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Volume 3

Board of Governors of the Federal Reserve System


Library of Congress Catalogue Card Number 70-609110
Copies of this report may be obtained from Publica­
tions Services, Division of Administrative Services,
Board of G overnors of the Federal Reserve System,
W ashington, D.C., 20551. The price is $3.00 per copy;
in quantities of 10 or m ore sent to one address, $2.50
each. Remittances should be made payable to the
Board of G overnors of the Federal Reserve System in
a form collectible at par in U.S. currency. (Stamps
and coupons are not accepted.)

Volume 3



William F. Staats


Parker B. Willis


Parker B. Willis


Hyman P. Minsky
Benjamin Stackhouse







Paul Meek


Robert C. Holland and George Garvy
Dolores P. Lynn



William F. Staats
Federal Reserve Bank of Philadelphia

Major F in d in g s_____________________________________________________________________ 3
Nature of the M a rk e t______________________________________________________________ 5

Marketing channels and institutions
Participants in the M a rk e t_________________________________________________________ 8

Evaluation of the M a rk e t____________________________________________________________ 14

Information gaps
Dealer practices
Tax factors
Commercial bank operations
Evaluation of the market
Prospects for future market developments
Basis for Federal Reserve System C o n c e rn __________________________________________ 18

Capital losses of banks
Disorderly capital markets
Municipal financing
Procyclical effect of market improvement
Alternatives for A c tio n _____________________________________________________________ 20

Direct involvement approach
“ Free market" approach
A p p e n d ix ______________________________________________________________________ 23




The main focus of this study is the second­
ary market for State and local government
securities.1 Such securities comprise the debt
instruments of many political entities that
exist in this country— such as States, State
agencies, cities, towns, other political subdi­
visions, and a large variety of special-pur­
pose public authorities. The most significant
characteristic of such bonds is that interest
on them is not subject to Federal income
tax. In many instances, therefore, these debt
instruments are referred to as tax-exempt
bonds— as well as municipal or public secu­
rities or bonds.
Because of the lack of adequate data on
such crucial variables as price, volume,
number of bids, spread, and types of issues,
an empirical analysis of past market per­
formance of municipal bonds has been im­
possible. Brokers regard such data as highly
confidential. Accordingly, this study has
been based upon interviews with a number
1 Irwin Friend et aL, The O ver-th e-C ou nter Securi­
ties M arkets (N ew Y ork: M cG raw -H ill Book C om ­
pany, Inc., 1958), pp. 3 and 4.

of market participants and upon limited
amounts of published material concerning
the market for State and local government
In contrast to the primary market, in
which the original sale of debt instruments
of government entities to investors occurs,
the secondary market refers to sales of such
instruments by investors to other investors.
There are several criteria for a good second­
ary market. First, there should be a free
interplay between large numbers of buyers
and sellers to whom adequate information is
available on issues, issuers, economic condi­
tions, prices, volume of activity, and other
pertinent material. Second, the buyer and
seller should be brought together at mini­
mum cost through efficient institutional
structures. Third, the market should be able
to adjust readily to temporary disturbances
in normal supply/demand relationships, thus
affording price continuity for particular
issues traded. These criteria provide the
basis for the following evaluation of the sec­
ondary market for municipal securities.

According to available evidence, the ex­
isting market structure and procedures ade­
quately provide for the orderly sale of mu­
nicipal securities— even during periods of
severe discontinuity in financial markets
such as occurred in 1966. Communications
networks enable sellers to exhibit bonds

throughout the Nation in less than 3 hours.
Large or small blocks of bonds of various
maturities— whether issued by well-known
or by quite obscure government entities—
may be sold through the secondary market,
even though conditions may dictate huge
discounts from redemption prices. Trading


costs, however, vary widely and depend
upon several factors: (1) sophistication and
experience of the trader;2 (2) size of the
block of bonds traded; (3) size and credit
standing of the issuer; and (4) whether trad­
ing takes place in the national or in a re­
gional market.
State and local government obligations
are clearly less liquid than U.S. Government
obligations during periods of rising interest
rates. Data in the Appendix suggest that
rates on municipals usually rise faster than
yields on U.S. Government securities. In
periods of rising interest rates, therefore,
banks and other holders are likely to suffer
larger capital losses on sales of municipals
than on sales of U.S. Government securities.
While the effective cost of capital losses may
be reduced because of the tax-exempt fea­
ture of municipals, such losses may be large
enough to cause some banks to refrain from
using municipal securities as a means of ad­
justing their reserve position.
Several factors seem to account for the
liquidity characteristics of State and local
government bonds:
1. Information that would allow optimal
choice of such bonds often is not available
at a reasonable cost because perhaps more
than 100,000 different issues of municipal
bonds are outstanding.
2. The market for these securities is a
dealer market, and it suffers from the char­
acteristics inherent in such a market, includ­
ing procyclical operations, which may ac­
centuate price swings and promote insta­
2A survey designed to shed light on the trading
habits and procedures of bankers seems advisable.
Lack of alertness and of m arket sophistication may
cause a banker to incur higher trading costs than
3 O f course, an im portant advantage of a dealer
m arket is that transactions may be accomplished more
quietly and with less disruptive effects than in an
auction m arket.

3. The two most important buyers in the
market— individuals and commercial banks
— have different objectives and patterns of
market participation.
4. Individual investors who want to avoid
taxable capital gains and trustees who want
to avoid difficulties with beneficiaries tend
to eschew bonds selling at a discount in the
secondary market. The behavior of these in­
vestors acts as a depressing influence on the
market during periods of rising interest
5. Large and growing participation of
commercial banks as investors in the munic­
ipals market has accentuated the market’s
cyclical weakness because these banks tend
to liquidate large amounts of such bonds
during periods of tight money.
It might be desirable public policy to in­
crease the relative liquidity of State and
local government obligations and to enhance
the ability of commercial banks to use them
more effectively in situations requiring short­
term asset adjustments. This would be a dif­
ficult task, however, because it would in­
volve basic changes in the structure of the
capital market and in the institutions that
are part of that market. Whether to advo­
cate even attempting such a task depends
upon one’s political philosophy— among
other things. Nevertheless, for purposes of
discussion and perhaps as suggestions for
additional depth analysis, the following al­
ternatives for action are presented: One
would involve direct action— that is, partic­
ipation in the market by some agency such
as the Federal Reserve System. Another
would be a “free market” approach that
would build upon institutions now existing
in the market.
As a first possibility in the direct action
category, the Federal Reserve System might
undertake to moderate sharp cyclical fluc­
tuations in prices of municipal bonds by
buying or selling such bonds in the market.


This policy, however, would have a reserve
effect counter to the prevailing posture of
monetary policy; hence it would require off­
setting operations in the market for U.S.
Government securities. Depending upon the
magnitude of those offsetting operations,
such action might have disruptive effects on
the Government securities market.
Second, some Government agency might
act as a broker in the market— with the pur­
pose of reducing trading costs and of facili­
tating the substitution, where appropriate,
of an auction process of price determination
for the negotiation process, which is the
method now prevalent. This agency might
also increase or improve the availability of
information on current market conditions
essential to investment decision-making. It
should be noted, however, that private
brokers are quite active and that they are
increasing the scope of their activities in the
secondary market for municipal bonds.
Hence it might be inappropriate for any
Government agency to attempt to displace
existing brokers.
Third, the Federal Government might un­
derwrite a program of guaranteeing bond
issues of selected State and local govern­
ments. Such a guarantee would put all of
these selected issues on the same credit-risk
basis and would eliminate much of the
heterogeneity that plagues the market. As a
result, investors would need less informa­
tion, and the costs of trading might thereby
be reduced.
“Free market” alternatives do not directly


affect the mechanism of the secondary mar­
ket for municipal securities, but they might
help reduce the price instability caused by
heavy liquidation of such securities by com­
mercial banks in periods of tight money.
This might be accomplished by encouraging
use of State and local government bonds as
collateral for member bank borrowing from
the Federal Reserve. Thus, instead of selling
municipal bonds to obtain funds to protect
reserve positions and sustain lending activ­
ity, commercial banks would place these
bonds temporarily with the central bank.
Legislation to permit implementation of this
proposal has been pending in the Congress
for a number of years. Also, the Federal
Reserve System might accept municipals
from banks under repurchase agreements.
Undesirable reserve effects conceivably
might result from recourse to either of these
free market alternatives, but such results
might not prove to be unmanageable.
For the efficient operation of the capital
markets, for equitable financing of State and
local governments, and for efficient portfolio
management of commercial banks, it is de­
sirable that cyclical instability in the sec­
ondary market for municipal bonds be re­
duced. Yet, all proposals for achieving that
objective may be expected to meet with
some disapproval. Perhaps the most practi­
cal (and the least objectionable) of the pro­
posals is the one that would make taxexempt securities eligible as collateral for
member bank borrowing from the Federal

The secondary market for municipal bonds
involves hundreds of dealers operating
throughout the country and trading secur­
ities of great heterogeneity. As in the market
for U.S. Government securities, no orga-

nized exchanges exist; rather, nearly all
transactions involve a dealer, and most
prices are negotiated by the purchaser and
seller without recourse to the auction proc­
ess, which is dominant in the stock market.



Because municipal bonds are traded over
the counter, no precise data are available on
the volume of activity in these bonds. Two
factors determine the volume— the total
amount of bonds outstanding and the rate
of turnover.
The volume of municipal bonds outstand­
ing in mid-1966 totaled $104.8 billion.4 All
of these bonds could have been sold in the
secondary market one or more times. Dur­
ing the 1957-66 period, the amount of mu­
nicipal bonds outstanding increased at a
compound annual rate of 7.45 per cent.
Furthermore, rapid growth is expected to
continue because expenditures of the N a­
tion’s 80,000 State and local governmental
entities are projected to rise sharply over the
next decade. In fact, the volume of munici­
pal securities outstanding is expected to be
about $211 billion by the end of 1975.5
The dimensions of the recent growth in
municipal debt may be assessed by compar­
ing it with the growth of U.S. Government
debt. As shown in Chart 1, per capita State
and local government debt has grown at a
rapid rate in the postwar period, whereas
per capita Federal debt has declined. On
June 30, 1966, municipal debt outstanding
represented more than 24 per cent of the
total public debt compared with just 15 per
cent 10 years earlier, and this ratio is ex­
pected to continue to increase. In view of
the large and rapidly increasing amount of
municipal bonds outstanding, a larger sec­
ondary market seems inevitable.
However, as already indicated, the size
of the secondary market depends not only
4Annual R ep o rt of the Secretary of the Treasury on
the State o f the Finances for the Fiscal Y ear E nded
June 30, 1966 (W ashington: U.S. G overnm ent P rint­

ing Office, 1967), p. 777.
5 State and L ocal P ublic Facility N e ed s and Financ­
ing, vol. 2. Public Facility Financing, Joint Economic
Committee, Congress of the U nited States (W ashing­
ton: U.S. G overnm ent Printing Office, 1966), p. 21.

on the volume of municipals outstanding,
but also on the rate of turnover of the bonds.
This rate varies from year to year, depend­
ing on monetary conditions and the distribu­
tion of issues among various types of inves­
tors. It should be noted that figures on turn­
over may be considerably less accurate than
those for amounts of municipal securities
1 June 30, 1948-65

Data from Tax Foundation Inc.

Using an estimate of sales in 1959,6 Rob­
inson7 computed a turnover rate of 20 per
cent for municipal bonds. This estimate may
be a fairly reasonable approximation of the
actual rate that prevails currently. Although
the margin of error in this estimate may be
large, the estimate is based upon a respected
empirical study, and it is the best one avail­
able to date.
Applying the 20 per cent turnover rate to
the amount of bonds outstanding in mid1966 ($104.8 billion) gives $21 billion as
an approximation of the volume of trading
in the secondary market for municipal secu­
rities in 1966. This estimate is substantiated
to some degree by independent estimates—
6 Irwin Friend, A c tiv ity on O ver-the-C ounter M ar­
kets (Philadelphia: University of Pennsylvania Press,
7 Roland I. Robinson, P ostw ar M arket fo r State
and L ocal G overn m en t Securities (Princeton: Prince­
ton University Press, 1960), p. 144.


ranging from $12 billion to $25 billion— ob­
tained from authorities in the market.

Municipal bonds have been issued by thou­
sands of governmental entities ranging from
the City of New York to the Ysleta (Texas)
Independent School District and from the
State of Montana to the Running Springs
Ranch Protection District in California.
During the last 10 years, some 65,300 long­
term municipal bond issues were brought to
market. In early 1967 perhaps more than
100,000 different issues were outstanding.8
Municipal bonds generally fall into three
main categories: (1) general obligation
bonds, which are secured by and payable
from taxes collected by the issuer; (2) reve­
nue bonds, which are payable from earnings
derived from revenue-producing facilities
acquired with the proceeds of the bond sale,
from certain pledged excise taxes, or from
specified rents or leases; and (3 ) housing
authority bonds, which are issued by local
housing authorities but are guaranteed by
the U.S. Government. Nearly three-quarters
of the volume of municipal bonds outstand­
ing are general obligation issues; however,
both revenue and housing authority bonds
have increased more rapidly than general
obligation issues in the past decade.
The secondary market for municipal
issues tends to divide into two parts— the
regional market and the national market—
although the division is not absolute. Most
issues of small, lesser-known governmental
entities are traded among investors in the
area around the issuer, although some of
these bonds do move through financial cen­
ters in New York City and Chicago. On the
other hand, major issues— such as those of
States, State agencies, and large cities—
8 The B on d B u yer’s M unicipal Finance Statistics,
vol. 4 (N ew Y ork: The B ond B u yer , M ar. 1966), p.

enjoy widespread interest and ownership.
The market for bonds of well-known issuers
is concentrated in the Nation’s financial cen­
ters, but a large amount of these bonds is
traded throughout the Nation.
M arketing channels and institutions

There are several ways an investor can sell
municipal bonds.
1. Find an acquaintance who is willing
to purchase the bonds at a mutually agree­
able price.
2. Sell the bonds to a dealer at a mu­
tually satisfactory price.
3. Order a dealer to sell the bonds
through a broker at the best bid.
4. Order a dealer to sell the bonds as
agent at a stated price.
5. Contract with a dealer to advertise the
bonds for competitive bidding over the deal­
er’s name.
The first two methods are suitable only when
the amount of bonds to be sold is small; thus,
the latter three are more significant.
Inasmuch as four of the five methods in­
volve dealers, it may be well to call atten­
tion to the difference between dealers and
brokers. Dealers buy and sell bonds for their
own account, whereas brokers never take a
position in bonds but buy and sell them as
agents for dealers.
Because information on offerings and
prices is so vital to participants in the mar­
ket, elaborate communications systems have
been developed to make the major market­
ing channels more efficient: As of early
1967, one broker had already established a
large teletype network upon which offerings
of bonds are displayed and bids requested.
Another important market institution is the
Blue L ist; published each business day, this
list shows current offerings and the prices
asked. And “Munifacts” is a private teletype
service that keeps participants advised on
current news in the municipal bond market.


Dealers, brokers, individual investors, com­
mercial banks, and other institutions are all
active in the secondary market for munici­
pal securities. This section examines the
roles and activities of the various partici­

Dealers occupy a dominant position in the
secondary market for municipal bonds be­
cause they are involved in nearly every
transaction. Their activities largely deter­
mine efficiency of the market. There are cur­
rently more than 800 investment banks9 and
170 commercial banks1 that function as
dealers in municipal securities. These deal­
ers range in size from large, nationwide in­
vestment banking firms to small, one- or
two-man local operations. Most of the deal­
ers also underwrite new municipal issues.
All but five States have the main office of at
least one dealer, while 35 States have main
offices of seven or more dealers.1
In 1963 commercial banks located in 93
cities in 38 States had municipal bond de­
partments that were engaged in underwrit­
ing new issues of State and local government
securities and in maintaining markets in out­
standing issues. An analysis of Blue List ad­
vertisers suggests that perhaps as many as
100 of the 170 banks that have municipal
departments are relatively inactive traders.
Most of the banks operate in regional mar­
kets, and only about five banks are num­
bered among the “hard core” of 15 or so
9 State and L ocal P ublic F acility N eed s and Financ­
ing , op. cit., p. 180.
1 U.S. Congress, House, Comm ittee on Banking
and Currency, Increased F lexibility fo r Financial In­
stitutions. H earings on the following H.R. bills: 5845,
7878, 8230, 8245, 8247, 8459, and 8541, 88th Cong.,
1st sess., 1963, pp. 453-56.
1 D irectory o f M u nicipal B ond D ealers o f the
U nited States (New Y ork: The B ond Buyer, mid1965 ed.).

dealers who bid on nearly every municipal
issue sold in the secondary market.
Dealers— especially the larger ones— are
not only market-makers but also institu­
tional investors because they maintain in­
ventories or positions of varying size. Conse­
quently, both aspects of their operations
require analysis.
Investment operations. The optimal size
of a dealer’s inventory varies over time. In ­
vestigation has revealed that a large dealer,
for example, may maintain a municipal
bond inventory of $50 million or more,
even in periods of falling prices.1 In decid­
ing on how large an inventory to hold, a
dealer considers several factors. Perhaps the
most important determinant is the expecta­
tion of future market conditions. There is a
direct relationship between desired size of
the current position and expected prices at
the planning horizon. Obviously, if a dealer
expects higher prices, he will want to build
up inventories now in order to realize capi­
tal gains. Another important factor that in­
fluences the size of a dealer’s position is the
expected volume of activity in the primary
market. Most firms have some maximum
amount of capital with which to finance
both secondary and primary market activi­
ties. At times, dealers may need to shift re­
sources from the secondary to the primary
market, and this may make it necessary for
them to reduce their holdings of outstanding
bonds. Other factors of an institutional and
professional nature also help to determine a
desired level of inventory.
In terms of financing inventories of bonds,
banks usually have an advantage over non­
bank dealers. The main reason is that banks
(as dealers) are not so readily forced to
turn over or liquidate their inventories; con1 C alculated from the inventory list of a m ajor
dealer for M ay 9, 1966.



sequently, they may be better able to
weather periods of price weakness.
For most firms, the planning horizon is
rather short and flexible, according to deal­
ers interviewed. There appears to be a direct
relationship between the length of the plan­
ning horizon and the firm’s size. However,
all inventory decisions are reviewed fre­
quently— in most cases continuously— as
market conditions change.
There are two main constraints in the
management of inventories— position limits,
and the desire to continue making a market
in bonds. For example, even though there
may be a high probability of a sharp rise in
prices, there is a limit as to the amount of
bonds a given dealer will want to hold, or
will be able to hold. Similarly, even if prices
are expected to fall, a dealer who intends to
continue making a market must stand ready
to buy bonds at some price. The latter con­
straint is not very strong for the vast major­
ity of dealers, however, when the market be­
comes unusually weak. For example, during
the difficult days in 1966, there were in­
stances when only a handful of dealers con­
tinued to make markets in municipal bonds.
The rest were reluctant to bid for bonds in
the period of rapidly falling prices.
Market-maintenance behavior. The more ap­
parent function of dealers is to buy and
sell— that is, to make a market in— munici­
pal bonds. Dealers usually buy and sell for
their own trading accounts, but they also
may act as agents and buy and sell on behalf
of investors. In market-maintenance activi­
ties there is a significant difference between
larger dealers and smaller firms. Conse­
quently, the two are treated separately.
Small dealers are primarily investment
bankers involved in local or regional mar­
kets; that is, they tend to specialize in
issues of those governments located in or
near their area of operations. The operations
of small regional dealers are essential to the

over-all efficiency of the market for several
reasons: One, most municipal bonds traded
in the secondary market— even if originally
sold in national markets— tend to gravitate
back to the area of the issuer.
Second, some issues never reach national
markets even at the time they are sold in
the primary market; rather, they are sold
originally to investors in the immediate re­
gion, and they tend to stay in the vicinity
of the issuer. And third, the volume of these
smaller, local issues is such as to require a
substantial amount of market-making.
Smaller regional dealers are the principal
market-makers for such issues, most of
which lack national interest. It appears that
such dealers as a group transact a large vol­
ume of this business.1
These dealers seem to enjoy a high degree
of customer loyalty. Often an investor trans­
acts business with only one dealer. Thus, the
dealer is frequently in a position to enlarge
his own spread or gross profit. In contrast,
dealers in the financial centers often do busi­
ness with more sophisticated investors who
shop for the best prices when buying or sell­
ing. It appears that larger dealers in the
more competitive environment tend to have
a smaller gross profit margin on each trans­
action than the smaller, regional dealers,1
but this thinner margin is offset by the
greater volume of transactions on the part
of larger dealers.1
1 A 1949 study indicated th at registered broker3
dealers having net capital of less than $500,000 ac­
counted for 40.6 per cent of all broker-dealer resales
of State and local governm ent securities. See Friend,
A c tiv ity on O ver-th e-C ou nter M arkets.
1 Friend et al., The O ver-th e-C ou nter . . ., p. 354.

1 It has been suggested that one explanation for the
smaller gross profit m argin for the larger dealers is
that they trade prim arily in issues of well-known en­
tities having less credit risk. Such bonds have less
risk; so, a smaller gross profit margin is adequate,
according to the argum ent. A recent m ajor study,
however, argues that “the degree of credit risk in­
volved is not an intrinsic characteristic directly at­
tributable to size [of the issuer] alone.” State and
L ocal Public F acility N eed s and Financing, op. cit.,

p. 248.


Many small dealers have relatively limited
amounts of capital. Under such circum­
stances they attempt to hold little or no in­
ventory of municipal bonds and try to equate
sales and purchases over the very short run.
Dealers with a larger volume of capital are
able to hold larger inventories, and for them
the costs of holding these securities may be
In addition to the hundreds of small deal­
ers, there are more than 40 large, national
dealers who operate principally in the finan­
cial centers. Approximately 10 of these are
commercial banks, and the remainder are
investment banks. These national dealers
specialize in issues of large, well-known gov­
ernments although they deal in bonds of
small entities as well. For example, issues of
States, large State universities, State agen­
cies, large cities (population more than
500,000), agencies of the large cities, or
major counties (which consist primarily of
a large city) accounted for nearly threequarters of the inventory of one large dealer
in 1966.1
Although national dealers trade with in­
dividual investors through regional offices,
most of their volume traditionally has come
from institutional investors who are ex­
tremely knowledgeable and who usually
shop among several dealers when buying or
selling. Large dealers seem to operate in a
better market than their smaller counterparts
and as a group handle a greater volume of

Most brokerage activity in municipal securi­
ties is based in New York and is conducted
6 The negative inventory cost results from the com­
bination of several tax factors; for example, (1) in­
terest on municipals is tax exempt, and (2 ) interest
expense incurred in borrowing money with which to
carry municipals is tax deductible. (Technically, tax
exemption on interest received is not allowed when

principally by a handful of firms. The func­
tion of brokers is to bring buying dealers and
selling dealers together; to help accomplish
this, one broker maintains an extensive tele­
type network connecting nearly 200 (or
about one-third) of the major dealers in
municipal securities throughout the Nation.
Investors have access to a broker’s services
only through a dealer.
If an investor wants to sell a block of a
given municipal issue, he may call a dealer
and ask him to obtain bids. In turn, the
dealer may contract with a broker who re­
quests bids from other dealers. If, however,
a dealer prefers to advertise for bids him­
self— perhaps in a publication such as the
Blue List, which carries daily a list of bonds
for sale— he need not secure the services of
a broker. However, many dealers use a
broker, especially if they want quick action.
For their services, brokers receive a com­
mission, which usually amounts to either
$1.25 or $2.50 per $1,000 bond.
Because a broker’s reputation depends on
how many bids he can obtain for each issue,
he can be expected to devote considerable
resources to contacting numerous dealers—
especially those who may have a particular
interest in the specific type of issue offered.
Therefore, brokers play a valuable role in
the efficient operation of the market. Yet,
they handle only about 15 per cent of the
estimated total secondary market volume.
One important broker has estimated that all
brokers together handle from $2.5 billion to
$3.0 billion of municipal bonds in the sec­
ondary market each year.

Commercial banks, individuals, and insur­
ance companies are the principal investors
bonds are carried by debt, but this apparently may be
circum vented.)
17 Calculations m ade from the municipal bond in­
ventory of a m ajor dealer for May 9, 1966.



SECURITIES, JUNE 30, 1954-66
Type of investor













Commercial banks...................................
Insurance companies...............................
Mutual savings banks.............................
Government investment accounts..........
State and local governments...................
Miscellaneous investors...........................














Total.............................................. 100.0















S o u r c e . —Computed from Annual Report o f the Secretary o f the
Treasury on the State o f the Finances for the Fiscal Year Ended June

30, 1965 (Washington: U.S. Government Printing Office, 1966), p.
685. Data for 1966 secured from the Treasury Department.

in municipal bonds (Table 1). However,
the volume of activity of each investor group
in the secondary market does not necessarily
parallel the amount of municipals owned,
because the behavior pattern of each is dif­
Individuals. Individual investors generally
are regarded as “strong hands”— that is,
they tend to hold municipal bonds until ma­
turity; only infrequently do they sell. Most
individuals who participate in the market
for these bonds are in the higher income tax
brackets and they buy municipals because
of the tax-exempt feature (Table 2 ). Since
the beginning of income tax levies in the
United States, Federal tax law has excluded
interest on obligations of States, territories,
possessions of the United States, any politi­
cal subdivisions of the States or possessions,
and the District of Columbia from the gross
income of any holder of these obligations.1
Moreover, each State that imposes income
taxes permits taxpayers to exclude interest
on obligations issued by such State or any
of its political subdivisions from taxable in­
come. Similarly, cities that levy income taxes
on residents permit them to exclude interest
on debt securities of the taxing city. Thus,
a resident of New York City who holds New
York City bonds and whose income is taxed
by both the City and the State, as well as by

the Federal Government, would benefit
more from the tax-exempt feature of munici­
pal bonds than would a Texan who has the
same income but who does not face city or
State income taxes.
As of June 30, 1966, individuals owned
an estimated 36.5 per cent of the $104 bil­
lion in municipal bonds outstanding. This
proportion had declined from 40.9 per cent
in mid-1960, as commercial banks moved
heavily into municipals.
Commercial banks. Commercial banks have
long been important investors in municipal
bonds, mainly because of tax considera­
tions. Interest earned on municipal bonds
is not included in the taxable income of
commercial banks. Moreover, banks may
deduct from ordinary income any losses on
the sale of capital assets such as State and
local government obligations. Most other

1 Internal R evenu e C ode of 1954, Section 103.

DECEMBER 31, 1962
1962 income (in dollars)
0- 2,999......................................................................
3.000- 4,999......................................................................
5.000- 7,499......................................................................
7,500- 9,999......................................................................
10.000-14,99 9
15.000-24,99 9
25.000-49,99 9
50.000-99,99 9
100,000 and over..................................................................

Per cent

*Less than one-half of 1 per cent.
S o u r c e . —Dorothy S . Projector and Gertrude S. Weiss, Survey o f
Financial Characteristics o f Consumers (Washington: Board of
Governors of the Federal Reserve System, 1966).


taxpayers may use losses on capital assets
only to offset capital gains of the tax year or
future years. In addition, while other inves­
tors are prohibited from deducting interest
expense on indebtedness incurred to pur­
chase or carry tax-exempt securities, com­
mercial banks may deduct interest on de­
posits even though the deposits may be used
in effect to finance the purchase of taxexempt municipal bonds.
In recent years, banks’ romance with mu­
nicipals has reached a high intensity; in the
period from 1961 to mid-1965, banks put
more than 23 cents of each new dollar of
deposits into State and local government se­
curities— a sum large enough to purchase
more than half the net annual increase in
municipals outstanding. By mid-19 66, banks
held 38.5 per cent of outstanding State and
local government bonds.
Commercial banks are likely to become
even more dominant in the municipal securi­
ties market. During the next 8-year period,
banks are expected to boost their holdings
of State and local government obligations
by 170 per cent to about $107 billion. If so,
by the end of 1975 they will own about 51
per cent of the municipals outstanding.1
Medium-sized and large banks have been
leaders in the move to municipals. Smaller
banks— those with deposits of $5 million or
less— actually reduced their holdings of
municipals on balance in the early-tomid-1960’s (Chart 2 ). During the same pe­
riod acquisitions of municipals by medium­
sized and large banks showed a stairstep pat­
tern; that is, as bank size increased, so did
the allocation of funds to municipals. Banks
with $10 million to $25 million in deposits
put about 19 cents of each deposit dollar in
1 Estimates by W ray O. Candilis, D epartm ent of
Economics and Research, A m erican Bankers Associa­
tion, for the Joint Econom ic Comm ittee. See State
and L ocal P ublic F acility N e ed s and Financing, op.
cit., pp. 337-50.

municipals; for banks with $100 million and
over in deposits, the figure was almost 25
cents of every deposit dollar.
SECURITIES: Change in bank holdings,
December 1 9 6 0 -Ju n e 1965











100 & OVER

_______________________ TOTAL D E P OS I T S

IN M IL LI ONS OF DOLLARS ___________________________

* Holdings o f municipals declined.

During the decade of the 1950’s, the pro­
portion of municipal securities held by the
Nation’s 100 largest commercial banks fluc­
tuated between 10 and 14 per cent of the
total volume of municipal bonds outstand­
ing. In mid-1960 these banks held just under
10 per cent of all municipals. By June 30,
1966, however, they had increased their
share to nearly 18 per cent of all State and
local bonds outstanding and to 48 per cent
of the total owned by banks.
Figures for member banks are another in­
dication of the extent of concentration in
bank ownership of municipal securities. On
June 30, 1965, member banks with total de­
posits in excess of $100 million held more
than 65 per cent of all State and local bonds
owned by all member banks, but these banks
represented only 2.7 per cent of all member
banks (Table 3).



Size of bank
(total deposits
in millions of dollars)
Under 1.
Over 100

Number of

. .
. ,
, .


Percentage of
all member
bank holdings
of municipal





Large commercial banks tend to be “weak
hands” in the market. Empirical evidence
indicates that their investments in munici­
pals tend to decline absolutely around the
peaks of business cycles as the demand for
loans intensifies. It is probably true, as some
bankers have indicated, that smaller banks
usually hold their municipals to maturity,
but that the larger banks are willing to sell
such securities so as to be able to meet heavy
loan demand. For example, from September
30, 1965, to March 31, 1966, the 100 larg­
est banks reduced their holdings by $776
million, or about 4.3 per cent. One New
York bank reduced its municipal bond in­
vestments by $217 million— or more than
21 per cent— in the first 3 months of 1966
The market impact of the behavior of
large banks in 1966 was greater than indi­
cated by net changes in their municipal hold­
ings because of the switching they did for
tax purposes. These banks seeking to estab­
lish capital losses for tax purposes dumped
on the market a huge volume of shortmaturity, deep-discount municipals, then
immediately reinvested the proceeds of many
of these sales in long-term, high-coupon taxexempts. The effect of such switching was to
bend the municipal yield curve into a practi­
cally straight line for the first time in the
period for which data are available.2
2 See Chart A-3 in the Appendix.

In addition to liquidating some of their
holdings of State and local obligations in
1966, commercial banks sharply curtailed
their purchases of new municipal issues. In
contrast with 1965, when they bought about
75 per cent of all new tax-exempt securities,
in 1966 they absorbed less than 33 per cent.
The reduced demand for new issues helped
to push municipal yields to the highest level
in 30 years.
Other institutions. Various other types of
financial and nonfinancial institutions own
municipal bonds. Investment activity seems
to vary with both the type and the size of the
Unlike commercial banks, insurance com­
panies tend to hold municipal bonds to ma­
turity. Because their cash flows are fairly
predictable, insurance companies are not
likely to disrupt the market by heavy liqui­
dation of municipals. However, they may
sharply curtail their buying at the very time
banks are selling large amounts of bonds.
For example, purchases of municipals by
life insurance companies in 1965 were nearly
26 per cent less than in 1964, and it is prob­
able that purchases in 1966 declined by an
even larger percentage.
During the first half of the 1960’s, mutual
savings banks became less important inves­
tors in State and local obligations. In 1960
they held 1 per cent of the outstanding
bonds, but by mid-1966 the proportion had
dropped to about one-third of 1 per cent.
Also, savings and loan associations appar­
ently held a smaller share of total municipal
securities outstanding. For all of these thrift
institutions there is little income-tax incen­
tive to invest in municipals.
As shown in Table 1, corporations in­
creased their share of total municipal bonds
outstanding since 1954. Corporations ap­
parently found tax-exempt yields sufficiently
attractive to warrant increased investment,
although some of the increase may have


been related to growth in industrial develop­
ment financing via municipal debt. As is
true of commercial bank holdings, however,

little is known of the specific characteristics
of State and local bonds owned by corpora­

This section examines the factors that affect
the liquidity of tax-exempt obligations. Per­
fect liquidity is defined as the convertibility
of assets into cash immediately and with no
loss. There are, then, two elements of liquid­
ity: a price element and a time element.
The time element may be called marketabil­
ity— that is, convertibility of assets into cash
immediately (with no regard for price). An
asset may be highly marketable, however,
and yet be illiquid, if it can be sold quickly
only at a loss. Hence, perfect marketability
is a necessary but not sufficient condition to
perfect liquidity.
Because interest rates vary, it is not al­
ways possible to sell fixed-income securities
without loss. If this barrier to perfect liquid­
ity is taken into account, a perfect market
may be defined as one wherein a seller can
obtain the highest bid price immediately and
the buyer can find the lowest asked price
Evidence gleaned from participants in the
municipal bond market indicates that State
and local government obligations generally
are quickly convertible into cash. Marketing
channels and institutions discussed earlier
are sufficiently formalized and stable to ac­
commodate sales of municipal bonds, al­
though perhaps at deep discounts from the
redemption price. Use of the teletype and
telephone enables buyers and sellers to com­
municate easily and quickly, and a large vol­
ume of trading can be readily accommo­
dated. Our investigation was not able to
uncover any instances wherein investors
were not able to sell tax-exempt bonds in the
secondary market— even in the most critical

days of 1966. Because every bond offer at­
tracted at least one cash bid, we must con­
clude that municipal bonds are indeed m ar­
ketable. But price cannot be ignored. Some
would-be sellers in 1966 refused to sell at
bid prices they considered so low as to be
As already indicated, marketability alone
does not assure that municipal bonds are
liquid. Market values of all fixed-income se­
curities change as interest rates change, and
municipal bonds are no exception. Liquidity
of fixed-income securities, then, is a relative
thing. While it is difficult to obtain statistical
evidence that is conceptually sound (see
Appendix), it seems that several market ob­
stacles cause municipal bonds to undergo
relatively larger price fluctuations than other
security issues— thus precluding perfection
in the secondary market. These obstacles are
discussed in this section.
Information gaps

In order for a market to function perfectly,
all participants need to have complete knowl­
edge of all relevant information regarding
values of all investment alternatives. It is
often difficult and also costly for partici­
pants in the secondary market for State and
local government bonds to obtain this infor­
In addition to current market informa­
tion, the buyer or seller needs to have many
facts about each issue. These relate to: (1 )
credit standing of the issuer; (2 ) type of
bond; (3 ) purpose of issue; (4 ) coupon
rate; and (5) maturity.
However, not all of this information is


readily available. For example, an issuing
government’s credit status is a composite of
many considerations— including tax rates,
population growth, and legal tax limits. One
attempt to assign specific credit ratings to
each issuer on the basis of relative prices of
its issues outstanding in the m arket2 re­
sulted in about 30 different rankings.
Several types of institutions provide infor­
mation to participants in the market. Some
firms specialize in credit analysis, others pro­
vide current market news, some develop ex­
tensive reports on specific issues, and many
others provide current but limited price in­
formation. But all of these services are
costly; some investors, including many com­
mercial banks, may operate on a scale that
precludes them from using such services.
Because there are perhaps more than
100,000 issues of municipal bonds outstand­
ing, the volume of information that would
be required for optimum investment deci­
sion-making staggers the imagination. As a
practical matter, of course, no investor
makes a choice from among all 100,000
outstanding issues, but if he wants to be
assured of the best possible decision, he must
consider a large number of alternatives.
In that sense there is a marked contrast
between the heterogeneous municipal securi­
ties market and the market for U.S. Govern­
ment obligations. The latter market is char­
acterized by minimum variation in credit
risk among different issues; by availability
of more complete price information, because
the number of issues outstanding is small;
and by the small number of dealers who are
active in the market.
While it is not possible to measure the
magnitude of the effect of information gaps
upon the functioning of the secondary mu­
3 See W h ite s T ax-E xem pt B ond M arket R atings
(N ew Y ork: Standard Statistics Company, April


nicipal market, it seems that some adverse
effect in the form of excessive searching
costs does exist.
Dealer practices

The secondary market for State and local
government securities suffers from certain
unfavorable characteristics inherent in a
dealer market. For instance, dealer opera­
tions may be procyclical, accentuating price
swings and promoting instability. In periods
of sharply falling prices, as previously indi­
cated, most dealers in municipals tend to
abandon their market-maintenance responsi­
bilities. The number of dealers who usually
enter bids on all bonds offered in the second­
ary market regardless of market conditions
seldom exceeds 15. And, in periods of very
poor market conditions, even some of these
“hardcore” dealers bid so low that there is
little likelihood a trade will occur— except
at bargain prices. In several instances in
1966 only one bid was made on bonds
offered for sale— and this was often a joint
bid by two or three dealers. In addition,
dealers’ position or inventory policies tend
to contribute to price instability. In rising
markets, dealers may acquire large amounts
of bonds for their inventories, whereas in
periods of price weakness, they tend to re­
duce inventories.
Some dealers may allocate resources and
capital to the secondary market only after
covering their activities in the primary m ar­
ket. Consequently, operations in the second­
ary market may be weakened somewhat by
heavy activity in the new-issue market.
A dealer market does have one important
advantage that counters these disadvan­
tages: Large transactions may be accom­
plished rather quietly and without an exces­
sive effect on prices. Some bankers claim
that it is easier to sell substantial blocks of
tax-exempt securities than to sell U.S. Gov­


ernment securities because the number of
dealers in municipal bonds is so much larger.
For example, the State of New York con­
tains the main offices of 194 municipal bond
dealers, with the majority of these offices
located in New York City. In contrast, there
are only 16 dealers in Federal Government
securities in New York City and four else­
where in the Nation.
In terms of information availability, many
investors are not in the best position to bar­
gain knowledgeably or to choose the best
bond offerings. For this reason, dealers tend
to have an advantage over most investors.
It is likely that investors’ lack of complete
information gives dealers the opportunity to
boost their gross profit on many transactions
— especially in regional markets.
Tax factors

Tax factors are very important features af­
fecting the attractiveness of municipal
bonds. While interest income from munici­
pal bonds is tax-free, increases in prices of
bonds bought at a discount are taxable at
capital gains rates at the time of sale or ma­
turity unless the bond was originally issued
at a discount. The amount of the original
discount is exempt from Federal income tax.
Tax-conscious investors tend to eschew mu­
nicipal bonds selling at discounts in the sec­
ondary market unless such bonds can be
purchased at a price low enough to provide
an acceptable yield after capital gains taxes.
In fact, according to one investment coun­
selor, some investors refuse to purchase any
municipal bonds at a discount in the second­
ary market regardless of yield.
Trusts also find the tax-free interestincome feature of municipal bonds attrac­
tive, but they encounter frequent problems
stemming from factors of equity between in­
terest of the life tenant and of the remain­
derman. If a trustee buys a bond at a dis­
count in the secondary market, the life

tenant receives an annual income at the cou­
pon rate but the remainderman may be sub­
ject to substantial capital gains tax when he
comes into the trust. Consequently, accord­
ing to several interviewees, trustees usually
attempt to avoid difficulties with benefici­
aries by purchasing bonds only at par in the
secondary market.
Furthermore, tax laws of some States
compound the difficulty of pricing specific
municipal bonds. For example, some States
place a tax on personal property, but they
exempt bonds issued by governmental en­
tities within that State. Therefore, a bond
issued by Opa-Locka, Florida, is worth more
to residents of Florida than to residents of
any other State.
Obviously, the value of a given bond in­
creases as the tax advantages it confers in­
crease. Variances in tax provisions among
States may be detrimental to the efficient
interstate flow of funds into State and local
Commercial bank operations

Experience of the 1960— period suggests
a shift in the nature of investment by banks
participating in the municipal securities mar­
ket (Chart 3 ). Traditionally, banks have
purchased State and local government bonds
with the intention of holding them to matu­
rity, and they have relied on U.S. Govern­
ment securities as a temporary repository
for funds not needed for loans. When de­
mand for loans increased, banks simply
stopped adding to their small inventory of
municipals. Now, however, many banks are
beginning to view municipals as somewhat
more cyclical investments; when lending op­
portunities increase, they not only stop ac­
quiring new issues of municipals but also
sell some of their holdings.
The increasing importance of State and
local government obligations in bank port­
folios, coupled with the increased propensity





of bankers to liquidate such bonds in periods
of intense loan demand, points to greater
fluctuations in municipal bond yields over
the business cycle. Commercial bank liqui­
dation of municipal obligations in periods of
restrictive monetary policy tends to push up
yields on these securities faster than they
would have risen without extensive bank ac­
tivity in the market. Conversely, during pe­
riods of an expansionary (or less restric­
tive) monetary policy, heavy purchases of
municipals by banks tend to push rates
M arket participants generally agree that
heavy liquidation of State and local obliga­
tions by banks is the spark that touches off
periods of instability in the secondary mar­
ket. During the days and weeks of 1966 when
bank liquidation of municipals was at its
peak, the continuity of the municipal mar­
ket was markedly disrupted. Moreover, un­
certainty as to the magnitude of such liqui­
dation tends to cause some dealers to refrain
from even placing bids on bonds offered for
sale. The effect, of course, is an accelerated
decline in bond prices.
Evaluation of the m arket

When evaluated in the light of criteria set
out in the introduction, the secondary mar­
ket for State and local government obliga­
tions compares less favorably with the mar­
ket for U.S. Government securities.
Criterion 1: There should be a free inter­

play between the largest possible number of
public buyers and sellers having maximum
pertinent information. Because tax-exempt
securities appeal primarily to those individ­
ual and institutional investors that are able
to benefit from the tax advantage of munici­
pals, the number of possible buyers and sell­
ers is limited compared with the number that
may be active in the markets for corporate
or U.S. Government bonds.
Moreover, because of the huge number
of heterogeneous State and local government
bonds, it is difficult and costly for market
participants— especially individuals and in­
stitutions investing smaller amounts— to se­
cure sufficient information to be assured of
an optimal decision. Although market insti­
tutions gather and disseminate information,
their services may be too costly or too com­
plex for some investors, including many
commercial banks.
Criterion 2: The buyer and seller should
be brought together at minimum cost. The
secondary market for municipal securities
apparently consists of enough dealers and
well-developed marketing channels to en­
able buyers and sellers to find each other
quickly and at a reasonable cost. There is
evidence that investors trading with smaller
dealers in the regional sector of the market
may pay higher costs, but additional re­
search is needed to determine whether the
regional market structure is less perfect than
that of the national sector. In any case, the


institutional marketing framework appears
Criterion 3: The market should adjust
readily to temporary disturbances in the sup­
ply/dem and relationship so that price con­
tinuity may be maintained. The secondary
market for State and local government obli­
gations occasionally fails to meet this crite­
rion of a good market. The evidence is clear
that discontinuity sometimes plagues this
market. In periods of rapidly falling prices,
there may be as much as 6 points ($60 per
$1,000 bond) difference in the prices of two
consecutive trades in the same bond in a
single day. While an intraday difference of
6 points or more is not common, the lack of
bids tends to produce excessive price move­
ments from one trade to the next in times of
market weakness.
Moreover, an analysis of fragmentary data
indicates that in periods of rising prices the
spread between the highest and lowest bids
on a single issue usually ranges from $12.50
to $15.00 per $1,000 bond. But the spread
jumps to $30 or even $40 per $1,000 bond
when prices are weak.
Which of the principal market obstacles
is the most important cause of the discon­
tinuity is not clear. Some observers argue
that the dominant position of commercial
banks in the market makes these institutions
the prime factor in the behavior of the mu­
nicipal market. And it is true that, accord“ The operations of the J. J. Kenny Com pany in
New Y ork offer an excellent example of an efficient
marketing institution strengthening the secondary
m arket for m unicipal securities. Kenny operates an
extensive telephone and teletype netw ork that facili­
tates com m unication and trading between buyers and

ing to experience in 1966, times of peak
liquidation of tax-exempt securities by banks
corresponded with the periods of greatest
discontinuity in the market. But another im­
portant factor should not be overlooked: It
was also during these periods that all but a
handful of dealers abdicated their marketmaintenance responsibilities, and this added
to the discontinuity in the market.
P rospects for future m arket developm ents

Further development of the municipal mar­
ket may, in time, tend to moderate excessive
fluctuations in prices of municipal bonds.
For example, dealers increasingly may seek
to expand interest in tax-exempt bonds
among noninstitutional investors instead of
relying primarily on institutions that (when
they do buy) purchase large volumes of se­
curities. This could result in a greater pro­
portion of State and local obligations being
placed in “strong hands” of individuals, who
are not likely to dump the bonds in times of
a restrictive monetary policy. Moreover, ris­
ing personal incomes may make the taxexempt feature of municipals attractive to
more individual investors. Development and
promotion of municipal bond funds also may
improve the “breadth” of the market.2
Thus, as the volume of municipal bonds
outstanding continues to increase, more par­
ticipants hopefully will be attracted to the
market. This should moderate to some ex­
tent the perverse cyclical effects of commer­
cial bank activity in the market for State and
local government bonds.
2 See W illiam F. Staats, “A New Package for M u­
nicipal Bonds,” Federal Reserve Bank of Philadelphia
Business R e view (N ov. 1966).

Because much of the instability in the secondary market for State and local government bonds seems to result from the be-

havior of banks during periods of restrictive
monetary policy, the Federal Reserve System properly may be concerned about the


operation of this market as well as that of
other financial markets. In such periods mu­
nicipal bond yields tend to rise faster than
rates on U.S. Government securities (see
Appendix). Changes in interest rate levels
and in yield spreads have several effects:
(1) Commercial banks may find the munic­
ipal market a less attractive alternative to
the discount window as a source of funds
because of the increased costs in the form
of capital losses sustained upon liquidation
of municipals. (2 ) Capital losses suffered
by banks that sell municipals may impair
the efficiency of the banking system. (3) A
disorderly municipal market may lead to in­
stability in other capital markets. (4 ) Mu­
nicipalities and other governmental entities
are forced to pay higher rates or to postpone
debt issues during periods of restraint. (5)
Smaller municipalities may have difficulty
exporting their debt obligations at the low­
est realistic interest rates.
Nevertheless, a restrictive monetary pol­
icy, if it is to be effective, must curtail ex­
penditures somewhere in the economy. The
occasionally large price fluctuations in mu­
nicipals tend to transfer some of the impact
of restraint to banks that have large invest­
ments in State and local obligations and to
State and local governments. The rapid
cyclical movement in municipal yields may
serve to reinforce monetary policy.
Capital losses of banks

Substantial liquidation of tax-exempt securi­
ties by commercial banks frequently occurs
when interest rates are high, and it results
in sizable capital losses to the banks. These
losses must be considered as costs of liqui­
dating municipals to obtain funds. There­
fore, as prices of State and local government
obligations decline, the secondary market
becomes a less attractive alternative to the
discount window or to the Federal funds
market as a source of funds. Successful at­


tempts to moderate price fluctuations in mu­
nicipals may reduce the potential costs to
banks of using the market instead of, or as
a supplement to, the discount window or
other borrowing.
Disorderly capital m arkets

Obstacles in the secondary market for State
and local government bonds may have an
adverse effect on other capital markets.
While the linkage among markets is not
clear, there is likely to be some “spillover”
of instability. But if stability in capital mar­
kets could be maintained, it would tend to
moderate the uneven impact of monetary
Municipal financing

While the Federal Reserve System has no
statutory concern for governmental financ­
ing, its responsibilities are such as to keep
it aware of the social consequences that may
stem from the failure of local governments
to secure funds at reasonable rates for capi­
tal projects. Two aspects of the financing
problem are caused by imperfection in the
secondary market for State and local bonds:
one is cyclical, the other structural.
Cyclically, rates on municipal bonds tend
to move higher in relation to rates on other
capital market securities during periods of
tight money. This pattern of rate behavior
causes governmental entities across the Na­
tion to bear a large share of the burden of
monetary restraint. In some cases, local au­
thorities have been forced to postpone de­
sired capital improvements during tightmoney periods.
The structural problem of imperfection in
the secondary market may cause smaller,
lesser-known governmental entities to be
placed in an inferior position in the market.
Because of the heterogeneity of municipal
issues, the large amount of information re­
quired for investment decisions, and the dif­


ficulty and expense of securing information
on smaller entities, investors— especially the
larger institutional ones— tend to concen­
trate on bonds issued in large volume by
well-known government units. Consequently,
in order to attract investors, the smaller,
lesser-known governments may have to pay
higher rates of interest than may be justified
by risk factors alone.
The economic and social advancement of
the growing areas of the Nation may be en­
hanced by improving their ability to export
debt at the lowest reasonable rate of inter­
est. Elimination or reduction of the obsta­
cles in the secondary market for municipal
bonds should tend to facilitate financing by
the governmental entities that are lesser
Procyclical effect of m arket im provem ent

Any benefits to be obtained from reducing
the obstacles in the secondary market for
State and local government bonds should be
weighed against the sole advantage resulting
from these obstacles. Basically, excessive

price fluctuations in the municipal market
have a useful countercyclical effect of in­
determinable magnitude. When monetary
policy is restrictive, sharply higher interest
rates on municipal securities may cause
some governmental entities to postpone capi­
tal spending. Moreover, the prospect of siz­
able capital losses may inhibit some banks
from selling State and local bonds in order
to obtain funds for loans. While the “lockedin” effect probably is quite limited, the losses
may help to impede, at least slightly, the
growth of bank loans in periods of mone­
tary tightness. Therefore, some of the effects
of market obstacles are consistent with a
restrictive monetary policy.
In an assessment of the need for, and
effects of, market improvement, it is possi­
ble that the procyclical effects of such
improvement could be outweighed by the
resulting economic and social benefits. Be
that as it may, the Federal Reserve System
must consider any efforts to improve the
secondary market for municipals as part of
the over-all policy mix.

If it is desirable to remove some of the
imperfections in the secondary market for
State and local government bonds, two
broad approaches are possible. The first is
a “free market” approach, which would not
directly alter the basic structure or mecha­
nism of the existing market. The second
would require direct involvement in the
market— and in this approach there are
several potential means. These are possible
methods of action; they are not necessarily
recommended courses of action. Decision­
makers within the Federal Reserve System
must weigh the advantages and disadvan­
tages of each alternative.

Direct involvement approach

Imperfections inherent in the secondary
market for municipal bonds might be re­
duced in the following ways:
The Federal Reserve System might
moderate the sharp cyclical fluctuations of
prices in the municipal market by buying
or selling State and local government bonds.
In order to reduce such fluctuations, the
Federal Reserve would be buying munici­
pals during periods of restrictive monetary
policy and selling them in times of ease.
As pointed out earlier, however, such action
would have a reserve effect counter to the
prevailing posture of monetary policy.



Therefore, in order to achieve the desired
over-all monetary effects, the System would
have to offset its purchases of municipals
with sales of U.S. Government securities
in periods of monetary restraint. Such sales
could, in turn, have a disruptive effect on
the U.S. Government securities market.
Moreover, practical and operational diffi­
culties, as well as social and political ramifi­
cations, would be involved in such a policy.
(For example, would the Trading Desk fol­
low a “best price” policy in the case of an
Aaa-rated issue of a segregated school dis­
2. Another proposal for action involves
the brokerage function. Municipal bond
brokers apparently strengthen the market
for State and local obligations by creating
a stable marketing channel. Moreover, the
centralization of trading through brokers
facilitates gathering of current market in­
formation, which is essential to optimal in­
vestment decision-making. But only an esti­
mated 15 per cent of all transactions in the
municipal market involve brokers. Perhaps
this percentage could be increased if a
Government agency were to provide a
brokerage function— both regionally and
This proposal would meet stiff opposition
from many quarters— not the least of which
would be existing brokers, who have spent
many years and considerable effort and
capital in establishing their services and who
seem to be doing a creditable job at present.
Also, it may be argued that use of the
services of existing brokers will increase as
the size of the market expands and as the
economies of scale permit brokers to offer
better services. Strong philosophical objec­
tions to this proposal also may be expected
from the advocates of free and private
3. Another potential area of action would

involve reducing the heterogeneity among
the thousands of issues of municipal bonds
through some form of insurance or guaran­
tee by a Federal agency, perhaps along the
lines of that provided by the Federal Hous­
ing Administration and the Veterans Ad­
ministration. Such a backing would put these
issues on the same credit-risk basis and
would eliminate much heterogeneity. More­
over, it probably would reduce significantly
the information gap that hampers optimal
decision-making because no credit-risk in­
formation would be required under a Fed­
eral Government guarantee. Furthermore,
it would permit assembling obligations of
several different issuers into larger, more
efficient trading blocks. This proposal seems
to merit careful consideration.
“ Free m arket” approach

In contrast to the preceding alternatives for
action, the free market approach would not
directly affect the mechanism of the second­
ary market for municipal bonds, but rather
would seek to reduce the instability caused
by commercial banks’ heavy liquidation of
municipal securities in periods of tight
Many of the market participants inter­
viewed suggested that the Federal Reserve
System could make State and local govern­
ment bonds eligible for discount under Sec­
tion 13 of the Federal Reserve Act. At
present, banks can borrow from the Federal
Reserve under Section 10(b) by pledging
municipals, but the “penalty” rate for such
loans is usually V2 of 1 percentage point
above the basic discount rate.
Under existing discount policies, this pro­
posal might not prove very helpful because
of the aversion of banks to supervision con­
nected with discount operations. With the
“rules of the game” of discount policy and
administration currently under review, how­


ever, it might prove workable. Incidentally,
legislation permitting implementation of the
proposal has been under congressional con­
sideration for a number of years.
A similar proposal is for the Federal
Reserve System to enter into repurchase
agreements with banks that desire to sell
municipals. Such agreements might cover
a period of weeks or even months, and they
would give banks a large amount of flexi­
bility in the management of their funds.
However, such agreements might have an
effect on bank reserves that would be
counter to monetary policy objectives.


The proposals for possible action presented
in this section serve only to indicate addi­
tional areas of research. They are not neces­
sarily recommended courses of action. More
study will be required to evaluate fully the
potential effects of any action that public
policy might initiate in the secondary market
for municipal securities. If future develop­
ment of the market should reduce or elimi­
nate the obstacles to perfection, the need
for any action by outside institutions would
be obviated.
A pril 1967



A statistical c o m p a riso n o f m a rk e ts fo r m u n icip als
a n d fo r U .S. G o v e rn m e n t secu rities en tails diffi­
culties b ecau se o f (1 ) th e d e a rth o f av ailab le d a ta
on th e m u n icip al secu rities m a rk e t, a n d (2 ) th e
difference in p re v a ilin g m a tu rity d istrib u tio n s o f
th e tw o types o f secu rities.
C h a rt A - l show s th e a p p ro x im a te m a tu rity dis­
trib u tio n s o f F e d e ra l G o v e rn m e n t issues a n d of
S tate an d lo cal o b lig atio n s o u tsta n d in g . W h ile th e
d a ta u p o n w h ich th e c h a rt is b ased a re n o t p recise,
th e basic differences in m a tu rity d istrib u tio n s are
read ily ap p a re n t. U .S . G o v e rn m e n t securities are
heavily w eig h ted w ith s h o rt-m a tu rity securities,
w hile lo n g er-te rm secu rities m ak e u p th e b u lk o f
m u n icip al o b lig atio n s. C o n seq u en tly , yield co m ­
p a riso n s b etw een g iven m a tu ritie s o f G o v ern m e n ts
an d m u n icip als m a y n o t be to o reliab le.
T h e yield differen tials b e tw een lo n g -te rm F e d ­
e ra l G o v e rn m e n t secu rities (th o se h av in g m a tu ri­
ties o f m o re th a n 10 y e a rs) a n d m u n ic ip al secu ­
rities ( T h e B o n d B u y e r's in d ex o f 2 0 -y e a r b o n d s)
are show n in C h a rt A - 2 fo r th re e p e rio d s o f re ­
strictive m o n e ta ry p o licy since th e T re a s u r y F e d e ra l R eserv e a c c o rd in 1951: m id -1955 to the
e n d o f 1957, e a rly 1959 to m id -1960, an d early
1965 to m id -1966. (T h e en d o f th e th ird p erio d
w as th e d ate th e analysis w as m a d e .) In th e 1 9 5 5 57 a n d th e 1965—
66 p erio d s, th e differentials



SECURITIES, June 3 0 f 1966



Figures are estimates.

show ed a d eclin in g tre n d , w h ich in d ic a te d th a t th e
yields o n m u n icip als w ere risin g fa ste r th a n th o se
o n U .S. G o v e rn m e n t issues. T h e o p p o site o c cu rred
in th e p e rio d 1 9 5 9 -6 0 . H o w ev er, th a t p e rio d w as
c h a ra c te riz e d by u n se ttled co n d itio n s in th e m o n ey
a n d c a p ita l m a rk e ts. D u rin g th a t p e rio d a m a m ­
m o th steel strik e a n d a n ab so lu te d ecline in th e
m o n ey supply severely d isru p te d e x p ectatio n s—
especially in th e U .S. G o v e rn m e n t securities m a r­
ket. T h e re w as also a n u n u su a lly larg e in crease in
F e d e ra l debt, as th e G o v e rn m e n t b o rro w ed heavily

DIFFERENTIALS: U.S. Governments versus municipals






Differentials are for long-term securities in selected periods of restrictive monetary policy. The first panel is from the 31st week of
1955 to the 52nd week of 1957, the second panel is from the 7th week of 1959 to the 23rd week of 1960, and the third panel is from
the 6th week of 1965 to the 31st week of 1966. Data from Federal Reserve and The Weekly Bond Buyer.



19 5 6



19 6 2



Data from Federal Reserve and Salomon Brothers and Hutzler.

to finance a larg e deficit. T h e b e h a v io r o f th e yield
differential d u rin g this u n u su a l p e rio d does n o t in ­
validate th e c o n clu sio n th a t yields o n m u n icip al
bonds ten d to rise fa ste r th a n yields o n U .S. G o v ­
e rn m e n t securities in p erio d s o f restric tiv e m o n e­
ta ry policy.
C h a rt A - 3 show s yields o f in te rm e d iate -term
State a n d lo cal ob lig atio n s (S alo m o n B ro th ers an d
H u tz le r’s series o n m u n icip als w ith m a tu ritie s o f 5
y ears) an d F e d e ra l G o v e rn m e n t issues w ith 3- to
5-year m atu ritie s. A g ain , w ith th e ex cep tio n o f
th e 1 9 5 9 -6 0 p erio d , yield differentials n a rro w e d
d u rin g p erio d s o f restrictiv e m o n e ta ry policy. T h e
n arro w in g o f yield d ifferentials in d icates th a t p rices
o f m u n icip als d eclin e relativ ely m o re th a n prices



Data from Salomon Brothers and Hutzler.

o f U .S. G o v e rn m e n t secu rities o f c o m p a rab le m a ­
tu rity in p e rio d s o f risin g in te re st rates.
O ne asp ect o f th e effect o f ex tensive c o m m e r­
cial b a n k influence o n th e seco n d a ry m a rk e t fo r
m u n icip a l securities m ay be fo u n d in C h a rt A -4 .
In 1966 b a n k s liq u id a te d h u g e a m o u n ts o f low c o u p o n , sh o rt-m a tu rity S tate an d lo cal o bligations.
T h e y used som e o f th e p ro ceed s to m eet h eav y lo an
d e m a n d an d som e to p u rc h a se lo n g -term m u n ic i­
pals. B ecause o f th e larg e sales, yields h a d risen to
th e h ig h est levels in m a n y years, a n d b a n k s w ere
an xious to assu re th em selv es o f su ch yields fo r a
lo n g p erio d o f tim e. A s a resu lt, th e yield cu rv e fo r
m u n ic ip a l secu rities w as b e n t in to an alm ost
stra ig h t line fo r th e first tim e.



Parker B. Willis
Federal Reserve Bank of Boston

Major F in d in g s_____________________________________________________________________27
Negotiable CD’s ____________________________________________________________________33

Bank uses of funds
The Secondary M arket for C e rtific a te s ______________________________________________ 41

Participants and operating methods
Dealer purchases and financing
Supply and demand variables
Measures of trading
Market rates and yield spreads
Certificate characteristics
Dealer bid and offering rates
General features: 1961-66
The course of market activity: 1961-65
Changes in market activity: 1966
Market activity: mid-December 1966-January 1967
Future market activity
Proposals to Improve Marketability of C ertifica te s-------------------------------------------------------66

Issuance of certificates on a discount basis
FDIC insurance coverage
Dealer’s endorsement
Provision of information by Federal Reserve Banks
Group marketing of certificates of smaller banks
Purchase of certificates by the System Account
Extension of System repurchase agreements to dealers
Greater market freedom with respect to CD rates




This study is designed to serve several pur­
poses: (1) to evaluate the operations of
the secondary market for negotiable certifi­
cates of deposit (CD ’s) as a source of
funds complementary to the discount win­
dow; (2) to determine whether it is feasible
and desirable to promote a further develop­
ment of this market so as to modify com­
mercial bank reliance on the discount
window; and (3) if such is the case, to
recommend the degree, if any, to which
the Federal Reserve should become in­
volved in promoting the development of
this market.
The study includes an analysis of avail­
able data on CD’s to determine how the
existing market functions and the extent to
which banks of various types operate in it.
The analysis has been supplemented by

personal interviews with knowledgeable
market participants. These interviews at­
tempted to assess the current nature of the
market with respect to “depth, breadth, and
resiliency” and to ascertain any changes in
these market qualities over time— season­
ally, cyclically, or secularly. An attempt has
also been made to determine the underlying
causes for any deficiencies in market opera­
tions for the several classes of banks that
were studied.
Some consideration has been given to
procedures that could improve market oper­
ations. Also considered are the problems
that the Federal Reserve would encounter
if it were to act as a clearinghouse for in­
formation on the market, to function as a
broker, or to deal in such liabilities as an
integral part of open market operations.

