Full text of Review (Federal Reserve Bank of Dallas) : October 1979

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El Paso' Houston' San Antonio

October 1979
1 Fed Initiates Three Policy Actions
2 From Hearings on Monetary Policy and Inflation:
Statement by Paul A, Volcker, Chairman,
Board of Governors of the Federal Reserve System
8

Family Budgets and Inflation: Spending More! Enjoying It Less?

10

After the Peak?

13

Noncash Collection Service Modernized

16

Profitability of Bank Loan and Investment Functions:
Large Variations Among Banks

24

Collateral Procedures Uberalized at Fed'. Discount Window

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Fed Initiates Three
Policy Actions
In view of accelerating inflation, continued rapid
growth in money and credit, heightened speculation in commodity markets, and downward pressure on the dollar, the Federal Reserve initiated
three policy actions in early October.
The discount rate was increased from 11 percent to 12 percent. This is the rate member banks
pay when they borrow from their Federal Reserve
Bank.
An 8-percent marginal reserve requirement on increases in "managed liabilities" of member banksliabilities that have been actively used to finance
continued rapid expansion in bank credit- was established,t This means that the cost of these sources
of funds is increased insofar as the amount exceeds
the aggregate level in a base period in September
or $100 million, whichever is greater. These lia~
bilities include la rge time deposits, Eurodollar horrowings, repurchase agreements against U.S. Government and Federal agency securities, and Federal
funds borrowed from nonmember institutions.
Finally, and possibly most important, a change
was made in the method by which open markel
operations are conducted. This action places
greater emphasis in day-to-day operations on th e
supply of bank reserves and less emphasis on
confining sho rt-term fluctuations in the Federal
funds rate to a narrow range. Over recent years
the Federal Open Market Committee has fixed a
relatively narrow range for the weekly average
1. This marginal reserve req uirement also applies to U.S.
branches and agencies of foreign banks with worldwide
~ssets over $1 billion and to Edge Act corporations.
October !979/Voice

Federal funds rate as it has attempted to influence
the pace of monetary growth. To help achieve bet~
ter control over money and credit growth, the Fed~
eral Reserve will focus on the supply of reserves
and permit much wider fluctuations in the Federal
funds rate, day to day and week to week, in response to supply-demand forces in the market.
These actions will affect a number of banks in
the Eleventh Federal Reserve District. The increase
in the discount rate will affect any member bank
that borrows from the Federal Reserve Bank of
Dallas. During the fourth quarter of 1978, 81 member banks in this District borrowed at the discount
window an average daily amount of $110 million.
The greatest number of banks to borrow in any
three-month period occurred in the fourth quarter
of 1974, when 93 member banks borrowed an
average daily amount of $136 million.
The 8-percent marginal reserve requirement on
increases in the aggregrate amount of managed
liabilities will affect relatively few banks in the
Eleventh District. For the most part, only the
largest banks will exceed $100 million in managed
liabilities- the base amount above which the marginal reserve requirement is effective. Probably
fewer than 40 banks in this District will be affected.
The change in open market operations will have
a moderate effect on all banks that sell or purchase
Federal fund s, insofar as the range of rates for
individual days and from day to day may be significantly greater than in recent years.
The package of policies, overall. is intended to
reduce the recent rapid growth in total bank credit
and money to slower. less inflationary rates.
1

From Hearings on
Monetary Policy
and Inflation

Statement by
Paul A. Volcker. Chairman
Board of Governors of the Federal Reserve System
Washington, D.C.
before the
Committee on the Budget
U.S. House of Representatives
September 5, 1979

Mr. Chairman, members of this distinguished
Committee:
r am pleased to be able to participate in these
hearings on the Second Concurrent Budget Resolution for fiscal 1980. I might say that on receiving
your invitation, I felt it a bit incongruous that my
first appearance before a committee of the House
as Chairman of the Federal Reserve Board would
occur in the context of consideration of fiscal,
rather than monetary, policy. But the plain fact is
that our nation faces serious problems that require
interrelated governmental action, involving aU of
the main instruments of economic policy. No place
are the interrelationships more important than in
the area of fiscal and monetary policy. I hope that
2

our dialogue this afternoon will help throw !igh t
on the proper role for those instruments in today's
setting.
Surveys and other evidence indicate that the
most pressing economic concern of the American
people today is the persistent and rapid rise of
prices. In my judgment, that concern is not misplaced.
As you know, the acceleration of inflation this
year can be traced in considerable part to so-called
exogenous forces-the rise in food prices, and
much more importantly, the decision of the OPEC
countries to raise oil prices in an amount that, in
absolute terms, approaches the increase in 1973
and 1974. But even in appraising these sources of
inflationary pressure, I believe it would be wrong
to consider them independent of more general inflationary pressures in the United States and elsewhere. For instance, the desire of oil suppliers to
recover losses in real income implied by rising
prices of other goods and the weakness of the dollar appeared to be one factor contributing to the
OPEC pricing decision. Moreover, part of the challenge to economic policy today is to avoid to the
extent possible a kind of "leapfrogging" process
whereby rising prices and costs in one sectorenergy is the notable case-set off a whole sequence of adjustments in wages and prices in other
sectors as workers and business engage in a vain
attempt to achieve and maintain levels of real purchasing power that simply cannot be sustained in
an economy experiencing higher real energy costs
Federal Reserve Bank of naUal

and virtually no growth in productivity.
To be sure. the impact of inflation is uneven.
Those on fixed incomes suffer, while some people
who are well positioned-either by clever design
or by good luck-do manage to increase their
wealth. Even for the fortunate, however. such a
result is at best precarious. frequently built on
heavy indebtedness or highly speculative investments. In an environment of virulent inflation. such
as we find ourselves in today, there are no reliable
havens, and so the discomfort of our citizens is
hardly surprising.
Even these capricious effects on individuals and
the related concern reflected in the surveys do not
capture the insidious and debilitating effects of
inflation and inflationary expectations on our economic performance and growth prospects. It is not
entirely a coincidence that we can observe in these
recent inflationary years a declining tendency in the
profitability of investment. Calculations differ because of the accounting problems associated with
changing prices. However, one estimate indicates
that the annual after-tax return on corporate net
worth, measured. as it reasonably should be, against
the replacement cost of inventories and fixed assets. has averaged 3.8 percent during the 1970's,
a period characterized by rapid inflation, as compared to 6.6 percent in the 1960's. At the same
time, the uncertainty about future prospects associated with high and varying levels of inflation
tends to concentrate the new investment that does
take place in relatively short, quick payout projects. Or firms may simply delay investment commitments until the pressures of demand on capacity
arc unambiguously compelling-with the result
that capacity pressures can become strong even
before the labor force is fully utilized.
In other areas, inflationary expectations are reflected in a diversion of energies into essentially
speculative activities- ranging from the "froth"
of investing in art objects to the considered purchase, at the expense of heavy indebtedness, of
larger or second homes as an inflation hedge. When
returns from these activities are often judged
greater than from usual patterns of work and
saving, normal incentives are plainly distorted in
a manner inconsistent with orderly growth.
Another obvious result of our distressingly poor
price performance has been the recurrent weakness of the dollar in foreign exchange markets.
During much of 1978. the cumulating decline in
the value of the dollar abroad added an important
October 1979/Voic:e

further element of uncertainty and instability to
the United States and other economies. Following
the vigorous program introduced in November of
last year, the dollar rose somewhat against other
major currencies, helped by an improvement in
our current account and by indications of a relative strengthening of economic expansion abroad.
But the value of the dollar internationally began
to be questioned again as the trend of U.S. inflation worsened noticeably, and as many of our
trading partners acted forcefully to retard inflationary tendencies in their own economies. Although the situation in exchange markets appears
to have stabilized recently, that stability ultimately
rests on our ability to cope with inflation.
We need to deal with inflation and a vulnerable
dollar in the context of the slowing in domestic
economic activity that developed in recent months,
A moderation in the growth of aggregate demand
was welcome this year-even essential-if the
economy was to avoid the kind of pressures on
capacity that could only aggravate inflationary
forces. Policies of monetary and fiscal restraint
were directed toward that aim. Now it is apparent
that the drain of purchasing power implicit in
the sudden run-up in our oil import bill and
in energy prices generally-combined with the actual and feared shortages of gasoline-has led to
a contraction of real incomes and final demands.
During the second quarter, real gross national
product fell, primarily reflecting a drop in consumer spending, and further declines in some
areas of business activity continued into the summer. With sales falling, businesses have experienced some involuntary accumulation of inventories- most strikingly in the auto industry. but
to a lesser degree in other sectors as well.
Our reading of the most recent eCOnomic indicators suggests that a correction of these inventory imbalances is well under way. Orders have
been reduced, production schedules have been cut
back, and hiring has slowed. These adjustments
need not by themselves set in motion a deep or
prolonged contraction in activity. Indeed, while
the inflationary process itself has introduced important new uncertainties, some of the economic
and financial dislocations and imbalances that
usually have presaged severe cyclical declines
have been avoided. To be sure, the transfer of
income to foreign oil producers will continue to
exert a depressing effect on aggregate demand
over the near term. But the position taken in the

