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Statement of George W. Mitchell, Member,
Board of Governors of the Federal Reserve System

For the Conmittee on Banking and Currency
of the House of Representatives
May 24, 1966

I would like to briefly state my basic reasons for believing that
the Board's position with respect to Regulation Q ceilings is appropriate
at this time.

In doing so I want to make clear that I do not project this

view into a future in which conditions may be changed or changing.
I start with the proposition that the broad subject with which
this hearing is concerned is a flesh-and-blood problem, and I would like to
recall my diagnosis of its potential in a speech I delivered several months
ago, and has previously been referred to by Mr. Strunk.

At that time I considered in What respects contemporary credit
developments might, from either the over-all or the structural view, become
a cause for concern.

My choice of something to worry about, which may yet

turn out to be a real menace to our credit structure, was not that we had too
much debt in the aggregate or in broad economic sectors; nor was it the level
of credit quality which could be safely serviced by an expanding economy.
Rather, it was the growing business of borrowing short and lending long—
the transformation of liquid claims into long-term credits by depository
intermediaries.
Back on October 22, 1965, I pointed out that for the saver and
investor these intermediaries were offering the best of all possible worlds.
Thus the investor had a highly competitive return on his funds, and yet by
prevailing practice he was always instantly able to convert his deposit into
direct expenditure or direct investment if market conditions open up more




-2-

exciting earning opportunities.

The channelling of these flows into long-term

instruments has also provided more ample funds for use by corporations,
individuals and the various units of government.

And financial intermediaries

themselves by lengthening their portfolios and broadening their range of assets
have been able to live well off an increasingly slender interest rate differential.
"In surveying these uniformly pleasing results, however," I noted,
"that the question naturally arises whether they have been obtained by risking
serious destabilizing repercussions in the future.

Certainly while banks and

other savings institutions have been expanding the volume of liquid claims in
the hands of the public, they have been assembling in their own hands an
entirely different time profile of matching assets.

Not only are their loans

and investments far less liquid than the claims against them as has always
been true; they are far less liquid than they were five or ten years ago."
I went on in that speech to point especially to the liquidity risks
attaching to CD issuance, but my remarks could equally well have been punctuated
by illustrative references to the risks inherent in the passbook share accounts
of savings and loan associations.
"In considering the vulnerability of depository institutions to
savings outflows," I said, "the potentially disruptive contingency--and the
one that is most likely to create a challenge to monetary policy--lies in the
possibility of relatively sudden shifts of funds from 'time' deposits to
direct investment in equity or credit markets.

In this respect, negotiable

certificates of deposit constitute the most vulnerable segment of the total
since they are directly competitive with the full range of money market
instruments and are held by corporations and other institutions likely to




-3respond quickly to relatively small shifts in yield differentials.

Indeed,

the most immediate and direct constraint on monetary policy posed by the new
profile of bank liabilities may lie in the need to weigh carefully the impact
of specific actions on such differentials.
"More broadly, those charged with formulating monetary policy must
recognize that the process of transforming liquid savings into long-term
instruments does lack some of the automatic checks and balances inherent
in a single contract between the original saver and the ultimate borrower.
A widespread shift by depositors to other forms of asset holdings--say a move
by corporate holders of negotiable CD's into market instruments or by individual
savers into common stocks--might force readjustments in bank assets that would
have serious repercussions on those credit markets in which banks are inactive
and into which it may be difficult to entice other investors without signifi­
cantly higher yield incentives.
"This would be particularly likely in markets such as those for
municipal bonds and mortgages where bank participation has increased sharply
in recent years.

It might well occur whether the readjustment undertaken by

banks losing time deposits was confined to reduced takings of new issues or
extended to actual liquidation from existing portfolios."
These comments foretold a contingency which began to come into
being with the December, 1965, tightening in monetary policy and the subsequent
rise in market interest rates,

A major asset adjustment that would have been

required of banks (and an unexpected impact on their customers) was partially




-4eased by a change in Regulation Q.

This change permitted banks to offer higher

rates for what amounted to about 14 per cent of their total deposits.

So far

as the larger banks were concerned, it enabled them to be more competitive
with the security markets.

