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aa m PERSPECTIVES e c o n o m ic M A Y / J O M 1 1$)®S B a n k s a n d n o n b a n k s : A run fo r th e m o n e y F ir s t y e a r e x p e r ie n c e : Illin o is m u ltib a n k s sh o p c a re fu lly B a n k e r s ’ a c c e p t a n c e s r e v is it e d ECONOMIC PERSPECTIVES May-June 1983 C o n ten ts Volume VII, Issue 3 Banks and nonbanks: A run for the money E d ito ria l C o m m itte e Harvey Rosenblum, vice president and economic advisor Randall C. Merris, research economist Edward G. Nash, editor Roger Thryselius, graphics Nancy Ahlstrom, typesetting Gloria Hull, editorial assistant E co n o m ic P ersp ectiv es is p u b lish ed b y th e R e s e a rc h D e p a rtm e n t o f th e F e d e ra l R ese rv e Bank o f C h ica g o . T h e v iew s e x p r e s s e d a r e th e a u th o r s ’ an d d o n o t n e c e ssa rily r e fle c t th e v iew s o f th e Neck a n d neck, banks a n d their nonbank com petitors figh t fo r the lead in fin a n cia l sen ices, bu t with the Congress a n d the courts silent nobody is su re how level the track is. First year experience: Illinois multibanks shop carefully m a n a g e m e n t o f th e F e d e ra l R e se rv e Bank o f C h ica g o o r th e F e d e ra l R ese rv e System . S in g le-co p y s u b sc rip tio n s a r e avail a b le fre e o f ch a r g e . P lease sen d re q u e s ts f o r single- an d m u ltip le -c o p y s u b sc rip tio n s, b a c k issues, an d a d d re ss c h a n g e s to P u b lic In fo rm atio n C e n te r, F e d e ra l R ese rv e Bank o f C h ica g o , P.O . B o x 8 3 4 , C h ica g o , Illin ois 6 0 6 9 0 , o r te le p h o n e ( 3 1 2 ) 3 2 2 -5 1 1 1 . A rtic le s m ay b e re p r in te d p ro v id e d s o u r c e is c r e d ite d an d P u b lic In fo rm atio n C e n te r is p ro v id e d w ith a c o p y o f th e p u b lish ed m aterial. IS S N 0164-0682 13 M any sm aller a n d doum state banks fea red they w ould b e gobbled up when the 1981 Illinois m ultibank holding com pany act becam e law, but the holding com panies have—so fa r at least— taken a gou rm et approach. Bankers’ acceptances revisited A useful tool o f international trade fin a n cin g has becom e m ore im portant as bankers take a closer look at liability m anagem ent techniques. 21 Banks and nonbanks: A run for the money Harvey Rosenblum, Diane Siegel, and Christine Pavel For many years, commercial banks have com peted in some product lines with other financial institutions such as S&Ls, mutual savings banks, and credit unions. Recently, commercial banks have increasingly found themselves faced with new com petitors—manufacturers such as Gen eral Motors Corporation, retailers such as Sears, Roebuck and Company, and diversified financial concerns such as Merrill Lynch and American Express. This new mixed breed of nonbank financial companies and even nonfinancial com panies has been encroaching on banks’ “turf ” over the last decade. And banks, though con strained by regulations, have not willingly shared their traditional business of lending and deposit taking; rather, they have sought footholds in some of their new competitors’ markets. This article examines the expanded compe tition in the financial services industry first by quantifying the extent and impact of competi tion against depository institutions, especially commercial banks, by nonbank companies and then by looking at what depository institutions have done to meet their new competition. Nonbank C om p etition —An H istorical Overview Two decades ago the only significant nonfi nancial-based firms dealing in financial services were Sears and General Motors with 1962 respective net incomes from financial services of $50.4 million and $40.9 million.1 H arv ey R o s e n b lu m is v ic e p r e s id e n t and e c o n o m i c advi s o r in th e R e s e a rc h D e p a rtm e n t, F e d e ra l R ese rv e Bank o f C h ic a g o . D ian e S ieg el w a s a s u m m e r in te rn w ith th e R e s e a rc h D e p a r tm e n t d u rin g 1 9 8 2 and is n o w c o m p le tin g h e r M BA stu d ie s at th e U n iv ersity o f C h ica g o . C h ristin e Pavel is a r e s e a r c h assistan t at th e C h ica g o Fed. But nonfinancial-based companies have taken a major competitive position in financial services in the past ten years. Such companies have been offering credit and other financial services not as loss leaders to attract additional business, but as profit-making products.2 A sample of ten nonfinancial-based compa nies with impressive earnings from financial ser vices in 1972 is presented in Table 1. During 1972, these companies had net profits from financial activities that totaled $662.2 million. By year-end 1981, their earnings from financial ser vices had reached $1.7 billion, more than times the 1972 total and certainly more than can be accounted for by inflation. Only two of these companies had lower percentages of earnings attributable to financial services in 1981 than in 1972. The others had higher percentages; in fact, were it not for its finance subsidiary, General Motors would have posted a net loss in 1981. General Motors and Sears, with 1981 earn ings from financial activities of $365 million and $385 million respectively, each had approxi mately the same financial service earnings asj. P. Morgan & Co., the holding company for the nation’s fifth largest bank. Among the nation’s largest banking firms, only Citicorp, BankAmerica Corporation, and Chase Manhattan Corpora tion had earnings that exceeded the financial service earnings of these nonbank giants. Many of the manufacturers listed in Table 1 originally financed only their own products and therefore did not effectively compete with com mercial banks. But by 1972, many of these socalled “captive” finance companies were en gaged in financial activities unrelated to the sale of their parents’ products. 2Vi ‘ C le v e la n d A. C h ris to p h e , C o m p etitio n in F in a n c ia l S ervices , N e w Y o rk : First N ation al C ity C o rp o r a tio n , 1 9 7 4 . In th is s tu d y o f e le v e n c o m p a n ie s , C h ris to p h e p ro v id e s an in -d e p th v ie w o f th e relativ e im p o rta n c e o f b an k s and n o n fin a n cia l firm s in th e e x te n s io n o f c o n s u m e r c re d it. 2As p o in te d o u t in “ B a n k in g ’s N e w C o m p e titio n : M yths R o se n b lu m a n d Siegel, C o m p etitio n in F in a n c ia l Services: The Im p a c t o f N o n -b a n k E n try Staff Study 8 3 -1 fro m w h ic h th is a r tic le is ad a p te d , u p d a te s C h ris to p h e ’s w o rk and e la b o a n d R e a litie s,” E co n o m ic R eview , F e d e ra l R e se rv e Bank o f A tlan ta, J a n u a r y 1 9 8 2 , p p . 4 - 1 1 , b y W illia m F. F o rd , m any n o n b a n k firm s h a v e s o u g h t to e n t e r th e p r o d u c t lin es o f c o m m e r c i a l b an k s b e c a u s e b a n k in g a p p e a rs to b e m o r e p r o f ita b le re la tiv e t o th e ir tra d itio n a l lin e s o f bu sin e ss. Y e t, d e r a te s u p o n n e w c o m p e titio n in o t h e r s e g m e n ts o f th e b an k in g b u sin ess s u c h as b u sin ess c r e d it and retail d ep o sits. sp ite th e e n t r y o f th e s e n o n b a n k firm s, c o m m e r c i a l ban ks h av e r e m a in e d m o r e p r o fita b le th a n th e ir n e w c o m p e tito r s . Federal R eserve B ank o f Chicago 3 C onsum er Lending T a b le 1 F in a n c ia l s e r v ic e e a rn in g s of n o n fin an cial-b ased co m p a n ie s (e stim a te d ) 1972 Million dollars 1981 Percent of total earnings Million dollars Percent of total earnings $31 18.0% Borg-Warner $6.3 10.6% Control Data 55.6 96.2 50 Ford Motor 44.1 5.1 186 General Electric 41.1 7.8 142 General M otors 96.4 4.5 365 29.3 42.1 71 24.5 160.2 33.6 387 57.2 Gulf & W estern ITT Marcor Se a rs W estinghouse 29.2 n.a.1 8.6 109.6’ 9.0 12.4 110 209.0 34.0 385 51.1 15.2 7.6 34 7.8 662.2 n.a.' 1,732 'Not available because parent company had a net lo ss for 1981. ’General M otors and consolidated subsidiaries had a lo ss of $ 15 million after taxes; however, after adding $ 3 4 8 million of equity in earnings of such nonconsolidated subsidiaries as G M A C, General M otors had after-tax net income of $333 million. S O U R C E ; Harvey Rosenblum and Diane Siegel, C o m p e ti Staff Study 83-1 (Federal Reserve Bank of C hicago, 1983), Table 1, p. 12. tio n in F in a n c ia l S e r v ic e s : Th e Im p a c t o f N o n ba n k E n try , Over the last decade, some nonfinancialbased companies have made quite remarkable inroads in the area of consumer lending; none theless, banks have gained ground in some areas, most notably in credit cards. At year-end 1972, for example, the three largest banks held less consumer installment credit than the three larg est nonfood retailers. These, in turn, held less consumer installment credit than three large consumer durable goods manufacturers (see Figure la ). As shown in Figure lb , these rankings had changed by year-end 1981. Within this sam ple of nine companies, bank holding companies experienced the highest growth rate since 1972, in large part due to their credit card operations. The incursion of nonbank firms in the area of consumer lending is illustrated dramatically in the narrower field of auto loans. As shown in Figure 2, banks have the largest share in auto lending—47 percent at year-end 1981 — but this share is down 13 percentage points from its peak Figure 1 How the big co n su m e r installm ent credit holders sta ck e d up: 19 72 and 1981 billion dollars 20 This trend has continued. In 1981, over 90 percent of Borg-Warner Acceptance Corpora tion’s income and assets came from financing companies’ products, and less than 1 per cent of Westinghouse Credit Corporation’s fi nancing volume was related to Westinghouse products. For General Electric Credit Corpora tion, this trend toward financing non-G.E. prod ucts began in the mid-to-late 1960s; by 1972, less than 10 percent of General Electric Credit’s receivables represented G.E. products, and in 1981 only about 5 percent of General Electric Credit’s financing was for its parent’s products. Thus, not only have the earnings from finan cial activities increased as a percent of total earn ings for the majority of the companies listed in Table 1, but many of those companies which were originally captive have evolved to compete increasingly with commercial banks and others in the financial services industry. other 4 10 0 a 1972 $12.5 - $6.9 _ 50 $45.8 1981 General E lectric 40 Ford M o to r 30 General M o to rs 20 -- 10 - 0 L 3 m anufacturers 3 re ta ile rs 3 BHCs S O U R C E : Rosenblum and Siegel, Charts la and 1b, p. 16. Econom ic Perspectives ( new loans extended less liquidations ); in 1981, banks’ extensions of net auto loans were nega tive; and in 1982, banks made only 16 percent of 1978 1981 the net new auto loans that year. Finance com panies, however, made only 25 percent of the net new auto loans in 1978 but accounted for 72 percent of such loans in 1982. The sharp drop off in new business volume is also particularly noteworthy as it demonstrates a market in a state of flux, a condition conducive to large—even massive—shifts in market shares. The shift in the consumer lending market SOURCE: Rosenblum and Siegel, C hart 2, p. 22. away from commercial banks toward finance companies can also be seen in Figure 3. In 1978, commercial banks issued 55 percent of net new in 1978. Over this same three-year period, the installment debt ( new loans less liquidations) to share of auto loans held by the captive finance households; finance companies accounted for companies of General Motors, Ford, and Chrysler only 22 percent. By 1981, however, these rela had increased by 12 percentage points to 33 tive shares had more than reversed themselves as percent of the market. GMAC alone, in 1981, commercial banks moved away from consumer held $28.5 billion of auto loans, almost oneinstallment lending over the 1978-1981 period. fourth of all auto loans outstanding and double In fact, in 1978 commercial banks extended its share of just three years earlier. Bank of Amer almost $ 1.20 in new consumer installment credit ica, the largest auto lender among commercial for every one dollar of consumer installment loans liquidated, but by 1980, they extended banks, held $2.2 billion of auto loans at year-end only 95 percent for every one dollar of consumer 1981, a mere one-thirteenth of the total held by installment loans that were repaid or liquidated. GMAC, far and away the largest consumer lender Over this same period, finance companies in in the United States and probably the world. creasingly entered the consumer lending market; These figures, however, may be somewhat thus, by 1981, finance companies issued 72 per biased by recent events. The soaring cost of cent of net new consumer installment debt funds, binding usury ceilings in many states, and while commercial banks issued only 3 percent. use by General Motors, Ford, and Chrysler of below-market financing rates in an attempt to These shifts in market shares may be some boost sluggish sales have caused many lenders to what distorted by the fact that finance company exit the auto lending business in recent years. subsidiaries of bank holding companies are As shown in Table 2, commercial banks, in included with finance companies. Further com 1978, made 58 percent of net new auto loans plicating interpretation of the data is the ten dency of some banks to sell consum Table 2 er loans to their finance company S o u r c e s of net n ew autom obile cre d it by ho lder affiliates and vice versa. The division b etw een finance com panies and 1978 1981 1982 Dollar Dollar Dollar banks, however, is correct because billion Percent Percent billion Percent billion banks are regulated very differently * Com m ercial banks .8 16 10.9 58 -3 .5 than finance companies, regardless * Finance com panies 72 4.7 25 4.0 3.5 of their affiliations. * C red it unions 3.1 17 .6 12 .9 Also, the shifts in market shares * 18.7 8.4 4.9 100 100 in consumer installment lending are ‘ Percentages not shown b ecause market shares cannot be negative. n o t n e ce ssa rily p erm an en t but S O U R C E S : U .S . Board of G o vernors of the Federal R eserve System , Federal Reserve Bulletin 69 (May 1982), pp. A42-A43 and Consumer Installment Credit G .19 (March 1983). probably reflect cyclical as well Figure 2 C a r loans: Auto finance com p anies take a bigger slic e of outstanding loans Federal Reserve B ank o f Chicago 5 as secular forces working simultaneously. As can be seen in Figure 3, commercial banks recovered some market share in 1982, as did S&Ls and all other lenders at the expense of finance compa nies. In fact, finance companies lost almost 38 percentage points in only one year. Further more, the comeback of commercial banks and S&Ls in the consumer lending market is likely to continue through 1983 as banks and other de pository institutions that have been flooded with new funds in response to the successs of money market deposit accounts (MMDAs), Individual Retirement Accounts (IRAs), and other deregu lated deposit instruments becom e more willing to offer consumer installment loans. Further, S&Ls are likely to maintain a more significant presence in consumer lending than they did in the past as they continue to take advantage of the broader lending powers given them under the Depository Institutions Deregulation and Mone tary Control Act of 1980 and the Garn-St Ger main Depository Institutions Act of 1982. Just as the shift in market share in consumer installment lending has been dramatic, so too has the decline in net loan volume, falling by more than half—to less than $20 billion in 1981 from over $43 billion in 1978. Even more signifi cant was the decline in volume of net new con- new Figure 3 C o n su m er loans: b a n k s ta ke a beating m arket share (percent) s or sumer installment loans at commercial banks— down to $0.6 billion in 1981 from $23-6 billion three years earlier. During this same period, auto loans outstanding at commercial banks declined by $2.4 billion; in the prior three-year period (year-end 1978 vs. year-end 1975), auto loans at commercial banks grew by $29 billion. While commercial banks held less in auto loans in 1981 than they held in 1978, their out standing credit card receivables remained rela tively constant at about $17.5 billion over this same three-year period. In fact, it is in the area of charge cards that banks have done best against their nonfinancial-based competitors. In 1972, Sears had the leading credit card in the United States in terms of number of active accounts, charge volume, and customer account balances. By 1981, Visa was the undisputed leader by all three measures with MasterCard not far behind and Sears a distant third except in number of active accounts (see Figure 4 ). Beginning in 1980 Visa and MasterCard began displacing the cards issued by many retailers such as J. C. Pen ney and Montgomery Ward. Whether the success of Visa and MasterCard relative to the Sears card implies a victory for banks over a nonbank competitor is unclear since neither Visa nor MasterCard are banks. They are franchising companies that license a product to franchisees. The original franchisees were banks, but several hundred savings and loan associations, mutual savings banks, and credit unions have become franchisees during the last few years. Indeed, some of Visa’s recent growth is attributable to the popularity of Merrill Lynch’s Cash Management Account, which in cludes a Visa card. Business Lending commercial banks finance companies others* •Includes m utual savings banks, m ortgage pools, federal and rela te d agencies, s ta te and local g o vernm ents, and oth e r lenders. SOURCES: The B oard o f G o ve rn o rs o f the Federal Reserve System , Fe d era l R e s e r v e B u lletin 69 (M ay 1 9 82).pp. A 4 2 -A 4 3 and C o n su m e r In sta lm en t C re d it, G. 19(M arch 1983). 