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FEDERAL RESERVE B A N K OF ST. L O U IS AUGUST 1977 Utilization of Federal Reserve Bank Services by Member Banks: Implications for the Costs and Benefits of M em bership ........ 2 Estimates of the High-Employment Budget and Changes in Potential O u tp u t.......... 16 Income and Expenses of Eighth District Member B a n k s .................................. Vol. 59, No. 8 23 Utilization of Federal Reserve Bank Services by Member Banks: Implications for the Costs and Benefits of Membership R. ALTON GILBERT 1 HE proportion of commercial banks belonging to the Federal Reserve System has been declining for more than three decades. The percentage of banks in the Federal Reserve System decreased from 49.1 per cent of all commercial banks in 1945 to 39.3 percent at the end of 1976 (see Chart I). The percentage of total bank deposits held at Federal Reserve member banks declined from 86.3 percent to 73.8 percent over the same period. C h a rt I Membership Attrition The reason banks mention most frequently for withdrawing from Federal Reserve membership is the cost of reserve requirements imposed on members relative to reserve requirements of the various states for nonmember banks.1 However, the utilization of Federal Reserve Bank services by member banks must also be considered in an analysis of the costs and benefits of membership. The implications for the costs and benefits of Federal Reserve membership are analyzed on the basis of a survey of services used by member banks that are served by the head office of this Reserve Bank. RESERVE REQUIREMENTS AS A CAUSE OF MEMBERSHIP ATTRITION In general, state reserve requirements for nonmem bers are not lower than those for member banks.2 This observation is especially applicable to smaller banks, since in about half of the states reserve re quirements are flat percentages of various classes of 'P eter Rose, “ Exodus: W h y Banks are Leaving the F ed ,” The Bankers Magazine (W in ter 1 9 7 6 ), pp. 43-49. -R equired subscriptions to Federal Reserve Bank stock by m em ber banks can be considered a type o f interest bearing reserve requirement. M em ber banks must subscribe to stock o f their Federal Reserve Banks in amounts proportional to their capital and surplus. The annual yield on that stock is six percent. That rate o f return was a significant inducement to mem bership in the 1930s and 1940s when market interest rates w ere very low , but given the market interest rates o f recent years, the yield on Federal Reserve stock is now probably a neutral factor in the costs and benefits o f m em bership. Therefore, Federal Reserve Bank stock is not in clu ded in the follow ing discussion o f the reserve burden of m em ber banks or the costs o f membership. Page 2 deposit liabilities, whereas reserve requirements for member banks are graduated so that requirements are lower for smaller banks. The significant difference between the reserve requirements of member and nonmember banks concerns the types of assets they can use to meet their legal reserve requirements. In most states nonmember banks can meet their reserve requirements with vault cash, cash items in the process of collection (C IP C ), and demand bal ances due from other commercial banks. Member banks can meet their reserve requirements only with FEDERAL. RESERVE BANK OF ST. LOUIS vault cash and collected reserve balances at the Fed eral Reserve Banks. The reserve burdens of most nonmember banks are reduced substantially because they are permitted to use CIPC to meet state requirements. Their CIPC represent primarily the value of checks they have deposited with correspondent banks for which the correspondents have not yet received payment.3 On the other hand, when member banks deposit checks with Reserve Banks, they receive credit to their re serve accounts according to a schedule which depends upon the location of the banks on which the checks are drawn. Member banks receive immediate credit for some checks, but for others credit is delayed one or two days. The deferred credit schedule approxi mates the time required for the Federal Reserve System to receive payment for outstanding checks. To demonstrate the significance of CIPC for the relative reserve burdens of member and nonmember banks, the ratios of CIPC to reserve balances were calculated for a group of 49 member banks that are served by the St. Louis office of the Eighth Federal Reserve District and which regularly clear both local and out-of-region checks through this Reserve Bank. The four largest correspondent banks in the area were excluded from these calculations since their CIPC are exceptionally large in relation to their re serve balances. Average daily reserve balances of those member banks would have been 82.6 percent greater if they could have counted CIPC as part of their reserves.4 Another indication of the significance of CIPC is Knight’s estimate that, on average, only 56 percent of demand balances that banks hold at correspondent banks are collected balances.® Another significant difference between reserve re quirements of states and those of the Federal Reserve is that nonmember banks can meet state reserve requirements with deposits at correspondents. As indi cated below, correspondents offer respondent banks higher implicit rates of return on demand balances in the form of services than the implicit returns member :i N onm em ber banks are officially allow ed to count their C IPC as reserves in less than half o f the states. H ow ever, in the other states nonm embers can count C IP C as reserves b y recording all deposits o f checks w ith their correspondents as dem and balances du e from correspondents, w hether the funds are available for their use im mediately or w ith som e delay due to the time required for collection. 4Average daily reserve balances and C IP C w ere calculated for the period Septem ber 9, 1976, through January 12, 1977. 5R obert E. Knight, “ Com parative Burdens o f Federal Reserve M em ber and N onm em ber Banks,” Monthly Review, Federal Reserve Bank o f Kansas City (M a rch 1 9 7 7 ), pp. 24-25. AUGUST 1977 banks receive on their reserve balances at Reserve Banks. In addition, in about half of the states, non member banks can meet various proportions of their reserve requirements by holding interest earning gov ernment securities, and the Federal Reserve enforces its reserve requirements more rigorously than do most states.0 REASONS FOR ANALYZING THE UTILIZATION OF RESERVE RANK SERVICES RY MEMRER RANKS Empirical studies support the view that member banks have greater reserve burdens than nonmembers by showing that member banks have higher cash/asset ratios than nonmember banks of the same size, especially among smaller banks.7 However, these studies do not show in general that the reserves of member banks at Reserve Banks are larger than the demand balances that nonmember banks hold at cor respondents. The cash/asset ratios of member banks are higher than those of nonmembers because many member banks hold their required reserves at the Federal Reserve and hold substantial demand bal ances at correspondent banks. Therefore, analysis of the cost of Federal Reserve membership involves more than just comparison of reserve requirements of the Federal Reserve with those of the states. It also involves examination of reasons why member banks hold large balances with correspondents. One of the major reasons banks hold demand balances at correspondent banks is to compensate correspondents for their use of services. Thus it is relevant to examine the services that mem(iIn 30 states there are no specified dollar penalties for reserve deficiencies for nonm em ber banks. "Cash assets o f banks are generally measured as their vault cash, dem and balances due from correspondents, cash items in the process o f collection, and reserve balances at Reserve Banks. See Gary G . Gilbert and M anferd O . Peterson, “ R e serve Requirements, Federal Reserve M em bership and Bank P erfonnance,” F D IC W orking Paper No. 74-8, and “ The Impact o f Changes in Federal Reserve M em bership on Com m ercial Bank P erfonnance,” Journal of Finance (June 1 9 7 5 ), pp. 713-19; R obert E. Knight, “ Reserve Requirements, Part 1: Com parative Reserve Requirements o f M em ber and N onm em ber Banks,” Monthly Review , Federal Reserve Bank o f Kansas City (A p ril 1 9 7 4 ), pp. 3-20; R obert J. Law rence and D uane L ou gee, “ Determinants o f Correspondent Banking Relationships,” Journal of Money, Credit and Banking (A u gust 1 9 7 0 ), pp. 358-69; L u cille M ayne, The Effect of F e d eral Reserve System M embership on the Profitability of Illinois Banks, 1961-63 (C en ter for Research o f the C ollege o f Business Administration, Pennsylvania State University, 1 9 6 7 ); W alter A. Varvel, “ T h e Cost o f M em bership in the Federal Reserve System,” Federal Reserve Bank o f R ich m ond, W orking Paper 77-1, M arch 1977. Page 3 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1977 Table I P E R C E N T O F IN S U R E D C O M M E R C I A L B A N K S IN E A C H S IZ E G R O U P T H A T A R E M E M B E R S O F THE F E D E R A L R E S E R V E S Y S T E M A S O F D E C E M B ER 31, 1976 Asset Size (in millions) $ Percent 5 or less 18 . 7 % 5 - 9.9 25.5 38.0 10- 24.9 25 - 49.9 48.9 50- 99.9 58.5 100 - 299 .9 66.3 3 0 0 -4 9 9 .9 78.6 5 0 0 or more 86.7 S ou rce: Federal Deposit Insurance C orporation ber banks obtain from Reserve Banks and services that they receive from correspondents. Another reason for examining the use of Reserve Bank services by member banks concerns the size distribution of member banks. In most states reserve requirements for nonmember banks are either flat percentages of various types of deposit liabilities or less graduated than requirements of the Federal Re serve. Also, the ratio of CIPC to total deposits tends to be positively related to bank size. If relative re serve requirements were the only basis on which banks decided whether to be members of the Federal Reserve, these two reasons would cause the largest banks to have the greatest incentives to drop mem bership. Yet this is not the case. Table I indicates that the percentage of banks that are Federal Reserve members increases with the size of banks. Table II shows that the size distribution of banks withdrawing from membership during 1971 through early 1977 corresponds closely to the size dis tribution of all members at the end of last year, but that no banks with total deposits over $1 billion with drew from membership during that period. So there must be additional factors which influence the deci sions of banks concerning Federal Reserve member ship. One such factor is the utilization of Reserve Bank services by member banks. NATURE AND UTILIZATION OF FEDERAL RESERVE RANK SERVICES Services that Reserve Banks provide to member banks are discussed in approximately the order of cost to the Federal Reserve System of providing them, as indicated in Table III. Information on the utiliza tion of services by member banks of differing size is derived from a survey which includes 233 member Table II S IZ E D IS T R IB U T IO N S O F IN S U R E D B A N K S IN TH E U .S . T H A T W IT H D R E W F R O M F E D E R A L R E S E R V E M E M B E R S H IP , J A N U A R Y 1971 - M A R C H 1 9 7 7 , A N D ALL M E M B E R B A N K S , D E C E M B E R 31, 1 9 7 6 All Mem ber Banks Banks that W ithdrew from Mem bership Range of Total Deposits (millions of dollars) Num ber Percentage Cumulative Percentage up to 5 15 5 .0 % 5.0 % Percentage 6 .6 % Cumulative Percentage 6 .6 % 5 to 10 42 14.1 19.1 14.1 10 to 20 77 25.8 44.9 24.8 15.4 60.3 15.9 61.4 70.3 20 to 30 46 20.7 45.5 3 0 to 40 30 10.1 70.4 8.9 4 0 to 50 17 5.7 76.1 5.6 76.9 5 0 to 60 14 4.7 80.8 3.6 79.5 60 to 75 7 2.4 83.2 4.5 84.0 75 to 100 12 4.0 87.2 3.6 87.6 100 to 150 16 5.4 92.6 4.0 91.6 150 to 250 7 2.4 95.0 2.8 94.4 2 5 0 to 5 0 0 12 4.0 99.0 2.7 97.1 5 0 0 to 1,000 3 1.0 100.0 1.4 98.5 1,000 and over 0 0.0 100.0 1.5 100.0 Total 298 10 0 . 0 % 1 0 0 .0 % •Measured as o f Decem ber ‘‘ , 1976, excep t in 8 cases in which recent data were not available. In those cases total deposits were measured A around the tim e banks withdrew from membership. Page 4 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1977 Table III CO STS OF P R O V ID IN G SE L E C T E D S E R V IC E S T O M EM BER Total Federal Reserve System Service Check Collection Cost of Providing Services $ 1 2 4 ,5 6 6 ,9 6 9 Coin and Currency Pickup and Delivery Percent of Total Cost of These Services 6 5 .6 % BANKS IN 1976 Federal Reserve Bank of St. Louis1 Cost of Providing Services Percent of Total Cost of These Services $ 3 ,7 1 4 ,4 5 4 7 3 .1 % 5 0 ,2 2 0 ,6 4 4 26.4 946,11 1 W ire Transfers 5 ,6 7 2,666 3.0 124 ,69 5 2.5 Safekeeping of Securities 7 ,2 2 4 ,9 0 72 3.8 1 9 9 ,4 3 9 ’ 3.9 Discounts and Credits Total 2 ,3 03,49 0 $ 1 8 9 ,9 8 8 ,6 7 6 1.2 100 . 0 % 99,9 0 8 $ 5 ,0 8 4 ,6 0 7 18.6 2.0 100 . 0 % 1Cost data pertain only to head office operations. 2These figures include the cost o f p rov id in g some safekeeping services fo r nonm em ber banks. S ou rce: Federal Reserve System Board o f Governors, Functional Expense Report, 1976 Annual R eport, Section I, p p . 