Full text of Business Review (Federal Reserve Bank of Philadelphia) : September 1975

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September

Banking's Capital Shortage:
The Malaise and the Myth
The Dollar at Home and Abroad
Bank Loan Losses:
A Fresh Perspective

business review

The Fed in Print

FEDERAL RESERVE BANK of PHILADELPHIA




IN THIS ISSUE . .
Banking's Capital Shortage:
The Malaise and the Myth
. . . A basic reason that new bank capital is
in short supply is investor dissatisfaction with
the returns offered by bank securities.
The Dollar at Home and Abroad
. . . Despite double-digit inflation, the dollar
buys more at home than overseas because
foreign money and foreign goods cost more.
Bank Loan Losses:
A Fresh Perspective
. . . Though loan loss reserves have lagged
behind loan expansion, the industry's cushion
for absorbing probable losses is still quite
large.

On our cover: The Campbell Museum, located in Camden, New Jersey, is the only museum
of its kind in existence. The museum's collection consists of objects pertaining to the service
of soup and its equipage. It is international in scope with examples from 24 countries and
not limited to any one period. Although the first purchase was a rare American silver soup
tureen made circa 1795 (upper left), other objects of high quality as examples of popular and
individual choice are a Vincennes tureen of soft-paste porcelain (upper right), a Chelsea
tureen (soft-paste) made in 1762-63 (lower left), and a Russian silver tureen bearing the mono­
gram of Catherine the Great (lower right). (Photographs courtesy of The Campbell Museum,
Camden, N. J.)

BUSINESS REVIEW is produced in the Departm ent of Research. Editorial assistance is pro­
vided by Robert Ritchie, Associate Editor. Ronald B. W illiam s is Art D irector and Manager,
G raphic Services. The authors w ill be glad to receive comments on their articles.
Requests for additional copies should be addressed to Public Inform ation, Federal Reserve
Bank of Philadelphia, Philadelphia, Pennsylvania 19105. Phone: (215) 574-6115.



Banking’s Capital
Shortage:
The Malaise and
The Myth
By Ronald D. Watson

new capital is possible, but only if bank
regulators are willing to allow risks to in­
crease, and that isn't likely. The "shortage" is
occurring because banks are expanding their
assets more rapidly than reinvested profits
can boost capital. The obvious supplement to
retained earnings is new capital from public
issues of long-term debt and equity securities.
But bankers claim that declining stock prices
and higher interest rates have made the cost
of this new money (especially the equity) too
high. The problem is compounded by
generally weak markets for bank securities,
especially in the wake of several failures of
large banks in 1974. Most banks resort to out­
side financing only when other sources of
funds are no longer readily available.
Restricting the industry's growth to the rate
at which it can generate capital internally has
been suggested, but most banks are reluctant
to accept a policy that might mean losing
ground to other financial intermediaries or

Is it possible that bank capital—like oil—is a
scarce resource whose supply is in danger of
being exhausted? To read the financial in­
dustry's trade journals a person might con­
clude that Capital is a rare substance whose
supply can grow only at a strictly limited rate.
However, the current presumption that banks
can't raise the funds they want for strengthen­
ing their capital positions and expanding
deposits needs a lot of rethinking. Banks must
have capital to inspire public confidence and
absorb losses.1* If they can't get the capital re­
quired to support their operations, maybe
banks aren't serving the economy as effec­
tively as is generally assumed.
Clearly, the banking industry must raise ad­
ditional capital if it is to grow. Growth without

1Ronald 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




3

SEPTEMBER 1975

BUSINESS REVIEW

have most corporations). Of the new
securities issued by banks the bulk has been
debt (subordinated notes and debentures)
rather than common or preferred stock.4 In
general, internal funds are more appealing as
a source of capital than external funds
because their cost seems very low. Retained
earnings almost always look cheaper than
new common stock. A new stock issue may
dilute the earnings of current shareholders,
but retaining earnings never will. Further­
more, there are substantial transaction costs
associated with floating new debt or equity
issues publicly. Retained earnings may also
seem less costly than long-term debt which
carries an explicit obligation to pay interest.
Raising money through new issues of com­
mon stock has become even more expensive
in the last few years because bank stock prices
have declined dramatically even though ear­
nings have been growing. Bankers ac­
customed to seeing their shares sell for 15 to
20 times earnings in the early 1960s were dis­
mayed to see those prices drift into the 10 to
15 times earnings range in the late 1960s and
early 1970s and then plummet to the 5 to 10
times earnings range in 1974.5 As stock prices
decline, the number of shares that must be
sold to raise a fixed amount of new capital in­
creases. When this occurs, the current
stockholder's control of the bank is diluted
and his future dividends diminish relative to
what he would have received if the stock had
been sold at a higher price. And each jump in
equity cost has strengthened management's
resolve to avoid paying the cost of raising

even slowing the whole economy's growth.
Yet, further growth for banking appears to be
stymied. Internal generation of new capital is
too slow, outside capital seems too costly, and
the regulators are closing off the alternative of
expanding without additional capital.
This should not—and need not—be an im­
passe. If the problem looks insurmountable, it
may be that we are zeroing in on the wrong
target. The issue should not be one of “ how to
get capital for future expansion,” but “ are the
profit opportunities of this expansion great
enough to justify raising new capital at today's
prices?'' If the profits are there, banks can af­
ford to pay the going rate for capital. If they
aren't, then the capital should go to industries
that have better opportunities to use it. Bank
capital markets may be in poor shape, but that
alone shouldn't change the way the decision
to expand is made.
THE CAPITAL CHASM
The bank capital “ shortage” has been
brewing for several years, but recent projec­
tions of enormous capital shortfalls over the
next decade have significantly pepped up dis­
cussions of the problem. There have been
prophecies of a capital “ gap” (differences
between probable capital accumulations and
capital demands of the industry) of $16.7
billion2 by 1978 or $32.0 billion3by 1979. These
projections have intensified the industry's
awareness that the methods used for finan­
cing growth in the '60s may not be equal to
the task in the '70s.
Bankers have normally considered it im­
practical to try to close this gap with outside
sources of funds. Data on bank financing is
very sketchy, but the industry has a long
history of depending heavily on earnings
retention for additional long-term funds (as

4“ Report of Securities Issued by Commercial Banks and
Holding Companies,” Report #67, Corporate Financial
Counseling Department of Irving Trust Company, New
York, February 28, 1975.
5Keefe Bank Stock Manual(New York: Keefe, Bruyette,
and Woods Inc., 1974). Inflation and riskier bank port­
folios have been important reasons for the rising cost of
new debt and equity capital. However, many bankers
claim that public statements by regulators warning of
capital inadequacy problems have increased the cost of
funds even to very conservative banks by making in­
vestors wary of all bank securities—not just banks that
had been aggressive in using leverage.

2The Capital Adequacy Problem in Commercial Banks,
1974-1978 (Princeton, N.J.: The Institute for Financial
Education, 1974), p. 8.
3Warren R. Marcus, The Challenge to Banking: Capital
Form ation in the Seventies (New York: Salomon
Brothers, 1974), p. 6.




4

FEDERAL RESERVE BANK OF PHILADELPHIA

tance of maintaining profitability, the
problem will just reappear in a couple of
years. Asset growth will again be halted by the
capital adequacy barrier, but this time it will
be at an even lower standard.

funds with new stock issues.
Even debt capital has become more expen­
sive in the last few years. Not long ago sound
banks were able to sell their long-term
obligations at an interest rate of 5 to 6 percent.
However, an upward drift in rates and recent
concern about bank soundness have made
the going rate 8V2 to 10 percent these days.

More Debt. The second type of suggestion
for closing the capital gap consists of plans for
lowering the price that banks must pay for
their capital funds. The most common
proposal is that banks use more long-term
debt as a substitute for equity capital. As long
as debt hasn’t been overused, it has a cost
below that of equity and appears to be the
cheapest way to raise outside capital. Debt is a
particularly attractive form of capital in that it
is the one form of long-term funds whose cost
is a tax-deductible expense.6
Yet, substituting long-term debt for new
equity is also only a partial solution. Long­
term debt is an inadequate substitute for
equity because it has legal characteristics
which are different from those of common
stock. Its claim to interest is secondary to that
of depositors, so it backstops their claims. But
interest and principal must be repaid on time
if the bank is to avoid default, and operating
losses cannot be charged against debt
“ capital" (except in liquidation) as they can
against equity capital.
Accordingly, if bank’s asset growth is
financed with debt capital rather than equity,
the chance of incurring a large loss that would
wipe out the remaining cushion of equity
capital grows. The greater the amount by
which the growth of risky assets exceeds ex­
pansion of the equity cushion,thegreaterthe
risk of failure. Bondholders are also wary of
this heightened risk of failure. As the in­
vestors’ risks grow, the yield they demand on
their investment also climbs. As a result, heavy
use of “ cheap" debt capital will eventually

CURRENT REMEDIES FOR SPANNING
THE GAP: A WEAK BRIDGE
Even though there is no universally
accepted response to this problem, there
have been any number of suggestions. Some
have been directed toward loosening the
regulatory constraint on expansion while
other plans have been designed to reduce the
industry’s cost of capital. All of these
proposals have some merit, but none con­
stitutes a lasting solution to the problem.
Lower Capital Standards. Some effort has
gone into convincing the regulatory agencies
that banks don’t really need all the capital that
supervisors currently consider prudent. If
capital standards were lowered, still more ex­
pansion could take place. Bankers point to
the willingness of investors in the capital
markets (until very recently) to advance debt
funds to banks at interest rates nearly on a par
with other high-quality corporate borrowers.
This is interpreted as evidence that investors
(who are the first to lose their money if
banks fail) have considered banks to be good
risks. If regulatory standards on capital are too
conservative, reducing them would alleviate
the current bind on growth. Reducing capital
requirements might also enable banks to
maintain the lower standard through reten­
tion of earnings. However, such a hope might
be overly optimistic. A key reason that banks
haven’t maintained capital at the current stan­
dard through internal generation of profits is
that they have been willing to sacrifice profits
to achieve asset growth. If the regulator's
capital constraint is relaxed without a
simultaneous reexamination of the impor­




6There have recently been legislative proposals that all
dividend payments be treated as tax-deductible expenses
in the same way that interest payments are now deducti­
ble. If this change in the tax codes were enacted, it would
make stock a relatively more attractive way to finance
corporations.

