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March 1983
Vol. 65, No. 3

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5 Money M arket Deposit Accounts,
Super-NOWs and M onetary Policy

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17 The W ayward Money Supply: A Post-Mortem
of 1982
26 Bank Holding Company Perform ance Studies
and the Public Interest: Normative Uses for
Positive Analysis?

The Review is published 10 times per year by the Research and Public Information Department o f
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Federal Reserve Bank of St. Louis
Review
March 1983

In This Issue . . .




It has become almost commonplace to argue that M l doesn’t matter anymore.
First, there is widespread belief that recent financial innovations, such as superNOW and money market deposit accounts, will distort M l growth for some time
and reduce its usefulness for monetary policy. Second, the greater variability in
money growth over the past several years has induced some analysts to conclude
that M l growth can’t be controlled. The first two articles in the Review provide
evidence that these two perceptions are unfounded. The third article investigates
whether bank holding company performance studies, as currently conducted,
provide any useful information for policy decisions affecting bank holding com­
panies.
The first article in this Review, by John A. Tatom, examines the effects of newly
authorized money market deposit accounts and super-NOW accounts on mone­
tary aggregate measures and monetary policy. In “Money Market Deposit
Accounts, Super-NOWs and Monetary Policy,” Tatom describes the conventional
view that these new accounts have distorted M l and its interpretation while
leaving M2 and its policy usefulness virtually unaffected.
Disputing this conventional view, Tatom argues that the new accounts are not
unprecedented. He points out that money market deposit accounts are compara­
ble to money market mutual funds, and super-NOW accounts are similar to other
checkable deposits. After investigating the impact of these past innovations,
Tatom concludes that shifts to the new accounts are not likely to affect either the
controllability of M l or its relationship to measures of economic performance.
In contrast, while M2 is unaffected by shifts to super-NOWs, it is pushed up by
shifts to money market deposit accounts, thus altering the relationship of M2 to
such measures of economic activity as GNP. Thus, the usefulness of M l for the
conduct of monetary policy is unaffected by the new accounts. On the other hand,
M2’s usefulness has been reduced.
In the second article, “The Wayward Money Supply,” R. W. Hafer and Scott E.
Hein investigate the Federal Reserve’s ability to control closely the stock of
money. The authors examine this issue by simulating money growth for 1982 using
two alternative control procedures. The first procedure, advocated by some
analysts who are concerned by the growing number of financial innovations, is to
provide a constant rate of adjusted monetary base growth each month. Under this
procedure, money growth and base growth should be quite close if the money
multiplier follows a steady pattern. During 1982, however, the multiplier fluctu­
ated significantly. Thus, Hafer and Hein conclude, the adoption of a constantbase-growth strategy would not have materially reduced the variability of money
growth in 1982.
The second procedure is to use forecasts of the money multiplier to determine
the appropriate amount of monthly base growth over the year. Two forecasting
procedures were investigated, one based on the “naive” guess that next month’s
multiplier is equal to the current month’s, and another based on a more sophisti3

In This Issue . . .




cated statistical approach that models the time series of the multiplier. Using
either method, the resulting money growth simulated for 1982 was much closer to
the hypothetical policy target than that achieved by using the constant-basegrowth strategy. Moreover, quarterly deviations of money growth were reduced
substantially. Thus, a “post-mortem of 1982 money growth indicates that much of
the volatility in money growth last year was attributable to money multiplier
fluctuations, not erratic monetary base growth. Consequently, monetary policy
aimed at smoothing the growth of M l must anticipate and react to multiplier
movements.”
In the third article in the Review, “Bank Holding Company Performance
Studies and the Public Interest,” Donald M. Brown investigates whether per­
formance studies actually are capable of identifying performance differences
among banks and, hence, whether they are relevant to policy decisions about bank
holding company acquisitions.
The Board of Governors of the Federal Reserve System must make difficult
normative judgments about the desirability of bank holding company acquisitions.
Several of the prospective benefits that the Board has associated with such
acquisitions can be measured by bank financial ratios.
Brown reviews the results of previous studies that have investigated the effects
of holding company ownership on these financial ratios and finds that there are
significant weaknesses in their empirical results. Furthermore, the bank financial
ratios used to measure performance are subject to serious distortions. Brown
summarizes the methodological problems, most of which have been discussed
previously in the literature, then explains how deposit interest rate ceilings and
the nature of the banking firm and bank holding company organizations cause
distortions in the financial ratios. He concludes that performance studies are not
reliable guides to public policy toward bank holding company acquisitions.

Money Market Deposit Accounts,
Super-NOWs and Monetary Policy
JOHN A. TATOM

EW federal legislation allows depository institu­
tions to offer m oney m arket deposit accounts
(MMDAs) free of interest rate restrictions. The GarnSt. Germain Depository Institutions Act of 1982 in­
structs the Depository Institutions Deregulation Com­
mittee (DIDC) to authorize the new account not later
than 60 days after its enactment (October 15, 1982),
and requires that the account be “directly equivalent
to and competitive with money market mutual funds. ”
In addition, it specifies that the account have no mini­
mum maturity and that it allow up to three preautho­
rized or automatic transfers and three transfers to third
parties (checks) per month.1
In addition to authorizing this account beginning
December 14, 1982, the DIDC issued regulations
allowing a super-NOW account to be offered after
January 4, 1983; this account allows unlimited check­
ing, or third-party transfers, yet offers an unrestricted
interest rate. Both super-NOW and money market
deposit accounts require initial and minimum average
balances of at least $2,500. The primary difference
between them is that super-NOWs allow unlimited
checking and are counted as transaction accounts for
reserve requirement purposes, while money market
deposit accounts have limited checking privileges and
are not classified as transaction accounts.
As with prior innovations such as the development of
the money market mutual fund (MMMF), the savings
deposit with automatic transfer services (ATS), and the
negotiable order of withdrawal account (NOW), the
new deposits raise important questions about their
effects on monetary aggregate measures. Serious con­
cern has been expressed about the continued reliabil-

'See U .S. Congress, Garn-St. Germain Depository Institutions Act
o f 1982, 97th Congress, 2d Session, Septem ber 8, 1982. In the
implementation of the bill, the D ID C interpreted the latter to
allow up to six transfers per month, including up to three checks
per month.




ity of monetary aggregates as economic indicators and
their usefulness for monetary policy.2 Some analysts
have concluded that M l will be subject to large and
unpredictable changes that will adversely affect its
relationships with spending and inflation, while M2
will remain unaffected. As a result, it has been sug­
gested that the Federal Reserve should focus more
attention on M2 in the conduct of monetary policy.3
The analysis presented here indicates that these
concerns are exaggerated. New money market deposit
accounts will distort M2, not M l. Super-N OW
accounts are not likely to affect either aggregate. Since
M l and its interpretation are unlikely to be affected by
shifts to money market deposit accounts or superNOW accounts, it should remain as useful for the
conduct of monetary policy as it has been in the past.

THE NEW ACCOUNTS AND THE
MONETARY AGGREGATES
Table 1 presents the definitions of M l and M2 and
their components as of November 1982, the month
2An excellent review of the concerns raised by innovations is that by
John M. Berry, “The Fed ’s Policy Levers Are Becoming W eaker,”
Washington Post, Decem ber 12, 1982. He indicates that some
policymakers believe that recent and prospective innovations have
rendered M l “virtually meaningless in the short run,” and that M2
is a more useful target, at least temporarily. See also Edward P.
Foldessey, “New Bank Accounts May Force Fed to End Experi­
ment in Monetarism,” W all Street Journal, Decem ber 28, 1982.
3A shift of emphasis in monetary policy that began in October 1982
was motivated by the same type of argument. Then it was antici­
pated that the redemptions of All-Savers Certificates, especially in
October and November, would distort M l but not M2. Interest­
ingly, a year earlier, the concern with inflows to new All-Savers was
that they would lead to a surge in M2. See Daniel L. Thornton,
“The FO M C in 1981: Monetary Control in a Changing Financial
Environm ent,” this Review (April 1982), p. 20. The argument that
M l growth was distorted upward at the end of 1982 due to AllSavers redemptions is not examined below, since the pace of M l
growth in the last three months of 1982 was no larger than occurred
from July to October 1982.

5

MARCH 1983

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
The Components of M1 and M2 as of November 1982
_________
(billions of dollars)
M2

M1
$131.6

Currency

M1

41.3

Travelers checks
Demand deposits

238.0

Overnight Eurodollars2

Other checkable deposits3

100.5

Money market mutual funds4

185.8

Savings deposits5

362.2

Small time deposits

922.4

$474.6

Overnight RPs1

$ 474.6

4.5

6.6

$1,986.1

'Repurchase agreements at all depository institutions, not seasonally adjusted.
2Such deposits at Caribbean branches of U.S. financial institutions, not seasonally adjusted,
in clud es super-NOW balances (as well as ATS savings, NOW and credit union share draft balances).
4Excludes money market mutual funds held by institutions. Only general purpose and broker dealer
balances are included, not seasonally adjusted,
includes money market deposit account balances.

before the introduction of MMDAs.4 MM DA bal­
ances, which are not transaction balances, are in­
cluded in M2, while super-NOW balances are in­
cluded in M l, since they offer unlimited third-party
transfers, just as do demand deposits, ATS balances,
NOW deposits and credit union share draft accounts.

T h e “Source o f Shifts A pproach and
T h e Impact o f T h e New Accounts
”

A popular means of assessing the effects of these new
accounts on the monetary aggregates can be called the
“source of shifts” analysis. In this approach, one looks
at the items in table 1 and determines the source of the
funds that are shifted into each of the new accounts. Of
course, it is possible that funds added to one of the new
accounts might have come from financial assets not
listed in table 1 and this possibility is discussed later.
To clarify the use of this particular approach, however,
it is convenient to assume that funds shifted into the
new accounts come solely from other accounts shown
4On February 14, 1983, the Board of Governors of the Federal
Reserve System announced revisions in the monetary aggregates.
These revisions included two definitional changes for M2. First,
tax-exempt money market mutual funds which previously had
been excluded from the aggregates were included on the same
basis as taxable M M M Fs. Second, all IRA/Keough balances at
depository institutions and M M M Fs were removed from M2. The
data used in this study do not incorporate these revisions, but the
empirical results should not be affected by them.

Digitized for 6
FRASER


in table 1. The net effect for each aggregate can be
found by adding the balances in the new account and
changes in the balances of the sources of the funds.
The new money market deposit account is included
in M2. Consequently, shifts of funds from any other
com ponent in table 1 to money market deposit
accounts will leave M2 unchanged; of course, shifts
from M l deposits to MMDAs will reduce M l. Thus, if
total spending or GNP remains unchanged, shifts to
money market deposit accounts from other compo­
nents of M2 will not affect the velocity of M2 (the ratio
of GNP to M2), but the velocity of M l (the ratio of GNP
to M l) will rise if the shifts to MMDAs are associated
with a decline in M l.
In the case of super-NOW accounts, shifts of funds
among M l deposit components will leave both M l and
M2 totals unaffected. If funds included in M2 but not in
M l are shifted to super-NOW accounts, M l will rise
while M2 again is unaffected.
The conclusion of this approach is that M2 will be
unaffected by the new accounts, but that M l could fall
or rise. As a result, M l could be distorted and its
movements rendered meaningless during the period
of major shifts to these new accounts. This approach
indicates that it will have limited use as an indicator of
economic activity or a target for monetary policy. On
the other hand, since M2 is unaffected, it is argued that
its usefulness for policy is unchanged.

FEDERAL RESERVE BANK OF ST. LOUIS

M onetary Asset Portfolios and the Impact
o f the New Accounts
A broader approach is to examine the effects of these
new accounts on desired holdings of stocks of monetary
assets. In this approach, the actual purchases or sales of
financial (or real) assets provide little information about
the demand for or supply of M l. For example, when
individuals add to their non-transaction balances (i.e.,
increase their savings), they generally do so initially by
reducing their transaction balances; that is, they use
currency or checkable deposits. In the “source of
shifts” approach, this initial action would be inter­
preted as a reduction in the demand for transaction
balances relative to other financial assets and, there­
fore, a reduction in M 1, with no change in either M2 or
economic activity.
In a more general analysis, this conclusion is not
necessarily valid. Since countless individual transac­
tions tend to be offset daily by other transactions by the
same or other individuals, the vast majority of these
transactions have little effect on financial markets or
the nation’s economic performance. Only if individuals
change the share of their assets held as transaction
balances (money) vis a vis savings, or their average
money balances relative to income or spending, would
there be a meaningful change in economic behavior. In
the examination of the new accounts below, considera­
tions from this broader “portfolio approach” generally
reverse the “source of shifts” conclusions; the portfolio
approach suggests that the new accounts will distort
M2 while leaving M l virtually unaffected.

PROJECTED IMPACT OF MONEY
MARKET DEPOSIT ACCOUNTS
The money market deposit account was introduced
to allow financial institutions to compete directly for
deposits with money market mutual funds. The trans­
action services available with such accounts are lim­
ited, and are generally less than those currently avail­
able with money market mutual funds.
In addition to the sources listed in table 1, house­
holds and businesses could switch funds to MMDAs
from other asset holdings, including such financial
assets as U.S. savings bonds, Treasury bills or other
securities. If this were to occur, M2 would rise.5 Such
"The same argument can be carried a step further but is not central
to the discussion here. The monetary aggregate M3 includes, in
addition to M2, large time deposits, term repurchase agreements
and institutional money market mutual fund balances. Shifts from




MARCH 1983

reallocations in asset holdings are likely only if
MMDAs offer a new asset-holding opportunity. Prior
to MMDAs, however, asset holders could have held
MMMF balances. MMDAs changed the financial en­
vironment by allowing a federally-insured, MMMFlike instrument to be held more conveniently at a local
depository institution. If the additional convenience
and/or insurance are important, M2 will be increased
by shifts to MMDAs, while M l will be unaffected.
The only type of shift to MMDAs that could impinge
directly on M l is a shift of deposits from M l. Such a
shift is unlikely, however. MM DA balances do not
provide the transaction services offered by M l compo­
nents and do not change the opportunities available
before MMDAs, other than the insurance and conve­
nience noted above.6 Asset holders could have chosen
to hold less M l and more M MM F balances had their
higher yields been attractive compared with the lower
yield and transaction services of the M l components.
The decision to hold M l versus MMMF-type balances
should be little affected by the availability of money
market deposit accounts; their yield and convenience
do not appear to offer a substantial improvement over
previously available opportunities.