6 Commercial banks remain the predominant source of credit to all businesses, large and small. As can be seen in Table 3, banks have the lion’s share of short-term commercial and industrial loans (C&I loans) in the United States. The 15 largest bank holding companies held $ 141.6 bil lion of domestic C&I loans at year-end 1981, more than triple the total held by a selected group of 32 nonbank companies, most of whom E conom ic Perspectii es Figure 4 T h e bank c a rd s a c e out the biggest retailer on balan ce and volum e million accounts S e a rs M asterCard Visa number of active accounts at year-end billion dollars Se a rs M asterCard V isa customer charge volume S e a rs M asterCard Visa total custom er account balances at year end SOURCE: Rosenblum and Siegel, Table 9. p. 23. have made forays into banks’ traditional com mercial lending activities.3 The importance of nonbank lenders should not be underestimated. With $39.4 billion in C&I loans the 15 selected industrial companies were an important factor in the C&I loan market, holding almost three-tenths as much in loans as were booked domestically by the 15 largest bank holding companies. In addition, funds that large firms raise from banks and from the money and capital markets are used to provide loans to many small businesses. This trade credit, although an imperfect substitute for bank credit because it cannot be used to pay other creditors or meet employee payrolls, is the most widely used source of credit for small businesses, both in terms of the percentage of firms utilizing it and in dollar volume. Moreover, at year-end 1981 nonfmancial firms had $53 7 billion of com m er cial paper outstanding and nonbank financial firms had $77.4 billion of commercial paper out standing; some portion of this was used to pro vide credit to businesses. Banks are also an important source of funds for commercial mortgages and lease financing, but nonbank firms again should not be over ’T h e s e 3 2 c o m p a n ie s w e r e c h o s e n o n th e basis o f th e ir b e in g th e m o s t fre q u e n tly liste d n o n b an k in g -b ased c o m p e ti t o r s o f c o m m e r c ia l banks. M any fin an cial-b ased c o m p a n ie s hav e b e e n e x c lu d e d b e c a u s e th e y have d e m o n stra te d little o r n o in c lin a tio n t o in vad e th e tu rf o f c o m m e r c ia l banks. Federal Reserve Bank o f Chicago looked in these areas. As shown in Table 3, four insurance-based companies held more commer cial mortgage loans at year-end 1981 than did the 15 largest bank holding companies.4 The 32 selected nonbank firms also held more lease receivables at that time than did the top 15 bank holding companies on a worldwide basis and more lease receivables than did domestic offices of the nation’s more than 14,000 insured com mercial banks. If the sum of C&I loans, com mercial mortgage loans, and business lease fi nancing can be used as a proxy for total business credit, then it would appear that the 32 selected nonbanking-based firms have made sig nificant inroads into the commercial lending activities of commercial banks. rough Deposit-Taking Not only are banks experiencing competi tion from nonbanking-based firms in lending areas, but they are also witnessing the same phe nomenon in the area of deposit-taking. Substi tutes for bank deposits have been around as long as there has been a reasonably efficient second ary market for government and private securi- 4I n s u ra n c e c o m p a n i e s h av e p lay ed a m a jo r r o le in c o m m e rc ia l m o rtg a g e le n d in g f o r m a n y y ears. F u rth e r, m any b a n k s d o n o t h av e th e a b ility t o h o ld lo n g -te rm c o m m e r c i a l m o rtg a g e s b e c a u s e o f th e s h o r t-te rm n a tu re o f th e ir funds. 7 significant extent upon deposits as a source of B u s in e s s lending by s e le c t e d n on b an kin g -b ased firm s and funds to finance the b an k holding co m p a n ie s at ye ar-en d 1981 loans extended to their cu s to m e rs. M ostly, Commercial Commercial Total and Industrial Mortgage Lease Business their funds are raised Financing Lending Loans Loans in the money and capi (................................ ................. $ m i l l i o n ■ ................. ) tal markets at competi 15 Industrial/Com m unications/ 14,417* 39,365 1,768 55,550 tive rates; consequent Transportation! ly, the profit margins of 3,602 3,054 8,237 10 Diversified Financial! 1,581* most nonbank com 4 Insurance-Based 399 35,506 892* 36,797 panies which have fi — — 3 Retail-Based 606 606 nancial activities are 43,972 40,328 16,890* 101,190 not, and have never 15 Largest B H C s been, dependent upon Domestic 14,279* 175,342 141,582 19,481 International 123,067 118,021 5,046 the Regulation Q fran Total, To p-15 B H C s 24,527 14,279 298,409 259,603 chise. It has been esti Dom estic O ffices, All mated that roughly half Insured Com m ercial Banks 13,168 460,602 327,101 120,333“ of the 1980 profits of 31 of the 50 largest ‘ Includes dom estic and foreign lending and may include leasing to household or government U.S. banks could be at entities. tributed to their ability “ Includes all real estate loans except those secured by residential property. to pay below-market fFinancing by banking and savings and loan subsidiaries has been subtracted. rates on savings a c S O U R C E : H arvey Rosenblum and Diane Siegel, C o m p e t i t i o n i n F i n a n c i a l S e r v i c e s : T h e I m p a c t o f N o n b a n k E n t r y , S ta ff Study 83-1 (Federal Reserve Bank of Chicago, 1983), Table 10, p. 26. counts.* Thus, the con tinued phase-out of Qceilings is unlikely to damage the market position of nondepository ties. Treasury bills and repurchase agreements, firms in lending. for example, are close substitutes for bank de posits, including demand deposits. In 1973 a closer substitute for bank deposits The Banks’ Responses to Nonbank Com petition emerged—money market mutual funds ( MMFs). While not a big threat to banks when interest rates were relatively low, MMFs became very Commercial banks, as well as other deposi tory institutions, have attempted to meet the successful when rates rose, growing from only a nonbank challenge by offering some products few billion dollars in “deposits” in 1975 to over $230 billion by Decem ber 1982 when they and services—such as MMFs and discount bro reached their peak. At that time, Merrill Lynch kerage services—that had becom e the domain of nonbank financial firms (see box, chronology alone managed $50.4 billion in MMF assets, and 1). In addition, banks and other depository insti the Dreyfus Corporation managed $ 18.5 billion. tutions have tried to circumvent regulatory geo Originally offered by nonbank financial firms such as Dreyfus and the Fidelity Group, MMFs graphic barriers to compete on an even keel with attracted nonfinancial-based firms as well. Sears their nonbank rivals (see box, chronology 2). began offering the Sears U.S. Government Money Market Trust in late 1981 and later acquired Dean W itter Reynolds, a brokerage firm manag 'A le x J . P o llo ck . “T h e F u tu re o f Bank ing: a N ation al ing five MMFs. M arket an d Its Im p lic a tio n s ,” in P ro ceed in g s o f a C o n feren ce Although MMFs do comn£t&_wilh .hank oxuBaJuk^tU£ture a n d C o m p etitio n , F e d e ra l R e se rv e Bank o f C h ica g o , l 82 , pp 3 1 - 3 6 . deposits, few nonbank compar ies rely to any T a b le 3 RESEARCH LIBRARY 8 Federal Reserve Bank o f S t. L o u is Econom ic Perspectives Products and Services Banks and other depository institutions have not stood idle while deposits left their lowyielding accounts for MMFs. As shown in chro nology 1, banks and thrifts have designed various products to com pete with MMFs and, at the same time, to skirt a number of competitioninhibiting or cost-raising regulations. The Bank of California, for example, tried to shield an MMF-like account from interest rate ceilings by housing it in Bancal’s London branch, and Orbanco proposed a note that would pay market rates and have transaction features. These two schemes were stopped by the Federal Reserve Board, but other innovations have met with more success. Northwestern National Bank, for instance, began allowing its customers to bor row money on their six-month money market certificates through checking accounts in April 1981, and Talman Home, Chicago, introduced its Instant Cash Account in September 1982. While some depository institutions created products to compete with MMFs, others decided to join them rather than try to beat them. Banks and thrifts began collaborating with money fund managers like Dreyfus and Federated Securities to offer sweep accounts—accounts that sweep idle cash balances exceeding some predeter mined level into high-yielding MMFs. Finally, banks and thrifts no longer had to try to circumvent regulations by linking up with money fund managers in order to offer their customers MMF-like products. In early October 1982, the Congress passed, as part of the Garn-St Germain Depository Institutions Act of 1982, new legislation which permits banks and other depository institutions to offer the Money Market Deposit Account, and in Decem ber 1982, the DIDC authorized the Super NOW account. Both are designed to compete directly with MMFs.6 6B o th th e MMDA an d th e S u p er N O W a c c o u n t re q u ire an in itial d e p o s it o f * 2 ,5 0 0 , a r e f re e o f in te r e s t r a te ceilin g s, a n d a r e fe d e ra lly in su re d ; h o w e v e r, d e p o s ito rs c a n w r ite o n ly t h r e e c h e c k s p e r m o n th o n a n MMDA w h e re a s th e y c a n w r ite an u n lim ite d n u m b e r o f c h e c k s o n a S u p er N O W . S u p er N O W a c c o u n ts a r e r e s t r ic te d to in dividu als, c e r ta in n o n profit c o r p o r a tio n s , a nd g o v e rn m e n ta l u n its, w h e re a s MMDAs c a n b e o ffered t o an y entity . Federal Reserve Bank o f Chicago Another area dominated by nonbank finan cial firms which banks have sought to enter is discount brokerage services. Generally, banks have taken one of three paths in offering these services: collaborating with discount brokerage firms, acquiring existing brokerage firms, or establishing discount brokerage subsidiaries of their own. As shown in chronology 1, many banks and thrifts have taken the first route, hooking up with brokers such as Fidelity Brokerage Services and Quick & Reilly. Some, however, have opted for one of the other two routes. For example, Secur ity Pacific National Bank, which at first offered discount brokerage services through Fidelity, acquired Kahn & Company, a Memphis-based discount brokerage, in O ctober 1982. In Novem ber 1982, Security Pacific formed a subsidiary to provide back office support for other banks entering the discount brokerage field. More recently, BankAmerica Corporation acquired Charles Schwab & Company, the nation’s largest discount broker. Taking the third path, in Novem ber 1982, three S&Ls started Invest, a brokerage service which S&Ls nationwide can offer. In addition, since mid-1981 w henj. P. Mor gan & Co. formed a subsidiary to trade financial futures for Morgan Guaranty’s account, banks have increasingly been seeking to trade in the financial futures market for their own accounts as well as for their customers. Before they can act as brokers for third parties, however, banks must first get approval from the Comptroller of the Currency or, in the case of bank holding com panies, from the Federal Reserve Board. Then they must apply to the Commodity Futures Trad ing Commission (C FTC ) for registration as brokers. Among those that have cleared both stages of the regulatory process are J. P. Morgan & Co., North Carolina National Bank, Bankers Trust, and First National Bank of Chicago. Banks are also expanding into less financerelated fields such as data processing and tele communications. For example, Citicorp was recently given permission to offer an expanded range of data processing and transmission ser vices7 and, in June 1982, it purchased two trans7F e d e ral R eserve B u lle tin , A u gust 1 9 8 2 , p. 5 0 5 . 