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FDIC POLICY TOWARD

B

K FAILURES

Walter A. Yarvel

The marked increase in the number and size of
banks that have failed in recent years has focused
attention
on the problems
connected
with bank
failures and the appropriate
aid bank regulatory
agencies
should provide
to banks
in distress.
Since this aid is designed to maintain public confidence in the banking system, there is a need for
greater public understanding
of policies toward
banks with serious problems.
Special attention
is given in this article to the activities
of the
Federal
Deposit
Insurance
Corporation
in providing assistance
to insolvent banks.
The different forms this assistance has taken over the years,
as well as current
FDIC
policy as revealed
in
two recent
large bank failures,
are examined.
Special problems relating
to large bank failures
raise questions
concerning
the adequacy
of the
size of the deposit insurance fund, the constraint
this fund places on FDJC
decisions,
and the
coordination
and cooperation
among bank regulatory agencies necessary
to minimize the impact
of bank failures.
These issues will also be discussed.

*

The mandate given the FDIC by Congress in
1933 was quite cIear.
Its purpose was to ‘lpurchase, hold, and liquidate . . . the assets of banks
which have been closed;
and to insure the deposits of all banks.”
This prescribed
order of
duties supports the proposition that “the primary
function of deposit insurance
is, and always has
been, protection
of the circulating
medium from
the consequences
of bank iailures.
That insurance also serves the purpose
of guarding
the
small depositor
against loss from bank failures
cannot be denied, but this function is of secondary importance”
[3, p. 1911.
Deposit insurance
provides
a safety mechanism
against
a sudden
decline in the money supply through bank fail-

The prevention
of wholesale bank failures has
been the expressed
intent of Congress since the
establishment
of the Reconstruction
Finance Corporation and the enactment
of the Glass-SteagaIl
bill in 1932.
These emergency
measures
were
followed by the passage of the Banking
Act oi
1933, which was intended
to be a permanent
answer to the problem of widespread
bank failures (over 11,000 banks failed between 1921 and
1933, nearly half of these after 1930).
The Act
established
a national
deposit insurance
system
under the FDIC.
This was an important element
in the fight to restore confidence in the commercial banking system and resulted in a precipitous
decline in the number of failures after 1933, as
shown in Chart 1. Over the years deposit insurance has helped to strengthen
the banking system
and has served as a stabilizing
influence
on the
economy.
FEDERAL

RESERVE

BANK

OF

RICHMOND

3

Rather than simply reures (see box insert).
placing deposits of failed banks, deposit insurance

liabilities
of a failing bank protects depositors in
full.
It has been recognized,
however, that the

reduces the incidence of failure by assuring
public that bank deposits are safe-thereby

deposit assumption
method has additional
benefits not available
through
deposit payoffs.
In
some cases, the continuation
of banking services
to the community
and minimizing
the impact of
the failure may be vital considerations.

the
pre-

venting runs that can topple even sound banks.
The Federal
Deposit
Insurance
Corporation
was established
to assist in the protection
of the
nation’s money supply. Though the Corporation’s
raison d’etre is widely accepted, its operating methods
have been a controversial
issue.
The regulatory
agencies
in general and the FDIC in particular,
charged with carrying out Congressional
statutes,
must decide which of their powers gives the
greatest
support to the banking
system.
The
choice of methods employed by the FDIC
has
resulted from consideration
of the financial status
of the banks in question, different interpretations
of Congressional
intent,
and Congressional
inquiry itself.
This choice has been a difficult one
-one
that has caused debate in the past and will
undoubtedly
continue to do so in the future.
The FDIC has four alternative
procedures
that
may be followed in assisting
a failed or failing
bank.
These alternatives
are :
1. DIRECT
PAYMENT
OF INSURED
DEPOSITS:
Acting as receiver of the bank’s assets
and making direct payments to insured depositors;

2. DEPOSIT
ASSUMPTION:
merger with a healthy institution

Facilitating
a
or replacement.

by a new organization
with new ownership and
management, through loans and/or purchase of

assets, thereby protecting
3.

DIRECT

4.

DEPOSIT

LOANS:

all deposits;

Supplying direct financial

aid in an effort to correct. deficiencies
bank to continue in operation ;

INSURANCE

to allow the

NATIONAL

BANK:
Operating a Deposit Insurance National
Bank for a maximum of two years prior to a
deposit payoff or deposit assumption.

The first two methods of operation have been
authorized
since the establishment
of the Corporation and have been, by far, the most commonly used. While the maximum deposit insurance protection
has been increased
from time to
time (from $2,500 in 1933 to the present $40,000),
legislators
have taken the position that “it should
never be the policy of Congress to guarantee
the
safety of all deposits
in all banks”
[9, p. 21.
Under the direct payment to depositors
method
this mandate is maintained.
If a bank is closed
by the appropriate
state or Federal authority and
placed into receivership
for liquidation
of assets,
the insured deposits are paid up to the maximum
allowed by law. On the other hand, extension
of
advances
to other banks to assume the deposit
4

ECONOMIC

REVIEW,

FDIC
Activity
and Congressional
Supervision
When distress
situations
occur, the FDIC
has
attempted to safeguard the public’s trust in banking largely
through
a varying
policy of direct
deposit payoffs and deposit assumptions
via mergers.
Table I outlines FDIC assistance
to failed
banks since 1946.
It shows that FDIC officials
avoided the direct payment
of insured deposits
between
1946 and 1954.
Corporation
officials
felt that such procedures,
with the loss of some
depositors’
funds and an interruption
of banking
services,
did not provide the support needed to
maintain confidence
in the banking system.
Instead, mergers (usually consummated
with financial aid from the Corporation)
were the exclusive
method used over this period.
Congress challenged
the Corporation’s
avoidance of the direct payment
method through receivership
in 1951 [lo].
The contention
was that
the FDIC had insufficient
evidence in some cases
to base a decision on whether or not the assumption of assets by a healthy bank would reduce the
risk or avert a loss to the Corporation’s
insuranc:e
fund as required by law. Some legislators
argued
that the FDIC did not know the full extent of its
liability in all such cases, and therefore it may ble
preferable
for banks to be placed into receivership and direct payments
on all insured deposits
The Corporation,
nevertheless,
conbe made.
tinued its established
policies
until 1955, when
four deposit payoffs
were experienced.
The methods
used to assist distressed
banks
have undergone
Congressional
scrutiny
periodically since 1956, reaching full force in 1965. Seve:n
banks failed in 1964-all
being placed into retceivership
and only the insured
deposits paid.
The direct concern of legislators
this time, however, was not 100 percent
insurance
protection
versus limited protection.
Instead, the adequacy
and quality of Federal
banking supervision,
examination,
and interagency
cooperation
became
the main subjects
of Congressional
inquiry.
Of immediate concern to the Senate Committee
on Government
Operations
[ 1 l] was the growing
number of abuses by bank management
that had
been prime factors in the increasing
incidence of
SEPTEMBER/OCTOBER

1976

THE IMPACT OF BANK FAILURES
To

understand

is first

“high-powered
and

(3)

to

ratio

as

the

deposits

serves.

bank

of

(H),

three

currency

Federal
of

ratio

by

a fractional

reserve

result

in an equal

percentage

The
ratios

of

interest

and

the

sion

hold

to

money

imposed
and

banking,

is

than

The

unity,

public

supply,
of

cannot

rate

of interest

minants

of

rate

minus
net

of

service

rate

does

of

the

to wish
of

are

to

deposits

market

to

the

currency

the

creation

the

confidence
quences
‘Much

of

and

this

net
of

bank

re-

dollars

high-powered
things

equal

failures,

banking

to

nation’s

discussion

is

from

bank

unless

of

bank

factors

with

these
D/R

Since

deposits

or

impact
is

public’s

is significantly

currency.

it

the

have

two

total

essential.
that

can,

the

between
on

found

capita

in the

the

H constant).

as convertibility

per

ratio

is the

In

the

been

D/C

net

or

expected

ratio

when

paid

money
a

study

expected
major

net

deter-

may

varies

paid
may

with

on

to dump

high-powered

from
for

so
bank

(the
the

de-

public

If the withdrawal

many

money

in the

declines,

negative

normal

the

services

changes

deposits

become

it is only

with
and

free

deposits

of money-currency.

be forced

ratio

through

on

losses

conditions,

form

this

positively

rate

deposits

proportionally

between

implicitly

expected

on

such

increases

relation

explicitly

additional

neutralized,

problems

Federal

paid

expensive)

the

income

present

Under

(less

form

the

to deposits.

periods

interest

in

shift

Cagan

unless

of
is

its assets

acquired

on the
to

meet

deposits

and

public.

unless

liquidity

real

which,

lower

connecting

magnitude

the

reserve

The

in hri (assuming

Phillip

The

the

funds).

needs
the

at

During

scale,

its

[l],

alters

fractional

of a downward

multiplicative

to

A deci-

deposits.

money

either

desire

deposits

+- D/C].

of

payment

ratio.

reserves,

the

desira-

the

public’s

in

and

of

respec-

relative

D/R

Under
bank

as long

a

less

total

formula

deposit/currency

(interest
as

desirable

level

currency

the
the

assets

impact

the

addition,

on

and

in a decline

States

the

of

The

determining

losses).

rate

stock.

deposit/reserve
decisions
decisions,

and

while

high-powered

can have

interest

his

a large

liquidity

of

that

expected

all

more

on

its

bank

the

of

other

by

in

composition.

reduces

of

relative

deposits

the

demands,of

in
for

total

is
held

several

liquidity

impact

of earning

expected

deposits-i.e.,

lose

the

of

(D/R),

reserves

member

and

banks

ratic,?
an

-j- D/C)]/[D/R

to

United

and

ratio.

high,

responsibility

Some

the

it
(1)

money

plus

up

money,

bank

currency
its

system

result

variables

greatest

as

aggregate

currency

on

on

occurs
meet

supply,
money?

reserves

support

determined

by

D/C

consequent

will

ratio

the

show

of

paid

even
hold

in

results

charges

may

in

decisions.

have
in

well

money

the

in this

for

deposit/currency

suspensions
positor

demand

interest

the

H [ D/R(l

the

the

fraction

the

on deposits

interest

the

ratio of deposits
of

income,

the

M =

currency

Cagan’s
real

cash

can

of

and

held

may

contraction

in D/C

a shift

paid

the

While
expected
net

for

as

from

determine

the

examination

demand

vault
making

are

these

balances

viewing

ratio:

Since

an

the

bank

bank

deposit/currency

ratios

balances

affect

cash

smaller
in

a reduction

determine

is maintained.

to

stock

the

reserves

held

supply

smaller

the

deposit/currency

greater

banks

deposits

useful

cash

affect

a multiple

the

in

influencing

of

money

of

desired

law

balances

forces

therefore,

stock

however,

of

High-powered

change

the

money

stock

deposits

reserves

A

in

of these

their

by

cash

the

ratio,

and,

mdney

by

proportion
of

deposit/currency

of

offered

a withdrawal

reserves

system.

the

(D,‘C).

plus

bank

in

in the

components

as

changes

of

a larger

replaced,

of

deposits-thereby

services

amount

otherwise

two

change

magnitudes

composition

composition

aggregate

stock

The

the

currency

change

the

the

Requirements

bility
of

on

interdependent.

concerning

tively.

banking

bank
public

public

held

decline

changes

D/C).

effects

are

public

and

for

the

latter

money

under
D/R

the

Reserve-the

of deposits
(namely

by

held

high-powered

in a sudden

commercial

held

money

will

result

accounting

of

to currency

of

the

dollar

can
factors

(2) the

deposits

amount

with

One

failures

recognize

money”

the

defined
as

how

necessary

ON THE MONEY STOCK

for

banking
prevent

money

other
agencies

can

lead

to

massive

banks-regardless
to

indiscriminant

of

neutralize
runs

on

banks

supply.

