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For release at 10:30 a.m.
Pacific Standard Time
December 28, 1966

Interest Rates Versus Interest Ceilings in the Allocation of Credit Flows




Remarks of George W. Mitchell
Member, Board of Governors of the Federal Reserve System
at the
Annual Meeting of the
American Finance Association
San Francisco, California
December 28, 1966

Interest Rates Versus Interest Ceilings in the Allocation of Credit Flows

There is no need for me to assert or emphasize on this occasion
the importance of the role of prices and free markets in the allocation of
financial resources.

Academic training or professional indoctrination,

if not prejudice, has given all of us a well-established and relatively
similar orthodoxy.

There is also a derivative consensus on the impropriety

of price ceilings or floors, whether statutorily or collusively reached;
still it is this latter orthodoxy that I want to explore in a special
context today.
That special context is a period of monetary restraint such as
we have had in 1966.

Even though we grant that ceilings are inappropriate

in periods of monetary neutrality, ease or moderate restraint, may there
not be some degree of monetary restraint that creates conditions under
which one can argue that ceilings have an appropriate role to play in
protecting our financial institutions and relationships?
To start with, I want to make sure that we do not share the
popular degree of naivete about the nature of rate constraints on the
financial markets.

The shelters or barriers that collusionists or law

makers erect are always leaky under any significant pressure--and the
greater the pressure the less effective they eventually become.

Given

both time and the financial incentives, these constraints affect less
and less of the flow of funds.
However, in the meantime, or at times, statutory and institu­
tional constraints on the flow of funds have significant allocative
effects.

Usury laws and statutory interest rate ceilings are prime

examples of the ambivalence of limitations on credit terms.




A usury

-2statute may force a borrower into a more costly credit market or into a
loan repayment or discount plan with effective rates well beyond the usury
rate.

It may act as a floor instead of the intended ceiling, or it may

bar practical access to credit at all.

These and other possibilities

indicate the caution needed to evaluate the short-run protection afforded
to borrowers by usury statutes as well as the longer run changes they
induce by promoting or restricting institutional access to a given market.
Similarly, the constrictiveness of regulatory rate ceilings has
stimulated some aggressive banks to probe the inherent fungibility of
time money and, in doing so, achieve a precedent-breaking enlargement
of the Federal funds market, a large-scale domestic use of the Euro-dollar
market, and a surprising degree of moral suasion on their negotiable CD
customers.
The prime rate, a widely respected floor and ceiling for the
"better" loan customers of commercial banks, is another frequently cited
example of an artificial rate barrier.

Its allocative effects on bank

and nonbank sources of funds are muted because "better" customers must be
defined and that process introduces some flexibility in eligibility for
the rate; additional variance in the rate itself is achieved through the
discriminating enforcement of compensating balance requirements on
various customers.
A final example may make still clearer the importance of
avoiding a doctrinaire position in these matters.

It is generally known

that the statutes of the United States legally prohibit banks from paying
interest on demand deposits.




In the words of the Federal Reserve Act,

-3"No member bank shall, directly or indirectly, by any device whatsoever,
pay interest on any deposit which is payable on demand...."

But it is

equally well known that in substance, a return is being paid on demand
deposits in the form of bank services, and that these services are being
measured more and more precisely as account balance equivalents by the
electronic capacity for accounting minutia now beoming available.

The

legal prohibition, then, may limit the return paid on demand deposits
to the cost of services that a demand depositor can demand, but that is
all it does.

And in these times, I should add, there is also an implicit

loan commitment fee sense that is, in effect, earned by demand deposits;
namely, the value attributable to the access to bank credit that goes with
a prized demand deposit (one which the customer maintains well above
service requirements over the years).

This "right to accommodation" is

not inconsiderable whenever the customer asks for credit in a period of
really "tight" money.

Thus, even though they are handicapped by a nominal

interest rate ceiling of zero per cent banks are able to create powerful
incentives among their customers to hold substantial sums in demand deposit
accounts.
In light of the protean character of rate ceilings and floors,
I believe we must guard against over-emphasizing their role in an analysis
of financial allocation and in our proposals for reform.

We should also

be taking a close look at the public and private institutional factors,
including tax differentials and subsidies, which probably have a more basic
and enduring influence on financial resource allocation than all the rate
barriers and shelters combined.




-4With this slightly disparaging introduction to implications of
the title of this speech, let me develop the substance of my remarks by
refreshing your recollection of recent developments in financial inter­
mediation.
All would agree, I believe, that intermediation has been a major
factor in financial developments in the post-World War II years.

