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Working Paper 76-1 BANK ~UillAGEMENT, COMPETITION, AND INTEREST RATES: A PORTFOLIO MODEL OF DISCOUNT \vINDOW ACTIVITY William Federal Reserve July Jackson Bank of Richmond 1976 The views expressed here are solely those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Richmond. Introduction* The ability valuable to borrow incentive for behavior Fifth they appear at, that extensively borrow they differ? the maximizing extends should financial paper institutional changes. The resulting using time and borrowing determine why organizations If so, how do criteria activity? important The answers of bank portfolio behavior to in of receD,t years. Capital Asset portfolio model of a bank as a utility- This model of bank risk-return Pricing demand for borrowing do not? and microeconomic a theoretical varying to Do banking that our knolwledge investor. markets, window. over recent organizations member bank borrowing develops the a potentially Reserve System. markedly paper examines macroeconomic window is Federal varies from those climate financial empirically, credit discount enrich the well-known discount to the banking the individual questions This District differ Are both stormy of This or avoid, in determining these source organizations. of large at the a bank to belong Member bank use of this among banking funds Model to encompass imperfect financial services, and interest model of bank behavior at the discount management is rate tested window as the dependent variable. Portfolio Choice of The Capital competitive, especially Competitively Traded Asset Model explains unregulated Pricing markets. This Securities starting portfolio choice point the for *The author is indebted to Emily Cart, Peggy Nuckols, Marsha Shuler for computational assistance. in analysis and of 2. 2. bank portfolios for proofs is of this based on several assumptions (see [18,24,31,55] model). They are: (1) Investors choose portfolios single-period time horizon, Their of holding utility random variables: standard (2) Investors interest rate assets to asset only (3) utility a(R): risk (5) transactions Interest This equity valuation a based on the and risk--expected asset that at a low risky dominate risk- sets. efficient portfolios with a(R). positively class with within which their E(R) and negatively with marketable, with aversion. are divisible, and taxf1~ee. estimates rates horizon: basic opportunity choose a risk identical (6) is a riskless of assets a given costs, with within framework. can be combined with choose Markowitz Securities planning or lend This asset: investment varies assets 1:'eturn E(R), form combinations Investors operate a (R) .1 RF. maximum E(R) for (4) financial can borrow Investors they uti1ity-maximizing expected deviation as if Investors are not E!xpected to security returns wide analysis. no are price-takers of 1~eturn and risk model has found and portfolio salable for any asset. change over the are not state-dependent. acceptance Its in the implications theory may be 1The tildes denote random va1:,iables. Differentiation with respect to random variables, which assume values according to a prescribed probability density function, is of course impossible. Investors define utility over the anticipated mean and standard deviation of such distributions. ~ of i 3. clarified by examining behavior is the behavior to determine aggregated Under of individual market relationships. the conditions postulated by assumptions individual investors of competitive (1) follows through investors, security (6), the the continuous, whose markets utility twice function differentiable form: K k -U = f [E(R), where the utility increases with of the k-th expected investor return, au but a(R)], from holding decreases >0. au "ai"(R)' Rational functions. requires As the a larger probability aversion isoutility space. investors is defined locus is to An individual bears compensate investor's by his locus convex to the risk utility of constant axis more risk, for he the higher , degree of risk utility. This in risk-return That is, where second order conditions > 0 2 , a a - E~!~ a(R)2 > 0 are met by the second partial term.. Conservative they will <0. risk-averse investor return a E(R) a a(R) derivative possess representative of loss. risk: -a-am- thus expected with a portfolio accept only investors low risk. prefer low expected Aggressive investors returns since seek high ofI 4. expected returns assumptions strive for they maximum expected with market relationship return asset, emerges. tradeoff of risk. A is Rr is the riskless return be in a positive the for exceeds excess them again suffer hold loci, falling identical their the rate of that predicted on the is less than prices. _ rise appropriate all between utility [~=A' .~)J is price Assets the slope optimum tradeoff market portfolios market line. 'I is: zero, market until for portfolios Similarly, their investors of all risk and thus line should containing assets class will do not have to investors' expected is of risk," whose expected capital market line. Although portfolios, change of "the prices "capital and its + A 0' (R), by the capital shows the e:fficient of interest. demand; their lie whose return rate of risky risk-return on an asset defines constant, or minimum holdings reuationship -- investors risk, by combining E (R) = ~ where given a det:erminate line Following risk-averse the return The tradeoff market high risk. all for This between The capital if return the riskless equilibrium accept however, maximum expected assets degree which, (2) and (3), for risk for return isoutility and risk when 5. With returns, constant expected the investors absolute utility-maximizing can assume an risk aversion and normally portfolio exponential form relationship such where the k-th parameter investor's by his own risk AMB. toward this asset return low all low points by Line CML it line Chart is 1 > is originates such as as at~. O. tangent to the portfolio expects investor along utility investors maximize high They proportion crc ). of They investor lie a this lend asset portfolio closer to asset to to assume 2 See functions taking generate . implies falls when negative higher The unrealistic wealth marginal than average common risk. Their of along investors assumption behavior. increases utility. of It and that high very utility that high returns CML who expected quadratic suggests the with proportion riskless holds ~. utility low the this who when their hold down obtainable return that segment M denotes receive loci set moves highest increases isoutility portfolios. (R to the c, prefer The determined The It An return a 6). appears combination. made and (p. Point Conservative assets clarified combination. cases, axis. risky (R)/2)], c market portfolio risk are risk, capital risk-reward "average" investments the -ccr avoidance: combinations until portfolio" In at axis risk "market risk only Market risk efficient be asset Capital the [-c(E(R) investor along may risky The -exp preference. theory efficient - U(R)]= denotes position This of c for as:2 --2 E[ distributed risk fJ) 104 fJ) Q) 0 ~ > .