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review by the Federal Reserve Bank o f Chicago

Business
Conditions
1 9 6 4 Septem ber

Contents
Regulation Q: ceiling or umbrella?

Capital markets—
United States and Europe

Federal Reserve Bank of Chicago

Regulation Q: ceiling or umbrella?
In tere st rates on commercial bank time de
posits, which consist largely of savings ac
counts, have followed a generally rising trend
since the end of World War II. While time
deposit rates still are at levels generally lower
than those of competitive forms of savings,
the gap has narrowed somewhat. The ques
tion arises whether limits on time deposit
rates prescribed by regulatory agencies are
responsible for differences between the rates
offered by banks and by other savings insti
tutions.
E a rly y e a r s of reg u la tio n

In 1933 the Federal Reserve Board issued
its Regulation 0 establishing maximum rates
to be paid on time and savings accounts as
required by the banking act of that year. The
objective of the legislation was to limit com
petition for deposits among commercial
banks. It was widely held at the time that
bidding among banks for deposits had led to
“excessively high” interest rates and that the
related search for increased earnings to cover
inflated interest costs had contributed sub
stantially to the banking crisis.
The Federal Deposit Insurance Corpora
tion, in its 1934 Report, asserted the belief
that “the intent of Congress, through the

granting of these regulatory powers [was] to
prevent unsound competition among banks
and to check the tendency of competition to
raise the rates of interest to levels which may
imperil the sound operation of banks.” Fac
tual evidence on the relationship between
excessively high time deposit rates and the
tendency to seek out unsound assets, how
ever, has been too sketchy either to confirm
or disprove such a relationship.
Regulation Q initially set the maximum
rate member banks could pay on time de
posits at 3 per cent. In 1935 the ceiling was
reduced to 2.5 per cent in line with declines
in market rates of interest, including the rates
actually paid on time deposits. Except for
minor revisions in 1936 of rates for certain
maturities of time certificates of deposit, the
legal maximum remained unchanged until
1957.
During the late Thirties and Forties, rates
paid by banks were generally well below the
regulatory maximums, reflecting the large
supply of credit relative to demand. Rates
continued at about 1 per cent in the early
Fifties, in the United States as well as in the
District. Not until the third quarter of 1956
were there any marked advances in rates paid
by banks. About that time, banks began to

BUSINESS CONDITIONS is published monthly by the Federal Reserve Bank of Chicago. Charlotte H. Scott
was primarily responsible for the article "Regulation Q: ceiling or umbrella?"
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Business Conditions, September 1964

compete more aggressively for deposits in
order to increase their supply of loanable
funds as credit demand continued to expand.
Moreover, higher rates paid by competing
savings media such as savings and loan asso
ciations and credit unions had begun to retard
growth of bank time and savings deposits.
A survey of banks in 43 Seventh Federal
Reserve District urban areas revealed that on
July 1, 1956, the most frequently reported
rate on savings deposits was 2 per cent—a
half percentage point below the regulatory
ceiling. The survey data for the five major
areas are given below:
Maximum interest
rates paid
(per cent)

In te re st expense relatively
greater than before Regulation Q
per cent

total time deposits..

per cent

Savings
deposits
Time CDs
(number of banks)

C h ic a g o

1.5 or l e s s ...........

2 ........................... . . .
2 . 5 .........................

115

20
0
3
22

D e tr o it

1.5 or l e s s ...........

2 ...........................

2 . 5 ........................

I n d ia n a p o lis

1.5 or l e s s ...........

2 ...........................
2 . 5 ........................

0
9
0

1
1

M ilw a u k e e

1.5 or l e s s ...........

2 ...........................

0
25

2 . 5 .........................

0
10
1

D e s M o in e s

1.5 or l e s s ...........

2 ...........................
2 . 5 ........................

R e n e w e d in te re s t in tim e d ep o sits

Rate ceilings on savings and longer-term
time deposits were raised in January 1957
from 2.5 to 3 per cent. Commenting on this
action, the Federal Reserve Board of Gov
ernors stated that

*Ratios for 1927-38 are computed for aggregate dollar
amounts while figures for 1938-63 are averages of individ
ual bank ratios.