5

SEPTEMBER 1975

BUSINESS REVIEW

raise the cost of new equity and debt (both
new and refinanced) by causing the market
price of these securities to decline. This risk
"spillover” reduces the cost advantage of new
debt. It also hurts the financial position of the
current shareholders whose investment has
now dropped in value. If a bank's debt posi­
tion becomes excessive by market standards,
management will find that by cutting back on
the use of debt the shareholders' risk will be
reduced, the stock's price will tend to rise,
and the overall cost of funds will be lower
(even new equity issues become relatively less
costly than additional debt).

stock can be set above the current market
price of the stock. This type of security is sup­
posed to give the issuer a cheap source of
debt which will eventually be turned into
equity at a better price than new stock issued
right now—in a sense, the best of both worlds
for the bank.
Investment trusts and convertible debt
securities might be useful to a bank, but they
won't make the cost of new capital substan­
tially lower. Such a trust may improve the
overall marketability of a bank's securities,
making it easier for the institution to tap new
sources of capital. However, an investor
should be able to diversify his or her in­
vestments without the trust and has little
reason other than convenience to accept a
significantly lower return on pooled
securities than for the individual issues.
C onvertible bonds (and convertible
preferred stocks) are also useful, but again
they don’t solve the problem. On the surface
they look like a very cheap way to raise
money. But this is not the case. If a bank offers
a convertible bond, it may sell the securities at
a low interest rate and attractive conversion
price. However, it has still sold a debt issue,
and debt isriskierforthebankthan new equi­
ty. Holders of these bonds will only convert
them to stock if the price of the bank's stock
rises to a level above its conversion price in
the future. If a bank really wants debt capital
now and equity capital sometime in the
future, it might be better off to float a bond
issue initially, and then refinance it with a
common stock issue later at the stock's higher
price. In principle, there's no reason to expect
a bank to be able to raise capital substantially
more cheaply in the long run with convertible
securities than with ordinary debt and stock.

New Securities. One of the problems
preventing banks from using more debt
capital is the poor marketability of these
securities. Major banks that have market
recognition are able to sell large amounts of
debt at relatively low interest rates. However,
smaller banks that lack this reputation aren't
so fortunate. The market for their securities is
normally restricted to their operating region,
and borrowing costs may be higher than
those of a large bank of the same risk. To over­
come these disadvantages some smaller
banks have borrowed debt capital from their
big-city correspondents.7 There have also
been suggestions that smaller institutions use
investment trusts (like mutual funds) to pool
their securities. This device is intended to
sim plify the investor's diversification
problems while providing a wider market for
the securities of these banks.
Weakness in the stock and bond markets
has prompted some authors to suggest that
banks turn to convertible bonds for new
capital. These are securities that can be con­
verted into common stock if stock prices rise.
Convertible bonds usually have an interest
rate below that of nonconvertible debt.
What's more, the price at which holders are
allowed to convert their bonds into common

Cut Dividend Payout. The high cost of new
external capital has also prompted the
suggestion that banks boost earnings reten­
tion by gradually cutting the proportion of
earnings paid out as dividends. Retained ear­
nings are an appealing way to build equity
capital because the process doesn't create

7This may make the smaller bank’scapital position look
more sound, but it hardly enhances the stability of the
banking system.




6

FEDERAL RESERVE BANK OF PHILADELPHIA

when profit prospects don't warrant doing so
is no solution to the capital problem.

new shares which dilute earnings. The inter­
nal funds also increase the likelihood that
there will be higher earnings in subsequent
years.
But the suggestion that higher earnings
retention be used when equity capital costs
are high skips over some basic economics. If
the cost of new equity is prohibitive, the cost
of retained earnings should be treated as only
“ a bit less" than prohibitive. The cost of
retained earnings is closely linked to the cost
of new equity in the long run. In a world
without taxes these costs would be identical
except for the cost of underwriting new stock
issues. Taxes make retained earnings slightly
cheaper because investors whose profits are
retained for reinvestment by the bank will
avoid income taxes—at least until the
reinvested profits produce higher dividends
or until stockholders realize a capital gain on
their investment. Realizing a capital gain
would reduce the effective tax rate on the
profits from reinvestment.
The connection between the cost of retain­
ed earnings and that of new common stock
becomes clearer if we think of retained ear­
nings as bank profits that are being reinvested
within the organization for the benefit of the
shareholders rather than being paid out to
them in the form of dividends. Those same in­
vestors who want a very high return for in­
vesting in a new stock issue aren't likely to be
happy to have their profits reinvested for
them at significantly lower expected returns.
If investors currently expect 15 percent as a
return for investing in a bank's stock, they
must feel that 15 percent is a competitive
return given the risks of bank investment and
the alternative uses they have for their
money. If the bank can't earn enough profit
on these retained earnings to give the
shareholders that 15 percent return, it would
make the investors better off by giving them
the money as a dividend to invest as they see
fit. In the long run, reinvestment of retained
earnings at substandard rates will lower the
bank's overall rate of return, and investors will
bid down the price of the bank's stock.
Therefore, reinvesting retained earnings



Boost Earnings. The final proposal for clos­
ing the capital gap is one of speeding internal
equity creation by increasing earnings
margins. Greater profits would allow earnings
to grow faster, equity to expand faster, and
asset growth to be less impeded by capital.
The proposal that banks raise their profit
margins is the soundest and the most impor­
tant of this crop of "solutions." It comes the
closest to confronting the fundamental
reason that the industry finds itself “ unable"
to raise adequate capital. It is also the basic
component of a real solution.
THE FUNDAMENTAL PROBLEM
The problem that banks face isn't a shortage
of capital but an unwillingness or inability to
pay the "going rate." There is no question
that capital costs are high right now. By the
historical standard of the last three decades,
the only time they were higher was in the
latter part of 1974 when long-term interest
rates were above their present levels and
stock prices were extremely depressed. Ad­
justing to these rising capital costs is difficult
for all businessmen—and the reaction is likely
to be slow. Many bankers have delayed raisingcapital hopingthatafuturedrop in market
rates will reduce these capital costs.
Beyond the argument that rates may soon
drop, many bank managers are simply unwill­
ing to tolerate the dilution of earnings per
share that could accompany a new stock issue
(spreading the existing earnings pool over a
larger number of shares). Retained earnings
may have a high implicit cost, but it's a dif­
ficult cost to pinpoint. Diluted earnings,
however, suggest that management may have
made some errors somewhere along the line.
That makes dilution a difficult path to accept
(see Box).
Bankers may also be unwilling to pay the
high cost of new capital for the sound
economic reason that they cannot reinvest it
at a sufficiently high return. They may know

7

BUSINESS REVIEW

SEPTEMBER 1975

WHEN WILL DILUTION O CC U R ?
A com m on argum ent advanced against sell new stock issues is the co ncern that the stock's ear­
nings per share (E.P.S.) w ill be diluted by an increase in the num ber of shares outstanding. This is
true, and to the extent that a b an k’s ability to pay dividends is tied to its E.P.S., it is undesirable to
dilute earnings. H o w e ve r, this isn’t the w ho le story.
New equity capital does m ore than sim ply dilute the curren t earnings of the existing shares. The
new m oney can be invested profitably and used as a base for expanding other liabilities. It also
reduces the risk of the b an k’s capital structure. It is quite possible that shareholders of a bank that
sells new com m on stock can e xp e rie n ce a mild dilution of their earnings but be better off. The have
a sounder investm ent because their risk is low er and the bank now has a better equity base on w hich
to expand in the fu ture. As a practical m atter, new stock issues alm ost re q u ire dilutio n in the short
run. Stock must be sold in large enough blocks that the flotation and underw riting cost a re n ’t too
large a proportion of the total funds raised. But the new equity w ill then be sufficient for fu rth er e x­
pansion of fixed-cost liabilities and the bank can releverage the earnings to their fo rm er level.

Stock Price Dip. It’s alm ost an article of faith that new stock can't be issued after a fall in the bank’s
stock price w itho ut diluting earnings. D ilutio n may w ell o ccu r, but it isn ’t a foregone co nclusio n.
Suppose the N inth National B an k’s balance sheet is the fo llo w in g .
Cash
Bonds
Loans

( 0%)*
( 7%)
(11%)

Total

$ 100
500
600

Deposits
Borrow ing
Capital

$1200

Total

(6%)
(7%)
(20 shares
@ $5 per)

$ 600
500
100
$1200

Assum ing the bank's tax rate is 50 p ercent, its earnings per share w ould then be
revenues
(0 + 35 + 66)

-

expenses
(36 + 35)

=
=

incom e
30

-

taxes
15

=

profit
15/20 = $ .75 E.P.S.

Assum ing that the sto ck’s m arket p rice is equal to its par value, this is a 15-percent return on the
sto ckh o ld ers’ investm ent.

*The numbers in parentheses denote the effective yield on assets or the net cost of funds raised. Economic
theory suggests that a firm should utilize a source of funds until the marginal cost of the next dollar raised from
that source is exactly equal to the marginal cost of a dollar from any alternative source. If the bank described
above really found that its cost of obtaining new deposits was below the cost of new short-term borrowings, it
should tap that source until the marginal cost of deposits rises to the level of the cost of new borrowings.




8

FEDERAL RESERVE BANK OF PHILADELPHIA

Suppose this bank had some attractive investm ent and lending o ppo rtunities but needed ad­
ditional m oney to expand its assets. A total of $200 could be invested as fo llo w s:
20% in bonds at 7% = .014
80% in loans at 11% = .088
.102 = 10.2% before-tax yield
5.1% after-tax yield
Suppose, also, that the bank w ould have to rely heavily on purchased funds and new stock to raise
this m oney but could get it in the fo llo w ing w ay:
20% from new deposits
70% from borrow ings
10% from new com m on stock (4 new shares).
The average cost of these marginal sources of funds (adjusted for the tax ded u ctib ility of interest)
w ould be
Proportion

Tax-Adjusted Cost

.2

X

.7
.1

X

(.06 x .5 = .03)
(.07 x .5 = .035)
(.15)

X

=
=
=

.0060
.0245
.0150
.0455 = 4.55% tax-adjusted
cost of funds.

As long as funds can be raised at 4.55 percent and invested at 5.1 p ercent, the bank should e xp and .**
In fact, if the bank m akes this expansion its new balance sheet w ould be
Cash
Bonds
Loans

( 0%)
( 7%)
(11%)

Total

$ 100
540
760

Deposits
Borrow ings
Capital

$1400

Total

(6%)
(7%)
(24 shares
@ $5 par)

$ 640
640
120
$1400

and the E.P.S. of the ban k’s stock (in clu ding the new shares) w ould jum p to
revenues
(0 + 37.80 + 83.60)

expenses
- (38.40 + 44.80)

=
=

incom e
38.20

-

taxes
19.10

=
=

profit
19.10/24 = $ .796 E.P.S.

**Bankers continually confront choices between greater return with higher risk or lesser returns with lesser
risks. This analysis assumes that the bank’s overall risk has not been altered by the expansion. The proportion of
risk assets is up, but so is the bank's capital position. Therefore, the return expected by investors will not change.