The development of the secondary market
for CD’s accelerated the growth in amounts
of certificates outstanding, increased the
acceptance of certificates as a money market
instrument, and enabled CD’s to become
competitive with Treasury bills, commer­
cial and finance company paper, bankers’
acceptances, and other short-term instru­
ments as a medium for investment. In this
connection one of the principal functions
of the market has been to provide CD’s with
shorter maturities than those originally per­
mitted issuers by Regulation Q; these shorter

maturities have made it possible for original
holders of CD’s to liquidate them before
maturity, if need be, and for buyers to
acquire desired short-term certificates at
attractive rates. The market served this pur­
pose most fully after its initial development
— that is, during the period 1962-65 when
CD’s that might have had shorter-term
maturities were not issued because permissi­
ble ceiling rates were too low.
The increased versatility of CD’s issued
by leading banks in principal money centers
where a secondary market for certificates


has developed has enabled issuers to tap the
national pool of short-term funds without
a concurrent obligation to make a loan to
a customer. The mere existence of the mar­
ket, however, has increased the acceptance
of CD’s of all issuers.
The market has been most active when
profits could be obtained by “riding the
yield curve.” The potential for such profit
was greatest during the years 1962-65 when
prospects sometimes suggested that short­
term interest rates would be stable or would
decline. During these years Regulation Q
ceilings on the shorter maturities were some­
what below market rates for long periods,
and the ceiling— in effect— provided a
cushion against market loss as holdings
approached maturity. Because the yield
curve descended as maturity shortened, it
was possible for original holders to offer
their CD’s at lower rates (higher prices)
than those available at the time the certifi­
cates were acquired— thus establishing a
profit over and above the interest earned
during the period held. Dealers often were
able to acquire certificates on a favorable
“carry”— either with repurchases or with
dealer loans; to hold them for an additional
period to shorten the maturity; and then
to sell them or offer them for repurchase
again, depending upon the money market
outlook. Third-party buyers were also at­
tracted by the possibility of profits. In gen­
eral, however, there was a tendency for
over-all market activity to decline after the
change in Regulation Q in November 1964,
which permitted issuance of certificates
with maturities of less than 3 months.
The secondary market underwent radical
deterioration during 1966 after the estab­
lishment of a single rate for all CD’s with
maturities of 30 days or more. The year is
distinguished from the previous period by
the extreme influence of both rate and non­
rate factors. The potential for profits from

“carries” largely disappeared, and original
issues were available at maturities as short
as 30 days at maximum ceiling rates— par­
ticularly during the latter half of the year.
Dealer positions were exposed to under­
cutting. With the single rate of 5 Vi per
cent on all maturities, issuers could make
unexpected changes in rates on various
maturities. As market rates approached and
later exceeded ceiling rates during the sum­
mer, dealer positions and trading volume
dropped to very low levels. Distress selling
also characterized the market at times dur­
ing the year. After July, if certificates were
sold before their due dates, there was a
constant risk of loss on the principal.
During the latter part of December 1966,
dealers began to rebuild positions in antici­
pation of taking profits as interest rates
eased. By the year-end dealers had made
large additions to their inventories, as pros­
pects seemed to indicate an abrupt and rapid
movement toward lower levels of the over­
all structure of rates. Positions reached a
record high average in January 1967.
Dealers acquired some valume of CD’s with
desirable maturities at 5 Vi per cent. Trading
increased— but correspondingly less than
dealer inventories. While there was some
lengthening in maturities on new offerings
of CD’s as rates fell below the ceilings, some
issues with shorter-term maturities were also
This episode seems to represent a comple­
ment to the one in 1966 characterized by
the dramatic rise in rates. The secondary
market under “normal conditions”— a
period of general stability in interest rates
without constraints on various maturities
resulting from rate levels set by Regulation
O— is still to be tested.
Certificates of roughly 30 to 35 banks
form the bulk of the market and have ac­
counted for most of the trading. The market
classifies certificates according to three cate­


gories of issuing banks— prime, lesser-prime,
and off-prime. Although the designation
given to any bank may vary from one buyer
to another, prime generally includes from
12 to 20 banks; lesser-prime, from 35 to 45
banks; and off-prime, all other banks. In
general, prime and lesser-prime names in­
clude banks with deposits of at least $500
Most prime-name banks are banks of
international and national prominence, and
their certificates trade at the lowest yields.
Certificates of lesser-prime names trade at
a small spread above this level. Those of
off-prime names, if traded, carry a some­
what larger spread; at times their spreads
are negotiated. The common unit of trade
is $1 million, but denominations of as little
as $100,000—-like lesser-known names—
trade at slightly higher yields.
In 1966, with the change in character of
activity in the market, trading of bank
issues was limited to 15 to 20 of the best
names. Buyers revised their authorities to
purchase, and some firms even rescinded the
authority to buy CD’s. By February 1967
most of the previous authorities had not
been fully restored.
While the secondary market for CD’s per­
forms the basic function of enhancing
liquidity of certificates, it is limited in depth,
breadth, and resiliency. Limitations in terms
of these qualities— particularly when com­
pared with competing markets— arise prin­
cipally from the existence of Regulation Q
provisions that set maximum rates on vari­
ous maturities of certificates. Moreover,
some of the limitations of the secondary mar­
ket for CD’s may reflect its relatively short
period of development; during part of this
time it has been exposed to an unusual con­
jecture of events. In contrast, markets for
bankers’ acceptances and for Treasury bills
have developed over long periods and have
received official aids. Commercial and


finance company paper are not subject to
rate limitation.
From the viewpoint of depth there is no
substantial evidence of large orders on
dealers’ books at prices either above or
below the market, even at its peak of activ­
ity. At times dealers find it difficult to match
demand and supply, and they cannot always
adjust their positions readily because of the
irregularities that occur in both supply and
demand. These irregularities are caused by
a number of variables arising from the
interrelation of market and ceiling rates,
rigidity of the authorities under which many
borrowers operate, and the attitudes and
expectations of both issuers and buyers.
Holders sometimes face delays in “pressing
sales,” that is, when they need to sell a large
block of CD’s in a short period of time.
Corporations, for example, often make pur­
chases in the market only in response to
dealer offerings. On the other hand, dealer
purchases at times reflect merely an accom­
modation of the customer— the dealer be­
ing repaid with other business.
From the viewpoint of breadth, buyers
and sellers represent an increasing number
of divergent investor groups, but the princi­
pal buyers and sellers have been and still
are corporations. In many ways the CD
market is analogous to the municipal mar­
ket, in which there are many issuers but a
relatively small group of large investors.
From the viewpoint of resiliency, the
market is generally slow to adjust to rapid
changes in rates. New orders do not flow
in promptly to take advantage of sharp and
unexpected fluctuations in prices, and
changes in the rates cause no substantial or
rapid changes in inventories. Even with a
consistent increase in outstanding CD’s,
trading has declined. The volume outstand­
ing rose steadily from early 1961 to a peak
of about $18 billion in August 1966— dis­
playing a tendency toward progressive short­


ening of maturities, in part in response to
changes in Regulation Q. But trading on an
average day in August 1966 was only $22
million, in contrast to about $80 million in
January 1965. One factor causing the fall
in trading activity was the fact that an in­
creasing volume of short maturities was
available from issuers.
During the last quarter of 1966 both
dealer positions and trading reached his­
torical lows. Although dealer positions rose
rapidly in January 1967 in anticipation of
profits as rates shifted downward, trading
did not rise in proportion. Regulation Q
ceilings since 1961 have made the connec­
tion between the primary and secondary
markets more closely associated and have
made trading activity dependent to a large
extent on levels at which the ceilings were
set on various maturities in relation to other
market rates.
If Regulation Q continues to maintain a
single ceiling rate for CD’s with maturities
of 30 days or more, trading in the secondary
market will continue at very low levels as
long as new-issue rates are at the ceiling
and market rates on comparable maturities
are above the ceiling rate. Under these cir­
cumstances the supply of CD’s in the sec­
ondary market declines. Investors in out­
standing issues sell into the market only as
a last resort to avoid capital loss. Dealers
face a penalty cost in carrying positions.
Moreover, there is a competing supply of
desirable investments with coupons or yields
not subject to the restriction of regulation.
Although dealers will make some bids that
vary with maturity and reflect the structure
of market rates, this market shows discon­
tinuity as compared with some others when
money is tight. Many trades are negotiated
on an individual basis. Expectations of both
investors and dealers include the possibility
of a change in Regulation Q.
Trading should increase as market rates

of interest fall below the Regulation Q ceil­
ing and conditions permit issuance of new
CD’s. However, trading will fluctuate with
the ability of banks to issue maturities in
excess of the 30-day minimums, and it will
be the market that will supply paper with
the shorter maturities. Dealer positions will
be more exposed under these conditions
than they were when the regulation re­
stricted issues of certain maturities, and the
potential for profits may tend to be relatively
small. Hence, dealers will run the risk of
having issuers make unexpected changes in
rates at various maturities, thereby under­
cutting their positions. They are also ex­
posed to the risk of an unexpected change
in Regulation Q.
Even with a new-issue market substan­
tially larger than at present [mid-February
1967], secondary trading probably will not
reach the levels of 1964-65. Further devel­
opment of the market on comparatively
smaller volume under conditions that sug­
gest stable or declining rates, however,
could lead to a narrowing of spreads such
as has characterized trading in certificates
of lesser-prime and off-prime banks. Assum­
ing that the rate of growth that has char­
acterized the new-issue market subsides,
yields may also decline relative to competing
investments. Yields to date [mid-February
1967] have probably been sweetened to pro­
mote the market.
The spreads in yields that both primary
and secondary markets have established for
CD’s of some lesser-prime and off-prime
names arise from several factors. When their
authorizations permit discretion, buyers will
refuse certificates of lesser-known names
when those of better-known names are avail­
able at or near the same rate. In this sense
buyers discriminate against certificates of
the smaller and less well-known banks.
Differentiation of names became more wide­
spread after the failure of banks in Texas,


California, and Colorado in the years 1964
and 1965.
Premium yields arise in part as an induce­
ment to the buyer to take lesser-known
names and in part as compensation to the
dealer for additional marketing effort and
cost. Dealers state that they have to make
more effort and have to educate customers
in order to sell CD’s of lesser-known names.
Such certificates must be carried in position
longer; they are more difficult to place on
repurchase or on loan, even though CD’s
of some prime names may be included in
their package; and they cause the dealer
trouble and expense in checking the volume
of outstandings and in considering other
relevant information of the particular bank.
Some smaller banks with good reputa­
tions issue CD’s to local customers at the
same rates as prime banks issue them to
national customers, or possibly at lower
rates. Markets are differentiated, however,
and sales of locally oriented certificates in
the secondary market call for a higher yield
because the bank in effect is tapping the
national market at one step removed. Yield
spreads thus are viewed as an impersonal
market mechanism for regulating new issues.
Both the rate on the new issue and the pre­
mium yield in the secondary market in this
case do not reflect arbitrary actions but
rather a response to influences of the na­
tional short-term money market.
Yield spreads could be eliminated if
cash guarantee were made by the Federal
Deposit Insurance Corporation. Or if a
dealer would certify credit on a bank’s cer­
tificate— charging one-eighth of 1 per cent
as is the practice with acceptances— such
spreads could be reduced and standardized,
with improved marketability for the CD’s.
However, dealers believe that impersonal
market evaluation of credit risk should be
encouraged, and they do not want to assume
the obligation of certifying credits. Partici­


pating dealers view the market as selecting,
on this impersonal basis, those banks that
can grow or be “tided over” on the basis of
CD’s, but these dealers will not give a
guarantee of credit soundness.
If the Federal Reserve Banks were to act
as clearinghouses for information or to func­
tion as brokers in matching the demands
of smaller, expanding banks for funds with
any supplies of surplus CD funds at other
banks, these actions would be viewed with
concern by participants in the market. Both
issuers and buyers state that action would
be considered as tantamount to a guarantee
of soundness of the expanding bank. And if
the bank should become overextended, the
Federal Reserve would be blamed.
If there were no effective ceiling on rates
— so participants argue— any bank could
bid for funds, but the problem of rate dif­
ferentials would remain. The rate paid by
the individual bank would become an in­
creasing function of the average rate pre­
vailing in the market, the volume of CD’s
outstanding, and the amount of new issues
proposed. This development could conceiv­
ably lead to a more even flow in the market­
ing of issues. Under these conditions the
preliminary cost of offerings by smaller
banks might be reduced but not eliminated.
Such premiums would bring interest costs
on offerings by these banks to the ceiling
sooner where they would encounter other
inelasticities in the current market, such as
the inability to issue— or the increased diffi­
culty in issuing— certificates when large
banks are in the market. Improved market
techniques and the increasing familiarity of
buyers with good reputations will help to
reduce current differential yields in trading
on a number of names.
In early 1966 a large commercial paper
house, commenting on the “inequity of
money rates,” stated that the secondary
market yields on certificates of major money


market banks had been consistently higher
than those on major finance company paper
of similar maturities since August 1964.
This was attributed to weak secondary m ar­
ket support of CD’s. Money costs for smaller
regional and money center banks reflected
premiums above these rates. In an attempt
to improve the liquidity of CD’s and the
mechanical ease of trading— looking toward
reduction of the premium and a proper
yield relationship to the other money mar­
ket instruments— this firm suggested orga­
nization of a consortium of regional banks
and recognition of the firm as the leading
dealer in their secondary market certificates.
The firm would then undertake to make a
market that would reflect an “appropriate
dealer spread” such as exists in acceptances.
For instruments of members the dealer
would post daily rates and would advertise
a market with a spread of 10 basis points.
This market would be quoted in units of
5 basis points with various maturity cate­
gories similar to those for acceptances.
Adjustment to the rate scale would be made
when the dealer’s position reached key levels
in relation to the amount of financing avail­
able to the dealer.
Participating banks could post rates for
original issues of certificates at the sell side
of the dealer’s posted market rate, or at a
lesser rate. The participating banks would
provide the dealer with any financing neces­
sary to carry reasonable positions at a rate
equal to the interest earned on certificates
held in loan position less any trading loss
on certificates sold out of positions. In such
an arrangement no profit would result to
the dealer on certificates in position. This
plan was expected to provide that the issue
rate for members would be reduced sub­
stantially. On the assumption that the par­
ticipating banks would obtain Federal funds
to provide dealer financing, a profitable
arbitrage was expected between the Federal

funds rate and the interest earned on certifi­
cates held in loan. By establishing a known
and advertised market for the certificates,
it was anticipated that the issue rate for
participating banks would be reduced to
levels prevailing for major finance company
paper and bankers’ acceptances.
The consortium, however, could not be
formed. One reason was that most of the
prospective participants thought that they
were placing CD’s satisfactorily. Another
was that some participants thought that cus­
tomer relationships would be taken advan­
tage of and that the benefits of the arrange­
ment favored the dealer. Since losses would
be absorbed by the lending banks and the
cost of “carry” would equal the CD rate,
there would be no cost of “carry” to the
Many participants continue to describe
the certificate as a clumsy instrument; they
state that the preference among institutional
portfolio managers is for issuance of CD’s
on a discount basis. Issuance on a discount
basis would facilitate computation of pur­
chase and sale prices and would avoid the
awkward formula now in use. Furthermore,
issuance on a discount basis would make it
possible for holders to avoid showing book
losses unless a very sharp change in rates
occurred; some large buyers will not sell
into the market if a book loss would result.
If these changes were made, the resulting
advantages might increase the marketability
of certificates substantially.
Market participants stated that they be­
lieved that the Federal Reserve would per­
form a disservice if it entered the market
for CD’s on a bid basis. Destruction of
impersonal relationships was feared. Others
thought that the “feel of the market,” which
is provided now by changes in flows and
rates, would be lost.
A letter of inquiry from the Joint Eco­
nomic Committee of the U.S. Congress for­


warded to monetary economists in late 1965
asked whether the Federal Reserve should
“supplement its portfolio of Federal Govern­
ment securities with other types of assets
such as commercial loans, foreign exchange,
municipal securities, corporate bonds, mort­
gages, and commodities.”
The replies from 86 economists and
others interested in monetary economics
were published in January 1966. About
one-third of the respondents expressed the
opinion that current policy should be main­
tained because acquisition of private credit
instruments would involve entrance into
relatively narrow markets and impose bur­
dens of credit analysis. Purchases and sales


of selected issues would subject the Federal
Reserve to political pressures and criticisms
that should be avoided. Less than one-tenth
of the respondents preferred to give the
System as much flexibility as possible. They
indicated, however, that the System should
be free to determine its own policy.
About one-sixth favored operations in
private credit and municipal markets.
Advantages that were cited include in­
creased ability to influence the cost and
availability of credit and to stimulate cer­
tain sectors of the economy and certain
types of spending. One economist specifi­
cally recommended dealing in certificates of

CD’s have been used for many years by
commercial banks in the United States to
attract time deposits. In part these instru­
ments represented long-term savings, but
they were also used as temporary invest­
ment havens for funds of interest-sensitive
business firms and large investors. As far
back as 1900, certificates were popular in­
struments at many banks, particularly in the
Midwest and in parts of the South. Even
national banks— although they lacked the
express authority to accept time deposits—
reported the issuance of some certificates.
By 1913 when the Federal Reserve Act
was passed and the powers of national banks
to accept time deposits were clarified, com­
petition for these deposits was common
among national as well as State banks and
trust companies. With the rapid growth of
time deposits during the 1920’s, observers
noted that a large part of the increase rep­
resented funds that would ordinarily go into
demand deposits or commercial departments
of banks. They referred especially to funds
that were placed in savings deposits or CD’s

without definite maturity. Issuers did not
expect that these certificates would be
traded, even if they were issued in negoti­
able form. In fact, there was no organized
secondary market for such certificates, and
their volume was limited.
But after World W ar II a new setting
emerged— a more closely integrated bank­
ing system along with a national money
market. Many commercial banks accepted
time deposits as an accommodation to cor­
porate and other organizational customers,
but they did not actively solicit such de­
posits. Many certificates offered to corpora­
tions were tied to loan agreements and did
not draw interest.
As the postwar period developed, the
money market structure changed— passing
from one with an overhang of surplus re­
serves to one of relative reserve scarcity. In
addition, a new generation of financial offi­
cers emerged. These officers in charge of
corporate treasuries and in responsible posi­
tions in banks and the money markets—
encouraged by large cash flows, rising inter­


est rates, and other costs— established new
arrangements for sources of financing as
well as investment. As interest-sensitive cor­
porate treasurers trimmed their companies’
operating balances to low levels, some in­
stability and shrinkage of deposits resulted,
particularly at banks in New York City. At
the same time major banks in other areas
of the Nation were growing, and many
concerns were turning to these banks for
some of their principal banking services.
Deposits of New York City banks fell from
21 per cent of the total for all banks in the
United States at the close of World War II
to about 15 per cent at the end of 1960.
In order to combat both instability and
shrinkage of deposits, the New York City
banks announced in early 1961 that they
would begin to issue interest-bearing certifi­
cates. Issuance was expected to attract short­
term corporate funds lodged elsewhere in
the banking system and to provide an in­
strument that would compete for corporate
balances being invested in a variety of
money market instruments, principally in
Treasury bills.
In late February 1961 the First National
City Bank of New York began offering
certificates to domestic business corpora­
tions, public bodies, and foreign sources.
Two things concerning these certificates
represented innovations in financial markets.
One was that, according to public announce­
ment, the certificates would be negotiable.
And second, the Discount Corporation of
New York, a leading dealer in U.S. Govern­
ment securities, announced that it would
make a market for certificates to provide
liquidity, thus broadening the appeal of this
type of investment.

Public awareness of the negotiability of
these certificates and provision of a second­
ary market for them increased their appeal

considerably. Other banks quickly followed
the lead of First National City Bank in offer­
ing certificates, and other dealers joined in
making a market for the certificates. A little
more than a year later negotiable CD’s out­
standing at the nine largest banks in New
York City were estimated to total $1.3
billion, and almost that amount was out­
standing at the leading banks outside New
York— in Chicago and other principal cities.
This brought the countrywide total to about
$2.5 billion. The great bulk of these certifi­
cates was in large denominations— units of
$ 1 million or more— that trade easily in the
secondary market.
Member banks have been the chief issuers
of CD’s. Most nonmember banks are small,
and more than 90 per cent of them hold
deposits of less than $5 million each. These
banks are unable to issue certificates to any
extent, and in any event, none in denomina­
tions that appeal to investment buyers.
Issues of certificates in denominations of
$100,000 or more by member banks ac­
counted for 40 per cent of the increase in
time and savings accounts at the weekly
reporting banks from 1961 to the end of
CD’s underwent very rapid expansion in
1962— reflecting (1 ) the increasing accept­
ance of the instrument and (2) the develop­
ment of the secondary market, which had
begun in the spring of 1961. By the end of
1962 leading commercial banks in New
York City and Chicago had become by
far the largest issuers. They accounted for
one-third and one-sixth, respectively, of the
$5.8 billion outstanding. The marked
growth of the certificates at the large banks
reflected a liberalization of banks’ offering
policies. Previous policies had, for the most
part, limited issuance of certificates to occa­
sional customers and had been in sharp
contrast to the more liberal issuance policies
followed by many smaller banks and by



banks located in the South and Southwest.
The decision of the larger banks created a
new market for certificates and accelerated
the increase in volume of all issuers. At the
year-end the total outstanding amounted to
$5.8 billion and was in excess of, or close
to, the totals for most other short-term in­
vestment instruments (Table 1).
December 31, 1960 and 1962
In billions o f dollars
Certificates o f d e p o s it ....................................
Bankers’ acceptances ....................................
Comm ercial p a p e r ..........................................
Short-term municipal securities .................
Treasury bills ...................................................





Expansion continued at a rapid pace until
December 31, 1965, with year-over-year
monthly rates usually ranging from 29 per
cent to 35 per cent. In 1966, however, the
rate of gain slowed from 22 per cent in
January to 7 per cent in September; in
November the total actually declined by 6
per cent. At the end of 1963 outstanding
CD’s reached $10 billion; in 1964, $13
billion; in 1965, $16 billion; and in August
1966, a peak of more than $18 billion.
After August the total began to decline as
short-term market rates on certificates rose
and remained above the 5 Vi per cent ceil­
ing established by Regulation Q. By the end
of November more than $3.2 billion of CD’s
had run off and could not be renewed be­
cause of the tight money market and the
suppressing effect of the Regulation Q
In December, however, the atmosphere
changed. Largely in response to the easing
of rates during the month and the sub­
sequent rapid decline after the year-end,
banks were able to resume issuance of CD’s.
Between mid-December and the end of
January 1967, they issued about $3.1 bil­
lion of certificates, bringing the total out­

standing back to $18.1 billion. By the first
of February most banks with deposits of
$1 billion had posted rates of 5V4 per cent
for all maturities, while a few were offering
rates of 5 per cent.
The growth in CD’s was widespread geo­
graphically as well as by size of bank but
differed somewhat among Federal Reserve
districts (Table 2 ). In part these differences
reflect changes in certificate-issuance prac­
tices before 1961 and the policies of various
bank managements. Banks in the South and
the Southwest, which had issued certificates
before 1961, have a larger base; hence, they
reported a slower rate of growth.
Issuance of CD’s is concentrated in banks
with deposits of $1 billion or more. This
group of banks accounted for 72 per cent
of the total outstanding at the August 1966
peak as compared with 54 per cent at the
end of 1961. Even at that time certificates
issued by the largest banks accounted for
about the same percentage of outstandings
as did the total deposits of these banks to
total deposits of all issuers.
Issuance is further concentrated in the
leading banks in New York City, and banks
there have consistently maintained or in­
creased their relative share. New York’s
position as a money market gives it the
major share— almost 40 per cent— of issues
as compared with any other financial center.
The headquarters or financial offices of most
of the large domestic business corporations
are located within the city, and they nor­
mally would be expected to deal with local
banks. Even if corporations do not have
offices in New York, their financial officers
often visit the city, and some take out CD’s
there in anticipation of future customer rela­
Issues of smaller banks, however, have
experienced sharp increases, and the par­
ticipation of these banks is reflected in the
size of the certificates issued relative to the


December 30, 1961, and May 18, 1966
Denominations o f $100,000 or more


Millions of
Dec. 30,

New York.................
A tlanta......................
St. Louis...................
Kansas City..............
D allas........................
San Francisco...........


May 18,

Issuing banks

Percentage of all
banks in district

Dec. 30,












Dec. 30,


May 18,




May 18,









N ote.—Data for December 30, 1961, are based on a survey of 410 member banks (351 weekly reporting
banks and selected additional banks believed to have an appreciable volume of negotiable CD’s out­
standing). Some adjustment in the data for several Federal Reserve districts has been made to eliminate
CD’s under $100,000 in denomination. Data for May 18, 1966, are based on a survey of virtually all
member banks and on Federal Reserve Board Release H.4.2. Results of the surveys without adjustment
appear in the Federal Reserve Bulletin for April 1963, pp. 458-68, and August 1966, pp. 1102-36.

size of the issuer. As early as 1961 about
two-thirds of such small issuers had some
certificates outstanding in denominations of
$500,000 or more— a denomination ordi­
narily traded in the secondary market— and
about 83 per cent of the issuers had some
CD’s at least as large as $100,000— a de­
nomination traded on occasion in the early
market and with more frequency as the
market has developed.
Although the rise in volume has been
rapid and continuous, some seasonal pat­
terns in outstanding CD’s are evident. The
amounts decline around the quarterly tax
and dividend dates and later rise in sub­
stantial amounts in preparation for the next
Some bankers argue that the ability of
the larger banks to increase or decrease
time deposits by large amounts by making
small shadings in rates or by lengthening or
shortening the maturities offered has con­
tributed to increased flexibility in the ex­
pansion and contraction of the total supply
of money market instruments. In turn, this
factor has tended to reduce the size of

changes in money market rates associated
with a change in demand.
The market from time to time over the
period of development has exhibited a shortrun elasticity as to the size of the market.
When New York City banks withdraw cer­
tificates or issue fewer of them, banks out­
side of New York may increase offerings
and attract more funds. Unless offerings
are in local markets Regulation Q ceilings
also affect small banks more severely at
times than they do the large prime-name

In view of the growth in CD’s as a financial
instrument, a description of their most com­
mon characteristics seems to be in order.
Denominations. Certificates are offered in

a variety of denominations, ranging from
about $25,000 to $10 million and higher.
Denominations larger than $ 1 million, how­
ever, became a rarity as the secondary m ar­
ket developed. Limits are closely and di­
rectly related to the size of the issuing



In May 1966, 1,549 member banks re­
ported having negotiable CD’s outstanding
of less than $100,000 in denomination.
These banks were widely scattered across the
Nation, the largest number being found in
the Chicago, Kansas City, and Dallas Fed­
eral Reserve districts. These certificates are
not traded.1

bank. Smaller banks holding the excess bal­
ances of the generally smaller local or re­
gional organizations that they serve cannot
set limits beyond their customers’ reach, and
CD’s of these banks account for most of the
outstandings at the lower end of the de­
nominational range. Most often, however,
denominations are $100,000, $500,000, or
$1,000,000. The larger banks set their
lower limits in these ranges because they
compete only for funds that are interest
sensitive and that would otherwise enter the
money market. Limits have some flexibility,
and the large banks may set them aside at
times to accommodate valued customers.
In August 1966 about 2,200 member
banks— just over one-third of all member
banks— were issuing certificates. Certificates
of $100,000 or more were being issued by
some 632 banks ranging in deposit size
from more than $8 billion down to less than
$10 million. About 75 banks were found
in the latter size group, and 225 banks in
the $10 million to $50 million size group.
This number represented more than a four­
fold increase in the number of issuers that
held total deposits of less than $100 million
as compared with the year-end 1961. Banks
with deposits of $500 million and over,
however, accounted for more than threefourths of the total amount of certificates of
$100,000 or more outstanding.

Prime, lesser-prime, and off-prime issuers.

As certificate volume grew, buyers in both
the primary and secondary markets devel­
oped several classifications of certificates—
prime, lesser-prime, and off-prime. These
designations do not represent an evaluation
of the soundness of the issuer, but they are
generally representative of the relative mar­
ketability of the instrument. The prime
group comprises from 12 to 30 banks; the
lesser-prime, about 45 banks; and the offprime, all other issuers. Classifications of
the leading banks in the principal money
centers as prime or lesser-prime will differ
from buyer to buyer. Differentiations reflect
the buyer’s estimate of the management and
his opinion of whether the bank has been
prudent in its issues. All of the banks classi­
fied as prime by one buyer or another gen­
erally have deposits exceeding $1 billion,2
1 Federal Reserve Bulletin, August 1966, p. 1122.
2 Several banks with deposits of about $500 million
are considered prime by some buyers.

December 30, 1961, and August 31, 1966
Size (total
deposits, in
millions of

Under 100.............
1,000 and over. .. .

Dec. 31, 1961
Millions of Percentage

Aug. 31, 1966
- Number of

Millions of Percentage

Number of













N o t e . — Based on Federal Reserve Bulletin, April 1963, p. 458, and August 1966, p. 1125 and
Federal Reserve Board release G.9, Oct. 6, 1966.


and as noted earlier, they have issued the
bulk of the certificates.
Issuing rates. Prime banks issue certifi­
cates at the best rates when Regulation Q
ceilings permit— about one-fourth of a per­
centage point above rates on comparable
maturities of Treasury bills. Certificates of
lesser-prime names carry a spread of 5 or
10 basis points above the best rates. Other
issuers— generally the smaller banks— must
pay one-eighth to one-fourth per cent of a
percentage point more than prime banks, or
they negotiate a rate with the buyers. Thus
rates tend to vary with the size and reputa­
tion of the issuing bank— rising as size of
bank declines. All rates may be slightly
higher if CD denominations are less than
$1 million. Some smaller banks, which are
well known and respected in their com­
munities and have strong customer relation­
ships, tap regional or local markets at the
same rates as prime banks, or sometimes at
lower rates. Certificates are issued and
traded on a yield-to-maturity basis, and a
comparison with instruments issued and
traded on a discount-from-par basis— such
as Treasury bills— overstates the actual dif­
ference in yield.3
In issuing certificates it is necessary to
consider returns on competing instruments
other than Treasury bills— that is, on sales
finance company paper, commercial paper,
and bankers’ acceptances. Finance company
paper is the most important of these because
the volume outstanding is large and de­
nominations can be arranged to suit the
Maturities. Maturities of certificates have
varied from time to time along with changes
in current and prospective conditions in the
money market, supplies of competing instru­
3 This difference will vary w ith levels of interest
rates. Equivalent coupon yields on 3-month Treasury
bills will be 15 basis points higher than discount at
rates of SV2 per cent and 5 basis points higher at
levels of 2 V2 per cent.

ments, preferences of buyers and issuers, and
the strength of demand for bank credit, as
well as the provisions of Regulation Q in
setting rate ceilings for maturity ranges. As
the outstanding volume rose, average matu­
rities of certificates tended to shorten, drop­
ping from about 8 months in 1961 and
1962 to 2 months in November 1966.
Regulation Q ceilings restricted issuance
of maturities of less than 6 months prior to
July 1963 and less than 3 months prior to
December 1964. Buyers who wanted such
short maturities could find them only in
the secondary market at the going rate.
Although some certificates have been issued
with maturities of 2 to 5 years, these gen­
erally represent special situations. Maturities
of certificates issued by the larger banks
tend to be shorter and those of smaller banks
longer, reflecting in the latter case less
interest rate sensitivity on the part of cus­
tomers of the smaller banks. Increasingly,
during the first several years certificates
issued by the larger banks matured on
quarterly tax and dividend dates. In an
attempt to avoid concentrations and asso­
ciated “binds” on these dates, maturities
were later spread out when market condi­
tions permitted.
OF $100,000 OR MORE


1961—Nov. 30........................................................................ .......8 0
1962—Nov. 30........................................................................ .......7.5
1963—June 30......................................................................... .......5.3
1964—May 1 9 ....................................................................... .......4.1
Aug. 19................................................................................3.8
Nov. 18........................................................................ .......3.4

17......................................................................... .......3.5
19......................................................................... .......3.7
1 8 ....................................................................... .......3.9
17........................................................................ ....... 3 . 4

1966—Feb. 10......................................................................... .......3.3
May 18......................................................................... .......3.8
June 29......................................................................... .......3.7
Aug. 31................................................................................3.0
Sept. 28........................................................................ .......2 2
Oct. 26.................................................................................2.5
Nov. 30........................................................................ .......2.0
N o t e . — Data for 1961-63 are estimated. Data for other years are
from Federal Reserve surveys.


The over-all shortening of maturities that
has occurred is the result of liberalization of
Regulation Q ceilings and the activities of
the larger banks, principally in meeting
competition in the money market as Federal
Reserve credit policy was gradually tight­
ened. Variations in average maturity arise
from defensive shortening to avoid paying
higher rates or from defensive lengthening
as the spread between market and ceiling
rates widens. Buyers’ preferences at times
are also factors.

The major buyers of certificates, from
issuers as well as in the secondary market,
are corporations. Other buyers include com­
mercial banks;4 foreign official institutions;
institutional investors such as insurance
companies, savings banks, and savings and
loan associations; mutual funds; and individ­
uals. On occasion dealers have bought cer­
tificates directly, with the intent of reselling
in the secondary market. In some regional
markets State and local government units
are important buyers. When rising interest
rates reduce new-issue volume, some banks
in placing CD’s resort to the use of brokers
and dealers with wider business contacts.
These intermediaries obtain payment for
services by charging a finder’s fee or by
charging more than they paid.5
The deposit of time money at commer­
cial banks in exchange for a certificate is
4 M em ber banks may issue C D ’s to other mem ber
banks w ithout restriction, but a m em ber bank may
issue C D ’s to nonm em ber banks only to 10 per cent
of its capital and surplus.
5 p art of the finder’s fee in some instances may be
passed on to the purchaser either directly or indirectly
through concession pricing. If such practices raise the
effective yield paid by the bank above the ceiling rate,
they are considered to violate Regulation Q. W hen
these interest paym ents exceed the ceiling, the Federal
Deposit Insurance C orporation may consider the cer­
tificates not to be deposits and refuse insurance pay­
ments if the bank should fail. Cases involving broker
C D ’s and FD IC insurance coverage are still in litiga­


governed by both rate considerations and
customer relationships. Most corporate
treasurers prefer to place funds only with
banks at which they maintain working bal­
ances or important credit lines. Since the
larger corporations generally deal with sev­
eral leading banks, they place their funds
with those that offer the highest rates.
Corporate treasurers may place limits both
on total holdings of certificates and on
amounts held in individual banks. The
finance committees of some leading cor­
porations have set rigid lists of the banks
with whom they will place funds, and they
allow the treasurer no discretion in selec­
tion. These lists apply to original issues as
well as to certificates bought in the second­
ary market. Other buyers generally have less
specific guides, but like the larger corpora­
tions, they may recognize degrees within the
prime and other categories when taking
Most banks have imposed no formal
restrictions on resale of certificates by
original holders. Some banks, however, cau­
tion customers to hold their certificates and
to sell them into the market only as a last
resort. This caution became more wide­
spread with the disappearance of the yield
curve on CD’s in 1966. In general, the
liquidity of the CD market has not been
considered constant and completely depend­
able. Issuers prefer not to have buyers take
losses because they fear that losses might
inhibit future takings. Furthermore, the
issuers want their CD’s to “stand up” when
they do appear in the market.
Bank uses of funds

Banks generally try to avoid issuance of
certificates at the expense of a reduction in
their holdings of demand deposits. The over­
all total of certificates a bank will issue is
somewhat flexible. It may be raised as long
as there are profitable uses for the funds


and the outlook for certificates is favorable.
Some banks may express their maximums
in dollar terms; some as a percentage of
total deposits.
In setting limits, smaller banks are con­
cerned about the effects that certificates may
have on the deposit totals shown in their
published balance sheets. Inability to roll
over certificates may result in a decline in
total deposits from year to year. However,
the ratios of CD’s to total deposits at issuing
banks have been quite stable over time, par­
ticularly at the smaller banks. The level
seems to be closely related to bank size,
with the smaller banks maintaining lower
ratios than the larger banks.
Banks issuing certificates generally place
the proceeds in a “pool of funds.” The larger
banks, believing that certificates afford
greater stability of deposits, have used the
funds to seek attractive loans and invest­
ments, with more emphasis on loans as
markets tightened in 1965 and 1966. Unlike
other money market instruments, CD’s may
influence the reserve position of banks be­
cause of the lower reserve required against
time deposits. As the market evolved, a
number of leading banks adopted the prac­
tice of varying the rate offered on certificates
and in so doing used certificates as one
means of adjusting their money position.

Smaller banks, on the other hand, feeling
less sure of their ability to avoid run-offs
of certificates, generally do not use the funds
to support loans to the same extent as large
banks. Smaller banks employ the proceeds
largely for the purchase of municipal securi­
ties in the belief that such holdings can be
liquidated to advantage in the market when
For years commercial banks have been
important purchasers of municipal securi­
ties; in the period from 1952 to 1960 they
supplied about one-fifth of all such funds.
As banks began to compete for time money
after 1957 because of the more liberal rates
permitted by Regulation Q, they increased
their taking of municipal securities. And as
certificates gained in acceptance, the banks
became the dominant purchasers of munici­
pal securities, buying two-thirds of the offer­
ings from 1960 to 1966. As of year-end
1966 they held almost 40 per cent of the
total supply.
Certificates have increased the ability of
the banks to attract deposits from beyond
their normal service or market areas, thus
enabling them to meet a broader range of
demands. Some banks, however, have op­
posed the use of certificates and have issued
none because they feared that they would
be misled in determining minimum levels of
funds to be held as reserves and thus the

In per cent

Size (total deposits,
in millions of dollars)




Nov. 18 May 12 Nov. 17 May 18 Aug. 31 Oct. 26

All issuers....................................................







Under 100....................................................
1,000 and over
Outside N.Y.C.....................................












N o t e . —Figures



are from surveys conducted by the System for the dates shown.



maximum amounts that could safely be used
fer lending and investing. Furthermore, they


prefer not to incur a heavy burden of in­
terest expense.

Since the initial stage of development in
1961, the secondary market has provided
marketability— that is, has facilitated sales
to third parties before maturity— for most
certificates. However, not all certificates are
marketable. A number are issued by banks
that are not well known outside their service
areas, and others are too small in denomina­
tion to attract the large investors who par­
ticipate actively in the secondary market.
Furthermore, many original buyers of CD’s
do not buy with the intention of selling, and
if they need to rearrange their portfolios,
they use other investments such as Treasury
bills first.
The increased versatility that the market
provides for CD’s issued by the leading
banks in principal money centers enables
these banks to tap the national pool of short­
term funds without a concurrent obligation
for making loans to the customer. The mere
existence of the market, however, has in­
creased the acceptance of CD’s of all issuers
— regardless of their size or location.
In the secondary market certificates com­
pete principally with Treasury bills, bankers’
acceptances, and finance company paper.
Participants rate the markets for these short­
term investments as excellent for Treasury
bills and good for both bankers’ acceptances
and certificates. Whereas finance company
paper has no secondary market, issuers
under certain conditions will buy back the
paper prior to maturity, thus providing some
flexibility to buyers.
P a rtic ip a n ts a n d o p e ra tin g m e th o d s

The primary and secondary markets for
certificates are quite closely related. Both

include (1 ) the issuers, (2 ) the dealers
who provide an intermediary function, and
(3 ) the buyers of certificates. The dealers
buy, carry, and sell certificates at rates
that reflect current market conditions.
Certificates usually come into possession of
dealers from original holders, but at times
they come directly from issuers.6 Certificates
not acquired from these sources find their
way into the market through brokers and
to a more limited extent as resales to the
dealer by third parties. Buyers from dealers
are for the most part corporations, trustees,
and institutional investors.
To a certain degree the issuers also par­
ticipate in the market from the demand side
as buyers of, or lenders against, certificates
(other than their own) .7 A number of banks
buy certificates for investment only when
rates on certificates are out of line with
rates on other instruments. Some banks,
however, prefer not to buy certificates for
investment because they must be carried in
the “Cash and due from banks” account,
which suggests possible inefficiencies in
employment of funds. Furthermore, certifi­
cates are not thought to provide the same
degree of liquidity as other instruments.
As an auxiliary to the market, some issu­
ing banks assist customers who need to
liquidate their own certificates by canvassing
other customers as possible buyers, thus
6 Some dealers criticize this practice as being one
that violates the spirit of Regulation Q. In effect no
deposit has been made with the bank until the dealer
finds a buyer. Meanwhile, the certificate is carried
with borrowed funds.
7 bank is permitted to make a loan secured by its
own certificate only if it charges an interest rate at
least 2 per cent above the rate at which the certificate
was originally issued.


assuring a better price than if the CD’s were
sold into the market.
Development of a secondary market for
CD’s began early in the spring of 1961
when the Discount Corporation of New
York announced it would make a market—
that is, buy or sell certificates, or hold them
if necessary. Salomon Brothers & Hutzler
took similar action soon afterward, and as
the volume of issues grew, other nonbank
dealers in U.S. Government securities
entered the field. The core of the market
came to be centered around five leading
houses: in addition to those cited, the group
included First Boston Corporation, C. J.
Devine and Company,8 and New York
Hanseatic Corporation. These houses gen­
erally carried large inventories of certificates
— ranging from $40 million to $70 million
for an individual firm.
Other nonbank dealers were also active
in the market from time to time, but as a
rule they held only modest positions— per­
haps $15 million to $30 million. As the
market developed, several bank dealers in
U.S. Government securities acquired inven­
tories of varying size. These included
Bankers Trust Company, Bank of America,
and the First National City Bank of New
York (the last was in March 1965). Some
banks are opposed to assuming a dealer
function, however, on the grounds that they
would help other issues at the expense of
their own rather than helping the market
as a whole. Others state that costs are too
great in relation to potential returns.
Although smaller nonbank dealers seldom
take certificates into their inventories, they
act as brokers or as an auxiliary to the
dealer function. Similarly, a number of large
banks operate service departments for cor­
respondents and other customers— buying
or selling on orders from them. While Regu­

lation Q does not permit a bank to purchase
its own certificates for investment, it may,
as an agent, acquire them for customers.
Banks also purchase certificates issued by
other banks for the account of a customer.
D e a le r p u rch a se s a n d fin a n c in g

While on occasion dealers secure a market
before bidding on certificates, they do not
handle certificates on a consignment basis
but rather purchase the CD’s outright.
Dealers are generally careful not to buy too
large an amount of any given issue, and
they try to guard against development of
too large a floating supply of certificates in
general. They consider the issuer’s credit
standing as well as the amount of his out­
standing certificates.
In their purchases, dealers emphasize
profits to be gained from trading as well as
from carrying an issue. They buy the longest
maturities available that seem to offer prof­
its, considering the probabilities of nega­
tive, even, or positive carries. Aside from
the usual sales into the market, dealers at
times prompt customers to acquire large
amounts of CD’s from an issuer. Later that
day, or on the next, the dealer will take
over the certificates at an agreed price, one
that provides the original buyers with a
profit of 1 or 2 basis points. These are often
referred to as “take-outs.” In other cases
dealers’ customers that have temporary sur­
pluses of funds will take CD’s from issuers
with the understanding that the dealer will
purchase them within a short period of time
at par plus interest. These arrangements may
run from several days to 2 weeks, depending
on the rate outlook. Occasionally dealers
acquire certificates on reverse repurchases
to accommodate customers.
During 1961 through 1965 there were
relatively long periods of stability in short­
term interest rates and even some periods
8 Succeeded by Merrill Lynch, Pierce, Fenner &
when these rates showed a tendency toward
Smith, Inc., through purchase on May 13, 1964.


small declines. This stability made it possi­
ble for dealers to place portfolios of certifi­
cates on profitable carries. Since Regula­
tion Q ceilings precluded issuers from offer­
ing certain shorter maturities, dealers took
issues with long maturities, placed them on
repurchase or loan, and held them for a
period to reduce the maturity to shorter
term. The certificates could then be sold or
placed on repurchase again, depending
upon the money market outlook.
In the short run dealer positions vary
more or less inversely with the volume of
trading. Dealer inventories vary widely from
week to week but much less from quarter
to quarter. On a quarterly basis they average
about four times the volume of trading, a
ratio somewhat larger than for Treasury
bills or acceptances.
The capital of the dealers is small relative
to the volume of their business— particularly
since CD’s have been added to the line of
their investments. Hence, dealers have been
relying more and more on outside funds to
carry inventories. The rate paid for bor­
rowed money, as in the case of Treasury
bills and acceptances, must bear a close
relationship to the market rate for certifi­
cates. Higher rates on bank loans make
borrowing unprofitable.
Dealer portfolios are financed in several
ways: (1 ) on repurchase agreements with
corporations, insurance companies, State
funds, and other nonbank short-term
lenders; (2 ) on repurchase agreements with
agencies of foreign banks; (3 ) on loans
from commercial banks in New York City;9
or (4 ) under repurchase with out-of-town


banks. Dealers prefer repurchase agree­
ments because of lower cost, but they do use
bank loans for residual needs. Repurchase
agreements may be for overnight or may
run for several weeks or months. Bank loans
usually run for a day and must be renewed
each morning if necessary. Federal Reserve
facilities for repurchase agreements are not
available as they are for bankers’ accept­
ances and U.S. Government securities, in­
cluding those of Federal agencies.
As a matter of practice the securities that
underlie repurchase agreements or the col­
lateral on loans consist wholly of CD’s.
This arrangement is preferred to mixed col­
lateral for ease of administration if substitu­
tion of securities is necessary or if the loan
is reduced in size. Mixing CD’s with U.S.
Government securities, or with other accept­
able collateral, depends upon the relative
amounts of securities in inventory. Some
banks make loans at the rate charged for
call loans on U.S. Government securities
whereas others impose a higher rate on
certificates. Rates on repurchases are almost
always lower than those on loans, as is the
case with repurchases on U.S. Government
securities and on acceptances. Dealer loans
and repurchases were generally available
during the 1961-65 period at reasonable,
and at times, attractive rates. In 1966, how­
ever, as rates rose, costs became virtually
prohibitive, and at times some dealers could
not obtain funds. Others, fearing that financ­
ing would not be available, halted their
acquisitions of CD’s.

Banks, as well as most of the parties to
repurchase agreements, are careful about
issuers and will insist that the best names
9 The lending bank’s own certificates are generally underlie the transaction. A mixture of names
excluded from the collateral on the grounds that if
that include lesser-prime or even some offthe loan is defaulted, the bank as new owner would
prime issuers is acceptable on occasion, but
be redeeming the certificate prior to maturity. In ad­
dition, Regulation Q provides that a borrower shall
these arrangements become less desirable
be charged 2 per cent in excess of the interest rate on
to lenders as markets tighten. Banks whose
the certificate for any loan collateralized by the bank’s
outstanding certificates are believed to be
own certificates.


excessive are avoided even if the name is
well known. Proceeds of the repurchases
and proceeds from bank loans are available
in Federal funds.
B u ye rs

Since inception of the market, corporations
have been the principal buyers of certifi­
cates. Maturities of certificates are generally
determined by negotiation between the issu­
ing bank and the purchaser, and to an in­
creasing degree, CD’s have been written to
mature on tax and dividend dates or at the
end of a quarter, half-year, or year. In this
way CD’s are useful as an investment outlet
for corporate tax and dividend accumula­
tions and other special purposes, whether
acquired from the issuer or in the secondary
As the secondary market broadened,
however, an increasing number of divergent
investor groups with temporary surpluses
of funds became purchasers of CD’s. These
include foreign official institutions, States
and municipalities, commercial banks, in­
dividuals, and the range of institutional
investors including foundations. Some in­
stitutional investors such as insurance com­
panies buy certificates only when the yields
are higher than those on finance company
paper. States and municipalities use certifi­
cates for temporary investment of the pro­
ceeds of bond issues, and savings banks for
the accumulations of mortgagees’ tax
monies. Many buyers were more interested
in the market when it provided an oppor­
tunity to “ride the yield curve” than when
the certificate provided only investment in­
come. Most purchasers take round lots, but
on occasion investment management firms
will buy odd lots at higher yields and add
them to their accounts.
Investments in certificates are also made
through repurchase agreements in which
certificates underlie the transaction as an

alternative to direct investment. The repur­
chase allows the lender to invest without
risk of fluctuation in price and at the same
time to suit the maturity to his needs.
All buyers tended to become more selec­
tive toward the end of 1965 as issues of
certain banks increased substantially and
several other banks failed. Buyers further
restricted purchases as the market softened
in 1966.1 Some withdrew from the market
completely. Dealers do not endorse the CD’s
that they sell to the market, and usually they
make it a policy not to provide a credit
opinion on the issuer.
S u p p ly a n d d e m a n d va ria b le s

A number of interacting and interdependent
variables or factors affect both the primary
and the secondary markets for CD’s. These
forces affect not only the volume of issues
and maturities but also the volume of trad­
ing. These factors are discussed below:
Regulation Q ceilings. As offering rates
reach the ceilings set by Regulation Q,
banks are forced to withdraw from the
issue market because certificates become
noncompetitive with other instruments.
Under these conditions short-term interest
rates in the market rise relative to the
regulation’s ceiling. The rise of open market
rates above, or their fall below, the existing
rate ceilings leads to retardation or accelera­
tion, respectively, of new issues as interestsensitive investors move to obtain the high­
est possible yields. Maturities are also af­
fected under these circumstances; they tend
to shorten as rates approach the ceiling and
lengthen as they fall away. Similarly, as rates
move above the ceiling or fall below it, sup­
1 Restrictions involved reduction in amounts of
CD’s of particular banks, reduction in number of eli­
gible bank names from the 50 largest to the 21 larg­
est, and one large corporate buyer excluded from the
authorized list of the CD’s of all banks west of the



plies of CD’s in the secondary market be­
come less or more plentiful, respectively,
and trading volume is affected accordingly.
Dealers’ willingness and ability to carry in­
ventory are strongly influenced by such rate

Treasury tax anticipation bills is good, it is
more difficult for banks to issue certificates
with comparable maturity dates. Trading
volume in the secondary market also tends
to be smaller than it is when there are no
tax bills outstanding.

Pattern and size of corporate tax and
dividend payments. The volume of funds be­

Rate relationships and money market condi­
tions. At times banks refuse to pay the rates

ing accumulated for corporate tax and
dividend payments has a strong influence on
maturities of CD’s as well as on the amount
of the increase in issues at various times and
has led to a concentration of maturities on
these dates. Tax and dividend dates signifi­
cantly affect dealer positions and trading,
and inventories are determined with these
dates in mind. The peak of demand in the
market for certificates maturing on tax and
dividend dates comes about 1 or 2 months
before the payment dates.

that are necessary to replace runoffs of cer­
tificates, and they withhold issues tempo­
rarily. If so, would-be issuers of CD’s seek
needed funds elsewhere.

Liquidity position of corporations. When cash

flows shrink, lessened liquidity leads corpo­
rations to reduce both their takings of cer­
tificates from issuers and their purchases
in the secondary market. And when they
make an investment, they put considerable
emphasis on the ability to liquidate if neces­
sary. Treasury bills are generally preferred.
Under these conditions increasingly large
premiums over other investments must be
offered in order to move new issues and to
induce takings in the secondary market.
Strength of loan demand at the banks.

Expectations of continued or increasing
loan demands suggest profitable employment
of funds and encourage banks to become
more aggressive bidders for CD’s. If possi­
ble, banks tend to extend maturities of
issues. This factor has been an alternating
influence in every year and has affected
issue volume, particularly at large banks,
both in New York and in other areas.





If the supply of substitutes for CD’s such as

Inflows of other time and savings deposits.

If inflows of other time and savings deposits
are good, banks become less willing to issue
certificates— not only because of usual
higher cost relative to other savings forms
but also because of fear of transfer of time
deposits from one form to another.
Legal list statutes. Lists of legal invest­
ments vary from State to State for savings
banks and for trusteed and public funds. As
of August 1966, the Massachusetts savings
bank statute was changed to permit banks in
that State to hold certificates of commercial
banks; this broadened the issue market and
moderated the rollover problem of Boston
banks. Some short-term investors are legally
required to invest temporary holdings of
funds in U.S. Government securities. The
Comptroller of New York State is author­
ized to buy CD’s only if secured by col­
Corporate treasurers' authorities to hold
certificates. Although some policy limits on

takings of CD’s may be liberalized from time
to time, the existence of these limits contrib­
utes to widening spreads between yields on
Treasury bills and those on other obliga­
tions— particularly as supplies increase—
thus influencing trading at various times.
Limits apply to new issues as well as pur­
chases in the secondary market.
Overissuance of certificates. Overissuance of
CD’s by some banks, which arouses sus­


picion of the soundness or possible failure of
banks with substantial amounts of certifi­
cates outstanding, induces reappraisal of
policy limits of buyers, and at least tempo­
rarily affects the market as a whole or the
outlook for interest rates, will induce re­
views of authorities, which may lead on
occasion to temporary termination of buying
M e a su re s o f tra d in g

The general acceptance of CD’s as a money
market instrument is evidenced by compar­
ing market activity in certificates with that
for bankers’ acceptances and Treasury bills.
The volume of trading in the certificate and
acceptance markets is quite similar. In 1964
and 1965, years of active markets for both
instruments, the daily-average volume of
trading by months ranged between $43 mil­
lion and $79 million for certificates and $44
million and $49 million for acceptances. But
both of these markets were dwarfed by trad­
ing in Treasury bills; such trading on a dailyaverage basis ranged between $1.1 billion
and $1.5 billion per month. To a consider­
able extent the greater volume of trading in
Treasury bills reflects the larger volume of
these securities outstanding. Bills outstand­
ing in 1964 and 1965 averaged from $52
billion to $55 billion per month, acceptances
a little more than $3 billion, and certificates
between $11 billion and $12 billion in 1964
and $13 billion to $16 billion in 1965.
Trading versus issues outstanding. Com­
parison of the dollar volume of trading with
the volume of issues outstanding for each in­
strument shows that somewhat larger per­
centages of both acceptances and Treasury
bills are traded. In 1964 and 1965 dailyaverage trading volume ranged from 0.31
per cent to 0.64 per cent of certificates out­
standing, from 1.10 per cent to 1.78 per cent
for acceptances, and from 2.05 per cent to
2.80 per cent for Treasury bills in various

months. These differences reflect variations
from one buyer to another in use of the vari­
ous instruments to adjust portfolios, homo­
geneity of the instruments, and the amounts
outstanding at various maturities. In con­
trast to both certificates and acceptances,
Treasury bills are the most homogeneous of
all money market paper, for they differ
essentially only in maturity.
Corporate holders of certificates fre­
quently consider them an adjunct to short­
term U.S. Government securities. However,
if large blocks of investments must be sold
quickly to raise cash, financial officers usu­
ally use Treasury bills because of the de­
pendable continuity of one market. At times
it is difficult to liquidate large blocks of cer­
tificates in the market, although the market
can usually handle transactions of $5 million
to $ 10 million without any problem and $20
million on occasion. In other cases demands
by investors cannot always be met from
dealers’ inventories, and in many instances
switches in holdings among customers may
be necessary to supply the specified issuer
and maturity. To a much lesser extent the
same applies to acceptances. Only prime ac­
ceptances are traded in the market, and the
several maturity ranges for which quotes are
posted overcome some of their diverse char­




Comparisons of the dollar volume of dealer
inventories with the dollar volume of the
several instruments outstanding are also
significant. In 1964 and 1965 the dailyaverage volume of inventories as a percent­
age of daily-average volume of outstandings
resulted in ratios for various months ranging
between 1.12 per cent and 2.54 per cent for
certificates, 3.20 per cent and 10.74 per cent
for acceptances, and 3.84 per cent and 6.12
per cent for Treasury bills. The larger per­
centages of outstanding acceptances carried
in inventory reflect not only the relatively



smaller amounts outstanding in contrast to
Treasury bills and certificates but also the
prime character of the acceptance instru­
The high degree of quality of acceptances
is based upon the combination of the name
of the accepting bank, the contingent liabil­
ity of other parties to the instrument, the
feature of self-liquidity, and the eligibility
for purchase or discount at the Federal Re­
serve Banks, as well as the preferred position
accorded holders of acceptances of failed
banks. Even the prime eligible acceptances
of smaller banks with proven experience are
traded at the same rates as acceptances of
the leading banks. In addition, acceptances
have had about 50 years of development in
American practice. Like Treasury bills, ac­
ceptances may be bought under repurchase
agreements with the Federal Reserve under
certain conditions, and on occasion the Sys­
tem may buy them outright in the course of
its open market operations, a policy that was
developed in the 1920’s and renewed in
1955 as the Federal Reserve fostered the
growth of the market.
Certificates, on the other hand, do not
represent a standardized form of credit risk.
Thus the several rates that prevail in the
market correspond to the buyer’s analysis of
the issuer’s credit standing.1 Dealers, by and
large, trade only the better names, princi­
pally those of the 30 to 35 largest banks,
most of which have deposits of $ 1 billion or
more. The market supply of these prime
CD’s in relation to total CD’s outstanding is
not so large as it is in the case of accept­
ances.12 Occasionally certificates of banks
with deposits as small as $150 million to
$250 million are traded. In contrast to ac­

ceptances, certificates of medium-sized and
smaller banks— despite a reputation for
good management— generally must carry a
concession of about one-fourth of 1 percen­
tage point to attract buyers. Treasury bills
are the predominant instrument in the short­
term market, and dealer inventories must be
related to the large quantities outstanding of
each bill maturity. As a rule this assures
continuous availability of bills in the market
as compared with variations in supplies of
both acceptances and certificates at times.

1 Even in the absence of an analysis, buyers know
that CD’s of some big-name banks trade better than
others and will prefer the better names even though
careful examination of the record shows there is no
difference among names.
1 This note appears in right-hand column.

Acceptances are in effect a loan, and the accept­
ing bank can sell or hold the acceptance at its option.
CD’s are taken out by a depositor generally to be
held to maturity, and the initiative to sell rests with
the holder. In part, these distinctions explain the dif­
ferences in supply in relation to outstandings.

Transactions to positions. Activity in the
market may also be measured by comparing
the volume of transactions to the volume of
dealer positions. On this basis certificates
and acceptances compare favorably. In 1964
and 1965 the ratios computed on a dailyaverage basis ranged from 16 per cent to 50
per cent and from 13 per cent to 38 per cent,
respectively, for various months. Ratios for
both instruments were somewhat smaller
than those for Treasury bills, which ranged
from 38 per cent to 70 per cent.
Acceptance portfolios were generally
smaller in relation to turnover before 1964.
The increased inventories in 1964 reflected
the more continuous sales by banks to meet
reserve needs and the ability of dealers to
carry the larger amounts, for the most part,
at favorable rates. Portfolios of certificates
in relation to turnover are somewhat larger
than the ratios for Treasury bills. This dif­
ference arises from the potentials for profits
and reasonable “carries” in the absence of
abrupt rises in interest rates. Potentials for
profit on inventories of certificates are
greater than for acceptances, which have a
flat yield curve in each maturity range, in
contrast to the descending pattern to matur-


ity provided by Regulation Q prior to D e­
cember 1965. Potentials for profit have also
frequently been greater for CD’s than for
Treasury bills.
M a rk e t rates a n d yie ld sp re a d s

In the secondary market, CD’s compete with
the primary paper of the issuing bank, and
since the buyer of an original certificate has
the advantage of selecting the date of matur­
ity, the paper in the secondary market must
trade above current primary rates. Quota­
tions above this minimum are determined
largely by the movement of money market

rates as a whole, and particularly by prices
of competing instruments such as Treasury
bills, finance company paper, and accept­
Secondary market rates for CD’s gener­
ally fall between those for finance company
paper and acceptances on the one hand and
those for Treasury bills and issues of Fed­
eral agencies on the other. Generally, rates
on finance company paper and certificates
are within one-eighth of a percentage point
of each other. Acceptance yields are more
often below certificates, by about one-eighth
of a percentage point. These spreads widen
in tight markets.



Levels indicate maximum interest rates payable on C D ’s. Secondary market C D ’s. Salomon Brothers & Hutzler series.
All other, Federal Reserve.





Changes in relative supplies of market in­
struments— including bills— are an import­
ant influence on yields and on spreads
among the various types. This was well illus­
trated in the first half of 1965 as compared
with 1964 and was quite striking in 1966.
Treasury bill rates remained quite stable
during the first half of 1965 and 1966, but
most other short-term market yields rose
some 12 to 19 basis points and 40 to 70
basis points, respectively, in these periods.
These increases reflected in part the retire­
ment of tax-anticipation bills and official
purchases of U.S. Government securities.
More important, however, was the fact that
the outstanding volume of most other
money market instruments rose substantially
(Table 6 ).
First 6 months, 1964, 1965, and 1966
In billions of dollars
3-month maturities of—
Treasury bills...........................................
Bankers’ acceptances..............................
Finance paper..........................................
Certificates o f deposit...........................
Issues o f Federal agencies.....................

— .5
2 .0
— .9

—2 .8
— .3


Changes in demand for certain types of
instruments also affect yields. For example,
as indicated earlier, some short-term inves­
tors may not invest temporary funds in any
securities except U.S. Government securities
whereas others from time to time reach pol­
icy limits on holdings of CD’s and other pri­
vate obligations. Although these limits are
sometimes liberalized, their existence tends
to contribute to a widening of spreads be­
tween bills and other obligations in the sec­
ondary market at various times.
Dealer bids must be enough above bank
issuing rates on CD’s— with distinctions
being made for paper of prime, lesser-prime,

and off-prime banks— to insure a trading
profit while at the same time making a com­
petitive offer. In the first year of market
trading, spreads for certificates of primename banks ranged from 10 to 30 basis
points above bill yields, and they have gen­
erally remained within this range since then.
CD’s of prime-name banks outside New
York trade from 5 to 10 points higher than
those of similar banks in New York, and 15
to 40 points above bills; for off-prime paper
the ranges are 10 to 15 basis points and 20
to 55 basis points higher, respectively. CD’s
in denominations of less than $ 1 million gen­
erally carry higher rates. Denominations of
$500,000 are traded with some frequency
and denominations of $100,000 occasion­
ally. Market rates for prime certificates at
times, however, have been as much as a full
percentage point higher than those on Trea­
sury bills (Table 7 ).
Spreads between prime and nonprime cer­
tificates and between certificates and bills
vary from time to time as the appraisal of
the outlook changes for short-term rates.
Spreads narrow when a trend toward lower
rates (higher prices) is anticipated. Under
these conditions participants feel more con­
fident of the marketability of higher-yielding
though less liquid instruments such as cer­
tificates. Accordingly, they bid strongly for
higher yields to maximize income with the
expectation of greater potential for future
profits. When higher interest rates and lower
prices are expected, the less liquid instru­
ments become relatively less attractive, and
yield spreads widen. In this context CD’s
maturing around certain tax-payment and
dividend dates will always command higher
prices (lower yields) than those maturing
on other dates.
The amounts by which yields on C D ’s of
prime-name banks exceed those of some
lesser-prime and off-prime banks in the


In basis points unless indicated otherwise



Jan. 1 | June 30

Jan. 1 June 30

Jan. 1 June 30

3-month maturities of—
Treasury bill rate (per cent).................................







Spread from bill rate:
Bankers’ acceptances..........................................
Federal agencies..................................................
Finance paper......................................................
Certificates of d ep o sit.......................................







at even lower rates. Markets are thus dif­
ferentiated, and sales of locally oriented
certificates in the secondary market call for
added yields, since in effect the bank is
tapping the national market at one step
removed. In a sense, premiums are viewed
as an impersonal market means of regulat­
ing new issues. They may be a warning
that a particular bank is issuing a dispro­
portionate volume of CD’s. Both the rate
on the new issue and the premium yield in
the secondary market in this case do not
reflect arbitrary actions but a marginal
response to influences of the national short­
term money market.

market arise from several factors. Even
when the authority to purchase permits dis­
cretion, buyers will refuse certificates of
lesser-known names when those of betterknown names are available at about the
same yield, despite the fact that an analysis
would show about the same standing. In
this sense buyers discriminate against cer­
tificates of smaller, less-well-known banks.
Differentiation of names became more wide­
spread after the failure of banks in Texas,
California, and Colorado in 1964 and early
1965. A part of the premium consequently
represents an inducement to the buyer to
take CD’s of lesser-known banks.
Dealers state that it takes more effort to
educate customers to the point where they
will be interested in CD’s of lesser-known
names. Such certificates must be carried in
position longer; they are more difficult to
place on repurchase or loan, even though
mixed with prime names; and they afford
trouble and expense in checking amounts
already outstanding and in obtaining other
relevant information of the particular bank.
In some cases data are available only
quarterly or semiannually, and comparative
data are lacking. For this reason a part of
the premium represents compensation for
additional marketing effort and cost.

If there were no effective ceiling on rates,
any bank could bid for funds, but rate
differentials would remain. The rate paid
by the individual bank would become an
increasing function of (1 ) the average rate
prevailing in the market, (2 ) the amounts
of certificates outstanding, and (3 ) the size
of the proposed new issue. Inelasticities in
the current market— as exemplified by the
added cost paid by smaller banks, which
brings them to the ceiling sooner, or by the
inability or increased difficulty in issuing
certificates when the large banks are in the
market— might be reduced but they would
not be eliminated.

A number of smaller banks that are well
known in their communities issue CD’s to
local customers at the same rates as prime
banks issue CD’s to national customers, or

Similarly with no ceiling on rates, trad­
ing in CD’s would develop by competitive
forces in a fashion similar to that of com­
parable investments that are not regulated.



