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March 25, 1977
Conservativp Ranking
Much has been said about the turn
of events that led the economy
swiftly through the phasesof expansion, inflation, and recession
from 1970 to 1975. fv\uch has also
been said about the cautious expansion since 1975-a period in
which corporations and individuals,
motivated by memories of the earlier
have opted for more conservative spending and investment
patterns. For example, industrial
corporations have been reluctant to
finance inventories and capital expenditures, while attempting to
build up liquid assetsand to restructure their debt and equity.
Such reactions have been spurred
largely by fears of recurring economic and financial calamities that
until the 1970swere generally
thought to be relics of the past.
For commercial bankers as for others, the 1970shave seen three distinct phases: the period of economic expansion and surging inflation
from the fourth quarter of 1970
through the second quarter of 1974,
the period of declining inventory
demand and sharp recession from
the third quarter of 1974 through
the first quarter of 1975, and the
subsequent (and still continuing)
period of expansion. The first and
third of these periods are especially
interesting, because they represent
a contrast between aggressive bank
expansion (the first phase) and conservative management (the more
recent period).
Aggressiveexpansion
The first of these periods was one of
unprecedented bank growth, as
banks found many opportunities
for lending at attractive rates. Total
commercial-bank credit (net loans
plus investments) increased at an
extraordinarily rapid average annual rate of 13.1 percent, outpacing
even the 10.2-percent growth rate
of nominal GNP. The boom in
consumer-durables spending and
residential construction brought
about a commensurate demand for
consumer credit and mortgages
early in the period. Businessdemand for short-term credit then
soared as plant-equipment and inventory investment gained increasing momentum.
In retrospect, it is difficult to understand why banks were so willing
during this period to incur such
heavy risks in lending and investing.
The answer lies largely in the difference between risk perceived before the fact and that actually observed after the fact. As late as mid1974, most economic forecasts simply missed the impending sharp
drop in economic activity. Forecasters generally expected only a
modest decline in the economy,
and since early 1973 they had expected a gradual subsiding of the
inflation rate. Thus, at the time that
these loans were made, their
apparent risk did not seem unduly
great in relation to their high yields.
Recession. . . and conservatism
The sharp economic decline from
late 1974to early 1975 can properly
be termed a "surprise"-although
after the fact we might find any
number of reasons why it should
not have been. The onslaught of
the most severe recession since the
Great 'Depression, the continuation
(continued on page 2)
necess;Hi\vreflect the vievvs of the
F(:clerzdI<e.S2r\'e i3arlk of Sari Francisco, ilor
of Co\'C"rnors
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Federal
Systern.
of substantialinflation, and the increasein actual and expected defaults shook the businesscommunity. Although expectationsof inflation risk had been rising throughout the early 1970s,the deep decline in output in late 1974brought
a heightened awarenessof substantial business-cyclerisk aswell.
In light of the 1974-75recession,
expectationsincreasinglyfocused
on the destabilizing effects of earlier external shocks (such as the oil
embargo, quadrupled oil prices,
and crop shortagesLinstability of
government policies (suchas" stopgo" monetary and fiscal policies,
price and wage controls, and sharp
devaluationsof the dollar), and
instability in patterns of economic
and financial activity. Risk suddenly
seemedmuch greater than it had
been for decades.
Under pressurefrom equity
holders-as evidenced by declining
bank-stock prices-and from the
regulatory authorities, banks soon
adopted a more conservativeposture toward growth and toward the
risksthey were willing to accept. As
a result, bank credit hasgrown only
modestly in the recent economic
expansion,rising at a 6.3-percent
annual rate between the first quarter of 1975and the final quarter of
1976(comparedwith nominal GNP
growth of 11.3percent).
Slow growth may be partly due to
slackdomestic-loan demand, as
2
of tIle
{)f
corporations have attempted to reduce short-term debt. But it is also
the result of bankers'efforts to
follow more conservativepolicies.
For much of this period, bankshave
maintained an especiallywide differential (spread)between their
prime business-loanrate and
their offering rate on large
certificatesof deposit. In addition,
much of their credit increasehas
been in purchasesof Treasurysecurities. Despite certain signsof increasedaggressiveness,
such as
greater foreign lending and an extended maturity structure of Treasury securities,their posture generally has been quite conservative.
Bankshave shown this new conservatism,for example, by reducing
reliance on purchasedfunds, by
rebuilding assetliquidity, by restructuring,loans,and by attempting
to market greater amounts of capital.
Aggregate bank ratios
How have bank portfolio ratios
been affected by the recent conservatism?According to FederalReserveflow-of-funds accounts,there
has been a clear reversalof established p,ost-WWIItrends. By the
end of 1976,U.S.Treasurysecurities
constituted 11.7percent of commercial bank assets-a sizable increasefrom the 6.9-percentfigure
of mid-1974.Yet despite that turnaround in the Treasurysecurity/
assetratio, the late-1976ratio failed
to approachthe 1960figure of 26
percent or the 1952figure of 38
percent, but insteadsimply represented a return to the level of early
1972.
