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december Bank Liability Management: For Better or for W orse? M onetary Restraint, Regulation Q, And Bank Liability Management Banking on Debt for Capital Needs The Fed in Print business reefetc FEDERAL RESERVE BANK of PHILADELPHIA IN THIS IS S U E ... Bank Liability Management: For Better or for Worse? . . . Bank liability management has consider ably increased financial market com petition; however, some critics argue that it has brought reduced monetary policy effective ness and greater bank riskiness. Monetary Restraint, Regulation Q, And Bank Liability Management . . . In the '60s, when the Fed maintained interest rate ceilings on negotiable CDs, large banks began issuing other money market instruments to com pete for loanable funds. Banking on Debt for Capital Needs . . . Debt may be a useful source of funds for banks and a reserve cushion for the FDIC, but its usefulness as capital may be limited. On our cover: A thousand toys and banks in the Perelman Antique Toy Museum provide a dis tinctive walk through America's childhood. Located at 270 South Second Street in Philadelphia, the museum boasts a w ide assortment of mechanical penny banks that were patented in 1865 and are sought today by collectors. Fire engines, roller skates, trains, dolls, blocks, hansom cabs, and other types of toys on display tell the toy history of our nation. (Photographs by Sandy Sholder.) B U S IN E S S R E V IE W is produced in the Department of Research. Editorial assistance is provided by Robert Ritchie, Associate Editor. Ronald B. W illiam s is Art Director and Manager, Graphic Services. The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia, http://fraser.stlouisfed.org/ Philadelphia, Pennsylvania 19105. Phone: (215) 574-61 15. Federal Reserve Bank of St. Louis Bank Liability Management: For Better O r For Worse? By Stuart A. Schweitzer W ith the financial collapse of 1933 almost forgotten, today's byword for banks is competi tion. Banks no longer stand back from the finan cial fray, waiting for the public to come to them. A rising aggressiveness propels them into the financial markets where they are scrapping for business like everyone else. As an example, bank assets at one time consisted largely of cash items and U. S. Government securities, and bank lend ing activities were limited. Now, however, banks vie among themselves and with other lenders to extend credit to businesses and households. Similarly, while they once relied for their loan funds upon people's willingness to keep large balances in interest-free checking accounts, banks today offer double-digit interest rates to attract funds from diverse sources. In a nation whose economic system is based upon the principle that competition is the best way to achieve efficiency, word of banks' new competitiveness should be good news to the public. But some observers think otherwise. They argue that banks' enterprising behavior makes the banking and financial system less se cure, and monetary policy less effective, than if banks were more conservative in their behavior. Bank regulators have a duty to preserve the basic soundness of the financial system, but they must carefully avoid stifling the competition that breeds efficiency and service for bank customers. BANKERS JO IN THE FRAY Bankers have always faced a basic cash man agement problem. On the one hand, they must be ready at all times to make good on the checks written by their depositors. To succeed at this they either need to hold an abundance of cash or must be able to raise cash quickly. As bankers would say, they need to have liquidity. On the 3 BUSINESS REVIEW DECEMBER 1974 other hand, bankers also want to earn as large a profit as possible. And to do that they have to make interest-bearing loans and investments which can be hard to turn into cash on short notice. The last three decades have produced a major shift in bankers' willingness to trade off liquidity for earnings. Banks entered the post-World W ar II period with large holdings of Government securities that they had acquired as a part of the warfinancingeffort.1They also held fresh memo ries of the loan losses and bank failures of the 1930s. As the postwar years went on, however, the strengthened national economy and the avowed U. S. Government commitment to full employment made another depression seem in creasingly unlikely. That made loans a more attractive alternative to Government securities. At the same time, as the pace of economic activ ity accelerated, so did the volume of business requests for bank loans. Most bankers chose to accommodate their customers' loan demands— accepting reduced liquidity in exchange for higher profits. loan growth and a shortage of funds, banks sought new sources of liquidity. Money market banks in New York, as well as large banks in other cities, began issuing negotiable certifi cates of deposit (CDs) at competitive interest rates. These CDs were time deposits, and hence carried fixed maturity dates. They were made particularly attractive, however, by the develop ment of a secondary market for CDs $100,000 and larger, which meant these instruments could be sold before maturity if an investor needed his funds. The CD innovation was successful, and banks learned that liquidity could be found on both sides of the balance sheet. A bank needing funds could choose to go to the money market either with its assets or with its liabilities for sale. Banks choosing to practice "liability manage ment"— that is, issuing liabilities at competitive rates to fulfill cash needs— could combine asset liquidity with liability liquidity to support fur ther loan growth. Along with CDs, banks in the 1960s began is suing a multitude of other manageable liabilities. Federal funds trading, which had previously oc curred in limited volume, grew rapidly. Banks borrowed Euro-dollars from their foreign branches, and bank holding companies sold commercial paper and loaned the proceeds to their bank sub sidiaries. The effect is that, while virtually none of the funds at large banks were derived from liability management in 1960, nearly 30 percent originate with this source today. Banks are now vigorous competitors in the market for loanable funds. However, the increasing reliance on lia bility management as a source of bank liquidity is raising concern as to whether the practice is in the public interest. A "Shortage" of Funds. The growth in bank loans to business in the 1940s and 1950s was facilitated by stored-up liquidity— that is, banks' cash assets and U. S. Government securities, which represented roughly three-fourths of their assets in 1946. By the end of the '50s, however, bank lending capacity was largely depleted. Al though deposits had grown by about 50 percent in the postwar period, total bank loan volume had tripled. The loan-liquidity gap was widened further in the early '60s, when corporations began paring their demand deposit balances. Whereas corporate treasurers had formerly held large sums of idle money in interest-free checking accounts, they were now withdrawing these funds to pur chase interest-bearing assets such as Treasury bills and commercial paper. AGGRESSIVE BANKING: TOO M UCH OF A GO O D THING? Critics of bank liability management contend that, while the practice may offer some benefits to society, it may also have some costs that out weigh the public's gains. Competition may make the public better off, but opponents charge that the potential for reduced monetary policy effec Tapping New Markets. Faced with further 'In 1940, even before the United States' involvement in W orld W a r II, over 60 percent of member banks' assets were in cash items and U. S. Governm ent securities. 4 FEDERAL RESERVE BANK OF PHILADELPHIA tiveness and greater bank riskiness offset these gains. Many believe that liability management merely allows banks to get a bigger share of the credit pie without influencing total credit in the economy. Without liability management, they argue, funds would simply by-pass banks, going through other financial firms or directly from ultimate lenderto ultimate borrower. With liabil ity management, the argument goes, banks are in a better competitive position to attract and re lend funds, but the volume of the total creditflow is, for the most part, unchanged. If so, the effec tiveness of restrictive monetary policies proba bly is not impaired by the bank credit growth that liability management permits. In addition, many claim that liability manage ment does not affect the impact of tight policy on the economy because Fed policy works through changes in the money stock and not through changes in credit. An important ingredient of the money stock is, of course, demand deposits— a particular kind of bank liability.2 This raises the question of whether bank liability management makes control of money more difficult. Doesn't liability managementallow bankstoobtain more funds which they can then use to support more demand deposits? In our economy, the ultimate restriction on the banking system's ability to create demand de posits is the availability of reserves. Because member banks are required to hold reserves equal to a fraction (designated by the Fed) of outstanding deposits, the amount of these de posits they create is limited by the availability of reserves. So using an oversimplified illustration, if the reserve ratio is 20 percent and reserves amount to $30 billion, deposits cannot exceed $150 billion (20 percent of $150 billion is $30 billion). If the Fed increases reserves to $31 bil lion, demand deposits could rise to $155 billion. The world is more complicated than this simple example suggests because the reserve ratio fluc tuates. First, the required reserve ratio is different Competition and Public Gains. The chief benefit to society at large from bank liability management is that the practice has brought stiffer competition to financial markets. Com pared to the period before I960, when banks avoided com petitively bidding for loanable funds, the public now has additional financial options. Savers with funds to invest in short term assets can now buy not only Treasury bills and commercial paper but also bank CDs. Bor rowers whose loan needs might not have been accommodated at the banks can, because of lia bility management, choose between bank loans and other types of credit. W ith public use of these added options high, it is safe to conclude that the banks' terms are attractive and that the public has gained from their availability (see Box). However, if liability management creates significant offsetting costs to society, the public could wind up worse off despite the benefits liability management creates. Monetary Policy and Any Losses? Critics of bank liability management argue that it allows banks to circumvent a restrictive monetary poli cy. In the past when monetary policy tight ened and market interest rates moved up, rates on CDs and other bank deposits lagged behind because of restrictions on the rate bankers were permitted to pay. Since banks were less able to compete for funds because of these