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a n e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f C hicago Interbank lending— an essential function Dwindling world grain reserves Banking developments novem ber 1974 Interbank lending— an essential function 3 Dwindling world grain reserves 8 Current analyses focus on the trend of the federal funds rate as an indicator o f the thrust o f m onetary policy. Too little attention has been paid to some im portant economic functions o f the interbank loan m arket. Longstanding trends in production and consum ption have led to the current tight conditions in world grain reserves. Banking developments 13 Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department Federal Reserve Bank of Chicago, P. O. Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Department with a copy of any material in which an article is reprinted. 3 Business Conditions, November 1974 In te rb a n k lending an essential function The federal funds rate has become a closely watched indicator o f changes in money market pressures. This rate, as published, is a weighted average o f the interest rate paid on unsecured loans between banks for one day at a time. It tends to be at the low end o f the spectrum o f m oney market rates in periods o f m onetary ease and at the high end when authorities are trying to restrain m onetary expansion. These swings over the interest rate cycle reflect changes in the w illingness o f the monetary authorities to supply the banking system with sufficient reserves to support the current pace o f deposit growth. If deposits are growing faster than desired, the Federal Reserve slows down the rate at which it supplies reserves through open market operations so that the cost o f reserves (federal funds rate) rises and discourages banks from ex panding deposits and their holdings of assets (loans and investments). With current analyses generally focus ing on the trend o f the federal funds rate as an indicator o f the thrust o f monetary policy, too little attention has been paid to some important econom ic functions the in terbank loan market performs, whatever the policy posture. First, it contributes greatly to the efficiency o f the banking system in serving both credit and deposit customers. Second, it enhances the pre cision with which monetary policy is implemented. Every day several billion dollars are sold (loaned) by some banks and purchas ed (borrowed) by other banks in the federal funds market. Some transactions are arranged directly between the buyer and seller, but a large portion o f total activity is arranged through brokers. The great bulk o f the dollar volum e is in the form of transfers between deposit balances, also called “ reserves,” o f member banks at the Federal Reserve. Such shifts are effected for immediate credit to the borrower by a telephone or wire order on the part o f the lending bank. N onm em ber banks also par ticipate in the interbank loan market, through the reserve balances o f their cor respondents who are members. There is no measure o f the total amount o f such interbank loans, but daily reports from about 50 m ajor money market banks alone often show transactions aggregating more than $15 billion, equal to nearly h a lf o f the total outstanding member bank reserves. Individual trans actions range from less than $100 thou sand to more than $100 million. What ac counts for the demand and supply o f very short-term funds on the part o f banks? The role of reserves Reserves held by member banks at the Federal Reserve are working balances through which m any transactions (such as check clearings) are channeled. A bank that has a greater value o f checks written on its deposits than the value of checks deposited with it written on other banks pays the difference by drawing down its reserve account. N orm al deposit flows between depositors o f the thousands of commercial banks in the United States result in significant shifts in the distribu tion o f reserves am ong individual member banks. Besides the need to hold funds on 4 deposit with the Reserve banks to effect such payments, the Federal Reserve re quires that member banks hold on average for each weekly reporting period (Thurs day through W ednesday), an amount o f reserves—“ required reserves” —equal to a specified percentage o f deposits. By setting the percentage o f deposits that must be held as reserves (i.e., reserve requirements) and controlling the overall level o f reserves in the banking system, the monetary