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July 25, 1980
Rol ler Coaster
The nation's bankers, like everyone else,
have had to contend this year with an unparalleled range of experiences, from speculative boom to steep recession. During the first
quarter, they suffered through a soaring inflation and an unprecedented rise in interest
rates. During the second quarter, in striking
contrast, they experienced a steep decline in
interest rates, along with a massive weakening in other economic indicators.
Still, banks generally adapted well to this
roller-coaster environment. During the first
quarter, banks found the funds to meet overheated credit demands by purchasing nondeposit funds (such as Federal funds,
Eurodollars, and securities sold under repurchase agreements), and also by issuing
large amounts of time certificates (especially
six-month money-market certificates and
large negotiable CD's). Banks incurred high
costs, however, by acquiring these funds at
such record interest rates, and their earnings
situation consequently deteriorated. But
then, as the second quarter progressed, they
were able to run off some of these high-cost
liabilities because of declining credit
demands and a growing inflow of low-cost
demand- and savings-deposit funds. As a
result, earnings recovered for many banks as
the spring months progressed.
This volatility of earnings illustrates banks'
sensitivity to changes in the level of interest
rates. Traditionally, banks borrow short-term
funds and relend them for somewhat longer
periods. However, in so doing, banks assume
a risk of loss from rising interest rates because,
as liabilities mature, they must be replaced
with increasingly expensive liabilities. In
recent years, with the growing volatility of
interest rates, banks have tried to match the
maturities of their assetsand liabilities, but
frequently with imperfect results. As the first
half of 1 980 demonstrated, the mismatch
hurts earnings when rates rise, but helps earnings when rates fall. In a stable rate environ-
ment, then, bank earnings benefit from lower
interest-rate risk and are consequently less
volatile.
Managing the credit boom
Bank credit expanded rapidly at the outset of
the year, with total loans and investments
growing at a 15-percent annual rate in January and February. Borrowers tu rned i ncreasingly to banks to meet inflation-bloated credit
demands, which were aggravated by a widespread fear that inflation would not be
brought under control without severe liquidity crunch. Bank-credit demands also
grew because of borrowers' inability to
obtain funds from the temporarily moribund
bond market.
a
This credit expansion was costly to banks,
because of the sluggish growth of core"
deposits (demand and savings deposits),
which forced them to. rely heavi lyon h ighcost purchased funds. Relatively strong
demand-deposit growth during the ea.rly pari
of the year was virtually cancelled by a huge
outflow of savings deposits. Disintermediation from savings deposits had been a
problem since late 1978, as investors began
to switch funds to investments offering higher
rates of return. Most of these funds, however,
still remained in the banking system. Many
depositors moved their funds into moneymarket certificates (M MC's), and many others
shifted into money-market mutual funds,
which then invested much of their funds in
bank CD's. (CD's comprise roughly half of all
money-fund assets.)But the competition for
these and other interest-sensitive funds drove
interest rates upward, increasing banks' overall cost offunds.
1/
Interest-rate spreads generally narrowed in
the early months of the year, as this sharp rise
in costs outpaced the rise in yields on bank
assets.Most banks carried a substantial portion oftheir assetsin fixed-rate consumer and
real-estate loans, which had been placed on
unable or unwilling to borrow long-term
funds during the period of soaring interest
rates rushed to the bond market throughout
the spring months, setting new records for
new corporate issues. In many cases, they
used the proceeds from these issues to repay
high-cost short-term bank loans.
the books at a time when much lower interest
rates prevailed. Also, banks were reluctant to
raise the prime rate (and associated rates) as
rapidly as market rates rose, partly to retain
good corporate customers, and partly to
maintain competitive positions against
foreign-bank and commercial-paper lenders.
Applying the brakes
Period of repositioning
The Federal Reserve's tightening efforts in
February helped bring about a sharp contraction in money-supply growth, and growing competition for funds -along with the
Fed's March 14 credit-restraint program
further increased banks' cost of funds and
dramatically reduced their lending pace.
(The program limited banks' loan growth to a
6-to-9 percent annual rate, established 15percent reserve requirements on increases
in consumer credit and money-market fund
assets, and raised the marginal reserve requirement on large CD's and certain other
"managed liabilities" from 8to 10 percent.)
In this situation, banks found it necessary to
raise lending rates and cut back lending programs. Still, many banks experienced a continued narrowing of interest margins, and
since they could not offset low margins with
high lending volume, their earnings continued to suffer.
Throughout the second quarter, rllany banks
widened the spread between the average
yield on their loan portfolios and their marginal cost of funds, in an attempt to repair the
earlier damage to their interest margins and
earnings. By maintaining high loan rates, they
lost lending opportunities to the bond and
commercial-paper markets. However, they
also gained time to restructure their liabilities.
By altowing credit to contract, banks were
able to replace some of their maturing liabilities (acquired when rates were high) with
much lower-cost funds, thereby improving
earnings.