It has

great advantages for the institutions involved and their potential customers
on both sides, i.e., those from whom they borrow funds and those to whom
they lend.

These advantages are those of investment specialization and

efficiency, of enhanced liquidity for depositors, of a broader availability
of credit to smaller borrowers, and a generally more competitive environ­
ment all around.
The nonbank financial intermediaries recognized and exploited
these advantages in the immediate postwar period.

From 1947 to 1956,

the savings and loan associations, mutual savings banks and credit unions
grew over four times as rapidly as banks, and 70 per cent more than the
rise in GNP in current dollars.

To be sure, part of the explanation for

the slower growth of the banking system was the reduced (2.3 per cent)
annual growth rate in demand deposits, reflecting excess liquidity
inherited from the war and the recurrent need to temper inflation by
restrictive monetary policy actions.
It was clear to many bankers at the time that they were losing
out in the competition for consumer savings as the deposits and shares
of nonbank institutions gained increasing acceptance among households.
These competing institutions were demonstrating that it was possible




-5to buy money from supposedly interest-insensate consumers.

To make

matters worse for banks, many business customers, attracted by rising
market yields, were turning more and more to market instruments as a
repository for their liquid funds, and their deposits at banks showed
little growth.

Finally, with their deposit growth limited, their

customers' loan demands growing, and their portfolio of liquid assets
gradually becoming a smaller share of their total assets, banks, by
the mid-1950's, were coming under increasing pressure to find funds.
The increase in Regulation Q ceilings at the beginning of
1957 afforded banks additional leeway to compete for time and saving
funds.

I say additional leeway because many banks were not using what

leeway they had and were reluctant to see more added.
made effective use of the opportunity.

Others, however,

In the next five years total

interest-bearing deposits of banks expanded at an average annual rate
of about 10 per cent, or about twice the pace of the preceding decade.
In these years, from 1957 through 1961, the public's greater relative
share of financial asset acquisitions in the form of bank time deposits
was associated with smaller accumulations of demand deposits and a small
decline in their relative purchase of market instruments.

Claims on

nonbank depository institutions, however, continued to rise as a relative
share of total financial asset purchases.

Banks' share of total credit

flows rose to over one-fourth— up from slightly over one-fifth for the
period 1947 through 1956.

Nonbank depository institutions increased

their share about the same--from less than one-fifth to about one-fourth,
and nonbank nondepository institutions and direct market financing,
especially the latter, had declining shares of total credit flows.




-6A more dramatic shift in financial flows occurred in the 1960's.
Four increases in Regulation Q ceilings from 1962 through 1965 permitted
banks to continue to attract time and savings deposits.

The decision in

early 1961 of major money market banks to issue large denomination
negotiable CD's to business, State and local governments and others,
broadened the area of bank competition for funds and signalled the
beginning of intensive efforts by banks to attract more interest-sensitive
deposits.

And, I might point out, more than permissiveness and increased

aggressiveness was at work here.
also a major factor:

A kind of Schumpeterian competition was

many banks were forced to break away from past norms

not only to meet nonbank competition but also to react in kind to the
efforts of other banks to buy funds.
The net result was a further acceleration in time and savings
deposit inflows at banks to an average annual rate of 15 per cent from
1962 through 1965, with banks all over the country and of all sizes
sharing in this greater growth.

In this period there was a sharp decline

in the pace of public purchases of credit market instruments.

And as

time passed, and banks designed still more attractive consumer deposit
forms, nonbank depository claims also began to decline as a share of
financial asset purchases.

These shifts in competitive positions were

reflected in steadily growing credit flows to banks.

Over one-third of

total credit came from banks for the entire period 1962 through 1965,
and in 1965 the bank proportion reached 40 per cent.

Nonbank depository

institutions maintained their one-fourth share of credit flows initially,
but by 1965 their market position had declined to one-fifth.




Public

-7-

purchases of open market instruments declined to 10 per cent of total
credit flows— down from a high of 23 per cent in the earlier postwar
period.
But these changes in credit flows were not simply a mere
diversion of funds from one channel to another.

Two other major phenomena

were contemporaneously involved.
First, the rate of expansion of total financial asset acquisitions
of the public accelerated sharply.

In the consumer sector, for example,

total financial asset purchases rose from slightly over 5 per cent of
income from 1957 through 1961, to over 7 per cent of income from 1962
through 1965.

This development was the result of a complex series of

shifts in financial and real flows, including a much higher level of
borrowing— especially in the mortgage market.

