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Financial developments in the first half of 1974 did not follow the accepted script for a period of eco nomic slowdown. Hit by rampant inflation and record credit demand, financial markets behaved as if the nation were in the midst of a fullfledged boom. Money-market rates moved onto an escalator with no apparent terminus, and banks were caught in a maelstrom of seemingly unending business-loan demand. In some respects this was a repeat of the early 1973 experience, but many of the ingredients were quite different indeed. Much of the credit demand was either inflation-induced or else the result of shortages in supplies, energy and capital facilities. In long-term markets, investors held out for higher and higher yields as an end to the inflation spiral became more illusory, while pressures on short-term markets were even more intense. The monetary authorities maintained a restrictive stance be cause the first-half decline in real GNP was largely induced by special supply problems rather than by a deficiency in demand. Even so, the narrowly defined money supplv rose at more than a 7-percent annual rate, while bank credit ex panded at a 14-percent rate, in the West as elsewhere in the nation. Banks accommodated huge business demands for credit, including de mand diverted from the commercial paper and capital markets. But all time high asset holdings at record rates of return did not necessarily produce record earnings. Many banks saw their profit margins nar row as their own costs for funds rose in tandem with other money market rates and as the spread between their borrowing and lending rates narrowed. Those institutions which were heavily dependent on large CD's, Federal funds and other bor rowed funds became particularly vulnerable. In addition, net income declined at some banks because of capital losses on their security port folios and foreign-currency trans actions. With liquidity problems increasing, loan losses rose and potential problem situations multi plied. Overall, it was not an entirely happy period for banks. Business loans dominant Total loans increased by $35 billion in the first half of the year, with business loans accounting for over one-half of the total gain. Banks in the San Francisco District recorded a $6-billion increase, with the busi ness loan share coming to over onethird of that regional increase. (All data are seasonally adjusted.) Bor rowing by the business sector got off to a fast start in January, slowed in February and then spurted to more than a 40-percent annual growth rate in March and April. The torrid borrowing pace decelerated somewhat in the following months, luckily so because of the trouble the banks had obtaining funds. Higher operating costs, particularly for financing inventories, caused many business firms to draw heavily on their bank lines of credit. Some borrowing also reflected the effects of stockpiling in anticipation of further price increases. At the same (continued on page 2) Digitized for FR A SER 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. time, materials shortages caused escalating loan demand as firms be came unable to meet delivery schedules of finished products. Meanwhile, interim construction loans were stretched out as short ages prevented builders from completing projects. By the second quarter, banks began to get a spill-over from the capital markets, as costlier financing and investor selectivity made long-term offerings more difficult to arrange. This trend accelerated because of the unsettled conditions in the long term financial markets which fol lowed the Con Edison and the Franklin National situations and the failure of the Herstatt Bank in West Germany. In recent months, many national firms also drew upon their seldom-used lines of credit at regional banks. Bank loan demand surged further because of the narrowing differ ential which developed, especially in the period from late March through May, between the prime business-loan rate and the dealerplaced commercial-paper rate. The development of a two-tier paper market contributed to this shift, as many corporations and bank holding companies had trouble selling commercial paper. The prime rate was very volatile in the first half of 1974. In line with the abortive decline in money-market rates in late January and February, banks lowered their prime rate2 2 Digitized for FR A SER from 93A to 83A percent in four steps. Then, as price expectations worsened and money rates began their steep ascent, banks quickly reversed themselves and moved the prime up in 13 steps to a record 11% percent at mid-year. (The 12percent level was reached in early July.) Prime-rate increases appar ently failed to exert their usual rationing effect on bank credit demand, partly because they were associated with an unprecedented inflation rate which kept the "real" cost of borrowing low. Despite record rates, business demand for credit seemed insatiable. Costly