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January 18, 1980

TurbulentBut Profitable
Banking and financial markets were buffeted
in 1979 by i'nflation, recession fears,
increased international tensions, and then by
the Federal Reserve's decisive monetarypolicy actions of October 6. Funds generally
remained available to meet 1979 credit
demands, but interest rates were very high
and very volati Ie. Yet the nation's commercial
banks posted record profits during the year,
attesting to their ability to adjust to rapid
economic and financial changes. Those
profits reflected a robust 11 Y2-percent
expansion in bank credit, as well as a rate of
return on assets high enough to maintain a
favorable spread over banks' increasingly
costly funds.

environment. With the fourth-quarter
deceleration, the annual growth of the
narrow M 1 money supply (currency plus
bank demand deposits) fell within the 3- to
6-percent target growth range which the Fed
had announced earlier in the year. (This
figure adjusts for the impact on demanddeposit growth of automatic transfer-fromsavings accounts.) Again, with the late-year
deceleration, the growth of the broader M2
measure (currency plus a" bank deposits
except large negotiable CD's) came in only
slightly above the upper end ofthe 5- to
8-percent target range after having been
considerably higher earlier in the year.

Financialmarketsgrow

Policytightens
Faced with an acceleration of inflation at
home and abroad, the Federal Reserve
moved forcibly on October 6 to achieve
better control over money and credit
expansion. Earlier restrictive actionsincluding several boosts in the discount rate
(from 9Y2to 11 percent)-had failed to stem
the rapid growth of the money supply and of
the inflation indexes. Thus the Fed unveiled
its "Saturday night special" of October 6:
1) increasing the discount rate on memberbank borrowings a full percentage point, to a
record 12 percent; 2) imposing an 8-percent
reserve requirement on increases in the
aggregate total of certain "managed
liabilities," such as large time certificates
(CD's) and Eurodo"ar borrowings, and
3) making a fundamental change in the
System's monetary-control procedures to
focus on bank reserves, rather than on the
Federal-funds rate which governs interbank
borrowings.
These actions helped produce a significantly
slower growth in the money supply and bank
credit in the fourth quarter-and also a
greater volatility in money-market rates
before market participants accustomed
themselves to a new and unfamiliar operating

Net funds raised in 1979's financial markets
roughly matched the 1978 total, according to
preliminary estimates, as private-sector
borrowing offset a decline in debt financing
by the public sector. Although Treasury debt
increased only half as fast as in 1978, foreign
holders liquidated substantial amounts of _
government securities, forcing the Treasury to
rely more heavily on domestic purchasers to
finance its debt offerings. State-and-Iocal
governments showed modest increases in
borrowing and spending. In contrast,
Federally sponsored agencies boosted their
debt by record amounts, primarily in order to
provide support for the hard-pressed
mortgage-finance industry. In the private
sector, corporate long-term debt expanded at
about the 1978 pace, but corporate shortterm debt rose as firms increased their
reliance on bank credit and doubled their
sales of open-market paper.
Although funds remained available, they also
became more costly. Short-term rates were
three percentage points higher atthe end than
atthe beginning of the year, under the impact
of accelerating inflation, energy shocks, and
a tighter Federal Reserve pol icy. Rate
movements also became very volatile after
October 6. Money-market rates began

Opinion(; e'qJressed in this
do not
nc'cessarilv reflect the vievvs of the management
of (he
ReservE: Bank of San Francisco,
nor ()f the Board of Covernors 01 the Federal
Re:·,erve

SYstem.

climbing at midyear as business activity
quickened, then shot upward after the
October 6 policy package, and finally eased
in November'and December as the markets
learned how to operate in the new policy
environment. October's record rates on large
CD's, Federal funds and commercial paper
prompted banks to hike their prime businessloan rate to a record 1 5% percent, but they
later reduced that rate to 15 percent as thei r
cost of funds began to decline. In contrast,
Treasury-bill rates lagged considerably
behind other money-market rates.

In contrast to this uneven business-borrowing
behavior, bank mortgage lending continued
strong throughout 1979. (However, the
$32-billion increase lagged behind the
phenomenal 1 977 -78 pace.) Thesteep lateyear rise in mortgage rates could be expected
to dampen activity in this area, but it came
too late to affect 1 979 data because of the
long time-lag between mortgage
commitments and actual loan take-downs.
The major shift in loan demand last year
came from the household sector. Consumer
borrowing remained strong until about
midyear. Then the pace slackened
significantly asconsumers, as well as lenders,
became more cautious in response to rising
consumer-debt ratios, and as declining real
income and recession fears brought adecline
in consumers' large-ticket purchases.