,

Board's midyear report to the Congress-that the
economy should grow moderately in 1980-still
seems reasonable.
In the present circumstance, we need to be
especially cautious in interpreting any business
forecast; there are vulnerabilities in the present
situation on the downside, and there is also the
possibility that the downturn will prove shorter
and shallower than many now expect. The shaping of policy must appreciate and take account
of the risks on both sides. For instance, the traditional response throughout the postwar period
to any prospect of declining production and rising unemployment has been a sharp shift in monetary and fiscal policy toward expansion and the enhancement of aggregate demand-even at the risk
of adding to inflation. A decade or two ago, with
prices historically fairly stable, that risk was discounted. But now we have to face squarely the adverse consequences of premature or unduly large
moves to stimulate the economy. In exacerbating
the already serious problems of inflation and the
dollar, such moves would also feed back on the
underlying problems of investment, productivity,
and growth.
Some observers have suggested that this situation presents an intractable dilemma for policymakers: the need to sacrifice one set of economic
goals in the pursuit of another. But this dilemma
seems to me more apparent than real. Even in the
relatively short run, premature stimulative actions
could well prove ineffective rather quickly, and
even counterproductive, as their force is dissipated
in higher prices rather than real growth-in more
uncertainty, rather than less. Ultimately the perceived "trade-off" between unemployment and inflation would only be worsened. That is the lesson
of the 1970's, not just in the United States but
elsewhere.
I think we would all agree that, over the years,
labor and product markets have developed an increasing sensitivity to inflation. Expectations about
inflation are an important factor in wage bargaining, in price setting for many goods and services.
and certainly in interest rates. The plain danger
is that actions rightly interpreted as doing little
or nothing toward dealing with our underlYing
persistent problems of productivity and investment, but all too likely to produce more inflation,
will in fact have only a small and short-lived ex.
pansionary effect, regardless of their intent. Our
ability to avoid future instability in employment,

•

or to deal with chronic unemployment in urban
areas and among our young, would be damaged,
not enhanced.
Similar behavior dominates the foreign exchange
markets: exchange rates usually respond quicklyand sometimes excessively-when incoming economic data or news about policy actions alters the
outlook for inflation. Adverse repercussions on the
dollar generate in turn new uncertainty and inflationary pressures, partly because of the direct
effects on costs of imports and partly through the
reduced competitive restraints on prices of domestically produced goods. We have tasted too
much of the vicious circle of domestic inflation and
external depreciation to want to see that pattern
repeated. The dangers would extend beyond the
domestic economy. Because of the dollar's role as
an international store of value and medium of exchange- a role we cannot simply shrug off or dismiss consistent with our own interests and those of
our trading partners-its instability could pose a
major threat to the world system of finance and
commerce and even to our political leadership.
Obviously, then, our current economic difficulties
are tightly interwoven. They will not be resolved
unless we deal convincingly with inflation. Progress won't come easily or suddenly; among other
things the adjustment in prices of energy and petroleum-based products is far from complete. But
what we can do-what we must do-is begin the
process and prevent the inevitable rise in real
energy prices from fanning out into an acceleration
of general inflation.
Monetary and fiscal policies are not the only tools
we should bring to bear. But both monetary discipline and fiscal discipline-policies that are seen
to be disciplined- are absolutely basic to restoring
and maintaining a greater sense of stability.
For its part, the Federal Reserve intends to continue its efforts to restrain the growth of money
and credit, a growth that in recent months has
been excessive in terms of our own 1979 objectives-objectives that have only recently been
reviewed by our congressional oversight committees. Those efforts, combined with heavy credit
demands, have had the visible consequence of
some increases in short-term interest rates as the
availability of reserves has been limited through
open market operations. But J would also note
that the impact on longer-term securities markets,
generally considered more important for business
decisions, has been small. We seem to have here
Federal ReNrve Bank of DaHas

an illustration of the more general proposition
that actions to deal with the sources of inflationary
pressure should over time have a constructive
influence in restoring more stable and healthier
financial and economic conditions.
I frankly do not know whether needed restraint
on monetary growth will be reflected in further
increases in short-term rates; that will depend on
the course of economic activity, credit demand,
and other factors. But I do know that credit flows
at present are generally well maintained, and no
sustained decline in nominal interest rates can
reasonably be expected in the absence of a discernible slowing in the underlYing trend of
inflation.
Meanwhile, the moves in the direction of fiscal
restraint by the Congress and the Administration
have been a key ingredient in setting the stage for
a successful anti-inflationary effort. Substantial
progress has been made in the past year toward
reduction of the Federal budget deficit. Potentially
more significant, in terms of the longer-range outlook, is the sense of greater control on spending
that has been achieved by the efforts of this Committee and others.
Of course, the deficit has remained high, even
after years of business expansion, and reductions
in spending relative to GNP have been modest so
far. Moreover, with the economy likely to be sluggish in the months ahead, the operation of automatic stabilizers could lead to a temporary widening
of the gap between expenditures and receipts. That
in itself need not be disturbing- if budgetary decisions do not seem to throw us off the track of
restoring budget balance and restraining expenditures as the economy picks up. However, legitimate
doubts would be raised by sizable new spending
orograms not matched by savings elsewhere; indeed, such an approach would directly challenge
our ability to eliminate future deficits and could
only add to skepticism over the commitment to
contain inflation. Similar doubts would be aroused
by a premature commitment to tax reductionwelcome as such reductions would be over a period of time. I believe that we should be particularly wary of tax reductions that might have a
transitory effect in adding to the purchasing power
of consumers but that would accomplish little or
nothing toward stimulating investment, cutting
costs, or improving work incentives. For these
reasons, the members of the Federal Reserve Board
believe both the Administration's budget proposals
October 1979/Voh:e

and the Second Concurrent Budget Resolution
recommended by the Senate Budget Committee
represent a broadly appropriate and desirable commitment to hold the line on spending, to avoid
premature tax cuts, and to contain the size of the
deficit.
As I noted earlier, a broad range of uncertainty
must be assigned to any forecast of economic
events, particularly in view of the obvious vulnerability of the economy to a variety of exogenous
forces. In that connection, we cannot entirely exclude the possibility of recessionary tendencies
cumulating and intensifying, even if it would be
wrong to have current policy decisions dominated
by that single possibility. There is much more
danger- in terms of aggravating the inflationary
momentum-in prematurely anticipating the most
unfavorable hypothesis than in dealing in the most
orderly and effective way we can with the clear
and present fact of inflation.
Should economic trends develop in a clearly unfavorable direction and action come to be needed
to deal with sharp declines in output and employment, it would be crucially important that those
actions be integrated with the longer-term needs
of the economy. Specifically, any fiscal actions
should be designed to minimize any inflationary
impact in the short run while helping to deal positively with some of the sources of inflationary
pressures in the long run. Cost-cutting and incentive-building tax reductions broadly meet this
criterion; few spending programs do. We need to
give much more weight than in the past to the need
for both tangible capital formation and research
and development, for these activities underlie productivity growth.
I need not emphasize that even well-designed
tax reduction-reduction that could have important payoffs over time in improved productivity
and reduced cost pressures-has a cost in terms
of transitional deficits and increased competition
in the credit markets. Tax reduction, however
desirable over time, needs to be earned by a sustained commitment to spending restraint. Prematurely timed or poorly structured, the potential
gains could be swamped by adverse effects in an
inflation-prone economy.
The monetary and budgetary policies that I
have discussed seem to us in the Federal Reserve
essential if our commitment to controlling inflation
and stabilizing the dolIar is to have meaning. They
would lay the groundwork for changing expec-

,

tations about inflation in the short run and for
renewed growth and stability over a longer period
of time. I would emphasize that other efforts, in
the areas of wage-price policy, regulatory reform,
and the encouragement of market competition,
are important as welL We also must deal with our
energy situation, one that today leaves us vulnerable to fore ign sources of supply. But none of
these policies, important as they are, can substitute for commitments to fiscal prudence and res traint on the money supply.

Public concern is high- but out of that concern
grows awareness of the pressing need to solve
our inflationary problem. Therein lies our opportunity. I would suggest the American people are
coming to understand that there are no easy answers, but that failure to act consistently and
forcefully can only lead to worse results, both for
the vitality of our economy and for our world
leadership. Your budget making is quite clearly a
key element in the process.

