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For release at 10:30 a.m. EDI
Saturday, June 29, 1968




Banks and Money
Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
at the
Annual Convention of the
Michigan Bankers Association
Mackinac Island, Michigan
June 29, 1968

Banks and Money

Banks are unique among financial institutions because of
their special responsibility for money.
involve essential money functions.

Their day-to-day operations

Both monetary responsibilities

and money mechanics have always been shared by banks with sovereign
governments although the respective roles of each have often changed
over the history of banking.

At times, the public has preferred

banker's money to the sovereign's money.
have been reversed.

At other times, the preferences

In modern times, banker's money in one form or

another has been subsidiary to and dependent on the sovereign's
monetary decisions and arrangements, but it has become the dominant
form of money in our present-day society.
To illustrate the point in historical perspective, it is
interesting to note that during the decades just prior to the Civil
War in the United States, the Federal Government had abdicated its
monetary responsibilities so far as bank money was concerned.

State-

chartered banking institutions for deposit and note issue then provided
the major money resources of the nation.

While some of this bank money

was "sound," much was not because of inadequate State banking laws and
incompetent bankers.

This unsatisfactory condition led to the enact­

ment of the National Banking Act just a little over 100 years ago, and
to the imposition of a prohibitive tax on State bank notes.

By these

steps, the Federal Government reasserted its monetary authority and
began to reassume its monetary responsibilities.
A by-product of the National Banking Act of the mid-1860's
was that "State banks converted to national banks in droves, and State




-2banks were widely believed to be on their way to extinction1' in the
words of Friedman and Schwartz.

This expectation grew out of the

great importance then attached to the privilege of note issue by
banks, a privilege now reserved by the Federal Government and
presently exercised by the Federal Reserve System.

But events in

1867 did not produce the results then anticipated, mainly because
of the unexpectedly rapid emergence of deposits as a popular form
of money.

State banks found they could operate very effectively

without the privilege of note issue; and so they, as well as national
banks, grew and prospered.

The public's response demonstrated that

deposits were a more efficient form of money than notes and, there­
fore, the key to bank growth lay in attracting depositors.

This

public preference for deposits is even stronger now than it was then.
In 1867, deposits were 55 per cent of the total money supply and
today the proportion is close to 80 per cent.
I refer to these historical facts only to suggest that while
money is an essential feature of our society, its form may change.

At

one time or another we have used specie (gold and silver), Government
issue, bank notes, and bank deposits as our major types of money.
Other forms are possible.

Credit cards, overdrafts, or metering

devices could perform all or most of money's transaction function.
Of course, much of money's liquidity function has already been
shifted from money to near monies.

More important, today, perhaps,

than changes in the form of money are changes in its use and manage­
ment by the public.




Taken together, changes in form, use and manage­

-3-

ment may conceivably be so powerful as to impel major' alterations in
the institutions that make money their business.
1 believe that day has come.

We are now in the midst of

a change in money mechanics and management that has several vital
implications for bank policy makers.

The irresistible force at work

is the rapidly evolving application of computer and communication
technology, a force that does not depend on banking or any other
single sector of our economy for acceptance but generates its own
potential with new service products and reduced costs.

The technology

is now well established in most innovative sectors of our economy and
is assuming a wide range of tasks, including those far beyond the
capacity of a non-computerized operation as well as those -hat embody
the simplest clerical skills and any given standard of accuracy.
Some bankers are going to exploit this technology with
great imagination, determination and success; and, if some do, others
will profit from their experience.

The foreseeable result for banking,

as I visualize it, is an automated clearing system in which bank
customers arrange scheduled payments (credit transfers) from their
accounts by advising their own bank whom to pay, how much, and when.
The bank's computer (owned, leased or shared) will complete the
transaction electronically through local clearing exchanges or
through the Federal Reserve System's wire transfer network.
Credit transfers are not a novel device.

The System's

credit transfer mechanism has been in existence for a long time,
and when our new equipment now being contracted for is installed




in 1970 or 1971 we will have an enormously expanded intercity money
transfer capacity.

Moreover, we will also have the ability to

install in modular units as much additional capacity as is needed
for all nonlocal transfers, whether of the credit or debit (check)
type.
The credit-type transfers have many obvious advantages
over the check, but it makes very little difference so far as the
electronic equipment is concerned whether the transfer is in this
form or in the conventional check form.

