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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 O ctober 1974 International b a n k in g structural aspects of regulation The Board o f G overnors’ continuing and wide-ranging reassessm ent of U.S. international hanking regula tions stem s from increases in U.S. banking activity abroad and in foreign banking activity at home. Banking developments 3 12 S u b s c rip tio n s to B u s in e s s C o n d itio n s are a va ila b le to th e p u b lic fre e o f ch a rg e . For in fo rm a tio n c o n c e rn in g b u lk m a ilin g s, a d d re ss in q u irie s to R esearch D e p a rtm e n t Federal Reserve Bank of C h ica g o , P. 0 . B ox 834, C h ica g o , Illin o is 60690. A rtic le s m ay be re p rin te d p ro vid e d so u rce is c re d ite d . Please p ro v id e th e b a n k’s Research D e p a rtm e n t w ith a co p y o f any m ate ria l in w h ic h an a rtic le is re p rin te d . 3 Business Conditions, October 1974 In te rn a tio n a l b a n k in g — structural aspects of regulation By the end o f 1973, approximately 140 U. S. banks had established themselves in 150 foreign countries by means o f branches or subsidiaries. Until recently, a U. S. bank established an arm overseas primarily to extend traditional domestic bank services to overseas customers, in particular, the subsidiaries o f U .S. multinational cor porations. In more recent years, however, U .S. banking organizations have diver sified the scope o f services available to their overseas customers and with these s e rv ice s h a v e tried to attract new customers from the countries in which they are doing business. On the other side o f the coin, foreign banks have penetrated the U. S. market to the extent that 168 foreign banks from 38 countries had established some form o f organization in the United States by the end o f last year. Total assets in the United States o f foreign banking organizations exceeded $50 billion as o f mid-1974. Only a b o u t 60 o f the fo r e ig n b a n k in g organizations operating in the United States are directly engaged in a commer cial banking business, while the range o f activities o f foreign banks in the United States also includes investment banking, venture capital financing, and real estate development. These indications o f ongoing changes in the scope and nature o f the U. S. bank ing presence in foreign countries and the introduction o f a substantial foreign bank ing presence to the United States led the Board o f Governors o f the Federal Reserve System to create the Steering Committee on International Banking Regulation in February 1973. Composed o f four members o f the Board o f Governors and three Federal Reserve bank presidents, the Steering Committee is charged with the responsibility o f reassessing the structural aspects o f U .S. international banking regulations that involve home-country responsibilities for U.S. banks overseas and h ost-cou n try responsibilities for foreign banks operating in the United States. Home-country regulation of U. S. banking organizations overseas The Board o f G overnors o f the Federal Reserve System is the prime U. S. agency involved in regulating the international operations of U . S. banking organizations.1 The B oard’s statutory authority for this regulatory responsibility stems from: • Section 25 o f the Federal Reserve Act as amended in 1916, 1962, and 1966; • Section 25(a) o f the Federal Reserve A ct (added in 1919 and also known as the Edge Act); • The Bank H olding Com pany Act o f 1956 as amended in 1970. T he Board implements its statutory ’For purposes of this article, a U.S. banking organization includes the bank itself; the bank holding company, if pertinent; those subsidiaries of the bank holding company that are collateral af filiates of the bank; direct subsidiaries of the bank, for example, an Edge corporation; and indirect sub sidiaries of the bank, namely the equity interests of the direct bank subsidiaries. Again for this article, a foreign banking organization is defined as an organization, non-United States in origin, which in its home market and in foreign markets conducts ac tivities that are engaged in by what are commonly considered to be banks in those markets. 4 a u t h o r it y with F ederal Reserve regulations that apply to U .S . banking organizations that engage in overseas operations via: • Branches (statutory authority over member banks from Section 25 o f the Federal Reserve Act, implemented by the Board’s Regulation M); • Direct equity participations in foreign banks (statutory authority over member banks from Section 25 o f the Federal Reserve Act, implemented by Regula tion M); • Equity participations in foreign bank ing and nonbanking firms by U. S. bank holding com panies (statutory authority from the Bank Holding C om pany Act o f 1956 as amended in 1970, implemented by Regulation Y); • Branches and agencies o f Edge cor poration or agreement corporation sub sidiaries o f a bank, and equity par ticipations by such subsidiaries in