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MAY 1964 IN TH IS ISSU E Repurchase Agreements.. . .2 Negotiable Time Certificates of Deposit.. 14 FEDERAL RESERVE BANK OF CLEVELAND ECONOM IC REVIEW REPURCHASE AGREEMENTS tE INCREASINGLY complex and com r petitive nature of the central money market has encouraged the development of specialized money market instruments. One such instrument is the repurchase agreement, which is designed to fill the specific needs of a limited number and type of borrowers. These borrowers, principally dealers in G ov ernment securities, play a very important role in the money market.1 THE DEALER MARKET A repurchase agreement, which is used as a borrowing tool, is intimately connected with the functioning of the secondary market for U. S. Government securities. It is par ticularly significant for the small group of dealers that comprises the core of this market. The volume of marketable U. S. Govern ment obligations outstanding has expanded A repurchase agreement involves the sale nearly five-fold since the start of W orld War of securities and a simultaneous commitment II. W hile the major part of the growth occu r by the seller to repurchase the securities at a red during the war, the volume of marketable later date. Such agreements are used con Federal debt, after retreating moderately tinuously by dealers in Government securi through 1951, increased further to a record ties to help finance their operations. To better level of nearly $208 billion at yearend 1963. understand the need for and development of To facilitate the orderly transfer of securities, the repurchase agreement, it is first necessary an active and viable secondary market is to examine the environment in which it indispensable. A network of dealers provides originated. such a market for Government securities. 1 Government securities, as used in this article, refers to the marketable obligations of the U. S. Government. 2 At the present time there are about nineteen major dealers making primary markets in MAY 1 9 6 4 Government securities in the nation, six of stantly shifting demand and supply forces which are commercial banks. The bulk of all transactions in Government securities is ex that prevail in the market. ecuted through the facilities provided by the maintenance of representative prices, but these dealers. In the average week during it also gives assurance of reasonably narrow Competition among the dealers is vital to 1963, Government securities dealers han spreads in the bid and offering prices quoted dled transactions in securities with an aggre by the dealers. W hile spreads are rather gate par value of nearly $1.75 billion. narrow, they provide the principal oppor The dealers actually "make the market" tunity for dealer profits. Because dealers by standing ready to quote buying and selling act as principals in transactions, profits de prices for all Government securities traded. pend in part upon the dealer's ability to In making a market dealers act as principals, maintain a favorable spread between the cost buying and selling securities for their own of inventory and the price at which secur account. ities are sold. The considerable degree of Most transactions in Government securities risk involved in maintaining an active and take place in the over-the-counter market as continuous market chiefly stems from the opposed to an organized market such as the necessity that dealers position a substantial New York Stock Exchange. Buyers and sellers volume of securities, the value of which is of U. subject to market fluctuations. S. Government securities conduct their transactions through three principal types of intermediaries: (1) In the process of providing an active market Government in Government securities, the dealers a ccu securities dealers, (2) commercial banks, and mulate inventories during periods when the (3) securities brokers. supply of securities for sale exceeds customer W h ile tr a n s a c tio n s ca n b e e x e c u t e d demand at the prevailing price level, or through any of these professional groups, when the dealers' appraisal of the market virtually all final purchases and sales are indicates that rising prices on securities may handled by the nucleus of dealer specialists. enable them to turn a profit on their inventory Dealers transact business directly with cus position. These positions may, in turn, be tomers and with other dealers and inter reduced in periods when customer demand mediaries such as commercial banks and for securities increases, or when the dealers' securities brokers. Prices are determined by market appraisal indicates that lower prices negotiation between the dealers and their are in prospect. customers, or other intermediaries acting as fluctuate, therefore, depending upon demand agents for their customers. Negotiation, which and supply conditions and the market outlook. Inventory positions will involves the matching of dealer bid and offer ing prices with the prices buyers and sellers wish to receive, leads to transactions on NEED FO R B O R R O W ED FUNDS Because of the need to carry a sizable terms that are mutually satisfactory. Prices inventory change continuously as a result of the con availability and cost of borrowed funds to of Government securities, the 3 ECONOM IC REVIEW U . S . G O V T . SEC U R IT IES D EA LER S Chart 1 illustrates the need for borrowed funds more clearly, showing dealer trans 1. TRANSACTIONS, POSITIONS, AND FINANCING actions, inventory positions and total financing Mo n t h l y A v e r a g e s of D a i l y Fi gures figures are averages of daily figures, plotted from September 1960 to yearend 1963. The monthly.2 In the 1960-63 period the volume of transactions showed substantial, although irregular, growth. The average daily volume of transactions during 1963 was $1.73 billion, compared with an average daily volume of $1.55 billion during 1961. This represents an increase of nearly 12 percent in the aver age daily volume of transactions during the period. Transactions in issues maturing in less than one year, which normally comprise about three-quarters of total dealer trans actions, accounted for the largest share of the total increase. As indicated in Chart 1, dealer inventory positions, although much larger, tend to move with the volume of transactions.3 In the 196063 period, dealer inventory positions were on average about twice as large as the average Source of data: Board of Governors of the Federal Reserve System help finance an inventory position is crucial to the successful performance of the dealer function, so far as nonbank dealers are con cerned; bank dealer departments use mainly the bank's own funds. Permanent dealer capital provides an equity cushion; however, it constitutes only a small part of the total working capital requirements of the dealer. The bulk of dealer funds is derived from short-term borrowing. 