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POSSIBLE EFFECTS OF PRESENT ECONOMIC CONDITIONS ON BANK ASSETS By Edison H. Cramer, Chief, Division of Research and Statistics, Federal Deposit Insurance Corporation. Vermont Institute of Banking Group Vermont Bankers Association Burlington, Vermont September 16, 1950 POSSIBLE W fWOfS O? PRBSEffT ECGHOMIC COSDX7XOSS OH UAfr thè subject vhich I bave seleeted far diseusslon today 10 thè effect of current economie trend« upon thè assai* held by banks, particularly thè impact of *fc«»g<üg economie condltions on thè quality of bank asseta. lem kaov froa your ovn ©xperienee how a bus ine»s slump or "H a business boom affeets thè quality of bank a«sete, la a business reeesslon thè quality of bank aaeete tenda to deteriorate because some detterà to benk« are likely to flsd thenselves nnable to mset their obligatlons. In boom condltions, on thè other huid, business concerna generally fiad their profits to be batter thaa they had antlclpated and they bave little difflculty in meeting their eommltments» % thie you are meli acqualnted. With 1 a» aure, hovever, that you are mondering along vìth thè petóle In thè eastern pari of thè country, vhether ve are faced at thè preeent time vlth thè likellhood of a deepenlng depreeeloa or of recovery fren thè elight slump ve bave had during thè past year. fhie is a very practica! question on vhich an ecoaomiet ehould bave an opinion if aay one has. Hovever, I am mindful of ^ie economista ubo bave trled to prediet economie condltions in recent years. Uj professional colleagues bave developed guita a reputatici for gstting out too far on a limb. So 1 am gotng to try to keep off thè listo that yon vould undoubtedly bare me shake* But those of you ubo bare picked apples knov that if you hura a long pola yon can sometimos gst a alee big appiè vithout gstting out en a llmb. Vfhat I am geimg to do today le to tabe a poke at thè appiè vithout gstting my feet off thè ground. Vhai I vani to talk atout 1« a phase of thè relationehip of business conditions to tank asseto vhieh has not, t thiak, beea given srufficient attention by busineasnen, bunkera, or by professional econo mista. fhls ls thè interrelatìonehips betveen thè quantity of tank asseta, thè fuaXity of those asseta, sud changas la business conditions. thè first coisaent 1 vish to mùm ls thist fhere appears to be a very dose relationshlp betveen a ehange la thè quallty and a changa in thè euaatlty of baak asseta. Ve all tonar that thè faellty of teak asseti deteriorated badly during thè early yeer* of thè 1930*s. As se look back at that pariod ve tate sometimes inclinad to sey that thè benha aoftxlred a lot of inferior asseta in thè 192®'s. fo soste eartent thls may have basa trae« But a far »ore importan* faci la that asseta vhich vera good In 19®8 or 1929 bacane inferior in subsequent years* An additioaal fast that la not so veli knovn ls that thè guantlty of bank asseta, relative to a reasonable rate of grovth, began to shrlnk before thelr quality began to deteriorate. During thè prosperane years of thè middle 1920*0, vfaen prices vere falrly atable and there vas little uaeaploynsnt, bank asseta increased at «n arerage rate of «bota* 9 perceat per yeer, ibis appears to be a rate of grovtfe vhlch la in line vith thè needs of thè natíos for clrcul&ting medium, of vhlch bank deposita aro nov thè major pari* fhe rate of of tiñe has averaged aearly t perceat per yeer. fhere la aleo a long-tem trend far people to hold sor» deposita relative to thelr erpenditures, and thls la a little over 1 perceat par yeer. As 1 have saia, in thè middle 1920* s baak asseta Ineraaaed at osi average rate of about 9 perceat per ytar. But in 1929 there vas no _3grovth in bank UHtl. In 1930, bank u w t i dedlned Tagr about * parce»«, la 1931 *? 