9

SEPTEMBER 1975

BUSINESS REVIEW

Now suppose that inflation picks up or investors becom e w orried about the long-run profitability
of banks. Th e p rice of Ninth N ational's stock might drop from $5 to $4 a share. That represents a
significant increase in the cost of new equity capital to the bank (15 percent to 183/4 percent), and it
w ill now take five new shares rather than fo ur to raise the $20 of new equity. H o w e ve r, the fact that
these costs have risen is not sufficient reason to abandon the expansion. If profits from the new in ­
vestm ents are high enough to cover the jum p in equity costs, the bank should go ahead w ith its
plans. If overall profits are unchanged the new E.P.S. w ill be ...
$19.10/25 shares = $ .764 E.P.S.
This is far less attractive than the 79.6<t E.P.S. that the bank's shareholders w ould have received had
the stock price rem ained $5 a share. But both new and old shareholders are still better off w ith the
expansion than they w ould have been w itho ut it (76.4<t versus 75<t).
In sum m ary, and expansion that earns enough to benefit the new shareholders w ill autom atically
m ake the old ones better o ff. It's only w hen the new capital investm ent isn't profitable by the
m arket’s cu rren t standard of returns that expansion shouldn't be undertaken . D ilutio n w ill o ccur
o n ly w hen the w rong financial decision has been made or w hen the bank has exceed ed the bounds
of prudent leverage and has to sell m ore equity to get back to a safe capital structu re.

In the long run, the banking industry can
only pay a higher price for capital if it can pass
these costs along to customers in the form of
higher effective interest rates or higher fees
for other services provided. The ability to pass
costs along depends in great part on whether
the industry can preserve its cost advantage
over (or, at least, parity with) competing
suppliers of financial services. If bank loan
prices can't be competitive, profit oppor­
tunities will shrink and maintaining the in­
dustry's recent growth rate will be impossible.

that they need greater earnings to justify rais­
ing additional funds yet may be unable to in­
crease their margins because competitive
pressures are too strong. Any move to raise
earnings will be hard to sustain if other finan­
cial institutions don't consider themselves to
be under the same pressures. If only one bank
in an area raises its loan rate, its competitors
will have an advantage in selling their ser­
vices. In all probability the first bank will lose
some of its share of the market. It's only when
all banks feel the pressure to build their
capital (and no one has a clear cost advantage)
that profit margins can be raised successfully.
Even then, banks may lose some business to
other nonbank financial organizations unless
those firms are under equivalent pressure to
boost earnings.8

THE FUNDAMENTAL SOLUTION
The industry can pay the going rate for
capital if it is careful to use sound methods in
analyzing its costs of funds and return
available on new investments. In the long run,
solid financial analysis will be more effective
in loosening the industry's growth constraints
than plans to make bank securities more
marketable. Management will also find that
its own long-run interests are served by mak­
ing sound financial decisions. Asset growth
may be one measure of accomplishment, but
consistent profitability over the long haul
makes a banker's position more secure.

8This should not be interpreted as an approval of collu­
sion to raise prices. Even though the entire industry has
profits that are insufficient to attract new capital, each
bank must respond to the problem individually.
However, the more widespread the profits squeeze, the
more likely that individual banks will follow a move to
raise prices rather than try to increase their market share
by maintaining current prices for loans and services. In
the long run, competitive markets will generate equal
prices from all suppliers, but at a level which covers the
cost of all factors of production including equity capital.




10

FEDERAL RESERVE BANK OF PHILADELPHIA

The Cost of Funds. One of the most basic
problems that industry must confront is es­
timating the costs of its own sources of funds.
Bank management must determine where
new money is coming from, what its full cost
is, and what effect decisions to change the
bank's capital structure (and, thereby, its risk)
will have on the cost of these funds. The cost
of funds to a bank depends in part on the
riskiness of its capital structure—the propor­
tions in which it raises long-term versus short­
term funds and debt capital versus equity. A
bank may raise its next dollar of funds from
any of several specific sources, but it must
carefully maintain a balance of debt and equi­
ty as it grows over time. If this week's funds
come from debt sources, they will soon have
to be balanced with new equity. Since in­
creasing risk makes it impractical to expand
in d e fin ite ly using o n ly short-term
borrowings, bankers must include the cost of
funds from all of the sources that will even­
tually be tapped when they estimate the real
cost of additional funds.9. To be profitable,
any investment made by the bank should earn
enough profit to pay for all the funds used to
finance it.
Lending money at rates which cover only
the cost of funds borrowed to make the loan
will quickly lead to profit problems. The cost
of the new equity that must be raised to keep
risk exposure constant must also be covered
in the rate charged on the loan. Otherwise,
the cost of the bank's funds will rise even
further. If the cost of new capital is increasing,
the signal to management should be clear:

either reduce the bank's overall risk or be
prepared to earn a high enough return on
assets to pay for this capital. Successful opera­
tion over a long period requires that investors
be given an expected return on their funds
that is as high as returns available from other
comparable securities. The fact that markets
for the capital of smaller banks are especially
imperfect doesn't alter the fact that those
banks must have equity to expand and must
pay whatever the “ going market rate" is for
that equity.
A Minimum Return. Once a bank has es­
timated the price it must pay for new funds it
has a benchmark for judging alternative in­
vestments. A bank should only invest in loans
or securities (or combinations of them) whose
expected return is above the cost of the new
funds required to finance them. That seems
obvious. But the decision must be made on
the basis of the current cost of all funds that
will be raised during the next planning period
rather than just the cost of a block of short­
term debt which might be raised next week. It
should also consider the full effect that any
change in the bank's asset or liability risks will
have on the cost of any funds raised. Further­
more, if the bank expects to have more funds
than it needs to meet loan demand and li­
quidity requirements for an extended period,
simply investing them in the highest yielding
asset available may not be the best strategy.
The investment must still yield enough to pay
the full cost of these funds, or they should be
returned to those who have loaned to or in­
vested in the bank. This might be done by not
replacing maturing debt issues or by paying
extra dividends. In the long run, capital
markets should eventually force a bank in the
direction of managing its funds efficiently.
(Limitations on entry into banking and im­
perfections in the market for bank securities
may make market discipline less effective
than it is in unregulated industries.)

9A common technique for estimating a corporation's
cost of new funds is the weighted average method. A
business evaluates the net cost of raising additional funds
from debt and equity sources by estimating the cost of
each source and weighting the cost according to the
proportion that those funds will represent of any new
money raised. If a bank expects to finance 80 percent of
its growth with short-term debt costing 4 percent after
taxes and the other 20 percent of the expansion with new
stock costing 12 percent, its weighted average cost of
funds is .8 x .04 + .2 x .12 = .032 + .024 = .056 (5.6 percent).
See Box for a more thorough explanation of this process.




Shrink, If Necessary. If investment
prospects don't justify raising new funds, the
institution shouldn't try to expand. Doing so

11

BUSINESS REVIEW

SEPTEMBER 1975

petitiveness of banks vis-a-vis other financial
service organizations.
Firms operating in an unregulated world
have the right to raise their prices enough to
compete for the higher cost equity funds—as
long as their customers are willing to pay
those higher prices. Banks are free to make
some price adjustments, but they may not be
able to pass on higher money costs as effec­
tively as unregulated financial corporations. If
banking agency regulations or state usury
statutes inadvertently hold earnings below
the level needed to raise new capital, the in­
dustry's growth would be unnecessarily cur­
tailed.10
There is no way to know, right now,
whether this will be an important problem or
not. Bank regulators must be vigilant in assur­
ing that only the constraints that are necessary
to promoting the financial system's stability
are enforced. This problem becomes es­
pecially important as regulators weigh the
pros and cons of changes in capital re­
quirements and of expanded powers for both
banks and thrift institutions.

isn't in the best interests of either
shareholders or management. When the cost
of funds exceeds the returns available to a
bank, capital markets are giving management
a signal that alternative uses for its
shareholders' fund are relatively attractive. If
the bank can't earn a competitive return on its
equity, its stockholders can use the money for
other investments. A bank that reinvests
shareholder earnings when its return isn't on
a par with other securities of similar risk is
preventing shareholders from making better
use of their own money. Eventually, the
shareholders will sense this and try to sell their
stock. The falling stock price will put pressure
on management to correct the problem or
answer to the stockholders.
The market is also signaling the bank that
consumers and borrowers aren't sufficiently
interested in its banking services to pay the
prices that make the bank able to give in­
vestors a competitive return. Either another
financial organization can provide that ser­
vice at a lower cost or tastes have changed and
people don't really want the service at all.
Banks that can't afford to pay the going rate
for funds (because they can't pass their higher
costs on to their customers) should not expect
to get additional money.

CONCLUSION
Any projection of historical trends in bank
growth, profits, and dividend payout prac­
tices suggests that the banking system's de­
mand for external capital will expand rapidly
in the years immediately ahead. Yet the.
capital "gap" will probably sow the seeds of
its own resolution. If banks curtail their
growth because of an inability to find
profitable new investments (or to circumvent
the regulator's capital constraints), the least
attractive investments can gradually be culled

The Regulatory Constraint. If banks were
unregulated and absolutely free to buy
money and sell services in a competitive
business environment, these market forces
could resolve the "capital shortage"
automatically. But the fact is, they're not free
and, therefore, they do not work perfectly.
The industry, in fact, is tightly regulated, and
the regulations influence bank profits. Ex­
clusive rights to issue demand deposits and
limitations on entry into the industry are ex­
amples of implicit subsidies from Govern­
ment to commercial banks. Conversely,
capital adequacy constraints, reserve re­
quirements, and portfolio limitations tend to
lower bank profits. The point is not that these
constraints are "wrong" or “ unjust," but that
they influence the profitability and com­




10lt is also possible that their regulated environment
gives banks an advantage as money costs rise. In that in­
stance, regulations are giving banks an unearned com­
petitive edge and allowing them to increase their market
shares at the expense of nonbank businesses. This results
in just as great a misallocation of society’s resources as oc­
curs when bank profits and growth are unnecessarily
restricted.

