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94th Congress
1st Session




MAY 1975


Y 4.B


52-221 O


22/3: R 26/2

WILLIAM PROXMIRE, Wisconsin, Chairman
HARRISON A. WILLIAMS , JR. , New Jersey EDWARD W. BROOKE, Massachusetts
JESSE HELMS, North Carolina
JOSEPH R. BIDEN, JR., Delaware
ROBERT MORGAN, North Carolina
KENNETH A. MCLEAN, Staff Director
ANTHONY T. CLUFF, Minority Staff Director
ROBERT E. WEINTRAUB , Professional Staff Member


Recently I invited a number of non-governmental experts in the
field of bank regulation to prepare papers containing their views on
the major issues in bank regulation today. I did this because within
recent years, our commercial banking system has experienced tremendous pressure. Confidence in the soundness of our banking system has
been shaken by the recent collapse of several large banking institutions ; rumors persist that bank regulatory authorities have a number
of other banks on the critical list.
Profound changes have occurred in our Nation's banking system in
the last three decades. The pace of change in the way banking institutions conduct their business has accelerated in recent years and continues unabated . Because of the central role that banking institutions
play in the life of our economy, the time has come for a thorough discussion and comprehensive review of the changes which have taken
place and the resulting consequences that such changes have brought
us. Any discussion and comprehensive review of our banking system
would be incomplete without a thorough examination of the regulatory process governing the conduct of business by our banking
institutions. Precisely how the regulatory process has functioned during a period when the banking industry has undergone rapid and substantial change are significant issues which arise for discussion and
answer. In this context, consideration must be given to the kind of
appropriate legislative response which is called for by the results of
such an examination and questioning process.
In order to assist the Committee on Banking, Housing and Urban
Affairs in reviewing the adequacy of our present system of bank
regulation, I felt it important to obtain the views of distinguished
persons outside the government so that an objective starting point for
discussion purposes might become available. I am hopeful that this
Compendium will supply the necessary stimulus for this discussion. I
am grateful to each ofthe authors who gave freely of their time toward
the fulfillment of this important public objective and it is my hope
that this format can be used in the future by this Committee as a beginning for discussions on serious public issues.
Banking institutions occupy a unique and vital place in the economy.
They are the principal suppliers and allocators of credit to the various
sectors of commerce and industry. They are the principal institutions
in our society by which decisions at the governmental level to increase
or decrease the money supply are effectuated and translated into
reality in the market place. They are the principal institutions in which
the deposits and savings of individuals, partnerships and corporations
are held. They are, therefore, institutions which are imbued with an
exceptionally high degree of public interest. In consequence, the operations of these institutions must be sufficiently scrutinized to insure

that their important public purposes are fulfilled . No unfairness in
the supply and allocation of credit by any banking institution should
be tolerated . Every banking institution must so conduct its affairs that
it retains the ability to function without special governmental subsidy
in times of monetary restraint as well as in times of monetary growth.
Confidence in banking institutions must be maintained by individuals
as well as by industrial and commercial concerns. The continued trust
and confidence of the public in these institutions will be justified only
on the basis that the banking system and its individual components
conduct their business in a safe and sound manner eschewing unsafe
or unsound banking practices. Unfortunately, recent trends in the
banking system evidence a turning away by banking institutions from
the complete fulfillment of these public interest purposes.
Entry into banking is strictly controlled under applicable federal
and state law. The establishment of a bank or of a branch of a bank
usually entails a detailed consideration of a number of public interest
factors by the appropriate bank supervisory authority. Approval is
granted only upon favorable consideration of those factors including
the financial and managerial qualities of any proposal and perhaps
most importantly consideration of the convenience and needs of the
population of the community to be served by the institution . Where
the credit needs of the local population in which a bank or a branch
of a bank is located are not served by the bank located there, a serious
question arises as to whether the particular bank in question continues
to serve the convenience and needs of the community in a manner contemplated by the approving authority under applicable law.
At the close of World War II the banking institutions of this Nation
were exceptionally liquid . But it was not a position they could reasonably have been expected to maintain. As a result of wartime financing
by the Treasury, the major portion of their assets were held in securities issued by the United States Government. Their equity capital base
represented a sound proportion of the remaining risk asset portion of
their asset portfolios held in loans. After the war, government credit
demands fell while private demands rose sharply. As a result from
1945 to 1960, our banking institutions shifted their asset portfolios
out of securites and into loans to the point where the major portion of
banking assets were held in the form of loans. Concomitantly, however, bank equity capital was increased so that the capital to asset ratio
of banking institutions was not inadequate at the end of the period.
Since 1960 , banks have continued to shift out of U.S. Government
securities and into less liquid assets in the form of loans to the private
sector. Moreover, during the past fifteen years, the change in asset
portfolios has been accompanied by a similar massive shift in the liability portfolios of banking institutions to the point where some observers believe that the ability of the banking system to fulfill its basic
statutory functions in a way consistent with the public interest is at
issue and the stability of and confidence in the Nation's banking system
is threatened.
During the past fifteen years banking institutions have continued
to increase the size of their loan portfolios. Not only have the loan
portfolios been increased in quantity but the quality of the loan portfolios has been altered by a trend towards longer term loans and in-

creased maturities. This trend in altering the qualitative aspects of
asset portfolios has been magnified in some cases by a further shift in
the securities portfolios out of shorter term highly liquid U.S. Government securities and into longer term less liquid lower grade securities
subject to greater fluctuation in price as a result of changes in the
interest rate structure. While the asset base of banking institutions
has thus continued its trend toward less liquidity and much greater
risk, the nature of the liabilities utilized to support these asset structures have become increasingly volatile.
In order to support these increasing and changing loan and securities
asset holdings banking institutions have been innovative and competi-

tive in their quest for funds. But the innovations and competition are
not without dangers. In the immediate postwar period the liabilities
of banking institutions upon which assets were predicated consisted
mainly of demand deposits and household time and savings deposits
which, while volatile to a degree , represented a reasonably stable deposit base. During the past fifteen years this stable deposit base of
banking institutions has been seriously eroded . In order to support
increases in longer term loans and holdings of riskier securities banking
institutions have shifted their deposit liability base into forms of
deposits and borrowings which are more costly and often highly
volatile. Banking institutions have come to increasingly rely upon
overnight borrowings in the form of Federal Funds to support
a portion of their asset base ; other portions of their asset base have
been supported by the sale of large certificates of deposit which have
a fixed term, by Euro-dollar borrowings in the overseas market or by
the sale of short term commercial paper by parent holding companies.
This massive shift in the composition of the asset and liabilities
structures of banking institutions poses certain dangers to the banking
system .
In any situation where large short term borrowings or deposits must
be paid out, the particular banking institution may need sufficient
liquid assets which can be sold to make the payment without serious
losses which might adversely affect the bank's capital structure and
threaten its continued operation as a viable banking institution . The
trend toward longer term and higher risk assets in the banking system
represents a serious deterioration in the ability of banking institutions
to respond to liquidity needs commensurate with the risks entailed in
their acquisition of highly volatile deposit structures.
Furthermore, the shift in asset and liability structures have been
intensified by a concomitant deterioration of the capital position of
banking institutions generally. During the past fifteen years the gross
capital base of banking institutions has not kept pace with the growth
or deterioration in the quality of banking assets. Moreover, increasing
reliance by banking institutions during the period has been placed
upon debt forms of capital. Debt forms of capital have very serious
drawbacks and should not be relied upon as a significant source of
capital protection for the banking system. While they do offer some
protection to large depositors in the event of a bank failure, overreliance should not be placed upon this kind of protection. The reality of
bank failures is that the supervisory authorities have taken great pains
to prevent the failure of banking institutions. During such long peri-


ods of supervisory action, debt capital is not available as a source of
funds against which loan losses may be written off so that failure may
be averted and the banking institution continued as a viable entity.
Interest payments on the debt may be required to be continued even
during periods of extreme stress of a particular institution and any
resultant non-payment of interest may trigger acceleration provisions
in the debt instrument requiring the repayment of the entire amount
of the debt capital at the very time a bank may need to conserve earnings to avert a failure by writing off loan or other losses.
There are other very disturbing trends in the banking business
today. The past several years have seen the largest bank failures and
near failures in the history of our Nation. Liability management practiced by the use of volatile sources of funds to support illiquid and
high risk asset portfolios have been a major causative factor. In addition, insider self- dealing loans to bank directors and bank management have been significant causative factors in other situations. Still
other disturbing trends in banking institutions have been the use of
brokered deposits, the increased use by banks of loan commitments and
stand-by letters of credit as a source of earnings for banking institutions. The latter two forms of bank assets and liability management
serve to exacerbate severely the tendency of banking institutions to
increase the size of their asset portfolios at the expense of any significant regard for the stability of the sources of funds upon which these
loans must be based.
The record of recent bank failures and near bank failures reveal
that the Federal Reserve System acting in the capacity of a lender
of last resort, is often put under pressure to rescue a bank from the
consequences of its own mismanagement. A question is raised as to
whether it is in the public interest to continue to have the Federal
Reserve underwrite the liquidity of such particular banks in the circumstances characterized by recent bank failures and in view of the
deterioration of liquidity and capitalization of the banking system
as a whole. Bail-out type loans to shaky banks complicate monetary
policy, weaken incentives for sound management, misallocate the distribution of bank reserves, and jeopardize taxpayer funds.
There is evidence that problem banks are increasing in number and
size . The regulatory process must be reviewed to determine whether the
present structure of regulatory authorities which has not been fashioned in a systematic way is now adequate to the task of maintaining
a safe and sound banking system in the present day atmosphere.
Increasingly bank holding companies have come to occupy a dominant position in the Nation's banking system. Bank holding company
subsidiary banks hold most of the deposits in the banking system. Bank
holding companies have expanded their areas of operation far beyond
the geographic limits imposed upon their subsidiary banks. They have
tended to operate increasingly in leveraged positions. Supervisory care
should be taken respecting these institutions to insure that any subsidiary banks of a holding company are not misused by diverting income to
the holding company or by the holding company extracting inordinately high dividends from its subsidiary banks. There has been a recent tendency in the banking system on the part of management to view
their major goals as being the increase of earnings per share and a high
return on equity capital. That philosophy necessitates more highly

leveraged operations and increased risks. The regulatory authorities
must accept as their obligation the necessity to foster conditions where
the public interest factors regain their paramount position in the eyes
of managements of banks .
In a recent interview in a national magazine one banker commented
that in the future there will be less gambling by banking institutions
with short-term borrowed money and more screening of would- be
borrowers. That there has been gambling by particular institutions in
this regard is an undeniable fact. The bank regulatory agencies have
been slow in utilizing the supervisory tools available to them to proscribe these practices.
The record of recent bank failures and near failures reveals that the
regulatory structure of bank regulatory agencies is defective and unless
that structure is recast, there is virtually no hope that the regulatory
apparatus will be capable of insuring a safe and sound banking system. Continuation of the present supervisory structure will make it
extremely difficult, if not impossible, to correct the deficiencies in banking practices which have cropped up in recent years. Confidence in
the Nation's banking system cannot be maintained in this helterskelter regulatory atmosphere where authority is divided amongst
three agencies .
Prompt and early injunctive action under the Financial Institutions
Supervisory Act of 1966 might have forestalled the serious problems
which eventually resulted in the situations to which I have reference.
Disaster in these situations was averted only with massive injections
of liquidity by the Federal Reserve and by an eventual or potential
large infusion of funds by the Federal Deposit Insurance Corporation.
There simply is no capability in the fragmented patch-quilt structure
of Federal regulatory agencies to respond promptly, early and in a cooperative way to enjoin the continuous deterioration of banks supervised by these agencies until their situations attain crisis proportions.
One of the reforms in bank supervision urgently needed is a drastic
change in bank examinations procedures in order that the regulatory
authorities may comprehend and respond to the material changes
which are occurring with rapidity in banking institutions. The time
frame within which bank supervisors have to require corrections of
practices which have a potential to develop into unsafe or unsound
conditions and crisis situations has been greatly shortened by the pace
of change in the banking system. Only a restructuring of the bank
supervisory agencies into a single bank regulatory agency gives any
hope of being able to cope with the problem.
There must be established an ongoing supervisory computerized
network capable of obtaining information on the composition of bank
assets and liabilities on a frequent basis. Such a system would enable
a supervisor to determine at a glance the status of a bank-its capital ,
liquidity, asset and liability position- and compare that present status
with the standards of the regulatory agency. If a bank fails to meet
those standards, examiners can be dispatched immediately to ascertain the causes and institute necessary changes long before a crisis
occurs. Wherever potential unsafe or unsound conditions surface
prompt and effective injunctive action by the supervisory authority
must be undertaken under the Financial Institutions Supervisory
Act of 1966.



Expert opinion shows that this kind of updated supervision cannot
be achieved as soon as required- if it ever can be achieved in present
circumstances so long as Federal bank supervision remains fragmented among three agencies, each jealous of its prerogatives, each
determined to maintain its own carefully constructed empire. Expert
opinion reveals that it would take years—literally years of negotiation before an agreement could be reached within the existing regulatory framework concerning the kind of information needed to provide
an accurate picture of each bank, let alone devise appropriate standards
by which banks should be judged, and without which it would be impossible to achieve anything like conformity of supervision and competitive equality.
For this type of supervision to be effective, it would be necessary
to attract to the supervisory force highly qualified analysts who could
design and implement sound standards , examiners who could pinpoint
the trouble spots and effectuate immediate corrective action and supervisors with the will and capability-backed by strong Congressional
intent supporting basic legislation to enforce the standards and applicable laws with impartiality. This task cannot be accomplished under the present fragmented regulatory structure. It would be a manageable task for a single regulatory authority.
Unsafe and unsound conditions have proliferated in our banking
system because bankers have been able to play the fragmented structure, shifting back and forth among supervisory authorities whom
they have thought would best accommodate their views of the conduct
of banking business. Banks are now free to switch from one supervisory authority to another, seeking the most lenient supervisor. We
have an example of one banking institution in a state switching to the
jurisdiction of a particular supervisor for the purpose of having a
particular merger transaction approved. After the merger was approved and consummated the banking institution switched back again
to its original supervisor where it believed the merged operation could
be conducted on a more economical basis for the bank.

Cases such as this have their roots in the differing standards applied
by the banking regulatory agencies respecting merger applications
filed under the Bank Merger Act. One supervisory agency has been
more permissive in approving applications for merger of banks than
have the other regulatory agencies. The provisions in the Bank Merger
Act for the filing of competitive factors reports by the bank regulatory
agencies not having approval authority over a particular merger with
the jurisdictional bank regulatory agency were designed to assure uniformity of treatment among the banking agencies respecting bank
merger matters. These provisions of law have not achieved their intended purpose. Differing standards have been applied by the regulatory agencies while at the same time a large amount of time has been
dissipated by the regulatory agencies in compiling competitive factors reports which have been largely ignored as evidenced by the continued application of differing standards by the regulatory agencies.
Again, here is a task which is manageable and which can only be accomplished by the establishment of a single banking regulatory agency
at the Federal level.

The permissive attitude of one bank regulatory agency toward
mergers and other aspects of banking has directly led to a number of
banking institutions leaving the regulatory jurisdiction of one agency
and switching to the jurisdiction of another agency. This had led to a
tendency to regulate at the level of the lowest common denominator at
the Federal level. I believe this kind of lowest common denominator
regulation has been in part responsible for a trend toward concentration of banking resources in this Nation along with the trend toward
an illiquid and undercapitalized banking system. The fragmented regulatory structure is too cumbersome to cope with the problem. If one
agency denies the acquisition of a bank by a holding company the
bank holding company can turn right around and apply to have the
bank sought to be acquired merged into a bank under the regulatory
jurisdiction of another agency. There is in short , no coherent policy
at the Federal level to control the concentration of banking resources in
this nation .
I have not attempted to catalogue each deficiency in the existing
regulatory framework. This Compendium is offered as a starting point
for that discussion and the steps that will be necessary to correct the


Chapter I.- Entry and Establishment of Branches :
"A Theory of the Government Regulatory Process in Commercial
Banking," by Mukhtar M. Ali, associate professor, and Stuart I.
Greenbaum, professor, Kentuck University.
"In Quest of Reason : The Licensing Decisions of the Federal Banking
Agencies," by Kenneth E. Scott, professor of law, Stanford
"Regulation and Branching Laws," by Dennis C. Bottorf, vice president, corporate planning, Tennessee Valley Bancorp, Inc.-.
"Entry Policy," by Thomas M. Havrilesky and William P. YoheChapter II.- Banking and the Economy :
"Banking and the Economy," by Thomas M. Havrilesky.
"Banking and the Economy," by William G. Dewald, professor of
economics, Ohio State University ---"Banking and the Economy," by John J. Klein, professor of economics,
Georgia State University--"Banking and momentary Policy," by William E. Gibson, the Brookings Institute___
Chapter III.- Composition of Bank Assets and Liabilities :
"Changes in the Composition of Bank Assets and Liabilities ; Bank
Capital Adequacy ; and Bank Failures : Their Effect on the Liquidity
and Solvency of American Banks," by Paul M. Homan ….
"Economic Instability and Commercial Banking," by Stuart I. Greenbaum , professor of economics, University of Kentucky"Financial Instability, the Current Dilemma, and the Structure of
Banking and Finance," by Hyman P. Minsky, Washington University, St. Louis, Mo ---Chapter IV.- Capital Adequacy for Banks and Bank Holding Companies :
"The Adequacy and Structure of Capital for Banks and Bank Holding
Companies," by William M. Weiant and William A. Wood III,
Blyth Eastman Dillon & Co --"Bank Holding Company Capital," by Phyllis Pierson, Southern
Methodist University-"Bank Capital from the Perspective of Shareholder Interests-Implications for Bank Regulation," by John J. Pringle, Graduate School
of Business Administration, University of North Carolina_.
"Capital Adequacy of Commercial Banks : A Question of Balance,"
by Richard H. Pettway, University of Florida --Chapter V.- Examination Procedures :
"Bank Examination," by George J. Benston, Graduate School of Management, University of Rochester_
"Examination and Supervision : Indications and Inferences," by
Charles R. Whittlesey, professor of finance and economics___
Chapter VI.-Unsound Banking Practices :
"Standby Letters of Credit and Other Bank Guaranties," by Timothy
D. Naegele, Partner in law firm of Brownstein, Zeidman, Schomer,
and Chase__
Chapter VII.-Merger Policy :
"The Potential Competition Doctrine and Market Extension Acquisitions in Banking," by Bernard Shull, professor, Department of
Economics, Hunter College__













Chapter VIII.-Prevention of Failures : Domestic and International
Banking :
"Preventing Bank Failures," by George C. Kaufman, professor of
Banking and Finance, University of Oregon_.
"Forestalling Bank Failure," paper received from Gerald T. Dunne,
professor of law, Saint Louis University‒‒‒‒
"Prevention of Failure," by Edward E. Edwards, professor of
"Bank Failures and the Public Interest," by Dale Tussing, professor
of economics, Syracuse University.
"Preventing the Failure of Large Banks," by Thomas Mayer, University of California, Davis__
Chapter IX .-Regulatory Structure :
Letter from J. L. Robertson, former Vice Chairman, Federal Reserve
"Federal Bank Regulatory Reform," by Jeffrey M. Bucher, member,
Federal Reserve Board_
"1975 The Year for Federal Banking Regulation Reform," by John
E. Sheehan, member, Federal Reserve Board_
Memorandum re "1975-The Year for Federal Banking Regulation
Reform," from Carter H. Golembe Associates, Inc__.
"Issues in Bank Regulations," by Raymond J. Saulnier, professor of
economics, Columbia University___




Compendium of
Major Issues in Bank Regulation
Chapter I. - Entry and the Establishment of Branches
Rev. 2-75

Mukhtar M. Ali and Stuart I. Greenbaum*

Public regulation of commercial banking has a long and
fractious history in the U.S.

An administratively fragmented and

normatively obscure regulatory patchwork is the result .

In frustra-

tion , we periodically commission blue - ribbon panels to plumb the purposes
and mechanics of bank regulation and yet the basic understanding sought
seems to remain well hidden .
This paper seeks to explain one facet of the public regulation of
commercial banking , the control of entry and exit of firms (banks ) and
plants (branches) .

Much institutional detail is cut away and

the process in question is viewed as an optimizing problem confronting a
single regulatory agency .

A legislature , functioning as an ultimate

authority , commissions the regulator to serve as its agent .

The regulator

is provided with policy instruments and well -defined desiderata in the
form of a criterion function and is instructed to formulate and implement
optimizing policy .
In what follows , we provide a concrete interpretation of the criterion function which can be taken as illustrative although we believe
it represents a plausible description of Congressional will as reflected
in legislation .

We then posit alternative assumptions regarding the

behavior of the regulator and the nature of his control over entry and
exit and explore the properties of solutions to the optimizing problem .



The simplest formulation assumes that the regulator is perfectly loyal
to the legislature and that the regulator's control over entry ( exit )
is absolute .

The second formulation retains the assumption of loyalty

but assumes control of entry ( exit ) is uncertain .

We visualize fixed

entry standards whereby the regulator influences entry ( exit ) by manipulating instrument variables which are related stochastically to investors ' desired rates of entry ( exit ) .

The third formulation relaxes

the loyalty assumption and allows the regulator to alter the criterion
function so as to promote selfish ends .

A potential conflict of interest

arises from ( 1 ) the desire of the regulator to remain in office and ( ? )
the regulator's belief that his performance is evaluated on grounds other
than his ability to simply optimize the original criterion function .
Although the major arguments of this paper are rooted in the institutions of U.S. commercial banking , the underlying theory relates to
regulatory control in general .

Therefore , the analysis should have appli-

cability to most regulated industries as well as to other corporate
behavior where ownership and management are separated .
Section I presents an interpretation of the desiderata of bank
regulation -- " needs and convenience , " " efficiency " and " stability"
and then proceeds to map the desiderata into an index of banking industry
performance (the criterion function) .

Section II sets forth the properties

of a solution to the deterministic optimizing problem.

Section III recasts

the problem in stochastic terms and solution properties are reconsidered .
The fourth section examines the problem of possible conflicts of interest
(the agency problem) while the final section summarizes our conclusions .




Needs and Convenience
Assuming that all banking offices offer a complete array of

banking services on non-discriminatory terms , " needs and convenience "
can be interpreted as referring to the density and spatial distribution
of banking offices .

A spatial distribution norm presumably would con-

sider the location of banking offices relative to the distribution of
some weighted measure of population.1

Such a concept is difficult to

formalize in one or a few dimensions and we consequently chose to ignore
this aspect of " needs and convenience . " 2
Banking facility density will be measured in terms of the number
of banking offices (plants ) , B , relative to population , N.

We maintain

that increases in the ratio , B/N, unequivocally serve the " needs and
convenience" of the community by increasing customer proximity to banking
facilities .

On conventional consumer theory grounds , it is further

assumed that increments in convenience diminish as B/N rises .

Thus , we

define " needs and convenience" as

T₁ = T₁ ( B/N)

(1.1.1 )

and assume that

r₁ > 0 > r' "' .


We assume that commercial banking is characterized by a well -defined
production process so that , given factor prices , a long - run average cost



function for the firm can be written as follows :

( 1.2.1)

c (q; , b; )

where , for the ith firm , q¡ is output and b₁i ≥ 1 is the number of plants.³
The average cost function is assumed to be at least twice differentiable
and to have a unique minimum at qi = q* , bi = b* .
Efficiency loss associated with operating firms at other than


optimal size is


q₂ | c (q* , b* )

c(q¡ ,b;) |

Where F is the number of firms in the industry .

( 1.2.2)

Approximating ( 1.2.2 ) ,

we define " efficiency " as

= Q [c (q* , b* ) - c (a , b) ]

( 1.2.3)

where Q is industry output and q and б are average firm output and number
of plants , respectively .

We view Q , q* , and b* as exogenous from the

viewpoint of the regulator .

By controlling the industry's number of firms ,

F, and number of plants , B , the regulator determines q and б and thereby
controls the degree of " efficiency" at which the industry operates .


Contemporary concern for " stability" can be traced to the trauma

of the 1920's and ' 30's when , because of bank failures , many communities



found themselves with disastrous deposit losses and without sources of
credit .

Although federal deposit insurance has substantially reduced the

threat of deposit losses , concern for bank failures remains .

In a world

of imperfect capital markets , the disappearance of a source of credit can
result in readily identifiable capital losses and threats to the deposit
insurance fund also may concern some of the public .

In any case , there

seems little doubt that public concern for bank failures is part of the
bedrock of contemporary bank regulation .

Thus , we define stability as

F3 = T3 (AF)

( 1.3.1 )

where AF is change in the number of firms in the banking industry over
some specified time interval and
13 > 0 > I'3 ,
I3 =
= 0, for AF > 0.5
Note that I
13 reaches its maximum at AF = 0 and falls at an increasing rate
as AF takes progressively larger negative values .

According to this inter-

pretation , the public's concern for industry stability is unrelated to
either increases in number of firms (AF > 0) or changes in number of banking offices (AB ) .

Although a more inclusive concept of stability may offer
greater analytical appeal , our definition appears to be defensible .

Index of Banking Industry Performance
"Needs and convenience , " " efficiency" and " stability" are viewed as

distinctive forms of utility capable of being mapped into an index , e ,

52-221 O - 75 - 2




of banking industry performance :

0 = Σ α Fi

> 0.


Although (1.4.1 ) is linear in T¡ , note that utility- based non- linearities
have already been imbedded in ( 1.1.1 ) and ( 1.3.1 ) .

In contrast , г , is in

dollar units and is interpretable as forgone real income .

It would

appear, therefore , that the additional assumption of constant marginal
utility of income is required in support of ( I.4.1) .
Substituting ( 1.1.1 ) , ( I.2.3) and ( 1.3.1 ) into ( I.4.1 ) , we obtain

0 =

( B , F , AF :

N , Q , q* , b* ) .

( I.4.2 )

obtained at
has a unique maximum , say e
max '

Given our specifications ,

AF > 0 , F = F* , B = B* , which can be interpreted as a socially optimal
banking structure .

II .

Adjustment to the Optimal Banking Structure : The Deterministic Case
Any sub - optimal banking structure (B , F ) can be expected to

generate structural change since the regulator is assumed to act as a
single-minded agent of the legislature .
However , two distinct kinds of
adjustment are possible .

For BO + B* and F. < F* , adjustment is costless

and therefore instantaneous .

Alternatively , when FO > F * , adjustment will

be time consuming in general , because of the stability cost associated
with reducing the number of firms .
We turn now to explaining the process of adjustment in the case



where Fo > F* .

Assuming continuous time , suppose that in an arbitrarily

small interval ( t , t+At ) the change in number of firms is AF ( t ) , and the
total adjustment to be made at time t is [ F ( t ) - F * ] .

AF (t)
F (t) · F*

We define

= -kat , k > 0

( II.1)

so that k can be interpreted as the proportion of the gap , [ F ( t ) - F * ] ,
closed in a unit time interval .

F ' (t ) =



0 , ( II.1 ) can be written as

k [F ( t) · F* ] .


Assuming F ( 0) = Fo, the initial level , and that we adjust until F = F *
so that lim F ( t ) = F * , we solve ( II.2 ) and get
F (t) = F * + (F - F* ) ee -kt , t > 0 .


For a given k, ( II.3) describes the process of adjustment .


0 < k < ∞, the adjustment is time consuming and the adjustment period is
[ k¯¹ log ( 1- ) ¯¹ ] where
is the proportion of the initial gap closed .
For example , when k = 1/2 , 99 per cent of the gap will be closed in 9.2
time periods .

If k = ∞ , adjustment is instantaneous .

At any time t , the

amount of adjustment is AF ( t ) = - ( 1 - e¯k) (F¸- F * ) e˜kt , which approaches
zero monotonically as t → ∞ .
Let 0.t+ be the time t value of Ⓒ when the adjustment is according
to ( II.3 ) .

Then the loss at time t resulting from F ( t ) > F * is

L (t , k) = (0maxt) , for t≥ 0

( II.4)



and the cumulative loss is

L ( t , k) dt = α2 k

H (k) =


+ αz k


F -F *
= √

[£2 (B *; F* ) X
= £ 2 (B * , x+F *)-] dx


k(F -F* )

23 (0 ) - T3 (-x),- dx .

We wish to choose k so as to minimize H (k ) .9

Differentiating ( II.5 ) with

respect to k , we obtain

H' (k) =


¹3 ( 0 ) -F 3 { -k (F¸ - F * ) } - w,
21 .

( II.6)

Note that

H ' (k) = -∞ ,
limm H
and lim H ' (k ) =

> 0
(F。 - F * ) ²az8 :


{ -k ( F。 -F* ) } > 0. As lim H ' ( k ) < 0 and lim H ′ ( k) > 0 , there
where 8 = -1 &m
exists a k > 0 for which H ' (k) = 0 . Also note that the finite positve roots

of H ' (k) = 0 and those of k²H ′' (k)
(k ) = 0 are identical .

As г' (x) > 0 and



{ k²H ' (k)
(k ) } > 00..
Tő ( x ) < 0 , it can be shown that Ək {k²

Hence k²H˚ (k) = 0 and

H' (k) = 0 have unique non- zero solutions , say k* , at which H (k) will
attain its unique minimum .

Thus , we have a unique adjustment path of the

Since k* is also the solution to kk²HH' (k) =1 0 , we can show

type ( II.3 ) .

the following:



= 0;





> 0;



მთ .


0 ; and ( II.v)

< 0;

(II.iii )


{ k* (F。 - F*) } > 0.10

( II.i ) means that the adjustment path is independent of " needs and convenience . "

( II.ii ) and ( II.iii ) indicate that the proportional rate at

which the gap between actual and optimal number of firms is closed increases as the importance of efficiency increases and/or as the importance
of stability decreases .

( II.iv ) and ( II.v) indicate that as the gap

increases the proportion closed per period declines , but the absolute amount
of adjustment per period increases .

The finding that "needs and convenience"

needn't play a role in determining speed of adjustment of actual to optimal banking structure presupposes that B and F can be independently
selected .

In a unit bank setting , where B = F , the assumption is clearly

untenable and in a mixed unit - branch setting the independence assumption
is an approximation , at best .



The Simple Case

Up to this point , we have assumed that the regulator has absolute
control of the number of plants and firms in the banking industry .

A close



look at the institutional setting , however , suggests that a stochastic
formulation may be more appropriate .

We visualize a situation in which

the regulator establishes well -defined and fixed entry standards which
serve principally to exclude entrants with high failure probabilities
owing to lack of competence , capital and/or character .

All applicants

satisfying the minimum standards are granted charters and consequently
the number of new entrants depends , to a first approximation , on the
number of applicants .

Thus , the rate of entry will depend on the ex-

pected rate of return on investment in new banks and exit will depend on
the profitability of existing banks .

The regulator influences the ex-

pected rate of return on new bank investment as well as the profitability
of existing banks through its control of bank operating procedures .
addition , the central bank , which we view as either being the regulator
or operating in concert with the regulator , influences expected profits
according to the way in which it implements stabilization policy .


the relationships among entry and exit on the one hand and the various
instruments of control on the other hand must be viewed as stochastic
owing to the regulator's incomplete understanding of potential investors '
expectations and the linkages between policy instruments and actual bank
profits .
Still another kind of uncertainty arises because the number of
potential applicants as well as the number of present bankers vary stochastically over time .

This latter form of uncertainty -- system error

exists even in the absence of regulatory efforts to control entry .

Therefore ,



B , F , and F ' are random variables and , hence , Ⓒ is a random variable

as well .


Definition of the Optimum Banking Structure
The randomness of

necessitates redefinition of the optimum

banking structure and we chose the simplest alternative , i.e. , the one
obtained by maximizing E (0) instead of 0.

In what follows , we assume B ,

F ' are independent random variables and that all third order partial
F , and F
derivatives of the I functions are negligible .

Then ,

α22 (E ( B ) , E (F) ) + αzø ( E (F ' ) )
E (0) = ¤¸Ã¸ (E ( B ) /N ) + ¤¿Ã½

var ( B)


( E ( B ) /N) + α₂ var ( B) г½
2B ( E ( B ) , E ( F ) )

d₂ var ( F ) l'½µ
2F ( E ( B ) , E ( F ) ) + α, var ( F ' ) гy (E ( F ' ) ) ] .

( III.1.A.1 )

The variables , E ( B) , E (F ) , E ( F ' ) , var ( B ) , var ( F ) and var (F ' ) can be
employed for the purpose of maximizing E ( 0) .

However , the system error

accumulates over time and var ( B) and var (F) will grow indefinitely large
in the absence of adjustment .

We therefore postulate the following error

adjustment hypotheses :

dF (t) = -k₂ [ F ( t ) - E (F ) ] dt + o0₁1 du (t)

( III.1.A.2 )

dB(t) = -k₂ [B ( t ) - E ( B ) ] dt + 02 dv (t)

( III.1.A.3)




where k₂ > 0 , and o2 , 03 > 0 are error variances associated with adjustment of F and B, respectively ; u ( t ) and v ( t ) are independent stochastic
processes with orthogonal increments , mean values of zero and E{ du ( t ) | ²} =
E { | dv ( t ) | ² } = dt .

The adjustment postulates , ( III.1.A.2 ) and ( III.1.A.3 ) ,

indicate that k₂dt proportion of the errors are adjusted at every arbitrary
interval of length dt and the errors σ₁du (t ) and σ₂dv ( t ) arise due to
system error and uncertain control in F and B , respectively .
Rewriting ( III.1.A.2) and ( III.1.A.3 ) and as dt → 0 , we obtain the
following stochastic differential equations :

( tt)) + k₂ F ( t ) = k₂E ( F ) + σ₁u ' (t)

( III.1.A.4)

B ' (t) ++ k½ B ( t ) = k₂E ( B ) + σ₂v ' ( t )

( III.1.A.5 )

which , when solved [ 1,542-51 ] , yield
F (t) = E ( F ) + 0₁u(t)

( III.1.A.6 )

B (t ) = E ( B ) +· 0₂V (t)

( III.1.A.7)

for initial conditions

lim F ( t ) = E ( F ) , lim B ( t ) = E (B)


lim U(t ) = lim V(t) = 0,
t +o

where U ( t ) = √ e - k½( t - s ) du ( s ) , and V ( t ) = Š e -k₂ (t − s ) dv ( s ) .



From ( III.1.A.4) and ( III.1.A.6) , we obtain

F' (t) =
-k, 1 U (t) + gu ( t ) .

( III.1.A.8)

Note that

E { F ( t ) } = E ( F) , E { B ( t ) } = E ( B ) , E { F ' ( t ) } = 0


( III.1.A.9 )

var ( F ( t) } = o {(l-eZ-22²
K2 ) , var (B (t ) } = o2(1-9-22 -)}

( III.1.A.10)

var { F ' ( t ) } = o² [ 1 ++

( III.1.A.11 )

²( 1 - e¯2k2t) ] .

Therefore , var { F ( t ) } , var { B ( t ) } and var {{F
F ' ( t ) } increase through time
with limiting values of o / 2k2 , 02/ 2k₂ and o² ( 1 +k2/ 2) , respectively .
k₂ is indefinitely large , i.e. , when all accumulated errors are corrected
at every period of time , var { F ( t ) } and var { B ( t ) } are zero .

However ,

var {F ' (t ) } is o² because U ( t ) +0 as k₂* and only the immediate future
error is in FF ' (t) .
Upon selection of k₂ , E (F ' ) = 0 and var (B ) , var (F) and var (F ' )
are determined for every time period .
the choice of k₂ , E (B) and E (F ) .

Thus , E ( 0) can be maximized with

We treat k₂ as being chosen arbitrarily.12

As third derivatives of the I functions are negligible , E ( 0) is maximized
when E (B) = B* and E ( F ) = F* , where B* and F* are optimum values of B and
F in the deterministic case .

we have

With this definition of the optimum structure ,



Σ α.Γ ; +
2 , ry
max E (0 ) = 0x
ii • § 110² (1-0-2
max (t ) = 2i 0,5


21 - e - 2k₂t
12B + 0,02 (1-6-22 ) T
ZK2 ) г.
202 (1-0-22

a02 ( 1 +

2 ( 1-6-2k2t ) ) ry ]

( III.1.A.12 )

where functions and their derivatives are evaluated at E ( B) = B* , E (F) = F* ,
and E ( F ' ) = 0.

Note that max E ( 0) varies through time in contrast to the

deterministic case where we have a single

is less than
max and max E (0)

max by the amount of the right hand side of ( III.1.A.12 ) , excluding the

first term .


Adjustment to the Optimum Banking Structure

and F O > F* , we adjust the mean of B to B

at the out-

set and follow the error adjustment procedure described in ( III.1.A.3 ) .
The adjustment for F is as follows :
dF (t) = -k₁ [ F¸ ( t ) - F* ] dt -- k₂ [F ( t ) - F¸ ( t ) ] dt + σ₁du (t ) (III.1.B.1 )


F (t ) = E { F ( t ) } = F* + ( F。-F*) e˜¼¸ ¢

for t > 0,

> 0.
k₁1 >

( III.1.B.2 )



In ( III.1.B.1 ) , k₁ is the proportion of the gap between F⭑ ( t) and F


is closed each period and k₂ is the proportion of the error -- i.e. , the
gap between F (t) and E { F ( t ) } adjusted in each period .

Rewriting ( III.1.B.1 )

and as dto , F ( t ) follows a stochastic differential equation which when
solved with proper initial conditions , yields¹3

F (t ) = FF⭑ ( t)
t ) + 0₁U (t)


F ' (t) = F¦ ( t ) - k₂₁U ( t ) + σ₁u ' ( t) .

( III.1.B.3 )

( III.1.B.4)

In what follows , we assume that the regulator is risk neutral in
the sense that he seeks to simply minimize cumulative expected loss .
Using our definitions of expected values and variances of F ( t ) and F ' (t ) ,
we can approximate expected loss as

L(t , k₁ ) = 0max ( t ) - E { 0 ( t ) }

= α2 [T₂ (B * ‚ F* ) - 12 (B* , F+ ( t ) ) ] + az [ 3 ( 0 ) -3 (F ( t ) ) ] . ( III.1.B.5 )

The cumulative expected loss is

H(k₁ ) = SL (t , k₁ ) dt

(III.1.B.6 )

where ( III.1.B.6 ) is the equivalent of ( II.5) with k₁ replacing k .


optimum k₁1 = k* and properties ( II.i ) , ( II.ii ) , ( II.iii ) , ( II.iv ) and
(II.v) follow routinely . However , max E (0) is less than max in the amount
of the right hand side of ( III.1.A.12 ) , excluding the first term . Thus , the



introduction of uncertainty together with the assumption of risk
neutrality on the part of the regulator has the force of paring the
target value of 0, but rates of adjustment for both firms and plants
åre left unchanged and the solution properties of the deterministic
formulation are sustained .

III.2 Uncertainty Dependent on Adjustment Magnitude
The assumption that uncertainty in adjustment is independent of

the desired amount of adjustment , i.e. , 02 and o² do not depend on
E { F ' ( t ) } and E { B ' ( t ) } , appears to be unduly restrictive .

The recurrent

appeal to " gradualism" by government officials suggests that while the
policymaker has incomplete knowledge of the structural system within
which he operates , the bulk of available information pertains to the
system's local behavior .

Thus , the policymaker is most confident re-

garding responses to small variations in instrument variables and uncertainty increases with the magnitude of instrument variation .


if an instrument variable is pushed outside some unknown bounds , parameters of the policymaker's model are transformed into endogenous variables in

a more general and poorly understood structural system .


line of argument suggests F ' ( t ) and B ' ( t ) are heteroskedastic and

021 and o2 are increasing functions of
tively .

E { F * ( t ) } | and | E { B ' ( t ) } | , respec-

For simplicity , we assume

o} ( t) = 0} ( 0) [ 1+ | E{F ' ( t ) } | ² ]



o² ( t ) = o² ( 0 ) [ 1+ | E{ B ' (t) } | ² ]
with o (0) and o² ( 0) identical to o 1 and 03 in ( III.1.A.2 ) and ( III.1.A.3 ) ,
E { F ' ( t ) } = F ( t ) and E { B ' ( t ) } = B¦ ( t ) .
Although no change in the definition of the optimum structure is
needed and adjustment of firms remains as described in ( III.1.B.1 ) with
0₁ replaced by o₁ ( t ) , it is necessary to postulate a corresponding adjustment procedure for plants :

dB (t ) = -kŋ [ B¸ ( t ) - B * ] dt -k₂ [ B ( t ) - B¸ (t ) ] dt + 02 ( t ) dv ( t ) . ( III.2.1 )

The adjustment parameters , k₂ and k₂ , can be interpreted by analogy from
( III.1.B.1 )

and the discussion thereafter .

Arguing as before , we can

show that F ( t ) and B ( t ) follow stochastic differential equations which
when solved with proper initial conditions yield
F (t) = F* ( t ) +

( 0 ) U✩ (t)

( III.2.2 )

F ' ( t) = F ( t ) - k₂º1 (0) U* (t) + °1 (0)u ' (t)


B ( t) = Ba ( t) + 7 , (0 ) V ( t )



U₁ ( t) = √ e -k2 (t - s ) [ 1 + k{ (F¸ -F * ) ² e −2k¸s ] ¹ / ²du ( s )



B (t) = E{ B (t) } = B* + (B -B *) e -kzt


V* (t)
(t ) = } e-k2 (t - s ) [ 1 + k} ( B¸ -B* ) ² e−2kz5y1 / 2dv (s ) .

Provided Fo > F

and B + B* , we use the described adjustment

procedure and obtain expected values and variances of F ( t ) , B ( t ) and
F ' (t) .

Thus , the expected loss is

L (t , k₁ , kz ) = 0max (t ) - E {0 ( t ) }
and the cumulative expected loss is

H(k₁ , kz )

= a1W1 +
α2W2 + аз к



w₁ == S{ ø ( B * /N) - г¸ ( B¸ ( t ) /N) } dt¸
w₂ = S{г2 ( B * ‚ F*) -- 12 (B₁ ( t ) , F, ( t ) ) } dt ,

k₁1 (F¸ -F *)
= S


(F3(0) -3(-x)} dx ,

( III.2.5)



-B 2
R = { 0² (0) (8¸ -8 ″) ²


2B (
(— ™ ; •+ q₂2 %)

( 0 ) ( F - F * ) ²™ 2F ( )
으로 (0)


3 ∞ (0 ) (F¸- F *) ²™



+ аз

k₁₂ ·

(F_-F* )
(B -B )
¤½ (F¸ -F *) [a₂
2 2BF
4k 2

г3 ( 0 ) -гz [ -k₁1 ( F¸ - F * ) ]

* 2
- α2
2F 8k 02 (0 ) (F¸- F * ) ² rp


32 07 (0 ) (F。-F *) ² ry . ( 111.2.6 )




+ α₂

2B = T

= 0

г¡ ( B¸ ( t) /N) ≈ r¡ + ¦(B¸ ( t) -B *) I'¦ ,

we have
ƏH = (BO-B )

. 2"B) ( 1 - 1
02 ( 0)

(B¸- B*) ² (F¸-F* )
T2BF '
+ α2
(k₂ +kz ) ²


( III.2.7)



Let H (k,, k ) be minimized , at least locally , for k₁ = k₁ and k₂ = kz .

For a given kz ,


lim ан


ƏH =
аз 6
1(F -F*) ² αz
k. +∞o Ək.1

∞ (0 ) ( F¸ - F *) ²™½2F

+ α3k½ 0 (0) (F¸ -F*) ²ry] > 0

is defined following ( II.7) . Hence ,
= 0 has a finite positive
2 ƏH
solution , say k₁ (k¸) . If ( B - B˚ ) ™ ½
2FB > 0 , then JK1 {k}1 ak. -} > 0 and
k₁ (kz) is unique . However , in general there may be multiple solutions ,


and if k₁ ( k, ) is the smallest positive root , then

> 0 ,
k₁1 = k (kg)

and k₁ (kg ) minimizes H.
The following properties of k₁ ( k , ) and k₁ , given that k₂ can be
arbitrarily selected , are readily verifiable :

ək ,
( III.2.i )

= 0;

(III.2.ii )

> 0;

( III.2.iii )

< 0;





( III.2.iv )



0 according as (B - B* ) TR
2BF N0 ;

{k] ( F。-F* ) }

> 0 if (B¸-B * ) T
2BF ≥ 0 or if o (0)

is sufficiently large ;

0 according as г", BF0

( )


( III.2.vii )

( III.2.ix)


< 0;

(III.2.viii )


= 0;

with instantaneous branch adjustment (k¸* ) , k₁ ≤ k * and

equality holds if and only if o² ( 0 ) = 0 ;

> 0 , if and only if k₂ <

( III.2.x)

( III.2.xi )


" 2 2F , 1/2
1/2 ;

", F
0 according as (B¸- в*) г 2B


Properties ( III.2.i ) , ( III.2.ii ) and ( III.2.iii ) are equivalent
to ( II.i ) , ( II.ii ) and ( II.iii ) , respectively .

Property ( III.2.iv)

indicates that the proportion of the firm gap closed per period will increase (decrease) with the size of the gap , provided the ( B -B * ) 2BF is
positive (negative ) .

Unfortunately , we have no strong prior regarding

the sign of this term; T 2BF is a production function property and our
agnosticism reflects the primitive state of knowledge regarding the
technology of financial intermediation .

The cross -partial can be inter-

preted as a measure of the dependence of the optimal output size of plants

52-221 O - 75-3



(firms) upon the actual output size of firms (plants ) .

> 0
That is г",

indicates the optimal size of the plant (firm) increases with the actual
size of the firm (plant ) and г",
2BF < 0 indicates the optimal size of the
plant ( firm) varies inversely with the actual size of the firm (plant ) .
The principle of insufficient reason suggests the assumption that г 2BF = 0
in which case the optimal output size of plants ( firms) is independent
of the actual size of firms (plants ) .

However , if credibility is accorded

to the cost functions described in footnote 4 , we are left with the implication that I"
, > 0.

the term

(B - B * )

cannot be categorically signed .

However , if we can assume that actual regulation has not frustrated the
appropriate direction of plant adjustment , it follows that ( B - B * ) has
been uniformly negative in the post World War II era and uniformly posiƏk*
tive from 1920 to 1932. The logic of the dependence of OF on the sign
of the branch gap can be seen as follows : (1) If r 2BF > 0 and the number
of firms is being reduced (recall , we assume Fo > F* ) , in the process we
are reducing B* conditional on Fo;

( 2 ) If B < B * we will be closing the

branch gap while we are closing the firm gap .

However , iff B
Bo > B* , closing

the firm gap widens the branch gap , cet . par. We are left with the conclusion that we cannot predict changes in the proportional rate of firm
adjustment from changes in the size of the firm gap without additional
information about the production function .
Property ( III.2.v) relates the absolute magnitude of adjustment
to the size of the firm gap and again the term ( B - B * ) I 2BF plays a role .



However , non-negativity of this term is sufficient , but not necessary , for
a positive relationship between the absolute magnitude of adjustment per
period and the size of the firm gap .

Since this positive relationship can

also be assured by an order of magnitude restriction on o ( 0) , there is a
stronger presumption regarding this relationship than was the case in
( III.2.iv) .

Property ( ) indicates that when г",
2BF is positive (negative)
k and BO vary inversely (positively) .

Note that when г", > 0, increases

in B。 induce increments in F * conditional on BO and thereby reduce the
gap , (F - F* ) .

Properties ( III.2.vii ) and ( III.2.viii ) indicate that the

proportional rate of firm adjustment per period is retarded by uncertainty
regarding the number of firms in the industry , but is independent of uncertainty regarding plant population .

According to ( III.2.ix) , the firm

adjustment rate in the deterministic case is a special case of the firm
adjustment rate under uncertainty , i.e. , the adjustment rates are equal
when o ( 0) = 0 and k¸ → ∞.
The adjustment rate of firms , k , bears a complementary relationship with error adjustment ( III.2.x ) for small k₂ and the relationship
is substitutionary if k₂ is large .

Largeness of k₂2 is determined by the

relative importance of efficiency to stability ( a /az) and also the ratio
T /


As I
≈ 0 , k₂ must be infinitely large for the substitutionary

relationship to hold .

Thus , we conclude that for practical purposes k†

is an increasing function of k₂.

This can be explained as follows :


k₂ increases , the cumulative error in adjustment declines , but instantaneous



error increases .
increases .

Thus , both var ( B ) and var ( F ) decline , but var ( F ' )

Therefore , if г 3 ≈ 0 , with k₂ increasing we approach the

deterministic case and therefore k † increases .

Because branch adjust-

ment is not subsumed in " stability , " the above property carries over to
the relationship between k† and kg ( III.2.xi ) without qualification .
The interpretation of ( ) can also be employed to explain ( III.2.xi ) .
To study the properties of kz , let k ( k₁ ) be a solution to
= 0
which minimizes H, given k₁ . We note that the finite positive solutions
ƏH = 0 and kg
2 ƏH
of J
3 ak. = 0 are identical and we can verify that for a
given k₁ ,

2 ƏH
-} < 0 ,
lim { kz


2 ƏH
lim {kz3 ak.- } > 0 .
2 ƏH
> 0 , then J
JKz-} > 0 and if ( B - B * ) г'½2BF < 0 ,
Moreover , if ( B - B * ) Tг' '2BF
K3 { kz
3 ak
2 ƏH
(21 / then
{k ak -} > 0 , if and only if k > ( 2¹
- k₁ ) , where


F -F*
λ = α2


I'" + α₂T
+ 2B

을 -) > 0 .

Thus , k (k₁ ) is unique under proper conditions and k (k₁ ) and k
can be selected arbitrarily) will have the following properties :

( since k₁




> 0;

( III.2.xii )


(III.2.xiii )


> 0, if and only if ( B - B * ) г 2BF < 0;


= 0;


( III.2.xv)


( III.2.xvi )


< 0 , if and only if (B - B* ) T2BF > 0 ;

0 according as г",


(III.2.xvii )

3B - B *

( III.2.xviii )

{ kz | B - B * | } > 0, provided (B -B* ) г'½2BF > 0;

< 0;

( III.2.xix )


> 00;

( III.2.xxi )

ǝk (k₁ )


= 0;

≥ 0, provided (B -B * ) TRE
2BF > 0.15

The presence of dependent uncertainty radically alters plant ad-

justment since it raises the possibility of a time consuming process ( i.e. ,
kz < ∞) .

For the first time , heightened concern for " needs and convenience"

and/or " efficiency" accelerate the proportional rate of plant adjustment
( III.2.xii ) , ( III.2.xiii ) .

However , the rate of plant adjustment remains

independent of " stability" ( III.2.xiv ) .

Property ( III.2.xv) indicates that



a widened firm gap retards plant adjustment , but note our assumption that

(B -B* ) 12BF > 0 , along with our earlier caveats .

According to ( III.2.xvi ) ,

when B O>B* the proportional rate of plant adjustment increases (decreases)
with the magnitude of the plant gap if г",
2BF is positive (negative) .


previously with firm adjustment , there is a stronger presumption that the
absolute magnitude of adjustment will vary positively with the magnitude
of the gap than that the proportional rate of adjustment will increase
with the gap ( III.2.xvii ) .

In comparing ( III.2.xvii ) with ( III.2.v) , note

that the restriction on the order of magnitude of o ( 0) arises because of
stability cost .

Symmetrically with ( III.2.vii ) and ( III.2.viii ) , we find

that the proportional rate of plant adjustment varies inversely with uncertainty regarding the number of plants , but is independent of uncertainty
regarding the number of firms ( III.2.xviii ) , ( III.2.xix ) .
ship between k

and k₂ is monotonic ( III.2.xx ) .

The relation-

Property ( III.2.xxi ) is

the corollary of ( III.2.xi ) .

IV .

The Agency Problem
Thus far , we have viewed the regulator as an absolutely loyal agent .

As a simple extension of the legislature , the regulator single -mindedly
formulates and implements policy that will result in minimizing cumulative
expected loss , S [max E (0) · E {0 (t ) } ] dt . We now wish to recognize that

acting through an agent raises the problem of potential conflicts of interest .
If the regulator seeks to ensure his tenure in office , he may not minimize
cumulative expected loss , as defined .

Suppose that the regulator believes

his tenure in office depends , in part , upon his ability to execute stated



plans .

The regulator would then have an incentive to limit the magnitude

of var ( F (t ) }aand var { B ( t ) } .

Large firm and plant variances imply wide

departures of results from plans and zero variances imply perfect foresight .
Administrator cost at time t is therefore defined as

$ ( t) = 0 [ ²₁ (t ) , z2 (t ) ]

Z1 (t) = var {F ( t ) } ,
z2(t) = var { B (t ) } ,



*2 ,
21 '


0 , and

~ 0, but positive .

The revised cumulative loss function is

Ĥ( k¸‚k₂) = Y₂H + Y₂W

( IV.1 )

where H is defined in ( III.2.5 ) ,

W(k₁ , kz) = S $ (t) dt

and Y₁₂ > 0 are weights indicating the regulator's constant trade - off
between Hadministrator cost" and community loss .

As Y₂+0 we have the

special case of absolute loyalty and as Y₁0 we have the case of the
regulator behaving oblivious to the stated will of the legislature . "
Let k‡ and î

be the smallest positive roots of







1 Ək

+ Y ak



= 0,



= Y J
1 Kz + Y 2 JK3


and H, H and W are defined in ( IV.1 ) .
Also recall that ki and k
= ƏH


One can verify that


are the solutions of

= 0,


< 0 for k₁ < ki ,
экі < 0 for k


< k*.

Then , the following properties of k† are verifiable routinely :

( IV.i )

( IV.iii )

( IV.ii )




{k1 - îk*, }} < 0 ;

- k }} > 0 ;

Properties ( III.2.i , ii , iii , vi , vii , viii and xi ) of k₁ are
applicable to k₁ .
( IV.iv)



ƏF {k₁ (F¸ -F*) } ,









> 0.



< 0.


The agency problem further retards adjustment to the optimal banking
structure ( IV.i ) .

The magnitude of retardation varies positively with the

weight assigned to administrator cost ( IV.iii ) , and inversely with the
weight assigned to the legislature's criterion function ( IV.ii ) .

Many of

the solution properties of the dependent uncertainty case ( III.2) are sustained ( IV . iv) .

However , an increase in the firm gap will no longer increase

the absolute magnitude of adjustment without further qualifications (compare
( IV.v) and ( III.2.v) ) .

In addition , the complementarity between the firm

adjustment rate and error adjustment is lost ( compare ( IV.v) and ( III.2.x) )
as is the independence between the firm adjustment rate and uncertainty regarding branch population ( compare ) and ( III.2.viii ) ) .


regarding branch population now reduces the proportional firm adjustment
rate as well as the proportional branch adjustment rate .
The following properties of k

( IV.vii )


Kz < kzi

also are verifiable routinely :

* *
J (k3- kz)
< 0;
(IV.viii )

* *
a (k3- kz)
> 0;

Properties ( III.2.xii , xiii , xiv , xv , xviii and xxi ) of k3 are
applicable to k ;
( IV.x )



" Ə│B - B * | {k} | B - B * | } , JK



≥ 0;

( IV.xii )



ao (0)

< 0.



Properties ( IV.vii , viii , and ix) can be interpreted by analogy
with ( IV.i , ii , and iii ) .

Property ( IV.x) indicates the solution pro-

perties that are unaltered by the introduction of the agency problem .


perty ( IV.xii ) is the analog of ( ) indicating the loss of independence
between firm population uncertainty and branch adjustment .


The foregoing framework for analyzing public regulatory behavior

should seem quite conventional since the regulatory process is described
as a problem in dynamic optimization under uncertainty .
interacting entities :

We postulate three

an ultimate authority (a legislature) , an agent

created by the ultimate authority in order to effect its will (a regulatory agency) , and the object of control (the structure of the banking
industry) .

A criterion function ( index of banking industry performance)

describes value judgments originating with the ultimate authority .


mandate of the regulator is to operate on the structure of the banking
industry (the number of plants and firms in the industry) so as to maximize
the performance index over an infinite time horizon .

(This turns out to

be the same as minimizing our cumulative loss functions . )
If the regulator has absolute control over the number of plants
and firms in the industry, we have the special case of deterministic
optimization .

Generalization allows for uncertain control and the optimi-

zation problem becomes stochastic .

Similarly, the assumption of agent

loyalty is viewed as a special case which is generalized to allow for
systematic distortion of the criterion function arising from conflicts of
interest between the ultimate authority and the regulator .



Solutions are temporal rates of change in plants and firms in the
banking industry or , given initial conditions , time paths of the numbers
of plants and firms in the industry .
strong intuitive appeal .

Most of the solution properties have

For example , few will be surprised to learn that

the more importance the public attaches to " efficiency" of the banking
system, cet. par. , the faster the gap between actual and optimal size firms
will be closed , or that the introduction of uncertainty retards the adjustment process .

It also seems plausible , prima facie ,

that the existence of

a conflict of interest between the regulator and the legislature will
further retard the adjustment process .
intuitive theorems can be attributed to

The paucity of strongly counterthe generality of the framework

which is reflected in the weak restrictions placed on a1 , a2, az , Y1 and

More restrictive assumptions are likely to provide more striking

theorems , but the fact is that precious little is known regarding the paraNevertheless , our simple specification has served two useful

purposes :

( 1 ) theorems have been provided in support of conjecture and ;

( 2 ) it has been shown that despite discouraging institutional complexity ,
bank regulation can be formally described as an optimizing process .


tance of this latter point should lead to a redirection of professional
debate away from narrowly isolated issues and toward the macroscopic
questions of regulatory control .

Indeed , our analysis can be viewed as

primarily normative in that it identifies those variables and parameters
which require clearer definition and/or further study if public regulatory
policy is to serve the will of Congress more effectively .



The authors are associate professor and professor , respectively ,
at the University of Kentucky .

Income weights have intuitive appeal , but transactions and other
alternatives might serve as well .


If private markets could be relied upon to spatially distribute
banking facilities , the deletion would be justified . However , the
common practice of establishing branches in order to preempt locations well in advance of the development of an area speaks against
reliance on private markets .


Since this formulation is sufficiently general to be consistent with
all of the recently proferred bank output concepts [ 3 ] , we need not
concern ourselves with this definitional snare .


For example , if all plants are identical and their total costs (TCB)
are quadratic in output we have

TCB = T1

T₂ (q/b) + Tz (q/b)²

where q is firm output and ( q/b) is output per plant . Now , assume
the firm's total cost , (TC ) , is the sum of its plants ' costs plus
a term reflecting its research , planning , and coordinating activities .
These additional costs are assumed to be quadratic in the number of
plants the firm operates . Thus ,

+ 42 b +


3 b


+ b (TCB)

and the average cost of the firm is










+ (42 + 꼬
T1 )
F = 1/1

+ T ૧

3, T1 , Tz > 0 .

Recognizing that aq =

and b = B

M = AC₂ = V1F + (42 Q

B .
1 ) B + 132 +52+ 30

at q = q and b = б we have



Setting M' B = M' F = 0 ,

B = Q (

+ 2




F= Q(



της + 2 (4143)


+ τηλ + 2 (4/14/3 ) 1/2


q* = {



b• = 1 = → ¹

Note that since B > F by definition ,


In general , number of

plants per firm increases with ₁ and decreases with 3. When ₁ = 43
we have the special case of B = • and a unit
banking structure max^

imizes efficiency . As 1 → ∞ or 43. → 0 , F = 1 and the monopoly structure is indicated on efficiency grounds . We can also verify that


T". =

= -






2] < 0 ,

2 =






)] < 0,


2 .
M =
= [ (—³) (²) ] > 0 ,


> 0. Thus , T₂2 has a unique maximum and M has a
2B 2F
= 0, the optimal plant (firm) size
unique minimum . Note that when г",
and T

is independent of actual firm (plant ) size .


Change in the number of firms or net exit is defined as

AF = entry - exit

where entry and exit are non-negative . The question arises as to
whether stability should be treated as a function of AF or as a
function of exit ? If churning --i.e . , the smaller of entry or exit-largely replaces old banks with new ones at preexisting locations ,
the " source of credit " basis for stability suggests a net exit argument while the " deposit loss " basis suggests a (gross ) exit argument .
If new banks service areas formerly served by expired firms , new
sources of credit will likely replace old ones . However , new firms
cannot be expected to assume the deposit liabilities of expired banks .
Since federal deposit insurance has attenuated the importance of the
deposit loss consideration , we are left favoring the net exit argument .
A more complete analysis would distinguish between exit resulting
from bank failures and exit resulting from mergers .

For example , see [ 2 ] pp . 231-3 .


A sufficiently large a, may yield an exception .


The assumptions of continuous time and instantaneous rates of change
are merely mathematical conveniences . If we think of policy being
made in unit time intervals that are arbitrarily large multiples of
At , the proportion of the gap closed in each policymaking period is

AF (t)
F (t ) -F*

= - ( 1 -e

) , where AF (t ) = F (t+
(t + 1 ) · F (t) .

Note also that we are restricting our analysis to " golden rule" adjustment arcs which can be justified in terms of the policymaker's
need for " simple " rules .

In the interest of simplicity , we ignore the discounting of future
losses while recognizing the greater generality of seeking that k
e-Bt.ΑΘmax -t ) where ẞ is an appropriate
which will minimize

discount rate .



If the adjustment process is
F -F*
-kt , for t <
F (t ) =
F - F*
F* , for t >


where k is the amount of adjustment per unit of time , the corresponding
k* will retain properties ( II.i ) , ( II.ii ) , ( II.iii ) , ( II.iv) and ( II.v ) .
11 .

Greater generality is attainable by assuming separate and distinct adjustment parameters for plant and firm errors .

12 .
We might select that k₂ > 0 which maximizes the discounted expected
gain , S e¯ßtE {0 ( t ) } dt , where e-Bt
is an appropriate discounting factor .
This is equivalent to maximizing

h (k₂ ) = 7 e - ẞth (k₂ , t ) dt


h(k₂ ,t) = (1-2 ) (02 (

ry + α

2B²)} +

+ α
?{ ¸ryk²


h(k2) = (g(842k,y ) [0² (
Setting h ' (k2) = 0 , we obtain

k2 + Bk2₂ = A


2 2B } +
ry + α₂г

a 2 2F }],
{{α¸ïk² + α₂™½µ}






} +




Since A and B are both finite positive , k₂ is also finite positive
and is given by
k₂ = 1/2 { - B + (B² + 4 A) ¹ / 2 } .

Note that

( 12.i )

If o² = 0 , then k₂ = ∞ ;


k₂ is an increasing function of α , α , and σ2 ;

( 12.iii )


k₂ is a decreasing function of a,, o , and N.
In solving the differential equation , define F (t ) = F ( t ) - F * ( t ) and
F ' ( t ) = F ' ( t ) - Fi ( t ) . Then F ( t ) follows a differential equation
similar to ( III.1.A.4) and E { F ( t ) } = 0 .

14 .

Assuming T 2FB ≈0, we can show that
k* (k₁ ) = k*

15 .


The above discussion applies in the case where FO > F * . Let us
briefly consider the alternative case . Given that г (x ) ~ 0 for
x > 0 , for F < F* we have , approximately ,

H (k₁ , kz ) = α₁W1 + α2W2 - G




B* ) (} rï •
α₂™½ ) (
。 = § o²(0) (8¸

02 (0) ( F - F * )²TF

α₂ (F。 -F * ) ( B -B * )




(k₁ +kg) 2


a₂(F -F#)2
T2F (1
4k 2




α2(B - B* ) (F - F * )
(k₁ +kz ) ²



(B -B*) 2

Assuming r 2BF ~ 0, we have


01 (0)






52-221 O - 75 - 4

02 ( 0 )


22B') { 1






This problem is well -known among students of corporate behavior
where management and ownership are separated . Indeed , the problem
would appear to inhere in all large organizations where the delegation of authority is essential and where the agent possesses a
presumed " expertise" not shared by those with ultimate authority .


Whether the latter situation could be sustainable for any substantial
time is open to question . Where an agent is commissioned to deal
with a highly technical problem , e.g. , intelligence work or scientific
research , it certainly seems conceivable for Congress to be misled for
protracted periods .

18 .
JK1 = S $ 1₁₁ ( t) ( jk1) dt


JK1 = 02(0)


· t) e -2k₁t

-} [ ( 2k₁ (k₂ -k .

e-2k2t ] .

2k1 (k₂-k₁ )

• ½, (t ) =



½ , + { z¸ ( t ) - z¸ (∞) }

' > φυ

%, + {z₂ (t ) −z₂(®) } 0%¸²₂

are evaluated at

02 (0) (F。 -F*) ²



= Z₁ (∞) , and ZZ₂2 = Z₂ (∞) ,





k₁of (0)
8k2 (k₂+k.

k. ( 3k₂+ 2k¸ ) ( F¸ - F *) ² - 2 (k₂ +2k₂) ]
[ k₁₂



= k₁ (0) [2(B -B*) 2


(k₁ +kz) ´ (k₂+kz)

k₁ +2k2
2k2 (k₁ +k₂)

k₁ +2k2
2 ]
k2 (k₂+k1 )

Similarly ,


02 ( 0 ) ( B -B * ) ²
+ J $" + J.
} [J122
Z2 J30%122]




8k² (k₂+kz) ²

[kzk2 (3k2+2kz ) ( B¸- B * ) ² - 2 (kz+ 2k₂ ) ]





= k3º 1(0)

[2 (F_ -F*) 2

2 ].
k½ (k₂+kz)
Note that

R₁ ,J10 for all k₁ , k¸ > 0 .



> 0 , and

lim R₂ = lim J 2 = 0 ,

R2,J2 >>


0 for k₁ ,kz > 0 .

is negligible , we have
* 2122



> 0.

-) {~
(k₁ +k¸) ´ (k₂+k₁ )

2k₂ (kz+k₂)'




J. L. Doob, Stochastic Processes , (New York , 1953 ) .


G. C. Fischer , American Banking Structure , (New York , 1968 ) .


S. I. Greenbaum , " Competition and Efficiency in the Banking
Empirical Research and Its Policy Implications , " Journal
of Political Economy , 75 (August 1967 ) , 461-79 .




of Chicago
Law Review

In Quest of Reason :
The Licensing Decisions of the
Federal Banking Agencies*
Kenneth E. Scottt

In terms of both size and economic importance, the banking
business plays a pre-eminent role in the United States. At the end
of 1973 , commercial banks , mutual savings banks and savings and
loan associations held over a trillion dollars in total assets. There
were almost 20,000 separate institutions, of which 6,699 were federally chartered ; an additional 11,750 state chartered institutions
had federal deposit insurance from the Federal Deposit Insurance
Corporation (FDIC) ¹ or Federal Savings and Loan Insurance Corporation (FSLIC) .²
Along with the federal involvement and support goes an extensive structure of federal regulation . National banks are chartered
and supervised by the Comptroller of the Currency, and automatically receive deposit insurance from the FDIC . State banks are
chartered and supervised by the different state banking authorities; in addition, they may join the Federal Reserve System (and
thus automatically receive FDIC insurance) or the FDIC itself,
thereby incurring a secondary level of regulation and supervision .
* This article is based on a study undertaken for the Administrative Conference of the
United States. The views expressed, however, are solely those of the author and do not
represent an official position of the Administrative Conference. The author wishes to
thank the Comptroller of the Currency and his staff for their full and gracious cooperation in making charter and branch decision files available for this study.
Professor of Law, Stanford University.
1. Originally created by Act of June 16, 1933, ch. 89, § 8, 48 Stat. 168.
2. Originally created by Act of June 27 , 1934, ch . 847, tit. IV, § 402 , 48 Stat. 1256.



The University of Chicago Law Review


Federal savings and loan associations are chartered and regulated
by the Federal Home Loan Bank Board (hereafter FHLBB or
Bank Board) and are automatically insured by the FSLIC . State
savings and loans may also join the FSLIC to obtain insurance of
accounts. Tables 1 and 2 provide a statistical picture of the jurisdiction of the various federal banking agencies.
Since its institution in the early 1930s , federal deposit insurance
has gained widespread popularity and acceptance and is now regarded as a virtual necessity for any new bank or savings and loan ;
over ninety-seven percent of banking assets are held by insured
institutions. Whether directly through control over chartering or
indirectly through control over insurance of deposits, therefore,
the federal banking agencies determine entry into the banking
business . Moreover, through their approval powers over branches
for existing banks and savings and loans , the federal banking
agencies can to a large degree control entry into new markets and
further influence the structure of banking competition.
These are not unimportant powers, but they have not been the
focus of much public attention . This study inquires into the way
these powers have been and now are exercised, and it suggests
changes in regulatory procedures. The influence that the courts
have exerted over these procedures will also be examined with
some care .
We will begin with the area of primary supervision and direct
licensing controls: approvals by the Comptroller of the Currency
of charters and branches of national banks, and by the Federal
Home Loan Bank Board of charters and branches for federal
savings and loan associations. In the case of the Comptroller, it
will be necessary to analyze a rather long and complicated sequence of
in some detail- partly to convey a picture of past
difficulties , and partly to understand the posture in which the
agency now finds itself vis-à-vis the judiciary. Then we will turn to
the area of secondary supervision : decisions to admit state chartered banks to membership in the Federal Reserve System (FRS) or
in the Federal Deposit Insurance Corporation, or to approve their
branches; and decisions to admit state savings and loans to membership in the Federal Savings and Loan Insurance Corporation .
In both instances we will be toncerned with how much discretion
has been vested in the agency in question, and the grounds and
manner of its exercise .
Thereafter we will look at these decisions in more statistical
terms- in aggregate results for all four agencies over the period
of the last five years, and in a sample study of decision files for the






, 973



Federal State

S)( tate






Insured insured

o) f

National State

S)( tate

Licensing Decisions of Federal Banking Agencies


l t
of cen
l t
of cen






percent 100
l t 100
of cen










The University of Chicago Law Review

[42: 235

Comptroller. Based on all these materials, some concluding observations and recommendations will be offered .


The Statutory Foundation

The national banking system and the office of the Comptroller
of the Currency as its administrator were established by the National Bank Act of 1864,3 which superseded the National Currency Act of 1863.4 The language of those acts of over a century
ago is reflected today in sections 12 through 27 of the United
States Code . "Associations for carrying on the business of banking" may be formed by five or more natural persons, who must
enter into and sign articles of association , a copy of which is to be
forwarded to the Comptroller.5 The organizers must also execute
and file with the Comptroller an organization certificate, giving
among other things the bank's name, place of operation, and
amount of capital stock. The amount of capital required by law
ranges from $50,000 in localities with a population of no more
than 6000 to $200,000 in cities with a population of over 50,000.7
Upon receiving this information, the Comptroller is to
examine into the condition of such association , ascertain especially the amount of money paid in on account of its capital,
the name and place of residence of each of its directors, and
the amount of the capital stock of which each is the owner in
good faith, and generally whether such association has complied with all the provisions of this chapter required to entitle it to engage in the business of banking ; . . .8
If upon that examination “it appears that such association is lawfully entitled to commence the business of banking , the comptroller shall give to such association a certificate . . . that such association is authorized to commence such business. " The Comptroller
is authorized to withhold the certificate only when "he has reason
to suppose that the shareholders have formed the same for any
other than the legitimate objects contemplated by this chapter. " 10

Act ofJune 3 , 1864, ch . 106, 13 Stat. 99.
Act of Feb. 25 , 1863, ch. 58, 12 Stat. 665.
12 U.S.C. § 21 ( 1970).
Id. §§ 22-23.
Id. § 51 .
Id. § 26.
Id. § 27.



Licensing Decisions of Federal Banking Agencies


On its face, the statute does not seem to grant the Comptroller
broad discretion to determine whether a community should have a
new bank.¹¹ This fact bothered the district court in Pitts v. Camp , 12
and yet that court declared itself "impressed with the long and
continued practice of the Comptroller of considering the need of
the community [and ] with the fact that the weight of authority accepts the consideration by the Comptroller of the need factor without question." ¹³ The court then cited Sterling National Bank of
Davie v. Camp, 14 which had asserted : "It has always been recognized
that this legislation confers vast discretion on the Comptroller to
approve or disapprove a new charter application .'
These decisions considerably overstate the matter. It has not
"always been recognized" that the National Bank Act confers vast
chartering discretion upon the Comptroller, and it has not been
his "long and continued practice " to assert such discretion . The
dominant views of the mid -nineteenth century favored "free banking," as part of the general trend towards "free incorporation ”the idea that charters to do various kinds of business should be
readily available to anyone who complied with relatively simple
and specific statutory requirements, rather than be grants of special privilege by the legislature to those who obtained (or bought)
its favors. New York and Michigan passed free-bank laws in the
1830s , and by the time of the Civil War roughly half the states had
adopted similar measures.16 The National Currency Act and the
National Bank Act were designed as free-bank laws , and with that
origin in mind their language becomes perfectly comprehensible.¹7
11. The Court has difficulty in seeing language in those sections giving the Comptroller discretion in granting the certificate if the specific requirements of the act are
met. . . .
The statutory language, which the defendant contends makes the need of the new
bank a proper consideration and commits the determination of that need to the Comptroller's discretion, does not impress the court.
Pitts v. Camp, 329 F. Supp. 1302 , 1307 ( D.S.C. 1971 ) , vacated, 463 F.2d 632 (4th Cir. 1972) ,
vacated and remanded, 411 U.S. 138 (1973) .
12. Id.
13. Id. at 1307.
14. 431 F.2d 514 (5th Cir. 1970) , cert. denied, 401 U.S. 925 ( 1971 ) .
15. Id. at 516.
official history of the Office of the Comptroller.
17. See generally id . at 44-45 . See also B. HAMMOND, Banks and Politics in America 727
( 1957) ; 2 F. Redlich , The Molding of American BANKING 99-105 ( 1968) . In practice, the
first Comptrollers tried on occasion to make their own judgments felt, but the legal footing
for their efforts was minimal. "The law did not require the organizers to satisfy the Comptroller that they were qualified to engage in the banking business, that additional banking
facilities were needed, or that the proposed bank had reasonable prospects of success. "
Wyatt, Federal Banking Legislation , in BANKING STUDIES 44 ( F.R.B. 1941 ) .



The University of Chicago Law Review


For a period of a decade following the Civil War, limitations on
the amount of national bank-note circulation served indirectly
to limit chartering of national banks , but when that condition
ended in 1875 national bank charters were available for every
qualifying group.18 For the balance of the nineteenth century,
Comptrollers not only recognized but proclaimed their lack of
chartering discretion-for example , Comptroller Knox in 1881 :
"[T]he Comptroller has no discretionary power in the matter , but
must necessarily sanction the organization . . . of such associations
as shall have conformed in all respects to the legal requirements . "
A shift in position did not begin until 1908 , when a new Comptroller took office on the heels of the Panic of 1907,20 and it did not
become established policy until the 1920s.21 This new approach
did not acquire a respectable statutory foundation, however, until
the Great Depression led to the creation of the Federal Deposit
Insurance Corporation22 and enactment of the Banking Act of
1935.23 The latter enactment required the Comptroller, when he
chartered a new national bank, which automatically would become
an insured bank, to certify to the FDIC that he had "considered"
the same six factors that the FDIC was supposed to consider in
passing upon the application for insured status of a state nonmember bank: 24 "The financial history and condition of the bank, the
adequacy of its capital structure , its future earnings prospects,
the general character of its management, the convenience and
needs of the community to be served by the bank, and whether or
not its corporate powers are consistent with the purposes" of the
Federal Deposit Insurance Act.25 In this somewhat backhanded
fashion the law recognized-or, more accurately, created-the
Comptroller's chartering discretion . To the extent that there are
standards governing that discretion, therefore, they are to be
found in the Federal Deposit Insurance Act, not the National
Bank Act.
Turning to the subject of branching, we find that it goes without
mention in the National Bank Act of 1864.26 This legislative omission was regarded by early Comptrollers as prohibiting branch


R. ROBERTSON, supra note 16 , at 57-61 .
1881 COMP. Curr. Ann. Rep. 11 .
R. ROBERTSON, supra note 16, at 66-69.
Id. at 95-96.
The FDIC was created by Act of June 16, 1933 , ch . 89 , § 8, 48 Stat. 168.
Act of Aug. 23 , 1935, ch. 614 , § 101 , 49 Stat . 684, 688 , amending 12 U.S.C. § 264.
12 U.S.C. § 1814 ( 1970).
Id. § 1816.
Act ofJune 3, 1864, ch. 106 , 13 Stat. 99.

· 48


Licensing Decisions of Federal Banking Agencies


banking by national banks ,27 a view that was confirmed by the Attorney General in 191128 and ultimately by the Supreme Court in
1924.29 Meanwhile , branching by state banks had become extensive in a number of states , and considerable pressure built up
for allowing national banks to do likewise . During the 1920s the
Comptroller responded by approving "consolidations" as a device
for obtaining branches and by authorizing "offices" that were almost branches.30
A more satisfactory answer was achieved with the passage of
first the McFadden Act of 1927,31 which permitted national banks
to have "inside" branches (located in the same city as the head office) , and then the Banking Act of 1933,32 which authorized "outside" branches (located elsewhere in the state) , in both cases only
to the extent state law expressly authorized such branches for state
banks and subject to certain additional capital requirements. Assuming the geographical and capital requirements were satisfied ,
a national bank could establish, operate or move a branch only
with the "approval" of the Comptroller.33 No standards were provided to govern the grant or denial of approval .
The statutory picture for the Federal Home Loan Bank Board is
less complicated . Section 5 of the Home Owners' Loan Act of 193334
authorized the FHLBB , "giving primary consideration to the
best practices of local mutual thrift and home-financing institutions in the United States," to provide for the organization ,
chartering, and operation of federal savings and loan associations .
Section 5 (e) of the Act went on to provide the following standards :

No charter shall be granted except to persons of good character and responsibility, nor unless in the judgment of the
Board a necessity exists for such an institution in the community to be served , nor unless there is a reasonable probability
of its usefulness and success, nor unless the same can be established without undue injury to properly conducted existing
local thrift and home-financing institutions.35
The Home Owners' Loan Act of 1933 , like the National Bank
Act of 1864 , made no reference to the subject of branches. Never27.

R. ROBERTSON, supra note 16 , at 81-85 .
29 OP. ATT'Y GEN. 81 ( 1911 ) .
First Nat'l Bank in St. Louis v. Missouri, 263 U.S. 640 ( 1924) .
R. ROBERTSON, supra note 16, at 100-04.
Act of Feb. 25 , 1927 , ch. 191 , § 7 , 44 Stat. 1228.
Act of June 16, 1933 , ch. 89, § 23, 48 Stat 189.
12 U.S.C. §§ 36(c), (e) ( 1970).
Act of June 13 , 1933 , ch. 64, § 5 , 48 Stat. 132 .
12 U.S.C. § 1464(e) ( 1970).




The University of Chicago Law Review


theless, the Bank Board from the outset took the position that it
had the power to authorize branches, and was upheld when ultimately challenged in court.36 The statute even today is silent on
branching and obviously contains no standards to affect the
FHLBB's discretion when passing upon branch applications by
federal savings and loans .
So by different routes the two agencies emerge at about the same
point. Both face a short list of general standards in the relevant
statutes for charter approvals , and no standards whatever for
branch approvals . Furthermore , the charter standards are either
too narrow or too unspecified to serve as much of a guide for or
restraint upon the exercise of discretion . Of the Comptroller's
list of six factors, the first ("the financial history and condition of
the bank") is inapplicable to new charters and the last (corporate
powers " consistent with the purposes" of the Act) is a routine formality.37 The second and third (“ adequacy of its capital structure "
and “future earnings prospects" for the Comptroller , “reasonable
probability of its usefulness and success" for the Bank Board) do
have content, but depend on a conjectural exercise in financial
prediction. The fourth (“general character of its management” for
the Comptroller, "persons of good character and responsibility"
for the Bank Board) imposes a minimal constraint , occasionally in
issue but capable of being met by millions of possible applicants
and thousands of possible managing officers . It is therefore the
fifth ("the convenience and needs of the community to be served"
for the Comptroller, “a necessity . . . for such an institution in the
community to be served" and establishment "without undue injury to properly conducted existing local thrift and home- financing
institutions" for the Bank Board) that in most cases serves as the
ground for decision . For convenience, this latter criterion will be
referred to simply as the "need" factor.
Standards so judgmental and indefinite constitute in effect a
delegation by the legislature to the administrative agency of the
task of developing public policy in this area. We shall next examine
the manner in which the two agencies have done so .

36. First Nat'l Bank of McKeesport v. First Fed . Sav. & Loan Ass'n of Homestead, 225
F.2d 33 (D.C. Cir. 1955) ; North Arlington Nat'l Bank v. Kearny Fed . Sav. & Loan Ass'n ,
187 F.2d 564 (3d Cir.), cert. denied, 342 U.S. 816 ( 1951 ) . In its branch regulation, the
FHLBB has simply repeated the statutory charter standards. See 12 C.F.R. § 545.14(c)
(1974) .
37. A simple prohibition of the exercise of inconsistent powers would suffice . Cf. 12
C.F.R. § 332.1 (1974).



Licensing Decisions of Federal Banking Agencies


Decision Procedures and Judicial Review: Pre- 1965

One way for an agency to develop law and policy is by undertaking comprehensive studies , followed by the issuance of detailed
policy statements or regulations . Neither the Office of the Comptroller nor the FHLBB has availed itself of this approach . On occasion, general statements of "philosophy" appear in public
speeches or annual reports , 38 but they have never been carried to
the point of providing enlightenment as to how a particular application might fare .
Another way to develop policy is by the common law method of
case-by-case adjudication. In the period since the Comptroller
began regularly exercising approval discretion in the 1920s and
the Bank Board started performing that function for federal savings and loans in the 1930s, the two agencies have passed upon
thousands of applications for charters and branches , granting
some and denying others. Their procedures, however, have been
quite informal and customarily have not entailed providing written opinions or explanations of the decisions .
If one had consulted the Comptroller's regulations at the beginning of 1959 for information on how to obtain approval for a new
bank or a branch, he would have found that the application was
routed through various levels of the agency, with recommendations
attached at each stage ,39 but without any form of public hearing. A
field examiner would make an "investigation" of the application,
gathering unspecified kinds of economic and market data and
visiting existing banks in the locale to ask for their views . The applicant would not know what the investigator turned up , and objectors would not generally know even what was in the application, let alone the examiner's report. On request, an applicant or
objector would usually be given a "conference " with the Regional
Comptroller or another representative, without the presence of
other parties, at which he could voice his opinions on matters that
he thought might be relevant to the outcome. "Among other matters to be considered" in the case of a new bank charter, the regulations stated , were the six factors enumerated in section 1816 of
title 12 of the United States Code.40 For a branch application , the
regulations listed additional factors :
[T]he number of branches now in operation and their location ,
the proposed location of the new branch and the distance
38. See, e.g., 1964 COMP. CURR. ANN. REP. 2-4.
39. 12 C.F: R. §§ 4.1 , 4.5 ( 1959).
40. Id. § 4.1 (b) . A modified version is now contained in 12 C.F.R. § 4.2(b) ( 1974) .



The University of Chicago Law Review


from the head office , the nearest banking facilities , . . . the nature of the potential clientele and possible business available ,
including an estimate of contemplated volume within a reasonable period of time and the prospects of successful operation of the branch together with any other pertinent factors.¹¹
The process of evaluation whereby these relevant "factors" were
translated into a decision was not described in any published
source available beforehand , and the applicant would know nothing more if ultimately he was turned down : "If the decision is unfavorable the applicants are so informed . "42 In its entire history,
the Office of the Comptroller had never held a public hearing
on an application nor published a written opinion.43
Over at the FHLBB, applicants and their opponents were faring
better procedurally but not substantively. The Bank Board customarily released charter and branch applications to the public
and scheduled public hearings44 on either a "dispensable" or "nondispensable" basis.45 Information concerning the grounds for decision was about as hard to come by, however, as with the Comptroller. For charter applicants , the regulations merely required
data "sufficiently detailed and comprehensive to enable the Board
to pass" upon the four statutory criteria ; in the case of branch applications , the regulations required an applicant to
state the need for such branch office ; the functions to be performed ; the personnel and office facilities to be provided ; the
estimated annual volume of business , income , and expenses
of such branch office ; and [submit] a proposed annual budget
of such association.46
How such data eventuated in a grant or denial of the application
was not vouchsafed to the applicant in any form of written opinion ,
however, leaving the actual policies of the Board as obscure as
those of the Comptroller.
This state of affairs was not viewed critically by authorities in
administrative law. In its 1941 report, the Attorney General's
Committee on Administrative Procedure stated , in a passage cherished by the banking agencies :

41. Id. § 4.5(a)( 1 ) (1959).
42. Id. § 4.1 (d) (charters); id . § 4.5(a)(3) (branches).
43. Bloom, Hearing Procedures of the Office ofthe Comptroller of the Currency, 31 LAW &
CONTEMP. PROB. 723 ( 1966).
44. 12 C.F.R. §§ 543.2(c) , 545.14 , 542.2 ( 1959) .
45. See Breisacher, Practice and Procedure Before the FHLBB , 16 Bus. Law. 146, 148 ( 1960) .
46. 12 C.F.R. § 545.14 ( 1959).


1975 ]

Licensing Decisions of Federal Banking Agencies


The Committee recognizes, however, that . . . in determining
whether individuals are suited to engage in a banking business ,
or whether the community needs the bank, or whether a bank
should be insured and similar questions , a congeries of imponderables is involved , calling for almost intuitive special
judgments so that hearings are not ordinarily useful . . . .
The Attorney General's Committee therefore did not recommend
that the banking agencies be covered by the formal hearing requirements of the proposed legislation , and ultimately they were
not so covered by the Administrative Procedure Act of 1946.48
Professor Kenneth C. Davis in his Administrative Law Treatise visited
the same area in 1958 and found that all was well :
Probably the outstanding example in the federal government of regulation of an entire industry through methods of
supervision, and almost entirely without formal adjudication ,
is the regulation of national banks . The regulation of banking may be more intensive than the regulation of any other industry, and it is the oldest system of economic regulation . The
system may be one of the most successful, if not the most successful . The regulation extends to all major steps in the establishment and development of a national bank, including
not only entry into the business , changes in status , consolidations, reorganizations , but also the most intensive supervision
of operations through regular examination of banks .
The striking fact is that whereas the non -banking agencies
administer their systems of requiring licenses and approvals
by conducting formal adjudications in most cases involving
controversies, the banking agencies use methods of informal
supervision, almost always without formal adjudication , even
for the determination of controversies . . . .
Even though important groups in the nation are applying
pressures to try further to judicialize the administrative process , a close study of the methods of supervision used in the
regulation of banking, as compared with the methods of
determinations on a record of formal proceeding, might well
47. ADMINISTRative Procedure in Government Agencies , S. Doc. No. 8, 77th Cong. ,
1st Sess. 142-43 ( 1941 ) .
48. Act of June 11 , 1946, ch. 324, 60 Stat. 237. Technically this is because the requirements of section 5 only apply to cases of adjudication “required by statute to be determined
on the record after opportunity for an agency hearing," and as is evident the banking statutes do not so require for this class of decisions . See 5 U.S.C. § 554(a) ( 1970) ; cf. United
States v. Florida East Coast Ry. , 410 U.S. 224 , 241 ( 1973) (rulemaking) ; United States v.
Allegheny-Ludlum Steel Corp. , 406 U.S. 742 , 756-57 ( 1972) (same).



The University of Chicago Law Review


prove that the nonbanking agencies have a good deal to learn
from the banking agencies . Banking regulation is obviously
superior in its efficiency; if, as those who are regulated seem
generally to believe, banking regulation fully measures up in
qualities of overall fairness , then the only major question remaining is relative effectiveness from the standpoint of protection of the public interest.49
The same attitude prevailed in court when judicial review of a
decision was sought. To begin with, there was no provision in the
National Bank Act or in the Home Owners' Loan Act authorizing
court review of charter and branch decisions . Thus, the only hope
of obtaining review would be an original proceeding in a district
court, probably in the form of an action for an injunction or declaratory judgment, and there was considerable doubt as to
whether the Comptroller's decisions were reviewable at all.50 So far
as reported decisions show, no denied applicant or competing
bank had ever even tried to take the Comptroller to court over a
charter decision, and of course the nature of the applicable statutory standards made the prospects of success in such a proceeding rather uninviting. The branch law, on the other hand , by incorporating state law geographical restrictions ,51 posed the possibility of narrow and specific grounds of difference with the
Comptroller's position, and so cases were undertaken . A denied
applicant lost in Michigan National Bank v. Gidney,52 but did succeed in obtaining declaratory judgment review. In 1958 the
Comptroller was for the first time enjoined from authorizing a

49. 1 K. DAVIS, ADMINISTRATIVE LAW TREATISE § 4.04 ( 1958) . Professor Davis's position
had become more critical by 1966. See Davis, Administrative Procedure in the Regulation of
Banking, 31 LAW & CONTEMP. PROB. 713 ( 1966) .
50.. See Stokes, Public Convenience and Advantage in Applications for New Banks and
Branches, 74 BANK. L.J. 921 , 930 ( 1957) : "Well informed opinion is that there is no right of
appeal from a decision of the Comptroller of the Currency."
51. 12 U.S.C. § 36(c) ( 1970):
The conditions upon which a national banking association may retain or establish and
operate a branch or branches are the following:


(c) A national banking association may, with the approval of the Comptroller of the
Currency, establish and operate new branches: ( 1 ) Within the limits of the city, town or
village in which said association is situated , if such establishment and operation are at
the time expressly authorized to State banks by the law of the State in question; and (2)
at any point within the State in which said association is situated, if such establishment
and operation are at the time authorized to State banks by the statute law of the State
in question by language specifically granting such authority affirmatively and not
merely by implication or recognition, and subject to the restrictions as to location imposed by the law of the State on State banks . . . .
52. 237 F.2d 762 (D.C. Cir. ) , cert. denied, 352 U.S. 847 ( 1956) .

52-221 O - 75 - 5



Licensing Decisions of Federal Banking Agencies


branch, in National Bank of Detroit v. Wayne Oakland Bank,5³ and in
1959 he was enjoined again in Commercial State Bank of Roseville
v. Gidney.54 All of those cases involved the question of violation of
state law requirements as to location and did not challenge the
Comptroller's judgment on approval or disapproval as such.
For the Bank Board , the picture was not much different. It had
never been challenged on a charter decision , and the only branch
challenges were to its authority to authorize branches at all55 and
not to its exercise of discretion in a particular case .
The story of the attempt to obtain review of branch and charter
decisions really begins with FHLBB v. Rowe56 in 1960 , and the beginnings were not auspicious. As in most of the early cases, the
grounds primarily relied on were procedural . The plaintiff in
Rowe, a denied charter applicant, contended that he was entitled to
a hearing conducted by the Board in accordance with Administrative Procedure Act (APA) specifications . The District of Columbia
Circuit not only rejected that contention but went on to suggest
that judicial review of a charter decision would be available , if at
all, only under rather narrow circumstances , noting that Congress
had "clearly reposed in the Board a wide discretion" and had "not
in the Act provided for judicial review of the Board's order. "57
In the context of branch applications , the APA- hearing- entitleso the
ment argument had already been tried without success ,
plaintiff in Bridgeport Federal Savings & Loan Association
FHLBB59 instead attacked the form of Board hearing actually held .
According to the complaint, the hearing was inadequate to satisfy
procedural due process, since it involved restricted opportunity
for cross-examination and denial of access to internal reports and
information upon which the Board relied in approving a competitor's branch application . In upholding the Board , the Third
Circuit saw the hearing as playing a limited and even minor role
in the decision process :

The rulings of the Board are the result of its expert judgment ,
its policy, the reports , recommendations and analyses of its

53. 252 F.2d 537 (6th Cir. ), cert. denied , 358 U.S. 830 ( 1958) .
54. 174 F. Supp. 770 (D.D.C. 1959), aff'd, 278 F.2d 871 (D.C. Cir. 1960).
55. See text and note at note 36 supra.
284 F.2d 274 (D.C. Cir. 1960).
57. Id. at 275, 277.
58. First Nat'l Bank of McKeesport v. First Fed. Sav. & Loan Ass'n of Homestead, 225
F.2d 33 , 36 (D.C. Cir. 1955).
59. 307 F.2d 580 (3rd Cir. 1962) , cert. denied, 371 U.S. 950 ( 1963).



The University of Chicago Law Review


staff, plus any special evidence it might conclude necessary to
obtain by way of hearing.60
The culmination of such judicial deference was expressed at
about this same time in Community National Bank v. Gidney ,61 when
a competing bank attempted to overturn a branch approval by the
Comptroller on two grounds- not only violation of state law location requirements , but also lack of "necessity" for establishment
of the branch. In order to show that the Comptroller had abused
his discretion, plaintiff moved for discovery of documents in the
Comptroller's files relating to the examination and evaluation of
the branch application . The court's response was unequivocal :
In passing on branch applications , the Comptroller must necessarily utilize his great expert knowledge and consider questions of policy, as well as of fact, with respect to the interest of
the public; coordination with other federal and state supervisory agencies ; and banking conditions in general .
In view of the above cases and considerations , and especially
in view of the failure of Congress to provide any standards
by which this court could determine whether the exercise of
discretion by the Comptroller was " reasonable " or whether it
was "arbitrary", this court is of the opinion that Congress intended that the Comptroller have an exclusive and unreviewable power of discretion in determining whether or not to approve the establishment of branch banks pursuant to 12
U.S.C.A. § 36(c) . The Court , therefore , is further of the opinion that the discretion provided for in 12 U.S.C.A. § 36(c)
comes within the second exception to Section 10 of the Administrative Procedure Act and that this court is without jurisdiction to review the action of the Comptroller in the present
The full reach of that language implied that the Comptroller could
not be reviewed and reversed by a court even for an unmistakenable violation of the state law location requirements of section
36(c) of title 12 of the United States Code , and of course there
was already ample precedent to the contrary on that point.63 It is
not surprising that the district judge later modified his position ; 64
yet, if confined to the issue of how far to review a banking agency's


Id. at 584.
192 F. Supp. 514 (E.D. Mich. 1961 ) .
Id. at 518-19.
See text and notes at notes 53-54 supra.
See Community Nat'l Bank v. Saxon, 310 F.2d 224 , 225 (6th Cir. 1962).



Licensing Decisions of Federal Banking Agencies


ultimate judgment in approving or disapproving a charter or
branch, the passage shows an attitude that was pervasive at the
By the early 1960s, then, the licensing decisions of the Comptroller and the Bank Board were as impenetrable a mystery—or
"congeries of imponderables”—as ever. Neither policy statements
nor regulations provided a clear understanding of why decisions
came out as they did , and no written opinions were issued at the
end of the process to provide at least retrospective enlightenment.
Competing banks were able to get a court to look at and at times
overrule the Comptroller's constructions of state law branch location requirements but otherwise he was having no difficulty
defending his results in court.65 This period proved to be the highwater mark of judicial deference to the Comptroller's informal
ways and unexplained actions, and the tide turned swiftly.

The Smithfield Case and Its Aftermath

The landmark decision came in 1965 : First National Bank of Smithfield v. Saxon.66 It presented the familiar situation of a competing
bank objecting to the Comptroller's approval of a branch, but the
Fourth Circuit came at the problem from an unfamiliar angle . The
plaintiff had won in the district court on the ground that the APA
required the Comptroller to conduct an adversary hearing.67 The
Fourth Circuit, as had others before it, rejected this argument,
holding that neither the APA nor the requirements of procedural
due process commanded that the Comptroller proceed by way of
an adversary hearing.68
But then the court turned to the question of how, in the absence
of a trial-type hearing and findings based on an evidentiary record ,
judicial review could be achieved . As the majority of the panel
saw it, a "substantial evidence" scope of review was out of place
in these circumstances ; instead , it remanded the case to the district court for a trial de novo:

On the remand of this case , the plaintiff may adduce evidence demonstrating the impermissibility of the Comptroller's
65. See, e.g. , Continental Bank v. National City Bank, 245 F. Supp. 684 (N.D. Ohio
1965) ; Bank of Dearborn v. Saxon, 244 F. Supp. 394 (E.D. Mich. 1965) , aff'd, 377 F.2d 496
(6th Cir. 1967); Peoples Bank of Trenton v. Saxon , 244 F. Supp. 389 (E.D. Mich. 1965), aff'd,
373 F.2d 185 (6th Cir. 1967); Commercial Sec. Bank v. Saxon, 236 F. Supp. 457 (D.D.C.
66. 352 F.2d 267 (4th Cir. 1965).
67. First Nat'l Bank of Smithfield v. First Nat'l Bank of E. North Carolina, 232 F. Supp .
725 (E.D.N.C. 1964).
68. First Nat'l Bank of Smithfield v . Saxon, 352 F.2d 267 (4th Cir. 1965).



