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© ECONOMIC PERSPECTIVES m The Midwest prepares for interstate banking Regulatory innovation: The new bank accounts (bo) BKBES ( ECONOMIC PERSPECTIVES March-April 1984 Volume VIII, Issue 2 ^ E d ito ria l C o m m itte e vice president and associate director o f research Randall C. Merris, research economist Edward G. Nash, editor Harvey Rosenblum, graphics typesetting editorial assistant Roger Thryselius, Nancy Ahlstrom, Gloria Hull, Econom ic Perspectives is published by the Research Department of the Federal Reserv e Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the management of the Federal Reserve Bank of Chicago or the Federal Reserve System. Single-copy subscriptions are avail able free of charge. Please send requests for single- and multiple-copy subscrip tions, back issues, and address changes to Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690, or telephone (3 1 2 ) 322-5111. Articles may be reprinted provided source is credited and Public Information Center is provided with a copy of the published material. ___________ :_________________) IS S N 0 1 6 4 -0 6 8 2 C o n te n ts The Midwest prepares for interstate banking 3 Regulatory innovation: The new bank accou n ts 12 Midwestern bankers, quietly moinng into per missible areas of interstate banking, are probably exporting more banking services than the Midwest imports from other areas As the dust settles after the introduction of MMDAs and SNOWs, economists can more clearly see what happened and what it means for banking operations and monetary>policy T h e M idw est p re p a re s fo r in te rs ta te b an k in g Sue F. G reg orash Although interstate banking is not yet a nation wide reality and remains prohibited by the McFadden Act and the Douglas Amendment to the Bank Holding Company Act of 1956, many have already begun to hail its arrival. A variety of banking and related services are currently avail able on a multistate basis. For instance, a grow ing list of nonbanking activities permitted by section 4 ( c ) ( 8 ) of the Bank Holding Company Act of 1 9 5 6 —such as equity'financing, securities brokerage services, and futures commission mer chant activities—may be offered by bank holding com panies without geographical limitation. Banks may also expand across state lines via loan production offices, Edge Act corporations, and electronic funds transfer (E F T ) networks. In addition, the Garn-St Germain Depository Insti tutions Act of 1982 provides opportunities for banking organizations to purchase failing finan cial institutions across state lines. A question important to midwestem bank ing organizations and consumers in need of financial services is whether the region is a net supplier of such services to the rest of the coun try or a net importer of these services from outof-state institutions. The geographic source of financial services becom es an increasingly im portant issue as banking regulations are relaxed and as nationwide competition among banks and nonbank financial institutions increases. Con sumers benefit, both in the availability and price of services, when competition is keen. This article analyzes Seventh District finan cial services to determine whether the District is a net importer or exporter of financial serv ices. After analyzing current interstate banking activ ity coming from, or directed toward, the five Seventh District states, it is concluded that, although the District is a net supplier of inter-* Sue F. Gregorash is a regulatory economist at the Federal Reserve Bank of Chicago. The author acknowledges a study by David D. Whitehead, Federal Reserve Bank of Atlanta ( 1983 ), upon which certain portions of this article are based. A Guide to Interstate Banking, Federal Reserve Bank o f Chicago state financial services, a great potential lies large ly untapped. Examination of these activities is based primarily on numbers of office locations for the various services, not the dollar volume of activity generated from these offices or their assets. The bank-related activities of nonbanking firms will not be examined here.1 Perm issible interstate activities Bank holding companies are currently per mitted, under Section 4( c )( 8 ) of the Bank Hold ing Company Act of 1956 as amended and Regu lation Y, to engage in a broad scope of nonbank ing activities (Table 1). The offering of these services is not subject to the geographical limita tions of banking; e.g., a bank holding company located in Chicago may provide trust services through an o ffice in Phoen ix, Miami, or Anchorage. The number of bank holding companies headquartered in Seventh District states, along with the number of their 4 ( c ) ( 8 ) subsidiaries and offices is shown in Table 2. As of year-end 1981, Illinois, with 70 offices, led the District states in number of 4 ( c ) ( 8 ) interstate subsidiar ies. Bank holding companies headquartered in only three other states—New York, California, and Pennsylvania—have established more of these subsidiaries. Even so. District states are net receivers of 4 ( c ) ( 8 ) services with 368 offices located inside their boundaries, as opposed to 124 offices 'An interstate comparison based on total assets would be valuable; however, the difficulty in obtaining asset break downs by type of activity precludes such a comparison here. For an analysis of nonbank competition, see “Competi tion in Financial Services: The Impact of Nonbank Entry,” by Harvey Roscnblum and Diane Siegel, Federal Reserve Bank of Chicago, and “Banks and Nonbanks: A Run for the Money," , July/August 1983, and Harvey Rosenblum and Christine Pavel, “Financial Ser vices in Transition: The Impact of Nonbank Entry,” All of these publications are available from the Chicago Fed’s Public Information Department. Staff Study 83-1 Economic Perspectives Memoranda 84-1. Staff 3 T able 1 Permissible nonbank activities for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act and Regulation Y (December, 1983) A c tiv itie s p e rm itte d by re g u la tio n 1. Extensions of credit2 Mortgage banking Finance companies: consumer, sales, and commercial Credit cards Factoring 2. Industrial bank, Morris Plan bank, industrial loan company 3. Servicing loans and other extensions of credit2 4. Trust com pany2 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Investment or financial advising2 Full-payout leasing of personal or real property2 Investments in community welfare projects2 Providing bookkeeping or data processing services2 Acting as insurance agent or broker primarily in connection with credit extensions2 Underwriting credit life and accident and health insurance Providing courier services2 Management