restrictions, bank credit shrank. During the 1960s, however, banks began to issue unregulated obligations on which they paid market interest rates. They bor rowed from Euro-dollar, Federal funds, and commercial paper lenders. Aggressive liability management kept funds flowing into the banks for relending (see accompanying Chart Article). This process clearly permitted banks to use liability management to insulate themselves from some of the impacts of tight monetary poli cy. Indeed, the process continues to work today, especially since all interest rate ceilings on large CDs have been suspended. But a more important issue is whether liability management lessens the impact of monetary policy on the economy. A uthorities differ on what ought to be counted as money. A popular view is that money consists of the public's demand deposits and currency holdings. M any believe, however, that savings deposits at commercial banks should be included in money as well. 5 DECEMBER 1974 BUSINESS REVIEW FOR LARGE AND SMALL ALIKE? It's a truism that anyone who voluntarily conducts his business with a bank, when he could conduct that business with some other borrower or lender, is glad to have that bank around. Liability management is one device that banks have used to make themselves available for borrowing and lending. But does the little fellow gain as much from this availability as the big one? Let's look at savers and investors separately. Savers. The small saver has not reaped many benefits from liability management. After all, it is the corporations, wealthy individuals, and governmental units that can come up with the funds to buy a $100,000 CD, not the little guy. Large CDs paved the way for the savings certificates available to the small saver, but those certificates carry lower rates than do large CDs. A key element of liability management is the payment of competitive rates on savers' funds. Now, liability management has not produced the same sorts of gains for small savers as for large savers, not because banks are unwilling to compete for small savers' funds, but rather because of Federal Reserve and FDIC ceilings on the rates banks can pay on small deposits. These regulations serve a purpose which the nation values highly, protecting thrift institu tions (mutual savings banks and savings and loan associations) from a wholesale loss of funds. But the regulations, and not discriminatory bank behavior, are what stand between liability management and enlargement of small savers' financial options. Borrowers. W hat would borrowers' options be if there were no liability management and, in particular, no CDs? It seems plausible to assume that savers who now buy CDs would instead buy commercial paper. The funds now available to borrowers through bank loans would then be available through the commercial paper market. Very large businesses could borrow directly in that market. Other businesses and individualscould not issuecommercial paper, but could borrow from finance companies, which can. As above, those who actually borrow at banks when they have the choice of these other methods reveal themselves to be better off than they would be if banks couldn't loan to them. Another issue is whether loan customers of small banks suffer indirectly because of the liability management practices of large banks. The problem is that small banks are net lenders of Federal funds to large banks. Federal funds are excess reserves loaned for short periods by one bank to another. Many large banks, as part of their liability management activities, bid aggressively for Federal funds on a continuing basis. W hen large banks bid these funds away from smal I banks, the effect is for loanable funds to flow from the rest of the country to the major financial centers in the nation's large cities. Individuals and small firms that are borrowers from the small lending banks may well suffer in such cases. It might be suggested that this could all be prevented by appropriately regulating the Federal funds market. The Federal funds market occupies so special a place in the transmission of Federal Reserve monetary policy, however, that this would be impractical. Besides, any restrictions on the flow of Federal funds would probably be circumvented somehow. Banks are very innovative, and if it were profitable for the funds to flow to the big cities, the banks would find a way to get them there. Furthermore, the effect of inhibiting the funds flow would be to subsidize rural area firms and individuals whose borrowing opportunities are affected. If society wants to subsidize these firms and individuals, it can probably find a more efficient way. 6 FEDERAL RESERVE BANK OF PHILADELPHIA for different banks. Second, actual reserves held exceed required reserves on demand deposits by varying amounts.3 But the example does point out how the Fed can control demand deposits generally. As long as the demand deposit/reserve ratio is fairly predictable over time the Fed can control demand deposits through reserves. Banks' use of liability management techniques will not impair the Fed's ability to manage the nation's money stock, unless it makes the de mand deposit/reserve ratio more erratic. There is no evidence that this has happened to date. Overall, therefore, the impact of liability man agement on monetary policy effectiveness doesn't seem substantial. Bank credit growth is facilitated by aggressive bank competition for loanable funds. But total credit is probably unaf fected. Moreover, the Fed's ability to control the nation's money stock does not appear to be un duly hampered by the advent of liability man agement. Bank Riskiness and Public Losses. The prin cipal argument offered today, however, by those who oppose liability management is that it has reduced the soundness of numerous individual banks and therefore threatens the stability of the entire banking system. Most critics do not ques tion the industry's use of liability management per se, but contend that many banks have grown too reliant on the practice and do not maintain sufficient liquid assets to meet unforeseen cash needs. They claim that these banks are " i l liquid." The danger in being illiquid is clear— an otherwise solvent bank can be pushed into fail ure if it can't meet its cash needs. For even though a bank's assets might appear to exceed its liabilities, those assets might not hold their value if the bank had to sell them hurriedly to meet impending cash needs. If a forced sale made asset values decline by an amount greater than the level of bank capital,4 the bank would be come insolvent and then fail. The evidence on asset liquidity at the nation's banks is consistent with the critics' position. Throughout the postwar years, the proportion of bank funds invested in cash and other liquid assets has gradually declined. At the same time, loans— which are of lesser liquidity— have been a growing component of bank portfolios (see Chart). A large proportion of the liquid assets that banks still have is already committed to meet reserve requirements and requirements to hold collateral against government deposits. They are, therefore, largely unavailable to meet other cash needs. The evidence on liability liquidity is less clear. The fact that banks already have substantial vol umes of manageable liabilities on their books tells us nothing about how much liability liquid ity they have left. It does, of course, tell us of their need to turn regularly to lenders to "roll over"— or refinance— maturing liabilities. What we need to know, however, is whether banks can count on being able to roll over existing liabilities and sell new obligations when cash needs arise. A bank's ability to sell its liabilities depends in part on market conditions and on its willingness to pay market interest rates. The most important factor, however, is whether lenders think the bank is sound. Lenders have recently become particularly sensitive to the issue of bank safety. The high interest rates banks were paying for funds and the financial difficulties of the Franklin National Bank combined to make investors wonder whether other banks that use liability management for liquidity were still sound. Whereas in the past lenders often accepted bank soundness on faith, many became anxious about the creditworthiness of the banks whose CDs they bought. Some of these lenders responded by shifting their funds into larger banks. As a result, 3 This results partly because banks hold reserves in excess of requirements and in part because reserves are required against other bank liabilities. 4 An issue closely related to whether banks have ample liquidity is whether they have enough capital. See Ronald D. Watson, “ Insuring Some Progress in the Bank Capital Has sle," Business Review of the Federal Reserve Bank of Philadelphia, July-August 1974, pp. 3-17. 7 DECEMBER 1974 BUSINESS REVIEW ASSET LIQUIDITY FALLS BY THE WAYSIDE Percent of Total Assets 80 ----------------- NOTE: Data are as of December 31 of each year and apply to all commercial banks. SO URC E: Federal Reserve Bulletin the nation's largest banks now pay an interest rate below that paid by other liability-managing banks. Indeed, some lenders will now lend only to the largest banks, regardless of interest rate. Moreover, tight-credit periods make it particu larly difficult for banks to expand their use of liability management. Lenders might interpret a rapid build-up of a bank's manageable liabilities as a sign of stress at the bank, limiting the useful ness of liability management as a source of addi tional liquidity. Furthermore, it could even be counterproductive in such an environment for a bank to offer more than the rate paid by banks of similar size to attract new funds. Lenders might read the higher rate as an admission of great risk and scramble to get their funds out before the worst had a chance to happen. Thus, while it can't be proved that bank liquid ity on average is now too low, there is certainly justifiable concern about its adequacy. Reliance upon liability management as a principal source of liquidity could at some point leave some banks unable to cope with liquidity pressures. Society's losses from bank failures that might then occur could indeed offset the gains from the competition that liability management has gen erated. BALANCING COMPETING INTERESTS: THE PROBLEM As might be expected, a close appraisal of liability management reveals both public ben efits and public costs from the practice. The pub8 FEDERAL RESERVE BANK OF PHILADELPHIA lie gains from having access to financial markets that are more competitive than they would be without bank liability management. But the pub lic also loses from the increased potential for bank failures and from the possibility of a reduc tion in the effectiveness of monetary policy. Everyone has a stake in a stable and secure financial system— one that facilitates rather than impedes productive activity. Only if banks kept 100 percent reserves against their liabilities, however, would there be absolutely no risk of bankfailure from illiquidity. But if banks did that, there would be