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BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
January 11, 1971
CONFIDENTIAL (FR)
TO:
Federal Open Market Committee
FROM:
Mr. Broida
Enclosed are (1) a memorandum from the staff dated today
and entitled "Euro-dollar problem: Federal Reserve matched-sale
purchase transactions," and (2) a memorandum from Mr. Hackley
dated January 8, 1971, and entitled "Legality of 'matched salepurchase transactions' to induce banks to retain Euro-dollar
holdings."
It is contemplated that a preliminary discussion of these
materials will be held at the meeting of the Committee tomorrow,
at the conclusion of the discussion of monetary policy.
It
is requested that these materials be held in strict
confidence.
Arthur L. Broida,
Deputy Secretary,
Federal Open Market Committee.
Enclosures
Note:
The second copies enclosed
are for the use of the
Adviser accompanying you
from your Bank.
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January 11,
TO:
Board of Governors
FROM:
Division of International Finance
SUBJECT:
Euro-dollar problem: Federal Reserve
matched sale purchase transactions
1971
CONFIDENTIAL (FR)
This memorandum outlines the technical characteristics of
Federal Reserve matched sale-purchase transactions with member banks
designed to help moderate repayments of Euro-dollars.
Sales would be
made from the System's portfolio of U.S. Government securities with
offsetting purchase contracts to buy the securities back at specified
future dates.
The effectiveness of the matched sale purchase trans-
actions (MSP's) (and of a special Ex-Im security issued to achieve
the same objective) would be increased if certain amendments which
are set forth below were made in the Board's Regulation M.
An amendment by the FOMC to its continuing authority directive would be required to implement the proposal.1/
In the judgment of the staff, it would be most efficient for
the FOMC to specify in its continuing authority directive certain general criteria for MSP transactions, such as the method of allocation to
member banks, an outside limit on the maximum outstanding volume of
matched sales purchase transactions, the maximum maturity of the instrument, and the maximum interest rate spread allowable between sale and
1/
Draft language appears in the Appendix.
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Board of Governors
repurchase price.
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CONFIDENTIAL (FR)
Responsibility for making other decisions on the
MSP program might then be delegated to a subcommittee, whose decisions
would be dictated by operating experience.
Recommended Program:
It is recommended that the FOMC authorize a total outstanding
volume of MSP's of $1-1/4 billion initially;
as necessary, the Trading
Desk could make such agreements at a rate of $300 million a week over
the course of a month.
It is recommended that FOMC require that the
MSP be allocated to banks in proportion to their outstanding Euro-dollar
liabilities to branches (plus branch holdings of MSP's and Ex-Im Bank
securities) in the most recent computation period; reasons for rejecting other possible methods of allocation are discussed below.
The recommended maturity for the MSP (once the introductory
period is passed) is four weeks, with maturity to fall shortly after
the end of a computation period in order to adjust banks' holdings of
MSP's to their Euro-dollar liabilities as quickly as possible.
It is
recommended that the Federal Reserve fix an appropriate yield spread
for each offering of MSP's over the one-month Euro-dollar deposit rate,
perhaps beginning with a spread of 1/8 percentage point.
Through MSP transactions, and through sale of high-yield
Ex-Im Bank securities, allocated to banks along the lines set forth
above, the Federal Reserve, and the U.S. Government, would share with
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Board of Governors
CONFIDENTIAL
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(FR)
the banks the cost of the Euro-dollar borrowings of their branches in
excess of amounts relent abroad.
The share borne by the Federal Reserve
or the Government would be influenced both by the yield on the instru-
ment and the volume of such instruments allocated.
of Ex-Im Bank securities and Federal Reserve MSP's
A total allocation
(along the above
lines) amounting to $3 billion would eliminate the excess cost on 3/8 of
total Euro-dollar liabilities of about $8 billion; this would be equivalent to a cost saving of about 40 basis points on the total amount of
borrowings, and may be compared to an estimated cost of Euro-dollars
over domestic funds of roughly 1 percentage point.
Consultation with the Division of Research and Statistics and
with the Trading Desk indicates that an MSP, patterned along these lines,
could be implemented without creating serious problems for the management
of domestic open market policy.
Discussion:
The particular characteristics of the proposed MSP to be ex-
amined further are the relation of the MSP to requirement-free Eurodollar bases, the method of allocation to member banks, and the method
of pricing the MSP.
Relation to requirement-free bases.
The MSP could, as a matter of
principle equally well be made with the U.S. head office or with the
foreign branch.
If the MSP is sold to the head office, there would be
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CONFIDENTIAL
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Board of Governors
(FR)
no necessary reduction in head office liabilities to foreign branches;
the head office could purchase the MSP with the funds that otherwise
might be used to repay Euro-dollar borrowings from branches.
Thus, the
bank would retain its requirement-free base, unless it took specific
steps to reduce its base.