consulting to all depository institutions Sale at retail of money orders with a face value of not more than $1000, travelers checks and savings bonds’ 2 Performing appraisals of real estate’ Issuance and sale of travelers checks Providing securities brokerage services and related securities credit activities’ Arranging commercial real estate equity financing’ Underwriting and dealing in government obligations and money market instruments’ Foreign exchange advisory and transactional services’ Acting as a futures commission merchant’ A c tiv itie s p e rm itte d by o rd e r 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Issuance and sale of travelers checks2 6 Buying and selling gold and silver bullion and silver coin2 4 Issuing money orders and general-purpose variable denominated payment instruments1,2,4 Futures commission merchant to cover gold and silver bullion and coins1,2 6 Underwriting certain federal, state and municipal securities’ 2,6 Check verification1, 2' 4 Financial advice to consumers1, 2 Issuance of small denomination debt instruments’ Arranging for equity financing of real estate6 Acting as futures commissions merchant6 Discount brokerage emanating from bank holding companies located in District states. Although the District states house approximately 23 percent of the nation’s bank holding companies, their 4 ( c ) ( 8 ) activi ties account for only about 11 percent of the nation’s 4 ( c ) ( 8 ) interstate subsidiaries, and only 2 percent of the number of interstate offices. Bank holding companies and their nonbank subsidiaries may also participate in interstate expansion via loan production offices and Edge Act corporations. Eleven of the 13 Edge Act cor 4 porations in the Seventh District are located in Chicago; Detroit and Milwaukee have one each. Twenty interstate Edges emanating from District states are found in California, Massachusetts, Minnesota, and New York. Loan production office (LPO ) distribution is shown in Table 3. The twenty-six interstate LPOs are located in four of the five District states. There is no LPO activity in Wisconsin. Banks from Illinois and Michigan have originated 32 LPOs in 14 states outside their home states. In this activity, the Seventh District (that is, Illinois Economic Perspectives T able 1 (cont.) A c tiv itie s p e rm itte d by o rd e r (co n t.) 12. 13. 14. 15. 16. 17. 18. 19. 20. Operating a distressed savings and loan association Operating an Article XII Investment Co. Executing foreign banking unsolicited purchases and sales of securities Engaging in commercial banking activities abroad through a limited purpose Delaware bank Performing appraisal of real estate and real estate advisor and real estate brokerage on nonresidential properties Operating a Pool Reserve Plan for loss reserves of banks for loans to small businesses Operating a thrift institution in Rhode Island Operating a guaranty savings bank in New Hampshire Offering information and transactional services for foreign exchange services. A c tiv itie s d en ie d by th e Board 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. Insurance premium funding (combined sales of mutual funds and insurance) Underwriting life insurance not related to credit extension Sales of level-term credit life insurance Real estate brokerage (residential) Armored car Land development Real estate syndication General management consulting Property management Computer output microfilm service Underwriting mortgage guaranty insurance1 *34 5 Operating a savings and loan association1, 5 Operating a travel agency'■ 2 Underwriting property and casualty insurance1 Underwriting home loan life mortgage insurance1 Investment note issue with transactional characteristics Real estate advisory services 1Added to list since January 1, 1975. Activities permissible to national banks. 3Board orders found these activities closely related to banking but denied proposed acquisitions as part of its "go slow" policy. 4T o be decided on a case-by-case basis. 5Operating a thrift institution has been permitted by order in Rhode Island, New Hampshire, California, and Illinois. Subsequently permitted by regulation. SOURCE: Board of Governors of the Federal Reserve System and Michigan) appears to be a net provider of loan services to other parts of the country. Table 4 lists the states whose banks and holding companies have established interstate offices in D istrict states, w hether through 4 ( c ) ( 8 ) activity, LPOs, or Edge Act corpora tions. New York, Massachusetts, Minnesota, and California are the predominant states establish ing a presence in the Midwest. The Garn-St Germain Depository' Institu tions Act of 1982 provides another interstate opportunity. Banks and savings and loan associa Federal Reserve Bank o f Chicago tions may acquire failing financial institutions across state lines. The Act ranks these acquisi tions in order of preference, favoring combina tions between the same type of institution in the same state. In considering out-of-state offers, those institutions in adjoining states are to be given priority over those from non-adjacent states. Acquisitions by these favored parties, however, do not always prevail. On January' 20, 1984, the Board of Governors approved an application by Citicorp to acquire First Federal Savings and Loan Association of Chicago and its 5 T able 2 Interstate 4(c)(8) activity of Seventh District state bank holding companies Holding companies with interstate 4(c)(8) subsidiaries Holding companies with home office in state Holding company home state Illinois Subsidiaries Offices Onebank Multi bank Total 316 7 323 5 24 70 66 1 67 3 11 38 Indiana Iowa Holding companies 268 16 284 2 2 3 Michigan 18 24 42 1 3 6 Wisconsin 82 28 110 2 3 7 750 76 826 13 43 124 3201 430 3631 139 382 5500 23.4 17.7 22.7 9.4 11.3 2.3 District state Total U.S. total District as a % of U.S. total SOURCE: Federal Reserve Board data as of December 31, 1981 and the Federal Reserve Bank of Atlanta. 4(c)(8) refers to the section in the Bank Holding Company Act (together with Regulation Y) that permits bank holding companies to engage in nonbank activities. 