4 2 Data for transactions, positions, and financing are reported daily to the Federal Reserve Bank of New York by the major Government securities dealers. Averages of daily figures are released weekly by that bank and published monthly in the Federal Reserve Bulletin. The statistics are available only since September 1960. Dealer transactions include the par value of securities purchased or sold in the secondary market, but exclude allotments from and redemptions by the Treasury or Federal agencies and temporary transfers of securities under repurchase contracts. 3 Positions figures include the par value of holdings, reported on a commitment basis. This means that securities are counted as part of the dealer's position on the day the dealer agrees to purchase them, even though delivery has not been made. Conversely, securities are deducted from positions as soon as a commitment to sell has been made. The figures include all securities that MAY 1 9 6 4 daily volume of transactions. Dealer inven though the purchase will not have to be tory positions have expanded to accom m o date a rising volume of transactions, as well financed until the time of delivery, which may be a few days or even weeks later. C on as market expectations. The average daily versely, level of dealer positions during 1963 was positions immediately, but they must con $3.41 tinue to finance billion, or about one-fourth higher than the daily average figure of $2.75 billion sales of securities reduce the securities their until the delivery date. during 1961. More than three-fourths of the During 1963 the average daily volume of total increase was centered in positions in dealer borrowing was $3.56 billion, or nearly short-term issues. one-third higher than the average As might be expected, an increase in inventory positions has been accom panied by daily figure during 1961. The foregoing shows the magnitude of and a corresponding increase in the use of the growth in the operations of Government borrowed funds. Because dealers borrow securities dealers and illustrates the way in primarily to finance their inventory of securi which dealer transactions, ties, it is not surprising that the financing financing are closely related. If the dealers pattern in Chart 1 is nearly identical to the are to perform their market function, the positions pattern.4 The levels and move availability of financing is important. Without positions, and ments of the two series differ principally access to borrowed funds, dealers would not because positions are reported on a commit be able to maintain an orderly and active ment basis. W hen a dealer makes a commit market for Government securities. ment to purchase securities, the purchase is reflected in his position immediately, al- REPURCHASE TR A N SA CTIO N S Although small in numbers, Government dealers have sold under repurchase agreements, but exclude those that dealers have acquired under agree ments to resell at a future date (reverse repurchase agreements). "Matched agreements” , under which a dealer has outstanding repurchase and reverse re purchase agreement contracts that are virtually the same in amount and have the same maturity dates, are also excluded. securities dealers are one of the most impor tant users of short-term funds in the economy. To satisfy their financing needs, nonbank dealers have resorted to a variety of sources of funds, principal among which are nonfinancial business corporations. In this con nection, dealers have developed and per fected borrowing techniques, the most im 4 The financing data include the total amount of funds obtained by nonbank dealers against U. S. Government portant of which is the repurchase agree and Federal agency securities through either collateral loans or repurchase agreements and, for bank dealers, ment. the total amount of funds allotted by the bank to the dealer department through repurchase agreements. The figures are exclusive of any funds made available through ''day'' loans, that is, loans extended during the day and repaid by the close of the same day. opment and use of repurchase agreements Dealer access to temporarily idle corporate funds is closely tied to the devel because dealers are able to tailor these agree ments to the specific needs of corporate lenders. 5 ECONOM IC REVIEW Although repurchase agreements (com mutually agreeable period. A specified future monly referred to as RPs) are a special type delivery date is the distinguishing feature of of money market instrument, they are rela this type of transaction. In addition to pro tively uncomplicated and lend themselves viding financing to the dealer, a fixed-date easily to the needs of dealers in Government repurchase transaction allows the dealer to securities. (While the technique is adaptable accommodate a customer's demand for a to the borrowing needs of any group dealing Treasury issue with a specific maturity date in debt obligations, e.g., municipal securities that is either not available in the secondary dealers, this article discusses only the use by market or is in short supply. For example, a dealers in U. S. Government securities.) corporation with a temporary excess of cash There are three general types of repurchase that will be needed to meet a near-term divi transactions. Transactions differ principally dend or tax payment on a certain future date, in the