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Cyclical downturn in housing

CONTENTS

Housing construction is in a sharp
decline. Despite the gloom in the nearterm outlook, however, demographic
factors in the basic demand for housing
remain favorable.

Bank funds management
comes of age— a balance
sheet analysis
The instruments of discretionary
funds management have grown in
number since modern funds manage­
ment emerged in the early 1960s.
May/June 1980,

V o lu m e IV , Issu e 3

ECONOMIC PERSPECTIVES
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Sinking float
The Federal Reserve System has set
a sharp reduction in float as one of its
main operational goals. Daily average
float has been cut from more than $8
billion in early 1979 to less than $4 billion
in April 1980.

Cyclical downturn in housing
William R. Sayre
Housing construction is in a sharp decline. In
the first quarter of this year, starts were down
almost a third from the rate of mid-1979, ad­
justed for usual seasonal patterns. The decline
continued in the second quarter. With very
high mortgage rates as a major factor pushing
the cost of ownership up much faster than
income, many potential buyers have been
forced to postpone or cancel intended
purchases.
Despite the gloom in the near-term out­
look, demographic factors in the basic de­
mand for housing remain favorable. In time
these factors will reverse the current decline
and add impetus to the recovery that follows.
Housing cycles and GNP

The formation of new households—one
or more people occupying a separate housing
unit—combines with upgrading of housing
by existing households to create demand for
new units. The demand is highly volatile,
how ever, as decisions to form new
households or upgrade housing are usually
slowed or stepped up by the prospects for
income and employment, the cost and
availability of credit, the availability of un­
occupied housing units, and the price of
existing homes.
The volatility of new housing—and its im­
portance in business cycles—is reflected in
GNP data. The past quarter century has seen
four recessions, each preceded by a down­
turn in residential construction two or three
quarters earlier. Twice, there was a housing
recession with no corresponding “ official”
recession in business generally.
Measured by real GNP, adjusted for infla­
tion, recessions have averaged 2.8 percent
from peak quarter to trough quarter.
Recessions in real residential fixed investment
have averaged 22 percent, almost 8 times as

Federal Reserve Bank of Chicago




great. In the steepest housing recession, from
the first quarter of 1973 to the first quarter of
1975, real residential investment fell 44 per­
cent. The most recent peak, in the second
quarter of 1978, came with the snap-back
from an unusually harsh winter. By the first
quarter of 1980, real residential investment
had declined 13 percent.
Decline hits Midwest

Housing construction turned down
earlier this cycle in the North Central states,
often called the Midwest, and it has fallen
further than in the nation as a whole. From the
high in 1978, housing starts nationwide fell 14
percent in 1979. But in the Midwest, the peak
was in 1977. Starts fell 3 percent in 1978 and a
further 23 percent in 1979. Another substan­
tial decline is shaping up for 1980.
Several theories have been advanced to
account for the comparative weakness of
housing in the Midwest. The main factor,
however, is probably net outmigration of

Housing starts decline sharply
million units

3.0"

quarterly averages at seasonally
adjusted annual rates

1970 71 72 73

74 75 76 '77 78 79

'80

3

Business cycles in CNP and housing construction
(dollars in billions)

Real Cross National Product________
Decline
Quarter 1972 dollars Length
Percent

Real Residential Fixed Investment
Decline
Quarter 1972 dollars Length
Percent

Peak
Trough

3Q '57
IQ '58

685.6
663.4

2Q

3.2

2Q '55
1Q '58

36.0
28.7

11Q

20.3

Peak
Trough

1Q '60
4Q '60

740.7
731.9

3Q

1.2

2Q '59
4Q '60

39.2
33.4

6Q

14.8

Peak
No concurrent GNP cvcle
Trough

IQ '64
4Q '64

46.4
41.9

3Q

9.7

Peak
Trough

2Q '65
1Q '67

44.1
32.7

7Q

25.9

1.1

IQ '69
2Q 70

45.2
38.3

5Q

15.3

5.7

1Q 73
1Q 75

64.4
36.3

8Q

43.6

2Q 78

60.9

No concurrent GNP cvcle

Peak
Trough

3Q ‘69
4Q 70

1,083.4
1,071.4

Peak
Trough

4Q 73
1Q 75

1,242.6
1,171.6

Peak?

IQ '80

1,444.2

5Q
5Q

people and industry in recent years. The
movement was given added impetus by three
successive severe winters.
Trends in the Midwest contrast sharply
with those in the three leading Sunbelt states,
California, Texas,and Florida. Together, these
states accounted for 40 percent of the growth
in the nation's population in the 1970s and
almost as large a proportion of total housing
starts.
Credit costs soar

Because houses are nearly always bought
on credit, the trend of home sales and con­
struction is vulnerable to any change in the
cost and availability of mortgage loans. Last
year, mortgage rates began moving to un­
precedented highs. This April some lenders
were quoting rates as high as 17 percent, be­
fore conditions began to ease. That was in con­
trast to a typical mortgage rate of only 10.6
percent a year earlier.

4




Sharply higher rates and ever increasing
home prices have forced many potential
buyers to choose between unattractive alter­
natives: commiting much more of their in­
come to housing, buying a much less expen­
sive house than intended, or withdrawing
from the market completely. Buying a $53,000
home, the national average in early 1979,
required a monthly payment of $404. That
assumed a 25-year, 80 percent loan at 10.6 per­
cent interest. Buying a comparable house in
1980—at a price of $58,000 and at an interest
rate of 16 percent—requires a monthly pay­
ment of $631 to amortize the mortgage. The
monthly payment was up 56 percent in just
over a year, about five times the percentage
increase in average household income. Few
borrowers were ready and able to assume
such a burden. According to industry sources,
mortgage demand virtually disappeared
when rates passed 14 percent.
A sharp rise in mortgage rates affects
more than first-time buyers. People that

Economic Perspectives

Residential construction shows
large cyclical swings

SOURCE: Bureau of Economic Analysis.

already own their homes become less able
and willing to trade-up, even though large
equities can be used as downpayments. They
are less able, because fewer first-time buyers
are eligible to buy their homes, and they are
less willing, because they prefer to stay in
their present homes covered by mortgages
negotiated when interest rates were substan­
tially lower than now.
The situation is illustrated by the in­
cremental cost of credit to a household selling
a house with a “ cheap” 10 percent mortgage
to buy another house at a mortgage rate of 16
percent. If the loan being paid off is $40,000
and the new loan is $60,000, the effective in­
terest rate on the incremental $20,000 is 28
percent! Homeowners tend to stay put,
upgrading their homes through additions and
alterations.
C red it cost is also important to
homebuilders. Home construction is usually
financed with bank loans at 2 to 4 points over
the prime rate. Carryingcostscontinue until a
buyer is found. In April, some builders were
paying 24 percent to carry finished homes.
Prices would have to rise 2 percent per month
to offset this cost.

ed generally available for borrowers willing
and able to pay the price. The difference can
be attributed largely to the greater freedom
of S&Ls and other lenders to pay market rates
for funds raised and charge market rates for
funds advanced.
In 1966,1969, and 1973-74, the net inflow
of savings at S&Ls was substantially reduced—
sometimes to net outflows. Market rates of
interest, for example Treasury bill rates, had
risen above the rates S&Ls could pay on
regular deposits. In July 1978, when it was
clear that market rates were on the rise,
federal regulators authorized thrift in­
stitutions and commercial banks to sell sixmonth money market certificates at rates
equivalent to those paid on 26-week Treasury
bills. Asa result, mortgage lenders could com­
pete for funds and make credit available to
home buyers, although at a rising cost. This
greatly moderated the housing downturn in
1978 and most of 1979.
Residential mortgage debt increased
about $115 billion in 1978 and again in 1979.
This was twice the increase in the mid-1970s
and about five times the increase in the late
1960s. For the past three years, residential
mortgages have accounted for about 30 per-

