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Real World Risk and Bank Risk
I.
Introd uctio n and Sum m ary
II.
Real W orld Risk and Financial Institutions
III. A Perspective on Liability M anagem ent and Bank Risk
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2
structure left them more exposed to the decline in
the return to capital and to the increase in
interest rates which became so acute in the 1970s.
Eventually, short-term debt amounted to twofifths of corporate long-term debt, which meant
that firms had to roll oyer maturing debt more
frequently and thus become further exposed to
financial-market disturbances.
With inflation undermining the capital markets, corporations felt compelled as never before
to rely upon the banks for accommodation. Yet
the risk accompanying this heavy volume of
lending increased more than proportionately as
banks assumed risk that normally would be
shouldered by bond holders or owners of equity.
And as Runyon concludes, "While the changing
structure of balance sheets made corporations
more vulnerable to changes in financial markets,
bankers themselves were becoming bold innovators, shedding their traditional role as risk averters and becoming profit maximizers."
Jack Beebe picks up the discussion at this
point and demonstrates the extent of the shift in
banking attitudes. He describes the changes in
bank assets and liabilities that have occurred
since World War II, relates these changes to a
rise in bank exposure to market fluctuations, and
uses this historical perspective to draw relevant
implications for regulatory policy. "The relative
decline in liquid risk-free assets, the increase in
purchased short-term liabilities, the diminished
capital cushions, and the increased sensitivity of
bank equity prices to stock-market fluctuations
all provide evidence of increased bank exposure
to financial-market fluctuations."
As Beebe notes, the data are quite striking. On
the asset side, Treasury securities as a percentage
of bank credit outstanding dropped from 73
percent at the end of World War II-admittedly,
Inflation and related evils have severely affected financial markets and financial institutions
during the 1970s, as previous issues of the Economic Review have described in some detail.
How markets and institutions respond to the
resulting risk and uncertainty is one of the key
policy issues of this decade. In this issue, we
address that question by focusing on the interrelationship between the real economy and the
commercial-banking sector. As Herbert Runyon
notes in the first article, the "real" or nonfinancial world is a much riskier place than it was ten
to fifteen years ago, and this development has
reflected back upon the banks.
Runyon demonstrates the growing prevalence
of risk by comparing the performance of economic forecasters during the period 1971-75 with
their performance during a more stable earlier
period, 1961-65. He notes that serious over- and
under-estimates offorecast magnitudes occurred
during the early 1970s, because of several random shocks-such as wage/price controls and
OPEC actions-that introduced elements of
uncertainty not previously built into econometric or judgmental forecasting models. In particular, serious under-estimation of inflation marked
most forecasts of the period. "The deterioration
in the accuracy of forecasting results evident
during this period not only provided a source of
embarrassment to the forecasters themselves,
but also served as a measure of the uncertainty
and risk prevailing in real-world markets for
labor and commodities and services, with transmitted effects felt in financial markets as well."
Drawing from the experience of the more
stable 1950s and 1960s, corporations assumed
greater and greater risk by restructuring their
balance sheets in favor of debt rather than
equity. This higher leverage of their capital
3
a condition of abnormally high liquidity-to
only 10 percent in the 1972-75 period. Meanwhile, the loan share rose from 29 percent to 70
percent of total bank credit. On the liabilities
side, purchased funds increased since 1960 alone
from zero to 12 percent of the overall portfoliobecause of data limitations, even that is an
understatement-while traditional sources of
funds and capital (particularly equity capital)
declined as a share of the total. The leverage ratio
(total liabilities/ equity capital) consequently
rose from 11.0 to 13.3, and showed an even
greater increase when measured relative to
"risky" assets. Finally, available statistical measures indicate that bank-stock indexes have become substantially more sensitive to fluctuations
in the overall stock market over the postwar
period, and especially since the early 1960s.
These indicators of increased bank exposure
to financial-market developments have important implications for monetary policy. "Stringent
(that is, truly restrictive) limitations on purchased
funds could create a severe liquidity squeeze
within the U.S. commercial-banking system."
This reflects the fact that there is no large secondary market outside the commercial-banking
sector for loans as there is for securities, so that
loans are very difficult to sell in a liquidity
squeeze. In this situation, banks generally-and
not simply individual large banks-have come to
rely on liability management as their principal
source of liquidity.
Beebe notes that banks have purchased funds
not only to stabilize the variance of bank credit
during tight-money periods, but also to accelerate their growth during expansionary periods. In
this respect, liability management has increased
the banking sector's exposure to financialmarket fluctuations-for example, during the
1971-74 period, when banks increasingly purchased funds to meet loan commitments, but in
the process accepted a relative decline in their
capital cushions and liquid investments. "These
measures presumably would have promised high
returns in a stable economic environment but
they also served to make the banking system
more vulnerable in the unstable environment
since 1973."
However, liability management need not always be growth- and risk-oriented as it was
during the period of rapid bank expansion
through the early 1970s. Banks, in response to
the double-digit inflation and recession of 197375, have turned liability management into a
"conservative" strategy with a decline in purchased funds, slow growth in loans, and expansion of Treasury securities in bank portfolios.
This episode indicates that banks learn quickly
from experience, and suggests that policymakers
must weigh carefully regulatory attempts to
restrict the flexibility of liability management to
avoid perverse effects on the commercialbanking system.
4
Herbert Runyon*
It is a world of change in which we live, and a world of uncertainty. We live only by
knowing something about the future. . .This is as true of business as of other spheres
of activity. . .
Frank H. Knight, Risk, Uncertainty and Profit
forecasters during the period 1971-75 with their
performance during an earlier period, 1961-65,
when there was a demonstrably lesser degree of
uncertainty and less pressure from business upon
external sources of finance, particularly the
banking system.
The past several years have had a chastening
effect upon forecasters. Several random
shocks-the introduction of a system of wage/
price controls and the imposition of an oil
embargo with its concomitant quadrupling of
crude oil prices-introduced elements of uncertainty and risk that had not been built into
econometric forecasting models nor into the
assumptions and expectations of judgmental
forecasters. The deterioration in the accuracy of
forecasting results evident during this period not
only provided a source of embarrassment to the
forecasters themselves, but also served as a
measure of the uncertainty and risk prevailing in
real-world markets for labor and commodities
and services, with transmitted effects felt in
financial markets as well.
Serious over- and under-estimates of forecast
magnitudes occurred in the difficult period of the
early 1970s, which culminated in the 1974-75
recession, the most severe cyclical downturn in
forty years. In an evaluation of the forecasting
efforts of this period, Stephen McNees argued
that the forecast errors were atypical in terms of
their magnitudes. I Accordingly, the size of the
variations in realized values from anticipated
values was symptomatic of the heightened
uncertainty in the environment in which
decision-makers functioned.
The banking system has commanded more
than the usual public attention during the past
several years. In the process, Congress has
passed legislation requiring fuller disclosure of
bank assets, such as of the kinds ofloans made by
banks. Yet despite the sudden scrutiny of bank
lending practices, many observers have overlooked the fact that banks as financial institutions have changed greatly in the past two
decades. Banks have become more aggressive in
seeking out lendable funds and have widened the
spectrum of their borrowers, but at the cost of
increased risk exposure. The greater risk has not
been confined to banks alone. The "real" or
nonfinancial world is a much riskier place than it
was ten to fifteen years ago, and this development has reflected back upon the banks.
This increase in real-world risk has been
accompanied by a growing corporate reliance
upon external sources of funds. During the
relatively stable period of the 1950s and 1960s,
corporations restructured their balance sheets on
a massive scale, substituting debt for equity and
increasing the leverage of the firm. However, as
the world became more risky in the 1970s,
corporations found themselves more firmly
locked into external financing, and hence more
vulnerable to random shocks in the economy.
This paper examines the increase in real-world
risk and uncertainty that appeared in the 1970s,
and the effects of that increase in risk upon
financial institutions and markets. Our approach
is to compare the performance of economic
*Research Officer, Federal Reserve Bank of San Francisco.
