View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

SHORT-TERM INVESTMENT POOLS
Timothy

Q. Cook and Jeremy G. Duffield

Over the last decade numerous types of short-term
investment
pooling
arrangements
(STIPs)
have
emerged in the nation’s financial system.
The most
well-known
and widely publicized form of STIP is
However,
the money market mutual fund (MMF).
MMFs are only one of at least eight types of STIPs
that were operating in the United States at the end
of 1979. While the various types of STIPs differ in
some respects, such as the kind of asset held or the
type of investor, they are all alike in their basic function, which is to purchase large pools of short-term
financial instruments
and sell shares in these pools
to investors.
In almost all instances discussed in this
article, the, pool allows participants
to invest a much
smaller amount of money than would be necessary to
directly purchase the individual securities held by the
pool.

Money Market Mutual Funds
Because
MMFs
were discussed in great detail in two earlier articles
in this Review
[4, 5], the discussion
here will be
brief. The general operating characteristics
of MMFs
Minimum
initial investments
are fairly standard.
usually range from $500 to $5,000, although a very
small number
of funds require no minimum
and
others, designed for institutional
investors,
require
minimums of $50,000 or more. With the exception
of the small number of funds that limit their investors
to institutions,
MMF shares are available to any type
of investor.
Most funds have a checking option that
enables shareholders to write checks of $500 or more.
Shares can also be redeemed at most MMFs by telephone or wire request, in which case payment by the
MMF is either mailed to the investor or remitted by
wire to the investor’s bank account.

This paper examines
the STIP
phenomenon.
Section I describes the various forms of STIPs and
provides estimates of ( 1) the growth and total assets
of STIPs and (2) the proportion
of various money
market instruments
held by STIPs at the end of 1979.
Section II deals with the question of why this type
of financial intermediary
proliferated
and thrived in
the 1970’s. Some implications
of STIPs for the financial markets are explored in Section III.

MMFs are open-end investment
companies
that
vary considerably
in both the type and average maturity of securities they hold. A large percentage of
most MMFs’ holdings are in domestic and Eurodollar CDs, commercial paper and Treasury bills, but
various other high grade money market instruments
are also commonly purchased.
A small number of
MMFs have restricted their investments
to government securities,
apparently
to attract
more riskaverse investors, and an equally small number have
invested very heavily in Eurodollar
CDs.

I.
SHORT-TERM

INVESTMENT

Because MMFs are generally “no-load” mutual
funds, investors purchase and redeem MMF shares
without paying a sales charge.
Instead, expenses of
the funds are deducted-daily
from gross income before dividends are declared.
The difference between
the yield earned on a MMF’s assets and the yield
earned by the shareholders
is the MMF’s
expense
ratio.
(Alternatively,
this can be measured as the
ratio of total expenses on an annual basis to average
assets.)
In 1978 the expense ratio for different
MMFs ranged from .4 percent to 1.4 percent [4].
The weighted average expense ratio for the industry
as a whole was .55 in 1979.1

POOLS

Characteristics
of different STIPs are summarized
in Table I. While all STIPs basically function as
intermediaries
for short-term
securities,
they can
differ in several ways. First, some STIPs are open
to a wide variety of investors while others cater only
to a narrow group. Second, some STIPs hold many
different money
market instruments
while others confine their investment to one type of security.
Third,
some STIPs are “open-end” arrangements
that allow
investors to purchase and redeem shares of an everIn other
changing
pool of underlying
securities.
STIPs
investors
buy shares of a specific pool of
Other features that vary among STIPs
securities.
include minimum
investment
size, expense ratios,
and’ methods of investing and withdrawing
funds.
FEDERAL

RESERVE

1 The weighted average expense ratio for MMFs is calculated from expense data for 55 MMFs,
with fiscal
years ending near the end of 1979, presented
in LipperDirectors’ Analytical Data, May 1980.
BANK

OF

RICHMOND

3

The first MMF started
offering shares to the
public in 1972. By the end of 1974 there were 15
MMFs and by the end of 1979, 76 were in operation.
Total MMF assets at the end of 1979 were $45.2
billion.2
Short-Term
Tax-Exempt
Funds
Short-term
taxexempt funds (STEFs)
are the tax-exempt counterpart to MMFs.
STEFs invest primarily in securities
issued by state and local governments
(“municipals”), which pay interest
income that is exempt
from Federal income taxes. The first short-term taxexempt fund offered shares to the public in 1977 and
several others were formed in 1979. By mid-1980
there were at least 10 STEFs
operating with combined assets of over one-and-a-half-billion
dollars.
As a result of the type of financial assets they purchase, STEFs
appeal to investors
in high Federal
income tax brackets.
More specifically, an investor
facing the choice between two investments
that are
alike in every respect except that one offers a yield
that is subject to Federal income taxes, YT, while
the other’s yield is tax-free,
YTF, will choose the
alternative
that offers the highest after-tax
return.
That is, the investor will choose the tax-free investment option if YTF > YT(l-t),
where t is the inThus,
vestor’s marginal
Federal income tax rate.
by examining
the ratio of short-term
tax-exempt
yields to short-term
taxable yields it is possible to
determine
at what minimum
marginal
tax rate an
investor would be better off investing
in a STEF
than in a MMF. While this ratio varies considerably
over time, available evidence suggests that an investor probably has to have a marginal Federal tax
rate of more than 50 percent to achieve a higher
after-tax yield in a STEF than in a MMF.3
While after-tax yield comparisons
might indicate
that an investor with a very high marginal tax rate

2 Much of the data used in this article is available only
on a year-end basis. Consequently,
for purposes of comparison and for uniformity,
year-end
1979 data are used
throughout
the article for all STIPs.
In the six-month
period following the end of 1979, MMF assets grew to a
level of $76.7 billion.
3 The ratio of short-term
tax-exempt
to short-term
taxable yields varied from .421 to .492 in 1979 [8].
This
implies that a marginal tax rate of somewhere between
50.8 percent and 57.9 percent would have been necessary
to make an investor indifferent
between the choice of
taxable and tax-exempt
instruments
if no costs were
associated with investment.
If both the MMF and the
STEF had the same expense ratio, ER, the true marginal
tax rate which leaves the investor indifferent
is
YTF - ER
1YT - ER’
which implies that an even higher marginal tax bracket is
necessary to make the STEF the preferable alternative.

4

ECONOMIC

REVIEW,

would be better off in a STEF than in a MMF, one
major qualification
must be added. Largely because
of the small quantity of very short-term
municipal
securities
available for purchase,
STEF
portfolios
have generally been of longer average maturity than
MMF portfolios.
To the extent that STEF portfolios have longer maturities
than MMF portfolios,
the variation
in the STEF’s share price and in the
STEF investor’s principal will be somewhat greater
than for MMF shares. For some investors this may
lessen the relative attractiveness
of STEFs.
In order to minimize the perceived problem of a
varying share price, most STEFs
have opted, like
most MMFs, to maintain an average maturity of 120
days or less in order to gain exemptive orders from
the Securities and Exchange Commission permitting
the use of accounting policies that should enable the
maintenance
of a constant net asset value.4
As a means of achieving shorter average maturities, some STEFs have retained the right to use a
“put option” technique.
Under this arrangement,
the fund would purchase municipal securities, often
at a higher price (lower yield) than it would normally pay for these securities, at the same time acquiring the right or option to sell the securities back
to the seller at an agreed-upon
price on a certain
date or within a specified period in the future.
The
primary advantage of this technique is that it may
allow the fund to tailor a shorter term portfolio.
The major disadvantage
is that the fund is dependent
on the ability and willingness
of the seller to buy
back the securities.
Furthermore,.
there are also
thorny legal issues yet to be resolved, such as the
appropriate
method of valuing securities purchased
under put options and the tax status of securities
purchased under put options.
Unlike the yield curve for taxable securities, the
yield curve for municipals is almost always upwardsloping throughout
the entire range of maturities,
i.e., a higher yield is paid for securities of longer
maturity.
Consequently,
the tradeoff encountered
in
trying to maintain a very short average maturity in a
municipal portfolio is generally a lower yield on the
portfolio.
For this reason some STEFs retain the
option of holding an average maturity of one year or
over.
Short-Term
Investment
vestment
funds (STIFs)

Funds
Short-term
inare collective investment

4 These funds obtain a stable share value by using amortized cost or “penny-rounding”
methods of share price
These concepts
are described
in Cook
determination.
and Duffield [5].
SEPTEMBER/OCTOBER

1980

Table

CHARACTERISTICS

I

OF SHORT-TERM

INVESTMENT

POOLS
Annualized

Year First

Market

Funds

Minimum

One started
Money

Type of
Investors

Investment

1972

anyone

$1,000

to
for

End of 1979

Assets

$5,000

most common;
funds

Maturity

is

wide

range

Pool

Methods

(basis points)

wire,

weighted

open-end

check-writing,

maturity-of

institutions

require

weighted

$50,000

Ratio

Redemption

average

some

Expense

Type of

average

mail

ratio of 55

34 days

or more

Short-Term
Tax-Exempt

Funds

1977

investors
income
Federal

desiring
free

of

varies
$1,000

from

tax-exempt

120 to 150 days

similar

wire,

open-end

securities

to $25,000

check-writing,

taxes

to MMF

expense

mail

Short-Term
Investment

Funds

1968(?)

accounts
trust

of

bank

negligible

wide range;

department

mostly
commercial

n.a.;

open-end

paper

daily

transfer

n.a.

on request

by regulation
very short

Local Government
Investment

Pools

1973

state and

local

usually

none

wide

range

government

varies greatly

open-end

wire, checks in

n.a.

some cases

(see text)

bodies

(usually

24 hours

notice needed
withdrawals
greater

for
of

than

$1 million)

Credit

Union

Pools

1968

credit

unions

n.a.

mainly

Treasury

varies

open-end

n.a.

wire, draft

bills and
Federal

agencies

Short-Term
Investment

Trusts

1974

anyone

primarily

$1,000

Eurodollar

6 months
CDs

unit
investment
trust

funds

returned

maturity;

at

140

can sell

prior to maturity
subject to a charge

Shares

in Sills

n.a.

anyone

$1.000

Treasury

bills

3 or 6 months

similar to
unit
investment
trust

funds

returned

at

end of 3- or 6-month
investment;

can sell

prior to maturity
subject to a charge

varies

inversely

with maturity
and
of

with

size

investment;

expense

ratio

for a $5,000
investment
6-month
would

FEDERAL RESERVE BANK OF RICHMOND

in
bill

be 90

funds operated

by bank trust departments.

tive investment

fund is an arrangement

monies

of different

are pooled

to purchase

such as common
bonds,
ties.

accounts

the

in the trust department

a certain

stocks, corporate

or, in the case of STIFs,
The first STIF

A collecwhereby

was started

type of security,
bonds, tax-exempt
short-term

securi-

no later than 1968.5

By the end of 1974 there were over 70 STIFs

with

total assets of $2.7 billion. STIF assets grew rapidly
in 1978 and 1979 and by the end of 1979 total STIF
assets were over $32 billion.
STIFs
function
just like MMFs and offer the
same advantages to the accounts of the trust department.
In particular,
the minimum
investment
is
usually a negligible amount and funds can be put in
and withdrawn without transaction
fees.
That STIFs and MMFs provide virtually the same
services to their customers is illustrated by the fact
that many trust departments
use MMFs rather than
establish STIFs.
The decision to set up a STIF or
to use a MMF for its customers’ short-term assets is
largely dependent on the size of the trust department.
The larger the trust department,
the more likely it is
to have a STIF.
Survey data from 1978 (presented
in [5]) revealed that of the trust departments
with
assets of $100 million or less, fewer than 1 percent
had established STIFs and of the trust departments
with assets of $100 million to $500 million, only
about 10 percent had STIFs.
In contrast, almost 40
percent of the trust departments
in the survey with
assets of $500 million to $1 billion had STIFs and
about 65 percent of the departments
with assets of $1
billion or more had STIFs.
Most bank trust departments without STIFs use MMFs.6
Both the type and maturity
of assets held by
STIFs
reflect the Comptroller
of the Currency’s
Regulations
on the portfolios of STIFs.
The two
key regulations are that :
must
(1) at least 80 percent of investments
be payable on demand or have a maturity
not
exceeding 91 days, and

5 This is the earliest date for which the authors are aware
of the existence of a STIF.
It is possible that other
STIFs were formed prior to 1968.
6 Cook and Duffield [4] argue that the explanation
for
the use of MMFs by small- and medium-sized
bank trust
departments
is that both MMFs and STIFs are subject
to decreasing
average costs as assets increase.
Consequently, a small- or medium-sized
bank trust department
can get a higher yield net of expenses for its accounts by
investing in a MMF than by setting up a relatively small
STIF.
It should also be noted that some agency accounts of bank trust departments
are not eligible to invest
in STIFs but may invest in MMFs.