However, if the MSP were acquired directly by the branch (as
would be the case with the Ex-Im security),
there would ordinarily be
a reduction in head office liabilities to branches as the branch paid
for the security by reducing its claim on the head office.
It would be advisable to amend Regulation M to provide specif-
ically that a bank's requirement-free base should not be reduced by amounts
of MSP's or Ex-Im securities held by the branch.
Method of allocation.
The security should be allocated among banks ac-
cording to the volume of head office liabilities to branches plus branch
holdings of MSP's (and Ex-Im securities) in the most recently completed
computation period.
This method of allocation would probably provide the
best balance of equity and effectiveness.
Banks with large outstanding
head office borrowings from branches would obtain large allocations; banks
that held MSP's at head offices and repaid borrowings following the initial
allocation would obtain smaller amounts at future allocations.
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Board of Governors
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CONFIDENTIAL (FR)
Alternative methods of allocation that attempt to exert
additional leverage on banks to maintain borrowings appear likely to
involve significant inequities and/or deficiencies in coverage.
Two
examples are given below (on the assumption that the MSP's are held at
head office):
a) MSP's could be allocated in such a way that banks
that maintained Euro-dollar borrowings at or close to a recent level
(e.g. the average in the December computation period) would receive
larger allocations in proportion to their borrowings.
Thus, one could
provide that banks would receive allocations equal to X per cent of
their Euro-dollar borrowings so long as borrowings (in the current
computation period) were not more than 10 per cent below the December
average, but otherwise allocations would be equal to 1/2 X per cent of
borrowings.
This method of allocation would place banks that had
maintained borrowings at or close to original base-period levels at
a disadvantage compared to banks that had reduced borrowings earlier.
A bank that reduced its Euro-dollar borrowings in February 1971 would
obtain a smaller allocation than it would have obtained had it made
the same reduction in early December.
Such a method of allocation
would be inconsistent with the commitment in the Board's press release
of November 30, 1970:
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Board of Governors
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CONFIDENTIAL (FR)
Although the steps announced today were deliberately
made of modest scale, the Board has under review other
measures that might be adopted for the purpose of tempering the repayment of Euro-dollars while avoiding penalty
to banks that operate so as to retain their reserve-free
bases.
b)
Alternatively, one might provide that banks' eligi-
bility to acquire the MSP would be inversely related to the shortfall
of their Euro-dollar borrowings from the original base (May 1969 or
November 1970, whicever is higher).
Most of the MSP's will, in
any event, be allocated to banks that in the December computation period
were close to their original historical bases; these banks account for
75-80 per cent of total Euro-dollar borrowings.
Allocating them a
significantly larger than proportionate share of the MSP's would result
in only a minimal allocation for banks that have repaid substantial
amounts of Euro-dollars.
Yet, these latter banks still have substantial
amounts of borrowings outstanding;
three major New York City banks that
have reduced borrowings by 30-40 per cent from May base levels, still
account for about $2 billion of borrowings.
A formula for allocation providing that banks with borrowings
of at least 80 per cent of May 19 69 bases (or November 1970 bases, if
higher) would obtain MSP's equal to
X per cent of borrowings, and other
banks only 1/2 X per cent of borrowings, would encourage banks not to
repay below 80 per cent of the original base, but might well appear to
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CONFIDENTIAL (FR)
sanction repayments down to this level.
to imply sanction of such a reduction
It would probably be inadvisable
(which would total nearly $1-1/2
billion,
if it were general.)
It should be noted that there would be little or no basis in
equity for application of a formula that used the original May 1969 base-given the widely differing positions of individual banks in May 1969.1/
Moreover, a special formula would be required for banks that have been
using minimum bases (3 per cent of deposits) and are now required to
establish historical bases by January 20.
Neither the MSP nor the Ex-Im security should be transferable to
other banks, particularly in view of the fact that either would count toward
avoiding reduction of a bank's requirement-free base.
Transferability would
result in sale of the allocations by banks that did not value their bases
highly to banks that would retain their bases anyway.
Thus, the MSP (or
Ex-Im security) would tend to substitute for the most stable component of
Euro-dollar borrowings.
Maturity.
The MSP is more likely to be an effective technique for inducing
banks to retain Euro-dollar borrowings if its maturity is relatively short;
the shorter the maturity, the more closely branch or head office holdings
of it can be matched to the bank's performance in retaining Euro-dollars.
1/
If an auction technique were used as a method of distributing a
limited supply, banks that wished to maintain reserve-free bases anyway
would bid most strongly for the securities, since the yield to them on
the preferential asset would be pure gravy. As a result, the yield
under the auction could be bid down to a point where it was not attractive
to banks on the margin between repaying or retaining Euro-dollar borrowings.