5
Forecasting, Uncertainty and Risk
From the Roman augurs, who used the
entrails of animals, to present-day economists,
with their elaborate econometric models, men
have attempted in many ways to foretell the
future-and with varying degrees of success. In
this paper, we use the degree of forecasting
success as a measure of risk. For example, if a
decision maker consistently estimates the actual
values of the variables which are important to
him, there is no uncertainty. But if a decision
maker fails to estimate the actual values
accurately, uncertainty is generated-unless, of
course, the forecaster's methodology is clearly at
fault.
In our analysis, we compare individual
forecast observations with the. actual valueswhether output or prices-and also with the
mean estimates of forecast. This results in two
sets of comparisons which involve the dispersion
of forecast observations about the actual value
and the mean of forecast values, respectively.
The dispersion of observations around the actual
value reveals the degree of error offorecast. The
distribution of forecast observations around the
forecast mean says something about the relative
certainty of the forecasters as a group regarding
the outlook. The basic data-annual changes in
real GNP and in the inflation rate-are from the
compilation of published forecast estimates
made by the Federal Reserve Bank of Richmond. 2 The forecasts are limited to one year or
four quarters ahead of the periods to which the
forecasts apply. At this range, the manner in
which the forecast is constructed, whether
judgmental or in the form of an econometric
model, is largely a matter of indifference,
although it is generally agreed that judgmental
forecasts have an edge within a year or less, while
econometric models generally provide better
results over longer periods. 3
To adjust for trend, we express the estimates in
terms of percentage deviation from the actual
value or mean forecast value since the levels of
the forecast variables had risen substantially
between the two periods considered. Further, to
place the results on a common footing, we
compare the estimates in terms of the mean
absolute error (MAE)-the average variation of
the forecast observations from the actual value
(or mean forecast estimate) without regard to
Mean Absolute Error of the Forecast Estimates
of Real Output and the Inflation Rate,
1961-1965 and 1971-1975
Real Output
MAE
1961
1962
1963
1964
1965
Total
1971
1972
1973
1974
1975
Total
A
.025
.010
.018
.012
.029
.094
.008
.017
.013
.066
.011
.115
MAE
.007
.008
.007
.007
.004
.033
.008
.007
.003
.011
.011
.040
6
F
Inflation Rate
MAE
MAE
A
F
.004
.004
.005
.003
.003
.003
.003
.002
.004
.003
.019
.015
.007
.007
.034
.067
.009
.124
.006
.004
.003
.009
.007
.029
algebraic sign. 4 This simply means that we ignore
whether the forecast estimates are on the high or
low side of the actual value. The larger the MAE,
the greater the error of forecast for that
particular period.
The MAE has been calculated for the
variation of the forecast observations from the
mean value of the forecast estimates, MAE F , as
well as the variation from the actual values of
real GNP and the rate of inflation, MAEA (see
table). A low value for the mean forecast
estimate (MAE F ) implies a greater degree of
consensus among forecasters regarding the
outlook, since the dispersion of observations
about the mean is narrow. However, a low value
for MAEF does not necessarily go hand in hand
with a low value for MAEA, which represents a
"good" forecast. All the forecasters could be
wrong together, so as we shall see, conviction
and confidence are not sufficient conditions for
successful forecasting.
MAEA values for real GNP suggest some
improvement in forecaster's ability to predict
real output took place between 1961-65 and
1971-75, with the striking exception of 1974,
when, with few exceptions, forecasters missed
the turning point in the cycle. Still, a 6.6-percent
error in forecast estimates for that year does not
reflect favorably upon the forecasting fraternity,
especially since it exposed decision makers to a
large degre~ of risk. Moreover, MAEFvalues for
1974 and 1975 output show a larger varianceand thus more uncertainty-than obtained in
any earlier year of the two periods considered.
For the price forecasts, the MAEF was much
smaller in each period, indicating that forecasters held a much closer consensus on price
movements than they did for changes in real
GNP. Also, forecasters were significantly more
successful in estimating prices in 1961-65 than in
1971-75-not surprisingly since 1961-65 was part
of the longest period of price stability in recent
history. As Zarnowitz has shown, forecasting
ability is generally good during periods of
stability.5 From 1958 through 1965, prices
increased at annual rates of I Y2 - I:y,; percent,
strongly conditioning the price expectations of
forecasters. Moreover, during this period of low
and relatively stable inflation rates, corporations
substantially restructured their balance sheets,
selling debt in preference to equity under
compara tively favorable conditions in the
financial markets.
From 1968 through 1972, prices increased
about 5 percent annually, and the expectations
of decision makers gradually became geared to
this rate. But then prices increased even faster, in
an acceleration that was as sharp as it was
unexpected, with the inflation rate reaching 13
percent at the cyclical peak in 1974. Since
corporations had by this time reached a higher
"preferred" leverage ratio, the resulting reliance
upon debt financing made them particularly
vulnerable to the rising interest rates that
followed in the wake of a rapidly increasing
inflation rate.
Uncertainty and Risk
An increase in uncertainty in real markets
should not impinge heavily on financial markets
when corporations do not depend on them as a
steady source of funding. By the 1970s, however,
just such a dependence developed, as significant
changes occurred in corporate balance sheets.
Debt came to be used extensively in preference to
equity, and leverage rose from 25 percent in
1961-65 to 44 percent in 1971-75. This increase in
leverage, while it succeeded in increasing the
return to common stockholders, also made
corporations more vulnerable to changes in
interest rates, since interest payments have a
senior claim on corporate earnings. These shifts
are seen in Chart I, which illustrates the
relationships between interest coverage and the
capital income share of gross corporate product.
Interest coverage is defined as the ratio of profits
before taxes plus net interest, to net interest;
capital income is defined as corporate profits
plus depreciation adjustment plus net interest.
Interest coverage remained stable at about II
"times interest" throughout the entire 1961-65
period. Moreover, the return to corporate
capital increased steadily during that period, as
capital income rose from 7 percent to 10 percent
of gross corporate product, providing an increasing cushion against interest claims6 By 1971,
7
however, the picture changed as corporations
completed the transition to a more highly leveraged capital structure. The "times interest"
coverage ratio dropped sharply to a level of 5. In
addition the rate of return on capital, after peaking in 1966, trended downward from over 8
percent to 6 percent during the 1971-75 period.
The "times interest" ratio is a worthwhile
measure of risk because it measures the corporation's interest burden in terms of the relative
vulnerability or exposure of its balance sheetJ
Consider the relationship of the interest cover
and the rate of return on capital in each period.
The times interest ratio declined by more than
half between 1961-65 and 1971-75, while the
return on capital trended downward between
these two periods. Even if interest rates could
have been held constant, the corporate financial
position clearly entailed more risk in 1971-75.
And as will be seen later, interest rates were by no
means constant.
Chart 1
Interest Coverage and Return to Capital
Return to Capital
)I--
0.08
0,02
* Profits before tax plus net interest, divided by net interest
** Capital income as a percentage of gross domestic product
of nonfinancial
corporations
Financing a Capitai Expansion
At the same time that corporations were
realigning their balance sheets to achieve greater
financial leverage, they were also embarking
upon an extended capital boom. These two disparate developments combined to create greater demands upon external sources of funds,
especially short-term funds. In the early 1960s,
the ratio of short-term to long-term debt was
fairly steady, with short-term debt amounting to
one-quarter of outstanding long-term debt. Subsequently, the proportion of short-term debt rose
rapidly, except during the 1969-70 recession
(Chart 2). The increase in the relative amount of
short-term debt paralleled the increase in the
proportion of capital expenditures financed externally. This might suggest that the capi~l
expansion was financed in increasing degree by
dependence upon short-term financing. However, corporations also relied heavily on shortterm borrowings for inventory financing. In fact,
the sharp declines in the short-term/long-term
debt ratio in 1969 and again in 1975 largely
reflected the declining need for short-term inventory financing during those two periods of
receding economic activity.
Chart 2
Maturity Structure of Corporate
Debt and Ratio of Capital
Expenditures to Int€ll'nal Funds
Percent
Percent
38
34
l~
1
~
.....: Short-term debt!