foreign banking or nonbanking firms (statutory authority from Sections 25 and 25(a) o f the Federal Reserve Act, im plemented by Regulation K).2 Other regulatory agencies exercise jurisdiction over the foreign activities o f 2Edge Act corporations and agreement cor porations differ in several ways. Edge Act cor porations operate under federal charters granted by the Federal Reserve Board; agreement corporations operate under state charters, although they are sub ject to Federal Reserve regulation. There are some state corporations with charters identical to those of agreement corporations that are not agreement corporations. These corporations have not entered into a regulatory agreement with the Federal Reserve Board because no member bank has an ownership interest in them, and the Board’s jurisdiction is limited to specifying what is an accept able investment for a member bank. Receipt of an Edge corporation federal charter does not require the equity participation of a bank. Section 25(a) of the Federal Reserve Act does specify that a member bank’s equity participation in an Edge corporation shall be limited to 10 percent of its capital and surplus. Both Edge Act and agreement corporations can engage in international and foreign banking, either directly or via equity participations, but only Edge corporations can engage in finance operations. Federal Reserve Bank of Chicago U .S. banking organizations in specific areas. The Comptroller o f the Currency is responsible for the exam ination o f the overseas branches o f national banks. State b a n k i n g authorities retain complete jurisdiction over the foreign branching ac tivity o f state-chartered nonm em ber banks and share jurisdiction with the Board o f Governors for the activities o f overseas b ra n ch e s o f state-chartered member banks. However, the Board—not state banking authorities—has full jurisdiction over state b a n k s, m em bership notwithstanding, as regards investments in Edge corporation foreign subsidiaries and the foreign activities o f dom estic bank holding companies that hold state banks. Regulatory philosophy From a legal viewpoint, a branch o f a U. S. bank is an integral part o f the bank itself, while any other part o f the banking organization (i.e., any segment separately incorporated) is legally separable from the bank.3 The significance o f this legal struc turing is that the creditors o f the bank are legally separable from the creditors o f any other part o f the banking organization. T h is le g a l com pa rtm en ta liza tion o f creditors’ claims has been utilized by the Board as the basis for the regulation o f the organizational form s that U .S . banking organizations assume for their overseas activities. Ever since passage o f the Edge A ct in 1919, the Board has had the authority to allow a separately incorporated Edge cor poration to exercise those powers which, in the Board’s view, could be considered usual “ . . .in connection with the transaction o f the business o f banking or other financial operations in the countries, colonies, dependencies, or possessions in which it :iSee paragraph 5600 of the for the Board’s interpretation of the relationship of the branch to the bank. Published Inter pretations of the Board of Governors of the Federal Reserve System Business Conditions, October 1974 5 Organizational structure of U.S. banks and their affiliates overseas u.s. bank holding com pany Subsidiaries of the bank holding company S ubsidiaries overseas that engage in activities that dom estic subsidiaries are p rohib ited from engaging in U.S. bank Overseas branch Subsidiaries of U.S. bank E quity interests in foreign banks Edge corporation s * Subsidiaries that engage in either bank or nonbank activities Subsidiaries overseas that engage in activities that dom estic subsidiaries engage in 6 shall transact business.” But prior to 1962, the Board had no authority to alter bank ing powers to make foreign branches o f U. S. banks more suitable to operate in the countries in which they were located. In 1962, Section 25 o f the Federal Reserve Act was amended to give the Board statutory authority to allow a foreign branch o f a member bank to “ . . . exercise such further powers as m ay be usual in connection with the transaction o f the business o f banking in the places where such foreign branch shall transact business. Such regulations shall not authorize a foreign branch to engage in the general business o f produc ing, distributing, buying or selling goods, wares, or merchandise; nor . . . shall such regulations authorize a foreign branch to engage or participate, directly or indirect ly, in the business o f underwriting, selling, or distributing securities.” A further amendment to Section 25 in 1966 gave the Board power to authorize direct equity participation by U. S. member banks in foreign banking corporations. The am endm ent’s only limitation on the power exercisable by such a foreign organization is that the foreign bank can not be engaged in any activity in the U ni