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TOWARD MORE ACCURATE MACROECONOMIC
FORECASTS FROM VECTOR AUTOREGRESSIONS
Roy H. Webb

Several recent articles have used vector autoregressive (VAR) models to forecast national and
regional economic variables.1 Although the models
were small and in many cases the statistical techniques were relatively simple, the forecasts produced
were of comparable accuracy to predictions made by
forecasting services using much larger models, more
elaborate statistical techniques, and incorporating the
judgment of many analysts2 This article extends
the earlier work by first showing a method for improving VAR forecasts. That method is illustrated
in conjunction with the VAR model introduced by
Webb [1984]. Briefly, the source of improvement is
to determine lag lengths in the model by a clear-cut
statistical procedure, rather than by the typical practice of specifying an arbitrary length a priori. The
effect is to significantly reduce the number of estimated coefficients relative to an unrestricted VAR.
The article is organized as follows. First, a
rationale for using VAR models for forecasting is
presented. Next is a discussion of lag length selection. Empirical results from the proposed method of
lag length selection are presented in the following
section. Finally, those results are compared with
two other methods for improving a VAR model’s
predictive accuracy.
*An earlier version of this paper was presented to the
Western Economic Association Conference, Anaheim,
California, July 3, 1985. The author is indebted to John
Connaughton, Susan Dolman, Michael Dotsey, Thomas
M. Humphrey, Anatoli Kuprianov, William Lupoletti,
Yash P. Mehra, and Lee Ohanian for helpful comments.
Eric Hill provided valuable research assistance.
The
views and opinions expressed in this paper are those of
the author, and should not be attributed to other individuals in the Federal Reserve System.
1

For example, see Litterman [1984b] for national forecasts, and Kuprianov and Lupoletti [1984] for regional
forecasts.
2

The assertion that VAR models can be competitive
with major forecasting services has been made by Litterman [1984a], based on four years of actual forecasts.
That assertion has also been made by Lupoletti and
Webb [1984], based on fifteen years of simulated forecasts.

Why Use VARs?
Much of the recent interest in atheoretical methods,
including VAR models, reflects a growing disenchantment with conventional structural macromodels.
In part, that disenchantment is based on conventional
models’ spurious endogeneity/exogeneity distinctions,
their ad hoc treatment of expectations, a perceived
lack of correspondence between model equations and
the original motivating theory, and their need for
continuous ad hoc adjustments in order to produce
satisfactory results.3
A particularly appealing motivation for using VAR
models has been presented by Hakkio and Morris
[1984]. They view a VAR as a reduced form that
provides a flexible approximation to the reduced
form of any model included in a wide variety of
structural models. As such, they present empirical
evidence that a VAR model can be dramatically
superior to a misspecified structural model. Therefore, critics who believe that conventional macromodels are grossly misspecified have room to believe
that a simple VAR model might better approximate
the reduced form that would be derived from a model
that reflected the true structure of the economy.
Statistical Lag Length Selection
VAR models estimate future values of a set of
variables from their own past values. For example,
consider one of the equations from a VAR model:

where X is a vector of k variables, v is an integer
between 1 and k, t is an integer that indexes time,
is a constant term, ßi,j is a coefficient
and the ßs
are estimated by ordinary least squares), mi is the

3

Sims [1980] presents a particularly forceful and lucid
critique of conventional modeling strategies.

FEDERAL RESERVE BANK OF RICHMOND

3

lag length for variable i, and
is an error term.
In other words, the current value of each variable is
predicted by lagged values of itself and all other
variables in X. It is apparent that the value chosen
for each lag length is of some importance. Too
large a value means that too many coefficients are
estimated, resulting in a loss of precision in the estimates. But too small a value means that important
lagged terms are omitted, thereby producing biased
coefficient estimates. Both imprecision and bias will
increase forecast error variance.
Nevertheless, there is no generally accepted procedure for choosing a lag length. Many authors
simply present a number with no explanation for
how it was chosen. Others use traditional hypothesis tests, such as F-tests or likelihood ratio tests:
to compare alternative specifications. Those tests,
however, were designed for testing well-defined
alternatives derived from a priori theory. Since the
choice of lag lengths in a VAR model does not
involve theory-based dichotomies, the use of classical
hypothesis tests to determine the lag length is questionable.
In addition, the prevailing custom is to treat all
variables identically, thereby using one common lag
length for each independent variable in each equation.
It is possible, however, that identical treatment could
lead to the common lag length being too long in some
cases while being too short in others.
Traditional methods of choosing the lag lengths in
VAR models therefore seem to leave room for improvement. The strategy examined below is to consider each lag separately, and to use a statistical
procedure appropriate for exploratory data analysis
rather than hypothesis testing. For each equation,
lag lengths are chosen to minimize the Akaike information criterion, or AIC, which was originally
proposed for selecting the order of a univariate autoregression. The AIC is a function for which the
value depends on the number of estimated coefficients, and can be written as

extent that the additional coefficient improves the
in-sample fit, the residual variance declines. By
itself, that would generally4 cause the AIC to decline
by lowering the first term in equation (2). However,
estimating an additional coefficient with a fixed
number of observations tends to reduce the precision
of all the coefficient estimates. That is reflected in
the second term, which imposes a penalty for each
additional coefficient that is estimated. The minimum
AIC therefore reflects a balance between the two
opposing factors.
Although the minimum AIC can be determined by
inspection in small models, a problem arises as the
size of a model increases. Consider a five variable
VAR, with possible lag lengths from one to twelve
for each variable. Each equation would have 125, or
248,832, possible combinations of variables. Rather
than attempting to examine each possibility, an
alternative is to start with short lag lengths and add
coefficients as long as the AIC declines. A difficulty
arises, however, since with typical macroeconomic
data, the AIC does not decline smoothly as the
number of coefficients rises. Thus it is easy to reach
one of several local minima without finding the
specification that yields the global minimum AIC.
This paper uses an extensive search procedure that
is described in the Appendix. That procedure is
somewhat different from one proposed by Fackler
[1985], who addressed a related problem: using
Akaike’s final prediction error to determine the lag
lengths in a VAR model designed for indicating
causality.
In addition to its intuitive appeal, there is evidence
that the AIC has been used successfully in other
settings. Most notably, Meese and Geweke [1984]
investigated the performance of several methods of
choosing lag lengths for univariate autoregressions
that were used to predict 150 macroeconomic time
series. They found that the AIC produced the best
forecasts more often than any other method studied.
Empirical Results

where k again is the number of variables in the VAR
model, each mi is the lag length for the i’th variable
in the equation, p is the number of estimated coefficients, N is the number of observations used to
estimate the equation, and
is the maximum likelihood estimate of the residual variance.
The intuition behind equation (2) is straightforward, and reflects the tradeoff that exists with respect
to adding a coefficient to a statistical model. To the
4

The relative forecasting performance of several
models is examined by studying simulated forecasts
over a fifteen-year period. The models include an
unrestricted, five-variable VAR model (UVAR5),
the corresponding model specified by the AIC method
(AVAR5), an unrestricted six-variable VAR model
(UVAR6), the corresponding model specified by the
4

In a few cases the term (N-p) log
to an increase in p.

ECONOMIC REVIEW, JULY/AUGUST 1985

can increase due

BOX
AN ILLUSTRATIVE VAR MODEL
This box employs a simple two-variable VAR model to illustrate the techniques discussed in
the text. The variables are the T-bill rate (RTB) and the percentage change in the monetary
base (DB). With a common lag length of one, that model would consist of two equations :

where the
and ß’s are estimated coefficients. Current observations of RTB and DB can be used
to forecast future values by inserting the current values into the right sides of equations B1 and
B2 and then calculating a one-quarter-ahead forecast for each variable. Those values, in turn, can
be inserted into the right side of each equation and a two-quarter-ahead forecast prepared for each
equation. The same process can be repeated as many times as desired: in this way, a forecast can
be produced for as many steps ahead as desired.
In practice, longer lag lengths are usually necessary for accurate forecasts. A generalization of
the model presented above that allows for longer lags can be written

where the m’s represent the lag length for each variable in each equation. In order to choose specific
values for each m, suppose that lag lengths between one and four are under consideration for
equation B3. Since there are two variables on the right side and four possible lag lengths, there
are 42 possible choices. Based on data from 1952:2 to 1969:4, the sixteen regression equations
were estimated, values of the Akaike Information Criterion (AIC) were calculated, and the results
are displayed below.
Lag length for the monetary base, DB

The starred value represents the minimum AIC for the lag lengths that were examined. Therefore, in equation B3, ml1 would equal three and ml2 would equal one.
Another example is the construction of a “counter” variable (C). Suppose one wished to
construct a counter for the T-bill rate over a two-year period for which the values are shown below.
One could first construct the “indicator” variable (I) below, which would indicate the direction of
change of the T-bill rate by letting 1 represent an increase, -1 represent a decline, and 0 represent
no change. The next step would be to let the counter variable in a particular quarter equal the
cumulative sum of the indicator variable up to that point.
Variable

Quarter

A counter variable thus constructed could be added as an independent variable in either of the
equations above.

RMSE, is given by each entry in the first three
columns of Table I.
In order to more easily compare models, the final
two columns of the table include (admittedly crude)
summary statistics for each model’s performance.
The first measure is simply the sum of the RMSEs
for each variable at each horizon indicated. Lower
values, of course, indicate increasing accuracy. The
other measure is the sum of points awarded for the
relative performance of each forecast. For each
variable at each horizon, three points are awarded
for the most accurate forecast, two for the second
best, and one for the third best. (Points are split for
ties.) In this case, higher point totals represent:
better relative forecasts.
It is useful to initially consider the first three
models listed. The summary measures indicate that
the UVAR5 and AR models are rather evenly
matched. Considering only those two models, it
appears that the benefits from multivariate interaction in UVAR5 are almost exactly negated by the
burden of estimating too many coefficients. It is

AIC method (AVAR6) and a set of univariate autoregressive forecasts (AR).5
Table I contains forecast results for three key variables: the 90-day Treasury bill rate, the growth rate
of real GNP, and the growth rate of the GNP implicit
price deflator. Each model’s coefficients were estimated using quarterly data from 1952:2 to 1969:4.
Forecasts were then constructed for 1970:1 through
1971:4. Each model’s coefficients were then reestimated, using data from 1952:2 to 1970:1, and forecasts were constructed from 1970:2 to 1972:1. That
procedure was repeated until the model was reestimated and forecasts were prepared for every quarter
through 19841:3. Thus for each model a series of
out-of-sample forecasts was generated: 60 onequarter-ahead forecasts, 59 two-quarter-ahead forecasts, and so forth, up to 53 eight-quarter-ahead
forecasts. Those forecasts were then compared with
The root-mean-squared-error, or
actual data.
5

The lag lengths for the univariate autoregressions were
simply the own-lag lengths from the AVAR5 model.

Table I

FORECAST ERRORS, 1970 TO 1984

Model

Horizon

Interest
Rote

Real GNP

Implicit
Deflator

Sum 1

Sum

UVAR5

1
4
8

1.20
2.76
4.19

4.93
2.56
2.41

2.04
1.91
2.46

24.26

6

1
4
8

1.20
2.47
3.57

4.61
3.01
2.25

1.89
1.96
2.29

23.25

15

1
4
8

1.24
2.62
4.13

4.62
3.17
2.29

1.76
1.96

2.54

24.33

8

1
4
8

1.22
2.99
4.31

5.37
2.92
2.52

2.07
1.89
2.34

25.63

5.5

1
4
8

1.20
2.44
3.57

4.76
2.96
1.92

1.89
1.89
2.20

22.83

19.5

AVAR5

AR

UVAR6

AVAR6

2

N o t e : Column 1 contains the names of the models used to generate forecasts. Column 2 is the forecast horizon-the length of the forecast, measured in quarters. Columns 3 through 5 contain the
RMSE’s of post-sample forecasts. The interest rote is the 90-day Treasury bill rate. Real GNP and
the implicit deflator are percentage changes at annual rates. For those two variables, 4 and 8
Column 6 contains a summary
quarter changes are the average change over the particular period.
measure of model performance, namely the sum of the RMSE’s for each variable at each horizon.
Column 7 contains another summary measure, a point total that assigns three points for the most
accurate forecast for each variable at each horizon, two points for the second most accurate
forecast, and one point for the third most accurate forecast.

