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EVOLUTION IN BANKING COMPETITION
Walter A. Varvel and Henry C. Wallich*

Innovations
in the financial sector are undermining
the line of commerce view by eliminating
unique
banking
services
and
reducing
interdependence
among banking products.
Developments
encouraging
the separate pricing and marketing
of banking services are further increasing the effective competition
between banks and other providers of financial services.
Recent legislation
extends
interest-bearing
transaction
account authority
nationwide
to thrift
institutions,
substantially
expands the scope of their
activities, and provides for the phase-out of deposit
interest rate ceilings.
In this environment,
a reevaluation of competitive analysis in banking is necessary to ensure that it reflects the realities of the
marketplace.

The Supreme Court view of commercial
banking
as a “distinct line of commerce”
no longer reflects
market realities
in many sections of the United
States. The argument used by the Court to support
its findings were not universally endorsed at the time.
Today-they have been sufficiently eroded by changing
competitive
conditions
and financial innovations
in
the markets for financial
services to require a reassessment of the competitive position of commercial
banks.
The “line of commerce” view remains an integral
part of the competitive analysis conducted by federal
banking agencies in connection
with proposed bank
mergers and acquisitions.
Supreme Court determinations of the appropriate
definitions of the product
line and geographic markets in banking directly influence the market structure variables that are used
by regulators
as indicators
of market competition.
Experience
over the last two decades has led regulators to the general view that, for competitive analysis purposes, banks can be considered
to compete
only with other banks.
Commercial banking has been treated as a separate
line of commerce because it was thought to offer a
unique package or “cluster” of independent
depository and credit services to bank customers.
This
treatment has the effect of excluding from definitions
of product markets firms that compete with banks in
some but not all service lines. For example, in their
role as financial intermediaries,
banks face competition for funds from other depository institutions
as
well as from a myriad of liability instruments
offered
in the money market.
Moreover, on the asset side
of the balance sheet, bank credit is offered in competition with thrift institutions,
nonbank firms such as
finance and insurance
companies,
and retailers,
as
well as the markets for securities and commercial
paper.
Exclusion
of this competition
may at times
result in overstatements
of anticipated
anticompetitive results from bank consolidations,
* Henry C. Wallich
nors of the Federal

is a member of the Board
Reserve System.

The Supreme
Court Position:
Product
and Geographic
Markets
The Supreme
Court, in ruling
that commercial
banking
is the relevant
“line of
commerce” in bank merger cases,’ relied upon the
following arguments:
(1) some bank products and
services are so distinctive
that they are essentially
free of effective competition
from other financial institutions;
(2) other bank products
and services
enjoy cost advantages that insulate them from competition from substitutes offered by other institutions;
(3) banking
facilities
enjoy a “settled consumer
preference”
that gives them an advantage over similar nonbank services; and (4) the “cluster” of products and services termed commercial
banking
has
economic significance well beyond the various products and services involved.
In the Philadelphia
National Bank case, the Court
declared that banks offer a cluster of products (various kinds of credit) and services (such as checking
accounts and trust services) that are “so distinctive
that they are entirely free of effective competition
from products or services of other financial institutions.”
In the Court view, banks played a vital and
unique role in the national economy since they alone
were permitted
to accept demand deposits.
This

of Gover-

Note:
“Evolution in Banking Competition”
by Henry C.
Wallich and Walter A. Varvel is reprinted from The
Bankers Magazine, 163 (November-December
1980)

26-34.
FEDERAL

RESERVE

1 See the following
Supreme
Court decisions:
United
States
v. Philadelphia
National
Bank, 374 U.S. 321
(1963); United
States v. Phillipsburg
National
Bank,
399 U.S. 350 (1970); and United States v. Connecticut
National Bank, 418 U.S. 656 (1974).
BANK

OF RICHMOND

3

distinctive
power made banks the intermediaries
in
most financial transactions.
As chief repositories
for
consumer
and commercial
liquid balance’s; banks
facilitate the efficient transfer of funds from units
with surplus funds (creditors)
to deficit units (borrowers).
Our fractional reserve system, ‘moreover,
allows banks to create new money (deposits)
and
credit
and magnifies
banks’
importance
to the
economy.
Control of the checking account system was believed by the Court to invest banks with such advantages as to necessitate customer relations with banks.
Checking account powers were sufficiently important
to distinguish
banks from the institutions
that most
closely resembled them, the thrifts.
Later, in the
Connecticut
case where thrifts had recently received
authority
to offer check-like
Negotiable
Order of
Withdrawal
(NOW)
accounts to individuals,
the
Court again rejected inclusion of savings banks in
the same product line as banks since Connecticut
savings banks could not provide comparable commercial services to business customers.
In the Philadelphia

case, the Court

found

that in

other product
lines (e.g., small consumer
loans)
banks held a competitive
advantage
over -financial
institutions
that offered similar products.
Banks, the
Court

argued,

relied

upon

lower

cost

funds

(i.e.,

demand and savings deposits)
than did their chief
rivals in this market (consumer
finance companies)
who purchased funds at market interest rates, in subAs stated by the Court, the
stantial part, from banks.
reason for this competitive disadvantage
is that “only
banks -obtain the bulk of their working capital without
having-to pay interest . _. . thereon, by virtue of their
unique power to accept demand deposits. . . .”
Cost differentials
have not been consistently
cited
by the Court, however, to distinguish
between bank
Regulation
Q authorizes
and competitor
services.
thrift institutions
to pay an interest premium
on
savings and small time deposits (presently
¼ percent) above what banks can offer on identical instruThe Court did not believe this provided a
ments;
significant competitive advantage to thrifts, however,
On the conin the rivalry for depositors’ funds.
trary, bank savings retained the advantage of “settled
consumer
preference”
due to coincident
checking
account relationships.
In the Court’s words, “customers are likely to maintain checking and savings
accounts in the same local bank even when higher
savings interest is available elsewhere.”
Since thrifts
were not authorized
to offer checking accounts, it
was reasoned, consumers were willing to forego some
interest for the convenience
of one-stop banking.
4

ECONOMIC

REVIEW,

Most importantly,
perhaps, the Court has held that
it is the cluster of products and services that fullservice. banks offer that makes banking
a distinct
line of commerce.
Commercial

banks

are the only financial instituof financial products
and services-some
unique to commercial -banking
and others not-are
gathered together in one place.
The clustering of financial products and services
in banks facilitates convenient access to them for
all banking customers;
For some customers, fullservice banking makes possible access to certain
products or services that would otherwise be unavailable to them. . . .
tions in which a wide variety

The department
store nature
of banks, in other
words, represents
the only meaningful
alternative
for a significant
class of customers-reducing
the
effective competition
provided
by nonbank
firms.
The Court recognizes that banks do face direct competition in some individual product and service lines,
or submarkets
(savings,
personal
loans, mortgage
lending, etc.). Such submarkets, however, “are not a
basis for the disregard of a broader line of commerce
that has economic significance.”2
In the Court’s view, one-stop banking
provides
individual bank customers with unique access to the
wide range of financial services a bank offers. Maintaining a personal checking account, for example,
provides a customer with access to a wide range of
otherbank
services, to seek free financial advice from
bank management,
and increases the chances of obtaining credit when needed.
These services would
not be available to a significant number of customers
outside
of the banking
relationship,
the Court
argued.
In addition, since customer-bank
relationships were usually established because of locational
convenience
(near residence, employment,
or within
shopping patterns),
bank customers could minimize
the, time and resources expended (transactions
costs)
searching for and obtaining
financial
services.
In
this way, the Court
competitive advantage,

believed banks maintained
a
over thrifts and nondepository

institutions
and, therefore,
the aggregate of bank
products and: services should be treated as the relevant product line for competitive
analysis in bank
consolidation
proposals.
The uniqueness of some commercial
and services, cost advantages, “consumer
one-stop banking, and the importance

bank products
preference,”
of locational

2The Court declared that analysis of individual submarkets are appropriate, however, when. considering the
effect on competition of a merger between a commercial
bank and another type of financial institution.
United
States v. Phillipsburg National Bank.
MARCH/APRIL

1981

convenience
have been the dominant
considerations
in the Court’s position on the appropriate
definition
of the product market in bank merger cases. Locational convenience has also played a key role in Court
and regulatory definitions of the geographic markets
in competitive analyses.

competition.
The competitive
effects of proposed
mergers, therefore, have generally been judged within
localized geographic markets.
Analytical Method:
Concentration
Ratios
Section 7 of the Clayton Act requires the banking agencies to determine
whether the effect of a proposed
merger may be to substantially
lessen competition.
In the Philadelphia
National Bank case, the Court
pointed out that a prediction of anticompetitive
effects
“is sound only if it is based upon a firm understanding of the structure of the relevant market; yet the
relevant economic data are both complex and elusive.”
The Court felt that it was necessary
to
simplify the competitive analysis in order to provide
a guideline for sound business planning and to insure
that Congressional
intent was not subverted.

The Philadelphia
National
Bank Case In United
States v. Philadelphia
National Bank, the Supreme
Court stated that the area of effective competition
in
the known line of commerce must be selected from the
market area in which the seller operates and to which
the buyer can practicably turn for supplies.
In banking, the Court observed that individuals
and businesses typically do most of their business with banks
in their local communities
since they find it impractical to conduct their banking business at a distance.
The

Court

tomers,

recognized

however,

ping for banking

that

have different
services-“the

individual

bank

capabilities
relevant

In simplifying

cus-

the test of illegality,

on a sense of intense

in shop-

trend

geographical

toward

market is a function of each separate customer’s economic scale.” In general, said the Court, “the smaller

This concern,

the customer,
graphically.”

Congressional

concentration

concern

with a

in the U. S. economy.

ture,

the smaller

is his banking

market

in certain cases, with elaborate

Large

customers,

Since
services

on the other hand, often/have

access to banking

services

outside

geo-

con-

the local

the economic scale of consumers
of bank
varies, the Court settled on a “workable

compromise”
to “delineate
the area in which bank
customers that are neither very large nor very small
find it practical

to do their banking

business.”

struc-

3 The use of concentration
ratios is not based solely on
grounds
of simplification,
but also has some empirical
Concentration
measures
have been positively
support.
related with performance
variables
such as prices and
profits for a wide range of industries, including banking.
For a summary of this evidence, see Stephen Rhoades,
“Structure
and Performance
Studies
in Banking:
A
Summary and Evaluation,”
Staff Economic
Studies, No.
92, Board of Governors
of the Federal Reserve System,
1977. The Structure-Performance
relationship
has been
questioned,
however, by suggestions
that concentration,
instead of leading to collusive behavior. actually emerges
from competitive
behavior and reflects’ the superior performance of large firms.
For example, see-Yale Brozen,
“The Concentration-Collusion
Doctrine,”
Antitrust
Law
Journal (1977-78).

To date, the Court has agreed with the federal
banking agencies that the local area in which the
banks had their offices was an area of effective
RESERVE

dispensing,

proof of market

The Court accepts bank deposit concentration
ratios as prima facie evidence in antitrust cases. The
burden of proof is shifted to the banks to show that
the ratios do not accurately depict the economic
characteristics
of the market.
The Court requires
banks to introduce “significant
evidence of the absence of parallel behavior in the pricing or providing
of commercial bank services” in the market. This is a

The

Court acknowledged
that this compromise could only
approximate
the geographic
scope of the relevant
market, and that “an element of fuzziness would seem
inherent in any attempt to delineate the relevant geographical
market.”
The use of a single “fuzzy”
approximation
of the geographic
market flows directly from the choice of a single product line in
banking-the
cluster of bank products and services.
Clearly, a disaggregated
product line (e.g., demand
consumer
installment
loans, commercial
deposits,
loans, etc.) might dictate the use of multiple geographic markets for analytical
purposes, depending
on the respective geographic
areas over which the
customers
might practicably
turn for alternative
supplies.