Generally easy conditions

in this market in 1962-65 encouraged a higher turnover rate of existing
houses and probably a net withdrawal of equity from the housing market.
Mortgage borrowing relative to new housing expenditures rose from 61 per
cent in 1957-61 to 81 per cent in 1962-65.

It was the competitive return

on deposits and shares at intermediaries that made it relatively inexpensive
for consumers to retain liquid assets while borrowing to finance expenditures.
And it was the seeking of investment outlets by financial institutions that
made borrowing terms more attractive.

Thus, the result was that a higher

level of liquid asset acquisition by the public had a counterpart in a
higher level of borrowing.
The second major change from 1962 to 1965 was in the composition
of lending.




With greater inflows— at higher cost— certain intermediaries

shifted their lendir.g patterns.

Banks in particular stepped up their

purchases ci rocrtgages and municipals, taking one-fifth cf the former
market and thre*--fourths of the latter market in this period.

Moreover,

businesses sharpiy reduced their use of credit market instruments to
finance their greatly increased borrowing and turned increasingly to
mortgages and bank loans.
These shifts in borrowing and lending patterns, in turn, had
three major results for financial markets.

First, the increased bank

purchases cf long-term assets, the larger demand for mortgages by all
financial institutions, and the reduced financing by businesses in the
open market, were al'.. major factors in the unusual stability of long-term
rates from 1961 through mid-1965.

Second, the enlarged availability of

mortgage financing had its counterpart in the expanded volume of multifamily and commercial construction, as welli as the rise in residential
construction.

Third, the high level of efficiency of financial inter­

mediation meant that many borrowers--whose capital market alternatives
are limited--were able to obtain financing in amounts that would not
otherwise have been available.
Ali of these developments, 1 believe, cn balance made an important
contribution to national economic welfare In the years beginning in 1961
through mid-l965--helping to foster needed growth in economic activity,
fuller employment of our resources, more efficient and competitive
provision of financial services and yet with reasonable price stability
and some degree cf financial

restraint exercised on our continuing balance

of payments deficit.




However, the economic objectives and policy prescriptions that

-

9-

were suitable to the first five years of this decade were rendered inappropriate
by events over the course of the past year or so.
During 1965 prices began to rise more quickly, economic activity
accelerated with the rise in defense expenditures, and credit demands
expanded at a rapid pace.

The increasing credit demands and growing

inflationary pressures called for a progressively more restrictive stance of
monetary policy.

All these forces in interaction led to a sharp increase in

market interest rates in 1966 to levels far above previous postwar highs.
These higher market rates, in turn, outstripped the rates that financial
institutions were able and willing to pay on their deposit-type claims and
thus reduced their rate of growth.
Taking advantage of the higher ceilings on time deposits established
in late 1965, banks moved up their deposit rates still further and, accordingly,
their inflows of interest-bearing deposits declined only modestly in the first
eight months of 1966.

In this period, such deposits expanded at an 11 per cent

rate, compared to the 15 per cent average of the previous four years.

Savings

and loans and mutual savings bank inflows, which had decelerated each year since
1963, rose only 3 per cent in the first three quarters of 1966— a rate of
expansion below the interest accretion on their shares and deposits.

Since

these institutions tend to specialize in mortgages, mortgage credit availability
was sharply reduced and both real estate activity and expenditures for new
housing declined.
The large relative growth of "consumer-type" time deposits at banks
may have suggested that the loss of funds of nonbank institutions was due to
bank competition but the substantially offsetting decline in commercial bank




-10passbook savings indicated that the banks' "consumer-type" CD's were
highly competitive with their own savings a c c o u n t s . M e a n w h i l e , the sharply
increased pace of public purchases of market securities indicated that the
market was a major competitor for bank and nonbank intermediaries alike.
1/ See following table

Time and Savings Deposits at Weekly Reporting Banks
(In billions of dollars)
Level
Dec. 30, 1964

Change from
Dec. 30, 1964
to
Dec. 8, 1965

Change from
Dec. 29, 1965
to
1/
Dec. 7, 1966-

Total time and savings deposits

66.9

11.0

3.3

Negotiable CD's in denominations of
$100,000 and over

12.6

3.9

-1.1

State and local, foreign government,
and official institutions, etc.r/
Sub-total

9.8
22.4

1.3
5.2

.1
-1.0

3.8

1.4

8.0

40.7

4.4

-3.7

44.5

5.8

4.3

Item

Consumer-type time deposits^/
Savings deposits
Sub-total

1/ Changes in 1966 have been adjusted to eliminate the effect of (1) the redefinition
of time deposits in June to exclude hypothecated deposits (2) the weekly reporting
panel change in July.
2/ Includes U.S. Government, and financial institutions.
3/ Time deposits of individuals, partnerships, and corporations (IPC) less all
negotiable CD's in denominations of $100,000 and over. Therefore, the changes
reflect the deduction of CD's issued to all ownership categories, and not just
those issued to IPC groups. "Consumer-type time deposits" include small
holdings of time deposits by partnerships and corporations.