Unprecedented surge in interest
rates reversed in April
percent

Availability at a price

In marked contrast with earlier down­
turns in housing, mortgage credit has remain­

Federal Reserve Bank of Chicago



5

H o ld e rs of h o m e m ortgages, o n e to fou r units

1969

1971

1973

1975

1977

1979

(billion dollars, year-end)
Total

282.7

Savings and
loans

100.0% 327.6

416.2

100.0%

490.8

100.0%

656.6

100.0%

872.2

100.0%

43.0

187.1

45.0

223.9

45.6

310.7

47.3

394.4

45.2

117.7

41.6

M u tu al savings
banks

41.1

14.5

43.4

13.2

48.8

11.7

50.0

10.2

57.6

8.8

64.7

7.4

C o m m e rcia l b an ks

41.4

14.6

48.0

14.7

68.0

16.3

77.0

15.7

105.1

16.0

146.1

16.8

Life in su ran ce
co m p an ies

27.6

9.8

24.6

7.5

20.4

4.9

17.6

3.6

14.7

2.2

16.2

1.9

G o ve rn m e n t and
related ag en cie s'

19.1

6.8

25.2

7.7

29.7

7.1

42.1

8.6

40.7

6.2

64.9

7.4

1.8

0.6

7.3

2.2

14.8

3.6

30.0

6.1

60.5

9.2

103.4

11.9

34.0

12.0

38.1

11.6

47.3

11.4

50.3

10.2

67.3

10.2

82.5

9.5

M ortg ag e p o o ls2
In d ivid u a ls and
o th e rs'

141.0

100.0%

'Includes federal, state, and local governments and agencies, Federal National Mortgage Association (FNMA),
Federal Home Loan Mortgage Corporation (FHLMC), and Federal Land Banks.
Outstanding principal balances of mortgages backing securities guaranteed by Government National Mortgage
Association (GNMA), FFHLMC, or the Farmers Home Administration (FmHA).
O th ers include mortgage companies, noninsured pension funds, state and local retirement funds, real estate in­
vestment trusts, and credit unions.
SOURCE: Federal Reserve Board.

Holders of multifamily mortgages, five or more units
1969

1971

1973

1975

1977

1979

(billion dollars, year-end)
Total

53.2

100.0%

70.0

100.0%

93.1

100.0%

Savings and
loans

100.6

100.0%

111.8

100.0%

130.7

100.0%

37.6

28.8

11.7

22.0

17.5

25.0

228

24.5

25.5

25.3

32.5

29.1

M u tu al savings
banks

7.6

14.3

9.6

13.7

12.3

13.2

13.8

13.7

15.3

13.7

17.2

13.2

C o m m e rcia l b an ks

3.2

6.0

4.0

5.7

6.9

7.4

5.9

5.9

9.2

8.2

12.6

9.6

14.2

26.7

16.7

23.8

18.5

19.9

19.6

19.5

18.8

16.8

19.2

14.7

Life in su ran ce
co m p an ies
G o v e rn m e n t and
related ag en cie s1

4.2

7.9

7.5

10.7

12.9

13.9

19.2

19.1

20.0

17.9

22.9

17.5

M ortg ag e p o o ls2

0.0

0.0

0.1

0.1

0.6

0.6

1.3

1.3

3.1

2.7

7.0

5.4

12.2

22.9

14.5

20.7

19.3

20.7

15.3

15.2

12.9

11.5

14.1

10.8

In d ivid u als and
o th e rs'

'Includes federal, state, and local governments and agencies, Federal National Mortgage Association (FNMA),
Federal Home Loan Mortgage Corporation (FHLMC), and Federal Land Banks.
Outstanding principal balances of mortgages backing securities guaranteed by Government National Mortgage
Association (GNMA), FIHLMC, or the Farmers Home Administration (FmHA).
O th ers include mortgage companies, noninsured pension funds, state and local retirement funds, real estate in­
vestment trusts, and credit unions.
SOURCE: Federal Reserve Board.

6




Economic Perspectives

cent of the funds raised by all nonfinancial
sectors of the economy. This was more than
four times the funds raised through corporate
bonds.
Usury ceilings, like ceilings on deposit
rates, have also impaired the flow of funds
into mortgage markets at times. As credit
tightened in 1979, particularly after October,
usury ceilings were below market mortgage
rates in more than 20 states. Just before the
end of the year, a federal law suspended usury
ceilings nationwide for the first three months
of 1980. In March, another federal law re­
moved ceilings permanently.
When interest rates rose sharply this
spring, the volume of mortgage lending
plummeted. New mortgage loans consisted
almost entirely of credit to borrowers with
commitments secured earlier at lower rates.
Lenders, however, insist that mortgage credit
is available for qualified borrowers. The
collapse in lending, therefore, suggests that
mortgage borrowers are less able and willing
to compete with other sectors when rates are
very high. Many people willing to buy do not
have the income to qualify. Others, with
adequate incomes, may wish to postpone
purchases until conditions improve. Other
types of borrowers, such as governments and
businesses, do not usually have this flexibility.

year-end to account for 27 percent of all
deposits at S&Ls. “ Jumbo” CDs of $100,000 or
more, also offered at money market rates,
rose 13 billion, almost doubling the volume
outstanding. S&Ls also made heavy use of
Federal Home Loan Bank advances, which in­
creased $8 billion to a total of $40 billion.
Commercial banks at year-end held 17
percent of the home mortgages and 10 per­
cent of the apartment mortgages. Like S&Ls,
banks have relied heavily on money market
certificates and large CDs to raise funds.
Residential mortgages made up less than 13
percent of all financial assets at commercial
banks, compared with 75 percent at S&Ls.
The fastest growing source of residential
mortgage credit is “ mortgage pools.”
Lenders, usually mortgage bankers, assem­
ble pools of mortgages to be sold as
“ mortgage-backed securities.” The securities
are guaranteed by one of three agencies: the
Government National Mortgage Association
(GNMA), the Farmers Home Administration
(FmHA), or the Federal Home Loan Mortgage
Corporation (FHLMC). Mortgage pools out­
standing accounted for 12 percent of home
mortgages at the end of last year and 5 per­
cent of apartment mortgages. Ten years
earlier mortgage pools had less than 1 percent
of outstandings.

