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FOR RELEASE ON DELIVERY Monday, September 16, 1974 2:30P.M. (E.D.T.) MONETARY RESTRAINT AND FINANCIAL INSTITUTIONS Remarks of GEORGE W. MITCHELL Vice Chairman Board of Governors of the Federal Reserve System at the Canadian Conference on Banking Sponsored by The Canadian Bankers' Association Montreal, Quebec September 16, 1974 MONETARY RESTRAINT AND FINANCIAL INSTITUTIONS It is a pleasure to be here today to discuss the impact of Federal Reserve monetary policy on financial institutions in the United States. Monetary policy works by changing credit and liquidity conditions throughout the economy. The effects are reflected in higher or lower interest rates, lower or higher prices for debt instruments and many other assets, and changes in credit rationing and merchandising policies of lenders. All financial and non- financial companies, consumers, and governments are affected by monetary policy to some extent, since they all borrow or extend credit, or do business with firms which do. Thus, monetary policy has a pervasive impact on the economy, and its effectiveness is far from limited to responses by commercial banks. In fact, it is generally believed that certain nonbank financial institutions— particularly savings and loan associations and mutual savings banks— are too largely affected by monetary policy and particularly monetary restraint. The malfunctioning of these institutions in tight money periods is brought about by the sub stantial mismatch between the maturities of their liabilities and assets. -2Opinions differ as to how the impact of monetary restraint on the "thrifts" should be dealt with— whether by using government interest subsidies during such periods, by introducing interest rate flexibility into either or both their asset and liability contracts, by imposing limitations on the liquidity options of depositors, or just by living with it. I will come back to this problem in more detail later after first reviewing briefly the character of commercial banking and bank holding company operations in the U.S. and the ways those institutions are affected by monetary policy. Commercial Banks Commercial banks are the most important class of depositary institutions in the United States, with $836 billion in assets as of the end of 1973, excluding foreign branches and subsidiaries. Banks that are members of the Federal Reserve System hold about four-fifths of those assets. Among member banks are those institutions which are most sensitive to changes in monetary policy, sensitive, that is, in the sense of awareness of policy shifts. Many of these banks are also the earliest.reactors to monetary change in their asset and liability management. As is the case in most industrial countries, our banks are subject to considerable regulation and surveillance. There are periodic examinations of their assets and operations by government authorities and guidelines regarding minimum capital levels and dividend policy. In the U.S. banks are not allowed to pay interest -3on demand deposits and are subject to Federally set interest ceilings on smaller time deposits. Banks, however, are allowed to raise short term funds at market-determined interest rates. Today, about 27 per cent of the resources of our large banks come from such borrowed funds, primarily large negotiable certificates of deposit and overnight loans from banks and others, and to a much lesser extent commercial paper issued by affiliates and loans from foreign sources. U. S. banks are required to hold reserves set by either the Federal Reserve or the States, depending on whether they are members of the Federal Reserve System. For members of the Federal Reserve System, reserve requirements must be met in the form of cash or non-interest bearing balances at a Federal Reserve Bank. over 6 per cent of total deposits. Reserve balances average Requirements for non-member banks are, in some cases, lower than for members but, more importantly, in all States non-member banks may count as reserves one or more of the follow ing: interest bearing government securities, collected balances at other commercial banks which also are used to pay for services provided, and uncollected balances at such banks. In the U.S., bank loans to any single customer are subject to maximum loan limits, and loans to affiliates are limited in both form and amount. restriction. Specific types of loans are in many cases subject to For example, consumer loans are generally subject to State- set interest ceilings, and the Federal Reserve regulates certain bank loans secured by corporate stock. Banks are allowed to hold most types 4of debt securities but not equities, and to underwrite and make markets in Treasury, Federal agency, and certain types of State and local debt securities but, of course, not corporate stocks. While the figures vary greatly from bank to bank, the maturity structure of assets and liabilities in the U.S. banking system might seen to be somewhat out of balance, although not nearly to the same degree as that of the non-bank thrift institutions. Assets, primarily loans and to a lesser extent marketable securities, on average, have longer maturi ties than liabilities, primarily deposits. Except in periods of