-11After mid-1966, several developments began also to limit
expansion of time deposits at banks.

The most important of these

was the continued rise in market yields which made bank deposits
relatively less attractive because ceiling rates on negotiable CD's
were not advanced to keep pace.
The Federal Reserve policies on ceilings in this period
deserve comment.

System policy toward time deposits in general and

ceiling rates in particular was guided by two developments in 1966.
First was the aforementioned effect of policy moves on nonbank
institutions and the housing market.

In order to ameliorate these

conditions, the Board, in July, lowered the ceiling rate on the
so-called multiple maturity time deposits in order to reduce the
attractiveness of such deposits relative to nonbank claims.

In

late September, pursuant to new legislative authority, the Board
further reduced the ceiling rate on time deposits of less than
$100,000 from 5-1/2 to 5 per cent.

At the same time the Federal

Deposit Insurance Corporation and the Federal Home Loan Bank
established ceiling rates for mutual savings banks and savings and
loan associations.
The other development influencing System policy on time
deposits was the very rapid increase in business loans in the first
half of 1966.

Such loans expanded at an annual rate in excess of

20 per cent— more than in 1965--in the first seven months of 1966
and, in the summer, were accelerating despite reduced reserve




-12availability.

These loans, which were contributing to the capital

goods boom from which so much of the inflationary pressures were
emanating, were being financed from time deposit growth, as well
as from liquidation or curtailment of other elements in bank
portfolios.

To attack the problem from the time deposit side,

reserve requirements on time deposits at individual member banks
in excess of $5 million were raised from 4 to 6 per cent in July and
September.
But more importantly, ceiling rates on time deposits in
denominations above $100,000 were not raised as market yields
increased.

At first, banks were forced to issue shorter term

negotiable CD's, but by mid-August negotiable CD outflows began
and by the end of November amounted to $3.0 billion.

With other

forms of time deposits also under pressure, inflows of interestbearing deposits at banks from August through November decelerated
to a 1 per cent rate, and in October banks suffered an outflow of
time deposits for the first time since 1960.
Reduced time deposit inflows, given banking conventions
on the primacy of business loans at prime rates, were not enough
to ameliorate the problem, and could have led to sharp reductions
in bank credit other than business loans.

Thus, on September 1,

the presidents of the Reserve Banks wrote to all member banks
calling upon them to rely more on curtailment of business loans in
adjusting to liquidity pressures--including time deposit outflows—




-13and less on other portfolio items.

The letter indicated that

Federal Reserve discount facilities would be available for
extended use to help banks accomplish this objective.
The net result of all of these actions— or failure
to act differently— in the first three quarters of 1966 has been a
sharp reversal of the pattern of flows developed in 1962-65.

Bank

credit expansion has dropped from 40 per cent of total funds
raised in 1965 to 20 per cent over the first three quarters, and
6 per cent in the third quarter.

Nonbank depositary institutions

also accounted for a smaller share of credit flows— 11 per cent
for the first three quarters as compared to 20 per cent in 1965.
The public, in turn, has supplied over one-third of total funds
raised by its direct purchases of securities, up from 10 per cent
in 1965.
The disintermediation of credit flows this year has
moderated the pace of total financial asset accumulation by
reversing the consequences of the earlier increased intermediation.
Mainly it has rechanneled financial flows and altered borrowing
patterns and credit availability.

The reduced inflows to nonbank

institutions has resulted in a decline in mortgage borrowing
since most prospective mortgage borrowers have only limited
alternatives in financing outside of institutional lenders.
Many business borrowers also have found their ability to
substitute market borrowing for bank credit limited by their
size.

Other borrowers who can qualify for market financing have

found it an imperfect substitute for bank credit.




Issues of

-14market securities are less flexible, have higher interest rates and
transactions costs, and have longer institutional lags than would
be the case with a loan at a bank.

Thus, the diversion of funds to

market instruments from claims on banks and other financial
institutions--accompanied by rising yields and reduced credit
availability--has been a major transmission mechanism for monetary
restraint.
What will financial historians learn from the inter­
mediation trends of the past year as they view them against the
financial and economic background of the postwar period?

