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Review ________ ___
Vol. 67, No. 6

June/July 1985

5 Controlling Federal Outlays: Trends
and Proposals
12 The Monetary Control Art, Reserve
IiL\es and the Stock Prices of
Commercial Banks
21 Recent Changes in Handling Bank
Failures and Their Effects on the
Banking Industry
29 Are Weighted Monetary Aggregates
Better Than Simple-Sum M l?

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Federal Reserve Bank o f St. Louis
Review

June/Julv 1985

In This Issue . . .

The federal government in its February 1985 budget announced cuts o f about
$507 billion relative to current services estimates for the 1986-90 period. In the
first article o f this Review, “Controlling Federal Outlays: Trends and Proposals,"
Keith M. Carlson assesses the significance o f these proposed reductions by
comparing them with some longer-term trends in federal outlays. He concludes
that, while attempts to cut the proportion o f total federal outlays to GNP have
been unsuccessful thus far, the administration’s proposals, if achieved, w ould
reduce outlays relative to GNP. Historical comparisons show, however, that the
mix o f outlays between defense and nondefense has been altered quite dramati
cally, and a continuation o f this reversal is proposed for the future.
*

♦

In the second article in this issue, “The Monetary Control Act, Reserve Taxes
and the Stock Prices o f Commercial Banks,” G. J. Santoni shows that the reserve
requirements im posed on financial institutions have the properties o f a tax. With
the aid o f some simple examples, the author demonstrates that this reserve tax
varies with the interest rate and, prior to 1980, had differential effects on the
earnings streams and capital values o f banks. These differential tax effects are
important. Equity considerations aside, they artificially raise the operating cost o f
some firms relative to others engaged in essentially the same business. This
distorts the rates o f production among the differentially taxed firms and lowers
the value o f output for given costs.
Santoni discusses an important change in the tax em bodied in the Monetary
Control Act o f 1980. Specifically, the act raised reserve requirements for firms that
are not members o f the Federal Reserve System w hile lowering them for member
banks. The paper shows that the more uniform reserve requirements have
significantly reduced the differential effect o f interest rate changes on the stock
prices o f these two types o f banks. The legislation has raised the after-tax earnings
streams and stock prices o f member banks, other things the same, w hile lowering
both for nonmem ber banks.
*

In the early 1980s, the FDIC became concerned about a lack o f market discipline
im posed by large depositor's on the risks assumed by banks. The FDIC has
attempted to prom ote greater market discipline by allowing the uninsured
depositors o f some failed banks to suffer losses. There is some evidence, however,
of a double standard in these actions: the cases in which uninsured depositors
have been exposed to losses involve relatively small banks, whereas the unin
sured depositors o f the Continental Illinois Bank w ere protected from losses by
the FDIC in May of last year.
In the third article in this Review, “ Recent Changes in Handling Bank Failures
and their Effects on the Banking Industry," R. Alton Gilbert investigates whether
the FDIC s actions have induced uninsured depositors to shift their accounts to
the relatively large banks that appear to be too large to be allowed to fail. There is
no evidence o f a shift o f uninsured deposits from small to large banks. Instead,

In This Issue

there has been a small rise in the share o f large-denomination time deposits at
relatively small banks in the past year.
*

The introduction o f new financial instruments and recent financial deregula
tion have obfuscated the distinction between m oney and near-money assets. One
response to this situation has been the introduction o f w eighted monetary
aggregates, the construction o f which attempts to extract the m onetary services
provided by assets. In the final article o f this issue, "Are W eighted Monetary
Aggregates Better Than Simple-Sum M l? ” Dallas S. Batten and Daniel L. Thornton
investigate the properties o f two w eighted monetary aggregates and compare
these with the measure M l. Influencing econom ic activity is a central objective of
monetary policy, so an important attribute for a monetary aggregate to possess is
a close, predictable relationship with econom ic activity. Th e evidence, however,
indicates that the relationship between the tw o weighted measures and eco
nom ic activity, as measured by nominal GNP, has been no m ore predictable or
less variable than the relationship between M l and GNP. Consequently, these
w eighted aggregates do not demonstrate any apparent gain over M l that can be
exploited for monetary policy purposes.

Controlling Federal Outlays
Trends and Proposals
Keith M. Carlson

I n his February 1985 budget message, President
Reagan noted that
The past 4years have also seen the beginning of a quiet
but profound revolution in the conduct of our Federal
Government. We have halted what seemed at the time
an inexorable set of trends toward greater and greater
Government intrusiveness, more and more regulation,
higher and higher taxes, more and more spending,
higher and higher inflation, and weaker and weaker
defense.1
Yet, federal outlays as a proportion o f GNP w ere still
half a percentage point above what they w ere when
the administration took office in 1981.
The purpose o f this article is to summarize recent
trends in federal outlays and assess the administra
tion’s future plans by placing them in a historical
context.2The focus o f the discussion is on the behavior
o f federal outlays as a percent o f GNP — a measure
that was used initially by the administration to sum
marize the governm ent’s influence on the economy.

BUDGET OUTLAYS VS. CURRENT
SERVICES
Interpreting budget trends requires some reference
measure that can be used for comparison. The referKeith M. Carlson is an assistant vice president at the Federal Reserve
Bank of St. Louis. Thomas A. Poilmann provided research assistance.

ence measure used in the February 1985 budget is the
“current services budget.” According to the budget
document, "current services” estimates are defined as
. . . the estimated budget outlays and proposed budget
authority that would be included in the budget for the
following fiscal year if programs and activities of the
United States Government were carried on during that
year at the same level as the current year without a
change in policy.3
Current services estimates “provide a base against
which budgetary alternatives may be assessed."4
Table 1 summarizes both the administration’s 1985
proposals and the current services estimates for 1985
through 1990.5 A comparison o f the figures indicates
that the administration plans to cut federal outlays by
$507 billion between 1986 and 1990, with the largest
cuts coming in the last three years. W hen converted to
percentages, the cuts range from 5 percent in 1986 to
10.7 percent in 1990.
The bottom half o f table 1 shows the current ser
vices and proposed budget estimates as percentages
o f GNP. The proposed estimates represent sizable
decreases in the proportion o f federal government
outlays to GNP com pared with the current services
estimates.
Whether such proposed reductions in the propor
tion o f federal outlays relative to GNP w ill actually

'Office of Management and Budget (1985a).

3Office of Management and Budget (1985b), p. A-1.

2Even though the administration’s February 1985 proposals will not
be realized, these proposals provide a base for debate by Congress
whereby modifications will be made.

“Ibid, p. A-2.

5For alternative estimates of both the administration’s program and
current services, see Congressional Budget Office (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 1
Federal Outlays: Budget Estimates vs. Current Services, February 1985
In Billions of Dollars

Current services
Budget estimates
Difference

1985

1986

1987

1988

1989

1990

$960.4
959.1

$1024.5
973.7

$1109.2
1026.6

$1200.0
1094.8

$1262.8
1137.4

$1332.8
1190.0

$1.3

$50.8

$82.6

$105.2

$125.4

$142.8 |

$506.8
Percent difference

0.1%

5.0%

7.5%

8.8%

9.9%

10.7%

As a Percent of GNP
Current services
Budget estimates
Difference

24.8%
24.8

24.4%
23.2

24.4%
22.6

24.4%
22.2

23.8%
21.4

23.4%
20.9

0.0%

1.2%

1.8%

2.2%

2.4%

2.5%

NOTE: All figures include off-budget outlays.

occur depends crucially on both political consider
ations and future econom ic conditions — neither of
which can be forecast with much reliability.6One way
to assess the significance o f the proposed reductions,
however, is to compare them with some longer-term
trends in federal outlays. In this manner, it is at least
possible to see what such reductions w ou ld mean in a
historical context.

BUDGET OUTLAYS AS A PERCENT OF
GNP: A HISTORICAL PERSPECTIVE
To examine properly federal outlays relative to GNP
from a historical perspective requires adjusting out
lays and GNP separately for the direct influence o f the
business cycle.7 Since federal outlays generally rise
relative to GNP during recessions, the inclusion o f
such percentages without adjustment could distort
the interpretation o f underlying trends.

Total Outlays
The historical record o f cyclically adjusted federal
outlays as a percent o f adjusted GNP is summarized in
chart 1. Even with cyclical adjustment, this measure o f
government activity is still quite volatile, especially on
a year-to-year basis. Consequently, a trend line for the
period 1956-81 has been plotted in the chart.
Extending the trend line from 1982 through 1990
indicates that the administration has not been suc
cessful in reducing total outlays as a percent o f GNP in
the 1981-84 period. Moreover, the proposed 1985 level
o f outlays is w ell above the historical trend.
Chart 1 does show that the administration is pro
posing a path o f outlays after 1985 that differs dramati
cally from both the 1956-81 trend and its first four
years in office. If the administration’s proposals are
enacted, the size o f government w ould be reduced to
that prevailing in the mid-1970s.

The Composition o f Total Outlays
6See Carlson (1983).
7Federal outlays were adjusted for the cycle using correction factors
implicit in the work by de Leeuw and Holloway (1983). This meant
adjusting budget outlays in the same proportion as national income
accounts federal expenditures are adjusted to derive cyclically
adjusted expenditures. Following this procedure captures only the
automatic response of federal outlays to the business cycle, mean
ing that countercyclical fiscal actions are still reflected in the figures.
Trend GNP is middle-expansion trend GNP as defined by de Leeuw
and Holloway. See also Holloway (1984).

An examination o f total budget outlays relative to
GNP masks the contrasting differences taking place
between defense and nondefense outlays. Chart 2
summarizes these outlays relative to GNP. Nondefense
outlays and GNP are adjusted for the business cycle;
defense outlays are not adjusted because they are not
systematically related to the business cycle. The de
fense portion o f the chart shows the downw ard trend

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

C h a rt 1

Total B u d g e t O u t la y s a s a Pe rcent of G N P
Per cent

Percent

o f defense outlays relative to GNP from 1956 to 1981.
Since 1981, the trend has been reversed, with defense
spending rising to 6.3 percent o f GNP in 1984. The
administration plans for future defense spending to
continue to rise relative to GNP; the proposed budget
calls for defense outlays to reach 7.5 percent o f GNP
by 1990.8

fense outlays to be reduced to 13.4 percent o f GNP by
1990. If realized, the relative size o f the nondefense
budget w ould be reduced to levels prevailing in the
early 1970s.

The nondefense portion o f the chart shows that the
growth o f cyclically adjusted nondefense outlays rela
tive to trend GNP was extraordinarily rapid from 1956
to 1981. Such spending rose from 6.9 percent o f GNP in
1956 to 18 percent in 1981. Since 1981, however, the
ratio o f nondefense outlays to GNP has been reduced
relative to its 1956—81 trend.

Chart 3 summarizes nondefense spending by major
program category and emphasizes the m ethod o f car
rying out government activities. The purpose o f look
ing at these categories is to determine where the
nondefense budget cuts w ill fall.9

The administration plans for the reduction in non
defense outlays relative to GNP to continue; these
reductions are quite dramatic relative to the 1956-81
trend. The administration’s proposals call for nonde
8The administration indicates that its proposed defense outlays will
be less than the current services estimates (see the appendix to this
article for 1990 estimates). The Congressional Budget Office dis
putes this contention, claiming that the administration's defense
proposals are greater than current services estimates. See Con
gressional Budget Office (1985), p. 22.

The Composition o f Nondefense
Outlays

The largest proportion o f nondefense spending,
given this set o f categories, is payments for individuals.
This category includes both direct (for example, Social
Security benefits) and indirect (via grants to state and
local governments, such as M edicaid and assistance
payments) transfer payments by the federal govern
ment. According to the top tier o f chart 3, this spend
ing grew rapidly from 1956 to 1981; its trend has
apparently been reversed since 1983. The administra
t o r further detail relative to current services estimates, see the
appendix.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Composition of Total Budget Outlays
Percent o f G N P
Percent

N a tio n a l Defense O u tla y s

L J __ I__ L
Percent

221----------------------------N on d e fe nse O u tla y s

956-8

^T i i i i T
1956

iiii
62

Trend

iiii
68

iiii
72

iiii
78

iiii
82

iiii
88

T,)

1990

N O TE : N o n defense o u tla y s and GNP a rc c y c lic a lly a d ju s te d . N ondefens# o u tla y s in c lu d e u n d is trib u te d o ffse ttin g receipts.

tion plans to continue to reduce such payments rela
tive to GNP to 9.8 percent by 1990, a dramatic depar
ture from its growth over the 1956-81 period.
The categoiy labeled "all other grants" includes all
grants to state and local governments except transfer
payments. Included in this categoiy are grants for
wastewater treatment plants, highway construction,
community development, education, em ployment
and training assistance, and general revenue sharing.
The second tier o f chart 3 indicates that this category
o f spending has been reduced w ell below the 1956-81
trend line in recent years. The extent o f the cut is
dramatic — from a peak o f 2.6 percent o f GNP in 1978
to 1.5 percent in 1984. Furthermore, this categoiy is
projected for further cuts in the future, to 0.9 percent
o f GNP in 1990.

8 FRASER
Digitized for

The net interest category has attracted considerable
attention in recent years. Once a relatively insignifi
cant part o f the budget, it has risen considerably to the
point where policymakers n ow view it with major
concern.10 The third tier o f chart 3 shows that, after
rising from 1.3 percent o f GNP in 1956 to 1.6 percent in
1976, net interest rose steadily to 3.1 percent o f GNP in
1984. Projections o f net interest depend on a number
o f factors, the most important o f w hich is the future
course o f deficits and the projected level o f interest

'“This is because of the cumulative effect of net interest. Higher net
interest adds to the current deficit, which carries over to future years
in the form of a larger debt that must be financed. See Carlson
(1984).

RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

ctit

Perceat
%
%

%
\

%
X
\

P a y m e n ts 1o r In d iv id u c i Is
12

1956-81 Trendy

0~ 1 1 1 1q ~ l
h fceat

1 1 1' ~ 1 1 1 1 ~ ~ 1 1 1 1 = " i

i i

~ i

i ~~ i

i =

Perceat

0
Perceat

Pi riaat
4

0
P< reeat
i

Perceat

A ll O th e r !:e d e ra l O p e rations
Actual
4

1956-81 Trend
i

1 1 1 1
IfS i

l
i2

1 1 1
64

1 1 1 1
66

'JOTE G N P a n d p a y m e n ts f o r in d iv id u a ls a r e c y c lic a lly a d ju s te d . A l l

1 1 1 1

1 1 1 1
72

o th e r fe d e r a l

1 1 1
82

1 1 1 1
86

1990

o p e r a t io n s d o e s n o t in c lu d e u n d is tr ib u te d o f f s e t t in g r e c e ip ts .