Long-term corporate bond rates rose
modestly in the first half, accelerated during
the summer as inflation expectations
worsened, and then rose even faster in the fall
as fears surfaced about declining credit
availability. Throughout the year, the yield
curve retained an "inverted
shape, with higher yields on short- and
intermediate-term maturities than on longterm issues, as is typical of inflation periods.
Prime mortgage rates rose steadily over most
of the year, except in states with restrictive
usury laws; after October 6 they rose as high
" as 14 percent in some areas, exerting a
dampening impact on housing activity.

MMC'sdominantrole
To finance this credit expansion, banks relied
heavi lyon certai n types of ti me deposits and
on non-deposit sources of funds. Demand
deposits made only a relatively weak
contribution.
Money-market certificates (M MC's), with
their rates tied to the 6-month Treasury-bill
rate, were the most noteworthy source of
funds.
quadrupled in volume during
the year, offsetting an outflow in fixed-ceiling
savings deposits. Moreover, as banks shifted
into these new market-rate consumer
instruments, they relied considerably less '0
than usual on the normal deposit
"stabilizing" function of large-denomination
time certificates (CD's). In fact, CD issuance
remained practically unchanged in 1 979unlike 1 978 and other recent periods of high
interest rates-because banks could obtain
funds more cheaply through money-market
certificates and through non-deposit sources
such as Eurodollars.

Bank credit expands
Commercial-bank credit expanded by
$117 billion in 1 979-a substantial
11 Y2percent gain, although somewhat behind
the 1978 pace. Loans accounted for
84 percent of the total gai n -down from the
preceding year's 90-percentshare-as banks
built up their liquidity by adding to their
holdings of Federal agency and tax-exempt
securities while maintaining their Treasury
securities atthe 1 978 level. Business demand
for bank credit rose over $40 billion, an
accelerated 17 -percent rate, reflecting strong
corporate needs for working capital and for
increasingly expensive inventories.
However, this strength was concentrated in
the first and third quarters of the year. The
pace of business borrowing at major moneycenter banks, particularly in New York, far
exceeded that at small banks during most of
the year, but was' relatively weaker in the
fourth quarter.

Risingbankearnings
Bank income apparently reached a new peak
in 1 979, according to preliminary estimates
for the year. Operating earnings increased as
banks expanded their volume of earning
assets and simultaneously benefited from
2

BANK CREDIT - Four Years of Expansion
% Change

20

'; 7J_ll_LiI_
m"

15
10

-5

I

.
Real
Busmess Estate Consumer

Other
U.S.
Treasury

Loans &
__
---.J Investments
Investments
Source: Federal Reserve Board of Governors

business-loan expansion could remain fairly
strong as corporations continue to rely on
short-term financing instead of costly longerterm funding in the capital markets. Any
invol! Jntary inventory accumulation, as the
economy slows, also would call for increased
bank borrowings-at least in the short-term.
On the other hand, many large and some
middle-market corporations will continue to
use the commercial-paper market as a less
costly alternative to bank financing.

saari ng rates of retu rn on those assets- for
example, the prime business-loan rate rose
from a midyear level of 11112ercentto a fall
p
peak of 1 5% percent.
Money-center banks in particular benefited
from the large expansion in business loans at
rates tied to the higher prime rate. Regional
banks meanwhile profited from portfolios
heavily weighted with high-interest-rate
mortgage and consumer loans, even though
rates on such loans did not rise as fast as the
business prime. These developments helped
banks to maintain a favorable spread
between their return on assetsand their cost
of funds. Income statements at many banks
also improved because of reductions in the
amounts set aside for loan-loss reserves,
reflecting their more favorable experience
with loan write-offs and write-downs.

In contrast, a reduction in mortgage lending
appears assured for the early months of the
year, reflecting the recent high mortgage rates
which "rationed out" many potential firsttime home owners. Moreover, reduced home
construction has already become evident
because of restricted credit availability.
Again, in view of current economic
uncertainties,' consLirriers will probably
continue to restrict their purchases of largeticket goods and remain cautious about
expanding bank-held debt.