6

ECONOMIC

REVIEW,

(2) not less than 40 percent of the value of
the fund must be cash, demand obligations, and
assets that mature on the fund’s next business
day.
As a result of these regulations,
STIFs hold a substantial amount of variable amount notes (also called
master notes), which are a type of open-ended commercial paper that allows the investment
and withdrawal of funds on a daily basis and pays a daily
interest rate tied to the current commercial
paper
rate.
In addition, STIFs
hold a large amount of
standard
commercial
paper and a much smaller
amount of time and savings deposits and Treasury
securities.
A very small number of STIFs invest
primarily
in short-term
tax-exempt
securities.
Typically,
only the audit expenses of STIFs are
charged directly against the income earned by the
STIFs and it is only this expense that appears in the
STIF annual report.
Other expenses are covered
by fees charged to the accounts of the trust department. Consequently,
it is impossible to calculate the
expense ratio of STIFs from published reports.
Local Government
Investment
Pools
Local government
investment
pools (LGIPs)
were in operation in 11 states by the end of 1979.7 These pools
have been set up to enable local government
entities
(such as counties, cities, school districts, etc.,‘ and in
all but two states, state agencies) to purchase shares
in a large portfolio of money market instruments.
The primary purpose of state legislation establishing
the pools has been to encourage efficient management
of idle funds.
Since many local government
bodies have relatively small sums of money to invest, they would
seem to benefit most from LGIPs.
However,
in
many LGIPs the majority of assets represent state
funds.
Surprisingly,
through 1979 only a small percentage of eligible local government
bodies were
investing in the pools. Duncan [6] reports that in
July 1979 the percentage of eligible participants
contributing to LGIPs ranged from less than 1 percent
in Illinois to 35 percent in Massachusetts.
Except for the LGIPs of Massachusetts
and Illinois, the pools are administered
by the state treasurer’s office, often in conjunction
with the state
investment
board and a local government
advisory
council.
The Illinois pool is administered
by a bank
7 These states are California, Connecticut,
Florida, Illinois, Massachusetts,
Montana,
New Jersey,
Oregon,
Utah, West Virginia, and Wisconsin.
In addition, legislation was recently passed in Oklahoma providing for the
creation of a LGIP.
SEPTEMBER/OCTOBER

1980

trust department,
while the Massachusetts
run by an investment management
firm.

LGIP

is

type of security eligible for purchase by a Federal
credit union. Thus, in addition to U. S. Government
securities, the pool may purchase domestic certificates
of deposit but is prohibited from investing in Eurodollar CDs, commercial
paper and bankers acceptances.
The NAFCU
pool has maintained
a very
short average maturity, 30 days at the end of 1979.

In most respects, the operating characteristics
of
LGIPs are identical to those of MMFs.
Funds may
be invested by wire or check and withdrawn either by
telephone request, with payment sent by wire, or in
some cases by check.
Funds may generally be invested and withdrawn
on a daily basis, although
several LGIPs require 24 hours’ notice prior to the
withdrawal
of $1 million or more. While there are
usually no minimum investment
or withdrawal
constraints, small transactions
are often informally discouraged.
Interest
is earned daily, except in one
LGIP which distributes
income quarterly.

Short-Term
Investment
Trusts
Short-term
investment
trusts
(STITs),
or short-term
income
trusts, are a type of unit investment trust that invests
exclusively
in short-term
financial
instruments.
These funds are put together by groups of brokers
that sell shares in units of $1,000 to their retail customers. Unlike MMF shares, these shares represent a
claim to part of a specific set of securities.
Hence,
when these securities mature, the fund is terminated.
The first eight series of STITs were sold in 1974,
all by one broker group. No more STITs were sold
until September
1978 when the same broker group
again began to offer STITs.
A second broker group
began to market STITs
in January
1979.
From
September 1978 through the end of 1979, 47 separate
series of STITs
totalling $6.1 billion were sold to
the public. At the end of 1979 there were 35 series
of STITs outstanding
with total assets of $4.6 billion.

The pools invest in a broad range of securities
many of which would not be legally available to the
participants
if they invested their funds individually.
That is, many LGIP participants
are legally prohibited from directly investing in some of the types
of securities which the pool is authorized to purchase.
LGIPs
in different
states have followed widely
differing maturity
strategies.
Whereas at the end
of December 1979, the longest average maturity of
any MMF was less than three months, several LGIP
portfolios had average maturities
in the 1-to-3-year
range.
Others. maintained
average maturities
as
short as those of MMFs.

The maturity
of all but two of the STIT series
sold through
1979 was six months.
The assets of
the STITs put together by the first broker group
have been composed of (1) CDs of foreign branches
of U. S. banks, (2) CDs of foreign banks, (3) CDs
of U. S. branches of foreign banks, and (4) CDs of
domestic banks.
Of these, the first two categories,
which are “Eurodollar
CDs,” comprised 72.1 percent
of the total assets of the STITs offered by this group
in 1979.
The second broker group has generally
included in their STITs only CDs of foreign branches
(specifically,
London branches)
of domestic banks.

Credit Union Pools
Two short-term
pools have
been established for the investment
of surplus funds
of credit unions.
The government
securities pool of
the Credit Union National Association
(CUNA),
a
service organization
representing
more than 90 percent of the 22,000 credit unions in the U. S., represents one of the nation’s earliest short-term
pooling
arrangements,
having commenced operations in 1968.
This pool had over $1 billion in assets and more than
10,000 participating
credit unions at year-end 1979.
The other pool was created in 1976 by the National
Association
of Federal Credit Unions (NAFCU).

On an annualized
basis the expense ratios of the
STIT series sold in 1979 generally ranged from 140
to 150 basis points.8
(This is calculated as the sales
charge plus expenses of the Fund divided by the
offering price and annualized.)
This calculation
assumes that the STIT share is held to maturity.
The share can be sold prior to maturity subject to an

Both pools are operated as common trust funds by
bank trust departments.
In most respects they are
identical to other open-end STIPs.
Investments
and
withdrawals
may be made daily. Participating
credit
unions may request withdrawals
by telephone with
funds remitted by wire or they may write a draft on
their pool account and deposit it at their commercial
bank.
Drafts may not be used for third-party
payment.

8 The term “expense

ratio” is used broadly here to encompass all expenses, including sales charges, that lower
the investor’s net yield. There are two possible reasons
why the STIT expense ratio is higher than the MMF
expense ratio. First, the labor expenses of a STIT may
be greater because it requires a large network of dealers
to actively market the STIT shares.
Second, the size of
the average STIT,
is much smaller than the size of the
average MMF, so that MMFs may benefit more from
economies of scale.

CUNA’s pool invests solely in U. S. Government
and Federal agency
securities.
The average maturity
of its portfolio was seven-and-one-half-months
at the
end of 1979. The NAFCU
pool can invest in any
FEDERAL

RESERVE

RANK

OF

RICHMOND

7

additional charge, in which case the investor’s
tive expense ratio would be somewhat higher.

effec-

Other Types of STIPs
In addition
to the six
types of STIPs discussed so far, there are a small
number of STIPs for which data were not collected
for this article.
These fall into two categories.
Shares-in-Bills
One organization
of brokers and
dealers has established a program whereby investors
can purchase shares in specific three- and six-month
Treasury
bills.
From the investor’s point of view,
this program is similar to a unit investment trust that
invests exclusively in bills. The minimum purchase
requirement
is $1,000.
According to the program’s
advertising
literature,
it has been in operation since
1969. However, only recently has the program been
widely advertised,
suggesting
that it was relatively
insignificant
prior to 1979.9
The annualized
expense ratio of a bill purchased
through the program is inversely related to the size
and maturity
of the investment.
An investment
of
$5,000 in a three-month
bill has an annualized
expense ratio of 120 basis points while a $5,000 investment in a six-month bill has an expense ratio of 90
basis points.
Lastly, at least one
Other Open-End STIPs
other type of financial intermediary-life
insurance
companies-is
already operating
open-end
STIPs
and a second-savings
and loan associations-will
probably begin to do so in the early 1980’s.
Life
insurance companies provide investment
services for
various types of thrift and pension plans. In the past,
insurance
companies have offered these plans such
alternatives
as investing in commingled bond or stock
accounts.
Recently, some life insurance
companies
have also begun to offer short-term
investment commingled accounts.10
The Depository
Institutions
Deregulation
and
Monetary
Control Act of 1980 gives federal savings
and loan associations
the authority to provide trust
services. As noted above, most small- and moderatesized bank trust departments
use MMFs while large
trust departments
generally set up their own STIFs.

9 Interestingly,
unlike a STIT, the shares-in-bills
program is not organized as an investment
company.
Hence,
no prospectus
or annual report is published and no information on the size of the program is readily available.
The authors were unable to get this information
from the
sponsor.
10 The authors became aware of the existence
of life
insurance company STIPs late in the preparation
of this
article.
Consequently,
no attempt was made to gather
data for this type of STIP.

8

ECONOMIC

REVIEW,

The savings and loan associations who compete in the
market for trust services will have these same options. It is probable that some of the larger associations will establish their own short-term
investment
pooling arrangements.
STIP Growth and Percentage
Holdings
of Various Money Market Instruments
The growth
of
assets of each type of short-term investment pool and
the growth of aggregate
STIP
assets from 1974
through 1979 is shown in Table II.
Total STIP
assets. grew rapidly in the high interest rate period
of 1974.
Asset growth leveled off in 1976, when
interest rates reached a cyclical trough, and accelerated sharply from 1977 through 1979, a period of
rising interest rates.
Almost all types of STIPs
participated
in this rapid growth.
Assets of the six
types of STIPs for which data were available totaled
$88.5 billion at the end of 1979. MMFs held slightly
over half of this total.
Table III shows the composition
of STIP assets
by type of STIP and calculates the percentage
of
various types of money market instruments
held by
STIPs at the end of 1979. As the table illustrates,
by the end of’ 1979 STIPs
in the aggregate held
significant proportions
of some types of money market instruments..
In particular,
STIPs
held 36.5
percent of total commercial paper outstanding,
11.2
percent of total bankers acceptances outstanding,
and
8.4 percent of total CDs (i.e., all large time deposits
greater than $100,000).
Tables II and III confirm that STIPs have become a significant intermediary
in the financial system. The reasons for this development are discussed
in the following section.

II.
FACTORS

CONTRIBUTING

GROWTH

TO THE

OF STIPS

This section explores the reasons underlying
the
emergence of STIPs in the late 1960’s and their subsequent rapid growth.
Most public discussion
of
STIPs has focused on MMFs, explaining their rapid
growth as a reaction to the impact of Regulation
Q
deposit interest rate ceilings at commercial banks and
thrift institutions.
Specifically, this explanation
for
MMF growth is that when market rates have risen
above Regulation
Q ceiling rates, depositors without
sufficient funds to meet the minimum purchase requirements
necessary to invest directly in the money
market have turned to MMFs as a means of getting
a market yield on their funds.
According
to this
SEPTEMBER/OCTOBER

1980

Table

ASSETS

AND

NUMBERS

II

OF VARIOUS

FORMS

OF STlPs

(end-of-year)
Short-Term
Money

Market

Funds

Tax-Exempt

Short-Term

Funds

Investment

Local Government

Funds1

Short-Term

Investment

Pools

Credit

Union

Investment

Pools

Trusts

Total

Assets

Number

Assets

Number

Assets

Number

Assets

Number

Assets

Number

Assets

($ mil.)