~ ~u .~ 0 .-i Q», = ,~ """' t) -0 t-I ~ + -< Z ~ ~ <H ~ fJ).-i >~ orojoroj H~ ~ fJ)oroj t-I~ ~~ 104~ CCO fJ) ~ ~ oroj Q).~ ~CO ~~ US orojO '~.o fJ) oroj<l;O bO co .-i ~ ~oroj 104 fJ) Q) 0 >, oY.oY. ~ Q)~ ~ C/) ~ t-I ~ k2 b - ' 6. "0 ...~.-i co b 0 ~ Q) .-i ~ 0 u . u .c 104 <U ~ .-i H .c uco OJ Po oroj .-i co ~ < ~ OJ ~ ~ 104 oroj t-I ~ 0. >,104 oY.O fJ) U ~8: I I I I I ~ ~ ~ ~ U bO ~~ Q)Q) oroj fJ) >-.04 ~- oroj 0 >104 <UfJ) oroj.-i ~Q)oroj 0> U U ~ 0 fJ) Q)~ fJ) 104 = ~C/) ~ Q)~ ~ fJ», 0 t-I H ~.o <U .c I I I S I I I ~ 0 >.~ -~ U ~ III -~~~ ~ N U ~ bOfJ) COoroj -Q) « Q)~ II"" co I U ~ ~ oroj 104 OoY. ~ fJ) fJ)oroj OJ 104 > 104 104 OJ ~"O c""\oroj .c I\UOJ """' ,~ ~ <U 104 N<U"" ~Q)Q) 1\1o4P.-i 0 ~ " C) = U~ ~ co ~ oroj <U ~ >0 H t-I ~ ~ ~ -k2 Q ~ HZ U~, ~ ~ ~H ~~ -- 7. return find portfolios that are supported their utility are expanded by high these along points This certainty portfolios such as (Ra,cra). equivalents the behavior markets. decisions, investors to points describes in bond and equity and operating leverage Aggressive .along CML when their is maximized CML are theory by borrowing. It can also including real In particular, it portfolio of regulated of individual analyze financial behavior Banks as Institutional Unlike marketable basic securities. is supplying information obtained securities. than less that perceived securities) Banks issue at rates no explicit charge almost about ~ to budgeting and to analyze riskless a bank. (2), the their along a superior and "customer banks issue than (deposits) In particular, in high return such loans investors. i~1 less securitie~1 time lending ]~isk of extending by individual Their (5), in nonmarketable perceived and traditionally lying to assumption in only price-takers; bank loans to invest whose return invest entirely experienc:e assumption or less. interest income to banks Their And contrary (secondary Contrary through allows is capital financial institutions. bankf; do not indivisible demand curve. primary business can be modified Banks are not downs loping relationships" investors Investors most individuals, business of of ~. sector merger proposals. All the liabilities lending bearing rate. interest most demand deposits represent clnd savings pay a source of service deposits represent 8. a riskless (Federally insured in most cases) pooling of funds, asset to conservative nonbank investors. The resulting information, specialization, and lending is and transactions responsible for mediaries. Correspondingly, investnents available securities-only could. and equity To the Market extent elastic Line. adjusted return. It quantity setting firm an efficient This set preferred receive not that Line necessarily alternative Its from realizing would earns set invest in investors underlie it face the same the Capital an excess setting an unregulated risk- and partly of 'this full If level of risk, return would remains model, potential a hold Line . opportunity an unregulated it would be (RA- ~). intermediation, bank expect It to would since the available. regulation return. Market investment intermediary. investment bank could the Capital anyone by this context their it the higher excess "exploit" of direct In the also private a rate dominate~; to assume the market RA' loan!~, partly reflects to a financial return that that thus opportunity bank could markets 9) shows that portfolio available the . 2 (p. Bank Market risky do so, extends is of would financial But as it Chart it inter- bank dominates securitiel; that locus investment An unregulated debt infinitely efficient in borrowing of financial opportunity to an unregulated [35,40,49,50,55]. costs the existence the Markowitz any of the based on divisibility, may prevent Reserve banks requirements / ' ~ ,< 0 / ~ , /\ / /~ H ~<I' ~ < ~~ ~ ~E-t E-tH ...Z 0 r..1 z ~ / / / / \ 0/ / r..1 u: H tJ) ~ u E-tr..1 H~ ...::J r..1E-t ZH ~ ~ tJ) ~ ~ :z ~ H~ I \. ~ ~ . 9. ~ 9. ~<U '" v, ~~ <Uq) s.. S ~<U <U OCCU t: fJ) ~O t:.o ~~ <U. fJ) s.. .t:~b ." ~ <U 0.0:': ~ fJ) ~~ <0 s..5 ~<U t: > II-j fJ)<U O.t: fJ)~fJ) CU t: OJtUfJ) t:.t:<U ~fJ).-I ='OJfJ) O~o..t . S s.. ~ fJ)~ ~ t: ~ s..fJ)<U ~ <U t: fJ) .t:o..to..t ~ tU '" t: H o..t ~ o..t > =' .-I H ~ ~ =' 6'Z ~ ~ ~ \ ~ ~ ~ fJ) fJ) s.. >'<u / S ~s..<u b t:t: .t: Oo..ts.. CU ~ t: .-I >'6 UtU~ bOt:<U .-IfJ)<U =,~1I-j ~~ ~ QltUs.. s.. 0 t: fJ) s.. OfJ)<U U::JCU <uS~ s..o..t<U fJ)OC~ ~o..tQ ~ tU o..t .-I1I-j o..t ~1I-jt: c.; ~ t: <U ~~tU s..oo ~ s.. ~.o CU CU .t: U .os..~ 0 P- .00.0 I ~ I ~~ CU <UtUU ~S ~s..O I ='.t:fJ) &~~ I .-I<U<U I .I I I I I I I I ~~':y; < CU ~ I I ~ .cd" ~< N t:o..tt: CU~o..t N~ o<uo <U o..t~ U~ ~ t: CU \ ~ t: I s.. I 0 ~ ~ Z / /0 / ~~ / ~Z <0 Q ~ tj~ ~::J P-E-t rJ~ 10. clearly lower asset beyond return expected that returns, required on a portfolio since for transa(~tions containing i and E(Xi) r on portfolio falls the proportion denotes the expected cash is clearly proportionally terms, holding instead with required of secondary lower certainty Wi less reserves proportion to total market risk to risk, investor along the Capital restraint represent in The zero return expected cBLshholdings. asset return In risk-adjusted in th,e form of primary portfolio reserve profitability assets to a the capital of portfolio risk beyond 2. size, from could If in reserves a regulated RA to ~ be less same risk than the Proportional are held bank's . that preference requirements, assets, in reward If the for bank is very of a conservative whose portfolio further. certainty prohibitions and other some absolute speculative earnings the Chart appears lies Market Line. on earning risk-adjusted Line return with Moreover, in declines its private assuming Hence, reserves portfolio from invested from asset i. than~. reduces of required Line types return reserves Bank Market certain The weighted E(i i )'" of the portfolio portfolio Reserves averse purposes. equivalent. The effect assuming an inefficient n = i=l represents always n a~;sets is: ~ E(R) where wi cash is (All equivalent regulations level returns . does not points against lying of the holding prevent banks The resulting necessarily along zero-risk reduce a Bank Market intercept rate.) - 11. 