Indirect Effects P roduced by Differential
Reserve R equirem ents
One also must consider whether the shifts of funds to
the new money market deposit accounts indirectly
affect the monetary aggregates. Different monetary
assets have different reserve requirements. Financial
innovations that lead to shifts of funds into a new asset
could affect the demand for reserves and, given a fixed
supply of reserves, indirectly affect the monetary
aggregates. Such indirect effects have an important
influence on the monetary aggregates because they
the latter assets would raise directly M2 but leave M3 unaffected.
Shifts from the broad spectrum of financial assets beyond M3, of
course, would raise M2 and M3 directly.
6Some analysts may be concerned that MMDA accounts will attract
some transaction balances that will continue to be used as transac­
tion balances because of the limited transaction features of these
accounts and their unlimited access in person, by messenger or by
automatic teller machine. This concern appears to be unfounded;
nearly the same opportunity exists but was notusedw ithM M M Fs.
The same concern arose for M M M Fs, which generally allow unlim­
ited third party transactions, but often subject to a minimum size.
Surveys of check usage of M M M F balances show that a relatively
insignificant share of these balances are held in accounts with a
turnover rate (ratio of the value of all debits, including checks, to
average account balance) as high as that for NOW accounts. The
latter, in turn, is less than for demand deposits. The turnover rate
on all money market mutual fund shares is lower than for passbook
savings deposits at all financial institutions.

7

FEDERAL RESERVE BANK OF ST. LOUIS

influence whether the new accounts affect the various
money multipliers.7
Personal money market deposit accounts are not
subject to reserve requirements. Only nonpersonal
money market deposit accounts are subject to reserve
requirements, and these requirements are the same as
those on nonpersonal time and savings balances. The
deposit components of M l, the nonpersonal time and
savings components of M2, and the personal time and
savings components of M2 at member banks of the
Federal Reserve System are subject to reserve re­
quirements. To the extent that funds move from such
balances to MM DA balances, required reserves are
reduced. Given an unchanged stock of reserves, de­
pository institutions would tend to develop excess re­
serves. To avoid the unnecessary non-interest-bearing
reserves, banks can purchase assets, including new
loans.
Although the effect on the demand for reserves
would be largest for shifts to MMDAs from M l deposit
components, such shifts are unlikely to occur. Even if
they should occur, the reduction in M l would tend to
be offset exactly by the indirect increase in M 1 arising
from the reserve demand effect. The net result is that
M l would be unaffected and M2 would be raised —
just as if the shifts had come from financial assets not in
M2. If MM DA funds should come from time and sav­
ings deposits, the indirect effects would serve to in­
crease both M l and M 2.8

'See, for example, the discussion in John A. Tatom and Richard
Lang, "Automatic Transfers and The Money Supply Process,” this
Review (February 1979), pp. 2-10; and John A. Tatom, “Recent
Financial Innovations: Have They Distorted the Meaning of M l? ’
this Review (April 1982), pp. 23^35.
8In terms of a framework of the money supply process that uses this
Rank’s adjusted monetary base, M l usually is affected by MMDA
shifts only if there is a change in the adjusted monetary base. In the
absence of such a base change, M2 would rise but M l would be
unaffected by the shift to MMDA balances. The primary exception
is in the case of a change in the public’s desired holdings of time and
savings deposits at member banks relative to total checkable de­
posits. The multiplier is not very sensitive to such changes, howev­
er, and shifts of such funds to M M M F balances since 1978 have had
no appreciable effects on the M l multiplier over the past five years.
The correlation between monthly changes in the ratio of time and
savings deposits at member banks to the total checkable deposit
component of M l and changes in money market mutual fund
balances (general purpose and broker dealer) is 0.003 for the period
January 1978 to November 1982. The correlation coefficient using
quarterly data is 0.19. These coefficients indicate that shifts to
M M M Fs have not affected the M l multiplier through such a
channel in any systematic way. Had such growth in M M M Fs been
registered in member bank time and savings deposits, however,
the multiplier would have been lower and the adjusted monetary
base correspondingly higher. This will be the case with MMDAs;
shifts to MMDAs will have offsetting effects, raising the base and
lowering the multiplier during the transition.

Digitized for8
FRASER


MARCH 1983

If, as expected, money market deposit balances
come from MMMF balances or other non-reservable
components of M2, neither M l nor M2 will be
affected. Finally, if money market deposit accounts
arise from portfolio shifts from non-reservable assets
not in M2, M2 will increase, while M l will be un­
affected.

Initial Impact o f MMDAs
Money m arket deposit accounts have shown
tremendous growth, due in part to the relatively high
initial interest rates that depository institutions have
offered on them. In the first four weeks, deposits in
these accounts grew to $160 billion, over 75 percent of
the total assets of money market mutual funds. The
latter lost about $25 billion in share balances from
December 8, 1982, to January 12, 1983. At commercial
banks, savings deposits fell by $11.7 billion over the
same period.
A large part of the increase in MMDAs apparently
came from shifts of funds from time deposits. At com­
mercial banks, small and large time deposits fell by
$50.6 billion from early December to early January.
Despite the massive flows of deposits to MMDAs, M l
was little changed. For the four weeks ending January
12, M l averaged $479.5 billion, compared with $477.6
billion over the prior four weeks.9 Weekly information
for such a short period is severely limited and cannot
be regarded as more than suggestive evidence for the
effects of MMDAs on the money supply process and on
the interpretation of monetary aggregate movements,
however.

EVIDENCE FROM THE PAST:
THE IMPACT OF MONEY MARKET
MUTUAL FUNDS ON THE MONETARY
AGGREGATES
To assess the various consequences of MMDA shifts,
the effects of the advent of money market mutual funds
can be examined. Chart 1 shows money market mutual
fund balances (general purpose and broker dealer)
since the first quarter of 1974. These balances re­
mained relatively small until 1978.

9Since the latter period includes the first week in which superNOWs began, the absence of an apparent M l effect might be
interpreted as a consequence of offsetting effects of MMDAs and
super-NOWs on M l. However, when averages for the three weeks
up to and following the week ending Decem ber 15, 1982 are used,
M l is virtually unchanged, while MMDAs expanded by $119.8
billion.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

C h a rt 1

M oney M arket M utual Fund B alan ces
(General Purpose and Broker Dealer)

M M M F Effects on the Growth o f the
Monetary A ggregates
Since 1978, when M MM F balances began to expand
sharply, monthly changes in money market mutual
funds balances have been unrelated to monthly
changes in M l (using not seasonally adjusted data for
both series); the correlation coefficient between these
changes from January 1978 to November 1982 is 0.03,



which indicates no relationship whatsoever between
them. Similarly, monthly changes in M M M F balances
are unrelated to monthly changes in currency, demand
deposits or other checkable deposits.10 The history of
10The same statistically insignificant relationships are obtained
when quarterly changes from the first quarter of 1978 to the third
quarter of 1982 are examined. For example, the correlation coef­
ficient between quarterly changes in M M M Fs and in M l is
- 0 .0 9 .

9

FEDERAL RESERVE BANK OF ST. LOUIS

MMMF growth from 1978 to the present indicates that
M l growth is unlikely to be affected by the growth of
MMDA-type assets.
On the other hand, monthly changes in MMMF
balances are correlated positively with monthly
changes in M2; the correlation coefficient is 0.27,
which indicates a statistically significant positive rela­
tionship at a 95 percent confidence level.11 If all
MMMF growth were at the expense of other compo­
nents of M2, this correlation would be zero. Thus, the
pattern of M M M F growth indicates that the M2 mea­
sure is increased significantly by the growth of
MMDA-type assets.

M M M F Effects on the Com ponent Mix o f
the M onetary A ggregates
If MMDA-type balances are an attractive alternative
to holding deposit components of M l, then the mix of
M l components should be related to the growth of
MMMFs. This could happen if people held relatively
large idle checkable deposit balances that they wish to
switch to meet the high minimum balances required
by money market mutual funds and to obtain their
relatively higher yields. Because money market de­
posit accounts have a higher minimum balance
($2,500) than most money market mutual funds, such
an effect could be important for MMDAs.
A measure of the desired mix of M 1 components is
the currency ratio, the holdings of currency relative to
total checkable deposits. If the introduction of
MMDAs causes a shift from checkable deposits,
whether “idle” or not, it should show up in a higher
currency ratio. In fact, the correlation coefficient be­
tween monthly changes in the currency ratio and
monthly changes in MMMFs is negative, —0.21, but
not statistically significant at a 95 percent confidence
level. For quarterly changes from the first quarter of
1978 to the third quarter of 1982, the coefficient is
—0.03, again negative but insignificant. Thus, the cur­
rency ratio has not been positively affected by the
growth of money market mutual fund balances, con­
firming the previous conclusion that M 1 has not been
affected by growth in MMDA-type assets.
Chart 2 provides a partial indication of the likely
sources of growth in the new money market deposit
accounts. This chart looks at the nontransaction com-

n For quarterly data from 1/1978 to III/1982, this correlation is 0.43,
which is only significant at a 93 percent confidence level. For
seasonally adjusted M2 data, however, the coefficient is 0.478,
statistically significant at a 95 percent confidence level.

Digitized for 10
FRASER


MARCH 1983

ponents of M2, measured relative to the transaction
balance measure of money, M l. The ratio of the nonM 1 components of M2 to M 1 is shown from 1/1959 to
III/1982, as well as the ratio computed without
MMMF balances in the numerator. The broad non­
transaction components measure generally rises over
the whole period. After 1978, however, the instru­
ments that exclude M MM Fs decline sharply from
their prior trend. This indicates that the total of non­
transaction accounts in M2 has exhibited a faster trend
growth than M l, while the growth in M MM F balances
has taken place, in part, at the expense of the other
previously existing non-transaction components of
M 2.12

M M M F Effects on M easures o f Velocity
Whether MMDAs affect the meaning of the mone­
tary aggregate measures is indicated by changes in
these aggregates relative to total spending or GNP. An
analysis of how the velocity of M l (M2), the ratio of
GNP to M l (M2), has been affected by the growth of
MMMF balances provides useful information regard­
ing this question.
The correlation coefficient betw een quarterly
changes in M l velocity and quarterly changes in
MMMF balances from the first quarter of 1978 to the
third quarter of 1982, —0.15, shows no statistically
significant relationship between M l velocity and
MMMF balances. For the same period, the correlation
coefficient for changes in M2 velocity is —0.46, which
indicates a statistically significant negative relationship
between MMMF balances and M2 velocity.13 Since
1977, the velocity of M2 generally has been pushed
down, or its growth rate reduced, by the surge in
MMMFs. Thus, contrary to the “source of shifts” view,
MMDA-type assets have distorted the relationship be­

12The correlation between monthly changes in M M M F balances
and the other non-M l components of M2 from January 1978 to
November 1982 is —0.48, using not seasonally adjusted data. This
negative correlation is statistically significant at the 95 percent
level. For quarterly data from 1/1978 to III/1982, the same signifi­
cant negative relationship is observed; the correlation coefficient
is - 0 .5 7 .
13M2 velocity rose sharply from 1977 to 1980, and in late 1980 and
early 1981, despite the rise in M M M Fs. The unusually strong
growth probably is associated with the sharp rise in interest rates
during these periods. The velocity of M2 is strongly and positively
correlated with interest rates. The correlation coefficient for
changes in M2 velocity and quarterly changes in the 3-month
Treasury bill rate is 0.35 from 11/1959 to III/1982, while that for
M l velocity is 0.13. The former is statistically significant at a 95
percent confidence level, while the latter is not, A recent sharp
decline in M2 velocity in 1982, in part, reflects the decline in
interest rates.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Non-Transactions Components of M 2 Relative to M l
Ra tio

tween M2 and spending, but not between M l and
spending.

Summary o f Likely M M DA Effects

Ra tio

yielding NOW accounts, subject to the same reserve
requirements, but with a substantial initial and mini­
mum average balance of $2,500 and, in many cases,
substantial fees.

THE PROJECTED IMPACT OF
SUPER-NOWS

NOW accounts, which were permitted nationwide
beginning in January 1981, were included in other
checkable deposits. Previously, other checkable de­
posits were principally ATS balances nationwide and
NOW account balances in New England, New York
and New Jersey. Chart 3 shows the pattern of growth of
other checkable deposits from 1/1974 to the present;
they did not grow substantially until ATS accounts
were permitted in IV/1978. In December 1980, 9.1
percent of total checkable deposits were held in other
checkable deposits (i.e., checkable deposits other than
demand deposits). During the first year of nationwide
NOW accounts (through D ecem ber 1981), other
checkable deposits surged to 24.6 percent of total
checkable deposits. By November 1982, other check­
able deposits had risen further, to 29.7 percent of total
checkable deposits.

The introduction of super-NOW accounts similarly
is not without precedent. Super-NOWs are higher-

The surge in NOW accounts was limited by restric­
tions prohibiting businesses from holding such

The simple correlation evidence from the explosion
of money market mutual fund balances over the past
five years does not support the hypothesis that M 1 will
be reduced because of shifts from M l components to
the new MMDA accounts. The evidence associated
with the rapid growth of M MM F balances in the past
five years indicates that the M l measure will likely be
unaffected by MMDA shifts, while M2 will rise. In
addition, the evidence indicates that growth in
MMDA-type balances, like M MM F balances, will re­
duce the velocity of M2, but is not likely to affect M 1
velocity.




