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r CD CD 0) > Business Review 0 JZ _Q_ Seeding Science-Based Industry 0 "O Z Pressing Against the Ceiling? or How High Can the Loan/Deposit Ratio Go? CL H — o c 0 D Q 0 > L_ 0 0 0 (T Z L0 "O 0 U L Seeding Science-Based Industry . . . New research-oriented firms are difficult to nurture at best. Often in the past, they have found the environment in the Delaivare Valley less than best, but deeds and attitudes are changing in this respect, and the changes are all for the better. Pressing Against the Ceiling? . . . Credit demands in our full-employment economy are boosting the ratio of loans to deposits in commercial banks. Trend is likely to continue, but at a slower pace. B U SIN E SS REVIEW is produced in the Department of Research. Donald R. Hulmes prepared the layout and art work. The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to Bank and Public Relations, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19101. A report on interviews with scientist-businessmen on problems of . . . . INDUSTRY by Elizabeth P. Deuterm ann The young engineer looked his visitor squarely one. Behind the teak desk sits the engineer. Facing in the eye. “ Yes,” he said, “ Government contracts were essential when we started the firm. In 1957 window frames an almost rural panorama. To his almost a hundred per cent of our work was with the Pentagon. Not now, though. Today it’s only 42 per cent. Our research and development led to so many commercial applications we hadn’t ex pected.” With computer-like speed he ticked off new patents, products, and industrial customers, just as he had answered the previous questions. him is his visitor. To the engineer’s left a large right is the closed glass door providing a mirror image of the word President. The president of this company is one of three engineers who started their own business after leaving a larger firm. He was anxious to tell how they did it. For three hours he drew on his per “ How did I get initial financing? It wasn’t sonal experience to explain what made it easy or difficult to form his science-based firm. easy. It never is for a firm whose stock-in-trade is new technology. But I’ll tell you this. Financing a venture like ours is a lot easier here in Boston Why did he bother? Really, for the same rea son a golfer talks golf, or a skier, skiing. He was discussing something dear to his heart. than in many other places.” An hour passed be More to the point, why did the interview occur fore the engineer was asked if there were any ties at all? The answer lies in the intense contem between area universities and his company. “ Of course if it hadn’t been for Graduate School at porary concern with regional economic growth, M.I.T., I wouldn’t have come here from Texas in dustry will stimulate it. and the widespread hope that science-based in the first place. And that goes for a lot of our staff. We always know we can get good technical peo Home-grown R & D ple from local schools when we need them.” The scene of this questioning is an electronics From New York City to Sacramento, California, plant in suburban Boston. An interview is under work to increase jobs in their communities. Two way in one of the offices— a handsomely modern questions loom large in their minds. What indus thousands of private citizens and public officials 3 b usiness re v ie w tries will be the big employers of tomorrow? How engineer or scientist with an idea for a better can they get more of those industries in their mousetrap. Second, the man with the idea must regions? In response to question one, a number of major cities expect future jobs to be generated where he is employed must show receptiveness by research and development activities. R & D, to new ideas by tangible support of fledgling undoubtedly, is one of the nation’s most rapidly R & D companies. growing businesses. And it tends to concentrate want to start his own firm. Third, the community Take Philadelphia as an illustration. Some for where in the area an engineer is contemplating his resignation from a large company. He has growth, the urban developer’s prime concern is how his area can capitalize on it. A region can worked for years in computer research. He has not one, but ten ideas for improving a company increase its R & D activities in different ways. A popular and well-publicized approach is to product. And he strongly believes their adoption will boost sales tremendously. Since manage ment doesn’t agree, he is considering two alterna in large urban areas. So far, so good. But having identified an opportunity look outside the region for help— specifically, to lure a large Government laboratory. A more fundamental approach is to look inward and create the kind of community which stimulates tives. Should he go with another company or spin-off and start his own firm? Personally, he is eager to be his own boss. But something holds and supports the formation of new science-based firms. him hack. Long hours of conversation with engi neer friends who started their own companies have planted doubts in his mind. Soil testing From their experience, he has formed an What does it take for a community to be a good attitude that Philadelphia is not the best place place to start a science-based firm? A number of to start a new science-based firm. Whether this people think they know. But actually very little attitude is based on myth or reality, the image fact-finding has been done to answer this ques itself can be the determining