Long-term debt
1'~
30
~~O
Capital
Expenditures/
Internal
~
Financing
26
I
-1 100
22
1965
8
1970
197
In the past 20 years, corporations not only
borrowed more from banks but also rediscovered •the commercial-paper market, using
that alternative whenever market rates of interest
were more favorable than bank rates. Corporate
treasurers became increasingly sensitive to
interest-rate differentials, and raised as much as
possible in short-term markets whenever the
interest-rate spread was favorable. In fact, they
continued to rely on short-term funds even when
the spread turned against them. In the early
1970s, as interest rates rose to ever-higher levels,
corporations elected. to borrowatshort-termeven at higher rates-rather than commit themselves to long-term debt obligations. This introduced another element of risk, since short-term
debt must constantly be rolled over at possibly
ever-higher rates. And this is precisely what
happened, even while corporations increased
their short-term borrowings from a cyclical low
of 28 percent of total debt in 1972 to a peak of 37
percent in 1974.
Inflation and Interest Rates
Nat by coincidence, interest rates and prices
surged upward together during the 1971-75 period. The average long-term interest rate generally
moves on a roughly parallel path with the inflation rate, with a margin between the two series
representing the "real" rate of interest (Chart 3).
During the 1961-65 period, when the inflation
rate was in a narrow range of 11;2 to I % percent,
the long-term interest rate held very steady at 41;2
percent. Short-term interest rates similarly are
subject to inflationary expectations, although to
a lesser degree because they are also strongly
influenced by money-market conditions. The
banks' interest rate on short-term business loans
is not market determined, being administered or
set by the banks themselves, but it is still not
Chart 3
Interest Rates and the Inflation Rate*
Percent
14
Percent
12
12
10
10
Business-loan
rate
~
Inflation rate
(GNP price index)
1957
*
1960
1970
1965
All series smoothed by a five-month moving average centered on the third month.
9
1975
immune from market forces.
From late 1973 until the beginning of 1975, the
sharply rising inflation rate substantially exceeded the long-term rate on new bond issues. In
contrast, the short-term rate on business loans
followed the inflation rate upward in 1974 and
peaked at less than 1 percent below the inflation
peak. In those circumstances, it would seem
advantageous for borrowers to seek funds in the
long-term market rather than from banks because of the differential in favor ot1ong-term
rates. That didn't happen, however, as borrowers
turned increasingly to the banks. The explanation may be found in the special characteristics of
the 1973-74 inflation. In the words of Edward
Shaw, what we experienced was "dirty"
inflation-largely unforeseen and sporadicrather than "immaculate" inflation-the type
where lenders perceive perfectly the rate of
inflation and thereby become compensated
through the interest rate. 8 Borrowers may have
possessed less than perfect foresight as far as
inflation and interest rates were concerned. But
at the same time, they had doubts as to the
permanence of the existing high rates and they
chose to borrow short rather than long. The
banks were the logical source for such funds.
Corporations and Banks
Businesses have always borrowed from banks,
largely through short-term self-liquidating loans
for such purposes as the purchase and carrying of
inventories. However, in recent years, banks
have extended the maturity of business loans, so
that term loans with maturities greater than one
year now constitute about 40 percent of their
business-loan portfolios. Much of this shift reflected the tendency for corporations to rely
more heavily on the banks for all types of financing, including the longer-term financing
shifted from the capital market.
Chart 4
Percent
Bond Share and Bank-Loan Share
140
of Total Funds
Raised in Financial Markets
*
120
100
80
60
40
20
0
-20
-40
-60
-80
-100
1957
1!'l58
1976
*Percent of total net funds raised in financial markets by nonfinancial corporations.
10
periods at the going interest rates prevailing in
the capital market.
In 1974, the banks were almost literally "lend·
ers of last resort," because by then the raging
inflation and high rates of interest had severely
crippled the capital market. Until corporations
re·entered the capital markets in the easier condi·
tions of 1975, banks provided the major source
of external funds to business-and assumed a
commensurate share of risk while doing so. Their
assumption of a larger than ordinary amount of
risky loans reflected the fact that they were
lending greater amounts to a greater variety of
less·than·prime borrowers.
Nonfinancial corporations increased their reli·
ance upon banks steadily from 1970 through
1973, when nearly three·quarters of the net funds
they raised in financial markets came from banks
(Chart 4). The shift in 1970 and 1971 was proba·
bly prompted in some degree by the collapse of
the commercial·paper market following the
Penn Central debacle. But the percentage of
external funds raised in the capital market also
declined steadily during this period. Despite the
fact that the interest rate on bank loans exceeded
the rate on new bond issues, businessmen elected
to borrow from banks for a few months or a few
years rather than lock themselves in for longer
Conclusion
The world of the early 1970s was a riskier place
in which to transact business and to undertake
financing than was the world of the early 1960s.
The environment in which decisions were made
came to be cloaked in greater uncertainty. Mean·
while, by restructuring their balance sheets in
favor of debt rather than equity, corporations
assumed greater and greater risk because the
higher leverage of their capital structure left
them more exposed to a decline in the return to
capital and to an increase in interest rates. And
when the amount of their shorHerm debt grew
to nearly two·fifths of their outstanding long·
term debt, corporations had to roll over matur·
ing debt more frequently and thus became fur·
ther exposed to the vagaries of the financial
markets.
The inflation that made a shambles of the
capital markets in 1973 and 1974 forced nonfi·
nancial corporations to rely as never before upon
the banks for accommodation. Yet the risk
accompanying this heavy volume of lending
increased more than proportionately as banks
assumed risk that would normally be shouldered
by bond holders or owners of equity. And while
the changing structure of balance sheets made
corporations more vulnerable to changes in
financial markets, bankers themselves were be·
coming bold innovators, shedding their tradi·
tional role as risk averters and becoming profit
maximizers. All of these developments worked
together to place the financial markets and the
banking system under the severest strains of the
past 40 years.
FOOTNOTES
1. Stephen McNees. "An Evaluation of Economic Forecasts,"
New England Economic Review, Federal Reserve Bank of
Boston, November/December 1975, p. 3.
2. Thecompilation includes forecasts of annual changes in real
GNP and in a price series-the consumer price index for 196165, and the GNP implicit price deflator for 1971-75.
3. Carl F. Christ, "Judging the Performance of Econometric
Models of the U.S. Economy," International Economic Review,
February 1975, p. 57.
4. McNees. op. cit., p. 11.
5. Victor Zarnowitz, "Forecasting Economic Conditions: The
Record and the Prospect," The Business Cycle Today, National
Bureau of Economic Research, New York, 1972, p. 195.
6. William Nordhaus, "The Falling Share of Profits," Brookings
Papers on Economic Activity, 1:1974, p. 179.
7. Herbert Runyon, "Equity Shares and the Financial Markets,"
Economic Review, Federal Reserve Bank of San Francisco,
Summer 1976, p. 31.
8. Edward S. Shaw, "Inflation, Finance and Capital Markets,"
Economic Review, Federal Reserve Bank of San Francisco,
December 1975, pp. 5-6.
II
Jack Beebe*
Since World War II, U.S. commercial banks
have experienced a dramatic shift in asset composition, from an aggregate portfolio consisting
largely of reserves and U.S. Treasury securities
to one consisting largely of loans to the private
sector. Since 1960, banks have come to rely
increasingly on purchased money-market
funds varying their purchases by adjusting the
rates paid on these funds ("liability management")-while simultaneously allowing their
capital cushions to decline. These developments
have made banks more sensitive to financialmarket fluctuations and have made their liquidity depend importantly on their ability to purchase funds.