13 percent, la 1939 by 9 percent, aad during «ha early nonths ot 1933 by another 10 pareant. Aa «a kaov, thoae vare eleo thè yaam vhen bank asceta vere deterioratine In quality. fhe experienee of thè paat far yaara la another Illustration ot changea la «ha quali«? and quantity other. bardi aaaata aeeonpanying m a h Aa you kaov, bank amata ineremsd in quanti«? at a rapi« rate durine «he ver period froa 1939 to 19*5, end durine tbia periodi, «ha otbank amata eritlelaad by esaminerà decreaaed yaar by percentage year. lovever, alme 19*3 bank aamta bave iscreaaed very little, la I9b6 total aamta ot all eoamrelal and seringa baaks decllned by 5 percent, la 19*7 «bay increaaed by A percent, in 19*8 there aay change, aad in 19*9 they increaaed by 1 or S percent. vaa hardly Vita respect to quali«?, «ha percentage of aamta oritielaad 1? examinera reached ita lov la 19*6. A i a percentage vaa hlgher la I9A7 than ia 19*6, aad w a little hlgher ia 19*8 « m a ia 19*7. Our tabulations of «he reaulta of b m k exealnatlone aada la 19*9 ara not yet conplete. fhiè relationship betweeu changea ia thè fiiftstitgr «ia thoee ia thè quality of bank aaaata ralaaa thè queetioai If bank aaaata deteriorate % $ »ban thè quanti«? ahrinka aad toprevs in quaUty vhen thè quanti«? svallan, vhy ia thia trueT that relatlcnahipt la Vhat ara thè causal forces vhleh produce Before I atteapt to aaauar thia question X vould like to m k e another observation and ralaa another question. Ve knov « m * thè t i a m vhen bank aaaata deteriorate grmtl? In qmlit?, like thè •ari? yeara of «he 1930'a ara alao «lata of eeonoalc distreaa, aad thè tlaes vhen bank aaaata iaprore ia quallt? are generali? apenklag «ima of baaiaam luprovenent aad riaiag pricea m in thè y a a m fra» 1939 to 19^5« i» H m futóitj fili« ofeiermtic® load# to tilt ftnotista ti a— reXstod to of softïoztfcl&l. to tho föwstelty of of t&# qiMHritttx of If# tom* ff#1^ l«f«A4p m*f smst#* pfifft fu #bt ffXatiosî oo»4iticai#? to to# qi«stiosyi~~th* tli# f#Hfiitgr pm#ooi of til# tb# gint-lty of ##0#t# 9ÊH& tJao relation of til# quantity of task ««osto to tools### conditions. H# will t ;" #' tot# tis# ittoonH question first* Hint i# tt# rtiLstlost of t&s quantity Of #i###t# tO töBlS### efllB^ 'fet«wat L#t ## itafff##y tt# of totitoi* W o n #' t n yftiftf o ipaüg o# ss iny##t«Mst It so^psiys# ytiiHyao is It# portfolio o prcssissory sot# or o of # o m ott#r fovo of ^ u p t i o i of m iaâiit&iftl# o tools### ootnors* or o gowra*ont* X& ooMÉnspi tin t^mir ft m w it# m oroált* or pronto# to m y # usually Is tO# fona of & deposit account #tib¿set to ebook, u m ysofttl prtmrtly ## m # ft### deposit# of soltls^ yBysunt#■ îo tb# SsàitidbatóL or w t e rprl## # tank deposit I# # ftrwt of nniy* foot ## «nin^ng gold or #&imr i# # pro#### #f profoolm s o m o t » or circulating stadias* #0' tt# acquisition of yn#ot# lay tntóte# m d tti **w»i^--Tiwrouní orsatioo, of tank deposit# i» «Iso » pros### of producing warnstp or oircnlsttsg i s &iubu &# « n o t a ö i i m #ai*i m # *sst3# m o c k o# inxikiiig s b &o a m s p s t l i a M stoat « busto»# mât forty amar# sgot %*.thl# i# tin principal advantage of bank# that they sissy# supply circulating s m AIì». •*ma& therefore f tot# eaHsd t h m Ids## and MlBt#«" ¿/ Bosk#, H b » tin treasury milt# for g s ü m à « U t ar# sr# piaos# «t i b M ####t# ar# störet «ai hedâ as tt# tool# for tbs i n » of eimlaliag aedium. Hr# Ssyaaeaak, s matear of tts Board of Ôortmxr# of tin F t l n l Bi m t v o äyst## ts# aecurataly described H m nature of tesate# s# follov» i ’aragraphs T«3o1WU4 ianj\s T^V-Î iiniicLQexpiii ■Qn - 9- "ïakan u a whole, the commercial haaHng System la ftmàamentally a aeehaalsm for creating m o n e y . 