The University of Chicago Law Review


approval of a branch bank at Smithfield . Testimony to the
contrary will be receivable from the Comptroller. The Court
will then find the facts. Thereon , it will judge de novo the validity, in fact and in law, of the Comptroller's final action .
If after the court has made its fact findings, it then appears that the decision of the Comptroller is dependent upon
an exercise of discretion , the Court cannot substitute its discretion for the Comptroller's. However, it can set aside such
a determination if, in the light of the facts found by the Court,
it concludes that the Comptroller has abused , exceeded , or
arbitrarily applied his discretion.69
The problem seen by the majority in trying to "review" a totally
unexplained decision was undeniably real , but the dilemma created
by its solution was effectively pointed out by Judge Sobeloff in dissent:
How can the District Court conduct a proper examination
if the Comptroller has not disclosed what issues he is resolving? The District Court is told to make its own de novo factfindings, but it is still in no position to judge how far the
Comptroller's decision rests upon fact-findings which the
court deems erroneous and how far it is an exercise of discretionary judgment . . .
The Comptroller has not divulged his mental processes , and
his determinations of fact , rulings of law and exercises of
discretion and judgment are inextricably intermingled . The
District Court is thus placed in the unhappy position of choosing between two equally unacceptable alternatives . Either it
must blindly assume that the Comptroller's discretion rests
upon an adequate basis in fact , in which event the court review
almost inevitably becomes a meaningless gesture ; or the District Court, proceeding upon the basis of facts independently
determined by it , must act in ignorance of the nature of the
decision it is reviewing, in which case the court's judgment is
liable to usurp the Comptroller's function.70
The course of judicial review since Smithfield can be seen in precisely the terms Judge Sobeloff predicted : a fluctuation between
the unsatisfactory poles of futility and usurpation .
The latter outcome promptly became evident in Bank of Haw
River v. Saxon.71 Finding the Comptroller's hearing inadequate,
69. Id. at 272.
70. Id. at 274.
71. 257 F. Supp. 74 (M.D.N.C. 1966) .



Licensing Decisions of Federal Banking Agencies


the district court proceeded with review de novo, and in the process became Comptroller for a day. On the basis of the testimony
in court, which went "far beyond that which was before the Comptroller,"72 the judge defined the service or trading area of the
branch and concluded that the area was "already considerably
over-banked . Since the present ratio of existing banking offices to
population is far in excess of both State and National averages,
there can be no question but that the existing ,banks , with resources
well in excess of two billion dollars, amply meet the capital needs of
the Graham-Burlington area."
The judge also decided that , due
to a slow rate of population growth in the locale , it would not be
economically feasible to establish a new banking facility in the area .
He concluded : "No public interest, need or necessity has been
shown for the establishment of a branch of First National in
Graham, North Carolina, and it is impermissible for the Comptroller to approve the establishment of such a branch. ”74
When the grounds for decision are made explicit, as in Haw
River, it becomes possible to subject them to examination and critique, and the opinion in Haw River certainly shows the risks that
such scrutiny entails for the decision maker. The ratio of banking
offices to population in a somewhat arbitrarily defined service area ,
as compared with state and national averages, had become the
measure of need-a measure that, in the very nature of an average, would lead to the conclusion that something like half of the
country at any given time is "over-banked " , and always will be,
which might lead one to question either the suitability of the measure or its significance .
From the Comptroller's standpoint, however, the most important aspect of a decision like Haw River is that it demonstrated the
potential of de novo review for taking over his functions— not
necessarily performing them more poorly, but depriving him of
one of the major sources of the power and prestige of his office.
Efforts were soon made to extend Smithfield's de novo review to
a theretofore sacrosanct area: charter decisions . In Webster Groves
Trust Co. v. Saxon , 75 the Comptroller was for the first time subjected
to judicial review of a charter decision , in this instance at the behest
of a competing bank objecting to a grant, but the Eighth Circuit
refused to take the additional step of review by trial de novo.


Id. at 79.
Id. at 80.
370 F.2d 381 ( 8th Cir. 1966) .



The University of Chicago Law Review


The Comptroller is free to exercise his discretion in the granting of charters , free from any review on the merits of his action . However , if the Comptroller acts in excess or abuse of
his legal authority , to this extent his actions are subject to judicial review , with the burden of proof resting on the party
seeking the review.76
Of course, if the Comptroller never disclosed the basis for his action, it would be rather difficult for the party seeking review to
show an abuse of discretion . In effect, this was the other pole of
Sobeloff's dilemma : the futility of judicial review.
When a charter case came before the Sixth Circuit in Warren Bank
v. Camp," it adopted a more qualified position on the scope of review, reading the branch and charter cases together as conferring
on the district courts “a considerable discretion in determining the
form of review required ."78 In this blurring of prior distinctions ,
a trial de novo would not be required for every complaint, but only
where the plaintiff had made out “ a prima facie case of abuse of
discretion. "79 In an effort to do that, plaintiff moved to take the
depositions of the Comptroller and several subordinates, but this
was denied, absent a showing of "a prima facie case of misconduct . " 80 "What appellant seems to us to seek is an opportunity to
depose the Comptroller in order to probe his mind as to exactly
why he saw fit to exercise his discretion as he did in relation to the
grant of this charter. This appellant clearly was not entitled to
do ," 81 noted the court, citing Morgan IV.82 The result was to suggest that review de novo might be available even in the charter
area, but to establish preconditions that seemed unlikely of fulfillment.

Even if the effects of Smithfield were to be largely confined to
branch cases, however, that was still quite enough to have a major
impact on the Comptroller's office . The Smithfield court had
grounded the need for review by trial de novo on the Comptroller's "unilateral procedure ," which, lacking any form of adversary
hearing, deprived his fact findings of "the preferred position accorded by the substantial - evidence rule" and of any "opening-presumption of correctness . "83 To regain that preferred position , the

Id. at 388.
396 F.2d 52 (6th Cir. 1968).
Id. at 56.
United States v. Morgan, 313 U.S. 409, 421-22 ( 1941 ) .
First Nat'l Bank of Smithfield v. Saxon, 352 F.2d 267 , 272 (4th Cir. 1965) .



Licensing Decisions of Federal Banking Agencies


Comptroller's office in 1966 set about redoing its procedures.84
Most of the application and field examiner's report were made
available to the parties, and "conferences" with a member of the
Comptroller's staff were replaced by "hearings" with all parties
present, of which a transcript was kept. The Comptroller even began preparing written opinions in some contested branch cases in
which litigation was anticipated . The result was to put the Comptroller in a position similar to that already achieved by the Bank
Board , so that he was able to offer the reviewing court a fairly
thick record, replete with data and arguments, instead of a mere
order defended by procedural breastworks of burden of proof
and prima facie case .
Under his new procedures, it became the Comptroller's tactic
when confronted with a complaint to submit the administrative
file to the court and move for summary judgment. The administrative file usually had portions deleted as confidential or protected
by executive privilege-for example , when they involved reports
of examination of a bank, intra-agency memoranda, derogatory
letters, or trade secrets. But a good deal of data and testimony
could be found scattered through the record and, in some cases ,
brought together in an opinion to justify the agency's conclusion.
The new procedures came back before the Fourth Circuit in
First-Citizens Bank and Trust Co. v. Camp85 and had the desired effect. The court found that the Comptroller had provided the “adversary hearing ” that was lacking in Smithfield , even if the panel
conducting the hearing before the Regional Comptroller was no
more than “an investigatory or fact-gathering organ, not having
any fact-finding function. "86 Plaintiff was therefore not entitled
to a hearing de novo in the district court ; instead , "the scope of review should not be more rigorous than the substantial evidence
rule . " 87 With the aid of the Comptroller's opinion, the court concluded that the substantial evidence test was met, and the branch
approval was upheld . If a sigh of relief issued from the Comptroller's office, however, it proved to be short lived .

The Search for Standards

Ahother significant decision in the banking field had occurred
in 1966, with the Supreme Court's construction of section 36(c) of
title 12 of the United States Code in First National Bank of Logan v.

The following description is taken from Bloom, supra note 43, at 725-26.
409 F.2d 1086 (4th Cir. 1969).
Id. at 1090.
Id. at 1095.



The University of Chicago Law Review


Walker Bank & Trust Co.88 That statute authorized "inside" branches89
for national banks “if such establishment and operation are at the
time expressly authorized to State banks by the law of the State in
question. " Utah had a “home office protection" type of branching
law, which forbade banks from opening branches in a municipality
in which other banks were operating, except by buying out one of
the existing banks and taking it over as the branch . The then
Comptroller, James J. Saxon , believed in aggressively expanding
the powers and activities of the national banking system to their
fullest statutory potential; he argued that the Utah statute "expressly authorized ” branching and that was enough for section
36(c) . Since in his view the Utah takeover restriction was a mere
specification of "method" not incorporated by section 36(c) , the
Comptroller proceeded to authorize de novo branches for two
Utah national banks .
The Supreme Court, in a unanimous opinion , gave the Comptroller short shrift:

It is a strange argument that permits one to pick and choose
what portion of the law binds him . Indeed , it would fly in the
face of the legislative history not to hold that national branch
banking is limited to those States the laws of which permit it,
and even there "only to the extent that the State laws permit
branch banking. " Utah clearly permits it "only to the extent"
that the proposed branch takes over an existing bank.
As to the restriction being a "method ," we have concluded that since it is part and parcel of Utah's policy, it was
absorbed by the provisions of §§ 36(c) ( 1 ) and ( 2) , regardless
of the tag placed upon it.⁹⁰

In itself, Walker Bank did not seem of great import, since it merely
knocked down an attempt by the Comptroller to let national banks
have de novo branches where state banks could not . But a number
of lower courts started seeing more in it than that.
One of the problems in attempting to review decisions by the
Comptroller under section 36(c) was that the statute contained no
standards whatever for approving branches . Even under a limited
scope of review like the substantial evidence test, it is necessary to
ask: substantial evidence of what? It is possible to more or less duck
the question when the court is deciding for itself, as in Smithfield's
review de novo, or is giving the form of review with little substance ,

88. 385 U.S. 252 ( 1966).
89. See text at notes 31-32 supra.
90. 385 U.S. at 261-62.



Licensing Decisions of Federal Banking Agencies


as in telling the plaintiff that he has failed to discharge the burden
of showing an unexplained decision to be arbitrary, but it is harder
for a court to duck while at the same time it is maintaining that
the decision rests on substantial evidence .
In First-Citizens , the Fourth Circuit filled the void by using Walker Bank to incorporate in section 36(c) all the standards and findings required by North Carolina law and not just its restrictions on
the "extent" of branching allowed state banks . North Carolina is
a statewide branching state that does not restrict the "extent" of
branching at all, but it does set certain standards for the exercise
of the state bank commissioner's approval authority:
Such approval shall not be given until he shall [ find ] (i) that
the establishment of such branch or teller's window will meet
the needs and promote the convenience of the community to
be served by the bank, and (ii) that the probable volume of
business and reasonable public demand in such community
are sufficient to assure and maintain the solvency of said
branch or teller's window and of the existing bank or banks in
said community.s
Although the Comptroller, with reason, argued that Walker Bank
did not face and decide the question ofwhether such broad criteria , unrelated to either the geographical location of branches or the
"manner" of obtaining them (by acquisition or de novo establishment) , were intended to be imposed on the Comptroller by section
36(c) , the general language in the opinion about not picking and
choosing what portion of the law would bind him was apparently
enough to cost him the day; the court held that he was bound by
North Carolina's "need and convenience" and "solvency of the
branch" criteria. The Fourth Circuit conceded that these were
"nebulous concepts ,,"92 resulting in a “lack of definitive direction , "93
but at least they were better than the National Bank Act and provided the court with some basis for purporting to give substantial
evidence review .

The Comptroller, consistently with his view of Walker Bank, had
not expressly made even these vague findings in First-Citizens ,
but the court was willing to infer them from the general matters
discussed in his opinion and the fact of his ultimate conclusion of
approval. Although a number of, other courts, both before and

91. N.C. GEN. STAT. § 53-62(b) ( 1965) , quoted in First-Citizens Bank & Trust Co. v.
Camp, 409 F.2d 1086 , 1090 n.5 (4th Cir. 1969).
92. 409 F.2d at 1091 .
93. Id. at 1094.



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after First-Citizens , agreed with the proposition that section 36(c)
incorporated all state law standards and findings, the Comptroller did not readily acquiesce and continued in many cases to omit
express findings in the terms required by state statutes.94 Furthermore , after 1971 , the Comptroller cut back on the practice , begun
in 1966, of writing opinions in contested branch cases .
Bank made
Since the
any required state law findings binding upon the Comptroller,96
they were in an awkward position . Some courts were willing to continue to find the necessary state law determinations "implicit❞ in
the Comptroller's approval and review on that basis.97 On occasion, the Comptroller wrote an opinion after the case went to
court, and made the state law findings expressly.98 But in other
cases , where there were no opinions and no state law findings , the

court was unwilling to indulge in implications and simply reversed
the Comptroller outright and remanded to him for reconsideration.99
The matter came to a head in First National Bank of Catawba
County v. Wachovia Bank and Trust Co. 100 In a one page per curiam
opinion, the Fourth Circuit affirmed an injunction against the
Comptroller's issuing a branch certificate : “[W]hen the Comptroller expressly declined to make the findings required by § 53-62 (b) ,
although he made numerous other findings, he acted arbitrarily
and capriciously in approving Wachovia's application to establish
a branch. . . .” 101 Faced with what amounted to a rule of automatic
reversal, the Comptroller gave up and thereafter conceded , at

94. See, e.g. , American Bank & Trust Co. v. Saxon, 373 F.2d 283 , 291 (6th Cir. 1967) ;
Citizens Nat'l Bank of S. Md . v. Camp, 317 F. Supp. 1389, 1392 (D. Md . 1970); Industrial
State Bank v. Camp, 284 F. Supp. 900, 902-03 (W.D. Mich. 1968) , vacated as moot , 421 F.2d
1361 (6th Cir. 1969).
95. Cf. Clermont Nat'l Bank v. Citizensbank, 329 F. Supp . 1331 , 1336 ( S.D. Ohio 1971 ) .
The practice had in any event been largely devoted to North Carolina cases .
96. This conclusion was somewhat strengthened by the citation of Walker Bank in First
Nat'l Bank in Plant City v. Dickinson, 396 U.S. 122 , 130 ( 1969) , for the proposition that
state law controls "when , where, and how" branches may be authorized for national banks.
See also id. at 139 (Douglas, J. , dissenting but agreeing with proposition stated).
97. See, e.g. , Clermont Nat'l Bank v. Citizensbank, 329 F. Supp. 1331 , 1344-45 (S.D.
Ohio 1971 ); First Nat'l Bank of Fairbanks v . Camp , 326 F. Supp. 541 , 545 (D.D.C. 1971 ) ,
aff'd, 465 F.2d 586, 597 (D.C. Cir. 1972) , cert. denied, 409 U.S. 1124 ( 1973) . Cf. Farmers
Nat'l Bank v. Camp , 345 F. Supp. 622 , 629 ( D. Md . 1971 ) .
98. See, e.g. , Citizens Nat'l Bank in Gastonia v . Wachovia Bank & Trust Co. , 329 F.
Supp. 585 (M.D.N.C. 1971 ) .
99. See, e.g., Citizens Nat'l Bank of S. Md . v. Camp , 317 F. Supp. 1389 (D. Md. 1970).
100. 448 F.2d 637 (4th Cir. 1971 ).
101. Id. at 638.



Licensing Decisions of Federal Banking Agencies


least in the Fourth Circuit, that he was bound by state law findings
requirements. 102
What had been gained , or lost, in this running battle? The
Comptroller apparently feared that his approval discretion would
be hobbled by a tangle of state statutory findings and fought tenaciously to avoid it. Most state statutes, however, where they contained any standards at all, were as “nebulous" and lacking in “definitive direction" as the Fourth Circuit found North Carolina's
to be, 103 or as the Comptroller's own earlier list of "pertinent factors . " 104 By the same token , reviewing courts actually gained little
in the way of standards or findings by which to examine a record
for substantial supporting evidence. In any but a superficial sense,
the Comptroller was about as free and the courts as much at sea
as before. Looking ahead , it was possible that the state standards
would gradually undergo a process of judicial construction and
administrative interpretation that would give them real meaning,
and perhaps it was this kind of development that the Comptroller
sought to avoid.105 For the moment, however, it made little real
difference if the Comptroller was forced to express his conclusion
in terms of boilerplate findings like "needs and convenience" and
"public advantage" taken from state statutes .

Probing the Comptroller's Mind and Files

Although the Comptroller has under duress provided some
form of opinion or findings at times in branch cases , charter decisions are another story. The Comptroller has never written an
opinion in a charter case, and the courts have tended to regard
his discretion in charter decisions as especially unfettered and
their scope of review as correspondingly more narrow. For over a
century the Comptroller was never taken to court over a charter
decision, so far as the records show. The first party to do so was a
competing bank complaining of a charter approval, in Webster Groves
102. Bank of New Bern v. Wachovia Bank & Trust Co. , 353 F. Supp. 643, 646 (E.D.N.C.
1972). In other circuits, the Comptroller has continued to resist. See, e.g. , First Bank &
Trust Co. v. Smith, 509 F.2d 663 ( 1st Cir. 1975).
103. See text and note at note 92 supra.
104. 12 C.F.R. § 4.5 (a)( 1 ) ( 1959) ; see text and note at note 41 supra . This regulation was
revoked on Feb. 14 , 1963 ( 28 Fed. Reg. 1584), and has not been subsequently replaced by
any list of a similar nature.
105. However, state interpretations of state standards have not thus far been accorded
much of a role under section 36(c) . See, e.g. , First Bank & Trust Co. v. Smith, 509 F.2d
663 , 666 n.2 ( 1st Cir. 1975) ; First Nat'l Bank of Fairbanks v . Camp, 465 F.2d 586, 593-97
(D.C. Cir. 1972) , cert. denied, 409 U.S. 1124 ( 1973); Howell v. Citizens First Nat'l Bank of
Ridgewood, 385 F.2d 528 , 530 (3d Cir. 1967) .



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Trust Co. v. Saxon.106 The Comptroller contended his action was
not subject to judicial review and plaintiff had no standing , contentions that run through many of these cases with a uniform lack
of success.107 But if his decision was in principle reviewable , the
absence of any opinion or explanation made review undeniably
difficult . The court handled the case before it by putting on the
plaintiff the burden of showing that the Comptroller had abused
his authority, and then holding that burden unmet.108
Under the circumstances, how could the burden be met? Obviously, the plaintiff would have to find out the reasoning that
had led the Comptroller to his conclusion before he could demonstrate something wrong with it. In Warren Bank v. Camp, 109 the
plaintiff was denied the right to seek that information directly by
taking the depositions of the Comptroller and several subordinates.110 The only other possibility was careful examination of the
administrative file , in the hope that internal memoranda and recommendations would disclose the basis upon which the final decision was made , and a number of cases tried to pursue such an examination.
It was an approach with inherent limitations— what would you
learn about the reasoning behind the Comptroller's approval of
a charter if, for example, what the file contained was staff memoranda recommending denial? That was the situation in Sterling
National Bank of Davie v. Camp , 111 but there was a thick file “ replete
with evidence which would support either view,' " 112 and the court
was untroubled :
Although we cannot chart the subjectives of his discretionary
decision, it was obviously based on a composite of many factors
and much data. To say that one fact was erroneous and that
another fact was askew is not to infest the Comptroller's exercise of discretion with the scent of arbitrariness or capriciousness sufficient to set aside his decision . 113
In other words, the Comptroller might have some of his facts
wrong, but since you couldn't tell what his reasoning process was ,

106. 370 F.2d 381 ( 8th Cir. 1966).
107. They were finally laid to rest by Association of Data Processing Serv. Orgs. v. Camp,
397 U.S. 150 ( 1970) , and Camp v. Pitts, 411 U.S. 138 ( 1973) .
108. See text and notes at notes 75-76 supra.
109. 396 F.2d 52 , 56 (6th Cir. 1968) .
110. See text and notes at notes 77-82 supra.
431 F.2d 514 (5th Cir. 1970) , cert. denied, 401 U.S. 925 ( 1971 ).
112. Id. at 516.
113. Id. at 517.


1975 ]

Licensing Decisions of Federal Banking Agencies


there was no way to be sure it made a difference, and the plaintiff
loses again .
In Olsen v. Camp, 114 the plaintiff was for the first time a charter
applicant seeking judicial review of a denial , a category of case in
which going to court is even more unrewarding because of the
limited remedy available.115 The plaintiff sought discovery of the
administrative file , but the Comptroller claimed executive privilege for a substantial portion relating to the applicant group's
background and connection to certain other banks with which the
banking agencies were having supervisory differences. Since it
seemed likely this was the primary ground of the decision in the
case, the court was unwilling to simply uphold the claim; it ordered
some of the documents produced and the rest submitted to it in
camera for review, partial excision , and release.
Similarly, in Klanke v. Camp116 the court ordered the Comptroller to release to the plaintiffs "all Government records pertaining
to the denial of plaintiffs' charter application ," 117 though it later
allowed part to be withheld . But the court itself characterized obtaining judicial review based on the administrative file as "a hollow victory, " since the Comptroller would be "insulated from judicial
interference merely upon evidencing a minimal basis in reason
for his denial. " 118 The accuracy of that characterization was subsequently borne out, when the Comptroller obtained summary
judgment because the plaintiffs had not discharged the “onerous
burden" of showing that the Comptroller's decision was "totally
devoid of any rational foundation . "119
There were also attempts in some of the branch cases to open up
the administrative file more fully, in an effort to ascertain the
basis for decisions. Thus, the protestant in Citizens National Bank
of Southern Maryland v. Camp120 wanted to know the full content of

114. 328 F. Supp . 728 (E.D. Mich. 1970) .
If a competing bank prevails in a challenge to a branch or charter approval, it gets
an injunction and thereby blocks or delays the additional competition. But if an applicant
were to successfully challenge a denial, it would not get an order to the Comptroller to issue the desired approval, for that would in effect be mandamus relief which is not available
in so judgmental and discretionary an area. See, e.g. , Byse & Fiocca, Section 1361 ofthe Mandamus and Venue Act of 1962 and "Nonstatutory"Judicial Review of Federal Administrative Action,
81 HARV. L. REV. 308 , 332 ( 1967) . Instead, it would get a remand to the Comptroller with
instructions to correct his errors and reconsider, a prize of dubious value if the Comptroller remains unfavorably inclined.
116. 320 F. Supp. 1185 (S.D. Tex . 1970) .
117. Id. at 1188.
118. Id.
119. Klanke v. Camp , 327 F. Supp. 592 , 593-94 (S.D. Tex . 1971 ).
120. 317 F. Supp . 1389 (D. Md. 1970).



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the application and administrative file , parts of which had been
withheld as confidential . He obtained a judicial order that, after
remand, any undisclosed material should be submitted to the
court in a sealed record for in camera inspection.
Over the course of the decade , therefore , the Comptroller had
been forced to reveal most of the administrative file on branch
and charter decisions , though he was still keeping a portion of it
confidential, at least from litigants . Once revealed , however, it
proved only moderately enlightening. For a court concerned only
lest the Comptroller be doing something totally absurd or unfair,
the contents of the file were generally sufficient to support an affirmance . But for anyone seeking to understand the Comptroller's
values and policies and reasoning process , a file filled with varied
and conflicting views of subordinates provided disappointingly
little help .

The Renewed Assault

To sum up "progress" by 1971 , then, the Comptroller had been
led, or coerced , into adopting a more formalized hearing procedure . As revised anew in 1971,121 the Comptroller's regulations
required notice by publication of applications for branches or
charters, and the Regional Administrator of the Comptroller's office was required to notify local banks.122 On request, a hearing
would be held, primarily as an opportunity for protestants to
voice their objections . The application and field examiner's report and any filed objections were part of the public file , except to
the extent parts were excluded as confidential.123 At the hearing,
the applicant would usually introduce his application and rest ,
leaving it to the protestants to call witnesses (whose attendance
was voluntary and testimony unsworn) and submit evidence.
Though all parties were in the dark as to the Comptroller's precise standards, if any, there was a customary pattern-the protestant would try to show that the described service area was too
large, that when properly drawn it was overbanked already, and
that the local economy was stagnant, while the applicant would try

121. 36 Fed. Reg. 6888 ( 1971 ) .
122. 12 C.F.R. § 5.2 ( 1974).
123. Id. at § 5.3 . Most of the exclusions are based on claims that the information consists of either business trade secrets or derogatory comments on the applicant or protestants.
Reliance on the latter raises problems familiar from the days of the employee loyalty/security programs. Cf. Cafeteria & Restaurant Workers Union v. McElroy, 367 U.S. 866 ( 1961 ) ;
Greene v. McElroy, 360 U.S. 474 ( 1959) . But in very few cases do such considerations seem
to be of actual importance in the outcome. See text at note 214 infra.



Licensing Decisions of Federal Banking Agencies


to show the opposite. A transcript would be kept, at the protestant's expense, which if counsel were adept would be “ replete with
evidence which would support either view' " and contain “many
factors and much data. " 124 Some time thereafter, the Comptroller
would announce that he had approved or disapproved the application.
If it was a charter case, the Comptroller never wrote an explanatory opinion, though when he was taken to court in Klanke v.
Camp125 he did submit an affidavit which “ explained " his denial on
all available grounds. 126 By restricting its scope of review and putting all the burden on plaintiff, the court was able to find such a
purely conclusory "explanation", or none at all , sufficient.
For a while , the Comptroller wrote opinions in some branch
cases, but then he decided to cut back. Under the new practice ,
apparently the Comptroller would wait to see if suit was filed , and
then supply some explanation if necessary by requesting a remand
for that purpose127 or by simply mailing out a belated opinion . '
The courts insisted that the Comptroller's opinion or administrative file in some way support the findings required by state law,
but those too were "nebulous" and unhelpful .
In short, half a dozen years of litigation through numerous cases
had accomplished remarkably little in understanding just why the
Comptroller decided as he did.129 Once again , judicial patience
wore thin, and a series of reversals for the Comptroller followed .
The district court in Bank of New Bern v. Wachovia Bank & Trust
Co. 130 contemplated North Carolina's nebulous standards for
branches and felt "constrained to establish its own guidelines,"
coming up with a list of seven factors. 131 The court then applied

124. See text and notes at notes 111-13 supra.
125. 320 F. Supp. 1185 (S.D. Tex. 1970) .
126. The Comptroller informed the court that he
was convinced, among other reasons, that there was no adequate need for a banking
facility at the proposed location ; that the ability and experience of the proposed organizers was insufficient; that the requested new bank would not be successful under
its proposed leadership ; that the objects contemplated by the National Bank Act
would not be served; and that the granting of the charter application would be
detrimental to the public interest.
127. See, e.g., Farmers Nat'l Bank v. Camp, 345 F. Supp. 622, 624 (D. Md . 1971 ) .
128. See Citizens Nat'l Bank in Gastonia v. Wachovia Bank & Trust Co. , 329 F. Supp .
585, 586 (M.D.N.C. 1971 ) .
In 1969 Professor Davis thought he could discern a significant trend in the Comptroller's office toward reasoned opinions and controlled discretion, but the trend unfortunately died a-borning. See K. DAVIS, DISCRETIONARY JUSTICE 120-26 ( 1969).
130. 353 F. Supp. 643 (E.D.N.C. 1972).
131. Id. at 647-48.



The University of Chicago Law Review


these factors to the record evidence and Comptroller's opinion ,
attached its own weights , concluded that there would not be substantial evidence to support an approval , and accordingly granted
the plaintiff summary judgment against the Comptroller . New Bern
is not far removed from Haw River132 in its willingness to take over
the Comptroller's function , though it employed the language of
substantial evidence review rather than review de novo.
In Pitts v. Camp, 133 the Fourth Circuit encountered its first case
of charter review. Apparently there were no serious protestants ,
for no hearing on the application was requested or held . The
Comptroller disapproved the application and as usual wrote no opinion, simply informing the applicant by letter that :
On the basis of information developed by our Field Investigation, together with all other pertinent data relating to the
proposal, we have concluded that the factors in support of the
establishment of a new National Bank in this area are not
favorable. 134
Upon requesting and receiving reconsideration and submitting
additional data, the applicant group got a letter of renewed denial
and a glimmer of further explanation : “[W] e were unable to reach
a favorable conclusion as to the need factor. The record reflects
that this market area is now served . . . ." 135 The letter then listed
one bank, two savings and loans and one credit union servicing
the market area, which in no way distinguished the locale from a
great many others in which the outcome had been favorable .
Instead of manipulating procedural rules and a narrow scope of
review to sustain the Comptroller's ruling, the Fourth Circuit
pronounced it "unacceptable. ” “ It does not comply with the bare,
fundamental principle of agency decision : that its basis must be
stated . " 136 The court cited FTC v. Sperry & Hutchinson Co.137 and
Chenery 1138 for the proposition that the "orderly functioning of
the process of review requires that the grounds upon which the
administrative agency acted be clearly disclosed .
"139 The court

132. See text and notes at notes 71-74 supra.
133. 463 F.2d 632 (4th Cir. 1972) , vacated, 411 U.S. 138 ( 1973) , remanded , 477 F.2d 593
(4th Cir. 1973).
134. Id. at 633. This is the standard letter of denial.
135. Id.
136. Id.
137. 405 U.S. 233 ( 1972).
138. SEC v. Chenery Corp. , 318 U.S. 80 ( 1943) .
139. 463 F.2d at 633.

52-221 O - 75-6



Licensing Decisions of Federal Banking Agencies


remanded the case to the district court for a trial de novo, since
the Comptroller had twice "inadequately and inarticulately resolved the appellants' presentation. "140 In essence , seven years
after Smithfield, the court was back about where it started and again
had recourse to review de novo as a means of putting pressure on
the Comptroller to change his practices.
The United States District Court for the District of Columbia
took a different tack in Wood County Bank v. Camp , 141 in form a
protestant's appeal from a charter approval.142 The district court
found what none before it had been able to find-a fifth amendment procedural due process requirement for findings and reasons
by the Comptroller to support his decision, which the court characterized as adjudicatory in nature.143 Although the court could
muster little precedent for that requirement, it offered a number
of "practical reasons" that it found compelling:
The foremost of these is the facilitation of judicial review.
The Court is confronted here with an Administrative
Record of over a thousand pages of testimony, complex technical data, and recommendations of the investigating National
Bank Examiner and various members of the Comptroller's
staff. For the Court to properly review such a record in as
complex an area as the banking field and without the benefit
of the Comptroller's underlying reasoning cannot expeditiously be done . As Mr. Justice Cardozo said . . . "We must know
what a decision means before the duty becomes ours to say
whether it is right or wrong."
A second important reason for requiring findings is to prevent a reviewing Court from usurping the administrative factfinding function. For a Court to refrain from such encroachment of administrative function, a Court must know what
facts were found . . . .
A third practical reason for administrative findings is to
protect against careless or arbitrary action. 144

140. Id . at 634.
141. 348 F. Supp. 1321 (D.D.C. 1972) , vacated, 489 F.2d 1273 (D.C. Cir. 1973 ) .
The substance was closer to a branch approval : the applicant was an existing bank,
applying for a new charter as a branch-substitute in a unit banking state.
143. 348 F. Supp. at 1325.
144. Id. at 1326-27 (footnotes omitted).



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The court therefore ordered the case remanded to the Comptroller to supply findings and conclusions "sufficient for the
" 145
Court to grant Plaintiff the judicial review to which it is entitled ."
In increasing trouble once more , the Comptroller appealed Wood
County Bank to the District of Columbia Circuit and took Pitts to
the Supreme Court on a petition for certiorari.


Pitts and its Interpretation

The Comptroller in Camp v. Pitts 146 did not challenge before the
Supreme Court the Fourth Circuit's holding that his letters of explanation were inadequate for judicial review, 147 but he did attack
the procedure of remand to the district court for trial de novo.
The Supreme Court agreed :
It is quite plain from our decision in Citizens to Preserve Overton Park v. Volpe . . . that de novo review is appropriate only
where there are inadequate factfinding procedures in an adjudicatory proceeding . . . . [T] he only deficiency suggested in
agency action or proceedings is that the Comptroller inadequately explained his decision . As Overton Park demonstrates ,
however, that failure , if it occurred in this case, is not a deficiency in factfinding procedures such as to warrant the de
novo hearing ordered in this case . 148
Instead, said the Court, the proper remedy for an inadequate
explanation is to get more , by way of either affidavits or testimony,
to add to the administrative record . Since the Comptroller had already indicated the "determinative reason " for his denial , 149 that
was the ground that had to be supportable on the record with the
aid of the additional explanation.150 If it was not, then the proper

145. Id. at 1329.
146. 411 U.S. 138 ( 1973) .
147. 463 F.2d at 633-34.
148. 411 U.S. at 141-42 . De novo findings of fact and determination of the ultimate result should be distinguished from de novo review on questions of law; courts routinely review questions of law de novo in appeals from administrative decisions. See Seattle Trust &
Sav. Bank v. Bank of Cal. , 492 F.2d 48 (9th Cir. 1974) .
149. In the Court's rendition, this reason was "the finding that a new bank was an uneconomic venture in light of the banking needs and the banking services already available
in the surrounding community." 411 U.S. at 143 .
The appropriate standard of review for this purpose, the Court also held , was that
of section 10(e) ( 2) (A) of the APA: "whether the Comptroller's adjudication was ' arbitrary,
capricious, an abuse of discretion or otherwise not in accordance with law .' " Id . at 142, quoting from 5 U.S.C. § 706(2 )(A) ( 1970) . The "substantial evidence" test was deemed appropriate for reviewing findings based on a hearing record, which the statutes in question here do
not require. 411 U.S. at 141. Presumably, the former standard is a less demanding one af-


1975 ]

Licensing Decisions of Federal Banking Agencies


course was to vacate the Comptroller's decision and remand to him
for further consideration .
The Supreme Court therefore seemed to take away the only
club the Fourth Circuit had found effective in trying to change the
Comptroller's ways—de novo review. That method had always involved a more or less open intrusion upon the functions assigned
to the Comptroller by Congress , and was therefore inappropriate,
as the Court declared . What was regrettable was the Court's apparent unawareness of the eight years of running struggle between
the Comptroller and the lower courts, in which effective judicial
review had been frustrated determinedly and continuously.

On the other hand , the Court certainly left the door open for
the lower courts to force explanations that they could find comprehensible. Indeed , as Pitts made clear, Overton Park had limited
the rule of Morgan IV, about not probing into the mental processes
of decision makers by deposition or examination as witnesses, to
situations in which the decision maker had made formal findings
on a record . 151 That overruled Warren v. Camp152 and other cases
holding that the Comptroller could not be examined or deposed ,
and if litigants pursued the opportunity it would become a new
club of some force . If the Comptroller's inevitable objections about
the burden on his office were not received sympathetically, he
would almost surely move to forestall the embarrassments of crossexamination by providing fuller explanations—if not in contemporaneous opinions then through litigation affidavits. And if he
did not, the court was free to remand .
But if the door to more intelligible explanation was still open,
the general tenor of the opinion in Pitts was not very encouraging.
This can best be shown by examining how lower courts have subsequently used or construed Pitts . The District of Columbia Circuit vacated Wood County Bank and remanded it to the district
court for reconsideration in light of Pitts , and the district court felt
constrained to grant the Comptroller's motion for summary judg-

fording narrower review, but the distinctions involved have never been very clear. For example, would a finding not supported by evidence that was at least substantial not also be an
abuse of discretion? Courts now know which language to use , but it is not evident that they
will go about their job much differently; a district court subsequently considered the question in Grenada Bank v. Watson, 361 F. Supp. 728, 733 (N.D. Miss. 1973), aff'd, 488 F.2d
1056 (5th Cir. 1974) , and found "no substantial difference" between the two standards.
More recent and authoritative, if not more enlightening, discussion may be found in Bowman Transp. , Inc. v. Arkansas- Best Freight Sys. , Inc. , 95 S. Ct. 438 , 441-42 ( 1974) .
151. See Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402 , 420 ( 1971 ) .
152. 396 F.2d 52 (6th Cir. 1968) . See text and notes at notes 77-82 supra.



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[42 : 235

ment, though not without considerable protest.153 The court concluded with a plaint that in cases like Pitts judicial review was impossible and with a plea to Congress to put the Comptroller under
the hearings and findings requirements of the APA.
In First National Bank of Homestead v. Watson , 154 a competitor
challenge to a charter approval , the court cited Pitts for the proposition that, absent a showing that his action was arbitrary or
capricious, the Comptroller was under no obligation to explain
his decision.155 In Grenada Bank v. Watson , 156 the Comptroller had
without opinion approved a branch on the basis of the usual thick
hearing record plus brief and conflicting recommendations from
subordinates ; the court went back to implying state law findings
and noting that the record contained evidence that might, on
some theory, support them. Pitts was cited to the effect that the
Comptroller's decision must be upheld unless the record indicates
that it is “ arbitrary, capricious, an abuse of discretion or otherwise
" 157
not in accordance with law
The plaintiff in Bank of Commerce of Laredo v. City National Bank
of Laredo 158 requested remand to the district court to obtain from
the Comptroller some explanation of his charter approval as a
branch substitute for the defendant, but was turned down flatly
by the Fifth Circuit in a remarkably obtuse opinion. The court
cited Morgan IV and the pre-Overton Park banking cases for the
proposition that the plaintiff was barred by the "preponderant
weight of judicial precedent" from deposing the Comptroller or
requiring him to answer interrogatories. 159 Overton Park itself was
ignored, and Pitts was cited as a recent affirmance of this policy,
though the opinion had said the exact opposite.160 The real point

153. [ I ]n the case at Bar the Comptroller attempted to explain in three short sentences
his analysis of 1000 pages of economic data contained in the administrative record. . . .
The Comptroller explained his determinative reasons for the action taken by stating
summarily that the new bank would serve the convenience and needs of the relevant
market and have no serious effect on the existing institutions now serving the general
area. Under present requirements of procedural due process governing the Comptroller's decisions . . . the Court is constrained to deem the Comptroller's explanation sufficient.
Wood County Bank v. Camp, Civil No. 1277-72 (D.D.C. , May 24, 1973), aff'd, 498 F.2d
1063 (D.C. Cir. 1974) . See WASH. FIN. REP. , at T-2 (June 4, 1973) .
154. 363 F. Supp. 466 (D.D.C. 1973) .
155. Id. at 468.
156. 361 F. Supp . 728 (N.D. Miss. 1973) , aff'd, 488 F.2d 1056 (5th Cir. 1974).
157. Id. at 735.
158. 484 F.2d 284 (5th Cir. 1973) , cert. denied , 416 U.S. 905 ( 1974) .
159. Id. at 287.
160. “ If, as the Court of Appeals held and as the Comptroller does not now contest,
there was such failure to explain administrative action as to frustrate effective judicial re-



Licensing Decisions of Federal Banking Agencies


in Laredo was that the Fifth Circuit did not in that case feel any
need for additional explanation to undertake judicial review, ¹
and that in turn rested upon a willingness to hold the Comptroller
to a generous and undemanding standard—the court was willing
to glean from the staff recommendations and a “voluminous record" what " surely" was the determinative reason for the approval . 162
In Merchants & Planters Bank v. Smith163 the district court applied the limited scope of review of Pitts to a branch approval , suggesting it was sufficient if the Comptroller's determination had “a
rational basis in fact. " 164 Untroubled by the lack of any findings ,
conclusions, or opinion, the court pieced together conflicting file
memoranda and constructed what it felt "the agency thinking" must
have been. Needless to say, the Comptroller was sustained .
The only contrary note was First National Bank of Fayetteville v.
Smith , 165 reversing the Comptroller's approval of a charter in a
manner reminiscent of Haw River.166 The recommendations of
subordinates having gone four to one against approval, the court
concluded that the Comptroller must have accepted and relied
upon the grounds given in the one favorable recommendation , and
that advice became in effect the Comptroller's findings to be tested
against the record . 167 After noting that the standard for review was
whether the Comptroller's action was arbitrary or capricious, or
had no rational basis in the record , the court then waded through
the record-considering how much capital would be adequate,
choosing one expert over another on the bank's earnings prospects ,
judging whether the "need " would be better met by branches ,
and weighing the qualifications of the applicant group and proposed managing officer. Subsequently, however, the Eighth Circuit reversed this decision on the ground that the district judge,
though stating the correct standard of review, had actually exercised an independent judgment in place of that of the Comptrol-

view, the remedy was not to hold a de novo hearing but, as contemplated by Overton Park,
to obtain from the agency, either through affidavits or testimony, such additional explanation of the reasons for the agency decision as may prove necessary." Camp v. Pitts, 411 U.S.
138, 142-43 ( 1973).
161. 484 F.2d at 288.
162. Id.
163. 380 F. Supp. 354 (E.D. Ark. 1974) .
164. Id. at 356.
165. 365 F. Supp. 898 (W.D. Ark. 1973) .
166. See text and notes at notes 71-74 supra.
167. 365 F. Supp. at 904.



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ler; 168 the failure of the Comptroller to provide even a hint as to
how his own judgment had been arrived at occasioned no adverse
comment at all .
So judicial review of the Comptroller's decisions that is both
limited and intelligent seems to be a goal that is as far away as
ever. Even without trial de novo, there still seems to be only the
unattractive choice between pro forma endorsement and taking
over the policy judgments that were supposed to be the duty of
the Comptroller. An intermediate role for the courts is simply not
feasible unless the Comptroller can and will provide a clear and
consistent explanation of what he is doing, and that has not been
forthcoming .

The FHLBB Revisited

Meanwhile, during what for the Comptroller was a most turbulent decade , the Federal Home Loan Bank Board has sailed
along with remarkably little disturbance . It is true that the Bank
Board had no state law limitations on branches169 to raise issues of
interpretation and lead to litigation, and also that the Board was
from the outset willing to hold hearings and build up a record for
court inspection. The Board's position was therefore much less
vulnerable than the Comptroller's ; there were fewer obvious
points of attack. And certainly early decisions like Rowe 170 and
Bridgeport Federal171 would be discouraging to any would-be litigant, 172
But as the Comptroller's judicial battles created new doctrines ,
some of them had a clear potential for application to the Board
as well . And in 1970 the Board amended its rules for charter and
branch applications , 173 reducing the trial-type hearing that it had

168. First Nat'l Bank of Fayetteville v. Smith, 508 F.2d 1371 (8th Cir. 1974), petition
for cert. filed, 43 U.S.L.W. 3439 (U.S. Feb. 4 , 1975) (No. 963) .
169. Except to the extent the Board has imposed them on itself by regulation. See Lyons
Sav. & Loan Ass'n . v. FHLBB , 377 F. Supp. 11 (N.D. Ill. 1974); 12 C.F.R. § 556.5(b)( 1 )
170. FHLBB v. Rowe, 284 F.2d 274 (D.C. Cir. 1960) . See text and notes at notes 56-57
171. Bridgeport Fed. Sav. & Loan Ass'n . v. FHLBB, 307 F.2d 580 (3d Cir. 1962) . See
text and notes at notes 59-60 supra.
172. These decisions were reinforced by some of the observations about the Board's
“exclusive discretion" in Central Sav. & Loan Ass'n of Chariton v. FHLBB, 293 F. Supp . 617,
623-24 (S.D. Iowa 1968) , aff'd, 422 F.2d 504 , 507 (8th Cir. 1970), which upheld the Board's
authority to permit federal savings and loans to operate "mobile facilities," a sort of traveling branch.
173. See 35 Fed. Reg. 2509, 2510-12 ( 1970).



Licensing Decisions of Federal Banking Agencies


been holding for many years to a procedure involving the submission of written protests and an opportunity for brief oral argument thereon.174
New attacks by competing associations were, nevertheless , as
unsuccessful as before . In Guaranty Savings & Loan Association v.
FHLBB175 the court upheld this truncated "oral argument" procedure, and seemed to suggest that the Board's discretion over
branching was so wide as to constrict judicial review almost to the
point of nonexistence . And in Benton Savings & Loan Association v.
FHLBB176 the Board's resolution of branch approval in conclusory
boilerplate was likewise sustained , the court noting that Pitts had
been construed "to relieve the Comptroller and, by analogy, the
Home Loan Bank Board of any obligation to state with specificity
the reasons for their decision . "177

In 1974 the Board carried this truncation process yet another
step, amending the branch regulation to make oral argument available to a competitor only if it had filed a “ substantial" protest.178
In theory, this ever-widening divergence from the model of decisions based upon evidentiary hearings is going to increase the risk
that a court will hold the agency's factfinding procedures inadequate ; the Supreme Court in Overton Park listed that conclusion as
one of the two grounds that would justify de novo review.179 Yet so
far the courts have not developed the same disenchantment with
the Board's decision making that the Comptroller has managed
to evoke, and the evident possibility seems but a distant cloud.180
II .


Next we turn, more briefly, to the role of federal banking agencies with respect to state-chartered institutions . A state agency
is the primary supervisor for such institutions , making decisions

174. 12 C.F.R. §§ 543.2(e) , (f) and 545.14(g) , (h) ( 1971).
175. 330 F. Supp . 470 (D.D.C. 1971 ) .
176. 365 F. Supp . 1103 ( E.D. Ark. 1973) .
177. Id. at 1104. The Board has, however, written opinions in letter form since 1968 in
some cases where litigation was anticipated , and has said that its present policy is to issue
explanatory opinions whenever requested.
178. 39 Fed. Reg. 789 ( 1974) . This is in line with the Bank Board's current "general
policy ... to encourage expansion through branching;" see 12 C.F.R. § 556.5(b)(5) ( 1974),
which also contains the wonderfully elusive warning that protests "will have to be increasingly persuasive" to have any effect.
179. Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402 , 415 ( 1971 ) .
180. The most recent tranquil acceptances of the Board's branch procedures are to be
found in Lyons Sav. & Loan Ass'n v. FHLBB, 377 F. Supp . 11 ( N.D. Ill . 1974) and Elm
Grove Sav. & Loan Ass'n v. FHLBB, Civil No. 72-C-305 ( E.D. Wis. , Mar. 3, 1975) .



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on charter and branch approvals and otherwise regulating their
investments and activities. But access to federal deposit insurance
is controlled by federal agencies and is for practical purposes as
necessary to commencement of operations as a charter.181 In admitting state institutions to membership and thereby to deposit
insurance, therefore , the Federal Reserve Board (FRB ) , Federal
Deposit Insurance Corporation, and Federal Savings and Loan
Insurance Corporation perform a sort of secondary charter approval function. Likewise, when a bank gets approval for a branch
from its state supervisor, it also has to obtain approval from the
FRB or, if not a member of the Federal Reserve System, from the
FDIC . There is, however, no counterpart requirement for insured
savings and loans to get branch approval from the FSLIC .
In performing these secondary approval functions , particularly
for branches , one would expect the federal agencies to play a narrower and more limited role than the primary supervisor making
the initial determination; but the process is not wholly an automatic endorsement of what the state has approved . Although the
court cases are few, the general picture is not dissimilar to the one
we have traced for primary approvals : a dearth of standards , a
lack of hearings, and the absence of opinions.


Federal Reserve Board

A state bank desiring membership in the Federal Reserve System makes application to the system's Board of Governors "under
such rules and regulations as it may prescribe "; 182 by way of standards the statute merely states that the Board "shall consider the
financial condition of the applying bank, the general character
of its management, and whether or not the corporate powers exercised are consistent with the purposes" of the Federal Reserve
Act. 183 The "financial condition" factor is amplified somewhat by
the requirement that a bank may not be admitted to membership
"unless it possesses capital stock and surplus which, in the judgment of the Board . . . are adequate in relation to the character
and condition of its assets and to its existing and prospective deposit liabilities and other corporate responsibilities. " 184 In addition ,
for a newly organized state bank that is not already insured , the

181. See Tables 1 & 2, p. 237 supra.
182. 12 U.S.C. § 321 ( 1970) .
183. Id. § 322.
184. Id . § 329.



Licensing Decisions of Federal Banking Agencies


Board must certify to the FDIC that it has "considered" the list of
six factors contained in section 6 of the Federal Deposit Insurance
Act.185 The rules and regulations prescribed by the Board for
membership applications are to be found in Regulation H,186 which
consists primarily of an assemblage of the pertinent statutory provisions and is thus not informative about additional bases of decision.
For the establishment of branches by a state member bank, the
approval of the FRB must be obtained.¹87 The statute says nothing
whatever about approval standards, and the regulation merely
notes that the request for approval "should be accompanied by
advice as to the scope of the functions and the character of the business which . . . will be performed by the branch and detailed information regarding the policy .
proposed to be followed with
reference to supervision of the branch by the head office. . . . " 188
There are no reported cases challenging either approvals or
denials of membership or branch applications . In Apfel v. Mellon , 189
the petitioner sought mandamus to force the FRB to approve an
application to form an Edge Act corporation, 190 another vehicle
for engaging in foreign banking; the argument was over whether
the statutory reference to approval by the FRB imported the exercise of judgment and discretion, and the court held that it did .
And in Old Kent Bank & Trust Co. v. Martin 191 there is one judge's
comment that, as to branches , “ [s ]ince 12 U.S.C.A. § 321 incorporates the policy of Section 36 , the Board's discretion over state
member banks must be construed as broadly as that of the Comptroller of the Currency . " 192

185. Id . § 1814. See text and note at note 25 supra.
186. 12 C.F.R. § 208 ( 1974). See also 12 C.F.R. § 265.2(f) (26) ( 1974).
187. 12 U.S.C. § 321 ( 1970) . This has been construed to apply only to de novo establishment and not to acquisition of branches by merger. Old Kent Bank & Trust Co. v.
Martin, 281 F.2d 61 (D.C. Cir. 1960) . The distinction is now moot since the Board's approval must be obtained anyway for a merger in which a state member bank is the surviving party, 12 U.S.C. § 1828 (c)(2) (B) ( 1970) .
188. 12 C.F.R. § 208(c) ( 1973) . The FRB has delegated its authority to approve domestic branches to the regional Federal Reserve Banks and to the Director of the Division of
Supervision and Regulation , in a manner that contains additional standards . 12 C.F.R.
§ 265.2(f) ( 1) , (c)( 10) ( 1974) . For foreign branches, the Board exercises approval authority
over national banks as well. 12 U.S.C. § 601 ( 1970) ; 12 C.F.R. § 213.3 (a) ( 1974) . If a branch
is denied, the Board will provide a “simple statement" of the grounds . 12 C.F.R. § 262.3 (e)
189. 33 F.2d 805 (D.C. Cir . 1929) .
190. See 12 U.S.C. §§ 611 et seq . ( 1970) .
191. 281 F.2d 61 ( D.C. Cir. 1960) .
192. Id . at 68 (dissenting opinion) .



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When a state bank that is not a member of the Federal Reserve

System applies for deposit insurance , the FDIC is supposed to “consider" the six factors which we have already noted 193 and also to
"determine , upon the basis of a thorough examination of such
bank, that its assets in excess of its capital requirements are adequate to enable it to meet all of its liabilities to depositors and
other creditors as shown by the books of the bank,” 194 a requirement designed for operating banks rather than newly formed ones .
The same six factors are to be considered by the FDIC in deciding
whether to approve new branches for insured state banks that
are not FRS members.195 The regulations add nothing except
some information about application forms and where to file
There are no reported cases involving judicial review of FDIC
decisions on membership and branch applications.197


The provisions governing applications for insurance of accounts
by state chartered savings and loans198 are to be found in section
1726(c) of title 12 of the United States Code :
The Corporation shall reject the application of any applicant if it finds that the capital of the applicant is impaired or
that its financial policies or management are unsafe ; and the
Corporation may reject the application of any applicant if it
finds that the character of the management of the applicant or
its home financing policy is inconsistent with economical home
financing or with the purposes of this subchapter. . . . In considering applications for such insurance the Corporation shall
give full consideration to all factors in connection with the fi-

193. 12 U.S.C. § 1816 ( 1970) . See text at note 25 supra.
194. 12 U.S.C. § 1815 ( 1970) .
195. Id . § 1828(d) .
196. See 12 C.F.R. §§ 303.1 , 303.2 , 303.10 , 304.3 ( 1973) . Authority to approve branches,
if certain conditions are met, has been delegated to the ' Director of the Division of Bank
Supervision. 12 C.F.R. §§ 303.11 (d)( 7) , 303.12 (c) ( 1974) .
197. The nearest approach is Magellsen v. FDIC, 341 F. Supp. 1031 (D. Mont. 1972) , a
tort action for money damages against the FDIC which was dismissed for failure to follow
the procedures required by the Federal Tort Claims Act; it contains some general references
to the FDIC's discretion in passing on insurance applications.
198. It is the “duty” of the FSLIC to insure the accounts of federal savings and loans .
The FSLIC is run by the three-man Federal Home Loan Bank Board , which charters federal savings and loans; for federal associations, therefore, the insurance decision is essentially part of the chartering decision.



Licensing Decisions of Federal Banking Agencies


nancial condition of applicants and insured institutions, and
shall have power to make such adjustments in their financial
statements as the Corporation finds to be necessary.
In these applications , since a newly organized savings and loan
will not have impaired capital and normally will assert that its financial and home financing "policies" will be whatever is necessary
for approval, the pivotal statutory criteria become "the character
of the management" and "all factors" in connection with financial
condition . The regulations do not expand upon these rudimentary criteria , but do contain a description of internal processing200 and a procedure for public notice of applications and opportunity for oral argument.201 As we have previously noted, the
FSLIC does not have any approval authority over the establishment of branches by state-chartered members.
There are no reported cases challenging FSLIC decisions to
grant or deny insured status to an applying institution .


Court cases and judicial opinions do not provide a comprehensive picture of agency decision making, since they are concerned with but a small and probably atypical fraction of all applications. We turn, therefore , to an overall statistical summary of
the licensing decisions of the federal banking agencies, and then
to a more detailed examination based upon a sample of actual decision files .

The Statistical Picture

The following tables show the licensing decisions of the four
agencies over the five year period from 1969 to 1973 , inclusive .
These statistics must be interpreted with caution, however, for the
policies followed by an agency, to the extent they are known and
predictable , shape the applications it receives. A low percentage
of denials, for example , would not necessarily mean an agency
was following a course of automatic approval ; it might mean only
that applicants had a clear understanding of when to expect disapproval, and in those situations did not waste time applying.
Nonetheless , there are some striking patterns revealed by the
figures, and they correspond to the distinction between primary
and secondary supervision already noted .

199. 12 U.S.C. § 1726(c) ( 1970).
200. 12 C.F.R. § 571.6 ( 1974) .
201. Id . §§ 562.4, 562.5.




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Table 3
Comptroller of the Currency Decisions

1. Charter
a. Approved
1) New
2) Conversion
b. Denied
1) New
2) Conversion
c. Withdrawn or
1) New
2) Conversion













711 (100)
411 (58)


263 (37)


351 (49)
63 (9)




Total No.













253 (35)
10 (2)


30 (4)
7 (1)

2. Branch
5356 ( 100)
4416 (82)
a. Approved
b. Denied
691 ( 13)
c. Withdrawn or
249 (5)
* Excluding mergers.
Source: COMP. CURR. ANN. REPS. 1968-1973, Tables 4, 6, 8.

The Comptroller, with respect to applications for national bank
charters and domestic branches, and the FHLBB , with respect to
applications for federal savings and loan association charters and
branches, act as primary supervisors , making the initial (and indeed the only) decision as to approval or rejection . Tables 3 and
4 present the data on their decisions. The rejection rates are high
enough to be quite meaningful ; over this most recent five year
period, the Comptroller denied 13 percent of all branch applications and the Bank Board denied 18 percent. Putting aside
conversions of existing state institutions to federally chartered institutions, the Comptroller denied 40 percent ( 253 out of 634) of
the applications for new national banks and the FHLBB denied
61 percent (79 out of 129) of the applications for new federal
savings and loans.
By way of contrast, the FRB, FDIC and FSLIC are in the position of secondary supervisors when they deal with institutions already chartered and regulated by state authorities. In performing
their statutory approval function over branches for state banks,

therefore, the FRB and FDIC are passing on issues previously
dealt with by state banking departments. Although the question




Licensing Decisions of Federal Banking Agencies

Table 4
FHLBB Decisions

2. Branch

a. Approved
b. Denied


















50 (25)
70 (35)

80 (40)

79 (39)
1 *
1 *


1 *





201 (100)
120 (60)



Total No.










1. Charter
a. Approved
1) New
2) Conversion
b. Denied
1) New
2) Conversion
c. Withdrawn
1) New
2) Conversion



2788 ( 100)





2275 (82)





503 (18)

c. Withdrawn
* Less than 2%
** Excluding mergers. (For 1973, limited service facilities are in parentheses.)
Source: FHLBB data.

10 *

of admission of a new applicant to system membership and deposit
insurance is more of an initial decision, the factors that the FRB,
FDIC and FSLIC consider under the relevant statutes are quite
similar to those that state authorities were supposed to consider in
their chartering decision, which precedes the membership application. The outcome is reflected in Tables 5 , 6 , and 7. The approval
rate on branch applications was 99 percent for the FDIC and almost 100 percent for the FRB. On membership applications, the
approval rate was 98 percent for both the FRB and the FDIC ;
only the FSLIC had a significant rejection rate of 30 percent.
With this latter exception, it is apparent that the main area in
which discretion is exercised , at least in a manner that applicants
do not fully comprehend and anticipate, is in the decisions of
those agencies that act as primary supervisors: the Comptroller
of the Currency and the Federal Home Loan Bank Board.

A Closer Look-The Comptroller

In order to understand better the agency decision-making process , a study was made of a number of Comptroller's office de-




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Table 5
FRB Decisions

1. Membership
a. Approved
1) Operating
2) New
b. Denied
1) Operating
2) New
c. Withdrawn
1) Operating
2) New
2. Domestic branch
a. Approved
b. Denied
c. Withdrawn






















2 (2)




16 (20)
63 (78)












81 (100)
79 (98)



Total No.

2 (2)





* Excluding mergers. The FRB also during this period approved 416 applications for
foreign branches of national and state member banks ; one was denied and one withdrawn.
Source: FRB data.

Table 6
FDIC Decisions

1. Insurance
a. Approved
1) Operating
2) Proposed
b. Denied
1) Operating
2) Propsed
c. Withdrawn
2. Branch
a. Approved
b. Denied
c. Withdrawn






















41 (4)
872 (94)
18 (2)
18 (2)




931 (100)
913 (98)







Total No.




3710 (100)

* Excluding mergers. (For 1972-73 , limited service facilities are in parentheses.)
Source: FDIC data.

3665 (99)
45 (1)



Licensing Decisions of Federal Banking Agencies


Table 7
FSLIC Decisions

a. Approved
b. Denied
c. Withdrawn





Total No.

125 ( 100)
84 (67)
37 (30)
4 (3)
Source: FSLIC data. No breakdown between operating associations and proposed
new associations was available.

cision files . That agency, was chosen since it has figured in most of
the significant judicial review litigation of the last decade and is the
most important of the primary approval agencies in terms of the
size of the industry segment it regulates.202 A random sample was
taken from charter decisions, branch approvals and branch denials
over the 1969-1973 period ; with the usual vicissitudes of files that
were checked out or missing, the study group consisted of twentyseven charter files (fifteen approved and twelve rejected) , twentynine branch approvals, and thirty branch denials. These are fairly small samples, and the analysis based on them is intended to be
suggestive , not conclusive. Nevertheless, it seemed desirable to
look at the decision process from the inside , since no similar study
had ever been undertaken.
1. Charter Decisions . The process formally begins when an “Application to Organize a National Bank"203 is filed with the Regional Comptroller. This is a short form containing little more than
the proposed name, locations, and initial capital of the new bank,
together with rather long and detailed biographical and financial
statements by each of the organizers.204 The applicant is separately
required to submit additional information , primarily on the issue
of profitability: the location chosen, the population and economic
character of the area the bank will serve, competing financial institutions in that area, and projections of deposit and loan growth
and of income and expenses.205 This information is frequently

202. See Tables 1 & 2 supra.
203. Form CC 7022-16.
204. Form CC 6021-05 and 7021-04 . The Comptroller customarily also requires these
forms from each director, officer and substantial stockholder (holding five percent or more
of the stock) of the new bank.
205. See Form CC 7022-18, set forth in the Appendix , pp. 297-98 infra .



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provided in the form of a “ market survey" prepared by a consulting firm .
The application is then assigned to a national bank examiner for
a field investigation. His comments and findings are rendered206 in
two parts, the "Examiner's Report of an Investigation ," which is
available to the public, and the " Confidential Memorandum" to
the Comptroller, which is not. The Examiner's Report summarizes some of the application information and gives a brief
economic description of the service area and community, but contains little in the way of evaluation. That is provided in the Confidential Memorandum, on a number of topics. The examiner
gives his views on how much initial capital the bank should have ;
he checks on the biographical and financial data furnished by the
principal figures in the proposed bank and offers his conclusions
about whether they are acceptable persons; and he answers questions such as these:
4. Is there a public need for the proposed bank or is
the area reasonably well served by existing banks and
branches? ...
5. Is it reasonable to expect that the available banking business will be adequate to support the proposed bank, if established , together with existing competitive banks and branches ,
or will an overbanked situation be created ? Indicate whether a
healthy or unhealthy degree of competition will accrue .
He concludes by recommending either approval or denial of the
application. Neither the form nor any standard instructions provide criteria by which these judgments and conclusions are to be
reached ; consequently, they rest largely on the personal attitudes
of the examiner to whom the application was assigned .
The applicant has to publish notice of the filing of the charter
application, and it is permissible , though uncommon, for objectors
to request a hearing.207 Otherwise, the application simply proceeds along a recommendation chain . The Regional Comptroller
adds his comments and recommendation to those of the local examiner, and then the application goes to Washington , where
three more recommendations are added-in turn , those of the
Director of the Bank Organization Division, an Economist, and a
Deputy Comptroller. These latter three recommendations are

206. See Form CC- 1956-OX .
207. 12 C.F.R. §§ 5.2, 5.4 (1974).

52-221 O 75-7



Licensing Decisions of Federal Banking Agencies


usually explained in a few sentences ; the basis given for the other
two recommendations is summarized in a paragraph or two. When
the form arrives at the Comptroller's desk for final decision, he has
five recommendations set forth on two pages . The Comptroller
signifies his decision by signing on the approval or rejection line ,
without any statement of reasons.
Although this decision procedure defies close analysis, as a number of courts have found out, it is possible to make some simple
breakdowns , based on the sample of twenty-seven charter files .
Table 8 shows the frequency with which the Comptroller agreed
Table 8
Staff Recommendations and Comptroller's Charter Decisions
(1969-1973 Sample)



Approved (15)

Recommendations of
Approval Rejection
1. Examiner
2. Regional Comptroller
3. Director, B.O.D.
4. Economist
5. Deputy Comptroller
Source: Comptroller's charter files.

with the recommendations

Percentage of

-- Rejected ( 12 )
Approval Rejection

of his various subordinates.


Comptroller disagreed with his field examiner's view in almost
half the cases , and with his more senior staff in about a quarter
of the cases, on the average. The disagreements were mostly over
implicit standards and values, for the examiner was the only one
to undertake a significant factual investigation and there were
few disputes along the recommendation chain over what could be
called a matter of historical fact.
Table 9 provides a picture of the extent to which these disagreements were clustered . It indicates the number of staff recommendations contrary to the Comptroller's decision in each case.
In forty-one percent of the cases, the Comptroller and his staff
were in complete agreement, but` twenty-six percent of the time
the Comptroller's decision was the opposite of the recommendation of a majority of his staff.
It is more difficult to get at the basis of these disagreements ,
since the Comptroller makes no statement of his reasons and the
statements of the last three staff members in the recommendation
chain are usually very brief and conclusory. In each case, however,




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Table 9
Comptroller's Charter Decisions and Contrary Recommendations
(1969-1973 Sample)



No. ofContrary Staff




Source: Comptroller's charter files.

a list was made of the factors cited by each staff member in support
of his conclusion , and the factors were grouped into four broad
categories : ( 1 ) factors related to predicting the bank's profitability,
such as past or projected future economic growth of the community, the business available to a new bank, the accessibility of its
location, and projections of loan and deposit growth and of income and expense ; (2) characteristics of the application and applicant group, such as the reputation, financial strength and experience of the organizers , the distribution of stock ownership and its
“local” character , and the adequacy of the proposed initial capitalization; (3 ) competitive aspects , such as the need for additional
competition in the locale, the prospect for injury to other banks ,
and the operation of state laws limiting entry to certain markets ;
and (4) factors seen as bearing on the convenience and needs of
the community, such as the absence or paucity of existing banking
offices in the locale, or the existence of adequate service at the
present time.
Attention was then focused on the thirteen cases in which the
Deputy Comptroller agreed with the Comptroller and disagreed
with one or more of his colleagues. In these cases disputes centered overwhelmingly on the matter of the "need" for a new bank.
In twelve of the thirteen cases, the opponents of charter issuance
viewed the locale as already adequately served and saw no indications of public need for a new bank. Those supporting charter issuance, on the other hand , most often cited rapid past or future
growth of the area (nine cases) , adequate capitalization of the
proposed bank ( eight cases) , need for a new bank or added competition (eight cases) , and the absence of any particular injury to
existing banks (eight cases) . The use and implications of these factors will be further discussed below.



Licensing Decisions of Federal Banking Agencies


2. Branch decisions . The procedure on branch applications is
generally similar to that for charters. The application form208 is
a single page, but here too there is a requirement to submit additional information on competing institutions in the area to be
served and the population and economic character of the locale.209
A national bank examiner then makes his field investigation , which
is again written up210 in two parts—a publicly available Report and
a Confidential Memorandum. The Report covers the same ground
as the application , summarizing it and adding to it in a few respects. The Confidential Memorandum contains the examiner's
comments on whether the bank has any problems "which may be
considered as factors against branch expansion" and on whether
any protests from other banks have "merit" ; he lists what he believes to be the favorable and unfavorable factors and gives his
opinion and recommendation . The Regional Administrator then
adds his comments and recommendation.
At the Washington office, the recommendation chain differs
slightly from the charter process. First comes the Director of the
Bank Organization Division , as before . Then views are added
either by one of the several Deputy Comptrollers with supervisory
responsibility for different regions, or by the Chief National Bank
Examiner. Next comes another Deputy Comptroller, and then the
application goes to the Comptroller for his final decision . The
recommendations of the Comptroller's subordinates are contained
on two pages of the form, and the Comptroller's own decision is
not accompanied by any indication of its basis.
Table 10 shows the frequency with which the Comptroller's
branch decisions were in agreement with various subordinates'
recommendations. As compared with Table 8 on charter decisions ,
the greater degree of agreement is striking. The same tendency is
evident in Table 11 ; in no case was a majority of the staff recommendations contrary to the Comptroller's branch decision , and in
seventy-eight percent of the cases there was unanimity.
The reasons for this greater consistency are not apparent.
Where conflict did occur, it usually (fourteen out of eighteen
times) took the form of a staff recommendation of approval for a
branch application that the Comptroller denied ; indeed , there
was unanimity on only two-thirds of the denials, as compared to

208. Form CC 7024-01 .
209. Form CC 7024-06, which in many respects is identical to the charter form in the
210. See Form CC- 1930-OX.



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[42 :235

Table 10
Staff Recommendations and Comptroller's Branch Decisions
( 1969-1973 Sample)


Percentage of

Approved (29)

Recommendations of*
Approval Denial
1. Examiner
2. Regional Administrator
3. Director, B.O.D.
4. Chief Nat. Bank Examiner
Deputy Comptroller
5. Deputy Comptroller
* In some instances, a recommendation was omitted.
Source: Comptroller's branch files.


Denied (30)

Approval Denial





Table 11
Comptroller's Branch Decisions and Contrary Recommendations
(1969-1973 Sample)
No. of Contrary Staff





Source: Comptroller's branch files.

ninety percent of the approvals . (Overall, it may be recalled , the
Comptroller approved eighty-two percent and denied thirteen
percent of all branch applications.211 )
When attention is centered on the cases involving disagreement,
as before, the key issue seems to be whether the branch would be
profitable . There was dispute over this in nine of the twelve cases;
proponents cited rapid growth in the area and argued that other
banks were doing well, while opponents contended that the area
was adequately served , that profitability of the new branch was
doubtful, and that the application was premature .

211. See Table 3 , p . 274 supra .


1975 ]

Licensing Decisions of Federal Banking Agencies


3. Decision grounds . What can be said about the Comptroller's
decision process and grounds for decision, as set forth in the application files? First of all , it is worth noting what factors do not
seem significant in most cases . Consider the factors enumerated in
section 1816 of title 12 of the United States Code , which constitutes the statutory framework for the Comptroller's exercise of
chartering discretion : "[ 1 ] The financial history and condition of
the bank, [ 2 ] the adequacy of its capital structure , [ 3 ] its future
earnings prospects, [4 ] the general character of its management,
[5] the convenience and needs of the community to be served by
the bank, and [6 ] whether or not its corporate powers are consis" 212
tent with the purposes of [the statute] .'
The first and second factors amount, in the case of a newly chartered bank, to its initial capitalization. In none of the sample cases
was inadequate capitalization mentioned as an adverse factor or
reason for denial, and for a rather simple reason: the applicants
will generally either conform their application to the amount of initial capital which the agency indicates it deems desirable , or abandon the application as not feasible under the circumstances. For an
operating bank seeking a branch, these factors have more content.
But if there is serious supervisory concern over its management
or capital adequacy or operating policies , a bank is made aware
that there is no point in its applying for a branch at any location.213
In effect, in both cases this issue is disposed of at an early stage and
is not reflected in the final figures.
The fourth factor, the general character of management, was

mentioned in some cases, but in fact was rarely determinative. A
lot of the charter application routine bears on this factor-the
long biographical and financial questionnaires required of the
organizers and principal stockholders and proposed managing
officers, and the investigation reports made on them by the field
examiner. It is generally understood , however, that if the agency
objects to any of these persons, he will be replaced or dropped
from the applicant group, so this factor too does not often determine the final outcome.214

212. 12 U.S.C. § 1816 ( 1970). See also 12 C.F.R. § 4.2(b) ( 1974).
213. This is made quite explicit in the FHLBB's treatment of "supervisory clearance”;
see 12 C.F.R. § 556.5 (a) ( 7) ( 1974) . The withholding of branches is also used as a form of
supervisory pressure on an institution to conform to what the agency regards as desirable
operating policies and practices.
214. The Comptroller insists that this part of the memorandum section of the examiner's report be kept confidential, to protect the anonymity of sources. The Comptroller's
policy carries with it the distinct possibility of personal unfairness , since disqualification may



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The sixth factor, corporate powers consistent with the purposes
of the act, to the extent it has any meaning at all, is satisfied by
the use of a prescribed form of articles of incorporation. It was
never referred to in any way in any sample case .
That leaves factors three and five, future earnings prospects
and the convenience and needs of the community; as already

noted, these were the central points of disagreement in the recommendation chain . For branches, the debate was usually over
whether the branch would be profitable , while for charters the issue was more often cast in terms of whether there was a "need"
for a new bank. Analytical distinctions between the two factors
were not clearly made, however. The discussion of community
need sometimes, though not often , involved an assertion that the
new entry would cause injury to existing banks or branches, but
that argument shaded into the argument that there was not enough
business for the new bank or branch to be profitable in the near
future .
Most of the Comptroller's decisions , therefore , seem to turn on
assessments of “need” and “profitability," and it is these two factors that warrant closer scrutiny. As it stands , each participant in
the recommendation chain forms his own judgment as to profitability and reflects his own concept of need ; there is no discussion
of, or explicit agreement on, the underlying premises . Unless that
consideration is systematically undertaken and articulated , the
Comptroller's decision process
either internally or externally.

will never be comprehensible ,

To afford an illustration of what would be entailed , let us explore these concepts somewhat further, from a critic's standpoint.
What does it mean to inquire whether the community "needs" a
new bank or branch? How is the public need for any new facility
or service determined , whether it be a bank or a department store
or supermarket? The answer for most products and services is
whether the public is willing to patronize it enough and pay
enough for it to be supplied at a profit-in other words, profitability is a measure of the extent of “need . " It ensures that the
social value of what is being provided , as measured by the public
itself and what it is willing to pay, exceeds the social costs of supplying it. It is not apparent why this is not the standard of need to
apply to banking offices as well. In the Comptroller's files there

be founded on erroneous or distorted information that is not subject to correction or rebuttal.


1975 ]

Licensing Decisions of Federal Banking Agencies


are numerous examples of the use of much cruder standards- for
instance, whether there are other banking offices that customers
can go to without incurring what is, in the examiner's opinion , too
much inconvenience , or whether a casual interview process with
local businessmen turned up statements that they wanted a new
bank. It is not at all clear that the "need" criterion does not resolve itself into the other key issue of profitability.
But why should the Comptroller be concerned with profitability?
That factor is usually the worry of those who are financing a new
venture ; they have the most at stake and every reason to go into
the matter as carefully as they can . It is hard to see why either
superior sources of information or superior thoroughness of
analysis would characterize the Comptroller's office as it grinds
through hundreds of applications each year. It is as if a Washington agency had to approve each decision of a grocery chain concerning location of new outlets . A presumed agency expertise must
find some rational foundation in its actual capacities, or it is an
empty shibboleth.
But suppose we put aside the question of whether the agency or
the applicant is in the better position to make judgments about the
profitability of a particular location, and assume that applicants
will make more mistakes than the agency will-how is the public
interest thereby threatened ? A bank simply closes down a branch
that does not become profitable; rather than attempting to secondguess the bank's profitability estimate , the Comptroller could
merely ascertain whether the bank could afford the cost of an error. Similarly, in the case of a new charter, the Comptroller could
merely require that the amount of initial capital be sufficient to
cover several years of operating losses.
A familiar rejoinder would be that we are concerned about the
effects of a mistaken judgment , not merely or even primarily on
the applicant, but on other institutions. In the jargon of the business , the concern is that new entry would lead to an "overbanked"
condition. In more general terminology, the argument is that errors of entry judgment (which by assumption are made more often
by applicants than by the agency) will at times produce excess
capacity. Although long run excess capacity in an industry is normally corrected by elimination of the industry's less efficient facilities or firms , the argument continues, banking is a special case
because the contraction may involve bank failure . At this point the
argument tends to become either emotional or obscure . To some,
the very words conjure up the collapse of the 1930s and the
thought is unacceptable, though the fact is that several hundred



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banks have failed since the 1930s.215 To others, apparently , a
policy of preventing bank failures is viewed as having major benefits but no costs.216
A less extreme position would be that, while entry controls and
a policy of failure prevention do have costs, they are outweighed
by the benefits . But that position too is open to criticism on both
theoretical and empirical grounds. For example, to what extent
do entry controls actually prevent bank failure? At best (or worst) ,
entry controls can confer a protected monopoly position on certain
firms; that may be reflected in the present market value of the
firm , but it does not constrain the future operations and policies
of risk-acceptance by the firm . Nor is it easy to see the large metropolitan centers and national banking markets, in which the big
banks operate, as protected monopolies; there are too many substantial competing firms. To the extent entry controls have successfully created monopoly positions (or "prevented overbanking,"
in the preferred phrase) , it is probably in local markets and smaller towns. Is the purpose of entry controls mainly to prevent the
failure of small banks ? Why, and for whose benefit ? Presumably,
it is not to protect the stockholders ; that is the very risk they undertake to bear. Perhaps to protect the depositors? But most of them
are covered by deposit insurance ; the smaller the bank, the higher
tends to be the percentage of its deposits that are insured.217 Deposit insurance merely transfers the loss to the FDIC , so perhaps
the need is to protect the insurance fund ? But the failure of small
banks is the kind of event that the FDIC and FSLIC insurance
funds can most easily handle, and there is little reason to doubt
their adequacy for this purpose.218

215. See 1973 FDIC ANN. REP. 227 (Table 121 ) .
216. For a quite contrary view, see Tussing, The Case for Bank Failure, 10 J. Law & ECON .
129 ( 1967) . Some of the costs to bank customers are reflected in the monopoly franchise
value that attaches to new charters upon approval, a phenomenon that troubles the banking agencies. Their response has been to block immediate resales of controlling stock, to
limit attorneys' fees charged successful applicants, and in general to try to suppress the
visible signs of the franchise value. See, e.g. , FHLBB, OUTLine of InformaTION Ex. G No.
20 ( 1967, rev. 1969) ; FDIC, Statement of Policy on Legal Fees, 37 Fed. Reg. 17778 ( 1972) .
217. As of June 29, 1968, 75 percent of total deposits in banks with under $5 million in
deposits were in accounts below the insurance ceiling (which was then $ 15,000) , while in
banks with over $ 100 million in deposits, the figure was 34 percent. See FDIC, SUMMARY OF
ACCOUNTS AND DEPOSITS IN ALL COMMERCIAL BANKS 5 ( 1969) . The insurance ceiling has
now been increased to $40,000 by Pub. L. 93-495. And a family can have a number of insured accounts in the same institution. See Scott, Some Answers to Account Insurance Problems ,
23 BUS. LAW. 493 (1968).
218. There would be even less reason if the insurance corporations were not required
to charge all firms a single rate regardless of individual risk. For a more comprehensive dis-


1975 ]

Licensing Decisions of Federal Banking Agencies


In short, the reasons for the Comptroller's concern with entry
controls, and with overriding applicants ' estimates of need and
profitability, are by no means self-evident or self-validating . If it
is to protect banks and their stockholders from losing money on
poor site selections , it seems unwarranted . On this score , it also
seems unsound, for it is hard to give credence to the proposition
that on the whole the Comptroller's staff in Washington or in the
field can judge the business potential of different locations across
the entire United States better than the applicants can. If it is to
protect depositors, or really the deposit insurance funds , from
losses due to failures caused by "unhealthy" competition, it seems
unnecessary on the one hand and largely impossible on the other.
Among other things, there are too many sources of competitive
pressure quite outside the Comptroller's control- not only state
banks , and savings and loan associations, but also, increasingly in
recent years, other investment media (such as mutual funds and
direct investment in the capital markets) and other sources of
loans (such as insurance companies , or direct access to the capital
markets through commercial paper or variable-rate notes) . It is
not surprising, therefore , to find that economists have become
dubious about the justification and effects of entry controls in
The foregoing discussion is not intended to reach a conclusion
or be definitive , but merely to open up the kind of issues that the
Comptroller should be facing in his administration of entry controls for national banks . What are the justifications and objectives of entry controls that the Comptroller believes have current
validity? What determinations , concerning need or profitability
or unhealthy competition or whatever , is he thereby required to
make? On what sort of findings of fact are those determinations
to be based?
The answers to those questions will not be obtained by opening
up the "confidential" part of the Comptroller's files, as some of
the cases220 sought to do, for they cannot be found there either.
So far as an examination of over a hundred branch and charter

cussion, see Scott & Mayer, Risk and Regulation in Banking: Some Proposals for Federal Deposit
Insurance Reform , 23 STAN. L. REV. 857 ( 1971 ).
219. See generally Alhadeff, A Reconsideration of Restrictions on Bank Entry, 76 Q.J. ECON.
246 ( 1962); Meltzer, Major Issues in the Regulation of Financial Institutions, 75 J. POL. ECON.
482 ( 1967) ; Peltzman, Bank Entry Regulation: Its Impact and Purpose, 3 NAT. BAnk. Rev. 163
220. See text and notes at notes 111-20 supra.



The University of Chicago Law Review


files reveals, the problem is one of developing explicit answers
and standards ; they simply do not now exist.
Although this discussion has centered on the Comptroller, its
applicability is not confined to him. In its essential characteristics,
the branch and charter decision process of the FHLBB has the
same shortcomings , though the Bank Board has much less often
been taken to court. The purpose has been not to single out the
Comptroller, but to use his procedures as a way of developing in
some depth the problems presented by all the federal banking
agencies in their licensing decisions .



The judicial cases recounted in the first part of this paper demonstrated the determined resistance of the Comptroller and other
agencies to providing applicants (and courts) with intelligible explanations of licensing decisions . The study of application files
strongly suggests that at least one reason for that resistance is that
there is no systematic and intellectually respectable basis for
branch and charter decisions . Instead, there is a process of ad hoc
recommendations and conflicting pressures, leaving fertile soil
for a suspicion that the outcome can turn on political favoritism or
outright corruption.221 In essence , the banking agencies have
failed to develop and announce public policy on these questions ,
although Congress, by enacting vague and general statutory standards, has in effect delegated to them a responsibility to do so.222
This failure cannot be justified or excused on the basis of insufficient time for study or reflection or the accumulation of experience; the Comptroller's office has been in existence , and making

221. The latest examples, involving charges of favoritism for Nixon supporters, have
concerned the Comptroller's approval of a national bank charter for a group that included
Dwayne O. Andreas, see N.Y. Times, Aug. 29, 1972, at 21 , col. 6, and id., Sept. 29, 1972, at
30, col . 1 ; the Comptroller's denial of a charter for a bank that would have competed with
Charles Rebozo's Key Biscayne Bank & Trust Co. , see id. , Oct. 17, 1973, at 27, col . 2; and the
FHLBB's approval of account insurance for a new state savings and loan in Key Biscayne
formed by Rebozo associates, see id. , Oct. 23, 1973 , at 37 , col. 4. See also 119 CONG. REC. H
9236-37 (daily ed. Oct. 17, 1973) ; id. at E 6658-60 (daily ed . Oct. 18, 1973) ; Hearings on
Financial Structure and Regulation Before the Subcomm. on Financial Institutions of the Senate
Banking, Housing, and Urban Affairs Committee, 93d Cong. , 1st Sess . 378-80 ( 1973).
222. Cf. Morton v. Ruiz, 415 U.S. 199, 231-32 ( 1974) : "The power of an administrative
agency to administer a congressionally created and funded program necessarily requires
the formulation of policy and the making of rules to fill any gap left, implicitly or explicitly,
by Congress. . . . No matter how rational or consistent with congressional intent a particular
decision might be, the determination of eligibility cannot be made on an ad hoc basis by the
dispenser of the funds."



Licensing Decisions of Federal Banking Agencies


such decisions , for over a century, and even the relative newcomers have had four decades .
Why has this state of affairs been so long invulnerable to assault
in the courts? Much of the explanation probably lies in the traditional view that an applicant for a bank charter or branch has no
"right" to engage in the banking business at the desired location ;
he is merely a petitioner for a “privilege " bestowed by the government, a suppliant for an act of largesse . Thus, the argument runs ,
he has no recognized "property" interest calling for due process
protection. This attitude is reflected in the almost unanimous
holding that the Comptroller and other agencies are not constitutionally required to reach decisions by way of trial-type hearings.223
The right-privilege dichotomy, as a touchstone for due process
analysis, has undergone a declin in recent years.224 Welfare
benefits were the classic case of governmental gratuities, to be dispensed in whatever manner the legislature might choose , but the
Supreme Court in Goldberg v. Kelly225 imposed the requirement of
a fair evidentiary hearing before they could be terminated.226 The
category of property interests protected by procedural due process
was enlarged to include government benefits to which a person
claims he is entitled.227 A " legitimate claim of entitlement"228 may
be based upon a statute whereby the government awards valuable
benefits or privileges , just as much as upon contract or historically
familiar forms of private property .
Although these cases show which way the wind is blowing, it is
doubtful that the Comptroller's house has yet been toppled by
them . They involve the termination of a preexisting (and thus relied upon) benefit or status , rather than an initial decision on an
application, and that consideration is usually viewed as strengthen229
ing the claim that due process necessitates an evidentiary hearing.22

223. See text and notes at notes 58-68 , 141-44 supra .
224. See Van Alstyne, The Demise of the Right-Privilege Distinction in Constitutional Law, 81
HARV. L. REV. 1439 ( 1968).
225. 397 U.S. 254. ( 1970).
226. The pre-termination fair hearing requirement was subsequently extended to driver's license suspensions, Bell v. Burson, 402 U.S. 535 ( 1971) , to parole revocations, Morrissey v. Brewer, 408 U.S. 471 ( 1972) , and to probation revocations, Gagnon v. Scarpelli, 411
U.S. 778 ( 1973 ) , but not to discharge from government employment, Arnett v. Kennedy,
416 U.S. 134 (1974).
227. Board of Regents v. Roth, 408 U.S. 564 ( 1972) ; Perry v. Sindermann, 408 U.S. 593
( 1972).
228. Board of Regents v. Roth, 408 U.S. 564 , 577 ( 1972) .
229. See, e.g. , Reich, The New Property, 73 YALE L.J. 733, 744 ( 1964). The distinction has



The University of Chicago Law Review


Furthermore, they involve situations where either the statute or
the agency has spelled out eligibility requirements for the benefit
with some precision or the plaintiff is already its possessor , so the
claim of "entitlement" is not difficult for a court to pass upon . By
contrast, where both statute and agency have left the bases for conferring the benefit utterly vague, the threshold showing of entitlement would seem impossible to make.230 Ironically, therefore , the
poorer the job an agency does in developing policy standards , the
more minimal will be the procedural requirements it must satisfy.
But even more basic is the fact that the recent due process cases
have been concerned with the need for a full evidentiary hearing.
Although that is admittedly lacking in the banking decision process, it is not as yet the factor whose absence seems critical and
whose presence is much to be desired . Judicialization of agency
decision making is a remedy often prescribed , but its costs in terms
of delay and expense frequently exceed by a wide margin its contribution towards improving the quality of decisions.231
At this stage , at any rate , the pressing need is for the articulation
of policy rather than for trial-type hearings . The immediate problem is not one of resolving disputes about historical facts, but of
specifying the purpose and bases of the exercise of controls over
entry into banking markets . In terms of legal form, that can be
achieved in one of two ways: by the adoption of policy statements
and the exercise of the rulemaking power , or by a process of caseby-case adjudication and reasoned opinions . The route of policy
not appealed to all courts. Compare Sumpter v. White Plains Housing Auth. , 29 N.Y.2d 420,
328 N.Y.S.2d 649 , 278 N.E.2d 892 ( 1972) , with Davis v. Toledo Metro. Housing Auth. , 311
F. Supp. 795 (N.D. Ohio 1970).
230. To have a property interest in a benefit, a person clearly must have more than an
abstract need or desire for it . He must have more than a unilateral expectation of it. He
must, instead , have a legitimate claim of entitlement to it.
Board of Regents v. Roth, 408 U.S. 564 , 577 (1972) .
231. Possibly the small group of cases where an applicant or organizer is rejected or excluded on personal grounds constitutes an exception. The present procedure of disqualification on the basis of secret evidence might not withstand legal challenge; it can be argued that
the person being branded as unacceptable is both stigmatized (at least within the agency.
and among the applicant group, and, given interchange of information among the banking agencies, on occasion with other agencies as well) and to some extent denied the liberty
to enter a recognized occupation . At the same time, the reasons for secrecy do not involve
lofty goals like protecting national security; in most of the sample cases, the adverse reports
concerned a poor credit rating or financial position , and the source was treated as confidential simply to avoid embarrassment. Under these circumstances, due process probably
entitles the barred applicant to an evidentiary hearing. Cf. Board of Regents v. Roth, 408
U.S. 564, 573-74 ( 1972) ; Willner v . Committee on Character and Fitness , 373 U.S. 96
( 1963) ; Norlander v. Schleck, 345 F. Supp . 595 (D. Minn . 1972) . Of course, as long as the
final decision remains so totally discretionary, most such persons will be dissuaded by their
colleagues from pursuing the matter and alienating the agency.



Licensing Decisions of Federal Banking Agencies


statements and rulemaking seems preferable , because it tends to
force the decision maker to confront the more fundamental questions and think through and justify comprehensive answers ; 232
that may explain its relative neglect . Alternatively, at least in theory,
an agency can develop a consistent policy in piecemeal fashion, by
separate adjudications-but the world will never know it unless
opinions are written and published .
There is little that courts can do to force an agency to use its
rulemaking authority,233 but they are in a better position to require
written explanations of decisions that are subject to judicial review,
even in areas in which neither due process nor the Administrative
Procedure Act234 requires trial-type hearings . The very concept
of limited review requires that the decision maker provide a reasoned justification for his action . As the Supreme Court said in
Chenery II:
If the administrative action is to be tested by the basis upon
which it purports to rest, that basis must be set forth with
such clarity as to be understandable . It will not do for a court
to be compelled to guess at the theory underlying the agency's action. . . . In other words , 'We must know what a decision means before the duty becomes ours to say whether it is
right or wrong ."
With a general decline in the level of automatic judicial deference
to agency expertise has come a corresponding recent increase in
the demand that agencies give reasoned explanations for their decisions , even when that is not required by the statute under which
they are acting.236 Most of these cases involve statutory review
(where the statute under which the agency is acting has an explicit
provision for court review) and that means that Congress intended
for the agency to have to explain and defend its decisions in court.

232. Cf. Robinson, The Making of Administrative Policy: Another Look at Rulemaking and Adjudication and Administrative Procedure Reform , 118 U. Pa. L. Rev. 485 , 526 ( 1970) ; Shapiro,
The Choice of Rulemaking or Adjudication in the Development of Administrative Policy, 78 Harv.
L. REV. 921 , 937-40 ( 1965) .
233. Compare NLRB v. Wyman-Gordon Co. , 394 U.S. 759, 764-65 ( 1969) , with NLRB v.
Bell Aerospace Co. , 416 U.S. 267 , 290-95 ( 1974) .
234. See 5 U.S.C. §§ 554 , 556-57 ( 1970).
235. SEC v. Chenery Corp. , 332 U.S. 194 , 196-97 ( 1947) . See also Burlington Truck
Lines v. United States, 371 U.S. 156, 167-69 ( 1962) ; Phelps Dodge Corp. v. NLRB , 313 U.S
177 , 197 ( 1941 ) .
236. See, e.g. , Natural Resources Defense Council v. EPA, 478 F.2d 875 ( 1st Cir. 1973) ;
Air Line Pilots Ass'n v. CAB , 475 F.2d 900 (D.C. Cir. 1973) ; Wellford v. Ruckelshaus, 439
F.2d 598 (D.C. Cir. 1971 ) ; Environmental Defense Fund v . Ruckelshaus, 439 F.2d 584 (D.C.
Cir. 1971).



The University of Chicago Law Review


In cases of nonstatutory review (where the statute lacks an express
judicial review provision and the plaintiff relies on the general
jurisdiction of the federal courts in seeking an injunction or declaratory judgment) , the courts have been more hesitant to intrude upon
agency discretion, even by merely asking for explanation in any
but a pro forma sense . But the same tendency is visible here ,237
and for the same reasons . Without explanation by the agency, as
the banking cases previously discussed make clear, the court in affording judicial review is reduced to an unhappy choice between
usurpation and futility .
There is no longer much room for dispute that charter and
branch decisions are subject to judicial review, at the behest of
either applicants or competitors.238 Though an applicant may have
no right to a charter or a branch , he has a right to have his application decided according to law by the agency, and the right to judicial review of that decision carries with it the necessity for explanation of its grounds.
The real issue is how little explanation will suffice . As satisfaction with the performance of administrative agencies has lessened ,
the level of understanding being required has risen , and remands
for a more intelligible explanation have become a commonplace.239
In nonstatutory review (which includes the bank licensing cases) ,
however, the courts have been less assertive , or at least less explicit.
Overton Park240 demanded simply "an adequate explanation" by the
Secretary of Transportation for his action , leaving it largely to the
district court to decide whether the administrative record already
provided one or had to be supplemented through formal , if belated, findings or actual testimony and cross examination . Pitts241
did not change this position , though it did intimate that a “curt”
explanation might be good enough.242

237. See, e.g., Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402 ( 1971 ) ; Citizens
Ass'n v. Zoning Comm'n, 477 F.2d 402 , 408-10 (D.C. Cir. 1973) ; District of Col. Fed'n of
Civic Ass'ns v. Volpe, 459 F.2d 1231 (D.C. Cir. 1971 ) , cert. denied , 405 U.S. 1030 ( 1972) .
238. See Camp v. Pitts, 411 U.S. 138 ( 1973) .
239. See, e.g. , Atchison T. & S.F. Ry. v. Wichita Bd . of Trade, 412 U.S. 800, 807-09
( 1973); NLRB v. Madison Courier, Inc. , 472 F.2d 1307 , 1321-26 (D.C. Cir. 1972); USV
Pharmaceutical Corp. v. Secretary of HEW, 466 F.2d 455 , 461-62 (D.C. Cir. 1972) ; Greater
Boston Television Corp. v. FCC, 444 F.2d 841 , 851-52 (D.C. Cir. 1970) , cert. denied, 403 U.S.
923 ( 1971 ).
240. Citizens to Preserve Overton Park v. Volpe, 401 U.S. 402 ( 1971 ) .
241. Camp v. Pitts, 411 U.S. 138 ( 1973) .
242. The authority of that intimation is undermined by the fact that the case was decided on the certiorari papers without either full briefing or oral argument. The Court was
in all likelihood unacquainted with the history of difficulties that had been encountered
in reviewing the Comptroller's customarily "curt" explanations of decisions .


1975 ]

Licensing Decisions of Federal Banking Agencies


But however full or inadequate the explanation that the courts
are prepared to demand , the requirements of good administration are an independent matter. Banking plays too central a role
in our economic system, and the issues at stake in the administration of entry controls are too important, for a continuation of the
present regime of unexamined and unexplained exercises of discretion. Whether they are ultimately forced to it by the courts or
not, the banking agencies should articulate their policies and their
reasons243 —and not in the curt and superficial manner of Pitts .
The usual response to such a recommendation is that writing
opinions in all cases would be a substantial burden on overworked
staffs, and generally of little value since decisions depend on particular fact settings. There are answers on a number of levels. First
and most fundamental, opinion writing is not the only or even the
preferable way of establishing a clear policy; the route of policy
statements and rulemaking, in terms of objective standards, would
be more comprehensive and satisfactory.244 It also makes more evident the gaps and inconsistencies in underlying premises and is
therefore less likely to be adopted . On the charitable assumption
that still more time and experience is necessary to work the problems through, perhaps a practice of case-by-case adjudication can
still be rationalized . Second , the overworked staff objection is generally available against doing anything not already being done, but
it has less application to the banking agencies than to most others.
These agencies do not depend on Congressional appropriations for
their funds, nor (with the exception of the FHLBB) on Congressional authorizations for their budgetary expenditures. If the job
is worth doing, the staff can be increased . Third, the point about
the limited value of most decisions does have merit. It has the most
merit when policies are inchoate and standards are undefined , so
that opinions consist of a list of the "relevant" factors in a particular
case and a conclusion , with the connecting links left to the reader's
imagination or the court's "opening- presumption of correctness . "
Still , if that is all the decision process has to offer, written opinions
at least expose the vacuity to the view of courts and critics, instead
of hiding it behind a protective veil of obscurity and trust in expertise .
243. The suggestion is not exactly a new one. See H. FRIENDLy, The Federal AdminisTRATIVE AGENCIES ( 1962) .
244. The validity of substantive informal rulemaking of this sort was recently considered at length and sustained , for the FTC, in National Petroleum Refiners Ass'n v. FTC,
482 F.2d 672 (D.C. Cir. 1973) , cert. denied, 415 U.S. 951 ( 1974) . See also Verkuil, Judicial Review ofInformal Rulemaking, 60 VA. L. REV. 185 ( 1974) .



The University of Chicago Law Review

[42: 235

Another line of objection to explanatory opinions is based on
the fact that applications are sometimes, though not often, rejected
on grounds that the agency believes would be substantially injurious to a bank or individual if made public. The existence of this
possibility in a few cases is not an excuse for a general policy of
non-explanation, and it ought not to be automatically invoked to
shield all negative information . However, instances may remain
where the agency believes it should not disclose certain information, in order to preserve (unwarranted) public confidence. If the
information pertains to the applicant bank or group, the applicant
could be afforded the option of withdrawing its request; if it pertains to an objecting bank, the ground could be expressly stated
but in general terms, such as "to prevent an adverse impact on
other institutions . "245
It is submitted, therefore , that opinions in at least part of the
cases should be regularly forthcoming. The following recommendations are designed to meet the need for a fuller explanation of
the licensing decisions of the federal banking agencies, while taking into account distinctions between the various types of decisions
and attempting to minimize the call on agency resources .

Recommendation 1. General. The federal banking agencies
should undertake to provide a full statement of their objectives
in approving or denying charter or membership applications and
branches, and should define in concrete terms the standards to be
applied . This can be done best by the adoption of policy statements and rules of general applicability, which should be as specific as possible . To provide additional clarity and understanding,
reasoned opinions should be issued in certain situations as set forth
It should be noted that as policy statements and definitions of
standards become more specific, it becomes less burdensome to
decide and explain individual cases.
Recommendation 2. Primary supervisor decisions: Comptroller and
the Federal Home Loan Bank Board . In the case of branch applications, the numbers are large and many approvals seem a matter of
routine . Probably only a small minority of approvals, but a much
larger fraction of denials , would occasion a desire or need for explanation. For branches, therefore , the Comptroller and the

245. If judicial review is sought, the court can, to the extent deemed warranted, afford
in camera or protective order treatment to the supporting evidence .