Federal Reserve Board
Solicits Comments
on Proposed Amendments
to Regulation T
Federal Reserve Regulation T deals with credit extensions by securities brokers and dealers to their
customers. The regulation limits the amount of
credit that may be extended to customers for purchasing or carrying securities, based on the amoun t
of cash and margin securities in their accounts.
The overall purpose of the margin requirements is
to prevent the excessive use of credit for purchasing or carrying widely traded securities.
The Board of Governors of the Federal Reserve
System has solicited comments on two proposals
to amend Regulation T. The first proposal would
permit brokers and dealers to extend credit on
mutual fund shares that are fully paid for and
deposited in a general account. Currently, only
banks and Regulation G lenders are permitted to
extend this credit. The Securities Exchange Act
of 1934 established that credit cannot be extended
on the initial purchase of these securities, and this
6

rule would not be changed by the amendment to
Regulation T. Only mutual fund shares that are
fully paid for would be affected by approval of
the first proposal.
The second proposal would permit options specialists to both purchase and sell short the stock
underlying the options in which they specialize,
with a 25-percent margin requirement. No maintenance requirement is imposed in this revision unless the account, if sold out, would have an unsecured debit balance. Further proposed revisions
would make it easier for options specialists to
perform their market-maki ng function.
Interested persons were invited to submit comments to the Board of Governors through October
15, 1979. Further information about specific features of the proposals may be obtained by contacting Consumer Affairs. Federal Reserve Bank of
Dallas, (214) 651-6171.
Federal Reserve Bank of Dallal

Federal Reserve Board to Revise
Truth in Lending Regulation

The Board of Governors of the Federal Reserve
System is revising Regulation Z and issued a proposal on July 25 to amend various sections of the
regulation. The revisions mainly pertain to the
degree of accuracy and treatment of payment
schedule variations in the calculation and disclosure of the annual percentage rate on loans to
consumers.
One of the most important disclosures required
by the Truth in Lending Act is the annual percentage rate, which provides a uniform standard consumers may use in comparing credit sources. It
measures the cost of credit fOf a given transaction
by expressing in percentage terms the relationship
between the amount financed and the finance
charge.
The Board is reviewing five issues: tolerance,
number of decimal places, ignoring irregularities,
accounting for irregularities, and reliance on charts
and tables.
The following is a synopsis of the new revisions
being examined by the Board:
1. Tolerance. The Board proposes that a unifonn
tolerance be applied in reporting the annual percentage rate for credit transactions. Currently, the
rate has to be disclosed as either an exact figure
or rounded to the nearest one-fourth of 1 percent·
age point. The Board favors a fixed tolerance of
one-eighth of 1 percentage point in either direction
from the exact annual percentage rate.
2. Number of decimal places. In the Board's
view, specification of the exact number of decimal
October 1919/Volce

places to be used in calcula ting and disclosing the
annual percentage rate is unnecessary. However,
with respect to open-end credit, the Board does
encourage specifying the number of decimal
places.
3. Ignoring irregularities. The Board proposes
amending Regulation Z to permit all creditors, in
making disclosures in closed-end credit transac·
tions, to disregard the effects of rounding of payment amounts to whole cents and changing the
dates of scheduled payments and advances that fall
on a Saturday, Sunday, or holiday. In addition, the
Board proposes to adopt a special rule to simplify
calculation and disclosure of the finance charge
and other credit terms by creditors in closed-end
credit transactions assessing finance charges on a
simple interest basis.
4. Accounting for irregularities. The Board is
seeking a new method to determine the length of
an irregular period, which, if adopted, would revise
Supplement I of Regulation Z. However, creditors
would not be bound to use this method in counting
odd days, so long as their method for accounting
for irregularities produces a rate within the tol·
erance limits of the regulation.
S. Reliance on charts and tables. The regulation
now maintains that an annual percentage rate or
finance charge error that results from an error in
a chart or table used by the creditor does not violate Regulation Z. The Board proposes to extend
this provision to include calculators and computers
that have fau1ty hardware.
7

Family Budgets and Inflation:
Spending More! Enjoying It Less?
By Mary G. Grandstaff

Most Americans always feel a strain on their budgets. For many, inflation draws the strings tighter.
As prices continue to rise at rapid rates and the
distribution of income deviates from its "usual"
patterns, more and more consumers are surprised
to find they must lower their level of living as
expenses press upon their disposable income. The
surprise is no less a shock. albeit less painful, to
those situated so they can raise their spending
levels apace with inflation than to those unable to
do so.
The urban family budget figures published annually by the U.S. Bureau of Labor Statistics provide estimates for costs of three standardized
levels of living- lower, intermediate. and higher.
In each of these budgets, the hypothetical family
consists of a husband that is an experienced worker and is employed full time, a nonworking wife,
a boy in his early teens, and a younger girl. The
budgets do not reflect how real families actually
do or should spend their money, nor are they intended to specify any minimum income or standard-of-living levels. Instead. they reflect the
assumptions made about the manner of living of
the family at each of the budget levels. Costs of
constant supplies of goods and services are adjusted to reflect the impact of inflation.
Analysis of the budget estimates indicates how
rapidly the costs of these standardized levels of
living have increased in recent years. The estimated intermediate-level budget for the urhan family of four in the United States rose at an average
annual rate of 8.1 percent between 1973 and 1978
to $18,622. The lower-level budget rose at an average annual rate of 7.1 percent to $11.546, while the
highest budget rose at an 8.5-percent average annual rate to $27,420.
The intermediate budget in the four southwestern metropolitan areas included in the Labor Bureau's annual family budget estimates averaged
from $16,211 to $17.114 in the autumn of 1978.

•

According to the budget estimates, Houston had
the highest intermediate cost of living among the
four areas. Not far behind. though. were Baton
Rouge, Dallas, and Austin. in that order.
Between 1973 and 1978, the intermediate family
budget rose at average annual rates of 7.9 percent
in Dallas. 8.1 percent in Austin and Baton Rouge,
and 8.6 percent in Houston. The higher-budget
costs rose slightly faster, while lower-budget costs
increased at slightly slower rates. Analysis of the
data indicates, however, that costs of goods and
services-consumption costs-did not always keep
pace with total budget costs. Estimated costs for
goods and services rose less rapidly than total
costs in all four areas for higher-budget families
and in each area except Austin for intermediatebudget families. For lower-budget families, on the
other hand, costs of goods and services rose faster
than the total budget because their income tax
burdens were smaller.
Each year since 1973, the base andlor rate for
social security taxes has risen. The increases have
had the greatest im pact on higher-budget famili es,
but even lower-budget families have experienced
higher growth rates for these taXes than for their
total budget.
Inflation and the progressive nature of income
taxes have also greatly boosted the tax burden for
many consumers. Again, the higher-budget families have received the largest negative impact
from higher income taxes. For these families,
personal income taxes rase at average annual rates
that were 3.9 to 4.5 percentage points fa ster than
for total consumption costs between 1973 and 1978.
For intermediate-budget families. personal income
taxes rose at average annual rates 1.2 to 2.2 percentage points faster than those for consumption
costs.
In most instances, inflation also increased the
cost of basic necessities more rapidly than discretionary items. As a result. the proportion of
Federal Reserve Bank of Dallal

Higher taxes and increased prices of essential items
have accounted for most of the growth in family budgets
in four selected southwestern metropolitan areas
AUSTIN,
TEXAS

~~~,,~,,~,,~~~ TOTAL BUDGET

•••••••••••••••••• 1 TAXES
111111111111111111111111111111111111111111111111111111 FOOD , HOUS lNG,

~
8ATON ROUGE,
LOUISIANA

~~~~;:~~:~:'ON,

~~""~,,~~,,~~

••••••••••••••••••••

11111111111111111111111111111111111111111111111111

~~.H"'.H"'~ OTHER GOODS AND SERVICES

DALLAS,
TEXAS

~""""""""~~""""~
•••••••••••••••••• 1
1111111111111111111111111111111111111111111111111111

~.H"'~
HOUSTON,
TEXAS

~,,~~"""~,,~~~,,~

•••••••••••••••••••••
11111111111111111111111111111111111111111111111111111111

~.H"'~.H"'~

o

10

5

15

PERCENT
AVERAGE ANNUAL RATE OF INCREASE, 1973-78,
FOR INTERMEDIATE-BUDGET FAMILIES

SOURCE: U.S. Bure a u 01 labor Stalistics.

budgets allocated to less essential goods or deferrable items fell for all three budget levels in each
of the four urban areas between 1973 and 1978.
And the proportion of the budgets that covered
essentials rose in each instance except in Baton
Rouge; for the intermediate- and higher-budget levels there, the proportions of the budget allocated
October 117t/Voice

for food and housing both declined. But generally,
the most rapid price increases in recent years have
occurred in medical care, housing, transportation,
and, sporadically, food.