(funds)

($ mil.)

(funds)

($ mil.)

(funds)

($ mil.)

(states)

($ mil.)

(pools)

($ mil.)

(sponsors)

Assets

Number

1974

1,715

15

2,660

73

394

4

1

3,906

102

090

4

1;947

3,427

92

2,034

6

1,816

8,409

136

3,044

10

1,151

2

($ mil.)

1

6,839

1

0

10,519

2

0

10,963

0

16,494

1,224

846

1975

3,696

36

1976

3686

48

1977

3,080

50

1978

10,858

61

30

1

25,125

na

3,845

11

1,074

2

665

1

41,597

1979

45,214

76

350

3

32,277

2512

4,779

11

1,237

2

4,614

2

88,471

Sources:

2

Investment

data

company

by

Institute

from

1

gathered

Common Trust

authors

Surveys;

funds

Collective
Funds

data

Fund

gathered

authors

ABA

from

by

data

funds

gathered

authors

from

by

prospectuses

funds

Investment

Survey

Report

(1978)

1 The STIF data
Fund Survey.
number

of large

estimates
Comptroller
2These

for

1978

Prior to

which
of

is year-end

1979,

trust departments
are

on

the

low

the Currency,

the

251 STlFs were

data

the Survey

operated

was

from

not reporting
side.
Federal
by

a special

conducted

American

Bankers

by the Comptroller

in those

years.

Association,

In addition,

assets were

In 1979 the
Common
Trust Fund Survey
Deposit
Insurance
Corporation,
and the

a total

of

155 bank

trust

departments

Collective

of the Currency.

and

Banks
reported

Investment
that

were

prior

was incorporated
into
Federal
Reserve Board.
5 trust

companies

owned

Funds

to year-end
the

Trust

The
by

Survey

not national

1979
bank

by
Assets
data
holding

Report.

banks
some
of

The STIF data

reported
banks.

Insured

is year-end
companies.

on

Hence,

the

Commercial
and

for

1974-77

a voluntary

covers

1974-77

Banks
all

basis

trust

is from
and

data

survey

the Common

there appear
should

conducted

departments.

be

Trust

to be

regarded

jointly

by

a
as

the

Table

COMPOSITION

OF STIP

ASSETS

AND

PERCENTAGE

OF MONEY

(end
U. S. Treasury
1 Year

Amount

Percent

($ mil.)
Market

of Assets

Greater

Than

Amount

Federal

1 Year

Percent

of Assets

($ mil.)

Amount
($ mil.)

of Assets

-

-

-

-

13232

4.1

65

0.2

-

Local

96

2.0

397

8.3

511

41.3

-

-

8.9

Credit

Pools

Union

Pools

Short-Term
Investment

Total

Held

(Dec.

-

Trusts

Amount

($ mil.)

of Assets

13,053

28.9

-

by

STlPs

-

3,551

5,076

1979)

-

-

9.9

-

-

26.4

946

19.8

-

-

-

277

22.4

37

3.0

-

-

-

-

1,060

23.0

-

5,559

Held

by

STlPs

1.4

18,291

217,900x

Market

Funds

Paper

n.a.

43,4126
19.9

Other
Tax-Exempt

Acceptances

Percent

Amount

of Assets

14,453

Short-Term

Percent

($ mil.)

Amount

10.7

-

343

4.845

-

Total

of Assets

2,146

4.7

7

45,214

2.1

Funds1

Investment

26,112

80.9

-

-

-

-

1,582

4.9

32,277

784

16.4

215

Government

Investment

Pools
Pools

Trusts

Investment

Held

Amount

by

STlPs

350

-

4.5

-

-

1.080

22.6

4,779

-

--

Union

97.9

-

-

-

412

33.3

1,237

-

-

Short-Term

-

-

-

--

4,614

5,227

88,471

41,349

5,060

113,282

45,321

343

Outstanding
1979)

Percent

Held

on

1978

($ mil.)

-

RPs)
Percent

-

Short-Term

(Dec.

Amount

of Assets

-

-

32.0

Percent

($ mil.)

of Assets

(includes

Funds

Tax-Exempt

1 Data

77.0

8,630

0.2

($ mil.)

Total

3,5544

a.4

275,479

255,252

Amount

Credit

11.2

-

3,1953

Bankers

local

of Assets

1,262

462

Commercial

Money

CDs
Percent

Outstanding

Percent

by

STlPs

36.5

STIF asset composition
Survey

were

2 May

include

some

3May

include

applied

a small

4 Includes

some

5 Includes

all

6 Includes

only

Sources:

Sources

Money
Federal

10

Amount

Government

Investment

the

BY STlPs

Eurodollar

Percent

($ mil.)

-

4,020

Short-Term
Funds1

Amount

-

-

HELD

Domestic CDs

Percent

3.6

Funds

Investment

Agencies

-

1,621

Funds

INSTRUMENTS

1979)

-

Short-Term
Tax-Exempt

of

MARKET

U. S. Treasury

Less Than

Money

III

Federal

amount

CDs of

large

Fund

for

deposits

Eurodollar
fund

Report.

Reserve

of

domestic

time

London

was

to 1979

agency

data
Total

Bulletin.

n.a.

n.a.

11.2

not

collected

total

in the

assets to get

1979
an

Common

estimate

Trust

of

1979

Fund

Survey.

Consequently,

the

asset

percentages

from

assets.

issues.
savings

branches
greater
CDs,
ore

same

small

of foreign
than

which

outstanding
London

and

time

$100,000
at the end

as in Table
Treasury

Eurodollar

deposits.

banks.

II.

at commercial

banks

and

of

almost

all

1979

MMF

securities,

CDs

ECONOMIC

ore

from

were

breakdown

for

domestic

CDs,

the

of

REVIEW,

Bank

thrift

institutions.

of the Eurodollar

domestic
commercial

and

SEPTEMBER/OCTOBER

Eurodollar

paper,

England.

1980

CDs

and

outstanding.
CDs

is calculated

bankers

from

acceptances

Donoghue’s

are

from

the

an investor with a given quantity of funds to invest in
short-term assets can either manage his own portfolio
or place these funds in a STIP which, in turn, will’
invest in money market instruments.

view “the entire money market fund industry would
not exist without that one regulation
(Regulation
Q).”11
In this article MMFs are viewed as part of the
wider phenomenon
of STIPs.
Another explanation
for the rapid growth of STIPs stresses technological
advances in the computer
and telecommunications
industries
that have altered the production
process,
improved the product and lowered the operating costs
of STIPs.
According to this view, “new technologies
like telecommunications
and data processing
have
provided means to give everyone equal access to the
free money markets and inflation is furnishing
the
incentive to go there.”12
The question of what has caused the growth of
STIPs is not only of interest in itself, but also has
implications
for the future of the nation’s financial
system.
The Depository
Institutions
Deregulation
and Monetary Control Act of 1980 phases out interest rate ceilings on deposits over a six-year period.
If STIPs have thrived only because they are a means
of circumventing
those ceilings, then they would not
be expected to survive as a financial intermediary
in
the long run.13

The investor’s decision to invest directly in the
money market or indirectly
through a STIP
will
depend primarily on the relative costs of each alterThese costs, which will vary with each innative.
vestor, are summarized
in Table IV, where they are
shown as the wedge between the gross yield paid by
the ultimate borrower
of funds and the net yield
received by the direct or indirect investor in money
market instruments.15
The top line in Table IV summarizes
the costs of
direct investment
in the money market.
The first
category consists of the brokerage costs of producing
a money market’ instrument
and selling ii to the
initial investor. The broker in this transaction
may be
an independent
agent or an agent of the ultimate
borrower or the borrower himself. In any case, these
brokerage
costs drive a wedge between the gross
yield paid by the borrower and the yield received by
the investor.
An important aspect of these brokerage
costs is that on a per dollar basis they are inversely
related to the size of the debt instrument.
At very
low levels, per dollar brokerage
costs are so high
that debt units are not produced.
Per dollar brokerage costs fall with increasing unit levels and gradually approach a constant.

The Demand
for STIP
Services
In order to
provide a framework for discussing the introduction
and growth of STIPs, it is useful to set up a simple
model of the demand for and supply of STIP serAs a first approximation,
investment
in a
vices.
STIP is considered solely as an alternative
to direct
investment in the money market.
(This is a simplification, since, as will be discussed below, STIP shares
are also an alternative
to financial products offered
by other types of financial intermediaries.)14
Thus,

The direct investor’s net yield is further reduced
by a number of costs that are specific to each investor. These “individual-specific”
costs include the
costs of managing
the portfolio of money market
instruments,
the costs of recordkeeping,
and whatever transportation
and inconvenience
(i.e., personal
time) costs are involved in carrying out transactions.
These individual-specific
costs of direct investment
are also generally inversely related on a per dollar
basis to the amount of funds the investor has to invest because of economies of scale in portfolio management and recordkeeping
activities.

11 This view was expressed by William Poole March 25,
1980 in a statement
before the Subcommittee
on Domestic Monetary
Policy of the Committee
on Banking,
Finance and Urban Affairs of the U. S. House of Representatives, reprinted in the July/August
1980 issue of the
Federal Reserve Bank of Richmond
Economic
Review.
12 This statement
was made by Walter Wriston
in an
address at the 1980 annual meeting of the Reserve City
Bankers
Association,
reprinted
in the April 11, 1980
edition of the American Banker.
It should be noted that
Wriston also cited Regulation Q as a factor contributing
to STIP growth.

The right-hand
side of Table IV shows that the
final commodity held by the direct investor is simply
a group of one or more money market securities
representing
the debt of one or more borrowers and
maturing
on one or more dates.
Here again the
attractiveness
of the end “product”
is in two im-

13 This raises the question of why it matters whether a
new form of financial intermediary,
such as STIPs, survives. The third section of this article argues that STIPs
have had significant
implications
for the financial markets.

15 The general analytical approach taken in this section
follows Benston and Smith [2]: “Essentially,
we view
the role of the financial intermediary
as creating specialized financial
commodities.
These
commodities
are
created whenever
an intermediary
finds that it can sell
them for prices which are expected to cover all costs of
their production, both direct costs and opportunity
costs.”