The secondary market freed from expecta­
tions about Regulation Q would fall into
place as a division of the money market.
Market yields would be determined by the
usual forces of supply and demand and the
reputation of the issuers.
C e rtific a te c h a ra c te ristic s

Certificates offered for sale in the early
period often had terms and final payment
dates that did not suit the requirements of
new buyers and thus had to be carried/by
dealers for long periods. Many CD’s were
carelessly executed, and the instrument had
to be standardized. Most of the early certifi­
cates were issued to a named payee or order;
this contributed to some awkwardness in
trading until authority was granted or the
practice developed for issuance in bearer
form. Similarly, banks outside New York
found it necessary, in order to reduce
delivery and collection expenses, to arrange
for issuing agents and alternative paying
agents in New York and other principal
money centers. In addition, it became the
general practice to pay off maturing issues
in Federal funds as opposed to clearing­
house checks. Currently, unless otherwise
agreed, CD’s bought and sold in the second­
ary market are deliverable in New York
the next business day following the date of
transaction, and payments are in Federal
The certificate market then and now is
more diverse than the other short-term
markets, including the acceptance market.
Acceptances are analogous in many ways
to certificates, but the market for them has
overcome many of the problems associated
with diversity through the establishment of
posted rates for three maturity ranges—
1 to 90, 91 to 120, and 121 to 180 days.
Moreover, the distinction between prime
and lesser-prime acceptances is practically
eliminated by the market convention (recog­

nized by the Federal Reserve Open Market
Desk) that any acceptance in the market is
a prime acceptance. Certificates can be and
are written in sizes large enough to trade
on an individual basis, and maturities are
mutually agreed upon by the issuer and
buyer. The maturity groupings used for
acceptances, which were designed to over­
come size and maturity differences related
to the underlying goods transactions, are not
appropriate for certificates.
D e a le r bid a n d o ffe rin g rates

Certificates are individual instruments, and
they differ by maturity and/or by issuer.
Dealers do not know of the existence of a
particular CD— of any specific maturity of
a particular bank— until that CD appears
in the market. The possible number of
maturity dates is large, and the certificate
may be prime, lesser-prime, or off-prime.
CD’s of several hundred issuers may appear
in the market, but the bulk of the trading
has involved the certificates of 30 to 35
of the leading banks. Issues of another 20
to 30 banks have appeared from time to
time. Only occasionally are certificates of
banks with deposits of $150 million to $250
million traded. In making a market for CD’s,
dealers cannot be expected to be familiar
with the credit standing of all issuers.
Furthermore, certificates are considered easy
to counterfeit, and dealers examine the
issues of even the best-name banks with
Lack of homogeneity of certificates pre­
vents the establishment of posted bid and
offered rates and of real breadth in dealer
trading. A dealer will bid only in response
to a specific certificate offering; however,
as the market has developed, the certificates
of best names have come to trade at yields
very close to each other. In the early market
the dealers’ spread between bid and offered
quotations was generally about 5 basis


points on 90-day maturities, but this later
narrowed to 2 to 3 basis points as strong
competition developed. The spread widens
as CD’s approach maturity with the decrease
in value of a basis point. If certificates are
held in position for several days or longer,
the rate will reflect interest accrual, financ­
ing costs, and the lesser number of days
to maturity, as well as any change in short­
term rates. Spreads between bid and asked
prices also widen in tight markets as dealers
move to protect themselves. Some inven­
tories must be liquidated, potential sales
are fewer, and purchases must be made in
a market where prices are declining. Hence,
dealers keep their offers down and at the
same time bid less for the certificates bought.
In 1966 bids declined by 5 to 10 basis points
on 90-day paper of better names and 25
points for lesser-known names.
In recent years some dealers have posted
offering rates for better names, but this is
not a general practice. Many issuers object
to the practice on the grounds that it appears
to rate the credit of issuers by differentiating
the prices of similar maturities even though
the shadings are small. In markets where
they exist, however, posted rates— bids and
offers— permit dealers to lighten or increase
inventories rapidly at prevailing rates. Short
sales in the CD market are unknown be­
cause of the difficulty in covering such a
sale— in view of the need for matching
maturity, coupon, and day of offering. Thus
the CD market lacks much of the continuity
and closeness in pricing that characterizes
other markets.
G e n e ra l fe a tu re s : 1 9 6 1 - 6 6

Activity in the secondary market divides
itself into two periods— the first running
from the establishment of the market in
1961 through 1965; and the second, the
year of 1966. Until the end of 1965, Regula­
tion Q ceilings and money market condi­

tions in general provided a favorable atmos­
phere for new issues. The expanding eco­
nomy stimulated an increasing variety of
uses for funds and also changes in the total
and in the pattern of business borrowing.
Time deposits in the form of certificates
became a larger share of the liquid asset
holdings of corporations and to some extent
displaced both money and market securities
such as Treasury bills in their liquid asset
The maximum rates permitted issuers
effectively restricted offerings of short matu­
rities— making them available only in the
secondary market at attractive rates. Market
rates for much of this period, it should be
noted, were sufficiently above the Regula­
tion Q ceilings on restricted maturities to
permit considerable leeway in potentials for
profits, and the volume of trading was large.
Inasmuch as Regulation Q ceilings on the
shorter maturities with some frequency were
a little below market rates, the ceilings pro­
vided a cushion against market loss as hold­
ings approached maturity. The descending
pattern of the yield curve for certificates as
they approached maturity permitted dealers
to offer certificates at lower rates (higher
prices) than when acquired— thus estab­
lishing a profit over and above the interest
earned during the period of holding.
Important in this connection were the rela­
tively long periods of rate stability, which
enhanced profit possibilities and encouraged
acquisition of inventories.
The upward adjustment in Regulation Q
ceiling rates to 5Vi per cent in December
1965, along with the shortening of the mini­
mum maturity against which the rate ap­
plied, from 3 months to 1 month, virtually
eliminated the slope in the yield curve for
certificates. This development coupled with
the rises in market rates in 1966— in re­
sponse to System policy and very strong
aggregate demand— brought to an end much




Data for 1963 estimated. Daily-average figures (in millions of dollars) for the year ending June 1962 are as follows: D e a le r p o s i­
tion s, range $10-$100; average $20-$30; V o lu m e o f tradin g, range $0-$35; average, $10-$15.

of the potential for dealer profits. This was
particularly true after rates pierced the
Regulation Q ceilings in midsummer. Trad­
ing volume, which had already diminished,
dropped sharply and then continued at very
low levels for the balance of the year. The
supply of certificates declined, and the char­
acter of trading changed.
The volume of certificates outstanding
rose quite steadily from early 1961 to mid1966 and then leveled off before declining.
Over the whole period there was some tend­
ency toward a progressive shortening of
maturities. Along with the rise in CD’s out­
standing dealer positions and trading volume
increased until the end of 1965. After that,
although outstandings continued to rise, the
market activity was substantially less than
in previous years— in part because of risk
of exposure to new issues of short maturities
and the constant risk of principal if sales

were made by holders before maturity.
Trading dropped sharply after July 1966,
as rates rose to record levels and new issues
of certificates became competitive with other
short-term investments of only 1 month or
slightly longer maturity. Dealers’ carrying
costs became prohibitive, and at times there
were fears that financing would not be
available. Trading in the secondary market
concentrated on maturities unavailable to
original buyers. Dealers’ bids frequently
represented book losses to investors and
so corporate treasurers and others held
their CD’s.
T h e cou rse o f m a rk e t a c tivity : 1 9 6 1 - 6 5

Banks were unable to issue certifi­
cates of less than 90-day maturity during
1961 because of the 1 per cent ceiling set
by Regulation Q. Treasury bills with
1-month maturities— comparable with the


shortest certificate maturity that could be
issued— traded well above this level.
Similarly, issue rates on certificates with
maturities from 90 days to 6 months were
only briefly competitive with bills of the
same maturity for several months during
the spring and summer, and they were at
the 2 Vi per cent ceiling from August to
the end of the year (Chart 3 ). Certificates
with maturity of 6 months or more afforded
the most flexibility during the year because
offering rates on these did not press the
3 per cent ceiling until November. The bulk
of issues consequently had this maturity.
The market in 1961 was generally thin.
Original buyers in many cases were con­
tent to hold their certificates, and dealers
had difficulty in matching demand and sup­
ply of certificates at quoted rates. In the
early part of the year dealer transactions
were undertaken for the most part only on
order. One or two dealers, however, began
with small positions— say, $5 million to
$10 million. As trading developed, however,
dealers cautiously acquired inventories, and
during the autumn their positions are esti­
mated to have ranged from $10 million to
$100 million and averaged from $20 million

to $30 million. Individual dealer positions,
however, showed wide departures from the
averages, and variation has been a char­
acteristic of positions even in years of peak
activity in the market. The volume of trad­
ing correspondingly was spotty to light—
ranging from nothing to $34 million— and
probably averaged from $10 million to $15
million. Dealers were able to adjust their
positions only with difficulty. Bid and asked
prices could be moved only within fairly
narrow limits because large changes would
induce arbitrage with other markets. Inter­
dealer trading was sporadic because of the
small market supply of certificates.
1962 .
Regulation Q ceilings were raised
on January 1, 1962, and banks increased
rates on new CD’s by about one-eighth of
a percentage point on 6- to 9-month matu­
rities and three-eighths of a percentage point
on maturities of a year or more. The new
ceilings were established at 3 Vi per cent
and 4 per cent for maturities of 6 months
and 1 year or longer, respectively. Rates for
other maturities were unchanged. This ac­
tion resulted in substantial new issues with
maturities of 6 months or longer.
Largest amounts of certificates then be-

Apr. 1, 1961—Jan. 1, 1962 P E R C E N T


90-179 DAYS




Jan. 1, 1962—July 17, 1963


180-269 DAYS
1 3. 0






2. 0





























270-365 DAYS

180-269 DAYS
H 3.5


1 3.0

1 2.5










_J___ I ___I ___ I____I____l _





4. 0


.................................... 1 1 1 1
J A S 0 N D J


1 1 1 1 1




came available to dealers, and the volume
of trading increased. Dealers acquired rea­
sonable inventories of 6-month maturities
from original holders and “aged” them—
placing some on repurchase agreements and
holding others for sale in the relatively near
future. Interest rate prospects were attrac­
tive for capital gains. Expectations for gen­
erally stable interest rates encouraged
dealers to build positions. Since the Regula­
tion Q ceilings established lower rates on
the shorter maturities than on the longer
ones, the yield curve descended as maturity
shortened. This enabled the dealers to offer
CD’s at lower rates (higher prices) than
when acquired— thus making a profit over
and above the interest earned during the
period held. Dealer positions are estimated
to have averaged between $125 million and
$225 million and trading between $25 mil­
lion to $45 million on an average day.
Certificates of perhaps as many as 50 banks
appeared in the secondary market at one
time or another during the year.
In 1963 the secondary market
became stronger, attracted more partici­
pants, and served a greater variety of in­
vestor groups. Trading was more active

July 17, 1963—
Nov. 24, 1964________________________ P E R


during the first half of the year but was
affected by fluctuations in interest rates dur­
ing the spring as the market anticipated
higher levels. Dealer positions are estimated
to have ranged from $100 million to $500
million and averaged $150 million to $250
million. Trading volume ranged between
$15 million and $75 million and averaged
$20 million to $30 million. Both dealer
positions and the transactions reached peaks
for the year during the spring. Issue rates
on certificates with maturities of less than
6 months had been at the ceiling all year
and those for maturities of 6 to 9 months
reached the ceiling in July. Only those
issues having maturities of 9 months to 1
year were competitive.
The market received its first major test
with the increase in the discount rate in
mid-July and the accompanying sharp rise
in Treasury bill rates. Regulation Q ceilings
were revised, establishing a 4 per cent ceil­
ing for certificates with maturities of 90 days
to 1 year and permitting banks to offer
shorter maturities than earlier. After these
changes all market rates adjusted upward
during the last half of July, and offering
rates were raised from 3% to 3 Vi per cent

Nov. 24, 1964-Dec. 6, 1965______________



Dec. 6, 1965-Oct. 31, 1966

90-179 DAYS

90-179 DAYS

5. 0


90-179 DAYS







3. 5






















































180-269 DAYS

180-269 DAYS

2. 5



180-269 DAYS
a n

































1 L


























1 I






on 3- to 6-month maturities and 3 Vi to
3% per cent on 6-month to 1-year matu­
rities. Issue rates and market rates on cer­
tificates continued to move upward during
the remainder of the year— increasing by
as much as 10 to 20 basis points in 3- and
6-month maturity areas in some months
(Charts 1 and 3 ).
The rise in market rates of interest
lowered the market values of outstanding
certificates, and some investors who nor­
mally would have sold before maturity chose
to hold their certificates rather than accept
a loss— thus contributing to a substantial
decline in trading after midyear. Activity
remained at low levels until fall. Trading
fluctuated between a low of $15 million on
the average in September and $55 million
in the last month of 1963. Dealer inven­
tories were also lightened, and, at the same
time, some dealers were reported to have
sustained large losses.
The adjustment of the secondary market
for CD’s to the abrupt rise in interest rates
was more sluggish than the adjustment in
Treasury bills. The spread in yields between
certificates and Treasury bills narrowed
sharply in July and remained narrow until
October. After October the volume of trad­
ing picked up, with activity centered in
maturities of less than 3 months. In con­
trast to the decline in dealer positions and
secondary trading, the volume of CD’s out­
standing rose sharply after July in response
to the lifting of the Regulation Q ceiling
and to strong loan demand, which permitted
and encouraged banks to seek funds aggres­
sively. The new terms of Regulation 0 , as
noted, also made possible issuance of matu­
rities of less than 90 days for virtually the
first time. By taking advantage of this, some
banks provided competition in this area with
the market supply. By the end of 1963 the
larger banks were quoting issuing rates close
to the 4 per cent maximum. The market

as a whole, however, was substantially
strengthened and broadened during the year.
The volume of trading in certifi­
cates reached new high levels during 1964,
considerably above those in 1963. On the
average there was a $10 million quarterover-quarter increase. Broad patterns of
activity associated with the four principal
quarterly tax and dividend dates, as well
as some trading for midyear and year-end
needs, also developed. Dealer positions
fluctuated, but inversely to trading; and
positions averaged about four times the
volume of trading. Both positions and trad­
ing reflected the relationships of both mar­
ket and issuing rates to Regulation Q ceil­
ings as well as the spread between these
rates and Treasury bill yields. These factors,
of course, influenced the maturities avail­
able in the market. Divergent trends in the
supplies of the various money market in­
struments moderately influenced the yield
spreads between Treasury bills and other
During the first quarter CD market rates,
which generally tended to be 30 to 40 basis
points above Treasury bill yields of a com­
parable maturity, were near the 4 per cent
ceiling on maturities of 3 months or longer.
At the end of March most large banks were
quoting interest rates of 4 per cent on new
certificates of 6 months or longer and about
3.9 per cent on 3- to 6-month maturities.
Smaller banks quoted 4 per cent across the
board. Since some shorter maturities were
available from issuers, dealers were reluc­
tant to increase inventories, and investors
met most of their needs from the banks.
The opening of the second quarter in
April brought a decline in market rates, and
rates on new 9-month certificates backed
away from the ceiling— thus providing
banks with a chance to sell longer-term
certificates. Rates changed little in May,
and dealers— anticipating favorable carries


— began to increase their positions. During
the first half of the year dealer inventories
averaged between $120 million and $280
million and trading volume between $60
million and $70 million.
Over the early summer the bulk of out­
standing certificates continued to have rela­
tively short maturities; about half carried
dates within 3 months and three-fourths,
within 5 months. Some declines in rates in
June and July again permitted issuance of
a modest amount of longer-term certificates.
Expectations for favorable carries and a
strong demand for certificates maturing
around the September tax and dividend date
led dealers to make further increases in
their inventories.
Because of high interest rates in the
market in August, September, and early
October, new issues maturing in 6 months
or more were at the 4 per cent ceiling from
the end of September until the change in
the discount rate and increase in Regulation
Q ceilings in late November. For some
weeks prior to the change prime banks had
not been able to attract any volume of cer­
tificates, and most issues were in the 4- to
5-month maturity range. Heavier dividend
payments relative to tax payments in Decem­
ber and a step-up in estimated tax payments
for 1965 also influenced the shortening of
maturities and at the same time heightened
interest in trading. The increase in certifi­
cates in the September—
November period
was only about $500 million.
Dealer positions reached new highs just
before the change in the discount rate and
the Regulation Q change in November, and
they have never regained these levels. Active
trading during the autumn, under the
umbrella of the 4 per cent issue ceiling on
maturities of less than 90 days, emphasized
the desirability of having CD’s mature on
or near tax and dividend dates or around
the year-end. During the last half of the


year dealer positions averaged between
$210 million in October and $322 million
in November, with trading averaging from
$70 million in July to $80 million in Octo­
ber. The bulk of the trading during the year
was again in maturities of less than 3
The new ceilings under Regulation Q
permitted issue rates of AVi per cent for
maturities of 90 days or more and payment
of 4 per cent on maturities of less than 90
days. This action ended the prohibitive 1
per cent ceiling on short maturities, which
had been in effect since 1936. Banks used
the new authority to obtain funds maturing
in less than 90 days and only reluctantly
paid the higher rates necessary to issue
longer-term certificates.
As the year closed, dealers began to
adjust inventories to the new interest rate
structure through run-offs and sales. Both
new-issue and secondary market rates
moved higher in December (Charts 1 to 3 ).
1965. After a tendency to level off in
January, short-term rates edged higher in
February and moved upward through the
remainder of the first quarter. Funds in the
short maturities became generally unavail­
able. Banks turned from the 30- to 89-day
maturities and began to seek deposits in
the 4- to 6-month or longer range. Large
banks in New York City and elsewhere—
anticipating strong loan demands, heavy
redemptions of CDs’ in June, and reduced
liquidity— aggressively competed for funds
and extended maturities.
In contrast, the smaller banks shortened
maturities. They experienced net reductions
in outstanding certificates during the late
winter and early spring. In part these banks
were hampered by rate ceilings and the
inelasticity in the market, which makes it
difficult for them to issue CD’s w'hen the
big money market banks are seeking funds.
There was also some unwillingness to pay


the necessary higher rates. New York City
banks accounted for nearly all of the in­
crease in outstanding certificates over the
quarter, and all were in the form of longer
maturities (Tables 4 and 8 ).
In response to the changes in Regulation
Q, the new rate setting, and issuance of
some shorter-term CD’s over the year-end,
dealers cut their positions to an average of
$150 million in January, an amount about
half the level at the end of December. The
volume of trading almost reached the Octo­
ber 1964 record of $80 million. Both buyers
and sellers were active in rearranging their
portfolios, and trading tended to center on
certificates maturing on the March and April
tax dates as well as certain dividend dates
in the spring. After appraising the new con­
text of market rates and possibilities for new
issues of CD’s, dealers began to rebuild posi­
tions. It seemed clear that upward fluctua­
tions in rates would continue and would
foreclose short-term issues. Positions were
increased to about $225 million on the aver­
age in March.
Through the spring New York banks
continued aggressively to seek funds with
longer maturities. As a result, issuing rates
were marked up, and market rates also
tended to be higher. The larger banks were
successful in issuing a sizable volume of
longer-term certificates. However, during
the spring, banks outside New York experi­

enced net reductions in outstanding CD’s in
all size groups. These banks were more
severely affected by rate ceilings than they
had been earlier in the year (Table 8 ).
In response to these factors, dealers in­
creased their positions to a peak for the
second quarter of about $275 million in
April. The volume of trading remained low,
averaging about $45 million in February,
March, and April. Trading became more
active after April until it reached $75 mil­
lion in July. Trading as usual centered on
certificates maturing on tax and dividend
dates. The $3.3 billion tax-anticipation bills
maturing in June— the largest since the
spring of 1962— moderated corporate buy­
ing to some extent.
Banks outside New York, faced with
increasing requests for loans, stepped up
their offerings of CD's during the early
summer. The New York banks had tem­
porarily withdrawn, and Treasury bill rates
had moved down. With the re-entry of New
York banks after midsummer, CD issues at
other banks slowed.
From August through November, issuing
rates of New York banks were close to or at
Regulation Q ceilings about half the time,
and total certificates outstanding showed
only a small increase. Aside from the rise
in market rates relative to the ceiling,
lessened corporate liquidity and wider use
of the capital market— with a consequent

In millions o dollars
aize oi oariK
(total deposits in millions
o f dollars)



Under 100.......................................................
1 000 and over...............................................






N o t e . —Data






— 13











-2 /


— 11




are based on Federal Reserve surveys for dates specified. Surveys of May 18, 1966, and Aug. 31, 1966, adjusted for change in


reduction in demand for bank credit—
helped to check the rate of growth of CD’s.
Contrary to experience since 1961, when
long-term rates had tended to fall and short­
term rates had moved up slowly, both longand short-term rates rose rather steadily
after mid-1965. Trading in the secondary
market reached a peak of about $78 million
in July, with demand centered on certifi­
cates maturing on tax and dividend dates
in the fall. After that, activity declined
irregularly until the year-end, except for a
small pick-up in trading in October for yearend maturity dates. As in the second and
third quarters of 1963, some of the decline
in activity was caused by the unwillingness
of many holders to liquidate at a loss.
Although dealer positions reached a high
for the year of $282 million in October
1965, both positions and the volume of
trading failed to reach levels attained in the
last half of 1964. As the fourth quarter
progressed, the market became thin and
uncertainty about the outlook for rates
developed— culminating with the changes in
the discount rate and Regulation Q early
in December. In general the market lacked
the breadth that had been characteristic of
1964 and early 1965 and reflected some
lessened over-all interest in new issues of
CD’s and some slowing in the volume
offered. The market also was affected sigficantly by the removal of the 1 per cent
ceiling on issues maturing in less than 90
days. Dealer positions were influenced by
less strong potentials for profits.
Changes in market activity: 1966

The secondary market suffered a sharp set­
back in 1966. The year is distinguished
from the previous period in several respects,
all of which significantly influenced activity
in the market. Among these forces are the
following: the pattern of both long- and
short-term rates; the new Regulation Q ceil­


ings, which established a single rate at 5 Vi
per cent for all maturities of 30 days or
more; the large increases in the ceilings; a
record rise in amount of CD’s outstanding
during the spring, followed by a marked
decline later in the year; the change in
character of trading; and greater diversity
in the supply of all short-term money market
instruments (Table 6 ).
While the December increase in Regula­
tion Q ceilings provided considerable flexi­
bility for banks to raise their rates, it also
made it practicable for banks to issue matu­
rities as short as 30 days. Over the year-end,
as market rates rose sharply and competi­
tion quickened, the banks— particularly
those in New York— preferred to empha­
size issuance of shorter maturities rather
than to pay the rates necessary to attract
longer-term money. Leading banks paid
4.80 per cent on 3-month certificates, and
out-of-town banks were paying up to 5 per
cent. At the same time there were small
increases in longer-term— 6 months and
over— maturities, which limited further
average shortening. In February the aver­
age maturity was 3.3 months. The volume
of Treasury tax-anticipation bills outstand­
ing for March and June made it more diffi­
cult to issue certificates for those dates.
Between November 1965 and February
1966, there was a small net decline in certi­
ficates outstanding. This was the first quar­
terly decline on record since CD’s were first
issued (Table 8 ).
As the year developed, both short- and
long-term rates continued the sharp rises
that had begun in the summer or fall of
1965, and the advance in rates became
more rapid as monetary restraint intensified
and reinforced upward rate pressures stem­
ming from heavy credit demands. New
issues of certificates accelerated with these
developments in March, and by mid-May
the volume had increased about $1.4 billion


— one of the largest quarterly increases.
Two increases in the prime rate after D e­
cember— particularly the one in March to
5 Vi per cent— made it possible and profit­
able to seek certificates aggressively.
Emphasis shifted toward sales of maturi­
ties of 6 months and over, in part to avoid
earlier rollover problems on tax dates and
in part because loan demands were expected
to continue strong. Offering rates were in­
creased more on longer maturities than on
short ones, and the average maturity in May
rose to 3.8 months. Market rates rose above
the CD ceiling in July, and certificates out­
standing leveled off and began to decline
in August. Run-offs amounted to about $3
billion at the end of November. Certificates
became competitive only with 1-month
maturities of market instruments. With the
increase in the prime rate in early July to
5 3 per cent, leading banks began issuance
of 30-day maturities at 5 Vi per cent.
Certificates of these banks subsequently be­
came available in the secondary market at
rates above 5 Vi per cent. The situation be­
came intensely competitive in the summer
as rates of all short-term and long-term
investments approached or reached record
Dealer positions in certificates during the
first quarter of 1966 averaged only about
$70 million, the smallest first-quarter hold­
ings on record. This contrasts sharply with
inventories that ranged from $150 million
to about $210 million in an average month
in 1964 and 1965. Although dealers: will
purchase certificates for inventory at even
or negative carries if the prospects for re­
selling at a small profit are good, the situa­
tion in the first quarter of 1966 exposed
them to undercutting of positions. Issuers
could make unexpected changes in rates at
various maturities. Trading averaged only
$40 million, about $10 million to $15 mil­
lion below the levels of the comparable

quarter in the two previous years. Trading
was affected by the increased availability
of shorter maturities from issuers, and the
Treasury tax-anticipation bill maturing in
March tended to cut market demand. One
or two corporations that were pressed for
cash and did not want to sell certificates at
a loss arranged reverse repurchases with
dealers until the March tax date. These
transactions accounted for part of the in­
crease in dealer positions in February and
During the second quarter of 1966,
although the competition for funds intensi­
fied, the supply of certificates with empha­
sis on longer maturities increased substan­
tially. Banks were willing to pay higher
rates, and corporations improved their
liquidity by selling new bonds. Treasury
bill rates had begun to drop in March, and
the yield spread between certificates and
bills widened substantially. Expectations
seemed favorable for carries. Dealers ac­
cordingly added to positions cautiously—
buying principally certificates maturing
around the September and December tax
and dividend dates. Inventories rose from
an average of $80 million in March to a
peak of $215 million in May. This level,
however, was well below that of previous
years (Chart 2 ).
Trading volume increased with the March
and April tax and dividend dates and
reached a high point in June for the mid­
year and early fall dates. The trading level,
however, never exceeded an average
monthly level of $55 million— roughly
equal to the trading lows in 1964 and 1965.
The money market atmosphere had changed,
and concern had developed about dealers’
ability to finance inventories and about the
availability of supplies. As rates rose, the
spread between yields on Treasury bills and
CD’s reached 101 basis points at the end
of June, with a large part of the spread



reflecting diverse movements in the supplies
of short-term investments during the halfyear (Tables 6 and 7 ). Toward the end of
June rates on loans to securities dealers
approached the banks’ prime rate and later
exceeded it. Dealer bids for CD’s in part
came to be based on the cost of carrying
them on loan and not on the basis of resale
price. Spreads between bid and asked quo­
tations widened.
As the secondary market weakened, some
corporate treasurers had their authority to
purchase certificates revoked and others
were limited or further restricted as to which
banks’ certificates they could buy. Depend­
ence upon the Treasury bill market for
liquidity was increased.
During the summer quarter both trading
and positions declined sharply to very low
levels. Inventories were cut from an average
level of $180 million in June to $35 million
in September when they leveled off. The
sharp drop reflected some “dumping” by
dealers at a loss. Trading volume was cut
almost two-thirds, to an average level of
$20 million.
The decline occurred at a time when
market rates broke through the Regulation
Q ceilings and then moved substantially
above them (Charts 1 to 3 ). Many sales by
investors thus could be made only at a loss
of principal funds, and there was some dis­
tress selling. During most of the time only
1-month maturities of new issues had yields

that were competitive with those on other
money market investments. Trading in the
market continued to concentrate on matu­
rities of less than 30 days and special situa­
tions. Market preference turned almost ex­
clusively to certificates of the major banks,
and generally there were between 20 and 25
issuers in the market. This condition char­
acterized the market until the middle of
Banks had begun to have difficulties in
rolling over certificates in late August. After
August outstanding CD’s declined steadily
and by early December about $3.2 billion
had run off. Both rate and nonrate factors
were contributing causes. Some banks ap­
pealed to customer loyalties to lessen run­
offs. Worry, apprehension, and even desper­
ation “dogged” dealers and investors alike.
Yields on short-term money market in­
vestments reached peak levels in September
and October, as shown in Table 9, and
remained high throughout October. As the
banks became still more restrictive in grant­
ing credit during the early fall, the increased
costs and shrinkage of availability of dealer
loans and repurchases compounded market
Some easing in short-term market rates
began in November and continued into
December, supported in part by a shift
toward ease in credit policy. The market
atmosphere improved slightly, and dealers
cautiously began to consider small increases

Yields in per cent; net change in basis points

Net change from
peak to—

3-month maturities of—
Treasury bills.......................................................
Finance paper......................................................
Federal agency issues.........................................
Bankers’ acceptances..........................................
Certificates o f deposit........................................

Nov. 3,

Dec. 22,

Nov. 3,




— 19

Dec. 22,


in positions. There was also some revival of
interest in market purchases by investors,
but the market remained soft. Attraction to
the market was chiefly the result of the
decline in Treasury bill yields, as they fell
substantially below certificate yields. Issue
rates remained at 5 Vi per cent for 30-day
or longer maturities, and banks continued
to have trouble in rolling over maturing
In contrast to these changes in the certifi­
cate market, activity in both the acceptance
and Treasury bill markets over the year
exceeded somewhat the levels of the pre­
vious period. Average daily volume of trad­
ing in acceptances in 1966 was about $63
million monthly, up noticeably from 1964
and 1965. Treasury bill trading rose to an
average monthly level of $1.5 billion, up
about $150 million.
Positions of acceptance dealers averaged
about $280 million, some $60 million higher
than the levels in 1964 and 1965. The larger
inventories carried by dealers resulted from
increased sales into the market by accept­
ing banks, as banks’ money positions came
under pressure. Banks’ holdings of their
own acceptances declined to about 30 per
cent of their total acceptance portfolio as
compared with 49 per cent and 36 per cent
in 1964 and 1965, respectively. Bypassing
of the dealer market was reduced. Investors
were attracted to acceptances by the high
interest rates relative to those on other in­
vestments. Dealers’ positions in Treasury
bills were about the same as in the two pre­
vious years.
Holdings of acceptances and Treasury
bills, however, were sharply reduced as the
cost of carries mounted during the summer,
and funds became short in supply. Accept­
ance inventories averaged only $ 181 million
in contrast with an average of $350 million
for the first two quarters. Repurchase agree­
ments by the Federal Reserve had been con­

sistently available until mid-July, but from
then until the end of September there were
none. Withdrawal of these agreements at
4 V2 per cent materially raised the cost of
“carry” and forced the lessening of inven­
tories during the third quarter. Similarly,
Treasury bill positions were cut almost in
half during the summer quarter, in part
because of rising costs but also because of
scarcity of bills and heavy demand.
The volume of acceptances outstanding
remained close to the 1964 and 1965 levels
as did Treasury bills. This contrasts with
the pattern of outstanding CD’s, which rose
to a peak in August and then declined very
sharply (Chart 4 ).
Reporting member banks

Actual cumulative change from Jan. 1 of each year.

Comparison of the dollar volume of trans­
actions with the dollar volume of outstand­
ings for each instrument indicates that
trading in both acceptances and Treasury
bills rose substantially. From January
through June trading volume ranged on the
average from 0.23 per cent to 0.30 per cent
of CD’s outstanding; from 1.22 per cent to



1.52 per cent for acceptances; and from
2.38 per cent to 2.73 per cent for bills.
The percentages for certificates were less
than half those reported for earlier years,
whereas the ratios for acceptances and bills
were more or less unchanged. As noted
earlier, activity in certificates was materially
affected by the establishment of a single
rate for all maturities and by the increases
in market rates relative to the ceiling. After
June trading in certificates shrank to 0.13
per cent of the total outstanding, while
trading in acceptances and bills remained
the same or increased slightly— ranging be­
tween 1.6 per cent and 1.8 per cent and 2.53
per cent to 3.00 per cent, respectively.
Comparison of the dollar volume of
dealer inventories to the dollar volume of
outstandings also shows a marked change
for certificates in 1966 as compared with
the previous period. From January through
June this ratio ranged on the average from
0.33 per cent in February to 1.20 per cent
in May, and in September and October
declined to 0.19 per cent and 0.27 per cent,
respectively. All of these ratios are small
fractions of those of previous periods and
reflect a greater change in positions than in
outstandings. The ratios for acceptances
ranged from 11.3 per cent in January to
8.6 per cent in June, dropped to 4.0 per cent
in August as markets tightened, and re­
turned to earlier levels during the fall. These
ratios for acceptances, except for the sum­
mer quarter, are similar to those of 1964
and 1965. Ratios for Treasury bills aver­
aged about 3.21 per cent and showed little
significant variation from earlier years. They
were lower, however, during the tight
market of the summer.
Perhaps the most striking contrast in
activity in the secondary market is in the
change in the dollar volume of transactions
in relation to the dollar volume of positions.
During the first half of the year these per­

centages for certificates ranged from 70 per
cent in February to 27 per cent in May and
were substantially above most months in
1964 and 1965. After June they ranged
between 22 per cent and 65 per cent.
Positions dropped somewhat more than
transactions did. For Treasury bills too, the
ratios were larger than in the earlier period
and reflected higher levels of trading and
some reduction in position as costs mounted.
During June and July, trading in bills ex­
ceeded positions by 40 per cent and 18 per
cent, respectively. Transactions in accept­
ances reflected the increase in investor
interest. Both trading volume and positions
rose, however, and the ratios were un­
Market activity: mid-December 19 66January 1967

A shift from outflow to inflow of certificates
began at banks in mid-December and ac­
celerated rapidly in January as declines in
market rates of interest made the instru­
ments relatively more attractive. CD’s issued
by large weekly reporting banks increased
by about $2 billion in January, a new
monthly record. The combined increase for
December and January amounted to $2.3
billion and brought certificates outstanding
back to a level of about $18.1 billion. As
short-term rates declined further after midJanuary, many of the larger banks reduced
their offering rates. At the month-end a
number of banks were offering rates of 5 Vs
per cent for all maturities, and some banks
posted a 5 per cent rate for CD’s with
3-month maturities. Even at this level yields
on new 90-day certificates exceeded Treas­
ury bill discounts by 50 basis points. Some
extensions in maturity ranging up to 3
months were also made.
In the easier atmosphere in December
and with prospects for further ease, dealers
began to rebuild positions in anticipation of


profits. Toward the year-end they made
large additions to inventories as develop­
ments seemed to suggest an abrupt and
rapid movement in the over-all structure
of rates to lower levels. Dealers acquired
maturities that were as long as possible,
most of them with June and December dates
carrying coupons of 5% per cent and 5 Vi
per cent. Some dealers later cut back on
their holdings of some of the longer matu­
rities and emphasized instead certificates
with early summer and early fall maturities.
Dealer positions for January averaged $360
million— a record high— and although trad­
ing volume increased, it failed to rise commensurately. For the month it averaged
only $60 million. Positions were six times
larger than the volume of trading as com­
pared with typical ratios of 4:1 in the
active markets of 1964 and 1965.
In part, trading volume did not increase
to its earlier proportions relative to positions
because of competition from new issues and
some lack of a balance in maturities in
inventories. Dealers were also reluctant
sellers. Improvements in availability of
financing at lower rates provided a “running
carry” or at least one that was only modestly
negative. In other markets dealers’ holdings
of securities also increased but not to the
same extent relative to trading.
This dramatic resurgence of positions
accompanying the rapid drop in market
rates was a complement to the equally

dramatic decline in inventories in 1966
associated with the sharp upward movement
in rates. It reflects largely the speculative
tendencies that may accompany the un­
winding of tight markets.
As shown in Table 10, downward adjust­
ments in yields on acceptances, finance
paper, and certificates were substantial in
January 1967, and they accounted for all
of the adjustment from the SeptemberOctober peaks for finance paper and some­
what more than half for the other two
investments. These drops in rates on money
market paper, which had previously shown
only sluggish moves, accompanied declines
in rates at the bank counter and in the
capital markets.
The secondary market for certificates
awaits a test of what it may consider are
normal conditions; that is, a period char­
acterized by stable or declining yields and
one free from the changes in Regulation Q
that have been a feature of market activity
to date. Patterns and levels of activity under
such conditions are unknown.
Future market activity
As long as Regulation Q provides a single
rate for maturities of 30 days or more— with
issue rates at the ceiling and market rates
on comparable maturities above the ceiling
— trading in the secondary market will con­
tinue at relatively low levels. The floating
supply of CD’s tends to undergo a constant

Yields, in per cent; net change in basis points
3-month maturities of—

Treasury bills.............
Finance paper............
Federal agency issues.
Bankers’ acceptances.
Certificates o f deposit

Net change from


Dec. 22,

Jan. 31,

1966 to
Jan. 31,

Dec. 22,
1966 to
Jan. 31,




— 108
— 125

— 11
— 100



suited from the provisions of Regulation Q.
The secondary market for certificates has
had a relatively short period of development
and testing. Nevertheless, it may be said
that a basic framework has emerged on
which future activity can build. Whereas
comparisons of the certificate market with
competitors are often made, they are not
altogether valid. None of the other markets
have been exposed to constraint similar to
that provided by Regulation Q. The accept­
ance market and Treasury bill markets, on
the other hand, are officially recognized as
markets in which the System conducts open
market operations, and dealers in both mar­
kets may have repurchase facilities extended
to them at times to help finance inventories.
Aside from these important aids, these mar­
kets have the distinct advantage over the
certificate market of a long period of devel­
opment in which practices and mechanisms
have evolved that contribute to their greater
breadth and other qualities.
With or without official recognition or
help, the certificate market of the future is
likely to be somewhat different from the
past. The future market— reflecting shifts
and refinements based on the historical ex­
perience of the monetary authorities, issuers,
buyers, and dealers— should be more con­
tinuous. Diverse characteristics of CD’s
should be further reduced, supplies should
be less variable, and progress should be
made toward a more standardized form of
credit risk. It is also to be expected, if
Regulation Q remains, that the spasmodic
periods of illiquidity for certificates asso­
ciated with changes in the regulation will
be avoided or substantially moderated.
Official and private action along these lines
should help to encourage a widespread in­
crease in demand, and this factor alone
should help to eliminate differentials in
1 This is particularly true of corporations that can­ issuing and trading rates for CD’s of many
not make the same flexible use of capital losses as
banks do in offsets against income.

decline. New issues are prohibited. Holders
of outstanding issues are deterred from sell­
ing because of capital loss,1 and dealers
face a penalty cost in carrying inventory.
Buyers show a strong reluctance to extend
maturities. Participants are also concerned
with the possibility of an unexpected change
in Regulation Q. Moreover, there is a com­
peting supply of desirable investments with
coupons or yields not subject to the con­
straint of regulation. Although dealers will
make some bids that vary with maturity and
reflect the structure of market rates, there
is evident discontinuity, and many trades
are negotiated individually. This back­
ground does not produce a well-defined yield
curve characteristic of some other markets,
even though tight.
When market rates fall below the Regula­
tion Q ceiling and stable or declining rates
encourage issuance of new CD’s, trading
volume should advance moderately. The
volume will fluctuate with the ability of the
banks to issue longer-term maturities, and
the market will supply the desired shorter
maturities. Dealer positions may be some­
what smaller under these conditions, be­
cause they are exposed to greater risk than
when the regulation prohibited issues of
shorter maturities. The potential for profits
will be relatively limited unless there is an
opportunity to “age” CD’s. Under the cir­
cumstances the dealer, as noted, runs the
risk of having issuers make unexpected
changes in rates at various maturities. The
new supply comes out and competes with
the old. The dealer is also exposed to the
risk of a change in the Regulation Q ceiling.
Even with a new-issue market substantially
larger than there is at present, secondary
trading probably will not reach the levels
of 1964-65, which to a great extent re­


As the CD market expanded, various pro­
posals designed to improve the marketability
and appeal of certificates to both buyers and
issuers were made by the monetary authori­
ties and participants. Some of the proposals
have the objective of providing easier access
to the market by small banks. Other sugges­
tions involve merely changes in market
Issuance of certificates on a discount basis

Many observers believe that the appeal of
certificates to corporate and institutional
portfolio managers would be greatly in­
creased if the certificates were issued on a
360-day discount basis instead of yield to
maturity. Issuance on a discount basis would
facilitate computation of purchase and sale
prices and would avoid the awkward for­
mula now used to make the conversion.
In addition, issuance on a discount basis
would make it possible for most holders to
avoid showing book losses unless a very
sharp change in rates occurred. Some large
buyers are not willing to sell into the market
if the sale would cause a book loss, and this
factor lessens the appeal of certificates as
compared with competing instruments. A
change to issuance on a discount basis might
result in a substantial gain in marketability.
Some banks state that placing CD’s on
a discount basis was considered when the
market began. This method was rejected
because (1 ) according to convention, cer­
tificates had been issued on a yield-tomaturity basis; (2 ) effective costs would
be higher; (3 ) interest accrues daily, and
the value of the deposit changes daily—
hence there would be a mechanical problem
in computing required reserves; (4 ) some
customers insist on a yield-to-maturity basis;
and (5 ) issuance of certificates on both

bases would split the trading market into
divisions and would lead to confusion. A l­
though some banks now believe that these
reasons exaggerate possible difficulties, they
think that it would be almost impossible to
turn the market around.
FDIC insurance coverage

Some observers suggest that complete insur­
ance coverage be granted certificates. This
proposal would obviously provide a high
degree of marketability. It is not clear, how­
ever, how this proposal can be justified
without applying the same coverage to
other deposits. Individual unit banks are
separately capitalized, differ substantially in
performance, and rise and decline in profit­
ability with their managements. Complete
insurance coverage would subsidize poor
management. This cost would seemingly be
greater than the benefit of improved mar­
ketability and attendant improved flow of
Dealer's endorsement

If a dealer would stamp or endorse bank
certificates— charging a customary fee as
in the case with acceptances— yield spreads
of lesser known banks could be standard­
ized and marketability improved. Dealers,
however, state that they do not want to
assume the obligation of certifying credits.
Furthermore, they believe that impersonal
market evaluation of credit risk should be
encouraged. The market currently decides
on an impersonal basis which banks can
grow or be tided over, but it does not give
a guarantee of credit soundness. Yield
spreads frequently give valuable warning
signs to the purchaser and perhaps to the


Provision of information by Federal Reserve

If the Federal Reserve Banks were to act
as a regional clearinghouse for information
about banks wanting to issue certificates
and about those willing to buy them, or if
they were to function as brokers in matching
deficit needs for funds of smaller banks
with surplus funds of other banks through
an exchange of certificates for deposits, the
market would view these actions with con­
cern. Participants state that such actions
would be considered tantamount to guaran*
teeing the soundness of the bank receiving
the deposit. And if the bank should become
overextended, the Federal Reserve would
be subject to criticism. Whereas this pro­
posal would promote flows of funds and
provide easier access to the market than
exists for some banks, it is not clear that the
needs of those banks are closely suited to
the average certificate maturity; their needs
by and large are considered to be somewhat
longer term.
Group marketing of certificates of smaller

In early 1966 a large commercial paper
house, commenting on the “inequity of
money rates,” stated that the secondary mar­
ket for certificates of major money market
banks had consistently yielded more than
the market for major finance company paper
of a similar range in maturity since August
1964. This was attributed to weak second­
ary market support of CD’s. Money costs
for smaller banks, whether in major centers
or in outlying regions, were reflected in
spreads above these rates. In an attempt to
improve the liquidity of CD’s and the
mechanical ease of trading them— looking
toward reduction of the premium and a
proper yield relationship to the other money
market instruments— the firm suggested that
a consortium of regional banks be organized


and that the firm be recognized as the lead­
ing dealer in the secondary market certifi­
cates for the consortium. Under this pro­
posal the house would undertake to make
a market reflecting a “proper dealer-spread”
such as exists in acceptances. For instru­
ments of members the dealer would post
daily quotations and would advertise a mar­
ket with a spread of 10 basis points. Yields
in such a market would be quoted in five
one-hundredths of a percentage point by
various maturity categories, as in markets
for acceptances and direct-issue commercial
paper. Adjustment to the rate scale for CD’s
would be made when the dealer’s position
reached key levels in relation to the amount
of financing available to the dealer.
Participating banks could post a rate on
an original issue of certificates at the sell
side of the dealer’s posted market; that is to
say, at a lesser rate. They could not post
a rate higher than that posted by the dealer.
The participating banks would provide the
dealer with financing necessary to carry
reasonable positions— the rates on such
financing to be equal to the interest earned
on certificates held in loan position less any
trading loss on certificates sold out of posi­
tions. In the arrangement the dealer would
not realize any profit on certificates held in
position. This plan was expected to allow
the issue rate for members to be reduced
substantially. On the assumption that the
participating banks would use the Federal
funds market as a source of money to pro­
vide dealer financing, it was expected that
there would be a profitable arbitrage be­
tween the Federal funds rate and the interest
earned on certificates held in loan position.
By establishing a known and advertised
market for the certificates, it was argued
that the issue rate for participating banks
would be reduced to levels prevailing for
major finance company paper and bankers’


The consortium was not formed. Most
of the prospective participants felt that they
were placing CD’s satisfactorily. Some
thought that advantage would be taken of
customer relationships. Others felt that the
advantage rested largely with the dealer.
Since losses would be absorbed by the lend­
ing banks and the cost of carries would
equal the rate earned on CD’s, the dealer
would sustain no cost at all for the financing.
Purchase of certificates by the System

In the interest of increasing the market­
ability of certificates of smaller banks, the
proposal has been made that the manager
of the Federal Open Market Account make
direct purchases of certificates from time
to time. Participants in the market state,
however, that such action would subject
the System to political pressures and criti­
cisms, which should be avoided. Beyond
this it is believed that the “feel of the
market” and the warning signs provided by
changes in flows under current conditions
would be lost. Although having little sub­
stance as to the likelihood, the eventuality
of official rate pegging is also a background
fear. In this general connection about onethird of the replies from monetary eco­
nomists to a U.S. Congress Joint Economic
Committee questionnaire in late 1965 re­
questing an opinion about broadening of
the list of credit instruments eligible for
purchase by the System Open Market A c­
count favored the maintenance of current
policy. Acquisition of private credit instru­
ments would involve entrance into relatively
narrow markets. Less than one-tenth of the
replies favored giving the Federal Reserve
more flexibility in this regard. One eco­
nomist, however, specifically recommended
dealing in CD’s.

Extension of System repurchase agreements
to dealers

Repurchase agreements by the System are
now entered into with dealers in acceptances
and in U.S. Government securities, and
some market participants favor the addition
of repurchase agreements on certificates.
Unless the certificate were made eligible
for purchase by the System Account and
eligible for discount, there seems little to
favor this proposal. Some have asked why
this market should be distinguished from
municipal bonds or mortgages of short-dated
maturity. If a recent proposal to make
acceptances ineligible for repurchase is
acted upon, inclusion of certificates would
be still harder to justify.
Greater market freedom with respect
to CD rates

The secondary market for certificates for
most of 1966 was a market by designation
rather than transaction. Although this state­
ment may not be an accurate characteriza­
tion of the current market, it is still a matter
of concern to participants in the market
and it raises a question about the kind of
secondary market that can be expected in
the future if Regulation Q is used aggres­
sively as one of the policy instruments to
control bank credit. The administration of
Regulation Q at various times in the past
has maintained unrealistic maxima of rates,
with the result that the CD facility as a
whole— both the new-issue market and the
secondary market— has not always been
attractive to users. Rigid ceilings have also
been responsible for development or expan­
sion of several financial arrangements that
may be considered questionable. These in­
clude use of repurchase agreements between
banks and corporations, use of brokers in
placing CD’s, expansion of the Euro-dollar


market, issuance of short-term unsecured
negotiable notes, and some loss of interestsensitive funds by nonprime banks to large
prime banks.
Market participants favor greater free­
dom in the establishment of certificate rates.
To this end they argue that all buyers would
use the facility more regularly if they had
assurance that it would generally be attrac­
tive to them. Under these conditions issuers
would not be forced to experience liquida­
tion of CD’s at maturity, and investors
would find marketability more reliable.
In the absence of official action to permit
the underwriting or subsidizing of CD’s,
and without radical change in the structure
of the banking system, economic forces and
the momentum of the national money mar­
ket will continue to draw a preponderant


share of CD’s to the large prime banks.
Corporate customer relationships and the
size of these banks are interacting and inter­
dependent factors, which explain these
banks’ share of market trading as well as
investors’ preferences for these names.
As in the acceptance market where there
is a high degree of concentration— 40 of the
125 accepting banks account for 80 per
cent of all acceptances outstanding and the
acceptances of these 40 banks comprise the
bulk of the trading— the market for interestsensitive CD funds is concentrated in the
important financial centers. The banks out­
side these areas service local markets, and
their customers by and large are less interest
sensitive. CD’s issued in these markets
should not be considered as being the same
as those issued by large banks.

February 1967


Parker B. Willis
Federal Reserve Bank of Boston

Major Findings_______________________________________________________________________________ _


Description of the M arket_________________________________________________________________________ 75

Interbank trading
Brokers, accommodating banks, and accommodating and correspondent
General patterns of funds activity
Country Banks and the M arket___________________________________________________________________ 80

Growth in participation
Sales of funds
Purchases of funds
Some district comments on funds trading
Federal Funds Versus Borrowing at Reserve B an k s____________________________________________86
The Federal Funds R a te ___________________________________________________________________________


The Market as a Source of and Outlet for Federal Fu nd s_____________________________________ 89
Alternative Instruments or Systems of Control__________________________________________________

Auctions of Federal funds
Federal Reserve Banks as clearinghouses for Federal funds transactions
of smaller banks
Bibliography_________________________________________________________________________________________ 93





This study has several purposes: (1 ) to
evaluate the operations of the Federal funds
market, with emphasis on the participation
of country banks as a source of funds com­
plementary to those provided by the Federal
Reserve discount window; (2 ) to determine
whether it is feasible and desirable to pro­
mote a further development of this market
so as to reduce commercial bank reliance
on the discount window; and (3 ) if such
is the case, to recommend the degree, if any,
to which the Federal Reserve should become
involved in that development. Federal funds
are balances on deposit with Federal Re­
serve Banks that, together with vault cash,
constitute the legal reserves that member
banks of the Federal Reserve System must
hold in a specified ratio to deposits. Federal
funds transactions refer to the lending
(selling) and borrowing (buying) of these
balances or claims on such balances at rates
of interest set by the parties to a transaction.
This study analyzes data on transactions
in Federal funds to determine how the exist­
ing market functions and the extent to which
banks of various types can and do operate
within it. Analysis has been supplemented
by interviews with “knowledgeable market

participants.” In these interviews probing
was directed to assessing the current nature
of these markets with respect to “depth,
breadth, and resiliency,” and to ascertain­
ing any changes in these market qualities
over time— seasonally, cyclically, or secu­
larly. An attempt was also made to deter­
mine the underlying causes for any deficien­
cies in market operations for the several
classes of banks studied.
Some consideration was given to proce­
dures that might improve market operations.
This related to the problem of Federal
Reserve involvement if the System were to
act as a clearinghouse for information about
market functioning as a broker for Federal
funds, or were to utilize the Federal funds
market as a medium for controlling open
market operations.
From time to time the performance and
characteristics of the Federal funds market
have been reviewed in detail by Federal
Reserve System committees and by members
of the staffs at the Reserve Banks. The bibli­
ography contains a list of System publica­
tions that discuss the function of the market,
variations in patterns of activity, and extent
of member bank participation.

1960’s— confirming and sharpening the
structural outline of the market and in­
creasing its dimensions. Throughout the
1920’s banks used Federal funds almost

The market for Federal funds has experi­
enced two periods of marked development
— the 1920’s and the 1950’s. Its develop­
ment during the 1950’s carried into the



exclusively in adjusting their reserve posi­
tions. While banks continued this method
of reserve adjustment in the later period,
the volume of Federal funds acquired in­
creased in importance both (1 ) as an out­
let for short-term investment of secondary
reserves and (2 ) directly or indirectly in
connection with the financing of U.S. Gov­
ernment securities dealers. And in the
1960’s an increasing number of banks
sought Federal funds to support their ex­
pansions of loans and investments.
Through the early 1950’s, the structure
of the market changed somewhat— shifting
from a direct exchange of Federal funds
among banks to an exchange through an
intermediary or a broker. The development
of facilities for matching the supply of and
demand for funds through a broker was
accompanied by an even faster growth in
market activity and in the number of accom­
modating banks. At the same time the mar­
ket changed from one that was primarily
regional and local in character to one that is
strongly national, with its center in New
York City. With the further growth of
accommodating banks outside New York
since 1960, and the matching of transactions
within correspondent groups, transactions
in the central market are now largely for
the purpose of clearing residual needs.
Currently it is estimated that more than
2,300 country banks, or more than one out
of every three, participate in the market
either as buyers, as sellers, or as both.
Participation rates range from about 17 per
cent in the Minneapolis district to 83 per
cent in the Boston district. Five districts
report a range of 40 to 50 per cent.
Similarly, virtually all of the reserve city
and large country banks are now active in
the market. The number of country banks
using the market has increased more than
fivefold since 1960.
As a rule, country banks are more often

sellers than buyers, and they sell substan­
tially more than they borrow. The typical
movement of Federal funds is from small
country banks to small city banks to major
city banks.
Country banks supply net to the market
about $800 million to $1 billion on a daily
average, constituting a fifth to a quarter of
the total volume of trading. This represents
from 10 per cent to 12 per cent of required
reserves of country banks. The increased
participation is reflected in reductions in the
ratio of their excess reserves to required re­
serves and in the ratios of balances due from
banks to total deposits.
Relatively few country banks rely heavily
on the Federal funds market as a source of
funds, and the effect of their aggregate
transactions on the market is negligible.
Average daily purchases do not exceed $300
million, or about 3.7 per cent of their re­
quired reserves. In sharp contrast to atti­
tudes of most of the large banks, many
country banks turn exclusively to the Fed­
eral Reserve as their source of borrowed
funds, although they use the Federal funds
market regularly to dispose of funds.
There is still evidence that a good many
small banks have no knowledge of the Fed­
eral funds market. In addition, some small
banks are innately conservative, and they
prefer to hold excess reserves rather than
run the risk of having to borrow to offset
deficits when they occur.
Transactions in Federal funds are accom­
plished rapidly and efficiently in increasing
volume for increasing numbers of banks at
nearly uniform rates. This reflects a high
degree of adjustment between demand and
supply and between price and quantity
The growth in unity and breadth of the
market during the 1960’s and the increase
in its efficiency have strengthened the “links”
among the various divisions of the money


market and the links of the money market
with the markets for longer-term credit.
A given volume of Federal funds now moves
through the market with a smaller change
in rates than in earlier years. Market par­
ticipants may move back and forth from one
sector to another of the shorter-term money
market in response to shifting rate differen­
tials without causing unacceptable price
The Federal funds market mechanism
now consists of four brokers and perhaps
as many as 70 accommodating banks in
principal cities throughout the Nation. The
number of regional accommodating bank
arrangements increased in response to com­
petition from large central money market
banks. More recently competition among
regional banks in soliciting business over
wider areas than earlier has forced local
competitors to establish facilities for their
own correspondents.
The variety of facilities for trading Fed­
eral funds is a product of the last 10 years.


The new facilities reflect heightened com­
petition among banks, changes in policies,
and more widely diffused knowledge of the
market. It is now possible for all but the
very small banks to keep most of their funds
fully invested. Transaction units have been
reduced from $1 million to $200,000 and
even to as little as $25,000 in some in­
There is no concrete evidence that small
banks find it difficult to gain access to the
market. As needs have grown, the market
mechanism has been modified to facilitate
their transactions.
Participants view the suggestions for a
Federal funds auction with concern.
Auctions would replace completely or radi­
cally alter the present range of facilities,
which now satisfy efficiently both sides of
the market— facilities that have evolved
over time “to bridge” the unit banks. The
sensitive index of pressures within the bank­
ing system provided by the Federal funds
rate would then be lost.

The money market is made up of institu­
tions that provide a mechanism for the ex­
change of cash balances for short-term
interest-bearing obligations or for the ex­
change of such obligations for cash balances.
At present most of these shifts in the form
of reserves are handled through a closely
connected nationwide network of arrange­
ments. Commercial banks are significant
participants in the money market as either
buyers or sellers of money market instru­
ments, largely to maintain their legal re­
serves at required levels. Among the instru­
ments they use are Federal funds. Purchases
or sales of Federal funds permit adjustment
for either a deficit or a surplus in a bank’s
reserve position at the Federal funds rate

and thus constitute an important element in
the administration of an individual bank’s
The market for Federal funds, now almost
50 years old, is a byproduct of Reserve Sys­
tem organization imposed on the American
unit-banking structure. It emerged in the
early 1920’s as an offshoot of the money
market. Normally, transactions in Federal
funds are for overnight, and the rate of in­
terest is negotiated or determined by the
supply and demand in the market. The mar­
ket cannot increase or decrease total mem­
ber bank reserves but can only redistribute
them and by so doing makes possible a fuller
use of bank reserves and resources.
Sometimes banks will deliberately run


“short” on their reserve positions by lending
reserves to other banks— thus causing or
sometimes increasing a daily deficiency that
they expect to cover later in the reserve pe­
riod. On the other hand, some banks depend
on this market as a source of funds for carry­
ing an overinvested position in loans or se­
curities for short periods.
Facilities for accomplishing Federal funds
transactions have been developed in large
part during the last 10 years. They reflect
the growth of the market, heightened com­
petition among large as well as many small
banks, changes in practice and policies of
participants, and more widely diffused
knowledge of the market. The market now
provides a way for all but the smallest banks
to maintain a more fully invested position.
A number of the smallest banks are unaware
of the market or have no desire to partici­
Member bank reserve balances are of uni­
form quality and can be transferred freely
throughout the United States. At present
such balances are bought and sold at sev­
eral locations in each Federal Reserve dis­
trict, but New York City still occupies the
prominent position and is the central mar­
ket because half of all transactions originate
in, or are handled by, that city and the
brokers and principal accommodating banks
are located there. Local selling points are
intimately connected with the central market
and with one another. They are linked in the
sense that price differences can bring trans­
actions from one market to another and that
some of the competing buyers and compet­
ing sellers carry out transactions in more
than one market within a district or in sev­
eral districts. In a real sense the market is
The two periods of marked development
in the Federal funds market— the 1920’s

and the 1950’s— have confirmed and sharp­
ened the structural outline of the market and
increased its dimensions. Throughout the
1920’s banks used Federal funds almost ex­
clusively as a method of adjusting their re­
serve positions. While banks continued this
method of reserve adjustment in the 1950’s,
the volume of Federal funds acquired in­
creased in importance both as an outlet for
short-term investment of secondary reserves
and directly or indirectly in connection with
financing of U.S. Government securities
dealers. In the 1960’s, an increasing number
of banks sought Federal funds to support ex­
pansion loans and investments.
Through the early 1950’s, the structure of
the market changed somewhat— shifting
from a direct exchange of Federal funds be­
tween banks to an exchange through an in­
termediary or a broker. The development of
facilities for matching the supply of and the
demand for Federal funds through a broker
was accompanied by an even faster growth
of activity and of number of accommodating
banks. At the same time the market changed
from one that was primarily regional and
local in character to one that is strongly na­
tional, with its center in New York City.
With the further growth of accommodating
banks outside New York since 1960, and
the matching of transactions within corre­
spondent groups, transactions in the central
market are now more largely for the purpose
of clearing residual needs. Thus, the func­
tions of the brokers changed from princi­
pally completing transactions for numbers of
individual banks of differing size to com­
pleting transactions to a greater extent for
the large money market and regional banks.
Interbank trading

Banks account for most of the activity in the
Federal funds market. On the average only
about 10 per cent of total activity is with
nonbank groups— chiefly U.S. Government



securities dealers, savings banks, and corpo­
rations— but at times, the proportion may
rise to 25 per cent. In 1966 on an average
day $3.5 billion to $3.8 billion shifted from
bank to bank, but at times the total came
close to $5 billion. The average amount has
increased significantly since the mid-1920’s
and had more than tripled by 1960. And the
number of banks participating has risen in
each year since 1950.

Brokers, accommodating banks, and
accommodating and correspondent systems

Some 300 member banks are regular par­
ticipants in the Federal funds market— buy­
ing and selling on from one to several occa­
sions in every reserve period.1 These banks
hold about 60 per cent of all commercial
bank deposits and include practically all
banks with $ 1 0 0 million or more of deposits.
The most active participants are found in
Federal Reserve cities, but some 40 of the
larger country banks have substantial regu­
lar dealings, and another 350 may trade as
often as 25 times a year. Some estimates
place the total number of participants as
high as 3,000 banks. Many of these will
have only one or two transactions during the
year and include banks that have deposits of
only $1 million to $2 million. Usually the
transactions of the smaller banks are sales,
which are made possible by excess reserves
arising from seasonal or temporary forces.

Until December 1958, when The Irving
Trust Company established its Federal funds
desk,2 Garvin Bantel Corporation, a mem­
ber of the New York Stock Exchange, was
the only broker in the Federal funds market,
and there were as few as seven or eight ac­
commodating banks, most of which were in
New York City. Garvin Bantel Corporation
had initiated its interdistrict business in 1948
and had encouraged participation by out-oftown banks. Participation by such banks be­
came significant in the early 1950’s, as in­
creasing numbers of banks began to direct
their transactions through that firm. Garvin
Bantel estimates that until about 1953 it
handled nearly 80 per cent of all trading in
Federal funds, but as the number of accom­
modating banks expanded, this proportion
dropped to 50 per cent in 1957 and later
fell to one-third. Since the entry of Mabon,
Nugent and Co., also a member of the New
York Stock Exchange, in the fall of 1963
and George Palumbo & Co., Inc., a money
broker, in November 1964, four firms have
shared the volume of Federal funds moved
through brokers. These firms are in daily
telephone contact with market participants,
and they act merely as agents in bringing
buyers and sellers together.
Although the volume of transactions han­
dled by brokers has increased since 1950, as
the number of banks seeking funds has risen,
most of the increase is the result of increased
trading by the larger banks. The number of
banks using brokers has failed to grow pro­
portionately. There are eight banks in New
York City and another 30 or more commer­
cial banks in other parts of the Nation— at
least two in each Federal Reserve district—

rA number of nonmember banks and agencies of
foreign banks are also traders— usually on the selling
side. The nonmembers include both small and large
banks and may number several hundred.

2 The Federal funds desk is run separately from
Irving Trust’s transactions in Federal funds for its
own account or for the accommodation of corre­



Number o f banks gross purchases
(millions of
30- 40

100- 250
350- 450

1 Figures are partially estimated approximate amounts. Lower
limits refer to earlier parts of designated periods.


that perform an accommodating business for
correspondents. Accommodating banks dif­
fer from brokers in that they generally deal
as principals and often trade on both sides
of the market. This group of roughly 40
banks constitute the major accommodators.
During the last 4 years, however, perhaps
another 40 have offered this service to a
limited degree.
The increase in the number of accommo­
dators in the Midwest, Southwest, and West
in 1964 and 1965 was significant. With the
exception of the San Francisco area,3 how­
ever, most of the important accommodators
are in New York, and with the brokers they
form the focal point of the market. Accom­
modators outside New York and San Fran­
cisco generally service correspondents on a
regional basis and may cross district lines to
a limited extent.
Some accommodators— two-way trading
banks— are net buyers, whereas others try
to maintain balanced positions. Although
all of the two-way traders are large banks,
not all large banks conduct two-way trading.
There are also differences in the use of the
market within a given area, including New
York. Many banks are referred to as adjust­
ing banks, for they may appear as net buy­
ers or as net sellers or they may run a bal­
anced position. The smaller the bank the
more likely it is to be exclusively a seller.
Development of regional accommodating
or correspondent systems facilitated the en­
trance of smaller banks into the market.
Such systems have been designed to meet
competition offered in regional markets by
the large central money market banks. More
recently, competition among the regional
banks, soliciting business over wider areas
than earlier, has forced local competitors to
3 Banks in the San Francisco Federal Reserve Dis­
trict accounted for more than one-sixth of the gross
transactions in Federal funds in 1966— a larger frac­
tion than for any other district except New York.
Two-way trades amounted to two-thirds of total trans­
actions of banks in the San Francisco District.

establish facilities for their own correspond­
ents.4 Perhaps more importantly these
arrangements reflect the attempt of the
larger banks in interior parts of the United
States to improve the flexibility of their own
reserve positions and to meet marginal needs
— thus helping to retain and improve their


number of
banks 1

(millions of dollars)



15- 20


100- 150




















650- 887

1 An accurate percentage o f Federal funds transactions cleared
through the brokers in relation to total activity cannot be computed
because of double counting. Not only does the activity of the accom­
modating banks overstate the net movement of funds from ultimate
supplier to ultimate user within a given day, but the activity of the
brokers will include some of the same transactions reported by the
accommodators. Hence, in a movement of Federal funds from Bank
X to Bank Y, two purchases may be reported—the purchase by the
accommodating bank from Bank X, and the purchase by Bank Y.
They may be identical. The Federal funds may ultimately move to Y
from the accommodating bank through one of the brokers.
S o u r c e . — Data for 1949-62 supplied by The Garvin Bantel Corp.
Volume data for 1963-66 based on reports of three brokers to the
Federal Reserve Bank of New York.

position in influence and size. The number
of banks involved in these arrangements
ranges from five or six to several hundred.
To a considerable extent these networks are
mutually exclusive.
Some leading correspondents have taken
an aggressive approach in developing trad­
4 For example, the promotion of trading in Federal
funds by large Dallas banks in 1965-66 forced city
banks in Oklahoma to offer trading services to coun­
try banks more willingly, and this has resulted in
extensive trading by Oklahoma banks.



ing positions in Federal funds to enable them
to provide a new business service— selling
or buying funds to or from their correspond­
ents— whereas others encourage only sales.
A few have adopted a passive attitude—
offering to buy or sell only upon specific
request from the smaller banks and being
reluctant to improve the familiarity of these
banks with the market.
Accommodating banks usually operate on
both sides of the market during the same
day. In providing or absorbing funds as a
service to correspondents, the accommodator generally will ( 1 ) to the extent possible,
match on its own books buy and sell orders,
which it receives from a correspondent or
customer bank; ( 2 ) when its own reserve
position is more than adequate, care for the
correspondent’s needs out of its own posi­
tion; and (3) when it is not possible to ac­
complish transactions by either ( 1 ) or ( 2 ),
use its best effort to cover a correspondent’s
needs in the national market. At times the
accommodating bank may even borrow from
its Federal Reserve Bank. In other cases the
lead correspondent5 acts only as agent, and
it pools sales of a customer bank with its
own. Funds purchased by smaller banks
usually come from the lead bank’s reserves.
All of the accommodating or correspon­
dent arrangements do not provide the same
degree of service, and some may limit their
service at certain times during the year.
In some cases they may require a collateral
loan agreement of the correspondent. When
the service provides for purchases of funds
by the smaller banks, the lead bank usually
sets up an informal line of funds. If the cor­
respondent’s needs exceed the level of its
credit line, the accommodating bank will
refer the request to an officer in charge of
the bank’s money position or the representa­
tive who regularly calls upon the particular
6 Refers to the dominant bank in the group.

bank. Minimum transaction units generally
range from $200,000 down to $25,000 in
size. Some, however, set $200,000 as the
minimum and will use $ 1 0 0 , 0 0 0 or less only
under pressure. Legal borrowing and lend­
ing limits are generally observed, and this
requires in a number of States that sales by
smaller State bank correspondents be se­
cured by U.S. Government securities.
Some lead correspondents charge oneeighth of a percentage point on purchases of
less than $1 million but will sell at the pre­
vailing rate regardless of the amount. Others
will take one-eighth of a percentage point on
sales. Some lead correspondents buy and sell
at the same rate. If the bank is acting as
agent or if sales are usually combined with
those of the lead bank, the correspondent
receives the rate on the combined transac­
tion. Few, if any, lead banks view the service
of providing Federal funds as a source of
Probably 85 per cent of the transactions
are for overnight and the rest range from 3
days to 2 weeks, with the rate being fixed
from day to day. In some instances Federal
funds remain at the bank’s disposal until
either party terminates the arrangement or
until the rate changes. There has been a ten­
dency to increase the length of transactions
with smaller banks to minimize costs.
General patterns of funds activity7

Trading in the Federal funds market has
shown a very rapid rate of growth since
World War II. This factor, along with the
large number of new entrants and the
spreading of knowledge about the market,
has tended to blur the cyclical pattern of
6 One typical regional trading system with 124 mem­
bers collected income and cost data for a 6-month
period. Gross income amounted to $5,000 and was
derived largely from rate spreads. Cost, without over­
head allocation, for overhead expenses exceeded in­
come slightly.
7 For more detail see the bibliography.


growth in such trading. In general, transac­
tions in Federal funds have grown at a
slower rate during periods of restrictive con­
ditions in the money market. The years 1965
and 1966 were exceptions. Those years pro­
duced record levels of transactions— reflect­
ing increased trading by all banks as policies
and practices changed, as well as a large
number of new entrants. Important factors
in these years were the significant shifts in
relationships of interest rates in the money
market, in part a result of monetary policy.
As a general rule, Federal funds activity
is highest over the longer run in periods
when the market is neither very firm nor
very easy. This reflects chiefly rate relation­
ships. When money is tight and demand
strong, the supply tends to dry up because of
greater profitability of other uses of short­
term funds. Under very easy conditions de­
mand is low, driving rates down to levels
where the increased supply seeks more prof­
itable outlets.
The major cyclical shifts in supply and
demand for Federal funds may be attributed
to banks that consistently borrow— some­
times in such funds and sometimes at the
Reserve Banks— to maintain their loan and
investment portfolios in periods of heavy
credit demands and monetary restraint. Al-

though many of these banks remain net
buyers as markets ease, their net purchases
are sharply reduced.
Federal funds activity also shows intra­
monthly variations in volume associated in
part with float but more importantly with
the ebb and flow of pressures on the large
banks caused by the complex of “operating
factors” such as the movement of corre­
spondent balances, financing needs of U.S.
Government securities dealers, Treasury
calls and deposits, and corporate tax and
dividend dates. The generalized pattern pre­
sents a sharp rise in activity at midmonth.
Intraweekly patterns of activity also exist,
but these have changed in recent years.
Trading is generally a little higher on Fri­
days when some banks try to obtain the
cumulative effect of transactions over the
weekend. And trading is often heavier
toward the end of the settlement week as
banks seek to bring their reserves to the
required level for their reserve computation
Smaller country banks as a rule seem to
divide their activity more or less equally
among the 12 months. In contrast, larger
banks may concentrate their activity during
certain periods of the year or may shift from
sellers to buyers or vice versa.