FEDERAL RESERVE BANK OF ST. LOUIS

rates. Given the administration’s overall plan for re
ducing the size o f the deficit and a projected decline
in interest rates, net interest outlays as a percent of
GNP is projected to continue rising through 1985, level
off for two years, then drop sharply to 1990; however, it
w ill still remain above the 1956-81 trend as extrapo
lated to 1990.
The "all other federal operations” categoiy includes
outlays for foreign aid, general science research and
space technology, energy programs, farm price sup
ports, housing credit activities and day-to-day opera
tions o f the government. Relative to GNP, as shown in
the bottom tier o f chart 3, this category of nondefense
outlays displayed a slight upward trend during the
1956-81 period; it has declined in recent years. The
jump in the estimate for fiscal year 1985 reflects pri
marily the surge in outlays related to the PIK farm
program. The administration plans to continue to cut
such outlays as a percent o f GNP through 1990. Such
proposed cuts are centered on farm price support
programs, foreign aid and loan activities o f the
government.

SUMMARY
The federal government in its February 1985 budget
announced cuts o f about $507 billion relative to cur
rent services estimates for the 1986—90 period. These
proposed cuts w ere com pared with recent trends in
federal outlays relative to GNP since 1956; the results
o f these comparisons are summarized in table 2. The
historical record indicates that, w hile attempts to cut
the proportion o f total federal outlays to GNP have
been unsuccessful thus far, the administration’s cur
rent proposals, if achieved, w ould reduce outlays rela
tive to GNP. The historical comparisons show the
present administration has altered the mix o f total
outlays between defense and nondefense quite dra
matically, and a continuation o f this reversal is pro
posed for the future.
Payments for individuals are scheduled to be cut
m oderately relative to GNP for each year after 1985. Net
interest as a percent o f GNP, which is currently climb
ing w ell above past trends, is projected to continue
rising through 1985, level off, then move back toward

JUNE/JULY 1985

Table 2
Summary of Trends
Relation to 1956-81
trend1
Percent of GNP
Total budget outlays
National defense
Nondefense
Payments for individuals
All other grants
Net interest
All other federal operations

1982-84

1985-90

Above
Above
Below
Below
Below
Above
Below

Below
Above
Below
Below
Below
Above
Below

'A straight line trend was fitted to the relevant measure of outlays
as a percent of GNP.

trend after 1987. Budget cuts, as measured by outlays
relative to GNP, are concentrated in “all other grants to
state and local governm ents’’ and in “all other federal
operations.” The governm ent’s program is ambitious:
in order to reduce total budget outlays to 20.9 percent
o f GNP by 1990, w hile at the same time increasing
defense outlays to 7.5 percent o f GNP, nondefense
outlays w ill have to be reduced to 13.4 percent o f GNP
from the current level o f approximately 18 percent.

REFERENCES
Carlson, Keith M. “The Critical Role of Economic Assumptions in
the Evaluation of Federal Budget Programs,” this Review (October
1983), pp. 5-14.
_________ “Money Growth and the Size of the Federal Debt,” this
Review (November 1984), pp. 5-16.
Congressional Budget Office. An Analysis of the President’s Bud
getary Proposals for Fiscal Year 1986 (February 1985).
de Leeuw, Frank, and Thomas M. Holloway. "Cyclical Adjustment
of the Federal Budget and Federal Debt,” Survey of Current Busi
ness (December 1983), pp. 25-40.
Holloway, Thomas M. Cyclical Adjustment of the Federal Budget
and Federal Debt: Detailed Methodology and Estimates, Bureau of
Economic Analysis Staff Paper 40 (U.S. Department of Com
merce, June 1984).
Office of Management and Budget. Budget of the United States
Government: Fiscal Year 1986 (February 1985a), p. M4
-------------- - Special Analysis: Budget of the United States Govern
ment: Fiscal Year 1986 (February 1985b).

APPENDIX: Composition of Federal Outlays
Federal outlays can be classified in terms o f two
analytical structures: budget function and major pro
10

gram categoiy. The functional classification presents
outlays according to the purposes that federal pro-

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table A1
1990 Federal Outlays: Current Services vs. Administration Proposals
(amounts in billions of d o l l a r s ) __________________________
Percent
difference

Current
services

Administration
proposal

Difference

$441.7

$428.6

$ -1 3 .1

590.6
48.9
369.2
140.8
31.7

555.0
40.8
355.4
130.6
28.2

-3 5 .6
-8 .1
-1 3 .8
-1 0 .2
-3 .5

- 6 .0
-1 6 .6
- 3 .7
- 7 .2
-1 1 .0

61.2
3.5
22.2
5.7

43.9
2.7
16.8
3.8

-1 7 .3
- 0 .8
- 5 .4
-1 .9

-2 8 .3
-2 2 .9
-2 4 .3
-3 3 .3

22.7
7.1

18.7
1.9

- 4 .0
- 5 .2

-1 7 .6
-7 3 .2

Net interest

164.2

137.7

-2 6 .5

-1 6 .1

Other federal operations'
International affairs
General service, space and technology
Energy
Natural resources and environment2
Agriculture
Commerce and housing credit
Transportation2
Community and regional development2
Education, training, employment and
social services2
Administration of justice
General government
Allowances

117.3
19.5
11.0
6.1
9.3
20.1
3.8
10.0
2.5

69.9
14.5
11.1
2.3
7.3
3.8
- 3 .7
7.6
1.7

-4 7 .4
-5 .0
0.1
- 3 .8
- 2 .0
-1 6 .3
- 7 .5
-2 .4
- 0 .8

-4 0 .4
-2 5 .6
0.9
-6 2 .3
-2 1 .5
-8 1 .1
-1 9 7 .4
-2 4 .0
-3 2 .0

11.6
7.4
6.1
9.9

9.5
6.9
4.9
4.0

-2 .1
- 0 .5
- 1 .2
- 5 .9

-1 8 .1
- 6 .8
-1 9 .7
-5 9 .6

-4 2 .1

-4 5 .0

- 2 .9

—

Category

...

National defense
Benefit payments for individuals'
Health
Social Security and Medicare
Income security
Veteran payments
Other grants to state and local governments'
National resources and environment2
T ransportation2
Community and regional development2
Education, training, employment and
social services2
General purpose fiscal assistance

Undistributed offsetting receipts

-3 .0 %

'Amounts shown are the sums for the functions listed under them, and differ slightly from the "major program category" amounts shown
in the budget.
2The budget gives current services estimates for the total. Estimates by major program category were estimated by the author.

grams are intended to serve. These functions are
grouped into 18 broad areas, including, for example,
national defense, international affairs, energy p ro
grams, agriculture, transportation, health and general
government programs. Three additional categories —
net interest, allowances and undistributed offsetting
receipts — do not address specific functions, but are
included to cover the entire budget.
Classification o f federal outlays by major program
category focuses on the m ethod o f carrying out an
activity. The major program categories are national

defense, benefit payments to individuals, grants to
state and local governments (other than for benefit
payments), net interest, other federal operations and
undistributed offsetting receipts. National defense,
net interest, and undistributed offsetting receipts cor
respond to the functional categories o f the same
name, but, the remaining major program categories
do not correspond to a simple summing o f functional
categories. Nonetheless, approximations can be made.
The accompanying table groups 1990 outlays by func
tion to show the approximate com position o f some o f
the major program categories.

The Monetary Control Act, Reserve
Taxes and the Stock Prices of
Commercial Banks
G. J. Santoni

C
L -J lN C E 1980 all depository institutions have been
required to hold reserve balances in the form o f Trea
sury coins and Federal Reserve notes either in their
own vaults or on deposit at their regional Federal
Reserve Banks. These reserve balances pay no interest,
so the foregone interest earnings on the investments
the firm could otherwise have made can be viewed as
a tax.1
This tax lowers the firm ’s expected stream o f future
incom e net o f taxes which, other things the same,
reduces the capital value o f the firm. The tax varies
with the general level o f interest rates as well as the
spread between bank lending and borrowing rates.
Prior to 1980, the tax had differential effects across
banks depending on the tax rate (required reserve
ratio) faced by these various firms. This was particu
larly true with respect to m em ber vs. nonmem ber
banks o f the Federal Reserve System.2 These differen
tial tax effects are important. Equity considerations
aside, they artificially raise the operating costs o f some
firms relative to others engaged in essentially the same
business activity. This distorts rates o f production and
the allocation o f resources among the differentially
taxed firms and lowers the value o f output for given
costs.
The Monetary Control Act o f 1980 im posed uniform
reserve requirements on all depository institutions by
raising reserve requirements for nonm em ber banks,
while lowering them for mem ber banks. The purpose

o f this article is to analyze the effect this legislation has
had in eliminating the differential tax effect o f interest
rate changes on m em ber vs. nonm em ber banks. In
particular, the paper examines w hether the act was
effective in revising the response o f bank capital values
(stock prices) to interest rate changes. Since any revi
sion in differences in tax rates between groups gener
ally benefits one group over another, the paper pro
vides some rough estimates o f this as well.

RESERVE REQUIREMENTS: PRE-1980
Prior to the Monetary Control Act, reserve require
ments for nonm em ber banks w ere set by the various
state banking authorities. These differed across states
with respect to the reserve ratio, the form in which the
reserves w ere required to be held, the m ethod and
frequency o f policing and the penalty im posed for
deficiency.3 W hile differences existed, the reserve re
quirements o f state banking authorities generally w ere
more lenient than those o f the Federal Reserve System.
This appears to have been so with respect to the form
o f the reserves, policing and penalties for deficiency.4
Specifically, 30 o f the 50 state banking authorities
allowed banks to hold at least a portion o f their re
serves in interest-earning assets, 36 states did not
require periodic reporting o f reserve and deposit bal
ances and 22 had no monetary penalty for deficient
banks/1In contrast, Fed members had to hold reserves
either in their vaults or on deposit at a Federal Reserve
Bank. These reserve balances earned no interest.
M em ber banks reported their deposit and reserve
balances to the Fed on a weekly basis, and a monetary
penalty was enforced for deficient banks.
The left side o f table 1 gives the reserve require-

G.J. Santoni is a senior economist at the Federal Reserve Bank of St.
Louis. Thomas A. Pollmann provided research assistance. This paper
was produced in conjunction with the Center for Banking Research at
Washington University in St. Louis and appears in the working paper
series published by that institution.
'For discussions of the effects of differential reserve requirements,
see Fama (1985); Cargill and Garcia (1982); Gilbert (1978); Gilbert
and Lovati (1978); Prestopino (1976); Goldberg and Rose (1976)
and Knight (1974).
2See Goldberg and Rose (1976) and Prestopino (1976).

3See Gilbert and Lovati (1978), Prestopino (1976) and Knight (1974).
"See Gilbert and Lovati (1978), p. 32, and Knight (1974), p. 12-13,
for listings of the various state requirements.
5Seven states imposed reserve requirements that were roughly
identical to those of Fed members. These states were Arkansas,
California, Kansas, Nevada, New Jersey, Oklahoma and Utah.
Nonmember banks in these states are excluded from the data
sample in the tests conducted below.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 1: Depository Institutions’ Reserve Requirements (percent of deposits)1

Type of deposit and
deposit interval
(millions of dollars)

Member bank requirements
before implementation
of the Monetary Control Act
Percent

Effective date

12/30/76
12/30/76
12/30/76
12/30/76
12/30/76

9 1/2
113/4
123/4
16V4

Time and savings234
Savings

3/16/67

3 %
2Vz
1

3/16/67
1/8/76
10/30/75

6
2Vz

12/12/74
1/8/76
10/30/75

Time5
0-5, by maturity
30-179 days
180 days to 4 years
4 years or more
Over 5, by maturity
30-179 days
180 days to 4 years
4 years or more

Percent

Effective date

Net transaction accounts7

Net demand2
$ 0 - 2
2 - 10
10-100
100-400
Over 400

Type of deposit,
and deposit interval
(millions of dollars)

Depository
institution requirements
after implementation of the
Monetary Control Act6

$0-$29.8
Over $29.8

3%
12

1/1/85
1/1/85

3%
0

10/6/83
10/6/83

11/13/80

Nonpersonal time deposits s
By original maturity
Less than 4 years
4 years or more
Eurocurrency liabilities

All types

SOURCE: Federal Reserve Bulletin, November 1980, p. A8.

'For changes in reserve requirements beginning 1963, see Board's Annual Statistical Digest, 1971-1975 and for prior changes, see Board’s Annual Report for
1976, table 13. Under provisions of the Monetary Control Act, depository institutions include commercial banks, mutual savings banks, savings and loan
associations, credit unions, agencies and branches of foreign banks, and Edge Act corporations.
2(a) Requirement schedules are graduated, and each deposit interval applies to that part of the deposits of each bank. Demand deposits subject to reserve
requirements are gross demand deposits minus cash items in process of collection and demand balances due from domestic banks.
(b) The Federal Reserve Act as amended through 1978 specified different ranges of requirements for reserve city banks and for other banks. Reserve cities
were designated under a criterion adopted effective November 9, 1972, by which a bank having net demand deposits of more than $400 million was
considered to have the character of business of a reserve city bank. The presence of the head office of such a bank constituted designation of that place as a
reserve city. Cities in which there were Federal Reserve Banks or branches were also reserve cities. Any banks having net demand deposits of $400 million
or less were considered to have the character of business of banks outside of reserve cities and were permitted to maintain reserves at ratios set for banks
not in reserve cities.
(c) Effective August 24, 1978, the Regulation M reserve requirements on net balances due from domestic banks to their foreign branches and on deposits
that foreign branches lend to U.S. residents were reduced to zero from 4 percent and 1 percent, respectively. The Regulation D reserve requirement on
borrowings from unrelated banks abroad was also reduced to zero from 4 percent.
(d) Effective with the reserve computation period beginning November 16, 1978, domestic deposits of Edge corporations were subject to the same reserve
requirements as deposits of member banks.
N egotiable order of withdrawal (NOW) accounts and time deposits such as Christmas and vacation club accounts were subject to the same requirements as
savings deposits.
"The average reserve requirement on savings and other time deposits at that time had to be at least 3 percent, the minimum specified by law.
5Effective November 2, 1978, a supplementary reserve requirement of 2 percent was imposed on large time deposits of $100,000 or more, obligations of
affiliates and ineligible acceptances. This supplementary requirement was eliminated with the maintenance period beginning July 24,1980. Effective with
the reserve maintenance period beginning October 25, 1979, a marginal reserve requirement of 8 percent was added to managed liabilities in excess of a
base amount. This marginal requirement was increased to 10 percent beginning April 3,1980, was decreased to 5 percent beginning June 12,1980, and was
reduced to zero beginning July 24,1980. Managed liabilities are defined as large time deposits, Eurodollar borrowings, repurchase agreements against U.S.
government and federal agency securities, federal funds borrowings from nonmember institutions and certain other obligations. In general, the base for the
marginal reserve requirement was originally the greater of (a) $100 million or (b) the average amount of the managed liabilities held by a member bank, Edge
corporation, or family of U.S. branches and agencies of a foreign bank for the two statement weeks ending September 26,1979. For the computation period
beginning March 20, 1980, the base was lowered by (a) 7 percent or (b) the decrease in an institution’s U.S. office gross loans to foreigners and gross
balances due from foreign offices of other institutions between the base period (September 13-26, 1979) and the week ending March 12, 1980, whichever
was greater. From the computation period beginning May 29,1980, the base was increased by 7-1/2 percent above the base used to calculate the marginal
reserve in the statement week of May 14-21,1980. In addition, beginning March 19,1980, the base was reduced to the extent that foreign loans and balances
declined.
6For existing nonmember banks and thrift institutions, there is a phase-in period ending September 3,1987. For existing member banks the phase-in period is
about three years, depending on whether their new reserve requirements are greater or less than the old requirements. For existing agencies and branches
of foreign banks, the phase-in ended August 12,1982. All new institutions will have a two-year phase-in, beginning with the date that they open for business.
Transaction accounts include all deposits on which the account holder is permitted to make withdrawals by negotiable or transferable instruments, payment
orders of withdrawal, telephone and preauthorized transfers (in excess of three per month), for the purpose of making payments to third persons or others.
8ln general, nonpersonal time deposits are time deposits, including savings deposits, that are not transaction accounts and in which the beneficial interest is
held by a depositor which is not a natural person. Also included are certain transferable time deposits held by natural persons and certain obligations issued
to depository institution offices located outside the United States. For details, see section 204.2 of Regulation D.
NOTE: Required reserves must be held in the form of deposits with Federal Reserve Banks or vault cash. After implementation of the Monetary Control Act,
nonmembers may maintain reserves on a pass-through basis with certain approved institutions.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