ted States except that w hich is “ incidental to the international or foreign business o f such foreign bank.” The 1970 amendments to the 1956 Bank H olding Com pany A ct— in Section 4(c)13—provided the Board with the discretion to allow dom estic bank holding com panies to acquire foreign non bank corporations engaging in activities w h i c h w o u l d n o t b e p e rm issib le domestically, if the foreign com pany did no business in the United States except as incidental to its international or foreign business. When, in 1963, the Board revised Regulation M, the revision was designed to provide a limited degree o f additional flex ibility for overseas branch operations—for example, it allowed branches to create acceptances against trade taking place Federal Reserve Bank of Chicago w holly within a foreign country and to guarantee payments o f customs duties. Since 1963, the Board has not altered the pertinent sections o f Regulation M and, to insure the solvency o f banks, has embedd ed within the regulatory structure the tenet that overseas branches are extensions o f the domestic operations. In contrast to this conservative attitude toward the overseas activities o f branches, the Board has been willing to reevaluate the restrictions it places on the overseas activities o f U. S. b a n k in g org a n iza tio n s that assume anything other than the branch form. A particular example o f the Board’s flexibili ty in this area is seen in its allow ing U. S. banking organizations to set up invest ment banking subsidiaries to participate in the Eurobond market, a market which prior to the elimination o f U. S. capital con trols in January 1974 was substantially devoted to the satisfaction o f the overseas capital requirement o f U. S. multinational corporations. What has taken place over the past decade, therefore, is that the Board has been given the statutory authority to effect considerable liberalization o f the powers exercisable by U. S. banking organizations in overseas markets. However, the Board has been cautious in its augm entation o f the range o f overseas activities allowable to U. S. banking organizations, particular ly overseas branches. Other criteria In determining w hich activities will be allowable for U. S. banking organizations overseas, with the exception o f branches of member banks, the Board considers three factors:4 4The Board’s discretion in such matters is cir cumscribed by statute. An example of statutory limits is found in that part of Section 25(a) of the Federal Reserve Act that prohibits equity participation by an Edge Act corporation in a firm engaging “in the general business of buying or selling goods, wares, merchandise or commodities in the U.S.” Business Conditions, October 1974 1. What effect the overseas activity will have on the solvency o f the U.S. bank; 2. What effect the overseas activity will have on the concentration o f econom ic power; 3. What effect the overseas activity will have on the competitive position o f U.S. banking organizations vis-a-vis their foreign competitors. But the Board has the option o f adopting either o f two strategies in determining which activities will be allowable. The Board can require that the preponderance o f evidence indicates no adverse effects associated with allowing the activity, or the Board can require that the pre ponderance o f evidence does indicate adverse effects associated with allowing the activity. The first strategy obliges the Board to construct a list o f permissible ac tivities for U .S. banking organizations overseas. The second strategy obliges the Board to construct a proscribed list o f activities. The first strategy is, in fact, the one Canadian and Japanese banks account for two-thirds of U.S. foreign bank assets 7 presently used. Based on an “ approved list o f activities” compiled by the Board, U. S. banking organizations overseas engage in activities that are allowed domestically only for nonbank subsidiaries o f bank holding com panies—for example, con sumer finance and equipment leasing— and in activities that are not allowed dom estically—examples are investment banking, venture capital financing in volving substantial equity participations, and provision o f w arehousing services. These last-mentioned activities are per mitted on the premise that they are usual for banks in particular foreign markets, and therefore, the benefit o f allowing them offsets the incremental risk they pose to the soundness o f the bank and the bank ing organization. The Board has m ade it clear that some activities, such as general insurance un derwriting, are not permissible. The Board’s argument in these cases is that the activity is sufficiently different from those engaged in by banks in the United States— and is not a service com m only provided by banks in markets outside the United States—that it introduces an element o f risk that does nothing to offset competitive d isa d v a n ta g e s vis-a-vis foreign com petitors in foreign markets. However, the fact that an activity is