12

FEDERAL RESERVE BANK OF PHILADELPHIA

from their portfolios. By concentrating
available resources on the more profitable
business that remains, banks will be taking
steps to build capital internally. Better profits
and stronger capital positions will cut risks,
and banks will then be more able to compete
for new external capital. Competition from
the nonbank financial sector will remain, but
these organizations must also pay high prices
for additional capital. The key, however, is
astute use by banks of the money available to
them and prudence in raising only those
funds that can be reinvested profitably. As
long as the profit opportunities exist, banks
will have the opportunity and the justification
for raising whatever funds they need. When
expected profitability is insufficient, the




desire to expand must be held in check.
Regulators also face a challenge in the years
ahead. They must not only protect the
public's interest in its financial system but also
try to keep the game "fair." The regulatory
agencies can alter the competitive viability of
the industries they regulate. If these in­
dustries are to serve society and their
shareholders efficiently, they must be free to
respond to their changing economic environ­
ment. The desire to expand banking's capital
base rapidly is one development which can
only be accomplished successfully if regula­
tion doesn't prevent the industry from com­
peting for funds, investing rationally, and
passing rising costs along to customers who
are willing to bear them.
J

13




The Dollar at Home and Abroad
By John G. Bell
CHART 1
BECAUSE OF STEADY INFLATION IN THE U. S. OVER THE LAST
FIVE YEARS, THE DOLLAR TODAY BUYS FEWER GOODS IN THIS
COUNTRY THAN IT DID IN 1970.
Index of Purchasing Power of the Dollar* (1970 = 100)

1970
*

1971

1972

1973

1974

100
CPI

SO U RCE:

U. S. Department of Labor, Bureau of Labor Statistics.

14

1975

FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 2
YET THE DEPRECIATED DOLLAR HAS STILL HELD ITS PURCHASING
POWER FAR BETTER AT HOME THAN IT HAS OVERSEAS . ..
Index of Purchasing Power of U. S. Dollar*
In Selected Counties—1st Quarter, 1975
(1970 = 100)

SO U RCE OF COMPONENT FIG U R ES: International Monetary Fund




15

SEPTEMBER 1975

BUSINESS REVIEW




CHART $
. . . BECAUSE IT TAKES MORE DOLLARS TO BUY FOREIGN MONEY . . .
Percentage Change in Dollars Needed to Buy One Unit
Of Foreign Currency—1970 to 1st Quarter, 1975

SO U RC E:

International Monetary Fund

16

FEDERAL RESERVE BANK OF PHILADELPHIA

CHART 4
. . . AND FOREIGN MONEY BUYS FEWER FOREIGN GOODS.

Average Decline in Purchasing Power of
Selected Currencies in Their Home Countries
Percentage Change from 1970 to 1975

>.
E
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CD

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CD

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CD

CD

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CD

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SO U RC E:




International Monetary Fund

17

Bank Loan Losses:
A Fresh
Perspective
By Stuart A. Schw eitzer*

sion brings financial misfortune to many.
That brings to the fore the issue of bank
defenses against potential loan losses.
Analysts generally focus on a bank's
"reserves for possible loan losses" as its prin­
cipal defense against uncollectable loans.
Yet, over the past five years banks haven't
built up their loss reserves as rapidly as they
have increased their vulnerability to loan
losses. W hile this has distressed some
observers, there is a line of reasoning which
leads to the conclusion that there probably
isn't that much real cause for concern. The
logic goes something like this: Until recently,
bank loan loss reserves have been un­
necessarily large. In addition, most banks
have substantial earnings streams and capital
resources which can also be used to cover

Nobody likes to be in default on a loan. Yet,
even the best-intentioned borrowers are
sometimes unable to pay their debts. And
when they have difficulty paying their debts,
their troubles fall right into the laps of their
creditors. No wonder, then, that analysts of
banks and the banking system pay particular
attention to bank loan losses.
Loan loss rates at commercial banks have
been on the rise for some time. And some
bank experts say there's apt to be a record
volume of loan defaults this year, as reces­
*Dr. Schweitzer, formerly a Senior Economist at the
Federal Reserve Bank of Philadelphia, is now Assistant
Economist at Morgan Guaranty Trust Company of New
York. This article was prepared while the author was
associated with the Bank.




18

FEDERAL RESERVE BANK O F PHILADELPHIA

business community can seriously erode, for­
cing many firms to absorb operating losses
out of stockholders' equity. The next step for
such firms may be bankruptcy, since some of
them may become unable to pay their out­
standing debts. Bank loan losses would then
rise accordingly. Likewise, as unemployment
grow s d u rin g a d o w n tu rn , personal
borrowers may also fail to meet their debtrepayment obligations.
No one, of course, can be sure about the
impact of a recession on bank loan losses.
Conventional wisdom dictates that recession
and a higher rate of loan losses ought to go
together, although that hasn't been true in
all postwar recessions. Nonetheless, the
latest recession has been more severe than
other postwar downturns. Problems with
loans for real estate development, for exam­
ple, are particularly severe this time around.
These forces could mean that loan losses will
surge upward this year, as many Wall
Streeters say, but this will be known for sure
only in hindsight.

potential loan losses. Thus, according to this
reasoning, loan losses themselves pose much
less of a threat to bank soundness than the
danger of public overreaction to those losses.
BANK LOAN LOSSES: BACKGROUND AND
FOREGROUND
When the record books are finally closed
on 1975, the year's loan losses just may set
some records. Many bank watchers expect
the dollar volume of bank losses to hit an alltime high in 1975. And some argue that the
rate of such loan losses, as a fraction of bank
loans outstanding, will be higher than at any
time since the 1930s. These analysts could
turn out to be right. But it's important to
place the current situation in perspective.
The rate of bank loan losses is nowhere near
its high water mark, set in 1934. At the depths
of the Depression, com m ercial banks
“ charged off" over $3.40 of every $100 of
bank loans as uncollectable. In 1974, by con­
trast, about 38 cents of every $100 of loans
met a similar fate. Whatever may happen to
loss rates in 1975, they have little chance of
approaching their 1930s levels.

Loan Losses in the Public Eye. It is only
natural, therefore, that public attention is
now sharply focused on the loan loss
problem. Even banks are forewarning their
shareholders about higher losses in 1975.
Eyebrows are thus now raised over the ques­
tion of adequacy of bank defenses against
high loan losses. And most of the questioners
are concerned with the volume of funds
banks have set aside as reserves for possible
loan losses.

Upward Pressure on Loan Losses. In the
context of the postwar period, those predic­
tions of record loan losses for 1975 have a lot
going for them. Loan loss rates have been on
the rise for about 25 years now. And the
recession of 1974-75 is quite likely to accen­
tuate this trend.
An upward path of loan losses since 1950 is
unmistakable. While loan losses in the 1950s
amounted to less than 7 cents per $100 of
bank loans, the loss rate rose to just above 16
cents in the 1960s and to about 31 cents for
the 1970-74 period (Chart 1). A trend as
strong and as longstanding as that is not
quickly reversed. W hile the renewed
emphasis on conservatism in banking which
emerged in 1974 may eventually lower the
loss rate, that won't happen overnight.
On top of this longstanding trend is the
1974-75 re c e s s io n . As a d o w n tu rn
cumulatively worsens, the profitability of the




SETTING AND SUBDIVIDING THE LOSS
RESERVE
Most firm s and individuals maintain
reserves of some sort to assist them in
managing their financial affairs. These
reserves may be only a few dollars set aside in
a cookie jar or millions of dollars invested in
income-producing assets. But, in either case,
they help tide the household or business
over any financial rough spots that may oc­
cur. Since banks are forever advising the

19

SEPTEMBER 1975

BUSINESS REVIEW

CHART t
LOAN LOSS RATES HAVE BEEN ON AN UPWARD TREND.

Percent
.4 -----

Note:

Data are for insured commercial banks.

SO U RCE:

Federal Deposit Insurance Corporation.

generally, as are the bank’s liabilities and
capital accounts. When a loan held by the
bank proves uncollectable, the decline in the
value of the bank's loan assets can be “ charg­
ed off’’ against the loss reserve. That way, as
long as losses don’t exceed reserves, the
bank's earnings do not have to absorb loan
losses directly. Earnings are buffered from
the potentially wide swings in loan losses
from year to year. And the reserve helps to
cushion the bank against insolvency as well.

general public to "put something aside for a
rainy day/' it is only fitting that most banks
do the same. Loss reserves are the device that
most banks use to build protection against
normal variation in loan losses. Banks usually
plan to rely on their earnings and capital ac­
counts to cover extraordinary loan losses.
A bank that adopts the “ reserve method"
for covering its loan losses makes an addition
each year to its loan loss reserve.1 The
bank doesn’t earmark particular assets as part
of its loss reserve. Rather, the loss reserve
becomes a claim upon the assets of the bank

Taxes and Accounting for the Loss Reserve.
Besides offering smoother earnings and an
insolvency cushion, the reserve method also
offers banks smaller tax bills. A bank may
take tax deductions for the funds it transfers
to its loss reserves instead of for its actual

1Banks aren’t required to use the reserve method for
covering their loan losses. They are also permitted to be
on the “ direct charge-off method,” whereby they use
current earnings to meet loan losses as they occur.




20

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 1

THE TAX ADVANTAGES OF BUILDING LOSS RESERVES
U.S. tax laws give recognition to the fact that a portion of the interest received by a
bank eventually will be needed to cover its losses on uncollectable loans. Ever since
1921, banks have been permitted to deduct from taxable income a “ reasonable" volume
of transfers to a reserve for loan losses. Of course, since these tax deductions reduce a
bank’s taxes, it has always proven difficult for banks and the Government to agree as to
what is reasonable. For a long while banks were permitted to build a reserve consistent
with bank loss experiences during the 1930s. The last vestige of this was a U.S. Treasury
ruling in 1965 permitting banks to maintain reserves in an amount up to 2.4 percent of
their “ eligible loans."* Tax reform has since sent this percentage lower.
The U.S. tax system is heading toward application of the principle that a bank should
be able to shelter from income tax only those contributions to a loan loss reserve which
are consistent with its recent loss experience. That principle is a part of the Tax Reform
Act of 1969, but will not be fully effective until 1988. In the meantime, banks are per­
mitted to shelter a reserve whose ratio to eligible loans is either based on the bank’s loss
experience or else is subject to a stipulated maximum.** The maximum ratio currently is
1.8 percent, but will drop down to 1.2 percent in 1976. It will drop further to 0.6 percent
in 1982. Not until 1988 will banks be required to be on an “ experience basis" for their
loan loss reserves. Beginning in 1988, under current law, banks will be limited to a taxfree reserve no larger, as a fraction of their eligible loans, than the ratio of uncollected
loans to eligible loans on an average basis over the prior six years.
Thus, under current law, the tax benefit to a bank from handling its loan losses via the
reserve method will gradually decline. For a time, however, the size of the tax saving will
continue to be substantial. The U.S. Treasury estimates that over one billion dollars of
tax receipts will be lost to the Government in fiscal 1975 because of the generous
allowance for loan loss reserves at banks and savings and loan associations combined.
The tax loss is expected to remain close to that level in fiscal 1976. But it should decline
after that, as the maximum ratio of the reserve to eligible loans drops to 1.2 percent on
January 1, 1976. That reduction will have its impact in fiscal 1977.
♦According to IRS rules, not all bank loans are eligible to serve as a basis for the reserve computation. The
loans which are ineligible include Federal funds sold, loans backed by U.S. Government securities or bank
deposit balances, and loans guaranteed by the U.S. Government.
♦♦Regulations limit the size of the deduction for a transfer to the loss reserve during any single year to 0.6
percent of eligible loans.