RELATIVE CAPITAL VALUES AND THE
INTEREST RATE

Table 2
Member Bank Foregone Interest on
Reserve Balances (millions of dollars)
Net Demand
$

0
2
10
25
100
400
1,000
2,000
5,000

Required Reserves

Foregone Interest When
i = .08'

0.00
0.14
0.90
2.66
11.48
50.00
147.50
310.00
797.50

$ 0.000
0.011
0.072
0.213
0.918
4.000
11.800
24.800
63.800

'Foregone interest = i x required reserves

ments that applied to Federal Reserve m em ber banks
before Novem ber 1980.“ These reserve ratios w ere at
least as high as those im posed by the various state
banking authorities for nonm em ber banks and, in
most cases, they w ere higher.7

THE MEMBERSHIP TAX: PRE-1980
Other things the same, the m ore stringent reserve
requirements for Fed members raised the cost of
maintaining a given level o f deposits relative to the
cost experienced by nonmembers. Table 2 uses the
data in table 1 to calculate the tax for m em ber banks at
various levels o f net dem and deposits.8For example, a
member bank with $100 million in net dem and d e
posits was required to hold $11.48 m illion in reserves.
This resulted in foregone earnings of $918,000 per year
if the market rate w ere 8 percent.3 The decline in the
expected stream o f earnings was the reserve tax (in
this case, $918,000 per year). Since the capital value o f a
firm is the present value o f its expected earnings
stream, the tax reduced the capital value o f the bank as
well.
T h e Monetary Control Act was passed in March 1980, but the new
reserve requirements did not become effective immediately. The
right side of the table indicates the reserve requirements that would
have been imposed as of November 13,1980, if there had been no
phase-in period. In fact, these new requirements were phased in
over a period of years (see table 1, note 6). For the moment, the
discussion is focused on pre-November 1980 reserve requirements.

Not only does the reserve tax reduce the expected
earnings streams and capital values o f m em ber banks
(those with higher reserve requirements) relative to
nonmem ber banks, but the earnings streams and cap
ital values o f m em ber banks change relative to non
m ember banks with changes in either the general level
o f interest rates or the spread between bank borrow
ing and lending rates.

A Change in the General Level o f
Interest Rates
Table 3 illustrates the effect o f a change in the level
o f interest rates with the spread held constant. In
panel A, the rate at which banks can lend is assumed
to be 10 percent, w hile the rate paid on deposits (and
other sources o f funds) is 5 percent. The reserve re
quirement for m em ber banks is assumed to be 10
percent. For illustrative purposes, the non-interesteamings reserves o f nonmembers are assumed to be
zero. The table calculates the amount available for
lending, the annual net revenue and the capital value
o f the net revenue stream for each $100 o f deposits for
both a m em ber and a nonm em ber bank.
The reserve requirement lowers the amount that
can be loaned, the stream o f net revenue and capital
value o f the m em ber relative to the nonm em ber bank.
The capital value o f the m em ber’s revenue stream is
$40, w hile the nonm em ber’s is $50. The m em ber’s
capital value relative to the nonm em ber’s is 80 per
cent. Notice that the absolute difference between the
two capital values is equal to the required reserves o f
members ($50 — $40 = $10).
In panel B, both lending and borrowing rates are
assumed to increase to 20 percent and 15 percent,
respectively, w hile other things remain the same."' The
net revenue stream o f the nonm em ber does not
change w hile the m em ber’s stream falls. The increase
in interest rates causes the capital value o f both banks
to decline. M ore importantly, however, the capital
value o f the mem ber bank drops from 80 percent to 60
percent in terms o f the capital value o f the nonm em
ber bank.
Notice that, in this particular case, the absolute

7See Gilbert and Lovati (1978) for a listing of the reserve ratios
imposed by the various state authorities.
T h e calculation is intended for illustrative purposes only and ignores
the foregone interest on reserves held against time deposits.
This represents an upper bound to the tax since the bank would
maintain some reserves even if there were no legal requirement to
do so.

,0ln the example, the absolute spread is unchanged but the relative
spread (iB/iL) changes. If the ratio of the borrowing to the lending rate
remained constant as the general level of interest rates changed,
relative capital values would not change. The example is intended
for illustrative purposes. A more precise statement of the effect of
interest rate changes is given in the appendix.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 3
A Change in the General Level of Interest Rates and Relative
Capital Values1__________________________________
Members

Nonmembers

$100
10

$100

$ 90

$100

9
5

$ 10
5

Relative
Capital Value

Panel A: Lending rate = 10%
Borrowing rate = 5%
Deposit
Required reserves
Available for lending
Annual revenue (.10 x Loan)
Cost (.05 x Deposit)
Net revenue
Capital value (Net revenue/,10)

$ 40

—

$ 50

.80

=
Panel B: Lending rate = 20%
Borrowing rate = 15%
Deposit
Required reserves

$100
10

$100
—

Available for lending

$ 90

$100

Annual revenue (.20 x Loan)
Cost (.15 x Deposit)

$ 18
15

$ 20
15

Net revenue
Capital value (Net revenue/,20)

$ 15

=—

$ 25

===:

.60

'Conditions of the example are that deposits of both banks are $100, the
required reserve ratio for members is 10 percent and zero for nonmembers.

difference between the capital values o f the two banks
does not change. This is because the banks in this
example have the same level o f deposits and, thus, the
differential effect caused by m em ber bank reserve re
quirements remains constant (see the appendix for a
more formal presentation).

A Change in the Interest Rate Spread
Table 4 is similar to table 3 except that it illustrates
the effect on relative earnings streams and capital
values o f a change in the spread between the interest
rate banks charge on loans and the rate paid on
deposits. The top halves o f the two tables are identical.
In panel B o f table 4, however, the lending rate is
assumed to increase w hile the borrowing rate remains
unchanged. The earning streams and capital values of

both banks rise with the capital value o f the member
rising relative to that o f the nonmember.
In this example, the interest rate spread increases as
the bank lending rate rises, w hile the borrowing rate
remains the same. A qualitatively similar result would
occur if the borrowing rate declined, w hile the lending
rate remained the same.
While changes in the spread are potentially im por
tant, two problems arise when testing for this effect.
First, prior to 1981, the interest rate banks could pay
on deposits was subject to a ceiling. During much o f
the earlier portion of the sample period used here, the
ceiling was effective. As a result, changes in the spread
w ere highly correlated with changes in the general
level o f interest rates. Second, the spread between
lending and borrowing rates is the compensation

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 4
Changes in the Interest Rate Spread and Relative Capital Values1
Members

Nonmembers

$100
10

$100
—

$ 90

$100

9
5

$ 10
5

Relative
Capital Value

Panel A: Lending rate = 10%
Borrowing rate = 5%
Deposit
Required reserves
Available for lending
Annual revenue (.10 x Loan)
Cost (.05 x Deposit)
Net revenue
Capital value (Net revenue/. 10)

$ 40

$ 50

$100
10

$100
—

Available for lending

$ 90

$100

Annual revenue (.20 x Loan)
Cost (.05 x Deposit)

$ 18
5

$ 20
5

$ 13

$ 15

$ 65

$ 75

.80

Panel B: Lending rate = 20%
Borrowing rate = 5%
Deposit
Required reserves

Net revenue
Capital value (Net revenue/.20)

.87

'The conditions of the example are that deposits for both banks are $100, the required reserve ratio for
member banks is 10 percent, both banks pay 5 percent on deposits, and both extend loans at the same
interest rate. In panel A, the loan rate is 10 percent while, in panel B, the loan rate is 20 percent. The
borrowing rate does not change. The firm’s cost of capital is assumed to equal the lending rate.

banks earn for em ploying their specialized resources
to intermediate financial transactions. W hen borrow
ing and lending rates are free to move, as was true after
1981, competition among intermediaries assures that
the spread is just sufficient to cover costs. Unless there
is a change in the technology o f the intermediation
process, there is little reason to expect the spread to
vaiy significantly. For these reasons, the spread is
excluded in the following empirical analysis and at
tention is focused on variation in the level o f interest
rates."

"In regressions not reported here, the product of a dummy variable
and various proxies tor the spread were tested. The dummy variable
was used to control for the period of deposit rate ceilings that
prevailed prior to 1981. The dummy variable assumed a value of
one for the period since relaxation of the interest rate ceilings on
deposits (1/1981—IV/1983), and zero otherwise. The coefficient of

16FRASER
Digitized for

RESERVE REQUIREMENTS AFTER
THE MONETARY CONTROL ACT
The right side o f table 1 shows the reserve require
ments o f depository institutions after the im plementa
tion o f the Monetary Control Act.'- These reserve re
q u irem e n ts a p p ly to d e p o s ito r y in s titu tio n s
regardless o f Fed membership. They substantially re
duce the required reserve balances o f m em ber banks

this variable did not differ significantly from zero. The proxies for the
lending rate used to calculate the spread were the one-month
commercial paper rate, the 4 -6 month commercial paper rate and
the 90-day bankers acceptance rate. The borrowing rate proxy was
the Federal Reserve discount rate.
,2See table 1, note 6, for a discussion of the period over which the new
requirements were phased in. In the text, the phase-in period is
ignored unless otherwise mentioned.

FEDERAL RESERVE BANK OF ST. LOUIS

at each level o f net dem and deposits, w hile generally
increasing them for nonmem ber banks.
Table 1 also presents the pre- and post-reserve
requirements on time and savings deposits. Before the
Monetary Control Act, required reserve holdings
against personal and nonpersonal time deposits
ranged from 1 to 6 percent (with a minimum average
requirement o f 3 percent), w hile those on savings
deposits w ere 3 percent. The act reduced these re
quirements to zero for personal time and savings
accounts.'3 Since these deposits represent a substan
tial portion o f total time and savings deposits, this
change results in a significant reduction in member
bank required reserves.14Furthermore, the reserve re
quirement on managed liabilities and the supplem en
tary reserve requirement on time deposits o f $100,000
or more were reduced to zero in July 1980.
W hile the change in the level o f required reserves
mandated by the act is clearly important for some
issues, what is most important for the purpose o f this
paper is that this legislation imposes uniform reserve
requirements across m em ber and nonm em ber banks.
(See the insert on page 18 for a discussion o f some
other provisions o f the act.I

SOME IMPLICATIONS AND EVIDENCE
The phase-in period for the new reserve require
ments, which extended through 1984 for member
banks, w ill not be com plete for nonmembers until
September 1987. This w ill mitigate the quantitative
effect o f the change on the following estimates but the
expected qualitative effect should show through.''

The Effect o f Interest Rate Changes
on Relative Stock Prices
In an effort to evaluate the implications o f the above
argument, quarterly data on the share prices and
demand deposit liabilities o f 40 publicly traded bank
holding companies w ere examined. The holding com
panies w ere divided into two categories depending on

'3See table 1, note 8, for a definition of personal vs. nonpersonal time
and savings deposits.
'■•For example, for banks in the Eighth Federal Reserve District, the
personal portion of savings deposits was more than five times
greater than the nonpersonal portion, while the personal portion of
time deposits was more than four times the nonpersonal portion.
,5See Pearce and Roley (1983) and (1985).

JUNE/JULY 1985

whether the subsidiary banks making up an individual
holding company w ere members or nonmembers o f
the Federal Reserve System.16The stock prices o f each
holding company w ere adjusted for stock splits and
stock dividends, and simple quarterly averages o f
stock prices and dem and deposit liabilities w ere com
puted for each o f the two categories o f holding com
panies. The sample period runs from 1/1974—IV/1983.
The previous arguments im ply that the capital val
ues o f mem ber relative to nonm em ber banks w ill be
related in a specific w ay to certain other variables.
Consequently, the variable to be explained (depen
dent variable) in the following regression is the ratio o f
the average stock prices o f m em ber to nonm em ber
banks. For purposes o f the empirical estimate, the
dependent variable is expressed in log form.
The following empirical analysis is primarily con
cerned with the relationship between the dependent
variable and the level o f interest rates. Since an in
crease in the level o f interest rates is thought to reduce
member bank capital values relative to those o f non
member banks, the sign o f the estimated coefficient on
the level o f interest rates is expected to be negative.
Further, the above arguments indicate that the rela
tionship between these variables w ill change in a
particular way following implementation o f the M one
tary Control Act.'7Consequently, an interaction term is
included in the regression as an independent vari
able.18
The interaction term is included to test for the effect
that the M onetary Control Act has had in eliminating
the differential response o f the capital values o f m em
bers vs. nonmembers to interest rate changes. The
interaction term is the product o f a coefficient (to be
estimated), a dum m y variable and the .level o f the
interest rate. The dum m y variable assumes a value of
one for the period subsequent to implementation of
the M onetaiy Control Act, w hile its value is zero dur
ing the earlier period. Since the hypothesis suggests
that the uniform reserve requirements em bodied in
the legislation w ill eliminate the adverse conse-

16The data set includes only state-chartered banks. Nationally char
tered banks are required to be members of the Fed, but are ex
cluded from this sample mainly because they are much larger on
average than state-chartered banks and are subject to different
regulatory agencies.
"See the appendix for a summary of the theory that underlies the
estimating equation.
18The proxy employed for the general level of interest rates is the
corporate Aaa bond rate. A long-term interest rate was selected
since it is presumed to represent some average of current and
expected future shorter-term interest rates.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Chart 1

Ratio of M e m b e r Banks to N onm em ber Banks
Ratio

Ra tio

Some Other Provisions of the Act
The Monetary Control Act contains many other
provisions that have important implications for
financial firms and markets that are distinct from its
impact on required reserves. Most o f these provi
sions are not expected to affect m em ber banks any
differently than nonm em ber banks. There are two
exceptions, however.
Before the Monetary Control Act, the Federal
Reserve System provided certain services to m em
bers that w ere free o f direct charge. In addition,
members w ere allowed to borrow from the System
at the Federal Reserve discount rate. Neither o f
these services w ere available to nonm em ber banks.
The Federal Reserve System is now required by the
Monetary Control Act to charge for the banking
services it provides and to make these services
available to any bank that wants to use them. In
addition, borrowing from the Fed is no longer the

exclusive privilege o f m em ber banks.'
The effect o f these tw o changes is to raise the
capital values o f nonm em ber banks relative to
member banks and to offset the effect o f the reserve
requirement changes. It is unlikely, however, that
these two provisions o f the act com pletely offset the
effect o f the reserve requirement changes on rela
tive capital values. Prior to 1980, Federal Reserve
membership was declining both absolutely and
relative to all comm ercial banks (see chart 1). The
most frequently m entioned reason for leaving was
the System’s higher reserve requirements. Clearly,
for the banks that decided to leave and those new
banks that did not join, the System’s reserve re
quirements w ere too high a price to pay for “free”
services and access to the discount window.
'See Brewer (1980).

