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El Paso' Houston' San Antonio

September 1978
1

Today's Monetary Policy Affects Tomorrow's Economy

One-Bank Holding Companies Increase Rapidly

Southwestern Banks Improve Performance in 1977

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

Today's Monetary Policy
Mfects Tomorrow's Economy
By Patrick]. Lawler

Monetary policy is primarily concerned with the
future. Although day-ta-day decisions focus on
qUickly affected targets such as short-term interest
rates. bank reserves, or the money supply, the ultimate goals of policy are in terms of employment,
production, and inflation in future periods. So current decisions must take into account the lag between leday's short-run targets and tomorrow's
economy.
This lag occurs because firms and households
adjust gradually to changes in interest rates and
availability of credit. While short-term money market interest rates respond immediately. other interest rates that figure more importantly in
spenders' decisions-such as the bank prime lend~
ing rate, mortgage rates, stock and bond yields,
and the return on savings accounts- may take several weeks or more to change, if at all. As these
rates change. businesses and consumers adjust
their financial asset portfolios to reflect the
changes, and reconsider their spending plans.
An easier monetary policy, for example. makes
it cheaper to borrow and less rewarding to save.
Increased spending raises both production, to meet
the increased demand, and prices. Greater production provides increased profits and labor earnings,
which further stimulates investment and consumption, causing more inflation- and so on. Eventually
the increased spending works to increase interest
rates and the process reverses itself. The only
September ll78/Voice

lasting effect is on prices. In the meantime, however, production. unemployment, and the rate of
inflation are diverted from their original paths.
But whether these changes take a matter of
months or of years is critical. Current policy
choices must be made to suit the economy's needs
at some future time when the impact of current
policy is greatest. The needs of the economy in
the next quarter or two may be just the opposite
of its needs two years from now. Thus, knowing
the length of the lag between policy decisions and
their effect on economic activity is essential.
The length of the lag is of interest not only for
determining the correct anticyclical policy but also
for determining whether we should attempt to
smooth business cycles at all. If our forecasts of
the future are accurate enough. and if our ability
to predict the strength and timing of policy effects
is good enough, we can expect that a flexible monetary policy is an effective way to stabilize the
economy.
If a recession is predicted. for example. we could
offset some of the weakness with a shift to an
easier monetary policy. Knowing the length of the
time lag until the economy is affected would allow
us to determine just when to shift policy. But if
the major impact of a policy change occurs beyond
the time horizon of our best forecasts, a policy
rule. such as a steady growth rate of money. might
be preferable.
1

These widely differing conclusions reflect differences in definition as much as anything else.
There are several ways to define changes in monetary policy and many alternative measures of its
effects. Policy has been described variously in
different studies as a change in the rate of growth
of the money stock, a change in interest rates, or
a change in bank reserves. A one-time change in
one of the poHcy measures may be equivalent to
a continuing change in another. For example, an
increase in the money supply has the same effect
as a decrease in interest rates, initially, followed
by increases later on. So a policy of attempting to
lower interest rates permanently would cause a
longer lag since the lower rates would provide continued new stimulation to the economy.
Differences also arise as to the particular effects
of monetary policy that are of primary interest.
For example, some studies have focused on the
time lag for effects on the level of nominal GNP
(current-dollar gross national product). Others
have looked at the time lag for effects on the rate
of change of GNP. This makes the measured lag

Current policy choices must be made 10 suit
the economy's needs at some future lime
when tbe impact of current policy is greatest.
The needs of the economy in the next quarter
or two may be just the opposite of its needs
two years from now.

Conceptual difficulties
Attempts to measure the lags have led to widely
differing results. Some have found that the maximum effect on economic activity occurs within
three to six months. Others have estimated the
peak effect to occur two years or more after a new
policy starts. While most studies assume that the
lag is always the same, some results indicate the
lag is variable. It may be short at one time but
long another time, which poses a particularly difficult problem unless the differences are predictable.

Any policy change can be described in terms of the money supply.

bank reserves, or interest rates
CHART 1.

Three Definitions of the Same Policy Change

PERMANENT INCREASE
IN QUARTERLY AVERAGE M·1

CHANGE IN THREE-MONTH
TREASURY BILL RATE

1.1

BILLION DOLLARS

PERCENTAGE POINT

1.0 -

.6-

.2-

,.-----------.

.5-

.4 -

,
/

.2 -

.9.8 -

.7 -

.6 .5 -

CHANGE IN MEMBER BANK
NONBORROWEO RESERVES

.3 -

o --'1'1-'1

-.2 -

• ......... '"

rT'"T'"1

~"'r

02 04 02 04 02 04

1978

1980

,
,,,
,
,

-.1-

02 04 02 Q4 Q2 04
1979

###

_
o ________-.~-~-C-------,., --

II
I

.1 ii~""""'r

.1-

1979

1980

-.3I

-.4 --"101-10-11 rT'"T'"1 rT"T'"1
02 04 02 Q4 02 04
1978
1979
1980

Federal Reterv. Bank of Dallal

shorter even though the economy is affected in
the same way. Other important effects with still
different time lags include the effects on real out·
put (GNP adjusted for price changes) and on in·
flation,
Further problems arise in comparing lags be·
cause lags may differ in shape as well as in length,
For example, a policy that has virtually no effect
for a year and has its full effect from then on is
very different from one that has close to its max·
imum effect almost immediately but does not quite
reach its peak until after a year. Yet both have the
same lag between the time policy is changed and
the maximum effect of the change,
New lag estimates with the MPS model
Bedeviled by these definitional problems as well as
by the lack of high·speed computers, the studies
of the 1960's were conflicting and inconclusive,
But now, large structural models of the economy.
such as the MIT·PENN·SSRC (MPS) model, make
it possible to consider the effects of alternative
policies in some detail. A large structural model
of the economy provides the best framework now
available for analyzing monetary policy lags,
The model employed here is a version of the
MPS macroeconometric model currently used by
the staff of the Board of Governors of the Federal
Reserve System. It consists of a large number of
equations representing economic relationships that
have been estimated from historical data, The
equations are solved simultaneously in order to
take account of the sometimes subtle interactions
between economic variables,
Although these relationships may change over
time and may even be affected by actual policy
choices. a large model has a number of advantages,
It is easy to compare two different policies by ob·
serving how the economy could be expected to
behave differently with each over a past or future
period, In doing so, we avoid a problem of some
earlier studies that were unable to sort out the
effects of monetary influences from other sources
of cyclical disturbance in the economy. And by
examining policy in different time periods, we can
also check whether the lags vary over time in a
systematic way,
The best way to measure policy and its effects
is still not fully clear, The Federal Open Market
Committee (FOMC) makes policy decisions primarily in terms of the money supply and its
growth, so the more useful lag measures should
September 1978/Volce