9 r "\ C h ro n o lo g ie s of ch a n g e 1. B a n k s fight b a ck 2 . In te rsta te b a rrie rs cru m b le A p r 1 9 8 1 Citibank and N orthw estern N ational Bank allow their custom ers to borrow money on their six-month money market certifi cates through a checking account. M a r 1 9 8 0 South Dakota p a sse s legislation which allow s out-ofstate bank holding com panies to move credit card operations to South Dakota. Three years later, the state p a sse s a new bill that allow s out-of-state bank holding com panies to own state chartered banks which can own insurance companies. M a y 1 9 8 1 The Bank of California NA, San Francisco, introduces a new account to com pete with money market funds. B ecause the account is housed in the bank's London branch, B anC al sa y s it is not subject to interest rate ceilings and reserve requirements, but the Fed disagrees. M a y 1 9 8 1 J.P . Morgan & C o . form s a subsidiary to trade financial futures for Morgan G u aranty’s account. In July 1981, the Federal Reserve Board allow s Morgan G uaranty to execute trades for its custom ers; in Decem ber 1982, the Com m odity Futures Trading Com m ission approves. S e p 1 9 8 1 D reyfus Se rvice C orp. sw eep s e x c e ss cash from bank accounts into its money market funds, and other firms follow Dreyfus' lead. N o v 1 9 8 1 B a n k A m e ric a C o r p . p la n s to a c q u ir e C h a r le s S c h w a b & Com pany, the nation's largest discount brokerage firm; the Federal Reserve Board approves the acquisition early in 1983. J a n 1 9 8 2 Banks and thrifts collaborate with brokerage firms to offer discount brokerage se rv ice s to custom ers of the banks and thrifts. M a r 1 9 8 2 Orbanco Financial S e rv ic e s Corp., a Portland, Oregon, holding company, pro poses a note with a minimum denomination of $5,000, which bears market interest rates, and which has tran sac tions features. The Federal Reserve Board, however, disallow s the note. M a y 1 9 8 2 Three S& Ls receive perm ission to start a joint securities brokerage service that S& Ls nationwide can use to offer investment serv ices to their custom ers. The service, known as Invest, begins operations in November. J u n 1 9 8 2 Citicorp purchases two transponders on the W estar V satellite in preparation for global banking. J u l 1 9 8 2 The Federal Reserve Board allow s C itico rp to offer var ious data processing and data transm ission se rv ice s nationwide through a new subsidiary, Citishare Corp. A u g 1 9 8 2 The Com ptroller of the C urrency allow s First National Bank of C hicag o to form a subsidiary to trade in the futures market for its custom ers. In January 1983, the Com m odity Futures Trading Commission approves. S a p 1 9 8 2 Talman Home Federal Savin gs and Loan Association introduces its Instant C a sh Account to com pete with money market funds. The account requires a $5,000 minimum balance and pays the rate of a 6-month C D . F e b 1 9 8 1 Delaw are p a sses an out-of-state banking bill which opens the state to major money center banks. J u n 1 9 8 1 Citibank establishes Citibank (South Dakota) NA in Sioux Falls to handle its credit card operations. A u g 1 9 8 1 Marine Midland Banks, Inc., Buffalo, New York, infuses $ 2 5 million into Industrial Valley Bank and Trust Com pany, Philadel phia, by buying newly issued common stock and nonvoting preferred sto ck with w arrants to buy an additional 20 percent of Industrial Valley's common stock should interstate banking be permitted. S e p t 1 9 8 1 United Financial Corp., San Francisco , a subsidiary of National Steel and parent of C itizen s Savin gs and Loan, acquires an S&L in New York and one in Miami Beach. The Com bined S& Ls later become First Nationwide Savings. N o v 1 9 8 1 Casco-N orthern Corp., Portland, Maine, parent of C a s c o Bank and Trust Com pany, sells First National Boston Corp. 56,250 shares of its convertible preferred stock and warrants to buy addi tional common shares. In M arch 1983, First National Bank of Boston Corp, agrees to acquire Casco-N orthern. D e c 1 9 8 1 J.P . Morgan & Com pany estab lish es Morgan Bank (D el aware), to engage in wholesale commercial banking. D e c 1 9 8 1 Home Savin gs and Loan Association, Lo s Angeles, acquires one Florida thrift and two in M issouri. In connection with the acquisitions, Home Savings and Loan becom es Home Savings of America. J a n 1 9 8 2 North Carolina National Bank Corp. acquires First National Bank of Lake C ity, Florida, by using a legal loophole in a grandfather clause. J a n 1 9 8 2 Am South Bancorp, of Alabama, South Carolina National Bank Corp. and Trust Com pany of Georgia plan to merge into a single holding company if and when interstate banking is permitted. Until then, each is buying $ 2 million of nonvoting preferred stock in the other two. J a n 1 9 8 2 Home Savings of America, L o s Angeles, acquires five Texas savings associations and one in Chicago. M a r 1 9 8 2 Marine Midland Banks, New York, in vests $ 1 0 million in Centran Corp., Cleveland, in the form of newly issued nonvoting preferred stock and w arrants to buy over 2 million shares of Centran s common stock should interstate banking be permitted. S a p 1 9 8 2 North Carolina National Bank's N C N B Futures Corp. receives final approval from the Com m odity Futures Trading C o m mission to act as a futures comm ission merchant. J u n 1 9 8 2 Alaska's new banking law permits out-of-state banks to acquire Alaskan banks without the states of those banks enacting reciprocal legislation. S e p 1 9 8 2 The Federal R eserve Board allow s Bankers Trust New York Corp. to buy and sell futures con tracts for its custom ers through a new subsidiary, BT Capital M arkets Corp. In January 1983, the Commodity Futures Trading Com m ission approves. J u l 1 9 8 2 New York legislation amends the state's banking law to allow out-of-state bank holding com panies to acquire control of New York banks provided that the states of these banks reciprocate. S e p 1 9 8 2 Poughkeepsie Savin g s Bank applies to the FH LB B to acquire Investors Discount Corp., a Poughkeepsie discount broker age firm. O c t 1 9 8 2 The Com ptroller of the C urrency allow s Security Pacific, Lo s Angeles, to acquire Kahn & C o ., a M em phis-based discount brokerage firm. O c t 1 9 8 2 The D ID C authorizes an account which federal depository institutions can offer and which is “ directly equivalent to and com pet itive with money market funds." N o v 1 9 8 2 Security Pacific National Bank form s a subsidiary, S e cu r ity Pacific Brokers Inc., to provide back office support for other banks which offer discount brokerage services. D o c 1 9 8 2 The D ID C authorizes a Su per-N O W account which fed eral depository institutions can offer on January 5, 1983. __________________ ____ ___________________ 10 A u g 1 9 8 2 The Federal Reserve Board and the shareholders of Gulfstream Banks Inc., Boca Raton, Florida, approve the acquisition of Gulfstream Banks by North Carolina National Bank Corp. S e p 1 9 8 2 In the first reciprocal interstate bank acquisition between New York and Maine, Key Banks Inc. of Albany agrees to acquire D ep ositors C orp. of Augusta; the acquisition is expected to be completed by the end of 1983. D e c 1 9 8 2 The Federal Reserve Board allows Exchange Bancorp., Florida, to merge into North Carolina National Bank Corp., and the Fed approves the merger of Downtown National Bank of Miami into N CN B /G ulfstream Banks Inc. D e c 1 9 8 2 Both houses of the M assachu setts Sta te legislature p ass an interstate banking bill which allow s M assachu setts banks to expand into other New England sta te s on a reciprocal basis. The law is effective in 1983. _________________________________________ / Econom ic Perspectives ponders on the Westar V satellite, thus becom ing the first financial institution to own trans ponders in space. Geographic Barriers Banks seem to be meeting the challenges of nonbank competition in many of their new rivals’ product lines, but banks do not yet enjoy the same geographic freedom as their nonbank competitors. Although many of the products and services which banks and bank holding com panies provide are offered nationwide, such as those provided through nonbank subsidiaries like consumer finance and mortgage banking companies, the interstate expansion of a physical facilities is still generally prohibited. Nonetheless, as shown in chronology 2, banks and thrifts are preparing for the legalization of interstate banking, and—through mergers, ac quisitions, affiliations, relaxations of some state laws, and technological advances—interstate banking is slowly becoming a reality. Agreements to merge are the most common way in which banks and thrifts have been prepar ing for interstate banking. Usually, one institu tion agrees to invest in another by purchasing nonvoting preferred stock with warrants to buy additional shares of common stock should inter state banking be allowed. Although Citicorp was the first to use such a maneuver, many others have followed. In this manner, for example, Marine Midland Banks, New York City, invested $25 million in Industrial Valley Bank and Trust Company, Philadelphia, and $10 million in Cen tran Corporation, Cleveland.8 Some interstate mergers and acquisitions, however, have already taken place. In January 1982, Home Savings of America, Los Angeles, acquired five ailing savings associations in Texas and one in Chicago after acquiring a troubled Florida thrift and two in Missouri. Also in January 1982, North Carolina National Bank Corpora tion acquired First National Bank of Lake City, bank’s "T h e F e d e ra l R e s e rv e B o a rd p e r m its th e se lim ited in te r s ta te b an k in g a c tiv itie s if th e a c q u irin g c o m p a n y h o ld s n o m o r e th a n 2 4 . 9 p e r c e n t o f th e n o n v o tin g sh a re s, h o ld s n o m o r e th an 5 p e r c e n t o f th e v o tin g sto c k , and e x e r c i s e s no c o n t r o l o v e r th e b an k in w h ic h th e in v e stm e n t is b e in g m ade. Federal Reserve B ank o f Chicago Florida, through a loophole in a grandfather clause, and later expanded further in that state. Although the acquisitions by Home Federal and those by North Carolina National Bank Corpora tion are different in nature and purpose, five or ten years from now their effects will be the same. In some instances, interstate banking has been encouraged by individual states. In early 1980, South Dakota passed a law which allows out-of-state bank holding companies to establish banks to house credit card operations, and in June 1981, Citicorp moved its credit card opera tions to the newly established Citibank (South Dakota). In March 1983, South Dakota passed another law which allows out-of-state bank hold ing companies to acquire or charter state banks, which could own insurance companies. Dela ware passed its out-of-state banking law in Feb ruary 1981 to encourage banks to relocate cer tain activities in the state; since then 12 institu tions have established banks in Delaware, includ ing five from New York, four from Maryland, and three from Pennsylvania. However, these new banks do not compete with Delaware banks in general banking operations. In June 1982, Alaska enacted legislation that allows out-of-state banks to acquire Alaskan banks without reciprocal leg islation on the part of the states of those banks. New York, Massachusetts, and Maine enacted similar legislation but require reciprocity. Outof-state banks, therefore, can compete with banks in Alaska, New York, Massachusetts, and Maine, but Massachusetts limits interstate bank ing to the New England states. Interstate banking also occurs through banks’ and thrifts’ affiliations with nationwide brokers and investment firms. Alliances that would have been termed “unholy” not long ago are commonplace today. Through its network of some 475 offices, Merrill Lynch has marketed All Savers Certificates for Bank of America, Crocker National Bank, and two S&Ls, one in Florida and the other in Washington. Merrill Lynch also maintains a secondary market for retail CDs issued by banks and S&Ls and acts as a broker in the placement of retail CDs issued by more than 20 banks and thrifts, thus giving each of them a nationwide reach. Merrill Lynch is not alone in this regard but is joined by several other com 11 panies including Sears/Dean Witter, Shearson/ American Express, and E. F. Hutton. Together these four firms operate roughly 1,325 offices throughout the United States. Thanks to these and other firms like them, a comparatively small depository institution such as City Federal Sav ings and Loan of Elizabeth, New Jersey, can now compete toe-to-toe on a nationwide basis with Bank of America in the sale of federally insured retail CDs. The importance of the cooperative affilia tions between brokers and depository institu tions should not be underestimated, for it may represent one of the most significant reductions in entry barriers into the financial services busi ness. No longer is deposit and loan growth of a de novo bank or S&L constrained by its ability to generate deposits from its local customers. To the extent that it has profitable lending oppor tunities, a new depository institution can engage in liability management through the sale of bro kered, insured deposits by paying above the going market rate. The availability of federal deposit insurance should make depositors virtu ally indifferent to the identity of the institution they deal with. It is now conceivable that a de novo bank or S&L could develop a billion-dollar deposit base within a year or two of its opening. retail Conclusion Over the last decade, competition in finan cial services has increased as the number of firms grew and the geographic market became more and more national. Furthermore, deregulation tends to be accompanied by unbundling of prod ucts, and this has been the case in the financial services industry. Nonbank firms have been able to target and successfully enter the major and minor product lines of commercial banks. Thus the preeminent position of commercial banks has been eroded somewhat in consumer lend ing, business lending, and deposit-taking. But as nonbank rivals encroached upon banks’ tradi tional territory, banks responded where possible by invading some of their new competitors’ prod uct lines and by attempting to compete on a nationwide basis as do these competitors. Thus, by 1983, the line of com m erce that was once called commercial banking has evolv ed into a new line of commerce, the provision of financial intermediation services. Yet, the courts have continued to delineate commercial bank ing as a distinct line of commerce, separate from other financial services. In the eyes of the courts, banks compete only with other banks, but not with S&Ls, credit unions, finance companies, mutual savings banks, insurance companies, and so forth. This has been the prevailing view of the courts for two decades, having been decided in 9 in 1963. The evidence provided in this article illus trates quite clearly that technological advances and long overdue statutory and regulatory changes have blurred the distinctions between financial intermediation services offered by oldline, traditional financial institutions such as banks and S&Ls and the services offered by the financing arms of manufacturers, retailers, and diversified financial conglomerates. In the longer run, the survivors will be the low cost producers— irrespective of their charters. Perhaps then the line of commerce definition will be judicially or legislatively revised. Philadelphia National Bank 9U n ited S ta te s v. The P h ila d e lp h ia N a tio n a l B a n k e t al., 3 7 4 U.S. 3 2 1 , 9 1 5 ( 1 9 6 3 ) . This article is a brief summary of a more detailed monograph, Competition in Financial Services: The Impact o f Nonbank Entry, by Harvey Rosenblum and Diane Siegel, Staff Study 83 - 1. Copies can be obtained from: Public Information Center Federal Reserve Bank of Chicago P.O. Box 834 Chicago, Illinois 6 0 6 9 0 12 Econom ic Perspectives First year experience: Illinois multibanks shop carefully Sue F. Gregorash Many independent bankers in Illinois thought that their worst fears were being realized when Governor Jam es Thompson signed the multi bank holding company bill (Public Act 8 2 -1 ) into law on July 3, 1981. For years, these inde pendent bankers had battled multibank banking proponents, even to the point of splintering one statewide banking trade group, to protect inde pendent unit banking and avert the perceived threat of being swallowed up by the big Chicago banks. But, in the first year after the bill became effective on January 1, 1982, Illinois’ bank hold ing companies (BH Cs) did not deluge regulators with holding company applications. The changes in the Illinois banking industry have been, so far, orderly and evolutionary. The trade groups have mended their fences and reunited. Provisions o f th e act Illinois law imposes several restrictions, some of which are peculiar to the state, on pro spective multibank holding companies. First of all, it is noteworthy that Illinois does not allow branch banking; the 1981 law did not change that fact, save for the additional limited “com munity service facility”1 allowance. The law divided the state into five bank holding company regions (see b ox). Region I consists of Cook County, where the Chicago area’s major banks are located. Region II includes the five counties surrounding Region I, appropriately called the “collar counties.” Regions III, IV, and V group the counties of northern, central, and southern Illinois, respectively. Su e F. G r e g o r a s h is a re g u la to r y e c o n o m is t w ith th e F e d e ra l R ese rv e Bank o f C h icag o . 