This paper examines changes in bank assets
and liabilities since World War II, relates these
changes to a rise in bank exposure to real and
financial-market fluctuations, and uses this historical perspective to draw relevant implications
for regulatory policy. The relative decline of
liquid risk-free assets, the increase in purchased
short-term liabilities, the diminished capital
cushions, and the increased sensitivity of bank
equity prices to stock-market fluctuations all
provide evidence of increased bank exposure to
financial-market fluctuations. Because of the
increased risk exposure and because of the increased bank reliance on purchased funds as a
major source of liquidity, bank regulators must
weigh carefully the potentially perverse effects
that liability-management restrictions (such as
rate ceilings) can have on the banking sector's
liquidity and stability. Since 1973 regulators
have not used constraints on liabilitymanagement instruments as a means of tightening policy. The analysis of this paper supports
this direction in policy because sudden regulatory constraints on purchased funds can cause a
liquidity crisis within the U.S. commercialbanking industry. Furthermore, such constraints
may not be a necessary part of monetary policy.
Increased exposure to financial-market risk
does not necessarily imply that a bank's total risk
has risen. If the economy, financial markets, and
regulatory policy have become more stable (less
risky), then total bank risk might have declined
even in the face of increasing risk sensitivity. It is
generally accepted that perceived total risk in the
economy and in financial markets declined over
much of the postwar period through the late
1960s, and then increased in the 1970s. 1 Until
recently, bankers may not have perceived any
significant increase in the total risk of their
portfolios. But recent developments, particularly
since 1973, may well have changed this perception.
The first section of this paper discusses the
theoretical linkages between assets and liabilities
in the framework that considers the trade-off
between expected return and risk. The second
section examines postwar trends in bank assets
and liabilities, along with trends in the sensitivity
of bank equity prices to the stock market. The
third section analyzes the impact of changes in
the structure of bank assets and liabilities on the
cyclical sensitivity of banks, while the final
section presents the policy implications.
*Senior Economist, Federal Reserve Bank of San Francisco.
12
I. Theoretical linkages Between Bank
Assets and liabilities
Liability management and changes in bankasset composition are necessarily related. However, the relationships are complex and are
affected by factors external to banking-such as
general economic activity, net credit demands,
changing perceptions of and attitudes toward
risk, and regulatory constraints. Despite these
complications, portfolio theory as applied to
financial institutions suggests certain broad relationships between asset and liability structures.
If commercial banks operate in competitive
financial markets, then there are important implications for bank portfolios. 2 The spread (i.e.,
rate differential) between the rate earned on
assets and the rate paid on liabilities must be a
measure of the value of the service that banks
provide. Several aspects of this service are directly relevant to the relationship between bank
assets and liabilities. Among other functions,
banks invest funds and make loans. In performing this function, banks gather information,
forecast, and screen borrowers, and for this
receive a positive spread. In addition, banks pool
and at times absorb risk by placing deposit funds
across a spectrum of types and maturities of
loans and investments, and also absorb risk by
maintaining a capital cushion. (Thus, there is
risk diversification across instruments at a point
in time, and risk diversification over time such as
a business cycle.) To the extent that banks (or
their stockholders) take on risk, there should be a
compensating expected return. 3 The importance
of risk and the manifestation of risk diversification in bank portfolios are central to a study of
changes in banking assets and liabilities.
bank can accelerate its growth if it is willing to
pay more for purchased funds than other banks
do. However, a distinction must be made between the growth of a single bank and the growth
of the entire banking system. As banks seek to
accelerate their rates of growth, they will have to
borrow additional funds from outside the banking sector. These funds may come from either of
two sources: (1) an expanding level of total
financial activity in the economy, or (2) an
increase in the banking sector's share of total
financial activity. The latter aspect-"bank intermediation," or simply "intermediation"4-is
the more relevant measure in the context of this
paper, which focuses on the banking sector's
share of total borrowing and lending in the U.S.
economy.
An individual bank can increase its share of
bank intermediation by raising its rate on purchased funds marginally above that of its competitors, but when other banks follow this strategy, the effect will be to raise the market rate for
purchased funds (relative to open-market rates)
and to increase bank intermediation. If banks try
to ensure faster growth by bidding up the rate for
purchased funds (relative to other rates), they
will have to seek earning assets with higher
expected returns, and thereby maintain a positive spread that compensates for transaction
costs and risk. Thus, as banks increasingly use
liability management to gain a larger share of
total financial market activity, they will pay
relatively more for their purchased funds, and
will face the increasingly difficult task of achieving a high enough spread to offset the cost
involved. In a competitive market, this process
will likely force banks to seek earning assets that
entail higher risk and/ or less liquidity.
liability Management as a Source of Growth
Liability management has two principal motivations; it can be used both to control bank
growth and to purchase liquidity. Both of these
aspects imply theoretical relationships among
liability management, bank assets, and bank
risk.
Liability management is an effective means for
a bank to control its rate of growth. Put simply, a
liability Management as a
Source of Liquidity
Liability management not only enables a bank
to control its growth rate, but also enables it to
exert greater control over the variability of its
total liabilities-for example, by increasing purchased funds to offset a loss of demand deposits.
13
To the extent that a bank expects to reduce such
variability through liability management, it will
expect a commensurate reduction in the variability of total bank credit. Thus, it can extend credit
that entails greater transaction costs, greater
short-term price variation, and! or less
liquidity-the type of credit that financial market theory tells us should provide a higher expected yield. Therefore, an increase in liabilities
for which banks can freely vary the deposit rate
(and thus the quantity obtained) should be
associated with higher-yield bank credit. In this
respect, liability management provides a substitute for holding reserves, U.S. Treasury securities, or other low-yield short-term liquid assets.
That is, liquidity on the liability side of a bank's
portfolio (through, say, day-to-day trading in
certificates of deposit or Federal funds) is a
substitute for liquidity on the asset side (through,
say, day-to-day trading in Treasury securities).
Although purchased funds may substitute for
liquid assets, the two sources of liquidity are not
perfect substitutes. First, holding liquid assets to
meet future liquidity needs will normally result in
different returns and risk than will holding
illiquid assets with the anticipation of purchasing
liquidity when needed in the future. Consider
two banks, one that holds liquid (low yield)
assets against demand deposits on the presumption that these assets will provide for future
liquidity needs, and another that holds illiquid
(high yield) assets on the presumption that, if
necessary, it will later purchase funds to meet a
future run-off in demand deposits. The comparative profitability of the two strategies will
depend upon the ensuing financial environment.
If there is no run-off in demand deposits and no
liquidity squeeze, the strategy of holding illiquid
assets will prove more profitable. However, if
II.
demand deposits run off and market rates simultaneously rise, the strategy of holding liquid
assets may be more profitable.
Purchased funds and liquid assets are imperfect substitutes for another reason as weI!. Regulatory restrictions on liability managementsuch as Regulation Q ceilings on certificates of
deposit or increased reserve requirements on
Eurodollar purchases-may effectively limit
these funds as a source of liquidity to the
commercial-banking sector. To the extent that
banks rely on purchased funds rather than liquid
investments as the primary source of liquidity,
such restrictions can lead to a severe liquidity
squeeze, as in 1966 and 1969-70. Although similar restrictions have not been used in the last few
years, bankers cannot be certain that they will
not be employed in the future. A possibility of
regulatory restrictions---assuming they cannot
effectively be avoided-may render liability
management a poor substitute for liquid assets.
Implications for Aggregate Bank Portfolios
Both motivations of liability managementgrowth and liquidity5-suggest that an increase
in the use of liability management should be
associated with an increase in asset risk and! or a
decrease in asset liquidity. Thus, asset composition may change in several ways, such as a
decrease in marketability, increase in marketrelated or total risk, or increase in time to
maturity. However, there is no reason that such
changes should be motivated solely by changes in
liability management. In fact, major changes in
asset composition became well established prior
to the changes in liability management. Thus, the
two trends should be viewed as interrelated
changes in bank portfolio management.
Postwar Secular Trends in Assets and liabilities
Over the 1946-60 span, bank liabilities increased rather slowly (Chart I). The average
annual growth rate, 3.7 percent per year, fell
considerably below the 6.5-percent average increase in nominal GNP and the very rapid 10.5percent growth rate for deposits at thrift institutions (savings and' loan associations, mutual
savings banks, and credit unions). Throughout
this span, the commercial banking sector relied
principally on traditional demand and time
deposits as sources of funds. Neither source
expanded rapidly-2.5 percent annually for demand deposits and 5.6 percent annually for time
deposits. Banks normally held their rates on
individual time accounts below both the Regulation Q ceiling and S&L deposit rates. In addi14
rapid thrift-institution growth through the extension of Regulation Q to thrift-institution
deposits in 1966.