So far as the smaller banks were concerned, it

enabled them to be more competitive for local pools of funds.
But in both instances the banks were also competing with each other
and, more fatefully, with themselves.

They had in passbook savings about

$90 billion on which the ceiling was not changed.

To a considerable extent

they found promoting CD and open book accounts at 4-1/2, 5, or 5-1/2 per
cent attracted large transfers from their own lower-rate passbook savings
accounts and thus only raised the price on funds they already had.

This

redundancy of cost had a substantial moderating influence on their competitive
drive.
Furthermore, even with these higher deposit rates banks have not
been able to fully offset the lure of high-yield market instruments for
their customers; the most that banks altogether have been able to do is to
keep up a positive net inflow of time deposits, but with a growth rate far

below last year--a third less in January-April than in the comparable period of
a year ago.

Savings and loan association and mutual savings bank net inflows

have also been dropping— to a rate only half that of 1965.

Thus, all financial

intermediaries have been feeling the tug of higher market rates of interest.
Meanwhile the share of credit demands met through direct flows of savings to
the market has risen sharply as savers by-passed banks and other intermediaries

and put more of their funds directly into securities.

Last year the banking

system was able to accommodate two-fifths of the credit used by individuals,
businesses and governments; in the first quarter of this year, the banking
system's contribution fell to only about one-quarter of the total.




-5What does this background of fact and principle signify for how
we should approach today's problem?
I think it is clear that we all have a common goal of maintaining
the stability of our financial institutions and of providing savers with the
best yields and the greatest liquidity consistent with that stability.

I

would add that near-instant liquidity of time deposits at banks or savings
and loan associations is a privilege that must not be too widely shared.
It can hardly be shared at all with any very large number of that kind of
depositors whose withdrawals are stimulated by rate incentives.

A predictable,

even though large, turnover in savings accounts is one thing, and well within
financial managements' capabilities--a concentrated mass withdrawal to take
advantage of rising yields is an entirely different matter and much more
difficult to deal with.

This is one reason for the Federal Reserve rules

that today deny passbook accounts to business corporations and to State and
local governments, two type of depositors who are exceptionally sensitive
to rate differentials.
Today many depository institutions are recognizing the destabilizing
threat of rate changes, and they are trying to stratify their depositors,
according to sensitivity to yield differentials on the one hand and to
desire for liquidity on the other.

Those that are sensitive to higher

yields are being locked in with varying maturity arrangements; this is a
major virtue of the certificate of deposit.

Those that are more liquidity­

conscious are being offered lower yields in passbook-type accounts.




-6The rates, terms, and conditions offered vary widely from place to
place in the nation, reflecting the great variety of economic and financial
circumstances and the differing judgments of thousands of financial manage­
ments.

In the process several new mutations of deposit instruments have taken

place.

A few such mutations may be bad, or at least nonprofitable in the

longer run, but I regard as constructive those savings contracts that compel
the holder to accept some meaningfull restraints (maturity or otherwise)
on his ability to demand cash from his depositary institution and then pay
that holder well for his giving up of liquidity.

And for this reason,

denouncing longer-maturity, higher-yielding CD's just because they are of
small denomination strikes me as antithetic, not only to equity but also
financial stability.
In a problem as complicated as this one, it is possible to mistake
surface symptoms for underlying causes of disequilibrium.

The result of an

erroneous analysis may be to damage our financial intermediary system,
reduce the benefits of a competitive financial system, or to thwart the
effectiveness of monetary action, the major instrument of public policy
being used to counter emergent inflationary pressures at this juncture.
Bank and savings and loan competition has been vigorous for several
years now.

But it moved into the acute stage when monetary restraint reached

its current levels and it became obvious that the aggregate of credit would
not be large enough to go around.

The problem, in my view, is linked directly

to the way in which we are dealing with overheating, or the threat of




-7overheating, in our economy.

Were we using fiscal policy to counter these

pressures, I doubt the issue we are considering today would even have arisen,
greater reliance upon fiscal restraint would probably not have produced the
monetary stringency we now see around us or may be expecting.

Our problem

is clearly worse, however, because financial intermediaries have implicitly
promised more liquidity, yield and accommodation to their customers than
they can readily deliver.
Admittedly, there is room for differences of view on what, if anything,
should be done now.