loan losses. And the tax law’s generous stan­
dard regarding the size of the loss reserve
permits banks thereby to reduce their tax
payments (Box 1).
The tax deduction gives banks the incen­
tive to transfer the maximum amount allow­
ed by law to their loan loss reserves, and
most do just that. But they usually don’t
report all of those tax deductions as




operating expenses in their published finan­
cial reports. Although it may seem unusual,
it’s quite legal for a bank to report larger ex­
penses to the Government than to its
shareholders. The tax authorities permit a
bank to “ pay" for a transfer to its loss reserve
partly by provisions from operating expenses
and partly by provisions from retained ear­
nings. Either way, the bank's transfer to its

21

BUSINESS REVIEW

SEPTEMBER 1975

to cover a bank's loan losses is a long­
standing accounting axiom. It became a
banking rule, however, only after a 1969
agreement among the Securities and Ex­
change Commission, the Federal banking
agencies, and the accounting profession. Un­
der that agreement, the entirety of each
bank’s loan loss reserve as of January 1,1969
became a valuation reserve. Additions to the
valuation reserve had to be charged to the
bank’s income statement as expenses only
beginning with 1969. And only since 1969
have the other elements of the valuation
reserve been ineligible to cover loan losses.

loss reserve is tax-deductible. But the bank's
operating earnings aren't reduced when
retained earnings are used to build the
reserve.
The Three Parts of the Loss Reserve. In ac­
tual practice, most banks charge both retain­
ed earnings and operating expenses for
transfers to their loss reserves. This leads to a
loss reserve which has three components—a
valuation reserve, a contingency reserve, and
a deferred tax reserve. But the bank can't
cover loan losses out of all of these com­
ponents.
When a bank charges its operating ex­
penses to provide for estimated loan losses,
accountants record the result as an addition
to the bank's valuation reserve. When a
transfer is made from retained earnings to
the bank’s loss reserve, that’s recorded as an
addition to the bank's contingency reserve.
When the bank cuts its tax bill by taking tax
deductions for additions to its contingency
reserve, its tax saving is recorded in the
bank's deferred tax reserve (see Box 2 for a
numerical example). In principle, this ac­
count is used only for holding funds that will
eventually be paid to the Government as
taxes.
Of the three reserve components, accoun­
ting principles permit loan losses to be
charged only against the valuation portion.
While the contingency and deferred tax
items are part of the bank's total loan loss
reserve, they represent transfers made for
Federal income tax purposes only. If a bank's
loan losses should exhaust its valuation
reserve, the bank's next resource would be
its earnings rather than the other loss reserve
elements.2
The 1969 Agreement on Valuation
Reserves. The principle that the valuation
reserve be the only reserve element available

Choosing the Size of the Valuation
Reserve. The success of the reserve method
as a device for handling loan losses depends
on a bank's ability to anticipate its losses.
Ideally, a bank should set aside funds which,
over time, will just equal the loan amounts
that end up being uncollectable. To do this,
the bank must accurately assess the risk of
loss on each loan it holds. This is quite simple
for some kinds of loans—consumer loans, for
example, generate highly predictable loss ex­
periences. But some kinds of lending, often
involving large loans to business, generate a
more erratic flow of loan losses. It’s quite dif­
ficult to compute a proper addition to the
valuation reserve for such loans.
How large do a bank’s valuation reserves
need to be? Obviously, they need to be large
enough to cover the normal losses which
may be expected on the basis of actuarial
principles. In addition, the valuation reserve
might include a cushion against unusual
losses which may occur irregularly over time.
But it would be impractical and unnecessary
to make the valuation reserve large enough
to cover all the bank's unusual losses. Current
earnings and equity capital are always
available to backstop the loss reserve.
Translating these principles into action isn't

2A bank could regain use of its contingency reserve by
restoring that reserve to retained earnings and making a
tax payment in the amount of the deferred tax reserve.

But this would only be useful if the bank had exhausted
both its valuation reserve and its earnings and was
charging retained earnings to cover further loan losses.




22

FEDERAL RESERVE BANK OF PHILADELPHIA

BOX 2

THE THREE PARTS OF A LOSS RESERVE
All of the dollars in a bank’s loan loss reserve are not created equally. Instead, each
dollar comes from one of three sources—the bank’s revenues, its retained earnings, or
the taxes that it owes to the U.S. Government. An example will clarify just how this all
happens. But first, it may be useful to know why things need be so complicated.
The answer is our tax laws. It’s already been noted that banks are allowed to ac­
cumulate, free of corporate income taxes, more loan loss reserves than can be sup­
ported by loan loss experience. While banks are entirely willing to save on their taxes,
they want to do so in a way which doesn’t reduce the profits that they report to their
shareholders. This requires some financial gymnastics, but it can be done. What it re­
quires is that banks sort their loss reserves into three segments—the valuation, con­
tingency, and deferred tax portions of the overall loss reserve.
An example will help clarify this. Consider the status of the mythical Small-Loss
National Bank. Small-Loss National had revenues last year of $1000. Its operating ex­
penses, before any provision for loan losses, were $700. Its loan portfolio equals $10,000,
and its average annual loan-loss ratio equals 0.2 percent.
Small-Loss National has decided to “ charge” its revenues with a $20 addition to its bad
debt reserve ($20 equals 0.2 percent of $10,000). This $20 represents an addition to the
bank’s valuation reserve—it meets the test of being “ charged” against revenue as a bank
expense, and that’s what's required of funds added to the valuation reserve. The bank
thus reports its net income before taxes as $280 ($1000 minus $700 minus $20).
This $280 figure is what Small-Loss National tells its shareholders and the public
generally that it actually earned last year. In an effort to use legal means to reduce its tax
liability, however, it tells Uncle Sam something else. Remember, the U.S. Government
usually permits a bank to add more to its loss reserves—and therefore shelter more in­
come from current taxation—than the bank may need to cover loan losses. Suppose that
in Small-Loss National’s case, the Government will permit it a $50 deduction for transfers
to its loss reserve this year. Since it’s only willing to take $20 for its loss reserve out of
revenues, but it can shelter a total of $50 if it wants to, the bank looks elsewhere for the
other $30.
Here’s how the bank does it. Whereas shareholders were told that the bank actually
earned $280, the Government hears a different story. Taxable income is reported to the
Government as $250 ($280 less $30). That reduces Small-Loss National’s tax obligation by
$15 (assuming, for simplicity, that the bank’s tax rate is 50 percent). This $15 tax saving is
an addition to the deferred tax portion of the bank’s loan reserve.
Now, only another $15 is needed to make the bank’s total addition to its loss reserve
equal to $50. That final $15 is the other half of the $30 the bank is looking for. It
represents the shareholder’s half of the difference between the bank’s reported profit
of $280 and its taxable profit of $250. This $15 would have gone into the bank’s retained
earnings if it hadn’t been added to the loan loss reserve. It is assigned by accountants to
the contingency portion of the loss reserve.




23

BUSINESS REVIEW

SEPTEMBER 1975

simple, of course. And critics have been quite
vocal in criticizing the quality of bank
judgments about the size of their valuation
reserves.

valuation reserve as of year-end 1974 was
only about 1 percent larger than it was at the
start of 1969 (see Table). This relative con­
stancy of bank valuation reserves contrasts
sharply with the rapid growth of bank loans
and loan losses. Bank loans have nearly
doubled since the start of 1969 while the
dollar volume of bank loan losses has risen
nearly fourfold (see Chart 2).
How could valuation reserves have fallen
relatively so far behind? It's principally
because banks' entire loan loss reserves were
defined as valuation reserves when the ac­
counting rules were changed in 1969. That
change left the average bank with valuation
reserves of nearly 2 percent of loans outstan­
ding, which was enough to cover ten years of
loan losses at the rate at which such losses
occurred in the 1960s. Thus, even as loans
and loan losses grew substantially after
January 1969, few banks felt the need to
charge their revenues with more than the
minimum required amounts. The valuation
reserve cushion that banks had when the '69
rules change was enacted left them comfort­
able with the small contributions made from
'69 through '73.
It is notable that even during 1974, when
many banks for the first time reserved more
than the minimum amounts required under
the '69 rules, the ratio of valuation reserves to
loans continued to decline. And the ratio of
these reserves to new loan charge-offs fell off
even more. It is thus important to focus on
the relative protection against loan losses af­
forded by valuation reserves and banks'
other defenses, and to assess whether there's
been a material weakening of banking
soundness in this area.

VALUATION RESERVES FAIL TO KEEP PACE
Current regulatory rules require each bank
on the "re se rve m ethod” to make a
minimum addition to its valuation reserve
during each year, equal to its average rate of
loan losses for the last five years, applied to
its volume of loans outstanding on average
during the current year.3 This is only a
minimum addition to the bank's loan loss
reserve, however. Banks are instructed to
reserve more than the minimum amounts if
they anticipate loan charge-off rates
significantly higher than their five-year
average. That is where bank judgment comes
into play. And critics quickly point out that
bank judgment has produced declining loan
loss coverage by valuation reserves over the
past several years.
After 1969, when the agreement on expen­
sing of the valuation reserve was reached,
and through 1973, most banks provided only
the minimum amounts required as an addi­
tion to their valuation reserves. In 1974, many
banks altered this pattern and provided extra
amounts above and beyond the minimum set
by bank regulators. Evidence from quarterly
earnings reports indicates many banks are
continuing to provide extra amounts for loan
losses in 1975. In fact, the formula for loan
loss provisions seems to be playing a small
part in banks' decisions about how much to
provide for their loss reserves this year.
Between 1969 and 1974, while they were
reliant on the formula, banks charged off
nearly as much in uncollectable loans as they
added to their valuation reserves. Hence, the

LOSSES OUTPACE LOSS RESERVES: WHAT
ARE THE IMPLICATIONS?
The failure of bank valuation reserves to
keep pace with bank loans and loan losses
since 1968 is indeed striking. But this
developm ent may say more about the
meaningfulness of banks' prior earnings
reports than it does about any changes in the

Regulations do permit banks to be only partially on
the reserve method. That is, it would appear that banks
can build a tax shelter from some of their income but
still be on a direct charge-off basis for covering actual
loan losses. Banks doing this will be considered not to be
on the reserve method for the purposes of this article.