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

o f the two types o f banks is significant and positive.

Table 5
The Monetary Control Act and the Stock
Prices of Member Vs. Nonmember Banks
Estimate'
Ln(P„/PN) = .065 + .089 D„/DN - .055 i + .020 DUM-i
(.36)
(2.89)*
(4.68)* (4.56)*
R2 = .54
Rho = - .30
(2 .02 )*
where: P « /P n = the average stock price of member banks
relative to the average for nonmember banks
Dm/D n = the average level of member bank demand
deposit liabilities relative to the average for
nonmember banks
i = a proxy for the general level of interest rates.
The proxy is the level of the corporate Aaa
bond rate.
DUM = a dummy variable for the period since
implementation of the Monetary Control Act.
DUM = 1 for the period 1/1981-IV /1983 and
zero otherwise.2
'Significantly different from zero at the 5 percent level
't-values in parentheses. Adjusted for first-order autocorrelation.
The regression was checked for second-order autocorrelation
with the following result: Rho2 = .07, t-value = .46.
2The estimate deteriorates if D = 1 for the period 11/1980—IV/1983
and zero otherwise. This definition includes the period between
March 1980 when the legislation was passed and November
1980 when it was implemented.

quences experienced by m em ber banks w hen the
general level o f interest rates rise, the expected sign o f
the coefficient on the interaction term is positive. Were
it not for the phase-in period, the absolute values o f
this coefficient and the coefficient on the level o f
interest rates w ou ld be the same, indicating that the
elimination o f differential reserve requirements com
pletely eliminates the differential response of member
bank capital values to the level o f the interest rate.
Finally, the ratio o f m em ber to nonm em ber demand
deposit liabilities is included as a scale variable. The
sign o f the coefficient on this variable is ambiguous.
However, variation in the size o f members relative to
nonmembers can affect the dependent variable (see
appendix) and, if the regression does not control for
this variation, it can contaminate estimates o f the
other coefficients.

For the purposes o f this paper, the coefficients on
the interest rate and the interaction term are the most
interesting. As expected, the coefficient on the interest
rate is negative and significant, indicating that a higher
interest rate is associated with a low er value o f the
dependent variable.
The sensitivity o f the dependent variable to interest
rate changes is measured by its interest rate elasticity.
An estimate o f the average elasticity during the period
prior to the Monetary Control Act is given by the
product o f the coefficient o f the interest rate and its
average level (8.7 percent). In this case, the interest rate
elasticity is estimated to be — ,48( = .055 X 8.7). This
indicates that a 1 percent increase in the interest rate
reduces the share prices o f m em ber relative to non
member banks by about 0.5 percent.
Implementation o f the Monetary Control Act ap
pears to have mitigated this differential effect. The sign
o f the interaction term is positive and significant. The
coefficient, however, is less in absolute value than the
coefficient o f the interest rate. This is not surprising
given that the new reserve requirements w ere phased
in and that the phase-in w ill continue through 1987.
As o f this point in the phase-in (IV/1983), and with
the average level o f interest rates held constant at 8.7
percent, the interest rate elasticity is estimated to be
— ,30[ = (.020 — .055) X 8.7]. This represents a decline
o f about 40 percent in the interest rate sensitivity of
the dependent variable. It is important to recognize
that this sensitivity is reduced not only because the
sensitivity o f m em ber bank share prices to interest rate
changes declines but also because the legislation, by
imposing uniform reserve requirements on all banks,
increases the interest rate sensitivity o f nonmem ber
bank share prices.
The average level o f interest rates rose to about 13
percent subsequent to the Monetary Control Act. Had
the act not been in place, the share prices o f member
relative to nonm em ber banks w ou ld have declined by
about 24 percent [ = 100 X -.48(13.0 - 8.71/8.7], The
legislation, however, tem pered this to a decline o f only
15 percent [ = 100 X -.30(13.0 - 8.7J/8.7].

CONCLUSION

The Evidence

The reserve requirements im posed on the deposit
liabilities o f financial institutions have the properties
o f a tax. This tax varies w ith the interest rate and has

Table 5 presents the results o f the regression. The
variable included to control for differences in the scale

differential effects across banks depending on their
reserve requirements. An important change in this tax

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

was made in the Monetary Control Act o f 1980. The act
im posed uniform reserve requirements across all
financial firms by raising reserve requirements for
firms that were not members o f the Federal Reserve
System, w hile lowering them for mem ber banks. This
paper analyzes the legislation’s effect on the relation
ship between the interest rate and the stock prices of
member and nonmem ber commercial banks. As ex
pected, the legislation has significantly reduced the
differential effect o f interest rate changes on the rela
tive stock price o f these banks. In the process, it has
raised the after-tax earnings streams and stock prices
o f m em ber banks, other things the same, while low er
ing both for nonmem ber banks.

Prestopino, Chris J. “Do Higher Reserve Requirements Discourage
Federal Reserve Membership?” Journal of Finance (December
1976), pp. 1471-80.

APPENDIX
Relative Capital Values
Let P, D and r represent capital values, deposits and
the required reserve ratio as a function o f deposits,
respectively, w hile iL and i„ are the lending rate and
borrowing rate that are com m on to all banks. If the
subscripts M and N indicate values for m em ber or
nonmem ber banks o f the terms in the subscript, then:
Pm

DM[iL

r(DJ*iL

IbVil

Dm[1

Ib^ l

r(Dxl)]

P„ = DN(iL - i„)/iL = Dx(l - iB/i,l.

REFERENCES
Board of Governors of the Federal Reserve System.
cal Digest, 1941-70 and 1970-79.

Annual Statisti

Brewer, Elijah, et. al. “The Depository Institutions Deregulation and
Monetary Control Act of 1980," Federal Reserve Bank of Chicago
Economic Perspectives (September/October 1980), pp. 2-23.
Cargill, Thomas F„ and Gillian G. Garcia. Financial Deregulation
and Monetary Control (Hoover Institution, 1982).
Fama, Eugene F. “What's Different About Banks?,’’ Journal of Mon
etary Economics (January 1985), pp. 29-39.
Gilbert, R. Alton. "Effectiveness of State Reserve Requirements,"
this Review (September 1978), pp. 16-28.
Gilbert, R. Alton, and Jean M. Lovati. “Bank Reserve Requirements
and Their Enforcement: A Comparison Across States," this Re
view (March 1978), pp. 22-32.
Goldberg, Lawrence G., and John T. Rose. "The Effect on Non
member Banks of the Imposition of Member Bank Reserve Re
quirements — With and Without Federal Reserve Services,” Jour
nal of Finance (December 1976), pp. 1457-69.
James, Christopher. "An Analysis of Intra-Industry Differences in
the Effect of Regulation: The Case of Deposit Rate Ceilings,”
Journal of Monetary Economics (September 1983), pp. 417-32.
Knight, Robert E. “Reserve Requirements: Part 1: Comparative
Reserve Requirements at Member and Nonmember Banks," Fed
eral Reserve Bank of Kansas City Monthly Review (April 1974), pp.
3-20.
1980 Financial Institutions Deregulation and Monetary Control.
(Commerce Clearing House, Inc., 1980).
Pearce, Douglas K., and V. Vance Roley. “The Reaction of Stock
Prices to Unanticipated Changes in Money: A Note,” Journal of
Finance (September 1983), pp. 1323-33.
“Stock Prices and Economic News,” Journal of Business (January 1985), pp. 49-67.

P,/PN = — — [ 1 ---*
Dv
1

HDm)
rl
iA

A Change in Relative Scales:
d(Ps,/PJ
3(Dm
/DJ

rtD„.
1

dD.,
l
x
- [r'(DM
d(Dj/DN)
1 - iA

Dv <

A Change in the General Level o f
Interest Rates:
^
3i
D,
di, = di„ = di

iL2

r(DM)) < 0

A Change in the Member Bank Reserve
Schedule:
a iP M / P J

dr(DJ

D m

1 - i„/i,

A Change in the Lending Rate Relative
to the Borrowing Rate:
WPy/P-l

d(iA)

HDm)
D-,
Dn (1 -

iA )2

< 0

Note that iB/iLmust be less than one. An increase in this
ratio is consistent with a decline in the spread be
tween lending and borrowing rates.

Recent Changes in Handling Bank
Failures and Their Effects on the
Banking Industry
R. Alton Gilbert

I n SOME o f its public statements in recent years,
the Federal Deposit Insurance Corporation (FDIC) has
stressed the objective o f prom oting market discipline
o f the risks assumed by banks through the influence of
uninsured depositors.1 The FDIC has attempted to
accomplish this by allowing the uninsured depositors
o f some failed banks to suffer losses. In practice, the
cases in w hich uninsured depositors have been ex
posed to losses involve relatively small banks. As a
consequence, the managers o f some relatively small
banks claim that they have lost large-denomination
deposit accounts to larger banks as large depositors
reduce the risk o f losing part o f their deposits by
moving their accounts to relatively large banks.2
This paper investigates w hether the FDIC’s actions
in recent years indicate a double standard in the
treatment of large depositors at large and small banks.
Next, the paper analyzes the effects that such a double
standard w ould have on the operation o f the banking
system. Finally, it investigates w hether depositors
now act as though they perceive an increase in the risk
o f holding large-denom ination deposits at small
banks over holding them at large banks.

R. Alton Gilbert is an assistant vice president at the Federal Reserve
Bank of St. Louis. Laura A. Prives provided research assistance.
'Federal Deposit Insurance Corporation (1983) and Isaac (1983).
2Hill and Finn (1984) and King (1984).

FDIC ACTIONS IN BANK
FAILURE CASES
This section presents a brief description o f the
FDIC’s procedures in disposing o f the assets and de
posit liabilities o f insured banks that fail. A knowledge
o f these procedures is necessaiy to understand the
effect o f recent FDIC actions on the risks assumed by
large depositors at banks o f different size.

Deposit Payoff
A commercial bank is officially declared a failed
bank by its chartering agency — the Com ptroller o f the
Currency for a national bank, the state banking au
thority for a state-chartered bank. The FDIC becomes
the receiver o f a federally insured bank that fails, with
authority to dispose o f the assets and to pay off the
creditors.
One type o f action the FDIC can take as receiver o f a
failed bank is called a deposit payoff. The FDIC makes
payments to each depositor, up to the insurance limit,
as soon as the records o f deposit accounts can be
compiled. Depositors with accounts over the insur
ance limit becom e general creditors o f the failed bank
for the amount o f their deposits in excess o f the
insurance limit. They receive payments on the unin
sured portions o f their deposits as the FDIC liquidates
the assets o f the failed bank. W hether they receive full
payment on their uninsured deposits depends on the
liquidation value o f these assets.

F E D E R A L R E S E R V E B A N K O F ST. LO UIS

JUNE/JULY 1985

Purchase and Assumption Transactions

Modified Payout Procedure

For the FDIC, there are disadvantages to handling
the receivership o f a failed bank through a deposit
payoff. Banking services are tem porarily disrupted,
even for the fully insured depositors, w ho generally
must wait a few days to receive their funds. For the
uninsured depositors, even if they eventually receive
full payment, the delay can throw a wrench into the
financing o f their activities. Also, the acquisition o f the
failed bank’s assets may be more valuable to another
bank than to the FDIC, especially if the other bank
could continue to operate the failed bank as a going
concern.

In choosing between a deposit payoff and a P&A
transaction, the FDIC has had to decide which o f the
following objectives it w ould give the greatest weight:

The FDIC prefers to handle most bank failure cases
through what are called purchase and assumption
(P&A) transactions. In these transactions, all o f a failed
bank’s deposit liabilities are assumed by another bank,
which also purchases some o f the failed bank’s assets.
The FDIC initiates a P&A transaction by soliciting bids
from other banks for the purchase o f assets and the
assumption o f deposit liabilities o f a failed bank. The
FDIC specifies that an interested bank must assume
all deposit liabilities and acquire assets considered to
be o f good value (i.e., excluding loans and debt instru
ments that are not likely to be paid in full). Additional
cash w ill be provided by the FDIC if the value o f the
assets o f the failed bank offered for purchase is less
than the deposit liabilities to be assumed. Banks that
are interested in such a package o f assets and liabili
ties bid for it in terms o f a purchase premium. The
actual cash payment from the FDIC equals the liabili
ties o f the failed bank, minus the value o f the assets o f
the failed bank purchased by the bank w ith the w in
ning bid, less the purchase premium bid by that bank.
In deciding between a deposit payoff or a P&A
transaction, the FDIC uses a cost test. It estimates its
cost under both a deposit payoff and a P&A transac
tion, based on the bid o f the highest purchase p re
mium. The FDIC generally w ill accept the highest bid
for the P&A transaction if its net cost is low er than the
estimated costs o f a deposit payoff. These estimates
are not very precise, and the FDIC has tended to use
the P&A method except in situations in which:
1. there is virtually no interest by other banks in
acquiring the failed bank, or
2. fraud or other circumstances, such as contingent
liabilities, make it difficult to estimate losses and,
therefore, to apply the cost test.3

3Federal Deposit Insurance Corporation (1984), pp. 83-88.

1. to avoid disruption o f banking services, or
2. to prom ote market discipline by uninsured de
positors o f the risks assumed by banks.
If the FDIC tends to handle bank failure cases through
deposit payoffs, uninsured depositors must assume
the risk o f losses if their banks fail. In response, the
uninsured depositors might put pressure on their
banks to limit risk. But deposit payoffs, as w e have
seen, disrupt banking services.
The use o f P&A transactions prevents disruptions o f
banking services. This alternative, however, may give
uninsured depositors the impression that they are not
exposed to risk o f loss w hen their banks fail. As a
consequence, they w ou ld not attempt to restrain the
risks assumed by their banks.
To avoid the limitations o f both procedures, the
FDIC announced, in Decem ber 1983, that it w ou ld use
a new procedure for disposing o f assets and deposit
liabilities in some bank failure cases. The new “m od
ified payout procedure” was adopted to give the FDIC
more flexibility in m inim izing disruption o f banking
services, w hile exposing uninsured depositors to the
risk o f losses on their deposits.4
When a bank failure is handled through the m od
ified payout procedure, the FDIC makes full payments
to the insured depositors and partial payments to the
large depositors on the uninsured portions o f their
deposits; the partial payments are based on an FDIC
estimate o f the proceeds from the liquidation o f the
assets o f the failed bank. If recoveries on the assets
eventually exceed the initial estimate, the uninsured
depositors receive additional payments; if the pro
ceeds from liquidating those assets fall short o f the
initial payment, the FDIC absorbs the loss. The partial
payment disrupts the activities o f uninsured deposi
tors less than the traditional deposit payoff did.
In some cases handled under the m odified payout
procedure, the insured liabilities o f a failed bank are
assumed by another bank. This arrangement prevents
a disruption o f banking services for depositors with
full federal insurance. The procedures for arranging
this deposit assumption are similar to the procedures
in a traditional P&A transaction. The FDIC solicits bids

“Federal Deposit Insurance Corporation (1983), pp. III-4— III-6.