Mortgage credit sources

O utstanding residential mortgages
totaled more than $1 trillion at year-end
1979. That compared with $559 billion five
years earlier and $336 billion a decade earlier.
Home mortgages, for properties with 1-4 liv­
ing units, make up almost 90 percent of all
residential mortgages.
Savings and loan associations have long
been the main lenders for both homes and
apartments. At the end of 1979, S&Ls held 45
percent of all home mortgages outstanding
and 29 percent of apartment mortgages.
These proportions would have been lower
had S&Ls not been authorized to sell money
market certificates. Regular passbook
deposits at S&Ls fell $20 billion in 1979, but
money market certificates rose $84 billion by

Federal Reserve Bank of Chicago




Rise in mortgage debt has out­
paced new investment in housing
billion dollars

7

Most mortgage-backed securities are
bought by pension funds, trusts, mutual
funds, and other investors who usually do not
lend directly in the mortgage market. Their
participation has increased liquidity in the
mortgage market, particularly in times of tight
credit.
Another important factor in the residen­
tial mortgage market is the Federal National
Mortgage Association (FNMA), which auc­
tions commitments to buy mortgages. It raises
funds by selling its own securities. At year-end
1979, FNMA held about 5 percent of home
mortgages and 4 percent of apartment
mortgages.
Mutual savings banks held 7 percent of
the home mortgages and 13 percent of the
apartment mortgages. Located almost ex­
clusively in the northeastern states, their
share of the home mortgage market has fallen
over the years. They held 14 percent of home
mortgages in 1969.
The proportion of residential mortgages
held by life insurance companies has also
fallen in the past decade. At year-end 1979,
life insurance companies held 2 percent of
the home mortgages and 15 percent of the
apartment mortgages. Ten years earlier, they
held 10 percent of the home mortgages and
27 percent of the mortgages on apartments.
Part of the decline has been offset by
purchases of mortgage-backed securities,
particularly GNMAs.
Demographic trends favorable

A bullish factor in the long-run outlook
for housing demand is the high rate of net
household formation. The number of
households has increased an average of 1.6
million a year for the past tenyears.Thiscompares with annual averages of 1.2 million in
the last half of the 1960s and about 900,000 in
the 1950-65 period. Projections by the Census
Bureau show net household formation av­
eraging more than 1.7 million a year in the first
half of the 1980s.
This high rate is largely the result of rapid
growth in population aged 14 to 34, the years
most people become independent of their

8




parents and establish separate living quarters.
In the last ten years, the population that age
increased 16 million. It accounted for about
90 percent of the increase in total population.
Changes in the age structure of the pop­
ulation account for only part of the increase in
households, however. While the population
aged 14 to 34 increased 24 percent in the
1970s, the number of households headed by
people in that age group increased 54 per­
cent, or more than twice as fast.
The same pattern can be seen in nearly all
age groups. With the growing ability to main­
tain separate households, the number of
households has increased faster than the
population.
A fifth of all households consist of only
one person. Single people accounted for
more than half the increase in households in
the 1970s. Contributing to the high rate of
single-person household formation are
delayed marriages, higher divorce rates, and
increased longevity.
Income and independence

Closely associated with demographic
trends are changes in disposable income and
its distribution. Higher income, including
subsidies, sustains many independent
households of people who would otherwise
be forced to double up or live in institutions.
Despite temporary interruptions, real
household income has trended upward for
the past three decades. Adjusted for inflation,
disposable personal income per household in
1979 was up 12 percent from 1969,39 percent
from 1959, and 61 percent from 1949. On a per
capita basis, the rise was even steeper, up 28
percent over ten years, 67 percent over 20
years, and 100 percent over 30 years.
The faster growth in per capita income,
relative to income per household, reflects the
rise in the proportion of women working and
the related decline in childbearing. Last year,
51 percent of the women aged 16 and over
were in the labor force. That compared with
43 percent in 1969 and 37 percent in 1959. The
total fertility rate (an estimate of expected
lifetime births per woman) fell to 1.8 in the

Economic Perspectives

Income per capita has increased
faster than income per household
1969=100

•Disposable personal income, adjusted for inflation.

late 1970s. That compared wth 2.5 births per
woman in the late 1960s and 3.7 at the peak of
the baby boom in the late 1950s.
More than 3 million households live in
housing units directly susidized by the federal
government. Millions more receive subsidies
that allow them to spend more on housing—
for food, medical care, transportation,
heating, education, old age, and general
welfare.
Higher real income has facilitated not
only the formation of more separate
households but also substantial upgrading
over the years. The proportion of households
without complete indoor plumbing is less
than 2 percent, compared with 6 percent in
1970 and 15 percent in 1960. Houses built in
recent years are larger, have more bedrooms
and bathrooms, and are more likely to have
central air conditioning and fireplaces than
the typical new house in 1970.
Although real income per household has
trended upward since World War II, it could
fall in 1980. That, with the higher mortgage
rates, would tend to reduce demand for new
housing.

Federal Reserve Bank of Chicago




Homeownership and home prices

Two out of three households own their
own homes. And homeowners accounted for
three-quarters of the increase in the number
of households in the 1970s.
Changes in the composition of
households throw into question the validity
of comparisons of home prices with
household incomes. Many households with
two incomes and no children can commit
more of their income to mortgage payments
without over-extending themselves. A better
measure of the affordability of houses may be
a comparison of home prices and per capita
income.
Measured by the deflator for residential
structures, new home prices rose 136 percent
between 1969 and 1979. During that time,dis­
posable personal income per household rose
107 percent, but disposable income per capita
rose 137 percent, about the same as the rise in
home prices.
Prior to 1969 income, however measured,
had been rising faster than the cost of con-

Long decline in home prices relative
to income reversed in the 1970s
1969=100

•Deflator for nonfarm residential structures.

9

structing new homes. From 1949 to 1969 in­
come per household rose 128 percent, in­
come per capita rose 148 percent, while home
prices rose only 50 percent. Despite the re­
cent run-up in home prices, in 1979 these
prices were still lower relative to income than
in 1959 or 1949.
Nearly all mortgage contracts call for
equal monthly amortization payments. With
this outlay fixed , the total cost of
homeownership to a typical household has
risen much slower than rent, prices generally,
and income.
According to the National Association of
Homebuilders, the cost of owning a new
home was about $2,340 in 1969. That included
property taxes, insurance, and repairs (all of
which have increased sharply), as well as
mortgage payments. Keeping the mortgage
payment constant, while escalating other
ownership costs in line with CPI components,
ownership cost of the same home was $3,130
in 1979. This was an increase of 34 percent
over the ten years, compared with increases
of 67 percent in rent, 98 percent in the CPI,
and 107 percent in household income.
The rise in home prices has increased the
net worth of most homeowners. In six of the
last seven years, the appreciation in home
prices exceeded the average interest rate on
all outstanding home mortgages held by S&Ls.

Homeownership has proved to
be a bargain
1969=100

10




Home prices have outrun both
the price level and mortgage rates
percent

Over the ten years ended in 1979, home prices
appreciated an average of 9 percent a year.
The rate on outstanding mortgages averaged
7.6 percent.
A fte r ta xe s, the advantages of
homeownership were even greater. Interest
and property taxes, the major expenses of
ownership, are tax deductible. Income and
capital gains from ownership are essentially
tax exempt. The tax-free imputed income a
homeowner receives is the equivalent of the
rent he would pay if someone else owned his
house. Most owners, after sale of their homes,
can avoid capital gains taxes indefinitely—
through the rollover privilege when another
home is bought and through the $100,000 ex­
emption for sellers over 55. Because the estate
tax exempts $160,000, most capital gains on
homes escape taxation on the death of the
owner.
These tax advantages are magnified by in­
flation, which has pushed households into
progressively higher tax brackets. For some
homeowners, the rise in home prices exceed­
ed the after-tax cost of borrowing, even when
mortgage rates reached record levels.

Economic Perspectives

Rents have lagged landlord costs
1969=100

*As measured in the CPI.
**Boeckh Index for apartments, hotels and office buildings.