41-69. banks served by the head office of this Bank. Banks are ranked by total assets and divided into groups of 20 each, except for group 12, which includes the 13 largest banks in the survey. Results, summarized for each group, are presented in Table IV. Check Collection The service to member banks that is the most ex pensive for Reserve Banks to provide to members is collection of checks. The Federal Reserve System provides the only national system of check collection, through which 13.2 billion checks were cleared in 1976. This represents about 45 percent of all checks written in the nation last year. Member banks may deposit for credit to their re serve accounts checks drawn on any other domestic bank that remits at par.8 There is no direct charge to member banks for this service. Since the early 1970s, nonmember banks located in zones served by Regional Check Processing Centers have been permitted to deposit at Reserve Banks checks drawn upon other banks in their regions. Deposits of such checks are credited to the reserve accounts of member banks that serve as correspondents. There is no charge to nonmember banks for this service. Nonmember banks collect out-of-region checks through their correspond ents. All checks deposited with Reserve Banks must be encoded with bank routing numbers and dollar amounts. Banks depositing more than a certain mini mum number of checks must sort checks by location of the banks on which the checks are drawn. 8A non-par bank charges a fee w hen checks drawn upon accounts o f its depositors are presented for collection b y any means other than at the bank’s ow n teller w indow . Reserve Banks w ill not accept checks drawn upon such banks for deposit to a m em ber bank reserve account. As o f D ecem ber 31, 1975, there w ere only 73 non-par banks in the nation. A survey of checks deposited with this Bank was conducted in January of this year. Column (4 ) of Table IV reports the percentages of banks within each size group that deposited more than five checks dur ing that month.9 A large majority of banks with total assets under $100 million clear checks through correspondents. For each bank that deposited more than five checks with the Reserve Bank, the number of checks depos ited in January was multiplied by 12 to get an annual rate, and averages within each size group are re ported in column ( 5 ) .1 A few large banks deposited 0 most of the checks. For instance, the 12 largest banks deposited 79 percent of all checks, and the five largest deposited 74 percent. These figures actually under state the share of checks directly deposited by the largest banks since several of these large banks send checks drawn on banks in other Federal Reserve dis tricts directly to the other Federal Reserve Banks. The survey does not include information on the number of such checks. Another function involved in check clearing is that of banks paying their Reserve Bank for checks drawn upon them (remitting for the Fed’s cash letters). The percentages of banks in each group that remit by having their reseive accounts debited are indicated in 9There w ere 15 m em ber banks that deposited from one to five checks in January. T o in clude those banks in the percentages in colum n ( 4 ) w ou ld exaggerate the num ber o f banks using the Reserve Bank’s ch eck clearing facilities. 10T he volum e o f checks deposited w ith Reserve Banks in the first quarter o f each year tends to b e about three percent b elow the volum e for the previous fourth quarter. Therefore, these figures proba b ly understate the annual rate at w hich banks deposit checks. Since the Board o f Governors o f the Federal Reserve System reports volum e o f checks data only on a quarterly basis, there is no accurate means o f adjusting on e m onth’s data for seasonal influences. Page 5 FEDERAL RESERVE BANK OF ST. LOUIS column (6 ). Those member banks not using this method arrange for the reserve accounts of their cor respondents to be debited, the same method of settle ment that is used by nonmember banks. This settlement function is analyzed as a separate service since the method that member banks use for settlement involves costs and benefits which are dif ferent from the costs and benefits involved in the method used for clearing checks. If member banks choose to settle through their reserve accounts, they incur transactions costs involved in meeting their weekly required reserves. If they settle through cor respondents, they must compensate correspondents for record keeping and for the transactions costs which they create for their correspondents. In most size groups in Table IV, the number of banks that have their reserve accounts debited for checks drawn upon them is greater than the number that deposit checks directly with the Reserve Bank. This is probably because depositing checks directly with the Reserve Bank involves more processing by member banks (encoding and sorting) than corre spondents require. Remitting for the Fed’s cash letters through the reserve account involves only somewhat more frequent adjustments to a member bank’s re serve account than remitting through a correspond ent’s account. However, most of the smaller member banks use a correspondent’s account to settle for checks drawn upon themselves. For instance, of the 100 smallest members in the survey, only 16 settle through their reserve accounts, and of the next 100 largest, 38 settle through their reserve accounts. AUGUST 1977 Information on the coin and currency service used by member banks is presented in columns (7 ) - (10) of Table IV. Column (7 ) indicates that most member banks receive armored car service. Almost all of the others receive Federal Reserve coin and currency service through the mail ( see column 8 ). The remain ing member banks receive money service from correspondents. When member banks receive money shipments or deposit coin and currency at the Reserve Bank, they can have the Reserve Bank debit or credit their re serve accounts or those of their correspondent banks. Such practices vary among member banks, as indi cated in column (9 ). The method of debiting and crediting for a bank’s money service, either through its reserve account or a correspondent account, can be considered a separate aspect of this service, as in the discussion above about settlement for checks drawn upon a member bank. The degree to which member banks of various sizes use the Federal Reserve’s coin and currency service is quantified in column (10) in terms of fees that member banks using this service would be charged as nonmembers. The annual value of coin and currency service to each member bank was calculated at fees charged nonmember banks based upon utilization of that service in September, October, and November of last year. For banks in each size group that receive money service from the Reserve Bank, the average annual value of their money service is presented in column (1 0 ).1 1 Wire Transfers Coin and Currency Service One of the important operational functions of Re serve Banks is removing defective currency from cir culation and issuing new currency. Reserve Banks provide both member and nonmember banks with coin and currency. Armored car service for pick up and delivery of coin and currency is made available daily at offices of member and nonmember banks in metropolitan areas surrounding offices of Reserve Banks and weekly in other areas. Banks not located on armored car routes receive coin and currency from Reserve Banks through the mail. This service is pro vided to member banks without charge, whereas non member banks are charged fees to cover costs. Re serve Banks charge both members and nonmembers a fee for wrapped coin to cover the cost of that operation. Page 6 A Reserve Bank service that is offered exclusively to member banks at no charge is wire transfers — transferring funds electronically from the reserve ac count of one member bank to the reserve account of any other member bank in the country.12 This system is used heavily for conducting transactions in the Federal funds market and for making payments for large business customers. Many of the large member banks use the wire transfer service through on-line equipment, initiating and receiving notice of transac11There were not sufficient data to calculate the fees mem ber banks receiving coin and currency service through the mail w ou ld have been charged for such mail service as non members. T he value o f the “ m ailed-m oney” service for m em bers was calculated based upon what they w ou ld have paid as a nonm em ber for the same value o f coin and currency shipments provided through armored car service. 12There is a charge for transfers o f less than $1,000. U T IL IZ A T IO N OF FEDERAL R ESER V E BANK S E R V IC E S BY M E M B E R (4 ) $ (1 0 ) G roup Num ber 1 2 3 4 5 6 7 8 9 10 11 12 A ve rage A nn ual Implicit Su b sid y to Mem ber Banks from M o n e y Service $ 6 6 4 .4 2 838.1 1 8 3 0 .9 5 8 1 3 .5 6 1,046.53 2,23 0 .8 0 1,799.80 2 ,0 3 6 .8 0 2 ,0 8 7 .8 0 3 ,3 7 6 .0 0 5 ,3 9 2 .8 0 1 2 ,9 9 0 .7 7 $ 6,312 8,268 10,351 12,998 16,395 19,995 23,766 27,536 3 4 ,0 3 7 4 6 ,7 5 5 107,641 1,743,592 (1 1 ) Percent of Banks Initiating W ire Transfers Frequently3 15% 10 5 30 20 50 35 65 65 70 75 85 _ $ 6,384 8,270 10,533 13,009 16,422 20,394 24,158 27,580 34,5 2 7 46,8 3 6 107,932 (1 2 ) O f Banks Initiating W ire Transfers Frequently, A verage Annual Number 68 102 102 134 92 95 94 191 31 2 176 704 19,649 (7 ) 5% 0 15 25 10 30 10 40 40 35 70 92 A ve rage A nnual Num ber of Checks Cleared by Banks that Clear Checks Through the Reserve Bank Percent of Banks Remitting for the Fed’s Cash Letters Through Debits to Their Reserve Accounts Percent of Banks Receiving Arm ored Car Service 2 1 ,816 0 2 1 5 ,7 4 0 837,271 2 3 2 ,4 1 6 3 8 3 ,0 4 2 3 6 5 ,4 7 2 3 6 0 ,9 5 9 1,172,64 9 9 5 0 ,3 3 7 1,778,20 3 16 ,3 5 5 ,8 8 9 Percent of Banks that Clear Checks Through the Reserve Bank2 15% 0 20 25 20 35 20 50 50 35 75 92 75% 45 55 65 75 75 85 90 95 100 100 100 (1 3 ) Percent of Bank Holding U.S. Government Securities in Book Entry at the Reserve Bank 30% 70 50 40 55 70 55 80 75 75 70 100 (1 4 ) O f Banks H olding Securities in Book Entry, Average Am ount4 (thousands of dollars) $ 4 2 7 .0 985 .3 1,082.5 1,631.6 1,216.7 1,051.4 1,475.1 2,038.8 2,466.1 1,254.0 5,945.0 1 23,808.8 (1 6 ) (1 5 ) SURVEY1 (8 ) 20% 50 40 30 20 25 15 10 5 — — — (1 7 ) Percent of O f Banks Holding Banks that Percent of Banks Definitive Securities were Regular Holding Definitive at the Reserve Borrowers at Bank, Average Securities at the Discount Am ount4 Reserve Bank W indow (thousands of for Their dollars) 1 9 7 5 -1 9 7 6 5 Investment Account 25% 35 35 30 45 50 35 70 65 80 65 69 $ 49.4 40 3 .0 623.3 1,669.5 859.8 1,427.1 1,915.7 1,713.4 2,896.3 2,762.6 5,025.2 13,196.0 (9) O f Banks Receiving M o n e y Service Through Armored Percent of Car or M ail, Banks Receiving Percent Having M o n e y Service Reserve Account Through the Debited and M a il Credited 5% 0 5 15 10 10 0 20 10 0 15 23 53% 58 74 58 47 60 60 75 65 70 70 92 (1 8 ) Annual Cost of Services Used by Mem ber Banks as Percent of Their Average Daily Reserve Balances6 0 .5 9 4 % 0.294 0.449 0 .3 4 4 7 0.275 0.752 0.313 0.481 0.880 0.589 1.015 1.693 AUGUST 7 1977 Page *The 233 banks in the survey are Eighth District banks in Illinois and M issouri that were m embers during the period Septem ber 1976 through January 1977. 2These banks deposited six o r m ore checks with the Reserve Bank durin g January 1977. 3These banks initiated six or m ore w ire transfers during the months o f N ovem ber and December 1976. 4These are p a r values o f securities held in safekeeping as o f Novem ber 30, 1976. 5These banks borrow ed in tw o different m onths or fo r 15 days or m ore in either 1975 o r 1976. *T-iur ^an ^s *n ea ch size group the cost o f services utilized was summed and divided b y the sum o f their average daily reserve balances in the period Septem ber 9, 1976, through January 12, 1977. T he cost o f clea rin g a check is estim ated at $0,015. This is above the unit cost reported in the Federal R eserve’s Functional Expense R ep o rt; this cost figure is used as an estimate o f unit costs w ith the relevant capital costs added. The basis fo r assigning costs to the m oney service is the schedule o f fees fo r that service charged nonmem bers. F or banks initiating w ire transfers with on-line equipm ent, the cost o f each w ire transfer initiated is estimated at $0.30, based upon d ata from the Functional Expense Report. F o r banks n ot on-line f o r w ire transfers, the cost o f each w ire tra n sfer initiated is estim ated as $2, which is approxim ately the cost assigned to this service in the account analysis studies o f correspondent banks m ade by the Federal Reserve Bank o f Kansas City. 7One bank was deleted from group 4 because its utilization o f Fed services was so much greater than that o f other banks o f sim ilar asset size that the percentage that cost o f services is o f reserve balances w ith this bank included was unrepresentative fo r other banks o f that asset size. ST. LOUIS 3,89 1 .6 7,179.8 9,59 2 .3 1 1,706.4 15 ,051 .6 17,723 .6 21,7 9 0 .2 25,991 .2 3 0 ,9 5 2 .0 40,961.1 69,1 0 6 .8 4 2 5 ,1 7 3 .8 (3) Minimum (6 ) 1 9 7 6 -7 7 OF 1 2 3 4 5 6 7 8 9 10 11 12 (2) Maxim um S IZ E , BANK (1 ) A verage G roup Num ber (5) O F V A R IO U S RESERVE Total Assets of Banks in Each G ro u p as of 6 / 3 0 / 7 6 (thousands of dollars) BANKS FEDERAL Table IV FEDERAL RESERVE BANK OF ST. LOUIS tions through their own terminals. Other member banks initiate wire transfers by telephone, giving em ployees at Reserve Banks details of transactions. Non member banks may use this funds transfer system only indirectly through member banks. During 1976, member banks initiated 21 million wire transfers with a total dollar value of $35,617.8 billion. Based upon