factor in the birth tion. Hence the investigation reported here. The approach was through case studies of firms of a new company in the area. And the image apparently does exist. in two metropolitan areas: Boston. Philadelphia is the largest metropolitan The attitudes of company founders interviewed in Philadelphia suggest the Delaware Valley is Philadelphia and area in the Third Federal Reserve District. Bos not regarded as an outstandingly good area in ton has an outstanding reputation as a research which to launch a new R & D-oriented business. and development center. It is alleged to be a Scientist-businessmen frequently cited Boston, community where science-based firms find it easy to take roots and grow. with envy, as a case in contrast. Is it possible that if another group had been studied, their feelings Is it really easier to start a research-oriented business in one community than in another? And if so, why? evidence points to such attitudes being wide Germination and climate would have been different? Probably not; the spread among scientists and engineers.* And the mere fact that they are held is important; in itself, it can inhibit growth. There are three basic requirements for starting a science-based company. First, there must be an 4 *This question is discussed in detail on pp. 9-10. b usin ess re v ie w These are summary evaluations. On what are munity is able and willing to help him. A strong they based? What do the Boston founders think communication network in financing circles leads they have going for them that their Philadelphia the money-seeking scientist to a local source of counterparts find lacking? The answer is in the capital. Interviewees point to commercial banks in financial climate and the university complex. Boston as an important link in this network. If FINANCING banks cannot supply the seed money, they know To begin operating, the science-based firm natu who can. They know because they’ve made rally needs seed money. The founder first looks science-based industry a specialty. As a result, around the home territory where he lives and has the engineer-turned-entrepreneur who seeks fi worked. How expeditiously he obtains funds nancing can sit down to discuss his needs with varies with his financial sophistication. Those less an engineer-turned-banker. The latter, a vice- knowledgeable eventually discover that personal president at one bank, is dramatically advertised in local news media as the man who “ finances the frontiers of science.” Promotion is one thing. Delivery is what counts. From the interviewees’ viewpoint, Boston banks deliver. This holds both for initial financ ing and for sustaining financing over the difficult first five years— at which time the company is considered to have come of age and finds financ resources or wealthy friends, rather than financial institutions, most frequently give the breath of life to the infant industry. Risk capital for a venture based on new technology— say, solid state physics— is not readily available any place in the country. ing less of a headache. The responses strongly suggest that this rapport with the scientific com munity and financial support of banks is a great asset to the growth of new R & D industry. Entrepreneurs interviewed in the Delaware Valley do not find their banking community quite so understanding. They think local banks Nevertheless, such risk capital does appear could be of much greater assistance— indirectly, less difficult to obtain if financiers are scientif if not directly— in getting a fledgling off the ically sophisticated. The scientist-businessmen we ground. This attitude, whether justified or not, talked with find this sophistication in the Boston can inhibit growth not only in R & D but also in local banking itself. If the scientist seeking funds financial community. Financiers, they say, be lieve that a high proportion of new jobs in the next ten years will be in industries growing out of initially assumes local banks can’t or won’t help current research and development. A high pro in turn, may assume this indicates a lack of him, he won’t knock on their doors. The banker, portion of future profits for lenders will have the demand for R & D financing. The scientist-execu same root. Because Boston bankers believe this, tives interviewed felt that when banks cannot one company president noted, the financially directly finance a risky business, they can func ignorant scientist-entrepreneur can readily learn tion as important intermediaries. They can bring eager risk-takers and scientists together. of sources of venture capital. The financial com 5 b usin ess r e v ie w HIGHER EDUCATION In this sequence of events, an obvious question Founders of science-based firms strongly be arises. What holds the future entrepreneur to an lieve local universities are vital to company for mations— and to their futures. The Boston cor area between graduation and groundbreaking? The same answer applies both to Philadelphia porate heads think their area’s graduate schools and Boston. In every case in our study, a primary play a fundamental role in the growth of the region’s R & D companies. The Philadelphia reason for locating new companies in their respec tive areas was that it was home for one or more executives interviewed do not believe local uni versities provide as much stimulation to growth of the founders. It was not necessarily the home of birth. In many instances it had become home of their industries. This is the second major way in which Boston