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a n e c o n o m ic review b y th e F e d e ra l R e s e r v e B a n k o f C h ica g o A B C s of figuring in terest 3 The m ethod used to calculate interest can have substantial effect on the am ount o f interest paid. Savers and bor rowers should be aware not only o f nominal interest rates but also o f how nom inal rates are used in calcu lating total interest charges. Banking developments 12 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, September 1973 A B C s of figuring interest During periods when market interest rates are rising, commercial banks, savings and loan associations, and other financial insti tu tio n s find themselves competing for funds with direct market investments such as Treasury bills and corporate bonds. Because yields on market investments are determined by the interplay of supply and demand, they are free to go above the ceil ing rates established by regulatory bodies on certain classes of consumer-type savings deposits. When market rates move above deposit ceiling rates, funds have a tendency to move out of deposits and into direct market instruments to obtain the higher yields. During most of 1973, market rates have been above the permissible ceiling rates for regulated consumer-type savings deposits. To make such deposits as attrac tive as possible, banks and savings and loan associations (S&Ls) have been anxious to offer and advertise the greatest dollar am ount of interest legally possible on all classes of regulated deposits. “Continuous com pounding” and figuring annual interest on a “ 360-day year”—both permissible under the law—are techniques used to in crease the dollar am ount of interest paid per given am ount of deposit. In July 1973, regulatory authorities raised the maximum interest rates that financial institutions could pay on various categories of savings deposits by lA to lA percentage points, and ceilings were re moved entirely on deposits of $1,000 or more maturing in not less than four years. (Later, ceiling-free deposits for any one bank were limited to 5 percent of its total time and savings deposits.) But increases in rates not withstanding, the exact am ount of interest income earned by depositors continues to depend on the rate of interest selected by their depository institution and on the method that institution uses to cal culate interest. On the other side of the coin, the dollar am ount of interest borrow ers pay on loans granted by financial insti tutions also depends on the interest rate charged by the lender and on the method the lender uses to com pute interest. W hile various interest calculation methods continue to be used, Truth-inLending legislation, to a certain degree, has eliminated some of the confusion con cerning costs of consumer credit. This legis lation requires that the “ annual percentage rate” be disclosed to the consumer. Con gressional hearings are now in progress on analogous Truth-in-Savings legislation. The confusion resulting from different interest calculation methods can be lessened, how ever, once the relationships among the dif ferent methods are understood. Interest calculations Interest represents the price borrowers pay to lenders for credit over specified periods of time. The am ount of interest paid depends on a number of factors: the dollar am ount lent or borrowed, the length of time involved in the transaction, the stated (or nominal) annual rate of interest, the repaym ent schedule, and the method used to calculate interest. If, for example, an individual deposits $1,000 for one year in a bank paying 5 percent interest on savings, then at the end of the year the depositor may receive in terest of $50, or he may receive some other amount, depending on the way interest is calculated. Alternatively, an individual who borrows $1,000 for one year at 5 percent 4 and repays the loan in one paym ent at the end of a year, may pay $50 in interest, or he may pay some other am ount, again de pending on the calculation method used. Simple interest The various methods used to calculate interest are basically variations of the simple interest calculation method. The basic concept underlying simple interest is that interest is paid only on the original am ount borrowed for the length of time the borrower has use of the credit. The am ount borrowed is referred to as the principal. In the simple interest calculation, interest is com puted only on that portion of the original principal still owed. Example 1: Suppose $1,000 is bor rowed at 5 percent and repaid in one pay ment at the end of one year. Using the simple interest calculation, the interest amount would be 5 percent of $1,000 for one year or $50 since the borrower had use of $1,000 for the entire year. When more than one paym ent is made on a simple interest loan, the m ethod of computing interest is referred to as “in terest on the declining balance.” Since the b o rro w e r only pays interest on that amount of original principal