ECONOMIC REVIEW, JULY/AUGUST 1985

also interesting to note the AR model’s best relative
performance was at the one-quarter interval. That
result is intuitively plausible, since one might expect
the benefits of multivariate interaction to be greatest
at longer intervals.6
Comparing the UVAR5 and AVAR5 models illustrates the improved accuracy attainable from estimating fewer coefficients. As can be seen in Table II,
which contains the specification of the models, the
AVAR5 model7 contains only 75 coefficients. In
contrast, the UVAR5 model contains 155 coefficients
-31 per equation. The substantial reduction in the
number of coefficients suggests a possible avenue for
further improvement: the smaller number of coefficients in AVAR5 might leave enough room for
another variable to be included.
As Table I indicates, forecasting accuracy at
various horizons for the three variables of interest
was improved by adding a sixth variable. Finding
that sixth variable required a fair amount of search,
however.8 It quickly became evident that an additional variable would fail to improve the accuracy of
forecasts if any one of three conditions held : (1) the
additional variable did not appreciably augment the
explanatory power of in-sample regressions for which
the dependent variable was one of the three key variables; (2) when the additional variable was the
dependent variable, the in-sample fit of its regression
equation was poor; or (3) the additional variable
itself could not be predicted accurately in post-sample
forecasts.
The third condition is worth emphasizing, since it
may not be obvious to the casual user of VAR forecasts. For example, in searching for a sixth variable
for AVAR6, preliminary regressions (with GNP,
the deflator, or the interest rate as the dependent
In Lupoletti and Webb, a similar comparison between
Charles Nelson’s actual ARIMA forecasts and the
UVAR5 simulated forecasts found the ARIMA forecasts
uniformly superior at a one-quarter horizon, the VAR
forecasts uniformly superior at a four-quarter horizon,
and mixed results at a two-quarter horizon.
6

The lag lengths in both the AVAR5 and AVAR6
models were chosen by using data from 1952:2 to 1969:4.
The post-sample forecasts that were prepared over a
fifteen-year interval were all derived from that single
setting of lag lengths for each model. It appears likely
that periodic respecification of the models would have
yielded more accurate forecasts.
7

Variables examined included the foreign exchange value
of the dollar, the NYSE composite price index deflated
by the PCE deflator, manufacturers’ unfilled orders
deflated by the producer price index, business fixed
investment and personal savings (both expressed as a
percentage of GNP), and growth rates of employment
and federal debt.
8

Table II

LAG LENGTHS FOR EACH EQUATION
IN EACH MODEL

Note: The entries in this table represent the lag lengths for each
variable in each equation in each model. An entry of zero
indicates that the variable is excluded from that equation.
A positive number indicates the number of lags that were
A constant
included, beginning with the first lagged value.
term was also included in each equation. The variables are
as follows: RTB, 90-day Treasury bill rate; DX, real GNP,
first difference in logs times 400; DP, GNP implicit price deflator, first difference in logs times 400; CU, capacity utilization rate, manufacturing; DB, monetary base, St. Louis version, first difference in logs times 400; and GX, federal government expenditure as a percentage of GNP.

variable) fit better within the sample period when
either a stock price index or the foreign exchange
value of the dollar was included as an explanatory
variable. Attempts to predict those two variables
were unsuccessful, however, with forecasts at all
horizons having a Theil U-statistic substantially
greater than one. (That statistic indicates that simply
using the last observation of the stock index or
exchange rate as the forecast would have been more
Not suraccurate than the model’s prediction.)

FEDERAL RESERVE BANK OF RICHMOND

7

prisingly, a model containing such a poorly predicted
variable produced less accurate forecasts of the other
variables at four- and eight-quarter horizons, since
the poor forecasts of one variable added noise to other
forecasts. 9
In brief, evidence presented in this section suggests
that specifying the lag lengths in VAR models by
using the AIC can improve the accuracy of forecasts.
The benefits are twofold. First, there is a substantial
reduction in the number of estimated coefficients.
That reduction allows the remaining coefficients to
be estimated more accurately. At the same time, the
coefficients extracting the least information from the
data are the ones removed. The second benefit is
that additional variables can be added once the profligate parameterization of an unrestricted VAR
model is reduced. These additional variables may
contain information that is not contained in the
original data.
Other Techniques
The most widely used method for reducing the
parameterization of VAR models was proposed by
9

Of course, movements of a price determined in a competitive financial market should not be able to be predicted with such publicly available information as lagged
variables.
If so, that would indicate the persistence of
unexploited profit opportunities.

Litterman. 10 In essence, his method involves imposing prior beliefs concerning some statistical properties of the data. Those beliefs, often referred to as
Bayesian priors, include such ideas as (1) macroeconomic data can be accurately described as random
walks around a trend, and (2) a variable’s own lags
are better predictors of that variable’s future values
than are lags of other variables.
One example of Bayesian restrictions was imposed
on UVAR6, with the results given in Table III under
the heading BVAR6.11 The comparison between
AVAR6 and BVAR6 is of particular interest, since
each model takes a different approach toward effectively restricting the parameterization of a VAR
10

For example, see Litterman [1979] and Doan, Litterman, and Sims [1983].
11

The exact setting is given by the RATS statement
SPECIFY(TIGHT=.l,DECAY=.9).5

which imposes a particular pattern on the lags in the
model, a particular relationship between own lags and
lags of other variables, and the standard deviation of the
prior.
No experimentation was conducted to find the
setting that worked best within the sample period-it is
hoped that the results are indicative of the benefits of
using priors for real-time forecasting.
See Doan and
Litterman [1984] for more discussion of the exact meaning of the restrictions that were imposed.
In addition, it should be noted that Litterman’s priors
are most oft-n used for variables expressed in levels,
whereas three variables in UVAR6 are expressed as
percentage changes. No experimentation was conducted
to determine if the form of the priors should be changed
in such a case.

Table III

FORECAST ERRORS, 1970 TO 1984

Note: Column 1 contains the names of the models used to generate forecasts. Column 2 is the foreColumns 3 through 5 contain the
cast horizon-the length of the forecast, measured in quarters.
RMSE’s of post-sample forecasts. The interest rate is the 90-day Treasury bill rate. Real GNP and
the implicit deflator are percentage changes at annual rates. For those two variables, 4 and 8
quarter changes ore the average change over the particular period.
Column 6 contains a summary
measure of model performance, namely the sum of the RMSE’s for each variable at each horizon.
Column 7 contains another summary measure, a point total that assigns the most accurate forecast
for each variable at each horizon two points, and the second most accurate forecast one point.

8

ECONOMIC REVIEW, JULY/AUGUST 1985

model. Both methods are atheoretical from an economic point of view. The Bayesian method, however,
relies on a priori statistical restrictions, whereas the
method used to construct AVAR6 lets the data determine the form of the model.
A different approach to improving forecast accuracy was given by Neftci, who proposed a method for
incorporating the stage of the business cycle into
VAR models. He first constructed an “indicator”
variable I for the unemployment rate U by letting It
equal one if the unemployment rate in quarter t is
higher than in the previous quarter, letting It equal
minus one if the unemployment rate declined in
quarter t, and letting It equal zero if the unemployment rate was unchanged. He then constructed a
“counter” variable C by setting

The counter variable (lagged one quarter in order to
avoid adding contemporaneous information) can then
be added to the equations of a VAR model. Neftci
found that the counter significantly improved the
explanatory power of the equation explaining the
unemployment rate.
Table III shows what happens when one employs
Neftci’s method to construct a counter variable for
the capacity utilization rate and then adds that variable to equations in AVAR6. The resulting model is
labeled CVAR6. Since the counter is a nonlinear
transformation of the capacity utilization rate, it can
add information that would not be picked up by OLS
regressions containing the capacity utilization vari-

able. It is possible that the additional information
helps to incorporate the stage of the business cycle.
As Table III indicates, there are mixed results in
comparing AVAR6 and the two alternatives. The
two summary measures give different orderings of
the three models. Looking at individual variables,
AVAR6 was most accurate for predicting the implicit
deflator, BVAR6 was most accurate for predicting
real GNP, and CVAR6 was most accurate for predicting the T-bill rate. Without additional information it is difficult to assert with any confidence that
one model is likely to outperform the others in the
near future.
Conclusion
The results in this article document the improved
forecast accuracy that can be obtained by restricting
the parameterization of a VAR model. Although
the gains are consistent, they are not dramatically
large. Initial experiments with other techniques of
improving forecast accuracy did not yield consistently
large additional improvements.
Researchers interested in improving atheoretical
forecasts may continue to investigate methods of
restricting the parameterization of VARs. Further
work may also examine the benefits of combining
forecasts. For example, Lupoletti and Webb have
documented small but consistent improvements in
accuracy from combining dissimilar forecasts. At
some point, however, it will be appropriate to ask if
we are near the boundary of forecast accuracy, given
the limited information in historic macroeconomic
time series.

APPENDIX
SETTING LAG LENGTHS IN VECTOR AUTOREGRESSIONS
Consider the following equation from a vector autoregression

where n is the number of observations,
is the maximum likelihood estimate of the residual variance, and p is

THE PROBLEM
where X is a vector of k variables, v is an integer between

error term. The problem addressed in this Appendix is
choosing values for the mi’s. The choice can be made by
attempting to minimize the Akaike Information Criterion
(AIC)

The AIC has been primarily used by other authors to
determine the lag length in univariate autoregressions.
For that task it is easy to find the minimum AIC by
inspection of a small number of alternatives. For the
multivariate case, finding the minimum can be more
For k variables and a maximum lag of L
difficult.
periods, there are Lk possibilities. It can quickly become
infeasible to compute the AIC for all potential alternatives.

FEDERAL RESERVE BANK OF RICHMOND

9

Accordingly, some strategy for examining a subset of
alternatives is necessary. Designing such a strategy is
complicated by two characteristics that were observed
First, the AIC often has
with macroeconomic data.
many local minima. Therefore, from an arbitrary starting
point it is likely that a sequence of lag-length selections
will fail to converge to the set of choices that yields the
global minimum of the AIC. Second, the partial derivative of the AIC with respect to a particular lag length
depends on the other lag lengths. Therefore it is possible
that lengthening a particular lag will lower the AIC even
though a shorter lag length belongs to the set that minimizes the AIC.
The strategy for selecting lag lengths in this paper has
five elements: (1) Choose a starting specification. A
specification is defined as a particular value (possibly
zero) for the lag length of each variable that might enter
the equation. (2) Lengthen the lag for each variable by
one period. Consider adding a term (that is, lengthening
the lag length for one variable by one period) if it lowers
the AIC more than any other term examined. (3) Look
several steps ahead, in order to avoid converging to a
local minimum. (4) When steps (2) and (3) fail to
find a lower AIC after several attempts, stop adding
terms. (5) Examine the final values in each lag, to see if
removing a term lowers the AIC. Each element of the
strategy is discussed below. An objective of the strategy
is to minimize the role of judgment in finding a specification, in addition to finding a specification that is likely
to have an AIC in a reasonably small neighborhood of
the global minimum.
1. Starting Specification
Experimentation revealed
that the choice of the starting specification would often
affect the final specification. Since univariate autoregressions with a lag length of four often forecast macroeconomic data fairly well, all specification searches began
with an own lag of four, a constant, and no other
variables.
2. Adding Terms Alternatives to the starting specification included adding one period to the own lag, or
adding one period for an additional variable. The process
of lengthening each lag in turn by one period, while
holding other lags constant, is the first step of the adding
After looking at the effects of lengthening
procedure.
each lag, the term that lowered the AIC by the largest
amount was added to the equation, unless it led to a
cul-de-sac (as described in the next paragraph).
3. Look Ahead It was observed in some cases that,
although adding one term did not lower the AIC, adding
more than one did. Therefore a three-step look-ahead
procedure was built into the search. That is, even if
adding one term failed to lower the AIC, two additional

10

attempts were made at lengthening that lag. Even with
the three-step look-ahead, however, it was still possible
to take the wrong path and reach a cul-de-sac. Therefore, when the AIC failed to decline, six more attempts
were made to add terms. In each attempt one term was
added, even if the AIC rose. In many cases the additional search would successfully bypass a local minimum
and find an even lower value for the AIC.
4. Stop Adding When the AIC failed to decline after
six rounds, no further attempts were made to add more
terms. In most equations that endpoint represented a
seemingly reasonable specification. For real GNP, however, the process added many variables while only reducing the AIC by a small amount. The result was an
equation that appeared overparameterized. Therefore, a
limit of thirty-one coefficients (the number of coefficients
in each equation of the unrestricted five-variable VAR)
was imposed on the GNP equation.
5. Subtracting Variables The four preceding steps
produced specifications that would occasionally include
values at the end of lags with suspiciously low t-statistics
in regression equations. Therefore attempts were made
to remove those particular terms and to recalculate the
AIC. This step resulted in a lower AIC in a few cases.
To mechanize the procedure, the final lagged value for
each variable was removed and the AIC recalculated. If
the AIC declined, the term that lowered the AIC by the
greatest amount was removed and the procedure repeated.
This procedure is necessary since the adding process
could include a term that would make redundant a term
added earlier.
CONCLUSION
The efficacy of this strategy in approaching the global
minimum of the AIC is unknown. Further investigation
may employ Monte Carlo studies in order to compare
this strategy with other approaches to selecting lag
Intuitively, this strategy has the appeal of
lengths.
avoiding certain pitfalls by including techniques for bypassing local minima and removing redundant variables.
The other objective, minimizing the role of judgment
in specifying equations, can be more readily assessed.
Judgment is used in setting the following values: the
initial specification, the number of look-ahead steps, the
number of repetitions of the adding procedure attempted
before stopping, and the maximum number of estimated
coefficients per equation. Compared to other methods of
specifying equations, however, that is a small amount of
judgment. The procedure is therefore compatible with
the atheoretical spirit that has motivated many authors
to use VAR models.

ECONOMIC REVIEW, JULY/AUGUST 1985

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Research
Working Paper 84/10. Federal Reserve Bank of
Kansas City, November 1984.
Kuprianov, Anatoli, and William Lupoletti. “The
Economic Outlook for Fifth District States in
1984 :
Forecasts from Vector Autoregression
Models.” Economic Review, Federal Reserve Bank
of Richmond 70 (January/February 1984) : 12-23.
Litterman, Robert B. “Techniques of Forecasting Using
Vector Autoregressions.” Working Paper 115,
Federal Reserve Bank of Minneapolis, November
1979.