and Philadelphia scientists view during the long time spent in graduate school or working in the region. their communities differently as seed-beds for R & D firms. Lengthy residence in an area gives a new entre How can universities stimulate the growth of science-based industry? A direct way is by spin ning-off companies. For example, a professor may be a frustrated businessman at heart. If he also is bursting with ideas for marketable new products, he may form his own firm. More likely, however, the university’s role in initiating corporations takes a less direct route. preneur a necessary knowledge of territory. He feels more confident in taking a chance on a company of his own on home ground. Experience has given him contact with local competitors. He can put his finger on local sources of supplies and business services peculiar to his specialized needs. So the thought of starting a company any place other than home is rarely considered. This is quite unlike the large corporation which hires One path is through high-quality graduate training in engineering and physical sciences. Universities which offer outstanding opportunities for study and research act as magnets to attract the nation’s most talented students to a region. Let’s assume one of these men takes a job with a local company when his graduate study is com pleted. Time passes before he is ready to start his own firm— if that is his goal. Rarely does the scientist jump straight from the laboratory to executive row. First he must acquire some knowl edge of final products and markets— knowledge which he doesn’t gain in the laboratory. He gets this education in a position above the starting ideal branch location. Only on one occasion did one. Having acquired it, he departs and forms his we encounter a spin-off that did a location survey beyond home base. Even in this exception, the own local company. The community has a new economic asset— a job producer, a tax source, a corporate headquarters. It must give some of the credit to the top-notch graduate school which first attracted the company founder to the region. Digitized for 6 FRASER site chosen was influenced by the desire of one founder to go back home. Many science-based firms in the Delaware Valley and in Boston were started by professors b usiness re v ie w and by their graduate students. Whether one area corporations produces more firms than the other by these School graduates who court the “ innovation” formed by well-heeled Business means, no one really knows. However, it may be market. They actively seek out scientists with significant that university offshoots were much new ideas to back financially. easier to track down in Boston than in Philadel Men who have organized science-based firms phia. In addition, the founders contacted in both point to other ways the university community aids regions think Boston has the lead. For Boston, their growth. Consulting is one of them. The this is another stimulant for a scientist to start a small, new company depends on university per company. Seeing one’s colleagues succeed as sonnel to solve technical problems. Having such company founders encourages one to try it him self. consultants readily available is an asset to the firm. Apparently the big era for attracting the future Professors of engineering and science also act corporate head to Philadelphia via the graduate as consultants to Boston banks investing in new school was in the ’forties. One reason, undoubt R & D ventures. For example, the future profit edly, was the outstanding reputation of the Moore ability of an innovation in chemical process con School of Engineering in computer research. The trol may be hard for a banker to evaluate. There Philadelphia scientist-executives interviewed be fore, he turns to a consulting professor he knows lieve this type of graduate school pull has greatly who specializes in the same research field as the diminished in the last twenty years. Indicative of bank’s client. This practice tends to ease financing Boston’s greater attraction today is that it pro duces nine doctorates in engineering and physics for new firms with growth potential in technical areas. to every one coming out of universities in the Philadelphia area. Furthermore, many Boston professors actively The university graduate school is not only a source of tomorrow’s corporate heads, but of men who will work for young research firms today. serve on boards of directors of both science-based firms and area banks. This has generated greater rapport among financiers, universities, and the Interestingly, not one Philadelphia executive sug R & D industry. The founder of the Boston sci ence-based firm feels he profits from the resulting gested that a good reason for being in the area was the availability of technical talent. Only one increase in mutual understanding and cooperation. This type of understanding is felt to be seri failed to stress this in Boston. There, new science- ously lacking in Philadelphia. It grows in Boston based firms depend more heavily on local grad uate schools for employees than is the case in the the university complex and scientists in business. Delaware Valley. The demand is not just for engi Such ivy-industry ties are considered to be weak neers and scientists. It particularly includes grad uates of the Harvard Business School. in the Delaware Valley. The Business School graduates have shown from the many ties described which exist between The other side of the fence considerable interest in new R & D ventures in the Boston area. For many young firms, a very fruit These attitudes of would-be entrepreneurs toward ful merger of business and scientific training has sities are the factors most frequently cited as resulted. In addition, Boston executives frequently inhibiting growth of new science-based firms in mentioned a number of local venture capital the Delaware Valley. In other important respects, availability of financing and the role of univer 7 business r e v ie w entrepreneurs view spin-off influences as equally favorable in both regions. For example, one requirement is that sufficient low-cost space be available for incubation. In both regions such space is available where the tech nology-based firm wants it— in the suburban ring surrounding the old core city. Founders of new firms in Philadelphia and Boston agree that low-cost space is no problem— “ except in the city.” Costs are lower in the suburbs. But this is not the foremost reason why they distinctly prefer a suburban location. Aesthetic appeal and numerous conveniences weigh much more heavily. Hence, abandoned textile plants, for instance, in the older sections of the two cities don’t attract incubating R & D firms. City slums, traffic con gestion, distance from home to work, and inade in Philadelphia or Boston did not give the com quate parking space repel new companies. In both pany any particular advantage in receiving needed core cities where redevelopment efforts are geared Government support. to attract R & D firms, overcoming suburban pref erences and finding means to reduce space costs Shade and sunlight present a real challenge. The preceding If science-based firms are to attract and hold technical personnel in a region, it must rate high science-based firms are easier to start in Boston discussion suggests that new than in Philadelphia. Therefore, one would ex as a desirable place to live. Both Philadelphia pect to find more new R & D companies blossom and Boston rate high. The scientist or engineer ing in the former region. Experience does seem prefers to live in a major metropolitan area. He to indicate that R & D spin-offs are easier to locate wants as many advantages of the country as pos in Boston than in Philadelphia. Other evidence indicates that special char sible, without losing those which only the big city provides. Some companies interviewed con acteristics of the Boston scientific community sidered, as they grew, establishing branches in make it a more probable spin-off producer than rural areas to lower costs. They didn’t do it. the Delaware Valley. Compared to the Philadel Strong staff resistance to isolation from the urban phia area, Boston employs more scientists. A scene killed expansion into rural areas. Another aid to successful spin-offs is often a higher proportion of them are working in re search and development. By contrast, scientists Government contract to support R & D until the in the Philadelphia area are more production- firm’s reputation is established. In the majority of the case studies, Federal customers were essen oriented. In addition, those in the Boston area have a higher degree of educational attainment tial at the start of the company. But company than scientists working in Philadelphia. founders did not feel that contract awards were influenced by their addresses. That is, just being in Philadelphia are engaged more heavily in Digitized for 8 FRASER The story is similar for engineers. Engineers b usiness re v ie w production, sales, and marketing than in Boston, to attract outstanding professors of engineering where they are employed to a greater extent di and science to the faculty. rectly in research and its management. This con In addition, universities of the region are centration of high-quality brainpower, oriented working in concert to develop the University toward research and development, is the basic City Science Center. One specific goal of the source of new ideas which lead to new companies. Science Center Corporation is to assist the incu Nevertheless, the Philadelphia region does have bation of science-based firms. This is also the a strong resource of technical manpower for objective of the Regional Development Labora seeding new science-based industry. Among the tory— a brainchild of the West Philadelphia Cor nation’s major metropolitan areas, Philadelphia poration ranks seventh as an employer of scientists. There Economic Development Corporation. are 29,000 engineers and physicists living in the Philadelphia region compared to 21,000 in Bos ton. In addition, the number of engineers in both fruitful way of improving the region’s environ areas grew at about the same speed between 1950 and 1960. This manpower pool is potentially and the Southeastern Pennsylvania These community efforts are aimed at the most ment for formation of new firms. They are be ginnings in the opening of new channels of com munication among the scientific, university and a valuable source of scientific entrepreneurs and financial communities of the area. A better under of new R & D firms in the Delaware Valley. standing and appreciation of the symbiotic rela In the past few years the Philadelphia com tionship of these three groups can provide the munity has become increasingly aware of the importance to its economy of home-grown sci stimulating and supportive environment Philadel phia needs to become a more fertile seed-bed of ence-based companies. The area’s banks are demonstrating greater interest in supporting new science-based industry. R & D enterprises. Bankers’ initiative helped lead to the formation of the Southeastern Pennsyl vania Development Fund to fill a financing gap for neophyte firms. A formal program is under way to educate local bankers in new technologies which promise industrial growth in the region. Recently, a number of universities in the area have stepped up their drive for better graduate programs in science and engineering. One ex ample is the program of the new Laboratory for Research on the Structure of Matter at the Uni versity of Pennsylvania. This will attract grad uate students to the area for research into the science of materials. The Drexel Institute of Tech nology is in the process of greatly strengthening its graduate program— having received permis sion last year to grant doctoral degrees. The Institute also is moving actively and successfully T H E M ETHO DO LO G Y OF T H IS IN V ES TIG A TIO N A N D T H E M EA N IN G OF T H E FIN D IN G S The Delaware Valley firms whose founders were interviewed in this investigation were selected by carefully reviewing all available sources of infor mation on research-oriented companies. The firms themselves then were contacted, to iden tify those formed during the postwar years by persons from local universities or companies. When such a firm was identified, arrangements were made to interview one of its founders. No firm refused an interview. The Boston firms were selected similarly, but those actually interviewed were chosen so as to approximate the Delaware Valley firms in age, size, industry and origin of founder— whether from a university or a research-oriented industry. One firm contacted refused an interview without prior high-level contacts being established. The required entree then was obtained prior to fur ther requests for interviews, and there were no more refusals. In one case, the founder had left to form another new firm, but granted an inter view nevertheless. To insure comparability, each person inter viewed was asked the same questions. However, 9 b usin ess r e v ie w interviews were open-ended; they averaged three hours in length. Questions asked were based on a thorough review of suggested hypotheses as to why new science-based firms are established. The questionnaire served to test the hypotheses themselves and to determine where responses differed between Boston and Philadelphia. Answers to the majority of the questions did not differ very much between the two areas. But with respect to two questions, responses differed strikingly. The two questions concerned the im portance of local universities in the formation of new science-based firms, and the attitude of local banks to the financing of the small sciencebased firm. On the first issue, the interviews in every case took off from the question, “ Do local universities play any role in stimulating new science-based firms?” All 13 company founders responded, as follows: Philadelphia Boston Universities play an important role 0 6 Universities play small role 7 0 It is possible, of course, to pick from two areas, where opinion really does not differ on a subject, 13 people (7 from Area 1; 6 from Area 2) whose opinions differ in such a way that all those from Area 1 react negatively and all those from Area 2 react positively. The probability of this occurring accidentally (that is, solely as a chance event) is .00058. In other words, in 13 cases, chance alone would produce so violent a difference, when in reality opinions in each area were split the same way, only once in 1716 tries (58 times in 100,000 tries). The financing issue was opened with the ques tion, “What is the attitude of local banks to financing for the small, science-based firm?” One company founder in Boston disclaimed current knowledge on the subject; accordingly, there were 12 responses, as follows: Philadelphia Boston Attitude “good” or “excellent” 0 5 Attitude “ unreceptive,” “ poor” or “bad.” 7 0 The probability of accidentally picking 12 peo ple from two areas where opinion really does not 10 differ on a subject (7 from Area 1; 5 from Area 2) and finding that all those from Area 1 react negatively and all those from Area 2 react posi tively, is .00126. That is, chance alone would produce so violent a difference in 12 cases, when in reality opinions in each area were split the same way, only once in 792 tries (126 times in 100,000 tries). The probability that these findings are acci dental manifestly is extremely small; they are one-in-a-thousand cases. Therefore, in all prob ability they reflect either real differences of opin ion on these points in the two areas, or else they reflect bias either in the selection of firms or in the way the interviews were conducted. The method of selecting firms has been out lined; lists were assembled, firms were contacted, and when one met the criterion of being a spin off from a Delaware Valley university or industry its founder was interviewed. Boston firms were selected by trying to match characteristics of the local firms that had been interviewed. These selection procedures were imposed by the diffi culty of enumerating the total population of spin off firms in each area. This selection method does not satisfy all the conditions of a random procedure, so it is possible that it favored “ nega tives” in Philadelphia and “ positives” in Boston. There is nothing in the way firms were selected to support such a contention, however. Arguing against it is the fact that on all issues except universities and financing, the responses