52-221 O - 75-8



Licensing Decisions of Federal Banking Agencies


FHLBB should furnish written opinions only when so requested
by the applicant or by objectors, or when the agency believes the
case presents issues of general importance . It would be appropriate to charge the requesting party an amount commensurate with
the time cost of opinion preparation.246
Charter decisions are considerably fewer in number and , at
present, more obscure in their grounds—in the Comptroller's case ,
even to his own staff, let alone applicants or protestants . An
opinion should be furnished as a matter of course in all charter
denials, since this is the most critical entry barrier, and in approvals
when requested .
Recommendation 3. Secondary supervisor decisions: Federal Reserve
Board, Federal Deposit Insurance Corporation and Federal Savings and
Loan Insurance Corporation . Branch approvals by the FRB and
FDIC seem well-nigh automatic , no doubt because of reliance on
the primary approval of other authorities , and an opinion requirement in all cases would seem excessive . Rejections are something of an extraordinary event, however, and should always be
accompanied by a full explanatory opinion .
Membership applications may not wholly fall into the same category, though only the FSLIC has a significant rejection ratio . It
would probably be worthwhile to furnish written opinions on request, which would presumably be forthcoming mainly in the
event of denial.
Recommendation 4. Publication . All four agencies should systematically collect and publish their licensing decisions and
opinions in some convenient form . Depending on frequency and
length, those of general importance might be included as part of
monthly publications such as the Federal Reserve Bulletin or Federal
Home Loan Bank Board Journal , or as an appendix to annual reports; others might be published as a separate series and made
available in public files at the agency's Washington and field offices.247
As a concluding caveat, it must be recognized that opinions may
be a necessary ingredient in the development and application of
a coherent and well- defined policy of administration of entry con-

246. See 31 U.S.C. § 483a ( 1970) ; National Cable Television Ass'n v. United States ,
415 U.S. 336 (1974).
247. Cf. 5 U.S.C. § 552(a) (2) ( 1970), as amended by Pub. L. No. 93-502, 88 Stat. 1561 .



The University of Chicago Law Review


trols , but they do not ensure such a policy. The opinions will be
largely worthless if they consist of no more than a list of factors or
a recital of facts , followed by a leap to the conclusion boilerplate
without articulation of the connecting theories and standards and
tradeoffs.248 The decade of judicial decisions previously reviewed
shows a growing disinclination on the part of courts to approve
what they cannot follow, so long as they can view it as well intended and not corrupt . That tendency toward greater judicial
rigor is to be applauded , but it is even more important that the
agencies themselves move at last to discharge the policy making
responsibilities inherent in the broad discretion conferred upon
them by the Congress .

248. Judge Jerome Frank paid his respects to such "woosh-woosh" opinions in Old
Colony Bondholders v. New York, N.H. & H.R.R. , 161 F.2d 413 , 449-52 (2d Cir. 1947)
(dissenting opinion) .




Licensing Decisions of Federal Banking Agencies






( 1 ) Population of city, town , county, village or municipality in which the
proposed bank is to be located as of the last decennial census and a
present estimate.
(2 ) (a ) Estimated population of the service area, for last decennial census
and a present estimate from which the proposed bank is expected to
generate 75% or more of its loans and deposits.
(b) This area extends from the proposed bank location approximately
miles east ;
Imiles north;
miles south;
miles west.
(Area must be outlined on the maps and aerial photographs submitted )
(3 ) Provide the following information with respect to each competitive bank
and branches thereof located within the service area of the proposed bank
(if complete branch figures are not available use consolidated figures) .
In nonpar, so indicate.
Location marker
Date established
if within three
number, names
and addresses
Distance by road
mileage and direction
from proposed bank

Interest rates paid Interest rates
on savings deposits normally reand certificates of Iceived on shortterm business
and instalment

Hours of business

Estimate of commercial bank share
of mortgage loan

Rate of
return on
capital for
three years


(4) Provide handy- sized duplicate maps (with a scale of miles and compass
points) of the city or area appropriately labeled to show the location
of the proposed bank and the names and locations of all banks and branches,
including applications pending and those approved but not opened. Aerial
photographs of reasonable coverage, including expected service area are
helpful , and if available, one so labeled should be submitted. The expected
service area of the proposed bank should be clearly outlined on the maps
and on aerial photographs.
(5 ) Provide the following information with respect to Savings and Loan, Building
and loan, and Mutual Savings Banks located within the proposed service area.
Names and

Date established
if within three



Distance by road
mileage and
direction from
proposed bank

(6 ) Indicate the number of the following institutions within the proposed service
area three years ago and the number of each at the present : Credit Unions,
Finance companies, Insurance companies granting loans, and other institutions
granting loans.
*Include applications pending and those approved but not opened.

Form CC 7022-18
Rev 3/71



The University of Chicago Law Review


(7) Indicate degree of intensity of competition in service area by Savings and
Loan, Mutual Savings Banks , Credit Banks , etc.
(8) Provide a copy of any survey made preliminary to filing the application for
the proposed bank and also the cost for any such survey.
(9) Comment on the economic character of the area to be served.
A. If area is largely residential , state whether homes are generally owneroccupied, the extent of housing development , type , quality, price level,
average age, number of unsold new homes, and prospect for continued
B. If primarily industrial or business, state the number and general types
of business , and in the cases of principal employers, give the name of
each company or firm, number of employees , and payroll , and comment on
the consistency of employment and special skills required .
C. Shopping center locations should be fully described. State the number
of units, size as to total land and building area, number of individual
parking spaces , accessibility to surrounding communities, the extent to
which signed leases have been obtained , the names of principal lessees ,
and provide information as to their financial responsibility, if not
national concerns.
D. Provide information regarding population growth potential ; new businesses
recently established or planned, etc. Discuss the traffic pattern, the
street and road facilities, and their adequacy. Describe geographical
barriers, if any.
(10) If no bank in community, where is banking business conducted by residents?
(11 ) Past banking history of community.
(12) Proposed ownership of stock , is it to be widely distributed or closely
held . Amounts to be taken by organizers , proposed directors, officers
and their families.
(13 ) Financial position of city, town , village , school districts and county.
Discuss tax collections, showing total levy, percentage collected and
arrears, etc.
(14 ) List the major types of loaning demands proposed bank expects to serve.
(15) Give estimates of the volume of total deposits , showing the amount of
public funds included in total and total loans expected at the end of
the first year of operations , second and third year.
( 16) A detailed projection of earnings and expenses must be submitted showing
the breakdown of income and expenses for each of the first three years of
(17) Give the following information regarding banking house and equipment as
it applies :
(a) If to be purchased, the separate costs of land, building, furniture
and fixtures , and vault .
(b ) If to be leased, give terms in brief and describe the quarters.
(c) If property is to be purchased or leased from a director, officer,
or large shareholder, state name and other pertinent data .
(d) Give expiration date of any option to purchase or lease.
(e) If new construction, furnish anticipated completion date.
(f) If a temporary location is planned, furnish exact address , distance
and direction from permanent location, and period it will be occupied.
(g) State the approximate period of time that will be required to place
bank in operation in temporary and/or permanent site.
(18 ) What plans have been made to obtain fidelity insurance covering all
individuals authorized to collect , receive or deposit funds from stock







Dennis C. Bottorff
Vice President





Nashville ,







31 ,





The issue of the need for change in bank regulation was
aptly stated by Walter Wriston , Chairman of the Board

of First National

City Corporation .

"The business

history of America is strewn with corporate wrecks , whose
managements failed to perceive that the nature of their
competition was changing fundamentally .

Railroads are

an often cited but still classic example of this principle .
Less often noted is the fact that the railroads were so
strait - jacketed by regulation that they often failed to
attract the management needed to survive in a rapidly
changing world . "

"The public is entitled to the best service at the lowest
cost that the marketplace can provide .

Moreover , a free

marketplace is still the best economic system ever constructed to provide the greatest good for the greatest
number ... Today's regulation must be based on today's
realities if the commercial

banking system is to be per-

mitted to survive current competitive challenges . "

Entities which fail

to change as their environment

changes will surely become as extinct as the dinosaur .
The environment in which banking institutions operate
is rapidly changing , yet the distribution system of



banks is still highly constrained to narrowly defined
artificial geographical

boundaries .

It is necessary

for banks and bank regulation to adapt accordingly .

Historically , commercial
portion of the total


banks have supplied a major

credit market .

Commercial Bank Share of Total Credit Market



Flow of Funds Accounts , 1965-1973 ,
Board of Governors , Federal Reserve
System .

Banks ' future ability to continue to supply that level
of credit will be severely limited by their ability to
attract investors '

equity .

The days of growth in assets

which are not supported by a corresponding growth in
equity are over .


regulating authorities are exer-

cising their power to prevent capital
from declining further .

adequacy ratios

The Fed has been badgering

banks to raise more capital

- equity capital , especially .

A typical example is represented by the Fed's decision
declining the Bank of America's application to acquire a
foreign insurance company .

Henry C. Wallich and John F.

Sheehan , Fed Governors , expressed their opinion .



" We agree that the applicant's capital

position is

somewhat lower than what the Board would consider
appropriate .

We also agree with our colleague's

concern over the tendency of many U.



organizations to pursue a policy of rapid expansion
and agree that funds earmarked for expansion by U. S.
banking organizations with capital

positions not con-

sidered appropriate should be used instead to strengthen
the capital

positions of such organizations . "

Considering the Fed's conviction to prevent further
decline in banks '


ratios and with the uncertainty

in the capital markets , many banks will have to limit
their growth in assets to an amount which can be supported
by internally generated capital .

If this posture is applied to the entire banking community , by 1980 there will be $ 135 billion of loan demand
which would have normally been funded by banks that will
need to be supplied by other sectors of the credit market .

It might be helpful to demonstrate the process by which
this projection was generated .

In 1973 , the total

market was estimated by the Fed at $ 1.930 trillion .
has been demonstrated that the growth in credit and
growth in GNP closely parallel

one another .





Relation of Total Credit Market to Current
Dollar GNP

Compound Annual Growth



7.1 %

7.1 %
10.1 %





The Banking Industry , Lessons of
1974 ; A Study by Alex . Brown & Sons .

If we assume a real

growth of GNP of 4% per annum ( which

coincides with the Bureau of Labor Statistics '


published in a recent study , " The United States Economy in
1985 " , Monthly Labor Review , December ,

1973 ) and an in-

flationary growth of 8% per annum , the total

credit market

would reach $ 3.809 trillion by 1980 .

If we apply an 8% compound growth in earnings (the maximum
projected growth rate for the industry by Alex . Brown &
Sons in December ,

1974 ) to the industry's 1973 level of

earnings , $ 6.579 billion , and reduce the industry's dividend payout percentage based on the historical

trend ( See

Exhibit 3 ) , the industry would generate internally
$ 34 billion of equity .

Without deterioration in capital

ratios , this equity would support a total
$ 1.183 trillion by the end of 1979 .

credit of




Recent Trends and Projected Dividend Payout

Dividend Payout Ratio





FDIC Annual




2 The Payout Ratios for years 1974 through
1979 were projected by establishing a Linear
Regression Trend Line using the Least Squares
Method and Historical Data for years 1964-1973 .

For the banks in 1979 to supply the same percentage of
the total

credit market as they did in 1973 , they would

need to fund $ 1.318 trillion or $ 135 billion more than
projected .

This would require at least $ 10.2 billion or

$ 1.6 billion per year of externally generated capital to
support the credit expansions .

In December 1971 , the President's Commission on Financial
Structure and Regulation ( the Hunt Commission ) submitted



a report of its findings which concluded that the public
is entitled to the benefits of a sound , dynamic , and
innovative financial

system responsive to shifting needs .

Unless the banking industry can attract the externally
required capital to support the additional credit needs ,
the public will be deprived of the type of financial
structure recommended by the Hunt Commission .

Unfortunately, our branching laws which restrict geographical expansion to narrowly defined territories
tend to limit the industry's ability to attract capital .
It creates a highly fragmented industry with relatively
few banks of sufficient size to qualify in the open
market competition against other industries for capital .

As a partner in one of the leading investment banking
firms put it ,

" Institutional

investors ( who , by the way ,

represent the major market for bank equity offerings )
want to hold relatively large dollar positions , at least
$ 250,000 ,

but at the same time limit their ownership to

no more than 5% of the bank .

In many cases , they will

not consider investing in a bank whose market value for
its stock is less than $ 100 million . "

Since many banks are selling below book value , we can use
the bank's stated book value to estimate the number of
banks which qualify .

As of December 1973 , less than 125



or .9% of the approximately 14,000 banks would meet
the institutional

investor criteria .

At the same

time , companies with whom banks are in competition for
the capital are increasing their position in the financial

services market without regulation .


inequities of the competition for the financial


market were well developed in a recent publication ,
" Competition in Financial
Christophe .

He noted ,

" The nation's three largest

retailing chains engage

Services " , by Cleveland A.

in a broad cross - section of

service activities ranging from corporate

venture capital

investing and mortgage banking to

consumer finance and insurance underwriting .

In the

consumer - oriented markets , they are an especially potent
factor .

As of January , 1973 , the three firms had con-

sumer installment receivables outstanding equal to more
than 11 % of the total consumer installment loans held by
nearly 14,000 commercial

banks in the country ... these

entrants have tremendous flexibility in developing and
offering new services , expanding into growth markets ,
and fully employing their human , organizational and

strengths .

Essentially , these companies are

regulated by the standards of the marketplace as to the
activities in which they engage and the organizational
and financial policies that they employ . "



Although the major banks could compete for capital ,
is doubtful


that they can supply the need for credit

because branching laws will prevent them from conveniently serving both the credit and deposit markets .

Only through consolidation will their be a structure
in the banking industry which will
pete effectively for capital .

permit banks to com-

Branching laws should

allow banks to open facilities throughout the United
States as the need in the marketplace dictates .

Only Congress can provide for this consolidation .


first step would be to allow holding companies to own
banks in states other than that in which the holding
company is domiciled .

The state laws would necessarily

need to continue to govern the branching rights for
those banks within that state .

The second step would be

for Congress to enact legislation that would permit

banks to branch throughout the state rather

than conform to branching rights accorded State chartered
banks .

There should be sufficient lag time between the

date the legislation is passed and the date it would
become effective to allow State legislatures to adjust
their laws .

The establishment of a national

distribution system would

place a greater burden on the federal authorities to police


-9- and last

the geographical

expansion and strengthen their areas

which determine the need for additional

With the right to consolidate ,

expansion .

the industry would

consist of larger , but fewer banks .

The ability of

the industry to attract capital would be greatly
enhanced and the ability to supply the future needs
for credit would be improved .


By Thomas M. Havrilesky and William P. Yohe

Approval for branches of national banks is the responsibility of the Comptroller of the Currency; for state banks it lies with the state banking commission, with deposit insurance subject to approval by the Federal Deposit Insurance
Corporation .

However , the McFadden Act constrains national banks to the same

branching standards as the state banks in a state .

Only 12 states permit both

statewide branching and have not vetoed holding company activities . '

Moreover ,

federal law prevents banks or bank holding companies from operating bank offices
in more than one state.
In the past decade and a half, banking firms ( fueled by chronically inflationary monetary policy ) have had the wherewithal ( and internal organizational
incentive ) to grow .

Because investment in new branches is confined to certain

geopolitical areas and because of severe constraints on competition for deposits through explicit payment of interest , commercial banks instead compete for
deposits by making concessions to customers in other areas of banking and non2
banking activity .
Consequently , there has been , on a nationwide basis , an in-

We thank Martin Bronfenbrenner , Kalman Cohen and Edward Kane for helpful
comments . We alone are responsible for error .
The 1970 amendments to the Bank Holding Company Act permit the Federal
Reserve to establish guidelines for determining when " controlling influence " may
is not held
exist even if 25% or more of stock
Present guidelines include 5%
or more of stock plus interlocking directors or offices or combined ownership by
officers , directors , major shareholders , and holding companies of 25% or more of
operating bank's stock . (William H. Kelley, " Bank Structure - Consolidation of
Banks Reshaping Texas Markets , " Business Review , Federal Reserve Bank of Dallas ,
January 1972 , pp . 1-7 , esp. p. 2.)
This is a key aspect of many of the problem areas in modern banking - e.g . ,
bank and bank holding company expansion into nonbanking activities . See the remarks of Thomas Havrilesky in Chapter 11 , " Banking and the Economy . "


efficient allocation of investment in branches- to little in some parts of the
country, too much in others .

For example , a number of only marginally profitable

branches have been started in recent years .

As an example of this disproportion-

ate allocation , in mid- 1972 , banks in the nineteen statewide branching states accounted for about twenty- three percent of total U.S. deposits but thirty- five percent of new branches opened from 1960 to 1972.3
Mergers and New Charters






the Office of






the Comptroller of the Currency.

It has consistently been easier to get the Comptroller's approval for mergers and
charters than when the jurisdiction lay with the Federal Reserve (mergers where
survivor would be state member bank ) or FDIC (mergers where survivor would be a
state nonmember bank and all branch and charter applications of state chartered
banks ) .

Further, there have been cases where new state banks , faced with FDIC

disapproval , have sought and obtained Federal Reserve membership ,because this forces the
FDIC to provide deposit insurance .

In these cases , the Federal Reserve has over-

reacted to the recent and substantial declines in membership by state banks
(caused by mergers and voluntary withdrawals to take advantage of lower state reserve requirements ) .5
Compiled from data in FDIC , Summary of Accounts and Deposits in All Commercial Banks - June 30 , 1972 : National Summary (Washington , D.C .: FDIC , 1973) .
Robert Eisenbeis , " Differences in Federal Regulatory Agencies ' Bank Merger Policies , " Proceedings of a Conference on Bank Structure and Competition ,
October 26-27 , 1972 , Federal Reserve Bank of Chicago , 1973.
5 Edward G. Boehm , " Falling Fed Membership and Eroding Monetary Control :
What Can Be Done?" Business Review, Federal Reserve Bank of Philadelphia , June
1974, pp. 3-15.

52-221 O - 75-9


Regulatory Reform
The approval of mergers , charters and branches should be administered by a
single regulatory agency .

To minimize conflict of regulatory interest and ex-

cessive closeness of the regulating body to the banking industry, this agency
should not be the agency that conducts bank examinations , nor should it be the
agency responsible for monetary stabilization policy .
should be conducted and no regulatory

Professional evaluation

personnel should be political appointees or

too closely associated with the banking industry .

This would minimize the like-

lihood of coloring the approval process with invidious considerations .
All banks should be permitted to compete through branching , either by fullservice outlets or through automated " facilities , " on a nationwide basis . This
would end dual regulation and its effect of excessively protecting existing banking firms in some areas from new entry with little apparent improvement in bank
safety.6 Regulatory laxity in approving mergers and the enormous cost of resolving merger problems would be reduced , because a nationwide branching system would
encourage de novo entry rather than entry by merger and acquisition .


caprice in approving entry would be reduced because bank managers rather than
bank regulators would decide which markets were " overbanked . " 7, Excessive concen-

Safety in banking can be improved and bank customers and bank managers can
have better information and react more efficiently to risk by a system of deposit
insurance premiums graduated to reflect the riskiness of a bank's portfolio , a
likely feature of a private deposit insurance industry . See Sam Peltzman , " The
Costs of Competition : An Appraisal of the Hunt Commission Report , " Journal of Money Credit and Banking , November 1972.
The failure to define banking markets makes branch approval a rather superficial procedure . The regulatory authorities have never agreed upon precise
ways to delineate the market area of a bank or branch in merger , branch and charCounties , Census tracts , townships , SMSA's , urbanized areas , Ranally
Metropolitan Areas , and various marketing techniques have all been used . Further ,
the Survey of Consumer Finances no longer publishes the distribution of checking
account holdings by individuals by income brackets ; these are needed to implement
the American Bankers Association method of establishing deposit potentials . See
Paul R. Schweitzer , "The Definition of Markets , " mimeograph , Banking Markets Section , Board of Governors of the Federal Reserve System , 1973 .
For further details see our remarks on the convenience and needs doctrine



tration of offices and pre- emptive branching in any local market could be minimized by a rule limiting any bank to a specific number of offices per 100,000 population per country .

Excessive national concentration could be handled by en-

forcement of anti -trust laws .
All banks under the proposed system would be subject to the same set of re9
serve requirements on all classes of funds .
The end of dual regulation would
end the tendency of the Federal Reserve to provide incentive for membership through
regulatory laxity and monetary stabilization policy would not be impeded by deposit shifts between member and nonmember banks .
Recently, considerable criticism has been leveled at the dangers associated
with the expansion of banks and bank holding companies into nonbank activities .
The drift into nonbanking activities is , in part , explained by the geographical
constraints imposed on the fixed capital investment of banking firms as well as

legal constraints on competing for funds through payment of interest on deposits .
The proposed system would encourage efficient and growth- oriented commercial banks
to grow within the banking industry and not to spread their managerial ability too
thinly into nonbanking activities .

It will tend to keep banking expertise more

efficiently allocated within the banking industry proper .

It would thereby reduce

the many problems associated with the nonbanking activities of expansion - minded
banking firms .
To some extent the problems associated with excessive marginally profitable
branching within small geographic areas also arise

because branching competition

9 The Federal Reserve's proposal for uniform reserve requirements is given
in Boehm , op . cit . , p.13 . The costs and benefits of zero reserve requirements deserve
close inspection .
To place this issue in a fuller focus , see Thomas Havrilesky's remarks in
Chapter XI .


has been used as a substitute for interest- rate competition in the industry.
ceilings were removed from interest rates payable on all deposit classes at the
same time that geographic restrictions were removed , there would be less superfluous investment in branches .

( See Footnote 10. ) When compared with price ( in-

terest rate ) competition , intensive branching in the same community is a highly
inefficient way of attracting customers .

It allows for little reversibility and

low cost , competitive experimentation by the banking firm .

In addition , locational

convenience and promotional services are unlikely to be as efficiently consumed
as interest income by bank customers .

While nonprice competition (which includes

locational competition ) would be likely to persist in an oligopolistic banking
industry, social welfare , in the efficiency sense , would probably be advanced by
increased price competition .
The Future of Local and Regional Banking
It has sometimes been contended that if geographic branch restrictions were
eased , local and regional banks would virtually disappear because of the competitive advantages of large statewide or interstate banks .

Empirical evidence as

well as observation of trends in statewide branching suggest that local banking
and statewide branch banking can profitably co- exist .

From 1960 to mid- 1972 ,

nearly 1,600 banks disappeared through mergers and other absorptions , while more
than 2,000 new banks opened .
One half of the new banks (most of them in Florida ,
Illinois and Texas ) originated in states permitting only unit banking , and , presumably, the majority of these banks are subsidiaries of multibank holding com-

11 Federal Deposit Insurance Corporation , Summary of Accounts and Deposits in
All Commercial Banks- June 30 , 1972 , National Summary (Washington , D.C .: FDIC ,
1973) , pp. 7-8.


panies , an obvious device for circumventing geographic branching restrictions .
Similarly, a fourth of the new banks came from limited-area branching states ,
where multibank holding companies are also important for circumventing geographic branching restrictions .

However , a fifth of the new banks and nearly 40

percent of the mergers occurred in statewide branching states , which suggests
another important reason for new bank formation :

filling a void created by the

disappearance of so many local and regional banks .
In North Carolina , despite statewide branching and intensive nonprice competition by statewide branch banks , local and regional banking has flourished .
Recent research has shown that intensive selling expenditure is not prima facie
evidence of barriers to new entry into the industry.
In fact , casual observation indicates that in each of the seven major metropolitan North Carolina banking markets where locally owned and operated banks were acquired or merged into
statewide branch banks in the 1960-1974 period , after a short lag , local citizens
banded together to form one or more new local banks .

Statewide branch banks and

local banks are , in the case of many banking services , apparently not perfect substitutes .

"Chain banking , " has also long been a way of securing common control of
banks , while avoiding state and federal regulation of branching and holding companies . Identified links are : interlocking stock ownership , directorates , and
officers as well as loan links . (See Footnote 1. ) Where corporate stockholders
are concerned , a particularly insidious link potentially arises through nominee
corporations of bank trust departments , savings bank ownership of commercial bank
stock, and insurance company ownership of bank stock . (See , House of Representatives , Select Committee on Small Business , Chain Banking : Stockholder and Loan
Links of 200 Largest Member Banks (Washington , D.C .: Supt . of Documents , 1963) .
Like multibank holding companies , chain banking is probably more prevalent in states that limit or restrict branching . Despite branching restrictions ,
multi - office banking obtains . Because of branching restrictions , it obtains in
a manner that undermines the informational content of conventional statistics on
banking market structure .
Thomas Havrilesky and Robert Schweitzer , " The Durability of Consumer Preferences : Some Evidence from a Banking Market" ( forthcoming ) .



The Convenience and Needs Doctrine
Ironically, both antecedent mergers and the subsequent formation of new
unit banks have been justified by the " convenience and needs doctrine . "

This is

sufficient evidence that the " convenience and needs doctrine " is excessively

In the case of a merger , " convenience " is often interpreted to mean

a wider range of depository, trust , and lending services at the several branch
locations of the merged banks.14

In the case of a locally owned and operated

bank it is interpreted to mean the " convenience " of personalized service and/or
loan access by small local businessmen in periods of tight money , when large statewide branches are impelled to meet their advance lending commitments to their
large customers elsewhere .

(This raises the questions as to whether the unmerged

banks could not , through correspondents , loan participations , etc. , provide the
same range of services and whether the merged banks are not providing an " inconvenience" in the way of impersonalized service and/or inaccessibility of loans to
small businessmen . )

Clearly , the convenience and needs doctrine should carry

consistent operational implications for regulatory bodies .
should not be the overriding criterion in merger cases .

In addition , it

Concluding Comments
Rather than conclude the presentation at this point , a fuller focus may be
obtained by reading the related remarks of Thomas Havrilesky in Chapter XI , " Banking and the Economy . "
14 For a tabulation of " convenience and needs " benefits in holding company cases involving bank acquisition , see Michael A. Jessee and Stephen A. Seelig , "An
Analysis of the Public Benefits Test of the Bank Holding Company Act , " Monthly
Review, Federal Reserve Bank of New York , June 1974 , p . 153.
15In the Bank Merger Act of 1966 , regulatory authorities are supposed to balance public interest ( " convenience and needs" ) against the competitive impact of
mergers . Approval is possible if the former outweighs the adverse competitive


Chapter II.- Banking and the Economy

By Thomas M. Havrilesky

Over the past decade and a half , commercial banks have actively sought opportunities for growth .

New deposit instruments , innovative lending arrangements ,

imaginative extension of customer services and expansion of operations into regional , national , and foreign markets have characterized this period .

Waves of

bank mergers and acquisitions and the development of bank holding companies further reflect the

quest for growth .

In the wake of these developments , a few manifestations of aggressive expansion have tarnished the industry's reputation for prudence .

Unprofitable and an-

ticompetitive mergers and acquisitions and the spread of bank holding companies
into excessively diverse lines of business are occasionally condemned in the financial press .

These practices generate suspicions that laxity and excessive dif-

fusion of accountability prevail amongst the banking industry's regulatory bodies .
In addition , the financial press is concerned about the need for regulations in
the areas of equity capital , liability management , and lending practices .
I shall argue that while a reorganization of the regulatory structure and
more stringent restrictions on acquisitions and nonbanking activities are necessary, there should occur , at the same time, an elimination rather than an increase
in the degree of restriction on traditional banking activities .

I shall contend

that a more liberal regulatory atmosphere with regard to branching and the unrestricted payment of interest on all classes of deposits , together with a stricter
attitude toward anticompeitive mergers and nonbanking activity , will create a

I am grateful to flartin Bronfenbrenner , Kalman Cohen , Edward Kane , and
William P. Yohe for helpful comments . Responsibility for error is solely my own .



more stable , more efficient , and safer system .

A more stable , more efficient

and safer banking system together with desperately needed restraint in fiscal
and monetary policies , will , in turn , produce a healthier economic environment.
Restrictions on traditional commercial banking operations often are suggested as a means of impeding :
tions ,

( 1 ) further thinning in bank equity capital posi-

(2 ) aggressive and costly liability management policies , and

generous advance lending commitments to large depositors .

( 3 ) overly

The latter two prac-

tices are widely said to have militated against the periodic tight money policies
of the Federal Reserve System during the past decade .

Moreover , all three phenom-

ena are said to have recently impaired confidence in the solvency and liquidity
of many banks .
In contrast , I will show that much of the recent vulnerability of the commercial banking industry has developed because of ( rather than in spite of) existing regulations ( namely interest rate ceilings and branching restrictions )
and a decade of dangerously inflationary monetary policy .

Added statutory regu-

lation of equity capital ratios , asset composition and liability composition , except in the case of tacitly unsound banking practices , are unlikely to make our
commercial banking system much less vulnerable or much more sensitive to monetary policy without sizable social losses from a more inefficient allocation of
credit .

Equity Capital
Observers have become alarmed over the rapid growth of banking assets relative to banking equity in the past decade .

Many view as culpable the industry's

ingenuity at attracting funds from unconventional sources .

The growth rate of

bank assets has soared far ahead of the rate at which bank equity could be readily



expanded in this growth -oriented industry .
growth in the monetary base .

Yet bank assets cannot grow without

The inflationary policies of the Federal Reserve

System have themselves promoted the erosion of bank equity capital ratios .
brief examination of the incentives for inflation in government and central banking will show that in order to protect our financial system and our economy we
need an enormous disciplining , not of the traditional practices of our commercial
banking industry , but rather of the fiscal and monetary policies of our government and central bank.
Because tax increases would directly displace private spending , government
officials are rewarded for delivering government largesse to their constituents
without (explicitly) raising taxes .
pressure on interest rates .
private spending .

The resulting chronic deficits impart upward

However , higher interest rates would also displace

Moreover , high and rising interest rates are anathema to the

savings and loan industry, which is protected from paying competitive rates by
ceilings on deposit rates of interest .

Consequently, Federal Reserve officials

come under considerable palpable pressure ,

often rationalized as a concern for

" sectoral " problems , ( e.g. , housing ) 2 to increase the growth rate of the money
supply thereby keeping nominal interest rates from rising rapidly.

As recent

Presidential administrations have succumbed to a desire for immediate , visible
" success" with too little regard for long - run consequences , deficits and concomitant pressures on an increasingly compliant Federal Reserve to sustain low interest rates

have grown .

As a result ,

the growth rate of the narrow money supply

jumped from slightly less than four percent during the 1960's to about seven
percent in the 1970-74 period .

1 See Sanford Rose , " The Agony of the Federal Reserve , " Fortune (July , 1974)
and Leonard Silk , Nixonomics ( Praeger , New York, 1973) .
Sherman Maisel , Managing the Dollar ( Norton , New York, 1973 ) .



Unanticipated acceleration in the growth rate of the money supply in a fully
employed economy causes , after a lag , unanticipated increases in the rate of inflation .

Thus , in a fully employed economy the initial rise in government spend-

ing must ultimately bring about a reduction in private spending- not explicitly
through tax increases or interest rate increases- but rather invisibly through
unanticipated erosion of the real value of privately held monetary assets .
Paradoxically , once the rate of inflation generated by accelerated money
supply growth becomes fully anticipated , nominal interest rates must rise .


vidual creditors will insist upon an " inflation premium" in their interest income and rising interest rates , which the Federal Reserve so arduously resisted ,
will obtain .
Thus , the incentive structure in government and central banking leads to inflation or , viewed in conjunction with government programs to reduce the cost of
being unemployed , to " stagflation . "

Before we can reform this perverse incentive

structure3 many observers are fearful that dissatisfaction with runaway inflation
may lead to a permanently controlled


Within the context of our chronically inflationary monetary policy and its
continual inflationary pressures on interest rates , there should be little wonder
over the secular increase in bank credit as a proportion of total credit .
period of secularly rising market rates of interest and falling equity prices ,
bank loans at the sticky prime rate became a most attractive source for marginal
borrowing relative to commercial paper and other open-market sources .


See , for example , Thomas Havrilesky, " A New Program for More Monetary Stability, " Journal of Political Economy ( January- February , 1972 ) and Thomas Havrilesky and Robert Sapp and Robert Schweitzer , " Tests of the Federal Reserve's Reaction to the State of the Economy , " Social Science Quarterly (March 1975 ) .



interest rates fall in less inflationary times , loan quality should improve , as
should capital adequacy) . '

One must conclude that the equity capital cushion

in the banking industry was eroded , not so much by imprudent penchant for growth
within banking , as by the lack of sensible monetary and fiscal policies within
government and the central bank.5
Liability Management
Major sources of funds for the rapid expansion of bank credit in the past
decade and a half have been large , negotiable certificates of deposit and nonnegotiable time deposits .

It can be argued that, as a result , society has bene-

fitted because these instruments broaden the array of relatively safe forms in
which weath may be held .
to society .

However , these innovations are not made without cost

Innovative shifts in the supply of various liabilities impair the

Federal Reserve's ability to control the money stock and bank credit .
ample, in 1969 and early 1970 , a short - lived burst of monetary stringency by
the Federal Reserve boosted market rates of interest above the ceiling rates on
these types of deposits . Restrictions on competition in one market created pressures to circumvent these restrictions in other markets .

Faced with sizable

This is especially true during periods , such as the present , when bank
management is eager to quell public concern over bank vulnerability.
Ideally, the amount and composition of a banking firm's capital should
reflect the sensitivity of its stockholders and creditors to the riskiness of
its asset and liability management . However , because of FDIC insurance , shortterm creditors ,
bank depositors , do not fully respond to this riskiness . Consequently , the private cost of risk to bank management does not reflect the full
social cost ( bank failure ) of risk . If the FDIC varied its insurance premiums
directly with decreases in long - term capital and liquidity , and if this information were made public , the social cost would be more efficiently be signaled to
bank managers and reflected in bank capital positions . See Ronald D. Watson ,
" Insuring Some Progress in the Bank Capital Hassle , " Business Review , Federal
Reserve Bank of Philadelphia (July-August , 1974) .



deposit losses on one hand and with major loan commitments to important depositors
on the other , the large money market banks were able to circumvent the interest
rate ceilings in the deposit market by " borrowing " nondeposit funds in other markets .

First , they borrowed Eurodollars from their own foreign branches .

Then ,

after the Federal Reserve imposed a reserve requirement on Eurodollar holdings ,
they tapped the proceeds of the domestic , commercial paper sales of their holding
company affiliates .

Neither of these sources was subject to interest rate ceil-

ings ; however , both sources of funds became subject to reserve requirements by
late 1970. As a consequence , banks increasingly resorted to finance bills , stand6
by letters of credit and " other liabilities " as sources of funds ." In summary ,
attempts to enforce direct regulations , interest rate ceilings , on the deposit
market led to circumvention via other markets .

This called forth new direct re-

gulation in the form of reserve requirements which in turn generated successful
searches for even newer sources of funds.7
The lesson here is that alert firms in a market economy have an inherent
informational advantage over government regulators .

Short of a completely con-

trolled economy, the costs and benefits of information search and response are
such that the aggressive firm can circumvent specific , direct regulations more
quickly than government regulators can devise new ones and revise old ones .


less governmental policymakers adopt easily enforced incentive-rules that impose
a per unit fee for a measurable class of behavior in all markets , e.g. , deposit

By 1975 only standby letters of credit were not subject to a reserve requirement . Consequently, banks increasingly resort to issuing long term offerings to attract funds and thereby to sustain lending commitments , a costly practice during the current period of concern over bank safety.
Some have argued against reserve requirements as an unfair tax on bank earning power.



insurance fees graduated to reflect the risk of capital and liquidity positions
(see Footnote 5 ) , the regulation of traditional banking activities is likely to
prove costly and anemic , if not counterproductive .
Aside from impairing the ability of the monetary authority to control the
money stock, it has been argued that successful innovations in liability management have actually enabled banks to continue to make excessive advance lending
commitments to big depositors .

The danger in this practice is that advance loan

commitments constitute a potentially enormous drain on bank funds during periods
of bank illiquidity .

The asset liquidity of commercial banks has declined through-

out the postwar period , and when lenders believe a bank to be unsound , its ability to obtain liquidity by refinancing its existing liabilities or sell new obligations on reasonable terms is impaired .
deal with liquidity pressures .

This could leave the bank unable to

Bank failure could result .

(Once more , however ,

in less inflationary times , liquidity positions should improve , especially as
banks respond to signals from their customers and regulators that they ought to

do so. )8
It should be emphasized that innovations in liability management , however
vulnerable they have made banks and have complicated the policy process of the
Federal Reserve , are a joint product of ceilings on deposit rates of interest , reserve requirements , and a decade of inflationary monetary policy.

Had ceilings

on large certificates of deposits been removed in 1966 instead of 1970 , there
would have been little need for costly reliance upon Eurodollars to finance advance lending commitments , and little need for banks to seek funds in the commercial paper market .

Because uninsured commercial paper would not then have dis-

Ideally, the public's concern over the risk of deteriorating bank liquidity and capital positions should be more quickly transmitted to bank management .
Scaling and publicly announcing the rates on deposit insurance to reflect risk
are often suggested as a means of more efficiently transmitting this concern (see
Footnote 5) .



placed insured certificates of deposit in many portfolios , there would have been
much less distress when Penn Central failed to refinance its commercial paper in
1970. The Penn Central crises that Federal Reserve officials takes so much credit for averting need not then have impaired sound monetary policy.9
Loan Commitments and Other Concessions
It is contended that restrictions on advance lending commitments would reduce the vulnerability of commercial banks to liquidity problems during periods
of monetary tightness , minimize the need for fairly radical innovations in liability management and thereby simplify monetary policymaking .

Once again , this prob-

1em cannot be separated from the inflationary policies of the Federal Reserve
System and the network of interest rate ceilings .
Because of a zero ceiling on interest payable on demand deposits , commercial
banks have had to compete for deposits by making concessions in other banking and
nonbanking markets .
view of banking .

This phenomenon underlies the so - called " package of services"

In some markets banking and nonbanking services will be priced

by commercial banks below marginal cost in order to attract funds of the same
customers in the deposit market .

For example , a banking service , a line of bank

credit , will be extended in the loan market to large potential and actual depositors at the prime rate as a means of attracting their funds in the market for
demand deposits .
Recent inflationary growth in the monetary base has provided commercial
banks with an increased basis for expansion at the same time that it has driven

It is ironic that restrictions on traditional banking activity , such as
interest rate ceilings ( once rationalized as helping to insure bank safety by
encouraging banks not to compete for deposits ) , have actually contributed to
bank vulnerability.




market rates of interest further above the deposit rate ceilings .


by law from locational competition for funds through branching and constrained
by law from price competition for funds through higher interest rates on deposits ,
banks have had to utilize concessions in other markets as means of attracting
funds .

The emphasis has been on ancillary services ( often by nonbanking affili-

ates ) 10 and greater advance lending commitments to big depositors .
As market rates of interest rose further above ceiling rates and as these
lending commitments were called , commercial banks engaged in increasingly costlier means of attracting funds .

It should be clear that the most obvious way

to minimize advance lending commitments ( and the subsequent costly innovations
in liability management discussed earlier ) would have been to establish sound
monetary and fiscal policies and to abolish geographic restrictions on branching
as well as interest ceilings on all classes of deposits , including demand deposits .

The Case Against Restrictions on Banking Activities (and For Restrictions on " NonBanking" Activities )
Deposit rate ceilings lead to a misallocation of resources .

Criteria for

the extension of bank credit include the size of the borrower's deposits .


amount of a borrower's deposit wealth is unlikely to be perfectly correlated with
the social value ( the profitability and riskiness ) of his investment project .

The enormous growth in bank holding companies over the 1965-1973 period
when market rates of interest soared simply reflect the industry's response to
deposit rate ceilings , branching restrictions and the liberal attitude of the
Comptroller of the Currency (before 1970) toward approving nonbanking activity
by commercial banks .
For further discussion of branching policy, see the remarks of Thomas
Havrilesky and William P. Yohe in Chapter VII , " Entry Policy. "



As a consequence , bank credit will often be denied to small borrowers or borrowers with weak cash positions , even though their projects are highly profitably
and of low risk .

This fundamentally explains the presence of all sorts of capri-

cious , mischievious and even discriminatory considerations in the extension of
bank credit ( e.g. , equity kickers ) .

It constitutes an efficient and hence so-

cially costly misallocation of resources .

In a period of high and rising inter-

est rates when lines of credit are exercised by the large ( but not necessarily
the most credit- worthy) depositors , it may also explain deterioration in the
quality of bank assets which should improve naturally when interest rates decline. )
It is often suggested that " social priorities" can be served by added regulation of the allocation of bank credit to 'credit- starved" areas .

It is unlike-

ly that the fortunes of small and weak or underprivileged borrowers can be assisted by further restrictions on asset portfolios of commercial banks .
have already discussed how interest rate restrictions lead to discrimination
against small borrowers.


restrictions would surely generate further in-

efficiencies in the allocation of credit by allowing further invidious , discriminatory and often political , considerations to color the allocation of credit
and by creating new constituencies that further politically constrain the supply of capital from being responsive to changing needs .

Our economic history

is replete with examples of government interference with market allocations , including the capital market , in the name of helping the weak and underprivileged
but ultimately benefitting only the strong and powerful , who generally possess
social and political power to influence the allocative decision far out of
proportion to their ability to compete in the market .

Like federal interven-

tion in other areas , such efforts will likely lead not only to a less desirable



allocation of resources but ultimately to a more inequitable distribution of

For example , federal government intervention in mortgage markets has

led to a large stock of unsold , vacant housing (while other forms of capital are
in short supply)



mortgages going to high - income borrowers .

large volume of subsidized
As another example , federal govern-

ment intervention in agricultural production has aggravated the food shortage ,

resulted in inflexible , energy intensive
rather than land intensive , methods of
farm production , and allowed millionaire farmers to continue to receive aid .
The persistent gap between political promise and costly, tragic results further
erode the average man's faith in government in these perilous times .

In addi-

tion , it should again be pointed out that direct regulation in specific markets
is unlikely to succeed because of the inherent informational and response disadvantage of regulators .

We know so little about how markets interact and how

banks will respond to direct regulation that government intervention in this
form is likely to fail .
Nonprice competition for deposits tends to cause inefficiencies in the
consumption of banking services .

Small depositors are bribed with indivisible

lumps of locational convenience , advertising and promotional goods and services
which they cannot so costlessly utilize as cash payment of interest .


an explicit payment of interest in cash would further advance the welfare of the
small depositor than would a set of china or a wrist -watch .

Locational and pro-

motional expenditures tend to impart fewer ( informational and locational ) benefits to bank customers than would the cash payment of interest , especially when
there are geographic restrictions on branching activity ( see Footnote 8 ) . The
thorough-going reliance on nonprice competition in retail banking is also likely
to result in operational inefficiencies in the production of banking services .
As a means of attracting deposits in lieu of interest rate competition , loca-


- 75 - 10



tional and promotional expenditures are much more indivisible and hence less
subject to experimental adjustment by banking firms .

Furthermore , because of

the likelihood of rival retaliation , they tend to lock banking firms irreversibly
into high selling expenditure budgets and heavy investment in branches .


a high degree of nonprice competition could also conceivably result in barriers to
the market entry of new banks .
The abolition of deposit rate ceilings would probably simplify monetary policy.

Where deposit rates are flexible , there would be less necessity for inno-

vative shifts in the banking firms ' supply of depository, lending , and other

The behavior of banks and the nonbank public would be more predict-

able , and this would be reflected in a more stable relationship between changes
in the control - variable or instrument of monetary policy and subsequent changes
in the growth rate of the money supply and the level of interest rates .

This ,

in turn , would be reflected in more stable relations in macroeconometric and
other models used for economic forecasting and policymaking .
If interest rate ceilings and geographic branching restrictions were removed , there would also occur a reduction in the tie- in selling of services below cost as a means of attracting funds .

The ability to compete for deposits

by unrestricted price and locational competition would curb the incentive for
banks and bank holding companies to attract funds by activities in markets for
services far outside the purview of their own banking expertise and the exper-

Thomas Havrilesky and Robert Schweitzer , "The Durability of Consumer
Preferences : Some Evidence from a Banking Market" ( forthcoming ) .
13 This sort of stability ( and a reduction in the erosion of Federal Reserve
membership ) could be further advanced by uniform ( perhaps uniform at zero ) reserve requirements for all member and nonmember banks and all sources of funds
and/or the payment of interest by the Federal Reserve on member bank deposits .



tise of bank examiners and regulators .

For example , it is unlikely that a

banking background is relevant to insurance underwriting , computer services or
the travel - agency business .

The allocation of banking resources to diverse non-

banking fields surely is inefficient and reduces bank profits and capital adequacy.

Aside from possible adverse effects on competition in

these nonbanking

markets in the long run , new nonbanking activities by commercial banks impose
new risks (for example , operating losses and damage suits ) on the banking firm .
In addition , regardless of their legal separateness , in the absence of external
restrictions the resources of the bank would probably be used to meet claims
upon a failing , nonbanking affiliate ( especially if nonbank enterprises are under
capitalized ) .

Shaky nonbanking affiliates also would tend to impair public con-

fidence in the banking firm as the legal limits of bank support of nonbank affiliates may not be well known .

Finally , despite restrictions in current law , one

should not completely dismiss the inequity of bank financing of affiliate expansion with subsidized , FDIC insured , funds .
These considerations suggest that there is little justification for differential restrictions on the nonbanking activities of banks and bank holding companies .

They form the basis for enactment of more stringent restrictions on the

nonbanking activity of commercial banks and bank holding companies in the inter14
est of bank safety .
Combined with earlier arguments for less strict regulation
A way of achieving this restriction in the public interest that does not
entail the difficulties of costly, anemic and invidious enforcement might be to
insure all deposits and to tie deposit insurance rates to measures of the risk
of the activity, as reflected in the capital structure of enterprise . While
this sort of scheme would be more applicable to traditional banking activities
(see Footnote 5 ) , its extension to nontraditional activities would provide banks
and the banking public with information concerning the perceived riskiness of
these activities . The direct prohibition of some activities yields banks and
the banking public the misleading information that their activities are infinitely
risky whereas nonprohibited activities are not . Variable deposit insurance rates
would be a likely feature of private deposit insurance industry. See Sam Peltzman , "The Costs of Competition : An Appraisal of the Hunt Commission Report , "
Journal of Money Credit and Banking ( November 1972) .



of traditional banking activities and sounder fiscal and monetary policies ,
tighter restriction on the nonbanking activities of commercial banks would produce a more efficient and safer financial environment .
Concluding Comment
An overly restrictive regulatory environment for traditional banking activities in conjunction with an excessively expansive monetary policy , has created
an ambiance in which commercial banks must continually develop new nonprice means
of attracting funds .

When compared to unrestricted price and locational competi-

tion , these innovations generate considerable inefficiency. In addition , and in
contrast to the ancient rationale for these restrictions , it can be cogently argued that they tend to reduce bank safety.
ization policy.

Finally, they impede monetary stabil-

The solution to these problems entails creating a more liberal

competitive environment for banks and promoting a good deal more anti - inflationary
militance in the fiscal and monetary policies of government and the central bank.

[1 ] Alfred Broaddus , " The Banking Structure , " The Federal Reserve Bank of Richmond Monthly Review ( November, 1971 ) .
[ 2] Arthur Burns , " Maintaining the Soundness of Our Banking Sytem, " Federal Reserve Bank of New York Monthly Review ( November, 1974) .
[3] Federal Reserve Bank of Boston , Policies for a More Competitive Financial
System ( 1972) .
[4] Edward J. Kane , " All for the Best : The Federal Reserve Board's 60th Annual
Report , " American Economic Review (December , 1974) .
[ 5] R. E. Knight , " Comments on the Hunt Commission Report , " Federal Reserve
Bank of Kansas City Monthly Review (October , 1972)..
[6] D. Leinsdorf and D. Etra , Citibank ( Grossman , 1974) .
[7] Samuel Peltzman , "The Costs of Competition : An Appraisal of the Hunt Commission Report , " Journal of Money Credit and Banking ( November , 1972) .



[8] Thomas R. Saving , " Toward a Competitive Financial Sector , " Journal of Money
Credit and Banking ( November , 1972) .
[9] Ronald D. Watson , " Insuring Some Progress on the Bank Capital Hassle , "
Business Review Federal Reserve Bank of Philadelphia ( July-August , 1974) .



Submitted to Senate Committee on Banking ,
Housing and Urban Affairs

January 31 , 1975

William G. Dewald
Professor of Economics
The Ohio State University


My discussion of banking and the economy is organized into three
sections .

Bank liability management and effectiveness of monetary policy .


Federal Reserve control of the money supply.


Required reserve ratios .

It is argued that the banking system cannot escape restrictive effects
of monetary policy through liability management but that existing reserve
requirement regulations and Federal Reserve guides to monetary policy
actions contribute to financial instability and should be modified .


particular , the Federal Reserve should restore reserve requirements based
on deposits in the same reserve settlement period and , most importantly ,
the Federal Reserve should be required to announce target quarterly
monetary growth rates in advance and be held accountable for any deviations
from targeted rates .

Interest rate ceilings on deposits should be elimi-

nated for the purpose of stimulating competition and efficiency in financial markets .
The banking system through liability management can " run but not hide'
from restrictive monetary policy actions .
The existence of Federal Reserve Regulation Q time deposit rate ceilings has made it appear that banks , especially large banks , could avoid
restrictive effects .

In the years since 1970 when certificates of deposit

with denominations of $100,000 or more were exempted from Regulation Q
ceilings , large CD's have grown at phenomenal rates :

41 percent in 1974


in contrast to 10 percent for other commercial bank time and savings deposits , only 6 percent for deposits and shares in nonbank thrift institutions , and 3 percent for demand deposits adjusted .

The deposits of

"large banks " (160 weekly reporting banks ) increased 12.0 percent in the
year ended November 27 , 1974 , in comparison with 10.6 percent for other
commercial banks .

The main change in shares since 1970 was not an increase

in deposits held by large banks or the share of total deposits of bank and
nonbank thrift institutions held by banks .

Rather there was a significant

increase in the share of time deposits to total deposits and a rising
share of time deposits issued by commercial banks .

At issue is whether

commercial banks , especially large banks beset by restrictive monetary
policies that limited growth in demand deposits , simply managed to compete
more actively for time deposits in order to finance demands for bank credit ,
thus negating the effects of restrictive monetary policies .
Several facts must be made clear .

First , time deposit growth generally

has outpaced demand deposit growth during expansions .

It did secularly

not only in the past decade but in the preceding decade as well .

Second ,

demand deposit growth , through slow relative to time deposit growth in
1974 and other recent years ,

has been very high by historical standards .

Third , and most important , rapid increases in deposits ( and prices and
interest rates ) in recent years have a root cause not in the behavior of
financial institutions , large or small , but in the profligate monetary and
fiscal policies of the U.S. government :

huge federal deficits financed

exessively by Federal Reserve open market purchases and/or reduced member
bank required reserve ratios .


Financial policies that imposed ceilings on interest rates and reduced competition for savings played a role in the apparent redistribution
of interest bearing deposits to large banks .

Large CD's were freed from

ceiling rates in 1970 because competitive factors were attracting dollars
out of large U.S. banks either into primary securities or the Eurodollar
market .

The investors involved were giant businesses and governments that

have world-wide investment alternatives .
highly competitive .

In other words the market is

Regulation Q ceilings on other deposits curbed compe-

tition , extracted a cartel return from savers with limited investment
alternatives , and induced depositors with alternatives to make withdrawals ,

to purchase primary securities as well as instruments such as vari-

able rate notes issued by large banks , shares in money market mutual funds
that could invest in large CD's and the like .

It is clear that Regulation

Q served to increase somewhat the time deposit growth of large banks
relative to small banks and other financial institutions but that high
rates of deposit growth generally resulted from federal government budget
deficits and creation of fiat money .

High interest rates resulted from

high demands for credit and inflation , and high interest rates generally
served to attract deposits out of instruments subject to ceilings .

Thus ,

it was not " restrictive " but " easy" monetary policy which generated the
market conditions that redistributed deposits .
Nevertheless there is an aspect of the competition for deposits that
bears analysis in the context of " restrictive effects of monetary policy . "
A simple example illustrates this important point .

Suppose the Federal

Reserve sells $100 of securities and reduces bank reserves by $100 .


commercial bank deposits are interpreted as independent of deposits and


shares at nonbank financial institutions , a $100 decline in bank reserves
would force a $ 1,000 decline in bank deposits on the assumption that there
is a 10 percent required reserve ratio and no excess

reserves .

Such a

process is termed " disintermediation " because the public exchanges claims
on banks as financial intermediaries for primary securities .

Central Bank






Deposits of Public



- 900




Deposits with Banks


+ 1,000

On the other hand , if bank deposits are substitutes for deposits and
shares at nonbank financial institutions , a $100 decline in bank reserves
would force more than a $1,000 decline in total " liquidity " (bank and
nonbank deposits and shares held by the public ) provided that banks attracted some deposits from nonbanks .

One would expect this , particularly

if nonbanks are more restricted by interest rate ceilings than banks , as



is probably the case .

Suppose the $100 open market sale by the Federal

Reserve induced commercial banks not only to sell securities but to
raise implicit and explicit interest rates on deposits which attracted
$100 in deposits from nonbank financial institutions .

The latter are

assumed to hold 10 percent of their deposits as reserves with commercial
banks .

In this case , commercial banks would as before be required to sell

$900 in securities to the public and to extinguish $1,000 in deposits ,
$990 owed to the public and $10 to nonbanks .


Deposits of Public

- 900

Deposits of nonbanks






Deposits with


Deposits and shares
of Public






Deposits with


Deposits with

- 100



But in addition , nonbank financial institutions , due to a $100 withdrawal


of deposits and shares , would be forced to reduce earning assets by $90
to restore reserve losses needed to meet requirements . Total liquidity
would decline by $1,090 , reinforcing the $1,000 deposit decline at banks .
The public in effect engages in even more disintermediation in the face
of restrictive monetary policy actions if there is competition for deposits
among financial institutions and particularly , if nonbanks are unable to
match deposit interest rate increases made by commercial banks in response
to Federal Reserve open market sales .

A correlary is that the Federal

Reserve need take smaller restrictive actions on bank reserves to reduce
total liquidity by a given amount if banks compete with nonbank financial
institutions in issuing deposits .
The conclusion is warranted that the apparent ineffectiveness of
restrictive monetary policy actions on large banks is at least in part a
manifestation of monetary policy pulling down growth rates of other financial institutions even more than growth rates of commercial banks .
last half of 1974 provides an illustration .


Commercial bank demand de-

posits increased at only a 1 percent annual rate , reflecting rapid increases in currency held by the public relative to base money issued .
Time deposits at commercial banks increased at an 11 percent annual rate
in comparison with only 5 percent at nonbank thrift institutions .


deposits at large weekly reporting banks increased at a 16 percent annual
rate , led by a 33 percent advance in large CD's not subject to interest
rate ceilings .
How might the government modify existing regulations to avoid the
redistribution of deposits among financial institutions that results


from effective interest rate ceilings during periods when market interest
rates are high?

The answer is most apparent --eliminate ceiling interest

rate regulations .
suppliers .

Let competition direct funds to efficient deposit

Prevent the government from acting as a price -fixer to keep

rates offered small depositors below competitive rates .

The benefits of

such de -regulation would include eliminating much of the distortion in
financial markets due to high interest rates , e.g. , the shortage of lendable funds for thrift institutions that specialize in housing credit ,
costly generation of new financial investments and institutions to by-pass
the regulations , and too low rewards for small savers .

The continued wild gyrations in monetary growth rates in recent
years , and perverse movements , such as recent declines in the rate of
monetary growth despite the recession , reinforce the conclusion that the
Federal Reserve continues to gauge its monetary policies by interest
rates (or the equivalent ) .

Consequently such banking practices as making

loan commitments could delay the restrictive effects of monetary policy ,
and worse , could induce the Federal Reserve to accommodate destabilizing
shifts in planned spending and credit demands in the economy.


banks make commitments to finance $100 billion of inventory investments
and that the associated increase in the demand for goods could not be met
at existing prices .

When the loans were effected banks would be forced

to borrow or sell securities which would raise interest rates sharply .
If the Federal Reserve accommodated the money market by purchasing securities
to prevent rates from rising as much as they otherwise would in the short


run , the result would be that monetary and credit expansion had been induced by the economy .

The resulting policy stance would give the appear-

ance of being restrictive because interest rates rose , but it is unambiguously expansionary because the Federal Reserve put base money into the
economy by purchasing securities .
The fundamental principle on which the Federal Reserve was founded
was the commercial loans principle which requires the Federal Reserve to
pump base money into or out of the economy to permit banks to meet loan
demands .

It is an insidious principle !

Major changes in money and bank

credit that have occurred in the past 60 years are attributable to Federal
Reserve accomodation of government and private surges in the demand for
credit .

It is unreasonable to blame private lenders and borrowers for

errors of monetary policy , despite the fact that particular private banking policies may have induced destabilizing reactions from the monetary
authorities .
In 1968 , the Joint Economic Committee , under the Chairmanship of
Senator William Proxmire , held hearings on Standards for Guiding Monetary
Action in which I participated . Two articles of mine based on that
testimony are appended .
The Committee recommended that the Federal

Reserve explain its broad outline of expected economic developments and
corresponding monetary policy actions .

The Committee recommended that

variation in monetary growth rates on a quarterly average basis be

1 " Federal Reserve Policy and the Money Supply , " Bulletin of Business
Research , The Ohio State University , Vol . XLIII , No. 6 ( June , 1968 ) , 1 ,
6-9 and " Economic Effects of a Controlled Money Supply , " Bulletin of
Business Research , The Ohio State University , Vol . XLIII , No. 6 (July ,
1968) , 6-9 .


limited normally within the range of 2 to 6 percent annual rates .


there were deviations outside that range , the Federal Reserve was to be
asked to explain , presumably since larger than 6 percent growth might be
deemed essential during a recession or a banking crisis whereas smaller
growth than 2 percent might seem appropriate during a period of rapid
inflation .

It was felt that long term structural changes in the money

markets might also require the guidelines to be modified in time .
Despite the wide band on quarterly monetary variation , the Federal
Reserve has not effectively controlled monetary growth in the ensuing
years .

In 1972 and 1973 when inflationary demands got out of hand , the

monetary growth rate exceeded 6 percent quarter after quarter .

In 1974

as the recession developed and worsened , monetary growth decelerated
toward the lower end of the recommended range .

Thus , in recent years ,

as in earlier years , monetary growth rates have often been just the reverse of what one would expect if money were controlled to affect the
economy .
In 1968 , I was among those who argued that the Federal Reserve had not
controlled variation in money within reasonable limits but that it could
if it tried ; and if it did , reduced variation in monetary growth rates
would contribute to economic stability .

In the meantime , we have experi-

enced the consequences of bad monetary management :

recessions in 1969/70

and presently , during and after persistent deceleration in monetary growth ,
and in the intervening years an inflationary boom accompanied by persistently high rates of monetary growth.

Thus , recent experience adds con-

firming evidence to the relationship between monetary policy and the
economy .


On the basis of such evidence Congress at this time is reasonably
making its recommendations with respect to monetary control even more
forceful and clear than in the past .

It should require that the Federal

Reserve announce in advance its target monetary growth rates for the
coming quarter ; and , if the target is subsequently missed , say by more
than a percentage point , not only require an explanation of why it was
missed from every official who participates in Federal Reserve Open Market Committee policy making or implementation but also require that the
target rate the next quarter be adjusted to compensate for the error in
achieving the target the preceeding quarter so as to avoid such disasterous
cummulations of errors as observed in 1930-33 or 1936-37 .

Considering the

economic perils our country faces today as a consequence of misguided
monetary and fiscal policies , it is timely that Congress assert its prerogative to direct the Federal Reserve toward moderating variability in
monetary growth rates and to require full accountability for nonperformance .
Reserve requirements are a key instrument of monetary policy .
bank requirement ratios are higher for demand than time deposits , and are
higher for both time and demand deposits in larger total amounts at individual banks .

Nonmember banks and nonbank thrift institutions are subject

to regulations of the state in which they are chartered or in the case of
federally chartered savings and loan associations , regulations of the
Federal Home Loan Bank Board .

The main difference between member bank re-

quirements for either time or demand deposits and those applicable to
other institutions is not so much in the level or requirements ratios but
in the definition of legal reserves that can satisfy requirements .


Nonmember bank institutions can generally count deposits with commercial
banks as reserves and sometimes approved securities as well .

But member

banks can only count deposits with Federal Reserve Banks and currency and
coin holdings as legal reserves .

Despite over 60 years of Federal Reserve

free and cut -price services , U.S. financial institutions including member
banks continue to demand the services of deposits (correspondent balances )
with large commercial banks , particularly for check collections that cannot be made as well if at all by the Federal Reserve .
It is clear that the existence of reserve requirements act as a tax
to the extent that banks hold non-interest bearing reserves they would
not otherwise hold .

This tax may be judged efficient or not on the basis

of its effects on the allocation of real resources .

To the extent that

large banks and banks issuing demand deposits have more variable deposits ,
they may reasonably be assessed a higher fraction of the costs of maintaining the Federal Reserve last resort loan facilities and other functions
which banks with volitile deposit flows might use more than other banks .
However , existence of lower requirements for small banks in fact reflects
the historical pattern and that small banks

hold disproportion-

ately large amounts of correspondent balances .

Therefore they have the

weakest attachment to Federal Reserve membership because the required
reserve tax is such a burden .

A detailed proposal of mine to improve

the efficiency of reserve requirement regulations for banks and nonbank
thrift institutions is appended ."
It would permit correspondent balances
to be counted as legal reserves for all depository institutions .

2 " Reserve Requirements for Banks and Savings Institutions : A Proposal For Reform," Bulletin of Business Research, The Ohio State University ,
Vol . XLVI , No. 4 (April , 1971 ) , 1-8 .

52-221 O 75 - 11


Unless there are uniform required reserve ratios , shifts in deposits
from one reserve requirement class to another affect the amount of reserves that banks are required to hold , and thus necessitate that Federal
Reserve policy actions offset any undesired change in the overall issue
of deposits or bank credit that might result .

It has been demonstrated

that such effects are readily estimated so that the Federal Reserve could
control the monetary supply process in spite of shifts of deposits from
one requirement class to another .

I also append an article that demon-

strates that the average required reserve ratio is a highly predictable
magnitude based on the predictability of the deposit distribution among
required reserve classes . 3
One particular aspect of the existing requirements machinery is a
likely cause of part of the poor monetary control record of the Federal
Reserve .

It is that requirements for a current settlement week are

based on the weekly average of deposits subject to reserves two weeks
earlier .

Consequently , required reserves are absolutely fixed in the

current settlement period .

Even though banks can carry forward deficits

up to 2 percent of the requirements , if the Federal Reserve were so
oriented , it conceivably could determine an amount of bank reserves too
small to meet the reserve requirements .

But in point of fact the ac-

commodating posture of Federal Reserve open market operations typically
works in just the opposite way .

Banks can generate deposits and credit

3 " The Required Reserve Ratio for Member Banks , " Bulletin of Business
Research , The Ohio State University , Vol . XLVIII , No. 9 ( September , 1972 ) ,


without a requirements constraint in the current weekly settlement period .
The Federal Reserve tends to validate the change two weeks hence by
supplying sufficient reserves to meet requirements .

No single action

would do more to endow the Federal Reserve with the capability of controlling monetary growth rates than the restoration of reserve requirements
based on current deposits . * The only factor more important would be a
willingness of the Federal Reserve authorities to use their powerful

instruments for such a purpose .

actually lagged one day .


Federal Reserve Policy and the Money Supply
The uncertainties of the nation's current economic situmore emphasis to limiting erratic variation in the rate of
ation, accentuated by the long deadlock between the Adgrowth in the money supply or even to providir , a steady
ministration and Congress over federal tax and spending
rate of monetary growth to keep pace with real output.
policy, give new prominence to the nation's monetary
This article considers, first, the question whether recent
policy. Monetary policy actions by the Federal Reserve to
policy of the Federal Reserve has been aimed at controlling
the growth of the money supply. Second, it considers
heighten or ease credit conditions have long been a center
whether the Federal Reserve could control the money
of controversy. The record suggests that actions by the
Federal Reserve have often been mistaken or ill-timed.
supply if it wished to. The conclusion briefly is that the
Federal Reserve has not tried to control short-term variaMany critics argue that the monetary authorities have tried
too hard to limit short-run fluctuations in interest rates, and
tion in monetary growth, but it could if it tried. A subsehave measured their policies in terms of changes in interest
quent article will consider the probable consequences of a
rates. These critics hold that the Federal Reserve could
policy designed to provide steady growth in the supply
of money.
make a greater contribution to economic stability by giving
Has the Federal Reserve Controlled Monetary Growth?
To the question whether the Federal Reserve has consciously sought to limit variation in monetary growth, the
answer is no. The evidence is that monetary growth has
been very erratic. Money (defined as private demand deposits and currency in the hands of the public) increased
7.2 per cent during 1967. If that were the desired rate,
there would have been a very strong tendency for weeks
(Continued on page 6)


Federal Reserve Policy and the Money Supply ( Continued from page 1)
The Committee has tended in recent years in its direcwhen the rate of monetary growth deviated from that
tives to hedge its statements about money market pressures.
average to be followed by weeks when its growth rate
For example, the Committee has directed that desired con-,
deviated from the average in the opposite direction . The
fact is that there were 27 occasions in 1967 when the actual
ditions be attained subject to particular developments that
percentage change in the money supply (seasonally admight occur between meetings. Shocks related to Treasury
justed) deviated in the same direction from the annual
financing, bank credit, money, and liquidity developments
have been referred to in this way. The directive has been
average for two weeks or more; ten periods, for three
unclear about what precisely would have to happen to
weeks or more; and three periods, for four weeks. It is
not likely that these changes could have occurred
change desired market conditions and by how much.
According to the record for the December 12, 1967,
the Federal Reserve finding out soon enough to try to react.
Preliminary but accurate weekly data are published with
meeting, the Committee directed the Manager to conduct
a lag of only one week.
operations for the purpose of
Observed deviations from average monetary growth
"...moving slightly beyond the firmer conditions that
over even longer periods give further evidence that the
have developed in money markets partly as a result of
Federal Reserve does not control monetary growth. The
the increase in Federal Reserve discount rates provided,
however, that operations shall be modified as needed to
average annual rate of increase in money was 2.6 per cent
from 1957 through 1967. Relative to that historical trend,
moderate any apparent significant deviations of bank
monetary growth accelerated to a 3.6 per cent annual rate
credit from current expectations or any unusual liquidity
from August 1962 through August 1965. This acceleration
in the rate of monetary growth probably made sense in
During the intervening period until the January 9, 1968,
terms of economic policy goals, though it could have come
meeting, bank credit, estimated by total bank deposits, inearlier. But as the economy approached capacity utilization
creased at a 3 per cent annual rate, but money narrowly
the monetary growth rate, rather than decelerating, acdefined increased at an 11 per cent annual rate. It is precelerated further to 7.6 per cent from August 1965 through
sumably not a coincidence that free reserves did decrease
April 1966. Through the rest of 1966-during the "credit
as directed and were widely interpreted as an indicator of
crunch"-there was no growth at all. As mentioned, monetightening policy despite the fact that monetary growth
tary growth accelerated to 7.2 per cent in 1967. A similar
had proceeded at such a rapid rate.
on-again, off-again monetary growth is shown in money
A similar directive was issued by the Committee at its
broadly defined to include commercial bank time deposits.
next meeting. During the following four weeks free reThe directives of the Federal Open Market Committee
serves fell further; the rate of bank credit growth was
to the Manager of the Open Market Account in New York.
about the same; and monetary growth proceeded at about
offer the best testimony of what it is that the Federal Rea 1.5 per cent annual rate.
serve tries to do. The directives are usually phrased in such
As this episode illustrates, it is clear that the Federal
terms as reserve "positions" or "availability," money marReserve has not tried to control monetary growth, at least
ket "conditions" or "pressures." The key measure is net
not directly. The proximate targets at which the Federal
borrowed reserves (negative free reserves)—the arithmetic
Reserve has aimed have typically been achieved. The timing
difference between member bank borrowings from the
of changes in desired money market conditions reveals that
Federal Reserve and excess reserves. "Long experience has
the Federal Reserve has been quick to pick up evidence of
shown that any departure from a relatively steady ratio
a need for action. But actual policy actions and money supbetween bank credit expansion and the reserves supplied
ply changes have often been in the wrong direction and of
at Federal Reserve initiative sets forces into operation that
inappropriate magnitude. The policy of manipulating
tend to encourage bank credit expansion when free remoney market conditions or interest rates can be likened
serves exist and to restrain bank credit expansion when
to a baseball player who can't hit curve balls. The policy
net borrowed reserves exist." Net borrowed reserves and
is satisfactory if market conditions are at an equilibrium
market interest rates are correlated ; and it is to one or both
associated with achievement of objectives. But otherwise,
of these that the Committee usually refers. In the termiwhen the economy throws curves, tardy adjustments in denology of the Committee, easing conditions are measured
sired money market conditions lead to strikeouts, as the
by declines in interest rates or net borrowed reserves, while
monetary managers swing behind the economy, where it
tightening or firming conditions are measured by the comwas rather than where it is.
parable increases. When conditions in New York differ
Could the Federal Reserve Limit Variation in the Rate of
from those elsewhere, the Manager may indicate that the
Monetary Growth if It Tried?
"feel of the market" is tight, even though aggregate measures indicate the contrary.
Generations of American university students have
1 The Federal Reserve and the Treasury Answers to Questions from
learned that Federal Reserve open market operations can
the Commission on Money and Credit, Englewood Cliffs, N.J.: Prentice2
Federal Reserve Bulletin, March 1968, p. 306..
Hall, Inc., 1963, p. 9.


be used to control bank reserves and other money that is
non-controlled factors. A large part of the variability in
issued by the Treasury or the Federal Reserve. This sonon-controlled factors that affects average bank reserves
called "high-powered" or "base" money in turn has been
and other base money could readily be offset over a week
interpreted as the cornerstone on which the money supply
or two by open market operations of sufficient magnitude.
depends. The quantity of money is determined within a
Changes in the ratio of the money supply to the volume
of bank reserves and other base money are accountable to
supply and demand or market framework. But the operation of this market process is subject to important policy
changes in the distribution of money among deposits subject to different reserve requirements, between monetary
constraints, including the amount of base money and the
and non-monetary deposits, between base money reserve
legal requirements imposed on banks to hold base money.
A number of recent studies have examined the determiholdings of banks and currency holdings of the public,
and, finally, between bank required and excess reserves.
nation of the quantity of money within a market frameThese changes reflect both supply and demand factors in
work. In general, they show that more than 80 per cent
of the quarterly variation in the money supply can be
the money market. There is a relatively strong seasonal
traced to readily identifiable market forces.
pattern in variation with respect to some of these nonBut these statistical results are not altogether relevant
controlled distributional factors; and there is knowledge
with respect to their response to market interest rates and
from the point of view of actual monetary control. It is
not necessary to fix open market policy or reserve requireto spending. Though non-policy factors are important, a
ments over an entire three-month period, as is implied in
large part of the quarterly changes in money are accountthe use of quarterly models. The Federal Reserve obtains
able to changes in reserves (and other base money) and in
weekly money supply statistics with a lag of one week. It
reserve requirements. At but one remove from the money
is promptly alerted to significant deviations in monetary
supply, more than two-thirds of the variation in changes
growth from the desired rate.
in net deposits of member banks over half-monthly periods
The Federal Reserve must of course take into account
was accountable to changes in bank reserves, changes in
various non-controlled factors that affect the supply of or
required reserve ratios, and predictable changes in distridemand for base money. It presently makes day-to-day
bution of deposits subject to different reserve requirements.
and week-to-week projections of likely changes in these
(Continued on page 8)


Federal Reserve Policy and the Money Supply (Continued from page 7)
Though the deposit distribution is very stable in the short
run, taking account of seasonal factors and of market
prices reduces prediction errors by about 50 per cent from
those based on the naive alternative of assuming that there
would be no change in the distribution from period to
period. The estimates suggest that more than half of the
time prediction errors would be one-half billion or less.
These errors in prediction must be interpreted in the
light of an attempt to control monetary growth. Errors
could be reduced substantially over longer periods than a
week or two if monetary policy were implemented so as to
offset prediction errors in one period by compensating
changes in the target the following period. For given settings of policy instruments, reasonable predictability of
deposit changes and of changes in the quantity of lawful
money over very short periods supports the conclusion
that the Federal Reserve could ordinarily manipulate its
instruments to have a highly predictable impact on the

Ratio Scale
Billions of Dollars

amount of member bank deposits and money on a monthto-month or quarter-to-quarter basis.
A question must be raised with respect to the actual
relationship of money to policy instruments if monetary
control became the proximate policy objective. If the Federal Reserve utilized its instruments to constrain monetary
growth to a desired level, induced changes in interest rates
could feed back to affect changes in money. If the structure
of the economy has been such that policy instruments have
moderated interest rate variability, then estimates of financial behavioral patterns could be expected to be biased.
A simple illustration makes this clear. Suppose there is
a change in demand for bank credit which prompts banks
to sell securities. The effect would be to increase market
rates of interest on private and government securities. But
if the monetary authority conducts open market operations
to prevent these increases, it would increase the amount of
base money in the system. The immediate effect would be

Money Stock
Monthly Averages of Daily Figures
Seasonally Adjusted

Ratio Scale
Billions of Dollars
























150 ‫يليلا‬
Percentages are annual rates of change between periods indicated . They are
presented to aid in comparing most recent developments with past " trends. "
Latest data plotted : April preliminary


Prepared byFederal Reserve Bank ofSt. Louis



to moderate the increase in interest rates. Statistical data
would show that changes in the amount of base money
are directly associated with changes in the quantity of
bank credit and deposits. The question is whether there
would be a comparable increase in the quantity of money
and bank credit if the Federal Reserve initiated the action
by purchasing the same quantity of securities had there
not first been an increase in the demand for bank credit.
There is little question that the Federal Reserve could
increase the quantity of base money by any given amount.
This would induce banks to extend credit and to issue deposits. In the immediate run this would decrease interest
rates. And that in turn would induce the public to borrow
and to add to deposit holdings. From cycle to cycle or
historically over long periods, it is reasonable to conclude
that these policy actions have played an independent role.
The question is whether they have played an independent
3 Milton Friedman and Anna J. Schwartz, A Monetary History of the
United States, 1867-1960, Princeton: Princeton University Press, 1963.

role, week to week and month to month; and if they have
not, how can one interpret the short-term relationship
between money and bank credit, and the instruments of
Though the evidence is incomplete, it would appear
that the predictability of base money and the distribution
of money are sufficiently reliable that actual manipulation
of controlled variables to limit variation in monetary
growth could be accomplished. There is no need over
reasonably long periods of time, certainly on a quarter-toquarter basis, for average monetary growth to deviate from
desired rates. The Federal Reserve could control the supply
of money if it were so desired.
WILLIAM G. DEWALD is Associate Professor of
Economics at The Ohio State University. This article is
adapted from his recent statement before the Joint Economic Committee of the U.S. Congress in its Hearings
on Standards for Guiding Monetary Actions.

Annual Rate of
Per Cent Change in
FOMC Directive
Week Ending1
Bank Creditз
(Per Cent)
about the
24, 1967 "...
October conditions
Nov. 1, 1967
but preopmarket,
in the
to the extent
be modified,
erations shallfinancing,
more than
14, 1967in".the money
but preoperations
shall betendency
modifiedforas bank
any apparent
significantly more than currently expected."7

Nov. 22, 1967





but operations
be modified
stemming from international financial uncertainties."8

Dec. 6, 1967

- - 1.4




December 12, 1967 ".. . moving slightly beyond
that have
as a result
of the
rates provided,
of bank
any apparently significant deviations moderate
liquidity pressures."9

Dec. 20, 1967
Jan. 3, 1968

- 5.77

- 7.96



9, 1968 ".that have
in the
of the
a result to
partly asannounced
market ininrecent
that operations shall be modified as needed
bank credit from current expectations."10

Jan. 17, 1968
Feb. 7



- 67


1 Averages of weeks ending Wednesdays for money supply changes and free reserves and of weeks ending Saturdays for
the 3-month Treasury bill rate. Dates shown are Wednesdays. All data are derived from Federal Reserve Bulletins. 2 Average of
money narrowly defined to include public holdings of currency and coin and demand deposits. Approximated by average
commercial bank total deposits. Average member bank excess reserves less borrowings from the Federal Reserve. 5 Average
market yield on 3-month Treasury bills. "Record of Policy Actions," Federal Reserve Bulletin (February 1968) , p. 157. 7"Record of Policy Actions," Federal Reserve Bulletin (February 1968) , p. 163. 8 "Record of Policy Actions," Federal Reserve Bulletin (March 1968), p. 294. "Record of Policy Actions," Federal Reserve Bulletin (March 1968) , p. 306. 10 "Record of Policy
Actions," Federal Reserve Bulletin (April 1968) , p. 380.


Economic Effects of a Controlled Money Supply
There was a strong seasonal in interest rates in the U. S.
before the establishment of the Federal Reserve. This has
since been moderated by Federal Reserve actions. There
was no apparent seasonal in interest rate variation from
month to month during that period of the 1930's when the
Federal Reserve did not make any open market transactions
for a few years; but there were substantial month-to-month
changes in interest rates, presumably reflecting non-policy
factors. Finally there is the testimony of Federal Reserve
officials who have continually reported large changes in
uncontrolled factors in the short run that would cause
sharp changes in market interest rates and money market
conditions in the absence of cushioning operations.
I am willing to conclude that there would be increased
short-term variability in market interest rates if the Federal
Reserve tried to moderate variation in monetary growth.
Cyclical and Long-Run Variability in Interest Rates
Limiting variation in monetary growth would likely
decrease long-run interest rate variability. This statement
is made with the full knowledge that it is an affront to
conventional wisdom.
Monetary growth in the postwar period has been lowest around cyclical peaks ; it has accelerated subsequently;
and, then, during expansions, has sometimes accelerated
further and sometimes decelerated. It is reasonable to infer
that interest rates would have been lower and would have
fallen faster around cyclical peaks if monetary growth had
proceeded at its long-period average. Similarly a steadier
rate of monetary growth would have had interest rates
higher than the actual lows at cyclical troughs since these
periods often coincided with high points in rates of monetary growth.
There are separate short-term and long-term forces that
affect the relationship between monetary policy and interest
rates. The most familiar argument involves the short run
when increases (decreases) in monetary growth could be
expected to decrease (increase) interest rates. The point is
that policies which expand the money supply provide banks
and others with the wherewithal to increase the demand
for investments, the effect of which is to bid up their prices
or, equivalently, to reduce interest rates. This argument
depends on the presence of relatively sticky prices and
wages, and, by implication, less than capacity utilization of
resources. When these conditions hold, it is possible for
declining interest rates to stimulate demand without causing offsetting price and wage increases.
Though one cannot be absolutely sure, it is reasonable
to believe that cyclical interest rate variability of this type
would be reduced by policies that limit variation in rates
of monetary growth. The present cyclical interest rate pattern mainly follows the business cycle, with peaks and
troughs roughly coinciding with peaks and troughs in
economic activity. To the extent that steady monetary
This article is a sequel to one in last month's BULLETIN
OF BUSINESS RESEARCH, "Federal Reserve Policy and the
Money Supply," which made the point that the Federal
Reserve has not consciously sought to limit variation in
monetary supply. That article argued further that the Federal Reserve could control the money supply if it wished.
The point is of some significance because of growing
concern over the ambiguous goals of monetary policy and
the uncertainties of how monetary actions relate to these
goals. Many economists now urge that, in the interest of
maximum contribution toward economic stabilization, Federal Reserve policy should be directed toward providing
a stable, uniform rate of growth in the money supply.
This article considers the economic effects that could
result from such a policy. It deals first with effects on variations in interest rates, both over the short run and over
the cycle; in employment and in economic efficiency; and
in the external value of the dollar. It concludes that a
policy of controlling growth of the money supply, though
not ideal, would be an improvement over past policies.
Short-Term Variation in Interest Rates
For evidence of the effects of stable monetary growth on
interest rate variations one must look beyond the United
For many years the Federal Reserve has acted as a
shock absorber, preventing short-term interest rates or other
measures of money market conditions from departing
significantly from desired values. The desired values have
been subject to change, but, for a given level, changes in
any of the uncontrolled factors that would otherwise affect
market yields and money market conditions have been
offset by policy reactions. Indeed, on many occasions the
immediate effect on money market conditions of one
monetary policy action has been almost altogether offset by
The evidence suggests increased short-term variability
in interest rates if the Federal Reserve moderated variability
in monetary growth. There is greater seasonal and random
variability in free market rates of interest on short-term
instruments in other countries, where the central bank
takes a less active role in moderating short-term shocks to
the financial system, than in the United States.
In Australia, there are relatively wide spreads between
the buying and selling prices of the monetary authority. It
takes a larger change in money market conditions to induce
an open market operation. The market is free to determine
interest rates on short-term instruments over a much wider
range of values than in the United States, and there is
substantially more variability in rates of interest in the shortterm money market in Australia than in the United States,
though it is importantly limited by speculation and international capital flows where rate changes are expected to be


interest to compensate them for their sacrifice of present
growth would represent an acceleration (deceleration) in
purchasing power in real terms and for the expected decline
observed growth around cyclical peaks (troughs), moderin the value of money. Under these circumstances policies
ating variation in monetary growth would tend to damp
interest rate variability at the extremes, and could also be
to accelerate (or decelerate) monetary growth would
increase (or decrease) interest rates.
expected to force interest rates to decline earlier and to preOne cannot be sure what effect moderation in variation
cede cycle peaks in economic activity. The argument is that
in monetary growth would have on overall interest rate
around cyclical peaks when monetary growth has been
slowest, a relative increase in monetary growth would tend
variability over the business cycle; but it is reasonable to
to decrease interest rates. The implication is that the timing
expect that interest rates, rather than rates of monetary
growth, would tend to lead economic activity, and that
of interest rate changes, the effects of which are inevitably
lagged, would be reset to start stimulative effects earlier
cyclical extremes in interest rates would be damped. It is
eminently clear that limiting variation in monetary growth
than under the present policies. These policies have resulted
in deliberate actions to make high interest rates or tight
would be associated with less long-term variation in interest
money market conditions coincide with business cycle
rates than has been observed historically. The extremely
low interest rates that obtained after the financial collapse
peaks and to make low rates coincide with cycle troughs.
the banks in the 1930's resulted from an extremely low
The argument that is least familiar involves the long
run when increases (or decreases) in monetary growth
level of demand at least partly accountable to unduly
could be expected to increase (or decrease) interest rates.
restrictive monetary policies that had occurred earlier.
This involves a reformulation of expectations of future
Today's extremely high interest rates are at least partly
accountable to the high rates of monetary expansion and
prices on the basis of observed effects of monetary growth
on prices. Let us suppose that an increase in the rate of
aggregate demand over the recent years. To the extent that
monetary growth supports an increase in demand. Then
moderating variation in monetary growth could damp
cumulating inflation or deflation in the economy, it is reathis would tend to increase prices, which in turn would
sonable to conclude that it would also limit interest rate
eventually induce savers and investors to anticipate further
variability. I believe that lessening variability in monetary
price increases. Borrowers would be willing to pay more
growth would have this effect.
interest for dollars whose purchasing power was expected
to depreciate, and savers would demand to be paid enough
(Continued on page 8)



Economic Effects of a Controlled Money Supply (Continued from page 7)

interest rates in recession serve the purpose of stimulating
Variations in Unemployment and Economic Efficiency
demand. As mentioned, if monetary policy actions and
There is a question whether monetary policy actions
acceleration in monetary growth lag behind cyclical peaks,
have been counter-cyclical in their effects, and whether
it follows that a more stable rate of monetary expansion at
limiting variation in monetary growth would increase or
cyclical peaks would speed declines in interest rates. A
reduce the counter-cyclical effects of monetary policy
similar statement could be made about interest rates when
actions—an issue about which there is a lively current arguthe
economy approaches full utilization of resources. The
ment in the economics profession.
of declines in interest rates after cyclical peaks
Those who have argued that monetary policy actions
has been the bane of Federal Reserve policy. Since policy
are perverse and play a major role in the pro-cyclical variaactions affect the economy with a lag, it is incumbent to
tion in monetary growth rates would conclude that limiting
introduce, and without delay, counter-cyclical policies of
such variation would reduce the amplitude of the business
sufficient magnitude to have a measurable effect upon the
cycle. This implies reduced variability in capacity utilization
economy. When the need for policy response has been
or unemployment and an increase in economic efficiency.
established, gradualism in declines in interest rates or inBut even if monetary policy actions have affected the
creases in free reserves have often placed the Federal
economy in the right direction, the question is whether that
in the position of taking policy actions that were
effect is as great over the cycle as the effect that would have
actually perverse in preventing interest rates from falling
resulted if monetary growth had been stabilized. This deas
they would have in the absence of actions. This
pends on the timing of the reaction of policy to economic
has typically been associated with a misconception on the
performance and the effect of policy action on objectives.
part of the Federal Reserve, which has often interpreted
Empirical results suggest a relatively short lag in the
declining interest rates or easing money market conditions
response of policy aims to changes in economic conditions
as expansionary, and rising interest rates or tightening
but a rather long lag in the response of the economy to
money market conditions as contractionary-failing to take
policy actions. Part of this response comes in a very short
of the independent effect of its own actions.
time, but it is distributed over many months and is variable
The actual change in quantity of money and bank
from cycle to cycle. Empirical results would also suggest
credit can give important clues about whether policy acimportant responses in expenditure to interest rate changes
tions have been sufficiently expansionary in the face of a
in six months to a year, though much longer average lags
economy or sufficiently contractionary in the face.
have been estimated. An interesting theoretical model develof inflation. The money supply might not always increase
oped in recent years suggests that changes in the money
even with expansionary policy actions, because of the effect
supply, if made an independent factor, would tend to cause
of factors outside the control of the Federal Reserve. Neveraugmented changes in market interest rates, which would
theless, when there has been a decline in the demand for
have the effect of speeding the adjustment to monetary
commodities at the onset of recession, it would be reassurpolicy actions in contrast to the lag that one would expect
ing that the impulse of policy was in the right direction if
simply on the basis of the relationship of expenditure to
the money supply actually increased, at least at the average
interest rates. If one assumes that limiting variation in
rate it had grown in the past. And when there has been an
monetary growth would have the effect of increasing
inflationary increase in the demand for commodities, it
interest rate variation seasonally, it is reasonable to expect
would be reassuring that the impulse of policy was in the
that economic efficiency would be improved and that unright direction if the money supply increased at no more
employment variation over the year would be reduced,
than its long period average rate.
though perhaps not very much. The argument is that when
By this standard money grew too little in the year endinterest rate variation is moderated over the year, the econing June 30, 1960, as the economy moved into recession, and
omy loses the effect of one kind of price change that could
too much in 1967 under opposite conditions. The rate of
direct factors of production to employment during periods
growth in the supply of money can be interpreted in the
that would otherwise be slack.¹
same way as early election returns which provide an indiThe potential effects of interest rates on the allocation
cator of the final outcome of an election.
of resources are much greater over cycles than seasons . Low
The quantity of money can reflect the thrust of policy
1 Over the year there are periods of intense employment utilization,
action on the economy before the actual effects of those
peaking at the end of the harvest season and pre-Christmas production in
October. The high point in unemployment is in June, when the labor
actions are felt in expenditure, employment, and prices.
supply is increased at the end of the school term, followed by a low point
This has been the main point in the argument of my colin industrial production in July. One should expect that relatively lower
for businesses
interest rates before and during June would make it easier
league, Karl Brunner, regarding the interpretation that one
to finance their operations and increase their utilization of labor in June
put on money supply changes. Analysis by Brunner
and July and that relatively higher interest rates later in the year would
marginally shift production to earlier periods. If there is no financial
and his collaborator, Allan Meltzer, has shown a much
penalty for operation during periods of high-level resource utilization,
closer correspondence between the money supply, variously
other than the relative scarcity of labor, then part of the potential power
of the price mechanism in directing resources toward employment during
defined, and economic activity than can be found through
slack production periods is emasculated.



such alternative measures of the stance of monetary policy
The reason why the Federal Reserve has so often puras interest rates and free reserves.
sued policies that caused monetary growth rates to accelIt is reasonable to conclude that limiting variation in
erate with accelerating economic activity and to decelerate
monetary growth rates and letting interest rates vary seawith decelerating economic activity is associated with the
sonally would moderately reduce average unemployment.
idea that the thrust of policy actions is measured by interest
Limiting monetary growth variation cyclically would be
rates and money market conditions. An implication is that
expected to reduce the amplitude of the business cycle and
monetary policy actions have often tagged along behind
increase economic efficiency.
fiscal policy, rather than exerted an independent role.
Expansive or contractive monetary policy actions can be
Effects on Foreign Exchange Rate Adjustment
induced by budget deficits or surpluses when the Federal
One implication of limiting variation in monetary
Reserve acts to prevent interest rates from changing as
growth rates is that the United States would be committed
much as they otherwise would. The test of whether the
to the policy of giving priority to domestic objectives. It
Federal Reserve has added to the inflationary or deflationary
might be necessary to change the value of the dollar in
impuse of fiscal policy is not whether interest rates went up
terms of other monies from time to time. But there is no
or down but whether the Federal Reserve sold or bought
reason why one should expect balance of payment dissecurities or took equivalent actions with its other policy
equilibrium to be a greater problem than it is now. In fact,
instruments. It is typical, though not necessary, for such
if moderated variation in monetary growth had the effect
rising budget surpluses as those in 1959 to induce deflationof damping the business cycle, the critical problem of
ary Federal Reserve policy actions and for such budget
inflation and an associated balance of payments deficit
deficits as those in 1967 and 1968 to induce inflationary
Federal Reserve actions.
would be reduced. This would make the dollar more
Central bankers the world over share the Federal
attractive as an international reserve currency. If not only
the United States but other countries initiated policies of
Reserve's misconception of the proper measure of the stance
moderating variation in monetary growth and other poliof its policy actions. This misconception is particularly
cies that have the effect of stabilizing domestic prices and
dangerous when the level of total demand is at a peak and
maintaining production reasonably near capacity, there
begins to decline. In this situation it is natural for interest
would be much less reason than now for the price of one
rates to decline and money market conditions to ease in the
currency to change in terms of others.
absence of any Federal Reserve policy actions. The danger
Over the years, as tastes and productive capabilities
is that the Federal Reserve may be fooled into interpreting
change in different countries, one should expect that it
declines in interest rates as a sign of expansionary policy
would be necessary to adjust foreign exchange rates. But
despite the fact that it takes actions to prevent interest rates
such fundamental disequilibrium in currency values is best
from falling as far or as fast as they would if there had been
eliminated by foreign exchange rate adjustments and not
no policy actions. Similarly, during inflationary periods
by inflation in surplus countries or deflation (and depresrising interest rates can lead the Federal Reserve to mission) in deficit countries. If more stable monetary growth
interpret its policy stance.
rates than we have had should result in greater relative
In the previous article I mentioned the analogy of this
inflation here than overseas, the implication is that forpolicy to a baseball player who can't hit a curve. That
eigners would eventually get more dollars than they would
analogy can be extended to include the policy of moderating
want and the price of the dollar would fall. On the other
variation in rates of monetary growth. It is a natural curve
hand, if limiting variation in monetary growth should
ball hitter just as the Federal Reserve policy is a natural
result in less inflation here, the implication is that we would
strikeout. Moderating variation in monetary growth-on
accumulate additional foreign currencies or gold-eventuthe basis of the kind of curves the economy has offered in
ally more than we would want—and the price of the dollar
the postwar period-would automatically tend to damp
would have to rise in terms of other currencies.
the worst excesses of induced monetary policy reaction to
the economy. Fifty-five years of swinging behind the econAn Improvement in Policy?
omy, where it was rather than where it is, would seem a
I have argued that moderating variation in monetary
fair test of the central bankers' policy. It may be time to
growth would be an improvement over past policies. This
substitute a new policy-particularly when one considers
does not mean that a constant rate of growth in money
the ominous prospects our economy faces today because of
policies in the recent past.
which to compare counter-cyclical policy actions. The economic record suggests that a constant rate of increase in the
WILLIAM G. DEWALD, Associate Professor of Economics at The Ohio State University, presented this
money supply would have provided more expansive action
material in his statement on May 9, 1968, before The Joint
before and after cyclical peaks than we actually had. It
Economic Committee of The United States Congress in its
would have provided less expansive actions during the
Hearings on Standards for Guiding Monetary Action.
Korean War and the present Vietnam War.