This restructuring process became particularly evident in June. Demand deposits,
which had been declining earlier in thequarter, increased substantially in June as the Fed
supplied more reserves to the banking system
in an attempt to bring money growth back on
target. In addition, households switched
funds to passbook savings as rates on alternative investments (especially MM C's)
declined and investors sought increased Iiqu idity. But despite the expansion of core
deposits, banks did not put much effort into
expanding credit. Instead, they used the inflow of core deposits to replace high-cost
I iabi I ities, such as large CD's, that matured in
June.
In March, a deteriorating economy served to
reduce overall credit demands, as did also the
credit-restraint program,which led consumers to repay outstanding debt. Indeed, by
June, each of the major loan categoriesbusiness, mortgage, and consumer-was actually declining (see chart). The competition
for lendable funds consequently slackened,
despite further outflows of core deposits, and
interest rates tumbled at a rate that astounded
veteran observers.
Interbank comparisons
Wholesale (commercially oriented) banks
experienced a more noticeable earnings improvement than retail (consumer oriented)
banks between the first and second quarters.
The liabilities of wholesale banks are heavily
concentrated in short-term, interest-sensitive
funds -such as 30- to 90-day CD's and overnight funds -and so they suffered the sharp-
The second-quarter decline in lending activity was most obvious in the business-loan
category, where outstandings declined at an
8.3-percent annual rate as a reflection of the
recession-caused drop in loan demandand also as a reflection of the recovery in the
bond market. Corporations that had been
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est increase in cost of funds. However, they
were able to prevent severe margin deterioration by raising rates on their large portfolios
of floating-rate loans. During the second
quarter, wholesale banks, with their short
average-maturity structure, were the first to
benefit from the rapid decl i ne in interest rates.
As rates'began to fall, they moved quickly,
replacing liabilities acquired when rates were
high with dramatically lower-cost liabilities.
Meanwhile, by lowering their prime rate at a
relatively slow pace, they were able to
achieve wider-than-average interest margins.
fall. On the other hand, their interest margins
have already improved somewhat because of
a second-quarter inflow of low-cost core
deposits.
outlook?
The nation's banks are not likely to repeat
their profits performance of 1978 or 1979, but
many could still post relatively strong earnings during the remainder of this year. Bank
credit may expand somewhat because of the
phase-out of the credit-restraint program, but
much of th is effect wi II be dissipated because
of the conti nued weakness of econom ic activity. By the same token, slow credit growth
will reduce competition for lendable funds
and help stabilize rates on purchased funds at
relatively low levels.
Retail banks, withtheir substantial coredeposit base, did not experience the extremely rapid rise in average cost of funds
experienced by wholesale banks during the
first quarter. However, retail banks' margins
sti II deteriorated because, in the face of the
sharp rise in M M C rates, their large portfolios
of fixed-rate assets prevented them from raising average yields rapidly. Retail banks also
recorded a less dramatic improvement during
the rate decline of the second quarter, because their liabilities are concentrated in 6month M M C's and relatively long-term time
deposits. This spring's rapid decline in rates
will not cause a substantial reduction in their
cost of funds until after the high-cost certificates purchased last winter finally mature this
Change(%)
In that stable rate environment, banks with
relatively high-cost liabilities still on the
books shou Id be able to ru n off those I iabi 1ities and improve their interest margins. (The
removal of the special reserve requirement
on managed liabilities also will help reduce
their effective cost of funds.) Overall, earnings should benefit from a relatively stable
rate environment and from a wider spread
between what banks earn and what they pay
forfunds.
Barbara Bennett
Annual Change in
Outstan din g Loans
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10
-1 0
3
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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsand Liabilities
LargeCommercialBanks
Loans (gross, adjusted) and investments'"
Loans (gross, adjusted) - total#
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U. S. Treasury securities*
Other securities'"
Demand deposits - total#
Demand deposits - ad justed
Savings deposits - total
Time deposits - total#
Individuals, part. & corp.
(Large negotiable CD's)
WeeldyAverages
of Daily Figures
Member BankReservePosition
Excess Reserves ( +)/Deficiency ( - )
Borrowings
Net free reserves ( + )/Net borrowed( - )
Amount
Outstanding
7/9/80
136,640
115,104
33,310
46,555
23,603
1,001
6,276
15,260
44,564
32,139
28,576
61,615
53,247
22,003
Weekended
7/9/80
10
2
8
Change
from
Change from
year ago
Dollar
Percent
7/2/80
-
186
274
319
44
76
48
20
68
221
1,184
368
- 951
- 791
580
-
-
Weekended
7/2/80
35
11
46
7,573
8,546
1,865
7,748
1,188
674
1,358
385
299
75
2,074
11,473
11,662
4,555
5.9
8.0
5.9
20.0
5.3
.- 40.2
- 1'7.8
2.6
0.7
0.2
6.8
22.9
28.0
26.1
Comparable
year-ago period
4
281
285
'" Excludes trading account securities.
# Includes items not shown separately.
Editorialcommentsmay be addressed
to theeditor (William Burl(e)or to the author.... Freecopiesof this
andother FederalReservepublicationscanbeobtainedby callingor writing the PublicInfonnationSection,
FederalReserveBankof SanFrancisco,P,O.Box7702,SanFrancisco94120.Phone(415)544-2184.
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