search for funds Throughout the nation, banks en countered increasing difficulties in their search for funds to fuel the massive asset explosion. Private de mand deposits rose about $1 billion over year-end 1973. However, this gain was more than offset by a re duction in U.S. Government deposits, which remained at un usually low levels throughout most of the six-month period. Time deposits (other than large CD's) rose more than $16 billion, even more than in the comparable 1973 period, despite a second-quarter slowdown. Nonetheless, the bulk of deposit funds came from large-denomina tion CD's, which increased by $21 billion in the January-June period to an $85-billion total. Western banks contributed disproportion ately, accounting for about one-fifth of the total increase. Rates for CD's moved in step with other money- market rates, dipping below 8 per cent in February and rising to a record 12 percent at the end of June. Despite this cost upsurge, some major Western banks maintained an overall cost advantage on time de posits by continuing to pay a belowceiling rate of 4.5 percent on pass book savings, which represent a large segment of their total time deposits. Meanwhile, banks in creased non-deposit sources of funds, with sharp gains in capital issues and bank-related com mercial paper, the latter reaching the highest level since August 1970. As reserve pressures increased, bor rowing at the Federal Reserve Banks also rose, reaching a record level of $3.6 billion in late May when accommodation of Franklin National Bank added to an already heavy demand. In the San Francisco Dis trict, a somewhat different borrow ing pattern prevailed— relatively heavy but not exceeding some of the 1973 highs. The cost of bor rowing at the discount window increased in late April, with an 0.5percent hike in the rate to a record 8.0 percent. But the heaviest bor rowing was in the form of Federal funds, unused member-bank bal ances on deposit with Federal Re serve Banks. With rising reserve pressures, the cost of these funds rose from a low of 9.0 percent in February to 11.9 percent in June and 13.6 percent in early July. Troubled outlook Unease prevailed in money and credit markets as the third quarter began, highlighted by the unsettled3 3 Digitized for FR A SER conditions in the capital, commer cial paper and acceptance markets which followed the Con Edison, Franklin National and Herstatt Bank situations. With the develop ment of two-tier financial markets, some borrowers have been paying premium rates and some have had serious trouble finding accommoda tion. As a result, borrowers from other markets are turning increas ingly to banks to meet their credit needs. These demands have con verged upon banks at a time when financing requests were already high, and when the "bite" of mone tary policy was already becoming uncomfortable. C = 3 Since the demise of price controls in late April, banks have made up ward adjustments in mortgage, con sumer and small-business loan rates, which for two years had been kept artificially low in relation to other rates. As time goes on, these ad justments should impact favorably on net operating income, and should also help banks in control ling their loan demand. In addition to higher costs for funds, banks are faced with increas ing delinquencies on consumer and mortgage loans, and also with grow ing liquidity problems of some major customers. A return to more stable capital and money-market conditions will relieve current pres sures, but banks nonetheless will have to emphasize loan monitoring and improved liability management during the remainder of the year. Ruth Wilson o c=3 u c n S i n q s e M • i J E i n • u o S a - i o • E p E A 8 N • o i| E p | H BA A BH • E jU J O p | E 3 • B U O Z U V • E > jSB | V BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 7/3/74 Change from 6/26/74 Change from year ago Dollar Percent - + 8,914 + 8,590 7 + 3,163 + 2,851 + 814 - 860 + 1,184 + 7,001 + 720 + 231 + 5,889 - 284 + 6,414 - 407 + 4,284 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* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) 83,509 65,456 1,246 23,349 19,529 9,369 4,976 13,077 78,842 21,669 1,237 54,313 17,991 27,081 6,385 13,920 Weekly Averages of Daily Figures Week ended 7/3/74 Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed (—) Federal Funds— Seven Large Banks Interbank Federal funds transactions Net purchases (+ ) / Net sales (—) Transactions: U.S. securities dealers Net loans (+ ) / Net borrowings ( - ) — + + + - + — — + + — — — 75 74 41 22 75 21 98 97 218 83 200 525 72 363 273 269 Week ended 6/26/74 Comparable year-ago period 6 141 147 146 174 - 28 + 1,428 + 1,163 + 563 + - -2 7 8 - 50 247 197 172 - + 11.95 + 15.11 — 0.56 + 15.67 + 17.09 + 9.51 14.74 + 9.96 + 9.75 + 3.44 + 22.96 + 12.16 1.55 + 31.03 — 5.99 + 44.46 - 167 ‘ Includes 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. Digitized for FR A SER
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