring the con siderable expense of developing systems of their own. Also unlike independent plans, it allows them to provide cards their custo mers can use outside the immediate trade area. It allows the sponsoring bank to expand the areas of both its credit card operations and its potential consumer lending. Michigan Bankards are offered in Mich igan by 74 banks. So far, more than 600,000 credit cards have been distributed for use at some 12,000 retail businesses in Michigan. More than 900,000 First Wisconsin Charge Cards have been issued through 145 banks, and almost 5,000 Wisconsin merchants ac cept the cards. The Michigan Bankard can ordinarily be used only at businesses signed up with affili ate banks in Michigan. The only interchange agreement with another system is in the Up per Peninsula of Michigan, where sales slips are exchanged with First Wisconsin. First Wisconsin is a member of Interbank Card, a still larger affiliate system set up to exchange sales slips nationally. Banks affili ated with the Interbank system issue cards of their own design, but all cards carry a symbol identifying them as acceptable to any bank or merchant in the system. Merchants receiving another Interbank 13 Federal Reserve Bank of Chicago card handle it as though it were a local card, phoning the authoriza tion center about large purchases, and depositing sales slips at their local bank. Settlement between banks is made by sending a draft on the bank that issued the card being sent through the usual clear ing channels and by airmailing the sales slip to that bank. A national exchange system makes bank credit cards more competitive with travel and enter tainment cards. It also makes it possible for bank customers to purchase a broader range of serv ices over a greater area. How the systems work independent system » b ills c a rd h o ld e r I '1' I l I '1' I card issuing bank \ m a k e s p u rc h a se usin g cre d it c a rd , ICS r .- , i r ( i ■ [ D s /ip . , r merchant affiliate system b ills c a rd h o ld e r ran A unique system 14 Midwest Bank Card is a re gional exchange system. Head quartered in Chicago, it is unique among systems providing inter change privileges. Organized by five Chicago banks in the fall of 1966 to provide a means of com peting with each other while offer ing merchants and cardholders the benefits of interchangeable credit cards, Midwest Bank Card is now the largest credit card system in the district and one of the largest in the country. Because of the unit banking structure in Illinois, the originating banks developed a sys tem that provided: 1 ) credit cards acceptable to all merchants par ticipating in the system but indi vidualized for each sponsoring bank, 2 ) independent action for sponsoring banks, 3) arrangement for clearing sales slips between sponsoring banks, 4) opportuni- i card issuing bank t m a k e s ' p u rc h a se u sin g c r e d it c a rd \ d is c o u n t s \L2jL1=3 ^ v|* ,. sa te s sh p d is c o u n t s sa te s sh p merchant affiliated bank interchange system * b ills c a r d h o ld e r m a k e s 'p u r c h a s e u sin g c re d it^ c o rd interchange exch an ge of s a le s s lip s a t p a r merchant d isc o u n ts so le s ^ s l/p d isco u n ts h o /e s sh p m j j I 'l 'B 'l 'B 'l i I affiliated bank card issuing bank Business Conditions, June 1968 ties for participation by correspondent banks, and 5) open membership to any commercial bank. There are now 14 sponsoring banks in the system— all in Illinois, Indiana, and Michi gan, and 13 of them in the Seventh District. More than 820 banks participate in the sys tem—750 of them in the district. The system has more than 3 million cardholders and the cards are honored by more than 60,000 Midwest merchants. Midwest Bank Card’s central office coordi nates activities of sponsoring banks much as a clearing house. It maintains standards for credit cards, forms, and equipment; arranges for the interchange and clearing of items; establishes requirements for merchants and banks participating in the system; and pro motes technical development of the system. The office has no operating facilities and pre scribes no standard price for credit card service. Sponsoring banks operate much the same as Michigan National and First Wisconsin in soliciting affiliated banks, and the affiliates perform the same functions. W ho e x te n d s th e cre d it? Even though nearly 1,000 district banks provide credit cards, only 58 have credit out standing on them. Because the bank sponsor ing the card bills the customers, it also ex tends the credit to them—the credit being extended on the basis of revolving loans. The affiliated bank only extends credit for the few days between discounting of the sales slips and receipt of funds from the sponsoring bank. Although this affiliate arrangement lodges most of the credit with a few large sponsoring banks, there appears to have been no substi tution of credit card borrowing for other forms