In a period of heavy demands for funds and
a relatively high structure of interest rates
generally, it would be desirable to permit in
dividual member banks greater flexibility to
encourage the accumulation of savings than
was available under the existing maximum
permissible rates. It also appeared to the
Board that there was insufficient reason to
prevent banks, in the exercise of management
discretion, from competing actively for time
and savings balances by offering rates more
nearly in line with other market rates.
Although many banks increased rates on
time deposits immediately after the change in
regulation, it does not necessarily follow that
the maximums previously in force had pre-

Federal Reserve Bank of Chicago

vented all or even most from doing so earlier.
Thus, in late 1956 only about 5 per cent of
the urban banks in the Seventh District were
paying the maximum permissible rate on sav
ings deposits. Furthermore, while more than
20 per cent of the District’s urban banks
raised their rates in early 1957—after the
change in Regulation Q—the rate hikes in
almost three-fourths of these cases repre
sented increases to 2 or 2.5 per cent. Such
changes, of course, could have been made
before the revision in Regulation Q.
Rates paid by banks generally averaged
higher in the Twenties than in recent years
(see chart). During these years rates at Des
Moines banks were higher than those at
banks in other major cities of the District—
Chicago, Detroit, Indianapolis and Milwau
kee—and apparently this relationship also
held in the early Fifties. While Des Moines
banks boosted their rates on savings deposits
from 2 to 3 per cent in early 1957, it was
In Chicago, Detroit and Milwaukee
rates of interest on time deposits
higher now than in late Twenties
per cent

Announced or advertised rates are used in some of
the charts in this article while in others so-called
"effective" rates are reported; the latter are com
puted by dividing actual interest payments during a
particular period by an average of balances held
during that period. An analysis of data for recent
years shows that fluctuations in announced rates on
savings deposits at most banks move fairly closely
with effective rates on all time deposits combined,
undoubtedly reflecting the fact that savings deposits
generally constitute the bulk of total time deposits.
Indiana has been omitted from some of the tabu
lations

since the

state

regulation

has

not

been

changed concurrently with Federal regulations. Other
states that regulate time deposit rates have, in con
trast, generally revised their ceilings immediately
after changes in the Federal maximums.

not until mid-1959 that most Chicago banks
made similar changes.
Prior to the 1957 revision in regulatory
ceilings, Detroit banks could have moved
rates upward to meet savings and loan com
petition had they considered it desirable and
still have been below the regulatory ceilings.
The prevailing rate on savings deposits at De
troit banks in 1956 was 1 per cent. On time
certificates of deposit, however, Detroit
banks paid the same maximum rate as was
available on savings and loan share accounts
(2.5 per cent).
The fact that banks in certain of the larger
cities maintained interest rates on time and
savings deposits at levels below the regula
tory ceiling indicates that Regulation Q had
not handicapped these banks in competing
for savings. Undoubtedly there were factors
more important than Regulation Q that con
tributed to the slower growth of commercial
bank savings relative to some other financial
institutions. One such factor is the growth in
individuals’ savings made possible by the
generally sustained rise in personal income

Business Conditions, September 1964

since the end of World War II and the effect
that rising income may have had on increas
ing the number of savers and prompting the
use of a greater variety of savings forms. In
addition, banks may not have sought time
funds via rate increases as vigorously as, say,
savings and loan associations, partly because,
unlike their competitors, they did not have to
rely solely on savings funds for loan expan
sion. Moreover, supplies of credit were ample
relative to demand as reflected, for example,
in comparatively low loan-deposit ratios.

P ro p o rtio n of banks paying
Regulation Q's maximum rate
generally quite small
per cent
100 '

C om petition in te n sifie s

The pace of time deposit growth usually
quickens, at least temporarily, following rate
increases. In the 33 urban areas of the Dis
trict where prevailing interest rates rose in
1957, the commercial banks reported large
increases during the year in savings deposit
balances. In contrast, in the 10 areas where
the prevailing interest rate remained un
changed, savings deposits declined.
Encouraged by the 1957 response to high
er rates and the continued growth of time
deposits during the recession year of 1958
and seeking additional funds to accommodate
rising loan demands in the face of slow
growth in demand deposits, many banks,
where regulatory maximums permitted, fur
ther increased their rates on time deposits in
1959. During the third quarter of 1959, 34
per cent of the banks in the District’s urban
areas raised rates paid on savings deposits.
With the rise in market rates of interest
from 1960-61 recession lows, pressure for
higher ceilings began to mount. Negotiable
time certificates of deposit—designed to
make time deposits more attractive to corpo
rate investors—were introduced at large Chi
cago banks in February 1961 and at smaller
banks shortly thereafter. (Certificates of de
posit had long been available to individuals

1956

1957

1958

1959

I960

1961

1962

1963

N ote: Proportion of member and nonmember banks with
announced rate the same as Regulation Q ceilings in 43
urban areas of Illinois, Iowa, Michigan and Wisconsin; pro
portion of banks with averag e effective rate within 0.50
percentage points of Regulation Q ceilings for all member
banks in the four states.

and others in some areas of the District but
unlike the new CDs issued by the larger
banks, these were not generally considered
marketable.) By the end of 1961, declines in
negotiable time CDs outstanding appeared
likely since the existing ceiling rates would
not allow banks to continue to offer rates
competitive with yields on other short-term
money market instruments.
At that time more than 86 per cent of
the District’s urban banks were offering the
ceiling rate of 3 per cent for savings deposits
and nearly all were offering 3 per cent on
other types of time deposits. One develop-