11

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Chart 3

O th e r Checkable Deposits
B illi o n s of d o l l a r s

B illi o n s of d o ll a rs

The primary concern over super-NOWs is not re­
lated to shifts from existing NOW accounts, however.
Instead, as was the case when nationwide NOW
accounts were introduced, the concern is that non­
transaction balances will shift into the new accounts,
distorting the M l measure. By some estimates, only
about 70 to 75 percent of new other checkable deposits
in 1981 came from other transaction balances. Conse­
quently, it was thought that as much as 25 to 30 percent
of other checkable deposits represented a distortion of
the aggregates, especially overstating the growth of
the “true” transaction balance component of M l.
The problem with such estimates, as explained ear­
lier, is that the source of the initial funds for a new
account may be irrelevant. Previous studies of the
effect of NOWs on the money supply process and on
the relationship of M l to economic performance have
shown that shifts to NOW accounts did not distort
measured M l, nor damage its usefulness as an indica­
tor for total spending, inflation or monetary policy
developments.14 There is no reason to believe that
super-NOW accounts will have different effects from
those previously observed with NOW accounts.

accounts and by the lack of incentives for many deposi­
tors. Under existing regulations, the first restriction
applies to super-NOW accounts, although the DIDC
has asked for public comment on allowing businesses
to hold the new super-NOW account. The second
restriction, limited incentives, will be even more im­
portant with the super-NOW account than the NOW,
because of the relatively high minimum balance re­
quirement.
An individual considering holding a super-NOW
account must weigh the higher yield on existing aver­
age balances currently held in a NOW account against
the interest penalty borne on funds that would have to
be shifted from higher yielding assets to meet the
increased minimum balance requirements. Because
super-NOW accounts, unlike MMDA or M MM F
accounts, are subject to reserve requirements of about
12 percent, the interest rate paid on super-NOW
accounts is likely to be lower than that on MMMFs or
M M D As by about 12 percent of current MMMF rates.
In November 1982, this difference was about 1 per­
centage point; for a range of M M M F rates of 6 percent
to 16 percent, this differential or penalty would vary
from 72 to 192 basis points. These are clearly signifi­
cant spreads for otherwise similar assets. Thus, only
individuals already holding relatively large checkable
deposits, for example, those holding more than $2,500
on average, are likely to have an incentive to switch to a
super-NOW account.
Digitized for12
FRASER


Additional E vidence on the E ffects o f
NOW Accounts
Some additional evidence bearing on the likely im­
pact of super-NOWs can be obtained by looking at the
correlation between quarterly changes in other check­
able deposits since the introduction of ATS accounts
(IV/1978) and certain factors that influence the link
between monetary policy actions and M l. The factors
examined should be affected if desired portfolio hold­
ings are altered by shifts to other checkable deposits
such as super-NOWs.
One such factor is the currency ratio. The currency
ratio should decline if the demand for total checkable
deposits were increased relative to that for currency to
meet minimum balance requirements or because the
return on other checkable deposits had increased. The
correlation coefficient for changes in other checkable
deposits and changes in the currency ratio from IV/
1978 to III/1982 is —0.27 using seasonally adjusted
data, and 0.15 using not seasonally adjusted data;
14See Tatom, “Recent Financial Innovations: Have They Distorted
the Meaning of M l? ”; Scott E . Hein, “Short-Run Money Growth
Volatility: Evidence of Misbehaving Money Demand?” this Re­
view (June/July 1982), pp. 27-36; and Jerry Jordan, “Financial
Innovation and Monetary Policy, ” in Federal Reserve Bank of St.
Louis, Financial Innovations: Their Im pact on Monetary Policy
and Financial Markets, Proceedings of a Conference held at St.
Louis, Missouri, October 1 and 2, 1982 (forthcoming).

FEDERAL RESERVE BANK OF ST. LOUIS

neither is statistically significant. Correlation coeffi­
cients for quarterly changes in other checkable de­
posits and quarterly changes in the ratios of commer­
cial bank (and all depository institutions) small (and
total) time and savings deposits to total checkable de­
posits also fail to show any statistically significant nega­
tive relationships that might be expected due to shifts
of nontransaction balances to measured transaction
balances.15

MARCH 1983

Chart 4

G ro w th Rates of GNP and M 2 11
Percent

P erc e nt

Finally, if the growth of other checkable deposits
represented such non-transaction balances, the veloc­
ity of M 1 would be negatively and significantly corre­
lated with the growth of other checkable deposits. The
correlation coefficient for quarterly changes in M l
velocity and quarterly changes in other checkable de­
posits over this period is positive, 0.16, but statistically
insignificant.16

IMPLICATIONS FOR MONETARY
POLICY
The choice between monetary aggregate targets is
influenced by both the controllability of the aggregate
and the stability of its relationship to measures of eco­
nomic performance, especially total spending or GNP.
Typically, on both criteria, M l is superior to other
aggregates in statistical examinations of the historical
record.17
Despite this evidence, there is widespread concern
that recent financial innovations have affected the
meaning or controllability of M l and that, during
periods of such “turbulence,” M2 is a better policy
target than M l.18 What is sometimes missed in discus15The correlation coefficient for quarterly changes in the ratio of
member bank total time and savings deposits to total checkable
deposits, not seasonally adjusted, and quarterly changes in other
checkable deposits, not seasonally adjusted, is 0.15, for the period
since IV/1978; this also is not statistically significant. The M l and
M2 multipliers have been unaffected by changes in other check­
able deposits.

sions of the relative merits of M2 and M l, however, is
that the 1980 redefinitions of the aggregates changed
the M2 measure substantially while changing M l only
moderately. The substantial difference between the
old and current M2 measures arises from the inclusion
of some financial assets that are competitive with time
and savings deposits in the current definition of M2,
especially money market mutual funds.19

T h e Relationship Betw een the M onetary
A ggregates and GNP

16The growth of other checkable deposits such as super-NOW
balances also is uncorrelated with M2 velocity movements. The
correlation coefficient between quarterly changes in other check­
able deposits and M2 velocity is 0.18 for the period from the fourth
quarter of 1978 to the third quarter of 1982.

Movements in M2 have been dominated by move­
ments in money market mutual fund balances for
several years. As a result, the usefulness of M2 as an
indicator of economic performance has been reduced
substantially. Chart 4 shows the annual growth rates of
M2 and GNP for four-quarter periods since the first
quarter of 1977. Empirical assessment of the rela­
tionship of M2 and GNP growth affirm the relationship

17See R. W. Hafer, “Much Ado About M 2,” this Review (October
1981), pp. 13-18; and Keith M. Carlson and Scott E. Hein,
“Monetary Aggregates as Monetary Indicators,” this Review
(November 1980), pp. 12-21.

Money — A Restatem ent,” in Milton Friedman, ed., Studies in
The Quantity Theory o f Money (University of Chicago Press,

18Berry, “The Fed ’s Policy Levers,” provides this conclusion but
also notes, however, that the velocity of both M l and M2 dropped
in 1982, raising some doubt about the usefulness of either aggre­
gate as a target for monetary policy. A decline in velocity, abso­
lutely or relative to trend, is not unusual in a recession, however,
since measured income declines relative to permanent income.
See, for example, Milton Friedman, “The Quantity Theory of




1956), especially pp. 18-19. The correlation coefficient for
quarterly velocity changes and unemployment rate changes is
—0.35 and —0.41 for M l and M2, respectively, from III/1959 to
III/1982. Both are strongly statistically significant and indicate the
negative effect of recessions on velocity.
19See R. W. Hafer, “The New Monetary Aggregates,” this Review
(February 1980), pp. 25-32.

13

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

C h a rt 5

G r o w t h Rates o f M l a n d M 2 Q

1961 62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

1982

Q F o u r - q u a r t e r r a te s o f c h a n g e .

indicated in the chart. There is no correlation between
the growth rates of M2 and GNP over the whole fiveyear period (the correlation coefficient is 0.04); over
the past three years (1/1979 to III/1982), however, the
correlation coefficient ( —0.61) is significantly negative
at a 95 percent confidence level.20
20Experiments with reduced-form regression equations bear out
the breakdown as well. Hafer, “Much Ado About M 2,” presents
equations using M l or M2 growth that indicate the superiority of
M l. W hen a sample period of 11/1961 to IV/1977 is extended to
III/1982, a standard Chow test indicates that the stability of the
M2-GNP relationship breaks down. Experiments with the con­
strained GNP equation presented in the appendix to John A.
Tatom, “Energy Prices and Short-Run Economic Performance,”
this Review (January 1981), pp. 3-17, substituting M2 for M l yield
the result that at a 99 percent confidence level, the equation with
M l is stable after 1977, but that with M2 is not. Simulations of the
IV/1977 equation yield systematic and relatively large underesti­
mates of GNP growth until 1/1981, then systematic and large
overestimates of GNP growth to III/1982. O f the 19 quarters
simulated, six of the errors are greater than twice the standard
error of the equation estimated and the root mean square error of
the estimates is 5.10 percent, compared with an in-sample stan­
dard error of 2.80 percent.

Digitized for14
FRASER


In contrast, the growth rate of GNP is highly and
significantly positively related to the growth rate of
M l, both for the entire five-year period (the correla­
tion coefficient is 0.67), and for the 1/1979 to III/1982
subperiod (the correlation coefficient is 0.58).21

T h e Controllability o f M onetary A ggregates
The problem with using M2 as an indicator of eco­
nomic performance is reflected in the breakdown of
the relationship between M l and M 2.22 Chart 5 shows
■'For the conventional contrasting view, see Berry, “The Fed ’s
Policy Levers.” He notes that the relationship of M2 to GNP has
been “quite stable and trendless with, say a 10 percent increase in
M2, almost always associated with about a 10 percent increase in
G N P.”
“ The breakdown in the positive and strong relationship for the past
several years is not unprecedented. There was no relationship
during 1962-66 when M2 growth changed little, but M l and GNP
growth accelerated sharply; the correlation coefficient for M2 and
GNP growth over this period is 0.24, not statistically significant at
conventional levels.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

M l a n d M 2 Multipliers '

2 R a tio o f M l a n d M 2 to th e A d ju s te d M o n e ta r y Base.

the annual growth rate of M l and M2 for four-quarter
periods since 1960. Until 1977, the growth rates are
highly positively correlated (the correlation coefficient
is 0.65).23 This relationship disappears after 1976; the
correlation over the period 1/1977 to III/1982 drops to
0.23, which indicates the absence of a statistically
meaningful relationship.
This evidence provides some insight into the issue of
the relative controllability of the monetary aggregates;
this issue is crucial in the choice of a monetary policy
target. The central bank directly controls only its own
portfolio, so it can determine precisely only the mone­
tary base. If the relationship between the base and
monetary aggregates is unstable or even highly vari­
able, the achievement of policy objectives is more
difficult. In this case, the difficulty would be hitting the

“ Kenneth C. Froewiss, Financial Market Perspective, GoldmanSachs Economics (D ecem ber 1982), p. 3, shows that the growth in
M l plus the savings components of M2, has been inversely related
to that of the remainder of M2 since mid-1978. He argues that this
is evidence that M2 is no longer a reliable guide to monetary
policy.




target successfully. M2 is subject to substantially high­
er control errors than M l.24 Over the past several
years, this has been apparent in the disparate behavior
of M l and M2.
Further evidence on this issue is available from the
analysis of the ratios of M l and M2 to the adjusted
monetary base, the M l and M2 multipliers. These
multipliers are shown in chart 6 from 1/1959 to III/

24It should be noted, however, that in short-run control experi­
ments, the error dispersion statistics for current-month aggregate
projections have been found to be smaller for M2 than for M l
using both judgmental forecasts and the Rasche-Johannes multi­
plier forecasting method. See David Lindsey, et al., “Monetary
Control Experience Under The New Operating Procedures,” in
Board of Governors of the Federal Reserve System, Federal
Reserve Staff Study, New M onetary Control Procedures (Febru­
ary 1981), pp. 1-102.
The conclusion in the text is based on quarterly estimates of the
relationship between monetary growth rates and the growth rate
of the adjusted monetary base, such as those in John A. Tatom,
“Money Stock Control Under Alternative Definitions o f Money, ”
this Review (November 1979), pp. 3 -9 ; or Hafer, “Much Ado
About M2, ” where the standard error of aggregates is higher for
M2 than for M l.

15

FEDERAL RESERVE BANK OF ST. LOUIS

1982. The earlier analysis indicates that NOWs did not
affect the components of the M l or M2 multiplier,
while the growth of MM DA-type assets affected only
M2. A direct correlation analysis of the multipliers
bears out these findings. The correlation coefficient
between quarterly changes in the M2 multiplier and
quarterly changes in M MM F balances since 1/1978 is
strongly and significantly positive (0.82); changes in
the M l multiplier, on the other hand, are unrelated to
movements in MMMFs (the correlation coefficient for
the same period is 0.12). Changes in other checkable
deposits have had no significant effect on either the M l
or M2 multiplier over the same period; the correlation
coefficient equals 0.23 and 0.38, respectively.25

Summary
Based on the evidence above, it appears likely that
the growth of money market deposit accounts will
complicate efforts to control M2. The new accounts
will tend to raise the M2 multiplier and reduce the M2
velocity, making M2 more difficult to control and to
interpret for policy purposes.
The new accounts do not appear to pose a problem
for M l. Its controllability and its relationship to spend­
ing are not likely to be affected by the changes accord­
ing to the evidence from similar recent institutional
changes.