acute or long-continued monetary restraint, the rather heavy dependence on high-cost short-term funds does not cause serious problems for the larger banks. One line of defense brought into increasing use is to tie interest rates on a large portion of business loans to the prime rate or to the cost of borrowed funds. As a result, the banks are generally able to meet many loan demands profitably by paying market interest rates for short-term money market funds. In addition, all large banks in the United States are members of the Federal Reserve System and, therefore, may bridge over temporary liquidity stresses with loans from a Federal Reserve Bank through the discount window. Such loans may be secured by a variety of high quality assets. Smaller banks likewise have, on balance, avoided serious liquidity problems, but for generally different reasons. Their demand for loans is usually more predictable and controllable, their deposit -5base tends to be more stable, and they do not rely to any appreciable extent on the more volatile money market sources of funds. Seasonal peaks and periodic liquidity needs are generally met through loans from large correspondent banks, and for member banks the Federal Reserve discount window is available. In periods of severe or long-continued monetary stringency the quality and liquidity of a bank's portfolio can deteriorate and its deposit base can erode at the very time its access to money market funds dries up. The most serious cases of illiquidity and insolvency are resolved through the actions of the Federal Deposit Insurance Corporation (FDIC)— often by sale of the troubled bank or a portion of its assets and liabilities to a strong bank, and in a few cases by liquidation. Over 99 per cent of U.S. bank deposits are in banks insured by the FDIC; depositors are insured up to a maximum of $20,000, and thus small deposi tors suffer no more than inconvenience as a result of the troubles of their banks. The performance of U.S. banking institutions during periods of monetary tightness has been, on the whole, to maintain the strength and flexibility of the banking system's basic back-up role to the country's financial structure. In the process of passing along restraint, the economy's more essential credit needs, though compromised and adjusted in one way or another, have been met in large measure according to the creditworthiness standards used by bankers. Since there is a potential for substantial losses during periods of strain, the process has often -6 involved operational therapies for both borrower and lender. As is evident today, banking's operating responsibilities and initiatives have not been blunted by widespread uncertainties in markets and profit prospects. It is obvious, however, that not all bankers have lived up to the performance of the system as a whole. Some have not been able to visualize the need to adjust their commitment policy to a period of mone tary restraint lying ahead. When they should have been husbanding their resources to meet outstanding commitments, they have continued to assure borrowers of future access to credit beyond their ability to obtain funds without great strain in markets of growing selectivity and rising interest rates. It usually turns out that the market is a harsh disciplinarian and one from whom the appeal procedure is costly. In times of uncertainty markets seldom display fine discrimination or take into account extenu ating circumstances. By and large, I think the market's disciplines, activated by recent levels of monetary restraint, are having a salutory effect on the banking system— instilling precautionary policies with respect to the equity base, the use of short-term sources of funds for long-term commit ments, the taking of positions in foreign exchange, the giving of guaran tees, and other practices that no amount of regulatory admonition or jawboning cotild effect. Fortunately, in the bankers' spectrum of allegiances to profits, soundness, and liquidity there are a preponderant number who still give highest priority to soundness and liquidity. -7 These possibilities lead me to the judgment that as banking becomes more complex, more specialized, and more competitive and, as given banking enterprises, encompass more and larger markets, they must become more responsive to a changing monetary environment. Moreover, since m o d e m banks have turned to a much greater dependence on markets as a source of funds, market vicissitudes, especially those arising from monetary conditions, reinforce the need for policies adaptive to such conditions. Bank Holding Companies In recent years, the bank holding company movement has had a dramatic impact on U.S. banking. That impact has been on the banking structure and the range of activities in which banking organizations engage; its pervasiveness is evidenced by the fact that about two-thirds of U.S. banking assets are now owned by bank holding companies. While the effects of the 1970 amendments to the Bank Holding Company Act on the U.S. banking structure are only peripherally related to the theme of my renarks today, they, along with new systems of deposit accounting and check money transfer, are indeed altering the technology of banking and the nature of its response to changes in the monetary climate. Two of U.S. banking's most prominent features are being eroded— duality in regulation and the relative importance of lending-borrowing decisions by large numbers of independent unit-banks. 