less competition to issue loans, which would impose costs on the public in other ways. Most would agree that 100 percent re serves are not needed, and that with a bit less liquidity, banks could start competing in loan markets without becoming unsound. The prob lem isto identifythe best amount of liquidity fora bank. Ideally, from society's standpoint, the right amount of bank liquidity is that which produces the greatest net benefits for society— that is, which maximizes the difference between the public's benefits and its costs. Identifying that amount is a tricky business, since the public's costs and benefits are not readily measured. At taining it is even trickier, however, since the costs that banks respond to are the ones that affect their stockholders' profits, and these amounts may not include all the costs which are important to society at large.5That is where bank regulators— the Federal Reserve, the Comptrol ler of the Currency, the FDIC, and the 50 state banking departments— come in. An important part of their job is to balance the interests of society and the banks, insuring that banks re spond to social as wel I as private considerations. ment has been profitable for the banks, its heavy use has reduced liquidity below where the pub lic's net benefits are greatest. Indeed, many banks have already begun reducing their re liance on liability management, in response to signals from the market and from regulators that they ought to do so. But whether banks will end up acquiring enough liquidity to reach the so cially “ right" position depends on the framework regulators establish to promote that end. The Framework Today. Market forces and regulatory pressures currently play a role in limit ing bank reliance on liability management. The role of market forces, on the one hand, is limited by the fact that investors know relatively little about the soundness of individual banks. They cannot efficiently respond, therefore, to changes in the creditworthiness of borrowing banks. Bank regulators, on the other hand, conduct periodic examinations of all insured banks. Armed with hard facts about a bank's condition, a regulatory agency can press for changes which it deems advisable. However, regulators have proceeded cautiously in this area because they don't have clear standards against which an in dividual bank's liability management activities can be judged. At present, the limits on bank liability man agement are not at all firm. Bankers get some signals about how far they should go, but those signals may not always be strong enough to curb their behavior. It is possible, therefore, for indi vidual banks to get into a liquidity bind even though the banking system as a whole is sound. To protect confidence in the banking system from the possible excesses of a few banks, the Federal Reserve stands ready to meet its respon sibility as “ lender of last resort."6 A founding purpose of the Fed was to prevent general liquid ity crises, and it has traditionally stood ready to lend to solvent but illiquid banks when no one BALANCING COMPETING INTERESTS: METHODS Many argue that, although liability manage 6See, for example, “ Maintaining the Soundness of Our Banking System/' an address by Arthur F. Burns, Chairman, Board of Governors of the Federal Reserve System, at the. annual convention of the American Bankers' Association, Honolulu, H awaii, O ctober 21, 1974. 5 h en a bank fails, its stockholders lose whatever they W have invested. But the public may lose the uninsured portion of its deposits and other bank debt, and the failure may undermine confidence in other banks as well. 9 DECEMBER 1974 BUSINESS REVIEW keep them from spreading. One bank's failure could easily beget deposit outflows at other banks. That might well cause those other banks to fail and seriously undermine confidence in the entire banking system. else would do so. At the same time, however, "lender of last resort" loans from the Fed's dis count window are intended to protect banks from illiquidity only while they make appro priate asset and liability adjustments. Discount window loans are not designed to insulate banks from the need to make those adjustments.7 The window's function is to insure bank safety for the public's benefit, not to provide a subsidy to bank stockholders. Therefore, while the "lender of last resort" function is a valuable safety valve, it is not a sub stitute for regulatory and internal bank manage ment policies that insure adequate liquidity for banks. The problem is to build into the banking system measures that will bring these policies about and to balance the benefits properly against any reduction of financial market com petition. There's no quick way to do so, how ever, for the regulators' short-run options are few. It will take new approaches to achieve these kinds of results. Should the Regulators Set the Standards? Another way for bank regulators to insure that banks maintain an ideal reliance on liability management is for them to impose their stan dards on banks directly. Once those standards were met, banks would be able to meet cash needs with less strain, which would do much to reduce the pressure of deposit runoffs. The reg ulators may not have the means to enforce their standards, however. The record of bank innova tion in response to regulatory actions isthat tradi tionally banks have found loopholes faster than regulators could plug them. If regulators were to limit bank reliance on one or more kinds of liabilities, banks would probably devise a new method of attracting funds. But even if regulatory standards could be en forced, it's not clear what those standards should be. What is the ideal liquidity ratio for a bank? To what extent should banks be allowed to trade off liquidity for earnings? Until light is shed on these issues, the regulators could easily adopt improper standards. The public could incur sig nificant costs if the standards were wrong, with out the regulators ever knowing it. It would seem preferable to seek solutions which protect the public by allowing the interplay of economic forces to reflect changing preferences. Should the Banks Stand Alone? One approach that is frequently suggested, but which seems seriously flawed, is to let failing banks fail. In such a world, if a bank assumed too much risk and couldn't meet its obligations, the Fed wouldn't extend it credit. Advocates say that banks, knowing there would be no one around to bail them out, would plan accordingly. The dis cipline of the market would then be all that was needed to produce the "right" mix of conser vatism and risk-taking in banking. There is some merit in the notion that banks should either stand on their own or fail. That would encourage greater efficiency in banking, since inefficient and poorly managed banks wouldn't have much chance of survival. The problem with this approach, however, is that it might be difficult to isolate bank failures and Closing the Information Gap. Still another approach, which employs the discipline of the market, would be to give the investing public better information than it now gets about banks' financial health. As matters stand now, the in formation lenders have on the banks they deal with is typically quite sketchy. Thus, they often proceed on intuition, rules of thumb, and, worst of all, rumor. There's no more effective way to prevent rumor than to present the facts. If the public knew key elements of an up-to-date examiner's 7 The discount w ind ow also extends credit to member banks to help with significant seasonal outflows of funds, and to provide long-term help to overcom e some “ em ergency" situations— such as those occurring from natural disasters that affect the communities they serve— as well as for short term "adjustm ent" credit. 10 FEDERAL RESERVE BANK OF PHILADELPHIA report on every bank, it could make an informed selection among borrowing banks. But the key is that the facts would have to be current. National banks are now examined roughly every eight months, and state-chartered banks approxi mately once a year. That sort of timetable leaves plenty of opportunity for major changes in a bank's condition to occur between examina tions. If bank examinations were updated at, say, quarterly intervals, this could not happen.8Then, if the examiner's quarterly summary of each bank's capital, asset, and management quality were available to the public, rumor might not readily sweep the financial market.9 An important advantage of this plan is that bank soundness would have the profit motive on its side. Investors wouldn't lend to banks that had anything less than a clean bill of health, unless they were paid premium interest rates. That would add an extra incentive for banks to curb their risk exposures and to maintain greater liquidity. Furthermore, while this idea may be new in banking it is applied every day in the bond market. Bond market investors are able to rely on the published ratings of bond issues, w hich are based on extensive information collected by private agencies. The proposed release of examiners' ratings would afford that same benefit to investors in short-term bank debt. The only difference would be that risk information would come from public regulatory agencies instead of private firms. Such an approach could not be implemented overnight, of course. For one thing, the release of examiner's ratings is now illegal. It would take an act of Congress to change that. What's more, the regulators would need time to gear up for more frequent examinations.1 The banks would also 0 need time to prepare for their new environment. Those banks which now have less than the best possible examiner's report, and which may now be working with the regulators to correct their problems, should be given time to get their houses in shape for public scrutiny. If it were announced, say, that banks have two years to get ready, that might do the trick. The banks would have time to correct any adverse situations, and conditions would start improving immediately. LIABILITY MANAGEMENT: IT'S HERE TO STAY In comparison to ordinary deposit banking, liability management is a more aggressive way to run a bank. That aggressiveness has meant added options for the public, but many feel that heavy use of the technique has also harmed the public by making the achievement of monetary policy objectives more difficult. They also say that it has made the banking system less liquid and there fore potentially less stable than it should be. True, liability management can provide banks with liquidity beyond that available in their as sets, but liability liquidity is found in a bank's ability to issue and sell new liabilities. Those obligations that are already on a bank's books only increase its needsfor liquidity, not its supply of liquidity. The banks are aware of their greater vulnera bility to shifts of financial market sentiment when they rely on liabilities for liquidity. They are un likely to curtail their operations, however, unless market forces or regulatory actions compel them to do so. As long as reduced liquidity and ex panded liability management are profitable for the banks, they will continue to pursue these practices. The market currently provides some incentives for banks to stay liquid, and many 8 n Novem ber 12, 1974, Comptroller of the Currency O James E. Smith announced new procedures to update periodically his office's information on national bank loan quality and liquidity. Henceforth, he announced, all national banks w ill be required to provide the Comptroller with regu lar reports of past-due loans. The 200 largest national banks, furthermore, w ill be required to supply quarterly reports on asset and liability maturities. ,0ln part, this time would be needed to take on and train the additional examiners required to meet the more fre quent examinations timetables. The regulators would also need time, however, to coordinate their examination ac tivities in order to insure com parability of their examination reports. 