of consumer borrowing at affiliated banks. The effect is apparently to increase total consumer credit, rather than reduce the affiliate banks’ portfolio of consumer credit. In some cases, affiliates may participate with the sponsoring bank in the revolving credits generated by cardholders. This ar rangement is not widely used in the Seventh District, but it may provide a possible avenue for future expansion of consumer lending at smaller banks. To the extent that credit cards substitute for charge accounts at local merchants, their use may tend to reduce merchant needs for bank financing to carry accounts receivable. There are no indications, however, that the financing needs of merchants have been de clining. The increased ability of small mer chants to compete on credit sales may even increase business activity and indirectly in crease, rather than decrease, merchant needs for local bank credit. Com petition in re v o lv in g cred it With the participation arrangements avail able in the district, banks of all sizes can offer credit card service without committing large amounts of resources. Banks not want ing to offer credit cards can offer alternatives in the form of check credit, overdraft, or other revolving credit plans. These alternatives have some advantages over credit cards. Where credit cards can be used only with a participating merchant, these credit plans can be used anywhere. The only requirement is that the business be will ing to accept a check. Also, if a customer needs cash, he can get it by using his credit facility at the bank. Check credit plans provide a customer a line of credit he uses with specially prepared checks. Use of a check activates a loan that he can repay in full or on a revolving basis. Overdraft plans are similar, except that 15 Federal Reserve Bank of Chicago loans against the customer’s line are activated by checks drawn against his regular checking account. If the balance in the account is not sufficient to cover the check, the customer is automatically given a loan. As with check credit, he can repay the loan when he receives his statement, either in full or on a revolving basis. Despite the advantages of check credit, overdraft, and other forms of revolving credit, relatively few district banks have used these plans as substitutes for credit cards— an ob vious exception being in Iowa, where, with no credit card services, eight banks offer re volving credit or overdraft plans. Elsewhere, 111 banks offer these alternatives to credit cards, but 79 of them also offer cards. There are several reasons for a bank of fering both check credit and credit card serv ices. Many banks, seeing differences in the markets served by credit cards and the other forms of revolving credit, provide both to serve a wider spectrum of credit needs. Other banks consider check credit an answer to most special credit needs but also provide credit cards either to meet local competition or to be active in a service that could become increasingly important. A number of banks began offering check credit in the late 1950s and early 1960s. By the mid-1960s, 57 offered check credit. The number almost doubled in 1966 and 1967 but still grew slower than the number offer ing credit cards. Because banks can offer check credit with little expense — the processing procedures are similar to those already used for checks and loans—there may be substantial oppor tunities for further expansion of check credit and overdraft plans. The number of banks offering credit card plans could also increase further. However, there are few areas of the district outside Iowa where customers do not already have access to credit card service. Unless the form of credit cards and the serv ices they provide are significantly changed, future growth in credit cards in the Seventh District will probably be reflected largely in the amount of credit outstanding, and pos sibly in the number of banks affiliated with existing systems, rather than in the number of banks issuing cards. BUSINESS CONDITIONS is published m onthly by the Federal Reserve Bank of Chicago. Roby L. Sloan w a s p rim a rily responsible fo r the article "Returns to labor and cap ital in a g ri culture" and K arl A . Scheld fo r "B a n k credit cards: saturation in the M idw est?" Subscriptions to Business Conditions a re a v a ila b le to the public w ithout charge. For in fo rm a tion concerning bulk m ailin g s, address inquiries to the Federal Reserve Bank of Chicago, Box 834, Chicago, Illinois 6 0690. A rticles m ay be reprinted provided source is credited. 16 Modern Money Mechanics: This w orkbook on deposits, currency, and bank reserves—w ith T-account descriptions of the m onetary expansion process and the factors affecting mem ber bank reserves—has been revised. Copies of the new edition can be obtained by w riting the Research Departm ent, Federal Reserve Bank of Chicago.
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