be related to these measures. Although money is
controlled only within broad limits, a decision to
increase or decrease the boundaries of the range
of tolerance almost certainly results in faster or
slower money growth.
The preferred policy measure should depend on
the alternatives actually considered. Policymaking
is a continual process. Each quarter. new decisions
on long-term policy are made. A decision to change
current policy, by affecting the future course of
the economy, would probably also change future
policy from what it would otherwise have been.
What, then, is the correct measure of the effect of
the current change? We could assume future policy
unchanged, or we could include the effects of future policy changes caused by the first change.
The broadest view of the problem would be to ask,
How does action taken in this quarter affect the
range of future options for production and inflation? But the answer would require consideration
of an infinite number of possible future policies.
To simplify the analysis, we will limit ourselves
to comparing a variety of policy options with one
specific set of present and future actions. This
base set assumes that the narrowly defined money
supply (M-1) is carefully controlled, growing at an
essentially steady rate consistent with recent
FOMC long-term targets over a three-year period.
One plausible policy alternative would be to
add a small amount to the money supply initially
and then maintain the same increment in future
periods. To examine this policy, we simulated the
MPS model over a three-year period starting with
the second quarter of 1978, based on information
available in May. We compared the one simulation,
which assumed that the base policy was followed,
with an alternative in which $1 billion was added
gradually during 197B-Q2 and maintained so that
the money supply was $1 billion higher than in
the base simulation in each succeeding quarter.
The same policy change can be expressed in terms
of changes in either interest rates or bank reserves, but the patterns of these variables are more
irregular (Chart 1).
The results show an increasing effect on nominal GNP throughout (Chart 2). The maximum effect
would occur more than three years after the change
in policy. Had we extended the simulation further,
the size of the effect would eventually have started
to decline and then moved up and down in a cyclical fashion, settling at about $7 billion of in·
crease in GNP as a result of the $1 billion increase
in money.
3

The lag in the effects of monetary policy
depends on which effects are examined
CHART 2.

Effects of a $1 Billion Increase in the Money Supply
on Different Variables

CHANGE IN NOMINAL GNP

----_...----

CHANGE IN REAL GNP

12--------------------------- 12--------------------------,..#

BIUIQN DOLLARS

10-

"I'"

BILL.ION DOL.LARS

10 -

I
I
I

I
I

0-,-,-,
Q2

1978

0-,,--,.......
Q2

1980

1979

1978

1980

1979

CHANGE IN INFLATION RATE

CHANGE IN GROWTH RATE OF REAL GNP

.14 - - - - - - - - - - - - - - - - - - - - - - - - - - -

PERCENT (ANNUAL RATE)

.12 -

.4-

.10 -

.3 -

.08 -

.2 -

.06 -

.1 -

" ""

""" ,
"

O ----------------->.~,--------------

-.1 -

0-,,--,.......
Q2
Q4
1978

•

.--

111 . . . .- -

-.2 - , - , - ,

Q2
1979

Q2
Q4
1980

Q2
1978

Q2
1979

Q2
Q4
1980

Federal R••erve Bank 01 Dallas

If reversed quickly. the effects of monetary policy are mild
CHART 3.

Effects of a $1 Billion Temporary Increase, Then Decrease,
in the Money Supply

CHANGE IN REAL GNP

•

BillION DOLLARS

42-

-- _--,

....

0-----'-",,·...............
=,- - - - - - -

........ _----_ ..

-2 -

r02

1978

02
1979

1980

The major goals of policy, however, arc to influence real output and the rate of inflation. The
lagged effects on these variables peak much earlier
in the MPS model. These lags are probably more
relevant. The maximum effect on inflation of the
alternative policy is a little more than 0.1 percentage point after two years. Real GNP is increased by $5 for each additional dollar of money,
with the peak effect coming in a year and a half.
The major effects on production growth appear
even more quickly-in the two quarters immediately folloWing the quarter during which the policy
was changed.
Which of these measures is the most relevant
depends on the goals of policy , If the intent is to
smooth the boom and recession parts of a business
cycle, the effects on the level of real GNP are most
pertinent. But if the goal is to stay on a steady
growth path, information about the effects on the
rate of growth of real GNP would be more useful.
Each might be preferred at different times.
Policymakers need not commit themselves ir~
revocably so far into the future, however. Another
reasonable alternative policy would be to increase
the money supp ly by $1 billion in the first period
then gradually reduce it by the same amount in
September 1978/Volce

-.04 -T""""-'

02
04
1978

02
04
1979

04
02
1980

the next period, so that the money supply returns
to its level in the base policy simulation by
the end of the second quarter,
The results (Chart 3) indicate a very short lag,
with all the effects comparatively minor. This sug·
gests that if a mistaken monetary policy is reversed quickly, the error need have but little effect
on the economy, Or alternatively, if the money
stock is allowed to drift up unintentionally during
one quarter, compensating action during the fol~
lowing quarter will prevent any serious damage.
The length of the lags in the effects of policy
varies considerably over time in the MPS model.
By using the model to simulate historical periods,
we can compare what actually occurred with what
the model estima tes would have happened had
there been a permanent $1 billion addition to the
money supply at some point in the past.' We ran

1. The model was run over past periods using actual
exogenous variables. The equations were adjusted so that
prediction errors were eliminated. Next, the model was
rerun with a n additional $1 billion of money (M-l) in
each period. This result was then compared with
what actually occurred.
5

Lags in the effects of monetary policy
tend to be shorter in economic expansions
CHART 4.

Number of Quarters Until Peak Effect of Money Increase
on Real GNP and Inflation

12---------------------------------------------------------OUARTERS

11-

r;\

B-

"" "
\

76-

1-\
f
\

., !
I --

...... ,\
it

.. I
-............ ~

':0

"-"
':0'-:,

"
"

1970

1971

Q2
1972

1973

_,/
•

-0l'

.......... REAL GNP

!.!

