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For release on delivery about 3:30 P.M.
Central Daylight Time Tuesday, Sept. 13, I966
Talk by Darryl R. Francis, President,
Federal Reserve Bank of St. Louis, before the
Kentucky Bankers Association, Louisville, Kentucky
September 13, 1966

The commercial banks of the United States are currently
subject to exceptional dynamic change. The central force m this
rapid development is a tremendous demand for loan funds.
I propose in this discussion (l) to outline some of the basic
facts relative to recent trends in banking, (2) to consider the causes
of our present situation, and (3) to examine effects and some necessary

Basic F^cts
By way of background, commercial banking has had three phases
in the past 20 years. First, up to i960 the banks were not our most
dynamic financial institutions. The decline in the relative role of
commercial banks had been going on since the beginning of the century.
In 1900 commercial banks had 55 per cent of the assets of all financial
institutions; by the 1950's this had fallen to about one-third.


fact that commercial bank deposits were 78 per cent of all deposit-type
funds in 1950 and by i960 had fallen to,65 per cent is evidence that
the trend continued for another decade.
Beginning about I96I and extending until last year commercial
banks began to play a more vital role in the nation's financial picture.
From i960 to 1965 total time and savings deposits increased 15 per cent
per year, or twice as fast as in the previous decade. Demand deposits

also increased much faster in I96O-65 than in the previous five years.
As a result of these faster growth rates, commercial banks regained
a part of the ground lost in prior years.
During the past year the course of commercial banking was
again in some respects reversed in response to changing economic

The changed circumstances


(l) Excess total

demand for production has developed, primarily in response to a highly
stimulative Federal budget.

(2) A great demand for loan funds by

business has followed from the excess demand for goods and services.
(3) These great loan fund demands in the private sector, plus the
direct effects of the Federal budget on borrowing and saving, have
pushed the demand for funds ahead faster than the growth in fund


This demand and supply situation has pushed market

interest rates steadily upward.
Since a year ago yields on long-term bonds have risen 50
basis points and on 90-day Treasury bills 150 basis points. Rates
paid on large negotiable certificates of deposit have risen a full
percentage point, and rates on commercial paper, one-and-a-half
percentage points.

(5) Under these circumstances of rapidly rising

interest rates, the rates paid by financial intermediaries such as
commercial banks and savings and loan associations have lagged behind
other rates.

Intermediaries have thus found it increasingly difficult

to maintain their role in the flow of saving into investment.


have tended more to invest their saving directly, and funds have tended
more to flow through the open market at the expense of financial

Underlying Causes
I turn now to some of the underlying causes of these changed

In response to the market demand for investment and loan

funds, interest rates in general have been pushed up rapidly during
the past year.

The rates paid by commercial banks have not led in

this movement and, indeed, may have lagged the general trend.


open market rates increased in response to supply and demand forces,
loanable funds tended to bypass commercial banks.

It became necessary

for commercial banks to increase the rates they paid to avoid further
deterioration of their relative role in the financial process. Bankers
strive to be able to meet the financial needs of their customers.


is in response to these general market forces that interest rates have
risen on large negotiable CD's, as well as on other certificates of
deposit, and on savings accounts.

If banks had not raised these rates,

funds would have flowed to a much greater extent through other avenues
and much less through the commercial banks.
At this point let me give you my views as to why interest
rates have gone up so greatly in the past year.
generally trend'

Interest rates

upward in periods of economic expansion.

behavior of rising rates occurred from 1961 to 19&5-

During the past

year, however, rates spurted upward much more rapidly.
this great rate increase during the past year?

This usual

Why have we had

As I see it, the

increase came from a jump in demand for loan funds, not from a
restriction on supply.

At least it did not come from any Federal


Reserve restriction before this past summer.

In the year ended in

May, Federal Reserve credit grew 8 per cent, bank reserves 5 Pe**
cent, bank credit 9 Per cent, and the money supply 6 per cent.


do not appear to be restrictive rates of growth.
It was said that the Federal Reserve was a major factor
causing higher interest rates when the discount rate and the
Regulation Q ceiling were raised in early December 1965*


interest rates had already been moving up strongly for several months
prior to these actions.

In the last half of 19&5 Treasury bill

yields had moved above the discount rate. Also, practically every
other interest rate had trended strongly upward.

The discount rate

and the Regulation Q ceiling were adjusted upward only after market
rates had moved.
We find then that interest rates moved up because of the
great demand for loan funds.