Federal Reserve Bank of Chicago

ment widely viewed as an indication that
banks were limited by the rate ceilings was
the increase in the number of banks resorting
to “fringe benefits” and non-rate inducements
to strengthen their appeal to savers.
Several large Chicago banks announced a
switch in late 1961 from semiannual or
monthly computation of interest to calcula
tion on a daily basis (that is, interest paid
from day of deposit to day of withdrawal).
This practice, however, was not generally
adopted. A 1962 survey by the American
Bankers Association indicated that more than
75 per cent of all banks in the Midwest con
tinued to compute interest semiannually dur
ing 1961.
Effective January 1, 1962, Regulation Q
was revised to permit member banks to pay
3.5 per cent on savings deposits on hand less

than one year and 4 per cent on deposits held
for longer periods. The Board of Governors
explained its action as follows:
For some time prior to this action, a number
of commercial banks had contended that a 3
per cent maximum rate restricted them in
their efforts to compete for savings and time
deposits. The action taken by the Board had
the effect of increasing freedom of competi
tion and enabling each member bank to de
termine the rates of interest it would pay in
light of the economic conditions prevailing
in its area, the type of competition it must
meet and its ability to pay. The action also
had the effect of enabling member banks to
compete more vigorously for foreign deposits
. . . . Further, it was contemplated that the
action would give member banks the latitude
that might be needed, for a considerable
period ahead, to provide an added incentive

Rates paid on savings at Seventh District banks
and savings and loan associations in late 1963
Wisconsin
Maximum announced interest rate
at commercial banks

Illinois
Total

Cook County

Other

(per cent)

Indiana

Iowa

Michigan

Milwaukee
County

Other

(per cent of banks)

Under 2.5...................................

—

2 .5 .............................................

—

91
—

50
26

3 .0 .............................................

3 .5 .............................................

4 .0 ............................................. .

37
41

—

Num ber o f banks............................... . 433

158

—

81
—

Dividend rate on shares at
savings and loan associations
(per cent)

—

92
4

4.125-4.25................................. .

57
22

4 .5 .............................................

—

Num ber o f associations....................... 800

166

196

175

3 .5 .............................................
3.75-4.0..................................... .

Note: Commercial bank figures are for all banks in urban areas of the Seventh District; savings and loan figures
are reporting associations in the entire state. The ratio of reporting associations to all operating associations is as
follows: Illinois, 61 per cent; Indiana, 82 per cent; Iowa, 91 per cent; Michigan, 93 per cent and Wisconsin, 74 per cent.

Business Conditions, September 1964

for accumulation of the savings necessary to
finance the future economic growth that
would be essential to the expansion of job
opportunities for a growing population . . . .

In early 1962 more than 39 per cent of all
District urban banks posted increases in rates
on savings deposits and over two-thirds raised
rates on other time deposits. These percent
ages were roughly similar to those for the
nation as a whole: 49 per cent of all mem
ber banks in the United States raised rates on
savings deposits in early 1962, with more than
four-fifths of these moving their rates above
the previous ceiling of 3 per cent. Almost all
member banks that raised rates on time de
posits other than savings moved them up to
3.5 or 4 per cent. The move to higher rates,
however, cannot be taken as a direct measure
of the effect the previous rate ceilings had had
in holding rates down.
Most of the banks serving individual local
communities offer identical rates for savings
deposits although in most communities these
rates are below the maximum rate permitted.
This has been true in both small and larger
areas. In the largest metropolitan areas
where rates have varied somewhat they have
been virtually the same for the larger banks.
There is some evidence that markets for
bank savings are relatively localized. For
example, in Decatur and Springfield, Illinois,
and Sioux City, Iowa, banks are paying the
maximum authorized rate on savings deposits
even though lower rate levels prevail in sur
rounding communities.
The similarity in rates among banks within
market areas implies, among other things,
that most banks set interest rates on savings
and time deposits primarily in response to
competitive market factors. Furthermore,
while some of the commercial banks’ closest
competitors for savings, such as savings and
loan associations and credit unions, do not

confront rate restrictions similar to those of
commercial banks, the competitive nature of
the savings market is such that there is a
spillover of the effects of bank regulation.
The cu rre n t situation