"::;"
"C
>-w
"0Q2

..,~ .. ".""..

~
-'
c

\. --../,

•••••

•...... " .... ,......,

.....

:::t

0--.
Q'

"\.

2 - -'
c
1 -

INFLATION RATE

_ ,.. ______ ,

....."'..... -.,'
-:.•. ,,~..

o:;)

-".

."".... ""."""\o.--~

,- 5I
3-

~r~~.

, "'•••.j
•'.
I "'ttl'

10-

">"

1974

1975

..--

Q2
1977

1976

1978

QUARTER IN WHICH MONEY WAS INCREASED

simulations starling with each quarter from the
fourth quarter of 1970 to the second quarter of
1978. Chart 4 shows how the peaks of the lags
have changed over lime. For each simulation
the vertical axis indicates how long it took for the
money addition to have maximum effects on real
GNP and the inflation rate.
The results differ dramatically, depending on
when the addition to money was made. If the
money supply had been increased during the third
quarter of 1973 by $1 billion more than it actually
was, with further additions unchanged from their
6

historical quantities, the maximum effect of the
addition on real output and inflation would have
been felt only three quarters later, the second
quarter of 1974. But the effects of an increase in
money during 1974-Q1 would still have been growing at the end of 1976, 11 quarters later,
Although our results span less than two full business cycles, it appears that the length of the lags
in policy effects behaves cyclically. Long lags
occur at the recession trough of 1970-Q4 and immediately after, and throughout the recession of
1973-Q4 to 1975-Q1 and immediately after. The
Fede~al

Re.erve Bank of 0.11••

The model indicates a longer lag in the effect of
monetary policy on the rate of inflation during the
latest expansion than during the 1970-73 expansion.
This is somewhat puzzling since the model assumes the underlying structure of the economy to
be unchanged over time. The difference may stem
from the fact that the last recession was much
deeper than the previous one, so that unemployment rates have generally been much higher during
the latest expansion. With greater slack in labor
markets, a marginal decrease in unemployment has
a less rapid effect on wages and prices in the
model.
Not only do the peaks of the lag distribution
change over time. but the shapes and amplitudes
change also. Chart 5 illustrates some representa-

lags are short only during economic expansions. 2
This cyclical behavior supports the popular view
that it is harder for monetary policy to "push on a
string," or get things moving in a recession, than
to restrain a boom. When existing capital is fully
employed. a small change in product demand alters
the investment needs of the economy immediately.
But when existing plants and equipment are underutilized , an increase in product demand requires no
new investment.
2. The long lags in the most r ecent quarter may reflect
the very weak outlook of the ve rsion of the MPS model
used here, which does not contain any of the
judgmental adj ustments that might be made for
forecasting purposes.

The pattern of lagged effect on real output varies over time
CHART 5.

Lagged Effects of Money Increase on Real GNP
for Selected Starting Points

,.-._._ ......""'.

8--------------------~~~~----------------------------

BILLION DOLLARS

, . 1'''

"'"
;·~/,,,,,,,,,,,".. .
;;'i~
.........,,' --

... ..,*.,

....,.,

1977-04

.....

... .""

"::....,'x.

"., ,'

.'" •,,

_ _ _ ////~

,.,,,,

•••~,.,

... . ...

--'"

111/

I I~

/ "

"'"

If(, ••
•••••••

"'" .......... " ..: ......

.......

.'. I

.-,.,~'"y '
•••

~.,'

2..

II'

1973-04
' •

II'

1970-04

o------------------------------------~

____________

-2-

1972-02

QUARTERS AFTER POLICY CHANGE

September 1979/Voice

•

Fighting inflation would have taken stronger policy measures
in 1975 or 1977 than in 1972
CHART 6.

Lagged Effects of Money Increase on the Rate of Inflation
for Selected Starting Points

.40-----------------------------------------------------------PERCENT (ANNUAL RATE)

.35 -

.30-

.25.20 .15 -

.10-

.05-

aUARTERS AFTER MONEV INCREASE

tive lags of policy effects on real output.! In recent
quarters the potential effects of policy have been
more powerful than in the past. An increase in
money in last year's fourth quarter would have
raised price-deflated GNP a year later by almost
$8 for each additional price-deflated dollar of
money.
The shape of the lags indicates the importance
of correct timing in monetary policy. The lag structure for policies begun in 1972-Q2 is typical of
lags relating to money increases initiated from late
1971 through 1972. By the ninth quarter after a
money increase. 1974~Q3 . the model estimates that
real GNP would have been lower than it actually
was. Thus. had the money supply grown more

3. To improve comparability, the effects on real output

were multiplied by tbe value of tbe GNP dena tor in the
starting period. Thus, the chart in effect shows the
impact of an initial $1 billion increase in real money (the
price-deflated money supply).

rapidly than it actually did in late 1972 and early
1973, the peak of the boom would have been higher
but the decline in production would have gone
deeper_ Alternatively, greater restraint during that
period would have reduced the peak of the boom
but would have softened the recession.
Lag structures of the effects on inflation also
differ widely [Chart 6),· The ability to reduce in~
nation appears to have been much weaker during
the current expansion than during the last. The
maximum effect on the inflation rate of an equal
change in money relative to GNP was more than
twice as great in 1971 as last year. This probably
results from the overexpansion of the economy in
1973. when policy changes in late 1971 and in 1972
4_ Here, to improve comparability, the effects on the rate
of inflation were multiplied by the ratio of 1972 GNP
to actual GNP in the starting period. The chart therefore
indicates the effects of money increases equal in size,
relative to the size of the economy, to a $1 billion
increase in 1972.
Federal Reserve Bank of Dallas

would have hnd their greatest impact. No such
boom is or has been projected by the model; therefore. marginal changes in labor market tightness
have less effect on inflation.

Much of the effect of a policy decision made
today to permanently increase or decrease the
money supply occurs far into the future--8o
far, in fact, that fore casts of GNP for the
relevant periods are probably not reliable.

may be disruptive to the economy. In general, it
should be possible. each quarter, to make partial
corrections in policy for past forecast errors. Thus,
the faster forecasts are corrected. the more effective countercyclical monetary policy can be.
Unfortunately, as the table again indicates, the record is not particularly good.
The success of discretionary monetary policy
also depends on how ambitious it is-that is, the
extent to which policy attempts to offset cyclical
disturbances. If policy seeks to smooth business
cycles only partially, forecast errors may be less
serious. For example, a policy designed to lessen
the severity of a recession by half will still be
useful if an accurate forecast would have predicted
a somewhat larger or smaller recession.