As indicated earlier, one purpose of this
study was to evaluate the use of the Federal
funds market by country banks as an alter­
native source of funds.
Growth in participation

Participation of the smaller country banks
in the Federal funds market began to accel­
erate early in the 1960’s and became increas­
ingly widespread after 1962. Before that,
banks with less than $ 1 0 0 million in de-

posits seldom traded in that market. The
standard unit of trading was $1 million, a
relatively large amount for small banks. Fur­
thermore, it was more than such banks
would generally have for sale and more than
they would need for reserve adjustment. The
small banks usually carried excess reserves,
and if these amounts were not sufficient to
meet their reserve losses, they would borrow
at the Federal Reserve or from correspond­
ents with whom they lodged excess funds
or they would buy Treasury bills.



By district
Federal Reserve district


Reserve city
number 1

Country banks

trading 2

Per cent

Reserve city
number 1

New York..........................................


















St. L ouis.............................................








4 5 .9

Kansas City.......................................
San Francisco....................................


















Country banks
number 3

trading 2

Per cent

1 Percentage of Reserve city banks trading ranged from 50 to 100
per cent in 1961 and from 95 to 100 per cent in 1966. The smaller
percentages apply to Midwest and Southwest districts.
2 Data for Boston, Philadelphia, New York, Richmond, Chicago,

Minneapolis, and Kansas City Districts derived from surveys. Other
data partially estimated.
3 Data are for the beginning of 1966.
S o u r c e . — Federal Reserve Bulletin June 1966, pp. 894-95; and
May 1962, pp. 646-47.

The forces underlying increased partici­
pation by the smaller banks in the Federal
funds market have been present for some
time. The basic force was the combination
of rising short-term interest rates and in­
creased banking costs, which provided a
strong stimulus, particularly after 1964.
In 1961 probably as many as 400 country
banks traded funds at one time or another
during the year (Table 3 ). These banks gen­
erally ranged in size from $75 million to
$100 million or more in deposits. In 1966
about 2,500 country banks, or one out of
every three, traded at least once during one
reserve period in the year. This represents a
fivefold increase in numbers since 1961 and
a doubling since 1964. Included are banks
with deposits of as little as $1 million, and
some are found in every Federal Reserve
district.8 The greatest growth in participa-

tion, however, has been among banks in the
deposit grouping from $10 million to $50
million. For banks with deposits of $10
million or less, it is estimated that between
15 per cent and 72 per cent of the number
in the several districts participate (Table 4 ).
In general, activity is related to bank size—
the proportion of banks that trade increases
with each size class up to the level of $50
million in deposits. Participation now in­
cludes significant percentages of banks in
the third and fourth size categories, where

8 The Minneapolis District has the lowest rate of
participation of any district—probably because of the
bank holding companies located there and the large
number of very small banks. One large holding com­
pany arranges purchases and sales for its members
through the Bank of America, with appropriate en-

tries to reserve accounts at the Federal Reserve Bank
of Minneapolis. About two-thirds of the trading banks
in the Minneapolis District are members of this bank
holding company.
The repeal of Section 6 of the Bank Holding Com­
pany Act in July 1966 and concurrent withdrawal of
the Federal Reserve Board’s ruling of 1959 prohibit­
ing trading of Federal funds between bank subsidi­
aries of a holding company apparently had had little
effect on trading by the end of 1966. After July 1
subsidiary banks of a holding company were in effect
permitted to deal with each other at arm’s length and
were consequently as free to trade Federal funds as
were any other banks within the limits and collateral
requirements of Section 23A of the Federal Reserve


banks are ranked by size of deposits into
six groups of 1,000 each. The fifth and sixth
groups comprise banks of less than $5
million in deposits— found in greatest num­
bers in the Midwest and South where activ­
ity rates are lowest.
The reduced size of the trading units in
correspondent trading arrangements has not
only encouraged small country banks to
enter the market but has increased the fre­
quency of their trades within reserve periods.
It is no longer necessary to accumulate funds
during a part of the reserve period to meet
transaction sizes.
By district

number 1

Banks trading
Federal funds
Number 2

Per cent
of total

age of
all country

B oston............................
New Y ork.....................










St. Louis.......................





Kansas City.................
D allas...........................
San Francisco.............









1 Based on numbers of banks shown in annual member bank
operating ratios or monthly reviews o f the Federal Reserve Banks.
2 Figures for Boston, Philadelphia, New York, Richmond, Chicago,
Minneapolis, and Kansas City Districts derived from surveys. Data
for other districts are partially estimated.
N o t e . —Data are for banks with deposits of $10 million or less.

Even so, most of the trading in Federal
funds continues to be concentrated in a rela­
tively small number of large banks in the
money market centers. About 46 banks, a
third of which have deposits of $1 billion or
over, account for three-fourths of all trans­
actions. It is the transactions of these banks
that have the greatest impact on the money
market. The tendency up to the mid-1960’s
was toward increasing concentration, but a

small lessening in concentration has devel­
oped with the rise of regional correspondent
systems with widespread participation on the
part of country banks. Although the average
dollar volume of transactions of most of the
country banks is relatively small in the ag­
gregate and does not have a substantial im­
pact on the money market, the transactions
of these banks play a continuous role that
is marginally important to management of
reserves of most participants.
Sales of funds

Although country banks of all sizes both buy
and sell Federal funds, they are generally
sellers more often than buyers, and they sell
substantially more than they borrow. The
typical movement of Federal funds is from
small country banks and small city banks to
the major city banks. On balance, country
banks supply net to the market from $800
million to $1 billion daily on the average, or
from one-fifth to one-quarter of the total
volume of trading. This amount represents
from 1 0 to 12 per cent of the required re­
serves of country banks. Most of these funds
come from banks with at least $25 million
of deposits.
The increased participation of country
banks in the market is reflected in the reduc­
tion of the ratio of their excess reserves to
required reserves and in the ratio of demand
balances due from banks to total deposits.
In 1961 these ratios were 8.0 per cent and
7.0 per cent, respectively. By 1966 they had
declined to 3.5 per cent and 5.4 per cent,
respectively— suggesting that the decline in
excess reserves is real and not simply a trans­
fer of funds from one nonearning asset to
another. The growth in sales of Federal
funds by country banks has been greater
than the decline in their excess reserves. The
fall in the ratio of demand balances due
from banks occurred despite a modest in­
crease in the level of such balances; in 1966


these balances averaged 12 per cent higher
than in 1961, whereas total deposits had
risen by 49 per cent. The increase in the
balances for the most part reflected operat­
ing needs. Relatively few leading corre­
spondents are reported to have insisted on
larger balances in return for providing Fed­
eral funds. Some participants are reported to
have made voluntary increases in deposit
balances because they liked the service.
Many smaller country bankers indicate
that trading in Federal funds has reduced
their reliance on purchases or sales of Trea­
sury and other money market instruments
as a means of reserve adjustment. In general,
these bankers continue to feel that Treasury
bills and similar instruments involve incon­
venience, cost, and exposure to market loss
when used to adjust reserve positions within
the 2-week settlement period. Some indicate
that their reluctance to place liquid reserves
in Treasury bills had resulted in mainte­
nance of excess reserves at a level higher
than that which they found desirable since
they entered the Federal funds market.
Smaller banks thus have reduced their
nonearning assets by selling Federal funds,
and in some cases they have substituted
these funds for other earning assets. And the
larger city banks have bought Federal funds
to facilitate maintenance of a position in
loans and investment with relatively high
Country banks can be net sellers only to
the extent that city banks are buyers. The
eagerness of the larger banks to buy in re­
cent periods is reflected in the breaking
down of large transaction units into units of
$200,000 and less. An increasing number
of larger country banks are acquiring Fed­
eral funds and are then “laying them off” or
arranging arbitrage— in the form of a repur­
chase agreement with U.S. Government se­
curities dealers made at a higher rate than
the purchase; or some may put the funds


into Treasury bills when the rate on bills is
attractive relative to the Federal funds rate.
Purchases of funds

On the buying side, relatively few country
banks rely heavily on the Federal funds mar­
ket as a source of funds, and the effect of
their aggregative transactions is negligible.
Average daily purchases probably do not ex­
ceed $300 million— or not more than 3.7
per cent of required reserves. And many
smaller banks have no need to borrow from
any source.
A bank’s appraisal of the advantages and
disadvantages of using the Federal funds
market or the discount window or of liqui­
dating Treasury bills is a major factor in its
decision of how to adjust its deficits. Fre­
quently, the decision reflects practical con­
siderations where convenience seems to be
more important than cost.
In sharp contrast to attitudes of most of
the larger banks, many country banks indi­
cate that they seldom obtain funds in the
Federal funds market although they use that
market regularly to dispose of excess funds.
These banks apparently have no hesitancy
about borrowing from the Federal Reserve.
In fact, they prefer to resort to the discount
window rather than to attempt to obtain
Federal funds or to liquidate securities, par­
ticularly in a declining market or when the
outlook for rates is uncertain. In this group
are banks that never buy Federal funds and
some that buy them only when there is a
rate advantage.
These banks cite the following advantages
of using the Federal Reserve discount win­
Convenience. Notes can be prepared in
advance and collateral is already in safe­
keeping. This avoids the necessity for trying
to locate Federal funds, particularly when
they might be scarce.



Funds can be obtained from the
Federal Reserve later in the day. In certain
cases, the time differences between New
York and the West are very important.
Dependability. The Federal Reserve is a
more dependable source of funds, and banks
can borrow the extra amount needed; some­
times this amount may exceed the amount
that can be legally borrowed in the market.
Cost. Borrowing at the Federal Reserve
is slightly cheaper when rates are nominally
the same because interest is figured on a
365-day basis instead of the 360 days for
Federal funds. Because balances are main­
tained at the Federal Reserve Banks, the
argument is that some use should be made
of them. And if banks turn to the corre­
spondent, it is possible that the correspond­
ent bank would ask that the requesting bank
deposit additional balances, which would tie
up more funds and raise the cost to that
Some district comments on funds trading

The following comments by Federal Reserve
Banks in several districts reflect the prac­
tices and attitudes of smaller banks toward
use of the Federal funds market.
We are reasonably sure that the large Chicago
banks do not encourage their country correspond­
ents to purchase Fed funds, particularly in the
current situation, but some individual banks can
get overnight money this way largely due to com­
petition among large banks for correspondent bal­
ances. It is our impression that the Fed funds
available to small banks from their correspondents
are considered part of the package of correspond­
ent services and that a banker that keeps a good
balance may be able to get Funds if he wants them.
But it seems much more likely that he may prefer
to draw down his balance temporarily when he
needs short-term money. W e still find evidence
that there are a good m any small banks that do
not know anything about Federal fu n d s and som e
seem unaware that they can buy as well as sell.

(Italics supplied.) Letter, FR Bank, Chicago, Sept.
19, 1966.

Most banks meet reserve deficiencies in the short
run primarily by buying Federal funds or borrow­
ing from the Federal Reserve. Large banks tend
to incur deficiencies more frequently than small
banks and therefore rely more heavily on both
sources of funds. Of the 120 banks in the survey
with deposits of less than $5 million, 4 per cent
bought Federal funds and 12 percent borrowed at
the discount window in 1965 but less than 1 per­
cent tapped both sources. In the next size classifica­
tion $5-$ 10 million, only 2 percent of the 129
banks used both sources while 13 percent bought
Federal funds and 17 percent borrowed from the
Federal Reserve. The proportion using both
sources rose rapidly to 8 percent in the $10-$25
million range, 29 percent of the $50-$ 100 million
banks and 82 percent of banks with deposits over
$100 million.
The proportion of banks buying Federal funds but
not borrowing at the discount window also rose
with bank size up to the $100 million level, then
dropped strongly from 43 percent to 9 percent . . .
The combination of those buying Funds and those
using both sources grew steadily with bank size
ranging from 5 percent to 91 percent. Thus, the
larger the bank the stronger the tendency to bor­
FR Bank, Richmond, M onthly R eview , Sept. 1966,
pp. 10 and 11.
The results of the survey indicate that only a lim­
ited number of Ninth District member banks made
use of the Federal funds market. Among those that
did enter the market, size and frequency of trans­
action seemed directly related to size of bank.
The average frequency of purchase like size of
transaction varied by size of bank: small banks
made fewer purchases than large banks. For ex­
ample, each of the seven banks with deposits of
between $4 and $8 million that entered the market
on the buying side made an average of 7.6 pur­
chases. On the other hand, each of the largest-size
buyers, $32 million and over averaged 48.6 pur­
The average number of sales among banks that
were active in the selling side of the market was
somewhat lower, 17.4, than the number of pur­
chases per bank. Average sales were pulled down
by the behavior of the larger banks, those with $16
million and more in deposits; on the average each
of the larger banks made fewer sales than pur­
Several banks, however, returned their question­


naire with the co m m ent that they had never heard
o f Federal funds.

The negative attitude of some city banks (in trad­
ing Funds with smaller correspondents) may be
explained by their status as members of one or
another of the several holding companies that ex­
ist in the district . . . Larger city banks that are
members of a holding company (are) legally able
to trade funds with some of the country banks they
serve as correspondents but not with others. Their
attitude towards trading with country banks may
reflect a desire to avoid having to discriminate
among customers.
(Italics supplied.) FR Bank, Minneapolis, M onthly
R eview , July 1966, pp. 6-8.

New York
Second District country member banks as a group
entered the market more often as sellers than as
buyers— in accord with the fact that country banks
. . . hold relatively high levels of excess reserves.
. . . most of the participating banks . . . with less
than $10 million in total deposits entered the mar­
ket only as sellers. . . . participating banks in the
intermediate size range, $10 million to $25 million
in deposits was fairly evenly divided between banks
that just sold funds and banks which acted as both
buyers and sellers while most banks with deposits
of $25 million or more traded at various times on
both sides of the market. Even among banks which
both sold and purchased funds, however, the fre­
quency of transaction on the selling side was sub­
stantially greater than on the purchasing side.
FR Bank, New York, M onthly R eview , May 1966,
p. 115.
Some 30 percent of the nonbuyers and 45 percent
of the nonsellers suggested that they feel too small
to be active in Federal funds. As would be ex­
pected, these banks are indeed almost always very
small and typically are located in rural areas. It
should be important, however, that there are many
banks as small or even smaller that are active . . .
The true explanation is, therefore, that manage­
ment is either unaware of the opportunities offered
by the market or feels that the potential profit from
Federal funds transactions does not justify the
“trouble” of entering the market.
. . . only 15 and 17 percent of the nonsellers and
buyers respectively noted that they were unaware
o f Federal fun d s and m ost o f them are the smaller
banks. (Some lead correspondents) have appar­

ently not been so active (as others) in acquainting


their country correspondents with the Funds m ar­
Country member banks which avoided Federal
funds because they preferred other methods of bor­
rowing and lending were frequently large institu­
tions, frequently situated in urban areas. Rather
than buy they borrow directly from correspond­
ents or at the discount window.
(Italics supplied.) FR Bank, Philadelphia, M o n th ly
R eview , August 1966, pp. 8-9.

Kansas City
No accurate figures on the number of member
banks trading in Federal funds resulted from the
survey. Some guesses are possible, however. Under
10 per cent of the member banks with deposits of
less than $5 million trade Federal funds. Approxi­
mately 25 percent or less of the banks with deposits
of $5-$ 10 million participate in the market. About
50 percent of the member banks in the $10-$50
million size range participate. Over 90 percent of
the over $50 million banks participated through
member correspondents.
The number of banks participating in the Federal
funds market is apparently largely dependent on
awareness and familiarity with the market and
many smaller banks in the District are unac­
quainted with Federal funds and the large city
banks are not encouraging familiarity. The num­
ber of participating banks is growing rapidly, how­
ever, as knowledge of the market spreads through
other channels.
Most of the smaller banks
funds are sellers of funds.
explanation of this except
ditional aversion of small

that are trading Federal
The city banks have no
for reference to the tra­
banks to borrowing.

Letter, FR Bank, Kansas City, December 16, 1966.
San Francisco
Recent data from District Federal funds reporters
indicate that both California and Pacific N orth­
west banks have been selling and purchasing funds
from other District Banks. Some of these transac­
tions have been in small magnitudes— indicating
the probability that the transactions were with rela­
tively small banks.
A check with our Discount Department disclosed
no complaints by banks applying at the discount
window about lack of access to the Federal funds
It would appear, therefore, that small banks in the
San Francisco District do have access to the Fed­
eral funds market through their correspondent or


other banking relationships. The only bar would
appear to be for the smallest banks which cannot
profitably participate in the m arket on the sell side
because of the small volume of their lendable
June 30 call report data . . . indicate that even
banks with less than $2 million in deposits partici­
pated in the Federal funds market on both the buy

and sell side. This confirms interviews with Dis­
trict banks— which make a market in Federal
funds— that small country banks were actively par­
ticipating in the market at times in such small
amounts that interest costs probably did not cover
the communication cost of the transaction.
Letter, FR Bank, San Francisco, November 11,

On an average day in the late 1920’s, Fed­
eral funds traded for all member banks
ranged from about 4 to 10 per cent of re­
quired reserves. In the late 1950’s and early
1960’s this ratio ranged from about 7 to 12
per cent of these requirements. At the time
of this writing, the ratio is close to 25 per
cent. By this measure, trading in Federal
funds has become of substantially greater
relative importance than in earlier periods.
It should be noted, however, that the reserve
requirement level is about 2 0 per cent higher
than in the 1920’s. Meanwhile, trading in
Federal funds has shown a much greater
rise; compared with the lower limit of the
trading range, it has increased 15 times, and
compared with the upper limit, it has risen
about 10 times; compared with the 1950’s,
the ranges have more than tripled.
If the daily-average volumes of discounts
and of trading in Federal funds are com­
bined, the total at times in the 1920’s
reached about 50 per cent of required re­
serves in contrast to about 1 2 per cent in

heavy trading days in the 1950’s and 21 per
cent in recent periods. Thus, borrowings
from the Reserve Banks made up a substan­
tially larger part of the reserve base in the
credit superstructure of the 1920’s than in
recent decades.
It should also be noted that borrowings
from the Reserve Banks during periods of
expansion in the 1950’s and 1960’s aver­
aged about $ 1 0 0 million less than in the
late 1920’s. However, the composition of
total borrowing as suggested by these figures
above was reversed; the ratio of Federal
funds to borrowings in the 1920’s was about
one to four; now it is four or five to one. It
may be said that in the 1920’s Federal funds
were considered a supplement to discount­
ing but that in the 1960’s discounting had
become a supplement to trading in Federal
funds. Although transactions in Federal
funds relieve the individual bank from use
of the discount window, they do not relieve
the banking system as a whole from reliance
on the Federal Reserve.

Except for a period of about 2 years in the
late 1920’s and a similar period beginning
in the midautumn of 1964, the Federal
funds rate has fluctuated between the dis­
count rate and a lower limit at one-eighth to
one-half of a percentage point. Because of
their access to the discount window at the

Reserve Banks, member banks have not
usually been willing to pay more than the
discount rate. The lower limit of the Federal
funds rate is set at the point where banks
recover costs, even though some accommo­
dating banks may absorb some of these costs
in promoting the market.









Data from N .Y . H e ra ld T ribu n e and Federal Reserve Bank of N ew York. Federal funds data not available in series form prior to
April 1928.

Transactions in Federal funds among
banks are now quoted in terms of the effec­
tive or prevailing rate— the level at which
the great bulk of transactions are accom­
plished. The quote is considered representa­
tive of rates for the entire market— New
York City and elsewhere. Quotations above
and below the effective rate, when they
occur, merely indicate a range of quotations
on a given day. During the postwar period
the quotations have usually changed by onefourth of a percentage point, but more re­
cently, as in other markets, the change has
frequently been one-eighth of a percentage
point— reflecting the extent of competition
within this market and the relation to rates
in alternative markets. Differentials of onefourth of a percentage point were also a
characteristic of the 1920’s.
The premiums that were bid on Federal
funds during the 1920’s ranged from oneeighth of a percentage point to more than a
full percentage point above the discount rate
when the latter was at levels of 4, 4 Vi, 5,
and 6 per cent. The willingness of banks to
pay this rate was attributed to lack of eligi­

ble paper or to fear of criticism at the Re­
serve Bank because of their loans on stocks.
The premium bid of the m id-1960’s devel­
oped from the efforts of leading banks to ob­
tain a larger volume of reserves for lending
and investing and from fears that they would
be criticized if borrowing from the Federal
Reserve were used for extended or continu­
ous periods. At times the premium that
emerged was l 5 percentage points above
the AVi per cent discount rate, and on N o­
vember 2, 1966, it was 13 percentage
points higher. The discount rate was not
changed after it had been raised to 4 Vi per
cent in December 1965, and the premium
on Federal funds was undoubtedly larger
than it would have been if the discount rate
had been raised to conform with general in­
creases in market rates. In a sense the Fed­
eral funds rate became a discount rate. Dis­
cipline exercised at the discount window
insured that Federal Reserve advances were
not a steady and continuous source of sup­
ply for any given bank; hence banks had to
obtain reserves from the Federal funds mar­
ket, and demand forced up the rate on these






D ata from Federal Reserve Bank of N ew York.

funds. Administration of the discount win­
dow in the 1950’s and 1960’s was more se­
vere than in the 1920’s and was substituted
for the higher discount rate levels that had
prevailed in the earlier period.
This was particularly true in 1966. In late
summer the System released a letter dated
September 1 calling for the cooperation of
member banks in curtailing expansion in
loans to businesses. The letter indicated that
if member banks experiencing deposit losses
made efforts to reduce the expansion of their
loans instead of cutting further into munici­
pal securities, credit would be extended to
them for a longer period than usual. The
banks, however, did not take advantage of
this offer to any extent and made most of
their adjustments without the System’s assist­
ance, showing a strong preference for the
privacy of the Federal funds market.
Paying more than the discount rate for
Federal funds reflects the elasticity of the
demand for these funds. In fact, the market
may be said to represent a source of mar­
ginal demand and supply, one in which in­

creases in either demand or supply quickly
result in higher or lower interest rates in con­
trast to some other markets where competi­
tion is less perfect. The Federal funds rate
acts as a sensitive indicator of shifting pres­
sures in the banking system— particularly
when related to the supplier of the funds, to
the volume of the flows, and to the depth of
the demand. The huge flow of Federal funds
during the past 2 years and the widespread
participation of banks of all sizes in the mar­
ket underscore this characterization.
Transactions are accomplished rapidly
and efficiently in increasing volume for a
growing number of banks at nearly uniform
rates. Thus, there is a high degree of adjust­
ment between demand and supply and price
and quantity exchanged. The several mar­
kets and several market rates that may exist
at any given time are the result of forces of
the same general character but of different
magnitudes. The rates are not unrelated to
each other but reflect distinct prices, and the
departures from the effective rate merely
reflect a wider range of quotes on a given






ttt I





t f t V flt







The vertical lines represent each day’s range from the low bid to the high offer. “Effective rate” is the rate at which the largest vol­
ume of business was transacted.

day.9 Lack of perfect adjustment and of a
uniform rate arises from institutional fric­
tion, the absence of knowledge of the mar­
ket as a whole, and the use of Federal funds
by nonbank groups and others.

The growth in unity and breadth of the
Federal funds market and the increase in its
efficiency during the 1960’s have strength­
ened the links among the various divisions
of the money market and the links of the
money market to the longer-term credit mar­
ket. A given volume of Federal funds will
9 See Chapter 4, Trading in Federal Funds—Find­
now move through that market with less
ings of a Three-Year Survey, by Dorothy M. Nichols,
Board of Governors of the Federal Reserve System,
change in rates than formerly, and the mar­
Washington, D.C., September 1965, for a detailed
ket participants may move back and forth
discussion of the determination of rates and rate
from one sector of the money market to an­
structure. This study provides a detailed analysis of
Federal funds transactions by the 250 to 260 banks
other in response to shifting rate differentials
that reported to the System between September 1959
without causing disruptive price changes.
and September 1963.

In general, the Federal funds market has
permitted and encouraged banks to reduce
their excess reserves and, in addition, has
helped to distribute reserves supplied by the
Federal Reserve through open market opera­
tions, the discount window, and reductions
in the level of required reserves. For all
banks the market provides an important
means of adjusting their reserve positions,
and the condition or atmosphere in the mar-

ket is related to developments in other seg­
ments of the short-term market.
The Federal funds market also represents
a source of and an outlet for these funds
over periods of time. Deposit swings, how­
ever, force short-run variations in the size of
purchases or sales. Transfers of reserves
from selling banks to buying banks— in
addition to reducing the excess reserves of
the selling banks— influence the composi­


tion of assets in the banking system. Net
buyers of Federal funds absorb the obliga­
tion of extending credit to a variety of users.
The small country banks use the market
principally as an investment medium, and
their widening use of the market in recent
years has caused them to compute reserve
requirements more accurately and to sell ex­
cesses to city banks. Country banks are
much less active on the buying side, and as
was indicated earlier, some prefer to go to
the Federal Reserve when the need to bor­
row arises. Most of the country banks that
do not participate in the Federal funds mar­
ket hold deposits of $5 million or less. Some
of these banks have no familiarity with the
market, but others state that they expect to
enter the market in the future if conditions
are suitable. Banks of this size that do par­
ticipate are almost exclusively sellers, but a
few of them state that they would borrow if
With country member banks in the Fed­
eral funds market now numbering more than
2,500, some of which are small banks in
terms of their total deposits, it is doubtful
that the dimensions of this market will in­
crease substantially in the future. There are
considerable differences in management
capability of very small nonparticipating
banks. Furthermore, many of them would
find it too costly to participate, even as sell­

ers. This cost is measured in terms of main­
taining statistics on their flows of deposits,
following market developments, and com­
munication. On the buying side, the question
may be raised whether small banks should
be encouraged to become borrowers for the
periods of time necessary to support addi­
tions to their portfolios even if the demands
by their customers could be met in this way.
The same question may be raised about
some of the large city banks, which may
have exploited borrowing sources outside
the Federal Reserve. Considerable skill is
necessary to use short-term markets as a de­
pendable source of reserves.
However, some observers feel that easier
access to borrowings in the Federal funds
market should be provided for small banks.
Proposals to facilitate this include auctions
in Federal funds and the performance of a
brokerage function by the Reserve Banks;
these proposals are discussed next.
Clear-cut evidence of the difficulty of ac­
cess to the Federal funds market is lacking,
particularly in a review of the growth and
development of the market previous to this
study. Additional participation or more
continuous participation in the market by
the small banks, if desired, can be accom­
plished by breaking down the innate con­
servatism of nonparticipants and by broad­
ening their knowledge of the market.

The Steering Committee, summarizing issues
involved in reformulation of the “Discount
Mechanism and Concept” has stated that
over and above the considerations of control
mechanisms, the efficacy of alternative in­
struments of systems of control must be con­
sidered from the broad viewpoint of over-all
public policy and the discount mechanism as
a whole.

Auctions of Federal funds

One suggested modification is to replace the
present purpose constraints with a quantita­
tive limitation on borrowed reserves through
regular auctions of predetermined amounts
of Federal funds (reserves). In each reservecomputation period the banks could bid for
Federal funds and pay for them by tendering


their own liabilities— auctions might be used
as the major source of reserve credit or for
particular purposes.
The Steering Committee has also raised
the following questions relating to the possi­
ble use of auctions: What becomes of open
market operations— as a provider of credit
for certain other purposes or as a supple­
mental tool to correct errors in the auction
process? What policy measures other than
price of Federal funds auctioned would be
needed to insure a proper allocation of Re­
serve Bank credit? Who should determine
how often and what volume of reserves to
auction? How would the funds be auctioned
— in the Federal funds market, or by a pro­
cedure similar to that for selling Treasury
bills, or by a new method?
In an academic seminar discussing
changes in the discount window 10 a sugges­
tion was made that the auction be run on a
13-week cycle, say $500 million each week.
Unsatisfied demands during a given week
would be met at a penalty rate, that is, at a
rate above the auction. Another suggestion
was to hold the auction daily or with some
other regularity— with arrangements for fill­
ing noncompetitive bids at the average rate
in the auction and for providing any addi­
tional amounts needed at a penalty above
the average rate.
Advantages advanced for the auction pro­
posal were that it would: broaden the Fed­
eral funds market to the smallest bank in the
smallest transaction, stabilize the total of
System loans (the amount of rediscounts
could be fixed forever or could be changed)
provide a market-determined rate (as com­
pared with the discount rate), and prevent
the banking system from running out of lia­
bilities as a means of payment.11
1 Academic Seminar in Changes in the Discount
Window, May 11, 1966, unpublished, Board of Gov­
ernors of the Federal Reserve System, pp. 158 ff.
1 Ibid., p. 162.


The disadvantages noted were that it
would be difficult to determine the amount
to be auctioned and that determination of
the amount against projected demand would
in effect set the rate— in other words, the
problem of determining the quantity is simi­
lar to that of fixing the rate.
Without additional detail or assumptions
a complete analysis of the effects of the auc­
tion proposal on existing institutions in the
money market is not possible. Offhand, how­
ever, it seems that the proposal, in order to
be successful, would have to replace com­
pletely, or at least in substantial part, the
present range of facilities, which now satisfy
quite efficiently the requirements of both
sides of the Federal funds market— facilities
that have evolved over time “to bridge” the
unit banks. Such facilities include the dis­
count window. The market would be given
an official status, and such action would
present new problems for the System in that
more continuous and up-to-date judgments
must be substituted for those now made by
market participants.
On the assumption that the auctions
would be limited to sales of Federal funds,
formulas for awards would have to be deter­
mined in such a way as to prevent cornering
of the market and disorderly trading after
the funds had been sold. Otherwise rate
fluctuations of large amplitude could often
be expected. It is not clear how open market
operations could be used to compensate for
errors if too large a volume of funds were
supplied in an auction. Even with present
techniques— including reverse repurchase
agreements— open market operations could
not be used with the continuity necessary to
complete the adjustments.
Trading in Federal funds continues
throughout the day— reflecting the con­
stantly shifting needs of banks. The present
market mechanism centralizes buyers and
sellers for all practicable purposes at a single


point, and changes in ownership of funds are
facilitated by the willingness of numbers of
participants to match demand and supply—
absorbing or making the residue available
at a price.
If the Federal Reserve were to enter this
mechanism, the mechanism would be mate­
rially altered: the Federal Reserve would
become a central point for sales and would
be forced to communicate, directly or
through agents, with hundreds of banks— a
mechanical problem of some magnitude
even with the aid of computers.
It would be difficult to demonstrate that a
better allocation of Federal funds would be
achieved or that the efficiency of the market
would be improved. Compensating for errors
on the short side at a penalty rate (above
the auction average) or with additional auc­
tions suggests the necessity for precise esti­
mates of needs, and the existing data cannot
provide these estimates. Setting the penalty
rate in the periods between auctions would
bring about problems in determining the
Systemwide penalty differential and the basis
on which it would be applied. Market ex­
pectations could feed on themselves with
disturbing effects on rates if the auctions
were frequent and variable in amount, as
would appear to be necessary.
Thus, in attempting to overcome these
rate fluctuations, the System might be
obliged to abandon its auction and establish
an administered or pegged rate. In this
event, changes in the rate would raise prob­
lems similar to those associated with deci­
sions to change the discount rate. Sales of
Federal funds in auctions might after a time
lead to demands that the System also pur­
chase Federal funds, resulting in an enor­
mously complex operation in which the Sys­
tem might in fact become the whole market.
Under the proposal if some banks were
able to secure more Federal funds than they
could in current markets, other banks would

command a smaller amount; or within the
framework of the administered price they
might have to pay more than they could con­
veniently afford. There is no means of pro­
viding an objective test as a basis of refer­
ence for administrative action, whether de­
signed to achieve direct-use allocation of
Federal funds or a new structure of prices
that would encourage reallocation of funds
among users.
The present market for Federal funds
works efficiently, and it is relatively free
from frictions that would limit free flows of
funds, as evidenced in the coherent and con­
sistent structure of rates. Rates on Federal
funds are now considered an excellent meas­
ure of pressures within the banking system,
and they aid in forming a range for other
rates and in strengthening the short-term
rate anchor in relation to rates in the capital
market. The discount rate provides a refer­
ence point, as the sensitive market rates
move above and below it. As noted earlier,
the widespread participation in the Federal
funds market and the closer links of that
market to other parts of the money market
have led to more rate stability and smaller
fluctuations than earlier.
Unless clear-cut advantages can be shown
for the proposal, it seems unwise to tamper
with the current market mechanism. Changes
in either the money or the capital markets
that disturb confidence can have dispropor­
tionate effects elsewhere in the economy.
Federal Reserve Banks as clearinghouses for
Federal funds transactions of smaller banks

The suggestion has been made from time to
time that the Federal Reserve Banks estab­
lish facilities for matching the requests for
sales and purchases of Federal funds of the
small banks in their districts. This service
would be strictly that of a broker. The Re­
serve Banks would match demand and sup­
ply to the extent possible and would refer



unsatisfied needs to other participants in the
market. Telephone and other communica­
tion costs would be absorbed by the Reserve
Banks. This proposal is less radical than the
auction, but it presents many of the same
problems. It involves the question of direct
intervention in the market and excites ex­
pectations of further intrusions.
With the present high degree of develop­

ment of the market and the lack of evidence
of unsatisfied needs, there seems to be no
justification for further consideration of the
proposal at this time. Available information
about the market shows a high degree of
participation, especially by large banks. The
market provides ample facilities, and it is
expected that further participation by small
banks will come about as the need arises.
March 1967

Board of Governors of the Federal Reserve System. The Federal
Funds Market— A Study by a Federal Reserve System Com­
mittee. Washington, D .C .: Board of Governors of the Federal
Reserve System, May 1959.
-------. “New Series on Federal Funds,” Federal Reserve Bulletin,
August 1964.
Madden, Carl H. The Money Side of “The Street.” New York:
Federal Reserve Bank of New York, 1959.
Nichols, Dorothy M. Trading in Federal Funds—Findings of a
Three-Year Survey. Washington, D.C.: Board of Governors
of the Federal Reserve System, September 1965.
Roosa, Robert V. Federal Reserve Operations in the Money and
Government Securities Markets. New York: Federal Reserve
Bank of New York, 1956.
Willis, Parker B. The Federal Funds Market— Its Origin and
Development. Boston: Federal Reserve Bank of Boston, Octo­
ber 1964.
Federal Reserve Bank Monthly Review Articles

New York:
Colby, William G., Jr., and Platt, Robert B. “Second Dis­
trict ‘Country’ Member Banks in the Federal Funds
Market,” May 1966.
“Federal Funds,” March 1950.
Baxter, Nevins D. “Country Banks and the Federal Funds
Market,” April 1966.
-------. “Why Federal Funds?” August 1966.
Rothwell, Jack C. “Federal Funds and the Profits Squeeze
— A New Awareness at Country Banks,” March 1965.


Federal Reserve Bank Monthly Review Articles— Continued

“Trading in Bank Reserves,” December 1960 and October
“Federal Funds in the Fifth District,” June 1961 and Sep­
tember 1966.
“Reserve Management at Fifth District Member Banks,”
September 1966.
Brandt, Harry, and Wyand, Robert R., II. “Using a Sharper
Pencil?” Part I, November 1965.
Crowe, Paul A., and Wyand, Robert R., II. “Using a
Sharper Pencil?” Part II, December 1965.
Hirsch, Albert A. “Adjusting Reserves through the Federal
Funds Market,” October 1962.
Nichols, Dorothy M. “Marketing Money: How ‘Smaller’
Banks Buy and Sell Federal Funds,” August 1965.
Duprey, J. N. “Country Bank Participation in the Federal
Funds Market,” July 1966.
Griggs, William N. “Federal Funds Market in the South­
west,” November 1961.
San Francisco:
“The Role of Twelfth District Banks in the Federal Funds
Market,” June 1961.
Toby, Jacob Allan. “Fed Funds: The Western Market,”
September 1966.


Hyman P. Minsky
Washington University


Introduction _________________________________________________________________________________


The Economics of Euphoria________________________________________________________________ 100


Cash Flow s___________________________________________________________________________________ 103


Financial Instability and Income Determination_________________________________________ 106

Appendix to Section IV: A model

How Does Tight Money W ork?_____________________________________________________________ 114


The Theory of Financial Stab ility________________________________________________________ 117

Attributes of stability
The “ banking theory” for all units
Modes of system behavior
Secondary markets
Unit and system instability

An Aside on Bank Examination___________________________________________________________ 124


Regional Aspects of Growth and Financial Instability__________________________________ 130


Central B an kin g __________________________ ; _________________________________________________132
Bibliography ________ ______________________________________________________________________ 135



The original draft of this paper was written
in the fall of 1966 and it was revised in
January 1970. I wish to thank Maurice I.
Townsend, Lawrence H. Seltzer, and
Bernard Shull for their comments and en­
couragement. Needless to say, any errors of
fact or fancy are my responsibility.
Hyman P. Minsky



Every disaster, financial or otherwise, is
compounded out of initial displacements or
shocks, structural characteristics of the sys­
tem, and human error. The theory devel­
oped here argues that the structural char­
acteristics of the financial system change
during periods of prolonged expansion and
economic boom and that these changes
cumulate to decrease the domain of stability
of the system. Thus, after an expansion has
been in progress for some time, an event
that is not of unusual size or duration can
trigger a sharp, financial reaction.2
Displacements may be the result of system
behavior or human error. Once the sharp
financial reaction occurs, institutional de­
ficiencies will be evident. Thus, after a crisis
it will always be possible to construct plausi­
ble arguments— by emphasizing the trigger­
ing events or institutional flaws— that
accidents, mistakes, or easily corrected
shortcomings were responsible for the
In previous work, I have used an accelerator-multiplier cum constraining ceilings
and floors model to represent the real eco­
nomy. Within this model the periodic falling
away from the ceiling, which reflects param­
eter values and hence is an endogenous
phenomenon, is the not unusual event that

A striking characteristic of economic experi­
ence in the United States is the repeated
occurrence of financial crises— crises that
usher in deep depressions and periods of
low-level economic stagnation. More than
40 years have passed since the financial
shock that initiated the Great Depression
of the 1930’s, a much longer period of
time than between the crises and deep
depressions of the previous century.1 Is the
experience since the Great Depression the
result of fundamental changes in the eco­
nomic system and of our knowledge so that
crises and deep depressions cannot happen,
or are the fundamental relations unchanged
and our knowledge and power still inade­
quate so that crises and deep depressions
are still possible?
This paper argues that the fundamentals
are unchanged; sustained economic growth,
business cycle booms, and the accompany­
ing financial developments still generate
conditions conducive to disaster for the
entire economic system.
1 For the chronology of mild and deep depression
cycles see M. Friedman and A. J. Schwartz, “Money
and Business Cycles.”
In that chronology all clearly deep depression cycles
were associated with a financial crisis and all clearly
mild depression cycles were not. Friedman and
Schwartz choose to ignore this phenomenon, preferring
a monolithic explanation for both 1929-33 and
1960-61. It seems better to posit that mild and deep
depressions are quite different types of beasts and the
differences in length and depth are due to the absence
or occurrence of a financial panic. See H. P. Minsky,
“Comment on Friedman and Schwartz’s ‘Money and
Business Cycles.’ ”

21. Fisher, “The Debt-Deflation Theory of Great
3 See M. Friedman and A. J. Schwartz, A Monetary
History of the United States 1867-1960, pp. 309 and
310, footnote 9, for a rather startling example of
such reasoning.


can trigger the “unstable” financial reaction
— if a “proper” financial environment or
structure exists. The financial reaction in
turn lowers the effective floor to income.
Once the gap between floor and ceiling
incomes is large enough, I assumed that the
accelerator coefficient falls to a value that
leads to a stagnant behavior for the eco­
nomy. In this way a set of parameter values
that leads to an explosive income expansion
is replaced by a set that leads to a stagnant
economy. I assumed that the gap between
floor and ceiling income is a determinant
of the accelerator coefficient and that the
immediate impact of financial instability is
to lower the floor income, because financial
variables— including the market value of
common stocks— determine the position of
a conventional Keynesian consumption
This view neglects decision-making under
uncertainty as a determinant of system be­
havior. A special type of uncertainty is
inherent in an enterprise system with de­
centralized decisions and private ownership
of productive resources due to the financial
relations. The financial system of such an
economy partitions and distributes uncer­
tainty. A model that recognizes the problems
involved in decision-making in the face of
the intrinsically irrational fact of uncertainty
is needed if financial instability is to be
understood. A reinterpretation of Keynesian
economics as just such a model, and an
examination of how monetary constraint—
whether due to policy or to behavior of the
economy— works, are needed before the
stability properties of the financial system
and thus of the economy can be examined.
It turns out that the fundamental instability
of a capitalist economy is a tendency to ex­
plode— to enter into a boom or “euphoric”

4 H. P. Minsky, “Financial Crisis, Financial Sys­
tems, and the Performance of the Economy,” and
“A Linear Model of Cyclical Growth.5

This paper will not present any empirical
research. There is, nevertheless, need to:
(1 ) examine updated information of the
type analyzed in earlier studies, (2 ) explore
additional bodies of data, and (3 ) generate
new data (see Section V II). Only with this
information can the problem be made pre­
cise and the propositions tested.
There is a special facet to empirical work
on the problems at issue. Financial crises,
panics, and instability are rare events with
short durations.5 We have not experienced
anything more than unit or minor sectoral
financial distress since the early 1930’s.
The institutions and usages in finance, due
to both legislation and the evolution of
financial practices, are much different today
from what they were before the Great
Depression. For example, it is necessary to
guess the power of deposit insurance in
order to estimate the conditions under which
a crisis can develop from a set of initial
events.6 The short duration of crises means
that the smoothing operations that go into
data generation as well as econometric
analysis will tend to minimize the impor­
tance of crises.
Because of such factors it might be that
the most meaningful way to test proposi­
tions as to the cause and effect of financial
instability will be through simulation studies,
where the simulation models are designed
to reflect alternative ways that financial in­
stability can be induced.7
In this paper, Section II discusses dif­
ferences between an economy that is simply
growing steadily and one that is booming.
5The large and long contraction of 1929-33 can be
interpreted as a succession of crises compounding an
initial disturbance.
6 Perhaps the financial history of 1966 can be in­
terpreted as a test of the power of deposit insurance
to offset the destabilizing aspects of financial con­
7 H. P. Minsky, “Financial Crisis, Financial Sys­
tems, and the Performance of the Economy,” pp.
326-70, where a number of “primitive” simulations
are presented.


The characteristics of a euphoric economy
are identified. This section develops the
proposition that, in a boom or euphoric
economy, the willingness to invest and to
emit liabilities is such that demand condi­
tions will lead to tight money markets—
defined in terms of the level and rate of
change of interest rates and other financing
terms— independently of the rate of growth
of the money supply.
Section III focuses upon cash flows due
to income production, balance sheet rela­
tions, and transactions in real and financial
assets. The likelihood of financial instability
occurring is dependent upon the relation­
ship between cash payment commitments
and the normal sources of cash, as well as
upon the behavior of markets that will be
affected if unusual sources of cash need to
be tapped.
Section IV develops the role of uncer­
tainty as a determinant of the demand for
investment within a framework of Keynesian
Section V examines alternative modes of
operation of monetary constraint. In a
euphoric economy, tight money, when
effective, does not operate by inducing a
smooth movement along a stable investment
schedule; rather it operates by shifting the
liquidity preference function. Such shifts
are typically due to a liquidity crisis of some
Section VI explores the domains of sta­
bility both of the financial system and of
the economy. These domains are shown to
be endogenous and to decrease during a
prolonged boom. In addition, the financial
changes that take place during a euphoric
period tend also to decrease the domain
of stability and the feedbacks from euphoria
tend to induce sectoral financial difficulties
that can escalate to a general financial panic.
If such a panic occurs, it will usher in a
deep depression; however, the central bank


can abort a financial crisis. Nevertheless,
the tensions and tremors that pass through
the financial system during such a period
of near crisis may lead to a reconsideration
of desired portfolio composition by both
financial institutions and other economic
units. A rather severe recession may follow
such a reconsideration.
Sections VII and VIII deal with two
special topics, bank examinations and re­
gional impacts. In Section VII it is argued
that a bank examination procedure center­
ing around cash flows as determined by
balance sheet and contractual relations
would be a valuable guide for Federal
Reserve policy and an important instrument
for bank management. Such an examination
procedure would force financial-unit man­
agers and economic policy-makers to con­
sider the impact upon financial units of the
characteristics of both the real economy
and the financial system.
The discussion of the regional impact of
Section VIII centers around the possibility
that there is a concentration of financially
vulnerable units within one region. In these
circumstances the escalation of financial
constraint to a financial crisis might occur
though financially vulnerable units, on a
national basis, are too few to cause difficulty.
Section IX sets forth some policy guide­
lines for the Federal Reserve System. It is
argued that the discount window should be
open to selected money market position
takers (dealers) and that the Federal Re­
serve should move toward furnishing a
larger portion of the total reserves of banks
by discounting operations. This policy
strategy follows from the increased aware­
ness of the possibility of a financial crisis
and of the need to have broad, deep, and
resilient markets for a wide spectrum of
financial instruments once a financial crisis
threatens so that the effects of such a crisis
can be moderated.

In the m id-1960’s the U.S. economy experi­
enced a change of state. Political leaders and
official economists announced that the eco­
nomic system had entered upon a new era
that was to be characterized by the end of
the business cycle as it had been known.8
Starting then, cycles, if any, were to be in
the positive rate of growth of income. The
doctrine of “fine tuning” went further and
asserted that even recessions in the rate
of growth of income could be avoided.
Contemporary business comments were con­
sistent with these official views.
The substance of the change of state was
an investment boom: in each year from
1963 through 1966 the rate of increase of
investment by corporate business rose.9 By
the m id-1960’s business investment was
guided by a belief that the future promised
perpetual expansion. An economy that is
ruled by such expectations and that exhibits
such investment behavior can properly be
labeled euphoric.
Consider the value of a going concern.
Expected gross profits after taxes reflect the
expected behavior of the economy, as well
as expected market and management devel­
opments. Two immediate consequences fol­
low if the expectation of a normal business
cycle is replaced by the expectation of steady
growth. First, those gross profits in the
8 J. Tobin, The Intellectual Revolution in U.S. Eco­
nomic Policy Making.
9 Investment by nonfarm, nonfinancial corporations,
Purchase o f physical assets
Billions of


Growth rate
(per cent)

*The “crunch” of 1966 occurred in late August/early
September; it put a damper on investment and the purchase
o f physical assets declined to $74.1 billion in 1967.
S o u r c e . — Economic Report o f the President , 1969, Table

present-value calculations that had reflected
expected recessions are replaced by those
that reflect continuing expansion. Simultane­
ously there is less uncertainty about the
future behavior of the economy. As the
belief in the reality of a new era emerges,
the decrease in the expected down or short
time for plant and equipment raises their
present values. The confident expectation
of a steady stream of prosperity gross profits
makes portfolio plunging more appealing to
firm decision-makers.
A sharp rise in expected returns from real
capital makes the economy short of capital
overnight. The willingness to assume lia­
bility structures that are less defensive and
to take, what would have been considered
in earlier times, undesirable chances in order
to finance the acquisition of additional capi­
tal goods means that this shortage of capital
will be transformed into demand for finan­
cial resources.
Those that supply financial resources live
in the same expectational climate as those
that demand them. In the several financial
markets, once a change in expectations
occurs, demanders, with liability structures
that previously would in the view of the
suppliers have made them ineligible for
accommodations, become quite acceptable.
Thus, the supply conditions for financing the
acquisitions of real capital improve simul­
taneously with an increase in the willing­
ness to emit liabilities to finance such
Such an expansionary new era is desta­
bilizing in three senses. One is that it quite
rapidly raises the value of existing capital.
The second is an increase in the willingness
to finance the acquisition of real capital by
emitting what, previously, would have been
considered as high-cost liabilities, where the
cost of liabilities includes risk or uncertainty


borne by the liability emitter (borrower’s
risk). The third is the acceptance by lenders
of assets that earlier would have been con­
sidered low-yield— when the yield is ad­
justed to allow for the risks borne by the
asset acquirer (lender’s risk).1
These concepts can be made more precise.
The present value of a set of capital goods
collected in a firm reflects that firm’s ex­
pected gross profits after taxes. For all
enterprises there is a pattern of how the
business cycles of history have affected their
gross profits. Initially the present value
reflects this past cyclical pattern. For ex­
ample, with a short horizon

i/_ Qi .




l + r 1+ ( l + r 2 2+ ( l +/-3 3

where Q\ is a prosperity, Q is a recession,
and Qs is a recovery gross profits after taxes,
(Q 2<<3 3 < Q 1)- With the new era expecta­
tions Q / and Q ' , prosperity returns replace
the depression and recovery returns. As a
result we have: V (new era) > V (tradi­
tional). This rise in the value of extant
capital assets as collected in firms increases
the prices that firms are willing to pay for
additions to their capital assets.
Generally, the willingness to emit liabili­
ties is constrained by the need to hedge or to
protect the organization against the occur­
rence of unfavorable conditions. Let us call
Q " and Q " the gross profits after taxes if
a possible, but not really expected, deep
and long recession occurs. As a risk averter
the portfolio rule might be that the balance
sheet structure must be such that even if
Q " and Q " do occur no serious conse­
quences will follow; Q " and Q "— though
not likely— are significant determinants of
desired balance sheet structure.1 As a result
1 M. Kalecki, “The Principle of Increasing Risk.”
11W. Fellner, “Average-Cost Pricing and the The­
ory of Uncertainty,” and “Monetary Policies and
Hoarding in Periods of Stagnation,” and S. A. Ozga,
Expectations in Economic Theory.


of the euphoric change in “state,” the view
grows that Q ” and Q ” are so unlikely
that there is no need to protect the organiza­
tion against them. A liability structure that
was expensive in terms of risk now becomes
cheap when there were significant chances
of Qs" and Q " occurring. The cost of capi­
tal or of finance by way of such liability
structures decreases.
Financial institutions are simultaneously
demanders in one and suppliers in another
set of financial markets. Once euphoria sets
in, they accept liability structures— their
own and those of borrowers— that, in a more
sober expectational climate, they would have
rejected. Money and Treasury bills become
poor assets to hold with the decline in the
uncertainty discount on assets whose returns
depend upon the performance of the eco­
nomy. The shift to euphoria increases the
willingness of financial institutions to ac­
quire assets by engaging in liquidity-decreas­
ing portfolio transformations.
A euphoric new era means that an invest­
ment boom is combined with pervasive
liquidity-decreasing portfolio transforma­
tions. Money market interest rates rise be­
cause the demand for investment is increas­
ing, and the elasticity of this demand
decreases with respect to market interest
rates and contractual terms. In a complex
financial system, it is possible to finance in­
vestment by portfolio transformations. Thus
when a euphoric transformation of expecta­
tions takes place, in the short run the amount
of investment financed can be independent
of monetary policy. The desire to expand
and the willingness to finance expansion by
portfolio changes can be so great that, unless
there are serious side effects of feedbacks,
an inflationary explosion becomes likely.
A euphoric boom economy is affected
by the financial heritage of an earlier, more
insecure time. The world is not born anew
each moment. Past portfolio decisions and


conditions in financial markets are em­
bodied in the stock of financial instruments.
In particular, a decrease in the market value
of assets which embody protections against
states of nature that are now considered
unlikely to occur will take place, or alterna­
tively there is a rise in the interest rate that
must be paid to induce portfolios to hold
newly created assets with these characteris­
tics. To the extent that such assets are long
lived and held by deposit institutions with
short-term or demand liabilities, pressures
upon these deposit institutions will accom­
pany the euphoric state of the economy.
In addition the same change of state that
led to the investment boom and to the in­
creased willingness to emit debt affects the
portfolio preferences of the holders of the
liabilities of deposit institutions. These in­
stitutions must meet interest rate competi­
tion at a time when the market value of the
safety they sell has decreased; that is, their
interest rates must rise by more than other
The rising interest rate on safe assets
during a euphoric boom puts strong pres­
sures on financial institutions that offer pro­
tection and safety. The linkages between
these deposit institutions, conventions as
to financing arrangements, and particular
real markets, are such that sectoral depres­
sive pressures are fed back from a boom to
particular markets; these depressive pres­
sures are part of the mechanism by which
real resources are shifted.
The rise in interest rates places serious
pressures upon particular financial inter­
mediaries. In the current (1966) era the
savings and loan associations and the mu­
tual savings banks, together with the closely
related homebuilding industry, seem to take
a large part of the initial feedback pres­
sure. It may be that additional feedback
pressures are on life insurance and consumer
finance companies.

A little understood facet of how financial
and real values are linked centers around the
effect of stock market values.1 The value
of real capital rises when the expectation
that a recession will occur diminishes and
this rise will be reflected in equity prices.
The increased ratio of debt financing can
also raise expected returns on equities.
Inasmuch as owners of wealth live in the
same expectational climate as corporate
officers, portfolio preferences shift toward
equities as the belief in the possibility of a
recession or depression diminishes. Thus, a
stock market boom feeds upon and feeds
an investment boom.
The financing needs of the investment
boom raise interest rates. This rise lowers
the market value of long-term debt and
adversely affects some financial institutions.
Higher interest rates also increase the cost
of credit used to finance positions in equities.
Initially, the competition for funds among
various financial sectors facilitates the rapid
expansion of the economy; then as interest
rates rise it constrains the profits of in­
vesting units and makes the carrying of
equities more expensive. This first tends
to lessen the rate of increase of equity
prices and then to lower equity prices.
All in all, the euphoric period has a short
lifespan. Local and sectoral depressions and
the fall in equity prices initiate doubts as
to whether a new era really has been
achieved. A hedging of portfolios and a
reconsideration of investment programs
takes place. However, the portfolio commit­
ments of the short euphoric era are fixed
in liability structures. The reconsideration
of investment programs, the lagged effects
upon other sectors from the resource-shift­
ing pressures, and the inelasticity of aggre­
gative supply that leads to increases in costs
1 R. Turvey, “Does the Rate of Interest Rule the
Roost?” J. M. Keynes. The General Theory of Em ­
ployment, Interest and M oney, Chapter 12.


combine to yield a shortfall of the income
of investing units below the more optimistic
of the euphoric expectations.
The result is a combination of cash flow
commitments inherited from the burst of
euphoria and of cash flow receipts based
upon lower-than-expected income. Whether
the now less-desirable financial positions
will be unwound without generating sig­
nificant shocks or whether a series of finan­
cial shocks will occur is not known. In
either case, investment demand decreases
from its euphoric levels. If the boom is
unwound with little trouble, it becomes quite
easy for the economy once again to enter
a “new era”; on the other hand, if the un­
winding involves financial instability, then
there are prospects of deep depressions and
The pertinent aspects of a euphoric
period can be characterized as follows:


1. The tight money of the euphoric
period is due more to runaway demand than
to constraint upon supply. Thus, those who
weigh money supply heavily in estimating
money market conditions will be misled.
2. The run-up of short- and long-term
interest rates places pressure on deposit
savings intermediaries and disrupts indus­
tries whose financial channels run through
these intermediaries. There is a feedback
from euphoria to a constrained real demand
in some sectors.
3. An essential aspect of a euphoric eco­
nomy is the construction of liability struc­
tures which imply payments that are closely
articulated directly, or indirectly via layer­
ings, to cash flows due to income produc­
tion. If the impact of the disruption of
financing channels occurs after a significant
build-up of tight financial positions, a fur­
ther depressive factor becomes effective.

Financial crises take place because units
need or desire more cash than is available
from their usual sources and so they resort
to unusual ways to raise cash. Various types
of cash flows are identified in this section,
and the relations among them as well as
between cash flows and other characteristics
of the economy are examined.
The varying reliability of sources of cash
is a well-known phenomenon in banking
theory. For a unit, a source of cash may be
reliable as long as there is no net market
demand for cash upon it, and unreliable
whenever there is such net demand upon
the source. Under pressure various financial
and nonfinancial units may withdraw, either
by necessity or because of a defensive finan­
cial policy, from some financial markets.
Such withdrawals not only affect the poten­
tial variability of prices in the market but

also may disrupt business connections. Both
the ordinary way of doing business and
standby and defensive sources of cash can
be affected.
Withdrawals on the supply side of finan­
cial markets may force demanding units
that were under no special strain and were
not directly affected by financial stringencies
to look for new financing connections. An
initial disturbance can cumulate through
such third-party or innocent-bystander im­
pacts. Financial market events that disrupt
well-established financing channels affect the
present value and cash flows of units not
directly affected.1
For most consumers and nonfinancial
(ordinary) business firms the largest source
1 Thus the disruption of the southern California
savings and loan mortgage markets in mid-1966 af­
fected a l l present values and cash flow expectations
in the economy.


of cash is from their current income. Wages
and salaries are the m ajor source of cash
to most consumers and sales of output are
the m ajor source for business firms. For
financial intermediaries other than dealers,
the ordinary cash flow to the unit can be
derived from its financial assets. For ex­
ample, short-term business debts in a com­
mercial bank’s portfolio state the reserve
money that borrowers are comm itted to
make available to the bank at the contract
dates. A m ortgage in a savings and loan
association’s portfolio states the contractual
“cash flow to” for various dates. F or finan­
cial m arket dealers cash receipts usually
result from the selling out of their position,
rather than from the commitments as stated
in their inventory of assets. U nder ordinary
circumstances dealers as going concerns do
not expect to sell out their positions; as they
sell one set of assets they proceed to acquire
a new set.
The ordinary sources of cash for various
classes of economic units will be called cash
flow from operations. All three types of
cash flow from the operations described
— income, financial contracts, and turnover
of inventory— can be considered as func­
tions of national income. The ability to meet
payment commitments depends upon the
normal functioning of the income produc­
tion system.
In addition to cash flow from the sale of
assets, dealers— and other financial and non­
financial units— can meet cash drains due
to the need to make payments on liabilities
by emitting new liabilities. This second
source of cash is called the refinancing of
Furtherm ore, liquidating, or running off,
a position is the third possible way for some
units to obtain cash. This is what retailers
and wholesalers do when they sell inven­
tories (seasonal retailers actually do liqui­
date by selling out their position).

The financial assets and liabilities of an
economic unit can be transform ed into time
series of contractual cash receipts and pay­
ments. The various items in these contrac­
tual receipts and payments depend upon
national income: the fulfillment of the terms
of mortgage contracts depends upon con­
sumer disposable income and so forth.3
Estimates of the direct and indirect im pact
of variations in national income upon the
ability of units in the various sectors to meet
their financial commitments can be de­
Each economic unit has its reserve, or
emergency, sources of cash. F or many units
the emergency source consists of positions
in some m arketable or redeemable assets.
Savings bonds and time deposits are typical
standby sources of cash for consumers.
A corporation may keep a reserve in Treas­
ury bills or other money m arket instruments
to meet either unusual needs for cash or an
unexpected shortfall in cash receipts. Hoards
of idle cash serve this purpose for all units.
Cash has the special virtue that its avail­
ability does not depend upon the normal
functioning of any market.
In principle the norm al and secondary
sources of cash for all units can be identified
and their ratio to financial commitments
can be estimated. By far the largest num ber
of units use their income receipts to meet
their financial commitments. M ortgage and
consumer instalment payments for con­
sumers and interest and sinking fund pay­
ments for businesses would be financed
normally by income cash flows.
The substitution of a deposit by customer
B for a deposit from custom er A in a bank
1 This becomes the rationale for a cash flow bank
examination. The deviation of actual from contrac­
tual cash flows depends upon the behavior of the
1 The Minsky-Bonen experiments in H. P. Minsky,
“Financial Crisis, Financial Systems, and the P er­
form ance of the Econom y,” were primitive attempts
to do this.


liability structure may be viewed as the
refinancing of a position. The typical finan­
cial unit acquires cash to meet its payment
commitments, as stated in its liabilities, not
from any cash flow from its assets or by
selling assets but rather by emitting sub­
stitute liabilities. (The only financial orga­
nizations that seem to use cash flows from
assets to meet cash flow commitments are
the closed-end investment trusts, both
levered and unlevered.)
When a unit that normally meets its finan­
cial commitments by drawing upon an
income cash flow finds it necessary, or
desirable, to refinance its position, addi­
tional pressures may be placed upon finan­
cial institutions.
Some financial relations are based upon
the periodic liquidation of positions—for
example, the seasonal inventory in retailing.
Capital market dealers or underwriters
liquidate positions in one set of assets in
order to acquire new assets. However, if
organizations that normally finance their
payments by using cash from either income
or refinancing of positions should instead
attempt to sell their positions, it may turn
out that the market for the assets in position
is thin: as a result a sharp fall in the price
of the asset occurs with a small increase in
supply. In the market for single-family
homes a sale is usually not a forced sale,
and to a large extent sellers of one house
are buyers or renters of another. If home­
owners as a class tried to sell out their
houses, the market would not be able to
handle this without significant price con­
cessions. But significant price concessions
mean a decline in net worth—not only for
the selling unit but for all units holding this
asset. More particularly, a fall in price may
mean that the offering units may be unable
to raise the required or expected cash by
dealing in the affected asset.
As an empirical generalization, almost all
financial commitments are met from two


normal sources of cash: income flows and
refinancing of positions. For most units—
especially those that have real capital
goods as their asset—the selling out of their
position is not feasible (no market exists for
a quick sale); for others, aside from marginal
adjustments by way of special money mar­
kets, it is an unusual source of cash.
A further empirical generalization is that
asset prices—prices of the stock—can fall
much more rapidly than income prices—
prices of the flow.1 Any need or desire to
acquire cash that leads to attempts to sell
out positions in reproducible assets will re­
sult not only in large-scale decreases in net
worth but also in market prices for repro­
ducible assets that are far below their cur­
rent cost of production.
Even in the face of a widespread need
or desire to acquire cash by selling assets,
not all assets are allowed to fall in price.
The price of some assets will be stabilized by
central bank purchases or loans (refinancing
positions); such assets can be called pro­
tected assets.
Financial instability occurs whenever a
large number of units resort to extraordinary
sources for cash. The conditions under
which extraordinary sources of cash have
to be tapped—which for financial units
means mainly the conditions in which posi­
tions have to be liquidated (run off or sold
out)—are the conditions that can trigger
financial instability. The adequacy of cash
flows from incom e relative to debt, the ade­
quacy of refinancing possibilities relative to
position, and the ratio of unprotected to pro­
tected financial assets are determ inants of
the stability of the financial system . The

trend or evolution of the likelihood of finan­
cial instability depends upon the trend or
evolution of the determinants of financial
1 This is the content of the alleged wage rigidity
assumption of Keynesian theory. See H. G. Johnson,
“The ‘General Theory’ after Twenty-five Years.”