8- For you duality in supervision may be a misnomer, but in the U.S. we view the dual banking system as the alternative of State to Federal chartering and supervision. Outside of the United States bankers interested in establishing offices here see the "dual" system as a fifty-one sided regulatory structure whose features may have much in common but too much in variance. The situation calls to mind the variations in national regulatory standards existing in Western Europe. However, by contrast, in Europe there is a considerable effort to achieve harmonization of such policies through the activities of the EEC. Harmonization of standards and practices in banking regulation is not deliberate policy in the U.S. even among the States. As banking becomes more complex and technical it seems to me that the role of the national banks in the United States will grow and their leadership in the holding company movement will become pronounced. The choice of bank managements, especially those serving the nation, regions, or large metropolitan areas, will tip even more decisively toward Federal charters. At the same time, it remains a possibility that harmonization among the States could occur or that many of them could graft their regulatory systems onto Federal standards and administration as has been done in other areas of regulation. -9 - Non-Bank Affiliates In addition to owning banks, bank holding companies are allowed to engage in a variety of specified bank-related businesses that have been approved by the Federal Reserve Board. The most important of these so far as domestic operations are concerned are mortgage banking, consumer lending, business financing, and leasing. These are activities which involve an exposure to changing monetary conditions not incurred in such other approved operations as: bookkeeping and data processing services, acting as a trust company, as an investment or financial advisor, as an insurance agent, as an underwriter for credit life and accident or health insurance on extensions of credit by the holding company system, issuing and selling travelers checks, providing courier services, buying and selling gold and silver bullion and silver coin, and providing management consulting advice to non-affiliated banks. All acquisitions and de novo entries into these bank-related activities must be approved in advance by the Federal Reserve Board on the basis that public benefits in the form of greater convenience, gains in efficiency and increased competition offset possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. Other than approving and denying such applications, the Board does not regulate non-bank activities of bank holding companies but other Federal or State agencies may do so. -10The bank holding company statute allows banking organizations to operate bank-related activities across State lines, in some cases nationwide. Entry and expansion in these markets take place through acquisitions, de novo entry, or the growth of existing affiliates. Foreign banks owned by holding companies have generally chosen to limit their U.S. activities to commercial banking per se. and none are taking advantage of entry into the range of bank-related businesses now engaged in by many U.S. banks. The impact of monetary restraint on firms engaged in mortgage banking, equipment leasing, or general lending to individuals or businesses is through their exposure to market forces and is most acute for those companies that borrow short and lend long. Affiliation of such firms with a bank holding company has often been sought to reduce the severity of market pressures on availability and cost of funds to them. Affiliation also has been sought to enlarge their capital base by using the expanded resources of the holding company and its associated entities. More often than not holding company affiliation by these specialized lenders appears to have worked to the advantage of both parties, but such arrangements have not been tested over a long enough period of time to justify firm conclusions with respect to either the corporate or public interest. emerged. At least two significant facts have One is that a bank holding company is not an inexhaustible source of capital and credit to its affiliates. Another is that since -11- holding companies themselves are also subject to the price and availability discipline of the market, high interest rates so affect their stability or profitability as to cause them to reduce their commitments even to their own subsidiaries. It is possible to be somewhat more specific as to the particular exposures of types of firms that have sought affiliation with bank holding companies. Mortgage banking firms engage primarily in the origination of mortgages which are sold to investors, either with or without firm takeout agreements. These firms also have a "bread and butter" opera tion— the servicing of mortgages, generally those they originate. Mortgage loans in the United States are generally made at fixed interest rates, and rates paid on new mortgages do not