Implications for policy
To put these lags in proper perspective. they must
be considered in relation to the accuracy of forecasts of the economic variables that policy is designed to affect. As indicated in the accompanying
table. a recent survey by Victor Zarnowitz of the
accuracy of major forecasts found large forecasting errors over the 1970-75 period.~ Predictions of
real GNP four quarters beyond the forecasting date
were off by 2.4 percentage points on average, and
the errors swelled to 5.2 percentage points for
forecasts eight quarters in the future. Although
forecasts have been more accurate since 1975,
errors of this magnitude create a critical problem
for policy. Much of the effect of a policy decision
made today to permanen tl y increase or decrease
the money supply occurs far into the future-so
far. in fact. that forecasts of GNP for the relevant
periods are probably not reliable.
But policy decisions are not immutable. Forecasts improve as the time period being forecast
draws near, as indicated in the table. The costs of
an erroneous forecast depend on how quickly it
is corrected. As observed above (Chart 3J. if
error is discovered quickly, a reversal of policy
can prevent much damage from being done. If,
however. a policy change is predicated on a mistaken forecast that is not corrected until after the
forecast period is over. the full effects of the policy

Policy may also be more effective at some stages
of the cycle than at others. Wallace Duncan found
that one- and two-quarter forecast errors were
higher near turning points." This suggests that
it should be easier to follow a discretionary policy
during long expansions. when predictions are more
accurate and policy lags are fairly short, than near
cyclical peaks and troughs.

5. '"How Well Do Economists Forecast Gtowth,
Recessions, and Innatlon?" Economic Outlook USA 5
(Spring 1576): 22-25.

6. "Forecasting the Economy- The Stock Market Versus
Econometric Models," Review, Federal Reserve Bank
of Dallas, December 1977, pp. 5·13.

September 1910/Voice

Forecast errors are larger
for more distant time periodS
(Errors in quarterly multiperlod
forecasls of GNP and real GNP,
1970-75, In percentage points)
A"a l
Span 01 10rK"1

One quarter .....
Two quarters ....
Three quarters ...
Four quarters ....
Five quarters ...
Six quarters .....
Seven quarters ...
Eight quarters ...

GN'

..S

.53
1.25
1.90
2.43

.98
1.42

1.73
2. 19
2.59
2.96
3.15

3.06

3.63
4.68

5.24

NOTE: Fillyral II......11.. 01 m. .n
.blolut•• n'Ofi In percentall"
chino",. u.lng . . .mpl" 01 major
10r.C'lt,.
SOURCE: ZI,nowllz. "How wan 00
Economltll Foree.,t Growlh.
Alc ..llonl, and InIi IUon?" p. 24.

•

Conclusions
The foregoing analysis should make it dear that
there is no easy answer to the question, When will
the effects of current policy actions be felt by the
economy? There are different lags for different
types of policy alternatives, for different starting
dates, and for different goal variables.
For one specific policy option, a permanent
change in the money supply, the MPS model indicates that peak effects on real output and inflation
occur as early as three quarters and as late as
three years or more after the change.

Considered in relation to errors in economic
forecasts, the policy lags are quite long. The major
effects of policy generally occur beyond the range
of reasonable forecast accuracy. Nevertheless,
monetary policy is flexible enough to adjust to
minor forecast errors, especially during expansions. During recessions, however, forecasts are
particularly poor and, in the MPS model, monetary
policy is relatively weak and acts only with long
lags.

New member banks
Baybrook National Bank, Friendswood, Texas, a newly organized institution
located in the territory served by the Houston Branch of the Federal Reserve
Bank of Dallas, opened for business August 14, 1978, as a member of the
Federal Reserve System. The new member bank opened with capital of
$750,000 and surplus of $750,000. The officers are: Thomas A. Boone, President and Chief Executive Officer; A. W. Schmidt, Chairman of the Board
(Inactive); and Mary Evelyn Clift, Cashier.
Southwest National Bank, Hobbs, New Mexico, a newly organized institution
located in the territory served by the EI Paso Branch of the Federal Reserve
Bank of Dallas, opened for business September 5, 1978, as a member of the
Federal Reserve System. The new member bank opened with capital of
$750,000 and surplus of $750,000. The officers are: S. D. Levenson, Chairman
of the Board; Gary C. Lawrence, President: and Richard W. Jones, Vice
President and Cashier.
South Park National Bank, San Antonio, 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 September 5, 1978. as a
member of the Federal Reserve System. The new member bank opened
with capital of $500.000, surplus of $500,000, and undivided profits of
$250.000. The officers are: H. Gilmer Williams. Chairman of the Board
and President: Wendell H. Rees. Jr. , Cashier; and Jesse Santiago, Loan
Officer.

New nonmember bank
Bank of Kerrville, Kerrville. Texas, a newly organized nonmember bank
located in the territory served by the San Antonio Branch of the Federal
Reserve Bank of Dallas, opened for business August 3, 1978.

F.,d.,f81 Rueno., Bank of Dall••

Gf'ed Quotes ~~

Brief Ex cerpts from Recent Federal Reserve Sp eeches, Statements, Publications, Etc.