from the same persons failed to show statistically sig nificant differences; that is, such differences as did materialize between the two areas were well within the range expected on the basis of chance alone. The interviews were kept comparable by em ploying the same questionnaire and interviewer in each. Company founders expressed them selves freely and at length. It is possible that they were led to express opinions contrary to or more highly colored than their real ones— nega tively colored on the one hand and positively on the other. The investigation was so designed as to guard against this happening, however. The findings, therefore, probably did not arise by accident or from controlled selection or con trolled responses, though this is not certain. If none of these factors determined the results, then they reflect real differences between the areas on the two questions. PRESSING AGAINST THE CEILING? OR HOW HIGH CAN THE LOAN/DEPOSIT RATIO GO? by David P. Eastburn As credit demands press harder and harder on on the same basic forces that have shaped its past. supplies, a recurring question in board rooms As chart 1 also shows, putting the question in and executive dining rooms of commercial banks is “ how high can the loan/deposit ratio g o ? ” investments gives the same general picture as Bankers look at a ratio of 62 per cent for all loans as a percentage of total deposits. This is a commercial banks and ratios of 70 per cent and above for many individual banks and conclude that the ceiling can’t be very far away.* much more fruitful way of looking at the question because the most important factor determining terms of loans as a percentage of total loans and Older bankers with long memories, of course, may recall even higher ratios back in the 1920’s. As CHART 1 chart 1 shows, the ratio for all commercial banks was just under 80 per cent early in the twenties, and at the end of the decade was still as high as The LOAN/DEPOSIT RATIO has experienced two broad swings in the past 45 years— declining from 1920 to 1944, and then rising since World War II. The ratio of loans to loans and invest ments has moved generally the same way. 70 per cent. But memories tend to be short, and as top positions of more and more banks are Ratio taken by younger men whose experience is limited to post-Depression years, the present ratio is, to all intents and purposes, a new peak. The broad rise from 17 per cent in 1944 to 62 per cent today seemingly just can’t continue at the rate it has been going. What has moved the ratio in the past? The future of the loan/deposit ratio will depend *Some calculate the ratio by deducting uncollected items from deposits and expressing loans as a percentage of “ adjusted” deposits. This produces a ratio for all com mercial banks of 67 per cent. IT b usin ess r e v ie w CHART 3 CHART 2 Changes in EARNING ASSETS HELD BY COM MERCIAL BANKS help to explain ups and downs in the loan/deposit ratio. The rise in the ratio in recent years results from the increase in loans relative to Governments and municipals held by banks. Changes in earning assets of banks are strongly in fluenced by changes in NET PRIVATE AND PUBLIC DEBT OUTSTANDING. As private debt has expanded in recent years relative to Federal and state and local government debt, much of this private debt has found its way into bank portfolios in the form of loans. Billions of Dollars *“ Other securities.” 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965" e— estimated. the loan/deposit ratio is the kinds of assets bank ers decide to put their funds into. As chart 2 shows, bankers ever since World War II have commercial banking. But in a broad sense, their chosen to acquire loans rather than Federal which they have little or no control. Among these Government securities. This accounts for the are wars and the general state of the economy. These affect the banker’s decisions by influenc broad rise in the loan/deposit ratio during that decisions are made for them by events over period. The broad decline through the 1930’s and ing the kinds of instruments available for him to World War II was caused by the opposite move acquire. Trends in major types of debt outstand ment—acquisition of Government securities at a ing in the economy, presented in chart 3, show a rate greater than loans. Bank holdings of munic striking similarity to trends in bank assets in ipal securities were a relatively neutral factor during most of the earlier period, but after World chart 2. During the Depression and World War War II began to become more important and in rapidly than private and state and local govern the last five years have really spurted.* ment debt. As bankers took large amounts of Federal Government securities into their port Individual bankers consider many things in deciding the kinds of assets to acquire, and in this, of course, lies much of the art and skill of II, Federal Government debt increased more folios, this kind of instrument became a much larger proportion of total earning assets. In the postwar period, on the other hand, * Throughout this article, data on municipal securities actually are “ other” (i.e., other than Federal Government) securities held by banks. Municipals constitute the great bulk of “ other securities.” 