fluctuate over the cycle as widely as other long-term rates, due in part to statutory ceilings on certain such rates and to consumer attitudes toward a long-term commitment to indeterminate interest costs. Thus, during periods of monetary restraint, mortgages become less attractive relative to other investments for the investors who buy loans from mortgage bankers, and the volume of originations and commitments decreases. Another activity of mortgage bankers— arranging construction loans and permanent financing for projects in which the mortgage banker is not himself taking a position— suffers when long-term financing becomes more expensive and in some cases unavailable. -12The mortgage banker, to the extent he takes a position in his originations, is exposed to a considerable range of risk and windfall from changing levels and patterns of interest rates. Moreover, his firm takeout agreements may not stand up— or may be significantly deferred— during periods when fund flows are being diverted from their customary channels. If he is forced to carry such an inventory, the cost of his short-term borrowing rises and his sources of funds may dry up just as the portfolio of uncommitted mortgages becomes most difficult to sell, and as permanent investors become unable to meet prior commitments. Placing an operation of this type in a bank holding company does not insulate it from the restrictive effects of monetary policy. The problems may be passed on to a more skillful asset-liability manager with greater credit resources, but even that is not a certainty. The practical issue is likely to be one of prior claims and customer loyalty. A mortgage banker who has maintained strong bank lines buttressed by generous balances over the years has a prior claim on several lenders' allegiance. A captive mortgage banker has a "family" holding company connection but it is confined to a single institution. It is difficult for me to say whether one of these arrangements is generically superior to the other. - 13 - Consumer finance companies, another important area of bank holding company activity, are also subject to market discipline but primarily because of the statutory framework within which they operate. Consumer loans are almost always made on an instalment basis— about 75 per cent are unsecured personal loans or loans secured by automobiles, and the remainder are secured by consumer durables, mobile homes, and real estate for home improvements. These loans run from two to three years, with payments usually made monthly throughout the life of each loan. The interest rate and other terms of such loans are generally regulated by the various States, and are an inflexible constraint on finance company operations. Rates charged on such loans tend to be asymptotic to statutory ceilings and show relatively little response to over-all increases in market rates, while costs of borrowed funds are highly interest-sensitive. As a result, finance companies experience an earnings squeeze during periods of monetary tightness and enjoy flush earnings as interest rates fall. The companies do, however, adjust their lending policies through non-price methods— such as changing their willingness to accept risk. In a changing or cyclical monetary environment finance companies and the public probably have more to gain from affiliation with bank holding companies than mortgage bankers. The principal advantage to the finance company is that the availability of funds might be improved. The holding company is more likely to be able to bridge over interest rate fluctuations and to stretbh out the maturity of its borrowings so that they more nearly approximate those of the assets. -14The important gain from the public point of view is the possi bility of bringing down the costs of consumer loans. Cost of money is not nearly as important an element of cost in consumer lending as it is in mortgage loans, for example. In consumer loans administration, risk, and over-head costs count heavily. The Federal Reserve Board in approving the acquisition of finance companies by holding companies has placed great stress on their willingness and capacity to cut non-interest costs by using a more efficient distribution system, unbundling risks, extending maturities and in general achieving a more realistic and equitable relationship of cost and price to varied circumstances of consumer borrowers. Business finance companies and factors generally provide specialized forms of financing or lending to companies whose credit standings make them unacceptable credit risks for banks. Host loans made are for periods of up to 90 days, and are secured by accounts receivable and inventory. In addition, many finance companies also make some medium-term loans secured by equipment or real estate. Since their short-term loan portfolios turn over every few months, and business loans are not generally subject to the legal constraints on terms and rates applicable to loans to individuals, these companies can rather quickly adjust their interest income in response to changes in their short-term borrowing costs. Honetary restraint brings on an environment which creates both problems and opportunities for business finance firms but its impact on the viability and scale of their