11. These restrictions strengthen public application tends limit accounting confidence of risk-asset to reinforce risk-averse solvency are not as though is to not traded utility preference." goals [17, p. judgments of banker prudence, isoutility loci Bank utility functions involve positive offset utility the dollar liabilities The risk will full true sheets, of liability 33, and Risk 36, Since "bank management behaves and attempts to about stockholder regulation, with and stockholder the properties marginal shown above. utility of return, cost, and negative risk. Increased returns costs of assuming marginal are required to increased 38,47,51]. Aversion preference holding functions. liability and psychological [2,22, Bank Portfolios balance or and 764.] generates of asset utility markets,3 of its They try profitability, det:ermined preferences utility profit-maximizers. of liquidity, in "perfect" on the basis marginal Regulatory in particular, have homogenous! expectations The combination negative ratios, they by banks. unconstrained subjectively stockholders maximize capital behavior conflicting according bank stock while Investors Banks thus the of return, the b.anking system. and other Banks as Institutional to reconcile in riates of individual interregional banks may be suggested and intertemporal variations by their in 3"Simply attempting to maximize the market value of the stock not yield the highest utility if the market does not reflect the value of the bank and if its stockholders are unable to obtain the value by liquidating their holdings." [17, p. 764]. 12. demand constant liability Vault Federal e 10,12,28]. Consider the following asset and schedule: Cash: ~ [2,9, Cash, Other Borrowed Funds Sold Correspondent Federal Funds Purchased Government ~ Other Deposits ~ =' ~ Government ~ 'Pol -~ ~ =' co ~ 4J cx: Securities Certificates of Deposit ~ CI) ~ ~ ~ 4J Securities IPC Demand Deposits 'Pol 0 .Q IPC Time and Savings Deposits Fixed Assets Capital: Total Assets Total Financial This simplified of assets return, and operating balance sheet and liabilities curve prevails More liquid corresponding capitalized of to value. in these accounts may shift a bank. characteristics conditions. assets Illiquid, receive credit risk returns. assets, equipment used in operations, the require lower and high somewhat risky portfolio (The cost, if a downsloping money periods.) generally low or zero Fixed for the risk-return "normal" tight cx: Equity are identical orders ~ Liabilities=Assets under and volatility yield risks Debt, ~ ~ ~ Loans cx: largely loans returns, predictability earn the highest nonmarketable j~ven higher expected of plant and returns than loans. Conversely, risk ~ ~ 'Pol < ;:I ~ cu ~ ~ ~ ~ ~ Balances Reserves of withdrawal more liquid or unavailability assets possess generally higher volatility. increases as liability The 13. volatility to increases short-run from debt withdrawal, through liabilities. t-lhi1e the require~nts) may decrease sloped yield available curve, l'Any increase in dollar the portfolio paribus_, deposit should find both accumulates the risk Hence, or may sell in drains secondary severe be sought maturity connection between adjustments only rising. enough to or volatility of operations in the discount While assets a bank's of higher longer term bank risk preference thus occurs through the balance short run. the in cash drains, at the by the promise running deficiencies short-run raises returns. banks window, may and liabilities, overall risk The and shorter term sheet identity: 4 Kaufman's study  orders the variability of deposits as follows: U.S. Government deposits> demand deposits due to banks> other demand deposits ~ other time deposits ~ total demand deposits> total deposits> time and savings deposits> savings deposits. -" '--'-'.'"c. '" cc.c. p. thus raises create of their . Such a bank acceptance borrow of the I' [33, thereby levels management activities. any category and should assets, exposure. funds, risk a positively Ceteris aggressively risk To meet these reserve liability to match the to lend long" liability reserves. or engage in other risk and/or reserve deposit set. risk based on volatile for management" opportunity overall short-term size or aggregate aggregate subject given total "liability cash below required liquidity banks reserve loans its or operational higher and its asset legal attempt increases return its to the individual a bank's short retains increasing of worsens not liquid increases, at:tached of is (ad.1usted 1jlquidity increa~;ing "borrows of depleting probability with volatility that oj: liabilities as their the volatility unambiguously A bank cost which 4 to highly depol;its, uncertainty rises balances and eq1~ity capital, 120]. 14. r assets = r liabilities are attainable although in only longer in provides by accepting term the long run. assets and equity. low risk earning risk in be almost the ratios short run, can be attracted as important [2,28,49,50]. on these asset and !'capital'! should profits new evidence liability deposits Liabilities determining Higher as (The Appendix relationships.) Demand Variations These portfolio along a given avoidance. Bank Market reserve-adj us ted Bank Market Line that level It result attain environment Line, environment. assets differences bank risk should also vary both into returns available somewhat riskier a higher level ratios of utility rise the barriers bank structure. . to entry, in Chart to all assets available The resulting returns from that underlies the 3. then or liabilities. encourage banks They can clearly profitability) relaxation customer growth. higher banks (risk-adjusted This High Demand income or population demand curve Line usted in demand may result each bank to achieve bank loan "normal" returns increase from a concentrated allows the previous efficient This High Demand Bank Market encompasses individual and a reserve-adj shows the greater less-elastic Loan/deposit interbank 15) depicts of economic activity: The higher to shift 3 (p. Bank Market from a high the higher, varying bank earning Chart in a more favorable may also describe and over time. For example, steeper Line: The demand for cross-sectionally market preferences [24, of assumption relationships, and (5) 36]. / ~~ ~ Z 1-1 ~ § ~ />o~ /' 1-1 .o~ ~@ "';"--' 15. 