On inflation
"Inflation usually is the final link in a chain of well meant actions. The benefits of
a tax cut, of increased public spending are felt within a few weeks or quarters. The
penalty in terms of inflation, may not come until after a couple of years or even
later. Inflation is the long-run consequence of short-run expediencies. Life, to be sure,
is a succession of short runs, but every moment is also the long run of some shortrun expediency of long ago, We atc now experiencing the long-run consequences
of the short-run policies of the past. These consequences are as unacceptable as rain
on weekends, and just as easy to change. If we continue to meet current problems
with new short-run devices, the bill will keep mounting.
"We will not defeat inflation if we always take the short view. We will then
always find that the cost of fi ghting inflation is always too high, the short-run loss
of output and employment too great. We shall find ourselves ignoring inflation, in
the hope that it will somehow not grow worse. That is pure self-deception ....
Inflation ignored accelerates."
Henry C. Wallich, Member, Board of
Governors of the Federal Reserve System
"Honest Money" (Remarks at the M.B.A.
Graduation Exercises of the Fordham
Graduate School of Business, New York,
New York, June 28, 1978)

" Inflation is a more fundamental although more slowly operating factor in
influencing the international value of the dollar than the current or capital account
deficit. In the short run, to be sure, it is the level of business activity that primarily
influences imports and exports and therewith the exchange rate. That clearly has
been the experience of the United States and of the dollar. But in the longer run,
inflation rather than the cyclical gap is likely to be the dominant force, to the extent
that U.S. inflation differs from inflation abroad."
"Success against inflation would directly strengthen the dollar and would also
help to reduce the current account deficit. There remains the question what other
influences can be brought to bear on this gap in our international accounts."
Henry C. Wallich, Member, Board of
Governors of the Federal Reserve System
"Trade, Capital Flows, and Currencies"
(Remarks at the 8th International Management Symposium at the S1. Gall en Graduat e
School for Business and Public Admini stration, S1. Gallen. Switzerland, May 8, 1978)
September 1t'S/Voice

Fewer and better regulations
"Establishment of a high-growth, low-inflation economy would be facilitated by
extensive reform of costly governmental regulations. Regulatory activities in the
health, safety and environmental protection areas may not always achieve the desired
outcome at minimum costs, and they need to be reviewed with that thought in mind.
"Similarly, market- and price-regulation programs should be carefully reexamined
to ensure that their benefits outweigh their costs."
"In the same vein, it is important that we carefully consider alternatives fo r those
programs that lend to limit competition and raise prices. Notable examples are import
controls, price supports, and the Davis-Bacon and Walsh-Healy Acts. In addition, it
seems appropriate to consider deferring the increase in the minimum wage that is
scheduled for January 1, 1979, given its implications for costs and for youth
employ ment opportunities."
G, William Miller, Chairman, Board of
Governors of the Federal Reserve System
"Miller: Cutting Federal GNP Share to 20%
Would Expand Housing, Business Capital"
(American Banker, July 17, 1978)

"Turning to the extension of the current deposit ceiling rate authority, the Board
continues to believe tha t such rate ceilings-and the mandated deposit rate differentials between banks and thrifts-should be removed over the long run to promote
equity for small savers and economic efficiency. Although in practice rate ceilings
probably can be removed only gradually, groMAS competitive inequities under the
present rate st ructure make it imperative that the process of removing artificial rate
and differential restrictions begin soon."
Philip C. Jackson, Jr., Member, Board of
Governors of the Federal Reserve System
(Statement before the Subcommittee on
Financial Institution s Supervision. Regulation
and Insurance of the Committee on Banking.
Finance and Urban Affairs, U.S. House of
Representatives. July 26, 1978)

"The national policy of barring interstate banking, as embodied in the McFadden
Act, needs review. Banking has changed. The structure of the economy and its
fi nancial needs have also changed since the McFadden Act was passed over 50 years
ago. Pending completion of that review, however, it is inconsis tent with the principle
of national treatment and unfair to domestic banks to allow foreign banks to continue
to expand offices across State lines."
G, William Miller, Chairman, Board of
Governors of the Federal Reserve System
(Statement before the Subcommittee on
Financial Institutions of the Committee on
Banking. Housing and Urban Affairs, U.s.
Senate, June 21, 1978)
12

Federal Reserve Bank of Dalla.

National monetary policy
"We can debate a specific monetary policy on its merits, but from any standpoint,
I can see no public purpose to be served by limiting the effectiveness of the central
bank. Monetary policy is made for the entire nation, not a limited sector of the
banking community. All depository institutions are chartered in the public interest
and all should be directly supportive of and participants in the implementation of
policy."
Philip E. Coldwell, Member, Board of
Governors of the Federal Reserve System
(Statement before the Committee on Banking,
Finance and Urban Affairs, U.s. House of
Representatives, July 31, 1978)

Board Proposes to Lighten
Penalties for Early
Withdrawal of Time Deposits
The Board of Governors of the Federal Reserve
System has issued for comment a proposal to lighten the penalty required for early withdrawal of
certain types of time deposits at member banks.
The proposal, an amendment to Regulation Q
(which covers interest on deposits), is expected to
benefit particularly time deposits in long-term Individual Retirement Accounts (IRA's) and Keogh
Plan retirement accounts.
Under the Board's proposal, changes would be
made in the penalties member banks are required
to impose in the case of early withdrawal from
either time deposit open accounts-accounts that
have a specified maturity date-or notice accounts-those that have no specified maturity but
require the depositor to give notice (commonly 90
days) of intent to withdraw all or part of the
account.

September t978/Voh::e

One-Bank Holding Companies
Increase Rapidly
By Corol C. Modeley

The number of one-bank holding companies has
increased dramatically since the Bank Holding
Company Act Amendments of 1970, popularly
known as the one-bank holding company act. This
relatively new development is spreading rapidly as
bankers seek the tax advantages of the holding
company form of ownership of smaU banks. The
trend has only recently caught on in the Southwest, particularly in Texas, where the number
of one-bank holding company approvals has
jumped from a total of 3 for the 1971-74 period
to 20 in just the first half of 1978. As of June 3D,
1978, there were 82 one-bank holding companies
in the Eleventh Federal Reserve District, which
includes Texas and parts of Louisiana, New Mexi·
co, and Oklahoma.
Advantages and disadvantages
The major reason for most one· bank holding company formations is to reduce Federal income tax.
Interest payments to service the debt incurred by
a holding company to acquire a bank's stock are
totally tax·deductible, whereas interest deductions
by an individual are generally limited to $10,000
a year. Also, if a consolidated income tax return
is filed, dividends from the bank to the holding
company are not taxed, as such income would be
if the dividends were paid to individual stock·
holders.
For a better understanding of the tax advantages
of the holding company, a simple comparison of
the tax situation of the owner of bank stock both
14

ONE·BANK HOLDING
COMPANIES IN TEXAS

December 31
1974 ...
1975 . ..
1976 . .....
1977 ..........
June 30, 1978 . . .