operations does not seem to be differentially adverse to any significant degree. -15Leasing companies have also been a popular form of holding company activity. Under Federal Reserve regulations, leases that such affiliates are permitted to make must be on a full payout basis, in order that the transaction can be kept substantially equivalent to an extension of credit. Personal property leases generally have durations of 3 to 10 years,- while real property leases of durations of up to 40 years are allowable. Many leasing companies have a considerable dependence on short term bank loans and commercial paper despite their generally longer term asset structure. To the extent a holding company affiliation can effect a better asset-liabillty maturity match, exposure to availability constraints obviously can be lessened. Non-Bank Savings Institutions The imract of monetary restraint on savings and loan associa tions, mutual savings banks and credit unions has already been alluded to. I return to it because of the great importance attached to reducing that impact or ameliorating it> Savings anu loan associations exist in all 50 States, and had $272 billion in assets as of ci'.e end of 1973, 85 per cent of which were mortgage loans. Most of these S&L's are members of the Federal Home Loan Bank System, and are thus eligible for capital advances from a Home Loan Bank to meet liquidity pressures, commitments, and, to some degree, continued expansion. $20 billion. At present these advances amount to ¿bout -16Mutual savings banks are State-chartered institutions, existing in only 17 States, and had $107 billion in assets as of the end of 1973. They have broader authority than S&L's to invest in assets other than mortgages. Still, 69 per cent of their assets are in mortgages. No mutual savings banks are members of the Federal Reserve System, and only a few belong to the Federal Home Loan Bank System. Therefore, mutual savings banks rely mainly on their own portfolios and commercial bank lines of credit to meet liquidity strains. Credit unions are a rapidly growing type of depository insti tution in the U.S. and now have assets totaling $29 billion. These institutions are tax-exempt mutual associations, whose only deposit offering is the equivalent of a savings account. All shareholders or depositors are required to have a common bond for association, generally it is employment or religion. Credit unions receive the deposits of members and make shortand medium-term secured and unsecured loans to members, often *t rates lower than are available elsewhere. Interest ceilings on their deposits are currently well above those of other depository institutions on savings deposits. In fact, most credit unions pay lower rates than their ceiling .-ate, but higher rates than savings deposit rates at thrift institutions. Thus,far, credit unions seem to be in the position of being little affected by shifts in monetary policy in contrast to the major thrift institutions. 17- A great deal of attention— official, institutional, and academic— has been given to the problem of smoothing out the severe fluctuations in the home building industry during periods of monetary restraint and maintaining the viability of thrift institutions that play such an essential role in its financing. It is becoming more and more apparent' that intermediation through deposits is becoming an unstable foundation for these institutions. As the U.S. financial system has become more market oriented, thrift institutions face increased competition from market instruments aimed at attracting the kinds of funds that traditionally flowed to than or have come to them in periods of monetary ease when market instruments have been competitively inferior. Money more% which a decade ago bred large idle balances in demand deposit accounts or low interest-bearing ti .e accounts, have changed. minimized transaction balances. "Money management" has Savings pools which formerly were indifferent, if not unaware of developments in market yields on debt, have become interest-sensitive "hot" money. Thus, thrift institutions today are much more dependent on depositors who are able and prepared to shift from deposits to market instruments according to yield and liquidity advantages. Thus far thrift institutions have not been able to cope with this change in environment. Their managements regard the maintenance of a level of depositor interest rates necessary to hold or attract funds as involving risks and operating losses i-.hey cannot afford. On the other hand, paying lower interest rates than c«upeting market instruments -18leads to a decline in their footings, a break in loan customer relation ships and, of course, a drying up of mortgage funds. In the U.S. the dilemma of the "thrifts" is partially assuaged by the imposition of government ceilings on interest rates paid their depositors. Similar ceilings are imposed on commercial banks. These ceilings have generally helped to control potentially destructive rate competition among institutions during periods of high interest rates. However, they have also assured the diversion of funds from financial intermediaries to various types of market debt instruments and, in the long run, simply eroded further the market shares of