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Prepared for the Steering Committee for the Fundamental Reappraisal of the
Discount Mechanism Appointed by
the Board of Governors of the Federal Reserve System

The following paper is one of a series prepared by the research staffs of the Board of Governors
of the Federal Reserve System and of the Federal Reserve Banks and by academic economists
in connection with the Fundamental Reappraisal of the Discount Mechanism.
The analyses and conclusions set forth are those of the author and do not necessarily indicate
concurrence by other members of the research staffs, by the Board of Governors, or by the Federal
Reserve Banks.

DURING 1 9 6 6

Dolores P. Lynn
Federal Reserve Bank of i I w York
August 1967
(Revised July 1968)





Sources of pressure on the New York City money
market banks... • •


Monetary policy actions during the 1966 boom* •


Liquidity of the money market banks at the opening
of 1966


Sources of new loanable funds




Use of the discount window
Attempts by the City banks to curtail lending.



Cumulative gain of funds through increase in
liabilities or decrease in assets, eight major
New York City banks, 1966-68



Selected short-term interest rates, 1966-68



Cumulative change in negotiable certificates of
deposit and Eurodollars at eight individual
New York City banks, March 16 to December
28, 1966


Basic reserve position and borrowings at the
federal Reserve Bank, eight major New York
City banks, 1966-68...




By the end of 1965 the economy had already accomplished an
expansion unmatched for vigor or endurance by any other business
upswing of the post-World War II period.

The margin of unused

productive capacity and manpower resources had narrowed considerably,
and inflationary tendencies were on the rise.

During the ensuing

nine months, demand pressures in the economy failed to abate.
Business expenditures on plant and equipment accelerated further,
spending on services by states and municipalities rose, and Federal
government outlays increased sharply as a result of an escalation of
the Vietnam conflict and an expansion of domestic social programs.
Pressures in the credit markets were intensified through September 1966
as the corporate and government sectors competed for funds in an
atmosphere of increasing monetary restraint.

Capital market yields

soared to their highest levels in more than three decades, and demands
made on the commercial banking system induced near-crisis conditions.
Functioning in their traditional role of major supplier of business
credit to the nation, the eight large New York City money market

were the focal point of these pressures.

Sources of pressure on the New York City money market banks
The heavy corporate demands for bank credit during 1966 reflected
to a considerable degree an acceleration in the payment schedules for
corporate Federal income taxes and employees1 withheld income and social

1. Chase Manhattan Bank, First National City Bank, Manufacturers
Hanover Trust Co., Chemical Bank New York Trust Co,, Morgan Guaranty
Trust Co*, Bankers Trust Co., Irving Trust Co., and Marine Midland Grace
Trust Co.


-2security taxes, which increased corporate working capital requirements
in 1966 by an estimated $4.1 billion.

These sharply expanded needs

for funds occurred at a time when corporate liquidity was at low ebb
and the volume of internally-generated cash flow had begun to shrink.
Throughout the economic expansion that began in 1961, corporations had
allowed their holdings of cash and liquid assets to run down to minimum
levels in order to expand productive capacity, build up inventories,
and acquire a very large volume of trade receivables.

After the first

quarter of 1966, moreover, the rapid growth of corporate profits came
to a halt.

As 1966 progressed, corporations1 projections of their own

cash flows proved increasingly overoptimistic in the light of actual
developments, and the need for additional bank borrowing rose
In addition to increased working capital needs of corporations,
several other factors exerted pressure on the City banks during 1966. A
portion of the growing number of requests for business loans represented
a spillover of demand from the capital markets.

With yields on new bond

flotations moving rapidly to three-decade highs, many corporations sought
to avoid expensive long-term borrowing by financing investment outlays
temporarily at relatively favorable bank lending rates.

Secondly, life

insurance companies and savings banks requested loans, under lines of
credit that had seldom been used in the past, in order to take up prior
investment commitments.

