Unlikelihood of another 1966-type “credit crunch” is one of
the findings made by Dr. Pritchard in his study of whether the Federal Reserve
blundered in administering Reg. Q in 1966.
He singles out the lack of mortgage funds, rather than their cost, for
spawning the 1966 credit crisis and for collapsing the housing industry. Not until the damage was done, he points out,
did the Federal Reserve change its indiscriminate increase in Reg. Q which had
stopped the flow of funds into the housing industry. While he prefers lowering rather than rising
Reg. Q during tight money, the monetary economist says that should an increase
be decided it ought to be selectively confined to large negotiable CDS.
The “credit crunch” of 1966 was not a general
across-the-board credit crisis. It was
on the contrary quite limited, its impact being largely confined to the
residential-mortgage market. Business in
fact obtained too much credit in 1966.
During the first half of 1966 commercial and industrial loans of insured
commercial banks increased at the abnormally high annual rate of 16.4 per
cent. There was some slackening in the
last half of the year but overall the commercial banks financed a 13 per cent
net expansion of business loans in 1966.
Bank credit was the major source of financing that made
possible an unattainable rate of inventory accumulation. Toward the end of 1968 a huge overhang of
inventories developed and this was followed in the first six months of 1967 by
the severest inventory adjustment on record.
Inventory investment dropped from an annual rate of more than $18
billion to practically nothing.
In contrast to the plethora of credit being supplied
business by the commercial banks, the housing industry was being starved for
funds. Of the financial intermediaries
providing the bulk of mortgage credit the savings and loans were hardest
hit. Net inflows of funds virtually
ceased during the first seven months of 1966.
Since savings and loans supply about 45 per cent of residential mortgage
financing a sharp contraction in new housing starts was inevitable. It was the unavailability rather than the
cost of credit which forced a reduction in new housing starts from a level of 1,585,000
in January 1966 to a seasonally adjusted annual rate of only 848,900 in the
fourth quarter of 1966, the lowest rate on record since the end of World War
II.
The financial side-effects of the housing industry’s
collapse involved wide-spread losses and bankruptcies among builders and
contractors and threatened the solvency of many savings and loan
associations. But July 1966 the
financial crisis was so severe the Board of Governors of the Federal Reserve
System took the unprecedented step of allowing savings and loans whose solvency
was threatened to obtain credit assistance directly from the Federal Reserve
banks. The Board’s judgment of the
dimensions of the crisis is brought into sharper focus by pointing out that
even nonmember banks are not allowed to borrow from the Federal Reserve banks
except in an emergency, and then only if the advance is fully secured by United
States Government obligations.
Tight money seems to be the accepted official (and
unofficial) explanation of the mortgage credit crisis of 1966. The Present’s Council of Economic Advisers
advances this explanation in the 1967 Economic Report of the President (p.60);
and in the 1968 Report (p. 76) the Council reiterates that “Tight money was clearly
the primary factor accounting for the sharp decline in homebuilding (in 1966)…”
If tight money is the correct explanation then we should be
heading for another credit crisis in the residential mortgage market. Long-term interest rates including mortgage
rates are now at higher levels compared with 1966; the Federal Reserve is
currently following a monetary policy at least as restrictive as the period of
greatest restraint in 1966; and; and the spread between the rates the savings
and loan associations and the mutual savings banks are paying to savers and
market rates of interest are greater than in 1966. This spread in rates, the short-run
accompaniment of a tight money policy, presumably leads to disintermediation –
a shift by the public from indirect investment through financial intermediaries
to direct investment. The mortgage
markets suffer the sharpest effects of disintermediation since the
intermediaries most affected (savings and loan associations and mutual savings
banks) are major suppliers of mortgage credit.
These effects are only slightly compensated by the subsequent direct
investment. These
effects are only slightly compensated by the subsequent direct investment.
Unfounded Fears of Another Credit Crunch
Suggestions that another “credit crunch” is in the offing
have indeed appeared in the financial press. I think all such prognostications
are not only premature – they are unfounded.
Tight money was only a secondary cause of the 1966 mortgage credit
crisis. The primary cause was the Board
of Governors policy with respect to establishing the maximum interest rates
commercial banks can pay on time and savings deposits (hereafter referred to as
Regulation Q, its official designation).