“Forecasting with Bayesian Vector Autoregressions : Four Years of Experience.” Working
Paper 259. Federal Reserve Bank of Minneapolis,
August 1984.
“Above-Average National Growth in 1985
and 1986. Quarterly Review, Federal Reserve Bank
of Minneapolis 8 (Fall 1984) : 3-7.
Lupoletti, William M., and Roy H. Webb. “Defining
and Improving the Accuracy of Macroeconomic
Forecasts : Contributions from a VAR Model.”
Working Paper 84-6. Federal Reserve Bank of
Richmond, 1984. Journal of Business, forthcoming.
Meese, Richard, and John Geweke. “A Comparison of
Autoregressive Univariate Forecasting Procedures
for Macroeconomic Time Series.” Journal of Business and Economic Statistics 2 (July 1984) : 191Neftci, Salih N. “Is There a Cyclical Time Unit?”
Presented to the Carnegie-Rochester Conference on
Public Policy, University of Rochester, April 1985.
Sims, Christopher A. “Macroeconomics and Reality.”
Econometrica 48 (January 1980) : l-48.
Webb, Roy H. “Vector Autoregressions as a Tool for
Forecast Evaluation.” Economic Review, Federal
Reserve Bank of Richmond 70 (January/February
1984) : 3-11.

11

A REVIEW OF BANK PERFORMANCE
IN THE FIFTH DISTRICT, 1984
David L. Mengle and John R. Walter

Fifth District banks generated strong profits during 1984. Though return on assets (ROA) and return on equity (ROE) were somewhat lower than
in 1983, they were well above the average for the
previous five years.
The rise of market interest rates in the first half
of 1984 and their fall in the second half led to a net
interest margin performance different in the Fifth
District from that reported for all banks in the
United States. For example, Fifth District banks
were more successful than banks in the rest of the
nation at controlling interest expense as a percentage of assets. At the same time, although District
banks posted gains in interest income, banks reported
even stronger results nationwide. The result in the
Fifth District was a net interest margin lower than
any reported in the last six years. In comparison,
all U. S. banks reported a slight increase in net margin. Still, Fifth District margins remained well
above those in the rest of the nation.
One of the most important factors affecting bank
profitability in 1984 was the increase in provisions
for loan losses, both in the Fifth District and for the
whole United States. In addition, noninterest revenue and expense continued to play significant roles
in offsetting changes in net interest margins. Although Fifth District banks could not match the performance of banks nationwide in increasing noninterest income, they have continued to be successful
at reducing noninterest expense, a goal that has so
far eluded banks at the national level.
Because of Fifth District banks’ higher net interest
margin, lower provision for loan losses, and declining noninterest expense, they were able to continue
to outperform banks nationwide in both return on
assets and return on equity. In an era of steadily
declining profitability on the national level, banks in
the Fifth District have been able to maintain high
returns.
12

Interest Revenue
Gross interest ratio, defined as gross interest revenue divided by average assets, rose by 44 basis
points during 1984 to 10.02 for banks in the Fifth
Federal Reserve District (see Table I). This increase, in contrast with the decreases of the two previous years, reflects the generally higher market rates
experienced over much of 1984 shown in Chart 1.
With average market rates 1% to 1.5% above 1983
rates, 97% of Fifth District banks expanded their
level of interest income compared with 1983 and
70% increased gross interest income as a percent
of average assets. At the national level, the increase
in the gross interest ratio was even greater (see
Appendix).
This increase in gross interest revenue obscures
some differences between the performance of various
size categories of banks, as shown in Chart 2. For
example, medium-sized banks, that is, those with
total assets between $100 million and $750 million,

Chart 1

SELECTED INTEREST RATES

1982

ECONOMIC REVIEW, JULY/AUGUST 1985

1983

1984

Table I

INCOME AND EXPENSE AS A PERCENT OF AVERAGE ASSETS
FIFTH DISTRICT COMMERCIAL BANKS, 1979-1984
1979

Gross interest revenue

1980

1981

1982

8.49

Item

1984

9.46

11.15

10.86

9.58

10.02

1983

4.53

5.60

7.29

6.93

5.82

6.33

3.96

3.86

3.86

3.93

3.76

3.69

Noninterest income

0.80

0.90

1.01

1.03

1.16

1.15

Loan loss provision

0.26

0.26

0.25

0.28

0.25

Gross interest expense
Net interest margin

Securities gains or losses2

0.33
- 0.02

Noninterest expense

3.24

3.37

3.48

3.53

3.45

3.37

Income before tax

1.26
0.28

1.13
0.20

1.14
0.19

1.15

1.22

0.18

0.22

1.12
0.19

Taxes
Other3

- 0.04

- 0.09

-0.10

- 0.02

0.00

0.94

0.89

0.86

0.87

0.98

0.93

Cash dividends declared

0.30

0.32

0.33

0.37

0.34

0.31

Net retained earnings

ROA

- 0.04

4

0.64

0.57

0.53

0.50

0.64

0.62

13.51

12.79

12.56

13.12

15.21

14.62

80,671

88,280

97,217

108,439

12 1,173

137,131

ROE5
Average assets ($ millions)
(Discrepancies due to rounding errors)

Source: Consolidated Reports of Condition and Income as submitted by insured banks to their primary regulators.
1

Average assets are based on fully consolidated volumes outstanding at the beginning and at the end of the year.

2

Banks were required to report securities gains or losses above the tax line, on their income statements, for the first time
in 1984.
3

Includes securities and extraordinary gains or losses after taxes, for 1979-1983 data, and extraordinary items and other
adjustments after taxes for 1984 data.
4

5

ROA is net income divided by average assets.

ROE is net income divided by average
beginning and at the end of the year.

equity.

Average equity is based on fully consolidated volumes outstanding at the

had a gross interest ratio increase of 59 basis points
over 1983, while large banks (assets over $750 million) saw an increase of 46 basis points. In contrast, the smallest Fifth District banks (less than
$100 million) experienced only a 26 basis point increase in gross interest revenue. As in previous
years, this reflects the lower variability of the yields
on loans in smaller banks’ portfolios.
Table II shows that return on total loans for all
Fifth District banks rose by 21 basis points. The
insensitivity of small banks’ loan portfolios to interest rate changes led to considerably slower growth
in loan income than that achieved by the larger
banks. Specifically, 31% of small Fifth District
banks’ loan portfolios consists of mortgage loans,
which typically have fixed rates and long terms and
are therefore comparatively insensitive to fluctuations
FEDERAL RESERVE BANK OF RICHMOND

13

Table II

AVERAGE RATES OF RETURN ON SELECTED INTEREST-EARNING ASSETS
FIFTH DISTRICT COMMERCIAL BANKS, 1979-1984
item

1979

1980

1981

1982

1983

1984*

Total loans

11.25

12.50

14.48

14.14

12.38

12.59

Net loans

11.37

12.63

14.64

14.30

12.53

12.74

6.43

7.15

8.57

9.27

9.20

9.68

8.14

9.16

11.22

11.79

11.17

State and local

5.17

5.56

6.11

6.68

6.74

Other

2.88

3.25

4.20

5.82

5.96

10.09

11.28

13.18

12.68

11.11

Total securities
U. S. Government

Total interest-earning assets

11.77

* Total and net loans here include leases while in other columns they do not.

in market rates. In comparison, mortgages averaged
21% of medium banks’ and 13% of large banks’ loan
portfolios. At the same time, large banks held 30%
of their gross loan portfolios in commercial and industrial (C&I) loans, while medium banks held
26% and small banks held 20%. C&I loans tend to
be interest-sensitive because they often have short
terms or carry variable interest rates.
It is important to look closely at loan growth patterns since, as is made clear by Table III, the prom-

inence of loans relative to other assets in District
banks’ portfolios increased during 1984. Total loan
growth (Table IV) picked up during the last quarter
of 1984, and was spread evenly among most categories of loans. An exception to the pattern was
agricultural loans, which grew as a percent of total
loans during the first half of the year but declined in
the second half. The result was that, as total loans
grew by slightly more than 20% between the end of
1983 and the end of 1984, farm loans fell from

Table Ill

ASSET CATEGORIES AS A PERCENT OF TOTAL ASSETS
FIFTH DISTRICT COMMERCIAL BANKS, 1982-1984
1982

1983

1984

23.43

25.86

24.45

Loans and leases - Total
Home mortgages
Commercial real estate and development loans
Commercial and industrial loans
Consumer loans
Other loans
Leases
Agricultural loans
Less: Unearned income on loans

50.10
10.22
6.78
15.03
14.34
3.94
0.58
0.89
- 1.68

51.07
9.55
7.20
15.50
14.60
4.10
0.58
0.93
- 1.38

54.41
9.56
8.49
16.54
15.88
3.61
0.74
0.81
- 1.22

Less: Allowance for loan loss

- 0.59

- 0.61

- 0.71

Cash and due from balances

Asset Category

Securities

14.80

13.79

11.92

Fed funds

6.21

4.05

4.40

Other assets

6.04

5.84

5.52

100.00

100.00

100.00

Total
(Discrepancies due to rounding errors)

14

ECONOMIC REVIEW, JULY/AUGUST 1985

Table IV

QUARTERLY GROWTH RATES IN SELECTED LOAN CATEGORIES
FIFTH DISTRICT COMMERCIAL BANKS, 1984
Q1

Loan Category

Q3

Q2

Q4

Home mortgages

1.99

3.64

3.60

3.78

Commercial real estate and development loans

7.63

7.40

5.96

9.43

Commercial and industrial loans

6.94

5.09

1.64

6.06

Consumer loans

2.62

6.65

5.36

7.15

- 11.22

1.36

4.34

6.62

Leases

3.94

5.24

8.51

22.01

Agricultural loans

8.56

8.46

- 7.79

- 8.42

3.51

5.41

3.72

6.44

Other loans

Total loans

1.84% to 1.49% of this total. Within the agricultural loan category, loans secured by farmland, which
had remained fairly steady as a percent of total loans
during 1983, fell throughout 1984. Other agricultural loans, which rose during the first half of 1984
and fell during the second half, were lower in each
quarter than in the corresponding period in 1983.
Table II shows that gross returns on securities,
the ratio of securities income to average securities
outstanding, increased from 9.20% in 1983 to 9.68%
in 1984. This increase, however, was due almost
entirely to large banks’ strong performance, since
banks with less than $750 million in total assets
showed little or no improvement in return on their
securities.

funds grew much more rapidly than this average
figure. At the end of 1984, these relatively interestsensitive liabilities accounted for 24% of total liabilities. Such liabilities as small time deposits (those
in denominations less than $100,000), passbook savings accounts, individual retirement accounts, Super
NOW accounts, NOW accounts, and money market
deposit accounts (MMDA), all of which are included
in the Other Deposits category in Table V, produced a much smaller increase in interest expenses
because of the relatively less interest-sensitive nature
of these accounts. Because the deposits included in
the Other Deposits category together make up about
52% of all liabilities in Fifth District banks, they
helped to offset the higher funds costs arising from
the more interest-sensitive liabilities.

Interest Expense
Just as the higher market rates prevalent during
1984 pushed up interest revenue, so did they push up
interest expense. As a percent of average assets, interest expense in Fifth District banks increased 51
basis points from 5.82% in 1983 to 6.33% in 1984
(Table I).
Chart 3 reveals that the effect of higher market
rates on interest expense varied with bank size.
Fifth District banks with more than $100 million in
assets had an average increase of 54 basis points in
their interest expense ratio. For smaller banks,
however, the increase was a more modest 37 basis
points.
The average cost of interest-bearing liabilities in
Fifth District banks rose 60 basis points during 1984,
as reported in Table V. Contributions to this increase varied among the different categories of liabilities. The average cost of such liabilities as large
time deposits, deposits in foreign offices, and Fed

Chart 3

INTEREST EXPENSE RATIO*

FEDERAL RESERVE BANK OF RICHMOND

15

Table V

AVERAGE COST OF FUNDS FOR SELECTED LIABILITIES
FIFTH DISTRICT COMMERCIAL BANKS, 1979-1984
Item

1979

Subordinated notes and debentures

1981

1982

7.15
9.96
10.28
6.16

Interest bearing deposit accounts
Large time deposits
Deposits in foreign offices
Other deposits

1980

8.68
11.33
13.17
7.54

10.63
14.35
15.18
9.23

8.19

8.20

8.11

1983

1984

9.91
12.05
12.79
9.12

8.19
7.62
7.73
8.34

8.72
9.47
9.19
8.55

8.34

8.32

8.03

11.94

13.34

15.54

11.21

8.52

9.58

Other

6.98

8.65

13.49

11.29

8.75

9.18

Total

7.60

9.13

11.23

10.10

8.24

8.84

Fed funds

Fifth District institutions were considerably less
reliant on funds with volatile yields than were banks
nationwide. The relatively interest-sensitive categories of deposits provided 32% of total liabilities for
all U.S. banks, while the Other Deposits category
amounted to 41%. This helps explain the greater
increase in interest expense for U.S. banks during
1984 compared with banks in the Fifth District.
Demand deposits continued to decline as a percentage of total deposits in Fifth District banks. In
1983, these non-interest-bearing checking accounts
represented 25.5% of total domestic deposits. By the

end of 1984 this ratio had fallen to 24.8%, although
it should be noted that this decline was smaller than
that which had taken place from 1982 to 1983. As
the significance of demand deposits in the liability
structures of banks declines, interest expense as a
percent of liabilities or assets increases due to the
rise in the importance of interest-paying liabilities.
Because holders of demand deposits are compensated implicitly through services provided by their
banks, increases in interest expense should be offset
somewhat by diminutions in noninterest expense.

billion. During this same period, Super NOWs grew
by about $400 million. By the end of 1984, MMDAs
and Super NOWs together made up 14.5% of total
liabilities, while at the end of 1983 they accounted for
13%. On the one hand, if consumers replaced maturing certificates of deposit with MMDAs or Super
NOWS, this liability structure shift may have
lowered Fifth District banks’ total interest cost. On
the other hand, if depositors simply replaced regular
demand deposits and savings deposits with Super
NOWs and MMDAs, banks may have experienced
interest expense increases as the latter accounts grew
in importance.2
Michael C. Keeley and Gary C. Zimmerman (1985)
provide evidence regarding sources of funds for MMDAs.