length of time for which the agreement could employ excess funds in a repurchase is extended, with most agreements being agreement that expires on or near the speci short-term (extending for only a few days). An fied dividend or tax payment date. o v ern ig h t transaction, which is the shortest A less commonly employed variation of in duration, involves the purchase of Govern these standard repurchase transactions is the ment securities from a dealer for a period of reverse rep u rch a se one business day. Such a transaction is con back ". In this case, tingent upon the willingness of the dealer to securities from a seller with the stipulation enter into an agreement to repurchase the that he will resell the securities to the original securities the following day. To provide an owner. By use of this technique, the dealer interest return to the lender, the repurchase is able to borrow securities that he needs price exceeds the original sale price. O ver by supplying short-term funds to a customer. night transactions may be renewed each day, It is not unusual, however, for a dealer as long as dealer and purchaser agree. to obtain funds to finance a customer by a g re e m e n t or "sell a dealer purchases is entering into another repurchase contract for essentially the same as an overnight RP except a like amount of securities. Thus, the dealer that the agreement usually remains in effect acts as a financial intermediary in such until either of the two parties elects to ter transactions. An open rep u rch a se tra n sa ction minate it. Such agreements avoid the incon In virtually all types of repurchase trans venience of renewing overnight transactions actions, ownership of the securities involved daily when both parties have a continuing is transferred physically from seller to buyer need for this type of accommodation. In with the seller receiving payment in return. either case the dealer has satisfied his need Payment is generally made in Federal funds, for funds. which are immediately available as compared A fix ed -d a te rep u rch a se tra n sa ction , with the delayed availability of clearing which usually covers longer periods of time, house funds. W hen dealer RPs are consum binds both parties to the agreement for a mated with purchasers in distant cities, the 6 MAY 1 9 6 4 securities are usually transferred to a bank in New York City as custodial agent for the purchaser. Nonfinancial corporations usually The percentage distribution of dealer financing by source of funds is presented in Table I, which shows the average distribution avail themselves of the services of a com of financing for the same period. Data for mercial bank in arranging transfers of Federal New York City banks are shown separately funds to dealers under repurchase contracts. because these banks are not major suppliers Upon termination of a repurchase agreement of dealer financing under repurchase con the procedure is reversed, with the dealer tracts. New York City banks prefer instead to receiving the securities and, in turn, re employ funds at a higher rate of interest in mitting funds to the lender—including an collateral loans.5 As indicated in Table I, amount to cover the agreed upon interest however, New York City banks have been charge. Because repurchase agreements pro supplying an increasing share of total dealer vide for the physical transfer of securities, financing in recent years. During the past promissory notes are not involved. RPs differ three years these banks have becom e in in this respect from loans that are collateral creasingly competitive lenders to Govern ized by Government securities. ment securities dealers. Available data do W hile current data on the rate of interest paid by dealers in repurchase transactions are not systematically available, the rate should be consistently competitive with in terest rates on alternative sources of short U . S . G O V T . S E C U R IT IES D EA LER S 2. FINANCING BY SOURCE M o n th ly A v e r a g e s of D a i l y Figu res term funds. Nonbank securities dealers enter into repurchase agreements with a variety of lenders, most frequently nonfinancial cor porations, commercial banks, the Federal Reserve Bank of New York (acting on behalf of the Federal Reserve System), the various Federal Home Loan banks, and state and local governments. As an indication of the relative importance of these various sources of dealer funds, Chart 2 shows total dealer financing by source of funds from September 1960 through the end of 1963. As indicated by the chart, commercial banks and corpora tions supply the bulk of total dealer financing. During the 1960-63 period, these sources accounted for an average of nearly ninetenths of total dealer financing. Source of data: Board of Governors of the Federal Reserve System 7 ECONOM IC REVIEW TABLE I U. S. Government Securities Dealers Percentage Distribution of Total Financing By Source of Funds* Year 1960 (Last 4 months) . . 1 9 6 1 .................................... 1962 .................................... 1963 .................................... Average 1961-63 . . . ,. . . . . N. Y. City Banks Other Banks Corporations All Other Total 21.5% 24.8 26.4 26.4 25.9 22.4% 22.5 19.5 21.5 21.2 41.4% 43.2 43.5 41.2 42.6 14.7% 9.5 10.6 10.9 10.3 100.0% 100.0 100.0 100.0 100.0 . . . . . * Percentages derived from avera g e of daily figures for each period. Source: Board of Governors of the Federal Reserve System not indicate, however, that the New York The repurchase agreement specifies both City banks have becom e a significant lender the price at which a corporation buys the in the RP market. securities and the price at which the dealer The limited data available indicate that nonfinancial corporations the repurchases them. Therefore, the rate of principal interest is determined in advance and the sources of funds for repurchase agreements. corporate lender is virtually insulated against Because demand deposit balances in com mercial banks earn no interest, many com market risk. The borrowing dealer, in turn, panies in recent years have employed such which increases with the duration of the balances