a survey in November and December of last year, many of the banks either initiated no wire transfers or made minimal use of the service.1 Fre 3 quent users of the wire transfer service are defined as those initiating more than five wire transfers during the two month period; column (11) presents the per centage of banks in each size group that initiated wire transfers frequently. The number of wire transfers originated by fre quent users was multiplied by six to get annual rates; averages of those annual rates for frequent users of the service are presented in column (12). These calcula tions indicate that banks in the largest size group initiated most of the wire transfers. As additional evidence, the four banks that initiated the most wire transfers accounted for 86.8 percent of wire transfers that were sent by all banks in the survey, including those of the infrequent users. Safekeeping of Securities Reserve Banks hold securities in safekeeping for member banks at no cost to members. Securities are held in two forms: ( 1 ) C erta in F e d e ra l G o v e rn m e n t o b lig a tio n s are h e ld at R e s e rv e Banks in b o o k -e n tr y fo rm . N o p h y sica l d e b t ce rtifica tes are issu ed b y th e T rea su ry , b u t o w n e r sh ip re co rd s are k e p t o n th e b o o k s o f th e R e serv e Banks. C u stom ers o f m e m b e r b an ks m a y also h o ld F e d e ra l d e b t o b lig a tio n s in this fo rm , w ith th e m e m b e r b an ks a ctin g as their a gen ts fo r this service. O w n e rs h ip o f th ese secu rities m a y b e c h a n g e d th rou gh w ire transfers. ( 2 ) T h e o th e r fo rm in w h ic h secu rities are h e ld in s a fe k e e p in g at R es e rv e Banks is th at o f d efin itiv e secu rities ■ — a ctu a l p a p e r e v id e n c e o f d e b t o b lig a tio n s ( n o t lim ite d to F e d e ra l G o v e rn m e n t d e b t ) . R e serv e Banks c o lle c t b o n d c o u p o n s fo r m e m b e r b an ks at n o ch a rg e , a n d c o lle c t m a tu re d b o n d s at n o ch a rg e oth er than sh ip p in g ch a rg es fo r c o lle c t io n o u ts id e F e d e ra l R e s e rv e B ank cities. C o lle c t e d fu n d s are c r e d ite d to th e rese rv e a cco u n ts o f m e m b e r banks. 13O f the 233 banks in the survey, 78 initiated no wire trans fers during that period. All but three o f the banks not using that service had total assets less than $35 million. T he banks initiating from one to five wire transfers (5 7 in total) are also relatively small; all but nine had total assets less than $35 million. Page 8 AUGUST 1977 Reserve Banks hold, for nonmembers, Federal Gov ernment securities that are required as collateral for U.S. Government deposits at those banks. Reserve Banks also accept, from nonmembers, custody of se curities that are pledged as collateral to deposits of bankrupt estates. Other than in these two cases, non members are not allowed to keep securities for their own investment account or for the accounts of their customers in safekeeping with Reserve Banks. Columns (13) - (16) of Table IV present informa tion on securities that member banks hold in safe keeping with the Reserve Bank. Some member banks do not use this service, preferring to hold securities with their correspondents or in their own vaults. Use of the safekeeping service of the Reserve Bank is somewhat related to bank size, with a greater per centage of the larger banks using this service. How ever, more of the smaller banks use this service than they do the Reserve Bank’s check clearing or wire transfer services. Borrowing through the Discount Window Reserve Banks make loans to member banks for various purposes and durations. In the most common situation, a member bank borrows for only a few days at a time, presumably to adjust its reserve position to unanticipated deposit withdrawals or loan demands. This type of lending is called adjustment credit. Cer tain member banks with distinct seasonal patterns in loan demand and deposit flows qualify for seasonal borrowing privileges, under which they may borrow fixed amounts from Reserve Banks for several con secutive months. A third category of Federal Reserve lending is emergency credit, involving loans for ex tended periods of time to member banks experiencing financial difficulties that make other sources of funds unavailable to them at prevailing market interest rates. Emergency credit is made available at a higher discount rate than the rates for adjustment credit or seasonal lending. In some circumstances emergency credit can be made available to nonmember banks, but at a higher interest rate than emergency credit for member banks. The discount rate was above the Federal funds rate during most of 1975 and 1976. Therefore, banks that borrowed at the discount window during those years were generally borrowing to make short-term adjust ments to their reserve positions rather than borrowing to profit from a relatively low discount rate, as many banks did in 1974. Banks that are “regular” borrowers at the discount window are identified in this paper as FEDERAL RESERVE BANK OF ST. LOUIS those that borrowed in either two different months or for a total of 15 days or more in either of the past two years. These “regular” borrowers are assumed to be relying upon the discount window as an important source of short-term credit. Only 21 banks are identified as “regular” borrowers (see column (17), Table IV ).1 Note that 15 of them 4 had total assets of less than $35 million. Thus, al though most member banks do not borrow when the discount rate is above money market rates, the dis count window is an important source of short-term credit for several of the smaller member banks. Aggregating the Benefits of Membership The benefits of Federal Reserve membership are measured by summing the costs to the Federal Re serve of providing services to member banks and dividing by their respective average reserve balances at the Reserve Bank. This percentage is called an implicit rate of return on reserve balances. Average implicit returns are presented in column (18) of Table IV. The numerator of this ratio is an estimate of the cost to the Reserve Bank of providing check clearing, money service, and wire transfers. This approach over states the benefits of membership from these services to the extent that member banks use more of these services at zero explicit prices than they would as nonmembers, paying for services by explicit fees or correspondent balances. Means of allocating the costs of services to indi vidual member banks are discussed in Table IV. No suitable basis was devised for allocating the costs of safekeeping of securities and credit discount services to individual member banks, but, as indicated in Table III, the three services included in calculations in column (18) — check clearing, coin and currency service, and wire transfers — account for about 95 per cent of the costs of services provided. Therefore, allocating just the costs of these three services to member banks provides suitable estimates of the benefits of membership measured in terms of costs of services used. In all size groups the implicit rates of return on reserve balances are quite low.1 The highest per 5 ,4O nly 24 mem ber banks out o f 233 in the survey borrow ed at any time during 1975-76. Therefore, most o f the banks that borrow ed are identified as regular borrowers. lr,These rates o f return w ou ld be even low er if the costs o f services provided to members were strictly lim ited to those offered exclusively to mem ber banks. A large share o f the costs o f services provided to members in these calculations AUGUST 1977 centages are for the largest group of banks in the sur vey, averaging 1.69 percent. The calculated implicit returns for the largest banks are understated since they do not include the costs to the Federal Reserve System of clearing checks that several of those banks sent directly to other Reserve Banks. For the smaller member banks (the 200 smallest in the survey), the implicit returns average about one-half of one percent. IMPLICATIONS FOR MEMBERSHIP Data on implicit returns to the smaller member banks relative to their reserve balances indicate why smaller banks have incentives to withdraw from mem bership. The survey has too few observations on the utilization of Reserve Bank services by large banks to offer an explanation for why most large banks have remained in the Federal Reserve System. Smaller Banks Division of banks into categories of large and small is somewhat arbitrary. For purposes of this discussion small banks are identified as those with total assets less than $50 million (or roughly those in groups 1-10 in Table IV ). Table IV indicates that most of these banks use few Reserve Bank services. The implicit rate of return on reserves averaged about one-half of one percent for those banks. These results indicate that for most of the smaller member banks, Federal Reserve services are more expensive than the services of correspondent banks, which are close substitutes for the services offered by Reserve Banks. Implicit returns on demand balances at correspond ent banks, similar to the implicit returns on reserve balances discussed above, can be derived from studies of account analysis at correspondent banks. The cor respondent banks that perform account analysis keep records of services used by respondent banks and assign dollar values to the utilization of services based upon the costs to the correspondent banks of provid ing those services. Correspondent banks multiply the average collected demand balances of respondent banks by implicit interest rates, called earnings allow ances, to determine periodically whether respondent banks have been holding large enough demand bal ances to compensate for the services they use. is the cost o f clearing checks drawn upon banks located within the region served b y their ow n Regional Check Processing Center. N onm em ber banks may also present such checks to Reserve Banks for collection. Page 9 FEDERAL RESERVE BANK OF ST. LOUIS In a survey of 130 correspondent banks conducted by Knight in July 1976, the earnings allowances on collected demand balances, unadjusted for the re quired reserves of correspondent banks against those deposits, ranged from 3.34 to 6.19 percent with an average of 4.5 percent.10 These percentages indicate the implicit returns respondent banks may receive on their collected demand balances at correspondents if they fully utilize the services made available to them. Thus, correspondent banks make available signifi cantly more services per dollar of collected demand balances than do Reserve Banks, assuming that Re serve Banks are not substantially more efficient than correspondent banks.1 7 This conclusion could be challenged on the basis that the smaller member banks could increase their implicit returns on reserve balances substantially if they just made fuller use of Reserve Bank services. This issue is investigated by calculating the implicit returns on reserve balances for a group of banks 18For a description o f the m ethodology used in that study o f account analysis, see R obert E. Knight, “ A ccou nt Analysis in Correspondent Banking,” Monthly Review, Federal R e serve Bank o f Kansas City (M a rch 1 9 7 6 ), pp . 11-20. The earnings allowances reported in the survey o f July 1976 w ere for collected dem and balances o f respondent banks net o f required reserves that correspondent banks must hold against those deposits. In the discussion above, those earnings allowances w ere converted to a basis o f collected balances unadjusted for required reserves b y m ultiplying b y one minus the marginal reserve requirement on dem and deposits for correspondent banks, w hich is assumed to b e 16.5 per cent, the marginal reserve requirement for m em ber banks w ith dem and deposits greater than $400 m illion. This ad justment is m ade to the earnings allowances b y correspond ent banks to make them m ore com parable to the im plicit returns on reserve balances o f m em ber banks calculated above. 