Barbara Bennett

English

Research Papers in Economics

July 25, 1980 
Roller Coaster 
The nation's bankers, like everyone else, 
have had to contend this year with an unpar-
alleled range of experiences, from specula-
tive boom to steep recession. During the first 
quarter, they suffered through a soaring infla-
tion and an unprecedented rise in interest 
rates. During the second quarter, in striking 
contrast, they experienced a steep decline in 
interest rates, along with a massive weak-
ening in other economic indicators. 
Still, banks generally adapted well to this 
roller-coaster environment. During the first 
quarter, banks found the funds to meet over-
heated credit demands by purchasing non-
deposit funds (such as Federal funds, 
Eurodollars, and securities sold under re-
purchase agreements), and also by issuing 
large amounts of time certificates (especially 
six-month money-market certificates and 
large negotiable CD's). Banks incurred high 
costs, however, by acquiring these funds at 
such record interest rates, and their earnings 
situation consequently deteriorated. But 
then, as the second quarter progressed, they 
were able to run off some of these high-cost 
liabilities because of declining credit 
demands and a growing inflow of low-cost 
demand- and savings-deposit funds. As a 
result, earnings recovered for many banks as 
the spring months progressed. 
This volatility of earnings illustrates banks' 
sensitivity to changes in the level of interest 
rates. Traditionally, banks borrow short-term 
funds and relend them for somewhat longer 
periods. However, in so doing, banks assume 
a risk of loss from rising interest rates because, 
as liabilities mature, they must be replaced 
with increasingly expensive liabilities. In 
recent years, with the growing volatility of 
interest rates, banks have tried to match the 
maturities of their assets and liabilities, but 
frequently with imperfect results. As the first 
half of 1980 demonstrated, the mismatch 
hurts earnings when rates rise, but helps earn-
ings when rates fall. In a stable rate environ-
ment, then, bank earnings benefit from lower 
interest-rate risk and are consequently less 
volatile. 
Managing the credit boom 
Bank credit expanded rapidly at the outset of 
the year, with total loans and investments 
growing at a 15-percent annual rate in Jan-
uary and February. Borrowers tu rned i  ncreas-
ingly to banks to meet inflation-bloated credit 
demands, which were aggravated by a wide-
spread fear that inflation would not be 
brought under control without a  severe li-
quidity crunch. Bank-credit demands also 
grew because of borrowers' inability to 
obtain funds from the temporarily moribund 
bond market. 
This credit expansion was costly to banks, 
because of the sluggish growth of  1/ core" 
deposits (demand and savings deposits), 
which forced them to. rely heavi lyon h igh-
cost purchased funds. Relatively strong 
demand-deposit growth during the ea.rly pari 
of the year was virtually cancelled by a huge 
outflow of savings deposits. Disinterme-
diation from savings deposits had been a 
problem since late 1978, as investors began 
to switch funds to investments offering higher 
rates of return. Most of these funds, however, 
still remained in the banking system. Many 
depositors moved their funds into money-
market certificates (MMC's), and many others 
shifted into money-market mutual funds, 
which then invested much of their funds in 
bank CD's. (CD's comprise roughly half  of all 
money-fund assets.) But the competition for 
these and other interest-sensitive funds drove 
interest rates upward, increasing banks' over-
all cost offunds. 
Interest-rate spreads generally narrowed in 
the early months of the year, as this sharp rise 
in costs outpaced the rise in yields on bank 
assets. Most banks carried a substantial por-
tion oftheir assets in fixed-rate consumer and 
real-estate loans, which had been placed on the books at a time when much lower interest 
rates prevailed. Also, banks were reluctant to 
raise the prime rate (and associated rates) as 
rapidly as market rates rose, partly to retain 
good corporate customers, and partly to 
maintain competitive positions against 
foreign-bank and commercial-paper lenders. 
Applying the brakes 
The Federal Reserve's tightening efforts in 
February helped bring about a sharp con-
traction in money-supply growth, and grow-
ing competition for funds -along with the 
Fed's March 14 credit-restraint program 
further increased banks' cost of funds and 
dramatically reduced their lending pace. 
(The program limited banks' loan growth to a 
6-to-9 percent annual rate, established 15-
percent reserve requirements on increases 
in consumer credit and money-market fund 