authorities im pose a ceiling on the quanti ty o f deposits and credit that can be created by member banks. A member bank whose reserves just satisfy its reserve require ment is vulnerable to becom ing deficient in reserves in the event o f an unanticipated deposit outflow. This follow s since every dollar o f net deposit outflow lowers reserves by a dollar, while required reserves fall by only a fraction o f a dollar. Managing reserves A member bank can meet a reserve deficiency in a number o f ways. Normally, a bank will use w hichever w ay it finds to be least expensive. The bank can replenish reserves by selling assets. While this ap proach will produce the necessary reserve adjustment, it is inefficient, both for the in dividual bank and the system. It means a great number o f transactions, with all the costs involved in buying assets when deposits and reserves flow into the bank and selling assets when deposits and reserves flow out. This is a cumbersome w ay to make day-to-day adjustments, and involves the risk o f loss due to changes in market values. Another alternative is to borrow reserves from the Federal Reserve discount window at the adm inistratively set dis count rate. But the borrow ing privilege is not freely available on a regular basis. Its purpose is to cover unusual and temporary needs, and adm inistration o f the window imposes an im plicit cost in the form o f sur Federal Reserve Bank of Chicago veillance o f member banks that use it over extended periods o f time. Thus, today’s borrowings tend to reduce the willingness o f the Federal Reserve to accom m odate future borrow ings by the bank. A third approach for meeting potential deposit outflows is for a bank to maintain reserves at a higher level than required reserves dictate. This involves a cost in that the bank foregoes the return it could have earned on the “ excess” reserves if they were invested in assets. The interbank loan market offers banks yet another method o f adjusting to deposit inflow s and outflows. These trans actions, usually referred to as “ federal funds,” take advantage o f the fact that an outflow o f deposits and reserves at one bank is usually m atched by an equal in flow o f deposits and reserves at another bank. Thus, a loan equal to the deposit flow from the bank with the deposit inflow to the b a n k w ith the deposit outflow eliminates the disturbance to reserve positions at both banks. Since the inter bank loan market serves as both a source and outlet for reserves, it increases the ef ficiency o f reserve usage by permitting the banking system to operate with lower levels o f excess reserves. This greater ef ficiency, in turn, tends to increase the ear nings o f depositors (either in the form o f in terest or services) and to lower bank in terest charges to borrowers. Market behavior Since member banks must satisfy their reserve requirements over a weekly settlement period, the interbank loan market exhibits a distinct weekly pattern. Early in the settlement week (Thursday, Friday, and M onday), the federal funds rate tends to be fairly stable and slightly above the weekly average. On these days, the reserve positions o f individual banks and the banking system as a w hole are still relatively unclear and subject to change as Business Conditions, November 1974 the week progresses, so that the interest rate on interbank loans tends to hover near the banking system ’s expected rate for the week. This expected rate is likely to be heavily influenced by the interbank loan rates in recent weeks. A n y deviation from the expected rate would cause banks to vary the relative use they make o f the interbank loan market and the asset market and tend to eliminate the deviation. With a rate above the ex pected rate, the interbank loan market would attract sellers and discourage buyers o f reserves. Conversely, an inter bank loan rate below the expected rate would cause the asset markets to gain sellers and lose buyers o f reserves. This is especially so since the earlier in the week a bank makes an asset adjustment, the longer the holding period and the smaller the volum e o f transactions necessary to offset a given absolute loss o f reserves. Since transaction costs rise with the size and number o f the transactions, the earlier in the week the adjustment is made, the lower the transactions cost. These shifts from interbank loans to asset adjustments do tend to spread any upward or downward pressures on the fed funds rate to other short-term debt markets. The federal funds rate tends to be higher early in the week, de clining as the week progresses. daily rate as percent of weekly average T .0 2 4 •1 T.1.025 i T 1.015 Parenthesis enclose one standard devia tion (a measure of dispersion) above and below the mean Standard deviation is the square root of the sum of squares of deviations of observations from the mean of the observations divided by one less than the total number of observations. T J 1 .000 I • 0 .9 36 i J ____ I____ L Thurs. Fri. Mon. Tues. Wed. Data fro m Federal Reserve Bank o f New York, D a ily E ffe c tiv e Federal F unds Rate, S e p te m b e r 21, 1968-S eptem ber 11, 1971. 