The essential difference between Keynesian
and both classical and neoclassical eco­
nomics is the im portance attached to un­
certainty.1 Basic propositions in classical
and neoclassical economics are derived by
abstracting from uncertainty; the most that
uncertainty does is to add some m inor quali­
fications to the propositions of the theory.
The special Keynesian propositions with re­
spect to money, investment, and under­
employment equilibrium, as well as the
treatm ent of consumption, can be under­
stood only as statements about system be­
havior in a world with uncertainty. One
defense against some possible highly un­
desirable consequences of some possible
states of the world is to m ake appropriate
defensive portfolio choices.1
In an attem pt to m ake precise his view
of the nature of uncertainty and what his
“General T heory” was all about, Keynes
asserted that in a world without uncertainty,
171 include the conventional interpretation of
Keynes under the rubric of neoclassical economics.
This standard interpretation, which “took off” from
J. R. Hicks’ fam ous article— “Mr. Keynes and the
‘Classics,’ A Suggested Interpretation,” and which
since has been entom bed in standard works like G.
Ackley, Macroeconomic Theory— is inconsistent with
Keynes’ own succinct and clear statem ent of the
content of the general theory in his rebuttal to V iner’s
fam ous review ( “Mr. Keynes on the Causes of U n­
em ploym ent” ). Keynes’ rebuttal appeared with the
title “The G eneral Theory of Em ploym ent” and em ­
phasized the dom inance of uncertainty in the deter­
m ination of portfolios, the pricing of capital, and the
pace of investment.
1 J. K. G albraith in The Affluent Society and K. J.
A rrow in “U ncertainty and the W elfare Economics of
M edical C are” take the view that various labor and
product m arket deviations from competitive condi­
tions reflect the need to constrain the likelihood that
undesirable “states” of the world will occur. This
G albraith-A rrow view of the optim al behavior of
firms and households seems to com plem ent the view
in Keynes’ rebuttal to Viner. See also K. J. Arrow,
Aspects of the Theory of Risk Bearing, Lecture 2:
“The Theory of Risk A version,” and Lecture 3: “In­
surance, Risk and Resource A llocation.”

no one, outside a lunatic asylum, would
use money as a store of w ealth.1 In the
world as it is, money and Treasury bills are
held as assets. Portfolios reflect the choices
that sane m en m ake as they attem pt to
behave in a rational m anner in an inherently
irrational (unpredictable) universe. This
means that a significant proportion of wealth
holders try to arrange their portfolios so
that they are reasonably well protected
irrespective of which one of a num ber of
alternative possible states of the economy
actually occurs.
In m aking portfolio choices, economic
units do not accept any one thing as a
proven guide to the future state of the eco­
nomy. Unless there are strong reasons for
doing otherwise, they often are guided by
extrapolation of the current situation or
trend, even though they may have doubts
about its reliability.20 Because of this under­
lying lack of confidence, expectations and
hence present values of future incomes are
inherently unstable; thus a not unusual
event, such as a “salad oil scandal” or a
modest decline in income, if it occurs in a
1 J. M. Keynes, “The G eneral Theory of Em ploy­
m ent,” pp. 209-23. The exact quotation, in full, is:
“Money, it is well known, serves two principal p u r­
poses. By acting as a money of account it facilitates
exchange w ithout it being necessary that it should ever
come into the picture as a substantive object. In this
respect it is a convenience which is devoid of signifi­
cance or real influence. In the second place it is a
store of wealth. So we are told w ithout a smile on
the face. But in the world of the classical economy,
w hat an insane use to which to put it! F or it is a
recognized characteristic of money as a store of
wealth that it is barren; whereas practically every
other form of storing wealth yields some interest or
profit. W hy should anyone outside a lunatic asylum
wish to use money as a store of w ealth?” p. 215.
2 The doubts can take the form of uncertainty as
to w hat “inertia” should be attached: should it be
attached to the level, the rate of change (velocity),
or the rate of change of the rate of change (accelera­
tio n )?


favorable environment, can lead to a sharp
revaluation of expectations and thus of asset
values. It may lead not only to a sharp
change in what some particular rational
man expects but also to a marked change in
the consensus as to the future of the
Conceptually the process of setting a
value upon a particular long-term asset or
a collection of such assets can be separated
into two stages. In the first the subjective
beliefs about the likelihood of alternative
states of the economy in successive time
periods are assumed to be held with con­
fidence. A second stage assesses the degree
of “belief” in the stated likelihoods attached
to the various alternatives.
When beliefs about the actual occur­
rence of various alternative states of the
economy are held with perfect confidence,
the standard probability expected value cal­
culation makes sense. The present value of
a long-term asset reflects its (subjective)
expected yield at each state-date of the
economy and the assumed likelihood of
these state-dates occurring. Under stable
conditions, the expected gross profit after
taxes (cash flow) of the ith asset at the
t th date, Qu, will equal 2 p stQn where
Qu is the gross profit after taxes of the ith
asset if the 5th state of nature occurs (as­
sumed independent of date, could be modi­
fied to sit, the 5 +1 state of nature at the ttb
date) and pst is the (subjective) probability
that the ,y state will occur at the fth date.
The s states are so defined that for each
t, 2 pst = 1. These Qu, discounted at a rate
appropriate to the assumed perfect certainty
with which the expectations are held, yield
the present value of the ith asset, Vi.21
If it is wished, to each outcome Q a a utility
can be attached. The probability and present
value computation can be undertaken with respect to
utilities. The risk-aversion character of a decision
unit is represented by the curvature of the utility

U (Q u )


Assume that S is a set of mutually exclu­
sive and exhaustive states of nature. At date
t, one of the S, Sj will occur; the 2
= 1.
However, the probabilities, p8), which must
be attached to the alternative outcomes in
order to compute the expected gross profit
and the cash flow for date t, can be accepted
with varying degrees of rational belief. The
value of the ith asset will vary, not only with
the expected payoffs at various state-dates
of nature and the probabilities attached to
these payoffs, but also with the confidence
placed in the probabilities attached to the
occurrence of these various state-dates of
nature. That is, Qu = 0 (2 p stQn ) where
0 — 0 — 1 and 0 reflects the confidence with
which the particular weights are attached to
the likelihood of various states of nature
In other words, there are at least two
conjectural elements in determining the ex­
pected payoffs, Qu and hence V»: one is
that the Qn are conjectures; the other that
the probability distribution of possible states
of nature, as reflected in the p3, is not known
with certainty. Obviously, events that affect
the confidence placed in any assumed prob­
ability distribution of the possible alterna­
tive states may also affect the confidence
placed in the assumed expected payoff if
state s occurs, Qm. A computed present value
of any asset Vi may be accepted with a wide
function. A change in confidence can be depicted by
a change in curvature, decreased confidence being
indicated by an increase in curvature. If preference
systems can be assumed to reflect experience, then a
long period without a deep depression will decrease
the curvature and the occurrence of a financial crisis
will increase the curvature of the preference system.
The psychology of uncertainty and the social psychol­
ogy of waves of optimism and pessimism are two
points at which economists need guidance from the
relevant sister social sciences. Throughout any dis­
cussion of uncertainty and of economic policy in the
framework of uncertainty psychological assumptions
must be made. At times the conclusions depend
in a critical manner upon the psychological assump­


range of confidence— from near certainty
to a most tenuous conjecture. This degree
of acceptance affects the m arket price of
the asset.
The relevant portfolio decisions for con­
sumers, firms, and financial concerns are
not made with respect to individual assets;
rather, they are m ade with respect to bundles
of assets. The problem of choosing a port­
folio is to combine assets whose payoffs will
vary quite independently as the states of
nature vary in order to achieve the unit’s
objective; which for a risk averter might be
a minimal satisfactory state in any circum ­
stance. This might be stated as follows:
a portfolio is chosen so as to maximize V
given a specified valuation procedure sub­
ject to the constraint that V s > V for every
likely state of nature.2
The assets available are both inside and
outside assets: the outside assets consist of
money and Government debt.2 The nominal
value of a m onetary asset (money plus
Government debt) is independent of the
state of the economy. Governm ent debt can
exhibit variability in its nom inal value due
to interest rate variations, but in conditions
where business cycles occur, its nominal
value is not highly correlated with the ex­
pected nominal value of inside assets.
We assume that two types of periods can
be distinguished: one in which beliefs are
held with confidence concerning the likeli­
hood of alternative states of nature occur­
ring within some horizon period and the
second in which such beliefs are most in­
secure. In the second situation bets are
placed under duress. D uring these second
periods— when what can be called higherorder uncertainty rules— m arkedly lower
2 Alternatively, the desired portfolio objective can
be stated in terms of cash flows; this less conventional
view is examined in Section VI.
2 J. G. Gurley and E. Shaw, M o n ey in a Theory
of Finance.

relative values are attached to assets whose
nominal value depends upon the economy’s
performance. Periods of higher-order un­
certainty will see portfolios shift tow ard
assets that offer protection against large
declines in nom inal values. Even though
flexibility is almost always a virtue, the
premium on assets that perm it flexibility will
be larger in such periods of higher-order
uncertainty. F or many questions a rational
man has the option of saying “I don’t know”
and of postponing a decision. As a wealth
owner he must assess the worth of various
assets even when conditions are so fluid
that he would rather not make a decision.
Keynesian liquidity preference encom ­
passes both confidence conditions. Expecta­
tions as to the likelihood of different states
of nature may be held with varying degrees
of confidence. During periods of stable ex­
pectations, portfolios are m anaged so that
the outcome will be tolerable regardless
which state of nature rules. Most units tend
to weigh heavily the avoidance of disasters,
such as a liquidity crisis for the unit. Assets
that offer protection against a liquidity crisis
or temporarily disorganized asset m arkets
would be part of a rational portfolio under
all circumstances. In addition a preferred
m arket may exist for assets that obviate
against capital losses. Thus liquidity prefer­
ence is defined as a rational person’s demand
for money as an asset; this leads to a deter­
minate dem and function for money for any
value of higher-order uncertainty.24
In addition to periods when the likelihood
of various states of nature appear stable,
there are troubled periods when the sub­
jective estimates as to the likelihood of vari­
ous states of nature are held with m uch less
confidence. The risk-averter reaction to a
decline in confidence is to attem pt to in2 See J. Tobin, “Liquidity Preference as Behavior
Toward Risk,” pp. 65-68.


crease the weight of assets that yield flexi­
bility in portfolio choices, in other words,
to increase the value not only of money
but also of all assets that have broad, deep,
and resilient markets. Any increase in un­
certainty shifts the liquidity preference func­
tion, and this shift can be quite m arked and
Obviously, the reverse— a decrease in
uncertainty— can occur. If risk-averters are
dom inant, then an increase in uncertainty
is likely to be a rapid phenomenon, whereas
a decrease will require a slow accretion of
confidence. There is no need for a loss in
confidence to proceed at the same pace as
a gain in confidence.
Rapid changes in desired portfolios may
be confronted with short-period inelastic
supplies of prim ary assets (real capital and
government liabilities). As a result, the
relative prices of different assets change. An
increase in uncertainty will see the price of
inside assets— real capital and equities— fall
relative to the price of outside assets— gov­
ernm ent debt— and money; a decrease in
uncertainty will see the price of inside assets
rise relative to that of outside assets.
The nom inal money supply in our frac­
tional reserve banking system can be almost
infinitely elastic. Any events that increase
uncertainty on the part of owners of real
wealth will also increase uncertainty of com ­
mercial bankers. Unless prices of inside
assets are pegged by the central bank, a
sharp increase in uncertainty will result in
the price of inside assets falling relative to
both money and the price of default-free or
protected assets.
In a decentralized private-enterprise eco­
nomy with private commercial banks, we
cannot expect the money supply to increase
sufficiently to offset the effects of a sharp
increase in uncertainty upon inside asset
prices. Conversely, we cannot expect the
money supply to fall sufficiently to offset the


effects of a sharp decrease in uncertainty.
We should expect the private, profitmaximizing, risk-averting commercial banks
to behave perversely, in that with a decrease
in uncertainty they are willing and eager
to increase the money supply and with an
increase in uncertainty they act to contract
the money supply.2
Portfolios must hold the existing stocks
of private real assets, Treasury debt, and
money. Even during an investment boom
the annual increm ent to the stock of real
capital is small relative to the total stock.
However, in time the stock of reproducible
capital is infinitely elastic at the price of
newly produced capital goods. Thus there
is a ceiling to the price of a unit of the
stock of real capital in the current m arket.
This ceiling price allows for an expected
decline in the price of the stock to the
price of the flow of newly produced units.
The current return on real capital col­
lected in firms reflects the current function­
ing of the economy, whether prosperity or
depression rules. D uring an investment
boom current returns are high. Because a
ceiling on the price of units in the stock of
capital is imposed by the cost of investment,
a shift in the desired composition of port­
folios towards a greater proportion of real
capital cannot lower very far the short-run
5 The stagnant state that follows a deep depression
has been characterized by very low yields— high
prices— on default-free assets. One interpretation of
the liquidity trap is th at it reflects the inability to
achieve a m eaningful difference between the yields
on real assets and on default-free assets by further
lowering of the yield on default-free assets. An equiv­
alent but more enlightening view of the liquidity trap
is that circumstances occur in which it is not possible
by increasing the stock of money to raise the price
of the units in the stock of existing capital so as to
induce investment. In these conditions expansion­
ary fiscal policy, especially government spending,
will increase the cash flows th at units in the stock
of real capital generate. In otherwise stagnant condi­
tions this realized im provem ent in earnings will tend
to increase the relative price of inside capital, and
thus help induce investment.


yield on real capital valued at market price;
in fact because of prosperity and greater
capacity utilization this yield may increase.
As the outside assets—Treasury debt and
so forth—are now less desirable than in
other more uncertain circumstances, their
yield must rise toward equality with the
yield on inside or real assets. To paraphrase
Keynes “. . . in a world without uncertainty
no one outside of a lunatic asylum . . will
hold Treasury bills as a store of wealth
unless their yield is the same as that on
real assets.
As the implicit yield on money is pri­
marily the value of the implied insurance
policy it embodies, a decrease in uncertainty
lowers this implicit yield and thus lowers
the amount desired in portfolios. As all
money must be held, as bankers are eager to
increase its supply, and as its nominal value
cannot decline, the money price of other
assets, in particular real assets, must
In a euphoric economy it is widely
thought that past doubts about the future of
the economy were based upon e r r o r . The
behavior of money and capital market in­
terest rates during such a period is consistent
with a rapid convergence of the yield upon
default-free and default-possible assets. This
convergence takes place by a decline in the
price of—the rise in the interest rate on—
default-free assets relative to the price of—
yield on—the economy’s underlying real
In addition to default-free—government
debt plus gold—and default-possible—real
capital, private debts, equities—assets, there
are protected assets. Protected assets in vary­
ing degrees and from various sources carry
some protection against consequences that
would follow from unfavorable events.
Typical examples of such assets are bonds
and savings deposits.
The financial intermediaries—including

banks as they emit money—generate assets
that are at least partially protected. A rise
in intermediation and particularly a rise in
bank money, even if the asset acquired by
the bank carries default possibilities, may
unbalance portfolios in favor of default-free
assets. The ability of banking, through the
creation of money, to stimulate an economy
rests upon the belief that banks and the
monetary authorities are able to give such
protection to their liabilities. The liabilities
of other financial intermediaries are pro­
tected, but not so much as bank money;
thus their stimulative effect, while not
negligible, is smaller. In a euphoric eco­
nomy the value of such protection decreases,
and these instruments also fall in price rela­
tive to real assets or equities.2
To summarize, the relative prices of assets
are affected by portfolio imbalance that
follows from changing views as to uncer­
tainty concerning future states of the econ­
omy. A decrease in the uncertainty will raise
the price of units in the stock of real inside
assets for any given supply of money, other
outside assets, and assets that are in all or
in part protected against the adverse be­
havior of the economy; an increase in un­
certainty will lower these prices. For a given
state of uncertainty and stock of real capital
assets, the greater the quantity of money,
other outside assets, and protected assets,
the greater the price of units in the stock of
real capital. Investment consists of produc­
ing substitutes for items in the stock of real
capital; the price of the units in the stock
2 Incidentally, the phenom enon by w hich a decrease
in the value of some protection affects observable
m arket prices also exists in the labor market. Civil
servants and teachers accept low money incomes
relative to others with the same initial job opportunity
spectrum in exchange for security; civil servants value
security more than others. In a euphoric, full em ­
ploym ent economy the value of such civil servant
security diminishes. Hence in order to attract w ork­
ers, their relative m easured m arket wage will need
to rise.



is the demand price for units to be pro­
duced. To the extent that the supply of
investment responds positively to its dem and
price, the pace of investment flows from
portfolio imbalance.
The investment process can be detailed
as (1 ) the portfolio balance relation that
states the m arket price for capital assets as
a function of the money supply (Diagram
1), and (2 ) the investment supply function
that states how m uch investment output will
be produced at each m arket price for capital
assets (D iagram 2). It is assumed that the
m arket price for capital assets is the demand
price for investment output. The supply
curve of investment output is positively
sloped. A t some positive price the output
of investment goods becomes zero. The
m arket price of capital assets as determined
by portfolio preferences is sensitive to the
state of expectations or to the degree of un­
certainty with respect to the future.2
In Diagram 1, I have chosen to keep the
stock of capital constant. Thus V — PkK +
M, where V is wealth, Pk is price level of
capital, K is the fixed stock of capital, and
M is outside money. As M increases, V in­
creases because of both the rise in M and a
rise in Pk. l i M increases as m anna from
heaven, it would be appropriate for the con­
sumption function to include a W / P y varia­
ble ( Pv is the price level of current o u tput).
This would, by today’s conventions, add an
2 The investm ent argum ent builds upon R. W.
Clower, “A n Investigation into the Dynamics of In ­
vestment,” and J. G. W itte, Jr., “The M icrofounda­
tions of the Social Investm ent Function.” Both
Clower and Witte emphasize the determ ination of the
price per unit of the stock as a function of exogen­
ously given interest rates: they are wedded to a
productivity basis for the dem and for real capital
assets. The argum ent here emphasizes the portfolio
balance or speculative aspects of the dem and for
real capital assets. Thus, interest rates are computed
from the relation between expected flows and m arket
prices, that is, the price of capital as a function of
the money supply relation is the liquidity preference





upward drifting consum ption function to the
mechanism by which a rise in M affects
I f C = f ( Y ) and Y = C + /, then the
above diagram determines income as a func­
tion of M .2

2 Alternatively, the value of wealth can be kept
constant; thus V = P kK + M . An increase in M is ini­
tially an “open m arket operation” & M = P kK . H ow ­
ever, as portfolios now hold more money and less
capital goods, the price per unit of capital goods
rises. Capital is expropriated so that W rem ains fixed.
This is a pure portfolio balance relation.
If, starting from an initial position, Vo—PkoKo-\M 0, M is increased, then the Pk of the second variant
would lie above th at of the first variant. If M is
decreased, the P f of the second variant will lie below
that of the first. The constant wealth variant cuts the
constant private capital stock variant from below. I
have assumed constant capital stock K in drawing
D iagram 1.
2 If we assume th a t the future expected returns


It is impossible in this view to generate
an investment function I = f ( r ) that is in­
dependent of the portfolio adjustments of
the liquidity preference doctrine; investment
is a speculative activity in a capitalist eco­
nomy that is only peripherally related to
Two phenomena can be distinguished.
If M remains fixed as capital is accumulated,
a slow downward drift of the Q ( M ,K )
function (Diagram 1) will take place. A rise
in M is needed to maintain real asset prices
in the face of the rise in the stock of real
capital.3 Alternatively, if portfolio prefer­
ences change, perhaps because of a change
in uncertainty, then, independently of the
impact of real accumulation, the Q (M ,K )
function will shift. It is the second type of
shift that occupies center stage in the
Keynesian view of the world. And this has
been neglected in both monetary and invest­
ment analysis.
At all times investment demand has to
take into account the returns received dur­
ing various expected states of the economy.
from capital are known, then the equation Pu=
Q ( M , K ) can be transformed into r = Q ( M , K ). With
every quantity of M a different price will be paid for
the same future income stream; a larger quantity of
money will be associated with a higher market price
of existing capital and thus a lower rate of return
on the market value of capital. In a similar way, the
investment relation can be turned into an 1 = 1 (r)
relationship. This requires the same information on
expected returns as is used in transforming the port­
folio relation. In turn the I = I ( r ) and the r = Q ( M )
can be transformed into I = Q ( M) . Because K and
not Y is an argument in the equation P k= Q ( M , K ),
the I —S, L —M construction is not obtained.
3 This footnote appears in right-hand column.

As the result of a shock, the weight attached
to depression returns may increase. As the
dust settles there is gradual easing of the
views on the likelihood of unfavorable states
of nature. The weight attached to liquidity
is decreased and a gradual increase of in­
vestment will take place.
Hopefully we know enough to supplement
investment by honorary investments (Gov­
ernment spending) so that the expected
returns from capital will not again reflect
large-scale excess capacity. Nevertheless, if
a shock takes place, some time elapses be­
fore its effects wear off. In these circum­
stances honorary investment may have to
carry the burden of maintaining full employ­
ment for an extended period.
The essence of the argument is that
investment activity may be viewed as an
offshoot of portfolio preferences, and that
portfolio preferences reflect the attempt by
rational men to do well in a world with
uncertainty. Any shock to portfolio prefer­
ences that leads to a sharp drop in invest­
ment results from experiences with port­
folios that have gone sour. On a large scale,
portfolios go sour in the aftermath of a
financial crisis.
3 Underlying preferences need not be such that for

Pk to remain constant

dM dK

^ ma^

or evert
s ee Arrow, “Aspects of
°r even M
the Theory of Risk Bearing.” Friedman’s well-known



result is that



. See M. Friedman, “The

Demand for Money: Some Theoretical and Empirical
Results,” pp. 327-51.



T he m odel can be written as follow s:

( 1)

C = C(Y}_
I = I ( P IS, W )
P k = L{M, K)


P i - d —P



M 0= M S


Ms (M o n e y ), K (capital sto c k ), and W (w ages
are all exogenous, Pu= 1.
Sym bols have their usual m eaning: w e add Pis
as the supply price o f a unit o f investm ent, P k as
the market price o f a unit o f existing real or in­
side capital, and P i.d is the dem and price o f a
unit o f investm ent.


\ P i s > 0 dPns >0
> 0,
0 dW
dP k
dP K <0
dM > 0, dK

E quation 4 is unstable w ith respect to view s
as to uncertainty; it shifts “d ow n ” w henever un ­
certainty increases. T his portfolio balance equa­
tion (th e liquidity preference fu n ction ) yields a
market price for the units in the stock o f real
capital for each quantity o f m oney.
G iven W, I adjusts so that Pis=Pk (equations
3, 5, and 6 ) . O nce I is given C and Y are then
determ ined (equations 1 and 2 ) . N ow h ere in this
m odel does either the interest rate or the produc­
tivity o f capital appear. “L iquidity preference”
(equation 4 ) determ ines the m arket price o f the
stock o f real assets. A shift in liquidity preference
m eans a shift in equation 4, not a m ovem ent
along the function.
In the m odel, the tune is called by the market
price o f the stock o f real capital. G iven a cost
curve for investm ent that has a positive price for
zero output, it is possible for the dem and price
to fall below the price at w hich there w ill be an
appreciable production o f capital goods. Thus, the
com plete collapse o f investm ent is possible.
O f course, productivity in the sense o f the ex­
pected quasi-rents is alm ost always an elem ent in
the determ ination o f the m arket price o f a real
asset or a collection o f assets. H ow ever, this for­
m ulation m inim izes the im pact o f productivity as
it em phasizes that the liquidity attribute o f assets
m ay at tim es be o f greater significance in deter­
m ining their m arket price than their productivity.

T he perspective in this form ulation is that o f busi­
ness cycles, not o f a full-em ploym ent steady state.
Productivity o f capital takes the form o f ex­
pected future earnings (gross profits after taxes)
o f a collection o f capital goods within a producing
unit. In any real w orld decision, the earnings on
specific items or collections o f capital must be
estim ated, and the heterogeneity o f the capital
stock m ust be taken into account.
O nce earnings are estim ated, then given the cur­
rent market price, a discount rate can be co m ­
puted. That is, w e have


i= l



/a +'•.•)'

w hich states the arithm etic relation that the value
o f the capital stock is o f necessity equal to the
discounted value o f som e know n stream o f re­
turns, Qi. If the current m arket determ ines Pk • K
and if a set o f Q is estim ated, an interest rate can
be com puted. If it is w ished, equation 4 can be
suppressed by using equation 7, that is,


= L(M,K)

/ .£ a + r i ) t
If a transaction dem and for m on ey is added, if
the Qi are interpreted as a fu nction o f Y, if all
a are assumed equal, and if K is suppressed as
being fixed in the short run then
(4 ")

M 0= L ( r , Y )

m ay be derived.
F or the investm ent decision, w e m ay assume
that the future return o f the increm ent to capital
is the sam e as to the stock o f capital. W ith the Oi
know n and assum ed independent o f the short-run
pace o f investm ent, then
(3 ')


- j . E .i d + * '

Thus given the fact that the supply price o f in­
vestm ent rises w ith investm ent (constant W ) ,
greater investm ent is associated w ith a low er in­
terest rate. That is,


/= /(> , y) and ^ <0

Both equations 4" and 3" are arithm etic trans­
form ations o f 4 and 3. Equations 4 and 3 repre­
sent market phenom ena, whereas 4" and 3" are


computed transformations of market conditions.
For financial contracts such as bonds the Q i
are stated in the contract. Even so the yield to
maturity is a computed number— the market num­
ber is the price of the bond.
When the interest rate is not computed, the
investment decision and its relation to liquidity
preference are viewed in a more natural way. Of
course, for real capital the Q i reflects the produc-

tivity in the form of cash flows, current and
expected. But the productivity of capital and
investment affect present performance only after
they are filtered through an evaluation of the
state of the irrational, uncertain world that is the
positioning variable in the liquidity preference
function. Productivity and thrift exist, but in a
capitalist economy their impact is always filtered
by uncertainty.

Tight money, defined as rising nominal
interest rates associated with stricter other
terms on contracts, may work to restrain
demand in two ways.3 In the conventional
view tight money operates through ration­
ing demand by means of rising interest rates.
Typically this has been represented by move­
ments along a stable negatively sloped de­
mand curve for investment (and some forms
of consumption) that is drawn as a function
of the interest rate. An alternative view that
follows from the argument in Section IV
envisages tight money as inducing a change
in expectations in the perceived uncertainty,
due to an episode such as a financial crisis
or a period of financial stringency. This
within Diagrams 1 and 2 can be represented
by a downward shift in the infinitely elastic
demand curve for investment.
The way in which tight money operates
depends upon the state of the economy. In
a non-euphoric expanding economy, where
liability structures are considered satisfac3 “Tightness” of money refers to costs (including
contract term s) for financing activity by way of debt.
H igh and rising interest rates plus more restrictive
other terms on contracts are evidence of tight money.
Tightness has nothing directly to do with the rate of
change of the money supply or the money base or
what you will. Only as these money supply phenom ­
ena affect contract terms do they affect tightness.
N onprice rationing by suppliers of finance means
that the other term s in financing contracts for some
dem anders increase m arkedly. The tightness of money
is not measured correctly when only one term in a
contract, the interest rate, is considered.

tory, monetary restraint will likely operate
by way of rationing along a stable invest­
ment demand curve. In a booming euphoric
economy, where high and rising prices of
capital are associated with a willingness on
the part of firms to “extend” their liability
structures and of financial intermediaries to
experiment with both their assets and their
liabilities, tight money will be effective only
if it brings such portfolio, or financial struc­
ture, experimentation to a halt. A recon­
sideration of the desirability of financial
experimentation will not take place without
a triggering event, and the reaction can be
both quick and disastrous. A euphoric boom
is characterized by a stretching, or thinning
out, of liquidity; the end of a boom occurs
when desired liquidity quickly becomes sig­
nificantly greater than actual liquidity.
In a euphoric economy, with ever-increasing confidence, there is an increase in the
weights attached to the occurrence of states
of nature favorable to the owning of larger
stocks of real capital. Thus, an upward drift
in the price of the real capital-money sup­
ply function occurs (Diagram 1, p. 111).
This shift means that for all units both
the expected flows of cash from operations
and the confidence in these expectations are
rising. Given these expectations, an enter­
prise assumes that with safety it can under­
take (1) to emit liabilities whose cash needs


will be met by these now-confidentlyexpected cash flows and (2) to undertake
projects with the expectation that the cash
flows from operations will be one of the
sources of finance. In a euphoric economy
the weight attached to the necessity for cash
reserves to ease strains due to unexpected
shortfalls in cash flows is ever decreasing.
In a lagless world—where all investment
decisions are taken with a clean slate, so
to speak—current investment spending is
related to current expectations and financial
or money market conditions. In a world
when today’s investment spending reflects
past decisions, the needs for financing today
can often be quite inelastic with respect to
today’s financing conditions: and today’s
financing conditions may have their major
effect upon investment spending in the
future. Thus, there exists a pattern of lags
between money and capital market condi­
tions and investment spending conditions.
This lag pattern is not independent of eco­
nomic events. A dramatic financial market
event, in particular a financial crisis or wide­
spread distress, can have a quick effect.
For units with outstanding debts, tight
money means that cash payment commit­
ments rise as positions are refinanced. This
is true not only because interest rates are
higher but also because other terms of the
units’ borrowing contracts are affected. In
addition, if projects are undertaken with the
expectation that they would be financed in
part by cash generated by ongoing opera­
tions, and if the available cash flows fall
short of expectations—due perhaps to the
increased cost of the refinanced inherited
debt—then a larger amount will need to be
financed by debt or by the sale of financial
assets. This means that the resultant balance
sheet can be inferior to and the cash flow
commitments larger than the target envis­
aged when the project was undertaken.


Conversely, if gross profits rise faster than
costs, so that a smaller-than-expected por­
tion of investment is financed by debt, the
resultant balance sheet will be superior to
that expected when projections were made.
In this way, investment may be retarded or
accelerated by cash flow and balance sheet
Deposit financial institutions are espe­
cially vulnerable to tight money if their
assets are of significantly longer term than
their debts; they are virtually refinancing
their position daily by offering terms that
are attractive to their depositors. A rapid
rise in their required cash flows due to
interest costs may take place, which can
lead to a sharp reduction in their net income.
Thus, during a euphoric expansion the
effects of tight money are more than offset
for units holding real capital, whereas for
other units, such as savings banks, tight
money means a significant deterioration in
their financial position whether measured
by liquidity or net worth.
In a euphoric economy the willingness to
hold money or near money decreases. The
observed tightness of money—the rise in
interest rates on near monies and other
debts—is not necessarily caused by any
undue constraint upon the rate of increase
of the money supply; rather it reflects the
rapid increase in the demand for financing.
An attempt by the authorities to sate the
demand for finance by creating bank credit
will lead to rapidly rising prices: inflationary
expectations will add to the euphoria.
Euphoric expectations will not be ended by
a fall in income, as the strong investment
demand that is calling the tune is insensi­
tive to the rise in financing terms.
8 For a more detailed analysis of how financial
actualities may relate to project decisions, see H. P.
Minsky, “Financial Intermediation in the Money and
Capital Markets.” See also E. Greenberg, “A StockAdjustment Investment Model.”


In a euphoric economy characterized by
an investment boom, cash payments become
ever more closely articulated to cash re­
ceipts; the speculative stock of money and
near monies is depleted. Two phenomena
follow from this closer articulation. The size
decreases, both of the shortfall in cash re­
ceipts and of the overrun in cash payments
due to normal operations, that will result
in insufficient cash on hand to meet pay­
ments. The frequency with which refinanc­
ing or asset sales are necessary to meet
payment commitments increases. Units be­
come more dependent upon the normal
functioning of various financial markets.
Under these emerging circumstances there
is a decrease in the size of the dislocation
that can cause serious financial difficulties
to a unit, and an increase in the likelihood
that a unit in difficulty will set other units
in difficulty. Also, even local or sectoral
financial distress or market disruptions may
induce widespread attempts to gain liquidity
by running off or selling out positions in
real or financial assets (inventory liquida­
tion). This action in turn may depress
incomes and market prices of real and
financial assets. We may expect financial
institutions to react to such developments
by trying to clean up their balance sheets
and to reverse the portfolio changes entered
into during the recent euphoric period. The
simultaneous attempt by financial institu­
tions, consumers, and firms to improve their
balance sheets may lead to a rupture of
what had been normal as well as standby
financing relations. As a result losses occur,
and these, combined with the market dis­
ruptions, induce a more conservative view
as to the desired liability structure.
The view that, in conditions of euphoria,
tight money operates by causing a re-evalua­
tion of the uncertainties carried by economic
units is in marked contrast to the textbook

analysis of tight money seen as operating
by constraining expenditures along a stable
investment function. If an expansion is tak­
ing place in the absence of a transformation
—by way of euphoric expectations—of pre­
ferred portfolios and liability structures then
the system can operate by rationing along
a stable investment relation. Then tight
money may lead to a decline in investment
and a relaxation of monetary constraint may
reverse this decline: conventional monetary
policy can serve as an economic steering
But once the expansion is associated with
the transformation of asset and liability
structures that have been identified as char­
acteristic of a euphoric economy, tight
money will constrain demand only if it
induces a shift either in the demand func­
tion for money or in the price function for
capital goods. For this to happen the ex­
pansion must continue long enough for
balance sheets to be substantially changed.
Then some triggering event that induces a
reconsideration of desired balance sheets
must occur. A financial crisis or at least
some significant amount of financial distress
is needed to dampen the euphoria. The fear
of financial failure must be credible in order
to overcome expectations built on a long
record of success.
During an emerging euphoric boom, the
improvement in expectations may over­
whelm rising interest rates. As a result of
the revision of portfolio standards, the sup­
ply of finance seems to be almost infinitely
elastic at stepwise rising rates. Typically,
this “infinitely” elastic supply is associated
with the emergence of new financial instru­
ments and institutions,3 such as the use of
Federal funds to make position, the explo­
sive growth of negotiable CD’s, and the
3 H. P. Minsky, “Central Banking and Money Mar­
ket Changes.”


development of a second banking system.
Under these circumstances, a central bank
will see its restriction of the rate of growth
of the money supply or the reserve base
overwhelmed by the willingness of con­
sumers, business firms, and financial institu­
tions to decrease cash balances: increases
in velocity overcome restrictions in quan­
tity. The frustrated central bank can try to
compensate for its lack of success in con­
straining expansion by further decreasing
the rate of growth of the money supply,
thus forcing a more rapid development of
a tightly articulated cash position. Such a
further tightening will occur within a finan­
cial environment that is increasingly vulner­
able to disruption. The transition will not be
from too-rapid economic expansion to sta­
bility by way of a slow deceleration, but a
rapid decline will follow a sharp braking of
the expansion.
With some form of a financial crisis likely
to occur after a euphoric boom, it becomes
difficult to prescribe the correct policy for
a central bank. However, the central bank
must be aware of this possibility and it must
stand ready to act as a lender of last resort
to the financial system as a whole if and
when a break takes place. With the path
of the economy independent in its gross
terms of the rate of increase of the money
supply and of the relative importance of
bank financing, the central bank might as
well resist the temptation to further tighten


its constraints if the initial extent of con­
straint does not work quickly. The central
bank should sustain the rate of growth of
the reserve base and the money supply at a
rate consistent with the long-term growth
of the economy. This course should be
adopted in the hope, however slight, that
the rise in velocity—deterioration of bal­
ance sheet phenomena described earlier—
will converge, by a slow deceleration of the
euphoric expectations, to a sustainable
steady state.
In particular during a euphoric expansion
the central bank should resist the temptation
to introduce constraining direct controls on
that part of the financial system most com­
pletely under its control—the commercial
banks. The central bank should recognize
that a euphoric expansion will be a period of
innovation and experimentation by both
bank and nonbank financial institutions.
From the perspective of picking up the
pieces, restoring confidence, and sustaining
the economy, the portion of the financial
system that the central bank most clearly
protects should be as large as possible. In­
stead of constraining commercial banks by
direct controls, the central bank should aim
at sustaining the relative importance of com­
mercial banks even during a period of
euphoric expansion; in particular, the com­
mercial banks should not be unduly con­
strained from engaging in rate competition
for resources.

In Section IV it was concluded that normal
functioning requires that the price level, per­
haps implicit, of the stock of real capital
assets be consistent with the supply price of
investment goods at the going-wage level.
The euphoric boom occurs when portfolio
preferences change so that the price level of

the stock rises relative to the wage level,
causing an increase in the output of invest­
ment goods. A sharp fall in the price level
of the stock of real assets will lead to a
marked decline in investment and thus in
income: a deep depression can occur only if
such a change in relative prices takes place.


Attributes of stability

In the discussion of uncertainty, we identi­
fied one element that could lead to a sharp
lowering of the price level of the existing
stock of capital. A sharp change in the de­
sired composition of assets in portfolios—
due to an evaporation of confidence in views
held previously as to the likelihood of vari­
ous alternative possible state-dates of the
economy—will lower the value of real assets
relative to both the price level of current
output and money. Such a revaluation of the
confidence with which a set of expectations
is held does not just happen.
The event that marks the change in port­
folio preferences is a period of financial
crisis, distress, or stringency (used as de­
scriptive terms for different degrees of finan­
cial difficulty). However, a financial crisis—
used as a generic term—is not an accidental
event, and not all financial structures are
equally prone to financial instability. Our in­
terest now is in these attributes of the finan­
cial system that determine its stability.
We are discussing a system that is not
globally stable. The economy is best ana­
lyzed by assuming that there exist more
than one stable equilibrium for the system.
We are interested in the determinants of the
domain of stability around the various stable
equilibria. Our questions are of the form:
“What is the maximum displacement that
can take place and still have the system re­
turn to a particular initial equilibrium
point? ’ and “Upon what does this ‘maxi­
mum displacement’ depend?”
The maximum shock that the financial
system may absorb and still have the econ­
omy return to its initial equilibrium depends
upon the financial structure and the linkages
between the financial structure and real in­
come. Two types of shocks that can trigger
large depressive movements of financial vari­
ables can be identified: one is a shortfall of
cash flows due to an over-all drop in income,

and the second is the distress of a unit due
to “error” of management. But not all reces­
sions trigger financial instability and not
every financial failure, even of large finan­
cial units, triggers a financial panic or crisis.
For not unusual events to trigger the un­
usual, the financial environment within
which the potential triggering event occurs
must have a sufficiently small domain of
The contention in this paper is that the
domain of stability of the financial system is
mainly an endogenous phenomenon that de­
pends upon liability structures and institu­
tional arrangements. The exogenous ele­
ments in determining the domain of financial
stability are the government and central
banking arrangements: after mid-1966 it is
clear that the exogenous policy instrument
of deposit insurance is a powerful offset to
events with the potential for setting off a
financial crisis.
There are two basic attributes of the fi­
nancial system that determine the domain of
stability of the financial system: (1) the ex­
tent to which a close articulation exists be­
tween the contractual and customary cash
flows from a unit and its various cash re­
ceipts and (2) the weight in portfolios of
those assets that in almost all circumstances
can be sold or pledged at well nigh their
book or face value. A third element, not
quite so basic, that determines vulnerability
to a financial crisis is the extent to which ex­
pectations of growth and of rising asset
prices have affected current asset prices and
the values at which such assets enter the fi­
nancial systems.3 The domain of stability of
“Assets enter the financial system when they are
used as collateral for borrowing. A newly built house
enters the financial system through its mortgage,
which is based upon its current production costs. If
the expectation takes over that house prices will rise
henceforth at say 10 per cent a year, the market value
of existing houses will rise to reflect the expected
capital gains. If mortgages are based upon purchase
prices, once such a house turns over, the values in the


the financial system is smaller the closer the
articulation of payments, the smaller the
weight of protected assets, and the larger the
extent to which asset prices reflect both
growth expectations and realized past appre­
ciations. The evolution of these attributes of
the financial structure over time will affect
the size of the domain of stability of the fi­
nancial system. An hypothesis of this, as
well as the earlier presentations of these
ideas, is that when full employment is being
sustained by private demand, the domain of
stability of the financial system decreases.
In addition to the impact of such full em­
ployment a euphoric economy with its
demand-pull tight money will be accom­
panied by a rapid increase in the layering of
financial obligations, which also tends to de­
crease the domain of stability. For as layer­
ing increases, the closeness with which pay­
ments are articulated to receipts increases
and layering increases the ratio of inside
assets to those assets whose nominal or book
value will not be affected by system be­
havior.3 A euphoric economy will typically
be associated with a stock market boom and
an increase in the proportion of the value of
financial assets that is sensitive to a sharp
revaluation of expectations.
Even though a prolonged expansion,
dominated by private demand, will bring
about a transformation of portfolios and
changes in asset structures conducive to fi­
nancial crises, the transformations in port­
folios that take place under euphoric condi­
tions sharply accentuate such trends. It may
be conjectured that euphoria is a necessary
prelude to a financial crisis and that euphoria
portfolios of financial institutions reflect growth ex­
pectations. This happens with takeovers, mergers,
conglomerates, and so on. It is no accident that such
corporate developments are most frequent during eu­
phoric periods.
3 The relevant assets structure concept is outside
assets as a ratio to the combined assets (or liabilities)
of all private units, not the consolidated assets.


is almost an inevitable result of the success­
ful functioning of an enterprise economy.
Thus, the theory of financial stability takes
into account two aspects of the behavior of
a capitalist economy. The first is the evolu­
tion of the financial structure over a pro­
longed expansion, which affects the nature
of the primary assets, the extent of financial
layering, and the evolution of financial in­
stitutions and usages. The second consists of
the financial impacts over a short period due
to the existence of a highly optimistic,
euphoric economy; the euphoric economy is
a natural consequence of the economy doing
well over a prolonged period. Over both the
prolonged boom and the euphoric period
portfolio transformations occur that de­
crease the domain of stability of the financial
Financial instability as a system charac­
teristic is compounded of two elements. How
are units placed in financial distress and how
does unit distress escalate into a systemwide
The “ banking theory” for all units

It is desirable to analyze all economic units
as if they were a bank—or at least a finan­
cial intermediary. The essential characteris­
tic of such a financial unit is that it finances
a position by emitting liabilities. A financial
institution does not expect to meet the com­
mitments stated in its liabilities by selling out
its position, or allowing its portfolio to run
off. Rather, it expects to refinance its posi­
tion by emitting new debt. On the other hand
every unit, including banks and other finan­
cial units, has a normal functioning cash
flow from operations. The relation between
the normal functioning cash flow to and the
refinancing opportunities on the one hand
and the commitments embodied in the lia­
bilities on the other determine the conditions
under which the organization can be placed
in financial distress.


It is important for our purpose to look at
all organizations from the defensive view­
point: “What would it take to put the orga­
nization in financial distress?” This aspect
will be made clearer when we discuss bank
and other examination procedures.
Solvency and liquidity constraints. All eco­
nomic units have a balance sheet. Given the
valuation of assets and liabilities one may
derive a net worth or owner’s equity for the
unit. The conditional maximization of own­
er’s equity may be the proximate goal of
business management—the condition reflect­
ing the need to protect some minimum own­
er’s equity under the most adverse contin­
gency as to the state of the economy.
A unit is solvent—given a set of valuation
procedures—when its net worth is positive.3
A unit is liquid when it can meet its payment
commitments. Solvency and liquidity are
two conditions that all private economic or­
ganizations must always satisfy. Failure to
satisfy either condition, or even coming close
to failing, can lead to actions by others that
affect profoundly the status of the organiza­
Even though textbooks may consider sol­
vency and liquidity as independent attrib­
utes, the two are interrelated. First of all,
the willingness to hold the debt of any orga­
nization depends in part upon the protection
to the debt holder embodied in the unit’s
net worth. A decline in net worth—perhaps
the result of revaluation of assets—can lead
to a decreased willingness to hold debts of a
unit and hence to difficulties when it needs
to refinance a position. A lack of liquidity
may result from what was initially a solvency
3 The comm on valuation procedures take book or
m arket value. F o r purposes of both m anagem ent and
central bank decisions it would be better if valuation
procedures were conditional, that is, of the form : if
the economy behaves as follows, then these assets
would be w orth as follows.

Similarly, a net drain or outflow of cash
from an organization may lead to a need to
do the unusual—to acquire cash by selling
assets. If, because of the thinness of the mar­
ket, a sharp fall in the asset price occurs
when such sales are essayed, then a sharp
drop in net worth takes place, especially if
the organization is highly levered.
We can identify, therefore, three sources
of a decline in the price level of the stock
(capital), relative, of course, to the flow
(income and investment). One is a rise in
the weight attached to those possible states
of the society that make it disadvantageous
to hold real assets, and financial assets whose
value is closely tied to that of real assets. The
second is the fall in asset values due to a
rise in the discount caused by uncertainty.
The third is a decline in asset values as the
conditions change under which a position in
these assets may be financed. In particular,
whenever the need to meet the cash payment
commitments stated by liabilities requires
the selling out of a position, there is the
possibility of a sharp fall in the price of the
positioned asset. Such a fall in asset prices
triggers a serious impact of financial markets
upon demand for current output.
The need for cash for payments. Cash is
needed for payments, which are related to
financial as well as income transactions. The
layering of financial interrelations affects
the total payments that must be made. To
the extent that layering increases at a faster
rate than income, over a prolonged boom, or
in response to rising interest rates, or during
a euphoric period, the payments/income
ratio will rise. The closer the articulation by
consumers and business firms of income re­
ceipts with payments due to financial con­
tracts, the greater the potential for financial
Each money payment is a money receipt.
As layering increases, the importance of the


uninterrupted flow of receipts increases. The
inability of one unit to meet its payment
commitments affects the ability of the wouldbe recipient unit to meet its payment com­
Three payment types can be distinguished:
income, balance sheet, and portfolio, each
of which can in turn be broken down into
subclasses.3 These payment types reflect the
fact that economic units have incomes and
manage portfolios.
The liabilities in a portfolio state the pay­
ment commitments. These contractual pay­
ment commitments can be separated into
dated, demand, and contingent commit­
ments. To each liability some penalty is at­
tached for not meeting the commitment:
and the payment commitments quite natu­
rally fall into classes according to the seri­
ousness of the default penalty. In particular,
the payment commitments that involve the
pledging of collateral are important—for
3 Incom e p aym ents are those payments directly re­
lated to the production of current income. Even
though some labor costs are independent of current
output, the data are such th at all wage payments are
in the income payments class. All of the “Leontief”
paym ents for purchased inputs are such income pay­
Balance sheet paym ents during a period are those
payments that reflect past financial commitments.
Lease, interest, and repaym ent of principal are among
balance sheet payments. F or a financial interm ediary
either withdrawals by depositors or loans to policy­
holders are balance sheet payments.
Portfolio p aym ents are due to transactions in real
and financial assets.
Any paym ent may be of a different class when
viewed by the payor or the payee. To the producer
of investment goods the receipts from the sale of the
good is an income receipt; to the purchaser it is a
portfolio payment.
In addition to types, payments may be classified by
“from w hom ” and “to whom .”
If money consisted solely of depositors subject to
check, then total payments would be the total debits
to accounts and total receipts would be credits to
accounts. Hence, it is the im plication for system sta­
bility of total clearings, where the financial footings
are integrated with the income footings, that is being


they provide a direct and quick link between
a decline in market value of assets and the
need to make cash payments. That is, they
are a type of contingent payment commit­
ment that involves the supply of additional
collateral or cash whenever a market price
falls below some threshhold. This margin or
collateral maintenance payment commit­
ment can be a source of considerable dis­
organization and can lead to sharp declines
in asset prices.
Another aspect of balance sheet payment
commitments is the source of the cash that
will be used to make the payments. Three
sources can be distinguished: the flow due
to the generation of income; the flow due to
the assets held in a portfolio; and the flow
due to transactions in assets, either the emis­
sion of new liabilities or the sale of assets.
For each unit, or class of units, the trend
in payment commitments relative to actual
or potential sources of cash generates the
changing structure of financial interrela­
tions. The basic empirical hypothesis is that
over a prolonged expansion—and in partic­
ular during a euphoric period—the balance
sheet commitments to make payments in­
creases faster than income receipts for pri­
vate units (layering increases faster than in­
come) and so total financial commitments
rise relative to income. In addition, during
euphoric periods, portfolio payments (trans­
actions in assets) increase relative to both
income and financial transactions. The
measured rise in income velocity during an
expansion underestimates the increase in the
payment load being carried by the money
8 In various places, I have tried to estim ate by
proxies some of these relations. Em pirical investiga­
tion of stability could begin with a more thorough
and also an up-to-date exam ination of these paym ent
relations. The relations mentioned in this section are
discussed in detail in my paper, “Financial Crisis,
Financial Systems, and the Perform ance of the E con­


Modes of system behavior

Three modes of system behavior can be dis­
tinguished depending upon how ex post sav­
ings are in fact offset by ex post investment.
The offsets to saving that we will consider
are investment in real private capital and
Government deficits. For convenience, we
will call real private capital inside assets and
the accumulated total of Government defi­
cits, outside assets. Thus, the consolidated
change in net worth in an economy over a
time period equals the change in the value
of inside assets plus the change in the value
of outside assets.
At any moment in time the total private
net worth of the system equals the consoli­
dated value of outside plus inside assets.
Assuming the value of outside assets is al­
most independent of system behavior, the
ratio of the value of outside to the value of
total or inside assets in the consolidated ac­
counts is one gross measure of the financial
The savings of any period are offset by
outside and inside assets. The ratio of out­
side to inside assets in the current offset to
savings as compared to the initial ratio of
outside to inside assets will determine the
financial bias of current income. If the Gov­
ernment deficit is a larger portion of the
current offset to savings than it is of the
initial wealth structure, then the period is
biased toward outside assets; if it is smaller,
the period is biased toward inside assets; if
it is the same, then the period is neutral.
Over a protracted expansion the bias in
financial development is toward inside
assets. This bias is compounded out of three
elements: (1) Current savings are allocated
to private investment rather than to Govern­
ment deficits; (2) capital gains raise the
market price of the stock of inside assets;
and (3) increases in interest rates lower the
nominal value of outside, income-earnings

assets. Thus, the vulnerability of portfolios
to declines in the market price of the con­
stituent assets increases.3
In the long run, portfolio balance has
been maintained by cycles in the relative
weights of primary assets accumulated:
historically the portfolio cycle centered
around business cycles of deep depressions.
However, to judge what is happening over
time it is necessary to evaluate the sig­
nificance of changes in financial usages.
The existence of effective deposit insurance
makes the inside assets owned by the bank­
ing system at least a bit outside. The same
is true for all other Government under­
writings and endorsements of private debt.
Thus, with the growth of Government and
Government agency contingent liabilities
even growth that is apparently biased toward
the emission of private liabilities may in fact
be biased toward outside assets. An attempt
to enumerate—and then evaluate—the vari­
ous Government endorsements and under­
writings of various asset and financial
markets in these terms is necessary when
estimating the potential of an economy for
financial instability.
Secondary markets

The domain of stability of the system
depends upon the ratio of the value of those
assets whose market value is independent
of system behavior to the value of those
assets whose market value reflects expected
system behavior. The value of a particular
asset can be independent of system behavior
either because its market is pegged or be­
cause the flow of payments that will be
made does not depend upon system per­
formance and its capital value is largely
independent of financial market conditions.
3 This is, of course, an assertion as to the facts,
and the truth of these statem ents can be tested. P er­
haps with a government sector that is 10 per cent of
G N P, such statem ents are less true than with one that
is 1 per cent of G NP.



F or secondary markets to be an effective
determ inant of system stability, they must
transform an asset into a reliable source of
cash for a unit whenever needed. This means
that the secondary m arket m ust be a dealer
m arket; in other words, there needs to be
a set of position takers who will buy signifi­
cant amounts for their own account and
who sell out of their own stock of assets.
Such position takers must be financed.
Presum ably under norm al functioning the
position taker is financed by borrowing
from banks, financial intermediaries, and
other private cash sources. However, a
venturesome, reliable position taker must
have adequate standby or emergency financ­
ing sources. The earlier argum ent about
refinancing a position applies with special
force to any money m arket or financial
m arket dealer.
The only source of refinancing that can
be truly independent of any epidemics of
confidence or lack of confidence in financial
markets is the central bank. Thus if the set
of protected assets is to be extended by
the organization of secondary markets, the
stability of the financial system will be best
increased if the dealers in these secondary
m arkets have guaranteed access to the
central bank.
It might be highly desirable to have the
norm al functioning of the system encompass
dealer intermediaries who finance a portion
of their position directly at the Federal
Reserve discount window.
If a Federal Reserve peg existed in the
m arket for some class of private liabilities,
these liabilities would become guaranteed
sources of cash at guaranteed prices. Such
assets are at least in part outside, and they
would increase the dom ain of stability of
the system for any structure of other
The extension of secondary markets to
new classes of assets and the associated

opening of the discount window to new
financial intermediaries may compensate at
least in part— or may even more than
compensate— for the changes in financial
structure due to the dom inance of private
investment in the offsets to saving during a
prolonged boom.
Unit and system instability

Financial vulnerability exists when the
tolerance of the financial system to shocks
has been decreased due to three phenom ena
that cumulate over a prolonged boom :
(1 ) the growth of financial— balance sheet
and portfolio— payments relative to income
payments; (2 ) the decrease in the relative
weight of outside and guaranteed assets in
the totality of financial asset values; and
(3 ) the building into the financial structure
of asset prices that reflect boom or euphoric
expectations. The triggering device in finan­
cial instability may be the financial distress
of a particular unit.
In such a case, the initiating unit, after
the event, will be adjudged guilty of poor
management. However, the poor m anage­
m ent of this unit, or even of m any units, may
not be the cause of system instability. System
instability occurs when the financial struc­
ture is such that the impact of the initiating
units upon other units will lead to other
units being placed in difficulty or becoming
tightly pressed.
One general systemwide contributing fac­
tor to the development of a crisis will be a
decline in income. A high financial commitm ent-incom e ratio seems to be a necessary
condition for financial instability; a decline
in national income would raise this ratio
and would tend to put units in difficulty.
Attem pts by units with shrunken income
to meet their commitments by selling assets
adversely affects other initially quite liquid
or solvent organizations and has a destabiliz­
ing impact upon financial markets. Thus, an


explosive process that involves declining
asset prices and income flows may be set
in motion.
The liabilities of banks and nonbank
financial intermediaries are considered by
other units (1 ) as their reservoirs of cash
for possible delays in income and financial
receipts and (2 ) as an asset that will never
depreciate in nom inal value. Bank and
financial interm ediary failure has an impact
upon m any units— more units hold lia­
bilities of these institutions than hold lia­
bilities of other private-sector organizations.
In addition such failures, by calling into
question the soundness of the asset struc­
ture of all units, tend to modify all desired
portfolios. A key element in the escalation
of financial distress to systemwide instability
and crisis is the appearance of financial
distress among financial institutions. W ith­
out the widespread losses and changes in
desired portfolios that follow a disruption
of the financial system, it is difficult for a
financial crisis to occur. The development
of effective central banking, which makes
less likely a pass-through to other units of
losses due to the failure of financial institu­
tions, should decrease the likelihood of the
occurrence of sweeping financial instability
that has characterized history.
From this analysis of uncertainty it ap­
pears that, even if effective action by the
central bank aborts a full-scale financial
crisis by sustaining otherwise insolvent or
illiquid organizations, the situation that made
such abortive activity necessary will cause

private liability emitters, financial inter­
mediaries, and the ultimate holders of assets
now to desire more conservative balance
sheet structures. The movement toward
more conservative balance sheets will lead
to a period of relative stagnation.
The following propositions seem to follow
from the preceding analysis:
1. The dom ain of stability of the finan­
cial system is endogenous and decreases
during a prolonged boom.
2. A necessary condition for a deep
depression is a prior financial crisis.
3. The central bank does have the power
to abort a financial crisis.
4. Even if a financial crisis is aborted by
central bank action, the trem or that goes
through the system during the abortion can
lead to a recession that, while more severe
than the mild recessions that occur with
financial stability, can be expected never­
theless to be milder and significantly shorter
than the great depressions that have been
experienced in the past.40
4 The above was w ritten in the fall of 1966. If
the crunch of 1966 is identified as an aborted financial
crisis, then the events of 1966-67 can be interpreted
as a particularly apt use of central bank and fiscal
policy to first abort a financial crisis and then offset
the subsequent decline in income. It is also evident
from the experience since 1966 that if a crisis and
serious recession are aborted, the euphoria, now com ­
bined with inflationary expectations, may quickly take
over again. It may be that, for the boom and infla­
tionary expectations evident in 1969 to be broken, the
possibility of a serious depression taking place again
must become a credible threat. Given the experience
of the 1960’s, it m ay also be true that the only way
such a threat may be made credible is to have a
serious depression.

Com m ercial banks and other deposit insti­
tutions are periodically examined. I do not
intend to offer a critique of current bank
examination objectives and techniques or
to inquire into whether such examination

is useful or necessary. I assume that bank
examination will continue and that the only
negotiable issue is its nature.
As now carried out, bank examinations
enable the examining authority to determine


the creditworthiness of the institution and
fraud are not obvious. The determ ination of
creditworthiness is an extension of the
lender-borrow er relationship, and the exam ­
ination for fraud and mismanagement is a
consumer protection function. It is argued
here that a bank examination procedure that
focuses on cash flow relationships can be a
useful source of inform ation for Federal
Reserve policy-making.
Typically, the end result of a bank exami­
nation is a balance sheet, which places prices
on assets. M any assets of financial institu­
tions— such as bank loans— do not have
an active m arket. Such assets are priced
at their face value, especially if they are
current, even though they would sell at a
discount if a m arket existed.41 Items that
are not current— what some call scheduled
items— are valued at some arbitrary ratio
to face value in arriving at the balance sheet.
A n excess proportion of scheduled items is
taken as indicating a need for corrective
action by the institution. It is obvious that
the examiners’ balance sheet reflects many
arbitrary rules, especially to the extent that
valuation is divorced from current m arket
prices. A n arbitrary element enters into
every placing of a price on assets for which
no broad, deep, and resilient m arket exists.
In addition, measures of the adequacy of
capital and liquidity are derived. These
measures reflect examiners’ experience. It
may be that an examination procedure that
focuses on cash flows will lead to a more
precise evaluation of capital adequacy and
Even though the value placed upon a
financial asset may be the result of an
arbitrary valuation procedure, the commit4
1 Of course, with a decline in m arket interest rates,
the assets would sell at a prem ium . The bias in w rit­
ing this report has been to examine the effect of
m onetary constraint and rising interest rates. This
essay is a creature of its time— midyear to fall 1966.


ments of the emitter of the instrum ent are
precise. The commitments are to m ake pay­
ments— either at specified dates, on demand,
or upon the occurrence of some stated con­
tingency. Both assets and liabilities of a
financial institution are such contracts. The
examiner, by reading the outstanding con­
tracts, can m ake a time profile of con­
tractually dated cash flows to and cash flows
from the unit. Each profile of dated pay­
ments and receipts needs to be supplemented
by behavioral relations detailing the condi­
tions under which dem and and contingent
clauses of contracts will be exercised. Thus,
a time series of the needs and sources of
cash, under alternative contingencies, can
be estimated.42
Cash flow analysis enables the authorities
to receive inform ation about the expected
impact of various economic policy opera­
tions upon the cash flow to and the cash
flow from various units and classes of units.
Whereas balance sheet analysis is essentially
static, a cash flow analysis of any financial
organization that forecasts cash flows at
some future date must be based of necessity
upon clearly stated assumptions as to (1 )
the values that certain systemwide variables
will take, and (2 ) the functional relation­
ships between these variables and the ele­
ments of the unit’s cash flows. The condi­
tional nature of any single statement makes
it necessary to vary the assumptions— to
map out how changes in param eters of the
assumed functions and in systemwide vari­
ables affect cash flows.
An evaluation of the expected cash status
of any institution, or class of institutions,
will depend upon assumptions as to how
42 Computer technology makes more feasible such a
transform ation of the exam ination procedure from an
analysis of values to an analysis of cash flows.
The emphasis upon capital values in bank and simi­
lar examination procedure, as well as in economic
analysis, may well reflect what were at one time
insurm ountable com putational difficulties.


the different m arket-determ ined variables
will behave. Thus, the examination proce­
dure will have to embody the results of
serious economic analysis. Bank and other
examination procedures should be forward
looking. T hat is, instead of asking questions
about the present status and the past history
of an organization, the questions should be
of the following form: “Given the present
status as an initial condition, what would
be the dated impacts upon the organization
of various economic system, financial m ar­
ket, and m anagem ent developments?” The
vulnerability of say the New Y ork m utual
savings banks to rapidly rising interest rates
on time deposits and the sensitivity of the
income and liquidity of West Coast savings
institutions to a decrease in the rate of
growth of the local economy would have
been obvious with such an analysis.
The proposed examination procedure
becomes an analysis of the unit that is con­
ditional upon the behavior of the economy.
Econom ic policy decisions cannot be made
on an adequate factual basis without some
knowledge of their impact upon various
classes of financial institutions. M uch of
what happens seems to surprise the authori­
ties: an adequate examination procedure
would minimize such surprise.
Cash flow analysis transforms every asset
into a generator of a cash flow to the orga­
nization. Financial assets may be subdivided
into three classes depending on how they
generate cash: cash itself, loans, and invest­
ments. There is no need to discuss cash
itself. Loans are those assets that generate
a contractual cash flow. The ability of the
owning organization to accelerate this cash
flow by sale is very restricted. We may as
well assume that it does not exist. However,
such assets may serve as collateral for loans,
for example at the discount window.
Investments, while they do embody con­
tractual cash flows, may also be salable

in a m arket. Their current m arket price
more or less states the cash flow that the
managers can generate if they choose to
sell out their position. True investments
would have broad, deep, and resilient m ar­
kets. Those of m any banks and other finan­
cial institutions have thin markets, and the
relevant cash flow to the organization from
such investments follows from the contract­
ual, rather than the m arketable, properties
of the asset.
Whereas current assets yield a cash flow
to an organization, the process of asset
acquisition results in a cash flow from the
organization. As a continuing organization
at each point in time a bank will have dated,
demand, and contingent commitments to
acquire assets. The commitments will be
both explicit— lines of credit or letters— or
implicit— the result of a long-term financial
relation between the bank and the poten­
tial borrower. Banks may similarly have an
implicit commitment to bid for local m unici­
pal issues.43
The cash flow to an organization due to
financial asset holdings reflects both the
flow of income and the repayment of princi­
pal. However, this division is not really
relevant— what is relevant is the amount
that is available from any cash flow for the
acquisition of new assets. That is, the cash
4 F or all economic units, such continuing financial
contacts and relations are valuable assets. True, im ­
plicit agreements may be not honored if a liquidity
squeeze occurs, but this imposes capital losses upon
the surprised and disappointed potential borrower.
One way in which widespread bank failures affected
the economy was by rupturing norm al financial chan­
nels. W hen the Bank of the United States in New
York failed in 1930, not only were there losses by
depositors but a fairly large portion of the New Y ork
garm ent trade was cast adrift w ithout a continuing
bank relationship. Thus in principle we can be cava­
lier with respect to financial constraint resulting in
loan contraction, but in fact we must recognize that
extreme constraint may cause losses to innocent by­
standers. See footnote 9, pp. 309 and 310, in M.
Friedm an and A. J. Schwartz, “Money and Business


flow to must be related to the cash flow
The debt liabilities of deposit and other
financial intermediaries are commitments to
pay cash— at some specified date, on de­
m and, or upon the occurrence of some con­
tingency. These commitments include both
the repaym ent of principal and interest pay­
ments; although for m any deposit institu­
tions interest payments are credited to the
depositors’ account and do not generate an
autom atic cash drain.
The debt liabilities of deposit institutions
can be separated into service and purchased
liabilities. Local dem and deposits and pass­
book savings are almost all service deposits.
The volume of such deposits will depend
upon the state of the local economy and the
action of local competitors. Purchased lia­
bilities include Federal funds and large
certificates of deposit for commercial banks
as well as out-of-state deposits for savings
and loan associations. M arket demand may
be volatile with respect to system perform ­
ance for purchased liabilities, but be stable
for service liabilities. A bank’s potential
ability to finance a position in assets without
recourse to extraordinary techniques in
times of m onetary constraint may depend
upon the extent to which its resources are
derived from service rather than from pu r­
chased liabilities. The potential for recourse
either to the discount window or to the sale
of assets in some secondary m arket is re­
lated directly to the extent to which pur­
chased liabilities are a source of funds. Thus
the cash flow exam ination will have to con­
sider the likelihood that the behavior of
the m arket for such bank liabilities will lead
to large cash flows out of the bank and thus
force it to resort to discounting or asset
Any cash flow analysis would need to
relate each earning asset— both loans and
investments— to the m arket in which it


may be sold or pledged. For each asset the
terms upon which financing is available to
the position takers or lenders in its m arket
need to be examined. In particular, the
breadth, depth, and resiliency of a m arket
can be guaranteed only if the central bank
or perhaps its chosen instruments stand
ready to finance position takers. Thus, if
new asset classes become im portant, the
examinations procedure might feed back to
the central bank the need for the develop­
m ent of new or strengthened secondary
markets or additional discount facilities.
For the demand and contingent liabilities
of deposit institutions the interesting eco­
nomic question is the conditions under
which the dem and or contingent claims will
be exercised.
The cash flow to and from an organiza­
tion because of dem and liabilities is a func­
tion of at least the terms offered by the
institution, the terms available elsewhere,
and for certain institutions, national income.
M any special variables that reflect the
specific contractual terms enter into deter­
mining the impact upon cash flows of
m arket-determ ined and policy variables.44
The content of cash flow analysis of a
financial intermediary can be m ade more
precise by illustrating how the technique
would be applied to a specific institution.
Let us take, for the sake of simplicity, and
also perhaps because of its recent relevance,
a savings and loan association. The assets
of such an institution will consist almost
4 In the Minsky-Bonem simulation experiments—
reported in my paper “Financial Crisis, Financial
Systems, and the Perform ance of the Econom y,” pp.
365 and 366— least-square regression lines were fitted
for new deposits and withdrawals at savings and loan
organizations as functions of disposable income. F or
particular savings and loan organizations similar
functions would need to be estim ated and such func­
tions would include local economic conditions as well
as interest rate variables, rather than just aggregate
income data as was true in our rather primitive anal­


entirely of long-term fully amortized mort­
gages. Because of the rapid growth of these
institutions the representative portfolio is
rather young. This means that the cash
flow to the organization on account of its
assets is a relatively small percentage of the
total liabilities. In addition to such mort­
gages there will be some cash and Treasury
bills—but at most these will be a small
percentage of total assets. Thus even allow­
ing for the cash flow that the management
can generate by selling assets, the cash flow
to the organization during one short period
(say 90 days) cannot be more than 5 to
10 per cent of total liabilities.
Ignoring stand-by and lender-of-last-resort
refinancing as a potential supplier of cash,
these organizations must at all times offer
interest rates attractive enough so that no
appreciable flight of deposits will occur.
However, as they cannot discriminate readily
among depositors, they must pay all de­
positors whatever is needed to keep the
marginal depositor.
In the summer of 1966, the need arose
to raise interest rates on all deposits to
prevent large-scale withdrawals of some de­
posits. This resulted in a sharp rise in the
total cost of deposit funds. At the same time
savings banks were locked into young port­
folios whose contracts reflected the lower
interest rates of the past. The cost of money
in many cases may be penal, but unlike
the classical penal rate case, the penal rate
will rule not for a short time but may
stretch over many years.
The penal rate of classical banking theory
was an expensive way of refinancing a posi­
tion that ran off in a relatively short span
of time: 90 to 180 days. As a result of the
short original dating of the contracts—within
6 months almost all of the initial assets of
a commercial bank will be repaid—the turn­
over time for assets is short. New assets will
be acquired as old ones are repaid, but only

at interest rates that are consistent with the
higher cost of money. Thus, when the cost
of money rises, the relevant question is not
just “How long will the interest rates be at
this higher level?” but also “How long will
it take for almost all assets in the portfolio
to carry rates consistent with the new rate
on liabilities?” If portfolios are heavily
weighted with young, fully amortized, long­
term contracts, this turnaround time can
be many years. A cash flow examination
procedure would state how long it would
take for say 25 per cent, 50 per cent, and
75 per cent of assets to adjust to new higher
—or lower—costs of money.
If interest on liabilities is a cash flow
from the organization, a period in which
a net cash flow out is financed by selling
assets can occur when interest rates rise.
If interest on liabilities is credited to the
accounts of the depositors, deposit lia­
bilities will rise relative to assets, and net
worth will decrease. In both cases demand
commitments to pay will increase relative
to both the contractual cash flow to the
unit due to assets and the ability of manage­
ment to generate a cash flow by selling
marketable assets.
There is no necessity to enlarge upon
the relevant conditional relations. For
example, one possible reaction by a deposit
institution to prospective pressures for cash
payments is to increase the ratio of cash
and marketable securities to other assets.
This means that instead of feeding cash
flows generated by its mortgage portfolios
to the now high-yielding mortgages, a hardpressed savings and loan association will
withdraw from the mortgage market and
use cash flows to acquire low-yielding but
marketable assets: it prepares its cash and
near-cash position to withstand a deposit
For each of various assumptions as to
how units react to a cumulative cash flow


to or cash flow from, a time series of asset
and liability positions can be derived.
Presumably in the example given, the cash
flow from, because of withdrawals, can
actually be greater than the cash flow to
for some periods. Even if such withdrawals
do not occur, and even if we do not value
assets at the current—estimated—market
price, the growth of demand liabilities that
results from the crediting of the high in­
terest rate income to deposit accounts will
lead to an increase in the ratio of deposit
liabilities to cash flow to the organization.
Thus, it may become an ever more difficult
problem to retain deposits.
A conditional cash flow examination of
individual and of classes of financial institu­
tions would determine the impact upon the
institution or class of institution of various
policy-determined conditions.
One proposition favored by nonacademics
is that the high cost of funds forces financial
intermediaries into making risky loans that
carry a high contractual interest rate. From
the preceding cash flow example the cost of
funds can rise so rapidly, relative to the
fixed returns on the assets, that the organiza­
tion will foresee that a liquidity crisis at
some stated date is certain if it follows a
conservative policy in the placement of ac­
cruing cash. If it sells its low-yield, fixedmarket-price investments, reduces its cash
position, and uses the cash flow on principal,
income, and new deposit accounts to pur­
chase high-yield, high-risk assets, then, if all
turns out well, it avoids a liquidity crisis.
That is, whereas the conservative portfolio
policy yields a financial crisis with a prob­
ability of almost one, the more radical port­
folio policy yields a finite probability greater
than zero of avoiding the liquidity crisis. In


these conditions the chancy portfolio policy
is safer than the risk-free policy.
A conditional cash flow analysis of indi­
vidual, and classes of, financial institutions
will estimate the impact of various alterna­
tive policy and market-determined condi­
tions upon the individual institutions and
the set of institutions. For example, there
may be a limit to tight money—due to the
running losses, as illustrated earlier—that a
nonbank financial intermediary, such as
the savings and loan associations, can
stand. The Federal Reserve must look be­
yond the commercial banking system to
determine whether, or in what circum­
stances, its actions are destabilizing.
A unified procedure for examining all
financial institutions that focuses on their
cash flows will be of help not only to unit
managements but also to regulatory authori­
ties. One advantage of this approach is
that through the information obtained the
distribution of impacts can be estimated.
Such an examination procedure should en­
able us to determine how many units are
pushed over or pushed too close to some
threshold by some constraining event that,
for example, lowers the average return to
a financial intermediary.
The development of an examination pro­
cedure for cash-flow-oriented banks and
other financial institutions would involve a
great deal of experimentation not only with
observations of individual banks—the data
gathered in examinations—but also with the
system attributes that are relevant to deter­
mining individual bank behavior. Fortu­
nately, the recent interest in banking and
bank markets has generated a body of studies
that can be used as a starting point for the
analysis of the behavior of financial institu­
tions under alternative conditions.