Many Indiana banks raised rates on sav
ings deposits in early 1964 following the
change in state regulation but at most banks
outside Indiana rate schedules have remained
unchanged since 1962. As of June 1964 only
one-fourth of all banks in urban areas of the
District were offering the ceiling rate of 4 per
cent on savings deposits held one year or
longer. The proportion of “4 per cent banks”
was higher in Illinois and in Michigan than in
either Iowa or Wisconsin, but even in the first
two states it was no more than 35 per cent.
No bank in Indiana was paying 4 per cent on
savings deposits since the maximum rate re
mains at 3.5 per cent by state regulation. In
contrast with rates on personal savings de
posits, almost all banks in the District’s urban
centers were at the legal ceiling of 4 per cent
on at least some maturities of time CDs issued
to individuals.
Competitive interest rate relationships
have at times made it possible for banks to
offer lower rates on time certificates of de
posit issued to corporations, other businesses
and governments than on CDs offered to in
dividuals. In mid-1964, however, rates on
new time CDs of negotiable form issued to
corporations by large Chicago banks were
quoted in the 3.75 to 3.80 per cent range for
shorter maturities and 3% to 4 per cent for
maturities of six months or longer. Rates on
CDs issued to corporations appeared to be
close to Regulation Q ceilings at most banks.
Commercial banks compete for corporate
funds primarily with short-term money mar
ket instruments, particularly Treasury bills.
Rates of interest on corporate time deposits,

Federal Reserve Bank of Chicago

which are more flexible than rates on savings
deposits, tend to reflect demand and supply
conditions in short-term money markets.
During the period from late 1961 to mid1963, when banks were prohibited from pay
ing more than 2.5 per cent on certificates of
deposit maturing in less than six months and
rates on Treasury bills of comparable maturi
ties were yielding more than 2.5 per cent, the
volume of CDs issued in the shorter-term
maturity range was small. The bulk of issues
carried longer maturities.
Prior to m id-1963, investors wanting
shorter CD maturities usually could buy them
in the secondary market at higher yields than
were obtainable directly from banks. Maxi
mum rates of interest payable on certificates
with maturities of 90 days to one year were
raised to the same level as the ceiling on oneyear certificates in mid-1963. The Board of

M a xim u m in te re s t rates
permitted on savings
and other time deposits*
Effective date
January 1
Maturity

1936

Ju ly 17,

1957

Rates paid by savings and loan
associations generally above
ceiling on savings deposits at banks

J-----1 I___ I___ I___ I___ I___ 1 I___ L .1..., I___ I___ I
___
___

1947

1949

1951

1953

1955

1957

1959

19611963

Governors, in stating the reasons for the re
vision, again noted that the action was taken
because it appeared that the regulation had
begun to have a restrictive effect on com
mercial banks in their competition for time
funds.

1963

1962

Sum m ary

(per cent
Savings deposits
1 year or more . . . . .

2.5

3.0

4.0

Less than 1 year . . . .

2.5

3.0

3.5

Other time deposits1
1 year or more . . . . .

2.5

3.0

4.0

6 months to 1 year . .

2.5

3.0

3.5

4.0

3 to 6 m o n th s........ .

2.0

2.5

4.0

Less than 90 days . . .

1.0

* Amendment to Regulation Q effective October 15,
1962 made time deposits of foreign central banks and
governments and international institutions exempt from
regulatory ceilings for a period of three years.
Tim e certificates of deposit and open-account time
deposits.

The current ceiling rates on savings depos
its are not limiting the ability of most Mid
west banks to pay the rates they wish. In a
number of areas banks have maximum rates
on personal CDs equivalent to the rates sav
ings and loan associations are paying on share
accounts (see table). The fact that rates be
ing paid have been set at the legal maximums
does not necessarily indicate that many banks
would pay higher rates if they were allowed
to do so.
Not enough is known about the structure
of savings markets to explain fully the be

Business Conditions, September 1964

havior of banks in relation to Regulation Q.
While some banks may look upon the regu
lation as a hindrance to setting the rates that
they desire to offer, other banks may settle
upon the regulatory limits as providing the

top rates that all banks—both large and small
—in the community can safely pay. This situ
ation results in divergent views on the proper
posture of public policy in the setting of inter
est rate maximums.

Capital markets—
United States and Europe
I n August, Congress enacted the temporary
interest equalization tax proposed by the Ad
ministration more than a year earlier. The tax
—2.75 to 15 per cent on new or outstanding
foreign bonds maturing in three years or more
—has the effect of adding approximately one
percentage point to the cost of borrowing in
the United States capital market and is in
tended to discourage such financing. A 15 per
cent levy also is placed upon purchases of
foreign stocks. Because of historical depend
ence on American investment funds, Cana
dian issues are exempted from the tax, as are
those of less developed countries.
New foreign security issues in the first half
of 1963 were sold in the U. S. market at
a 2 billion dollar annual rate—four times
as much as in 1960. Proposal of the tax—
retroactive to July 1963, the time of its an
nouncement—brought about a virtual cessa
tion in foreign flotations and a concomitant
improvement in the balance of international
payments (see chart). It remains to be seen
how effective the tax will be in dampening
such transactions. Some analysts have sug
gested that enactment of the tax will stimulate
foreign issues, now that uncertainties on its
precise nature have been removed. Rapid

economic expansion in Europe accompanied
by high profits has enabled European bor
rowers to pay interest rates that are very high
by United States standards.
The Administration decided upon the
interest equalization tax reluctantly, because
it has been American policy to encourage free
capital markets at home and abroad. It is
widely expected that further developments
already under way in foreign capital markets
eventually will reduce existing disadvantages
of floating securities in home markets and
make the tax unnecessary.
Among the materials assembled by the
Treasury Department in support of the tax
proposal is a 280-page study, “A Description
and Analysis of Certain European Capital
Markets.” This report highlights the great
differences between the structure and per
formance of capital markets in the United
States and the principal nations of Western
Europe.
Many European business firms and gov
ernmental or quasi-governmental bodies at
tempt to satisfy their needs for funds in the
United States because their own capital mar
kets are not large enough or well-enough
organized to accommodate sizable capital