not allowable for a foreign banking organization in its own home market does not mean that the Board will prevent U .S. banking organizations in that market from engaging in that ac tiv ity . F or ex a m p le, U. S. banking organizations in Canada can engage in le a sin g services, but Canadian law prohibits Canadian-chartered banks from doing so. The Board also has indicated that it would turn down requests to approve overseas activities that involve a signifi cant adverse im pact on concentrations o f econom ic power, even if the granting o f ap p r o v a l w ou ld n ot en d a n g e r bank s o u n d n e s s nor v io la te statutory Federal Reserve Bank of Chicago 8 limitations. This, in fact, occurred when the Board denied the application o f the Bank o f Am erica Corporation and the Allstate Insurance Com pany for a foreign joint venture. In its denial, the Board in dicated: The Board was equally concerned with the fact that this application proposes a joint venture between the largest U .S. banking organization and one o f the nation’s largest in surance com panies, w hich, as noted above, is wholly-owned by the largest retailer o f general merchandise in the U .S. Close working relationships abroad between large U .S . banking organizations and large U .S. in surance com panies could in time weave a matrix o f relationships between the joint venturers in the U .S. and abroad that could lead to an undue concentration o f econom ic resources in the domestic and foreign commerce o f the United States. The Board concluded that such potential ly adverse effects could result from the proposed application and that such potential effects would clearly not be consistent with the purposes o f the Bank Holding Com pany Act, nor in the public interest.5 The strategy o f the Board’s construct ing a proscribed list o f activities m ay be referred to as “ When in Rome do as the Romans do, B U T,” w hich is to say that the Board passes regulatory jurisdiction over fo re ig n operations o f U.S. banking o rg a n iza tio n s to appropriate foreign regulatory bodies but reserves the right to proscribe those specific activities it deems objectionable. To be on the proscribed list, activities would have to fit into one o f several categories: 1. Activities involving risks that are 5 Federal Reserve Bulletin, July 1974, pp. 517-519. sufficiently different in a qualitative sense from th ose p reviou sly en c o u n t e r e d b y U .S. b a n k s , b oth domestically and in international and foreign businesses, and that must be prohibited in the interest o f averting potential threats to the solvency o f the U.S. banking organization. A possible example o f an activity in this category would be com m odity speculation. 2. Activities that so violate traditional U.S. standards concerning separation o f banking and commerce that they would clearly have an undesirable feed back on U.S. markets. A s an example, it is within the realm o f possibility that a U.S. banking organization’s overseas interest in a foreign steel firm might adversely affect the bank’s willingness and ability to serve the banking needs o f U.S. manufacturers in the steel in dustry. 3. Activities involving U.S. banking organizations and U.S. or foreign business firms in joint ventures that either limit the access o f other U.S. banking organizations to particular foreign markets or limit the access o f foreign firms to the U.S. market. To avoid such joint ventures, the Board could provide a description o f potential partners whose joining would be con sidered objectionable. O f the two strategies, the first is rather cautious, the second rather liberal. The Board has the statutory authority to imple ment the second strategy and m ay do so when the evidence indicates that U.S. banking organizations require a freer rein in their overseas activities to compete e ffe c tiv e ly with foreign banks. The Board’s current policy o f follow ing the strategy requiring the evidence to show no adverse effects from an activity indicates a desire to minimize the risks introduced to U.S. banking organizations by overseas activities. Business Conditions, October 1974 9 Banks from 22 nations* are authorized to operate U.S. banking businesses number of banks Japan ........................ Canada .................... United Kingdom . . . Host-country regulation of foreign banks in the United States B ra z il.......................... n ! IP I Mm ■ ■ HiHi ■ F ra n c e ........................ m m Switzerland ............ I West G e r m a n y ___ m Hong K ong.............. I Ira n ............................ I Is r a e l........................ I Pakistan .................. I ‘ There is one bank in the United States from each of the following nations: Argentina, Columbia, Greece, India, Korea, Mexico, the Netherlands, the Philippines, Singapore, and Thailand. There is also one joint-venture bank owned by banks of several western European nations. The responsibility for regulating the entry o f foreign banks into the United States is primarily a concern o f the in dividual states. With few exceptions, state banking authorities extend the initial authorization to a foreign bank to engage in commercial bank activities in the Uni ted States through the branch, the agency, or the subsidiary form o f organization. For branches and agencies o f a foreign bank to enter a state, the state issues a license which, in effect, allows the foreign bank to use the home-country charter for banking operations within the state, subject to state regulation. A branch license permits a foreign bank to accept domestic deposits; an agency license does not. Just as branches o f U.S. banks overseas are in tegral parts o f U.S. banks, so branches and agencies o f foreign banks in the United States are integral parts o f foreign banks. A foreign bank entering a state via the sub sidiary form o f organization receives a state charter for a legally separable bank ing entity that is no different than any other banking entity chartered by that state. A m ong the privileges available to U.S.-chartered banks is having deposits in sured by the Federal Deposit Insurance Corporation—a privilege not available to U.S. branches or agencies o f foreign 10 banks. A s o f mid-1974, only a few states allowed foreign banks access to their markets in any form. The most prominent states doing so are New York, California, and Illinois; prominent states w hich ex clude access are Texas and Florida. Under the Bank H olding Com pany A ct o f 1956 as amended in 1970, the Board o f Governors o f the Federal Reserve System acquired jurisdiction over certain U .S. a ctiv itie s o f fo r e ig n banking organizations that have a U.S.-chartered bank subsidiary. The Board’s jurisdiction involves restrictions that apply to these organizations as well as to U.S. bank holding companies. These restrictions dis allow the control o f U.S.-chartered banks in more than one state except where grand fathering privileges exist, and limit non bank subsidiaries o f both U.S. and foreign bank holding com panies in the United States to the “ permissible activities” listed by the Board (pursuant to Section 4(c)8 o f the act). The Board does not have any jurisdiction over the branch o f a foreign bank. A state m ay license a branch o f a foreign bank even if that bank already has a branch in another state, or if the bank’s nonbanking subsidiaries engage in what the Board lists as “ nonperm issible” ac tivities. Three strategies for the federal regula tion o f the U.S. banking activities o f fo re ig n b a n k in g o r g a n iz a tio n s are available: 1. Restrict the U.S. activities o f foreign banking organizations to a set o f bank ing and finance activities clearly related to servicing trade between the United States and other countries. 2. Allow the continuation o f the current situ a tio n , w h ere foreig n banking organizations are largely ignored in fed era l b a n k in g statutes—that is, jurisdiction will continue to reside with the states. 3. Provide a federal statutory frame work that would treat foreign banking Federal Reserve Bank of Chicago Foreign banks in Chicago The Illinois Foreign Banking Office Act, approved in August 1973 and effec tive October 1, 1973, permits foreign b a n k s to esta b lish state-licensed branches in C hicago’s “ L oop,” with banking powers equivalent to statechartered banks. In the past year, 20 foreign banks have filed applications for branches with the Illinois Com missioner o f Banks and Trust Com panies, and 18 licenses have been issued. Licensees include some o f the largest and best-known multinational banks: Banque N ationale de Paris, Banque de l’lndochine (a part o f the Suez group) and the Credit Lyonnais o f France; Commerzbank and Dresdner Bank o f Germany; the N ational Bank o f Greece; Bank Leumi le Israel; Banca Commerciale Italiana; the Sanw a Bank and the Sumitomo Bank o f Japan; Algemene Bank Nederland; Swiss Bank C orporation; Barclays Bank Inter national, The Chartered Bank, Lloyds Bank International, and the N ational W estm in ster Bank o f the United Kingdom; the European Banking Com pany, a branch o f a U.K. m erchant bank owned by seven m ajor European banks; the H ongkong and Shanghai Bank o f Hong Kong. Applications are now pending from the Banco Real and the Banco do Brasil, both o f Brazil. Branches o f foreign banks in Chicago had been preceded in recent years by state-chartered subsidiaries. The First Pacific Bank, a subsidiary o f the Dai-Ichi K angyo Bank o f Japan, was chartered in 1971; and the Banco di Roma (Chicago), a subsidiary o f the Banco di Roma o f Italy, was chartered in 1972. Business Conditions, October 1974 activities in the United States in a m anner equal to that in which U.S. b a n k in g organizations are treated dom estically. In assessing the impact that adopting any o f these strategies will have, the follow ing questions should be answered: 1. What will be the strategy’s im pact on the position o f U.S. banking organi zations and foreign banking organizations in the U.S. markets in which they compete? 