59
48
52

$2,316.1

2,672.3

2,079.5
2,157.5

2,620.3

NOTE: Includes compan le. lor which regulalOry
approval hilt blli n granted but . cqlll·
slUon 01 bank alock has not been
completed.

before and after a one-bank holding company
formation may be helpful. The important point
is that before the holding company is formed,
there are two taxpayers but after the holding
company is formed. there is only one.
Assume that an individual borrows to acquire
controlling interest in the stock of a bank. In this
situation there are two taxpayers. The bank pays
tax on its taxable income, and the stockholder
also pays tax on his dividend income. The stockholder may deduct certain expenses from this
taxable income. but because of a provision in the
Internal Revenue Code, called the investment interest limitation, the individual is not allowed to
deduct most of the interest he pays on his stock
acquisition debt.
Federal Relerve Balik of Dallu

When a one-bank holding company is formed,
assuming it controls 60 percent or more of the
stock of the bank, it can file a consolidated tax
return. In this case there is only one taxpayer, and
the net income of the bank (before taxes) is attributed to the bank holding company. From the
bank's taxable income the holding company can
deduct the interest paid on its indebtedness. This
interest deduction, which the individual stockholder is effectively denied, can considerably reduce the tax bill of the holding company.
Another reason for forming one-bank holding
companies is to use them as vehicles for future
expansion through acquisitions of additional
banks or other permissible closely related businesses. While one-bank holding companies that
are intended to become multibank organizations
normally are virtually debt-free at the outset, those
that have tax savings as the major motivation
usually assume the debt of the controlling stockholders of the bank. Using the amount of debt
assumed by the holding companies as the criterion,
it appears that about three-fourth s of the one-bank
holding companies organized in Texas since 1970
have been largely tax-motivated.
In addition to these two main benefits, the onebank holding company is also a useful device for
the rearrangement or succession of stockholder
interests. Because a holding company is an ongoing concern, ownership transfers can be
achieved with more fl exibility than for privately
owned banks. Formation of a one-bank holding
company is common, for example, when the stock
of a bank is largely owned by an individual nearing retirement. In this case, the holding company
acquires the individual's bank stock and issues
nonvoting preferred stock to the individual and
voting common stock to his heirs. This procedure
has the advantage of providing income to the individual for his retirement while passing control
to his heirs. Moreover, many tax practitioners believe this procedure favorably affects the individual's estate tax es, because more of the increase
in stock value that results from the bank's growth
can be expected to flow to the common stock
(owned by the heirs) than to the preferred.
One-bank holding companies also have the usual
advantages of the corporate form of ownership.
For example, when the holding company acquires
an individual's bank stock and assumes his acquisition debt, the individual is no longer personally
liable for that debt; the liability passes to the
holding company.
Septembet1978/VOIClI

Another advantage of the one-bank holding
company is that it can be used as a vehicle for
borrowing money. Because all or most of the
bank's shares are concentrated in the holding
company, the shares can be used as collateral for
borrOWing. A holding company formed with little
debt can immediately become a source of capital
to the bank. A tax-motivated holding company
typically has no excess debt capacity at the outset,
but after some of the original debt is retired, it
too could become a source of additional capital to
the bank.
While the one-bank holding company is a valuable tool for realizing tax benefits, future expansion, succession flexibility, reduced stockholder
liability, and capital maintenance, it is not without
its drawbacks. Compared with its bank, a onebank holding company is subject to additional
regulation, such as by the Securities and Exchange
Commission, as well as additional supervision by
agencies haVing existing relationships with the
bank, such as the Federal Reserve and the Internal
Revenue Service. Organizational expenses increase, especially for legal and accounting functions; and administrative expenses rise, mainly as
a result of the additional reporting requirements.
Moreover. a state franchise tax-currently
amounting to an annual rate of $4.25 per $1,000
of a corporation's total capital, surplus, and undivided profits-must be paid by one-bank holding
companies in Texas.
The Federal Reserve's role
The Federal Reserve Board was given responsibility for the supervision and regulation of bank
holding companies by the Bank Holding Company
Act of 1956. In carrying out this responsibility,
the Board issued Regulation Y.
Prior Board approval is required for any company to acquire "control ," usually 25 percent or
more of the stock, of a bank. Because one of the
Federal Reserve's responsibilities is to ensure the
safety and soundness of the nation's banking system, holding company applications are carefully
reviewed to ensure that the proposed formation
will not weaken the bank. In general, the one-bank
holding company movement has not had adverse
effects on the soundness of banks. On the contrary, in instances where the one-bank holding
company achieves certain tax benefits and reduces
the cash drain on the bank. the company can serve
as a source of additional strength.
15

The first step in forming a one-bank holding
company is to file an application with the Federal
Reserve Bank serving the district in which the
bank is located. In the case of banks in the Eleventh District-Texas, northern Louisiana, southern New Mexico, and southeastern Oklahomaapplications are sent to the Federal Reserve Bank
of Dallas.
Upon receiving a holding company application,
the Federal Reserve Bank does a background investigation and, if necessary, requests additional
information. After receiving a complete record,
the Federal Reserve System has 91 days to approve or deny the application. In cases handled
by the Reserve banks under delegated authority,
45 days are allowed to approve the application.
While the Reserve banks may, under delegated
authority, approve certain holding company applications, all applications for which denial is recommended must be referred to the Board. Two onebank holding company applications from the
Eleventh District have been denied since 1970.
However, this does not present a complete picture.
Prior to a final decision, there is often a good deal
of discussion between the applicant and the Federal Reserve. As a result of problem aspects discussed, some applications are never filed. In addition, a number of applications are withdrawn after
the Federal Reserve indicates informally that approval is unlikely. In many other cases, applications are strengthened before filing so as to satisfy
requirements for approval.
After an application is formally approved, the
applicant must wait an additional 30 days to give
interested parties, including the Justice Department, time to object. The Justice Department may
try to stop the transaction under the antitrust laws.
Under delegated authority, Federal Reserve
banks may approve holding company applications
when they meet the following criteria. among
others: no more than 75 percent of the holding
company's acquisition cost for the bank's stock
is represented by debt incurred by the holding
company; the initial debt can be retired in 12
years; and no controversial "policy issues," issues to which the Board has not yet spoken, are
involved.
The delegated-authority criteria indicate the
major areas of concern to the Board of Governors
in holding company proposals and, in some cases,
spell out fairly clear standards for approval. However, not all applications meeting the specified
minimum criteria will be approved, nor will all
16

applications failing to meet these specific criteria
be denied. AU relevant information is considered.