In the administration of its Regulation Q policy the Board allowed the
commercial banks during the first seven months of 1966 to pay higher interest
rates on certificates of deposit than savings and loan associations and the
mutual savings banks could pay on share certificates and savings deposits. Such an interest rate differential has
existed in no other period. It was this
factor, unique to 1966, that triggered the residential mortgage credit crisis
of that year. Data subsequently cited
fully document this assertion.
Recent Monetary Policy and Interest Rates
From an extremely easy policy in 1967 the Federal Reserve
has shifted toward a definitely tight money policy. From February 1967 to February 1968 the
member banks were allowed to operate with net free reserves (free reserves are
equal to the excess of excess reserves over member bank borrowings from the
Federal Reserve banks). For most of 1967
net free reserves fell in the $150 - $250 million range. Allowing bank credit to expand at a rate of
11.1 per cent in 1967 provides further evidence of the extreme case that
prevailed. This rate compares to a rate
of 5.4 percent in 1966 and an annually
compounded rate of about 5 per cent for the whole period from 1946-1966.
Beginning in February of this year the Federal Reserve has
veered sharply toward restraint. Net
borrowed reserves (the excess of borrowings from the Federal Reserve banks over
excess reserves) replaced net free reserves.
Currently net borrowed reserves are falling in the $200 - $400 million
range, a level comparable to the levels greatest credit restraint in 1966. Since the inception of the current tight
money policy the Federal Reserve through its open market operations has kept
total legal reserves of member banks moving virtually sidewise at a level of
approximately $25.6 - $25.9 billion. If
this policy were continued throughout 1968 (a highly unlikely possibility)
there would be little if any net expansion of bank credit.
The near-term effect of this restrictive policy plus the
inordinate volume of deficit financing requirements of the federal government
and the reluctance of nonbank investors to “go long” in creditorship
securities, except at premium rates that amply discount the present accelerated
rate of inflation, has caused long-term interest rates to reach the highest
levels in this century. Rates are
significantly higher than in credit crisis year of 1966. For example, the current average AAA
corporate bond rate is 6.2 per cent compared to 5.5 per cent, the highest level
reached by this series in 1966.
Similarly the current average yield on new FHA mortgages is 6.8 per cent
compared to an average level in 1966 of 6.4 per cent.
Lack of Loan-Funds Rather Than the Cost of Loan-Funds the
Cause
Obviously it was the lack of funds rather than the cost of
funds that spawned the credit crisis of 1966.
The principal financial institutions that hold residential
mortgages (savings and loan associations, mutual savings banks, life insurance
companies and commercial banks) reduce their net acquisition of nonfarm
residential mortgage debt from $18.5 billion in 1965 to $10.9 billion in
1966. Savings and loan associations
alone accounted for $18.5 billion of this decline, while mutual savings banks
accounted for another $1.4 billion.
These two financial intermediaries thus account ted for $6.4 billion or
84 per cent of the total decline – and these are the two financial intermediaries
most affected by the Board of Governors Regulation Q policy. The nonnegotiable, multi-maturity time
certificate of deposits of the commercial banks is to most savers apparently
interchangeable with share certificates of savings and loan associations and
savings deposits of mutual savings banks.
Regulation Q Policy and Effects
In December 1965 the Board of Governors raised the
permissible interest ceiling on time certificates of deposit from 4 ½ to 5 ½
per cent for member banks. The Federal
Deposit Insurance Corporation (FDIC), as it always does, made the Board’s
ceilings applicable to all nonmember insured banks. Most commercial bankers on the basis of their
evaluation of the competitive situation opted to pay rates at or near the
ceilings. Although this was the fifth in
a series of rate increases promulgated by the Board and the FDIC beginning in
January 1957, it was unique in that it was the first increase that permitted
the commercial banks to pay higher rates on savings than savings and loan s and
the mutual savings banks could competitively meet.
There is evidence that the Board’s primary objective in
raising Regulation Q ceilings in December 1965 by a full percentage point was
to “bail out” certain large New York city banks. These banks, beginning in 1961, stated
issuing large denomination negotiable certificates of deposit (CD’s). This
instrumentality has many of the marketability and liquidity qualities of
Treasury bills. Its use enabled these
large banks to draw funds out of banks all over the country and indeed the
world. By late 1965 market interest
rates had risen to levels that no longer made 4 ½ per cent CD’s
attractive. Consequently as they matured
they could not be replaced, the issuing banks had large outflows of funds and
faced a liquidity crisis.
