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PERSPECTIVES ECONOMIC mm wm j a m u ia m / ummmmwo* C h ic a g o : c ity of th e big s tr a d d le s E c o n o m ic e v e n t s in 1 9 8 2 — a c h ro n o lo g y In t e r e s t ra te vo la tility in h is to r ic a l p e r s p e c t iv e W h a t is a b a n k ? About o u r read ers ECONOMIC PERSPECTIVES conducted a readership survey in May 1982. From the results of that survey we have learned a great deal about the people who read this journal. You may be interested in how you described yourselves. You are well educated. Sixty percent of the readers of ECONOMIC PERSPECTIVES have graduate or professional degrees. An additional thirtyone percent have undergraduate degrees. By occupation or status, you are executives (30% ), professional (28% ), economists (17% ), and noneconomist educators (9% ). Most of you are employed in banking or other financial business (34% ), the academic world (22% ), and the nonfinancial business sector (18% ). However, some of you are in the government/regulatory agency sector (9 % ) and in agriculture ( 8%). It adds up to a reader profile that many larger publications would be as delighted to have as we are. Moreover, knowing who you are will help us continue to provide articles of interest and value to you. \ ECONOMIC PERSPECTIVES C o n ten ts Jan u ary-Feb ru ary 1983 Volume VII, Issue 1 Chicago: city o f the big straddles E d ito ria l C o m m itte e Harvey Rosenblum, vice president and economic advisor Randall C. Merris, research economist Edward G. Nash, editor E con om ic events in 1 9 8 2 —a ch ron ology Roger Thryselius, graphics Nancy Ahlstrom, typesetting Gloria Hull, editorial assistant Interest rate volatility in historical perspective E c o n o m i c P e r s p e c t i v e s is p u b lish ed by th e R e s e a rc h D e p a rtm e n t o f th e F ed eral R ese rv e Bank o f C h ica g o . T h e view s e x p r e s s e d a r e th e a u th o r s ’ and d o n o t n e ce ssa rily re fle c t th e v iew s o f th e m a n ag em en t o f th e F e d e ra l R ese rv e Bank o f C h ica g o o r th e F e d e ra l R e se rv e System . S in g le-co p y s u b sc rip tio n s a r e avail a b le fre e o f c h a rg e . Please s e n d re q u e s ts fo r single- an d m u ltip le -c o p y s u b sc rip tio n s, b a c k issu es, an d a d d re s s c h a n g e s to P u b lic In fo rm a tio n C e n te r, F ed eral R eserv e Bank o f C h ica g o , P.O . B o x 8 3 4 , C h ica g o , Illin ois 6 0 6 9 0 , o r te le p h o n e ( 3 1 2 ) 3 2 2 -5 1 1 2 . A rtic le s m ay b e re p r in te d p ro v id e d s o u r c e is c r e d ite d and P u b lic In fo rm atio n C e n te r is p ro v id e d w ith a c o p y o f th e pu b lish ed m aterial. __________________________/ ISSN 0164-0682 3 New York is still the Big Apple, but Chicago plays Top B anana in several field s o f fin a n cia l innovation. 8 10 The interest rate surges o f 1980 a n d 1981 were not particularly u nusual in historical term s— what did the dam age was an underlying high level o f inflation. W hat is a bank? Or, When is a hank a nonhank ? The ques tions a re im portant; the answ ers fro m the Federal Reserve B oard have been subtle a n d evolutionary> . 20 Chicago: city of the big straddles Paul L. Kasriel and Randall Merris C. Chicago is a full-service financial center. In assessing the city’s role in the national and inter national marketplace, it is useful to delineate two broad classes of financial services. One class contains those financial services o f which Chicago is major supplier and market partic ipant; the other, those services of which Chicago is major supplier and market maker. Chicago has retained its historical promi nence as a financial center through its contin uing ability to meet the investment and credit demands of a large segment of the local market and to com pete in the national and international marketplace (See Box). And Chicago in recent years has developed a unique niche—as the birthplace of financial futures and exchangebased options trading. This article focuses primarily on Chicago as national and international center for futures and options trading. In addition to describing current activity in these markets, some explana tions are offered for Chicago’s emergence as the capital of financial futures and options. Some assessment also is made concerning Chicago’s prospects for retaining its leadership in futures and options and for remaining a prominent sup plier of banking and other financial services. a the a the the Futures trad in g today In 1981, the three Chicago futures ex changes—the Chicago Board of Trade (C B T), the Chicago Mercantile Exchange (CM E) in cluding its International Monetary Market ( IMM) division, and the MidAmerica Commodity Ex ch an g e-acco u n ted for about 77 percent of the total contract volume of all organized futures trading in the U.S. In O ctober 1982 the dollar value of the CBT’s and CME’s combined open interest (i.e., the number of contracts still outPaul L. K asriel is a s e n io r e e o n o m is t, an d Randall C. M e rris is a r e s e a r e h e e o n o m is t in th e R e s e a rc h D e p a rtm e n t o f th e F e d e ra l R e se rv e Bank o f C h ica g o . T h is a r tic le is a d a p te d fro m a p a p e r p r e s e n te d at th e Illin ois E c o n o m ic A sso cia tio n m e e tin g s, C h ica g o , N o v e m b e r 1 9 8 2 . Federal Reserve Bank o f Chicago standing) is $48.8 billion, or 80 percent of the dollar value of total U.S. futures open interest. The Chicago Board Options Exchange ( CBOE ) in 1981 accounted for about 53 percent of all exchange-traded options contract volume in the U.S. In 1980, the market value of contracts on the CBOE was $27.9 billion or about 61 percent of the total market value of exchange-traded U.S. options. In 1976, the combined CBT and CME volume was about 25 million contracts. By 1981, their combined volume had skyrocketed to more than 73 million contracts traded—a 192 percent increase over those six years. A signifi cant portion of this phenomenal growth can be attributed to continued development of finan cial futures—i.e., foreign currency and interest rate futures. In 1976, financial futures accounted for about 2 percent of CBT-CME volume. In 1981, this had risen to almost 39 percent. Currently, the CBT’s Treasury bond futures contract is the most actively traded futures con tract in the United States. In 1981, the average daily dollar volume (at par value) in the CBT’s Treasury bond futures contract and the CME’s 90-day T-bill futures contract was $27.7 billion. This was $3 billion more than the daily average of transactions in the cash market in all maturities of U.S. government securities of the 36 reporting dealers. So, not only is Chicago the dominant center in futures trading, but in a sense, the dominant center in U.S. government securities trading. C hicago’s past in futures That Chicago became the dominant center of futures trading in general was to a large extent a matter of geography. The 1848 completion of a canal joined Lake Michigan to the inland tribu taries of the Mississippi River. This canal pro vided inexpensive water transportation for corn from the interior to Chicago. But corn harvested in late fall and early winter could not be moved from the interior on frozen waterways and thus, 3 had to be stored at river grain elevators until the spring thaws. As a result, river elevator operators were subject to considerable price risk over the winter. To hedge this risk, grain elevator opera tors began to sell corn in the late fall at a firm price for May, or forward, delivery in Chicago. The Chicago Board of Trade was organized in 1848 for the purpose of trading these forward, or time, contracts in com . Over time, rules were promulgated that dealt with trading conduct and delivery grade standards. The Chicago Board of Trade became a full-fledged futures exchange in 1865 when a clearinghouse was established. The Chicago Mercantile Exchange traces its ancestry back to the Chicago Produce Exchange, formed in 1874. This exchange served as a cash market for butter, eggs, poultry, and other perish able agricultural products. In 1898, the butter and egg dealers withdrew from this exchange to form the Chicago Butter and Egg Board. Later, as the exchange’s cash business in butter and eggs waned, its membership looked for additional lines of business to revive it. Because there was a considerable amount of forward contracting in eggs and, perhaps, be cause the neighboring CBT had been trading futures for years, the membership decided to trade futures in butter and eggs. Trading began in 1919, and the exchange became known as the Chicago Mercantile Exchange. More than half-a-century later, a major break through occurred in futures trading when the newly-formed International Monetary Market division of the Chicago Mercantile Exchange began trading foreign currency futures in 1972. This innovation pioneered the concept of trad- r Som e financial dim ensions Chicago is home to some of the largest finan cial institutions in the nation, including • 2 of the 10, and 5 of the 100, largest com mercial banks ranked by total assets; • 2 of the 10, and 4 of the 50, largest savings and loan associations ranked by total deposits. The Chicago SMSA is home to 10 of the 100 largest finance companies ranked by total capital and to some of the largest insurance companies, investment banking houses, and brokers and deal ers in bonds and equities. Chicago is a major supplier of retail and wholesale banking services in local, national and international markets. Some figures: • The 4 0 4 insured domestic commercial banks in the Chicago SMSA hold approximately $97 billion* in domestic assets, accounting for 5.6 per cent of such assets of all insured U.S. banks. • The 95 domestic banks located in Chicago have domestic assets of about $76 billion. • The 95 domestic Chicago banks have about $ 18 billion of domestic assets exposure to non-U.S. residents, representing about 9 percent of such foreign lending of all U.S. domestic banks. • Two Chicago banks rank among the nation’s 10 largest holders, and 3 more are among the top 25 holders, of interbank demand deposits. • Domestic Chicago banks own 8 Edge co r porations—5 in Chicago and 3 elsewhere—en gaged strictly in international banking operations. • Chicago banks and Chicago offices of for eign banks own about 20 branches of Edge corpo rations in U.S. locations outside of Chicago. • Domestic banks headquartered outside of Chicago own more than a dozen Chicago offices of their Edge corporations. • Foreign banks have established 42 Chicago branches since 1973 when foreign bank branches were permitted under Illinois law. • Foreign banks are majority owners of 2 domestic Chicago banks and 4 Chicago offices of Edge corporations. • The 48 Chicago offices of foreign banks have total assets of about $10 billion, representing about 4 percent of the total assets of all U.S. offices of foreign banks. • Eight Chicago banks have over 6 0 foreign branches with total asset exposure to non-U.S. resi dents of about $40 billion. • Chicago banks and Chicago offices of for eign banks have established about 25 International Banking Facilities since December 1981 when these in-house foreign depositor)-lending facilities were authorized by Federal Reserve regulation. "D ollar a m o u n ts a re as o f J u n e 3 0 , 1 9 8 2 . 4 Econom ic Perspectives ing futures in something other than a physical commodity.1 Soon, interest rate futures appear ed —GNMA futures (O ctober 1975, CBT), 90day T-bill futures (January' 1976, IMM), and Treasury’ bond futures (August 1977, CBT). Contracts in other maturities of government securities, and commercial paper, domestic CDs, and Eurodollar time deposits have since been introduced. The Eurodollar contract also rep resented a breakthrough by introducing cash settlements for open expired contracts rather than actual delivery' of the “commodity.” The acceptance of cash settlement has spawned the development of stock market index futures. Futures on the S&P 500 stock index began trading at the IMM in April 1982. In just six months, the daily volume of trading in this contract rivaled that of 90-day T-bill futures, the IMM’s most successful previous financial futures contract. The CBT introduced options on finan cial futures in October 1982. In 1973, Chicago was the site of another financial innovation—exchange-traded options on equities at the newly-created Chicago Board Options Exchange. When the CBOE opened, it listed call options in 16 stocks and put options in none. At year-end 1981, calls had grown to 120 and options to 119. The CBOE also introduced options trading on U.S. government securities. It is understandable that Chicago became a dominant center in futures trading for agricultur al products, given its location and transportation facilities. But how did it com e to be dominant in the trading of futures and options on financial instruments? By all rights, New York City, the U.S. center of equities and fixed-income securi ties, also ought to lead in the trading of their derivative instruments. The reason for Chicago’s dominance in these instruments has to do with economies of scale and that nonquantifiable vari able, entrepreneurial spirit. W orking’s hypothesis A good part of futures market “infrastruc ture” was in place in Chicago at the beginning of 'W h ile th is w a s a m ile s to n e fo r fu tu re s trad in g, it sh ou ld b e n o te d th at th e r e w as a lread y a w ell-estab lish ed in terb an k fo rw a rd m a rk e t in fo reig n c u r re n c ie s . Federal Reserve Bank o f Chicago the 1970s. The physical plant and management already existed. Moreover, there already existed a group of well-capitalized and experienced local floor traders who could provide the requi site liquidity to the markets so as to attract public participants—hedgers as well as speculators. Stanford University’s Holbrook Working, a dis tinguished student of the futures markets, high lights the importance of this infrastructure: An exchange that conducts futures trading in a number of different commodities can provide a more uniformly fluid market for any one of them than could an exchange dealing only in that one commodity. That is especially true for a commodity in which trading is light. To maintain a highly fluid market, scalpers must operate on an almost infinitesimally small profit margin, and a professional floor trader can afford to do that only if he does a great volume of busi ness. That is not possible on a single commodity exchange with a small volume of trading; but it is possible in a small futures market operating on a multi-com modity’ exchange, where a floor trader is not restricted to dealing only in that one commodity. Futures markets that are indi vidually small can prosper modestly on a m u lti-com m odity exch an g e w hereas attempt (s ic ) to operate them separately would fail, for much the same reason that retail trade in a small and isolated town must be conducted in a “general store” rather than a number of specialty shops.