62 offices statewide under this provision of the Garn Act.2 The most rapidly growing type of interstate expansion is by means of EFT or automated teller machine (ATM) networks. Each of the District states is involved in some form of interstate EFT network. Table 5 lists the EFT networks in each District state and indicates those that are inter state. Note that the majority of EFT services available in the District are provided by net works based in the District. Often these regional systems will join to gether to form a national network. For instance, four regional systems in the District have recently Federal Reserve Bulletin 2See 70 157 ( February 1984). Also, for a discussion of Citicorp’s acquisition of Fidelity Federal Savings and Loan Association of San Francisco, sec 68 656 ( October 1982). Although this acquisition was approved prior to the passage of the Garn-St Germain Act, it generally complies w ith the procedure later finalized. Federal Reserve Bulletin 6 becom e members of Nationet, a national EFT network tying 3,408 financial institutions in 26 states. In October 1983, when Nationet became a nationwide network, it had a total of 12 member networks; the members from District states include Iowa Transfer System, Des Moines, Iowa; Magic Line, Detroit, Michigan; Electronic Funds Illinois, Inc., Chicago, Illinois; and Tyme Corporation, Browndeer, Wisconsin.3 In addition, the Board of Governors recently granted approval for a joint venture—Money Transfer System, St. Louis, Missouri—to begin operating in Missouri and Kansas.4 This organiza tion plans to expand to Iowa, Illinois (which requires an ATM reciprocity agreement), and Kentucky'. This data processing network includes a system of shared ATMs and will recruit savings 'Robert M. Garsson, “Nationet Launches 26-State ATM Operation,” October 14, 1983, pp 1, 15. 469 American Banker, Federal Reserve Bulletin 643 (August 1983). Economic Perspectives Table 3 T able 4 Loan production office activity Holding company activity in Seventh District by state and type of activity LPOs entering the District states State 21 8 Indiana 1 1 Iowa 2 2 Michigan 2 2 Wisconsin 0 0 Illinois Total 4(c)(8) Activity States Offices 10* 26 LPO activity originating from District states States State Organizations Offices entered Illinois 4 31 13 Michigan 1 1 1 5 32 14 Total ‘ This figure represents the total number of states outside the Seventh District with an established LPO presence within the District. Due to intradistrict movements and states with an LPO presence in more than one District state, this figure does not represent the sum of the numbers above it. SOURCE: Federal Reserve Bank of Atlanta survey of the top 200 banking organizations. 1983. and loan associations as members as well as banks.s California Connecticut Delaware Illinois Indiana Maryland Massachusetts Minnesota New York Oregon Pennsylvania Rhode Island Wisconsin Location in District IA IL IN Ml Wl X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X LPO California Georgia Illinois Kentucky Maryland Massachusetts Missouri New Jersey New York North Carolina Ohio Pennsylvania Washington X X X X X X X X X X X X X X X Interstate Edge State banking laws The banking laws of each of the Seventh District states are summarized in Table 6. Multi bank holding companies, intrastate and inter state, are prohibited in Indiana. Only Iowa and 'One means of interstate expansion whose legality has not yet been decided is proposed by Dimension Financial Corporation. Dimension proposes to establish 31 “nonbank banks” ( i.e., banks that do not issue commercial loans and thus do not fall under the statutory definition of a bank in section ( 2 ) of the BHCA) in 25 states nationwide. The application was filed in March 1983 with the Comptroller of the Currency and no ruling has been made to date. An Illinois bank located near the site of a proposed Dimension “bank" and several other banking associations are protesting the application for two reasons. First, they assert that the nationally-chartered “banks” to be acquired by Dimension are subject to the Bank Holding Company Act and violate its interstate banking prohibitions (section 3(d ), the so-called Douglas Amendment). It has also been charged that Dimen sion itself would be a subsidiary of a savings and loan associa tion, causing further legal and regulatory' complications. Federal Reserve Bank o f Chicago California Massachusetts Minnesota New York X X X X SOURCE: Federal Reserve Bank of Atlanta survey of the top 200 banking organizations. 1983. Illinois allow grandfathered out-of-state bank holding companies to continue expanding with in the state. None of the states currently has a reciprocal interstate banking agreement with another state. Illinois’s recently enacted law allowing multibank holding companies restricts their expansion to designated regions of the state. These limitations are also imposed on the grandfathered out-of-state holding companies.6 6Furthcr analysis of the Illinois multibank law may be found in “First Year Experience: Illinois Multibanks Shop Carefully,” by Sue F. Gregorash, May/June 198.3. Economic Perspectives, 7 Table 5 District participation in EFT networks Interstate (yes/no) Number of states covered Illinois The Answer System ATM Network Management Corp. Cash Station Computer Research Co. Easy ‘ Electronic Funds Illinois, Inc. Money Network Shared Network Corp. Yes No No No No No No No No No 1 1 1 1 1 1 1 1 1 Ohio Ohio Ind iana Access 24 Jeanie The Owl Network No Yes Yes 1 3 3 Iowa Io w a *lowa Transfer System Yes 3 Wisconsin M ich ig a n Any Time Teller Continet •M agic Line *Tyme Corporation Yes Yes No Yes 2 3 1 2 Wisconsin Minnesota Wisconsin W iscon sin A.O. Smith Data Systems Division Continet Fast Bank *Tyme Corporation No Yes Yes Yes 1 3 5 2 State of origin (if interstate) Michigan Wisconsin Network ‘ Member of national EFT network (Nationet). SOURCE: EFT Interchange: A Directory of Shared ATM Services, American Bankers Association, 1982. These bank holding companies are exercis ing their opportunities to expand in Iowa and Illinois, as seen in Table 7. General Bancshares Corporation of St. Louis received Board approval in August 1983 to add a fourth bank to its Illinois holdings. Northwest Bancorp in Minneapolis owns 11 banks in Iowa and is the largest bank holding company in that state. Its most recent Iowa acquisition was in 1980. The only Seventh District bank holding company to ow n banks outside of its home state to date is Northern Trust Corporation of Chi cago. Within the past two years it has begun acquiring banks in Florida pursuant to a grand father provision in Florida’s banking law. At yearend 1983, Northern Trust Corporation owned four banks in Florida. 