15. . U) ~ > ~~ H cet/) ~ ~o; ~"V 'O~ ~o; ~~ ~~ ~ I &g. ~ HIQ ~~ ~ o.-! ~ 0 H ~ H ~p... CUo ~p. I-I~ ~ '00 ~>; > ~ ~~ ~~ ~~ HH 8 .0 ~ ~ ~ ~ .90~ U) 0 Ho.-! ~~ ~IQ CUt/) ~ ~ 0.-1>; ~U) ~.3 1-1 IQCU >0; ~ H ~ 0 ~~ U)S H >; bOU) CC~ CU~ 0 \ ~ 0 ' """"-.e-' ~ M'g OCU tSZ1 ~U) ~ H~ ~~ ~ ~ ~ (J.o \\ \ , . alS ~ o.-!~ U)O .0 IQ ~ ~ CI) ~ ~~ ~ ~ ""~ ~ < 0 ""~;'::: ~ ~~ \\ 0 \ ' t§~ \ \ ~ ~ ~ ~ ~ ~ > ~,.. \ '0 \ \ \ 0 ~;' Z ~~ \0 \ ..\ ~ ~ ~ iii ~\ ~ .<' ~ '", ~ 1iIV- ~rv~ iii v ~c:.. ~~ iii ~ ~~ >..c ~o.-! 0,..1 ~ PI E IQ~ bO .0 S IQO"", ~~ ~~~~ , /~~ Z~ '- , ,. !j~ "/ ~ / ~ ~ ~ ~ ;,:::~ I-I~ ~~ /' t§~ ~ / , ~>; ~~ ~ ~ CUO .oS ~~ > ..c o.-IbO U)o.-! U)~ gg ~ CU ~ .0 t~ ~~ ~~ ~~ 16. restrictions on branching transfer to the resources across realistic related to that economic health rate on Bank of ~furket in Market it increases Line . This financial investors The can required then of lines. It profitability geographic climate banks is highly territory. even more dramatic money raises the risk1ess the and slope the Capital rises height have and rotates >0.' receive to conforms When tight line ~ a~ All its ability as state a bank's of Lines. interest, the general such that Variations effects the distances observation the limit of when RF increases: 'i!-C!-ffi >0. aRF a higher return at the same risk level. E (R) rises: ~~~- >0 at equilibrium. oRF The Bank to assumption rates to rise, (6). the accommodate particularly becomes relative ~Iarket Bank the to by extensive security sloped returns liability their portfolios banks may increase loans . management despite their stimulus, . Their loan rise, Tight money periods behavior. Banks and industrial rates when banks contrary . increases. commercial disintermediation aggressive this state-dependent usually customers when to highly demand for long-term positively strongly are bank rising of reacts returns demand for that more Line as loan seek [38,44]. This to attempt loans, supply returns are pattern function increase also tyPified or expand maintain Even As conservative is shown in 17. Chart 3 when the steeply sloped riskless Tight rate increases Money Bank Market to RC. Line The higher, stimulates more bank risk acceptance. Bank Risk, Utility, and Borrowing Member bank borrowing a bank. It but the also cost of involves only forms Reserve of the cost opportunity of other Federal not represents of explicit liability management, to borrow earning assets, marginal cost Federal Reserve of the is subjective represents  discount the and the to rate, opportunity implicit cost " the marginal pressure element minus the pretax pecuniary return on of borrowing. a strong such as loans cost of disuti1ity asset management, Bank "surveillance. The incentive a source on extensively to the the amount of borrowing true cost and psychological borrowing banks adds of borrowing. and C represents If the dollar B cost of borrowing: ~ <0 dB ' according this to [2, reluctance preference 21,47]. Only the to borrow. and interest ~ <0 ac' rates lure Accordingly, should 2 and ~ a B2 of high returns both influence >0 individual borrowing. overcomes bank risk 18. The Financial Climate When the profit-conscious discount rate banks should intermittent rate and Borrowin~ benefit below earning lags behind rising to be attracted of Federal Reserve money market discount the window. System membership, asset rates, rates, RF in One a discount then becomes available. bill rates, (See Chart 4, p.19). As Treasury climb in tight opportunity assets money periods, cost of any bank along tend to exceed distance Federal funds its position exceeds Federal funds incentive the rate their 48, rate the Bank Market its total extensions discount tight discount of borrowing Model, rises. The reserve 3, the Line position would vertical line utility would. by borrowing then borrow ~ buy of loans. bank reserve in Chart by a greater bank would of other exceeds rate Pricing secondary Money Bank Market increase larger In a "normal" cost disutility position instruments money periods. When the rate, reserve-deficient overcome banks by the resulting profit to borrow. Empirical level the its bank loans l3J. discount A more aggressive to fund usually [7,11, along Asset by selling Tight bank could run. Moreover, may find increases the prevailing than short reserves the resulting Even a conservative in the the demand for of adjusting simultaneously the Capital of interest 53J--and with studies find rates--financial interest rate that borrowing demand [1, may vary 2, 5, 11, differentials--opportunity with both 13,15,22, the 30, P ercent 19. $ Billions 13 4.0 11 3.0 Member bank borrowings from Federal Reserve Banks (right scale) 9 2.0 7 1.0 5 'I 3 3-month Treasury bill rate on new issue (left scale) 0 Discount rate -FRB Daily avg. rate (left N. Y. scale) 1 1967 1968 1969 1970 1971 1972 1973 1974 1975 Chart 4. Adjusted aggregate borrowings, the Discount Rate, and the Treasury bill rate, January 1967, through June 1975. (This borrowings series removes the emergency credit extended to the Franklin National Bank in 1974. The amount by which borrowings by large New York City banks from May 1974, through October 1974, exceeded the corresponding 1973 amounts is subtracted from the aggregate series for a nonconfidential adjustment.) , 20. costs of asset and liability profit-seeking most of money" [19, Treasury is is that more loans. the The Supply discount with of Federal ). of "... periods of tight to their of greater of Treasuries when rates speculate are on capital investment when loan gains should demand falls; relationships demand for the demand for in borrowings discount rate borrowings most markets generally in Chart relationship varies [4,42, directly, 4. Borrowings of member banks when they window appears funds of the business Conversely, form of low' risk derived The accommodation for that support direction use of funds to price-quantity not inversely, tion to liquidation incentive most profitable The aggregate borrowed form then decline. contrary the their 29]. This The corresponding 53]. during borrow Indeed, [3, 6, Government securities. borrowings is because banks have a profit represent A occur banks then holdings, to borrowing falling, by the observation of Regulation unlikely toward related supported This p. 61]. security utility in is the violations It is behavior management [14,15,20]. at the existing discount Reserve or monetary credit--is conditions. their term, isoutility an