5 Later in the week (Tuesday and Wednesday), the federal funds rate is more volatile and tends on average to decline from its level earlier in the week. The rate is more volatile because the relationship b etw een reserves held and required reserves within the settlement week becomes clearer and the possibility of a reversal o f deposit flow s within the settle ment week has diminished. In addition, in dividual banks are more willing to accept a federal funds rate that is sharply different from the longer-run expected average because the transactions cost o f adjusting reserves through asset changes late in the week is relatively high. The closer the end o f the settlement week, the larger the volume o f asset changes required to offset a given reserve loss for that week. Because the probabilities o f deposit outflows decline as the end o f the settle ment week approaches, the need for a cushion o f excess reserves declines and the federal funds rate tends to m ove down. Faced with accumulated excess reserves that approach worthlessness at week’s end, the bank is w illing to loan reserves at a lower rate. A bank waiting until the end of the settlement week to make up a reserve deficiency will, on average, get funds at a lower rate, but will be risking greater variance from the longer-run average rate. The market and credit allocation The interbank loan market also assists the banking system in achieving a more efficient distribution o f credit. Banks serve an intermediary role in the allocation o f credit—acquiring funds when deposits are made by the public, then using these funds to extend credit through loans or the purchase o f securities. However, deposits are not likely to be distributed among banks in such a w ay that the best credit needs o f the econom y can be efficiently met by each bank individually at the local level, especially in a banking system with 6 Federal Reserve Bank of Chicago many unit banks that operate in fairly small market areas. Some banks are unable to satisfy relatively attractive credit requests out o f their own deposits, while other banks have surplus funds after satisfying relatively less attractive credit requests. By enabling individual banks to be continuous lenders or borrowers o f funds over sustained periods o f time, the interbank loan market divorces the extension o f credit from the ability o f individual banks to attract deposits. A gain, this increases the efficien cy o f the credit market, raising the return to deposit holders and lowering the cost of bank credit to borrowers. Data available on federal funds trans actions indicate that smaller banks in the aggregate are net lenders and larger banks are net borrowers, although the size and com position o f these flow s vary greatly in the short run in response to temporary deposit shifts. Small banks usually par ticipate in the market through their larger correspondents, which, in turn, offset any undesired im pact on their own positions in the national market. B a n k s that are p ersisten t net borrowers (buyers o f federal funds) are financing part o f their assets through the interbank loan market. Banks that are Large banks tend to be net buyers of federal funds, while small banks are net sellers 8 m oney m arket banks 45 other weekly reporting banks 8 8 0 other district member banks Average daily net purchases of federal2 funds: 1973 (m illio n s) Seventh Federal Reserve District Banks Average total deposits:1 1973 (m illio n s) 3 5 3 9 .8 9 24 9 .1 5 4 3 3 .5 7 12 .86 The market and monetary policy 3 2 .2 6 -1.08 The Federal Reserve usually im plements monetary policy by buying or selling governm ent securities in the open market. This alters the level o f reserves in 1 Data from June 1973 and December 1 9 73 call reports. 