In seeking solutions, we must keep in mind that there are

both short- and long-run problems involved, cyclical as well as secular
developments with which to cope.

In the short run, we have to quell the

hysteria and break the paralysis that seem to be gripping some participants
in and observers of the financial scene.

The financial structure is essentially

resilient and well managed, and there exist governmental mechanisms established
for the very purpose of easing adjustments that must come in the wake of shifts
in demands for goods and for financial services.

While not denying that a

problem exists for all financial intermediaries— as a result of the Government's
reliance on monetary policy as the main tool of economic restraint— the
situation hardly warrants the crisis atmosphere that has developed in some
quarters, or the over-reaction by portfolio managers which threatens to
curtail housing activity unnecessarily sharply.
What is important is to be sure that in dealing with the short-run
problem, we do not adopt solutions that in the long run will hurt more than
help.

I believe the best and most lasting solution lies in permitting

intermediaries, savers, borrowers, and the market to work out their own




-7overheating, in our economy.

Were we using fiscal policy to counter these

pressures, I doubt the issue we are considering today would even have arisen,
greater reliance upon fiscal restraint would probably not have produced the
monetary stringency we now see around us or may be expecting.

Our problem

is clearly worse, however, because financial intermediaries have implicitly
promised more liquidity, yield and accommodation to their customers than
they can readily deliver.
Admittedly, there is room for differences of view on what, if anything,
should be done now.

In seeking solutions, we must keep in mind that there are

both short- and long-run problems involved, cyclical as well as secular
developments with which to cope.

In the short run, we have to quell the

hysteria and break the paralysis that seem to be gripping some participants
in and observers of the financial scene.

The financial structure is essentially

resilient and well managed, and there exist governmental mechanisms established
for the very purpose of easing adjustments that must come in the wake of shifts
in demands for goods and for financial services.

While not denying that a

problem exists for all financial intermediaries— as a result of the Government's
reliance on monetary policy as the main tool.of economic restraint— the
situation hardly warrants the crisis atmosphere that has developed in some
quarters, or the over-reaction by portfolio managers which threatens to
curtail housing activity unnecessarily sharply.
What is important is to be sure that in dealing with the short-run
problem, we do not adopt solutions that in the long run will hurt more than
help.

I believe the best and most lasting solution lies in permitting

intermediaries, savers, borrowers, and the market to work out their own




-8salvation.

Most of them are doing well enough now and others are taking

constructive corrective measures.

If governmental actions are needed,

they should be actions designed to remove restrictions and inhibitions,
rather than those which hamper adjustment to evolving economic needs.




-

9-

I would like to add a postscript to my statement, with respect to the
impact of monetary conditions of recent years on the smaller banks of the nation
and, by inference, on the effect of restricting their use of CD's and open book
accounts.

Unfortunately, our statistical knowledge of how small banks are

faring depends upon Call Report data which are not very current.

From data

for June 30, 1965, the latest information we have, I think it clear that small
banks were holding their share of the market for demand deposits, losing out on
passbook savings, gaining slightly on CD's and open book accounts held by State
and local governments and gaining well on CD's and open book accounts held by
individuals, partnerships and corporations.
Using June 30, 1961 as a comparison year, defining small banks by the
total of their deposits in each of these categories, and choosing deposit levels
in each case to set off 75 per cent of the 13,543 banks in the nation, these
are the results:
(1)

Banks with demand deposits of less than $5,110,000 had 11.6 per cent
of the demand deposit market in 1961 -- 11.5 per cent in 1965.

(2)

Banks with less than $3,250,000 in passbook savings had 13.0 per
cent of that market in 1961 —

(3)

and dropped to 10.9 per cent in 1965.

Banks with less than $1,310,000 in CD and open book accounts to
individuals, partnerships and corporations had 7.1 per cent of that
market in 1961 and gained to 11.9 per cent of it by June 30, 1965.
These data are now almost a year old and what the statistics for

June 30, 1966 would show is partly a matter of conjecture— my conjecture
would be the smallest 75 per cent of the banks are still holding their own
on demand deposits, still losing on passbook savings and more dependent than
ever on the small CD and open book account to hold their share of the time
deposit market.