FEDERAL

“warrants

market behavior,
or probable anticompetitive
The Court thought that “a merger which
effects.”
produces a firm controlling
an undue percentage
share of the relevant market, and results in a significant increase in the concentration
of firms in that
market, is so inherently
likely to lessen competition
substantially
that it must be enjoined in the absence
of evidence clearly showing that the merger is not
likely to have such anticompetitive
effects.”
The
Court endorsed the use of concentration
ratios, therefore, as an indicator of proposed mergers.3

In the Court’s view, both small borrowers and depositors were largely limited to their
localities for the satisfaction of their financial needs.
venient
area.

said the Court,

the Court relied

RANK

OF RICHMOND

5

difficult task since, in the Court’s own terms, relevant
data is “complex and elusive.”4
Competitive analysis has focused on shares of bank
deposits (as a proxy for bank products and services)
controlled by individual banks.
Concentration
ratios
are calculated in cases involving banks determined to
be presently competing within the same geographic
market, as well as for cases involving banks operating
in separate banking markets but viewed as potential
or probable future competitors.
In existing competition cases, mergers are generally prohibited
if the
combined market shares significantly
increase concentration in the market.
In the latter application, a
consolidation
is generally not allowed if it either (a)
eliminates a procompetitive
influence exerted by an
outside bank on a concentrated
market or (b) removes a likely entrant to a concentrated
market that
can reasonably be expected to contribute to the future
deconcentration
of the market.
Effects on Bank Markets
The line of commerce
view and the resultant
analytical methodology
have
provided close approximations
of actual competitive
conditions in many banking markets.
The policy has
undoubtedly
preserved
competition
among banking
institutions
in numerous
markets by limiting banks’
ability to buy out competitors.
This has contributed
to preventing
increased banking
concentration
and
possible adverse competitive consequences.
In some
markets,
however,
the predicted
anticompetitive
effects of a merger proposal may be overstated,
resulting in denials of cases that could have been approved without significant
anticompetitive
results.
U. S. antitrust standards declare a consolidation
is
legal unless it tends to create a monopoly or subThe concern is to
stantially
reduces competition.
prevent one firm or a small group of firms from
gaining sufficient market power to charge monopoly
prices and realize monopoly profits.
In cases where
the Court’s view misrepresents
the actual competitive
situation in the market, however, prohibiting
a bank
consolidation
may represent
an unwarranted
interference with the free flow of commerce.
Competition
can be stifled by not allowing bank ownership
to
pass from inefficient,
unaggressive
hands to more
efficient, innovative control. The number of potential

bidders
chase

for bank

reducing

6

ECONOMIC

REVIEW,

or potential

potential

ing its market
Empirical
to economies
size banks.

demand

indicate

that banking

As output

(measured

increases,

generally

increase

less than

services.

is subject

of scale, at least for small- and medium-

serviced)
through

economize

pur-

participants,

for bank stock, and lower-

accounts
growing

by limiting

market

value.
studies

on

lower unit costs either

banking

Banks

therefore,

can often

to provide

banking

can expect to benefit

through

of

costs

proportionally.

used

Bank customers

by the number

average

consolidation,
resources

lower prices

from

and/or

service charges for bank products or through access
to expanded output.
If competitive pressures do not
force banks to pass on savings to customers,
bank
profits may increase.
Bank capital should benefit
through increased retained earnings--enhancing
bank
asset growth.
The evidence on scale economies in banking has
led George Benston to conclude that “unless a merger
reduces meaningful
competition,
it should not be
prevented.
Otherwise,
operating
and other inefficiencies may be continued,
desirable change stifled,
and owners of resources prevented from using their
property as they wish.”5 The vast majority of bank
merger proposals, it should be noted, fall well within
the range where economies
might be anticipated.
Since real private and social costs can result from
prohibiting
these consolidations,
the analysis used in
evaluating
the competitive
impact on the relevant
product market should be sound.
Inherent
Weaknesses
The central
core of the
Supreme Court’s line of commerce determination
is
its finding that the entire aggregate of bank products
and services represents
an economically
significant
“[I]t is the cluster of products and services
market.
that full-service banks offer that as a matter of trade
reality makes commercial banking a distinct line of
This finding and the resulting methodcommerce.”6
ology employed by the Court and banking agencies
have been criticized since its inception.
We believe
this criticism reflects some basic flaws in the Court
argument.
In a landmark

4 Demonstrating
an absence of parallel behavior is difficult for products
and services
subjected
to extensive
regulatory
price restrictions
(e.g., prohibition
of interest
on demand
deposits,
deposit rate ceilings,
and usury
Administered
rates have regularly
fallen below
laws).
market rates, forcing institutions
to uniformly
pay (or
charge) the maximum allowable rates. Price competition
among depository
institutions
will be much greater following recent legislative changes.

stock is reduced

by existing

relevant

product

case involving
market,

the definition

the Court declared

of a

that “the

“The Optimal
Banking
Structure:
5 George
Benston,
Theory and Evidence,” Journal of Bank Research (Winter 1973), pp, 220-37.
6 United
MARCH/APRIL

States
1981

v. Philadelphia

National

Bank.

commodities

reasonably

by consum-

interchangeable

ers for the same purposes

make up that part

bank services. Empirical evidence reveals that a high
cross-elasticity
of demand exists between bank time
deposits and savings deposits at thrifts.
Moreover,
disintermediation
from both bank and thrift deposits,
when market interest rates increase relative to deposit rates, indicates that other market instruments
are at least partial substitutes
for these services.
Close substitutes for various bank credit services are
similarly
offered by nonbank
institutions.
Banks
cannot make pricing decisions without regard to the
availability of substitute products from both bank and
nonbank
institutions.
Yet the accepted analytical
methodology
implies they can.

of the

trade or commerce.
appears

. . .”7 Based on this standard, it
the Court has aggregated bank products and

services

beyond

reasonably

the

point

interchangeables

where

commodities

are

by consumers.

The various products and services that banks offer
appear to be customer-specific,
i.e., they are directed
toward specific customer groups.
There are at least
two distinct categories of customers that use bank
services-individuals
and commercial
enterprises.
Banks can be viewed as providing a cluster of consumer products and services to individuals
(demand
and savings deposits, consumer and mortgage credit,
trust services. etc.) and a separate cluster to businesses (cash management
services, commercial
and
industrial loans, etc.). Though individual customers
may well benefit from the provision of either of these
clusters by a single institution,
there is very little
reason to expect that individuals or businesses utilize
both clusters.
There seems to be little or no crossover across cluster categories by customers.
The financial needs of each group are distinct and serve to
restrict their respective demands to different clusters
of bank products and services. Planning and marketing activities reflect this with separate consumer and
corporate departments
within banks and separate advertising

programs.

to specialize
wholesale
Contrary

Indeed,

almost

Use of concentration
ratios, including
only bank
deposits, ignores the competitive
influences exerted
by thrifts and other institutions
that supply substitute
services. Since the Court’s analysis is not affected by
the presence of competition
for individual bank services from nonbank firms, the significance
of computed concentration
percentages
has been seriously
questioned.
The Court “blithely assumes that percentages of the same magnitude
represent the same
degree of market power, irrespective
of the amount
of competition
from neighboring
markets.”
It thus
ignores “the extent to which competition
from savings and loan associations, mutual savings banks, and
other financial institutions
that are not commercial
banks affects the market power of banks.”9

many banks have chosen

exclusively

If concentration
ratios misrepresent
the market
power of banks, and the existence of nonbank institutions in the market also affects banks’ ability to
influence prices, the predictive usefulness, of concentration ratios that exclude those institutions
is diminished.
In particular,
judgments
based solely on
bank deposit concentration,
ignoring competitive
realities in the market, may overestimate
adverse competitive effects, leading to unwarranted
denials of
bank consolidation
proposals.

in either the retail or

sides of the business.
to the Court’s

assertion,

the entire

bank

product line, therefore, does not appear to have economic significance-it
does not appear to be a relevant market-for

it is not marketed

to any one class

of customers.
It is only across the cluster of consumer products
and services that the pricing or
service level decisions of the commercial
have an impact on its consumer clientele.

bank

can

The Court and banking agencies appear at least
aware of the danger of sole reliance on concentration
ratios. In a 1974 decision, 10 the Court acknowledged
that concentration
ratios “can be unreliable indicators
of actual market behavior.”
In addition, the Comptroller of the Currency and Federal Reserve Board
have given limited consideration
in recent years to
the competitive presence of thrifts in assessing anticompetitive consequences of proposed mergers.
Concentration
ratios are sometimes “shaded” to reflect

At the same time, the Court’s definition of the line
of commerce in commercial banking excludes products and services
changeable”

of other institutions

with or close substitutes

that are “interfor individual

7 United
States v. DuPont
& Co., 351 U.S. 377, 395
(1956). The emphasis in this determination.
it should be
noted; is on the demand characteristics
of the consumers
of the product.
8 The
Court declared
that interchangeability
shown by demonstrating
either (a) products
same function or (b) the responsiveness
of
one product to changes in the price of the
price cross-elasticity
of demand).
If “a
elasticity
of demand. exists between
them;
products compete in the same market.”

can be
perform the
the sales of
other (high
high cross. . . the

FEDERAL

RESERVE

9 Justice Harlan, joined in part by Chief Justice Burger,
in a dissenting opinion to the Phillipsburg
decision.
10 United
(1974).
RANK

States

OF RICHMOND

v. Marine

Bancorporation,

418 U.S. 602

7

significant competition from thrifts when concentration data suggest the case might be borderline.11
Erosion by Innovations
and New Competition
However justified and effective established interpretations have been in preserving
and promoting
competition for banking services, competitive
forces in
these markets have not stood still. Today, banks face
intensive
competition
across a rapidly broadening
scope of product and geographic markets from other
banks, thrifts, and other financial and nonfinancial
firms.
This evolving competition
represents
an attempt by the market system to meet the financial
requirements
of the U. S. economy.
Price, product,
and geographic
restrictions
have limited the ability
of banks to fulfill these needs and have induced unregulated sectors of the economy to fill the void.
The new competition
banks face has seriously
undermined
the relevance of some of the Court determinations
in bank competition
cases.
Today,
banks no longer enjoy a monopoly in the provision
of transaction
accounts to consumers.
At the same
time, banks are experiencing
an all-out invasion of
their other product as well as geographic
markets
from both traditional
and new competitors.
In addition, cost advantages banks may have once enjoyed
over competitors
have largely been eliminated
as
banks increasingly
rely on market sources of funds
purchased at market interest rates.
The thesis that
banks enjoy a “settled
consumer
preference”
over
competing
institutions
is hardly supported
by the
Finally,
strong economic forces are. inevidence.
ducing banks and other institutions
to “unbundle”
service packages and separately
market and price
financial services.
The Supreme Court deemed some bank services as
so unique that they are entirely free of competition
from other financial institutions.
Demand deposits,
commercial
loans, trust services, and credit card
plans were cited at various times to distinguish banks
from nonbank institutions.
Developments
in recent
years, however, suggest that the strength
of this
argument has been greatly diminished.
Checking accounts were first subjected
to thrift
competition
when S&Ls were authorized
to allow
telephone transfers
from savings accounts to third
parties in the 1960s. In 1970, S&Ls were permitted
11 A Board order involving
First Bancorp of New Hampshire (November 2, 1978), for example, noted that “thrift
institutions
held a significant
amount of deposits which
lessened the severity of the effects of the proposed transaction on competition in the market.”
More recently! the
Board approved a large New Jersey bank merger, citing
significant thrift competition
as a factor (Fidelity Union
Bancorporation,
June 5, 1980).