Despite sharp declines during the 1966 and
1969 credit crunches and the 1970 recession,
bank liabilities grew very rapidly from 1961
through mid-1974 as a whole. This period experienced relatively rapid economic growth and a
strong rise in private-both consumer and
business-spending and debt. But in addition,
the banking sector's intermediary role increased
significantly, reversing the earlier decline. As
shown in Chart 2, bank intermediation declined
from over 31 percent in 1946 to 26 percent in
1960, but then rose to 32 percent by the end of
1974 before declining somewhat again.
Chart 1
Commercial Bank Liabilities""
(Year-End Outstandings. 1946-75)
$ Billions
1,000
Ratio Scale
500
100 L -
L.
1950
-'---
J
--"--
1955
1960
1965
"-
1970
_---.J
1975
* Growth
rates are annual compound rates between initial and terminal vearS.
Liabilities are net of commercial bank interbank deposits and Federal" fund
purchases.
Source: Flow-of-funds accounts
Secular Shifts in Bank-Asset Composition'
tion, many banks did not accept corporate time
accounts.
Throughout the 1950s, most banks accepted
slow growth either as sound banking practice or
as something largely beyond their control.
Monetary policy, regulatory constraints, and the
memories of the turbulent 1930s all probably
contributed to this conservative posture. However, as mOl~ey-market rates rose in the 1950s,
corporations began to shift their funds out of
banks (particularly New York banks) and into
money-market instruments. To compete effectively for corporate deposits and to acquire funds
for lending, New York banks began in February
1961 to issue negotiable certificates of deposit
(CD's), other city banks then followed, and
security dealers began making a secondary market for these instruments.
Chart I shows the pronounced acceleration in
the growth of bank liabilities after 1960. Over the
1960-75 span, bank liabilities increased at a 9.1percent average rate (compared with average
growth rates 00.6 percent for nominal GNP and
10.1 percent for thrift-institution deposits).
Banks arrested their earlier relative decline largely through the success of their innovations in
liability management, such as large negotiable
CD's, Federal funds transactions,6 and borrowings from foreign branches (Eurodollars). Other
contributing factors included favorable monetary and regulatory policies, which until the late
1960s did little to inhibit the growth of purchased
funds, and the reduction in the hitherto very
The composition of bank assets has changed
dramatically over the postwar span. Nonearning assets, vault cash and member-bank
reserves, have risen at a sluggish pace, principally
because (1) a slow increase in demand deposits
has led to a net reduction in the effective
required-reserve ratio and (2) more effective
reserve management, motivated by rising interest rates, has reduced aggregate excess reserves.
Thus, earning assets have risen from about 85
percent of bank assets in 1945-48 to about 90
percent in 1972-75.
Of greater consequence, however, has been the
pronounced postwar shift in the composition of
earning assets. Marketable U.S. Treasury securities declined from an average of 63 percent of
aggregate bank credit outstanding in the 1945-48
Chart 2
Bank Intermediation -Stocks*
Percent
(Year-End Outstandings, 1946-15)
35
30
25
20
L-_---'--1950
*
L
---'---
L
---'---
-l
1955
1960
1965
1970
1975
Commercial bank credit market instruments outstanding as a share of total
nonfinancial credit market debt.
Source: Flow~of-funds accounts
15
period to an average of 10 percent in the 1972-75
period. Other governments-state, local and
Federal agency-increased their share of bank
credit outstanding from 5 to 19 percent over the
same time span, and in particular, the loan share
of the total jumped from 29 to 70 percent.
Banks entered the postwar era with what in
retrospect can be considered abnormally high
liquidity. At the end of 1945, U.S. Treasury
securities constituted 73 percent of bank credit
outstanding. Thus, banks were able to accommodate a substantial increase in loan demand by
liquidating Treasuries, reducing their holdings
from $91 billion in 1945 to $61 billion in 1960.
Since 1960, the Treasury share of bank credit has
continued to decline from 30 percent to only 10
percent in 1972-75. This period also marked the
spread of liability management, and with minor
exceptions (until late 1974) was characterized by
heavy demand for private credit. In this environment banks were willing, if not anxious, to
accommodate a rising market for bank loans by
purchasing funds and simultaneously reducing
their cushion of liquid secondary reserves (and
capital accounts). Bankers may have been consciously taking additional risk with the expectation of greater reward. But in addition, in view of
the apparent decline in perceived market risk in
U.S. financial markets, bankers may not actually
have been aware of any substantial rise in their
total risk. In any case, bank asset structures
became increasingly susceptible to financialmarket fluctuations, despite the fact that liability
management also provided (in theory) a buffer to
offset asset illiquidity.
Contrasted to the declining share of U.S.
Treasury securities was the growing postwar
importance of Federal agency and state-local
government issues. Treasury and agency issues
may be considered substitutes for each other, but
the latter carry some additional default risk and
may be of longer maturity. Municipal securities
may carry substantial default risk and vary
widely in maturity. Thus, the shift in security
holdings from U.S. Treasury to Federal agency
and state-local government securities should be
viewed as a shift away from liquid low-risk
assetsJ
Secular Trends in Liabilities and
Capital Positioning
Postwar developments in liability management and capital structure are reflected in a
change in the composition of aggregate bank
liabilities, as shown in Table 2. (Large-bank data
show more striking changes in liabilities, as they
do for assets, but the emphasis here is on the total
commercial-banking sector.) During the 1950s,
bank liabilities consisted of equity capital and
Table 1
Secular Changes in the Composition of
Bank Credit Outstanding
Percentage of Total Loans and Investments, 1952-75
Investments
loans'
1952-55
1956-59
1960-63
1964-67
1968-71
1972-75
3
Total
C&I
Real
Estate
To Individuals
Other
Total
U.S.
Treas.
S.&l.
Gov't.
Other'
46.3
54.6
59.1
65.4
67.3
70.0
18.8
11.7
22.1
21.0
23.6
25.2
24.8
13.7
14.6
16.3
16.6
18.0
9.7
11.6
13.2
14.8
15.1
15.0
6.2
7.2
10.2
10.8
10.4
12.3
53.6
45.4
40.9
34.5
32.7
30.0
42.6
34.2
28.6
19.2
13.9
9.8
7.6
8.4
10.0
13.0
15.3
14.9
2.6
2.1
1.8
2.4
3.5
5.4
1 Equals "other loans" in Federal Reserve Bulletin, i.e., excludes Federal funds sold and securities purchased under agreements
to resell.
2 Consists mostly of securities issued by Federal agencies.
3 Averages of semi-annual call data over each four-year period.
Source: Federal Reserve Bulletin,assets of all commercial banks.
16
funds from zero to 12 percent of the portfolio is
very important. Likewise, when viewed in terms
of leverage, the small decline in equity from 9.1
to 7.5 percent of total liabilities is also important.
This change represents an increase in the leverage ratio (total liabilities/ equity capital) from
11.0 to 13.3. If measured relative to "risky assets," leverage has of course shown an even
greater increase. (Again, the change has been
greater for large banks than for others.) Thus,
between 1960 and late 1974, we have witnessed
two striking secular trends-an increase in purchased funds and a decline in banks' capital
cushion-along with the decline in asset marketability mentioned earlier.
Although the compositional shift from liquid
assets to illiquid assets (Table 1) was well established prior to the advent of liability management (Table 2), the developments were closely
related. On the asset side, rising interest rates,
high private demand for bank loans, small Federal deficits, and a gradual waning of Depression
fears led banks to reduce noninterest-bearing
reserves and shift funds from liquid investments
to (high yield) loans. On the liability side, rising
interest rates (combined with Reg Q ceilings) and
a favorable economic environment provided the
incentive for banks to move more aggressively
into financial markets by purchasing more funds
"traditional" sources of funds-net demand deposits, time deposits other than large CDs, and
small amounts of Federal Reserve float and
borrowing from Federal Reserve banks. Equity
capital increased as a portion of total liabilities
during the 1950s. But since 1960, purchased
funds have risen from zero to 12 percent of the
overall portfolio, while traditional sources of
funds and capital (particularly equity capital)
have declined as a share of the total.