Cash inflows at both these types of financial

intermediaries were seriously diminished during 1966 by the process of

-3disintermediation set in motion by the sharp increase in market yields
on securities relative to those available on institutional savings.
Moreover, life insurance companies were subjected to heavy cash withdrawals through borrowing by policyholders at low contractual rates of
interest, and for other related reasons, while savings banks experienced
some loss of savings to the commercial banks, which were permitted to
pay higher rates of interest on certain types of accounts.
Finally, requests for bank accommodation by businesses anticpating further interest rate increases were a constant and significant
source of pressure on the banks.

Throughout the first three quarters

of 1966, banks were deluged with requests for business loans that were
generated not only by specific investment projects or working capital
needs, but also by a strong desire to obtain an adequate liquidity
margin for possible future needs.

In borrowing for anticipatory

purposes, many businesses activated lines of credit that had been
dormant for long periods in the past.

Equally symptomatic of the

spreading uncertainties regarding the future cost and availability
of credit were the large-scale attempts by corporations to obtain
additional bank lines of credit, increases in existing lines, and
conversions of existing lines into formal, legally binding commitments
for revolving credits or term loans in exchange for the payment of a
customary commitment fee.
The prevailing belief during this period that interest rates
must continue to head upward was caused by the increasing congestion

-4in the capital markets, mounting demands for credit at commercial
banks, and a step-up in military activity in Vietnam.

The mood of

pessimism was reinforced by the absence of fiscal measures to restrain
inflation and its implication for monetary policy.
Monetary policy actions during the 1966 boom
Between the end of 1965 and September 1966, the Federal Reserve
System utilized all of the instruments of general monetary control and
also attempted to apply selective monetary pressures in its efforts to
brake the boom.

In December 1965 the discount rate was raised from 4

per cent to 4 1/2 per cent, signaling a shift from the mild restraint
that had prevailed during most of 1965 to a more positively restrictive

This increase brought the discount rate temporarily into line

with other money market rates, which had been moving up rapidly.


the strong upward surge of interest rates that followed, however, the
discount rate was left far behind the market.

In order to avoid the

possibility of a further interest rate escalation, the System refrained
from raising the discount rate again in 1966, but continued to scrutinize
member bank borrowings carefully as requests at the discount window
Subsequent to the discount rate change in December 1965,
gradually increasing pressure was applied to member bank reserve
positions through System open market operations, and aggregate net
borrowed reserves of the banking system rose steadily from about
$100 million in the final 1965 week to nearly $600 million in the

-5last week of September 1966.

Reserve requirements against time

deposits other than savings accounts were raised to the statutory
ceiling of 6 per cent in two increases of one percentage point each,
the first effective in July and the second in September*



the period of rising credit demands, officials of the System expressed
increasing concern over the inflationary threat in the economy and
the urgent need for credit restraint.

Moral suasion toak the form

of periodic informal counseling of member banks by officers of the
individual Reserve Banks as well as public speeches and statements
of System officials. Member banks were urged to curtail their lending
and to become more selective in granting loans so as to avsid extending
credit for speculative ventures, for corporate acquisitions, or for
other non-productive purposes.
Maintaining the 5 1/2 per cent interest rate ceiling on largedenomination negotiable certificates of deposit (C/D's), in the face of
a sharp increase in yields on competing types of money market instruments,
was one important way in which the System attempted to restrain the
growth of bank credit during 1966.3

In refraining from raising the

2. These higher percentages applied only to l!other time deposits11
in excess of $5 million at each member bank. Reserve requirements against
time deposits below this limit and savings deposits remained unchanged
at 4 per cent. Subsequent to these increases, the statutory maximum
reserve requirement against time deposits was increased to 10 per cent.
3. However, the maximum interest rate payable on multiple-maturity
time deposits was reduced to 5 per cent for maturities of 90 days or
more and 4 1/2 per cent for 30- to 89-day deposits, effective July 20,
and the maximum rate payable on single-maturity time deposits of less
than $100,000 was reduced to 5 per cent, effective September 26. Previously, no distinction had been made between the single- and multiplematurity categories of other time deposits. The reductions in the ceiling rate on multiple-maturity and smaller denomination single-maturity
deposits affected those deposits most directly competitive with deposits
or shares in savings institutions.