which has not yet been repaid, interest paid will be smaller the more frequent the payments. At the same time, of course, the am ount of credit the borrower has at his disposal is also smaller. Example 2: Using simple interest on the declining balance to com pute interest charges, a loan repaid in two payments— one at the end of the first half-year and another at the end of the second half-year —would accumulate total interest charges of $37.50. The first paym ent would be $500 plus $25 (5 percent of $1,000 for one-half year), or $525; the second pay ment would be $500 plus $12.50 (5 per Federal Reserve Bank of Chicago cent of $500 for one-half year),or $512.50. The total am ount paid would be $525 plus $512.50,or $1,037.50. Interest equals the difference between the am ount repaid and the am ount borrowed, or $37.50. If four quarterly payments of $250 plus in terest were made, the interest amount would be $31.25; if 12 monthly payments of $83.33 plus interest were made, the in terest am ount would be $27.08. Example 3: When interest on the de clining balance method is applied to a loan that is to be repaid in two equal payments, payments of $518.83 would be made at the end of the first half-year and at the end of the second half-year. Interest due at the end of the first half-year remains $25; therefore, with the first paym ent the bal ance is reduced by $493.83 ($518.83 less $25), leaving the borrower $506.17 to use during the second half-year. The interest for the second half-year is 5 percent of $506.17 for one-half year, or $12.66. The final $518.83 paym ent, then, covers in terest of $12.66 plus the outstanding bal ance of $506.17. Total interest paid is $25 plus $12.66, or $37.66, slightly more than in Example 2. This equal paym ent variation is com monly used with mortgage paym ent sched ules. Each paym ent over the duration of the loan is split into two parts. Part one is the interest due at the time the payment is made, and part two—the remainder—is applied to the balance or am ount still owed. In addition to mortgage lenders, credit unions typically use the simple in te r e s t/d e c lin in g balance calculation method for computing interest on loans. Consumer instalment loans are normally set up on this method and in recent months a number of banks have also begun offering personal loans using this method. Other calculation methods Add-on interest, bank discount, and Business Conditions, September 1973 compound interest calculation methods dif fer from the simple interest method as to when, how, and on what balance interest is paid. The “effective annual rate,” or the annual percentage rate, for these methods is th at annual rate of interest which when used in the simple interest rate formula equals the am ount of interest payable in these other calculation methods. For the declining balance m ethod, the effective annual rate of interest is the stated or nominal annual rate of interest. For the methods to be described below, the effec tive annual rate of interest differs from the nominal rate. Add-on interest. When the add-on in terest method is used, interest is calculated on the full am ount of the original principal. The interest am ount is immediately added to the original principal and payments are determined by dividing principal plus in terest by the number of payments to be Add-on interest: the more frequent the payments, the higher the effective rate effective annual rate* (percent) *Based on 5 percent add-on, one-year loan. 5 made. When only one paym ent is involved, this method produces the same effective in terest rate as the simple interest method. When two or more payments are to be made, however, use of the add-on interest method results in an effective rate of interest that is greater than the nominal rate. True, the interest am ount is calculated by applying the nominal rate to the total am ount borrowed, but the borrower does not have use of the total am ount for the entire time period if two or more payments are made. Example 4: Consider, again, the twopayment loan in Example 3. Using the add-on interest m ethod, interest of $50 (5 percent of $1,000 for one year) is added to the $1,000 borrowed, giving $1,050 to be repaid; half (or $525) at the end of the first half-year and the other half at the end of the second half-year. Recall th at in Example 3, where the declining balance method was used, an effective rate of 5 percent meant two equal payments of $518.83 were to be made. Now with the add-on interest method each paym ent is $525. The effective rate of this 5 percent add-on rate loan, then, is greater than 5 percent. In fact, the corresponding effective rate is 6.631 percent. This rate takes into account the fact that the bor rower does not have use of $1,000 for the entire year, but rather use of $1,000 for the first half-year, and, excluding the in terest paym ent, use of $508.15 for the second half-year. To see that a one-year, two equal pay ment, 5 percent add-on rate loan is equi valent