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Board of Governors
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CONFIDENTIAL
(FR)
With a maturity of four weeks, holdings could be adjusted following the
end of each computation period; banks that repaid borrowings would obtain
correspondingly smaller allocations upon maturity of their current holdings.
Pricing.
It is recommended that the Federal Reserve set both the sale and
the repurchase price on the MSP, as well as specifying an allocation for
These prices would be fixed to provide a yield to the bank equal
each bank.
to the one month Euro-dollar deposit rate plus a small margin (e.g.,
1/8 per-
centage point); at current Euro-dollar rates the yield would be about 6-1/4
Additional information on appropriate pricing may be obtained
per cent.
from the experience in offering the Ex-Im security.1/
An alternative technique that was examined by the staff was for
the Desk to solicit bids from each bank for its specified allocation.
The
bank making the bid would presumably attempt to guess the Desk's reservation price.
But given the purpose of the MSP (and the constraint that
allocations reserved for one bank would not be offered to another bank),
it was not clear how the Desk could arrive at meaningful reservation prices.
Thus, it appeared advisable, at least in the initial offerings, for the
Federal Reserve to set a price that clearly covered the cost of Eurodollars plus a reasonable margin.2/
1/ The one-month rate would be appropriate both in light of the maturity
of the MSP and of the fact that about 45 per cent of the Euro-dollar deposits
of foreign branches mature within one month.
2/
Little is known about tax considerations that might affect the willingThe issue is probably not
ness of foreign branches to acquire securities.
significant so long as the margin between the yield on the MSP and the cost
of Euro-dollars is very small.
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Board of Governors
Amount.
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CONFIDENTIAL (FR)
Although the MSP, as outlined above would provide no
special marginal incentive for banks to retain Euro-dollar borrowings,
it would lessen the costs to banks of retaining requirement-free bases.
(Alternative methods of allocation would provide marginal incentives,
but at some cost in coverage or equity;
see pages 5-7 above.)
The cost
sharing could take the form of either a high rate of return (over and
above the cost of Euro-dollars) on a small volume of MSP, or a slight
margin over the Euro-dollar rate on a larger volume of MSP's.
By and
large, the latter form of cost sharing would be preferable from the
standpoint of minimizing the political risk.
If one assumes total liabilities to branches are $8 billion,
an offering of $2 billion of MSP's (at a yield equal to the cost of
Euro-dollars to the bank) would eliminate the excess of cost to banks
on 1/4 of their total borrowings.
This would be equivalent to a cost
saving of 25 basis points on the total amount of borrowings.
It would
be a somewhat greater cost saving on that portion of their Euro-dollar
borrowings that the banks are considering repaying, since in any case
borrowings would not be repaid completely.
If banks repaid $2 billion
of borrowings in addition to reducing their liabilities to branches by
$2 billion to enable the branches to acquire the securities, the second-
round allocation to refund the maturing MSP would provide a larger cost
saving:
the $2 billion of refunding MSP's would be allocated to banks
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Board of Governors
with $6 billion of borrowings
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CONFIDENTIAL
(FR)
(together with maturing MSP's); the cost
saving would be 33 basis points on average outstanding borrowings.
Thus,
it would probably not be necessary to issue MSP's equal to the total
volume of borrowings; at some point the cost saving would be sufficient
to induce banks to preserve the remainder of their bases.
It would appear that a combined authorization of MSP's plus
Ex-Im securities of, say, $3 billion would represent an adequate amount
for planning, at least initially.
Issuance of this amount would enable
the Federal Reserve and the Government together to cover almost one-half
of the excess cost of total Euro-dollar borrowings--at the present
1 percentage point cost of Euro-dollars over domestic funds--and to
cover a somewhat higher proportion of the excess cost on those borrowings that are potentially subject to repayment.
The entire amount may
not be required, but the need can best be assessed only after the response
of banks to the initial tranches has been determined.
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APPENDIX
Add the following paragraph 4 to the Continuing Authority Directive
With Respect to Domestic Open Market Operations:
"4. For the purpose of moderating movements of Euro-dollar
liabilities of member banks, the Federal Open Market Committee authorizes
and directs the Federal Reserve Bank of New York, for the System Open
Market Account, to enter into special agreements ('paragraph 4 agreements')
with member banks providing for the sale of U.S. Government securities by
the Reserve Bank to the member bank on a cash or regular delivery basis,
and for the purchase by the Reserve Bank from the member bank of the same
amount of the same issues of securities within
weeks or less, subject to
the following conditions:
"A. A member bank shall be eligible to buy securities under
paragraph 4 agreements in an amount equal to a specified fraction of its (A) daily average deposits described in § 204.5(c)
of Federal Reserve Regulation D and (B) daily average net balances described in § 213.7(a)(1) (reduced by the daily average
amount of any deposits subject to § 204.5(c)), each for the
latest computation period as described in the specified sections.