2/ Iveryone la favillar vith the fact that vhen something vhich peopl* need or uant becomes very plentiful Ita value drops* and vhen it becestes «care* ita raina risas» and demani* teonoaist® cali thia the lav of supply fhis principi* of raina, or lav of supply and damand, applie* ta money, («ad I «a uelag the t a m money ta Includa tank deposita) just aa It doaa ta other things vhieh ara used by human belngs. When money beco®*« mora plentiful, It becornes la®« vuluable par mit* Vhen money beeomes la«« plentiful, It bacon«« aera valuable par mit» That 1« ta ««y, aonataiy Shrlakage, relative ta a reasonable rata of grcvth, 1« mlmost cartai» to rasait la a falllng levai of prisa«. But vith falllng prisa« business prospect* bacon* « d a m a and business dépréssion 1* aura to foUov* On the other hand, aometary expansion, relative to a reasonable rata of grovth, 1« almost sortala to resuit la a rising laval of pricea. Bhaa prisa« ara rlslag busineas prospects bacon* more favorable and prosperity easues. Buriag pariods of dépréssion, tba obligations of business concerna beccate risky and precarlous* Thls aaaas that the suality of thè asseta of baaks— vhicb eonslst to a veagr large entent of the obligations of busl&ess~~falls* Bartog periodi of prosperity just the opposite takes place. So ve conclude that there 1s a very real causal connection betveen the çucatlty of bank asseta on the one haod, m â business conditions aad thè gualìty of bank asseta, on the other» Thia causal relation ruas from the change in the gucatity of bank asseta, in the fora of déviation from a reasonable rate of grovth# to change la f/Ml"Érïgj»^ (19*8). at federai Home loen Bank df iev Tork buelaess condition«, and to change ia the quality of the esset» of the banks. fh«t is to «ay# an increase ia the quantity of bank aasets et aore then a reaaoaable rate of growtfe leade to price Inflation and aa unhe<by business boom, but also an ia^aroveatat in the qmlity of ***** aeseta* A contraction ia bank aaeets, of e w the abseace of grovth, lw !i to a decline ia business «ad deterior&tion ia the euality of bank aaset«. With thi« relatioaahip betveea the quaatity of bank aeeet«, cm tim am haad, and buaiaee« condition« and quality of bank aasete, oa other, ve need to aak aaother laportant queetion. caase« change« ia the quentity of bank a««et«f Wimt i« it that If chaaglng basine»» condition« are prisaerily the re«ult «ad not the cause of change« ia the quantity of bank eseet«, how do chaage« ia the quentity of baak asset« occur? $o «neuer thi« question ae come back to the fundamental ehareeterlstie of bank« as «torage place« for asset« ehieh «re aoaeiited. buiiness i« inhereatly expoawionary. fhi« kiad of fhe reason for thi» 1« that the mar® asset« ia «torage oa ehlch the «torage ooncern receive« an incaae the greater 1« it« Profit. Cansequeutly the aore assets they een acquire, the better. fhi« fundamental chsracterlstic of bank« ha« beea recogaited 4.©r nore thaa a Century • it i« the inherent teadency of banke to thelr esset« «ad therefore their Obligation« used m cireulating medium vMch ^ **ä* tt aeee««ary for govexsomat« to place so many liaitaticm» m the Operation» of bank», fhe mein purpose of beaklng legislation ha« aliays beea t© prorlde a guide to the eequisltloa of aaset« by the ****** in order that the beaklng System e i U prcwride a «uitable aaount of cireulating aedlua— neither too little aor too auch. -7 la the ««rly history of banking legislation la the united States, limitations nere planed on the kinds and amounts ©f assets which banks eould acquire, and banks tare generally required to hold a portion of their total assets in the for« of gold or silver. The limitations on kinds of assets never provided a suitable restraint to the quantity of bank assets| reserve requirements proved to be much more effective for this purpose. ®ader the Rational Bank Act of 1063, national banks were required to hold specified reserves in proportion to their deposits. These reserves consisted in part of deposits in other banks and in part of lawful money. frm that tine to establishment of the federal Reserve System the aa^oy limitation on the expansion of banks was the amount of their lawful money reserves* These vere in part gold and silver money in the form of coin or certificates but they also included several types of United States govern* meat obligations — the