to a one-year, two equal payment, 6.631 percent declining balance loan, con sider the following. When the first $525 payment is made, $33.15 in interest is due (6.631 percent of $1,000 for one-half year). Deducting the $33.15 from $525 leaves $491.85 to be applied to the out standing balance of $1,000. The second $525 payment covers $16.85 in interest 6 (6.631 percent of $508.15 for one-half year) and the $508.15 balance due. In this particular example, using the add-on interest method means that no m at ter how many payments are to be made, the interest will always be $50. As the number of payments increases, the bor rower has use of less and less credit over the year. For example, if four quarterly payments of $262.50 are made, the bor rower has the use of $1,000 during the first quarter, around $750 during the second quarter, around $500 during the third quar ter, and around $250 during the fourth and final quarter. Therefore, as the number of payments increases, the effective rate of interest also increases. For instance, in the current example, if four quarterly pay ments are made, the effective rate of in terest would be 7.922 percent; if 12 monthly payments are made, the effective interest rate would be 9.105 percent. The add-on interest method is commonly used by finance companies and some banks in determining interest on consumer loans. Bank discount. When the bank dis count rate calculation method is used, interest is calculated on the am ount to be paid back and the borrower receives the difference between the am ount to be paid back and the interest am ount. In Example 1, a 5 percent $1,000 loan is to be paid back at the end of one year. Using the bank discount rate method two approaches are possible. Example 5: The first approach would be to deduct the interest am ount of $50 from the $1,000, leaving the borrower with $950 to use over the year. At the end of the year he pays $1,000. The interest amount of $50 is the same as in Example 1. The borrower in Example 1, however, had the use of $1,000 over the year. Thus, the effective rate of interest using the bank dis count rate method is greater than that for the simple interest rate calculation. The Federal Reserve Bank of Chicago effective rate of interest here would be 5.263 percent—i.e., $50 + $950—compared to 5 percent in Example 1. Example 6: The second approach would be to determine the am ount that would have to be paid back so that once the interest am ount was deducted, the bor rower would have the use of $1,000 over the year. This am ount is $1,052.63, and this becomes the face value of the note on which interest is calculated. The interest am ount (5 percent of $1,052.63 for one year) is $52.63, and this is deducted leaving the borrower with $1,000 to use over the year. The effective rate of interest, again, is 5.263 percent. The bank discount method is commonly used with short-term business loans. Generally there are no intermediate payments and the duration of the loan is one year or less. Compound interest. When the com- Compound in terest: over time, compounding increases the amount of in te re st paid cumulative interest amounts* (dollars) ‘ A m ount paid on $1,000 at 5 percent annual interest rate. Business Conditions, September 1973 7 pound interest calculation is used, interest is calculated on the original principal plus all interest accrued to th at point in time. Since interest is paid on interest as well as on the am ount borrowed, the effective interest rate is greater than the nominal in terest rate. The compound interest rate method is often used by banks and savings institutions in determining interest they pay on savings deposits “loaned” to the institutions by the depositors. sumed to be 365 days long. Historically, in order to simplify interest calculations, financial institutions have often used 12 30-day months, yielding a 360-day year. If a 360-day year is assumed in the cal culation and the am ount borrowed is ac tually used by the borrower for one full year (365 or 366 days), then interest is paid for an additional 5/360 or 6/360 of a “year.” For any given nominal rate of interest, the effective rate of interest will be greater when a 360-day year is used in the interest rate calculation than when a 365-day year is used. This has come to be known as the 365-360 method. Example 7: Suppose $1,000 is de posited in a bank that pays a 5 percent nominal annual rate of interest, com pounded semi-annually (i.e., twice a year). At the end of the first half-year, $25 in interest (5 percent of $1,000 for one-half year) is payable. At the end of the year, the interest am ount is calculated on the $1,000 plus the $25 in interest already paid, so that the second interest payment is $25.63 (5 percent of $1,025 for one-half year). The interest am ount payable for the year, then, is $25 plus $25.63, or $50.63. The effective rate of interest is 5.063 percent which is greater than the nominal 5 percent rate. T h e more often interest is com pounded