The fraction, which shall be the same for all member banks, shall
be specified from time to time by the Federal Open Market Committee, or on behalf of the Committee by the Subcommittee named
in paragraph 6 of the authorization for System foreign currency
operations.
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APPENDIX
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"B. The aggregate amount of paragraph 4 agreements outstand-
ing at any one time shall not exceed $_
billion.
"C. Paragraph 4 agreements, which shall be non-transferable,
shall specify prices for the sale of securities to the member
bank and for the subsequent purchase of securities by the Reserve
Bank from the member bank, in such a manner that the net yield
to the member bank under the agreement is not more than _
basis
points in excess of the current market rate on one-month Eurodollar deposits.
"D. Within the limitations set forth above, the terms of
paragraph 4 agreements, and the timing and size of specific
offerings of such agreements, shall be subject to such directions
as may be issued from time to time by the Federal Open Market
Committee, or on behalf of the Committee by the Subcommittee
referred to in paragraph 4A above."
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JAN
CONFIDENTIAL
12
1971
(FR)
January 8, 1971.
To:
Federal Open Market Committee
From:
Mr. Hackley
Subject: Legality of "matched
sale-purchase transactions" to
induce banks to retain Eurodollar holdings.
It has been suggested that, as a means of inducing American
banks to retain Eurodollar liabilities, the System might offer Government obligations for sale to banks having such liabilities, with
a simultaneous agreement to purchase such obligations at a specified
date at a rate that would provide the banks with an attractive yield.
This memorandum relates to the legality of such "matched sale-purchase"
transactions.
Although in form such transactions would involve the sale and
purchase of Government securities, it might be contended that in substance they would amount to a borrowing of money by the Reserve Banks
and that the Reserve Banks have no authority to borrow money. At times
in the past, purchases of securities with agreements to resell them at
a certain date (straight "RP's") have been questioned as constituting
loans of money rather than legitimate open market operations; but the
validity of such transactions now appears to have the legal support of
almost 50 years of "administrative practice" known to Congress. Although matched sale-purchase transactions have been used as a tool of
domestic monetary policy since 1966 without legal challenge, they are
not supported by such a long period of administrative practice.
One of the arguments advanced in the past in support of straight
RP's is that, even if they amount to "loans", the Reserve Banks have
statutory authority to lend money to both member banks and to individuals, partnerships, and corporations on the security of Government obligations. The Reserve Banks do not, however, have authority to borrow
money - which, it might be argued, is the effect of matched sale-purchase
transactions.
It might be contended that the proposed matched sale-purchase
transactions would not be designed to effectuate legitimate purposes of
Federal Reserve open market operations. Traditionally, such operations
have been regarded as designed to affect the reserves of member banks and
thereby to regulate domestic bank credit. The present proposal would be
aimed solely at persuading American banks to retain Eurodollar holdings
in order to prevent an outflow of dollars to foreign central banks that
might threaten a reduction of the U.S. gold stock. It appears to be
conceded that the Desk might have to offset the proposed transactions
by substantial purchases of securities in order to effectuate current
monetary policy; and this fact suggests that the proposed transactions
would not be within the usual concept of open market operations.
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Federal Open Market Committee
On the other hand, there are considerations that would appear
to support the legality of the proposed transactions.
argument,
In the first place, although it is not believed to be a strong
the transactions would be in the form of sales and purchases
of Government securities and thus literally within the scope of the express authority of the Reserve Banks.
Even if in substance the transactions should be regarded as
Reserve Bank borrowings, they would be no different in this respect
from matched sale-purchase transactions conducted since 1966 as a means
of absorbing bank reserves. The legality of such transactions has not
been questioned and "administrative practice", even for a period of less
than five years, might be regarded by a court as supporting the validity
of the transactions. In this connection, it may be noted that in recent
years drawings by the System under its network of "swap" arrangements
have in effect constituted borrowings of money and that the legality of
such drawings has not been questioned.
Finally, with respect to the purpose of the proposal, the
System's foreign currency operations have been designed to "help safeguard the value of the dollar in international exchange markets" rather
than to affect member bank reserves and bank credit. Such foreign currency operations were upheld legally in 1962 not only by Counsel for
the FOMC but by the Treasury's General Counsel and, reportedly, by the
Attorney General of the United States.
Section 12A of the Federal Reserve Act provides that the time,
character, and volume of open market operations shall be governed with
a view "to accommodating commerce and business and with regard to their
bearing upon the general credit situation of the country". It may be
argued that, like foreign currency operations, the proposed securities
transactions would clearly have a bearing, even though indirectly, upon
the general credit situation of the country.
While the question is not free from doubt, it is my opinion,
particularly on the basis of analogous precedents, that the proposed
matched sale-purchase transactions contemplated by the present proposal
would be legally supportable.
@FedFRASER