2 Data from Federal Reserve Bank of Chicago fo r 1973. continuous lenders (sellers o f federal funds) are passing up the return on credits they could extend to other customers in favor o f the return on interbank loans. This behavior is reasonable for both buyer and seller if the rate on interbank loans is below the rate o f return available to the buying bank on its loans and investments, but above the rate available to the selling bank. Lending or borrowing funds in the in terbank loan market over sustained periods o f time involves an element o f in terest rate risk when effected through a series o f one-day loans. The decision to use the federal funds market as either a source o f or outlet for funds over a sustained period incorporates expectations about the course o f interst rates, by both borrower and lender. If the one-day loan rate rises above the lender’s expected levels, then his return increases; a fall below his expected levels decreases his return. Conversely, a rise above the borrower’s expected one-day rate lowers his return, while a fall below in creases his return. Reallocating funds to higher rates of return within the banking system could be a ccom p lish ed without subjecting the banks involved to the risks o f interest rate fluctuations by m atching the maturity of the asset purchased, or foregone in the case o f the lender, with an interbank loan of equal maturity. In recent years, the development o f the market in so-called “ term federal funds” has this potential. While involving transfers o f immediately available reserves, these interbank loans may have maturities o f as long as one year, but the rate o f interest over the maturity o f the loan is set at inception. Business Conditions, November 1974 the banking system and thereby the quan tity o f bank deposits, bank credit, and the level o f interest rates. The Federal Reserve pays for the securities it buys with a check drawn on itself. When the check is deposited by the seller o f the securities, it increases reserves and generates an ex pansion in bank deposits, an increase in bank credit, and a lowering o f interest rates. Similarly, a sale o f government securities by the Federal Reserve is paid for by a check drawn on reserve balances so that bank reserves fall, lowering deposits and bank credit, and raising interest rates. Because policy action has its first im pact on bank reserves, because the federal funds market reflects the relationship of the supply and demand for these reserves, and because banks have choices between interbank loans and other money market instruments, this market tends to serve as a conduit through w hich the effects o f policy are spread throughout the credit markets. The holding o f excess reserves— reserves which are not used to full poten tial in supporting deposits—constitutes a slippage in the process o f implementing policy. Unexpected fluctuations in the percentage o f total reserves held as excess reserves ham per m onetary policy by in ducing fluctuations in the level o f bank deposits, the quantity o f bank credit ex tended, and the level o f interest rates. By permitting banks to offset flow s o f funds within the banking system, the interbank loan market reduces fluctuations in excess reserves and thereby increases the preci sion o f m onetary policy. T h e fe d e ra l fu n d s market also provides valuable inform ation for the short-run implementation o f monetary policy. The m onetary authorities face a number o f problems in determining what daily open market actions are appropriate to the achievem ent o f money, credit, and 7 interest rate targets. Deposit changes, for example, are not known accurately for a week or two. A n d despite elaborate projec tions, the volum e o f reserves is not known precisely until the follow ing day. These uncertainties are important because open market operations are not the only factor causing changes in the reserves o f the banking system. There are three principal sources o f uncertainty in reserve fluctuations: (1) drains or inflow s due to exchanges by the banks o f vault cash for reserves at the Federal Reserve; (2) changes in the amount by w hich credits made to payee member bank reserve ac counts in the check clearing process exceed funds not yet collected from paying banks ( k n o w n as F ed era l R eserv e float); (3) changes in the rate at which the Treasury’s balance at Federal Reserve banks are disbursed to commercial banks. These outside factors, which often affect reserves by several hundred million dollars in a single day, produce changes in deposits and interest rates in precisely the same way as Federal Reserve operations. In attempting to