in ways that permit a more efficient contract and the maturity of the underlying use of cash. At the same time, corporate securities. In return for accepting this risk, treasurers the have are sought new methods of employing excess cash reserves. RPs serve as a convenient and relatively riskless in vestment medium for such funds. assumes all of the market risk, the degree of dealer pays relatively less for the borrowed funds. W hile commercial banks may utilize re purchase agreements in a more limited way than corporations, banks outside New York 5 A collateral loan to a dealer is secured by U. S. Government obligations but, unlike an RP transaction, ownership of the securities does not change hands. Since dealer loan demands tend to be largest when the reserves of New York banks are under the most pressure, the banks are reluctant to offer rates to dealers that may be as low as can be obtained elsewhere. In ad dition, because the bulk of dealer funds is committed to inventory positions, their average deposit balances are relatively small and provide little bargaining power with the banks. 8 City have found RPs a convenient and profit able manner in which to employ excess reserves. One reason may be that the rate on RPs often exceeds the rate in the Federal funds market (an alternative outlet for idle bank reserves). In addition, some banks may prefer the added safety associated with an RP as opposed to an unsecured sale of Federal funds. MAY 1 9 6 4 The Federal Reserve Bank of New York also makes repurchase agreements. In contrast to M ARKET IM PORTAN CE O F RPs RPs with corporations and commercial banks, Charts 1 and 2 are helpful in appraising the magnitude of the credit needs of Government RPs involving the Federal Reserve Bank are securities dealers and the principal sources of usually entered into at the initiative of the Bank, although dealers may provide some impetus through inquiries about the possi credit. More specific data, however, bility of making such agreements. Although the Federal Reserve utilizes repurchase agree ments primarily as a supplemental tool for the conducting of open market operations, such transactions have the effect of supplying financing to Government securities dealers. RPs with the Federal Reserve are made for maturities of no longer than fifteen days and usually involve securities with a maturity of no more than 24 months. The rate of interest is usually equal to the discount rate of the Federal Reserve Bank of New York or the average issuing rate on the most recent issue of 3-month Treasury bills, whichever is the lower. During 1963, the average daily are essential to an evaluation of the relative importance of repurchase agreements in the total supply of credit. The best available statistics, which are presented in Chart 3, cover a relatively brief period of time—from October 30, 1958.6 1957 through December 31, The information presented in the charts may be unrepresentative due to the inor dinate amount of speculative buying that existed in the Government securities market during the first half of 1958 and the liquida tion of these speculative positions during the following months of declining prices and rising interest rates. The data are, neverthe less, useful in gaining an approximation of the volume of Federal Reserve holdings of U. S. Government securities under repurchase importance of RPs as a source of financing. agreement was $114 million, representing only about 3 percent of the average daily volume of total dealer financing. It is evident, therefore, that dealers do not rely on the Federal Reserve as an important supplier of financing. In periods when funds are not readily available elsewhere, however, RPs purchased by the Federal Reserve Bank of repurchase agreements accounted for an During the period covered in the chart, average of nearly 64 percent of total dealer financing. W hile the volume of RPs outstand ing varied widely from week to week (from a high of $1,729 million to a low of $278 million), RPs represented a relatively constant share of total financing during the period. In only one week during the entire period did New York can provide an important part of repurchase agreements account for less than the dealers' residual borrowing requirements. one-half of total dealer borrowing. Other sources of dealer financing via repurchase transactions consist of Federal Home Loan Banks, savings banks, and state and local governments. These other sources, however, account for a relatively small share of total RP transactions. 6 Data in the chart are from the Treasury-Federal Reserve Study o f the Government Securities Market, Part II, "Factual Review for 1958'', pp. 142-43. The figures were derived from a survey of 12 nonbank dealers and 5 bank dealers. Outstanding loans and re purchase agreements were reported as of each Wednes day from October 30, 1957 through December 31, 1958. 9 ECONOM IC REVIEW U . S . G O V T . S EC U R IT IES D EA LER S bank borrowing for unexpectedly large needs while making more consistent use of re 3. LOANS AND REPURCHASE AGREEMENTS F i g u r e s p l o t t e d a s of W e d n e s d a y e a c h w e e k nonbank purchase transactions as a source of funds. In Chart 3, it should be noted that re for tw elve a n d five b a n k d e a le r s purchase agreements with nonfinancial cor porations accounted for the bulk of total RPs outstanding during the period.7 The total volume of funds derived from nonfinancial corporations during the period was in the form of repurchase agreements. Excluding the last four months of 1958, RPs held by nonfinancial corporations accounted for an average of nearly 72 percent of the total outstanding. RPs with all lenders other than nonfinancial corporations accounted for little more than one-quarter of total RPs outstanding on aver age during the period. RPs placed with banks outside New York City represented an J F M A M J J A S O N average of 53 percent of the funds derived D 1958 from these commercial banks. Agreements reported with New York City banks were a Source of d a t a : T reasu ry-Federal Reserve Stu dy o f the G overnm ent S ecu rities