'C o m m u n ity s e rv ic e facilities offer fe w e r s e rv ic e s th an a fu ll-se rv ice b ra n c h . T h ey a r e lim ited to re ce iv in g d ep o sits, c a sh in g and issu in g c h e c k s , drafts, and m o n e y o r d e r s , c h a n g in g m o n e y , an d r e c e iv in g p a y m e n ts o n e x is tin g in d e b te d n ess. B an k s w e r e p e r m itte d by p r e v io u s law to estab lish a m a x im u m o f tw o facilities. Federal Reserve Bank o f Chicago Holding companies are restricted to acquir ing banks in their designated region and one region. For instance, BHCs located in Region IV can acquire banks in that region, as well as in Region III or Region V, but not both. “Designated region” is defined in the law to be the banking region of the holding company’s largest subsidiary bank ( in terms of total assets). Once a BHC has indicated a preference for a contiguous region via an acquisition, it is pre cluded from acquiring banks in any other con tiguous region. Region I has only one contiguous region, i.e., the collar counties around Cook County. ( Region V is similar in this respect.) This design intentionally prevents the big Chicago banks from acquiring downstate Illinois banks and severely limits Chicago BHCs’ geographic expan sion capabilities within the state. The new law also prohibits BHCs from contiguous acquiring a bank ch a rte re d after January 1 , 1 9 8 2 , until the bank has been in business for at least ten years.2 This provision was incorporated into the law to prevent the state’s larger holding compa nies from saturating the state with de novo banks. A BHC located outside of Illinois can acquire an Illinois bank only if it owned at least two banks in Illinois prior to the effective date. This section was added to the law to grandfather one particular preexisting holding company rela tionship and to limit entry into Illinois by out-ofstate BHCs. The new law has no provision for reciprocal interstate bank holding company ac quisitions. Finally, the bill allows each bank to establish a third “community service facility.” These facili ties can be established either within the home county or within ten miles of the bank’s home office location. 2An a m e n d m e n t to th e law , e ffe ctiv e J u n e 2 3 , 1 9 8 2 , e x e m p ts fro m th e 1 0 -y e a r r e q u ire m e n t failing banks and b an ks c h a r te r e d so lely as a v e h ic le fo r reo rg a n iz a tio n . 13 Banking in Illinois p rio r to th e m uhibank act At year-end 1981, Illinois, after Texas, was the state with the largest number of commercial r banks—more than 1,300. In fact, 8.8 percent of all commercial banks in the United States are in Illinois. This large number is due primarily to the absence of branch banking in the state. With such a large number of commercial Illinois’ new bank m arketplace The major provisions of the Illinois mul tibank holding company act that was signed July 3, 1981 include: • Multibank holding companies, effec tive January 1, 1982, are perm issible in Illinois. • The state is divided into 5 regions: Region I: Cook County Region II: McHenry, Lake, Kane, DuPage and Will Counties Region III: Northern Illinois Region IV: Central Illinois Region V: Southern Illinois • Holding companies may be formed and may acquire banks in no more than two contiguous banking regions. • No holding company may acquire a bank chartered after the effective date until the bank has been in business for at least 10 years. • Holding companies headquartered outside of Illinois may acquire an Illinois bank if the corporation owned at least two banks in Illinois to the effective date. only prior • Allows for one “Community Service facility” W ithin hom e county or adjacent county (if in adjacent—not more than 10 miles from main bank). Facility cannot be less than one mile from existing main bank premises of another bank—subject to several ex emptions (e.g., a two-mile limit in municipalities with population less than 10,000 which have 3 or more banks). 14 Seventh District portion of Illinois Econom ic Perspectives banks there exists a large supply of potential candidates from which to form multibank hold ing company groups. Table 1 shows bank distri bution and deposit size in each of the bank hold ing company regions. By far the largest concentra tion of deposits—65 percent of all domestic deposits held by banks in Illinois—is in Cook County. On the other hand, the data show a much more even distribution of banks through out the remainder of the state, with the largest concentration—30.8 percent—located in Region III. Multibank activity in 1982 Table 1 Illinois banks and deposits by region December 31, 1981 Com m ercial banks Number Percent Total deposits Amount Percent ($ b illio n ) Region 1 313 23.8 $59.3 64.9 Region II 161 12.2 7.1 7.8 Region III 408 30.8 11.9 13.0 Region IV 212 16.0 6.2 6.8 Region V 229 17.3 6.8 7.4 1,323 100.0 $91.4 100.0 S ta te totals S O U R C E : Reports of Condition, 12 /3 1/81 . During 1982, 33 multibank holding com pany applications were filed with the Federal Reserve Bank of Chicago. Twenty-four of these applications, involving 47 banks, were approved and consummated in the first year under the new act (see Table 2 ). The remaining nine applica tions were approved, but had not yet been consummated. Most of the holding company activity o c curred in the northern and northeastern por tions of the state. Regions I and III were the most active in 1982, with 42 percent of the acquiring BHCs located in Region I, and 29 percent in Region III. Forty percent of the acquired banks are located in Region III, including the seven banks acquired by United Bancorporation, Inc., of Rockford, the largest holding company (in number of banks) formed in 1982. Although more than fifty percent of the state’s banks are located outside a standard met ropolitan statistical area (SMSA), only 19 per cent of those acquired in 1982 ( 9 banks) are located outside an SMSA, indicating a pre ference, at this stage, for banks in metropolitan areas. Many of the early applications formalized what may be best considered de facto multibank arrangements. For example, three applications, encompassing 18 acquired banks, involved pre existing chain banking relationships. Chain bank ing is defined as the control of two or more commercial banks by the same individual or group of individuals. Prior to the Illinois multi bank act, chain banking had been the market’s response to the prohibition against branching Federal Reserve B ank o f Chicago Note: Colum ns may not add to total due to rounding. and multibank holding companies in Illinois. In addition, eight of the 47 banks acquired had some other tie to the acquiring holding company. Some had previously been affiliated with the other banks in the holding company. Others had principals (officers or directors) in common; or the BHC held 5 percent or less of their stock. Four banks had a previous corre spondent relationship with the lead bank of the acquiring holding company and two out-of-state banks were acquired under a grandfather provi sion in Florida’s banking law. Only 15 out of the 47 banks acquired did not have a previous rela tionship with the acquiring BHC.3 First-year BHC activity in Illinois has been similar to, though somewhat more active than, early multibank experience in other states. Of these, the multibank state most structurally sim ilar to Illinois is Texas. Like Illinois, Texas is a state with many commercial banks; they are prohibited by state law from branching; and sev eral chain banking relationships had been estab lished in the state.4 The 1970s was a decade of 'F iv e o f th e s e b an ks w e r e a c q u ire d by e ith e r C o n tin e n ta l Illin ois C o r p o r a tio n , H a rris B a n k co rp , In c., o r N o rth e rn T ru st C o r p o r a tio n an d h ad p r e v io u s re sp o n d e n t re la tio n sh ip s w ith th e le a d b an k s o f th e s e h o ld in g c o m p a n ie s; h o w e v e r, th e im p o rta n c e o f th e s e p r io r re la tio n sh ip s m ay b e d is c o u n te d s o m e w h a t d u e to th e g r e a t n u m b e r o f re s p o n d e n ts s e rv ic e d by th e s e la rg e c o r r e s p o n d e n t banks. 4It sh o u ld b e n o te d , to o , th a t s tr u c tu r a l d iffe re n c e s e x is t b e t w e e n th e tw o s ta te s in p o p u la tio n an d d e p o sit g ro w th , in c o m e lev els, an d g e o g ra p h ic and in stitu tio n a l c o n c e n t r a tio n o f d e p o sits. 15 BHC expansion in Texas. There were four mul tibank holding companies in existence in Texas at the beginning of 1971, increasing to nine by the year’s end, holding 14 percent of statewide deposits.15Illinois, by comparison, had 24 multi bank holding companies after the first year, representing approximately 28 percent of state wide commercial bank domestic deposits. Thus, Illinois BHCs hold approximately twice the per centage of statewide commercial bank deposits than did Texas after its first year of active multi bank expansion. 'J o h n R. S to d d en , “ M ultibank H o ld in g C o m p a n ie s — D e v e lo p m e n t in T e x a s C h a n g e s in R e c e n t Y e a rs ,” B u sin ess R etneu' (F e d e r a l R e s e rv e Bank o f D allas, D e c e m b e r 1 9 7 4 ) , p. 4 . r Means o f acquisition Two basic forms of acquisitions—cash pur chase and exchange of shares—are employed in bank holding company acquisitions. Sellers who receive cash or notes, under certain circum stances, are required to pay capital gains taxes. Thus, if cash and/or notes are received, install ment reporting is frequently used and taxes are paid as the cash is received. On the other hand, exchanges of shares can be structured so that selling shareholders receive multibank holding company stock (either common or preferred) without having to recognize any economic gain. Such gains are postponed until the stock is sold. This form of acquisition is generally referred to Shopping hints: bank value and price Book values are used in Table 2 to com pare acquisition prices because of ease of cal culation and because they seem to be the common denominator used by bankers in discussing acquisitions. However, the limita tions of using book value as a measure of value should be recognized. First, book value is based on historical figures and does not con sider the “going concern” value of the firm. Second, book values are even more distorted during inflationary times when the market value of bank assets ( in particular bonds and mortgages) are depressed. In addition, this effect complicates accounting for goodwill and the valuation reserves resulting from the purchase. Financial theory suggests that a more appropriate means of calculating a bank’s worth is to determine the present value of the future earnings of the bank. This may be done by projecting the bank’s earnings per share into the future, determining the present value, and comparing this figure to the bank’s cur rent stock price. If the present value is greater than the current stock price, the acquisition is worthwhile. Traditionally, the discount rate 16 "\ used is the cost of capital; however, others have suggested that the planned rate of return on common equity is more appropriate for bank acquisitions. * None of the Illinois multibank applica tions received in 1982 indicated that they used the present value method to determine the offer premium. Nor do we have informa tion to tell us whether or not the acquired banks evaluated their offers based on this method. Some are reluctant to use the present value method because of the conjectural nature of the projections, as well as lack of a current stock price or sufficient depth of market for small or closely-held institutions with inactively traded stocks. In fact, some bank stock analysts feel that shares of a bank that represent a control block are worth more than other shares of the same bank, * * further complicating the present value calculation. ‘J e r o m e C. D arnell, “ H o w M u ch is Y o u r Bank W o r th ? ” C o m m ercial W est, J u n e 1 4 , 1 9 7 5 , pp. 6 - 1 2 . * ‘ L arry G. M e e k e r an d O . M a u ric e Jo y . “ P r ic e P r e m i u m s fo r C o n tro llin g S h ares o f C lo se ly H eld S to ck ,” J o u r n a l o f B u sin ess, Vol. 5 3 , no. 3 , pt. 1 (J u ly 1 9 8 0 ) , pp. 2 9 7 - 3 1 4 . Econom ic Perspectives T a b le 2 1 9 8 2 Illin o is m u ltib an k ho ldin g c o m p a n y fo rm a tio n s a n d a c q u is it io n s ( S e v e n t h D is t r ic t po rtio n) 12-31-81 Holding Company B ank(s) Acquired total deposits* Illinois C a sh offer or BH C Located in S M S A Date of 12-31-81 12-31-81 exchange book valuef Region (Y e s - No) Consummation R O A** RO E” of shares (1.0 = book value) 10.84 cash 1.46 N/A Ratio of price to ($ million) 1. First Colonial B ankshares Corporation. Chicago 165.6 1 Y es 28.1 1 Y es 3,200.2 1 Y es All American Bank oJ Chicago (10% additional shares) 3-26-82 0.82 2. Northern Trust Corporation. Chicago Security Trust Com pany of Sa raso ta. N.A., Saraso ta. Florida N/A N/A N/A 4-5-82 N/A N/A N/A 129.9 1 Y es 5-17-82 1.05 cash 1.61 14.2 2 Yes 10-1-82 0.66 13.46 9.04 cash 1.98 N/A N/A N/A 11-1-82 N/A N/A N/A N/A 84.8 1 Y es 23.62 exchange 1.30 exchange 1.68 O'H are International Bank. Chicago The First Bank. Naperville Northern Trust Bank of Florida, N.A., Miami. Florida 3. Madison Financial Corporation. Chicago First National Bank of Wheeling. Wheeling 16.0 1 Y es 4-19-82 1.00 107.8 1 Y es 4-19-82 -0 .65 321.0 3 Y es 45.8 3 Y es 4-20-82 0.92 11.16 exchange 0.60 43.4 3 Y es 4-20-82 0.39 5.10 exchange 0.52 5-3-82 1.53 16.72 combination, Madison National Bank of Niles. Niles - 4. Com mercial National Corporation, Peoria Prospect National Bank of Peoria. Peoria University National Bank of Peoria, Peoria 5. First Freeport Corporation, Freeport The Polo National Bank. Polo 100.1 3 No 229 3 No primarily 1.65 (exchange portion) exchange 6. Gary-W heaton Corporation. Wheaton 172.4 2 Y es Batavia Bank. Batavia 32.9 2 Y es 50.8 1 Y es 18.8 1 Y es N/A 4 Y es 12.6 4 28.3 6-17-82 0.75 12.26 exchange 1.02 6-23-82 0.85 10.06 cash 1.46 No 6-25-82 0.66 8.51 N/A N/A 3 No 6-25-82 0.50 7.57 N/A N/A 154.5 1 Y es 26.7 1 Yes 6-30-82 0.18 3.49 exchange 1.03 249.4 1 Y es 26.8 1 Y es 7-23-82 -0 23 -4 .99 cash 1.41 7-30-82 1.12 16.12 choice of cash 7. Steel C ity Bancorporation, Chicago Thornridge S ta te Bank. South Holland 8. Charleston Bancorp, Inc., Springfield The Bank of Charleston, Charleston Farm ers Sta te Bank of Fulton County. Lewistown (Both acquired under emergency provisions) 9. North Sh o re Capital Corporation. Wilmette The Morton G rove Bank. Morton G ro ve 10. M PS Bancorp, Inc., Mount Prospect Tollway-Arlington National Bank of Arlington Heights. Arlington Heights 11. Marine Bancorp, Inc., Springfield 451.2 4 Y es 52.1 4 Y es American National Bank of Champaign, Champaign or notes 0.44 (cash portion) 12. Harris Bankcorp. Inc., Chicago Argo State Bank, Summit R oselle S ta te Bank and Trust Com pany. Roselle 3.499.5 1 Y es 42 1 i Y es 8-4-82 1.48 18.75 cash 1.00 111.7 2 Y es 10-1-82 0.59 9.90 cash 1.41 Federal Reserve Bank o f Chicago 17 T a b le 2 (c o n tin u e d ) 1 0 8 2 Illin o is m u ltib a n k ho ld in g c o m p a n y fo rm a tio n s a n d a c q u is it io n s ( S e v e n t h D is t r ic t p o rtio n) 