[2].

FEDERAL

RESERVE

BANK

OF

bank

RICHMOND

withdrawals
their
failures
that

of

financial
may

and
have

position.

It is

maintain

public

serious

conse-

The
FDIC,
actions
by bank
management.
charged with supervising
the bank in receivership and making payments to depositors, and the
Federal
Reserve,
responsible
for making funds
available
to member banks in times of financial
stress (over $9 million to San Francisco
National), were precluded from entering
a joint effort
to rehabilitate
the bank prior to its closing.
The

Investigation
of several
banks
bank failures.
involving dishonesty
on the part of bank officials
revealed a lack of interagency
cooperation.
The
cause of the failure of the San Francisco
National
Bank in January
1965, for example, was not revealed to the FDIC or the Federal Reserve System until the bank was placed in receivershipover seven months following the finding of illegal

Table

INSURED

BANK

FAILURES, DEPOSIT

I

PROTECTION,

FDIC DISBURSEMENTS

AND

1946-1975
Banks
in
(FDIC

YeCir

Placed

Banks’

Receivership

Banks

Deposits

Receivership)*

Direct

Assumed

1

-

1947

From

in

FDIC

FDIC

Disbursements
Deposit

($

in

Payoffs

Assumptions

($ Thousands)

Thousands)

-

Disbursements

Deposit

-

-

5

1946

FDIC

Receiving
Loans

265
1,724

-

i948

-

3

1948

-

4

1950

-

4

-

2

-

1,884
1,340

1951
1952

-

3

-

2

-

1954

-

2

3,182

-

1953

269
2,552

-

5,039
902

1955

4(4)

1

-

4,459

2,343

1956

10)

1

-

2,981

463

-

1,056

1957

2(l)

1958

30)

1959
1961
1962

5(5)
-

1963

m

1,856

-

4,799

-

10)

-

-

30)

1960

1
-

-

6,191
-

-

-

1964
1965

-

-

19,247

-

7(5)

231

2,801

12,471

-

3(3)

2

-

11,383

456

1966

l(l)

-

732

14,339

1967

-

1968

4(4)
-

6
-

7,864
-

5,053

1969

4(4)

5

-

7,652

i a,552

1970

4(4)

3

1971

5(3)

1972

l(l)

1
-

1973

3

3(3)
-

1975

3(3)**

**
***

One
Deposit
FDIC

Note:
Source:

6

bank

placed

insurance
disbursements

Deposit
Annual

poyoff
Report

into

10

national
in

state

banks

were

in

connection

1975

figures
of

of

are
the

for

Federal

Dec.

bank

formed
with

31

Deposit

of

authorities
by

the

its

Insurance

in

1957;

receiver

insurance

respective

ECONOMIC

109,245

16,105

year

of

two

173,201
N.A.***

N.A.***
each

closed

responsibilities
plus

Corporation,

REVIEW,

two

167,748

16,781
-

1
-

4

receivership

19,696

53,739

1
-

3

1974

*

26,691
1

estimated

in

1958,

1959,

and

1971.

banks.
totalled
additional

$305.6

million.

disbursements

annually.

SEPTEMBER/OCTOBER

1964,

1976

for

the

respective

banks.

members of the Senate committee
concluded that
cooperation
and liaison among the Federal banking agencies
were absolutely
vital to the public

This authority
has been used only three times
-July
1971, January
1972, and August 1976and
then only with rigid constraints.
In the first two

interest.

cases,
the Corporation
required
that existing
shareholders,
not the FDIC, bear the existing loss
potential
on the bank’s assets.
The FDIC
also
prohibited
dividends
from being paid, required
new officers and directors to be subject to FDIC
approval, and further restricted
each bank’s activities.
In the most recent case, direct assistance
was granted
to keep the bank going for three
weeks until a deposit assumption
could be arranged.

Legislation
designed
to aid the regulatory
agencies in protecting
banks from criminal
acts
and gross mismanagement
followed with the passage in 1966 of the Financial
Institutions
Supervisory and Insurance
Act, which provided cease
and desist powers and provisions
for removal of
officers and directors.
An increase in the number
of problem
banks, plus the limited use of the
newly provided supervisory
powers spurred another Banking
and Currency
Committee
investigation in 1971.

The fourth alternative
method for protecting
depositors, the organization
of a deposit insurance
national
bank, was utilized twice during 1975.
Section 11 of the Federal Deposit Insurance
Act
authorizes
the FDIC
to transfer
all the insured
and fully secured deposits in the closed bank to
the new bank. Those funds are then available to
their owners to the same extent as they were in
the closed
bank.
Deposit
insurance
national
banks can remain in existence a maximum of two
years, during which time the FDIC
can make a
public offering of stock in the new bank. Through
this procedure, the Corporation
hopes to encourage local communities
to consider the establishment and capitalization
of a new bank before a
final disposition oi assets and transfer oi deposits
from the insolvent bank.

In his statement
before the Committee
[S, pp.
10-111, Frank
Wille,
Chairman
of the FDIC,
outlined the Corporation’s
procedures
and priorities concerning
failing banks.
Mr. Wille emphasized that the Corporation
had no say in the
closing of insured banks-this
was the responsibility of its chartering
authority:
the Comptroller
of the Currency in the case of national banks or
the appropriate state authority in the case of state
banks.
It is mandatory,
however, that the Corporation serve as the receiver of all national banks
and serve as receiver
of state banks when appointed.
When this happens, the FDIC Board of
Directors
generally
determines
whether the deposit payoff
or deposit
assumption
procedure
should be foIlowed.
The second method is utilized, however, only when the prospective
cost to
the Corporation
is less than the cost through the
deposit payoff alternative.
A prerequisite
to a
deposit assumption,
of course, would be an existing or newly organized
bank that is willing to
enter into such a transaction
and that is acceptable to the appropriate
chartering
authority
as
well as to the FDIC.

Congressional
interest
in the FDIC’s
role in
recent years, however, has shifted away from the
metl~od that the Corporation uses to handle the protection of depositors’ funds to the question of the
Agency’s role in the prevenfion of bank failures. The
Corporation
has not escaped criticism
on its depositor
insurance
methods
during this period:
though.
The Hunt Commission
Report expressed
the view that the dominant
criterion
used by
Federal
insurance
agencies
in meeting
claims
should be the needs and welfare of the community
involved, not the minimization
of payouts from
the insurance fund [G, p. 731. The Commission’s
report suggested
the need for a reevaluation
of
deposit
insurance
legislation.
This important
issue had clearly been subjugated
in legislative
priorities,
however,
to the prevention
of bank
failures.
Increasing
emphasis has been placed on
the Federal
regulatory
agencies’
responsibilities
in preventing
bank failures.
These agencies have
long sought to promote sound banking through
examinations
wherein management
and financial
conditions
are evaluated.
In the course of these

The Corporation
added new scope to its operations in 1971 when it used, for the first time, the
direct loan authority
granted in 1950.
At that
time, the Corporation
was authorized
to provide
direct financial assistance
to an insured operating
bank in danger of closing whenever, in the opinion of the FDIC
Board of Directors,
the continued operation of such a bank was essential
in
providing adequate banking service in the community.
Even in this case, assistance
is withheld
if individuals responsible
for the bank’s poor condition will benefit financially
or if it appears that
assistance
may be required
over a prolonged
period.
FEDERAL

RESERVE

BANK

OF

RICHMOND

7

examinations,
attempts are made to discover and
correct unsafe or unsound practices
or violations
of law and regulations
before such practices prove
fatal to the bank.
Congressional
and regulatory
attention
has
shifted to detection of bank problems at an early
Congress
and
enough date to prevent failures.
the financial
community
have come to expect
bank regulators
to step in and salvage a bank in
trouble either as a corporate entity or as a party
to a merger.
The number of bank failures is not
The Federal
the Corporation’s
concern, however.
Deposit Insurance
Corporation’s
primary function
has been the protection of the banking system from
the consequences of bank failures-i-e.,
the creation
of problems for otherwise
healthy banks and destabilizing
influences
on the nation’s
money
Former
FDIC
Chairman
Frank Wille
suPPlY*
interprets
the Corporation’s
mission to be one of
minimizing
the impact of a bank failure.
When an insured bank, despite efforts at correction, progresses to the point where actual failure
appears likely, FDIC . . conceives its mission to be
not the prevention of failure at whatever cost but
the protection of depositors and the maintenance
of public confidence in the banking system as a
whole despite the failure. We seek, in other words,
a ‘soft landing’ which minimizes the impact of a
bank failure in a community . . . [123.

But how does the Corporation
presently
feel this
responsibility
is best
carried
out?
For
this
answer it is best to look to recent experience.
Two Recent Failures
Examination
of recent
FDIC
policy and procedure
in handling
bank
failures is quite revealing.
The largest failures in
U. S. history, as well as the most publicized
in
recent years,
have been those experienced
by
U. S. National Bank of San Diego (USNB)
and
Franklin
National
Bank, New York.
Criminal
charges have been filed in both instances
alleging
improper or illegal actions by top management.
Each case reveals
that conscious
efforts
were
made to misrepresent
the true financial conditions
of the banks and to deceive regulatory
authorities.
The failure of U. S. National
Bank of San
Diego on October 18, 1973, at the time the largest
bank in U. S. history to collapse ($934 million in
deposits),
was the subject of a hearing before the
Bank Supervision
and Insurance
Subcommittee
of the House Banking
and Currency
Committee.
At that time, Mr. Wille
pinpointed
the steps
taken by the Corporation
incident to the transfer
of certain assets and liabilities
to Cracker
National Bank, San Fran,cisco.
Of particular
inter8

ECONOMIC

REVIEW,

est to the Subcommittee
were the FDIC’s
involvement with USNB since its identification
.as
a problem bank and the Corporation’s
consideration of the alternative
methods available to it to
protect the bank’s depositors and other creditors.
In the last few weeks before USNB was closed,
during which time the FDIC began preparations
in the event the bank did fail, Corporation
personnel went to San Diego for the purpose of
obtaining specific and detailed financial
information to be utilized in discussions
with banks i:nterested in acquirin, v USNB’s offices and banking
business.
Concurrently,
reviews
of the Com:ptroller’s
examination
reports,
provided
to the
Corporation,
were started in order to measu’re
the FDIC’s
insurance risk. Estimates
were th.at
an insurance payoff in this case would necessitate
an initial FDIC
outlay of approximately
$700
million and would result in the immediate loss Iof
the use of nearly $230 million to the approximately 3,300 depositors whose deposits exceeded
the $20,000 insurance limit in effect at that time.
In the judgment of the FDIC Board of Directors
and outside
bankers
involved
in consultation,
such action would have shaken public confidence
in the nation’s entire banking system, with especially severe repercussions
in California.
considering such a payoff to be the last resort, the
Corporation
also rejected
direct
assistance
to
USNB
because
the statutory
requirement
that
the continued operation of the bank was essential
to provide adequate banking service in the cornmunity could not be substantiated.
It was also
felt that USNB’s
controlling
stockholder,
responsible for many of the bank’s difficulties,
would
benefit financially
from the assistance.
The Corporation
began to formulate
a tran:saction proposal that it hoped would transfer substantially
all the banking business of USNB
at a
sufficiently
high price to satisfy the requirement,
as interpreted
by Congress and the FDIC,
that
the merger would minimize the loss to the Co:rporation’s insurance fund. It was recognized that
if this could not be arranged the payoff method
would be implemented.
Serious discussions
were
begun with three major California
banks that
expressed
an interest
in acquiring
USNB.
In
order to insure competitive
bidding, the remaining four banks in the state capable of assuming
nearly $1 billion in liabilities were also contacted.
Two of these decided not to participate
in thle
bidding for internal reasons, while the other two
confronted serious antitrust problems.
After consultations
with the Antitrust
Division of the DeSEPTEMBER/OCTOBER