24

FEDERAL RESERVE BANK OF PHILADELPHIA

LOAN CHARGE-OFFS HAVE NEARLY OFFSET PROVISIONS
FOR THE LOSS RESERVE BY INSURED BANKS.
THUS, THE VALUATION RESERVE HASN’T RISEN
APPRECIABLY SINCE 1969
(In Billions of Dollars)
Year
1969
1970
1971
1972
1973
1974

Valuation Reserves Loan Charge-offs Provision for Loan Valuation Reserves
During Year
Losses during Year
At Year-end
At Start of Year
$5.22
5.25
4.97
4.75
4.84
4.94

$5.25
4.97
4.75
4.84
4.94
5.28

$ .52
.70
.87
.97
1.26
2.29

$ .49
.98
1.09
.89
1.16
1.95

TECHNICAL NOTE: The valuation reserve as of January 1,1969 is the total loan loss reserves of all banks as of
December 31, 1968. This is pursuant to the regulatory assignment of all loan loss reserves to the valuation
reserve in 1969. Data on the valuation reserve as of successive year-end dates have not previously been
published. These data have been computed for the purposes of this article as follows:
Year-end Valuation Reserve = Start-of-Year Valuation Reserve
+ Provision for Loan Losses during Year
- Loan Charge-offs during year
DATA SOURCE: All data from columns (2) and (3) and for the first entry in column (1) are from the FDIC

industry's vu ln erab ility. Bank valuation
reserves smooth out a bank's earnings record
and make that record more meaningful to in­
vestors in the face of irregular loan losses.
But, as guarantors of bank solvency, they are
quite limited. A bank’s earnings and equity
capital are more significant defenses against
unusual loan losses.

loss provision upon its latest five-year rate of
charge-offs—a given year’s loan loss will
have an effect only 20 percent as large on the
bank's earnings in that year.*4 Actual losses in

4An example may help here. Suppose a bank has had
loan charge-offs equal to 20<t per $100 of loans during
each of the past five years, imagine that its current year
charge-off rate was $1 per $100. Then its latest fiveyear average would equal

Effects on Earnings. When a bank employs
the reserve method, its earnings in any year
are considerably insulated from its actual
loan loss experience during that year. The
bank's reported earnings in each year are
reduced by that year’s contributions out of
revenues to its valuation reserve. As long as
the bank follows the regulatory formula to
compute its current minimum provision for
loan losses—that is, if the bank bases its loan



4 x Q.20 + 1 x 1.0Q = 36
5
The bank would have to boost its valuation reserves
this year by 36c for every $100 of loans outstanding.
That’s only 16c per $100 higher than last year’s require­
ment of 20c per $100. And it’s only 20 percent of the 80c
per $100 runup in this year’s loss ratio.

25

SEPTEMBER 1975

BUSINESS REVIEW




CHART 2
VALUATION RESERVE “COVERAGE” OF RISK EXPOSURES HAS
FALLEN SHARPLY SINCE 1969 RULES CHANGE.
Percent

Ratio
Left scale

12.0
Right scale

11.0

10.0
9.0
8.0
7.0

6.0
5.0
4.0

Valuation Reserves
Net Charge-offs

3.0
2.0*

1.0
0 ----- 1------1----- 1----- 1----- 1----- 1----- 1------------------------ o
1968 1969 1970 1971 1972 1973 1974
Note:

Year-end data; insured commercial banks.

SO U RCE:

FDIC Annual Reports and previous Table.

26

FEDERAL RESERVE BANK O F PHILADELPHIA

a given year may be above or below the
year's addition to the valuation reserve; if so,
the valuation reserve w ill absorb the
difference between the year's loss provision
and the year's actual losses.5 In this way, an­
nual variations in a bank's loan loss ex­
perience which will end up offsetting one
another within a five-year period have their
biggest impact on the valuation reserve
rather than on earnings.
The valuation reserve does more than just
smooth out a bank's earnings record. The
reserve also helps make that earnings record
more meaningful as a statement of the bank's
underlying profitability. That is, the buffering
function of valuation reserves helps to prevent
erroneous signals about bank profitability
from being conveyed to the public because
of a one-time change in the charge-off rate.
But this only holds when banks adhere rigid­
ly to the principle of the reserve method.
Suppose a bank boosted its interest revenue
by extending more risky loans. Since the
loans are riskier than those the bank had
been issuing, the fraction of those loans like­
ly to prove uncollectable a year or two hence
is higher than the bank has been charging off
recently. If the bank takes proper account of
this, it will provide extra amounts for its
valuation reserve concurrent with its receipt
of higher interest payments. That is, it will
reduce its reported net income to reflect
more meaningfully the profitability of its
current operations.
Has this feature of the reserve method ac­
tually worked in the past few years? Ap­
parently not. Until recently, banks have not
felt compelled to build up their valuation
reserves in order to handle their growing
loan losses. The 1969 rule change left them
with plenty of loan loss coverage. Now, to

the extent that many banks have since used
up the valuation reserve cushion that the
rule change gave them, income statements
will now begin to reflect relatively larger
charges for the loan loss reserve than in the
past. That is, banks' net operating earnings
apparently have been somewhat overstated
since 1969 because funds that might ordinari­
ly have been "spent" to build loan loss
reserves have not been expended.6 Crude
estimation suggests that during 1969-74,
banks were spared enough loan loss expense
to boost their net earnings after-tax by nearly
8 percent (Box 3). Now that valuation
reserves seem no longer to be inflated, bank
profits will no longer contain this bonus.
This may hold some implications for the
success that banks will have in raising funds
in both the debt and equity markets. While
lenders and shareholders are, of course, con­
cerned with bank soundness per se, they are
also keenly interested in bank profitability.
For one thing, sustained profitability is itself
an indicator of bank soundness. For another,
bank profits are a measure of the bank's
ability to make additional interest or divi­
dend payments. Thus, to the extent that
banks lose the profits advantage they held in
the years after 1969, they may also now lose
some of their attractiveness to investors. Of
course, investors may have previously
recognized any overstatement of bank earn­
ings and entered that into their analyses. If
so, elimination of the artifical boost to profits
from loss re s e rv e p ro v isio n s won't
significantly affect bank fund-raising efforts.
Loss Reserves as Solvency Insurance. While
there is no substitute for loss reserves as an
earnings stabilizer, earnings and equity
capital are effective substitutes for loss
reserves as solvency insurance. A bank with
uncollectable loans runs the risk of insolven­
cy. But if a bank should "run out of" valua-

Continuing with the above example, suppose the
bank has $1000 in loans outstanding. Its charge-offs this
year are 1 percent of $1000, or $10. Its contribution to
the valuation reserve is 0.36 percent of $1000, or $3.60.
Thus, the valuation reserve will decline this year by
$6.40.




6Bank profits were overstated before 1969 as well. The
focus here is on considerations following the 1969 rule
change, however.

27

SEPTEMBER 1975

BUSINESS REVIEW

BOX 3

1969 RULING ON VALUATION RESERVES
BOOSTED BANK PROFITS
Computing the “ right” volume of loan loss reserves for a bank to maintain is a very
tricky procedure. But let's take an intellectual “ giant step.” Suppose that, for the bank­
ing system as a whole, valuation reserves ought to equal—as they did at year-end 1974—
about 1 percent of loans outstanding. Many banking observers think a valuation reserve
ratio of 1 percent is about right for the industry as a whole, so the assumption may be all
right. We'll come back to this assumption shortly.
The valuation reserve ratio which the banking system held as of the start of 1969 was
just under 2 percent. This high ratio was attained because banks were permitted to
classify their entire loan loss reserve as a valuation reserve on January 1,1969. This gave
them $5.22 billion of valuation reserves as of that date.
Over the years since 1969, banks have added a net of only $.06 billion to their valua­
tion reserves. That is, additions to bank valuation reserves have exceeded loan chargeoffs against these reserves by only $.06 billion. This small addition to bank valuation
reserves was concurrent, of course, with substantially increased loan and loan loss
volumes. Banks got away with so small a net increase only because they had so much in
valuation reserves to start with.
Now, back to that assumption. Imagine that banks had been assigned the “ right”
volume of valuation reserves back in 1969. Instead o’f $5.22 billion, they would have had
only $2.65 (1 percent of $265 billion in loans) billion at that time. Then, banks would
have had to work harder in order to reach the “ correct” level of valuation reserves by
year-end 1974. The banks would have had to charge their earnings with—and reduce
their profits by—a total of $2.57 billion more than they actually did over the 1969-74
period. This amounts to nearly 6 percent of bank operating earnings, pre-tax, and nearly
8 percent of bank net earnings, after-tax, during 1969-74. If valuation reserves are now at
the “ right” ratio to loans, then this profit bonus will no longer be available to banks.

great as 1974 charge-offs. And equity capital is
what a bank turns to if its earnings are ex­
hausted. While each of these multiples is
substantially less than their values of a few
years ago, it's difficult to argue that they
aren't now high enough.
Thus, the com bination of loan loss
reserves, operating earnings, and equity
capital appears sufficient to protect most
banks from loan losses well above those
they've been experiencing. Of course, those
defenses may not be adequate to keep all
banks afloat, should loan losses jump. But
judgments about the adequacy of reserve

tion reserves in meeting a calamitous loan
loss, its earnings and capital accounts could
still absorb the loss.
A bank's net operating earnings would be
its next line of defense should its valuation
reserves be exhausted. And, for the banking
system as a whole, there's a lot of room to
cover loan losses out of earnings. Earnings,
before tax, in 1974 were over four times as
great as charge-offs. This meant that valua­
tion reserves and earnings together were
over 7.5 times as great as charge-offs.
Furthermore, the banking system's equity
capital represents an amount 30 times as




28

FEDERAL RESERVE BANK O F PHILADELPHIA

While a recession needn't necessarily
bring higher loan losses to commercial
banks, the issue of adequate loan loss
coverage is still meaningful at this juncture.
Valuation reserves—the loan loss reserves
out of which a bank normally “ covers" loan
losses—have grown very little over the past
five or six years. Meanwhile, the volume of
bank loans and loan losses has risen substan­
tially. Thus, the degree of loan loss coverage
which valuation reserves can provide has
fallen substantially.
Banks are aware that they must have the
resources to absorb loan losses internally.
Otherwise, they realize, they can get into the
same kind of financial hot water as their
defaulting borrowers. Do banks need to
cover more than three years' worth of losses
with valuation reserves? That's how much
coverage they had at year-end 1974, and it
may be enough for all but a few institutions.
Besides, loan loss reserves may not be the
best measure of a bank's ability to remain
solvent in the face of unusual losses. Loan
loss reserves help stabilize a bank's earnings
and are the bank's first line of defense when
faced with loan losses. But the bank's ear­
nings and equity capital are typically far more
meaningful than loss reserves as resources in
the battle against unforeseen loan losses.
These resources must be available to cover a
wider set of contingencies than just a bank's
loan losses. But their sheer size relative to the
historical experience which commercial
banks have had with loan losses is reassuring
indeed. Potential loan losses don't appear as
overwhelming when viewed in the perspec­
tive as they would if loan loss reserves were a
bank's principal defense.

provisions shouldn't rest solely on whether
each individual bank is sound. A more impor­
tant issue is whether the banking system as a
whole is safe. If too many individual banks got
into trouble from loan losses, that could en­
danger the entire system. But the dimensions
of the capital, earnings, and loss reserve
protection now existing render this most im­
probable.
Capital as the Ultimate Insurance against
Loan Losses. It's good to know that the bank­
ing system is well buffered from loan losses.
But it's troublesome to consider all of the
attention that's been placed upon loss
reserves by students of this issue. Loss
reserves are one of the guarantors of bank
solvency, but their role is small in com­
parison to that played by bank capital. The
real issue surrounding the industry's ability
to withstand higher loan losses is the same as
that surrounding its ability to withstand
higher losses in other areas—the adequacy of
bank equity capital. True, there's lots of con­
troversy over how much bank capital is
needed. But that's where there ought to be
controversy, for loss reserves are just a varia­
tion on the bank capital theme.
APPEARANCES ARE DECEIVING
As banks have expanded their roles as
department stores of finance, their ex­
posures to the risk of loan losses have also
grown. With a severe recession on the books
for 1975, the likelihood of particularly high
loan losses at banks this year has raised
questions about the ability of the industry to
handle such losses.