FEDERAL RESERVE BANK OF ST. LOUIS

for the purchase o f some o f the assets o f the failed
bank and the assumption o f the fully insured deposit
liabilities. The FDIC provides cash to cover a gap
between the value o f assets purchased and the fully
insured deposit liabilities assumed, minus any pur
chase premium. The FDIC then receives the remain
ing assets and makes a partial payment to the unin
sured depositors. This approach to handling bank
failure cases has similarities to both the deposit payoff
and P&A transaction procedures.

IS THERE A DOUBLE STANDARD IN
THE FEDERAL INSURANCE OF LARGE
DEPOSIT ACCOUNTS?
The official limit on deposit insurance coverage,
currently the first $100,000 for each depositor at each
depository institution, is the same for insured banks of
all sizes. There is circumstantial evidence, however,
that the FDIC provides large depositors at a few o f the
nation’s largest banks greater protection from loss
than large depositors at smellier banks. There is no
official statement o f this double standard by the FDIC;
if it exists, it must be inferred from the FDIC’s actions
in bank failure cases.

FDIC Actions in Bank Failure Cases
Before 1982
Until 1982, every bank failure involving assets greater
than $100 million had been handled through P&A
transactions, thus protecting the uninsured deposi
tors from any losses.’ From 1968, w hen the FDIC
adopted its current procedures for P&A transactions,
through 1981, only 32 o f the 108 bank failure cases
w ere handled through deposit payoffs. These 32
banks, which had average total assets o f $10.4 million,
had relatively few deposit accounts in excess o f the
insurance limit. The other 76 had average total assets
o f $171 million.6These FDIC actions could have con
vinced most large depositors that, in effect, they had
com plete insurance coverage o f their deposit ac
counts, even if their accounts exceeded the officially
stated insurance limit.

Greater Emphasis on Market Discipline
by Large Depositors and the Penn
Square Case

JUNE/JULY 1985

about a lack o f market discipline im posed by large
depositors on the risks assumed by their banks. This
concern was stimulated by the view that various forms
o f deregulation gave bankers greater freedom to as
sume more risk.7
The response o f the FDIC to the failure o f the Penn
Square Bank o f Oklahoma City in 1982 reflected, in
part, an intention to increase the degree o f market
discipline by large depositors. The FDIC closed the
Penn Square Bank, w hich had total assets o f $517
million, and paid off each depositor up to the federal
insurance limit.
A recent history o f the FDIC mentions two reasons
for closing the Penn Square Bank and paying off the
depositors, rather than protecting the uninsured de
positors through a P&A transaction. First, it was not
possible at that time for the FDIC to determine the
costs o f alternative methods o f handling the case.
Second, the FDIC was concerned that, if the large
depositors o f the Penn Square Bank w ere protected
from losses, market discipline o f the risks assumed by
banks through the influence o f large depositors w ould
be eroded. The FDIC concluded that paying off the
depositors o f the Penn Square Bank, up to the insur
ance limit, and allowing the uninsured depositors to
suffer losses, w ould cause investors to perceive a
greater risk in holding large-denomination deposits.8
The handling o f the Penn Square case indicated
that, in order to prom ote market discipline by large
depositors, the FDIC was w illing to apply the deposit
payoff procedure in the failure o f a much larger bank
than it had in the past. This case did not reveal,
however, w hether the FDIC w ould put a limit on the
size o f a failed bank that w ou ld be handled through a
deposit payoff. Thus, the FDIC’s actions in this case
did not indicate w hether the risks o f holding large
deposit accounts had risen more for those with ac
counts at small banks or large banks.

Initiation o f the Modified
Payout Procedure
The next major action by the FDIC to induce unin
sured depositors to restrain the risks assumed by their
banks was the adoption o f the m odified payout proce
dure. As m entioned above, an important objective for
adopting this procedure was to expose uninsured

In the early 1980s, the FDIC became concerned

5Federal Deposit Insurance Corporation (1984), p. 93.

H'his concern about a lack of market discipline is expressed in
Federal Deposit Insurance Corporation (1983).

6lbid., table 4-2, p. 65.

8Federa! Deposit Insurance Corporation (1984), pp. 97-98.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

depositors to some risk o f loss if their banks fail, while
m inim izing the disruption to banking services.
The first bank failures handled under the m odified
payout procedure occurred in March 1984. From
March through May 1984, the FDIC used the new
m odified payout procedure in nine bank failure cases.
In two o f those cases, the banks w ere closed and the
FDIC made payments to all depositors. The only dif
ference between these two cases and the usual de
posit payoff case was that the uninsured depositors
received partial payments when their banks were
closed, instead o f receiving any payments after the
FDIC liquidated the assets.
In the other seven cases handled under the m od
ified payout procedure, other banks assumed the fully
insured deposit liabilities o f the failed banks and pur
chased some o f their assets. Since other banks w ere
interested in bidding for the assets and fully insured
deposit liabilities o f the§e seven banks, it is likely that
their uninsured depositors w ould also have been pro
tected from losses through P&A transactions if the
FDIC had not adopted the m odified payout proce
dure.
All o f the seven bank failure cases handled under
the m odified payout procedure, with assumption o f
fully insured deposit liabilities by other banks, in
volved relatively small banks. The total deposits o f
those seven banks ranged from $16 m illion to $116
million, with a mean o f $54 million. Their uninsured
deposits on average w ere $1.6 million.

The Continental Illinois Crisis
The rapid withdrawal o f foreign deposits from the
Continental Illinois National Bank, Chicago, created a
financial crisis for that bank in May 1984. The FDIC,
the Federal Reserve, and the Com ptroller o f the Cur
rency became concerned about the effects that the
failure o f Continental w ould have on other depository
institutions and econom ic activity in general. These
agencies issued a joint news release on May 17,1984,
that described a program o f assistance for Continen
tal. That joint news release includes the following
statement:
In view of all the circumstances surrounding Conti
nental Illinois Bank, the FDIC provides assurance that,
in any arrangements that may be necessary to achieve
a permanent solution, all depositors and other general
creditors of the bank will be fully protected and ser
vices to the bank’s customers will not be interrupted.
This statement indicates that, although the FDIC
wishes to induce large depositors to restrain the risks

assumed by their banks, there is an upper limit on the
size o f banks at which large depositors are subject to
losses.
From June 1984 through May 1985, the FDIC han
dled six more bank failure cases by arranging for the
assumption o f the fully insured deposit liabilities by
other banks, but limiting payments on uninsured de
posits to the proceeds from liquidating the assets of
the failed banks. Total deposits o f those six banks
range between $4 m illion and $46 m illion (a mean of
$26 million), with average uninsured deposits of about
$400,000/’

A Review o f FDIC Actions in
Recent Years
The actions o f the FDIC since mid-1982 reveal the
following pattern: T o prom ote market discipline by
large depositors, the FDIC is willing to close a failing
bank with total assets as large as $500 million. In
practice, the m odified payout procedure, which was
adopted to prom ote market discipline by large deposi
tors, has been used in the failure o f a few relatively
small banks. Banks as large as Continental Illinois
appear to be exempt from this policy. This combina
tion of FDIC actions may im ply that the risk o f holding
deposits in an account that exceeds the federal insur
ance limit has increased in recent years, unless that
account is at one o f the largest banks in the nation.

IMPLICATIONS FOR THE OPERATION
OF THE BANKING SYSTEM
If large depositors think they are protected from
losses by holding their funds at relatively large banks,
they w ill have no incentive to m onitor the risks as
sumed by these banks or to put pressure on the
management o f these banks to restrain risks. Thus, by
protecting depositors at relatively large banks from
losses, the FDIC may have reduced the restraints on
risks assumed by relatively large banks.
Actions that favor uninsured depositors at relatively
large banks also may have implications for trends in
the nation’s banking structure. The share o f the na
tion’s banking assets at a few o f the relatively large
banks may rise over time, as large depositors shift their
funds to the relatively large banks to reduce risks.

9ln some of these six cases, the large depositors did not receive
partial payments when the banks failed, because it was difficult for
the FDIC to estimate recovery on the assets it assumed.

FE D E R A L R E S E R V E B A N K OF ST. LO UIS

HAVE DEPOSITORS RESPONDED TO
THE DIFFERENTIAL TREATMENT OF
LARGE AND SMALL BANKS?
Before concluding that the recent actions o f the
FDIC in bank failure cases have the implications for
the banking system discussed above, one must deter
mine w hether depositors have responded to what
appears to be differential treatment o f large and small
banks. There are various reasons w hy the events d e
scribed above might not affect the behavior o f unin
sured depositors. Large depositors may have believed
for some time that the FDIC w ould not allow a bank
the size o f Continental Illinois to fail. The FDIC had
acted in the past to prevent the failure o f relatively
large banks with total assets smaller than those of
Continental.10Thus, the announcement o f the deposit
guarantee for Continental in May 1984 may have come
as no surprise.
Alternatively, holders o f uninsured deposits may
continue to have confidence in their ow n banks de
spite the increased risk o f keeping their accounts at
small banks. Or, they might not be aware o f the im pli
cations o f FDIC actions in recent bank failure cases.
There are two potential pieces o f evidence that
w ould support the view that depositors consider the
risk o f holding uninsured deposits at small banks to
have risen relative to the risk o f holding deposits of
similar size at large banks. First, interest rates that
small banks offer to attract large-denomination d e
posits must rise relative to the interest rates offered by
large banks. Second, the share o f total time deposits at
all commercial banks in accounts above the insurance
limit must rise at relatively large banks and decline at
small banks, as depositors shift their large-denomina
tion deposit accounts to relatively large banks. Both of
these patterns w ould have to begin after mid-May
1984, when the FDIC announced the deposit guaran
tee o f Continental Illinois Bank.

THE EVIDENCE
Data on th e in teres t rates p a id on la rgedenomination time deposits are not available for rela
tively small banks. Consequently, the observations are
limited to those for the allocation o f large time de
posits among large and small banks.

10See the Federal Deposit Insurance Corporation (1984), pp. 89-97.

JUNE/JULY 1985

Data from Weekly Reporting Banks
There is no official list o f banks that are too large to
fail. As an approximation to the group o f banks that
may have such status, this paper uses the 30 largest
banks in the nation.” Small banks are identified as
those smaller than w eekly reporting banks (which
include all comm ercial banks with total assets o f $1.4
billion or more as o f Decem ber 31,1982).
Chart 1 does not indicate a sustained pattern o f
decline in the share o f large-denomination time de
posits at small banks or a rise in the share at relatively
large banks after m id-M ay 1984. The share o f largedenomination time deposits at the small banks did
decline from almost 40 percent in the first week o f May
1984 to about 37 percent in the last w eek in June o f last
year. That change might reflect an initial response by
depositors to the handling o f the Continental Illinois
situation by the FDIC. In contrast, that decline might
reflect a seasonal pattern; the share o f largedenomination time deposits at small banks declined
between the same weeks in 1982. Whatever the cause
o f that dip, it was more than reversed by October of
last year, and the share o f large time deposits at small
banks continued to rise through May 1985. The share
of large-denomination deposits at small banks de
clined in June 1985, as it had in June o f 1982 and 1984.12

Data on Small Banks from the Report
o f Condition
Observations in chart 1 may suffer from several
measurement problems. First, the banks with total
assets just below $1.4 billion are included together
with much smaller banks. A finer breakdown o f banks
by asset size may be necessaiy to detect an outflow o f
large-denomination time deposits from small banks.
Second, some o f the time deposits in denom ina
tions o f $100,000 or more are in accounts o f exactly

"In September 1984, the Comptroller of the Currency, C.T. Conover,
was reported in the press as saying that the federal regulators would
not allow the largest 11 banks to fail; later, however, he denied
stating any cut-off figure for banks too large to fail. See Trigaux
(1984).
12The patterns in chart 1 reflect differential effects of the authorization
of money market deposit accounts (MMDAs) at large and small
banks. Large time deposits at all commercial banks declined sharply
after the announcement that MMDAs would be available in midDecember 1982. These deposits had peaked in October 1982, but
by May 1983, had declined by about $50 billion. During the same
period, large time deposits at small banks rose by about $13 billion.
Thus, the small banks do not seem to have been affected by the
substitution between large-denomination deposits and MMDAs in
the same way as the larger banks.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Chart 1

Share of L a rg e -D e n o m in a tio n Time Deposits
at Large a n d Sm all B a n k s
Percent

Percent

100

1982

1983

1984

1985

N O T E : L a r g e t im e d e p o s i t s a r e in d e n o m i n a t i o n s o f $ 1 0 0 , 0 0 0 o r m o r e . L a r g e b a n k s a r e t h e w e e k l y r e p o r t i n g b a n k s ,
a n d s m a l l b a n k s a r e b e l o w t he s i z e o f w e e k l y r e p o r t e r s . T h e t o p 3 0 b a n k s a r e t he l a r g e s t c o m m e r c i a l b a n k s ,
in t ot al a s s e t s , a s o f D e c e m b e r 1984.
Late st d a t a plotted: J u n e

$100,000, and, therefore, are fully insured. Thus, the
percentage o f time deposits in denominations of
$100,000 or more overstates the percentage o f time
deposits in accounts that are only partially insured.
The third possible measurement problem is that
many o f the small banks are subsidiaries o f large
banking organizations. Uninsured depositors may be
less concerned about possible losses o f their deposits
at a relatively small bank if it is a subsidiary o f a large
banking organization.
The relevance of these possible measurement prob
lems can be investigated with data from the Report o f
Condition o f each commercial bank. Table 1 presents
the percentage o f large-denomination time deposits
in the banking system at groups o f relatively small
banks in various size categories. T o eliminate banks
that are subsidiaries o f relatively large banking organi

zations, the banks in table 1 are in organizations with
total banking assets less than $1 billion.
The issue o f w hich large-denomination time d e
posits are only partially insured is m ore difficult to
settle. In attempting to exclude time deposits in d e
nominations o f $100,000 or m ore that are fully insured,
the best approach available with the existing data is to
exclude from the calculations those banks with brok
ered deposits in denominations o f $100,000 or less,
which are called "retail brokered deposits.’’ Deposit
brokers typically break down the funds they place at
an individual bank into units o f $100,000 or less for
their individual investors, so that the deposits o f each
investor are fully insured. The banks with retail brok
ered deposits, therefore, are the ones likely to have the
largest proportion o f time deposits in denominations
of exactly $100,000.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 1
Percentage of Large-Denomination Time Deposits in Various Size Banks1
Bank size category
(millions of dollars)

Number
of banks

1985

1984
March

June

September

December

March
0.19%

0.14%

0.15%

0.16%

0.17%

$10 to 25

1,450

1.13

1.14

1.18

1.21

1.33

$25 to 50

1,464

2.60

2.58

2.64

2.66

2.89

$50 to 100

966

3.94

3.89

3.98

3.93

4.28

$100 to 300

584

5.63

5.80

5.79

6.11

$300 to 500

2.37

2.38

2.46

2.45

2.50

Under $10

$500 to 1,000
Total

422

2.33

2.36

2.40

2.53

2.59

5,039

18.14

18.13

18.62

18.74

19.89

'The same banks are included in each size group as of each of the five Report of Condition dates. As of each date, these banks reported no
retail brokered deposits. These banks are assigned to the same size group as of each date, based on their total assets as of March 1984.
For banks in each group, the sum of their time deposits in denominations of $100,000 or more are calculated as percentages of
large-denomination time deposits as of the same date at all commercial banks that reported no retail brokered deposits.