1976

partment of Justice, it was decided these last two
banks would be contacted
only if no acceptable
bids were obtained from the other three banks.

bids from se\-era1 Kew York banks and named
European-American
Bank and Trust Co. as the
winner in the bidding to assume all oi the deposit
liabilities
and certain
assets
of Franklin
with
FDIC assistance.
The next morning Franklin’s
104 branches in the Sew York area opened for
business as usual as branches of European-American. The apparent ease with which the deposit
assumption
\=:as completed
was, in fact, the end
result of five difficult months of contractual
negotiations
wish potential
buyers.
During
this
period, the FDIC attempted to insure competitive
bidding by more than one bank on a contractual
basis acceptable
to all parties.l
The restriction placed on the use of the deposit assumption

Once it became obvious that the failure was
imminent,
the FDIC
took steps necessary
to
guarantee
an efficient,
expedient
solution.
Segotiations
on a purchase and assumption
proposal
among the three banks and the Corporation
were
agreed upon. In case the bidding did not realize
a premium that would conform to statutory
requirements,
a contingency
plan for a payoff was
Mr. Wille’s
statement
before the Subdrawn.
committee
was, therefore,
carefu1 to emphasize
that the Corporation,
after careful consideration
of all available
alternatives,
chose to meet its
obligations
through
the method
greatest benefit to the public within
straints.

method was :he decision
assistance
exceeding
the
necessary
to pay off all
terms of sale resulting in
the deposit insurance fund
the deposit payoff method
lowed.

that was of
statutory con-

Within three hours of the closing of USNB by
the Comptroller
and the FDIC
being named as
receiver,
bids were accepted
and analyzed as to
their sufficiency,
and court approval to the proposed acquisition
was granted.
The next morning all of USSB’s
offices reopened at their usual
business
hours as branches
of Cracker National
Bank.
The threat of destabilizing
and disruptive
influences
on the American
banking system was
thus averted.

not to contribute
cash
$750 million estimated
insured
deposits.
If
a smaller payout from
could not be arranged,
would have been fol-

During the time of negotiations,
it became apparent that rile assisted
sale of Franklin
would
not be possible
without
a coordinated
effort
among the banking agencies.
The Comptroller
of
the Current:.
constantly
monitored
Franklin’s
financial condition whiIe the Federal Reserve advanced the bank nearly $1.75 billion through its

When Franklin
Sational
Bank ($1.7 billion in
deposits)
failed in October
1971, it captured the
distinction
of becoming
the biggest bank failure
in U. S. history.
Once the twentieth largest bank
in the country, Franklin’s
failure resulted from a
series of poor management
decisions.
Banking
analysts
generally
agree that the bank’s lack of
earning
power, combined
with relatively
high
loan losses,
large losses
in foreign
exchange
transactions,
and heavy reliance
on the use of
short-term
borrowings
in the money market to
back relatively
long-term
loans, made its failure
a foregone
conclusion.
Of the 65 banks in its
size category
($1 billion
to $5 billion
in deposits),
Franklin
ranked last in earnings
power
with a return on assets of only .23 percent.
Massive withdrawals
of deposits (53 percent of total
deposits)
followed
the announcement
of large
foreign exchange losses in May 1971. Only heavy
borrowings
from the Federal
Reserve
System
kept the bank afloat until Comptroller
James
Smith determined
the bank to be insolvent
and
appointed
the FDIC as receiver.

: For a detailed disckxure of the FDIC’s participation in the solution
to the Franklin pz~biem, see [IS].

Following
earlier,
the

?Federal Reserve s+.-antes were subsequently assumed by the FDIC
and will be repaid hr~ely through liquidation of Franklin assets
held by <be FDIC.

the USXB
Corporation

discount

RESERVE

in an effort

to seek

an efficient

Where widespread public reaction to a precipitous bank fanure is possible, and time is needed to

work out a more orderly

solution, either the Fed-

eral Reserve or the FDIC may be willing to advance funds to the bank on a short-term, secured
basis [12].

FDIC
concern for the level of uninsured
deposits and the interruption
of banking
services
within a community
has clearly made the direct
pavoff of insr?red deposits an undesirable
alterd
native in the case of large banks.
Consideration
of the impact a bank failure has on the financial
community
(in Franklin’s
case both national and
international
in scope) has become of major im-

precedent
of a year
immediateI>accepted
FEDERAL

window

solution to the crisis.”
Interagency
cooperation
may: in fact? have ad\-anced to the stage where
the System was “buying time” for the best solution possible, as Mr. Wille implied.

BANK

OF

RICHMOND

9

It is
portance
to the regulating
authorities.3
entirely conceivable
that a policy of minimizing

If this view is accepted, there
need for regulators
or legislators

the shock waves of a bank failure in the economy
may eventually
come into direct conflict with the

potential
disaster.

requirement
that a deposit assumption
be shown
to minimize a threatened
loss to the Corporation
insurance
fund. This potential conflict certainly
calls into question sole reliance on the comparison
between direct liabilities
of the FDIC under the
deposit payoff and deposit assumption
techniques
as the basis for choosing between these methods.
This comparison
has become necessary
due to
great concern in the past with the absolute size
of the insurance
fund and its ability
to cover
excessive
bank failures.
Since the impact on the
insurance
fund has served as a constraint
on the
Corporation’s
attempts
to give maximum
support to the nation’s money stock, examination
of
this restriction
seems in order.

fund were altered to exclude the contingency
for
failures resulting
from the conduct of stabiliz.ation policy, assessment
rates could be lowered to
correspond
with the experience
of failures resulting from bank practices.
A major practical problem of implementing
such a program,
howeve:r,
would be in distinguishing
bank failures attri’b-

Adequacy of the Insurance
Fund
Kenneth Scott
and Thomas Mayer, in an article [7] based upon
research
undertaken
for the Hunt Commission,
argue that insurance assessment
rates have forced
banks to bear substantially
more of the costs of
bank failures
than they have generated.
Acknowledging
that banks should be expected
to
cover losses attributable
to fraud, misconduct,
and “normal”
managerial
failure,
they present
evidence supporting
their contention
that assessment rates have been sufficiently
high to generate a large surplus over what is needed to cover
these losses.
The only justification
for such rates is the contingency for failures due to gross perturbations in
the economy attributable to the conduct of national
fiscal and monetary policy. Deposit insurance for
this fourth category of failures seems fully warranted on macroeconomic
grounds as a safeguard
against sharp and unplanned contractions in the
money supply.
The cost of this category of coverage, however, should be borne directly by the federal government as the party responsible-and
not
placed on banks . . . and their customers [7, p.
9001.
3If. in fact. we have 100 nercent den&t insurance for large banks.
the-question arises whether the same protection should be-afg$ei
small banks on equitable as well as competitive grounds.
discussion of the need for review of present deposit insurance legislation, particularly concerning large bank failures, see [4] and [5].
The latter argues that 100 percent deposit insurance would eliminate
the conflict in social goals that arises when considering whether a
large bank should be allowed to fail.
Optimal resource allocation
suggests that inefficient firms, regardless of size, must be allowed
The stabilization goal. on the other hand, suggests that
to fail.
large bank failures should be prevented lest they lead to runs on
Complete
other banks and to a reduction in the money supply.
protection for depositors (but not stockholders) would retain the
disciplinary impact potential failure has on bank management but.
at the same time, would serve to insulate the money stock from the
hazards of large bank failures. Since the FDIC usually protects all
deposits. eliminating the insurance ceiling de ju,
as well as &
facto would remove the uncertainty that large depositors now face.
Such a policy would also eliminate the potential conflict between
the objectives of minimizing the destabilizing impact of a bank
failure and minimizing the cost to the deposit insurance fund.

10

ECONOMIC

REVIEW,

would be little
to look upon a

exhaustion
of the insurance
fund as a
If the concept of the “adequacy”
of the

utable to stabilization
policy from other causes.
Past losses and disbursements
have largely been
attributable
to the first three causes of failures.
From this experience
the accumulation
of funds
for insurance
purposes may have been excessive.
The argument
for increased
Government
support of the insurance fund is not needed, howeve:r,
to draw attention
to the facts that the present
fund is substantial,
has never been threatened
by
depletion,
and presently
has a potentially
urnlimited source of additional
funds.
The U. S.
Treasury
stands behind the FDIC
in case the
insurance
fund is threatened.
With a present
reserve
of approximately
$6.7 billion,
the Corporation also has what amounts to a blank check
It can draw another $3 billion
on the Treasury.
immediately
and after a short delay can obtain
any additional
amount if needed.
Although
527
insured banks have failed since the Agency was
established,
additional Treasury
funds have nev’er
been used.
Through
42 years of operation,
the
FDIC has incurred losses of $247 million, including estimated
losses on active
cases-approximately 3.7 percent of the present
fund.4
This
loss experience
suggests the Corporation
has prcotected the insurance fund in an extremely
capable
manner.
Minimization
of the loss to the insurance fund may interfere,
however, with the pri-

mary function
zation
shares

of deposit insurance-the

of the money supply-a
with the Federal Reserve

stabili-

responsibility
System.

it

FDIC and the Fed: A Common Bond
The Federal Reserve,
through the conduct of monetary
policy, attempts
to maintain the domestic money
supply at levels consistent
with the financial
health of the nation’s economy.
Through
its dis‘The trend toward large bank failures may have further implications for the adequacy of the insurance fund. however. If one of
the largest banks in the country were to fail, initial FDIC cash
outlays would likely exceed the present level of the fund.
This
would be the case even if liquidation of the bank’s assets held by
the Corporation resulted in a zero loss to the fund.
Under such
circumstances. Treasury assistance would presumably be required
in the interim.

SEPTEMBER/OCTOBER

1976

count mechanism
and as supervisor
of a large
number
of commercial
banks, the Fed has acknowledged
responsibility
to provide funds on a
secured basis to solvent but temporarily
illiquid
banks. The purpose of this “lender of last resort”
function is to insure the viability of banks experiencing
short-term
liquidity
problems-thereby
protecting
the public’s
confidence
in banking,
thus preventing
runs on bank deposits and destabilizing
impacts on the money supply. Deposit
insurance has a similar rationale.
By minimizing
the risk of deposit loss from bank failure, deposit
insurance
limits the potential
cost of holding
money in the form of deposits.
This discourages
the withdrawal
of deposits that, if widespread,
can cause a sharp reduction in the money supply.
The distinction
between a temporarily
illiquid
bank and an insolvent one provides the Federal
Reserve
a benchmark
with regard to which the
decision to employ its lending function may be
made.
Our system of bank supervision
and review usually provides the regulatory
authorities
with the information
necessary
to pass on the
financial
conditions
of individual
banks.
Once
it is determined that a bank cannot remain viable,
the problem of how its operations
and liabilities
should best be handled arises.
The FDIC
disposes of those necessary failures in a manner that,
while in the public’s best interest,
gives masimum support to the circulating
medium.

regulatory
process in banking has been initiated
by Congress
and will, undoubtedly,
receive further attention
in future years.
Public confidence-the
very foundation
of the
banking system’s existence-is
based, fortunately,
on more than just the banking agencies’ capacity
to “bail out” banks in trouble.
For in some cases,
whether
because of fraudulent
actions by bank
officials
or the inability
of regulators
to correct
management deficiencies, banks ynust be allowed to
fail.
Public confidence in the banking industry is
based on the belief that banking authorities can
assure stability through a coordinated program of
regulation and supervision designed to limit bank
failures only to unavoidable cases and to efficient
disposition of fhose banks that do faiZ.
Summary
Recent
experience
has revealed
extensive coordination
and cooperation
among Federal banking authorities
in the handling of failing
banks.
This is both encouraging
and crucial to
the effort to support the banking system.
This
interagency
cooperation
has made it possible for
banking authorities
to lend maximum support to
the nation’s money supply in those cases where a
bank failure cannot be avoided.
Adhering
to a
policy of minimizing
the shock waves to the rest
of the financial
community,
the FDIC
has recently shown a decided preference
for the deposit
assumption
method where statutory requirements
can be met. But what will happen if the method
that is in the public’s best interest
comes into
conflict with the constraint
that the assumption
route may only be used if it minimizes
the loss
to the Corporation’s
insurance
fund?
What
would have been the impact on the economy had
US;?;B
or Franklin
Xational
been placed in receivership and only the insured deposits paid off?
It is doubtful that the degree of confidence
in
the banking system would have remained as high
as it did had thousands of depositors lost millions
of dollars in uninsured
deposits.
Yet it is clear
what action the FDIC is required to take if such
a conflict
occurs.
The concern
for the effect
individual
failures
have on the insurance
fund
could, under current legal requirements,
eventually force the Corporation
to resort to a large deposit payoff that may damage the public’s trust
in banking and the regulatory
authorities’
ability
to support the nation’s
money supply.
If the
latter continues as the objective
of deposit insurance, a reevaluation
of insurance
legislation
appears necessary
to resolve the problems
raised
by large bank failures.