29

SEPTEMBER 1975

BUSINESS REVIEW

BANK CRIMES
Bank security —
FR Bull June 75 p 390

The Fed in Print

BANK EARNINGS
What do banks produce? —
Atlanta May 75 p 70

Business Review Topics
First and Second Quarters 1975
Selected by Doris Zimm ermann

1974: Lower bank earnings —
Atlanta June 75 p 100

Articles appearing in the Federal Reserve
Bulletin and in the monthly reviews of the
Federal Reserve banks during the first & se­
cond quarters of 1975 are included in this
compilation. A cumulation of these entries
covering the years 1972 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.
To receive copies of the Federal Reserve
Bulletin, mail two dollars for each to the
Federal Reserve Board at the Washington ad­
dress on page 39. 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
39.

Member bank income in 1974 —
FR Bull June 75 p 349
BANK HOLDING COMPANIES
Bank holding company review
1973/74 — Part I —
Chic Feb 75 p 3
Bank holding companies — Part II —
Chic April 75 p 13
Concentration levels in three
District states —
Chic June 75 p 10
BANK LIABILITIES
Liabilities that banks manage —
Chic June 75 p 3
BANK LIQUIDITY
Liquidity pressures intensify —
Atlanta Feb 75 p 24

BALANCE OF PAYMENTS
A monetary view of the balance
of payments —
St. Louis April 75 p 14

BANK LOANS
Changes in bank lending practices,
1974 —
FR Bull April 75 p 221

U. S. international transac­
tions in 1974 —
FR Bull May 75 p 187

Loan commitments at selected
large commercial banks: New
statistical series —
FR Bull April 75 p 226

BANK COMPETITION
Uniform price and banking market
delineation —
Atlanta June 75 p 86

Data series on loan commitments
(G-21) FR Bull May 75 p 337

BANK COSTS
Customer profitability analysis.
Part I: Alternative approaches
toward customer profitability —
Kansas City April 75 p 11




BANK LOANS — BUSINESS
A time series analysis of

30

FEDERAL RESERVE BANK OF PHILADELPHIA

BANKING INTERNATIONAL
International banking (Debs)
NY June 75 p 122

business loans at large
commercial banks —
Rich May 75 p 8
BANK LOANS — CONSUMER
Consumer lending at commercial
banks —
FR Bull May 75 p 263

BONDS — YIELDS
The determination of long-term
interest rates: Why were bond
yields so high in 1974? —
Bost May 75 p 35

BANK LOANS — FARM
IMPROVED FUND AVAILABILITY AT
RURAL BANKS available —
FR Bull June 75 p 390

BRANCH BANKING
BRANCHING RESTRICTIONS AND
COMM ERCIAL BANKING COSTS
available —
Phila Jan 75 p 18

Farmer's financial position —
Rich May 75 p 15

BUCHER, JEFFREY M.
Statement to Congress, March 6,
1975 (consumer protection)
FR Bull March 75 p 157

BANK MARKETS
Banking markets and future
entry —
Atlanta March 75 p 30

Statement to Congress, April 22,
1975 (credit rationing) —
FR Bull May 75 p 280

BANK MERGERS
PENNSYLVANIA BANK MERGER SURVEY:
SUMMARY OF RESULTS available —
Phila March 75 p 13

BUDGET
Highlights of the new budget —
Dallas April 75 p 6

BANK PORTFOLIOS
Government securities — large
banks employ flexible maturity
structures —
Dallas Feb 75 p 10

BUDGET — FAMILY
Household — sector economic
accounts —
FR Bull Jan 75 p 11

BANK SIZE
ECONOMIES OF SCALE OF FINANCIAL
INSTITUTIONS available —
Phila Jan 75 p 18

Family budgets in 1974 —
Minn April 75 p 5
Urban family budgets —
Dallas June 75 p 7

BANK SUPERVISION
Banking supervision and monetary
policy (Hayes) —
NY May 75 p 99

BURNS, ARTHUR F.
Statement to Congress,
January 30, 1975 (fiscal
policy) —
FR Bull Feb 75 p 60

BANKING — FOREIGN BRANCHES
Foreign operations subsidiaries
interpretation —
FR Bull March 75 p 169




Statement to Congress,
February 6, 1975 (money supply) —
FR Bull Feb 75 p 62

31

SEPTEMBER 1975

BUSINESS REVIEW

Forecasts 1975 —
Rich Jan 75 p 20

Statement to Congress,
February 7, 1975 (recession
and inflation) —
FR Bull Feb 75 p 69

BUSINESS FORECASTS 1975
available —
Rich Jan 75 p 24

Statement to Congress,
February 25, 1975 (money supply) —
FR Bull March 75 p 150

Long term projections show
solid growth in East Texas —
Dallas Feb 75 p 1

Statement to Congress, March 6,
1975 (theft of interest rate
data) —
FR Bull March 75 p 155

Economic developments in 1974 —
Dallas March 75 p 6

Statement to Congress, March 13,
1975 (fiscal policy) —
FR Bull March 75 p 161

Financial developments in the
fourth quarter of 1974 —
FR Bull March 75 p 121

The current recession in
perspective, May 6, 1975 —
FR Bull May 75 p 273

Regional wrap-up ‘74: Doldrums
descend on District economy —
Phila March 75 p 16

Statement to Congress, May 1,
1975 (business forecast) —
FR Bull May 75 p 282

The District economy in
perspective: 1974 —
Rich March 75 p 3

The current recession in
perspective —
Rich May 75 p 2

Financial forecasts: 1975 —
Rich March 75 p 22
Financial developments in the
first quarter of 1975 —
FR Bull June 75 p 341

The current recession in
perspective —
Atlanta June 75 p 94

BUSINESS INDICATORS
Deflated leading indicators
revisited —
Bost Jan 75 p 3

BUSINESS CYCLES
The seventh business cycle —
Chic March 75 p 10

PACIFIC BASIN ECONOM IC INDICA­
TORS available —
San Fran Spr 75 p 30

BUSINESS FORECASTS & REVIEWS
1974: A year of recession —
Atlanta Jan 75 p 2
Review and outlook 1974-75 —
Chic Jan 75 p 3

CANADA — FOREIGN TRADE
U. S. — Canadian economic
relationships —
Kansas City Feb 75 p 10

The economy in 1974 —
FR Bull Jan 75 p 1
Review and outlook —
Minn Jan 75 p 1
Financial highlights:
Rich Jan 75 p 10




CAPITALISM
A public policy for a free
economy (Francis) —
St. Louis May 75 p 2

1974 —

32

FEDERAL RESERVE BANK OF PHILADELPHIA

Inflation, unemployment, and Hayek —
St Louis May 75 p 6
CENTRAL BANKS
The classical concept of the
lender of last resort —
Rich Jan 75 p 2
Central banking across the
Atlantic: Another dimension —
Phila May 75 p 3
Central — bank policy towards
inflation —
San Fran Spr 75 p 31

DISINTERMEDIATION
1974 disintermediation —
District impact —
Chic Feb 75 p 11
DISCOUNT RATES
Change in discount rate —
FR Bull Jan 75 p 51
Change in discount rate —
FR Bull Feb 75 p 118
ECONOMIC DEVELOPMENT
On economic growth —
Kansas City Feb 75 p 3

CLOTHING INDUSTRY
Growth in manufacturing comes
with development of markets —
Dallas March 75 p 1
CONSTRUCTION
District housing construction —
Minn April 75 p 2
CORPORATE PROFITS
Inventory valuation adjust­
ments greatly influence
corporate earnings —
Phila May 75 p 13
COST OF LIVING
The cost of buying: It
takes more dollars but
less work —
Phila April 75 p 8

Is there a future for economic
man (Eastburn) —
Phila April 75 p 3
ECONOMIC STABILIZATION
The 1975 national economic
program: Another exercise
in fiscal activism —
St Louis March 75 p 2
EDUCATION
Which school resources help
learning? Efficiency and
equity in Philadelphia public
schools —
Phila Feb 75 p 4
EQUALITY OF EDUCATIONAL OPPOR­
TUNITY QUANTIFIED: A PRODUC­
TION FUNCTION APPROACH
available —
Phila March 75 p 13

DEMAND DEPOSITS
Yields on checking accounts
rise in recent years —
Phila March 75 p 14




EDUCATION — FINANCE
INTRADISTRICT DISTRIBUTION OF
SCHOOL RESOURCES TO THE DISAD­
VANTAGED: EVIDENCE FOR THE
COURTS available —
Phila Jan 75 p 18
Philadelphia city and school
district budgets: A year of
austerity —
Phila April 75 p 12

33

BUSINESS REVIEW

SEPTEMBER 1975

tion of funds —
Dallas Jan 75 p 1

EURODOLLARS
The impact of the Eurodollar
market on the effectiveness
of monetary policy in the
United States and abroad —
Bost March 75 p 3

FEDERAL RESERVE BANKS — DIRECTORS
Board of Directors —
Atlanta Feb 75 p 20
Directory of Federal Reserve
banks and branches —
FR Bull Feb 75 p 89