The only requirement for

achieving computer-age efficiency is that once the authorization
instrument— whether a check or some other type of instrument--comes
to a bank, no attempt be made to have the physical processing of
such instrument laboriously duplicate (trail along behind) the path
of lightning-fast electronic settlement.
In a system of this type, deposits would still be money
but the amount needed for any given level of activity could be very
much reduced, with depositors managing their payments and receipts
on a much more closely scheduled basis.

This situation would be in

sharp contrast to that described by a commercial banker in Latin
America with whom I recently visited.

The annual rate of inflation

in his country has varied from 25 to 60 per cent in recent years
and 1 was trying to find out how a commercial bank could get resources
with which to operate under such circumstances.
"it's very simple.

"Well," he said,

For any loan or service we have a high compen­

sating balance requirement, and beyond that we live on float.




We

do this by encouraging our customers to believe that -presentation
is likely to occur within a week, instead of the two weeks it
usually takes."
I don't know how large a role this type of float plays
in determining the size of demand deposit balances in the U.S.
today.

Judging from turnover rates in financial centers, which

have been running as high as 130 times per year in New York City*,
it must be a declining factor in well managed corporate accounts.
But an electronic settlement system would make possible still
further economization of such balances as well as considerably
lower holdings for individuals, governments, nonprofit groups and
noncorporate businesses.

These groups, in the aggregate, probably

have three times as much in demand deposits as corporations.
The erosion of demand deposits in many sections of the
country has been a steady process in the postwar years.

Taking

the country as a whole, at year end in 1947, demand deposits (excluding
interbank) were 73 per cent of the commercial banking system's deposit
resources, a decade later they were 69 per cent, and today they are
51 per cent.

A good many factors other than automation are involved

in the relative decline in demand deposits— higher interest rate
levels, restrictions on bank service areas, competition from nonbank
intermediaries and the financial markets have all contributed to
that trend.

The prospect for further relative declines in demand

deposits due to changes in money mechanics and to other factors is
sufficiently realistic to justify concern for the future role of
banking.




-6But before we start to view the present plight of the
banking system with undue alarm, let me cite some global statistics
indicating that up to now the banking system's postwar "renaissance"
has not been going too badly.

Since banks deal in debt or credit

it is appropriate to gauge their success in terms of the credit
they have outstanding compared with that of other financial institu­
tions and instruments.

Banking's share of this market rose from

28 per cent in 1960 to 31 per cent in 1967, that of nonbank financial
intermediaries from 39 to 40 per cent in the same period.. These
increases were absorbed by a decline in the market share supplied
directly by the public.
How have banks managed to finance the maintenance of
their share of the credit market on a relatively declining demand
deposit base?

The answer, as you well know, has been a very

substantial increase in the volume and variety of their non-demand
liabilities.

This development is epitomized by a whole new string

of terms that have entered everyday banker conversation, such as
CD's, RP's, Euro-dollars, Golden Passbooks, and that old govern­
mental favorite in a new set of private clothes, savings bonds.

These liability innovations have helped the banking system,
on average, to maintain its share of the market up to now, yet in
point of fact their exploitation has been highly uneven among banks.
The chances for long continuing the recent rates of advance in
these areas are being increasingly curtailed by market, institu­
tional, and environmental limitations.




Furthermore, as 1 am sure

you would be the first to remind me, there are other very
serious threats to banking’
s market position emanating from
regulatory postures, and some of you might point particularly
to those of the Federal Reserve Board.

What would I say to that?

I assume critics would be concerned specifically with
such substantial issues as Regulation Q ceilings, regulatory
barriers to various liability innovations such as capital
debentures, promissory notes, and other attempts on the part of
banks to penetrate money and capital markets to secure funds to
take care of their loan customers.

Some bankers would doubtless

mention a too-strict policy on operating subsidiaries and on
chartering, on branching, and on holding company and merger
applications.
All of these barriers to your attempts to grow, or at
least hold your own, are man-made in the sense that they represent
regulatory judgments imbedded in the law or annexed to it, and I
am sure at least some of you feel these should be removed or
modified, preferably by interpretation but by legislative action
if necessary.