12-31-81 Holding Company Bank(s) Acquired Illinois C a sh offer or Ratio of price to BHC Region Located in S M S A Date of 12-31-81 12-31-81 exchange book valuet (Y e s - No) Consummation R O A** R O E** of shares (1.0 = book value) 14.966.6 1 Y es 29.7 1 Y es 7-28-82 0.84 10 35 cash 2.62 18.5 2 Y es 9-8-82 0 78 9.33 cash 1.65 7-30-82 N/A N/A N/A N/A 7-31-82 0.69 9.09 exchange total deposits* ( $ million) 13. Continental Illinois Corp.. Chicago Continental Bank of Buffalo Grove, N.A., Buffalo Grove Continental Bank of Oakbrook Terrace. Oakbrook Terrace 14. Northwest Funding Co., Inc., Rockford Northwest Bank of Winnebago County, Rockford (de novo) 15. Suburban Bancorp. Inc., Palatine N/A 3 Y es N/A 3 Y es N/A 1 Y es 43.8 1 Y es Palatine National Bank. Palatine N/A. pre-existing chain Suburban National Bank of Palatine. Palatine 11.5 1 Suburban Bank of Cary-G rove, Cary 24.0 2 Y es 7-31-82 16.1 1 Y es 7-31-82 30.5 1 Y es 7-31-82 15.1 1 Y es 10.6 1 Y es N/A 3 Y es 220.8 3 Y es Y es 7-31-82 1.17 11.99 exchange 0.85 9.65 exchange -0.16 -1 .55 exchange 2.15 24.79 exchange 7-31-82 0.29 3.06 exchange 7-31-82 1.06 11.97 exchange 8-2-82 0.70 6.81 exchange Suburban Bank of HoffmanSchaumburg, Schaumburg Suburban Bank of Rolling Meadows, Rolling Meadows Suburban National Bank of Elk G rove Village, Elk Grove Village Suburban National Bank of Woodfield, Schaumburg 16. First Community Bancorp, Inc., Rockford First National Bank & Trust Company of Rockford, Rockford N/A. pre-existing chain North Towne National Bank of Rockford, Rockford First Bank of R oscoe, Roscoe 26.4 3 Y es 8-2-82 0.95 13.53 exchange 8.8 3 Y es 8-2-82 0.93 7.70 exchange 8-2-82 0.81 8.54 exchange 9-3-82 -1 .52 _ cash 0.50 9-17-82 1.43 12.97 cash 1.24 10-1-82 2.16 21.83 combination, First Bank of Lo v e s Park, Lo ves Park 17. Transworld Corp., Lake Forest 12.5 3 Y es 11.6 2 Y es 21.7 1 Y es 127.7 4 Y es 16.0 3 No N/A 4 Y es 6.3 4 No Dempster Plaza Sta te Bank, Niles (33%) 18. First Busey Corporation, Urbana Roberts Sta te Bank, Roberts 19. Mt. Zion Bancorp, Inc., Mt. Zion The Hight State Bank, Dalton City primarily cash 1.61 (cash portion) 20. United Bancorporation, Inc., Rockford N/A 3 Y es 8.9 3 No United Bank of Rochelle. Rochelle 10-31-82 0.84 5 86 exchange N/A. pre-existing chain United Bank of Rockford, Rockford 13.4 3 Y es 10-31-82 2.06 24.96 exchange United Bank of Ogle County N.A., Oregon 26.8 3 No 10-31-82 0.84 13.16 exchange 61.1 3 Y es 10-31-82 1.51 20.04 exchange United Bank of Lo v e s Park, L o ves Park United Bank of Southgate. Rockford 23.9 3 Y es 10-31-82 0.62 8 94 exchange 39.2 3 Y es 10-31-82 0.86 10.07 exchange 106.6 3 Y es 10-31-82 0.89 8.21 exchange United Bank of Belvidere, Belvidere United Bank of Illinois, N.A., Rockford 18 Econom ic Perspectives T a b le 2 (c o n tin u e d ) 1 9 8 2 Illin o is m u ltib an k ho ld in g c o m p a n y fo rm a tio n s a n d a c q u is it io n s (S e v e n t h D is t r ic t p o rtio n ) 12-31 81 Holding Com pany B an kU ) Acquired total deposits* Illinois Located BH C Region in S M S A Date of 12-31-81 12-31-81 exchange book valuef (Yea - No) Consummation R O A ** RO E” C a sh offer or of shares (1.0 = book value) Ratio of price to ($ million) 21. M cLean County B ancshares. Inc.. Bloomington N/A 3 Y es 78.7 3 Yea 10-30-82 1.13 18.37 exchange 1.00 5.0 3 Yea 10-30-82 2.24 15 13 cash 1.24 N/A 3 Yea 19 4 3 No 12-1-82 2.25 20.08 cash 1.50 N/A 4 No 56 4 No 12-3-82 1 68 15.43 cash 1.50 239.9 1 Y es 15 4 2 Yea 12-24-82 082 10.73 choice of cash 2 11 (ca th portion) M cLean County Bank. Bloomington Stanford S ta te Bank, Stanford 22. Central of Illinois Inc., Sterling Citizen s Sta te Bank of Mount Morris. Mount Morris 23. Mid-Central B an csh ares Corporation. Charlesto n Ashm ore Sta te Bank, Ashmore 24. O ak Park Bancorp. Inc. O ak Park The Dunham Bank. St. Charles or combination ‘ Deposit data from Reports of Condition, December 31. 1981. **R O A and R O E data from Sheshunoff and Company, Inc., The Benks o f Illinois 1982. fA simple, unadjusted method w as used here for calculating book value premiums. The bank s net worth, as provided in the financial statem ents of each application, w as divided by total common shares outstanding. This value w as compared with the cash offer, or in the ca se of an exchange of shares, with a similar net worth/outstanding shares ratio for the holding company, also taking into account the exchange ratio. Som e agreem ents calculated an “ adjusted book value.“ usually adjusted to reflect the current credit worthiness of the bank's loan portfolio. Therefore, book values and premiums calculated here may differ from those stated in the actual merger agreement. as a tax-free reorganization. Because of the tax consequences, cash offers are usually higher (i.e., the premium over book value is greater) than those for share exchanges. Approximately one third of the banks were acquired by means of a cash purchase. Cash offers ranged anywhere from a low of one-half of book value to a high of 2.62 times book, with the average being 1.46 times book. At least one hold ing company provided the option of either a lump sum or an annuity distribution. The majority of bank acquisitions in Illinois in the first year were structured around an exchange of shares. Exchanges of bank shares for holding company shares averaged 1.11 times book, ranging from 6 0 percent of book to 1.68 times book value.6 All of the holding companies formed by chain banks involved exchanges of shares. Most of the banks commanding high ac quisition premiums were above average in prof itability, and were not previously related or affil iated with the acquiring BHC except for, o c casionally, a correspondent relationship with the BHC’s lead bank. The majority of the premiumpriced banks are located in Regions I and II in the Federal R esen t Bank o f Chicago Chicago banking market. There are various explanations why a bank would command a premium in a crowded market with so many alternatives. (The Chicago banking market, defined as Cook, DuPage, and Lake C ou n ties, con tain ed 3 7 0 banks at 1 2 /3 1 /8 1 .)7*At least three are plausible. First, a suburban bank in an attractive high-income and fast growth area might be exceptionally attrac tive to a BHC. Second, given Illinois’ prohibition against branch banking, the BHC may be looking for location only—in essence de facto branches— 6T h e s e r a tio s a r e c o m p a r a b le to th o s e p re s e n te d fo r r e c e n t a c q u is itio n s in N e w J e rs e y , Pennsylvania, and M assa c h u s e tts , w h e r e ty p ical offerin g s w e r e 1 .6 tim e s b o o k value f o r c a s h o ffe rs a n d 1 .2 tim e s b o o k v a lu e fo r e x c h a n g e s o f sh a re s. (S e e Paul S. N a d le r, “ B an k A cq u isitio n s Seen F ro m B o th S ides,” B a n k e rs M o n th ly M a g a zin e, S e p te m b e r 1 5 , 1 9 8 2 , p. 9 ). A lso, in th e s e c o n d q u a rte r o f 1 9 8 2 , th e w e ig h te d a v e ra g e p r i c e to b o o k v alu e fo r B H C a p p lic a tio n s r e c e iv e d by th e F e d e ra l R e s e rv e w a s 1 .4 tim e s. T h is figu re is b a se d o n offers in th e fo rm o f c a sh , n o te s , e x c h a n g e s o f s to c k , o r c o m b in a tio n s . (S e e “ M e rg e r, A cq u isitio n P re m iu m s Fig u r e d ,” B a n k in g E x p a n sio n R ep o rter, V ol. l , N o . 1 9 , O c t o b e r 1 8 , 1 9 8 2 , p. 8 . ) ’ See 1 9 8 1 ). 67 F e d e ral R eserve B u lle tin 7 2 7 (S e p te m b e r 19 and thus purchases one of the smallest banks available. Under this approach the acquiring holding company is less concerned with the acquired bank’s overall c o n trib u tio n to earnings.8 A third reason cited by large BHCs for their interest in acquiring small banks is their concern over the Federal Reserve Board’s reaction to possible anticompetitive effects of the acquisi tions. In addition to the BHC’s own financial and managerial considerations, the acquiring bank must take into account the BHC Act of 1956 which prohibits the Board from approving any acquisition or merger whose effect may be “sub stantially to lessen competition.” Future Trends What implications does the Illinois multi bank holding company act have for the future of bank structure in the state? One impact is increased commercial bank concentration, both statewide and in local banking markets. But, on a statewide basis the trend toward increased con centration did not develop in 1982. In fact, just the opposite occurred. The shares of commer cial bank domestic deposits held by the state’s fifteen largest banking organizations decreased from December 1981 to June 1982. At Decem ber 31, 1981, these fifteen organizations held 44.7 percent of statewide deposits, and by June 3 0 ,1 9 8 2 , they held 44.2 percent. During this six month period three of these organizations be came multibank holding companies. The decrease in concentration is due primarily to decreasing deposit levels in the state’s five largest banking organizations in comparison with the rest of the state. With 1,323 commercial banks in Illinois at the end of 1981, it will be some time before statewide concentration levels begin to show significant increases. Several applications in process at year-end 1982 are formalizations of pre-existing chain banking relationships, including the Midwest Associated Banks of America group,9 a chain of 20 commercial banks in Regions II and III, which became the largest multibank formation in the nation to date. Similar applications involving other chains will no doubt be submitted in the future. Several of the multibank holding companies established during 1982 are continuing to ex pand. First Busey Corporation, Urbana; Com mercial National Corporation, Peoria; and Northern Trust Corporation, Chicago, have had applications approved to acquire a total of five additional banks, but these were not consum mated in 1982. In addition, First Community Bancorp, Rockford; Steel City Bancorporation, Chicago; First Freeport Corporation, Freeport; and Suburban Bancorp, Palatine, all had applica tions accepted for processing by the Federal Reserve Bank of Chicago during the latter part of 1982 that had not been acted upon by year-end. Certain early acquisitions of suburban banks lead to the conclusion that, as has happened in other states, the multibank law is being used as a de facto branching strategy. A question remains as to whether the Illinois multibank holding company act is merely the wedge being used to liberalize the attitudes of Illinois bankers and the public, to be followed by a more liberal branch ing law proposal. Bankers had, literally, years to prepare them selves for the eventual passage of the bill which was lobbied for (and against) so strongly. Why haven’t more applications been filed? With the midwestem economy suffering from the worst economic downturn since the Depression, many bankers in Illinois were forced to postpone their acquisition plans. Some of the early acquisitions that involved high-priced offers caused other hopeful marriage partners to price themselves out of the market. The net effect of the act, based on first year experience, appears to be minimal. However, with declining interest rates and the expanding familiarity with the Illinois law, multibank hold ing companies and their subsidiaries will become significant forces in Illinois in the future. "D o u g las H. G in sb erg , “B ank H o ld in g C o m p a n y E x p a n 9See a p p lic a tio n b y F irst M id w e st B a n c o r p , In c., J o lie t, sio n S trateg ies: T h e Illin ois B an k H o ld in g C o m p a n y A c t,” B a n k in g L aw J o u r n a l , V ol. 9 9 , no. 7 (A u g u s t 1 9 8 2 ) , pp. 6 0 0 -6 0 1 . Illinois, to a c q u ire 2 0 ban k s in Illinois, a p p ro v e d by th e B o a rd 20 o f G o v e rn o rs o n F e b ru a ry 2 8 , 1 9 8 3 - A lth o u g h th e a p p lica tio n in volved 2 0 banks, th e a ctu a l ch a in in clu d e s 2 6 banks. Econom ic Perspectives Bankers’ acceptances revisited Jack L. Hervey The ten-fold increase in world trade over the past twelve years, to more than $1.8 trillion in exports in 1982, has been accompanied by the rapid growth of short-term credit to finance the international movement of goods. The U.S. bank ers’ acceptance market has played an important part in providing this expansion in credit financ ing for both U.S. and worldwide trade. An estimated 17 percent of the total U.S. export-import trade in 1970 was financed in the bankers’ acceptance market (see Figure l ) . 1 By 1974 only 13 percent of U.S. export-import trade was financed through acceptances. This down ward trend was reversed in the last half of the 1970s when both export and import accep tances expanded rapidly. The portion of U.S. trade financed by acceptances increased to about 22 percent by 1981. The proportion expanded further in 1 9 8 2 —to 28 percent—as a result of a continued expansion in the accep tance market that occurred at the same time that exports and imports were contracting. International trade credit is particularly important because of the often lengthy time between shipment by the exporter and delivery to the importer. In some cases, the importer prepays prior to shipment of the goods; in oth ers, the exporter extends credit on “open account” until delivery. Often, however, the transaction involves a third party who agrees to pay the exporter upon shipment and to receive payment from the importer at some agreed upon future date. For this credit service, the third party receives the principal and an interest return plus a fee, or commission, associated with the ser vices provided, including the risk of nonpayment by the importer. Open account credit continues as an important component of trade financing, especially when trading partners are well known to each other and the risk of nonperformance is low. However, when the transaction involves a relatively high degree of risk, such as when buyer and seller are not well known to each other, third party involvement (with a better informa tion network) typically takes place. The risk of nonperformance increases the expected costs associated with an export-import transaction and acts as a deterrent to trade. Therefore, trade can be facilitated if this risk can be shifted to a third-party at a known cost. More complete information typically, through foreign correspondents, in addition to risk pooling, allows the third party, who specializes in credit, to bear such risks at a lower expected cost than Figure 1 The sh a re of U .S . international trade fin an ced by a c c e p ta n c e s p e rc e n t J a c k L. H erv ey is a S e n io r E c o n o m is t at th e F ed eral R e se rv e B ank o f C h ica g o . T h is a rtic le u p d ates and e x te n d s “B a n k ers a c c e p ta n c e s ”, B usiness C o n d itio n s , F ed eral R eserve Bank o f C h ica g o (M ay 1 9 7 6 ) , pp. 3 -1 1 'T h e e s tim a te s a r e b ased o n th e a v e ra g e a m o u n t o f e x p o r t an d im p o rt a c c e p t a n c e s c r e a t e d a n d a ssu m e a 9 0 -d a y a v e ra g e m atu rity . (O u ts ta n d in g s a re fro m th e F ed eral R e s e rv e B an k o f N e w Y o rk , “B a n k e r’s D o llar A c c e p ta n c e s — U n ite d S ta te s,” a m o n th ly r e le a s e o f th e O ffice o f P u blic In fo rm a tio n , s e le c te d is s u e s .) A s h o r te r o r lo n g e r av erag e m a tu rity w o u ld a lte r th e e s tim a te s. If a 6 0 -d a y av erag e m a tu r ity w e r e a ssu m e d , fo r e x a m p le , th e v o lu m e o f e x p o r t and im p o rt a c c e p ta n c e s c r e a t e d in 1 9 7 0 an d 1 9 8 2 as a p r o p o r tio n o f to ta l U.S. e x p o r t s an d im p o rts w o u ld in c r e a s e to 2 5 p e r c e n t an d 4 0 p e r c e n t, re sp e ctiv e ly C o m m e rc ia l b an k ers in d ic a te th a t a v e ra g e m a tu rity v aries o v e r tim e bu t th at a 9 0 -d a y a v erag e is a r e a so n a b le assu m p tio n . Federal Reserve Bank o f Chicago NOTE: Shares are based on average acceptance m aturities o f 90 days. 21 an exporter who specializes in goods. Histori cally, the desire for such risk shifting in trade arrangements led to the development of bills of exchange such as bankers’ acceptances.2 in the secondary market, either to a specialized acceptance dealer or directly to an investor. At year-end 1982 about 88 percent of total bankers’ acceptances created were “outstanding”—i.e., not held in the accounts of the accepting banks. A bankers’ accep tan ce A cceptance m arket grow th A bankers’ acceptance originates from a draft drawn to finance the exchange or tempor ary storage of specified goods. It is a time draft that specifies the payment of a stated amount at maturity, typically less than six months in the future. The draft becom es a “bankers’ accep tance” when a bank stamps and endorses it as “accepted.”3 For the price of its commission, the bank lends its name, integrity, and credit rating to the instrument and assumes primary respon sibility for payment to the acceptance holder at maturity. The drawer of the draft retains a secondary liability to the acceptance holder, contingent upon the inability of the accepting bank to honor the claim at maturity. The draft underlying an acceptance some times is preauthorized by a “letter of credit” issued by the importer’s home bank. The largest dollar volume, however, are “outright” or “clean” acceptances—often arising from an agree ment between a foreign bank (for their custom er) and the accepting U.S. bank. The drawer of the acceptance may extend credit to the importer by simply holding it until maturity and then collecting payment of the face amount from the accepting bank. Alternatively, the drawer can receive immediate payment by selling the acceptance at a discount, typically to the bank that created it.4 The bank that discounts the acceptance may hold the instrument in its investment portfolio, treating it like any other loan financed from the bank’s general funds. More commonly, the bank sells the acceptance 2H isto rian s have tr a c e d th e o rig in o f th e se in stru m e n ts to th e tw elfth ce n tu ry . 