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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 . 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 . 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 . 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 ) 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  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  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 : “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  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 . 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 . 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 . 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  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  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. . 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 . 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