such institutions. Recently, thrift institutions have been able to lengthen their liability structures by selling medium-term certificates of deposit, but this trend has not gone far enough to avoid substantial outflows of funds. Thu3, the "infrastructure" of thrift institutions up to now has not proved capable of providing stable flows of funds to the housing indus try in an environment of high and fluctuating interest rates. Conclusion The usefulness of monetary policy in achieving stabilization goals depends upon its effectiveness and public acceptance. In the United States monetary stringency has had uneven sectoral impacts on large credit-using industries and the financial institutions serving them. In the judgment of some, the severity of these impacts justifies a credit allocation system based on a political judgment of social priorities rather than a market rationing of creditworthy borrowers. -19Others would moderate reliance on monetary restraint by confining it to shorter periods of time or lesser severity. Still others see no better solution than "putting up with" the sectoral imbalances. There seems to be no easy answer nor a swift solution to the problem, par ticularly in its acute stages. Assuming we need to use monetary policy for stabilization purposes, and I believe we do, the most realistic course of action is one of diffusing the impact of monetary restraint so that its effects are marginally important but not drastic for any particular sector. Several changes affecting financial institutions and markets are required to distribute better the impact of monetary restraint. however, they involve realizing two objectives: In the main, (1) equalization of the competition between markets and depository institutions; and (2) reduction of the dependence of these institutions on short maturity funds and those obtained with the assurance of instant liquidity to the depositor. Markets are relatively free and in order to compete with them depository institutions need to be freed of certain external and internal constraints. Since market competition is limited to no more than a portion of the sources of funds tapped by depository institutions, the degree of freedom needed to meet that competition may also be limited. For example, among the depository institutions commercial banks do not have the range of freedom which markets enjoy yet they have been quite successful in meeting market competition within the range of depository arrangements they are permitted and willing to offer. -20The problem of short maturities for certificates of deposit and instant liquidity for depositors is more intractable but the fact must be faced that depository institutions have promised and made available greater liquidity than is consistent with financial stability in periods of stress. Just as the cost of monetary restraint has fallen too heavily on some sectors of the economy, the cost of present-day liquidity is too heavy a burden for depository institutions. Exposure to disintermediation at financial institutions can be greatly reduced by increasing the yields for longer run commitments of funds and by decreasing the availability or increasing the cost of liquidity. For example, in some degree this could be accomplished by reducing or eliminating reserve requirements on longer term deposit instruments and imposing or increasing such requirements on all deposits subject to instant withdrawal, a feature of both demand deposits at commercial banks and of savings deposits at all depository institutions. The commercial banks, "thrifts" and other financial institu tions with marked differences in the maturity profiles of their assets and liabilities must themselves take steps to lessen their exposure and that of their loan customers to monetary restraint. They can do it by pruning the liquidity options available to depositors especially those on larger blocks of interest-sensitive funds. The liquidity exposure involved in the typical savings or demand deposit account, however, does not create a problem for institutions or the economy. Of the 100 million savings and demand depositors in the U.S. commercial banks, 80 per cent -21 have balances of less than $1,000. The behavior of these funds is pre dictable with a high degree of certainty and is not a source of difficulty. The problem lies in the interest-rate-induced behavior of the larger account holders. It seems to me depository institutions have been moving slowly in the direction of more realistic terms for lending and borrowing con tracts as they have come to realize market competition must be met. In performing their intermediation functions, they are also contributing to stability by increasingly differentiating terms among their deposit customers. Not all recent changes have been for the good however. The popularity of short dating in liability management certainly has adverse implications for stability today. Thus, much more progress along the line of dispersing liquidity stresses throughout the economy is needed to significantly abate the more severe sectoral impacts of monetary policy. These changes, however, will require time to become institutional policy and to secure public acceptance. -0 O 0 -
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