^ W ork in g’s hypothesis may partially explain why N ew Y ork City’s futures exch an g es have failed to ca p tu re a larger m arket share of finan cial futures trading. In S eptem ber 1 9 7 8 , the A m erican C om m odity E xch an ge (A CE ), a subsid iary' of th e A m erican Stock E xch an ge, began trading GNMA futures. ACE added 90-day T-bill futures and Treasury’ bond futures to its menu in Ju n e 1 9 7 9 and N ovem ber 1 9 7 9 , respectively. By S eptem b er 1 9 8 0 , h ow ever, ACE volum e was so low that it was acq uired by the newly-organized N ew Y ork Fu tu res E xch an g e (N Y F E ), a subsid iary o f the New Y ork Stock Exchange. -H o lb ro o k W o rk in g , “ E c o n o m ic F u n c tio n s o f Fu tu res M a rk e ts," in S elected W ritin g s o f H o lb ro o k W orking ,” c o m p iled by A n n e E. P e ck , B o a rd o f T ra d e o f th e C ity o f C h ica g o , 1 9 7 7 , p. 2 8 4 . 5 ACE’s demise could have been predicted from Working’s hypothesis. It was a new ex change trying to trade low-volume contracts. It lacked a significant group of experienced and well-capitalized local floor traders to provide the necessary liquidity. Moreover, the exchange did not offer a diversified set of contracts or any high volume contracts to support the traders. And all of the ACE contracts were already being traded relatively successfully on the Chicago exchanges. NYFE, until recently, seemed destined to meet with the same fate as its acquisition. NYFE was also trading duplicates of futures contracts traded at the Chicago exchanges. Recently, however, volume on the NYFE tyas picked up because of its new and exclusive futures contract on the New York Stock Exchange index. Another New York exchange, the Commod ity Exchange (COM EX) also has ventured into financial futures. COMEX, unlike ACE and NYFE, is an established exchange and the leader in metals (gold, silver, and copper) futures trading. With established and high volume contracts, COMEX might have been expected to generate more than minimal volume in financial futures. But again, COMEX’s financial futures contracts are essentially duplications o f established Chicago contracts. A somewhat different outcome has occurred with regard to options trading. The CBOE began trading call options on equities in April 1973. Unlike the Chicago exchanges’ experience with financial futures, CBOE’s dominance in equity options trading has diminished, with competi tion coming from options trading on the Ameri can Stock Exchange (January 1 975), the Phila delphia Stock Exchange (June 1 9 7 5 ), and the Pacific Stock Exchange (March 1 9 7 6 ). Despite this competition, the CBOE retained over 50 percent of the options contract volume in 1981. Chicago’s financial future The outlook for Chicago to continue as the financial center in futures and options trading is good indeed. The use of financial futures by insti tutions is still in its infancy. In this new era of increased interest rate volatility and deregula tion of our financial system, depository institu 6 tions will be forced to manage their assets and liabilities more actively if they are to survive. Financial futures and options are additional tools that can be employed to this end. Recently, large banks have begun to estab lish financial futures units either in-bank or in holding-company subsidiaries to provide con sulting and brokerage services to the public. Given their correspondent relationships with smaller banks and other financial institutions, these large-bank financial futures units can be expected to generate increased institutional participation in the futures markets. Stock index futures, options on futures, and options on fixedincome securities have started trading only in recent months. The industry believes that these new instruments will match the success of the IMM’s S&P 500 index futures contract. The outlook for Chicago’s share of the market of other financial services may not be quite so sanguine due to secular production and population trends. The composition of U.S. out put appears to be moving more toward the ser vices and light manufacturing industries, and away from capital goods and heavy manufactur ing in which the Midwest has specialized. A pos sible offset may be the entrance of traditionally nonfmancial businesses into the financial ser vices industry. Sears Roebuck and Company is an obvious example. Sears, with such subsidiaries as Allstate Insurance, Dean W itter Reynolds, and Coldwell Banker, along with its mammoth con sumer credit card operations, may becom e a major provider of retail financial services. This potential is enhanced by Sears’ relative lack of regulatory impediments. With regard to banking, the current move toward deregulation and, to a limited degree, decreased taxation should help Chicago banks compete locally, nationally, and globally. In De cember 1981, the Federal Reserve authorized the opening of International Banking Facilities (IBFs). Through their IBFs, U.S. banking offices may accept deposits from and make loans to foreign residents, including foreign banks, with out being subject to Regulations Q and D or to FDIC insurance coverage and assessments. More over, Illinois has granted favorable tax treatment under state law for IBF operations. Econom ic Perspectives Illinois state law prohibits statewide com mercial bank branching. This regulation has surely put Chicago banks at a disadvantage to their New York and California counterparts. If it were not for well-developed federal funds and large negotiable CD markets devoid of Reg Q ceilings, Chicago banks would be at an even greater disadvantage. A minor crack in the Illi nois law was made in 1981, effective 1982, when multibank holding companies were permitted on a limited basis in contiguous counties. To develop a specific plan for local business and political leaders to follow in order to enhance Chicago’s financial role would be very difficult. However, actions that would tend to diminish Chicago’s role readily come to mind. In the m id-1970s an existing stock transfer tax in New York City was increased and a new bond transfer tax was imposed. In response, many securities firms threatened to move and, in some cases, actually relocated. Securities ex changes also gave thought to relocating. In reac tion to the actual and threatened exodus of the securities industry from New' York City, the bond transfer tax was repealed, and in 1976 the burden of the stock transfer tax was reduced. By June 1981, the collection of the New York City stock transfer tax had been phased out. Increased taxation and/or regulation of financial production in which Chicago special izes would, all else the same, detract from the city’s role as a provider of these products.' The worst case for Chicago would be to tax the futures and options industries sufficiently to induce them to move elsewhere. A step along that “ worst case” path was nearly taken in 1973 when a local revenue proposal emerged that would have imposed a transfer tax on transac tions consummated on organized financial ex changes located in Chicago. In response to this proposal, the CBT and CME began investigating 'T h is d isc u ss io n is f o c u s e d o n th e im p a c t o f in cre a s e d ta x a t io n an d re g u la tio n o f fin an cial p r o d u c ts on C h ica g o as a p r o v id e r o f th e s e s e rv ice s. It d o e s n o t a d d re ss th e issue o f w h e th e r th e p u b lic in te r e s t is b e t t e r s e rv e d by s u c h ta x a tio n o r re g u latio n . Federal Reserve B ank o f Chicago relocation sites outside the Chicago city limits. The transfer tax proposal was withdrawn. At the national level, amendments to the Futures Trading Act of 1982 were introduced that would have empowered the Commodity Futures Trading Commission (C FTC ) —the Fed eral agency with regulatory jurisdiction over U.S. futures trading—to impose a transaction fee or tax on all futures trades in order to defray some of the Commission’s expenses. These amend ments were defeated. However, the final form of the Futures Trading Act of 1982 passed by Con gress and signed by the President authorizes the CFTC to charge appropriate fees for services rendered and activities performed incidental to its regulatory responsibilities. User fees may not be as onerous as a transaction tax , but they still represent an increase in the cost of conduct ing futures trading. Increased taxation or regula tion at the national level could be just the boost needed to get a proposed Bermuda-based futures exchange or the London International Financial Futures Exchange, which opened its doors and floors in September 1982, off and running. If the notion of driving our futures business offshore appears to be farfetched, consider what has hap pened in banking. Many analysts would agree that Regulations Q and D have played a signifi cant role in the growth of the London and Carib bean Eurodollar markets. Chicago has truly com e of age as an interna tional financial center and, in many areas, as an unrivaled financial innovator. In his poem “Chicago,” Carl Sandburg characterizes the city as “Stormy, husky', brawling.” To observe the trading in the pits of Chicago’s exchanges is to understand his description. Writing today, Sandburg might sav: Frozen pork belly trader of the world, International market maker, stacker of wheat futures, Player with stock options, financial futures, And, now, options on futures; Stormy', husky, brawling. City of the big straddles. perse 7 Economic events o 1982—a ff chronology J a n 1 So cial Security wage base rise s from $ 29,700 to $32,400. Tax rate rises from 6.65 to 6.7%. (On January 1, 1983, base rises to $35,700 with tax rate unchanged.) M a y 1 3 Braniff files under Chapter 11, after suspending all flights. M a y 1 7 Drysdale Government Securities defaults. M a y 2 3 U .S. Steel plans to close big Alabama plant. M a y 31 Hughes Tool C o . reports the number of active oil and gas drilling rigs in steepest decline ever from record high in December. J a n 8 Ju stice Dept, drops 13-year antitrust suit against IBM. J u n 2 S a le s of new one-family homes in April reported at low est level ever in series starting in 1963. J a n 1 0 Se ve re cold and heavy snow s hit the M idwest, disrupting activity. Chicago reports record low 26 degrees below zero. (January 17 pattern is similar.) J u n 5 Raw steel plant operating rate at 42.5% is low est since 1938. (It falls below 30% at year-end.) J a n 1 3 Com m erce Dept, estim ates real plant and equipment spend ing by business will fall 0.5% in 1982. (S e e D ec 10.) J u n 6 Israeli troops invade Southern Lebanon to attack P L O gueril las. (S ee Aug 25.) J a n 2 0 (JAW halts contract concession talks with Ford and GM. J u n 11 Com m erce Dept, determines that imported foreign steel receives government subsidies. (S e e Jan 11.) J a n 2 6 Sta te of the Union address calls for no tax increases, higher defense spending, and transferring 40 social programs to the states. J u n 1 4 French franc devalued by 6% and Italian lira by 3%. F a b 1 Auto companies offer rebates to spur lagging sales. J u n 1 4 Argentine forces in Falkland Islands surrender to British. (S ee Apr 2.) F a b 6 President Re'agan s fiscal 1983 budget projects decline in deficit to $92 billion from $9 9 billion, 5% rise in total outlays to $758 billion, led by increased defense spending. (S e e O ct 26.) J u n 1 8 U .S. government announces ban on sale s of gas pipeline equipment to U S S R by foreign licensees using U .S . pipeline-related technology. (Ban relaxed Nov 18.) F a b 8 20-year Treasury bonds (constant maturity) yield 15.06% high for the year. (S ee Nov 19.) J u n 21 Initial estim ate of second quarter G N P show s small rise. Improvement in other sta tistics raise s hopes that recession may be ending. (S e e D ec 21.) F a b 1 0 Councji of Econom ic A d visers projects 5% growth rate in the second half of 1982. F a b 1 0 Federal Reserve Chairman Volcker announces monetary growth targets for 1982: M l, 2.5-5 5%; M2, 6-9%; and M3, 6.5-9.5% . (S e e Jul 20.) J u n 2 5 George P. Shultz succeed s Alexander Haig as S e cretary of State. J u n 2 8 Supreme Court voids Bankruptcy Act of 1978 as giving special judges too much power. F a b 1 7 C hrysler will sell army tank division to General Dynamics. J u n 2 8 Supreme Court upholds due-on-sale clau ses in mortgages. F a b 1 8 Mexico floats peso; it drops by 28% in dollar terms. F a b 2 2 Spot market price of Saudi light crude oil reported below $ 3 0 per barrel, depressed by oil glut. O fficial price is $34. J u n 2 8 Federal R eserve Board v o te s in principle to require con temporaneous reserve accounting for banks and thrifts. (On O ctober 5 the Board votes to implement change starting February 1984.) F a b 2 3 Most major banks reduce prime rates from 1982 high of 17 to 16.5%. J u n 2 9 DID C authorizes $20,000 minimum C D with 7-31 day matur ity and ceiling rates tied to 91-day T-bills, starting Septem ber 1. F e b 2 4 "Shelf registration", approved by S E C , facilitates corpo rate issuance of securities. J u l 1 Ten percent personal income tax cut becom es effective. Social security checks rise by 7.4%. F a b 2 5 C on gressional Budget O ffice projects deficit at $111 bil lion in fiscal 1982 and $121 billion in fiscal 1983. (S ee Sep 1.) J u l 5 Penn Square Bank of Oklahoma C ity, large-scale originator of energy loans, closes after examiners find it to be insolvent. F a b 2 8 Ford w orkers approve new labor contract containing some concessions. (GM workers approve similar pact April 9.) J u l 7 General Electric union settlem ent provides estimated 28% pay increase over 3 years, assuming 7% inflation. M a r 1 Team sters approve 37-month national labor contract with some con cession s on w ages and work rules. J u l 2 0 Federal Reserve reduces discount rate from 12 to 11.5%, first of seven cuts in 1982. (S e e D ec 14.) M a r 2 FHA and VA mortgage rates lowered to 15.5% from 1982 high of 16.5%. (S e e Nov 12.) J u l 2 0 Federal R eserve retains the 2.5-5.5% growth target for M l in 1982, but faster growth will be tolerated "for a time." (S e e Feb 10.) M a r 1 0 President Reagan bans imports of Libyan oil. J u l 2 7 Federal court enjoins proposed change in method of calcu lating "prevailing w ages" paid on federal construction under DavisBacon Act. M a r 31 United S ta te s Gold Com m ission rejects gold as basis for domestic or international monetary system s. A p r 1 Japan renews its ceiling of 1.7 million auto exports to U .S. A p r 2 Argentine forces seize Falkland Islands. (S e e Jun 14.) A p r 3 UK im poses economic sanctions on Argentina in wake of seizure of the Falkland Islands. Limited san ctio ns by other W estern countries follow. A p r 8 S E C finds "nonperforming" loans up sharply at large banks. A p r 2 6 Spector-Redball, large trucking firm, files under Chapter 11, citing price cutting under deregulation. A p r 2 9 President Reagan calls for constitutional amendment requir ing a balanced budget. (S e e O ct 1.) M ay 1 Banks and thrifts begin to offer 91-day C D s with ceiling rates tied to Treasury bills, and 3'/2-year C D s with no ceiling. M a y 2 Exxon halts huge shale oil development in Colorado. M ay 11 Import quotas on sugar imposed by presidential order. 8 J u l 3 0 United Steelw orkers conference rejects industry-requested changes in existing labor contract. (S e e Nov 19.) A u g 2 Federal Reserve reduces discount rate to 11%. Major banks cut prime rates to 15%. A u g 4 Federal R eserve requests com m ents on planned priced ser vices changes, including "noon presentm ent", originally scheduled for August implementation. (Revised plan announced Decem ber 27.) A u g 5 Mexico controls foreign currency accounts. A u g 9 AEG-Telefunken, giant German electrical firm, declares bankruptcy. A u g 11 Dow Jo nes industrial stock index clo se s at 777, low for the year. (S e e Dec 27.) A u g 11 Agriculture Dept, fo recasts record corn, soybean crops. A u g 1 2 Lombard-W all, government securities dealer, files for bankruptcy Econom ic Perspectives A u g 1 6 Federal Reserve reduces discount rate to 10.5%. Treasury bill rates drop sharply to low est level in 2 years. Major banks reduce prime rates to 14.5%. A u g 1 9 Tax Equity and Fiscal Responsibility Act (T EFR A ) raises taxes by cutting loopholes, eliminates about one-third of 1981 co r porate tax cuts. A u g 2 0 New York Sto ck Exchange ends week with record volume and record rise in stock prices. O c t 1 5 Far-reaching G arn-St Germain Depository Institutions Act widens lending pow ers of S& Ls, etc. O c t 2 6 Treasury reports budget deficit for fiscal 1982 reached $111 billion, exceeding 1976 record of $66. (S e e Feb 6.) N o v 1 Auto company financing units offer cut rate car loans. N o v 1 “ Voluntary" restrictio ns on steel exports from the European Community to the U .S. go into effect. A u g 2 2 Private bankers agree to 90-day rollover of Mexican debt. N o v 2 Election results: D em o crats gain 26 se ats in the House, but Republicans retain 8-seat margin in the Senate. A u g 2 4 Federal court approves AT&T plan dividing system into regional companies. N o v 3 Dow Jo n e s industrial stock index clo se s at 1065, exceeding record set in January 1973. A u g 2 5 International H arvester agrees to sell most of its construc tion equipment business to D re sse r Industries. N o v 5 C h rysle r w orkers in Canada strike for immediate wage increases. (S e e D ec 12.) A u g 2 6 Manville C orp. files under Chapter 11 because of a sb e sto s health suits. N o v 1 2 Yuri Andropov becom es So viet leader, succeeding Leonid Brezhnev who died November 10. A u g 2 7 Federal R eserve cuts discount rate to 10%. N o v 1 2 FH A -V A ceiling mortgage rate cut to 12%, lowest in over 2 years. (S e e Mar 2.) S a p 1 M exico nationalizes banks, broadens exchange controls. S a p 1 Con gressional Budget O ffice expects deficit in fiscal 1982 of $112 billion, rising to $155 billion in 1983. (S e e Feb 25.) N o v 1 4 Polish government frees opposition leader Lech W alesa. S a p 1 Aluminum com panies report primary output in July fell below lowest rate of 1975 recession. N o v 1 5 D ID C authorizes banks and thrifts to offer Money Market Deposit Account with no interest ceiling, minimum balance of $2,500, and limited checking, beginning Decem ber 14. S a p 9 House by 3-1 vote overrides veto of supplemental appropri ations bill, called first big defeat for President Reagan. N o v 1 8 U .S. relaxes sanctions against European companies related to the Soviet gas pipeline to W estern Europe. (S e e Jun 18.) S a p 1 3 IC C approves merger of Union Pacific, M issouri Pacific, and W estern Pacific. (Final legal barrier lifted Decem ber 22.) N o v 1 8 Ford plans to shut California auto assem bly operations due to import competition, virtually ending W est C o a st auto output. S a p 1 7 Com m odity Credit Corporation authorizes up to $1 billion in loan guarantees for sale s of agricultural commodities to Mexico. N o v 1 9 Presidents of United Steelw orkers locals reject contract. S a p 1 9 Railway engineers begin 4-day national strike to keep pay differential over other railway workers. N o v 1 9 20-year Treasury bonds (constant maturity) yield 10.42%, low for the year. (S ee Feb 9.) S a p 2 4 F.W . W oolworth will liquidate its 336 W oolco stores. N o v 2 2 Federal R eserve cuts discount rate to 9%. Prime rate falls to 11.5%, the prevailing rate at year-end. S a p 2 6 Allied Corp. wins control of Bendix, ending takeover strug gle that involved Martin M arietta and United Technologies. N o v 2 9 G A T T meetings end without resolving U .S. protests on Common M arket's subsidization of agricultural exports. S a p 2 7 International H arvester will close its Fort W ayne truck plant to consolidate output in Springfield, O. D o c 5 FH A reports record number of mortgage loan applications in November. (Uptrend continues through year-end.) S a p 2 8 Federal R eserve Board approves acquisition of Fidelity S&L in Oakland, Calif., by Citicorp. D o c 6 D ID C authorizes Super N O W accounts, rem oves 7-31 day C D rate ceiling, and reduces minimum for short-term C D s to $2,500, effective January 5, 1983. O c t 1 Federal em ployees receive 4% general pay boost, in addition to annual step increases. Military pay also rises 4%. D o c 7 House rejects funding for MX missile. O c t 1 House re je cts balanced budget amendment urged by P resi dent Reagan and passed by the Senate. D o c 1 0 Com m erce Dept, estim ate show s 4.8% decline in real plant and equipment spending in 1982. (S e e Jan 13.) O c t 1 UAW begins strike at Caterpillar Tractor, after rejecting concessions. (Strike continues past year-end.) D o c 1 3 UAW in C anada agrees to end 5-week C hrysler strike for pay hike. (U .S. workers approve similar pact Decem ber 17.) O c t 1 Helmut Kohl elected to succeed Helmut Schmidt as W est German chancellor. D o c 1 4 Federal Reserve cuts discount rate to 8.5%, lowest since O ctober 1978. O c t 1 New one-year extension of U .S .-U S S R grain pact begins. D o c 1 5 Industrial production estimated to have dropped again in November to 12% below July 1981 peak. O c t 6 Clark Equipment will close four Michigan plants. O c t 7 International H arvester management tells stockholders "the company's pro sp ects for survival are in substantial doubt." O c t 7 U AW announces that rank and file has heavily rejected pro posed C hrysler contract. (S e e D ec 12.) O c t 8 Septem ber unemployment rate is estimated at 10.1%, high est since 1941. (Rate reaches 10.8% in Decem ber.) O c t 8 Export Trading Com pany (E T C ) legislation signed into law. O c t 9 Chairman Volcker sa y s Fed will temporarily place less em phasis on M l in monetary policy, because of distortions. O c t 1 0 Sw eden devalues krona by 16%. O c t 1 2 Federal Reserve reduces discount rate to 9.5%. O c t 1 3 Major banks cut prime rates from 13 to 12%. O c t 1 5 Social Security will borrow in November for first time. D o c 1 6 Housing starts estimated at 1.4 million annual rate in November, highest since January 1981. D e c 2 0 Mexico devalues peso again. D o c 21 O P E C officials meeting in Vienna fail to agree on oil pro duction quotas for member nations. D o c 21 Com m erce Dept, estim ates real G N P decline in fourth quarter. (S e e Jun 21.) D o c 2 3 C o n g re ss p a sse s 5 cent per gallon gas tax hike to fund construction and repairs of highways, bridges, and transit system s. D o c 2 7 Bethlehem plans to end most steelmaking at Lackawanna. D o c 2 7 Dow Jo n e s industrial stock index c lo se s at 1071, all-time high. (S e e Aug 11.) D o c 2 9 Adm inistration predicts 3% rise in real G N P to fourth quarter of 1983, following 1.2% decline in past four quarters. J Federal Reserve Bank o f Chicago 9 Interest rate volatility in historical perspective Harvey Rosenblum and Steven Strongin On October 6 ,1 9 7 9 , the Federal Reserve changed its procedures for implementing monetary pol icy. Prior to that date, the Federal Reserve had sought to bring the rate of monetary growth in line with its desired target rate of growth through changes in the federal funds rate. Through its open market operations, the Fed supplied or absorbed whatever level of reserves was necessary to achieve the targeted federal funds rate. To^influence the price of reserves (i.e., the federal funds rate), the Fed had to give up control over the quantity of reserves. But after O ctober 6, 1979, the Fed began controlling the quantity of reserves it supplied through open market operations (i.e., the level of nonborrowed reserves); in so doing, the Fed eral Reserve had to let market forces determine the price of reserves—the interest rate. Under these circumstances, the federal funds rate was free to move over a much wider range than before. Since this change in the Fed’s of implementing monetary policy, much attention has been focused on the increased volatility of interest rates and the adverse econom ic conse quences that seemed to have followed from the change. It is frequently asserted that the in creased variability of interest rates stems pri marily—and in the eyes of some observers, entirely—from the Fed’s change in operating procedures. And indeed, by most conventional measures the degree of variability of interest rates (both long- and short-term rates) did increase markedly in the year or two following October 6, 1979 in comparison with the two years or so prior to that date. But to use such a short span of time to analyze interest rate volatility and its impact may involve a myopic view that obscures the underly- method H arvey R o sen b lu m is v ice p re s id e n t and e c o n o m i c ad v isor and Steven S tro n g in is a r e s e a r c h e c o n o m is t in th e R esearch D e p artm en t o f th e F ed eral R eserv e Bank o f C h icag o . 10 ing fundamental causes and consequences of rate variability. Because interest rates respond to shifts in both supply and demand for credit, changes in interest rates and interest rate volatil ity may be due to factors other than Federal Reserve actions. This article examines interest-rate volatility over the 86-year period from 1897-1982. When viewed over this longer time horizon, the inter est-rate volatility of the last few years does not seem particularly unusual. What was unusual is that the sharply higher volatility followed a period of unusual tranquility, thus making the adjustment to the new environment all the more difficult for economic entities unprepared for the change in economic conditions. Further, the interest rate variability of the last few years is not vastly different from that of many other two- or three-year periods over recent decades. Thus, there is circumstantial evidence that the change in the Fed’s operating procedures in O ctober 1979 may have been only a minor factor contrib uting to the increased rate volatility, and that other factors were simultaneously contributing to the increased interest rate movements. How ever, no attempt is made in this paper to suggest what might have happened had there been change in Fed operating procedures in October 1979. no Volatility since the m id-1950s When the behav ior of interest rates is exam ined over recent years, sev eral observations are readily apparent. First, interest rates have tended to rise, on average, since World War II. Second, the level of interest rates has tended to fluctuate over a wider range during the later part of the postwar period than during the early part. Third, the peak level of rates in each cycle has tended to exceed the peak level of rates reached in the previous business cycle. This is seen in Figure 1, w hich shows the level for the federal funds rate Econom ic Perspectives Fig u re 1 over the 1954-82 period. The pattern is very much the same for all short-term money market rates. The three-month Treasury bill rate and the 4-6 month prime commercial paper rate all show the same pattern. The sharp increase in the variability of the federal funds rate is shown in Figure 2, which Federal Reserve Bank o f Chicago depicts the standard deviation1 of the federal funds rate over the 1973-82 period. The stan'T h e g ra p h s p r e s e n te d in th is p a p e r a r e b ased o n m oving c a lc u la tio n fram es. F o r e a c h w e e k , a sta n d a rd d ev iation o r s o m e o t h e r m e a su re o f v o latility is c a lc u la te d , using th e data fo r th a t w e e k an d th e p re v io u s 1 2 w e e k s. ( C e rta in grap h s are c a lc u la t e d w ith a o n e -y e a r sp an an d u se th e p r e c e d in g 51 w e e k s .) 