12 bankers have responded to, and indeed contrib uted to, the tremendous surge of the private economy. Their acquisitions of loans have been b usin ess re v ie w part of the process which has generated such a The picture is much more complicated than rapid increase in private debt. In contrast, growth this, of course, but here let’s consider only one of Federal debt has been relatively limited and refinement. This has to do with the share of out helps to explain the decline in bank holdings of standing debt which commercial banks, vis-d-vis Government securities. The expansion in state other investors, acquire. Chart 4 shows commer and local government debt has offered more cial banks’ share of outstanding debt since 1920. opportunities for hanks to acquire this type of It indicates that banks in recent years have instrument. acquired a rising share of private debt, but a In broad terms, then, the types of assets which declining share of Federal Government debt. An bankers decide to hold have been influenced other way of putting this is that the ratio of loans strongly by the types of debt instruments avail to loans and investments and the ratio of loans to able. When Federal Government debt has risen deposits have grown even faster than one would more rapidly than state and local and private expect simply on grounds of the growth in out debt, banks have acquired Government securities standing debt; bankers have hurried the trend relative to other assets. When, as in the postwar along in recent years by acquiring an increasing period, private debt has risen more rapidly than share of outstanding private debt. Government debt, banks have increased the importance of loans relative to investments. This fact, probably more than anything else, explains the behavior of both the ratio of loans to loans and investments and the ratio of loans to deposits. Outlook for 1970 This review of forces at work in the past brings us back to the question posed at the outset: how much higher can the loan/deposit ratio go? With out making any predictions, it is possible to figure CHART 4 how high it might go by, say, 1970, assuming cer The COMMERCIAL BANK SHARE OF OUTSTANDING DEBT also helps to explain behavior of the loan/deposit ratio. In the past few years, banks have ac quired a larger share of outstanding private debt, thus pushing up the loan/deposit ratio even faster than would have resulted from shifting debt patterns alone. tain conditions. These conditions involve: (1) trends in the various kinds of debt outstanding; Ratio (2) commercial banks’ share of that debt. Some of the many possible assumptions that could be made are shown in the table on the next page. In the first column, we assume simply that trends continue as they have been going in recent years. Private debt would keep rising very rapidly and commercial banks would continue to get a rising share of it. State and local government debt also would rise rapidly, and the commercial bank share would expand at the exceptionally fast rate of recent years. While Federal Govern ment debt also would rise, commercial banks would reduce their share, as they have been doing e— estimated. * Ratio of “ other securities” to state and local govern ment debt. for some time. Any banker who expects things to keep going as they have been, in other words, can get an 13 b usiness r e v ie w Assumed O utstanding debt— Private Continues trend of recent years Federal Governm ent State & local ern m ent tren d gov- C om m ercial bank share of— Private debt Federal G overnm ent debt State & local gov’t debt to 1970 Increases fa st as in years Increases fa st as in years Increases fa st as in years 3 as A recent as recent as recent assumed to keep growing at the recent rate and commercial banks do not reduce their share of it quite so rapidly. State and local government debt would also continue to rise as fast as it has been, but commercial banks would not in crease their share of it quite so rapidly. Given these assumptions, the loan/deposit ratio would Increases fa st as in years Declines fast as in years Increases fa st as in years 3 as A recent 3 A as recent 3 as A recent Ratio of lo an s/lo a n s & 72% investm ents 7 0% Ratio of loans/deposits* 66% 64% * Estim ated from relationship to ratio of lo an s/lo a n s & investm ents in recent years. come out to about 64 per cent. Bankers who foresee other possibilities will get other loan/deposit ratios. More extreme assumptions would tend to produce more extreme results. But the odds are against either extreme — either a very high, or very low ratio-—as we look ahead. A very high ratio would suggest boom conditions in the private economy until 1970, with commercial banks extending their idea of the loan/deposit ratio in 1970 by looking at the bottom of the first column. This shows a competitive position; at the same time, municipals and Governments held by banks would have to ratio of about 66 per cent. This, of course, is increase much more slowly or decline relative to higher than the ratio today. But it is not as high as one would expect simply by projecting the loans. While these conditions are possible, they don’t appear to be the most likely. trend of the loan/deposit ratio in recent years. The reason, primarily, is the very rapid growth of any size is quite remote. As chart 1 shows, It seems still clearer that a decline in the ratio to continue for the next several years, municipals the ratio has not dropped consistently and sub stantially since the 1930’s and World War II. would become an increasingly important part of The only developments which could bring about of municipals in bank portfolios. If this were bank earning assets and tend to hold down the such a drop would seem to be an international rise in the loan/deposit ratio.