FARM INCOME
Mixed year for farmers —
Chic Jan 75 p 10

FEDERAL RESERVE BANKS — EARNINGS
The Federal Reserve paid the
U.S. Treasury $5,550,000,000 —
Atlanta Jan 75 p 3

FARM OUTLOOK
Prospects for food and agri­
culture in 1975 —
St. Louis March 75 p 13

Payments to U. S. Treasury of
$5,550 million in 1974 —
FR Bull Jan 75 p 51

Agriculture:
Outlook for 1975
is cloudy —
Rich March 75 p 19

Should the Fed sell its ser­
vices? —
Phila Jan 75 p 11

FARM POLICY
A dispersed or concentrated
agriculture? The role of
public policy —
Kansas City March 75 p 3

FEDERAL RESERVE BANKS — OPERATIONS
Annual operations and executive
changes —
Phila Jan 75 p 19

FARM PRICES
Seasonality of agricultural
prices —
Kansas City June 75 p 10

Operations of the Federal Reserve
Bank of St. Louis — 1974 —
St. Louis Feb 75 p 8
FEDERAL RESERVE BOARD
Rules regarding delegation of
authority Dec. 30, 1974 (sala­
ries at banks) —
FR Bull Jan 75 p 29
Changes in staff June 23, 1975
(Denkler) —
FR Bull June 75 p 391

FARM PRODUCTION
Benefits of 1974’s bad weather
accrued to District farmers —
Atlanta Feb 75 p 18
Planting changes to reduce
farm production expenditures —
Atlanta May 75 p 76
FEDERAL ADVISORY COUNCIL
Survey of bank response to
Federal Advisory Council
statement on lending policies —
FR Bull March 75 p 129

FEDERAL RESERVE — FOREIGN EXCHANGE
Treasury and Federal Reserve
foreign exchange operations —
FR Bull March 75 p 131
Treasury and Federal Reserve
foreign exchange operations
(Coombs) —
NY March 75 p 39

FEDERAL FUNDS MARKET
Market expansion aids mobiliza­




34

FEDERAL RESERVE BANK OF PHILADELPHIA

Treasury and Federal Reserve
foreign exchange operations:
Interim report —
FR Bull June 75 p 364

FOREIGN TRADE
World trade patterns disrupted —
Chic Jan 75 p 14

Treasury and Federal Reserve
foreign exchange operations
interim report —
NY June 75 p 140

FUEL
Louisiana and the energy shortage
Atlanta Feb 75 p 14
Better use of existing reserves
may yield more than exploration Dallas April 75 p 1

FEDERAL RESERVE — MONETARY POLICY
Testing time for monetary
policy (Hayes) —
NY Feb 75 p 18

The energy trade: The United
States in deficit —
Bost May 75 p 25

FEDERAL RESERVE SYSTEM —
PUBLICATIONS
Publications committee (Board) —
FR Bull June 75 p 389

GOLD
Federal Reserve responsibilities
in private sales interpretation —
FR Bull Jan 75 p 33

FERTILIZER INDUSTRY
Fertilizer outlook —
Chic May 75 p 8

Monetary effects of the sale of
gold —
St Louis Jan 75 p 18
Gold—
San Fran Win 75 p 3

FINANCIAL INSTITUTIONS
Nonbank thrift institutions in
1974 —
FR Bull Feb 75 p 55

GOLD available —
Phila April 75 p 31
GROSS NATIONAL PRODUCT
A monetary model of nominal
income determination —
St Louis June 75 p 9

FISCAL POLICY
Financing government through
monetary expansion and infla­
tion —
St Louis Feb 75 p 15

HOLLAND, ROBERT C.
Statement to Congress, May 12,
1975 (credit rationing) —
FR Bull May 75 p 296

Budget deficits and the money
supply —
Kansas City June 75 p 3
FOOD SUPPLY
Foods of the future —
Chic March 75 p 3

HOUSING
Pilot survey on possible housing
discrimination —
FR Bull May 75 p 336

FOREIGN EXCHANGE RATES
Interdependence, exchange rate
flexibility, and national
economies —
Kansas City April 75 p 3




INCOME
Money and income: Is there a
simple relationship? —
Kansas City May 75 p 13

35

BUSINESS REVIEW

SEPTEMBER 1975

INDEXATION
Indexing inflation: Remedy or
malady? —
Phila March 75 p 3

LABOR MARKET
Labor market primer —
Kansas City Jan 75 p 10
Interpreting recent labor market
developments —
Kansas City March 75 p 11

INFLATION
ECONOMICS OF INFLATION available —
Phila Jan 75 p 10

MEDICAL COSTS
Medical care: Rising costs in a
peculiar marketplace —
Rich March 75 p 6

A primer on inflation: Its
conception, its costs, its conse­
quences —
St Louis Jan 75 p 2

Rising medical care expenditures:
A growing role for the public
sector —
Phila June 75 p 13

Unusual factors contributing to
economic turmoil (Francis) —
St Louis Jan 75 p 9
Inflation: Its cause and cure —
St Louis Feb 75 p 2

MITCHELL, GEORGE W.
Statement to Congress, May 8,
1975 (Federal Reserve banks
audit) —
FR Bull May 75 p 288

A perspective on stagflation —
Phila May 75 p 19
World inflation —
San Fran Spr 75 p 3

MODELS (STATISTICS)
The St. Louis equation and monthly
data —
St Louis Jan 75 p 14

Toward an explanation of simul­
taneous inflation — recession —
San Fran Spr 75 p 18
Temporary or ongoing is the ques­
tion for the 1970's —
Dallas June 75 p 1

THE INFORMATION VALUE OF DEMAND
EQUATION RESIDUALS: A FURTHER
ANALYSIS available —
Phila March 75 p 13

INFORMATION DISCLOSURE
Rules regarding availability
of information. February 19,
1975 —
FR Bull March 75 p 167
INTEREST RATES
Minnesota's usury law:
evaluation —
Minn April 75 p 16

MONETARY POLICY
The making of monetary policy:
Description and analysis —
Bost March 75 p 21
Open market operations in 1974 —
FR Bull April 75 p 197

An

The interdependence of national
monetary policies —
San Fran Spr 75 p 41

INTEREST RATES — PRIME
The prime rate —
Chic April 75 p 3




MONETARY STABILIZATION
International money and inter­
national inflation 1958-1973 —
San Fran Spr 75 p 5

36

FEDERAL RESERVE BANK OF PHILADELPHIA

MONEY MARKET
Financial markets strained —
Chic Jan 75 p 23

Securities transactions of
Federal Reserve banks (staff
memorandum) —
FR Bull May 75 p 295

MONEY SUPPLY
A time series analysis of the
control of money —
Kansas City Jan 75 p 3

Operations in Federal Agency
securities —
FR Bull June 75 p 389
PENSION PLANS
The elementary microeconomics
of private employee benefits —
Kansas City May 75 p 3

Revision of the monetary base—
St Louis April 75 p 23
MONOPOLIES
Restrictive labor practices in
baseball: Time for a change? —
Phila June 75 p 17

Member banks as trustees of
retirement plans —
FR Bull June 75 p 389

MUNICIPAL FINANCE
Anatomy of a fiscal crisis —
Phila June 75 p 3

PETROLEUM INDUSTRY
Economic consequences of the
OPEC cartel —
Dallas May 75 p 1

NEGOTIABLE ORDER OF WITHDRAWAL
The early history and initial
impact of now accounts —
Bost Jan 75 p 17

International trade and finance
under the influence of oil —
1974 and early 1975 —
St Louis May 75 p 11

OPEN MARKET OPERATIONS
COMMITTEE MINUTES 1969 available
for inspection at National
Archives and Federal Reserve
banks —
FR Bull Feb 75 p 118

PORTS
The port of Chicago —
Chic May 75 p 3
PROPERTY TAX
Needed: A new tax structure for
Massachusetts —
Bost May 75 p 3

Rules regarding availability of
information; rules of organiza­
tion —
FR Bull March 75 p 170

RECESSIONS
The Southeast in recession —
Atlanta Jan 75 p 6

Rules regarding availability of
information —
FR Bull April 75 p 245

Light in the tunnel —
Chic Jan 75 p 30

Monetary policy in a changing
financial environment . . . —
NY April 75 p 70

Two stages to the current
recession —
St Louis June 75 p 2

The FOMC in 1974: Monetary
policy during economic uncertainty —
St Louis April 75 p 2




REGULATION D
Amendment January 30, 1975 —

37

SEPTEMBER 1975

BUSINESS REVIEW

Nonborrowed reserves or the
Federal funds rate as desk
targets — is there a difference? —
Bost March 75 p 31

FR Bull Feb 75 p 103
Amendment May 22, 1975 —
FR Bull May 75 p 306

REQUIRED RESERVE RATIOS, POLICY
INSTRUMENTS, AND MONEY STOCK
CONTROL available —
Phila March 75 p 13

REGULATION G
Interpretation —
FR Bull Jan 75 p 33
REGULATION M
Interpretation —
FR Bull May 75 p 307

SHEEHAN, JOHN E.
Resignation effective June 1,
1975 —
FR Bull May 75 p 335

REGULATION Q
Amendment December 23, 1974
(investment certificates) —
FR Bull Jan 75 p 28

SOCIAL SECURITY
The impact of social security
on personal saving —
Bost Jan 75 p 27

Amendment May 16, 1975 —
FR Bull May 75 p 307

STATE FINANCE
Government purchases accelerate —
Chic Jan 75 p 20

Interpretation —
FR Bull May 75 p 308
Amendment to Regulation Q —
FR Bull June 75 p 389

State government finances —
Minn April 75 p 9

REGULATION T
The structure of margin credit —
FR Bull April 75 p 209

TEXTILE INDUSTRY
Basic changes in production
spark opportunities for growth —
Dallas March 75 p 3

REGULATION Y
Bank holding companies activi­
ties . . . Interpretation —
FR Bull April 75 p 245

TIME DEPOSITS
Changes in time and savings
deposits at commercial banks —
FR Bull Jan 75 p 13

REGULATION Z
Interpretation —
FR Bull Jan 75 p 33

Changes in time and savings
deposits at commercial banks
July-October 1974 —
FR Bull June 75 p 556

Interpretation —
FR Bull June 75 p 375

UNEMPLOYMENT
Unemployment rate gives only
part of the picture —
Dallas Jan 75 p 7

RESERVE REQUIREMENTS
Change in reserve requirements —
FR Bull Jan 75 p 51
Why not pay interest on member
bank reserves? —
Phila Jan 75 p 3




Observations on unemployment:
Burdens and benefits —
Minn Jan 75 p 11

38

FEDERAL RESERVE BANK OF PHILADELPHIA

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 19105

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

39

business review
FED ER A L R E SE R V E BANK
OF PHILADELPHIA
PHILADELPHIA, PA. 19105