11 dard deviation did increase significantly imme diately after the adoption of reserves targeting by the Federal Reserve in O ctober 1979. However, several points are worth noting in Figure 2. First, in the first few months following the change in operating procedures, the standard deviation of rates rose quite sharply in comparison uith the r standard deiiation o f rates in the two years prior to the operational shift. But it was only' slightly higher than that during the first two years of the 1973-82 period. Second, the truly significant spike in rate volatility, as measured by the standard deviation, centered on the Spring of 1980, when the Special Credit Restraint Pro- M easuring Rate Volatility To measure volatility a number of choices must be made. • What data series should be used? • What frequency of data should be used (daily, weekly, monthly, yearly, e tc .)? • Over what time period should the volatility measure be calculated? • W hat sta tistica l m easu re should be employed? The choices made in this paper, and the rea sons for them, are discussed below'. Two interest rates, the federal funds rate and the 4-6 month prime commercial paper rate, were used. The Federal funds rate was chosen because it is the rate w hich the Federal Reserve affects most directly through open market operations. The prime commercial paper rate was used because it provided the most consistent series over nearly a century, allowing a broader historical perspective. How ever, other rates, such as the U.S. Treasury bill rate, were tested and provided almost identical results in the periods for which they were available. W eekly data w ere analyzed. This was a com promise between the need for a large number of observations that daily data would have provided, and the fact that very’ short-term fluctuations, such as interday or intraday fluctuations, are important primarily to floor traders or highly active specula tors and are of little relevance to Federal Reserve policy. The period over which volatility is calculated is crucial. Many previous examinations of volatility differ from this study with respect to period. Usu ally, the date of a particularly important event is chosen; volatility measures are then calculated for equal periods before and after, and the two num bers are compared. This methodology has a serious bias toward finding a shift, because if there had been any change either in the before or after period then the analysis would falsely relate that change to the 12 tested event. Another problem with this method ology is that it is impossible to tell which of the two periods was anomalous. To avoid these problems, volatility calcula tions were made for each week using that week and either the previous 12 weeks ( one quarter) or that week and the previous SI weeks (one year). The volatility measures were then plotted against time, so that the reader may see when volatility was high or low and when it was changing without having to rely tin the authors' perceptions of when major structural changes took place. It also be comes easier to spot short-term anomalies such as the Credit Restraint Program and to adjust one’s perceptions accordingly. The choice of volatility measure might at first seem crucial. Surprisingly, except for the very important distinction between measures which adjust for the level of interest rates (relative mea sures) and those that do not (absolute measures), very little difference could be found between mea sures. The two basic statistical measures chosen were standard deviation and range. These two were picked because both are well known and reasonably easy to calculate. Many other measures were tested but, as mentioned above, no substantive differences were found. Adjustments were made for level by calculat ing the natural logarithms of the interest rates, and then applying the same statistical measures as were used in investigating absolute volatility. This changes the measure to one of percentage changes. That is, an absolute change from 10% to 11%, mea sured by simple subtraction, is a change of the same magnitude (one percentage point) as a change from 1% to 2%. But when logs are taken, a change from 10% to 11 % is the same as a change from 1% to 1.1%. Thus, by taking logs the standard deviation and range become relative volatility mea sures, measuring the volatility relative to the cur rent level of interest rates. _______________________ _________________________ Econom ic Perspectives gram was invoked by President Jimmy Carter. Third, interest rate volatility has subsided considerably since the demise of the Credit Re straint Program. One problem with using the standard devia tion as a measure of volatility is that it represents the variation of rates about the mean. The probability of an absolute change in interest rates of 50 basis points2 may be different when the level of rates averages 10 percent than when it averages 4 percent. As shown in Figure 1, the average level of interest rates has been much higher in the last few years than it was ten, twenty, or thirty years ago. Measures of the variation of interest rates can correct for this problem (see Box). Indeed, when a relative measure of variation, the standard deviation of the natural log of the fed eral funds rate, is used, the increase in the volatil ity of the federal funds rate in the post October 1979 period does not appear as dramatic as when the standard deviation, an absolute mea sure of variation, is used. This can be seen in Figure 3- Note once again the dating of the spike in variability during Spring 1980. An examination of the relative variability of the federal funds rate over the 1954-82 period, absolute relative -’A b asis p o in t is 0 .0 1 p e r c e n ta g e p o in ts. T h u s a ch a n g e o f SO b xsis p o in ts r e p r e s e n ts S 0 ( .0 1 )= 0 .S p e r c e n ta g e po in ts. plotted in Figure 4, suggests that the volatility experienced during the last fewyears was neither unknown nor excessive by the standards of the period. A longer-run view o f volatility To provide a greater understanding of recent phenomena. Figure 5 places these events in a longer-term historical context, by plotting the relative volatility of the prime commercial paper rate from 1897 to 1982. The commercial paper rate is the only relatively consistent short-term interest rate series going back this far in time. When viewed in this long-term context, the experience during the post October 6, 1979 period is neither unprecedented nor particularly unusual. There have been many spikes in rate volatility —the most significant ones having oc curred in 1898, 1914, 1931, 1933, 1942, 1958 and 1980. Each of these episodes was followed by a return to a period of more “normal” variability. To illustrate this point more clearly, Figure 6 divides the 1897-1982 period into three approximately equal subperiods of about 29 years each. Figure 6a shows that during the 1897-1925 period the nation experienced inter est rate volatility not very different from that F ig u r e 3 Federal Reserve Bank o f Chicago 13 Figure 4 F ig u re 5 which has prevailed during the last three dec ades. This can be seen by comparing Figures 6a and 6c. The period from the formation of the Fed eral Reserve in 1914 until the 1930s (Figures 6a and 6 b ) was a period of comparative interest rate tranquility. During the depths of the Great Depression, interest rates were at very low levels and changes in rates of only a few basis points were enough to cause large jumps in the mea sure of relative variation (Figure 6b ). Similarly, during World War II and until the Federal 14 Reserve-Treasury Accord in 1951, the Federal Reserve sought to peg rates at low and stable levels; again, any small variation in rates in a period such as this was sufficient to produce a sharp increase in relative measures of rate vola tility. Finally, examination of the 1955-1982 period ( Figure 6 c ) reveals that the first half of the 1970s had much greater relative rate volatil ity on average than the 1960s. During most of the second half of the 1970s, rate volatility subsided considerably, thus magnifying the relative impact of the increased volatility after October 6, 1979. Economic Perspectives Fig u re 6a F ig u re 6 c Federal Reserve Bank o f Chicago 15 Examination of rate volatility over a long time calls into question the usual methodology for analyzing current volatility. Most analyses of recent rate volatility have typically involved comparing an absolute measure of variation (generally an unadjusted standard deviation) during the period just before O ctober 1979 (often January 1976-September 1979, a period of extremely low volatility) and the two- or three-year period immediately following O cto ber 6 ,1 9 7 9 . Such a comparison leads to a signifi cant overstatement of recent instabilities. More over, while there was a large increase in volatility shortly after the 1979 Fed changes, a substantial proportion of the*increase is associated with the Special Credit Restraint Program during 1980. In fact, after the Credit Restraint Program was re scinded, rate volatility declined to more nearly normal levels. Econ om ic im pact o f rate volatility But from the point of view of monetary policy, which is transmitted to the economy through very short-term shocks or absorption of shocks in the money and credit markets, the relative or log measure of volatility is probably superior, especially when one is attempting to assess the “market’s” uncertainty with respect to Fed behavior. The reason for this is fairly straight forward; the volatility of interest rates measured by an absolute measure increases as the level of rates rises. When rates are 5 percent, they simply cannot fall 11 percentage points, as they did during the Credit Restraint Program. Thus, as inflation has increased over the last 20 years, and with it the general level of interest rates, volatil ity has also trended up. Policy actions must be taken—and judged—in the environment in which they are made. The same willingness on the part of the Fed to smooth interest rates in terms of missing monetary growth targets will lead to much greater interest-rate volatility in a period characterized by 15 percent rates than in a period with 7 percent rates. This does not change the fact that the econ omy is primarily affected by sustained absolute shifts in the level of interest rates. And these longer-term movements in rates have increased significantly. This particular aspect of rate vola tility cannot be dismissed lightly. Indeed, to the extent that rate movements in one direc tion or the other for several weeks or months at a time, substantial changes in portfolio values and in actual and perceived levels of wealth will occur. Increases in interest rates produce de clines in wealth which are generally followed by declines in spending; therefore longer-term rate movements that persist over substantial time periods can and do influence the level of eco nomic activity.3 Great care must be taken in interpreting any given measure of rate volatility. For example, if an absolute measure of rate volatility is used, 1981 shows nearly three times the volatility shown by rates in 1971. If a relative measure such as the log of the rate is used, the difference between rate volatility in 1971 and 1981 is inconsequential (see Figures 8b, 8 c). In terms of the econom ic impact of the rate movements involved, neither representation of rate volatility is necessarily more correct than the other. Rather, the “correctness” depends upon the nature of the problem being analyzed. To assess the risk associated with holding a portfolio of fixed income securities during a period in which interest rates are changing, it is appropriate to look at the absolute measure of changes in rates.3 Thus for any given initial secu rity yield and holding period, a 50-basis point change in interest rates affects the value of that security by about twice as much as an interest rate change of 25 basis points.4 'T h is re la tio n sh ip h o ld s fo r sm all c h a n g e s in ra te s; fo r la rg e r r a te m o v e m e n ts, th e p ro p o rtio n a lity o r c o r r e s p o n d e n c e h o ld s, b u t th e p ro p o r tio n a lity f a c t o r d o e s n o t re m a in c o n s ta n t b e c a u s e th e rela tio n sh ip is n o n lin ear. 'A s sh o w n in M ichael H o p ew ell and G e o rg e G. Kaufm an, “ B on d P ric e V o latility an d T e rm to M atu rity: A G en eralized R e sp e cifica tio n ,” A m erican E co n o m ic R e tie u \ S e p te m b e r 'C h a n g e s in in te re st ra te s also have an im p a c t o n in c o m e in th a t in c o m e a s so cia te d w ith h ig h e r in te r e s t ra te s is r e d is trib u te d fro m b o r r o w e r s to savers. S in ce e a c h o f th e se g ro u p s m ay have d ifferen t m arginal p ro p e n s itie s t o sp en d 1 9 7 3 , pp. 7 4 9 - 5 3 , E q u atio n ( 7 ) , th e p e r c e n ta g e c h a n g e in th e p r ic e o f a se cu rity , A P /P , is p ro p o rtio n a l to th e ab so lu te ch a n g e in th e in te re st ra te , A i, tim e s th e d u ra tio n , D, o f th e secu rity . 