Reserve Requirements for Banks and Savings Institutions :
A Proposal for Reform
Reserve requirements are a governmental financial control that require chartered financial institutions to maintain a minimum percentage of cash and sometimes other
highly liquid assets relative to deposit obligations. Historically reserve requirements were considered as a device
to make deposits and bank notes safe from loss. In recent
years the conventional interpretation emphasized that requirements serve principally as a money and credit control
device, limiting the ability of the financial system to issue
liabilities relative to available government issued financial
claims that banks and the public hold as assets.
Research of the money supply process over the last
decade has established the capability of making accurate
predictions of the basic elements on which money and
related assets depend . Research has also established that
the elimination of reserve requirements would not reduce
the potentiality for monetary control very much. Hence,
the argument for reserve requirements must depend on
other than monetary control factors. If none can be found,
there should be no requirements.
An argument is presented in this article for the existence
of reserve requirements to provide a source of temporary
funds for financial institutions. Requirements also serve
as a taxing device to reimburse the government for certain
special services that it provides chartered financial institutions and for certain special market privileges that are
granted by their charters. The proposals presented here are
designed to improve the efficiency of the financial system
and to eliminate inequities between individual institutions
that exist in the present reserve requirements structure.
Uniform standards are proposed in the sense that deposits
in a particular class should be subject to the same require-

ments for every insured bank or savings institution unlike
the present system.
Nonuniformity in Present Reserve Requirements
Legal reserves to meet requirements for banks that are
members of the Federal Reserve System are defined to include only holdings of vault cash and balances with Federal
Reserve banks. Nonmember banks are also allowed to count
balances with reserve depository banks in financial centers.
(Loss of this privilege is the principal deterrent to Federal
Reserve membership.) Some nonmember banks and savings and loan associations are allowed to count not only
vault cash and deposits as legal reserves, but also U.S.
Government securities and certain other highly liquid earning assets. Mutual Savings Banks which are exclusively
chartered by states have absolutely no asset reserve requirements, nor do nonmember banks in the state of Illinois.
Requirements are generally higher for demand deposits
than time or savings deposits and for time or savings
deposits at banks than at savings institutions. There are
higher requirements for demand or time deposits above
$5,000,000 at any member bank than for amounts up to
$5,000,000. Reserve city member banks have the highest
requirements against their demand deposits. Requirements
for country member banks and nonmember banks in most
jurisdictions are approximately the same.
Attempts to impose federal reserve requirements standards on all banks have been resisted successfully over the
years. Universal standards were expected to emerge after
the National Banking Act in 1863 and again after the Federal Reserve Act in 1913. The original Federal Deposit
(Continued on page 2)


Reserve Requirements

(Continued from page 1)

Insurance legislation in 1933 went so far as to require all
insured banks to become members of the Federal Reserve
System within three years, but this requirement was first
extended and was finally dropped. The Douglas Committee in 1950, the Patman Committee in 1952, and the Commission on Money and Credit in 1961 each recommended
that all commercial banks or insured banks be made subject to member bank reserve requirements and also that
banks and savings institutions be made subject to uniform
requirements on time and savings deposits. The Heller
Committee in 1963 proposed that banks and savings institutions be made subject to uniform requirements on time
and savings deposits and that requirements on demand
deposits be based on bank size rather than geographical
location. Nevertheless, resistance to reform has been so
great that the most basic inequities in the reserve requirement structure exist to this day.
The Strategy for Reforming Reserve Requirements
The Commission on Financial Structure and Regulation was created last year by President Nixon to appraise
the financial environment in the United States with a view
toward reforming the patchwork of existing regulations
on both efficiency and equity grounds. The Commission
in its forthcoming report toward the end of 1971 or early
1972 might be expected to recommend that uniform reserve requirement standards be imposed. The lesson of
history is that such a recommendation in itself would come
to naught. The approach suggested in this article is designed to take some of the sting out of uniform standards
by adapting requirements in certain vital respects to the
actual practice of financial institutions, and by introducing
a bold new last resort lending facility for banks and savings institutions based on reserve requirements. The proposal is tailored to the peculiar financial structure in the
United States with dual (state and federal) chartering and
regulation of financial institutions and thousands of small
banks and savings institutions tied together by a unique
"correspondent banking system." Small banks and savings
institutions look to large city correspondent banks for
wholesale financial services such as holding reserves, collecting checks, shipping currency, lending on short term ,
and effecting security transactions. Largely comparable
services are provided by Federal Reserve Banks. Despite
the general expectation to the contrary at the time of the
establishment of the Federal Reserve in 1913, the correspondent banking system has maintained dominance
in providing wholesale banking services to the vast majority of financial institutions in the United States. The
present proposal recognizes the continued viability of the
correspondent banking system, both as a political and
economic force.
Most banks and savings institutions are presently under
some federal regulations insofar as they are members of
the Federal Deposit Insurance Corporation or the Federal
Savings and Loan Association Insurance Corporation. They

find such insurance important to their successful operations. It is proposed to subject all federally insured financial
institutions to uniform requirements standards but with
a liberal definition of legal reserves to satisfy requirements
and deposits subject to requirements. Accordingly, the
burden of adjustment would not be so great as to generate
the kind of political counteractions that have killed every
other attempt to impose uniform reserve requirement
The key plank in the proposal is as simple as it is profound. It is to define legal reserves to meet requirements
for banks so as to include not only vault cash and Federal
Reserve Balances, but also demand deposit balances with
authorized city correspondent banks, as is the actual practice of most nonmember banks. The fact is that reserve
requirements for nonmember banks are not generally lower than country member bank requirements. The deterrent
that has kept well over half of the banks from joining the
Federal Reserve System has been that their correspondent
balances would no longer be counted as legal reserves if
they joined the Federal Reserve. It would make no difference to a bank whether it held balances with a correspondent or with the Federal Reserve if the services offered
were comparable. But they are not. As a result, nonmember
banks are unwilling to take on the burden of meeting legal
requirements with the Federal Reserve in addition to maintaining balances with correspondent banks so as to benefit
from their superior services.
In general, the principle on which the proposal is based
is to follow the actual practice with respect to reserves that
has evolved in the United States. The intent is to eliminate differences in requirements for equivalent deposits
at different institutions, and to improve the efficiency of
the reserve requirements system in absorbing financial disturbances. The principal of uniform reserve requirement
standards is endorsed without violating the character of
the correspondent banking system .
The Proposal Summarized
1. Define deposits subject to reserve requirements in
three classes : gross demand deposits of financial institutions subject to reserve requirements ("interbank deposits"
for brevity), other gross demand deposits, and gross time
and savings deposits.
2. Define legal reserves to meet interbank deposits requirements to include only vault cash and balances with
Federal Reserve Banks. Define legal reserves to meet other
demand deposits requirements to include also balances
with Federal Home Loan Banks and member banks of
the Federal Reserve System, balances with foreign banks
denominated in convertible currencies, and convertible
currencies. Define legal reserves to meet time and savings
deposits requirements to include also U.S. Government
3. Set required reserve ratios permanently at specified
percentages in each requirement class. Establish uniform




reserve settlement periods, but stagger them so that only
a fraction of the institutions settle on any particular settlement day. Base requirements for the current settlement
period on the daily average of obligations subject to requirements for the same period. The principle of granting
one day's grace in settling reserve accounts is effected by
basing requirements for the settlement period on the average opening of business figures, and legal reserves on close
of business figures.
4. Permit member banks to pay interest on demand deposits due to financial institutions subject to reserve requirements. Pay interest on legal reserves held in vault
cash or in balances with Federal Reserve Banks or Federal Home Loan Banks at a fixed margin below the
Treasury bill rate. Establish a new last resort lending procedure for banks and savings institutions. Lend them their
own required reserves up to a specified percentage of their
requirements or their capital at a penalty interest rate set
a fixed margin above the Treasury bill rate.
5. Eliminate check collection float by requiring simultaneous entry of reserve changes in the accounts of payor
and payee financial institutions or in the accounts of correspondent banks or Federal banks holding their reserves.
Eliminate check collection and clearing services of the
Federal Reserve Banks.
6. Require all federally insured depository financial institutions to submit to these requirements. Included are
commercial banks, mutual savings banks, savings and loan
associations, and credit unions under present federal

Check Collections and Reserve Requirements
Before the Federal Reserve was established it was expected that Federal Reserve Banks would take over check
clearing and collections totally from correspondent banks.
There was no intention to add a second check collection
system to the existing one. The relative size of the correspondent banking system did decline, but, to the surprise
of almost everyone, it remained of about equal importance
with the Federal Reserve in holding banker's balances; and
it has actually dominated in providing check collection
services. The average value of out-of-town checks processed
through correspondents varies from more than 90 percent
in the case of small banks to about 40 percent in the case
of the very largest banks. Approximately 80 percent of
small member banks actually prefer clearing through correspondents rather than through the Federal Reserve System, despite the availability of the Federal Reserve check
collection service to them. Nearly half of the large banks
actually prefer clearing through correspondents rather than
the Federal Reserve.¹
These facts about the correspondent banking system
are well known to bankers, but are commonly misunderstood by the public and are often misrepresented in money
and banking textbooks. The success of the correspondent
banking system can be attributed to its tailoring of check
collection services to fill in rather wide gaps in the free
service offered by the Federal Reserve. The Federal Re1971

serve has little or nothing to offer by way of foreign collections, nonpar check collections, and noncash collections.
It is utilized only minimally on short-haul collections, but
extensively for long-haul collections.
The proposal offered here recognizes the success of
private banks in this field and would turn over the existing Federal Reserve machinery for collecting checks to
them. This arrangement is actually the one that obtains
in many other countries.
It is important to realize that even if the Federal Reserve gave up its collection of checks, it would continue to
issue the ultimate reserves of the financial system . Control
of those ultimate reserves is unquestionably the most vital
function of the Federal Reserve. But to effect such control
the Federal Reserve need not handle any checks except insofar as one member bank chose to settle a debt owed
another through the Federal Reserve, or a member bank
withdrew currency from the Federal Reserve to hold in its
own vaults or for shipment to correspondents. There has
developed in the United States a unique two-tiered central
banking system with the Federal Reserve mainly serving
city correspondent banks which in turn serve country
banks as well as other customers. There is no denying the
importance of the Federal Reserve as the central bank, but
the fact remains that city correspondents provide the bulk
of the wholesale banking services for smaller commercial
banks and nonbank financial institutions in the United
As legal reserves are presently defined for member
banks, deposits subject to reserves are adjusted by deducting the sum of cash items in the process of collection and
balances due from domestic banks from gross demand deposits. Time deposits are subject to requirements without
adjustment. The cash items deduction under the present
system is made necessary to avoid counting some reserve
balances twice, as would be the case if a bank collecting a
check could add the amount to its reserve balances before
the paying bank had subtracted the amount from its balances. The present system of deducting cash items from
gross demand deposits is a very arbitrary method of resolving the problem of allocating reserves to collecting
and paying banks. The collecting banks get a credit through
reduced reserve requirements of only a fraction (the required reserve ratio) of their collections items. In theory,
there need be no redistribution of reserves between collecting and paying banks if there were an even flow of
checks between them. But, in fact, there is a very uneven
distribution. New York City banks have nearly half of the
checks in collection which is about twice their percentage
of the gross demand deposits of all member banks. There
has resulted a net transfer from country banks to New
York City barks in partial offset to the higher reserve
requirements of New York City banks. The proposed elimination of check collection float would distribute reserves
on the basis of actual reserve transfers and not by an arbitrary formula based on checks in collection and balances
due from banks.
(Continued on page 4)


Reserve Requirements (Continued from page 3)
Elimination of check collection float would simplify
the calculation of deposits subject to reserve requirements
with differential requirements on interbank and other demand deposits. If deposits subject to requirements were
defined as under present member bank regulations, it
would be necessary to classify checks in collection as interbank or other demand deposits for the purpose of deduction from their respective gross totals to calculate deposits
subject to requirements. The problem of such sorting was
the only major objection in the early years of the Federal
Reserve to imposing differential requirements on interbank and other demand deposits. Though modern data
processing makes such sorting a very simple process indeed, it is proposed to eliminate check collection float and
thus the necessity that collection items be sorted in order
to calculate required reserves.
Another problem with the proposal to eliminate check
collection float is associated with the present definition of
remittance under the uniform commercial code, which
requires physical transfer of a debt instrument for title
to be transferred. The obviously efficient way to transfer
money balances is electronically with the physical transfer
of the instruments following as a confirmation of the transaction. Hence it is proposed that the existing law with
respect to money transfers be revised in the light of modern information transmitting and storing technology to
permit electronic transfers of titles to such negotiable instruments as bank checks.
The proposed changes in reserve requirements regulations would make deposits of financial institutions with
large money market banks in financial centers still more
attractive than they have been historically. This in itself
would benefit city banks. But, in addition, reserve requirements should be set sufficiently low on interbank deposits
to insure that there is some net transfer of earning assets
to member banks to reward them for taking over a function from the Federal Reserve.
Liquidity Aspects of Reserve Requirements
The connection between reserve requirements and
liquidity was once considered the key factor on which to
base requirements. This view has been ridiculed in recent
years because required reserves are not really reserves at
all but rather a requirement that must be satisfied to avoid
penalties. Fractional reserve requirements have the property
of varying directly with deposit inflows; hence requirements fall with withdrawals, thereby automatically providing some funds to meet withdrawals. But with fractional reserve requirements, only a fraction of the funds needed
to meet withdrawals is provided.
The financial crises of the 1930s prompted many students of banking to propose 100 percent requirements for
the purpose of making bank deposits safe, and subject to
government control. Such an extreme serves to demonstrate several quite different aspects of liquidity associated
with required reserves. First, assets backing deposits could

not depreciate in terms of deposits. Government issued reserves are the standard for payments and hence are perfectly liquid. There would be absolutely no risk of default
if every dollar of financial obligations were backed by a
dollar of standard money. Second, a withdrawal of deposits would automatically free a like amount of cash assets from requirements to meet fully the withdrawal, unlike
the situation with fractional requirements. Third, deposits
would not provide banks with assets available for investment as under the fractional reserve system, but only with
sufficient reserves to meet requirements. Earnings would
have to be supported from investment of the capital of the
institution and from fees collected for various banking
services. Generally, one hundred percent required reserves
would make required reserves totally illiquid except to
meet a withdrawal but totally liquid to meet a withdrawal.
Under present fractional reserve regulations, the liquidity of required reserves does not amount to much. Member bank required reserves are available to make payments
within a settlement period, but the average reserve holding
for the settlement period must fall within a very narrow
range of the requirement. It is possible for banks to carry
forward deficits of up to 2 percent of their requirements
but this amount is so small that unless they hold sufficient
excess reserves above requirements, deposit withdrawals
force banks to make almost matching portfolio adjustments
over the settlement period. The situation is often worse
for nonmember banks and Savings and Loan Associations
which have been required to maintain their reserves to
meet requirements on a continuous basis.
The proposal of this article is intended to increase the
liquidity of required reserves to meet withdrawals. The
proposal extends changes in the structure of reserve requirements regulations that were introduced for member
banks and Savings and Loan Associations during the past
decade. Savings and Loan Associations subject to federal
regulations are now allowed to carry reserve deficiencies at
a cost of a penalty interest rate set 2 percentage points above
the Federal Home Loan Bank advances rate. The authority
of member banks to carry forward reserve deficiencies
from one reserve settlement period to the next was extended from one percent to two percent of their requirements.
The proposal is to widen the deficit carry-forward provisions and extend the provisions to all financial institutions subject to requirements, and to modify and extend
to banks the penalty interest rate on deficits that has been
established for Savings and Loan Associations.
Other reserve requirement changes in recent years have
tended to reduce the liquidity of reserves held against requirements. This result accompanied the shortening of the
reserve settlement period for country banks from half a
month to two weeks in 1959 and then to one week in 1968.
Placing country member banks and city banks on the same
reserve settlement schedule probably reduced bank liquidity
by eliminating the opportunity for institutions that are
(Continued on page 5)


Reserve Requirements (Continued from page 4)
settling on a particular day to obtain necessary accommodation from those that are not settling. These changes have
thus contributed to the needless settlement-day financial
commotion of recent years. The proposal is to lengthen
settlement periods at least to two weeks or perhaps four
weeks or a month. It is also proposed to stagger settlement periods so that only a fraction of the financial institutions subject to requirements settle on any settlement day.
The most significant reduction in the availability of
reserves to meet withdrawals was probably associated with
recent regulations that have based the current requirements
for member banks and Savings and Loan Associations on
lagged obligations. The intention in promulgating this
structural change was to ease the burden of reserve management for financial institutions by making it possible
for them to know exactly what their requirement is for
a particular settlement period. But the result with respect
to the liquidity of reserves to meet withdrawals is unambiguously negative. To illustrate, suppose the required
reserve ratio is 15 percent and that deposits subject to requirements had been $1,000 two weeks earlier, so that the
requirement for the current settlement period is $150 . A
$100 loss of deposits would not reduce the requirement
at all. A bank with no excess reserves would have to reduce
holdings of assets other than legal reserves or borrow legal
reserves in order to meet requirements. Under the old
regulations (and the proposed regulations) a $100 withdrawal would reduce requirements by $15 so that only
an extra $85 rather than $100 would be needed to meet
requirements. The proposal presented here would restore
the simultaneous relationship between required reserves
and deposits, thereby providing some automatic release of
reserves to meet withdrawals.
Before the Federal Reserve Act, banks were encouraged
to use their reserves fully to meet withdrawals. The penalty for a deficit was a prohibition on making new loans,
as was the penalty for deficits of Savings and Loan Associations until recently. Comptrollers of the Currency before
1914 interpreted the regulations with respect to deficits
far more liberally than many people today realize. In the
first place, the Comptroller did not always find out about
deficits because bank reports were not filed on the basis of
daily figures. Even when the Comptroller uncovered a
deficit, he was not legally bound to require the bank to
make it good, and sometimes he did not. Finally, even if a
bank was notified to make good its deficiency, it had 30
days to comply. The present proposal would reconstitute
reserve requirements regulations to improve their efficiency
in meeting unexpected withdrawals along the line of more
permissiveness with respect to deficits. On the assumption
most of the reserves held by financial institutions in recent
years have been required, even a 100 percent deficit carryforward would amount to about only 10 percent of deposits and 100 percent of capital, amounts that seem quite
safe, particularly in view of the fact that the interest rate
on deficits should be set a fixed margin above the Treasury

52-221 O- 75 - 12

bill rate, a penalty large enough to make it unprofitable
to use deficits as a long-term source of funds.
The proposed extension of deficit carry-forward limits
provides effective last resort lending to individual institutions so hard pressed by unexpected withdrawals or credit
demands that they are willing to pay a penalty in order
to avoid an expected even more costly adjustment. It would
appear that another of the Federal Reserve functions would
be stripped away by putting last resort lending to individual institutions on automatic pilot.
It is true that there would be no need for the Federal
Reserve to maintain a discount window to accommodate
member banks with short-term loans. But the last resort
lending function of the central bank encompasses much
more than merely lending to individual institutions. Management of the ultimate reserves of the financial system
would require that the Federal Reserve offset any undesired overall effects of too little or too much last resort
lending. It would do so by open market operations to
absorb or supply reserves directly to the financial system .
Thus, the proposal essentially breaks the last resort
lending function into two parts. The first is that which
is made available to individual banking and savings institutions through deficit carry forward provisions as a substitute for the existing last resort lending by Federal Reserve Banks or Federal Home Loan Banks to their respective members. The second is that which is generally
available from all sources though principally from Federal Reserve open market operations.
Proposed Changes to Increase the Demand
for Legal Reserves
There is ample evidence that financial portfolio managers are very sensitive to alternative opportunities in investing funds at their disposal. Cash management of financial institutions is particularly sensitive because cash holdings generally yield no pecuniary returns. Any increase
in the level of interest rates makes economizing on cash
holdings more profitable and induces increases in non-cash
assets at the expense of cash. Economizing on cash is not
a costless operation, but requires surveillance of the cash
position and alternative investment opportunities as well as
the direct costs of frequent adjustments in asset holdings.
Buying a security whose price is attractive in comparison
with holding cash requires a transactions cost in terms of
real resources expended in reaching a purchase agreement
and in transferring titles to assets. The higher market
rates of interest are the greater the inducement for economizing on cash and the greater the amount of real resources that would be expended on cash management.
Legal reserves above requirements are like an inventory. The larger the inventory of excess reserves, the greater the amount of withdrawals or other payments that can
be accommodated without forcing a market transaction
to restore the inventory. Hence, payment of interest on legal
reserves. would be expected to increase the demand for ex(Continued on page 6)


Reserve Requirements (Continued from page 5)
cess reserves and to reduce the associated volume of transactions to economize on reserve holdings. The proposal
would allow reserve depository banks to pay interest only
on deposits of financial institutions subject to requirements,
but similar benefits would derive from allowing banks
to pay interest on other demand deposits too. It is also
proposed that Federal Reserve Banks pay interest on deposits, a practice that is already employed by Federal Home
Loan Banks. It is recommended that the rate be set at a
fixed margin below the Treasury bill rate. Similar proposals to pay interest on reserves have been made by economists who often disagree about other matters; for example, Milton Friedman and James Tobin.
Differential Reserve Requirements on Interbank,
Other Demand, and Time Deposits
There is an argument of ancient vintage that reserve
requirements are a device to provide central banks and
governments with operating funds. Requirements provide
the government with the equivalent of tax revenues from
the saving in interest payments that would otherwise be
paid. Essentially, financial institutions subject to requirements are forced to hold noninterest bearing cash assets
which permits the government to finance its operations
with less interest bearing debt than otherwise.
J. M. Keynes characterized required reserves or agreed
upon "traditional" reserves as a device to compel banks to
... share part of the expense of maintaining the ultimate reserves of the System as a whole-without the
existence of which the convenient practice of ' eligible'
bills and eligible' collateral might sometimes break
A comparable statement appeared in the Report of the
Macmillan Committee in 1931 and is presumably attributable to Keynes, who was a member of the Committee.
It is the idea of English banking that the joint-stock
banks should agree voluntarily to maintain large reserve deposits with the Bank of England to provide
the central institution with adequate resources to
manage the monetary system and safely furnish the
member institutions with precisely those conveniences
for rapidly liquidating earning assets upon which
the latter depends when determining the amount of
their cash resources."
Is there any reason why requirements should be set at
different levels on different classes of deposits ? One reason
is to protect inefficient firms from competition. But that
is what is wrong with the existing structure. Economic
efficiency requires that like functions be taxed equivalently.
This basic principle requires that deposits in a given functional class should bear the same requirements whether
issued by small or large banks, or by savings institutions
or commercial banks.
Another reason for differential requirements is that
there may be different costs imposed on the government

with respect to different classes of deposits. Such a consideration is presumably behind the consensus that requirements be higher on demand deposits than time deposits since demand deposits function as money and presumably require special management. The most controversial issue involves the difference in requirements against
interbank and other demand deposits. If there is a consensus it would be that there should be no differential,
despite the fact that the relative concentration of interbank
deposits in financial centers was historically the key
factor on which higher requirements for central reserve
city and reserve city banks was based.
Despite the weight of opinion in favor of uniform requirements on interbank and other demand deposits, a
case can be made for the tradition of higher requirements
on interbank demand deposits and for the differential between demand and time deposits. The central bank (under
a fixed exchange rate regime of international payments)
is required to hold international reserves of gold and convertible currencies in order to provide last resort loan
availability to the financial system. This was Keynes' argument. If it is true that issuers of deposits in the various
classes depend to different degrees on the last resort loan
facility of the central bank, then it is reasonable that they
be assessed differentially to cover its fixed costs.
Thus, the argument for higher requirements on interbank deposits depends on the empirical question whether
interbank deposit issuers are more likely to require last
resort loans. Historically, central money market banks
have become the focus of any general financial crisis. Even
in normal times, let alone financial crises, there is strong
evidence that interbank demand deposits are much more
volatile than other demand deposits, and demand deposits
are more volatile than time deposits (Table 1) . Emphasizing day-to-day variability as the criterion for allocating
costs is appropriate insofar as last resort loans are only a
temporary source of funds to individual borrowers to
avoid costly alternative adjustments in the immediate run.
Thus there is an argument for differential requirements
on interbank, other demand, and time deposits on the
basis of differential costs of maintaining the last resort loan
The second defense of differential requirements on
deposits is that there is appropriately a different fee for
different degrees of infringement on the government patent
to issue money. Governments have a very profitable activity in issuing notes, base-metal coins, and deposits in exchange for goods and services. A bank charter is an inordinately valuable piece of property because it authorizes
issue of deposits or notes as very close substitutes for
government-issued money and usually in a market where
entry of potential competitors is restricted. This theme is
developed in recent theoretical writings about the wealth
effect associated with money creation. There is an additional benefit to issuers of money and money substitutes
to the extent that inflation imposes a tax on money holdAPRIL


Table 1
Variability in Half-Monthly Changes in Deposits by Class of Deposits, 1947-1959
(Millions of Dollars)
Interbank Demand Deposits
Gross Demand Deposits
Standard Mean
Standard Mean
Deviation Level
Ratio Deviation Level
$150 $37,061
$1,169 $105,428 .011
$367 $12,196


All Member Banks
Central Reserve City
22,736 .020
New York
34 .059
New York
419 .043
376 .053
2,469 .014
4,906 .015
St. Louis
Kansas City
3,158 .021
San Francisco
10,139 .014
2,993 .016
5,420 .005
New York
227 .066
St. Louis
Kansas City
2,587 .012
3,379 .016
2,102 .018
San Francisco
Source: J. 1 Deposits, Reserves and Borrowings of Member Banks, Board of Governors of the Federal Reserve System.
ers that would to some extent be collected by financial
institutions as co-issuers of money with the government.
On the basis of these considerations one can interpret
reserve requirements as a device for banks and savings
institutions to pay a tax for the right to encroach on and
share in a government monopoly to issue standard money.
The differential in requirements might then be justified
on the basis of the degree of substitutability between government-issued money and deposits in the various classes.
Another way of expressing the argument is in terms of the
amount applicants for a charter would pay for the right
to issue interbank demand deposits, other demand deposits, and time or savings deposits. In any event, the
proposal would set differential required reserve ratios on
interbank, other demand, and time deposits but make the
ratios uniform for insured financial institutions.
It is interesting that New York banks as a group decided voluntarily to maintain 25 percent standard money
reserves against their net deposits in 1860. This percentage
was subsequently adopted under the National Bank Act
in 1863. One can speculate that this requirement would
translate roughly into a 50 percent requirement on interbank deposits and a 15 percent requirement on other deposits the requirement that was imposed on country










banks. Reserve city banks had a 25 percent requirement,
but only half of it had to be held in standard money; the
balance could be in correspondent balances. Under the
National Banking Act no distinction was made between
demand and time deposits for requirements purposes, part(Continued on page 8)
Published Monthly at The Ohio State University
Columbus, Ohio
ROY F. CROMER, Associate Editor
Copyright, 1926, by The Ohio State University
STEPHEN S. CASTLE, The University ofAkron
RAYMOND F. BARKER, Bowling Green State University
JOSEPH BLACKSHERE, Central State University
ROBERT E. HASTINGS, Cleveland State University
ROBERT J. SAUNDERS, Kent State University
ROBERT H. MYERS, Miami University
JAMES A. LEE, Ohio University
JOHN L. MASON, University of Toledo
ROBERT DOLPHIN, JR., Wright State University
DUMITRU TEODORESCU, Youngstown State University
Subscription Rates: $4.00 for 1 year; $7.00 for 2 years


Reserve Requirements

(Continued from page7)

ly because time deposits were not very important then
and partly because they were sometimes withdrawable on
demand, though technically subject to notice. Using the
distribution of deposits in the three proposed requirement
classes, the actual requirements in 1910 translate roughly
into 50 percent on interbank deposits, 15 percent on other
demand deposits, and 5 percent on time deposits.
The world of banking and finance has changed a lot
in the last century, but it is clear that differential requirements had a functional basis historically in the correspondent banking system. The strangest feature of the financial
structure in the United States is that to this day the major
banks in New York and regional financial centers continue to provide the equivalent of central banking services
to their financial institution customers despite the existence
of the Federal Reserve Banks as official central banks.
Small banks and most nonbank financial institutions
likely would rely on correspondent banks to an even
greater extent for their central banking services under the
proposed financial structure. Small banks and nonbank
savings institutions would be the principal beneficiaries
of the proposed payment of interest on excess reserves
and increased liquidity of required reserves. City banks
would benefit from additional balances and the earning
assets they support. They would probably also gain from
permission to count foreign balances with banks as legal
reserves, which is justified to the extent the central bank
can reduce its own holdings, the more that is held by the
private financial system.
City banks are presently the most important coordinating force with respect to the large number of small
financial institutions in the United States. The proposal
recognizes their unique role as a link between the Federal
Reserve and the financial system. The ultimate beneficiary
from the reforms would be the public insofar as increased
efficiency would be reflected in lower costs and higher
quality of financial services.
The proposal should not be interpreted as one to
abolish the Federal Reserve. Though some Federal Reserve functions would be curtailed, the implication of the
proposal is quite the contrary. The Federal Reserve is esBULLETIN OF
The Ohio State University
1775 South College Road
Columbus, Ohio 43210

sential as the central reserve agency-the bank of issue.
Fifty years of intermittent banking crises under the National Banking Act proved that the correspondent banking
system was not self-stabilizing without a central reserve
creating agency. The existence of an agency to create reserves for financial institutions is critical in a banking
system with inherent instabilities. The Federal Reserve
under this proposal would be required to manage open
market operations efficiently to anticipate and offset the
added linkage introduced by counting correspondent balances, U.S. Government securities, and foreign currencies
as legal reserves and by allowing possibly large reserve
requirement deficits. These reserve management functions
cannot be handied very well by the private banking system.
Nevertheless, far too much was reformed in 1913 when
the Federal Reserve was established to perform a variety
of functions that private banks had performed very well,
rather than solely to manage reserves and the money supply. The present proposal is designed to rationalize the
reserve requirements structure in the United States. It is
largely based on the observed economic and political success of the correspondent banking system. It would eliminate inequities between individual enterprises and increase
the availability of required reserves to meet payment needs.
It is hoped that the Commission on Financial Structure
and Regulation recommends such reforms to the President
in its forthcoming report and that both financial institutions and the public support the proposed reform of reserve requirements in the United States.
1Ira O. Scott, A Report on the Correspondent Banking System. Suband Currency,
committee on Domestic Finance, Committee on Banking
House of Representatives, 88th Congress, 2nd Session, December 10, 1964.
2J. M. Keynes, A Treatise on Money, Vol. II, 1930, p. 71.
3Report of the Committee on Finance and Industry, London, 1931,
Section 370.
WILLIAM G. DEWALD is Professor of Economics at
The Ohio State University. This article is adapted from
his recent proposal for reserve requirements reform submitted to the Presidential Commission on Financial Structure and Regulation.
Non-Profit Org.
U.S. Postage
Columbus, Ohio
Permit No. 711






The Required
Evidence is presented in this article that the distribution
of deposits among different member bank reserve requirement classes is highly predictable. Such predictability is
crucial to control of the money supply should that be a
proximate objective of monetary policy. The analysis goes
beyond earlier models in relating the distribution of deposits to seasonal factors and relative interest rates,' but it
does not deal with many other elements of the money supply process including currency held by the public, excess
reserves held by banks, nonmember bank deposits, and
sources of variation in member bank reserves. The paper
focuses on the effect that the distribution of member bank
deposits subject to different requirements has on the average member bank required reserve ratio. Elsewhere I have
proposed required reserves reform on criteria of allocative
Required Reserves and Monetary Control
The Board of Governors of the Federal Reserve System
determines required reserve ratios for member banks within
legal limits. The Banking Act of 1935 gave the Board
authority to change required reserve ratios up to double
those fixed in the original Federal Reserve Act. It is hard
to believe, even after all these years, that the Board actually
did double requirements in 1936 and 1937. What followed
was a major contraction in the money supply and economic
activity-a cruel event in the best of times but a senseless
catastrophe in the middle of the Great Depression.
Today nearly everyone pays more attention to the money
supply than a generation ago. It is now widely accepted that
changes in money are at the least one of the important
determinants of spending, and hence of the price level and
employment. Nevertheless, the Federal Reserve (Fed) has
only recently begun to attach importance to and assume
responsibility for monetary control. In 1972, it has been

Reserve Ratio for Member Banks
reported to have adopted a new tactic of directing the
Manager of the Federal Open Market account to buy and
sell government securities for the purpose of controlling
member bank reserves (other than the small amount required to be held against U.S. Government deposits) . This
technicality is really of great importance if true, for it
would reverse the experience of more than half a century
in which the Federal Reserve attempted to control "money
market conditions" as measured by market interest rates
or member bank free reserves. Since empirical studies show
a much closer relationship between bank reserves and the
money supply than between measures of money market
conditions and the money supply, the new tactic is a harbinger of reduced slippage in the monetary control process.³
Required reserve ratios and the amount of bank reserves are the two major blades of the monetary control
scissors, now that the Federal Reserve has indicated an
attempt to control reserves. It becomes specially relevant
to evaluate how sharp a cutting edge for reserve control
is provided by the required reserves blade.
The evidence presented here shows that the cutting
edge is particularly sharp, at least with respect to member
bank net deposits. Net deposits of member banks subject
to requirements are sometimes discussed under yet another
name, "the bank credit proxy," which has frequently been
mentioned in the Minutes of the Federal Open Market
Committee in recent years as a convenient measure of
Deposits, the main component of the money supply,
are limited by (a) the amount of member bank net reserves and (b) the average required reserve ratio.
The reciprocal of the average required reserve ratio is
the maximum amount of deposits that each dollar of re(Continued on page 2)



Definition of the Average Required Reserve Ratio
The required reserve ratio applicable to deposits of the
ij class is defined as qij, where i is the index for class of
bank and takes values 1, 2, or 3 for central reserve city,
reserve city, or country member banks respectively. Though
the central reserve city classification was dropped officially
in the 1960s, it was arbitrarily maintained for the purpose
of this study. The symbol j is the index for class of deposits. It takes the values 1 or 2 for net demand deposits or
time deposits. Dj represents deposits subject to requirements in the ij class. The associated requirement is qijDij.
Thus, total required reserves for a reserve settlement period
are defined as
= Σ
ΣqijDij .
i = 1 j⋅= 1
The average member bank required reserve ratio q is
simply the ratio of total required reserves to net deposits.
q depends on a weighted average of the six requirement
ratios. The weights are the ratios of deposits in each requirement class to the sum of deposits overall. The ratio
of deposits in the ij class to total deposits is defined as
dij Dij/D. It follows that
Σ digij .
D i = 1 j =1

The question posed is: How much does unexpected variability in the distribution of deposits among requirements
classes (di's) affect the average required reserve ratio for
given values of required reserve ratios?
The Distribution of Deposits: Major Movements
The choices depositors make, about the distribution of
deposits are reflected in ratios of deposits in the various
requirement classes to total member bank net deposits.
The distribution would be expected to respond to long-term
changes in the geographic distribution of population,
wealth, and spending. The desired deposit distribution
would change over the short term of a business cycle with
changes in relative rates of return on member bank deposits in the various classes and on other assets. Seasonal
payments variations would also affect the distribution.
Historically there have been large secular changes in
the member bank deposit distribution. The ratio of member
bank time deposits to total net deposits fell from 41 percent
in 1929 to 19 percent in 1943, and then increased to 34
percent in 1960 and to 55 percent in 1968 (Table 1 ) . The

Net Demand Deposits
Central Reserve City Banks
Reserve City Banks
Country Banks
Time Deposits
SOURCE: Federal Reserve Bulletin. Data are daily averages for January.

Required Reserve Ratio ( Continued from page 2)
serves could support, and in turn, the ratio of member bank
reserves to the average required reserve ratio is the maximum net deposits that member bank reserves could support
given the underlying required reserve ratios and distribution of deposits among requirements classes.
For example, if bank reserves are $40 billion and the
average required reserve ratio is 10 percent, maximum deposits would be $400 billion, since the reserve requirement
(.10 $400 billion) would just be satisfied with the $40
billion of available reserves. Banks would have a deficit
reserve position if deposits exceeded $400 billion for the
given amount of reserves and average required reserve
ratio. The maximum could be changed by policy actions
that affected either of these two key elements of the money
control process.
The actual amount of net deposits can differ from the
maximum for two main reasons: (1) excess reserves and
(2) the distribution of deposits among different reserve
requirement classes. Since excess reserves have been very
small in recent years, this factor is not now an important
source of linkage in the monetary control process.
This paper is directed at the second major source of
slippage in the deposit control process-unpredicted shifts
in deposits from one requirement class to another. Since
required reserve ratios differ among classes, such shifts can
cause unexpected changes in the average required reserve
ratio, and maximum deposits, and cause errors in controlling deposits even if total reserves, excess reserves, and the
individual reserve ratios are known.

ratio of net demand deposits at central reserve city banks
rose from 21 percent in 1929 to 35 percent in 1943 as low
yields and high expected risks on earning assets made interbank deposits relatively attractive assets to bankers. Declines
in interbank balances as well as relatively greater economic
growth in other than central reserve cities contributed to
the decline in the central reserve city net demand deposit
ratio to 16 percent in 1960 and only 10 percent in 1968.
The average required ratio was virtually stable at 7.2
percent until the 1933 banking crisis after which it drifted
higher as rapid demand deposits gains outpaced time deposits, which remained largely unchanged. The average
was about 8.5 percent in August 1936 when requirements
were raised 50 percent. After a six-months hiatus, requirements were pushed to the legal limit, 100 percent above
the level that had obtained from 1917 through August
1936. The average ratio in May 1937 was about 16.8 percent. A year later requirements were reduced somewhat.
The average tended to drift upward in the 1930s as demand
deposits gained relative to time deposits and as country
bank deposits failed to keep up with city bank deposits.
Interbank deposits with city banks rose significantly during









8 8 8





















(Continued on page 4)





Required Reserve Ratio (Continued from page 3)
these years. As a consequence of such redistribution of
deposits, when the Federal Reserve again pushed requirements up to their maximums in late 1941, the average
ratio topped 18 percent, whereas with the same ratios in
1938, it had been less than 17 percent.
Thus the average required reserve ratio is importantly
affected by both requirement ratios and the distribution
of deposits. From the peak requirement ratios in 1948, the
average has been lowered generally during business cycle
contractions and raised during expansions. But there has
been a general downtrend to bring the average ratio to 8.6
percent in December 1971, virtually the same ratio as obtained before requirements were doubled in the midst of
the Great Depression. Chart 1 shows the average required
reserve ratio monthly from 1944.
The Distribution of Deposits: A Function
of Interest Rates and Other Factors
Theoretically one expects the distribution of deposits to
be affected in two ways by rates of interest on time deposits and alternative financial instruments. First, an increase in time deposit rates relative to other market interest
rates would be expected to increase time deposits relative
to demand deposits. The increased return on time deposits
would attract funds from other assets including demand
deposits which pay no pecuniary return. Second, a proportionate increase in both time deposit rates and other
interest rates would be expected to increase time deposit
ratios, as assets other than demand deposits would become
more attractive with an increase in the general level of
rates, a proposition confirmed in studies of the aggregate
demand for money.
Changes in the averages over the period 1943-68 are
patterned as the theory predicts. A higher level of rates
after 1959 was associated with a decrease in demand deposit
ratios, and narrowing the differential between the rates on
Treasury bills and time deposits after 1959 was associated
with an increase in time deposit ratios. Hence, the data
broadly support the interest rate hypothesis. But more
powerful analysis is needed to distinguish interest level
effects from interest differential effects. The hypothesis is
specified formally as follows:
1 ) dij* = yij + a₁j (RB + RT) + B₁j ( RB — RT) + ujj
where di * is the desired deposit ratio as a function of the
level of Treasury bill rates and time deposit rates
(RBRT) , the difference between the rates ( RB - RT) ,
and other factors 7ij. The term uij is an error term with
mean zero and variance ij. The interest rate hypothesis is:
Demand Deposits
(j = 1)
Time Deposits
(j = 2)
A simple partial adjustment model is specified such that
the deposit ratio is changed each period by a fraction

(1 - A ) of the difference between the actual and the desired deposit ratio.
2) Ady- ( 1 - A ) | dj- ( dij) -11.
The adjustment coefficient hypothesis is that :
0 < ( 1 − dij) < 1 .
Substituting equation 1 ) into 2) and solving yields the
equation form actually estimated.
-1 + άij (R1 +Rт) +ẞú ( Rr—R↑) .
3) dij = yíj + λij (dij) −1
YG (1A ) Yuajj = ( 1 — λ¡¡) αij ·
- ( 1 -λυ) βα
βί =
Yij represents 24 seasonal dummy variables to capture regular seasonal movements in the deposit distribution and a
post-1959 dummy variable to test for any structural shift
associated with the regulatory and market changes that
occurred in the 1960s.
Estimates of the Deposit Distribution
The results tend to confirm the interest rate hypothesis
with one major exception (Table 2) . Numerically small
but generally expected effects of interest rates on the deposit
distribution were estimated . Errors relative to the averages
were about twice as high for central reserve city deposit
ratios than others, an indication that central reserve city
banks act as shock absorbers for the banking system. Central reserve city banks have much the largest share of interbank demand deposits, which are highly volatile.
Turning to the subperiods, the data for 1943-59 yielded
results that strongly tend to confirm the hypothesis. The
1960-68 results were mixed with a glaring disconfirmation
in the case of the central reserve city time deposit ratio.
This exception, involving the unexpected result that an
increase in the level of interest rates was associated with a
(Continued on page5)
Published Monthly at The Ohio State University
Columbus, Ohio
ROY F. CROMER, Associate Editor
Copyright, 1926, by The Ohio State University
STEPHEN S. CASTLE, The University of Akron
RAYMOND F. BARKER, Bowling Green State University
JOSEPH BLACKSHERE, Central State University
PHILLIP GRUB, Cleveland State University
ANANT R. NEGANDHI, Kent State University
ROBERT H. MYERS, Miami University
JAMES A. LEE, Ohio University
JOHN L. MASON, University of Toledo
ROBERT DOLPHIN, JR., Wright State University
DUMITRU TEODORESCU, Youngstown State University
Subscription Rates: $4.00 for 1 year; $7.00 for 2 years


Required Reserve Ratio ( Continued from page 4)

Deposit Ratios
Demand Deposits
Central Reserve
Reserve City


Standard Error/Mean
Lagged Deposit Ratio
1943-59 1960-68 1943-68 1943-59 1960-68 1943-68 1943-59 1960-68 1943-68 1943-59 1960-68 1943-68
Expected SignExpected Sign +
-.04806 .01350 -.00469
.04089 -.008150 .01396
(1.22) (-24) (.56)
(-2.14) (1.27) (-38)
-.02047- .00629 .00080
.02888* .00377 .00649
(-2.24) (1.10) ( 13)
(1.66) (21 )
-.01080-00704-01147. .05161° .04139* .02700
(-1.30) (-1.01) (-1.92) (2.53) (1.83) (1.85)

Expected Value 0 ≤ X≤1
(141.5) (159.8) (248.5)
.9756* 1.002
(118.5) (466.4) (457.5)
(152.5) (313.7) (379.2)










Expected Value 0 ≤ X ≤1
Expected Sign
Expected Sign +
.9949* .0131 .0103 .C142
.00890-03028 .00426
.02006-02931* -.02337* .9907* 1.018
(1.86) (-2.88) (.91 )
(-3.00) (-2.00) (-3.03)
(153.4) (160.6) (305.6)
.9799* .0077 .0056 .C074
.04178* .05807* .03815 -.05774.07993-05580* .9725
(4.16) (2.11) (4.27)
(135.1) (80.56) (207.9)
(-4.10) (-2.42 ) (-4.25)
.03352 .06862. .03238. -.04189-04409.03115* .9754
.9810 .0080 .0053 .0073
(-2.71) (-1.48) (-2.22)
(3.53) (3.18) (3.78)
(138.5) (105.9) (214.0)
a Not shown are regression coefficients of 24 seasonal dummy variables and a post 1959 dummy variable. Their values are briefly described in the text.
T-values in parentheses.
Deposits and required reserve ratio data are daily averages for country bank settlement periods: semi-monthly periods from the second half of June, 1943
through the first half of December, 1959, and bi-weekly periods through May 15, 1968. All observations were used in estimating the deposit distribution,
but the estimated average required reserve ratio was calculated only through through July 14, 1966-the effective date of differential required reserve ratios by size of bank. The source of the deposit data was the Federal Reserve report: J.1: Deposits, Reserves, and Borrowings of Member Banks. Time deposit
rates were quarterly averages as utilized in the Brookings Model. (Frank De Leeuw, "A Model of Financial Behavior," in James S. Duesenberry and others.
The Brookings Quarterly Econometric Model of the United States, Chicago: Rand McNally & Company, 1965, pp. 456-530). Other data were obtained
from the Federal Reserve Bulletin.
Coefficient has right sign and is statistically significant at the .05 level.
Time Deposits
Central Reserve
Reserve City

decline in the time deposit ratio at central reserve city
banks, is perhaps attributable to measurement errors. Maximum interest rates under Fed Regulation Q were effectively circumvented in the 1960s by large money market banks
issuing Eurodollar deposits and other liabilities that at
least for a time remained outside the regulations. The post1959 period itself was insignificant except for the case of
the central reserve city time deposit ratio which was estimated to be positively affected during the period of the
1960s over and above the effect of interest rates as measured .
Seasonal factors were estimated to have a small but
significant effect on the deposit distribution. There were
relative time deposit gains early in the year and losses late
in the year. Significant time deposit losses occurred in June
and especially December. Overall there was relatively more
seasonality in time than in demand deposits ratios. The
major demand deposit regularity was that city banks gained
demand deposits significantly during the last half of December, presumably as large Federal Reserve open market
operations failed to get fully assimilated into the banking
The effect of the level of rates (RB + RT) on demand
deposit ratios was relatively weak but the effect of the level
of rates on time deposit ratios was generally significant and
positive (except for central reserve city banks over 1960-68) .
An increase in the level of interest rates of one percentage
point was estimated to increase time deposit ratios at re1972

serve city and country banks by .0003 to .0004 during the
1943-59 period and .0006 to .0007 during the 1960-68 period.
Even these relatively large impact effects represent only a
minute fraction of the average ratios that were observed.
The effect of differences in the rates (RB - RT) on the
demand deposit ratios was quite different for each of the
bank classes. Only 4 of 9 coefficients were significantly
positive as expected. There was no significantly consistent
effect on the central reserve city or reserve city demand
deposit ratios. However, the country bank ratio was estimated to be significantly positively affected in each period
by the interest rate differential with impacts of .0003 to .0005.
The estimated effect of the difference in rates on time
deposit ratios was strongly in agreement with theoretical
expectations. Eight of the 9 coefficients were significantly
positive as expected. But even the largest of these-the effect on the reserve city time deposit ratio over 1960-68- is
only 5 percent of the average ratio.
Perhaps the most important empirical finding of all is
that the estimated speed of adjustment coefficients were
very small, which suggests that the deposit distribution is
very stable in the short run. This finding is particularly
clear when the results are presented as elasticities. A one
percent increase in the level of interest rates was estimated
to increase time deposit ratios at reserve city and country
banks by .01 to .02 percent in each of the periods-a highly
(Continued on page 6)



larger errors than otherwise were associated with periods
after required reserve ratios were changed.
The conclusion is warranted that the ability to predict
the average required reserve ratio ranks exceedingly high
relative to normal standards in economics. On the evidence
of very small feedback impacts of interest rates changes
on the deposit distribution, it is reasonable to believe that
such an empirical stability provides a key factor on which
the monetary authorities could rely with confidence if
they seriously direct their instruments toward monetary
control. If money is out of control, as may well be the case
in 1972, it should not be blamed on slippage due to unexpected shifts in deposits subject to different requirements
but to the ineptitude or unwillingness of the Federal Reserve to keep a firm grip on bank reserves.


The Fed announced in June its unanimous approval
of two regulatory changes intended to restructure reserve
requirements of member banks and the check collection
system. The changes, which were to be introduced on
September 21, would
apply the same reserve requirements to member
banks of like size, regardless of a bank's location
in place of the former differentiation based on the
reserve city-country bank classification (see tables
below) .
• require all banks (including most nonmember
banks) served by the Fed's check collection system
to pay-in immediately collectable funds -for
checks drawn on them the same day the Fed
presents checks for payment.
Proposed Net Demand Deposit Requirements
StatementWeek StatementWeek
Net Demand Deposits
First $2 Million
$ 2-$ 10 Million
$ 10- 100 Million
$100 400 Million
Over $400 Million
Reserve Requirements of Member Banks at the present
time are as follows:
$5 Million $5Million
Net Demand Deposits
Reserve City Banks
Country Banks
Time Deposits (All Banks)
Savings Deposits
Other Time Deposits


Required Reserve Ratio Continued from page 5)
inelastic response, yet by far the largest that was estimated.
In contrast, a one percent increase in the interest rate differential was estimated to lower time deposit ratios by a
mere .001 to 002 percent.
The data overall tend to confirm the proposition that
although the deposit distribution responds in a regular
way to interest rates in the long run, it cannot be affected
very much on impact. The largest estimate was that a one
percent increase in the level of interest rates would increase
the country bank time deposit ratio over 1960-68 by a
trifling .0233 percent-perhaps a magnitude small enough
for the Fed to ignore in directing open market operations
toward control of bank reserves and deposits.
It is appropriate to note that small initial adjustments
can add up to substantial effects on the equilibrium deposit distribution because the adjustment periods are very
long. However, even the long-run elasticities that could
be estimated were all less than unity, a finding that typically
comes out of demand for money studies.
The Results Expressed in Terms of
Average Required Reserve Ratios
The payoff with respect to the distribution of deposits
subject to different reserve requirements is in applying it
to impacts of policy instruments on the economy. This section reports estimates of the average required reserve ratio
for the period July 1, 1943 through July 20, 1966 and for
subperiods before and after December 15, 1959. The estimates were based on a slight variant of the deposit distribution model of the previous section. No post-1959
dummy variable was included and the interest rates themselves were entered as independent variables rather than
sums and differences in the rates. Both models yielded almost identical standard errors.
The average required reserve ratio was .1315 over the
entire study period. It is notable that almost all variation
in its level and movements was attributable to the estimated deposit distribution and the required reserve ratios
for the periods 1943-1959, 1960-1966, and 1943-1966 as reported in Table 3. Though small in every case, consistently
1943-59 1960-66
Average (M)
Standard Deviation (SD)
.000019 .000242 .000150
Standard Errorof Estimate (SE)
First Differences:
Standard Deviation (S)
Standard Error of Estimate (SE) * .000019
⚫ The errors are the same because the estimate change in q is ▲â = â
q-1. Hence the error eâq = ( - q-1) — (q — q-1) .

These changes were to be accompanied by a temporary waiver of penalties for requirement deficiencies


for those few member banks suffering an increase in
requirements of more than 2 percent of their net demand
On balance the average member bank was expected
to benefit substantially from the new regulations. The
Fed estimated that about $3.5 billion in required reserves would be freed which implies a reduction in the
average required reserve ratio from .086 to .077, based
on the deposit distribution for the four weeks ending
June 14, 1972. Large banks were expected to get the most
benefit in dollars released; but small member banks,
the largest percentage reduction in their requirements,
and hence the major contribution to their profit margins.
It was planned that about half of the released reserves
could be absorbed by the change in check collection
procedures requiring all banks to which the Fed presents
checks for payment to remit in immediately available
funds the same day. This was expected to eliminate a
major source of Federal Reserve float, which represents
a credit to bank reserves because the Fed on average
under present regulations credits reserve accounts of collecting banks before debiting accounts of paying banks.
The balance of the released reserves was expected to be
absorbed by Fed sales of open market securities to member banks.
Representatives of nonmember banks, which would
also have been required to make payments faster than
before but without benefit of reduced requirement ratios,
obtained on September 19 a ten-day restraining order
from the U.S. District Court for the District of Columbia
barring introduction of the same day-payments rule. Because the rule changes were interrelated, the Fed Board
of Governors indefinitely postponed the effective date
of both the reserve requirement and check collection
regulations pending judicial determination.
A number of other changes have been promulgated
in recent years :
• Differential requirements on the basis of bank size
were established for time deposits in 1966. The
principle was extended to demand deposits in 1969;
and as noted the Fed has now proposed making
bank size the only basis for requirement differences on demand and time deposits.
• The reserve settlement period for country banks
was shortened by one-half in 1968, making the
week ending Wednesday the uniform settlement
period for all member banks ; the requirement for
current settlement was based on daily average deposits lagged two weeks rather than on the current
average as before; and banks were authorized to
count their average vault cash from two weeks
earlier plus the currently held deposits average
with the Fed as legal reserves to satisfy requirements for the current period.


• Also in 1968 banks were permitted to carry forward to the next settlement period excess or deficit
reserves up to 2 percent of requirements whereas
previously deficit carry forwards were limited to
1 percent of requirements, and there was no opportunity to carry forward excesses.
As a consequence of these changes in the regulations,
the present requirement system differs from that which
obtained during the study period of this articlemost fundamentally in that the current availability of
legal reserve balances is no longer as tight a constraint
on current levels of deposits. The irony is that the
Fed seems to be taking steps that weaken its control
over deposits at the very time that it is expressing publicly a new concern for monetary control.

William G. Dewald, Monetary Control and the Distribution of
Money. Ph.D. dissertation, University of Minnesota, 1963.
George J. Benston, "An Analysis and Evaluation of Alternative
Reserve Requirement Plans," Journal of Finance, Vol. XXIV, No. 5
(December 1969), 849-70.
2William G. Dewald, "Reserve Requirements for Banks and Savings Institutions: A Proposal for Reform." Bulletin of Business Research, The Ohio State University, Vol. XLVI, No. 4 (April 1971 ), 1-8.
3 For example, Albert E. Burger, The Money Supply Process, Belmont, Calif.: Wadsworth Publishing Co., Inc., 1971 ; also A. J. Meigs,
Free Reserves and the Money Supply, Chicago: University of Chicago
Press, 1962.
+ "In recent years the Federal Open Market] Committee has been
making use of daily-average statistics on total member bank deposits
as a 'bank credit proxy'-that is, the best available measure, although
indirect, of developing movements in BANK CREDIT. Because the deposit
figures are compiled on a daily basis with a very short lag, they are
more nearly current than available bank loan and investment data.
Moreover, average deposit figures for a calendar month are much
less subject to the influence of single-date fluctuations than are the
available month and data on total bank credit, which represents estimates of loans and investments at all commercial banks on one daythe last Wednesday of each month." (Board of Governors of the
Federal Reserve System, 57th Annual Report, 1970, p. 95.)
"... System open market operations until the next meeting of
the Committee shall be conducted with a view to maintaining the
prevailing firm conditions in money and short-term credit markets;
provided, however, that operations shall be modified if BANK CREDIT
appears to be deviating significantly from current projections ..."
Board ofGovernors of the Federal Reserve System, 56th Annual Report,
1969, p. 171.
WILLIAM G. DEWALD is Professor ofEconomics
at The Ohio State University. This article, adapted from
an invited paper prepared for The President's Commission on Financial Structure and Regulation, expands on
ideas presented by the author in the April 1971 issue of
The Bulletin of Business Research in an article entitled
"Reserve Requirements for Banks and Savings Institutions: A Proposal fer Reform."




John J. Klein
Professor of Economics
Georgia State University

A Paper Prepared for the

Committee on Banking , Housing and Urban Affairs
United States Senate

January 1975




List of tables


Non-member Banks and Monetary Policy
Non-member and member bank growth , 1947-74



Number of banks
Assets of banks
Bank deposits
Bank loans and investments
Preliminary results of a statistical model
of loan and investment behavior


Non-member and member bank reserve requirements
and reserves


Summary and recommendations


Bank Asset and Liability Mangement - Their Relationship
to Monetary Policy
General analysis of bank asset and liability
management and the economy
The dilemma for banks
The dilemma for the national economy


Examples of liability management and the economy
Euro -dollars
Commercial paper of bank holding company
Loan commitments to corporate customers
General comment on the preceding forms of
liability management
Competition with nonbank financial institutions
the search for time deposits
Effects on bank reserves from the sale of CDs







Summary and discussion of legislative recommendations


Summary of Legislative Recommendations ; Comment on
Additional Areas of Inquiry for the Senate Banking




List of Tables

1. Number of Commercial Banks and Number of Non-member Banks


2. Number of Banking Offices in the United States


3. Assets of All Commercial Banks and Non-member Banks


4. Other Demand Deposits of All Commercial Banks and
Non-member Banks


5. Time Deposits of All Commercial Banks and Non-member


6. Loans of All Commercial Banks and Non- member Banks


7. Investments of All Commercial Banks and Non-member


8. Comparison of Reserve Requirements on Demand and
Time Deposits set by the 50 States for Non-member
Banks and those set by the Federal Reserve



Banking and the Economy

A Paper Prepared for the Committee on
Banking , Housing and Urban Affairs
United States Senate

John J. Klein*

Commercial banks are unique financial institutions , for they are
the sole creators of demand deposits , our principal "means of payment"
money .

Like other financial institutions banks make loans and investments

and create various forms of liquid assets , but normally no other
financial institutions have the legal authority to allow their creditors
to transfer claims to money through the use of checks .

This uniqueness

of commercial banks , coupled with the close relationship of money stock
changes to changes in aggregate economic activity , places a special
responsibility upon federal regulatory agencies such as the Federal
Reserve to oversee bank operations in a manner that promotes economic
stability .
Yet , banks , as we all recognize , are responsible to their stockholders .

Like other businesses , banks are profit- seeking corporations ,

and in order to expand profits they need to increase the volume of their
loans and investments .

To do so , however , may prove difficult when

the monetary authority seeks to restrain demand , particularly in a
period of rising prices .

Thus banks are faced with a dilemma - how

Professor of Economics , Georgia State University , Atlanta , Georgia .


to expand earnings in the face of restriction by the monetary authority .

This paper is concerned with the response of the banking system
to monetary policy .

The paper is organized into two main sections , the

first dealing with the seldom studied non-member banks , and the second
examining the various forms of bank asset and liability management in
different phases of the business cycle .

Section ( 1 ) provides a detailed examination of the behavior
of non-member banks , banks over which the Federal Reserve is
seeking to expand its control . I show that non-member banks
frequently behave more procyclically than member banks and
that this complicates the efforts of the Federal Reserve
to regulate the economy . Reserve System membership is
shown to be on the decline , quite probably as a result
of the fact that non-member banks may often hold their
reserves in correspondent balances and/or interest earning
assets .

The implications that arise out of commercial bank asset
and liability management efforts to circumvent the dilemma
of earnings versus economic stability are examined in
Section ( 2 ) . I discuss how the struggle for reserves
by member banks during periods of a restrictive monetary
policy and disintermediation adversely affects individual
commercial banks , savings institutions and the housing
industry .
Legislative recommendations to the Senate Committee on
Banking , Housing and Urban Affairs appear at the end of
Sections ( 1 ) and ( 2 ) and are grouped together in a
brief third section . These recommendations are : ( 1 ) the
extension of Reserve System membership to non-member
banks ; ( 2 ) the extension of Reserve System membership to
savings institutions ; ( 3) the removal of interest rate
ceilings on member bank , non-member bank , and nonbank
financial institution financial deposit liabilities ; and
(4) the granting to small savers the opportunity to
compete more effectively for short term government securities
and high yield paper issued by businesses . This group
of recommendations are predicated upon the



view that microeconomic financial controls , as contrasted
with macroeconomic controls , severely distort the allocation
of funds in the economy .

1. Non-member Banks and Monetary Policy 1/
a) Non-member and member bank growth , 1947-1974
This section of the paper examines the relative growth of member
and non-member banks since 1947.

The relative growth pattern is

established with a view to discussing the economic and institutional
sources of differing member and non-member bank behavior patterns .

Number of banks .

Table 1 markedly illustrates the growth of non-member

banks relative to all commercial banks over the last 27 years . 2/ We note
first that all commercial banks gradually declined in number through 1962 ,
whereas non-member banks declined through 1954.

Following 1954 non-

member banks stabilized in numbers through 1958 , after which they grew,
accelerating their rate of growth relative to all banks .

The gradual

downward movement of all commercial banks through 1962 occurred
principally because the number of consolidations and the mergers of
banks was greater than the number of new banks created .

Member banks

bore the brunt of the decline ; there was a tendency for small member

This section is based in part upon two earlier research studies of
mine (Monetary Policy and Non-member Banks , September 1971 ; Commercial
Bank Behavior : Non-member Bank Operations Relative to Reserve City and
Country Member Banks , March 1972 ) which were supported by the Bureau of
Business and Economic Research , Georgia State University . I am also
grateful to Joseph M. Prinzinger , Assistant Professor of Economics , State
University of New York at Oswego , for permission to consult his unpublished
doctoral dissertation , The Effect of Membership Status in the Federal
Reserve System on Bank Profit : A National Study , Georgia State University , 1974 .
The data could have been extended further back , but there is a break
in the data in 1947 due to revision in all commercial bank figures .



- 75 - 13



Table 1 : Number of Commercial Banks , and Number of Non-member Banks
December 1947 - June 1974 , End of Year Data . *


Number of

Number of

of banks that
are non-member

Change in Column ( 3 )
(( G
row) rate ) +


























1974 (June)





*Computed as each successive figure in the column showing the percentage
of banks that are non-member divided by the preceding figure .
Source : Federal Reserve Bulletin , 1947-1974 .

Various issues .


banks to withdraw from the system and to operate as insured non-member

banks .

In addition , many of the new banks that were formed were small

and chose to operate as insured non-member banks .
It is not difficult to see why all banks in addition to non-member
banks grew in number from 1963 to 1965.

The explanation is institutional .

This was the period during which James Saxon was Comptroller of the

Saxon was anxious to have national banks (which by law are

required to be members of the Federal Reserve System) grow.

As a

result he liberalized rules concerning national bank operations .


example he gave national banks the ability to sell unsecured promissory
notes , go into leasing and act as factors .
member banks to become national banks .

This induced some state

The Chase Manhattan Bank , for

example , is a dramatic example of a large member bank that switched from
a state to a national charter .

In addition , some new banks as they

were formed chose to become national banks under the liberalized rules
of the Comptroller of the Currency rather than to become insured nonmember banks .

If a bank applies for and receives a charter from the

Comptroller of the Currency membership in the Federal Reserve System is
automatic .

Likewise , some non-member banks switched from non-member to

national member bank status .

The net result was that while non-member

banks grew in number , member banks grew more rapidly and in one year ( 1964 )
non-member banks even dropped relative to the number of all banks .
Beginning in 1966 and continuing through 1970 we see an accelerated
rate of non-member bank growth .

To contrast the growth of member and

non-member banks we find that from the beginning of the period (December
1965 ) to the end (December 1970 ) the net change in the number of banks .



was -454 in member banks and +336 in non-members .

The total number of

banks declined in this period , all of it in member banks , whereas nonmember banks grew in number and increased their relative rate of change
from 0.7 percent in 1966 to 1.4 percent in 1970.
for national banks had ended .

The Saxon period

Whereas in 1966 , for example , only

seven national banks had switched from national to non-member bank
status , the number in 1970 was 39. 3/ State member banks continued
their switch from member to non-member bank status , with 32 losses in
1966 and 38 in 1970 . 4/1
In addition we should note that this was a period of high employment and monetary restriction .

While it is true that the money stock

increased rapidly from 1966 through 1968 , the demand for funds was still
greater than the increased money stock .

The rise in the rate of interest

at that time provides one sign of the shortage of funds that existed .
The last two years of the period were principally ones of a very tight
monetary policy through mid 1970 , the stock of money growing only
slightly .

It seems logical that a restrictive monetary policy will

induce an accelerated growth of the number of non-member banks .


restrictive policy directly impinges on member banks , and should therefore
induce new banks as they are formed to seek non-member status in such
economic circumstances .

This is not to say that a restrictive policy

has no effect on non-member banks , only that they are not directly
affected .

Board of Governors of the Federal Reserve System , Annual Report , 1966 ,
p . 348 ; 1970 , p.238 .

4/ Ibid .



Since 1970 a new growth path for numbers of banks has emerged .
total number of commercial banks has increased and is now at its highest
level since the early 1940's .

The number of non-member banks has

continued growing , while the decrease in the number of member banks has
stopped .

The number of all banks has increased 651 and non-member banks

have increased 657.

Whether these changes are permanent or are merely a

temporary shift in the long run gradual decline in number of all banks
cannot be ascertained at this time .
It is difficult to determine the economic or institutional
reasons for this altered behavior pattern .

On the basis of an

institutional force such as the difference in the nature of reserve
assets for member and non-member banks ,

as we shall examine more fully

at a later stage in this paper , the number of member banks should have
continued to drop since 1970.

A student of mine has postulated that

in periods of economic stress a bank may become a member of the
Federal Reserve System, or may join the Federal Reserve System if

starting a new bank to obtain the security that the System offers . "
This is an attractive hypothesis .
ful .

The last four years have been stress-

There have been two inflationary recessions ( 1970 and 1974) ; some

form of wage- price controls existed from mid 1971 to early 1974 ; there
were two devaluations of the dollar ( 1971 and 1973 ) ; the energy crisis
developed ; and there were the political traumas of the Watergate affair .
Yet the hypothesis is not convincing .

We have had other recent periods

of economic and political stress , and comparable bank behavior has not

Joseph M. Prinzinger , Op . cit . , p . 151 .



taken place . For example , three recessions occurred from 1953 through
1960 , a period during which total bank numbers decreased with all of
the decrease in member banks , there being no non-member bank growth at
all .

Additionally , for the economic stress hypothesis to hold , the

growth rate of non-member banks relative to member banks should decline
during economic stress .
Looking into additional data on bank composition shows the nature
of the changes that have occurred since 1970 , but does not provide an
explanation .

Table 2 shows the number of banks and banking offices that

were national , state member and non-member during four years , 1962 , 1966 ,
1970 and 1974.

From 1962 to 1966 , the Saxon period , we see the growth

of national member and non-member banks .

State member banks declined .

From 1966 to 1970 , national and state member banks decreased , while the
non-member banks grew in number .

From 1970 to 1974 , the pattern that

prevailed during the Saxon period has returned .

National member and

non-member banks have increased while state member banks have continued
their decline , although at a much slower pace than in earlier years .


banks usually have chosen to become either national members or state
non-member banks .

In addition , when banks have changed their status , they

have usually changed from member to state non-member banks .
turnaround of national bank declines leads one to speculate that
there currently might be an effort by the Comptroller of the Currency
to make national bank status more attractive , as it was in the Saxon era .
Another change that has occurred in banking numbers recently has
been the phenomenal growth of bank holding companies , both multi-bank
and one bank holding companies .

From 1963 to 1970 bank holding company



Table 2 : Number of Banking Offices in the United States .
December 1962 , 1966 , 1970 and June 1974. *




Dec. 31 , 1962




Dec. 31 , 1966




Dec. 31 , 1970




June 30 , 1974




Dec. 31 , 1962




Dec. 31 , 1966




Dec. 31 , 1970




June 30 , 1974




Type of office

Banks (head
office )

Branches ,
offices , and

National Bank figures include one bank in Puerto Rico and one bank
in Virgin Islands .
Source: Federal Reserve Bulletin , August 1974 , p . A- 79 .



groups holding more than 25 percent of the voting stock of banks
increased from accounting for 6.5 to 11.8 percent of all bank offices
and 8 to 16.2 percent of all bank deposits./
Since 1970 multi-bank holding companies holding less than 25
percent of the stock of their subsidiaries and one bank holding
companies have become subject to the provisions of the Bank Holding
Company Acts .
more inclusive .

Accordingly our data on holding company growth is now
At the end of 1972 there were 1,607 bank holding

companies operating 2,720 banks and 13,441 branches , and accounting
for 61.5 percent of all U.S. bank deposits .

At the end of 1973 , there

were 1,677 bank holding companies operating 3,097 banks and 15,374 ·
branches , and accounting for 65.4 percent of all U.S. bank deposits .
About half of the holding companies are member banks and they account
for 86.5 percent of bank holding company deposits .
The Federal
Reserve is processing an increasing number of various applications for
holding company proposals .

For example , it approved 203 , 383 , and 689

in 1971 , 1972 , and 1973 respectively.-

Federal Reserve Bulletin , June 1964 , p . 783 and August 1971 , p . A- 98.

Federal Reserve Bulletin , June 1973 , p . A- 104 .

Federal Reserve Bulletin , June 1974 , p . A- 83 .

Board of Governors of the Federal Reserve System , Annual Report ,
1971 , p . 225 , 1972 , p . 211 , 1973 , p . 251 .




The data show the significance of holding company growth , and that
both member and non-member banks seek group status .

It appears that

neither member nor non-member bank status provides an advantage to
banks that seek to gain the benefits of the holding company devise .
However the opening up of

additional reserve funds that are provided an

individual bank through the holding company expansion technique could
well provide an explanation for the recent upturn in number of banks ,
both the rise in non-members and the halt of the decrease in

members .

Assets of banks .

Table 3 shows the growth of all commercial bank assets ,

non-member bank assets , the percentage that non-member bank assets were
of all bank assets , and the annual percentage change in the percentage
that non-member bank assets were of all bank assets for the same period
as covered by Table 1.

In the succeeding paragraphs when the term

"growth rate" is referred to , we mean the percentage change in the
percentage of assets that are non-member bank assets .
The number of non-member banks , as previously shown , grew from
51.2 to 59.8 percent of all banks , an overall increase of 17 percent ,
whereas the assets of non-member banks grew from 15.0 to 21.7 percent
in the same period , an overall increase of 45 percent .
in both categories is up .

Thus the trend

However , non-member banks have grown even

more rapidly in asset size than in number , relative to member banks .


one takes the low point of non-member bank asset size ( 1950 ) and compares
it with 1974 , the growth is still more significant since here we see that
non-member bank assets grew from 13.1 to 21.7 percent , an increase of
66 percent .



Table 3 : Assets of All Commercial Banks and Non-member Banks
December 1947 - June 1974 , End of Year Data . *
(in billions of dollars )


All Commercial Non-Member
Bank Assets
Bank Assets



of Assets
that are
(3 )

Change in
Column (3)
(Growth Rate )+


























1974 (June )





Computed as each successive figure in the column showing the
percentage of assets that are non-member divided by the preceding
figure .
Source : Federal Reserve Bulletin , 1947-74 .

Various issues .



Whereas the trend in non-member bank asset size relative to
member banks is upward through the period subsequent to 1950 , this
movement appears to have been more cyclical than were changes in the
number of banks .

When decreases in the growth rate of non-member bank

size relative to all banks took place they usually occurred in recession .
Thus there were decreases in the 1948-49 , 1953-54 and 1960-61 recessions ,
as well as in the mini- recession of 1966.
not conform to this pattern .

The recession of 1957-58 did

In addition there was a sharp drop in

the rate of growth in non-member bank assets relative to those of
member banks in the 1970 and 1974 contractions .

It should be noted

that in 1970 , non-member bank numbers increased at a very rapid rate .


earlier attributed this to the restrictive monetary policy of the first
half of that year , whereas the decreased growth rate of non-member bank
assets may have been caused by the recession .

An implication of the

decreased growth rate of non-member bank assets in some recessions is
that small non-member bank and member bank asset changes respond in a
comparable manner during periods of economic decline , periods when
most banks reexamine their portfolios in light of increased credit risk
and economic stress .

A complementary implication is that the decrease

in the demand for funds that occurs in recession tends to affect all
banks equally .

Accordingly , member and non-member banks should be

expected to grow at a similar rate during recession .
The converse of these conjectures is that non-member banks during
periods of prosperity , a restrictive monetary policy , and strong credit
demand will not be as directly affected by government economic policies
and will therefore grow more rapidly than member banks .

This has already



been postulated in our discussion of the growth of numbers of banks .


can also be conjectured that , in years of economic expansion but
comparative monetary ease , non-member banks will grow more rapidly
than member banks , but not by as much as when there is monetary

restriction .

Most banks , as profit seeking businesses have a tendency

to expand on the upward part of the business cycle , particularly in the
absence of monetary restriction .

However , member banks are always

directly subject to the Federal Reserve , are more regulated than nonmember banks , and accordingly can be expected to grow more slowly in
response to an added demand for funds , even when the Fed's policy is
not restrictive .

The fact that the Fed's policy may not be particularly

on the upward part of the cycle enables the member banks to

satisfy a greater part of the expanding demand for funds than would
otherwise be the case .

Thus the non-member banks can be expected to

grow more rapidly than member banks is such periods , but not as
rapidly as when the Fed sharply restricts the expansion of member
bank credit .

The data referred to in the following paragraph gives some

support to these conjectures .
The decade 1952 through 1961 was one of slow relative growth in
assets for non-member banks .

In only one year , 1959 , a year of monetary

restriction and economic upturn did non-member bank assets grow
markedly relative to member banks .

The 1960's were characterized by

monetary ease and slow relative growth of non-member bank assets
until the latter part of the decade .

The years 1966-68 , it will be

recalled , were restrictive only in the sense that the demand for funds
grew more rapidly than a quickly expanding supply .

However , monetary


policy was restrictive in 1969.

This was the year of most rapid

growth in non-member bank positions , both in number and assets .
Finally , 1973 gave rise to a boom economy and a shortage of funds
in spite of a rapid growth in the money stock .
became very restrictive in mid 1973.

Federal Reserve policy

Accordingly relative non-member

bank asset size again increased sharply .

Thus 1959 , 1969 and 1973

bear out the conjecture that in periods of monetary restriction there
will be an expansion in the relative growth rate of non-member banks .
The period from 1971 to 1972 is difficult to interpret with
respect to the relationship between bank size and the business cycle .
This , it will be recalled , also applied to bank number changes .


should relative asset growth of non-member banks have shot up so strongly in
1971 and fallen again in 1972 ?

These were years of a comparatively easy

monetary policy , when the money stock grew rapidly and both member and
non-member banks had an improving reserve position .

Unfortunately no

explanation seems readily available .
Overall these observations on bank asset size indicate that
non-member banks generally experienced 1 ) a drop in their growth rate
and became more comparable to all banks in periods of recession , 2 ) an
increase in their growth rate in years of clear - cut monetary restriction
and economic expansion , and 3 ) a lower growth rate in years of economic
expansion without monetary restriction than in those years of expansion
that were accompanied by monetary restriction .

Based upon these

observations , the Federal Reserve has the most to fear from an
expansion of non-member bank growth during periods of economic expansion
and monetary restriction .

These are periods when the Federal Reserve is



trying to restrain inflation .

The relative growth of non-member banks

at such times suggests that they are adding to the demand for goods at
a rate faster than is healthy for the economy .

This is not to say

that , as profit seeking financial institutions , non-member banks are
deliberately subverting the actions of the Fed .

It is merely the

natural outgrowth of the more favorable status of non-member bank
reserve requirements .

Bank deposits .

Table 4 provides data on bank " other demand deposits " .

These are demand deposits owned by the non-bank public and exclude the
holdings of the U.S. Government and the interbank deposits of other
commercial banks .
The data in Table 4 shows that movements in the growth rate of
non-member bank demand deposits usually were in the same direction as
the growth rate of their assets.

However , it should be noted that

the non-member bank growth rate of demand deposits relative to member
banks was less volatile than that of assets in the 1950's whereas it
became more volatile in the 1960's and 1970's .

I have no satisfactory

a priori or empirical explanation for this behavior change .
Non-member bank demand deposits grew from 13.9 percent of all bank
demand deposits in 1950 ( their low point ) to 23.3 percent in June of
1974 , an overall increase of 68 percent .

Again , as in the case of bank

assets , the recessions of 1948-49 , 1953-43 , 1960-61 and 1974 , as well
as the mini-recession of 1966 , gave rise to a decrease in the growth

The growth rate refers to the annual percentage change in the
percentage of all bank deposits that are owed by non-member banks .


Table 4 : Other Demand Deposits of All Commercial Banks and
Non-member banks December 1947 - June 1974 , End of
Year Data . *
( in billions of dollars )




Percentage of
Deposits that
are Non-member

Change in
Column (3) ..:
(Growth rate ) +




























1974 (June). . . .

252.4 ·




*Computed as each successive figure in the column showing the percentage
of other demand deposits that are non-member divided by the preceding
figure .
Source : Federal Reserve Bulletin , 1947-74 . Various issues .



rate of non-member bank demand deposits .
The recession of 1970 was an exception to this general pattern ,
the growth rate of deposits rising instead of declining as was the case
with the growth rate of assets .

The explanation for the different

behavior pattern is difficult to explain .

It is possible that the

decline in the demand for funds affected member bank demand deposits
more sharply than it did non-member bank demand deposits .


since Federal Reserve economic policy first affects member banks ,
it is plausible that the very restrictive policy of the Fed , persisting
as it did into mid- 1970 , restrained member bank deposit growth while
leaving non-member bank deposits essentially unaffected .
It was earlier postulated that non-member banks would increase
their growth rate of assets relative to member banks sharply in periods
of expansion accompanied by monetary restriction .

The years 1959 , 1969

and 1973 were the principal examples of this behavior .

This held true

with respect to demand deposits in the 1959 and 1973 expansions , but
not in that of 1969.

Additionally the conjecture that non-member bank

growth rates will be slower in periods of monetary ease and economic
expansion , does not hold up well for demand deposits .

This is primarily

true for the 1960's when , as mentioned earlier , non-member bank deposit
growth , while positive as we postulated , was quite volatile .
the years 1971 and 1972 contradict the hypothesis as they did in the
case of bank assets .

It seems as though one can best explain non-member

and member bank behavior in periods of recession and those expansions
accompanied by monetary restriction .

Of course , these periods of

unemployment and inflation , are also when the Fed takes its most



aggressive action .
While it is not always possible to explain the year to year
behavior of the growth of non-member banks , it is obvious that the
long run trend is upward , particularly because most years since World
War II have been ones of economic expansion .

Hence non-member banks

have become increasingly important for additions to demand deposits , our
principal "means of payment " money.

Should this trend continue , as

already noted , the task of the Federal Reserve to regulate the growth
of the money stock will become increasingly difficult .
Non-member bank time deposit growth is different from that of
assets and demand deposits .

It is only recently that non-member

banks have increased in importance as creators of " store of value"
money , time deposits .

Table 5 shows that non-member bank time deposits

exhibited no marked trend relative to all banks until the late 1960's .
They were 19.9 and 20.0 percent of all time deposits in 1947 and 1969 ,
respectively .

In the period between these two years they simply grew

along with the dramatic pace that was set by all bank time

deposits .

Since then non-member bank time deposits have increased

to 23.3 percent of all bank time deposits .
Some comment should be made concerning the relative growth of
all bank demand and time deposits .

In the decade from 1950 to 1960 ,

demand deposits grew by one third while time deposits doubled in size .
The greater growth of time deposits is to be expected in periods of
relative prosperity , when saving is positive .
deposits earn no interest for the saver .

After all , idle demand

In addition , time deposits

are a more attractive source of funds for a commercial bank since , while

52-221 O - 75 - 14



Table 5 : Time Deposits of All Commercial Banks and Non-member
Banks , December 1947- June 1974 , End of Year Data . *
( in billions of dollars)





Percentage of Percentage
Deposits that Change in
are Non-member Column ( 3 )
(Growth Rate ) +





























1974. (June ) .... 398.2 ...

Computed as each successive figure in the column showing the percentage
of time deposits that are non-member by the preceding figure .
Source: Federal Reserve Bulletin, 1947-74 . Various issues .



carrying an interest cost , time deposits have a lower reserve requirement
and a lower turnover cost than do demand deposits .

In the next decade ,

from 1960 to 1970 , demand deposits increased 57 percent , while time
deposits rose 223 percent .

Since 1970 the greater growth of time

deposits has even increased .
Aside from 1969 , a year of disintermediation , time deposits have
increasingly outstripped demand deposits in growth since 1960.

Much of

this greater growth is attributable to the successive increases in
interest rate ceiling placed upon time deposits under Regulation Q
by the Federal Reserve and other monetary authorities such as the
Federal Deposit Insurance Corporation and the Federal Home Loan Bank
Board .

Bank loans and investments .

Tables 6 and 7 show the behavior of commercial

bank loans and investments from 1947 through 1974.

Bank loans grew

more rapidly throughout this period than did bank investments .

From 1947

to 1974 , bank loans grew 1,288 percent while bank investments grew only

143 percent .

This was a remarkable growth of risk assets .

Yet it was

a growth to be expected , given the overall prosperity of the period .
Banks simply increased their holdings of high yield assets relative to
low yield assets in response to a healthy national economy and the
profit motive .
Bank loan and investment behavior also reflects this response to
the national economy and the profit motive during the business cycle .
All banks generally cut back on the growth of their investments in
periods of economic expansion , particularly when accompanied by



Table 6 : Loans of All Commercial Banks and Non-member Banks .
December 1947 - June 1974 , End of Year Data . *
( in billions of dollars )


(1 )



of Loans that
are Non-member

Change in
Column ( 3 )
(Growth rate ) +


























1974 (June) . 529.0




*Computed as each successive figure in the column showing the percentage
of all loans that are non-member divided by the preceding figure .
* Source : Federal Reserve Bulletin , 1947-74 . Various issues .


Table 7 : Investments of All Commercial Banks and Non-member Banks .
December 1947- June 1974 , End of Year Data . *
( in billions of dollars )




Percentage of Percentage
Change in
that are Non- Column (3)
(Growth rate ) +

( 1)



























1974(June )







+Computed as each successive figure in the column showing the percentage
of all investments that are non-member divided by the preceding figure .
*Source: Federal Reserve Bulletin , 1947-74 . Various issues .



monetary restriction.

The expansion years of 1948 , 1950 , 1955-56 ,

1959 , 1965-66 , 1969 and 1973 are excellent examples of this behavior .
In addition , banks typically seek high interest yielding loans in
periods of economic expansion .

Thus in the expansion years of 1958 , 1950-52 ,

1955-56 and 1959 bank loans increased their rate of growth .

Since all

of the 1960's after 1961 were prosperous and expansionary , we find that
bank loans expanded rapidly during this period , aside from 1966 , the
year of the mini - recession .

The expansionary inflation years of 1972

and 1973 also led to a sharp expansion of bank loans .

This was in

part caused by large peacetime federal deficits and increases in the
stock of money until mid- 1973 .
During years of recession bank investment and loan behavior
differed from the preceding pattern .

Here we find that all bank loan

growth declined markedly in the recessions of 1948-49 , 1953-54 , 1957-58 ,
1960-61 , the mini - recession of 1966 , and the recessions of 1970 and 1974.
During a number of these recessions banks turned to less risky investments ,
increasing their rate of investment acquisition in the recessions of
1948-49 , 1953-54 , 1957-58 , 1960-61 , and 1970.

This pattern did not

hold during the 1974 recession , primarily due to the excessively
restrictive monetary policy followed by the Federal Reserve as it
sought to combat a supply induced inflation with demand restraining
monetary policy.
Overall the behavior described here , as is generally known among
economists ,

indicates that banks . prefer to move 1 ) toward high

yield risk assets such as loans during periods of prosperity and
expansion , 2 ) away from high risk assets during recession , 3 ) away. "


from low yield relatively safe investments in periods of prosperity
and expansion , and 4 ) toward the safer investment assets in recession .
This is clearly profit maximizing , risk averting , and procyclical
behavior .

The move to bank loans during prosperity adds to bank earnings

and aggregate demand .

The move away from strong loan growth and toward

investments in recession adds to bank safety and decreases the growth
of aggregate demand .

These are undesirable macroeconomic results .

The growth of demand should decrease in boom and rise in recession .
What we have discussed is typical of all banks and will be referred
to again in the second section of this paper .

Is there any difference

in this behavior pattern when we look at member banks as compared with
non-member banks ?

The general pattern that emerges from the data on

year to year growth in member and non-member bank loans and investments
is similar to that just described for all banks .

Yet differences arise

when we observe the growth rate of all non-member bank loans and
investments as a percentage of all bank loans and investments .

Column (4)

in Tables 6 and 7 shows that non-member bank loans grew in prosperity
and expansion but often more slowly than in less prosperous years .


slower growth is particularly noticeable in the expansions of 1950-52 ,
1955-56 , 1959 , and 1961-68 which followed the contractions of 1948-49 ,
1953-54 , 1957-58 , and 1960-61 respectively .

Since 1968 this pattern

may have changed , with non-member bank loan growth rates rising most
sharply in the expansion year of 1969 , falling in the recession of
1970 , rising again in the expansion of 1971 , but falling again since

The implication of this behavior pattern is that non-member bank



loans moved less procyclically than member banks through 1968 but may
now have moved into a more procyclical pattern of growth .
The behavior of non-member bank investments confirms this observation .
Every year , with the exception of 1967 , in which there was a decrease
in the percentage change in the percentage of investments that are
non-member was a year of recession .

This applies to each of our post

Non-member banks expanded their holdings of

World War II recessions .

investments in recession , but more slowly than member banks .

Again this

means that non-member banks acted less procyclically than did member
banks .
It may appear from the preceding analysis that the supposition
that non-member banks accentuate the business cycle is false .
would be an erroneous conclusion , however .


The changes in loans and

investments of both member and non-member banks is procyclical .


difference is that member bank behavior appears to be more procyclical
than that of non-member banks .
of Federal Reserve policy .

This reaction could well be a result

The fact that Federal Reserve policy first

affects member banks may force them to behave as they do .

Suppose , for

example , that the Fed decides to restrain monetary growth in an
expansion and that it sharply restricts the ability of member banks to
lend .

These banks , having favorable lending opportunities , are forced

to seek loanable funds .

One way of acquiring funds through asset

management is to reduce the volume and/or the growth of investments .
The funds acquired can then be placed into the more profitable loans .
Non-member banks , on the other hand , not being directly affected by the
policies of the Fed , need not reduce their investment growth as sharply



to find the funds for loan growth .

Accordingly non-member banks merely

would appear to act less procyclically than member banks during periods
of monetary restraint .

Now consider recession .

Member banks , having

so sharply reduced investment growth in the boom, now feel a need for
a much higher degree of safety and less risk in their asset portfolios .
Accordingly their loan growth would drop sharply as their investments

rise .

Non-member banks , not having been so severely pressed for funds

in the boom, already have a greater fraction of their assets in relatively
safe form and therefore do not need to add investments to their portfolios
as rapidly as member banks .

The net effect is that non-member bank invest-

ments may grow more slowly in recession than those of member banks .

Preliminary results of a statistical model of loan and investment behavior .
Given the difficulties of interpreting the bank loan and investment
behavior of non-member and member banks , I have made a preliminary
effort to set up a statistical model of how bank loans and investments
respond to various macroeconomic variables .

Since the study is only in

its initial stage , I shall only briefly outline the procedures used and
the tentative results .
The dependent variables examined are : ( 1 ) non-member bank loans
and investments , LInm; ( 2 ) member bank loans and investments , LIm;
(3 ) country bank loans and investments LI ; ( 4 ) all commercial bank
loans and investments , LIac

(5) non-member bank loans , Lnm; (6 ) member

bank loans , Lm; ( 7) country bank loans , LC ; and ( 8 ) all commercial bank

loans , Lac
Each of these dependent variables is regressed against
macroeconomic variables in a multiple regression equation .



The macroeconomic variables are : ( 1 ) i , the prime interest rate ;
(2 ) Y , personal income ; ( 3 ) P , the consumer's price index ; and ( 4) the
unemployment rate , U.

It was expected that LI and L would be positively

related to i , Y , and P , but inversely related to U.

Since commercial

banks trade off loans and investments , it was expected that the
relationship between LI and the independent variable would not be as
good as that between L and those variables .

Bank reserves were not

included in the model as a variable due to the difference in the meaning of reserves for member versus non-member banks .
studied covers 1957 through 1970.

The period

The regressions were performed

using first the absolute figures and then first differences .

The data for total loans and investments shows a high R

as is

to be expected when using time series and absolute figures .
was the most significant variable .

As noted earlier , it was expected

that LI would vary positively with Y, i , and P and negatively with U.
The expectations for Y and U were confirmed by the test in absolute
values .

Overall the results seem best for non-member banks , thereby

giving some credance to the conjecture that non-member banks react
more procyclically than do member banks .
The results concerning loans show a somewhat different pattern for
non-member banks .

Lnm are positively related to all the independent

variable , indicating that , aside from changed sign relative to U,
non-member banks behave even more procyclically than do their total
loans and investments .
The tests in first differences were designed to eliminate serial
correlation . Of course this was at the expense of the high R and the



greater degree of significance which we had with the tests run on the
basis of absolute values .

The changing of the direction of some of

the coefficients indicates that some lag in the reaction of LI and L
to the independent variables may be present , a force that needs to be
examined in future statistical tests .
Crude and tentative as these results are , they seem to indicate
that non-member banks behave more procyclically than member banks , an
observation that would be corroborated by simple observation of Tables
1,3 and 4 , but contradicted by Tables 6 and 7 .

b) Non-member and member bank reserve requirements and reserves
The ability of an individual commercial bank to create deposits is
limited by ( among other things ) its reserve requirement .

The amount of

reserves required to back deposit liabilities varies widely for nonmember banks as compared with member banks .

For non-member banks the

reserve requirement is set by each state while the Board of Governors
sets the requirement for all member banks .
The argument is sometimes made that reserve requirements are
typically lower for non-member banks than for member banks and that
this is why so many banks prefer to remain outside of the FederalReserve

In point of fact reserve requirements for non-member banks are

are not typically lower than those for member banks as we can see by
an examination of Table 8.

As we can see from Table 8 , in 1971 there

were only fiften states which had reserve requirements on demand
deposits for non-member banks which were lower than those set by the
Federal Reserve for member banks .

Ten states had the same requirements

as the Fed , while 25 states actually had higher reserve requirements .




Table 8: Comparison of Reserve Requirements on Demand and
Time Deposits set by the 50 States for Non-member
Banks and those set by the Federal Reserve . *
Selected years , 1962-71


Number of States
with higher
Requirements for
Non-member Banks
than for
Member Banks on :

Number of States
with lower
Requirements for
Non-member Banks
than for
Member Banks on :














































Number of States
with the same
Requirements for
Non-member Banks
as for
Member Banks on :


*Source :

Joseph M. Prinzinger , Op . cit . , pp . 21 - 23 .

+ Demand Deposits

Time Deposits





The same pattern held for the reserve requirements on time depoits .
Only two states had reserve requirements on time deposits for non-member
banks which were lower than those set by the Federal Reserve for
member banks .

Sixteen states had the same requirements as the Fed ,

while 32 states had higher reserve requirements .
Additionally an effort was made to ascertain whether or not the
relative level of reserve requirements would be related to the numbers
of member versus non-member banks in the various states .
pattern was observed .

No discernable

Of the states where member bank reserve require-

ments on demand deposits were lower for member banks , in only two , Ohio
and Wyoming , did member banks clearly outnumber non-member banks .


the other hand , where reserve requirements on demand deposits were
lower for non-member banks , in half the states , member banks were a
majority of the number of banks in the state .

Thus it appears that if

there is a pattern to membership in the Federal Reserve System it is
not related to the relative reserve requirements of member versus nonmember banks .
Although member banks appear to have an advantage over non-member
banks with respect to the absolute level of reserve requirements on
deposits , non-member banks can hold these reserves in a wider variety
of assets than member banks.Whereas member banks must maintain
their reserves in the form of vault cash or reserve deposits at their
district Federal Reserve banks , non-member banks , depending on state laws ,

11/ The following discussion is based in part on : Joseph M. Prinzinger
and John J. Klein , An Analysis of State Banking Laws and their
Relation to Bank Profits . Manuscript in preparation , 1975 .


may hold their reserves in the form of vault cash , correspondent balances
at other banks , U.S. government securities , state and local government
securities , federal funds sold , cash items in process of collection , and

certificates of deposit.12 /
The vast majority of small to medium size banks , principally nonmember banks , need the services of a correspondent .

To obtain these

services , a respondent bank places deposits with a correspondent bank
which supplies check clearing , loan participation aid in asset management ,
domestic and foreign currency , computer facility , bond purchase , etc. ,
services .

All fifty states allow non-member banks to hold their reserves

at certain correspondent banks .

Therefore , non-member bank reserves in

all fifty states can be used to buy correspondent services .

On the other

hand , small and medium size member banks must draw down their earning
assets to purchase correspondent services .

Member banks cannot use their

required reserves at the Federal Reserve banks to buy these services .
Thus non-member banks have a lower opportunity cost than member banks in
buying correspondent services .

From this it follows that the banking laws ,

which allow non-member banks to hold their reserves as correspondent
balances , result in non-member banks having a lower ratio of non- earning
assets to total assets than do member banks .

For example , the ratio of

cash assets to all assets for non-member and member banks was 9.1 and 15.7

percent respectively on June 30 , 1974.13/

For a detailed breakdown of the nature of non-member bank reserve
assets see : Robert E. Knight , " Reserve Requirements " , Federal Reserve
Bank of Kansas City , Monthly Review , April 1974 , Appendix , pp . 15-20;
and Joseph M. Prinzinger , Op . cit . , Chapter 2 .
Federal Reserve Bulletin , December 1974 , p . A- 16 .



In addition to permitting non-member banks to hold their reserves
in the form of cash or correspondent balances , some 25 states allow
non-member banks to hold reserves in a manner that yields an explicit
return .

U.S. government securities are the most common form of interest

earning assets that are allowed to serve as reserves for non-member banks .
Overall , however , there is a great diversity in the form in which nonmember banks may hold their reserves , as the preceding paragraph has
already indicated .

In Georgia , for example , certificates of deposit

of other Georgia banks , both of member and non-member banks , may be held
as part of reserves .
Apparently the variety of interest earning or service providing assets
in which non-member banks may hold their reserves is more than sufficient
to cancel out the negative aspects of high reserve requirements in some
states for non-member banks .

It is this item , the composition of non-

member bank reserves , which we believe to be the key to the general
desire of small and medium size banks to remain or become non-member
banks .

A low ratio of non- earning assets to total assets and its con-

comitant high profit potential are strong incentives for the growth in
numbers of non-member banks .
Other legal differences between member and non-member banks such
as capital requirements and par status could also be analyzed .
balance , however , these differences are features


of bank membership

status that are relatively unimportant in light of the incentive which
the composition of non-member bank reserve assets gives to non-membership

status .



c ) Summary and recommendations
The more important results of this analysis of non-member banks
and monetary policy can be summarized as follows :
( 1 ) Non-member banks have grown relative to all banks in numbers ,
assets , loans , investments , and deposits since 1947.
(2 ) The relative growth of non-member bank assets is usually
lowest in recession and greatest in periods of economic
expansion accompanied by monetary restriction .
( 3 ) The relative growth of non-member bank demand deposits is
usually lowest in recession and greatest in periods of
economic expansion accompanied by monetary restriction .
(4 ) Commercial banks generally move toward high yield risk assets
in periods of prosperity and away from such assets in recession .
(5 ) Member bank changes in loans and investments appear to behave
more procyclically than those of non-member banks .

This may

be the result of Federal Reserve policy actions , however .
(6 ) Very tentative statistical tests indicate that non-member
banks may respond to macroeconomic variables more procyclically
than member banks .
( 7) Reserve requirements for non -member banks are not typically
lower than those of member banks .
( 8) Non-member banks , in contrast to member banks , may often hold
their reserves in correspondent balances and/or interest
earning assets .
These observations demonstrate that an increasing portion of our
"means of payment money" , demand deposits , are being created by non-member



banks .

Since these banks are not directly under the control of the

Federal Reserve , it follows that , as non-member banks continue their
growth , the efforts of the Fed to regulate the economy will ultimately
become more difficult .

Under such circumstances , the Fed would have to

increase its direct control over its member banks in order to bring about
a desired change in the money stock .

This would be a process that ,

hypothetically, could induce a further withdrawal of banks from Federal
Reserve membership .

The more attractive form in which non-member banks may

hold their reserves , I feel , is the source of the relative decline in
System membership .
To resolve the problems created for monetary policy by the ever
increasing importance of non-member banks , I recommend that non-member
banks be made subject to the same reserve requirements as comparable
size member banks .

This could probably be most expeditiously brought

about by requiring that all commercial banks be member banks .

Over the

years , the Federal Reserve itself has made such recommendations .


frequently disagree with Federal Reserve policy actions , but on the matter
of uniform reserve requirements I wholeheartedly approve of the Fed's
recommendations .

I do not agree with one economist who recently

argued that " The Fed's continued interest in universal reserve requirements ... traces both to its desire to eliminate the problem of eroding
System membership and to its hunger for greater regulatory dominion . "-

Edward J. Kane , " All for the Best : The Federal Reserve Board's 60th
Annual Report . " American Economic Review, December 1974 , p . 844 .

52-221 O - 75 - 15



2. Bank Asset and Liability Management · Their Relationship to Monetary
This section examines the relationship between monetary policy and the

various forms of bank asset and liability management .

We shall touch upon

asset and liability management in general and then look at specific forms
such as Euro - dollar borrowings , commercial paper sales of bank holding
company affiliates , loan commitments to corporate customers , and the


competition with non-bank financial institutions for savings funds .
of this material has already been touched on in section ( 1 ) when we
dealt with the loans and investments of all banks .

Additionally bank

asset and liability management in so far as it relates to the economy in
general is a means of competing for reserve funds and is primarily of
importance during periods of economic expansion , monetary restriction ,
and disintermediation .

During recession , reserve funds are ample and

banks can concentrate on obtaining an asset portfolio which maximizes
return and minimizes risk .

For these reasons we can be somewhat terser

than we were in section ( 1 ) and concentrate on the logic of asset and
liability management rather than directly observe the behavior of banks
in all phases of the cycle.a) General analysis of bank asset and liability management and the economy
The dilemma for banks .

Commercial banks , like other businesses , are

private , profit seeking corporations .

They can be expected to maximize

profits , hopefully in a manner that is consistent with bank safety .


raise earnings , banks must grant more loans and make more investments , and

Portions of the discussion which follows are based upon my book ,
Money and The Economy , 3d edition , Harcourt , Brace & Jovanovich Inc. ,
1974, pp. 74-83 , and 91-93 .



in order to do this they must have more funds (reserves ) .


usable reserves for the commercial banking system are provided only when
the monetary authorities lower reserve requirements or purchase U.S.
government securities in the open market .

Thus , the commercial banking

system must depend upon the decisions of regulatory agencies to grant
additional reserves .
How can banks increase earnings and profits during periods of
economic expansion and monetary restriction when additional reserves are
not available to them?

One obvious solution is to reduce expenses .

In a

competitive industry like banking , however , most firms are already striving
for reduced costs .

Another alternative is to engage in more aggressive

liability management .

By selling more certificates of deposit , offering

the legal maximum on all types of time deposits , borrowing in the federal
funds market , acquiring Euro - dollars , having nonbank subsidiaries sell
commercial paper , etc. , the individual bank is able to acquire additional
reserves · but , as we shall see , these procedures simply benefit some
banks at the expense of others .
Yet another alternative available for increasing profits is to change
the composition of the bank asset portfolio - that is , to improve on bank
asset management . This alternative usually involves making relatively
more high income producing loans and investments .

Higher- yielding loans

and investments , however , are likely to be risky .

An increased proportion

of risk assets in a bank portfolio will impair the quality of that bank's
assets in the view of government supervisory agencies .
Ultimately , the solution to what many bankers view as serious
problems - a high proportion of risk assets and inadequate bank capital



appears to lie in the creation of more usable reserves by the Fed .


wisdom of such an approach , of course , depends upon the national economic
situation .

The dilemma for the national economy .

The manner in which commercial banks

increase the growth rate of loans and decrease that of investments in
periods of prosperity and hold down the level of loans and increase
investment growth in recessions suggests the following concerning the role
of the commercial banking system during economic fluctuations .
First , commercial bank loan creation in periods of recovery helps to
increase demand deposits and stimulates demand , output and employment in

the economy .

Demand deposits have grown markedly in the last two decades

and - aside from the relatively prosperous Vietnam war period 1 most of
the growth has come in the year or two following each recession .


were periods of monetary ease , when commercial banks had adequate reserves .
Second , when banks put their funds in investments rather than in
loans during recessions , it slows the pace of recovery.

The money balances

held by borrowers are active and stimulate the economy , but the money
balances used in the purchase and sale of securities are relatively inactive .
This behavior by banks is justified ; available funds go into securities in
part because of the lack of qualified borrowers .
for banks to hold excess reserves .

The alternative would be

Since putting funds into securities

tends to push down interest rates , it contributes more to

recovery than

would a policy of holding excess reserves .
And third , commercial bank activity may also have an adverse effect
on the economy during periods of high employment , rapidly growing gross
national product , and rising prices .

In these periods , banks attempt to


avoid monetary restrictions by reducing investment growth and increasing
loans .

This transfers money balances from security purchasers ( relatively

inactive spenders ) to borrowers (active spenders ) .

Thus , even with no

change in the money supply , bank loan and investment policy may increase
inflationary pressures by increasing the velocity of money and thus the
demand for goods .
The preceding comments related to asset management .

Similarly ,

banks aggressively seek reserves by using liability management in periods
of economic expansion and monetary restriction .

To the extent that

liability management results in increased growth of time deposits relative
to demand deposits , bank loans and assets will increase and accordingly ,
inflationary pressures will be accentuated .

In addition , to the extent

that liability management results in an increased turnover of the money
stock , the velocity of money will increase and inflationary pressures will
be reinforced .

Thus despite Federal Reserve monetary controls , commercial

banks may intensify , rather than dampen , the cyclical swings of the
Some discussion of these macroeconomic relationships follows in
the next section where we briefly consider several specific forms of
liability management .
b) Examples of liability management and the economy

Euro-dollars . Large banks , particularly those with foreign branches , have
an opportunity to obtain reserve funds in the Euro- dollar market .


dollars are created when the ownership of demand deposit liabilities at
American banks is transferred to foreign banks .

If a foreign bank

then sells or lends its Euro-dollar holdings to a foreign branch of a
U.S. bank , the Euro- dollars are now owned by the foreign branch of an



American bank .

The dollars , of course , are still in the United States as

liabilities of some other American bank .

The foreign branch that owns the

Euro-dollars will now transfer the ownership to its home office in the
United States .

The home office will seek payment and , in so doing , will

acquire reserves from the American bank whose..deposit liabilities served as
Euro-dollars .
actions .