Federal Reserve Bank of Chicago

issues readily. Virtually all capital markets
outside the United States either are undevel
oped or severely limited in the size of the
flotations that they can absorb. Moreover,
operation of these markets is closely circum
scribed by custom as well as by regulations
imposed by public or governmentally sanc
tioned private bodies.
W h a t a r e ca p ita l m a r k e ts ?

The network of facilities and arrangements
by which capital funds are gathered and in
vested in long-term debt or equity is an im
portant feature of every developed nation.
While the term “capital market” may call
to mind only sales of large issues of govern
ment securities handled by dealers and invest
ment bankers and marketings of corporate
securities by such agencies or by private
placement, many needs are financed in other
ways. Much capital is acquired in relatively
small amounts—some on the basis of rather
informal arrangements. The results are the

Foreign se c uritie s marketed in the
United States slowed in mid-1963
million dollars

same, that is, the transfer of funds from those
having investible surpluses to those seeking
to use them. Small business firms and home
buyers who borrow from relatives or friends
or from local banks or savings and loan as
sociations have an important role to play in
the capital market, to use the term in a broad
sense.
To serve the economy well and promote
economic growth, capital markets must chan
nel funds into the most productive uses. This
process requires, first, facilities for the prep
aration and distribution of new issues of
shares or obligations, that is, “primary mar
kets” and also “secondary markets”—the
stock exchange is a prime example—in which
outstanding securities may be traded. The
presence of viable secondary markets ena
bles investors to purchase securities with the
knowledge that these can be disposed of when
desired and thus tends to broaden the market
for new issues.
Not all capital market instruments are
readily marketable. For example, of the 280
billion dollars of mortgage loans outstanding
in the United States at the end of 1963, nearly
three-fourths were in the form of “conven
tional” mortgages, that is, loans not federally
insured or guaranteed, which are too local
ized and varied to possess wide marketability.
Moreover, the shares of many small corpora
tions are not traded on organized exchanges.
Size of c ap ital m a rk e ts

1959

I9 6 0

full year

1961 I f ;

1962

1963

annual rates half years

1964

The United States capital market is much
larger than those of other nations, and, there
fore, can absorb large issues with relative
ease. Total capital market instruments out
standing in this country—including corporate
stocks and bonds, mortgages, Federal and
state and local government securities and for
eign securities—amount to more than 1 tril
lion dollars (see table). This is more than

Business Conditions, September 1964

O u tsta n d in g capital market instruments, December 31, 1962
Business

State and
local
government

Mortgages

Total

GNP
1962

1 11

1,039

556

324

314

2
*

136

♦

1
*

20
21

13
13

Foreign

Bonds

Stocks

105

484

251

133

United Kingdom......................

France.....................................

G erm any................................

Ita ly ........................................

l
4
*

8
4
*

Central
government

(billion dollars)

United States.......................... . ..
Seven European countries........

Nether, ands............................

Belgium...................................

Sweden...................................

20
*

3
*

* N o t available; very small in the case of foreign securities.

three times the combined total for the seven
wealthiest nations of Western Europe—
Germany, the United Kingdom, France, Italy,
the Netherlands, Belgium and Sweden. The
total output of goods and services—a rough
measure of the “size” of an economy—is only
75 per cent greater in the United Slates than
the total for these seven nations combined.
Gross security issues (excluding mortgages),
moreover, have been four or five times as
great here as in the seven European nations
in recent years.
Gross saving in the United States—includ
ing private and public outlays on construction
and equipment, but excluding durable con
sumer goods—is close to 20 per cent of
national product. Most European countries
estimate even higher savings rates. But in
comes in the United States are more than
twice as high on a per capita basis, and total
saving, therefore, is much greater.
Western Europe, of course, does not con
stitute a single capital market. Each nation
is a compartment within which access to

capital funds by foreigners may be closely
restricted.
West Germany has the largest national in
come of any nation in the Free World outside
the United States, with the United Kingdom
close behind; both countries are at levels only
one-seventh that of the United States. Switz
erland, noted as a financial center, has a total
national income less than 2 per cent of this
country’s.
In the period from the end of 1958 through
the first half of 1963, 4.3 billion dollars of
foreign securities were sold in the United
States, about 55 per cent consisting of Cana
dian issues (see chart). During this period
all European markets combined accommo
dated only 1.4 billion dollars of foreign
issues—half were placed in Switzerland. The
United Kingdom absorbed 400 million dol
lars in new securities, virtually all from Com
monwealth countries with which special
financial and trading relationships are main
tained. The other nations accepted only small
quantities of foreign securities. The Nether-