Apartment construction slides

Multifamily starts accounted for only 28
percent of all housing starts in the second half
of the 1970s, compared with 43 percent in the
first half. The slowdown was concentrated in
large apartment buildings intended for un­
subsidized tenants. Probably less than 300,000
such units were built last year. The stock of
unsubsidized apartment units probably fell in
1979, as the number of new units was more
than offset by abandonments and conver­
sions to condominiums.
One reason for the slowdown in apart­
ment construction is that rents have not kept
up with either construction costs or operating
costs. Rents increased 67 percent in the 1970s.
But the cost of building apartments
(measured by the Boeckh index) rose 114
percent. Property taxes rose 63 percent,
maintenance and repairs 123 percent, and
property insurance 148 percent.
Like homeowners, investors in apartment
buildings have benefited from price ap­
preciation. Unlike homeowners, however,
these investors must pay taxes on income
from rental property and they usually have to
pay capital gains taxes. Legislation in the past
decade has reduced some of the tax privileges
that investors in rental properties once had.
These include the immediate write-off of

Federal Reserve Bank of Chicago




construction-period interest and taxes, and
accelerated depreciation.
Some potential investment in rental
property has been prevented by rent control
or the threat of rent control. New York City
still controls rents, as it has in modified form
since World War II. Other metropolitan areas
with a substantial proportion of the popula­
tion under rent controls include Boston, San
Francisco, Los Angeles, and Washington, D.C.
Investors fear they will lose the prerogative of
adjusting rents as market conditions change.
Under rentcontrols, repairsand maintenance
are often deferred. Buildings deteriorate
from neglect.
Construction of small apartment
buildings has fared better than large
buildings. More than 120,000 two to four-unit
buildings have been started every year for the
past three years. These were three of the best
years on record. One reason for continued
construction of these buildings is that the
owners usually occupy one unit. Another is
that rent controls and other regulations usual­
ly are not enforced as vigorously for small
apartment buildings.
Because eligibility rules permit up to 40
percent of all households to qualify for sub-

Federal housing subsidies surged
during the 1970s
million dollars

1960 '62 '64

'66

'68

70

72

74

76

78

'80

•Estimated.
SOURCE: Bureau of Economic Analysis.

11

sidized housing, the number of subsidized
units constructed is determined by the
amount of money authorized by Congress.
Federal housing subsidies will approach $5
billion this year, compared with $4 billion in
1978 and $1 billion in 1971. For the past two
years, starts have totaled about 150,000 a year,
more than a fourth of all multifamily starts.
Under Section 8, the principal subsidy
program, lower-income tenants pay a max­
imum of 25 percent of their admitted income
in rent. Owners receive an additional pay­
ment from the government which guarantees
them a “ fair market rent/' Most Section 8
tenants occupy units that were not covered
under this program when they were built.
Condominiums have become an impor­
tant part of the multifamily market in recent
years, largely because they give owners the
same tax advantages as owner-occupied
single-family houses. More than 160,000 units
for sale as condos or co-ops were started in
1979. That compared with 135,000 in 1978, and
108,000 in 1977. Other new apartment struc­
tures are built with the intention of convert­
ing them to condos in a few years, when the
depreciation that could be allowed becomes
small relative to income from rent. Advance
Mortgage Corporation estimates that 145,000
units were converted to condominiums in
1979, against 85,000 in 1978and 45,000 in 1977.

12




Conclusion

Builders, lenders, and many potential
home buyers are under severe financial
pressure and will remain so for at least the
remainder of 1980. Although credit con­
ditions began to ease in May, lending rates
remained very high by historical standards.
The general economy appears to be in re­
cession. Until these conditions are reversed,
continued weakness in new housing seems
unavoidable. Starts could be less than 1
million this year.
Beyond the current downturn, prospects
for housing are promising. New household
formation is expected to average 1.7 million a
year for the next five years. And households
will probably continue upgrading their stan­
dards of housing, with the result that aban­
donments could average 500,000 units a year,
mostly in inner cities. An average of about
200,000 units a year will be added to the stock
of second homes. These factors combined
create a basic demand for 2.4 million new
units a year. With manufactured home
shipments providing about 300,000 new hous­
ing units annually, starts must average more
than 2 million units a year over the next five
years to avoid a serious housing shortage. This
compares with annual averages of 1.8 million
in the 1970s and 1.4 million in the 1960s.

Economic Perspectives

Bank funds management comes
of age—a balance sheet analysis
Elijah Brewer
Changes over the past decade giving bank
management greater control over growth, li­
quidity, and profitability have led bankers to
seek guidelinesfortheappropriatestrategy in
managing bank funds.
The search comes partly, of course, from
the rapid evolution from core-deposit bank­
ing into banking based on purchased funds,
banks becoming not so much deposit creators
as financial intermediaries and the profitabili­
ty of banks depending not so much on the
difference between lending rates and quasifixed deposit rates as the highly variable
spread between borrowing and lending rates
in constant flux. Control of growth, liquidity,
and profitability is achieved by keeping in­
terest rates on money market sources of funds
competitive with the returns available on
other money market instruments.
Various instruments are used in adjusting
bank portfolios. Negotiable CDs and non­
deposit instruments are most often associated
with funds management, but the whole
balance sheet of interest sensitive items, both
assets and liabilities, can be managed to some
extent. Management of all types of interest
sensitive assets and liabilities has had an effect
on the strategies used for generating and
deploying funds at a bank's discretion.
Nature of funds management

Management strategy focuses on interest
sensitive funds that can be increased or
decreased at the bank’s initiative— in contrast
to flows of funds that are beyond the bank’s
control. The notion, however, that some

Federal Reserve Bank of Chicago




assets and liabilities are subject to dis­
cretionary management, while othersare not,
is elusive. No crisp distinction can be made,
certainly not one that is always accurate. But
because of the way banks operate under
different conditions, it is possible to identify
candidates for the set of variables subject to
discretionary control and candidates for the
set that are beyond discretionary control.
Discretionary balance sheet items are
those items over which, under ordinary cir­
cumstances, the bank has considerable shortrun control. In contrast, nondiscretionary
balance sheet items are those assets and
liabilities over which the bank has little, if any,
short-run control.
In managing their discretionary
liabilities, banks can issue only the in­
struments allowed under state and federal
laws. Limits are set in terms of maturity,
denomination, rate of interest, insurance
status or creditor preference, and the holders
that will be allowed. Deposits at most banks
are subject to reserve requirements and in­
terest rate ceilings based largely on maturity
and denomination. Other liabilities are ex­
empt from these restrictions, but they are
closely constrained regarding the lender,
allowable collateral, or overall “ borrowing
limits” relative to capital stock and surplus.
Not all banks are subject to the same
restrictions. Federal statutes and Federal
Reserve regulations governing the operation
of national and state member banks, plus
parallel interest rate constraints on non­
member banks with FDIC insurance, have
had the most important effects on the over­
all structure of bank liabilities.