2. What will be the strategy’s im pact on n o n b a n k i n g co m p e titio n in U.S. markets? That is to say, what would be the relationship between foreign bank ing organizations and foreign direct in vestors in the United States? One possibility is that the more liberal the access that foreign banking organizations have, the greater their ability to promote foreign direct invest ment in the United States and, conse quently, the more significant the impact o f foreign direct investors on the state o f 11 competition in the United States. 3. Will the strategy provide reasonable bank supervisory safeguards for the c r e d it o r s o f fo r e ig n banking organizations? 4. How will the strategy affect the treat ment o f U.S. banking organizations overseas by foreign banking regulators? The Federal Reserve System ’s Steer ing Committee on International Banking Regulation has concluded that foreign banks in the United States should be treated in the same manner that domestic U.S. banks are treated—i.e., the principle o f nondiscrim ination or national treat ment. The committee believes that this strategy provides for responsible regula tion o f foreign banking activities in the United States, while allowing foreign b a n k i n g orga n iza tion s to contribute healthy stimulation to U.S. markets. The Steering Committee is preparing legisla tion to implement this strategy. Allen Frankel Federal Reserve Bank of Chicago 12 an kin g develo pm en ts Treasury innovations and the banks Some longstanding cash m anagem ent practices o f the Treasury Department are undergoing changes that are likely to have significant effects on the entire banking system. Already, calls on Treasury tax and loan accounts have been speeded up and the size o f weekly U.S. Treasury bill financ ings is being keyed to more immediate needs. Further m odifications are likely to follow from the findings o f a recently com pleted study o f Treasury tax and loan ac counts. The study concluded that the value o f Treasury tax and loan deposits to banks is now greater than the value o f the ser vices that banks supply to the Treasury in return for the deposits. At the very least, proposed changes will mean smaller average U.S. Treasury deposits in commer cial banks. What are tax and loan accounts? Treasury tax and loan accounts (TT&L accounts) are demand deposits that the Treasury holds at com m ercial banks. In 1973, these deposits averaged $4.9 billion. O f the nation’s 14,368 banks, 13,693 were classified as special depositories entitled to hold Treasury deposits as o f July 31, 1974. The TT&L accounts are the first resting place for a large portion o f govern ment receipts. M ost tax receipts flow into these accounts.* A t times, banks are per *Currently eligible for credit to the TT&L ac counts are: withheld income taxes, employer and employee social security taxes, railroad retirement taxes, a number of excise taxes, estimated and actual corporate income taxes, and federal unemployment taxes. mitted to pay for all or part o f their own and their customers’ subscriptions to new government securities by crediting these accounts. Government funds remain in these accounts until needed and then are transferred to Treasury balance accounts at Federal Reserve banks, from which all government disbursements are made. The TT&L accounts provide a means by which funds can be transferred from the general public to the Treasury and back again without seriously disrupting the nation’s banking system and the m oney market. If funds were to flow directly and immediately from the public to the Treasury’s Federal Reserve account— completely bypassing commercial banks— wide fluctuations in bank reserves (and thus in credit availability) would result because o f the lack o f synchronization between government receipts and expen ditures. Government receipts would im mediately drain reserves from the banks until the funds were returned to private deposits via government expenditures. The existing TT&L account system moderates these potentially disruptive reserve effects. To the extent that Treasury balances at the Federal Reserve are kept at a constant level, flow s between the govern ment and the public are reflected in shifts between private deposits and Treasury deposits at commercial banks without affecting total loanable funds. In the absence o f TT& L accounts, any undesired effects o f increases or decreases in Treasury deposits at the Federal Reserve could be offset by Federal Reserve open market operations on a very large scale. As an indication o f the required amount, the Treasury’s total operating balance (its balance at the Federal Reserve, the TT&L balances at commercial Business Conditions, October 1974 banks, plus other miscellaneous demand balances) dropped from approximately $6.4 billion at the beginning o f June 1974 to $2 billion on June 12, and then increased to $10.2 billion on June 20. Without TT&L ac counts and based on a m onthly average level o f reserves o f $36.4 billion, these swings in the