The loan/asset ratio tells a similar
story. This ratio reached a post-war
peak of 65.2 percent in mid-1974
and since has declined to 61.5 percent, roughly in line with the level
maintained throughout most of the
1966-72period. In contrast, the ratio was 53 percent in 1960 and 38
percent in 1952.
The structure of liabilities also
shows a reversal in trend, with
banks conservatively reducing their
reliance on purchased funds. Measured as a percentage of assets,
purchased funds-large CDs, net
Federal funds, Eurodollar purchases,and loans sold to holding
companies-peaked in the third
quarter of 1974at 16.0 percent. (The
figure had been roughly zero prior
to 1961). By the end of 1976, banks
managed to reduce the ratio to 12.7
percent, about where it had been in
mid-1973. The ratio of capital to
assets,which had declined steadily
from 9.5 percent in 1961 to a low of
8.1 percent in mid-1974, then recovered strongly to 8.7 percent by
the end of 1976, approximately the
figure maintained from 1968
through 1971.
The future
What do these figures tell us? First,
the recent conservative direction of
banking has reversed established
postwar trends in the aggregate
bank balance sheet, restoring a situation that existed roughly at the
start of the expansion in the early
1970s.The shift has not taken the
bank sector back to the more conservative assetand liability structures of earlier postwar years. But
3
then, those structures may be largely outdated, partly because of the
higher level of FDIC insurance and
Federal Reserve efforts to prevent
or lessen the impact of bank failures.
Second, the new conservatism
could be reversed if bank-loan demand accelerates and banks become more bullish in an atmosphere of renewed economic
growth. Already there are rumblings that large banks are {{awash
with liquidity" and are nervously
awaiting (and making anticipatory
commitments for) a pickup in
domestic-loan demand. Conceivably, such a development could
lead, as in the early 1970s,to a
narrowed differential between
bank borrowing and lending rates,
rapid increases in purchased funds
and in loans, and declines In bank
capital ratios. Whether that will
actually happen will depend largely
upon supervisory pressures to
maintain capital ratios and upon
bankers' willingness to take risk,
which in turn will depend in part on
their forecasts of risks and returns.
Presumably, they will retain some
painful memories of
mid-1970s,
but it remaihs to be seen how much
attention they wi II pay to those
memories if the current economic
expansion continues without an
inflationary upheaval. The stage is
set for another bank boom, but
whether it will look like the 1970-74
boom will depend largely upon
bank policies.
Jack Beebe
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8 AN KI N G D ATA- TWIE1
UFTHflEDIERAILRIESER-VIE
lDBSTllUCT
amounts in
rYlllllrnnc\
Amount
Outstanding
Selected Assetsand liabilities
large Commercial Banks
3/09/77
Change
from
3/02177
Loans (gross, adjusted) and investments*
Loans (gross, adjusted)-total
Security 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*
States and political subdivisions
Savings deposits
Other time deposits:j:
Large negotiable CD's
93,269
71,388
1,506
23,321
22,040
12,392
8,985
12,896
92,694
26,726
266
64,255
5,495
31,337
25,446
8,829
+
+
616
372
11
+
57
+
51
+
5
+ 227
+
17
+ 731
+ 747
0
+ 136
166
+, 137
+ 129
+
64
Weekly Averages
of Daily figures
Week ended
3/09/77
Change from
year ago
Dollar
Percent
+
+
+
+ 5,541
+ 5,363
560
+ 393
+ 2,468
+ 1,611
+ 126
+
52
+ 4,898
+ 2,200
99
+ 2,782
- 913
+ 6,286
- 2,029
- 3,413
Week ended
3/02177
-I-I-
+
+
+
+
+
+
-
6.32
8.12
27.11
1.71
12.61
14.94
1.42
0.40
5.58
8.97
27.12
4.53
14.25
25.09
7.38
27.88
Comparable
year-ago period
Member Bank ReservePosition
ExcessReserves (+)/Deficiency
Borrowings
Net free(+)/Net borrowed H
H
+
+
83
1
82
+
140
+
302
+
108
+
68
9
2
11
+
+
9
0
9
federal funds- Seven large Banks
Interbank Federal fund transactions
purchases (+)/Net sales H
Transactions with U.S. security dealers
Net loans (+)/Net borrowings H
+ 1,352
+
547
*Includes items not shown separately. :j:lndividuals, partnerships and corporations.
Editorial comments may be addressedto the editor (William Burlce)or to the author. . • .
Information on this and other publications can be obtained by calling or writing the Public
Information Section, Federal Reserve Bank of San francisco, P.O. Box 7702, San francisco 94120.
Phone (415) 544-2184.
@FedFRASER