-6C/D rate ceiling, the System sought not only to affect the availability
of bank credit but also to avoid stimulating further upward interest
rate adjustments in the credit markets, and, thereby, to alleviate some
of the pressure on mutual savings banks resulting from disintermediation.
By July, the existing C/D rate ceiling posed a serious threat to the
ability of the money market banks to attract new funds.

Since 1961,

when it first began to become an important outlet for surplus funds of
corporations and other large investors, the C/D had been a major source
of new funds for commercial banks, particularly the New York money
market institutions.

Although the rates payable on these instruments

had always been subject to regulation, the ceiling under Regulation Q
had been adjusted upward whenever necessary by the System in response
to changes in other market rates of interest.

The last such adjustment

had been made in December 1965, simultaneous with the increase in the
discount rate.
The accelerating business demands for credit were regarded by
the System as the most threatening single element in the bank credit

The growing apprehension within the System over the strength

of bank business lending was eventually made public in a letter issued
by the System to member banks on September 1, near the peak of the
financial market pressures.

In this letter, which called attention

to the 20 per cent annual growth rate in bank business loans over the
first eight months of 1966, the System stated that "Federal Reserve
credit assistance to member banks to meet appropriate seasonal or
emergency needs... will continue to be available as in the past11

-7and that tfa greater share of member bank adjustments should take the
form of moderation in the rate of expansion of loans, and particularly
business loans/1

The letter warned that this goal would be kept in

mind by the individual Reserve Banks in granting credit at the discount
window and, at the same time, it offered the privilege of discount
accommodation for extended periods of time to those banks cooperating
in achieving this goal. The September 1 letter attracted much comment
and gave rise to various interpretations.

In the meantime, officers of

the individual Reserve Banks continued to examine carefully trends in
loans, investments, deposits and borrowings of banks that were problem
or potential problem borrowers.
Liquidity of the mone,y market banks at the opening of 1966
A lionfs share of the pressure on the banking system resulting
from the combination of excessive credit demands and monetary restraint
during 1966 fell on the eight large money market banks in New York
City. Over the post-World War II period, the role of the New York
City banks as a major supplier of business credit had hardly diminished,
despite the more rapid economic growth of many regions outside the
industrial northeast and mid-Atlantic states.

In 1966, the large

New York City banks held about 29 per cent of total business loans
outstanding at all member banks, only a slightly lesser share than the
31 per cent in 1946.

Some explanation for the continued prominence

of the New York City banks in business lending may lie in the widespread
trend toward the integration of industry during the postware period
4. Ratios are computed on the basis of data for New York City
member banks classified as reserve city banks (or central reserve
city banks prior to July, 1962). The eight major money market banks
account for 92 per cent of the total assets of this group.


through mergers and consolidations.

With the substantial increase in

the relative size of individual business units, the City banks,
possessing unusually large legal lending limits, have remained almost
uniquely capable of accommodating the nation's prime borrowers. They
may also have continued to be regarded by corporate business, in general,
as an unfailing source of funds during periods of credit stringency.
In contrast, resources of the major New York City banks have
shown a distinct tendency to decline relatively during the same era.
Between 1946 and 1959, the City banks1 share in total deposits of all
member banks declined from 22 per cent to less than 17 per cent.
Although it rose temporarily to 20 per cent during the years 1960-65
through the aggressive promotion of negotiable C/Dfs, this share fell
to less than 18 per cent by the end of 1966 as a result of a sharp
decline in C/D liabilities.5
The decline in the ability of the money market banks to attract
funds by means other than the issuance of negotiable certificates of
deposit appears to be a secular phenomenon directly related to a revolution in the management of corporate funds that has been taking place
over the postware period.

Throughout this era of generally restrictive

monetary policy and rising interest rates, corporate financial managers
have become increasingly aware of the cost of holding uninvested cash
and of the possibility of simultaneously pursuing the goals of liquidity,
safety, and income.