Certainly

these trends will appear to have had a dominant influence on both
the amount of credit and the channels of credit flow in recent
years, and particularly in 1966.

While one does not write history

as it unfolds, contemporaries' understanding of the past and
expectations of the future are germane to any subsequent appraisal.
It seems to me that the salient points for evaluating credit and
banking policy are about as follows:




1.

The tools available for a policy of monetary restraint
are still powerful.

This is true despite the increasing

dependence of banks on intermediation and the decreasing
dependence on a very modest expansion of the money supply
in recent years.

Neither development eroded the ability

of the System to slow the expansion of credit once
inflationary pressures threatened to get out of hand




-

15-

since it retained firm control over ceiling rates banks
may pay for interest-bearing claims.
The demand deposit numbers, for those who watch money
supply developments closely suggest a potential
weakening of monetary control.

Thus, GNP in constant

dollars grew at an annual rate, of 3.5 per cent between
the mid-50's and the mid-60fs, and money supply at an
annual rate of 2.0 per cent.

In the 60* s alone,

growth in money has been at 3.0 per cent annual rate and
GNP 4.6 per cent.

Output, using the crude measure of

GNP in constant dollars, continued to grow about
1-3/4 times as rapidly as money supply.

These figures

indicate the monetary base is steadily shrinking toward
a pure transactions composition with future changes in
demand for demand deposits comparable to those for coin
and currency todayLooking ahead, most of the implications of money
technology and banking practice point toward an
accelerated erosion, relatively and absolutely, in
money supply as the operation of the money transfer
system is modernized and the competition among inter­
mediaries for inactive funds continues to drive non­
working balances out of the demand deposit aggregates.




-162.

The larger and more aggressive commercial banks of the
Nation--some 700 with 70 percent of total deposits-are not content with an institutional growth proportioned
to the growth in the demand deposit component of the
money supply.

Since 1955 this would have been an

annual growth rate of only 1.8 per cent.

Thus, they

have already been forced into an intermediation role;
for the future, the prognosis is the same— a, fortiori.
Because commercial banks as a whole have expanded time
deposits at an average annual rate of about 11 per
cent since 1955, their total deposits grew almost
exactly in step with GNP in current dollars— 5.5
per cent.
To retain this position, banks have had to compete
with other intermediaries and with money and capital
markets.

The effective constraint on their activities

was not the usual price at the central bank (discount
rate) nor discount window administration but ceilings—
economic, agreed to and regulatory— on what they could
pay for time money.

These ceilings, of whatever

nature, turned out to be a major vehicle of monetary
restraint.




-173.

The conventional lock-in effect of monetary restraint is a
familiar phenomena in which holders of debt assets are
temporarily inhibited from making new investment decisions
using the proceeds from the sale of such assets by the
realization of significant losses (assuming no offsetting
tax tolerances).

Growing intermediation in the past

decade has significantly added to the potency of this
type of monetary restraint, by immobilizing the inter­
mediary which encounters interest rate levels to which
a timely adjustment for it is difficult, if not impossible.
It is not just a matter of losses from a decrease in the
market value of debt assets— but the far more chilling
prospect of an unexpectedly drastic cutback in cash
flow on which the intermediary has lodged its major
dependence for liquidity and a regular lending policy
of advance commitment.

The experience is one of becoming

priced out of many markets for new funds, and facing the
loss of funds in hand because depositors demand instant
liquidity in order to move to higher yielding assets.
It includes the erosion of heretofore stable expectations
as to elements of cash outflow (e.g., policy loans) or
cash inflow (mortgage refinancing).

The concomitance

of these adverse developments has produced among some
intermediaries in 1966 an immobilization of investment
decisions, in spades, so to speak.




-

4.

One final point.

18-

After financial tensions have eased and

more stable relationships come to prevail -it seems
probable that many intermediaries will be considering
policies which will insulate them, in part at least,
from the financial shocks experienced in 1966.

These

policy alternatives will surely be aimed at a closer
meshing of maturity profile of assets and liabilities.
Customers of financial institutions will not have carte
blanche access to liquidity or credit without regard
to monetary conditions.

Assurances of this type will

have price tags or qualifications, or both.

A greater

wariness of "hot" money should be evident either in its
avoidance or in the circumscription of its use.

The

restructuring of liabilities and assets, including as
much diversification as the law allows or can be amended
to allow, also seems likely.
Intermediation, as events of the postwar years have shown,
has great advantages for our economy but the past year
has shown it is not without disadvantages too.

An agenda

of needed financial improvements for the future should
include proposals to make intermediation a still more usable
and stable element in our financial system.