16 persist an d a r e likely to p u rc h a s e a d iffe re n t b a sk e t o f g o o d s and s e rv ic e s, in c o m e and e m p lo y m e n t o f m any e c o n o m i c g r o u p s w ill b e a ffe cte d by in te re st r a te c h a n g e s th a t p e rs is t f o r m o re th an a few days o r w eek s. Econom ic Perspectives To gain some insight into these longer-term rate movements, the range of values of a given interest rate over a period of time is used as a proxy' for longer-term in interest rates. Two such measures are shown: the range of rates over thirteen-week (quarterly) and over oneyear periods. Figure 7 shows the range of the federal funds rate over thirteen-week moving periods for the 1971 -82 period. By this measure, the impact of the change in rates on portfolio values since O ctober 1979 seems extraordinary, particularly as a measure of uncertainty. Prior experience would not have predicted the extent o f this volatility' and its effect on portfolio values. Although the extent of quarterly rate swings may have subsided to more “normal” levels in 1982, the impact of the rate swings during 1980 and 1981 on quarterly earnings statements of banks and other financial institutions was particularly severe for those institutions with asset-liability structures not hedged or immunized against in interest rates. This view of rate volatility is shown in Figure 8b which shows a moving one-year range for the prime commercial paper rate over the 18971982 period. Once again, the episodes of high rate volatility occurred in the roughly two decade period prior to the formation of the Fed eral Reserve and during the 1973-75 period. The two years prior to October 1979 were periods of tranquility; and unprecedented, and presumably suings changes unanticipated, volatility followed beginning in 1980. The wealth and spending impacts must have been significant. Interest rate swings are measured over this period in relative terms in Figure 8c. This portrayal of rate volatility illus trates that interest rate swings, relative to the rates in existence at the time, were of the same order of magnitude on several occasions in the past. That is to say, if one had expected money market rates to reach 20 percent, then one should have expected, based on previous expe rience, that rates would move over an eight per centage point range (from 12 percent to 20 p ercent) within this period. In a sense, this experience is not very different than rate move ments from 1.2 percent to 2.0 percent (a move ment of only 80 basis points ) during the 1930s, a period when similar relative rate swings occurred. The longer-run perspective also provides further evidence that the episode of rate be havior shown in Figure 7 is not, then, necessarily due to the Fed’s operating procedures adopted in O ctober 1979. Significant changes in the magnitude of rate swings occurred in the past even before there was a Fed to have operating procedures. In fact a good case can be made that the episode of volatility' illustrated in Figure 7 reflects an interaction between 1) higher infla tionary' expectations that had been developing since the mid-1960s, 2 ) the resultant higher F ig u r e 7 Federal Reserve B ank o f Chicago 17 Figure 8a Figure 8b Figure 8c 18 Econom ic Perspectives n i n iiin r — i i 1975 1985 A interest rates, and 3 ) greater uncertainty about the Fed’s commitment to attenuating these infla tionary forces, particularly in the face of ex tremely large federal budget deficits. Indeed, were it not for the high average level of interest rates—an inevitable result of the inflationary excesses of the late 1960s and early to m id-1970s—it would not have been possible to have rate swings as large as they were in 1979-1981. Thus, with a lower average level of rates, the wealth effects stemming from the last few years’ relative interest-rate volatility would have been less. But to achieve a sustained lower level of interest rates, it is first necessary to reduce inflation and with it, inflationary expec tations, w hich was the goal of the Fed’s October 6, 1979 operating procedures. The relationship between the level of inter est rates and the volatility (as measured by longer-term swings) of interest rates is illus trated clearly in Figures 8a, b, c. Clearly, there is a strong relationship between Figures 8a and b. However, Figure 8c, showing the relative mea sure, shows little, if any, relationship with the level of interest rates. Sum m ary i nr I I I I I | I I i 1975 1985 The charts presented here illustrate a mixed picture of interest-rate volatility. In a longer term historical context, the relative rate volatility of the last few years was not unprecedented, and depending on how and over what period it is measured, rate volatility in the last few years can be shown to be not at all unusual by the stan dards of even the last decade or so. On the other hand, the high level of rates over this recent period has increased the abso lute size of the range of rate movements and it is this measure that has the greatest impact on the value of security portfolios. Nevertheless, these rate movements and their associated wealth effects may have had less to do with the Federal Reserve’s choice of operating procedures than with the extant level of interest rates—deter mined largely by past and anticipated rates of inflation. rl I I i i I l I i i | i i i i i i | i i ) 1975 1985 Federal Reserve Bank o f Chicago 19 What is a bank? John J. Di Clemente In a well known U.S. Supreme Court opinion on pornography, Associate Justice Potter Stewart wrote: . . . criminal laws in this area are constitu tionally limited to hard-core pornography. 1 shall not attempt to define the kinds of material 1 understand to be embraced with in that shorthand description; and perhaps 1 could never succeed in intelligibly doing so. But I know’ it when I see it, and the motion picture involved in this case is not that.1 This “know it when I see it” principle has some adherents in the financial community, par ticularly with regard to the ambiguities sur rounding the question, “What is a bank?” In an article appearing in , Walter Wriston, chairman of Citicorp and Citi bank, discusses banking and its future.2 For Wriston, the banks of the 1990s are already here; the only trouble is that bankers are not running them. Wriston suggests that nonbank companies can now do everything a bank does—and more. Wriston’s view essentially reduces to a set of simple propositions: Banks and bank holding companies are highly regulated entities. At the same time, nonbank companies have been ex panding into areas that had traditionally been the domain of banks. These nonbank companies are not nearly as restricted in what they may offer customers or where they may make the offering. Accordingly, in Wriston’s view, banks and bank holding companies are at a significant competi tive disadvantage. Euromoney J o h n J . Di C le m e n te is a re g u la to ry e c o n o m is t in th e r e s e a r c h d e p a rtm e n t o f th e F e d e ra l R e se rv e Bank o f C h icag o . T his a r tic le is d raw n fro m a le n g th ie r stu d y to a p p e a r as Staff M e m o ra n d a 8 3 - 1 , The M eeting o f P a ssio n a n d In tellec t: A H isto ry o f th e Term "B an k " in th e B an k H o ld in g C o m p an y A ct, F e d e ra l R e se rv e B ank o f C h ica g o , 1 9 8 3 T h e a u th o r th an k s D avid A lla rd ice , K it O ’B rie n , Ed N ash, and D iana But if nonbank financial institutions can do everything a bank can do, why are they not called “banks”? Or, more importantly, why are such nonbank financial institutions relieved of the regulatory burdens to which banks and bank holding companies are subjected? Is banking by its nature so mutable that it defies definition, leaving one to rely on the “know it w hen I see it” principle? It is not the purpose here to attempt a full description of a bank. Without establishing a context in which the term is to be used, it would be nearly impossible to do so. Accordingly, this article seeks to examine the term “bank” only as it is defined in the Bank Holding Company Act of 1956 (th e BHCA) and its later amendments. Inasmuch as the Board of Governors of the Fed eral Reserve System ( the Board) has the respon sibility of administering the BHCA, it is pertinent to determine the Board’s views on what is or is not a bank. Moreover, because the question of whether an institution is a bank for purposes of the BHCA has been litigated only once,' the Board’s views on the subject possess enormous weight. The legislative history Banks, like certain other financial institu tions, act as mediators between borrowers and lenders, making loans and incurring liabilities to creditors ( including deposit holders ). But at the time Congress was debating whether to subject bank holding companies to effective regulation by the Federal Reserve, banks were considered to be “unique” institutions, distinguishable from other financial intermediaries. The uniqueness lay in their power to create liabilities (demand deposits ) that are used as a transaction medium. A la m p rese fo r helpful c o m m e n ts . Ja c o b e llis v. O hio 3 7 8 U.S. 1 8 4 , 1 9 7 ( 1 9 6 4 ) . -’W a lte r B. W ris to n , “ Bank (O c to b e r 1 9 8 1 ). Digitized for20 FRASER n' B u r g e r ”, E u ro m o n ey ' W ilshire O il C o m p an y o f T exas v. B o a rd o f G o v ern o rs o f th e F e d e ral R eserve S ystem , 6 6 8 Fed. 2 d . 7 3 2 ( 3 d . C ir. 1 9 8 1 ). Economic Perspectives This distinguishing feature gave banks a key role in the payments mechanism.4 Because of their preeminent role in the nation’s payments system, banks became subject to stringent federal regulation. The regulator)' framework that developed was one designed primarily to safeguard the integrity of the pay ments mechanism and to protect holders of bank deposit liabilities. But regulation of bank holding companies lagged the development of compre hensive bank regulation by several decades. The call by the Board to regulate bank hold ing companies was made a full decade after the bank failures of the late 1920s and early 1930s. In its the Board noted that its existing authority to supervise bank holding companies under the Banking Act of 1933 was severely limited and that: Annual Report o f 1943 A c c e p t e d r u l e s o f la w c o n f i n e t h e b u s i n e s s o f b a n k s t o b a n k in g a n d p r o h ib it th e m fro m e n g a g i n g in e x t r a n e o u s b u s i n e s s e s s u c h a s o w n i n g a n d o p e r a t i n g in d u s t r i a l a n d m a n u f a c t u r i n g c o n c e r n s . It is a x i o m a t i c t h a t th e le n d e r an d b o r r o w e r o r p o te n tia l b o r r o w e r s h o u ld n o t b e d o m in a te d o r c o n tr o lle d by t h e s a m e m a n a g e m e n t . . . T h e r e is n o w n o e f fe c tiv e c o n t r o l o v e r th e e x p a n s io n o f b a n k h o l d i n g c o m p a n i e s e i t h e r in b a n k i n g o r in a n y o t h e r f ie ld in w h i c h t h e y c h o o s e t o Not until 1956 were the Board’s wishes satisfied by the enactment of the BHCA. The purpose of the BHCA was two fold. First, it was intended to prevent undue concentrations of banking resources by bank holding companies. Second, the BHCA was to control the commin gling of banking and nonbanking interests. The potential adverse consequences of such commingling preyed on the minds of the legisla tors framing the BHCA. Bank holding companies might, for example, insist on making unsound loans to the holding companies’ nonhank affil iates to the eventual detriment of the hank, its depositors, and the public. Or, they might deny credit to or discriminate unfairly against the competitors of their nonbank affiliates. There was also the possibility of tie-in arrangements in which an individual or business would be re quired to purchase additional services offered by the hank holding company as a condition of receiving bank credit. All three consequences revolve around the use of to create an unfair competi tive advantage for the holding company and its subsidiaries. Unfair use of credit by holding companies was thought to have occurred in the past and it seemed therefore reasonable to pro tect against its possible misuse in the future. bank credit e x p a n d . . . T h e B o a r d b e lie v e s , th e r e f o r e , t h a t it is n e c e s s a r y in t h e p u b l i c i n t e r e s t a n d Original a ct—a ch arterin g test in k e e p i n g w i t h s o u n d b a n k i n g p r i n c i p l e s t h a t t h e a c tiv i t i e s o f b a n k h o l d i n g c o m p a n i e s b e r e s t r i c t e d s o le l y t o t h e b a n k i n g b u s i n e s s a n d th a t th e ir a c tiv itie s b e r e g u la te d , as a r e t h e a c t i v i t i e s o f b a n k s t h e m s e l v e s .' The original definition of bank in section 2 ( c ) of the BHCA employed a chartering test. “ Bank” was defined to include: A n y n a tio n a l b a n k in g a s s o c ia tio n o r any s ta te b a n k , s a v in g s b a n k , o r tr u s t c o m p a n y , •In a d ifferen t c o n t e x t , th e U.S. S u p rem e C o u rt a tte ste d to th e " u n iq u e n e s s ” o f c o m m e r c ia l banks in d e cid in g upon b u t s h a ll n o t i n c l u d e a n y o r g a n i z a t i o n o p e r th e leg ality o f a ban k m e r g e r u n d e r th e fed eral a n titru st laws. e ra l R e s e rv e A c t, o r a n y o r g a n iz a tio n w h ic h T h e C o u rt n o te d b an k s’ u n iq u e ability to a c c e p t d em an d d e p o s its an d th e ro le banks play in th e p ro v isio n o f b u sin ess c r e d it. In d e te rm in in g th a t th e c lu s te r o f p r o d u c ts and s e r does not do v ic e s d e n o te d by th e te rm “c o m m e r c ia l ban k in g" c o m p o s e d a d istin c t line o f c o m m e r c e fo r bank m e rg e r analysis, th e C o u rt sta te d : Some commercial banking products or services are so distinctive they are entirely free of effective competition from products or services of other financial institutions; the checking account is in this category. a tin g u n d e r s e c t io n 2 5 o r 2 5 ( a ) o f th e F e d b u s in e s s w ith in th e U n ite d S t a t e s .6* As am en d ed —the activities test As originally enacted, the term “bank” was too broadly defined to accomplish the purposes 321 , 336 6S e c tio n s 2 5 a n d 2 5 ( a ) o f th e F e d e ra l R eserv e A ct p e r m it th e e sta b lis h m e n t o f “A g re e m e n t C o rp o ra tio n s ” and 'B o a r d o f G o v e rn o rs o f th e F