9lt would also help if the number of rating categories used were large enough and their definitions narrow enough to reveal small changes in a bank's circumstances. That way, the user of an examiner's report could readily distinguish major and minor changes in bank condition. 11 DECEMBER 1974 BUSINESS REVIEW know about each bank's health and let investors and the banks work things out between them selves. That way, there is a substantial chance that the competitive benefits of liability man agement can be preserved, while the threat of bank failures can be reduced. K bankers have recently begun to take account of these incentives. However, it is largely up to the regulators to promote greater bank liquidity. The regulators can try to do this administratively by telling the banks what liquidity ratios they must attain. Or they can tell the public what they ECONOMICS of INFLATION Inflation is currently a major problem facing the U.S. Can policymakers curtail it? If so, how much will their actions "co st" society? Is inflation "b a d ," and if so, why? Are there ways of "living with inflation" that cushion its negative impact on the individual and society? Six articles reprinted from the Philadelphia Fed's Business Review address these questions in detail and seek to promote an understanding of the problem for both policymakers and the general public. Copies are available free of charge. Please address all requests to Public Information, Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105 12 Monetary Restraint, Regulation Q, and Bank Liability Management CHART 1 IN 1970 THE FEDERAL RESERVE REMOVED THE INTEREST RATE CEILING APPLICABLE TO CERTAIN NEGOTIABLE CERTIFICATES OF DEPOSIT OF COMMERCIAL BANKS.* PRIOR TO THAT TIME IT HAD ATTEMPTED TO USE THIS CEILING AS AN INSTRUMENT OF MONE TARY RESTRAINT BY REFUSING TO INCREASE IT AS RAPIDLY AS MONEY MARKET RATES HAD RISEN. Percent Percent * Maximum rates on all 30-89 day, single-maturity CDs in denominations of $100,000 or more were suspended on June 24, 1970. Maximum rates on certificates of longer maturity were removed on May 16, 1973. NOTE: Shaded areas in all charts represent periods when commercial paper rates were above maximum rates on CDs. SO U R C E: Federal Reserve Bulletin 13 DECEMBER 1974 BUSINESS REVIEW CHART 2 14 FEDERAL RESERVE BANK OF PHILADELPHIA CHART 3 15 DECEMBER 1974 BUSINESS REVIEW CHART 4 THIS HELPED TO OFFSET CD RUNOFFS AND SUSTAIN THE GROWTH OF MONEY MARKET LIABILITIES AT LARGE COMMERCIAL BANKS. Billions of Dollars Billions of Dollars 16 Banking On Debt fo r Capital Needs By Ronald D. Watson banking industry in years ahead. Debt may be a useful source of funds to the banks and a reserve cushion for the Federal Deposit Insurance Cor poration, but its value in protecting society from bank failures is very limited. Bank supervisors may someday regret it if they sacrifice equity capital standards in the mistaken belief that debt is just as good. Ninth National Bank is under fire from the bank supervisors. Convinced that the bank is undercapitalized, the regulators are demanding an additional $1,000,000 of capital stock. H ow ever, the bank's management knows that with stock prices depressed there will be severe dilu tion of the current stockholders' earnings and ownership control if new stock is sold. Instead, it counters with an offer to add $1,000,000 of long-term debt to the bank's capital structure, arguing that the debt will protect the depositors just as much as a new stock issue. This alternative puts the regulators in an un comfortable spot. Long-term debt has some of the characteristics of equity capital, but it's an imperfect substitute. Should they compromise and take whatever depositor protection is offered by long-term debt or insist that new stock be sold? The choice isn't easy, and the precedents that bank supervisors are now setting will greatly influence the profitability and solvency of the IS DEBT CAPITAL? Suppose a bank wants to use debt as a substi tute for equity in raising new capital— why should society care? If debt has characteristics that make it similar to common stock in the way it protects depositors from the bank's losses, the regulators have little cause for objecting to its use. But, if debt is substantially less effective than stock in protecting both the individual bank and the banking system, there is good reason for bank supervisors to prevent banks from treating it like equity capital. 17 DECEMBER 1974 BUSINESS REVIEW Common Stock as Bank Capital. For the func tions that capital must perform in a commercial bank— protecting depositors and allowing the bank to absorb losses without failing— common stock has long been regarded as the best form of capital. It has no maturity date, so the bank need never worry about paying it off. In addition, divi dend payments are not a legal obligation, so failure to pay them will not bring the bank's operations to a halt. Finally, as long as the equity capital accounts exceed any losses suffered, the bank is considered solvent. This last point is of critical importance. Capital must be available to absorb both oper ating losses— the result of current expenses ex ceeding current revenues— and capital losses on investments— whether they result from falling bond prices, loan defaults, broken leases, or any thing else. As long as losses can be fully offset against capital invested by the bank's owners, the legal claims of depositors or other creditors are not compromised, and the bank can con tinue to function. Charging losses against the bank's equity capital accounts is a normal busi ness practice. It's only when losses are so great that they wipe out these capital accounts and impair the bank's ability to pay its liabilities in full, that the institution will be forced to close.1 Mild losses on investments and temporary operating deficits are sufficiently common in banking that it is in the best interests of the de positors, investors, and the economy for banks to have a cushion of equity capital. W ith capital to absorb losses, most banks can operate without interrupting their operations, forcing the FDIC to cover their depositors' claims or disrupting the public's confidence in its banking institutions. The key question that regulators must confront is "can the amount of capital needed to protect depositors differ from the amount of equity needed to keep the bank going?" Debt as Bank Capital. Long-term debt has characteristics quite different from common stock, and these differences are important to de ciding whether it is a good capital substitute (see Box 1). First,;-the maturity of debt is fixed. Any bank debt issue of seven or more years to matu rity can be classified as a capital note and listed on the balance sheet as a capital account item. Many debt issues have much longer maturities, but 25 years is normally an upper limit. Maturities of that length certainly differentiate these bonds from ordinary deposits which may be withdrawn on very short notice. A long-term issue must eventually be repaid, but the banker knows exactly when that payment obligation must be met and can plan ahead. In all probabil ity the debt issue will be refinanced by the sale of new debt rather than repaid from internally gen erated funds. However, the fact that the bank must be able to refinance the bonds sometime near the matur ity date creates a risk that equity capital will never pose. The chance that credit markets would refuse to provide a bank with the volume of new money that it needs to refi nance outstanding debt is small, but the possibility still exists. Inability to roll this debt over could put the bank in default on the obligation and lead to a failure. Another key difference between long-term debt and common stock is the bank's legal obli gation to pay interest when it becomes due. Dis tributing a dividend to stockholders regularly and punctually is very important to a bank that wants its stock to perform well in the markets, but in an emergency, dividends can be omitted. In terest cannot. Surprisingly, the cash costs of servicing debt capital that carries no sinking fund provision2are 'W h en eve r the losses charged against a bank's capital are sufficient to offset its entire reserves, retained earnings, and surplus accounts and would partially impair its common stock account, regulators step in to reorganize, merge, or close the bank. As a practical matter, a bank must have a significant equity cushion to function for any extended period of time. If any bank realizes losses that wipe out most of its equity cushion, it would be obliged to raise new capital very quickly, if it intends to stay in business. 