2

Chart 4

MMDA AND SUPER NOW GROWTH

Since the reduction of the importance of demand de-

posits in the Fifth District was small relative to total
liabilities, it is unlikely that much of this shift from
noninterest expense to interest expense took place
during 1984.
In 1984, Fifth District banks did not experience
the same rapid growth in MMDAs and Super NOW
accounts that occurred in 1983.l As seen in Chart 4,
MMDA growth was steady throughout the year, expanding by $3.7 billion during the year, from an initial figure of $14.1 billion to an end-of-year $17.8

1

See F. Ward McCarthy, Jr. (1984), pp. 24-S.

16

ECONOMIC REVIEW, JULY/AUGUST 1985

Net Interest Margin
Since interest expense in the Fifth District rose
more quickly relative to average assets than did interest income in 1984, net interest margin declined
from 3.76% to 3.69%. This seven basis point decline
contrasts with the one basis point increase enjoyed
by banks on the national level, and is also difficult to
explain given that the spread between the prime rate
and the 90-day certificate of deposit rate increased
through most of the second half of 1984. However,
the negative net interest margin growth in the Fifth
District conceals the differences between banks in the
three size categories (see Chart 5). Although net
margin decreased eleven basis points for small banks
and eight for large banks, it actually increased by six
basis points for medium-sized banks.
Table VI breaks down various aspects of net interest margin performance for all Fifth District
banks and for the three size classes. Looking at per-

Chart 5

NET INTEREST MARGIN*

Table VI

CHANGES IN NET INTEREST MARGINS IN RELATION TO INTEREST INCOME AND
INTEREST EXPENSE GROWTH RATES AND BALANCE SHEET COMPOSITION
FIFTH DISTRICT COMMERCIAL BANKS, 1984

1
Rote-sensitive liabilities include Super NOW accounts, and money market deposit accounts.
In addition, the following ore included
provided they have immediately adjustable interest rates or maturities of one year or less: time deposits. deposits in foreign offices, and
nondeposit interest-bearing liabilities.

2

Rate-sensitive assets include those loons and leases, debt securities, and other interest bearing assets with immediately adjustable
interest rates or with maturities of one year or less.

FEDERAL RESERVE BANK OF RICHMOND

17

formance for the aggregate of all banks, it appears
that the major differentiating factor between banks
experiencing higher and those experiencing lower net
margins is ability to generate higher interest income
growth. In 1983, the situation was just the opposite,
there being little difference between interest income
performance while ability to reduce interest expense
was crucial to higher margins. Further, in 1983 this
was true for all three size classes.3 A closer look at
the 1984 numbers shows, however, that there are
more differences between banks than is apparent
from the aggregate figures for all banks. Among
small and medium banks, for example, interest income and interest expense growth were of roughly
equal significance in determining changes in net margins. For large banks, however, interest income
growth was a far more important determinant of
margins than was interest expense growth.
It is more difficult to draw any strong conclusions
from differences between banks with regard to the
sensitivity of banks’ assets and liabilities to changes
in interest rates. During a period of rising market
rates, holding relatively interest-sensitive assets and
interest-insensitive liabilities should cause margins
to rise. Alternatively stated, if the duration of assets
is less than that of liabilities, assets will be repriced
(at higher rates) more frequently than liabilities.4
Looking at the aggregate of banks, it appears that
interest-sensitive assets could have been helpful to
those banks having higher net margins. Once the
figures are broken into size classes, however, relative sensitivities become less informative. More definite statements could be made on this subject if durations of bank balance sheets were computed, but
that is beyond the scope of this paper.
As noted above, Fifth District banks with between
$100 million and $750 million in total assets at the
end of 1984 produced a six basis point rise in their
net interest margin overall. However, only 37% of
these banks had an increased net margin ratio, the
others experiencing a decline. Medium-sized banks
with improved net margins were, in fact, larger in
terms of total assets than the average for their cate-

gory. As a group, small banks experienced the largest decline in net margins. Only 33% of these banks
were able to improve their net margins compared to
last year.
Noninterest Revenue and Expense
Noninterest income in Fifth District banks was
12% higher during 1984 than in 1983. Asset growth
exceeded noninterest income growth, however, so
noninterest income relative to assets fell by one basis
point (Table I). Service charge income, which
made up about 34% of noninterest income, increased relative to average assets over 1983, as did
leasing income (Table VII). These increases were
offset by declines in Other Noninterest Income,
which includes such items as income from fiduciary
activities, credit card fees, and safe deposit box
rentals. In contrast, noninterest income at the national level rose significantly in 1984, the major
contributing factor being an increase in Other Noninterest Income.
Fifth District banks’ flat noninterest income performance was more than offset by an eight basis
point decrease in noninterest expense as a percent of
assets, compared to a ten basis point increase at the
national level. Decreases in both salaries expense
and bank premises costs contributed to this fall. The
decline in the Fifth District was largely the result

Table VII

NONINTEREST INCOME AS A PERCENT
OF AVERAGE ASSETS
FIFTH DISTRICT COMMERCIAL BANKS
1983 AND 1984
Item

1983

1984

Total noninterest income

1.16

1.15

Service charge income

0.37

0.39

Leasing income

0.07

0.08

Other noninterest income

0.72

0.69

3.45

3.37

Total noninterest expense

4

Duration may be defined as the weighted average life
of a security or as the sensitivity of the value of a
security to interest rate changes. See George G. Kaufman (1984).

18

1.74

0.60

0.56

Other

McCarthy (1984), pp. 26-7.

1.78

Bank premises
3

Salaries

1.07

1.07

2.29

- 2.22

Noninterest margin
(Discrepancies due to rounding errors)

ECONOMIC REVIEW, JULY/AUGUST 1985

of a twelve basis point average decline at large banks,
medium banks experiencing only a three basis point
decline and small banks a two point rise. At the national level, noninterest expense was pushed up by
both salaries and Other Noninterest Expense, which
includes such costs as legal fees, federal agency assessments, travel expenses, and telephone bills.
Loan loss provisions in Fifth District banks grew
more in 1984 than in any of the past four years. In
fact, relative to average assets, this expense item was
approximately one-third greater in 1984 than in the
previous year. Although this is a significant increase
by Fifth District standards, some perspective may be
gained by comparing the Fifth District results in
Table 1 with the national loan loss provisions shown
in the Appendix. Through 1981, loan loss provisions for the Fifth District banks were similar to
those for all U. S. banks. In 1952, however, loan
loss provisions relative to assets grew 50% over the
previous year for all U.S. banks, while they went up
by only 12% in the Fifth District. Similarly, 1983
national loan loss provisions grew by over 20%,
while in the Fifth District they actually declined.
Thus, although the 32% Fifth District increase in
1954 loan loss provisions represents a greater change
than does the national change of 17%, it should be
borne in mind that Fifth District loan loss provisions
as a percentage of assets remain significantly lower
than those for the aggregate of all banks in the
nation.
Within the Fifth District, most of the increase in
provision for loan loss took place during the fourth
quarter. Banks with more than $750 million in assets were principally responsible for the larger than
normal increase, since these banks as a group increased provisions by ten basis points relative to assets. This increase was to a great extent made necessary by rapid loan growth. At the same time, small
and medium-sized banks increased their provisions
an average of only two basis points.
Loan and lease chargeoffs net of recoveries were
.29% of total loans and leases in Fifth District banks
in 1984, essentially unchanged from the previous
year. In comparison, the 1984 figure for all U.S.
banks was .71%. Past due, nonaccrual, and renegotiated loans and leases amounted to 3.32% of total
loans in Fifth District banks in 1984, while they
averaged 5.07% for all U.S. banks. The most significant illustration of Fifth District banks’ continu-

ing pattern of conservative writeclown policies may
be seen in the ratio of current year recoveries to previous year chargeoffs, which gives an indication of
how aggressively loans are being charged off. This
ratio was 30.5% for Fifth District banks in 1984,
while the same ratio for all U.S. banks was 20.3%. 5
Since this ratio generally increases as banks both enforce vigorous collection procedures and take less
time to write off doubtful loans, there is no evidence
that Fifth District banks have abandoned their tradition of conservative chargeoff policies.
Profits and Dividends
Profits before taxes relative to average assets fell
by ten basis points from 1983 levels at banks in the
Fifth District. Small and large banks had fifteen
and eleven basis point declines, respectively, while
medium-sized banks realized a nine basis point increase. Had Fifth District banks not increased provisions for loan losses, income before taxes relative
to average assets would have been only two basis
points below its 1983 level. Taxes as a percent of
average assets fell by five basis points at both large
and small banks but increased by four basis points at
medium-sized banks.
Return on assets (ROA), defined as net income
divided by average assets, declined for the aggregate
of Fifth District banks from .98% in 1983 to .93%
in 1954. As Chart 6 shows, however, these figures
mask interesting variations among banks of different
sizes. For example, large banks produced an average
decline in ROA of four basis points to .88%. Although these institutions experienced declining net
margins and noninterest income along with a significant increase in provisions for loan losses, they
enjoyed lower noninterest expenses, losses on securities, and taxes. Medium-sized banks, where the
1.05% ROA represented a rise of five basis points
over 1983, had higher net interest margin, greater
noninterest income, and lower noninterest expense
than in 1983. However, some of these gains were
offset by a slight increase in provision for loan losses,
an increase in securities losses, and higher taxes.
Small banks’ ROA fell on average by nine basis
points to 1.12%. This decline was the result of a
5

For a more detailed breakdown of this ratio on the
national level, see Federal Deposit Insurance Corporation
(1985), p. 13.

FEDERAL RESERVE BANK OF RICHMOND

19

74 basis points (see Chart 7). For all U.S. banks,
the average ROE fell from 11.24% in 1983 to
10.63% in 1984.
Dividends paid out by Fifth District banks to
stockholders declined from .34 cents per dollar of
average assets in 1983 to .31 cents in 1984. Small
banks paid out 31% of net income as dividends,
which was the lowest payout for the three size categories. Medium banks distributed 39% as dividends,
while large banks paid out 33%. The average dividend to net income ratio for all banks in the United
States was 49% in 1984, compared to only 34% for
Fifth District banks.

Chart 6

RETURN ON ASSETS*

Capital Adequacy
*Net income divided by average assets.

substantial decrease in net interest margin with other
factors cancelling one another. In comparison, for
all U.S. banks, the average ROA fell from .67% in
1983 to .64% in 1984.
Return on average equity (ROE) decreased by
59 basis points to 14.62% for all Fifth District banks.
Despite this decline, ROE in 1984 was still high
compared with the preceding five years. As shown
in Table VIII, aggregate leverage (average assets
divided by average equity) increased thirteen basis
points over last year, but this was not sufficient to
counteract the effect of lower return on assets.
Again, the aggregate numbers conceal some variation, since medium-sized banks’ ROE increased by

Capital 6 was augmented at Fifth District banks in
1984. According to the data in Table IX, banks in
the Fifth District increased primary capital from
7.24% of adjusted assets in 1983 to 7.28% in 1984,
6

The measure of capital used here is not precisely the
same as that used by any of the regulatory agencies. In
this article, primary capital includes common stock,
perpetual preferred stock, surplus, undivided profits,
capital reserves, mandatory convertible instruments up
to a certain percentage of primary capital, reserves for
loan and lease losses, and minority interest in consolidated subsidiaries. Secondary capital (total capital less
primary capital) includes limited life preferred stock,
subordinated notes and debentures, and those mandatory
convertible instruments not eligible for primary capital.
In addition, the measure used here subtracts intangible
assets from average assets plus loan loss reserves (to
yield adjusted assets), and from capital. For a detailed
explanation of capital adequacy standards, see R. Alton
Gilbert et al. (1985).

Chart 7

RETURN ON EQUITY*

20

ECONOMIC REVIEW, JULY/AUGUST 1985

Table IX

CAPITAL ADEQUACY
FIFTH DISTRICT AND ALL U. S. COMMERCIAL BANKS
1983
Small
Banks

Medium
Banks

Large
Banks

Total

Primary ratio

11.65

8.00

6.35

7.24

Total ratio

11.70

8.15

6.61

7.46

Primary ratio

9.48

7.80

5.69

6.73

Total ratio

9.78

8.10

6.04

7.02

Fifth District

All U. S. banks

1984
Fifth District
Primary ratio

9.60

8.35

6.64

7.28

Total ratio

9.63

8.41

6.92

7.49

Primary ratio

9.24

7.94

6.35

7.11

Total ratio

9.31

8.15

6.66

7.36

All U. S. banks

and total capital from 7.46% to 7.49%. Primary and
total capital ratios were higher for Fifth District
banks than for all U.S. hanks both in 1983 and 1984,
although the capitalization ratios increased by a
somewhat greater percentage nationally than was the
case in the Fifth District.
The only size category of banks that experienced
declining ratios was that of small banks, and this was
true nationally as well as for the District. This
should not be a cause for concern, however, since
capitalization of small banks as a group was well
above the threshold of regulatory concern7 in both
years. Large Fifth District banks increased their
primary ratio by 29 basis points while the average
for all large banks in the country grew by 66 points.
Even with the greater increase at all large U. S.
banks, however, large Fifth District commercial
banks remained, on average, more extensively capitalized at the end of 1984 than did their peers
throughout the country. Finally, medium-sized banks
in the Fifth District increased their capital ratios at
about the same rate as did large District banks, while
The FDIC and Comptroller have established 6 percent
as the minimum total capital ratio, while the Fed generally considers under 6 percent to be undercapitalized, 6
percent to 7 percent acceptably capitalized, and over 7
percent to be adequately capitalized. For a description
of the Federal Reserve standards, see 50 Fed. Reg. 16057.
7

all U. S. banks in the middle category reported minor
increases. The inference to be drawn from all this
is that Fifth District banks are as a group well capitalized by national standards, although it should be
borne in mind that such averages as are presented
here conceal a great deal of variation among individual banks, especially in the smallest size category.
It is of interest to examine more closely how
growth in capitalization was brought about. Increasing equity capital is one means of augmenting capital
ratios, and in 1984 Fifth District banks increased
equity capital by 13.4%. Retained earnings, the
difference between net income and cash dividends,
provided 77% of this increase. Table VIII shows,
however, that leverage increased in the Fifth District in 1984, which in turn implies that asset
growth continued to outpace equity growth. Thus,
higher capital to assets ratios were not attributable
to increases in equity capital. Rather, higher allowance for loan losses was apparently the most significant factor contributing to the rise for District banks.
For all U. S. banks, the most important factors were
increases in subordinated notes and mandatory convertible debt.
Concluding Comments
Fifth District banks’ 1984 performance, relative to
the average for all U. S. banks, was outstanding.
Fifth District banks had a much higher ROA and
ROE than the national average. Their loan chargeoffs and nonperforming loans relative to total loans
were a fraction of the national average. Finally, Fifth
District banks had capital ratios which demonstrated
stronger capital positions than their peers nationwide.
These strong capital ratios not only show the results
of the District’s traditionally conservative approach
to banking, but also place District banks in a good
position for continued growth in 1985.
Still, District banks should note that their higher
performance levels conceal some significant differences between them and other banks in the nation.
First, interest revenue in the Fifth District was below
the national level. Second, noninterest income performance was far better at the national level than in
the District. Finally, although net interest margins
in the Fifth District remained higher than those for
the nation, they have been declining steadily in the
District while staying fairly steady nationwide. In
the coming years, it will be important for banks in
the Fifth District to pay attention to these areas,
while continuing to make the most of their considerable strengths.