'D ra fts d ra w n o n an d a c c e p te d by n o n b an k e n titie s are ca lle d “tr a d e a c c e p ta n c e s .” 'T y p ica lly th e te r m s o f th e le tte r o f c r e d it sp ecify w h e th e r th e b u y e r o r se lle r is r e s p o n s ib le fo r p a y m e n t o f th e c o m m is s io n ( d i s c o u n t) d u e to th e bank. If th e resp o n sib ility fo r th e d is c o u n t is n o t s p e c ifie d in th e a g r e e m e n t, c o n v e n tio n d icta te s th at th e s e lle r is liable fo r th e ch a rg e s . 22 Bankers’ acceptances are used for two prin cipal types of financing—for domestic trade and storage and international trade. An additional small volume of acceptances are created for the acquisition of the dollar exchange by certain countries that have periodic or seasonal short ages in their dollar foreign exchange reserves. Although the dollar volume of trade accep tances has grown rapidly since the early 1970s, domestic acceptances have remained a small though relatively stable proportion of total ac ceptances over the past decade. Domestic ac ceptances increased from about $200 million at year-end 1969 to more than $3 billion at the end of 1982, about 4 percent of total acceptances. Passage of the Export Trading Company Act of 1982 may facilitate a substantial expansion in the size and relative importance of bankers’ acceptances for domestic shipments. This act, effective October 8 ,1 9 8 2 , removed a longstand ing statutory requirement that title documents must accompany a bankers’ acceptance origi nated for domestic shipments in order for such an acceptance to qualify as eligible for discount by the Federal Reserve. Because this previous re quirement discouraged the use of bankers’ accep tances for shipments of domestic goods, 80 per cent or more of the volume of domestic accep tance creation typically has been originated to finance storage rather than trade. International trade acceptances account for the bulk of U.S. bankers’ acceptance activity, typ ically representing more than 90 percent of the total acceptance market. International accep tances are of three basic types: acceptances to finance U.S. exports; acceptances to finance U.S. imports; and third-country acceptances to finance trade between foreign countries or goods stor age within a foreign country. The phenomenal growth of U.S. exportimport acceptances has been fostered by the Econom ic Perspectives increased proportion of U.S. trade financed by acceptances, which to a large degree is due to increased attention to liability management by bankers, as well as by the expanded value of U.S. trade. Gross acceptances created to finance U.S. exports increased from $1.2 billion at year-end 1969 to $16.3 billion at the end of 1982. Over the same period, acceptances to finance imports increased from $1.9 billion to $17.7 billion. Even more impressive has been the growth in third-country acceptances which have in creased from $2.3 billion at year-end 1969 to $42.3 billion at year-end 1982. Accompanying this 18-fold increase in dollar volume, thirdcountry acceptances have captured a larger share of the (to ta l) international acceptance market—rising from 42 percent to 53 percent of gross acceptances created in the 1970-82 period. Expansion of the third-country' market largely reflects increased usage of U.S. acceptances by Japanese, South Korean, and other Asian traders, especially in the wake of higher oil import costs for these nations after the oil price increases of 1973-74 and 1979-80. Bankers active in the acceptance market indicate that a substantial proportion of thirdcountry acceptances are for financing oil ship ments, and growth in third-country import bills appears consistent with this claim (see Figure 2 ). During 1974, third-country acceptances in creased from $2.7 billion to $10.1 billion. The volume increased from $16.2 billion to $35.3 billion during the period 1979 to mid-1981. Dollar exchange acceptances, arising from exchange shortages brought about by seasonal trade patterns in some countries, are the only acceptances not based on specific merchandise trade or storage. They are available only in for eign countries designated by the Board of Gov ernors of the Federal Reserve System. Such acceptances are relatively minor in volume, con stituting only about 0.2 percent of total accep tances at year-end 1982. Investm ent in accep tan ces Acceptances have characteristics that are attractive to borrowers, bankers, and investors when compared to other short-term financial Federal Reserve Bank o f Chicago Figure 2 U .S . b a n k e rs’ a c c e p ta n ce m arket expanded rapidly o ver the past decad e billion dollars •Includes acceptances to finance dom estic shipm ents and storage and do lla r exchange acceptances. N ote: T otal acceptances as o f the end o f the quarter including acceptances held by accepting bank. instruments. This appeal has been basic to the recent rapid growth of the acceptance market. Borrower costs for bankers’ acceptances compare favorably with the interest and nonin terest charges on conventional bank loans. In comparing interest rates on acceptances and other bank loans, the acceptance rate must be adjusted upward to reflect that it is quoted on a discount basis. Although typically not quoted on a discount basis, interest rates on conventional bank loans must be adjusted upward in cases where the loan contract requires a borrower to maintain compensating balances in excess of normal working balances at the lending bank. Maintaining these noninterest-earning deposits increases the effective cost of the bank loan. Interest rates on acceptances also compare favorably with commercial paper rates. Many borrowers lack sufficient size or credit standing to issue these unsecured notes at competitive rates. For small borrowers, issuing costs or commissions add appreciably to the costs of commercial paper. Bankers’ acceptances have several charac teristics that enhance their attractiveness to bankers and make them competitive with alter native money-market instruments. A bank earns a commission, currently from 50 to 100 basis 23 points, simply by originating an acceptance. In the process, the bank does not commit its own funds unless it chooses to discount the accep tance. Once discounted, the acceptance can be sold in the well-developed secondary market, providing the bank with a degree of liquidity and portfolio flexibility not afforded by most conven tional loans. The amount of credit extended to an indi vidual customer may also be expanded through bankers’ acceptances. Statutory restrictions limit the amount of conventional credit extended to a single bank customer by a Federal Reserve member bank. However, by the creation, dis count, and sale of acceptances in the secondary market, a bank can facilitate a further extension of credit to a single customer up to an additional 10 percent of the bank’s capital, provided that the acceptances are eligible for discount by the Federal Reserve.5 Bank funds received by the sale of eligiblefor-discount acceptances in the secondary mar ket are not subject to reserve requirements under current Federal Reserve regulations. This practice has proved especially useful for channel ing funds from the nonbank sector to bank credit customers during tight credit periods when Regulation Q ceilings have reduced the flow of funds to banks.6*15 ’An o u tstan d in g a c c e p ta n c e o f a m e m b e r bank th at m e e ts th e elig ib le fo r d is c o u n t r e q u ire m e n ts s p e cifie d in S e c tio n 1 3 o f th e F e d e ra l R ese rv e A ct is n o t in clu d e d in th at ban k’s legal len d in g lim it fo r co n v e n tio n a l lo a n s — eq u al to 1 5 p e r c e n t o f p aid-in c a p ita l and su rp lu s, un d ivid ed profits, su b o rd in a te d d e b t, and 5 0 p e r c e n t o f its lo an lo ss r e se rv e , to any o n e b o rro w e r. An o u tsta n d in g a c c e p t a n c e — w h ic h m e e ts S e ctio n 1 3 ( 7 ) c o n d itio n s o f th e F e d e ra l R ese rv e A c t— o f a U.S. b ra n c h o r a g e n cy o f a fo re ig n ban k s u b je ct to re se rv e r e q u ire m e n ts u n d e r S e c tio n 7 o f th e In te rn a tio n a l B anking A ct o f 1 9 7 8 is also e x c lu d e d fro m th at b an k ’s p e r c u s to m e r lim it fo r c o n v e n tio n a l loans. S ta te -c h a rte re d n o n m e m b e r banks and s ta te -c h a r te r e d U.S. b r a n c h e s an d a g e n c ie s o f fo r eig n banks a r e s u b je ct to sta te -im p o s e d lim itatio n s o n loans. In Illinois, fo r e x a m p le , s ta te -c h a rte re d n o n m e m b e r U.S. banks have a legal lim it fo r c o n v e n tio n a l lo an s to a sing le b o r r o w e r o f 1 5 p e r c e n t o f c a p ita l and su rp lu s, e x c lu d in g un divided profits. An I llin o is -c h a rte re d n o n m e m b e r bank m ay c r e a t e a c c e p ta n c e s fo r a sin g le b o r r o w e r , s e p a ra te fro m its legal len d in g lim it o n c o n v e n tio n a l lo an s, in an a m o u n t up to 1 5 p e r c e n t o f c a p ita l an d su rp lu s o r , if th e e x c e s s is s e cu re d , up to 5 0 p e r c e n t o f c a p ita l and surplus. 6S ee G ary L. A lford, “T ig h t c r e d it an d th e ban k s . . . 1 9 6 6 an d 1 9 6 9 c o m p a r e d ,” B u sin ess C o n d itio n s , F e d e ra l R e se rv e Bank o f C h ica g o (M ay 1 9 7 0 ) pp. 4 - 1 1 . 24 Investors hold bankers’ acceptances for yield, security, and liquidity. The rates of return on acceptances have been competitive with the returns on other money-market instruments such as commercial paper and negotiable certif icates of deposit. Many investors view accep tances as one of the safest forms of investment, given the primary obligation for repayment of the accepting bank and the secondary liability of the acceptance drawer. Top quality acceptances are highly liquid in the active secondary market. Federal Reserve accep tan ce activities Federal Reserve authority to regulate the creation of bankers’ acceptances by depository institutions and to acquire bankers’ acceptances for its own portfolio is derived from the Federal Reserve Act of 1913. Such authority has been modified by the 1915 amendments to the Act, provisions of the Monetary Control Act of 1980, and Section 207 of the Export Trading Company Act of 1982. This legislative authority provides the basis for the bankers’ acceptance regulations of the Board of Governors of the Federal Reserve System—primarily Regulations A, D, and K and regulations relating to Federal Reserve openmarket operations. The regulations are aug mented by published Board interpretations of rules governing creation, discount, and redis count of acceptances. Early Federal Reserve regulations of accep tances created by its member banks focused on assurances of the quality of the instruments and the soundness of the creating banks. The Board also placed limits on the volume of acceptances available for potential discount at the Federal Reserve. Three avenues were provided for the Federal Reserve to legally acquire bankers’ ac ceptances. The twelve Reserve Banks in the Fed eral Reserve System were permitted to discount (technically rediscount) member bank accep tances deemed “eligible for discount,” to advance funds secured by member bank acceptances, and finally, the Federal Reserve could purchase and sell bankers’ acceptances through open-market operations. Each of these transactions affected total reserves in the banking system. Historically, most Federal Reserve transac Econom ic Perspectives tions in acceptances arose through open-market operations.