greenbacks, certain other obligations Issued during the Civil War, and the Treasury notes of I89O issued on the basis of silver bought by the Treasury. With establishment of the federal Reserve System in 1914 and the amendments to the federal Reserve Act of 1917 the character of reserves was changed, Reserves of banks which are members of the federal Reserve System consist only of deposits in the federal Reserve banks. Changes in these deposits occupy the position in the banking system end in the economy which Changes in lawful money reserves of national banks occupied from 1865 to 1914, Since 1917 the dominant factor limiting the expansion of bank assets and deposits has been the amount of mesther bank reserve balances* and during most of this time the banks have kept fehtrir assets and deposits close to the limit permitted by their reserves. ffe* great contraction la bank assets from 1908 to 1933 was »ado necessary by a shrinkage la bank reserves. Similarly, the absence of growth la bank deposits since 1$&5 rafleots aa absence of growth la bank reserves# shea the dollar amount of those reserves Is adjusted for changes la percentage requirements* fiese considerations lead us back to another question. What are the forces vhloh influence the quantity of bank reserves? As 1 have said, under the present situation the significant part of bank reserves consists of the »saber bank reserve Federal Reserve banks# balances la the When ve lock at the Federal Reserve bjmfrst we find the sane type of operation as in the commercial banks; they also are storage concerns for monetised assets# the Federal Reserve banks hold, or store, gold certificates, United States government obligations, and a ®®all amount of bankers acceptances, commercial paper, and loans to industrial enterprises, la the early years of the system, the Federal Reserve banks held such larger amounts of business obligations Which they bad discounted for member banks. the monetary liabilities of the Federal Reserve banks are of three sorts! (1) Federal Reserve notae, which ve all use as pocket aonayf (2) deposits of the United itates Treasury and of foreign banks and governments sad some miscellaneous deposit account*] and (3) member banl reserve balances, The ammmt, or quantity, of the first two of these types of monetary liabilities --the Federal Reserve notes, end the Treasury, foreign end miscellaneous deposits— depend respectively upon how much currency people want and what balances the Treasury and foreigners keep 1m the Reserve banks# The Federal Reserve has little control over them# However, the Federal Reserve authorities have wide powers to 9 ehangt the «uanilty of asseta bald by the Federal Reserve baoks. On the one band, they can reduce discount ratee and encourage memfeer banks te borro», or they can go out and purchase United States governaeat Obligation® in tbe ©pm market at vhatever prie© i® neeessary te pay te get them. On tbe other hand, the Federal Reserve authoritles can ralee discount ratee má diseourage borxwing by mesber baaks, er they dost teli een® of thetr otm holding® of United States goverameat obligations ln the open market. Tea are, 1 presume, familiar vith the procese by vhlch these transaetlons sffect member bank reserve balance®. Without tracing this procese in detall, ve can san up the resulte of eil such transaetlons by seying that the quantity of metìber bank reserves ls the differenee betveen the quantity of the aseets held by the Federal Reserve banks and the m m of Federal Reserve notes, Treasury end foreiga end siseelleneous deposite ln the Federal Reserve banke, and thè capitai assonate of the Federal Reserve banke. Xnasaueh es the Federal Reserve authoritles have espíe povere to change the terms on vhich they acquine or relinquish asseta those authoritles have the advantage ln all transaetlons ln vhich the Federal Reserve bank® ere engaged. That ls to say, changos ln the fuantlty of asseta of the Federal Reserve