Regulatory
Review
There is a recognized
need
for bank examiners and analysts to keep up with
trends and innovations
within the banking industry.
The banking agencies’ capabilities
in meeting their examining responsibilities
are dependent
on obtaining
enough information
to reveal the
true condition
of each bank.
This places great
importance
on the
supervisors’
investigative
skills.
Regulators
have expressed
a need for
greater attention to the safeguards to bank soundness and stability.
This concern joins the continuing
goals of promotion
of competition
in
banking and adaptation of the banking system to
meet changing
needs for credit as the focus of
regulation.
The Federal
banking
agencies,
charged
with
supervising
the country’s commercial banks, have
acknowledged
that current
esamination
procedures may be inadequate
to the task of dealing
with the sophisticated
policies of today’s banks.
A move toward continuous
monitoring
rather
than single examinations
is, therefore, underway.
In addition,
an estensive
review of the entire
FEDERAL

RESERVE

BANK

OF

RICHMOND

11

References

1. Cagan, Phillip. The Demand for Currency Relative
to the Total Money Supply.
Occasional Paper 62,
National Bureau of Economic Research, 1958.
Milton and Anna J. Schwartz.
2. Friedman,
Monetary History of the United States, 1867-196$
Princeton : National Bureau of Economic Research,
1963.
“The Deposit Insurance Legis3. Golembe, Carter.
lation of 1933.”
Political Science Quarterly, Vol.
LXXXV
No. 2 (June 1960), 194.
“Failures of Large Banks: Impli4. Horvitz, Paul.
cations for Banking Supervision and Deposit Insurance.”
Journal of Financial and Quantitative
Analysis, Vol. X No. 4 (November 1975), 589-601.
5. Mayer, Thomas. “Should Large Banks Be Allowed
to Fail?”
Journal of Financial and Quantitative
Analysis, Vol. X No. 4 (November 1975), 603-10.
6. Report of the President’s Commission on Financial
Structure
and Regulation,
Washington,
D. C.:
Government Printing Office, 1971.
“Risk and
7. Scott, Kenneth and Thomas Mayer.
Regulation in Banking:
Some Proposals for Federal Deposit Insurance Reform.”
Stanford Law
Review, 23 (May 1971), 857-902.

12

ECONOMIC

REVIEW,

8.

U. S. Congress.
House.
Committee on Banking
and Currency.
Recent Bank Closings.
Hearings
before the Committee on Banking and Currency,
92d Cong., 1st sess., 1971.

Senate.
Committee on Banking
9. U. S. Congress.
and Currency.
S. Rept. 1269 To Accompany
S.
2822, Slst Cong., 2d sess., 1950.
10.

U. S. Congress.
Senate.
Committee on Banking
and Curreicy.
Nominations.
Hearings before i
subcommittee of the Committee on Banking and
Currency, 82d Cong., 1st sess., 1951.

11.

U. S. Congress.
Senate.
Committee on Government Operations.
Investigations
Znto Federallly
Hearings before the Permanent
Insured Banks.
Subcommittee
on Investigations
of the Committee
on Government Operations, 89th Cong., 1st sess.,
1965.

12.

Informal talk before the Arizona
Wille, Frank.
Bankers Convention, Phoenix, Arizona, October 11,
1974.

13.

“The FDIC and Franklin National
Wille, Frank.
Bank : a Report to the Congress and All FDIC
Insured Banks.”
Delivered at the 81st annual convention of the Savings Banks Association of New
York State.
Reprinted in the American Banker,
December 11, 1974.

SEPTEMBER/OCTOBER

1976

ER

DEFICITS, INFLATIO

D MONETARY

GRO

CAN THEY PREDICT INTEREST RATES?
William D. Jackson

cial markets-to
be determined
mand and supply curves.3

This article traces the short-run impact of fiscal
policy, inflation, monetary growth, and economic
activity
on interest rates.
Its theoretical
framework is a loanable funds theory of interest rate
determination,
which incorporates
both neoclassical and Keynesian
elements.
This framework
is
useful for analyzing the crowding out effect, real
versus
nominal
interest
rates, the relative
importance
of Ml, X2, and M3, and the inflationsavings
relationship
in a financial
markets
setting.
The implications
of this theory are tested
against
interest
rate movements
during recent
years.
The resulting equations may be useful to
investors in predicting the impact of fundamental
economic
changes
on interest
rates, an impact
that may not be evident in term structure
yield
curves.’

Investment
demand also responds to changes
in output.
If output rises, firms find it profitable
to invest in plant, equipment,
and inventories.
As output rises, the demand for residential
housing eventually
increases.
The investment
schedule in Figure ! would thus shift to the right when

LYield curves that relate short rates to long rates can shift dramatically over time.
For comparisons of the predictive ability of
economic and term structure interest rate mode%. see Michael E.
Echols and Jan W. Elliott, “Rational Expectations in a Disequilibrium Node1 of the Term Structure,” Am&can
Econonic
Review
(March 19X),
pp. 28-44: Martin Feldstein and Gary Chamberlain,
“Multimarket Expectations and the Rate of Interest,” downal of
Monez/, Credit
a%d Banking
(November
1973).
pp. S73-902: and
Lacy H. Hunt, “Alternative Econometric Models for the Yield on
Sgug?gn
Corporate Bonds,” Butiness Economics
(September
1973),
.
-.
(Homewood:
Prices
(New

FEDERAL

2 Several versions of loanable funds theories are described in Joseph
W. Canard. An Inzrodaction
to the T~GO~J of lntcrcst
(Berkeley:
Universiv
of CalZornia Press, 1959); Frederich A. Lutz, The
Theow
oi Interest
(Chicago: Aldine. 1969): and S. C. Tsiane.
“Liquid%- Preference and Loanable Funds Theories, Multiplier and
Velocity Analyses:
2
Synthesis,” Anzerican
Economic Review
fSeptember 1956). pp. 539-64. Less technical treatments appear in:
John A. Cochran, Xoxw, Banking
and the Economy
(New York:
Macmillan, 1967): Charles X. Henning et. al.
Financial
Markets
and the Econowzy (Enzlewood Cliffs: Prentice-Hall, 19’76); SIurras
E. P&&off
et. (II’. Fincmcial
Institutions
and Marketa
(Boston:
Mifflin, 1970): and John G. Ranlett, Monet
and Banking
(New
York: Wiley. 1969).

Irwin,
York:

RESERVE

by de-

The RCSUZX~‘ jor Loanable Funds
In the traditional theory, the demand for loanable funds was
for the purpose of financing
investment
in real
sector assets, such as commercial
and residential
construction,
inventories,
and plant and equipment. The demand for such investment
depends
upon the cost of capital, for which interest rates
of investment
serve as a proxy. The productivity
-its
rate of return-is
determined
by income,
technolo,gy,
and the existing
stock of capital.
The lower the cost of capital, the higher the net
return from investment:
its productivity
less its
interest
cost.
The same sort of relationship
applies
to household
investment
in residential
housing, which is largely financed by mortgage
borrotving.
The investment
schedule, the I line
in Figure
1, shows
that more investment
is
planned at lower interest rates.

Loanable
Funds Theory
Current loanable funds
theory builds on the foundation of an eighteenth
century doctrine that was concerned with savings
and investment
in a barter
economy
with no
governmental
sector.”
The modern inclusion of
government
finance, money, and inflation in the
analysis
allows “the .interest rate”-a
composite
of the spectrum of interest rates in related finan-

?&lark Blaw. Economic
Tkeow
in Retrospect
1968); Don Patinkin, Monczr, Interest,
and
Harper, 1965 ) .

directly

BANK

OF

RICHMOND

13

essentially
on current

irivestment demand, despite borrowing
account by certain governments.4

The demand for loanable
funds (LFD)
thus
consists
of the sum of FD and I, as shown in
Figure 1. (Consumer credit other than mortgages
is treated

as a deduction

from

savings.)

The Supply of Loanable Funds
The supply of
loanable funds is a rather complex sum of savings
by individuals
and businesses,
changes
in the
flow of credit extended by financial
institutions,
and variations
in the public’s
desire to hold
money.

real output rises, through
relationship.

the so-called

accelerator

The modern loanable funds theory recognizes
that government
deficit financing
also creates a
demand for loanable funds. Ma&ive government
spending
in recent years could not have been
funded entirely by taxes without creating
social
unrest and reducing
real output.
Governments
borrowed
in private
credit markets
to fill the
resulting gap.
Federal Government
demand for
funds is insensitive
to changes in interest
rates.
This interest-inelastic
demand for funds is shown
as the line FD in Figure 1. In a large-scale
model
of the economy, the FD demand for funds could
determined
by
income
be endogenous,
i.e.,
through
income taxes and by politically
determined Government
spending. In practice, Federal
planners specify a given deficit as a measure of
fiscal stimulus, making the deficit a largely predetermined
(exogenous)
policy tool.
In contrast,
funds raised by state and local
governments
largely
represent
capital
expenditures on education, highways, housing, and public
utility projects.
These
long-term
projects
resemble
business
capital
expenditures
in their
sensitivity
to interest rates.
For example,
state
and local interest
rate laws may prohibit
new
debt issues by these governments
at rates exceeding specified ceilings.
Their demand for funds is
14

ECONOMIC

REVIEW,

Savings
by individuals
respond positively
to
the reward for thrift at a given level of income:.
The higher
the interest
rate, the greater
the
amount of future consumption
that can be obtained by refraining
from present consumption.
Hence, the savings schedule S slopes upward in
Figure 2. The supply of savings schedule also
responds to changes
in income, shifting
to the
right as higher income allows consumers
and
businesses
to save more. This income effect may
be more important
that the interest
effect on
savings.
The traditional
theory of the supply of loan.able funds incorporates
changes
in the flow of
bank credit, which result from changes
in the
supply of money.
Newly created reserves (highpowered money)
flow through the banking system when the central bank engages in open market purchases
of Government
securities.
This
causes banks to possess more nonearning reserves
than they wish to retain and to use this liquidity
to purchase
financial
claims until their cash is
again in balance with their other desired portfolio
holdings.
The resulting increase in the supply of
loanable
funds is represented
by the horizontal.
distance Am in Figure 2.
Commercial
banks tend to increase their credit
output derived from the new reserves more when
interest
rates are high than they do when rates
are low.
Banks
decrease
their excess reserves
This
when the reward for lending increases.5

‘State and local governments as a grc.up generated a surplus of
$51.7 billion from 1969 through 1975. mainly through their pension
funds.
Over half the new municipal security issues from 1964
through 1974 funded the four types of capital expenditures cited.
(All statistics in this article are taken from Federal Reserve sources
such as Flow of Funds accounts
and Federal
Reserve
Bulletins.)
5 When earning asset returns are high enough, banks not only
practice this form of asset management but also increase the size
of their portfolios by borrowing nondeposit funds: certificates of
deposit, discounts and advances from the Federal Reserve, etc.
Funds borrowed at the discount window increase the money supply,
as well as bank credit.