8

to make preauthorized
nonnegotiable
transfers from
savings accounts to third parties for household related expenditures.
This authority was expanded to
cover any expenditure
in 1975. In a major development in 1972, state chartered mutual savings banks
began offering
Negotiable
Order
of Withdrawal
(NOW)
accounts in Massachusetts
and New Hampshire.
In 1974, Congress authorized
all depository
institutions
in the two states to offer such accounts, a
privilege extended to the remaining
New England
states in 1976, New York in 1978, and New Jersey
in 1979.
Pennsylvania
savings banks also offered
an instrument
perceived
by the public to be the
functional
equivalent
of checks, the NINOW
or
noninterest-bearing
NOW
account.
The direct
competition
between
banks and thrifts for these
transaction
accounts has been fierce.
In response to the apparent success of the NOW
experiment,
in late 1978 federal regulators
authorized automatic transfers
from savings to checking
accounts
nationwide
for banks.
The Consumer
Checking Account Equity Act of 1980 extends NOW
account authority nationwide
to all federally insured
banks, savings banks, and S&Ls.
Another development
of large dimension
was the
credit union share draft, first authorized
on an experimental
basis in 1974 and made permanent
in
1978. Share drafts and consumer lending powers at
credit unions present major new competition
for
banks, since there are over 22,000 credit unions in
the country with total membership
including nearly
25 percent of all American households.
The new banking
legislation
also expands
the
ability of S&Ls to compete effectively with banks for
consumer business. S&Ls are newly enabled to diversify their portfolios to hold up to 20 percent of
total assets in consumer loans, commercial paper, and
corporate debt securities.
They are further authorized to engage in credit card operations and to exercise trust powers similar to national banks.
These
services eliminate
several key distinctions
between
banks and S&Ls, at least with respect to services
offered to consumers.
In addition, S&Ls do make commercial and business loans secured by real estate and, since the 1960s,
have offered savings accounts to state and local governments
and businesses.
Savings banks generally
have wider authority
to provide business services.
In several states these institutions
can make commercial and business loans.
Though these institutions
have not presented major competition
to bank commercial services to date, the recent legislation
authorizing federally chartered
savings banks to hold

ECONOMIC REVIEW, MARCH/APRIL 1981

paper markets, with bank loans accounting for only a
small portion.
Relative growth rates of savings deposits in recent
years also calls into question the Court argument that
banks enjoy a “settled consumer preference”
in the
competition
for consumers’ savings due to the convenience of maintaining
savings and checking accounts at one institution.
Recognizing
that competition for the savings dollar among banks and thrift
institutions
had increased,
a 1968 District
Court
decision13 concluded that a settled consumer preference no longer prevailed.
Competition
among these
institutions,
therefore, was required to be reflected
in the concentration
ratios used to measure competition.
The nationwide
extension of transaction
accounts
to thrifts suggests these institutions
may be the ultimate beneficiaries
of “consumers’
preference”
in the
coming years.
Though banks and thrifts can both
pay 5¼ percent interest on NOW accounts, thrifts
are initially pricing this service more liberally than
banks (lower minimum balance requirements,
etc.).
Continuation
of the interest differential
on savings
along with more liberal branching authority in many
states may provide
a competitive
advantage
for
In addition, credit union share drafts pay
thrifts.
higher interest than NOW or ATS accounts.
We
might expect to see, therefore,
an acceleration
of
growth of savings and small time deposits at thrifts
relative to commercial banks.
Finally, economic conditions, innovations
in financial markets, and new technology are breaking down
traditional
methods of marketing
banking
services.
Banking customers are more interest-sensitive
than
ever before and are demanding
higher’ yields for
surplus funds.
In response, the financial system is
clearly moving toward payment of market rates for
Institutions
resisting
this
all categories of funds.
trend will experience
a reduced, ability to attract
customers.
Government
policymakers
recognize that
restrictions
on depository institutions’
ability to pay
market rates on deposits has contributed
greatly to
the rapid growth of “near-deposit”
market instruments, most notably money market fund shares that
reached the $80 billion asset level by mid-1980.
These funds provide a highly liquid, low denomination investment yielding a market return
not subject
to Regulation
Q or deposit reserve requirements.
To a limited degree, they can even be used as transaction accounts.
In this new environment,
an increasing proportion

up to five percent of their assets in commercial and
industrial
loans and to accept business demand deposits should give significant
impetus to increased
competition.
In some key aspects thrifts might even enjoy some
competitive advantages
over banks.
Federally chartered S&Ls enjoy statewide branching
privileges in
limited-branching
and unit-banking
states.
In addition, through
Remote Service Units, S&Ls allow
customers to make deposits to and withdrawals
from
accounts at stores and other places away from the
institution’s
offices.
The competitive
position
of
thrifts relative to banks is further enhanced by the
1980 Depository
Institutions
Deregulation
Act provision. continuing
the ¼ percent differential
interest
rate ceiling structure for six years.
A second development
undermining
the Supreme
Court arguments
supporting
the line of commerce
view has been the sharp rise in the cost of bank
funds.
The dominance
of noninterest-bearing
demand deposits in bank liability structures
has been
steadily eroded by inflation, high interest rates, and
the resulting
efforts of consumers
and business to
economize on holdings of idle, nonearning
cash balances. In 1960, demand deposits held by individuals,
partnerships,
and corporations
accounted for 63 percent of total bank liabilities.
This figure fell to 40
percent by 1970 and stood at only 31 percent in
1978.12 Much of the growth in bank time and savings
deposits has taken place in negotiable certificates of
deposit and other time deposits, particularly
those
categories
exempted
from interest
rate ceilings.
Banks’ commercial customers have further attempted
to minimize cash balances through use of repurchase
agreements
that allow firms to earn market interest
on excess transactions
balances.
Increased
reliance on the Federal funds market
and other categories such as Eurodollar
borrowings
have also expanded the portion of bank funds acquired under market conditions.
The result has been
a sharp increase in banks’ marginal
cost of funds.
Since the marginal cost of funds is the prime determinant of bank prices, competitive
cost advantages
banks once may have enjoyed over nonbank
competitors
such as finance
companies
have largely
evaporated.
In addition, it is not true today that
finance companies
rely on bank loans as a major
source of funds.
These companies derive most of
their funds from the corporate debt and commercial
12 Marvin
Goodfriend,
James
Parthemos,
and Bruce
Summers, “Recent Financial Innovations:
Causes, Consequences for the Payments
System, and Implications
for
Monetary
Control,” Economic Review, Federal Reserve
Bank of Richmond
(March/April
1980).
FEDERAL

RESERVE

13 United States v. Provident
1 E. D. Pa. 1968.
BANK

OF RICHMOND

National

Bank, 280 F Supp.

9

of bank business will likely be conducted
on an
explicit price basis.
Customers
receiving
market
interest on deposits can expect to pay full-cost prices
for other services provided by their depository
institutions.
It may no longer be feasible for firms to
offer a wide range of specialized services to their
depositors
free or at subsidized
prices.
Another
force contributing
to this result is recent legislation
requiring
the Federal
Reserve
System to charge
explicit, per-unit prices for the payment system services provided
to depository
institutions.
These
charges, by necessity, will also be passed on to customers.,.
The emergence of an explicit pricing environment
should contribute
to the further
“unbundling”
of
bank products and services.
Explicit pricing may
also reduce customers’ costs of obtaining information
about financial services.
This may reduce the importance of locational convenience
in banking relationships-especially
in an electronic banking environment.
Electronic
Funds Transfer
Systems are reducing
the importance of one-stop banking.
Proliferation
of
credit
and debit cards,
preauthorized
transfers,
automated
teller machines,
point-of-sale
terminals,
as well as telephone and mail banking, expand the
geographic
scope of the “locally-limited”
customer
and increase the ability of distant institutions
to provide effective competition in local areas. As a result,
increased scrutiny of geographic as well as product
markets will be required in bank consolidation
cases.
Changes in Competitive
Analysis
Some disaggregation of the relevant bank product line seems necessary, therefore, before economically relevant markets
can be defined for antitrust
purposes.
At the same
time, significant competition from nonbank firms that
affects banks’ ability to set prices and service levels
must be included in the competitive analysis.
We are
not suggesting total disaggregation
and examination
of concentration
ratios for every individual
service
line.
Some aggregation
still seems relevant.
For
instance, treating the consumer and commercial
(or
retail and wholesale)
sides of banking as separate
lines of commerce would allow an analysis of competition in the products and services produced by institutions separated according to the types of customers
that use them.
This treatment
would appear consistent with the emphasis the Court placed on customer demand characteristics
in its definition
of a
relevant product market in United States v. DuPont.
Disaggregation
and analysis of multiple product
markets will require careful evaluation
of the relevant geographical markets over which customers can
10

ECONOMIC

REVIEW,

“practicably
turn for supplies.”
Clearly, the potential of electronic banking
and the possibilities
of
relaxing
prohibitions
on interstate
banking
in the
near future will blur geographic
delineations
and
require an intensified research effort in this area.
It is our belief that there is no longer sufficient
justification
for excluding
thrift institutions
from
the competitive
analysis in markets for consumer
services.
These institutions
have now attained the
status of being fully competitive with banks. In fact,
until the interest differential on savings and branching differences are eliminated, thrifts may even enjoy
a clear advantage in competing for consumer business.
Their deposits should be included, therefore,
in the calculation of concentration
ratios for antitrust
purposes.
Considering
the limitations placed on the ability of
savings and loan associations
and credit unions to
compete for commercial business, however, these institutions can probably continue to be excluded from
the analysis of the market for commercial
services.
This may not be the case for mutual savings banks
with their commercial
lending
and deposit-taking
The Supreme Court apparently
anticipated
powers.
the inclusion of these institutions
as competitors with
banks : “At some stage in the development of savings
banks it will be unrealistic to distinguish
them from
commercial banks for purposes of the Clayton Act.
In Connecticut,
that point
may well be reached when
and if savings banks become significant
participants
in the marketing
of bank services to commercial
enterprises.”14
A disaggregation
of the product line into consumer
and commercial categories would require dual analyses, possibly involving the use of an expanded geographic market definition for business services. With
this methodology
it might be possible to conclude,
for instance,
that a proposed
acquisition
would
have no significantly
adverse
competitive
consequences on the market for consumer banking services
(based on personal deposit market shares) while the
impact on the business product line (based on business deposits or commercial
loan shares) warrants
denial of the application.
The above suggestions are by no means definitive.
They are viewed merely as the minimum
changes
necessary at the present time to reflect competitive
reality in the marketplace.
They may only represent
the initial recognition
on the part of the Courts and
the regulators of the evolution underway in banking
competition.

14 United
MARCH/APRIL

States
1981

v. Connecticut

National

Bank.