Considerations in one·bank
holding company applications
The primary considerations in one-bank holding
company applications are financial and managerial
factors, particularly as they relate to the capability of the holding company to service its debt.
It is essential that the holding company not become a drain on the bank's financial strength.
Accordingly, the principal issue in the evaluation
is whether the holding company can service its
debt and pay normal operating expenses and, at
the same time, maintain the capital of its subsidiary bank on a par with that of similar banks. The
bank should be able to earn enough to maintain
its capital at an acceptable level-at least 8 percent of total assets-and still pay the dividends
required by the holding company.
Also important in the evaluation of financial
factors is the reasonableness of the projected
cash flows. In addition, consideration is given
to any practices that might adversely affect the
bank's capital, such as payment of excessive compensation to the holding company or its principals.
The proposed management of the holding company is also evaluated. Dividend policy is important in this evaluation. The dividends should
be realistic compared with those of peer-group
banks and not be subject to any statutory restrictions, in addition to having no adverse effect on
the bank's capital.
Commitments by the applicant are sometimes
an important consideration in a case where an
applicant's program to service its debt and maintain capital includes two or three marginal years.
Commitments, such as forgoing payment of dividends by the subsidiary bank or injecting additional capital into the bank whenever the capitalto-assets ratio falls below a certain figure , may
make the difference between approval and denial
if the application is otherwise sound.
Although competitive considerations usually do
not play a major role in one-bank holding company formations, occasionally they do. For example, competition is a factor when the principals
of the applicant company also have control of
other banks in the same market.
In addition to approving holding company applications, the Federal Reserve has three other major areas of holding company supervision. First,
Federal Reurv .. Bank of Dalla.

the Federal Reserve requires a number of reports
from all holding companies. Second. the Federal
Reserve has the authority and responsibility to
inspect periodically each bank holding company
and its non banking subsidiaries. Third. the Federal Reserve can use supervisory measures such
as cease-and-desist orders in the case of unsafe
or unsound practices, violations of statutes or
regulations. or failure of a bank holding company
to comply with conditions imposed by the Board
of Governors.

Structuring a one-bank holding company
In structuring a one-bank holding company. certain steps are commonly taken. To achieve the
tax benefits, it is necessary for the holding company to own at least 80 percent of the bank. This
enables the holding company and the bank to file
a consolidated tax return so that the holding company can offset interest expenses against the subsidiary's earnings. It is also beneficial to the stockholders of the bank to qualify for a Section 351
exchange under the Internal Revenue Code so
their bank stock can be exchanged for stock of
the holding company without gain or loss being
recognized.
Acquisition of the bank stock is usually handled
in one of two ways. The more common of these is
for the holding company to directly exchange its
stock for that of the bank. Although this is the
easier method, it has one major disadvantage. If
some of the stockholders do not wish to exchange
their stock for that of the holding company. the
holding company wiII have mi nority stockholders,

and the threat of future minority stockholder litigation constitutes a potential difficulty for the
holding company's management.
Another common method of bank acquisition.
which ensures I OO-percent ownership of the bank,
is through an interim bank merger. In this method.
a charter for a new bank is obtained. However.
the new-or interim-bank never opens but, instead, is merged with the bank to be acquired.
Under Texas law, only two-thirds of the stockholders of a company must approve a merger for
it to be executed. This allows IOO-percent control
of a bank with only two-thirds stockholder approval, but laO-percent stockholder approval is
necessary in a direct-exchange transaction. Stockholders of the existing bank who do not consent
to the merger are entitled to redeem their stock
for cash. at a value to be determined by impartial
appraisers.
Both methods for forming one-bank holding
companies are being used at an increasing pace
in the District. This trend reflects the fact that a
growing number of bankers are seeking the tax
and other advantages that a one-bank holding
company offers. The principal advantage, of
course. is a reduction of the tax burden of indi·
vidual ownership of a bank. Because the holding
company saves taxes, it can redirect cash to the
servicing of its debt and, at the same time, reduce
the dividends needed from its subsidiary bank.
This allows the bank to retain more earnings, augment its capital. and become a stronger institution. The spread of one·bank holding companies,
if properly used, has the potential, therefore , for
impacting favorably on banking in the Southwest.

Regulation 0 Amended
Executive officers of member banks may not re·
ceive more favorab le credit terms than those
offered to the general public. according to a recent
amendment to Federal Reserve Regulation 0, effective June 3D, 1978. Regulation 0 deals with
loans by member banks to their executive officers
and applies to bank credit cards, check credit, or
similar plans.

September 1978/Voice

Southwestern Banks
Improve Performance
in 1977

Commercial banks in the Southwest generally im·
proved their performance in 1977 in such areas as
return on assets, return on equity, and net losses
on loans, according to data released by the Federal Reserve Bank of Dallas. The Bank recently
published its annual statement covering operating
ratios of commercial banks in the Eleventh Federal Reserve District, which includes Texas and
parts of Louisiana, New Mexico. and Oklahoma.
Return on assets. a key measure of bank profitability, reached or exceeded the sought-after 1,0percent ratio for banks with average deposits between $10 million and $500 million. The highest
average return on assets- I.12 percent-was
achieved by banks in the $25 million-SSO million
deposit range. While return on assets increased
during 1977 for banks in four deposit size categories, it decreased for three other groups. The
percentage dropped significantly, from .63 to .56,
for banks having under $5 million in deposits.
Banks with
average depo.its
(Millions
of dollars)

Under $5 ......
$5 to $10 ......
$10 10 $25 .....

$25 to $50 .....
$50 to $100 ...
$100 to $500 ...
Over $500 .....

19'77

1976

.56%

.63%

.89

.93

1.08
1.12
1.07
1.00

1.03

.83

1.04

.95
.83
.84

Return on equity improved for banks in alI deposit size categories. The highest return was at-

tained by banks with $50 million to $100 million
in deposits. Their average return was 15.08 percent, up from 13.89 percent in 1976.
Banka with
average depo.it.
(Million.
of dollars)

Under $5 ......
$510$10 ......
$10 10 $25 .....
$25 10 $50 .....

$50 to $100 ....
$100 10 $500 ...

Over $500 .....