Table 2 provides indirect evidence on the extent to
which the time deposits in denominations o f $100,000
or more exceed the insurance limit at banks with no
retail brokered deposits. The FDIC collected data
through June 1981 on various types o f deposit ac
counts that exceeded the insurance limit. As o f June
1981, the percentages o f time deposits in denom ina
tions o f $100,000 or m ore are only slightly higher than
the percentages in accounts that exceeded the insur
ance limit. Thus, as o f June 1981, ve iy high percent
ages o f time deposits in denominations o f $100,000 or
more w ere only partially insured. Also, for banks o f
comparable size, the percentages o f time deposits in
denominations o f $100,000 or m ore in June 1984 are
similar to the percentages in June 1981. These com
parisons o f observations in table 2 provide a basis for
concluding that high percentages o f the time deposits
in denominations o f $100,000 or more, as o f June 1984,
w ere only partially insured. Data are not available,
however, to provide direct evidence on this issue.
Data on retail brokered deposits for all federally
insured commercial banks are not available before
March 1984. Beginning with the quarterly Report of
Condition in March 1984, each bank reports the total
dollar amount o f all brokered deposits and o f retail
brokered deposits. Data based on the Report o f Condi
tion, therefore, are limited to the period since March
1984.
The purpose o f the calculations presented in table 1

is to determine w hether banks in various size groups
have increased or decreased their share o f largedenomination time deposits in the banking system.
Banks in each o f the size groups have the following
characteristics: First, each bank filed a Report o f Con
dition on all five dates. Second, each bank reported no
retail brokered deposits on each date. Third, each
bank is assigned to one size class for all five dates,
based on its total assets as o f March 1984. Thus, each
size group includes the same banks for each o f the
Report o f Condition dates.
The numerator o f each percentage in table 1 is the
sum o f time deposits in denominations o f $100,000 or
more for a given group o f banks, as o f a Report of
Condition date. The denom inator is the sum o f largedenomination time deposits o f all commercial banks
as o f the same date, excluding those banks that re
ported retail brokered deposits.
As o f March 1984, these 5,039 banks accounted for
about 18 percent o f large-denomination time deposits
o f the banking system. By March 1985, that percentage
rose to almost 20 percent, and the share o f largedenomination time deposits rose for each o f the seven
groups o f banks. Thus, the evidence in chart 1 and
table 1 are consistent: the share o f large-denomination
time deposits at relatively small banks is higher in
early 1985 than a year earlier, before the announce
ment o f the federal guarantee o f all deposit liabilities
at the Continental Illinois bank.

F E D E R A L R E S E R V E B A N K OF ST. LO U IS

JUNE/JULY 1985

Table 2
Average Percentages of Time Deposits in
Large-Denomination Accounts
Bank size
category
(millions of
dollars of
total deposits)

Percentage of
time deposits
in accounts
larger than
$ 100,000,

June 1981*

Percentage of time deposits
in accounts of
$100,000 or more
June 1981

June 19842

Under $10

14.9%

17.2%

21.1%

$10 to 25

16.9

18.2

20.8

$25 to 50

20.4

21.4

22.7

$50 to 100

25.6

26.9

26.6

$100 to 500

34.8

37.3

34.1

$500 to 1,000

43.2

46.6

36.7

'The numerators and denominators of these percentages include time deposits of individuals,
partnerships, and corporations and public funds invested in time and savings deposits at commercial
banks.
2Banks included in the calculations for June 1984 have no retail brokered deposits; they are in banking
organizations with total banking assets less than $1 billion.

CONCLUSIONS
The Federal Deposit Insurance Corporation (FDIC)
has been putting greater emphasis in recent years on
increasing the incentives for large depositors to re
strain the risks assumed by their banks, by allowing
the uninsured depositors o f some failed banks to
suffer losses. FDIC actions designed to promote mar
ket discipline by large depositors, however, have af
fected primarily relatively small banks. In contrast, the
FDIC guarantee o f all deposit liabilities o f the Conti
nental Illinois National Bank in May o f last year indi
cates that the large depositors o f a few o f the nation’s
largest banks may have no risk o f losses if their banks
experience large reductions in the value o f their
assets.
This contrast in treatment o f large and small banks
might be expected to induce large depositors to shift
their accounts to a few o f the nation’s largest banks.
The data available to test this hypothesis have some
limitations. The most appropriate conclusion, given
the nature o f the data, however, is that large deposi

tors have not shifted their accounts from small to large
banks since the announcement o f the FDIC guarantee
o f all deposit liabilities o f Continental Illinois.

REFERENCES
Federal Deposit Insurance Corporation. “Deposit Insurance in a
Changing Environment” in A Report to Congress on Federal De
posit Insurance (April 1983).
----------------The First Fifty Years: A History of the FDIC, 1933-1983
(Washington, D.C., 1984).
Hill, C. Christian and Edwin A. Finn. “Confidence Crisis: Big Deposi
tors’ Runs on Beleaguered Banks Speed the Failure Rate,” Wall
Street Journal, August 23, 1984.
Isaac, William M. Address before the Management Conference of
the National Council of Savings Institutions, New York, December
6,1983.
King, A. J. “Treat Small Banks, Continental Similarly,” American
Banker (May 31,1984), pp. 4, 12.
Trigaux, Robert. "Comptroller Trying to Dispel Reports of ‘Guaran
tees’ for Top 11 Banks Only,” American Banker (September 28,
1984), p. 3.

Are Weighted Monetary Aggregates
Better Than Simple-Sum M l?
Dallas S. Batten and Daniel L. Thornton

A HE past 10 years have been marked by financial
innovation and deregulation, much o f which has
blurred the distinction between transaction and sav
ings deposits. Traditional non-interest-bearing trans
action deposits now pay explicit interest like savings
deposits, w hile a number o f savings-type deposits
with limited transaction characteristics have been
developed.
A number o f analysts believe that these financial
developments have altered significantly the relation
ship between M l growth and the growth o f GNP,
rendering the narrow monetary aggregate less useful
as an intermediate target for m onetaiy policy.' Others
have objected on broader grounds, arguing that these
innovations illuminate the problem o f simply adding
up various financial assets (currency, dem and de
posits, NOW accounts, etc.) to obtain a "simple-sum”
monetary aggregate. They argue that various assets
have different degrees o f “m oneyness” — that is, the

Dallas S. Batten is a research officer and Daniel L Thornton is a senior
economist at the Federal Reserve Bank of St. Louis. Paul G. Chris
topher and Rosemarie V. Mueller provided research assistance.
'The Federal Open Market Committee was so concerned by these
developments that it altered the relative weights given to M1 and the
broader monetary aggregates several times during the 1981-82
period in making its policy recommendations and suspended the
use of M1 as an intermediate policy target in fall 1982. Furthermore,
some analysts have been so concerned that M1 is no longer a useful
target of monetary policy that they have suggested a return to the
Keynesian system of interest rate targets or a reliance on a broader
simple-sum monetary aggregate, like M2, M3 or some measure of
credit, as an intermediate target. Still others have suggested that the
Fed target directly on nominal GNP (though the procedures for
pursuing this target are seldom discussed in detail). See Thornton
(1982,1983). Simple-sum M1 was re-introduced as an intermediate
policy target in 1984; see Hafer (1985).
These other suggestions have been investigated elsewhere. The
use of interest rates as an intermediate policy target is predicated on
the existence of a liquidity effect, which has been shown to be short
lived and weak. See Brown and Santoni (1983) and Melvin (1983).
For empirical evidence on M1 and M2, see Batten and Thornton
(1983) and on the broader debt measure, see Hafer (1984).

monetary services that each asset provides — so that
the dollar amount of each asset should be w eighted by
its degree of moneyness in obtaining a suitable m one
tary aggregate. Such an aggregate presumably should
have a closer and more predictable relationship with
econom ic activity and may be affected less by financial
innovations. The most novel and innovative sugges
tions have com e from individuals w ho have con
structed weighted m onetaiy aggregates based on al
ternative theoretical considerations. Tw o recent and
popular innovations along these lines com e from W il
liam Barnett (1980) and Paul Spindt 11985).A central issue now is w hether w eighted m onetaiy
aggregates are better intermediate policy targets than
simple-sum aggregates like M l. A necessary condition
for using a m onetaiy aggregate as an intermediate
policy target is that there be a close and predictable
relationship between the m onetaiy aggregate target
and the objectives o f econom ic policy/' Thus, if an
aggregate can be found that has a closer and more
predictable link to econom ic activity, it could be useful
in conducting countercyclical stabilization policy.4
The purpose o f this article is threefold. First, we
review briefly the important issues associated with
constructing weighted and simple-sum m onetaiy ag
gregates and discuss the alternatives suggested by
Barnett and Spindt. Second, w e compare and contrast
these weighted m onetary aggregates with simple-sum
M l. Finally, w e investigate whether there is a more
stable and predictable relationship between the alter

2Earlier work along these lines includes Chetty (1967) and Ham
burger (1966).
3The strength of the relationship between the ultimate goals of policy
and the intermediate policy target is only one of the criteria for
evaluating a monetary target.
"This should not be interpreted to imply that monetary policy can be
used successfully for short-run economic stabilization. This is
merely a necessary condition; it is not sufficient.

FEDERAL RESERVE BANK OF ST. LOUIS

natives proposed by Barnett and Spindt and GNP, than
between simple-sum M l and GNP. W e investigate this
by examining the behavior o f the incom e velocity of
each o f these aggregates.

THE MOTIVATION FOR WEIGHTED
AGGREGATES

JUNE/JULY 1985

criteria.7 Perhaps the most frequently used criterion
was the closeness o f the relationship between a partic
ular monetary aggregate and GNP."

The Effect o f Financial Innovations
The difficulty in distinguishing between m oney and
non-money assets has been exacerbated by financial
innovation and deregulation. Several savings-type as
sets with lim ited transaction characteristics have been
d e v e lo p e d (e.g., m o n e y m arket m utu al funds
(MMMFs), m oney market deposit accounts (MMDAs)
and automatic transfer services (ATS)) and mediumof-exchange assets now pay explicit interest (e.g.,
NOWs and Super NOWs). Additionally, there have
been a number o f other innovations that have in
creased the substitutability between medium-ofexchange and non-medium-of-exchange assets, such
as overnight repurchase agreements (REPOs) and con
tinuous com pounding o f interest on savings-type d e
posits.9 Hence, the distinction between transactionand savings-type assets has been blurred even more.

Monetary theory has em phasized two different, but
not mutually exclusive, functions o f money: a medium
o f exchange and a store o f wealth. The medium-ofexchange function was em phasized in the work of
Fisher (1911), w hile the store-of-wealth motive was
em phasized by Pigou (1917), Marshall (1923) and
Keynes (1936). It has been recognized for some time
that different financial assets perform these functions
to different degrees. For example, currency and de
mand deposits are both generally acceptable as media
o f exchange, but are not perfect substitutes for this
purpose in all transactions. Furthermore, these assets
bear no explicit interest and, as a consequence, are
poor stores o f wealth relative to interest-bearing sav
ings and time deposits o f equal risk.

The Role o f Index Numbers

Because assets such as time and savings deposits
cannot be used directly in exchange, it was comm on
to define m oney to include only medium-of-exchange
assets. It was not until Friedman (1956), Friedman and
Meiselman (1963) and Friedman and Schwartz (1970)
em phasized m oney’s role as a “temporary abode of
purchasing pow er” (i.e., a temporal bridge between
the sale of one item and the purchase o f another), that
it became comm on to consider broader monetary
aggregates that included non-medium-of-exchange
assets/'

If different assets have different degrees o f m oney
ness, w e may wish to aggregate (add) them with re
spect to this hom ogeneous characteristic. This point
can be made more clearly with a physical example. A
ton o f coal, a kilowatt o f electricity and a barrel o f oil
are not hom ogeneous in terms o f their volumes or
weights and, hence, cannot be aggregated in terms o f
these measures. If, however, w e are concerned with
their energy equivalences, measured say by BTUs, they
can be thought o f broadly as hom ogeneous and can be
aggregated in terms o f their BTU equivalence. The

Once the medium-of-exchange line o f demarcation
between m oney and non-money assets was breached,
however, it became difficult to isolate any other char
acteristics that differentiate m oney from non-money
assets.'1As a result, many economists defined m oney
as that group o f assets that satisfied some empirical

'Although not all of the studies have employed the same empirical
criteria, many have focused on the relationship between the pro
posed monetary aggregate(s) and economic activity. Furthermore,
not all agree that money can be defined empirically, e.g., Mason
(1976).
frequently, the assets considered had to satisfy an auxiliary condi
tion, for example, they must be “gross substitutes.” See Friedman
and Schwartz (1970) or Friedman and Meiselman (1963).

According to Laidler (1969), the debate about whether non-mediumof-exchange assets are money dates back, at least, to the Napole
onic wars.
6Some characteristics that have been used include liquidity, substi
tutability between non-medium-of-exchange and pure medium-ofexchange assets, and the strength and stability of the relationship
between a composite of various financial assets and nominal in
come. Additionally, Pesek and Saving (1967) have argued that,
since money has its primary effect on the economy through a wealth
effect, an asset’s moneyness should be determined by the extent to
which it is part of society’s net wealth. See Laidler (1969) for a
discussion of this point.

9The impact of these innovations on the substitutability between
medium-of-exchange and non-medium-of-exchange assets can be
made clear via an example. At one time, it was common for deposi
tory institutions to compound interest quarterly on savings and time
deposits, so that interest was paid only on balances on deposit on
the day of compounding. Such practices severely limited the advan
tage of these accounts over demand deposits as temporary abodes
of purchasing power, since the interest income gain from temporar
ily switching from demand deposits to savings deposits could be lost
if the transaction had to be made prior to the quarterly compounding
date. Other changes that permitted an easier transfer between
medium-of-exchange and non-medium-of-exchange assets would
have a similar effect.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

same is true for aggregating financial assets, but, since
they are expressed in dollars, it may seem more natu
ral simply to add dollar amounts o f assets that have a
high degree o f moneyness, how ever defined. This is
the rationale for the construction of simple-sum m on
etary aggregates.
Unfortunately, adding dollar amounts o f assets is
not the same as aggregating them by a homogeneous
measure o f their moneyness. As the dollar amounts of
various components change through time, they may
represent different levels or degrees o f moneyness.
Conversely, the same dollar value o f the aggregate
com posed o f different dollar values o f its various com
ponents may not represent the same level o f monetary
services. Consequently, the dollar (simple-sum) aggre
gate may misrepresent the amount o f such services
provided.
Index numbers can be used to aggregate assets by a
homogeneous characteristic. Conceptually, they en
able the construction o f an aggregate based on this
characteristic so that changes in the index reflect only
changes in some quantitative measure o f this charac
teristic. It is not surprising, therefore, that both
Barnett and Spindt use index aggregation to construct
their alternative w eighted monetary aggregates. (The
assets included in simple-sum M l, Barnett’s broadest
monetary aggregate (MSI4) and Spindt’s aggregate
(MQ) appear in the insert on this page."’)