Consequently, more corporations now hold demand

balances with commercial banks to minimum working levels and invest


See footnote 4.

surplus cash in a widened array of a high-quality money market

During 1966, however, the banks generally demanded

larger compensating balances when making loans to corporations.
Although corporate programs to economize cash have had an impact
throughout the banking system, their effect has been more severe
at the money market banks in New York City which have traditionally
relied on corporate demand deposits as a major source of loanable
funds. While the negotiable C/D has enabled the major New York
City banks, in effect, to recoup some portion of corporate funds
previously lost to the money market, it represents an extremely
volatile and expensive source of funds for these institutions.
On balance, it appears that demands for loan accommodation at the
City banks have tended to increase faster than the means to satisfy
these demands*
Although reductions in the burden of required reserves have
permitted the City banks to utilize a progressively larger proportion
of their funds for the acquisition of earning assets, this development
has only partially mitigated the effects of the relative loss of deposits
to banks in other regions of the country.

Over the post-World War II

period, required reserves of the major money market banks in New York
City increased little, in absolute terms, despite a sharp growth in
total deposits.

This decline in the effective ratio of required

reserves to total deposits, from a peak of 22 per cent in 1948 to about

-109 per cent in 1966, occurred under the combined influence of successive
reductions since the Korean War in reserve requirements against demand
deposits under Regulation D (partly through the elimination of the
central reserve city classification in July 1962) and a shift in the
composition of deposits in favor of time and savings accounts.
The eight New York City money market banks were, at the end
of 1965, less well-equipped to handle an oncoming barrage of credit
requests than they had been at any previous time during the postwar

Over the course of the cyclical expansion begun early in

1961, these banks had allowed their liquidity to fall to a
historically low level. By the end of 1965, the loan-to-deposit
ratio of the eight institutions, as a group, had risen to 73 per
cent, compared with 63 per cent for all commercial banks. The New
York City money market banks entered 1966 with their liquidity at
unprecedentedly low levels and with a very large proportion of their
deposits rather precariously held; more specifically, highly volatile
negotiable certificates of deposit accounted for nearly one-sixth of
the total.
Sources of new loanable funds
The New York City money market banks responded to the
acceleration of credit demands in 1966 primarily through intensive
efforts to maximize their ability to meet these demands and,
secondarily, through the adoption of programs to ration demands


See footnote 4.

-11and to scale down lending operations. At the start of the year, the
negotiable certificate of deposit promised to be the major source of
loanable funds for these institutions, as it had been in 1965. The
maximum interest rate payable on time deposits under Regulation Q had
just been raised (in December 1965, simultaneously with the discount
rate increase) to a flat 5 1/2 per cent for all maturities over 30
days, from former rates of 4 per cent on 30- to 89-day maturities and
4 1/2 per cent on maturities of 90 days or more. The 1 to 1 1/2
percentage point increase in the rate ceiling had restored the banks
to a favorable competitive position relative to other issuers of
money market instruments and had apparently allowed them ample
maneuvering room in their efforts to attract funds.
As a result of the rapid upward movement in money market
rates beginning early in 1966, however, the City banks raised C/D
offering rates frequently, attaining the new ceiling rate within a
fairly short time. As early as March, one New York City bank posted
the ceiling rate of 5 1/2 per cent on the 9- to 12-month maturity
category of C/D's. Other City banks soon joined in the move to the
ceiling by raising rates first on the longest maturity and then on
progressively shorter maturities.

By the beginning of August, an

offering rate of 5 1/2 per cent was in effect "across the board11 at
most New York money market banks.
Late in August, however, the negotiable C/D, except in the
shortest maturity category, had little appeal for investors. Money

-12market rates (discount basis) had risen to 5 7/8 per cent on prime
four- to six-month commercial paper, 5 3/4 per cent on 90-day bankers'
acceptances, 5 5/8 per cent on three- to six-month directly placed
finance company paper, and about 5 per cent and 5.40 per cent,
respectively, on three- and six-month Treasury bills. These rates
were equivalent to investment yields ranging upward from about 5.14
per cent and 5.63 per cent, respectively, on three- and six-month
Treasury bills to 6.10 per cent on prime commercial paper, compared
with the 5 1/2 per cent yield on C/D's.