CONCLUSION
Strong concern has been expressed that newly au­
thorized financial instruments at depository institu­
tions will substantially alter M l, thus reducing its use­
fulness as a target for conducting monetary policy. In
particular, the current concern is that M l will be either
pushed upward by additions of idle or non-transaction
balances to meet the higher minimum for super-NOW
accounts, or pushed downward by shifts of idle or
non-transaction balances from demand and NOW de­
25The M2 multiplier is negatively related to movements in short­
term interest rates. From 1/1978 to III/1982, the correlation coef­
ficient between changes in the M2 multiplier and those of the 4- to
6-month commercial paper rate is —0.47. The M l multiplier is
not statistically correlated with changes in rates.

Digitized for16
FRASER


MARCH 1983

posits to MMDAs. Since such shifting is primarily
between assets within the M2 measure, it has been
widely asserted that the shifts do not affect the measure
of M2 and, by implication, will not distort its meaning
or usefulness for the conduct of monetary policy.
A broader view of the money supply process reaches
the opposite conclusions. The newly created money
market deposit accounts are non-reservable deposits
with limited transaction services and are quite similar,
in practice as well as in legislative intent, to money
market mutual funds. The principal differences are
federal insurance and geographic convenience. Simi­
larly, super-NOW accounts are virtually identical to
NOW accounts, except that a $2,500 minimum balance
is required by law and the instrument is free of rate
regulation.
Money market mutual fund-type assets, like money
market deposit accounts, have no effect on M l or its
velocity. Increases in such assets do tend to raise M2,
however, and to reduce its velocity. Super-NOWs are
similar to other checkable deposits and are unlikely to
affect M l or M2 measures or their relationships to
spending. In principle, the higher yields on superNOWs compared with other transaction balances
could lower currency demand relative to total transac­
tion deposits, thereby increasing both the demand for
M 1 and its multiplier. The evidence from the introduc­
tion of ATS and, later, NOW accounts provides no
support for this conjecture, however.
Finally, it does not appear that M2 is likely to be
superior to M l as a target for conducting monetary
policy. The conventional view that the M2-GNP rela­
tionship is both statistically significant and stable has
not been supported by the experience over the past
several years.26

2<’The argument here is not that monetary policy cannot be con­
ducted successfully using an M2 targeting procedure. The evi­
dence cited above only shows that MMDA accounts are likely to
raise M2 growth relative to monetary policy measures like the
adjusted monetary base, and relative to spending. Continuous
monitoring of the effect of new accounts on M2, as well as success­
ful monitoring of the effect of interest rate movements on the
supply and demand for M2, in principle, could allow movements
in the M2 target range that would be compatible with the attain­
ment of policy objectives.

The Wayward Money Supply: A
Post-Mortem of 1982
R. W. HAFER and SCOTT E. HEIN

c

k J lN C E the Federal Reserve changed its operating
procedures in late 1979 to achieve greater control over
monetary aggregate growth, money stock (M1) growth
has been highly volatile.1 This volatility continued
through 1982: M l grew at annual rates of 16.7 percent
from November 1981 to January 1982, 3.0 percent
from January to July 1982, and 13.1 percent from July
to December 1982.
Increased volatility in money growth can produce
adverse economic consequences under certain condi­
tions. Both economic theory and evidence suggest that
substantial short-run deviations in money growth from
its longer-run trend affect the growth of spending and
real economic activity.2 For example, as chart 1 illus-

An earlier version o f this p ap er was presented at a Business E co­
nomics and Public Policy W orkshop at Indiana University. We
would like to thank all the participants f o r helpful comments,
especially Lawrence S. Davidson and M ichele Fratianni.
'F o r example, the standard deviation of quarterly M l growth from
IV/1979 to IV/1982 is 5.91. In contrast, the standard deviation for
M l growth from IV/1976 to III/1979 was 1.45.
Some may argue that this comparison is misleading, because the
fluctuations in recent years likely will flatten out over time as
evolving seasonal patterns are captured in the recalculation of
seasonal factors. Others, however, have been highly skeptical of
revisions in seasonal factors, arguing that such revisions artificially
smooth away outliers. For example, William Poole and Charles
Lieberman, “Improving Monetary Control,” Brookings Papers on
Economic Activity (2:1972), pp. 293-335, have stated that “one of
the dangers of the X - l l model is that outliers are all too easily
explained away by a superficial appeal to changing seasonals” (p.
332).
^This type of analysis was presented first by Clark Warburton, “Bank
Reserves and Business Fluctuations,” Jou rn al o f the American
Statistical Association (Decem ber 1948), pp. 547-58, reprinted in
Clark Warburton, D epression, Inflation, and Monetary Policy:
Selected Papers 1945-1953 (The Johns Hopkins Press, 1966), pp.
36-47. Analyses in this tradition also are presented in Milton
Friedman and Anna J. Schwartz, “Money and Business Cycles,”
Review o f Economics and Statistics (Supplement: February 1963),
pp. 32-78; William Poole, “The Relationship of Monetary D ecel­
erations to Business Cycle Peaks: Another Look at the Evidence,”
Journ al o f Finance (June 1975), pp. 697-712; and most recently
Milton Friedman, “Misleading Unanimity,” Newsweek (February
7, 1983), p. 56.




trates, large negative deviations of money growth from
its trend have been associated with each period of
economic decline since 1958.
The increased volatility in money growth has led
many observers to question whether the Federal Re­
serve has the ability to control money growth
adequately.3 Some analysts have suggested that the
Fed must make certain technical changes, such as
implementing contemporaneous reserve accounting,
altering discount rate policy and restructuring reserve
requirements, to better control the money stock.
This article examines whether more stable growth of
the money stock could have been achieved in 1982
without any of the proposed technical changes. To this
end, two simple money stock control procedures are
used to simulate money growth in 1982. One proce­
dure involves increasing the monetary base at a steady
rate. The other involves changing base growth to
offset expected money multiplier changes. The latter
procedure is shown to achieve the hypothetical annual
growth target with little volatility in quarterly money
growth.

3For contrasting views on this issue, see Milton Friedman, “The
Wayward Money Supply,” Newsweek (Decem ber 27, 1982), p. 58;
“The Pitfalls of Mechanical Monetarism,” The Morgan Guaranty
Survey (February 1981), pp. 8-13; and Milton Friedman, “Improv­
ing Monetary Policy,” Newsweek (July 28, 1980), p. 60. More
sophisticated analyses are presented in Board of Governors of the
Federal Reserve System, New M onetary Control Procedures,
Federal Reserve Staff Study, vols. 1 and 2 (Board of Governors,
1981).
One argument is that “large swings” in the demand for money
are direct causes of observed variability in money growth. For
example, see “Statement by Lyle Gramley, member, Board of
Governors of the Federal Reserve System, before the Subcommit­
tee on Domestic Monetary Policy of the House Committee on
Banking, Finance and Urban Affairs, March 3, 1982,” Federal
Reserve Bulletin (March 1982), pp. 174-78. For an alternative
analysis, see Scott E. Hein, “Short-Run Money Growth Volatility:
Evidence of Misbehaving Money Demand?” this Review (June/
July 1982), pp. 27-36; and Kenneth C. Froewiss, “Speaking Softly
But Carrying a Big Stick,” Economic Research (Goldman Sachs,
Decem ber 1982).

17

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

C h a rt 1

Rates of C h a n g e of M o n e y Stock (M l)
Percent

Percent

1960 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 8 0 81 82 1983
[X Two-quarter rate o f c h a n g e.
[2 Twenty-quarter ra te of change; d a t a prior to 1st quarter 1964 a re M l on the old basis.
S h a d e d a re a s represent periods of business recessions. 1 9 8 1 -8 2 tr o u g h is t e n t a t iv e .

18FRASER
Digitized for


MARCH 1983

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
M1 Growth Rates in 1982
Quarterly Growth Rate

Monthly Growth Rate
Preliminary
12/81- 1/82

23.1%

Revised

21.5%

1/82- 2/82

-3 .4

0.5

2/82- 3/82

2.7

1.6

3/82- 4/82

11.5

1.9

4/82- 5/82

- 2 .4

8.6

5/82- 6/82

-0 .3

2.7

6/82-• 7/82

- 0 .3

2.7

7/82- 8/82

10.9

10.8

8/82- 9/82

14.9

13.6

9/82- 10/82

22.6

15.5

10/82-•11/82

18.3

14.4

11/82-■12/82

9.2

11.4

12/81-■12/82

8.5

8.6

MONEY STOCK GROWTH IN 1982
Table 1 lists M l growth for 1982 on a monthly and
quarterly basis. The respective growth rates are calcu­
lated for both preliminary data and the recently re­
vised data, which incorporate both benchmark revi­
sions and revised estimates of seasonal factors. It is
apparent that the recent revisions have smoothed sub­
stantially the fluctuations in both monthly and quarter­
ly money growth. With the exception of March and
April, the revised monthly growth rates all are closer to
the average growth rate over the period. Thus, the
standard deviation of the monthly growth rates is re­
duced substantially by the revisions: 6.84 vs. 9.59.
Similarly, the standard deviation of the quarterly
growth rates is 4.73 for the revised series and 6.62 for
the preliminary series.
This suggests that at least part of the volatility in
money growth last year is attributable to poor pre­
liminary data. For example, the revised numbers indi­
cate that the original estimates of strong money growth
in April, October and November all were exaggerated.
Similarly, the original estimates of negative money
stock growth in February, May, June and July were
incorrect; the revised data show that money growth
was positive during these months.
The fact that revisions in money stock measures have
reduced the volatility in money growth is comforting,
ex post. For a policymaker making decisions in 1982,
however, the extent of the revisions was unknown and



Preliminary

Revised

IV/81-1/82

10.9%

11.0%

1/82-11/82

3.3

3.3

11/82-111/82

3.5

6.3

II1/82-1V/82

17.1

13.9

IV/81 —IV/82

8.5

8.5

the volatility of observed money growth could have
been considered excessive. Because this present
analysis addresses the issue of reducing the volatility of
money growth in an ongoing policy setting, we ignore
the recent revisions in money stock numbers; policy­
makers would not have had this information in 1982
when decisions were being made.4

ACHIEVING GREATER MONEY
GROWTH CONTROL IN 1982: TWO
ALTERNATIVE PROCEDURES
Could the Fed have achieved a more stable pattern
of money growth in 1982 than that evidenced by table
‘'This approach is supported by a recent Federal Reserve Board
report dealing with the problem of seasonal adjustment. In that
report, it is stated that “since the original projections [of seasonal
factors] are what policymakers and other users of the data have to
work with currently in making decisions, the revised data may give
an erroneous impression, after the fact, of what the basis for the
decision was.” Board o f Governors of the Federal Reserve System,

Seasonal Adjustment o f the Monetary Aggregates: R eport o f the
Committee o f Experts on Seasonal Adjustment Techniques (Feder­
al Reserve Board, 1981), p. 35. Cited in David A. Pierce, “Seasonal
Adjustment of the Monetary Aggregates: Summary of the Federal
Reserve’s Committee Report "Jou rn al o f Business and Economic
Statistics (January 1983), pp. 37-^42. Our treatment only adds
realism to the simulations carried out. It does not affect any sub­
stantive conclusions about comparing alternative operating proce­
dures: If revised data are used, the constant-base-growth strategy
still results in quarterly money growth volatility in 1982 similar to
that indicated by revised data, but much greater than that associ­
ated with the multiplier monitoring approach.

19

FEDERAL RESERVE BANK OF ST. LOUIS

1? This question is examined by analyzing two alterna­
tive control procedures, each controlling M l growth
by altering the adjusted monetary base (hereafter re­
ferred to as base).5
The first procedure involves simply holding the
growth of the base constant over the year.6 Because
there generally is a direct relationship between
changes in the growth rate of the base and the money
stock, a constant rate of base growth will, on average,
yield a predictable growth rate o f money. This
approach produces stable short-run M l growth,
however, only if the rate of change of the money multi­
plier — the connecting link between changes in the
base and money — remains constant over time.
Although this typically is the case over longer periods
of time, it is not true over time spans as short as a
month or a quarter. Thus, even though base and
money growth are closely related over periods of a year
or more, short-run money multiplier changes can
cause short-run money growth to deviate substantially
from any particular base growth. This is the primary
weakness with this procedure.
The second control procedure alleviates the shortrun discrepancies between base and M l growth by
anticipating changes in the multiplier and, then, offset­
ting them by appropriate changes in base growth. This

’The base is controlled essentially by Fed actions. On the issue of
the Fed’s ability to control the base, see Anatol B. Balbach, “How
Controllable is Money Growth?” this Review (April 1981), pp.
3-12.
That study found that “the Federal Reserve can control the
monetary base even on a w eekly basis if it so desires. There is, of
course, no question that it can do so over longer periods of time. ” In
this light, no adjustment in achieving a monetary base objective is
made. On measuring the base (on an adjusted basis), see R. Alton
Gilbert, “Revision of the St. Louis Federal Reserve Adjusted
Monetary Base,” this Review (Decem ber 1980), pp. 3-10; and John
A. Tatom, “Issues in Measuring An Adjusted Monetary Base,” this
Review (Decem ber 1980), pp. 11-29.
'This approach has been advocated in recent statements of the
Shadow Open Market Committee. This is because “[C]urrent
institutional changes have less effect on the growth of the base than
on most other aggregates. ” See "Policy Statement of the Shadow
Open Market Committee, March 16, 1981,” Annual Report, Cen­
ter for Research in Government Policy & Business (June 1981), pp.
31-35, especially pp. 33-34. This advocacy also is found in the
September 14, 1981, “Policy Statement. ” This argument presup­
poses that stable M l growth may not be desirable with all of the
current institutional changes. In contrast, the present article pre­
supposes that stable M l growth is desirable and seeks to determine
the extent to which it may be achieved. O f course, the desirability
o f stable money growth depends on the stability of the demand for
money, a matter not addressed in this article. Fo r a study that also
recommends base instead of money stock targeting, see Leonall C.
Andersen and Denis S. Karnosky, “Some Considerations in the
Use of Monetary Aggregates for the Implementation of Monetary
Policy,” this Review (Septem ber 1977), pp. 2-7.