14 While STIPs do compete with other financial intermediaries, they specialize in providing
one type of, serThus, in
investment
intermediation.
vice : short-term
terms of their risk and expected return characteristics,
STIPs are most clearly a substitute for direct investment
in the money market.
FEDERAL

RESERVE

BANK

OF

RICHMOND

11

portant
ways inversely
related to the size of the
investment.
The investor with a larger amount of
capital can enjoy greater diversification
through holding the debt of several issuers.
He also has more
liquidity since with a large number of securities he
can schedule the rate of maturity of the portfolio at a
more regular and steady pace to meet expected and
unexpected needs.16
The second row of Table IV summarizes the costs
of investing in money market instruments
indirectly
through a STIP.
As in the case of direct investment,
the first costs are brokerage costs. However, because
the STIP’s size enables it to purchase money market
instruments
in large units, these costs per dollar of
investment will be lower than those incurred by most
investors in the money market.
The next costs associated with indirect investment
are the intermediary’s
operating and regulatory costs.
Operating costs include account administration,
sales
administration,
portfolio management
and all other
labor and capital costs of operating
a short-term
intermediary.
Potential regulatory costs include two
types. The first are licensing and reporting expenses.
The second are those related to government
controls,
such as interest rate ceilings and reserve require(An example of this type of regulation
ments.
affecting STIPs
is the special deposit requirement
imposed on MMFs in March 1980.) That is, if the
yield passed on to the ultimate investor is below what
would be paid in the absence of government
controls,
then this difference can be thought of as an additional “cost” to be absorbed by the investor.17
The third type of costs absorbed by the indirect
These costs
investor are individual-specific
costs.
will be less than or equal to the individual-specific
costs of direct investment
in the money market, pri-

16 Actually, the greater liquidity and diversification
of a
larger portfolio
are fundamentally
a result of the high
brokerage
costs per dollar involved in offering
small
If brokerage
costs were zero, a small
units of debt.
portfolio could have liquidity and diversification
equal to
that of a large portfolio.
17 This statement
assumes that the increased regulatory
costs are absorbed by depositors.
In certain cases, such
as binding interest
rate ceilings, the regulatory
costs
might create excess profits which in a competitive
environment
could be offset by other actions of the intermediary.
For instance, part of the increased regulatory
costs of binding interest rate ceilings at the deposit institutions may have been offset through such avenues as
gift premiums, which increase the true yield of a deposit,
and increased
branch offices, which decrease the individual-specific
costs of using a deposit institution.
However, the pattern of disintermediation
in periods when
market rates have risen above Regulation
Q ceilings,
such as 1969, 1973, and 1974, suggests that such responses
have not fully offset the regulatory
costs imposed by
Regulation
Q on depositors.

12

ECONOMIC

REVIEW,

SEPTEMBER/OCTOBER

1980

marily because most expenses related to portfolio
management
and recordkeeping
will be absorbed by
the STIP.
Other potential individual-specific
costs
associated with using a STIP-e.g.,
the search costs
in choosing a STIP and the costs of communication
-will
remain.
These costs will be discussed below.

specific cost savings of using a STIP, and (3) the
value placed on any additional
diversification
and
liquidity of using a STIP-are
inversely related to
the amount of funds available for investment.
Each
decline in OCS+RCS
will result
in additional investors (with greater and greater amounts to invest)
using STIPs.
Consequently,
the demand for STIP
services with respect to the “price” of intermediation,
OCS+RCS,
will be downward sloping.

As shown on the right-hand
side of Table IV, the
investor who invests indirectly in the money market
through a STIP acquires a different
financial commodity than the direct investor.
This commodity is
essentially
a one-day instrument
backed up by a
diversified portfolio.18
Here too, the extent of, the
difference between the products is a function of the
size of the investor’s capital. The smaller the capital,
the greater the gain in liquidity and diversification
achieved by indirect investment in the money market
through a STIP.

The relative
all parameters
development

This

STIP
less

SC = individual-specific
costs
indirect (S) investment

(D)

(D)

or

the

are also a substitute,
products

specialized intermediaries
Consequently,
factors

although
offered

not a

by other

such as commercial
affecting the relative

An earlier study by the authors [4] found that the
long-run average cost curve for MMFs was downward sloping up to a certain level of assets (i.e., $50
to $100 million) and then flattened out. There was
no evidence of increasing unit costs (i.e., decreasing
returns to scale) within the asset size range of the
40 MMFs studied.
Since other STIPs
fulfill the
same function as MMFs, they should have similar
operating characteristics
and expenses.20 The aggregate long-run STIP supply curve is a horizontal line

This relation will differ for each investor, because
all items on the right-hand
side-(
1) the brokerage
cost savings of using a STIP,
(2) the individual-

of the STIP product applies only
These STIPs,
however,
hold 95
assets.

20 For simplicity this discussion assumes that all STIPs
offer the same product and hence have the same costs.
As discussed in Section I. however. STIP features do
vary somewhat.
Furthermore,
for some investors certain
STIPs are not acceptable
substitutes
for other STIPs.
Nevertheless,
since the discussion here concerns the factors affecting the STIP industry as a whole, these product differences are ignored.

19 This framework focuses on the difference in costs, and
hence expected
net return, of investment
in a STIP
relative to direct investment.
The potential increase in
diversification
and liquidity achieved through investment
in a STIP does not fit easily into this one-dimensional
framework.
However, imputing a value to these factors
simplifies matters and provides a good approximation
of
reality.
FEDERAL

by treating

The Supply of STIP Services
An individual
STIP will supply short-term financial intermediation
when that service can be sold at a price that covers
the STIP’s average costs. These costs include both
operating costs and regulatory costs. The STIP will
choose the mix of labor and capital at each level of
output that minimizes its operating costs. This mix
will be a function of relative prices and will change
over time as these relative prices change.

p = value placed on increased liquidity and diversification achieved through
investment
in
STIP19

18 This characterization
to open-end
STIPs.
percent of total STIP

Any

attractiveness
of these financial products
to STIP
shares will also affect the STIP demand curve.

or indirect

of direct

curve.

if the individual-specific

is oversimplified

one, for financial

banks.

costs of STIP
of direct

demand

are

that affects one of these three items will

discussion

shares

perfect

costs of STIP

BC = brokerage costs
( S ) investment

STIP

the relaand p

demand for STIP services only as a substitute
for
direct investment in the money market.
In actuality,

where

RCS = regulatory

SCD-SCS,

shift the curve. For instance,

OCS+RCS<(BCD-BCS)+(SCD-SCS)+p

OCS = operating

of the

costs, BCD-BCS,
costs,

costs of using a STIP were reduced then the demand
curve would shift to the right.

In this framework
the decision to use a STIP
depends on whether the costs of intermediation
are
less than the resulting savings in brokerage and individual-specific
costs plus the gain in diversification
and liquidity.
Algebraically,
the investor will use a
STIP
instead of investing
directly in the money
market if

(1)

brokerage

tive individual-specific

RESERVE

BANK

OF

RICHMOND

13

at the point where unit costs of the individual
stabilize at a constant level.21

POTENTIAL

Factors
Potentially
Increasing
STIP
Assets
Table V contains a summary of developments
that
might increase STIP assets. Items listed under (1)
and (2) simply summarize the discussion up to this
point. The third category makes the additional point
that other intermediaries-such
as banks and savings
institutions-offer
financial
commodities
that are
close substitutes
for STIP shares, notably time and
savings deposits. If increased operating or regulatory
costs at the depository
intermediaries
widen the
wedge between market yields and the deposit yields
offered by these intermediaries,
the demand for STIP
services will shift to the right.
While
the most common
explanation
for the
growth of STIPs is that they are solely a reaction to
the impact of Regulation
Q on other financial intermediaries, Table V shows that numerous other factors could have contributed
to this growth.
Several
developments
in the past decade lend support to the
view that some of these other factors have been significant.
The rest of this section discusses the explanations for STIP growth in the context of the framework developed above.
The Effect of Deposit Interest Rate Ceilings on
the STIP Demand Curve
In several
periods,
beginning
in the 1960’s, short-term
interest
rates
have risen well above Regulation
Q deposit interest
rate ceilings at the deposit institutions.
During these
periods, the spread between market rates and Regulation Q ceiling rates has increased the regulatory
costs borne by those investors with insufficient funds
to invest directly in the money market (i.e., to disThe argument
that STIPs
are a
intermediate).
result of Regulation
Q is that the increased regulatory costs at the deposit institutions
have created the
opportunity
for STIPs,
which are not subject to
Regulation
Q, to provide short-term
intermediation
services to investors at! a lower cost (or price) than
the deposit institutions.
In terms of the simple model developed above,
when market rates rise above deposit interest rate
ceilings, the increased regulatory costs of investment
21 The horizontal long-run supply curve follows from the
assumption
that after a certain asset level is reached,
average unit costs of the firm are constant
as output
increases.
Some smaller MMFs with costs above the
industry expense ratio nevertheless
supply MMF services.
They waive some of their expenses in order to be competitive with larger MMFs, with the goal of growing to
an asset level where costs can be fully passed on to
shareholders.
See Cook and Duffield [4].

14

ECONOMIC

Table

STIP

REVIEW,

FACTORS

QUANTITY
(1)

Factors

Causing

the STIP Supply

(a)

a fall

in the cost of

Q fall

in the regulatory

STIP-Related
Demand
(a)

a

Factors

inputs

Curve
used

to Fall

in STIP operations

costs imposed

Causing

a

THE

ASSETS

on STlPs

Rightward

Shift

in the

STIP

Curve
decrease

investing
(b)

INCREASING

OF STIP

(b)

(2)

V

an

in

individual-specific

costs

associated

with

in a STIP

increase

in

the

value

placed

on

liquidity

and/or

diversification
(c) Q fall

in the

units,
to the

(3)

Factors

an

increase

financial
(b)

an

Shift

to

in

costs of

Other

STIP
direct

Financial

in the STIP

Demand

in the operating

or

large

versus

brokerage

small

debt

costs relative

investment

Intermediaries

Causing

a

Curve
regulatory

costs of

other

intermediaries

increase

financial

costs of

a decline

brokerage

Related

Rightward
(a)

brokerage

causing

in the individual-specific

costs of

using

other

intermediaries

in a deposit institution
cause a rightward shift in the
STIP demand curve and an increase in the quantity
of STIP assets.
The extreme form of this view of
STIP growth is illustrated in Figure 1. In this case
when deposit interest rate ceilings are not binding,
the demand curve for STIP services does not even
intersect the supply curve (i.e., STIPs can not sell
their services as a short-term intermediary
at a price
that covers their costs).
Only when money market
rates rise above the deposit rate ceilings does the
demand curve. for STIP services shift far enough to
intersect the supply curve.
An implication
of this
view is that when market rates fall below the deposit
rate ceilings, funds flow back into the deposit institutions and STIPs are no longer an economically viable
intermediary.
The pattern of STIP growth supports the view
that binding Regulation
Q ceilings have been an important determinant
of STIP growth.
As shown in
Table I, STIPs grew at a rapid pace in 1974-75 when
market rates rose well above Regulation
Q deposit
ceiling rates. Similarly, in the 1978-80 period of very
high differentials
between money market rates and
deposit ceiling rates, STIPs again grew at a rapid
pace.
While Regulation Q interest rate ceilings have undoubtedly contributed
to the growth of STIPs, there
are several possible criticisms of the view that ReguFirst,
lation Q alone has been responsible for STIPs.
SEPTEMBER/OCTOBER

1980

on closer inspection the timing of STIP growth is
not totally compatible with the Regulation
Q explanation.
No MMFs emerged in the 1969-70 period
despite very large spreads between, money market
rates and Regulation
Q ceiling rates.
Furthermore,
when money market rates dropped below deposit
ceiling rates in 1976 and 1977, STIP assets were in
general stable while the number of some types of
STIPs in operation actually increased.
In addition,
the Regulation
Q explanation
offers no insight into
why some types of STIPs, such as at least one STIF
and one credit union pool, were in operation years
prior to the first MMFs.

Many STIP investors have sufficient funds to invest
directly in the money market and are using STIPs
as an alternative to direct investment, not simply as a
substitute
for deposits.22
These investors
include
corporations,
local governments,
pension funds, and
other institutional
investors.
They also include individuals with relatively large sums to invest, especially some customers of brokerage firms who find
MMFs a convenient
place for funds pending direct
investment
in other financial instruments.
A final criticism of the position that Regulation
Q
alone is responsible
for STIPs
is that it can not
explain the emergence of some types of STIPs, such
as STEFs and STITs, that are not close substitutes
for bank deposits.
STEFs provide tax-free income,
which deposit institutions
cannot do. And STITs
provide access to the Eurodollar
CD market.
Eurodollar CD rates are generally higher than domestic
CD rates and the spread between Eurodollar
and
domestic CD rates has typically risen in high interest
rate periods.
In such periods STITs
provide indirect investment
in Eurodollar
CDs.