Assuming under the circumstances an increase in ceilings was
justified it should have been a selective increase confined to the large
denomination negotiable CD. The Board
contends it did not have this selective power.
If this explanation is accepted then the Board should have insisted from
the beginning that large banks as well as small banks follow the old fashioned
practice of storing their liquidity.
They should not have been permitted to attempt to buy their liquidity
through an open market instrument.
Essentially the negotiable CD is a device for buying liquidity. But it obviously cannot fulfill this function
if the issuing banks do not have the option of raising the rates they pay to
meet any market conditions that may prevail.
In other words if the Board did not as it insisted have selective
control powers over interest ceilings for the various types of CD’s issued by
the banks,. It was, by allowing the
banks to introduce the negotiable CD abdicating its Regulation Q power.
Major Policy Blunder
In any event the nonselective increase in Regulation Q
ceilings proved to be a major policy blunder.
The effect of the 5 ½ per cent ceiling was to dry up through the
intermediaries, especially the savings and loan associations. Savers, instead of transferring the ownership
of demand deposits which they had saved to the savings and loan associations
and the mutual savings banks simply converted these demand deposits into time
deposits. The higher rates paid by the banks
also cause some disintermediation from the savings and loan associations and
the mutual savings banks to the commercial banks.
In the seven months following the Board’s and the FDIC’s
action, time deposits in commercial banks grew by $10.1 billion. Share accounts (and certificates) in savings
and loan associations by contrast grew by only $0.5 billion, and savings
deposits in mutual savings banks grew by only $1.1 billion. Annual rates of growth were respectively 7.0
per cent for commercial banks, 0.45 per cent for savings and loans, and 2.1 per
cent for mutual savings banks.
As a consequence of the virtual stoppage in any net inflow
of funds into the savings and loans, and the sharp decline in mutual savings
bank deposits growth, the residential mortgage market collapsed. Mortgage money simply dried up, we had a
“credit crunch.”
Thoroughly alarmed by the deteriorating situation the Board
(and the FDIC) reversed their earlier action and on July 20, 1966 made the
first reduction in interest rate ceilings on time deposits since February 1, 1935. The maximum rates payable on multi-maturity,
nonnegotiable CD’s were reduced from 5 ½ to 5 per cent on certificates maturing
in 90 days or more, and from 5 ½ to 4 per cent for certificates maturing in
less than 90 days. These are the
“consumer type” CD’s issued by the banks that are most competitive with the
share accounts and share certificates issued by the savings and loans and the
savings deposits offered by the mutual savings banks.
A second reduction in Regulation Q ceilings was effected on
September 26, 1966 when the maximum rates payable on single maturity negotiable
and nonnegotiable CD’s of less than $100,000 denomination were reduced from 5 ½
to 5 per cent.
Since banks were generally paying rates at or near the
maximums allowed these changes had a considerable effect on the relative
attractiveness of time deposits vies a vies share accounts in savings and loans
and savings deposits in mutual savings banks.
Restored was some of the rate and the mutual savings banks had
traditionally enjoyed. When the Federal
Home Loan Bank Board (FHLBB) and the FDIC were given (September 1966) temporary
emergency powers to fix dividend and interest rate ceilings for savings and
loans and mutual saving banks they established ceilings which preserved to a
small degree a rate differential advantageous to the intermediaries. Ceilings were fixed (with certain exceptions)
at 4 ¾ per cent for share accounts and 5 ¼ per cent for share certificates of
savings and loans, and 5 per cent for savings deposits of mutual savings banks.
The effects of restoring a rate differential in favor of the
intermediaries is apparent in the reversal of the trends of the first seven
months of 1966. Time deposits in
commercial banks which had increased $10.1 billion in the first seven months
and stood at a figure of $156.8 at the end of July grew by only $2.0 billion
during the remainder of the year.
Share accounts in savings and loan associations by contrast
which stood at a figure of $110.9 billion at the end of July had $3.1 billion of
their total 1966 growth of $3.6 billion during the last five months of the
year.