Digitized for 20
FRASER


MARCH 1983

procedure involves using one-period-ahead multiplier
forecasts to determine the extent to which the base
should be expanded or contracted.7 Two methods of
forecasting money multiplier developments are con­
sidered for this procedure.

T he Constant-Base-Growth P rocedure
Analysis of M l growth and its volatility requires
choosing some desired target level or range. In the
analysis which follows, the top of the announced 1982
annual M l target range — 5.5 percent growth — was
selected as a hypothetical operating target.8 Table 2
enumerates the desired monthly level of M l that
would be consistent with achieving this growth target
with no short-run variation in M l growth (see column
1). Because the money stock is the product of the
multiplier and the base, the growth rate of M l (M l) is
approximately equal to the growth rate of the money
multiplier (m) plus the growth rate of the base (AMB):
(1)

Ml = m + AMB.

As equation 1 shows, it is necessary to predict m in
order to determine the appropriate AMB to provide.
During the last 12 years (1970-81), the level of the
money multiplier has been declining on average; m has
averaged —1.1 percent. Thus, over this period, base
growth, on average, exceeded M l growth by 1.1 per­
cent. This was assumed to continue in 1982. To achieve
the desired M l growth of 5.5 percent under the base
control procedure considered here, therefore, the
money multiplier is “predicted” to decline at a 1.1
percent rate during 1982. Given the assumed rate of
decline in the money multiplier, a constant 6.6 percent
rate of increase in the base would be needed to yield
the targeted 5.5 percent money growth. This required
base path (in levels) is shown in column 3 of table 2.
The constant-base-growth strategy would have re­
sulted in stable money growth only i f the money multi­
plier declined in a steady fashion as presumed. During
1982, however, the money multiplier was highly vola­
tile by historical standards (see column 2 of table 2).
For example, based on original data, the difference
between the maximum and minimum level of the mul-

7A similar argument for using money multiplier forecasts as a basis
for policy actions is presented in Balbach, “How Controllable is
Money Growth?” and James M. Johannes and Robert H. Rasche,
“Can the Reserves Approach to Monetary Control Really W ork?”
Jou rn al o f Money, C redit and Banking (August 1981), pp. 298-313.
8It should be noted that the Federal Open Market Committee
temporarily ended its practice of adopting short-run targets for M 1
in October 1982, because of difficulties in interpreting its behavior.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Table 2
M1 Growth Under Constant 6.6 Percent Base Growth
(seasonally adjusted, original data)
Simulated M1 growth rate
Period

Targeted M11
(1)

12/81

Actual multiplier

Simulated base1

Simulated M11

Monthly

Quarterly

(2)

(3)

(4)

(5)

(6)

2.5951

1/82

$442.9

2.6142

$170.8

$446.5

2/82

444.9

2.5826

171.7

442.9

- 9 .3

3/82

446.8

2.5809

172.6

445.5

7.3

16.4%

4/82

448.8

2.5837

173.6

448.5

8.4

5/82

450.9

2.5566

174.5

446.1

- 6 .2

6/82

452.9

2.5374

175.4

445.1

- 2 .7
5.8

7/82

454.9

2.5354

176.4

447.2

8/82

456.9

2.5388

177.3

450.1

8.1

9/82

459.0

2.5598

178.2

456.2

17.5

10/82

461.0

2.5893

179.2

464.0

22.6

11/82

463.1

2.6142

180.2

471.1

19.7

12/82

465.1

2.6096

181.1

472.6

3.9

7.8%

1.5

4.2

17.0

Simulated M1 growth: December 1981 to December 1982, 7.2%
Actual M1 growth:

December 1981 to December 1982, 8.6%

1Billions of dollars.

tiplier in 1982 was 0.079. During the past decade this
difference was exceeded by multiplier developments
only during 1974.
Column 4 in table 2 shows the simulated money
stock levels for 1982 holding base growth at a constant
6.6 percent throughout 1982, and assuming that the
money multiplier would have behaved exactly as it
did.9 Two important results emerge from this simula­
tion. First, the patterns of both monthly and quarterly
M l growth produced by the constant-base-growth
approach (columns 5 and 6) are similar to those that
actually occurred. For example, the very strong money
growth observed in January would have been lessened

9It might be argued that the actual money multiplier pattern would
have been considerably different if the Federal Reserve actually
had operated under such a control procedure. In this case, the
resultant money growth would have been different from that re­
ported here. This criticism is predicated on the belief that changes
in base growth are associated with changes in the money multi­
plier. This belief is not well supported by recent data, however.
For example, base growth was relatively stable in 1982, yet money
multiplier growth was more volatile than any year since 1974.
Moreover, for the period 1979 to 1982, the correlation between
monthly base and multiplier growth is an insignificant 0.07. Thus,
money multiplier movements do not appear to be related signifi­
cantly to monetary base growth.




only slightly by adopting a constant-base-growth
strategy (23.1 percent vs. 16.4 percent). M l growth
from January through July 1982 would have been even
weaker than actually occurred (1.2 percent vs. 0.3
percent), and the strong M l growth from July to D e­
cember 1982 would have been reduced only slightly
(15.1 percent vs. 14.2 percent).
The similarity between actual and simulated M l
growth for 1982 is not an aberration; base growth was
indeed fairly stable last year. The volatility in M l
growth last year was attributable, in large part, to
money multiplier developments, not erratic base
growth. Thus, those critical of the Fed for the volatile
money growth last year should recognize that a constant-base-growth strategy would not have mitigated
this problem.
The second important finding is that M l growth
from December 1981 to December 1982 would have
exceeded the hypothetical target by 1.7 percentage
points if the base had grown at a steady 6.6 percent
over the year. The hypothetical growth rate target was
5.5 percent; M l growth would have been about 7.2
percent under a policy of constant base growth. This
“miss” of the annual M l target occurred because the
money multiplier essentially was unchanged between
21

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Table 3
M1 Growth Using Last Month’s Multiplier as a Forecast of This Month’s Multiplier
(seasonally adjusted, original data)
___________
Simulated M1 growth rate
Period

Targeted M11
(1)

12/81

Actual multiplier

Simulated base’

Simulated M11

Monthly

Quarterly

(2)

(3)

(4)

(5)

(6)

2.5951

1/82

$442.9

2.6142

$170.7

$446.2

2/82

444.9

2.5826

170.2

439.5

-1 6 .6

3/82

446.8

2.5809

173.0

446.5

20.9

4/82

448.8

2.5837

173.9

449.3

7.8

5/82

450.9

2.5566

174.5

446.2

- 8 .0

6/82

452.9

2.5374

177.1

449.5

9.2

7/82

454.9

2.5354

179.3

454.5

14.2

8/82

456.9

2.5388

180.2

457.5

8.2

9/82

459.0

2.5598

180.8

462.8

14.8

10/82

461.0

2.5893

180.1

466.3

9.5

11/82

463.1

2.6142

178.9

467.6

3.4

12/82

465.1

2.6096

177.9

464.3

-8 .1

15.3%
7.0%

3.7

9.2

7.0

Simulated M1 Growth: December 1981 to December 1982, 5.3%
Actual M1 Growth:

December 1981 to December 1982, 8.6%

’ Billions of dollars.

December 1981 and December 1982, instead of de­
clining at an assumed rate of 1.1 percent as it had on
average over the preceding 10 years. Thus, both the
pattern and average level of money growth last year
were affected by unusual money multiplier develop­
ments, developments that would have had adverse
impacts on a constant-base-growth rule.

MONITORING MONTHLY
MULTIPLIER DEVELOPMENTS
The previous section demonstrates that short-run
money multiplier movements must somehow be taken
into account if more stable money growth is to be
achieved. One way to accomplish this is to obtain
one-month-ahead money multiplier forecasts and to
adjust base growth to offset increases or decreases in
the multiplier. Two ways of doing this are considered.

Naive Forecast: Monthly M onitoring o f the
M ultiplier
The simplest procedure to forecast next month’s
money multiplier is to assume that it will equal the
Digitized for22
FRASER


current month’s multiplier plus a random error (|xt)
which can be assumed to be zero on average:10
(2)

m t = m t _ ! + n ,.

Once the multiplier is forecast, the amount of base
needed to achieve the desired level of M l is then
determined residually. For example, if the multiplier
is forecast to be 2.60 next month and the target for M l
next month is $450 billion, the policy directive would
be to achieve a $173.1 billion ($450/2.60) base level
next month. In this way, multiplier changes, to the
extent that they are forecast, are offset by altering the
base to maintain a desired path for M l. If the multi­
plier were projected to be only 2.50 next month, for
example, then this procedure would require $180 bil­
lion ($450/2.50) in base to achieve the same M l target
of $450 billion.
Table 3 summarizes the results for 1982 using this
technique to achieve the same steady 5.5 percent
growth rate of M l as before. In comparison to the
constant-base-growth strategy, monthly monitoring of

10See Balbach, “How Controllable is Money Growth?”

MARCH 1983

FEDERAL RESERVE BANK OF ST. LOUIS

multiplier developments mitigates both problems of
excessive volatility and missing the annual objective.
The variability in quarterly M l growth is reduced sub­
stantially under the multiplier monitoring procedure
(compare columns 6 in tables 2 and 3). In particular,
this procedure would not have produced the sharp
midyear slowdown in money growth relative to
trend. The simulated money growth from 1/1982 to
III/1982 under this procedure would have been 6.4
percent, substantially higher than the 2.8 percent
growth simulated under the constant-base-growth
strategy.
Moreover, it also would have produced more stable
quarterly growth in M l last year than that simulated
with the constant-base-growth strategy: the standard
deviation of the quarterly growth rates is 6.76 for the
constant-base-growth strategy and 2.27 for the proce­
dure using naive multiplier forecasts. This increased
quarterly stability is achieved, however, at the ex­
pense of slightly more volatile monthly money growth.
For example, the standard deviation of the simulated
monthly M l growth for the constant-base-growth
approach was 10.21; the figure for the simulated M l
growth using the multiplier forecast approach was
11.27 percent.
The increase in the monthly volatility of M 1 growth
is a direct consequence of the procedure itself; the
monthly m onitoring procedure achieves stable
quarterly money growth by reacting quickly to unex­
pected monthly disturbances in the money multiplier.
Thus, when the multiplier declined sharply in May,
this procedure produced a swift policy response in
terms of sharply increased base growth in subsequent
months. Consequently, the money stock would have
been much closer to the hypothetical target level in
August than was the case with the constant-basegrowth strategy.

monetary control described here would be superior to
the constant-base-growth strategy.11

M ore Sophisticated M ultiplier Forecasts:
Time Series Techniques
The forecasting technique described above — using
last month’s multiplier — is simple but ad hoc. There
is no a priori reason to suspect that such a forecasting
procedure would be especially reliable. Thus, more
sophisticated time series forecasting models should be
considered.12
Statistical evidence suggests that one can improve
upon the preceding forecasting model, which merely
uses last month’s multiplier as a prediction for this
month’s multiplier.13 This improvement is derived by
developing a time series model that explains changes
in the multiplier (i.e., mt — mt_x) by using the in­
formation contained in the non-random component of
the forecast errors from equation 2. More formally, the
time series model chosen is represented by
(3)

m, - mt_i = (xt + bi |xt _!

"T his operating procedure previously has been shown to reduce
quarterly money volatility and better achieve the long-run objec­
tive in 1980 (in Balbach, “How Controllable is Money Growth?”).
Similar gains also would have been achieved in 1981. Based on
first-revised data and aiming for a D ecem ber 1980 to D ecem ber
1981 growth rate of 7.0 percent, this procedure would have
yielded 7.2 percent simulated growth, with the lowest quarterly
growth rate being 4.5 percent and the highest quarterly growth
rate being 8.2 percent. The actual growth for this period was 6.4
percent, with the quarterly growth rates ranging from 0 .5 percent
to 8.9 percent.
12The following analysis continues in the tradition of Eduard J.
Bomhofl, “Predicting the Money Multiplier: A Case Study for the
U .S. and the Netherlands, Jou rn al o f Monetary Economics (July
1977), pp. 325-45; James M. Johannes and Robert H. Hasehe,
“Predicting the Money Multiplier,” Jou rn al o f Monetary E co­
nomics (July 1979), pp. 301-25; Johannes and Rasche, “Can the
Reserves Approach to Monetary Control Really W ork?” and
Michele Fratianni and Mustapha Nabli, “Money Stock Control in
the E E C Countries,” W eltwirtschaftliches Archiv (Heft 3:1979),
pp. 401-23.

This simple procedure of controlling M 1 growth also
is much more successful than the constant-basegrowth strategy in achieving the desired M l growth
target of 5.5 percent. M l growth from December 1981
to December 1982 would have been 5.3 percent under
this simple multiplier forecasting procedure, com­
pared with a 7.2 percent growth rate under the con­
stant-base-growth strategy.

13As a first step in such analysis, the autocorrelation of the first
difference in the money multiplier (m, — in, j ) was examined for
the period January 1959 to Decem ber 1981. For last month’s
multiplier to be an effective forecast of this month’s multiplier, the
change in the multiplier should not be autocorrelated. Any evi­
dence of autocorrelation suggests that there is information in the
past history of the multiplier that could be used to improve the
forecast.

If policy were directed toward achieving stable quarter-to-quarter M l growth and strengthening the Fed’s
ability to hit an annual target, the simple technique of

Examining the autocorrelation function of the multiplier ’s time
series indicates that, for the sample period January 1959 to D e­
cem ber 1981, the hypothesis that current changes in the multi­
plier are independent of past changes can be rejected at the 5
percent significance level.