M a rket consistently negligible proportion of funds Volatility was evident in the volume of total derived from these banks. Repurchase trans financing during the period due principally actions with all other lenders represented an to wide swings in the volume of loans, par average of 48 percent of funds borrowed from these sources. ticularly those from New York City banks, which ranged from a high of $1,820 million If it can be assumed that the financing to a low of $201 million. As a share of total pattern evident in Chart 3 is representative dealer financing, loans ranged from a high of the pattern that has existed since that time, of 55 percent to a low of 16 percent. W hen it would mean that a growing utilization of dealer financing as repurchase agreements by Government secu during the first seven months of 1958, loan needs were largest, rities dealers has accompanied the increase volume expanded sharply to accommodate in the volume of total dealer financing, as the increased demand for funds. As the need outlined in Chart 2. It can be safely assumed for financing diminished, loan volume was contracted more sharply and more quickly than the volume of RPs. This pattern seems to confirm the hypothesis that dealers utilize 10 7 Corporate RPs actually exceeded the volume of total RPs periodically during the latter part of 1958, pointing up the offsetting effect of resale agreements with com mercial banks during those periods. MAY 1 9 6 4 that virtually all of the financing supplied by 1948-58 period is probably a reflection of the corporations during the period from Septem ready availability of funds to dealers and the ber 1960 through the end of 1963 was in the accompanying relatively small demand for form of RPs. Based on the results of the dealer financing during those years. The use 1957-58 market study, it may also be assumed of RPs expanded with the sharply higher that roughly 50 percent of total financing financing derived from banks outside New York City Treasury-Federal Reserve accord of 1951. and other nonbank sources was obtained With the Federal Reserve no longer com requirements that followed the through repurchase transactions. Therefore, mitted to support the market price of G overn the volume of RPs outstanding has expanded ment securities, an important part of the considerably in the 1960-63 period, and function of maintaining an active and orderly continues to account for the largest proportion market fell to the Government securities of total dealer financing. dealers. With an inflated volume of securities CO ST ADVAN TAGE The growing use of repurchase agreements outstanding, which resulted from wartime financing, dealer inventory and financing requirements were greatly enlarged. is the result of a number of factors, chief Rate comparisons indicate that repurchase among which is the cost. Because the dealer transactions are generally consummated at a function involves the financing of substantial lower rate of interest than the rate charged on inventory positions, the cost of credit is a collateral loans. The last two columns in the crucial factor in determining profitability of table show that the average rate on RPs was dealer operations. Available data suggest consistently below the loan rate during the that RPs provide funds at a markedly lower period covered, with the differential ranging cost than alternative sources. Table II, which presents a sample com from a low of 15 basis points in 1949 to a high of 71 basis points in 1953. The average parison of the rates that dealers paid for differential during the entire 1948-58 period various types of funds in the 1948-58 period, was about three-eighths of one percent. In points up the cost advantage of RPs.8 While addition, the rate on RPs with nonfinancial coverage is limited to the responses of only a corporations was, with few exceptions, the few dealers, the data should be representative lowest rate available. The willingness of of the experience of all participants in the corporations to participate in RPs at such highly competitive Government securities favorable rates to dealers explains their market. The absence of rates on repurchase dominant position in this market. Although agreements during the early part of the relatively low, the corporate RP rate may be 8 Data used in the table were obtained from Table V-4 higher than rates on other money market of A Study of the Dealer Market for Federal Gov ernm ent Securities. Materials prepared for the Joint Economic Committee, Congress of the United States. United States Government Printing Office, Washington, D. C., 1960, p. 88. instruments that are available to corporations. Furthermore, the features of flexible maturity and minimum market risk enhance the attractiveness of RPs to a corporation. 11 ECONOM IC REVIEW TABLE II U. S. Government Securities Dealers Reported Rates on Loans and RPs 1948-1958 (in percent) COLLATERAL LOANS Year REPURCHASE AGREEMENTS Banks N. Y. Banks Outside City Outside Banks N.Y.C. Other3 N.Y.C. 1.25 1948 1.31 1949 1.38 1950 1.88 1951 1952 2.00 2.25 1953 1954 2.00 1955 2.63 3.38 1956 3.75 1957 1958 2.13 1948-58 Average 2.18 NonAverage Average Spree rate on rate on loans Financial Federal RPs RPs Corporations Reserve Otherb Loans 1.13 1.25 2.00 2.00 2.25 2.50 2.00 2.63 3.50 3.75 2.38 1.00 1.25 1.50 1.88 1.88 1.88 1.19 2.25 3.13 3.50 1.63 0.80 0.85 1.38 1.63 1.63 1.38 1.82 2.19 2.63 3.31 1.57 1.38 1.88 1.63 2.63 3.06 1.56 2.31 1.92 2.08 1.68 — — — — — 1.38 2.13 2.88 3.00 2.50 1.75 .94 1.88 2.75 3.32 1.94 1.13 1.27 1.63 1.92 2.04 2.21 1.73 2.50 3.34 3.67 2.05 0.80 1.12 1.38 1.67 1.69 1.50 1.51 1.96 2.72 3.17 1.89 .33 .15 .25 .25 .35 .71 .22 .54 .62 .50 .16 2.11 1.90 2.13 1.76 .37 — 1.50 — 1.75 1.75 — — 1.00 — 1.63 — a Principally Foreign Agencies b P rincipally F e d e ra l Home Loan Banks, savin gs ban ks an d state an d lo cal governm ents Note: Percentages are midpoints in the range of rates reported, by source of funds, by a small number of dealers. Data for some of the dealers are based on end of the calendar y ea r reports; for other dealers, dates in the second quarter of the y ea r were