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September 27,1974

Bank capital has slipped appreciably
over the past five years, measured
in relationship to such common
yardsticks as risk assets, invested
assets, or total assets. The ratio of
equity capital to invested assets—
perhaps the most widely used
measure— dropped from .111 in
1969 to .094 in 1973, and a further
slippage (if slight) apparently oc­
curred in the first half of 1974. The
ratio is necessarily inexact, because
of the exclusion of hard-to-measure
foreign branch assets, but it gives a
broad measure of the declining
long-term trend.
For regulatory authorities, this de­
velopment has prompted increased
alertness to conditions in the
banking industry. For bank analysts,
recognizing the rapidly changing
complexion of the industry, this
shift has triggered an intensive re­
search effort in an attempt to deter­
mine the function and optimal
size of bank capital.
Some researchers have claimed, on
the basis of historical evidence, that
the decisive factor in bank failures
is not inadequate capital, but rather
the incompetence or defalcation of
management. But however useful
this finding may have been in past
periods, it does not appear to be
relevant to the present situation.
Some recent studies suggest
measuring the adequacy of capital
in relationship to the risk posture
of the individual bank, or alterna­
tively to the weighted sum of such
factors as asset quality, management
quality and debt ratios.

Too much fine-tuning?
Historically, bank capital ratios have
tended to decline over time, partly
because the greater stability in the
economy has reduced the margin of
uncertainty in banking, and partly
because the growth in management
expertise has permitted finer tuning
of bank operations. However, events
of the past year have caused regu­
latory authorities to question
whether fine-tuning has gone too
far, especially in the increasing trend
toward liability management.
Banks used to depend primarily on
low-powered deposit flows to
finance asset expansion, but now
with their increased profit con­
sciousness, they tend to rely more
on purchased money to make
profitable loans and investments.
(Large certificates of deposit are
included in this category, although
they are technically deposits.)
Leveraging of this type represents
a greater degree of risk, in the sense
that highly leveraged banks are
most vulnerable in any kind of
liquidity squeeze. The ratio of pur­
chased funds to invested assets
jumped from 22.5 percent in 1969
to 31.6 percent in 1973, and the
ratio definitely worsened further
in the first half of this year. (The
denominator of the ratio includes
"other" time deposits IPC, which is
composed mainly of large CDs, plus
net Federal funds purchased and
other liabilities for purchased funds.)
During the past year, some banks
have found themselves in a liquidity
squeeze because of a number of
(continued on page2)

Opinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federal Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.

worrisome factors— high borrowing
costs, heavy bank loan demands,
inappropriate maturity structures
of assets, and other difficulties asso­
ciated with borrowing short and
lending long. In a squeeze of this
type, which is accentuated by heavy
dependence on purchased money,
deposit flows decelerate because of
disintermediation while borrowing
costs soar because of high interest
rates. Moreover, with this liquidity
squeeze, bankers are forced to be­
come more selective in granting
loans. These factors do not neces­
sarily lead to capital impairment,
but impairment can result as dis­
intermediation forces banks to sell
long-term assets and incur capital
losses in the process.
Liquidity and capital
A recent study by First National City
Bank points out two functions of
bank capital: "First, to permit ac­
quisition of the institutional struc­
ture necessary to perform the inter­
mediation function and provide
related services, and second, to
provide protection against unantici­
pated adversity leading to loss in
excess of normal expectations."
This functional definition is correct
as far as it goes, but it doesn't go
very far, and could lead the layman
to think that capital is simply a stock
of money set aside by a bank for
these specific purposes. It overlooks
the need for banks to have an ade­
quate margin of capital left over


after covering unanticipated losses
— a margin adequate enough to
maintain public confidence in dis­
turbed financial markets.
Capital is listed on the liability side
of a bank's balance sheet, represent­
ing essentially the amount of long­
term money that has been invested
in the institution. Impairment of
capital can result from deposit out­
flows or from loan, security or
operating losses, any one of which
can force the bank to adjust its
assets to the new liability situation.
A high percentage of liquid to total
assets of course makes these adjust­
ments less painful.
Regulators' mandate
The mandate of the regulatory
authorities is to protect depositors'
interests, and above all to protect
the integrity and viability of the
financial system. Regulators gen­
erally carry out this mandate by
attempting to ensure bank solvency.
Capital is considered a yardstick of
the strength of the bank because it
represents a market evaluation of
the institution, placed upon it by
outside investors. The concern for
solvency, then, or viability, must
include consideration of a bank's
earnings flow along with its risk
The onset of the bank holdingcompany movement has added a
new dimension to discussions of
adequate capital. Authority to regu­
late the expansion of bank holding
companies has been vested in the