Reserves for all commercial banks are unchanged by such

One U.S. bank has gained reserve funds at the expense of some

other domestic bank .

The lending ability of the bank borrowing the

Euro-dollars is enhanced and that of other banks decreased .

It should

be noted that the Federal Reserve discourages use of the Euro-dollar
market by large banks

by imposing a reserve requirement on Euro- dollar

borrowings - currently 8 percent .

Commercial paper of bank holding company affiliates .

Short-term promises

to pay, called commercial paper, are still another liability management
source of funds for large commercial banks . They are issued and sold by
bank holding companies and their non-bank affiliates . 1 When , for example ,
nonbank affiliates sell commercial paper , it is paid for with checks drawn
on the commercial banks of the purchasers of the paper.

These checks are

deposited in the checking accounts of the nonbank affiliates at the
commercial bank affiliate of the bank holding company.

The commercial bank

accepting the deposits acquires reserves from the banks on which the checks
were drawn .

The nonbank affiliates then purchase loans and investments

held by the affiliate bank .

When we combine the balance sheets of the

affiliate bank and its nonbank affiliates , we find , on balance , that there
are more reserves available to the commercial bank and that there is an
increase in commercial paper liabilities .

Just as in the case of Euro-dollars


reserves for all commercial banks are unchanged by such

actions , but

one bank has gained reserves at the expense of other banks .

The Federal

Reserve also discourages the issuance of paper by bank holding company
affiliates through the imposition of reserve requirements .

Loan commitments to corporate customers .
large commercial bank

Loan commitments may be made by a

to issuers of commercial paper .

guarantees the commercial paper .

In effect the bank

The deposit accounts of the corporate

customer are not increased by the bank since no liability has been directly
incurred by it .

When the commercial paper is sold , the seller deposits

the funds in his checking account and will use the proceeds in his operation .

The commercial bank will receive reserve deposits from other

commercial banks , those whose customers purchased the commercial paper .
There is no change in the total of commercial bank reserves .
change in the ownership of reserves takes place .

Rather a

Commitments of the

type described here became subject to reserve requirements in 1974 .

General comment on the preceding forms of liability management .


banks , and in particular the very large commercial banks , have become
increasingly ingenious in their efforts to acquire additional reserve
funds .

The Euro - dollar market developed in the 1960's .

The commercial

paper issues of non-bank affiliates became important in the credit curnch
of 1969.

In addition to the previously described loan commitments , there

has been the recent development of finance bills , acknowledgments of
advance , and special types of due bills .

All of these credit instruments

are difficult to understand , especially for anyone not directly connected
with day to day bank operations .

Yet they all have the same end · the



acquisition of reserve funds .

This enhances the lending ability of

those banks successful in their quest for funds , but reduces that of all
other banks .

No change in the total of bank reserves generally occurs .

All these activities redistribute a given volume of reserves among the
commercial banks .
c ) Competition with nonbank financial institutions - the search for
time deposits
Theoretically , the yield on one type of liquid asset relative to
yields on other types influences the demand for that asset .

For example ,

should the yield on time deposits rise relative to yields on competing
financial assets , the volume of time deposits demanded will rise and the
demand for other liquid assets will decline .

Because the higher yield

on time deposits makes them a more attractive savings form 9 more of these
deposits will be demanded and fewer other liquid assets will be purchased .
Conversely , a relative decline in yield on a financial asset will decrease
the demand for that asset .

Hence it can be argued that the demand for a

liquid asset is an increasing function of its own yield and a decreasing
function of other yields .

Should the yield on competing liquid assets

remain the same relative to the yield on time deposits , we would expect
little substitution to occur .

The presumed objective of the Federal

Reserve's use of Regulation Q has been just this - namely , to allow time
deposit rates to keep pace with yields on other liquid assets .

However ,

this policy has not been successful .
The period ending around 1960 was one of relative decline for
commercial banks as direct contributors to the pecuniary assets of the
economy .

This decline can be partly attributed to the failure of the

Federal Reserve to adjust ceilings payable on time deposits under Regulation Q.



Other lending institutions such as savings and loan associations offered
substantially higher yields on time deposits than commercial banks .


nonbank financial institutions successfully competed with commercial banks
for idle cash and deposits of individuals in the economy .
When one borrows from a lender other than a commercial bank , money is
not created .

These financial institutions lend funds directly , usually

in the form of demand deposits at commercial banks .

As a result , the

dollar volume of loans and investments made by commercial banks decreases
in relation to those of other institutions , although for the economy as a
whole there is an increase in economic activity .

The total of the money

stock is unchanged but there has been an increase in its turnover .


other words , the velocity with which the money stock changes hands in
the economy has increased .

Surprisingly , commercial bank reserves are

unchanged , but the activity in their deposit liability turnover has
expanded because of nonbank financial institution increased lending
operations .
The relative growth of commercial bank assets increased sharply in the
1960's and 1970's .
Reserve policy .

This is partly attributable to a change in Federal

The Federal Reserve along with other federal regulatory

agencies has increasingly used Regulation Q in such a way as to raise the
rates payable on time deposits by commercial banks relative to those paid
by mutual savings banks and savings and loan associations .

The result

has been a marked increase in outstanding certificates of deposit issued
by commercial banks .

Many members of the public increased their rate of

purchase of CDs issued by commercial banks and decreased their rate of
purchase of CDs issued by nonbank financial institutions .



Effects on bank reserves from the sale of CDs .

When a bank sells a CD

to a new depositor , the bank creates a new time deposit liability and
receives an increase in its reserves .

The increase in the bank's reserves

occurs because the purchase of the CD will have been made with checks
drawn on other commercial banks .

If, for example , the funds came from

savings and loan share accounts , then the checks were drawn on the
commercial bank used by the savings and loan association .

Or if the

CD had been purchased by a business , then the business would have used idle
demand deposits , quite probably from accounts originating in other
commercial banks .

The net effect will be a change in the ownership of

bank reserves away from some commercial banks that have not been
successful in competing for funds .

There is no change in the total

of reserves in the banking system as this competitive process takes
place .

There is , however , some change in the level of required reserves .

Since time deposits have a lower reserve requirement than demand deposits ,
bank required reserves will have decreased and excess reserves increased .
This enables the banking system as a whole to expand its loans
somewhat .

The extent of the expansion depends upon the relative

magnitude of the reserve requirements on demand versus time deposit
accounts .
How are the nonbank financial institutions affected by a loss
of savings and loan share accounts and other comparable time deposits ?

The nonbank financial institutuions redeem their liabilities

with their holdings of commercial bank demand deposits .

Since these

deposits serve as cash reserves of the nonbank financial institutions ,
any reduction constitutes a decrease in their reserves and thus in
their lending ability .



d) Disintermediation
Disintermediation occurs when interest yields on such forms of
liquid wealth as treasury bills and paper issued by businesses rise above
the interest rates paid by financial intermediaries on their liabilities .
This process typically occurs in periods of credit restraint ; 1966 , 1969 ,
and 1973 provide the most recent examples .

When people at such times

decide to reduce their savings deposits at nonbank financial institutions ,
they acquire funds that were serving as reserves for those institutions
and thereby force a contraction in lending activity .

Subsequently , the

money acquired is used to purchase such financial assets as treasury
bills .

The housing industry , which needs mortgage funds provided by

such nonbank financial institutions as savings and loan associations , is
severely hampered .

Businesses and individuals may also decide to redeem

certificates of deposit issued by commercial banks and purchase treasury
bills or commercial paper issued by other businesses instead .


action reduces bank time deposits and increases demand deposits which
require higher levels of reserves .
lending activity .

The effect is a reduction in bank

These contractionary forces may cool an economic

boom, but they create serious adjustment problems for banks ,
savings institutions , and the housing industry .

e) Summary and discussion of legislative recommendations
The more important implications of the relationship of bank asset
and liability management to national economic health during periods of
economic expansion and monetary restriction can be summarized as
follows :



(1 ) Commercial bank asset management increases inflationary
pressures by increasing the velocity of money and the demand
for goods .
( 2) Commercial bank liability management increases inflationary
pressures by increasing a ) the velocity of money , b ) the growth
of bank loans and assets , and c ) the total of deposit funds
(demand plus time deposits ) .
(3 ) Special forms of liability management have developed in recent
decades as banks have attempted to solve the dilemma of how to
maximize profits within the context of a restrictive monetary
policy .

While most commercial banks make this effort , large

banks appear to be in a better position to do this than are
small member banks .
(4) Both asset and liability management normally result in a changed
distribution of reserve assets among banks without there being
any change in the total of bank reserves .

The recently developed

special forms of liability management tend to shift the ownership
of bank reserves away from small member to large member banks .
This in turn can be viewed as a force that induces small member
banks to leave Reserve System membership .
( 5) The recent uses of Regulation Q have resulted in periodic
dis intermediation for non-bank finanacial institutions and
chaos in the housing industry .
(6 ) The Regulation Q ceilings have also resulted in some disintermediation
for commercial banks , primarily because of an induced change
in the composition of bank liabilities away from time deposits
toward the higher reserve requirement demand deposits .



To solve the economic and equity problems posed by bank asset and
liability management , I recommend the following :
(1) The extension of Federal Reserve System membership to savings
institutions .

This would , in effect , convert mutual savings banks and

savings and loan associations into commercial banks .

Such a proposal

has previously been recommended by the President's Hunt Commission
report .
My view on requiring these institutions to become commercial
banks is based on the belief that these institutions are too specialized
in the nature of their assets ( they lend long ) and liabilities (they
borrow short ) .

If they were to become commercial banks , they could more
readily diversify both their assets and liabilities . Most institutions
would probably continue to specialize in mortgage loans , but the proposal
would insulate the housing industry from the chaos that periodically
results when disintermediation forces a sharp and sudden decrease in the
normal growth rate of nonbank financial institution reserves .

The present

efforts of our regulatory agencies to expand the variety of nonbank
financial institution liabilities

are to be applauded , but I feel that

these efforts are merely short run expedients to a long run problem, the
disproportionate effect of disintermediation on one industry , housing .
( 2 ) The removal of interest rate ceilings on member bank , nonmember bank , and nonbank financial institution deposit liabilities .
Interest rate controls , like price controls in general , give rise to a
malallocation of resources in the economy .

Interest rate ceilings pose

no problem so long as credit conditions are easy and the demand for and

The Report of the President's Commission on Financial Structure and
Regulation . Reed O. Hunt , Chairman . Washington D.C. , December 1971 .



supply of funds set

the rates paid to savers and charged borrowers

at levels beneath the legal ceilings .

Once the rates are up to the

maximum ceilings , financially astute investors of idle funds will place
their funds into those financial instruments whose rates of return are
not controlled .

The effect is disintermediation and a diversion of

funds from the controlled into the uncontrolled financial instruments .
It could be argued that instead of freeing interest rates there
should be regulation of the entire interest rate structure of the
economy .

According to my view , this would be a disaster since interest

rate differentials would be frozen and could not be quickly adjusted to
changes in the demand for various liquid assets .

How long will it take

for us to recognize that interest rate regulation is ruinous?


Locke , best known for his Two Treatises on Civil Government ( 1690 ) and
his influence on Thomas Jefferson , already in 1692 argued that a) the
level of interest should be determined by the relationship between the
amount of money needed and the amount available , b ) if the amount needed
for trade was great relative to the supply , the interest rate would be
high , and c ) if the rate of interest were legally to be forced beneath
a competitive level , no additional borrowing could take place because
lenders would be unwilling to lend.17/
(3 ) Small savers who typically hold savings accounts and purchase
small denomination CDs should be allowed to compete more effectively
for short term government securities and high yield paper issued by
businesses .

The Treasury should be required to sell its securities

John Locke , Consequences of the Lowering of Interest and Raising the
Value of Money, 1692 .



in less than the customary $ 10,000 denominations .

Currently the funds

of small savers , by being channelled to savings institutions , lead to an
increased flow of low cost funds to the housing industry and , aside from

dis intermediation , constitute a subsidy tothat industry.

This line of analysis suggests that our monetary authorities need to

reexamine their objectives · should they counter the cycle or give support
to selected industries ?
My recommendations have focused on the problems arising out of
interest rate ceilings and disintermediation .

Bank asset and liability

management , and the large bank special forms of liability management
do not require special legislation .

Cyclical increases in velocity that

accompany asset and liability management are an inevitable outgrowth of
an appropriately restrictive monetary policy .

Banks need to have some

flexibility to adjust their portfolios so as to maintain their profit
positions vis- a-vis firms in other industries .

The special forms of

liability management that have been developed by large banks can be
viewed as an effort to adjust to their high legal reserve requirements .
I believe that declining Reserve System membership among some small
banks is primarily a result of the lower cost forms in which non-member
banks may hold their reserve assets rather than a result of large member
bank access to fund advantages .

Admittedly this is a judgment that is

probably incapable of being empirically verified .
3. Summary of Legislative Recommendations ; Comment on Additional Areas
of Inquiry for the Senate Banking Committee

This paper has focused on non-member bank behavior and bank asset
and liability management techniques and their relationship to the



general economy during periods of economic expansion and monetary
restriction .

I have made four legislative recommendations :

( 1 ) Non-member banks should be made subject to the same reserve
requirements as comparable size member banks .
( 2 ) Reserve System membership should be extended to savings
(3) Interest rate ceilings on member bank , non-member bank ,
and nonbank financial institution deposit liabilities
should be removed .
(4) Small savers should be allowed to compete more effectively
for short term government securities and high yield paper
issued by businesses .

In addition I have made a fifth recommendation :
Bank asset and liability management , and the large bank special
forms of liability management do not require special legislation .

There are numerous problems in the area of monetary policy that
can be analyzed .

However , I have chosen here to comment on those

issues that relate most directly to bank regulation .

There are a

series of additional questions to which the Senate Banking Committee
should address itself .

Among these are :

(1 ) What should be our monetary policy goals ?
(2 ) What should be the criteria for evaluating the performance
of monetary policy?
(3 ) Does the Federal Reserve correctly use its policy instruments
to counter economic fluctuations ?
I have not commented on these questions because they take us beyond the
realm of commercial bank regulation .

They are appropriate questions for

study by the Senate Banking Committee , however , particularly since
the Constitution directly charges the Congress with the responsibility
of making laws concerning money .

John J. Klein
Professor of Economics
Georgia State University


Prepared for The United States Senate Committee on
Banking , Housing and Urban Affairs
Compendium on Issues on Bank Regulation
January 1975

William E. Gibson*
The Brookings Institution

This paper analyzes several important changes which have taken
place in the character of banking practices and in the nature of the
impact of monetary policy in recent years .

The analysis is used to

answer several important questions about the recent effects of banking
on the economy .

Because these changes have been quite fundamental ,

they have far-reaching implications for the conduct of monetary policy
and the operation of the U. S. financial system .
In the past few years important changes have taken place in the
way in which U. S. commercial banking balance sheets are structured and
in the way in which banks operate .

These have brought a corresponding

change in one of the ways in which monetary policy affects the economy .
Briefly , the change has been away from controlling and distributing credit
by non-price means when the Federal Reserve has desired slower credit

*The author is a member of the Economic Studies Program of The
Brookings Institution . The views expressed are those of the author , and
not necessarily those of the officers , trustees , or . other staff members
of The Brookings Institution .

52-221 O - 75-16


growth and toward controlling it through borrower response to less
attractive credit terms .

Borrowers are now induced to reduce or post-

pone borrowing plans by higher cost of funds rather than as a result
of finding no funds available at any cost from traditional lending

sources .

This change has therefore been associated with a shift to a

fairer, more equitable and more productive allocation of credit during
periods of rising interest rates .

Throughout most of the 1960s there were comprehensive controls on
the interest rates which commercial banks could pay to attract new funds
to lend.

Since 1933 banks have been unable to pay interest on their

checking accounts and have been subject to ceilings on the rates they
could pay on their savings and time deposits .

Because these types of

deposits were the nearly exclusive sources of funds for banks to lend
( capital and surplus constituting the remainder ) , controlling the rates
which could be paid on these deposits could limit the amount of funds which
banks could attract and thereby control the quantity of loans the banking
system could grant .

Requlation Q ceilings on bank deposit interest

rates were kept at levels which provided moderate inflows of funds on
average but were retained at these levels when market interest rates rose
well above them in 1966 , 1969 and 1970.

When this happened , new depositors were

dissuaded from putting new funds in banks , and indeed many withdrew
funds to take advantage of higher yields on open market instruments .
Not everyone could do this because of the minimum size of market
instruments , but enough depositors --typically those with larger deposits-did so to constrain severely the funds available for bank lending .



this way the Federal Reserve limited the growth of bank credit in times
of rising interest rates .

Banks tended to be cut out of the credit

granting process during these periods , although open market credit
sources remained available to borrowers , at rising interest costs .
Under this system if one wished to borrow at such times it was
not enough simply to need the money , be a sound credit risk and be
willing to pay market interest rates .

If one wished to borrow from a

bank he also had to meet the bank's rationing criteria , and he had to
happen to do business with a bank which happened to have funds available
to lend .

The rationing criteria usually meant that the borrower had to

have been doing business with his bank for a relatively long time .


borrowers who could meet these criteria were most often large , established
business firms-the very borrowers which had best access to open market
alternative sources of funds , such as the commercial paper market or the
corporate bond market .

Particularly hurt were small businesses , new

businesses and young people , all of whom either had not had time to
develop a banking connection or were too small to carry much clout
with their bankers .
As an example , a new businessman with a project which could enable
him to manufacture and sell a product at a lower price than existing firms
could not obtain funds to finance it because he was not a depositor of
long standing .

At the same time , the existing firms in the industry

which could not produce their products so inexpensively could borrow
simply because they had banked somewhere for a long time .

This was

true in spite of the fact that the new borrower could have even afforded


to pay a somewhat higher rate of interest .

He could not borrow because

banks typically limited what loans they could make to customers of long
association .

The same trouble in borrowing applied to consumers and home

buyers who turned to commercial banks .

In recent years , this phenomenon has changed , both because market
pressures have rendered it less effective and because the Federal Reserve made
some regulatory changes which modified this approach to credit restriction .
Several Federal Reserve actions were involved .

First , on June 24 , 1970 , it

eliminated the ceilings on large ( $100,000 and over ) negotiable certificates
of deposit of 30-89 day maturity in response to the market liquidity squeeze
generated by the difficulties of the Penn-Central railroad .

The on May 16 ,

1973, it removed the ceilings on the remaining classes of large certificates , although federal statute still prohibits interest on any bank deposit of maturities less than 30 days in the United States .

July 5, 1973,

it created a new class of smaller certificates ( $1,000 and over ) of four to
10 years ' maturity on which there were no rate ceilings , although a ceiling
of 7 percent was imposed on these in November of that year.
As a result , in recent times when market interest rates have risen
commercial bank deposit rates have tended to rise with them, so that banks
have been able to continue to attract and lend funds .

For instance , in

the three months ending October 31 , 1973, the 4 to 6 month commercial
paper rate rose to an average of 9.79 percent , and the rate on commercial


bank negotiable certificates of deposit rose above 9 percent .

In the

The rate was 9 percent cr higher on over 70 percent of the volume
of large negotiable certificates , and 9

percent or more on nearly half

the volume during those three months .

same three months of 1966 , on the other hand , the commercial paper rate
averaged 5.91 percent , but banks were only able to pay 5

percent on

their largest and longest deposits , and could pay only 4 or 5 percent on
most of their deposits .
been clear :

The effect on the stability of bank deposits has

in the 1966 period bank time and savings deposits rose by

only 0.2 percent , while in the 1973 experience ( a similar period of sharply
rising interest rates ) , they grew by 2.3 percent .
These changes have meant that when market interest rates rise banks
can continue to obtain funds to lend , but they must of course pay rates
to attract them from the market to borrowers .

The primary limitation of

the volume of loans which banks grant is now the willingness of borrowers
to pay higher rates , rather than the ability of banks to obtain loanable
funds .

This is an equally real form of limiting loans , because any

borrower will want to borrow less at higher interest rates .

No borrower

has an insatiable appetite for funds at very high rates .
It is also a fairer and more productive way of allocating

credit in the economy .

The new businessman with the more productive

process in the example above can now obtain funds to produce and sell
his product at a lower price even if overall credit restriction is
desired .

This is a fact which is easily lost sight of because bank


borrowers pay somewhat higher interest rates under the new approach than
under the old .

The thing that is always extremely hard to remember but

which cannot be ignored is that in the old days although quoted rates were
somewhat lower than they would be under similar market conditions now, these
low rates were enjoyed by only the select few who were able to obtain loans
from banks .

The question is whether people are better off borrowing

nothing at one rate or borrowing what they need from banks at a slightly
higher rate .

Previously many, many borrowers were limited to far less credit

than they required or were left unable to obain funds from traditional
lenders at all .

No doubt many of these borrowers--and, we should remember

that these were primarily new businesses, small businesses , young people
and consumers of limited incomes --were forced to borrow from sources outside traditional institutions and perhaps outside the law.

The usurious

rates charged on such loans are far above any charged by banks in 1973 or
Although this shift in the way in which credit is restrained might
seem to have been produced by the Federal Reserve's regulatory changes , it was
actually inevitable and was progressing independently of the Federal
Reserve's actions to lift some ceilings and make uniform the reserve requirements on market- related sources of bank funds ( certificates of deposit ,


Eurodollar borrowing from branches and finance bills ) .

in two ways .

This trend was devel-

First , banks were discovering and inventing new

ways to obtain more funds by paying higher interest rates .

The most

spectacular development in this direction was the increased use of
Eurodollar borrowing from overseas branches in the late 1960s .


allowed an individual bank to obtain more funds to lend by paying a
higher rate , just as lifting deposit rate ceilings has now .


action increases bank reserves in the United States , however , so that
the Federal Reserve did not lose control of money and credit .


For a demonstration of this point , see William E. Gibson ,
"Eurodollars and U. S. Monetary Policy , " Journal of Money , Credit and
Banking , Volume III , No. 3 (August 1971 ) , pp . 649-65 .

do , however , reintroduce interest rate competition for funds into the
banking system and tend to see that funds are allocated to borrowers on
the basis of cost rather than friendship or length of service .
Second , it was becoming increasingly clear that limiting bank
credit did only that and had increasingly less impact on growth of
total credit .

In response to the ceilings on bank deposits , more and

more funds simply flowed around banks rather than through them .


flowed directly from savers to market instruments such as Treasury bills ,
federal agency securities , commercial paper , corporate bonds and the
like .

As on the borrowing side , it was the small and less sophisticated

savers who were hurt by the ceilings ( as they still are ) because they


lacked the size of deposit or expertise to benefit from higher-yielding
opportunities in other instruments .

Because total credit was still

growing , a given policy was having progressively less impact on the
economy .
The tendency for funds to flow around banks rather than through
them which can be called "nonintermediation" -was an alarming develop-

ment .

In anything but the shortest of time horizons , this is the

greatest threat to the health and stability of the banking system .


U. S. cannot obtain the considerable benefits of ours , the world's bestdeveloped banking system if people simply refuse to use it .
The Federal Reserve acted to curb this deterioration of the role of the
banking system and thus reinforced the trend already under way .


allowed banks to use interest rate competition to attract large deposits
which had identifiable open market alternatives .

It stopped short of

a complete freeing of rates which small savers could receive on the
justification of a competing equity .

Large savers can now obtain the

benefits of high open market rates through banks because they could .
obtain them anyway in the open-market .

Smaller savers who have no

alternatives are still subject to deposit rate ceilings .
In the eyes of many , stopping the liberalization of interest
ceilings at this point was a good idea because it protected the weakest
of thrift institutions and banks who could not withstand more interest
rate competition without being merged into

more efficiently operated

institutions . It also benefited those stock savings and loan associations
which had built up attractive records of earnings growth and would have


had a much harder time regaining their status as market favorites with
stockbrokers if their interest costs rose .

It also , of course


the wealth and bonuses of the owners and managers of these institutions .

A number of important questions exist regarding the current and
future relationship between banking and the economy in the United States .

Are large banks able to avoid the restrictive effects of monetary

policy through liability management?
The term " liability management" has several meanings , but the
broadest describes the practice of expanding loans and investments far beyong levels of demand and household time deposits by bidding for non-deposit
sources of funds and marketing additional negotiable certificates of deposit .
As the above discussion makes clear , the answer to the question depends on what
is meant by the restrictive effects of monetary policy .

If it means

can banks use liability management to lend when interest rates are rising ,
the answer is yes .

This does not , however , mean that bank loans will

continue to expand without limit when rates rise .

Banks must raise lending

rates because their lendable funds cost them more , and higher interest
costs are effective deterrents to borrowing .

No borrower will wish as

much money at 8 percent as he did at 5 percent , so that bank credit is
rationed through interest rates just as surely as it was through the
old " drying up" method .

In addition , credit flows more surely to its

most productive uses rather than the old-time borrowers or firms with
special influence at banks .

Commercial banks should not be places where borrowers cannot obtain
funds at any prices at times of high interest rates because their banks have
no funds to lend .

The restrictions which produce this state of affairs induce


savers to circumvent the banking system which was established to help them
and thereby force many disadvantaged borrowers to turn to sources which
public policy would rather that they not patronize .

During periods

in which the Federal Reserve restricts reserve and money growth and
raises its interest rate targets , banks should lend less briskly than
otherwise .

They should make it more costly and difficult to borrow when

market rates rise in order to discourage borrowing .

As the system is

now constituted , this is what happens .

Does the practice of making loan commitments to corporate

customers delay the impact of monetary restraint?
Commitments can only delay the impact of monetary policy by
affecting the cost or availability of funds .

In earlier years they

affected the distribution of funds among borrowers , but since they did
not change the total volume of funds available to banks for lending ,
they primarily made life more difficult for banks .

Banks had to cut

back noncommitted lending even further than otherwise in order to meet
commitments .

Of course , if the Federal Reserve stepped in to supply

reserves to make it easier for banks to handle their commitments , this
would delay the impact of monetary restraint .

But the Federal Reserve is

not obliged to do so and in general , such actions would dull bank incentives
to be careful with the volumes of their commitments .

Presently the only delaying effect comes if the interest rate on
borrowing is fixed in the commitment , for then the borrower would borrow
too much .

Under the new approach to bank lending when market rates rise

funds are available - at higher cost-to borrowers with or without commitments .

My impression is that most commitments do not fix the interest

rate on the loan but rather stipulate that the lending be done at the


rate in effect on new ( uncommitted ) loans at the bank during the loan
period .

A commitment probably makes the borrower feel marginally more

comfortable --indeed , this is why he is willing to pay a fee to obtain one .
( Parenthetically, the shift to price allocation of funds should mean a
slowing in the growth of the importance of commitments . )

In my judgment ,

however, the delaying effect on a monetary policy shift is small .
If credit allocation returned to the old system of nonprice
rationing , commitments could be an important problem for monetary policy ,
however .

They could imperil the safety of the banking system if banks

were committed to make loans and could not meet the commitments at any
price because of being unable to obtain lendable funds at any price .
This is another reason why the old appraoch is no longer workable .

To what extent has the development of bank holding companies

insulated banks from tight money?
Bank holding companies have probably marginally helped banks on
the availability constraint , for holding company borrowing is an additional
source of funds to a bank seeking to expand its loans .

There are , however ,

on the abilities of holding companies to send funds " downstream"

to banks and the reverse .

Typically this means that a holding company

supplying funds to its bank must make the contribution in the form of an
equity infusion , something it would probably be reluctant to do during a
" tight money" period .

In any case , however , as described above , the

availability constraint is no longer generally binding on banks .


themselves can raise funds at some price and therefore no longer need
holding companies for this purpose .
If anything , the holding company development might work in the other
direction, because many nonbank affiliates need considerable amounts of


financing during periods described as " tight money . "

Mortgage companies

and real estate investment trusts typically need funds far worse than
banks during such periods , so that in many cases the holding company's
existence probably increases rather than reduces the pressure on a bank's
lending resources .


Does the absence of reserve requirements on nonmember banks

or the lower level of reserve requirements on time deposits impede the
efficient conduct of monetary policy?
The requirements on nonmembers and time deposits are not
important impediments to the effective use of monetary policy .
context , what is required is predictability in these deposits and in
shifts among them , just as the Federal Reserve must predict shifts between Treasury deposits and demand deposits and among demand deposits
among banks of different sizes and locations .

If the Federal Reserve

can forecast with reasonable accuracy what shifts are going to take place ,
it can take the appropriate measures to offset them so that desired monetary policy thrust will be unaffected .
The best evidence available suggests that these shifts are quite
predictable .

In fact , it suggests that the Federal Reserve could pre-

dict these shifts more accurately than it apparently has .

To what extent do current banking practices contribute to

Commercial banks by themselves have rather little to do with the
overall rate of inflation .

Indeed , the banking industry has been

characterized by one of the best recent histories of productivity
growth in our economy .

If banks today provided the services they now

do with the technology of , say , 1950 , we would be paying costs far
above those currently charged for these benefits .


The inflation problem is connected with banking if one includes
central banking , as the Federal Reserve controls money and credit in
the economy , and thereby impacts spending .

But while this topic is

enormously important and the appropriate subject of considerable analysis ,
space does not permit an adequate treatment of it here .


Does the growth of deposits from the oil exporting nations

constitute a threat to the stability of our domestic banking system?
Any large increase in the deposits of banks reduces the ratio of
capital to deposits unless corresponding increments to bank capital
are made .

The present inflow of deposits from oil -exporting nations

comes at a time when the capital ratio is already on the low side of
normal for many banks , and at the same time equity markets do not permit
new capital to be raised on terms which are at all favorable by comparison
with recent history.

These deposit inflows are therefore intensifying

the need for additions to the capital base of the U. S. banking system.
In addition , there are two particular types of risk associated
with U. S. bank's participation in the recycling of oil payments , withdrawal risk and default risk .

Although oil dollars cannot be withdrawn

from the world's financial system as a whole , they can be removed from an
individual bank or group of banks suddenly, necessitating possible uncomfortable adjustments for banks losing deposits .

The oil receipts are

often viewed as being more volatile than average deposits , primarily for
political motivations , although I am not aware of any evidence that they
have been to date .


Banks can and likely will protect themselves against this problem
by offering a deposit interest rate structure which contains a substantial rate disadvantage for very short-term funds .

In this case they will

either induce recipients of oil payments to make long-term and more stable
deposits or will have to pay a small enough rate of interest to make
taking the withdrawal risk profitable .
One might fear that particularly zealous banks will overextend
themselves and acquire too many oil funds , thus making themselves too
vulnerable to sudden withdrawals .

Precisely, this same line of reasoning

led to the imposition of Regulation Q ceilings in 1933 to prevent imprudent competition .

However , no evidence has ever been presented which

suggested that in the absence of controls banks would engage in competition which was in any meaningful sense unhealthy on a significant
scale , either before 1933 or after . Even if they did , however , the Federal Reserve remains available
to lend to any institution whose viability is seriously threatened by the
withdrawal of oil funds .

Indeed , this was a key reason for the establish-

ment of the Federal Reserve System , and it has performed this function
admirably recently .

It is difficult to imagine that withdrawals could

proceed fast enough to tax the Federal Reserve's resources seriously .
The recycling also means , however , that bank assets could become
concentrated in loans to the governments of a few oil-importing nations .
Based on current payments trends , these loans could far exceed the capital
of many banks .

In many cases U. S. banks will be hesitant to lend to

foreign governments , as the credit risks appear questionable.
But European countries must be able to obtain dollars in great


quantities if they are to be able to afford higher-priced oil .

And they

have some leverage on many U. S. banks , as large American banks typically
have substantial operations abroad, which account for a disproportionately
large share of their profits .

Permission to continue these foreign opera-

tions could be used as a hostage to induce U. S. banks to lend .

Thus one

would expect considerable pressure on the banks to lend and therefore to
concentrate default risks among a very few borrowers .

Some major defaults

by European governments could threaten the U. S. banking system in this
case beyond the Federal Deposit Insurance Corporation's ability to
protect depositors .
Since the bulk of the oil revenues now seems to be coming into
U. S. financial markets , I think that we would be wise to consider having
the U. S. government , a multi-government group or an international
organization help with recycling and share some of these risks .

I believe

that the U. S. would be well advised to join with other nations or cooperate
with an international body to spread the default risks of the loans and
depoliticize both the borrowing and repayment burdens .

In this way we would

help protect the stability of our banking system in the face of these. oil payments
flows , as well as improving the efficiency of the overall flows of these funds .

How can banits , and especially money center banks , be made more

responsive to anti-inflationary policy?
Some care should be exercised in defining what "more responsive"

is .

Banks should not simply close down their lending operations when

the Chairman of the Board of Governors of the Federal Reserve System
announces that the inflation rate is too high .

When market interest



rates in general and rates on bank liabilities in particular are rising
banks should be more reluctant to lend at any interest rate level but should
not cut off borrowing completely .

In earlier years the latter happened,

but the financial system has been beneficially moving away from this technique .
One way to improve upon the present situation is to make inflation
less profitable to banks .

There is no necessary reason why banks should

be made better off by inflation , and they only do if the yields on their
assets rise faster than those on their liabilities .


Present banking

structure assures that this will be the case , however , when rapid actual
inflation adds inflationary premia to interest rates .

Statutes and

regulations now prohibit interest on demand deposits and control
interest rates on household time deposits , so that a major portion of
bank costs is under a very effective system of cost control .
inflation increases and market interest rates rise , bank profits tend
to rise automatically , since the yields rise on most of their assets
but remain low on most of their liabilities .

If bank costs rose by as

much as their revenues during an inflation they would be far less in
favor of continuing inflation .

The way to bring this about is to

remove the constraints on the rates which banks pay on their liabilities
by removing the prohibition on interest payments on checking accounts
and lifting the ceilings which small savers receive on their saving .
If this were done competition would lift banks ' costs with their revenues
and they would cease to benefit from rapid rates of inflation .

( The

benefits to consumers from receiving more interest on their funds which
banks use would also be a substantial benefit , of course ..)


Chapter III.- Composition of Bank Assets and Liabilities



"Their Effect on the Liquidity and Solvency
of American Banks "

Paul M. Homan

Prepared for
The United States Senate
Committee on Banking , Housing and Urban Affairs

January , 1975

52-221 O - 75-17



What has been the basis for the recent expressions of concern over
the soundness of the American banking system? Regulators and industry
leaders alike have been asking some hard questions of themselves in 1974 ,
especially after the failure of Franklin National Bank in October 1974
and the U.S. National Bank , San Diego a year earlier . Were these multibillion dollar institutions oddities in the industry or were the problems
incurred by these banks symptomatic of fundamental weaknesses developing in
the banking system itself?
The jury is still out on these questions , but all current banking
studies inevitably focus on the trends affecting the liquidity and capital
adequacy of banks and the banking system. Liquidity and capital considerations are essential to the operation of any bank . Moreover , they cannot
be separated , for one always affects the other . An old maxim of banking ,
however , gives liquidity the priority : liquidity can be used as a substitute
for inadequate capital , but capital cannot substitute for inadequate
liquidity . Later bank capital adequacy and bank failures will be discussed .

At the conclusion of World War II , banks were flush with liquid
assets , held principally in the form of cash balances and highly
marketable U.S. government securities . At the same time , the banks
enjoyed a large and relatively stable low cost deposit base . From this
financial posture , commercial banks were ideally situated to accommodate
the heavy loan demand which resulted from the rapid economic expansion
of the late forties and fifties . But despite a large absolute growth
in loans , the commercial banking system's share of the total credit market
actually declined during this period , reaching a low of 26.5% in 1960.1/
A lagging deposit growth seriously hampered the expansion of lending
capacity during the 1950's . Especially hard hit were the large money
center banks . For example , during the fifties total deposits at New York
reserve city banks rose 31% , compared with 53% at other banks and over
300% at savings and loan associations.2/ Inflows of deposits were affected
by heavy rate competition from non-bank financial intermediaries ,
chiefly thrift institutions which enjoyed preferential deposit rate


Alex . Brown & Sons , The Banking Industry , Lessons of 1974 , December 1974 .

2/ Arnold A. Dill & Monroe Kimbrel , " Other Sources of Funds , " The Changing
World of Banking , Prochnow and Prochnow , Editors , Harper & Row , 1974 .



differentials . Moreover , idle demand deposits held by sophisticated
individuals and corporations were increasingly channeled into consumer
goods , business operations and more lucrative money market instruments .
Faced with a prospect for a highly profitable loan business in a
period of rising interest rates , while at the same time suffering from
sluggish deposit growth, the banks chose to rapidly expand loans at the
expense of liquidity . This was accomplished by liquidating securities
during the late forties and early fifties . Later , most available
liquid funds derived from new deposit growth , retained earnings and equity
capital issues were utilized for loan expansion . As a result , the loan to
deposit ratio for the commercial banking system rose steadily during the
immediate post-war period , reaching a high of 51% in 1960 ( Table Two ) .
As the banks entered the 1960's , some way had to be found to expand
their lending capacity to meet the still rising and lucrative loan demand .
Further asset shifts by trading off liquid assets for loans were now
impossible in significant proportions without exceeding the bounds of
prudence . The lack of significant deposit growth was still the overriding
factor restricting lending capacity . The dilemma was solved in the decade
ahead by increasing use of liability management techniques and a relaxed
regulatory environment .
1960-1974 - The Shift to Liability Management
Until 1960 bank liquidity theories had concentrated on the composition
of bank assets and the various degrees of liquidity in the asset accounts .
Theoretically , a bank should be able to meet its demand and maturing
obligations with cash whenever necessary . But short of a crisis of
confidence and a resulting run on the bank , this ultimate test seldom
For the normal bank , therefore , different levels of liquid and
non- liquid assets --ranging from cash to fixed investment in banking
premisis--are possible . The degree of liquidity that needs to be maintained
on the asset side is largely a function of the composition and maturity
structure of the deposit base , the growth rate of the deposit base , and
the bank's ability to borrow. Asset growth is affected by the same
factors and the ability to attract equity funds .
Prior to the sixties excess liquidity tended to be maintained in
the banking system because of a lack of flexibility on the liability
side of the balance sheet . During times of liquidity stress , banks had
access to the traditional federal reserve discount window , but such
access was expected to be of short duration . Other borrowing was seriously
limited by legal borrowing limits , by discouragement from regulatory authorities , by conservative bank managements , and by a lack of access to
national money markets . Banks had no negotiable liability instruments to
compete with money market issues of others . Moreover , asset growth was



limited to the bank's ability to attract deposits or capital funds from
Sources which were predominantly local or regional in nature . Only a
few giant banks had access to a narrow national market for funds , and
few mechanisms existed for the transfer of excess liquidity in regions
with low credit demand to those with heavy credit demand . In these
circumstances only limited growth was possible for the system, and
commercial banks played a declining role in the economy relative to
other financial institutions .
To solve the problem, a whole new philosophy of liquidity- liability
management began to emerge in the early sixties . This process is aptly
described below by two writers in the field , Leland Prussia and L. G. Gable :
This theory acknowledges the importance of proper asset management
to provide liquidity but also recognizes the growing importance of
the diverse ways in which banks raise funds through the accumulation
of a widening array of liabilities . In large measure this new
theoretical evolution has occurred under conditions of continuously
expanding credit demand where cyclical liquidity relief has been
harder to achieve . In consequence , this theory places less reliance
on the generation of liquidity through asset composition and cash
flow with shifting emphasis to acquisition of deposits and the
purchase of a wide array of borrowed money from federal funds to
long-term debt capital.3/
In a simple sense the philosophy of " Liability Management "
means to create , i.e. , accept , locate , and purchase additional
liabilities to meet loan requests , commitments and depositorcreditor demands ...
In adopting and following a Liability Management philosophy ,
the banker must make two assumptions : First , he must assume that
additional liabilities can always be created to meet the demands of
borrowers and creditors . And second , with the remote possibility
that additional liabilities cannot be created in sufficient volume
to satisfy the demands of borrowers and creditors , there will
always be a sympathetic Federal Reserve Bank as a lender of last

3/ Leland S. Prussia , Jr. , " Bank Investment Portfolio Management , "
The Changing World of Banking , op . sit .

L. G. Gable , " Liability Management --An Indictment , "
of Commercial Bank Lending, August 1974 .

The Journal



With this philosophy , bankers greatly increased their flexibility
to grow , to meet customer demands for credit , and to operate with less
liquidity even in periods of tight money .
Two important developments in the early 1960's enabled banks to
place into practice the concepts of liability management . First , the
federal funds market grew and prospered . This market enables purchasing
banks to borrow excess reserves from selling banks , thus transfering
idle lending capacity in the system to geographical areas of greatest
credit demand and greatly increasing the mobility of money . Moreover ,
the market has not been seriously restricted by regulatory action .
The Federal Reserve System has tolerated the growth of the federal funds
market by not significantly changing the reserve requirements of banks .
The Comptroller of the Currency early-on exempted federal funds from
the borrowing limitations of 12 U.S.C. 82 .
Second , the negotiable certificate of deposit in denominations of
over $100,000 was introduced in 1961 and a large secondary market in
CDs quickly materialized . The negotiable large CD provides liquidity
to the holder which enables it to compete with other money market
instruments such as treasury bills and commercial paper . The large
CD was subject to the interest rate requirements of Regulation Q and
proved highly volatile during the tight money periods of 1966 and
1969/70 . Each time money market rates for competitive instruments
moved above the Q limits , banks experienced either an absolute outflow
or a decline in new CDs placed with the banks . This meant that a vital
source of funds was unstable during periods of greatest need . Although
the Federal Reserve belatedly increased the rates that could be paid on
large CDs during periods of tight money , it was actually after the violent
fluctuations in the inflow and outflow of funds had taken place . Finally ,
large CDs were exempted from Regulation Q restrictions in 1973 , but
before this happened , banks had already progressed in developing other
non-deposit sources of funds .
In order to replace funds lost in the CD markets during 1966 and
1969/70 , banks began to tap the Eurodollar market . Eurodollars are dollardenominated deposits with foreign banks or branches of U.S. banks overseas .
Large domestic banks with overseas branches already in existence could
easily borrow in this market and use the proceeds to relend to the parent
for domestic credit expansion and liquidity requirements . Regional banks
also stepped up their international operations by establishing branches
abroad , usually for the sole purpose of gaining access to the Eurodollar
market .
In the late sixties Eurodollars were exempt from Regulation Q and
also from reserve requirements . This greatly enhanced their attractiveness
as a source of funds . Later , reserve requirements were imposed but this
move has not materially diminished their importance to commercial banks .




During the late sixties , banks were also taking advantage of the one
bank holding company structure . The growth of bank holding companies
since then has been phenomenal . For example , registered bank holding
companies held 14.3% of total banking deposits in 1969. By year-end 1973
their share had grown to 65.4% of total deposits . This structure offered
the banks the unique opportunity of expanding across geographical barriers
prohibited to banks and to diversify their product mix , subject only to
the provisions of the Bank Holding Company Act of 1956 , as amended in 1970 .
The structure has the additional advantage of permitting access to sources
of funds which had previously been denied to banks or seriously curtailed
by regulatory authorities . The initial rush to the holding company
structure during 1969 and 1970 was , in part , the result of tight money
conditions and the concomitant liquidity squeeze of that period . Holding
companies found that they could borrow subject only to the dictates of
the money markets but without legal restrictions encountered by banks .
Funds derived from lines of credit with other financial institutions ,
from commercial paper borrowing , and from debt capital issues could
be downstreamed to captive banks for liquidity needs and credit expansion .
Beginning in 1969 commercial banks also began to use guarantee
facilities and back-up commitments extensively . Guarantees typically
take the form of standby letters of credit or working capital acceptances .
Both enable customers to obtain credit from third parties with the bank
guaranteeing payment in the event of a default by its customer . Back-up
commitments take the form of lines of credit established for customers
borrowing from more volatile and unstable sources of credit than banks .
Guarantee facilities and commitments are used extensively to back up
commercial paper issues of customer corporations , to back up working
capital and project loans by others to the bank's customer , and to
provide surety in lieu of bonds issued by others in connection with
real estate development and construction . Lucrative fee income is the
consideration for the bank . In addition , these transactions do not
require an outlay of the bank's funds , except in cases of default or
the customer's inability to attract funds from other lenders .
Other non-deposit sources of funds such as securities sold under
repurchase agreement , time federal funds , and loans sold under repurchase
agreement provide additional tools to the liability manager . The growing
use of debt capital is also evident ; although regulatory agencies
generally limit the use of debt capital to approximately 30% of total
capital funds .
Liability management techniques developed since 1960 also include
an array of new deposit instruments such as time deposit open accounts
and savings bond type CDs .
The growth of deposits since 1960 was also aided by a benign regulatory
environment . In the early sixties the Federal Reserve moved to rapidly
expand the money supply and bank reserves . Regulation Q ceilings were



raised and rate differentials paid by banks and thrift institutions on
deposits were narrowed . Banks became more competitive and increased
share of the consumer savings market from 37% in 1961 to 16% in 197d their
A Decline in the Liquidity and Marketability of Security Holdings
Historically , holdings of securities provided excellent secondary
liquidity for banks . Portfolios consisted principally of no- risk U.S.
government short term obligations which could be sold in a large market
at prices near their book values . Since the war two significant changes
occurred : first , security holdings significantly declined as a percentage
of assets ; second , in the pursuit of profits , banks diversified the
portfolio by moving away from U.S. obligations into longer term , higher
risk , and less marketable tax exempt issues . For example , banks held
just over 50% of their assets in securities in 1947 with U.S. government
obligations comprising nearly 90% of total securities . The comparable
figures for October 1974 were 21% and 27% , respectively . Both trends
obviously reduced liquidity in the system but were natural responses in
meeting loan demand and the borrowing requirements of state and local
political subdivisions . No one has suggested an optimum level or mix of
securities for the banking system . But for the individual bank a low level
of securities obviously hinders its chances of successfully meeting a
liquidity crisis . Moreover , if a bank's portfolio contains a disproportionate
amount of long term, high risk, tax exempt issues which were purchased
during periods of easy money at high cost , significant bond depreciation
could result during tight money periods . In this circumstance bond sales
for liquidity purposes can be accomplished only by incurring a substantial
loss .
Loans--The Real Problem
The tremendous growth of loans since 1960 has exceeded all other major
commercial bank balance sheet items with the exception of purchased monies .
For example , loans increased 453% during the 1960-74 period , compared to
304% for deposits ( including large CDs ) ; 340% for total assets ; 229% for
securities ; and 295% for capital funds . The decline in liquidity is
manifest in the high loans to deposits + borrowing ratio of 69.6% ( 71.7%
for large banks ) registered in October 1974. This compares with 62.6%
only four years ago and 51.1% in 1960 (Table Two ) .


Alex . Brown & Sons , op. sit .



But good quality loan portfolios have varying degrees of built-in
and fairly predictable liquidity . Consumer type loans such as real estate
mortgages and many types of installment loans produce substantial amounts
of monthly cash through amortization programs . Business term loans and
short term seasonal loans also contribute to liquidity in the same manner .
In addition , loans and participations in loans can be packaged and sold
to others ; although this practice is sometimes difficult under tight
money conditions and rising interest rates when potential buyers may
also be illiquid or when the market requires substantial discounts on
fixed rate loans .
Despite the fact that loans can produce substantial cash flow, the
evidence is still overwhelming that bank loan portfolios are less liquid
than they once were . The trend has been toward long term loans accompanied
by a decline in asset quality .
Real Estate Loans
Speculative real estate lending and investing which led to the demise
of many banks in the 1930's resulted in a host of real estate laws which
severly restricted bank real estate lending until the 1960's . Since then
most of the laws have been amended , or favorable rulings and regulations
have permitted banks to make real estate loans without undue restriction .
The Financial Institutions Act of 1973 would eliminate real estate lending
restrictions altogether .
Banks used their new found freedom in the real estate field to rapidly
expand loans . Good results were apparent until 1974 when recession ,
inflation , and a prolonged period of high interest rates combined to place
the real estate industry in its worst depression since the thirties .
holding large fixed-rate real estate portfolios , speculative construction
loans to marginal borrowers , development loans in economic depressed
areas , and mortgages in high unemployment areas experienced actual losses ,
an inability to package and sell loans without substantial loss , heavy
delinquencies , foreclosures on non-income producing and unmarketable property ,
or combinations of each . In addition , many banks had issued back-up
lines of credit or letters of credit which supported the commercial paper
borrowings of Real Estate Investment Trusts ( REITs ) , many of which had been
organized , marketed to the public , and advised by the banks , themselves .
When several of the REIT's reported substantial losses , the commercial
paper market for their issues quickly dried up ; and banks were forced to
fund the back-up lines of credit . The result has been large fixed loans of
uncertain repayment prospects . Substantial losses have already been
taken in REIT loans and others appear imminent .
Consumer and commercial real estate loans in recent years have been
granted with increasingly longer terms , at fixed rates , and with less
downpayment required . While this has been beneficial to the community ,
it has resulted in less liquidity for the banks and a reduction in quality .


-8Consumer Loans
During the 1960's banks received heavy competition in the consumer
credit area , especially from such large corporate giants as Sears and
the automobile manufacturers . This competition continues unabated today .
For example , consumer credit balances outstanding of $4.3 billion at
Sears , Roebuck & Co. at the end of 1972 exceeded Mastercharge accounts
(5662 banks ) with $2.8 billion and National Bankamericard accounts
(4,525 banks ) with $2.3 billion . Moreover , at year-end 1972 , the
three largest banks in the country held $ 4.3 billion in consumer
installment credit , compared to $6.9 billion for the three largest
retailers and $12.5 billion for the three largest manufacturers .
In the face of this competition , banks have relaxed traditional
consumer lending policies and practices . Most consumers can now qualify
for a bank credit card , auto loan , personal loan , or overdraft facility
with little more than a job and a request for credit . While this has
resulted in heavy losses for some banks , the general experience has been
good . Bankers are quick to point out that the losses are usually
generously covered by the extremely high-- sometimes usurous--rates
charged . Once again liquidity and quality has suffered but within tolerable
limits .
Commercial Loans
Since 1960 and especially since 1969 , the heaviest demand for bank
funds has come from the corporate non- financial sector , the banks '
traditional customer . Rapid economic expansion from 1961 through 1968
certainly increased loan demand but other factors also came into play
after 1968. An Alex . Brown & Sons study describes these factors as follows :
The rapid increase in the corporate share of the total credit
market , particularly since 1960 , is traceable to increased cash.
requirements resulting from the acceleration in the rate of
inflation and the slow growth of internally generated funds . In an
inflationary environment , the cost of inventories and capital
equipment , which when combined account for about 75% of corporate
uses of funds , rises rapidly . The reasons behind the failure of
internal cash flow ( retained earnings and depreciation allowance
less inventory profits ) to keep pace with cash requirements are not
well understood ; however , they are related to the post-war decline
in corporate profits as a percentage of sales and of GNP , as well as

6/ Cleveland A. Christophe , Competition in Financial Services ,
for First National City Corporation , New York , 1974 .




taxes payable on inventory profits which in an inflationary environment
are substantial . As a result , internally generated funds as a
percentage of corporate financial uses of funds has declined since
the early 1960's.1/
The comparison of internally generated funds to corporate uses of
funds is remarkable . For example , the study by Alex . Brown & Sons shows a
high ratio of 76% for the period 1955-60 , compared with a post-war low ratio
of 53% for the period 1970-74 . The trends mentioned above are extremely
important to the banking sector since the factors creating the corporate
demand for funds also relate to the asset quality of the loans produced
from such demand . That is , loans to corporations exhibiting declining
profitability and cash flow along with increased leverage , rising debt
and high cost debt servicing often are unable to make the financial recovery
necessary to pay the loan or arrange for a refinancing through access to
the long term debt and equity markets . In these circumstances , while the
loan may not advance to a loss , it nevertheless becomes fixed , lacks
marketability and liquidity , and actually becomes a long term debt investment
by the bank .
Corporate borrowers of this type may be " too large to fail , " requiring
banks to prop up the borrower with new money after bad rather than take a
prohibitive loss by putting the company out of business . One need only
to point to the recent experience with Penn Central , Lockheed and Memorex
for examples . While these infamous corporations are worst cases , the decline
in the economy , together with high interest rates , tight money and inflation ,
has produced others . REITS and certain firms in the real estate , airline
and aerospace industries have long been problem borrowers .
Just how many of these slow , poor quality loans exist in bank portfolios
is not known since regulatory authorities do not publish classified loans
( i.e. , loans rated substandard , doubtful or loss ) listed in examiniation
reports . But they certainly are a part of the growing volume of classified
assets which , when significant enough , places banks on the "watch" or " problem
bank" lists of bank regulatory agencies . For example , the Comptroller has
recently identified over 150 problem banks . The FDIC reports over 200 problem
banks .
The collapse of the equity and debt capital markets since 1969
has tended to increase the banking system's intermediary role , especially
in corporate lending . This has been especially true in 1973/74 when savers ,
concerned with the economic decline , the decline in corporate profitability
and liquidity , and the falling stock market , turned to banks , especially
large banks , which not only offered high rates of interest and a greater
return , but also provided a safer haven for invested funds .


Alex. Brown & Sons , op . sit .




Corporations , not wishing to substantially dilute shareholders '
interests because of the low prices being paid for their stock , avoided
equity issues as a means of raising funds . Moreover , the heavy premiums
being paid on long term debt issues further discouraged corporations from
using this vehicle as a viable alternative . Many corporate treasurers
adopted a " wait and see " attitutde , hoping economic conditions would improve
and interest rates would come down . In the meantime , they greatly increased
bank borrowing to satisfy the cash requirements of their companies , paying
record interest rates in the process . Few guessed that interest rates
would remain high for a prolonged period of time or that the economy
would continue its slide into a recession .
For the banks this meant a marked increase in longer term loans with
less quality , both of which tended to reduce liquidity in loan portfolios .
While bankers have traditionally resisted a borrower's attempt to borrow
short for long term needs , they nevertheless sought to help the corporate
sector bridge the gap until equity and debt markets improved .
Bullet loans ( term loans with flat maturities of 5 years or more )
were developed to give the corporations a little breathing room . So
called revolvers with grace periods of three to four years before a
term amortization program is triggered is the more common form used
by banks to satisfy the same purpose . Bank examiners call the latter
an " evergreen credit " since the borrower usually comes into the bank
just prior to the maturity of the grace period and arranges for another
revolver with an additional grace period . Thus , the loan tends to
revolve forever , or at least until the company goes into bankruptcy .
The upshot of these developments is that many corporations have
greatly increased their high cost short term debt since 1969 in a period
of declining profits and cash flow . The heavy debt servicing burden
has placed many in a precarious financial condition with uncertain debt
repayment capacity . The effect on the banks is just beginning to be recorded .
Many major banks substantially increased their loan loss provisions during
1974 in anticipation of a rise in actual losses . Many analysts believe
the ratio of losses to year-end loans may rise next year to the .40% to .60%
range , which would be an historically large percentage .
Aside from the above , the move to extended credit terms to corporations
also relates to commercial banking's changing role in the short term credit
In the late sixties bank lending capacity was substantially
curtailed during periods of tight money . Corporations , in their never
ending search for funds , soon found a channel for direct access to the
money markets through the use of commercial paper issues .


" Heard on the Street , "

Wall Street Journal , December 23 , 1974 .



The growth of the commercial paper market in recent years has
seriously affected bank short-term lending , forcing the banks into the
medium term credit market ( over one year but less than fifteen years ) .
Business term loans for plant and equipment expansion have increased
enormously as a result . Banks have also engaged extensively in direct
and indirect leasing on a term basis . Other examples abound , but all
have tended to lengthen the maturities of bank loan portfolios and in
the process , reduce their liquidity .
The extensive use and misuse of back-up commitments and guarantee
facilities ( mentioned above ) also affect liquidity in the banking system ,
especially in tight money periods . Commercial paper issuers or other
direct borrowers in the money markets frequently have prearranged lines
of credit or standby letters of credit to back up these obligations . In
times of a market collapse , such as the commercial paper collapse in 1970 ,
banks are forced to fund these commitments , even though they may be undergoing a liquidity crisis themselves . In addition , the evidence suggests
that some banks do not apply the same credit criteria to contingent
obligations that they do to direct credits . The experience at the United
States National Bank of San Diego and the banks ' recent experience with
REITs are evidence enough of this deficiency .
International Assets
The international activities of the commercial banking sector
have become major concerns for the industry in 1974 , especially in
light of the violent impact the energy crisis has had on international
financial markets .
Chief among these concerns has been the widely fluctuating foreign
exchange markets which have caused substantial losses for international
banks speculating in the market . Heavy foreign exchange losses have
precipitated the failure of many banks , including the Franklin National ,
and seriously impacted the earnings of others . This , in turn , has undermined the public's confidence in the banking system in many countries .
Banks dealing in the Eurodollar credit market typically did business
with so -called " name companies " until this year . Little regard was paid
to normal credit analysis since defaults were rare . But with European
banks and corporations experiencing a worse liquidity crisis than our own ,
bankers soon found out that other banks could fail and that European
industrial corporations could present problems as big as some domestic ones .
Moreover , the energy crisis precipitated fundamental economic disequilibrium
for some countries increasing the possibility of a major country default .
Italy and the United Kingdom are major candidates .
In the developing countries , the situation is much the same . Spurred
by heavy competition and the attractiveness of high yields , commercial



bankers have poured money into these countries in recent years . Loans
were granted with extremely generous grace periods of three to five years
with final maturities extending to fifteen years . Bankers are now
locked-in on many of these loans while economic deterioration continues
to take place .
As a result of these factors and others , international loan portfolios
have tended to deteriorate in quality and lose liquidity .

The Uses of Capital
Although some definitions of capital include only bank equity
capital , most analysts are agreed that gross capital funds should be
used in determining a bank's capital adequacy . Gross capital funds are
equal to the sum of equity capital , reserves ( against loans and
securities ) , and long term debt which is subordinated and which carries
maturities beyond seven years .
Observers are also at odds over the uses of capital . However , most
would agree that capital serves the following general role :
The purposes of capital are , first , to permit a bank or holding
company to gain competitive entry by acquiring the necessary infrastructure to operate and , second , to serve as a residue of financial
strength to permit the parent holding company or subsidiaries to
withstand abnormal losses ( i.e. , losses not covered by current earnings ) ,
enabling the institution to regain equilibrium and re -establish a
normal level of profitability ..
In the event of liquidation , capital provides protection to
both depositors and other creditors . It also diminishes the outlay
of FDIC insurance reserves since that agency usually insists that any
funds derived from the liquidation of an insolvent bank's assets be
applied to the FDIC outlay before subordinated debt holders and shareholders receive consideration on their claims .
Capital also serves an important psychological role :
maintaining the confidence of public lenders and investors in the
institution's ability to meet maturing demands in most market conditions ,
to sustain present and contemplated growth patterns , and to conform to
industry and regulatory standards .


George J. Vojta , " A Dynamic View of Capital Adequacy , "
of Commercial Bank Lending , December 1974 .

The Journal



Capital Trends
Since the 1880's when capital /total assets exceeded 60%, there
has been a steady decline in the ratio . By 1900 the ratio had fallen to
20% or less . The rapid economic expansion following World War I
reduced the ratio still further to approximately 13% . The heavy
financing requirements of World War II reduced the ratio to its low
point of about 6% by 1945 , but banks were flush with liquidity at the
end of the war and capital increases were not critical . By 1960 banks
had improved the ratio to 8.2% , but since then there has been a steady
decline . By October 1974 the ratio had fallen to 7.1% for all commercial
banks and to 6.7% for the large banks ( Table Two) .
The capital /asset ratio seems to vary with the size of the bank,
As banks get larger , the growth in assets is disproportionately greater
than the growth in capital . Thus the ratio is usually smaller for the
giant banks . Consider the ratios of the following holding companies
which include Bankamerica Corp. , the largest banking company in the world :


Bankamerica Corp.
Chase Manhattan Corp.
First Chicago Corp.
Continental Illinois Corp.

(Billions )




*Taken from data compiled for year-end 1973 by Phyllis Ann Pierson ,
Debt in the Capital Structure of Bank Holding Companies , Indiana
University , Graduate School of Business , 1974 .

Capital /asset ratios as well as other capital ratios only serve
to point out trends . No ratio has ever been devised which can be used
to provide with reasonable certainty an insight into the appropriate
level of capital for the individual bank or the banking system as a
But ratios are widely quoted by all industry observers , not
intentionally as some believe to identify a weakness in the banking
industry , but to serve as a point of departure in analyzing the system's
capital structure . The same is true for the individual banking
For example , although the companies mentioned above have some
of the lowest capital ratios in the country , they are also among
the most respected world-wide financial institutions . Although the
Federal Reserve has moved to somewhat restrict their ambitious expansion
plans , no one is yet suggesting that these banking companies are grossly
undercapitalized or in peril of failing merely because their capital
ratios have fallen .
Since capital ratios are imperfect measures of capital adequacy ,
what is the proper approach?



Measuring Capital Adequacy
Regulators are too often accused of a heavy reliance on capital
ratios in their approach to capital adequacy , but this is seldom the
case . For example , the FDIC manual makes it clear that a bank's
capital structure must be evaluated in light of six factors : management ,
assets , earnings , deposit trends , fiduciary business and local
As early as 1962 the Comptroller's Office discarded the ratio
approach to capital adequacy and instructed examiners to consider :
management , the liquidity of assets , the history of earnings and the
retention thereof, the quality and character of ownership , the burden
of meeting occupancy expenses , the potential volatility of deposit
structure , the quality of operating procedures , and the bank's capacity
to meet present and future financial needs of its trade area , considering
the competition it faces.11/
What these regulators know and what others sometimes fail to realize
is the simple fact that capital adequacy for the individual bank relates
to a myriad of factors affecting its condition . Certainly , banks operating
with large proportions of high quality liquid assets and good earnings
have different capital requirements than those operating with less liquidity ,
poorer quality assets and lower profitability .
Regulators have a significant advantage over outside CPAS or market
analysts in determining the condition of a bank . On the spot examinations
enable examiners to perform a comprehensive asset appraisal .
quality assets are classified and listed in reports of examination
according to their degree of deterioration . The aggregate volume of
assets classified substandard ( slow assets with some loss potential ) ,
doubtful ( 50% loss probability ) , and loss is related to gross capital
funds . In the Comptroller's Office , banks having such ratios exceeding
40% are considered problem banks and receive immediate attention . When
the ratio exceeds 80% the situation is usually considered hazardous
with the future of the bank imperiled . Sterner measures are taken at this
point including the use of " cease and desist " orders . It should be
remembered , however , that asset quality is only one factor determining
capital adequacy . Nevertheless , the method described above does provide
the examiner and regulators with an estimate of the losses and potential
losses that may have to be applied against the bank's capital structure .

10/ George A. LeMaistre . speech delivered to the Alabama Bankers
Association , reprinted in the American Banker , November 8 , 1974 .

James E. Smith . " Assessing the Capital Needs of Banking , "
of Commercial Bank Lending , January 1974 .

The Journal



In-bank examinations also provide access to all of the bank's
records . The examiner is therefore much better equipped to examine all
aspects of asset- liability management and all factors relating to the
condition of the bank .
Denied access to vital information affecting a bank's liquidity ,
quality of assets , and solvency , the outside bank analyst is only imperfectly
capable of assessing the condition of a bank and its capital adequacy .
It is no wonder that regulators scoff at proponents wishing to let the
market police the banking industry .
But what of the industry's approach to capital adequacy? Certainly ,
bankers should be as capable as anyone of assessing their capital
requirements , and they do not suffer the information gap that the market
does .
The large bank view of capital adequacy is perhaps best expressed
by George Vojta , writing in his Bank Capital Adequacy . Vojta suggests
that for an on-going bank operating in conditions short of total
economic collapse-- such as the depression-- capital adequacy should be
submitted to two tests :
...first an " earnings test , " which requires that current earnings
amount to at least twice the level of total expected normal loss , and
a " capital cushion test , " which requires that total capital funds
aggregate to twice times the five year average of total loss experience
multiplied by twenty . The capital cushion test measures the bank's
ability to withstand unexpected loss . The " rule of twenty" capital
cushion test is deemed a minimally prudent margin of safety provided
the bank satisfies the two for one earnings test , management is
rated superior by the examiners , substandard loans and other
potential losses do not exceed 50% of total capital funds and
concentration of more than 10% of non-bank private risk assets /liabilities
do not exist.12/
This view places a premium on good management . Specifically ,
management's ability to consistently provide excellent earnings .
It gives a bank the flexibility to expand into more speculative
and higher risk ventures so long as the increased losses resulting
from such action are consistently exceeded by increased earnings .
In these conditions loss absorbtion capacity from current operations will
rise , and less reliance will have to be placed on existing gross capital
funds--the capital cushion . Moreover , to the extent that earnings
exceed losses and dividends , the capital cushion rises .


George J. Vojta.

Bank Capital Adequacy , New York :

Citibank , 1974 .



Vojta summarizes his point as follows :
Since earnings basically are a quality indicator of managerial
performance , this analysis leads to the view that management competence
is the critical factor in maintaining the solvency of a parent
holding company or its subsidiaries.13/
Using Vojta's concept of capital adequacy , a bank or holding company
could theoretically expand indefinitely without regard to the level of
capital maintained against assets , deposits or any other balance sheet
account , with the provisio that management keeps earnings high , losses
low , and substandard and other potential losses below 50% of total
capital funds .
To counter the argument that the decline in the capital ratios of
the banking system is an unhealthy development , Vojta presents some
interesting statistics measuring the growth of capital and earnings in
the system against the level of loan losses (his table is reproduced on
the following page ) .
Vojta's table shows that the banking system's growth in capital ,
loan loss reserves , the FDIC Fund , and total earnings have all been
massively larger in absolute terms than the growth in loan losses .
other words , the profitability of the system has increased the capital
coverage of loan losses from a ratio of about 12 : 1 in 1949 to roughly 64 : 1
in 1973. Given the substantially greater degree of earnings , capital ,
and insurance protection in the system to cover the losses experienced ,
Vojta concludes that it is therefore reasonable to argue that the decline
in capital ratios in the system in itself need not be viewed as alarming .
The Vojta/industry view of capital adequacy with its emphasis on
management , earnings , and loss absorbtion capacity is probably correct
in- so - far as it explains that a bank , even with a high relative level
of capital , will lose the public's confidence and its ability to survive
if it is mismanaged and unprofitable .
The industry and the regulators do not seem far apart in their
views of capital adequacy . Both view " management " capability as the
prime factor in assessing a bank's condition . The regulators would
rank liquidity and asset quality not far behind in importance , while the
industry would perhaps rank earnings above these factors : But the point
is that capital adequacy can only be determined by a subjective analysis
of all factors affecting the bank's condition . Emphasis must be given
to those factors of most importance which will vary from bank to bank and
will also vary with prevailing economic conditions , either locally ,


George J. Vojta .

52-221 O - 75 18

" A Dynamic View of Capital Adequacy , " op . sit .




All Insured Commerical Banks*
(all figures in billions of dollars)
Loans, excl .
Reserves Against
Fed Funds
Loan Losses

*Yearly averages Dec.-June-Dec.
**Break in series, 1969

Insured Commercial
Banks and NonDeposit Trust
(all figures in billions
of dollars)


Net Income
After Taxes




nationally or internationally . These conclusions are borne out by the
experience with bank failures and the events of 1974 , both of which are
discussed below .
The experience with failed banks since 1930 provides some clue to
capital adequacy on a " worst " case basis . The Horace Secrist studies of
bank failures in the thirties have recently been given a new look by
L. G. Gable who reworked and analyzed the data with the following general
conclusions :
( 1)


Ratios of loans to deposits , capital to risk-assets ,
deposits to resources , capital to deposits, and
capital to resources are poor measures of capital
adequacy .
The absolute level of capital , taken alone , gives
little indication of a bank's capacity to survive .
Capital must be analyzed in conjunction with other
important banking factors with the most important
being liquidity , the quality of assets and the
volatility of the deposit /borrowing base.14

A modern study by John Stocum of 57 bank failures in the period 1960
to 1972 took a different approach and identified three major causes of
bank failures :


( 2)
( 3)

In 35 cases , failure was precipitated by improper
loans to officers , directors or owners, or loans to
out-of-territory borrowers . Misuse of brokered
funds was involved in 20 cases .
17 cases involved defalcation , embezzlement or
manipulation .
5 cases involved inept management of loan portfolios.15/

While fraud , inept management and self- serving loan practices were
the major causes of failure in the modern study , notice that 35% of the
cases involved volatile deposit structures through the use of brokered
funds . Gable also found " a high correlation between failure and time of
failure and relative dependence of funds other than deposits and capital .
The less reliance on such nondeposit capital sources of funds , the
greater the chances of survival . " 16,


L. G. Gable . " Bank Capital--We Are Being Misled , " The Journal of
Commercial Bank Lending , December 1974. See also : Horace Secrist ,
National Bank Failures and Non-Bank Failures , ( Bloomington , Indiana :
The Principia Press , 1938 ) .

15/ John J. Slocum, " Why 57 Insured Banks Did Not Make It--1960 to 1972 , "
The Journal of Commercial Bank Lending , August 1973 .


L. G. Gable , " Bank Capital--We Are Being Misled , "

op.cit .



With respect to the primary role of liquidity , Gable said :
Regardless of how strong a bank might appear to be from the
relationship of its capital to total resources , or capital to
to risk assets , it must have some non-risk assets , i.e. , liquidity ,
to be strong , and the greater the volume of non-risk assets , relatively
speaking , the greater the strength .:
An FDIC study comparing a group of problem banks with a control
group of non-problem banks showed that problem banks had many of the same
characteristics as the failed banks above :

Significantly higher rates of growth of assets and
deposits were found for problem banks .
( 2 ) This growth was not matched by pari -passu expansion
of capital ; this led to the steady deterioration in
the average problem bank's capital position .
( 3 ) Capital growth of problem banks were restrained by
operating expense inefficiency .
( 4) Problem banks had less liquidity than control banks .
Moreover , the average problem bank's liquidity
position deteriorated over the period ( 1969-1972 )
studied relative to the average control bank .
(5) The liquidity of problem banks tended to fluctuate
violently over time , while control banks maintained
a balanced and stable liquidity position during the
same years.18/
None of the above studies are totally conclusive as to what factors
lead a bank into failed or problem situations . However , once again , all
focus on the importance of liquidity and the volatility of deposits in
assessing bank capital adequacy-- facts that are often ignored by
practitioners of liability management techniques .
It is also important to note that the failed bank studies were
conducted prior to the recent era of the "big bank failure . " For
example , the Slocum study included banks , the largest of which had total
assets of only $113 million . In fact , most of the banks failing since
the depression were extremely small " one man shops . "
Big Bank Failures
Prior to 1973 the banking industry enjoyed a relatively acceptable
failure rate among the 14,000 banks in the system . Those that did fail

17/ Ibid .


Joseph F. Sinkey , Jr. , " The Way Problem Banks Perform , " The Bankers
Magazine , Autumn 1974 , Vol . 157 , pp 40-51 .



impacted largely on the local or the regional level . There was little
national concern about the solvency and safety of the system itself
resulting from these small failures , for the banking system is not designed
to totally preclude failures of individual banks . The failure of certain
firms is a necessary by-product of any competitive industry , and banking
remains competitive despite strict entry requirements and extensive
regulation . So long as bank failures did not violently impact on the
public or the industry itself, they were viewed as tolerable .
But the failure since 1973 of three multi-billion dollar banks has
raised questions anew about the direction the American banking industry
has taken . Their failure has served to undermine the public's confidence
in other banks and the system itself . Moreover , serious questions have
arisen about the regulatory and market environment of banking .
The United States National Bank , San Diego ( USNB ) was the first
of the billion dollar institutions to fail . The bank was closed in
October , 1973. One year later , Franklin National Bank , New York was
declared insolvent and closed . Security National Bank of Long Island
was merged with another bank just prior to failing in January , 1975 .
These banks had many things in common with the smaller failed banks
mentioned above . All had inept management , significant proportions of
poor quality assets , a highly volatile deposit/borrowing base , and fast
growth rates .
The USNB was perhaps the most unusual case . A massive fraud ,
involving over $400 million in loans , was perpetrated by the bank's
controlling stockholder and chairman , C. Arnholdt Smith . The funds were
used for working capital support for Smith's conglomerate empire which
had speculated and lost heavily in real estate , airline , taxi cab , tuna
processing and other ventures .
A quirk in the regulations and the laws (See Comptroller's Ruling
7.1310 and 12 U.S.C. 84 ) enabled C. Arnholdt Smith to circumvent the requirement
that national banks may not lend more than 10% of their capital funds
to a single borrower . Obligations of a parent corporation are combined
under the law with obligations of subsidiaries in which the parent owns
or controls a majority interest . If the parent is not borrowing , loans
to subsidiaries are not combined except where repayment comes from a
single source , one or more loans accommodates the parent , or when the
borrowers are not separate concerns in reality but merely divisions of
a single enterprise .
Smith effectively used the latter provision by never having his
parent corporation borrow. Instead , he created numerous subsidiaries ,
each of which was entitled to borrow up to 10% of the bank's gross
capital funds . Although all the loans were eventually combined as a
violation of the lending limits , once the examiners had the proof that


-21the parent was benefitting , it was too late to save the bank . The burden
of proof in cases like this lies with the examiner . As a practical matter ,
in large banks generating thousands of transactions between examinations ,
it is extremely difficult for the examiner to check or even test check
the use of loan proceeds . Moreover , if loan proceeds are laundered through
other banks , the examiner has no way of knowing if Subsidiary A ultimately
uses Subsidiary B's loan proceeds . Had the law contained an automatic loan
combination rule for subsidiaries , USNB and Smith might have thought twice
about exceeding the lending limits .
Smith also benefitted from the laws governing affiliate transactions
(See 12 U.S.C. 371c and 221a ) . Although he had working control of both
the bank and Westgate California (the conglomerate holding company ) , he
did not have a majority ownership interest in either and thus did not have
legal control under the provisions of 221a . Without legal control proof
the examiners could not call Westgate an affiliate of the bank and require
the bank to conform to the strict provisions of 371c in lending to its
affiliates or subsidiaries thereof . A more restrictive law recognizing
that control can be achieved with ownership interests of far less than
50% may have precluded Smith from lending more than $400 million to
companies which were , in reality , affiliates of the bank .
The Franklin and Security cases differed somewhat from USNB in that
fraud was not a major factor in their failures . Some fraud in connection
with foreign exchange dealings has been alleged in Franklin's case , but
this was not the primary reason for Franklin's demise . In Franklin's
case , the following factors were of prime significance :
(1 )

High concentrations of assets in low yielding fixed rate bonds
and loans .
(2) A heavy dependence on high cost purchased funds .
( 3 ) Rapid growth and attendant high operating costs , especially
for real estate holdings .
(4 ) Foreign exchange speculation resulting in losses .
( 5) Heavy loan losses .
(6) A poor quality speculative loan portfolio .
(7) Declining earnings for several years resulting from the
above factors . Finally , a loss situation in 1974 .
Although the reasons behind the sudden merger of Security
National are still unfolding , the principal ones mentioned are :
(1 )

A costly expansion program into the New York market
which seriously affected earnings .
(2 ) A poor quality loan portfolio with heavy losses taken or
anticipated especially in the real estate area . The
purchasing bank estimates a loss as high as $140 million .
( 3) A heavy reliance on purchased funds .
No doubt a host of other factors also contributed to the demise
of these large banks . Certainly , prevailing high interest rates , tight
money and an economic recession had their not inconsiderable impact .


The scenario for these banks runs the same as for those smaller banks
which have failed from time to time in the past : Mismanagement of assets
leads to losses or a ridgidity of assets which cannot be sold except at a
loss . Loss of earnings from such assets is further compounded by the high
cost of funds used to purchase the assets . Earnings thus decline and public
confidence also declines . When losses or the expectation of losses become
great enough , the uninsured depositor and/or money market lender deserts
the bank . The bank experiences a liquidity crisis since assets are too
fixed or are of such poor quality that they cannot be sold for cash . For
a while the bank relies on the Federal Reserve as a lender of last resort ,
but this proves only a stop- gap , and the bank fails .
While all banks fail along similar patterns , three factors were
present in the failure of the billion dollar banks which tended to
differentiate them from banks failing in the past .
First , all three banks may have failed prematurely because of a
phenomenon which has come to be called " a modern run on banks . " All
supported their rapid growth with purchased funds which were not only
interest sensitive , but extremely confidence sensitive .
With this type of liability structure--which is not at all uncommon
for most large banks--these banks were extremely vulnerable to the whims
of the money markets . In each case , when significant problems were
disclosed and market rumors about substantial losses became generally
known , the money market lenders to the bank deserted in droves , causing
a massive outflow of funds . This created a liquidity crisis in each of
the banks and placed them in imminent danger of failing . George LeMaistre
describes what happened in Franklin's case , but his description could
just as easily be applied to USNB and Security :
The Franklin experience suggests that deposit insurance
maintains the confidence of most smaller depositors in the face
of even the worst sort of adverse publicity . On the other hand ,
the willingness of the lender of last resort and the stabilizing
efforts of the other agencies do not seem to have stimulated the
confidence of large individual institutional depositors in this case
sufficiently to cause the return of such funds . Thus , the
greatest danger to a financial institution today seems not to be a
loss of confidence by the public at large , but rather the mistrust
of other financial institutions , corporate entities and the very
large individual depositor.19


George A. LeMistre , op . sit .



The important implication here relates to the timing of the outflow.
The money market lenders did not wait to see whether or not the problems
in these banks could be worked out in cooperation with the regulatory
authorities . Nor did they wait to see whether the large capital structures
of these institutions could perform their " capital cushion" function and
absorb the actual or potential losses indicated at the time . Instead ,
they deserted--perhaps prematurely--and never returned .
For other banks operating with extensive reliance on sensitive
money market funds , the lesson is obvious . As LeMaistre says : "Hot funds
are easily lost in an economy in which there are many institutions
competing for funds , and a setback which would not otherwise be disastrous
may lead to a loss of confidence and the outflow of such funds .
In other words , the massive loss of funds itself could trigger a failure
before the institution had the opportunity to demonstrate its capacity to
weather a temporary crisis .
Compounding this problem is the fact that even the sophisticated
money markets have incomplete information concerning most banks operating
in the market . Thus , the inability of the market to properly analyze the
true condition of a bank makes it extremely vulnerable to rumors of
trouble in individual banks . The market may therefore grossly exaggerate
a particular problem confronting a bank and choose to deny the bank access
to the market .
The second tendency differentiating large bank failures from
preceding small ones was that all three banks were able to reach an
incredible size before being subjected to the disciplines of the money
market and the regulatory authorities , notwithstanding the fact that in
the Franklin and USNB cases , early evidence was present suggesting that
these banks were mismanaged and financially over- extended .
The regulators have admitted that there were remiss in the handling
of USNB and Franklin and that the problems in these banks should have
been detected much earlier . Certainly , more could have been done ; but
even if earlier action had been taken , the banks most likely would not
have survived .
USNB's problems stemmed from a massive fraud ( mentioned above )
whereby funds were channeled into speculative ventures of C. Arnholdt
Smith . Smith guessed wrong and was a victim , in part , of the economic
downtown and high interest rates . Since examinations can only uncover
fraud or poor quality assets in a bank after the fact , there is little
regulators can do if management decisions result in a quick deterioration
of asset quality . This happens occasionally between examinations and



Ibid .


-24it may have happened in Smith's case . The fraudulent loans started
building up in 1969 and very quickly . The examiners detected the fraud
in 1972 , but even if the fraud had been detected in 1970 , chances are
that it was already of such a size as to jeopardize the survival of the
bank .
Franklin's case was slightly different . The bank had been mismanaged
for years with the full knowledge of the industry and the regulators .
Yet until late 1973 , management was at least capable of generating small
profits for the institution . Management's incorrect assessment that
interest rates would fall in 1974 led it to invest heavily in fixed
rate securities . At about the same time heavy foreign exchange speculation
was undertaken . These activities happened in a short period of time in
late 1973 and early 1974. Both decisions resulted in heavy losses and
led to the ultimate demise of the bank . How could the regulators have
anticipated these decisions ?
Many would argue that the regulators should have removed the
management of USNB and Franklin much earlier than they did .
banks operated with some profitability through the 1960s and early 1970s ,
and their asset conditions were not considered critically unsatisfactory .
What would have been the basis for a removal proceeding? These proceedings
are seldom , if ever , used except in cases involving dishonesty . This is
because lengthy hearings are often involved . Moreover , regulators fear
that proceedings initiated to remove incompetent management may produce
a loss of public confidence in the bank which could by itself precipitate
failure .
Part of the explanation for the regulators ' inability to forestall
the failures of USNB , Franklin , and Security may lie in the fact that
poor management decisions quickly resulted in asset problems of such a
magnitude as to make it impossible for regulators or anyone else to save
the banks .
The third and final element involved in the big bank failures , which
differed from those failures taking place since the depression , was the
impact the failures had on the system as a whole . These failures , together
with failures abroad , large losses reported by major banks in foreign
exchange transactions , and heavy loan losses being reported domestically ,
led to a marked decline in the public's confidence in the system .
To this point , we have attempted to isolate the major changes taking
place in the composition of bank assets and liabilities since World War II
with emphasis on the evolution of a new liquidity theory--liability
management .
Using techniques of liability management , bankers were able to
substantially increase their fund sources and maintain them , even during



periods of monetary restraint . This greatly increased their flexibility
to lend and grow . Secure with the assumption that additional liabilities
could always be created to provide liquidity , many banks moved into
higher yielding loans and securities in the pursuit of profits .
longer term and higher risk asset concentrations which diminished liquidity
and quality .
But the growth of assets and deposits far exceeded the growth in
capital funds ; and capital ratios have shown a steady decline since 1960 ,
especially in the larger banks . This trend has created a great deal of concern
about the capital adequacy of the system. The modern view of capital
adequacy , however , discounts the use of capital ratios in favor of subjective
judgments based on the analysis of all of the factors relating to a
bank's condition . Capital adequacy , then , must be judged in relation to
the management , liquidity , quality of assets , earnings , volatility of the
deposit structure , and other factors .
The history of bank failures tends to support the contention that
capital is only one factor in a bank's capacity to survive . More important
is a bank's ability to weather a liquidity crisis . The experience with
large bank failures during the last two years points to the hazards for
banks operating with a heavy reliance on purchased money market funds .
Due to the market's imperfect ability to analyze a bank's true condition ,
massive outflows of funds can sometimes be triggered by adverse publicity
or rumors of trouble . Denied access to a primary source of funds , the
bank undergoes a liquidity crisis and must rely on the lender of last
resort . Ultimately , failure occurs if the bank is unable to adjust its
asset structure to provide liquidity without incurring substantial losses
in the process .
Regulators may also be unable to prevent a failure , especially when
poor management decisions result in a quick asset deterioration of such
a magnitude as to jeopardize survival .
Until 1974 the banking industry had shown a remarkable capacity
to both keep its problems to a minimum and to provide the fundamental
and innovative framework necessary to finance the rapid economic expansion
taking place since 1960. But the combination of steadily rising interest
rates , tight money conditions , and a prolonged economic recession in 1974
brought to the surface many problems which had been building over time .
First, the events of 1974--which included bank failures both here
and abroad ; heavy loan losses ; significant foreign exchange losses ;
and the deterioration of asset portfolios of banks heavily involved in
loans to struggling real estate firms , airlines , defense contractors ,
retailers , public utilities and other marginal borrowers-- led to a
pronounced decline in the confidence the public had in the system .



Second , the decline in confidence manifested itself in the rush to
safe havens for funds . The very largest banks with unquestioned--but
perhaps undeserved--national and international reputations were the direct
beneficiaries , since the money markets made the judgment that bigness also
meant safest . Regional and smaller money center banks operating in the
money markets were often denied funds altogether or were forced to pay
high premiums for a limited amount of funds . Many had to scramble to
avoid negative margins and to assure liquidity adequate to meet the claims
against them . The lesson here is that all banks do not have the same
access to the money markets . This was a rude awakening for many banks
practicing liability management .
Third, many banks found themselves with large quantities of fixed
rate loans and securities which were funded in prior years with short- term
purchased funds . These purchased funds had to be replaced in 1974 with
higher cost funds . This created declining or negative spreads on the fixed
rate portfolios . Moreover , the fixed rate portfolios could not be sold
except at substantial discounts . Management's failure to properly match
interest-sensitive liabilities to interest- sensitive assets resulted in
an acute liquidity crisis for many banks .
Fourth , the declining economy and speculative ventures of the past
resulted in an increasing number of borrowers , including large corporations
in certain industries , who experienced declining cash flows to such an
extent that they could not service their heavy debt loads . For the banks
who had made liberal and speculative loans to these borrowers , this meant
that they either had to take heavy losses , or at the very least ,
reschedule the debt . This not only affected their liquidity but also
led to a large rise in poor quality assets .
Finally , the decline of liquidity and the rise in poor quality
assets greatly concerned both the money market participants and the
regulators . Both became concerned about the capital adequacy of some
banks . Perhaps it is important to digress and point out a trend which
has had regulators concerned for years .
Bank examiners list in reports of examination a bank's classified
poor quality assets . These are normally in categories called substandard ,
doubtful and loss . All classified assets have some degree of loss , so
the aggregate classified assets are compared to the gross capital funds
of the bank . This ratio provides some measure of capital's loss absorbtion
capacity and is also a prime factor in determining bank capital adequacy .
The ratio of classified assets to gross capital funds has risen
dramatically in recent years in many individual banks and the system as
a whole , basically for the following reasons :



(1 )

The pursuit of growth and higher profitability has
induced banks to relax traditional credit and investment
standards . This has greatly increased the dollar amount
of loans and investments of a marginal and therefore classified
nature .

( 2 ) During the years of economic stability since 1960 ,
classified assets may not have risen relative to loans
and investments , but since asset growth far out-paced capital
growth in this period , classified assets tended to rise in
relation to capital .
( 3)

During periods of economic decline , especially since 1969 ,
classified assets rose relative to loans and relative to
capital . This is because recession results in a great many
marginal borrowers .

It is the rise in the classified assets to gross capital ratio , together
with declining liquidity , that so concerns regulators , not merely the
fact that capital ratios have declined . These concerns have prompted
regulators to curtail the expansion ambitions of banks with inadequate
or marginal capitalization .
Besides the regulatory pressure , there is other evidence that bank
capital ratios may have reached the point beyond which they will not
to go . It became clear in 1974 that some banks were not as
well managed as was formerly believed ; that some banks had seriously
extended themselves with an inordinate number of marginal loans and
investments ; and that banks had generally gone too far , too fast .
Serious concern about the liquidity and solvency of the system manifested
itself in ways mentioned above , but there was also a vote of no confidence
in the equity and long term debt markets .
Prices of individual bank shares dropped 40% to 60% in a short
eight month period . Prices dropped dramatically not only for banks with
known management and asset problems , but also for well-run and highly
profitable institutions . Bank holding company commercial paper--once at
the very top of market preferences -- fared poorly relative to other
issues , and many companies were forced to pursue alternative sources of
At the end of 1974 , large prime banks found that they had to pay
a premium on their debt issues far in excess of the rates paid by nonbank prime corporations .
Current regulatory and market pressures , then , will likely force
the banks into a retrenchment period . Expansion may more and more
become a function of proportional increases in capital . But capital
growth will be largely limited to increases in retained earnings since
banks will not risk diluting shareholder interests through equity issues ;
nor will they make extensive use of high cost long term debt issues .



Faced with this situation , many large banks have already announced
slow growth policies . In addition , commercial bankers will likely try to
improve both their liquidity and asset quality in an effort to regain
public confidence . This could mean that less money will be available for
loans and that the money that is available for new loans will be
allocated increasingly to larger , safer borrowers . For liquidity purposes ,
banks will likely increase their holdings of cash assets at the expense
of loan growth . They will also try to more evenly match interestsensitive liabilities with interest- sensitive assets . A movement out of
fixed rate mortgages and consumer loans into loans to corporations with
rates varying with prime could result . To mitigate the latter possibility ,
an effort may be made to impose a variable rate feature on some categories
of consumer and mortgage loans .
What impact will the present trends in banking have on the system's
ability to satisfy both the short and long term needs of the economy?
If projections are correct , a heavy demand for funds will continue
unabated . For example , a New York Stock Exchange report ( " The Capital
Needs and Savings Potential of the U.S. Economy " September , 1974 )
forecasts a cumulative capital shortfall of $650 billion by 1985 .
The strongest demand for funds is expected to be from business borrowers ,
specifically borrowing for plant and equipment spending . Total business
borrowing is expected to account for 56% of incremental borrowing between
1974 and 1985 , while business borrowing currently accounts for about
40% of total credit outstanding .
Deposit growth is expected to lag considerably behind loan demand
to 1985. The gap between the amount of funds required for asset expansion
and the quantity available must be covered by increasing dependence on
purchased funds . As many banks learned in 1974 , the larger national
and international banks have significant advantages in the heavily
competitive market for funds . Thus more mergers and a movement to
larger banks will likely take place in the future to take advantage of
these economies of scale .
If regulatory and market pressures force the banks into slow growth
policies coupled with greater asset selectivity , they may be incapable
of providing the necessary financing to fill the gap . Henry Kaufman of
Salomon Brothers mirrors the opinion of many observers when he says :
"Commercial banks aren't in a postion to make a substantial volume of
loans to a broad spectrum of borrowers , an important prerequisite for
economic growth . " He sees this as an " unprecedented impediment " to
quick economic recovery .
In these conditions , banks are likely to favor large corporations
with whatever new monies are available . This is because corporations
are safer and more willing to accept rates which vary with prime .
This effect and the fact that the heavy demand for limited funds will
likely keep interest rates high , will work to the detriment of small
and medium-size businesses and consumers .



High interest rates , an inadequate supply of credit and the huge
capital gap will adversely effect business activity and the standard
of living unless corrective measures are undertaken and soon .
The policy recommendations being made to bridge the capital gap and
to assure a viable banking system in the years ahead inevitably involve
questions concerning the economy , banking structure and regulation , and
bank supervision . Most of these recommendations are beyond the scope of
this paper or are adequately treated in other papers being prepared for
the Committee ; however , a few general comments about the industry seem
appropriate .
There is no denying that serious problems exist in the banking
industry . Our recent experience with major bank failures punctuates
the need for tighter regulation and supervision of banks , especially
those overly dependent on volatile fund sources . Moreover , many banking
abuses could be diminished by changes in the laws applicable to
stand-by letters of credit , bank guarantees , affiliate transactions ,
director and management loans , and the like . Regulators , increasingly
embarrassed by the large bank failures , have already moved to solve
some of these problems by improving bank examination techniques , by
taking quicker and more forceful action with problem banks , and by
corrective regulations designed to curb excesses in certain areas .
There is also no question that the capital adequacy of many banks
is marginal at best and that the system has gone through an alarming
decline in liquidity . Public confidence in the industry is at its
lowest since the 1930s .
But it should be remembered that unsound banking practices and
regulatory deficiencies are only partial--and perhaps insignificant-explanations for the industry's problems . The unstable economic
conditions of the past few years certainly have had a much greater
impact on the industry . Banks , after all , mirror the economic conditions
of industries to which they lend . Some observers see the poor economic
conditions of the 1970s and the lack of effective governmental monetary
and fiscal policies as the primary causes of the banking system's
problems . Perhaps James E. Faris , President of the Conference of State
Bank Supervisors , speaks for the industry and the regulators when he says :
With a few exceptions --and unfortunately they are
serious and have received a great deal of notoriety-the commercial banks of this country are demonstrating
a remarkable capacity to weather the really terrible liquidity
and interest rate situation caused largely by the extreme
fluctuations in monetary policy over the past few years . A less
healthy banking system would not have survived as well as our
has . And , to the extent that problems do exist , there is no



convincing evidence that they are caused by the current regulatory
structure per se . They more fully reflect individual people problems
which , we submit , might have been far worse under a more centralized
system lacking the inherent checks and balances of the present
structure . At least we can say with certainty that a centralized
monetary policy decision-making process
ocess has yielded poor
results over the past decade.21/
The importance of the relationship between the economy and the
banking system should always be kept in mind by those seeking change in
banking structure and supervision . An over-reaction to the events of
1974 resulting in a more restrictive operating environment for banks
would not only penalize well managed banks for the excesses of a few ,
but could also have debilitating effects on financing capacity and
ultimately , economic growth .
If the industry is to continue to have the capacity to perform its
traditional intermediary role in meeting the financing requirements of
the nation , a pro- competitive environment is essential . Banks must be
allowed to grow and have access to a variety of fund sources . A highly
competitive industry with an increased reliance on volatile , interestsensitive fund sources , however , will probably mean failure for a few
mismanaged and over-extended banks . For others it will mean an increased
reliance on the lender of last resort , the Federal Reserve System.
This may seem a high price to pay , but an alternative system with
less competition , more regulation and less growth could effectively bar
major segments of business and consumers from access to bank credit .
Government would have to step in and fill the gap , and government has
never proven its ability to efficiently allocate credit .
For a country that has traditionally emphasized competition for most
industries , the choice seems obvious . Banks should be allowed to compete
to the maximum extent possible . The present level of regulatory supervision
should suffice in assuring protection for bank depositors and creditors .
Improvements in supervision can obviously be made , but all must recognize
that the regulatory experience with the big bank failures proved the adequacy
of the present system . These banks were all merged out of existence with
no loss to depositors or general creditors . In future economic conditions
short of chaos , the FDIC insurance fund should prove adequate in insuring
protection to depositors and creditors of those banks which will fail from
time to time .
The weaknesses which have surfaced in the banking industry and bank
supervision obviously require public policy remedies of some magnitude .
But efforts to reform and change the system should come only after the larger
problem of improving the economy has been solved , for the banking system in
any country is only as good as the economy in which it functions .

21/ James E. Faris .

American Banker , January 16 , 1974 , editorial section .

( mounts





























)( 0.5




















Borrowings Capital









52-221 O 75 19



Total s







% 7































Alex Brown & Sons . The Banking Industry , Lessons of 1974.
Alex Brown & Sons , Dec. , 1974 .
Christophe , Cleveland A. Competition in Financial Services .
First National City Bank , 1974 .
Hahn , Philip J. The Capital Adequacy of Commercial Banks .
The American Press , 1966 .

Baltimore :

New York :

New York :

Haywood , Charles F. and McGee , L. Randolph . The Expansion of Bank Funds
in the Nineteen-Seventies . A study prepared for the Trustees of the
Banking Research Fund Association of Reserve City Bankers . Chicago :
Association of Reserve City Bankers , 1969 .
New York Stock Exchange . The Capital Needs and Savings Potential of the U. S.
Economy , Projections through 1985. New York Stock Exchange , Inc. , 1974 .
Pierson , Phyllis Ann . Debt in the Capital Structure of Bank Holding Companies .
A doctoral dissertation . Indiana : Indiana University Graduate School
of Business , 1974 .

Prochnow and Prochnow , Eds .
Harper & Row , 1974.

The Changing World of Banking .

New York :

Recent Bank Closings : Hearings before the Committee on Banking and
Currency , House of Representatives . Washington , D.C .: Government
Printing Office , March , 1971 .
Secrist , Horace . National Bank Failures and Non-Bank Failures ,
Indiana : Principia Press , 1938 .
Vojta , George J.
Bank , 1973 .

Bank Capital Adequacy .

New York :

Bloomington ,

First National City

Articles , Pamphlets and Speeches

"Banking in the United States--a survey . "
1974 .

The Banker , Vol . 124 , #583 , Sept. ,

Burns , Arthur F. " Maintaining the Soundness of Our Banking System. " Address
at the 1974 American Bankers Association Convention , Honolulu , Hawaii ,
Oct. 21 , 1974 .
Faris , James E.
Section .

American Banker , Jan. 16 , 1975 , quoted in the Editorial


The Journal of Commercial

Gable , L. G. "Bank Capital --We are Being Misled . "
Bank Lending , Vol . 57 , #4 , Dec. , 1974 .

The Journal of Commercial

Gable , L. G. " Liability Management --An Indictment .
Bank Lending , Vol . 56 , #12 , Aug. , 1974 .
" Heard on the Street . "

Wall Street Journal , Dec. 23 , 1974 .

Hempel , George H. " An Evaluation of Recent Trends in the Raising of Bank
Capital .
Paper presented to the Southwestern Finance Association ,
Dallas , Texas , March 30 , 1974 .

LeMaistre , George . A speech delivered to the Alabama Bankers Association ,
reprinted in the American Banker , Nov. 8 , 1974 .
LeMaistre , George . " Insider Dealings and Financial Restructuring . "
Journal of Commercial Bank Lending , v. 57, Oct. , 1974 .

Rose , Sanford . "What Really Went Wrong at Franklin National . "
. 90, Oct. , 1974

Fortune ,

Sheehan , John E. "Bank Capital Adequacy--Time to Pause and Reflect . '
Journal of Commercial Bank Lending , v . 56 , Jan. , 1974 .
Sinkey , Joseph F. , Jr. " The Way Problem Banks Perform . "
Magazine , v . 157 , Autumn , 1974 .