This, in turn, was due to the very

easy Federal budget beginning a year ago. An easy budget led to
excessive total demand for loan funds.
Treasury actions have also exerted upward pressure on
some interest rates.

Interest yields on long-term U. S. Treasury

bonds have recently been about k.QO per cent, 55 basis points
above the k.25

per cent maximum the Treasury is allowed to pay

on new issues. The market rate on these securities rose above
the k.25

per cent limit about September I965.

Since then, the

Treasury has been forced to do all its financing with securities

bearing five years' maturity or less.

As a result, the average

maturing on Treasury securities has declined from 6k months a
year ago to 59 months.

This trend may be interpreted as a

progressively stimulative or inflationary factor.

With the

Treasury estopped from issuing securities with more than five
years1 maturity, the yield on 3-to-5~year U.S. issues has
moved upward from U.25 a year ago to 5 per cent in June, and
to the neighborhood of 5-3/^ Ve* cent in recent weeks.
Another remarkable aspect of Federal government debt
management has been with respect to agency issues. Here the
yields have risen more than yields on comparable direct obligations
of the government.

The sale to the public by various agencies

of participations in their portfolios has placed upward pressure
on their interest rates.
The main key to lower interest rates without further
upward pressure on prices would be a less expansive budget. This
could be achieved through either an increase in tax rates to pay
for Federal expenditures or a reduction of expenditures. Attention
is beginning to be given to this possibility.
Market Interest Rates Affect Bank Deposits
In response to rising market rates in late I965 and
relatively inflexible rates paid by banks, commercial banks began
to find it difficult to hold deposits.

The maximum interest rate

on certificates of deposit was raised at the end of 1965*


in early I966, the rates on l*-to-6-month prime commercial paper and
on prime bankers' acceptances were about 5-0 per cent. Rates on both

were well below the new 5-l/2 per cent Regulation Q limit. Under
these circumstances, banks were permitted to meet competitive
market rates. However, these market rates moved steadily upward
and in June reached about the upper limit that commercial banks
are permitted to pay on time deposits.

In July rates on such

paper moved above the maximum level permitted by Regulation Q.
Recently commercial paper rates have been 38 basis points and bankers1
acceptances 25 basis points above the maximum that can be paid on
bank certificates of deposit.

Consequently, banks are facing very

great difficulties in attracting and holding funds.

The volume of

time deposits has recently been under great downward pressure due
to the higher rates being paid on open market funds.
Bankers experienced their first difficulties in attracting
and holding funds almost exactly a year ago.

Through August I965

CD's were increasing at a rate of about 33 per cent a year.


September, however, the rapid rate of increase of CD's fell markedly.
Since then their rate of increase has declined until in the last
three months they rose at a rate of only 3 Pe** cent a year. With
regard to total time and savings deposits banks were able to continue
to increase these accounts through October I965 at about the 15 per
cent rate of the past five years.

This was due to rapid increases

in savings-type CD's and in savings accounts. But since last October
the rate of increase in total time and savings deposits has declined
from the 15 per cent rate to a 9 Ver

cent rate in the last three months.

This experience has, in general, been common to all the financial intermediaries.

Commercial banks, however, have fared better than some others.

Recent Decline of Demand .Deposits
While banks have been able to attract time and savings
deposits somewhat less rapidly since last fall than previously,
demand deposits continued to grow at a relatively high rate until
quite recently.

Private demand deposits grew 5-1/2 per cent during

the year ending in May 1966.

This was the fastest growth in demand

deposits for any year since the Korean War.

Thus, monetary expansion

or restraint, up to three months ago, was not a factor in the tightness
of credit markets and the rising interest rate.

Such pressures

appear to have come from the demand side and not from monetary actions.
This picture may have changed somewhat in the past few

Private demand deposits have declined in the past three


The money supply, of which these deposits are the main

component, has accordingly declined.
in several years.

This is the first such decline

In this connection I want to emphasize two points:

First, the reduction of money supply was not responsible for the rise
in interest rates and the tight situation of the banks during the past
year as a whole. Up until May or June of this year bank reserves and
the money supply were rising rapidly.

Second, in view of the general

inflationary situation and the stimulative Federal budget, monetary
restriction may be necessary if we are to avoid progressive inflation.
So long as the basic supply and demand situation with respect
to loan and investment funds produces high general interest rates, it
is necessary for the commercial banks to go along with these trends.
Banks must both pay high rates and charge high rates if they are to

perform their function in the economy.