Federal Reserve Bank of Chicago

lands, for example, permitted no foreign
issues at all in three of the five years of the
period. Although, historically, the Nether
lands has been a prime financial center, for
eign issues in recent years have been allowed
only in times of balance of payments surplus.
R estrictio n s an d re g u la tio n s

The new U. S. equalization tax may be
contrasted with regulations in the various
European nations governing capital market
operations, both foreign and domestic.
Checks on the free flow of funds there are
numerous and complex and should be taken
into consideration when American interna
tional financial problems and policies are
under discussion.
Capital markets in Europe traditionally
operate under the general guidance of public
policy, expressed through government agen
cies or semiofficial cartels. Certain of the
restrictions date from the early Thirties when
the worldwide financial crisis led to extra
ordinary measures. Others, however, were
imposed in the chaos of the postwar period.
After World War II, scarce foreign exchange
was carefully mustered and channeled to
needs deemed essential by public authorities.
Some of these controls remain in effect today,
well after conditions that created them either
have disappeared or have been substantially
ameliorated.
Capital market regulations abroad are not
confined to international issues. In Germany,
for example, there are no special restrictions
on foreign issues. But such flotations are very
rare. There are three main reasons. First,
security sales are costly. Second, a large share
of savings is pre-empted and channeled by the
government. Third, the Central Capital Mar
ket Committee, a private organization with
out statutory power, effectively controls the
timing and amount of new issues. (This com

mittee is a good example of the important
financial institutions found abroad that lack
counterparts in the United States.) In short,
while the German capital market is “freely
open’’ to foreigners, barriers confronting
most outsiders are virtually insurmountable.
In most of Europe special licenses are re
quired before foreign issues can be floated.
Few of these have been granted in the post
war period, except in the case of the securities
of certain international financial institutions.
Switzerland and the Netherlands possess
well-developed capital markets, and long
term interest rates there recently have been
below those in the United States. But both
countries restrict capital issues, domestic and
foreign, to amounts the market can absorb
comfortably without pushing rates up. All
other European governments control, in large
degree, the conditions and terms of new
domestic issues, and most have the power
either to veto individual new issues or to
postpone them indefinitely. In short, capital
and money markets abroad are insulated to
a substantial extent, not only from foreign
influences, but also from market forces at
home.
Until World War I, the London market
dominated the international financial picture.
Fifty years ago 85 per cent of the new issues
in the United Kingdom came from outside,
compared with about 10 per cent recently.
In the past year, however—particularly dur
ing consideration of the interest equalization
tax—the London capital market has expe
rienced a sharp rise in the volume of foreign
capital issues marketed.
Since 1932, new security issues in the
United Kingdom, domestic and foreign, have
been under government control. Currently,
only foreign issues and those of local authori
ties are restricted, but statutory authority to
require approval of all domestic issues re-

Business Conditions, September 1964

Fo re ig n bond issues floated
in the United States have
dwarfed those sold in Europe
billion dollars

0
1
2
3
4
---1
1 1 1 1 -- 1 1 1 1
Canadian

United States

Other

O
total Europe

Switzerland

United Kingdom

■

Netherlands

Germany

Sweden

i
i
i

mains. In addition, the Bank of England
operates a “queue,” which determines the
timing of all issues of 1 million pounds and
more.
Special arrangements in Europe also con
trol purchases of existing foreign security
issues by citizens. In the United Kingdom, the
Netherlands and Belgium, special arrange
ments must be made for the acquisition of
foreign exchange for such transactions. Ex
change rates for transactions in goods are
stabilized, but prices of foreign exchange used
in security purchases move more freely.
Heavy demand for foreign issues by investors
in these countries can result in a substantial
premium on available exchange and may
make such purchases prohibitive.
Most national governments have ready
access to the capital funds of their citizens
largely because there is little danger of legal

default and because their issues are broadly
marketable. This advantage is fortified in
various ways in Europe. In France, govern
ment issues have first priority and other issues
are held off the market when necessary. In
several other nations—Germany, for exam
ple—substantial taxes are levied on private
and foreign issues, which do not apply to
issues of the federal, state or municipal gov
ernments, or other institutional borrowers
whose quests for funds are encouraged by
public policy.
G o v e rn m e n t in in d u stry