banke ln excees of changas ln their llabllltles other then rnember batìk reserve accounts are causally dependent upon the pololee adopted by the Federal Reserve authoritles theaselves. The actione of the Federal Reserve authoritles are thereíore the ultimate causai determinassi of the fuantlty of wetibor batìk reserves. In addltlon to these povera to control the quantity of bank reserves, Federal Reserve authoritles heve thè pover— vithln fairly vide limits— to control their effeet on the gaaatity of batìk depoelte by chaaging the legal reserve pereeatage reouiremente. Before 1 close these remarks, or apply them to the situation durlag the coming year, let as summarise the processes and causal sequences which 1 have described. In say talk, 1 have moved, step by step, from the quality of bank assets to the policies and actions of the Federal Reserve authorities. In summary, let us reverse the order and start with the policies of the Federal Reserve authorities. When we do this, we have the following steps or events in a causal sequences (l) decisions of Federal Reserve authorities which affect the quantity of assets in the Federal Reserve banks or which change percentage requirements; (2) changes In the quantity of Federal Reserve bank assets which result from those decisions; (3) changes in member bank reserves which accompany the changes in Federal Reserve bank assets; (k) adjustments made by commercial banks as a result of changes in their excess reserve balances, that is, acquisition of additional assets when their reserve position Is favorable or relinquishment of assets if their reserve position is unfavorable; (5) changes in the quantity of bank deposits which accompany the changes in commercial bank assets; (6) pressure on interest rates and on the price level which results from changes in the quantity of bank deposits — higher interest rates and a falling price level when the quantity of deposits contracts or fails to grow at a reasonable rate, and lower interest rates and higher prices when deposits increase* at more than a reasonable rate; (7} changes in business prospects and profits and in the volume of sales of output which result from the changes in quantity of circulating medium and its pressure on prices; and (8) changes in the quality of bank assets which result from changes in the prosperity of the business concerns whose obligations comprise a large part of the assets of the banks. Mwt m m m m atilch ym ta t e are mm% msxism, X m wx*, ta imm m c m m m exproaeed. What are t e p r o f i t s t e ^ in queatity «ad telitgr of t e k m m t s dsriag t e este aie M x t e or a ter* Frota wy r e m s af t e causal mtçxmm fading ta c h m & m in the fueaUtar «ad «ueHir «f teak asseta it la alear t e i ta aasEwr this X must fareeæt t e t e l a t e e af t e rateai Beeerve auterltte* S a m la Washington ite tajr ta keep la tatuali vite te- of tla* la t e Feteal Besare* Serate«, t e 1 tettate «o aake a formmt regard!^ Iterai Basent* «cites. t e w a t te cite* t e t la t e or t e appiè trae v&teh % do V t e I @at sar siteut gettlag t e on a ü»fo la tklss f l t e # t e rateai Esserea amofiaMamts, m J t e SB asad Aisgust $, 19^9, of fcrteaslng rsâacttes la percentaje resere* requiraattaxta ispüa& \ a teatteial tereaae la effective reserves, t e teee a protefciltty or considerate æ t e a a r e^aaatei seste* t e record fra» t e addale to ite m û #f 19^9 tea* timi th* rate of expansion la effective teak reserves m m t e aa hlgk aa «otdLd t e e t e a p o e t a d frai t e cteraater or t e « ï w « t o | t e t&ird* atea t e e t e y part of t e s yser a P«*i of ite expansion vixich dtà ocaur la ite lattar teif of 19I9 h »« olïtesr tea^cnaaeUed* fo m Just t e i t e s i t e te tea t e t e it t e t e a relate to t e t e s * eteittes it la desitela to go teft to te aaarfcte parte« Itolag t e w , w-loas partloterlr frow 19^3 t e l l afte t e ftel drive teard te te af 1$*5* federal Eoserve telate tea direeted taaard provlding comercial laite utili su increaelng of t e k réservail le arder t e t t e t ete could particípate, ixjdtrectîy tf sot âlreottr, le Zim m i m t e toge gaveras®»! défiait. jiir' V .