A second, and more important,
criticism of the
view that Regulation
Q alone has been responsible
for STIP growth is that it ignores other possible
factors listed in Table V that could have influenced
the equilibrium
level of STIP
assets.
A related
criticism of the Regulation
Q argument
is that it
assumes STIPs are solely a substitute for deposits.
In fact, STIPs
specialize in the intermediation
of
short-term
funds.
As shown above, investors with
sufficient funds to invest directly in the money market
will nevertheless invest indirectly through a STIP if
the costs of intermediation,
adjusted for the gain in
liquidity and diversification,
are less than the resulting savings in brokerage and individual-specific
costs.

Figure

Effects of Technology
on STIP
Operations
and
on the STIP
Supply
Curve
The position
that
Regulation
Q alone is responsible for STIP growth
fails to consider technological
developments
over the
last several years that have significantly
lowered the
operating costs of short-term financial intermediaries.

1

As they are presently
operated,
STIPs
are extremely capital intensive
intermediaries
for which
computers and sophisticated telecommunications
systems play a pervasive role. 23 Computers are essential
to the STIP
accounting
system.
Given the large
number of securities held in the STIP portfolio and
the rapid portfolio
turnover
of STIPs,
the daily
valuation of the portfolio and the calculation
of the
daily dividend would be extremely difficult without
An even more important
function
of
computers.
computers
is the administration
of shareholder
accounts.
Computers handle such diverse functions as
the crediting of daily dividends to each account, the
writing and mailing of monthly dividend checks and
account statements, and the recording of every transSome bank trust departments
even employ
action.
automated
accounting
systems which provide
for

THE EFFECT OF INTEREST RATE CEILINGS
AT THE DEPOSIT INSTITUTIONS ON
THE DEMAND FOR STIP SHARES

22 Evidence that for many investors MMF shares are not
merely a substitute
for deposits is given in Cook and
Duffield [5].
23 This assertion and the following discussion are based
on conversations
with STIP officials, and examination
of
STIP computer software descriptions and other literature
put out by various types of STIPs.
See, for example,
the ABA’s Trust Software Buyer’s Guide [l].
FEDERAL

RESERVE

BANK

OF

RICHMOND

15

The increase in the use of computers since 1969
(and earlier)
resulted from the sharp declines in
computer costs that occurred over that period. Computers perform three major services for STIPs : they
(1) make calculations,
(2) store data, and (3) print
information.
The unit cost of each basic service has
fallen sharply.
The decline in costs is shown in
Table, VII for two of the three services.24
A second and related technological
development
affecting the cost of STIP operations
was the development
of sophisticated
telecommunications
systems such as Inward Wide Area Telecommunications
Service (“800” numbers)
and computerized
switchboards.
This technology was important because the
vast majority of investors in STIPs do business over
the phone, mostly by long distance.
Long distance
calls are the rule because STIPs have to pool large
amounts of funds to achieve economies of scale and
this necessarily makes them an “out-of-town”
financial intermediary
for most investors.
By lowering the costs of communication
with customers, technological
developments
in the telecommunications
industry
have lowered the operating
costs of STIPs and enabled them to provide shortterm financial intermediation
at a lower price.
Of
particular importance is the Inward Wide Area Telecommunications
Service, which was initially made
available in the late 1960’s. Since 1970 the cost of
the Inward WATS has fallen significantly.25

daily unassisted
transfer
of excess cash (above a
small minimum
amount)
from eligible accounts to
the STIF.
Some STIPs,
such as MMFs, STEFs,
and STITs, also use computers as an important tool
in sales administration.
Newspaper
advertisements
are monitored
for sales and cost effectiveness
with
Computers also print, and mail
the aid of computers.
letters to prospective
shareholders,
often in a sequence timed by the computer.
STIP expenses for labor to manage portfolios are
also quite low, because most STIPs
confine their
assets to prime, low-risk money market instruments.
As a result, STIP portfolio management
is generally
guided more by rules defining the type of instrument
eligible for purchase than by labor intensive study of
issuers

whose debt is being purchased.

the majority
commercial

of MMFs
paper

restrict

their

to the highest

rated A-l

by Standard

and most

of the remainder

For instance,
purchases

quality

of

category,

& Poor’s or P-l by Moody’s,
restrict

their

purchases

to the two highest quality categories, rated A-l or
A-Z by Standard & Poor’s or P-l or P-Z by Moody’s.
It is important
to note that the use of computers
by financial organizations
that operate STIPs,
such
as mutual fund groups and bank trust departments,
has increased greatly over the last ten to fifteen years.
In December
1969, the Securities
and Exchange
Commission
surveyed 41 mutual fund groups on the
extent to which they used computers for different
functions.
The results, shown in Table VI, indicate
that, for each of the four functions shown, only about
half of the mutual fund groups were using computers.
If the same survey were taken today, the results
would show the use of computers by virtually
100
percent in each case.

24 The authors were
the cost of a line of
with people in the
cost of this service

25 In nominal terms the cost in Virginia of a full period
zone 5 Inward WATS service dropped from $2,225 per
month in 1970 to $1,675 per month in 1980.

Table

FUNCTIONS

FOR WHICH

IN DECEMBER
Number
Size of

of

Percentage
a Computer

Large

27

14

41

Administration

78

WERE

Note:
Source:

16

Large

fund

Institutional

groups

are

Investor

those
Study

with

$100

BEING

FUND
that

Employed

Administration

63

USED

GROUPS

Trading

57

Total

Account

89

Small

COMPUTERS

Percentage

Firms Using

Sample

VI

BY MUTUAL

of

Firms in

Firm

1969

unable to locate time series data for
printed output.
However, discussion
computer industry indicates that the
also dropped sharply.

Computers

for

of the Securities

or more

and

ECONOMIC

44

46

in assets.

Exchange

REVIEW,

36

Commission.

SEPTEMBER/OCTOBER

Administration

52

29

million

General

Administration

52

56

Tasks Specified

Sales

1980

59

43

43
54

Table

THE
Monthly

DECLINE

VII

OF COMPUTER

Rental

Monthly

basis points. This is comparable to the expense ratio
of no load mutual bond
funds.26 It is inconceivable
that the MMF expense ratio would be so low if the
heavy recordkeeping
and administrative
functions of
MMFs were performed manually instead of by computer.
To the extent
that’ technological
progress
has
altered the production process and reduced the costs
of STIPs, the STIP supply curve has shifted downward.
As shown in Figure 2, this has lowered the
STIP expense ratio, and- increased the quantity of
STIP assets.27

COSTS
Cost of Data

Rental.

Cost Per Million

Cost Per Million

Processing

Bytes of Main

Bytes of Direct

(cost per 100,000

Memory

Access Storage

calculations)

1957

$105,608

1956

$153.00

1958

$ .26

1964

28,800

1964

75.00

1964

.12

1976

3,800

1970

8.30

1972

.02

1979

430

1973

4.85

1979

.01

1979

1.35

source:

IBM

Data

Processing

Effect of Technology on the Demand for STIP
Services It can also be argued that technological
factors have increased the demand for STIP services

Division.

Additional
evidence of the impact of technological
progress
in the computer
and telecommunications
industries
on STIP costs ‘comes from a comparison
of the share turnover
rates and costs of STIPs to
those of intermediaries
for long-term financial assets.
Table VIII
shows the share turnover
rates (i.e.,
annual redemptions
divided by average assets)
of
MMFs, which are operated by mutual fund groups,
and STIFs,
which are operated by bank trust departments, and the share turnover rates of long-term
bond funds operated by the same sectors.
The table
illustrates that the account turnover activity at STIPs
is roughly 15 times greater than that of intermediaries for long-term
financial
instruments.

26 This statement
is based on a survey of 18 no-load
corporate bond funds and no-load tax-exempt
bond funds
in Weisenberger
[12].
The average expense ratio of
these no-load bond funds in 1978 was 78 basis points.
This expense
ratio is not directly comparable
to the
MMF expense ratio because (1) bond funds probably
spend more resources on portfolio management
and (2)
the average size of bond funds is much smaller than that
of MMFs.
Both of these factors bias the expense ratio
comparison
in favor of MMFs.
27 Dunham [7] stresses the contribution
of MMFs to the
goals of multiproduct
firms, such as mutual fund groups,
as an additional factor increasing
the supply of MMFs
beginning in 1974.

Figure

Clearly, this difference in turnover activity results
in a far greater amount of administrative
and recordkeeping activity for MMFs
than for bond funds.
Nevertheless,
as was shown in Table I, the weighted
average expense ratio for MMFs in 1979 was only 55

Table

2

THE IMPACT OF DECLINING COMPUTER
COSTS ON THE STIP SUPPLY CURVE
STIP
Expense
Ratio

VIII

ANNUAL
SHARE TURNOVER
RATES
STlPs AND BOND FUNDS

OF

(1979)
Mutual Fund
Groups

Bank Trust
Departments

STIPs

2.84

2.77

Bond Funds

0.19

0.15

Note:

Share
over

Mutual

Source:

stitute’s
ment
of

turnover

average

estimates

reported
were

fund

in

ore

data

“Trends

collective

rates

calculated

as annual

redemptions

assets.
are

in Mutual
ore

the

investment
their

collected

by

the

Investment

Activity.”

average
funds

annual
the

from
Fund

of
of

reports.

the

share

12 bank
(No

Company

Bank

turnover

trust

other

In-

trust departrates

departments

annual

STIP

reports

Assets

authors.)

FEDERAL

RESERVE

BANK

OF

RICHMOND

17

by decreasing the individual-specific
costs of using a
STIP.
The most important
development
in this
regard is the widespread
availability
among most
types of STIPs-especially
MMFs and STEFs-of
the toll-free 800 number.
As noted above, because
STIPs are generally out-of-town intermediaries,
virtually all business is conducted over the phone, mostly
over long distance.
With the availability
of 800
numbers,
investors
can get information
about a
STIP, inquire about yields, or purchase or redeem
shares by simply picking up the phone. There are no
financial
costs, and other individual-specific
costs
would appear to be negligible.
With respect to the
history of STIPs, it is important to realize that the
use of 800 numbers by mutual funds is a fairly recent
phenomenon.
In 1972, for example, only a few small
mutual funds made 800 numbers available to investors. By 1974-75 the number had grown to about a
dozen.
By the spring of 1980, however, almost all
money market mutual funds and many other types of
mutual funds had 800 numbers.28
It is interesting
to note that the convenience
of
obtaining all one’s financial products at one financial
intermediary
has been thought to be so significant
that savings and loan associations and mutual savings
banks have been allowed by law to pay a differential
of at least 25 basis points over what banks can pay on
time and savings deposits.
In the framework of this
section, the reason for this differential is to offset the
marginal individual-specific
(i.e., transportation
and
inconvenience)
costs of inducing an investor to do
business with a second financial intermediary
(i.e.,
in addition
to banks, where the investor has his
For STIPs
the toll-free long
checking account).
distance number has made these costs fairly insignificant. To the extent that toll-free long distance numbers have lowered the individual-specific
costs of a
STIP
investment,
the demand schedule for. STIP
services has shifted permanently
to the right.
Other Factors
Affecting
the Demand
for STIP
A nontechnological
factor that also may
Services
have lowered the individual-specific
costs of investment in STIPs
is the establishment
of STIPs
by
intermediaries
that are already providing other types
These include (1) brokers,
of financial
services.
which offer shares in MMFs, STEFs, and STITs,
(2) mutual
fund groups,
which offer shares in

28 These statements are based on a survey of various
issues of the Mutual Fund Directory published by ‘Investment Dealers Digest and Donoghue’s Money Fund
Directory of Holliston, Massachusetts.
In the spring of
1980, 64 of the 78 MMFs and STEFs listed in the Money
Fund Directory had 800 numbers.
18