1C om p a rison s o f im plicit returns that m em ber banks receive on their reserve balances to the earning allowances at cor respondent banks understate to some extent the differences in im plicit yields on reserve balances and collected dem and balances at correspondent banks. This bias results from the fact that correspondents are not charged fees fo r the R e serve Bank services they use as part o f their service to respondent banks, and therefore, do not have to include the costs to the Reserve Banks in offering those services in their im plicit charges to respondent banks in order to price their services profitably. An objection m ight b e raised to this conclusion on the basis that correspondent banks must set their im plicit charges on services they offer to respondent banks high enough to cover their costs o f Federal Reserve m em bership in terms o f foregone eam ings on the large reserve balances they must hold. If this objection is valid, it w ould mean that com parison o f im plicit returns on reserve balances to eam ings allowances at correspondent banks w ou ld overstate the differences in yield on reserve balances in terms o f services relative to the im plicit yields on dem and balances at correspondents. H ow ever, this objection is not valid since the eam ings allowances reported above equal the eam ings allowances from the recent study o f accounts analysis at correspondent banks m ultiplied b y one minus the marginal reserve requirement on dem and deposits, thus rem oving this second source o f potential bias. Page 10 AUGUST 1977 with total assets less than $50 million which make relatively full use of Reserve Bank services. Each of the banks included in this analysis regularly clears local and out-of-district checks directly through the Reserve Bank. There are 34 such banks served by the head office of this Bank. Their total assets as of June 1976 ranged from $8.8 to $49.9 million, with average assets of $27.6 million.18 All of these banks receive coin and currency service from the Reserve Bank, and all but three of them initiated wire transfers. The average implicit return to these banks on their reserve balances is 1.32 percent. Thus, although mem ber banks which utilize Reserve Bank services more fully than average can increase their implicit returns on reserve balances substantially, their implicit re turns still will be low relative to the implicit interest rates on collected demand balances at correspondents. Significance of the Costs of Membership — Given the relatively low implicit returns to member banks on their reserve balances, a remaining question is the size of the costs of Federal Reserve membership in relation to bank profits and capital. If the costs of membership are positive but insignificant, current members would not have strong incentives to with draw from membership. The costs of membership are estimated for a group of member banks which make minimal use of Reserve Bank services. The character istics of those banks and the procedure for calculating their costs of Federal Reserve membership are pre sented in the Appendix. Membership costs of banks making minimal use o f Reserve Bank services are analyzed because measuring the costs to those banks of obtaining services as nonmembers requires few assumptions. For the 54 banks included in the analysis, the costs of Federal Reserve membership averaged 1.8 percent of their equity capital in 1976. The cost of member ship as a percent of 1976 profits before income taxes and securities gains and losses averaged 11.2 percent among 49 banks with positive profits last year. These calculations indicate that for the smaller member banks making little use of Reserve Bank services, there is a substantial cost associated with Federal Reserve membership. W hy D o So Many of the Small M ember Banks Make Minimal Use of Reserve Bank Services? — This 18T w o other banks had these characteristics but w ere excluded from this analysis because their utilization o f services was unusually great. Apparently those banks serve as ch eck p roc essing centers for other banks in their holding com panies. \ FEDERAL RESERVE BANK OF ST. LOUIS analysis has not explained why most of the smaller member banks make little use of Reserve Bank serv ices. Explanations could be offered for each service separately. For instance, one explanation for why most of the small member banks clear checks through correspondents is the Fed’s encoding and sorting re quirements. However, a more general explanation, which is supported by the evidence in the sections above, is that most of the smaller member banks find the transactions costs of managing their reserve ac counts, while using Reserve Bank services, greater than the benefits derived from using those services. Use of Reserve Bank check clearing services in volves frequent debits and credits to a member bank’s reserve account. Having a reserve account debited and credited for money shipments also creates some problems for a member bank in managing its reserve position. When a member bank orders a currency shipment, its reserve account is debited, but the funds transferred to the bank as vault cash are not counted as part of reserve assets for two weeks. For the current reserve settlement week, the funds withdrawn from the bank’s reserve account must in general be re placed with funds from another source in order to meet reserve requirements. Use of other Reserve Bank services — wire transfers, safekeeping of securities, and borrowing through the discount window — in volves similar adjustments to the reserve positions of member banks. Member banks know the average reserve balances they are required to hold during each reseive settle ment week at the beginning of the week, and most member banks receive statements daily on the bal ances in their reserve accounts. Even though the Reserve Banks provide members with this information, member banks incur transactions costs in managing their reserve positions if they are using Reserve Bank services which involve frequent debits and credits to their reserve accounts. Banks using such services must monitor their reserve positions closely, project debits and credits to their reserve accounts, sell assets or borrow funds to avoid reserve deficiencies when there are unanticipated debits, and buy assets or lend funds to avoid large excess reserves when they have unan ticipated credits. Large banks cope with such reserve management problems by employing specialists in that function. According to the explanation for the behavior of the smaller member banks developed in this section, a large proportion of them prefer not to incur the trans actions costs that result from using Reserve Bank AUGUST 1977 services directly. Instead they prefer to hold relatively idle balances at the Reserve Bank to meet reserve requirements, obtaining services through correspond ents and using their demand balances at correspond ents as their working balances. As explained above in the discussion of account analysis at correspondent banks, correspondents require respondent banks to hold average demand balances in some proportion to the costs of services they use. However, correspondent banks require this balancing out less frequently than once a week, thus allowing their respondent banks more flexibility in the use of their demand balances than Reserve Banks allow members in the use of their reserve balances. Data from the survey discussed above include several observations which tend to support the hypothesis that many of the smaller member banks avoid using Reserve Bank services because of the reserve manage ment problems that would result. Note in columns (6 ) and (9 ) of Table IV that in most size groups more banks have their reserve accounts debited and cred ited for money shipments than have their reserve accounts debited for checks drawn upon them. A member bank orders money shipments in advance and therefore can plan its reserve management over a re serve settlement week, taking such entries into consid eration. In contrast, debits to a member bank’s reserve account in remitting for the Fed’s cash letters come in amounts and with timing that cannot be foreseen accurately. Therefore, one explanation for why more member banks order money shipments through their reserve accounts than settle for checks drawn upon them through their reserve accounts is that debits and credits due to money shipments create smaller trans actions costs in managing their reserve positions. Another observation that supports this view is that the smaller banks which do use services involving frequent debits or credits to their reserve accounts tend to use other such services. Use of one such serv ice forces a bank to deal with the problem of manag ing its reserve account subject to frequent debits or credits. Thus, using other such Reserve Bank services imposes a smaller marginal burden. There are 58 banks among the 200 smallest in the recent survey that either deposit checks directly with the Reserve Bank or pay for checks drawn upon them through their reserve accounts. Use of these services involves the most frequent and unpredictable debits and credits to reseive accounts. Of these banks, 52, or 89.7 percent, have their reserve accounts debited and credited for money shipments; of the other 142 mem Page 11 FEDERAL RESERVE BANK OF ST. LOUIS ber banks among the 200 smallest in the survey, only 69, or 48.6 percent, have their reserve accounts deb ited and credited for money shipments. A similar difference in behavior exists among these banks with respect to use of the wire transfer service. Of the same 58 banks, 39, or 67.2 percent, initiated more than five wire transfers during a two-month period, whereas among the remaining 142 banks, only 33 banks, or 23.2 percent, initiated wire transfers that frequently. Many of the member banks that did not initiate wire transfers through the Reserve Bank prob ably did so through correspondents. The discussion above indicates a preference among the smaller member banks for holding relatively idle balances at Reserve Banks to meet their reserve re quirements and holding more active demand balances at correspondents which serve as their working bal ances. Results in Table V, using observations for all Eighth District member banks, reflect such a pattern of behavior. One measure of activity in reserve balances and demand balances at correspondents is the standard deviation of daily balances divided by the mean of daily balances. For banks in each size group ex cluding the 25 largest banks, their demand balances at correspondents are, on average, more variable than their reserve balances, indicating that the smaller member banks tend to hold relatively idle balances with the Reserve Bank and use their demand bal ances at correspondents as their working balances. Another measure of variability in daily balances presented in Table V is the average number of days that balances in an account did not change from the previous day. To indicate the limits on these numbers, the data used cover 126 days, and the minimum num ber of days a bank’s reserve balance could remain unchanged is 36, due to weekends and holidays. Many of the smaller member banks leave their reserve bal ances unchanged for several days in a row. The number of days reserve balances remained unchanged averaged 76.5 among the 60 smallest banks and tended to decline as bank size increased. The number of days demand balances at correspondents remained unchanged were approximately the minimum for banks in all size groups. Member banks that use the services of correspond ents, instead of the services provided by their Re serve Banks, must hold substantial demand balances at correspondents to compensate for the services they use. Thus, many member banks bear double reserve Page 12 AUGUST 1977 burdens, meeting the reserve requirements of the Federal Reserve and holding demand balances at correspondents that are large enough to exceed the reserve balances that would be required of them as nonmember banks. In most states nonmember banks can meet their reserve requirements with demand balances at corre spondents and CIPC. The last column of Table V indicates that in all size groups Eighth District mem ber banks hold average daily demand balances at correspondents plus CIPC that are larger than their average daily reserve balances at the Reserve Bank. The ratio of demand balances at correspondents plus CIPC to reserve balances is especially high among the smallest member banks and the largest member banks in Table V, the large correspondent banks having especially large CIPC.1 0 These observations do not necessarily imply that most member banks would hold the same level of demand balances at correspondents if they became nonmembers. Several studies show that nonmember banks hold larger demand balances at correspondents than member banks of the same deposit size.20 The observations in the last column of Table V do indicate that most member banks hold assets that would count as reserves if they were nonmember banks which are larger than their current reserve balances at the Re serve Bank. W hy D o So Many of the Small Banks Retain Fed eral Reserve Membership? — The analysis above in dicates that there are substantial costs associated with Federal Reserve membership, and yet, as indicated in Table I, many of the banks in the smaller size groups are members of the Federal Reserve. Access to the Federal Reserve services discussed above does not provide sufficient benefits to offset the opportunity costs of required reserves. Therefore, the remaining '''T h e numerator o f this ratio is dem and balances at corre spondents plus C IP C for the follow in g reasons. O ne reason concerns the differences am ong m em ber banks in the w ay they record deposits at correspondents. Some banks record the value o f deposits to accounts at correspondents as C IP C until the funds are collected; others record deposits at cor respondents as dem and balances when they make deposits, whether the funds w ill be available for their use im m edi ately or in a few days. Therefore, adding C IP C to dem and balances at correspondents is necessary for getting co m parable observations am ong banks. M em ber banks that clear checks through their Reserve Banks are required to record uncollected funds as CIPC . If these banks were nonm em bers, those C IPC w ou ld count as reserve assets. Therefore, these funds are in cluded in the numerator o f the ratio in T able V, w hich shows the extent to w hich m em ber banks hold double reserve assets. - nSee references in footn ote 7. F EDERAL. Table V MANAGEMENT OF CASH A SSETS BY E IG H T H D IS T R IC T M E M B E R Smallest in G roup of Banks $ 5 7 2 9 0 .2 $ 3 7 2 4 8 .4 Average for Group of Banks $ 4 5 7 7 1 .7 0.4791 A verage Number of D ays Due From Balances W ere the Same as on the Previous Day Average Ratio of Due from Balances Plus CIPC to Reserve Balances 36.40 0 .6 3 7 4 40.40 3.22 39.20 2.55 2 3 3 1 5 6 .5 5 2 1 6.0 11 192.3 0 .3 4 5 4 39.15 0 .2 7 3 5 3 4 8 4 6 .5 290 4.0 3 7 4 3 .6 0 .2 0 6 9 40.55 0 .2 6 1 7 39.35 1.43 ST. LOUIS Largest in G rou p of Banks A verage Number of D ays Reserve Balances W ere the Sam e as on the Previous Day OF 1 A verage Daily Reserve Balances (thousands of dollars) Standard Deviation of Due from Balances Divided by M ean Balance: A verage of These Ratios for Each G roup of Banks BANK G ro up s of 20 Banks Ranked from Largest to Smallest (First G roup has 5 Banks) Standard Deviation of Reserve Balances Divided by M ean Balance: Average of These Ratios for Each G roup of Banks Demand Balances Due from Correspondent Banks RESERVE Reserve Balances at the Federal Reserve BANKS1 1.50 4 287 3.8 2205.8 25 1 9 .6 0 .1 9 0 9 4 0 .6 0 0 .2 4 5 5 39.20 5 2 1 7 6 .7 1659.2 1 896.8 0 .1 4 4 0 43.5 0 0 .3 4 2 9 35.8 0 1.30 6 1630.1 1411.4 151 0.4 0 .1565 45.55 0 .2 8 2 6 37.70 1.55 7 1 3 9 9.9 1254.2 13 2 2 .7 0.2071 4 2.0 0 0 .3148 37.05 1.45 8 1 2 4 5.8 1096.5 115 1.7 0 .1 5 0 3 4 9 .3 0 0 .3 0 3 4 35.20 1.06 9 10 8 7 .0 971.1 1023.9 0 .2 0 3 3 45.0 5 0 .3438 38.75 1.31 10 9 6 9 .9 843.5 912 .9 0 .2274 46.8 0 0.3 3 2 3 34.10 1.50 53.0 0 0.3 6 4 8 37.85 1.35 11 84 0 .9 762.6 808.3 0 .1 4 5 4 12 76 2 .0 706.9 73 7 .7 0 .1 1 8 5 57.3 0 0 .3 2 0 2 36.75 1.69 0 .3 0 0 2 34.50 1.66 13 7 0 5 .0 633.8 662.1 0 .1 5 6 6 57.25 14 63 2 .5 585.5 604.8 0 .1 5 7 9 55.35 0 .3 1 6 0 36.45 1.97 33.4 0 1.57 15 5 8 4 .9 479.8 5 3 8 .7 0 .2 0 6 9 52.9 5 0 .2 7 8 6 16 478.1 408.2 452.2 0 .1 8 7 4 6 4.2 0 0.3 0 2 5 45.35 1.66 1.78 17 4 0 7 .7 344.2 37 6 .7 0 .1 9 8 8 6 4.9 0 0 .3 8 6 2 36.30 18 33 9 .9 289.9 31 1.8 0 .2 4 3 3 5 9.2 5 0.3301 36.05 2.11 2.45 19 289 .9 256.2 271.5 0 .2 1 3 2 60.15 0 .3 1 6 0 31.50 20 255 .3 212.2 231 .7 0.1 6 3 3 82.65 0 .3 7 0 4 32.20 2.24 22 198.8 136.5 170.0 0 .2 1 8 3 70.15 0 .2 9 0 7 33.75 134.8 7.4 91.7 0.301 8 76.55 0 .4 0 3 5 35.75 3.27 AUGUST 21 3.49 13 1977 Page *The 425 banks included in these calculations are all Eighth District banks that were members o v e r the period Septem ber 9, 1976 through January 12, 1977. All observations apply to that period. FEDERAL. RESERVE BANK OF ST. LOUIS privilege of Federal Reserve membership which ap pears to account for retention of membership by the smaller banks is access to a lender of last resort through their Reserve Bank’s discount window. That privilege is a type of insurance policy on availability to credit during periods of financial difficulty, whether that difficulty occurs within the individual bank or in the whole economy. The cost of membership to a bank can be considered its premium paid for this form of insurance. Since the Federal Reserve has a monopoly on offering the service of lender of last resort, it can charge high premiums for that service, as indicated by the costs of membership calculated above. Larger Banks There remains the question of why most of the larger banks remain in the Federal Reserve. One possible explanation is that the large member banks use enough Reserve Bank services to more than com pensate them for the opportunity costs of the reserve balances they hold. Table IV provides information on this explanation. Dividing the cost to the Reserve Bank of providing services to banks in the largest group by their average reserve balances yields an implicit rate of return of only 1.69 percent. For the three largest banks in the survey, that implicit rate of return is 1.83 percent. As noted above, these figures are understated somewhat because the checks sent by some of these banks directly to other Reserve Banks are not accounted for. But even allowing for that fac tor, the large member banks receive a low rate of return on their reserve balances in terms of the costs of the services they use. However, membership may still be profitable for the large banks if access to Federal Reserve services allows them to earn large profits as correspondent banks. These results do not support the view that the larger banks retain their membership in the Fed eral Reserve because of high implicit returns on their reserve balances. There are too few large banks in cluded in the survey of the utilization of services by member banks to draw strong conclusions about the generality of these results or the reasons why the larger banks retain their membership in the Fed. However, it is unlikely that many of the large member Page 14 AUGUST 1977 banks receive very high implicit rates of return on their reserves in the form of services, since for the Federal Reserve System as a whole the cost of provid ing services to member banks is approximately one percent of total reserve balances held by members at Reserve Banks. Therefore, the Federal Reserve is effectively imposing a tax on the banking industry, even with Federal Reserve membership being volun tary. The tax takes the form of interest foregone by member banks on their reserve balances less the costs to Reserve Banks of providing services to member banks. At an interest rate of five percent, that tax in 1976 was about $1 billion.2 1 CONCLUSIONS An analysis of the costs and benefits of Federal Re serve membership is incomplete without information on the degree to which member banks use the services provided by their Reserve Banks. Member banks with total assets of less than about $50 million make rela tively little use of Reserve Bank services, using the services of correspondents instead. There is evidence that the costs of this arrangement to many of the smaller member banks are lower than the costs of managing their reserve accounts if they made fuller use of Reserve Bank services. Member banks making minimal use of Reserve Bank services bear substantial Federal Reserve membership costs, averaging 11.2 percent of profits and 1.8 percent of equity capital for one group of banks. Most of the major correspondent banks have re mained members of the Federal Reserve. The large banks are heavy users of Reserve Bank services, but their implicit returns on reserve balances in the form of services are substantially higher than the implicit returns to the smaller member banks, but are still rather low. 21M em ber bank reserves h eld at Reserve Banks averaged $26.2 billion in 1976. Suppose the opportunity cost to m em ber banks from holding those reserves is 5 percent, the average yield on U.S. Governm ent Treasury bills last year. T he total opportunity cost o f holding reserves w ou ld be $1.3 billion. W ith the total costs to Reserve Banks o f offer ing services to m em ber banks betw een $200 m illion and $300 million, the total im plicit tax on banking was about $1 billion. AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS APPENDIX Calculation of the Costs of Federal Reserve Membership T h e p u r p o s e o f th e fo llo w in g ca lcu la tion s is to estim a te th e in c o m e that s e le cte d b an ks fo r e g o b y b e in g m em b ers o f th e F e d e ra l R e s e rv e S ystem . M e m b e r b an ks in clu d e d in this analysis h a v e th e fo llo w in g ch a ra cteristics: (a ) th e y cle a r ch e ck s a n d rem it f o r th e F e d ’s cash letters th ro u g h corre s p o n d e n ts, (b ) th e y h o ld n o secu rities in s a fe k e e p in g , and (c) n o n e o f th em are regu la r b o rro w e rs th ro u g h the d is co u n t w in d o w , as id e n tifie d a b ov e. Banks w ith th ese ch a ra cteristics are ch o s e n sin ce b e c o m in g a n o n m e m b e r w o u ld h a v e less e ffe c t o n th eir o p e r a tions than o n o th e r b an ks in th e su rv ey a n d b e ca u s e sp e cific d o lla r am ou nts c a n b e a ssign ed less a rbitrarily to th e R e se rv e B ank services th ey u se than fo r oth er banks th at m a k e u se o f a d d ition a l R e s e rv e B ank services. In total, 5 4 banks m e e t th ese co n d itio n s ; th eir total assets ra n ge fr o m $ 3 .4 m illion to $ 4 4 .5 m illion . O n ly s ev en o f th ese 5 4 banks h a v e a n y d e m a n d d e p o s it liabilities d u e to o th e r c o m m e rcia l banks, a v e ra g in g $ 3 3 th ou sa n d d u r in g th e tw o w e e k s e n d in g Janu ary 12, 1 9 7 7 . T h e s e banks d o n o t a p p e a r to b e fu n c tio n in g as co rre s p o n d e n ts to an y sign ifican t d e g r e e ; th erefore, n o a d ju stm en t is n ecessa ry fo r loss o f co rre s p o n d e n t b a n k in g profits d u e to th ese banks b e c o m in g n o n m em b ers. T h e first ste p in v o lv e s estim a tin g h o w m u ch a b a n k c o u ld in crea se its e a rn in g assets if it b e c a m e a n o n m e m b e r ( assu m in g its total assets rem ain u n c h a n g e d ) . S in ce Illin ois has n o reserve req u irem en ts, m e m b e r b a n k s in Illin ois are a ssu m ed to in crea se th eir ea rn in g assets b y th e a m o u n t o f th eir a v e ra g e reserv e b a la n ce s at th e R e s e rv e Bank. O f th e 5 4 b an ks in this analysis 3 5 are lo ca te d in Illin ois. T h e ca lcu la tio n s are m o r e c o m p le x fo r M issou ri banks. R e se rv e re q u irem en ts fo r n o n m e m b e r banks in M issouri are a p p ro x im a te ly e q u a l to th ose o f F e d e ra l R e serv e m e m bers. N o n m e m b e r banks in M issou ri m a y h o ld their reserve assets o n ly as va u lt ca sh , d e m a n d b a la n ces at c o r r e s p o n d e n ts, o r ca sh item s in th e p r o ce ss o f co lle c tio n ( C I P C ) . B anks are a ssu m ed to h a v e th e sa m e a v era g e le v e l o f va u lt ca sh a n d C IP C w h e th e r th ey are m e m b e r o r n o n m e m b e r banks. T h e reserves n ecessa ry to satisfy a b a n k ’s state re se rv e req u irem en ts are c a lcu la te d as its a v e ra g e reserve b a la n c e at th e R e s e rv e B ank p lu s its a v e ra g e d e m a n d b a la n c e at co rre s p o n d e n ts a n d C IP C m u ltip lie d b y the b a n k ’s m a rg in a l reserve req u irem en ts o n d e m a n d d ep osits. U n d e r F e d reserv e req u irem en ts, d e m a n d b a la n ce s at c o rre s p o n d e n ts a n d C I P C are s u b tra cte d in ca lcu la tin g d e m a n d d e p o s its s u b je ct to reserve req u irem en ts, w h erea s th at d e d u c t io n is n o t m a d e fo r n o n m e m b e r b an ks in M issouri. I f a b a n k ’s d e m a n d b a la n ce s at co rre s p o n d e n ts are la rg er than w h a t w o u ld b e re q u ire d to m e e t state reserv e req u irem en ts as a n o n m e m b e r bank, th e b a n k is a ssu m ed to in crea se its ea rn in g assets b y th e a m o u n t o f its cu rren t re s e iv e b a la n ce s at th e F e d if it b e c o m e s a n o n m e m b e r. I f a b a n k ’s d e m a n d b a la n ce s at c o rre s p o n d e n ts are sm aller than w h a t w o u ld b e re q u ire d to m e e t state reserv e req u irem en ts, th e a m o u n t b y w h ic h that b a n k c o u ld in crea se its ea rn in g assets is ca lcu la te d b y a d d in g its a v e ra g e reserve b a la n c e at th e R e se rv e B ank to its a v e ra g e d e m a n d b a la n ce at co rre s p o n d e n ts a n d su b tra ctin g its re q u ire d re s e iv e b a la n ce at co r r e sp on d en ts as a n o n m e m b e r b a n k . A v e ra g e d a ily reserve b a la n ces, d e m a n d b a la n ces at corre s p o n d e n ts, a n d C I P C are m ea su red o v e r th e p e r io d S e p te m b e r 9, 1 9 7 6 , th rou gh January 12, 1 9 7 7 . T h e in c o m e fo r e g o n e as a m e m b e r b a n k is ca lcu la te d as fo llo w s : (1 ) th e d olla r a m ou n ts b y w h ic h a b a n k c o u ld in crease its ea rn in g assets as a n o n m e m b e r is m u ltip lie d b y five p ercen t. (2 ) th e fo llo w in g a m ou n ts are c a lcu la te d in ( 1 ) a b o v e : d ed u cted fro m that (a ) th e a nn ual c o s t to th e b a n k o f o b ta in in g its c o in a n d c u rre n c y s e rv ice as a n o n m e m b e r bank; (b ) th e n u m b e r o f w ire transfers th e b a n k m akes at an a nn ual rate m u ltip lie d b y $ 2 , th e a p p rox im a te co s t o f in itia tin g a w ire transfer as a n o n m e m b e r ba n k ; (c ) fo r b an ks h a v in g th eir reserv e a cco u n ts d e b ited a n d cr e d ite d fo r m o n e y sh ip m en ts, the n u m b e r o f su ch le d g e r entries in a yea r ch a r g e d at ten cen ts p e r en try. T h is a m ou n t is a p p ro x im a te ly th e im p licit c h a rg e b y c o r re s p o n d e n t banks p e r le d g e r en try in their a c c o u n t analysis. A m o n g th e 5 4 banks, th e resu ltin g m ea su re o f in co m e fo r e g o n e fo r e a ch b a n k a vera ges 1.8 p e r c e n t o f 1 9 7 6 e q u it y ca p ita l. F o r th e 4 9 b an ks w ith p o s itiv e profits in 19 7 6, in c o m e fo r e g o n e as a m e m b e r o f th e F e d e ra l R e s e rv e a v e ra g e d 1 1 .2 p e r c e n t o f th eir 1 9 7 6 profits. Page 15 Estimates of the High-Employment Budget and Changes in Potential Output KEITH M. CARLSON 0 NE of the more novel approaches to the problem of assessing the impact of the Federal budget on economic activity was the development of the concept of the high-employment budget. The purpose of this concept was to standardize the budget position on some high-employment norm and thereby remove the e f f e c t of variations in e c o n o m i c a c t i v it y o n t h e meas ured budget surplus or deficit. Proponents of the highemployment budget argue that estimation of the Federal budget at an assumed full-employment level of activity provides a better measure of the impact of the budget on the economy than the actual surplus or deficit ( see Chart I ). Central to the calculation of the high-employment budget is the estimate of potential GNP — that rate of production consistent with “full” utilization of economic resources in “normal” times. In general, this definition is very imprecise, and several estimates have been developed by different analysts over the years. Most recently — since 1973—-a controversy has developed as to the estimated impact of energy de velopments on the economy’s productive potential. If, as has been argued, the run-up in energy prices has affected potential output, estimates of the highemployment budget must be adjusted accordingly. A measure of fiscal action that is not revised in accord Page 16 ance with the revision of potential GNP will provide misleading information as to the stance of fiscal policy. With regard to the current status of estimates of potential output, a consensus has not evolved. On the one hand, the 1977 Annual Report of the Council of Economic Advisers presented one set of revised esti mates, based primarily on a reevaluation of recent productivity trends and a redefinition of the “fullemployment unemployment rate.”1 On the other hand, a series for potential output was recently dis cussed in this Review which incorporated the effects of energy developments since 1973.2 Two new estimates of the high-employment budget are presented here and compared with previous esti mates. Most of the differences between the new and the old estimates occur after 1973. The differences are of such magnitude that the implications for fiscal policy are somewhat different with the increase in the relative price of energy and its associated effects on potential output. 