Medium-of-Exchange Assets and the
Definition of Monetary Aggregates
SimpleSum M1

MSI4

X
X
X
X

X
X
X

Medium-of-Exchange Assets
Currency
Travelers checks
Demand deposits
Other checkable deposits
Credit union share draft
accounts
MMDAs
MMMFs
Savings deposits subject
to telephone transfer
Non-Medium-of-Exchange Assets
Savings deposits not
subject to telephone
transfer
Small time deposits
REPOs
Eurodollar deposits
Large time deposits
U. S. savings bonds
Short-term Treasury
securities
Commercial paper
Bankers acceptances

X
X
X
X
X
X
X
X
X

Monetary Services Index (MSI)
Barnett has developed a number o f monetary aggre
gates based on the idea that the essential function of
m oney is to bridge the temporal gap between the sale
o f one item and the purchase o f another. Assets that
serve this purpose must be easily and quickly convert
ible into and out o f medium-of-exchange assets. Fol
lowing a suggestion o f Friedman and Schwartz (1970)
— see Barnett and Spindt (1982) — Barnett extends the
approach o f estimating the substitutability between
non-medium-of-exchange assets and a pure mediumof-exchange asset em ployed by Chetty (1969), Ham
burger (1966) and others. Specifically, he applies index
number theory to construct indexes o f financial assets
that reflect the total utility, relative to some base pe-

10Other monetary service indexes (MSI) include the assets in simplesum M1, M2 and M3. We ignore these here because MSI4 is the
only MSI that has an intuitively appealing rationale, given the asset
motive on which it is based. In particular, it attempts to extract the
“moneyness” from a broad range of financial assets. In contrast, the
narrower MSI are constrained by the assets arbitrarily included in
each.

riod, attributable to the m onetary services obtained
from these assets."
This approach can be easily understood by thinking
o f assets that provide monetary services as being on a
continuum with pure medium-of-exchange assets
(currency) at one end and "pure’’ store-of-wealth as
sets at the other. The pure medium-of-exchange as
sets earn no interest and are useful only as a medium-

"The construction of these aggregates need not be based solely on a
utility maximization approach. If it is based on other objective
functions, however, its interpretation is altered.
Originally, Barnett called these aggregates “Divisia monetary
aggregates” because a Divisia index was used to construct them.
The Federal Reserve Board, under whose auspices these aggre
gates were originally constructed and are still maintained, has
recently undertaken a substantial revision to correct inconsistencies
and errors in the original computer programs and data, and to
incorporate new data not readily available at the time these aggre
gates were initially constructed; see Farr and Johnson (1985). The
Divisia index is no longer used to construct these aggregates.
Consequently, they are no longer referred to as Divisia monetary
aggregates but are now called "monetary services indexes” (MSI).
Since the data reported here reflect these recent changes, this new
terminology is adopted here as well.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

of-exchange.'2 The pure store-of-wealth assets earn £
market interest rate but are not useful as a temporary
abode o f purchasing power, although they may be
used to transfer purchasing pow er over longer periods
o f time. Consequently, the latter group o f assets pro
vides no monetary services by this criterion. The as
sets that fall between these extremes yield monetary
services greater than zero but less than those o f the
pure medium-of-exchange assets.

contrast, the velocity o f the MSI and simple-sum M l
can change even if there is no change in their turnover
rates. Hence, w e should expect to see a more stable
relationship between M Q and GNP.14

Simple-Sum M l

The MQ Measure

By weighting each com ponent equally, simple-sum
aggregates im plicitly assume that each com ponent is
a perfect substitute for the others in providing m one
tary services. Furthermore, the narrow aggregate,
simple-sum M l, excludes both non-m edium -ofexchange assets and some assets with lim ited transac
tion characteristics like MMMFs and MMDAs. The
br oader simple-sum aggregates, like M2, M3 and the
Fed’s broadest measure, total liquidity (L), include
larger amounts o f non-medium-of-exchange assets.
Consequently, these broader simple-sum aggregates
may misrepresent significantly the monetary services
provided by including non-medium-of-exchange as
sets, which provide relatively low levels o f monetary
services, on an equal footin g w ith m edium -ofexchange assets, which provide relatively high levels
o f monetary services.

Spindt’s w eighted monetary aggregate, MQ, is an
index o f transaction assets w hose weights are based
on each asset’s turnover, along lines originally sug
gested by Fisher 11922). This measure is based on a
pure transaction approach to m oney and, thus, marks
a clear departure from the MSI o f Barnett. Further
more, Spindt’s measure weights each o f its com po
nents by a measure o f turnover in purchasing final
output (GNP); assets with relatively high turnover rates
receive relatively larger weights.13

A financial innovation that results in a shift from
assets not in simple-sum M l to assets in simple-sum
M l w ould cause the same change in measured
money, regardless o f the source o f the shift. In con
trast, similar innovations w ou ld cause different
changes in the MSI or MQ. The extent o f the impact
depends on the difference between the asset's own
rate o f return and that o f the pure store-of-wealth
asset (for the MSI) and on the asset’s relative turnover
rate in the purchase o f goods and services (for MQ).

Despite the fact that the turnover rates are used in
the calculation o f MQ, the m oney stock measure
moves only when there is a change in monetary ser
vices between periods, so that its velocity changes
only when there is a change in the turnover rates. In

As a result, these new aggregates mav be affected
less by innovations. For example, to the extent that the
nationwide introduction o f NOW accounts on January
1,1981, drew deposits out of savings accounts (i.e., idle
balances) into NOW accounts, the growth o f simplesum M l w ould be inflated. In contrast, because NOW
accounts bear an interest rate closer to the pure storeof-wealth rate, they receive a smaller weight in the
MSI. Consequently, if this regulatory change resulted
in a significant shift out o f savings-tvpe assets into
NOW accounts, the MSI might be affected less bv this
regulatory change.

The monetaiy-service flow from each asset is based
on its "user cost" as measured by the difference be
tween the rate o f interest on a pure store-of-wealth
asset and the own rate o f return on each asset. Cur
rency, which has an own rate o f zero, has the highest
user (opportunity) cost. Medium-of-exchange assets
like demand deposits (which bear no explicit interest,
but bear some im plicit interest, e.g., gifts or no service
charges) have a smaller user cost and, hence, receive a
smaller weight. Non-medium-of-exchange assets that
yield explicit returns closer to those o f the pure storeof-wealth assets receive still smaller weights.

12Technically, currency, like all financial assets, also acts as a store
of wealth; however, the argument is that there exists an asset (fully
insured savings deposits) that perform this function better with equal
risk. Consequently, no maximizing individual would willingly hold
currency purely as a store of wealth given such an alternative.
13lt is clear from this discussion that two distinct, but related, issues
are involved here. The first centers around whether the asset or
transactions measure (approach) is preferable. The second is a
question of the appropriate weighting scheme. These issues are
related in the sense that if the asset approach is preferred, then, by
implication, the MSI weighting scheme is preferred as well, since not
all of these assets can be used directly in transactions. If the
transactions approach is preferred, however, the question of the
weighting scheme remains open. The best weighting scheme may
still involve the difference between the own rate and the rate on the
most liquid non-medium-of-exchange asset.

Digitized for
32FRASER

To the extent that NOW accounts are used predom i
nantly as a store o f wealth rather than a medium o f
exchange, M Q w ould be affected to a lesser degree

'"For a discussion of this point, see Spindt (1985). At a more technical
level, Spindt (1983) has shown that it is only possible to interpret
these aggregates sensibly by using an intertemporal measure.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Chart 1

Growth Rates of Monetary Aggregates

1971

than simple-sum M l by NOW account growth because
NOW accounts initially had a low er turnover rate in
transactions than did currency and demand deposits.
Also, M Q and broader MSI contain savings-type assets
not included in simple-sum M l (e.g., money market
mutual funds). Consequently, their growth rates
w ould be affected less if the growth in NOW accounts
resulted from a shift out o f such deposits. If, however,
most o f the growth in NOWs came from demand
deposits, then simple-sum M l w ould be relatively
unaffected and the growth o f both MQ and the MSI
would decrease since dem and deposits had larger
weights than NOWs in MQ and the MSI.
The advantage these aggregates propose to offer,
however, is not without costs. The calculation o f the
weights in the MSI and MQ requires more information
than that required to construct simple-sum M l. Con
sequently, the construction o f these alternative aggre
gates may introduce larger measurement and specifi
cation errors than those o f omission and inappro
priate weighting associated with simple-sum M l (see
the insert on the next page).15

,5We say “might be” here for several reasons. What is the appropriate

1984

A COMPARISON OF GROWTH RATES
AND WEIGHTS
As an initial step in the examination o f alternatives
to simple-sum M l, a comparison o f the year-over-vear
growth rates o f simple-sum M l (hereafter denoted as
M l), M Q and the broadest m onetaiy service index
(MSI4) is presented in chart 1. Several interesting
points emerge.
First, the growth rate o f MSI4 has not conform ed to
that o f the other two m onetaiy aggregates anytime
during the I/1971-IV/1984 period. Second, up to 1981,
the growth rates o f M l and M Q are similar and move
together. The mean growth rates for M l and MQ over
the I/1971-IV/1980 period are 6.6 and 6.8 percent, re
spectively; the standard deviations for the same aggre
gates are 1.36 and 1.00 percent, respectively. On the
other hand, MSI4 growth during this period is signifi
cantly higher and more variable; its average growth
was 8.08 percent with a standard deviation o f 3.26

weighting scheme is an open question. Furthermore, if we could
decide on the most appropriate scheme from a theoretical point of
view, the magnitude of the weights would still be an empirical issue.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Information and Estimation Requirements
of the MSI and MQ Aggregates
The construction o f the monetary service indexes
and M Q require more information than is entailed
in the construction o f a simple-sum aggregate with
identical components. In each case, data on the
quantities o f each com ponent are necessary;
however, both the MSI and MQ require additional
information and, hence, are open to sources o f
error not contained in the simple-sum aggregates.
The MSI require inform ation that is often
incom plete or unavailable. Consequently, certain
explicit (or in some cases, implicit) assumptions are
m ade that m ay ren d er them less useful as
in term ed iate p o lic y targets. First, th ey use
information on the ow n rate o f interest on each
com ponent. In m any cases, actual data are
unavailable so they must be assumed, estimated or
set equal to some ceiling rate. For example, the
rates on passbook savings deposits at mutual
savings banks and savings and loans are assumed to
be at their ceiling rates, w hile the rate on demand
deposits held by businesses are proxied by the rate
on directly placed finance company commercial
paper, adjusted for reserve requirements.
The own rate o f return on all currency and
demand deposits held by households is assumed
to be zero. At first, this may seem inappropriate
because the ow n rate o f return to holding currency
is the negative of the expected rate o f inflation. This
assumption is appropriate, however, as long as the
interest rate on the pure store-of-wealth asset
(M oody’s series o f seasoned Baa bonds) also reflects
expectations o f inflation. Nevertheless, changes in
inflationary expectations may distort the measure
o f m on etary services associated w ith oth er
components, because many o f these rates are set at
ceiling levels that w ill not respond rapidly to
changing expectations o f inflation. Hence, the
estimate o f the user cost may erroneously change
with changes in expectations o f inflation. This
assumption, however, is less appropriate in the

34FRASER
Digitized for

case o f demand deposits, because such deposits
may yield some explicit return.
Furthermore, the theoretical m odel on which
these aggregates are based requires that all yields
be for an equivalent holding period. As a result, all
assets are converted to a one-month holding period
y ie ld by a T reasu ry secu rities y ie ld curve
adjustment. Moreover, the reference rate that
determines the user cost is the maximum o f the Baa
corporate bond rate and the rates on the assets
contained in the aggregate. Therefore, the user
costs are sensitive to changes in the yield curve. In
addition to these, a number o f other estimations
and assumptions are made (see Farr and Johnson
(1985)).
Likewise, Spindt’s MQ measure is based on a
n u m b e r o f a s s u m p t i o n s n e c e s s i t a t e d by
measurement problems. For example, no turnover
statistics are available for either currency or
travelers checks and the turnover statistics for the
other components are gross turnover, not final
product (GNP) turnover, as is necessary to be
consistent with the underlying theory. As a result, a
number of assumptions and estimates are made to
generate the final product turnover rates used in
the construction o f MQ (see Spindt (1983)).
The extent to which these aggregates are affected
by the various estimates and implicit assumptions
is, o f course, unknown. It could be that there exists
a "law o f large numbers” so that, on average, these
measurement errors cancel each other. No such
law, however, need exist. C onsequently, the
potential advantages that these aggregates might
o f f e r m us t be d e t e r m i n e d b y s t a t i s t i c a l
comparisons like those presented here. Of course, if
such comparisons show little or no advantage of
these aggregates over simple-sum aggregates, it
suggests that w e need to rethink the theory on
which they are based or the way in which these
aggregates are estimated.