13

The table shows a slightly condensed ver­
sion of the balance sheet of large weekly
reporting member banks on January 2,1980.
Assets of these banks totaled $716 billion (line
9) . That was just under half the total assets of
the entire banking system.
Although there are comparatively few
large weekly reporting banks, they often
purchase large amounts of funds in money
markets to meet loan demands and deposit
withdrawals. Most banks do not have easy
access to money market sources of funds. As a
result, they do not have clear discretion in the
management of funds. For the few banks that
practice active funds management, a clear un­
derstanding of the balance sheet items sub­
ject to immediate control is prerequisite to
the determination of asset-liability manage­
ment strategies.
Regulations restrict discretion

The distinction between deposits and
debt liabilities has grown increasingly fuzzy.
For purposes of reserve requirements or in­
terest rate ceilings, several bank liabilities are
now defined as deposits. The traditional
sources of bank funds, demand deposits (line
10) and consumer-type savings deposits (line
11) , are nondiscretionary items.
Demand deposits, being deposits against
which checks are drawn, are subject to the
highest reserve requirements. Interest cannot
be paid on domestically owned demand
deposits. Savings deposits, having no specific
maturity, are subject to the lowest reserve re­
quirement. They are also subject to the lowest
interest rate ceiling under Federal Reserve
Regulation Q. Because of interest rate con­
straints, neither demand deposits nor savings
deposits are under short-run bank discretion,
though such core-deposit flows can be in­
fluenced through bank advertisement and
marketing efforts.
These flows are estimated in advance, but
the estimates are subject to wide error. Banks
usually consider time deposits other than CDs
(line 12) as nondiscretionary. Because maturi­
ty schedules are known in advance, time
deposits can be forecasted. But they are also

14




Assets and liabilities of all large
weekly reporting commercial banks

(January 2, 1980)

Assets

Million dollars

1. Cash items (including reserves. Cl PC)
2. Investment account securities
U.S. government securities
Obligations of states and
political subdivisions
Other securities
3. Trading account securities
4. Federal funds sold and
reverse RPs
5. Broker and dealer loans
6. Commercial and industrial loans
7. Other loans (including real
estate and consumer instalment)
8. Other assets (including lease
financing receivables)
9. Total assets

113,746
47,052
49,923
2,650
8,422
34,300
7,739
158,296
221,223
72,554
715,905

Liabilities
10.
11.
12.
13.
14.
15.
16.
17.
18.

Demand deposits
Savings deposits
Time deposits (other than large CDs)
Large CDs
Federal funds purchased and RPs
Borrowing from Federal Reserve
Treasury tax and loan notes
Other borrowing
Other liabilities and subordinated
note and debentures
19. Total liabilities

219,175
74,613
64,450
128,319
100,742
1,545
6,906
14,692
59,957
670,399

subject to rate ceilings under Regulation Q ,
and although they can sometimes be in­
fluenced by changes in deposit rates, which
implies some discretion, they cannot always
be controlled. Both interest rate ceilings on
these deposits and reserve requirements vary
with the maturity.
Legislation, signed by the President on
March 31, 1980, will phase out interest rate
ceilings on deposits over a six-year period.
The implementation of the six-year phase out
of rate ceilings underRegulationQ will havea
significant impact on the flow of funds to in­
dividual banks. By changing offering rates,
banks not only will be able to influence core­
deposit flows but also consumer-type time
deposit flows.
Banks can now offer two new floating
rate consumer-type time accounts. Since
mid-1978, they have been allowed to offer

Economic Perspectives

$10,000 minimum-denomination, six-month
maturity time certificates at issuing rates tied
to the average weekly rate on six-month
Treasury bills with the same maturity.
Through use of these floating rate certificates,
they have been able to influence their
consumer-type time deposits. Beginning this
year, they can also offer a new cateogry of
nonnegotiable time certificates with initial
maturities of 2 Vi years or longer at monthly
issuing rates 75 basis points below the average
daily yields on 21/2-year Treasury securities.
The interest rate is determined for any month
by the average yield available on Treasury
securities during the last three business days
of the previous month.
In March 1980, the Federal Reserve im­
posed a temporary ceiling rate of 11.75 per­
cent on new 2 12-year money market cer­
/
tificates issued at commercial banks. When
yields on 21
/2-year Treasury securities rise
more than 75 basis points above the ceiling
rate, the flow of funds into 2 12-year money
/
market certificates is limited.
While the table does not show bank
capital explicitly, criteria are set for capital
needs as the implementation of bank funds
management unfolds. Capital is not, of
course, a short-run decision variable. Nor
does it change much over the near term.
The most important component of bank
capital is equity, which consists of common
and preferred stock, surplus, undivided
profits, and capital reserves. Capital notes and
debentures (included in Iine18) have recently
substituted for generally more costly equity
accounts as sources of bank capital. Because
capital can be used both directly to extend
credit and indirectly as a base for attracting
additional funds, bank funds management
considers capital needs and discretionary
sources of funds at the same time.
Assets beyond short-run control

On the asset side, cash items in line 1,
consisting primarily of reserves, interbank
balances, and cash-items-in-process-ofcollection, are beyond bank control. They
must, therefore, be forecast. The far greater

Federal Reserve Bank of Chicago




part of a bank's cash represents reserves re­
quired to support deposits.
To satisfy reserve requirements and
provide working balances, member banksare
required to hold as reserves at the Federal
Reserve Bank a proportion of their average
deposits for every weekly reporting period
(Thursday through Wednesday). Because the
reserves to be held in the current week are
based on deposits two weeks earlier (lagged
reserve requirements), every bank knows at
the beginning of a statement week what its
reserve balance will have to average that
week. Any imbalances between its average
daily reserve balances and its average daily
required reserve are especially important in
determining day-to-day funds requirements.
Treasury holdings and state and local
obligations (line 2) are estimated on the basis
of recent experience. These investment
categories are not discretionary, because they
are needed to meet pledging requirements
against government deposits, but there are
some elements of discretion in line 2. “ Free
governments" can be used for repurchase
agreements (line 14). And as state and local
obligations often total more than required,
they can usually be sold.
Trading account assets in line 3 are
securities banks hold solely for their market­
making activities. Many large banks not only
purchase securities for their own investment
but also serve as underwriters for government
securities and CDs, distributing new securities
to their customers in line with customers' in­
vestment needs. Banks hold trading portfolios
of these securities apart from their own in­
vestment accounts and stand ready to buy and
sell them at prices that reflect current yield
trends.
Trading account assets are more dis­
cretionary than most assets. This is because
the trading positions at some banks depend
on funds the bank allocates to its dealer
department, though this allocation depends
much on the level and structure of interest
rates. At other banks, trading positions are
financed by the bank's own dealer depart­
ment, much like nonbank security dealers.
Although banks can change their lending

15

policies to control commercial and industrial
loans, and other loans over the long run, they
often consider these loans nondiscretionary
over the short run. This is because the bank
funds group assumes that business loan de­
mand will be accommodated. Instalment loan
repayment schedules are given and decisions
regarding credit risk exposure have already
been made. Fluctuations in the volume of
loans, especially commercial and industrial
loans, tend to reflect the importance of bank
customers as a source of deposits as well as
other business. For other loans, the customer
relationship is much weaker, at least in the
short run.
Linkage between banks as lenders and
businesses as borrowers has been strengthen­
ed by the tendency of banks to make com­
mitments to lend in the future. The result is a
significant reduction in the flexibility a bank
has in managing its loans, especially as poten­
tial borrowers often pay a fee for the commit­
ment. The dollar amounts of loan com­
mitments can be controlled, however, by
changing both interest and noninterest terms
on credit lines.
Other assets and liabilities included in
lines 8 and 18 can be considered residual
categories. They reflect items not explicitly
categorized in the Federal Reserve's "Report
of Condition" instructions. Other assets in­
clude such items as income earned but not
collected, prepaid expenses, and other minor
items. Other liabilities include accrued ex­
penses, dividends declared but not yet
payable, and the IRS bad-debt reserve.
There is an entry for net balance due to
foreign branches under "other liabilities." If
the balance results in a net "due from," the
amount appears in "other assets." Though
business with foreign branches can be in­
fluenced by rate changes, the business is so
discretionary that it shows up adequately in
either "other liabilities" or "other assets."
The projected changes in non­
discretionary and semi-discretionary assets
and liabilities over the next month, say, will
produce a number that, if negative, means
funds must be raised. If positive, which it
hardly ever is at large money center banks, it

16




means funds are available for investment.
Two asset and four liability items are usually
used to dispose of funds or generate funds at a
bank's discretion.
Instruments of discretionary management