within a particular time period, the greater will be the effective rate of interest. In a year, a 5 percent nominal annual rate of interest compounded four times (quarterly) results in an effective a n n u a l rate of 5.0945 percent; com pounded 12 times (m onthly), 5.1162 per cent; and compounded 365 times (daily), 5.1267 percent. When the interval of time between compoundings approaches zero (even shorter than a second), then the method is known as continuous com pounding. Five percent continuously com pounded for one year will result in an effective annual rate of 5.1271. How long is a year? In the above examples, a year is as Example 8: Suppose $1,000 is de posited in a bank paying a 5 percent nominal annual rate of interest, com pounded daily. As pointed out earlier, the effective annual rate of interest for one year, based on a 365-day year, is 5.1267 percent. The interest payable on the 365th day would be $51.27. Daily compounding means that each day the daily rate of 0.0137 percent (5 percent divided by 365 days) was paid on the $1,000 deposit plus all interest payable up to that day. Now suppose a 360-day year is used in the calcu lation. The daily rate paid becomes 0.0139 percent (5 percent divided by 360 days) so that on the 365th day the interest amount payable would be $52. The effective annual rate of interest, based on a 360-day year, would be 5.1997 percent. Example 9: Suppose that a $1,000 note is discounted at 5 percent and payable in 365 days. This is the situation discussed in Example 5 where, based on a 365-day year, the effective rate of interest was seen to be 5.263 percent. If the bank discount rate calculation assumes a 360-day year, then the length of time is computed to be 365/360 or 1 1/72 years instead of one year, the interest deducted (the discount) equals $50.69 instead of $50, and the effec tive annual rate of interest is 5.267 percent. Federal Reserve Bank of Chicago 8 In terest paid under the Rule of 78 is always more than under the declining balance — but how much more depends on: The term of the original loan contract difference in interest paid (dollars per $100 of interest) The effective annual rate of interest Business Conditions, September 1973 When repayment is early In the above examples, it was assumed that periodic loan payments were always made exactly when due. Often, however, a loan may be completely repaid before it is due. When the declining balance method for calculating interest is used, the borrow er is not penalized for prepayment since interest is paid only on the balance o u t standing for the length of time that amount is owed. When the add-on interest calcula tion is used, however, prepayment implies that the lender obtains some interest which is unearned. The borrower then is actually paying an even higher effective rate since he does not use the funds for the length of time of the original loan contract. Some loan contracts make provisions for an interest rebate if the loan is prepaid. One of the common methods used in deter mining the am ount of the interest rebate is referred to as the “ Rule of 78.” Applica tion of the Rule of 78 yields the percentage of the total interest am ount that is to be returned to the borrower in the event of p re p a y m e n t. The percentage figure is arrived at by dividing the sum of the inte ger numbers (digits) from one to the number of payments remaining by the sum of the digits from one to the total number of payments specified in the original loan contract. For example, if a five-month loan is paid off by the end of the second month (i.e., there are three payments remaining), the percentage of the interest that the lend er would rebate is 1+2+3=6 h-1+2+3+4+5= 15, or 40 percent. The name derives from the fact that 78 is the sum of the digits from one to 12 and, therefore, is the denom inator in calculating interest rebate percentages for all 12-period loans. Application of the Rule of 78 results in the borrower paying somewhat more in terest than he would have paid with a com parable declining balance loan. How much more depends on the effective rate of in terest charged and the total number of 9 payments specified in the original loan con tract. The higher the effective rate of in te r e s t charged and the greater the specified total number of payments, the greater the am ount of interest figured under the Rule of 78 exceeds that under the declining balance method. (See chart.) The difference between the Rule of 78 interest and the declining balance in terest also varies depending upon when the prepayment occurs. This difference over the term of the loan tends to increase up to about the one-third point of the term and then decrease after this point. For example, with a 12-month term, the difference with prepayment occurring in the second month would be greater than the difference that would occur with prepayment in the first m onth; the third-month difference would be greater than the second-month dif ference; the fourth month (being