-.<sai -S M la X p ü effort# "iaifiHI b«gaa to te » d e to belt the growth la assets end beak reserve«, bet the actions taken were not of auch fores until the latter part of 19%?, Aa vas stated in the Federal »«serre Bulletin of October 19%0j n81nce the war, and particularly since mid-19%7, Federal Reserve credit policies and the Treasury fiscal end debt management program have had aa a major objective aa such restraint on monetary and credit expansion as sms consistent vith maintenance of orderly end atable conditions in the market far Government securities*" j/ The policies of 19%7 end 19%8, which are described in the same issue of the Federal Reserve Bulletin, were not as restrictive as asny economists thought desirable* However, their impact appears to tore been heavier than was anticipated by the Federal Reserve authorities themselves or by most of the reasonably well-informed observare outside the Fedirai Reserve system* In to m s of effective bank reserve a peek was reached at t o end of 19%?* Baring t o next year end a half effective reserves declined by ? percent in comparison with a normal growth for a year end a half eetimaisd at over ? l/f percent (3 percent per year compounded) * Relative to a normal growth, therefore, effective reserves declined by approximately 15 percent frm t o beginning of 19%6 to t o middle of 19%9* Tou are familiar with t o fact that a peak in prices and in business activity vac reached in t o autumn of 19*3. between t o two wars* this was a typical lag aa indicated by t o experience the stop in business, tough not severs, hsd become obvious in t o spring sad early summer of 19%9, before t o Federal Reserve authorities announced reductions in percentage reserve requirements • l/ Federal Beaerve Bulletin, Qetiher 194Ö, pflÜäS’l' * Ht« la JVam aad August 19*9 suggaeted tbat Tb« « m o nna— ■melmareductlons ln pw — m requl— ts would rsleese n&arir tb— billioa dollars of reeorveo ty tbe end ©f August. — -obrtb af tbe aouxmt bald la tbe «t«t« of tbe ye&rj aal about — bai there basa no aff»aettiag action tbe aeafeer Raa— » Syataa would h— This of tbe Federal been enablad to increase tbalr depoalta by 18 pea-oaat. Benaver, during tba thraa — (rf tba yoar tba estuai aoount of rasar— folloving tbe — lat della» was redueed about by $2 bllllaai tbat lf| aearly tvo-tliird3 of tba isdiMtios 1b perceats©# rsaaraa » » i r a — ita — off-set by otber Federai Reeerve principelly tba « l a of Baited Sta— aat raeult — Sba tbat ficco thè middle to thè end of 1 & 9 effectiva »aervee Inoreaeed ty a little e— *»■ * Ooveru— it obligatIons. ? pereent. Silice a aortal grorth Ft**’ *• •*«** * */» paeeaut, tbta naano «hat — er— iaoieaved relative to trend durlag tbe half-ysar by about 5 pereant, thus rastori»* about caie-tbird of tbe l o « during tbe precedine yaar «al a half. Aa you b w t thè efibet of thè reeultiag expanalon in & — lta — e h m ma l busisase sentiaant and a feeling tbat tba a little Depression would aot beo— a big — aad — 14 soca disappeer. Somme, I m a tba fcagtaalag af tba yaar aaotber «— rem tba flirt ef tba yaar to N — b 89 — ***"“ *“**•* M ut hae M c r M r i p e « r t . 81— tbe ao— 1 g— effettive voi— th to* tbat *M«ö» of tlao lo a little over l peroeot, tuia la a declina relative to tfmA ot **** th*B 5 P— « t la 1— 0Jw *««ìU v» pollay «boald serti— * * * <wr — aaat aoda»— do— tfcan a «— ter of a yaar. for aavaral a— aataa, wfaiob a* — aeatba — a— aa— if « M a recovery te be hopefolly aaticlpated by gorernaent officiale «ad buslnes» m , ooetxr duriag 1950. will not X» that event* wo ehould expect the general level of prieee to continue to drlft dovnward, bueinese to be slnggiah, and uneaployaent to oontinue to increase» fhe quality of bank asaete vould then probably cantinue to deterlorate.
@FedFRASER