ECONOMIC

REVIEW,

MMFs and STEFs, and (3) bank trust departments,
which provide MMF and STIF
services to their
accounts.
The use of STIPs by brokerage firms; mutual fund
groups, and bank trust departments
decreases the
individual-specific
costs of using a STIP for some
investors by lowering the information
costs associated with choosing a STIP, and by increasing
the
convenience
of using a STIP.
This point is significant because the assertion
that in the absence of
Regulation Q, STIP money would flow back into the
deposit institutions
typically assumes that individualspecific factors
such as convenience,
information
costs, and transportation
operate in favor of the local
However, this may not be the
deposit intermediary.
case for investors
who use STIPs
in conjunction
with other financial services offered by brokers, mutual fund groups, and bank trust departments.
The Possible
Impact
of
The 1969-70 Period:
Blue Sky Laws
An interesting
question
is why
MMFs did not start up in 1969 and 1970 in reaction
to the large spreads between money market rates
and Regulation
Q ceiling rates prevailing
in that
period.
One possible explanation
is the impact of
mutual funds,
state “Blue Sky Laws” regulating
that for years have set maximum
mutual fund exIf these maximums
were below the
pense ratios.
expense ratios needed for MMFs to cover their costs,
then MMFs would not form even in reaction to very
large spreads between money market rates and deposit ceiling rates, such as appeared in 1969-70. In
such a case a downward
movement
in the MMF
supply curve would be required to get an expense
ratio that was both economically
viable and legally
permissible.
In fact there is some evidence that Blue Sky Laws
might have been a binding constraint
on the ability
of MMFs to serve as a money market intermediary
at a price that covered their costs. An Investment
Company Institute survey conducted in January 1976
found that 26 states had formal or informal limits on
the expense ratios that could be passed on to shareowners29
Fourteen of these states had limits of 1½
percent of assets, eleven had limits of 2 percent of
the first $10 million of assets, 1½ percent of the next
$20 million and 1 percent of the balance, and one had
a limit of 1½ percent of the first $30 million of assets
and 1 percent of the balance.
In practice, virtually

29 In a follow-up Investment
in October 1979, 10 of these
suspended the limitations on
six states indicated that they
SEPTEMBER/OCTOBER

1980

Company Institute survey
26 states had eliminated or
expense ratios and another
would grant waivers.

all MMFs limit their expense ratios to be no higher
than the lowest-expense
ratio permitted in any state
in which the MMF is doing business.
Data on MMF
expenses indicate that in 1977-78 several MMFs had
expense ratios near or at the limit imposed by Blue
Sky Laws.30
This suggests that in the 1969-70
period, when the expense ratio necessary to cover
costs was almost certainly
much higher, Blue Sky
Laws may have prevented
MMFs from forming in
reaction to the large spreads between money market
This
rates and deposit ceiling rates at that time.
possibility
is also supported
by the fact that two
other types of STIPs, which are not subject to Blue
Sky Laws, were in operation in 1968.
One possible set of conditions that may have characterized the 1969-70 period is shown in Figure 3,
which assumes the same initial situation of no intersection between supply and demand curves as shown
in Figure 1. When market rates rise above deposit
ceiling rates, the MMF demand curve shifts to the
right and intersects the MMF supply curve at point
A. However, at point A the Blue Sky Law expense
ratio is below the MMF supply curve so that MMFs
can not cover their costs. Consequently,
there is no
response by potential MMFs.
‘If this set of circumstances characterized
the 1969-70 period, it would be
an interesting
case of one government
regulation
(Regulation
Q) creating an economic incentive for a
new financial intermediary,
but another government
regulation
(Blue Sky Laws) preventing
that intermediary from operating.
Of course, it is possible that MMFs would not
have started in 1969-70 even without Blue Sky Law
expense ratio limits. The absence of the 800 number,
which is a development
that was much more important to the success of MMFs than to STIFs or credit
union pools, may have limited the rightward shift in
the MMF demand curve when Regulation Q became
binding. Furthermore,
mutual funds may have viewed
the large spreads between MMF rates and Regulation Q ceiling rates as a short-run aberration
which
did not justify the costs of starting
up a MMF.
Finally, certain aspects of the mutual fund industry
itself, such as the emphasis on equities and the near
total reliance on the “load” form of distribution,
may
have worked against the starting of MMFs.
Consequently, it is impossible to positively attribute
the
absence of MMFs in the 1969-70 period to the Blue
Sky Laws. In any case, without the decline in com-

Figure

THE EFFECT OF BLUE SKY LAWS ON THE
MARKET FOR STIP SHARES
STIP
Expense
Ratio

STIP
Assets

puter costs and the increased use of computers prior
to the mid-1970’s, Blue Sky Laws would have hampered the growth of MMFs in 1974 and thereafter.

In summary,
both government
regulation
and
other factors have contributed
to the growth of
STIPs.
However,
the position taken here is that
even in the absence of government
regulations affecting the deposit institutions,
developments
over the
last 10 to 15 years would have created the economic
incentive for a specialist in short-term financial intermediation.
In particular, technological
developments
in the computer and telecommunications
industries
have influenced both the supply of and demand for
STIP
services.
On the supply side technological
progress
has altered the production
process and
lowered the operating costs of STIPs.
As a result
many STIPs can operate at annual expense ratios as
low as 40 to 50 basis points.
On the demand side,
800 telephone
service has lowered the individualspecific costs of using a STIP.
In addition the widespread use of STIPs by financial service organizations such as mutual funds, brokerage
firms, and
bank trust departments
also has lowered, for many
investors, the individual-specific
costs associated with
a STIP investment.

30 Expense data for 40 MMFs collected by Cook and
Duffield [4] covering the 1977-78 period indicated that 18
had expense ratios (before expense waivers) greater than
1 percent and 9 had expense ratios. greater than 1¼
percent.
FEDERAL

RESERVE

3

BANK

OF

RICHMOND

19

III.
FINANCIAL

IMPLICATIONS

MARKET

to rates
deposits.

OF STIPS

paid on commercial
The purpose

rate competition
Before
tions

considering

of STIPs,

short-term

the financial

it is necessary

investment

options

prior to the emergence
hold deposits
ary.
tion

of STIPs.

deposits

generally

investment,
rate

market

interest

was purchase
minimum
option

ceilings

bankers

as

acceptances.31

ally only available
$100,000, although

little

1969.

to Regula-

CDs, commercial
These securities

option
a

market

paper, or
are gener-

denominations
of
will sell commer-

In this environment

investors

issued.

could be divided

three groups by the amount of funds they
invest
in short-term
financial
instruments.

into

had to

of the Interest
the coverage

to thrift

of

institutions.

underlying

Regulation

Q

was that most deposit holders

small investors

who were locked into

as the only available short-term
investment
As a result, if market rates were to rise above

option.

third

are sometimes

rate ceilings

the mid-1970’s

deposits

as small as $25,000 and bankers

less than $100,000

interest

through

policies, thereby

The passage

Act in 1966 expanded

were relatively

frequently

The

deposit

“excessive”

among banks that might

risky loan and investment

The implicit ‘assumption

or no

second

for deposits

to bank failures.

Adjustment

intermedi-

sector money

in minimum
a few issuers

cial paper in amounts
acceptances

early

of private

such

were

The

leading

they could

bills, which has required

since

was purchase

subject

rates.

of Treasury

of $10,000

instruments,

required
that

encourage

implicathe three

to investors

First,

but were

Q interest

below

available

in a bank or other financial

These

minimum

market

to review

bank time and savings

was to prevent

fixed Regulation
massive

Q ceiling rates, there would not be a

flight of funds out of the deposit

into other financial

assets.

That

institutions

this reasoning

largely correct can be seen by examining

was

the behavior

of savings deposits at the deposit institutions
in 1973
and 1974, when short-term market interest rates rose
to levels over twice as high as the Regulation
ing rate
savings

on these
deposits

deposits.

While

slowed markedly

Q ceil-

the growth

during

of

this period,

total savings deposits actually increased despite the
huge positive differential
between market rates and

One
group with less than $10,000 had access only to small
denomination
time and savings deposits.
A second

Regulation

group

verely damaged the ability of the deposit institutions
to raise funds at below market interest rates. As a

with $10,000

additional

option

but less than

of purchasing

$100,000

Treasury

had the

bills.

The

final group with at least $100,000 could also invest in
private sector money market instruments.
The fundamental
have made

importance

this distinction

of STIPs

among

is that they

investors

largely

result,
lation
This

sometimes

month

investment

options

are

altered

alteration

lation

all three

rates.

after interest rates began to rise above ReguQ ceiling rates in 1977, regulators
funda-

mentally

meaningless.
Because all forms of STIPs have minimum purchase requirements
as low as $1,000 and
lower,

Q ceiling

The emergence of STIPs, by providing access to
money market yields to virtually
all investors,
se-

the application
came in June

Q ceiling

(“money

rate on 6-month

market

Treasury

of Regulation
deposit

certificates”)
bill rate.

Q.

1978 when the Reguwas

certificates

tied

Subsequently,

to the

6-

Regulation

effectively available to all types of investors, regardless of the amount of short-term
funds at their dis-

Q ceiling rates on 4-year and then 2½-year deposit
certificates were also tied to market rates of compar-

posal.

able maturity

This

increased

access

to the money

market

through STIPs has several implications for the financial markets which are discussed below.

One

suggested

STIPs

stitutes

Banking

rates

Act of 1933 and were initially

applied

only

of STIPs

31 This categorization
is a slight oversimplification.
Some
short-term
Federal agency issues are also sold in relatively small denominations
and a small number of, corporations
market commercial
paper in small denominations through the mail to individuals.
20

ECONOMIC

REVIEW,

other

were

simply

forms

for MMFs.

bank

SEPTEMBER/OCTOBER

to

the

emergence

to the deposit institutions

are either perfect
If binding

placed

departments
many

that

to MMFs.

probably

securities.
of
was

the coverage of Regulation Q ceiling rates
That response ignores the many other

to MMFs.
forms

response

as a competitor

to expand
The Impact of STIPs on the Administration
of
Regulation Q Interest Rate ceilings
Deposit
rate ceilings under Regulation
Q originated with the

U. S. Government

on MMFs,

STIFs

For

1980

Q were

departments

Q ceiling
effect

from

instance,

are virtually

If Regulation

trust

the major

be to shift funds

of STIPs.

or close sub-

Regulation

would

MMFs

for bank

to
trust

perfect

substitutes

placed

on MMFs,

that now use MMFs

would start STIFs.
Similarly for many individuals
STITs are close substitutes for MMFs.
If Regulation Q ceilings were imposed on MMFs, many individuals would undoubtedly
shift their funds out of
MMFs into STITs.
As a result STITs would probably develop for additional
types of money market
instruments,
such as commercial paper.

In 1978 the Federal
erous

out of deposit

interest

STIPs,

rate

ceilings

other

Developments

than

such as changing

have also played
deposit
taken

interest

regulatory

rate ceilings.32

rate ceilings.
from Section
computer

these other

clusion

that

of STIPs.
the

areas

defined

of

banks

may

demise

factors,

ceiling rates can be partly attributed

agreements

were included
shares

included

Q

to these techno-

In fact,

Aggregates

Since

the

1970’s, the Federal Reserve has used various
tions of the money supply-the
“monetary
gates”-as

targets

of monetary

policy.

STIFs

early
definiaggre-

Specifically,

target

included

little over time.

Prior to a redefinition
of the monetary aggregates
in early 1980, no form of STIP shares was counted
Section

I of this article

However,

and summarized

time deposits

of commercial
in M-2.

The best example

of open-end

aggregates,

than $100,000)

time

at banks

deposits

in function

the $12 to $15 billion of

funds

invested

or in a LGIP.

are included

in MMFs

are

In the former case

in M-2, while

in the latter

Because

MMF

unit receives

assets at the end of 1979 constituted

only about one-half of total STIP assets, the new
M-2 excludes roughly one-half of total STIP assets,

STIPs,

ally be withdrawn

on demand.

identical

perfect

is STIFs.

in STIFs are excluded.
The same type
arises when a local government
invests

all of which should

as small

are almost

department

such as STIFs and LGIPs, are virtually identical in
liquidity to savings deposits in that both can generas liquid

not

aggre-

logically

are virtually

case they are not. Yet the government
the same liquidity in either case.