Because of data limitations, Table 2 understates the growing importance of liability management. First, it includes among "traditional"
sources the rapidly-growing category of time
deposits other than large CDs, although the
distinction between the time deposits and large
CD .categories has become increasingly fuzzy,
particularly since Regulation Q ceilings no longer apply to some time-deposit categories. In
addition, the table includes only part of the rapid
increase of purchased funds transacted through
holding companies, and excludes certain "offbalance sheet" items such as arbitrage transactions through agencies of foreign banks.
Despite data limitations, the figures in Table 2
show both a rapid increase in the importance of
purchased funds and a decline in the equity (and
total capital) base since 1960. When viewed as a
source of liquidity, the increase in purchased
Table 2
Secular Changes in the Composition of Commercial Bank Liabilities 1
Percentages of Total liabilities, 1952-75
Purchased Funds
Traditional Sources
Large
Federal
Demand Time, Excl.
Totaf2 Dep.,Net Large CDs Total" CDs' Funds, Netli.! Eurodollars
1952-556
1956-59
1960-63
1964-67
1968-71
1972-75
89.3
88.0
85.5
82.0
79.0
73.8
62.4
57.7
51.0
42.4
37.2
30.9
26.3
29.5
33.6
38.9
41.0
42.4
0.3
0.1
2.3
5.7
7.3
12.2
0.0
0.0
1.9
4.6
4.8
9.3
0.0
-0.1
0.0
0.4
1.0
2.1
0.3
0.2
0.4
0.7
1.4
0.4
Capital
Total Equity
8.0
8.7
9.1
8.8
8.5
8.1
8.0
8.7
9.1
8.4
8.0
7.5
Debt Misc.
----
0.0
0.0
0.0
0.4
0.5
0.6
2.4
3.2
3.2
3.4
5.2
5.9
Liabilities are net of interbank demand deposits and interbank Federal funds purchases.
Includes borrowing from Federal Reserve banks and Federal Reserve float, not shown separately.
3 Includes loans sold to holding companies, loans from foreign banking agencies, and time accounts at foreign banking
agencies, not shown separately.
• Negotiable CDs over $100,000.
5 Consists of security RP's and float on commercial bank interbank loans.
6 Averages of year-end outstandings.
Sources: Flow of funds accounts for all items except equity capital which is from Federal Reserve Bulletin.
I
2
17
return in the market. For example, if a stock has
a beta of 0.5 (perhaps a utility stock), we should
expect on average far a IO-percent change in the
level of the stock market to result in a 5-percent
change in this stock's price. In contrast, if the
beta is 1.5 (an airline stock), the same market
return would result in a 15-percent change in the
stock's price on average. (By definition the average stock's beta is 1.0.)
It is well known that the stock market is highly
influenced by expectations regarding the general
economic and financial environment. If banks
are insulated from this environment, bank stocks
should not be very sensitive to factors that affect
the overall stock market and bank stocks should
have a low beta. Estimated betas for Standard
and Poor's stock index of nine New Yark City
and sixteen large banks outside New York City
show that this was indeed the case for the postwar period through the 1950s (Table 3). However, since about 1960 these bank-stock indexes
have become substantially more sensitive to
fluctuations in the overall stock market (S&P
500). Since the stock market generaily reflects
anticipated business and financial conditions,
these data suggest that common stocks of large
for bank lending. Furthermore, banks utilized
purchased funds to provide some of the balancesheet flexibility lost through the compositional
shift in assets.
Stock Market Evidence of Bank Risk
These interrelated developments-the decline
in asset liquidity, the growth of liability management, and the decline in bank capital--suggest
that U.S. banks have become more exposed to
risk, particularly the risk associated with general
economic and financial conditions.
There is a way to test this proposition. Financial theory makes wide use of the "market model" and the concept of "beta."8 Using the market
model, returns of an individual security (or
group of securities) are regressed against the
returns in the overall stock market to determine
the extent to which the individual security (or
group of securities) is sensitive to overall stockmarket fluctuations. (The model is shown in the
notes to Table 3.) The stock market is represented by a broad index such as the Standard and
Poor's Composite of 500 stocks (S&P 500). The
resulting beta value is a measure of the sensitivity
of the return of the individual security to the
Table 3
Betas of Standard and Poor's Bank-Stock
Indexes Against the S&P 500.11
9 NYC Banks
1947-49
1950-52
1953-55
1956-58
1959-61
1962-64
1965-67
1968-70
1971-73
1974-762
16 Banks Outside NYC
Beta
Std. Error
01 Beta
"R 2
Beta
Std. Error
01 Beta
R'2
.39
.36
.37
.37
.63
.98
.89
1.11
.68
1.09
.10
.12
.12
.11
.17
.11
.23
.17
.19
.18
.31
.18
.19
.22
.28
.69
.28
.53
.25
.52
.56
.47
.35
.50
.49
1.06
.74
1.09
.78
1.22
.16
.13
.12
.10
.12
.09
.18
.14
.14
.18
.25
.26
.18
Al
.31
.81
.32
.63
.47
.59
I Based on rates of change in last-Wednesday-of-the-month prices after 1952 and monthly-average prices for preceding
periods. The regression model is:
In(P banks, t+ 1 ! P banks, t) = a + b IniP 500, t+ 1 ! P 500,t) + e
Data tor 1976 are through August.
Source: Standard and Poor's price indexes for 9 NYC banks. 16 banks outside NYC and composite of 500 stocks.
2
18
banks have become more sensitive to the economic and financial climate in the past several
decades.
The· betas of these bank-stock indexes rose
primarily between the late 1950s and early 1960s
and have since fluctuated around the higher
level. The R-squared values also rose during
these intervals of rising beta, indicating a closer
association between changes in these stock series
III.
and changes in the overall stock market and
indicating that a greater percentage oftheir total
price fluctations is now market-related. The shift
between the 1950s and 1960s occurred as large
banks aggressively moved into the money markets to purchase funds, extended their loan
commitments rapidly, and allowed their equity
leverage to rise.
Liability Management and the Cyclical Stability of Banking
An important question raised by the developments discussed above is whether the liquidity
provided by liability-management (purchased)
funds can compensate for the decline in asset
marketability experienced over the postwar period. If banks can stabilize the short-term variation in total liabilities (by varying the rate paid
on purchased funds), then liability management
can reduce the risk inherent in declining asset
marketability. If purchased funds have actually
served this function, then we should expect to see
a reduction over time in the short-term variation
of total bank liabilities, and therefore greater
cyclical stability in bank credit. Is there any
evidence that bank credit has become more
cY9lically stable?
Some evidence is provided by the pattern of
bank intermediation-the share of total
nonJ?inancial-sector borrowing provided in the
form of commercial-bank credit (Chart 3). (The
measure in Chart 3 is based on flows and is thus
more sensitive to cyclical variation than is the
measure based on stocks in Chart 2.) The movement of quarterly data reveals two important
characteristics. First, there is a good deal of
variability throughout the entire period. Analysis of the two underlying series that form the
ratio shown in Chart 3 shows that both the flow
of bank credit and the flow of total funds raised
by nonfinancial sectors vary considerably and
are highly correlated, but that the flow of bank
Chari 3
Bank Intermediation-Flows
Percent
80
60
0952.H976.3l*
l"
Monetary
Deceleration
I
NBER
Recession
y
.'
II
40
f{.-
,,~
o
-20
-40
1952
1955
1965
1960
1970
1975
* Quarterly flows of commercial bank credit market instruments as a share of total funds raised by nonfinancial sectors including new equity issues.
Sources: Actual data from flow-of-funds accounts. Dating of periods from Poole for periods of monetary deceleration, NBER for recessions, and Friedman for
periods when CD rate exceeded ceiling ratc.