The reserve base of the banks in a region
must be earned, and to keep such reserves,
the return offered must be competitive. The
global reserve base is the result of Federal
Reserve policies.4 Every change in reserves
appears initially as a change in reserves in
some particular set of banks. However, even
if the Federal Reserve has a policy or pro­
gram that directs the initial change in re­
serves toward some region, the ultimate
regional distribution depends upon market
forces. Any change in the reserve base of
the banks within any region will be the
result of either an income or an asset trans­
action with the rest of the country. The
monetary system of every region is equiva­
lent to a very strict gold standard, where
reserves for a region are the equivalent of
gold for a country.
National economic growth is the result
of the growth of the various regions. Some
regions grow more rapidly—and some less
rapidly—than the economy. The available
evidence indicates that the reserve base of
the various regions grows at a pace that is
consistent with the growth of the region.
That is, even if there is a trend in velocity
in both the country and the regions, the
relative velocity will change but slightly.
If there is a rapidly growing region em­
bedded in a slowly growing country—as
was true of California during the 1950’s—
the money supply and the reserve base of
the rapidly growing region will also grow
rapidly. Thus, in the 1950’s while demand
deposits in the United States were growing
slowly, demand deposits in California were
growing rapidly.4
4 Even if there are changes in the reserve base that
are not due to Federal Reserve policy, the total re­
serve change is the result of Federal Reserve action—
or inaction.
4 See M insky (ed.), California Banking in a G r o w ­
ing Econom y: 1946 -19 75.

In the case of California, two identifiable,
large, and rapidly growing sources of bank
reserves were (1) the excess of Federal
Government payments over receipts in the
State and (2) the flow of funds to the State
to finance home construction. Other sources
of reserves undoubtedly exist, but they were
not identifiable at the time of the research
underlying this section.
During the decade of the 1950’s, the
financing of housing generated a large flow
of funds toward California. It has been esti­
mated that as much as 40 per cent of the
total financing for house-building in Cali­
fornia came from out of the State. This flow
of funds into California reflected both the
export of mortgages and a rise in out-ofstate deposits in California savings and loan
associations. About 20 per cent of the de­
posits in California savings and loan asso­
ciations were from out-of-state depositors.
A build-up in the stock of mortgages and
deposits owned by out-of-state investors
means that an increasing reserve drain takes
place to meet the commitments as stated
in this growing stock of liabilities. That is,
without an appropriate offsetting growth in
the cash flow from new mortgages, deposits,
or other items, the growing stock of out­
standing liabilities will tend to generate pay­
ments that lower the region’s reserve base.
Any slowdown in the influx of funds to the
region on account of the housing market
can lower the growth prospects for commer­
cial banks and for the State’s money supply.
Mortgages, especially the standard fully
amortized contract, generate a known, dated
series of payments; the only variation in
the cash drain from the region due to the
stock of mortgages will be due to an in­
ability to make payments, prepayments, or
the sale of mortgages. Given that there is
some experience on prepayments and sales,


it seems clear that the outstanding foreignowned (out-of-state) mortgages yield a
known cash drain from the region’s banks.
The cash flow due to all depositors but
especially those from out of state, at Cali­
fornia savings and loan associations will
depend upon safety and profitability.
Deposit insurance eliminates concern or
doubt about the safety; thus, the cash flow
to California because savings and loan de­
posits depend upon relative interest rates. A
variety of rate-sensitive “hot monies” exist
as deposits in these institutions; some of
these would be sensitive to small differen­
tials in interest rates. We would expect these
potentially hot-money deposits to be the
large out-of-state accounts.
Even though all deposits—local and out
of state—should be equally sensitive to rate
differentials, the convenience factor may
dominate in the case of local, mostly pass­
book deposits. A rapidly growing region
must maintain a rate structure that attracts
funds and that retains previously acquired
out-of-state deposit funds. Thus, California
savings and loan associations must keep a
favorable interest rate premium, even if the
demand for financing of housing is slack.
Defensive rate competition is based upon
the unit’s liability structure. Note that if
the national cost of money is high, the sup­
ply price of finance from these institutions
will remain consistent with this cost of
money, even though local demands for
financing may be slack.
One impact of monetary constraint in a
euphoric economy is that a rise has taken
place in other market interest rates relative
to the rate on savings and loan shares
(deposits) in California. The observation
that the California mortgage market ex­
hibited signs of disorderly conditions in mid1966 needs no documentation. Due to rate
competition, these deposits have stopped
increasing Even if there is a net increase


in deposits (at a slower rate) the net in­
crease may be compounded of a decrease
in foreign (out-of-state) deposits and an off­
setting rise in domestic (in-state) deposits.
During recent periods of monetary con­
straint, the housing-related financial markets
have tended to generate a decrease in Cali­
fornia’s reserve base. If all else remains the
same, this means that either monetary
velocity in California must increase relative
to that of other geographical sectors, or the
rate of growth of income must decrease.
There is nothing sacred about the favored
growth experience of California, nor is there
any reason why the national authorities
should operate to keep California growing
more rapidly than the country as a whole.
However, tight money will be particularly
hard on California homebuilding, mortgage
financing institutions, and commercial
banks. This will be compounded if a rate
ceiling is adopted to prevent competition
for deposits. Nonconstrained market instru­
ments are substitutes for savings and loan
liabilities, and a potential expansion of the
retailing of such market instruments is a
threat to deposit institutions.
A decline, or a slowdown, in the growth
of commercial bank reserves in a rapidly
growing region will lead to a decline in
locally available credit through commercial
banks. California banks are traditionally
light on secondary reserve assets. The oppor­
tunity to sustain loan growth by decreasing
investments is minimal.
Monetary constraint, after a period of
rapid growth—especially if it is a reaction
to a spread of euphoria from a previously
rapidly growing region to the country as a
whole—will put serious pressures upon the
banks and other financial institutions of the
previously rapidly growing region. The
regional concentration of financial duress
may trigger a more general spread of
distress than if the same total financial


tightness were more evenly distributed
The practitioner of monetary policy must
be aware that there are different regional

pressures due to monetary constraint and
that contagion phenomena within a region
may be one way in which financial insta­
bility may be initiated.

The modern central bank has at least two
facets: a part of the stabilization and
growth-inducing apparatus of Government
and the lender of last resort to all or part
of the financial system. These two functions
can conflict.
For the United States, central bank func­
tions are decentralized among the Federal
Reserve System, the various deposit insur­
ance and savings intermediary regulatory
bodies, and the Treasury. The decentraliza­
tion of central banking functions and re­
sponsibilities makes it possible for “buck
passing” to occur. One result of this de­
centralization, along with the fact of usage
and market evolution, is that there exists a
perennial problem of defining the scope and
functions of the various arms of the central
bank. The behavior of the various agencies
in mid-1966 indicates that ad hoc arrange­
ments among the various agencies can serve
as the de facto central bank. However, even
though central banking functions are dis­
tributed among a number of organizations,
the fact that the Federal Reserve System
appears first among them should not be
obscured. The Federal Reserve may have to
make markets in the assets or liabilities of
the other institutions if they are to be able
to carry out their assigned subroutines.
The Federal Reserve System undertook,
when the peg was removed from the Gov­
ernment bond market, to maintain orderly
conditions in this market. Maintaining
orderly conditions in a key asset market is
an extension of the lender-of-last-resort
functions in that it is a preventive lender

of last resort. “If we allow the now dis­
orderly conditions to persist, we will in fact
have to be a lender of last resort” is the
underlying rationalization behind such ac­
tion. Maintaining orderly conditions in some
markets serves to protect position takers in
the instrument traded in these markets. This
protection of position takers may be a
necessary ingredient for the development
of efficient financial markets.
The stabilizer and lender-of-last-resort
functions are most directly in conflict as
a result of such efforts to maintain orderly
conditions. If constraining action, under­
taken to stabilize income, threatens the
solvency of financial institutions, the central
bank will be forced to back away from the
policy of constraint.
If a financial crisis occurs, the central
bank must abandon any policy of constraint.
Presumably the central bank should inter­
vene before a collapse of market asset values
that will lead to a serious depression. How­
ever, if it acts too soon and is too effective,
there will be no appreciable pause in the
expansion that made the policy of constraint
I have already discussed one way in which
tight money can cause financial instability;
that is,-asset holders that are locked into
assets bearing terms born in times of greater
ease are forced into risky portfolio decisions.
In addition the very rise in interest rates,
which measures tight money, induces sub­
stitutions in portfolios that makes financial
instability more likely. Thus, intervention
on grounds of lender of last resort and re­


sponsibilities for maintenance of orderly
conditions become more likely during such
In exuberant economic conditions central
banking has to determine, once distress ap­
pears, just how disorderly markets can be­
come before the lender-of-last-resort func­
tions take over and dominate its actions.
Perhaps the optimal way to handle a
euphoric economy is to allow a crisis to
develop—so that the portfolios acceptable
under euphoric conditions are found to be
dangerous—but to act before any severe
losses in market values, such as are asso­
ciated with an actual crisis, take place. If
monetary conditions are eased too soon,
then no substantial unlayering of balance
sheets will be induced, and the total effect
of monetary actions might very well be to
reinforce the euphoric expansion. If condi­
tions are eased after a crisis actually occurs
—so that desired portfolios have been re­
vised to allow for more protection—but the
effective exercise of the lender-of-last-resort
function prevents too great a fall in asset
prices, then the euphoria will be terminated
and a more sustainable relation, in terms
of investment demand, between the capital
stock and desired capital will be established.
If the lender-of-last-resort functions are
exercised too late and too little, then the
decline in asset prices will lead to a stagna­
tion of investment and a deeper and more
protracted recession. Given that the error of
easing too soon only delays the problem of
constraining a euphoric situation, it may be
that the best choice for monetary policy
really involves preventing those more severe
losses in asset prices that lead to deep
depressions, rather than preventing any dis­
orderly or near-crisis conditions. If capital­
ism reacts to past success by trying to ex­
plode, it may be that the only effective way
to stabilize the system, short of direct in­


vestment controls, is to allow minor finan­
cial crises to occur from time to time.
Note that the preceding is independent of
the policies mix. If, as seems evident, the
tight money of 1965-66 was due more to
a rapid rise in the demand for money than
to a decline in the rate of growth of the
supply of money, a greater monetary ease
combined with fiscal constraint would not
have done the job. If we accept that a major
expansionary element over this period was
the investment boom and that the expendi­
tures attributable to Vietnam only affected
the degree, not the kind, of development,
then an increased availability of finance
would have resulted in increased investment
and nominal income. A changed policy mix
would have constituted further evidence of
a new era. Of course, the fiscal constraint
could have been severe enough to cause
such a large decline in private incomes that
existing commitments to make payments
could not be met. A financial crisis or a
close equivalent may be induced by too
severe an application of fiscal constraint
as well as by undue monetary constraint.
Within the Federal Reserve System, from
the perspective of the maintenance of finan­
cial stability or at least the minimization
of the impact upon income and employment
of instability, a reversal may be in order of
the trend that has led to the attenuation of
the discount window. If secondary markets
are to grow as a way of generating both
liquidity while the system is functioning nor­
mally and protection while the system is in
difficulty, then the dealers in these markets
will need access to guaranteed refinancing.
The only truly believable guaranty is that
of the central bank.
However, a central bank’s promise to
intervene to maintain orderly conditions
in some market will be credible only if the
central bank is already operating in that
market. If the central bank is not operating


in the market, then it will not have working
relations with market participants and it
will not be receiving first-hand and con­
tinuous information as to conditions in the
market; no regular channels that feed in­
formation about market conditions will exist
as now exist for the Government bond
market. Thus, the Federal Reserve will need
to be a normal functioning supplier of
funds to the secondary markets it desires
to promote.
At present, only a small portion of the
total reserve base of banks is due to dis­
counting at the Federal Reserve System.
Discounting can serve three functions—a
temporary offset to money market pressures,
a steady source of reserves, and the route
for emergency stabilization of prices. In
order to set the ground for the Federal
Reserve System to function effectively in the
event of a crisis that requires a lender of
last resort, the Federal Reserve normally
should be “dealing” or “discounting” in a
wide variety of asset markets. One way to
do this is to encourage the emergence of
dealer secondary markets in various assets
and to have the Federal Reserve supply
some of the regular financing of the dealers.
It might be that a much higher percentage
of the bank’s cash assets than at present
should result from discounting, but the dis­
counting should be by market organizations
rather than by banks.

Monetary and fiscal constraint may not
be enough once the Keynesian lessons have
been learned. The monetary-fiscal steering
wheel had assumed a mechanistic deter­
mination of decisions that center around un­
certainty; the system’s doing well may so
affect uncertainty that an arsenal of stabili­
zation weapons including larger rationing
elements may be necessary.
Let us assume the present arsenal of
policy weapons and objectives. The policy
objectives will be taken to mean that the
high-level stagnation of the 1952-60 period
does not constitute an acceptable perform­
ance. Under these conditions, the lender-oflast-resort obligations of the Federal Re­
serve, redefined as allowing local or minor
financial crises to occur while sustaining
over-all asset prices against large declines,
become the most important dimension of
Federal Reserve policy. The lender-of-lastresort responsibilities become also the
arena where human error may play a sig­
nificant role in determining the actual out­
come of economic situations.
It is only in a taut, euphoric, and poten­
tially explosive economy that there is much
scope for error by the central bank. The
importance attached to human error under
these circumstances is due to a system char­
acteristic—the tendency to explode—rather
than to the failings of the Board of
Fall 1966 (revised January 1970)


Ackley, G. Macroeconomic Theory. New York: Macmillan,
Arrow, K. J. “Aspects of the Theory of Risk Bearing.” Yrjo
Jahnsson lectures. Helsinki: Yrjo Jahnssonin Saatio, 1965.
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Care,” American Economic Review, December 1963.
Clower, R. W. “An Investigation into the Dynamics of Invest­
ment,” American Economic Review, March 1954.
Economic Report of the President. Washington, D.C.: U.S. Gov­
ernment Printing Office, 1969.
Fellner, W. “Average-Cost Pricing and the Theory of Uncer­
tainty,” Journal of Political Economy, June 1948.
---------. “Monetary Policies and Hoarding in Periods of Stag­
nation,” Journal of Political Economy, June 1943.
Fisher, I. “The Debt-Deflation Theory of Great Depressions,”
Econometrica, October 1933.
Friedman, M. “The Demand for Money: Some Theoretical and
Empirical Results,” Journal of Political Economy, August
Friedman, M., and Schwartz, A. J. A Monetary History of the
United States, 1867—
1960. Study by the National Bureau
of Economic Research, N.Y. New Jersey: Princeton Uni­
versity Press, 1963.
---------. “Money and Business Cycles,” Review of Economics
and Statistics, Supplement, February 1963.
Galbraith, J. K. The Affluent Society. Boston: Houghton Mifflin,
Greenberg, E. “A Stock-Adjustment Investment Model,” Eco­
nometrica, July 1964.
Gurley, J. G., and Shaw, E. Money in a Theory of Finance.
Washington, D.C.: Brookings Institution, 1960.
Hicks, J. R. “Mr. Keynes and the ‘Classics,’ A Suggested Inter­
pretation,” Econometrica, April 1937.
Johnson, H. G. “The ‘General Theory’ after Twenty-five Years,”
American Economic Review, papers and proceedings, May
Kalecki, M. “The Principle of Increasing Risk,” Economica,
November 1937.
Keynes, J. M. “The General Theory of Employment,” Quarterly
Journal of Economics, February 1937.
---------. The General Theory of Employment, Interest and
Money. New York: Harcourt, Brace, and Company, 1936.



Minsky, H. P. “A Linear Model of Cyclical Growth,” Review of
Economics and Statistics, May 1959; also in Gordon, R. A.,
and Klein, L. R., A.E.A. Readings in Business Cycles,
vol. 10. Homewood, 111.: Richard D. Irwin, Inc., 1965.
--------- (ed.). California Banking in a Growing Economy:
1946-1975. Berkeley, California: University of California,
Institute of Business and Economic Research, 1965.
---------. “Central Banking and Money Market Changes,”
Quarterly Journal of Economics, May 1957.
-------- . “Comment on Friedman and Schwartz’s Money and
Business Cycles,” Review of Economics and Statistics.
Supplement, February 1963.
---------. “Financial Crisis, Financial Systems, and the Perform­
ance of the Economy,” in Private Capital Markets. Prepared
for the Commission on Money and Credit, N.Y. Englewood
Cliffs, N.J.: Prentice-Hall, Inc., 1964.
---------. “Financial Intermediation in the Money and Capital
Markets,” in Pontecorvo, G., Shay, R. P., and Hart, A. G.
Issues in Banking and Monetary Analysis. New York: Holt,
Rinehart and Winston, Inc., 1967.
Ozga, S. A. Expectations in Economic Theory. Chicago: Aldine
Publishing Co., 1965.
Tobin, J. The Intellectual Revolution in U.S. Economic Policy
Making. Noel Buxton lecture. Essex, England: The Uni­
versity of Essex, 1966.
---------. “Liquidity Preference as Behavior Towards Risk,”
Review of Economic Studies, February 1958.
Turvey, R. “Does the Rate of Interest Rule the Roost?” in Hahn,
F. H., and Brechling, F. P. R. (eds.). The Theory of
Interest Rates. New York: St. Martin’s Press, 1965.
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Benjamin Stackhouse
Federal Reserve Bank of New York

Introduction_____________________________________________________________ 1 3 9
Sum m ary and conclusions
Definition of liquidity
Seculartrend in com m ercial bank liquidity

Supervisory Approaches to Liquidity_________________________________________ 142
One approach to liquidity
Other liquidity standards

Liquidity Standards and Changes in Discount Policy_____________________________149
Appendixes __________________ ____________ ______________________________ 150




The purpose of this study is to examine the
relationship between Federal Reserve dis­
count policy and bank supervision. Bank
supervision, being concerned with the con­
dition of individual components of the com­
mercial banking system, is affected pri­
marily by discount policy as that policy,
in turn, affects the supply of funds avail­
able to individual member banks to meet
anticipated demands.
Any change in discount policy that in­
creases or decreases the supply of funds
will necessarily lead to some adjustment in
liquidity management for individual banks.
It is one of the responsibilities of bank
supervision to identify possibly needed
adjustments and, where appropriate, to
counsel banks how best to make them.
This study considers the present approach
to liquidity used by examiners for the New
York Federal Reserve Bank and compares
this approach with some other liquidity
standards; it concludes with some comments
on the consequences for the bank examiner’s
approach to commercial bank liquidity of
proposed changes in discount policy.
Summary and conclusions

The changing asset structure of banks, the
development of new money market instru­
ments, and the decline during the postwar
period in commercial bank liquidity as
measured by traditional indices have focused
attention on the problem of bank liquidity.
The primary responsibility for maintaining


adequate liquidity rests with the individual
bank; this is particularly true under the
present Regulation A, which provides that
the Federal Reserve Banks may extend
credit only to banks on a short-term basis
except in emergency or other unusual situa­
tions. Under these circumstances super­
visors place great emphasis on liquidity in
their examinations of banks. A number of
formulas have been developed to assist both
bank management and the examiners by
providing useful reference standards for
assessing and evaluating bank liquidity.
Various proposals made in connection
with the over-all study of the discount
mechanism would liberalize the administra­
tion of the System’s facilities so as to pro­
vide greater assistance to the banks in
supplying funds either on a short-term basis
or perhaps for longer periods of time. Any
liberalization of Regulation A to permit
readier access to the discount window
would, of course, tend to reduce the need
for member banks to make provision for
their own liquidity because they could rely
to a greater extent on their Reserve Bank.
Under a more liberal discount policy the
examiner’s emphasis would be shifted to
some degree from the volume of securities
in the bank’s short-term liquidity position,
and additional emphasis would be placed
on the quality and soundness of longerterm assets, on the adequacy of capital, and
on the adequacy of earnings to cover the
costs of borrowing. Examiners would con-


tinue to criticize any bank that used the
discount facilities for purposes inconsistent
with statutory and regulatory requirements
or with sound banking principles.
Definition of liquidity

Bank liquidity may be defined as the ability
of a bank to meet its known and foreseeable
demands for money. These demands may
come from the bank’s depositors or they
may come from customers seeking credit.
A bank is considered to have an adequate
liquidity position when it can meet normal
cash withdrawals and requests for loans
without having to sell or liquidate mediumor long-term assets. Adequate liquidity can
be achieved by holding, in addition to cash
or its equivalent, a sufficient quantity of
other assets readily convertible into cash—
secondary reserves—and by spacing maturi­
ties of its loans and investments to assure
the necessary inflow of cash.
Aside from the requirements that banks
must maintain certain amounts of reserves
against their demand and time deposits,
there are no uniform supervisory standards
governing the liquidity of U.S. banks. The
responsibility for maintaining adequate
liquidity is left to the individual bank, which
must exercise this responsibility in the light
of the ever-changing conditions under which
it operates.
Our definition of liquidity is asset oriented
and suggests that banks provide for their
normal liquidity needs out of their own
resources. It is recognized, however, that
many banks rely in some instances on
borrowing as a source of funds for meeting
deposit withdrawals and credit demands. In
descending order of importance, these bor­
rowings—all of a short-term nature—are
purchases of Federal funds, loans from cor­
respondents, sale of securities under repur­
chase agreements, and direct borrowings
from the Reserve Banks. In recent years

negotiable time certificates of deposit and
Euro-dollar deposits have been developed,
and they in turn have provided still other
sources of funds.
While these various types of essentially
short-term funds provide a cash flow, each
such short-term borrowing represents an
additional requirement for liquid funds to
be repaid at some near-term date. From
time to time the inability to borrow may
create problems for some or all banks, be­
cause funds are not always readily available
from outside sources at reasonable cost in
time of need.
Borrowings from the Reserve Banks or
from other sources, such as those mentioned
earlier, do provide funds to meet short-term
demands. However, borrowings from the
Reserve Banks differ in character from
other short-term borrowings. Under Regula­
tion A as revised in 1955, control of the
discount window rests with the Reserve
Banks. In practice banks traditionally have
been reluctant to borrow from the Reserve
Banks; that is, they have preferred to obtain
needed funds from other sources. Several
of the proposals to liberalize the use of the
window might alter or at least modify banks’
attitudes regarding borrowings from the
Reserve Banks and the use of the discount
window as a “lender of last resort,” and
they call for reconsideration of the general
concept of bank liquidity.
Secular trend in commercial bank liquidity

Although the need for individual institu­
tions to maintain adequate liquidity has
always been a well-recognized tenet of the
American banking system, it has become
increasingly important since World War II.
Between 1934 and 1944 liquidity problems
were generally of minor concern in the
affairs of commercial banks. In the early
part of this period the Federal Reserve
System, for the most part, maintained a


stimulative monetary policy and inflows of
gold were large. Credit demands expanded
little, however, and excess reserves of mem­
ber banks ranged between $1 billion and
$5 billion. Moreover, since the loan de­
mands of business were at a low ebb, com­
mercial banks invested heavily in U.S.
Government securities. By 1940 they held
a volume of Government securities that was
nearly equal to the volume of loans in their
The financing of the war effort during the
early 1940’s greatly intensified this trend and
caused the growth in the volume of Govern­
ment securities held by commercial banks
to outstrip the growth in loans by large
amounts. By the end of 1945 the volume
of Government securities held by commer­
cial banks was more than 3V2 times the
aggregate of their loan portfolios. Not all
of these securities were of short term, but
since the Federal Reserve System was sup­
porting the Government securities market
in this period—and continued to do so
until early 1951—all such securities were
fully liquid regardless of maturity; that is,
they could be readily converted into cash
without loss.
The post-World-War-II period has seen
an expanding economy, one that has sought
more and more bank credit. While deposits
have increased during this period, their
growth has not been sufficient to meet in
full the expanding demand for credit. As
this demand increased, commercial banks
reduced their holdings of Government secu­
rities in order to enlarge their lending
activities, and thus their liquidity positions
underwent a somewhat steady deterioration.


This changing asset structure of the com­
mercial banks and the revision in 1955 of
Regulation A, which emphasized the re­
sponsibility of the individual banks for
maintaining adequate liquidity, created an
interest in the development of a more so­
phisticated approach to the measurement of
liquidity needs. Improved measures would
enable both the managers and the super­
visors of commercial banks to make more
accurate evaluations of the liquidity posi­
tion of a bank.
In 1961 commercial banks began to use
negotiable CD’s on a large scale. The ex­
tensive use of this additional source of funds
changed somewhat the structure of banks’
liability accounts. While this new money
market instrument was designed to protect
banks from the drainage of deposits to other
short-term markets, it soon came to'be used
in an aggressive manner. Through the use
of CD’s, many banks were able to attract
a large volume of deposits within a rela­
tively short period of time and to expand
their loans far more than would have been
possible by the liquidation of securities.
More recently, the large commercial banks
have looked to the Euro-dollar market as
an additional source of funds.
Recourse to these new types of time
deposits and other liabilities as sources of
funds has made more complex the banks’
problems of maintaining adequate liquidity,
and has altered to some extent the tradi­
tional methods of assessing liquidity posi­
tions. In turn, use of CD’s has increased the
pressure for the development of a more so­
phisticated approach to the measurement of
liquidity needs.


One approach to liquidity

Revision of Regulation A in 1955 led the
Federal Reserve Bank of New York to
develop a new approach to the problem of
commercial bank liquidity in the examina­
tion of State member banks in the Second
District. This included a means of measur­
ing bank liquidity that was designed not
only to provide non-money-market banks
with a convenient method of analyzing their
own situations but also to assist examiners
and supervisors in evaluating liquidity posi­
tions of banks.
The liquidity formula adopted by the
Federal Reserve Bank of New York in 1955
was introduced to its bank examiners by a
bulletin noting that under the revision of
Regulation A, “The responsibility of pro­
viding for normal seasonal swings of funds,
or for finding funds to expand the loan
portfolio, is placed squarely on the indi­
vidual member bank.” The bulletin de­
scribes the liquidity formula as a means of
assisting examiners in appraising the degree
to which a bank has provided itself with
adequate liquidity, and as a possible guide
to member banks themselves. It emphasizes
that the formula does not provide a hardand-fast rule, that it has no substitute for
logical reasoning or more extensive analysis,
and that it is primarily designed as a start­
ing place or rough screening device to
focus proper attention on liquidity problems
that may exist in individual commercial
banks. In the following discussion, this em­
phasis on the limitations of the Federal Re­
serve Bank of New York’s liquidity formula
in the total evaluation of a commercial
bank’s liquidity is important to keep in
mind. In the final evaluation of liquidity
that accompanies every report of examina­
tion of a State member bank in the Second
District, the New York Reserve Bank ex­

aminer brings to bear not only the results
of the application of the liquidity formula,
but also his knowledge of the bank’s history
and of the financial markets in which it op­
erates, his understanding of the broader fi­
nancial and economic developments affect­
ing the bank’s operations, the pattern of the
bank’s borrowings at the discount window
and elsewhere, and his discussions with the
management of the bank and with his col­
leagues in the Examinations and Discount
Departments of the New York Bank.
This liquidity formula has been refined
and expanded since 1955. The instruction
memorandum currently used by the Exam­
inations Department of the New York Fed­
eral Reserve Bank, dated February 15,
1965, may be found in Appendix A. The
basic principles of the formula are sum­
marized below:
Rationale of the New York Reserve Bank
formula. The New York Reserve Bank’s
liquidity formula endeavors to evaluate a
bank’s liquidity requirements and position
as follows: (1) projects a bank’s liquidity
position over and above its day-to-day re­
quired reserves and the minimum cash bal­
ances it must maintain with correspondents,1
and (2) projects a bank’s liquidity needs
on the basis of a loss of deposits concurrent
with an expansion of loans. These projec­
tions make possible a fairly comprehensive
and effective appraisal of a bank’s loan and
investment policies.

1 The form ula and the other analyses described later
in this paper generally do not take into consideration
the cash flow from term and other amortizing loans
that would be available for liquidity purposes. In
practice, the cash flow from loans is generally rolled
over into new loans to m aintain the loan portfolio.
Nevertheless, the cash flow does provide a bank some
freedom of action with respect to liquidity; for ex­
ample, in extreme emergencies, a bank could curtail
its lending activities and use the cash flow from loans
to meet deposit withdrawals.


Since banks need liquidity not only for
the everyday operations but also to meet
future demands for funds, the formula
classifies the liquidity needs of banks
and the instruments held into three time
S h o rt t e r m ...............
M ed iu m t e r m ..........
L o n g e r t e r m .............

U nder 1 year
1 u p to 2 y ears
2 u p to 5 years

These liquidity needs and instruments are
described as follows.
L iqu idity requirem ents for deposits . The
New York Reserve Bank’s formula dis­
tributes deposits into three classes—volatile,
vulnerable, and residual—based upon the
degree of stability. So that each deposit
class will have adequate liquidity coverage,
the formula requires that a bank maintain
specified percentages of such deposits in
short-, medium-, and long-term liquid assets.
Demand and time deposits are considered
separately, but the liquidity requirements for
each type depend on how the deposits are
classified—that is, in which of the three
categories they fall.
V olatile deposits are those most likely to
be withdrawn, including seasonal deposits.
They should be covered in full by liquid
assets of the shortest maturities.
Vulnerable deposits are those the sudden
or unexpected withdrawal of which would
place heavy pressure on the bank’s liquidity
position. These are usually the larger de­
posits—that is, deposits including volatile
deposits that are in excess of Vi of 1 per
cent of total deposits. Deposits classified
as “volatile” are deducted from the sum of
the larger deposits to arrive at the total
of vulnerable deposits. The formula re­
quires a liquidity provision of 20 per cent
against such deposits in the form of socalled medium-term instruments.
Deposits classified as residual are “hard­
core” deposits. They may be fully invested
in earning assets. However, the formula


prescribes that banks, as a precaution,
should hold liquid assets to cover 10 per
cent of all residual demand deposits and 5
per cent of all such time deposits. In addi­
tion, the formula specifies higher liquidity
requirements for certain types of deposits
deemed to be subject to unusual liquidity
L iqu idity

requirem ents


portfolio .

Banks also need to hold certain amounts of
liquid funds so as to be able to make addi­
tional loans or investments. Such holdings
protect a bank from having to borrow un­
duly or to dispose of securities, possibly at
a loss, to meet the credit needs of its cus­
tomers. Loan demand is divided into three
categories: seasonal, unexpected, and pro­
jected. Patterns in seasonal lending tend to
be similar year after year and can be esti­
mated in large part from past experience.
Unexpected demand is estimated in an arbi­
trary way as a figure equal to twice the
bank’s legal lending limit for unsecured
loans. Seasonal and unexpected loan de­
mands require full coverage in short-term
liquid instruments. Projected demand re­
quires 100 per cent coverage, but the cover­
age may be divided equally between short­
term instruments and those maturing in
1 to 2 years.
The anticipated liquidity needs for de­
posits and portfolio are totaled for each
time category to show the aggregate needs
for liquid assets.
L iqu idity instrum ents held. The liquidity
instruments held are generally considered
to consist of cash or bank balances (pri­
mary reserves) and investments in assets
readily marketable with minimal risk of
loss (secondary reserves). For purposes of
liquidity analysis such liquid assets are
classified according to their remaining matu­
rity—short-term, medium-term, and long­
Not all primary reserves are available


for liquidity because some of the balances
are required for everyday operations. Thus,
only those primary reserves that are in ex­
cess of established working needs are con­
sidered as qualifying for liquidity purposes.
Likewise, some of the secondary reserves,
covering such items as brokers’ loans and
loans to correspondent banks, involve nor­
mal customer relationships, and it is un­
likely that a bank would permit these re­
serves to fall below certain specified levels,
except in cases of extreme contingency.
Thus, only the amounts of secondary re­
serves in excess of the average amounts of
such loans over the previous 12 months or
in excess of the minimum amounts specified
by the management may be considered
liquid assets.
The liquidity instruments in the three
categories are totaled, and any borrowings
are deducted from the short-term category.
Net liquidity in the three time categories is
determined by deducting liquidity require­
ments from total holdings of liquid assets.
A composite liquidity index is computed
by weighting the dollar amounts of the
liquidity requirements and net volume of
instruments held in each of the three time
categories and by comparing total dollar
amounts of the instruments held to the
dollar requirements. A composite index of
100 or more is normally considered to
denote adequate liquidity.






and maintained reserves to determine
whether or not the bank is handling its
money position properly. If the review shows
periodic closing of reserve periods with
either deficiencies or large amounts of ex­
cess reserves, the examiners discuss the
situation with the management and make
recommendations for correcting it.
2. A complete analysis of the bank’s
borrowing activities for the period between
examinations, based in part on the record
of the bank’s borrowings from the Federal
Reserve Bank, the reasons advanced for
such borrowings and when appropriate, dis­
cussions with members of the Reserve Bank’s
Credit and Discount Department; and also
a determination of the principal sources
of borrowings, with particular emphasis on
the volume and steadiness of the bank’s use
of the discount window as compared with
purchases of Federal funds and the use of
other sources of borrowings; and how the
borrowings were used and why they were
needed—for example, to cover seasonal de­
posit fluctuations or inaccurate projections
of deposit and loan growth, or because the
bank had overextended its loans and
3. A general review of the bank’s loan
and investment policies to determine the
extent to which they have affected the
liquidity position. Such an analysis would
include a review of outstanding loan com­
mitments and of the distribution of loans
by type and a projection of the cash flow
from the loan and investment portfolios.
4. Consideration of general trends in na­
tional and local economic and financial con­
ditions, including such factors as interest
rates, loan demand, and the state of capital
markets that may affect liquidity.

appraising a bank’s liquidity. Since, as stated
earlier, the New York Reserve Bank’s
liquidity formula serves merely as a start­
ing point or a rule-of-thumb in evaluating
liquidity, the Bank’s examiners make other
analyses that are equally important in the
over-all evaluation of a bank’s liquidity
position and its loan and investment poli­
Evaluation of the New York Reserve Bank’s
examining approach to liquidity. While the
cies. Such analyses include the following:
A review of the bank’s procedures liquidity formula and other analyses dis­
cussed earlier constitute the general ap­
in computing the daily record of required


proach used by the New York Reserve
Bank’s examiners in appraising the liquidity
position of a bank, the manner in which the
examiner uses these analytical tools depends
entirely upon the judgment of the individual
examiner. He will use the ones best geared
to the specific circumstances of a particular
bank. The examiner’s conclusions are predi­
cated on a careful consideration of the fol­
lowing basic concepts with regard to appro­
priate utilization of borrowed funds—
regardless of source—to support a bank’s
1. That borrowings at the Reserve Bank,
regardless of size, are objectionable if they
do not conform to the 1955 revision of Reg­
ulation A.
2. That steady and somewhat heavy bor­
rowings from sources other than the Reserve
Bank may be considered normal at New
York City banks because these banks are in­
volved in the money market. The extent to
which such borrowings are used to support
non-money-market operations is an import­
ant factor in determining whether the bor­
rowing activities of these banks might be
subject to criticism.
3. That steady and somewhat heavy bor­
rowings from sources other than the Reserve
Bank are objectionable if used to support an
unsound expansion of loan portfolios or
other practices inconsistent with prudent
In view of the differences in the appropri­
ateness of borrowings, and since there are
wide differences in the operations of nonmoney-market banks compared with the op­
erations of banks connected with the money
market, the approach to liquidity and bor­
rowings in these two broad classifications of
banks differs considerably, and the evalua­
tion of the approach should be reviewed ac­
Non-money-market banks. Traditionally,
non-money-market banks have been reluc­


tant to borrow from any source; instead they
have preferred to obtain needed liquidity by
making adjustments in their own loan and
investment portfolios. In many cases, par­
ticularly among the smaller banks, there has
been a lack of understanding of liquidity.
Where this has occurred, banks either have
had too little liquidity to cover their needs
or more often, at the other extreme, have
had too much liquidity, with a resultant loss
of income.
The New York Reserve Bank’s liquidity
formula has proven to be a valuable instru­
ment to the examiners in evaluating liquidity
of non-money-market banks in this District.
More important, because of its relative sim­
plicity, the formula has been useful in assist­
ing the management of these banks to better
understand how much liquidity the banks
should have and how such needs can be met
without resorting to excessive use of the Re­
serve Bank’s discount facilities or without
selling assets at a loss. In other instances it
has helped management to recognize an ex­
cessive liquid position and to make the
necessary adjustments to improve earnings.
We believe that the formula has made it pos­
sible for examiners and bank management to
develop a mutual understanding of liquidity
and of the appropriate utilization of borrow­
In recent years the Federal funds market
has provided the country banks with a con­
venient and flexible means of adjusting their
excess reserve positions. Previously, country
banks had been largely excluded from the
use of this market because the unit traded
was too large. However, with the increased
demand by large city banks for borrowed
funds to maintain positions in relatively
high-yielding assets, these large banks, at
least in the Second Federal Reserve District,
have been willing to trade in much smaller
units to tap the excess reserves of even the
smallest institutions. Access to the Federal


funds market has enabled the country banks
to put otherwise idle funds to profitable use.
While these banks generally enter the mar­
ket on the “selling” side, the increase in their
knowledge of this market permits them on
occasion to purchase Federal funds—thus
reducing their dependency on the discount
Examples of the types of comments made
by the New York Reserve Bank examiners
in connection with non-money-market banks
that have been found to have excessive
liquidity positions and marginal liquidity
positions may be found in Appendixes B
and C, respectively.
Money market banks. The application of
the New York Reserve Bank’s liquidity
formula to money market banks poses some­
what different problems. For one, the form­
ula was not designed primarily for applica­
tion to these large banks; for another, these
banks maintain a close and continuing watch
over their liquidity positions and attempt to
provide the necessary liquidity through a
wide variety of transactions that have not
been fully recognized in the formula.
Whereas these large banks have their
normal levels of deposits of individuals, part­
nerships and corporations, the examiner’s
analysis of the liquidity position and the ap­
plication of the formula are governed largely
by the extent to which these banks are fi­
nancing money market transactions, such as
loans to U.S. Government securities dealers,
operation of U.S. and municipal bond trad­
ing accounts, and so forth. It is generally
recognized that these banks support such
money market transactions by borrowing. In
addition, these banks as a general rule are
actively engaged in providing correspondent
services to banks located throughout the
United States. For example, they are a
major source through which country banks
can adjust their reserve positions by selling
Federal funds. Many of the large banks have

been relying to an increasing extent on the
availability of such funds when projecting
their own liquidity requirements.
Moreover, in recent years these large
banks probably have encountered greater
changes in their deposit structure than have
the country banks. In this period their de­
mand deposits have shown little growth, and
in order to obtain funds for lending, the
large banks have relied to an increasing ex­
tent on expansion of time deposits. The time
deposits generated have been largely in the
form of negotiable CD’s. In common with
most banks, the short-term liquid asset port­
folios of money market banks have also
shown a steady decline, as these banks have
converted such assets into longer-term,
higher-yielding loans to offset the increased
costs of the growing volume of their time
and savings deposits. The tight money con­
ditions that existed in 1966 and the unstable
short-term money rate structure placed se­
vere strains on the liquidity positions of
most of the money market banks. As a
result, a number of these banks increased
their borrowing from various sources to sup­
port their heavily invested positions in loans
and securities as well as their money market
Because of these conditions, the exam­
iners have had to analyze each situation
carefully and to modify the liquidity form­
ula, as needed, in order to arrive at satisfac­
tory conclusions with respect to the actual
liquidity position of a money market bank.
For example, the liquidity requirements
against certain types of deposits, such as the
negotiable CD’s, did not appear realistic in
the light of present conditions and were in­
creased. In addition, the examiners have
given consideration to the relationship be­
tween a bank’s activities in the money mar­
ket and the volume of borrowings from all
sources to support these activities.
Examples of the type of comments made


by the New York Reserve Bank’s examiners
in connection with money market banks
with adequate liquidity positions and those
with tight liquidity positions may be found
in Appendixes D and E, respectively.
Summary. The New York Bank’s liquidity
formula has been a useful tool for both
examiners and bank management in evaluat­
ing and discussing liquidity and borrowings
of banks—particularly of non-money-market
banks. The present liquidity formula is
somewhat inadequate when applied to the
money market banks in part because of their
increased reliance on liability management.
Modifications of the formula, based in part
on experience during the period of tight
money in 1966, are needed to make the
formula more effective for that purpose.
Other liquidity standards

A variety of ratios and other formulas are
used to measure bank liquidity. Probably
the two ratios most widely used are the
liquid assets/liabilities ratio and the loan/
deposit ratio. The liquid assets/liabilities
ratio shows the relationship of the means of
cash payment to the possible demands for
payment. It is expressed as a percentage and
is usually computed by relating the sum of
cash and balances due from banks, loans to
brokers and dealers, and short-term Govern­
ment securities less any borrowings to total
deposits less cash items in process of collec­
tion and reserves on deposit at the Federal
Reserve Bank. The loan/deposit ratio, as
the name implies, relates the volume of
loans outstanding to the volume of deposits;
it indicates the extent to which deposits are
tied up in relatively illiquid assets.
These ratios, used either in combination
or separately, are at best only rough meas­
ures of a bank’s liquidity position. They are
not considered adequate for supervisory pur­
poses because they omit any consideration
of such important items as the flow of funds


from loan repayments, the amount of funds
that a bank may be called upon to supply,
and the varying stability of different types
of deposits.
The examining staff of the Board of Gov­
ernors of the Federal Reserve System in­
cludes a liquidity calculation section in its
Form for Analyzing Bank Capital (Appen­
dix F). Among the formulas for measuring
the liquidity position are those used by the
examiners for the Comptroller of the Cur­
rency and the examiners for the New York
State Banking Department. Each of these
measurements is described here briefly.
Board of Governors. As noted, the exam­
ining staff of the Board of Governors of
the Federal Reserve System includes a liquid­
ity calculation in its Form for Analyzing
Bank Capital.2 In the strictest sense, the
liquidity calculation is not a measurement
of a bank’s liquidity position but merely in­
dicates the extra capital that would be
needed to cover possible losses in the event
that a forced liquidation of portfolio assets
was required to supplement liquidity pro­
vided by primary and secondary assets. The
calculation is based on certain assumptions
as to deposit shrinkage, made on the basis
of a review of historical data by the Board’s
Comptroller of the Currency. The formula
currently used by the examiners of national
banks is explained briefly in the “Regional
Newsletter, Second National Bank Region,
July 1966,” a copy of which is included as
Appendix H. It is a much simpler formula
than that used by the New York Reserve
Bank and relates liquidity only to deposit
liability. Liquid assets are considered to be
cash and balances due from banks, the mar­
ket value of the bank’s unpledged security
2 See Appendix F. This form (F R 363) is com ­
pleted by the New Y ork Reserve Bank examiners d ur­
ing their examinations of all Second D istrict State
m em ber banks.


portfolio (including bonds pledged in excess
of legal requirements), and Federal funds
sold. From the total of such assets are de­
ducted borrowings, Federal funds purchased,
and required reserves. The resulting figure
is considered to be the net liquid asset posi­
tion of the bank. A net deposit figure is ob­
tained by deducting secured deposits from
total deposits. The liquidity ratio (expressed
as a percentage) is computed by dividing
net liquid assets by net deposits.3It is under­
stood that the Comptroller’s office would
consider a percentage of 35 per cent or more
as reflecting a reasonably adequate liquidity
The value of this formula in the analyses
of the liquidity positions of national banks
cannot be readily determined because dis­
cussions of liquidity and borrowings in re­
ports of examination of these banks are gen­
erally not extensive. This liquidity formula
appears to serve as a rough rule-of-thumb
for calculating deposit liquidity as on the
examination date. It does not include any
consideration of the liquidity needs for the
portfolio; nor does it include any projection
of liquidity needs for deposits and loans.
New York State Banking Department. At
each examination bank examiners for the
State of New York compute a “quick-asset
ratio” that is similar to the liquid-assets/liabilities ratio described earlier. The quick
assets consist of cash and balances due from
banks; the market value of readily market­
able stocks and bonds (excluding securities
deposited for purposes other than as security
for deposits or borrowings, as for example,
securities deposited to secure trust activi­
ties); loans secured by readily marketable
collateral; and other quick assets. Secured
deposits and borrowings are deducted from
3 t the year-end call for statem ents of condition for
1966, the three Federal supervisory agencies requested
banks under their supervision to complete liquidity
form s patterned after this form ula.

total quick assets to arrive at net quick
assets, the sum of which is related to net
liabilities, which consist of total liabilities
less the secured deposits and borrowings.
The New York State Banking Depart­
ment considers this ratio to be a useful meas­
urement of the proportion of a bank’s assets
that are intrinsically liquid in character.
However, such a measure of the bank’s li­
quidity position contemplates the liquidation
of secured loans, thus implying an unusual
and severe contingency. To supplement the
quick-asset ratio and to measure the extent
to which immediate conversion of assets into
cash is possible without interfering with the
normal activities of the institution, the de­
partment has developed a “primary liquid­
ity” formula. This formula is explained in
Supervisory Circular Letter CB-14 (Appen­
dix G).
The primary liquidity formula is similar
to the New York Reserve Bank’s liquid­
ity formula, except that it does not distrib­
ute the liquidity requirements and the instru­
ments held into different time periods. In
addition, the use of liquidity instruments as
primary reserves in the formula is limited,
for the sake of uniformity, to the five types
listed in Circular Letter CB-14. Moreover,
the formula does not include a reduction in
primary reserves due to outstanding borrow­
ings; such borrowings are treated rather as
a deduction from the total of quick assets in
the quick-asset ratio.





The New York Reserve Bank
liquidity formula differs in concept from
those developed by the staffs of the Comp­
troller and the Board of Governors. The
New York approach attempts to gauge the
relationship between those assets that may
be liquidated readily with little, if any, loss
in order to meet the foreseeable needs of a
bank with respect to changes in loan volume
or deposit losses during the normal course of


its business. Such an approach is also used
to some extent by examiners of the New
York State Banking Department.
Formulas of the examining staffs of both
the Comptroller and the Board of Gover­
nors, on the other hand, seek essentially to
determine a bank’s ability to meet any de­
posit loss short of going into liquidation;
neither formula recognizes the liquidity
needs for the portfolio. The formula of the
Board’s staff is the more sophisticated, how­
ever, since it places a ceiling on any possi­
ble deposit losses and recognizes that under
certain circumstances a bank may have to
rely for liquidity on assets other than those
considered to be primary or secondary
Comparison of these various measures of
liquidity for a typical country bank, includ­
ing the different types of ratios and the
formulas used by the examining staffs of the
New York Reserve Bank, the Board of Gov­
ernors, and the Comptroller, is shown in
Appendix I. A computation of primary
liquidity according to the formula used by
examiners for the New York State Banking
Department has not been made because that
formula is similar to one used by the New
York Reserve Bank.
These ratios and formulas indicate the
following regarding the sample bank’s
liquidity position:
1. Loan/deposit ratio, at 68.6 per cent,
indicates a fairly heavy loan position. Mem­
ber banks in New York State outside of New
York City had an average ratio of about 61
per cent at year-end 1966.
2. Liquid-assets/liabilities ratio, at 11.8
per cent, seems to reflect an adequate posi­


tion when compared with the December 21,
1966, average ratio of 8.2 per cent for all
weekly reporting member banks in the Sec­
ond Federal Reserve District outside of New
York City.
3. On the other hand, New York State's
quick-asset ratio, at 41.4 per cent, indicates
a tight liquidity position. The average ratio
for all banks in New York State outside of
New York City was 55 per cent in 1966. It
should be noted, however, that the State
Banking Department also reviews the bank’s
liquidity position on the basis of the State’s
primary liquidity formula discussed previ­
4. The New York Reserve Bank’s liquid­
ity formula reflects an adequate liquidity
position on the basis of the consolidated
index of 113. Net liquidity is adequate for
the short- and long-term categories, but
there is a deficit for the medium-term cate­
gory. Moreover, the examiner’s comments
regarding this bank (see Appendix C) indi­
cate that if certain large public demand de­
posits were reclassified as volatile, the bank’s
short-term position might not appear so
5. The Board of Governors’ Form for
Analyzing Bank Capital shows that the ratio
of actual capital to required capital for this
bank was too low and that the bank needed
additional capital of $206,000 against as­
sets, other than primary and secondary re­
serves used for liquidity. This amount would
represent 25 per cent of the total capital
6. The Comptroller of the Currency’s
liquidity formula, at 30.3 per cent, also re­
flects a tight liquidity position.

Changes in discount policy including such
concepts as a basic borrowing privilege and
a seasonal borrowing privilege, all of which

involve freer and perhaps more frequent
access to the discount window, would of
course require some modification of the


examiner’s approach to liquidity and over­
all evaluation of bank management and loan
and investment policies. Under such a liber­
alized discount policy, the bank examiner
may have the additional responsibility of
counseling the management of some banks
as to how to operate effectively in a new en­
vironment. Bank supervision would have the
responsibility of reminding management of
the possible dangers of relying too heavily
on the window and of assuring that the banks
retain the skills needed to manage their
liquidity positions in times when exclusive
reliance on borrowings may be unprofitable.
The studies made in connection with the

reappraisal of the Federal Reserve discount
mechanism have served to re-emphasize the
desirability of establishing uniform stand­
ards of capital and liquidity and the need to
take changes in discount policy into account
in developing such standards. One result has
been the establishment within the Federal
Reserve System of a study group to consider
the various approaches to capital adequacy
and liquidity and the possibility of introduc­
ing such techniques and cash flow analysis
in the evaluation of liquidity, with a view
toward developing standards that may meet
with general acceptance among bankers and
bank supervisors.
November 1968

An explanatory memorandum of the Bank
Examinations Department, Federal Reserve
Bank of New York, February 15, 1965


The problem of bank liquidity is essentially that of
having available sufficient funds— or marketable
assets readily convertible into funds— to meet at all
times the demands for money that may be made
on a bank. Adequate liquidity is the basic protec­
tion afforded against losses that could develop
should the bank have to sell or be forced to liqui­
date creditworthy assets in an adverse market.
Maintaining adequate liquidity, therefore, means
having enough funds on hand or readily available
with which to meet the actual or potential demands
for funds by the bank’s depositors or borrowing
The liquidity requirements of an individual bank
will vary from day to day as funds flow into and
out of the bank. Management’s responsibility is to
measure these requirements and to anticipate them
on a current and continuing basis. Our objective,
therefore, has been to develop a yardstick capable
of systemizing the variables involved and produc­
ing as accurate and simple a measure as possible.

The Bank Examinations Department of the Federal
Reserve Bank of New York has for some time been
using a measure of bank liquidity as an adjunct
to its regular bank examinations. Several years’
development of bank liquidity standards and their
application in the field has seen widening interest
on the part of bankers and supervisory authorities
in the objectives of such measurements. The first
of these is to provide bankers with a convenient
means of analyzing their own situations, thereby
encouraging closer attention to their liquidity posi­
tions. The second is to aid bank examiners and
supervisors in evaluating management’s perform­
ance in maintaining sound liquidity positions. A
third objective might be to create a measure of
relative liquidity that could be used to evaluate the
impact of credit policy changes on groups of banks.
Banks, themselves, for the most part have not
developed any systematic procedures for estimat­
ing liquidity needs. Rough measures generally used,
such as loan/deposit ratios or ratios of liquid assets


to total loans and investments, do not adequately
reflect prospective dem an ds for funds. Most often
liquidity needs have been estimated by intuition
born of experience or calculated so as not to be
“out-of-line” with other banks whose needs may be
entirely different. A need for guiding principles
and uniformity of approach seemed clear. For
these reasons, the Liquidity Position Form de­
scribed in detail later was developed as a basis
for management’s necessary exercise of judgment.

A form for estimating the liquidity position is
shown in Table 1. The liquidity requirements are


first computed, as will be described. The holdings
of liquid assets are then listed and compared with
needs to arrive at a net liquidity (excess or deficit)
in the individual banks’ positions. Both require­
ments and holdings of liquidity instruments are
shown separately for short-term needs (under 1
year), medium-term needs (1 to 2 years), and
longer-term needs (2 to 5 yea rs). Excesses of liquid
assets in the shorter maturities may of course be
used to satisfy the longer-term requirements.
These time periods play a key part in deciding
upon how to assign and apportion liquid assets.
Liquidity requirements have been established pri­
marily to provide for normal or seasonal changes

Am ounts in thousands of dollars

Per cent

Maturity in years
Under 1


Deposit liquidity
Demand deposits
Less: Volatile.........................................................................................
Less: Large.............................................................................................
Time deposits
Negotiable CD’s........................................................................................
Less: Above...........................................................................................
Deposit requirements...........................................................................
Portfolio liquidity
Seasonal loan demand..................................................................................
Unexpected demand......................................................................................
Projected (special loan increase)..................................................................






‘ l7







’ 54



’ 5







Portfolio requirements........................................................................


Aggregate requirement...................................................................................




Liquidity instruments held
Excess reserves and correspondent bank balances.....................................
Acceptances, brokers’ loans, commercial paper, and loan participations
High-grade securities
Under 1 year...........................................................................................
1 - 2 years.................................................................................................
2-5 years.................................................................................................
Firm commitments from others to purchase assets...................................


Aggregate holdings........................................................................................
Less: Borrowings...................................................................................
Net holdings..................................................................................................
Aggregate requirement................................................................................
Excess, or deficit (—), dollars......................................................................


Liquidity index..............................................................................................


* Adjust percentage in accordance with legal reserve requirement.











in deposits an d lo an d em a n d plus a m arg in o f safety
fo r cyclical v a ria tio n s o r u n fo reseeab le events.
L iq u id ity in stru m e n ts th a t m a tu re w ith in 1 y ear
are co n sid ered th e first line o f p ro te c tio n , an d th e
only holdings sufficiently fluid to m eet c o rre sp o n d ­
ingly sh o rt-te rm liq u id ity needs. B ut d efense in
d e p th is also advisable to allow fo r m a n e u v e ra b il­
ity in less p re d ic ta b le circu m stan ces. L iq u id assets
w ith m atu ritie s o f 1 to 2 an d 2 to 5 y ears are m o re
realistically term ed sh iftab le reserves. S egregating
these fro m liq u id ity h oldings em phasizes th e essen­
tial difference, even th o u g h b o rd erlin e distin ctio n s
are o ften difficult to ap p ly .1
1 This note appears in right-hand column.

N o te from preceding column.

1 Depending upon m arket conditions, shiftable re­
serves may sometimes prove highly liquid. However,
these cannot always be relied upon to meet short-term
liquidity needs. Instead they are relied upon to meet
the longer-term demands anticipated on the form.
These reserves can, however, serve as reinforcem ents
for converting during emergencies when there are
liquidity deficits and no alternatives available. But
they do not fully pass the m ajor test of “liquidity”—
the ability to convert to cash with no risk of sizable
loss whenever sold. O f course, the passage of time,
as well as shifts in response to changing money m ar­
ket conditions, may see securities of over-1-year m a­
turity flowing into the under-1-year liquidity classifica­
tion with appropriate changes in entries on the form.

D em an d s fo r fu n d s o n a b a n k m ay be m ad e by its
d ep o sito rs o r by its cu sto m ers seeking credit.

B ankers k n o w fro m exp erien ce th a t th e m a jo r p o r­
tio n o f liq u id ity n eed is relate d d irectly to th e v ol­
u m e an d stab ility o f th e ir d em an d an d tim e d e­
posits. O bviously, n o t all dep o sits are eq u ally ac­
tive an d do n o t re q u ire th e sam e degree o f liq u id ­
ity. T h e actu a l req u ire m e n t is rela te d to th e lik e li­
h o o d th a t any specific dep o sit o r g ro u p o f deposits
will be w ith d raw n . F o re c a sts c a n n o t be m ad e w ith
certain ty , b u t it is feasible to ra n k p o te n tial d e ­
m an d s fo r fu n d s by degrees o f in ten sity : th o se th a t
will surely o cc u r; th o se th a t are likely, b u t n o t c e r­
tain to o ccu r; an d finally, those th a t are less likely
bu t, u n d e r c e rta in circu m stan ces, c o u ld possibly
occur. T hese gro up in g s are m o re p recisely show n
on the liq u id ity p o sitio n fo rm as volatile, v u ln e ra ­
ble, and resid u al deposits. T im e deposits are c o n ­
sidered sep arately becau se o f th e ir so m ew h at g re a t­
e r stability u n d e r n o rm a l circu m stan ces.

Volatile deposits. T h e g re a te r th e lik elih o o d o f
w ith d raw al, th e larg e r th e p erce n ta g e o f liqu id ity
req u ired an d th e sh o rte r th e m atu ritie s o f th e liquid
assets th a t sh o u ld be held. D eposits w ith th e g re a t­
est likelihood o f b ein g w ith d ra w n are te rm e d v o la­
tile and should be co v ered fully by liq u id assets
w ith th e sh o rtest m atu ritie s, ran g in g fro m cash to
high-grade securities, an d o th e r in stru m e n ts m a ­
tu rin g w ith in 1 y ear. P re sc rib in g 88 p er cen t as
the liquidity n eed d irectly reflects th e c u rre n t m em ­
b e r b a n k legal reserv e re q u ire m e n ts set at 12 p e r

c en t fo r d e m a n d deposits a t c o u n try m em b e r
b a n k s.2 T h is am o u n ts to saying th a t th e to ta l o f th e
tw o types o f reserves covers th e v olatile w ith d ra w ­
als in full. T h e d o lla r e n try o f v olatile d e m an d
deposits ($ 1 ,1 5 0 ,0 0 0 in T ab le 1) is n o t th e p ro d u c t
o f g uessw ork b u t reflects th e b a n k ’s a c c u m u lated
experience. T y p ical o f v olatile deposits are th e
local p ay ro ll acco u n ts th a t are b u ilt u p w eekly
o r biw eekly and im m ed iately ch eck ed ag ainst; th e
m u n icip a l deposits o f tax m onies th a t w ill be
d raw n dow n over a specified p erio d o f tim e to
m eet m u n icip al expenses; an d seaso n al d eposit
flu ctu atio n s th a t are also of th e sam e ch a ra cte r.
T h e e x te n t o f su ch sh o rt-te rm d ep o sit sw ings
can be show n m o st sim ply by a c h a rt o f m o n th -en d
d ep o sit to tals. C h a rt A - l show s th e b a n k ’s re ce n t
ex p erien ce in clea r visual fo rm . C h a rt A - 2 sim i­
larly d epicts th e v o latility o f tim e deposits. T h e
tre n d line co n n e c tin g th e low points d eterm in es
th e base lin e.3 A t any p a rtic u la r p o in t o n th e c h a rt
th e a m o u n t o f d eposits above th e base line is
2 F or banks in reserve cities the com parable per­
centage would be 83.5 per cent.
3 In charting deposits, or the loan figures mentioned
later, there will sometimes be unusually sharp in­
creases or decreases. These may not represent a
change in trend but rather a change in level. F or ex­
ample, if a new large deposit account is obtained—
or if one is lost— it will raise or lower the level of
total deposits w ithout affecting the trend. The base
lines may therefore have to be adjusted upward or
downward w ithout changing their directions. This
further underscores the continuing need for m anage­
ment to exercise judgm ent in the individual situations
confronting its bank.




considered volatile and required to be covered in
full by liquid assets plus the automatic release of
required reserves.
By the same token, the aggregate amount below
the line indicates the nonvolatile deposits. This
status does not, however, exempt such deposits
from the need for some liquidity. Should unusual
withdrawals carry deposits below the base line, the




on the bank’s liquidity position. They are likely to
be the bank’s larger deposit accounts.4 These ac­
counts, in any event, should be identified and more
closely followed by the officer responsible for the
liquidity position. Experience will generally show
that most of the volatility of demand deposits will
be in these large and therefore vulnerable accounts.
(A time deposit, of course, can be large and vul­
nerable even though it does not fluctuate at all.)
Volatile deposits, having already been deter­
mined and provided for, are therefore deducted
from the total of large demand deposits to deter­
mine the vulnerable deposits in Table 1 and a 20
per cent requirement of 1- to 2-year maturities is
set up for them. The choice of intermediate rather
than shortest-term maturities would seem to pro­
vide reasonable protection against possible but un­
anticipated withdrawals of substantial magnitude.
Residual deposits are those remaining deposits
that are neither volatile nor vulnerable. They rep­
resent what is often referred to as the “hard core”
of stable deposits that can be fully invested in earn­
ings assets. A more conservative view, however,
calls for a precautionary margin of liquidity even
for such stable deposits. A 10 per cent requirement
in liquid assets with maturities ranging up to 5
years, when market conditions justify,5 is sug­
gested. To the ultraconservative this requirement
may seem low. But it should be remembered that
this requirement, as well as that against vulnerable
deposits, is supplemented to the extent of 12 per
cent of the demand deposit loss (4 per cent for
time deposits) by the release of required reserves.


need for a second, or even a third, line of liquidity
defense will come into play. These liquid assets,
however, may be comprised of securities of some­
what longer-term maturities if interest considera­
tions justify it from an investment viewpoint. As
shown in Table 1, these longer-term assets are as­
signed against the vulnerable and residual de­
Vulnerable deposits are those whose sudden or
unexpected withdrawal would place heavy pressure

Although under normal circumstances there may
be less immediacy with respect to liquidity needs
for time deposits, banking practice and experience
have shown that time deposits share several char­
acteristics normally attributed to demand deposits.
For this reason much that has been said about de­
mand deposits applies to time deposits as well.
For example, time deposits also often exhibit sea­
sonal fluctuations: Christmas club accounts are al­
most entirely seasonal and such seasonality, readily
4 For purposes of uniform practice “large deposits”
have been defined as those exceeding, in round figures,
half of a per cent of total deposits.
5 Investment specialists counsel lengthening m aturi­
ties when interest rates are relatively high and short­
ening m aturities when interest rates are low.


discernible from Chart A— , represents a volatile
portion of time deposits requiring full liquidity re­
serves. This protection is afforded by a 96 per cent
reserve of liquid assets in conjunction with the 4
per cent release of required reserves brought about
by a time deposit decline.
Large savings deposits, as noted earlier, can be
vulnerable without being volatile. Against such de­
posits, together with large time deposits held in­
definitely (such as State time deposits in many
localities), a 20 per cent liquidity reserve in me­
dium-term liquidity assets is recommended.
Negotiable time certificates of deposit are also
considered vulnerable and a liquidity requirement
of 20 per cent is prescribed. These certificates are
usually short term and, therefore, the liquidity re­
serve generally should be in short-term liquidity
Special time deposits refers to some large time
deposits that management may know will be with­
drawn at maturity or even after a relatively short
period of time. An example of such deposits would
be the proceeds of a school bond issue scheduled
for disbursement as the school construction pro­
gresses. Such accounts are considered special de­
posits and require specific liquidity provision in
the light of their prospective withdrawal.
Residual liquidity reserves of 5 per cent for re­
maining time deposits are prescribed for the same
reasons set forth earlier in connection with demand
deposits. Maturities may be of somewhat longer
term and, in times of high interest rates, might be
concentrated toward the longer end of the 2- to 5year range.