the onethird point) would be greater than both the third-month difference and the fifth-month difference. After the fifth month, each succeeding m onth’s difference would be less than the previous m onth’s difference. Example 10: Suppose that there are two $1,000 loans that are to be repaid over 12 months. Interest on the first loan is calculated using a 5 percent add-on method which results in equal payments of $87.50 due at the end of each month ($1,000 plus $50 interest divided by 12 months). The effective annual rate of interest for this loan is 9.105 percent. Any interest rebate due because of prepaym ent is to be deter mined by the Rule of 78. Interest on the second loan is calcu lated using a declining balance method where the annual rate of interest is the effective annual rate of interest from the first loan, or 9.105 percent. Equal pay ments of $87.50 are also due at the end of each m onth for the second loan. Suppose that repayment on both loans occurs after one-sixth of the term of the loan has passed, i.e., at the end of the 10 s e c o n d month, with the regular first m onth’s payment being made for both loans. The interest paid on the first loan will be $14.74, while the interest paid on the second loan will be $14.57, a difference of 17 cents. If the prepaym ent occurs at the one-third point, i.e., at the end of the fourth month (regular payments having been made at the end of the first, second, and third months), interest of $26.92 is paid on the first loan and interest of $26.69 on the second loan, a difference of 23 cents. If the prepaym ent occurs later, say at the three-fourths point, i.e., at the end of the ninth m onth (regular payments having been made at the end of the first through eighth months), $46.16 in interest is paid on the first loan and $46.07 in in terest paid on the second loan, a difference of but 9 cents. Bonus interest Savings institutions are permitted to pay interest from the first calendar day of the month on deposits received by the tenth calendar day of the m onth, and also on deposits withdrawn during the last three business days of a month ending a regular quarterly or semi-annual interest period. If a savings institution chooses to do this, then it is paying for the use of the depo sitor’s money for some period of time dur ing which the savings institution does not have the use of the money. The effective rate of interest is, therefore, greater than it would be otherwise. Example 11: Suppose that on Jan uary 10, $1,000 is deposited in a bank pay ing 5 percent interest compounded daily based on a 365-day year and that funds deposited by the 10th of any m onth earn interest from the 1st of that month. On the following December 31, 355 days after the deposit is made, interest for 365 days is payable on the deposit, or $51.27. The bank, however, had the use of the funds for Federal Reserve Bank of Chicago only 355 days. The effective rate of in terest, or that rate which when com pounded daily for 355 days would yield the interest am ount $51.27, is 5.1408 percent. Although savings institutions choosing to pay interest for these grace periods are prohibited from advertising an effective yield which takes this into account, depo sitors should be aware of the effect such practice has on the price paid for the use of their money. Charges other than interest In addition to the interest which must be paid, loan agreements often will include other provisions which must be satisfied. Two of these provisions are mortgage points and required (compensating) deposit balances. Mortgage points. Mortgage lenders will sometimes require the borrower to pay a charge in addition to the interest. This ex tra charge is calculated as a certain per centage of the mortgage am ount and is referred to as mortgage points. For ex ample, if 2 points are charged on a $10,000 mortgage, then 2 percent of $10,000, or $200, must be paid in addition to the stated interest. The borrower, therefore, is paying a higher price than if points were not charged—i.e., the effective rate of in terest is increased. In order to determine what the effective rate of interest is when points Eire charged, it is necessary to deduct the dollar am ount resulting from the point calculation from the mortgage am ount and add it to the interest am ount to be paid. The borrower is viewed as having the m ort gage am ount less the point charge am ount rather than the entire mortgage amount. Example 12: Suppose th at 2 points are charged on a 20-year, $10,000 m ort gage where the rate of interest (declining Business Conditions, September 1973 11 balance calculation) is 7 percent. The pay ments are to be $77.53 per month. Once the borrower pays the $200 point charge, he starts out with $9,800 to use. With pay ments of $77.53 a m onth over 20 years, the result of the 2 point charge is an effec tive rate of 7.262 percent. The longer the time period of the mortgage, the lower will be the effective rate of interest when points are charged because the