The Bankers

Slocum, John J. "Why 57 Insured Banks Did Not Make It --1960 to 1972. "
v. 55 , Aug. , 1973 .
Journal of Commercial Bank Lending .
Smith , James E. "Assessing the Capital Needs of Banking . "
Commercial Bank Lending , v . 56 , Jan. 1974 .

Journal of

Storrs , Thomas . A paper presented to the American Economic Association ,
reprinted in American Banker , Jan. 6 , 1975 .

Tyce , John .

" Company gearing :

The Threat to Banks .

Euromoney , Aug. , 1974 .

Van Horn , Charles . " Banks with Good Earnings Can Perform Better in Five
Areas . " American Banker , v . 137 , Aug. 2 , 1972 .
Vojta , George J. " A Dynamic View of Capital Adequacy . "
Commercial Bank Lending , v . 57 , Dec. , 1974 .
Wille , Frank . " The FDIC Views of Capital Adequacy . "
Commercial Bank Lending , v . 57 , Dec. , 1974 .

Journal of

Journal of


Wille , Frank . " The FDIC and Franklin National Bank : A Report to the
Congress and All FDIC Insured Banks . " A speech before the 81st
Convention of Savings Bank Associations of New York State , Nov. 11 ,
1974 .

Wille , Frank . " Status Report to the Congress on the Receivership of United
States National Bank . " A statement before the Subcommittee on Bank
Supervision and Insurance , Committee on Banking and Currency , House of
Representatives , Dec. 12 , 1974 .




Stuart I. Greenbaum*

This paper discusses certain weaknesses of present- day banking
institutions 11- both public and private . Section I describes selected
developments in the banking system's balance sheet over the past thirty
years . A purpose is to indicate the gradual
more recently not so
gradual - increase in banking system risk exposure , or erosion of
liquidity and capital protection . A second purpose is to provide background for the subsequent discussion , in Section 11 , of weaknesses in
our system of public regulation . More specifically, we discuss inadequacies in the information base upon which regulatory policy is founded .
These inadequacies are found in the accounting practices employed in
valuing the bank's earning assets and liabilities . In the balance sheets
used for regulatory purposes , lines of credit , roll -over agreements ,
revolving credits and other commitments ars totally ignored . Items not
omitted, such as loans and deposits , are improperly valued and this may
be particularly important in the case of demand deposits . Taken together ,
the accounting inadequacies tend to insulate the balance sheet from the
effects of economic instability and thereby obscure problems the regulators presumably are concerned with detecting . A discussion of the diffusion of regulatory authority follows . A concluding section summarizes
our findings and offers related conjectures .

Visiting professor of banking and finance at Northwestern University
and professor of economics at the University of Kentucky . This paper
was sponsored by the Banking Research Center of Northwestern University.
Although his views are at variance with some of those expressed herein, a deep debt is owed Donald P. Jacobs for both intellectual and
material support . I also wish to acknowledge helpful suggestions from
Robert A. Taggart .


Economic Instability and Commercial Banking

of institutions .

instability is widely recognized as threatening the viability
Clearly , among these are our financial institutions .


tic, new vintage bank failures are available for contemplation and muted
warnings , in tones dire and tenebrific , are circulated by people in high places .
Is it possible that our time- honored assumption

regarding the soundness of our

banking system is open to serious question ? If so , why has this deterioration
occurred? Moreover , what can be done to remedy the underlying problems so as
to restore the desired soundness ? No claim is made to fully answering these
questions in the present paper . However , clues are provided .
of World War Ii .

traces selected developments in banking since the termination
A purpose of this section is to indicate the gradual 13

more recently not so gradual - 109 increase in banking system risk exposure .
second purpose is to set the stage for the subsequent discussion , in Section 11 ,
of weaknesses in our system of public regulation .

More specifically , we discuss

inadequacies in the information base upon which regulatory policy is founded .
The question of diffusion of regulatory authority is also addressed . A concluding
section summarizes findings and offers related conjectures .


Developments in Banking , 1945-75
The period 1945-70 may yet come to be known as a (the ) halcyon age

for commercial banking .

The banking system entered the postwar

period with enormous liquidity owing to (a ) the methods chosen by


ment to finance the war, and ( b ) the legislative , regulatory and attitudinal
legacy of the Great Depression .

Professor Klebaner notes



Between mid- 1940 and mid- 1945 banks bought a volume
of U.S. bonds equal to their total assets in 1940.
Treasury obligations comprised at least half of total bank
assets from 1943 to 1947. ( p . 164 )
Klebaner goes on to observe

The rate of return on national bank capital in 1945
was the highest in the 75 years for which official records
were available . . . The ratio of capital to total assets ,
which had been trending downward since 1875 , when the series
begins , reached a low of 5.5 percent in 1945. However , the
ratio of capital to assets other than cash plus United States
government obligations was 25.5 percent in 1945, about the
same as in the late 1930's . The F.D.I.C. was reassured by
the fact that the ratio of assets rated sub- standard by
bank examiners -- 48.2 percent of adjusted capital as recently as 1939 -- was down to 7.6 percent in 1945 , the
lowest level since the beginning of deposit insurance . By
the end of World War II , the financial damage inflicted on
the banking system by the Great Depression had been repaired. Banks were in a strong position to meet the demands
of the postwar economy . ( p . 164-5 )
Perhaps because the trauma of the 1930's was still fresh in the minds of
bankers and regulators alike , the banking system played a very limited role
in financing the World War 11.

Again , according to Klebaner ,

Though bank loans to commerce and industry expanded
moderately after 1943, in the final stage of the war in mid1945, they were slightly below the 1941 total . . . Total bank
loans, $21.7 billion at the end of 1941 , were again at that
level by the end of 1944 , after having declined to $ 18 billion
by mid 1943. ( p . 162 )

Essentially, the banking system restricted itself to monetizing
debt .


Non-defense related loans were severely restricted while most defense-

related lending to the private sector was done directly by government agencies .
Thus , the banking system came out of the war with surprisingly low loan- deposit
ratios , as well .



Two major forces shaped

post-World War

1 trends in the banking

First , interest rates entered a period of secular escalation .

Second, stable economic growth made the experience of the 1930's increasingly
irrelevant in shaping the expectations of bankers and regulators .
the siege mentality was becoming increasingly anachronistic .

Less than 20

years later proud men spoke of having conquered the business cycle , apart from
minor oscillations .

Economic science had, once and for all ,

diminished risks inherent in the Capitalist system .
it became
sheet .

Under the circumstances ,

inappropriate for the banker to maintain a 1945 balance

Such behavior bespoke "head in the sand , " "behind the times " or

the prototypica ! intractable , Sewell Avery .

Bankers were surprisingly quick

to shed their Corinthian column image , along with their primary and secondary

reserves .

Bank loans were increased rapidly , increasing both the loan


and the loan/deposit ratio.

Measures of capital adequacy

showed deterioration , as well . The capital to risk-assets ratio declined
throughout the period .

The capital /asset ratio actually rose through about

1960, but declined thereafter .

The role of demand deposits as a source of bank

funds also declined as the industry discovered " liability management . "
Traditional lines of industry demarcation , both functional and geographical ,
became blurred .

Bankers rushed abroad , first following the needs of their

foot- loose customers , but then came the siren call of exotic

financial instruments and tax avoidance ploys (see Brimmer and Dahl ) .


bank holding company became the dominant vehicle for diversifying into previously
proscribed activities ( see Jacobs , Beighley and Boyd ) as the latter movement
was abetted by the 1970 amendments to the Bank Holding Company Act of 1956.



That legislation provided for the creation of a " laundry list " of activities into
which more enterprising bankers might venture .
The congeries of change in the banking system's policies can be viewed as
a voluntary recomposition of the balance sheet aimed at enhanced return
on equity .

Such behavior made good sense on two grounds :

(a) rising interest

rates increased rewards for assuming risk and , probably much more importantly ,
(b ) the perception of risk kept changing , reinforcing the substitution induced
by ( a ) .

This period also can be characterized in terms of a series of

largely successful efforts by bankers to circumvent regulatory
designed to reduce the probability of bank failures .
is probably unfair to both bankers and regulators .


But such a characterization
There is no reason to

suspect that regulators were misled or understood the implications of bank
behavior any less well than the bankers themselves .
But some time after 1965 the halcyon age apparently ended.
had President Kennedy's economists finished ballyhooing the achievements of
economic science than the seeds of their embarrassment were sown in the fields
of Viet Nam .

To some it might

done him in.

Rising inflation was the harbinger, but certainly not the sole

seem that man's hubris once again had

cause or symptom , of heightened economic instability .

This was a period of

collapse of the Bretton-Woods Agreement and disappearing anchovies , of social
unrest in America and widespread drought abroad .
shamed into resignation and
former adversaries were

An American president was

traditional allies



embraced under the guise of

detente .


In addition ,

petroleum producers established a potentially disastrous precedent for other primary
materials producers in effectively cartelizing the industry .

In short, the

period after 1965, and particularly after 1970, was one in which numerous seemingly



unrelated shocks


the economic system .

Quite expectedly,

the system lurched, to and fro, while stabilization policymakers sought to
administer offsetting shocks .

The tools used were both conventional and





opportunity to argue that stabilization policy aggravated the problem .
By the mid 1970's , and even earlier , the central issue was crystal clear
to the banking fraternity .

The industry had undergone thirty years of adaptation

on the assumption that severe economic instability was little more than a

artifact .

The rude shattering of this article of

faith raised fundamental questions of viability .

Can the banking system as

presently constituted withstand volatile gyrations in interest rates and
capacity constraints on the industry's output without a much higher
mortality rate among firms than in recent years

(see Minsky )? Can bunks

expeditiously reverse their policies of the past thirty years so as to forectall
failures? What is appropriate regulatory policy in an era of economic instability when the industry finds itself extraordinarily vulnerable?


Latent Weakness Exposed
The secular erosion of bank liquidity and capital increased the fragility

of the banking industry. Recent economic instability ,
which we view as an exogenous increase in non- diversifiable risk in the economy
at large , is providing the first serious test of our newly constituted banking
system. The recent flurry of bank reorganizations suggests that in the absence
of greater success in stabilizing the economy we will face increasingly serious
problems in stabilizing the banking industry.

Indeed , 1970 may have marked



the end of an era in which bank failures were notable for their rarity and when
observed almost always involved small banks and trivial externalities .
The changed milieu also exposed two previously latent weaknesses of
regulation that seemed unimportant because of the low risk inherent in the
banking system .

These weaknesses are found in the information base upon which

regulatory policy depends and in the diffusion of regulatory authority .

To be sure ,

what now appear to be serious flaws may have been optimal

arrangements under previously placid circumstances .

In a system with little

risk, devotion of substantial resources to data collection will appear wasteful .

Moreover , while some would maintain that the structure of regulatory

agencies is little more than historical artifact , others see the diffusion of
regulatory responsibility as a desirable arrangement for avoiding undue concentration of power .

In any case , the newer circumstances of increased bark

vulnerability would appear to call for a careful review of public policy ir these
two areas .

The following sections describe what appear to be central problems

associated with the information base and the structure of regulatory agencies .

II .

A. The Informational Content of Accounting Data
Investors , regulators , and perhaps to a lesser degree management , rely

on accounting data as indicators of the firm's present condition
its prospects .

as well as

Despite acknowledged discrepencies between accounting and market

magnitudes , the former are used presumably because they are inexpensively
obtained and a certain stability of relationship between accounting and market
magnitudes can be relied upon much of the time .

Economic instability weakens

the relationship between accounting and market data and undermines the usefulness of conventional income statements and balance sheets .

That is , inexpensive


information sources are destroyed and the cost of information increases .
Consequently, uncertainty rises and a generalized welfare loss is sustained .
Book values can be viewed as estimators of market values .


asset ( liability ) maturities exceed one period , rising ( falling ) interest
rates introduce bias in the estimators .

But this may be a minor problem for

the magnitude of the bias is often readily ascertainable . ( This is not to say that
losses associated with changing interest rates are a minor problem. ) Potentially
more serious is the loss of efficiency of the estimator resulting from greater
volatility of interest rates .

Greater sampling is required at presumably

substantial cost and a higher discount rate (supply price of capital ) will
be applied to the firm's expected earnings stream .
To be sure , this phenomenon is not unique to financial institutions .
Its significance can be expected to vary across industries as the cost of
obtaining data from alternative sources varies .

Those industries whose assets

and liabilities are traded in active secondary markets should suffer least .
This suggests that the financial services industry may be better positioned than
most to sustain economic instability .

Neverthe loss , many of the bank's

assets and liabilities are not traded on active secondary markets .

For example ,

demand deposits are not and, in fact, cannot be traded among banks , since the
rents they generate depend upon local market characteristics .

Neither are

loans , particularly loans cum roll -over agreements , or credit lines .


balance sheet items are subject to considerable variation in periods of economic
instability , as will be explained shortly.

Consequent ly the informational

content of accounting balance sheets (Condition Reports ) is subject to considerable deterioration .



II .


Credit Lines

In principle , each item in the income statement representing a continuing
stream of payments or receipts should have a counterpart in the balance sheet .
However , convention dictates omitting lines of credit in the construction of
Condition Reports .
This convention may have arisen because of problems in
conceptualizing the liabilities implied in credit lines or in a desire to
give balance sheets the most risk- free appearance possible .

Whatever the case ,

the omission takes on increasing importance in times of economic instability .
Consider a bank commitment made at time t = 0 to lend any amount up to
L* at time t = 1.

By assumption , the effectuared loan will have a one-period

term-to-maturity and the rate of interest on the loan will be the prime rate

(rp ) plus a constant ( k ) .


The quid pro quo is a fee paid at t = O in amount

The present value ( V ) of such a contract to the bank can be expressed

as follows:

= αL*


[E ( r ) - {E (r

) + k }] E (L ),

( 1+r ) [ I + E ( r >]

( 1)

and E ( ... ) is the expected value operator and rm is the marginal cost of
funds to the bank ." If Elrm > > {E ( r ) + k } , then C > 0 and C is
the appropriate liability entry on the bank's balance sheet . aL* would be



the corresponding asset entry and V would be the increment to the bank's
capital account.
Some might argue that the "floating prime " convention implies E ( r,m
E( rp ) in which case C < 0, provided k > 0. In this case , banks function
strictly as brokers , not as intermediaries , and Co is an asset entry .
number of considerations seem to contradict this view of C as an asset .
First , if banks face relevant capacity constraints , rm is positively unbounded
whereas r

the customary basis on which credit line interest rates are quoted ,
appears to vary within a much more limited range . Secondly , despite increased

volatility since adoption of the "floating prime ," the

intervals over

which the prime rate remains fixed are not trivial , whereas r,m can be expected
to vary continuously in time.

In addition , r, is determined externally to the

At least to a first approximation , the prime rate can be viewed as

being competitively determined .

On the other hand , r,m is subject to internal

as well as external influences .

A bank presumably can alter its marginal cost

of funds by appropriate portfolio policy.
rigidly linked .

Hence , the two rates are not

Finally, if C ≤0, the market could be expected to compete

a to a maximum value of zero , and negative values of a are not observed in
practice .

Hence , we infer C >0 and is properly a liability entry on the

bank's balance sheet .
Whether balance sheet recognition of credit lines will result in capital
dilution , say in terms of the debt/equity ratio , will depend on whether
V is greater or less than the banks debt/equity ratio at the time the credit
line is contracted .

In turn , the magnitude of V will depend upon the degree

of competition in the market for credit lines at the time of the transaction .
In any case , this issue is less important for present purposes than the question



of how economic instability influences bank balance sheets via its effect
on credit lines .

First , consider

E ( L ) = S g( L ) L dL

where g (L ) is the density describing the probability that a loan of any given
amount will be effectuated at t = | ,

In times of economic instability , the

bank's customers can be expected to be rationed out of some of their alternative
sources of credit .
higher values of L,

Hence , g (L ) shifts redistributing the probabilities toward
thereby increasing E ( L ) .

As a consequence , Co is un-

ambiguously increased while al * remains unchanged .
increase with an attendant


Hence , the bank's liabilities

of capital .

This effect is reinforced when we recognize that economic instability
will increase

( r ) , as well .

increase more siowly than E (r

To be sure , E ( r

) will rise too , but it should
) owing to the fact that the prime rate does

not vary continuously, even under the "floating prime " regime . Since


) + k] E (L )

[I + E (r

> 0

DE (r )
( 1 + r___) [ 1 + Ė ( r

) ]²

a capital loss is also sustained via an interest rate effect in times of economic

In the case where the credit line is tacit and part of an ongoing customer
relationship , OL * is replaced by a term representing the present value of
the customer relationship .

Provided the value of the customer relationship

is unaffected by economic instability , the argument proceeds pari passu . For
this to be the case , the economic instability must be viewed as short- lived and



the customer relationship
are able

as enduring .

Thus , so long as banks

and choose to honor their commitments , the effects of instability

are invariant to whether credit lines are explict or tacit .

However , should

the bank find itself unable or unwilling to honor its credit line commitments ,
plicit .

will vary according to whether the commitments are tacit or exPrimary costs in the former case are destruction of the customer

relationship which means a writing down of assets .

In the latter case , where

the fee (aL* ) is prepaid , a legal remedy can be anticipated .

In both cases ,

secondary costs may be sustained as well when information regarding the bank's
breach of contract is disseminated .

Although these secondary costs may be

independent of the form of the agreement and may substantially exceed the
primary costs , there is no reason to expect the primary costs to be the same
in the two cases .
Estimating the orders of magnitude of effects of economic instability
on capital dilution via credit lines is exceedingly difficult .

Paucity of

data on explicit lines and the total absence of data on tacit lines are only
the most immediate difficulties .

Ascertaining E ( rm ) and g ( L ) and their

sensitivity to economic instability may be even more challenging .

In any

case , there is no reason to expect such effects to be trivial , particularly
when initial levels of capital are widely believed to be low normatively as
well as historically .

Moreover , the central position of the customer relationship



in the banking literature and the practical need for contractual lines of
credit by firms active in the commercial paper market would seem to support
the view that potential effects of instability via credit lines may be quite
substantial .



Loans and Roll - Overs

Virtually all loan contracts involve roll -over commitments .
of these commitments varies widely , of course .

The strength

But even the most transient

loan customer assumes the probability of renewing his loan exceeds the probability


de novo,




vided he has satisfied the strictures of the original loan contract .


importantly, the banker perceives a cost associated with failing to accommodate
a request for loan renewal , provided the customer relationship has any force .
Certainly ,

if the customer is transient, the customer relationship is weak

and the roll -over commitment consequently will be a weak one .

Nevertheless ,

the banker will rarely refuse a customer's roll -over request without misgivings .
Roll -over commitments can be viewed as a credit line sold as a tie- in
with a loan contract .
applies .

In this case , the discussion of the previous section

Alternatively , the roll -over agreement can be viewed as transforming

the term-to-maturity of the loan into a random variable .
loan of $ 1 for one period .
loan's present values (

Consider a bank

Using the notation of the previous section , the

) can be written :

Itr + ко

= B > I

(2 )

The accounting for this loan transaction would presumably involve replacing

52-221 O - 75-20



one dollar's worth of some asset on the balance sheet with B in the loan
account and ( B- 1 ) would be carried to the bank's capital account.
that B > I is a necessary condition for the bank to undertake a loan .


if the bank knows with certainty that the loan will be renewed for one and
only one period, its value is







1 + E ( rp ) + k
= Y >‫ا‬
(Itr. >[ 1+
E (r_ )]





with y on its asset account and adjusts the capital account accordingly.


however, the loan renewal is uncertain , the present value of the loan is


l" ≤ PB + ( 1 - p) Y

where p is the probability the loan will be terminated after one period .
The equality holds in ( 4 ) when there is no discount applied for uncertainty
regarding term-to-maturity.

Alternatively, facing uncertainty regarding loan

renewal , the banker may adjust ko so that
r ୧୧୨ + k*

l¹ *= π+r

I + E(r¸¸
PI) + k*
+ ( 1 +r_ ) [ I +
E ( r_
m )]


생 = PB + ( I - p ) y*.

The expected term-to-maturity of the loan is


y* > Y




E (T) = 2 - P.

Banks generally carry their loan assets on the assumption that p= 1 . Thus ,
they understate term-to-maturity .
instead of

which creates

= B if and only if B = y*.
to imply rising r

The loan assets are typically valued at B


bias .

Given that p < 1 ,

As earlier , if we interpret economic instability

lrmi) , then y will fall whereas B remains unchanged .
and EE(r

Thus , as presently carried on the bank's balance sheet , loans are independent
of E (r

) and thus are unaffected by economic instability .

evaluated according to

, such would not be the case .


Rising E ( rm ) would

immediately imply loan and capital losses .
Still another deleterious effect, akin to the rising E ( L ) in our discussion of credit lines , is sustained due to rising economic instability.


the likelihood of a loan renewal request increases , p will fall , further

' ' relative to B.

Of course , the banks can offset the tendency

for p to decline by adopting a less acquiescent attitude , but this " leaning
against the wind" seems more likely to retard the decline in p rather than
reverse its direction of movement .

II .



The ability to attract a large and stable volume of funds at low and
virtually fixed cost is the hallmark of commercial banking .
are referred to as demand deposits is incidental .

That such liabilities

From the bank's point of view

these are long-term liabilities and to the extent that the cost of maintaining
or servicing demand deposits is lower than the alternative cost of funds with
similar term-to-maturity, the convention of carrying deposits at par value

· 296


leads to overstatement of the bank's liabilities and understatement of capital
(see Taggart and Greenbaum ) .

The liabilities should show the capitalized

value of the cost of maintaining deposits and the difference between the
capitalized value and the par value should be viewed as the capitalized
value of part of the bank's locational monopoly profit ( rent ) , which should
appear in the capital account .

If the cost of such deposits are somehow

inflated to the point where the implied interest rate on deposits equals
the alternative cost of funds , the monopoly rents disappear and it then
becomes appropriate to carry deposits at par .

Viewing deposits as perpetuities ,

this argument can be formalized as follows :

[ DM + Ro]

where DB is the par or book value of deposits , DM is the market value , Ro is
the rent earned by the bank on deposits , rD is interest rate appropriate for
discounting income and expense streams associated with deposits , and i is the
risk-free rate of return .

The market value of deposits is


where c is the cost per period per dollar of servicing deposits .

The locational

rents are defined as

( i-c)DB

If we wish to allow for the presence of reserve requirements against deposits
(K) , ( 6 ) becomes




[ i ( l -k ) - c] DB


In practice , whenever a bank attracts a deposit of say $ 1 it will increase
its deposit liabilities by $ 1 and an equivalent entry will be made on the asset
side of the balance sheet .

According to the present argument , the bank should

increase its deposit liabilities by DΜ'/DΒ and the capital account should be
augmented by Ro/Dg. When roD > i the bank's increase in footings [ ( DM/DgB ) +
(RD'/DB ) ] will be less than the book value ( $ 1 ) of the increase in liabilities.4

But this is not the main point .

Even when p = i an error in accounting is

made because RD', which is an increase in the bank's net worth, is treated as a
liability .
In addition to demand deposits , banks sell a variety of short- term
interest-sensitive liabilities , such as negotiable CD's .

Prices for these

securities are determined in highly competitive markets where information is
widely diffused and location is of little consequence .

Hence , these claims

embody virtually no rents and they are properly carried at par on the bank's
balance sheet .
Economic instability has two broad implications for the bank claims

( 1 ) high interest rates induce the public to substitute negotiable

CD's and other similar claims for demand deposits; (2 ) this substitution , which
effectively means a greater economizing on money balances -- a substitution of
labor inputs for funds in the payments process -- leads necessarily to greater
demand deposit volatility for all individual banks , i.e. , higher ro. For each
dollar shifted from demand deposits to , say negotiable CD's , the bank's capital
is reduced by [ i ( l - K) - c ]/r d and liabilities are written up by about the same

amount (assuming rp

1 ).

Crude estimates of the order of magnitude of this



effect over the period 12/64 to 11/74 suggest that capital accounts of all banks

may have declined

between $3.3 billion and $30.9 billion ( see Table 1 ) .

The lower estimate assumes that deposit rents , [ i ( l - K ) - c] , are 0.5 percent
and the increase in large denomination negotiable CD's as a percent of total
deposits measures the relevant deposit shift.5 The larger value assumes the
deposit rents are 2.5 percent and the decline in the proportion of demand
deposits to total deposits measures the relevant deposit shift (see rows
(1) and (2 ) of Table 1 ) .

In both cases r,D is assumed to be 8.0 percent .


estimated capital erosions are 5.4 percent and 50.2 percent , respectively , of
the 6/74 total capital accounts for all banks ( $61.6 billion ) .

Over the mo e

recent period , 12/70 to 11/74 , our estimates of capital erosion range
$2.8 billion to $ 17.1 billion , or

4.5 percent

6/74 recorded capital of the industry .


to 27.8 percent of

These capital losses are due ex-

clusively to the shifting of demand deposits to interest- sensitive shortterm deposits and not to the increased volatility of remaining demand deposits .
This latter effect presumably manifests itself in terms of an increase in the
rate used to discount the flows of deposit expenses and rents



example , if r,D rose from 7 to 8 percent , as a result of increased deposit
volatility and other uncertainties surrounding deposit stability , the implied
loss of bank capital would range between $ 1.9 billion and $ 9.6 billion , or

3.1 to 15.6 percent of capital on the books of the banking system in midThese estimates employ our earlier assumptions regarding [ i ( I -K ) - c ]

and are calculated


the demand deposit component of money

supply as of November 1974. To be sure , DM and the market value of the bank's footings


-18Table 1






(1) Demand Deposits/
Total Deposits






(2) Large Denomination CDs/
Total Deposits






($ billions )
(3) A(1 ) x Total Deposits ,
11/74 ($630.8 billions)



(4) A (2) x Total reposits ,
11/74 ($630.8 billions)











(5 )

(Rp₂ /Dg) x (3 )


(RD /DB) x (4)


(RD₂/DB ) x (3 )


B x (4)

Note :

= .0625 : [ i ( l -k) - c] = .005 , *D = .08

( D2/DB) = .3125:

[ i (1 -k) · c] = .025,

Source: Federal Reserve Bulletin

D = .08



will decline as well when rp rises , but this should be small comfort if
the system is operating with

II .

critically low levels of capital .

A.4 Bank Holding Companies
The bank holding company has become a formidable vehicle for effecting

diversification into areas of endeavor hitherto foreclosed to banks . In addition ,
it has fostered overall growth of the industry along with an erosion of capital .
All this has been achieved without materially affecting the balance sheets of
the banking system .

This feat of accounting leger demain was perpetrated by

establishing a separate balance sheet for the bank holding company of the form:

EB +Es

= D..
H + E.H


where EB is equity of the bank, EEs
S is equity of the non- bank subsidiary , DH
is the debt of the bank holding company and EH is the holding company's
equity .

The validity of this accounting presupposes that the financial integrity

of the bank is independent of the affairs of the non-bank subsidiary as well as
of the holding company.

That is , creditors of the subsidiary or the holding

company cannot seek legal remedy against the bank, nor will the bank voluntarily
assume obligations of these units , nor will the public's confidence in the bank
be impaired in the event of untoward developments at either the subsidiary
If the independence assumption is unwarranted , the

or the holding company .

propriety of present accounting practices becomes

dubious .

For example ,

if the bank is an effective guarantor of the system's integrity it seems proper
to consolidate the holding company into the bank .

Thus , if the bank's balance


-20sheet is

A = DB + EB


before consolidation , it becomes


S + AB = DB + DH + EH

after consolidation .

Thus , the convention of representing the bank in terms

of ( 8) has the effect of ( a ) understating the bank's size , ( b ) understating
the bank's holdings of equity , and ( c ) overstating the bank's capital relative
to assets or debt .

Points ( a ) and ( b ) require little explanation .

so long as EcS > 0.

Point (c ) , however , is not true in all cases .

They follow
If the

bank holding company issues no debt ( DH = 0 ) , conventional measures of capital
adequacy , such as the det/equity ratio or the capital /assets ratio , will show
improvement .

To the extent that there is a problem at all , it will be manifest

in the deterioration in the " quality of assets . "

company issues debt in excess of [ 1
increases ,

However , if the bank holding

(E /A ) ] Es , the bank's debt/equity ratio

7 and present accounting procedures will overstate the bank's

capital position .

In practice , the level of holding company debt required

to cause dilution is quite modest .

Consider that the recorded capital /assets ratio

for the banking system as a whole was on the order of .055 at year- end 1973. Assume
that the assets of non- bank subsidiaries are on the order of 2.5 percent of
consolidated holding company assets ( [ Ag + A ] , using present terminology ) .8
If we further assume (A /E ) = 2.0, i.e. , the subsidiaries are financed with
half debt and half equity , the critical debt-assets ratio for the holding
company is 0.176 and the critical debt-equity ratio is 0.214 . According to
Jacobs , Beighley and Boyd, large bank holding companies had debt/equity ratios
on the order of 0.45 in 1973. 9 Thus , capital erosion is a commonly observed
concomitant of the holding company form .

In its nascent stage the bank




holding company typically emits equity equivalent to the bank equity it
absorbs .

No capital erosion is sustained at this stage.

But when the holding

company subsequently purchases non- bank subsidiaries without selling equity
of at least Eg/Ag per dollar of equity purchased ( Es ) , capital erosion is sustained .

Moreover , whenever the parent sells debt for downstream passage, as when the
holding company purchases some of the bank's earning assets , capital erosion
occurs .

Given the serious doubts regarding the bank's independence within the

holding company , the consolidated accounting seems both preferable and more
consistent with conservative accounting practices than the prevailing approach .

II .


Diffusion of Regulatory Authority

The complexity of the structure of ban', regulatory institutions has
exercised scholars and practitioners alike .

For example , The President's

Commission on Financial Structure and Regulation maintained "

. . that the

widest feasible options among chartering and supervisory agencies should be
created and maintained

(The Report of . . . ) . "

In commenting on this view,

former Secretary of the Treasury Joseph W. Barr argues " ... that diffused
power over financial institutions has caused this nation untold grief and
anguish since the days of the Continental Congress .

(p. 206 )" William T.

Dentzler asserts that Barr's view
is not supported by evidence in modern times , however
accurate it might have been earlier . That flabby regulatory
activity or competition in leniency was the proximate cause
of financial disaster in the twentieth century gets harder
to sustain with the passage of each decade . ( p . 212 )
One can


interminably with, such sweeping assertions.



This is not our purpose .
clarification .
"flabbiness . "
authority .

However , one aspect of Dentzler's statement merits

The twentieth century was not a period of consistent regulatory
In fact , the period witnessed growing diffusion of regulatory

We entered the twentieth century with but one federal bank regulatory

authority , the Office of the Comptroller of the Currency .
of the century we added the Federal Reserve System .

In the second decade

The third federal regulatory

authority was created in the fourth decade , and in the seventh decade we
added a fourth .

Clearly , Mr. Dentzler's statement would be more accurate if

his time-frame was restricted to the post-World War II period .

But we have

already argued that this period was extraordinary in at least two respects .
First, it was an era of unparalleled economic stability .
the period with historically high levels of liquidity .

Second, banks entered
Hence , it can be argued

that the present regulatory framework has yet to be severely tested .


the eighth decade of the twentieth century , we find the milieu quite change
so that it now seems plausible to expect our regulatory institutions to be
tested for the first time .
The primary rationale for diffusion of regulatory authority is that in
creating a form of competition among regulators we reduce the likelihood of
capricious behavior based on undue concentration of power .

The issue raised is

whether diffusion of authority is the optimal means for achieving the objective.
Given that the regulatory authorities are instrumentalities of the legislature charged with implementing an articulated , if somewhat vague , mandate
and also are subject to legislative oversight , why should it be necessary to
create competition among agencies in order to limit capriciousness ?
a kind of paradox here .

There is

If regulators overstep their powers , they are subject

to removal from office for malfeasance . Thus , the objective of competition among



regulators must be to discourage ( full ) use of

mandated powers.

But if it

is considered undesirable to exercise the mandated powers , why were they granted ?
why not simply circumscribe such powers as are
deemed excessive and thereby alleviate the need for multiple regulatory agencies?
If there were no costs associated with the proliferation of regulatory agencies ,
the question would be uninteresting .

But certainly this is not the case

(see ,

Ali and Greenbaum , [b] ).
Perhaps most evident and least important among these costs are the resources consumed as a result of duplication of efforts and inter-agency
bickering in jurisdictional disputes .

These problems have been rendered

manageable by assigning supervisory responsibility for national banks to the
Comptroller's Office , state- member banks to the Federal Reserve , and other
insured banks to the F.D.1.C.

Still many day- b- day issues require inter- agency

cooperation that , at times , is difficult to elicit .

The problem stems from

the inescapable fact that communication and harmonization of views is more
difficult between agencies than within an agency .
A second type of cost is traceable to the same source .

In times when banks

are failing , or in jeopardy of failing , expeditious action may be of utmost importance .

Public confidence is at issue and delay may be interpreted as in-

decisiveness .

Diffused authority inevitably tends to retard

reactions.10 What was a virtue in times of economic stability , becomes an
Achilles Heel in times of stress !
.A third type of cost may be of transcendent importance .

Diffusion of

authority tends to frustrate a holistic view of the regulatory problem ( see ,
Greenbaum and Haywood) .

Public regulation is essentially an optimizing

problem in which a legis tature creates an agent for the purpose of implementing
its will .

The legislature conveys its objective function and a set of instruments

to the agent along with instructions to use its instruments ( make policy )



so as to optimize the objective function ( see , Ali and Greenbaum, [ a] ) . Generally ,
the objective function is somewhat ill -defined and subject to change .


addition , the instruments may be inadequate or inefficient for the purposes
at hand.

A subsidiary responsibility of the agent is to advise the legislaregarding

definition of objectives and

selection of

instruments .

Quite naturally , the agent is viewed as an expert in its area

of activity .

However , fragmentation of responsibility among agents tends to

narrow their focus leading to a kind of myopia .

For example , the F.D.I.C.

could easily overestimate the importance of the integrity of the deposit
insurance fund .

Similarly , the Federal Reserve might conceivably become pre-

occupied with
monetary policy .

the banking system's usefulness as a conduit for
The Comptroller might concern himself with some notion of

balance within the "dual system . "
with geographically narrow issues .

State authorities , of course , are occupied
Who will then ask about the overall

motivation and intent of regulation? One might even ask if it wasn't the
to avoid this central issue , on the part of anti -regulation interests ,
that led to the proliferation of agencies and the fragmentation of responsibilities?
In placid times , these questions are easily ignored.

In times of stress , they

come to the fore .


We have argued that secularly rising interest rates combined with extra-

ordinary economic stability in the post-World War II period prompted banks to
trade-off liquidity and capital protection for enhanced return . This portfolio recomposition was a reasoned and reasonable reaction to a new

weltanschauung in which

economic stability was viewed as a permanent



condition .

Unfortunately , events of the 1970's have proved the new view

somewhat premature , at best .

Thus we find ourselves with a banking system

that is much more vulnerable than the one we had but a few years ago.


quick transformation of the banking system's balance sheet to the status quo ante



impractical .

We are therefore left with

the question of what can be done in the realm of public policy to mitigate
the vulnerability and/or its implications .
It is maintained that current accounting practices in banking are seriously
inadequate if such data are to indicate the contemporaneous condition and
prospects of the firm and industry.

Both earning assets and liabilities are

improperly measured in a way that systematically insulates the balance sheet
from the effects of economic instability .

Without an adequate data base ,

regulatory oversight and control is impossible .

Indeed , recent calls for the

development of an "early warning system " to identify banks in trouble can be
viewed as recognition of our more explicit arguments relating to bank accounting

If unsound accounting practices are eliminated ,

the balance

sheet becomes an early warning system.
A second issue raised relates to the diffusion of regulatory authority .
This effective but inefficient device for limiting the power of regulators
warrants reassessment in a time when prompt action on the part of regulators
may be of heightened

importance .



[1] Labor contracts are similarly omitted .
[ 2 ] For simplicity , independence among random variables is assumed .
[ 3] Explicit accounting for the possibility of failing to honor commitments
will alter both the asset and liability components of V and both will
be sensitive to variations in E ( rm ) . Thus , ignoring the possibility
of breach of commitments simplifies the analysis considerably . The
assumption is justified to the extent that bankers view the costs of
breaking their commitments as always prohibitive . But it is in times
of stress that this is least likely to be true .
[ 4] This means that when the bank purchases one dollar of assets with the
proceeds of one dollar in D , the assets embody an element of rent , as
well . That rent element of assets can be represented as [ 1- ( DM
) /DB ] ,
Μ + R
or ( Ii /r ) . By arbitrarily assigning the asset rent to deposits
have Ro = R. + ( 1 1
ro - c)Dg/ro and footings will then increase
i/ro) = ((rp
one dollar for each dollar increase i DB'

[ 5] Large denomination negotiable CD's are those of weekly reporting banks ,
exclusively . Total deposits are for all banks , but include only money
stock components .
[ 6] For detailed discussions of this issue , wherein it is maintained the
independence assumption is questionable at best , see Chase and Areeda .
[ 7]

An unchanged debt/equity ratio for the consolidated bank implies
EH = EB + (EB/AB )ES .

Since from (7)
E.. = E
H ES + EB - DH'
it follows that

[ 8]


Jacobs , Beighley and Boyd found that among a sample of 100 bank holding
companies , selected from among the 150 largest in the U.S. in 1973,
non-bank subsidiaries accounted for 2.1 percent of consolidated holding
company assets . These subsidiaries generated 4.0 percent of total
earnings .



[ 9]

Our assumption that (A /E ) = 2.0 considerably understates the observed
leverage among non- bank subsidiaries in Jacobs , Beighley and Boyd . Moreover, as leverage among the non-bank subsidiaries is increased the critical
debt/equity ratio for the holding company declines . For example , if
(As /Es ) = 5.0 ,
the critical value for ( DE ) = 0.088 .

[ 10] For an illustration , see C. Welles fascinating account of the Franklin
National debacle .



Ali , M.M. and Greenbaum , S. 1. [ a] "The Regulatory Process in Commercial Banking . "
Proceedings of a Conference on Banking Structure and Competition ,
Chicago: Federal Reserve Bank of Chicago , 1972 .
[ b] "Stabilization Policy, Uncertainty and Instrument Proliferation. "
Economic Inquiry, forthcoming .
Areeda , P.E. " Discussion . " A discussion of The Bank Holding Company
A Superior Device for Expanding Activities ?, by Chase , S.B. Jr. ,
Policies For A More Competitive Financial System: A Review of the Report of the President's Commission on Financial Structure and Regulation, Boston : Federal Reserve Bank of Boston , 1972 .
Barr , J.W. "A Revised Regulatory Framework . " Policies For a More Competitive
Financial System: A Review of the Report of the President's Commission
on Financial Structure and Regulation , Boston : Federal Reserve Bank of
Boston, 1972 .
Brimmer, A.F. ar.d Dahl , F.R. "Growth of American International Banking:
Implications for Public Policy . " Journal of Finance , XXX ( May 1975 ) .
Chase , S.B. Jr. "The Bank Holding Company - A Superior Device for Expanding
Activities?" Policies For a More Competitive Financial System : A
Review of the Report of the President's Commission on Financial Structure
and Regulation , Boston : Federal Reserve Bank of Boston , 1972 .
Dentzler , W.T. "Discussion . " A discussion of A Revised Regulatory Framework ,
by Barr , J.W. , Policies For a More Competitive Financial System: A
Review of the Report of the President's Commission on Financial Structure
and Regulation , Boston : Federal Reserve Bank of Boston , 1972 .
Greenbaum , S. 1. and Haywood , C.F. " Secular Change in the Financial Services
Industry. " Journal of Money , Credit and Banking 111 , pt. 2 (May 1971 ) .
Jacobs , D.P. , Beighley , H. P. and Boyd J.H. The Financial Structure of Bank
Holding Companies . Chicago : Association of Reserve City Bankers , in
press .
Klebaner , B. Commercial Banking in the United States :
Illinois : Dryden Press , 1973.

A History .

Hinsdale ,

Minsky, H.P. "Financial Instability , The Current Dilemma , and The Structure
of Banking and Finance . " A paper prepared for a compendium of the
Senate Committee on Banking , Housing and Urban Affairs , in press .

Taggart , R. A. and Greenbaum , S. 1.

"Bank Capital Adequacy . " Unpublished mss .

The Report of the President's Commission on Financial Structure and Regulation .
Washington D.C .: U.S.G.P.0 . , 1971 .
Welles , C. " The Needlessly High Cost of Folding Franklin National , " New York
7 (November 18 , 1974) .

52-221 O - 75 - 21



Hyman P. Minsky
Washington University
St. Louis , Missouri

A paper prepared for a Compendium of the Senate Banking Committee , January
1975 .



In a talk in Honolulu in October 1974 , Chairman Burns of the Board of

Governors of the Federal Reserve System informed the American Bankers Association of his concern with " maintaining the soundness of our Banking System" .
After noting that " --questions have been raised about the strength of our
nation's , and indeed the world's , banking system" , Chairman Burns pinpointed
five causes for his concern .
--first the attenuation of the banking systems ' base of equity
capital ; second , greater reliance on funds of a potentially
volatile character ; third , heavy loan commitments in relation
to resources ; fourth , some deterioration in the quality of
assets ; and , fifth , increased exposure of the larger banks
to risks entailed in foreign exchange transactions and other
foreign operations .
Chairman Burns concluded his talk by noting that " our regulatory
system failed to keep pace with the need , " and that , "--a substantial
reorganization (of the regulatory machinery ) will be required to overcome
the problems inherent in the existing structural arrangement .'
In truth , over the era since the end of World War

II , and more parti-

cularly in the past decade , when the Federal Reserve and other monetary
authorities responded to the siren call of monetarism , our bank regulatory
system not only failed to keep pace with the need for control created by
the evolving banking and financial system, but in addition the quality of
regulatory control deteriorated as the regulations became increasingly
permissive .

The lessons of history , to the effect that unregulated or

inadequately regulated financial institutions and markets tend to generate
unstable financial relations , were forgotten.

The Federal Reserve and the

other authorities substituted the pursuit of a magic bullet , a " correct "
monetary variable , that would automatically achieve the objectives of
stabilization policy , for apt regulation .

The lesson of history was lost ,



even as the credit crunch of 1966 and the Penn-Central /Commercial Paper
Market crisis of 1970 showed that there were present dangers that a financial crisis could occur .
In this paper I will mainly address myself to these properties of our
financial system that make financial crises and debt deflations a normal
outcome of system behavior .

The paper will take up the following :


economic behavior which tends to make the financial system at times fragile
(a fragile financial system is susceptible to financial crises and debt
deflations ) , the pressures from profit maximizing behavior that leads to
increases in leverage and speculative finance by banks , the data from the
flow of funds accounts which enables us to trace the increase in the fragility of the financial system in the years since 1951 , and some tentative
suggestions for economic policy in the current situation
financial system and of regulatory practices .

These suggested reforms ,

while not promising to eliminate the tendency to financial instability ,
might serve to slow down the development and lessen the repercussions of
fragile situations .
Fundamentally, unless policy makers are aware of the possibility of
financial instability and unless they recognize that these possibilities
are inherent in our economic system , they cannot correctly diagnose what
can go wrong and therefore the measures they undertake will not be apt .
Even though the Federal Reserve system has had to cope with the episodes
of financial instability , these phenomena have not been inter

ted in the

views that guide monetary policy and their recommendations to the Congress
and the Administration for economic policy measures .

The primary objective

of this paper is to help increase the awareness of the Congress and other
policy makers of the fact that financial instability exists and that this



fact has to affect our policy prescriptions in both the short run, when
we try to work out of our present inflation/ depression dilemma , and in the
longer run when we consider reforms of our banking and financial structures .



II .

The Roots of Financial Fragility
A basic attribute of the financial arrangements in our economy is that

control over the capital assets used in production by ordinary business
firms , as well as the ownership of financial assets by financial institutions ,
is financed by some combination of debts , both long and short term , and an
equity interest .

Another basic attribute is that debt instruments set up

a contractual commitment to pay dollars , and that there is a meaningful
penalty for any economic unit which does not fulfill these payment commitments .
The dollar payment commitments are on account of both principal and interest ,
and the conditions which determine the size and the dating of the cash payments that are due are set forth in the debt instruments .

With greater or

smaller certainty , depending upon the conditions in the contracts , the liability structure of every economic unit can be translated into a time series of
contractual cash payments .
As the contractual cash payments are on account of both principal and
interest , a given face value of debt in the form of short term notes ( i.e.
the face value of the debt as well as an interest charge is due in say six
months ) will require a greater cash payment in the near term be made than
the same face value of debt in the form of long term bonds ( i.e. a long term
bond only requires payment of interest until its due date , say twenty years
from now) .

The cash flow commitments in a debt structure are determined by

the time to maturity of the debt .

Any analysis of the impact of debt which

ignores this time shape of payment commitments can be misleading .
The capital assets controlled by a business firm are valuable either
(1 ) because the firm is expected to generate a series of cash receipts , net
of the payments to cooperating factors , by using these capital assets in its
business operations or ( 2 ) because some other firm is willing to buy them



because this other firm believes it could use these capital assets to generate cash in business operations .

These cash flows from operations , which

are imputed to the capital assets owned by the firm , are the sum of the gross
profits after taxes and the interest paid on outstanding debt .

That is ,

capital assets are valuable because they are expected to yield cash in the
form of net profits , depreciation allowance , and funds that are used to pay
interest on debts .

In a fundamental sense, in our economy capital assets are

valuable not because they are productive but because , at least potentially ,
they can be so used as to generate profits .
The typical financial instrument in a portfolio generates cash as the
terms on the financial contract are fulfilled .

The exception is money -

cash itself - which in the portfolio represents an ability to fulfill contractual obligations and purchase goods , services , or assets that does not depend
upon the fulfillment of any contract .
is in the form of deposits in banks .

(In fact , in our system , most money
Therefore I am implicitly assuming that

banks will always honor valid checks that are drawn on accounts .

When banks

fail and depositors lose - as often happened prior to deposit insurance -

this assumption is violated .

It is interesting to note in passing that there

were significant runs on both the Franklin National Bank and the Security
National Bank as stories about their predicament spread . )
However, if a particular type of financial instrument is widely held
and broadly acceptable it may be used to generate cash for a firm or financial
institution by being sold or used as collateral for a loan .

This ability to

generate cash quite easily by sale is what is meant by liquidity .


assets and financial instruments form a spectrum of assets in terms of liquidity .

Those assets which have poor marketability are valuable only for the

cash they are expected to generate as they are used in production , whereas



money , which generates no cash , is valued solely for its liquidity .
Thus the balance sheet of any economic unit - ordinary business firm,
financial institution , or household - can be looked at as a generator of
cash towards and cash from the unit .

A fundamental attribute of our economy

is that there exists a complex system of borrowing and lending .


this borrowing and lending is based upon some margins of safety which presumably are necessary to induce both the borrowers and the lenders to " do
their thing . "

In order to understand how our economy operates , it is neces-

sary to understand what effect this system of borrowing and lending has upon
system behavior and in particular how the margins of safety that are acceptable at any time depend upon market values as well as the subjective valuations of both borrowers and lenders .
We can distinguish two types of economic units by the nature of their
cash receipts /contractual cash payment relation .

Units engage in hedge

financing if expected cash receipts over every relevant time period in the
future exceed

their contractual payment commitment , whereas units engage

in speculative finance if for some time periods , usually near term , the contractual payment commitments exceed the expected cash flow from either
"operations " or " contract fulfillment . "

The place of a financial system on

a robustness - fragility scale depends upon the relative extent and the nature
of speculative finance in the total financial position .
Inasmuch as all economic units can be looked at in terms of these cash
receipts - cash payment commitments one focus of the control of financial
institutions exercised by regulatory authorities should be a cash flow analysis of liabilities and assets .

Such a cash flow analysis should look at the

cash flow relations as a conditional phenomena , and the economic events
which could make fulfillment of the contractual commitments questionable



should be identified by the regulatory authority .

One weakness of existing

bank regulation and bank examination proceedures is the tendency to look at
balance sheets and income statements while virtually ignoring cash flow
relations .
There are both rational reasons and market processes which lead firms ,
households , and financial institutions into speculative finance .

The relative

weight of speculative and hedge financing in the economy determines the likelihood of financial instability .

A financial system in which financial

instability can be induced by relatively small changes , or by a multitude of
channels , is fragile .

If it takes large changes and there are only a few

channels by which financial instability can be induced then the financial
system is robust .
However , even for hedge financing units , there exists the possibility
that the cash flow from operations will be interrupted - ' accidents ' can
occur which require unexpected cash outlays .

Thus a unit , in order to make

its promise to pay on debts believable , will keep some cash on hand as , so
to speak , an insurance policy

for both the debtor and the creditor .


appropriate ratio of cash on hand to debt payments commitments is a subjective phenomena and it depends upon the views of the borrower and lender about
the likelihood that the expected cash flow from operations will in fact be
realized .

If over a period of time the cash flow from operations equals or

exceeds that which was ' expected ' when financing relations were first established , then it is likely that the view as to what is appropriate in cash
holdings will decrease ; the inverse is true if the cash flow from operations
falls short of expectations .
For a firm which hedge finances its positions in capital assets , the
expected cash flows from operations are expected to exceed the cash payment



commitments over each period .

As a consequence , if the cash payment commit-

ments and the expected cash receipts are capitalized at the same interest
rate , the present value of the receipts will exceed the present value of the
payments ; i.e. , the market valued "equity " will be positive and for a hedge
financing unit this equity will remain positive regardless of changes in the
interest rate .
The positive equity provides a margin of safety for the holders of debts ,
although in truth , for hedge financing units this margin of safety is nothing
but a reflection of the difference between the cash flows .

However , the

current value of the margin of safety in equity values is inversely related
to interest rates , the higher interest rates the smaller the margin of safety
as measured by equity .
To an economic unit , the cash , that is kept on hand as an insurance
policy , is , in one sense , barren:

although it yields a return in safety and

convenience , it does not yield a measured cash flow .

As it ' sits ' in port-

folios it represents unused purchasing and financing power .

If financial

instruments exist which offer both a close approximation to the safety and
convenience that cash yields and some net cash flow , these instruments can
be substituted in portfolios for the cash that is held in such " expectational "
or " speculative " balances .

Obviously , if a financial instrument offers a

good measure of safety and convenience , its price per dollar of positive
returns will be higher than the price per dollar of returns of those instruments , which , even though protected by equity and the excess of cash flows
over payment commitments , do not offer such safety and convenience .
Inasmuch as the near future is usually better perceived than the more
distant future and as the swing in the market price of a financial instrument
as market interest rates vary is smaller for short term than for long term



instruments , there is a presumption that the instruments which yield safety
and convenience together with income and thus are a good substitute for cash
assets will be short term .

Out of the need to keep cash on hand , to assure

the lender to hedge financing units that minor difficulties will not seriously
affect the ability of the borrower to meet commitments , a supply of short term
finance arises .

Furthermore the more favorable terms available on short term

debt induces firms , households , and financial institutions to use such debt :
short term debt financing can be cheaper and thus an organization borrowing
short can earn a higher net cash flow imputed to its equity interest .
A dynamic economy is characterized by innovations and in our economy
innovations occur in finance as well as in techniques and products .


principal focus of financial innovation in our economy has been the development of instruments and institutions by which otherwise idle pools of cash
are , so to speak , activated as a source of finance for enterprise .
Historically, the origin of commercial banks rests , in part , upon banks
offering a more convenient substitute in the forms of demand deposits for
what was then cash , specie .
in speculative finance .

In many ways , banks are the " model" unit engaged

Demand deposits and pass book savings deposits are

at least in principle of shorter duration than the bank's loans and investments .

So , for a bank the possible cash outflow can exceed the contractual

cash receipts over a time period .

To allow for this contingency , commercial

banks , even when unregulated , keep a significant ratio of cash to deposits .
Furthermore , they keep a portion of their assets in liquid form : i.e. , in a
form which could be sold in a market with many participants .

These liquid

assets constitute a supply of short finance upon favorable terms .
In a modern banking system, a cash drain from a bank will typically show
up as a clearing loss , which implies that other banks in the system have



clearing gains .

The liquid assets in the banking system are those which can

easily be transferred from one bank to another to facilitate the adjustments
to clearing losses and gains .

The existence of marketable assets enables a

bank to adjust to transitory clearing losses and gains without affecting its
ability to engage in financing those units which cannot easily generate
broadly marketable assets .
Just as the specialized durable capital assets of ordinary business firms
cannot be " traded " easily in order to meet cash payment commitments , so the
basic loan portfolio of a bank consists of assets whose marketability is
limited .

The holding of secondary reserve is a phenomena that is common to

all units which have financed positions in capital or financial assets , which
have limited markets , by debt .
In the history of banking , from time to time the acquisition of funds
by selling assets in markets ran into difficulties .

Central banks evolved as

the institution which , either by lending or by operating in financial assets ,
assured that any excess requirements for cash would be met by a new infusion
of cash .

Even though the emphasis in the recent literature on Central Banking

has been upon the effect of Central Bank operations in controlling the economy ,
it must be remembered that the initial incentive for Central Banks came from
the need for a lender of last resort , i.e. , an institution that would support
the liquidity of banks and other financial institutions when such support was
necessary .
Even though speculative finance is most clearly characteristic of banking ,
the tendency to borrow short to finance positions in long assets is a quite
pervasive characteristic of the economy.

Once a unit borrows short in order

to finance a position in long assets , cash payment commitments over the near
time periods exceed the cash receipts expected over this time period .



such circumstances , the firm , like a bank , will either have to sell assets
or borrow to repay debt .

The borrowing to repay debt may either take the

form of funding the short term debt , -i.e . , selling long term debt to pay off
the short term debt - or it may take the form of issuing new short term debt

to repay short term debt - simply refinancing the debt .
For example , the construction business is heavily dependent upon being
able to replace short term debt by long term debt .

Construction financing

is for the duration of the building time and upon completion of the project
is replaced by " permanent " long term mortgage financing .

The period following

the Penn-Central crisis of 1970 saw a burst of long term debt financing as
firms replaced short term financing with long term debt .
When a unit is in an hedge financing situation the expectation is that
the cash flow it will receive from operations will exceed the cash payment
commitments .

If the expected cash receipts exceed the cash payment commit-

ments for every time period , and if the discount rate applicable to cash
receipts are not too much greater than the discount rate applicable to cash
payments , then the equity in the unit will be positive .

In a sense , interest

rate changes and vagaries of financial market behavior will not seriously
affect the liquidity or solvency of the firm .

To a large extent the only

thing that can go wrong is in the cash receipts from operations .

The risks

for a hedge unit are the ' business risks ' due to the product and factor
markets in which it operates .
The picture is quite different for a unit that engages in speculative
finance .

First of all , because the cash payments commitments come earlier

than the cash receipts , changes in interest rates can affect the solvency of
the firm :

a rise in interest rates will lower the relative present worth of

later cash flows and can lead to a negative net worth .

Secondly , the unit



can be brought into difficulties because of changes in the short term financial market .

If a financial market upon which it is dependent becomes dis-

organized , or if a unit it counts on for refinancing is in difficulty , it
may be either unable to acquire the cash to pay debt or it may have to pay a
very high price .

Thus while a hedge unit is impervious to say changes in

short term interest rates or changing market preferences with respect to
financial instruments , a speculative unit is vulnerable to such changes .
Thus a speculative unit is doubly vulnerable :

not only may things go wrong

in its product and factor markets , but things may go wrong in the financial
markets upon which it is dependent .
A clear example of the dangers inherent in speculative finance is found
in the predicament of the United States savings banks over the past decade .
The predominant asset in the portfolio of these institutions are fixed interest rate - fully amortized - long term mortgages , whereas their liabilities
are mainly short term :

at one time these liabilities were predominantly

virtual demand liabilities , today there is a fair mixture of dated certificate
of deposits in their liability structure .

The mortgage assets generate a

cash flow towards the unit that does not fluctuate with market interest
rates , whereas the units need to meet market interest rates if they are to
hold deposits .

Thus in a period of rising interest rates , the cost of hold-

ing deposits increases relative to the cash that is generated by portfolios .
In drawing up the "balance sheets " of these units , the mortgages that
are current are always valued at their face value .

However , when market

interest rates rise , the market value of these mortgages fall , whereas the
market value of the savings banks virtually demand liabilities do not fall .
Thus the "balance sheets " of these units , if assets were valued at market
rather than at face , could show a negative net worth .

In fact , for most of



the past decade , the savings institutions · and perhaps many of the life

insurance institutions - have had a negative market value net worth :
on the basis of market values they were insolvent .

i.e. ,

Many of the problems in

our home financing and construction industry can be related to this technical insolvency of these institutions .
Incidently , there is a rather simple solution to the problem of the technical insolvency of savings institutions .

It is to make the standard mort-

gage a long term fully amortized variable interest rate instrument .
transition should have been made early in the 1960's .


An emphasis upon the

quantity of money, rather than upon the pattern of market interest rates , in
monetary policy is fundamentally inconsistent with the institutional arrangements we have for financing real estate .

Reform of the standard mortgage is

long overdue , and should be an integral part of any broad gauged reform of
our financial system.
As mentioned earlier , a hedge financing unit will keep cash or its
equivalent in its portfolio as an insurance policy against some shortfall in
its cash receipts .

A speculative financing unit has to keep cash or its

equivalent on hand , not only because of possible shortfalls in its cash flow
from its business but also because something may go wrong in the financial
markets it depends upon for refinancing .
Of course cash or its equivalent can be ' promises to lend . '

The loan

commitments by banks ,which is one concern Chairman Burns articulated , reflect
the need of units which engage in speculative finance to have a "fall back"
position in their financing .

In a world where money is tight and expensive ,

a promise to supply cash becomes a substitute for cash .

In a financial

system with a large volume of speculative finance , the promises to lend by
commercial banks play the same support function for speculative borrowers as



the implicit promise of the Federal keserve to support the commercial banks
plays in the banking system .

Thus units which borrow by issuing commercial

paper have lines of credit at banks to back up their commercial paper .
Before industrial corporations became heavy borrowers in the commercial paper
market , the various classes of finance companies that issued commercial paper
used bank lines of credit as a ' guarantee ' to their lenders that they could
repay the commercial paper when the due date arrives .
Note that the inherited cash flow relations of a unit which engages in
hedge financing are impervious to changes in financial market conditions : it
can fulfill its contracts as long as the cash flow from operations are a
reasonable approximation to those that were expected when the contracts were
made .

Of course the performance of the unit may fall short of expectations

either due to management or judgemental errors or to a decline in business
activity .

If we can ignore the management and judgemental errors as being

an always present phenomena , in a world where hedge financing is the rule ,
whatever financial market disturbances occur will follow declines in aggregate income .

Furthermore , in a world where hedge financing predominates ,

financial dislocations due to fraud or incompetence such as , for example , the
Billy Sol Estes and the salad oil cases of relatively recent history will not
cause widespread repercussions .
For units that engage in hedge financing , changes in the terms upon
which financing is available through bonds or bank loans will affect current
and future decisions to acquire assets .
by private units is investment .

The net acquisition of capital assets

Thus , in a world characterized by hedge

financing by business firms , changes in financial markets will affect spending
as firms take the new financing terms into consideration .

Monetary policy

changes which affect interest rates will work on the economy only as they



affect spending .

This "one route only" between financial markets and income

is the basis for the standard policy prescriptions .
On the other hand , for units which are engaged in speculative finance
changes in the terms upon which financing is available will affect not only
such spending as is externally financed , but also the terms upon which refinancing is available and the equity market valuation of the position of the
unit .

By affecting refinancing terms , the future cash flow commitments due

to past decisions are affected - and if the current refinancing terms throw
either the cash flows or the equity position into a too unfavorable relation
refinancing may not be available .

Thus illiquidity and insolvency - the

two roots of bankruptcy - are much more likely to occur in a regime heavily
weighted by speculative finance than in a regime dominated by hedge finance .
But it is not only the likelihood of bankruptcy which depends upon the
relative weight of speculative and hedge financing in the economy .
as the portfolio assets which normally are not used to acquire cash by sale
of assets do have the potential of being sold to acquire cash , units faced
with refinancing problems will try to use such assets .
are not normally traded , their markets are rather thin .

Because these assets
This means that an

increase in the supply available can lead to a sharp decline in market price .
Once the price of second hand capital assets is substantially below the
current production costs of similar newly produced assets , the production of
such assets capital assets comes to a halt .

This situation characterized the

housing market in the 1930's , and is a present threat in the difficult
financial position of the Real Estate Investment Trusts .

An example of the

fall in asset prices in financial markets is the break that occurred in the
price of municipal bonds in 1966 when banks tried to make position by selling
some of their bond portfolios .

52-221 O - 75 22



A fall in asset prices due to the need to sell out positions in asset
prices in attempts to acquire cash can lead to much greater declines in
asset prices than would occur simply from swings

in interest rates .


the likelihood that investment will be severely affected as a result of
financial market changes is much greater in an environment in which speculative finance looms large than in one that is dominated by hedge finance . But
a severe decline in investment is one of the attributes of a deep depression .
A severe decline in income transforms units that hedge financed positions into
speculative financing units as the cash flows from operations falls below the
initial expectations .

Thus in a world in which speculative finance looms

heavily , the adverse investment effects from speculative finance can lead to
a large enough drop in income so that even the hedge financing units have
difficulty meeting their commitments .
Thus in an economic environment in which speculative finance is sufficiently large , there are a number of chamels by which a restrictive monetary
policy can affect the economy .

One is by affecting the financing terms for

current and future spending i.e. , the only route by which restrictive monetary
policy affects income in a regime dominated by hedge finance .

A second works

through affecting the financial viability of ordinary firms and financial
institutions .

By forcing units into exotic attempts to remain viable , this

second route can lead to widespread financial instability .

Furthermore in a

world with speculative finance a deep depression is much more likely to occur,
so that the units which initially hedge financed can be brought into a difficult situation by a decline in their cash receipts .

In a world where specu-

lative finance is important , financial crises , debt deflations , and deep
depressions can be a consequence of monetary policy actions .
The likelihood of a financial crisis occurring can be called the fragility



of a financial system .

If all units are engaged in hedge financing , then

a financial crisis can occur only if the fall in income is sufficiently large
so that cash receipts from operations for a sizeable number of units falls
below the cash payment due on debts .

If the margin of safety in expected

cash flows are significant , then a financial crisis can occur only if a large
decline in income first occurs .
financial crisis .

Purely financial conditions cannot cause a

Under these circumstances , a financial crisis is unlikely

and the financial system can be considered robust .
If some units are engaged in speculative financing, then purely financial
market changes - such as higher interest rates

can throw the cash payment--

cash receipts relations into disarray in the absence of a prior large decline
in income .

The larger the extent of speculative financing in an economy , the

larger the number of units that can be adversely affected by financial
market changes .

Furthermore , if we think of the extent to which positions

in non-marketable or difficult to market assets are financed by short term
liabilities as a measure of the degree of speculative financing by units that
engage in speculative financing , the units which have gone further in speculative financing can be thrown into difficulties by smaller changes in financial market conditions than is true for units which speculatively finance
only a small proportion of their positions .
Therefore the larger the proportion of units that engage in speculative
finance and the larger the proportion of assets that are financed by short
liabilities the smaller the change in financial market conditions that can
cause a reversal of cash flow relations or a transformation of the net equity
value to a negative number .

That is the susceptibility of a financial system

to a financial crisis depends upon the extent and the degree of speculative
finance ; the extent and degree of speculative finance determines the relative



fragility of an economy .
Inasmuch as the deep depressions of history are associated with financial crises and debt deflations and whereas such financial market distrubances are absent in the mild depression cycles , monetary constraint in a
regime of speculative finance can have much more serious consequences than
in a regime of hedge financing .
The ability to control income , employment , and prices by monetary policy
is circumscribed by the consequences of policy actions .

If monetary constraint

leads to the likelihood of a debt deflation and a deep depression restraint
cannot long be sustained .

If , for example , the Federal Reserve responds by

monetary constraint to an inflationary situation and this leads to what the
Federal Reserve perceives as an imminent threat of financial instability , the
Federal Reserve will respond , as in 1966 and 1970 , by abandoning restraint and
moving to support the weak institutions and the threatened markets .


support operations lead to a sharp infusion of actual or potential Federal
Reserve Credit into the financial system .
One relation that makes financial instability an imminent threat is a
high ratio of cash payment commitments to the cash flows from operations .
Inflation , especially as it accelerates after a pause , leads to a rapid increase in the gross profits , inclusive of interest payments and after taxes ,
from operations of business firms .

Thus some of the danger of a debt- deflation

can be floated off by accelerating inflation .

An aborted financial crisis ,

following monetary constraint , will lead to a pause in income growth or even
a decline in income .

The monetary and fiscal response to such a recession ,

in a regime heavily laden by speculative finance , tends to validate the
instruments used in the speculative finance and sets the stage for further
adventures in specualtive finance .

Thus every success by the Federal Reserve



in supporting a fragile financial situation accompanied by success , due to
monetary and fiscal policy actions , in offsetting recessionary tendencies
in income will lead to an acceleration of inflationary pressures .
Since the middle sixties we have experienced three episodes of imminent
financial crises : the credit crunch of 1966 , the liquidity squeeze/Penn
Central crisis of 1970 , and the current difficulties .

All three of these

imminent crises followed upon periods in which monetary constraint was used
as the major anti-inflationary weapon.

In both 1966 and 1970 the imminent

crisis was aborted by Federal Reserve action , and monetary and fiscal policy
were used both to sustain the economy and induce expansion .

Inflation after

the resumption of expansion following the 1966 episode was at a higher rate
than before 1966 , and similarly the inflation between 1971 and 1974 was
worse than between 1967 and 1970 .
We seem to be trapped in a dismal cycle which has the following states :
monetary constraint , threatened financial instability , Federal Reserve
support of the financial system, monetary and fiscal policy to sustain and
increase income , and accelerating inflation - which leads to monetary constraint .

The resolution of this dismal cycle can be achieved only if we

achieve a more robust financial environment .
of speculative finance in the economy .

We need to reduce the weight




Commercial Banking as a Speculative Enterprise
Because commercial banks are the key private financial institutions ,

developments in commercial banking are of central importance in determining
where the economy is on the robustness /fragility scale .

Commercial banks are profit maximizing , highly levered, speculative
enterprises .

Profit maximizing by banks can be interpreted as an endeavor

to maximize the rate of return on owner's equity , i.e. book value .


divided by equity can be taken to be the product of two items : profits per
dollar of assets and assets per dollar of equity .

Bank management can seek

to maximize profits by operating on the returns earned on assets , the cost
of liabilities , operating and management costs , or the ratio of assets to
book value .

That is to increase profits banks can either become more efficient

or increase their leverage .
Much of what happened in banking over the era since World War II , as well
as some of the present policy dilemnas , follow from the speculative nature of
banking .
The profit equation of a bank and some of its implications are illustrated
by the following example .

If a bank makes 1% on total assets , net of operating

and liability costs and after taxes , and has $15 of assets for every dollar
on equity it will make 15% on equity .

If such a bank pays one third of these

net earnings in dividends , then the book value or equity will increase by 10% ,
the ratio of retained earnings to book.

If the equity base increases by 10%

due to retained earnings , then for the rate of return on equity to remain the

same - which we can assume is a minimum management objective - it is necessary
either to increase the net rate of return on assets or to increase



and the liabilities other than equity .

We can assume that when things are

going well management will endeavor to achieve a rate of growth of total
assets and the liabilities other than equity at least as large as the rate
of growth of equity .
Regardless of the actual achieved rate of return on equity and the
actual ratio of dividends to earnings , we note that the internal dynamics
of banking will determine a rate of growth of bank assets that management will
try to achieve , and this rate of growth is related to the rate of growth of
bank net worth due to retained earnings .

In addition to retained earnings,

bank equity can grow as a result of new issues of bank stock , either by
existing banks or as new banks are organized .

We can expect bank asset

growth to be related to the sum of internally generated equity and externally
acquired equity .
However bank asset growth is also constrained by the need to keep cash
reserves against deposits .

In our system these reserve ratios against deposits

are determined by the various regulatory authorities - by the Federal Reserve
for member banks and by a combination of the state regulatory authorities
and the Federal Deposit Insurance Corporation for non-member banks .


member banks these reserves are in the form of vault cash and credits in the
Federal Reserve banks ; for non-member banks these reserves are in the form
of vault cash and deposits in banks - typically member banks .
If commercial banks had simple liability structures- as in the textbook
examples where demand deposits and equity are the only liabilities

and if

there was a fixed ratio of cash reserves required against demand deposits ,
then the growth of member bank reserves would limit the growth of deposits .



If , in these circumstances , bank equity grew at a faster rate than bank reserves ,
the equity-assets ratio would increase ; the leverage in banking would decrease .
In the simple textbook examples , where all banks are member banks , Federal
Reserve open market operations would determine the amount of assets banks
could debt finance by determining the reserve base of banks .

If the Federal

Reserve set a limit to the growth rate of deposits that is smaller than the
growth rate of equity due to retained earnings and new issues of bank stocks ,
then the ratio of assets to equity would fall , and the overall rate of return
on equity would tend to decrease .
Such a decrease in the rate of returns on equity would make it less
attractive to retain earnings in banks .

The payout ratio would increase and

over time bank equity growth would decline towards the rate at which the
effective reserve base is growing .

Eventually, bank assets and bank capital

would tend to grow at the same rate as the reserve base .

A parallel acceler-

ation of the rate of growth of bank capital would take place if reserve and
demand deposits grew more rapidly than equity .
In truth , the simple textbook model of commercial banks misspecifies
the nature of banking in many ways .

There are many types of bank liabilities

and these liabilities differ in their reserve absorption : some bank liabilities
do not absorb reserves at all .

Furthermore , in the United States the existence

of non-member banks means that for many banks the potential stock of assets
that can be used as reserves is very much larger than the amount actually used
as reserves .

It is no accident that over the post-war period the total assets

of non-member banks have grown significantly faster than the growth of member
bank assets .

Whenever Federal Reserve policy constrains the growth of member



bank reserves , the growth of non-member banks was not constrained by any
reserve deficiency.

As Federal Reserve constraint almost always means a

rise in interest rates , the profit potential for existing and newly created
non-member banks increased during periods of constraint .

An acceleration

of the growth of non-member banks is one the improved profit
potential of banking that exists when interest rates are high and rising .
Thus there are pressures on banks to have their profits grow at least
at the same rate as

quity .

If reserves grow at a lower rate than equity ,

banks will attempt to shift their liability structure towards those liabilities which have smaller reserve requirements , so ' asset growth can be consistent
with equity growth , and they will shift their assets and liabilities around so
that they can earn a higher net return on assets .

Banks presumably are always

managing their assets and liabilities in an effort to earn as high a net
return as they can.

However, if earnings can keep apace with equity growth

by such asset- liability management they will be less prone to press for
higher equity ratios .
Of course there is nothing sacred about any period's asset-equity ratio .
The existing ratio at any date is a reflection of the historical development
of banking and presumably reflects current views as to what the potential
loss on bank assets can be .

Objectively , if we recognize that the bank's net

worth is the margin of safety that banks provide those to whom they are
indebted , the appropriate ratio of equity to total assets should depend upon
the risks of losses and defaults embodied in the earning assets of banks .
Thus if bank assets are heavily weighted by default and risk free short term
government debt

then a smaller ratio of book value to total assets will



provide a target margin of safety than if the banks earning assets are heavily
weighted by default possible private debt .

Similarly , if long and short term

interest rates can vary , a bank whose assets are primarily short term can
provide a given margin of safety with a smaller ratio of equity to assets
than a bank whose assets are primarily long term.
However , what is an acceptable ratio of total assets to equity at any date
will depend more upon the prevailing mood of bankers , the users of their liabilities , and the regulatory authorities as to the safety of various types of
assets than upon the objective criteria .

A period of success by bankers and

the economy will tend to develop views that bank equity is too high relative
to total assets : that higher levering ratios are both possible and, if there
is a pressure for bank financing, desirable .

If such a run of success is

accompanied by some new institutional protection - be it the Federal Reserve
in the 1920's or Federal Deposit Insurance and Fiscal Policy as a guarantor of
"perpetual" prosperity in the 1950's and 60's - the temptation to increase
leverage will be reinforced.

Thus the ability of banks to increase leverage

depends upon the mood of the times , even though the profit potential from
higher leverage is always present .
Note that the ability of banks to increase their assets depends upon the
supply of acceptable assets from business , other financial institutions ,
government , and households .

However , the very mood which makes bankers willing

to increase their asset- equity ratios also makes bankers and their borrowers '
views of the future more optimistic.

An increase in the optimism with which

the future is viewed increases the willingness of other economic units to



borrow and the willingness of bankers to lend .

The supply of bankable assets

increases even as the demand for such assets by banks increases .
Inasmuch as the traditional bank liabilities - demand deposits and pass

book time deposits · absorb reserves , albeit in different ratios , the ability
of banks to expand assets at an appreciably greater rate than available
reserves expand depends upon the ability of banks to invent non-traditional
liabilities and get them accepted by creditors .

Thus the pace of bank growth

in excess of the growth of bank reserves depends upon innovations which
involve new types of bank obligations .

These obligations need to be more

reserve efficient than the traditional bank liabilities .

Banks that are en-

deavoring to expand their assets at a faster clip than the growth in reserves
need to innovate in both the type of instruments in their liability structure
and how they manage their liabilities .
The new thing of the 1960's in banking , liability management banking ,
is an outgrowth of two items : a willingness of banks to increase their assetequity ratio and an acquiescence of bank examiners in this process .


as some of the devices that have been used to increase the effective bank assetequity ratio don't show up on the bank's balance sheet (such as loan commitments)
the active acquiescence of bank examiners was not needed .

Liability manage-

ment banking is a logical outcome of the fact that banks are profit maximizing
institutions and the slow growth in bank reserves throughout the post -war
period .
The history of banking since World War II falls into two phases .
first phase , banks were working off the legacy of war finance .

In the

They started

with very high ratios of government debt to total assets in their portfolio



and they were able to sustain profit growth by acquiring private debt .


addition , the memory of the depression of the Thirties was still relatively
fresh and a conservative view of what was permissable dominated bank manage- .

The recessions during the Eisenhower years also reinforced this


Even though

the Federal Funds Market reappeared in the middle fifties ,

in the early years of this market many banks were hesitant to participate
or only participated in a selective fashion .

Only with success did the

market become fully generalized .
During this first phase , which was mainly characterized by increasing
the ratio of loans to government securities in the banking system, total
assets and bank equity grew at about the same rate .

Between 1950 and 1963

total assets of the commercial banking system grew by 91% whereas bank
equity grew by 95% .

During this first period , profit growth by banks was

achieved mainly by increasing the weight of loans in the asset structure ,
although with the reintroduction and maturing of the Federal Funds market ,
the excess reserves that characterized the initial ' situation were utilized .
The second phase began after the banks had worked off their excess
liquidity , inherited from war financing , and as the relative success of the
economy dimmed the memory of the great depression .

In a situation where

there is no excess liquidity in the banking system, profit growth required
that bank assets grow at a more rapid rate than bank equity .

Thus from 1963

through 1973 bank assets grew 162% whereas bank equity grew by 99% .

Thus ,

more rapid growth of bank assets than of bank equity required the introduction
and management of liabilities that did not absorb reserves to the same



extent as the traditional liabilities .

Thus banks introduced negotiable

certificates of deposit , borrowings of Euro-dollars , and resorted to

commercial paper to raise funds in the 1960's and 70's .

In addition , lines of

credit tended to replace actual loans .
In Table I , data on the growth rates of Total Financial Assets ,
Financial Net Worth , Demand Deposits and Bank Reserves for each year since
1950 are presented .

Whereas in the average between 1950 and 1963 Total

Financial Assets and Financial Net Worth grew at about the same rate , Demand
Deposits grew at a substantially smaller rate and Vault cash plus member bank
reserve hardly grew at all .

Since 1963 all four of these measures grew at

substantially higher rates than earlier .

However , now Total Financial

Assets grew at substantially greater rates than Financial Net Worth , whereas
Demand Deposits and Reserves grew at approximately the same rate , but still
lower than the rate of growth of Financial Assets and Financial Net Worth .
Obviously , banks have developed techniques by which asset growth can
exceed demand deposit and reserve growth , and during the years since 1961
asset growth has consistently exceeded equity growth .

As the most rapid

expansion of vault cash and member bank reserves took place in 1966 and 1971 ,
the years of after the credit crunch and the liquidity squeeze , there is a
presumption that the growth in reserves was induced by the Federal Reserves '
fear that inadequate liqudity would worsen the threatening crisis rather than
by any Federal Reserve objective of increasing income at a rapid pace .


the banking system as now constituted , any interpretation of the meaning of
changes in the reserve money available to banks that ignores the Federal
Reserves ' responsibility to support distressed financial markets can be


-28Table I

Commercial Banking
Annual % Growth Rates of Financial Assets , Financial Net Worth
Demand Deposits and Reserves

1951 - 1973
Total Financial

Source :


Financial Net

· 1.16


Vault Cash and
Member Bank Reserves

- 5.85
- 2.75
- 2.60
- 3.58
- 3.03
-- 2.88

Board of Governors of the Federal Reserve System: Flow of Funds
Accounts : 1945-1972 (August 73 ) and 1974 Supplement 1965-1973
(September 74) .



misleading .

In 1966 and 1971 , the growth of the reserve base may well have

been due to the Federal Reserve's efforts to prevent a financial crisis
rather than to any strong effort to reflate the economy .

The paradox of

monetary policy in our present environment is that if the Federal Reserve
is successful in aborting a threatened financial crisis , then it may very
well have provided sufficient reserves to the banking system to fuel an
inflationary recovery .
It is to be noted that the fundamental instability in the economy is
the upward expansion by banks and the

borrowers that leads to an increase

in speculative finance in the economy .

Those who borrow from banks borrow

on short term, and therefore tend to be speculators .

A regulatory climate

which does not appreciate that the financial developments over an extended period
of good times will tend to breed the financial environment which leads to
the likelihood of crises and hard times will not serve the economy well .




Some Data on the Robustness or Fragility of Finance
The profit equation that is true for banks is also true for business

firms : the return on net-worth equals the profits per unit of assets times
the ratio of assets to net worth .

Thus the same incentives to increase lever-

age exists for ordinary firms as exists for banks .

But to lever by borrowing

it is necessary to provide the borrowers with some margins of safety .

However ,

what is acceptable at any time as a margin of safety depends upon the current
evaluation of future prospects .

Thus the willingness as well as the ability

to debt finance positions in capital assets will respond to the way in which
the past performance of the economy is interpreted as a guide to future performance .
For ordinary business firms we can define three measures of the margins
of safety provided to borrowers .

One is the ratio of cash flow receipts to

cash flow payments on account of debts .

Another is the ratio of cash and

near cash assets to debts : these are the cash kickers kept on hand to meet
commitments in case something goes wrong .

A third is the extent to which

the firm is engaged in hazardous financial practices ; i.e. , the extent to
which unconventional financing techniques are being used .
In Table II data for the years 1951-1973 on some measures of the financial
position of the non- financial corporate sector in the flow of funds accounts
are presented .

In columns II , III , and IV data on the cash flow and the stock

of cash or equivalent assets relative to debts are presented .

The information

in these columns are to be interpreted as being indicative of the changes either
in the ratio of cash flow to relative to cash payment commitments or of the

ratio of cash to cash payment commitments .

Unfortunately , data on the cash


-31Table II

Robustness / Fragility
Non Financial Corporations
United States -- 1951 - 1973



Fixed Investment
Internal Funds

Internal Funds

Demand Deposits



7.4 .


Source :




Protected Open Mkt Paper ,
Assets ( 1) + Fin Co.Debt
÷ Debts
÷ Debts



Board of Governors of the Federal Reserve System: Flow of Funds
1945-1972 (August 73) and 1974 Supplement 1965-1973
(September 74) .

Demand Deposits , Time Deposits + Government Securities

52-221 O -75-23



payment commitments embodied in the debt structure are not available in the
published accounts , all that is available is a measure of the debts .
In fact , the growth of debt underestimates the growth in cash payment
commitments due to debts because it ignores the large increase in interest
rates over the period since 1951 and most particularly in the years since the
mid 1960's .

The deterioration in the cash flow position of corporations is
much greater than the data in Table II because of the large swing in interest
rates .

For units which engage in speculative finance , the extraordinarily

high interest rates of 1973/74 serve as a self- fulfilling prophecy of financial
difficulty .

It is also worth noting that the drop in interest rates that

occurs during a decline in income tends to ease the cash flow commitments of
units that engage in speculative finance .
short term rates .

if they can get financing at the lowe:

However , to the extent that the financial pressures of a

period such as 1973/74 reduces the felt margins of safety of firms engaged in su
finance , they will have lost on their credit rating .

Furthermore , a period of

financial difficulties will result in an increase in the differentials between
the interest rates to the best credit risks and other less secure debts .
In Column II of Table II the ratio of internal funds (gross profits after
taxes) to debts if presented .

This ratio showed no significant trend between 19

and 1965 : in this period it ranged from a low of 14.1% in 1961 to a high of 16.7
in 1965; it stook at 16.2% in 1965.
as interest rates rose .

Following 1965 this ratio fell rapidly even

It stood at 10.6% in 1970 and it has recovered slightly

to 11.4% in 1973 .
In Column III of Table II data on the ratio of corporate demand deposits
to debts is presented .

With the exception of 1954 when the ratio increased ,



this ratio has fallen each year .
stood at 4.8% .

In 1951 it stood at 18.8% and in 1973 it

Given that corporate borrowers from commercial banks are

required by the banks to keep compensating balances , we can assume that very
little of the demand deposits in 1973 constituted excess liquidity available
to meet contingencies either in operations or in finance .
As is shown in Column IV of Table II , in 1951 protected assets , which
are demand deposits , time deposits and government securities owned by nonfinancial corporations equaled 1/3 of their debt ;
fallen to 8.5% .

in 1973 this ratio had

Inasmuch as the time deposits and government debt are truly

superfluous to operations , the protection against contingencies as evidenced
by these portfolio changes has seriously deteriorated .
A similar picture of deteriorating liquidity is evident in the ratio of
open market paper and finance company debt to total borrowings of non-financial
corporations .

Although the numbers remain small , there has been a trend

which indicates an increased reliance as such non regular sources of funds

by corporations in recent years .
The evidence from Table II adds up to an increased vulnerability of
non-financial corporations to financial difficulties .

Not only are the payments

on account of debt a higher ratio to cash flow than hitherto , but the quantity
of financial assets that are kept as reserves for contingencies have gone
down .

All in all , the quality of the paper that would enter the books of

banks from a corporate sector whose ratios were those of the fifties would
be considerably higher than the quality of the paper that would emanate from
a corporate sector with the ratios as shown for the seventies .



Column I of Table II shows the ratio of the Non Financial Corporation
Sector's expenditures on fixed investment to the internal funds generated by
the firms .

In the years between 1951 and 1967 this ratio cycled around 100% ;

in 1953 it stood as high as 112.2% and in 1955 at 90.5% .

Beginning in 1968

when it stood at 111.1% a run of years with very high ratios of Fixed Investment to Internal Funds occurred ; a high of 131.9% was reached in 1970 and the
ratio stood at 128.4% in 1973 .
It is this high ratio of Fixed Investment to Internal Funds , plus the
repercussions of the debt financing of corporate take- overs , that has led
to the observed decline in the ratio of internal funds to debts and the rapid strippin
of the excess liquidity from the corporate sectors .

Our problems of fragility

in part stems from the high ratio of fixed investment to internal funds in
In order to increase the robustness of the non-financial corporate
sector we need a run A years such as occurred in 1961-65 when in the aggregate
recent years .

corporate internal funds exceeded the spending

n fixed investment .

In Table III some data on the financial position of commercial banking
for the years 1951-1973 are presented .


data reinforces the data on

growth dates of various assets and debts that was discussed earlier .


deterioration in the ratio of financial net worth to total liabilities is
indicative of the increase in leverage since the early 1960's .

Note that the

ratio of financial net worth to liabilities peaked in 1960 , the year in
which the negotiable certificate of deposit was introduced .
In 1951 , well nigh 60% of total bank liabilities were, offset by no
default assets : U.S. government securities , vault cash ,and member bank
reserves .

In 1973 less than 20% of liabilities were in no default assets .




Table III

Robustness / Fragility
Commercial Banking
United States -- 1951 - 1973
Financial Net
Worth ÷
Total Liabilities

No Default
Assets (1)
Total Liabilities

Bought Funds (2)
Total Liabilities





Source :

Board of Governors of the Federal Reserve System: Flow of Funds
1945-1972 (August 73) and 1974 Supplement : 1965-1973
(September 74) .


U.S. Government Securities , Vault Cash and Member Bank Reserves .


Large Negotiable L.D.'s , Other Inter-bank Claims , Credit Market Debt ,
Liabilities to Foreign Affiliates , Borrowing at F. R. Banks and
Other Miscellaneous Liabilities .



the same time as these qualitative changes in assets were taking place , the
dependence of banks on bought funds increased .

Bought funds , which includes

large negotiable CD's , other interbank claims , credit market debt , liabilities
to foreign affiliates , borrowings at Federal Reserve Banks and unclassified
miscellaneous liabilities , are volatile or emergency funds .

While such market

funds were less than 4% of bank liabilities in the early 1950's , they were a
full 24% of liabilities in 1973 .
The above estimate of the dependence of commercial banks on bought funds
underestimates the dependence because Federal Funds are not included .


funds being loans between banks drop out of the consolidated sectoral balance
sheets that make up the flow of funds accounts .
Thus if we take three measures of fragility/robustness of the banking
system, the ratio of equity to liabilties , the ratio of secure assets to
liabilities , and the ratio of bought or volatile funds to liabilities , it is
clear that the banking system was much less robust in 1973 than in 1951.


developments with respect to no default assets and bought funds would require
a higher ratio of equity to liabilities in 1973 than in 1951 , if the equity
ratio were to meet some objective standard in providing a margin of safety
to depositors and other lenders .

However , the subjective standards of

acceptability changed , especially after the early 1960's , thus the fragile
structure that now rules evolved .
We cannot say what values of the ratios we discussed leads to a financial
system so fragile that a financial collapse is likely.

First of all , data

for the 1920's is not available in the same detail as our current data , and



no debt-deflation has really occurred since 1929-33 .

Secondly, since the

1920's there have been significant institutional changes , such as Federal
Deposit Insurance and the emergence of big government .

Federal Deposit Insur-

ance has effectively insulated depositors in banks against losses ; in fact in
recent bank failures it has virtually assured all except stock owners against
losses .

Big government by making a huge deficit a systemic response to a

decline in income acts to introduce default face assets into a financial
structure , thus increasing its robustness .
This ability to abort threats of financial crises has not been a free
lunch: success in sustaining a fragile financial structure when debt deflations
threaten has led to accelerating inflation .




Conclusions :

Reform and Recovery

It seems evident that in good times the financial system is transformed
from being robust to being fragile .

The reaction of the financial system to

monetary and fiscal policy actions is conditioned by where the economy is
in this robustness-fragility scale and in the ongoing financial market
developments .
If financial markets are robust and if the usages in finance are rather
stable then monetary ease will tend to increase income , employment, and prices
and monetary constraint will tend to decrease income , employment , and prices .
These income , employment, and price reactions to monetary changes are the
basis of the standard policy prescriptions for monetary policy .
If financial markets are undergoing significant institutional and usage
changes , which usually means that there is a strong demand for external financing by business , households , and various levels of government , then the effect
of monetary ease upon income , employment, and prices will be amplified and a
monetary constraint will be offset in all or part by the ongoing money market
changes .

This situation will see monetary ease leading to an inflationary

expansion , and monetary constraint will be relatively ineffective in constraining demand .

Monetary constraint will not be effective until the expan-

sion of financing , within a regime of constrained growth in bank reserves ,
makes the financial system sufficiently fragile so that there is a felt threat
of an imminent financial crisis or credit crunch .

This wave of apprehension ,

if offset by the Federal Reserves support action , will lead to a recession .
As Federal Reserves support actions feed reserves into the banking system at
a rapid rate , the stage is set for a renewal of an inflationary expansion
accompanied by increasing fragility in the financial system .
Once the financial system is sufficiently fragile so that financial



market changes can easily destabilize financing relations , then monetary
constraint will first threaten the stability of the financial system and
only, as the threat of instability affects business and household spending
will it constrain income , employment , and price level growth .

In these

financial circumstances the economy is seemingly always threatened by one
or two disasters - a runaway inflation or a debt -deflation followed by a
deep depression .
There are no simple always applicable rules for monetary policy .


any time , the appropriate use of the powers of the Federal Reserve depends
upon the existing financial environment .

Unfortunately , because the consid-

erations with respect to the effect of financial system robustness or fragility
are foreign to the economic theory that guides Federal Reserve actions , poorly
advised policy actions have been taken over the recent past .

In particular

monetary policy or control over monetary growth are inapt foundations for
economic policy in a regime of fragile finance .

We need to recognize that

simple rules and slogan solutions will not serve in situations such as now
rule .
During the debt-deflations and deep depressions of history , the financial
system was transformed from being fragile to being robust .

Today we know

that by a combination of Federal Reserve support operations and fiscal policy
we can avoid the debt deflation and deep depressions , but in a regime of
fragile finance the price for this success is accelerating inflation .
there an alternative to the dismal cycle of inflation , threatened financial
crisis , pause or recession , and renewed nay accelerating inflation we have
experienced over the past decade?

Can we use monetary and fiscal policy to

achieve a robust financial system without going through the trauma of a deep
depression and once we achieve a robust financial system are there reforms



of institutions , regulatory practices , and stabilization policy which would
attenuate if not eliminate the tendency for speculative financial practices
to make the financial system fragile?

The above are the serious questions

which must concern us all today .
In order to develop a robust financial system out of the current fragile
system we need a depression without a depression; i.e. we need a period in
which corporate investment is less than corporate retained gross profit after
taxes , so that corporations repay debts , acquire financial assets such as
government bonds , and reduce their borrowings from the open market and
finance companies .

We need a period in which households reduce their mort-

gage and consumer debt .

We need a period in which bank equity grows more

rapidly than assets , in which banks increase the ratio of government debt
to loans in their portfolios , and in which the reliance of banks on bought
funds is decreased .

We need all that without widespread bankruptcy , mass

unemployment , and wholesale deprivation .
The recommendations for economic policy that follow from the above
statement of our needs fly in face of todays conventional policy wisdom.
This is so because the financial considerations , which loom so large in the
argument I have advanced , are either ignored or given very small weight in
the economic analysis which provides the basis for the conventional policy
proposals .
The argument presented in this paper implies that a correct policy posture in the current situation will not encourage private debt finance spending .

Thus rather than increase the investment tax credit , it should be

repealed .

If it is our desire to ease the tax burden on corporations , we

should consider a reduction in the corporate tax rate , or a rise in the
amount of corporate income taxed at the lower 22% rate above the present

351 .


$25,000 limit .

The Federal Reserve should once again be authorized to

institute down payment and term to maturity regulations on mortgages and
consumer credit , with the objective of cutting household debts .

If aggre-

gate income is sustained the above policies in time will directly generate
the needed improvement in corporate and household balance sheets and indirectly improve the balance sheets of banks and other financial institutions .
The basic weapon to sustain income and employment should be a reinstituted and modernized W.P.A. , C.C.C and N.Y.A. (In order to ease the inflationary burden of social security upon the economy , an older worker's employment arm should be developed as part of this effort . )

The employment oriented

income maintenance mechanisms of the depression days were quite different
from the present day public service employment schemes , for they were outside
normal government operations .

The reason for using the W.P.A. etc. as the

basic income and employment sustaining device is that the pattern of private
demand for investment that will emerge after corporations , households , and
financial institutions balance sheets are more robust will more clearly
reflect consumer preferences than if the recovery effort is dominated by
government spending and subsidies for special outputs , which is the alternative and by now traditional income maintenance route .

Furthermore , an

emphasis upon housing or private investment in the recovery program is an
emphasis upon those dimensions of output that are normally financed by debt .
Conventional policy will tend to increase the debt burden, whereas our major
need is to decrease private debt relative to income and secure assets .


a major investment program is required by the energy problem, then the current
needs of the economy imply that these investments should be directly financed
by the government , rather than by the government inducing or subsidizing
private investment .



The above are some broad principles to guide a program to simultaneously
sustain employment and increase the robustness of the financial system.
also need reforms that will tend to place barriers in the way of speculative
finance so that the financial system does not quickly become fragile again .
One reform that is needed is in perception .

Business men , legislators and

regulators have to be aware , while things are going well , that the tendency
to speculate and thus destabilize the economy is a fundamental characteristic
of our financial system.

In particular during periods of good times the

bank regulatory authorities need to lean against the wind by constraining
the growth of total bank assets relative to bank equity and of the ratio of
assets at risk relative to default free assets in bank portfolios .
Another needed reform is to impose a cash flow perspective upon regulations ; in particular the bank examination proceedure should shift to an
emphasis upon the cash flow commitments and cash flow receipts of banks .


margin of safety embodied in required bank capital should be increased whenever the extent to which banks rely upon potentially volatile liabilities
increases .
can emit .

It may be desirable to limit the types of liabilities that banks
Inasmuch as the bank holding company device has been used by the

very largest banks to greatly increase their assets relative to equity , a
review of the desirability of bank holding companies , especially for the
largest banks , is in order .

It may be desirable to have different asset

equity requirements and different demarkations of permissable activities for
the larger and the smaller banks .

The constraints should be more stringent

for the larger banks than for the smaller banks rather than as at present
when the constraints are more relaxed for the larger banks .
The regulatory authorities should view commitments to lend and acceptances as reserve absorbing liabilities .

It might be desirable to divorce



overseas branches from the large banks and establish the various networks
of overseas branches as independent institutions .
A philosophy about the permissable structure of corporate liabilities
should be adopted .

In particular corporate take-overs and conglomorate

mergers that increase the ratio of the consolidated external debt of the
surviving organization over that of an initial pro forma consolidation of
balance sheets should be disallowed .
If instability and the current inflation/ depression dilemma are the
result of fragile finance it is necessary to adopt measures which get us
out of the current fragile situation and which impose barriers to the easy
emergence of fragile financial relations .

The above policy suggestions , are

offered in the spirit that these issues should be on the agenda for discussion
as we grope with our current difficulties and hopefully emerge from these
trying times with a better set of policies to control and support our economy
than we now have .
Thus the concerns voiced by Chairman Burns in his Honolulu talk are not due
to transitory phenomena but due to the fundamental tendencies for speculative
finance to loom ever larger in the financial system whenever the economy does
well over an extended period .

Policy and reform must be based upon a recog-

nition that this basic flaw exists and must try to cope with the flaw rather
than evade or paper over the problem.