8 Since the passage of the Depository' Institu tions Deregulation and Monetary’ Control Act of 1980, the Garn-St Germain Act, and prior and subsequent de jure and de facto deregulation of the banking industry, banks and thrift institu tions are becoming more direct competitors. In general, savings and loan associations are subject to less restrictive state branching and expansion laws than are banks. In Seventh District states, savings and loan associations may branch state wide. Table 8 shows the interstate expansion of savings and loan associations affecting the Sev enth District. As banks and savings and loan insti tutions begin to compete more and more for the same customers, some form of parity should be established regarding their respective expansion powers. Economic Perspectives Table 6 Impediments to expansion: state banking laws State O ut-of-state entry permitted Reciprocity Intrastate bank holding company expansion permitted Branching Illinois Only permits expansion of grandfathered companies' None2 No branching; limited service facilities only Within a designated region or contiguous region Indiana None None Limited No multibank holding companies permitted Iowa Only through expansion of grandfathered companies' None Full-service facilities permitted within county of head office or in a contiguous county Statewide; subject to size limit of 8 percent of total state deposits Michigan None None Same or adjacent county as head office if within 25 miles; home office protection Statewide Wisconsin None None Same or adjacent county as head office if within 25 miles; home office protection Statewide 'Iowa and Illinois allow expansion by companies with bank or trust company subsidiaries grandfathered by the 1956 Bank Holding Company Act. The Illinois multibank holding company law, effective January 1, 1982, grandfathered an additional out-of-state holding company. ’Illinois law requires a reciprocity agreement for its interstate ATM network participants. Table 7 Interstate bank activity (August 31, 1983)* Out-of-state banking organizations having bank subsidiaries in District states Number of organizations Number of banks Number of branch offices Illinois 1 4 4 Iowa 1 11 50 Wisconsin 3 6 22 1 4 NA District state banking organizations with banking activity outside home state Illinois •Branch office data as of December 31, 1981. SOURCE: Board of Governors of the Federal Reserve System. Federal Reserve Bank o f Chicago 9 wide. Out-of-state bank holding companies own more subsidiary Interstate savings and loan activity banks inside Seventh District states involving Seventh District states (March 1983) than Seventh District bank hold Coverage Name of institution Home state ing companies own in the rest of the nation, primarily due to ac Ml, FL, NY, TX 1. Empire of America Michigan quisitions prior to the Douglas Federal Savings Association Amendment and the grandfather California CA, FL, IL, MO, TX 2. Home Savings of America, provisions of Iowa and Illinois law. Federal Savings and Loan Most of the bank holding compan ies with a nationwide presence Michigan Ml, VA 3. Bay Savings Bank have offices in Seventh District Indiana IN, KY 4. Union Federal Savings and states. As with international bank Loan of Evansville ing offices, many of these offices SOURCE: Federal Home Loan Bank Board. have been established as a conve nience to the banks’ current cus tomers and not for the purpose of usurping market share from local banks. Summary Although the District is a net supplier of interstate services, potential still exists for expan On the whole, the Seventh District states sion. The Seventh District states house almost are net exporters of interstate banking services, one-quarter of the nation’s bank holding com except for 4 ( c ) ( 8 ) activities. The District is well panies, yet it does not provide a proportionate covered with EFT networks, and the services share of most interstate financial services. Furof four of these networks are available nation T able 8 10 Economic Perspectives ther, it would seem that bank holding eompanies in financial centers such as Chicago and, to a lesser extent, Detroit, would be among the nation’s leading innovators in interstate activity. A possible explanation for this relative inactivity is the restrictive state banking laws in Indiana and Illinois that limit multibank holding com pany expansion and thus encourage one-bank holding company formations, accounting for the District’s disproportionately large share of hold ing companies. Many of these one-bank holding companies are small and have not yet diversified into nonbanking activities even on a local basis, much less an interstate one. Unlike New England, neither the District nor the Midwest has established any regional cohesion, as is demonstrated currently by the absence of reciprocity agreements in this area. In fact, the limiting intrastate multibank holding company laws of Illinois and Indiana tend to discourage intra-regional support. Future Barring any blanket authority at the national level for interstate acquisitions, development will probably continue in the same areas of EFT, 4 ( c ) ( 8 ) activities, loan production offices, and expansion by grandfathered bank holding com panies. Now that some of the larger bank holding companies have established themselves in major Federal Resen'e Bank o f Chicago metropolitan markets across the country, they may seek to establish offices in smaller, regional markets, and, conversely, regional bank holding companies may establish themselves in metro politan areas. For instance, First Union Corpora tion of Charlotte, N.C., recently opened an office in Chicago. Its purpose is not so much to com pete for Chicago business as it is to enhance its image in its home region, the Southeast. NCNB National Bank of North Carolina, also in Char lotte, and Wachovia Financial Corporation, Winston-Salem, N.C., had previously established Chicago offices.'7 Some banks and holding companies have entered into contractual agreements to combine should it ever becom e permissible by state or federal law. Such a case exists in the Seventh District, where First Bank System, Inc., Minne apolis, has announced an agreement to acquire Banks of Iowa, Inc., Cedar Rapids, and its 11 subsidiary' banks. Other banks may be actively developing their correspondent network and enhancing services and computer hardware/soft ware compatibility' with their respondent banks in hopes of cultivating potential marriage part ners. In most services, the Seventh District appears to be among the leaders in interstate banking activity. "Steven L. Strahler, “Outsiders Grasp for Chicago’s Busi nesses,” October 17, 1983, p. 29. Crain ’s Chicago Business, 11 R eg u lato ry in n o v a tio n : T h e n ew b an k a cco u n ts G illian G arcia a n d A n n ie M cM ahon Financial innovations are new ways to make money. Many, and usually the most successful innovations are initiated by the market. They are introduced by financial firms in response to opportunities to earn profits. Some innovations take advantage of technical progress. Others occur in response to government regulation. Yet other innovations, such as the money market deposit and Super NOW accounts, are initiated