COMMERCIALPAPER
Peter A. Abken

Commercial
issory

paper is a short-term

note that is generally

tions on a discount
to other
market
porations

basis to institutional

corporations.

unsecured

unsecured

sold by large

Since

prom-

investors

commercial

been dominated

with the highest

credit

by large

ratings.

and

paper

and bears only the name of the issuer,

has generally

$120 million in outstanding
commercial paper ; some
of the largest issuers individually
have several billion
dollars in outstanding
paper.
Exemption
from registration
requirements
with
the Securities and Exchange Commission reduces the
time and expense of readying an issue of commercial
paper for sale. Almost all outstanding
commercial
paper meets the conditions
for exemption,
namely:
(1) that it have an original maturity of no greater
than 270 days and (2) that the proceeds be used to
finance current transactions.
The average maturity
of outstanding
commercial paper is under 30 days,
with most paper falling within the 20- to 45-day
range.

corporais
the
cor-

In recent

years commercial paper has attracted much attention
because of its rapid growth and its use as an alternative to short-term
bank loans.
The number of
firms issuing commercial
paper rose from slightly
over 300 in 1965 to about

1,000 in 1980.

Moreover,

the

of commercial

paper

outstanding

volume

in-

creased at an annual rate of 12.4 percent during the
1970s to a level of $123 billion in June 1980. This
article describes the commercial paper market, focusing primarily
on the 1970s, the period of greatest
change and growth.

Placement
Issuers place commercial
paper with
investors either directly using their own sales force
or indirectly using commercial paper dealers.
The
method of placement depends primarily on the transDealers generally
action costs of these alternatives.
charge a one-eighth
of one percent commission
on
face value for placing paper.
Therefore,
if a firm
places $100 million in commercial
paper using the
intermediary
services of a dealer, commissions would
cost $125 thousand.
There are six major commercial paper dealers.

Market Characteristics
The principal issuers
of
commercial paper include finance companies, nonfinancial
companies,
and bank holding
companies.
These issuers participate in the market for different
reasons and in’ different ways.
Finance companies
raise funds on a more-or-less
continuous basis in the
commercial paper market to support their consumer
and business lending.
These commercial paper sales
in part provide interim financing between issues of
long-term debentures.
Nonfinancial
companies issue
commercial paper at less frequent intervals than do
finance companies.
These firms issue paper to meet
their funding
requirements
for short-term
or seasonal expenditures
such as inventories,
payrolls, and
tax liabilities.
Bank holding companies use the commercial paper market to finance primarily
bankingrelated activities such as leasing, mortgage banking,
and consumer finance.

Firms with an average amount of outstanding
commercial paper of several hundred million dollars or
more generally find it less costly to maintain a sales
force and market their commercial
paper directly.
Almost all direct issuers are large finance companies.
The short-term credit demands of nonfinancial
companies are usually seasonal or cyclical in nature,
which lessens the attractiveness
of establishing
a
permanent
commercial
paper sales staff.
Consequently, almost all nonfinancial
companies, including
large ones, rely on dealers to distribute their paper.
There is no active secondary market in commercial
paper. Dealers and direct issuers may redeem commercial paper before maturity if an investor has an
However,
dealers and
urgent demand for funds.
direct issuers discourage
this practice.
Early redemptions of commercial paper rarely occur primarily because the average maturity of commercial paper
is so short. One major commercial paper dealer estimates that only about two percent of their outstanding commercial paper is redeemed prior to maturity.

Denominations
and Maturities
Like other instruments of the money market, commercial paper is sold
to raise large sums of money quickly and for short
periods of time. Although sometimes issued in denominations
as small as $25,000 or $50,000, most
commercial
paper
offerings
are in multiples
of
$100,000.
The average purchase size of commercial
paper is about $2 million.
The average issuer has
FEDERAL

RESERVE

BANK

OF RICHMOND

11

Quality Ratings
The one thousand
or so firms
issuing paper obtain ratings from at least one of
three services, and most obtain two ratings.
The
three rating companies that grade commercial paper
borrowers are Moody’s Investors
Service, Standard
& Poor’s Corporation,
and Fitch Investor
Service.
Table I shows the number of companies
rated by
Moody’s, classified by industry.
This table, covering
881 issuers, gives a good indication
of the industry
grouping of issuers.
Moody’s describes its ratings
procedure as follows :

Table I

INDUSTRY GROUPING OF COMMERCIAL PAPER
ISSUERS RATED BY MOODY‘S
November 3, 1980
Number
of Firms
Rated

Industry Grouping
Industrial

Percentage
of Total
Firms Rated
42.0

Public Utilities

193

21.9

Finance

Moody’s evaluates the salient features that affect a
commercial paper issuer’s financial and competitive
position. Our appraisal includes, but is not limited
to the review of factors such as: quality of management, industry strengths and risks, vulnerability to business cycles, competitive position, liquidity measurements, debt structure, operating
trends, and access to capital markets.
Differing
weights are applied to these factors as deemed
appropriate for individual situations.1

370

155

17.6

Bank Holding

119

13.6

9

1.0

Insurance

25

2.8

Transportation

10

1.1

881

100.0

Mortgage Finance

Total

Source:

Moody’s Bond Survey, Annual

Review.

The other rating services use similar criteria in eval-

uating issuers. From highest to lowest quality, paper
ratings run:
P-l, P-2, P-3 for Moody’s; A-l, A-2,
A-3 for Standard
& Poor’s; and F-l, F-2, F-3 for
Fitch.
For all rating services as of mid-1980, the
average distribution

of outstanding

commercial

paper

for the three quality gradations was about 75 percent
for grade 1, 24 percent for grade 2, and 1 percent
for grade 3. As will be discussed below, the difference in ratings can translate into considerable
ences in rates,

particularly

during

periods

differ-

of finan-

cial stress.
The multifaceted
rating system used by Moody’s
reflects the heterogeneous
financial characteristics
of
commercial paper.
Paper of different issuers, even
with the same quality rating, is not readily substitutable.
Consequently,
commercial
paper tends to be
difficult to trade, and bid-asked spreads on paper of a
particular
grade and maturity
run a wide 1/8 of a
percentage point.
Backup Lines of Credit
In. most cases, issuers
back their paper 100 percent with lines of credit from
commercial banks. Even though its average maturity
is very short, commercial paper still poses the risk
than an issuer might not be able to pay off or roll
over maturing
paper.
Consequently,
issuers use a
variety of backup lines as insurance against periods
of financial stress or tight money. These credit lines
are contractual
agreements
that are tailored to issu1 Sumner N. Levin, ed., The
Business Almanac (Homewood,
1979), pp. 256-57.

12

1979 DOW Jones-Irwin
Ill.: Dow Jones-Irwin,

ECONOMIC

REVIEW,

ers’ needs.
Standard
credit line agreements
allow
commercial paper issuers to borrow under a 90-day
note.
Swing lines provide funds over very short
periods, often to cover a shortfall in the actual proceeds of paper issued on a particular day. Revolving
lines of credit establish credit sources that are available over longer periods of time, usually several
years.
Noninterest
Costs of Issuing Commercial
Paper
There are three major noninterest
costs associated
with commercial paper : ( 1) backup lines of credit,
(2) fees to commercial banks, and (3) rating services fees. Payment for backup lines is usually made
in the form of compensating
balances, which generally equal about 10 percent of total credit lines extended plus 20 percent
of credit lines activated.
Instead of compensating
balances, issuers sometimes
pay straight fees ranging from 3/8 to 3/4 percent of the
line of credit; this explicit pricing procedure has been
gaining acceptance in recent years.
Another
cost
associated
with issuing commercial
paper is fees
paid to the large commercial banks that act as issuing
and paying agents for the paper issuers.
These
commercial banks handle the paper work involved in
issuing

commercial

paper

and collect

the proceeds

from an issue to pay off or roll over a maturing issue.
Finally,
rating services charge fees ranging
from
$5,000 to $25,000 per year to provide ratings for
issuers.

Foreign

issuers pay from $3,500 to $10,000

per year more for ratings,
service.
MARCH/APRIL

1981

depending

on the rating

Investors
Investors
in commercial paper include
money center banks, nonfinancial
firms, investment
firms, state and local governments,
private pension
funds, foundations,
and individuals.
In addition,
savings and loan associations
and mutual savings
banks have recently been granted authority to invest
up to 20 percent of their assets in commercial paper.
These groups may buy commercial paper from dealers or directly from issuers, or they may buy shares
in short-term investment
pools that include commercial paper.
Except for scattered statistics, the distribution
of commercial
paper held by the various
investor groups is not precisely known.
At year-end
1979 all manufacturing,
mining, and trade corporations held outright over $11 billion in commercial
paper.
A substantial
but undocumented
amount is
held by utilities, communications,
and service comCommercial
banks held approximately
$5
panies.
billion in their loan portfolios, while insurance companies had about $9 billion. Much commercial paper,
about one-third
of the total amount outstanding
or
through
short-term
$40 billion, is held indirectly
investment
pools, such as money market funds and
short-term
investment
funds operated by bank trust
departments.
At year-end
1979, short-term
investment pools held 32.5 percent of all outstanding
commercial paper.
History
of Commercial
Paper
Commercial
paper
has a history that extends back to colonial times,
prior to the existence of a banking system in America.
The precursor
of commercial
paper was the
domestic bill of exchange, which was used to finance
trade as early as the beginning
of the eighteenth
Bills of exchange allowed the safe and
century.2
convenient
transfer of funds and provided a shortterm loan between the time of purchase and payment
for goods.
As financial
intermediation
evolved,
banks and paper brokers began discounting
paper.
The supply of negotiable paper was held by commercial banks or by entrepreneurs
investing
surplus
funds.
In marked contrast to today’s commercial
paper
market, firms that relied upon commercial paper in
earlier times were usually inferior credit risks that
could not obtain bank credit.
Reflecting this difference in credit risk, commercial
paper rates in the
early nineteenth century were much higher than bank
lending rates. Another basic difference between the
early and contemporary
commercial
paper markets
2 A bill of exchange is an order written by a seller instructing a buyer to pay the seller a specified sum of
money on a specified date.
FEDERAL

RESERVE

is the type of obligation
commercial
paper represented.
Up until the mid-nineteenth
century, paper
bore both the names of the buyer of goods (the commercial paper issuer) and the seller of goods (the
commercial paper drawee),
and was issued in odd
denominations
according to the value of the underlying transaction
being financed.
Hence, commercial
paper was called two-name
because if the issuer
failed to pay an investor upon maturity of his outstanding paper, it became the obligation of the drawee. As trade and financing practices changed after
the Civil War, commercial paper began to be issued
extensively
as one-name paper, i.e., paper was only
the issuer’s obligation.3
Also, the face value of the
paper was unrelated to a specific purchase or shipment of goods and was instead issued in round lot
denominations.
From the last quarter of the nineteenth
century
until the early twentieth, commercial
paper allowed
borrowers
and investors to take advantage
of substantial seasonal and more persistent
interest rate
differentials
that existed in different regions of the
country.
Because of the decentralized
banking system that restricted
individual
banks to particular
states and even localities, banks could not readily
exploit regional interest rate differentials.
However,
commercial
paper was marketed
throughout
the
country.
Commercial
banks were able to invest in
commercial paper issued in high interest rate areas.
Similarly, firms could obtain funds more cheaply by
selling commercial paper to banks in low interest rate
areas instead of relying entirely on local bank loans.*
In the 1920s, commercial
paper borrowers
included manufacturers,
wholesalers, and retailers in a
There were about
wide variety of product lines.
4,400 firms borrowing in the commercial paper market as a seasonal supplement
to bank credit, which
was the primary source of funds. Virtually all paper
was handled by dealers. Finance companies emerged
as major commercial paper borrowers
as the automobile

industry,

sales finance,

and small-loan

com-

panies grew in importance.
In 1920, the largest
sales-finance
company, General Motors Acceptance
Corporation,
began to place its paper directly with
investors and set maturities
specified by investors.
Other large finance companies
began direct placement about a decade later.
3 For an extensive account of commercial paper’s early
history, see Albert O. Greef, The Commercial Paper
House in the United States (Cambridge: Harvard University Press, 1938), pp. 3-114.
4 Greef, pp. 46, 55, 412-14.
BANK