Federal funds transactions and repur­
chase agreements are especially useful in dis­
posing of funds and generating funds at the
bank's discretion. These entries appear on the
asset side in line 4 and the liability side in line
14.
Federal funds are unsecured overnight
interbank loans settled in immediately
available funds. These transactions often
involve transfers of reserve balances from
reserve-surplus banks to reserve-deficit
banks. Banks, however, can purchase federal
funds from correspondent banks that find this
outlet provides both greater liquidity and,
when short-term interest rates are high,
better average returns than securities.
Execution of federal funds transactions
involves only accounting entries on the books
of the borrower and lender. Correspondent
banking transfers of federal funds consist of
reducing the correspondent bank's demand
deposit balance at the bank and crediting the
account-designated "federal funds pur­
chased" from the correspondent. It is easy to
see that the federal funds market is not
limited to the borrowing and lending of
reserve balances.
Immediately available funds can also be
acquired (or disposed of) through the sale
(or purchase) of securities. Repurchase
agreements (RPs) in government securities
are particularly useful in providing a bank
loanable funds. Reverse RPs are used to dis­
pose of excess funds.
RPs involve the purchase of immediately
available funds through the sale of govern­
ment securities—with a commitment on the
part of the bank to repurchase the securities
at a specified date and price. RPs are most
commonly made for one business day,
though longer maturities are frequent.
There are no reserve requirements or in­
terest rate ceilings on RPs of $100,000 or more.

Economic Perspectives

RPs on securities of less than $100,000 with
maturity greater than 90 days are subject,
however, to the same interest rate ceiling as
deposits of similar maturity.
Repurchase agreements are effectively
secured federal funds, collateralized by
government securities. In providing a bank
loanable funds, they also create a liability to
repurchase the securities at maturity. The en­
try on the liability side (line 14) is securities
sold under agreement to repurchase.
Conversely, banks with excess funds can
enter into reverse RPs. From the perspective
of the supplier of funds, the agreement in­
volves the purchase of blocks of securities,
with a commitment on the part of the seller to
repurchase the securities at a specified date
and price. The bank loses funds but gains
securities for the duration of the contract.
Securities purchased under agreements to
resell appear on the asset side as reverse RPs
in line 4.
Large CDs (line 13) are the most impor­
tant source of discretionary funds. CDs can be
negotiable or nonnegotiable instruments
payable on a certain date not less than 30 days
after the deposit.
As large negotiable CDs can be issued
directly to corporate treasurers and tailored
to meet maturity requirements, they cultivate
a “ reverse customer" relationship. They can
be sold more impersonally, however, through
security dealers that also maintain secondary
markets. Within limits depending on itssize,a
bank can influence the volume of its out­
standing stock of CDs by adjusting its offering
rate.
Eurodollar borrowings have become an
important discretionary source of purchased
funds. Eurodollars are deposits denominated
in U.S. dollars at banks outside the United
States, including foreign branches of U.S.
banks. These deposits arise when the owner
of a demand deposit at a U.S. bank transfers
ownership of the deposit to, say, a foreign
branch of a U.S. bank in exchange fora dollardenominated deposit claim against the
branch. These claims usually take the form of
a time deposit, but overnight and call deposits
are also made. The domestic bank gains

Federal Reserve Bank of Chicago




access to the funds by crediting “ due to
foreign branches" on its balance sheet.
Eurodollar borrowings are not an explicit
category in the Report of Condition. Rather,
net balances due directly to related foreign
institutions are reported as a memorandum
item on the consolidated balance sheet.
Changes in this item show the discretionary
flow of funds between banks and their
foreign branches.
The Federal Reserve in August 1978
reduced reserve requirements (under
Regulation M) on net borrowings of member
banks from their foreign branches to zero
percent from 4 percent. Because Eurodollar
borrowings are also exempt from interest rate
ceilingsand maturity minimums, they provide
banks with foreign branches diversity of
sources and maturity of discretionary funds.
Although there is a zero percent
reserve requirement on Eurodollar bor­
rowings and no basic reserve ratio on
purchases of federal funds and repurchase
agreements with institutions that are not
members of the Federal Reserve, an 8 percent
marginal reserve requirement was establish­
ed in October on total “ managed liabilities,"
and raised to 10 percent on March 14. These
include large CDs, Eurodollar borrowings,
and RPs and federal funds borrowings from
nonmember institutions above a base level.
All these sources of funds are still under bank
discretionary control. The amount of manag­
ed liabilities above a base level, however, has
been made more costly by the application of
marginal reserve requirements.
Borrowing from Federal Reserve banks
(line 15) is less important than CDs in terms of
dollar volume. As borrowing by member
banks is intended to cover unusual short-term
needs, the borrowing privilege is not freely
available on a regular basis. Administration of
the discount window imposes an implicit cost
in the form of Federal Reserve surveillance of
banks that use the window for extended
periods. Because current borrowings tend to
reduce the willingness of the Federal Reserve
to accommodate future borrowings, banks
use the window sparingly, conserving their
access for times of urgent need.

17

Treasury tax and loan notes (line 16) are
interest-bearing obligations of banks. The
government holds its cash balances in two
types of accounts—demand deposit balances
at Federal Reserve banksandTreasury tax and
loan (TT&L) note balances at commercial
banks qualifying as special depositaries.
All Treasury checks are paid through
Federal Reserve banks, which are the fiscal
agents of the federal government. Through
periodic “ calls,” the Treasury orders funds in
TT&L accounts transferred to Federal Reserve
balances. TT&L balances, which come mostly
from tax collections, must be transferred im­
mediately on call or purchased by the bank at
a rate of interest a quarter-percent below the
federal funds rate.
Given that rate of interest, the amount
borrowed is determined by the rate of flow of
deposits through the tax and loan accounts of
banks that hold TT&L note balances. Funds ac­
quired through this arrangement depend also
on the amount and frequency of Treasury
calls.
Other borrowing in line 17 is intended to
reflect the total amount of short-term funds
that are not specifically reported elsewhere
on the liability side of the balance sheet. Term
federal funds and loans sold under
repurchase agreements are two of the most
important items in this category.
Term federal funds are federal funds
purchased for a maturity of more than one
day, in practice, anywhere from two days to a
year. Because term federal funds have maturi­

78




ty longer than one business day, the Comp­
troller of the Currency in 1978 made them sub­
ject to both overall “ borrowing limits” and
“ lending limits” relative to capital stock and
surplus.
Loans sold under agreements to
repurchase surfaced in 1969. They are similar
to security RPs, except that they are not ex­
empt from reserve requirements and interest
rate ceilings. As the Federal Reserve defines
loans sold under agreements to repurchase as
deposits, they are subjected to all the
regulations governing deposits of similar
maturities. Loans sold under agreements to
repurchase are also subject to overall
“ borrowing limits” relative to capital stock
and surplus.
On the asset side in line 5, loans to
brokers and dealers for the purpose of carry­
ing securities are under the bank's short-run
discretion. They are call loans, payable on de­
mand. Banks do not have an irrevocable com­
mitment to renew them. If, for example,
federal funds cost more than a bank is willing
to pay, it can terminate some dealer loans as
another source of funds. Reducing an asset is
just as much a source of funds as increasing a
liability.
The instruments of discretionary funds
management have grown in number since
modern funds management emerged in the
early 1960s. This evolution is a continuing
process. There is little doubt that as economic
and money market conditions change, so will
the instruments of bank funds management.

