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F o r release on deli v e r y Wednesday, October 24, 1973 10:30 a.m. M.S.T. (1:30 p.m. E.D.T.) LESSONS F R O M CREDIT RES T R A I N T Remarks by Robert C. Holland Member, Board of Governors of the Federal Reserve System before the 59th Annual Fall Conference of T he Robert Morris Associates Phoenix, Arizona October 24, 1973 I a m very glad to be here and to be a part of your conference. I say so partly because, as a Ro b e r t Mor r i s a l u m n u s myself, it is p l e a s a n t to be back rubbing elbows w i t h lending officers and hea r i n g stories of the latest additions to the legends of fabulous loans. I a m glad, too, to be able to p a y my resp e c t s to your outgoing President, who has been a close pe r s o n a l friend of mine since the days he and I first began to learn about such things as the p r i m e rate. But I a m also glad to join you in d i s c u s s i o n for another reason. All of us here have been living through another episode of painful credit restraint, and it behooves us to help e a c h other learn the most we can from that experience. been "just another" per i o d of tight money. Indeed, this has not It has had its own p e culiarities a n d distinctions, the most obvious of w h i c h is that it generated histo r i c highs in most interest rates, p u s h i n g them to levels that w o u l d have been unthinkable only a few years ago. In recent weeks, of course, some rates have m o v e d ba c k down somewhat. I believe a p e r s o n w o u l d be both rash and premature, however, to regard that movement as a sure harbinger of a swel l i n g flood of easy credit to follow. What can be concluded, I think, is that w e are far enough through the current interlude of credit restraint to dr a w some instructive lessons from its course. - 2 - W h y did interest rates climb so high? forces s e e m to have been at work. Thr e e fundamental First and foremost, we have an e x t r a ordinarily strong inflation on our hands. It expanded credit demands markedly, and its erosion of the value of the dollar led borrowers, savers, and investors alike to add an inflationary p r e m i u m to the interest rates at whi c h they were w i l l i n g to do business. The stronger the inflationary outlook, the bigger that p r e m i u m became, and the higher interest rates escalated. Second, in the struggle of governmental policies to hold down that inflation, a disproportionate share of the burden has b een left to monetary policy. Fiscal policy, instead of reining in demands in timely fashion, in fact prod u c e d inflation-fueling deficits during the formative stages of the boom. Price and wage controls, while slowing up some of the symptomatic w a ge-price spiral, have done little to correct the causative excesses of demands over supplies, and sometimes these controls have b e e n downright counterproductive in their side effects. In the end, the bulk of the task of squeezing out excess demand has once a g a i n been left to m o n e t a r y restraint. Given one of the biggest p e acetime inflationary excesses in our history, it should be no wonder that the countering credit restraint has had to go to extreme lengths. But there has bee n a third force pe r v a s i v e l y at w o r k increasing the size of interest rate swings. This is the tendency - 3 - for a growing share of credit restraint to be a c h i e v e d via price deterrents - higher interest rates - w i t h a d e c r e a s i n g share being e f f e c t u a t e d by nonprice restraints on credit a v a ilability - e.g., rationing, loan ceilings and the like. Part l y this reflects en h a n c e d governmental efforts to cushion sectors hardest hit by credit restraint - par ticularly housing - by bo r r o w i n g in the central money markets and channeling the funds directly or indirectly to users. Partly this reflects a continuing secular improvement in pr i v a t e institutions and marketing practices, freeing up old financial bottlenecks and inhibiting conventions an d increasing the general fluidity of supplies of and demands for credit. Finally, this rate behavior also reflects a deliberate change of policy emphasis by the Federal Reserve. In the previous cycle of tight money, the Fed supplemented its general monetary restraint by various devices to hold down bank credit availability dire c t l y - most importantly, by holding interest rate ceilings on big CD's well below the rates on competing market instruments. Circumventions of that approach developed quickly, both inside the banking system and outside. This time the Federal Reserve suspended rate ceilings on big CD's entirely, and adjusted upwa r d ceilings on consumer-size time and savings deposits. These actions were designed to enable institutions to better compete w i t h the marketplace for funds, wi t h i n the