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2:30 P.M. EST

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
meeting of banking chair holders
organized by The American Bankers Association
Watergate Hotel
Washington, D.C.
Monday, January 6, 1975

2:30 P.M. EST

Remarks by
Henry C. Wallich
Member, Board of Governors of the Federal Reserve System
at the
meeting of banking chair holders
organized by The American Bankers Association
Watergate Hotel
Washington, D.C.
Monday, January 6, 1975

The impact of inflation on financial institutions has been
so pervasive that I am tempted to respond with a list rather than with
a discussion.

I shall limit myself to those aspects that are of

particular interest to a central banker.

The views expressed are my

own, but since I find them persuasive, I hope to learn that some of
you share them.
Banking textbooks tell us that in inflation, debtors prosper
while creditors suffer.

Financial institutions in general are net

creditors and most of them have indeed suffered from the prevailing

But the ways in which this injury has come about are a

good deal more complex than the simple textbook statement seems to imply.




Much of the injury has occurred, not through the net debtor
or creditor position of particular intermediaries, but because most
financial intermediaries, on balance, borrow short and lend long.
This is a useful social function in a world where long-term money
typically is scarcer than short-term money and therefore at a premium.
Such maturity transformation has also been profitable, for the same

short-term rates usually have been below long-term rates.
But inflation has changed this relationship during the

recent period when inflation was accelerating and when short-term
interest rates were rising.

This has meant that in recent times,

financial institutions have slipped into a basically losing position,
paying more for borrowing short, while making
the yield on their longer term lending.

no comparable gains in

This rests, fundamentally, on

a widespread belief, which I share, that inflation is going to be

That belief, in turn, is reflected in a yield structure in

which long-term rates will tend to be below short-term rates because
they take into account the expected future situation when the rate of
inflation and therefore interest rates will be lower.
Such inversion of the usual relationship between short


long rates -- should it be repeated frequently in the future -- raises
important questions.

These questions go perhaps to the viability of

some financial institutions themselves.

If the prospect that this

type of situation will recur, perhaps frequently, does not cut quite
that deeft it seems certain, nevertheless that some of their financial
practices must come under serious question.

To take some examples:




Fixed interest rates on mortgages, and even fixed monthly payments,
may not be possible to sustain for thrift institutions.


of medium- or long-term loans from short-term sources would become

The impact on housing finance and nonresidential

construction as well as possibly on the savings habits of large
numbers of people, would be very adverse.
This possibility, arising from inflation, adds another to
the many, and to my mind, compelling, reasons why we should be prepared
to make sacrifices to bring inflation to a halt.
My remarks so far have been concerned with the consequences
of inflation when it is correctly anticipated and assuming - - a s , I
repeat, I do -- that the correct anticipation at this time is that it
will be reduced.

Much of the impact of inflation on financial institu­

tions has come, however, from an incorrect anticipation of past infla­

Long-term loan contracts, especially mortgages, have been

written on the assumption of zero or minimal inflation, which meant
moderate interest rates.

Failure of these expectations to be realized

has put lenders on the spot.

Thrift institutions and to a lesser extent

commercial banks have suffered disintermediation.

Pension funds have

found their bond portfolios depreciating, while inflation has also hit
the equity portion of their portfolios.

I shall return to this topic




The failure of borrowers and lenders alike to anticipate
inflation correctly seems to me to contain an important lesson.
lesson says that inflation is very difficult to anticipate.


It is

altogether impractical to base an economy on the hope that people
will guess right on inflation.

The nature of inflation is to

accelerate, unless it is strongly resisted.

Hence people will

generally be fooled by inflation.
To argue that in an economy where inflation is correctly
anticipated everything would work much as it would in an economy
with stable prices, with income, interest rates, and all the rest
in real terms being scarcely affected, ignores

the realization of

And while people undoubtedly would make every effort

to guess right the risk of error for everybody would be so enormous
that high risk premia would have to be built into every contract.
The resulting uncertainty and disarray would be a severe drag on
our standard of living.
Inflation hits financial institutions partly through the
damage it does to nonfinancial units.

Pension funds, as I noted,

suffer when inflation collapses the stocks in which they have

Banks suffer when inflation undermines the credit of

their borrowers.

I would like you to observe these processes.

Since corporations are in the aggregate net borrowers,
one would expect them -- on the theory that debtors benefit from
inflation -- to be beneficiaries.

On this theory, even a corporation




with a net debtor-creditor balance of zero would not be hurt.
Future sales and profits would rise, but so would the interest
rate at which future profits would be discounted, leaving the
discounted present value unchanged.
But the stock market tells us otherwise.

A principal

impact of inflation on corporate fortunes is via the tax system.
Inventory profits are taxed as ordinary income.

So is that part

of profits that really represents depreciation, given skyrocketing
replacement costs.

These taxes eat into cash flow and require

the firm to step up its borrowings even faster than prices are

Higher leverage increases the risk and depresses the


A lower market value for the equity in turn makes equity

financing more costly and often less feasible, which leads to a
further build-up of debt.

The firm’ weakened financial position

works against long-term borrowing and pushes it into short-term

Meanwhile interest charges mount and cut further into

Through vicious cycles of this kind, inflation undermines
first the liquidity and eventually the solvency of firms.

The news

from abroad teaches us how quickly, at high rates of inflation,
this can lead to threats of bankruptcy and to large transfers of
assets from the private sector to the government.