achieve desired monetary effects in its day-to-day actions, the Federal Reserve estimates the inter bank loan rate that is consistent in the short run with the desired level o f deposits and supporting reserves. Movements o f the actual rate outside the targeted range provide clues that reserves are either insuf ficient or excessive, and consequently point to the need for policy actions. Thus the rate on interbank loans per form s as a two-directional transmitter. It signals temporary im balances in the market that trigger day-to-day open market action. But over weeks or months, the trend o f this rate reflects the monetary authorities’ response to the strength o f credit demands and monetary growth. Robert D. Laurent 8 Federal Reserve Bank of Chicago D w in d lin g w o rld I grain ■ reserves World grain consum ption has expanded sharply in the Seventies in response to both population growth and rising world a f f lu en c e. D u rin g the same period, however, adverse weather conditions have slowed the rate o f increase in world grain production. A s a result, world grain r e s e r v e s — a s m easu red by e n d i n g carryover stocks—are likely to fall below 87 m illion metric tons* by mid-1975. This level would be 54 percent below the record h ig h level o f the late Sixties, and equivalent to about 9 percent o f the w orld’s annual grain consumption. The current tight grain reserve situa tion w as a m ajor reason for holding the re cent W orld Food Conference in Rome. Although a number o f issues were in volved, the basic concerns o f the con ference centered on the necessity to stimulate world food production, the need for m aintaining adequate food reserves, and the provision o f food to areas where starvation conditions exist. The issues and the recom m endations o f the World Food Conference will likely be topical for a long time. T his article is intended to provide a better understanding o f the trends in production and consumption that led to the tight condition in world grain reserves. *S ta tis tic a l measures in th is a rtic le are based on the m e tric system. The fo llo w in g equations can be used to co n ve rt m e tric figu res in to U .S . eq uivale nts. 1 hectare = 2.471 acres 1 q u in ta l = 220.4622 pounds 1 q u in ta l/h e c ta re = 89.293 po un ds/acre 1 k ilo g ra m = 2.2046 pounds 1 m e tric to n = 2,204.622 pounds Business Conditions, November 1974 9 Less left over World grain reserves have experienced two periods o f significant tightening since the beginning o f the Sixties. Total grain r e s e r v e s — a s m easu red b y e n d i n g carryover stocks—amounted to 174 million metric tons in mid-1961, equivalent to about 27 percent o f annual consumption. The level declined to a low o f 113 million metric tons, or 15 percent o f world con sumption, by mid-1966, after two years o f particularly sharp gains in consumption. With the aid o f good weather and new seed varieties, production outpaced rising con sumption during the latter part o f the Six ties, boosting ending carryover grain stocks to a high o f 187 m illion metric tons by mid-1969, equal to 24 percent o f annual world consumption. T he subsequent trend, however, has been decidedly downward as consumption has accelerated, while in creases in production have been somewhat slowed by adverse weather conditions. The continuing depletion o f coarse grain (com , sorghum, barley, oats, and rye) stocks and the absence o f a significant recovery in wheat stocks h ave led to the re cent tightness in world grain reserves. Current estim ates indicate mid-1975 carryover stocks o f coarse grains will be equivalent to less than 7 percent o f annual world consumption. Wheat stocks will likely be equivalent to 14 percent o f world consumption. The reduction in grain reserves has U.S. and world wheat reserves, by volume and as a percent of consumption U.S. and world coarse grain reserves, by volume and as a percent of consumption million metric tons been particularly evident in the United States. In the early Sixties, U.S. carryover stocks o f wheat consistently exceeded an nual utilization (consum ption plus ex ports) and were equivalent to roughly oneh a lf o f world stocks. Similarly, U.S. carryover stocks o f coarse grain were equivalent to about one-half o f annual utilization and around three-fourths o f world reserves. The willingness and the ability o f the United States to export grains during the “ feed the w orld” cam paigns o f the mid-Sixties and early Seven ties led to com paratively large declines in dom estic grain stocks with respect to world stocks and to utilization from dom estic supplies. percent of consumption million m etric tons 140 percent of consumption 140 — -------United States World 120 ----------- World 100 - 80 80 60 40 20 J 20 0 0 ■ 60/61 62/63 *USDA estimate. 