OF RICHMOND

13

Commercial banks held by far the largest portion
of commercial paper outstanding,
which served as a
secondary
reserve asset.
Although
no secondary
market existed in commercial paper, banks nonetheless regarded paper as highly liquid because the impersonal nature of the credit usually meant there
would be no requests for extensions
or renewals.
Moreover, paper provided banks with an opportunity
to diversify their portfolios by industry
and geographical area. After 1914, some categories of paper
became eligible far discount by the Federal Reserve,
which further increased commercial paper’s liquidity.
Although the volume of directly placed paper increased during the 1920s, the total volume of paper
outstanding
declined.
The outstanding
volume of
commercial paper fell precipitously
between 1929 and
1932 from $420 million to $94 million, as the demand
for business credit fell sharply in the Great Depression. In addition, the number of issuers diminished
from several thousand
to several hundred.
From
1933 to the outbreak of World War II, the amount
of commercial
paper outstanding
increased
fairly
steadily to $840 million, reflecting improvement
in
the general economy, the growing role of consumer
credit in financing consumer durables, and the rapid
rise of finance companies.
Consequently,
by 1941
commercial
paper outstanding
had returned
to the
levels of the first half of the 1920s.
There was a
decline in outstanding
commercial paper from 1941
to 1945, however.
The immediate postwar period brought a resurgence in the commercial paper market and by 1951
the market recovered almost to its 1920 peak. The
market had changed substantially,
however.
On the
issuer side of the market, directly placed paper, predominantly
paper issued by the three largest finance
companies,
rose to about two-thirds
of all paper
outstanding
by the early 1950s from about only onefifth at the trough of the Great Depression. - On the
investor
side, nonfinancial
corporations
were now
beginning to invest liquid assets in commercial paper
instead of placing them strictly in demand deposit
Banks were simultaneously
relying to a
accounts.
much greater extent on Treasury
securities as secondary reserve assets and were no longer the principal purchasers
of commercial paper.
Developments

Since

the Mid-1960s

Two

events

stimulated growth in commercial paper in the 1960s.
First, during the last three quarters of 1966, interest
rates rose above Regulation

Q ceilings

on bank nego-

tiable certificates of deposit (CDs), making it difficult for banks to raise funds to meet the strong
14

ECONOMIC

REVIEW,

corporate loan demand existing at that time. Without sufficient funds to lend, banks encouraged their
financially
strongest customers to issue commercial
paper and offered back-up lines of credit.
Many
potential commercial paper borrowers who formerly
relied exclusively
on bank short-term
credit now
turned to the commercial
paper market.
Consequently, the annual growth rate of total outstanding
commercial paper rose from 7.8 percent in 1965 to
46.6 percent in 1966.
Second, credit market tightness recurred in 1969
as open market interest rates rose above Regulation
Q ceilings, again boosting growth
in commercial
paper.
Financial
innovation
by banks contributed
to this growth.
The banking system sold commercial
paper through bank holding companies, which used
the funds to purchase part of their subsidiary banks’
loan portfolios.
This method of financing new loans
resulted in rapid growth in bank-related
commercial
paper during late 1969 and early 1970, as is seen in
Chart 1. The annual growth rate of total outstanding
commercial paper more than doubled to 54.7 percent
in 1969.
In August
1970, the Federal
Reserve
System imposed a reserve requirement
on funds
raised in the commercial paper market and channeled
to a member bank by a bank holding company, or
any of its affiliates or subsidiaries.5
As a result,
bank related commercial
paper outstanding
plummeted late in 1970 and early in 1971. This episode,
however, marked only the beginning
of bank use of
commercial
paper, which would regain prominence
by the mid-1970s.
The Penn Central Crisis
The commercial
paper
market grew steadily during the 1960s.
Only five
defaults occurred during this decade, the largest of
which amounted to $35 million.
In 1970, however,
the commercial
paper market was rocked by Penn
Central’s default on $82 million of its outstanding
commercial paper.
The default caused investors to
become wary of commercial paper issuers and more
concerned
about their credit worthiness.
In the
aftermath
of the Penn Central default, many corporations
experienced
difficulty
refinancing
their
Financial
disruption
maturing
commercial
paper.
was lessened due to a Federal Reserve action which
removed Regulation
Q interest rate ceilings on 30to 89-day CDs and temporarily
liberalized
the discount policy for member banks.
These actions insured that funds were available
from commercial
banks to provide alternative
financing
for corporations having difficulty rolling over commercial paper.
5 See page 17 and footnote
MARCH/APRIL

1981

6.

After the Penn Central episode, investors became
more conscious of credit worthiness and more selective in their commercial
paper purchases.
During
this period,
the heightened
concern
over credit
worthiness was evidenced by a widening rate spread
between the financially strongest and weakest paper
issuers.
Although some paper had been rated long
before the Penn Central crisis, paper was now rated
on a widespread basis.

“administered”
rates, such as the prime rate.
No
restraints
were placed on open, market rates, however. This policy triggered flows of funds between
controlled
and uncontrolled
credit markets as the
relationship
between administered
rates and market
rates changed.
As interest rates rose in 1972, banks
came under pressure from the CID to moderate their
prime rate increases.
By early 1973, the prime rate
was held artificially below the commercial paper rate
as a consequence of CID policy. Nonfinancial
firms
substituted
short-term
bank credit for funds raised
through commercial paper issues.
Consequently
the
volume of nonfinancial
commercial paper outstanding
fell sharply during the first and second quarters of
1973, as is seen in Chart 1. In April of 1973, the
CID tried to stem the exodus from the commercial
paper market by establishing a dual prime rate. One
rate for large firms moved with open market rates,
while the other for smaller firms was controlled.
Despite these measures, the spread between commercial paper rates and the prime rate persisted and
substitution
out of paper continued.
In the fourth
quarter of 1973 CID controls were removed and the
commercial paper rate dropped below the prime rate,
causing
substantial
growth
in commercial
paper.
This growth continued
throughout
1975.

Interest Rate Controls
Wage and price controls
imposed
during
the early
1970s dampened
the
growth of the commercial
paper market.
On October 15, 1971, the Committee on Interest and Dividends (CID)
established
voluntary
restraints
on

Chart 1

OUTSTANDING

COMMERCIAL

PAPER

The 1973-75 Period
The recession of 1973-75
strained the paper market as investors
became increasingly concerned about the financial strength of
commercial
paper issuers.
Reflecting this concern,
the quality rate spread (the difference between the
interest rates on highest quality paper and medium
quality paper) rose from about 12 basis points in
January
1974 to 200 basis points in November
of
that year. Chart 2 shows movements in the quality
spread from 1974 to 1980. Utility companies experienced problems
selling commercial
paper as their
ratings were downgraded.
Real Estate Investments
Trusts
(REITs)
were another group to encounter
problems in the commercial
paper market.
Loan
defaults and foreclosure
proceedings
early in the
recession led to financial difficulties and resulted in a
downgrading
of REIT paper.
As a result, many
REITs
and utilities were forced to turn to bank
credit.
Bank holding companies
also experienced
difficulty issuing commercial paper in the spring of 1974.
The failure of Franklin
National Bank caused widespread concern about the strength of other banking
organizations.
As a consequence,
smaller bank holding companies in particular
found it hard to place
their paper.
Nonetheless,
the aggregate volume of
outstanding
bank-related
commercial paper remained

Source: Board of Governors of the Federal Reserve System.

FEDERAL

RESERVE

BANK

OF RICHMOND

15

Chart 2

YIELDS AND SPREADS ON 30-DAY

relatively
unchanged
during this period of uncertainty.
In general, the strongest paper issuers with
prime ratings
sold their paper without
problems
during the 1973-75 recession, although less financially sound issuers had to pay a premium to acquire
funds in the commercial paper market.
The Late 1970s After the 1973-75 recession the
commercial paper market grew rapidly.
The volume
of outstanding
nonfinancial
commercial
paper expanded at a 31.9 percent compound annual rate from
the first quarter of 1976 to the first quarter of 1980.
Over the same period, nonbank financial paper grew
at a 20.1 percent compound annual rate and bankrelated paper at a 27.9 percent annual rate.
The
number of commercial
paper issuers increased subFor example, issuers rated by
stantially
as well.
Moody’s Investor
Service increased
from 516 at
year-end 1975 to 881 at year-end 1980.
16

ECONOMIC

REVIEW,

COMMERCIAL

PAPER

The recent rapid growth in the commercial paper
market owes much to the secular substitution
of
short-term for long-term debt, which accelerated because of the high rate of inflation in the late 1970s.
Volatile interest rates due to uncertainty
about the
future rate of inflation make firms hesitant to structure their balance sheets with long-term,
fixed rate
assets and liabilities.
In addition, because of inflation’s debilitating

effects on equity markets,

debt has

grown more than twice as fast as equity during the
past decade.
On the demand side, investors
also
have become wary of long-term fixed rate securities
because of the uncertainty
about the real rate of
return on such commitments
of funds.
Therefore,
funds have tended to flow away from the capital
markets and into the money markets.
A large share
of these funds have been channeled into the commercial paper
MARCH/APRIL

market.
1981

Nonfinancial
Paper
As nonfinancial
firms acquired familiarity
with open market finance during
the 1970s, they gradually
reduced their reliance on
short-term bank loans. This is understandable
since
use of open market funds offers the potential
for
substantial
savings to corporate borrowers compared
to the cost of bank credit.
Large commercial banks’
primary source of funds for, financing
loans is the
CD market, where interest rates are roughly equal to
commercial
paper rates.
In addition,
the cost of
funds to commercial banks includes reserve requirements.6
Noninterest; expenses associated with lending also add to the cost of bank operations.
These
various costs drive a wedge between open market and
bank lending rates, and the spread between the prime
rate and the commercial paper rate is a good proxy
for the difference in financing costs facing companies
that need funds.
Large, financially sound nonfinancial
firms, therefore, have relied to an increasing extent on the commercial paper market for short-term
credit.
The
ratio of nonfinancial
commercial paper to commercial
and industrial
(C&I)
loans at large commercial
banks, rose from about 11 percent in the mid-1970s
to almost 25 percent in 1980. Chart 3 shows the
movements in the ratio of paper to loans from 1972
to 1980.
Banks reacted to this loss of market share by becoming more aggressive
in pricing loans.
Since
1979, for example, some banks have begun making
loans below the prime rate.
In a Federal Reserve
Board survey of 48 large banks, the percentage
of
below prime loans rose from about 20 percent of all
commercial loan extensions in the fourth quarter of
1978 to about 60 percent by the second quarter of
1980. Most of these loans were extended at rates
determined
by cost of funds formulas.
In addition,
the average maturity of loans over $1 billion, which
make up almost half of all C&I loans in volume, fell
from about 3 months in 1977 to a low of 1.2 months
in August 1980. Loans below prime had an average
maturity
of well under one month.
These below
prime loans were in the same maturity range as the
average maturity for commercial paper.

same time to provide services to support their customers’ commercial paper issues.
Some banks have
offered customers more flexible short-term
borrowing arrangements
to allow commercial paper issuers
to adjust the timing of their paper sales.
Morgan
Guaranty Trust Company, which originated this service, calls its open line of credit a “Commercial
Paper Adjustment
Facility”
and prices the service
below the prime rate.
Commercial banks also provide back-up lines of credit and act as issuing agents,
as discussed above.
In

summary,

paper

market

commercial

competition
is changing

banks.

of loans to their

reduced
mercial

partly
paper

activity

now focuses

their customers’

because
market,

the

the lending

Although

large volume of short-term
ability

with
banks

business
largest

commercial
practices

still

of

extend

a

loans, the profit-

customers

has been

of competition with the comand some commercial
bank
on supporting

commercial

the issuance

of

paper.