SEPTEMBER/OCTOBER

1976

behavior increases
Am) curve relative

interest elasticity
to the S curve.

of the (S +

ing markedly
portant form

when
of the

these deposits
public’s wealth

are an imholding.?

The increased
supply of loanable
funds Am
may be derived in practice from changes in Ml,
M2, or M3. Ml, the sum of currency and demand

The supply of loanable funds also varies with
the public’s demand for money.
For example,
financial
innovations
such as credit cards lower

deposits,
is directly
responsive
to changes
in
monetary
policy.
M2, defined as Ml plus noncertificate
time and savings
deposits
at banks,
and M3, defined as M2 plus similar deposits at
nonbank financial institutions,
are more inclusive
measures of liquidity in the economy.6

the public’s demand for cash and demand deposits.
The supply of loanable funds increases
when the public desires to exchange Ml balances
for financial
claims.
Such an exchange
of Ml
for financial claims is known as dishoarding
and
results in a higher ratio of income to money, or
higher velocity, for the economy.
This increase
in the supply of credit is represented
by an increase in the horizontal
distance between S and
the total supply of loanable funds in Figure 2the distance DH.
(Below some low interest rate
level, such as R, in Figure 2, the public will
prefer additional liquidity rather than the inconvenience of low-yielding
financial claims and will
hoard.) *
The sum of savings
S, changes
in

These monetary
aggregates
are important
determinants
of the supply of credit funds to mortgage and other longer-term
borrowers
by financial institutions.
Increased
savings and/or shifts
from the public’s desired Ml balances
into insured earning assets result in increases
in consumer time and savings deposits (part of M2 or
M3), which are quickly supplied to credit markets
by financial
institutions
after
provision
for
(rather low) required reserves.

credit flows Am, and net dishoarding
DH defines
the total supply of loanable
funds-the
LFS
curve in Figure 2.

The increased supply of loanable funds Am is a
multiple of any increase in reserves through the
well-known
credit multiplier.
The size of this
multiplier
is sensitive
to changes in the public’s
desire to hold time and savings deposits, increas-

Interest Rate Determination As in other markets,
the price of loanable funds is determined
by the
intersection
of supply and demand.
With income held constant, the market for loanable funds
may be represented
in Figure 3 by LFD, the demand ; LFS, the supply ; and Rf, the equilibrium
price or interest rate.
The quantity of loanable
funds offered and accepted is Qf.

e See Alfred Broaddus, “Aggregating
the Monetary Aggregates:
Concepts and Issues,” Economic Review. Federal Reserve Bank of
Richmond, (November/December 1975), pp. 3-12.

Y Changes in credit can be several times the amount of the change
in high-powered money. One version of the potential credit expansion multiplier is defined “if the public holds demand deposits,
currency. and [time and savings deposits] in the proportions 1:c:t
. . . the combined acquisition of credit instruments by banks and
intermediaries” would be:

1+c+t
rd

+ c +

(rt + rdrs)t

X

where X is excess reserves available to support credit expansion,
rd is the reserve requirement for demand deposits. rt is the reserve
requirement for time and savings deposits held at the central bank.
and r is the subjective “reserve requirement” for intermediary

DH

deposiis held in demand deposits of commercial banks. The larger
the proportion of time and savings deposits, particularly those of
nonbank intermediaries, that the public desires to hold, the larger
the potential multiplier. Warren L. Smith, “Financial Intermediaries
and Monetary Controls,” Qwwterly
Journal of Economics (November
1959). pp. 533-53.

I

>

’

Loonable

FEDERAL

BThe treatment of net dishoarding as an addition to the supply of
loanable funds is based on the increase in the velocity of Ml shown
later. Dennis H. Robertson, “Mr. Keynes and the Rate of Interest,”
in Readings
in the Theory of Income Distribution,
ed. by William
Fellner and Bernard F. Haley (Philadelphia: Blakiston, 1946).
High velocity, one consequence of high interest rates, dampens
them in the next time period. See John Kraft and Arthur Kraft,
“Income Velocity and Interest Rates.” Journal
of Money,
Credit
and Banking
(February 1976). pp. 123-5.

Funds

RESERVE

BANK

OF

RICHMOND

15

I

The

Crowding

framework

Out Effect

The

loanable

is well suited to the analysis

funds

of crowd-

ing out. This concept refers to the displacement
of private borrowings
by Federal
deficit financing. Repeating
the previous schedules in Figure
4, at the rate Rf Federal deficit financing
at the
level FD and private investment
financing at the
Suppose that the Federal deficit
level I1 occur.
increases to FD’. The demand for loanable funds
shifts rightward
to LFD’ by the increase in the
deficit.
If the supply of loanable funds schedule
remains constant, the interest rate increases from
Rt to Rz. The Federal sector borrows FD’ despite

creased to 02; the larger deficit then displaced
(92 - Q) -(FD’ - FD) = (I1 - 1~) of private

sector

funds.

In any

case,

the

rise

in interest

rates is one indicator
of the resulting
pressures
on private capital expenditures.
If the deficit is successful
in raising
income
during a depression,
investment
spending
may
not be excessively
depressed.
But when income
rises, this rightward
shift in LFD reinforces
the
Investment
will be damprise in interest rates.
ened over time.
An additional effect of deficit financing on the
state of investor
confidence
that influences
the

the higher interest rate structure.
But the higher
rate Rz depresses business investment.
If income

position of the I curve has been hypothesized.
For example, in one Keynesian
model,

and the state of investor confidence
remain unchanged,
investment
capital funds decline from
11 to 12.

under conditions of a budget deficit there exists
;A’ inverse relationship between investment and

The fall in investment
will not usually equal
the rise in Federal borrowings.
The extent of the
crowding out depends on the elasticity
and position of the I curve.
If investment
is highly interest
elastic,
capital
espenditures
will decline
markedly.
If investment
is fairly insensitive
to
interest rates, most planned capital expenditures
will continue to be made. In the example of Figure 4, private capital funds declined by less than
the increase
in deficit financing.
At the higher
rate Rz the total supply of loanable
funds in-

[the change in Government bonds].
, . . [the]
appearance of public hostility and fear of deficit
spending
(adverse expectations)
can, in theory,
profoundly interfere with the stimulative eaiy;.
of the fiscal action causing the deficit.
extreme, a perverse result, i.e., a negative spendings multiplier . . . might even be obtained.9

Inflation
While the above analysis
assumed a
noninfIationary
economy,
the
loanable
funds
framework
is well suited to the analysis of inflation and financial markets.
Inflation
erodes th.e
purchasing
power of Ioanable funds.
?Vhen th:is
loss of purchasing
power is subtracted
from th.e
nominal rate, the real rate of interest is obtained.
This real rate equals the nominal rate only when
prices remain constant.
If, for esample, the interest rate is 7% w-hen the price level is rising
steadily at 4%, the real rate is 3%.
Most loanable funds theorists, following Irving
Fisher, assume that borrowers
and lenders reac:t
Borrowsymmetrically
to anticipated
inflation.
ers recognize
that they will repay their debts i,n
The productivity
of investmen.t
cheaper dollars.
in nominal terms rises by exactly the anticipate’d
rate of inflation.
Similarly,
lenders
recognize
that they will receive
debt repayments
in less
valuable
dollars.
Their real reward for saving
declines
by the anticipated
rate of inflation.
Under these assumptions,
the demand for funds
would shift upward to the right by the expected
rate of inflation, while the supply of funds would
shift upward to the left by the same amount.
The
nominal rate of interest would rise by exactly the
Neither the real
amount of expected
inflation.
rate nor

with

the quantity

inflation.

This

of credit

flows

hypothetical

would

var:?

situation

2 Richard J. Cebula, “Deficit Spending, Expectations, and Fiscd
Policy Effectiveness,” Public Finance (19X3), pp. 365-6.

16

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1976

i.s

repayment
will be in cheaper
dollars, but also
because the productivity
of new capital rises.l’
The total demand for loanable funds may not
increase by the full extent of the anticipated
inflation, however.
Some users of capital find that
their borrowing
capacity cannot keep pace with
the total cost of capital investment.
These users,
such as price-regulated
utilities,
many potential
home buyers, and some state and local governments, may find that they are priced out of the
They are very sensitive
to the
capital market.
nominal rate of interest,
as well as to the nonMoreover,
interest
cost of capital investment.
Federal deficit financing should not be stimulated
by inflation in the short run.
LFD thus shifts
upward by an amount less than the inflation.
In
Figure
5, the demand for loanable
funds will
shift to a position such as LFD”
if a rate of
inflation 7~is anticipated based on actual inflation.
Borrowers
as a group would pay Ri to obtain the
pre-inflation
quantity of funds Qf.
Inflation
also affects
the supply of loanable
funds, but not in the manner prescribed
by Fisherian loanable funds theory.
As discussed earlier,
illustrated
in Figure 3.*O The LFD”
and LFS”
curves fully embody the rate of inflation rr (R,
Th e quantity of loanable funds flowminus R,).
ing through credit markets remains Qi.

u The demand for external finance will increase even when persistent inflation lowers the return on existing capital investment. John
Lintner, “Inflation and Common Stock Prices in a Cyclical Context.”
in Anmud Report.
(New York: National Bureau of Economic Research, 1973). pp. 23-36: and Lintner. “Inflation and Security
Returns,” Jownd
of Finance (May 1975). pp. 25940.

The true relation between inflation,
the nominal rate, and the real rate is, however,
more
complex than in the above scenario.
Both nominal and real rates are affected by asymmetrical
inflation-induced
shifts in LFD and LFS.
Inflation stimulates
LFD, as is well known.
It
enhances
the nominal
dollar returns
available
from current investment.
Future output can be
sold at higher dollar prices.
Moreover,
physical
investments
made today should be less costly
than those made in the future, when their prices
are expected
to be higher.
The probability
of
capital gains from selling capital assets then rises.
Inflation
also raises expected wages.
Employees demand protection
of their standard of living
through higher nominal wages.
Minimum wage
levels are raised in response to the inflation, reinforcing the rise in labor costs by setting everhigher floors underneath wages.
Employers
then
attempt to substitute
capital for labor.
The investment demand curve increases under inflationary conditions,
not only because
expected
debt
lo Donald J. Mullineaux, “Inflation Insurance: An Escalator Clause
for Securities,” Business Review,
Federal Reserve Bank of Philadelphia, (October 19’72). pp. 11-12.