chosen. Source: A Stu dy o f the D ealer M a rk et fo r Federal G overnm ent Securities, (see footnote 8). W hile it is not certain that a rate structure inventory positions. Since, on average, ap such as that in Table II still prevails, con proximately four-fifths of dealer positions are tinued use of this specialized money market comprised of securities maturing within one instrument would seem to depend heavily year, the rate of return on inventory is usually on the existence of a favorable differential relatively low. Unless dealers can finance between the cost of funds raised through RPs and alternative rates on loans. their positions at a cost that is below the rate of return on their inventory of G overn ment securities, a "carry loss" is incurred. SUMMARY The successful operation of the Govern If the cost of carrying securities is not at least ment securities market, and in turn the offset by profits from the sale of securities, dealers, dealer incentive to carry securities would be is heavily dependent upon the availability of credit at a cost that does not dampened. consistently securities might, in turn, contribute to dis exceed 12 the return on their Dealer unwillingness to hold MAY 1 9 6 4 orderly market conditions because the sta at a rate of interest satisfactory to them. They bilizing force of dealer participation would have relied on repurchase agreements as a be absent. means of acquiring credit. It appears that To date, dealers have evidently been able future use of RPs will hinge on the relative to satisfy their demands for borrowed funds cost advantage of this type of financing. RECENTLY PUBLISHED BOARD O F G O V ER N O R S O F THE FEDERAL RESERVE SYSTEM W A SH IN G TO N , D.C. "U. S. Trade and Payments in 1963’ Federal Reserve Bulletin, April 1964 FEDERAL RESERVE BANK OF BO STO N B O STO N , MASSACHUSETTS "Bank Competition and Business Loan Rates’ New England Business Review, March 1964 FEDERAL RESERVE BANK O F CH ICA GO C H IC A G O , ILLIN O IS "The Resurgence of Corporate Profits” Business Conditions, April 1964 FEDERAL RESERVE BANK O F KANSAS CITY KANSAS CITY, M ISSOURI "Sugar: A New Era Begins" Monthly Review, March-April 1964 FEDERAL RESERVE BANK O F NEW YO R K NEW Y O R K , NEW YO R K "Techniques of Member Bank Borrowing at the Federal Reserve” "Edge Act and Agreement Corporations in International Banking and Finance” Monthly Review, April and May issues, 1964 FEDERAL RESERVE BANK O F RICHMOND RICHM OND, V IRG IN IA "State Government Expenditures, 1950-62” Monthly Review, May 1964 13 ECONOM IC REVIEW NEGOTIABLE TIME CERTIFICATES OF DEPOSIT I N FEBRUARY 1961, a commercial bank in A negotiable time certificate of deposit is New York City announced that it would begin to issue negotiable time certificates of a receipt given by a bank for the deposit of funds. The bank promises to return the amount deposit and that a U.S. Government secur deposited plus interest to the holder of the ities dealer had agreed to make a secondary certificate of deposit on the date specified on market for such an instrument. At yearend the certificate. The fact that the bank agrees 1963, less than three years after the intro to pay the amount of the deposit plus interest duction of this new money market instrument, to the holder of the certificate of deposit the volume of negotiable time certificates of allows the certificate to be negotiable and to deposit outstanding (commonly called CDs) be traded prior to the actual maturity date. totaled approximately $10 billion, and CDs This provided an impetus for negotiable time were being issued by approximately 300 certificates/ of deposit to becom e an important commercial banks. The total volume of CDs money market instrument. outstanding has already surpassed that of The widespread use of CDs by large money commercial and finance company paper as market banks reflects an attempt to prevent well as bankers' acceptances, and is only further reduction of the proportion of total slightly less than the combined dollar volume bank deposits accounted for by those banks. of both types of money market paper (see Banks located in New York City, Chicago, Table I). and other major metropolitan areas depend 14 MAY 1 9 6 4 upon corporations for a significant part of the increasing size of the loans required by their total deposits; however, corporate bank business firms as well as the postwar merger balances have been pared throughout the movement among manufacturing organiza postwar period as.financial managers have tions. Such developments have resulted in attempted to place an increasing share of the need for many corporations to rely upon their cash assets in highly liquid, short larger banks for credit because of the legal term investments. This trend is an outgrowth limitations on the size of loans that a commer of improved cash management techniques, cial bank may make to a single business higher short-term interest rates during the borrower. postwar period, and an attempt to improve earnings. Until the widespread issuance of CDs, the major banks did not accept corporate time Despite the relative decline in corporate deposits. Reluctance to do so was based large demand deposits at major money market ly on the assumption that funds would be banks, these same banks have been called switched from demand to time deposits, upon to provide a larger proportion of total thereby increasing bank operating costs with bank loans to business. This reflects, in part, out increasing total deposits; however, the 1. VOLUME OF TIME CERTIFICATES OUTSTANDING - Percentage D is t r ib u t io n by Fe der al R e se r v e Districts* * D a t a include all outstan din g time certificates of $ 10 0, 0 00 or more at w e e k ly reporting member b a n k s Source of d a t a : Bo ar d of G o v e rn o r s of the F ed er a l R es er ve System 15 ECONOM IC REVIEW TABLE II TABLE I Original Purchasers of Time Certificates Outstanding December 5, 1962 Estimated Volume of Selected Money Market Instruments Outstanding at Yearend (millions of dollars) 1960 1961 1962 1963 Commercial and Finance Company Paper Bankers' Acceptances $4,497 4,686 6,000 6,747 $2,027 