•

After the Peak?
Excerpts from an address by
Henry C. Wallicb, Member
Board of Governors of the Federal Reserve System
Washington, D.C.

to the
New York Society of Security Analysts
New York, New York
August 27, 1979

The recession anticipated by the Fed's forecast
is not of the V-shaped variety, as that of 1974-75,
but of the saucer type, like most postwar recessions. I would like to say a few words about the
general appropriateness of anticipating a recession
at this time, somewhat independent of the specifics
of the situation. If the expansion which began in
the spring of 1975 peaked out in the first quarter
of 1979, which remains to be seen, it would have
lasted approximately four years. This would make
it the longest peacetime expansion since World
War II, well in excess of the average duration of
cyclical expansions in peacetime. which has been
of the order of 2 to 3 years. Our economy has been
cyclical for as long as we have reliable records.
We have learned that our ability to curb the business cycle is far more limited than what Keynesian
economic theory, until quite recently at any rate,
has sought to make us believe. In view of all this,

,.

it does not seem to be unreasonable to say that the

expansion had probably run its course and that a
slowdown was "due."
The view that our economy is cyclical must contend. to be sure, with the historical fact that recessions do not fall into a single pattern. Inventory
fluctuations. induced by speculative accumulation
as the economy approaches capacity, have been
the most frequent ingredient. Fixed-investment
booms and recessions have also been a characteristic feature of many but not all cycles. Given the
lags built into the productive process, periods of
2 to 3 years seem to be sufficient to allow substantial imbalances in either inventory or fixed investment or both to occur that need to be worked off.
But it is quite possible for an expansion to proceed with sufficient moderation so that neither of
these imbalances arises. The expansion then could
go on without interruption as long as growth stays
within potential.
The recent expansion has been characterized by
an absence, broadly speaking, of the familiar inventory and investment excesses. It is significant,
therefore, that contractive tendencies nevertheless
are making themselves felt. This time it is consumption that is principally responsible for the
slowdown. Weak consumption is in part the result
of exogenous factors. such as the rise in energy
prices. But endogenous factors. too, are weighing
upon co nsumption , such as the mounting volume
of consumer debt. the low saving rate, and very
particularly the decline in consumer purchasing
power resulting from earlier price increases. We
must remember that the acceleration of inflation
which cut into income and consumption began
Federal Reserve Bank of Dalles

well before the rise in energy prices. It goes back
to 1978, when capacity limits were being approached. A dema nd-pull type of price rise originated then that was intensified by food and weather befo re impulses from the e nergy side took over.
Thus, by a different mechanism which did not involve inventory or investment excesses, the cyclical character of the economy has once more
asserted itself.
I believe that these cyclical characteristics of

to environmental restrictions, as well possibly as
defects in our methods of measuring capacity.
That oncoming shortage of capacity could be
seen a long time ahead, beginning in 1975. Investment during the expansion that began in 1975 was
low almost throughout its course. Business fixed
investment averaged about 9.6 percent of GNP
while numerous estimates suggested that continued growth at historic rates would require it to
be of the order of 11 or 12. When, during 1977,

our eco nom y need to be more clearly understood

unemployment declined dramatically 'Without a

and better kept in mind if we want to avoid repeating the policy mistakes of the past. If we treat
every recession as a unique event, surprising and
explainable only by the failure to adopt simple
and obvious remedies, we misread the facts. If
we conclude that recessions are simply mistakes,
due to nothing but the incompetence of economists
or the ineptitude of policy makers, we are likely
to take the wrong turn. We shall be driven to repeat the familiar sequence of policy switches since
1961 , from fighting unemployment to fighting inflation and back to fighting unemployment, with
each temporary objective inadequately attained
while the temporarily neglected evil was gathering strength. In this way we have ratchetted ourselves up to very high rates of inflation and at
times high rates of unemployment. A policy of
less fine tuning and greater steadiness, keeping in
mind both inflation and unemployment at all times,
seems better suited to the short-run cyclical character of our economy.
Next, I would like to examine some particular
features of our present situation. I shall begin with
the very high rate of inflation, which implies a
half-life for the dollar of something like 5 to 7
years unless materially brought down. As I noted
earlier, this inflation has had both endogenous and
exogenous origins, and at different times has refl ected both demand-pull and cost-push. The demand-pull phase began late in 1978. By historical
precedent, capacity utilization was still somewhat
below the levels at which capacity pressures and
supply limitations had tended to make themselves
felt. Tn the past, these pressures have been felt at
percentages in the high 80's for manufacturing and
at about 90 percent for materials. On this occasion,
pressure seems to have been felt in the middle 80's
for manufacturing and high 80's for materials.
Among the reasons for this seems to be obsolescence of some productive facilities owing to the
rise in energy prices since 1973, and perhaps also

commensurate increase in output or of capacity
utilization while fixed investment accelerated, earlier concern about an impending capital shortage
was temporarily muted. But the additional employment was mainly outside the manufacturing
sector, and economic growth was associated with
very low productivity gains. As it turned out, we
were indeed reaching capacity limits both of labor
and of capital. Policy moved too late to slow the
economy down for a soft landing. In the last quarter of 1978, a final surge of activity and an acceleration of inflation made clear where the productive
limits of the economy were situated.
Early in 1979, inflation received further impulses
from food and weather, as already noted, combined
with very poor productivity experience. Mounting
energy costs took over thereafter and are still at
work raising the producer and the consumer
price indexes.
The only favorable development in this picture
has been the moderate behavior of wages. Given
the decline in real wages since early 1978, which
has played an important role in the decline in
consumption, it would not be surprising to see a
strong effort on the part of wage earners to regain
lost ground. But since that ground is lost not only
to labor but to the entire economy as the OPEC
"tax" and shrinking productivity eat away at domestically disposable income, an effort to maintain
or increase standards of living would be doomed
to failure. It could only contribute to further inflation. That this has not happened so far is one
of the few elements of strength in our situation.
That it may happen in the near future is one of
our greatest dangers.
A similar risk existed in 1974, when the rate of
inflation reached 12 percent. Wages accelerated
very moderately following this development, as
indicated by the 1975 rise of 7 percent in hourly
earnings and of 8.5 in compensation per hour. The
risk that these increases might go into wages was

Octobe1' !97tI/Voice

11

avoided. In part this was probably due to th e fairly
tight policies maintained, at the cost of a substantial rise in unemployment. In 1976, inflation accordingly was cut by more than half, to a rate of
4.8 percent.
The evidence of the 1974-76 episode seems to
show th at inflation is capable of being reduced.
Our aim during this new round of double-digit
inflation must be to make possible a similar reduction by preventing the inflation from spilling over
into wages, without a commensurate cost in unemployment. Once inflation does enter into wages,
the wage-price spiral tends to prevent reduction
in inflation, as th e experience of the last 50 years
makes clear.
Labor income in the aggregate did not suffe r
damage from the 1974-75 wage restraint, relative
to the share of other income recipients. Labor's
share in GNP was 61 percent in 1973, 62 percent
in 1974, and 61 percent in 1975. Undoubtedly there
were shifts within labor income between strong
and weak bargainers.
An important ingredient in the present inflation
outlook is the position of the dollar on foreign exchange markets. The impact of exchange rate depreciation on the domestic price level has turned
out much la rger than many observers expected. The
need to maintain a strong dollar is enhanced
accordingly.
Of the three principal factors that affect the
exchange value of the dollar-the current account
balance, inflation, and interest rates-only the first
is clearly moving in favor of the dollar. Fortunately, it has also revealed itself as the most powerfu l, at least in the short run. Activity in the United
States is deceleratin g while abroad it is still going
at a good, although oil-diminished, rate. Our current account, by the end of the year, should be
again moving toward surplus. It can be expected
to go into surplus in 1980. Historically, the income
effect, reflecting GNP movements, has always
proved much stronger than the price effect, reflect-

12

ing the real exchange rate, in shaping the current
balance. That should be decisive in the present
situation, even if a stronger dollar, a higher rate
of inflation, and worsened productivity exert some
influence in slowing down the improvement. It
has often been observed that relative price levels,
as influenced by inflation differentials among countries, become significant only in the longer run
and with considerable delays. It is worth remembering also, in this context, that the effective exchange rate of the dollar has depreciated, since
March 1973, by about 17 percent in real terms
an d that its appreciation. since October 1978,
again in real terms, has only amounted to about 3
percent.
Interest rate relationships have deteriorated for
the dollar since th e most favorab le differential was
reached in late 1978. At the present time. the differen tial between U.S. short-term rates and a
weighted average of foreign short-term rates has
been more than halved. It has been observed that
as inflation began to accelerate in 1979 all over
the world, most other count ries raised their interest rates quite substantially while the United States
raised discount and Federal funds rates more moderately. But it must also be noted that interest rate
increases in other countries occurred in the context of expanding economies while the United
States economy has been slowing down.
During the period in 1978 when interest rate
differentials were moving in favor of the dollar.
the beneficial results were disappointin gly slow to
materialize. Perhaps this has reflected a tendency
of real interest rate differentials to move less favorably than nominal differentials. More to the
point. however, seems to be that ga ins from investment at more favorable interest rates accrue only
very slowly. Gains- or losses- from exchange
rate movements can materialize very Quickly.
Where exchange rates are strongly influenced by
other factors, therefore, the influence of interest
rate differentials appears to be secondary.