FEDERAL RESERVE BANK OF RICHMOND

21

APPENDIX
INCOME AND EXPENSE AS A PERCENT OF AVERAGE ASSETS1
ALL U. S. COMMERCIAL BANKS, 1979-1984
1979

Item

1980

1981

1982

1983

1984

Gross interest revenue

8.62

9.87

11.81

11.19

9.50

10.11

Gross interest expense
Net interest margin

5.50
3.12

6.78
3.09

8.75
3.07

8.02
3.17

6.36
3.15

6.95
3.16

Noninterest income

0.78

0.89

0.99

1.05

1.12

1.27

Loan loss provision

0.24

0.25

0.26

0.39

0.47

0.55

2.54

2.63

2.76

2.91

2.95

3.05

1.12
0.28
- 0.04

1.10
0.28
- 0.03

1.04
0.24
- 0.04

0.91
0.17
- 0.03

0.84
0.18
0.00

0.82
0.19
0.01

0.80
0.28
0.52

0.79
0.29
0.50

0.76
0.30
0.46

0.71
0.31
0.40

0.67
0.33
0.34

0.64
0.31
0.33

ROE5

13.90

13.70

13.20

12.20

11.24

10.63

Average assets ($ billions)

1,593

1,768

1,940

2,100

2,253

2,398

- 0.01

Securities gains or losses2
Noninterest expense
Income before tax
Taxes
O t h e r3
R O A4
Cash dividends declared
Net retained earnings

(Discrepancies due to rounding errors)
Source: Federal Reserve Bulletin, 1981, 1984 (1979-83 data), Consolidated Reports of Condition and Income as submitted
by insured banks to their primary regulators (1984 data).
1

2

3

4

5

See Table I, footnote 1.
See Table I, footnote 2.
See Table I, footnote 3.
See Table I, footnote 4.
See Table I, footnote 5.

References
Federal Deposit Insurance Corporation. “Commercial
Bank Performance in 1984.” Economic Outlook,
April 1985, pp. 7-15.
Gilbert, R. Alton, Courtenay C. Stone, and Michael E.
Trebing. “The New Bank Capital Adequacy StanFederal Reserve Bank of St. Louis,
dards.”
Review 67 (May 1985) : 12-20.
Kaufman, George G. “Measuring and Managing Interest Rate Risk: A Primer.” Federal Reserve Bank
of Chicago, Economic Perspectives 8 (January/
February 1984) : 16-29.
Keeley,, Michael C., and Gary C. Zimmerman. “Competition for Money Market Deposit Accounts.”
Federal Reserve Bank of San Francisco, E c o n o m i c
Review (Spring 1985), pp. 5-27.
McCarthy, F. Ward, Jr. “A Review of Bank Performance in the Fifth District, 1983.” Federal Reserve
Bank of Richmond, Economic Review 70 (July/
August 1984) : 21-9.

22

ECONOMIC REVIEW, JULY/AUGUST 1985

THE MONETARY CONTROL ACT AND
THE ROLE OF THE FEDERAL RESERVE
IN THE INTERBANK CLEARING MARKET
Anatoli Kuprianov

I. INTRODUCTION

The Monetary Control Act of 1980 changed the
terms of Federal Reserve participation in the interbank clearing market. It required services? which
had previously been made available free of charge to
Federal Reserve member banks, to be priced competitively and made available to all depository institutions on equal terms. This article explains why
Congress legislated this change. To do this, the
article investigates the origins of the debate over the
Federal Reserve’s role in the payments system that
arose in the decade preceding the enactment of this
legislation.
Two principal issues surfaced as part of this larger
debate; namely, Federal Reserve access and pricing
policies. The first dealt with the terms of access
to Federal Reserve payments services. Debate over
this issue arose as a result of thrift industry deregulation. To make use of new transaction account
powers, thrifts requested access to the Federal Reserve’s clearing network. The industry was granted
indirect access to some Federal Reserve services, but
not always on the same terms as those enjoyed by
commercial banks. Subsequent thrift industry demands for a nondiscriminatory access policy were
supported by the Justice Department’s Antitrust Division, and finally resulted in congressional action to
institute such a policy.
Pricing policy dealt with the pricing of Federal Reserve services. Debate over this issue arose for three
reasons. First, since the Federal Reserve did not
price its services explicitly, an expansion of its service offerings in the 1970s raised concerns among
market participants that private sector competition
in these new areas could be preempted. Second, mea-

sures then under consideration by Congress to end
the Federal Reserve’s increasingly serious membership problem were expected to result in a considerable loss of revenue to the U.S. Treasury. Pricing
was adopted to mitigate this revenue loss. Third, a
nondiscriminatory pricing policy was essential to the
resolution of the access policy issue. The pricing
provisions of the Monetary Control Act effectively
resolved all of these issues.
This article is organized as follows. Section II discusses the origins of the debate over granting nonmember institutions direct access to Federal Reserve
services. In this discussion, attention is focused on
thrift industry deregulation as a driving force behind
the debate over access policy. Section III reviews
the debate over issues related to Federal Reserve
pricing. Section IV presents a summary of the article
and some concluding comments.

II. ACCESS TO FEDERAL RESERVE SERVICES

Before the Monetary Control Act was passed,
member banks obtained most payments services from
the Federal Reserve. As a result of the Federal
Reserve’s expansion of its Regional Check Processing Centers (RCPCs) in the early 1970s, many
privately-operated clearinghouses c1osed.1 Nonmember banks therefore tended to rely on correspondents,
1

Many of the regional clearinghouses that closed when
the Federal Reserve expanded its RCPC system have
reopened since Federal Reserve pricing was initiated in
1981. In addition, there has been new entry into this
market as a result of pricing. See Joanna H. Frodin,
“Fed Pricing and the Check Collection Business: Private
Sector Response,” Federal Reserve Bank of Philadelphia,
Business Review (January/February 1984), pp. 13-21.

FEDERAL RESERVE BANK OF RICHMOND

23

most of which were members of the Federal Reserve, to clear checks and for other payments services. These correspondents were permitted to “pass
through” their respondents’ checks to the Fed and
also to resell other services such as the wire transfer
of funds over Fedwire, the Federal Reserve’s electronic funds transfer network. In this way, nonmember banks were able to gain indirect access to
Federal Reserve services.
When thrift institutions first began to offer limited
third-party payments services, they needed access to
a clearing network. A newly organized automated
clearinghouse (ACH) system, designed to handle the
electronic transfer of recurring payments from transactions deposits held with banks, appeared to be
ideally suited to the limited powers initially granted
to thrifts. Access to this system was controlled by
the commercial banking industry, however, and
bankers demanded regulatory reform that would
eliminate much of the special treatment enjoyed by
thrifts as the price of direct access. Thus, the question of access was linked to the broader issues dealing with the regulatory reform of the financial services industry. To complicate matters further, the
Federal Reserve had assumed a major role in the
operation of the ACH network. This operational
role subsequently involved it in the ensuing debate
over access policy.
Thrift industry deregulation and regulatory reform of the financial services industry constituted key
issues in the debate over ACH access policy. Their
importance necessitates a brief review of these issues. This is followed by a detailed review of the
debate over thrift industry access to the ACH network. The response of the commercial banking industry and the Federal Reserve to these events is
examined. Finally, the role of the Justice Department in resolving the debate over access policy is
explained.
Deregulation and the Entry of Thrift
Institutions into the Payments System

Accordingly, the resulting laws and regulations were
intentionally designed to limit competition. Restrictions on interest rates paid to depositors acted to
limit competition among all financial institutions,
while other rules limited the range of activities permitted for financial institutions. These rules placed
each institution into a distinct category (for example,
thrift institutions or commercial banks), and then
restricted the activities permitted for firms in each
category.
Within this scheme, making commercial loans and
accepting demand deposits were activities relegated
to commercial banks and prohibited to federally insured thrifts. The latter were to specialize in gathering consumer time deposits and extending mortgage
loans. To help them attract such deposits, Regulation Q gave thrifts a slight competitive advantage in
the form of somewhat higher interest rate ceilings
than those imposed on commercial banks.
Until the late 1960s, this regulatory structure appeared to work more or less as its architects had intended. Most thrifts were able to operate profitably
by borrowing money at relatively low, short-term interest rates while acquiring mortgage loans which
paid higher, long-term rates. Because of interest rate
regulation, the increased fluctuations in interest rates
that began in the late 1960s resulted in severe disintermediation in the thrift industry. This disintermediation created funding problems for the industry
as a whole. As a result, many thrifts became interested in diversifying their operations into new
areas with the hope of restoring profitability.
Congress did not begin to deal with these issues
comprehensively until the passage of the Depository
Institutions Deregulation and Monetary Control Act
of 1980 (DIDMCA) and the Garn-St.Germain Act
of 1982. However, the events of the decade preceding the enactment of these measures conspired to
bring about a process of piecemeal deregulation
driven by underlying market forces.2 To help its
members attract deposits and thereby mitigate the
2

The U. S. financial regulatory structure that
emerged from the Great Depression was designed to
prevent a recurrence of the financial chaos experienced in that episode. The prevailing view then was
that excessive competition among financial institutions contributed to instability in financial markets.
24

Detailed accounts of the events of this period and the
debate that accompanied the financial industry deregulation are available in Thomas F. Huertas, “The Regulation
of Financial Institutions: A Historical Perspective on
Current Issues,” in George J. Benston, ed., F i n a n c i a l
Services: The Changing Institutions and Government
Policy (Prentice-Hall, 1983), chap. 1, and also in Almarin
Phillips and Donald P. Jacobs, “Reflections on the Hunt
Commission,” ibid., chap. 9.

ECONOMIC REVIEW, JULY/AUGUST 1985

effects of disintermediation, the Federal Home
Loan Bank Board (FHLBB) authorized federallychartered savings and loans to permit preauthorized,
nonnegotiable third-party transfers from consumers’
savings accounts for household-related expenses in
1970. These rules were further liberalized in 1975 to
permit such transfers for any purpose.
The New England states acted more aggressively
to help their state-chartered thrifts attract deposits.
In 1972, state-chartered mutual savings banks in
Massachusetts and New Hampshire were permitted
to begin offering NOW accounts. These deposits
were, for all practical purposes, interest-bearing
checking accounts. In response, Congress granted all
depository institutions in these two states similar authority in 1974. This authority was later extended
to depository institutions in all the New England
states in 1976.3 Thrifts and other financial institutions nationwide were not permitted to offer interestbearing checkable deposits until 1980, when the
DIDMCA was passed.
To make use of these new powers, thrifts needed
increased access to the nation’s payments system. In
New England, the Federal Reserve agreed to process
and clear NOW account drafts for thrifts on terms
similar to those extended to nonmember commercial
banks. On a national level, the thrift industry became interested in acquiring access to the newly developing system of automated clearinghouses. The
eventual resolution of this issue provides an interesting case study in antitrust law. Understanding the issues that were debated, however, requires some
knowledge of the unique aspects of the automated
clearinghouse system’s organizational structure.
The Organization of Automated
Clearinghouses
An automated clearinghouse, or ACH, is a computerized facility that performs basically the same
functions as an ordinary clearinghouse. Rather than
processing and sorting paper checks, however, an
automated clearinghouse processes payments information stored on magnetic tapes and transmitted
over a telecommunications network.