Mutual Savings banks were less affected but were able to
post a gain of $1.5 billion in the last five months of 1966, compared with $1.1
in the preceding seven months; bringing total savings deposits tin these
institutions to $55.0 billion by the end of 1966.
Almost immediately after the Board’s and the FDIC’s actions
in reducing interest ceilings there was an easing in the mortgage markets and
the near panic conditions that had prevailed were soon dissipated. But an
industry with the long leads and lags of the construction industry and as
demoralized as housing was in 1966 cannot quickly be turned around. It has only been recently that new housing
starts have approached the levels prevailing in January 1966. The most recent available figures are (on a
seasonally adjusted annual basis) 1,419,000 for January 1968 compared with
1,585,000 for January 1966
Misconceptions of the Role of the Commercial Banks in the
Savings-Investment Process
If, as here contended the primary cause of the 1966 crisis
in the residential mortgage market was the Board’s Regulation Q policy, some
inquiry into the Board’s concept of the role of the commercial banks in the
savings-investment process seems in order.
Certainly the Board would not precipitate a general credit crisis in the
mortgage markets in order to accommodate a few New York city banks however
big. Nor can we question the Board’s
motives. Certainly it was not the
Board’s objective to “elbow home-building to the end of the line.” Quite the contrary in fact William McChesney
Martin, Jr. Chairman of the Board of Governors in evaluating the Board’s
December 1965 action in raising Regulation Q ceilings made the following
reassuring statement “I expect a continued ample flow of funds into residential
construction.” (Federal Reserve Bulletin, December 1965, p. 1673)
Why did this forecast go awry? I think the explanation is to be found in the
Board’s basic misconceptions concerning the role of the commercial banks in the
savings-investment process. On the same
page from which the above quote is taken Chairman Martin makes this statement:
“Now I’d like to add something about our increase in maximum rates on time
deposits. This part of the action was
designed to permit the banking system as whole (boldface added)…to expand their
resources sufficiently to provide the economy with additional credit…” And on page 1675 Chairman Martin explains
that the time deposit rate ceiling was raised “…to allow the economy to use
more efficiently the funds already (boldface added) available…”
There is the clear implication in these statements that
commercial banks are financial intermediaries, that they loan out time deposits
and that a growth of time deposits will increase the volume of loans the banks
can make. This is made even more
explicit in his “Statement to Congress” (Federal Reserve Bulletin, February
1967, p. 213) “Viewing credit flows in broader perspective, all financial
intermediaries – banks (boldface added) as well as thrift institutions – were
falling behind in the competition for savings flows:…”
Commercial Banks From a System Standpoint Do Not Loan Out
the Public’s Savings
If the banks do not loan out the public’s savings what do
they loan out? And the answer is” when the commercial banks make loans to or
buy securities from the nonbank public they acquire these earning assets by
creating new money. This new money almost
invariably takes the form of demand deposits (our check-book money). From a system standpoint the commercial banks
do not loan any existing deposits, demand or time; nor do they loan out the
equity of their owners, nor the proceeds from the sale of capital notes or
debentures or any other type of security.
It is absolutely false to speak of the commercial banks as financial
intermediaries not only because they are capable of “creating credit” but also
because all savings held in the commercial banks originate within the banking
system. The source of time deposits is
demand deposits, either directly or indirectly via the currency and undivided
profits accounts of the banks. It is of
course possible for currency hoards (a form of monetary savings) to be returned
to the banks in exchange for time deposits.
But this can never be a net source of time deposit growth since all
currency held by the nonbank public was at some prior time withdrawn from the
commercial banks and involved the cashing of demand and/or time deposits.
Only on a short-term seasonal basis could currency flows result
in a growth of time deposits. On a net
annual basis currency flows are out of, not into, the banking system.
This upward trend in the public’s holdings of currency has
been consistent and it has been large.
Currency holdings of the nonbank public which stood at a figure of $6.4
billion at the end of 1939 now are in excess of $39 billion. During the same period the commercial banks
have expanded their earning assets from $40.7 billion to approximately $357 billion.
The commercial banks acquired this vast increment of $316 billion in their
earning assets by creating an approximately equal volume of new demand
deposits.
In the normal course of being transferred a small fraction
of demand deposits is saved. Since 1939
the public has chosen to make a net transfer amounting to $170 billion of these
saved demand deposits into time deposits.