In many ways the high and

increasing general level of interest rates is disruptive and

But if the general level of rates needs to be kept

down, total demand for loanable funds must be reduced.

Public policy

can accomplish this only by influencing the supply and demand situation
with respect to the total product of the economy.

The only way we

know to accomplish this is by a more restrictive Federal budget which
may be shaping up and possibly also by a somewhat less rapid monetary

It is to be noted that the rapid upward movement of

interest rates in the past year started just when we reached a very
high level of resource utilization.

Simultaneously, the stance of

the Federal budget became the most stimulative in many years. More
rapid monetary expansion would tend to drive up total demand.


for investment funds would rise further, and after these increments
to the credit supply are absorbed, interest rates will continue up.
So long as the basic influence of supply and demand conditions
upon interest rates is stimulative, attempts to restrict rates paid
by various types of borrowers will only interfere with the most efficient

of the economic system.

Limitations upon the interest

rates paid or charged by financial institutions, including the
commercial banks, mean that funds will flow through other avenues,
notably the open market.

When funds flow through the open market,

a special advantage is given to those who can most effectively use
that market.

Both users of funds and suppliers of funds in that

market are benefited.

Generally speaking, more use of the open market

means that the big borrowers get special access to funds and big
savers get special benefits of the higher interest rates paid.


the other hand, when interest rates paid by the banks are limited,
small borrowers who cannot get use of the open market tend to be
deprived of their customary share of funds.

Furthermore, small

savers who cannot get use of the open market tend to receive relatively
low interest rates.

In other words, such restrictions tend to be most

damaging to one group for which help is intended, namely, the small

Effects and Necessary Policies
As demands for loan funds have continued unabated or even
increased, and as the flow of funds to the banks has declined in
recent months, banks have had a hard problem allocating available

Because of the great investment plans of business, and the

increasing needs for funds to finance payrolls, inventories and
sales credit, bank loans to business have expanded with exceptional

In some respects this may have been a reasonable rise of

credit from the standpoint of the banks and of the economy in general.
At a time, however, when total demand is excessive and planned
investment exceeds planned saving, it is necessary that some plans
get cut out. At such a time it may be reasonable that the plans
cut will be those for long-term investment, that is, those for capital
goods which will yield their services only over a long period of time.
It is reasonable that investment for the time being be concentrated in capital goods which will produce most in the near future.

Longer-term investment may be postponed until total demand has been
brought into line with productive capacity and planned investment
in line with planned saving.

This is what has happened.


credit has been flowing in greater measure to meet the short and
intermediate needs of business.

It has been flowing in less measure

to meet the very long-term uses of housing and public construction.
The demand for housing credit, and in a sense the needs, may have
been somewhat less intense than for short- and intermediate term
production credit.

During the past year, while the interest rate

on corporate bonds has increased about 3^ P e ^ cent, that on conventional
first mortgages has increased 13 per cent-.
Commercial banks have done a tremendous job of adapting
their operations to the stresses and strains of the past year.
have had to adjust to the excessive demand for loan funds.


In the

face of rapidly rising market interest rates you have attempted to
retain deposits and attract new funds. You have had some success;
your total time and savings deposits have continued to increase,
though at a declining rate.
In conclusion, if we are to avoid the disruptive effects of
continuing increasing high interest rates, we must have proper
limitations on total demand for goods and services.

These could be

provided primarily by an adequately restrictive Federal budget and
by accompanying limitation on monetary expansion.

The President has

asked Congress to suspend for 16 months the 7 per cent tax credit for
new business investment in equipment and the accelerated depreciation

of buildings and structures.

In addition, the Secretary of Treasury

has announced a freeze on new borrowings by Federal agencies until the
end of the year.

These actions should, to some extent, serve to

moderate over-all demand in the economy and strains on credit and
financial resources.
The steps which are necessary to restrict total demand in
general and price inflation are the same as those necessary to limit
the demand for investment funds. These steps will also keep in
bounds the upward surge of interest rates. A tighter Federal budget
and monetary restriction can do the two necessary jobs.
down total dollar spending and stop inflation.

They can keep

They can keep down

credit demand and keep interest rates in bounds.

If these steps can

be taken, the current problems of banks, savings and loan associations,
and other financial institutions can be solved.