ed eral R eserv e System , 3 0 t h ( US. “ E d g e C o r p o r a tio n s ” , re sp e ctiv e ly , w h ich a re to en g ag e p rin cip a lly in in te rn a tio n a l o r fo re ig n banking. (S e e B o a rd ’s R eg u la tio n K c o n c e r n in g in te rn a tio n a l b an king re g u la tio n s.) v. The P h ilad e lp h ia N a tio n a l B a n k , 374 U.S. (1963)-) A n n u a l Report, 1 9 4 3 ( 1 9 4 4 ) , pp. 3 6 -3 7 . Federal Reserve Bank o f Chicago 21 of the legislation. To remedy this defect, when the BHCA was amended in 1966, the definition of bank in section 2 ( c ) was amended to read: “ B a n k ” m e a n s a n y in s titu tio n th a t a c c e p t s d e p o s i t s t h a t t h e d e p o s i t o r h a s a le g a l r ig h t to w ith d ra w o n d e m a n d . . . In explaining the change from a chartering test to an activities test the section-by-section sum mary of the reported bill reads: S e c t i o n 2 ( c ) o f t h e [B H C A ] d e f i n e s “ b a n k ” t o i n c l u d e s a v in g s b a n k s a n d t r u s t c o m p a n ie s , a s w e ll as c o m m e r c i a l b a n k s. T h e p u rp o se o f th e [B H C A ] u n d u e c o n c e n tra tio n w as to re stra in o f c o n tro l o f c o m m e rc ia l b an k c re d it, an d to p re v e n t a b u se b y a h o l d i n g c o m p a n y o f its c o n t r o l o v e r t h is t y p e o f c r e d i t f o r t h e b e n e f i t o f its n o n b a n k in g s u b sid ia rie s . T h is o b je c tiv e c a n b e a c h i e v e d w i t h o u t a p p ly i n g t h e [B H C A ] t o s a v in g s b a n k s , a n d t h e r e a r e a t l e a s t a f e w i n s t a n c e s in w h i c h t h e r e f e r e n c e t o “ s a v in g s b a n k ” in t h e p r e s e n t d e f i n i t i o n m a y r e s u l t in c o v e r i n g c o m p a n i e s t h a t c o n t r o l t w o o r m o r e i n d u s t r i a l b a n k s . T o a v o id th is r e s u l t , t h e b ill r e d e f i n e s “ b a n k ” a s a n in s t i tu tio n th a t a c c e p t s d e p o s its p a y a b le o n d e m a n d (c h e c k in g a c c o u n t s ) , th e c o m m o n ly ac c e p t e d t e s t o f w h e t h e r a n i n s t i t u t i o n is a c o m m e r c i a l b a n k s o as to e x c l u d e in d u s tria l banks and n o n d e p o s it tru s t com p a n ie s ." Although Congress was concerned with the possible abuse of bank business credit, the defi nition of “bank” adopted in 1966 made no men tion of the credit activities of the organizations to be defined. Accepts dem and deposits an d m akes com m ercial loans In 1970, section 2 ( c ) was again amended. The definition of “bank” was narrowed to include: a n y in stitu tio n . . . w h ic h ( 1 ) a c c e p t s d e p o s its th a t th e d e p o s ito r h a s a le g a l rig h t to w i t h d r a w o n d e m a n d , a n d ( 2 ) e n g a g e s in t h e b u s i n e s s o f m a k in g c o m m e r c i a l lo a n s . The added requirement that an institution be engaged in commercial lending was intro- duced by Senator Edward Brooke (R., Mass.). While not explained, the amended definition appears to be consistent with the original intent of the BHCA. Section 2( c ) was most recently amended by enactment of the Garn-St Germain Depository Institutions Act of 1982 (P.L. 97 -3 2 0 ). The act excludes from the definition of “bank” any insti tution that is insured by the Federal Savings and Loan Insurance Corporation or chartered by the Federal Home Loan Bank Board. (The signifi cance of this exclusion is addressed here in the section entitled “Are Thrifts Banks?” ) A narrow ing o f definitions With each successive amendment of sec tion 2 (c ), the definition of “bank” has been nar rowed, having moved from a chartering test in 1956 to activities tests in 1966 and 1970. Unfor tunately, Congress left little more than the defi nitions cited as a guide in the administration of the BHCA. Of course, the Board can rely on the purposes and objectives of the BHCA in carrying out its mandate. This course of action is not without pitfalls, for it may be the case in certain situations that the BHCA’s literal language and Congressional intent are not in harmony. In these circumstances, the Board has given rela tively greater weight to the BHCA’s purposes. ( See discussion of , below .) Wilshire B oard adm inistration o f th e BHCA and th e definition o f “bank” The recent ( 1 9 8 2 ) decision by the Comp troller of the Currency approving the application of McMahan Valley Stores of Carlsbad, Calif., to establish banking units in its retail furniture stores is one in a series of events which raise the issue of the proper definition of “bank” for BHCA purposes. Reportedly, the establishment de novo of Western Family Bank by McMahan Valley Stores marks the first time the Comptroller’s office has granted a nonfinancial institution permission to open a bank.8 Other initiatives in "B ank H o ld in g C o m p a n y A ct A m e n d m e n ts o f 1 9 6 6 , S. R ept. 1 1 7 9 , 8 9 C o n g ., 2 d Sess. 22 8 W all Street J o u r n a l, A u gust 1 0 , 1 9 8 2 , p. 3 8 . Econom ic Perspectives the recent past also have important ramifications for the financial system and the Board’s adminis tration of the BHCA and its interpretation of the term “bank”. Among these are the acquisition of Valley National Bank of Salinas, Calif., by House hold Finance Corporation and the acquisition of Fidelity National Bank, Concord, Calif., by Gulf & Western Corporation. All three of these “bank” acquisitions have been by nonbank holding companies. Since, by definition, a company that owns or controls a bank is a bank holding company and therefore subject to regulatory review of its activities and acquisitions, why were these bank acquisitions not subject to official Board review and approval? Why are not Gulf & Western, McMahan, and Household Finance deemed to be bank holding companies pursuant to the BHCA? The answer to these questions lies in the definition of the term bank in section 2 ( c ) of the BHCA and action taken by the acquirers of these institutions ( which, for lack of a better term, may be referred to as “consumer banks” ) to substantially alter the institutions’ activities so that they fall outside the reach of that definition. The definition of bank as contained in sec tion 2 ( c ) of the BHCA as amended in 1 9 7 0 has three elements: ( 1) location; ( 2 ) the accep tance of demand deposits; and ( 3 ) the engage ment in commercial lending activities. The defi nition expressly excludes those organizations, such as Edge Act and Agreement Corporations, whose major purpose is to finance and facilitate international and foreign trade. In addition, fed erally chartered or insured savings and loan associations and savings banks are excluded from coverage. The location element has raised few inter pretative problems since its administration. But, elements ( 2 ) and ( 3 ) serve to define those activ ities which make an institution a “bank” for pur poses of the BHCA. One note of caution is in order. The inter pretations and postures by the Board are usually developed within a framework of particular applications or proposals, each with their own set of circumstances. Therefore, not only is it important to read the Board’s words at their face value, it is also of paramount importance to Federal Reserve Bank o f Chicago understand the circumstances surrounding the words.9 D efining the activities w hich make institutions “banks” The table “Board Actions Bearing on the Definition of Bank’ ” lists cases in which the Board or its staff undertook to define the activi ties which make institutions “banks” for BHCA purposes. The table is divided into two sections to allow an examination of the specific question of whether thrift institutions should be regarded as “banks.” W hat is a “co m m ercial loan ” and what is m eant by “engages in the business o f m aking co m m ercial loan s”? The commercial loan element of section 2 ( c ) has been addressed by the Board in several letters written in the early 1970s. It has been most recently addressed in the Board’s con sideration of a proposal by Dreyfus Corporation, New York, N.Y., to acquire banks in New Jersey and New York in 1982. The Board’s earliest pronouncement under the 1970 definition of bank in section 2 ( c ) was made in a letter responding to a proposal by Greater Providence Deposit Corporation to have its commercial bank divest itself of its commer cial loan business. The question before the Board, therefore, was, “What is a commercial loan?” In response to the proposal, the Board wrote that it . . . is o f t h e v i e w t h a t “ c o m m e r c i a l l o a n s ” , a s u s e d in s e c t i o n 2 ( c ) , m u s t b e r e g a r d e d a s i n c l u d i n g a ll l o a n s t o a c o m p a n y o r in d i v i d u a l , s e c u r e d o r u n s e c u r e d , o t h e r th a n a lo a n th e p r o c e e d s o f w h ic h a r e u s e d to a c q u i r e p r o p e r t y o r s e r v i c e s u s e d b y th e 9In a d d itio n to th e BH C A , th e B o a rd h as th e re sp o n sib il ity o f a d m in is te rin g o t h e r leg islatio n w h ich n e c e s s ita te s from tim e to tim e a d e fin itio n o f c e r t a in te r m s s u ch as “d em an d d e p o s its .” ( See, fo r e x a m p le . R e g u la tio n s D an d Q . ) B e c a u s e th e se o t h e r R e g u la tio n s a d m in is te re d by th e B o a rd w e r e fo rm u la te d fo r d iffe re n t p u rp o s e s , it is p o ssib le fo r th e te rm "d e m a n d d e p o s its " to b e d efin ed o n e w ay fo r p u rp o s e s o f th e BH C A and in s o m e o t h e r m a n n e r fo r o t h e r r e g u la to r)’ p u rp o se s. 23 B oard A ctio n s B earin g on the Definition of " B a n k ” C ase Is s u e G r e a t e r P r o v id e n c e Would a commercial bank continue to be a "bank" upon divestiture Letter of July 1, 1971 of its commercial loan business? B o a rd R e s o lu tio n Commercial loans are considered all loans to individuals or businesses, secured or unsecured, other than a loan the proceeeds of which are used to acquire property or se rv ice s used by the borrower for his own personal, family, or household purposes, or for charitable purposes. If the commercial bank ce ase s to engage in the business of making commercial loans, either directly or indirectly, it would not be a "bank”. G r e a t e r P r o v id e n c e Letter of July 29, 1971 To what extent may a demand deposit-taking institution support the commercial lending functions of affiliated A demand deposit-taking institution may not supply or make available funds to any commercial lending affiliate except through dividends. Section 2(c) contemplates a single organizations? B a n q u e N atio n a l d e P a r is 58 F R B 311 (March 1972) institution and is inapplicable when there are two truly separate entities. Are credit balances at Article XII New York Investment Com panies the equivalent of demand d ep osits? Credit balances at Article XII New York Investment Com panies are not demand deposits because such balances arise only incidentally to transactions which such institutions are legally permitted to perform. New York Invest ment Com panies may not accept deposits and credit balances may not be used in the sam e manner as checking accounts other than to make payments in connection with the importation or exportation of goods. B o s to n S a f e D e p o s it Loans made to individuals that are used for occasionally makes loans to Letter of June 8, 1972 Is a trust company that business purposes are "commercial loans". individuals who use the proceeds for business purposes a "bank"? However, the trust company would not be deemed to be engaged in the business of making commercial loans if: (1) such loans are made on a limited and occasional basis; (2) the loans are made as an accommodation to trust custom ers; (3) com mercial loan business is insignificant in relation to the trust company's total business; and (4) the institution does not solicit commercial loan business or maintain a credit department. T h e B a n k of T o k y o , Ltd. Would a company established to The institution would not necessarily be a engage in international transactions and empowered to received "due-to customer accounts", which are similar to credit balances at New York "bank". However, because it would closely resemble a "bank", permitting its establishment Investment Com panies, be a "bank"? companies. E u r o p e a n - A m e r ic a n Should Article XII New York Investment Com panies be 63 regarded as "banks”? Although credit balances at New York Investment Com panies are in many respects the functional equivalent of demand deposits, such companies should not be regarded as "banks" because (1) they may not offer checking account facilities to the general public; (2) there exist legal, 61 F R B F R B 449 (July 1975) 595 (June 1977) would violate the spirit of section 3(d) of the B H C A (the “ Douglas Amendment"), which limits interstate banking by holding historical, and adm inistrative distinctions between credit balances and deposit accounts in New York; and (3) C o n g re ss exhibited a general intent to exclude international banking corporations from the definition of "bank". 