1The Annual Report of the Council of Economic Advisers (W ashin gton , D .C .: U.S. Governm ent Printing Office, 1 9 7 7), pp. 45-57. For discussion o f this series, along w ith a presen tation o f tw o other estimates o f potential output, see G eorge L. Perry, “ Potential Output and Productivity,” Brookings Papers in Economic Activity, 1 ( 1 9 7 7 ), pp. 11-60. -R obert H. Rasche and John A. Tatom , “ Energy Resources and Potential GNP, ” this Review (June 1 9 7 7 ), pp. 10-24. AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS DEVELOPMENT AND USE OF HIGHEMPLOYMENT BUDGET Although the concept of high-employment budget ing has been in existence since the 1940s, it did not gain prominence in government policymaking until the early 1960s.3 Since then, reliance on the concept has waxed and waned with the tides of economic and political developments. From 1966 to 1969, for example, the concept received little attention in fiscal policy discussions because with the economy operat ing at a high level of employment, measured budget surpluses and deficits approximated their high-employ ment values. Since 1969 the concept has been kept before the public but has not been assigned a key role in the formulation of budget policy.4 One reason that the high-employment budget has not been cast in a focal role in the fiscal policy process is that it is a hypothetical budget. Since it is an analytical tool designed by economists, its useful ness hinges on an understanding of certain elements of economic theory. Policymakers and the general public are understandably suspicious of a hypothetical figure based on theory that is not generally understood. Another reason the high-employment budget has not become generally popular among policymakers is that there is no official time series available from the Federal government. Without the perspective provided by a continuous time series, it is difficult to interpret any particular estimate. Until such a series is prepared and published by an official Government agency, it is doubtful that the concept will receive general acceptance either by policymakers or the public.5 Several years ago, in an attempt to fill this void in the Government’s data set, the Federal Reserve Bank 3For a discussion o f the developm ent o f the high-em ploym ent budget concept, see Herbert Stein, The Fiscal Revolution in America (C h ica g o : University o f C hicago Press, 1 969), pp. 185-196, 220-240. For an update, see Alan S. Blinder and Robert M. Solow, “ Analytical Foundations o f Fiscal P olicy,” in The Economics of Public Finance ( W ashington, D .C .: The Brookings Institution), pp. 3-115. 'T h e closest the high-em ploym ent budget cam e to being a ccepted on an official basis was in the fiscal 1972 budget, published in January 1971. H ere, for the first time, tables w ere published in the bud get docum ent relating to the “ full-em ploym ent budget margin,” and a rationale for fiscal policy was discussed within this framework. • r,Still another reason that the con cept has not been generally a ccepted is that economists themselves cannot agree (ty p i ca lly ) on its usefulness and significance. See Blinder and Solow. C h a rt I Fiscal M e a s u r e s (+ ) S « r p lu s ; ( - ) D e fiu t Quarterly Totals at A n n u a l Rates Se ason ally Adjusted . .. B i l li o n s Of D o l la r s ... B illlO M . n „ 0» D o l ' « r * -100 -120 1969 1970 1971 1972 1973 1974 1975 1976 1977 Sources: U.S. Departm ent of Commerce and Federal Reserve Ban k of St. Louis Latest data plotted: 2 n d q u a rte r estim ated of St. Louis began publishing a series on the highemployment budget.6 This was done for purposes of providing a series that could be used to provide perspective whenever the concept was used. The assumptions required to prepare these estimates are somewhat arbitrary, but the measurement procedures have remained consistent over time. The alternative estimates which have been made by critics of this series have not been followed up in the form of regular updating and publication.7 RATIONALE FOR HIGH EMPLOMENT RUDGET Initially, the rationale for the high-employment budget was developed within the framework of a simple Keynesian model of national income determi nation.8 This model is one that is still in general use in the macroeconomic section of introductory eco nomics textbooks. The essence of the theory is that the level of economic activity is determined by the saving and spending propensities of economic units. When fiKeith M. Carlson, “ Estimates o f the H igh-Em ploym ent Budget: 1947-1967,” this Review (June 1 9 6 7), pp. 6-14. "See the references in Blinder and Solow. 8For discussion within the context o f this simple m odel, plus additional refinements, see Blinder and Solow. Page 17 FEDERAL. RESERVE BANK OF ST. LOUIS viewed in conjunction with the saving- spending plans of private economic units, the high-employment budget provided a means of estimating what was re quired by way of fiscal stimulus or restraint to achieve full employment. The usefulness of the high-employment budget does not rest with the Keynesian model of national income determination. Theoretical developments have oc curred in recent years which have modified the inter pretation of the high-employment budget but have not negated its use as an analytical tool. In particular, recognition of the interaction between monetary and fiscal actions has led to some considerations that were neglected in earlier discussions. Identifying Active vs. Passive Elements in Budget Originally, the purpose of the high-employment budget was to provide a measure of the impact of fiscal action that was superior to the actual surplus or deficit. Economists have been aware of the problems of interpreting the Federal budget position for many years. The reason for difficulty in interpretation is that actual surpluses or deficits contain both active and passive components.9 The active aspect of the budget refers to the effect of discretionary actions, that is, the effect of changing tax rates and expendi ture programs. The passive component is the auto matic response of expenditures and/or receipts to variations in economic activity. With tax rates and unemployment insurance programs as set by Con gress, different levels of economic activity will yield different amounts of receipts and expenditures. The high-employment budget does, in principle, provide a measure of the active part of the budget. However, problems in the method of estimation re main, as the active vs. passive classification is not that clearcut or automatically identifiable. For example, on a high-employment basis tax receipts tend to increase from one period to the next because the economy is growing. In addition, inflation causes receipts to rise even without a change in statutory rates.1 Conse 0 !,F or further discussion using this term inology, see Keith Carlson, “ T he Federal Budget: Perspectives and Prospects,” this Review (O cto b e r 1 9 7 6 ), pp . 2-7. 10This point is discussed at som e length in Arthur M. Okun and N ancy H. Teeters, “ T h e Full E m ploym ent Surplus Revisited,” Brookings Papers on Economic Activity, 1 (1 9 7 0 ), pp. 90-96. See also N ancy Am m on Jianakoplos, “ T he G row ing Link Between the Federal G overnm ent and State and L ocal G overnm ent Financing,” this R eview ( M ay 1 9 7 7), pp. 13-20. Page 18 AUGUST 1977 quently, the high-employment budget might suggest active tightening in fiscal policy, when in fact the increase in the surplus might simply be a reflection of inflation, that is, prior stimulus. Guiding Policy Decisions Provision of a crude indicator of the direction of fiscal actions is an important purpose of the highemployment budget. In addition, there is a purpose implied by its connection with the underlying theo retical framework — to actively use this budget con cept in the process of achieving economic goals.11 One use of the high-employment budget for pur poses of policy requires information on the values of planned saving and investment. Critics have sug gested that this type of information is very difficult to develop.12 Many economic models have been de veloped to explain the saving-investment process.13 However, with many different models available, and with each assigning a different role to fiscal actions, a particular high-employment budget number probably means something different to each model builder. Another interpretation of the high-employment budget stresses the interaction between fiscal and monetary policies.14 According to this monetarist in terpretation, fiscal actions have short-run effects on GNP, but over the longer run, unless accompanied by a change in the rate of monetary expansion, these fiscal effects will be negligible.15 In fact, the main value of the high-employment budget is that it pro 11Initially this purpose was associated with short-run “ fine tuning,” b u t m ore recently the emphasis seems to have shifted to the long run and the use o f high-em ploym ent budgeting as a means o f im posing fiscal discipline. This was the view in the President’s fiscal 1972 bud get message. for example, W arren L. Smith’s com m ent in Staff Papers and Other Materials Reviewed by the President’s Commission on Budget Concepts (W a sh in gton : U.S. Govern '-S e e , ment Printing Office, O ctober 1 9 6 7 ), pp. 450-55. 1;iFor a discussion o f existing m odels o f the U.S. E con om y, see Law rence R. Klein and E dw in Burmeister ( e d s .), Econometric M odel Performance (P hiladelphia: University o f Pennsylvania Press, 1 9 7 6). ]4For a theoretical discussion o f the interaction betw een m onetary and fiscal policy, see Karl Brunner, “ Inflation, M oney and the R ole o f Fiscal Arrangements: A n Analytic Fram ework for the Inflation Problem ,” in Mario M onti (e d it o r ), T he New Inflation and Monetary Policy (N e w York: Macm illan, 1 9 7 6 ), pp. 25-89. 1'’Probably the best known work demonstrating this “ crow dingout effect” is Leonall C . Andersen and Jerry I. Jordan, “ M onetary Fiscal A ctions: A Test o f their Relative Im portance in E con om ic Stabilization,” this Review (N ovem b er 1 9 6 8 ), pp. 11-24. For a recent update o f this w ork showing that fiscal policy n ow has an effect on GNP, see Benjamin M. Friedman, “ Even the St. Louis M od el N ow Believes in Fiscal Policy,” Journal of Money, Credit and Banking, IX (M a y 1 9 7 7 ), pp. 365-367. FEDERAL RESERVE BANK OF ST. LOUIS vides information about the impact of fiscal actions on interest rates. It is this credit market effect that is crucial in determining the effect of fiscal actions on economic activity in the long-run. This credit market effect depends, in turn, on the strength of private credit demands.16 The response of the monetary authority to interest rate pressures is instrumental in the determination of long-run growth and inflation. If the monetary author ity does not respond to interest rate pressure, an increase in the high-employment deficit in the pres ence of strong private credit demands indicates that the Federal government is bidding resources away from the private sector. And shifts in the mix of out put between public and private sectors can affect the growth rate of potential output. If, on the other hand, upward interest rate pressures are resisted by the monetary authority, the money supply will increase, and eventually inflation will result. CONSIDERATIONS UNDERLYING REVISED ESTIMATES Once the procedures for estimating the highemployment budget were developed, the matter of updating was somewhat mechanical, requiring as the major input an estimate of potential GNP each quar ter.17 The source for these estimates was the Council of Economic Advisers, which during the period from 1967 through 1976 usually indicated their estimate of the growth of potential GNP in their annual report. Review of Procedure The Federal sector of the national income accounts provides the basis for preparing estimates of what receipts and expenditures would be at high employ ment. The estimation procedure involves the follow ing steps for high-employment receipts: (1) Defining