Federal Reserve Bank of Dallas

Noncash Collection
Service Modernized
Collection of matured corporate and municipal
coupons for credit to member banks has been updated and improved to provide more timely and
efficient service, effective October 9.
Formerly, the Federal Reserve hanks acted as
collection and distribution centers, receiving and
sorting matured corporate and municipal coupons
and then presenting them to the appropriate paying agents. That process involved substantial
paperwork and, in some cases, long delays in collecting the funds; it required numerous accounting
entries between Reserve hanks and their depositors
and excessive handlings.
Old concept paves new way
Studies by a Federal Reserve task force have concluded that procedures used routinely to clear
millions of checks each day could be applied , with
modifications, to collection of matured corporate
and municipal coupons.
The new procedures are designed to achieve uniformity of service throughout the Federal Reserve
System, increase the efficiency in coupon processing for all parties, decrease the number of accounting entries and reconcilement problems, and expedite the flow of funds from coupon collections
through the banking network.
The "new trick" to coupon deposits is bulk processing, replacing individual handling of coupons.
Under this concept, credit for incoming deposits
is passed on a letter total basis rather than on
each individual item contained in the deposit, even
though the items may be presented to different
paying agents. Credit to the depositor is divorced
from receipt of payments for the items from the
individual paying agents. Credit is passed to depositors on a fixed, preset time schedule. Envelopes
are presented to paying agents in bulk form, and
receipt of payment is monitored from total consolidated shipments to individual paying agents
October 1971/Voice

instead of items from individual depositors. Paying
agents can pay the value of the total collection
letter in a single payment. Clerical efforts on both
ends of the collection process are then reduced.
Credit availability schedule set forth
In submitting coupons for collection, depositors
are required to send separate cash letters for each
of the following categories:
• Matured city items
• Matured country items
• Future due city items
• Future due country items
For each category, there is a specific timetable
as to when credit will be passed. The schedule is
designed to (1) minimize coupon floa t, (2) encourage sending securities well in advance of maturity,
and (3) encourage direct sending of securities by
providing faster credit for items sent direct.
Further information
The Federal Reserve Bank of Dallas Circular 79119, dated July 25, 1979. explains the proper manner for completing the standard forms and the
accompanying transmittal letters. Any questions
concerning the standard Coupon Cash Letter form s,
or the Systemwide Cash Processing procedures in
general, may be directed to:
Dallas Office
William Cheshier ............ (214) 651-6179
Lola Martin
..... ...... (214) 651-6379
El Paso Branch
Jerry Silvey
. ........... (915) 544-4730
Vicky Acuna ................ (915) 544-4730
Houston Branch
James Lockhart
.. ......... (713) 659-4433
Dorothy Boaz ..... .... ...... (713) 659-4433
San Anlonio Branch
Tony Valencia ............... (512) 224-2141
Herb Barbee ........... . .. .. (512) 224-2141
1S

-Ped Quotes~~
Brief Excerpts from Recent Federal Reserve Speeches, Statements, Publications. Etc.

"Federal Reserve policy on foreign acquisitions of American banks is in accord
with U.S. policy of welcoming foreign investment in general. We believe that our
economy and our financial system benefit from fore ign competition, and from foreign
capital so long as the investment is sub ject to the same rules and regulations that apply
to domestic companies. This principle of national treatment is embodied in the letter
and spirit of the International Banking Act, and it underlies the exercise of the Federal
Reserve's responsibilities regarding foreign banking in the United States.
"It needs to be emphasized that there is a framework of law covering foreign
acquisitions of U.S. banks and that recent acquisitions have been made in accordance
with law. I refer to Section 3 of the Bank Holding Company Act. The Federal Reserve
evaluates proposed acquisitions according to standards set forth in the Act; the
financial and managerial capabilities of the acquiring company. the convenience and
needs of the community to be served. and the effect on competition and concentration
of resources in the United States. In my view. these are appropriate standards for
assessing individua l applications.
"When the fore ign investor is an individual, rather than a bank or bank holding
company, the standards are those of the Change in Bank Control Act of 1978, which
took effect this past March. That Act requires individuals seeking to acquire control
of a bank to give the relevant Federal bank regulatory agency 60 days' prior
notification. The proposed acquisition may be disapproved if it would substantially
lessen competition, result in a banking monopoly in any part of the United States,
jeopardize th e financial stability of the bank or otherwise be contrary to the
interests of the bank to be acquired.
"As to the impact of foreign acquisitions on the supply of banking services to
meet the needs of U.S. industry and co nsumers, probably the best protection in this
regard is the competitiveness of U.S. banking. All owners of banks are free to change
the cha racter of the bank's business-for example, from retail to wholesale.
However, banks that do not meet the needs of their community quickly lose business
to those that do . As businessmen, foreign bankers can be expected to recognize that
fact and act accordingly. Moreover, the Bank Holding Company Act requires the
Board in acting on any proposed acquisition to consider the convenience and needs
of the community being served. In this connection, the Board reviews the effects of
an acquisition on the services offered by the bank being acquired and generally
expects some showing of improved services. Fu rther, fore ign-owned banks- like
domestic banks-are subject to the Community Reinvestment Ac t, which requires
the Federal bank regulatory authorities to evaluate the extent to which a bank is
servicing all elements of its community, and also the Equal Credit Opportunity
Act, which prohibits discrim ination in lending."
Henry C. Wallich, Member, Board of
Governors of the Federal Reserve System
(Before the Subcommittee on Commerce,
Consumer, and Monetary Affairs, U.S. House
of Representatives, August 1, 1979)
14

Federal Reaerve Balik of DaUa.

"Activities giving rise to unreported income, whether earned from legal or illegal
sources, have been called the underground economy. The scope and nature of the
underground economy has an important bearing on U.s. tax policy and also may be
relevant to the understanding of developments in the economy and financial markets.
For these reasons, the Board welcomes any efforts that may be made to measure
the extent of the underground economy."
"Even though the Federal Reserve's data on currency and demand deposits are
highly accurate and measured on a consistent basis over time, there are no reliable
estimates on what portion of the u.s. currency in circulation is held in the United
States and what portion is held abroad. U.S. currency balances may be held abroad
as a store of wealth and, in a few countries, such balances evidently even serve as
a major medium of exchange. Therefore, fluctuations in the currency ratio may reflect
changes in economic and political conditions abroad.
"Apart from variations resulting from currency held abroad, movements in the
currency to deposit ratio also reflect domestic above·ground economic activity. In
fact, as the IRS study noted, research by the Federal Reserve staff indicates that both
the trend and cyclical movements in the currency to deposit ratio over most of the
1960s and 1970s can be explained adequately by movements in real income and
consumption expenditures, prices, and interest rates-variables which are recognized
as important determinants of currency and deposit holdings.
"Since mid·1974, however, the currency to deposit ratio has moved up more
sharply than can be accounted for by movements in those determinants. The
increase in the ratio appears to be a result of a downward shift in the demand for
demand deposits and not an upward shift in the demand for currency. Currency
holdings continue to be predicted accurately by movements in real consumption
expenditures, prices, and interest rates. The weakness in demand deposit growth, on
the other hand, appears to be associated with a variety of new developments in the
money market. For households, innovations such as NOW accounts, ATS accounts,
and money market mutual funds have become increasingly important substitutes for
demand deposits. For business firms, sluggish deposit growth has reflected the growing
use of cash management techniques and deposit substitutes such as security
repurchase agreements.
"Thus, there are plausible explanations of the post World War II rise in the ratio
of currency to deposits which do not rely on the growth of an underground economy.
I do not mean to imply that the underground economy does not exist or that currency
is not used more extensively as a medium of exchange for underground transactions.
The point is that other factors affect the currency to deposit ratio, and they must be
taken into account when separating above·ground currency holdings from underground currency holdings."
Nancy H. Teeters, Member, Board of
Governors of the Federal Reserve System
(Before the Subcommittee on Oversight of the
Committee on Ways and Means, U.S. House
of Representatives, September 10, 1979)
October 1971t/Volce