Prepared for the Fifth Annual Pittsburgh Conference on Modeling
and Simulation Apr. 24-26 , 1974
(By Hyman P. Minsky, Professor , Economics Department,
Washington University , St. Louis, Mo. )
Two steps have to be accomplished before we can empirically model
financial instability . One is to develop a theory in which the properties
that determine the relative stability of a financial system and of the
economy are endogenous . The second is to define measures on the
economy and financial system which can be used to estimate trends
in the relative stability of the financial system and the economy.
The fundamental outline of a theory of financial instability can be
derived from Keynes' General Theory ** * 1 and Fisher's description
of a debt deflation.2 As is well known, much of Keynes' General Theory
was lost in the development of today's standard Macroeconomics.3
In some very important senses, what was lost is more significant than
what has been retained, for Keynes in The General Theory advanced
a "financial" theory of why the economy was so susceptible to fluctuations. In my interpretation , fluctuations are treated as a succession
of system states and each system state " breeds " the seeds of its own
destruction . Of particular importance in this scenario is the way in
which a steady growth pattern evolves into a boom and how the boom
leads to an unstable panic prone system. The fundamental instability
is the way in which a period of steady growth evolves into a speculative boom. Central to this evolution is the endogenous determination
of the accepted or desired liability structure of not only ordinary
business firms (corporations) but also banks, generically defined to
include the entire set of financial organizations. The spectacular panic
and subsequent debt deflation is of secondary importance for our
present concerns .
The best currently available data base for estimating trends in the
financial system is to be found in the Flow of Funds accounts of the
Federal Reserve System. These data as now constructed give us only
hints as to the cash flows set up by financial instruments-they do
not give us the actual cash flows . Hopefully, as research proves the
validity of the cash flow approach to modeling financial interrelations ,
the Flow of Funds accounts will be modified into sectoral cash flow
accounts. Inasmuch as this paper attempts to cover a wide territory
it, of necessity, is a road map rather than the actual journey .
The fundamental proposition of the financial instability theory of a
capitalist economy is that the capitalist market mechanism is flawed ,
in the sense that it does not lead to a stable price-full employment
equilibrium , and that the basis of the flaw resides in the financial
system. We immediately note that financial instability is rooted in
actual existing institutions. This is not a theory for all economic
1 Keynes, J. M., "The General Theory of Employment, Interest, and Money," New York; Harcourt,
Brace & World, 1936.
2 Fisher, I., " The Debt-Deflation Theory of Great Depressions" , Econometrica, vol. 1, 1933, pp. 337-357.
3 Minsky, H., "John Maynard Keynes," New York, Columbia University Press. Forthcoming.


systems, rather it is a theory of how a particular economy works . It
is fully consistent with the theory to have economic processes vary
as institutions change.
The focus of the theory is the desired and actual liability structures
of economic units in particular or ordinary business enterprises and
financial institutions . A critical insight underlying the theory is that
the desired liability structures for financing positions in real and
financial assets by firms and financial institutions are due to endogenously determined expectations and preferences. Liability structures
are not determined by technology, as are production techniques , or
by exogenously given preference systems, as is assumed in demand
theory. It is in the determination of desired liability structures
associated with asset positions (and the reciprocal asset holdings
associated with liability structures) that the dark and mysterious
forces of uncertainty are really at home. Uncertainty is the fundamental analytical construct of this theory, and preferences with
respect to uncertainty as well as units perception of uncertainty are
taken to be endogenously determined by the past performance of
the economy .
In a recent article , Professor Friedman used the Patinkin resolution 5 to the standard or bastard Keynesian presentation of the
possibility of an underemployment equilibrium in a capitalist economy
as the key to the assertion that a capitalist market mechanism is not
flawed . Prior to the acceptance of the Patinkin resolution , it was
argued that ( 1 ) product market equilibrium determines the aggregate
demand for labor, (2 ) at a given money wage rate this demand can be
less than the available supply, and (3 ) that the decline in money
wages that follows upon the excess supply of labor might not be an
efficient process for eliminating the excess supply.
Patinkin rescued the in principle validity of money wage declines
as an effective device for eliminating aggregate unemployment by
introducing money wages and prices as a determinant of consumption
demand . The rationalization for this proposition is the real balance
effect, which introduces the money balance divided by the price level
into the consumption function . This feedback via money prices and
consumption demand in the Patinkin resolution assures that the
demand for labor as determined in the commodity market will be
consistent with the productivity-preference determination of full
employment equilibrium.
In a sense, the Patinkin resolution has an in principle validity
because it would be operative even after a full-blown debt-deflation
process triggered by the fall in money wages and prices has run its
course . The Patinkin resolution , which is fundamental to modern oneclassical economics , implicitly accepts the view that the road to full
employment might very well run through hell.
The Patinkin resolution is peculiar in that once it yields the so -called
full employment equilibrium, no questions are asked as to whether
the equilibrium so defined contains ongoing processes which can
rupture the equilibrium. If we look closely at what goes on when the
system achieves such an equilibrium, we readily uncover ongoing
4 Friedman, M. , "A Theoretical Framework for Monetary Analysis,” Journal of Political Economy,
vol. 78, pp. 193-238.
5 Patinkin, D. , "Money, Interest, and Prices: An Integration of Monetary and Value Theory." 2nd ed. ,
New York, Harper & Row Publishers, Inc., 1965.


processes that tend to destroy the equilibrium. These ongoing processes tend to rupture the equilibrium in an upward direction , i.e. , from
full employment, the system tends to generate a more than full
employment speculative boom.
In a world where external finance exists , and where money broadly
defined is an ever evolving concept whose supply is essentially
endogenous, the change from less than full employment to sustained
full employment leads to changes in the valuation of various capital
assets and in the desired external internal financing ratio . Capital
assets are desired only indirectly because of their productivity . The
immediate determinant of the demand for capital assets is the cash
flows on quasi-rents , that the capital assets are expected to yield in
the ongoing functioning economy. Furthermore, the basic speculative
element, in an economy in which external finance exists, is the extent
to which "owners" of capital assets and their "banners" externally
finance positions .
Capital assets, both newly and previously acquired , as collected in
firms, are expected to yield a series of quasi-rents, O₁, and their current
market valuation Pk, is a capitalized value of these flows . If these
capital assets are being produced, their supply price P1, will be " consistent" with P. If P varies , other things such as wages and financing
conditions remaining the same, then the pace of production of these
capital assets, investment, will vary.
Because of the way in which corporations report their performance
and the way in which financial contracts are written, we can think of
the Q's as discrete quarterly or annual results . Because of the memory
of past downward deviations of income from full employment, during
which realized cash flows were lower than full employment cash flows,
at the time full employment is first achieved as a result of, say , a
Patinkin process current expected cash flows have a mean value Qt
which is lower than the then current full employment cash flows Q.
Furthermore , because the economy has in the past exhibited fluctua2
tions, there is an expected variance o

to the currently expected

cash flows .
As the Patinkin process sustains full employment, the realized
quasi-rents are greater than expected and the variability of the quasirents is smaller than in the anticipated variability . Expectations are
affected by realizations in a world with uncertainty, thus as full
employment is achieved and sustained , Q; increase and $ Q2 , decreases .
If expectations become based upon full employment growth , then
expectations become that Q = ( 1 + g) Qor and the expected variance
around this growth path approaches zero as time in full employment
increases .
Positions in the collection of capital assets owned by firms that
yield Qt are financed by some combination of equity shares and debts ,
Similarly, positions in collections of financial instruments owned by
financial institutions are financed by some combinations of ' capital
and surplus' and debts . Debts are best characterized by the cash
payment commitment as stated in the contract. These cash payment


commitments can be demand , dated , or contingent . For everydemand
or contingent cash payment commitment there is a frequency distribution of the expected cash payments. Thus with greater or smaller
certainty, the liability structure of an economic unit can be translated
into a time series of expected cash payments. These cash payments are
on account of both "interest" and "principal. " A given amount of
debt in the form of a six month note requires a payment of the face
amount and interest in six months, a fifty year bond requires only
the payment of interest for fifty years . The principal is not due until
the final date .
We will define two types of financing units : units which hedge and
those that speculate . The hedge finance unit expects the cash flow
from operating capital assets (or from owning financial contracts) to
generate more than sufficient cash to meet contractual commitments .
If "CC" are the contractual cash commitment on debts, Q are the
is the variance of the expected cash

expected quasi-rents , and o

flows , then for a hedge investor we have that



is sufficiently great so that the subjective probability of an
actual Qin CC is acceptably small .
Equation 1 can be rewritten as
If we capitalize the cash flow commitments , written as K(CC) , and
the quasi-rents that capital assets are presumably "assured" of earning
at the same rate , so that

Px. 1— K (Q₁—λo 2.),
we have that K(CC₁ ) <Pk, i1 there is a margin of safety in the market
value of assets, over the face value of the debts . (P <K(CC) is the
conditions for insolvency) . We can write this as
Px = µK(CC) ; µ >1 .


We can assume that the cash payment commitments on debts are
taken to be more certain than the cash flows from the capital assets ,
and that the "owners" of the debts also assume greater variability
in the Q than they are willing to tolerate in the cash they recieve on
the debts. As a result, the capitalization rate for the cash commitments
by both the borrowers and the lenders will be greater than on the cash
52-221 O 7524


flows from capital assets , so that the need for a margin of safety on
resumed market value of assets over liabilities implies that the
Qi>CC by some margin.
A hedge financing unit expects the cash flow from operations to
generate sufficient cash to meet payment commitments on account
of debts . However, further protection is possible by having a unit
own excess money or marketable financial assets-i.e. , it is convenient
(as an implicit insurance policy) to hold assets in the form in which
debts are denominated . Thus a balance sheet of a hedge investor will
include K(CC) of money or bonds in addition to the P of capital
assets . Thus we have that

Px + nK(CC) = K( CC) + Eq . , n < 1

Thus for a hedge financing unit there are three parameters which
determine desired portfolios : the margin of safety in asset values . M,
the cash flow margin 7, and the liquid asset kicker 7 .
A unit speculates when CC for some periods is greater than expected
Qt. In particular, a unit is speculating when CC exceeds the expected
because the CC includes the repayment of principal . Thus a speculator can be defined as a unit in which for some near term i CC >Qi
and for which the capitalized value of the Qs exceed the capitalized
value of the CC. , i.e. , Pi>
ki K₁ (CC).
This is so because once the early or CC's are "paid" no further
"CC's" enter into the capitalization formula . It is the earnings of the
capital assets beyond the date of the speculative debts that yields
the margin of safety which induces both the debt owner and the
capital owner to engage in speculative finance.
Of course for a speculative finance unit, debt is repaid by the proceeds of new debt ; thus, the conditions that CC >Q and Px >
K (CC) hold as a process in time.
For a unit engaged in speculative finance, the difference between
CC, and Q for these " early on periods " has to be met by refinancing .
Thus a prerequisite for speculative finance is for a market to exist
in which both borrower and lender believe that the firm can raise
CC - Qi of cash without negotiations the sale of Q yielding assets.
Note that if CC >Qt for near term i's and nevertheless P >K(CC)
at some set of capitalization rates, then at another set of capitalization rates, associated with higher interest rates , K(CC) >Pr . Thus for
a speculative finance organization solvency (the excess of P over
K(CC) depends upon the ruling interest rates . Inasmuch as the
viability of speculative finance depends upon the existence of a
margin of safety in the value of capital assets over the value of debts ,
rising interest rates will decrease the margin of safety of a speculative
firm simply because the expect Q's are later dated than the contractual
payments on debts .
The need for a speculator to regularly raise CC-Q of cash through
some set of money markets implies that the operations of a speculator
is dependent upon the normal functioning of these financial markets .
Thus, whereas a hedging unit is dependent only upon the normal
functioning of product oriented markets (or upon the fulfillment of
contracts for a financial unit) a speculative unit is dependent upon
the normal functioning of both product and money markets . A
speculator has a dual dependency .


η K(CC) in
A speculative unit will also carry a liquid asset kicker ʼn
order to protect the unit against transitory quasi-rent or money
market difficulties . We can expect n to be greater for a speculative
unit than for a hedge unit.
Thus for a speculative unit we have
P >K(CC); P = µK(CC) , µ >1





(Q₁ +do 2); T > 1



Px +nK(CC) = K( CC) + Eq . , n < 1 .

Once again we have parameters which measure the balance sheet ,
cash flow, and portfolio margins . The initial difference between hedge
and speculative finance conditions is in the size of 7, a secondary
characteristic is in the size and composition of n K(CC) . A third
difference is that whereas for a hedge unit Pf >K(CC) for all capitalization rates , for a speculative unit there exist some rates for which
K(CC) > Px.
Let us redefine our cash flow commitment and quasi-rent relation
to distinguish between the views of bankers and corporate managers
on the maximum acceptable cash flows due to debts . We have that
the maximum desired cash flow commitments by bankers

CC₁= To (Q₁—λo 2).

and by the corporate management is

Heroically, we assume that both the bankers and their customers agree

on the expected cash flows Q. and the variance o
The actual cash flow commitment will be determined by the shortside of the acceptable ratios : CC, is the minimum of CC, and CC..
Our normal expectation is that as a Patinkin process leads to a recovery, business will be more optimistic than bankers so that CC. ==
CCCCC, because Tь<Tc.
As the Patinkin process sustains success, three things happen :
results improve so that actual quasi-rents exceed expected quasirents , the observed variance of quasi-rents, especially on the downside , is less than the expected variance, and the willingness to commit
quasi-rents to debt payment increases. (7 increases .) The objective
conditions as measured by realized Q's, and the subjective conditions


by which the past affects the value of 7 , both change in a direction
that is conducive to increasing the cash payment commitments CC.
Typically, businessmen will both perceive the increased profitability
and will be willing to raise the ratio of CC to Q before the existing lot
of bankers . As a result of this difference , some businessmen will seek
alternative "banking" connections and will be willing to pay a premium for external finance . The profit situation is conducive to finan6
cial innovation and a growth of "fringe" banking relations will
take place .
As full employment is achieved and sustained , businessmen are
willing to carry increased cash payment commitments with the inherited set of capital assets. In a world with innovative finance , this
will be reflected in achieved financing relations . If ACC, is this increment of cash payment commitments, then KA(ACC ) is the increment
of purchasing power available. In the world of corporations and
corporate finance, this KA (ACC ) is available for the purchase of
capital assets . (A simple analogy is a margin stock market ; a rise in
stock prices increases the available funds in portfolios which can be
used to purchase stock. )
Continued success of the economy leads to the uncovering of "purchasing power" over capital assets in the portfolios of existing organizations , and this purchasing power leads to rising prices of capital
assets and an increased pace of production of capital assets .
Thus we have that the rise in CC reflects the rise in the willingness
of business to increase cash flow commitments and of the uncovering
of bankers and banking organizations that will go along with the
desires of business . On the other hand , the quasi-rents grow at the
rate at which full employment income is growing . The rate of growth
of cash flows due to financial commitments y is greater than the rate
of growth of quasi-rents g. The ratio of cash flow commitments to
cash payment commitments increases .
In terms of the safety margin in the price of capital assets , we
have that P /K(CC) decreases , even allowing for the increase in
P due to the acceptance of full employment quasi-rents as the
It is important to note that the purchasing power uncovered in the
liability structure can be applied to the purchase of items in the stock
of capital assets as well as to the financing of investment . One aspect of a sustained full employment period that has not been emphasized sufficiently is that the liability structure associated with the
stock of capital assets changes . Typically, these changes are the result
of corporate maneuvers such as take overs .
The initial defining distinction between a speculative and a hedge
financing unit is that for a speculative unit payments on debts
(principal and interest) exceeds quasi-rents whereas for a hedge
unit the quasi-rents exceed the cash commitments . Thus, a speculative
unit is always refinancing its position by the issuance of debt.
Minsky, H., "Central Banking and Money Market Changes," Quarterly Journal of Economics, vol.
LXXI, pp . 171-187.


A speculative unit requires that good markets exist for its debt ;
that these markets have a large number of participants and that the
supply of financing available will be elastic with respect to small
concessions in terms by the speculative firm. Basically, this comes
down to the ability of a firm to sell liabilities in a number of different
markets ; it might have a variety of liabilities which it sells in a
number of different markets and the amount it sells in each market
depends upon conditions in the market .
The supply side of the "money markets" largely comes from the
n K(CC) , the liquidity kicker, kept by both hedge and speculative
units so as to have assets which play the role of an insurance policy
with respect to a short fall of either Q's or refinancing. The owners of
the liquidity kickers are in a sense borrowing more than they really
need so as to have this protection . Therefore , as liquidity kickers are
necessary to dispel the fears and uncertainties of both lenders and
borrowers, the units holding such kickers are predisposed to use the
funds rather than leave them idle-if "safe enough" assets are available that fill the needs for standby reserves . Obviously, short term
liabilities that are easily transferable into "cash money" are good
substitutes for liquid assets .
Thus we have that a variety of assets make up the cash kicker,
ʼn K(CC) . Some are debts of banks and other financial intermediaries ,
others are short term liabilities of government units, and still others
are direct debts of private firms. There is a speculative element in the
composition of the cash kickers . The speculative spectrum varies
with the extent of the market for the assets and the degree of protection afforded for the assets by the actual or implicit central banks .
If we split the ʼn K(CC) into its component parts, with 7m being
money, ng being government debt, and 7, being the debts of non
bank private units, we have that
nK(CC) = nmK( CC) + ngK( CC) + n₂K(CC)

1 = 7m + ng + np

The relative sizes of ¹m, ng and ηρ indicates the speculative aspects
η η
of asset structures .
An organization which speculates depends upon its ability to sell
its private debts to organizations which keep what we have called cash
kickers . One primary source of such financing is of course commercial
banks, and the composition of commercial banks assets is a prime
indicator of the aggregate speculative posture of an economy, However, as commercial bank ability to absorb private debt is limited not
only by bank capital but also by reserves supplied by the Central
Bank, the aggregate ability of banks to absorb private speculative
debt is limited . Thus units willing to speculative finance will seek
alternatives to bank financing -and these alternatives will tend to
increase 7k in the holdings of private units .
Once speculative finance exists for private units, the continued
viability of these units depends upon the willingness of units to absorb


their debts . For this to occur it is necessary for the K(Qi) to exceed
the K(CC) , i.e. , the units must be solvent. From the above we see two
persuasive influences of rising interest rates : one is that rising interest
rates will tend to have a greater proportional effect upon K(Qi) than
on K(CC) for speculating units because the Q are later than the CC,
the second is that rising interest rates increase CC without any associated increase in Qi.
During a period of sustained full employment , the parameters that
affect the desired cash flow commitments and desired portfolio
composition undergo systematic changes which increase the cash
flow commitments relative to quasi-rents and increase the ratio of
private as against monetary and government debts in the cash
positions of units.
Demand for capital assets is financed by a combination of expected
flows from income production , the portfolio changes resulting from
the K(ACC) financing , and the shifts in portfolio preference of asset
holders reflected in the rise in
/ʼn for a broad set of asset holders .
The increased effective demand for capital assets that results increases P and the production of investment goods . The increase in
P becomes capital gains , and the capital gains in portfolios increases
the margin of safety available for external finance. The increased
production of investment goods leads to increased income above
the Patinkin process full employment.
During a period in which P is rising, the greater the ratio of debt
financing of positions in capital assets the greater the ratio of gain in
the value of equity. Thus the initiators or leaders in debt financing
do well as full employment is sustained . In particular, the heavier
debt financing units among the business organizations will be those
who engaged in speculative finance. Inasmuch as speculative finance
is sucessful, and as units which speculatively finance their positions
succeed in meeting their financial commitments, units which initially
finance their operations in a hedge manner will tip over to a speculative
financing technique, and units will increasingly hold their cash assets
in the form of private debts.
Thus a period of sustained full employment spills over into a boom.
The proportion of units which are speculating increases. An increasing
proportion of total cash payment commitments on account of debts
require refinancing through evermore sophisticated markets .
One result of the increase in speculative finance is that for a given
K(CC) —for a given nominal face value of debt the amount of
payments required increases . In order to draw this increased short
term finance out of the ʼn K(CC) held by units , the interest rate on
short term private debts to private portfolios rise , and along with this
the longer term interest rates increase. By the very nature of interest
rate payments , the rise in interest rates increases the cash payment
commitments. The rise in the longer term interest rates decreases
K (Q) relative to K (CC) for speculative units , thereby decreasing
the margin of safety in portfolios.
The cumulative effect of a boom leads to ever greater dependence
upon speculative finance and to a run up of CC. The basic source of
capital values, and of the cash flows to meet payment commitments ,


the Q's are restricted to growing at the rate at which full employment
income grows , g, unless the proportion of income that goes to capital
increases or the Q's grow in nominal terms because of inflation . We
can assume that there is a limit to the extent to which the Q's can
grow as a proportion of income. Thus , to sustain a boom process , inflationary growth in the Q's are required .
As we have generated a process by which the growth of CC depends
upon past success, validating past CC commitments by inflation only
leads to further growth in CC.
We do not at this stage need to break the inflationary boom. The
break occurs when units revalue ( 1 ) the desired cash commitments
relative to quasi-rents , (2) the extent to which they wish to engage
in speculative finance, and (3) the ratio of private to monetary and
government debt in their portfolios . This break can be set off by ( 1 ) a
random bankruptcy, (2) a downturn in income and employment so
that the quasi-rents decrease, or (3) the repercussions of a decline in
the rate at which banks can add to their holdings of private debt .
However, the break or crisis and the debt deflation process are of
secondary importance the primary instability of capitalist finance
in our theory is "upward ."
We have set up a framework within which the development of a
speculative boom out of sustained full employment can be analysed .
The two results are that cash payment commitments will increase
relative to the quasi-rents and that the financial assets of banks and
the holders of liquidity kickers will show increasing ratios of private
debt . Furthermore, the process by which this takes place the using
of a portion of the initial margin of security and of initial holdings of
money in the cash kicker will tend to raise the price of capital assets
and the pace of investment . The resulting capital gains and increased
income validates and reinforces the speculative thrust. The feedbacks
to speculation , once full employment is achieved and sustained ,
reinforces speculation .
Even though the flow of funds accounts as they stand are quite
poor from the perspective of our theory, the data indicate that the
destabilizing process or the type we have described has been going on.
The ratio of liabilities to corporate gross profits after taxes has increased over the postwar decades, and the " quality" of the assets
which make up the cash kicker have decreased. It is clearly evident
from the growth of markets such as the commercial paper market
that a larger portion of units are engaged in speculative finance . In
particular, the postwar period has seen a growth of fringe banks .
Any organized set of data , such as the flow of funds accounts , is a
reflection of a theory which defines what is and what is not important.
In the flow of funds accounts the empahsis is upon the financing of
investment. The argument we have been advancing suggests that the
emphasis should shift to the cash commitment constraints which the
liability structure imposes. The term to maturity of various classes
of debt is an indicator of the cash flow needed ; perhaps as a first
step , corporate and household debt should be divided by time to
maturity in the sectoral balance sheets .


A concept of " position making" might be introduced for each sector .
The position making instrument is that instrument which will be sold
(be it an asset or a liability) if the unit requires cash. Changes in the
dependence of units or sectors upon financial market rather than
quasi-rents for cash needs as stated by liabilities is an indication of
trends in the relative stability of the financial system .
What we have done above is introduce a framework for the analysis
of the stability of a financial system. Systematic empirical analysis
lies in the future. Casual empiricism, based upon simple manipulations
of the data in the flow of funds accounts, leads to measures which
indicate that the American economy today is substantially more
unstable than earlier in the postwar period.


Chapter IV. - Capital Adequacy for Banks and Bank Holding


William M. Weiant
William A. Wood III


Main Office: One Chase Manhattan Plaza, New York, N.Y.



Summary and Conclusions

Why the Questions About Capital Need to be Raised



Regulatory Attitudes


PART III: The Rating Agencies


PART IV: Attitudes and Approaches of the Banking Industry



Strategies for Capital Planning

PART VI: Capital and the Implication for Capital Investors

• 24

Exhibit I :

Form for Analyzing Bank Capital

Exhibit II: Standard and Poor's Corporation: Bank and Bank Holding Company
Financial Data Questionnaire
Exhibit III : Moody's Investors Service, Inc.: Moody's to Assign Ratings to
Bank Holding Company Long-Term Debt
Exhibit IV: Rating Agencies - Explanation of Investment Grade Bonds Ratings
Exhibit V: Selected Intermediate and Long-Term Debt Ratings
of Banks and Bank Holding Companies
Exhibit VI : Summary of Public Offerings of Intermediate and Long-Term Straight
Debt by Banks and Bank Holding Companies For Cash of
$10,000,000 or More

This memorandum is not, and should not be construed as, an offer to sell or the solicitation of an offer to buy any securities. The information set forth
herein has been obtained from sources which we believe to be reliable, but is not guaranteed as to accuracy or completeness by, and is not to be construed as
a representation by Blyth Eastman Dillon & Co. Incorporated. The information and expressions of opinion herein are subject to change without notice.
BLYTH EASTMAN DILLON & CO. INCORPORATED / Main Office: One Chase Manhattan Plaza, New York, N.Y. 10005 (212) 770-8000



The purpose of this report is to raise some important questions relating to present and
future capital levels in the financial services industry, present the opinions and approaches of
federal regulators, rating agencies and selected bank holding company managements, and
attempt to synthesize these ideas into some tentative conclusions about capital planning
strategy for banks and bank holding companies. It is our hope that the views expressed here,
which are those of the authors solely and not necessarily of Blyth Eastman Dillon & Co.
Incorporated, will stimulate further discussion and thus advance the understanding of the
industry and its capital needs.

We particularly appreciate the cooperation we have received from the Federal Reserve
Board, the Office of the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, Moody's Investors Service, Standard & Poor's Corporation, Fitch Investors
Service and certain bank holding companies.

September 1974

William M. Weiant
William A. Wood III

Mr. Weiant, a First Vice President, heads Blyth Eastman Dillon's Financial Services Industry
Group, which is responsible for coordinating the activities of the firm to meet the needs of
banks and other financial institutions. One of the senior members of the firm's Research
Department, he specializes in banks, savings and loans, real estate investment trusts and finance
companies. He is a Chartered Financial Analyst and Vice President ofthe Bank and Financial
Analysts Association.

Mr. Wood is a member of the Financial Services Industry Group and an associate in the firm's
Corporate Finance Division.


The questions about the capitalization of the banking industry are only one important facet of a
broader philosophical issue relating to the role banks and bank holding companies will play in the
financial system of the United States in the future. For example, capital adequacy becomes less
important if banks are to be a protected industry in which the Federal Deposit Insurance Corporation
and the Federal Reserve protect not only insured depositors but investors ( including owners of
certificates of deposit) as well. If, on the other hand, the banking industry truly wishes to operate in a
less regulated environment, subject to the increased scrutiny of depositors, investors and lenders, and
without automatic access to the Federal Reserve except in times of industry-wide crisis , then attention to
capital levels and capital structure is mandatory.
We believe that the trend toward nationwide financial systems will continue and that bank
holding companies can be at the forefront of the movement . We feel it desirable for bank holding
companies (and other financial intermediaries) to expand geographically and functionally; for banks
serving multinational customers to expand overseas; and for banks and bank holding companies to
consolidate into larger, more economical units as permitted by changes in banking laws. The dependence
on purchased funds to support expansion of assets will continue, reflecting the basic changes occurring
within the domestic financial markets.
The combination of the rapid changes in the system of financial intermediation , unusual
economic conditions and declining capital ratios in the banking industry has caused concern among
regulatory authorities. The Federal Reserve has stated that the money and capital markets do not yet
have sufficient information about banks to determine the capital needs of the industry.

We believe that the financial markets
assume a growing role in assessing the
capital needs of banks because investors and depositors are becoming increasingly aware of
the changes taking place in the financial system and of the need for more careful analysis. Demands for
greater amounts of information are being made also by the Securities and Exchange Commission and the
rating agencies.
The questions about capital adequacy and structure are complex. There is no "proper" capital
structure or "desired" level of capital . We suggest , however, that the following considerations are very
pertinent to the selection of a capital planning strategy:
- The principal objectives should be the maintenance of public confidence in the banking
industry, the protection of depositors and the maximization of the market value of
shareholders ' equity over the long term .
- A capital strategy for a bank holding company should include both the selection of an
appropriate capital structure for each unit in the group and the determination of the
location(s) within the group at which to carry out financing activities. A capital


structure should be simple and straightforward. All equity financing and all financing
for the subsidiary banks(s) should be done at the parent level.
Bank holding companies should have as a long-term goal for non-bank subsidiaries that
are large users of capital the development of a capital structure in these subsidiaries
that will enable them to borrow independently in the capital markets.
Near-term capital strategies should be continuously re-evaluated as the non-bank
subsidiaries develop, taking into consideration the ability of the group to generate
earnings and cash flow, the potential danger of over-reliance on the ability to "roll
over" debt at maturity and the attitudes of investors and third party lenders.
Each area of activity should be thoroughly analyzed , including detailed consideration
of anticipated risks and potential growth and profitability.
Earnings are the first line of defense to absorb operating and loan losses and maintain
public confidence. The recent decline in return on assets suffered by many banks
should be the principal area of concern to management because this has eroded the
ability to absorb losses and generate capital internally.
Capital is inextricably linked to liquidity. Its principal function is to absorb unusual
loan losses or losses caused by the sale of assets to meet deposit and liability run-offs.
To a greater extent than heretofore , banks should be required to meet liquidity
problems internally if they result from mismanagement . Assistance by the Federal
Reserve in such cases should be temporary and at punitive rates of interest.
Capital notes should be included in the capital base of a bank because their ability to
absorb losses on liquidation helps to maintain public confidence in the bank's viability
during periods of adversity.
The appropriate level of long-term debt included in a bank's capital base should be
determined by an analysis of many factors, including especially the ability to service
the debt , and not merely by arbitrary application of "acceptable" percentages of total



The development of U.S. money and capital markets has traditionally been based on an
assumption of relatively low rates of inflation and stable interest rates. The economic uncertainty of the
recent past, and the prospect for continued high interest and inflation rates, are therefore causing
questions to be raised about the stability of our markets and of our entire system of financial
intermediation. During this critical period, the banking industry, the heart of the financial system, has
undergone important and dramatic changes of its own, while at the same time experiencing substantial
declines in its capital ratios ( see Table 1 ) . This combination, even without the major problems which
have recently achieved national prominence, has given rise to questions of capital adequacy and capital
structure. The discussion seems likely to continue for the foreseeable future, especially since to date
there is little agreement among bankers, regulators, rating agencies, institutional investors and investment
bankers concerning even basic definitions and methods of capital measurement.


Capital Ratios - All Commercial Banks

Capital/Total Assets
Capital/Loans and Investments
Capital/Total Deposits









Source: Federal Reserve Bulletin, July 1974.

Among the more important changes in the industry are the following:
• The achievement of earnings per share growth and a high return on equity capital has
become a major goal of bank management.
• The liberalization of some state banking laws, the formation of multi-bank holding
companies and the opening of loan production offices have broadened the geographic
scope of banking.



• Changes in federal banking laws relating to one-bank holding companies have
permitted substantial geographic and product diversification .
• The number of banks expanding overseas has greatly increased.
• Banks and bank holding companies have become more dependent on " purchased
liabilities”—certificates of deposit, federal funds and commercial paper.
• Many banks have experienced declines in their profit margins (as ineasured by the rate
of return on total assets) , and traditional methods of measuring profitability, such as
earnings per share and return on equity, have often proved misleading.
We believe the trend toward nationwide financial service companies will continue. The
recommendations of the Hunt Commission and the President's Proposals on Financial Reform for the
gradual elimination of most of the distinctions among existing financial intermediaries, will provide
much of the impetus. The bank holding company will be at the forefront because it is an ideal corporate
structure in which to consolidate, efficiently, a variety of financial activities including consumer finance,
mortgage banking, leasing, real estate advisory services and others.
Diversification into these "non-bank activities" can provide (a) sources of earnings which are
contracyclical to those of the bank, (b) entry into financial activities with potentially higher returns on
assets and invested capital than banking and (c) the establishment or acquisition of a network of offices
which can be important in the development of regional and national financial systems. The expansion of
bank holding companies to provide these additional financial services will require careful attention to
methods of allocating capital to ensure adequate return on incremental assets and shareholders' equity.
The need for diversification by banks into related financial activities is underscored by the fact
that the days of cheap deposits and easy lending are over. Even smaller banks increasingly must buy their
funds in the money markets. Interest rates on traditional kinds of bank loans are being depressed by
growing competition from the commercial paper market, short and intermediate term, public debt
markets and direct corporate placements with institutional investors and captive finance subsidiaries of
non-financial companies. As a result, banks and bank holding companies are being forced to absorb more
risk to maintain a reasonable spread over the cost of incremental funds, by entering more "difficult"
areas of financial specialization such as factoring, leasing, and construction lending.
The real cause of the problem of capital adequacy for select banks is their inability to maintain a
high return on assets. If a bank whose earnings and assets are growing at 12%-15% is able to maintain a
return on assets for many banks has not increased certain assumptions, will grow at the same rate as its
assets (see Table 2). But if it experiences declining returns on the increasing assets, its capital ratios will
shrink (see Table 3) . Unfortunately, the average rate earned on assets for many banks has not increased
as rapidly as their average cost of funds. Also, non-interest expenses, such as loan losses, building
expenses and labor costs have risen faster than non-interest income. The result has been a deterioration in
the rate of return on assets, in some cases to very low levels.


Growth ofCapital - High ROA



return on assets
per year growth in assets
dividend payout
equity capital/assets
$100,000 $112,000 $ 125,500 $ 140,500 $157,500 $ 176,500

Assets: Year-end (000)
Earnings (000)
Dividends (000)











Increase in equity capital (000)








Equity Capital: Year-end (000)
Capital/Assets: Year-end










Growth of Capital - Low ROA



Assets: Year-end (000)
Earnings (000)
Dividends (000)

return on assets
per year growth in assets
dividend payout
equity capital/assets
$100,000 $ 112,000 $ 125,500 $ 140,500 $ 157,500 $176,500

Increase in equity capital (000)
Equity Capital: Year end (000)
Equity Capital/Assets : Year-end























Banks that have accepted declines in return on total assets have made themselves vulnerable to
unexpected adverse circumstances. Higher loan losses, major writedowns of the investment portfolio,
foreign exchange losses, or changes in the regulatory climate (imposition of interest rate ceilings on loans,
removal of maximum interest rates payable on savings deposits, etc. ) can all have adverse effects on
earnings and ultimately cause capital erosion . For example, Franklin National Bank's illiquid
investments, increasing loan losses and deteriorating return on assets left it unable to withstand the
sudden and unexpected earnings impact of extraordinary bond trading and foreign exchange losses.
The Franklin National episode also demonstrated that a bank which suffers a serious earnings
setback, at a time when it is ill-prepared to withstand it, may experience a "crisis of confidence", both
within its own industry and among the public. If, as a result of that crisis of confidence , it becomes
unable to borrow in the federal funds market , unable to renew its certificates of deposit , and/or unable
to prevent a massive overflow of savings deposits, the bank in all likelihood will fail unless rescued.

Summary Comments
The rapid growth in size and scope of activities of banks and bank holding companies is likely to
continue. The forces underlying the changes in our capital and money markets and in our system of
financial intermediation will foster further expansion of bank holding companies.


52-221 O - 75 - 25


In the view of the three federal regulatory agencies-the Office of the Comptroller of the
Currency, the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance
Corporation-the banking industry occupies a unique role in the U.S. economy. The well-being of
business depends to a large extent on the strength of the financial system of which commercial banking is
the central element. For John Sheehan, a Governor of the Federal Reserve Board , this means that banks
have "...a responsibility going far beyond that of the ordinary business concern. Bankers have a
responsibility not only to their shareholders but also to the economy and the nation as a whole. "
That banking is a regulated industry has both positive and negative implications. There is limited
entry to the industry, providing partial protection from competition. Bank examinations add stability
and help to prevent failures, which protects shareholders' equity position . The Federal Reserve provides
funds as " lender of last resort ". Most importantly, as the principal instrument for the execution of
monetary policy, banks benefit from a built-in growth in the volume of earning assets . The major
negative aspect is that bank and bank holding company managements do not have total freedom in
decision-making. Certain activities are precluded, some locations are not open to entry, and mergers and
acquisitions must be individually approved, a process that can take considerable time.
The three regulatory agencies are faced with a somewhat delicate task in their supervision of the
nation's banking system. As stated recently by Jeffery Bucher, a Governor of the Board :
"Historically, United States Bank supervision and regulation has been... focused on the
protection of bank deposits through prevention of unsafe and unsound banking
practices... The whole idea was to avoid financial castastrophe by putting the regulatory
hand into commercial bank practices and forbidding certain procedures regarded as too
The goal has been to preserve public confidence. Despite the fact that there are no definitive
methods of measuring levels of confidence nor of gauging the impact of events such as the recent
well-publicized bank failures, the regulatory agencies generally believe that the system of supervision and
regulation works well and that the relatively small number of bank failures so indicates.
Although this cautious approach is most understandable, especially in view of the insurance risks
undertaken by the FDIC and the assumed responsibility of the Federal Reserve to provide funds as
"lender of last resort" to a bank suffering a liquidity crisis (even if due to the bank's own
mismanagement ), the agencies themselves realize that regulation cannot be such as to reduce all banks to
the median level of competence. The FDIC's chairman, Frank Wille , said last April :
"None of us should ignore the lessons of the past but we must also recognize that the
name of the game today is competition and service , not the protection of institutional



safety and solvency or the protection of bank managements against the effects of their
own business decisions and policies. In the final analysis, the task... is to assure
confidence in the nation's banking system without fostering an overcapitalized position
which would be properly subject to criticism as an inefficient use of increasingly scarce
capital resources."
The fostering of an innovative , competitive banking system, designed to provide the most service
to the public at the lowest cost, must therefore also be a major goal of the regulatory community, and its
policies on bank capital must reflect that goal.
All three federal agencies appreciate the difficulty of determining the appropriate level of capital
for an individual bank, to ensure its ability to absorb operating losses and to provide for the protection
of its depositors in the event of failure and liquidation without at the same time overly restricting its
ability to compete in its servicing of customers. Brenton Leavitt, Program Director of Banking Structure
of the Federal Reserve , feels that an adequate level of capital is " that will satisfy reasonable and
knowledgeable people that it is adequate to protect against contingencies that should be anticipated
without placing on the banks an onerous burden which will unnecessarily restrict their competitive
capabilities." He further states:
"At this time there does not appear to be any wholly satisfactory way to determine a
specific level of capital necessary to maintain a safe and stable banking system. This,
however, does not obviate the need for, and continued search for, a standard of capital
adequacy to be used by bank regulators, given the ineffectiveness of marketplace policies
due to the special nature and sheltered position of banks.”
Perhaps because the regulators realize the difficulty in quantifying capital adequacy, they are
fairly well in agreement that the capital and money markets are at present not able to properly evaluate
the risks associated with banks. Chairman Wille argues that banking is by nature so complex and secretive
that he questions whether it is realistic to expect depositors, buyers of debt securities and equity
investors to demand the necessary information, especially from smaller banks, so that the protective
regulatory cloak can be lifted and free market forces permitted to operate.
Federal Reserve Board
Of the approximately 14,000 banks in the United States, about 6,200 are members of the
Federal Reserve . About 4,600 of these members are nationally chartered; primary regulation rests with
the Comptroller of the Currency. The balance are state chartered; the Federal Reserve Board has primary
responsibility for their regulation and supervision.

Form ABC
Although aware of the importance of various qualitative factors in determining appropriate
capital levels for individual banks, the Board has attempted to develop some formal statistical methods
for guiding their evaluations.


In 1956, the Board began using the Form for Analyzing Bank Capital, known as Form ABC (see
Exhibit I ) . This form attempts to assess overall capital adequacy in three ways: asset risk, liability
volatility and overall capital ratios. The asset risk calculation involves the assignment of varying amounts
of capital for the credit risk and market risk of each asset category. The total level of capital appropriate
is the sum ofthe requirements for credit and market risk, for trust operations, and for covering "adjusted
total assets". Liability volatility involves a determination of the potential liquidity requirements for each
class of liability, and a comparison against the net liquidity available from assets (after providing for
market and credit risks) to arrive at net capital required for liquidity purposes . Overall capital ratios
measure the adjusted capital structure and adjusted equity capital (as defined in the form) against
(a) total assets, (b) deposits and (c) assets less primary reserves and U.S. Treasury and Agency securities.
Liquidity ofthe Banking System

The Federal Reserve Board is concerned about the decline in the liquidity of the banking system,
especially coupled with the increase in purchased liabilities which it characterizes as "less stable". The
liquidity of the system, traditionally measured as the ratio of cash and U.S. Government securities to
total assets, has decreased from 33.1% in 1965 to 24.6% in 1973, while large certificates of deposit have
risen from 107% to 26.9% of total deposits during this same period. (Source: Federal Reserve Bulletin) .
Governor Sheehan has stated :

"A generous cushion of equity capital would give the bank added flexibility when setbacks (outflows of deposits) occur and would likely enhance its position with
knowledgeable lenders."
While a large capital position might increase the public's confidence during difficult periods, the capital
of a bank is not held in liquid form and is therefore not available to meet liquidity crises. (See Part IV:
"Attitudes and Approaches of the Banking Industry-The Vojta Study".)

Overseas Expansion
Governor Sheehan recently stated that a factor supporting his contention that banks should not
permit their capital positions to decline further is the tremendous growth in foreign assets of U.S. banks.
In his view, "there are some disquieting aspects of this expanded business ". While there has not yet been
any indication that such expansion has any greater credit or liquidity risks than domestic banking, the
Federal Reserve is of the belief that the overseas activities of all but a very few major banks may prove to
be less than soundly based. A careful bank-by-bank analysis by both regulators and investors is
appropriate, including such factors as the amount of assets actually at risk (much of the business is
redeposit activity and loans insured by government agencies) , the total sources of funds available and the
maturities of both assets and liabilities.



Comptroller ofthe Currency
The Office of the Comptroller of the Currency, within the Treasury Department, has primary
responsibility for the supervision of the approximately 4,600 nationally chartered banks which account
for 60% of all bank assets. About 1,400 of these national banks are affiliates of bank holding companies
which account for roughly 75% of the assets of all bank holding companies.
The Comptroller's office has examined capital structure more from a qualitative than quantitative
point of view. Comptroller James Smith recently stated, "I personally believe that no strict formulation
can substitute for the factor of human judgement in determining capital adequacy." A national bank
examiner therefore puts special emphasis on eight qualitative factors in assessing a bank's capital
- Quality of management
-- Liquidity of assets
- History ofearnings and the retention thereof
- Quality and character of ownership
- Burden of occupancy expense
- Potential volatility of deposit structure
- Quality of operating procedures
- Capacity to meet present and future financial needs of the trade area, consideringthe
competition faced.
The Comptroller has avoided the use of "acceptable" ratios largely because of the belief that
many banks would be encouraged to permit their capital ratios to decline to accepted minimums. As a
guide, however, the Comptroller's Office has done some work on relating total classified assets* to gross
capital funds, including reserves, feeling that the volume of classified assets is one measure of the degree
of potential loss in a bank's asset portfolio. Banks with a ratio of classified assets to gross capital funds
below 20% are "A" banks, 20%-40% are "B" banks, 40%-80% are "C" banks and over 80% are "D"
This approach assumes that "A" banks can safely reach higher loans-to-capital ratios than can
banks in the "D" category. (Approximately 85% of national banks are "A" banks.)

The Role of Long-Term Debt
The Comptroller believes, as does the FDIC's Chairman, that some debt can properly be included
in the capital base of a bank despite the obvious basic differences between debt and equity. The Federal
Reserve is still considering the matter, as indicated by some recent comments of Mr. Leavitt:
"Debt cannot be used to cover losses while a bank is solvent, and as such cannot be used
to maintain the bank as a going concern until earnings recover . On the other hand, debt
does serve to give the uninsured depositors added protection in the event of liquidation,
* Classified assets are those which examiners find to be subject to some type of criticism.


essentially contributing to the maintenance of confidence. The importance of debt in
serving this latter function, however, is difficult to determine... Currently the policy of
the Comptroller of the Currency and the Federal Deposit Insurance Corporation is to
allow approximately one-third of the required capital to be long-term debt . The Board
has not expressed a policy. "

Federal Deposit Insurance Corporation
The FDIC insures the deposits of almost all banks and examines the 7,800 state chartered banks
(only about ten of which have total assets of greater than $ 500 million) which are not members of the
Federal Reserve. The reports of the Comptroller and of the Federal Reserve are accepted by the FDIC
for its insurance purposes for national banks and state chartered member banks.
Despite the fact that the FDIC examines so few large banks , many of its attitudes regarding bank
regulation and examination have broad applicability. For example, Chairman Wille views capital ratio
analysis as but the starting point in a thorough evaluation of a bank's position:
"The Corporation has traditionally been concerned with the general level of capital ratios,
because of the close relationship between these ratios and the Corporation's risk.
However, this emphasis on capital ratios ... should not be taken out of context and
misconstrued as a minimum standard applicable to individual banks. On the contrary,
banks are sufficiently dissimilar as to the quality and character of their assets, the relative
competency of their managements, and the relative stability of the economic
environment in which they operate... If any generalization may be made, it is that the
capital of any given bank should be sufficient to support the volume, type, and character
of the business presently conducted, provide for the possibilities of loss inherent therein,
and permit the bank to continue to meet the reasonable credit requirements of the area

Bank Holding Companies
The increase in the number of bank holding companies and their rapid expansion into areas
permitted by the Federal Reserve under the Bank Holding Company Act are of concern to the regulatory
community. Governor Robert Holland said last April :
"To my mind one of the critical issues in this area today [ the need to insure the safety
and soundness of the nation's banking system] is whether or not the risks undertaken by
a holding company parent and its non-bank subsidiaries may eventually have to be borne
by the firm's banking subsidiaries. "
The Comptroller's Office feels similarly about national banks forming or joining holding
companies. David Motter, Deputy Comptroller, said recently,
"There is no realistic way to avoid bank association with the difficulties experienced by
the [ holding company] affiliates. In other words, since banking is built upon public



confidence, it is unrealistic to assume that a bank would stand idly by and allow the
insolvency of a related affiliate."
The regulatory agencies have indicated their interest in the overall capital structure of ban
holding companies but have not as yet put forth any specific recommendations . Governor Sheehar.
recently stated that the Federal Reserve Board "... must, given the law, look carefully at the capita.
position of holding companies and their banks".
The desire of the regulators is of course to ensure the safety of the subsidiary bank. They feel
that one method of accomplishing this is to finance the holding company and non-bank subsidiaries such
that the bank is not adversely affected by affiliation with them. As Deputy Comptroller Motter has
"In our office we look with favor upon the affiliation of a national bank with a parent
holding company only when the net effect is to strengthen the position of the bank."
The regulatory concern is also reflected in a view of the FDIC:
"For the most part, acquisitions of related businesses under the 1970 Bank Holding
Company Act Amendments have not been accompanied by significant additions to
equity... There is no capital cost associated with the incremental additions to
earnings... Insofar as they result in thinner equity coverage the concern of bank
regulators will increase."
The Federal Reserve's concern for the capital adequacy of banks and bank holding companies is
clear from recent decisions involving applications for acquisitions primarily of non-bank activities. In
denying Chemical New York Corporation permission to acquire CNA Nuclear Leasing Inc. , the Board
"One of the primary purposes of a holding company is to serve as a source of financial
strength for its subsidiary banks . In the Board's judgement a proposal such as this to
acquire an extremely leveraged company with very heavy requirements for funds, could
seriously impair that ability."

The Federal Reserve also denied First Chicago Finance Corporation, an Edge Act subsidiary of
First National Bank of Chicago, permission to acquire shares of two overseas financial institutions. In the
refusal, the Federal Reserve stated that the bank, which is regulated by the Comptroller ofthe Currency,
had experienced slower growth in capital than in assets and that the preferred use of funds would be to
increase the capital and liquidity positions of the bank. *
With the passage of the 1970 Amendments to the Bank Holding Company Act, the Federal Reserve was given the responsibility to
regulate the organization and expansion of all bank holding companies, rather than simply multi-bank holding companies as prescribed
under the original Act. Although the Amendments did not provide for any changes in the direct regulation of member banks in a holding
company, the Board is now raising questions about the capital adequacy of all banks in a holding company regardless of whether it has
primary regulatory responsibility. The assumed authority for the Board's actions is that the Bank Holding Company Act requires the
Board to consider all relevant financial factors in reviewing an application. 1


In a paper on Bank Holding Company Supervision and Regulation, the staff of the Federal
Reserve noted, "The Board's overriding objective is to permit expanded activities, competition and
greater innovation by banking organizations within the stability of the banking system. " This involves in
their view a need to "...devise a regulatory posture that prevents inappropriate use of debt by bank
holding companies."
The staff report indicated uncertainty as to the role to be played by the private markets in
allocating credit among holding companies. It states as a primary benefit the fact that restraints could be
imposed by rating agencies, commercial paper buyers and investors who "...can move more quickly than
regulatory authorities to motivate bank holding companies to cut debt." The staff's underlying concern,
however, is that:
"The private marketplace is less careful in evaluating commercial paper and long term
debt of bank holding companies... Private investors have the overly simplistic view that
the strength of the bank holding company is of necessity little different from the strength
ofthe major banking subsidiaries."

Summary Comments
There appear to be, in the final analysis, three fundamental and interrelated questions in this area
of bank regulation and supervision:

- To what extent should banking be a protected industry?
-To what extent can the regulatory agencies permit the holding company movement to expand
without jeopardizing the ability to regulate and to effect monetary policy?
-To what extent should the regulators allow the marketplace to participate in the
determination of appropriate capital structure for banks and bank holding companies?
It appears, based on their recent speeches, that the regulators are hopeful that the private sector
will eventually play a greater role in determining appropriate capital structure for banks and bank
holding companies. For the present , however, the regulatory attitude seems best summarized by a recent
statement of Governor Sheehan:

"[We should] vigorously resist a further decline in bank capital ratios while we reflect
carefully on the complex issues involved and make certain that banks remain in a solid
competitive position. "




The three major rating agencies-Moody's Investors Service , Standard & Poor's Corporation and
Fitch Investors Service-have been assigning and publishing ratings for publicly offered debt securities for
more than 50 years. Reliance on these ratings by the investment community has increased significantly
during this period, so much so that the rating agencies have come to be viewed as quasi-public institutions
responsible for protecting the investor. Securities ratings , designed to provide investors with an indication
of the relative probability of timely payment of interest and repayment of principal, aid in gauging
quality because debt issues are measured on a consistent basis.
Ratings can have an impact on the interest cost and marketability of public debt issues, since the
pricing of such issues is influenced by, among other things, the range established by publicly traded debt
securities with the same rating; and since the lower the rating, the more difficult it will usually be to find
investors interested in accepting the implied degree of risk, particularly during periods of tight money.
Many institutions are precluded from purchasing debt securities which do not bear one of the top three
or four "investment grade " ratings. (See Exhibit IV) . Others are prohibited from purchasing debt issues
which do not have ratings from at least two of the agencies. As a result almost all public debt issues
eligible for a rating are in fact rated, whenever possible by two agencies.
The concept of associating investment quality with ratings by these agencies has become so
throughly a part of the evaluation of debt securities that even debt issues which are placed privately with
institutional investors are often referred to in terms of the rating they might have been assigned. In
addition, a rating may affect not only the cost and marketability of the debt issue rated, but of a
company's other securities as well . The investment community usually regards the most recent bond
rating as an indication of over-all investment quality, which can affect the company's general credit
standing. Some investors believe that a company's common stock cannot be of investment grade if its
senior debt securities are given a relatively low rating.
For a number of reasons, the services have been somewhat hesitant to rate the commercial paper
and long-term debt of banks and bank holding companies. The primary reasons for caution are the
unique role that banks play in the economy and the laws designed to protect the stability and reputation
of the banking system. Other important reasons are the lack of readily available detailed information on
bank and bank holding company activities and the fact that bank debt , both short and long-term, is a
relatively recent phenomenon (see Exhibit VI ) . Initially, the long-term debt of banks and bank holding
companies was rated only by Fitch, and the commercial paper of bank holding companies was rated only
by a division of Moody's. In the last 12 months Moody's has begun to rate the long-term debt of
bank holding companies and Fitch began in 1972 to rate their commercial paper. Standard & Poor's has
also begun recently to rate commercial paper of bank holding companies and is presently considering
whether to rate their long-term debt .



At the beginning of 1974 , Moody's began rating long-term debt of bank holding companies which
had at least one non-bank subsidiary ( see Exhibit III ) and have thus far assigned a rating to nine such
issues. (A division of Moody's has assigned commercial paper ratings to bank holding companies since
1969 and is currently rating about 85 of them).

At present Moody's has a two-part procedure in providing a rating for long-term bank holding
company debt. Ratings are assigned only to bank holding companies which make an application.
Moody's first undertakes an appraisal of a proposed debt offering and makes its results known only to
the bank holding company. The holding company may choose to have the rating published by Moody's
or it may decline. If the company elects to have the rating made public, then Moody's will do so and will
undertake to maintain its surveillance of the bank holding company . Once the decision has been made to
publish a rating, the company may not subsequently reverse its decision.
Information requested by Moody's from a bank holding company generally includes, among
other things, financial projections, anticipated leverage, operating margins, liquidity, amount of legal
limit loans, geographic distribution of loan portfolio, industry categories of loans and outstanding lines
of credit for principal industries. Moody's requires consolidating statements of income and balance
sheets, and analyzes all significant non-bank activities. (Moody's feels these non-banks subsidiaries do not
have the same " quality of earnings" as do banks. As a result, a bank holding company having a large
amount of non-bank activities may receive a lower rating than one which is primarily a bank. ) Moody's
also meets with management in order to obtain an understanding of its overall philosophy and principal
Moody's dislikes overdependence on short-term purchased liabilities and the assumption by some
bank and holding company managements that the rollover of such instruments can be accomplished even
in difficult markets. Moody's also dislikes "double leverage", which is the application by the parent
company of the proceeds of its own debt issues to make equity investments of its bank and non-bank
subsidiaries. This process is often followed by additional independent borrowing by the subsidiaries.
Moody's prefers financing to be accomplished by the user of the funds wherever possible , and feels that
each non-bank subsidiary should have a capital structure which is appropriate to its industry. In
analyzing capital structure , Moody's includes deposits, federal funds and other short-term borrowings,
long-term subordinated indebtedness and equity. The valuation portion of the loan loss reserve, which is
the portion which can be used to absorb loan losses, is included in equity. A convertible debenture is
considered to be equity only when it is selling below conversion value and conversion seems likely prior
to maturity; recognition is also given to subordinated debt when appraising a senior debt issue.

Moody's appears to place greater emphasis on capital strength than on earnings . Thus far, the
highest ratings have typically gone to such money center banks as Bankers Trust and Manufacturers
Hanover, where Moody's has attached significance to overall management expertise and the many
available sources of liabilities.



While most of Moody's initial ratings have been Aaa (see Exhibit V) , we believe that eventually
they may concentrate in the A area, and that a number of bank holding companies may not qualify for
an investment grade rating.
Standard & Poor's
Standard & Poor's has been critical of the lack of information historically provided by banks to
the marketplace . Russell Fraser, Vice President of the Corporate Finance Department, feels "...the
banking industry has never before been subject to the searching appraisal which any debt issuer must
ultimately expect," and he believes this must change . Standard & Poor's has therefore taken a cautious
approach to rating bank holding company long-term debt . After gathering and studying information for
the past year, it hopes to make a decision within a few months on whether it will provide such ratings.
Standard & Poor's initial step in evaluating its ability to rate bank holding company debt was the
design of computer programs sufficiently sophisticated, and a data basis sufficiently large, to permit
adequate analysis of the complex inter-relationships , including the regulatory restrictions thereon,
among the principal bank or banks, the parent company and the non-bank affiliates. A data base has now
been accumulated for 62 bank holding companies which agreed to provide information , and 112
ratios have been developed to be used principally as a screen at the beginning of the evaluation process
(see Exhibit II for Standard & Poor's questionnaire) . This statistical analysis includes the bank's
operating and balance sheet ratios , loan and investment yields, liquidity measurements, loan losses,
capital ratios and interest coverages, the relationship of bank data to the consolidated figures, and various
income and balance sheet information about the parent company.
Among the areas of concern to Standard & Poor's are the holding companies' apparent lack of
self-regulation, inadequate long-range financial planning, over-reliance on purchased liabilities, simplistic
capital allocation methods and the low levels of equity capital in some non-bank areas. Their principal
concern , however , is "double leverage". Standard & Poor's measures the " double leverage ratio" obtained
by dividing the holding company's equity in all subsidiaries by its own net worth, and also calculates the
"double leverage payback period", which is the number of years earnings of the subsidiaries required to
retire the debt of the parent.
Standard & Poor's prefers that debt of the parent be downstreamed as debt of the subsidiaries, so
that funds may be subsequently upstreamed without regulatory approval. It also likes to know which
activities are the real users of any borrowing so as to have a better understanding of the true obligor
within the holding company.

Fitch has been rating long-term debt issues of bank and bank holding companies since 1964 and
commercial paper since 1972. (It is the only agency which rates the debt of banks) . There are
approximately 140 banks and holding companies whose long-term debt has a Fitch rating, and eight
whose commercial paper has been so rated.



Fitch has indicated that the ratings assigned are based on an examination of earnings history, rate
of return on assets and on capital invested, degree of leverage employed, growth in deposits and loans,
composition of the loan portfolio, history of loan losses, mix of passbook and time deposits, degree of
liquidity and reliance on short-term debt, degree of involvement in international activities, nature of
non-bank subsidiaries, and apparent quality and depth of management. Wherever possible and
appropriate, Fitch obtains statistical data for each bank and non-bank subsidiary and for the parent .
alone, as well as on consolidated basis.
Fitch holds many of the same concerns regarding banks and bank holding companies as do
Moody's and Standard & Poor's:
the rate of overseas expansion by some banks
– the rapid diversification into non-bank areas
- inordinate reliance on short-term purchased liabilities
- lack ofsophisticated financial planning
Fitch feels that non-bank subsidiaries should be as independent of the affiliated bank as possible,
and that an appropriate capital structure in each such subsidiary will result in a properly capitalized bank
holding company.

Commercial Paper
More than 80 bank holding companies have issued commercial paper, principally to finance
the activities of their non-bank subsidiaries. Moody's has assigned 24 ratings of P- 1 and 61 of P-2 ;
Standard & Poor's has assigned 7 of A- 1 and 11 of A-2 . Neither has assigned a rating below that level.
Fitch has given out seven F-1 ratings, one F-2.

Moody's rating criteria for commercial paper are the same as for long-term debt issues. Bank
holding companies must have equity of at least $40 million to qualify to be rated, and of $ 150 million to
be considered for a P- 1 rating. There must be at least one non-bank subsidiary. Standard & Poor's does
not have such cutoff points, nor do they specifically require the existence of non-bank subsidiaries. Fitch
follows the same policy as Standard & Poor's.

Summary Comments
Increased participation by the rating agencies in the process of determining appropriate capital
structures for banks and bank holding companies seems assured . We hope that this will relieve some of
the burden of the regulatory community, upgrade the sophistication of depositors and investors, and
encourage bank and bank holding company managements to accelerate development of financial
planning systems .



The greater availability of ratings and the possibility of multiple ratings not only will assist
investors in evaluating the quality of bank holding companies and the impact of their on-going
diversification efforts, but also will be influential in broadening the market acceptance of bank and bank
holding company securities. During the next several years, while the capital and money markets develop
a better understanding of the banking industry, we believe that ratings ( or lack thereof) can be ofgreat
importance in the marketing of the industry's debt issues.



The managements of many banks and bank holding companies have not addressed themselves to
some of the fundamental questions about capital adequacy and capital structure. There has been a quest
for growth in assets and earnings by many banks with an apparent willingness to accept declining returns
on assets and greater leveraging of equity capital ( in the form of more debt and higher asset to capital
Bank managements have been generally unreceptive to suggestions that the industry might need
additional equity capital. Many feel that the decline in capital ratios over the past ten years or so is
appropriate for several reasons , most especially the improvements in the quality of bank management
and the increase in the ability of the Federal Reserve to regulate and stabilize the financial markets.
Bankers believe that returns on equity must be sufficiently high to enable banks to compete
successfully for capital in the financial markets. In their view, the desired return on equity is to be
accomplished primarily by further increases in leverage.
Many decry what they perceive as the overly restrictive policy of the regulatory community,
particularly the Federal Reserve ; they feel that capital ratios determined in Washington are increasingly
arbitrary and outdated, and that the appropriateness of a bank or bank holding company's capital
structure should be determined by the marketplace . George Vojta, a Senior Vice President at First
National City Bank, has gone so far as to state:
"The overriding objective of regulatory policy must be to prudently promote the
evolution of bank and bank holding companies in pro-competitive terms. Cognizance
must be given to the fact that banks can only perform the intermediation function by
competing against a formidable array of bidders for funds in the money and capital
markets. Success in the market place necessitates management of banks to prudently
maximize earnings and the return on capital."
William Dougherty, President of NCNB Corporation , has also questioned the regulatory approach
toward capital:
"Commercial banking should be an integral part of the mainstream of private enterprise
and should be regulated in terms generally appropriate to private enterprise . Enterprises
operate as going concerns, and are evaluated in terms of profits and rates of return on
capital. Capital in an on-going enterprise must be sufficient to anticipate periods of
relative difficulty and provide a prudent margin of safety. However, a business which
maintains a level of capital sufficient to withstand exaggerated risks of ruin will incur
some competitive disadvantage in the marketplace ... Of foremost importance is the fact
that if banks are to compete for capital in the marketplace and remain viable growing


enterprises, they must be able to earn a competitive return on equity and must be
permitted to utilize debt capital in their capital structure ." (Emphasis is added.)
Many bankers express dismay at their potential inability to compete , despite their international
office networks and their management expertise, against foreign banks with less restrictive
regulatory environments. They point to the fact that 17 of the 20 largest banks in the world are foreign
banks, whereas ten years ago there were only ten foreign banks in this group. Wesley Lindow, President
of Charter New York Corporation, states, "A deliberate policy and practice of resisting declining capital
ratios could place large U.S. banks at an additional disadvantage with respect to large foreign banks. " As
Table 4 shows, foreign banks other than the British do have lower capital to asset ratios (and therefore
greater leverage) . These banks also tend to have much lower returns on assets and lower returns on

Comparative Ratios for Selected Banks

Income as
Loans as a Equity & Subordinated Income as
Debt as a % of
a % of
a % of
Total Assets
Country Total Assets
Capital(b) Total Assets(
Bank of America (12/31/73)(a)
First National City Bank (12/31/73)(a)
Chase Manhattan Bank ( 12/31/73)(a)
Banque Nationale de Paris ( 12/31/72)
Dai-Ichi Kangyo Bank (9/30/73)
National Westminster ( 12/31/73)
Barclays Bank (12/31/73)
Sumitomo Bank (3/31/74)
Fuji Bank (9/30/73)
Credit Lyonnais (12/31/72)
Societe Generale (12/31/72)
Mitsubishi Trust (9/30/73)
Sanwa Bank (3/31/73)
Royal Bank of Canada (10/31/73)
Dresdner Bank (12/31/72)
Westdeutsche Bank ( 12/31/72)
Manufacturers Hanover Trust Co. (


(a) Holding company consolidated. Difference deemed not material.
(b) Income is before securities gains and losses.






The Vojta Study
The principal recent study on bank capital is Mr. Vojta's Bank Capital Adequacy (February
1973). Mr. Vojta feels that the Federal Reserve's Form ABC is overly conservative because its capital
requirements seek to protect a bank against "simultaneous worst case loss experience in all categories of
risk ", which is unnecessary and at variance with a going concern approach. He maintains that capital
levels should relate to environmental conditions short of economic crisis :
"The capital account of a bank is not adequate to maintain solvency in the event of a
major liquidity crisis nor can the capital account withstand the pressure of a major run
once public confidence in the particular bank has been irretrievably lost . Effective
defense against ultimate crisis comes from lenders of last resort. The admissible
liquidity-related risks for capital adequacy purposes are the earnings risks associated with
sub-optimal asset liquification or liability refinancing."
Mr. Vojta does not believe that it should be the role of the Federal Reserve to "bail out" banks
which have created their own crises , and he perceives a gradual change in the regulatory attitude toward
acceptance of this approach. He does feel that the government should intervene in a crisis period in
bankingjust as it does for other industries.
Building in part on Form ABC, Mr. Vojta proposes a management of risk approach to capital
adequacy. This involves assessment of the risk-taking capacity of the bank (its ability to absorb losses) in
six areas where quantification in historical terms is possible : credit (loan losses) , liquidity, investment,
operating, fraud and fidelity, with the greatest emphasis on credit risks . He believes that earnings should
be the first line of defense against losses. Prudent management should require that anticipated earnings
(after taxes, accounting provision for losses, dividends and other charges) should be at least twice
expected loan losses as estimated by management based on economic projections and other known
factors. * The earnings test serves both as a warning device to management to indicate degree of risk in
relation to expected earnings and as an effective screen to determine which activities are not generating
sufficient earnings .
Capital, the second line of defense, is expected to absorb losses beyond normal management
expectations. Mr. Vojta's " capital cushion test" requires that a prudent level of capital funds aggregate at
least 40 times the average loan losses ofthe past five years.
Table 5 indicates that as at December 31 , 1973 only three of the ten largest U.S. banks satisfied
Mr. Vojta's earnings test and only six met the capital cushion requirements.
* Both taxes and dividends are available to absorb losses; it is useful, though, to calculate the ability to absorb losses without a dividend
interruption which could damage public confidence.



The Vojta Approach to Capital Adequacy
(Dollar amounts in millions)
Loan Losses

Earnings Test
Bank of America
First National City
Chase Manhattan
Manufacturers Hanover
Morgan Guaranty
Chemical New York
Bankers Trust
Continental Illinois
First Chicago
Security Pacific

Capital Cushion Test

Bank of America
First National City
Chase Manhattan
Manufacturers Hanover
Morgan Guaranty
Chemical New York
Bankers Trust
Continental Illinois
First Chicago
Security Pacific






2.03X 1.51X
46.32 38.42
(0.7)(c) 2.48(c) 1.76(c)


(a) Net income less dividends, for fiscal 1973.
(b) Net loan charge-offs for 1973 used for illustration because of
recent increases in loan losses.
(c) Five year average losses ($21 million) used.
(A) Before additional transfers to loan loss reserves.
(B) After additional transfers to loan loss reserves.


52-221 O - 75-26



Table 6 illustrates the capital and earnings requirements for a hypothetical bank , using the Vojta

Earnings and Capital Cushion Tests


Loan Losses
Dividend payout

$100 million
$ 70 million
$210,000 (0.30% of loans)

Earnings Test : Earnings (after dividends and transfers to reserves) should be twice expected loan losses).

Loan losses expected
Earnings required (after dividends)
Earnings required (before dividends-40% payout)
Required return on assets


Capital Cushion Test : Capital funds (including loan and contingency reserves) should be 40X loan losses.

Loan losses

X ) 40

Required capital funds


Assets/capital ratio
Loans/capital ratio

The "Scenario" Aproach
Some banks and bank holding companies are attempting to assess the sufficiency of capital in
relation to specific categories of risk and under clearly defined economic and political hypotheses. This
kind of analysis is generally based on the following assumptions:
1. The principal role of capital is to absorb losses.
2. The types of risk faced must be precisely defined to reflect the present business




3. Assumed business and political conditions must be clearly stated based on historical
4. Capital planning should be based on the "going concern " concept. There should be no
assumption in assessing capital adequacy , for example, that a bank's building or other
properties will be liquidated.
5. Capital levels should not be planned to provide for another "Great Depression".

6. Liquidity is viewed in terms of its potential cost and not as an availability problem.
Purchased funds are always available at some price. A bank need not attempt to
maintain liquidity adequate to survive a collapse of the banking system, which can
be prevented only by the Federal Reserve (assumed to have both the desire and the
capacity to do so).
The "scenario" approach includes (a) identification of the major risks of doing business-credit,
liquidity, operating, foreign exchange, investment, fiduciary and legal; (b) identification ofthe full range
of possible economic and political environments applicable to each risk category, considering "normal"
conditions as well as "worst case" situations (abnormal business conditions, inferior management
performance and adverse regulatory changes such as the withdrawal of deposit insurance) ; (c) estimation
of the possible losses in each category under each assumed "scenario” and determination of the total loss
potential; and (d) comparison of this total with existing levels of capital.
The "scenario" approach requires management to evaluate the environment, to consider the
interrelationships of the various kinds of risks which may be encountered, and to estimate the potential
impact of these risks on the capital structure of the bank or bank holding company. The usefulness of
the results of this analysis will depend greatly on the quality of management's estimates and evaluations.

The "Building Block" Approach
NCNB Corporation has as its objective the development of a capital structure which, through an
appropriate mix of equity, long and short-term debt , provides maximum return on equity without undue
risk to depositors, lenders or shareholders. It has determined that a "building block" approach best
achieves that objective. Under this "building block " approach, the desired capital structure of the
consolidated entity is determined by summing the hypothetically appropriate capitalizations for each
bank and non-bank subsidiary. Because of the diverse activities of the various subsidiaries NCNB feels
that broad holding company guidelines alone would be less meaningful.
The hypothetical capital structure for each subsidiary is arrived at by analyzing the prevailing
capital structures within its own industry and then determining the features of the NCNB subsidiary
which might warrant modification of industry norms. Such features would include earnings record,
quality and depth of management, loss and delinquincy experience, mix of assets and geographical
markets served.



The "Single Unit" Approach
The "building block" approach to bank holding company capital structure seems to be widely
accepted. In a Federal Reserve study of 27 bank holding companies, 18 indicated use of this method.
The other nine, and holding companies like them, place greater emphasis on a "single unit"
approach, in which (a) subsidiaries do not need "traditional" capital structures if they are too small to
effect independent outside financing, (b) the proper capitalization of a holding company is not
necessarily the sum of the appropriate capital structures of its subsidiaries, and (c) the marketplace
determines broad debt/equity guidelines for holding companies which may bear little resemblance to the
results of a "building block " analysis . They believe that the holding company should have greater debt
capacity than the total of the debt supportable by its subsidiaries individually, because a large diversified
organization enjoys the advantages of a more stable stream of earnings and a greater capacity to raise
capital than do small independent firms.
This approach also assumes that it does not matter whether debt is incurred at the subsidiary
holding company level, so long as consolidated cash flow is sufficient to service the debt.

Summary Comments
The approaches to capital planning put forward thus far by those studying the subject appear to
differ more in emphasis than in substance. Many banks, particularly the largest ones, feel that the capital
markets, rather than the regulators, should determine appropriate capital structure for banks and bank
holding companies, and that the ratios of the federal regulators are outdated and arbitrary. There seems
to be agreement that earnings levels, loan loss experience and levels of risk associated with different asset
categories and areas of activity should all be considered, and that each method of analysis-"earnings
test", "scenario", "building block" and "single unit" can contribute to the determination of an
appropriate capital structure for a bank or bank holding company.



The combination of the rapid changes occurring in the banking industry and the financial
markets and the decline in capital ratios will cause regulators, rating agencies and investors to pay much
closer attention in the future to the financial structure of banks and bank holding companies than has
thus far been the case.
The industry itself, however, has offered few constructive suggestions to assist in resolving the
questions of (a) what levels of capital in banks are appropriate to absorb unexpected earnings problems
and maintain the public confidence necessary for the viability of the industry, and (b) how to structure
and finance parent holding companies and non-bank subsidiaries in a manner that ensures the continued
well-being of affiliated banks. It is our impression that many bankers , large and small, have looked to the
regulatory agencies to determine necessary capital levels and have resisted capital increases until
regulators became insistent. Few banks have developed an indication of their overall capital needs
through a systematic analysis of the capital requirements of individual areas of activity.
Among the suggestions that have been made by some bankers is that lower capital ratios should
be permitted in order that U.S. banks may compete, domestically and abroad, against more highly
leveraged foreign banks. However, this suggestion may overlook (a) the much heavier concentration of
the banking industry in most other countries and (b) the closer government control of these banks,
including partial government ownership in some countries. If this were the price of greater leverage it
might be higher than U.S. banks would be willing to pay.
It has also been suggested that banks should be allowed a greater use of debt because their low
common stock prices make the sale of additional equity prohibitively dilutive. However, low stock prices
are not unique to the banking industry and, in fact, the superior returns on equity achieved by some
banks and bank holding companies have often been rewarded by high price/earnings multiples relative to
those of other industries.

Principal Considerations
Any discussion of capital planning should avoid the tendency to oversimplify and over-generalize
the very complex questions involved. There is no single "appropriate capital structure" for all banks, or
even for any group of banks. Each bank and holding company has unique capital needs which change
over time. There are, however, several considerations that we think managements of banks and holding
companies will have to take into account in carrying out their capital planning.
1. A principal objective of capital planning must be the development of a capital structure which
will maximize the market value of shareholders' equity on a sustained, long-term basis.
Leveraging of shareholders' equity by means of long and short-term debt should be used
judiciously because, while moderate leverage can produce higher earnings, the price/earnings


multiple accorded these earnings may decline as the degree of leverage proceeds beyond levels
acceptable to the marketplace.
2. The capital structure should be developed in such a way as to maintain public confidence,
especially in affiliated banks. A basic assumption must be that the Federal Reserve may not
provide sufficient funds to banks which, through their own mismanagement, lose the
confidence of the marketplace .
3. Capital allocation to areas of activity within an organization should be based on a thorough
evaluation of the nature of each activity, anticipated risks, growth potential and expected
4. Capital planning must provide for sufficient earnings and cash flow to service the debt ofthe
organization, wherever located.
The degree to which the regulatory community will relinquish to the marketplace the
responsibility for determining the appropriate capital structure for banks and holding companies has still
to be resolved. Many bankers have urged that the marketplace should perform this function, but the
regulators are not yet convinced. Mr. Leavitt of the Federal Reserve stated recently that the banking
industry has "tended to be virtually unchecked by the free market discipline exerted on other
industries." He feels that because of the confidential nature of a bank's assets, "the market cannot be
relied upon to determine the optimum point between profitability and stability." This confidential
nature "makes it difficult for the market to police bank leveraging," with the result being a "dependence
on the supervisory function."
We believe, however, that this dependence on the regulators will decrease over time and that the
money and capital markets will assume a greater role in assessing risks, evaluating profitability and
allocating capital to the most efficient users within the banking industry. Our confidence is based in part
on the following changes already occurring in the marketplace:
1. The Securities and Exchange Commission is requiring more complete disclosure by bank holding
2. Buyers of commercial paper and large denomination certificates of deposit, the most
important sources of additional funds for the majority of bank holding companies and banks,
are more carefully evaluating the financial strength of issuing institutions.
3. The Securities and Exchange Commission is requiring fuller disclosures by bank holding
companies, especially about non-bank activities, as indicated by recent prospectuses for
floating rate note issues.
4. Rating agencies are requiring additional information . As stated by Standard & Poor's, if the



banking industry " going to become a significant participant in long and short-term debt
markets, then [ it] should at least be willing to release the same quality of information other
borrowers in the public market must publish. " *

Capital Planning for Banks
Capital planning, in our view, can be divided into three parts, relating to (a) the bank subsidiaries,
(b) the non-bank subsidiaries and (c) the parent holding company.
The "appropriate" capital structure for a bank is not well defined , in large part because of the
rapid changes in the industry and the general absence of understanding of banks in the capital markets.
The more that is learned about banks, however, especially about their lack of homogeneity, the less it seems
desirable or feasible to attempt to set fixed capital ratios for the banking system or even for "categories"
Similarly, there is no formula approach available to a bank's management to determine whether
its capital is adequate. There are , however, several approaches that can be used to analyze the capital
structure of a bank. Some are of greater value than others, but each of them will yield certain insights
into the problem of determining appropriate capital levels.
1. Form ABC of the Federal Reserve – Although criticized by many bank managements , Form
ABC suggests a method of analyzing capital from the standpoint of market risk, credit risk and
liquidity. It also indicates areas of concern to the Federal Reserve which has been the most
vocal in pressing the issue of declining capital ratios.
2. Relative industry position - Bank managements and regulatory authorities have historically
measured capital adequacy by looking at an individual bank in relation to banks with similar
characteristics of size, location, business mix, etc. Regulatory attention tends to focus on
banks that deviate significantly from the mean, although changes in industry norms are
acceptable and desirable if they reflect improvements in management techniques and do not
produce additional problems . As always , banks that are at the extremes will be watched closely
by the marketplace.
3. Earnings and capital tests suggested by the Vojta study - The Vojta approach can be broadly
applied as a management tool to indicate the degree of risk assumed to achieve various earnings
4. The "Scenario" approach - This method involves a study of the risks involved in all areas of
activity and the loss potential associated with each area in specific business and political
* Some banks question the amount of information needed by the marketplace since substantial data are provided to various regulatory



Management should consider what part capital plays in the maintenance of public confidence.
Principally, it acts to absorb unexpected adversities such as management errors , major loan losses , foreign
exchange losses and other like occurrences in such a way as to avoid any suspicion in the marketplace as
to the bank's viability and thus prevent liquidity crises before they happen. We believe, however, that
capital should also be sufficient to withstand abnormal losses occasioned by the forced sale of assets to
meet deposit run-offs or similar liquidity crises.

✓ The Importance of Earnings
A bank's first line of defense against operating losses is earnings. Therefore, the importance of a
bank's maintaining a high return on assets cannot be overemphasized . The most obvious benefit is the
enhancement of public confidence, but there are others of significance.
1. As the marketplace becomes more sophisticated in its analysis of the industry, lenders and
investors will increasingly wish to place their funds with more profitable banks.
2. Banks with a high and constant return on assets have a demonstrated ability to employ higher
priced "purchased liabilities" profitably.
3. More profitable banks will be better prepared to withstand expected or unexpected increases
in loan losses, sudden writedowns of investments and other adverse circumstances (see Table
4. Because of its ability to cover higher fixed interest charges on capital notes, a more profitable
bank will be able to safely include larger amount of debt in its capital base.
5. A high rate of return on assets enables a bank to generate significant amount of capital
It has been customary to focus on earnings before securities gains and losses as the measure of
profitability. Growth in equity, however, may be a better indicator of earnings performance . In recent
years, equity capital has grown at a slower rate than income before securities transactions because
securities losses have been more prevalent than gains and because net loan charge-offs have exceeded the
provision for loan losses charged against income for many banks . Many, in fact , have unrealized
securities losses which represent a potential drain on future earnings , compounded by a low capital
position which precludes them from realizing these losses in order to free funds to take advantage of
higher yields available in the market. For such banks, earnings before securities transactions are a poor
measure of performance .

Ј Capital and Liquidity
Earnings, we have stated, should be sufficient to meet operating problems and most loan losses,
and historically have fulfilled this role. The function of capital, then, is to act as a "second line of
defense" to absorb truly unusual losses such as those sustained through the forced sale of assets
(principally the loan portfolio, since most ofthe investment portfolio would likely be already pledged in



Ability to Withstand Loan Loss Increases
(Dollars in Millions)

Bank A

Bank B

Total Assets



Total Loans
Earnings Before Taxes and Loan Losses

$ 70,000
$ 1,350

$ 70,000

"Normal" Situation
Provision for Loan Losses *
(0.30% of Total Loans)



Earnings Before Taxes
Net Income
Return on Assets


Unexpected Loan Loss Increase
Provision for Loan Losses
(1.00% ofTotal Loans)

Earnings Before Taxes


$ 700

$ 700



* For accounting purposes, loan losses may be written off only against the valuation portion of the loan loss reserve, which is the portion
created by charges against earnings. The balance of the loan loss reserve consists of (a) a transfer from retained earnings and (b) a deferred
tax portion. These transfers are made to obtain the maximum tax benefits under IRS guidelines which allow loan loss reserves to be 1.8%
of eligible loans.
In recent years, net charge-offs have generally exceded provisions for loan losses. For most banks the valuation portion is still many times
the likely level of charge-offs for 1974, but a prudent policy should require that the provision for losses be at least equal to actual
some fashion to meet deposit run-offs or similar liquidity-related problems. The ability to realize funds
through the sale of assets will help to determine the level of capital required to absorb such losses. Thus,
liquidity and capital are inextricably tied together.
We do not believe that an individual bank can or should maintain a degree of liquidity or level of
capital sufficient to meet crises that are industry-wide. We recommend, however, that a bank that ,
through its own mismanagement, suffers an outflow of deposits or other funds should be required to
meet these outflows through liquidation of its assets . If such assets cannot be liquidated on short notice
owing to tight money conditions or to the bank's own difficult circumstances, and the Federal Reserve
must provide funds to avoid severe disruptions in the money markets, such assistance should be provided
only at very punitive rates of interest .


The Federal Reserve has, in fact, recently proposed an amendment to its regulation governing
member bank borrowing, providing for a higher rate when large assistance is needed over a prolonged
period. We believe this is an appropriate proposal, although we feel the special rate suggested ( 10%) is
not sufficiently high. The Federal Reserve we suggest, cannot criticize the marketplace for assuming that
banking is a protected industry if at the same time it cushions shareholders of a bank by providing
liquidity before the capital account has been exhausted by losses on the sale of assets. Furthermore, we
believe that the attitude of the regulatory community should be less protective toward investors who buy
certificates of deposit in competition with other money market instruments.
We should state, however, that liquidity management involves more than the ability to sell assets.
It involves the successful coordination of the maturities of assets and liabilities and requires an awareness
ofthe following:

1. All sources of funds available to a bank, holding company or non-bank subsidiaries.
2. Present and potential penetration of these sources of funds.

3. Dependence on local versus national funds.
4. Cost of funds versus those paid by competitors.
5. Funds generated directly versus dealer originations.
6. Maturity ofliabilities by days, weeks and months.
7. Historical patterns of deposit stability.

8. Seasonal patterns of deposit stability.
9. Scheduled maturity of loans and other assets, percentage of loans historically paid off and
percentage rolled over.
10. Commitments to disburse funds .
11. Percentage of earning assets and liabilities at fixed interest rates versus those tied to money
market rates.



The Role of Debt as Capital
The capital notes of a bank are by law subordinated to the claims of depositors in the event of
bankruptcy and liquidation of the bank's assets. This characteristic, however, as noted earlier, has not yet
convinced the Federal Reserve that capital notes should be included in the capital base of a bank because
the Board prefers to evaluate banks on a "going concern" basis. On that basis, debt capital is regarded as
a less than perfect substitute for equity because (a) it cannot be used to absorb losses (except in
liquidation), (b) it must be repaid at a specific date and (c) interest must be paid on debt whether earned
or not.
We believe that capital notes should be included in the capital base of a bank. Their ability to
protect depositors by absorbing losses in the event of liquidation may in fact assist in maintaining public
confidence in the viability of the bank during periods of extreme adversity. For this or similar reasons,
the Comptroller of the Currency, the FDIC and the financial markets allow some debt to be included in a
bank's capital.
Several factors must be considered in determining how much debt is appropriate . These include
the size and location of the bank, the quality of its management especially as evidenced by its earnings
and loan loss record, the degree of access to other sources of funds, and especially the ability of the bank
to service the debt. The attitude of the financial markets has traditionally been that banks may include
up to 35% of their capital in the form of debt, a figure derived perhaps from the position taken by the
Comptroller of the Currency. We believe this emphasis on capitalization percentages may be overly
arbitrary and would prefer to see greater stress placed on coverage ratios ( for both interest on long-term
debt and total interest) and net interest spread. It is our opinion, moreover, that banks which have
demonstrated (a) above average profitability as measured by return on assets, (b) below average loan
losses and (c) astute liquidity management should be permitted in the future to increase asset/capital
ratios, even beyond current levels, and to increase the percentage of capital notes in their capital base,
perhaps significantly, without being penalized by the capital markets. On the other hand, many banks
with below average returns on assets, no demonstrated liquidity management capability and a high level
of loan losses are probably over leveraged at present and should plan to increase their capital/asset ratios
and reduce their level of debt as a component of capital.

Capital Planning for Non-Bank Subsidiaries
Capital structures acceptable to the marketplace have been fairly well defined for finance
companies, and to a lesser extent for mortgage banking and leasing companies and other areas of activity
permitted to bank holding companies by the Federal Reserve Board . We believe that non-bank
subsidiaries that finance their own activities independently will be required by the capital and money
markets to structure themselves in accordance with these norms.



Subsidiary Finance Companies
A principal area of diversification for bank holding companies, thus far, has been consumer
finance. In some cases acquisitions have been made of large independent consumer finance companies
with well-established credit relationships. In most cases, however, bank holding companies have
purchased relatively small consumer finance companies with limited access to funds. The goal has been to
reduce the overall cost of funds to these subsidiaries either by supplying funds from the parent company
or by combining a number of small independent companies into a larger entity which would be of
sufficient size to finance itself economically.
The capital structure of a finance company can be divided into three distinct classes: equity
(including preferred) ; capital base, which includes subordinated debt and equity; and senior debt,
including both short and long-term maturities. Large consumer finance companies such as Beneficial and
Household typically are permitted to have as much as $7 in total debt for every $ 1 of common equity.
Smaller companies, however, are generally less leveraged, with approximately $4 of debt for every $ 1 of

Typical Capital Structure for a Consumer Finance Company
Equity (including preferred)


Subordinated Debt


Capital Base


Senior Debt (long and short)


Total Capital


Instalment sales finance companies have typically enjoyed a higher degree of leverage (about $9
of debt for every $ 1 of equity) because of the liquidity of the loan portfolio . Commercial finance
companies appear to fall between consumer and instalment sales companies.
Financing these companies has become more difficult during the past few years . Increases in the
capital base must be almost entirely in the form of equity because unfavorable market conditions have
made it virtually impossible to sell significant amounts of subordinated debt . A bank holding company
must be aware in any acquisition of finance company that it might be difficult to roll over existing
subordinated debt, which would necessitate an infusion of additional equity or subordinated debt by the
parent company.

Mortgage Banking Subsidiaries
As a result of a substantial number of acquisitions, bank holding companies have come to
dominate the mortgage banking industry. For example , five out of the ten largest mortgage banking
companies are affiliated with bank holding companies.


Mortgage banking companies have traditionally been relatively small and highly leveraged. The
bulk of financing has been in the form of short-term bank borrowings. For most of the postwar period,
mortgage bankers concentrated their efforts in the warehousing of FHA and VA insured mortgages.
Because these mortgages were government guaranteed and because in most cases the mortgage banking
companies had firm take-out commitments from institutional investors, commercial banks permitted
mortgage bankers to enjoy a high degree of leverage.
Recently, however, many mortgage bankers have moved into the conventional mortgage field and
have become aggressive in construction lending. Some mortgage bankers have therefore attempted to
segregate the capital requirements of various activities, with warehousing of government-insured
mortgages leveraged approximately 20: 1 while construction and development loans might have
maximum leverage of 5 : 1 or 6: 1.

Typical Structure for a Mortgage Banking Company

Non-Current Liabilities


Current Liabilities


Total Liabilities and Equity


Capital Planning for Parent Holding Companies
We believe that bank holding companies should have as a long-term goal for non-bank subsidiaries
that are large users of capital the development of a capital structure which will enable these subsidiaries to
borrow independently in the capital markets. The principal reasons for having such a goal are (a) to
increase the parent's rate of return on its investment in these subsidiaries through leveraging, (b) to
achieve debt/equity ratios in subsidiaries, such as consumer finance companies, which cannot be attained
at the parent company level and (c) to enable management to evaluate more realistically the relative
profitability of each area of activity. Non-bank subsidiaries that finance themselves will be
expected by the marketplace to have capitalizations similar to those of independent companies in their
respective industries. Subsidiaries which are in the formative stages , however, or those which are very
small in comparison to their affiliated bank(s) , may require less attention to capital structure and sources
of funds. A capital strategy, therefore , which is appropriate when non-bank activities are not significant
should be continuously re-evaluated as these activities become more important , particularly when the
decision is made to finance bank or non-bank activities through the issuance of debt securities at the
subsidiary level to third parties, which will introduce new considerations into the parent's capital




Some Basic Considerations
In determining the appropriateness of any capital strategy, the management of a holding
company should consider the following questions.
1. Are the projected internal cash flows sufficient to meet the obligations, especially the
debt service requirements, of the group?
Bankers have long been accustomed to using demand and savings deposits, in actuality short-term
funds, to finance loans and investments which are often of much longer maturities, relying on the ability
to estimate expected withdrawals of these deposits, and on the Federal Reserve window if necessary.
Some bank holding company managements may be relying on their ability to similarly "roll over" or
refinance debt obligations , especially commercial paper borrowing which during periods of turmoil in
the money and capital markets could be extremely difficult for all but the very largest and most
creditworthy companies. Furthermore, bank holding companies have no true " lender of last resort"
because backup bank lines are not always reliable.
2. Is there too great a reliance on the ability of the subsidiaries to pay dividends or lend
to the parent company?
Because most non-bank subsidiaries are very small in comparison to their affiliated banks, the
marketplace has become accustomed to looking to the bank subsidiaries to support the debt of their
parent companies even though the proceeds of such debt have often been invested in non-bank activities.
This may be an erroneous perspective, however, because of the regulatory restrictions on the flow of
funds from a bank to its parent or non-bank affiliates. For a national bank to pay a dividend in excess of
the total of (a) net profits for the current fiscal year and (b) net earnings retained for the two previous
years, requires the prior approval of the Comptroller of the Currency. The Comptroller may in fact limit
the amount of such a dividend under authority granted by the Financial Institutions Supervisory Act
which prohibits unsafe or unsound banking practices. The recent increase in emphasis by regulators on
banks' capital levels may result in further restrictions on the ability of a bank to pay large dividends to its
parent. In any event, for most holding companies the total amount that the bank subsidiaries could pay as
dividends without regulatory approval is smaller than the amount of outstanding debt of the holding
company maturing within any 12-month period.
Loans by a bank to its affiliates are limited also. A bank may lend only up to 10% of its capital
nd surplus to any one affiliate (including a parent) , and up to 20% to all affiliates combined. In
adition, loans to affiliates must be secured by specified marketable securities with a value equal to 120%
the loan amount.*
The ability of most non-bank subsidiaries to pay dividends may be even less reliable than that of
e banks, for two reasons. First, the volatility of their earnings may be significantly greater than those of
ne Federal Reserve is attempting to clarify the distinction between an investment in an affiliate, which does not have to be collateralized,
..d a loan, which does. The thrust of the regulation is to prevent a bank from providing credit to an affiliate under the guise of an
vestment transaction.


a bank. Second, if the subsidiaries are borrowing independently from third parties, there may be
indenture provisions restricting the payment of dividends to the parent.

3. Do the methods of downstreaming funds to the subsidiaries and the asset structure of
the subsidiaries permit repayment of funds to the parent when required?
The types and maturities of the financing instruments used by the holding company to
downstream funds will be important, in fact, only if the subsidiaries are borrowing from third parties.
Always significant, however, is whether or not the liquidity in the assets of the subsidiaries is available to
meet short-notice funds requirements ofthe parent.
4. What will be the attitude of third party lenders and equity investors?
Lenders generally prefer that the debt be incurred at the level within the group where the funds
are to be used. Failing that, they like to be able to "track" the funds, to observe the movement of
borrowing proceeds to the subsidiary where they are needed. Lenders also require to know how the
funds to service the debt will be generated, and there may be resistance to the appearance of additional
borrowing by a holding company to service existing debt.
Equity investors in a bank holding company desire that the capital structure of the group and of
each of its parts represent the appropriate blend of debt and equity which will result inmaximizing the
market value oftheir investment, without the incurrence of undue risk.
5. Does the approach to capital planning provide sufficient management control to
prevent a debt-heavy capitalization?
While the capital markets (and the regulators ) can be relied on to bring pressure to bear in some
circumstances, the capital planning process itself should bring out sufficient information on the areas of
activity within the organization, risks involved, earnings potential, ability to support certain amounts of
debt so that informed decisions can be reached as to the appropriate capital structure for the parent
company and for the group.
Approaches to Capital Planning
There are two basic aspects to a capital planning strategy for a bank holding company:
(a) selecting a capital structure which can be supported and serviced by the group, and (b) determining
whether to carry out the financing activities at the parent or subsidiary levels (or both). * There appear to
be four fairly distinct methods of combining these two features into a planning approach, although
variations may be appropriate in certain circumstances.
A. A "Single Unit" structure , with "Centralized Financing" (that is, with all financing carried out
at the parent level) .

* Athird, the selection of appropriate financing instruments, is discussed later.



B. A "Building Block" structure, with "Centralized Financing".
C. A "Building Block" structure, with "Decentralized Financing" (that is, with much, ifnot all, of
the financing carried out by the subsidiaries).
D. A "Modified Building Block" structure, with part of the financing done at the parent level and
part carried out by a second level "Non-Bank Holding Company ".

Each of these combinations may have application to a particular bank holding company at a
particular point in its development. *
A. "Single Unit " Structure Centralized Financing
As discussed in Part IV, the capitalization of a holding company under the "single unit"
approach may or may not be the same as would result from aggregating the hypothetically appropriate
capital structures of the subsidiaries. The parameters accepted by the capital markets are the principal
guideline. All financing is accomplished at the parent level, and funds are downstreamed to subsidiaries in
both debt and equity form.
This capital strategy may be most appropriate when the non-bank subsidiaries are very small and
the affiliated bank(s) is the only significant asset in the group, which is the case with most bank holding
companies at the present time. In such circumstances, the parent is borrowing on the bank's equity, and
the debt is serviced by the bank's earnings. The method used to pass funds down to the bank and
non-bank subsidiaries is relatively unimportant since the parent is effectively the only entity with any
"call" on these funds.
This method may not impose sufficient discipline on management, since it relies generally on the
ability of the whole group to generate sufficient cash to service the debt. The parent may find itself
relying on its ability to refinance its debt in order to service it, especially in the case of commercial paper
borrowings. There is also a danger of the holding company borrowing too heavily against the equity ofits
bank subsidiary, especially on a short-term basis, to fund the growth of the non-bank subsidiaries.
Finally, this strategy may not provide sufficient information to management to properly evaluate the
return on investment from each area of activity.
B. "Building Block" Structure , Centralized Financing
Also as discussed in Part IV, the capitalization of the parent company under the "building block"
=pproach represents the sum of the hypothetically appropriate capital structures of each of the
bsidiaries. These hypothetical subsidiary capitalizations are based on traditional structures for
dependent companies in their respective industries. This closer attention to the structure of the
bsidiaries may be appropriate when, though still quite small, they pass through the formative stage and
become large enough to require greater management concern for the return earned on investment.
The combination of decentralized financing activities with a "single unit" approach to capital structure is possible but would be
nwieldy in practice.


Centralized financing permits the sale of fewer, larger issues with lower total issuance expense and
reduced interest costs.
Because all financing is centralized, the method of investing funds in subsidiaries is relatively
unimportant. The ability to service the debt is based on the earnings of the subsidiaries and the liquidity
oftheir assets.
With a "building block" based structure the capitalization of the holding company should relate
in total to the asset structure of the subsidiaries, providing a degree of management discipline against
excessive leveraging. There remains the financial flexibility to allow one subsidiary to "over-leverage"
while another (perhaps the bank, for regulatory reasons) may have an excess of equity.
Lenders and investors may prefer the "building block" approach over the "single unit” approach
because they may see more easily how the capital structure is rationalized, where funds are employed and
how debt service can be met under various operating assumptions. With centralized financing, though,
lenders will still be one level removed from the use ofthe debt proceeds .
C. "Building Block" Structure , Decentralized Financing
As non-bank subsidiaries become larger, the total of subsidiary capital structures may result in a
capitalization at the parent company that the financial markets will not accept in a bank holding
company. Thus, the decentralized method of financing may permit the aggregate borrowing capacity of
the subsidiaries to exceed that permitted to the holding company on a consolidated basis.
There are many variations of decentralized financing, especially as subsidiaries undergo the
transitional stage from total dependence on the parent for debt and equity funds , to partial borrowing
from third parties (perhaps initially with a parent company guaranty of subsidiary borrowings) , to a
position where all the equity is owned by the parent and all the debt is raised from third party lenders
with no parent guaranty. The "borrowing capacity" of the parent should be held in reserve to enable it
to act in effect as "lender of last resort " to its subsidiaries.
We believe a preferable variation of this method is for the non-bank subsidiaries to finance
themselves independently, but for all long-term debt financing for the bank(s) to be carried out at the
holding company level. If the bank itself does no third party borrowing, the holding company's
credibility in the debt market is greater, since the strength of the bank will be seen to be more directly
supportive ofthe parent's debt.
The interest cost to an independently financing non-bank subsidiary will likely be greater than
the cost to the parent and thus it may seem preferable at first glance to borrow as much as possible at
parent level. As the parent company increases its borrowings to fund its subsidiaries' needs, however,
its own cost of money, may increase and eventually exceed that of the individual operating units.


52-221 O - 75 - 27


Each self-financing subsidiary will have to maintain its capital structure within parameters
acceptable to the marketplace or within the limits permitted by its own debt agreements and be capable
of servicing its own debt. Over-reliance on the ability to roll over or refinance outstanding debt will be a
potential concern at the subsidiary level, but no longer at the parent (except to the extent the parent
finances a bank subsidiary) . Reliance by the parent on the ability of the subsidiaries, especially the
affiliated bank(s), for dividends or loans will be reduced to the extent that subsidiaries finance
themselves, although the moral obligation of the parent or affiliated bank( s) to “rescue” an affiliate that
becomes unable to meet maturing liabilities is a question that must be faced.
The transitional stages from centralized financing to completely independent borrowing by the
subsidiaries present their own special requirements for careful capital planning. During the period when a
subsidiary is borrowing both from the parent and from third parties, the subsidiary's debt agreements
may restrict its ability to pass up funds to the parent, while the parent may still be relying on such funds
to service its own debt . Lenders to the parent will also be aware of the situation and may be unhappy
with their position of subordination to the third party lenders at the subsidiary level.
D. "Modified Building Block" Structure, "Non-Bank Holding Company" Financing
Some bank holding companies have given consideration to an approach whereby certain
non-bank activities are "carved out" and set up as subsidiaries of a second level holding company, as in
the diagram below.

Parent Holding Company

Bank (s)



- Leasing




- Etc.



All financing for the bank(s) and certain of the subsidiaries is carried out at the parent holding
company level and for the "carved out" subsidiaries at the non-bank holding company level. The assets,
liabilities and equity of the "carved out" subsidiaries would be excluded from the debt agreements of the
parent. The capitalization of the non-bank holding company would likely approximate the sum of the
"building block" capital structures of its subsidiaries.
This method of structuring and financing the group may be most appropriate at a time when
non-bank subsidiaries are too small to carry out independent financing individually without a parent
guaranty, yet large enough together so that the parent is becoming unable to fund them without using up
all of its own borrowing capacity or relying too heavily on the strength of affiliated bank(s) (which,
among other things, displeases the regulatory community). This method can provide a means of
satisfactorily handling the transitional stages from centralized to decentralized financing.
Questions relating to the asset structure of subsidiaries, the timely generation of funds to service
the debt and the dangers of over-reliance on the ability to roll over borrowings must be considered at the
non-bank holding company level and to a lesser extent in the parent company. The attitude of a third
party lender to the non-bank holding company must also be taken into account. The lender may see
more clearly where his funds are being used and may take comfort from the stability afforded by the
diversification within the sub-group (and perhaps from what he may see as a moral obligation of the
bank(s) to its affiliates). Against these he will weigh the fact that he is one level removed from the actual
user of the funds and, most importantly, he may have serious reservations about the ability to
successfully combine diverse activities in a non-bank holding company.