19
credit is by far the more volatile series. Thus, the
flow of bank credit is more sensitive to changes in
economic and monetary conditions than is total
borrowing in the economy, anc-l_larger relative
changes in the flow of bank credit are the principal cause of variations in the extent of intermediation.
The second characteristic is the shift in the
pattern of quarterly deviations after 1961. Quarterly stability was practically nonexistent prior
to that year. In contrast, the period since 1961 is
marked by spans of relative stability interrupted
by a few intervals of extreme instability. This
change in the pattern of stability may be attributed in part to liability management, or it may be
the result of changes in economic conditions and
in monetary policy, including effects of Reg Q.
within the period (Table 4 and Chart 3). Later,
during the 1966 and 1969 periods, when liability
management was constrained by effective Reg Q
ceilings, disintermediation was severe despite
attempts by banks to circumvent restrictions. In
sharp contrast, during the one recent period of
monetary restraint in which liability management was not constrained (1973:4-1974:3), bank
intermediation was exceedingly high (38 percent,
compared with the 1972-75 average of 32 percent). In this last period, bank intermediation did
not decline significantly until the onslaught of
the "inventory" recession in late 1974. Thus,
there is strong evidence that unconstrained liability management can enable banks to maintain
intermediation during periods of monetary deceleration.
Because of the influence of monetary and
economic conditions on bank intermediation, it
is necessary to examine liability management
and the stability of bank credit in a framework
that recognizes broad changes in these external
factors. Specifically, we may ask whether liability management has enabled the banking sector
to stabilize the degree of bank intermediation
during periods of "tight money." Although there
is no commonly accepted method of defining
tight money periods, two criteria provide a rough
approximation: (I) a deceleration in the growth
rate of money (M I) preceding business cycle
peaks,9 and (2) the existence of binding ceiling
rates on CDs, with secondary-market rates rising
above the allowed ceiling rate on new CDs.
According to these criteria, there have been six
tight-money periods since 1952, separable into
three different categories: (1) pre-liability management (i.e., prior to 1961), (2) liability management with constraints (the 1966:3-1966:4 10
and 1969:2- I 969:4 periods), and (3) liability
management without constraints (the 1973:41974:3 period). The latter distinction arises because, in the last several years, monetary policy
makers have ceased using such constraints as
ceilings on large CDs and high reserve requirements against Eurodollar deposits. 11
Table 4
Bank Intermediation-Flows
Four-Year Averages
Percentage
Before Liability
Management
1952-55
1956-59
20.0
17.2
After Liability
Management
1960-63
1964-67
1968-71
1972-75
30.8
34.8
30.2
32.3
Periods of Monetary Deceleration
and/or Binding CD Rate Ceilings
Before Liability
Management
1952:4-1953:2
1955:4-1957:2
1959:4-1960:2
10.7
17.1
6.2
Liability Management
With Constraints
1966: 3-1966:4
1969:2-1969:4
9.2
12.6
Liability Management
Without Constraints
During two of the three pre-liabilitymanagement periods of monetary restraint, disintermediation was substantial, while during the
other it was modest-although highly variable
1973:4-1974:3
Data definitions and source: See Chart 3.
20
38.3
This evidence can be supported by a more
detailed examination of changes in major bank
assets and liabilities (Table 5). In this analysis,
bank credit is divided into loans and investments, and liabilities into traditional sources (net
demand deposits, time deposits other than large
CDs, borrowing from Federal Reserve banks,
and Federal Reserve float) and other liabilities
(principally purchased funds and capital).
If purchased funds are to stabilize total bank
credit in periods of monetary restraint, their
growth rates should increase (or not decrease as
much as those of traditional sources). Actually,
"other liabilities" increased rapidly during the
pre-liability management periods of monetary
restraint, at a 3.3-percent average quarterly rate
of increase. Although perplexing at first glance,
this has a straightforward explanation, since the
increase was almost entirely in equity capital
(which includes retained earnings) and bank
profits were high in these periods. Loan growth
was not unduly restrained during these periods,
because funds were available from other liabilities (particularly equity capital) and from net
liquidation of investments.
In contrast, severe bank disintermediation
occurred during the 1966 and 1969 periods of
constrained liability management. For these
periods on average, traditional sources grew
slowly, 0.6 percent quarterly, compared with a
1.9-percent average for the 1961: 1-1976: 3 span.
The growth rate of other liabilities (0.8 percent)
was also low-especially low compared with a
4.6-percent average for 1961: 1-1976:3. Consequently, during the 1966 and 1969 tight-money
periods, controls on purchased funds reduced
the increase in these funds far below normal, so
that loan growth was severely restricted despite
the liquidity provided by net saies of investments.
The 1973:4-1974:3 period of monetary deceleration, in which Regulation Q ceilings were effectively removed, shows an entirely different pattern. Bank growth was rapid over this period.
Other liabilities increased at a whopping 7.0percent quarterly average rate, while loan
growth averaged 3.2 percent quarterly. In addition, there seemed to be little need to liquidate
investments to meet loan demand, since purchased funds fulfilled this function. (Of course,
banks no longer had much flexibility for liquidating investments, since Treasury securities and
other investments had already been reduced to
only a small share of total bank assets.)
Table 5
Average Quarterly Rates of Change in Major
Commercial Bank Assets and Liabilities*
Average Secular Rates
Pre-liability Mngt.
Post-liabilitv Mngt.
1952:1-1960:4
1961 :1-1976:3
Bank Credit
Loans
Investments
Liabilities
Trad. Sources
Other Liab.
1.2%
2.0
0.3
1.0
0.9
3.0
2.2%
2.4
1.8
2.2
1.9
4.6
Average Rates In Periods of Monetary Restraint
Pre-liab. Mngt. Post-liability Management
1952:4-1953:2
1955:4-1957:2
1959:4-1960:2
Bank Credit
0.6%
Loans
2.4
Investments -1.2
Liabilities
0.5
Trad. Sources 0.4
Other Liab. 3.3
Constrained Unconstrained
1966:3-1966:4
1969:2-1969:4 1973:4-1974:3
0.6%
1.5
-1.1
0.6
0.6
0.8
2.6%
3.2
1.1
2.8
1.7
7.0
"Average percentage changes at quarterly rates in seasonally
adjusted quarterly outstandings.
Definitions:
Total Bank Credit: Total bank credit (net of interbank
deposits and Federal funds transactions).
Loans: Sum of mortgages. consumer credit, bank loans,
n.e.c., and security credit.
Investments: Total bank credit minus loans as defined
above.
Total Liabilities: Total liabilities (net of interbank deposits
and Federal funds purchases).
Traditional Sources: Sum of net demand deposits, time
deposits other than large negotiable CDs, borrowing from
Federal Reserve banks, and Federal Reserve float.
Other Liabilities: Total liabilities minus traditional sources
as defined above.
Source: Flow of Funds Accounts.
21
ties have actually declined because of a marked
drop in the amount of purchased funds.
Three questions immediately come to mind.
Are we reverting back to a 1950-style pattern of
bank portfolios and capital structures? Is the
recent reversal attributable largely to forces
external to banking (i.e., regulatory, economic
or financial changes) or rather to a concerted
effort on the part of bankers to reduce the risk
exposure of their portfolios? Is the shift a precursor of future banking trends or is it merely
transitory?
Answers to these questions extend beyond the
boundaries of this paper, but some response is
merited. First, despite the significance of these
developments, casual analysis suggests that the
recent conservative trend has not moved major
liquidity and capital ratios back beyond where
they were in the early 1970s. The second question
has stirred considerable controversy,12 but no
final answers can be reached until we assess the
relative importance of the factors-regulation,
economic trends, and bank portfolio
management-that have been instrumental in
the recent reversal in trend. The same considerations will determine the answer to the third
question-the permanency of this recent shift in
bank behavior.
Recent Reversal in Liability Management
The rapid increase in purchased funds and
expansion of bank loans to mid-1974 ultimately
proved destabilizing to the bank sector, given the
(unforeseen) recession in late 1974. But there is
no reason that unconstrained liability management must always result in increased risk. The
expansion following the inventory recession of
1974:4-1975: I has been one in which earlier
trends in liability management have been reversed and bank portfolios have become less
risky, as seen in the following table. (The figures
may be compared with those in Table 5, top.)