limits of their earning capacity and to the - 4 - extent called for in their own business judgment. T h e reafter, w h e n big CD's seemed to bulge large this spring and summer, f i nancing an u nduly sharp loan expansion, the Federal R e serve dealt w i t h this development not by reimposing relatively low rate ceilings, but by introducing higher reserve requirements on increases in large CD's, thereby absor b i n g reserves and increasing the internal cost of funds to banks. This w a s market-type deterrence, and I think it w o r k e d reasonably well. To be sure, the course of events this time has not be e n entirely smooth--witness the bumpy experience w i t h the 4-year time certificate--but on balance the contrast w i t h other recent periods of restraint - both here and ab r o a d - is a marked one. I regard this tendency toward a greater dependence u p o n p r i c e as against nonprice rationing in credit restraint to be desirable on balance. It seems to me to hold the p r o m i s e of wo r k i n g both more fairly and more efficiently over the long run and this should apply whether you are m o netarist or n o n m o netarist in your monetary theory. But w h ether or not you agree it is desirable, I w o u l d argue that it is inevitable: the evolution of m a r k e t forces is in this direction, powered by attractive incentives generated by our essentially p r ivate enterprise system. Like it or not, I believe you and I have to adapt to this trend. If it is true that we face a future w i t h r e l a t i v e l y large interest rate fluctuations, you may be tempted to ask, "How h i g h - 5 - will interest rates g o ? 11 There is a brief and simple answer high enough to make some borrowers flinch. To p e r f o r m their stabilizing function in time of inflation, interest rates will need to go high enough so that some borrowers are led to defer spending in order to avoid pay i n g those rates. It could be that the interest burden will exceed their capacity to pay; it could be that the high rates will simply irritate them beyond their poi n t of tolerance, or it could be that rates will seem so high relative to w h e r e they might fall w i t h i n a few months that it will prove a good business gamble to wait. W h a tever the reasons, some discouragement of borrowing is necessary. W h a t are the implications of all this for bank lending policies? I w o u l d not presume to give you a definitive list, but several logical consequences seem quite clear to me. For one thing, banks and other lending institutions can best transmit such m o n etary restraint by avoiding arrangements w i t h customers w h i c h insulate them from higher costs on new borrowings in times of tight money. This is p a r t icularly true w i t h respect to cyclical borrowers - those whose credit demands bulge most in a boom - and pro m i n e n t a m o n g these are a variety of larger businesses. W e must tread cautiously here in d i scussing lending rates, in order not to run afoul of the anti-trust statutes or the Committee on Interest and Dividends. But I want to p o int out to you that w h e n - 6 - the Committee came up w i t h its so-called "dual p r i m e rate" concept, it wa s effectively furthering the principle I have just referred to, insofar as that could be done w i t h i n the constraints of a broadscale p r o g r a m of wage and price controls. Under that concept, the large-business prime rate was allowed to evolve toward a rate floating up and down w i t h short-term money m a rket rates - and the p r e p o n d e r a n c e of larger cyclical borrowers from banks seem to be covered by that loan pricing policy. Looking back on this experience, I b e l ieve a fair observer w o u l d have to say that the "dual prime rate" ap p r o a c h has w o r k e d r e asonably well, as controls go. If so, an important reason is that it was in good part simply an extension and formalization of a p r i c i n g tendency already extant w i t h i n the ban k i n g community namely, distinguishing between big national and smaller local b usi n e s s customers in adjusting lending rate charges. Some of the m e m bers of your organization helped the Committee on Interest and D i vidends to a better understanding of this fact, and I think your customers, your shareholders, and your communities are better off as a result. Another lending policy that deserves r e v i e w is that w i t h respect to bank loan commitments. Banks maki n g commitments are p r o m i s i n g assured future a v a i l ability of funds to their customers, and recent developments are suggesting changes in bot h the range - 7 - of costs w h i c h banks might face in bidding for the promised funds and in their ability to garner them. The flat banker statement that, ’ W e ' l l pay whatever it takes to raise the money to cover our c o m m i t m e n t s , 11 has