64/65 66/67 68/69 70/71 72/73 J 74/75* 0 10 Federal Reserve Bank of Chicago Production expands irregularly World grain production is expected to total 916 million metric tons in fiscal 1975, down nearly 6 percent from last year but 43 per cent above the levels o f the early Sixties. (Alm ost all o f the U.S. grain harvest occurs in the first six m onths o f a fiscal year.) Since the start o f the Sixties, annual fluc tuations in world grain production have ranged from an increase o f nearly 11 per cent (1971/72) to a decline o f nearly 6 per cent (1974/75). Year-to-year fluctuations in the Sixties resulted largely from consistent ups and dow ns in wheat production. More recently, production o f both coarse grains and wheat h as exhibited large swings. Despite the ups and dow ns in world grain production, the overall trend has been decidedly upward. Based on a twoyear m oving average (a technique that smoothes large annual changes and more accurately reflects the trend), increases have ranged from a low o f 0.1 percent (1970/71) to a high o f 5.7 percent (1967/68) and averaged 3.0 percent since the early Sixties. Since 1969, the average increase in world grain production has slowed frac tionally to 2.8 percent as two years o f sharp declines offset much o f the increases recorded in two bumper crop years. The overall uptrend in world grain production has been achieved largely through increased yields rather than in area harvested. The w orld’s annual grain production came from an average o f 473 World grain production percent, fiscal 4961-62=100 percent, fiscal 1961-62=100 160 150 140 130 120 110 100 *USDA estimate 11 Business Conditions, November 1974 m illion hectares in the first half o f the Six ties. The harvested area expanded slightly during the latter h a lf o f the Sixties then dipped in the early Seventies. However, significant increases occurred in both fiscal 1974 and 1975 when, according to current estimates, the area harvested m ight average 504 million hectares. O f this, the coarse grain harvest should ac count for 284 m illion hectares and the wheat harvest for 220 million hectares. Yields per harvested hectare have registered significant increases since the early Sixties. During the past three fiscal years, world wheat yields have averaged 16.4 quintals per hectare, up from 11.8 in the early Sixties. Similarly, coarse grain yields have averaged 20.9 quintals per hec tare, up from 15.5 in the early Sixties. Wheat yields in the United States have averaged 22 quintals per hectare, and coarse grain yields have averaged 45.5 quintals per hectare in the past three fiscal years. High yields are the m ajor reason why the United States ranks number one in world grain production and exports. The United States typically accounts for about one-fourth o f the w orld’s grain production and for around one-half o f world trade in grain. Interestingly, o f the w orld’s top six grain-producing areas, only the United States has been a consistent net exporter during the past two years. Grain production and trade balances for the world’s major producing areas: average for fiscal years 1973 and 1974 Wheat _________ Coarse grains______ Trade balance* Production Trade balance* Production (m illion m etric tons) United States USSR Western Europe Eastern Europe PRC India Canada Argentina Australia South Africa Other 34.7 +31.4 -7 .5 -0 .5 -3 .8 - 5.6 - 2.3 + 13.6 + 2.1 + 5.4 + 0.2 44.3 97.8 51.0 31.1 28.0 25.6 15.5 6.7 9.2 8.1 World total 352.0 *A " + " indicates net exports while f l 184.4 83.5 81.4 54.8 31.4 15.9 18.6 16.5 4.2 8.2 +18.1 -5 1 .1 79.2 70.8f 578.1 ' ' indicates net imports. tTotal world trade. +40.0 - 5.0 -1 9 .2 - 2.6 - 1.4 -0 .8 + 2.5 + 6.4 + 1.8 + 1.8 f l +18.2 -4 1 .7 70.7 f Federal Reserve Bank of Chicago 12 Consumption exceeds population gains World grain consum ption will decline in fiscal 1975—primarily through grain fed to livestock—as the result o f a reduced harvest and low reserves. The decline will be in sharp contrast to the trend that has seen world grain consum ption rise, or hold virtually unchanged, annually since the start o f the Sixties. During this period, the annual rise in world grain consumption has averaged 3.2 percent, well above the 2 percent annual growth