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December 3,1976 The Yellow Brick Road To some observers, Congress' ef forts toward a legislative restructur ing of the nation's depository insti tutions evoked memories of the difficulties faced by Dorothy and her varied companions in following the Yellow Brick Road to Oz. There were, for example, the perils of the dark forest—perils largely unseen, but the more to be feared because of this. Then too, there was the constant threat of danger from the Wicked Witch of the East, who wanted to augment her already formidable powers by acquiring the magic shoes which alone protected Dorothy from harm. The characters in the Frank Baum stories and the Broadway musicals based on them quickly learned that cooperation was essential to the attainment of their objective. In contrast, this year's travellers soon parted company, variously accusing one another of lacking courage, heart, and even brains, of deliber ately setting up straw men, and of not having any real interest in actu ally reaching the Emerald City— in this case a more viable and compet itive financial structure. Off to see the Wiz As the year commenced, the pros pects for reform appeared fairly good. In December the Senate had passed the Financial Institutions Act—a somewhat distant descend ant of the Hunt Commission report of 1971. On the House side, legisla tive proposals evolved out of the late-1975 FINE study (Financial Insti tutions and the Nation's Economy). The FINE study incorporated a set of tentative “Principles" which, in the view of some observers, had a stronger pro-competitive thrust than the Senate's bill. The FINE Principles included the Senate's proposals regarding uni form tax treatment, the payment of interest on demand deposits, con sumer lending, and the extension of third-party payment powers to all depository institutions. But in addition, the Principles called for reduced restrictions on branching and the definite termination of Regulation Q interest-rate ceilings after five years. In the interests of both equity and the effective im plementation of monetary policy, the FINE study also advocated the imposition of Federal Reserve re serve requirements on the deposit liabilities of all federally insured depository institutions. Forks in the road In response to the clamor of the prospective travellers, the design of the Yellow Brick Road began to change almost immediately. The first mark-up of a House bill (The Financial Reform Act of 1976) wit nessed the elimination of a number of the key Principles. Some changes were made at the insistence of builders and the building trades, who opposed a substantial diversifi cation of thrift institution powers because they feared a possible re duction in the flow of funds to housing. As a result, the removal of (continued on page 2) 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, interest-rate ceilings was again con ditional on circumstances existing at the end of 51 years. The thrifts /2 also have insisted that even with broadened lending and deposit powers, they still need to offer a 14percent differential over the banks' ceiling to be able to compete for savings, and thereby to maintain an adequate flow of funds to housing. For their part, commercial banks were unhappy at the prospect of groundrules that would confer many of their traditional powers upon their competitors while al lowing the latter the continued protection of an interest-rate differ ential. In addition, many banks (small banks in particular) became worried about one specific proposal—the payment of interest on demand deposits. They felt that, on balance, this proposal would raise the average cost of bank funds significantly, with an attendant in crease in costs to bank customers, while lowering the average cost of funds to the thrifts. (According to the American Bankers Association, a 2-percent interest rate on demand deposits—assuming no change in service charges—would mean a 23percent decline in earnings, which could only be offset by a 1.2percentage point increase in either loan rates or service charges, or by some combination of the two.) Yet significantly, major S&L groups, ear ly in the year, reversed their tradi tional stance in favor of checkingaccount powers. They did this part ly to strengthen their argument for retaining their 14-percent differen tial on savings, but also in the belief that potentially expensive accounts were not needed so long as they had the prospective power to offer NOW accounts at a lower average cost than present savings accounts. The equity thrust of the original FINE Principles was weakened by a revision which would permit thrifts to offer third-party payment serv ices of any type (checking accounts, NOWS, etc.) where permitted by state law. Also, the Principles’ po tential for strengthening monetary control was weakened by a revision which would exempt institutions with less than $15 million in thirdparty accounts from System reserve requirements. When the bill finally was sent back to committee, it looked like such Ozian characters as the Shaggy Man and the Patch work Girl. Nevertheless, Chairman Reuss of the House