FEDERAL

RESERVE

BANK

OF

RICHMOND

17

that theory would have LFS shift upward to the
left in response to inflation.
As will be shown
however,
the supply of Ioanable funds actually
shifts to the right in response to inflation.
While
this reaction may not occur in a hyperinflationary
it has occurred
in recent
American
economy,
esperience.
Clearly,
inflation
reduces the expected
future
value of present cash holdings.
W~ealth holders
attempt to reduce their Ml balances when inflation “taxes” the value of their money holdings.
This dishoarding
increases
the supply of funds
available
to purchase
interest-bearing
financial
assets that are partially
protected
against inflation by nominal interest payments.12
LFS shifts
to the right by the distance
DH” in Figure
5.
The partial supply of loanable funds curve (LFS
+ DH”) increases
more rapidly as higher inflation is expected to deplete the value of Ml.
Moreover,
of expected

inflation
increases
future real income

the uncertainty
Most
streams.

people feel that a high rate of actual inflation,
particularly
if it exceeds a “normal” rate of inflation, indicates that their future expenses will increase more rapidly than their future incomes.
This feeling
is particularly
rational
when (1)
is imported
from
abroad
cost-push
inflation
through
cartelized
commodities
or devaluations
and (2) inflation
shifts individuals
into higher
income tax brackets and raises other taxes.
Most
individuals
feel that they cannot raise their income to match these uncontrollable
increases
in
Furthermore,
the probability
the cost of living.
of complete
income compensation
for inflation
decreases as the rate of inflation increases.
Even
;j the prospect of higher real income appears as
likely as the prospect of lower real income during
inflations,
the resulting
increased variance of expectations
of real earnings
decreases
the confidence with which most people view the future.
To hedge against. this uncertain
future,
lessconfident consumers increase their rate of current
saving.13
Contrarv d to the conventional
wisdom,
r”Dean S. Dutton, “The Demand for Money and the Expected Rate
of Xmwy,
Credit and Banking (Noof Price Change,” Jounal
vember 19X),
pp. 861-V: Robert A. Mundell, “A Fallacy in the
Interpretation of Macroeconomic Equilibrium,” .Jounal
of Politicd
Economy
(February 19651, pp. 61-6: Mundell, “Inflation and Real
Interest,” Journal
oj Political Econom?~ (June 1963), pp. ‘230-3:
Lester D. Taylor, “Price Expectations and Households’ Demand for
Financial Assets.”
Ezpbmtions
in Economic
Research
(Fall 1974).
pp. 268399.
I3 F.

Thomas Juster and Paul Wachtel, “Inflation and the ConBrookinos
Paper.s on Ecmwmic
Activity
(No. 1. 1972). pp.
71-121; Hayne E. Leland, “Saving and Uncertainty:
The PreJovmal
oj Economics
cautionary Demand for Saving.” Quarterly
(August 1968). pp. 466-73: Agnar Sandmo, “The Effect of Uncertainty on Saving Decisions.” Review
of Economic
Studies
(July
19’iO). pp. 353-60.
sumer.”

18

ECONOMIC

REVIEW,

consumers

then

save by reducing

their

spending

on purchases of durable goods-automobiles
and
household furniture
and fixtures.lJ
If the inflation is unanticipated,
consumers may even reduce
their expenditures
on nondurable
goods and services to increase their savings.
In addition, the desire of most individuals
to
protect the capitalized value of their earning asset
holdings stimulates
saving behavior when interest rates rise during inflationary
periods.
The
real value of portfolio earning assets declines in
inflationary
periods, not only because the earnings expected
from capital are received
in depreciated
dollars, but also because
the rate of
discounting
of this earnings stream-the
“pure”
rate of interest
plus a premium
for assuminlg
financial
risk-also
rises.l”
This wealth effect,
which dampens consumption
and stimulates
saving, is not balanced
out by net debtors feeling
wealthier in real terms during an inflation.
Mos#t
debt is owed by businesses
and governments,
whose real wealth position does not directly enter
into most individuals’
evaluation of their personal
portfolio positions.
Finally,
inflation
does not directly
diminis‘h
the very large supply of funds that institutiona.
The purinvestors
provide to credit markets.
chasing
power of money is not an important
factor in the investment
decisions
of bank and
nonbank
institutions
whose liabilities
are mea.sured in dollars. They seek the highest “prudent”
nominal rate of return from their financial assets
once the size of their portfolios
is determined.16
A large
this form

body of empirical
of saving behavior

evidence
confirms
in the -4merican

I4 The large expenditures on consumer durable goods in 1972-73
stemmed partly from the artificial restraint on their prices dictated
by price controls. These prices were expected to rise rapidly when
controls would be removed.
‘j Financial wealth can be defined as:
WA+?+?

r

P

where W is wealth, M is the quantity of money, B is the quantity of
bonds expressed in terms eq;livalent to perpetual bonds with a
31 coupon, r is the current market interest rate, E is the expected
earninns stream from real capital, and P is the market-determined
rate of discount for profits.
Deflating all terms by the price level
defines “real” financial wealth. Joseph R. Bisiqnano, “The Effect
of Inflation on Savings Behavior,” Economic
Review,
Federal Reserve Bank of San Francisco, (December 1976), p. 21.
It can be shown that when inflation raises the nominal rate of
discount r for riskless bonds, it increases the nominal rate of
discount P for risky financial investments to an even greater
extent.
The prices of equities fall with the resulting increase in perceived
financial risk, as well as with the increase in required return du,@
to higher interest rates.
lsLintner, Thomas Piper, and Peter Fortune, “Investment Policies
of Major Financial Institutions Under Inflationary Conditions,” in
National Bureau of Economic Research, op. tit., p. 98.

SEPTEMBER/OCTOBER

1976

economy
during
recent
inflations.17
Inflation
shifts the savings schedule (given income) by a
distance S” in Figure 5 ; inflation does not decrease
it.
The suppIy of IoanabIe funds schedule
increases
from LFS
to LFS”
(LFS
+ DH” +
S”) in an inflationary
climate typical of recent
experience.

positively
with income Y and anticipated
inflation rr.ig The Federal deficit FD is assumed to
be exogenous.
The supply of loanable funds is:

Under these conditions
the demand for funds
exceeds the supply of funds at the no-inflation
interest
rate Ri.
With this excess demand for
credit, the nominal rate of interest
rises to R,.

where savings vary positively
with the real rate,
income, and anticipated
inflation.
Changes
in
credit Am based on changes in money are treated
as exogenous
in the short run. The inclusion of

(2)

the dishoarding

I +

where the investment
inversely
with interest

FD

=

I(r,

Y, rr) +

=

S(r,Y,n)

term

is discussed
interest

later

(p. 21).

rate, subtract

(1) and collect terms.
shows the determi-

A number of previous studies of the determinants of rates were reviewed before completely
specifying
the equations
to test the loanable
funds theory. 2o The results of these studies are
generally
consistent
with the loanable
funds
framework,
but they contain enough contradictory findings to warrant a new investigation.

FD

1s Smithy ‘Monetary Theories of the Rate of Interest: A Dynamic
Synthesis,” Review
of Economics
and Statistics (February 1958).
pp. 15-21; Tsiang, Zoc. cit.
20Leonall C. Andersen and Keith M. Carlson, “An Econometric
Analysis of the Relation of Monetary Variables to the Behavior of
of Price DeterPrices and Unemployment,” in The Econometrics
mination, ed. by Otto Eckstein (Washington: Board of Governors of
the Federal Reserve System, 1972). PP. 166-83; J. A. Cacy. “Budget
Review, Federal Reserve
Deficits and the Money Supply,” Monthly
Bank of Kansas City, (June 19751, PP. 3-9; G. Marc Choate and
Stephen II. Archer, “Irving Fisher, Inflation. and the Nominal
Rate of Interest,” Journal
of Financicrl and Quantitative
Analysis
(November 1975). pp. 675-85; Donald M. DePamphilis. “Long-term
Interest Rates and the Anticipated Rate of Inflation,” Business
Economics
(May 1975), pp. 11-18; Echols and Elliott, ZOO. cit.;
Fddstein and Chamberlain, ZOC. cit.: Feldstein and Eckstein. “The
Fundamental Determinants of the Interest Rate,” Review of Economics and Statistics (November 1970). pp. 363-75: William E.
EcoGibson, “Interest Rates and Monetary Policy“ in Monetary
no&es, ed. by Gibson and George G. Kaufman (New York: McGrawHi& 1971). pp. 311-29; Gibson. “Price-Expectations Effects on
Interest Rates,”
in Gibson and Kaufman,
Ibid.,
pp. 339-51;
Gibson and Kaufman. “The Sensitivity of Interest Rates to Changes
in Money and Income,” Journal
of Political
Economy
(June 1968),
pp. 472-8; Stephen M. GoIdfeId, Commercial
Bank Behavior
and
Economic
Activity
(Amsterdam: North-Holland, 1966) : Michael 3.
Hamburger and William L. Silber, “An Empirical Study of Interest
Rate Determination,” Review
of Economics and Statistics
(August
1969), PP. 369-81; Hunt, Zoc. cit.; Thomas J. Sargent, “Commodity
Price Expectations and the Interest Rate.” in Gibson and Kaufman,
op. cit.. pp. 330-S; Robert H. Scott, “Liquidity and the Term Structure of Interest Rates.” Quarterly
Journal
of Economics
(February
1965). pp. 135-45: Silber. Portfolio
Behavio+ of Financial
Institutions
(New York: Holt, 1972): and Yohe and Karnosky. Zoc. tit.

Ii The saving rate is significantly related to measured uncertainty
in the economy. For example. from 1962 I through 1975 II, personal
savings/disposable personal income was correlated -0.68 with the
Survey Research Center Index of Consumer Sentiment. This Index
was correlated -0.79 with the rate of inflation.
Correspondingly,
the personal saving rate was correlated 0.54 with the annualiaed
rate of change in the Consumer Price Index over this period.
More extensive confirmation of these relationships is provided by:
Susan W. Burch and Diane Werneke, “The Stock of Consumer
Durables, Inflation and Personal Saving Decisions,” Review of
Economics
and Statistics
(May 1975), PP. 141-54: Saul II. Humans.
“Consumer Durable Spending: Explanation and Prediction,” Bsookings Papers on Economic
Activity
(No. 2! 1970). pp. 173-99; Juster
and Taylor, “Towards a Theory of Savings Behavior,” American
fk’n;?
Revrew
(May 1975). PP. .203-24: Juster and Wachtel,
’ . George Katona. Psychologzcal
Economics
(New
York:
Elseviery 1975) : William Poole, “The Role of Interest Rates and
Inflation in the Consumption Function,” Bmokings
Papers
on
Economic
Activity
(No. 1, 1972), PP. 211-20; Burkhard Strumpel
et. al.. teds.), Human
Behavior
in Economic
Affairs
(San Francisco : Jossey-Bass, 1972 ) ; Taylor, “Price Expectations:” and Taylor,
“Saving Out of Different Types of Income,” Brookings
Papers
on
Economic Activity (No. 2, 1971). pp. 383-415.
1sWilliam P. Yohe and Dennis S. Karnosky, “Interest Rates and
Price Level Changes, 1952-69.” Review, Federal Reserve Bank of
St. Louis, (December 1969), pp. 18-38; A. John Steigmann, “On
Inflation and Interest Rates,” Business
Economics
(May 1975). pp.
72-3.

RESERVE

DH

Nominal and real rates increase when the Federal Government
runs a deficit and when the
Nominal and real interest
money supply falls.
rates rise when real output increases if the incomeinduced investment
exceeds the income-induced
Nominal interest rates rise during inflasaving.
tionary periods if investment
demand rises more
than the supply
of savings
plus dishoarded
money.
Finally,
the theory
developed
above
postulates
that real rates fall during inflations.

demand for funds varies
rate r-a
real rate-and

FEDERAL

Am +

equation (2) from equation
The resulting
relationship
nants of interest rates.

Loanable
Funds Theory and Predicting
Interest
Rates
The loanable funds theory can be stated
in equation form. The demand for loanable funds
is :
=

S +

To solve for the nominal

Inflation
stimulates
financial
flows : loanable
funds flowing through financial markets rise from
Qf to Qg in Figure 5. The greater flows of funds
are associated
with an incomplete
adjustment
of
the nominal interest rate to inflation.
The dishoarding and saving adjustments
to inflation, increases in the supply of credit by financial institutions, and the inability
of some borrowers
to
adapt to inflation prevent the full adjustment
of
LFD and LFS to experienced
infIation in a period less than the very long run. Only then could
all desired income and portfolio adjustments
to
presumably
fully anticipated
inflation
be made.