by the regulators themselves. Whatever their source, financial innovations have repercussions for the management of financial institutions. And they have important implications for the conduct of monetary' policy. Both of these topics are discussed in this paper. The Money Market Deposit A ccount In the Garn-St Germain Depository Institu tions Act of 1982, the Congress authorized an account to provide depository institutions with an instrument that is “directly equivalent to and competitive with money market mutual funds.” The result was the money market deposit account ( MMDA ). Money market mutual funds ( MMMFs ) had grown rapidly after their introduction in 1972 (Figure 1). They allowed the public to earn market rates of interest, at times when Reg ulation Q was binding, and they offered limited transactions features. This set of characteristics proved very popular. The MMDA offers these features and more. It has been widely available since December 14, 1982. It is federally insured and pays an interest rate that is restricted only by the discretion of the institution ( on initial and maintained aver age balances of $2,500 or more ). Its features vary' Gillian Garcia is a senior economist at the Federal Reserve Bank of Chicago. Annie McMahon, a student intern at the Chicago Fed when this article was written, is now a banking associate at Continental Bank of Illinois. The authors thank Thomas Gittings, Anne Marie Gonczy, Randall Merris, and Harvey Rosenblum for helpful comments. 12 from institution to institution, but the authoriz ing act decrees some common denominators. The account offers limited transaction features: six transfers per month —pre-authorized, auto matic, or by telephone, of which no more than three may be by check. Personal withdrawals are unlimited, however. On personal accounts the account carries no reserve requirements; a 3 percent reserve is imposed on nonpersonal accounts. If the average balance falls below $2,500, the NOW account ceiling com es into effect. The finer details of the account’s configura tion were established by the Depository' Institu tions Deregulation Committee (D ID C ).1 The DIDC was so pleased with the press and financial community’s enthusiastic response to the pend ing account that it was encouraged to quickly authorize another account, the Super NOW account (SNOW), that became available on Jan uary 5, 1983The Super NOW Account This account is a second regulatory' innova tion to help banks and thrifts to compete with money market mutual funds. The SNOW account clientele is more limited than that of the MMDA (which is unrestricted). SNOWs are available to households, government agencies, and nonprofit organizations, as are NOW accounts in general.*2 The SNOW account has unlimited transaction features, and pays unregulated interest rates on 'The DIDC was established by the Depository Institu tion’s Deregulation and Monetary Control Act ( DIDMCA) of 1980, to co-ordinate the different federal regulators prog ress toward the deregulation of interest rates. 2The NOW account was extended nationwide in Janu ary 1981, as authorized by the Depository Institutions Deregulation and Monetary Control Act. At that time it was available only to households and to nonprofit organizations. Its clientele was extended by the Gam-St Germain Deposi tory Institutions Act, to include federal, state, and local government deposits. Economic Perspectives Figure 1 Funds in M M M F s , M M D A s , and S N O W a c c o u n ts $ billions S O U R C E : B oard of G o vern o rs of the Federal Reserve. initial and maintained balances of $2,500 or more. But it carries reserve requirements as a transaction account (currently at 12 percent). Account e x p e rie n ce The MMDA has been extremely popular to date and has been a notable success in attracting funds. As the data in Figure 1 show, it grew rapidly after its introduction, surpassed MMMFs, which were declining in volume, six weeks after its introduction. After one more week, MMDAs had exceeded the $242 billion peak that MMMFs had attained in November 1982, ten years after their introduction. By the end of May 1983, MMDAs had reached $360 billion in value. They are a success by any standard. The SNOW experience has been less spec tacular. Its particular configuration of features has proved less popular than that of the MMDA. The account exceeded $25 billion after nine weeks and had reached $38 billion by December 1983. Effects on depository institutions It is evident that the two accounts have been successful and that MMMFs have suffered Federal Reserve Bank o f Chicago as a result. In an attempt to measure these effects, a simple time series analysis of the behav ior of the three accounts was undertaken. The motivation for this approach is described in the box. The results of these analyses are reported in the figures that follow. C om m ercial banks: The simple time series model that best fits commercial bank savings and small time depos its was estimated from monthly data for the period January’ 1959 through November 1981. The data show that the model tracked the behav ior of the actual series so well that it is virtually impossible to discern divergences between the actual and model values in Figure 2. Based on this past behavior, the series is extrapolated into the period after November 1981 in the chart. It shows that the regression model continued to fit well, until the advent of the MMDA. Thereafter, the series diverges noticeably from trend. While MMDAs are considered to be primar ily a household sector savings vehicle, they have some transactions features. For this reason, they are excluded from Federal Reserve data on sav ings and small time deposits. Figure 2 shows that funds in this small account series fell sharply 13 Figure 2 C o m m e r c ia l b a n k d e p o s its f o r e c a s t deposits (log) after November 1982. On the other hand, the value of MMDAs p lu s savings and small time deposits at commercial banks has risen sharply since that time. These findings reinforce the intuitive notion that some, but not all, of the funds entering the new accounts have come from in-house sources, such as passbook savings deposits and six-month money market certifi cates. The residuals, that is the differences between the actual and the predicted values for commer cial bank combined deposits, are shown in Fig ure 3. The chart demonstrates that the introduc tion of the MMDA raised the growth rate of small deposits far above the previously expected experience. In short, the account’s introduction dramatically raised the total value of funds that commercial banks obtained from consumers and small businesses. Money Market Mutual Funds: A similar