If we continue along this route, we shall not long have
to look abroad for examples of the consequences -- we shall be seeing
them at home.
Financial institutions would benefit, along with everybody
else, from a clearer visibility of the affairs of enterprises to
which they lend or in which they invest.

We would understand the

damage done a great deal better if financial statements of business
reflected more correctly the impact of inflation.

The shift to

LIFO accounting which appears to be taking place, and the use of
accelerated depreciation for tax purposes and the investment tax
credit are doing some good in holding down the damage from

But they fall far short of what is needed, and they

also fail to give a meaningful statement of the affairs of the

Only so-called price level accounting or some similar

device can reveal fully what is happening to assets, liabilities,
equity, and rates of return.
That brings me to the problem that commercial banks face
in the presence of inflation.

Banks clearly are involved with


Without increases in bank deposits there could be no


This does not mean that this increase must be regarded

as the cause of inflation.

It may be a result that is unavoidable

under given economic or political circumstances.

Banks also are




net creditors, unless they happen to have unduly large real estate
or similar assets.

In that case they are condemned by the textbook

to play the role of a loser from inflation.
the process is a very complex one.

Here, too, however,

The final result, moreover, is

to weaken the equity position of banks.

This is a matter of great

concern to the central banker in his dual role as maker of monetary
policy and as regulator and supervisor of the banking system*
On the earnings side, banks have many things going for
them in an inflation.

Unlike nonfinancial corporations, which

simply experience an increase in the dollar value of sales, gross
receipts of banks rise both because the level of assets increases
and because the interest rate rises.

In addition, banks benefit

from the greater value, to them, of the prohibition to pay interest
on demand deposits and from Regulation Q ceilings on the controlled
part of their time deposits.

The resultant sharp increase in gross

earnings, however, has not been carried down to net.

The high marginal

cost of money, the continued presence in portfolios of low interest
long-term assets, mounting loss experience, and other factors bring
about a reduction in the net earnings per dollar of assets even
while gross earnings go up sharply.
Because inflation, while it reduced the commercial banks1
net return on assets, also reduced the ratio of equity to assets,
the return on equity has not greatly changed*

For many banks, the




return on equity has increased slightly.

Since this has happened

at a time when the risk factor in the banking business has clearly
increased, one is tempted to conclude that the process of competition

has worked very well and very quickly in the banking business:


great gain in gross receipts was competed away and the return on
equity was held to what, given the increase in risk, might be
regarded as the competitive level.
I do not know whether bankers believe that they improved
their real rate of return by raising earnings per share slightly.
If they did, however, I should be compelled to say that this view
involves a serious delusion.

The fact is that bank capital has

not kept up with the rate of inflation.

Being net creditors banks

have seen the real value of their stockholders1 investment eroded.
This poses a problem not only for the stockholder, but for the
monetary system which rests upon the banks and for the central banker
who seeks to influence it.
The shrinkage of bank capital relative to bank liabilities
is evident whether we look at it in terms of book value or of market

For regulatory purposes, and for the protection of the

depositor, it is to book value that we ordinarily look.


value reflects the market's view of the present value of future

For a bank whose market value has kept pace with inflation

one might feel tempted to say that no inflation loss had occurred,




even though I would not necessarily advocate the use of market value,
reflecting earning power, for regulatory purposes.

The fact is,

however, that for many banks market value today is below book value.
Book value in a bank is a more meaningful number than in
a manufacturing corporation, because a solvent bank owns financial
claims that, in the absence of unfaborable circumstances, could be
liquidated to pay off liabilities and leave something for stock­

Unfortunately, an increase in book value is much harder

to achieve than an increase in market value, since in the absence
of new equity issues it must come out of retained earnings.


an economy in which bank liabilities grow at a rate only slightly
in excess of the real rate of growth, and where the rate of return
on bank capital is in the proximity of 10 per cent, it is quite
possible to keep the ratio of bank capital to deposits or to total
assets constant by retaining somewhere near one-half of post-tax

Retention equal to 5 per cent of capital would do it

when liabilities are also rising at 5 per cent.
But this happy symmetry cannot prevail in an inflationary
economy where bank assets and liabilities tend to rise at much higher

Thus capital becomes inadequate, and that is what has

happened in the American economy.

It happened once before, during

World War II, when war financing greatly bloated the size of the
banking system.

Over the following years, most banks greatly

improved their capital positions, until the present erosion set in.
Largely because of the weakened capital position of some of our




large banks, the Federal Reserve Board instituted a go-slow policy
with respect to acquisitions of new assets by bank holding companies.
I would like to end with a few necessarily much condensed
comments on what might be done about this situation.

The present

condition of the banking system is not altogether satisfactory.
One way in which the banking industry could add to its strength
would be to reverse the process through which it has been going,
by increasing earnings per dollar of assets.

The increase in

profits would then be used to build capital from retentions or to
sell stock that would have become more attractive thanks to higher

It is not clear whether the competitive process would

make this road an easy one.

In any event, it would probably involve

some shrinkage in the role of bank credit relative to other credit
sources, at a time when some of these alternative sources also are
not flowing very freely.
Moreover, I do not regard bank capital as the most
economical way of protecting the depositor and the monetary system.
Bank capital, like money, has no social cost, since both essentially
are generated by the same process through the central bank.


bank capital, like money, does have a private cost, since it must
compete with alternative uses of capital.

This suggests that bank

capital is an expensive way of protecting the system.
us to think of more economical ways.

It behooves




Nevertheless, increases in bank capital, although clearly
a second best in terms of cost, still represent the most immediate

Inflation has greatly increased the urgency of that solution.