Methods of Financing.
Various security instruments are generally available to banks and bank holding companies to
finance their permanent capital requirements. These include intermediate or long-term straight debt,
convertible debt and straight or convertible preferred stock, all of which may be issued publicly or privately,
as well as the public sale of common equity. Although rare, warrants to purchase common stock could be
offered in conjunction with all of the foregoing securities. Additionally, a potential source of interim
capital is the floating rate note. However, it is significant that while floating rate issues have had final
maturities of up to 25 years, they are commonly subject to redemption after two years at the option of
the holder and thus may not prove to be a "permanent" form of capital. Naturally, the amount, timing
and selection of a specific form of financing must be tailored to a particular bank or bank holding
company's situation and requirements, as well as general conditions in the financial markets.

Summary Comments
The banking industry should take greater advantage of the current opportunity to help resolve
the capital questions , and the broader related issue of the development of the bank holding company, in
a manner as favorable as possible to the wishes of the industry. It should do so by careful analysis of the
complexities of the issues and more frequent and forceful public presentation of its opinions. The



maintenance of public confidence in the banking industry and the maximization of the market value of
shareholders' equity over the longer term demands the creation of a greater awareness in the financial
markets of the problems, potential and realities of the industry.



The current discussion about capital should not come as any surprise to investors. Capital
adequacy and capital structure are important areas of analysis in determining the relative attractiveness
ofequity investments in bank or bank holding companies .
Although not new to those who are close to the industry, the questions about capital have been
highlighted and have become the concern of a broader spectrum of investors as the result of some recent
Federal Reserve Board decisions. The latter denied applications at least in part because the capital
position of the applicant was somewhat lower "...than the Board would consider appropriate in light
of... recent asset growth".
These questions must be put in their proper perspective . Distinctions should be made between
the capital needs of the industry and those of select bank holding companies. Most of the discussions
about the need for large amounts of additional capital for the banking industry have been based on the
assumption that trends of the past few years-including declining returns on assets , higher asset/capital
ratios, and maintenance of current payout ratios-will continue. However, managements are aware of the
erosion in the return on assets and the substantial increases in many cases in the asset/capital ratio . We
believe that basic industry changes will take place in asset management and loan pricing, which will
stabilize and quite often improve the return on assets. It seems to us that banks should not attempt to
price their loans in competition with the commercial paper market unless greater differentiation is made
in interest rates charged to various customers . Specifically, the prime lending rate in the future is likely
to be higher relative to other short-term interest rates than has been true in the past few years. This
means that the differential between the cost of funds and the rate charged under floating prime rates will
widen, especially as interest rates decline.
The mix of loan portfolios is apt to change. Banks are obtaining a better understanding of overall
account profitability which will in many instances lead to a weeding out of unprofitable relationships
and increases in prices. Greater emphasis will be placed on higher yielding activities including commercial
finance, factoring, construction lending and lending to medium-size businesses.
Given the concern about capital, dividend payout ratios will, in all probability, continue to
decline modestly. Dividend increases will occur at a slower pace than earnings growth.
Some of the deterioration in the capital/asset ratios in the past few years can be traced to
abnormal conditions in the money and capital markets , such as the rapid expansion of the money supply
and the unfavorable conditions in the long-term debt and commercial paper markets. A more moderate
(though entirely satisfactory ) rate of expansion in bank earning assets seems likely during the next few
years, given the Federal Reserve's desire to slow the rate of inflation .



Capital Adequacy
We believe that some of the concern about the capital need of the industry is excessive . It would
be incorrect, in our view, for investors to assume that all banks and bank holding companies will require
additional equity. Nontheless, investors, like regulators , rating agencies and managements themselves, are
faced with a difficult task in assessing whether capital for an individual bank or bank holding company is
"adequate". The following factors, among others, should be considered:
1. Capital ratios -– A starting point in analyzing capital adequacy is an examination of levels and
trends in selected ratios such as assets/capital, loans/capital and capital/deposits.
2. Relative positions – Since capital adequacy is relative and not absolute, an individual bank
should be analyzed in comparison with the industry generally and with companies of similar size and
serving the same functional and geographic markets .

3. Return on assets - A high and stable return on assets demonstrates that a bank has been able
to profitably employ high cost sources of funds and hopefully will be able to do so in the future. Profits
are the first line of defense against operating problems and loan losses.
4. Loan losses - Loan losses should be viewed in the context of net chargeoffs, the relationship
of net chargeoffs to the provision for loan losses, and the level and trend in the valuation portion ofthe
loan loss reserve.
5. Liquidity - There appears to be no reliable method of measuring bank liquidity, especially
since most banks purchase liabilities to meet liquidity demands. Better information will have to be
developed about the scheduled maturities of certificates of deposit, stability of categories of deposits at
various stages of the economic cycle , and cash flow available from the asset structure.
6. Investments - Although investments typically account for only 5%-10% of assets, analysis of
portfolio strategy can provide an insight into a bank's approach to liquidity management. Close attention
should be paid to average maturities, market value versus book value, investment ratings and overall

7. Management - Though difficult to evaluate with precision, this is probably the most
important consideration . Good management will anticipate changes in the operating environment and
will take appropriate steps to preserve the earnings capability.
8. Diversification - Diversification in types of lending, customer base and geographic markets is
desirable because it can help stabilize earnings over a cycle and reduce the exposure in any one type of



9. Non-bank activities - Analysis of the capital adequacy of a bank must be viewed within the
context of the holding company structure where applicable . Proper capital structure requires that the
parent company and non-bank activities have sufficient cash flow to meet debt service.

The Equity Markets
We expect more penetrating analysis by depositors and investors to lead to a further
differentiation in the price/earnings ratios in the " two-tier" bank stock market that has developed in the
past few years. Banks and bank holding companies are not homogeneous and therefore deserve a broad
range of market valuations, similar to those in other industries. Banks and bank holding companies which
compare favorably with the above standards will be in a preferred position to attract all forms of funds.
One major change likely to occur relates to the issuance of certificates of deposit and sale of commercial
paper. Until now, size appears to have been the principal determinant of market acceptance. Finer
distinctions will be made in the future as buyers analyze earnings, liquidity, management, etc. more
carefully. Some large banks and bank holding companies now able to sell CDs and commercial paper may
find it more difficult in the future, while strong regional banks and bank holding companies should find
greater market receptivity.
A bank or bank holding company meeting the above criteria should not require substantial
amounts of additional equity capital from external sources. A high level of profits will permit the bulk of
additional capital to be generated internally. As noted in Part I , a bank with a 0.6%-0.7% return on assets
can ejoy earnings growth of 12%-15% per year without any deterioration in its capital position (assuming
an asset/capital ratio of 25X and a 30% dividend payout).
Some banks and bank holding companies however, may face severe problems. The banks in the
greatest need of capital often are those with the lowest price/earnings ratios, the lowest returns on assets,
the highest levels of loan losses, the highest payout ratios and the highest amount of debt included in
capital. These companies must increase their return on assets before contemplating the sale of additional
equity which, under present conditions, would improve capital/asset ratios only minimally while diluting
per-share earnings considerably. Many of these banks will have to curtail sharply their expansion of assets
in order to permit capital to increase relative to present assets. This could mean little, if any, growth in
Finally, bank holding companies may find it more difficult in the future, to make acquisitions of
any significant size if the Federal Reserve continues to use its approval authority as a lever to force banks
to increase their capital. The banks and bank holding companies which have already diversified,
therefore, may well be in a preferred competitive position.

Summary Comments
We believe that the Federal Reserve is using capital adequacy as a tool of monetary policy. By
emphasizing the need for banks to improve their capital ratios, the Federal Reserve has forced many to
significantly slow their growth in assets, which is a goal ofcurrent policy.The Federal Reserve's attention
to capital could lessen substantially if monetary policy should require an expansion of loans to fuel
overall economic growth .



3/72 ABC)



FORM FOR(Amounts
in thousands ofBANK
dollars) CAPITAL
Exam. Date Yr. Mo. Day
Outstanding Cent Calculation
are shown
of: ....... Consumer instalment"
Demand deposits, IPC
Savings deposits
but not earned
Time deposits, IPC, under $100,000
is to
Time deposits, IPC, $100,000 & over
be aggregated
until it equals
Deposits of banks
Other deposits
(c) "CashRequired
assets" reserves
are shown.........
net of:
(d) 25:"TOTAL ASSETS" are shown net of assets classified
Otherliabilities (a)
Special factors:
Per Cent Amesat Per Cent Amount
Federal funds sold
paper & bankers acceptances
Securities maturing
under 1 year:
U.S. Treasury
Government agencies
State, county & municipal
OtherGroup I
Securities maturing 1-5 years:
U.S. Treasury
Government agencies
State, county& municipal
Securities maturingASSETS
5-10 years:
U.S. Treasury
Government agencies
State, county & municipal
OtherGroup 1
Loansspecially secured or guaranteed
Securities maturing over 10 years:
U.S. Treasury
Government agencies
State, county & municipal
Loans: Real estate1
Consumer instalment (a)
All other
(6) FIXED,
Bank premises & OTHER ASSETS
reverseof quality,
side foryield
and narrower
Furniture & fixtures; other real estate
Group 2 securities
Assets classified substandard
Accruals & other assets
(12) TOTAL CAPITAL CALCULATION (sum of iines 7 through 11)
divided byline (12)) .S.
line (129) equity capital divided by
assetsstructure as a percent
- total assets minus primary reserves, U S. Treasury and Agency securities
%;total deposits
assetscapital as a percent
appearon reverse side.




Athorough appraisal of the capital needs of a particular bank must take due account of all relevant factors affecting the bank.
These include the characteristics of its assets, its liabilities, its trust or other corporate responsibilities, and its management-as well as
the history and prospects of the bank, its customers and its community. The complexity ofthe problem requires a considerable exercise
The groupings and percentages suggested in the Form for Analyzing Bank Capital can necessarily be no more than aids to
the exerciseofjudgment.
The requirements indicated by the various items on the form are essentially "norms" and can provide no more than an initial presumption as tothe actual capital required by a particular bank. These "norms" are entitled to considerable weight, but various upward
or downward adjustments in requirements may be appropriate for a particular bank if special or unusual circumstances are in fact
present in the specific situation. Such adjustments may be entered under "Special factors" indicated on the Analysis Form.
The requirements suggested in the Analysis Form assume that the bank has adequate safeguards and insurance coverage against fire,
defalcation, burglary, etc. Lack of such safeguards or coverage would place upon the bank's capital risks which it should not be called
COMPUTATIONS which take account of quality, yield and narrower maturity ranges. For determining market risk take
the followingsteps:
1. Distribute the bank's holdings of U.S. treasury, U.S. Agency and State and Political Subdivisions in the following matrices:
U.S. Treasury
Book Rate
OverThrough Rate¹
2 3
S 10
10 20
U.S. Treasury
and subdivisions
U.S. Treasury corporations
OverThrough Yld.2 Market2 Yid.
1 2
S 10
10 20
Total marketvalue
The preferred
in below.
a given cell and dividing
byif average
the parmethod
value isofrate
rate maygenerated
be imputed
to complete
currentor average
yield a (approximate
yield issue
baseas for
for each
may be
from actual
used to obtain
above with
by selecting
that isshown)
ofas closeto
that particular
15 yearsValueor
under theindividual
coupon rate
issue selected
across to maturity
Enter obtained
maturity from
yield aunder
If information
is unavailable,
enter market
at or near
the time ofthepricing.
2. Price the securities in each cell to yield at the high yield rate set forth in the high yield matrix. Note: Price as though each cell
was a single issue using average coupon rate and total par value. Assume maturities for each cell as follows: 1-( 1 year); 1-2 (1½ years);
2-5 (3½ years); 5-10 (7%½ years); 10-20 ( 15 years); 20 (25 years (except assume 20 years for U.S. Agencies]). Note: If bank has a concentration of lower quality municipal securities add about 50 basis points to high yield for "States and political subdivisions".
3. Determine the amount of maximum probable market depreciation in each cell by subtracting the market value obtained from
step 2. above from the book value of securities. Enter actual figure for maximum potential market loss in the appropriate market risk
column, combining where necessary in order to conform to distribution as appears on the front of the Form. If computations show
potential market appreciation enter zero for market risk.

Method for Imputing Coupon
Par value + Market value = Assumed price
Locate assumed price in the Comprehensive Bond Valuation Tables assuming a coupon equal to average current yield. Trace the price to
the yield to maturity column in the tables. The yield to maturity is the imputed average coupon rate of that particular cell. (Note: Owing
to the
restraints of the table size the yield may have to be interpolated; a more precise method for obtaining the yield may be achieved
by utilizing the mathematical equation for determining such yields.)
Note: If the above data are unavailable and as an alternative but less desirable method, the following percentage charges may be used:
All securities maturing under 1 year, 1 per cent; 1-5 years, 8 per cent; 5-10 years, 15 per cent; over 10 years, 25 per cent.
1 Adjusted
capital Capital-Adjusted
structure-Total capital
on securities and loans minus assets classified loss and 50 percent ofassets classified doubtful.
Adjused Equity
capital accounts
debt capital.




Bank and Bank Holding Company
Financial Data Questionnaire

The following pages have been designed to give Standard & Poor's a data base
for ratio analysis of fully-consolidated holding company operations. A companion
questionnaire (Part II) applies to banking subsidiaries only. We have made every
effort to stay within standard classifications widely used in good financial reporting.
Please note the following:
1. With the exception of Table E, the formats of Parts I and II are similar.
Part I requests a fully-consolidated history, Part II requests a consolidated history of
bank(s) only, including all divisions and subsidiaries thereof.
2. Averaging of balance-sheet items is necessary, on a daily and/or weekly basis.
Where monthly or quarterly averages only are available, please indicate approximate
fraction of each year's data so computed.
3. Italicized captions refer to selected data closely related to the data aggregate
immediately above.
4. All data should be consolidated on a line-by-line basis.
5. All data for all years should be on a fully-pooled basis, and pro forma where
acquisitions on a purchase basis have occurred.
Please return your completed questionnaire to Mr. Norman Johnson of our Corporate
Finance Department, together with a copy of each of (a) your 1973 annual report,
(b) your 1974 quarterlies to date, and (c) your 1973 10-K and any prospectuses
filed in 1974. Your management will be supplied with a computer printout of the
ratios we develop for your company, together with median and/or mean ratios for
our comparative universe.
Any definitional questions should be directed to Mr. Johnson (212-924-6400) .


1. Cash and due from banks *
2. Total investments:
3. U.S. government securities
4. U.S. agency obligations
5. State and municipal obligations
6. Other securities
7. Trading account
8. Temporary
repos, commercial
etc.) funds,
9. Certificates
internationalofdeposit10. Customers acceptances held
of loss reserve
11. Total loans (gross
and unearned income):
12. Broker/Dealer
13. Commercial
14. Consumer-instalment
15. Consumer-credit card
16. Real estate-short term/interim
17. Real estate-permanent
18. Mortgages held for sale
19. International-foreign office
20. Direct lease financing
21. (less: supporting liabilities)
22. Bank premises and equipment
23. Other assets
24. Total Assets
*Exclude interest earning assets, e.g. CDs and Eurodollars





1. Total Deposits:
2. Demand: (Total)
Public funds
7. Time: (Total)
Consumertime (Regular savings,
certificates, clubs, etc.)
certificates (domestic):
12. Federal
repos- funds
under purchased
1 year* and
borrowed funds13. Other
under 1 year
14. Borrowed funds-1-7 years*
15. Mortgages payable
16. Unearned discount
17. Liability on acceptances
taxes and
18. Accrued
other expenses
19. Other liabilities
20. Contingency Reserves
21. Loan Loss Reserve
22. Total Long-Term Debt: *
23. Holding Company:
26. Bank(s)
27. Non-Bank Subsidiaries:
30. Preferred Stock:
31 . Parent Company
32. Subsidiaries
33. Common Stock
34. Surplus
35. Undivided Profits
36. (Less Treasury Stock)
37. Total Equity Capital
38. Total Liabilities and Capital
*Maturity classification should be by original maturity



1. Total Revenues:
2. Interest and fees on loans
Interest and dividends on
3. taxable
Interest and dividends on
4. tax
free securities
Trading account
5. income-interest
6. Trading
income-net profits
7. Other interest income
8. Trust income
9. Service charges on deposits
10. Other income
11. Total Expenses:
12. Salaries and employee benefits
13. Interest on time deposits
on federal funds
14. Interest
and repos
on other borrowed
15. funds-under
1 year
Interest on other borrowed
16. funds-over
1 year
17. Net occupancy expense
18. Rental income
19. Equipment expense
20. Provision for loan losses
21. Gross charge-offs
22. Recoveries
23. Other expenses
24. Income (before minority interests):
before taxes and
25. Income
securities transactions
26. Applicable income taxes
27. Income
securities transactions
28. Securities gains (losses)
29. Extraordinary items (if any)
30. Net income
31. Total minority interest (if any)
32. Total Dividends Declared:
33. Common
34. Preferred





1. Rates Earned (tax-equivalent) :
2. Loans (Total):
Consumer-credit card
Real estate7.
Real estate-permanent
International-foreign office
investments (Federal
10. Temporary
funds, repos, commercial paper, etc.)
11. Certificates
12. Securities:
Tax free
15. Rates Paid:
F 16. Time deposits (Total):
club, etc.)
certificates (domestic)
Foreign time
I 20.
funds and repos
21. Federal
under 1 year
borrowed funds22. Other
under 1 year
23. Borrowed funds- all other
24. Other Data (at year-end):
of employees
25. Number
(full-time equivalent)
26. Number of locations





Debt Maturity Schedule as of 12/31/73 (In thousands)
Non-Bank Subsidiaries
1. 1974
2. 1975-1979
3. 1980-1984
4. 1985-1989
5. 1990-1994
6. Beyond



Name ofperson to contact if Standard & Poor's has any questions:.
Phone number:




S& P

Bank and Bank Holding Company
Financial Data Questionnaire

The following pages have been designed to give Standard & Poor's a data base
for ratio analysis of banking operations. A companion questionnaire (Part 1) applies
to fully-consolidated holding companies. We have made every effort to stay
within standard classifications widely used in good financial reporting.
Please note the following:
1. With the exception of Table E, the formats of Parts I and II are similar.
Part I requests a fully-consolidated history, Part II requests a consolidated history of
bank(s) only, including all divisions and subsidiaries thereof.
2. Averaging of balance-sheet items is necessary, on a daily and/or weekly basis.
Where monthly or quarterly averages only are available, please indicate approximate
fraction of each year's data so computed.
3. Italicized captions refer to selected data closely related to the data aggregate
immediately above.
4. All data should be consolidated on a line-by- line basis.
5. All data for all years should be on a fully- pooled basis, and pro forma where
acquisitions on a purchase basis have occurred.
Please return your completed questionnaire to Mr. Norman Johnson of our Corporate
Finance Department, together with a copy of each of (a) your 1973 annual report,
(b) your 1974 quarterlies to date, and (c) your 1973 10-K and any prospectuses
filed in 1974. Your management will be supplied with a computer printout of the
ratios we develop for your company, together with median and/or mean ratios for
our comparative universe.
Any definitional questions should be directed to Mr. Johnson (212-924-6400) .


1. Cash and due from banks*
2. Total investments:
3. U.S. government securities
4. U.S. agency obligations
5. State and municipal obligations
6. Other securities
7. Tradirig account
8. Temporary
repos, commercial
etc.) funds,
deposit9. Certificates
10. Customers acceptances held
11. Total loans (gross of loss reserve
and unearned income):
12. Broker/Dealer
13. Commercial
14. Consumer- instalment
15. Consumer-credit card
16. Real estate-short term/interim
17. Real estate-permanent
18. Mortgages held for sale
19. International-foreign office
20. Direct lease financing
21. (less: supporting liabilities)
22. Bank premises and equipment
23. Other assets
24. Total Assets
*Exclude interest earning assets, e.g. CDs and Eurodollars



- 75 - 28







1. Total Deposits:
2. Demand: (Total)
Public funds
7. Time: (Total)
Consumertime (Regular savings,
certificates, clubs, etc.)
certificates (domestic):
funds purchased and
12. Federal
repos-under 1 year*
borrowed funds13. Other
under 1 year*
14. Borrowed funds-1-7 years*
15. Mortgages payable
16. Unearned discount
17. Liability on acceptances
18. Accrued
other expense
19. Other liabilities
20. Contingency Reserves
21. Loan Loss Reserve
22. Capital Notes
23. Preferred Stock
24. Common Stock
25. Surplus
26. Undivided Profits
27. Total Equity Capital
28. Total Liabilities and Capital
*Maturityclassification should be byoriginal maturity




1. Total Revenues:
2. Interest and fees on loans
Interest and dividends on
3. taxable
Interest and dividends on
4. tax
free securities
Trading account
5. income-interest
6. Trading
income-net profits
7. Other interest income
8. Trust income
9. Service charges on deposits
10. Other income
11. Total Expenses:
12. Salaries and employee benefits
13. Interest on time deposits
on federal funds
14. Interest
and repos
Interest on other borrowed
15. funds-under
1 year
Interest on other borrowed
16. funds
over 1 year
17. Net occupancy expense
18. Rental income
19. Equipment expense
20. Provision for loan losses
21. Gross charge-offs
22. Recoveries
23. Other expenses
24. Income (before minority interests):
Income before taxes and
25. securities
26. Applicable income taxes
Income before
27. securities
28. Securities gains (losses)
29. Extraordinary items (if any)
30. Net income
31. Total minority interest (if any)
32. Total Dividends Declared :
33. Common
34. Preferred




1. Rates Earned (tax-equivalent) :
2. Loans (Total):
Consumer-credit card
Real estate7.
Real estate- permanent
International-foreign office
investments (Federal
10. Temporary
funds, repos, commercial paper, etc.)
11. Certificates
12. Securities:
Tax free
15. Rates Paid:
16. Time deposits (Total) :
club, etc.)savings,
certificates (domestic)
Foreign time
funds and repos21. Federal
under 1 year
borrowed funds22. Other
under 1 year
23. Borrowed funds-all other
24. Other Data (at year-end) :
of employees
25. Number
(full-time equivalent)
Banking-foreign office
28. Number of locations:
Banking-foreign office





Book Value and Maturity at 12/31/72
2-5 Years 6-10 Years
10 Years

1 Year



U.S. Treasury
U.S. Gov't Agencies
States & Political Subdivisions
Other Debt Securities
Non-debt Securities
as of



Value at

as of 12/31/72
Yrs. - Mos.

as of 12/31/T
Yrs.- Mos.

U.S. Treasury
U.S. Gov't Agencies
States & Political Subdivisions
Other Debt Securities
Non-debt Securities


Name ofperson to contact if Standard & Poor's has any questions:.
Phone number:.





99 CHURCH STREET, NEW YORK , N. Y. 10007 (212) 267-8800


Moody's Rating Policy Review Board has decided , after
an extended study , to initiate a rating system for the long - term
debt of bank holding companies , effective immediately . Bank
holding companies presently have about $ 4 billion of publicly
offered long- term debt outstanding and are expected to be calling upon the investing public for additional large sums of debt
capital in the years ahead .
Moody's ratings in this area are
designed to provide meaningful assistance to investors seeking
an independent evaluation of the quality of these securities .
Debt securities of banks will not be rated , at this
time , nor will bank holding companies which do not have nonbank subsidiaries .

In recognition of the unique characteristics of the
banking industry , it is necessary for Moody's to make certain
exceptions to its usual bond rating policies and procedures .
They are as follows :
1. Ratings will be limited to Moody's first four
categories , Aaa , Aa , A and Baa , which are investment
grade ratings .
2. The bank holding company will be given the initial option to submit a two - part application . Part I
of the application will contract for a general review
and Part II will contract for the assignment and dissemination of a Moody's rating . Applications will
be processed in separate stages and application under
Part I will not obligate the bank holding company to
contract for Part II of the application .
However , once a Part II application has been executed and the assignment and dissemination of a Moody's
rating has been effected , it is Moody's responsibility
to the investing public to maintain continuing surveillance of that rating and to make any adjustments
which are deemed appropriate by its Senior Rating
Committee .



- 2 -

3. Application for ratings will be accepted only
from bank holding companies with a minimum equity
of $ 40 million .
In addition , consideration for a
Aaa rating will be given only to the debt of bank
holding companies with equity of at least $ 150
million , with the understanding that size alone
will not dictate the top rating level .
Equity , for the above purpose , is defined as
the aggregate of common stock , preferred stock ,
surplus and undivided profits plus the valuation
portion of loan loss reserves .
Subordinated debt
will not be treated as equity for this purpose .
However , it is noted that in the process of our
analysis of debt quality , consideration will be
given to the so -called " quasi -equity " nature of
subordinated debt .

Otherwise , Moody's will use its traditional approaches
in rating bank holding company debt .
This involves not only
debt ratios and interest coverage but importantly an investigation into the many factors which can influence the stability or
direction of these measurements . Such factors will include :
liquidity , maturity and geographic diversification of assets ;
structure of the investment portfolio ; structure and maturity
of liabilities ;
loan loss experience ; the magnitude , trend
and quality of earnings ;
flow of funds from bank to parent
company; management and its policies ; and indenture covenants . Our ratings will recognize ( 1 ) sources of funds available to subsidiary banks ;
(2 ) the liquidity of subsidiary bank
assets and , ( 3) regulatory supervision .
Moody's policy in respect to withdrawal or suspension
of ratings based upon insufficient information governs and will
be exercised at the discretion of its Senior Rating Committee .

Issuers may submit to Moody's an application on all
their outstanding long -term debt at any time , whether or not
they have immediate financing plans .
Initially , the fee for
a general quality review (Part I ) will be $ 2,500 . The fee for
Part II , which will be processed only after the completion of
Part I of the application , will involve an additional charge



- 3 --

of $2,500 for assignment and dissemination of the ratings and
continuing surveillance of the corporation's rated debt .
aggregate fee therefore , assuming application is made for Part
II , will not exceed $ 5,000 . , our maximum fee for other corporate debt issuers .
Once a rating has been assigned , the fee schedule
for subsequent financings will be geared to the principal amount
of the proposed new issue .
In line with schedules currently
in effect , the rating on a new offering will entail a fee of
1/100th of 1% of the amount of the new issue with a minimum of
$600 and maximum of $ 5,000 .
Part I of the application , if
requested , will involve a fee equal to one -half of the ultimate
fee .
If Part II of the application is submitted , subsequent
to the completion of Part I , the aggregate fee will become
payable upon completion of the financing .
Ratings on bank holding company long- term debt will
be reviewed in Moody's Bond Survey and listed in Moody's Bank
& Finance Manual and Bond Record . As always , it is desirable
for company management , directly or through their underwriters ,
to arrange a meeting with us prior to the assignment of a rating .

January 2 , 1974



Moody's Investors Service

Bonds which are rated Aaa are judged to be of the best quality. They carry the smallest degree of
investment risk and are generally referred to as "gilt edge". Interest payments are protected by a large or
by an exceptionally stable margin and principal is secure. While the various protective elements are likely
to change, such changes as can be visualized are most unlikely to impair the fundamentally strong
position ofsuch issues.

Bonds which are rated Aa are judged to be of high quality by all standards . Together with the
Aaa group they comprise what are generally known as high grade bonds. They are rated lower than the
best because margins of protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present which make the long-term
risks appear somewhat larger than in Aaa securities.
Bonds which are rated A possess many favorable investment attributes and are to be considered
as higher medium grade obligations. Factors giving security to principal and interest are considered
adequate but elements may be present which suggest a susceptibility to impairment sometime in the

Bonds which are rated Baa are considered as lower medium grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payments and principal security appear adequate for
the present but certain protective elements may be lacking or may be characteristically unreliable over
any great length of time. Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.

Standard & Poor's Corporation
AAA Bonds rated AAA are highest grade obligations. They possess the ultimate degree of protection as
to principal and interest. Marketwise they move with interest rates, and hence provide the maximum
safety on all counts.

Bonds rated AA also quality as high grade obligations, and in the majority of instances differ
from AAA issues only in small degree. Here, too, prices move with the long-term money market.


Bonds rated A are regarded as upper medium grade. They have considerable investment strength
but are not entirely free from adverse effects of changes in economic and trade conditions. Interest and
principal are regarded as safe . They predominantly reflect money rates in their market behavior, but to
some extent, also economic conditions.

BBB The BBB, or medium grade category is borderline between definitely sound obligations and those
where the speculative element begins to predominate. These bonds have adequate asset coverage and
normally are protected by satisfactory earnings. Their susceptibility to changing conditions, particularly
to depressions, necessitates constant watching. Marketwise, the bonds are more responsive to business
and trade conditions than to interest rates. This group is the lowest which qualifies for commercial bank

Fitch Investors Service
AAA Bonds of this rating are regarded as strictly high grade, broadly marketable, suitable for
investment by trustees and fiduciary institutions, and liable to but slight market fluctuation other than
through changes in the money, rate. The factor last named is of importance varying with the length of
maturity. Such bonds are mainly senior issues of strong companies, and are most numerous in the railway
and public utility fields, though some industrial obligations have this rating. The prime feature of an
"AAA" bond is a showing of earnings several times or many times interest requirements with such
stability of applicable earnings that safety is beyond reasonable question whatever changes occur in
conditions. Other features may enter, such as a wide margin of protection through collateral security or
direct lien on specific property as in the case of high-class equipment certificates or bonds that are first
mortgages on valuable real estate. Sinking funds or voluntary reduction of the debt by call or purchase
are often factors, while guarantee or assumption by parties other than the original debtor may influence
the rating.


Bonds in this group are of safety virtually beyond question, and as a class are readily salable while
many are highly active. Their merits are not greatly unlike those of the "AAA" class, but a bond so rated
may be ofjunior though strong lien-in many cases directly following an "AAA" bond or the margin of
safety is less strikingly broad. The issue may be the obligation of a small company, strongly secured but
influenced as to rating by the lesser financial power of the enterprise and more local type of market.


"A" bonds are strong investments and in many cases of highly active market, but are not so

heavily protected as the two upper classes or possibly are of similar security but less quickly salable. As a
class they are more sensitive in standing and market to material changes in current earnings of the
Company. With favoring conditions such bonds are likely to work into a high rating, but in occasional
instances adverse changes cause the rating to be lowered.
BBB Dependence on current earnings is more manifest in the "BBB" division. Bonds of this type may
be held with fair assurance if a relatively high yield is desired, but they should be watched closely as to
current results of the Company or signs of possible reverses. While such changes may occur, it is true as
well that many “BBB” bonds have good changes of higher rating with expanding earnings and a more
seasoned position of the company.


Fitch Investors Service

Bankers Trust Company
The Chase Manhattan Bank
Morgan Guaranty Trust Company
The Philadelphia National Bank
The Fidelity Bank
First Pennsylvania Bank
Union Bank
Bank of America NT & SA
First Chicago Corporation
Central Penn National Bank
National Bank ofTulsa
First National Bank of Oregon
First Wisconsin Bankshares Corporation
Girard Trust Bank
Manufacturers Hanover Trust Co.
Virginia National Bank
Dominion Bankshares Corporation
Continental Illinois Corporation
First National Boston Corporation
United States National Bank of Oregon
First Banc Group of Ohio, Inc.
The Northern Trust Company
The Bank of Tokyo of California
First Bank System, Inc.
First Wisconsin National Bank of Milwaukee
The Omaha National Bank
National Bank of Detroit
First Security Corporation
First National Bank ofArizona
BancOhio Corporation
Barnett Banks of Florida, Inc.
Midlantic Banks Inc.
Provident National Bank
BankAmerica Corporation
Chemical New York Corporation
United Virginia Bankshares Inc.
Third National Corporation
First Tennessee National Corp.
First Amtenn Corporation
CBT Corporation
Harris Bankorp, Inc.
Northwest Bancorporation
Continental Bank
Industrial National Corporation
Tennessee Valley Bancorp. , Inc.


The First Pennsylvania Banking & Trust Co.
Bankers Trust New York Corporation
Security Pacific Corporation
Manufacturers Hanover Corporation
Western Bancorporation
Mellon National Corporation


Crocker-Citizens National Bank
Wells Fargo Bank
The Bank of California
United California Bank
Wachovia Bank and Trust Company
Manufacturers and Traders Trust Company
Charter New York Corporation
The Fort Worth National Bank
Marine Midland Banks, Inc.
Savings Banks Trust Company
NCNB Corporation
Industrial National Corp.
American Fletcher Corporation
First Union, Inc.
Hartford National Corporation
First Empire State Corporation
United Jersey Banks
Lincoln First Banks Inc.
First National State Bancorporation
First National Holding Corp.
Union Commerce Corporation
First & Merchants Corporation
Virginia Commonwealth Bankshares, Inc.
First Commercial Banks, Inc.
Central Bancshares Corporation
United Jersey Banks
Wells Fargo & Co.
First Virginia Bankshares Corp.
Cameron Financial Corp.
Mercantile Bancorporation Inc.
First City Bancorporation ofTexas, Inc.
Greater Jersey Bancorp.
Alabama Financial Group


Bank ofCommonwealth
Bank ofVirginia Co.
Shawmut Association, Inc.



Moody's Investors Service

Bankers Trust New York Corporation
Continental Illinois Corporation
First National Boston Corporation
Manufacturers Hanover Corporation
Mellon National Corporation


First Security Corporation
Mercantile Bancorporation
Sun Banks of Florida, Inc.


New England Merchants Company, Inc.
Shawmut Association, Inc.




OF $ 10,000,000 OR MORE

























Through August 31. Includes floating rate issues.


Phyllis Pierson
Southern Methodist University
January 29, 1975

The question of the adequacy of commercial bank capital can no longer
be treated by investigation of commercial banks in isolation . With the upward
surge of one-bank holding companies in the late 1960s and the subsequent
increase in the formation of multibank holding companies , the structure of
the commercial banking industry has changed dramatically . The issue of
bank capital adequacy is inextricably involved with the issue of holding
company expansion and must be examined in that context . There are no
statutory restrictions or specific regulations that apply to holding company
capitalization . However , the Federal Reserve has begun to impose such
limitations indirectly through its general authority to regulate bank holding
companies under the Bank Holding Company Act as amended in 1970. The
Board has become increasingly concerned that holding companies are undercapitalized and that bankers are using the holding company device to achieve
degrees of leverage sufficiently high to endanger the safety and soundness
of their affiliated banks .
The decision of Congress to leave administration of the expanded Bank
Holding Company Act to the Federal Reserve paved the way for substantially
more centralized bank regulation and supervision than was generally expected
at the time . The rapid increase in the number of bank holding companies has
brought banks holding two -thirds of the deposits of U. S. commercial banks
under a substantial measure of Federal Reserve control . Continuing growth
in bank holding company formation and expansion virtually assures the
primacy of Federal Reserve in bank regulation and supervision . The


structure , functions , and environment of bank holding companies
today are what the Federal Reserve says they should be . The Bank
Holding Company Act , as amended in 1970 , provides the basic framework for regulation . Federal Reserve Board policies with regard to
bank holding companies are revealed in Regulation Y and the published
interpretations of the Board appearing in the Federal Reserve Bulletin
and the Federal Register . Next in importance are decisions on holding company
and merger applications that also appear in the Federal Reserve Bulletin
and the Federal Register . The Board has statutory authority to delegate
certain of its functions to the Reserve Banks , and Reserve Banks
have been given authority in a large number of Section 3 cases , those
involving holding company formations and bank acquisitions . To
assist in the adjudication of these cases the Board has promulgated
its " Rules Regarding Delegation of Authority . "

The norms of Federal Reserve judgment concerning holding company
acquisitions and mergers can be stated by reference to six C's --concentration ,
competition , convenience to the public , competence , conflicts of interest ,
and capital . Federal Reserve judgments on the degree of competition and
concentration as well as on capital adequacy all have a certain
degree of commonality . In the opinion of many , the Board , exercising
its regulatory responsibility under the Bank Holding Company Act ,

The latest version of these rules appears in the Federal Reserve
Bulletin of May , 1974 , pp . 358-362 and August 1974 , pp . 588-589 .


has usurped the role of the primary supervisors of banks , particularly
that of the Comptroller of the Currency . Although the decision of the
primary regulator of a particular bank has always been considered by
the Board , the fact that the primary supervisor has not been adversely
critical is no guarantee that the Board will not raise questions on
its own and insist on corrective action . It is increasingly evident in the .
attitudes and actions of the Board of Governors that , no matter who the
primary supervisor of the banks may be , the Federal Reserve will have the
final say about the capital adequacy of banks affiliated with bank holding
companies and the capital adequacy of the holding companies themselves . The
matter of the form and adequacy of capital of bank holding companies and
holding-company banks is one of the most perplexing supervisory problems
confronting regulators today .
Federal Reserve's power to judge the degree of concentration ,
competition , and capital adequacy and to determine activities closely
related to banking has given it enormous power . We are beginning to see
a single regulatory body that shapes the operating profile of a business .
The judgment whether the Federal Reserve has been innovative or unduly conservative has varied widely with the observer . Federal supervision
and regulation is nevertheless changing as bank holding companies change .
The bank holding company was formerly an appendage to a lead bank , a
convenience to that bank , freeing it to some degree from the functional and
geographic constraints that might otherwise hinder it . The new type of bank


holding company that has emerged in recent years has become the
command center of a complex intercorporate structure wherein banking
is but one subsidiary element along with many others such as factoring ,
mortgage banking , finance companies , and computer service operations .
During the Congressional hearings preceding passage of the 1970 amendments
to the Bank Holding Company Act, Chairman Burns insisted that the
Federal Reserve's intention was to regulate only bank holding companies ,
leaving responsibility for supervision of the banks to their statutory agencies .
This argument might have applied to the old - style bank holding company . But
in the judgment of the Federal Reserve modern bank holding companies ,
because of the complex and diverse nature of their operations , require
regulation by the Federal Reserve of all their component parts . Indeed ,
the Board of Governors has recently received additional authority . The
cease-and-desist authority of the Financial Institutions Supervisory Act
of 1966 has been expanded to authorize the Board to initiate cease -and- desist
proceedings to prevent unsafe or unsound practices in the conduct of the
affairs of the bank holding company or to prevent violations by the company
of any law, rule , regulation , or condition imposed by the Board in connection
with granting applications . This power in essence gives the same authority
to the Board of Governors over bank holding companies and any of their
nonbanking subsidiaries that Congress had previously given the federal
supervisory agencies over banks .
The environment within which banks and bank holding companies

52-221 O - 75 - 29


operate has changed markedly in the 1970s . The 1970 amendments to
the Bank Holding Company Act have had the effect of stimulating bank
diversification and reconstituting the organizational base of the banking
industry . The Hunt Commission in its Report of December 1971 called for
additional legislative and regulatory change to encourage greater competition
among financial intermediaries . Recommendations for public policy have
suggested that there be an evolution of financial structure aimed at satisfying
the service requirements of today's economy .
The viability of the bank holding company has been confirmed by
the marketplace . Diversification of assets by individual companies is
steadily being accomplished . Institutional differentiation is rapidly
occurring; there are at one end of the spectrum large , highly diversified enterprises operating in world markets and at the other equally successful
smaller enterprises offering limited services in an immediate trading area.
Well-managed holding companies now generate earnings streams and returns
on capital that compare favorably with those of manufacturing corporations .
Commercial banking , within the holding company context , has re -entered
the mainstream of the private enterprise system . Significant problems remain ,
especially in the realm of holding company capitalizations . Regulatory policy
must be constantly reformulated to allow bank holding companies to make
necessary adjustments to sustain competitive viability . The Federal Reserve's
approach to capital adequacy can either support the constructive cause of
banking reform or complicate it to the detriment of the public interest .


Bank Capital Adequacy
Before dealing with recent changes in the financing strategies of bank
holding companies and the Federal Reserve's reaction thereto , it is necessary
to examine more closely the changing capitalization of commercial banks and
the response of federal bank supervisors to those changes .
Standards of what constitutes adequate bank capital have changed
over time as the business of banking has changed . Bank capital ratios
have been declining for the last century and a half . In the early 1800s ,
the ratio of capital to total assets was in the range of 70 percent . By 1900
the ratio had fallen to about 20 percent . The rapid economic expansion in
the decade following World War I reduced the ratio to just under 13 percent .
There was a steady decline in the capital/assets ratio from the Depression to
its lowest level in 1945 of about six percent . The ratio rose to just under ten
percent in the 1950s and has declined in recent years to less than seven percent .
(See Table 1 ) The capital/ deposit ratio , while higher than the capital/
asset ratio , has exhibited similar historical trends . The ratio of capital to
risk assets was almost 60 percent in the late 1870s , 25 percent by 1900 ,
and 15 to 18 percent in the 1920s . This ratio peaked during World War II ,
as commercial bank holdings of U. S. government securities soared , and has
declined steadily since then to its present eight to nine percent level .
Examination of aggregate capital ratios does not fully reveal the extent
of the capital decline . Table 2 indicates that substantial differences in the

Data taken from Wesley Lindow , " Bank Capital and Risk Assets , "
National Banking Review 1 ( September 1963) : pp . 29-46



Table 1
Capital Ratios of Insured Commercial Banks


Total Capital
Accounts ($ B )

Capital as a % of
Total Assets
Risk Assets*

Capital Notes and
Debentures as a % of
Total Assets







































































* Risk assets :

Total assets less cash and due from banks and U.S.
Treasury securities .

'As of June 30 , 1974 .

Source :

Federal Deposit Insurance Corporation , Annual Report and
Federal Reserve Bulletin , December 1974 .




Table 2
Capital Ratios of Insured Commercial Banks
By Size of Bank
June 30 , 1973

(millions of

(millions of
dollars )

as a % of

" a % of

as a % of







Less than 1



1 to 2



2 to 5






5 to 10






10 to 25






25 to 50






50 to 100






100 to 500






500 to 1,000






6.9 .




1,000 or more


* Less than .05 percent

Source :

Federal Deposit Insurance Corporation , Assets and Liabilities
Commercial and Mutual Savings Banks , June 30 , 1973 , p . 113 .


capital ratios of commercial banks are a function of the size of the institutions .
As a general rule , the larger the bank , the lower the capital -asset and capitalrisk asset ratios become . The decline is especially evident for the very

largest banks in the system .
Changes in the aggregate capital ratios in the postwar period
suggest that bank supervisory authorities have taken a somewhat more
lenient attitude toward the proportion of assets constituting adequate
capital , particularly with respect to capital/risk asset ratios . Yet
these ratios continue to be the focus of attention , not to say concern ,
of some supervisory officials . It is not only the decline in the relative
level of total capital accounts that is the continuing focus of supervisory
attention . In the early 1960s virtually all bank capital was common equity
(common stock , surplus , undivided profits , and equity reserves ) . In
1960 and 1961 long -term debt and preferred stock accounted for less than
.2 percent of total bank capital . This pattern changed markedly during the
mid-1960s . Since 1963 , almost thirteen percent of the increase in bank capital
has been in the form of increases in long -term debt . Capital notes and debentures ,
as of December 31 , 1972 , represented 7.82 percent of total bank capital .
The ratio of long-term debt to total assets rose from .01 percent in 1961 to .55
percent in 1972. And as before , the larger the bank , the higher its debt
capital ratio is likely to be .
Bank supervisors and bank managers are apparently agreed on the
presumed roles of bank capital . Capital is required to permit a banking


firm to gain entry into markets by allowing it to acquire assets and physically
establish its operations . In the ongoing business , capital should serve as
a residue of financial strength to enable the bank to withstand abnormal
losses arising from materially adverse sale of assets , shrinkage of deposits
and other liabilities , and/or the occurrence of loss from trust operations and
other contingencies that cannot be absorbed by current earnings . It is not
the loss in asset values per se that calls for adequate capital but a combination of
asset losses coupled with liquidity pressures that force taking those losses
at an impropitious time in amounts too large for earnings to absorb . Third ,
and foremost in the view of bank regulators , capital should provide a cushion
to protect depositors in the event of liquidation .
Most scholarly inquiry into the amount of capital deemed necessary
to perform its traditional functions has resulted in the same conclusion :
the level of bank capital has not been causally related to the incidence
of bank failures.¹ Most banking crises have occurred during periods of

1 See Horace Secrist , National Bank Failures and Non-Bank Failures ,
(Bloomington , Indiana : The Principia Press , 1938 ) ; Curtis L. Mosher ,
The Causes of Banking Failures in the Northwestern States , (Minneapolis :
Federal Reserve Bank of Minneapolis , 1930 ) ; T. L. Popejoy , " Analysis
of Causes of Bank Failures in New Mexico , " University of New Mexico
Bulletin , 1931 ; Bruce T. Robb., " State Bank Failures in Nebraska , "
(Lincoln , Nebraska : Studies in Business ) No. 35 , April 1934 ; Robert
Brodky , " State Bank Failures in Michigan , " Michigan Business Studies
7 (1935) ; Howard D. Crosse , Management Policies for Commercial Banks ,
(Englewood Cliffs , New Jersey : Prentice -Hall , Inc. , 1962 ) , p . 181 ;
Philip J. Hahn , " The Conflicts in Standards of Bank Capital , " Bankers
Magazine 48 ( Summer 1965) : 38 ; Roland I. Robinson and Richard H. Pettway ,
Policies for Optimum Bank Capital , (Chicago : Association of Reserve
City Bankers , 1967) ; Robert E. Barnett, " Anatomy of a Bank Failure , "
Magazine of Bank Administration 48 (April 1972 ) ; and Thomas G. Gies
and Vincent R. Apilado , " Capital Adequacy and Commercial Bank Failure , "
Bankers Magazine 155 (Summer 1972 ) : 24-30 .


prolonged cyclical instability , when failures were the consequence of rapidly
declining liquidity of firms and households that would not or could not be
met by banks , with ultimate loss of public confidence in the banking system .
The level of bank capital has never been established as a material factor in
survival or failure . In fact, banks that failed during the Great Depression
had higher capital ratios than non-failing banks , probably because deposit
erosion raised the ratios of capital to assets and capital to deposits . More
recent bank failures have been caused by inept management practices ,
defalcation , fraud , self- serving loans to bank management , management
decisions involving the misuse of brokered funds , or bad loans to borrowers
outside the bank's normal territory . In sum , only dishonesty or sheer
incompetence or a combination of the two are required to break a bank.
Traditional ratio tests of capital adequacy have not enabled regulators to
either anticipate or prevent the failure of a commercial bank .
The Supervisory Approach to Capital Adequacy
The relationship between capitalization and deposits was the first
ratio used explicitly by regulators to assess capital adequacy . By 1900
a ten percent capital/ deposits ratio was well established as the regulatory
norm . As a consequence of the experience of the Great Depression , nearly
all banks were below the ten percent standard . It was at this time , when
the realization struck that capital should more logically be related to assets
than to liabilities , that the FDIC began to use the capital/total asset ratio .
The inflation of bank assets during World War II , caused mainly by increases


in banks ' holdings of riskless government securities , rendered the capital/
total asset ratio obsolete ; it was replaced by the capital to risk assets ratio ,
with 20 percent originally considered adequate . The concept that capital
should be judged relative to the risks inherent in the earning asset portfolio
remains dominant in regulation today .
In 1956 the Board of Governors adopted a capital analysis form using
an adjusted-risk assets approach with a liquidity test that categorizes all
assets according to their level of risk and assigns capital requirements to
each category . On the liability side of the balance sheet , volatility ratios
are applied to the liability accounts to derive the total gross capital provision
required for liquidity purposes . From the gross provision the liquidity
inherent in segments of the asset portfolio is subtracted to derive net capital
required for liquidity purposes . There is an additional capital provision to
cover trust department liabilities ( 300 percent of gross earnings ) and other
contingencies peculiar to the bank . The general capital adequacy test
compares actual capital funds (capital , surplus , undivided profits , and all
other reserves except depreciation and amortization reserves ) with required
capital computed as the sum of the capital provisions for fixed assets ,
asset protection , liquidity , trust operations , and other contingencies .
In practice a ratio of actual capital to required capital as computed of 80
to 85 percent has been considered adequate .
The Board revised its capital analysis form in 1972 , creating a bias
toward more conservative levels of capitalization and for equity capital


as opposed to debt capital . Secondary reserves are separated into a distinct
category calling for special treatment . Asset risk factors are separated
into " credit risk " and " market risk . " The capital provision for liquidity is
essentially unchanged . Capital requirement ratios are more conservative
than in the 1956 form . The capital provision for trust operations is reduced to
200 percent of gross earnings , and the provision for special factors is
continued . An additional capital requirement of two percent of adjusted
net assets (total assets net of assets classified doubtful or loss ) is added .
Total required capital is the sum of capital required for asset-related market
risk, for asset-related credit risk , for adjusted net assets , for gross trust
department earnings , and for special factors . The liquidity calculation
compares total liquidity requirements for liabilities with net liquidity available
from assets , after provision for credit and market risk . A shortfall of net
liquidity requires additional capital funds . The total capital requirement
calculation is compared to the " adjusted capital structure" of the bank
(total capital accounts plus reserves on loans and securities minus assets
classified loss and 50 percent of assets classified doubtful ) and to " adjusted
equity capital " (adjusted capital structure less debt capital ) . Capital ratios
are reintroduced . " Adjusted capital structure" as a percentage of total
assets (total assets less primary reserves and U. S. Treasury and agency
obligations ) and as a percentage of total deposits are computed , as is
"adjusted equity capital " as a percentage of total assets and deposits .


In assessing capital adequacy of state insured nonmember banks ,
the Federal Deposit Insurance Corporation continues to rely basically
on the ratio of capital funds , net of investments in fixed and substandard
assets , to average total assets . In practice , most state regulatory bodies
use procedures philosophically aligned with those of the FDIC and the
Federal Reserve .
However , the primary supervisor of national banks , the Comptroller
of the Currency , has departed from prevailing regulatory standards by
officially substituting a focus on managerial performance expressed in general
guidelines appropriate for banks operating under normal business conditions
for traditional static ratio analysis to determine capital adequacy . The
Comptroller's office no longer relies on what it regards as arbitrary capital/
asset or capital/ deposit ratios because such formulas do not adequately
account for more important factors such as the quality of management,
liquidity of assets , the history of earnings and retention thereof, the quality
and character of ownership , the burden of meeting occupancy expenses ,
potential volatility of the bank's funds structure , the quality of operating
procedures , and the bank's capacity to meet present and future financial

needs of its trade area .
National banks are examined by the Comptroller of the Currency and
presumably must follow the guidelines of that office with respect to capital
adequacy . However , as mentioned previously , the Federal Reserve's judgments
on capital adequacy are presently the controlling standard for all banks


affiliated with bank holding companies . Approval of capitalization levels
by the Comptroller is of no practical significance to an affiliated national
bank that has been ordered by the Federal Reserve to augment capital as
a condition of approval of an application of its parent holding company .
George Vojta , Vice-President for Corporate Planning of the First National
City Bank and the industry's leading spokesman on the subject of capital
adequacy , has expressed grave concern over the Federal Reserve's
forcing of its capital standards on holding companies and their affiliated
banks . He views the implicit assumptions in Federal Reserve methodology
with alarm .
For capital adequacy purposes , banks continue to be viewed in static
terms . Incidence of major adversity in the business environment is
presupposed . " Worst case " probabilility assumptions establish the
magnitude of the ratios applied to assets , liabilities , and the capital
provision formula for trust operations and other contingencies .
The presumptive current mandate of public policy is that commercial
banking in the holding company context is to re-enter the mainstream
of private enterprise , diversify into related fields , and compete in the
market place .
A capital adequacy standard which posits a level of capitalization as that
necessary to protect a business against the incidence of simultaneous
" worst case " loss experience in all categories of risk is at variance with
the view of banking as an on- going business enterprise . Capital in
an on-going business must be sufficient to anticipate periods of relative
difficulty and provide a prudent margin on safety; a business which
maintains a level of capital sufficient to withstand judgmentally exaggerated
risks of ruin will incur a competitive disadvantage in the market place .
The effect of the Board's test (s ) of capital adequacy is to create a bias
for all banks to capitalize to the lowest standards of competence , the
highest standard of risk , and to disregard the factual differentiation
in business performance that is now characteristic of commercial banking .

George Vojta, Bank Capital Adequacy (New York: First National
City Bank , 1973 ) , pp . 14-15 .


Mr. Vojta advocates a dynamic appraisal of capital adequacy for
banks and holding companies that would allow their evolution in procompetitive
terms . He acknowledges that the net worth of a commercial bank or a holding
company must be sufficient to acquire the institutional structure necessary
to perform the intermediation function and provide related service , but he
considered earnings the all- important consideration . The holding company's
consolidated earning power should be sufficient to absorb losses and pay
dividends , and the residual should accumulate to increase net worth .
The higher the level of income , the greater the ability to sustain losses and
the smaller the need for a residual capital cushion .

Bank holding companies

with nonbank subsidiaries are enterprises that differ from banks in their
profit and risk dynamic . In an on-going enterprise management competence

becomes the critical factor in maintaining solvency .
Prudence dictates that bank management anticipate recurrent crises .
In the absence of countervailing action by the monetary authorities ,
disaster conditions carry the risk of massive deposit/liability shrinkage
and totally illiquid asset portfolios . In these circumstances capital
funds aggregating to not less than 100% of total liabilities , held in cash ,
are required to prevent insolvency . Since the banking system operates
on a fractional reserve basis , a capital cushion to this extent is , by
definition , not available . It is time to draw the realistic conclusion that
in environments which bring the financial system close to collapse ,
the only recourse to all institutions --including banks --is to the capability

Loan losses charged off during 1971 --when the industry experienced
its highest loss rate since 1939--amounted to only 2 percent of the
capital of the industry or approximately 23 percent of 1971 income before
securities transactions . If one looks to the large banks that suffered the greatest
losses in this period , the largest proportionate loss amounted to 65 percent
of total earnings .


of the authorities to manage the economy out of crisis . Public confidence
is and must be retained by the general expectation that the authorities
will not hesitate to act in this manner . In severe cyclical swings caused
by economic policies , the authorities must assume responsibility for
public confidence in the financial system . This does not mean that
government is expected to bail out mismanaged institutions; but neither
should financial institutions be expected to be so over capitalized
as to bail out government's mismanagement of the economy . As a matter
of fact and practicality , the economic disaster case should be excluded
as a relevant scenario for capital adequacy purposes . 1
Bank Holding Company Leverage
The remarkable increase in the growth rate of commercial banks in
recent years has contributed to the increasing use of debt as a source of
capital in order to help provide the capital foundation for the rapidly expanding
asset base . Federal bank supervisors , particularly Federal Reserve authorities ,
have expressed concern over the increased use of debt capital by commercial

banks . 2 But the banks themselves no longer present the major problem.
Rules already exist limiting the aggregate debt capacity of banks , and most
banks have remained below the approximate one -third limit to avoid regulatory
displeasure and to retain some degree of future financing flexibility . Beginning
in 1969 the focus of the capital problem changed dramatically as the industry
underwent a structural change brought about by the conversion of many
commercial banks to subsidiaries of bank holding companies . The capital-

Vojta , op . cit . , pp . 21 .
2 The use of senior securities is not limited to banks and bank holding
companies . Savings and loan associations have also begun to use debt securities
to supplement capital . See David W. Cole , " Capital Debentures : A Tool of
Liability Management for Savings and Loans - Parts I and II , " Journal of the
Federal Home Loan Bank Board , November 1972 , pp . 8-16 , December 1972 ,
pp . 29-37.


16 raising function for many institutions switched from the bank itself to the
parent holding company . An examination of the extent of bank holding

companies ' entry into the debt markets reveals the magnitude of the change.
In the 1963-1974 period , there were 497 public and private debt issues by
banks and bank holding companies aggregating more than $ 10 billion . Of this
amount 85.7 percent was obtained through public issues , and about 20
percent was convertible into common stock . As Table 3 suggests , both
relative levels and rates of change in interest rates appear to influence the
timing and amounts of debt issues . Debt increased rapidly while rates were
low in the early and mid - 1960s . There was a drastic fall -off in 1966 ,
probably attributable to the rapid runup in rates that occurred in that year .
Debt continued to increase at a retarded rate in 1967 and 1968 , the paucity of
issues (17 public a

19 private in the two years ) probably being accounted

for by both rising rates and uncertainties that accompanied formations of
one-bank holding companies . New debt issues continued unpopular in 1969
and 1970 during the period of substantially rising interest rates.

The basic data sources for this inquiry were the bi -monthly and
annual publications Report of Debt Securities Issued By Commercial
Banks and Holding Companies prepared by the Corporate Financial
Counseling Department of the Irving Trust Company and available on
request from the bank . The reports , in addition to describing each
issue , provide pro forma capitalization figures and relevant measures
of leverage .
2 The amount of long -term commercial -bank debt outstanding actually
declined in 1969 .







760,144 26
116,234 3
221,851 7
317,549 13
248,010 6
78,250 19
647,908 57
313,862 71
101,000 10

39,800 0
24,994 1
7,385 1
84,100 1
176,173 3
293,850 14
123,300 N.A.

6· ,000


















)|($ 00
Issues )Amount

.$- ,130

, orporate




Debt again grew rapidly in 1971 and 1972 as rates dropped from their 1970
peaks . According to testimony from market participants , rising rates in
1973 unquestionably worked to reduce the amount of debt issuance in that year .
About half of the large amount of debt issued in 1974 came before rates
reversed a three-month downward course in March; most of the remainder
is in the form of variable rate notes . In general , during periods of rising
rates and declining price- earnings multiples , the indebtedness that was
issued was very often convertible into common stock in order to have a lower
interest cost ( 50 to 250 basis points ) and , after conversion , to issue common
stock at a price higher than the current market price , or more recently

with a variable interest rate .
Beginning in 1971 there was a dramatic rise in the debt of commercial
banking institutions . Banks and bank holding companies together publicly
issued about $2.045 billion of capital notes and debentures in the period 19631970 , an annual average of approximately $ 292 million . In 1971 and 1972
alone they issued $ 3.645 billion . For the period 1971-1974 the total was

1 The 1974 figures cited above include eight floating -rate note issues
totaling $1,130 million . The notes are a new form of money market instrument
whose interest rate is computed every six months by adding a 100 basispoint premium to the average Treasury bill yield for the prior three weeks .
The notes are obligations of the holding company designed to tap the
retail savers ' market . The purpose of these issues appears to be to reduce
the companies dependence on the commercial paper market . The most
unusual feature of the notes is that they are redeemable at par with accrued
interest at the option of the holder beginning two years after the date of issue
and every six months thereafter . Thus , even though the notes have original
maturities of 15 to 25 years , they are essentially short-term debt because of
the retirement option . The notes should not be regarded as part of the longterm capital base of the holding company available to support senior borrowings
because there is no assurance to senior lenders that the securities will remain
a part of the company's long -term capitalization .


- 75 - 30


approximately $6.717 billion , or an average of $ 1.679 billion a year .
As shown in Table 4 , debt as a percentage of total external financing
of banks and holding companies exhibits the same pattern . Public and private
debt issues constituted 92.4 percent of such financing in 1971 , 91.6 percent
in 1972 , and 98.2 percent in 1974.
These aggregate data do not reflect the full impact of the emerging influence
of bank holding companies in the capital markets . Tables 5 and 6 separate
the debt issuance of bank holding companies from the combined bank and bank
holding company totals . The data indicate that the impressive increase in
indebtedness in recent years has been in large part by bank holding companies
rather than banks . From 1964 through 1968 , total new debt of bank holding
companies accounted for only 9.8 percent of the aggregate amount and 4.8
percent of the number of issues . The years 1969 through 1974 were markedly
different. In the post- 1968 years holding companies accounted for 79.6
percent of the dollar amount of debt issued and for 56.1 percent of the number
of issues . More recently the relative impact of bank holding companies has
increased . In 1973 , holding company issues accounted for 91.2 percent of the
aggregate dollar value and 71.1 percent of the number of debt issues as
compared to a year such as 1967 , when holding company debt issues were only
23.3 percent of the dollar value and 20 percent of the number of separate
issues . In terms of cumulative amounts issued , from 1963 to 1970 bank holding
companies issued about $434 million of debt securities , an average of $62



Table 4

Bank and Bank Holding Company
Sources of External Financing by Type

Notes &

Notes &







Mortgages ,


0.4 %


Includes floating-rate note issues

Less than .05%

Source :

Computed from data in Table 3 .







Table 5
Bank Holding Company Debt Issues

Public Issues



of Issues

Private Issues

Total Issues

.- 01,800

of Issues


531, 580


6, 439 , 551

Includes floating-rate note issues .

of Issues






Table 6
Bank Holding Company Debt Issues As A Percentage
of Total Bank and Holding Company Issues

Public Issues

Total Issues

Private Issues


# Issues







# Issues








# Issues

Includes floating-rate note issues .

Source :

Computed from data in Tables


and 5 .


million a year . In 1971 and 1972 they issued almost six times that amount , or
$2.487 billion . From January 1971 through December 1974 , holding companies
sold new debt securities worth $ 5.975 billion , almost 14 times the amount
issued in the previous eight years . The pattern for banks is much different .
Banks sold capital notes and debentures in the amount of $2.34 billion in the
eight year period 1963-1970 and in the amount of only $1.46 billion for the
1971-1974 period .
The aggressive use of senior capital by banks and bank holding companies
has sharply increased the degree of measurable leverage of many of the issuing
firms . For instance , in both 1972 and 1973 , more than half the new debt issues
were by firms with debt/ total capitalization ratios of 30 percent or more , and more
than 20 percent of the issues in both years were by firms with debt/capital ratios
of 40 percent or more . For most bank holding companies the leverage
effect has had a positive effect on rates of return on equity .
The Changing Focus of Regulatory Concern
The Board of Governors has always been distrustful of the use of debt
capital . Capital additions to affiliated banks ordered by the Board are always.
required to be increments in equity- capital accounts . With the exception of
convertible debt issues likely to result in equity- capital additions in the
future , debt issues , in the Board's view , do little to augment the capital
foundation of a commercial bank as a viable concern; debt capital should not be
regarded as a substitute for equity capital . In recent years Brenton Leavitt ,


the Federal Reserve's Program Director for Banking Structure , has apparently
spent a significant proportion of his time on the telephone calling banks and
holding companies with acquisitions pending before the Board whose equitycapital ratios are lower than Federal Reserve deems desirable . His activities
in this area are so commonplace that the phrase " Leavitt call " has made its
way into contemporary banking jargon . Mr. Leavitt expresses several reasons
for the official distrust of debt capital in banks . Among these reasons are " ( 1 )
interest on debt capital must be paid whether or not the bank's condition
justifies payment; (2) such payments may fall due at inopportune times :
(3) the use of debt reduces the bank's reserve of borrowing capacity in the
marketplace; and ( 4) losses cannot be charged against debt capital except in
liquidation . " 1
The Board's increasing apprehension about the use of debt capital by
holding companies , while based on much the same reasoning as its worries
over bank debt capital , is grounded in fundamentally deeper issues , all of
which are not immediately obvious on the surface of Federal Reserve pronouncements . An examination of the reasons why holding companies issue
debt securities should reveal the real basis for Federal Reserve anxiety .
One purpose is to acquire additional subsidiaries , bank and nonbank .
The purchase of companies that have a rate of return in excess of the holding
company's cost of borrowed funds has a positive effect on earnings per share .

1 Brenton C. Leavitt , " The Philosophy of Financial Regulation , "
Banking Law Journal , Vol . 90 , No. 8 , August 1973 , p . 646 .


In contrast to the experience of recent years , the purpose of early debt
offerings was to bolster bank capital positions that had declined in the post-

World War II period .
A second reason for selling debt is to augment the equity capital of bank
subsidiaries that may be under supervisory pressure to improve their
capitalization . In this case , the holding company uses the proceeds of the
debt issue to purchase additional common stock of the banks.¹
A third reason is to reduce the effective borrowing costs of the holding
companies ' subsidiaries . The advantage in having the parent company issue
the debt to the public is that it is probably better known , has a superior credit
rating , and can therefore obtain funds at lower effective cost . The proceeds
from the sale can be passed downstream to the subsidiaries in return for
their debt instruments . An alternative that might also lower the firm's
borrowing costs would be for the holding company to guarantee its
subsidiaries ' debt issues .
Finally , holding companies , which have become increasingly profit
oriented , may use debt to lever their income streams to benefit from the potentially
favorable effect on return to equity of increased leverage . Boosting earnings
tends to raise the value of the companies ' stock , with the consequent effect of
making future acquisitions less expensive on a share-exchange basis . In fact ,

Great concern has been caused by the use of " double leverage , "
whereby the parent levers itself by selling debt and uses the proceeds to buy
equity in its subsidiaries , which can subsequently issue more of their own
debt securities because their equity base has been enlarged .


the opportunity to lever their total operations beyond the point that bank
regulatory authorities have allowed bankers to lever their banks may be
one of the greatest attractions that managers see in the use of the holding
company form of organization .
High debt ratios for holding companies , in and of themselves , bring
forth negative reactions from the Board . The greater the portion of debt
in the holding company's capital structure , in the Board's view , the more
likely it is that the company will require large dividends from its banks in
order to service its debt . The payment of large dividends by the banks ,
because such payments reduce the retention of earnings , could gradually
erode the banks ' capital positions , thereby decreasing their ability to withstand
adversity . The Board's position is that bank holding companies should be
ready sources of strength to their subsidiaries for expertise and capital
funds in time of need rather than the other way around . The Federal
Reserve considers it essential that bank holding companies and their nonbank
subsidiaries be soundly financed " so that they will , if anything , be in a position
to add to the strength of their affiliated banks and in no way dilute or ' trade

on ' that banking strength . " 1
The Board's authority to evaluate the capital structure of bank holding
companies derives from Section 3 of the Bank Holding Company Act , which
requires the Board , in acting on holding company applications for acquisitions

NCNB Corporation , 1972 Federal Reserve Bulletin , p . 844. See also
First Southwest Bancorporation , Inc. , 1972 Bulletin , p . 301 ; Bezanson
Investments , Inc. , 1972 Bulletin , p . 804; and Northshore Capital Corporation ,
1972 Bulletin , p . 809 .


or mergers , to consider " the financial and managerial resources and future
prospects of the company or companies and the banks concerned . . . " The
Board has increasingly exercised this general authority in order to assure
compliance with its standards of capital adequacy . There have been numerous
cases in which the Board has approved applications on the condition that
equity capital be added or debt position improved or strengthened .
The Board, when it found the problem sufficiently serious , has denied
applications on the grounds that subsidiary banks were inadequately capitalized
or that there was too much debt in the capital structure of the parent holding

company .

The frequency of these denials has increased in recent months .

In reality the major worry of the Federal Reserve is the tendency of
more highly levered holding companies to become deeply involved in nonbanking activities , or the other way around , the tendency of holding companies
with significant nonbank activities to become more highly levered . Because
the business of banking consists largely of intermédiation through simultaneous
borrowing of deposits and lending directly through loans or indirectly through
the purchase of financial securities , the major risks involved are credit
risks and risks of illiquidity . However , approved nonbanking activites

See, for example , Federal Reserve Bulletin , 1968 , pp . 511 , 515 ,
773-775; 1969 , pp . 611 , 612-613 , 962 , 964; 1970 , pp . 291 , 293 , 845 , 847;
1972 , pp . 298 , 299 , 804 , 812-814 , 817-818 , 819-821 , 826-828 , 829-831 ,
836-837 : 1973 , pp . 21 , 24 , 30 , 106 , 192 , 460 , 528 , 585 , 589 , 594 , 680 ,
752 , 760; and 1974 , pp . 40 , 130 , 300 , 366 , 367 , 369 , 372 , 375 , 389 .
2 See for example , Federal Reserve Bulletin , pp . 1261 , 1263 ; 1966 ,
p . 971 ; 1972 , pp . 301 , 809 , 1026; 1973 , pp . 462 , 599 , 698 ; and
1974 , pp . 123 , 127 , 131 , 309 , 362-363.


entail additional risks that include the possibility of operating losses , significant

exposure to costly damage suits , and additional credit risks such as might be
involved with the extension of short-term credit in the form of unsecured accounts
receivable . Consideration of these different types of risk complicates the job
of determining and enforcing standards of capital adequacy .
Entry into nonbanking activities has been significant . Entry has been
accomplished both by the acquisition of existing firms and by the establishment
of new firms . Between January 1971 and June 1974 , Federal Reserve
granted permission to acquire or start de novo 2305 nonbanking businesses .
In the Board's view , significant nonbanking activity adds a degree of vulnerability
to bank holding companies . Because they are not subject to all the protection
afforded banks as a result of close supervision , nonbanking companies can
fail in the ordinary course of business . In the final analysis , the real problem
is that the failure of a holding company or one of its nonbanking subsidiaries
could jeopardize the banking subsidiaries.2
Peter S. Rose and Donald R. Fraser , " Bank Holding Company Diversification
into Mortgage Banking and Finance Companies , " Banking Law Journal 91
(November-December 1974 ) : 977 .
A recent event exemplifies this particular concern of the central bank .
On December 30 , 1973 , Beverly Hills National Bank disclosed that it would be
unable to meet $2 million in maturing commercial paper obligations that had
been sold through the bank to private investors . The holding company's liquidity
problems stemmed from slow repayments of $7.6 million in real estate loans
made by the holding company itself . Under his " cease -and - desist " authority ,
the Comptroller of the Currency ordered that the bank pay no dividend to
its parent company . Although the bank was solvent and had satisfactory
liquidity the close connection between the parent and the affiliated bank caused
the bank to lose $30 million in deposits within a few days , forcing the sale of the
bank to Wells Fargo Bank . See " Beverly Hills NB Placed on Sale to Meet $2
Million Obligation of its Parent Company , " American Banker , January 2 , 1974 ,
. p . 1 and " Forced Sale of Beverly Hills NB Shows Tight Tie Between HC , Affiliate ,
Smith Says , " American Banker , January 25 , 1974 , p . 1 .


Because of the greater risk involved in nonbanking activities it may be
preferable , for reasons of bank safety , to have these activities performed by

separate subsidiaries of bank holding companies rather than by the banks
themselves , that is , the bank holding company may be an effective device
for sheltering banks from risk . Samuel B. Chase , Jr. , Advisor to the Board , has
expressed this viewpoint in numerous public appearances in recent years .
Theoretically the resources of banking subsidiaries are not exposed to the .
risks run by nonbank subsidiaries of the same firm . Each subsidiary is
a separate legal entity; the losses of one should have no direct effect on the
profits or capital of another . Neither the parent nor sister subsidiaries are
legally obligated to make good on the obligations of a subsidiary that goes
into receivership . If the parent company should fail ( e.g. , Beverly Hills
Bancorporation) , only its equity interest in subsidiary banks is available to
satisfy claims on the parent . In reality , any parent company debt is subordinated
to the debt of its subsidiaries.2 In any liquidation of a holding company or
its subsidiaries , it would appear that depositors of subsidiary banks would have to
be paid before the banks could remit funds to the parent for liquidation of
holding company obligations .

See, for example , Samuel B. Chase , Jr. , " The Bank Holding CompanyA Superior Device for Expanding Activities ? " Policies for a More Competitive
Financial System (Federal Reserve Bank of Boston ) , June , 1972 , pp . 77-87 .
The discussion that follows is a distillation of Mr. Chase's arguments .
U. S. National Bank in San Diego had approximately $15 million of capital
notes outstanding . Neither Crocker National Bank , which purchased
U. S. National , nor the FDIC has assumed these obligations because the notes
represented subordinated risk capital put directly into the bank by investors .


Practical doubts can be raised with regard to the degree of the
bank's insulation from risk on two grounds :

(1 )

(2 )

The legal separateness of affiliated corporations might turn out
to be fictional because courts would " pierce the corporate
veil , " treating the holding company and all its subsidiaries
as one legal person in the event that one subsidiary fails .
Holding companies would not , in fact, be willing to " walk away "
from bankrupt subsidiaries but would use all of their resources ,
including those of banking subsidiaries , to meet obligations
of a failing subsidiary.2

The more likely case , from the Federal Reserve's viewpoint , is that
operating difficulties or debt servicing problems in nonbank operations could
drain the bank's resources . There are several possible means of tapping
the resources of banking subsidiaries . One way is for the bank to extend
credit directly to troubled non-bank subsidiaries or indirectly to the parent
to be re-lent to subsidiaries . Alternatively , the bank could divert funds
"upstream " to the parent through inflated dividend payments . Finally , the
bank could buy some or all of the assets of a failing subsidiary .
There are some existing safeguards against such practices . The Federal
Reserve Act limits extensions of credit to affiliates . Loans of insured banks to
separate affiliates cannot exceed ten percent of the bank's capital and surplus
and cannot exceed twenty percent for loans to all affiliates combined .
Moreover , such loans must be collateralized by " stocks , bonds , debentures or
other such obligations " having a market value at the time the loan is made in
excess of the amount of the loan.2

2 Chase, op . cit . , pp . 81-82 .
12 U. S. C. § 371C .


Laws that restrict the size of bank dividends generally are applicable
to upstream dividends . National banks must obtain the Comptroller's
approval before ( 1 ) paying dividends out of capital and surplus or ( 2)
paying dividends in any calendar year that are greater than the sum of net
profits for that year and retained earnings for the two preceding years .
Similar restrictions apply to state member banks except that approval in
their case must be obtained from the Board of Governors . As a general rule ,
state banking laws restrict the payment of dividends out of capital .
Bank purchases of assets of failing subsidiaries are also constrained .
The Federal Reserve has interpreted the law governing loans of insured banks
to affiliates so broadly that the statute is taken to cover the purchase of
assets . As previously noted , the Federal Reserve now has the statutory
authority to prevent such unsound practices if affiliated banks are threatened .
Insulating Banks From Risk: Alternative Solutions
It should be evident at this juncture that the growing concern of the
Board of Governors over the increasing use of debt capital by bank holding
companies is not simply a reflection of their antipathy toward debt per se . The
issue is much more complex than the relatively simpler question of the use
of debt capital by banks themselves . It is deeply rooted in the rapid and
dramatic changes in the profile of the financial services industry that

have occurred in recent years .

1 12 U. S. C. §§ 56 , 59 , 60 .
12 U. S. C. § 324.


As viewed by federal regulators , the function of bank and bank holding
company supervision is to protect the public's deposits by preventing , as
far as possible , those types of unsafe and unsound banking practices that could
result in bank failures . In this regard it becomes necessary to insulate
affiliated holding company banks from the risk of nonbanking activities and
from the risk of higher leverage utilization by their parent holding companies .
Most of the recommendations that have been offered to help accomplish this end
are to some extent unsatisfactory to either the Federal Reserve or to the banking

industry .
First, the Board could require increased holding company or nonbanksubsidiary equity capital to act as a buffer for the increased risk involved
with nonbanking activities . Second , the Federal Reserve could examine the
loans of nonbank subsidiaries in the same manner that it now examines state
member bank loans and require additional capital dependent on the classification
of those loans . Third , legislation could be passed that extends the dividend
restrictions applicable to member banks to all banks that are subsidiaries of
holding companies , that specifically limits or prohibits the purchase of assets
by banks from their parents or sister subsidiaries , and/or that requires
regular reporting of intercorporate transactions . Holding companies could
be required to covenant with the Board , as a condition for approval of nonbank
acquisitions , that they will not support failing nonbank subsidiaries , perhaps
with the proviso that such support could be given with Board approval .
Another alternative is federal legislation specifying that in no case shall banks be


held liable for the debts of their parent holding companies or sister subsidiaries .
Such a law might require that nonbank subsidiaries have names distinctly
different from those of affiliated banks and that their advertising and communications
with customers and creditors carry explicit statements that their debts are
not guaranteed by banking subsidiaries of the same holding company .
Federal Reserve could attempt without benefit of new legislation to impose
some of the above requirements under its general powers to regulate bank
holding companies and its recently granted cease -and- desist authority to
prevent unsafe and unsound practices of holding companies that may threaten
the solvency of subsidiary banks . One other partial solution offered might
have particularly distressing consequences . It has been suggested that one
way of preserving cash in banks or holding companies during periods of
economic stress would be to establish the right of some third party , perhaps
a federal regulatory body , to temporarily negate the contractual obligation to
service debt . If this provision were contained exclusively in the debt
instruments of bank holding companies and banks , investors would
either require the payment of a penalty interest rate commensurate with the
higher degree of risk or purchase securities not containing such a provision .
In either event the sale of debt instruments by the industry would be severely
hampered without any assurance that commensurate public benefit would
result in the form of greater bank liquidity or greater public confidence in
the ability of the banking system to withstand economic adversity .


It is the hope of members of the banking industry that drastic measures
that could penalize a sizable segment of the bank holding company community
not be taken by the Federal Reserve as a quick , easy " solution " to its present
supervisory dilemma . Rather a careful case-by- case approach is preferred
so as not to lump all holding companies in the same mold and subject them
all to rules of thumb similar to those that characterize Federal Reserve's

approach to bank capital adequacy standards .

In fact , many bank holding

companies , because of existing regulation , are already at a competitive
disadvantage in the market place and do not wish to be constrained by further
regulation , as the following section suggests .

Competition in Financial Services
The need for bank holding companies to be allowed greater financial
flexibility may be highlighted by examining their competitive position relative
to one subset of their major competitors that also offer funds -intermediation
and other money-related services . These entrants to the market are industrial-and retailing -based companies that are basically regulated only by
the standards of the marketplace as to ( 1 ) activities in which they may engage
and (2) organizational financial policies that they may employ .

Comptroller of the Currency James Smith has recently stated that he would
like to see his office once again resume its role as final judge of the capital
adequacy of affiliated national banks . His statement evidences the concern
about Federal Reserve's increasing encroachment upon the regulatory territory
of other federal bank supervisors . The Federal Reserve remains convinced ,
however , that it is the only federal agency without " tunnel vision " on these
matters and consequently the only one capable of making fully informed
judgments on capital . See " The Fed gets tougher about bank capital , " Business
Week, February 16 , 1974 , p . 118 .

52-221 O 75 31


Cleveland A. Christophe , Investment Officer for First National City
Bank , studied the competitive environment in one sector of the financial services
industry--the market for consumer credit--to determine the nature and
magnitude of the competition with bank holding companies by major retailers
and consumer-durables manufacturers . As of January , 1974 , the nation's
three largest retailing chains --Sears Roebuck , J. C. Penney , and Marcor
(Montgomery Ward ) -- had consumer installment receivables outstanding equal to
more than eleven percent of total consumer installment loans held by all
commercial banks in the country . Sears ' customer account balances at
year- end alone were greater than those of either National Master Charge
(6163 banks ) or Bank Americard ( 5226 banks ) . As of December , 1972 ,
General Motors , Ford , and Chrysler owned finance company subsidiaries
whose net receivables and capital funds ranked respectively first , second , and
seventh among U. S. finance companies . General Motors Acceptance Corporation
had outstanding retail receivables on December 31 , 1973 , of more than
$8.7 billion , an amount equal to 12.6 percent of total consumer installment
credit held by all commercial banks . In 1972 , Sears , International Telephone
and Telegraph , Control Data , and Gulf & Western all received more than a
third of their earnings from financial operations . Sears alone earned more in
that year from its financial service operations than the total net income of any
bank holding company in the country .

Cleveland A. Christophe , Competition in Financial Services
(New York: First National City Bank , 1974) , pp . 5-10 .


Present regulation restrains bank holding companies from responding
effectively and efficiently to changing public needs and environmental
conditions . Nonfinancial- based enterprises are thus provided a significant
competitive advantage over commercial banks and bank holding companies .
These firms presently compete in a broad cross section of financial service
markets , including many areas denied bank holding companies . They have
no direct federal regulator requiring approval , ex ante or ex post , before
expansion into most financial areas can be accomplished . Furthermore , there
is no requirement that these firms prove that the public benefit will be served
in some manner by their entry into the field . This lack of direct regulation
gives nonfinancials a greater capacity to innovate new products and services
than is possessed by bank holding companies , which must seek prior Federal
Reserve approval before developing new services or experimenting with new
distribution techniques .
A nonfinancial enterprise can , with relative ease , enter de novo almost
any geographic area and offer a full range of financial services , frequently
from its merchandising location . Branching restrictions prohibit banks
from operating on a nationwide basis , thus limiting their ability to compete
effectively , except by means of a separate subsidiary , in consumer and small
business markets outside their base operating area , foreclosing consumers
and small businessmen from the broad competitive choices available to large
corporate borrowers . Bank holding companies are also at a relative disadvantage
in entering new markets by acquisition . Ceteris paribus , a seller is better
off to contract with a nonfinancial corporation because the transaction can
be consummated more quickly and with greater certainty than with a bank


holding company that must first gain regulatory approval .
Another important advantage of nonfinancial companies is their trememdous
financing flexibility . A nonfinancial corporation is free to design its
capital structure subject only to constraints imposed by the market . On
the other hand , Federal Reserve Board regulations limit a bank holding
company's managerial freedom to decide not only its total level of capitalization
but also the mix of capital instruments and the timing of their issuance . For
example , nonbank-related finance companies often sell their own short-term
notes in minimum denominations of fifty dollars , a practice denied nonbank
affiliates of bank holding companies .
The Federal Reserve is duly concerned with the soundness of the banking
system and the safety of the public's deposits . Banks are still the core
businesses of most bank holding companies , dominating the balance sheets
and profit and loss results of the typical diversified bank holding company .
But excessive concern over banking safety that manifests itself in regulations
that fetter the nonbank operations of holding companies , rendering them less
effective competitors in the domestic and world -wide marketplace , could
handicap such firms to the extent that greater rather than less reliance and
pressure is exerted on subsidiary banks to guarantee the financial viability
of the total holding company operation .

The Decline in Capital Ratios
From December 31 , 1969 to June 30 , 1974 , assets of insured commercial


banks have increased from $530.7 billion to $ 872.0 billion while capital
accounts have increased from $39.6 billion to $61.0 billion . The decline in the
ratio of capital to assets of banks and bank holding companies is an undeniable fact . However , the Federal Reserve's continued insistence that
declining capital ratios are a major threat to the safety and soundness of
the banking system needs to be brought into proper perspective lest
Congress or the Federal Reserve take action to attack the symptoms of the
disease rather than treating its underlying causes .

For a decade the commercial banking system has attempted to adapt its
operations to an environment characterized by alternating periods of rapid
economic expansion and recession accompanied by increasing inflationary
pressures . Above- average rates of growth of the money supply , condoned
if not engineered by the central bank , have had a profound impact on the
rates of growth of the banking system , on the price level and on interestrate levels . Capital , particularly equity capital , has become an increasingly
scarce resource for all segments of the economy . The rise in the cost of
capital has provided an incentive for firms to economize on this relatively
scarce resource . All firms , including banks and bank holding companies ,
have had to place greater reliance on the use of debt , especially in light
of the two year decline in the stock market that has drastically increased
the cost of equity capital . The banking system has been forced to assume a
greater role in financing the business community's increased cost of new
investment in plant and equipment and rapidly inflating needs for working
capital . The Treasury's continued effort to finance government expenditures


by selling its debt to large institutional investors and more recently to small
savers has further increased the pressure on the banking system to finance
business activity normally financed in corporate securities markets . The
resulting growth of bank assets , particularly since 1971 , has far outstripped
the banking system's ability to increase capital through external issues of
equity or through retention of earnings , even in light of substantial reductions
in dividend-payout ratios . The Federal Reserve has become increasingly
apprehensive about the decline in the equity base of the banking system--a
problem largely of the Federal Reserve's own making .
The Federal Reserve has been attempting to rectify this supposed evil
by forcing a moderation in the asset growth of bank holding companies by
the acquisition and/or de novo operation of additional subsidiaries by bank
holding companies that are in its determination " inadequately capitalized . "
More important, the Board of Governors has overridden the authority granted
by Congress to the Comptroller of the Currency to supervise and regulate the
nation's federally chartered banks . The most common course of action has
been to order capital additions for national banks whose capital structure has
already been approved by the Comptroller . It is in the best interest of
the efficient operation of our financial system that power to supervise banks
reside in the federal agency to which that power was originally granted .
The capital adequacy of subsidiary holding company banks having been first
determined , the question of the capital adequacy and capital mix of holding
companies should be subject to greater capital market discipline .


Reasons have been advanced supporting the view that the money and capital
markets , which ordinarily function so efficiently , are subject to serious
imperfections in market judgments about bank holding companies . It is
frequently alleged that the investing public has been unable to assess the
differences between holding companies and their lead banks and that this
inability causes investors to purchase the securities of a holding company
with the misguided view that the success and soundness of the lead bank and
that of the holding company are synonomous . Some of this confusion should
lessen in the future because the major rating services are beginning to
rate the long -term debt obligations of bank holding companies . There is
still a decided lack of information available to investors for use in evaluating
the riskiness of holding company operations and consequently the riskiness of
their debt and equity securities . If holding company managements do not
voluntarily publish the balance sheets and income statements for all their
subsidiaries , including banks, they should be required to do so by law . The
publication of such data and the publication by the FDIC of aggregate data for
banks affiliated with holding companies would not only increase the ability
of the market to make correct judgments but would also enable the academic and
business communities to conduct research that may aid regulators and legislators
in making their decisions .
It is also argued that shareholders and long-term creditors of bank
holding companies impose fewer constraints on their operations because
investors do not bear the full cost of failure of a banking institution .


Supposedly federal government insurance of deposits up to $40,000 per
account and the inconvenience to communities involved and the disruption of
public confidence in the banking system resulting from bank failures are
in fact social costs not met by individual investors . One proposal recently
advanced to shift some of the social costs of insuring against bank failures
back to banks and their shareholders is to vary the cost of FDIC deposit
insurance in response to changes in the riskiness of a bank's assets and its
liability mix , thereby forcing banks that desire to increase the riskiness of
their operations to pay proportionately more of the cost to society of assuming
those risks . Publication of such information would further aid sequrities
markets in determining costs for the firm's capital.¹
It is also alleged that market discipline is dulled because banking is a
regulated industry and federal regulators virtually guarantee the solvency
and liquidity of banks that encounter difficulty . Because the risk to investors
is thereby reduced , bank holding companies ' cost of capital is lower than the
level that adequately reflects the true risk of their operations . This argument
is no more valid than saying that for the same reasons the market is incapable
of accurately determining the risk- adjusted cost of funds for the public
utility industry . Investors in public utilities are just as confident that the
federal government would not allow a major public utility to fail bacause of
the disruptive effects on the nation's economy and the threat to " public
confidence" in the utility industry .

See Ronald D. Watson , " Insuring Some Progress in the Bank Capital Hassle , "
Federal Reserve Bank of Philadelphia Business Review , (July- August 1974 ) : 3-18 .


There is no foolproof method for the determination of capital adequacy
for commercial banks . However , the application of static methods of ratio
analysis to determine allowable limits of debt utilization and adequate levels
of total capital is inappropriate and may unnecessarily reduce the competitive
viability of banking firms without commensurate public benefit . Rather , a
preferred approach is the one used by the Comptroller's Office that views
banks as viable enterprises and emphasizes the importance of management
expertise and earnings performance . As of June 30 , 1974 , national banks
examined by the Comptroller constituted less than one-third of all commercial
banks , yet they controlled almost 60 percent of commercial bank assets and
deposits . Moreover , most of the nation's largest commercial banks , upon
whose success the viability of the banking system ultimately rests , are federally
chartered and thus subject to rational , soundly based methods of capital adequacy
determination .
Depositors of affiliated banks are not subjected to increased risk by the
substitution of debt for equity capital as long as the firm is managed well enough
to generate a satisfactory return on its assets and to keep operating expenses
at carefully controlled levels . Continuation of normal historical relationships
of income and expense that reflect honest , sound business investment and lending
decisions should be sufficient to eliminate concern , even if the level of debt
capital should become a much greater proportion of total capital than is presently
the case . Although equity ratios have declined in recent years , the use of debt


capital has not had a major impact on the level of total borrowings by bank
holding companies . It appears that longer-term debt capital has in many cases
been substituted for shorter borrowings in the form of deposits , federal funds
purchased, commercial paper , and other short forms of indebtedness .
Banks are essentially dealers in debt . The relationships created by
deposit acceptance are the same as those created by the issue of notes or
debentures . In both instances a liability is created; only the evidence of
obligation is different . In one case it is a credit on the bank's books; in the
other it is a written promise to pay . In the first case , the obligation is discharged
by paying the orders (checks ) of the firm's creditors , in the other by redeeming
formal debt instruments . These are differences of degree but not of kind .
For most banking firms , there has been a change in the liability mix over time
coupled with a decline in the equity base . But borrowed funds are borrowed
funds . Whether borrowing is evidenced by deposits , federal funds purchased ,
loans from other banks (including the central bank) , commercial paper , or
longer-term capital notes or debentures is really immaterial . Interest must
be paid on all such liabilities , except demand deposits; inability to make any
interest payments can result in technical insolvency . Federal Reserve spokesmen
would have us believe that debt in the capital accounts is in some sense different

Examination of the financial reports of a group of major banking
holding companies indicates that the use of debt capital has increased total
borrowing only marginally , for most firms from approximately 88-90 percent
of assets up to the 90-92 percent range . See Phyllis A. Pierson , Debt in
the Capital Structure of Bank Holding Companies , (unpublished doctoral
dissertation , Indiana University Graduate School of Business ) 1974 : pp .
163-207 .


from other bank debt , that interest on such debt must be paid " whether or
not the bank's condition justifies payment, " that such payments may fall due
at " inopportune" times , and so on . But the same possibilities are associated
will all bank debt , short term or long term .
The real problem of holding company management does not originate in
too little equity , too much debt , or too little long -term capital but rather in
earnings that are too low or expenses that are too high . If banks and bank
holding companies are to provide financial intermediation services in the most
efficient manner possible , they must not be prevented from achieving a preeminent position in the increasingly competitive financial services industry
by the imposition of strict and rigid rules regarding capital adequacy or capital
mix . Much greater attention should be paid to the ability of management to
manage both assets and liabilities . On the asset side , the ability to make
lending and investment decisions that minimize credit and market risk while
providing reasonable profit results is essential . Poor (or illegal ) loan and
investment decisions result in a doubtful asset portfolio with consequent
high security or loan losses that reduce the retention of earnings . One of the
first lessons learned in the study of finance is that it is impossible to
obtain cash from depreciation or from any equity capital accounts . Funds can
only be provided by incurring new liabilities or by liquidating assets . If a
firm's assets are either extremely illiquid or incapable of collection or liquidation ,
then no realistically conceivable amount of equity serves as adequate protection
to creditors . For a successfully operated holding company , debt capital provides


essentially the same " cushion " of safety for the bank's depositors as does
equity capital . Cost considerations aside , increases in either account provide
equally satisfactory sources of funds for firms that seldom , if ever , incur
absolute operating deficits .
Federal Reserve directives with the de facto effect of limiting debt capitalization
of bank holding companies force bankers to find alternative sources of borrowed
funds that are more volatile with respect to interest cost and schedule of
repayment . As the economy grows more complex , the tools that banks and bank
holding companies need to fulfill their roles as catalysts of economic resources
must likewise increase in complexity and variety . Regulatory authorities
have not demonstrated that supervisory constraints benefit the public interest
to any greater degree than would result if managers of financial institutions were
allowed more freedom to manage the asset and liability compositions and

maturity structures of their firms .
The supervision and regulation of banking institutions have been complicated
in recent years by allowing bank holding companies to engage in activites
closely related to banking . Allegedly in the interest of preventing bank
failure , restrictions on entry into banking have been routinely imposed since
banks were first chartered in this country . If a bank does fail , the question
usually asked is " who stole what? " On the other hand , there are very few
restrictions on entry or exit into mortgage banking or consumer finance
(except, of course , for bank holding companies ) . Closely related independent
nonbanking firms can and do fail in the ordinary course of business . Combining these types of activities in the same firm with banks adds a degree
of vulnerability to bank holding companies and increases the regulatory " burden"


of the Federal Reserve . The Board has thus become increasingly concerned
with the financial viability of bank holding companies . It appears that
Federal Reserve , in searching for a means of moving holding companies in
a direction that increases the probability of financial solvency ,
has chosen to use its general authority under the Bank Holding
Company Act to place increased emphasis on capital adequacy with limitations
on incurring debt . This authority provides a convenient lever for the Federal
Reserve , and the Board is presently exerting its considerable force to insure
that the industry develops in directions that it deems desirable . Therefore ,
it is highly improbable that the board will ever issue specific regulations on
capital adequacy or utilization of long -term debt by bank holding companies .
The current absence of formal regulation gives the Federal Reserve a potent
weapon that can be employed as often'and as long as the Board sees fit , with
virtually no effective resistance possible for either holding companies or other
federal bank supervisors and with no official public explanation required .
It is therefore incumbent upon holding company managers to develop capital
plans that can be explained and adequately justified to federal regulatory authorities
and to the investing public . The absence of detailed analysis of its operations
and supporting rationale for the firm's capital structure decisions leaves a bank
holding company open to criticism . Holding companies whose capital structures

There are two methods presently used to develop capital plans that
can be adequately justified . One is a variant of NCNB Corporation's " building
block" approach , in which each subsidiary's capital structure is determined
independently and judged relative to that of other firms in the same line of
commerce . The other is a total system approach that allows for capitalization
levels lower than the sum of the company's constituent parts when the consolidated
company generates more stable earnings as a consequence of positive diversification
benefits .


are arbitrary and whose judgments do not reflect proper consideration of the
underlying principles of corporate financial management have very little ground
to stand on when confronted with " arbitrary " Federal Reserve directives to
alter their capital structures . The banking community must accept the fact
that the Federal Reserve , because of its power to rule on all applications for
expanded activities by bank holding companies , can force its will on all
companies who approach the Federal Reserve for approval . The only way
for bank holding companies to avoid imposition of rigid , static methods of
analysis of capital adequacy by the Federal Reserve is to present viable ,
well substantiated alternative approaches to solution of the problem consistent
with the accepted theory of capitalization of the firm and with the financial
experience of holding companies in nonbanking activities . A helpful first
step would be the voluntary publication by all holding companies of the balance
sheets and income statements of their constituent subsidiaries .
Perhaps the debate over debt in the capital structure of bank holding
companies will in the future be resolved in much the same matter as the historical
question of what constitutes adequate reserves . Primary reserves were once
thought of as a source of bank liquidity , and considerable time and intellectual
effort were devoted to the determination of optimal reserve requirements .
Today it is recognized that the important function of reserve ratios is as a
fulcrum for the implementation of monetary policy . Although current discussion
regarding capital requirements presumably is grounded in concern for the safety
of bank deposits , historians may one day recognize that the Federal Reserve's
increasing emphasis on bank holding company capitalization was nothing more


than the means by which the central bank controlled the movement of bank
holding companies into closely related activites . The appropriate use of
long-term debt capital may one day become only one of the routine decisions
about liability management made by all the firms in the business .




Prepared for the Committee
on Banking , Housing and Urban
Affairs , U.S. Senate

John J. Pringle

January , 1975

Graduate School of Business Administration
University of North Carolina at Chapel Hill


January 1975


John J. Pringle*
Nearly all of the literature on bank capital views the issues from the
1 This paper
standpoint of the interests of depositors and the monetary system.
takes a different viewpoint , that of the interests of shareholders .

In a paper

prepared primarily for the Congress and the regulatory authorities , an analysis
of the capital issue from the standpoint of shareholders may seem misplaced .
However, commercial banks in the United States are private economic units , and
it can be presumed that shareholder interests have considerable influence in
bank decision-making . An analysis of the capital decision from the perspective
of shareholder interests may yield insights useful in improving regulation , or
alternately, insights into behavior that might be anticipated if regulation
• of capital were de-emphasized and shareholder interests became dominant.
The viewpoint of this analysis is normative , that is , the focus is on the
way in which bank managements should behave in carrying out their obligation to
optimize with respect to shareholder interests . Only very brief remarks are made
at certain points with respect to the way in which bank managements actually have
behaved with respect to capital.

As is traditional in microeconomics , it is

presumed here that optimizing with respect to shareholder interests is consistant
with efficient utilization of economic resources and hence with the interests of
society in general .
Implicit in much of the literature on bank capital adequacy is an
assumption that there exists a fundamental conflict between depositor interests

*Graduate School of Business Administration , University of North Carolina
at Chapel Hill
¹See, for example , [ 1 ] , [ 3 ] , [ 4 ] , and [ 5 ] .

52-221 O - 75-32



and shareholder interests with respect to capital . Depositors are presumed
always to want more capital and shareholders always less . The behavior of bank
capital ratios in recent years suggests that this opinion may be held not only
by bank regulators but by some bank managements as well . While the first
proposition , that more capital always is better for depositors , probably is true
up to a point , a major thesis of this analysis is that the second is not true ,
i.e. , that optimizing behavior with respect to shareholder interests does not
necessarily lead to low levels of capital .

It will be argued that the

"fundamental conflict " assumed to exist with respect to capital is much less
significant than generally believed , if it exists at all .
This analysis deals with the capital issue in banks , not bank holding
companies. The implications of the holding company form of organization , in
which a parent company typically acts as an intermediary between the bank and the
capital markets , are not considered .

Given the importance of the holding

company as an organizational form in banking , its implications for a variety of
regulatory issues deserve careful study . With respect to capital specifically,
the holding company complicates an already complex issue , and its implications
should be analyzed separately from the basic issues s