Automated clearinghouses in the United States
were developed through the cooperative efforts of
commercial banks and the Federal Reserve System.
These efforts began in 1968, when the Special Committee on Paperless Entries (SCOPE) was created
by a group of California banks to study alternative
means of reducing the volume of paper checks processed by banks. That same year the American
Bankers Association (ABA) created the Monetary
and Payments System (MAPS) Planning Committee, which subsequently recommended the formation of a national system of automated clearinghouses.
With some assistance from the Federal Reserve,
SCOPE completed the development of a computer
software package and a set of operating rules in
1972. The California Automated Clearinghouse Association (CACHA) was formed that same year and
was the first automated clearinghouse in the United
States. In response to a formal request from
CACHA, the Federal Reserve Bank of San Francisco agreed to provide the necessary clearing and
settlement facilities and assumed responsibility for
operating the automated clearinghouse. These services were made available at no explicit charge to all
banks that were members of CACHA.
Over the next several years, the number of regional ACHs grew rapidly. In virtually every case,
Federal Reserve Banks assumed responsibility for
operating these facilities. The first privately operated ACH was not formed until December 1975,
when the New York ACH (NYACH) began operation. Today there are over 30 separate ACH associations in operation in the United States; most
continue to be operated by the Federal Reserve.4 The
regional automated clearinghouses are linked together by a nationwide telecommunications network,
also operated by the Federal Reserve.5

4

Norman Penny and Donald I. Baker, The Law of Electronic Funds Transfer, (Boston: Warren, Gorham, and
Lamont, Inc., 1980). Chapter 3 contains a history of the
development of automated clearinghouses in the United
States.
5

3

Alfred Broaddus, “Automatic Transfers from Savings
to Checking: Perspective and Prospects.” Federal Reserve Bank-of Richmond, Economic Review 64 (November/December 1978) : 3-13, contains a detailed chronology
of innovations in third-party payment services during this
period.

This nationwide ACH network was completed in 1978.
As with the regional automated clearinghouses, the nationwide network was organized through the joint efforts
of the banking industry and the Federal Reserve. Further
details may be found in Board of Governors of the
Federal Reserve System, “Nationwide EFT Network,”
Federal Reserve Bulletin 64 (October 1978): 823-24.

FEDERAL RESERVE BANK OF RICHMOND

25

Although Federal Reserve Banks assumed responsibility for managing the routine operations of
most of the newly organized automated clearinghouses, the ACH associations themselves were governed by rules adopted by their member institutions.
Association rules not only governed routine operations, but also dealt with the more fundamental questions concerning organizational structure such as the
terms of membership and conditions imposed on
access to services. These rules permitted all commercial banks (including banks that were not members of the Federal Reserve System) access on equal
terms. Banks that were not members of the Federal
Reserve System were required to maintain accounts
with member banks for purposes of settlement, however, since nonmember institutions did not keep
reserves with Reserve Banks.
When the development of an electronic alternative to the existing system of clearing paper checks
was initiated in 1968, the question of whether thrifts
should participate in such a system was not an issue
since most thrifts could not then offer deposits with
third-party payment powers. This had changed by
the time CACHA began to operate in 1972, however,
because of the FHLBB’s 1970 rule and the advent of
NOW accounts in New England.
The California Savings and Loan League approached CACHA in the summer of 1972 to inquire
about the possibility of participation in the newly
formed ACH. Subsequently, several savings and loan
associations applied for membership in CACHA.
At first, thrifts expressed an interest only in receiving ACH credits (such as automatic payroll deposits) and debits originated by others. After some
negotiation, CACHA offered to permit thrifts to
establish “pass-through” accounts with banks that
were members of the ACH. Membership in the
ACH on the same terms as commercial banks, however, was denied. This meant that thrifts wishing to
originate ACH transactions were required to deal
with a correspondent bank, which would initiate
transactions on their behalf. This proposal was consistent with the ABA’s recommended access policy.

requests for access to its check-clearing system by
New England thrifts. In the latter case, thrifts
were permitted to establish pass-through clearing accounts (amounting to three percent of their NOW
account deposits) with a Federal Reserve member
bank, which would then clear checks and NOW account drafts through the Federal Reserve Bank of
Boston on their behalf. This policy gave New England thrifts access to check-clearing services on the
same terms as those extended to nonmember banks.6
In contrast, the ABA’s policy treated all commercial banks alike, while imposing different conditions on thrifts. In retrospect, this difference in the
two policies was a crucial one. Apparently thrifts
were willing to accept a pass-through access policy
when that same policy was uniformly imposed on
nonmember banks. In the case of automated clearinghouses, thrifts claimed that the banking industry’s
discriminatory access policy put them at a competitive disadvantage.
To the banking industry the issue of ACH access
was intimately tied to the broader issues of thrift industry deregulation and, more generally, to regulatory reform of the financial services industry. The
rationale for the existing regulatory structure, which
treated thrifts more leniently in several important
respects, was based on the premise that thrift institutions were not permitted to compete in certain traditional banking markets. Bankers viewed the thrift
industry’s attempts to gain direct access to ACH services as an attempt to circumvent the legal restrictions that prohibited thrifts from offering demand
deposits. In addition, they argued that their industry
had borne the cost of developing the ACH system,
and that the thrift industry was attempting to gain
a “free ride” as a result of these efforts.’
The ABA did not completely rule out equal access to the ACH system. However, it demanded
equal regulatory treatment of thrifts, including the
imposition of more stringent reserve requirements
(such as those imposed on banks) and the abolition
of the more favorable interest rate ceilings enjoyed
by thrifts under Regulation Q, as the price of such
access. Direct access to ACH facilities for thrifts

Banking Industry Policy on ACH Access
The ABA’s proposed policy on ACH access for
thrifts was similar to the “pass-through” policy
adopted by the Federal Reserve in response to earlier
26

6

See Penny and Baker, The Law of Electronic Funds
Transfer at 19-7.
7

Penny and Baker at 19-26.

ECONOMIC REVIEW, JULY/AUGUST 1985

(or any clearing facilities for that matter) was opposed “. . . unless authorized through legislative restructuring of the nation’s financial system and
equalization of regulatory and reserve obligations
have been achieved.“8
Federal Reserve Policy on ACH Access
The Federal Reserve became involved in the debate over ACH access because of the major role it
had assumed in the operation of that system. Thrifts,
unable to secure access on the terms they desired
from the ACH associations, appealed to both the
Federal Reserve and Congress to grant them direct
access to these systems. Initially the Federal Reserve supported the banking industry’s proposed access policy, citing essentially the same concerns as
those expressed by the bankers. Congress took no
formal action during the early stages of the debate,
but appeared to agree with the Federal Reserve’s
position.
Like the banking industry, the Federal Reserve
viewed ACH transactions as a substitute for paper
checks. By law, banks were prohibited from paying
explicit interest on demand deposits.
The B o a r d
expressed concern that permitting thrifts direct access to the ACH system, including the authority to
directly originate ACH transactions, could undermine legal restrictions prohibiting the payment of interest on demand deposits. It therefore argued that
only those institutions explicitly authorized by Congress to offer demand deposits should be permitted
direct access to the ACH system. Representative
Ferdinand St. Germain of the House Banking Committee appears to have shared this view.9
In 1973, commercial banks had not yet received
authority to originate preauthorized, third-party
payments from customers’ savings accounts such as
that granted earlier to federally-chartered savings
and loans. This meant that customers of commercial

banks were required to originate ACH payments
from non-interest-bearing checking accounts. A customer of a federally-chartered thrift, however, could
originate such payments directly from a savings account. The ban on direct access did not prohibit
thrifts from offering this service to their customers,
but the banking industry apparently felt that permitting thrifts direct access under existing regulations
would give them a greater competitive advantage in
this area. The Federal Reserve Board, facing an
acute membership problem and therefore aware of
member banks’ perceptions of unequal and unfair
regulation, viewed thrifts’ newly acquired third-party
payments powers as a breach in existing regulations,
and did not wish to ratify the existence of this “loophole” by helping the thrift industry gain direct access
to ACH services. In the end, however, competitive
pressures led to the extension of similar authority to
commercial banks, while thrifts gained even greater
powers. 1 0
As a long-run solution to the problem of thrift access, the Federal Reserve proposed reforms that
would place thrifts on a more equal competitive footing with commercial banks. As part of these reforms, legislation that would permit thrifts to join
the Federal Reserve System was proposed. Under
this plan, thrifts that joined the Federal Reserve
would be granted direct access to all the System’s
payments services. Thrifts that became members
would also be required to bear all the costs of membership, however, such as meeting the same reserve
requirements imposed on member banks. Until such
legislation was enacted, the access policy proposed
by the banking industry was viewed as an adequate
short-term solution. The following statement by
Governor George M. Mitchell of the Federal Reserve
Board summarizes the Board’s policy:
If Congress said, we want all the institutions to be
part of the money system, then there wouldn’t be
any question about it. You know what the arguments are for making them more like banks, giving
them the same reserve requirements and giving
them the same interest rate ceiling arrangementsthat is essentially what we are talking about.1 1

8

“Fed Urged to Move Cautiously on EFTS; Many See
Dangers to Private Competition,” American Banker,
April 9, 1974. This article also summarizes the comments
of a great many other interested parties, including thrift
industry groups, on the issues of pricing and access to the
automated clearinghouse network. The views expressed
by CACHA on this issue mirrored those of the ABA.
9

See comments of Rep. Ferdinand St. Germain, in Electronic Funds Transfer System (EFTS)/Failure of the
U. S. National Bank of San Diego, Hearings before the
Subcommittee on Bank Supervision and Insurance of the
House Committee on Banking and Currency, 93 Cong. 1
Sess. (GPO, 1974), p. 26.

10

Commercial banks were first permitted to make preauthorized, nonnegotiable third-party transfers from customers’ savings accounts in September of 1975, five
months after the FHLBB further liberalized similar
third-party transfer powers for federally-chartered
savings and loans. Once again, see Broaddus, “Automated Transfers from Savings to Checking.”
11

Electronic Funds Transfer System, Hearings, p. 30.

FEDERAL RESERVE BANK OF RICHMOND

27

The Federal Reserve’s expanded membership proposals were also intended to provide a means of recovering the added costs of servicing thrifts under a
policy of direct access. Giving thrifts access on the
same terms as banks would require the Federal Reserve to bear the cost of servicing additional end
points on its ACH system. Setting explicit fees for
ACH services offered a means of recovering the
added cost of servicing thrifts directly, but the thrift
industry argued that any fees should be imposed uniformly on all institutions receiving ACH services.
The increasing seriousness of the Federal Reserve’s
membership problem made the Board reluctant to
charge its member banks for payments services.
It was widely acknowledged that the Federal Reserve’s membership problem was due to the cost of
the non-interest-bearing reserves member banks were
required to hold. In contrast, nonmember banks and
thrifts faced less stringent reserve requirements
which could often be satisfied by holding certain
interest-bearing bonds (most commonly, state or federal government bonds). Since the Federal Reserve
was effectively prohibited from paying explicit interest on reserves, it offered payments services to its
members at no explicit charge as a means of paying
implicit interest. As inflation and interest rates rose
throughout this period, however, the cost to banks
of maintaining required reserves rose and banks
began to withdraw from the System at an increasing
r a t e .1 2
From the Federal Reserve’s perspective, imposing
explicit fees for payments services would amount to
double-charging its members for services already
paid for by holding required reserves. In addition to
12

During this period, the Federal Reserve repeatedly
expressed concerns that the continuing withdrawal of its
members would make it more difficult to conduct monetary policy. One notable concern in this respect was that
diminished access to the Federal Reserve’s discount
window (which was then largely limited to member
banks) might hamper the Fed’s ability to deal effectively
with a financial crisis. See, for example, “Statement by
William E. Miller, Chairman, Board of Governors of the
Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, House of Representatives, July 27, 1978,” Federal Reserve Bulletin 6 4
(August 1978): 636-42. Other writers have stressed the
potential loss of revenues earned from the non-interestbearing reserves member banks were required to hold as
the primary reason for concern over the membership
problem. This latter view is adopted by Marvin Goodfriend and Monica Hargraves, “A Historical Assessment
of the Rationales and Functions of Reserve Requirements,” Federal Reserve Bank of Richmond, Economic
Review 69 (March/April 1983): 3-21.

28

being viewed as being unfair, it was feared that the
adoption of such a pricing policy would further exacerbate the System’s membership problem.1 3
Thrift industry groups, on the other hand, opposed
the Federal Reserve’s proposals for regulatory reform and expanded membership. Instead, these
groups put forward proposals to impose equal access
charges on both thrifts and commercial banks while
opposing any reforms that would extend the same
regulatory treatment faced by commercial banks to
their own industry. 1 4
To summarize, then, the Federal Reserve Board
supported the banking industry’s pass-through access
proposals for thrifts until such time as those institutions received explicit authority from Congress to
offer transactions accounts to the public. Any
explicit extension of such authority to thrifts was
expected to be accompanied by other regulatory reforms that would place thrifts and commercial banks
on a more equal competitive footing. Additionally,
the Federal Reserve proposed that thrifts be permitted to obtain membership in the System as a
means of gaining direct access to its clearing network. The thrift industry, however, was more interested in gaining direct access to the ACH system
than in regulatory reform, and vigorously opposed
these proposals. Instead, industry representatives
argued that thrifts should be granted immediate access on the same terms as commercial banks without’
regard to the resolution of the regulatory issues that
concerned both the banking industry and the Federal
Reserve. The thrift industry subsequently received
aid from the Antitrust Division of the U.S. Justice
Department in arguing its case.
Access Policy and Antitrust Law
The Justice Department’s Antitrust Division sided
with the thrift industry in the debate over the issues
of access and pricing, arguing that any access policy
that treated thrifts differently from banks violated
existing antitrust laws. This argument was based
on an established Access Principle, which the Justice
Department explained as follows :
13

See Statement of George W. Mitchell, Member of the
Board of Governors of the Federal Reserve System,
Electronic Funds Transfer System. Hearings, pp. l-11.
14

For a summary of the thrift industry’s comments on
the Federal Reserve Board’s proposals see “Fed Urged
to Move Cautiously on EFTS . . .”