simple representation of the expe riences of money market mutual funds is given in Figure 4. The chart shows the deviations of the actual from the predicted values for money market mutual fund volumes. Here the predic 14 tions arise from a time series regression equation that is estimated through November 1982, just prior to the advent of the new accounts. After prediction difficulties during 1 9 7 4 —typical in the period immediately following the introduc tion of a new financial instrument —the regres sion successfully tracks the behavior of MMMFs until the advent of MMDAs. Thereafter, the behavior of the money market mutual funds se ries stands in marked contrast to the experience of banks’ consumer deposits. Actual growth rates of MMMF assets in the post-November 1982 period fall substantially below those pre dicted by the pre-MMDA behavior. To make sure that this finding did not arise artificially as a result of ending the estimation period for the regression immediately before the introduction of the new account, another exper iment was conducted. The regression was recal culated with the estimation period ending twelve months before the initiation of the new account.3 The conclusions are unchanged. This second JThe commercial bank model was also estimated for both periods. The commercial bank series produce undistinguishably simitar results regardless of whether the estima tion period runs through November 1981 or November 1982. Economic Perspectives Figure 3 B a n k s m a ll t i m e a n d s a v in g s d e p o s it s in c lu d in g M M D A s — r e s id u a ls rate of growth (percent) Figure 4 M M M F s — re s id u a ls rate of growth (percent) Federal Resen e Rank o f Chicago 15 simple model is reasonably successful in estimat ing the behavior of MMMFs until December 1982. From that month on, as previously, the regression substantially overestimates fund resid uals. This second MMMF regression, not repro duced in this article, highlights one new facet of fund behavior. While the funds continued to grow during 1982, their growth rate had begun to decline even before the introduction of the new accounts. However, the MMD account has significantly worsened the environment for money market funds. Thrifts: The results of similar experiments for thrift savings and small time deposits do not produce such unambiguous results. The reason is that in December 1982, when the new accounts began to be available, thrift deposit levels were already substantially below' trend (Figure 5). This expe rience resulted partly from disintermediation, partly from the recession that was then bottom ing out, and partly also from some public loss of confidence in the industry as a result of the S&L crisis.4 The worst of the thrift deposit losses occurred during 1982. Consequently estimating a time series model through that year and pro jecting future deposit levels based on past, weak experience shows the actual growth rates achieved after the introduction of the new accounts to have been substantially and beneficially affected. This interpretation is shown in Figure 6 which portrays regression residuals from the full period (through November 1982) regression. However, re-estimating the regression to stop in November 1981 leaves the industry expecting a more optimistic outcome for 1982 than, in fact, occurred. Predicting industry per formance beyond that year and comparing actual experience with the projections show substan4The S&L crisis is described in Carron (1 9 8 2 ) and the Federal Reserve Bank of Chicago 1983 a,b). Figure 5 Thrift institution deposits fo re ca st deposits (log) 16 Economic Perspectives Figure 6 Thrift small time and savings deposits including MMDAs—residuals rate of growth (percent) 4 - t r e n d line t h ro u g h 1982 3 - 2 - 1 - 1 I i 1959 i i '61 i___i__ i___ i__ i___ i__ i__ l__ i___ i__ i___ i__ i___ i__ i___ i___i— i— i— i----1___ i '63 '65 '67 '69 tially negative residuals (Figure 7 ). The intro duction of the two new accounts a year later reverses the deteriorating deposit position. The actual growth rates early in 1983 are restored to levels approaching those expected from expe rience through 1981. But they do not return the industry near par for long—the early 1983 gains are lost by the end of the year. '71 '73 '75 '17 ’79 '81 '83 commercial banks continued to grow, while those at thrifts were declining.'5 Consequently, while the total, combined value of bank and thrift funds in MMDA accounts varied little in the second half of 1983, their composition was changing markedly—shifting from thrifts to banks. In sharp contrast, MMMF levels were seriously depleted following the introduction of the two regulatory innovations. Contrasting e x p erien ces Im plications for m anagers Thus, after November 1982, the values for commercial bank and thrift savings and small time deposits were raised substantially above their earlier levels. Although both banks and thrifts benefited from the two accounts, the two residual series show some differences. Com mercial banks benefit unambiguously and more than thrifts. Moreover, commercial banks account growth was sustained after the initial spurt, while thrifts relinquished some of their initial gains as 1983 progressed. Indeed, during the second half of 1983, the value of MMDA funds in Federal Reserve Bank o f Chicago The inflow of funds into banks and thrift consumer-type accounts has the potential for two effects upon operations. To the extent that ’ It is acknowledged that deposit flows are not totally exogenous to banks and thrifts. In particular, where deposits pay unregulated rates, institutions can influence their de posit flows by varying the rates they pay. Advertising and other promotional activities are also relevant, as will be discussed in a later article in this journal. Moreover, MMDAs, which can be instantly withdrawn, are potentially more use ful to banks than to thrifts, because banks’ asset portfolios have shorter maturity and duration than thrifts (Kaufman 1984). 