2Sinking funds are provisions found in bond contracts which require the bank to make periodic repayments to reduce the principal amount of the debt. Most bank debt being sold currently makes expl icit provision for some repay ment of principal prior to the issue's final maturity date. 18 FEDERAL RESERVE BANK OF PHILADELPHIA BOX 1 W HY DEBT? Aggressive bank management finds long-term debt a very appealing way to raise new money. It has characteristics which make it ideal for simultaneously supporting new growth of assets, raisingthe return on common stock, and preserving existing shareholders' control of the business. The key advantages offered by long-term debt are . . . Relatively Low Cost. Interest payments on debt are classified as a tax-deductible expense for the bank. Therefore, if its marginal tax rate is 48 percent, each $ 1 of interest expense will cut the bank's tax bill by 48 cents (giving the debt an effective after-tax cost of only 52 cents per dollar spent). A dollar distributed as common stock or preferred stock dividends is not tax-deductible, and, therefore, has an after-tax cost of $1. The tax-deductibility of interest charges would be irrelevant if bankers were forced to pay twice as much for new debt as they pay for new common stock. However, they don't pay twice as much. Debt is normally a much less expensive form of new funding for a bank than new equity. Common stock issues normally pay a current dividend yield of only 4 to 7 percent compared to the market interest yield on debt of 8 to 10 percent. Yet, few investors would be willing to buy the stock if increases in those dividends were not probable. The after-tax cash costs of new bond and common stock issues may be comparable in the first year or two, but dividend hikes on the common stock will soon make the long-run costs of equity capital far higher than those of debt. Another factor affecting the cost of new capital is flotation costs. Debt has the upper hand here also. W h ile there are exceptions to any rule, the cost of raising debt capital by selling capital notes or debentures is usually lower than the cost of a common stock issue of the same size. It may also be easier to privately place debt issues than new stock issues— especial ly when current stockholders have preemptive rights to acquire proportionate shares of any new stock created. Long-term debt may be cheap for other reasons as well. As long as the debt is not classified as a deposit, the bank is under no obligation to hold reserves against those funds. In addition, while Federal Reserve member banks are required to invest a portion of their equity capital funds in Federal Reserve Bank stock, this requirement doesn't apply to debt capital. Nor do banks have to pay a deposit insurance fee on these funds. Leverage. The fixed and relatively low cost of long-term debt makes it ideal for levering a bank's earnings. As long as the return earned on the funds raised through a new debt issue exceeds the cost of borrowing those funds, these "excess" revenues can be distributed among the stockholders— amplifyingtheir return (see Appendix). However, each dollarof debt issued by the bank represents a claim to earnings and assets that takes precedence over that of the shareholders. Those obligations are also legally binding. If the bank should fail to meet an interest or principal repayment, those creditors can ask the regulatory authorities to close it down. The risk that leverage entails may make debt unattractive when its proportion becomes sufficiently high. 19 DECEMBER 1974 BUSINESS REVIEW BOX 1 (Continued) Control. A bank's present ownership may also be attracted to debt because it represents a new source of long-term funds which will not have a voice in the management of the institution. If new common stock were issued to augment the bank's capital, the new share holders would have the right to vote for the board of directors. Bondholders have no such privilege. Therefore, if the current stockholders are willing to bear the risk of added debt, they can expand their bank without relinquishing any control of the organization. Soothing the Regulators. Many banks having capital adequacy problems with the supervi sory authorities have turned to long-term debt as a source of new capital. Debt might be sufficiently attractive to some banks that it would be raised as a source of new funds regardless of whether it could be used as capital. The fact that regulators have been willing to accept modest amounts of it as a substitute for equity capital makes it all the more appealing. no greater than the costs of most common stock. Bank stocks normally pay dividends of 3 to 6 percent of their current selling price, while debt issues must carry interest payments in the 7 to 10 percent range. However, interest expenses are tax deductible to the bank, so the after-tax cost of long-term debt is reduced to the 3V2 to 5 percent level— roughly the same as the cash flows for dividends on a common stock issue. This means that debt is no more difficult for a bank to service than common stock under normal conditions. The difference is in servicing the two forms of financing during an emergency when interest payments are obligatory and dividends are not. It is also possible for a bank which issues large amounts of long-term debt when interest rates are high to be stuck with very expensive funds if rates subsequently drop. Banks operate with very thin spreads between the return on their assets and the cost of the money they borrow. If the interest income on their loans and investments falls more rapidly than the cost of their funds, profit margins can turn into loss margins. The use of a "call provision," through which the bank can redeem its debt at a penalty price, is one way to control this risk. However, exercising this call privilege may take time, and the bank must continue to pay both the high interest and the penalty before it can rid itself of these costly funds. A third characteristic of long-term debt that is important to the analysis is its claim to payment vis-ci-vis depositors. Like equity capital, virtually all long-term debt is subordinated— it receives payment of principal and interest only after the claims of depositors have been discharged fully. Debt outranks common stock in claiming what ever funds are left after depositors have been paid, but both serve to protect the interests of the depositor. Subordinated debt should increase public confidence in the safety of an uninsured bank deposit. It is this feature of bank debt that proponents hold out as its primary benefit and the reason that regulators should allow freer use of debt as a capital substitute. Bankers Opt for More Debt. Arguingthat long maturities and subordination of debtholders' claims to those of depositors make long-term debt a good substitute for equity, bankers are now eagerly adopting it as the cheapest and easiest way to raise new capital. W hile some banks used debt prior to the Great Depression, most of the emergency Government financing of the industry that took place during the 1930s was in the form of debt capital. Following this period, banks tried to rid themselves of this debt as quickly as possible because it was commonly interpreted as a sign of weakness. In 1962 the Comptroller of the Currency reestablished debt as an acceptable form of financing for national banks, and its use has been expanding rapidly ever since. Between 1963 and 1973 the total capital of insured commercial banks more than doubled,3 3However, during the same period, the total assets of commercial banks expanded even more rapidly (from $311 20 FEDERAL RESERVE BANK OF PHILADELPHIA CHANGES IN THE CAPITAL STRUCTURE OF INSURED COMMERCIAL BANKS (in millions) 16 93 17 93 A $130 Capital Notes and Debentures Total: Source: $25,322 Total: $57,603 Report of Call—insured commercial banks—12/31 but the debt portion of "long-term capital" ex panded to more than 30 times its original size— from $1 30 million to over $4 billion (see Chart). Long-term debt now constitutes nearly 8 percent of all bank capital. debt for equity just magnifies the potential risks because it increases a bank's legal payment obli gations. In addition, the development of bank holding companies has heightened the uncer tainty since their capital positions may be quite complex and even harder to evaluate than those of the affiliate banks (Box 2). BANK REGULATORS AREN'T CONVINCED W hile bank regulators have sanctioned the use of some debt, they are apprehensive about both the degree to which it is a substitute for equity and the amount of debt a bank can safely carry. The proportion of equity capital to risky assets in banks has declined markedly in the last 15 years, and supervisors fear that this has in creased the risk of bank failures. Substituting Limits to Debt Use. As a result of these risks, regulators are quite reluctant to allow banks to acquire more than modest amounts of long-term debt. Regulatory agencies normally maintain a basic standard which limits long-term debt to a third of the bank's total capital funds. Banks which might have difficulty managing this much debt are often limited to less. This is not an inconsequential proportion, but some banks would try to raise more if there were no supervi sory restraint. billion to $827 billion) so the relative capitalization (in cluding both debt and equity) of the industry was shrinking. 21 BUSINESS REVIEW DECEMBER 1974 BOX 2 HOLDING COMPANIES COMPOUND TH E DEBT PROBLEM If defining debt limits for a commercial bank seems a tangled problem, assessing the impact of a leveraged holding company owning a leveraged bank creates a "Gordian knot" for the supervisor. The evolution of bank holding companies (BHCs) has raised some very important regulatory questions, but so far no supervisory "Alexander" has discovered the sword which will allow him to carve out a solution to this analytical nightmare. There are three elements which make this problem particularly sticky, both for the regulator and the capital market which provides this debt. Joint Operating Risks. Little information exists to help analysts determine the extent to which BHCs are either more or less risky than their component parts. Part of the theory behind forming BHCs is the complementarity of the related financial activities. The entrepreneurs who form these financial conglomerates argue that each affiliate in the BHC could help to backstop the others since periods of tight credit or recession would impact differently on each. Accord ingly, many BHCs have been capitalized at less than the sum of the capital required to operate each business separately and have relied more heavily on borrowed funds to finance their activities. Whether this practice will create inordinate risks is difficult for either the market or the regulators to determine. Who Backs the Holding Companies' Debt? A second point of great confusion is the extent to which the BH C can rely on its banking affiliate to guarantee loans to the parent corporation. Regulators are doing everything in their power to insulate the bank from the holding company, because they do not want the bank's soundness sacrificed to the aims and needs of the BHC. Supervisory authorities have set firm guidelines on the extent to which banks can be tapped for support of the parent organization but those limits are not presently clear to the investing public. Recently a financial problem experienced by the parent holding company of the Beverly Hills National Bank in California caused a "ru n " by depositors on the subsidiary bank which was, at the time, quite sound. This run created such severe liquidity problems for the bank that it eventually failed. Until the public and the investing community become fully aware of the limitations on bank support of a BHC, the market may be prone to underestimate the risk of BHCs. This is important to society because underassessment of risk will lead to artificially low capital costs and overextension by the BHCs. Double Leverage. The term sounds sinister and appropriately so. Double leverage is the practice of using debt money raised by the BHC parent to make equity investments in subsidiaries. It is an especially useful way to get around regulatory requirements concerning the capital adequacy of subsidiaries. If bank supervisors insist that the bank subsidiary increase its equity capital, the holdingcompany parent may borrow moneyto make such an investment. On the surface the bank is now safer because it does have more equity capital. But the larger BHC organization isn't any more safe. It will need the affiliate bank's dividends to pay the debt service on these new borrowings. 