^ Until March 1977 the Fed’s Domes tic Open Market Desk, located at the Federal Reserve Bank of New York, bought and sold bankers’ acceptances. Fed purchases or sales from dealers in the secondary' acceptance market increased or decreased reserves, respectively, in the banking system in the same manner as its dealer purchases and sales of U.S. Treasury secu rities. Compared to total open market opera tions, however, Fed purchases and sales of acceptances were small. The Federal Reserve Open Market Commit tee in March 1977 directed the Open Market Desk to discontinue the outright purchase of bankers’ acceptances for the Fed’s own account. One reason for the discontinuance was that Fed eral Reserve direct purchases and sales were no longer deemed necessary' to support the welldeveloped secondary market for acceptances. Acceptance activity for the Fed’s own account now is confined to repurchase agreements. The Fed also acts as an “agent” for foreign central banks wishing to acquire acceptances for investment purposes. Until the practice was dis continued in November 1974, the Federal Re serve also added its endorsement to such accep tances, thus enhancing the security of the instru ments by effectively guaranteeing payment. A ccep tan ce eligibility The Federal Reserve Act (section 13 7 ) specifies the general conditions under which a member bank can create an acceptance and lim its the dollar volume of acceptances that may be outstanding by an individual bank. Acceptances that m eet the requirements specified in Section 13( 7 ) ( see Table 1) are at eligible fo r discount 'F e d e r a l R e s e rv e System m o n e ta ry p o lic y w as initially c o n d u c te d th ro u g h th e re d is c o u n t o f b a n k e rs’ a c c e p ta n c e s an d o t h e r e lig ib le p a p e r. H o w e v e r, by th e m id - 1 9 2 0 s p u r c h a s e s o f g o v e rn m e n t s e c u ritie s e x c e e d e d h o ld in g s o f dis c o u n te d bills. In s u b se q u e n t y e a rs o p e n m a rk e t o p e ra tio n s o f th e S y stem d o m in a te d re d is c o u n tin g . F o r a d iscu ssio n o f th e h is to r ic a l b a c k g ro u n d o f b a n k e rs ’ a c c e p ta n c e s , s e e an a r tic le by M ich ael A. G o ld b erg , “C o m m e r c ia l L e tte rs o f C re d it and B a n k e rs A c c e p ta n c e s ,” pp. 1 7 5 - 1 8 5 , in B elow th e B o tto m the Federal Reserve, as specified in Section 1 3 (6 ). Supervision and regulation of bankers’ acceptances have evolved around this concept of eligibility, thereby influencing the structure of the market. Eligibility also has served as a quality benchmark in the secondary market. Some bankers’ acceptances are by the Federal Reserve ( according to rules of the Federal Open Market Committee) under marginally less stringent conditions than are those that are eligible for discount ( see Table 1). It should be noted that any acceptance that is that is, meets the conditions of 1 3 (7 ) of the Federal Reserve Act, is also eligi ble for purchase. The reverse, however, is not true. An acceptance that meets all the conditions of 1 3 (7 ) save that it has a maturity greater than six months and up to nine months is eligible for purchase but not for discount. is also somewhat misleading. Under current regulations this terminology actually refers to requirements that apply to repurchase agreements between acceptance dealers and the Fed, not an outright purchase for the Fed’s own account. Before the Federal Reserve will enter into a repurchase agreement for an individual acceptance, the bank creating it must have estab lished itself in the market and must have met Federal Reserve requirements that qualify the bank as a “prime bank.”8 The prime bank require ments must be met for acceptances in each eli gibility category—discount or purchase—before the acceptance can be used in a Fed repurchase agreement. Bankers’ acceptances that do not quality as eligible for discount or purchase by the Federal Reserve are referred to as acceptances. In effect, this means that all accep tances that do not meet the conditions of Section 1 3 (7 ) are ineligible. Such a classification could include acceptances that are eligible for pur chase but are of “long” maturities. The market treats such acceptances as ineligible. Reserve requirements against funds obtained from the rediscount of acceptances in the sec purchase eligible for eligiblefor discount, chase Eligible for pur ineligible t o r a d isc u ss io n o f th e c o n d itio n s n e c e s s a ry fo r a bank t o b e d e s ig n a te d a p r im e ban k, s e e R alph T. H elfrich , “T ra d in g in B a n k e rs ’ A c c e p ta n c e s : A V ie w fro m th e A c c e p ta n c e D esk o f th e F e d e ra l R e se rv e Bank o f N ew Y o r k ,” M o n th ly L ine: The U se o f C o n tin g e n c ie s a n d C o m m itm e n ts b y C om m e rc ia l B a n k s , Staff S tu d ies 1 1 3 ( B o a rd o f G o v e rn o rs o f th e R eview , F e d e ra l R e s e rv e B an k o f N e w Y o rk ( F e b ru a ry 1 9 7 6 ) F e d e ra l R ese rv e S ystem , 1 9 8 2 ) . pp. 5 6 - 5 7 . Federal Reserve Bank o f Chicago 25 Table 1: bankers' a cce p ta n ce s— ch a racteristics governing eligibility, re se rv e requirem ents, and aggregate accep tan ce limits Federal Reserve System treatment Eligible for discount' Eligible for purchase2 Reserve requirements apply if sold 3 Aggregate acceptance limits apply4 B a n k e r s ' a c c e p t a n c e c a t e g o r ie s 1. Specific international transactions a. U S. exports or imports Tenor • 6 months or l e s s ..................................................... 6 months to 9 m on ths........................................... yes5 no yes yes no yes yes no b. Shipment of goods b e t w e e n foreign countries: Tenor • 6 months or l e s s ..................................................... 6 months to 9 m on ths........................................... yes5 no yes yes no yes yes no c. Shipment of goods w ith in a foreign country: Tenor - any term .................................................................... no no yes no yes5 no no no no yes yes no yes no no no no7 yes yes no a. Dom estic shipment of goods8: Tenor ■6 months or l e s s ..................................................... 6 months to 9 m on ths............................................ y e s5 no yes yes no yes yes no b. Dom estic storage - r e a d ily m a r k e t a b le staples secured by warehouse receipt issued by independent warehousem an:6 Tenor - 6 months or l e s s .................................................... . 6 months to 9 m o n th s............................................ yes5 no yes yes no yes yes no c. Dom estic storage - a n y goods in the U .S. under contract of sale or going into channels of trade secured throughout their life by warehouse receipt: Tenor - 6 months or l e s s ....................................................... 6 months to 9 m o n th s.......................................... .. no no yes yes yes yes no no 3. Marketable time deposits (finance bills or working capital acceptances) not related to any specific transaction Tenor - any t e r m ...................................................................... no no yes no d. Storage of goods within a foreign country— re a d ily m a r k e t a b le s t a p le s s e c u r e d b y w a r e h o u s e re c e ip t issued by an independent warehousem an:6 Tenor - 6 months or l e s s ..................................................... 6 months to 9 m onths........................................... e. Dollar exchange - required by usages of trade in approved countries only: Tenor - 3 months or l e s s ..................................................... more than 3 m o n t h s ............................................. 2. Specific domestic transactions (i.e., within the U .S.) This table is an adaptation from a table presented in an unpublished paper from the 7th Annual C IB C o nference at New O rlean s. O ctob er 13, 1975 by Arthur Bardenhagen, V ice President, Irving Trust Com pany. New York. 'In accordance with Regulation A of the Board of G o vern o rs as provided by the Federal R eserve Act. ‘ Authorizations for the purchase of accep tances a s announced by the Federal Open M arket Com m ittee on April 1, 1974. 3ln accordance with Regulation D o f the Board of G o vern ors as provided by the Federal Reserve A ct. 'M ember banks may accept bills in an amount not exceeding at any time 150 percent (or 200 percent if approved by the Board of G o vern ors of (a s defined the Federal R ese rve S y ste m ) of unimpaired capital sto ck in FR B . C hicag o C ircu la r No. 2156 of April 2, 1971) A ccep tance s growing out of d om estic transactions are not to exceed 50 percent of the total of a bank's total acceptance ceiling. 'T h e tenor of nonagricultural bills may not exceed 90 days at the time they are presented for discount with the Federal Reserve. 'A s of May 10. 1978. the Board o f G o vern o rs issued the interpretation that bankers' acceptances secured by field warehouse receipts covering readily m arketable stap les are eligible for discount. Readily m arketable staples are defined, in general, a s nonbranded goods for which a ready and open market e xists. There is a regularly quoted, easily accessib le, objective price setting mechanism that determines the market price of the goods. 'P ro ce ed s from the sale of an eligible for discount dollar exchange acceptance are not specifically exempted from reserve requirem ents under Regulation D. Section 204.2 a (v ii) (E ) e ffe c tive Novem ber 1 3 .1 9 8 0 . of the Board o f G o vern o rs as are other accep tances that meet the condition of Section 13(7) of the Federal R ese rve act. H ow ever, the Federal R ese rve B o ard 's legal sta ff issued an opinion Ja n u a ry 15, 1981, stating that the p roceeds from the sale o f eligible dollar exchange acceptances are exempt from reserve requirements. 'P rio r to the amendment to Se c tio n 13(7) of the Fed eral R ese rve act (O cto b e r 8, 1982) dom estic shipment accep tances required docum ents conveying title be attached for eligible fo r discount to apply. N O TE: Tenor re fe rs to the duration of the acceptance from its creation to m aturity. An eligible for discount acceptance must be created by or endorsed by a member bank, according to Se ctio n 13(6) of the Federal R eserve A ct. 26 Econom ic Perspectii>es ondary market are an important consideration in acceptance creation and regulation. Until 1973 member banks’ funds derived from the sale of eligible as well as ineligible acceptances were free from reserve requirements. In mid-1973 the Federal Reserve Board ruled that member banks who derived funds from ineligible acceptances— those that did not meet Section 1 3 (7 ) conditions —had reserve requirements on those funds.9 The Monetary Control Act of 1980 brought nonmember institutions under the reserve require ment authority of the Federal Reserve.10 Regula tions to implement this act also extended reservefree treatment to funds derived from the sale of acceptances in the secondary market by these institutions. To qualify as nonreservable funds the underlying acceptances (technically eligible for purchase) were to be “of the type” specified in Section 13( 7 ) of the Federal Reserve Act. These rules have blurred the distinctions between acceptance eligibility for discount and for purchase. Member bank officials indicate that most acceptances created by these banks are eligible for discount. The secondary market ap plies a lower discount (i.e., interest rate) to acceptances that are eligible for discount and to all eligible acceptances from prime banks. To the limited extent that nonmember depository institutions create acceptances, their instruments tend to meet the conditions of Sec tion 13 (7 ). Therefore, the funds obtained through rediscount in the secondary market are treated as nonreservable. Most institutions avoid creating ineligible acceptances, because such instruments are not well received in the secondary market. In addi tion, reserve requirements apply when these acceptances are rediscounted in the secondary 9In th e e a rly 19 7 0 s fund s d e riv e d fro m th e sale o f in elig ib le a c c e p ta n c e s w e r e n o t su b je ct to re se rv e re q u ire m e n ts. A n u m b e r o f ban k s u se d th is fa ct to a d v an tag e d u rin g p e rio d s o f tig h t c r e d it by c r e a tin g a su b stan tial v o lu m e o f f in a n ce bills, o r w o rk in g ca p ita l a c c e p ta n c e s (in e lig ib le ), and p lacin g th e m in th e s e c o n d a r y m ark et. T h e B o a rd o f G o v e rn o rs im p o se d r e s e r v e r e q u ire m e n ts in m id -1 9 7 3 o n ban k funds a c q u ire d th ro u g h s u c h in stru m e n ts, sh arp ly cu rta ilin g ban ks’ a ctiv ity in in elig ibles. l0P r io r to th e M o n etary C o n tro l A ct o f 1 9 8 0 , re se rv e r e q u ire m e n ts o n n o n m e m b e r ban k funds a c q u ire d fro m th e sale o f in e lig ib le b a n k e rs’ a c c e p ta n c e s in th e s e co n d a ry m a rk e t w e r e s e t by s ta te b an king law s. Federal Reserve Bank o f Chicago market. To the extent ineligible acceptances arise, they are usually held in the account of the bank that created them. The secon d ary m arket Banks place acceptances in the secondary market through two channels—direct placements and a network of dealers who “make a market” in the instruments. The direct sale of acceptances in-house by banks’ newly established money-market and in vestment departments has helped these banks to satisfy customer demand for short-term invest ments with relatively high yields. Such direct sales allow banks to avoid the added costs of selling through acceptance dealers—still the primary outlet for acceptances. Bankers’ acceptances are sold in the second ary market by a small group of money-market dealers who act as intermediaries between banks and investors. The dealer network is centered in New York City, where about 50 percent of the dollar volume of all acceptances is created. The Open Market Desk of the Federal Reserve Bank of New York is the center of Federal Reserve acceptance activity. The dealer market has five tiers. The first tier consists of the ten largest acceptance creat ing domestic banks. Because acceptances of the top-tier banks are generally viewed as the safest and most marketable, these instruments com mand the lowest rates (i.e., discounts) in the dealer market. Second-tier banks are the next-tolargest U.S. banks in terms of acceptance crea tion. By virtue of their reputation among dealers and investors, second-tier acceptances usually trade at rates very close to rates for the first tier. Third- and fourth-tier institutions are those remaining U.S. banks that are somewhat active in the dealer acceptance market. Secondary market rates on lower tier acceptances vary consider ably across these instruments, but are substan tially higher than rates for the top two tiers. The fifth tier of banks consists of foreignowned institutions. A subcategory within this tier includes acceptances originated by U.S. branches of Japanese banks. These “Yankee BAs” and others in the fifth tier trade at considerably higher rates than acceptances of comparable U.S. 27 banks. The main reason appears to be the lack of investor recognition of the names and credit standings of these foreign banks—even those among the largest banks in the world. Presum ably, rate differentials between fifth-tier accep tances and those in the upper tiers will be lower in the future if information and efficiency in the secondary market improves." Acceptances in the top two tiers are eligible for discount, having been created by member banks.