Banking and Currency Committee has made it clear that the reform proposals “are not dead,” and that the new Con gress will be focusing more intently on the problem of asymmetry be tween the thrifts’ asset and liability structures. He has also noted that the groundrules even now are be ing rapidly altered at the state level, a situation that cannot be left “to the chaotic action of the 50 states.” Hectic activity This spate of legislative action at the state level has involved the confer ring of some form of checkingaccount authority upon thrifts in New England, New York, Illinois, Wisconsin and Oregon. In several cases, these new powers have in cluded authority to offer overdrafts. Activity in the area of electronic funds transfers also is having an impact, notwithstanding the Su preme Court's recent ruling that bank electronic terminals (CBCT's) are "branches" within the meaning of the McFadden Act, and thereby subject to state branching laws and restrictions. A large California S&L now makes it possible for its savings-account customers to pay for groceries with a simultaneous electronic debiting and crediting procedure. Such developments are rapidly eroding the traditional dis tinction between different types of accounts, and are reshaping competition among financial insti tutions and also altering the link ages of monetary control. Both of these forces for change— state legislative actions and the new EFT developments— have strong consumer overtones, and herein may lie the means for unraveling the gordian knot that has tied up the restructuring of the nation's depository institutions. For exam ple, some consumer groups appear to be increasingly disenchanted with the view that savers should be forced to subsidize certain borrow ers because of the Reg Q ceilings on their savings deposits. Others claim that Reg Q fails to meet its primary social justification— housing— because in an era of growing consumer awareness of investment alternatives, interestrate ceilings will become progres sively less effective in forestalling future disintermediation of deposit funds. Consumers also are becom ing more aware that inflation itself is the chief enemy of housing— contributing to a doubling of home prices in nine years—and that unless inflation is curbed, housing will not be protected by any num ber of Dorothy's magic shoes. Increasingly, consumers also may demand an explicit rather than an implicit return on their funds— including demand deposits, whose distinction vis-a-vis savings deposits even now is being altered by NOW accounts and preauthorized trans fers from savings deposits, as well as proposed telephonic transfers to demand deposits. Yet consumers will have to realize that increases in the cost of funds to lenders may mean higher costs to borrowers; in the real world there is no such thing as a "free lunch," such as Dorothy and the Tin Woodsman were able to pluck from the lunch-pail tree. In the area of EFTS, a more consis tent attitude on the part of consum ers and bankers alike may be neces sary towards both liberalized branching and EFTS— including the use of CBCT's by banks. Hostility may be not only anti-competitive but also self-defeating, simply be cause the thrifts are not subject to the McFadden Act. In fact, EFTS holds considerable potential for the development of consumer and small-business services, which traditionally have been the stock in trade of the small banks. If the banks don't take advantage of this potential, the thrifts and other com petitors very likely will, and small banks in particular may be left be hind in Munchkin Land. Verle Johnston uojguiqseM • Mein • uo §3 j o • epBA3|\| . ogepi • e jU J O p |B 3 . E U O Z jJ V • B>jS E |V PQ HBMBH BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 11/17/76 91,218 69,258 1,569 22,557 21,166 11,640 8,865 13,095 89,773 26,048 329 61,874 4,730 28,929 26,158 10,045 Weekly Averages of Daily Figures W eek ended 11/17/76 Member Bank Reserve Position Excess Reserves Borrowings Net free(+)/Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+)/Net sales (-) Transactions of U.S. security dealers Net loans (+)/Net borrowings (-) + Change from year ago Dollar Percent + Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Com mercial and industrial Real estate Consumer instalment U.S. Treasury securities O ther securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Governm ent deposits Time deposits—total* States and political subdivisions Savings deposits O ther time deposits}: Large negotiable C D ’s Change from 11/10/76 + 4,792 + 4,307 + 191 333 + 1,511 + 1,266 + 231 + 254 + 2,080 + 1,523 146 + 916 1,121 + 7,208 - 3,830 - 5,546 - + + + + + - + - - 320 371 234 64 120 20 218 473 168 21 182 218 68 206 249 74 W eek ended 11/10/76 + + + + + + + + + + + - 5.54 6.63 13.86 1.45 7.69 12.20 2.68 1.98 2.37 6.21 30.74 1.50 19.16 33.18 12.77 35.57 Comparable year-ago period + 17 3 14 - + 11 0 11 - 3 0 3 + 719 + 366 + 1,531 + 307 + 706 + + 544 "Includes items not shown separately. ^Individuals, partnerships and corporations. Editorial comments may be addressed to the editor (William Burke) 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.