Portfolio liquidity, as the term is used here, con­
sists of liquid funds for the purpose of making ad­
ditional loans or investments. These holdings safe­
guard the bank against the need of having to bor­
row unduly or sell securities at a loss in order to
meet the foreseeable credit needs of its customer.
Three categories of loan demand are identified:
seasonal, unexpected, and projected.
Seasonal loan demand is one of the surer fluctu­
ations bankers can anticipate. Chart A -3 shows
month-end loan figures similar in principle to Chart
A - l. The trend line, this time connecting high (in­
stead of low) points, is the loan ceiling— the
amount to which loans may be expected to rise
seasonally or periodically based on recent experi­
ence. The amounts by which loans at any time

drop below this ceiling measure the bank’s liquid­
ity needs to meet normal or seasonal loan varia­
tions. These seasonal needs should be provided
for in full.


Unexpected and unusual loan demand, by defini­
tion, cannot be foreseen. A minimum provision
would seem to be an additional fund of liquid
assets equal to at least 20 per cent of capital and
surplus (twice the 10 per cent legal loan limit on
unsecured borrowings). The bank is then reason­
ably prepared to accommodate some loan requests
from good customers who may not have borrowed
in recent years and whose need for credit is not
reflected in the chart.
Projected loan increase superimposes on the pre­
ceding categories any definite loan expansion plans
that management may have in mind and provides
for any expected net increase in the community’s
demand for credit in the foreseeable future, at least
to the extent that such demand may exceed accom­
panying deposit increases. Additional liquidity
provision should be made and closely related to
the size of demands and to the time when such de­
mands are expected. No specific requirement can
be allocated other than by management with its
detailed knowledge of the local community and its
In addition to the foregoing, there may exist a
need for further modification of this formula ap­
proach. Management may know of some change
in policy to become effective in the near future
that would affect the bank’s liquidity requirements.
For instance, a change in the rate of interest paid
on savings accounts or time accounts might be ex­
pected to change the deposit level materially. If
such a situation exists, an adjustment of the liquid­
ity requirements should be made.



Adequate liquidity means the bank’s ability to meet
the immediate and potential demands for funds as
outlined earlier. Liquid assets are generally thought
to consist of cash or bank balances (primary re­
serves), and investments in short-term assets read­
ily marketable with minimal risk of loss (secon­
dary reserves). Such liquid assets are subdivided
on the liquidity position form into maturity cate­
gories having varying degrees of ready convertibil­
ity into money.

A bank requires some working balances at all
times to carry on its daily business. For this rea­
son, a portion of bank balances, over and above
the required legal reserves, is not truly liquid; and,
for purposes of this analysis, the liquidity holdings
should include only that part of primary reserves
that is freely available. Only excess reserves, there­
fore, and correspondent balances exceeding essen­
tial working balances are countable as liquidity in ­
struments held.

The remaining stocks of liquid assets include
money market loans such as brokers’ loans and
commercial paper, and investment-grade securities
maturing within 1 year.6
The distribution of longer-term high-grade se­
curities enumerated on the form is directly related
to the nature of the individual bank’s deposits and
its potential loan demands spelled out earlier. (It
is worth repeating that the legal reserves freed by
withdrawals of demand and time deposits are
among the liquidity sources. Although not enu­
merated as a liquidity instrument they have been
implicitly recognized in the setting of 88 and 96
per cent in liquid reserves against volatile demand
and time deposits.)
6 There are instances, however, where short-term
securities are pledged to secure specific deposits and
certain banking functions. In such cases, pledged
short-term securities should not be considered avail­
able for meeting liquidity requirements—unless avail­
able nonliquid securities holdings may be substituted
in their place.

The aggregated figures on either side of the liquid­
ity scale provide useful information. However,
better perspective for bank appraisal is obtained
by netting the two categories and showing the
bank’s excess or deficit liquidity balance in each
category. The illustration given on the liquidity
position table shows, for example, that the bank
is in balance regarding its shortest-term liquidity
requirements and holdings and is in a surplus posi­
tion relative to its longer-term needs.
In the process of comparing requirements with
holdings, banks’ responses to cyclical changes
should come to light in the aggregated statistics
over a period of time.7 It is well, however, to em­
phasize here that the Bank Examinations Depart­
ment regards its immediate function more narrow­
ly, and gives primary attention to the condition of
individual banks on a case-by-case basis.
7 distinction must be drawn, however, between the
banking system and the single bank. While liquidity
of the entire system is the concern of the monetary
authorities, the liquidity position of the individual
bank is local management’s responsibility and may
either directly reflect or run counter to general trends

Because of wide differences in size of banks, it
would be helpful to convert the individual net
dollar liquidity positions to a liquidity index that
would lend itself to drawing interbank comparisons
on a comparable base. This is illustrated on the
last line of Table 1. Such indicators lend them­
selves to a study of relationships between banks’
liquidity indexes grouped by bank size, unit or
branch structure, geographic location, and, going
further, with other statistics of local or nationwide
economic and business data.
Comments up to now have been mainly re­
stricted to short-term liquidity positions of banks.
The longer-term securities, however, account for
an important share of holdings and the bank’s
ability to meet its projected longer-term deposit
and loan responsibilities. Although a distinction
has been drawn between short-term and longerrange liquidity needs, it may prove useful to com ­
bine the short- and longer-term categories into a
composite index that gives recognition to the total
liquidity distribution over time.


Table 2 illustrates the method followed in com­
puting the consolidated index of liquidity. The
Bank Examinations Department has assigned
weights to the dollar amounts of liquidity require­
ments and net liquidity holdings. The weights are
tailored to the relative importance of short-, me­
dium-, and longer-term liquidity needs. The dollar
amounts, rather than the liquidity indexes shown
in Table 1, are used in arriving at the consolidated
index, in order to avoid any distortion.

The major purpose of the liquidity position form
is to lend assistance in measuring liquidity rather
than to establish a grading system. Nor is there any
intention of imposing a formal liquidity ratio upon
banks to which they must adhere in a way
comparable, say, to legal reserve requirements. It
should also seem clear that ways toward improve­
ment in banks’ practice and the methods of ac­
counting therefor are, as yet, far from closed.
The most likely way toward improvement in
both directions lies in objective appraisal by the


Under 1 year........................... .. 2X
.. I X
.. .5 X








Consolidated index: 101

bank examiner followed by frank discussion with
management. But the examiner’s “still photograph”
taken at the time he is on the premises will require
continuing follow-ups by the banker since liquidity
needs will obviously vary as funds flow into and out
of the bank. For this reason no formula can be so
perfect as to displace the continuing need for man­
agement’s educated judgment in the local and spe­
cial circumstances confronting its bank. It is im­
portant, however, to reinforce judgment with some
formal guides. Wider use of the method described
here should contribute toward achievement of that

The bank, not having borrowed for several years,
maintains at all times an apparently excessive
amount of liquid assets. This excessively liquid
position is not the result of board policy, but stems
rather from an apparent total absence of effort on
the part of management to employ profitably all
available funds. In 1965, the reserve account bal­
ance was in excess of that required by a daily aver­
age of approximately $125,000. Because of the
pressing demands of daily activities, management
admittedly maintains “a safe cushion” in the re­
serve account so that it will not be forced to make
a daily calculation of the requirement. The regular
offers of a correspondent bank to purchase excess
Federal funds are always refused because the re­

serve position is unknown. In addition, the bank
sold to a correspondent bank mortgage participa­
tions aggregating about $300,000 on June 1, 1965.
As of examination date, about $100,000 of the
proceeds of this transaction had not been rein­
vested and remained with the correspondent bank.
The elimination of these excess balances would
leave the bank still in a highly liquid position, with
about 20 per cent of the investment account in
Treasury bills. As standby liquidity protection,
management has an open commitment from the
correspondent bank to purchase an unlimited
amount of this bank’s mortgage portfolio. The loss
of potential earnings inherent in a situation such
as this was discussed with management.

Our formula indicates that the bank’s liquidity
position has improved between examinations, primarily due to a shortening of maturities of high-

grade securities. Total liquidity holdings under 2
years now aggregate only about $45,000 less than
requirements over the same period. However, if


in computing this formula, a few large public
demand deposits were considered as volatile (as
indeed they appear to be) rather than vulnerable,
liquidity requirements for “under 1 year” would
be increased by as much as $150,000. The basic
liquidity problem appears to stem from the bank’s
failure to properly invest short-term public de­
posits. Cyclical increases of public funds in the
spring and fall of each year usually run off rap­
idly at precisely the same time that loan demands
and other deposit withdrawals reach their cyclical
peaks. Without the additional public money, the
bank’s liquidity holdings during these periods are
hardly sufficient to cover the seasonal demands.
This bank has been forced to borrow regularly
from the Federal Reserve Bank over the past few


years. Since last examination, there were eight
borrowing periods which totaled 46 days. Average
borrowings were $ 66,000 per day, and the bank’s
reserve balance was deficient during three report­
ing periods. Almost all borrowing occurred dur­
ing periods of heavy public deposit withdrawals
with inadequate short-term asset protection, ex­
cept for Government securities which the bank
was reluctant to sell. Holdings of Treasury bills
will now be increased in an attempt to alleviate
this problem in the future. Management was re­
ceptive to the suggestion that future short-term
borrowing requirements might be better satisfied
by means of the Federal funds market or from
correspondents rather than at the discount win­

This bank continues a policy of maintaining a
fully invested position and, in so doing, operates
close to the minimum of liquidity requirements.
For the most part, management has been able
to operate satisfactorily because it has various
means of supporting its heavily invested position.
These means include the bank’s correspondent
relationship with about 1,500 banks throughout
the United States, and various corporate, institu­
tional, and municipal entities that look to this
bank for the investment of their excess funds. An
important service offered correspondent banks is
the management of their reserve positions, which
results in this bank’s heavy activity as a purchaser
of Federal funds. The bank also occasionally bor­
rows heavily at the discount window of the Fed­
eral Reserve Bank. As a result, the bank’s money
position desk maintains a close daily watch over
the flow of funds placed at its disposal. It builds
up heavy reserve deficits at some time during each

reserve period that are later offset by borrowed
funds. As a consequence, the bank generally main­
tains its daily reserve position with a minimum
average excess of $1 million or less over its re­
quired reserves.
Current projections of the bank’s liquidity re­
quirements, over the second quarter of 1965,
have set a loan growth of about $300 million. The
funds to support these projections are expected
to be generated primarily by increasing negotiable
CD’s by a like amount. It would appear, how­
ever, that if the bank for some reason were unable
to hold and/or attract additional CD growth,
heavy pressures may develop on the bank’s money
position such as those that have sometimes existed
in prior years. If such a situation should arise, it
may be necessary for the bank to liquidate a por­
tion of its municipal bond holdings and place
additional reliance upon borrowings to support its
heavily invested position.

Comparing daily averages for 1964 with those of
September 1966, deposits increased $146 million,
borrowings increased $278 million, and securities
decreased $29 million, for a total of $453 million
which is the amount of loan increase during the

same period. Therefore, an obvious conclusion
would be that the major portion of the loan ex­
pansion has been supported by borrowings, mostly
Federal funds. Management has always contended
that borrowed funds were used primarily to sup­


port loans to non-money-market borrowers. For
this reason alone, the bank’s borrowing activities
can only be described as excessive, particularly
since a review of the bank’s liquidity position
shows that there has been no reduction in lending
activities and an appreciable decrease in liquid
assets to cover short-term needs.
Time C D ’s totaled $452 million ($402 million
negotiable), a decrease of about $150 million
since last examination. The heavy run-off is at­
tributed primarily to a tight-money position of
corporate depositors and the more attractive
yields in other short-term investment instruments.
The bank’s ability to borrow Federal funds at
more attractive rates has apparently detracted
from the desirability of generating additional C D ’s
or even of maintaining outstandings at the 1965
examination level. It is difficult to obtain any reli­
able estimate of how long the negotiable C D ’s will
be carried and apparently no provisions have been
made for meeting a further run-off of these vola­
tile-type deposits.
Average loans outstanding show a continual
increase since 1964, with the major increases oc­
curring in term loans and mortgages. While man­

agement estimates term-loan and mortgage repay­
ments of $212 million and $330 million, respec­
tively, over the next 2 years, unused commit­
ments in both of these loan categories aggregate
about $433 million. All of these commitments
will not be drawn down, but it is quite probable
that the total drawdowns will exceed repayments
in the next year. Every effort is reportedly being
made by management to curtail the loan expan­
sion, with all new loan applications carefully
screened to determine how they can turn down
requests without impairing customer relationships.
Loans reached their highest level in the past year.
Investment securities have been maintained at
about $600 million with $233 million in U.S.
securities and the balance primarily in tax-exempt
securities. While the maturity distribution is con­
siderably less long term than in other banks, liqui­
dation of securities to meet liquidity needs would
result in sizable losses.
In connection with the above, attention is di­
rected to the fact that, while this bank was an
infrequent borrower at the discount window, the
examiner was very much concerned over the large
volume of borrowings from other sources.



F 33


April 1956
B A N K : ________________________________________
LOCATION: ---------------------------------- — ---------------BASED ON REPORT OF EXAMINATION AS OF


(Dollar Am ounts in Thousands)
Cash Assets
Guar. Portion of CCC or V-loans
Comm. Paper, Bnk Accept. &
Brks’ Lns
U.S. Govt. Secs:
Certificates, etc. (to 1 yr.)
Other (1-5 yrs.) (Incl. Treas.
Inv. Series A & B)
Other Secs. Inv. Rtngs 1 & 2 or
Equiv. (to 3 yrs.)
U.S. Govt. Secs. (5-10 yrs.)
Ins. Portion FHA Rep. & Modr’n
Loans on Passb’ks, U.S. Secs, or
CSV Life Ins.
Short-term Municipal Loans

Per Cent Amount

47% of Demand Deposits i.p.c.
36% of Time Deposits i.p.c.


100% of Deposits of Banks



100% of Other Deposits


100% of Borrowings


Allow, for spec, factors, if info,
available ( + or — )


A. Total Provision for Liquidity

B. Liquidity available from Prim, and
Secondary Res. (“amt. outstanding”
less cap. required thereon)


U.S. Govt. Secs. (Over 10 yrs.)
FHA and VA Loans
(Gross of Res.)
Investments (not listed elsewhere)
Loans (not listed elsewhere)
* Plus 15% of 1st $100,000 of portfolio, 10% of
next $100,000 and 5% of next $300,000.
Bk Prem., Furn. & Fixt., Other
Real Est.
-----------Stocks & Defaulted Secs.
------------Assets Classified as “Loss”
Assets Classified as “Doubtful”
Assets Classified as “Substandard”
Accruals, Fed. Res. Bk. Stock,
Prep. Expen.

Liquidity to be provided from assets
in Groups 2, 3 or 4 (zero if B equals
or exceeds A, otherwise A less B)
D. Liquidity available from Min. Risk
Assets (90% of “ amt. outstanding”
in line 2 )
E. Liquidity to be provided from assets
in Groups 3 or 4 (zero if D equals or
exceeds C, otherwise C less D )

F. Liquidity available from Intermediate
Assets (85% of “amt. outstanding”
in line 3)


G. Liquidity to be provided from Portfolio
Assets (zero if F equals or exceeds E,
otherwise E less F)

Extra Capital Required on Any Assets in
Groups 2-4 Used for Liquidity


( 6 ) ALLOWANCE FOR TRUST DEPT. (Amt. equal to
300% of annual gross earnings of Department)
2-4 USED FOR LIQUIDITY (zero if line C in Liquidity
Calculation is zero, otherwise Total in line H )
INFO. AVAILABLE ( + or — ) (see notes on
reverse side)

6.5% of line C
4.0% of line E
9.5% of line G
H. Total Extra Cap. Req.

(10) ACTUAL CAP., ETC. (Sum of Cap. Stock, Surplus, Undiv. Profits, Res. for Conting., Loan Valuation Res.,
Net unapplied Sec. Valuation Res., Unallocated Charge-offs, and any comparable items) $_
(Exclude Depreciation and Amortization Reserves)
(M O R E than requirement (10 minus 9) ....................................................+ $ —
(LESS than requirement (9 minus 10) ........................................................—$_
(12) RATIO OF ACTUAL CAPITAL, ETC. TO REQUIREM ENT (10 divided by 9) ................................................




A thorough appraisal of the capital needs of a particular bank must take due account of all relevant factors affecting the
bank. These include the characteristics of its assets, its liabilities, its trust or other corporate responsibilities, and its manage­
ment—as well as the history and prospects of the bank, its customers and its community. The complexity of the problem requires a
considerable exercise of judgment. The groupings and percentages suggested in the Form for Analyzing Bank Capital can necessarily
be no more than aids to the exercise of judgment.
The requirements indicated by the various items on the form are essentially “norms” and can provide no more than an initial
presumption as to the actual capital required by a particular bank. These “norms” are entitled to considerable weight, but various
upward or downward adjustments in requirements may be appropriate for a particular bank if special or unusual circumstances are
in fact present in the specific situation. Such adjustments could be made individually as the requirements are entered for each
group of assets; but it usually is preferable, particularly for future reference, to combine them and enter them as a single ad­
justment under Item 8 , indicating on the Analysis Form or an attached page the specific basis for each adjustment.
The requirements suggested in the Analysis Form assume that the bank has adequate safeguards and insurance coverage against
fire, defalcation, burglary, etc. Lack of such safeguards or coverage would place upon the bank’s capital risks which it should
not be called upon to bear.
Concentration or Diversification.—The extra requirement of 15% of the first $100,000 of portfolio, 10% of the next $100,000,
and 5% of the next $300,000, as specified in Item 4, is a rough approximation of the concentration of risk (lack of diversification)
which is likely in a smaller portfolio, and which is usually reflected in the somewhat larger proportion of capital shown by most
banks with smaller portfolios. This requirement is applied to all banks, but is naturally a larger portion of the total capital
requirements of banks with smaller portfolios. However, a particular portfolio, whatever its size, may in fact have either more
or less concentration of risk than other portfolios of similar size. If there is in fact substantially greater or lesser concentration
of risk in the portfolio assets of the particular bank—as for example dependence upon a smaller or larger number of economic
activities—it would be appropriate to increase or decrease requirements correspondingly.
Drafts Accepted by Bank.—When drafts have been accepted by the bank, ordinarily the customers’ liability to the bank
should be treated as Portfolio Assets if the acceptances are outstanding, or the acceptances themselves should be so treated if
held by the bank.
Rental Properties.—Bank premises, furniture and fixtures, and other real estate are assigned a 100% requirement as a first
approximation, since these assets usually are not available to pay depositors unless the bank goes into liquidation, and even then
they usually can be turned into cash only at substantial sacrifice. However, some properties which bring in independent income, such
as bank premises largely rented to others, may be more readily convertible into cash by selling or borrowing on them, and in such
situations it may be appropriate to reduce the 1 0 0 % requirement by an amount equal to an assumed “sacrifice” value, such as,
say, two or three times the gross annual independent income.
Stocks.—In the case of stocks, their wide fluctuations in price suggest a 100% requirement as a first approximation. However,
in some cases it may be appropriate to reduce the 1 0 0 % requirement against a stock by an amount equal to an assumed “sacri­
fice” value, such as the lowest market value reached by the stock in, say, the preceding 36 or 48 months.
Hidden Assets.—In some cases assets may be carried at book values which appear to be below their actual value, and may
thus appear to provide hidden strength. However, any allowance for such a situation should be made with great caution, and
only after taking full account of possible declines in values and the great difficulty of liquidating assets in distress circumstances.
Deposited Securities.—The requirement for the trust department should in no event be less than the amount of any securities
deposited with the State authorities for the protection of private or court trusts, since such securities are not available in ordinary
circumstances to protect the bank’s depositors.
Percentages of Deposits.—The provision for 47% liquidity for demand deposits of individuals, partnerships, and corporations
actually represents 33V3% possible shrinkage in deposits, plus 20% of the remaining 6 6 % % . 36% of time deposits i.p.c. repre­
sents 20% shrinkage, plus 20% of the remaining 80%. In both instances, the provision for 20% liquidity for remaining deposits
is to help the bank continue as a going concern even after suffering substantial deposit shrinkage.
Among possible special factors to be considered in connection with the liquidity calculation would be concentration or
diversification of risk among deposits. This m ight' be due to such things as dependence upon a smaller or larger number of
economic activities, or preponderance of large or small deposits—large deposits usually being more volatile.
Liquidity Available from Assets.—Liquidity available from primary and secondary reserves is assumed to equal the amount of
those assets less only the regular capital required thereon, since the regular capital specified for these assets assumes forced liqui­
dation. However, the regular capital specified for other assets (i.e., those in Groups 2-4) is only a portion (approximately 40%)
of that required for forced liquidation. Therefore, in determining the liquidity available from such other assets, the amount of such
other assets must be reduced by more than the regular specified capital.
Extra Capital Required.—This extra capital is to cover possible losses in forced liquidation of assets other than primary and
secondary reserves in case they had to be used to provide liquidity. The 4% indicated for Line E amounts to an automatic addi­
tion to the 6.5% that has already been applied to Line C, and results in a total extra requirement of 10.5% of the liquidity to be
provided from Intermediate Assets. Similarly, the total extra requirement on the liquidity to be provided from Portfolio Assets
is 20%. If the same amounts of extra capital were stated as percentages of the assets to be liquidated rather than of the liquidity
to be provided, the percentages would be smaller, namely, 6 % of Minimum Risk Assets, 9% of Intermediate Assets, and 15%
of Portfolio Assets.


This Department has been studying a new approach to the problem of
primary liquidity of the state banks and trust companies and similar types
of institutions under its supervision. The basic premise is that each bank
should maintain an adequate amount of cash and other assets which can
be quickly converted into cash with a minimum risk of loss to meet any
foreseeable or potential deposit decline or other cash needs without
resort to borrowing except for temporary purposes such as adjustment
of reserve balances. Provision should be made for the fluctuation of
deposits, with appropriate consideration to concentrations in large bal­
ances and those of a temporary nature.
To assist the Department in preparing statistics on this subject, each
institution is requested to analyze its deposits as of the last business day
of each month. If, however, your experience shows that total deposits are
usually at the lowest point during some other part of the month, we
recommend that a focal date within that period be selected instead of
the last business day.
A deposit segregation should be made each month, as at the last busi­
ness day or the focal date, as follows:
1. Date
2. Deposits of U.S. Government, states, and political subdivisions
(including time)
3. Deposits of other domestic and foreign banks (including time)
4. Other demand deposits
5. Savings deposits
6 . Other time deposits
7. Total deposits

The figures may be adjusted to the nearest thousand dollars. A record
should be retained by the bank covering at least the period between
examinations by this Department, and is to be made available to the
examiner. The executive officers will probably find it helpful to retain
this record for a more extended period to enable them to study seasonal
trends and other pertinent factors affecting the liquidity position.
If each institution will compute the aggregate difference between the
current total in each type of deposit with the lo w e s t monthly figure for
the preceding twelve months, it should have a fair estimate of the mini­
mum amount of “primary reserves” which it should have available to
meet its ordinary requirements. It is unlikely that the “low” point in each
of the deposit segregations will occur in the same month of a yearly



period, but any over-estimate due to such circumstances will provide a
margin to cover unexpected developments. If, however, the deposit level
is lower than in the preceding year, further study should be made of the
causes, and a projection made of potential future trends and liquidity
requirements with special consideration to deposits of a temporary nature,
and to heavy concentrations of deposits in a small number of accounts.
In addition to being prepared to meet potential deposit losses, the
institution should also make adequate provision to cover its outstanding
loan commitments, the ordinary seasonal credit requirements of its cus­
tomers, projected new loan demands, and other factors which may deplete
its liquid assets.
The term “primary reserves” as used in the preceding paragraph will
consist of the following assets:
1. Cash, demand cash items, and balances due on demand from
banks i n e x c e s s o f t h e r e s e r v e s r e q u i r e d t o b e m a i n t a i n e d against
2. Readily marketable securities maturing within two years (at
market values),
3. Loans to brokers and dealers in securities,
4. Bankers acceptances and prime commercial paper which are
readily marketable through brokers and dealers in such paper,
5. Federal funds sold.
Since reserves against deposits required by the Banking Law or Federal
Reserve regulations may not be drawn down without penalty for deficien­
cies, only the excess reserves maintained, demand balances due from
nonreserve depositaries, and demand cash items are allowed in this form­
ula. Securities maturing within two years are allowed at market value.
They can usually be disposed of with relatively moderate, if any, loss.
The other assets which are classified as “primary reserves” can also, as
a rule, be quickly disposed of with minimum loss. While some institutions
may hold other assets of similar marketability and quality to meet the
qualifications of “primary reserves,” for the sake of uniformity only those
listed above will be used for this purpose.
The Department intends to use the primary reserve formula as a
supervisory guide to supplement the quick asset ratio shown on Schedule
2A of the examination report. Although the latter is useful in revealing
the proportion of assets intrinsically liquid in character, the former will
indicate to what extent immediate conversion to cash is possible without
interfering with the normal activities of the institution.
Your cooperation is requested in facilitating the work of our examiners
in compiling these data.

Very truly yours,
E. H. Leete
Deputy Superintendent
of Banks



The present “tight-money” market in which our banks are operating
has led to increasing loan-to-deposit ratios and narrowing liquidity posi­
tions. While most bankers are conversant with the rule-of-thumb stand­
ards relating to deposit ratios, we find that many National bankers are
unfamiliar with the method of computation and standards utilized by
this Office in analyzing their liquidity position.
Since this is a topic of mutual interest, a copy of our form is shown
below. Based on our experience with the formula over the past two
years, this Office makes a detailed analysis of the asset structure when
Net Liquid Assets to Net Deposits is 30 per cent or less.
It will be noted that the formula eliminates the market value of
pledged bonds but does include municipal and corporate securities as a
source of liquidity.
We would appreciate receiving the views and comments of bankers
with respect to the merit of the guidelines.
Cash and due from b a n k s ..............................................


Market value— unpledged bonds ...................................


Market value of excess pledged b o n d s ........................


Federal funds sold ...........................................................


Subtotal .................................................................. ..........................


Federal funds purchased.........


Required reserves......................

L es s:



Net liquid assets .......................................................................................... (A)
Total deposits .................................................................... ..........................
L ess:

Secured deposits ..........................................................................

Net deposits ...........................................................................= = = = =
Net liquid assets/net deposits ( A ~ B ) (per cent) . . . .




In thousands of dollars unless otherwise indicated
Cash and due from banks......................................................
Reserves with FRB and cash items in process.....................


Investment account*
U.S. G ovt.............................................................................
Other securities....................................................................


Loans and discounts...............................................................
Less: Valuation reserves......................................................


IP C ....................................................................................
U.S. Govt.........................................................................
States and municipals......................................................
IPC ....................................................................................
CD’s (nonnegotiable)......................................................
States and municipals.....................................................
O th e r ...............................................................................


(Total deposits)............................................................ (5,658)
Other liabilities........................................................................
Book capital funds.................................................................

Fixed assets..............................................................................
Other assets..............................................................................


Tota' assets...........................................................................


Total liabilities.....................................................................


♦Maturity distribution (par value):
Under 1 year.................................................................... .......229
1-2 years..................................................................................192
2-5 years..................................................................................491
Over 5 years..................................................................... .......860

Securities pledged to secure deposits, total (par value)........


Total deposits..........................................................................
Less: Cash items................................................
Reserves at FRB.......................................




Loan/deposit (per cent)......................................................
Liquid assets/liability (per cent).........................................
Cash and due from banks.......................................
Brokers and dealers loans.......................................
U.S. Govt, securities (up to 2-yr. maturities).......


T o ta l....................................................................



Less: Borrowings.....................................................

6 8 .6


New York State's quick-asset ratio (per c e n t) ....................
Cash, due from banks,
exchanges and demand items.............................
Unpledged securities (market value)...................... 1,756
Loans secured by readily marketable collateral. ..
Total quick assets................................................
Less: Secured deposits and borrowings.................



Total liabilities.........................................................................
Less: Deposits and borrowings secured by pledge of assets..



Net quick assets................................................


Net liabilities................................................................




Amounts in thousands o f dollars


Deposit liquidity
Demand deposits:
Volatile............................................................................................. .........................
Large............................................................................................. .......................
Less: Volatile.............................................................................. .......................

Under 1 year

1-2 years

2-5 years


Total.............................................................................................. .......................
Less: Large...........................................................................................................

Per cent






Time deposits:
Less: Volatile and vulnerable................................................












Deposit requirements..........................................................................
Portfolio liquidity
Seasonal loan demand................................................................. ..........................
Unexpected demand...................................................................... .......................
Projected loan increase................................................................. .......................








Portfolio requirements........................................................................




Aggregate requirements....................................................................





Under 1 year

Liquidity instruments held
Excess reserves and correspondent balances......................................................................................................... ............127
High-grade securities maturing in—
Under 1 year......................................................................................................................................................... ............ 229
1-2 years................................................................................................................................................................ .............. . .
2-5 years............................................................................................................................................................................. . . .
Net liquidity

Under 1 year

1-2 years

2-5 years





1-2 years

2-5 years

Aggregate holdings........................................................................................................................................................
Less: Borrowings........................................................................................................................................................




Net holdings..............................................................................................................................................................
Aggregate requirements..........................................................................................................................................
Excess, or deficit (—) ...............................................................................................................................................


— 101


Liquidity index, (net holdings)/(aggregate requirements)...................................................................................




Consolidated index
Under 1 year................................................................................
1-2 years.......................................................................................
2-5 years.......................................................................................



Consolidated index, (liquidity requirements)/(net holdings) .
N ote.—For examiner’s comments relating to this bank’s liquidity position and borrowings, see Appendix D.








FR 363
April 1956
BANK. _________


SAMPLE BANK__________________________________________

(D o lla r Am ounts in T h o u sa n d s)





_132 _

Cash Assets


Guar. Portion of CCC ot V-loens

47% of Demand Deposits i.p.c.


100% of Deposits of Banks
100% of Other Deposits
100% of Borrowings
Allow, for spec, factors, if info,
available (♦ or - )


U.S. Govt. Secs:


Certificates, etc. (to 1 yr.)
Other (1*5 yrs.)(lncl. Treas
Inv. Series A 4 B)
Other Secs. Inv. Rtngs 1 & 2 or




Equiv. (to 3 yrs.)

2 ,7 1 2

B. Liquidity available from Prim, and


C. Liquidity to be provided from assets in
Grbups 2,3 or 4 (zero if 8 equals or ex­
ceeds A, otherwise A less B)


Ins. Portion FHA Rep. & Modr’n Loans
Loans on Passb'ks, U.S. Secs, or CSV


Life ins.


cap. required thereon)


Short-term Municipal Loans



Secondary Res. (‘ ami outstanding* less


U.S. Govt. Secs. (5-10 yrs.)



A. Total Provision for Liquidity

Comm. Paper, Bnk Accept. 4 Brks‘ Lus


1 >2 9 7

D. Liquidity available from Min. Risk



Assets (90% of ‘ amt outstanding*


in line 2)
E. Liquidity to be provided from assets
in Groups 3 or 4 (zero if D equals or
exceeds C, otherwise C less D)

U.S. Govt. Secs. (Over 10 yrs.)


FHA and VA Loans

17 *f



3% Tine Deposits i.p.c.
6 of




1 , 00 9

F. Liquidity available from Ir
Assets (85% of ‘ amt. outstanding* in
line 3)


G. Liquidity to be provided from Portfolio
Assets (zero if F equals or exceeds E,
otherwise E less F)


(4) PORTFOLIO ASSETS (Gross of Res.)

6 X2

Investments (not listed elsewhere)
Loans (not listed elsewhere)

.3 t i l l .



* P lu . 15% of 1st 110 0,0 00 of portfolio, 10% of no>t $100,000
ond 5% of no>t $300,000.

Bk Prem., Fum. 4 Fint., Other Real Est.



Stocks 4 Defaulted Secs.
Assets Classified as * Loss*


Assets Classified as ‘ Substandard*


Extra Capital Required on Any Assets in Groups 2-4


Assets Classified as 'Doubtful*




Used for Liquidity


Accruals, Fed. Res. Bk. Stock, Prep. Expen. _



6.5% of line C
4.0% of line E

(6) ALLOWANCE FOR TRUST DEPT. (Amt. equat to 300% of annual gross earnings of Department)
Liquidity Calculation is zero, otherwise Total in line H)



9.5% of line G




H. Total Extra Cap. Req.

(see notes on reverse side)




(10) ACTUAL CAP., ETC. (Sum of Cap. Stock, Surplus, Undiv. Profits, Res. for Conting., Loan Valuation Res., Net unsppfied Sec. Valuation Res., Unallocated Charge-offs,
and any comparable items) (Exclude Depreciation and Amortization Reserves)

( 0m u 9
1 in s )


6 -U -



L S th nr q ir mn (9m u 1 ) ...
E S a eue et
in s 0
( 2 R T O ACTU C P L. ETC. T R Q IR M N ( 0d id d b 9
1 ) A IO F
O E U E E T 1 iv e y )

-1 2 2 1



In thousands of dollars unless otherwise indicated
Cash and due from banks.....................................................................................................................................................................
Market value, unpledged bonds............................................................................................................................................................1
, *96
Market value, excess pledged bonds.....................................................................................................................................................J
Federal funds sold.................................................................................................................................................................................. ..............0
Less: Borrowings........................................................................................ ............................................................................................
Federal funds purchased............................................................ ..................................................................................................
Required reserves.........................................................................................................................................................................
Net liquid assets......................................................................................................................................................................................
Total deposits.........................................................................................................................................................................................
Less: Secured deposits....................... ....................................................................................................................................................
Net deposits.............................................................................................................................................................................................

.......... 360

(Net liquid assets)/(net deposits) (per cent).........................................................................................................................................



Paul Meek
Federal Reserve Bank of New York

Summary of Findings_____________________________________________________ 171
A View of the Policy Process________________________________________________ 173
Direction of Open Market Policy_____________________________________________174
Implementation of the FOMC’s Policy________________________________________ 176
Open Market Operations and Changes in Discount Administration__________________ 179




the framework provided by Regulation A
governing individual bank access to reserves
borrowed from the Reserve Banks, the Fed­
eral Open Market Committee acts in this
way to influence bank behavior in the inter­
est of achieving national economic objec­
This paper sketches the process whereby
the decisions of the FOMC are brought to
bear on the liquidity of commercial banks
through open market operations and the dis­
count window. It describes broadly how the
Manager of the System Open Market Ac­
count relies on patterns of bank behavior
and the Federal funds market to aid in the
day-to-day decisions that carry out the
FOMC’s instructions. The paper also ven­
tures some observations on the implications
for discount policy of the need for inte­
grating open market and discount policies,
and on the constraints that these implica­
tions impose on changes in the administra­
tion of the discount window.

The basic responsibility of any central bank
is monetary management— managing the
liquidity and credit conditions of the entire
economy, primarily through its influence on
the commercial banking sector. In the
United States, open market operations are
the principal instrument for exercising the
Federal Reserve System’s initiative in affect­
ing the full range of credit and monetary
conditions. As the ultimate source of liquid­
ity to the economy, the System cannot con­
trol total bank reserves precisely in the very
short run because the monetary system of a
modern economy must be able to respond
flexibly to wide week-to-week changes in
the demand for currency, bank deposits, and
credit. But the System can and does exert a
strong influence over the growth path of
total bank reserves, deposits, and credit by
varying over time the division between re­
serves provided without strings through open
market operations and those provided with
strings through the discount window. Within

The nationwide level of member bank bor­
rowing from the Federal Reserve Banks is
an important element in the money market
conditions that the FOMC instructs the
Manager of the System Open Market Ac­
count to achieve, particularly in periods of
monetary restraint. In specifying the money
market conditions to be achieved, the

FOMC, in effect, determines that such mem­
ber bank borrowing will stay within a cer­
tain range— that is, that member banks
somewhere in the banking system will be
forced to borrow at the discount window in
an aggregate that corresponds on average to
the Committee’s desires regarding money
market conditions. The Committee increases


monetary restraint and affects commercial
bank behavior by having the Manager,
through the Trading Desk of the Federal
Reserve Bank of New York, reduce the pro­
vision of reserves by open market operations
in relation to the demand for them so that
member banks come into the window in
larger numbers and/or more often. Banks
appear individually at the discount window
and are exposed to its discipline, but it is the
FOMC that regulates the discipline imposed
on the banking system as a whole.
From the Trading Desk’s standpoint the
daily-average level of member bank borrow­
ing at the discount window over the 7 days
of the statement week is an important and
workable operational guide— one that in­
terrelates with a number of other money
market indicators. Armed with statistical
forecasts of member bank reserves and a
knowledge of bank patterns of reserve man­
agement, the Desk can make reasonably
good judgments of the level of unsatisfied
demand for reserves that is likely to appear
at the discount window after the operation
of the Federal funds market. The Manager
can ordinarily detect when actual reserve
availability is appreciably larger or smaller
than expected— without knowing at the
moment the cause of the deviation— and he
can adjust his actions accordingly.
The FOMC is not concerned with mem­
ber bank borrowing or any other money
market indicator for its own sake, but as an
operational means of providing for the econ­
omy’s short-run cash needs and of influenc­
ing the growth of bank credit and the be­
havior of interest rates over the long run.
Member bank borrowing provides only a
first— and imperfect— approximation to the
money market conditions that are consistent
with achieving the Committee’s longer-run
financial objectives. The relation between
the Federal funds rate and the discount rate
at a given level of such borrowing is prob­

ably a somewhat better short-run indicator
than borrowing alone of the effectiveness of
open market operations in influencing the
banking system in the desired direction. The
behavior of such monetary aggregates as
bank credit and the money supply— in con­
junction with interest rates— provides even
better evidence on this point, although the
monetary aggregates are not themselves
targets that the Manager can hit directly in
the short run. In an effort to improve the
responsiveness of open market operations to
changing external circumstances, the FOMC
introduced in 1966 a new form of the direc­
tive that has provided for varying its shortrun operational targets in accordance with
the unfolding behavior of bank credit. Thus
far, this approach seems to be a promising
one for improving the implementation of the
System’s monetary policies.
Changes to be made in the operation of
the discount mechanism should maintain the
responsiveness of the banking system to the
policy moves of the FOMC. Discount policy
will necessarily remain a principal cutting
edge of a policy of monetary restraint, im­
posing on a succession of individual banks
— beginning with the larger money market
banks— the need to adjust assets and/or lia­
bilities within a reasonably short time period
in order to repay borrowing from the Fed­
eral Reserve. Such a requirement need not
interfere with liberalizing the access of small
banks to the discount window for seasonal
liquidity needs. Under any set of rules of dis­
count administration, however, the FOMC
will need to be able to direct open market
operations to increase or to reduce the pres­
sure on a major segment of member banks
— certainly the larger ones. Discount policy
will need to provide incentives for banks to
pay off their borrowing at the discount win­
dow in fairly short order. For operational
purposes, changes in the discount rules
should probably be timed to coincide with


a period of monetary ease. Such timing
would enable both the Federal Reserve Sys­
tem and the financial community to grow


accustomed gradually to the new framework
within which open market policy would be

As noted, any central bank has primary re­
sponsibility for managing liquidity and credit
conditions in the economy through its influ­
ence on the banking sector with a view to
promoting national economic objectives. To
exert this influence, a central bank develops
policy instruments that enable it to initiate
policy changes and to give centralized direc­
tion to the implementation of its policy.
Central banking in the United States has
developed, and has come to rely on, open
market operations as the most efficient
means for influencing national liquidity and
credit conditions. This development flows
naturally from the growth of the specialized
and interdependent financial markets and
institutions that serve a highly developed
economy. The System bases its policy judg­
ments on its reading of the full range of
financial flows and interest rates in relation
to economic developments and objectives,
rather than narrowly on the behavior of the
banking system alone. Moreover, the Fed­
eral Reserve is the ultimate source of liquid­
ity to the entire financial system and thereby
to the economy. It must make its operational
decisions about liquidity needs on the basis
of centralized information about the bank­
ing sector and the evidence provided by the
financial markets themselves about those
needs. From a policy standpoint, open mar­
ket operations provide a logical and natural
point of contact between the Federal Re­
serve and the financial system.
In managing the reserves of the banking
system, the monetary authorities have two
interlocking responsibilities. Routinely, they
enable the banking system to provide in the

short run for the highly variable needs of
the economy for cash— both currency and
bank deposits. Over the longer run, they
seek to influence the liquidity of the econ­
omy, financial flows, and interest rates with
a view to fostering national economic ob­
jectives. A central problem of monetary
management is to keep short-run flexibility
from impairing long-run policy objectives.
The Federal Reserve System depends on
an integration of open market policy and
discount policy to carry out these dual re­
sponsibilities. In the very short run, open
market operations flexibly provide reserves
in accordance with the shifting cash needs
of the over-all economy. Discount policy, on
the other hand, provides a limited adjust­
ment mechanism for both the individual
bank and the banking system when reserves
fall short of reserve requirements— assuring
short-run accommodation at the discount
rate. Over the long run, however, individual
banks cannot rely on continuous borrow­
ing from the Federal Reserve, and therefore
such borrowing generates a need for adjust­
ment of assets or liabilities that is missing
as long as reserves are being provided with­
out stint by open market operations.
Open market operations and the discount
window, as operated under the current Reg­
ulation A, enable the banking system to
meet the economy’s short-run cash needs
without undue strain. These needs fluctuate
from day to day and from week to week
in relation to the increase in money supply
that takes place over the course of a full
year. Member banks as a group will have to
borrow from their Reserve Banks to cover


their reserve deficiencies in a given week to
the extent that open market operations in
that week fail to compensate for changes in
currency outstanding, bank deposits, other
factors affecting reserves, or unused reserves
that accumulate within the banking sys­
tem. Such borrowing will be necessary what­
ever the reason for the deficiency— whether
it is deliberate System policy, an unexpect­
edly large bulge in deposits at tax payment
time, or a much sharper decline in float
than had been anticipated. The geographic
pattern of such borrowing depends to a large
degree on the movement of deposits and
reserves, including the important redistribu­
tion of reserves among individual banks that
is effected through the Federal funds market
and the correspondent banking system. As a
result of providing “an elastic currency” and
of acting as lender of last resort, the System
must give up precise control over total deposits and currency outstanding in the very
short run.
The System, nonetheless, exerts leverage
on the process of credit creation through
open market policy applied against the ful­
crum of the discount policy as embodied in
Regulation A. The essence of Regulation A
has been that an individual member bank’s
borrowing from its Reserve Bank is to be
temporary. The discount window is not to
provide a continuing supplement to a bank’s
resources. Hence, member banks have been
expected to adjust their assets or liabilities
over a period of weeks so that borrowing
from their Reserve Bank will no longer be
necessary. Given this fulcrum, the FOMC
can consciously direct open market opera-

tions to change the amount of borrowing
that member banks in the aggregate must
undertake, and thus to influence directly
bank lending and investment decisions. In
this context, it can be seen that the discount
rate has little effect on the aggregate level of
member bank borrowing. (The influence of
the discount rate— by its relation to other
interest rates— instead comes through its
effect on the calculus of commercial bank
policies and actions, and thereby on the rate
of bank credit growth.)
The interaction of open market policy and
discount policy over the cycle is familiar. If
the economy requires stimulation, the Sys­
tem uses open market operations to flood
the banks with reserves that can be em­
ployed in loans and investments. The dis­
count rate is also lowered, although member
bank borrowing will naturally fall to a fric­
tional minimum as open market operations
supply reserves in abundance. As the econ­
omy expands and less stimulation is re­
quired, the System typically supplies reserves
through open market operations somewhat
less freely in relation to expanding credit
demands. This policy change forces mem­
ber banks to come to the discount window
in increasing numbers and/or with increas­
ing frequency. As the FOMC steps up the
degree of restraint, open market operations
insure that more and more banks are grad­
ually affected by the necessity of not abusing
their privilege of borrowing at the discount
window, but of reserving it for the increas­
ingly frequent occasions on which they have
exhausted alternative means of balancing
out their reserve positions.

The System has used open market policy as
its primary continuing instrument, both for
providing liquidity to the economy in the

short run and for influencing liquidity, credit
conditions, and spending over the longer run.
In making policy, the FOMC must embody


its policy prescription in instructions to the
Manager of the System Open Market Ac­
count that are operationally feasible. Essen­
tially, the Committee does this by: (1)
specifying the terms on which the reserve
needs of the banking system are to be ac­
commodated by the Manager on a week-toweek basis, and ( 2 ) varying the terms from
time to time to influence bank liquidity and
the financial variables in the direction de­
sired. In recent years, the FOMC has speci­
fied the terms of accommodation— that is,
money market conditions— in terms of a
number of indicators. These indicators in­
clude free reserves, member bank borrow­
ing from the Reserve Banks, the Federal
funds rate in relation to the discount rate,
and Treasury bill rates.1 The FOMC has
sometimes given particular weight to one of
these. For example, shoring up Treasury
bill rates for balance of payments reasons
was an active concern in the early stages of
the economic expansion that began in 1961.
In the main, however, the Committee has
come to rely less than in the 1950’s on any
single measure, such as free reserves. It tries
instead with the aid of its staff to specify
for a constellation of variables the ranges of
short-term variation that are believed to be
consistent with a projected rate of growth
in total bank deposits over the next month
or so.
As noted earlier, the System wants to
exert a degree of influence on the lending
and investment decisions of banks— and an
important means of exerting this influence
is by governing aggregate recourse to the
discount window. It is the essence of a shortrun accommodative posture, when policy is
not changing, for open market operations to
Free reserves are defined as the excess reserves of
m em ber banks less their borrowings from the Federal
Reserve Banks. This form ulation is equivalent to the
difference between the nonborrowed reserves and re­
quired reserves of mem ber banks.


seek to maintain daily-average member
bank borrowing at a reasonably stable level
on a week-to-week basis. Then, the pressure
exerted by discount officers on borrowing
banks to adjust assets and to repay the Re­
serve Banks will be reasonably steady. Dis­
crete changes in the levels of average mem­
ber bank borrowing, and the pressures
exerted by the System on bank management,
flow from the FOMC’s decisions rather than
emerging haphazardly as a byproduct of
other factors affecting reserves.
A problem remains. The Manager may
successfully maintain member bank borrow­
ing from the Reserve Banks and the other
elements of money market conditions within
the prescribed ranges, but bank credit and
a variety of interest rates may behave differ­
ently than the FOMC expected. Such dis­
crepancies are likely to be particularly large
— and significant— when the economy’s de­
mand curve for credit is shifting rapidly in
either direction. The FOMC may then find
that interest rates and the rate of bank credit
growth turn out to be higher than it intended
at times when credit demands are burgeon­
ing, and lower than it intended at times
when credit demands are falling sharply.
The reasonably short interval of 3 to 4 weeks
between FOMC meetings provides consid­
erable assurance that large shifts in credit
demands will be detected rather promptly.
The Committee has sought in recent years,
however, to increase the rapidity of its re­
sponse to changing conditions.
To this end the FOMC began experiment­
ing in 1966 with a new form of its directive
governing the conduct of open market op­
erations. It included a proviso clause that
instructed the Manager to change conditions
in the money market in a prescribed direc­
tion if the rate of bank credit growth differed
significantly from what was expected. (Other
conditioning elements— such as the timing
of Treasury financing and pressures on


liquidity— continued to be employed as
well.) For example, the operational para­
graph of the directive adopted by the FOMC
on September 13, 1966, is as follows :2
To implement this policy, System open market
operations until the next meeting of the Commit­
tee shall be conducted with a view to maintaining
firm but orderly conditions in the money market;
provided, however, that operations shall be modi­
fied in the light of unusual liquidity pressures or
of any apparently significant deviation of bank
credit from current expectations.

In the process of implementing this and suc­
ceeding directives, the Manager of the Sys­
tem Open Market Account gradually leaned
toward a little less firmness in the money
market as bank credit persistently fell some­
what short of projected levels.3 By the time
the Committee voted on November 22,
2 Board of G overnors of the Federal Reserve Sys­
tem, A nn ual R e p o rt, 1966 (W ashington: 1967), p.
3 Ibid., pp. 248-56.

1966, to promote “somewhat easier condi­
tions in the money market,” the proviso
clause had already led to a clearly discerni­
ble shift in money market conditions away
from the degree of restraint prevailing in
August and September.
The inclusion of the bank credit proviso
clause in the Committee’s directive did not
represent any downgrading of member bank
borrowing from the Reserve Banks as an
important policy variable. The new direc­
tive merely provided a procedure for in­
creasing or reducing the degree of restraint
— and the level of such borrowing— under
specified conditions in the interval between
meetings of the FOMC. The direction of
open market operations in periods of mone­
tary restraint necessarily must include some
implicit specification of the range of member
bank borrowing from the Reserve Banks
that the Manager is to foster in the banking
system as a whole.

The Manager of the System Open Market
Account and his colleagues at the Trading
Desk operate in, and operate on, a financial
environment whose dominant short-run char­
acteristic is variability.4 To be sure, factors
affecting reserves such as Federal Reserve
float, currency in circulation, and member
bank deposits— through their effect on re­
quired reserves— behave in roughly similar
patterns at corresponding times from year
to year. But the day-to-day behavior of these
factors in a particular year differs, almost
routinely, from an average of the behavior
of past periods. Changes in the timing of
Treasury financings and tax collections have
See Paul M eek and Jack W. Cox, “The Banking
System— its Behavior in the Short R un,” M on th ly
R eview of the F ederal R eserve Bank of N e w Y o rk ,
A pril 1966, pp. 84-91.

been especially noteworthy in the past few
years. The distribution of reserves among
different groups of banks and the marginal
use made of reserves by these banks change
frequently also. Interest rates, too, can vary
considerably over the interval between
FOMC meetings in response to a multiplic­
ity of real and expectational forces. The
conduct of open market operations involves
a continuing strategy of successive approxi­
mation to the FOMC’s specification of
money market conditions.
Operationally, the Manager focuses in the
first instance on the behavior of bank re­
serves during the statement week and money
market clues to that behavior. Affecting his
strategy for each week is the knowledge that
the excess reserves held by the banking sys­
tem change from week to week as a result


of changing conditions of reserve distribu­
tion and use. Country banks, for example,
usually build up excess reserves in the first
week of their reserve settlement period and
then run them down by $150 million to
$200 million in the second week of this
period. Unusual churning in the money or
Government securities markets— as on a
quarterly corporate tax date— will increase
the volume of unused reserves that are likely
to pile up somewhere in the banking sys­
tem. The Manager can maintain the steady
degree of pressure on the banks desired by
the FOMC— to keep member bank borrow­
ing from the Reserve Banks reasonably
stable— only by allowing the daily average
of free reserves to vary with the distribution
and utilization of reserves from statement
week to statement week.
The Manager depends importantly in his
daily judgments on the close connection be­
tween member bank borrowing from the
Reserve Banks and other indicators of
money market conditions— in particular, the
information on reserve availability and/or
use provided by the Federal funds market.
Each morning, the Manager receives infor­
mation on borrowing from the Reserve
Banks by all member banks on the previous
day and estimates of total and required re­
serves for major groups of banks for the
previous day. (Estimates of total reserves
are usually accurate within $50 million, al­
though occasionally errors exceed $100 mil­
lion. ) The Manager also receives reports on
the previous day’s activity of 46 major re­
serve city banks in trading Federal funds
and in lending to Government securities
dealers. The Manager has estimates of daily
levels of free reserves stretching 3 to 4 weeks
ahead— projections that rely on the patterns
of factors affecting reserves observed in sim­
ilar periods of past years. On the basis of
this information, experience with the shift­
ing strategies that banks pursue in managing


their reserve positions, and knowledge of
any large special strains such as occur at
times of a Treasury financing, the Manager
and his associates will formulate their ex­
pectations of how the Federal funds market
should behave that day.
The Trading Desk matches these expecta­
tions against the developing situation re­
vealed by its continuing contact with the
Federal funds brokers, the money desks of
the major New York City banks, and the
closely related efforts of the nonbank deal­
ers in Government securities to finance their
positions. The Federal funds market reflects
with considerable accuracy the marginal
availability of bank reserves and the demand
for them on each day. If the Federal funds
market is much tighter than the reserve data
suggest should be the case, the Trading
Desk will not usually know whether it is
because Federal Reserve float is $300 mil­
lion lower than expected, or because coun­
try banks are holding on to more excess re­
serves than usual. But the Desk will get a
fairly clear indication that member bank
borrowing from the Reserve Banks is likely
to bulge unless reserves are provided through
open market operations. Therefore, in such
circumstances, the Desk is likely to supply
reserves in a volume intended to moderate
the mounting tightness. Its intervention may
tend to affect the willingness of a few banks
to wait another day or two before resorting
to the discount window. Conversely, the
Desk may respond to easier-than-expected
conditions in the Federal funds market by
deferring action to supply reserves or by
actually mopping up reserve excesses.
A major strength of the System’s conduct
of open market operations in recent years
has been the extent to which this day-to-day
decision-making meshes with the FOMC’s
policy objectives of maintaining a fairly
even degree of restraint on the banks in the
short run. As described earlier, the Manager


is essentially making daily judgments about
the marginal demand for reserves that will
go unsatisfied in the Federal funds market
and will be likely to appear at the discount
window. The Manager is able to detect
changes in the degree of pressure on bank
reserve positions and to cast the System’s
weight on the other side of the scales. He
cannot control member bank borrowing at
the Reserve Banks with much precision on
a daily basis, but he can adapt his weekly
strategy to resist large deviations in average
borrowing from the range embodied in the
money market conditions specified by the
Committee. Such borrowing and the degree
of firmness in the Federal funds market are
opposite sides of the same coin. The Com­
mittee’s objective of influencing bank be­
havior has a practical day-to-day focus.
Member bank borrowing from the Re­
serve Banks is really only an approximation
to the degree of monetary pressure or ease
that the Manager is instructed to foster in
order to further the System’s longer-term
goals. The Federal funds rate itself, in rela­
tion to the Federal Reserve discount rate, has
become increasingly a sort of fine-tuning de­
vice in daily reserve management. The
FOMC’s increased attention to this rate as
a supplemental indicator of the interaction
between bank policies and the credit de­
mands falling on the banks reflects expanded
member bank activity in the Federal funds
market.5 The Federal funds rate has proved
increasingly sensitive as an indicator of the
banking system’s need for reserves, trading
at rates above and below the discount rate.

5 Treasury bill rates were useful as such an indica­
tor at one stage. In the 1960’s, however, Treasury bill
rates have become much less meaningful because
alternative means of bank reserve adjustm ent have
multiplied and bank holdings of Treasury bills have
declined in relation to the total volume of bills out­
standing. The C om m ittee’s concern with Treasury bill
rates in the 1960’s was more the product of balance
of payments than of domestic considerations.

Use of the Federal funds rate as a condi­
tioning element in the Committee’s instruc­
tions to the Desk has been clearly evident in
periods of monetary ease. At such times
open market operations provide reserves in
such volume that member bank borrowing
at the discount window falls to a frictional
minimum. In seeking to promote rapid
growth in bank credit, the System not only
lowers the discount rate but also keeps the
cost of reserves in the Federal funds market
below the discount rate. It thereby seeks to
insure that open market operations are sup­
plying reserves more rapidly than the banks
are using them to expand loans and invest­
ments— in effect, maintaining pressure on
the banks to expand credit.
The appearance of Federal funds trading
at a rate well above the discount rate in
1966 brought a new dimension to bank be­
havior and probably to monetary policy as
well. The increase in the size of the premium
from one-eighth of a percentage point in
early March to 1Vi to 1Va percentage points
in early September 1966 was associated with
a marked increase in the degree of effective
restraint on bank lending and investment.
The increase in restraint was probably con­
siderably greater than that which in earlier
years would have been associated with the
rise of average member bank borrowing
from the Reserve Banks from $551 million
in March 1966 to $776 million in Septem­
ber 1966. The behavior of bank credit, the
money supply, and interest rates in 1966
was consistent with such an interpretation.
By October 1966 a number of Committee
members were specifying among the money
market conditions to be achieved an upper
range of the premium on Federal funds to
1 to IV2 percentage points— presumably,
with a view to easing the pressure on the
banking system.
Both member bank borrowing from the
Reserve Banks and the Federal funds rate


provide objectives that the Manager can
achieve reasonably well within his opera­
tional horizon of the statement weeks be­
tween FOMC meetings. Open market op­
erations bear directly on both of them. The
Manager’s influence over other interest rates
— for example, the Treasury bill rate or the
yield on long-term Government securities—
is much more indirect and uncertain.
Changes in the expectations of market par­
ticipants can easily outweigh any marginal
influence the Manager may exert in the
course of pursuing the FOMC’s marginal
reserve objectives. For balance of payments
reasons a few years ago, a sustained System
effort coordinated with the Treasury’s issu­
ance of Treasury bills was necessary to shore
up bill rates.
The implementation of the directive’s
bank credit proxy involves a shading of
money market conditions over the interval
between FOMC meetings. In determining
its application, the Manager is guided by


the relation between the FOMC’s desired
range of growth for total bank deposits for
a month or so ahead and updated projec­
tions of those deposits prepared weekly by
the staffs of the Board of Governors and of
the Federal Reserve Bank of New York.
Should bank credit appear to be expanding
more rapidly than the FOMC indicated was
acceptable, the Manager would consider a
shift in the direction of greater restraint if
permitted by other conditioning elements in
the Committee’s instructions— for example
Treasury financing. Such a move would in­
volve promoting a higher level of member
bank borrowing from the Reserve Banks,
and possibly also a somewhat higher Fed­
eral funds rate, than had prevailed on aver­
age before implementation of the proviso
clause. Since the interval between meetings
is only 3 or 4 weeks, the Federal Open Mar­
ket Committee itself determines whether
such a shading is to be held, carried further,
or reversed.

As noted earlier, monetary policy is an inte­
gration of open market policy and discount
policy. The Open Market Committee basi­
cally determines the desired aggregative
level of member bank borrowing from the
Reserve Banks by its specification of the
money market conditions that the Manager
is to achieve. Discount officers encourage
the individual borrowing banks to pay off
their borrowing after a time— by asset ad­
justments if necessary. Monetary policy ex­
erts restraint on the banks because the dis­
count window is not continuously open to
individual banks. Open market operations
are used quite consciously to vary the pres­
sure on the banks to adjust their lending and
investment policies.
Monetary management in a modem econ­

omy is so closely related to the performance
of the money and credit markets that there
is no desirable alternative to open market
operations as a policy instrument. There is
general agreement that discounting cannot
provide efficiently a centralized management
of reserves that is integrated with national
liquidity needs. Fortunately, there do not ap­
pear to be any major obstacles ahead in the
future use and development of open market
operations as a policy tool. In the unlikely
event that the supply of U.S. Government
and Federal agency securities in the hands
of the public should become so limited as to
impair open market operations, such opera­
tions could be conducted in the debt obliga­
tions of other issuers.
A great virtue of the present arrangements


is that policy-making is centralized in the
Federal Open Market Committee. The Com­
mittee exerts its leverage on the monetary
process against the fulcrum of a reasonably
uniform policy of discount administration.
The linkage between money market condi­
tions and bank credit may change, but the
Committee now can be reasonably sure that
such changes do not reflect an independent
monetary policy being pursued by discount
officers. At first glance it might appear de­
sirable to vary discount administration over
the cycle to reinforce the effects of the Com­
mittee’s open market policy— either in the
direction of ease or of restraint. But changing
institutional arrangements repeatedly would
unpredictably shake up the banking system’s
behavior, increase the already considerable
difficulty of deciphering its response to open
market policy changes, and impair the Com­
mittee’s growing ability to give instructions
to the Manager of the System Account that
relate meaningfully to the Committee’s own
bank credit and interest rate objectives. The
Trading Desk would probably find its task
complicated considerably if the behavior of
the money market and the banking system
were being affected by changes in discount
administration. There would not appear to
be any substitute in monetary management
for the centralized policy direction and cen­
tralized execution that open market opera­
tions make possible.
The discount window will continue to
play a key role in enforcing a policy of
monetary restraint. It is axiomatic to such
a policy that the banking system cannot be
permitted to borrow from the central bank
without restraint those reserves that are ab­
sorbed, or are not supplied, by open market
operations. Any revision of the System’s
approach to discounting must provide a
mechanism for limiting the access that the
individual banks in the banking system have

to reserves via their own initiative. Since bor­
rowing at the window must remain a princi­
pal cutting edge of monetary restraint, one
cannot allow the total to rise and fall except
as a reflection of monetary policy. To allow
banks to borrow without restraint— for ex­
ample, to meet long-term growth needs or
to deal with aggregative intramonthly and
seasonal reserve needs— would involve loss
of control over the reserve base.
The present system of administrative ra­
tioning on the basis of the current Regula­
tion A meets the test of providing an ade­
quate fulcrum for the FOMC’s exercise of
monetary restraint. But the rules of discount
administration could be modified or changed
without impairing this function. Under a
different set of rules, administrative ration­
ing could permit all banks more frequent or
longer access to the window than at present
before administrative counseling began.
Under such rules it would probably take
considerably longer to achieve a given de­
gree of monetary restraint, but the System
could undoubtedly achieve its objectives in
The lag between a policy move toward
restraint and its effect on bank behavior
would probably be less under a hybrid sys­
tem in which small banks were allowed to
borrow for seasonal needs in amounts speci­
fied in advance while large institutions re­
mained on a short tether as at present. Small
banks with marked seasonal patterns could
negotiate with the discount officer of their
Reserve Bank in advance a credit line for
continuous borrowing for the period in ques­
tion— perhaps as much as 2 or 3 months—
thereby enabling them to reduce their own
provision for seasonal liquidity needs. Such
a borrowing facility would recognize the
limited time that bankers in such institu­
tions can give to daily liquidity manage­
ment, and would be an added attraction of


System membership. Only borrowing above
a seasonal amount would be subject to ad­
ministrative scrutiny for disciplinary pur­
poses. The frequency of such borrowing per­
mitted before administrative counseling was
called into play might also be increased
somewhat. Aggregative member bank bor­
rowing at the discount window would pre­
sumably be higher under such a hybrid sys­
tem than under the present system for a
given degree of monetary restraint. In pe­
riods of easy money some seasonal borrow­
ing might be added to the frictional borrow­
ing already experienced. As the Committee
moved toward restraint, one would expect
borrowing to rise to higher levels than at
present, without necessarily involving any
very sizable swings in total borrowing
around the policy-determined level.
Access to reserves borrowed from the
Reserve Banks could also be limited through
a structure of quantitative limits and dis­
count rates. There has always been a con­
siderable body of academic opinion that has
felt that the discount rate should be a penalty
rate. The 1966 experience, of course,
showed that policy could be quite restrictive
with a discount rate well below outstanding
market rates. Such a discrepancy, however,
does raise some questions of the desirability
of providing reserves to the banking system
at an unrealistic rate and of equity between
borrowing and nonborrowing banks. These
questions are of limited significance as long
as borrowing at the discount window is a
small part of total reserves, but they would
become more important if revisions in dis­
count policy increased substantially the pro­
portion of total reserves represented by such
A structure of quantitative borrowing lim­
its and discount rates could supplement or
substitute for administrative counseling as a
means of affecting bank behavior. Such a


system might involve, for example, an auto­
matic boost in the effective cost of borrow­
ing from the System once borrowing ex­
ceeded a certain proportion of required
reserves, a certain frequency, or some com­
bination of the two. Conceivably, it could
alleviate some of the problems of equity that
emerge between borrowing and nonborrow­
ing banks, although there are manifold prob­
lems in designing an equitable system be­
cause the sizes of the reserve swings
experienced by banks vary so widely. One
might also expect that such a system would
reflect to some extent the degree of restraint
being achieved by the Committee— that is,
borrowing at penalty rates would increase
with the degree of restraint.
Whereas a structure of rates or quantita­
tive borrowing limits may be a suitable
means of trying to influence the reserve base
and credit conditions in countries without
well-developed money and credit markets,
it is hardly an acceptable substitute for open
market operations as the primary instrument
of general control in this country. One may
question whether the complexities of even a
supplemental system might not render the
conduct of monetary policy and its impact
on economic activity even more mysterious
and subject to misunderstanding than at
Both policy and operational factors
suggest a number of considerations to be
observed in any process of modifying the
present rules of discount administration. The
importance of fostering uniform administra­
tion is self-evident. A corollary of this is
that changes in discount administration
should be of the once-over variety. The pol­
icy decisions of the Committee and the op­
erations of the Desk could adjust to modified
rules without major difficulty, provided there
were no continuing change of the rules nor
any effort to substitute discount policy for


open market policy. In making discount
rule changes that may seem desirable for
purposes of dealing with individual banks,
it would also seem advisable to time the
changes to coincide with a period in which
monetary policy was expansive, and borrow­
ing by member banks was near a frictional

minimum. Then, discount officers, the com­
mercial banks, the Federal Open Market
Committee, and the Trading Desk could all
adapt gradually over the expansionary pe­
riod to the effect of the changed regulations
on bank behavior and monetary develop­
February 1968


Robert C. Holland, Board of Governors of the Federal Reserve System
George Garvy, Federal Reserve Bank of New York

The Money Market Environment______________________________________________________________ 187
Modified Market Performance as a Result of Amendments to Regulation D ________________ 187
Market Influence of Short-Term Adjustment Credit Under Generally Stable Money
Market Conditions__________________________________________________________________________ 188
Interaction of Short-Term Adjustment Credit with Changing Money Market
Conditions ___________________________________________________________________________________ 190
Interaction of Short-Term Adjustment Credit with Changes in Discount Rates_____________ 191
Additional Effects of Seasonal Credit on the Money Market________________ ________________ 193
Effects on the Money Market of Extension of Emergency Credit___________________________194
Conclusion .