22 FEDERAL RESERVE BANK OF PHILADELPHIA BOX 2 (Continued) As long as the bank is fully insulated from the BHC, financial risk is being transferred from the bank to the parent corporation. There is nothing inherently wrong with this if the market for BHC securities is sensitive to these risks, can evaluate them correctly, and charges the parent a risk premium which accounts for the actual risk of the organization. However, imperfections in this evaluation process may cause problems like the Beverly Hills National Bank failure and wind up imposing a heavy cost on society. EXAMPLE Suppose, for example, a bank and its BHC are capitalized in the following way: ____________ BHC_________ Banks stock Other stock $ 10 10 $ 0 Debt 20 BHC common stock BANK SUBSIDIARY Assets COM BINED OTHER SUBSIDIARIES $100 Assets $90 10 Deposits Common stock $50 $40 10 Liabilities Common stock If the bank regulators were to request another $10 of bank equity capital because they felt the bank was too risky, they would be saying that society's best interests require that this system have additional capital . . . as follows: ____________ BHC_________ Banks stock Other stock $20 10 $ 0 30 Debt Common stock r---------- "V BANK Assets $ 110 $90 20 COM BINED OTHER SUBSIDIARIES Deposits Common stock Assets $50 $40 Liabilities 10 Common stock If the BH C were to resort to double leverage to satisfy the capital request, it would raise the needed $10 from debt sources rather than new stock . . . _ _ _________BHC Bank stock Other stock $ 20 10 $10 20 Debt Common stock r---------- "X BANK Assets $ 110 $90 20 COM BINED OTHER SUBSIDIARIES Deposits Common stock Assets 23 $50 $40 Liabilities 10 Common stock DECEMBER 1974 BUSINESS REVIEW Box 2 (Continued) The bank would have additional equity capital but the holding company system would not. Presumably the capital market will discipline BHCs' use of double leverage, but any imperfec tions in its collective analysis or in depositors' ability to differentiate financial problems of holding companies from those of the banking subsidiaries may generate great social costs not borne entirely by the investing community. dence in other banks or the financial system as a whole, and it may deprive the local community of needed services and competition. These "ex ternal" costs of the failure make it inappropriate for bank supervisory authorities to let the banks (interacting with the capital markets) have a free hand in setting debt capital standards. In principle, the capital markets themselves should also limit a bank's use of debt in its capital structure. As the proportion of debt financing grows, the risk inherent in the financial leverage it produces also grows. (Leverage is the use of funding whose cost is fixed to try to increase the profits of the shareholders. See Appendix) W hile replacing costly common stock with less expen sive debt funds may be profitable when leverage is moderate, increasing leverage risk will even tually prompt investors to demand a higher yield from both the debt and equity securities of the bank. Eventually the average costs of the bank's long-term funds will begin to rise, and the institu tion will be discouraged from any further attempt to substitute debt for equity. However, there is little evidence to date that investors find the level of bank debt disturbing enough to make them demand substantially higher yields to cover this risk. However, bank leverage creates risks for soci ety at large beyond those borne by investors. As is common for regulated industries, investors can't be counted on to discipline borrowing banks because those investors don't bear all of the costs of the institution becoming overex tended. In the case of a bank that receives assis tance from the regulators to stay in business, the bond and stockholders are given a partial re prieve and may not pay any "Social Darwinist" piper for the risks taken by the bank. This reg ulatory backstopping hardly discourages the substitution of debt for equity and may enable the investors to make a higher return from the added leverage. In the event that a bank fails, the security hold ers may lose everything they've invested, but the public may also incur costs as a result of the failure. A bank closing may undermine confi Real Protection? Differences of opinion on bank debt as capital, therefore, boi I down to the function assigned to capital. If capital's sole task is thought to be the protection of bank's depos itors— the stance taken by many bankers— then debt is a proper form of capital. In the event of a failure, the bank's losses would be offset against debt capital as well as equity capital before the FDIC or the depositors were required to absorb any losses. However, if the function of preventing failures by absorbing losses is also assigned to bank capi tal, debt is less useful. Losses cannot be charged against debt capital in an operating bank, so debt capital will not reduce the risk of failure. To the extent that long-term debt is substituted for eq uity capital, the risk of bank failures is height ened and the attendant costs to society also in creased. Since it is the job of the supervisory authorities to worry about the social costs of bank failures, most regulators are far less en thusiastic than the rest of the bankingcommunity about the growth of debt capital. DEFINING A THEORETICAL LIMIT Any ideal solution to the problem of setting limits on bank debt capital must come to grips with the fundamental economic factors just de veloped. First, bankers find leverage profitable, but only because capital markets do not consider 24 FEDERAL RESERVE BANK OF PHILADELPHIA promote social goals, but it makes no sense to create a set of debt prohibitions which cost soci ety more in the long run than the benefits pro duced are worth. Unfortunately, implementing the theoretical solution is far more difficult than simply stating it. Defining the actual dollar val ues of the costs and benefits described above would be a formidable undertaking. most banks overleveraged. In addition, the in flexibility of a bank's obligation to pay interest and repay principal makes debt a riskier form of financing than equity capital. Investors in bank securities understand and accept this risk, but they don't bear all of the costs associated with a bank failure. Finally, long-term subordinated debt may serve one of the regulator's goals— protecting depositors— but it is of no use in ab sorbing the losses that cause banks to fail. Ac cordingly, it is of little use to the regulator who expects capital to prevent failures. Even in principle, setting debt capacity rules which accommodate these factors is a difficult task. W hile regulators find debt riskier than eq uity, the only defensible reason for bank super visors limiting its use is to make society better off. If debt, in fact, magnifies the likelihood of bank failures— and their resultant social costs— limiting it is reasonable. However, if debt allows banks to achieve greater profitability or to pro vide services at a lower cost without seriously jeopardizing society's interests, there are costs to restricting its use.4 Any regulatory restriction placed on bank capital is apt to make the bank less efficient in using money. The institution may be forced to use more long-term capital or less debt than investors feel it needs. The result may be higher prices for bank services or less expan sion of banking activity than would otherwise be the case. Ideally, society's interests would be served best by limiting debt to the level where the added social costs associated with preventing banks from selecting the exact amount and composi tion of their capital structure are just offset by the additional social benefits of a lower bank failure rate.5 It makes sense to use regulatory power to * SOME PRACTICAL SOLUTIONS? Regulatory agencies have a number of possi ble options available to them for "solving" this problem of bank debt use. The first is simply to prohibit its use. This approach would prevent any possibility of a bank substituting debt for equity capital when, in fact, it needs the equity. However, this alternative is hardly sensible. It in no way solves the problem of assuring capital adequacy, and it deprives banks whose capital is "adequate" of a very useful source of additional funding. The other extreme in the spectrum of options is to adopt a market rule for limiting debt. This would be the easiest road for bank supervisors to follow in the short run, but the existence of social costs to bank failure that are not borne by the investors make this an imperfect approach. Rely ing on the capital markets to discipline banks' use of debt capital would probably lead to great er use of debt than would be ideal from society's standpoint. A long-run solution probably lies in a middle-of-the-road approach. Change the Terms on the Debt. A third possi bility might be to require that banks using long term debt as a capital supplement alter the form of the debt securities to offer additional protec tion against failure. There are three properties of long-term debt securities that regulators find bothersome: (1) losses cannot be charged against debt capital without liquidating the bank; (2) interest must be paid whether the bank is profitable or not; and (3) the debt must eventu- 4Since the most important reason for a business to prefer debt to equity is the tax-deductibility of interest payments, it isn't at all clear that society as a whole reaps any benefits from the alleged efficiencies of debt “ cap ital". However, reassessing the logic of our corporate tax structure is beyond the scope of this article. benefits from reduced bank failure. However, each tighten ing of the debt ceiling may force banks further from the capital structure they would most like, thus makingthem less efficient from the point of view of the private economy. 