23

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Table 4
M1 Growth Using One-Month-Ahead Money Multiplier Forecast
Estimated Model: mt = -0 .0 0 2 + |xt + 0.196
(seasonally adjusted, original data)
Simulated M1 growth rate

Period

Targeted M11
(1)

12/81

Actual
multiplier

Forecast
multiplier

Simulated base1

Simulated M11

Monthly

Quarterly

(2)
2.5951

(3)

(4)

(5)

(6)

(7)

1/82

$442.9

2.6142

2.5914

$170.9

$446.8

2/82

444.9

2.5826

2.6078

170.6

440.6

-1 5 .4

3/82

446.8

2.5809

2.5855

172.8

446.0

16.0

4/82

448.8

2.5837

2.5798

174.0

449.5

9.7

446.6

- 7 .5

5/82

17.3%

450.9

2.5566

2.5809

174.7

6/82

452.9

2.5374

2.5594

176.9

449.0

6.5

7/82

454.9

2.5354

2.5397

179.1

454.1

14.7

8/82

456.9

2.5388

2.5342

180.3

457.7

10.0

9/82

459.0

2.5598

2.5359

181.0

463.3

15.6

10/82

461.0

2.5893

2.5531

180.6

467.6

11.6

11/82

463.1

2.6142

2.5793

179.5

469.3

4.7

2.6096

2.6049

466.0

- 8 .2

12/82

465.1

178.6

7.3%

3.6

9.2

8.3

Simulated M1 Growth: December 1981 to December 1982, 5.7%
Actual M1 Growth:

December 1981 to December 1982, 8.6%

1Billions of dollars.

where |xt is the error from equation 2. An examination
of the data revealed that the error in the multiplier
process last month (|At_ i) exerted a statistically signifi­
cant effect on the change in the multiplier for this
month. Moreover, the analysis indicated the existence
of a slight negative trend in the data. Using this extra
information and estimating the appropriate version of
equation 3 for the period January 1959 to December
1981 yielded the following results:

more reliable model of the multiplier than the naive
model used in the previous section, there is really little
substantive difference between the two models. The
naive model (equation 2) suggests that changes in the
multiplier are random disturbances (|xt), while the
time series model (equation 4) only adds a negative
trend term and the impact of last period’s disturbance
(|xt_ j). Thus, there may well be little difference in the
forecasts.

(4)

The results found in table 4 suggest that this is
indeed the case. The time-series model given by equa­
tion 4 was used to forecast the monthly values of the
multiplier for 1982 by continuously updating the fore­
cast to incorporate last month’s money multiplier de­
velopments. The one-step-ahead money multiplier
forecasts are listed in column 3. The table also shows
the amount of base injection (column 4) required each
month to achieve the hypothetical 5.5 percent M l
growth path if the multiplier behaved as the time series
model predicted. In addition, the table lists the level
and growth of M l that would have resulted from the
simulated base injections had the multiplier behaved
as it actually did (columns 5, 6 and 7).

mt — mt_ ! = —0.002 + |xt + 0.196 fxt

where again |xt represents the random, unforeseen
“innovation” to the multiplier process.14
While, for this sample, equation 4 is statistically a
14All data are seasonally adjusted. The estimated standard error
of the model is 0.00118 and the Ljung-Box Q-statistic Q(12),
distributed as a \2 with 10 degrees of freedom, is 11.53. Because
the reported Q-statistic is even less than the 30 percent critical
value (x2 = 11.80), the hypothesis of independent residuals can­
not be rejected, even at this high level.
For further details on this approach to forecasting economic
time series, see C. W. J. Granger and Paul Newbold, Forecasting
Economic Time Series (Academic Press, 1977).

Digitized for24
FRASER


FEDERAL RESERVE BANK OF ST. LOUIS

The simulated money growth developments using
this procedure are similar to those using the naive
forecast strategy (see table 3). For example, the aver­
age monthly M l growth simulated in table 4 is 5.9
percent; the comparable figure using the naive model
(table 3, column 5) is 6.2 percent. The quarterly
simulations are also similar; in particular, the two suc­
cessive quarters of very weak money growth simulated
under the constant-base-growth strategy are avoided
by either of these forecasting procedures.
Because the multiplier forecasts derived from the
naive and sophisticated models are not that different,
the lessons learned from the naive model results are
supported by the evidence found in table 4 for the
more sophisticated model.15 In particular, this multi­
plier forecasting procedure comes closer than the
constant-base-growth strategy to achieving the hypo­
thetical M l growth target. In addition, quarterly vola­
tility in money growth is reduced substantially using

15While the 1959-81 sample period results indicate some statistical
gain over the naive model in explaining changes in the multiplier,
the forecasting experience from 1982 shows that, as a practical
matter, little would have been gained from employing the more
sophisticated model. This is a limited sample on which to draw,
however, and one should not conclude that the simple no-change
model is equally sufficient in all time periods.




MARCH 1983

either multiplier forecasting technique.16 Thus, if
quarterly money growth fluctuations affect real eco­
nomic activity as suggested earlier, the multiplier fore­
casting approach to conducting monetary policy
appears superior to the constant-base-growth strategy.

CONCLUSION
Monetary policy actions that utilize a constant-basegrowth procedure generally will not achieve stable
short-run money growth. A post-mortem of 1982
money growth indicates that much of the volatility in
money growth last year was attributable to money
multiplier fluctuations, not erratic monetary base
growth. Consequently, monetary policy aimed at
smoothing the growth of M l must anticipate and react
to multiplier movements. This article shows that either
a naive approach to multiplier predictions or a more
sophisticated time series model would have enabled
policymakers to achieve smoother quarter-to-quarter
changes in M l by varying the growth of the adjusted
base to offset changes in the multiplier.

16F or an earlier analysis of this type that reaches similar conclusions,
see Albert E. Burger, “The Relationship Between Monetary Base
and Money: How Close?” this Review (October 1975), pp. 3-8.

25

Bank Holding Company Performance
Studies and the Public Interest: Normative
Uses for Positive Analysis?
DONALD M. BROWN

X _ T NDER the Bank Holding Company Act of 1956,
the Board of Governors of the Federal Reserve System
must consider the convenience and needs of the com­
munity when ruling on applications by bank holding
companies to acquire bank subsidiaries. In each case,
the Board must decide, first, whether the benefits
ascribed by the applicant would be realized and
second, whether the proposed acquisition would fur­
ther the public interest.
In its past decisions, the Board has focused on some
specific potential effects of holding company acquisi­
tions in assessing whether the acquisition would fur­
ther the convenience and needs of the community. A
number of these appear to be related to standard finan­
cial ratios computed from the financial statements of
banks. The impact of bank holding companies on these
financial ratios has been investigated and widely re­
ported in a host of bank performance studies. Thus,
although there is no evidence that the Board has used
such studies in reaching its decisions, bank perfor­
mance studies could provide useful information about
holding company acquisitions.
The primary purpose of this article is to determine
whether performance studies actually are capable of
identifying performance differences among banks and,
hence, whether they are relevant to policy decisions
about bank holding company acquisitions. The first
section briefly reviews the convenience and needs test
as it relates to bank acquisitions and its implementation
by the Board of Governors. The second section
summarizes the results of previous performance stu­
dies. The third section investigates the conceptual dif­
ficulties with interpreting financial ratios as measures
of bank performance. The final section draws conclu­
sions about the implications of performance studies for
both bank performance and public policy toward bank
holding companies.
Digitized for 26
FRASER


THE BOARD AND THE
CONVENIENCE AND NEEDS TEST
Bank holding companies must apply to the Federal
Reserve Board for permission to acquire a bank.1 In
analyzing the application, the Board must consider the
effect on the convenience and needs of the community
and must weigh this effect against anticompetitive
effects stemming from an acquisition. According to the
present judicial interpretation of the Bank Holding
Company Act, the Board cannot apply competitive
standards stricter than those in the anti-trust laws (see
box).
The Federal Reserve Board’s treatment of conveni­
ence and needs in bank holding company applications
has been investigated through examination of pub­
lished Board orders relating to its various decisions.2
'Bank Holding Company Act of 1956, as amended, 12 U .S.C . 1841

et seq.
2Jules Backman, The Batik Holding Company Act, Bulletin No.
24-25 (New York University, C .J. Devine Institute of Finance,
April-June 1963); and Michael A. Jessee and Steven A. Seelig, “An
Analysis of the Public Benefits Test of the Bank Holding Company
Act,” Federal Reserve Bank of New York Monthly Review (June
1974), pp. 151-62. These articles were reviewed by Anthony W.
Cyrnak, “Convenience and Needs and Public Benefits in the Bank
Holding Company M ovem ent,” in The Bank Holding Company
Movement to 1978: A Compendium (Board of Governors of the
Federal Reserve System, 1978), pp. 263-89. Jessee and Seelig later
updated their study through June 1976; their findings, with respect
to the Board’s treatment of convenience and needs in bank acquisi­
tions, essentially were unchanged from their original study. See
Michael A. Jessee and Steven A. Seelig, Bank Holding Com­
panies and the Public Interest (D. C. Heath and Company, 1977),
chapter 5.
The Jessee and Seelig study is more relevant because its sample
period, January 1971 to mid-1974, postdates amendments to the
Bank Holding Company Act. The early 1970s was a period of rapid
bank holding company expansion. During the 3lA years covered by
the Jessee and Seelig study, the Board issued orders approving 434
holding company applications to acquire banks, while 47 denial
orders were issued (including orders denying some non-bank ac­
quisitions). Comparatively, only 37 orders were issued during
Backman s sample period of 1956-62.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Legal Provisions and Interpretation of the Bank
Holding Company Act
The circumstances under which a bank acquisition
must be denied are set out in the following section of the
Bank Holding Company Act, which is generally referred
to simply as section 3(c):
The Board shall not approve —
(1) any acquisition or merger or consolidation under this
section which would result in a monopoly, or which
would be in furtherance of any combination or con­
spiracy to monopolize or to attempt to monopolize the
business of banking in any part of the United States, or
(2) any other proposed acquisition or merger or consolida­
tion under this section whose effect in any section of
the country may be substantially to lessen competition,
or to tend to create a monopoly, or which in any other
manner would be in restraint of trade, unless it finds
that the anticompetitive effects of the proposed trans­
action are clearly outweighed in the public interest by
the probable effect of the transaction in meeting the
convenience and needs of the community to be served.
In every case, the Board shall take into consideration the
financial and managerial resources and future prospects of
the company or companies and the banks concerned, and
the convenience and needs of the community to be
served.1

In section 3(c)(2), the phrase “may be substantially to
lessen competition, or to tend to create a monopoly” was
taken verbatim from section 7 of the Clayton Act.2 Its
adoption was dictated by the Supreme Court’s decision in
the Philadelphia National Bank case of 1963 in which the
Court first applied the competitive standards of section 7
to block a bank combination.3
‘ 12 U .S.C . 1842(c).
215 U .S.C . 18.

3United States v. Philadelphia National Bank, .374 U .S. 321
(1963).

In these published orders, the Board addresses the
benefits claimed by the applicant; it also may cite
factors it finds inimical to the convenience and needs of
the community.3 The benefits most often cited in
orders approving bank acquisitions by holding com­
panies are shown in exhibit A.4
^The orders are legal documents, written according to a formula and
varying little in their wording. The effect of bank acquisitions on
convenience and needs is described frequently as “consistent with
approval. ” The orders do not include an analysis of the quantitative
effect of prospective benefits; consequently, the weight attached to
a benefit in any application generally is not evident from the text of
the order.
4Jessee and Seelig, Bank Holding Companies, table 5-1, pp. 52-53.
The same table with only minor changes appears in Jessee and




The Clayton Act does not mention a countervailing role
for convenience and needs. In the Philadelphia decision,
the court asserted that “a merger the effect of which ‘may
be substantially to lessen competition is not saved be­
cause, on some ultimate reckoning of social or economic
debits and credits, it may be deem ed beneficial. ”4
W hether the amended Bank Holding Company Act has
precedence over the anti-trust laws is a legal question. It
has been moot so far, because the Board has never
approved an acquisition when it found an anti-trust viola­
tion.
The Board maintains that the last sentence of section
3(c) subsumes actual or potential adverse competitive
effects that do not amount to violations of the anti-trust
laws.5 Though it found no anti-trust violation, the Board
in 1979 denied on competitive grounds the application of
County National Bancorporation to acquire T. G. Bancshares Company because “considerations relating to the
convenience and needs of the community to be served are
insufficient to outweigh the anticompetitive effects that
would result from consummation of this proposal. ”fi This
decision later was overturned by the Eighth Circuit Court
of Appeals.' Thus, the present judicial interpretation is
that convenience and needs effects are distinct from anti­
competitive effects of bank acquisitions by bank holding
companies.
4Ibid.,

p.

371.

’ 12 C .F .R . 250.182.
6County National Bancorporation, ‘Order Denying Acquisition
and Formation of Bank Holding Companies, ” F ederal Reserve
Bulletin (September 1979), pp. 763-64.

‘County National Bancorporation v. B oard o f G overnors o f the
Federal Reserve System, 654 F.2d 1253 (8th Cir. 1981).

What C onveniences? W hose N eeds?
The Board of Governors has a difficult task in im­
plementing the convenience and needs test. A chief
difficulty is that the interests of all sectors of the com­
munity do not coincide. A policy of making only “riskfree” loans, for example, may benefit some depositors
at the expense of prospective borrowers and the bank’s
Seelig, “Analysis of Public Benefits T est,” table 1, p. 153. The
authors’ use of six categories of benefits is misleading, as section
3(c) of the Bank Holding Company Act requires that benefits fit into
three categories: financial or managerial resources, future pros­
pects or convenience and needs.