Subsequently yields increased

further, through mid-September in the case of Treasury bills and through
mid-October in the case of commercial paper; briefly during the fall,
three-month Treasury bills, as well as the longer bill maturities,
enjoyed a yield advantage over C/D's. Yields on commercial and
finance company paper remained stable at their peak levels through
the end of the year, while market yields on Treasury bills and on
bankers1 acceptances declined after reaching their respective peaks
in mid-September and late November.

Nevertheless, the longer Treasury

bill maturities maintained their yield advantage relative to C/D's
until the latter part of November and bankers' acceptances, along
with commercial paper, continued to yield higher than C/Dfs through
the year-end.

Thus, despite a general easing of market tensions in

early fall, the negotiable C/D did not become a competitive money
market instrument again until just before the turn of the year.


Becduse of the changing structure of money market rates, the
C/D performed very pdorly diiritig 1966 as a magnet for new loanable
funds, contrary to indications at the end of 1965. As Chart 1 shows,
this instrument drew a negligible sum into the City banks during the
first eight months of the year in spite of the frequent and substantial upward rate adjustments. Increases in offering rates during
January and February did attract some new money, but further increases
were necessary in March in order to stem the unfavorable tide of net
C/D redemptions that developed in that month &nd to prepare the banks
for heavy seasonal credit demands during the tax period. The March
rate increases led to a $0.6 billion expansion in the volume of outstanding C/D liabilities by mid-April. This improved flow of C/D
funds enabled the City banks to supply without much difficulty the
unusually large corporate credit demands that developed as a result
of the Treasury's accelerated tax payment schedule. Borrowing needs
of U.S. Government securities dealers were also heavy at this time
as the dealers attempted to replace funds lost through the expiration
of repurchase agreements with nonfinancial corporations around the
tax date.
During May, the money market banks raised C/D offering rates
again, leaving little room for further adjustments under the legal
maximum, and by early August the 5 1/2 per cent rate was quoted on
all maturities by the majority of the eight banks. The rate increases
during the summer permitted the City banks to hold their C/D liabilities

Chart I

Billions of dollars


Billions of dollars

Due to own foreign branches

Holdings of U. S. Government

Loans to U. S. Government
securities dealers

Negotiable certificates
of deposit

Note: Data are based on Wednesday levels, except loans to U. S. Government securities dealers, which are based on the daily average
amount of Federal funds and New York Clearing House funds loaned to dealers during weeks ended on Wednesday.The latter include funds
supplied to dealers under repurchase agreements.
Source: Federal Reserve Bank of New York.

-15fairly constant, but they failed to generate additional funds to enable
the banks to handle renewed seasonal tax-related pressures, loan requests from nonbank financial institutions, and an extraseasonal demand
for business loans.
The larger-than-seasonal demand for business loans that began
to appear early in May and persisted into the fall of 1966 reflected,
to a considerable extent, a substantial increase in the volume of anticipatory borrowing by corporations. Over the summer, expectations


increases in interest rates and concern over the future availability
of credit became widespread.

These apprehensions were bolstered by

evidence of increasing monetary restraint and by an awareness that the
money market banks, then offering the maximum permissible rate on C/D's,
would be severely limited in their ability to expand loans further.
While precautionary borrowing was, thus, generated by the actual and
prospective situation in the money and credit markets, it contributed
to existing pressures• As credit demands became increasingly urgent,
the New York money market banks were subjected to rapid withdrawals of
C/D funds beginning in the latter part of the summer.

During the brief

span between mid-August and mid-December, C/D liabilities of the large
City banks fell by $2.1 billion.
In early summer of 1966, the New York City banks anticipated the
large losses of funds that eventually occurred as a result of C/D redemptions. Those which had foreign branches were prepared to meet them
by borrowing Eurodollars through these branches. Although the Eurodollar