5 The benefits of debt ceiling regulations could be defined as the total cost to society of bank failures if there are no lim its on debt minus the cost of failures when debt ceiling regula tions are in effect. The tighter the debt limit, the greater the. 25 BUSINESS REVIEW DECEMBER 1974 ally be repaid or refunded. Nothing can be done about the first problem, but the second and third could be mitigated by using different kinds of debt securities. The risk of a fixed interest commitment might be overcome if banks were to issue debt on which interest was paid only if earned (these are called income bonds or revenue bonds). Nor mally securities such as these are issued by cor porations only when they are in financial trou ble, so bankers would strongly argue that inves tors would not accept the bonds and the banks should not be required to use this kind of secu rity. True perhaps, but 15 years ago issuing long-term debt or preferred stock was also con sidered a sign of weakness for a bank. Investors might need time to become accustomed to the idea, but if the bank is sound the additional risk to the debtholder (and the resultant risk premium in the interest rate) should be modest. Requirements that sinking funds be estab lished by banks to guarantee periodic repay ments of debt principal are another possibility, although these provisions are already a common feature of new issues. This would not prevent banks from refinancing rather than retiring their bonds, but it would reduce the likelihood that very large quantities of debt capital would have to be refinanced all at once. Endless variations in the terms of debt issues are possible— witness the recent floating rate capital notes— but any alteration attempted must meet the IRS guidelines which distinguish bonds from preferred stock. Once the bond issue begins to look like a preferred stock, the interest ex pense loses its tax-deductible status and its effec tive cost to the bank doubles.6 O f greater importance, however, is the fact that the modifications which change the surface details of long-term debt instruments don't eliminate the basic characteristics that make it a risky substitute for equity capital. Some risks can be reduced— and these might justify requiring banks to issue only income bonds or to use sink ing funds with their debt— but they are the lesser ones from the standpoint of society. The debt must still be repaid at some future date, and the bank must be able to absorb losses out of capital accounts other than its long-term debt. Variable Rate Deposit Insurance. Proposals to alter the terms of bank debt are aimed at reduc ing the social costs of failure by making it less likely to occur. A somewhat different tack might be to shift some of the social costs of insuring society against more bank failures back to the banks and their shareholders. If the FDIC varied the cost of its deposit insurance according to the risk of each bank it insures, the effect would be to raise the implicit cost of funds for banks that adopted particularly risky asset or liability portfolios. If a bank wished to substitute debt capital for equity capital, it would be free to do so but would be obliged to pay for the added costs its action imposed on society. Estimating these costs and setting deposit insurance fees based on risk would be extremely difficult, but it should be possible to construct a rational rate schedule. Despite potential imprecision, confronting the problem would still be preferred to the current practice of making no explicit attempt to calcu late either the costs or benefits of bank regula tion. This proposal was recently offered in the context of setting overall capital adequacy stan dards, but it also covers the problem of selecting a proper debt/equity mix of capital.7 SHORT-TERM REGULATION Controlling social costs through variable de posit insurance rates might be the simplest and most flexible solution to this controversy. How ever, it is not a widely accepted solution and implementing it would take time even if it were adopted. In the meantime regulators still seek 6 n October 8, 1974 President Gerald R. Ford proposed O allowing corporations to deduct the fixed dividend costs of preferred stock issues from taxable income. If this suggestion were enacted, preferred stock should become a very attrac tive alternative to long-term debt. 7For a more complete discussion of this point, see Ronald D. Watson, "Insuring Some Progress in the Bank Capital Hassle,” Business Review of the Federal Reserve Bank of Philadelphia, July-August 1974, pp. 3-18. 26 FEDERAL RESERVE BANK OF PHILADELPHIA existence. Beyond that, any debt supplement to capital that isn't potentially destabilizing be cause of excessive debt service requirements would be a plus, because it would provide addi tional protection for the claims of depositors in case of a general banking emergency. What the industry needs is some objective quantitative analysis of the real risks of long-term debt and the real social costs of bank failures. In the meantime, assessing the proper mix of debt and equity capital must remain a subjective judgment— a decision based on the regulators' concern not only for protecting the economy from a financial panic but also for minimizing the costs to the financial community of operating with less debt capital than it can successfully manage. guidelines for restricting debt capital use to a level close to the theoretical ideal. Unfortunately, no magical thumbrule exists. Each bank is different, and debt capacities vary widely. The "id e a l" limit to a bank's use of long term debt as a capital supplement depends on the risk that debt creates. The ability to utilize debt successfully depends on the quality and maturity structure of the bank's assets, the com position of its liabilities, the skill of its manage ment, the stability of its competitive environ ment, and its access to money markets, among other factors. The regulators' only guideline is the basic re quirement that equity be sufficient to allow a bank to charge any reasonably predictable losses against capital without jeopardizing its basic APPENDIX TH E PURPOSE OF LEVERAGE The potential advantages of long-term debt capital in a bank's capital structure can best be seen from a numerical example. Suppose your bank starts with a capital structure of $500,000 composed simply of 10.000 shares of common stock issued and selling for $50 each. If the bank were to realize net operating revenues of $100,000 per year before taxes the shareholder's return could be computed as follows: Net Revenue $100,000 -Incom e Tax (50 percent) 50,000 10.000 shares Earnings After Taxes -- 10,000 shares r Earnings per share Return per share 50,000 5.00 5.00 _ jq percent 50.00 Now suppose that the bank could change its capital structure by replacing some of its equity with long term debt. If the bank could sell $250,000 of debt at an interest cost of 10 percent and could use the proceeds of this sale to repurchase its own common stock in the market, it would shift from an all-equity capital structure to one that is half equity and half debt. Even though the cost of the debt is 10 percent— the same as the return earned for the common shareholders— the remaining stockholders would see their earnings rise.* The increase in profits for the stockholders occurs because the interests costs are treated as tax-deductible expenses. *Some increase in the return per share would be necessary to compensate stockholders for the higher risk they now bear. 27 BUSINESS REVIEW DECEMBER 1974 Net Revenue - Interest $100,000 25,000 Earnings Before Taxes — Taxes (50 percent) 75,000 37,500 Earnings After Taxes h 5,000 shares Earnings per share Return per share 37,500 Earnings Before Taxes — Taxes 85,000 42,500 Earnings After Taxes ■ 5,000 shares e Earnings per share Return per share 42,500 7.50 7,50 = 15 percent 50.00 The long-term debt will also lever earnings if the bank's net revenues can be increased without additional capital. Suppose operating earnings were to rise 10 percent. Net Revenue $110,000 - Interest 25,000 8.50 = 17 percent 50.00 Without the leverage provided by the fixed cost of long-term debt a 10-percent jump in earnings would result in only a 10-percent increase in earni ngs per share (to $8.25). Elowever, with the debt capital, earnings per share advance by more than 10 percent when there was a 10-percent increase in operating income. A caveat: The sword of leveraged earnings cuts two ways, lust as a 10-percent increase in operating earnings will cause earnings per share to jump more than 10 percent, a drop in corporate earnings of 10 percent wil I result in a disproportionate erosion of earnings per share. Leverage can be a highly risky practice— especially in large doses— since a substantial drop in earnings may make it impossible for a firm to meet its debt repayment obligations. This is normally grounds for starting bankruptcy proceedings. s NOW AVAILABLE: INDEX TO FEDERAL RESERVE BANK REVIEWS Articles which have appeared in the reviews of the 12 Federal Reserve Banks have been indexed by subject by Doris F. Zimmermann, Librarian of the Federal Reserve Bank of Phil adelphia. The index covers the years 1950 through 1972 and is available upon request from the Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsyl vania 19101. 28 BANK HO LD ING COMPANIES The Fed in P rin t Citicorp . . . floating rate notes— FR Bull July 74 p 527 Delegation of authority, July 31, 1974— FR Bull Aug 74 p 588 Economic forces facing the bank holding company movement (Francis)— St Louis Sept 74 p 8 Business Review Topics, Third Quarter 1974 Selected by Doris Zimmermann , Articles appearing in the Federal Reserve Bul letin and in the monthly reviews of the Federal Reserve banks during the third quarter of 1974 are included in this compilation. A cumulation of these entries covering the years 1970 to date is available upon request. If you wish to be put on the mailing list for the cumulation, write to the Publications Department, Federal Reserve Bank of Philadelphia. Jo receive copies of the Federal Reserve Bulle tin, mail two dollars for each issue to the Federal Reserve Board at the Washington address on page 33. You may send for monthly reviews of the Federal Reserve banks free of charge, by writing directly to the issuing banks whose addresses also appear on page 33. BANK LIABILITIES PRO BLEM S IN LIABILITY M A N A G EM EN T available— Bost July 74 p 13 BANK LOANS, REAL ESTATE Commercial banks and mortgages— Chic Sept 74 p 3 BANK PORTFOLIOS Banking developments— Chic Aug 74 p 13 BANK SUPERVISION Appendix: Selected bank regulations in Eighth District states— St Louis July 74 p 19 Summary description of information system for banking agency reports— FR Bull Aug 74 p 543 Rating the financial condition of banks: A statistical approach to aid bank supervision— NY Sept 74 p 233 Summary description of information system for banking agency reports— San Fran Sept 74 p 24 BANK CAPITAL Insuring some progress in the bank capital hassle— Phila July-Aug 74 p 3 BANK CHARTERS State laws affect the pace of new bank charters— Phila Sept 74 p 7 BANK COMPETITION Branching, holding companies, and banking concentration in the Eighth District— St Louis July 74 p 11 BANK TAX State taxation of Fifth District banks— Rich July 74 p 19 BRIMMER, ANDREW F. BANK EARNINGS Public utility pricing, debt financing, and consumer welfare— Rich July 74 p 3 Income and expenses of Eighth District member banks - 1973— St Louis July 74 p 8 29 DECEMBER 1974 BUSINESS REVIEW BUCHER, JEFFREY M. Statement to Congress, June 20, 1974 (equal credit)— FR Bull July 74 p 487 Statement to Congress, July 31, 1974 (interest rates)— FR Bull Aug 74 p 560 Compensating balances and effective lending rates— Atlanta July 74 p 104 CONSUMER PRICE INDEX A primer on the consumer price index— St Louis July 74 p 2 BUDGET The Federal budget dollar (graphs)— Dallas Sept 74 p 7 CREDIT RATIONING CREDIT ALLO CATIO N T EC H N IQ U ES AND M O N ETARY POLICY available— Bost July 74 p 14 BURNS, ARTHUR F. CREDIT UN IO N S Letter to banks on ISBAR— FR Bull Aug 74 p 550 Statement to Congress, July 30, 1974 (inflation control)— FR Bull Aug 74 p 554 Statement to Congress, August 6, 1974 (inflation)— FR Bull Aug 74 p 561 Statement to Congress, August 21, 1974 (budget)— FR Bull Sept 74 p 653 Credit unions as consumer lenders in the United States— Bost