This raise the total volume of time deposits held in the commercial
banking system from the miniscule level of $15.3 billion at the end of 1939 to
the present vas sum of $186 billion.
Most of this growth ($135 billion) has been since the Board inaugurate d
its policy of higher and higher Regulation Q ceilings.
‘The Board has thus been an indispensable accessory in
erecting an institutional savings structure (time deposit banking) the effect
of which is to block the flow of a vast volume of monetary savings into
investment – into job creating activities.
The following simple illustrations are designed to portray
the principles involved in bank “credit creation,” and the roles of the
commercial banks in the savings-investment process
The first “T” account illustrates the effect on the
consolidated balance sheet of the banking system when a loan of $10,000 is made
to the nonbank public:
Commercial banks
Loans $10,000 Demand
deposits $10,000
As a consequence of a “meeting of minds,” and because demand
deposits are acceptable as a means-of-payment by the public, the banks are able
to write up their earnings assets by $10,000 giving the borrower in exchange
for his note a net addition to his checking account of $10,000. And note this: There will be no effect on prices,
production, employment or any Gross National product (GNP) item until the borrower
of these newly created deposits spends them and spends them in such a way as to
increase the demand for goods and services.
Spending the newly created demand deposits will have no
effect on the size of the banking system:
Commercial banks
Loans $10,000 Demand
Deposits $10,000
(-)Demand deposits $10,000
(+)Demand deposits $10,000
Limits on this expansion process must be, and are, built
into the structure of the banking system.
This is accomplished by require the banks to hold asses called legal
reserves. Legal reserves must be held in
at least a minimal relationship to the volume of demand and time deposits,
e.g., 12 per cent of demand deposits and 5 per cent of time deposits. The aggregate of bank legal reserves held by
the banks, both member and nonmember, is in turn controlled by the Federal
Reserve System through its so-called open-market operations.
Assume that after a number of transfers the recipients of
demand deposits are able to save $1,000.
How is this illustrated on the consolidated balance sheet? The answer is: it cannot be illustrated, for
monetary savings, from the standpoint of the banking system is a function of
velocity or rate of turnover of deposits, it is not a function of volume. The growth of bank held savings thus results
in no alteration of the “footings” of the consolidated balance sheet. And as long as monetary savings are held in
the commercial banks either in the form of demand or time deposits the rate of
turnover of these deposits is zero.
Unfortunately the impact on the economy is not zero, it is
decidedly negative. Monetary savings
involve a prior cost of production to business and when the funds are not
returned to the marketplace a depressing effect is exerted on the economy.
Savers have four principal options at their disposal: (1)
leave the savings in the form of demand deposits – and lose any explicitly
return: (2) transfer the saved demand deposits to some financial intermediary
in exchange for earning assets: (3) invest the funds directly; and (4) shift
the demand deposits into time deposits.
No matter which alternative is selected there will be no
effect, per se, on the size of the banking system or the volume of earning
assets held by the system. The fourth
alternative will of course alter the “mix of bank’s liabilities.
Loans $10,000 Demand
deposits $10,000
(-)Demand
deposits $1,000
(+)Time
deposits $1,000
Of the four alternatives only (2) and (3) are a “use” of
savings from the standpoint of the economy.
Only (2) and (3) enable monetary savings to be used in such a way as to
finance GDP items. In neither (1) nor
(4) are the savings being used to finance investment. Both in reality are a form of stagnant money.
The fact that the earning assets held by the commercial
banks are approximately equal to their demand and time deposits liabilities is
often cited to prove that demand and time deposits are actually being
invested. It bears reiteration that no
investment can take place unless money is turning over. The turnover of money involves the transfer
in the ownership of demand deposits and this is the exclusive prerogative of
the nonbank owners of these deposits.
The earning assets held by the commercial banks are not
therefore investment or even evidence of consumption. Their existence provides only presumptive
evidence that investment (or consumption) has taken place; on the assumption
that the recipients of the banks newly created demand deposits have transferred
the ownership of these deposits to the producers of goods and services.