-16market is generally a costly source of funds, the relatively strong
surge of money market rates in the United States toward the end of
1965 had resulted in a considerable narrowing of the differential between domestic money market and Eurodollar rates. During the first
half of 1966, for instance, rates on Eurodollars were only about 3/8
of a percentage point higher than rates on comparable maturities of
negotiable C/D's sold in New York City (Chart II). This interest
rate differential widened over the balance of 1966 as interest rates
abroad reversed their course. Nevertheless, the cost disadvantage
to the City banks of acquiring Eurodollars was partly compensated for,
throughout 1966, by the fact that these liabilities are not subject
to reserve requirements or to assessments by the Federal Deposit
Insurance Corporation.
Eurodollar borrowings constituted the only major source of
new funds for the money market banks during 1966, and they were the
principal means by which the City banks survived the severe drains
resulting from net runoffs of C/D f s during the last four months of the
year. As Chart I shows, liabilities to own foreign branches at the
eight money market banks climbed sharply between June and December
from a plateau reached in the first quarter of 1966. For the year
as a whole, cumulative borrowing of Eurodollars by the City banks
amounted to $1.8 billion, an amount roughly equivalent to the decline
in C/D liabilities*

As a group, these banks began to step up their

Eurodollar borrowing fully two months before the heavy redemptions of

Chart II


Note: Data plotted are the seven-day average rate on Federal funds for week ended Wednesday,the rate most often quoted on Wednesday
by nine large New YorkCity banks on new negotiable certificates of deposit, and the Wednesday rate on Eurodollar deposits.
Source: Federal Reserve Bank of New York.

-18C/D f s began.

Consequently, the basic reserve position of these institu-

tions improved sharply, though temporarily, in August and early September,
Virtually all of the major money market banks used Eurodollar
borrowings as an offset to C/D losses (see Chart III). Individual banks
varied in their approach to the Eurodollar market, however. A few banks
began to seek these funds after a downward trend in their C/D liabilities
had become clearly visible or at the same time as C/D losses commenced.
On the other hand, some borrowed Eurodollars considerably in advance
of C/D runoffs. Some banks built up liabilities to foreign branches
gradually over the period of C/D outflows, compensating for losses of
funds as they occurred. Other money market institutions borrowed
heavily initially, then allowed these foreign liabilities to remain on
a plateau until the latter part of the year, when the greater part of
interest-sensitive C/D funds had been withdrawn. Most of the eight
banks1 cumulative borrowings of Eurodollars corresponded roughly to
cumulative C/D losses. At two institutions, however, Eurodollar
borrowings were quite heavy relative to C/D runoffs.
Although little is known about the maturities of Eurodollars
borrowed by the City banks, it may be reasonable to assume that some
portion of the aggregate amount represented overnight or call money,
while a relatively larger amount represented funds acquired by the
foreign branches on longer-term contracts. Maturities may have varied
widely from bank to bank, however, since some branches overseas characteristically seek short-term Eurodollar deposits while others seek
somewhat longer maturities.











Note: Vertical scale is identical for all eight banks.

Source: Federal Reserve Bank of New York.







In order to increase the availability of Eurodollars for its
domestic lending operations, one New York City institution in April
1966 began to sell negotiable certificates of deposit at its London
office at yields slightly lower than those available for comparable
maturities of regular Eurodollars,

At the same time, the bank organized

a secondary market for Eurodollars C/D f s.

Within a short time, the

majority of other money market banks with branches in London had begun
to sell these instruments.
The major purpose of the C/D sales abroad by the money market
banks was to acquire more funds through the Eurodollar market*


offering the C/D f s in relatively small denominations (the minimum of
$25,000 compared with a regular Eurodollar deposit minimum of $250,000
and a New York negotiable C/D minimum of $100,000), the banks set
their sights on the funds of small investors who had not previously
participated in the Eurodollar market.

In addition, however, the City

banks hoped to benefit by acquiring Eurodollars at a reduced cost and
by improving their ability to retain funds that might otherwise be
lost through the redemption of domestic C/D f s by foreign holders in
the event of interest rate increases here or abroad.

C/Dfs sold in

London are not subject to any rate limitation such as that imposed by
Regulation Q.

The creation of the Eurodollar C/D market did not add

significantly to the supply of Eurodollar deposits in foreign branches
of the major money market banks.

It is, however, illustrative of the

resourcefulness of these institutions in attempting to locate new
sources of funds for lending.