elastic supply rate 56]. discount window--whether Over the longer banks decreases to create it is not supposed (For [39, "open" approach schedule for The administra- or "shut" to vary exceptions "counseling" loci initially with to this of extensively away from the return to requests changes in policy, see borrowing axis. This 21. "surveillance" is individual essentially bank borrowing The Determinants run. the result of prolonged . of Borrowings Borrowings short endogenous, thus are primarily The more aggressively demand-determined in the a bank seeks profitable loans, the lower will be its effective liquidity, and the more it utilize the discount window. The higher its into loans, more it relative would characterize to its be expected individual incoming cash flow to borrow. outgoing is likely cash flow from deposits, the These relationships banks and the banking system [2, 3, 7, 9, 10,14,16,20,29,32]. "Aggressive-management" items, such as Federal and time deposits positively and internal held, savings borrowings, section the ratio related that is supported analysis of all of borrowed to 'volatile" comprise control. connection internal or highly certificates of deposit Less volatile, such as cash, cash should accounts, reserves to balances other securities, related portfolio items, somewhat atheoretical required His study reserves and is negatively or subject are to bank management. member banks . reserves be fund-providing, correspondent "attitudes," by Morgan's loans, should be negatively more "conservative" between volatile Government deposits, Government securities, and vault reflecting This borrowing items, funds sold, deposits, purchased, to borrowings. reserve Federal funds including related fund-using and crossshows that is positively related to to greater items bank to .~ 22. Empirical Sources of Borrowing Borrowing marizes amounts of borrowed as the behavior and frequency reserves dependent managerial variable for The hypotheses empirical explanatory microbanking studies, of 80-95% of the is initially used examined. financial, borrowings. are of the general to required and the inevitable "e'l tends observed ratio and The supply elastic.S to be tested of borrowed variables are the competitive, BIRR = f (Xl' where the ratio figure sum- analysis. of the demand for be fairly that the averaged This variables represent determinants should reserves. independent largely of borrowings of borrowing: to required Twenty-eight These variables can be shown by one measure x2' ..., reserves error to be extremely linear form: xn ),e~ depends term "el'. large, on n (In most on the order variation.) 5 The possibility that inter-District differences in borrowing behavior may reflect varying attitudes of discount administrators has been raised . Such variations would amount to regional monetary policy. It is more likely that computed inter-District differences in borrowing indicate differences in bank attitudes toward the discount window, bank structure, or the demand for bank services. These microeconomic factors should be more important determinants of borrowing than the nonprice rationing that would occur if some discount windows were open wider than others [2, 39, 52,52]. Moreover, all of Hinderliter's  attempts to quantify non-price rationing in timeseries analysis were unsuccessful. .-.23. The portfolio are portrayed characteristics by the variables of these available from banking reserve organizations position accooots: ASSETS CASH Actual reserves plus process of collection deposits; CaRR Correspondent balances total deposits; DEMDEP Demand deposits deposits; FFPUR Federal funds total assets; purchased FFSOLD Federal assets; sold GOVDEP u.S. total Government deposits; deposits GOVSEC I '. The average organization; asset U.S. total Government assets; securities LOANS Loans and discooots foods size of each banking cash items in divided by total held divided divided by by total divided divided by by total divided by divided divided by by total assets; OTHERSEC Other securities bonds") divided (such as "mooicipal by total assets; SAVDEP Savings deposits deposits; TlMEDEP Time deposits (including deposit) divided by total USSEC u.S. Government securities divided Government deposits: a proxy for Government securities; VCASH Vault cash divided divided by total certificates deposits; by total of by u.S. unpledged deposits. 24. The popular portfolio image of large managers smaller banks. might suggest It of securities involves transactions [9, 16]. Sone. of these Others, with lower borrowing 41]. since proportional to organizations includes banking that for desired in that generate (zero-one) organization: mu1tibank higher J" "",~,"","," the of funds should depress may be into be less output returns of micro-demand variables companies that exhibit banks is Virginia holding """ of these should account, than banking stimulate borrowings. effects, the analysis show the location tested all of each The possibility different banking; companies. -- """..,""", should . . branching 6They dominate are multibank Virginia low cash relationship assets factors sources banks, DC, MD, NC, SC, and VA. holding large smaller funds, borrowing to nondeposit the demand for the existence binary than similar size economies relatively of banks are taken reserve is and other to stimulate characteristics deposit Variations than more than of alternative The assets-borrowing when other particularly costs borrow fluctuations, such as the tend aggressive and borrowing preferences, bank access transactions [16, negative To test would such as larger deposit risk factors, banks, size and availability of cash management, of larger they would between relative economies ratios that The relationship more complex. banks as highly borrowing behavior by the VA variable. firms in .-., the sample '-? 6 from ~"'",., 25. Financial rates demand variations and interest rate are represented differentials. by interest They are: DRATE Fifth District discount rate, under sections 13 and l3a of Regulation A; FFRATE Federal funds rate; FFLD Federal funds less TBILL New issue 3~onth Treasury bill rate; TLD New issue 3~onth discount rates. Treasury bill less The higher the level be borrowing. is usually in the Although associated discount ferentials should Q2. Q3. Banks that in an increase lessens rate. the rates; the higher discount rate in borrowing, should itself an increase the FFLD and TLD interest dif- depress borrowing. borrowing 48.53.54]. are examined interest an increase with rate Finally. [13.20, of any single discount activity may follow The possible by binary variables seasonal that seasonal influences represent patterns on borrowings each quarter: Ql. and Q4. Examined The sample organizations consists consolidated of 23 large companies are large management. They hold approximately in each location: ~~"" District on a member-bank basis. bank holding deposits Fifth -"~.