*12 Indeed, dealers are disinclined to trade acceptances that are ineligible for discount or that meet only minimum requirements of eligi bility for Fed purchase. All dealers exclude ineligible acceptances from the conventional tier structure, and some dealers refuse to trade ineligible acceptances. Current regulatory issues Prior to the amendment of Section 13( 7 ) of the Federal Reserve Act in O ctober 1982, total outstanding acceptances of an individual bank— acceptances created but not held by the bank— were limited to an amount equal to or less than . . one-half of its paid-up and unimpaired capi tal stock and surplus.” Subject to approval from the Federal Reserve Board, the limit on outstand ing acceptances could be raised to an amount up to 100 percent of paid-in capital and surplus. These ceilings posed problems for many major acceptance banks in the late 1970s, even though all major acceptance creating banks had been allowed to expand their individual limits ( “aggregate ceilings”) on the total volume of acceptances outstanding to 100 percent of capi 1'F o r ad d itio n al d e ta ils o n th e o p e r a tio n o f th e s e c o n d a ry m a rk e t, s e e W illia m C. M e lto n an d J e a n M. M ahr, “ B an k ers A c c e p ta n c e s ” Q u a rte rly R e tie u 1 o f th e F ed eral R e se rv e Bank o f N e w Y o rk , V ol. 6 , N o. 2 (S u m m e r 1 9 8 1 ) pp. 3 9 -5 5 . tal stock plus su rplus.13 Rapid grow th in acceptance volume outpaced the modest growth in banks’ capital and threatened to slow the growth of the acceptance market or divert much of the growth to smaller regional banks and U.S. branches of foreign banks. Legislation relaxing the ceiling on outstand ing acceptances, introduced in the Congress in 1981, finally was enacted in O ctober 1982 as part of the Export Trading Company Act of 1982. Section 207 of this act amended Section 1 3 (7 ) of the Federal Reserve Act in five significant areas, including increases in the aggregate ceil ings on acceptances (see box on recent legisla tion ). For the most part, this legislation avoided a number of fundamental issues and simply focused on relaxing the permissible ceiling for accep tances as an expedient for market expansion. Further flexibility for individual institutions was provided by permission for “covered” institu tions to “participate out” acceptances with other “covered” institutions (m em ber banks and U.S. branches of foreign banks). Through such participations, they are, in effect, permitted to pool the amount of acceptances as a percent age o f their joint capital. The accep tan ce creating bank is allowed to remove the partici pated acceptance from the amount that counts against its total aggregate ceiling and the amount is added to the total that counts against the other bank’s aggregate ceiling. The debate over this legislation has prompt ed renewed interest in a broad range of issues, including concentration in the primary and secondary acceptance markets, application of reserve requirements to acceptances, regulatory and institutional features of the secondary mar ket, and the more basic issue of the uniqueness of acceptances for regulatory purposes. The provisions of the Export Trading Com1'C e ilin g s o n th e to ta l a m o u n t o f elig ib le a c c e p ta n c e s 12R e ca ll th at a m e m b e r ban k a c c e p ta n c e th at m e e ts th e r e q u ire m e n ts o f S e c tio n 1 3 ( 7 ) is elig ib le f o r d isc o u n t. F o r a n o n m e m b e r bank, an a c c e p ta n c e m e e tin g th e s a m e c o n d i tio n s is elig ib le fo r p u r c h a s e ( s e e T a b le 1 ) . A m e m b e r o r n o n m e m b e r ban k m ay c r e a t e an a c c e p ta n c e th at is elig ib le o u tsta n d in g by an individual b an k m ay hav e r e su lte d in an a n o m a ly in th e m a rk e t. S u p p o se a m e m b e r b an k c r e a t e s an fo r p u rc h a s e b u t th a t d o e s n o t m e e t th e r e q u ire m e n ts o f S e c tio n 1 3 ( 7 ) , b e c a u s e its o rig in al m a tu rity is in e x c e s s o f re q u ire m e n ts , it b e c o m e s in elig ib le fo r re g u la to r y 'p u r p o se s an d su b je c t t o r e s e r v e r e q u ire m e n ts. H o w e v e r, th e s e c o n d 1 8 0 days. P r o c e e d s f ro m th e s a le o f s u c h an in elig ib le a c c e p ta n c e in th e s e c o n d a ry m a rk e t w o u ld b e su b je c t to re se r v e re q u ire m e n ts. ary m a rk e t w ill tr e a t th a t a c c e p t a n c e as eligib le. It sh o u ld b e n o te d th a t th is in fo rm al in te r p r e ta tio n is w id ely , b u t n o t un iform ly , a c c e p t e d and , c o n s e q u e n tly , n e e d s c la rifica tio n 28 a c c e p ta n c e th a t is elig ib le fo r d is c o u n t in all r e s p e c t s , e x c e p t th e ban k n o w e x c e e d s its S e c tio n 1 3 ( 7 ) a g g r e g a te ce ilin g . B e c a u s e s u c h an a c c e p t a n c e d o e s n o t m e e t all S e c tio n 1 3 ( 7 ) Econom ic Perspectives r R ecent accep tan ce legislation Section 13( 7 ) of the Federal Reserve Act (1 2 U.S.C. 3 7 2 ), the principal statute governing accep tance creation, was amended in Section 207 of the Export Trading Company Act of 1982. Section 207 contains five modifications in the regulations govern ing acceptances, four of which deal with ceilings on outstanding acceptances of individual financial institutions. • The volume of outstanding acceptances— those sold in the secondary’ market—was raised from 50 percent to 150 percent of an individual financial institution’s “paid-up and unimpaired capital stocks and surplus.” This 150 percent rule applies to the maximum amount of outstanding acceptances that an individual institution can have and still qualify its acceptances as eligible for dis count under Section 1 3 (6 ) or purchase under Federal Open Market Committee regulations. Sub ject to Board approval, the 150 percent rule is relaxed. The upper limit on outstanding accep tances then becomes 2 0 0 percent of a financial institution’s paid-up capital and surplus. The pre vious limit subject to Board approval was 100 percent. • Member banks and U.S. branches and agen cies of foreign banks ( “covered institutions” ) now are permitted to participate an acceptance with other such institutions, provided that the partici pation meets Federal Reserve regulation. By “par ticipating out” a portion of its acceptances to another institution, the creator of the acceptances does not need to count the participated portion in pany Act could slow, or even reverse, the re structuring of the supply side of the market in recent years, evidenced by increased acceptance origination at regional banks and U.S. branches of foreign banks (see Figures 3 and 4 ). A recon centration of the market, prompted by the increase in acceptance ceilings for large banks, actually might be favored by the secondary market. Such concentration deepens the market for the most liquid acceptances in the top tiers at the expense of growth and deepening of the market for acceptances in the lower tiers. Banking, trade, transportation, and com munications have changed drastically over the more than 50 years of acceptance legislation. It Federal Reserve Bank o f Chicago calculating its level of outstanding acceptances—it does not count against its aggregate ce ilin g provided that the participating institution is a Fed eral Reserve member or a qualified U.S. branch or agency of a foreign bank. • Any federal or state branch or agency of a foreign bank subject to reserve requirements under Section 7 of the International Banking Act of 1980 now becomes subject to the provisions of Section 1 3 (7 ) of the Federal Reserve Act. In particular, these institutions become subject to aggregate ceilings on outstanding acceptances, stated in terms of the outstanding acceptances of all U.S. branches and agencies of a given foreign bank as a percentage of the total capital and surplus of the parent institution. No federally imposed aggregate ceilings on outstanding acceptances previously applied to foreign institutions. • Total acceptances arising from domestic transactions (shippingand storage) may not exceed 50 percent of an individual institution’s allowable outstanding acceptances, including participations. The previous ceiling for domestic acceptances was 50 percent of an institution’s paid-in capital and surplus. • Shipping documents conveying or securing title no longer must be attached at the time of origination for eligible acceptances that finance domestic shipments. This change eliminates a cru cial difference in the definition of eligible accep tances between foreign and domestic acceptances in the shipments category. Figure 3 Regional ban ks in c re a se their sh a re of the a c c e p ta n ce m arket 29 Figure 4 A c c e p ta n c e s outstanding from U .S . b ran ch es and a g e n cie s of foreign banks triple sin c e 1 9 78 billion dollars 14 " 1974 '75 76 '77 '78 '79 '8 0 '81 '82 NOTE: Based on year-end data. can be argued that the regulation of bankers’ acceptances has failed to keep pace. Implemen tation of the Monetary Control Act of 1980 left little practical application for the concept of eligibility for discount as applied to member bank acceptances. The principal application of this concept, as specified in the amended Sec tion 1 3 (7 ) of the Federal Reserve Act, arises in outlining the administrative rules for accep tances of nonmember depository institutions. The maturity, or tenor, of created accep tances has been a point of confusion in the market. According to amended Section 1 3 (7 ) and subsequent legislation, member banks may create acceptances eligible for discount with maturities up to 180 days. Under current Open Market Committee regulations, depository insti tutions in general may create acceptances eligi ble for purchase with maturities up to 180 days. Neither category with a 180-day maturity is sub ject to reserve requirements when sold in the secondary market. However, Open Market Com mittee regulations also permit the creation of acceptances eligible for purchase with maturi ties up to 270 days. Such acceptances with maturities over 180 days are subject to reserve requirements when sold in the secondary mar ket. Confusion sometimes arises because of the regulatory anomaly that acceptances eligible for purchase with original maturities between 180 30 and 270 days are subject to reserve requirements when sold in the secondary market, even if the remaining maturity at the time of such sale does not exceed 180 days. Two regulatory and institutional aspects of the secondary acceptance market deserve care ful reexamination. One such feature is the extensive paper shuffling that results from accep tances being physically transported from banks to dealers to investors. Existing technology for book-entry and electronic transactions could be applied to make secondary market transactions substantially more efficient, especially for inves tors not located near dealers. A second feature needing reexamination is the tier structure of the market, which probably understates the quality of acceptances in the lower tiers, particu larly the dollar acceptances of foreign banks. Back to basics Bankers, regulators, and economists dis agree over basic issues of the uniqueness of bankers’ acceptances and the appropriateness of special regulations covering these instruments. The argument for uniqueness derives from the linkage between the provision of credit and a specific trade transaction matched in maturity and amount. This linkage is considered the basic distinguishing feature of an acceptance. The opposing view, however, emphasizes that it is becoming increasingly difficult to identify many acceptances on the basis of such a linkage to trade. The importance of the linkage of an accep tance to specific imported goods derives from the traditional “self-liquidating” nature of the credit provided by an acceptance. That is, the credit obligation of the acceptance can be liqui dated through the sale of the imported goods to which the acceptance is specifically tied. It can be argued, however, that the self-liquidating nature of acceptances does not provide a con vincing rationale for the special regulatory status of acceptances. To understand the funding properties of an acceptance, it is useful to compare a bank’s acceptance activity to its funding of a conven tional loan through the sale of a certificate of deposit (C D ). Three principal differences exist Econom ic Perspectives for the two types of bank funding operations. The first is that under current regulations the funds obtained through the sale of an eligible bankers’ acceptance in the secondary market are not subject to reserve requirements. Therefore, acceptances provide a potentially cheaper source of funds than CDs on which reserve require ments are applied. Second, theoretically an acceptance is tied to a specific transaction for a stated time period. While it is true that the importer may extinguish its liability at any time by prepaying it to the accepting bank, there is little incentive to do so because the effective cost of the credit extended would increase. In the case of CD funding of trade credit, the maturity of the loan and the maturity of the CD funding instrument in most cases would not coincide. The loan may be secured by the trade shipment, but the loan and the traded goods are not directly related to the CD. Bank funds raised through CD issuance are fungible—i.e., these funds can be used for any permissible bank investment purpose. On the other hand, an acceptance theoretically is tied to a specific transaction. The acceptance may not be “rolled over,” (unless under exceptional cir cumstances such as the goods being tied up at dockside due to a dock strike, for exam ple) nor may a new acceptance be created to cover the same transaction. If an extension of credit were needed to finance the transaction for a longer period than permitted under the terms of the original acceptance an alternative credit arran gement would be required. If the lending bank were to extend the customer’s credit, the funding of that loan would have to incorporate some alternative liability management arrangement. Therefore, trade financing through acceptances and through loans financed by CDs have differing implications for asset-liability management. The third difference between these funding techniques deals with the types of investor security provided by the instruments. For a bankers’ acceptance acquired in the secondary market, the investor is protected by the primary liability of the acceptance bank and the second ary, or contingent, liability of the drawer of the acceptance. The CD holder has only the primary liability of the issuing bank (plus deposit insur ance protection up to S I00 ,0 0 0 ). To date, the distinctions between bankers’ acceptances and other funding methods have been viewed by legislators and regulators as suf ficient reasons for treating acceptances as spe cial instruments. As a result, bankers’ accep tances continue to be distinct financial instru ments that are growing in importance and gaining increased market approval. This view could ch an g e in th e future, h ow ever, for as the size of the market increases, the issues of uniqueness and preferential regulation are likely to receive a more critical appraisal. Bibliography Alford, Gary L. “Tight credit and the banks— 1966 and 1969 com pared," Federal Reserve Bank of Chicago, Business Conditions, (May, 1970)4-11. Bardenhagen, Arthur. “Bankers' Acceptances under Federal Regula tion," unpublished paper presented at the Seventh Annual GIB Conference, New Orleans, October 13,1975. New York: Irving Trust Bank. Continental Illinois National Bank and Trust Company of Chicago. Commercial Letters o f Credit. International Banking Depart ment, Chicago. ________________ Guide to Bankers’Acceptances. Financial Services Department, Chicago. Federal Reserve Bank of New York. “Banker's Dollar Acceptances— U nited States.” M onthly statistical release, O ffice of Public Information. First National Bank of Chicago. Collections, Letters o f Credit, Accep tances. International Trade Finance Division, Chicago. Goldberg, Michael A. "Commercial Letters of Credit and Bankers Acceptances,” Below the Bottom Line: The Use o f Contingen cies and Commitments by Commercial Banks, Staff Studies 113, Board of Governors of the Federal Reserve System, 1982. Federal Reserve Bank o f Chicago Hacklev, Howard H. Lending Functions o f the Federal Reserve Banks. A History. Washington: Federal Reserve Board, 1973. Hatfield, Henry. Bank Credits and Acceptances 5th ed. New York: Ronald Press, 1974. Helfrich, Ralph T. “Trading in Bankers’Acceptances: A View from the Acceptance Desk of the Federal Reserve Bank of New York," Federal Reserve Bank of New York, Monthly Review, LVIII (February, 1976), 51-57. Hervey, Jack L. “Bankers’ acceptances.” Federal Reserve Bank of Chi cago, Business Conditions, (May, 1976), 3-11Kvasnicka, Joseph G. “Bankers’ acceptances used more widely," Fed eral Reserve Bank of Chicago, Business Conditions, (May 1965), 9-16. Melton, William C. and Mahr,Jean M. “Bankers’Acceptances," Federal Reserve Bank of N ew York, Quarterly Review, VI No. 2. (Summer, 1981), 39-55. U.S. Board of Governors of the Federal Reserve System. Federal Reserve Act (approved December 23, 1913) as amended. (Also, 12 USCA various sections). 31 ECONOMIC PERSPECTIVES Public Information Center Federal Reserve Bank of Chicago P.O. Box 834 Chicago, Illinois 6 0 6 9 0 P le a se a tta ch a d d re ss lab el to c o r r e s p o n d e n c e r e g a rd in g y o u r su b scrip tio n . B U LK RATE U .S . P O S T A G E PAID C H IC A G O , ILLIN O IS PER M IT N O . 1 9 4 2
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