27

FEDERAL RESERVE BANK OF ST. LOUIS

Exhibit A
Benefits Cited in Orders of Approval
Convenience and needs:
Providing an alternative source of services to a market
Increased lending capacity to support strong economic growth
in an area
Increased lending capacity to stimulate growth in economically
depressed areas
Expansion of specialized credit services
Increased competition:
Increased competition through de novo entry
Reduction of rates charged on loans or other sen/ices
Strengthening the competitive position of a small firm through
affiliation with a larger bank holding company
Increasing competition by changing a limited service institution
into a full-service firm
Changing a conservative firm into a more aggressive competi­
tor
Improved efficiency:
Economies of scale
Complementary skills
Improved financial resources:
Acquiring a financially weak firm
Improving the debt-to-equity ratio of the acquired firm
Injecting a specific amount of equity capital into the acquired
firm
Providing “ access to the greater financial resources” of the
holding company
Injecting a specific amount of equity capital into existing bank
subsidiary
Improved managerial resources:
Alleviating management succession problems
Providing management depth
Access to managerial resources of holding company
Other benefits:
Lowering management fees for subsidiary banks

stockholders.5 A relevant social welfare function would
be required to relate the anticipated effects of bank
holding company acquisitions theoretically to “the
public interest. ” Economists have not produced such a
’ Some prospective borrowers would be denied credit and stock­
holders would earn a lower return on their investments. Depos­
itors who are restricted to below-market interest rates (for exam­
ple, a zero rate on non-personal demand deposits) probably could
not gain, but might lose, if the bank made “risky” loans.
The interest of the bank’s stockholders is of only secondary
concern, because the Board’s legislative mandate is to safeguard
the convenience and needs of the community. Jessee and Seelig
cite statements to this effect by members of the Board. See Jessee
and Seelig, “Analysis of Public Benefits T est,” p. 161.

Digitized for 28
FRASER


MARCH 1983

function; consequently, the benefits cited by the
Board, at best, are ad hoc approximations to the public
interest. This is generally the best that can be done
when normative assessments are required.
A separate issue that the Board must face is whether
the effects that it has associated with convenience and
needs will actually result if the acquisition is approved.
For example, will an acquisition actually convert a
staid bank into a more aggressive lender? Empirical
investigations of this issue are available in a host of
bank performance studies that have examined the
effects of ownership on bank operating characteristics.
Thus, in this instance, positive studies of bank operat­
ing characteristics might provide some useful back­
ground for the normative evaluations required of the
Board.

RESULTS OF PERFORMANCE
STUDIES
Performance studies have used different samples
and empirical approaches. Not surprisingly, they often
have attributed different effects to bank holding com­
pany ownership; they are remarkably consistent,
however, in several important ways.
First, the studies have found virtually no difference
in financial ratios between independent and bank hold­
ing company banks, prior to the acquisition of the latter
by holding companies.
Second, holding company banks generally hold a
higher proportion of their assets in loans and the
obligations of states and municipalities, and a smaller
proportion in cash and U.S. government securities,
than comparable independent banks.
Third, bank holding companies generally have not
had a sizable effect on the performance measures of
their subsidiary banks. Holding company ownership
typically has had a statistically significant effect on only
a small proportion of the financial ratios included in the
various performance studies. It has not been near the
top of the list of factors that influence measures of bank
performance.6 The single exception is the study re­
6Mayne and Jackson each computed beta coefficients, which are
intended to measure the relative importance of the independent
variables in a multiple regression. They both estimated several
regession equations, so their results cannot be summarized conve­
niently. In most of their regressions, bank holding company own­
ership was of middling or lesser importance. See Lucille S. Mayne,
“A Comparative Study of Bank Holding Company Affiliates and
Independent Banks, 1 9 6 9 -1 9 7 2 ,” Jou rn al o f Finance (March
1977), pp. 147-58; and William Jackson, “Multibank Holding
Companies and Bank Behavior” (Working Paper 75-1, Federal
Reserve Bank of Richmond, July 1975).

FEDERAL RESERVE BANK OF ST. LOUIS

porting that holding company banks are more highly
leveraged than independent banks.'
In other respects, the findings have been less consis­
tent. There is conflicting evidence on the effects of
holding company ownership on (1) service charges on
demand deposits and interest rates on time and savings
deposits, (2) operating expenses, and (3) financial
leverage (the ratio of total assets or debt to capital).
Table 1 summarizes the results of performance studies.

ARE RANK PERFORMANCE STUDIES
RELIARLE GUIDES FOR PURLIC
POLICY?
Bank performance is worth investigating, regardless
of its implications for public policy toward bank hold­
ing company acquisitions. If the methodology is valid,
bank performance studies can help economists under­
stand how market characteristics affect bank operating
results and why bank holding companies account for an
increasing share of banking activity. But these studies
also may indicate the likelihood that some of the bene­
fits identified in previous Board orders will result from
acquisitions of banks by bank holding companies.
Consider again exhibit A, the benefits cited in pre­
vious Board orders approving bank holding company
acquisitions. Some of these benefits could be mea­
sured by financial ratios: The level of a specialized
credit service could be represented by the ratio of a
particular type of loan to the loan portfolio. Competi­
tion or the interest rate on loans could be represented
by the ratio of interest revenue to the loan portfolio.
Aggressiveness could be measured by the ratio of total
loans to total assets. Economies of scale could be mea­
sured by the ratio of operating costs to total assets. The
debt-to-equity ratio could be computed from a bank’s
financial reports. Other benefits are unrelated to finan­
cial ratios; management “depth” or problems of succes­
sion, for example, cannot be measured by any ratio.
The same financial ratios that could be used to mea­
sure certain prospective benefits of bank holding com­
pany acquisitions also appear in performance studies as
measures of bank performance (see table 1).
Bank performance studies share a common meth­
odology. They compare independent banks and bank
' Mingo found that the difference increased with the level of market
concentration. In the most highly concentrated banking market in
his sample, the ratio of capital to total assets was 38 percent lower in
holding company banks, other factors held constant. The lower
ratio is equivalent to higher leverage. S e eJo h n J. Mingo, “Manage­
rial Motives, Market Structures and the Performance of Hold­
ing Company Banks,” Economic Inquiry (September 1976), pp.
411-24.




MARCH 1983

holding company subsidiaries on the basis of various
financial ratios, computed from the consolidated re­
ports of income and condition that all insured banks
periodically file with their regulators. These reports
have standard formats that vary only slightly for large
banks and banks engaged in certain foreign enter­
prises.8 The same financial ratios, therefore, can be
compared for all insured banks. The performance
studies hypothesize that “good” or “bad” performance
depends on the values of these financial ratios. Neither
the relationship between performance and the finan­
cial ratios, nor the predicted effects of bank holding
companies on the ratios, is derived theoretically. Like
the measures of the public interest discussed previous­
ly, these ratios represent ad hoc measures of per­
formance.
Are these ratios reliable guides to either bank per­
formance or the public interest? It seems not.9 First,
the empirical approaches employed in performance
studies have various shortcomings. Second, these
ratios are distorted by differences in accounting
method, organizational structure and portfolio com­
position that cannot be captured by balance sheet and
income statement data; moreover, they are not strictly
comparable across independent banks and holding
company banks.

Weaknesses o f Em pirical A pproaches
Early performance studies used t-tests of differences
in the means to evaluate the effects of holding com'tThe reports consolidate the financial results of a bank’s main office,
subsidiaries and branches (if any).
9Bank performance studies generally did not draw policy implica­
tions from their findings. Although early studies made explicit
reference to the statutory convenience and needs test, their con­
clusions generally were limited to discussions of bank perfor­
mance. Later studies did not refer to the convenience and needs
test. Mayne went so far as to say that her results “do not relate to
increased services or convenience . . . ” See Mayne, “Comparative
Study, p. 157. If she was referring to the Federal Reserve Board’s
interpretation of the public interest, then she was too circumspect.
On the other hand, Jackson averred that holding company acquisi­
tions of “well-managed” banks promise “few public benefits. ” See
Jackson, “Multibank Holding Companies,” p. 26.
Despite their unwillingness to make policy recommendations,
the authors of performance studies apparently have an implicit
standard for deciding whether bank holding companies are bene­
ficial. For example, Rose and Scott described a higher ratio of other
expenses to total assets among holding company banks as “alarm­
ing” and a lower ratio of farm real estate loans to total assets among
holding company banks as a “deficiency.” See Peter S. Rose and
William L. Scott, “The Performance of Banks Acquired by Holding
Companies, ” Review o f Business and Economic Research (Spring
1979), pp. 29 and 31. All the performance studies refer to “bank
performance.” The term implies an objective or subjective stan­
dard for distinguishing superior from inferior performance.

29

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1983

Table 1
Empirical Results of Performance Studies____________________________________
Univariate Studies

Lawrence
Revenues and Expenses
Operating Revenue/
Total Assets
(+ )
Net Income/Total
Assets
Total Operating
Expenses/Total
Assets
(+ )
Other Operating
Expenses/Total
Assets
(+ )
Salaries and Wages/
Total Assets
n.s.
Prices
Service Charges/
Demand Deposits
Deposit Interest/
Time and
Savings Deposits
Interest on Loans/
Total Loans
Portfolio Composition
Loans/Total Assets
Business Loans/
Total Assets
Real Estate Loans/
Total Assets
Installment Loans/
Total Assets
U.S. Government
Securities/Total
Assets
Cash/Total Assets
State and Municipal
Securities/Total
Assets
Leverage (Total
Assets or
Debt/Capital)

Talley

Multivariate Studies

Ware

Hoffman

(+ )

(+ )

n.s.

n.s.

n.s.

n.s.

(+ )

n.s.

(+ )

5

Johnson
and
Meinster1

Jackson

Mingo2

(+ )

n.s.

n.s.

(+ )

(+ )

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

(+ )

n.s.

n.s.

n.s.

n.s.

(+ )

(+ )

<+)

n.s.

(+ )

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

(+ )

(+ )

n.s.

(-)
(-)

(-)
n.s.

n.s.

n.s.

(-)

(-)

(+ )

)

(+ )

(+ )

n.s.

(+

(-)

Graddy
and
Kyle4

(+>

n.s.

)

Mayne3

n.s.

n.s.

(+

Fraas

Rose
and
Scott

(-)
n.s.

n.s.
(-)

n.s.

n.s.

(-)

n.s.

(+ )

(+ )

n.s.

n.s.

(+ )

n.s.

n.s.

(+ )

n.s.

n.s.

(-)

(+ )

(+ )

(-)

n.s.

(+ )

(-)

n.s.

n.s.

n.s.

n.s.

(+ )

(+ )

(-)
(-)

(+ )

(+ )

n.s.

(+ )

n.s.

(+ )

n.s.

(+ )

(+ )

n.s.

(-)
(-)

(-)

(+ )

(-)

n.s. Not statistically significant at the confidence level selected by the author(s).
( + ) Indicates that the financial ratio was higher for holding company banks, ceteris paribus.
( - ) Indicates that the financial ratio was lower for holding company banks, ceteris paribus.
'The four financial ratios indicated as significant were the independent variables in a multiple-discriminant analysis that compared
independent and holding company banks four years after the latter were acquired by holding companies.
2The reported results refer to the coefficient of the holding company dummy variable. In addition, an interaction variable between
concentration and the dummy variable was positive and statistically significant in the equation for real estate loans/total assets and negative
for business loans/total assets and capital/total assets.
3Mayne estimated equations for each of the four years 1969-72. The results are reported here as significant if the dummy variable she used
entered an equation significantly in at least two of the four years.
4The reported results refer to the coefficient of the holding company dummy variable. In addition, six different interaction variables involving
the dummy variable were statistically significant in at least one of the authors' 13 equations. In three equations, two of the interaction
variables were statistically significant, and in five equations, one of the interaction variables was statistically significant.
5ln the t-tests of differences in the means, holding company banks were found to have had a higher ratio of other operating expenses to total
assets in the second year following acquisition by a holding company, but a lower ratio in the third year.


30


FEDERAL RESERVE BANK OF ST. LOUIS

panies on the post-acquisition performance of subsid­
iary banks.10 In attempting to control for the influence
of other factors on performance, these studies paired
holding company banks with similarly-sized indepen­
dent banks from the same market. These studies failed
to adequately control for bank size and market charac­
teristics, and high correlations among financial vari­
ables made univariate tests of statistical significance
uninterpretable.11 The univariate studies also can be
criticized for eliminating from further study banks that
could not be suitably paired.
Most recent performance studies have used multi­
variate statistical techniques, principally multipleregression analysis.12 Until recently, the multipleregression models were single-equation models,
which were estimated using ordinary least squares
regression analysis. These models compared perfor­
mance at a point in time, rather than over a post­
acquisition period. The effect of holding companies on
bank performance was estimated by including a dum­
my variable representing holding company ownership.
Some studies also included interaction variables.13
The multivariate studies have several weaknesses.
First, most of them presumed that performance differ­

10Robert J. Lawrence, J'he Performance o f Bank Holding Com­
panies (Hoard of Governors of the Federal Reserve System, 1967);
Samuel H. Talley, The Effect o f Holding Company Acquisitions
on Bank Performance, Staff Economic Studies 69 (Board of Gov­
ernors of the Federal Reserve System, 1971); Robert F. Ware,
“Performance of Banks Acquired by Multi-Bank Holding Com­
panies in Ohio,” Federal Reserve Bank of Cleveland Economic
Review (March-April 1973), pp. 19-28; and Stuart G. Hoffman,
“The Impact of Holding Company Affiliation on Bank Perfor­
mance: A Case Study of Two Florida Multibank Holding Com­
panies” (Working Paper Series, Federal Reserve Bank of Atlanta,
January 1976).
''Rodney D. Johnson and David R. Meinster, "An Analysis of Bank
Holding Company Acquisitions: Some Methodological Issues,”
Journal o f Bank Research (Spring 197.3), pp. 58-61.
12Rodney D. Johnson and David R. Meinster, “The Performance of
Bank Holding Company Acquisitions: A Multivariate Analysis,”
Journal o f Business (April 1975), pp. 204-12; Jackson, “Multibank
Holding Companies;” Arthur G. Fraas, The Performance o f Indi­
vidual Bank Holding Companies, Staff Economic Studies 84
(Board of Governors of the Federal Reserve System, 1974);
Mingo, “Managerial Motives, Market Structures and Perfor­
mance,” pp. 411-24; Mayne, “Comparative Study,” pp. 147-58;
Rose and Scott, “Performance of Banks,” pp. 18-37; and Duane B.
Graddy and Reuben Kyle, III, “Affiliated Bank Performance and
the Simultaneity of Financial Decision-Making,” Jou rn al o f Fi­
nance (Septem ber 1980), pp. 951-57. Johnson and Meinster used
m u ltiple-discrim inan t analysis; the others used m ultipleregression analysis.
13These were the studies by Mingo, and Graddy and Kyle. See Ibid.
The interaction variables were products of the dummy variable
and other independent variables. They tested the hypothesis that
an independent variable’s effect on bank performance depended
on the bank’s form of ownership.