operating balance would have first added approximately 12 percent to total reserves and then drained 22.5 per cent from them. How TT&L accounts work Com m ercial banks run a highly ef ficient tax collection system for the U.S. Government by helping to insure that receipts are available for Treasury use much more rapidly than would be the case under alternative collection systems. For example, a corporation can simply make its federal tax payments through its own bank, then the bank will debit the cor poration’s account and credit its own TT& L account. This eliminates delays due to check clearings and saves the Treasury the expense o f handling a large volume o f remittances. C r e di ts to T T & L a cco u n ts as paym ents for Treasury securities benefit both the governm ent and the banks. One o f the o r i g i n a l purposes o f a federal depository system w as to provide an incen tive for banks to serve as distributors o f Treasury securities. This incentive is heightened when banks are allowed to pay for their purchases o f new Treasury issues by crediting their TT&L accounts. The Treasury authorizes this means o f pay ment only in financing operations where new cash is being raised. With this privilege, a bank can acquire an earning asset with no immediate drain on its reserves, although its required reserves in crease because o f the higher level o f TT&L deposits. O f course, a number o f days later, as calls are made on the TT&L accounts, the bank will lose reserves in an amount 13 equal to the dollar value o f the new securities it has purchased. Because the TT& L credit is valuable, banks are often w illing to outbid nonbank investors for a new issue when the privilege is granted. Consequently, banks usually take the lion’s share o f any offer ing when TT& L paym ent credits are allow ed. For example, in each tax anticipation bill offering with TT&L privileges during the 1971-73 period, banks, on average, were awarded 93 percent o f the total public allotments. In the process o f outbidding other investors for new issues, the banks will sometimes purchase the new securities at rates below market. How far below the market, if at all, the Treasury can issue its debt depends on the estimated length of time banks will hold the new TT&L deposits and general market conditions. By encouraging bank participation in Treasury financings, the banks have become, in effect, underwriters o f govern ment securities over the years and have developed a vast customer network. Thus, even when TT& L payment privileges are not granted, banks remain instrumental in the efficient distribution o f new Treasury issues by providing advice to customers and handling their subscriptions. Banks not only help the Treasury dis tribute its marketable debt, but its nonmarketable debt as well, specifically, savings bonds. M ost banks stand ready to issue and redeem savings bonds and to assist businesses in setting up payroll savings plans. Banks and other financial institutions that act as paying agents for the redemption o f savings bonds are reim bursed for these services at the rate o f 15 cents for each o f the first 1,000 bonds redeemed during the quarter and 10 cents for each bond in excess o f 1,000. Although financial institutions receive no direct reimbursement for issuing savings bonds, commercial banks are implicitly compen sated by earnings derived from TT&L ac count balances. 14 Effects of high interest rates On several occasions over the years, studies have compared the value o f the interest-free TT&L account deposits to banks with the costs o f services provided by the banks. Studies completed in 1960 and . 1964 concluded that banks, in the aggregate, were just about breaking even on their TT&L accounts, and if anything, were absorbing a loss. These conclusions were reversed in the 1974 study, largely because o f the effects o f high interest rates. Higher short-term rates provide a much greater earnings potential on TT&L balances. Moreover, it would appear that, in contrast to ten years ago, more banks are charging their customers for such Treasury-related services as cashing Treasury checks, handling subscriptions for new Treasury securities (other than savings bonds), and handling matured Treasury securities. One o f the principal objectives o f the most recent study was to determine whether the earnings value o f TT&L deposits exceeded the costs o f the services provided to the Treasury by the banks. At the outset o f the investigation it was decid ed that the only services for which the TT&L account itself should be considered com pensation would be those directly related to handling these accounts, specifically, (1) the m aintenance o f the TT&L account and (2) the processing o f federal tax deposits through the TT&L ac count. On the basis o f a survey o f 600 banks, it was concluded that the aggregate earn ings derived from TT&L accounts were far in excess o f the costs o f m aintaining these accounts. The rate selected to measure the earnings value on the TT& L account was