15

Profitability of Bank Loan
and Investment Functions:
Large Variations Among Banks
By Mary G. Grandstaff

Bank profitability depends largely on earnings received from interest-bearing assets and net costs
a nd expenses associated with acquiring and maintaining them. As with any profit-oriented firm,
bank managements must know the relative net
earnings on the various types of income-producing assets in order to maximize their profits.
The proliferation of bank services in the past
decade, however. has made it increasingly difficult for many banks to classify incomes and expenses by activity type. The Functional Cost Analysis (PCA) Program conducted annually by th e
Federal Reserve Bank of Dallas provides participating member banks with important income and
expense data for a number of major bank functions, including investments and various types of
loans. These data not only enable a participating
bank to determine the relative profitability of each
function but also provide comparisons with the
average experience of other participating banks
in the same general deposit size a nd similar
fu nctions.
The PCA Program provides income and expense
data for five funds-using functions: investmen ts,
real estate mortgage loans, instalment loans, creditcard loans, and commercial, agricultural, and other
loans. An analysis of these data provides insights
into the relative profitability of each function. That
profitability depends on three factors: earnings

"

from the income-producing assets, expenses incurred in acquiring and maintaining them, a nd the
cost of funds used to acquire them.
Cost of money
The cost of money at a commercial bank is determined by three faclors: the amount of interest
paid on available funds, operating expenses incurred in acquiring and maintaining them, and any
nonportfolio income received from them. Determining the exact source of funds used fo r individ-

Considerable variation in cost of funds is
evident among !Janks. Since cost of money
is a major expense and one for which the
variation bank to bank is substantial, it
merits close attention. If a bank can reduce
the cost of money without losing volume
or reducing return on assets, it can improve
profitability.

ual functions would be very difficul t if not
impossible. Therefore, the PCA Program uses a
"pool-of-funds" method in allocating funds to the
various funds -using functions. With this method,
Fede ~al

Roserve BaDk of DaUu

an average cost of funds is calculated for each
bank and applied equally for funds used in all
functions at that bank.
Suppose, for example, that a bank had $12 million in available funds-comprised of $4 million
in demand deposits, $6 million in time and savings deposits, and $2 million in nondeposit funds.
Assume further that the net costs of obtaining and
maintaining those funds were 3 percent, 7 percent,
and 5 percent, respectively. With the pool-offun ds app roach, the cost of funds fo r this bank
would be $640,000, or 5.3 percent of availab le
funds. And using the pool-of-funds method, the
cost of funds used for a $10,000 loan or a $10,000
security at this bank would be an identical $5305.3 perce nt of the volume of funds used. Therefore,
the cost of funds has no impact on the relative
profitability of a bank's individual functions. It
does. however, have a sizable impact on a bank's
overall profitability, as well as its profitability in
relation to other banks of comparable size and
operation.
Considerable variation in cost of funds is evident
among banks. Since cost of money is a major expense and one for which the variation bank to
bank is substantial, it merits close attention. If a
bank cnn reduce the cost of money without losing
volume or reducing return on assets, it can improve profitability. Opportunities apparently exist
October 19'19/Voice

for some banks to reduce their cost of funds. At
the 83 banks that participated in the 1977 FCA
study, cost of money ranged from 3.0B percent
to 6.31 percent of available funds. And, on average,
the cost of funds at the ten high-profit banks was
more than a full percentage point lower than at
the ten low-profit banks. This occurred even though
the low-earning banks had a higher average ratio
on income from service and handling charges on
deposits and a slightly lower average interest expense ratio. It occurred because high-profit banks,
on average, had conSiderably lower operating
(noninterest) expense rati os on deposits.
Investment functi on
As with all the banking functions, individual banks
experienced wide variation in profit levels on investments. Net earnings on investments ranged
from 6.65 percent on the funds invested to a Joss
of 0.49 percent (Table 1). The ten banks with the
highest net return on investments had average net
earnings of 4.92 percent, compared with 1.13 percent at the ten least profitable banks. The spread
reflected a combination of higher income ratios
and lower expense and cost-of-money ratios at
the high-profit banks.
Under the FCA Program format, earning assets
in the investment function are classified as U.S.
Government securities. tax-exempt securities and
17

Table 1
EARNINGS ON INVESTMENTS
AT TEN BANKS WITH HIGHEST OR LOWEST
NET EARNINGS ON INVESTMENTS
(F rom data lor 63 member banks participating in 1977 Fu nctional
Cost Analysis Program, Eleventh Federal Reserve District)
A. pereenl 01
R .n~

lOl~I

In ...eslman"

Nti!(d~d

01

b.n~ · .

10111

,n~om.

Operlling
• • pens n

eost 01
money

COSlol
money

earnings

11.764
9.399
8.372
9.767
8.868
7.822
9.128
7.863
6.542
8.586
9.011

0.289
.038
.101
.333
.110
.095
.183
.127
.101
.156
.1 54

11.475
9.361
8.271
9.434
8.757
7.727
8.944
7.736
8.440
8.428
8 .857

4.826
3.837
3.292
4.682
4.098
3.084
4.328
3.235
3.973
4.043
3.940

6.649
5.524
4.979
4.751
4.660
4.643
4.616
4.500
4.467
4.385
4.917

5.891
6.883
6.877
6,943
6.749
5.958
7.057
6.056
6.415
6.632
6.546

.209
.248
.404
.008
.354
.174
.325
.238
1.603
.812
.438

5.682
6.635
6.473
6.935
6.396
5.784
6 ,731
5.818
4.812
5.820
6.109

3.677
4.763
4.722
5.290
4.896
4.4 10
5.742
5.130
4.826
6.312
4.977

2.005
1.871
1.751
1.645
1.500
1.375
.989

T01.'

depwilt'

., .. ... ....... ..

'"

Hlgh·proUt banks
52
2()

.3
60
12
31
78
25
23

...... ....

..............
.........

.......... ...
..............

Average .. .....
low·profit banks
70 .. ............
55
13 ...........
26
71
, ....
30
50
79
76
83
Average .....

.... ....

I Demand depoSits

~ nd

time and sa.,ng' deposits

loans, other securities, and Federal funds sold.
Some banks also had small amounts of other liquidity loans that were included in the investment
function. Each of these types offers differen t
rates of return, and an individual bank's management must determine the best mix of these investments for its own circumstance.
In making decisions on types of investments. it
is important that a bank have some idea of its
probable overall profitability. As an example, the
book rate of return on tax-exempt securities generally is well below that of all other types of
investments. However, the fact that income from
these securities is tax-exempt can make them very
attractive to many banks because adjusting the
rate to a taxable basis usually makes such securities the highest-earning type of investment.
For the ten banks with the most profitable investment functions, for instance, the average rate of
18

....

-.014
- .492
1.132

return on tax~exempt securities was only 5.23 percent. compared with 7.23 percent on U.S. Government securities, 7.39 percent on other securities.
6.04 percent on Federal funds, and 7.62 percent on
other liquidity loans. After adjustment for taxes,
however. the tax-exempt securities yielded an
average return of 10.05 percent- or well above all
the other types of investments. While the low~profit
banks also generally realized a somewhat higher
rate on their tax-exempt securities after adjustment for taxes, the advantage was muted at these
banks because of their lower tax brackets.
The high-profit banks generally placed the largest share of their investments in tax-exempt secu~
rities. apparently in an effort to reduce tax liabilities. On average, these securities amounted to
slightly over three-fifths of all investments at the
ten most profitable banks. The ten low-profit
banks, on average, held less than one-fifth of their
Federal Rqerve Bank of Dan..

investments in the form of tax-exempt securities.
as they elected to hold larger proportions of their
investments in U.S. Government securities and
Federal funds.
The ten high-profit banks received investment
income that amounted to 9.01 percent of the funds
invested. compared with 6.55 percent at the lowprofit banks. The more profitable banks also were
able to hold their expense ratio on investments to
less than half that of the low-profit banks. This
was largely accomplished through higher productivity. Although the investment portfolio of the
former averaged more than twice that of the latter
banks, the number of officers and employees in
this function averaged about 30 percent and 50
percent, respectively, lower at the high-profit
banks.

Real estate mortgage loan function
Net earnings on real estate mortgage loans at the
banks participating in the 1977 FCA study ranged
from a net profit of 5.27 percent on the total portfolio to a net loss of 2.72 percent (Table 2). Mortgage loans were not offered by 9 of the 83 banks.
As would be expected, the more profitable banks
experienced higher yields andl or lower expenses
and money costs.
The ten banks with the most profitable real estate mortgage loan fun ctions reported an average
income ratio on these loans that was 2.25 percentage points above the average for the ten least profitable banks. Moreover. expenses in relation to total
real estate mortgage loans at the latter banks, on
average, were four times greater than at the highprofit banks, and the cost of money was more than

Table 2
EARNINGS ON REAL ESTATE MORTGAGE LOANS
AT TEN BANKS WITH HIGHEST OR LOWEST
NET EARNINGS ON THOSE LOANS
(From dala lor 83 m ember banks participating in 1977 F unctional
Cost Analysis Program. Elevent h Federal Reserve District)
" S percent 01 tot al .n l e>lal. mo.lgage lo.ns
R. nk 1>1
b.nk· S
totl l
deposits·

H5gh.prolil banks
54
20
12
............
78
.... .. . .. .