_____________________ ________ ________________________________________________ 195




The purpose of this paper is to explore,
insofar as a priori knowledge permits, the
kind of interaction that might be expected
between the national money market and a
redesigned discount mechanism as proposed
in the Final Report of the Steering Commit­
tee (vol. 1 of this series) and to outline the
kinds of adaptations that the Federal Re­
serve would probably be required to make
in the conduct of its open market operations.
This paper thus differs in concept and
orientation from other studies that have
been prepared in connection with the reap­
praisal of the Federal Reserve discount
mechanism. Generally speaking, the other
papers endeavored to analyze past, present,
or prospective conditions and to draw from
such analyses inferences as to the circum­
stances in which the current discount mech­
anism proved to be inadequate and in what
respects it might be improved. This paper
takes the proposed new discount mechan­
ism as given, and tries to evaluate how such
a mechanism might interact, in practice,
with likely money market conditions and
open market policy.
The purpose of the proposed redesign of
the discount window is to make better use
of monetary tools to achieve System objec­
tives and to improve the functioning of the
banking system in general. More liberal ac­
cess to Federal Reserve credit at the dis­
count window does not imply easier mone­
tary policy. Rather, such access would
redistribute responsibilities for facilitating

adjustments to the posture of credit policy.
The proposed design of the window should
enhance the ability of member banks to
meet the needs of their customers, without
reducing the effectiveness and precision of
open market operations.
Our growing economy has required a
continuous broadening over the years of the
banking system’s reserve base. And over the
long run, the Federal Reserve System will
still have to provide substantial amounts of
bank reserves, even if its efforts to achieve
greater price stability are successful and its
additions to reserves are held to a rate com­
mensurate with noninflationary growth of
the economy. Thus, the impact of the shift
to the proposed new system on the money
market and on open market operations must
be viewed against the background of a longrun process of net reserve injection, the pre­
cise time profile of which is subject to sea­
sonal factors as well as to changes in System
policy objectives related to cyclical develop­
Under the present Regulation A, the dis­
count mechanism contributes little to an
appropriate growth in aggregate reserves
of banks or to accommodating recurrent
seasonal swings in the reserve base. Because
of the reluctance-to-borrow convention, a
large part of the needs of member banks for
adjusting reserves from one reserve period
to another are accommodated through
System open market operations. Thus, over
the year, open market transactions show a


large volume of purchases followed by sales
— and vice versa— to accommodate the
fluctuating reserve needs of the banking
system. As a result, in any given year
open market transactions (disregarding ex­
changes) are several times as large as the
net addition to the reserve base.
Restoration of the discount mechanism
to the role of a buffer willingly used by
member banks to make initial adjustments
to fluctuations in their loans and deposits
and to meet part of regular seasonal bulges
in demand for loans will result in a change
in the composition of reserve injection. Such
injection will be more immediately guided
by the needs of individual banks. A some­
what larger proportion of the provision of
reserves will occur at the window rather
than at the initiative of the Trading Desk.
But since the Desk will continue to be in
charge of implementing the over-all objec­
tives of credit policy, as defined periodically
by the Federal Open Market Committee, it
will need to adjust the actual conduct of
its operations to the new role that the Report
of the Steering Committee assigns to dis­
counting. If the amount of reserves created
at the initiative of member banks is at times
excessive in the light of current targets of
Federal Reserve policy, the Trading Desk
will need to offset such excesses by appro­
priate operations. Normally, part of the
reserves that banks lose and seek to re­
plenish by borrowing at the window will
find their way to banks that are anxious
to reduce their borrowings from the Federal
Reserve, and the net injection through
the window will tend to be smaller— and at
times considerably smaller— than the gross
flow. This should be kept in mind in inter­
preting the rough estimates of gross poten­
tial borrowing cited in the Report.
The greater initiative that member banks
will be able to exercise in the initial dis­
tribution of reserves to support long-term

growth and to accommodate seasonal and
cyclical swings in bank credit, as well as in
the levels and composition of deposits, will
have significant effects on the money mar­
ket. The Trading Desk will need to make
certain corresponding adjustments in its
operating procedures and projection tech­
niques. The redistribution of the responsi­
bility for flexibility in the provision of re­
serves to member banks will, on balance,
reduce the volume of open market trans­
actions without diminishing the Desk’s cen­
tral role in implementing Federal Reserve
The primary purpose of this paper is to
explore the probable impact of the proposed
changes on money market processes. There
is no intention to minimize either the chal­
lenge to the Trading Desk or the magni­
tude of its task. Yet, the proposed changes
in discount philosophy and procedures
affect the Trading Desk in a quantitative
rather than in a qualitative way. The re­
quired adjustments involve, in the main, a
restructuring of the patterns of reserve flows
with which the Desk is confronted in its
day-to-day operations; it is believed that
these problems can be solved by gradual
adjustment, as the impact of the new policies
progressively affects credit conditions.
In the next section, attention will be di­
rected toward the likely operation of short­
term adjustment credit at the discount
window in conjunction with ordinary money
market conditions as they may be moder­
ated by the recent adoption of changes in
reserve regulations. Succeeding sections will
describe how such short-term adjustment
credit might interact with money market
developments as credit demands change
cyclically, and as the general Federal Re­
serve instruments— open market operations,
reserve requirements, and changes in the
discount rate— are employed to implement
changes in monetary policy. Another sec-


tion will discuss how these relationships
might be affected by the operation of seasonal credit assistance and emergency credit


assistance. The last section explores some
implications of the redesigned discount window for open market operations.

The national money market is the arena in
which excesses and deficiencies in supplies
of, or demands for, liquid funds by a variety
of participants are balanced out, insofar as
those participants have the means, directly
or indirectly, for reaching this market. Some
of these excesses and deficiencies are highly
transitory— that is, of a few days’ duration;
others are expected to continue for longer
periods— that is, several weeks, a season,
a cycle, or indefinitely. In some instances
those that supply funds and those seeking
funds, as well as market intermediaries, are
likely to be uncertain as to the duration or
prospective dimension of the excesses or
deficiencies accruing to them.
The response to such liquidity surpluses
or deficits is conditioned largely by expecta­
tions as to their size and duration. In addi­
tion, responses of those participants with
surpluses and those with deficits are affected
by their basic portfolio positions, by their

view of the current and prospective condi­
tions in the money market, and anticipated
future trends in basic economic and finan­
cial conditions. Guided by these considera­
tions, including estimates of the alternative
costs involved, participants in the money
market choose among the alternatives open
to them for adjusting excess or deficient
liquidity. For member banks— the only cate­
gory to be discussed in this paper— the
Federal Reserve discount window is one of
the alternatives, albeit one with unique
terms and conditions.1
Member banks vary widely— in liquidity
needs, in swings in cash positions, in de­
mands made on them, and in their ability
to make short-run adjustments in their as­
sets and liabilities.
For a fuller discussion of present money m arket
perform ance, bank adjustments through the money
m arket, and the m arket interaction of existing m one­
tary instruments, see “Discount Policy and Open M ar­
ket O perations,” pp. 169-82.

A special influence on the responses of
member banks to variations in liquidity is
their need to satisfy specified reserve re­
quirements, on the average, within each
designated reserve period, in accordance with
the existing provisions of Regulation D. The
Board of Governors adopted certain changes
in Regulation D; the revisions, which be­
came effective in September 1968, were ex­
pected to alter bank use of the discount
window somewhat and therefore are taken
into account here.

Briefly, the new reserve regulations (1)
shorten the reserve periods for country
banks to the same 1 -week duration already
applicable to reserve city banks; ( 2 ) base
requirements on deposits 2 weeks earlier;
(3) allow holdings of vault cash 2 weeks
earlier to be used (along with the current
week’s reserve balance at the Reserve Bank)
to satisfy reserve requirements; and (4)
provide for the carryover of either deficien­
cies or excesses in average reserves of up
to 2 per cent of requirements from one


reserve period into the next period (but no
Banks thus are able to operate with cer­
tain knowledge of their reserve requirements
and of their vault cash credit with respect
thereto at the beginning of each reserve
period. On the other hand, banks remain as
uncertain as ever about the flow of their
deposits during the current week and about
the effect of this flow upon their reserve
and “due from” balances. The cost of this
uncertainty in terms of actual reserves is
fractionally larger because the fractional off­
setting effect of any deposit movement on
current required reserves under the previous
regulation has been eliminated.
The provision for an automatic 2 per cent
carry-forward should moderate bank efforts
to dispose of any end-of-period reserve ex­
cesses or to meet moderate deficiencies, be­
cause it provides a limited alternative to
forcing such adjustment through the market
near the end of reserve periods when supply
and demand schedules have been most
Shortening of the reserve period for coun­
try banks to 1 week increases reserve adjust­
ment activities for those country banks that
tend to experience offsetting deposit or loan
movements in successive weeks, but that
choose not to carry enough excess reserves

to meet peak needs. On the other hand,
numerous country banks for precautionary
reasons up to this time have tended to
accumulate excess reserves throughout most
of their 2 -week reserve periods and then
near the end of those periods have dumped
such accumulated credit into the Federal
funds market or into their balances with
correspondent banks; with only 1 week in
which to cumulate reserves, the absorptive
capacity of the rest of the money market
would not be swamped so often by such
It is believed that these changes in reserve
regulations will tend, on balance, to moder­
ate the reserve adjustment activities of most
of the banks, and hence to reduce some­
what their demand for end-of-period accom­
modation at the discount window. However,
for a minority of country banks that are
subject to swings in deposits or loans that
are largely reversed from one week to the
next, requests for intermittent assistance at
the discount window may expand consider­
ably. But on balance, the method of reserve
computation introduced in 1968 is likely
to reduce both the recourse of country banks
to the discount window for adjustment pur­
poses and the periodic bulge in excess re­
serves supplied by these banks to the Federal
funds market.

For purposes of this discussion, generally
stable market conditions are taken to in­
clude (and in part depend upon) a stable
pattern of use of the discount window for
obtaining short-term adjustment credit. This
implies that, as a rule, member banks are
making only moderate use of System dis­
count facilities but are willing to increase
their use of the window should their flows

of funds turn adverse.2 A minority of banks
are assumed to be using only a small frac­
2 In most instances, bank use of the discount win­
dow in response to changing circumstances is expected
to be substantially symmetrical; that is, what a bank
would be inclined to do if an influence changed in
one direction would be about the inverse of what that
bank would do if the same influence changed in the
opposite direction. For purposes of simplicity and
clarity, influences and responses are described in a
consistent direction in the text, however.


tion of their basic borrowing privilege,
another minority are assumed to be using
most of their basic borrowing privilege, and
only a few banks are assumed to be borrow­
ing in excess of their basic borrowing
privilege in either amount or duration and
thus to be subject to administrative review.
Under the circumstances indicated, it is
believed that interest rates on most of the
alternative types of instruments readily
available for adjusting liquidity— the mar­
kets for which are dominated by banks—
would be separated from the discount rate
by margins no more than equal to the costs
of the attendant transactions, credit risk,
market or liquidity risk, customer-relations
effects, and the like.
In this environment banks experiencing
what they think will be quickly reversible
drains of funds should be inclined to offset
such drains by borrowing at the discount
window. Their ability to do so will depend
to a large extent upon whether they had
previously used little or most of their bor­
rowing leeway under the basic borrowing
privilege. The longer-lived these drains of
funds are expected to be, the more inclined
banks would be, at the outset, to initiate
correspondingly long-term adjustments in
their portfolios, except insofar as they would
need some transitional time to become rea­
sonably certain of trends or to arrange
orderly adjustments.
If a drain of funds should hit a sizable
proportion of banks simultaneously, there
could be a considerable rise in the nation­
wide total of borrowing. If this occurred,
and if the cause of the drain was of a
reserve-absorbing nature (for example,
an outflow of currency), the aggregate
reserve base of the banking system would
remain little changed. If, on the other hand,
the drain consisted of a deposit shift from
one group of banks to another, the step-up
in borrowing by the deposit-losing group


would enlarge the national total of reserves.
The deposit-receiving banks could be ex­
pected to dispose of some of their resultant
reserve surpluses through the money market,
and to that degree the supply of Federal
funds (and similar money market instru­
ments such as dealer loans) would be ex­
panded. In most circumstances the interest
rates on Federal funds and money market
instruments would tend to decline, and
banks in debt to the Federal Reserve could
be expected to try to refinance such debt
by borrowing in the now-cheaper funds mar­
ket, absorbing redundant reserves in the
process. However, if the outstanding amount
of adjustment borrowing at the discount
window were too small or if the time remain­
ing in the reserve period were too short to
permit full absorption of the redundant re­
serves, day-to-day rates in the money market
would drop still lower— unless some buy­
ing to build up carryovers developed or
banks receiving part of the newly created
funds used them to repay their debts at the
window. If the decline in such rates seemed
too great to be compatible with the cur­
rently desired money market atmosphere,
the Trading Desk would need to sell securi­
ties (outright or through reverse repurchase
agreements) to absorb the redundant
Substantially, the reverse of the process
outlined here should take place if the
initiating factor were an inflow rather than
a drain of funds at the banks in question.
As a result of greater reserve-adjustment
activity stemming from more general use of
the discount window, the national total of
adjustment borrowing (within and outside
the basic borrowing privilege) would prob­
ably fluctuate over a wider range from day
to day and from week to week than occurs
under the present system, but it would still
oscillate around a longer-run trend that is
generally level. Open market operations


would probably undergo smaller, and per­
haps also less frequent, day-to-day and weekto-week fluctuations; it is difficult to docu­
ment this probability, however, because such
operations are undertaken in relation to the
total of all influences affecting member bank
reserves and not borrowing alone. Open
market operations to supplement rather than
to offset swings in borrowing would be called
for whenever data on the composition of
borrowing suggested a cumulative build-up
of adjustment pressure at the discount win­
dow. Such situations would notably arise
when a greater share of adjustment borrow­
ing was tending to take place outside the
basic borrowing privilege and was therefore
under administrative review, and/or when
the preponderance of banks was moving
toward the upper threshold of use of the
basic borrowing privilege.
Interest rates on those instruments of

liquidity adjustment for which banks are
by far the main suppliers and purchasers
would tend to fluctuate less widely than
under the present system so long as under­
lying conditions remained stable. On the
other hand, interest rates on instruments
ordinarily utilized by the System in its open
market operations would tend to be in­
fluenced less by System operations under­
taken to even out reserve positions in the
short run and more by the ebb and flow
of private investor interest. This would mean
that at times such rates might be subject
to wider swings than under the present sys­
tem and at other times to smaller swings,
depending upon the extent to which changes
in investor interest and in the volume of
operations undertaken by the Trading Desk
to meet banks’ adjustment needs would
have been mutually offsetting or reinforc­

When underlying money market conditions
begin to undergo a basic change— either
because of shifts in credit demands or be­
cause of a change in Federal Reserve policy
— the proposed short-term adjustment credit
facilities should work to spread the influence
of such a change somewhat more gradually,
but also more broadly, throughout the bank­
ing system. Recourse to the discount window
may be expected to make reserves available
sooner at the point of need than they would
be if they were redistributed through bank
portfolio adjustments, after having been in­
jected through open market operations.
A cyclical expansion in demands for bank
credit could be expected in the first instance
to elicit an accommodative response from
the bank subject to such demands. As the
consequent rise in deposits, and perhaps

also an expansion in currency, effectively
absorbed reserves, member banks would
be inclined to undertake sufficient borrow­
ing to offset such absorption at least
Thus, as the credit expansion and re­
sultant reserve absorption spread and
cumulated, progressively more and larger
borrowing by banks would be induced. The
borrowing banks, in turn, would gradually
reach thresholds at which they were moved
to rely more heavily on alternative methods
of adjustment. For some banks, this might
happen as they drew close to their own
desired maximum use of the basic borrowing
privilege; for others, it might occur only
after they had exhausted their basic borrow­
ing privilege, had moved on into other
adjustment borrowing, and had finally en­


countered Reserve Bank pressure to repay.
The speed with which the banks reached
these stages would depend, of course, on
the combined effects of the reserve absorp­
tion and of bank willingness to use the
discount window up to the limits outlined
here. It would also depend on the degree
to which reserves originally lost by the bor­
rowing banks would be used by the receiv­
ing banks to reduce their indebtedness rather
than to expand credit. There would un­
doubtedly be differences in behavior be­
tween specific periods of expansion and
among different economic areas and groups
of banks.
As borrowing banks shifted to adjustment
outside the discount window, interest rates
on the alternative adjustment instruments
utilized would rise, both absolutely and re­
lative to the discount rate. Most directly
affected would probably be the Federal
funds rate, since it is dominated by bank
reserve adjustment actions. The results—
higher money market rates, a tighter bor­
rowing posture at the discount window, and
the contracted supply of total reserves— if


unalleviated, would presumably tighten the
availability of credit on a broader scale, thus
deterring some borrowers. This shift, by
itself, would operate in the direction of gen­
eral monetary restraint. Monetary policy­
makers would then have to decide whether
the tauter trends emerging in reserves,
credit, and interest rates were desirable in
the changing economic environment, or
whether they wished to moderate such trends
by buying enough securities in the open
market to offset at least in part the cur­
tailed availability of reserves at the discount
Conceivably, of course, the requirements
of policy might lead the Federal Open
Market Committee to accelerate rather than
to moderate the financial system’s adjustment
to the changing supply of reserves. In those
instances, even though borrowing at the
discount window was becoming larger and
more widespread, parallel sales for the Open
Market Account might be desirable. As an
alternative an increase in reserve require­
ments might be used to speed the adjustment
and to elicit greater attention to it.

The influence of a change in the discount
rate on the money market and on borrow­
ings of short-term adjustment credit sought
at the discount window will differ consider­
ably, depending upon whether the change in
the discount rate is leading market rates or
is simply following a change in general
money market rates and conditions.
Let us consider first a situation in which
a combination of expanding demands for
credit and of less-expansive System open
market operations has increased the reserve
pressures on banks. As pointed out in the

preceding section, this process, if carried
on long enough, will impel more and more
banks to undertake their reserve adjust­
ments outside the discount window, and the
pressure of such added demand for avail­
able reserves will tend to raise interest rates
on Federal funds and various money market
instruments correspondingly. By the same
token, reserves borrowed at the discount
window at the existing discount rate will
appear relatively cheaper.
This relative cheapness of discounting
might entice some additional borrowing by


banks that still had not used all of their
basic borrowing privileges to make their
first adjustments in reserves in this way.
On the other hand, a sizable and growing
proportion of banks would have used all
of their basic borrowing privileges and have
come under administrative review; the banks
in this second group would seek to effect
their reserve adjustments outside the dis­
count window— not for reasons of com­
parative cost but in order to comply with
the standards for repayment of adjustment
credit, and to be able to proceed to orderly
portfolio adjustments when and as needed.
In these circumstances an increase in the
discount rate following recent increases in
other money market rates would not appre­
ciably alter the pattern of adjustment of the
second group of banks. Such an increase
would therefore not engender through these
banks any significant additional upward
pressure on market rates and would not
reduce the incentive for them to delay the
required adjustments. However, the increase
in the discount rate would narrow the rate
incentive for the first group of banks to
borrow at the discount window. To the
extent that the first group rechanneled its
reserve adjustment activities away from the
discount window and into the market, up­
ward pressures on market rates would in­
crease. Generally speaking, the more the
discount rate lags behind market rate in­
creases, the larger the second group of banks
should be relative to the first, and the less
likely it would be for the eventual “follow­
ing” increase in the discount rate to trigger
much additional upward pressure on market
A somewhat different pattern would tend
to emerge, however, if the discount rate
were to be leapfrogged ahead of the rates
on the most closely related instrument of
reserve adjustment. First, such a “leading”
increase in the discount rate would increase

the relative cost of borrowing compared with
alternative reserve adjustment instruments.
All member banks that had been borrow­
ing, but not in a large enough amount or
for a long enough duration to bring them
under pressure to repay, would then find
it advantageous to seek less-expensive means
of financing their reserve deficits. Their
added financing efforts in the money market
should quickly bring upward rate pressures
to bear on other money market instruments.
To the extent that these banks were success­
ful in this endeavor, and thus were enabled
to retire debt at the Federal Reserve, the
aggregate supply of reserves would be cur­
tailed. In consequence of all these actions,
a correspondingly tauter atmosphere should
soon prevail in the central money market.
The effects of decreases in discount rates,
under the redesigned discount mechanism,
are likely to be generally the reverse of those
outlined for increases but not precisely
symmetrical. So long as the borrowing pres­
sure on the banking system is sufficient to
keep a large number of banks borrowing
over and above their basic borrowing
privilege, reductions in the discount rate
should have only modest, easing effects on
other money market rates. The fact that the
bulk of the banks were still under pressure
to repay their indebtedness to the Reserve
Banks should tend to keep the rates on
Federal funds and similar private instru­
ments of reserve adjustment relatively high.
However, once credit contraction or ex­
pansive open market operations have made
enough nonborrowed reserves available for
such “over-privilege” borrowing to be sub­
stantially repaid, most banks should again
be importantly influenced in their choice of
reserve adjustment media by the relative
costs thereof. Thereafter, reductions in the
discount rate should be followed promptly
by enough rechanneling of reserve adjust­
ment pressures to the discount window and



away from other avenues to cause sym­
pathetic rate declines on other such media.
If monetary policy should ease suffi­
ciently, however, to encourage the retire­
ment of virtually all adjustment borrowing
from the Federal Reserve, then money mar­
ket rates would tend to become unhinged
from the discount rate and to drop to levels
that would equilibrate the demand for and
supply of nonborrowed reserves.
Consideration of typical interactions and
sequences suggests a very close association
between the discount rate and rates on alter­
native instruments of reserve adjustment
so long as member bank adjustment borrow­
ing is large enough to affect market rates
but not large enough to bring a significant
proportion of the banking system under
pressure to repay. As credit demands and
monetary policy shift over the cycle, dis­
count rates would presumably be raised or
lowered more or less commensurately in

order to achieve the System’s objectives.
However, there would be a tendency for
rates on alternative instruments of reserve
adjustment to rise even higher relative to
the increased discount rate near peaks of
strong cyclical borrowing pressure and to
drop even lower relative to the lowered dis­
count rate during cyclical troughs when
borrowing was slack.
All of this discussion has abstracted from
the “announcement effect” of any changes
in the discount rate on interest rates and
availability of funds in the money market.
Such effects are conditioned so much by the
attitudes prevailing at the time of a given
rate change that any generalization is very
risky. Nonetheless, it appears that such
effects would be most marked when no ac­
tion on the discount rate was expected. This
would probably occur when the discount
rate was used to lead rather than to follow
movements in market rates.

The seasonal borrowing privilege provided
in the proposed redesign of the discount
mechanism should work to moderate the
effect on the money market of the reserves
supplied or absorbed in response to chang­
ing seasonal demands. But since banks
would be required to meet the first portion
of their seasonal drains of funds (up to an
amount equal to 5 to 10 per cent of their
average deposits) out of their own resources,
it is likely— judging from inadequate
empirical evidence— that the great bulk of
seasonal oscillations in fund flows within
the banking system would continue to be
met by resorting to the usual reserve adjust­
ment techniques. However, to the extent
that seasonal adjustments are met at the
window— either through the seasonal bor­
rowing privilege or under the basic borrow-

ing privilege— the need for seasonal open
market operations of the conventional sort
would be reduced.
The typical user of the seasonal borrow­
ing privilege is expected to be a relatively
small bank experiencing a large seasonal
swing in relation to its available funds.
Given the diversity of seasonal needs and
their patterns, it is likely that the total
amount of reserves advanced to such banks
would rise and fall more or less gradually.
Since the banks will be expected to negotiate
their seasonal borrowing needs with their
Reserve Banks over their full seasonal period
insofar as is feasible, the general timing and
amount of reserve injections from this source
should be fairly well defined in advance.
In addition, the discouragement of tem­
porary repayment of such credits with funds


obtained from the money market when it
turns easy for a day or two will tend to
minimize abrupt changes in the level of
borrowing under the seasonal arrangement.
Inasmuch as the volume of seasonal
borrowing should change gradually and
more or less predictably, it should be possi­
ble to insulate most of this borrowing from
day-to-day changes in money market atmos­
phere. Seasonal borrowing, therefore, would
have little more significance on policy than
on float. This means that it should be possible
to project the aggregate flow of reserves
from use of the seasonal borrowing privilege
with about the same degree of accuracy as
for other market factors affecting reserves—
including the component of seasonal credit
that will remain hidden in borrowing under
the short-term adjustment provisions. If the
total of seasonal borrowing and other fac­
tors appeared to supply too many reserves in
any period, open market sales would be

employed in the usual way to maintain the
desired conditions in the money market.
Undoubtedly there will be a tendency for
use of the seasonal borrowing privilege to
rise as banks and their customers become
familiar with this special facility. And it is
probable that requests for seasonal credit
assistance will tend to grow in periods of
tight money or relatively low discount rates,
and contrariwise to shrink when credit con­
ditions are easy or when the discount rate
is unusually high compared with rates on
alternative instruments. But so long as the
business of the Nation’s largest banks is
such that these banks are unlikely to meet
the terms of the regulation and therefore
are prevented from suddenly becoming sea­
sonal borrowers, the total dimensions and
variability of seasonal credit assistance at
the discount window should be well within
a scope that can be handled by present
methods of open market operations.

The very nature of emergencies makes it
hard to predict the consequences of any
efforts to deal with them.
For the most part, it can be assumed that
the occasional needs of individual member
banks for emergency credit assistance at
the discount window will be small and in­
frequent enough to have no significant effect
(in quantitative terms) on the over-all flows
of reserves through the money market.
When the emergency assumes the aspect
of a large-scale regional, sectoral, or even
national liquidity squeeze, however, the
probable effects of discount window assist­
ance on the money market cannot be dis­
regarded. In any crisis of such proportions,
System open market operations would have
been undertaken to bring about approxi-

mately the desired degree of over-all credit
availability. Undesirably tight conditions in
any specific group of institutions, therefore,
would be related to the inability of such
institutions to command a suitable redis­
tribution of the national total of liquidity,
unless the emergency were of national scope.
Extension of emergency credit to such
groups of institutions by the Reserve Banks
would thus be not so much a substitute for
money market activities that they might
otherwise undertake as it would be an in­
dependent and complementary source of
funds for the alleviation of undue pres­
If the funds drained from the institutions
experiencing the emergency accrued to
others in the financial system, and if this


development led to an undue easing of re­
serve availability in the money market, the
System would need to undertake open mar­
ket sales of short-term securities to absorb
such reserve excesses. In such an environ­
ment, investor demands would be shifted
toward liquid assets in general, and Treas­
ury bills in particular— creating a ready
market for such sales by the Trading Desk.
Provision is made in the final report of
the Steering Committee for another kind of
emergency credit assistance. This assistance
would apply not to institutions in trouble,
but rather to markets for the most important
types of securities, should such markets be­
come so disorderly that open market opera­
tions in the kinds of assets purchasable by
the Trading Desk would not calm them.
In such circumstances it is possible that the
Reserve Banks could extend emergency
credit to institutions as at least a partial
substitute for further substantial efforts on
their part to dump securities into disrupted
The reserve effects of such lending could
be sizable, and loans could bulk so large


as to tax the ability of the Trading Desk
to offset quickly any undue creation of
reserves. Here again, market demand for
Treasury bills would probably become
strong, thus facilitating the offsetting open
market operations. But in certain circum­
stances, emergency assistance through the
window might be the only feasible means
of averting dangerous or even disastrous
developments and such assistance would be
justified even if the simultaneous or sub­
sequent absorption of excess liquidity should
prove to pose difficult problems for the
Trading Desk.
Indeed, it is quite conceivable that as
much as or more importance would attach to
the psychological effects of emergency credit
actions at the window as to their reserve
effects. Markets plagued by fears of a
liquidity crisis seek reassurance more than
anything else. The knowledge that the Re­
serve Banks were lending to alleviate a
widespread emergency— or were prepared
to do so— might well do more to promote an
orderly functioning of the market than the
actual reserve funds so injected.

Each of the major types of credit assistance
envisioned under the redesigned discount
mechanism is likely to have a different effect
on the money market and on the kind of
complementary open market operations
needed. However, these influences are not
expected to exceed the ability of the market
and the Trading Desk to deal with them.
Many of the major categories of credit should
serve to reduce on balance over the year
demands on the money market and the Desk
by providing an alternative for adjustments
that in the past have required alternating
purchases and sales of securities, at times
in quite unreceptive markets.

The estimates of the potential maximum
extension of credit for reserve period adjust­
ment (under the basic borrowing privilege)
and for seasonal needs that are given in the
Steering Committee Report are large in
comparison with the net amounts added to
bank reserves in recent years— including
those required to offset gold losses and cur­
rency outflows. However, it is unrealistic to
assume that such totals will ever be reached,
even for short periods, because the condi­
tions laid down for borrowing under the
basic borrowing privilege would require all
banks to be out of debt simultaneously dur­
ing a fairly protracted period prior to any


rapid build-up of indebtedness to the Sys­
tem. Furthermore, the estimated upper limit
would be reached only if all member banks
borrowed maximum amounts, irrespective of
their actual needs and in spite of the rule
against reselling borrowed funds. It is
much more likely that in a period of grow­
ing restraint some banks will enlarge their
borrowings fairly early and thus will be
subject to strong administrative pressure to
adjust their assets by the time aggregative
borrowings rise toward a statistical maxi­
mum as monetary conditions tighten fur­
ther. One cannot guess how far below the
potential maximum total bank borrowing
will tend to remain in a time of extreme
restraint. Only experience will show what
typical profile short-term adjustment bor­
rowing will assume in response to extreme
tightening, but it is unlikely that the esti­
mates in the report will even be approached.
And in any case the shift to the new policy
could be made gradually.
On the other hand, provision of a sizable
part of the seasonal needs of the banking
system through the proposed seasonal credit
accommodation is expected to result fairly
soon in the emergence of a different pattern
of residual seasonal demands for reserves
to be met through open market operations.
Given the fact that few money market
banks, if any, are likely to become eligible
for the proposed accommodation, it is im­
probable that the shift envisaged will require
more than routine adjustments in projections
and operations. Indeed, because the new
types of assistance available at the Federal
Reserve discount window will interact with
existing processes and institutions in new
ways, adjustments to the new types will take
some time, and they may not progress
smoothly. Some transitional uncertainties
are inevitable.
Interpretation of money market condi­
tions by analysts— and more importantly,

by the Trading Desk— leans heavily on
magnitudes that have come to be regarded
as having special relevance in reflecting
current and prospective conditions. It is
obvious that any change in procedures, in­
cluding those flowing from the quite farreaching recommendations of the Steering
Committee, will result in changes in the
level and pattern of several such variables,
particularly member bank borrowing. It
may be some time before representative or
stable patterns emerge and before analysts
acquire sufficient confidence in interpreting
and projecting changes in the magnitudes of
these variables that are essential for eval­
uating money market conditions and the pos­
ture of System policy. But all of these mag­
nitudes are affected from time to time by
innovations, modifications in procedures,
shifts in preferred adjustment processes, and
bankers’ changing attitudes, and other rea­
sons, as well as by changes that reflect the
more fundamental structural shifts that are
continuously taking place in our economy
and in the financial system.
A specific level of borrowing— and of
net borrowed reserves— acquires its mean­
ing from the cumulative experience of mar­
ket participants who come to associate it
with a certain average bank attitude and a
certain market atmosphere. The relation­
ship between given conditions is not fixed
and mechanical, but is subject to change
as a function of variations in market pres­
sures, in bankers’ attitudes and policies, and
in other factors (as the experience of recent
years amply demonstrates). A range of net
borrowed reserves of $200 million to $300
million has a specific meaning when related
to levels in recent periods, but may have
been associated with significantly different
credit conditions 10 years earlier.
Given the fact that specific levels (or
ranges) of net borrowed (or free) reserves
acquire their analytical and policy signifi-


cance as a result of collective rationalization
of the way in which they are associated with
specific kinds of market and credit condi­
tions, it is reasonable to assume that similar
associations will become just as firmly estab­
lished once Federal Reserve standards and
their administration, as well as bank atti­
tudes, have been modified by the adoption
of the window design proposed by the Steer­
ing Committee. A degree of tightness that
recently has come to be associated with,
say, borrowings of $600 million and net
borrowed reserves of $300 million may then
be identified with, say, borrowings of $1
billion and net borrowed reserves of $900
million. Both the new and the old levels will
synthesize essentially the same combination
of conditions and attitudes and will convey
substantially the same message to market
It should become clear to the market
fairly soon that temporary bulges in borrow­
ing around holidays are merely a technical
alternative to providing and then absorbing
equivalent amounts of reserves through open
market operations, and that such temporary
borrowing under the basic borrowing privi­
lege affects over-all credit conditions no
more than corresponding “defensive” oper­
ations by the Desk.


It is expected that market participants
and analysts, as well as all those within the
System who are connected with formation
and execution of policy, will learn— as they
have in the past— to live with the new
levels and relationships and to interpret
these levels and relationships with no less
insight and imagination than they have in
the past.
Uncertainties and frictions might be re­
duced by a campaign to acquaint all par­
ticipants with the objectives and expected
modus operandi of the new system, or by
introducing the new system in tranches over
time. The amount and frequency targets
recommended in the Steering Committee
report could be announced as ultimate goals,
but initial levels could be set lower and
raised gradually in the light of cumulative
Finally, both during the transition and
thereafter, a much more sophisticated moni­
toring system may be required to keep the
policy-makers and the operational staffs who
are concerned with discounting and open
market operations fully aware of the chang­
ing interaction between member bank bor­
rowing and the money market and the im­
portance of this interaction for monetary
July 1968



Dolores P. Lynn
Federal Reserve Bank of New York

Sources of Pressure on the Eight City Banks_________________________ __________ 201
Monetary Policy Actions During the 1966 Bo om ________________________________202
Liquidity of the Eight City Banks at Beginning of 1966 _____ _____________________ 204
Sources of New Loanable Funds ____ __________ ______ _________ ______________ 205

Certificates of deposit
Other sources
Use of the Discount Window________________________________________________ 212
Attempts by the Eight City Banks to Curtail Lending________________________ __
_ 213




By the end of 1965 the U.S. economy had
already been expanding for some time with
a vigor and endurance unmatched by any
other business upswing of the post-WorldWar-II period. The margin of unused pro­
ductive capacity and manpower resources
had narrowed considerably, and inflationary
tendencies were on the rise.
During the first 9 months of 1966
demand pressures in the economy continued.
Business expenditures on new plant and
equipment accelerated further, spending on
services by States and municipalities rose,
and outlays by the Federal Government
increased sharply as a result of an escala­
tion of the conflict in Vietnam and of an
expansion of domestic social programs.
Pressures in the credit markets intensified
as the corporate and government sectors

competed for funds in an atmosphere of
increasing monetary restraint. Yields on
capital market instruments soared to their
highest levels in more than three decades,
and demands on the commercial banking
system induced near-crisis conditions. These
pressures focused on the eight large New
York City money market banks (herein­
after referred to as the “eight City banks,”
or sometimes as “City banks”) because
these eight banks have traditionally been
the major source of business credit for the
Nation .1
The group comprises Chase M anhattan Bank,
First N ational City Bank, M anufacturers Hanover
T rust Company, Chemical Bank New Y ork T rust
Company, M organ G uaranty T rust Company, Bank­
ers T rust Company, Irving Trust Company, and M a­
rine Midland Grace T rust Company.

porate liquidity was at low ebb and inter­
nally generated cash flows had begun to
During the economic expansion that began
in 1961, corporations had allowed their
holdings of cash and liquid assets to decline
to minimum levels as they expanded pro­
ductive capacity, built up inventories, and
acquired a large volume of trade receivables.
Moreover, after the first quarter of 1966
the rapid growth of corporate profits came

The heavy corporate demand for bank
credit during 1966 reflected in large part
an acceleration in the payment schedules for
both Federal income taxes of corporations
and the income and social security taxes
that corporations had withheld for their
employees; payments of these taxes in­
creased corporate working capital require­
ments in 1966 by an estimated total of
$4.1 billion. These sharply expanded needs
for funds occurred at a time when cor­



to a halt. As the year progressed, it became
apparent that corporations’ projections of
their cash inflows had been overly optimistic,
and the need for additional borrowing from
banks rose accordingly.
Several other factors, in addition to the
increase in needs of corporations for work­
ing capital, exerted pressure on the eight
City banks during 1966: First, a portion
of the growing number of requests for busi­
ness loans represented a spillover of demand
from the capital markets. With yields on
new bond flotations moving rapidly to threedecade highs, many corporations sought to
avoid expensive long-term borrowing by
financing investment outlays temporarily at
relatively favorable bank lending rates.
Second, cash inflows at life insurance com­
panies and savings banks were seriously
reduced by the process of disintermediation
that had been set in motion by the sharp
increase in market yields on securities rela­
tive to those available on institutional sav­
ings. Moreover, life insurance companies
were subjected to heavy cash withdrawals
as a result of borrowings by policyholders
at low contractual rates of interest, and for
related reasons, while savings banks experi­
enced some loss of savings to the commer­
cial banks, which were permitted to pay
higher rates of interest on certain types of
accounts. Therefore, in order to meet prior
investment commitments, these two types of
financial intermediaries sought loans under

commercial bank lines of credit that had
seldom before been used.
Finally, requests for bank credit by busi­
nesses anticipating further increases in in­
terest rates were a constant and significant
source of pressure on the banks. Through­
out the first three quarters of 1966 banks
were deluged with requests for business
loans that were generated by specific invest­
ment projects or working capital needs and/
or by a strong desire to obtain an adequate
liquidity margin for possible future needs.
To obtain these funds, many businesses
activated lines of credit that had been
dormant for long periods. Equally sympto­
matic of the spreading uncertainties regard­
ing the future cost and availability of credit
were the large-scale attempts by corpora­
tions to obtain additional lines of bank
credit or increases in existing lines and to
convert existing lines into legally binding
commitments for revolving credits or term
loans in exchange for the payment of a
customary commitment fee.
During this period the prevailing belief
that interest rates must continue to rise was
caused by the increasing congestion in the
capital markets, by mounting demands for
credit at commercial banks, and by a stepup in military activity in Vietnam. The
mood of pessimism was reinforced by the
absence of fiscal measures to restrain in­
flation and by the increased burden that
this absence placed on monetary policy.

From late 1965 to September 1966, the
Federal Reserve System used all of its in­
struments of general monetary control, and
applied selective monetary pressures where
possible, in its efforts to brake the boom.
In December 1965 the discount rate was
raised from 4 to 4 V2 per cent— signaling a
shift from the mild restraint that had pre­

vailed during most of 1965 to a more
aggressively restrictive policy. This increase
brought the discount rate at least tem­
porarily into line with money market rates,
which had been moving up rapidly. In the
strong upward surge of interest rates that
followed, however, the discount rate was
left far behind market rates. In an effort


to avoid a further escalation in interest rates,
the System refrained from raising the dis­
count rate in 1966 , but it continued to
carefully scrutinize member bank borrow­
ings as requests at the discount window
After the change in the discount rate in
December 1965, the System gradually in­
creased pressures on member bank reserve
positions through open market operations.
Demand for bank credit continued to ex­
pand, however, and the banking system in­
creased its aggregate net borrowed reserves
from about $100 million in the final week
of 1965 to nearly $600 million in the last
week of September 1966. The Board of
Governors raised reserve requirements
against time deposits other than savings
accounts to the statutory ceiling of 6 per
cent in September 1966;2 such rates had
been raised from 4 to 5 per cent in July
of that year.
Throughout 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 took the
form of periodic informal counseling of
member banks by officers of the individual
Reserve Banks as well as public speeches and
statements by System officials. Member
banks were urged to curtail their lending
and to become more selective in granting
loans so as to avoid extending credit for
speculative ventures, for corporate acquisi­
tions, or for other purposes that were non­
An important way in which the System
attempted to restrain the growth of bank
These higher percentages applied only to “other
time deposits” in excess of $5 million at each mem ber
bank. Reserve requirem ents against time deposits be­
low this limit and those against savings deposits re­
mained unchanged at 4 per cent. Subsequent to these
increases, the statutory m aximum reserve requirem ent
against time deposits was increased to 1 0 per cent.


credit during 1966 3 was by maintaining the
interest rate ceiling on large-denomination
negotiable certificates of deposit at 5Vz per
cent in the face of sharp increases in yields
on competing types of money market in­
struments. By holding the rate ceiling on
CD’s, the System sought not only to curtail
the availability of bank credit but also to
discourage further upward interest rate
adjustments in the credit markets and
thereby alleviate some of the pressure on
savings and loan associations and mutual
savings banks caused by disintermediation.
Ever since 1961, when corporations and
other large investors had begun to use CD’s
as an important outlet for surplus funds,
the CD had been a major source of new
funds for commercial banks, particularly the
eight City banks. Although rates on most
money market instruments by July 1966 had
risen considerably above the 5 Vi per cent
maximum permissible rate on CD’s, the
Federal Reserve did not respond by raising
the CD ceiling, as it typically had in the
past. As a result this maximum rate limita­
tion was posing a serious threat to the ability
of the eight City banks to attract new funds.
The accelerating demand by business
for credit in the summer of 1966 was re­
garded by the System as the most threaten­
ing single element in the bank credit pic­
ture, and the growing apprehension over
the strength of bank lending to business
was eventually made public in a letter issued
by the System to member banks on Septem­
However, the m axim um interest rate payable on
multiple-maturity time deposits was reduced to 5 per
cent for m aturities of 90 days or m ore and to 4 Vi
per cent for 30- to 89-day deposits, effective July
20. The m aximum rate payable on single-maturity
time deposits of less than $ 1 0 0 , 0 0 0 was reduced to
5 per cent, effective September 26. Previously, no
distinction had been m ade between the single- and
m ultiple-maturity categories of other time deposits.
The reductions in the ceiling rate on multiple-maturity
and on sm aller-denom ination single-maturity deposits
affected those deposits most directly competitive with
deposits or shares in savings institutions.


ber 1 , 1966, near the peak of the pressures
on the financial markets. This letter, which
called attention to the 20 per cent annual
growth rate in business loans by banks dur­
ing the first 8 months of 1966, stated that
“Federal Reserve credit assistance to mem­
ber banks to meet appropriate seasonal or
emergency needs . . . will continue to be
available as in the past . . .” and that
. .
a greater share of member bank adjustments
should take the form of moderation in the
rate of expansion of loans, and particularly

business loans.” The letter warned that this
goal would be kept in mind by the indi­
vidual Reserve Banks in granting credit at
the discount window; at the same time
it offered the privilege of discount accom­
modation for extended periods of time to
those banks that cooperated in achieving
this goal. Meanwhile, officers of the indi­
vidual Reserve Banks continued to examine
carefully trends in loans, investments, de­
posits, and borrowings of banks that were,
or might become, problem borrowers.

A lion’s share of the pressure on the
banking system that resulted from the com­
bination of excessive credit demands and
monetary restraint during 1966 fell on the
eight City banks. Although the industrial
Northeast and the mid-Atlantic States had
shown less-rapid economic growth than
many other regions of the country from
World War II to 1966, the role of the eight
City banks as a major supplier of business
credit had declined very little. At the begin­
ning of 1966 these eight City banks held
about 29 per cent of total business loans
outstanding at all member banks compared
with 31 per cent in 1946.4 A partial ex­
planation for this continued prominence
may lie in the widespread trend toward the
integration of industry during the postwar
period through mergers and consolidations.
With the substantial increase in the relative
size of individual business units, the eight City
banks— the legal lending limits of which are
unusually large— have continued to be al-

most the only banks capable of accommodat­
ing the Nation’s prime borrowers. Also, cor­
porate businesses may have continued to
regard these banks as an unfailing source of
funds, even in periods of credit stringency.
Even though the eight City banks lost
funds to other regions of the country from
World War II to 1966, their total deposits
showed a sharp growth for the period as
a whole. At the same time, moreover, their
required reserves increased little in absolute
terms because reserve requirement percent­
ages were reduced. Over the period the
effective ratio of required reserves to total
deposits declined from a peak of 22 per
cent in 1948 to approximately 9 per cent
in 1966.5
In relative terms, however, resources of
the eight City banks showed a distinct tend­
ency to decline after World War II. Between
1946 and 1959, the eight City banks’ share
of total deposits of all member banks de­
clined from 22 per cent to less than 17 per

This and similar ratios quoted later are computed
on the basis of data for New Y ork City m em ber
banks classified as reserve city banks (or central
reserve city banks prior to July 1962). The eight City
banks account for 92 per cent of the total assets of
this group.

This decline occurred under the combined influ­
ence of successive reductions since the K orean war in
reserve requirem ents 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. See also footnote 4.



cent. Although these banks succeeded in
raising their share to 20 per cent during
the years 1960-65 through the aggressive
promotion of negotiable CD’s, by the end
of 1966 their share had again fallen to less
than 18 per cent as a result of a sharp
decline in CD liabilities.
The decline in the ability of the eight City
banks to attract funds by means other than
the issuance of negotiable CD’s appears to
be directly related to the revolution in the
management of corporate funds that has
taken place over the postwar period. During
this era of generally restrictive monetary
policy and rising interest rates, corporate
financial managers have become increas­
ingly aware not only of the cost of holding
uninvested cash but also of the possibility
of simultaneously pursuing the goals of
adequate liquidity, safety, and income.
Consequently, many corporations now keep
demand balances with commercial banks
at minimum working levels and invest their
surplus cash in a widened array of highquality money market instruments. In order
to obtain bank loans during 1966, however,
corporations were required to maintain
larger compensating balances on deposit
with lending banks.
Although corporate programs to invest
cash have had an impact throughout the
banking system, the effect has been more


severe at the eight City banks, which have
traditionally relied on corporate demand
deposits as a major source of loanable funds.
While the use of negotiable CD’s has en­
abled the eight City banks, in effect, to
recoup a portion of the corporate funds
previously lost to the money market, this
repatriation has represented an extremely
volatile and expensive source of funds for
these institutions. On balance, it appears
that the volume of funds available for lend­
ing at the eight banks has tended to increase
less rapidly than the demands for credit.
To summarize, by the end of 1965 the
eight City banks were not so well-equipped
to handle a barrage of credit requests as
they had been at any previous time during
the postwar period. Over the course of the
cyclical expansion in the economy that had
begun early in 1961, these banks had
allowed their liquidity to fall to a historically
low level. By the end of 1965 their holdings
of U.S. Government securities were small,
and the loan-to-deposit ratio of the eight
as a group had risen to 73 per cent, com­
pared with 63 per cent for all commercial
banks. Thus the eight banks entered 1966
with their liquidity at unprecedentedly low
levels and with a very large proportion of
their deposits in the form of highly volatile,
negotiable CD’s; such deposits accounted
for nearly one-sixth of the total.

In view of this low level of liquidity and
of the strength of the demand for credit,
banks generally— and the eight City banks
in particular— were faced with the need
to expand both their sources of loanable
funds and the volume of such funds in 1966.
As already noted, CD’s had become an
important source of funds to many banks,
but the volume of CD’s declined sharply

after mid-1966 as interest rates on com­
peting instruments rose to unusually high
levels. To replace funds no longer obtain­
able from this source or from reductions
in their Government securities portfolios,
the eight City banks turned in large meas­
ure to the Euro-dollar market. They bor­
rowed little from their Federal Reserve


Certificates of deposit

The eight City banks responded to the
acceleration of credit demands in 1966 pri­
marily through intensive efforts to maxi­
mize their ability to meet these demands,
and secondarily through adoption of pro­
grams to ration demands and to scale down
lending operations.
At the beginning of 1966 negotiable CD’s
promised to be the major source of loanable
funds for these institutions— as they 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 in­
crease) to a flat 5 Vi per cent for all matu­
rities of 30 days or more from rates of
4 per cent on 30- to 89-day maturities and
AVi per cent on maturities of 90 days or
more. This increase in the rate ceiling had
restored banks to a favorable competitive
position relative to other issuers of money
market instruments and appeared to allow
banks ample maneuvering room in their
efforts to attract funds.
As a result of the rapid upward move­
ment in money market rates beginning early
in 1966, however, the eight City banks
raised offering rates on CD’s frequently and
hence soon reached the new ceiling rate.
As early as March one City bank posted
the ceiling rate of 5 Vi per cent on CD’s in
the 9- to 12-month maturity category. Other
City banks soon joined the move toward
higher rates— raising rates first on instru­
ments with the longest maturity and then
later on those with progressively shorter
maturities. By the beginning of August an
offering rate of 5 Vi per cent was in effect
“across the board” at most of the eight
City banks.
By late August, however, negotiable CD’s
— except in the shortest maturity category—
had little appeal for investors. Money mar­
ket rates (discount basis) had risen to

5% per cent on 4- to 6-month prime com­
mercial paper; to 5% per cent on 90-day
bankers’ acceptances; to 5% per cent on
3- and 6-month finance company paper,
directly placed; and to about 5 per cent and
5.40 per cent, respectively, on 3- and 6month Treasury bills. These rates were
equivalent to investment yields ranging from
about 5.14 per cent and 5.63 per cent,
respectively, on 3- and 6-month Treasury
bills to 6.10 per cent on prime commercial
paper, compared with the 5 Vi per cent yield
on CD’s.
Subsequently, yields increased further—
through mid-September for Treasury bills
and through mid-October for commercial
paper. For a brief period during the fall
both 3-month and longer-term Treasury
bills enjoyed a yield advantage over CD’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 bankers’
acceptances declined after reaching their
respective peaks in mid-September and late
November. Nevertheless, the longer-term
Treasury bills maintained their yield advan­
tage relative to CD’s until the latter part of
November; through the year-end, yields on
bankers’ acceptances and on commercial
paper were higher than the yields on CD’s.
Thus, despite a general easing of market
tensions in the early fall, it was not until
just before the turn of the year that nego­
tiable CD’s again became competitive with
money market instruments.
Because of the changing structure of
money market rates— and contrary to indi­
cations at the end of 1965— the negotiable
CD performed very poorly during 1966 as
a magnet for new loanable funds. As the
top panel of Chart 1 shows, this instrument
drew a negligible sum into the eight City
banks during the first 8 months of the year
in spite of the frequent and substantial





M a r.


S e p t.


D ec.

M a r.



S e p t.

D e c.

M a r.



Gains stem from increases in liabilities or decreases in assets.
Data are based on Wednesday figures, except loans to U.S.
Govt, securities dealers, which are based on the daily-average
volume o f Federal funds and N ew Y ork Clearing House funds

loaned to dealers during weeks ended on Wednesday. The
latter include funds supplied to dealers under repurchase agree­
F. R. Bank o f New Y ork data.

upward adjustments in rates. Increases in
offering rates during January and February
did attract some new money, but further
rate increases were necessary in March to
stem the tide of net CD redemptions that
developed in that month and to prepare
these banks for heavy seasonal credit de­
mands during the tax-payment period.
The March increases in rates led to an
expansion of $0.6 billion in the volume of
outstanding CD liabilities by mid-April.
This inflow of deposits enabled the eight
City banks to accommodate the unusually
large corporate demands for credit that

developed as a result of the Treasury’s
accelerated schedule for tax payments.
Banks were also able to meet the borrowing
needs of U.S. Government securities dealers
who were replacing funds lost through the
expiration of repurchase agreements made
with nonfinancial corporations around the
tax date.
During May the eight City banks raised
offering rates on CD’s again— leaving little
room for further adjustments under the
legal maximum— and by early August the
5V2 per cent ceiling rate was quoted on all
maturities by most of the eight banks. The


rate increases during the summer permitted
the City banks to hold their CD liabilities
fairly constant, but they failed to generate
enough additional funds to enable the banks
to handle renewed seasonal tax-related pres­
sures, loan requests from nonbank financial
institutions, and a more-than-seasonal de­
mand for business loans.
The larger-than-seasonal demand for
business loans that appeared early in May
and persisted into the fall of 1966 reflected
to a considerable extent a substantial in­
crease in the volume of anticipatory bor­
rowing by corporations. During the summer,
as previously noted, expectations of increases
in interest rates and concern over the future
availability of credit became widespread.
These apprehensions were bolstered by evi­
dence of increasing monetary restraint and
by an awareness that the eight City banks—
then offering the maximum permissible rate
on CD’s— would be severely limited in their
ability to expand loans further. While pre­
cautionary borrowing was thus generated by
the actual and prospective situation in the
money and credit markets, such borrowing
contributed to existing pressures. As credit
demands became increasingly urgent, the
eight City banks were subjected to rapid
withdrawals of CD funds beginning in the
latter part of the summer. During the brief
span between mid-August and mid-Decem­
ber, CD liabilities of these banks fell by
$2.1 billion to about $4.3 billion. Thus the
availability of loanable funds declined at
the very time that demand for such funds
was increasing.

In the early summer of 1966 the eight City
banks began to anticipate the large losses
of funds that eventually occurred as a re­
sult of CD redemptions. Those banks that
had foreign branches were prepared to
counter these redemptions by borrowing

Euro-dollars through such branches. Al­
though the Euro-dollar market is generally
an expensive source of funds, the relatively
strong surge of money market rates in the
United States toward the end of 1965 had
narrowed considerably the differentials be­
tween domestic money market rates and the
rates on Euro-dollars. During the first half
of 1966 rates on 1-month Euro-dollars were
only about % of a percentage point higher
than rates on short-term negotiable CD’s
sold in New York City (Chart 2 ). This in­
terest rate differential widened over the bal­
ance of 1966 as interest rates abroad moved
upward. However, the cost disadvantage to
the eight City banks of acquiring Euro-dollars was partly compensated for, throughout
1966, by the fact that these liabilities were
not subject to reserve requirements or to
assessments by the Federal Deposit Insur­
ance Corporation.
Borrowings in the Euro-dollar market
constituted the major source of new funds
for the eight City banks during 1966. In
fact, they were the principal means by which
the City banks survived the severe drains
resulting from net run-offs of CD’s during
the last 4 months of the year. As Chart 1
shows, for the eight City banks, liabilities to
their own foreign branches climbed sharply
between June and December from a plateau
reached near the end of the first quarter of
1966. For the year as a whole, net borrow­
ings of Euro-dollars by the eight City banks
rose by $ 1.8 billion, an amount roughly
equivalent to the decline in CD liabilities.
As a group these banks stepped up their
Euro-dollar borrowing fully 2 months before
the heavy redemptions of CD’s began. Con­
sequently, the basic reserve position of these
institutions improved sharply, though tem­
porarily, in August and early September.
Although virtually all of the eight City
banks used Euro-dollar borrowings to offset
CD losses (Chart 3 ), the timing differed








Data for Federal funds are the 7-day average rate for week
ended Wednesday; for new negotiable C D ’s, the rate most often

quoted on Wednesday by nine large N ew York City banks; and
for Euro-dollar deposits, the Wednesday rate.
F. R. Bank of New York data.

from one bank to another: Some borrowed
Euro-dollars considerably in advance of CD
run-offs. Some built up liabilities to foreign
branches gradually over the period of CD
outflows, compensating for losses of funds
as they occurred. Others did not begin to
seek such funds until a downward trend in
their CD liabilities had become clearly vis­
ible. And still others borrowed heavily at
first, then allowed these foreign liabilities
to remain on a plateau until the latter part of
the year when the greater portion of interestsensitive CD funds had been withdrawn.
Most of the cumulative borrowings of Euro­
dollars by the eight City banks corresponded
roughly to their cumulative CD losses. At

two institutions, however, borrowings of
Euro-dollars were quite heavy relative to
CD run-offs.
Although little is known about the ma­
turities of Euro-dollars borrowed by the
eight banks, it seems reasonable to assume
that some of the aggregate represented over­
night or call money, while a relatively larger
amount represented funds that had been ac­
quired by the foreign branches on longerterm contracts. Maturities may have varied
widely from bank to bank, however, since
some overseas branches characteristically
short-term Euro-dollar
whereas others seek somewhat longer ma­

Cum ulative change at eight City banks, Mar. 16 to Dec. 28, 1966

F. R. Bank of New York data.

In order to increase the availability of
Euro-dollars for its domestic lending op­
erations, one of the eight City banks began
in April 1966 to sell negotiable CD’s de­
nominated in Euro-dollars at its London of­
fice at yields slightly lower than those avail­
able for comparable maturities of regular
Euro-dollars. At the same time it organized
a secondary market for these Euro-dollar
CD’s. Within a short time the majority of
other money market banks with branches in
London had begun to sell these instruments.
By offering CD’s in relatively small de­
nominations— a minimum of $25,000 com­
pared with a regular Euro-dollar deposit
minimum of $250,000 and a minimum of
$100,000 for a domestic negotiable CD—
the banks set their sights on the funds of
small investors, who had not previously par­

ticipated in the Euro-dollar market. In addi­
tion, however, the City banks hoped to ac­
quire Euro-dollars at a reduced cost and to
improve their ability to retain funds that
might otherwise be lost through the redemp­
tion of domestic CD’s by foreign holders in
the event of increases in interest rates here
or abroad. One advantage of selling Euro­
dollar CD’s in London is that these CD’s are
not subject to any rate limitation such as
that imposed on domestic CD’s by Regula­
tion Q. As it turned out, the creation of the
Euro-dollar CD market did not add sig­
nificantly to the supply of Euro-dollar de­
posits in foreign branches of the major
money market banks, but it illustrates the
resourcefulness of these institutions in at­
tempting to locate new sources of funds for


Other sources

Although needs for new loanable funds were
intense during 1966, the eight City banks
did not rely on sales of U.S. Government
securities as a source for new loanable funds
after the first quarter. In periods of seasonal
increases in loan demand the banks did re­
duce their Government securities portfolios;
but then later, as the acute pressures eased,
they made net purchases. The use of the
U.S. Government securities portfolio as a
temporary adjustment mechanism con­
trasted sharply with its use as a more or less
permanent source of funds earlier in the
business expansion. During 1965, for ex­
ample, net sales of U.S. Government secur­
ities had been a major source of new loan­
able funds for the eight City banks, second
only to the issuance of negotiable CD’s. In
the first quarter of 1966 further liquidation
of such investments had provided another
$ 1.1 billion of loanable funds (as can be
seen in the lower panel of Chart 1 on page
The reduced reliance on the U.S. Govern­
ment securities portfolio as a source of funds
with which to meet accelerating loan de­
mands was primarily a reflection of the low
level of such holdings. By March 1966 the
combined U.S. Government securities port­
folio of the eight City banks had been re­
duced to its lowest level of the postwar
period as a result of the sustained liquidation
that had begun late in 1961. At this level
the bulk of the securities remaining in port­
folio may have been pledged against public
deposits and hence, were not salable.
Another factor tending to discourage sales
of securities by the eight City banks in the
summer of 1966 was the sharp increases in
market yields, which raised the cost, in terms

2 11

of capital losses, of liquidating coupon is­
In view of the sharply lower level of their
U.S. Government securities portfolios, these
banks— like most others— added to their
loanable funds in 1966 by selling State and
local government securities from their hold­
ings. But such sales were not enough to
meet the rising demands for funds, and pres­
sures in financial markets continued to rise.
Liquidation of these and other invest­
ments by banks after September 1 ran coun­
ter to the expressed wishes of Federal Re­
serve System policy-makers. Through public
statements, periodic counseling of individual
member banks, and the administration of
the discount window, System officials left no
doubt after that that they looked with dis­
favor upon further reductions in bank in­
vestments— and of holdings of tax-exempt
securities in particular— especially when ac­
companied by a sustained rate of expansion
in business loans. Member banks that en­
gaged in large-scale liquidation of such
securities thus tended to invite closer scrut­
iny if they should request discount accom­
modation at the Reserve Banks.
However, because of their relatively lim­
ited use of discount facilities during 1966,
for the eight City banks the possibility of in­
creased surveillance at the discount window
was not a significant restraint on liquidation.
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 second 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 34-year
high by August 1966.

2 12

The eight City banks generally operated
with substantial basic reserve deficits during
1966 (Chart 4 ). On occasion during the
first 8 months of the year, their combined
reserve positions underwent sharp, tempor­
ary improvement as a result of inflows of
CD funds and liquidations of securities, and
as a result of substantial Euro-dollar bor­
rowings during the summer months before
the heavy run-offs of CD’s began. During
the latter part of the year, however, the basic
reserve deficit worsened as a result of the
drastic decline in CD liabilities after midAugust. Consequently, the daily-average
basic reserve deficiency of the eight City
banks rose to nearly $500 million in the
fourth quarter of 1966 from roughly $350
million during the first three quarters of the
While their needs for funds to cover re­
serve requirements were consistently large
during 1966, the eight City banks made
relatively little use of borrowing facilities at

the Federal Reserve Bank. As shown in
Chart 4, substantial increases in the basic
reserve deficiency prompted only moderately
increased use of the discount window. More­
over, whatever borrowing these institutions
did at the Federal Reserve Bank was in­
variably the traditional overnight or short­
term type of accommodation. None of the
eight City banks took advantage of the
privilege of extended discounting offered in
the System’s September 1 letter to member
banks, despite the increase in basic reserve
deficits during the fall of the year.
The hesitancy of the City banks to ap­
proach the Federal Reserve Bank for assist­
ance, except at times of extreme emergency,
reflected in part the unwillingness of these
institutions to have their lending and port­
folio adjustment practices subjected to offi­
cial scrutiny. Moreover, they could now
meet a larger part of their needs for funds
by borrowing in the Federal funds market
than they could have in other recent

AT F.R. BANK, 1966-68: Eight City banks










Data are daily-average levels for weeks ended on Wednesday. Basic reserve position is 2-week moving averages.
F. R . Bank of New York data.



years. In the early 1960’s the City banks had
begun to borrow Federal funds from other
banks for the purpose of relending, particu­
larly to Government securities dealers, as
well as for the purpose of making day-to-day
adjustments in their reserve positions. As a
rule, rates on such funds were below the dis­
count rate in that period. But as the Federal
funds market broadened, the rate for Fed­
eral funds rose relative to the discount rate
and generally exceeded the latter after 1964.
Throughout 1965 the spread was about 10
basis points.
During 1966, however, the margin by

which the effective rate for Federal funds ex­
ceeded the discount rate began to widen and
by mid-June it was almost a full percentage
point (Chart 2 ). The sharp increase in the
differential reflected the City banks’ efforts
to operate without assistance from the Fed­
eral Reserve Bank as well as their continued
use of Federal funds to meet credit demands
of Government securities dealers and others.
In 1966, to an even greater extent than be­
fore, the eight City banks were permanent
debtors in the Federal funds market— auto­
matically renewing overnight loans and bor­
rowing for periods of more than 1 day.

Between December 1965— the time of the
increase in the discount rate— and August
1966, the eight City banks raised their prime
lending rate to business borrowers in four
steps from 4 Vi to 6 per cent. These increases
were dictated in large part 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 increases in the
prime rate— particularly those that occurred
in June and August— were also intended to
discourage loan applications from business
borrowers, they seem to have had little effect
on total loan demand.
Early in 1966 many of the eight City
banks adopted programs amounting, in ef­
fect, to voluntary credit restraint. These pro­
grams, 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 sig­
nificantly. Under these programs the City
banks denied requests for loans that 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 the size of
loans and lines of credit. Moreover, the
banks reported that they made fewer loans
at the prime rate and that they also raised
compensating balance requirements.
At the same time, however, the eight City
banks were hesitant to turn down loan re­
quests from old customers, or from new cus­
tomers whose business they had long so­
licited. For competitive reasons, as well,
some banks apparently reversed their origi­
nal position not to issue, for a fee, formal
commitments for revolving credits or term
loans even though they realized that a large
volume of outstanding commitments would
seriously limit their flexibility in time of
Despite the banks’ efforts and procedures
to restrain expansion in credit, and despite
their successive increases in the prime rate,
net increases in business loans of the
eight City banks in the second and third
quarters of 1966 exceeded the amount of
the increases in the corresponding quarters
of 1965 by roughly two-fifths. Not until the
fourth quarter of the year did business lend­


ing fall off. In that period the net increase
declined sharply to a less-than-seasonal $0.4
billion from $ 1.1 billion in the fourth quar­
ter of 1965.
This rather drastic change in the pattern
of business lending, however, probably re­
flected a slowdown in corporate demands as
much as efforts by the City banks to curtail
lending. Two factors that had contributed
significantly to the vigorous demand for
loans earlier in 1966 were no longer present
during the fourth quarter. Expectations of
further increases in interest rates had disap­
peared for the most part, 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 had announced a fiscal program to
combat inflation, and the U.S. Treasury had
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 many expected that an increase in in­
come taxes would be approved after the
November elections. By the end of Novem­
ber 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 had been in­
structed on November 22 to conduct open
market operations “. . . with a view to attain­
ing somewhat easier conditions in the money
market. . .
August 1967 (revised July 1968)