However, the cost of bank funds also rose
steeply as the year progressed, especially in
view of a shift from less costly sources of
funds (those subject to fixed deposit-rate
ceilings) to more expensive sources acquired
at accelerating market rates. Money-market
certificates largely replaced the outflow of
less-expensive savings deposits, and their
cost climbed as Treasury-bill rates rose. Even
the "core" savings deposits became more
expensive after midyear when the
Regulation Q ceiling rate rose from 5 to
5% percent. Costs on other liabilities-large
CD's, Eurodollars, Federal funds and
borrowings from the Fed-all rose to record
highs in the fourth quarter. In addition, after
October 6 those banks whose "managed
liabilities" exceeded their aggregate
September base became subject to an
8-percent marginal reserve requirement. But
overall, the 1 979 profits picture reflected
banks' successful weathering of last year's
highly volatile interest-rate environment.

The new 8-percent marginal reserve
requirement on managed liabilities should
increasingly be written into the cost of credit
expansion, because banks will find it more
difficult over time to stay within their
September base for such liabilities.
Meanwhile, a shift in banks' liability structure
from managed "purchased" liabilities
toward consumer-oriented market-rate
instruments should continue, reflecting the
popularity of M M C's and the new
authorization in January for 2Y2-year (and
longer) certificates tied to yields on Treasury
issues of like maturity.
The heavy weighting of bank portfolios by the
high-yielding earning assetsacquired last
year should help banks maintain a favorable
interest spread over thei r average cost of
funds, particularly if short-term rates ease
somewhat. At the same time, earnings in
coming months could be hurt by a slower rate
of loan expansion, and possibly by increased
loan losses. Under any scenario, banks may
have difficulty adjusting to 1980's financialmarket uncertainties.
h -I

Cloudedoutlook
Both domestic and international
uncertainties cloud the 1 980 outlook. The
full impact of the late-fall monetary-policy
moves will become more evident after the
normal early-year paydowns of high seasonal
December borrowings. However, the

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's'n

BANKING DATA-TWELFTHfEDERAL
RESERVE
DISTRICT
(Dollaramounts millions)
in
Selected
Assets Liabilities
and
Large
Commercial
Banks

Amount
Outstanding

Change
from

1/2/80

12/26/79

Change
from
yearago@
Dollar
Percent

- 393
137,846
Loans
(gross,
adjusted) investments*
and
+ 16,899 + 14.00
- 218
Loans
(gross,
adjusted) total#
115,111
+ 16.40
+ 16,218
32,529
Commercial industrial
and
98
+
+ 15.70
+ 4,404
43,5,16
Real
estate
+ 243
+ 8,597
+ 24.60
Loans individuals
to
24,619
+ 4,602
+ 23.60
+ 137
1,549
74
353
- 18.60
Securities
loans
7,189
U.s.Treasury
securities*
90
566
7.30
15,546
29
Othersecurities*
+ 1,303
+ 9.10
Demand
deposits total#
50,387
+4,091
+ 2,348
+ 4.90
Demand
deposits adjusted
35,775
+1,912
+ 10.10
+ 3,270
Savings
deposits total
28,839
1,602
5.30
+ 331
58,341
647
TimedePosits total#
+ 7,084
+ 13.80
Individuals, & corp.
part.
49,617
548
+ 7,999
+ 19.20
- 173
(Large
negotiable
CD's)
21,668
+ 1,507
+ 7.50
Weekly
Averages
Weekended
Weekended
Comparable
of Daily Figures
year-ago
period
1/2/80
12/26/79
MemberBankReserve
Position
Excess
Reserves )/Deficiency-)
(+
(
11
29
47
Borrowings
177
64
220
- 173
Netfreereserves )/Netborrowed )
(+
(188
35
Federal
Funds Seven
Large
Banks
Netinterbank
transactions
+ 1,784
+ 619
+ 694
[Purchases )/Sales
(+
(-)]
-1,201
21
Net,U.s.Securities
dealer
transactions
+ 369
[Loans )/Borrowings
(+
(-)]
* Excludes
tradingaccount
securities.
# Includes
itemsnotshownseparately.
@ Historical
dataarenot strictlycomparable to changes the reporting
due
in
panel;however,
adjustments
havebeenappliedto 1978datato remove muchaspossible effects thechanges coverage.
as
the
of
in
In
addition,for someitems,
historical
dataarenot available to definitional
due
changes.
Editorial
comments be addressed theeditor(WilliamBurke) to the author•... Free
may
to
or
copies
of
thisandother Federal
Reserve
publications be obtained callingor writingthe PublicInformation
can
by
Se(iion, FederalReserve
Bankof SanFrancisco,
P.O. Box7702,SanFrancisco
94120.Phone
(415).
544-2184.