~--""---~ enough to practice three-quarters the District banking These banks and liability of member bank of Columbia. Maryland. .'C" North " Carolina. c", 26. 26. -7 and Virginia. South Carolina, that serve a diverse group They operate of customers. Restricting Reserve District differences eliminates determine the possibility the other influences one business cycle through July The use of monthly 1975). of random, from day to day. reserves being aggregate reserve the analysis (It periods positions that discount may transient partly far average factors longer individual January variables 1971 minimizes that lagged affect bank reserves the ameliorates such as quarterly aggregate are examined over (recovery-boom-recession: based on two-week over any of the factors on borrowing roughly impact of confusing activity. The monthly the one Federal administration rationing--with borrowing ", ,':-: the sample to in District-by-District window--nonprice numerous offices effect of required deposits.) It than those relevant or yearly intervals. banks into does not possibly to bank Nor does nonhomogenous groups. Variable Relationshi~s The 28 variables independent and liability of each other. that may explain The behavioral management postulates that borrowings may not be model of a bank's strong relationships asset exist 7The smallest of these banking organizations held over onequarter billion dollars in deposits as of December 31,1974. West Virginia's small unit banks behave differently from those sampled . 27. among portfolio ratios themselves, as well as with the monetary climate. A test the independent analysis.8 analysis 9 numbers of variables while to "distmce" of the separates each other--" analysis between tionships between portfolio items, unrelated thus variables. interest It patterns rates, interest In this the explanatory analysis (not the strongest differentials, way, knowledge are is are dimensions. rate variables traits that portrays shows the mutually large related in multiple map" that analysis relate highly onto angles" a "road and seasonality. independent factor that clusters traits in of the data Essentially, It that present dimensionality coefficients at right is technique common influence compact space. correlation among made by factor a multivariate to each other. it Factor is reduces It multidimensional orthogonal the common relationships patterns of a relatively together; of variables--multicollinearity--is data set. that mutually extent the higher-order any large creates the Factor reveals to for relalocation, of how used to reduce multicollinearity. Methodolo8Z The factor 8 Multicollinear coefficients (a singular equations, particularly shown) suggests operational variables generate indeterminate cross-product deviation matrix) those computed with an intercept. specifications estimates of in regression 9William Jackson, Commercial Banking Performance and Structure: A Factor Analysis Appro~ch, Federal Reserve Bank of Richmond, ~~orking Paper 74-5,1974. 28. to test rates the initial Bank Market and interstate models, which indicates demand shifts a smaller dimensions regression analysis. set of possible hypothesis all that to-borrow" only theory of the 1930's, feel random short-term reserve gives the borrowing: differing it units each variable's influence the standardized Y = bl Y -~ Sy This regression the "need" "need- borrow caused by "b" + B 1 (--+-) Xl sl of each predictor 2 (--+-) X2 s2 regression bn ~ ...+ of the larger is its These model: + e (8) coefficients 8 of value predictors.lO of the b2 X2 + ...+ in their absolute coefficient, coefficients Xl are presented method of presentation the to the other standardized ., the null banks of interpreting The larger relative the that fo'r in which resembles postulated problem of measurement. into a random process, of the importance the serious lOThe computed are converted independent against of the regressions coefficients. on borrowing tested of unpredictable results comparison avoids are the It pressures. of standardized direct portfolio used as input hypothesis which the pressure Technically, the form null interest space and over time. They are essentially This disregards encompasses These regressions are zero. when they across of variables is which and the extended "causality". borrowing coefficients Model, demand variations, utilize that Line of:~ 8 n (-+ ) Xn sn e' where I's" represents the standard deviation of a variable. For each increase of one standard deviation of an explanatory variable, the standard deviation of Y should increase by that variable's S. The standardized coefficients of absolute dollar, binary, interest rate, and ratio variables can be compared directly. Conventional regression ("b") coefficients cannot be compared directly because of their different units of measurement. Colin Clark et. al., Business and E~onomic Forecasting: An Econometric Approa""Ch (HOmewood, Irwin: 1961),pp. 74-75. Robert Ferber and P. J. Verdoorn, Research Methods in Economics ~n~ Business (New York: Econometric Theory Macmillan, (New York: 1962), p. 99. Arthur Wiley, 1964), p. 54. S. Goldberger, '7. 29. coefficients have been used in many economic Bank Portfolios, Size, The test Table 1 (p. associated loans. cash, Federal minimizes while it volatile that other its typified Its bank that Regulation and funds soldll, and bank- organization Federal Government tends funds. It securities, involves relatively profit-oriented It enterprise returns. equation This than positively Government deposits. presumably suggests but rather better banking structure by fluctuating grow larger, banking Federal additions: liability an increasing large with and unpledged to borrow proportion. load reserves out loans. seeks high as they are in Government deposits, large reserve as a risk-accepting, tend model appears Government securities, borrowing short-term primary seeks This not associated 12 unpledged a typical deposits, behaves . size. That is, to purchase Line borrowings funds purchased. cash items, organization Bank Market 1 shows that They are negatively vault ing Table with including and Borrow!