Economic Perspectives

Sinking float
Thomas A. Gittings
Federal Reserve float—the additional bank
reserves the Federal Reserve creates when it
passes credit before it receives payment—
complicates monetary control and costs the
Treasury revenue. For these reasons, the
Federal Reserve System has set a sharp reduc­
tion in float as one of its main operational
goals. Daily average float has been cut from
more than $8 billion in early 1979 to less than
$4 billion in April 1980.
How Federal Reserve float is created

Float develops from the day-to-day
operation of the Federal Reserve's na­
tionwide check-clearing mechanism. Until
the creation of the Federal Reserve, checks
were cleared through private arrangements,
such as local clearing associations and
networks of correspondent banks. To cover
the cost of handling checks, banks and clear­
ing houses routinely deducted a charge from
the face amount of checks, a practice known
as non-par clearing.
With the creation of the Federal Reserve,
the government became involved in the
payments mechanism. The Federal Reserve
Act imposed on the system the requirement
that checks be cleared at par. Most checks
and check-like instruments, such as NOW ac­
counts and credit union share drafts, are still
cleared through correspondents and private
clearing associations. Many checks, however,
are cleared through the Federal Reserve, and
these are the checks that can affect the level
of Federal Reserve float.
The Federal Reserve’s check-clearing
mechanism works through a system of
deferred credits and charges. Federal Reserve
banks publish availability schedules showing
when credit will be passed on to banks
depositing checks. For checks drawn on local
banks, the schedules promise credit the same
day. For checks drawn on more remote banks,

Federal Reserve Bank of Chicago




the schedules defer credit as much as two
business days.
In all cases, however, banks presenting
checks are guaranteed credit according to the
schedule—even though the Federal Reserve
may not actually have collected on the
checks. This guarantee reflects the Federal
Reserve's longstanding belief that the ef­
ficiency of the payments mechanism requires
that banks know exactly when reserves will
become available.
Checks are sorted at the Federal Reserve
Bank according to the locations of the banks
they are drawn on. Nearly all the sorting is
done on high-speed equipment that reads
the magnetically encoded MICR numbers on
the bottom of checks. Only checks in poor
condition have to be sorted by hand.
Checks on banks in the same territory as
the depositing bank are delivered to the pay­
ing bank by courier or first-class mail. Checks
on banks in other territories are sent to the
Federal Reserve offices there, where they are
processed and delivered to the paying banks.
Since 1916, it has been the policy of the

Federal Reserve float
billion dollars

19

Federal Reserve not to charge paying banks
until they actually receive the checks and
have some time to process them.
The Federal Reserve Bank passes credit
and receives payment through the debiting
and crediting of reserve accounts. The
balances in these accounts are assets of the
commercial banks and liabilities of the
Federal Reserve Bank. The accounts are in
many ways likechecking accounts.That is one
reason the Federal Reserve System is often
called the banker's bank.
The Federal Reserve Bank, then, passes
credit to a depositing bank simply by
crediting the bank's reserve account. With an
entry in its accounting system, the Federal
Reserve increases the reserves held by the
banking system. Likewise, it receives payment
for a check by debiting the paying bank’s
reserve account.
If the debit and credit entries are not
made the same day, so that they offset each
other, reserves of the banking system as a
whole are changed. Anything that causes ac­
tual collection to deviate from the availability
schedule—unrealistic schedules, clerical
errors, equipment failures, bad weather,
transportation strikes, fuel shortages—can
cause an increase in float.
Federal Reserve float is not a new
development. For the first 25 years of the
Federal Reserve’s operations, float was low,
primarily because the deferred availability
schedule ran up to as many as eight days. A
three-day maximum deferment schedule was
adopted in 1940, and in 1951 the maximum
was reduced to two days. Any reduction in the
availability schedule that is not matched with
faster collection of checks causes float to
increase.

Its effects on monetary and fiscal policy

Federal Reserve float can have important
effects on both monetary and fiscal policy.
The additional reserves created by float can­
not be distinguished from the reserves
created by the Open Market Desk through
purchases of government securities. To offset

20




an increase in reserves that is out of line with
monetary objectives, the Open Market Desk
must sell securities from its portfolio.
Part of the trouble is that system float is
literally as variable and unpredictable as the
weather. One week in February last year, float
jumped from $6.6 billion to over $12 billion.
Most of the increase was due to a blizzard that
snarled transportation on the East Coast.
As the Open Market Desk uses estimates
of system float for the following day in
conducting its operations, misses in the
estimate—which occasionally are billions of
dollars—can create operational problems.
The magnitude of this problem can be sensed
from a comparison of system float with total
reserves. The daily average of total reserves
last year was around $40 billion. System float
averaged nearly $6.7 billion.
Float also results in lost revenue to the
Treasury. When the Open Market Desk sells
securities to offset the effect of float on
reserves, it reduces the Federal Reserve’s
portfolio. That reduces the interest payments
the system receives and lowers the earnings
the Federal Reserve can return to the
Treasury.
A first approximation of the loss to the
Treasury can be obtained by multiplying the
daily average level of system float by some
market interest rate. Since most open market
transactions involve securities maturing
within 90 days, an appropriate interest rate
would be some average of the federal funds
rate and the market yield on three-month
Treasury bills. This average last year was
between 10 and 11 percent. As float averaged
about $6.65 billion a day, the reduction in
Federal Reserve earnings due to float must
have been around $700 million.
This is only part of the story, however. If
the Federal Reserve could cut the daily
average of float in half, net receipts to the
Treasury would not necessarily increase by
$350 million. There are several reasons why it
would be less than that.
In reducing the public's holdings of
government securities and, therefore, the
Treasury’s interest payments to the public, a
reduction in float would also translate into

Economic Perspectives

W ays float co u ld be reduced

smaller total tax receipts. Some people have
guessed the reduction in tax receipts could
amount to half the increase in interest
payments returned by the Federal Reserve to
the Treasury. This would reduce the savings to
the Treasury to about $175 million.
Also, to reduce float the Federal Reserve
would have to increase its operating costs.
Expenditures on additional personnel and
equipment needed to step up the processing
of checks and speed movement between
Federal Reserve offices would reduce the net
earnings passed on to the Treasury.
The Treasury would also receive less
revenue from commercial banks, which will
have to make more sorts of checks and
prepare more cash letters. The additional
workload will increase costs and lower profits
and tax payments.
If float were cut in half in 1980, but at a
substantial increase in the costs of operations
of commercial banks and the Federal Reserve,
net revenue to theTreasury might increase by
only$100 million to $150million. That isabout
1 percent of the earnings the Federal Reserve
is expected to pass to the Treasury in fiscal
year 1980 and less than .02 percent of the total
receipts the Treasury expects to collect.
Regardless of the perspective—whether
current float is seen as involving high costs to
the Federal Reserve and the Treasury or
whether the costs are seen as comparatively
minor items—float itself had increased rapidly
in the last few years. From a daily average of
about $3 billion from 1970 to 1976, it rose to
$3.6 billion in 1977, $5.5 billion in 1978, and
$6.7 billion in 1979.
Reflected in this increase was the higher
value of checks and other collection items
cleared through the Federal Reserve, in­
cluding wire and securities transfers, interest
coupon collection, and automated clearing
house payments.
During that time, the costs of float also
rose sharply, reflecting in part the increase in
inflation. The interest rate on three-month
Treasury bills more than doubled, increasing
from a yearly average of 5 percent in 1976 to
more than 10 percent in 1979.