1911
7.18%
10.30
13.55
14.51
15.08
14.84
14.11

1916
6.24%
10.21
12.70
13.66
13.89
12.09
14.05

Net 108s88 on loans, another important measure
of bank performance, improved in 1977 for all
groups of banks in the Eleventh District. The largest banks had the lowest loan charge-off-.19 percent. which was down substantially from .53 percen t in 1976.
Banks with
average depo.its
(Millions
of dollars)

1977

Under $5 ......
$5 to $10 . ....
$10 to $25 .....
$25 to $50 .....

-.42%
-.55
-.42

$50 10 $100 ....

-.37
-.35
-.19

$100 to $500 ...
Over $500 .....

-.38

1916
-

-.49%
-.57
-.49
-.60
-.55

-.51
-.53

Federal Re.erve Bank of Dall.s

Interest and fees on loans, yet another measure
of bank performance, increased slightly or remained stable for all groups of banks except those
over $500 million in deposits. For these largest
banks, the average decreased from 9.27 percent in
1976 to 8.43 percent in 1977. This decline brought
interest and fees on loans at the largest banks to
the lowest charged by any group, while the highest
charged was 9.71 percent for banks with $5 million
to $10 million in deposits.
Banks with
average deposits
(Millions
of dollars)
Under $5 .... . .
$5 to $10.
$10 to $25.
$25 to $50 .....
$50 to $100 ....
$100 to $500 . . .
Over $500 .....

1977
9.58%
9.71
9.64
9.65
9.50
9.16
B.43

1976
9.09%
9.68

9.64
9.62
9.46
9.12
9.27

largest banks (over $500 million in deposits). Their
percentage of time and savings deposits was 51.72
and 52.60, respectively.
Banks with
average deposits
(Millions
of dollars)
Under $5 ......
$510$10 ......

$10 to $25 .....
$25 to $50 .....
$50 to $100 ....
$100 to $500 ...
Over $500 .....

1977

1976

51.72%
55.61
57.86
59.41
59.66
59.68
52.60

49.18%
54.26
56.70
58.12
59.04
58.45
51.42

Requests for copies of the report on operating
ratios-which includes ratios on profitability,
sources and disposition of income, distribution of
total assets, and distribution of loans at domestic
offices, as well as the rate of return on securities
and loans-should be made to the Bank and Public
Information Department of this Bank, (214)
651-6267.

Total operating expenses as a percentage of total
assets decreased consistently as the size of banks
increased, suggesting economics of scale. Beginning at 6.76 percent for banks having under $5 million in deposits, the ratio decreased slowly at first
but then moved rapidly to 5.45 percent for banks
over $500 million in deposits.
Banks with
average deposits
(Mi1Jions
of dollaH)
Under $5 ......
$5 '0 $10 ......
$10 to $25 .....
$2510 $50 .....

$50 to $100 ....
$100 to $500 ...
Over $500 .....

1977

1976

6.76%
6.73
6.48
6.34
6.20
5.92
5.45

6.6'?'/o

6.67
6.41
6.40
6.27
5.96
5.31

The ratio of time and savings deposits to total
deposits at domestic offices increased at all sizes
of southwestern banks in 1977. The highest was
59.68 percent for banks in the $100 million-$SOO
million deposit range, followed closely by 59.66
percent for banks with $50 million to $100 million
in deposits. The lowest ratios were for the smallest banks (under $5 million in deposits) and the
September ll78/Volce

South Texas Regional
Checks Processing
Center Expanded
Effective September 5, 1978, the area served by
the South Texas Regional Checks Processing Cen~
tef (RCPC) was expanded to include 36 banks in
the Rio Grande Valley. The South Texas RCPC is
at the San Antonio Branch of the Federal Reserve
Bank of Dallas and is one of three Repe's serving
banks in the Eleventh Federal Reserve District,
which includes Texas and parts of Louisiana, New
Mexico, and Oklahoma. The other two are in the
Houston and Dallas Federal Reserve offices and

serve the respective surrounding areas. The
Repe's provide same·day credit to participating
bank depositors that meet the 12:01 a.m. deadline
for deposits.
The South Texas RCPC was established in 1973
and expanded several times until it served all par·
Ucipating banks within a 70-miIe radius of San
Antonio. Prior to the latest expansion, 179 banks
were served by the RCPC.
The expansion will improve the collection of
checks in Sou th Texas and improve in ternal check
operations at the San Antonio Branch. The expanded territory includes four Texas counties in
th e Rio Grande Valley, an area that is experiencing
strong growth. Deposits held by Valley banks
amounted to $1,284 million at the end of April
1978, an increase of $135 million over a year
earlier.

Amendment Proposed
for Regulation Y
An amendment to Regulation Y that would allow
bank holding companies to provide check verification services has been proposed by the Board of
Governors of the Federal Reserve System.
Under the Bank Holding Company Act, bank
holding companies may not acquire shares of a
company unless it is engaged in an activity that is
"closely related to banking." The Board's Regulation Y, which regulates bank holding companies,
lists a number of activities that have been determined to be permissible for bank holding companies. The Board now proposes to add check verification to that list.
A check verification company accepts the risk
for some personal checks in return for a fee from
merchants. The company authorizes subscribing
merchants to accept certain personal checks, and
if an authorized check is not paid, the company
buys it from the merchant.
The Board's proposal to allow bank holding
companies to provide check veri6cation services
was made in response to an application by Barnett
Banks of Florida, Inc., to establish such a subsidiary.

Board Withdraws 1965
Interpretation of
Regulations G and U
The Board of Governors of the Federal Reserve
System has withdrawn a 1965 interpretation of
its margin regulations that generally required lend·
ers approving loans collateralized by securities
subject to margin requirements to personally meet
with the borrower to determine if his purpose
statement was true.
The new interpretation anows a lender to accept
purpose statements through the mail if the lender
adopts a program that requires detailed information from the borrower and inc1udes proper procedures to verify the truth of the information re·
ceived. Lenders in the Eleventh Federal Reserve
District should consult the Consumer Affairs Section of this Bank before setting up such a program.
The regulations affected by the new interpretation are those that deal with margin credit extended by banks (Regulation U) and nonbank cred·
Hors other than brokers and dealers {Regulation G}.
Federal Reserve BlInk of Dallas

Full text of Review (Federal Reserve Bank of Dallas) : September 1978

FRASER