I,

banks, which have always

Shares

were

presented in this
denomination
and

STIPs

money in a MMF

the basic characteristics
of STIP
shares are very
similar to the characteristics
of savings and small
been included

shares

of the monetary

in M-2, while the $32 billion of trust depart-

the funds

as shown in
in Table

MMF

some other

ment funds
of ‘anomaly

supply.

fund

of shares of all kinds of STIPs-sug-

of the monetary
bank trust

as part of the money

than

the information
low minimum

and MMFs

periodically
specified desired growth
rates
and M-2 as a means of attempting to achieve
In practice, these
its macroeconomic
objectives.
rates have changed

market

and organization
and provide almost identical services and liquidity to the accounts of the bank trust
department. 34 Nevertheless, under the new definition

it has
of M-l

growth

of

other

such as overnight

money

for MMFs.

substitutes
Monetary

deposits

addition,

in the new M-2.

other

short maturity

assets at each

gests that shares of all forms of STIPs
belong in M-2 under the new definition.

logical developments.
The

and

in the redefinition

gates.
However,
article-i.e.,
the

contributed

attempted

the new M-2 was
In

liabilities

were

1980 the aggre-

redefinition

institutions.

of

As a result,

small time and savings

deposit-like

STIP

of deposit

of Regulation

to include
and thrift

had

aggregates

In particular,

short-term
shares

markets

kinds of monetary

repurchase

It follows from this con-

ultimate

similar

monetary
The

that num-

the significance

and in early

level of aggregation.

It is interesting
to recall the conclusion
II that technological
progress in the

and telecommunications

to the growth

to combine

the view

would have led to the termination

redefined.33

were

financial

as then defined.

of the

reviewed,

gates

to end fixed

However,

aggregates

definitions

concluded

and reduced

thoroughly

a 6-year
growth

attitudes,

a part in the decision

here is that even without

STIPs

over
the

in the

the meaning

the monetary

The Depository
Institutions
Deregulation
and
Monetary Control Act of 1980 calls for a total phaseperiod.

developments

altered
the

Reserve

nitional

problem

of STITs

are

MMF

(i.e., deposits

less

be included.

could worsen

in that they mature

continues

This defi-

if the growth

to accelerate

of non-

1978-79 period.

Shares

STIPs

logically

as it did in the

in six

months or less. Shares of all forms of STIPs
available to investors in minimum denominations

are
as

33 The proposal to redefine the monetary
the resulting
redefinition
are described
10].

aggregates and
in Simpson [9,

low as $1,000.

32 See Snellings

34 The similarity
of the turnover rates for MMFs and
STIFs,
shown in Table VIII, supports
the view that
these different forms of STIPs provide roughly the same
liquidity to their investors.

[11].
FEDERAL

RESERVE

BANK

OF

RICHMOND

21

The Impact of STIPS
on Short-Term
Yield
Spreads Figure 4 shows the spread between
the
three-month
prime CD rate and the three-month
Treasury bill, rate. The figure shows that the spread
between the CD rate and the bill rate has risen in
periods when market interest rates have been high
relative to Regulation Q ceiling rates, such as 1969,
1973, and 1974.
To understand this relationship it is useful to focus
on the three investor
categories
described
above,
especially the group with sufficient funds to buy bills
but not other money market instruments.
When
interest rates are above Regulation
Q ceilings, many
deposit holders with sufficient funds withdraw these
funds from deposit institutions
(i.e., “disintermediate”)
to invest them directly
in higher-yielding
money market instruments.
Prior to the late 1970’s
the bulk of such investment
was directed towards
Treasury bills, because of the much larger minimum
amounts of funds required to purchase private-sector
money market instruments
such as CDs and commercial paper.
The massive purchases of Treasury
bills by individuals in periods of disintermediation
has driven
down bill rates relative to the rates on other money
market instruments.
This phenomenon
had its peak
effect in mid-1974 when the spread between private
sector money market rates and bill rates reached a
level as high as 400 basis points.
The inability of
most individuals
to meet the minimum purchase re-

Figure

quirements necessary to acquire private-sector
money
market instruments
prevented
them from reducing
this large differential
by switching their purchases
from bills to these instruments.35
The rapid growth of STIPs
in the late 1970’s
(along with the introduction
of floating Regulation
Q ceiling rates on 6-month money market certificates) has fundamentally
changed this situation, because STIPs have effectively broken down- the minimum investment
barriers that have prevented many
individuals from acquiring money market instruments
other than Treasury
bills.
In periods
of rising
spreads between private sector rates and bill rates,
the yields earned by most STIPs will rise relative to
the yield on bills. In these circumstances
households

35 This explanation
for the spread between bill rates and
other money market rates prior to the late 1970’s along
with data on Treasury bill purchases is given in detail in
The explanation
rests critically on the fact
Cook [3].
that sectors other than households-such
as commercial
banks and state and local governments
have been willing
to hold bills despite large spreads between bill and other
money market rates. This willingness occurs because for
numerous
reasons other money market instruments
are
not viewed as perfect substitutes
for bills by these sectors.
For instance, banks have used bills to (1) satisfy
pledging requirements
for state and Federal deposits, (2)
satisfy reserve requirements
in some cases, (3) make
repurchase
agreements
with businesses
and state and
local governments,
and (4) influence the ratio of equity
to risky assets, a ratio used by bank regulators to judge a
bank’s capital adequacy.
Private sector money market
instruments,
such as commercial
paper, are not perfect
substitutes
for bills for any of these purposes.

4

THE SPREAD BETWEEN THE THREE-MONTH

1968
Source:

22

1969

1970

1971

1972

1973

CD AND TREASURY

1974

1975

Federal Reserve Bulletin.

ECONOMIC

REVIEW, SEPTEMBER/OCTOBER 1980

1976

1977

BILL RATES

1978

1979

by providing
small investors an alternative
to deposits, STIPs have played a major role in forcing the
termination
of Regulation
Q deposit rate ceilings.
Second, STIPs have increased the liquidity associated with a given volume of outstanding
money market instruments.
As a result the shares of one type
of STIP-MMFs-were
included in a redefinition
of the monetary aggregates in 1980. For consistency,
the shares of other types of STIPs
should also be
included in the monetary
aggregates.
Third, the
presence of STIPs has increased the aggregate substitution from Treasury bills to other money market
instruments
in periods of widened differentials between private money market rates and bill. rates.
This increased substitution
should prevent the spread
between private money -market rates and bill rates
from rising to past peak levels.

and all other investors have the option of switching
out of bills into STIPs.
Furthermore;
most STIPs
are highly sensitive to yield, spreads.
Consequently,
the aggregate
substitution
of private-sector
money
market instruments
for bills in periods of rising
spreads should be greater than in the past.
As a
result the presence of STIPs
should prevent
the
spread between bill rates and private sector money
market rates from ever again reaching the levels of
1974. The evidence to date provides some support
for this view. As shown in Figure 4, in the 1978-79
period of rising interest rates the spread between the
CD and Treasury
bill rates rose only moderately
despite a huge increase in the spread between market
rates and the passbook savings ceiling rate.36

IV.
SUMMARY

References

Over the last decade numerous types of short-term
investment
pooling arrangements
have emerged in
the nation’s financial system. These pooling arrangements allow participants
to invest a much smaller
amount of money than would be necessary to directly
purchase the individual
securities held by the pool.
While the first STIPs were started as early as 1968,
rapid growth in STIPs
did not occur until 1974.
Aggregate
assets of STIPs
surged from a small
amount at the beginning of 1974 to $88 billion by the
end of 1979.
Both. government
regulation
and other factors,
especially technological
developments,
have contributed to the growth of STIPs.
A principal conclusion
of this paper is that technological developments
alone,
especially the sharp decline in computer costs and the
introduction
and widespread availability of 800 numbers, would have been sufficient
to induce many
STIPs
to begin operating
even in the absence of
deposit ceiling rates.
If this conclusion
is correct,
then STIPs
will survive the end of Regulation
Q
deposit rate ceilings.
Because STIPs generally have minimum purchase
requirements
of $1,000 or even lower, they provide
access to the money market to virtually all investors.
This increased access to the money market has had
several implications for the financial markets.
First,

1. American
Bankers
Association.
Trust
Buyers Guide, Washington,
D. C., 1979.

2. Benston,.George
J., and Smith, Clifford W., Jr. “A
Transactions
Cost Approach
to the Theory of Financial
Intermediation.”
Journal
of Finance,
XXX1 (May 1976) : 216-231.
3. Cook, Timothy.
“The Determinants
of Spreads
Bill and Other Money Market
Between Treasury
Rates.”
Journal of Economics and Business, forthcoming.
4.

and. Duffield,
Jeremy
G.
“Average
Costs of Money Market Mutual Funds.”
Economic
Review, Federal Reserve Bank of Richmond (July/
August 1979).

6.

“Money Market
Mutual Funds:
A
Reaction to Government
Regulations
or a Lasting
Financial
Innovation?”
Economic Review, Federal
Reserve
Bank of Richmond
(July/August
1979).

6. Duncan, Harley T. “Local Government
Investment
Pools:
Potential
Benefits for Texas Local Governments.”
Public
Affairs
Comment,
Lyndon
B.
Johnson School of Public Affairs,
The University
of Texas at Austin (August 1978).
7. Dunham,
Constance.
“The
Growth
of Money
Market Funds.”
New England Economic Review
(September/October
1980).
8. Municipal Market Developments.
February
Public Securities
Association,
New York.

10.

36 In March 1980 the spread between the CD rate and
the bill rate jumped sharply.
However, the rise in the
spread followed the imposition
on March 15, 1980 of a
15 percent reserve requirement
on assets above a base
level at money market funds.
The data on noncompetitive bids at Treasury bill auctions indicates a sharp rise
in the purchase
of bills by individuals
over the same
period.
RESERVE

6, 1980.

9. Simpson, Thomas D. “A Proposal
for Redefining
the Monetary
Aggregates.”
Federal Reserve Bulletin 65 (January
1979).
gates.”
1980).

FEDERAL

Software

“The Redefined
Monetary
AggreFederal Reserve Bulletin
66 (February

11. Snellings, Aubrey N. “The Financial
Services Industry:
Recent
Trends
and Future
Prospects.”
Economic Review,
Federal Reserve Bank of Richmond (January/February
1980).
12.

BANK

OF

Weisenberger
Investment
Companies Service.
Warren, Gorham & Lamont, Inc., New York, New York,
1979.
RICHMOND

23

INVESTMENTS FOR SMALL SAVERS
AT COMMERCIAL BANKS
lames F. Tucker

When the Federal regulators
of financial institutions issued new rules for the six-month
money
market certificate on March 8, 1979, they also stated
that they were reviewing the terms on other types of
deposits “with a view toward providing
improved
This
savings opportunities
for the small saver.”1
statement did not define the term small saver. However, from the nature of some of the regulatory
changes that followed, the regulators clearly showed
that they were concerned with savers having less than
The first group of
$1,000 available
for deposit.
regulatory
changes became effective as of July 1,
1979. Additional
changes became effective during
the first half of 1980.
The main purpose of this article is to explain the
array of these regulatory changes which were made
as amendments
to Regulation
Q, and to show how
they are designed to provide improved savings opportunities for the small saver.
In addition, because
these specific amendments
affect those sections of
Regulation Q pertaining to time and savings deposits,
some attention is devoted to a review of these deposits
as secure investments
for the small saver. The initial
section of this article compares the various time and
savings deposits as investments
for the small saver.
The latter section, however,
focuses on the time
deposit specifically referred to as the Small Savers
Certificate (SSC) by Federal regulators and analyzes
some of the factors that the saver should consider
before terminating
this certificate before maturity.