24 Econom ic Perspectives C ase Is s u e B o a rd R e s o lu tio n W ils h ir e Would Trust Company of New The Board is not bound by labels that parties Order of April 2, 1981 Jersey, Je rse y City, N.J., ce ase to be a bank upon conversion of its may place on transactions. The Board must look to the substance of transactions to determine whether they fall within the ambit demand deposit accounts to NOW accounts while still engaging in a commercial loan business? of the purposes of the BH CA. B ecause the conversion of the demand deposit accounts would have no real economic effect upon the bank and its deposit holders it would not serve to remove such accounts from the definition of "demand deposits” in section 2(c). W ils h ir e O il C o m p a n y of T e x a s v. B o a rd 668 Fed. 2d 732 (3d Cir. 1981) Would Trust Com pany of New Jersey, Je rsey City, N.J. cease to be a bank upon conversion of its demand deposit accounts to NOW accounts while still engaging in a commercial loan business? G u lf & W e s t e r n (Court decision) Board may look beyond the plain language in B H C A to ensure that application of the literal terms does not destroy the practical operation of the statute. Trust Com pany of New Je rsey is the type of institution that C o n g re ss meant to include in the definition of bank. D r e y f u s C o rp o ra tio n Letter of Decem ber 10, 1982 Gulf & W estern would not be a bank holding National Bank, Concord, Calif., if the bank divested itself of its commercial loan business? Letter of March 11, 1981 Would Gulf & W estern become a bank holding company upon the indirect acquisition of Fidelity of its commercial loan portfolio; its commitment to limit its lending to loans for personal, Would the Dreyfus Corporation become a bank holding company upon the acquisition of Lincoln State Bank, East Orange, N .J? How broad is the definition of “commercial loans"? company because Fidelity National Bank would no longer be a "bank" given the divestiture household, family, or charitable purposes; and the complete separation of deposit-taking activities from commercial lending activities of affiliates. The definition of “commercial loans" is broad in scope and includes the purchase of such instruments as commercial paper, bankers acceptances, certificates of deposit, and the sale of federal funds. If Lincoln Sta te Bank continues to accept demand deposits and purchases instruments of this type it would be a "bank" and the Dreyfus Corporation would be a bank holding com pany upon its acquisition. T h rift C a s e s C ase A m e r ic a n F le t c h e r 60 F R B 868 (Decem ber 1974) Is s u e Is the operation of a savings and loan association closely related and a proper incident to banking? B o a rd R e s o lu tio n The operation of savings and loan associations is closely related to banking. Board noted trend of lessening distinctions between thrifts and banks and indicated that should the trend continue thrifts may become "banks". In context of the particular proposal, the acquisition of a savings and loan a ss o ciation by a bank holding company w as considered a proper incident but the application was denied as a result of adverse financial factors and Board's “go slow" policy respecting nonbank acquisitions. (C o n t. o n Federal Reserve Bank o f Chicago n e x t p a g e .) 25 C ase Is s u e B o a rd R e s o lu tio n D .H . B a ld w in Is the operation of a thrift institution in general a proper Board affirmed its decision in A m e r i c a n F l e t c h e r that operation of savings and loan 63 activity for bank holding com panies? asso ciation s is closely related to banking. However, in general, such activities are not a proper incident to banking based on concerns relating to F R B 280 (March 1977) (1) the issue of regulatory conflict and problem of determining the permissible scope of savings and loan activities as conducted by a bank holding com pany affiliate; (2) possible erosion of institutional rivalry of banks and thrifts under common ownership; and (3) the possible undermining of the interstate banking prohibitions in section 3(d) of the BH CA. Board stated that C o n g ress should decide whether thrifts should be regarded as "banks" or “nonbanks” under the BH CA. F ir s t B a n c o rp o ra tio n / B e e h iv e 68 F R B Are N OW deposits at thrift institutions the equivalent of "demand dep osits”? 253 (April 1982) Board noted that institutions accepting NOW deposits reserve the right to require between 14-30 days' prior notice of withdrawal. But, this right is rarely invoked. Thus, for purposes of section 2(c), the Board believes that until the institution invokes the notice requirement, the depositor has a right to withdraw funds on demand. Accordingly, an institution that engages in commercial lending and accepts N O W deposits is a "bank". In te r s ta te / S c io to 68 F R B 316 (May 1982) Given that N OW deposits are equivalent to demand deposits in section 2(c), would a thrift whose commercial lending powers exceed those of federally chartered thrifts be a "bank"? Any thrift which accepts N O W deposits and exercises commercial lending powers beyond those granted federally chartered thrifts would be a"b ank". To become "nonbanks", such institutions must agree to limit their commercial lending activities so as to achieve parity with federally chartered thrifts. B a n k E a s t C o rp o ra tio n / P o rtsm o u th 68 F R B 379 (June 1982) Is the operation of a guaranty savings bank in New Hampshire a perm issible activity for bank holding companies given the fact that their commercial lending authority exceeds that of federally chartered thrifts? Guaranty savings banks are unique to New Hampshire and resemble savings banks. Their commercial real estate lending authority exceeds that of federally chartered thrifts. The acquisition, therefore, would be approved conditioned on the guaranty savings bank's promise to limit its commercial lending in order to achieve parity with federally chartered thrifts. C itico rp /F id e lity Are thrifts "banks" under the B H C A as certain protestants to 68 the proposal asserted ? F R B 656 (O ctober 1982) Board concluded that federal savings and loan associations are not "banks" under the B H C A for two main reasons. First, the lending activities of such institutions are highly specialized, concentrated as they are in home mortgages. Secondly, C o n g re ss had designed a separate and independent statutory structure for the regulation of federal savings and loan asso ciation s and their hold ing companies. Moreover, C o n g re ss included federal savings and loan asso ciation s under the definition of thrift institutions in section 2(i) of the B H C A . C o n gress did not intend to have federal savings and loan asso ciation s to be regarded as "banks". 26 Econom ic Perspectii >es borrower for his own personal, family, or household purposes, or for charitable pur poses . . . if your commercial bank ceases to engage in the business of making com mercial loans of this type either directly or indirectly by channeling deposits to an affil iated institution which does make loans of this type, it would not fall within the defini tion of “bank” . . ,1 0 This rather broad definition of “commercial loans” was expanded upon by the Board most recently in comments provided to the Federal Deposit Insurance Corporation regarding a pro posal by Dreyfus Corporation, a mutual fund manager, to acquire Lincoln State Bank, East Orange, N.J. In this letter the Board stated that the definition of “commercial loans” is: broad in scope and includes the purchase of such instruments as commercial paper, bankers acceptances, and certificates of deposit, the extension of broker call loans, the sale of federal funds, and similar lending vehicles." Even if an institution ceases to “engage in the business of making commercial loans”, the Board would still require assurances that the resulting demand deposit-taking institution not support the commercial lending activities of affiliates. In its letters in and , the Board indicated that the separability of deposit-taking institutions from affiliates engaged in commercial lending was to be complete if they are to avoid the appellation of “bank.”12 That is, deposit-taking institutions would not be allowed to supply or to make avail able funds derived from the acceptance of demand deposits or from other sources (except through dividends) to any commercial lending affiliate. The basis for this total separation is dic- Gulf & Western Greater Proindence " ’L e tte r d a te d J u ly 1, 1 9 7 1 , fro m K e n n e th A. K en y o n , D e p u ty S e c r e ta r y , B o a r d o f G o v e r n o r s , t o B ia g g io M. M a g g ia co m o , C o rp o ra tio n . P re s id e n t, G r e a te r P ro v id e n ce D e p o s it " L e t t e r d a te d D e c e m b e r 1 0 , 1 9 8 2 , fro m W illiam W . W ile s, S e c r e ta r y , B o a rd o f G o v e rn o rs, to W illiam M. Isaac, C h a irm an , F ed eral D ep o sit In su ran ce C o rp o ra tio n . fated by section 2( c ), which, in the Board’s view, contemplates a single institution and which would not apply where there are two truly separate entities. Even though an institution may extend commercial credit, it may not be “engaged in the business of making commercial loans” under certain circumstances. The Board had decided in the that although the demand deposit-taking institution did at times make “commercial loans”, it was not engaged in the business of making such loans within the meaning of section 2 ( c ) .1' The basis for this determination was fourfold: Boston Safe Deposit case ( 1 ) Boston Safe Deposit and Trust Com pany did not make commercial loans except on a limited and occasional basis; ( 2 ) the loans it made were to its trust cus tomers as an accommodation; ( 3 ) in any event, such loans w ere not in an amount in excess of two percent of Boston Safe Deposit and Trust Com pany’s total assets; and ( 4 ) Boston Safe Deposit and Trust Com pany did not solicit commercial loan business and did not maintain a credit department. Accepting D em and Deposits In order to be a bank within the meaning of section 2 (c ), an institution, in addition to being engaged in commercial lending, must also accept deposits that the depositor has a legal right to withdraw on demand. The legislative history' of section 2 ( c ) reveals that Congress used the term “demand deposits” and “checking accounts” interchangeably. Accordingly, it would appear " L e t t e r d a te d Ju ly 2 9 , 1 9 7 1 , fro m T h o m a s J. O ’C o n n ell, G e n e ra l C o u n s e l, B o a rd o f G o v e rn o rs, t o E rn e st N. A gresti, Esq. and le tte r d a te d M arch 11, 1 9 8 1 , from J a m e s M cA fee, A ssistant S ecretary , B o ard o f G o v e rn o rs, t o R o b ert C. Z im m e r, Esq. Federal Reserve Bank o f Chicago 1’ L e tte r d a te d J u n e 8 , 1 9 7 2 , fro m M ich ael A. G re e n sp a n , A ssistan t S e c re ta ry , B o a rd o f G o v e rn o rs, to L a u re n c e H. S to n e , V ic e P re s id e n t and G e n e ra l C o u n se l, F e d e ra l R eserv e Bank o f B o sto n . 27 reasonable to interpret the section to encom pass any organization that offered checking accounts to the general public. The case of v. , 6 6 8 Fed. 2d 732 ( 3d Cir. 1981), is the only case involving a judicial inter pretation of the term “bank” under the BHCA. And revolving as it does around the proper defi nition of the term “demand deposits”, it is inval uable to any understanding of how that term is applied by the Board. The case involved Wilshire Oil Company of Texas, Jersey City, N.J., which became a bank holding company on December 3 1 ,1 9 7 0 , as a result of the 1970 Amendments to the BHCA. At the time Wilshire Oil Company became a bank holding company by virtue of its ownership of Trust Company of New Jersey, Jersey City, N.J. (Trust Company), it also en gaged in various nonbank activities deemed impermissible for bank holding companies. Wilshire Oil Company was required either to cease engaging in the impermissible nonbank activities or to divest itself of its commercial bank by December 31, 1980. Wilshire Oil Company informed the Board that it intended to retain its nonbanking interests and that it would comply with the BHCA and cease to be a bank holding company through a plan whereby Wilshire Oil Company would alter the demand deposit-taking activities of Trust Company. The plan called for Trust Company to notify its demand deposit holders of Trust Company’s reservation of the right to require 14 days’ prior notice of withdrawal from such accounts. It was believed that this reservation of right to prior notice would legally remove the affected ac counts at Trust Company from the definition of demand deposit in section 2 (c ). The Board, in its Final Decision and Order of April 2, 1981, rejected Wilshire Oil Com pany’s contention. The Board concluded that Trust Company was a bank; Wilshire Oil Com pany was a bank holding company; and that the retention of Trust Company beyond 1980 re sulted in a violation of the BHCA. The Board’s reasoning, as reflected in the Final Decision and Order, was that the reserva Wilshire Oil Company o f Texas Board o f Governors Wilshire 28 tion of the right to require 14 days’ prior notice was a “sham transaction” intended solely to evade the BHCA’s requirements.1 4 Wilshire Oil Company petitioned the Court of Appeals for the Third Circuit for review of the Board’s action, centering its position on the literal reading of the BHCA. The Court of Appeals decided in favor of the Board, stating, in what amounted to a paraphrase of the Board’s Final Decision and Order, that: W h i l e t h e l a n g u a g e o f t h e [B H C A ] m a y b e t h e s t a r t i n g p o i n t in c o n s t r u i n g t h e s t a t u t e , w e m a y l o o k b e y o n d t h e p l a i n l a n g u a g e , if n e c e s s a r y ', t o e n s u r e t h a t a p p l i c a t i o n o f t h e lite ra l te r m s d o e s n o t d e s tr o y th e p r a c t i c a l o p e r a t i o n o f t h e s t a t u t e . 1' The Court of Appeals concluded that Trust Company is the type of institution that Congress meant to include within the definition of bank under section 2 ( c ) because Trust Company had made no functional change in its banking opera tions and the reservation of a right to require notice had no practical effect on the bank’s deposits.1 6 Wilshire Oil Company’s appeals were denied and the Circuit Court’s decision stands as the only judicial interpretation of the scope and applicability of section 2 ( c ) and the limits of the Board’s authority' with respect thereto. Credit Balances The issue of whether certain credit bal ances may be designated as being the functional equivalent of “demand deposits” has come before the Board on several occasions. ( See the , and cases in table.) This issue is particularly relevant as it concerns companies organized under Article XII of New York State Banking Law (so-called Article XII Investment Companies). Such companies have traditionally been employed as entry vehicles by foreign con cerns seeking to enter the U.S. and engage pri marily in facilitating foreign commerce. Banque National de Paris The Bank o f Tokyo, Ltd., European-American 1‘ Final D e cisio n and O rd e r, p. 1 3 , 18. 