Federal Reserve Board of Governors.
Each acquisition, merger or de novo
expansion of a bank holding com­
pany requires prior application and
approval on the basis of its com­
petitive effects, its impact on the
strength of the underlying bank,
and its explicit gains in service to
the public. The holding company,
in fact, is supposed to be a source
of second-line strength to the bank.
The Federal Reserve has approved
many applications over the past
three years, and has thus helped
project banking into a more com­
petitive atmosphere. In its rulings,
however, the Fed has recognized
that this movement involves in­
creased risk. Consequently, it has
insisted that each bank's activities
be regarded as distinct from those
of the holding company. The prime
concern of the regulatory authorities
is properly the individual bank, and
vigilance over its activities has only
been heightened by the advent of
the holding-company movement.
Dynamic tension
Federal Reserve Governor Holland
recently placed the question of
capital adequacy in terms of "a
kind of dynamic tension between
the forces impelling the progressive
activities of banks and the com­
pelling need for prudent conduct
of the nation's banking business."
For example, when bank holding
companies expand and diversify,
they seek to enter bank-related
businesses partly to reach new
sources of earnings, by performing


various services for a fee as an offset
to the slow growth in traditional
earnings sources. In so doing,
holding companies have sometimes
moved too rapidly into the fairly
extensive list of activities now per­
missible to holding-company
subsidiaries, both domestically
and overseas.




Ventures of this sort can involve
managerial talents qualitatively
different from those likely to be
familiar to most bankers. Sometimes
the proposed activity may require
a sizable amount of capital most
readily obtained through heavy
upstreaming of bank dividends to
the parent holding company. The
activity thus may divert capital and
management talent away from the
banking subsidiary, where they
might have been used to shore up a
thin capital position or a shallow
layer of management.
Viewing the rapid expansion of
banking activities in both domestic
and foreign markets, Holland
argues, "Prudence would dictate
that such expansion be supported
by a strong capital base and an ade­
quate liquidity position." Bank
managers are now being forced to
make the hard choice between
continuing expansion into highly
profitable fields or slowing that
expansion to permit augmentation
of capital and to ensure appropriate
Joan Walsh

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(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks


Loans (gross) adjusted and investments*
Loans gross adjusted—
Securities loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other Securities
Deposits (less cash items)— total*
Demand deposits adjusted
U.S. Government deposits
Time deposits— total*
Other time I.P.C.
State and political subdivisions
(Large negotiable CD's)


Weekly Averages
of Daily Figures

Week ended


Change from
year ago


+ 7,887
+ 8,147
- 503
+ 3,579
+ 2,426
+ 702
+ 771
+ 6,326
+ 154
+ 5,649
+ 125
+ 5,336
- 213
+ 3,456

— 67
+ 154
— 88
— 26

+ 10.35
+ 13.88
+ 17.56
+ 13.93
+ 7.99
+ 6.35
+ 8.55
+ 0.71
— 9.87
+ 11.21
+ 0.71
+ 22.52
+ 27.97

Week ended

year-ago period
-1 0 7
-2 9 0

Member Bank Reserve Position
Excess Reserves
Net free ( + ) / Net borrowed ( - )




+ 1,309



+ 241




+ 905


Federal Funds— Seven Large Banks
Interbank Federal fund transactions
Net purchases ( + ) / Net sales ( - )
Transactions: U.S. securities dealers
Net loans ( + ) / Net borrowings ( —)


*lncludes items not shown separately.

Information on this and other publications can be obtained by calling or writing the
Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco, California 94120. Phone (415) 397-1137.