~g- of the initial 30). studies, finding organizations smaller ones. that large proportion that may reflect to match The largest banking organizations of their they borrow supply banking ability and demand for organizations llAn institutional consideration is relevant: sold Federal funds was regarded as violating A during this period. l2The factor analysis reveals on different factors, reflecting reserves a decreasing the longer-term the required do of very funds were a borrowing the spirit of that vault cash and total cash items possibly differing bank characteristics. 30. TABLE 1. Borrowed Reserves/Required Reserves Explained by Portfolio Items Only* Explanatory Variable Standardized Regression Coefficient FFPUR 0.2672 t Statistic 7.06 Significance of t 0.0001 FFSOLD -0.2399 -8.08 0.0001 VCASH -0.2145 -4.81 0.0001 0.1703 3.51 0.0008 -0.1497 -5.65 0.0001 LOANS 0.1349 10.67 0.0001 USSEC -0.1031 -3.33 0.0013 ASSETS -0.0968 -2.65 0.0082 GOVDEP CASH R2 0.3242 F(8,1211) 72.63 *The intercept has been suppressed to lessen multicollinearity. The t statistic is computed under a null hypothesis of a zero relationship. Its significance is the probability that the relationship is zero (unity minus the confidence level). Stepwise mode estimation is used with the significance level for variable acceptance or deletion set at 0.05. This regression as a whole is significant at the 0.0001 level. Co ~- 31. generally able to obtain nondeposit commercial paper, common stock, terms than smaller ones during these liability and equity organizations borrowings of would large banks, (Such a finding The test between states, location of the appears variables each state, the These coefficients Columbia banking South Carolina the high demand for the positive economic activity suggests that in these borrow areas.l3 example, l~or 1974 per DC MD VA NC SC Bank ~larket ""'~ associated vary of the with has been suppressed. and District of somewhat more than similar This associated finding with The Virginia companies capita Lines The coefficients tend may reflect generally high coefficient to borrow slightly incomes were: $7,479 5,881 5,265 4,612 4,258 The Virginia coefficient appears to be more related companies than to economic activity. '", typical of multicollinearity.) Maryland, banks. services holding factors intercept Virginia, multibank size- intercept Carolina banking banking 2 (p. 32). conventional and North these and Borrowin8. in Table organizations that Any positive second hypothesis: show that extent low cash holdings. example Size, identify since funds, to depend on other relatively notes, on more favorable To the provide be a clear Portfolios, period. to borrow. appears would Bank Location, this items such as their such as capital and Eurodollars not desire relationship funds to bank holding 32. 32. TABLE2. Borrowed Reserves/Required Reserves Explained by Portfolio Items and Location* Explanatory Variable Standardized Regression Coefficient t Statistic Significance of t ~ VA 0.6542 6.37 0.0001 MD 0.6263 7.02 0.0001 DC 0.6228 9.29 0.0001 SC 0.4484 8.27 0.0001 NC 0.4242 7.02 0.0001 FFPUR 0.2896 8.79 0.0001 FFSOLD -0.2432 -8.43 0.0001 CASH -0.2329 -7.95 0.0001 VCASH -0.1503 -3.34 0.0012 SAVDEP -0.1388 -2.98 0.0033 USSEC -0.1232 -4.03 0.0002 GOVDEP 0.1201 2.44 0.0140 LOANS 0.0729 3.75 0.0004 R2 0.3815 F(13,1206) 57.22 *See the notes to Table 1. 'o~-.c.., "..~".,,' ." 33. more than similar apparently banks. large banks, since multibank seek out higher risk 14 These coefficients concentration ratio effects asset size, confirms tionship, confirms This equation, which is related relationship the expected positive and portfolio allocation to the to expectations. composition however, does not include It does include and borrowing. are a highly rela- dependable low risk The expected interaction lowers the influence a negative This finding deposit volatility-borrowings since savings deposits a bank. either the portfolio to location. between savings deposits source of funds for than non-affiliated change, contrary generally shown in Table 1. company banks do not appear to be related or to its This regression and returns holding between demand of the loan/asset ratio taken by itself. IAterest Rates, Portfolio The third Lines vary with Items, Seasonality. regression tests the financial of the seasonal borrowing to enter the equation location variables, of interest-related if the hypothesis climate. privilege, and Borrowi!!~~ In view of the importance it allows they are significant. whose effects variables. that Bank Market quarterly (It variables does not include should be swamped by the effects See Chart 3, p. 15.) - l4William Jackson, ~¥!.tiba~k ~ol~~ng ~ompan~~s and Bank Behav!~E, Federal Reserve Bank of Richmond, Working Paper 75-1,1975. ,!:\ '""""""""'cL"""""",,,J'.;;", I I 34. Table climate 3 (p. 35) indicates and bank decisions ratios. Its explanatory that lessens interaction between the importance power is fairly high the financial of some portfolio for a micro-banking regression. The Federal now the strongest purchased of interest ratio to the factor confirming the to appear at the competitors. with Finally, a negative collateral against No seasonal considered by aggressive periods banks management (Federal the demand for f ace no explicit economic rather that funds than coefficient banking a strong their regression, reappears, slightly securities ability with organizations than their Government appear in Table 3, the equation. of lack sold, borrowings. "seasonal The level is this and smaller again to ~ serve appear as reserves. to enter during larger despite variables eligible on reserves unpledged borrowed rate, not be used in window less coefficient, sold borrowings. bill The size the discount with funds is FFLD, and USSEC are so correlated LOANS could for differential Federal associated analysis.) tendency rate by the Treasury (It, that interest of borrowings. represented on borrowings. loan/asset discount to be strongly rates, according ~ less determinant continue influence the funds tight Rather, money, secondary unpledged need to borrow" terms. loan particularly reserves These banking temporal although U.S. suitable securities) organizations that cannot they were demand pressures those for felt asset describe apparently be described in 34. 