a ringing sound, but it can bet o k e n a simplistic p o licy that is very expensive both for the bank a n d for the c ommunity at large. To encourage more careful ba n k plan n i n g for how big a volume of commitments to make and how to balance bank r esources and cost-carrying ability accordingly, all three of the Federal bank supervisory authorities last spring directed letters on this subject to large banks under their jurisdiction, and asked their examiners to check the commitment policies of each bank they go into. A corollary commitment practice w o r t h y of further scrutiny is its pricing. Commitment fees can be thought of as a kind of insurance p r emium charged borrowers who are thus insured access to bank funds. But to the outsider, commitment fee-setting appears d ominated more by convention than by careful cost-benefit analysis. In particular, those fees do not appear adjustable to compensate for the risks of sharply higher bank costs that flow from the kind of cyclical fluctuations in money market interest rates and line take-downs that we have been experiencing recently. The kind of credit squeeze we have been living through always creates incentives for banks to find ways to lighten or 8 - - avoid some of the pressures on them. Sometimes this p r o d u c e s banking innovations that are useful and sound, and that b e come a par t of ongoing b a n k i n g behavior. But o c c a s ionally there emerge not-so-sound devices, whose advantages to either the b a n k or the borrower are short-lived--or even illusory-~and w h i c h are antagonistic to the long-run interest of banking and the public at large. There is one practice developing around the c o u ntry these days that I a m a f r a i d belongs in this latter category. I refer to banks issuing letters of credit to businesses that use them to support their own notes sold in the mark e t to raise m o ney e i ther for long-term i n v estment or for general s h o r t-term w o r k i n g capital. These are sometimes sold under the label of "documented d i s c o u n t notes.11 So used, these letters of credit function v i r t u a l l y as a guaranty, and therefore they are of questionable legality in some jurisdictions. A p a r t from their legal status, such letters of credit are o f t e n t i m e s not backed by adequate credit analysis nor constrained by either regulatory or management limj ts of the type applied to conventional loans. W h e n that happens, they impose credit and l i q uidity risks upon the bank that - if reali z e d - can be very dispropor t i o n a t e to the b a n k fs w i l l i n g n e s s and a b i l i t y to bear them. Furthermore, this kind of use of letters of credit is subversive of monet a r y policy, since it conveys the e q u i v a l e n t of - 9 - b ank credit outside the present scope of reserve requirements and other deposit regulations, yet in a form that is cushioned by the bank's name from the full rigors of competition in the open market for funds. All told, this type of use of letters of credit - much different in safety and in purpose from the typical letter of credit - strikes me as being p o t entially unsound and contrary to the purposes of monetary policy. Bank supervisory authorities are concerned with this development, and if bank managements themselves cannot deal w i t h the undesirable aspects of this credit use, the supervisors m a y have to do so. M u c h of this speech has dwelt upon the effects of interest rates fluctuating upward to relatively high levels. That is simple realism; we are currently in such a high-interest-rate phase. But if we are able to lick this stubborn p r o b l e m of inflation, the other influences I mentioned should wor k just as well to make interest rates fluctuate downward for significant spans of time. Moreover, this environment of sharply fluctuating interest rates is not necessarily any bonanza for bank profits. Increasing gross revenues from more loans at higher rates can easily be offset by investment p o r t folio losses and increased payments to attract and hold time and savings deposits. Indeed, how best to manage the raising of ba n k funds under circumstances of w i d e l y varying interest rates can be the subject of conferences in its own right. - 10 - Insofar as bank lending policies are concerned, let me conclude by pointing out that monetary policy depends upon them to spread i-s effects efficiently and rViirly among bank customers. How far monetary policy can go, and how successful it can be in serving its varied objectives, rests in important degree on what transpires across the desks of your lending officers. I hope that they and we all can draw the kind of object lessons from our latest experiences that will help us to make our next round of banking decisions better than ever.
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