-21Although needs for new loanable funds were intense during 1966,
the New York money market banks' sustained liquidation of U.S. Government securities ceased after the first quarter*

Portfolio adjustments

were used to tide the banks over periods of seasonal increase in loan
demand, but net sales at these times tended to offset by purchases
when acute pressures eased.

The use of the U.S. Government securities

portfolio as a temporary adjustment mechanism after the first quarter
of 1966 contrasted sharply with its use as a more or less permanent
source of funds earlier in the business expansion.

During 1965, net

sales of U.S. Governments had been a major source of new loanable funds
for the City banks, second only to the issuance of negotiable C/D f s,
and in the first quarter of 1966 the liquidation of these investments
had provided another $1.1 billion.
The reduced role of portfolio adjustments in the City banks1
program to meet accelerating loan demands was primarily a reflection
of the low level of holdings.

By March 1966, the combined U.S. Govern-

ment securities portfolio of the eight money market banks had been reduced to its lowest level of the entire postwar period as a result of
the sustained liquidation which had commenced late in 1961. At this
level, the bulk of securities remaining in portfolio may have been
pledged against public deposits and, hence, not saleable.


factor tending to discourage securities sales by the City banks in the
summer of 1966 was that the sharp increase in market yields raised the
cost, in terms of capital losses, of liquidating coupon issues.

-22After September 1, moreover, the liquidation of investments by
banks ran directly counter to the expressed wishes of Federal Reserve
System policy makers. Through public statements, periodic counseling
of individual member banks, and the administration of the discount
window, System officials left no doubt that they looked with disfavor
upon further reductions in bank holdings of tax-exempt securities,
especially when accompanied by a sustained rate of expansion in business loans. Member banks engaging in large-scale liquidation of such
securities, thus tended to invite closer scrutiny when requesting
discount accommodation at the Reserve Banks. This possibility of increased surveillance was not a significant restraint on liquidation,
however, because of the relatively limited use of discount facilities
made by the City banks during 1966. In fact, these institutions sold
off tax-exempt securities at a steady pace throughout 1966, gaining
about $0.5 billion from this source through June and a like amount
over the latter half of the year. These sales, occurring during a
period of heavy net new borrowing by state and local governments,
were a significant factor in the sharp rise in yields on tax-exempt
bonds to a thirty-four year high by August 1966.
Use of the discount window
The major New York City banks were generally in a position of
deep basic reserve deficit during 1966 (see Chart IV). At times during
the first eight months of the year, their reserve positions underwent
some sharp, temporary improvement as a result of inflows of C/D funds,

Chart IV

Billions of dollars

Billions of dollars
Borrowings at Federal Reserve Bank


Basic reserve position




Note: Data are daily average levels for weeks ended on Wednesday. Figures for basic reserve position are two-week
moving averages.
Source: Federal Reserve Bank of New York.


liquidations of securities, and substantial borrowing of Eurodollars ss
during the summer months in advance of the heavy C/D runoffs.


the latter part of the year, however, the basic reserve deficit
deepened to unusually high levels under the impact of the drastic
decline in C/D liabilities after mid-August.

As a result, the daily

average basic reserve deficiency of the eight banks rose to nearly
$500 million in the fourth quarter of 1966 from roughly $350 million
during the first three quarters of the year.
While their needs for funds to cover reserve requirements were
consistently heavy during 1966, the New York money market banks made
relatively little use of borrowing facilities at the Federal Reserve

As shown in Chart IV, substantial increases in the basic reserve

deficiency prompted only moderately increased use of the discount window.
Moreover, whatever borrowing these institutions did at the Federal Reserve
during 1966 was invariably the traditional overnight or short-term type
of accommodation.

None of the eight money market banks took advantage

of the privilege of extended discounting offered in the System's
September 1 letter to member banks, despite the increase in their
basic reserve deficits during the fall of the year.
The City banks1 hesitancy to approach the Federal Reserve Bank
for assistance, except at times of extreme emergency, partly reflected
the unwillingness of these institutions to have their lending and portfolio adjustment practices the object of official scrutiny.

It also

reflected the much heavier use made of the Federal funds market by the
money market banks in recent years.