point charge is spread out over more payments. In the above example, if the mortgage had been for 30 years instead of 20 years, the effective rate of interest would have been 7.201 percent. Example 13: Suppose that $1,000 is borrowed at 5 percent from a bank to be paid back at the end of one year. Suppose, further, that the lending bank requires that 10 percent of the loan am ount be kept on deposit. The borrower, therefore, has the use of only $900 ($1,000 less 10 percent) on which he pays an interest amount of $50 (5 percent of $1,000 for one year). The effective rate of interest is, therefore, 5.556 percent as opposed to 5 percent when no compensating balance is required. Required (compensating) deposit bal ances. A bank may require that a borrower maintain a certain percentage of the loan am ount on deposit as a condition for obtaining the loan. The borrower, then, does not have the use of the entire loan am ount but rather the use of the loan am ount less the am ount that must be kept on deposit. The effective rate of interest is greater than it would be if no compensating deposit balance were required. Summary Although not an exhaustive list, the methods of calculating interest described h ere are some of the more common methods in use. They serve to indicate that the method of interest calculation can sub stantially affect the am ount of interest paid, and that savers and borrowers should be aware not only of nominal interest rates but also of how nominal rates are used in calculating total interest charges. Anne Marie LaPorte Federal Reserve Bank of Chicago 12 anking developments Consumer deposit interest rates P re lim in a ry evidence indicates that a majority of district member banks raised the rates they pay on savings and time de posits of less than $100,000 to the new higher maximums perm itted as of July 1 and are offering ceiling-exempt, four-year obligations with minimum denominations of $1,000. The July amendments to the Federal Reserve’s Regulation Q permitted banks to compete more effectively for con sumer savings and thus slow the shift out of deposits into other investments in response to the sharp increase in market interest rates. In the most recent quarterly survey of time and savings deposits, almost twothirds of the 257 respondents in the Seventh District said they were paying the new 5 percent ceiling rate on passbook savings in early August, while more than three-quarters reported they had moved to the new ceilings on the various m aturity categories of time deposits. (The rate re ported for each category is the most common rate paid on the largest volume of new deposits.) In total, the survey banks account for 80 percent of all member bank savings and time deposits. The reporting panel includes all district member banks with deposits of $100 million or more. Although smaller banks comprise 60 per c e n t of this panel, these respondents include less than one-fifth of all the smaller district member banks, and the survey resu lts, therefore, may not accurately represent the pervasiveness of the rate adjustments that have taken place at the smaller banks. Among other things, the survey re vealed that a smaller proportion of the sur vey banks was paying the maximum rates in early August than three m onths earlier especially with respect to passbook savings accounts. However, the ceilings applicable in the earlier survey had been in effect since January 1970, and many banks adjusted to those levels only after a con siderable lag. Although some banks do not offer time deposits other than passbook savings, of those that do, the vast majority tend to offer the ceiling rate on such accounts. The proportion of responding banks that had not increased their passbook savings rate to 5 percent by early August was a relatively large 35 percent, and onesixth of these banks were still paying 4 per cent or less. Last May, only one-fourth of the survey respondents were still below the old 4V2 percent ceiling. Reluctance to raise rates on savings stems mainly from the large increases in costs entailed in the application of the higher rate to all outstanding accounts. New high-rate time accounts may draw former savings funds as well as new money, but because the higher rates apply only to new deposit contracts, the cost impact of such a shift is relatively small while the bank is assured use of th e funds over a longer period. Business Conditions, September 1973 13 In te re st ra te s paid on IPC time and savings deposits under $1 0 0 ,0 0 0 by 2 5 7 d istrict member banks1 b e tw e e n A pril 30 an d July 31, 1973, in contrast to a gain of more than 2 per Tim e (by m aturity class) cent in the compar Under 2Z 2 years able period of 1972. Savings 1 year 1-2 yrs. 1-2Vz yrs. and over 4 years Passbook savings at Aug. Aug. M ay Aug. May Aug. May May these banks declined 0.7 percent in the Maximum rate three months ended (percent) 4.5 5.0 5.0 5% 51 /2 51 /2 6 61 /2 July 31, 1973, com Percent of banks: pared with gain of