Financial Paper
Since the 1920s, finance companies have been important participants
in the commercial paper market.
They provide much of the
credit used to finance consumer purchases.
Historically, around 20 percent of outstanding
consumer
credit has come from finance companies.
Finance
companies also supply a large and growing amount
of business credit such as wholesale and retail financing of inventory,
receivables financing, and commercial and leasing financing.
About half of all the credit
Chart 3

RATIO OF NONFINANCIAL
CP* TO C&l LOANS OF LARGE WEEKLY
REPORTING COMMERCIAL
BANKS

Aside from becoming more competitive
with the
commercial
paper market, banks have tried at the
6 The following example illustrates
how reserve requirements on CDs increases
the cost of funds to banks.
Suppose the reserve requirement
against CDs is 3 percent and a bank’s CD offers a 12 percent yield.
Then
for every dollar obtained through the CD, only 97 cents
are available to lend. The funds idled as reserves increase
the effective cost of funds raised by issuing a CD. In
this example, the additional cost imposed by the reserve
requirement
is 37 basis points, i.e., 12 ÷ .97 = 12.37.

*Commercial
Source:

Paper

Board of Governors of the Federal Reserve System.

FEDERAL RESERVE BANK OF RICHMOND

17

extended by finance companies goes to businesses,
predominantly
to small- and medium-sized
firms.
The primary source of short-term funds for finance
companies is sales of commercial paper. In fact, the
outstanding
commercial
paper liabilities
of finance
companies were about five times as large as their
bank loans in the late 1970s.
Like nonfinancial
companies,
finance companies
since the mid-1960s
gradually increased the proportion
of borrowing
in
the commercial paper market compared to short-term
borrowing from commercial banks.
As seen in Chart 1, nonbank financial paper constitutes the largest proportion
of outstanding
commercial paper. Sixty percent of all commercial paper
is directly placed and the greatest proportion
of this
is finance company paper.
Finance company paper,
however, is issued by only a small fraction of the
total number of finance companies.
According
to
the Federal Reserve Board’s Survey of Finance Companies, 1975, 88 of the largest finance companies out
of a total of about 3,400 such firms issued 97 percent
of all finance company paper and extended 90 percent
of total finance company credit.
The outstanding
volume of bank-related
financial
paper has been extremely volatile compared to nonbank financial paper. As mentioned above, this market received a major jolt when the Federal Reserve
imposed reserve requirements
on bank-related
commercial paper issues in August 1970. Growth in outstanding bank-related
commercial paper resumed by
mid-1971, however.
This growth corresponded
with
record acquisitions of nonbank firms by bank holding
companies, which peaked at 332 nonbank firms acquired in 1973 and 264 firms in 1974. Some of the
primary activities of these newly acquired subsidiaries are commercial finance, factoring, and leasing.
The 1973-75 recession curtailed the growth in bank
paper, but growth resumed its upward trend by 1976
and has continued strongly since.
New Directions
for the Commercial
Paper Market Recently
several new groups of issuers have
entered the commercial paper market.
These include
foreign banks, multinational
corporations,
and public
utilities; thrift institutions;
second tier issuers relying on guarantees from supporting entities; and taxexempt issuers.
These issuers have found the commercial paper market to be a flexible and attractive
way to borrow short-term funds.
Foreign Issuers Foreign participation
in the commercial paper market has been growing
and will
probably continue to be an important
source of new
growth.
As of year-end
1980, Moody’s rated 70
18

ECONOMIC

REVIEW,

foreign issuers, which collectively had about $7 billion
in outstanding
commercial paper. These issuers fall
into three general categories : foreign-based
multinational
corporations,
nationalized
utilities,
and
banks.
Some large foreign multinational
corporations issue paper to finance their operations
in the
United States.
Others borrow to support a variety
of activities that require dollar payments for goods
and services.
Nationalized
utilities have been major
borrowers in the commercial
paper market largely
because their purchases
of oil require payment
in
dollars.
Finally, foreign banks raise funds for their
banking activity or act as guarantors
for the commercial paper of their clients by issuing letters of credit.
These banks have been among the most recent entrants into the market.
The commercial paper market is often the cheapest
source of dollars for foreign issuers.
A major alternative source of dollar borrowing
is the Eurodollar
market, where rates are generally linked to the London Interbank
Offered Rate (LIBOR).
Many foreign banks, for example, obtain funds in the commercial paper market for ¼
percent or more below
LIBOR.
Aside from cost considerations,
another
important motivation behind foreign participation
in
the commercial paper market is foreign issuers’ interest in obtaining
ratings and gaining acceptance
The exwith the American
financial community.
posure from selling paper helps to broaden a foreign
issuer’s investor
base and prepares
the way for
entering the bond and equity markets.
Two obstacles to foreign participation
in the commercial paper market are obtaining
prime credit
ratings and coping with foreign withholding
taxes on
interest paid to investors outside the country.
Ratings below top quality wipe out the cost advantage of
raising short-term
funds in the commercial
paper
market. To date, for example, no foreign banks have
issued paper with less than top ratings.
Withholding
taxes on interest paid to investors
outside the country also may eliminate commercial
paper’s cost advantage over the Eurodollar
market.
These taxes are intended to curtail short-term capital
outflows and are used in France, Belgium, Australia,
Canada, and other countries.
For foreign issuers’
commercial paper to be marketable,
the issuer must
bear the cost of the withholding
tax. The tax therefore raises the cost of acquiring funds using commercial paper.
By taking advantage
in the withholding

tax

of loopholes
laws,

circumvent these laws. For example,
French electric company, Electricite
MARCH/APRIL

1981

and technicalities

foreign

issuers

often

the nationalized
de France, one

of the largest foreign or domestic paper issuers, has
its commercial
paper classified as long-term
debt,
which is not subject to France’s 15 percent withholding tax on interest.
The reason for this classification
is that the utility backs its paper with a lo-year
revolving credit facility from its banks that establishes
the commercial paper borrowing
as long-term
debt.
French banks use a different approach to take advantage of a withholding
tax exemption
on shortterm time deposits like CDs.
They set up U. S.
subsidiaries to sell commercial paper and then transfer the proceeds to the French parent banks by issuing CDs to their U. S. subsidiaries.
In general, foreign issuers pay more to borrow in
the commercial paper market than domestic issuers
for two reasons.
First, almost all foreign commercial
paper issues have a sovereign risk associated with
the issuer that results from additional uncertainty
in
the investor’s mind about the probability
of default
on commercial
paper because of government
intervention, political turmoil, economic disruption,
etc.
This uncertainty
creates a risk premium
which increases the interest rate on foreign issues relative to
domestic issues. The size of the premium depends on
the issuer, the country, and the level of interest rates.
A second source of additional costs arises when foreign issuers pay to establish and operate U. S. subsidiaries to issue paper and, in the case of foreign
banks, incur reserve requirement
costs on commercial
In addition,
rating service fees are
paper issues.
higher for foreign issuers than for domestic issuers,
as mentioned earlier.
Nevertheless,
the commercial
paper market
is proving to be the least expensive
source of short-term
dollar funds for an increasing
number of foreign borrowers.

of MSBs to issue commercial paper has been largely
due to impaired MSB earnings, which make it difficult to obtain the high credit ratings necessary to
realize the cost advantage in borrowing
in the commercial paper market.
Savings and loan associations
have had access to
the commercial
paper market since January
1979,
when the Federal Home Loan Bank Board approved
the first applications
for S&Ls to issue commercial
paper and short-term
notes secured by mortgage
loans.
S&Ls use commercial
paper principally
to
finance seasonal surges in loan demand and to finance
secondary mortgage market operations.
Commercial
paper allows greater flexibility for S&Ls in managing
liquidity because they can borrow large amounts of
cash quickly and for periods as short as five days.
Relatively few S&Ls carry commercial paper ratings.
Of the 60 or so large S&Ls expected to participate in
the, market after the FHLBB
approved
the first
applications, only 12 had ratings from Moody’s as of
mid-1980, though all were P-l.
These S&Ls collectively had $327 million in outstanding
commercial
paper as of mid-1980.
The attractiveness
of commercial paper for S&Ls
and MSBs has been sharply diminished
as a result
of the Monetary
Control Act of 1980. Under the
Act, commercial
paper is considered
a reservable
liability, except when issued to certain exempt investors such as depository
institutions.
S&Ls and
MSBs have to hold reserves in the ratio of 3 percent
against outstanding
commercial paper, which is classified as a nonpersonal
time deposit. Reserve requirements increase the cost of funds raised through commercial paper and consequently
reduce the incentive
for S&Ls and MSBs to issue paper.

Thrift Commercial Paper
Both savings and loan
associations and mutual savings banks have recently
been allowed to borrow funds in the commercial
paper market.
Mutual savings banks (MSBs)
had
the authority
to issue commercial
paper, but faced
restrictions
on advertising,
interest payments,
and
minimum
maturity
that effectively prevented
them
from issuing commercial paper.
On March 3, 1980
the Federal Deposit Insurance
Corporation
(FDIC)
removed the restrictions and thereby cleared the way
for MSB participation
in the commercial paper market. The FDIC ruled that MSB commercial paper
must be unsecured,
have a maximum
maturity
of
nine months, sell, at a minimum price of $100,000,
state that it is uninsured by FDIC, and bear a notice
that the instrument
will pay no interest after maturity.
Despite the relaxation
of restrictions,
as of
early 1981 no MSBs have issued paper. The failure

Support Arrangements
Many lesser known firms
gain access to the commercial paper market through
financial support arrangements
obtained from firms
with the highest credit ratings.
Second tier issuers
frequently issue paper by obtaining a letter of credit
from a commercial bank. This procedure substitutes
the credit of a bank for that of the issuer and thereby
reduces the cost of issuing commercial paper.
This
kind of support arrangement
is known as “commercial paper supported
by letter of credit” and resembles bankers’ acceptance financing except that the
issuance of commercial paper is not associated with
the shipment of goods. Because the letter of credit is
appended to the, commercial paper note, commercial
paper supported
by letter of credit is alternatively
referred to as a “documented
discount note.”
Typically, letters of credit are valid for a specific term or
are subject to termination
upon written notice by