MARCH 1983

ences at a point in time were due to changes in per­
formance after the acquisition. Second, some studies
continued to pair independent and holding company
banks.14 Third, high multicollinearity involving in­
teraction variables may have biased the coefficient esti­
mates. Finally, single-equation models ignore inter­
dependence among bank decisions.15
Graddy and Kyle attempted to account for inter­
dependencies among financial ratios by estimating an
ad hoc system of 13 equations. Although it was an
improvement over earlier models, their model did not
capture the hypothesized complexity of the inter­
dependence among bank decisions; furthermore, their
in te rp re ta tio n o f c e rta in fin an cial ratio s was
questionable.1,1

Distortions in Financial Ratios
Specific distortions in the financial ratios can be
traced to the nature of the banking firm and the bank
holding company, and to the effect of regulation on
bank prices. Banks sell many different products and
acquire many different deposit liabilities. Revenues
and expenses depend on portfolio composition, and
prices depend on the size, type and risk of the assets
and liabilities in the portfolio. Bank holding companies
are vertically and horizontally integrated corporations.
This form of organization potentially affords real advan­
tages, but also creates accounting differences between
independent and subsidiary banks. Deposit ceilings
place a statutory limit on the price of certain kinds of
deposits, causing banks to engage in non-price com­
petition for loanable funds.

Problems with Ratios as Measures o f Price — Per­
formance studies represent the prices that banks
l4These were the studies by Johnson and M einster, and Mayne. See
Ibid. The former study actually used a sample of banks from
Lawrence’s original performance study.
l5Duane B. Graddy and Reuben Kyle, III, “The Simultaneity of
Bank Decision-Making, Market Structure, and Bank Perfor­
mance, Journal o f Finance (March 1979), pp. 1-18. This interde­
pendence causes the high correlations among financial ratios
noted earlier by Johnson and Meinster. The use of single equation
regression models under these circumstances introduces simul­
taneous equation bias into the ordinary least squares estimates of
the regression coefficients. Note that this criticism does not per­
tain to the Johnson and M einster study, in which financial ratios
entered only as independent variables in a multiple-discriminant
analysis.
1BThe authors’ choice of financial ratios to represent input and
output decisions led them to interpret certain ratios as quantities.
For example, the ratios of total loans to total assets, and salaries
and wages to total assets, were interpreted as quantities of output
and input, respectively. The authors' interpretation of the ratio of
total capital to total risk assets as the bank’s lending limit is
doubtful. See Ibid., pp. 7-8.

31

FEDERAL RESERVE BANK OF ST. LOUIS

charge for their products and pay for deposits as ratios
of income statement items to balance sheet items. For
example, the price paid for deposits has been mea­
sured by the ratio of interest paid on deposits to total
time and savings deposits, and the price of loans by the
ratio of interest received on loans to the loan portfolio.
There are four reasons that these financial ratios are
inadequate proxies for such prices.
First, the ratios do not account for a bank’s portfolio
composition.1' The sizes and types of a bank’s loans or
deposits affect its operating costs and, hence, the
prices the bank both pays and charges. These effects
are not captured by the ratios of income statement to
balance sheet items. Such ratios are actually weighted
averages of many different prices; they measure aver­
age revenues and average expenses rather than prices.
Second, the ratios include risk premiums. Banks can
be expected to charge higher rates of interest on loans
with greater perceived default risk. Banks that choose
to make riskier loans will tend to have higher average
revenue from loans (and also more bad debts),
although they may charge the same rate as other banks
for loans of comparable default risk. Interest rate risk
increases with the maturity of loans. Banks that choose
to make longer-term loans also will tend to have higher
average revenue from loans.
Third, the ratios fail to account for the effects of price
ceilings on some deposits. When the legal rate of in­
terest on deposits is fixed below the market rate, banks
have an incentive to incur non-interest expenses to
attract deposits. These additional costs are not counted
as interest expense on a bank’s income statement. Con­
sequently, the average expense ratio understates the
true cost of deposits. This understatement is probably
greater for some banks than for others, depending on
the demand and supply conditions for deposits in dif­
ferent banking markets.
Fourth, the ratios fail to account for interdependen­
cies among certain prices. Some banking services are
purchased in a package, for example, a borrower’s
agreement to maintain a compensating balance with
the lending bank in return for a lower nominal rate of

' ‘Graddv and Kyle did account for certain aspects of portfolio com­
position. Their equation for the average interest rate on loans
included as arguments the ratios of business, real estate, and
installment loans to total assets. Their equation for the average
deposit rate included as arguments the ratios of demand deposits
to total deposits and savings deposits to total time and savings
deposits. See Ibid ., p. 9. These specifications are an improvement
over those of other performance studies; nevertheless, they fail to
account for many aspects of portfolio composition, including size
differences within any category of loans or deposits.


32


MARCH 1983

interest on a loan. The true interest rate depends on
the size of the compensating balance; however, the
ratio measuring average loan revenue depends only on
nominal rates.
Different average revenue and expense ratios are
not necessarily due to different prices for a standard
product. Systematic differences in portfolio compo­
sition, risk or other business strategies between inde­
pendent banks and holding company banks cause
systematic differences in the average revenue and ex­
pense ratios. The ratios are ambiguous guides to the
prices banks charge for products and pay for deposits.

Problems with Ratios as Measures o f Efficiency — In
performance studies, the term “efficiency” is used to
describe the relationship between bank costs and some
measure of output, generally total assets but occa­
sionally total revenue. The relationship between total
costs and output is measured by the ratio of operating
expenses to total assets or total revenue; the rela­
tionship between two particular elements of total cost
is measured by the ratios of salaries and wages expense
to total assets and other operating expenses to total
assets. Smaller values of these ratios are interpreted as
evidence of lower cost (i.e., more efficient) production.
This interpretation is invalid.
Banks are multiproduct firms that obtain funds from
a variety of sources. Some banking products and some
sources of funds are more costly than others; therefore,
the operating expense ratios depend on the composi­
tion of a bank’s portfolio. Presumably, more costly
portfolios yield higher revenues, so the ratio of operat­
ing revenue to total assets depends as well on portfolio
composition. Because operating revenue also depends
on the control the bank exercises over price, no ratio
incorporating operating revenue is an adequate proxy
for a bank’s cost of production.
Bank holding companies are vertically integrated
organizations; the parent company provides a variety
of services to its subsidiary banks. In some cases, these
services have been centralized in the holding company
as an economy measure. In other cases, the salaries of
some bank employees are assigned arbitrarily to the
parent company instead of the subsidiary. In either
case, the salaries of some employees who provide ser­
vices to a subsidiary bank are carried on the books of
the holding company instead of the bank itself. This
introduces a systematic downward bias into the re­
ported salaries and wages expense of holding company
banks and, thus, a downward bias into the salaries and
wages expense ratio of holding company banks.

FEDERAL RESERVE BANK OF ST. LOUIS

Some bank activities are more labor-intensive than
others. Consequently, the salaries and wages expense
ratio may vary systematically between holding com­
pany banks and independent banks due to differences
in portfolio composition. This source of distortion may
reinforce or offset the downward bias discussed in the
preceding paragraph.
Bank holding companies usually charge their sub­
sidiaries for services provided by the parent company.
These charges, which are internal accounting trans­
fers, are referred to as management fees. As the “other
operating expense” category on a bank’s income state­
ment includes management fees, this expense is biased
upward if holding companies charge their subsidiary
banks for services provided.

Problems with Leverage as a Measure o f Capital
Adequacy or Risk — Leverage is the ratio of debt to
capital. A bank’s leverage may reflect the attitudes of
owners or managers toward risk; it may be related to
other factors as well. Performance studies have ad­
vanced one reason that holding company banks should
be less highly leveraged and another that they should
be more highly leveraged, irrespective of attitudes
toward risk.
Some performance studies have argued that bank
holding companies have greater access to capital mar­
kets than independent banks. As this advantage should
translate into a lower cost of capital, banks owned by
holding companies should hold more capital in relation
to debt than independent banks. On the other hand,
holding companies also are better able than indepen­
dent banks to diversify geographically.18 Other per­
formance studies have argued that geographically
diversified holding companies reduce their risk by
lessening their dependence on any single geographic
area. With this advantage, they should require less
capital for any given level of debt. Both arguments
have been used to rationalize empirical results. Be­
cause the arguments do not unambiguously predict the
effect of bank holding companies on the ratio of debt to
capital, leverage measures neither capital adequacy
nor risk.

lsBank holding companies can own non-bank subsidiaries in any
state, whereas banks are limited by state branching restrictions.
Banks cannot locate offices in states other than their home states,
and in some states are limited to conducting all or most of their
business from a single office. In states that restrict branching,
multibank holding companies can circumvent legal restrictions on
the geographical extent of a bank’s operation by acquiring or
chartering banks in different areas of the state. Thus, to some
extent they are substitutes for branch banks.




MARCH 1983

Certain accounting conventions obscure any com­
parison of the capital of holding company banks and
independent banks. Holding companies can borrow
funds to augment the reported capital of their subsid­
iary banks. (This practice is known as double leverag­
ing.) For accounting purposes, the funds are capital to
the bank and debt to the holding company; therefore,
the effect of the borrowing is to increase the leverage of
the parent company and decrease the leverage of the
subsidiary bank.
Does double leveraging improve the capital position
of the bank? To put the question differently, is a bank
that borrows through its parent holding company
actually exposed to less risk than an independent bank
that incurs the same debt itself? The answer depends
ultimately on whether a subsidiary bank is insulated
from the financial problems of its parent company. On
one hand, the bank is a separate legal entity; the hold­
ing company is prohibited legally from draining the
bank of its assets or capital. On the other hand, the
operating policies of the bank are dictated by the
parent company; if faced with insolvency, the holding
company is likely to operate the bank in a risky manner
in an attempt to meet the interest payments on its
debt. It seems that the practice of double leveraging
obscures the distinction between debt and capital,
causing an overstatement of the capital positions of
subsidiary banks and an understatement of risk.

Problems with Ratios as Measures o f Portfolio Com­
position — Several portfolio ratios are used in perfor­
mance studies. They measure the proportions of total
assets held as loans, cash, U.S. government securities
and so forth, and the proportions of the loan portfolio
devoted to different kinds of loans, such as business,
real estate and installment loans. Differences in port­
folio mix are partly responsible for the biases in other
financial ratios.
The portfolio ratios are less subject to potential dis­
tortion than other financial ratios. Nevertheless, cer­
tain portfolio ratios may be biased due to the division of
a bank holding company into bank and non-bank sub­
sidiaries. This division creates reporting differences
between holding company and independent banks.
For example, a mortgage loan by an independent bank
would be reported on the bank’s call report, but the
same loan by a holding company’s mortgage subsidiary
would appear on the books of the non-bank subsidiary.
Although non-bank subsidiaries account for a small
proportion of total holding company activities, the
legal and accounting divisions may distort particular
portfolio ratios, such as the ratio of real estate loans to
total loans.
33

FEDERAL RESERVE BANK OF ST. LOUIS

The portfolio ratios do not indicate unambiguously
the extent of lending to the local community. A higher
ratio of loans to total assets is not necessarily evidence
of greater local lending, because some loans on the
bank’s books may represent loan participations or
purchased paper.

CONCLUSION
The financial ratios used in bank performance stud­
ies are subject to substantial distortion when used to
assess the impact of bank holding companies on bank
performance. These distortions are attributable to the
nature of the banking firm and the bank holding com­
pany organization, and to the effect of regulation on
deposit interest rates. As a result, the performance
studies generally have not provided reliable evidence
about the effect of bank holding companies on either
bank performance or the factors that the Board of
Governors has identified as prospective benefits of
holding company acquisitions.
Previous investigations have found that the Board of
Governors has not given much weight to convenience
and needs. The finding that orders approving bank
holding company acquisitions “seldom dwelt” on the
benefits of the case when an acquisition had an unim­


34


MARCH 1983

portant competitive effect, and the slight weight given
prospective benefits in orders of denial seem to sup­
port this conclusion.19 This is consistent with the re­
sults of past performance studies, which usually have
attributed only small effects to holding companies, and
often have contradicted each other at that.
There is no evidence that the Board has relied on
either financial ratios or the results of performance
studies in reaching its decisions. The assessment made
in this article indicates that it should use neither.
Although the shortcomings of previous empirical
approaches eventually may be overcome, the prob­
lems with using financial ratios to measure either per­
formance or the public interest appear intractable.
Performance studies are not without potential value,
however. If properly designed, the studies can identify
differences between the reported operating results of
independent banks and holding company banks. These
differences may suggest directions for research into the
incentives for bank holding company formation and
growth. But they are not likely to provide useful evi­
dence of the desirability of bank holding company
acquisitions.
19Jessee and Seelig, “Analysis of Public Benefits Test, ” pp. 161-62.