a high-employment rate of production and calculating a high-employment level of GNP in nominal terms; AUGUST 1977 For high-employment expenditures, the only adjust ment that is made is for unemployment compensation. Unemployment benefits are calculated for the speci fied level of high-employment, and actual unemploy ment benefits are adjusted for deviations from the high-employment norm. Revised Estimates and Changes in Potential Output One of the reasons the high-employment budget came under attack in recent years was that it was calculated on the assumption that full employment was 96 percent of the labor force, that is, an unem ployment rate of 4 percent. Changes in the composi tion of the labor force in recent years suggest that a 4 percent unemployment rate is no longer realistic as an estimate of the level of full employment.18 If these labor force developments are ignored, the policy interpretation of the high-employment measure could have undesirable economic consequences. If, say, a balance is sought in the budget on a high-employment basis of 4 percent unemployment, when in fact the “natural rate” of unemployment is 5 percent, budget policy will probably err on the stimulative side.1 9 To make the estimates of the high-employment budget more credible, two new series on potential GNP were used in the process of preparing the re vised estimates. One new potential GNP series was prepared by the Council of Economic Advisers and is discussed in their 1977 Annual Report. The other was prepared by Robert Rasche and John Tatom and published in the June issue of this Review. For both series the estimates are supposedly consistent with a variable “full-employment unemployment rate.” In stead of being a constant 4 percent, the level of unemployment which is deemed consistent with full employment now varies between 4 percent in 1955 and 4.9 percent in 1976. (2) Estimating the major income shares of GNP at high employment, i.e. personal income, wages and salaries, and corporate profits; The Rasche-Tatom series also allows for the effects of energy developments on productive potential. The argument is that energy is an input in the productive process, and a sharp unexpected increase in its relative price changed the optimal production mix. The effect (3) Applying high-employment tax rates to the de rived income components, which serve as proxies for actual tax bases. 18Peter K. Clark, “ A N ew Estimate o f Potential G N P,” C ou ncil o f E con om ic Advisers, unpublished mem orandum , January 27, 1977. Also, see Perry. 16See Richard W . Lang, “ T h e 1975-76 Federal Deficits and the Credit Market,” this Review (January 1 9 7 7 ), pp. 9-16. 17N ancy H. Teeters, “ Estimates o f the Full-Em ploym ent Surplus, 1955-1964.” Review of Economics and Statistics, vol. 47 (A ugu st 1 9 6 5 ), pp . 309-21. 19T he C ou ncil o f E con om ic Advisers defines the natural rate (w h at they call full-em ploym ent rate) o f unem ploym ent as “ the low est rate o f unem ploym ent attainable, under the existing institutional structure, that w ill not result in accel erated inflation.” 1977 Annual Report of Council of E co nomic Advisers, p. 48. Page 19 AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS C h a rt | | Estim ates of Potential G N P * Sou rce: C o u n c il of E co n om ic A d v ise rs 'M e a s u r e d in constant (1972) dollars. was to reduce economic capacity below what it other wise would have been from 1974 to present. The two new potential GNP series are compared with the old CEA estimates in Chart II. The differ ences are quite small for 1947 through 1968, but then the series begin to diverge. By 1976, the difference between the old and the new CEA is $68 billion (1972 dollars) and $99 billion between the old CEA and the Rasche-Tatom series. Other Sources of Revision Although the new potential GNP series are the chief sources of the revision in the high-employment budget, there were other minor changes as well. The income share method is still used to derive proxies for the tax bases. The high-employment shares were re examined along with the high-employment tax rates (ratio of collections to assumed bases). One of the more important changes was a change in the defini tion of the tax base proxy for personal taxes. Previ ously, personal income was used as a proxy, but with transfer payments growing in importance as a source of personal income in recent years, the proxy was changed to personal income minus Federal transfers to persons. This change facilitates the procedure of estimating high-employment personal taxes. Page 20 All other tax base proxies remained unchanged, except that they were recalculated for the new poten tial GNP series and the high-employment shares were reexamined. Wages and salaries are used as the base for social security taxes, corporate profits after taxes as the base for coiporate taxes, and personal income as the base for indirect business taxes. The effect of the revisions on high-employment re ceipts is shown in Chart III. The changes from the old series are quite small for 1947 to 1968, but after 1968 the differences become greater. By 1976, receipts are $16 billion less for the new CEA series than for the old, and the Rasche-Tatom estimate is $24 billion less than the old CEA estimate. The contours remain the same, however. The revision also affected changes in high-employ ment expenditures since the assumed full-employment unemployment rate was raised. Only the unem ployment benefit component of spending is treated as variant with the level of economic activity. Both of the new series show the same expenditures at high employment since they are both estimated on the basis of the same full-employment unemployment rate. The two sets of revised data are presented in Table I. AUGUST 1977 FEDERAL. RESERVE BANK OF ST. LOUIS C h art III Estimates of H igh Em ploym ent (+ )S a rp lis ; (-)D ilic it Q u arterly Totals at A n n ual Rates 'B a s e d on alternative estim ates o f Potential Output. Latest d ata plotted: 4th quarter INTERPRETATION OF REVISED ESTIMATES Examination of Chart III shows that both of the revised estimates of the high-employment budget are substantially less than those based on the old CEA series. All three series can be said to depict the same general pattern of movement throughout the 1952 to 1972 period. However, following 1972 the series show diverging movements. The new series show that fiscal policy was becoming more stimulative from early 1970 through 1972. From late 1972 to early 1974, all series showed tightening, but the extent of tightening was greatest for the old CEA series. In 1974, there is some confusion as to the stance of fiscal policy depending on which series one is examining. The old CEA series showed moderate restriction, the new CEA series showed little change, but the Rasche-Tatom showed moderate stimulus. From late 1974 the pattern is similar, although the extent to which the high-employment budget has moved back toward surplus is least for the RascheTatom series. In terms of the impact of fiscal actions, 1976 is one of the more interesting years. The old CEA series indicates that fiscal actions were relatively restrictive in 1976, as indicated by a movement to balance late in the year. The two revised estimates, on the other hand, show that the budget imparted substantial stimulus to economic activity in 1976 because these measures of the high-employment budget were sub stantially in deficit. Some might argue that the status of fiscal action is such that economic growth is being stifled by contin uing large deficits in the high-employment budget, as shown by the revised estimates. As long as monetary growth is quite moderate, the effect of large highemployment deficits is to usurp funds from the pri vate sector, and to the extent that such funds would go to investment in plant and equipment, economic growth is slowed. SUMMARY AND CONCLUSIONS The high-employment budget, if viewed in the spirit in which it is constructed, can be a useful addi tion to the policymakers tool kit. Something as com plex as the impact of fiscal actions cannot be sum marized with a single number. It’s chief purpose is to transfer some o f the attention from the actual surplus or deficit. However, the high-employment budget serves its function best when used in conjunction with the measured surplus or deficit. The effect o f the recent revision of the series was to increase the deficit in recent years, reflecting a down Page 21 FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1977 Table I E S T IM A T E S O F THE H IG H EMPLOYMENT BUDGET* Billions of Dollars S e a s o n a lly A d ju s t e d a t A n n u a l R ate s Based on O ld CEA Potential G N P Based on New CEA Potential G N P Based on Rasche-Tatom Potential G N P Receipts Surplus/ Deficit Receipts Expenditures Surplus/ Deficit Receipts Expenditures Surplus/ Deficit 1 $ 2 3 1 .6 $2 3 4 .0 $ - 2.4 $ - 9.8 II 234 .9 242.4 III 237.4 IV 1972 Expenditures $ 2 2 5 .0 $ 2 3 4 .8 -1 7 .8 228 .4 243.1 -1 4 .7 237.1 0.3 230.2 23 7 .7 - 7.5 234 .0 23 7 .7 - 242 .0 259.0 -1 7 .0 234.5 25 9 .6 -2 5 .1 239 .0 259 .6 -2 0 .6 1 257.1 260 .9 - 3.8 249.6 261 .6 -1 2 .0 253 .9 261 .6 - 265 .5 261.5 4.0 257 .7 262.1 - 4.4 262.3 262.1 271 .9 263.9 8.0 263 .0 264 .6 - 1.6 268.2 26 4 .6 3.6 IV 280.2 270 .7 9.5 271.2 271.5 - 0.3 275.8 271.5 4.3 1 294.2 279 .6 14.6 282.6 280.8 1.8 284.3 280.8 II 305 .6 292.1 13.5 293 .6 293.3 0.3 292.2 293.3 - 1.1 III 319.1 30 4 .6 14.5 30 5 .0 30 5 .0 0.0 301 .9 30 5 .0 - 3.1 IV 33 1 .0 314.8 16.2 316 .5 314.1 2.4 313 .4 314.1 - 0.7 1 341 .4 329 .4 12.0 328 .9 329.8 - 0.9 32 3 .4 329.8 - 6.4 II 1975 $ -1 1.5 243.1 III 1974 $ 2 3 4.8 225.3 II 1973 $2 2 3 .3 7.5 306.8 344.5 -3 7 .7 296.5 346 .2 -4 9 .7 290.2 346 .2 -5 6 .0 - 3.7 7.7 0.2 3.5 III - 9.3 333.1 355.4 -2 2 .3 326 .3 35 5 .4 -2 9 .1 36 6 .6 -1 1 .6 342 .3 36 6 .7 -2 4 .4 33 5 .0 3 6 6 .7 -3 1 .7 1 363 .2 371 .9 - 8.7 349 .5 37 2 .5 -2 3 .0 34 1 .9 372 .5 -3 0 .6 37 3 .0 37 1 .6 1.4 358 .2 370.2 -1 2 .0 35 0 .0 370 .2 -2 0 .2 III 382 .2 383 .9 - 1.7 365 .4 38 5 .0 -1 9 .6 35 7 .0 38 5 .0 -2 8 .0 IV 1 97 7 353 .9 35 5 .0 II 1976 34 4 .6 IV 39 3 .4 398 .3 - 4.9 376.1 3 9 4 .7 -1 8 .6 36 7 .0 3 9 4 .7 -2 7 .7 1 392 .2 39 8 .7 - 6.5 381 .9 3 9 8 .7 -1 6 .8 II 402.1 40 9 .5 - 7.4 391 .4 40 9 .5 -1 8 .1 ~ D a ta 'for years p rior to 1972 are available on request from this Bank. ward revision in the estimate of potential GNP. The use of the high-employment budget series as an indicator of fiscal action was little changed, but as a Page 22 policy tool for puiposes of achieving full employment with relative price stability, its implications are some what different than before. Income and Expenses of Eighth District Member Banks: 1976 JEAN M. LOVATI ] V [ e m b e r banks of the Eighth District experi enced a moderate increase in net income in 1976. Net income of District member banks increased 9 percent from 1975 to 1976, about the same rate as it did the previous year. However, unlike 1975 in which operat ing income and expenses posted slight gains, both operating income and expenses registered increases exceeding ten percent in 1976. Loans outstanding, the major factor contributing to the higher income, posted a solid increase, after rising slightly in 1975. Increases in the amount of interest paid on deposits, the princi pal factor in the rising expense, reflected a large inflow of time and savings deposits. On average, Eighth District member banks fared better in 1976 than all member banks as a whole. Although net operating income for banks in the nation posted a stronger increase than comparable income at District member banks, the combined effect of income taxes paid and net securities gains favored the relative position of District banks. Income taxes of all member banks in the nation in 1976 were 33 percent higher than in 1975. This compares with a one percent de cline in income taxes paid by Eighth District banks over the same period. Net securities gains, including extraordinary items, significantly boosted earnings for both groups. This additional source of eamings ad vanced 220 percent for all member banks and 147 percent for District banks. The combination of these two factors resulted in a greater net income gain for the District than for the nation. Net income of all member banks in the nation rose 6.7 percent in 1976, compared to 9 percent for District banks. Operating Income and Bank Assets Operating income of Eighth District member banks increased $179 million or 11 percent in 1976 to $1,760 million (see Table I ). A year earlier operating income increased less than one percent. Income from loans, which rose more than $111 million, and that from U.S. Treasury securities, which rose about $40 million, primarily accounted for the change in operating income. These increases, however, were C h a rt I Distribution of Assets Eig h th D istrict M e m b e r B a n k s End o f Y e a r D a ta P e H **! (0 SO 40 30 20 10 0 1972 1973 1974 1975 1976 • I n c l u d i n g F e d e r a l F u n d s s o ld a n d s e c u r it ie s p u r c h a s e d u n d e r r e s a le a gre e m e n t. partially offset by a decline in receipts from Federal funds sold and securities purchased under resale agreements. Interest and fees on loans, which posted a 2.3 per cent decline in 1975, increased 12 percent in 1976. Increases in holdings contributed to the jump in this source of income. The volume of loans outstanding increased 13 percent in 1976 to $13 billion, after registering a 1.3 percent increase a year earlier.1 1All comparisons o f assets, liabilities, and capital are m ade as o f D ecem ber 31 o f each year. These data, as w ell as incom e and expense items for 1976 are not strictly com parable to such data for 1975 due to definitional changes in the Reports o f Condition and Income. Page 23 AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS Table I IN C O M E AND EXPENSES O F M EM BER E IG H T H FEDERAL RESERVE BANKS IN THE D IS T R IC T Percent C han ge Thousands of Dollars 19761 19752 1 9 7 5 -7 6 Total O perating Income ............................................................................................ $ 1 ,7 6 0 ,1 7 3 $ 1 ,5 8 1 ,2 4 9 1 1 .3 % Interest an d fees on loans ..................................................................................... 1,064,018 9 5 2 ,6 7 5 11.7 80 ,4 9 0 9 6 ,3 1 8 — 16.4 Interest on securities ............................................................................................. 4 0 1 ,1 0 8 3 4 4 ,1 5 6 16.5 U.S. Treasury securities ....................................................................................... 162 ,33 5 1 1 9 ,0 9 6 36.3 Other U.S. Governm ent securities ........................................................................ 8 5 ,0 3 9 147,641 7 9 ,4 4 3 7.0 O bligation s of States and political subdivisions ................................................... 1 3 8 ,7 0 6 6.4 O ther securities ................................................................................................ 6,093 6,911 — 11.8 Income from Federal funds sold an d securities purchased under resale agreements Trust department income ......................................................................................... 3 5 ,7 8 9 3 0 ,9 3 6 15.7 Service charges on deposit accounts ........................................................................ 36,721 3 1 ,9 1 7 15.1 Other operating income ......................................................................................... 1 4 2 ,0 4 7 1 2 5 ,2 4 7 13.4 Total O perating Expenses .......................................................................................... 1 ,5 1 1 ,0 5 0 1 ,3 4 4 ,4 9 6 12.4 Interest on deposits .............................................................................................. 6 7 9 ,6 3 9 610,381 11.3 Other interest expenses ......................................................................................... 6,933 6,4 4 3 Expense of Federal funds purchased and securities sold under repurchase agreements 103,841 111 ,6 0 5 Salaries and employee benefits ............................................................................. 3 3 1 ,7 4 6 2 83 ,60 2 17.0 7.6 — 7.0 Provision for possible loan losses ........................................................................... 6 7 ,8 8 3 5 5 ,3 4 2 22.7 Other operating expenses ..................................................................................... 3 2 1 ,0 0 8 2 7 7 ,1 2 3 15.8 Income Before Income Taxes and Securities G a in s (or Losses) ..................................... 2 4 9 ,1 2 3 2 3 6 ,7 5 3 Less applicable income taxes ................................................................................. 4 2 ,442 42,7 9 8 Income Before Securities G ain s (or Losses) ................................................................ 206 ,68 1 1 9 3 ,9 5 5 Net securities ga in s (or losses) after taxes ............................................................ 7,804 888 — — Extra charges or credits after taxes ........................................................................ 5.2 — .8 6.6 299 2,389 In c o m e .................................................................................................................................... ............ 2 1 4 ,7 8 4 1 9 7 ,2 3 2 8 .9 Cash Dividends Paid .................................................................................................. 72,9 2 5 7 0 ,7 8 6 3.0 Num ber of B anks ...................................................................................................... 428 427 Net *Data are not strictly com parable to 1975 due to definitional changes in the R ep ort o f Incom e fo r 1976. 2Data have been adjusted to exclude one bank which exerienced unusual conditions. Strong gains in holdings of real estate and automobile loans made up the bulk of the change in outstanding loans, increasing about 18 and 21 percent, respec tively. The largest category of loans, commercial and industrial, rose 10.5 percent to $4 billion. The rate of return earned on loans averaged 8.7 percent in 1976. Income from securities posted an increase of 17 percent in 1976. Whereas the 18 percent increase in this source a year earlier was fairly evenly distrib uted across security classes, interest on U.S. Treasury securities comprised the bulk of the gain in securities income in 1976. Interest earned on Treasury securities increased 36 percent in 1976. Holdings of U.S. Treas ury securities increased 12 percent with average yields Page 24 on these securities rising from 6.7 percent to 6.9 percent. Income derived from obligations of other U.S. Gov ernment agencies and Government corporations posted an increase of 7 percent. These securities, the majority of which were held in one- to five-year ma turities, earned an average yield of 7.5 percent. In terest earned on obligations of states and political subdivisions rose 6 percent. These securities, which earned a 5 percent rate of return, were held primarily in one- to ten-year maturities. The above gains in income were partially offset by a decline in income from Federal funds sold and securities purchased under resale agreements. This AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS Chart II Distribution of Liabilities, Reserves, an d Capital Accounts Eighth D istrict M t a b a r B o a k s deposits represented half of all liabilities. Total de mand deposits, on the other hand, increased 4 percent in 1976 and represented 38 percent of total liabilities. Provision for loan losses increased 23 percent in 1976 to $68 million, following a jump of 48 percent in 1975. Increases in the loan loss reserve account also occurred as a result of recoveries from loans previ ously written off, and additions from mergers. These sources added $20 million to such reserves, bringing the total to $88 million. Losses charged to the fund in 1976 amounted to $80 million, so that on balance, reserves on loans increased $8 million or 6.6 percent. Salaries and employee benefits increased 17 per cent in 1976 to $332 million. The average amount paid increased from $8,480 to $10,461 per employee and the number of employees declined 5.2 percent, as banks continued to automate banking transactions and increase output per worker. The rise in operating expenses was offset somewhat by a 7 percent decline in interest paid on Federal funds purchased and securities sold under repurchase agreements. Outiays for Federal funds purchased, which represented 6 percent of operating expenses, declined $8 million in 1976, reflecting the lower aver age rate of interest charged for these funds. Net Income source of income, which fell 16 percent in 1976, pri marily reflected a decline in the Federal funds rate. The rate averaged 5.1 percent last year, compared to 5.8 percent in 1975. However, this decline amounted to only $16 million as total income from Federal funds sold and securities purchased under resale agreements represented only 4.6 percent of total operating income. Eighth District member bank income before income taxes and securities gains or losses totalled $249 mil lion in 1976, an increase of 5.2 percent over 1975. Income taxes totaled $42 million, slightly less than the amount paid a year earlier. Securities gains and other credits, net of taxes, substantially helped earnings, adding over $8 million to income. After such adjust ment, net income of member banks increased 9 per cent in 1976 to $215 million. Operating Expenses and Bank Liabilities The average return on equity capital in 1976 in creased to 12.8 percent from 11.2 percent in 1975. The rate of return on equity capital ranged from 9.6 per cent for banks with assets of $300 million and over to 13.6 percent for banks with assets between $25 and $50 million in assets.2 Operating expenses of Eighth District member banks rose 12 percent in 1976 to $1,511 million, com pared to little change the year before. Greater outlays for interest paid on time and savings deposits, pro vision for loan losses, and employee salaries made up almost 80 percent of the rise in expenses. Interest paid on time and savings deposits repre sented the largest expense of District member banks, amounting to $680 million in 1976. Outlays for such deposit interest rose 11 percent in 1976, compared to an increase of 4.3 percent a year earlier. Total time and savings deposits on which the interest is paid increased 11 percent in 1976 to $12.4 billion. These Member banks paid dividends on common and pre ferred stock of $73 million, a 3 percent increase over -Averages for groups o f banks are unw eighted averages o f operating ratios o f individual banks. Incom e and balance sheet items used in constructing these ratios are averages o f the figures from the Reports o f C ondition for M arch 31, June 30, Septem ber 30, and D ecem ber 31, 1976 and the Report of Incom e for 1976, the com ponents o f w hich include both dom estic and foreign subsidiaries o f m em ber banks. Page 25 AUGUST 1977 FEDERAL RESERVE BANK OF ST. LOUIS Table II S E L E C T E D O P E R A T I N G R A T IO S F O R T H E Y E A R 1 9 7 6 1 M E M B E R B A N K S — E IG H T H F E D E R A L R E S E R V E D IS T R IC T G roup 1 Up to $ 1 0 million G rou p 2 $10 - $25 million G roup 3 $ 2 5 - $5 0 million G roup 4 G roup 5 G roup 6 $ 5 0 - $ 1 0 0 $ 1 0 0 - $ 3 0 0 $ 3 0 0 million million million A n d O ver All Mem ber Banks 12.00 12.71 13.57 12.57 12.64 9.62 12.75 17.42 20.81 24.78 25.34 32.53 41.95 23.1 6 7.03 Profitability Percentage of Equity Capital Net Income ................................... Percentage of Net Income Cash dividends paid .......... ......... -... ____ Sources and Disposition of Income Percentage of Total Assets Total operating income .................... 6.89 6.99 7.12 7.17 6.93 7.07 Salaries, w ages and fringe benefits ... 1.42 1.26 1.20 1.26 1.30 1.50 1.28 Interest on deposits ........................ 2.84 3.23 3.37 3.35 2.76 2.17 3.16 Total operating expense .............. 5.78 5.89 5 .94 6.04 5.75 6.41 5.91 Net income ................................... .98 .97 1.02 1.00 .96 .60 .98 Interest on U.S. Treasury securities ... 17.26 15.06 12.64 11.09 11.54 5.45 13.83 Interest on securities of U.S. G overn ment agencies and corporations ... ..... 1 2.98 8.69 7.63 6.11 4.85 2.30 8.40 Percentage of Total O perating Income Interest on obligations of states and political subdivisions .................. 5.61 8.97 10.31 10.63 9.49 6.05 8.95 Interest and fees on loans ............... 54.3 9 57.4 9 60.4 6 61.91 59.2 9 61.9 6 58.5 4 4.19 3.20 2.95 2.53 5.37 5.75 3.42 Income on Federal funds sold and securities purchased to resell .... .... ...... Rate of Return on Securities and Loans Return on Securities2' 3 Interest on U.S. Treasury securities ... 6.55 6.93 7.00 7.13 7.02 6.83 6.91 Interest on securities of U.S. Government agencies and corporations ................ 7.70 7.49 7.50 7.13 7.72 7.70 7.51 Interest on obligations of states and political subdivisions .................. 4.99 5.03 5 .0 0 5.03 4.87 4.94 5 .00 8.62 8.71 8.80 8.82 8.61 8.70 8.73 Return on Loans (excluding unearned income and Federal funds sold) Interest ond fees on loons Net losses (— ) or recoveries (~h ) on loans -------------- --------- ------------- — .16 — .27 — .22 — .21 — .30 — .74 — .24 O ther Ratios Total capital accounts to total assets4 .. 9.56 8.18 8.28 8.01 8.24 6.66 8.38 Time and savings to total deposits (domestic offices) ......................... 58.0 4 63.8 0 65.2 7 65.32 57.9 6 50 .9 6 62.7 / Interest on time and savings deposits to total time and savings deposits (domestic offices)2 .......... -... .......... 5.35 5.54 5.70 5.70 5.55 5.53 5 .57 Num ber of Banks ...... -............... 68 151 123 44 26 11 423 1Each ratio is an unweighted average o f the ratios o f individual banks com puted from the Reports o f Condition fo r March 31, June 30, Septem ber 30, and December 31, 1976 and the R eport o f Incom e fo r 1976, the com ponents o f which include both dom estic and foreign subsidiaries o f member banks. 2Group averages exclude banks n ot rep orting these items. 3Excludes trad in g a ccou nt securities. ^Includes subordinated notes and debentures, but excludes valuation reserves and deferred tax reserves. those paid in 1975. Fifty percent of the banks paid dividends ranging from 12 to 30 percent of net income, with the largest banks, in terms of assets, Digitized forPage 26 FRASER paying the largest proportion of net income in cash dividends and the smallest banks the lowest proportion. FEDERAL RESERVE BANK OF ST. LOUIS AUGUST 1977 Publications of This Bank Include: Weekly U. S. FINANCIAL DATA Monthly REVIEW MONETARY TRENDS NATIONAL ECONOMIC TRENDS Quarterly SELECTED ECONOMIC INDICATORS - CENTRAL MISSISSIPPI VALLEY FEDERAL BUDGET TRENDS U. S. INTERNATIONAL TRANSACTIONS AND CURRENCY REVIEW Annually ANNUAL U. S. ECONOMIC DATA RATES OF CHANGE IN ECONOMIC DATA FOR TEN INDUSTRIAL COUNTRIES (QUARTERLY SUPPLEMENT) Single copies of these publications are available to the public without charge. For information write: Research Department, Federal Reserve Bank of St. Louis, P. O. Box 442, St. Louis, Missouri 63166. Page 27