.. .. .... ......
....
.. ... .....

52
5

.

. . . . . . . ..

11

.. ......

51
65

63
Average

low·proflt banks
34

..
74

........
67 .. . .. .. . .. ..
6
50
..... .. ..
13 .. . .. ... .
45
........ .. ..
79 ..............
61
.... .... ..

...

Average

.. .. ..

TOIl!

income

Ope r.ting
•• penstlS

N b!, 'o~.Id·
cost 01
mone,

eoot 01
~"~

u. n l~.

9.643
8.348
8.058

4.376
3.292
3.084
3.236
3.837
3.368
4.205
4.168
4.707
4.882
3.896

5.266
5.056
4.974
4.848
4.707
4.573
4.539
4.397
4.374
4.288
4.702

4.589
5.238
5.212
4.720
4.412
5.742
4.722
5.034
5.130
4.826
4.963

1.630
1.269
.947
.880
.537
-.470
-.535
-2.150
-5.147
-24.108
-2.715

10.778
10.569
9.000
8.541
9.260
8.467
11.066
9.753
10.002
9.130
9.657

0.804

1.028
.992

8.544
7.940
8.744
8.565
9.080
8.970
8.598

8.712
8.807
6.577
6.633
7.639
8.780
7.406
3.401
6.535
9.563
7.405

2.479
2.300
.418
1.032
1.438
.551
.802
.454
6.552
26.047
4.207

6.219
6.507
6.159
5.601
4.949
5.273
4.187
2.883
-.01 7
-19.282
2.248

1.593
.942
.458
.716
.526
2.322
.926

.609

8.083

""

, Damand d.POslts and time and sa~lng s deposits.
2. Includes 11•• ·Yu, av,,"ge 1000 adiuSlmlnt wn... . ppllu ble.

October 1m/Voice

19

1 percentage point lower. Four of the ten least
profitable banks managed to hold their expense
ratios below the average for the high-profit banks.
but their income ratios were fairly low and their
cost of money was high. Three of the four experienced net losses in their real estate mortgage loan
functions.

If quality of loans is equal, the expenses

incurred in making and servicing mortgage
loans usually do not increase proportionately with volume. Thus. large loans, 8S a
rule, would he expected to be more profitable than smaller ones.

The average real estate mortgage loan portfolio
at the ten high-profit banks was about 15 percent
greater than at the ten low-profit banks. Nevertheless, the latter banks generally had an average of
almost one more person allocated to the functio n.
Each employee at the low-profit banks, on average, handled more loans, but the average size cf
those loans- $50.22(}-was only about 70 percent
as large as the $71,614 average size at high-profit
banks. If quality of loans is equal, the expenses
incurred in making and servicing mortgage loans
usually do not increase proportionately with volume. Thus, large loans, as a rule, would be expected to be more profitable than smaller ones.
Size of loan appeared to be the predominant factor
accounting for the differences between earnings at
high- and low-profit hanks.
Iostalment loan function
Income received on funds invested in the instalment loan portfolio generally provides banks with
the highest income ratio of all types of loans or
investments. In 1977, these ratios ranged from
14.76 percent to 7.97 percent at banks that participated in the FCA Program. The ten banks with the
most profitable instalment loan functions received
income averaging 13.00 percent of funds used.
while the ten low-profit banks obtained an average
of 12.19 percent (Table 3).
Expenses associated with making and servicing
these loans, however, also are usually considerably
higher than for any other income-producing asset.
In 1977, expenses for these loans ranged from 6.86
20

percent to 1.24 percent of total instalment loans.
The high expenses for these loans are a direct re·
suit of a larger number of loans and their smaller
size. As stated preViously, the cost of an individual loan does not decline proportionately with
a reduction in dollar amount. If other factorsquality, interest rate, and so on-are equal, the
cost of making and servicing a $100,000 loan may
be little, if any, greater than the cost of a $1,000
loan.
Instalment loans averaged $2,039 in size at the
ten banks with the most profitable instalment loan
functions in 1977 and $1,798 at the ten least profitable banks, a difference of only 13 percent. More·
over, the number and total dollar volume of
instalment loans at the ten high-profit banks averaged about 40 percent and 60 percent. respectively.
more than at the low-profit banks. Nevertheless,
the average low-profit bank had about 40 percent

Personnel at the average high-profit bank
handled about twice as many instalment
loans in 1977-in both number and volumeas personnel at the average low-profit bank.

more officers and almost 25 percent more employees than the average high-profit bank. Consequently, personnel at the average high-profit bank
handled about twice as many instalment loans- in
both number and volume-as personnel at the average low-profit bank. Thus, high-profit banks had
much lower average costs for making and servicing these loans.
The ten banks with the highest rate of profitability on instalment loans recorded average net
earnings of 5.33 percent on these loans. Low-profit
banks averaged a 0.39-percent net loss.
Credit·card loan function
The credit-card loan function at participating
banks shows the widest variations of all funcHons
in terms of profitability, mainly because of low
volume and high expenses. Only 19 of the 83 banks
reported credit-card loans, and data for some of
these banks are meaningless. In some instances,
volume was extremely low and expenses were
very high, indicating that those banks may still
Federal Reserve Bank of Dalla.

Table 3
EARNINGS ON INSTALMENT LOANS
AT TEN BANKS WITH HIGHEST OR LOWEST
NET EARNINGS ON THOSE LOANS
(From data for 63 member banks part icipating in 1977 Funct ional
Cost Analys is Program, Eleventh Federal Reserve District)
AS pe'cen t 0 1 10tal ins ta lme nt loan s
01
Dank's
totlt
deposits'

N ~l~~~d'

R an ~

Hlgh.prolll banks
54 ............
48
71
65
31
17
60
51
.
62
10 ..............
Average . .
Low·profit banks
12
61
80
74 · .
24 · .
55 . . . ...
50
73
67 .. .. . .. .. .. .. .
75
Average .. .. . ..

· . . . . . .. . . . . . .
..............
... .... .
· . ... ... .

... .. .. .... .
. . . . . ... . . . .
...... .. ....
.. .... ... .....
............ ..

TOl a l
Income

O~'11Ing

COlt of

" p,n.es

m one ~

CO" 0 1
mon.,

Ufnlngs

14.758
14.176
13.115
12.854
13.070
11 .262
12.861
14.103
12.450
11 .395
·13.004

3.422
3.038
2.416
2.487
3.337
2.045
3.557
2.776
2.548
1.914
2.754

10.688
10.490
10.502
10.020
9.604
9.218
9.223
9.162
9.589
9 .391
9 .789

4.376
4.852
4.896
4.707
4.328
3.988
4.098
4.168
4.679
4.531
4.462

6.311
5.638
5.606
5.314
5.276
5.230
5.126
4.994
4.910
4.859
5.326

10.345
13.276
11.1 19
12.273
12.325
13.900
11.891
12.397
12.686
11.730
12.194

6.254
7.387
5.672
7.105
7.408
7.843
4.377
7.544
8.855
8.569
7.101

3.746
5.248
4.581
5.168
4.269
4.579
5.165
3.584
3.603
2.048
4.200

3.084
4.826
4.326
5.238
4.367
4.763
5.742
4.335
4.720
4.442
4.584

.663
.421
.262
-.070
-.098
-.184
- .577
-.751
-1 .117
- 2.394
- .385

'"

1. OemaMf deposit. and time IMf $Iying5 de pos its.
2 Incluo:leS "v.· ,ea , aye ,ag" losa adjustme nt
I pplic aDle.

wn",

have been in the introductory stages of offering
this service.
With such limited data, conclusions regarding
the credit-card function are somewhat hazy. Excluding two banks with extraordinary experiences,
it appears that income on credit-card loans in relation to other types of loans was high- ranging
from a low of 14.01 percent of total credit-card
volume to a high of 43.55 percent.
As would be expected, the large number of these
relatively small size accounts also makes them the
most expensive type of loan for most banks. Again.
excluding the extraordinary banks, expenses at
most parti cipating banks totaled between 15 percent and 49 percent of funds used.
Thus, the credit-card function is not profitable
for all banks. However, 13 of the 19 banks with
credit-card functions registered profits for the
function. These profits usually were in the range
October 19'71t/Voice

of 5 percent to 7 percent.
The credit-card function is a relatively new area
for many banks- one of the major banking innovations of the 1960's. More experience with the
function could result in improved profitability and
use by a larger number of banks.