Quarterly Change (%)
1975:2-1976:3
1.4
0.5
3.3
Bank Credit
Loans
Investments
Liabilities
Traditional Sources
Other Liabilities
1.4
2.0
-0.6
In contrast with the overall 1961-74 period, total
bank credit and total liabilities have increased
slowly. Loans have been nearly flat, but investments (especially marketable Treasury issues)
have increased markedly. Deposits (excluding
large CDs) have accelerated, while other liabiliIV.
Conclusions-Policy Implications
positional shift in assets has reduced asset marketability on balance.
Bank growth accelerated rapidly after the
advent of liability management in 1961, and
subsequently (until late 1974) banks relied increasingly on purchased funds for both growth
and liquidity. With purchased funds available,
banks had an additional incentive to reduce asset
liquidity. Banks-particularly large bankspresumably considered holding additional liquid
assets to be a costly alternative to purchasing
liquidity. Thus, the compositional shift in bank
assets and the expansion of liability management
can be seen to be closely interrelated.
Trends in bank asset and liability management
cannot be appraised independently of the economic environment in which they occur. Bank
portfolios are structured within a framework
This paper has attempted to show that the
liquidity and stability of U.S. commercial banks
have become more sensitive to economic and
financial-market risk over the postwar span.
This trend has resulted primarily from changes in
bank portfolio management, on both the asset
and liability sides.
The marked reduction in liquidity of bank
assets over the postwar period has implications
both for liability management and for monetary
policy. Declining liquidity has been reflected in
the shift in assets away from noninterest-bearing
reserves and secondary reserves (U.S. Treasury
securities). Although this trend has been partly
offset by increased purchases of U.S. agency and
state-local government securities, the most important development has been the sharp increase
in loans to the private sector. Clearly, this com22
that depends largely upon expectations of ri~k
and return. Although this paper ha~ not examined postwar trends in total economic and
financial. risk, it is readilyapparerttthat the
banking sector's exposure (sensitivity) to such
risk hasrisen. The rela.tivedecline of"risk free"
assets·(reserves.and short-term Treasuryissues),
the relative decline of "interest insensitive" (traditionai) deposits, the diminishing capitalcushion of banks, and the rise of bank-stock betas all
provide evidence· of increased exposure to
financial-market developments.
These considerations together have important
implications for monetary policy. Stringent (that
is, truly restrictive) limitations on purchased
funds could create a severe liquidity squeeze
within the U.S. commercial banking system.
This is related to the fact that there is no large
secondary market outside the commercial bank
sector for loans as there is for securities. While
there is a wide market for Treasury bills, most
loans would be very difficult for a bank to sell in
a liquidity squeeze. In this situation, the banking
sector as a whole-and not simply individual
large banks-has come to rely on liability management as its principal source of liquidity.
Given this fact, it is not surprising that banks
devised ingenious instruments to circumvent CD
ceilings during the 1966 and 1969 tight-money
periods. Despite these efforts, bank disintermediation was heavy during those periods. Although it is difficult to assess the effects of
liability-management curbs on total financial
flows and total spending in the economy, the
effect on the. banking system was obviously disruptive.
Banks have purchased funds not only to stabilizethe variance of bank credit. during tightmoney periods,butalso to accelerate their
growth during expansionary •periods, In this
respect, liability management has increased the
banking sector's exposure to economic fluctuations. During the 1971-74 period, banksincreasingly purchased funds to meet loan commitments, but. in the process allowed their capital
cushions and liquid investments to decline in
relative terms. These measures presumably
would have promised high returns in a stable
economic environment, but they also served to
make the banking system more vulnerable in the
sharp recession at the end of 1974.
Policy-makers henceforth will be forced to
weigh carefully any perverse effects on the
commercial-banking system resulting from policies that attempt to restrict the flexibility of
liability management. Actually, it is not clear
that monetary policy needs to resort to such
tactics, or even that restrictions of this type
effectively curb economic spending. The 1973-74
tight-money period occurred without any resort
to direct controls over liability management.
This period of monetary deceleration mayor
may not have brought on the ensuing inventory
recession, but the recession occurred without any
prior curbs on liability management or severe
disintermediation of bank funds.
23
FOOTNOTES
1. See the paper by Herbert Runyon in this issue. Additional
evidence from varied sources supports this view. The PIE ratio
in the stock market rose considerably in the late 1950;' and early
1960s, and ignoring fluctuations of short duration, did not fall
dramatically until 1973. In addition, monthly variation in stock
market (S&P 500) returns generally declined through the late
1960s and then rose during the 1970s. Studies cite a number of
possible explanations for a postwar decline in the market's
perception of risk. William Nordhaus, "The Falling Share of
Profits," Brookings Papers on Economic Activity (No.1, 1975),
pp. 198-204: Henry Wallich, "Framework for Financial Resiliency," Conference on Financial Crises, New York University, May
21,1976: and Stuart I. Greenbaum, "Economic Instability and
Commercial Banking," Hearings of the Senate Committee on
Banking, Housing and Urban Affairs, 94th Congress (October
31 and December 1 and 8, 1975).
2. Many commercial banks operate in markets that are not
highly competitive, largely because of regulations that often
restrict entry of new banks or prohibit branch banking. Measured by dollar volume, however, most transactions take place in
competitive markets, as a result of the sheer dollar volume of
transactions at large city banks and the system of correspondent banking.
3. Financial theory suggests that (given diversified portfolios)
the pertinent risk to be considered is market-related and not
firm-specific, from the standpoint of either bank portfolios or
loan differentials. Small banks do not hold diversified loan
portfolios, in part because loans are concentrated in the local
geographical area-and their risk is thus partly firm-specificbut the most important problem for the commercial bank sector
as a whole is market-related risk.
4. The term "intermediation" is used throughout to mean the
commercial banking sector's share of financial-market activity.
Two closely related measures are used-one based on banks'
share of total financial market flows (lending and borrowing)
and one based on banks' share of stocks (total assets or
liabilities) in the financial markets.
5. This paper ignores a third reason for liability management:
legal avoidance of reserve requirements. New instruments have
normally been subject to reserve requirements only with some
time lag.
6. Banks had traded Federal funds among themselves in
earlier years, but had purchased only insignificant amounts
from outside the commercial banking sector until the mid1960s.
7. There are additional reasons for the rapid increase in bank
holdings of state-local government obligations. For one reason,
there was probably much less perceived risk on municipal
issues than there had been during the Depression of the 1930s.
Banks bought such issues also because of their strong ties with
local governments, or because of legal restrictions requiring
the pledging of government issues against deposits. Finally,
banks purchased municipals because they gained a comparative advantage from the tax-exempt status of such issues,
although this factor is now declining in importance because
other means are available of obtaining credits against taxable
income.
8. The market model and beta are described in recent textbooks on finance and investments. A short description is also
contained in Franco Modigliani and Gerald Pogue, "An Introduction to Risk and Return," Financial Analysts Journal,
March/April and May/June 1974.
9. William Poole, "The Relationship of Monetary Decelerations to Business Cycle Peaks," Journal of Finance (June 1975).
The Poole study ended prior to the recent recession, so some
judgment had to be made about this period. Although the NBER
dates the recent business-cycle peak within the fourth quarter
of 1973, the sharp "inventory recession" did not take effect until
late 1974. This study concentrates on the inventory recession
that occurred over the 1974:4-1975:1 period, because inventory
purchases and short-term credit demands remained strong
until this time. Using Poole's criterion and this recession dating,
monetary deceleration "prior to a business-cycle peak" occurred over the 1973:4-1974:3 period.
10. The period of effective CD ceilings in late 1966 coincided
with a deceleration in the growth of money. However, since an
NBER recession did not follow, the period did not meet Poole's
criterion.
11. For exact restrictions and dates of removal, see tables in
any issue of the Federal Reserve Bulletin.
12. See the contributions of Gilbert, Harris, and Kaufman
listed in the bibliography.
24
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25
@FedFRASER