FEDERAL

RESERVE

BANK

OF RICHMOND

19

either party.
To have a commercial
bank stand
ready to back up an issue of paper, an issuer must
pay a fee that ranges from one-quarter
to threequarters of a percentage point.
Although
commercial
paper with letter of credit
support reached an outstanding
volume of about $2
billion by mid-1980, this segment of the market is
still comparatively
small.
Many issuers of letter of
credit commercial
paper are subsidiaries
of larger
corporate entities.
These second tier issuers include
firms involved in pipeline construction,
vehicle leasing, nuclear fuel supply, and power plant construction.
Other commercial
paper issuers also have
acquired letter of credit support from commercial
banks, particularly
during the period of restricted
credit growth in early 1980. Issuers whose ratings
were downgraded
faced difficulty selling their paper
and paid substantial premiums over high grade paper.
Buying a letter of credit from a commercial
bank
reduced their borrowing
costs in the commercial
paper market and still offered a cheaper alternative
to short-term
bank loans.
Other supporting
entities that provide guarantees
or endorsements
are insurance
companies,
governments for government-owned
companies, and parent
companies for their subsidiaries.
For example, the
commercial paper of the nationalized
French utilities,
such as Electricite
de France, carries the guarantee
of the Republic of France.
Guarantees
or endorsements by parent companies for their subsidiaries
are
the most prevalent form of support arrangement,
Tax-Exempt
Paper
One of the most recent innovations in the commercial paper market is tax-exempt
paper. Except for its tax-exempt
feature, this paper
differs little from other commercial paper. To qualify
for tax-exempt
status the paper must be issued by
state or municipal governments,
or by qualified nonprofit organizations.
Like taxable commercial paper,
tax-exempt paper is also exempt from Securities and
Exchange
Commission
registration
provided
the
paper matures within 270 days.
Most tax-exempt
paper matures within 15 to 90 days.
These shortterm debt obligations
are alternatively
known as
short-term revenue bonds or short-term
interim certificates.
The outstanding

volume

of tax-exempt

paper

has

grown rapidly, rising from an insignificant
amount
in 1979 to about $500 million in 1980. It will probably exceed $1 billion in 1981. Much of the demand
for tax-exempt
paper comes from short-term
taxexempt funds, which had assets of $1.5 billion in
mid-1980, and from bank trust departments.
Many
20

ECONOMIC

REVIEW,

mutual fund groups are setting up tax-exempt money
market funds in response to the apparent increasing
demand for this type of investment.
A current shortage of tax-exempt
commercial
paper has depressed
the yields on outstanding
issues, making this instrument especially
attractive
to tax-exempt
issuers.
However, constraints
on public agency use of shortterm debt in some states may continue to limit the
supply of tax-exempt commercial paper.
Conclusion
The commercial
paper market
has
served the short-term
financing
needs of several
groups of borrowers to an increasing degree in recent
years. Many nonfinancial
companies, especially large
firms, have substituted
commercial
paper for shortterm bank loans to satisfy their working capital requirements.
Commercial paper has generally been a
less costly financing alternative than bank short-term
credit for these firms. Finance companies have relied
to a greater extent on commercial paper than nonfinancial companies for short-term financing and have
issued the greatest proportion
of outstanding
commercial paper. Most large finance companies realize
economies of scale by placing commercial
paper directly with investors.
Bank holding companies also
have depended on the paper market to finance their
banking-related
activities, which increased in size and
scope during the 1970s.
Other types of issuers have been recently attracted
to the commercial paper market because of the potential saving in interest costs over alternative
ways
of borrowing short-term funds. Foreign issuers have
sold a substantial
amount of commercial paper since
entering the market in the mid-1970s.
Foreign and
domestic issuers who lack sufficient financial strength
to offer commercial paper on their own have gained
access to the market via support arrangements
with
stronger financial or corporate entities.
Tax-exempt
issuers are expected to increase in number and generate larger supplies of tax-exempt
paper.
Thrift
institutions,
on the other hand, probably
will not
make much use of the market in the future because
recently imposed reserve requirements
on commercial
paper have reduced its cost-advantage
over other
sources of short-term credit.
Many investors find commercial
paper to be an
attractive short-term financial instrument.
Although
corporations
and other institutional
investors
held
most outstanding
cial intermediation

commercial paper in the past, finanby money market funds and other

short-term
investment
pooling
arrangements
given many new investors, especially individuals,
direct access to commercial paper.
MARCH/APRIL

1981

has
in-

References
1. “A Way to Upgrade Corporate
Week, March 31, 1980.

IOUs.”

12. Levin, Sumner N., ed. The 1979 Dow Jones-Irwin
Homewood, Illinois:
Dow
Business
Almanac.
Jones-Irwin, 1979.

Business

2. Board of Governors of the Federal Reserve System.
“Short-Term Business Lending at Rates Below the
Prime Rate.”
Federal Monetary Policy and Its
Effect on Small Business, Part 3. Hearings
before
a Subcommittee on Access
to Equity Capital and
Business Opportunities of the House Committee on
Small Business. U. S. Congress, House. Committee
on Small Business, 96th Cong., 2nd sess., 1980, pp.
318-327.

14. Moody’s Commercial Paper Record. Monthly Statistical Supplement.
Moody’s Investors
Service,
Inc. (November 1980).

3. Chell, Gretchen.
“Tax-Exempt
Commercial Paper
Beginning to Catch on as an Investment Medium.”
The Money Manager, July 21, 1980.

Quarterly
15. Moody’s Commercial Paper Record.
Reference Edition. Moody’s Investors Service, Inc.
(Fall 1980).

4.
“Domestic Financial Statistics.”
Bulletin, various issues.

13. McKenzie, Joseph A. “Commercial’ Paper : Plugging into a New and Stable Source of Financing.”
Federal Home Loan Bank Board Journal (March
1979), pp. 2-6.

16. Nevins, Baxter D. The Commercial Paper Market.
Boston: The Bankers Publishing Company, 1966.

Federal Reserve

17. Puglisi, Donald J. “Commercial Paper: A Primer.”
Federal Home Loan Bank Board Journal, 13
(December 1980) : 4-10.

“FDIC Eases Curbs on Mutuals Issuing Commer5.
cial Paper.”
American Banker, February 7, 1980.
6.
Grant, James.
in Commercial

“Crowding Out Chrysler . . . News
Paper.”
Barrons, August 4, 1980.

Below-Prime Rates
18. Quint, Michael. “Short-Term,
American
to Big Customers Seem Permanent.”
Banker, May 2, 1978.

7.
Greef, Albert O. The Commercial Paper House in
the United States.
Cambridge:
Harvard University Press, 1938.

19.

Backup.”

“Banks Give Paper Issuers
New
American Banker, September 27, 1978.

8. Hildebrand,
James L. “Enter Euro-Commercial
Paper.” Euromoney, July 1980.

20. “Selling Paper Abroad to Skirt a Ratings
Business Week, September 22, 1980.

9. Hurley, Evelyn M. “Survey of Finance Companies,
1975.” Federal Reserve Bulletin (March 1976).

The Money Market:
Myth,
21. Stigum, Marcia.
Reality, and Practice.
Homewood, Illinois:
Dow
Jones-Irwin, 1978.

10.

“The Commercial Paper
Federal Reserve Bulletin (June 1977).

Market.”

22. “The New Dynamics of the Market for Business
Credit.”
The Morgan Guaranty Survey.
March
1978, pp. 6-11.

11. Judd, John P. “Competition Between the Commercial Paper Market and Commercial Banks.” Economic Review, Federal Reserve Bank of San Francisco (Winter 1979).

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23. “The Rush Into U. S. Paper.”
January 26, 1981.

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21

1980: A DIFFICULT YEAR FOR FARMERS
Sada L. Clarke

While many factors influenced
the financial and
credit conditions
of Fifth District farmers in 1980,
three provided the major keys to the final story for
the year. These three were:
l

The severe drought and searing temperatures
which reduced crop output substantially
and disrupted livestock production.
l The sharply
higher prices of farm production
inputs relative to the prices of farm products that
exerted significant
downward pressure on net farm
income.
l

during

The unusually
high interest
the spring planting season.

rates,

especially

The three factors combined
to reduce farmers’
ability to service loans needed to buy farm operating
inputs and to make capital investments.
This situation caused many to reduce the use of purchased
inputs and to delay the purchase of machinery
and
equipment.
Moreover,
commercial
banks early in the year
were faced with credit controls and some evidence of
rising liquidity pressures, factors that reduced their
ability to provide loan funds early in the planting
season.
Many
farm borrowers,
particularly
in
drought-stricken
areas, had loan repayment
difficulties, and many had to request loan renewals or
extensions, causing the quality of farm loans to deteriorate.
All in all, it seems certain that many Fifth
District farmers, and farm lenders alike, will remember 1980 as a difficult year.

problems with the dry weather.
The severity of the
drought also varied from area to area within the
states.
Farmers
in the Northern
Coastal Plain,
where most of the peanuts are grown, and in the
Southern Piedmont felt the brunt of the drought in
North Carolina,
for example.
Coastal Plain and
Piedmont
producers
were also hardest hit in Virginia.
The influence of last summer’s dry, hot weather
on local farm production,
income, and credit conditions in 1980 was extremely
unfavorable.
The
drought’s role in causing sharp reductions
in crop
output, for example, was of unusual scope and severity.
Yields per acre fell drastically,
leading to
sharp cutbacks in production.
Four major cropspeanuts,
soybeans,
corn, and cotton-suffered
the
biggest declines.
But there were also significant reductions
in the output of all small grains except
wheat, fire-cured tobacco, Irish potatoes, and sweet
potatoes. While the peach and apple crops were only
slightly
below the previous
season, dry weather
limited the sizing of the fruit. There was also only a
slight decline in the production
of hay because the
sharply larger output in West Virginia all but offset
the smaller crops in other states.
Last year was an unusually poor year for the District’s peanut farmers.
Serious drought damage cut
both yields per acre and overall production 35 percent
below 1979 levels.
Moreover, a fairly sizable proportion of the crop did not make edible grade because
of poor quality.
With short supplies, peanut prices
rose sharply above loan levels, but the many growers
who sold or contracted their peanuts early may not
have benefited from the price increases.

Drought -A
Major Cause of Farmers’ Woes
Farmers’
financial conditions
in 1980 varied, to a
large extent, according to the severity of the drought
in their area.
Some were hit extremely
hard.
A
few, however, will probably be able to count it a
fairly good year. But when cash returns from marketing all crops and livestock are added together and
the high production
costs deducted, it is expected
that farmers’ net income in 1980 will show a sizable
decline from that in 1979.

Soybean producers fared almost as badly as the
peanut farmers.
Drought-reduced
output and peracre yields were both 32 percent under those in 1979.
Yields on some farms were so low that the soybeans
were cut for hay.
This season’s higher prices, al-’
though not as high as had been anticipated
earlier,
are helping to offset some of the sharp increase in
production costs.

Geographically,
the drought was widespread, with
the most extensive damage apparently
occurring
in
the Carolinas,
Virginia,
and to‘ a lesser degree in
Maryland.
West Virginia appears to have had few

especially
corn growers,
Feed grain producers,
came through the year in a little better condition
than the peanut and soybean farmers.
Even so,
drought cut the total size of the crop by 25 percent

22

ECONOMIC

REVIEW,

MARCH/APRIL

1981

and yields per acre even more. With short supplies
and record disappearance
(domestic
use plus exports) anticipated,
this season’s corn prices at the
farm are running well above last season’s level. But
the higher prices may not be able to offset the sharply
smaller crop and increased costs of production.

Most cattle feeders experienced
marketed
than

Flue-cured

growing

tobacco

growers-compared

with

the quality

the

increase

levels in response

to the 5 percent

in yields per acre and an 11 percent

larger

acreage.

Season average prices for the flue-cured
crop were up 4 percent over 1979 to set a new record.

The value of gross sales was 20 percent above 1979 ;
however, costs of producing
the 1980 crop were
sharply higher and may have resulted in lower net
returns

to producers.