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 1
Weights For Calculating Growth Rates of the Aggregates ( x 100)
M1
Year

CTC

1970

23.0

1971

23.2

1972

MSI4

OCD1

CTC

OCD1

OQP2

76.9

0.1

45.3

54.7

0.0

12.7

76.8

0.1

44.8

55.2

0.0

11.7

23.1

76.8

0.1

43.4

56.6

0.0

11.7

27.4

1973

23.4

76.5

0.1

40.5

59.5

0.0

13.4

1974

24.5

75.4

0.1

37.5

62.5

0.1

0.0

13.6

1975

25.7

74.1

0.2

36.8

63.0

0.1

10.5

21.2

CTC

OCD1

OCD2

23.4

0.0

27.0

0.0

61.3

0.0

61.0

24.3

0.0

62.2

23.1

0.0

63.3

0.1

0.2

68.1

OTHER
63.9

1976

26.7

72.8

0.6

34.5

65.1

0.3

0.1

10.6

21.2

0.1

0.2

68.0

1977

27.1

71.9

1.1

32.8

66.6

0.5

0.1

11.9

21.5

0.2

0.1

66.2

1978

27.5

71.0

1.5

30.9

68.3

0.5

0.2

13.7

20.7

0.4

0.2

65.0

1979

28.1

68.1

3.8

28.6

69.5

1.1

0.8

15.9

20.4

1.3

0.4

62.0
65.4

1980

28.9

65.7

5.4

27.0

68.9

2.1

2.0

13.7

17.7

1.7

1.5

1981

29.0

55.8

15.2

24.3

63.4

9.1

3.3

15.6

15.5

5.8

1.6

61.5

1982

29.2

51.1

19.7

24.6

57.9

12.5

5.1

12.4

12.7

5.6

4.5

64.7

1983

28.8

47.5

23.7

24.9

53.5

16.7

4.8

11.3

5.4

14.3

57.7

1984

29.2

45.2

25.5

23.4

53.4

17.8

5.4

11.9

10.5

6.1

14.9

56.5

percent. Third, during 1981, the growth rates o f M l
and M Q diverge dramatically, reflecting the nation
w ide introduction o f NOW accounts. From I/1982-IV/
1984, the two growth rates exhibit somewhat similar
movement, although the growth rate o f M l typically
exceeds that o f M Q b y approximately 1.5 to 2 percent
age points.
An interesting feature o f the growth rates is that
each can be expressed as a w eighted average o f the
growth rates o f its components. Since weighting is the
innovative notion behind these alternative aggregates,
an investigation o f these weighting schemes is an
instructive way to compare MSI4 and M Q with M l. For
M l, the weights are simply each com ponent’s share of
M l. The weights for the MSI are each com ponent’s
share o f the total expenditure for monetary services.
The price o f the monetary services o f each asset is the
difference between the yield on a risk-free store of
wealth and that asset's own yield. The expenditure on
each com ponent’s monetary services is this interest
differential times each component's quantity. There
fore, each weight is the ratio o f the expenditure on
each com ponent’s m onetaiy service to the total ex
penditure on m onetaiy services.
For MQ, the weights are each com ponent’s total
turnover as a percentage o f nominal GNP. In other
words, each component's weight is its quantity times
its final product turnover rate (i.e., its quantity-

w eighted velocity) as a share o f the sum o f these
quantity-weighted velocities over the assets in the
aggregate, that is, nominal GNP.
Annual averages o f these weights for the period
1970-84 are presented in table 1. The weights for the
assets in M l are aggregated into three basic groups:
those for (a) currency plus travelers checks (CTC), (b)
demand deposits (DD), and (c) other checkable de
posits (OCD1). The first three columns o f weights for
MQ are for the same asset groups as for M l. The fourth
column (OCD2) contains the weights for the assets in
MQ that are not in M l — m oney market mutual fund
shares, m oney market deposit accounts and tele
phone transfer savings accounts. The weights for MSI4
are organized similarly. The first three columns con
tain the weights for the same asset groups as are in M l;
the fourth column (OCD2) contains the weights for the
assets in MQ but not in M l. The fifth column (Other)
includes the weights o f all the other assets in MSI4.
When comparing the weighting schemes, one no
tices few similarities. Both the levels, as w ell as the
patterns o f movements and the relative magnitudes,
are considerably different. Only tw o similarities
emerge: The first is the general decline o f the weights
o f demand deposits for both M l and MSI4. Alterna
tively, the weight for dem and deposits in M Q in
creases until 1980, then declines. Even after this de
cline, the weight for dem and deposits in M Q currently

FEDERAL RESERVE BANK OF ST. LOUIS

is about the same as it was at the beginning o f the
1970s, w hile those in M l and MSI4 are approximately
40 percent and 55 percent lower, respectively. Second,
the weights o f other checkable deposits in all three
aggregates, w hile near zero during most o f the 1970s,
have risen dramatically in the 1980s. This rise corre
sponds to the increased availability o f new checkable
deposits with financial deregulation in the 1980s. The
levels and relative magnitudes o f these weights, how
ever, differ substantially across aggregates. In particu
lar, O C D l’s weight in M l is significantly larger than
that in either M Q or MSI4. Moreover, O C D l’s current
weight is about 56 percent o f dem and deposits’ weight
in M l and 58 percent in MSI4, w hile only about a third
o f demand deposits' weight in MQ.
The behavior o f currency’s weight across all three
aggregates also has been dissimilar. Currency’s weight
in M l has risen rather consistently since 1970, while
doing just the opposite in MQ. Consequently, changes
in the growth rate o f currency now have a larger
impact on the growth o f M l and a much smaller
impact on the growth o f MQ than earlier. In contrast,
currency’s weight in MSI4 has not changed apprecia
bly. The decline in demand deposits’ weight, however,
has led to a situation in w hich currency growth has a
larger impact on MSI4 than does an equivalent change
in demand deposit growth, a characteristic not shared
by either M l or MQ.
By construction, MSI4 contains a large group of
assets that, w hile liquid, cannot be exchanged directly
for goods and services. It is interesting to note how
large the weights o f these non-medium-of-exchange
assets are in MSI4. In fact, until the last two years, the
weights o f non-medium-of-exchange assets in MSI4
(those classified as "other” in table II have been 1-1/2
to 2 times larger than the weights o f the medium-ofexchange assets (the sum o f the first four MSI4
weights). Only in 1983 and 1984 have the weights o f
medium-of-exchange and non-medium-of-exchange
assets approached equality. Consequently, until re
cently, a one percentage-point change in the rate of
growth o f assets that cannot be exchanged directly for
goods and services had a substantially larger impact
on the growth o f MSI4 than did a one percentagepoint change in the rate o f growth o f transaction
balances.

JUNE/JULY 1985

predictable relationship with the goals o f policy. Since
the growth o f nominal incom e is one o f the principal
goals o f monetary policy, it is important that an aggre
gate’s incom e velocity be predictable if it is to be used
for short-run econom ic stabilization.
We begin with a simple comparison o f the levels of
the velocities o f M l, MSI4 and MQ. These velocities,
norm alized to 1/1970 = 1.0, are presented in chart 2.'“
The velocities o f M l and MQ follow similar patterns.
Both appear to increase at a fairly constant rate until
1980, then accelerate through 1981 and decline mark
edly after the nationwide introduction o f NOW ac
counts. Moreover, both have increased since mid1983. The major difference is that the velocity o f M l
was larger than that o f M Q until IV/1980 and has been
below it since the introduction o f NOWs.'7While MSI4
velocity has exhibited generally similar movements
since the end o f 1980, it grew much more slowly than
either M l or M Q velocity up to the beginning o f 1978
and then considerably more rapidly from 1978 to the
end o f 1980.18Moreover, as one w ould expect given the
composition o f MSI4, its velocity is significantly low er
than that o f the other two aggregates, reflecting the
slower turnover rate o f the non-medium-of-exchange
assets that are included in it.
The quarter-to-quarter growth rates o f the velocities
are presented in chart 3. These data indicate that the
growth rates of M l and MQ differ little over the period.
Indeed, the most significant difference in the growth
rates o f M l and M Q occurred in the first two quarters
of 1981. The velocities o f both aggregates grew rapidly
during the first quarter o f 1981, but the growth in the
velocity o f M Q (33.1 percentl was nearly double that of
M l (18.2 percent). Furthermore, the velocity o f M l
declined in the second quarter o f 1981, w hile that o f
MQ increased at a rate o f about 1 percent. In all other
cases, the turning points in growth rates o f M l and
MQ velocities coincide. In contrast, the growth rate of
MSI4 velocity differs from the others, being substan-

16The velocities for MQ and MSI4 are index numbers and, as such,
have no dimension. Hence, they must be normalized to some
arbitrarily chosen base period (1/1970 in this case). M1 velocity is
normalized similarly to facilitate the comparisons.
17This is consistent with the earlier observation that simple-sum M1
growth has been rapid relative to that of MQ since the nationwide
introduction of NOWs.

INCOME VELOCITIES OF
ALTERNATIVE AGGREGATES
For an aggregate to be useful as a short-run interm e
diate target o f m onetaiy policy, it must have a stable,

'8From 11/1970 to IV/1977, MSI4 velocity grew at a 0.3 percent annual
rate while MQ and M1 velocities grew at 2.9 percent and 3.2 percent
rates, respectively. MSI4 velocity growth accelerated to a 6.5 per
cent rate from 1/1978 to IV/1980 while the growth of MQ and M1
velocities rose only to 3.7 percent and 3.2 percent rates,
respectively.

JUNE/JULY 1985

FEDERAL RESERVE BANK OF ST. LOUIS

Chart 2

Velocities of Monetary Aggregates
Parent

P«rc»t

1.6

___'
#

1.4

H I..

1.2

1.4

MQ
1.2

MSI4
1.0

1.0

1970

1984

C h a rt 3

G r o w t h R a te o f V e lo c itie s o f M o n e t a r y A g g r e g a t e s
P trcu t

P t r u it

FEDERAL RESERVE BANK OF ST. LOUIS

JUNE/JULY 1985

Table 2
Tests of the Hypothesis of Zero Autocorrelation: 11/1970—IV/1984
Lag Length

Simple-Sum M1

MSI4

Critical \ 2 Value'

4.55

3.18

7.80

12.59

14.71

14.83

11.44

21.03

16.12

15.53

19.46

28.87

20.48

19.38

21.49

36.42

'At 5 percent significance level.

tially below them until late 1978 and above the others
until late 1980. Since 1980 the growth rates o f the
velocity o f all these aggregates have behaved similarly.

it w ould tend to suggest that it may be no easier to
predict MSI4 and M Q velocities than it is for M l
velocity.

The Predictability o f Velocity Growth

To test w hether the growth o f MSI4, M Q or M l
velocity contains such regularities, correlation coef
ficients between past and current values o f velocity
growth are calculated over the period 11/1970 to
IV/1984. If these correlations are not statistically sig
nificant, then past values o f velocity growth do not
contain information helpful in predicting current ve
locity growth and, hence, velocity growth cannot be
predicted by its ow n past history. The chi-squared
statistics for testing w hether the correlations between
past and current rates o f velocity growth are different
from zero for lag lengths o f 6,12,18 and 24 quarters are
presented in table 2. None o f these statistics is statisti
cally significant at the 5 percent level. Hence, the
hypothesis that each o f these series cannot be pre
dicted by its own past cannot be rejected. In other
words, the quarterly growth o f the weighted aggre
gates’ velocities is no more easily predicted by their
own past than is the quarterly growth o f M l velocity21

Studies have shown that econom etric forecasts of
M l velocity growth tend to produce relatively large
forecast errors. This result may be due in part to the
fact that velocity growth tends to fluctuate randomly
around a fixed mean, so that the expected future
growth rate in M l velocity is unrelated to its past
growth rates.13That is to say that M l velocity possesses
no regularities that w ill enable it to be predicted on
the basis o f its ow n past history. If a series contains
such regularities, then its past histoiy provides some
basis to predict its future, especially for a short time
into the fu tu re .21’
If the growth rates o f M Q and MSI4 velocities also
contain no such regularities, then they w ill be just as
difficult to predict as M l velocity from their ow n past
histories, and may be just as difficult to predict from
an econom etric m odel as well. Consequently, it can be
argued that a sufficient condition for M Q and MSI4 to
be preferable to M l as intermediate policy targets is
that the growth rates o f their velocities exhibit regular
ities not exhibited by M l velocity. O f course, this
finding w ould not preclude the possibility that these
velocities could not be predicted on the basis o f infor
mation not contained in the past histoiy o f the series
itself. Nevertheless, if no such regularities are present,

Since the above test indicates that the velocity
growth o f each o f these m onetary aggregates varies
randomly around its mean, it w ou ld be instructive to
examine w hether the velocity growth o f any one aggre
gate varies significantly less than that o f the others.
The means and standard deviations o f the growth
rates given in table 3 indicate that the standard devia
tion o f the growth rates o f velocity around their mean
levels is not significantly different for any o f the aggre
gates 22 Indeed, the standard deviation o f the growth

19Granger (1980) has shown that a series is essentially random if it
has no predictable pattern to it. Thus, a time series, X,, is random if
the correlation between X, and XH is not significantly different from
zero for all j.

21This result is generally consistent with Spindt’s (1985).

“ For example, see Hein and Veugelers (1983) and Nelson and
Plosser (1982).

^None of the tests of the hypothesis that the variances are equal
could be rejected at the 5 percent level.

F E D E R A L R E S E R V E B A N K O F ST. LOUIS

JUNE/JULY 1985

Table 3
Means and Standard Deviations of the
Growth Rates of Various Velocity
Measures: 11/1970-IV/1984
Mean

Standard
Deviation

Simple-Sum M1

2.67

4.99

3.17

5.85

MSI4

2.21

5.76

Aggregate

rates is smallest for M l. Thus, the evidence suggests
that the growth rates o f the velocities o f MSI4 and MQ
do not appear to be more easily predicted nor any less
variable than the growth rate o f M l velocity. Hence,
these aggregates may not be better intermediate m on
etary targets than M l.
While the above analysis indicates that MQ and
MSI4 have not been preferable intermediate targets
over M l during the 11/1970 to IV/1984 period, it does
not preclude that either (or both) o f these aggregates
may be better targets during the period o f financial
innovation, I/1981-IV/1984. The evidence already pre
sented, however, implies that this is not the case. In
particular, as seen in charts 2 and 3, both the level and
the growth rate o f each velocity behaved similarly from
1/1981 to IV/1984. All three velocities fell in mid-1981
and have rebounded since early 1983. Furthermore,
even though the growth o f each velocity is more vari
able during this period than it was during the preced
ing one, the standard deviations across velocity
growth rates are not statistically different. Like the
results for the entire period, the growth o f M l velocity
is the least variable over the I/1981-IV/1984 period.
Consequently, there have not been any substantive
changes in the relative performances o f these three
aggregates during the past four years."'

CONCLUSIONS

The introduction of new financial instruments and
the recent financial deregulation have confused fur
ther the distinction between money and near-money.
One response to this confusion has been the construc-

tion o f two m onetaiy aggregates as alternatives to the
simple-sum measures currently reported by the Fed
eral Reserve. These alternatives are the monetary ser
vices indexes and MQ. Each o f these new aggregates is
a w eighted index o f the same financial assets that
constitute the various measures o f m oney as currently
defined. The difference between the monetary ser
vices indexes and M Q lies primarily in the weighting
scheme em ployed to measure the m onetaiy services
provided by the assets that com pose each aggregate.
The m onetaiy services indexes use opportunity costs
o f holding these financial assets to calculate the
weights, w hile M Q em ploys the turnover rates o f these
assets. When investigated, these weighting schemes
differed substantially across the three monetary ag
gregates examined.
From a policymaking viewpoint, the primary m oti
vation for examining different monetary aggregates is
to find the one most closely associated with nominal
GNP. In this paper, w e com pared the growth and the
stability o f the velocity o f these alternative w eighted
m onetaiy aggregates w ith the conventional simplesum M l. W e found that the growth rate o f M l velocity
was somewhat slower than that o f MQ since the na
tionwide introduction o f NOW accounts in 1981; h ow
ever, there was little difference in the movements o f
these growth rates. Furthermore, the M Q velocity
growth was neither less variable nor more predictable
than that o f M l.
With respect to the broadest monetary services in
dex (MSI4), w e found some significant differences in
its growth rate and velocity relative to M l and MQ;
however, there was no difference in the predictability
or the variability o f MSI4 velocity growth. Conse
quently, neither MSI4 nor M Q has demonstrated any
apparent gain over M l for policy purposes, and both
are more difficult to calculate.

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label with subscription inquiries or
address changes.

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