Commercial, agricultural,
and other loan function
As with the other three loan functions , the more
profitable banks generally managed to have a higher income ratio and lower expense ratio on their
commercial, agricultural. and other loan functions.
Consequently, net earnings at the ten banks with
the highest profits in this function averaged 4.38
percent of the funds invested in these loans.
compared with an average loss of 0.95 percent at
the ten low-profit banks (Table 4). And again,
21

Table 4
EARNINGS ON COMMERCIAL, AGRICULTURAL,
AND OTHER LOANS AT TEN BANKS WITH HIGHEST
OR LOWEST NET EARNINGS ON THOSE LOANS
(From data for 83 member banks participating in 1977 Funct ional
Cost Ana lys is Proglam, Eleventh Federal Reserve District)
AS percen! o! !Olal commercial. allricul!ufal. and olhe. loans

N~r~~!d

R.nk o !
b'~k'S

10lal
oepa.,!s·

Hig h·pro m banks
68
.........
45

5'
78
7•
17
14

73

........

........
.. .... .... ....
..............
. .... . .. . . . .. .
..............

23
67 ...

46
47
56

...........
........

6.
81
80

83
13
50

OJ)e''1ing
e <pe nses

co!! of
mone1

COSIO!
money

e 8m ln!!s

15.875
12.024
9.046
8.466
10.863
8.185
8.874
9.557
8.350
10.067

1.997
1.264
.598
1.380
1.924
.442
.493
1.300
.594
1.123
1.1 12

13.506
10.535
8.005
7.086
8.939
7.743
8.306
8.055
7.744
8.203
8.812

5.212
5.034
4.032
3.236
5.13 1
3.988
4.567
4.335
4.043
4.720
4.430

8.294
5.501
3.974
3.850
3.809
3.755
3.739
3.720
3.70 1
3.483
4.383

8.776
8.944
8.962
9.695
8.886
8.297
7.689
'.960
8.532
9.311
8.905

1.965
2.782
3.651
1.639
3.597
3.388
3.101
4.295
2.158
4.762
3.134

5.232
5.386
4.262
5.156
4.111
4.817
3.545
4.401
1.967
.394
3.927

4.679
5.034
3.950
4.975
4.058
4.954
4.326
6.313
4.722
5.742
4.875

.553
.353

9.430

Average
Low·profit ba nks

62

lOial
,ncome

.. ...... .
Average . .. .

'"

.312
.181
.053
- .137
-.780
- 1.9 11
-2.756
- 5.348
-.948

I. Oem.nd oepas"s and lime and sa. in!!s depasil.
1. Includes l,ve'yea ' " ve'''ge ion adjustmenl wlle'e IOppllc,ble

the higher profitability largely reflected higher
productivity.
Although the average high-profit bank for this
function had an 83-percent larger dollar volume
of these loans than low-profit banks and a 65-percent larger number of loans. on average. high-profit
banks made and serviced th ese loans with 40 percent fewer personnel. Average loan size at the
higher-earning banks was $18.271. or 47 percent
greater than the $12,459 average at low-earning
banks. Nevertheless. personnel at high-profit
banks. on average, handled 77 percent more loans
than their counterparts at low-profit banks and 170
percent more in terms of dollar volume.
While instalment and credit-card loans may account for the largest number of loans. most banks
normally hold the largest portion of their dollar
volume of loans in the form of commercial, agri22

cultural, and other loans. The average size of indi·
vidual loans in th is function is usually well above
that of consumer-type loans . (Real estate loans
often may have a higher average size. but the number of these loans is very small in relation to commercial. agricultural. and other loans.)
In come from the function is not quite as high
as that obtained on consumer-type loans because
lending rates for commercial. agricultural, t!.nd
other loans are generally lower. Expenses, however, are considerably lower because of the larger
average loan size. As a result, net earnings from
commercial. agricultural, and other loans usually
are about in line with earnings on consumer-type
loans and slightly less than earnings on real estate
mortgage loans.
The foregoing discussion was not intended to
suggest that banks should place more emphasis
Federal Reserve Bank of naUa.

on any particular type of interest-bearing asset.
The relative profitability of functions changes in
response to economic conditions and individualbank growth, It is very important, however, that
banks closely analyze the operations of all their

While instalment and credit-card loans
may account for the largest number of
loans, most banks normally hold the largest
portion of their dollar volume of loans in
the form of commercial, agricultural, and
other loaDS, The average size of individual
loans in this function is usually well above
that of consumer-type loans.

major funds-using functions. The wide variations
in profitability of all functions at banks participating in the FCA study suggest some may have opportunities, through closer analysis of functions
and astute management, for improvement in various functions and, thus, overall profitability.
One interesting observation based on the results
of the 1977 FCA study was that many banks placing very high in terms of profitability in one or
more functions fell conSiderably lower in profit-

ability in other functions. Through close monitoring of functional profitability, banks can identify
areas where changes can improve overall results.
Another observation obtained from the FCA
study was that deposit size and age of bank have
only minimal effects on profitability in any bank
function. On average, the more profitable banks in
each function tended to be somewhat larger and
older than the lower-profit banks. The average deposit size of the high-profit hanks for the loan
and investment functions ranked from 41 to 52,
while low-profit banks ranked from about 50 to 59.
Nevertheless, several relatively small banks were
among the most profitable for various functions,
while some of the larger banks were among the
least profitable. Similarly, some banks organized in
the 1970's were among the most profitable for some
functions, while some banks organized before the
20th century were among the least profitable.
It also should be pointed out that allocation of
resources should never be solely dependent on
profitability levels. Such factors as customer needs,
market conditions, and risk are other major considerations. Thus, although it is important for a
bank to evaluate the profitability of its individua l
functions, in the final analysis it is the overall
performance of a bank in meeting its goals that is
most important. And it is the objective of functional cost analysis to help the bank attain its goals
with the highest possible level of profitability.

New member banks
First National Bank, Seminole, Texas, a newly organized institution located
in the territory served by the Head Office of the Federal Reserve Bank of
Dallas, opened for business September 24, 1979. as a member of the Federal
Reserve System. The new member bank opened with capital of $625,000
and surplus of $625,000. The officers are: Marion C. Bowers, Chairman of the
Board; Don W. Long, President; Robert Cosby, Cashier; and June Lange.
Assistant Cashier.
First National Bank, San Benito, Texas, a newly organized institution located
in the territory served by the San Antonio Branch of the Federal Reserve
Bank of Dallas, opened for business October 1, 1979, as a member of the
Federal Reserve System. The new member bank opened with capital of
$625.000 and surplus of $625,000. The officers are: Randall P. Crane, Chairman of the Board; Robert B. Dunkin, President; and Betty Morgan. Cashier.

October 1979/Volce

Collateral Procedures
Liberalized at Fed's
Discount Window

The Federal Reserve Bank of Dallas has implemented several changes intended to expand the
pool of available loan collateral for member banks
in the Eleventh District and si mplify its handling.
Some member banks. particularly Iarger banks.
have occasionally had insufficient eligible collateral to handle their borrowing needs.
The changes are reflected in revised Bulletin 2,
"Loans," which the Federal Reserve Bank of Dalla s
transmitted to the member banks on September 10,
1979. Some of the changes being implemented are:
• Loan participations and foreign paper can now
be accepted as collateral.
• Member banks may now enter into off-premises custody arrangements with the Federal Reserve
Bank of Dallas, in which they may agree to hold
certain types of loan collateral on their own premises rather than transmit it to the Federal Reserve
Bank or branch or to a correspondent bank, as in
the past.
The new off-premises collateral arrangements
apply to three types of collateral: one- to fourfamily residential mortgages, commercial and agricultural paper (including loan participations), and
24

Group I municipal securities. Discount window
credit secured by one- to four-family residential
mortgages and by "eligible" commercial and agricultural paper may be obtained at the basic discount rate. Advances secured by Group I municipal
securities and "ineligible" commercial and agricultural paper may be obtained at the Section
10(b) rate, which is one-half of 1 percent over the
basic discount rate.
Banks in the Eleventh District that are interested
in further information or want to receive the necessary forms for use under the new collateral procedures may contact the following:
Dallas Office
Jesse Sanders, Bill Hayden .... (214) 651-6240
EI Paso Branch
Robert Schultz ....... (915) 544-4730, Ext. 41
Houston Branch
C. O. Holt, Jr ......... (713) 659-4433, Ext. 44
San Antonio Branch
Thomas Cole ........ . (512) 224-2141, Ext. 13

Federal

Rese~

Bank of Dallas