LFD

=

+=+DH

But Rs is less than Rf plus the inflation rate V;
the real rate of interest
clearly declines.
This
lower real rate increases desired investment
along
LFD”.18

(1)

LFS

BANK

OF

RICHMOND

19

Interest Rate Equations
The empirical findings
of previous studies and the loanable funds theory

Which Monetary Aggregate
Influences
Interest
Rates?
There has been much discussion in recent

outlined
nominal

years concerning
the proper definition of money.
Of the various aggregates
suggested, the riskless
and highly liquid Ml, M2, or 313 seems appropri-

(3)

above suggest equations
for estimating
interest rates of the form:
RATEt
I,

=

The

time

+

11

2 ciFDt-i
i=O

where the following
pated :
COY

cos

>

+

+

bYt-1

n
$ di6t-i
i=O

coefficient

0, a<O,

subscript

a&

b>O,

t refers

values

Sci>O,

are antici-

Sdi>O.

to monthly

observa-

tions.
RATE
is the nominal rate. The constant
term COS captures the effects of any influences
that are not explicitly
considered,
such as a tendent>- for rates to assume some “normal”
level.
gron-th of money ,ir is
The annualized
rate of
the foundation upon which resulting larger credit
changes Am are based.
The lagged unemployment rate serves as an inverse proxy for the level
of real output Y. This closely watched coincident
indicator reflects excess demand in the labor and
It reflects
the difference
beproduct markets.
tween actual output and capacity
output.“l
It
is also associated
with the state of investor confidence in the economy.”
Moreover,
since it is
not defined in monetary
units, it should not be
subject
to inflationary
distortions
of measurement.
Unlike personal
income, which includes
transfer
payments
and which tends to increase
despite industrial fluctuations,
the unemployment
rate should reflect variations
in real GYP, which
is not available
on a monthly basis.
The esogenous Federal deficit FD should affect the economy
the annualized
rate of
I\-ith a I;L~. Similarly.
markets
price change I? should affect financial
These
lags arc based on
over a long period.
investor
reactions
to trends
in these
volatile
series, reflecting
delayed incorporation
of information into expectations.
The necessity
of incorporating
a dishoarding
term into equation (3)
requires a slight digression
on the definition
of
money.

ate in the loanable funds model. Broader aggregates incorporate
credit instruments
themselves,
which are subject to risk of default if less than
AAA quality and which are subject
to capital
loss of varying extent if interest rates rise. These
securities
are generally
either illiquid
(U. S.
savings bonds) or beyond the reach of most ind.ividuals (commercial
paper, Treasury
bills).
Any
of these three behaviorally
appropriate
aggregates could be used as the money variable in this
model.
The question
is, which one of these
measures influences
interest rates most strongly.
One answer to this question emerges from the
relationship
between changes in these aggregates
and credit flows.
X’ew Ml, flowing through the
banking system, was 8.2 percent of total funds
advanced
in credit markets
from January
1967
through December
1975. The more rapidly growing new M2 was 23.6 percent
of these funds.
And
explosively
growing
new
313, flowing
through nonbank depository
institutions
as well
as through banks, accounted
for 40.7 percent of
the credit market funds advanced in this period.
This evidence suggests that growth in M3 is more
closely related to the change in the supply of
credit than growth in Ml or M2.‘”
A second answer emerges from the velocity of
these monetary
aggregates.
Dishoarding
of Ml
has occurred in recent years. The income velocity
of Ml increased
secularly
from 4.3 in the fourth
quarter of 1965 to 5.3 in the fourth quarter of
1975.
The income velocity of 312, however, re:mained remarkably
constant
during this period.
It was 2.4 in the fourth quarter of 1966 and 2.4
in the fourth quarter of 1975.
The income velocity of X3 \-aried slightly around its beginning
and ending value of 1.5 during this period.

27Throufih Okun’s Law. “the unemployment rate can be viewed as a
pro.=- variable for all the ways in which output is affected by idle
resources.” Arthur M. Okun, “Potential GSP: Its Measurement and
Significance,” Procacdin.os
of the Business
and Economic
Stetistics
Section. American Statistical Association (1962). p. 99. Andersen
and Carlson. Zoc. cit.; Gary Smith, “Okun’s Law Revisited,” Qwzrterly Revieau oi Economics
and Business (Winter 19X), pp. 37-S.

Inflation,
institutional
factors such as changes
in the payments
mechanism,
and increasing
activity by nonbank financial institutions
have evidently lessened the traditional
role of Ml.
This
shift away from desired holdings of Ml, particularly from currency, into interest-bearing
dep0sit.s
stimulates
the supply of loanable funcls through
reduced reserve
ratios and the correspondingly
higher potential
loan/deposit
ratios.
Many sav-

ZIt is highly related to the Index of Consumer Sentiment, for
example. See the references in footnote 17, and Dwight M. Jaffee,
“Cyclical Variations in the Risk Structure of Interest Rates,”
Journal
of Monetar?J Economics
(1975),
pp. 309-25.

‘3The calculations in this and the following paraaraph are based
on Flow oi Funds data. See footnote 4 for references.

20

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1976

ings and loan associations have loan/deposit
greater than unity, for example.24

ratios

The considerations
that money should behave
as a medium of exchange
for goods and services
with a fairly constant velocity and that it should
serve as a store of real purchasing power (at least
partly protected against inflation by interest payments),
suggest that the growth of M2 and M3
may serve as better indicators
of liquidity than
the growth of Ml.
Essentially
zero dishoarding
of M2 and M3, as indicated by their stable velocity in recent years, correspondingly
suggests
that the DH term is not required
in empirical
interest rate equations.
Methodology
The extent to which the basic economic
influences
of income,
inflation,
deficit
spending, and changing credit flows influence interest rates may vary with the quality and term
to maturity of various securities.
To what extent
do the short- and long-term,
new issue or seasoned, taxable and tax-free, and risky and riskless
characteristics
of securities
alter the response of
their interest rates to fundamental
economic factors?
To study these questions, equations of the
form (3) were estimated
for the following rates:
the 3-month
new
issue
Treasury
bill
rate,
Moody’s 3-5 year U. S. Government
securities
rate, Moody’s
Industrial
A seasoned
long-term
bond rate, Moody’s new issue Municipal A rate,
and the long-term
-Government
bond rate reported by the Federal Reserve.
The equations are estimated on a monthly basis
from December
1966 through
December
1975.
Since the analysis
is concerned
with short-run
interest
rate responses
to economic
factors, the
maximum
time lag is limited to twelve months.
Economic Interactions:
The Fed’s Dilemma
Interactions
among fiscal policy, inflation,
money,
and unemployment
over longer periods reduce the
ability of single-equation
models to identify causality. In particular,
financing the Federal deficit
involves the indirect purchase
(“monetization”)
of part of the resulting
Federal debt by the central bank.
This causes the money stock to rise.
The resulting excess supply of money may create
later excess demand in the commodity market, as
well as current excess demand in the credit market, and Iead to subsequent
inflation.
The monex See footnote ‘7 and the other loanable funds credit multipliers
shown in Smith, “Financial Intermediaries.” A shift from currency
into nonbank deposits could increase loanable funds bu almost four
times the amount of the shift in Smith’s analysis.

tary authority
thus faces a cruel dilemma when
extensive
deficit financing
occurs.
Should the
money
decline

supply increase
enough to cushion
the
in investment
in the current
period, it

may generate inflation later. If monetary growth
is large enough to hold down current
nominal
interest rates despite the deficit financing,
it may
raise inflationary
expectations
and interest rates
in the future.
If money does not increase enough
to allow most planned investment
to be made,
future productive capacity will be markedly lower
than it would have been without the deficit.
This
condition
of lower-than-otherwise
output
may
result in shortages and future inflation.
Interest
rates may then rise to high levels unless the
demand for goods and services falls.
Interest Rate Equations
The estimated relationships of interest rates to Federal deficits, inflation, monetary
growth, and unemployment
are
reported in Appendix Tables I and II. Appendix
A discusses their technical aspects in detail.
For
the general reader, the empirical
results may be
summarized
briefly.
While the equations
estimate nominal rates, realized real rates may be
implied from the Iabb
=ed coefficients
on the inflation rate.
If yearly inflation terms are less than
unity, ex post real rates tend to decline.
Chart
1 illustrates
interest rate equations
in the sample period.

the effectiveness
of the
in matching actual events

In the chart actual rates
appear as solid lines, and rates predicted ex post
appear as dashed lines.
These equations explain
92 to 99 percent of the variation in interest rates
over the period.
(The predicted rates tend to lag
very slightly
behind actual rates, as would be
expected
from their use of lagged predictors.)
The predicted rates exhibit no secular tendency
to over or underpredict
actual rates.
In general, Federal
deficit spending increases
interest
rates with a four- to six-month
lag.
These deficits generally continue to drive up both
Federal and private borrowing
costs throughout
the remainder of a twelve-month
period.
The resulting
interest
rate pressure
is larger,
more significant,
and more prolonged
for the
Industrial
A and Municipal A rates than it is for
the similar maturity long-term
Government
bond
rate. Risk-averse
investors in the long-term bond
market evidently require a larger “risk premium”
on medium-grade
private securities
when deficit
spending reduces their state of confidence.
This
rise in interest rates restricts
the effectiveness
of

FEDERAL RESERVE BANK OF RICHMOND

21

the deficit

in raising

income.“”

This evidence

ports the view that crowding out, measured
directly
through interest
rates, has occurred
some extent in our economy in recent years.

su’pinto

Inflation
stimulates
nominal rates very significantly,
with both current
period
and lagged
effects.
The Treasury
bill rate, for examplet
reacts strongly
to inflation : approximately
half
of the impact of a sustained rate of inflation
pears in this rate over a ten-month
period.
cent inflation encourages
inventory
building,

apRere-

sulting
in heavy demand for bank loans and
commercial
paper. This puts upward pressure on
all short-term
rates, including
the Treasury
bill
Longer-term
rates, however,
adapt less
rate.
strongly to inflation.
The 3-5 year Treasury note,
Industrial
A, and Municipal A rates embody less
than one-quarter
of realized inflation rates within
When inflation occurs, the Industrial
A
a year.
rate reacts very rapidly, while the I-7. S. 3-5 year
security rate reacts more slowly, and the Municipal A rate generally
takes still longer to respond.
The
long-term
Government
rate
incorporates
only about one-eighth
of the actual inflation rate
during a twelve-month
period.
These
findings
are consistent
with the infiation-induced
shifts in the supply and demand
curves of the loanable funds theory above.
Real
rates fall when the price level increases
rapidly,
although to a different extent for each rate. Th.e
length of the period of past inflation
that realasset investors use to anticipate
inflation over the
period of their borrowing
should be positively
related to the length of the borrowing
contract.
Increasing
the rate of monetary growth lowers
interest rates.
But the effects of varying growth
rates of money are erratic
or insignificant
in
equations
that examine
them for lagged time
periods.“0
Growth in AI.3 lowers rates more than
In turn, growth in Ml lowers
growth in M2.
rates to a still lesser extent, sometimes
not significantly.
Monetary
growth is more imp0rtan.t
for shorter rates than for longer ones. Appendix
B examines these liquidity effects in more detail.
Realized
income has the influence
on interes,t
rates that theory suggests.
High unemploymenr,
typifying weak private sector excess demand (investment
minus savings)
for credit, lowers ail
2s Carlson and Roger W. Spencer, “Crowding Out and Its Critics.”
Review,
Federal Reserve Bank of St. Louis, (December 19%). PP.
2-11: Spencer and Yohe, “ The Crowding Out of Private Expenditures by Fiscal Policy Actions,” Rsthto, Federal Reserve Bank of St.
Louis. (October 1970), pp. 12-24.
2s Similar results appear in Gibson, “Interest Rates and Xonetar~
Policy,” lot. cit.