2,683 2,650 2,890 Percentage Distribution Time Certif icates of $ 100,000 and overa $ Certificates of $100,000 and over Certificates of $500,000 and over 69.0% 70.8% 15.5 13.5 6.2 2.6 6.7 7.5 1.5 6.7 100.0% 100.0% Businesses State and local governments Foreign official institutions* Individuals All other 796 2,782 5,442b 9,579 a Data cover all weekly reporting member banks Total b December 5 data *Foreign governments financial institutions. Sources of data: Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York and central banks and international Source of data: Board of Governors of the Federal Reserve System TABLE III Percentage Distribution of Time Certificates Outstanding by Deposit Size of Bank and Original Purchaser December 5, 1962 Deposit Size of Banks (millions of dollars) 1,000 Under 100 100-500 500-1,000 and over Total Certificates of $100,000 and over Businesses......................................... State and local governments Foreign official institutions . . Individuals......................................... O t h e r s .............................................. Total ............................... 2.0% 7.5 — 7.7 2.4 17.9% 34.9 7.1 37.8 21.8 25.0% 40.4 12.0 33.5 46.3 55.1% 17.2 80.9 21.0 29.5 100.0% 100.0 100.0 100.0 100.0 2.9% 20.7% 28.2% 48.2% 100.0% Source of data: Board of Governors of the Federal Reserve System 16 MAY 1 9 6 4 larger banks were caught in the interaction reflects the relative ease with which they can of increasing demands for credit by large business borrowers and a decline in the pro be sold, as well as the fact that FDIC insur ance covers only the initial $10,000 of de portion of business deposits from which these posits. Therefore, in the absence of FDIC demands for credit could be satisfied. There protection, corporate investors prefer to pur fore, CDs have offered larger banks an oppor chase CDs from larger, better-known banks. tunity to compete for corporate cash balances Table III shows the volume of CDs out that otherwise might be invested in other standing by original purchaser and by de money market instruments, e.g., U. S. Treas posit size of issuing bank as of Decembef^ 5, ury bills or commercial paper. 1962. The corporate preference for CDs of Prior to 1961, a small volume of CDs were larger denominations issued by larger banks issued primarily on a local and regional scale. is reflected in the fact that 55 percent of the At the close of 1960, nearly three-fifths of the CDs held by businesses were issued by banks total volume of CDs outstanding had been with total deposits of $1 billion or more. issued by banks in the west and southwest Table III also reveals that foreign official in United States. In contrast, by the end of 1963, stitutions had an even greater preference for nine large New York City banks accounted CDs of the largest banks. This may be ex for more than one-third of the total volume of plained by the fact that most foreign trans CDs outstanding, and banks located in the actions are carried out through New York city of C hicago accounted for nearly 10 City banks, and the fact that, as mentioned percent. earlier, there is a preference to purchase CDs from larger, better-known banks. DEVELO PM EN T O F THE MARKET On the other hand, state and local govern The growth in the volume of CDs outstand ments have concentrated their purchases of ing at nine major New York City banks from CDs from banks that have deposits in excess April 1961 to yearend 1963 is shown in Chart of $100 million but less than $1 billion. This 2. During this period, the volume outstanding may be partly explained by the fact that such increased from $0.4 billion to $3.4 billion. governmental units often maintain a certain At the end of 1963, the dollar volume of CDs allegiance to banks located within the same reported by the nine banks exceeded the local and regional areas. total dollar volume of all bankers' a ccep tances outstanding. Corporations hold the largest proportion COM PETITIVE STA N D IN G O F CDs Yields on CDs outstanding are competitive of CDs (see Table II). Larger banks attract a with rates on other short-term investments. significant part of corporate time deposits by Although yield comparisons cannot be made offering CDs in multiples of $1 million be prior to the spring of 1962 when rate infor cause corporate purchasers frequently desire mation on CDs first becam e available, the to place large sums of money with a major recent movement in CD yields has closely bank. The desire to hold CDs of larger banks paralleled that of other money rates. Chart 3 17 ECONOM IC REVIEW compares secondary market yields on CDs with three months remaining to maturity with rates on other money market instruments 2. NEGOTIABLE TIME CERTIFICATES OUTSTANDING N in e N e w Y o r k C it y B a n k s having comparable maturities. The rates are on a monthly average basis from May 1962 B i l l i o n s of d o l l a r s 4 .0 through December 1963. The CD rate aver aged 25 basis points higher than the 91-day Treasury bill rate and 18 points less than the 3 .5 3.0 rate on four- to six-month prime commercial paper. 2.5 Unlike other short-term investments such as bankers' acceptances, CDs are offered at a 360-day interest add-on basis rather than on a 2.0 1.5 365-day discount basis.1 CDs also permit investors to place large sums of money in a 1.0 short-term investment with a tailored maturity date. The only other short-term investments that offer such a wide range of maturity dates are Treasury bills, repurchase agreements 0.5 0 1961 1962 1963 1964 and finance company paper. Thus, investors Source of data: Federal Reserve Bank of New York are able to obtain CDs that mature on or shortly before corporate tax payment or This regulation is administered by the Board dividend dates. Recent studies indicate that of Governors of the Federal Reserve System. a major portion of CDs do mature on such Table IV shows the past and present maximum dates. The higher yield on CDs, however, rates that member banks are authorized to makes them a more attractive tax antici pay on time deposits. It is noteworthy that the pation investment than Treasury bills. rates have been increased twice since the widespread issuance of CDs in 1961. R EG U LA TIO N Q The most recent change in Regulation Q, O ne of the problems associated with the in July 1963, was intended to permit primary issuance of CDs involves the effect of Reg rates on CDs with original maturities of 90 ulation Q, which establishes the maximum days to one year to becom e more compet rate of interest payable on time deposits. itive with other short-term interest rates. 