Federal Reserve Bank of Chicago




To gain more insight into where float is
created in the collection cycle, the Federal
Reserve banks are adjusting their accounting
systems so some components of float can be
identified. These modifications will provide
improved techniques to evaluate the perfor­
mance of couriers carrying cash items
between Federal Reserve offices and to pay­
ing banks. They can also be used to monitor
the Fed's internal performance in handling
float-generating cash items.
Other methods of reducing float are:
By

sp eed in g

check

collection—

Guidelines have been established for justify­
ing additional expenditures to reduce float.
Subject to the guidelines, Federal Reserve
banks can hire more personnel, buy better
processing equipment, and arrange other
transportation and delivery services, provid­
ed the change will significantly reduce system
float by speeding collections.
By extending availability schedules—

Federal Reserve float could be sharply re­
duced by adjusting availability schedules to
reflect average clearing times. If experience
for a particular type of item showed 90 per­
cent of the funds collected in one day and 10
percent collected on the second day, the
Federal Reserve could pass credit according
to these percentages, increasing reserves 90
percent of the deposit in one day and 100 per­
cent in two days—a practice known as frac­
tional availability.
By giving priority to large checks—

Special attention is being given to the collec­
tion of large checks. Surveys of check items
collected by the Federal Reserve show that a
large part of the dollar volume handled is ac­
counted for by comparatively few checks. It
has been estimated, for example, that a fourth
of the float is generated by checks for a
quarter-million dollars or more.
Several plans have been proposed for
sorting out this small number of large checks
and giving them special handling. Any of the
proposals would affect the advantages of us­
ing Fed services. They would all require
presenting banks to makeadditional sortsand

21

separate cash letters for large checks. The
amount of paperwork—for presenting banks
and for Federal Reserve banks—could in­
crease substantially.
Under one proposal, large checks would
be given priority handling within the existing
check collection system. Under another,
large checks would be presented for collec­
tion electronically. And under still another,
they would be handled on a collection basis,
with the Federal Reserve passing credit only
after it received payment.
Under the second proposal, which is
consistent with the Federal Reserve's inten­
tions of going eventually to an all-electronic
payments mechanism, Federal Reserve banks
receiving large checks would copy the
necessary information onto computer files
that could then be sent to other Federal
Reserve offices through the system’s existing
electronic communications network. The
data would then be presented to the paying
banksand their reserve accounts debited. The
checks themselves could be delivered later or
simply stored at a warehouse.
The third proposal would mean large
checks were no longer paid according to a
deferred availability schedule.
Any of these proposals could reduce float
significantly. Before adopting any of them,
however, the Board of Governors will ask
member banks for comments.
By charging for float—Another approach
is now being taken to Federal Reserve float.
The Monetary Control Act requires the
Federal Reserve to charge for float and other
services and make its clearing services
available to all depository institutions.
By keeping the use of availability
schedules while charging depositing in­
stitutions for any float that was created, the
Federal Reserve will adopt a float manage­
ment practice of some commercial banks.
Since the Fed will be required to charge the
market rate for federal funds, the effect will
be to offset the revenue lost by the Treasury
through system float.
To implement this procedure, Federal
Reserve banks will have to significantly
change their accounting systems so that float-

22




creating transactions are properly identified
and assigned to the right depositing in­
stitutions. Although a fairly large initial invest­
ment will be required, the system should be
inexpensive to operate, especially when com­
pared with the costs of speeding up check
processing.
Charging for float, however, will have a
direct impact on banking costs to the public.
With member banks charged for the funds
the Federal Reserve created before it receiv­
ed payment, banks will try to pass the charges
on to their customers. Charging for float and
other check processing services will also
result in increased competition from private
clearing institutions.
Further in the future

All these ways of reducing float take for
granted that the Federal Reserve will con­
tinue processing a large part of the country's
checks and passing credit according to
deferred availability schedules. Although the
Federal Reserve sees these conditions as the
constraints within which it must operate, the
constraints could be changed.
The Fed could stop clearing checks—

With approval of Congress, the Federal
Reserve could phase out its check processing
operations. Then, instead of trying to deter­
mine the right prices for processing checks, it
could turn the function over to private clear­
ing houses and correspondent banks.
Private processors, in having to compete
for check collecting, would be subject to
market forces in setting their prices and
availability schedules. The Federal Reserve
could continue as the central bank, main­
taining reserve accounts for its member banks
without processing their checks.
Private clearing houses would notify
Federal Reserve banks at the end of the day of
the amounts to be debited or credited to
reserve accounts. The Federal Reserve System
already has such arrangements with several
automated clearing houses. If these
arrangements were extended to all check
clearings, Federal Reserve float could be
essentially eliminated.

Economic Perspectives

Unlike the hodgepodge of private clear­
ing arrangements before the Federal Reserve
was created, the system could be based on a
single nationwide clearing procedure in­
volving final adjustments in reserve accounts.
Schedules could be eliminated—Though
it might be the most drastic change, the most
straightforward approach would be the
elimination of deferred availability schedules.
Instead of credits being passed on the basis of
individual checks, they could be passed on
the basis of cash letters showing the total
amount of checks that one bank was pre­
senting for collection from another bank.
There are some basic policy issues inherent in
this proposal, as well as technical problems in
implementing it, as for example, the
redesigning of many operational procedures.
Because the procedure would represent
a fundamental change in how the Federal
Reserve passes credit, member banks would
be prompted to reevaluate their schedules for
making deposited funds available to their
customers. The Federal Reserve has taken the
position that availability schedules serve the
public interest by ensuring a reliable flow of
payments. As Governor Coldwell has said:
Thismeansthatwe (theFederal Reserve)
absorb the float resulting from major
snow storms, hurricanes and other
natural disasters. It also means that we
insulate the payments system from many
more routine problems—aircraft delays,
power outages, and so forth.
The benefits of this insurance need to be
weighed against the cost associated with
Federal Reserve float and efforts to reduce it.
Although certainty about the time
deposited funds will become available isconsidered important, the Federal Reserve could
still reduce the average level of float by adop­
ting more realistic availability schedules. Dur­
ing the winter, for example, when float often
increases drastically, an extended availability
schedule could be adopted to reflect system

Federal Reserve Bank of Chicago




experience with collections that time of year.
There are real costs associated with even
this fairly minor change, however. Member
banks would have to adjust the availability
schedules they use in passing credit to their
customers. Corporate cash managers and the
public generally would have to adjust their
plans to reflect the change.
The Giro system could be used—The ap­
proach to reducing Federal Reserve float that
would involve the most fundamental changes
in the existing system would be the replace­
ment of the check-based payments
mechanism with the Giro system advocated
by former Governor Mitchell, an expert on
the payments mechanism. Under this system,
anybody wanting to initiatea payment against
a bank deposit would notify the bank directly
whom to pay, how much, and when. Noti­
fication could be by phone, a check-like
form, or a standardized bill submitted by the
payee.
Having verified the request, the bank
would authorize a transfer from its reserve
account to the account of the payee’s bank
on behalf of the payee’s private account. The
information could be put on computer tapes
or could be sent directly to a clearing institu­
tion over a computer-to-computer telephone
connection.
Items to be cleared through the Federal
Reserve would be sorted according to re­
ceiving banks and transferred between
reserve accounts. The payee's bank would be
notified that it had an increase in reserves that
matched the credit to the payee’s account.
There would be no need for physical sorting
of paper checks. Payment instructions and
sorting would be done electronically.
Adopted nationwide, the system would
essentially eliminate Federal Reserve float. It
would also reduce the costs of processing
paper checks. Most European countries have
Giro systems that allow depositors to instruct
the post office to pay bills for them.

23