1' W ilshire Oil C o m p an y o f T exas v. B o a rd o f G o v e rn o rs o f th e F ederal Reserve System . 6 6 8 Fed. 2 d at 7 3 3 . '"Ibid., at 7.38. Econom ic Perspectives Credit balances arise from, and may be used to settle, a variety of transactions. Sources of credit balances at New York Investment Com panies may include, for example, the collection of bills of exchange, the sale of securities by customers, and the collection of interest pay ments and dividends on securities held for cus tomers’ accounts. Credit balances are primarily distinguishable from demand deposits because they only arise from customers who utilize other services at a New York Investment Company. Nonetheless, because such companies possess most of the powers of commercial banks in New York ( except being able to accept deposits) and since credit balances bear a close resemblance to demand deposits, the question has arisen as to whether they should be regarded as “banks” under the BHCA.1 7 The Board has maintained that credit bal ances at New York Investment Companies and similar organizations should not be regarded as demand deposits within the meaning of section 2 ( c ) and that such companies should not be considered to be “banks”. The Board’s determination in the matter of credit balances rests on several considerations. First, credit balances arise only incidentally to transactions legally permitted to New York Investment Companies. Such companies are not authorized to solicit or accept deposits of idle funds. Second, credit balances lack the conven ience characteristics of general checking ac count facilities since such balances may not be used in the manner of a checking account for personal or business transactions other than to make payments in connection with the importa tion or exportation of goods. Third, Congress had exhibited a general intent to exclude inter national banking corporations from the defini tion of “bank” in the BHCA.1 8 ''T h e g e n e ra l p o w e r s o f N e w Y o r k In v e stm e n t C o m p a n ies a r e e n u m e r a te d at s e c t io n SOS o f A r tic le XII o f th e N ew Y o r k B ank ing Law . S e ctio n 5 0 9 o f A rticle X II p ro v id e s th at: . . . nothing contained in this article shall prevent an investment company from maintaining for the account of others credit balances incidental to, or arising out of, the exercise of its lawful powers . . . l8S ee th e d isse n t by G o v e r n o r D avid M. Lilly in E urop e a n -A m e ric a n b a se d o n his v iew th at th e N ew Y o rk In v est m e n t C o m p a n y sh o u ld b e r e g a rd e d as a “b an k ," n o tin g th e a n o m a ly th a t, fo r m o n e ta ry p o lic y p u rp o s e s , th e B o a rd v iew s c r e d it b a la n c e s and d e m a n d d e p o s its as eq u iv alen ts. Federal Reserve Bank o f Chicago Are thrifts “banks”? The issue of whether thrift institutions ( sav ings and loan associations and savings banks) should be viewed as “banks” has broad implica tions for the future development of the financial services industry. As one example, if thrifts were deemed to be “banks” any company owning or controlling such a thrift would be subject to the BHCA. As it stands, under the Savings and Loan Holding Company Act19 companies owning but one savings and loan association are not subject to extensive regulation regarding the activities in which they7may permissibly engage. The history7 of bank/thrift affiliation is a tangled web of public policy concerns which have been addressed in previous Board Orders. (See the , , and cases in the table.) Here, the focus is whether the Board views thrift institu tions as “banks” or “nonbanks” under the BHCA. With the Board had determined that the operation of savings and loan associations is “closely related to banking”. Indeed, the Board noted the lessening of distinc tions between commercial banks and savings and loan associations.20 The Board, however, was not yet ready to bestow the title of “bank” upon savings and loan associations. In , the Board affirmed its decision that the operation of savings and loan associations is closely related to banking. But the board left it for Congress to decide whether such near-banks as savings and loan associations should be regarded as “banks” or “nonbanks”. Since , the powers of federally chartered thrifts have been significantly ex panded by the Depository Institutions Deregula tion and Monetary Control Act of 1980. The act authorized the issue of NOW accounts, which function as the equivalent of checking accounts at a commercial bank. Moreover, the asset powers of federal thrifts were considerably expanded.2 * 1 2 American Fletcher D.H. Baldunn Citicorp/Fidelity American Fletcher D.H. Baldunn D.H. Baldunn '’ S e c tio n 4 0 8 o f th e N ation al H o u sin g A ct. 2,1A m e ric an Fletcher, p. 8 6 9 . 2'S e e E co n o m ic Perspectives, S e p te m b e r /O c to b e r 1 9 8 0 , F e d e ra l R e se rv e Bank o f C h ica g o , e sp e cia lly pp. 1 8 -2 2 . 29 Given the expanded powers of thrifts, was the Board willing to regard them as “banks” under the BHCA? The answer to this query came in the Board’s discussions of the First Bancorporation/Beehive, Interstate/Scioto, BankEast Cor poration/Portsmouth, and Citicorp/Fidelity cases. ( See table.) First, the Board in determined that NOW deposits are demand deposits for the purposes of section 2 (c ). The Board noted that while institutions accepting NOW deposits reserve the right to require between 14-30 days’ prior notice of withdrawal, in practice the right is rarely in voked.2- Accordingly, a nonbank subsidiary of a bank holding company may not accept NOW deposits and also engage in the business of mak ing commercial loans, for such institutions are “banks” for BHCA purposes. Having concluded that the combination of accepting NOW deposits and making commer cial loans would qualify' an institution as a “bank”, the Board sought to distinguish the activ ities of savings and loan associations and savings banks from commercial banks. The basis for this reflects several considerations. First, the Board noted that the lending activ ities of federal savings and loan associations have historically been highly specialized and that such institutions continue to concentrate their loan portfolios in home mortgages. Second, the Board noted the design by Con gress of a separate and independent statutory' structure for regulation of federal savings and loan associations and their holding companies. Moreover, Congress, in constructing the BHCA, included federal savings and loan associations within the definition of thrift institutions under section 2 ( i) of the act. This, the Board stated, provided evidence of Congress’ intent not to have federal savings and loan associations re garded as “banks” under the BHCA.2' Beehive First Bancorporation/ Garn-St G erm ain powers for federally chartered thrifts. After Jan uary' 1, 1984, for example, both savings and loan associations and savings banks will be able to commit up to 10 percent of assets in direct commercial loans. The Board’s position that has been articu lated in and revolves around the then existing limited commercial lending powers of federally chartered thrifts. Any legislation that broadens thrift lending pow ers w ould necessitate that the Board reevaluate its position. Indeed, it might well have been that enactment of the Garn-St Germain legislation would have undermined the basis for the existing exemption of thrift holding companies from the BHCA. After all, the Board had previously stated that “to the extent regula tion is necessary at all, institutions providing the same services should be subject to substantially the same regulation in providing these services, regardless of their form of organization.”24 Congress, apparently, was aware of the dilemma the Board would have encountered had it merely expanded the commercial lending powers of thrifts w ithout indicating an intent to exclude federal thrifts from the definition of “bank”. Thus, Congress amended section 2 (c ). Section 333 of Garn-St Germain expressly ex cludes from the definition of “bank”, “an institu tion the accounts of which are insured by the Federal Savings and Loan Insurance Corporation or an institution chartered by the Federal Home Loan Bank Board.” Even though thrifts, exercis ing all the powers authorized under Garn-St Germain, may begin to resemble commercial banks to a significant extent, they would not be deemed “banks” for the purposes of the BHCA.2S* I Interstate/Scioto, First Bancorporation/ Beehive, BankEast/Portsmouth, Citicorp/ Fidelity •^“ S ta te m e n t by Paul A. V o lck e r, C h a irm a n . B o a rd o f G o v e rn o rs, b e fo re th e C o m m itte e o n Banking, H o using, and I rban Affairs, O c t o b e r 2 9 . 1 9 8 1 , " F ed eral R esert'e B ulletin, Vol. 6 7 (N o v e m b e r 1 9 8 1 ), pp. 8 3 3 - 4 5 . -Mn a d d itio n to th e e x p a n d e d c o m m e r c i a l len d in g The Garn-St Germain Depository' Institu tions Act of 1982 provides for new lending2 * p o w e r s alread y r e fe rre d to , G arn-St G e rm a in a u th o riz e s, a m o n g o t h e r th ing s, th e a c c e p t a n c e o f d e m a n d d e p o sits; in v e stm e n t in n o n re sid e n tia l real p r o p e rty up to 4 0 p e r c e n t o f a s se ts; in v e stm e n t in c o n s u m e r lo a n s up t o 3 0 p e r c e n t o f 22First B a n co rp o ra tio n /B e eh iv e, p. 2 5 3 - 30 asse ts; and in v e stm e n t in p e rso n a lty up to 1 0 p e r c e n t o f - ' C iticorp/Fidelity , pp. 6 0 - 6 1 . assets. Econom ic Perspectives Sum m ary and con clu sion The BHCA was enacted to effectively limit the concentration of control over banking re sources by bank holding companies and to separate banking from nonbanking interests. At the time the act was passed there was little debate on what constituted a bank. In fact, the act employed a chartering test to separate banks from nonbanks. However, this simple chartering test was found to be largely inconsistent with the purposes of the act. Through amendments to section 2 ( c ) of the BHCA, the definition of the term “bank” has been narrowed so that an insti tution must now satisfy a two-part activities test to be called a bank. The activities which make an institution a “bank” are ( 1) accepting demand deposits and ( 2 ) engaging in commercial lend ing activities. A review of letters and orders of the Board and its staff reveals that: • “Commercial loans” are considered to be all loans to individuals or businesses, secured or unsecured, except loans the proceeds of which are used for personal, household, family, or char itable purposes. The term also includes the pur chase of such instruments as commercial paper, bankers acceptances, certificates of deposit, and similar instruments. • To be “engaged in the business of making commercial loans”, an institution needs to con duct a regular commercial loan business on a more or less unlimited basis with such business constituting a significant portion of the institu tion’s total business. • The term “demand deposits” represents any deposit available to the general public which is accessible through checks or drafts payable to third parties. • The term “bank” contemplates a single institution. However, assurances must be given to insure that affiliate organizations are truly separate organizations and that the deposit taking activities of one affiliate are not support Federal Reserve Bank o f Chicago ing the commercial lending activities of another affiliate. Are thrifts banks for the purposes of the BHCA? Thrifts have typically been distinguished from banks as a result of their limited ability to offer services to commercial enterprises. Recent legislative initiatives have increased the com mercial lending authority of federally chartered thrifts. Based on previous rulings, the Board would have had to reevaluate its position. Congress was cognizant of the dilemma that the Board would have faced and in Garn-St Germain explicitly excluded federally chartered or insured savings and loan associations and sav ings banks from the definition of “bank”. Al though thrifts begin to resemble banks to a marked degree, they are not deemed to be “banks” for BHCA purposes. But whether insti tutions that possess the powers of federally char tered thrifts but are not federally chartered or insured are “banks” remains an open question. The Board has indicated that it is prepared to recommend changes in the definition of “bank” to Congress.26 The Board views certain acquisitions of ’’consumer banks” or “nonbank banks” by nonbanking companies as attempts to evade the requirem ents of the BHCA. The attempts by Dreyfus Corporation, a mutual fund manager, to acquire a bank in New Jersey and to establish a de novo bank in New York provide recent confirmation of this trend. It has becom e increasingly difficult to separ ate banks from nonbanks. These difficulties arise partly as a result of financial innovation spurred by the desire of institutions to avoid costly regu lation. Moreover, with increasing technological change, the term “bank” may becom e an anach ronism. In order to maintain the integrity of the BHCA, it is essential that consideration be given to revising the term “bank” so as to accomplish the purposes of the act without causing undue economic dislocations. " S e e B o a r d ’s D rey fu s C o rp o ra tio n le tte r, o p . cit. 31 ECONOMIC PERSPECTIVES Public Information Center Federal Reserve Bank of Chicago P.O. Box 834 Chicago, Illinois 6 0 6 9 0 P le a se a tta c h a d d re s s lab el to c o r r e s p o n d e n c e r e g a rd in g y o u r s u b scrip tio n . BU LK RATE U .S. P O S TA G E PAID C H IC A G O , ILLIN O IS PERMIT NO. 1942
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