CHANGES

IN REGULATION

member

to Regulation
Federal

1 Federal Reserve Board of Governors,
Press Release, March 8, 1979, p. 2.

24

Federal

ECONOMIC

Reserve

REVIEW,

effected

Q by the Board

through

amendments

of -Governors

of the

System.

Passbook Savings Accounts Prior to July 1, 1979,
Regulation
Q stipulated that no member bank could
pay interest on any savings deposit at a rate in excess
This regulation
of 5 percent (12 CFR 217.7(c)).
was amended by the Federal Reserve Board to increase from 5 percent to 5¼ percent the ceiling rate
of interest payable on savings deposits by member
banks. The ceiling rate for savings deposits that are
subject to negotiable orders of withdrawal
was left
at 5 percent.2
These new ceiling rates still deprive the small
saver of the higher rates available to investors
in
other financial instruments;
however, such ceilings
are scheduled to be phased out over a six-year period
which began March 31, 1980. The ceiling rates on
passbook savings accounts are expected to increase
by at least a quarter of a percentage point within the
first eighteen months, half a percentage point within
the next eighteen months, and half a percentage point
for each of the next three years.
Fixed-Rate

Savings Certificates

Prior

to July

1,

1979, Federal regulations
required a minimum
deposit of $1,000 on fixed-rate time deposit certificates
with

maturities

of four

years

or more

(12

CFR

217.7).
This requirement
no longer exists although
individual banks can set their own minimum deposits.
banks

amounts
All of the regulatory changes designed to help the
small saver were adopted and announced
jointly by
the Federal Reserve Board, the Federal Deposit Insurance Corporation,
the Federal Home Loan Bank
Board, and the National Credit Union Administration. The changes, with respect to Federal ‘Reserve

were

Reserve

Most

Q

banks,

are

now

issuing

these

certificates

much less than $1,000, thus enabling

small savers to obtain

a rate of interest

greater

in

many
than

the passbook rate for a fixed period of time.
The
various maturities and maximum rates of interest for
these fixed-rate

certificates

at member

banks

are as

follows :

2 Effective December 31, 1980 the ceiling rate on negotiable orders of withdrawal
accounts also will increase to
5¼ percent.
SEPTEMBER/OCTOBER

1980

Maturity

Maximum
Percents

30 days or more but less than 90 days

5¼

90 days or more but less than 1 year

5¾

1 year or more but less than 30 months

6

30 months

was required, and the amount of the penalty
exceed interest accrued or already paid.

6½

or more but less than 4 years

4 years or more but less than 6 years
6 years or more but less than 8 years

Effective June 2, 1980, a further change was made
in the penalty for early withdrawal
of funds from
time deposits. Under the new rules, for deposits with
an original maturity of one year or less, the penalty
is set at an amount equal to three months simple,
nominal interest.
For deposits with a maturity of
more than one year, the penalty is set at an amount
equal to six months simple, nominal interest.
Unlike
the previous
minimum
required penalty, this rule
may require a reduction in the principal sum of the
deposit if the withdrawal
is made during the early
months of the deposit.4

7¼
7½

8 years or more

did not

7¾

Before investing funds in one of these fixed-rate
certificates,
savers should understand
that such certificates are nonnegotiable
and are subject to a substantial penalty for early withdrawal.

Indeed there are critics of the new penalty for early
withdrawal
because of the possibility that the saver
could get back less than the original amount of savings placed in the deposit.
However, it should be
noted that a similar situation would also occur if the
saver were to liquidate a market security prior to
maturity in a rising interest rate environment.
In this
specific case regarding savings certificates, one should
understand
that much of the funds placed in these
time deposits are in turn used by banks to finance
certain credit needs of small savers.’ Thus, the small
saver, having been provided a market-oriented
rate of
return on a term deposit is, in effect, asked to share
more of the interest rate risk formerly borne by the
banks, a risk that could limit the bank’s willingness to
commit funds to the credit needs of small savers.6

Early Withdrawal
Penalty
Prior to July 1, 1979,
Regulation
Q provided that where a member bank
agreed to pay a time deposit prior to maturity,
the
bank had to impose an early withdrawal
penalty on
the funds withdrawn
(12 CFR 217.4(d)).
The
minimum
required penalty was a reduction
in the
rate of interest paid on the funds withdrawn to a rate
not to exceed the rate currently
prescribed
for a
savings deposit (5 percent) plus a forfeiture of three
months interest at such rate. Under this provision,
the amount of the early withdrawal penalty increased
significantly
the longer the deposit was maintained.
To reduce the severity of this penalty on small
savers, the Federal Reserve Board created a new
early withdrawal penalty by amending Section 217.4
(d) of Regulation
Q (12 CFR 217.4(d)).
In all
deposit categories for new certificates issued or renewed after July 1, the minimum required early withdrawal penalty on time deposits with original maturities of one year or less was established
as the
forfeiture
of three months interest on the amount
If
withdrawn
at the rate being paid on the deposit.
the amount withdrawn
had been on deposit for less
than three months, all interest was forfeited.
The
minimum required early withdrawal penalty on time
deposits with original maturities
of more than one
year was the forfeiture of six months interest on the
amount withdrawn
at the rate being paid on the
deposit.
If the amount withdrawn
had been on
deposit for less than six months, all interest was
forfeited. No reduction of interest to the savings rate

SMALL

SAVERS

CERTIFICATES

While the foregoing changes in Regulation Q were
key elements in the effort to improve savings opportunities for the small saver, ‘the major step in this
direction was the creation of the new Small Savers
Certificate (SSC).
To accommodate the small saver,
this certificate was authorized with no requirement
for a minimum denomination.6
The effective date for
the issuance of this new certificate was July 1, 1979,
and the certificate had a maturity of four years (or
more), with a ceiling rate based on the yield for

4 These new rules set the minimum penalty for early
withdrawal
of funds from time deposits. Member banks
are free to set even more severe penalties.
5 Statement
by Paul A. Volcker, Chairman,
Board of
Governors
of the Federal Reserve
System before the
Committee
on Banking,
Housing,
and Urban Affairs,
United States Senate, August 5, 1980, p. 8.

3 As the subsequent
discussion on Small Savers Certificates will indicate,
rates shown for maturities
of 30
months or more in this table are not the maximum available to small savers who are able to meet a member
bank’s minimum denomination
for a Small Savers Certificate.
FEDERAL

RESERVE

6 Individual
nations.
BANK

OF

banks

RICHMOND

may set their own minimum

denomi-

25

below those prevailing)
was adopted in part in recognition of the fact that Treasury
security yields are
frequently
below other market rates and generally
lead declines in other rates available to savers. Thus,
floating deposit rate ceilings related to such instruments would decline more rapidly than yields on
other available savings opportunities,
such as those
that include money market instruments.

4-year Treasury
securities.
Specifically, the ceiling
for member banks was set at 1¼ percentage points
below the yield on 4-year Treasury
securities.
During the first half of 1980, Federal regulators
approved additional changes in the SSC to improve
the savings opportunity
for the small saver. One of
these changes became effective on January 1, when
the minimum
maturity
for the certificates was reduced from four years to two and a half years. Also,
the yield on the new SSC was raised, by setting the
floating ceiling rate only ¾
percentage point below
the 2½-year Treasury yield. Although the improvement in the form of a reduction
in maturity
was
somewhat nullified on February 27 when a limitation
on the rate of interest was set at 11.75 percent, small
savers could still count on receiving a higher yield
on their SSCs than they could earn on fixed-rate
certificates
during
periods of high market
rates.
Effective June 3, three more changes brought pronounced improvement
in the SSCs for small savers.
One change allowed commercial
banks to pay the
ceiling rate of 11.75 percent after the Treasury yield
Prior to June 2, commergoes above 12.00 percent.
cial banks had to wait until the Treasury yield went
above 12.50 percent before they could pay the 11.75
percent ceiling. A second change allowed commercial
banks to pay a rate ¼
percent below the Treasury
yield instead of the ¾ percent allowed previously, although the 11.75 percent cap was maintained. A third
change allowed commercial banks to pay a minimum
ceiling rate of 9.25 percent on SSCs. That is, even
when the yield on 2½-year Treasury securities falls
below the rate at which the base ceiling would be activated (Treasury
yield less ¼ percent),
commercial
banks would still be allowed to pay up to 9.25 percent.

The changes in ceiling rates on SSCs that became
effective on June 3, 1980 are shown in Table I.
The basic ceiling interest rate on SSCs is determined by the U. S. Treasury Department
every two
weeks and is announced
late each Monday or early
Tuesday to become effective the following Thursday.
If Monday is a holiday, the average yield will be
based on the average for the five business days ending
the preceding
Friday, instead of Monday, and will
still be effective on the following Thursday.
Once the
rate is determined for a specific SSC, that particular
rate is paid throughout the 2½ years or more that the
deposit is outstanding.
The interest may be compounded and computed by member banks in accordance with any of the methods authorized by Section
217.3 of Regulation Q.
As a time deposit with a maturity of more than one
year, the SSC carries an early withdrawal
penalty
equal to six months simple, nominal interest.
As
stated earlier, savers should be aware that such a
penalty could require a reduction in the principal sum
of the certificate.
If savers withdraw
their funds
early for reasons other than a personal emergency,
savers should compute precisely the terms, on which
they would have to reinvest their funds in order to
justify such a withdrawal.
Table II illustrates these
terms when the rate is 9.25 percent, the maximum
that member banks can pay when the average yield
on 2½-year Treasury securities is below 9.50 percent.

The concept of minimum ceilings (which, at the
time the decision was made, were at levels near or

Table

SMALL SAVERS
Before
When

the 2½-year
Security

Yield

Above
12.50

and

June

CERTIFICATES:
2,

CEILING

RATES

BEFORE

After
When

Member

12.50

Banks May

Pay

the 2½-year
Security

11.75

below

Above

2½-year
bond rate
minus 75 basis points

9.50

26

May

28, 1980

telegram

to the Presidents

of all

ECONOMIC

Federal

REVIEW,

Reserve

Banks

from

SEPTEMBER/OCTOBER

JUNE

June

2, 1980

2, 1980

Treasury

Yield

Is:

Member

1980

Pay

2½-year
bond rate
minus 25 basis points

9.50

the Depository

Banks May

11.75

12.00

to 12.00

Below

Source:

AND AFTER

1980

Treasury
Is:

I

9.25

Institutions

Deregulation

Committee..

ADDITIONAL

Table II

COST OF TERMINATING
SMALL

SAVERS

A

End of
Month

Notes, At 9¼%, Compounded

Daily

Balance on
Account

Penalty for
Withdrawal

3

$512

$23.125

6

524

23.125

13.15% (2 years)

12

549

23.125

14.09% (1.5 years)

15

562

23.125

14.85% (1.25 years)

18

575

23.125

15.93% (1 year)

24

603

23.125

20.67% (0.5 year)

30

632

23.125

20.67% (0.5 year)

Rate Needed to
Break Even
12.72% (2.25 years)

FEDERAL

RESERVE

FOR SMALL

SAVERS

Generally, small savers are persons of very modest
means, thus the safety of their savings is important
To provide this safety, passbook savings
to them.
accounts, fixed-rate
savings certificates,
and small
savers certificates
issued by member banks are insured up to $100,000 by an agency of the Federal
Government,
namely the Federal Deposit Insurance
Corporation.

CERTIFICATE

With a Deposit of $500
Two-and-One-half-Year

AID

Interest earnings from passbook savings accounts,
fixed-rate savings certificates, and small savers certificates are subject to local, state, and Federal income
taxes.
However, effective with the 1981 tax year,
any combination
of interest earnings and dividends
may be excluded from taxable income up to $200 per
taxpayer on the Federal tax return ($400 on a joint
return).

BANK

OF

RICHMOND

27

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