Railroads, telecommunications, gas and
electric utilities, coal mines and important
manufacturing enterprises in most European
countries are owned and operated by govern
ment. In the United States, of course, gov
ernment enterprises play a much smaller
role. Less than 3 per cent of fixed investments
are made by government corporations and
enterprises while the proportions for some
European countries are as follows: Belgium
9, Netherlands 14, Sweden 22, France 26 and
the United Kingdom 29. In Germany and
Italy, the proportion of public to total invest
ment is roughly the same as in France and the
United Kingdom.
In addition, certain European governments
lend funds to favored private enterprises,
either directly or through intermediaries.
Operating budget surpluses of the federal and
state governments in Germany are made
available to housing, the utilities and indus
try .1 Authorities in France and Italy employ
various devices to assure that both shortand long-term funds loaned by the various
financial institutions are directed to enter’In most European countries the treasury pre
pares two budgets, an operating budget and a capital
budget. The former usually shows a surplus, while
the latter often requires large debt financing.

Federal Reserve Bank of Chicago

prises whose activities promote
the “national plan” for the econ
B o rro w in g costs in major countries in 1962
omy.
N e w industrial issues
Channeling of bank funds to
Yield
Issue Additional
Cost
Yieldto
cost
annual
to
cost
desired uses is aided in Europe
investor
amortized expense borrowers spread
by governmental powers unknown
(per cent per year)
in the United States. For example,
United States........
4.45
0.10
—
4.55
0.10
the four largest French commer
United Kingdom .. .
6.43
0.21
0.04
6.68
0.25
cial banks, with branches through
5.77
1.17
0.88
7.82
2.05
France...................
Germ any..............
6.12
0.76
0.14
7.02
0.90
out the country, have been nation
6.15
0.53
2.22
8.90
2.75
Ita ly ......................
alized since World War II. Much
Netherlands..........
4.81
0.45
0.05
5.31
0.50
of the housing credit in Germany
Belgium.................
5.57
0.43
0.12
6.12
0.55
is provided by municipal savings
Switzerland...........
4.02
0.36
0.04
4.42
0.40
banks. The central bank in Italy
SOURCE: Adapted, in part, from Lloyds Bank Review, July 1963.
controls the composition of com
mercial bank loan portfolios. Italy
also authorizes “special credit
institutes,” which provide inter
mediate term funds under government super
funds. These institutions have accounted for
vision for particular segments of the econ
38 per cent of the net acquisition of financial
omy, such as agriculture, electric utilities and
assets by households in the United States in
the motion picture industry.
recent years and an even larger proportion in
the United Kingdom. In Germany this pro
Home building has been strongly en
portion has been only 16 per cent and in
couraged in all major European countries in
France only 8 per cent.
recent years—even more than in the United
The relative unimportance of private life
States. Aid has been provided by a variety
insurance and pensions in most of continental
of devices, including public construction and
Europe reflects, partly, past experience with
ownership, tax incentives and preferentially
ruinous price inflation and partly the rela
low interest rates. Belgium channels 30 per
tively greater welfare benefits provided by
cent of all investment funds, public and pri
social security. In some nations huge reserves
vate, to housing, and the proportion is similar
have been built up in social insurance funds.
for most other countries. Nine of every 10
Sweden’s National Pension Insurance Fund
new dwelling units in France benefit by some
invests substantial sums in housing, public
form of subsidy. German housing takes about
utilities and bonds of private businesses.
50 per cent of the funds provided by the
capital markets, much of the total represent
America’s private insurance companies
play a much more important role in financing
ing security issues of mortgage banks which
are exempt from the tax on new private
business—through purchases of bonds, either
issues.
direct from the issuers, or through the capital
markets—than their European counterparts.
A striking characteristic of the continental
Clearly, limitations on the ability of insurance
nations in contrast with the United States or
investors to participate in business financing
the United Kingdom is the much smaller imin most large European countries impede the
portance of private life insurance and pension

Business Conditions, September 1964

development of strong primary and secondary
capital markets.
B u sin ess fin a n ce a b ro a d

The spread between the yield to investors
and costs to borrowers is very small in the
case of large private bond issues sold in the
United States, because markets are efficient
and highly competitive. A long-term, highgrade American corporate bond yielding 4.5
per cent to investors may cost the debtor 4.6
per cent with all underwriting and administra
tive costs amortized over the life of the issue.
In England this “spread” may be 0.2 to 0.3
per cent. In France or Italy the spread may be
as great as two full percentage points, and the
cost of a bond issue to the borrower may be
7.5 per cent or more per annum (see table).
There are several reasons for the large
spreads on European bond issues. Underwrit
ing fees commonly are 2 to 5 per cent even
when issues are sold to institutions. In addi
tion, there are taxes on the total value of new
issues in some countries—in Germany, for
example, the tax is 2.5 per cent on foreign
or nonexempt domestic issues and in Bel
gium, 0.7 per cent on domestic issues and 1.6
per cent on foreign issues.
High costs and regulations combine to re
strict the extent to which European firms use
their home capital markets. As a result they
rely heavily upon retained earnings and
depreciation allowances and short- or inter
mediate-term loans.
Nonmarketable business debt, mainly bank
loans, accounts for about 35 per cent of total
business debt in the United States compared
with 50 per cent in the United Kingdom, 76
per cent in France and 79 per cent in Ger
many. In some cases European bank loans
have maturities of three to five years and are
similar to United States “term loans.” Others,
however, are for very short terms, such as 90