35. TABLE 3. Borrowed Reserves/Required Reserves Explained by Portfolio Items, Interest Rates, and Seasonality* Standardized Regression Coefficient Explanatory Variable t Statistic Significance of t 9.20 0.0001 - FFLD 0.3186 FFSOLD -0.2735 -10.30 0.0001 FFPUR 0.1874 5.48 0.0001 TBILL 0.1747 6.91 0.0001 ASSETS -0.0771 -2.46 0.0135 USSEC -0.0581 -2.26 0.0225 R2 0.4499 F(6,12l3) 165.33 *See the notes to Table 1. Time variables are eliminated selection algorithm since they are not significant. ,...~ ~"." ~c."".._c,' -" by the .--36. Summary and Conclusi~?s This asset develops and liability extended it study to of individual management behavior. analyze provides a model bank reactions the framework bank risk-return While to regulation to examine the use of the of the portfolio model are tested by large District organizations risk Fifth banking model could and other Three versions forces, discount using be window. borrowing as an indicator of acceptance. Borrowing oriented banks approach volatile liabilities, deposits, items, asset vault lagging borrow cash, longer-term of this rate. behavior of money, the financial further raises rate market monetary aspects the as complementary, funds the rises, discount supply rate. short sold, cash as gross increases than the typically This as well run response Reserve policy. window, see seem to use borrowings not low- particularly of loans, Federal discount faster organizations dampens the of the banks thus rates banking exceeds in a way that their bank behavior from lending stimulates and Government They minimize "aggressive" return purchased Government securities. economy to restrictive Aggressive purchased funds funds profit- They accept such as Federal Individual when the absolute presumably mana~ement. loans. and unpledged money climate when the Federal supply portfolio management accounts discount procyclical a risk-accepting, such as Federal The incidence when a tight follow to their and extend earning '._-"""" this substitute, as the of (For .) and Federal sources funds of short- ,,",c I - 37. term reserve funds adjustments. apparently Conservative large This require with for banks "need" can practice deposit study borrowing banks appear that be considered It to holding that of borrowing. the accounts. to utility raise short count window, banking face They do organizations are negatively associated special treatment since with within required influences induced the is no seasonal time variables. and deposit run, in areas than similar on "Seasonal reserve spirit banks in pressures of Regulation less A activity prosperous also areas, suggests that more than similar general are inconsistent consistent risk acceptance. with the with the profit-risk window funds at an elastic "need" of a bank. of discount the extension particularly indeed economic It borrow of their relationships model of high to assume risk. indicator They are The availability in (FFLD). of the year, company organizations These systematic appears loan banks borrow banks--one managerial that times appropriate demand inducements unaffiliated theory volatile them "seasonal." are more likely multibank costs when macro and micro-level represent does suggest reflecting assets simultaneously may thus larger suggest at different borrowing" calling that Total Nor does it are examined without on these They do not from volatile suggest surveillance. in borrowing could in their asset management. withdrawals does not special borrowing dependence to borrow. borrowing. shifts relative depends on the difference potential not Their of credit during may be the decisive by these ti~ht banking money periods. inducement for rate thus organizations An open banks dis- to remain 38. 38. 38. members of the Federal predictable tions. by observing This study Bank Market Lines, in these Reserve System. lines, finds The use of this bank portfolio that as well are important banking ratios and money market organizations' as interstate determinants window may be location and interest-related of bank borrowing. condi- along shifts 39. APPENDIX: _Bank Portfolios and Profitabilit_~ The Bank Market exists Line between nominal liabilities. This banking data, necessary profitability connection since Fifth expressed and the reserve a strong riskiness can be tested District rate as a potential regression is variables are entered less 1,644 banks in than against connection of assets independent accounts do not cent of all the equation and micro- contain for the Table It after loan indicates losses source This ratios. the text, only until (then) is highly composition. that This that contribution their historically to reports high sample includes accordingly except from regulatory loans of funds that (Strong multicollinearitYt from being It time by interest more than 11 per- and savings included lower the balance broad categories of shown in Appendix returns shows that are a still through to four regressiont earn higher than demand deposits related This are deducted. cationt more variables in is banks. Bank profitability and liability the capital portfolio are derived and 1971.* insured asset of eighteen The data 44 states on bank equity the same way as those into 0.001. of 1969,1970, of return function computed in R2 is expensive that information. The accounting period Model indicates than investmentst equity capital depositst cost sheet is even a more and by impli- source identity, of funds. prevents in the regression.) *The data were provided by the Federal Deposit Insurance Corporation. They are described in William Jacksont Commercial Bank Regulation, ~trusture. and Performanc~ (doctoral dissertationt University of North Carolina, 1974). """',1.. ",.""'-" ,." ill_." -""" 40. 40. Appendix Statistical Characteristics Table of Profitability Standardized Regression Coefficient Explanatory Variable I Equation t Statistic Significance of t -- Loans/Total Deposits 0.9868 28.00 0.0001 Investments/ Assets 0.7454 25.59 0.0001 -0.4409 13.87 0.0001 -0.3022 8.31 0.0001 Equity Capital/ Assets Time and Savings Deposits/Total Deposits R2 0.9500 F (4,1640) 7787.29 On the side while profitability, asset on the sources of funds a strong positive risk and accounting decrease of liability profitability. association rates the balance exists sheet, side, greater longer-term These findings between bank asset loans less increase risky suggest or that liability of return.** **Ex ~ realized returns from highly risky loans declined later in the 1970Ts with a higher level of loan losses. The state of nature--a recession--generated the unfavorable portion of the distribution of returns for many banks. -""",," , 41. 41. REFERENCES 1. 2. Aigner, Dennis J., and Iolilliam R. 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