1 Bankers' acceptances do not carry a coupon rate of interest. The yield on such investments is determined by the purchase price, which includes a discount. At maturity, the owners receive the par value of the instru ment. CDs, however, do carry a coupon rate of interest so that the owners receive par value plus interest at maturity. 18 This change also concurred with the increase in the Federal Reserve discount rate from 3 to 3 }^ percent that also took place in July 1963. Because the payment of interest rates in excess of 1 percent on CDs with original maturities of less than 90 days is currently MAY 1 9 6 4 3. SELECTED M ONEY RATES ary market for $1,015,500. The purchaser will earn a yield of 3.6 percent if he holds Percent the CD to maturity. The original owner receives his $1 million plus $15,000 interest which he has earned at 4 percent, and an additional profit of $500. SECO N D A R Y MARKET As previously mentioned, a secondary market for CDs was established in 1961 by a small group of U. S. Government securities dealers. Near the end of 1963, dealer posi tions in CDs ranged between $150 and $200 million; the daily average volume of trading was between $25 and $50 million. There are a number of factors that deter mine the marketability of outstanding CDs, of which the most important are the identity of the issuing bank, denomination, and matur Sources of data: Board of Governors of the Federal Reserve System; Salomon Brothers and Hutzler ity. CDs issued by the larger, better-known money market banks are highly marketable, not permitted under Regulation Q, CDs are thereby commanding a higher price than not competitive with other money market those of other banks. As a result, lesser- instruments in this maturity range. Regula tion Q, however, applies only to the rate on in order to compensate for the sacrifice the CDs at the time they are issued, and not to the holder will make if forced to sell the CDs yields that investors receive on CDs pur prior to maturity. chased in secondary markets. Investors have known banks must offer higher rates on CDs Furthermore, many corporations have been able to purchase CDs with less than 90 adopted a policy of holding only CDs issued days to maturity in the secondary market, and by major money market banks or of those gain a return of more than 1 percent. For banks in which the corporation maintains example: an investor purchases a $1 mil demand deposits regardless of rate differen lion, six-month CD carrying an interest rate tials. This, of course, further restricts the of 4 percent from an issuing bank. If the secondary market for CDs of smaller banks. original purchaser holds the CD until matur The denomination of CDs is also a determi ity, he will receive his initial investment of nant of the strength of the secondary market. $1 million plus $20,000 interest. However, The most popular trading unit is $1 million, with 45 days remaining to maturity, the and most dealers are reluctant to acquire a holder chooses to sell the CD in the second certificate of less than $500,000. O ne reason 19 ECONOM IC REVIEW for their reluctance stems from the fact that TABLE IV CDs of smaller denominations usually are Maximum Rates of Interest Payable on Time Certificates of Deposit* (Percent) issued by lesser-known banks and are not readily marketable. Certificates of odd lot sizes usually sell at prices that yield from 10 to 15 basis points above the yield on the standard $1 million unit. The maturity or due date also plays an im portant part in determining the extent of the market for outstanding CDs. A certificate that is scheduled to mature immediately prior to a corporate tax date will usually enjoy a strong market. In addition, CDs scheduled Maturity (Months) 12 and over 6-12 3-6 Under 3 Effective Effective January 1, January 1, 1957 1962 3 3 2Vi 1 4 3'A 2Vi 1 Effective July 17, 1963 4 4 4 1 *For three years beginning O ctober 15, 1962, there is no re striction on the maximum rate of interest p ayab le on foreign time deposits. Source of data: Board of Governors of the Federal Reserve System to mature near quarterly dividend payment periods or the close of corporate fiscal periods are also in demand. Another source of dealer financing is through repurchase agreements with corpo In order to finance a position in CDs, deal rate investors. Dealers sell CDs to corpora ers may borrow from banks at a rate equal to tions and agree to repurchase them at a the call rate for loans with U. S. Government specified date, paying interest at a mutually securities as collateral. If the collateral for a determined rate. Data for dealer financing CD loan is a CD of the bank making the loan, to position CDs are not available prior to however, the rate has to exceed the primary rate of interest on the CD by at least two O ctober 1963, but the major source of financ ing in the latter weeks of 1963 was through percentage points in order to satisfy Regu repurchase agreements with corporations. lation Q. An additional element of reluctance Payment for CDs is made in Federal funds in making a loan to finance CD positions is (deposits at Federal Reserve banks). Partici the question of default. If a loan is secured pation in the CD market represents a new by a CD of the bank making the loan, subse type of Federal funds transaction. The use of quent default would find the bank as holder Federal funds rather than clearinghouse funds of its own CD prior to maturity, and Regula (deposits in commercial banks) makes pay tion Q prohibits redemption prior to maturity ment for CDs immediate rather than on the except in cases of emergency. following business day. 20
@FedFRASER