the average rate on new issues o f 3-month Treasury bills during the five-year period ended December 31, 1972, which was 5.5 percent. This rate was adjusted downward to account for reserve requirements and Federal Reserve Bank of Chicago FDIC assessments. U sing earnings rates ranging between 4.51 percent and 5.06 per cent, and extrapolating from the sample o f responding banks to all banks holding TT&L accounts, the Treasury estimated that in 1972, aggregate net earnings for the banks that were attributable to TT& L ac counts were over $300 million. Even after subtracting the costs o f issuing and redeeming savings bonds, the estimated earnings were $260 million. It should be emphasized that while the study indicates that in the aggregate banks are recording net earnings on TT&L accounts, some in dividual banks m ay be incurring losses. Possible solutions The Treasury has suggested a number o f ways in which it m ight recapture some o f these excess earnings. A m ong the cash management proposals under considera tion are: 1. Have banks pay interest on TT&L deposits: this would require Con gressional authority since the Banking Act o f 1933 prohibits the paym ent o f in terest on demand deposits. 2. the problem with this ap proach is that according to Federal Reserve regulations, funds must be left on deposit for a minimum o f 30 days if interest is to be paid. The average life o f a TT&L deposit is about 10 days. 3. this, too, would require Congressional authoriza tion. A possible drawback with this plan is that because o f the large amount o f funds involved, Treasury purchases o f a specific instrument m ight create tem porary rate distortions am ong the different money market instruments. Convert Treasury demand deposits to time deposits: Invest TT&L deposits in the money market on a day-to-day basis: 4. Hold a greater proportion of the Treasury’s operating balance at the Federal Reserve: presum ably the Federal Reserve would add to its port Business Conditions, October 1974 folio o f securities in order to offset the reserve drain caused by the redistribu tion o f Treasury funds. In so doing, the Treasury’s revenues would be increased since the Fed returns a portion o f its earnings to the Treasury each year. In addition to these proposals to in crease the earnings o f its idle cash balances, the Treasury has embarked on a program to more efficiently m anage the overall size o f its operating balance. Part o f this program involves more frequent ad justments o f bill offerings to better match the Treasury’s borrowing to its actual cash needs. Failure to make such adjustments in the past have led to temporary but un necessary buildups in Treasury balances. Implications for banks The Treasury’s new cash management program will work in the direction o f lower ing the Treasury’s interest-free demand deposits at com m ercial banks. To the ex tent that these balances are converted to time deposits, the cost o f funds to the banks could rise on a net basis after adjusting for differences in reserve requirements. If the Treasury chooses to hold a greater propor tion o f its operating balance in its Federal Reserve account, then, assuming open market operations are conducted to offset the resulting reserve drain, government deposits will be replaced by private deposits. For the banking system as a whole, this is not likely to raise the cost o f funds. However, there will probably be some distributional effects since reserves 15 would be drained from banks all over the country as calls were made on the TT&L accounts, whereas the offsetting reserve injections would flow initially to the money market banks. Thus, the money market banks could stand to gain in the sense that their demand for federal funds might be reduced somewhat. Another aspect o f the Treasury’s program involves a plan to compensate financial institutions on a direct fee basis for certain services performed for the government, such as sales and redemp tions o f savings bonds. A s mentioned earlier, banks—as well as other financial institutions—are reimbursed a nominal amount for each savings bond redeemed by them. However, the Treasury’s 1974 study indicates that this amount is far below the actual costs o f processing these matured securities. Financial institutions currently receive no direct compensation for issuing savings bonds, although banks are assumed to be implicitly rewarded through their TT& L account earnings. U n der the proposed arrangement, reimburse ment for the issuance and redemption o f savings bonds would be through fees at levels that closely reflect the actual costs incurred in processing these securities. These more realistic fees would enable the banks to recoup some o f the earnings they would lose due to the change in the handl ing o f TT& L accounts. A fee-basis compen sation plan would also benefit those finan cial institutions that have not enjoyed TT&L account earnings but nevertheless have performed these valuable services. ■
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