17 Figure 7 T h r ift s m a ll t im e a n d s a v in g s d e p o s its in c lu d in g M M D A s — re s id u a ls rate of growth (%) ® L i— i-------1-------- 1--------1--------1------- 1--------1------- 1------- 1--------1------- 1_____i_____ i_____ i_____ i_____ i_____ i_____ i_____i_____ i_____i_____ i_____ i_____ i_____ i 1959 61 '63 '65 '67 '69 the total volume of funds received by banks and thrifts rises, they are in a position to increase their lending activities. They can make more mortgages, consumer, and business loans and/or purchase more government securities. Profit able uses for the new funds must be found. Such overall changes are expected to show up in the data for the money aggregates. These will be discussed in the following section. On the other hand, the inflow in one area may be counterbalanced by outflows elsewhere. If MMDAs and SNOWs merely replace other funds, the total value of bank and thrifts liabilities (and, therefore, their assets) will not change. But the composition of their liability portfolios will be different. In fact, both of these possibilities occurred after the introduction of the new accounts. Total resources available to depository institutions rose and the composition of their portfolios changed. Figure 8 shows these changes in total volume and in composition for commercial banks and thrifts. During the first six months of the accounts, the sum of the most important elements in commercial bank liability portfolios rose 4.1 percent. It rose another 4.0 percent during the 18 '71 '73 '75 '77 '79 '81 '83 second half of 1983. Among the components, commercial bank demand deposits rose lethar gically, while other checkable deposits (which include SNOWs) continued the strong growth that they have shown since NOW accounts first became available nationwide in January' 1981. The bank savings and small time deposit series Figure 8 T h e c o m p o s itio n o f b a n k a n d t h r if t lia b ilitie s $ billions 2,000 1,600 Banks DD ML S D .S T D MMDAs OCD December 1982 June 1983 Thrifts FHLBA ML S D .S T D MMDAs OCD December 1983 NOTE: DD. demand deposits; FHLBA, FHLB Advances; ML. managed liabilities; including large CDs and RPs; SD, savings deposits; STD. small time deposits; OCD, other checkable deposits. Economic Perspectives declined as did the major managed liabilities. These declines are more pronounced in the first half of the year than the second. Among the two components of managed liabilities included here, large time deposits declined, while RPs in creased.6 The level of the principal market sources of thrift funds rose 9 0 percent in the first half of 1983 and 5.9 percent in the second half. Other checkables gained strongly, but savings and small time deposits declined significantly. RPs increased and in contrast to banks, so did large CDs, so that managed liabilities in general rose.7 However, S&L reliance on advances from the Federal Home Loan Bank Board (FHLBB) was substantially reduced. Consequently the semi annual increases in total thrift funds including advances was smaller (at 7.2 percent in the first half of the year and 5.3 percent in the second half). Im plications fo r th e m on etary aggregates Particular caution must be exercised in ap plying the methodology described in the box to any discussion of monetary' policy'. The monetary 6The large time deposit series most often quoted come from Federal Reserve Release H.6, which provides time se ries data on the components of the monetary aggregates. The M2 monetary aggregates include the majority’ of MMMF funds. Consequently, to avoid double counting at the M3 level (where large CDs enter the monetary aggregates), commercial bank sales of large CDs to MMMFs are excluded. However, the data on the availability of funds to depository institutions should include such CD holdings. These data are provided in the Federal Reserve series G10. The G10 series shows, as might be expected, sharper declines in large CD holdings at banks: Bank CD holdings n.s.a. $ billions H.6 scries G 10 series December 1982 June 1983 December 1983 270.0 3539 226.2 283.5 230.9 287.1 ’The rise in the thrift holdings of large CDs may be a reflection of the increase in brokered deposits. Federal Home Loan Bank staff estimated that brokered deposits at FSLIC-insured associations rose from billion in Decem ber 1982 to S28.8 billion at the end of December 1983Brokered deposits present problems to the bank and thrift deposit insurance agencies. (See Federal Home Loan Bank Board, 1984). $93 Federal Reserve Bank o f Chicago aggregates are closely monitored by the Federal Reserve. When it is clearly apparent that any aggregate (M l, M2, M3 or total domestic nonfinancial credit) is deviating from the System’s targeted ranges, remedial policy action is (n or mally) taken. For this reason, when a deviation from trend occurs, it is not apparent whether this has been engineered by the Fed in some change in policy, or whether the deviation results from some other event, such as the unex pected popularity of a financial innovation. The Federal Reserve eased its policy stance during the summer of 1982, and the growth rate of the monetary' aggregates accelerated. Conse quently, to estimate the time series models for the monetary aggregates with the date ending in November 1981 would confuse the issue. By 1983 the growth rate would have increased both in response to policy and possibly also because of the innovation of the two new accounts. For this reason, the estimation period ends in Novem ber 1982, immediately prior to the introduction of the MMDA. The time series models (Figures 9, 10, and 11) show that all three money aggregates were affected by the new accounts. The relative extent of the impact varies among the aggre gates, however. Figure 9 shows that the level of Ml was subjected to a positive shock during the first half of 1983 This is an interesting finding, because it was not known at that time whether the likely positive inflows of funds into Ml from SNOWs and expiring All Savers Certificates would be counterbalanced by possible outflows to MMDAs (w hich enter the aggregates first at the M2 level). Figure 11 shows that the inflows more than compensated for the outflows, so that the account grew rapidly. By midyear 1983, the surge in Ml growth was over. Since midyear 1983, Ml appears to be growing at a rate parallel to that experienced in late 1982, albeit at a higher level. This finding is reassuring, for it suggests that it is now' more feasible to return to using M 1 as the principal monetary' target. Indeed, the Board has recently announced that it will pay more attention to M1 during 1984 (Board of Governors, the Federal Reserve, 1984, p. 7 2 ). 