ECONOMIC REVIEW, JULY/AUGUST 1985

does not justify a denial of equal access to an automated clearing facility; thus, in a recent antitrust
case, the courts applied the bottleneck principle to
the transmission system of an investor-owned electric company, despite the fact that the “competitors” gaining access were municipally owned electric systems who enjoyed various tax and other advantages. This decision was affirmed by the Supreme Court in February 1973.1 7

Antitrust law requires that those who control an
essential facility must grant access to it on reasonable and non-discriminatory terms to all competi-

tors.1 5

In the context of antitrust law, an “essential” facility is one that provides a significant competitive
advantage to any market participants that have direct
access to that facility. No alternatives to the Federal
Reserve’s ACH system existed at that time. Moreover, it was argued that because the Federal Reserve
did not charge explicit fees for these services, no
competing private sector alternative was likely to develop. 16 The Justice Department’s view, therefore,
was that the ACH system operated by the Federal
Reserve was essential for purposes of antitrust law.
On these grounds, it was argued that thrift institutions should be permitted direct access to ACH services on equal terms with commercial banks. Like
thrift industry groups, the Justice Department favored the adoption of a system of nondiscriminatory
fees for these services.
The Justice Department’s position was apparently
based on the premise that thrifts should be permitted
to compete directly with commercial banks on equal
terms. As has already been noted, however, the regulatory structure existing at that time intentionally
discriminated between different types of financial institutions expressly to inhibit such competition. The
Justice Department was aware of the fact that thrifts
might enjoy certain competitive advantages as a result of these regulations, but argued that the existence of such advantages did not constitute sufficient
grounds under antitrust law to deny thrifts direct
access to an essential facility:
On the other hand, the fact that thrift institutions
may enjoy other regulatory or legal advantages
15

Comments of the United States Department of Justice:
Proposed Amendment of Regulation J and Related
Issues (May 14, 1974).
16

Earlier, the Federal Home Loan Bank of San Francisco had proposed to establish a separate ACH system
for savings and loans. Both the Federal Reserve and the
Justice Department objected to this proposal. T h e
Federal Reserve’s opposition stemmed from its view that
there should be a single nationwide EFT network, operated by the Federal Reserve. See “Mitchell Would Bar
S&L Access to EFTS, Except Through Commercial
American Banker, November 27, 1973. The
Justice Department favored leaving the market for EFTS
services to private sector competitors and so opposed any
entry from government agencies. A letter from Thomas
E. Kauper, Assistant Attorney General, Antitrust Division, to Garth Marston, Acting Chairman, Federal Home
Loan Bank Board, 1975 explained the Justice Department’s opposition to the proposed FHLB System.

The Resolution of the Access Policy Issue
The controversy over ACH access policy was finally resolved by a pair of antitrust suits brought
against the California and Rocky Mountain ACHs
by the Justice Department in 1977. A more liberal
access policy was instituted before then, however.
The Federal Reserve had adopted a policy that encouraged the admission of thrifts into the ACH associations it serviced a year earlier (although none of
these associations had adopted such a policy), and
had also instituted the direct delivery of ACH items
to thrifts.18 In a related development, NYACH permitted full membership and access for thrifts from
the time it was first organized in 1975.
In January of 1976, the Federal Reserve Board
modified its access guidelines to accommodate thrifts
that might become members of ACH associations
that it serviced. The new guidelines stated that
ACH deposits delivered to the Federal Reserve
could “. . . originate from any account having thirdparty payment powers, e.g., savings, NOW, share
draft accounts.“1 9 In contrast, earlier access guidelines had restricted authority to directly originate
17

Donald I. Baker, “Antitrust and Automated Banking,”
The Banking Law Journal 90 (September 1973): 703-18.
Mr. Baker was Deputy Assistant Attorney General and
Director of Policy Planning for the Antitrust Division
when this article was prepared. He also participated in
preparation of the Justice Department’s comments to the
Federal Reserve on the issue of access policy.
18

The direct delivery of ACH items to thrifts was instituted in 1975 as part of the Federal Reserve’s “interim
access guidelines.” Under these guidelines, thrifts that
received a sufficient number of ACH items and that were
located along existing check courier routes could receive
ACH items directly from the Federal Reserve. In addition, thrifts were-given permission to pick up items
directly from local Federal Reserve processing centers.
See Board of Governors of the Federal Reserve System,
“Access to Federal Reserve Clearing and Settlement
Proposed Policy,” Federal Register 4 0
Facilities:
(June 17, 1975): 25,641, and also Board of Governors of
the Federal Reserve System, “Interim Guidelines for
Direct Deposit of Federal Payments,” Federal Reserve
Bulletin 62 (January 1976): 66-67.
19

See Board of Governors of the Federal Reserve
System, “Collection of Checks and Other Items by
Federal Reserve Banks,” Federal Register 41 (January 21, 1976): 3,097-105.

FEDERAL RESERVE BANK OF RICHMOND

29

ACH transactions to banks and other institutions
“. . . legislatively authorized to maintain demand
deposit accounts.“20 In addition, language included
in the later guidelines appeared to encourage ACH
associations to adopt more liberal membership
policies.2 1
The ABA resisted attempts to liberalize ACH access policy, arguing, as before, that ACH associations should be permitted to determine access policy
for themselves and that only institutions legally authorized to offer demand deposits should be permitted to originate ACH transactions22 The right of access for thrift institutions was finally established
through two antitrust suits filed by the Justice Department in 1977. The first of these suits was
brought against the Rocky Mountain ACH. The
second was against the California ACH. Both of
these organizations obtained their services from the
Federal Reserve. In both cases the Justice Department argued that heavy Federal Reserve subsidies of
ACH services and the resulting absence of explicit
prices for these services effectively created local monopolies in this area. These subsidies, it was argued,
discouraged the emergence of a private sector competitor and so turned these ACHs into essential facilities. Therefore, the denial of direct access to
thrifts placed those institutions at a competitive disadvantage with respect to commercial banks in violation of established antitrust laws. The Justice Department won both suits, and soon thereafter all
ACH associations began to admit thrifts to membership. 23 These suits had no substantial effect on
Federal Reserve policies, however, since the access
20

Board of Governors of the Federal Reserve System,
“Access to the Federal Reserve Clearing and Settlement
Facilities.”

21

This is reflected in the following passage: “In providing clearing and settlement servic for ACH associations, the Board anticipates that these services will be
made reasonably available on a comparable basis to
depository institutions having need for such services.”
Board of Governors of the Federal Reserve System,
“Collection of Checks and Other Items by Federal Reserve Banks.”
22

Letter, Willis W. Alexander, Executive Vice President,
American Bankers Association to Theodore E. Allison,
Secretary of the Board of Governors of the Federal
Reserve System, March 19, 1976. This letter was published in Federal Reserve Services, Hearings before the
Senate Committee on Banking, Housing, and Urban
Affairs, 95 Cong. 1 Sess. (GPO, 1977), pp. 178-96.
23

A more detailed account of these suits is contained in
Penny and Baker, The Law of Electronic Fund Transfer

Systems at 19-25.

30

guidelines adopted the year before had made explicit
arrangements for eventual thrift membership in
ACH associations.
As a result of these suits, the Justice Department's
position on the issues of pricing and access greatly
influenced the provisions dealing with those issues
finally included in the Monetary Control Act. As
with many of the issues involving deregulation, the
enactment of legislation dealing with such issues
only served to ratify earlier developments in the
marketplace.
III. ISSUES RELATED TO FEDERAL RESERVE
PRICING POLICY

Debate over Federal Reserve pricing policy first
surfaced in the early 1970s as a result of two related
sets of issues. The first concerned the competitive
and antitrust implications of Federal Reserve pricing
policy. The second set of issues arose as a result of
the growing Federal Reserve membership problem
and congressional concern over the expected cost
of legislative proposals put forward to solve this
problem.
Concern over the effects of Federal Reserve pricing policy on market competition arose as a result of
its announcement of plans to develop and operate a
comprehensive nationwide electronic funds transfer
(EFT) network. Although Federal Reserve involvement in the development and operation of the
ACH system was actively encouraged by a large segment of the banking industry, it also resulted in debate over the appropriate role of the Federal Reserve in the nation’s payments system. The development of this new network was viewed by some as an
entry into new markets by the Federal Reserve.
Some bankers expressed concern that, unless the
Federal Reserve began to price its services explicitly,
private sector entry into these new markets would be
preempted. Separately, thrift industry complaints
regarding ACH access policy led to calls for the
adoption of a nondiscriminatory pricing system.
The membership problem experienced by the Federal Reserve during this period made the Board of
Governors hesitant to adopt such a policy, however.
In the end, Congress combined pricing policy reform
together with other measures designed to solve the
Federal Reserve’s membership problem in the final
version of the Monetary Control Act.

ECONOMIC REVIEW, JULY/AUGUST 1985

Pricing and Competition
Soon after the Federal Reserve System was established, Reserve Banks made facilities available for the
transfer of funds between member bank reserve accounts. Such transactions typically involved relatively large amounts and, like direct transactions between private correspondent banks, initially utilized
either Western Union or Postal Telegraph facilities.
In 1918, the Federal Reserve established its own
Morse code system to provide for a more rapid and
secure transfer of funds between banks. Since then,
the system has been gradually updated. Fedwire, as
it came to be called, became the primary facility for
the transfer of funds in the federal funds market. In
addition, commercial banks developed a number of
private funds transfer networks that offered similar
services. 2 4
The Federal Reserve Act had authorized the Board
to regulate transfers of funds among Reserve banks
and to receive deposits from member banks. The
Board interpreted this authority as providing the
statutory basis for the operation of its own wire
funds transfer network.25 In 1972, soon after MAPS
committee recommended the formation of a nationwide ACH network, the Federal Reserve announced
its own plans to develop and operate an integrated nationwide EFT network.26 The scope of this planned
network was broader than that of the network then
operated by the Federal Reserve in that it would provide facilities to process and transfer recurring ACHtype transactions in addition to the large-dollar types
of transfers the Fed had offered throughout its history. There was also some discussion of using the
Federal Reserve network for supporting a retail nationwide point-of-sale (POS) network.
There was a good deal of disagreement within the
banking industry on the need for the Federal Reserve
to expand its operations in the area of electronic payments systems. Many of the larger money center
24

A description of Fedwire and other privately
funds transfer networks is presented in David
“Daylight Overdrafts and Payments System
Federal Reserve Bank of Richmond, E c o n o m i c
71 (May/June 1985): 14-27.

operated
Mengle,
Risks,”
Review

banks, which were also major correspondent banks,
voiced concerns that the Federal Reserve’s development of a nationwide EFT network could preempt all
such private sector initiatives. The position finally
adopted by the ABA appears to have been designed
as a compromise between those bankers who favored
the planned expansion of the Federal Reserve’s EFT
network and others interested in expanding their
own profit-making operations. That compromise endorsed the Fed’s involvement in the ACH system,
but also advocated the adoption of “. . . a pricing system on a basis fully reflecting the costs which would
be incurred by a private sector effort . . .“27 for any
new services it offered. This proposal was intended
to protect private-sector incentives to offer competing
services.
In addition to industry groups, the Justice Department also favored the adoption of a system of competitively-set prices for EFT services offered by the
Fed. The Antitrust Division’s comments to the Federal Reserve cited two principal reasons favoring the
adoption of such a pricing system. The first of these
reasons was connected with the issue of access policy.
Here, it was noted that antitrust law required the
adoption of a nondiscriminatory pricing system for
essential services provided to competing firms on the
grounds that: “A discriminatory pricing system can
be as substantial a bar to competition as exclusionary
ru1es.“ 28 Additionally, the Justice Department also
expressed many of the same competitive concerns
voiced by financial industry groups; that is, that private sector development of such systems might be
discouraged if the Federal Reserve continued to offer these services at no explicit charge. To ensure
against such an outcome, the Federal Reserve was
urged to price its EFT services on the basis of fully
allocated costs and ‘. . . including an appropriate
allowance for capital costs.“29 It was argued further
that such pricing concerns were tied to the issue of
access because the presence of competing suppliers
would lessen the likelihood that any one such supplier’s services could become “essential.”

27

See “Fed Urged to Move Cautiously on EFTS . . .”

25

See “Federal Reserve Operations in Payment Mechanisms: A Summary,” Federal Reserve Bulletin 62 (June
1976) : 481-89.

26

“Evolution of the Payments Mechanism,” F e d e r a l
Reserve Bulletin 58 (December 1972) : 1009-12.

28

Comments of the United States Department of Justice,
Proposed Amendment of Regulation J and Related
Issues, p. 27.
29

Ibid., p. 28.

FEDERAL RESERVE BANK OF RICHMOND

31

Pricing Policy and the Membership Problem
In response to these events the Federal Reserve
Board announced its intent to establish a price schedule for its check-clearing and ACH services in January 1976, together with its liberalized access proposals. However, the Board continued to be concerned about the impact the adoption of such a pricing system might have on its worsening membership
problem and so was careful to explain that: “In developing the pricing schedule, consideration would be
given to the burden of required reserves maintained
by member banks.“30 No timetable for the implementation of this pricing system was given, and in
the end such a pricing system was adopted only after
passage of the Monetary Control Act and the resolution of the membership problem.
Serious consideration of the pricing issue emerged
in Congress in 1977 as part of the debate over legislation intended to alleviate the Federal Reserve’s
membership problem. Congressional attention initially centered on the costs of providing these services and the resulting loss of revenue to the Treasury, however, rather than the competitive and antitrust problems that concerned industry groups.
Legislation on Pricing
The Federal Reserve had long proposed the institution of universal reserve requirements as a
means of solving its membership problem. However,
such measures proved to be very unpopular among
nonmember institutions who lobbied vigorously
against them. As a result, legislation granting the
Federal Reserve the authority to pay explicit interest
on member bank reserves came under consideration.
Provisions extending such authority were included
in Senate bill S.1664, which was submitted by the
Carter administration in the spring of 1977. It contained two main provisions. First, it permitted all
depository institutions nationwide to offer NOW
accounts to consumers and imposed uniform reserve
requirements on those accounts. Second, the bill
granted the Federal Reserve permission to begin
paying interest on reserves. The bill also contained
language explicitly authorizing the Federal Reserve
to provide payments services to all depository institutions that offered NOW accounts.
Senate bill S.1664 was never enacted, largely because of the anticipated cost of the interest payments
it would have permitted. These concerns were noted
30

Board of Governors, “Collection of Checks and Other
Items by Federal Reserve Banks,” p. 3,098.