The overall financial condition
of hog producers
last year was mixed. With low hog prices during the
first half of the year, producers’ incomes were generally less than their cash expenses so meeting their
Improved
cash-flow commitments
was a problem.
hog prices during the second half brought some relief
from cash-flow difficulties, but net returns increased
only marginally
because of the higher feeding costs.
RESERVE

costs for feed and calves

returns

during

the final quar-

While last year’s big jump in production costs can
be attributed
to fairly sizable price increases
for
nearly all costs of production,
there were five major
culprits-namely,
fuels and energy, interest,
fertilizer, agricultural
chemicals, and farm and motor
supplies, in that order. Fuel and energy prices took
the biggest leap, rising some 38 percent over 1979.
This price increase not only caused farmers to have
to spend more money to run their machinery
and
equipment, but it also pushed up the prices of fertilizer and chemicals. Fertilizer prices, in turn, jumped
24 percent over the 1979 price level, and prices of
Meanagricultural
chemicals climbed 17 percent.
while, interest charges rose some 25 percent over
1979 rates, reaching historic highs. Farm and motor
supplies advanced 17 percent as did prices for farm
Sizable price gains for two other imporchemicals.
tant production
items also took more money out of
farmers’ pockets-for
example, a 13 percent increase
in the price of feed and a 12 percent upturn in the
prices of tractors and self-propelled
machinery.

The drought also had its effects on livestock and
With the reduced feed grain
poultry producers.
output, the price of corn and feed concentrates
increased rapidly last summer and fall, boosting feed
costs and hence the costs of production
significantly.
Moreover, the searing temperatures
that accompanied
the drought conditions caused thousands of broilers
to die and reduced rates of gain. With broiler prices
below the costs of production
in the first half of
1980, broiler producers were in an unfavorable
financial situation.
But after mid-1980, broiler prices
rose faster than costs, making production
profitable.
Egg producers,
on the other hand, remained
in a
cost-price squeeze throughout
the year, so they were
in an unfavorable
financial situation during most of
1980.

FEDERAL

the higher
increased

more

A Tightening
Cost-Price
Squeeze
The severity
of last year’s squeeze between farm costs and prices
was a major factor determining
farmers’ financial
conditions.
On average, however, it was actually the
soaring production costs, not falling farm prices, that
caused 1980’s relatively low net farm income. While
prices paid by farmers for production items, interest,
taxes, and wage rates jumped some 12 percent over
1979 levels, farm product prices averaged only about
2 percent higher. Farmers, in fact, had to pay higher
prices for all items of production
except feeder livestock.

of the flue-

cured crop was probably the most notable development of the year. Total production
rose 16 percent
from year-earlier

Fed cattle

in the second half, however,

Dairymen who were not adversely affected by last
summer’s
drought
remained
in a strong financial
condition in 1980. Slightly larger milk production
and higher support prices for manufacturing
milk
increased income from dairying to a level that mostly
offset the steadily rising costs of production.
The
financial condition of dairymen whose pastures, hay,
and other feed crops were damaged by drought was,
of course, much less favorable.

soybean, corn, and cotton producers--came
the year in fairly good shape. The hot, dry
season that reduced

offsetting

and bringing
ter of 1980.

losses on fed cattle

the first half of 1980.

prices strengthened

Cotton farmers no doubt will also remember 1980
as a very poor year.
Hit hard by the unfavorable
growing conditions,
yields per acre were down 33
percent.
So, despite a 19 percent increase in acreage
harvested, total cotton production dropped 20 percent
below the 1979 harvest.
Most cotton producers will
probably receive some benefit from the higher prices
this season, however.
peanut,
through

during

There is little doubt that all
of the cost-price squeeze last
it was more painful for some
the many crop farmers whose
BANK

OF RICHMOND

farmers felt the pinch
But of course
year.
than for others.
For
incomes were greatly
23

reduced by drought, the squeeze was no doubt exceedingly painful. It was also a rough experience for
many livestock
and poultry
producers,
especially
during the first half of 1980 when prices received for
feeder cattle, hogs, broilers, and eggs were generally
below year-earlier
levels.
For many of these producers, prices for their products were below the costs
of production.
Furthermore,
the severity of the costprice squeeze reportedly was expected to force many
small farmers, including many small, nonmechanized
tobacco growers, out of the farming business in 1980.
Bank
interest
rates
Interest
Rates
Volatile
charged on farm loans last year were unusually volatile, moving up and down from quarter to quarter as
if they were on a roller coaster.
The average rates
charged on loans to farmers virtually
skyrocketed
during the first quarter, shooting up 3.5 percentage
points over the previous quarter and 5.6 percentage
points from a year earlier.
With this surge, interest
rates rose to record levels, and farmers found themselves having to pay an average of 16.6 percent
interest to obtain a bank loan.
The trend in interest rates reversed in the second
quarter and actually dropped almost as sharply as
they had risen in the previous quarter.
Then, after
edging upward slightly during the third quarter, bank
rates on farm loans soared again during the last
quarter, hitting new highs that averaged 16.9 percent.
Rates varied by type of loan from quarter to quarter,
with interest charges on farm operating loans showing the largest year-to-year
increase.
But average interest rates do not tell the whole
story.
Increasingly,
as more bankers began pricing
their farm loans at variable
rates, many District
farmers found themselves having to pay the prime
rate, plus 1 or 2 percent.
Last year’s interest rates forced many farmers into
having to make some agonizing decisions:
Whether
to borrow or not to borrow was the big question.
Many farmers who would have had to obtain loan
funds to purchase “big ticket” items, such as machinery and equipment,
decided against buying in
1980. Some had to make the decision to reduce the
an item usually bought on
purchase
of fertilizer,
time.
Farm Loan Demand Weak
Because
of the extremely high interest rates and the high and rising
costs of production,
the demand for farm loans remained weak throughout
the year, particularly
so at
commercial banks. Bankers noted a continued weakening in the demand for farm loans as the year pro24

ECONOMIC

REVIEW,

gressed,

with the slowdown

quarter.

Farmers

apparently

windows

in large

numbers,

quarter

was reported

accelerating

in the fourth

stayed away from loan
since loan demand

to be well below

each

year-earlier

levels.
Even though interest rates at production
credit
associations and Federal land banks were lower than
those at banks, there was also a decided slowdown in
the rate of farm loan demand at these lending institutions.
The pace of new farmer borrowing
from
PCAs and the FLBs slackened during the first half
of 1980 and then fell below year-earlier
levels in the
second half-PCAs
by 5 percent and the FLBs by
28 percent.
The generally weaker loan demand by farmers last
spring and summer was most unusual.
But there is
little doubt that the situation helped to improve the
liquidity conditions of banks heavily involved in farm
lending.
This slack in farmer borrowing
appears to
have resulted from many factors. The most obvious,
perhaps, were these :
l High interest
rates that caused some farmers,
normally bank customers, to shift their loan demand
to PCAs where funds were available at lower rates
of interest.
l Many farmers voluntarily
cut back on their purchases-and
hence the need for borrowed fundsbecause
soaring
production
costs and depressed
prices for many farm commodities
were reducing
expectations for a break-even year, much less a profitable one.
l The Special Credit Restraint
Program,
particularly the misunderstandings
pertaining
to it, surely
played a significant role in reducing the demand for
non-real-estate
farm loans at banks during the spring
quarter.

The continued weakness in farm loan demand in
the third and fourth quarters, however, would appear
to have been related largely to:
l The
serious cash-flow
problems
that many
farmers were experiencing-problems
that reduced
their ability to repay outstanding
loans and made
them hesitant to assume additional debt.
l Moreover,
widespread
areas of the District
were declared drought disaster areas, so many farmers became eligible for disaster loans from the Farmers Home Administration
and/or the Small Business
Administration
at lower rates of interest.
l And, as one banker pointed out, “Current
high
interest rates have caused farmers to take a wait-andsee attitude.”
MARCH/APRIL

1981

Supplies
of Loanable
Funds
Ample
Bank supplies of farm loan funds in the Fifth District remained relatively ample throughout
the period of the
expected crunch last spring, although credit was extremely tight in some parts of the country.
There
was a little evidence that some banks heavily involved
in farm lending were faced with liquidity pressures
in the spring, yet the supply of production’ credit
seemed adequate to meet demand in most sections of
the District.
But in an effort to help farmers obtain
loan funds at better rates of interest, one-third of the
bankers ‘reporting said they referred ‘would-be borrowers to nonbank credit agencies in above-normal
numbers.
With the generally weaker farm loan demand evident in the first quarter continuing
throughout
the
year, the aforementioned
liquidity pressures
eased.
Bank supplies of farm loan funds improved
from
both the spring quarter and year-ago levels during
the second quarter,
showed further
improvement
in the third quarter, and remained at that improved
position during the final quarter of the year. Moreover, from one-fifth
to one-fourth
of the survey
respondents
in each of the last three quarters indicated that funds available
for lending to farmers
were greater than usual.
Other conditions
also pointed to the improved
availability
of farm loan funds at banks during the
last nine months of 1980. The best indication,
perhaps, occurred in the second quarter when not ‘a
single District bank-member
or nonmember-took
advantage
of the opportunity
to borrow from the
Federal Reserve Bank’s discount window under the
Fed’s temporary,
simplified seasonal loan program
implemented
in April.

lems for many Fifth District farmers.
Bankers, as a
result, experienced much slower loan repayment rates
and a sharper increase in requests for loan renewals
than in the same period a year earlier.
Not only was
the quality of farm loans held by banks much poorer
than at the same time in 1979, but- it was also well
below the level in 1977 when drought-reduced
farm
income also plagued District farmers.
Because of current farm financial and credit conditions, some refinancing
of farm loans will be necessary.
Some farmers reportedly
will have to obtain
the second disaster loan in recent years from the
Farmers
Home Administration
or the Small Business Administration
or sell out.
In Summary
Last year was, indeed, a difficult
year for Fifth District farmers.
It was also a year
that many farmers would like to forget.
As one
South Carolina banker described the situation, “Bad
weather, inflation, and high interest rates combined
made 1980 the worst year for farmers in recent history. ” Because of the need to obtain renewals and
extensions
of existing loans, many farmers in the
drought-stricken
areas are heavily burdened
with
debt. Some have experienced losses for three out of
the last four years, and for them conditions
seem
bleak. Fortunately,
however, the situation is not as
grim for all farmers.
Those not affected by last
year’s adverse weather,
the better managers,
and
those with other resources to fall back on remain in a
strong financial condition.
In view of the heavy- financial losses experienced
by many Fifth District farmers in 1980, it is encouraging

is much

RESERVE

more

promising.

improved
farm income
tighter supply conditions.

Repayments
Down, Renewals
Up
Measured
in
terms of loan repayment rates and loan renewals, the
quality of farm loans held by banks deteriorated
significantly during 1980. While the declining quality
of farm loan portfolios
represented
problems
for
many bankers throughout
the year, these problems
intensified as the harvest season progressed.
By the
fourth quarter, the combination
of drought-reduced
crop output and income and one of the tightest cost;
price squeezes in years had created cash-flow prob-

FEDERAL

to note that the agricultural
Higher

outlook
farm

for 1981
prices

and

are expected
because
of
Gross farm income prom-

ises to increase substantially,
rising more than production costs. Under this set of circumstances,
net
farm income will probably rebound from last year’s
level and may recover all of 1980’s losses. Of course,
the full realization
of these prospects
will depend,
to a great extent, on whether growing conditions are
more nearly normal and on whether higher farm
prices materialize

BANK

OF RICHMOND

as expected.

25

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