In contrast to the commercial banks the earning assets held
by the savings and loans mutual savings banks and other financial
intermediaries, are positive proof that expenditures have been made, that money
“changed hands” – for it is impossible for the financial intermediaries to acquire
earning assets without expending the money balances put at their disposal by
savers, or acquired through the retention of earnings
Time Deposits and the Lending Capacity of the Commercial
Banks
Since time deposits originate within the banking system,
there cannot be an “inflow” of time deposits and the growth of time deposits
cannot per se increase the size of the banking system.
However, due to the lower reserve ratios applicable to time
deposits a shift from demand to time deposits will, other things being equal,
increase the excess legal reserves in the system and will to that extent add to
the system’s incremental lending capacity.
Holding other things equal however ignores the dynamics of monetary
policy execution. In the short term the
Manger of the Open Market Account, following the general directives of the
Federal Open Market Committee (FOMC), seeks a certain level of net free or net
borrowed reserves. Any increase in
excess reserves will of course increase the volume of net free reserves, or
reduce the volume of net borrowed reserves.
If the change is at all substantial ($50) million or so) the Manger of
the Open Market Account will react by ordering open market sales sufficient to
offset the increase.
In the longer-term the “bank credit proxy” (the sum of
demand and time deposits) is the criterion relied on to determine whether the
level and rate of change of bank credit (earning assets) conforms to the
objectives of monetary authorities.
Since the monetary authorities make their determinations on
the basis of the size and not the “mix” or the bank credit proxy, there is no a
priori reason to assume that an expansion of time deposits will alter the
FOMC’s consensus as to the proper volume and rate of change in bank credit.
Monetary policy is conditioned by many diverse elements in
the economy; the level and rate of increase of prices; the level and expected
level of deficits in the international accounts of the country: the rate and
expected rate of unemployment; Treasury debt management requirements, etc.
To the extent that the growth of time deposits reduces
inflationary pressures, reduces deficits in the balance of payments, increases
unemployment, and in general dampens down the economy, to that extent will the
FOMC be induced to follow an easier or less restrictive monetary policy. Since time deposits do in fact exert a
depressing influence on the economy, it is quite probable that the growth of
time deposits does induce (in the indirect way noted) the Federal Reserve to
supply a larger volume of legal reserves to the banking system than otherwise
would be provided. Assuming the bank
system exploits this larger lending capacity it can then be said that the
growth of time deposits does bring about through these indirect effects on
monetary policy an increase in bank earnings assets and a larger banking
system. How much larger? No one can give an answer to that question.
Size however is not synonymous with profitability. Since time deposits are much more expensive
to maintain than are demand deposits (about $43 per $1,000 per year for time
deposits on the average compared to about $15 for demand deposits), any shift
from demand to time deposits will, from a system standpoint, increase bank
costs. Profits will be reduced since
this transfer results in no increase in bank earnings.
If these adverse effects on costs and profits are to be
overcome it is necessary to assume that the expansion of time deposits induces
the monetary authorities to follow an easier (or less restrictive) monetary policy. Furthermore, this change in monetary policy
results in the monetary authorities supplying the banking system with an
additional volume of reserves sufficient to enable the banks to expand their
earnings assets, and there by their net earnings, by an amount which will more
than offset the overall increase in costs associated with the growth of time
deposits and the incremental demand deposits resulting from the expansion of
bank credit.
It is indeed a moot question that these conditions have ever
been fulfilled.
Conclusion
A further reduction in Regulation Q ceilings is highly
desirable. A reduction in Regulation Q
ceilings would benefit the banks, the financial intermediaries, homeowners and
home builders, and in fact the whole economy.
Bank profits would rise because a lowering of rate ceilings
would reduce the ratio of time to demand deposits. All studies show (see list below) that the
lower the ratio of time to demand deposits the higher the ratio of profits to
the net worth of banks irrespective of the size of the bank.
The larger flow of funds through the financial
intermediaries that would result from such a reduction would ease mortgage
interest rates thereby stimulating residential construction.
It may be objected that this would further accentuate
inflationary pressures in the economy and worsen our balance of payments
situation. Both inflationary pressures
in the economy and our chronic deficits in the balance of payments are
primarily the result of excessive federal expenditures abroad on our far-flung
military establishment.
Let us cure these ills by attacking the source, not by
starving the domestic economy. In fact
no amount of domestic unemployment will cure our balance of payments problem
and reserve the dollar as the premier reserve currency of the world.
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