22

ECONOMIC REVIEW, SEPTEM5ER/OCTOBER 1976

five interest rates. *’
affect
shorter-period
period

Current
rates

exemption

business conditions
more than longer-

determinant

ones.

Finally,

for municipal

of this difference

The longer-term
the

constant

terms

incorporate

the

atory

effects
of other factors
that are not explicitly
considered.
For example,
the constant
in the
Municipal A rate equation is more than 100 basis
points below the constant
in the similar quality
Industrial
A rate equation.
The income
tax

year

Appendix Tables I and II present
ing equations
for the five interest

equations

ment,

Bill
Rote

I

I

results,
and

a useful

specifica-

economic

forces

when

informed

framework

supjudg-

for pre-

rates.

OF INTEREST

RATES

value, while the more typical deficit is indicated
by a positive figure. The inflation rate is defined
as the annualized rate of change of the consumer
price index.
The distributed
lags on Federal
deficits
and
inflation
employ
the smoothing
technique
of
third-degree
Almon
polynomial
approximation
without
constraints
on beginning
or ending
This technique
finds a time response
values.

Appendix

Equation
Statistics

interest

Nonetheless,

A

EXPLANATION

CHARACTERISTICS

factors

may provide

dicting

the estimatrates.
The

by other

These

of

role in shorter-

an operational

of fundamental

markets.

plemented

expectations

markets.

provide

tion of the effects

explan-

bill and U. S. 3-5

play a larger

longer-term

intercepts.

have better

Near-term

factors

than

on financial

between

equations

equations.

these

rates are measured
in basis points (100 basis
points equal one percent).
The growth rates of
money are given as revised seasonally
adjusted
annual rates.
The unemployment
rate is expressed as a seasonally adjusted percentage.
The
Federal
budget deficit is expressed
in units of
$trillions/lO.
A surplus is indicated by a negative

STATISTICAL

note

is an important

than the Treasury

term

APPENDIX
AN ECONOMETRIC

ability

institutional

?: It is not significant in the Industrial A equation. The simple
correlation between lagged unemployment and the Industrial A rate
is 0.71, suggesting that unemployment reduces investor confidence
in these slightly risky securities.
The confidence effect evidently
aImost overcomes the income effect for this rate. See William D.
Jackson, Deteminants
of Long-Tern
Bond Risk Premiums. Federal
Reserve Bank of Richmond, (1976).

bonds

Table

I

OF ESTIMATED

r

Security
Rote

INTEREST

Industrial
A
Bond Rote

RATE EQUATIONS

T

Municipal
A
Bond Rate

I

-

1

long-term
Government
Bond Rate

t
t
Coefficient Statistic Coefficient Statistic Coefficient15 StatisticCoefficient StatisticCoefficient Statistic

Predictor
M3 Growth Rote (1)
Unemployment
Rote (t-l)
FederalDeficit
(Sum
of Coefficients
t to t-11)’
Inflation
Rote (Sum
of Coefficients
t to t-11)*
Constant
ii*
Standard Error
Durbin-Watson

f’

peon of Dependent
Variable

-4.21
-54.2917

-4.7622

-3.71

-2.1123

-3.76

-3.62

- 25.0579

-1.77

-0.2153

-0.03

- 2.0967
-13.8815

-2.22

-1.1516

-1.29

- 11.4576

1470.5396

1.11

1653.1787

1.26

1168.5569

1.87

1956.4399

1.87

888.9832

1.15

46.7221
629.9043

5.91
8.96

23.6375
682.9395

2.49
7.32

12.4733
679.8755

4.69
12.82

18.8627
570.9873

2.34
6.41

12.7252
624.8027

2.15
9.52

0.9412
34.23
1.90
0.8493

0.9187
29.45
1.71
0.9244

0.9863
13.02
1.26
0.9609

0.9549
21.86
1.54
0.9660

0.9541
16.10
1.64
0.9573

575.7180

647.4338

758.1765

563.5535

603.5989

C

* Individual
distributed coefficients shown in Appendix Table II.
log
ore

FEDERAL

RESERVE

BANK

OF

RICHMOND

23

Appendix

DISTRISUTED

Time Log

TroClskUy
Bill
Rote
lnflotion
Rote

Federal
Deficit

LAG COEFFICIENTS

Table II
FOR INTEREST

u.s.3-5 Year
Security
Rote
Federal
Deficit
37.5810
(0.30) I

RATE EQUATIONS

Industrial
A
Bond Rate

Municipal
A
Bond Rate

Inflation
Rote

Federal
Deficit

Inflation
Rote

1.2608
(1.19)

89.7999
(1.61)

1.4806
(3.17)

28.4906
(0.30)

1.1662
(1.49)

3.1411

0.5053

Federal
Deficit

t

-57.4630
(-0.41)"

3.8679
(3.15)

t-1

-3.1176
(-0.02)

4.6892
(3.64)

-8.1634
(-0.06)

1.1932
(1.00)

47.5372
(0.79)

1.2841
(2.36)

5.3250
(3.67)

-10.5670
(-0.07)

1.3638
(0.98)

28.6808
(0.43)

1.3210
(2.04)

lpt;5

Inflation
Rote

I

Long-term
Government
Bond Rate
Federal
Deficit
-29.3344
(-0.42)

Inflation
Rote
1.1606
(2.01)

3.1280
(0.04)

0.7233
(1.07)

;;:go

37.4223
(0.46)

0.5914
(0.74)

t-2

53.9294
(0.35)

t-3

109.5951
(0.69)

5.7489
(4.08)

19.6125
(0.13)

1.6928
(1.20)

28.6467
(0.42)

1.5233
(2.28)

56.4860
(0.49)

0.4099
(0.37)

70.9156
(0.84

46850
(0.83)

t-4

159.7966
(1.06)

5.9345
(4.86)

71.6716
(0.50)

2.1007
(1.61)

42.8509
(0.W

1.8230
(2.87)

114.5848
(1.02)

0.77B9
(0.73)

100.9691
(1.22)

0.9243
(1.18)

t-5

200.4509
(1.41)

5.8552
(5.52)

134.8705
(0.97)

2.5078
(2.09)

66.7093
(1.02)

2.1520
(3.59)

179.9039
(1.65)

1.2945
(1.28)

124.9479
(1.55)

1.2295
(1.66)

t-6

227.4750
(1.62)

5.4846
(4.93)

198.4789
(1.45)

2.8345
(2.32)

95.6379
(1.48)

2.4423
(4.03)

242.1455
(2.24)

1.8585
(1.83)

140.2160
(1.76)

1.5206
(2.03)

t-7

236.7859
(1.62)

4.7962
(3.59)

251.7659
(1.80)

3.0011
(2.22)

125.0527
(1.91)

2.6258
(4.05)

291.0112
(2.64)

2.3725
(2.18)

144.1376
(1.77)

1.7179
(2.15)

t-a

224.3008
(1.48)

3.7637
(2.46)

284.0007
(1.98)

2.9281
(2.00)

150.3696
(2.26)

2.6345
(3.87)

316.2039
(2.83)

2.7383
(2.40)

134.0768
(1.63)

1.7415
(2.07)

t-9

185.9368
(1.23)

2.3605
(1.52)

284.4339
(2.03)

2.5357
c1.m

167.0049
(2.58)

2.4003
(3.47)

307.4258
(2.83)

2.8576
(2.60)

107.3978
(1.35)

1.5115
(1.87)

t-10

117.6107
(0.83)

0.5602
(0.42)

242.3937
(1.86)

1.7444
Cl.44

170.3742
(2.86)

1.8552
(3.39)

254.3783
(2.54)

2.6320
(2.86)

61.4646
(0.83)

0.9481
(1.40)

t-11

15.2397
(0.10)

147.0898
(1.12)

0.4746
(0.44)

155.8937
(2.64)

0.9311
(1.97)

146.7636
(1.48)

1.9632
(2.47)

i

-1.6638
(-1.33)

-6.3586
(-0.09)

-0.0286
(-0.04)

.

* The parentheses
contain+ statistics the coefficients
for
immediately
above.

without
constraining
the adjustment
path to a
predetermined
shape.’
The summed coefficients
appear in Appendix Table I, while the individual
tinlc. coefficients
appear in Appendix
Table
II.
7‘11~ .+:niiicance
of the coefficients
is given by
their t statistics.
An absolute value of t of 1.29
or more indicates
a statistically
significant
relationship.
The fi” statistics
have been corrected
for degrees of freedom (98).
The Cochrane-Orcutt
correction
for first-order

verted to units of the original
variables.
This
technique
is largely effective
in removing
autocorrelation,
as shown by the Durbin-Watson
statistic,
which is satisfactory
for all except the
Industrial
A and Municipal
A equations.
Their
high R-“s and ability to explain interest rates on a
month-by-month
basis during recent years suggest that the remaining
positive
autocorrelation
is not a serious problem.
Several variants of these equations
were est:i-

autocorrelation
is used.'
This technique
corrects
a common problem in time series analysis : “runs”
of successive
overprediction
and underprediction.
Its correction
factor for autocorrelation
is p. The
values of p indicate that these equations
are essentially
first-difference
transformations
recon-

mated.
Substituting
the index of industrial
production and its changes
for the unemployment
rate produced
insignificant
t values
for these
prosies of income and its change.
Anticipatoryexpectations
proxies for future income, such as
the new (deflated)
index of leading
indicators
and stock prices, are so correlated
with inflation,
monetary
growth, and unemployment
that they
added essentially
no new information
to the
analysis.

1 Phoebes J. Dhrgmes, Distributed Lags:
P-roblsms
of Estimation
and Fornwdatim
(San Francisco: Holden-Day, 19il);
James L.
Murphy. Introductory Eeonmnetrics
( Homewood: Irwin. 1973 ) .
~MurphY. lot. cit.

24

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1976

APPENDIX

B

Ml, M2, M3, AND INTEREST

Does the increasing
use of interest-bearing
time
and savings accounts as stores of liquidity mean
that the growth of M2 and M3 lowers interest
rates more than the growth of Ml? Alternative
versions
of the interest
rate equations
test this
hypothesis.
The monetary
growth coefficients
appear in Appendix Table III.
All of the other
esplanatory
variables
possess the same sign and
general

significance,

or M.3 represents
Growth
economy’s

whether
the k

growth

in Ml,

M2,

term.

in M3 is a more valid indicator of the
liquidity
than
is growth
in Ml.

Appendix

COEFFICIENTS

OF MONETARY

Growth

RATES

in M3 indicates

the liquidity

of the econ-

omy to a lesser extent than growth in M3.
A
traditional
indicator of monetary
policy, growth
in Ml has a weak influence on interest rates in
this specification.
Its liquidity effect is less than
one-quarter
of the liquidity effect of M3, falling
to insignificance
in the Municipal
A and longterm

Government

rate equations.

These

empiri-

cal results suggest that consideration
of broader
monetary
aggregates
in the implementation
of
monetary policy is a proper
the monetary authority.

Table

move on the part of

111

GROWTH

IN INTEREST

RATE EQUATIONS
Long-term

Rate

Treasury

of

Ml

U. S. 3-5

Year

Bill

Growth

Security

Rate

Rate

-1.1568

M2

-4.6281

-

-

*

The

parentheses

contain

6.4509

t statistics

(-2.03)

3.2594

-

-

4.7622

-2.1123

(-3.71)

for

the

coefficients

1.3622

(-3.41)

(-3.59)

(-4.21)

Rate

-0.5126

(-1.75)

(-4.29)
M3

Bond

-1.1013

(-1.62)’

Industrial
A

(-3.76)

immediately

above.

Municipal
Bond

Rote

-0.4634
(-1.12)
-1.6106
(-2.44)
-

2.0967

(-2.22)

A

I-!
Government
Bond

-

Rote

0.2350

(-0.77)
-

0.7274

(-1.48)
-

I.1516

(-1.66)

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