Let me touch on a few of these issues from a

policy, and not a legal, standpoint— not speaking in any sense
for the Board of Governors, but only for myself.
The chartering-branching-merger issue seems to me the
easiest to deal with on broad policy grounds (it is not always
so easy on a case-by-case basis).




Since I believe the banking

-8system will increasingly have to face the competition of the
market and nonbank intermediaries, it seems to me to follow
that paternalistic regulatory or statutory protection against
interbank competition is not going

to breed a generation of

bankers who can hold their own in the broader competitive
environment.

Therefore, I am in favor of liberal chartering,

branching, and market-extending merger policies when both public
and corporate interests can be served.

Most of the merger and

holding company cases that come before the regulatory agencies
are approved; nearly all of the rejections are on anti­
competitive grounds.
The major problem is to accommodate a transition into
today's economic environment by that part of the banking system
that is neither competitive nor particularly skillful at serving
the convenience and needs of its own community.

This should be

done without increasing, and most desirably by decreasing,
existing pockets of banking concentration insofar as that con­
centration applies to services that can only be supplied for
practical purposes by other local banks.

Judgments on these

matters are colored by appeals to nostalgia, simplistic
applications of concentration ratios, exaggerated descriptions
of decrepit managements, as well as by economics and facts.
The best approach usually depends on the existing economic
and banking environment.




-

9-

For example, the bank holding company format seems to
me to offer the best solution to better service and improved
efficiency in those states that have a strong tradition for unit
or limited branch banking.

It can solve succession, capital,

portfolio management and overhead service problems without
diluting the local direction of loan policy or discarding an
appropriate degree of local autonomy.
Turning to another of the items in my hypothetical
indictment, much of the criticism made of regulatory restrictions
against innovative steps taken by banks to acquire loanable
resources overlooks the environment in which such approval has
often been sought.

A novel device for attracting funds intro­

duced at a time when inflationary forces have the upper hand
and monetary restraint is severe is almost certain to be viewed
as a loophole to be sealed off rather than a better and more
efficient way of marshalling loanable resources.

Or, in such

circumstances, it may be regarded as a predatory raid on
weakened competitors.
In the Sixties, several new borrowing and deposit instru­
ments did come into use with limited or no regulatory interference.
For example, the federal funds and Euro-dollars markets have been
given complete freedom.

The negotiable CD has been under the

Regulation Q ceiling constraint, but the ceiling has been a




-

10-

limiting force only in periods of severe monetary restraint.
Certainly this instrument can hardly said to have been stunted
by regulation given the $21 billion peak to which it had mounted
by early this year, an amount equivalent to 15 per cent of all
private demand deposits.
But absence of regulatory restraints on these liability
instruments did not mean an absence of banker problems or potential
central bank problems.

All of these instruments during their period

of development were overused and misused by some banks.

Usually,

too great dependence was placed on the assumption that short-term
funds would always be available at a viable price and, therefore,
they were appropriate to finance term loans or the purchase of
municipal securities.

In some cases, lenders lulled by the daily

option of renewal did not exercise even elementary precautions
in extending credit in the federal funds market.
Experience has cleared up the worst abuses of the
instruments but the exposure to liquidity embarrassment and
potential crises remains a cause for concern.

Under ordinary

circumstances, institutions can accommodate losses of funds
from arrangements or contracts that involve instant liquidity
without difficulty, but in a period of rapid rise in interest
rates and great financial uncertainty the same institutions
heavily exposed to day-to-day options of their depositors and
creditors, no matter how sound their asset structure nor how




-11adequate the discount facility support from the Federal Reserve,
could be severely damaged.
Regulatory strictures on the diversification and more
aggressive use of liability instruments are not, therefore,
imposed for the purpose of restraining the growth of banks but
for the purpose of protecting our financial structure from the
disruptive effects of disintermediation. Borrowing short and
lending long is a powerful financial device for accumulating
resources and putting them to uses that often would not other­
wise be accommodated.

It has, however, the potential to maim

or destroy institutions that use it incautiously.
These views that I have been expressing on your
problems are not intended to be admonitory or advisory to you
but merely informatory of a central banker's attitude toward
some of his problems that interlace with yours.

Neither of

us will reach the millennium of solving all of our difficulties,
only of working on them.