19 As expected, because MMDAs are included first in the monetary' stock hierachy at the M2 level, this aggregate has been the most sharply affected of the monetary aggregates ( see Figure 10). M2 has not yet returned to its pre-innovation rate of growth.8 T h e conclusion is reinforced by the behavior of the residual series, which is not shown in order to conserve space. The picture for M3 ( in Figure 11), however, is different. An important part of the substitution in depository’ institution portfolios has occurred within the M3 level. For example, large time deposits enter at this level. Thus the picture of M3 behavior shows that this aggregate was only slightly affected by the new accounts. This pic ture is also borne out by the behavior of the residuals (not shown). r Tim e series forecasting The methodology’ adopted in this paper in volves forecasting. The predictions, derived from simple time series analysis, are then used in an innovative way. The combined impact of the two financial innovations is measured by comparing what actually happened after the introduction of the new accounts, with what is predicted to have happened if the accounts had not been introduced. The time series analy sis provides these predictions. The method used for predicting what w'ould have happened, absent the accounts, is intended to be agnostic. That is, it bases the forecasts of the future behavior of any economic variable at differ ent, regular intervals in time (a time series) entirely on the past behavior of that series. No information about the behavior of any other series is needed for this kind of forecast. This simplifies the forecasting process. Time series analysis says essentially: there is a pattern to the behavior over time of the series. Absent some innovation or other disturbance, this pattern is expected to continue. Computer programs exist for experimenting with many different patterns and statisticians have described ways to distinguish patterns that fit well from those that do not. Some of the patterns that might be observed result from seasonal variation in the data. These patterns are eliminated when the Federal Reserve seasonally adjusts its data. Conse quently, because seasonally adjusted data are used (whenever available) in this study, only nonseasonal patterns were (in general) found in the data. The m odel ch o sen The model that best fits the different series is a simple one—an autoregressive, integrated, moving average (ARIMA) of order (1 , 1 , 0 ) fitted to the logarithms of the data. Further technical informa tion on forecasting using time series modeling can be found in texts devoted to that subject (B o x and Jenkins, 1976; Nelson, 1973). Interpreting th e m odel Essentially, an ARIMA of order ( 1 , 1, 0) applied to log data says that the rate of growth of the time series in this period is equal to some proportion, of the previous period’s growth rate plus some error. To estimate the impact created by the new' accounts on any variable, the time series behavior of that variable is estimated up to some time before the new' account is introduced. Future behavior is then forecast based on this past experience. Next, the actual behavior is compared to that predicted. The differences between the two series (called the residuals) then estimate the effects of the innovation on the series’ growth rates. A caution It must be emphasized that this technique is not definitive. It can only be indicative of the effect of the innovation. Other events, beyond the intro duction of the new accounts, have occurred and these may have affected the behavior of the vari ables being studied. The present methodology takes no explicit account of these other factors. It should be used with appropriate caution, there fore. This caveat is particularly applicable to the money stock data, whose behavior is responsive to changes in Federal Reserve policy as w’ell as other economic forces. V_______________________________ 20 Economic Perspectives Figure 9 M l fo r e c a s t $ billions Figure 10 M2 fo re ca st $ billions Federal Reserve Bank o f Chicago 21 Figure 11 M3 fo re ca st $ billions Summary The analysis in this paper shows that the negative impact of the 1981-82 recession, disin termediation, and the S&L crisis on thrift deposit levels were reversed by the introduction of the new accounts. Thrift deposit levels were raised above their 1982 trend during the early months of the account and thereafter returned to trend. The effects on bank consumer deposits were far more positive. They were raised, and have re mained, substantially above trend. Money market mutual funds have lost their earlier advantage. Their strong pre-MMDA and SNOW growth has been reversed and declines have continued into January’ 1984. The accumulation of funds in the new accounts has been counterbalanced to a sub stantial extent by decreased depository7 institu tion reliance on other sources of funds, such as savings and small time deposits. Banks, but not thrifts, have decreased the levels of their large CD liabilities. S&Ls rely less on FHLBB advances. 22 The changes have had implications for the behavior of the monetary7aggregates. The level and the growth rate of M 1 rose during the first half of 1983 However, by the end of the 1983 the impact of the changes in the financial system on M1 appeared to be over. Consequently, it is now feasible to place increasing reliance on M 1 again in monetary7 policy determination and implementation. M2 was the most affected of the aggregates and M3 the least. R eferences Bulletin, Board of Governors of the Federal Reserve, “Monetary Policy Report To Congress,” February7 1984. Time Series Box, George E.P. and Gwilym M. Jenkins, , Holden-Day Inc., San Francisco, Revised Edition, 1976. Analysis: Forecasting and Control The Plight of the Thrift Institu Carron, Andrew S., \The Brookings Institution, Washington, D C. 1982. tions Economic Perspectives Federal Home Loan Bank Board, “Report on Brokered Deposits,” prepared by Representative Douglas Barnard, Jr., and quoted in the American Banker, March 26, 1984, pp. 5ff. Kaufman, George G., “Measuring and managing inter est rate risk: A primer” Federal Reserve Bank of Chicago, Economic Perspectives, January - Febru ary 1984. The Federal Reserve Bank of Chicago, Economic Pers pectives, March - April 1983 a. Nelson, Charles R., __________________, Leveling the Playing Applied Time Series Analysis for Managerial Forecasting. Holden-Dav Inc., San Francisco, Ca., 1973- Field. A Review of the DIDMCA of 1980 and the Garn-St Germain Act of 1982, 1983 b. Leveling the Playing Field A renew of the DIDMCA of I 'JHO and the Garn-St Germain Act of V)H2 READINGS IN ECONOMICS AND F IN A N C E fro m the Federal Reserve Bank o f Chicago Leveling the Playing Field, the most recent publication in the Federal Reserve Bank of Chicago’s series entitled ‘‘Readings in Economics and Finance", summarizes the major provisions and explores the potential ramifications of the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982. To order copies of this 55-page book, write: Public Information Center, Publications Division, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690, or call (312) 322-5112. Federal Reserve Bank o f Chicago 23 B UHIICAGJ ECONOMIC PERSPECTIVES Public Information Center Federal Reserve Bank of Chicago P.O. 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