Paying maximum n e a rly 2 percent 77 65 95 79 90 rate 81 93 77 during the compar Paying less 2 19 17 23 35 7 1 6 able period a year Not offering 0 2 0 3 2 3 17 6 earlie r. Consumertype time deposits 1Based on quarterly surveys as of the end of April and the end of Ju ly but including changes made the first week of August. declined 0.2 percent o v e r t h e th r e e months ended July 31. When the four-year Four-year, $1,000 minimum obligations ($425 million issued in July) are deducted from the totals, consumerThe most distinctive feature of the type time deposits declined 4.4 percent. July amendments to Regulation Q was the The net decline from April through removal of rate constraints from time deposits carrying maturities of four years July was concentrated at the large Illinois banks. Total time and savings deposits of or more in amounts of at least $1,000. This exem ption was later modified to apply individuals, partnerships, and corporations (IPC) declined about 3 percent at 40 only up to 5 percent of a bank’s total time and savings deposits. Of the survey respon Illinois member banks with total deposits over $100 million. dents, 87 percent of the large banks (total deposits of $100 million or more) and 70 Whether or not there were stirrings of a turnaround in August is questionable. percent of the smaller banks reported offer ing some such instrum ent. Characteristics Weekly data reported by 55 large district varied widely—33 different combinations banks indicate relatively small net inflows of terms were reported. Rates ranged from of consumer-type funds in August. The 6.75 percent to 8.50 percent; computation total rose less than $40 million, or 0.2 per was from simple interest to continuous cent, from August 1 to September 5. An com pounding; minimum denominations inflow of $330 million into the ceiling-free varied from $1,000 to $25,000. The most deposits in the period was largely offset by common type was a $1,000 denomination declines in savings and other time deposits at 7 percent compounded quarterly. subject to ceiling rates. The possibility that future gains in ceiling-free deposits either will offset de Flows of funds clines in other consumer-type deposits or contribute to net inflows is uncertain. A Despite the higher rates offered, total Joint Resolution of the Congress directing consumer-type time and savings deposits at the regulatory authorities to take action to the survey banks declined 0.5 percent limit the rates of interest paid on deposits 2 14 of less than $100,000 at financial interme diaries has been forwarded to the President for his signature. ■ Portfolio changes—first-half 1973 As would be expected in a period of strong loan demand and increasing mone tary restraint, bank investment portfolios declined during the first half of 1973. At Seventh District member banks, all of the decline was in U. S. Government securities. Holdings of both municipals and federal agency issues rose more than in the same period a year ago. Much of the record loan expansion was financed by a large net in flow of time and savings deposits. Total loans of district member banks, excluding sales of federal funds, rose $5.6 billion, or 12 percent, through midyear—a record volume and more than twice the rate of expansion in the comparable period of 1972. Holdings of U. S. Treasury secur ities declined almost 15 percent, which represented an offset of only about 22 per cent of the dollar increase in loans. On June 30, 1973, loans comprised 71 percent of total earning assets of all district mem ber banks, up from 67 percent a year ear lier. Governments accounted for less than 10 percent of total portfolios, down from 12 percent a year earlier. State and muni cipal obligations in the portfolios of these banks rose by 3.5 percent in the first half. They comprised about 15 percent of all earning assets and more than half of invest ment securities held at midyear. Holdings of U. S. agency securities rose 8 percent in the first half but were still only 3.4 percent of all loans and investments. These portfolio developments reflect a combination of normal cyclical adjustment patterns and the composition of securities supplied to the market. The trend over re cent years has been for banks to keep their portfolios of U. S. securities, which yield relatively low returns, within a fairly nar row band above the minimal levels consis Federal Reserve Bank of Chicago tent with collateral needs against govern ment (federal, state, and local) deposits. These holdings tend to increase in periods of slack loan demand and falling interest rates and to be liquidated when credit markets tighten. Fluctuations reflect, in part, changes in the trading accounts of those banks that have dealer departments, where inventory positions are affected both by the volume of new Treasury offerings and prospective changes in securities prices implied by interest rate expectations. At midyear, Government security portfolios of all district member banks were below