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cd\, ltD, k! ; \ '1--\\ Jlil L!, 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 Rut WI son 3 SS",! :> 1.Sl:11::1 UOl8u!ljseM. ljeln • uo8aJO• epei\aN • oljepi !!eMeH • e! UJoj!! E:) • euozpv • p>jserV JJ 'lUeJ 'O:lspueJjues lSL 'ON 11 WHld GI Vd 1 9V1 S0d ll VW SSV1J 1S1I1:I '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.