During the early 196O f s, the City

-25banks had beguti to borrow Federal funds from other banks for the purpose
of relending, particularly to Government securities dealers, as well as
for the purpose of making day-to-day adjustments iti their reserve positions. As the function of the Federal funds market broadened, the
rate for Federal funds rose in relation to the discount rate, and had
generally exceeded the latter since 1964. During 1966, however, the
margin by which the effective rate for Federal funds exceeded the
discount rate widened to nearly a full percentage point by mid-November
from about 10 basis points throughout 1965 (Chart II).

This sharp in-

crease in the differential reflected the City banks' determined efforts
to operate without assistance from the Federal Reserve Bank as well as
their continuing use of Federal funds for dealer and other lending

In 1966, to an even greater extent than formerly, the

City banks were permanent debtors in the Federal funds market,
automatically renewing overnight loans and borrowing for periods of
more than the usual one day.
Attempts by the Cify banks to curtail lending
Between December 1965, at the time of the increase in the discount rate, and August 1966, the large New York City banks raised their
prime lending rate to business borrowers in four steps from 4 1/2 per
cent to 6 per cent. These increases were largely dictated by the need
to maintain profitable operations in the face of the rapid rise in the
cost of loanable funds to the banks. Although the prime rate increases,
and particularly those occurring in June and August, were also intended

-26to discsuraga loan applications from businessfrorrorrars,they had
apparently little effect on total loan demand.
Early in 1966, many of the large City banks adopted programs
amounting, in effect, to voluntary credit restraint.

These programs,

aimed generally at moderating the pace of business loan expansion
through the exercise of greater selectivity in reviewing loan requests,
were not implemented with any great vigor until the summer, when the
gap between credit demands and the supply of bank funds for new lending
widened significantly•

Under these programs, the City banks denied

loan requests which were clearly for speculative or hoarding purposes,
turned down requests for term loans or formal loan commitments, and
discouraged applications for loans from new customers. They also
attempted to reduce loan amounts and lines of credit. Moreover, the
banks reported that they made fewer loans at the prime rate and also
raised compensatory balance requirements.
At the same time, however, the money market banks seemed very
hesitant to turn down loan requests from old customers, or from new
customers whose business they had long solicited.

For competitive

reasons, as well, some banks apparently went back on their original
intentions not to issue formal loan commitments for a fee, even with
the knowledge that the presence of a large volume of outstanding commitments would seriously limit their flexibility in time of emergency.
Despite the banks1 efforts and procedures to restrain credit expansion, and the successive increases in the prime loan rate, net
increases in business loans of the eight money market banks in the

-27second and third quarter

of 1966 exceeded by roughly two-fifths the

amount of increase in tt3 corresponding quarters of 1965. Not until
the fourth quarter of t\e year did business lending fall off. In that
period, the net increase in business loans declined sharply to a lessthan-seasonal $0.4 billion from $1.1 billion in the fourth quarter of
1965. This rather drastic change in the pattern of business lending,
however, probably reflected a slowdown in corporate demands as much as
deniale or scaling down of credit requests by the City banks.
During the fourth quarter of 1966, two factors which had contributed significantly to the vigorous loan demand earlier in the year
were no longer present.

Expectations of further increases in interest

rates had largely disappeared, and corporations, whose liquidity needs
were still large, had shifted part of their credit demands back to the
capital markets in response to a reversal of the upward trend in bond
yields. These favorable developments, in turn, had been prompted by a
number of factors tending to stabilize the credit markets in the fall
of 1966. Early in September, President Johnson announced a fiscal program
to combat inflation and the U.S. Treasury indicated that it would curtail
certain types of Government agency financing over the balance of the year.
Prospects for peace in Vietnam seemed to be improving, moreover, and hopes
were high for an income tax increase after the November elections. By the
end of November, the markets began to detect signs of a relaxation of
credit restraint and, indeed, the record of policy directives issued by
the Federal Open Market Committee shows that the New York Reserve Bank was
instructed on November 22 to conduct open market operations "with a view
to attaining somewhat easier conditions in the money market...11

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