the previous low of $7.1 billion reached in June 1970, and continued to decline in July and August. One factor th at may have contributed to the declining importance of Treasuries in banks portfolios is the changed treatm ent of capital gains under the Tax Reform Act of 1969. With capital gains now treated as ordinary income for tax purposes, banks have a greater incentive to reach out for h ig h e r-y ie ld in g assets than Treasuries. Moreover, the recent emphasis on liability m a n a g e m e n t has reduced reliance on Government securities as a source of liqui dity. This undoubtedly has been enhanced by the relaxation of ceiling rate constraints in the CD market since mid-1970. Holdings of other securities, by con trast, have followed a fairly steady upward trend, reflecting both their higher net yields relative to Treasuries, and sharply increased supplies reaching the market. Although the spread between short-term Treasury and U. S. agency issues has been reduced markedly in recent years, yields on ten-year or longer agencies still averaged about 40 basis points above their Treasury equivalents in the first half of 1973. Per haps even a more im portant factor ex plaining the acquisition of agencies was that net offerings of agencies in the first half of 1973 were more than three times as large as a year earlier. Securities issued by states and muni- Business Conditions, September 1973 15 accounts of individuals, partner ships, and businesses (IPC ac counts), obviated the necessity to liquidate municipals or even Securities to slow the rate of acquisition 2 U. S. Govt. Fed. Aqencv State and local Loans significantly. Percent change—first half of 1973 How do the asset changes at 3.5 7.7 11.9 -14 .6 District member banks in the first half of 3.1 4.9 -11 .4 Illinois 15.3 1973 compare with those of the 5.5 8.4 10.3 -15.2 Indiana same period of 1969, when a 5.3 13.8 -14 .5 9.1 Iowa similar rise in short-term interest 3.8 9.9 8.0 -18.1 Michigan .5 12.4 rates was taking place? Liqui -20 .6 9.2 Wisconsin dation of Treasury securities was Percent of total loans and investments, Ju n e 30, 1973 almost the same in both years. 14.6 3.4 9.8 71.0 District Other securities rose less in 1969, 14.0 3.5 9.6 71.5 Illinois with declines in agency issues 15.0 10.7 3.6 69.3 Indiana 15.8 6.1 13.5 64.1 Iowa offsetting a substantial rise in 15.9 2.7 71.1 9.3 Michigan municipals. Loans on the banks’ 12.5 3.2 8.7 74.8 Wisconsin balance sheets grew by only 3 percent in the first half of 1969, 1 Excludes corporate and other securities comprising about 1 percent of total loans and investments. as the major source of loanable 2 Excludes federal funds sold and securities purchased under f u n d s —in flo w s o f tim e de resale agreements. posits—dried up as market yields moved above maximum legal deposit in cipalities, generally exempt from federal terest rates under Regulation Q. During the taxes, have comprised a steadily rising share first half of 1973, IPC time and savings of bank investment portfolios. Earnings are undoubtedly a major factor in this growth. deposits for the district as a whole in creased by $3.3 billion, or 9 percent, the On a net after-tax basis, yields on ten- and major portion of which consisted of CDs in 30-year prime municipals have averaged denominations of $100,000 or more. For about 90 and 160 basis points, respectively, the same period in 1969, IPC time and above comparable Treasuries through most savings deposits decreased by more than of this year. Commercial banks are a major $300 million. During the earlier period, market for securities of local governments, however, the large banks were acquiring and they often underwrite general obli funds by borrowing in the Eurodollar gation issues. Furtherm ore, the purchase of market and by selling loans. tax anticipation notes of these entities is For the most part, asset changes in the clearly an im portant way that banks supply credit in response to community needs. first six months of 1973 on a state-by-state basis are similar to the district pattern. (See Nearly half of all outstanding state and table.) Illinois member banks recorded the local government debt obligations are held greatest increase in loans and the smallest by banks, and their expansion in bank p ort decline in Treasury securities. Private time folios is closely related to the volume of and savings deposits increased by 13.7 per financing. The pace of the banks’ acqui cent in Illinois. This was the largest increase sition of these issues is affected, of course, for any state in the Seventh District and is by their ability to attract funds in relation mainly attributable to the issuance of large to c u s to m e r credit demands. Deposit certificates of deposit by Chicago money growth in the first half of 1973, paced by market banks. ■ the 9 percent gain in time and savings Strong loan demand is reflected in the a s se t portfolios of d istric t member banks
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