rate in world pop ulation. Moreover, the annual increase in consumption has surged to 4.1 percent dur ing the past five-year period, due m ainly to a rising affluence that permitted higher living standards throughout the world. This accelerated rate o f increase is the most significant factor contributing to the tightening in world grain reserves. World grain consumption percent, fiscal 1961-62=100 *USDA estimate. Per capita grain consumption percent, fiscal 1961-62=100 tC e n tr a lly p la n n e d c o u n trie s in c lu d e USSR, Eastern E urope, PRC, N o rth Korea, N o rth V ietnam , and M o n g o lia . *U S D A e stim ate. The rising standard o f living has been most evident in developed countries and in centrally planned countries. But less developed countries also have experienced increasing per capita consum ption of grain. During the past three years, per c a p ita g ra in co n su m p tio n in less d e v e lo p e d cou n tries a v e ra g e d 103 kilograms, about 14 percent above the level o f the early Sixties. In centrally planned countries, per capita grain consumption averaged 290 kilogram s annually during the past three years, up 26 percent from the early Sixties. In developed countries, per capita grain consumption averaged 550 kilograms in recent years, a gain o f 20 per cent from the early Sixties. The higher level o f consumption in centrally planned countries and in developed countries large ly reflects a great per capita consumption o f coarse grains. Gary L. Benjamin Business Conditions, November 1974 13 B anking d evelo pm en ts Capital accounts include preferred and common stock, surplus, undivided Problems encountered by a few financial profits, and certain contingency reserves. institutions in recent months have in Besides equity capital, long-term in creased the concern of the public, the debtedness in the form of subordinated regulators, and bank management about notes and debentures is often included in the ability of individual banks to remain capital accounts. In addition, to the extent viable in the face of unusual losses or li a capital ratio is used as an indication of quidity strains. This concern has been the thickness of the loss cushion, reserves manifested in increased attention to bank specifically designated to absorb losses on capital. loans and declines in the value of securities Bank capital is often viewed as a should be counted as capital funds. cushion against losses and represents a Regardless of how inclusive a defini hard core internal source of bank funds. It tion of capital is used and regardless of can be measured in relation to deposits, to whether the capital is related to total total assets, to so-called risk assets, or to a assets, risk assets, or deposits, aggregate number of other variables. Which ratio is capital ratios of commercial banks have most relevant depends largely on whether declined over the past decade. This the observer is a depositor, some other shrinkage occurred despite the fact that creditor, or a stockholder. the dollar value of capital accounts has more than doubled because assets and deposits rose even faster. Capital ratios in downtrend While capital-to-risk-asset ratios attempt to relate the capital percent cushion to broad classes of assets 20 that are most likely to entail losses, equity capital and reserves/“risk” assets they are, at best, a very rough 15 - ' ______ ^ guide. Usually they are calculated on the basis of assets other than those considered to be riskless, equity cap ital/“risk” assets ' ' _____ such as cash and U.S. securities. 10 The gradual liquidation of the huge quantities of U.S. securities ac equity capital and quired during World War II has reserves/total assets resulted in a decline in these ratios all Seventh District commercial banks throughout the postwar era except -1 . 1 1 1 1 . Li 1.1 1 1 , 1 1 1 1 1 .1 J—L_J when overall growth slowed tem1953 55 ’57 ’59 ’61 ’63 ’65 ’67 ’69 ’71 ’73 porarily. At the end of last year, equity Note: “ Risk” assets, as calculated for use in capital plus loss reserves of district this chart, are total assets less: cash assets, U.S. obligations, and federal funds sold and securities com m ercial b an ks, in the bought under resale agreements. Data are not aggregate, amounted to 10 percent completely comparable over time due to of domestic assets other than cash, changes in available information. Bank capital ratios - 14 Federal Reserve Bank of Chicago Treasury and federal agency securities, and short-term federal funds sales and security