July 74 p 3 DEBT MANAGEMENT ISSUES IN FEDERAL DEBT M A N A G EM EN T available— Bost July 74 p 14 DISCOUNT OPERATIONS Member bank borrowing soared in Eleventh District last year— Dallas July 74 p 1 BUSINESS FORECASTS AND REVIEWS The trend of business— Chic July 74 p 8 Financial developments in the second quarter of 1974— FR Bull Aug 74 p 533 First half '74 review and outlook— Minn Aug 74 p 1 Recent economic developments in perspective— St Louis Sept 74 p 2 ECONOMETRICS IN TR O D U C T IO N TO THE USE OF EC O N O M ETRIC M O D ELS IN EC O N O M IC PO LIC Y M A K IN G available— Minn Aug 74 p 17 EDGE ACT Edge Act corporations: An added dimension to Southeastern international banking— Atlanta Sept 74 p 130 CAPITAL GAINS TAX FARM MARKETING Taxation of capital gains: Inflation and other problems— Bost Sept 74 p 3 The futures market for farm commodities - what it can mean to farmers— St Louis Aug 74 p 10 COMMERCIAL POLICY FARM OUTLOOK The pattern of U.S. tariffs: The myth and the reality— Bost July 74 p 15 Agricultural review and outlook— Chic Aug 74 p 3 30 FEDERAL RESERVE BANK OF PHILADELPHIA FUEL FEDERAL ADVISORY COUN CIL EC O N O M IC IMPACT A N D AD JUSTM EN T TO THE EN ERG Y CRISIS available— Atlanta July 74 p 99 FAC statement on bank lending policies, September 16, 1974— FR Bull Sept 74 p 679 FEDERAL RESERVE BOARD HOLLAND, ROBERT C. Changes in Board staff, July 16, 1974 (Partee and Doyle)— FR Bull July 74 p 527 Statement to Congress, July 24, 1974 (financial institutions)— FR Bull Aug 74 p 551 FEDERAL RESERVE— FOREIGN EXCHANGE INCOME DISTRIBUTION Treasury and Federal Reserve foreign exchange operations— FR Bull Sept 74 p 636 Treasury and Federal Reserve foreign exchange operations— NY Sept 74 p 206 The distribution of southeastern income— Atlanta Aug 74 p 114 INFLATION Mayo testimony on inflation— Chic July 74 p 3 "N e w math" of inflation— a 7-cent dollar?— Chic Sept 74 p 13 Inflation and economic policy (Eastburn)— Phila Sept 74 p 3 The current inflation: The United States experience— St Louis Sept 74 p 13 Problems of inflation and high interest rates (Balles)— San Fran Sept 74 p 3 FEDERAL RESERVE— MONETARY POLICY Statement to Congress, July 17, 1974 (Hayes)— NY Aug 74 p 186 FEDERAL RESERVE SYSTEM— PUBLICATIONS Revised rates for the Bulletin, August 1, 1974— FR Bull July 74 p 526 Revised rates for the Federal Reserve chart book— FR Bull Aug 74 p 609 FOREIGN ASSETS IN U.S. Foreign official institutions holdings of U.S. government securities— Kansas City Sept 74 p 11 INTEREST RATES— LAWS Usury laws: Harmful when effective— St Louis Aug 74 p 16 FOREIGN EXCHANGE INTEREST RATES— PRIME Foreign exchange markets: Booming and bustling— Phila Sept 74 p 12 The ABC's of the prime rate— Atlanta July 74 p 100 LABOR CONTRACTS FOREIGN TRADE The contractual cost-of-living escalator— NY July 74 p 177 Trends in U.S. international trade— Chic Aug 74 p 8 LABOR MARKET FOREIGN TRADE— DOMESTIC EFFECTS Recent labor market developments— FR Bull July 74 p 475 Strange happenings in the labor market— Atlanta Sept 74 p 140 The growing impact of international forces upon the economy of the U.S.— Dallas Aug 74 p 1 31 DECEMBER 1974 BUSINESS REVIEW REGULATION H MITCHELL, GEORGE W . Amendment September 16, 1974— FR Bull Sept 74 p 664 Amendment September 16, 1974 (flood areas)— FR Bull Sept 74 p 680 Statement to Congress, July 15, 1974 (bonds, index linked)— FR Bull July 74 p 490 MONETARY POLICY The role of monetary policy in dealing with inflation and high interest rates (Francis)— St Louis Aug 74 p 2 REGULATION J Amendment September 1, 1974— FR Bull Sept 74 p 665 REGULATION T MONEY SUPPLY Amendment July 25, 1974— FR Bull July 74 p 501 Federal regulation of stock market credit: A need for reconsideration— Phila July-Aug 74 p 23 Measuring the money stock— Atlanta July 74 p 94 The differential behavior of M1 and M2— Kansas City July 74 p 3 Revised money stock data— FR Bull Sept 74 p 681 Behavior of the monetary aggregates and the implications for monetary policy— Kansas City Sept 74 p 3 REGULATION U Amendment July 25, 1974— FR Bull July 74 p 501 REGULATION Y Amendment June 24, 1974— FR Bull July 74 p 504 OPEN MARKET OPERATIONS RESERVE REQUIREMENTS Record of policy actions, April 1516, 1974— FR Bull July 74 p 493 Record of policy actions, May 21, 1974— FR Bull Aug 74 p 580 Holdings of bankers acceptances; change in . . . Agency securities— FR Bull Aug 74 p 609 Record of policy actions, June 18, 1974— FR Bull Sept 74 p 656 Short-run reserve borrowing— Atlanta Sept 74 p 145 Change in marginal reserve requirement— FR Bull Sept 74 p 680 RURAL DEVELOPMENT Financing rural enterprise— Minn Aug 74 p 10 SOCIAL SECURITY Future of program threatened by inflation— Dallas Sept 74 p 1 PRICES Recent price developments— FR Bull Sept 74 p 613 TIME DEPOSITS Changes in time and savings deposits at commercial banks— FR Bull Sept 74 p 627 REGULATION F Amendment September 16, 1974— FR Bull Sept 74 p 664 TRANSFER OF FUNDS The changing payments mechanism: Electronic funds transfer arrangements— Kansas City July 74 p 10 REGULATION G Amendment July 25, 1974— FR Bull July 74 p 501 32 FEDERAL RESERVE BANK OF PHILADELPHIA UNEMPLOYMENT Statement to Congress, August 13, 1974 (petrodollars)— FR Bull Aug 74 p 567 The relation between income growth and unemployment— San Fran Sept 74 p 12 W O M EN — EMPLOYMENT WALLICH, HENRY C. The earnings picture for women: Slack job markets behind the downward trend— Phila July-Aug 74 p 19 Statement to Congress, August 14, 1974 (balance of payments)— FR Bull Aug 74 p 575 5 FEDERAL RESERVE BANKS AND BOARD OF GOVERNORS Publications Services Division of Administrative Services Board of Governors of the Federal Reserve System Washington, D. C. 20551 Federal Reserve Bank of Kansas City Federal Reserve Station Kansas City, Missouri 64198 Federal Reserve Bank of Minneapolis Minneapolis, Minnesota 55440 Federal Reserve Bank of Atlanta Federal Reserve Station Atlanta, Georgia 30303 Federal Reserve Bank of New York Federal Reserve P.O. Station New York, New York 10045 Federal Reserve Bank of Boston 30 Pearl Street Boston, Massachusetts 02106 Federal Reserve Bank of Philadelphia 925 Chestnut Street Philadelphia, Pennsylvania 19101 Federal Reserve Bank of Chicago Box 834 Chicago, Illinois 60690 Federal Reserve Bank of Richmond P.O. Box 27622 Richmond, Virginia 23261 Federal Reserve Bank of Cleveland P.O. Box 6387 Cleveland, Ohio 44101 Federal Reserve Bank of St. Louis P.O. Box 442 St. Louis, Missouri 63166 Federal Reserve Bank of Dallas Station K Dallas, Texas 75222 Federal Reserve Bank of San Francisco San Francisco, California 94120 33 BUSINESS REVIEW DECEMBER 1974 BUSINESS REVIEW FEDERAL RESERVE BANK OF PHILADELPHIA TABLE OF CONTENTS -1974 JANUARY MAY "Rent Controls: Panacea, Placebo, or Problem Child?" by Howard Keen, )r. and Donald L. Raiff "Pace of Housing Starts Slows as Deposit Growth at S&Ls Declines" "Helping Americans Get Mortgages" by Jack Clark Francis "Looking into the Fed's Crystal Ball" by David P. Eastburn "The Unhappy, Important Consumer" by Ann Castellano "The Taxman Rebuffed: Income Taxes at Commercial Banks" by Donald J. Mullineaux FEBRUARY JUNE "Airport Congestion: Can Some New Cures Get Off the Ground?" by Howard Keen, Jr. "Minority-Owned Banks: Profit Picture Improving" by Robert Ritchie "Regional Wrap-up 1973: Climb, Crunch, and 'Crisis' " by Curtis R. Smith Annual Operations and Executive Changes "In Support of Uniform Reserve Requirements" by David P. Eastburn "Falling Fed Membership and Eroding Monetary Control: W hat Can Be Done?" by Edward G. Boehne "The Case against Uniform Reserves: A Loss of Perspective" by Ira Kaminow "The Fed in Print" by Doris Zimmermann MARCH JULY-AUGUST "Philadelphia's School Resources and the Disadvantaged" by Anita A. Summers and Barbara L. Wolfe "M ilder Economic Impact with Continued Inflation Characterizes Recent Recessions" "Private Pensions: W h o Gets W hat W h e n " by George Oldfield "The Fed in Print" by Doris Zimmermann "Insuring Some Progress in the Bank Capital Hassle" by Ronald D. Watson "The Earnings Picture for Wom en: Slack Job Markets Behind the Downward Trend" by Vincent A. Gennaro "Federal Regulation of Stock Market Credit: A Need for Reconsideration" by James M. O'Brien APRIL SEPTEMBER "Philadelphia's Budgets: Past, Present, Future" by William A. Cozzens "Sales Levy Crucial to New Jersey's Tax Revenues" by John Wentz "Fighting Poverty with Jobs: Public and Private Payroll W eapons" by Jam ei L. Freund "Inflation and Economic Policy" by David P. Eastburn "State Laws Affect the Pace of New Bank Charters" by Donald A. Leonard "Foreign Exchange Markets: Booming and Bustling" by Janice M. Westerfield "The Fed in Print" by Doris Zimmermann 34 FEDERAL RESERVE BANK OF PHILADELPHIA N O V EM B ER (Cont'd.) Blues" by James J. Bacci and Robert H. Friedman "Sm all Bank Survival: Is the W o lf at the Door?" by Jerome C. Darnell and Howard Keen, Jr. O C TO BER "A n Economic Compact for the Latter '70s" by David P. Eastburn " W h y America's O il Supply Depends on High-Priced Foreign Sources" by Vincent A. Gennaro "Shortages: A Necessary Evil of the Future?" by Donald L. Raiff DECEM BER "Bank Liability Management: For Better or for W orse?" by Stuart A. Schweitzer "Monetary Restraint, Regulation Q, and Bank Liability Management" "Banking on Debt for Capital Needs" by Ronald D. Watson "The Fed in Print" by Doris Zimmermann N O V EM B ER "Crim inal Behavior and the Control of Crime: An Economic Perspective" by Timothy H. Hannan "Philadelphia Sings the Inflation % NOW AVAILABLE BROCHURE AND FILM STRIP ON TRUTH IN LENDING Truth in Lending became the law of the land in 1969. Since then the law, requiring uniform and meaningful disclosure of the cost of consumer credit, has been hailed as a major breakthrough in consumer protection. But despite considerable publicity, the general public is not very familiar with the law. A brochure, "W h a t Truth in Lending Means to Y ou ," cogently spells out the essentials of the law. Copies in both English and Spanish are available upon request from the Department of Bank and Public Relations, Federal Reserve Bank of Philadelphia, Phila delphia, Pennsylvania 19101. Available in English is a film strip on Regulation Z, Truth in Lending, for showing to consumer groups. This 20-minute presen tation, developed by the Board of Governors of the Federal Reserve System, is designed for use with a Dukane projector that uses 35mm film and plays a 33 RPM record synchronized with the film. Copies of the film strip can be purchased from the Board of Governors of the Federal Reserve System, Washington, D. C. 20551, for $10. It is available to groups in the Third Federal Reserve District without charge except for return postage. Persons in the Third District may direct requests for loan of the film to Truth in Lending, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19101. Such requests should provide for several alternate presentation dates. 35 FEDERAL RESERVE BANK of PHILADELPHIA PHILADELPHIA, PENNSYLVANIA 19105 business review FEDERAL RESERVE BANK OF PHILADELPHIA PHILADELPHIA, PA. 19105
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