* crisis or a depression. Either of these would The second column is intended for those bankers who may not be content to assume require a major step-up in Federal Government spending which would produce a large flow of simply a continuation of recent trends. In this Government securities into commercial banks. column, we assume that private debt will not rise The greater likelihood is that the loan/deposit as rapidly as it has been, nor will commercial ratio will rise higher by 1970 than it is now, but banks increase their share of it as rapidly. On not as fast as it has in recent years. the other hand, Federal Government debt is In the shorter-run * Municipals would rise from 14.7 to 18.0 per cent of total earning assets. The importance of assumptions about the behavior of municipals is illustrated by the fact that if all trends are assumed to continue as in recent years except that commercial banks’ share of municipals is assumed to level off at the present per centage, then the loan/deposit ratio would rise to 68.5 per cent. 14 Of course, 1970 is still some time away. In shorter periods the loan/deposit ratio responds, more than anything else, to fluctuations of the business cycle. As chart 5 shows, the ratio rises during economic expansions and declines during b usin ess re v ie w CHART 5 SHIFTS IN LOANS AND INVESTMENTS over busi ness cycles explain short-run changes in the loan/deposit ratio. Banks move into Governments when loan demand falls off in recessions (shaded portions) and out of Governments when loans pick up again. customers, banks sell Government securities. Their holdings of municipals have tended to grow more steadily, picking up in recent years as banks have sought higher-yielding investments. What this look at cycles indicates is that on top of the longer upward drift of the loan/deposit Per Cent ratio are superimposed particularly rapid spurts during periods of strong credit demand, such as the present. It is during these periods that con cern about the ratio mounts. Bankers see their holdings of more risky and less liquid assets rising and their holdings of less risky and more liquid assets declining. As they look ahead to still further demands on their resources, they examine their risk and liquidity positions more and more closely and. tend to become more selec tive in meeting further demands. Bankers may not find much comfort, there fore, in the longer-run projections presented above. Nor are they urged to. Sometime in the future they may look back on today’s ratio and regard it as fairly comfortable. Bankers have changed their views about customary levels **llnadjusted. Shaded areas represent periods of recession. of the ratio in the past and may well change them again in years to come. But right now, and looking to the immediate (shaded portions). The reason, of future, they feel squeezed by the rising ratio. To the extent this feeling induces them to look course, is that loan demand is strong when busi ness is good. At the same time, supplies of funds twice at demands for credit, it serves a useful purpose of relieving pressures in our current get tight and, in order to meet needs of their full-employment economy. recessions 15 FOR T H E R E C O R D INDEX BILLIONS $ Manufacturing Third Federal Reserve District Per cent change Banking United States Per cent change SUM M ARY MEMBER BANKS, 3RD F.R.D. Mar. 1966 from mo. ago year ago 3 mos. 1966 from year ago Mar. 1966 from mo. ago year ago Employment 3 mos. 1966 from year ago LO CAL C H AN G ES n+ -nfi-rri Metropolitan Statistical Areas* MANUFACTURING + 2 Electric power consumed + 10 Man-hours, total* .......... + 1 + l + l CONSTRUCTION** .............. +46 2 COAL PRODUCTION ....... + 8 + 5 + 4 + 9 -23 + 3 + + + + + 9 6 4 10 9 2 + 9 Payrolls Per cent change March 1966 from Per cent change March 1966 from mo. ago year ago mo. ago year ago Check Payments** Total Deposits*** Per cent change March 1966 from Per cent change March 1966 from mo. ago year ago year ago mo. ago + 9 Wilmington ..... 0 0 + 4 Trenton ............ + 11 + 10 BANKING (All member banks) Deposits ............................... — 1 Loans ..................................... + 2 Investments ....................... - 2 U.S. Govt, securities .... — 4 Other ................................... + 1 Check payments*** ........ + 4f + 4 + 10 - 1 -10 + 12 +17+ + + + + 6 10 1 8 11 16+ 0 + 2 - 2 — 4 0 + 4 + 6 + 14 0 - 9 + 11 + 16 + + + + + 8 14 1 7 12 15 + 4 -1 6 - 1 + 8 1 + 1 + 3 -14 - 3 + 8 +24 + 1 + 10 + 3 + 11 — 2 + 13 + 1 + 7 + 1 + 3 + 2 + 9 + 4 + 15 + 1 -3 1 + 1 + 1 + 4 + 2 + 4 + 9 — 1 + 2 Lancaster .......... + 1 + 7 + 2 + 14 + 9 + 17 + 1 + 10 Lehigh Valley .. + 1 + 1 + 4 + 4 + 3 +20 - + 5 - Philadelphia ..... 0 + 4 + 1 + 10 + 7 + 19 Reading ............ 0 + 4 + 1 + 9 - 6 + 12 1 2 + 6 0 + 6 + 10 ........................... Of ‘ Production workers only “ Value of contracts ‘ “ Adjusted for seasonal variation + 3t + 2f 0 0 + 4 + 3 + 4 + 2 tl5 SMSA’s ^Philadelphia Scranton .......... 0 + 5 + 3 + 12 - 2 + 15 — 1 Wilkes-Barre .... PRICES Consumer Altoona ............ + 16 + 18 Johnstown ........ + 12 + 14 - - Harrisburg ........ +45 + 5 0 1 + 1 + 2 Atlantic City .... + 2 + 4 + 2 + 10 — 2 + 14 + 1 + 9 York .................. 0 + 5 + 1 + 13 - + 8 0 + 4 1 ‘ Not restricted to corporate limits of cities but covers areas of one or more counties. “ All commercial banks. Adjusted for seasonal variation. ‘ “ Member banks only. Last Wednesday of the month.
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