resale agreements—down from 15 percent ten years ago. (See chart.) Loss reserves alone have amounted to a fairly constant 1.5 to 2 percent o f these assets. Because o f bank-to-bank variations in quality and liquidity within loan and in vestment portfolios, however, such ratios are not very accurate representations o f the capital cushion relative to actual risk, and can be especially m isleading if used by themselves to com pare individual banks. A more general capital relationship measures the proportion o f assets financed with internal funds—those supplied by owners o f the bank in contrast to depositors and creditors. This ratio in volves equity capital plus all reserves as a percent o f total assets. Changes in the ratio indicate whether the capital base o f a bank is keeping pace with its overall growth. A given ratio m ay or m ay not be “ adequate” depending on the quality o f the assets and of managem ent generally. For district com m ercial banks, the ratio o f equity capital and reserves to total assets (based on dom estic offices only) was about 7.5 percent at the end o f last year— down from the near 9 percent level o f the early Sixties but well above that prevailing in the early postwar years. The rise and fall o f this ratio over the past two decades reflects two stages in the banking system ’s m eth od s o f financing the needs of b u s in e s s e s , h o u s e h o ld s , and lo ca l governments. Throughout the Fifties, a substantial portion o f loanable funds were obtained through liquidating the G overn ments acquired during World War II. As this source was largely exhausted in the late Fifties, banks began to compete more aggressively for new deposits and oth er lia b ilitie s — so -ca lle d “ liability m anagem ent” —to support further loan ex pansion, greatly accelerating total asset growth in the process. But with the vast changes in the com position o f assets, today’s capital ratio appears thinner, relative to potential needs, than a lower ratio was 20 years ago. Individual bank ratios cover wide range around the district average Equity capital and reserves as percent of total domestic assets 5.00 and under 5.01-6.00 6.01-7.00 7.01-8.00 8.01-9.00 9.01-10.00 10.01-11.00 11.01-12.00 12.01-13.00 13.01-14.00 14.01-15.00 15.01-20.00 Over 20.00 of total assets [m illion dollars) 5.0 & under 5.110.0 10.1 15.0 15.125.0 4 7 25 46 61 56 46 27 18 14 11 13 33 4 14 68 141 152 111 52 29 16 14 5 7 1 9 19 72 113 88 48 21 8 7 1 1 1 1 6 44 116 146 103 52 24 7 4 25.150.150.0 150.0 (number o f banks) — 19 41 88 101 75 34 11 6 5 1 1 1 1 150.1250.0 Over 250.0 16 42 77 82 48 23 11 6 7 4 8 14 6 5 2 2 2 9 15 13 8 - - - 3 - 1 2 — 1 - — - 1 - - - — — Total 67 180 469 656 541 329 169 85 50 35 18 23 36 15 Business Conditions, November 1974 Range of ratios Condition report data as o f mid-1974 showed that equity capital and reserves in relation to total assets decreased as bank size increased. Differences between groups o f banks with total assets over $10 million were relatively small, with little variation am ong district states. However, the inclu sion o f foreign assets would produce significantly lower ratios for some banks in the largest size group. Individual bank ratios show a substantial dispersion which, in turn, was greater within the smaller size groups. More than one-half of the district’s 2,600 banks have assets o f less than $15 million. O f these, almost 25 percent report equity capital and reserves equal to 10 percent or more o f those assets. However, these smallest categories include a number o f fairly new banks whose ratios The ratios of equity capital and reserves to total assets decline as bank size increases Am ount o f bank assets A ll Seventh D istrict com m ercial banks,1 ______________as of June 3 0 , 1 974_____________ on June 3 0 , 1974 III, In d, Iow a M ich. Wis. District total (e q u ity capital and reserves as p erc en t o f total d o m e stic assets) 12.9 5 and under 8.7 5 .1 - 1 0 . 0 1 0 . 1 - 1 5 .0 7.9 1 5 . 1 - 2 5 .0 7.3 2 5 . 1 - 5 0 .0 7.2 5 0 . 1 - 2 5 0 .0 7.4 250.1 and over 6 .9 13.2 8 .7 7.8 7.5 7.8 7.0 6 .6 9 .4 8 .7 8 .2 8.1 8 .3 8.1 7.8 2 3.2 10.2 9 .0 7.8 7.6 7.2 7.0 10.3 8.5 7.7 7.8 7.6 7.6 6.3 11.4 8.8 8 .0 7.7 7.6 7.4 6 .9 ^Com m ercial banks excluding nondeposit trust companies. m ight be expected to be abnorm ally high. At about one-fourth o f all district banks, this capital and reserves-to-assets ratio was between 7 and 8 percent, and at nearly 30 percent it w as less. ■
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