32

by Senator Proxmire in the course of the hearings
held to consider the bill:
Frankly, I am troubled about. the proposal to permit the Federal Reserve to pay up to $600 million
a year to the Nation’s larger banks in the form of
interest on reserve balances . . . . Moreover, the
legislation fails to direct the Fed to begin charging
for the services currently valued at $300 million,
which it provides free of charge to member banks.3 1

It was widely understood that the services the
Federal Reserve supplied to its member banks served
as a means of paying implicit interest on required
reserves. Both the Treasury and Congress therefore
appeared to expect that the extension of this authority
would be accompanied by the institution of a pricing
system by the Federal Reserve.3 2 However, the
Board was hesitant to commit itself to an exact date
for the release of a proposed fee schedule or to set a
specific timetable for the enactment of a general
pricing policy before final action was taken to resolve
the membership problem.3 3
In addition to dealing with the Federal Reserve’s
membership problem, the Justice Department’s antitrust suits, which were successfully concluded at
about the same time, put pressure on Congress to act
on the problem of access policy. Members of Congress were very aware that over half the Federal
Reserve’s operating budget was devoted to the provision of payments services, and the prospect of
further requests for these services by nonmember
institutions promised to place further demands on
that budget. Soon after the hearings on S.1664 were
held, Senator Proxmire organized a separate set of
oversight hearings to review the role of the Federal
Reserve in the payments system and the issue of
pricing those services.3 4
In the course of these hearings, many representatives of the banking industry were asked for their
views on pricing and the appropriate role of the
31

Opening Statement of Senator Proxmire, in N O W
Accounts, Federal Reserve Membership and Related
Issues, Hearings before the Subcommittee on Financial
Institutions of the Senate Committee on Banking,
Housing, and Urban Affairs, 95 Cong., 1 Sess. (GPO,
1977), p. 3.
32

See, for example, Statement of W. Michael Blumenthal, Secretary of the Treasury, in N O W A c c o u n t s ,
Federal Reserve Membership and Related Issues, p p .
33

See, for example, Statement of Arthur F. Burns, Chairman of the Board of Governors of the Federal Reserve
System, in NOW Accounts, Federal Reserve Membership and Related Issues, pp. 26-59, especially p. 58.
34

Federal Reserve Services, Hearings Before the Senate
Committee on Banking, Housing, and Urban Affairs.

ECONOMIC REVIEW, JULY/AUGUST 1985

Federal Reserve in the payments system. Representatives of major correspondent banks and other
potential competitors favored a greatly reduced operational presence for the Federal Reserve. Others
who testified, however, including representatives
from a number of smaller banks as well as thrift
industry and credit union groups, supported the
maintenance of the Federal Reserve’s broad operational role in the payments system. While there
appeared to be no consensus on the exact services
the Federal Reserve should be permitted to offer,
there was universal agreement among market participants on the subject of pricing. It was widely acknowledged that private sector incentives to offer
competing services should be protected and that this
was best done by having the Federal Reserve adopt a
pricing policy that would foster such competition.
Pricing was also favored as a means of promoting
economic efficiency in the provision of payments
services. In the absence of pricing, financial institutions that received Federal Reserve services had little
incentive to conserve their use of such services or to
encourage the use of the potentially more efficient
emerging EFT services as a substitute for paper
checks. However, while these latter economic arguments were recognized and discussed briefly during
the oversight hearings, it was clear that the other
related issues, those concerning the ultimate cost to
the Treasury of the Fed’s payments operations and
the problem of fostering private-sector competition,
dominated congressional attention. All future legislative proposals dealing with the Federal Reserve’s
membership problem would also address the issues
of pricing and competition.
A year later, in May of 1978, Representative
Stanton of Ohio introduced another bill, H.R. 12706,
to permit the Federal Reserve to pay interest on
reserves. The Stanton bill differed from earlier legislative proposals in that it also contained language
explicitly requiring the Federal Reserve to set prices
for all its payments services:
. . . established on the basis of all direct and in-

direct costs actually incurred in providing the
services priced, including overhead, and an allocation of imputed costs that take into account the
taxes that would have been paid and the return on
capital that would have been provided had the
payment services been furnished by a private business firm.35

The bill explicitly authorized the Federal Reserve to
continue offering its existing line of payments services and also permitted it to offer new payments
services, “. . . including but not limited to payment
services that effectuate the wire transfer of funds.“3 6
Any new services offered by the Federal Reserve
were also required to be explicitly priced according to
the requirements set forth in the act. The bill also
addressed the access policy issue. Provisions contained in that legislative proposal required the Federal Reserve to make its payments services available
to all depository institutions on the same terms.3 7
Separately, an amendment proposed by Representative Reuss (then Chairman of the House Banking
Committee) would have limited the gross amount
of interest the Federal Reserve would be permitted
to pay out to the total of the profits it earned from its
payments services plus any profits earned on loans
made through the discount window.3 8 H.R. 12706
was not passed.
In the end, the House Banking Committee reported
out a new bill, H.R. 14072, that dropped provisions
authorizing the payment of interest on reserves and
instead imposed universal reserve requirements on
all commercial banks. The pricing provisions of the
Stanton bill were carried over substantially intact,
but included a number of new provisions giving the
Federal Reserve somewhat more flexibility in setting
its prices. As before, the Federal Reserve would be
required to set its prices sufficient to recover all its
costs, including an allowance for costs that would
be incurred by a private sector competitor, but new
language permitted these costs to be recovered “over
the long run.“3 9 Additional changes permitted the
Federal Reserve to depart from these strict cost
36

Ibid.

37

Of course, legal provisions such as this one, which require the adoption of nondiscriminatory access and pricing policies, do not necessarily require that all purchasers
be charged the same price under all conditions. Price
discrimination arises when price differentials charged to
different purchasers are unrelated to underlying differences in the cost of supply. Thus, the Federal Reserve
can charge institutions that are more costly to service
(because they are remotely situated, for example) a higher price than it charges other institutions without violating the requirements of the Monetary Control Act. For
a more detailed discussion of price discrimination, see
F. M. Scherer, Industrial Market Structure and Economic Performance 2nd ed. (Houghton Mifflin Company,
1980), chap. 21.
38

35

Federal Reserve Membership Act of 1978, H.R.12706,
in Monetary Control and the Membership Problem,
Hearings before the House Committee on Banking, Finance and Urban Affairs, 95 Cong. 2 Sess. (GPO, 1978),
pp. 13-17.

See Opening Statement of Chairman Henry S. Reuss,
House Committee on Banking, Finance and Urban Affairs, Monetary Control and the Membership Problem,
Hearings, pp. 34-53.
39

Federal Reserve Act Amendments of 1978, H.R. 14072,
ibid, pp. 509-22.

FEDERAL RESERVE BANK OF RICHMOND

33

recovery requirements when it was deemed to be in
the public interest to do so.
This same language was later included in H.R. 7,
The Monetary Control Act of 1979, which passed in
the House of Representatives the following year.
After a joint committee meeting, this bill was combined with a bill passed in the Senate to form the
Depository Institutions Deregulation and Monetary
Control Act of 1980. The final version of the bill
contained only minor changes in the language dealing
with the pricing of Federal Reserve services.4 0

IV. SUMMARY AND CONCLUSIONS
The Monetary Control Act radically changed the
terms governing the Federal Reserve’s participation
in the operation of the nation’s payment system. This
change was brought about because of a number of
related developments arising in the decade before the
act was passed that caused Congress to reevaluate the
Federal Reserve’s role in the payments system.
First, the Federal Reserve’s involvement in the
development and operation of automated clearinghouses, while encouraged by a large segment of the
banking industry, also raised questions concerning
which services the Fed should provide for the banking
industry. A number of market participants, notably
the larger money center banks and private clearinghouses, viewed this action as an expansion by the
Federal Reserve into new markets. These latter
groups voiced concerns that a large-scale expansion
of Federal Reserve service offerings could preempt
private sector initiatives, and lobbied to have the
Fed’s activities in this area limited.
Separately, the deregulation of the thrift industry
that began in 1970 resulted in the request for direct
access to ACH services. Since ACH technology was
new, no real alternatives to the ACH network operated by the Federal Reserve were available. The
banking industry determined the conditions of access
to this network, however, and this group set the
enactment of legislation that would eliminate many of
the regulatory advantages then enjoyed by the thrift
industry as a condition of direct access. Since the
Federal Reserve had a major role in operating this
system, ACH access became tied to the broader issue
of Federal Reserve access policy.
40

See Raymond Natter, “Legislative Intent Regarding
Pricing of Services by the Federal Reserve Board,” in
Federal Reserve Competition with the Private Sector in
Check Clearing and Other Services, H.R. Rept. No. 98676, 98 Cong. 2 Sess. (GPO, 1984), pp. 81-91.

34

The Justice Department supported the thrift industry’s request for direct access, arguing that antitrust law required equal access be granted to all
competitors. In 1977, the Justice Department secured
access for thrifts by successfully arguing that direct
access to ACH services was “essential” for purposes
of antitrust law.
These developments posed problems that were not
anticipated when the Federal Reserve Act was originally enacted. Before thrifts began to offer thirdparty payments services commercial banks were the
only institutions requiring access to clearing facilities
such as those operated by the Federal Reserve, and
any bank desiring direct access to the Federal Reserve’s services always had the option of becoming a
member of the System. Membership in the Federal
Reserve, however, meant bearing the costs associated
with the System’s reserve requirements. The thrift
industry therefore opposed access conditioned on
some form of Federal Reserve membership. The
ruling subsequently obtained by the Justice Department granted thrifts access to ACH services without
imposing the costs of membership.
At this time the Federal Reserve was already experiencing an acute membership problem because of
the relatively stringent reserve requirements imposed
on its member banks. Since the Fed was effectively
prohibited from paying explicit interest on these
reserves, its payments services served as a means of
paying implicit interest. Therefore, the adoption of a
nondiscriminatory price schedule, as the Justice Department argued was necessary under antitrust law,
threatened to further exacerbate the Federal Reserve’s membership problem.
With these problems in mind, it is easy to understand why legislative provisions addressing the issues
of access and pricing were included as part of a larger
package of reforms intended to alleviate the Federal
Reserve’s membership problem. The Monetary
Control Act lowered reserve requirements for
member banks and extended these same reserve
requirements to all depository institutions offering
transactions accounts, thus eliminating the previous
discriminatory treatment of member banks. By itself,
lowering average reserve requirements for member
banks could be expected to result in a reduction of the
revenues the Federal Reserve earned on these noninterest-bearing reserves and subsequently paid to
the Treasury. Extending these new reserve requirements to nonmember depository institutions, however, mitigated this revenue loss. Nevertheless, on
net, the lower average reserve requirements autho-

ECONOMIC REVIEW, JULY/AUGUST 1985

rized by the act were expected to result in a net
revenue loss to the Treasury. 41 Revenues earned by
the Federal Reserve from the sale of its services were
expected to offset a portion of these other lost revenues. Moreover, the adoption of a nondiscriminatory
fee schedule permitted equal access to be granted to
all depository institutions interested in receiving
Federal Reserve services. (The act also granted
access to the Federal Reserve’s discount window to
all institutions maintaining transactions accounts.)
Finally, since this last provision would put the Federal Reserve in more direct competition with private
correspondent banks, it was required to set its prices
based on all direct and indirect costs, including an
allowance for a return to capital that a private sector
competitor would have earned in supplying s u c h
services.
Federal Reserve pricing has stimulated the growth
of private clearinghouses as well as giving correspondent banks a greater incentive to process more of
their own payments transactions. At the same time,
nonmember depository institutions gained direct access to the Federal Reserve’s clearing network. On

net, the increase in private sector competition has
resulted in the Federal Reserve losing some of its
market share in the area of check-clearing services,
although not in all other service lines.4 2 In this
sense, the Monetary Control Act has limited the
Federal Reserve’s role in the payments system.
In other ways, though, the act authorized an expansion of the Federal Reserve’s role. Although the
Fed must now compete more directly with private
sector suppliers, it is no longer limited in offering its
services to member banks. In addition, the Federal
Reserve is now authorized to offer any new payments
services, provided that the fees charged for such
services are sufficient to cover all costs, including
imputed private sector costs. The original Federal
Reserve Act was written long before the most recent
wave of technological innovation in the telecommunications industry. Those provisions authorized the
Federal Reserve to clear checks and to otherwise
effect the transfer of funds for member banks, but
the extent to which the Fed was authorized to offer
new services based on new technologies was unclear.
This issue was resolved by the Monetary Control
Act.

41

On the basis of bank deposits reported for the month
of December 1977, this net revenue loss was estimated at
$155.6 million per year. See Monetary Control Act of
1 9 7 9 , H.R. Rept. 830, 96 Cong. 1 Sess. (GPO, 1979),
pp. 5-6.

42

See David B. Humphrey, “Resource Use in Federal
Reserve Check and ACH Operations After Pricing,”
Journal of Bank Research 16 (Spring 1985): 45-53.

FEDERAL RESERVE BANK OF RICHMOND

35


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102