days, and are continually renewed.
One reason why large numbers of Euro
pean firms have sought to borrow in the
United States is that profit margins have been
narrowing in recent years—partly as a result
of rising wage costs— and their supply of
internally generated funds has been less ade
quate than several years ago. If this trend
continues, greater dependence upon capital
issues will be required if Europe’s economic
growth is to continue unabated. At present,
capital markets are not sufficiently developed
to supply these needs.
A p p e a l to th e public

The typical family in continental Europe
is much less likely to hold corporate stocks
or bonds, either directly or indirectly through
institutions, than its American counterpart.
Low incomes are partly responsible. Also, the
European public is not well acquainted with
the security markets. Even the well-informed
are wary of stocks and bonds because busi
ness firms in Europe, particularly in France
and Italy, do not release comprehensive in
formation on their operations and recognized
techniques of investment analysis are not
easily applied to determine the relative worth
of shares.
Stock ownership in most countries also is
discouraged by tax structures that penalize
shareholding as compared with the incen
tives commonly provided to promote holding
of various types of liquid assets. In addition,
many well-known firms are entirely or largely
family owned. In the latter case, a secondary
market is apt to be thin, if it exists at all, so
that fair prices may not be obtained if a
shareholder desires to sell.
Investors in France, Germany and Italy
have experienced price inflation and unsettled
domestic conditions on a scale unknown in
the United States. Concern regarding future

Federal Reserve Bank of Chicago

price inflation tends to encourage stock
ownership in the United States where such
investments, rightly or wrongly, are con
sidered a suitable “hedge” against rising com
modity prices. To some extent this view pre
vails also in Europe; nonetheless, share
ownership has not become widespread.
T o w ard lib e ra liz a tio n

Financial leaders in most European coun
tries strongly advocate steps that would per
mit an easier flow of capital funds from savers
to users within national boundaries, and in
ternational, as well. Special study groups,
such as the Radcliffe Committee in the United
Kingdom and the Lorain Committee in
France, have made detailed recommenda
tions intended to promote such a develop
ment. These commissions have concluded,
though, that substantial government controls
over capital markets must be maintained.
Nevertheless, substantial international eco
nomic cooperation has been achieved in the
postwar period and further liberalization of
barriers inhibiting the free flow of goods and
funds over international borders is antici
pated. This cooperation has been notable in
the operation of the World Bank, the Inter
national Monetary Fund, the Organization
for Economic Cooperation and Development
(OSCD) and the European Economic Com
munity (EEC).
The OECD in December 1961 adopted
a code to liberalize capital markets. In 1963
EEC (the Common Market) proposed that
all capital markets be opened completely to
foreign issues by the end of 1967.
Specific recommendations to aid the devel
opment of capital markets include removal
of discriminatory taxes, broadening of the
investment discretion open to managers of
insurance companies and other institutions,

encouraging the expansion of mutual funds
and investment trusts that pool funds for
equity investments, increasing information
made available to investors by business firms
and a broadening of the types of securities
issued by corporations to include such instru
ments as preferred stocks, convertible deben
tures and variable income bonds to increase
financial flexibility. Most important, of
course, is the recommendation that regula
tions discriminating against foreign issues be
relaxed. Such changes are asked particularly
of such nations as Germany and France,
which import capital despite strong balance
of payments positions.
Experimentation with a number of new
devices also is advocated. The successful
development of the Eurodollar market in
which loans denominated in United States
dollars are made in Europe has encouraged
other innovations. One of these is the “unit
of account loan” denominated in various cur
rencies. In addition, proposals have been
made for loans that would be marketed simul
taneously in several countries and bear inter
est rates related to the prevailing levels in the
nations in which the issues were sold. Finally,
the recent strengthening of London’s position
as an international financial center, or entre
pot—particularly in the past year—has
added an encouraging note.
The objective of funds freely flowing from
one nation to another may not be wholly
realized in the two-year life of the interest
equalization tax, if ever. Nevertheless, the
world appears to be moving gradually, if
unsteadily, toward this goal. In the eyes of the
Administration, the interest equalization tax
is a necessary measure under current condi
tions and clearly preferable to such alterna
tives as general exchange controls or a capital
issues committee vested with wide discretion
ary authority.

Full text of Business Conditions (Federal Reserve Bank of Chicago) : September 1964

FRASER