assets, and raised the marginal reserve re-
quirement on large CD's and certain other 
"managed liabilities" from 8to 10 percent.) 
In this situation, banks found it necessary to 
raise lending rates and cut back lending pro-
grams. Still, many banks experienced a con-
tinued narrowing of interest margins, and 
since they could not offset low margins with 
high lending volume, their earnings con-
tinued to suffer. 
In March, a deteriorating economy served to 
reduce overall credit demands, as did also the 
credit-restraint program,which led con-
sumers to repay outstanding debt. Indeed, by 
June, each of the major loan categories-
business, mortgage, and consumer-was ac-
tually declining (see chart). The competition 
for lendable funds consequently slackened, 
despite further outflows of core deposits, and 
interest rates tumbled at a rate that astounded 
veteran observers. 
The second-quarter decline in lending activ-
ity was most obvious in the business-loan 
category, where outstandings declined at an 
8.3-percent annual rate as a reflection of the 
recession-caused drop in loan demand-
and also as a reflection of  the recovery in the 
bond market. Corporations that had been 
2 
unable or unwilling to borrow long-term 
funds during the period of soaring interest 
rates rushed to the bond market throughout 
the spring months, setting new records for 
new corporate issues. In many cases, they 
used the proceeds from these issues to repay 
high-cost short-term bank loans. 
Period of repositioning 
Throughout the second quarter, rllany banks 
widened the spread between the average 
yield on their loan portfolios and their mar-
ginal cost of funds, in an attempt to repair the 
earlier damage to their interest margins and 
earnings. By maintaining high loan rates, they 
lost lending opportunities to the bond and 
commercial-paper markets. However, they 
also gained time to restructure their liabilities. 
By altowing credit to contract, banks were 
able to replace some of their maturing liabil-
ities (acquired when rates were high) with 
much lower-cost funds, thereby improving 
earnings. 
This restructuring process became particu-
larly evident in June. Demand deposits, 
which had been declining earlier in thequar-
ter, increased substantially in June as the Fed 
supplied more reserves to the banking system 
in an attempt to bring money growth back on 
target. In addition, households switched 
funds to passbook savings as rates on alter-
native investments (especially MMC's) 
declined and investors sought increased Ii-
qu  idity. But despite the expansion of core 
deposits, banks did not put much effort into 
expanding credit. Instead, they used the in-
flow of core deposits to replace high-cost 
I  iabi  I  ities, such as large CD's, that matured in 
June. 
Interbank comparisons 
Wholesale (commercially oriented) banks 
experienced a more noticeable earnings im-
provement than retail (consumer oriented) 
banks between the first and second quarters. 
The liabilities of wholesale banks are heavily 
concentrated in short-term, interest-sensitive 
funds -such as 30- to 90-day CD's and over-
night funds -and so they suffered the sharp-...... _  ....  _  ..• _  .... _  .........  _-_ ........ _  .. _-_  ........•.......... 
est increase in cost of funds. However, they 
were able to prevent severe margin deterior-
ation by raising rates on their large portfolios 
of floating-rate loans. During the second 
quarter, wholesale banks, with their short 
average-maturity structure, were the first to 
benefit from the rapid decl  i  ne in interest rates. 
As rates' began to fall, they moved quickly, 
replacing liabilities acquired when rates were 
high with dramatically lower-cost liabilities. 
Meanwhile, by lowering their prime rate at a 
relatively slow pace, they were able to 
achieve wider-than-average interest margins. 
Retail banks, withtheir substantial core-
deposit base, did not experience the ex-
tremely rapid rise in average cost of funds 
experienced by wholesale banks during the 
first quarter. However, retail banks' margins 
sti II deteriorated because, in the face of  the 
sharp rise in MMC rates, their large portfolios 
of  fixed-rate assets prevented them from rais-
ing average yields rapidly. Retail banks also 
recorded a less dramatic improvement during 
the rate decline of  the second quarter, be-
cause their liabilities are concentrated in 6-
month MMC's and relatively long-term time 
deposits. This spring's rapid decline in rates 
will not cause a substantial reduction in their 
cost of  funds until after the high-cost certifi-
cates purchased last winter finally mature this 
fall. On the other hand, their interest margins 
have already improved somewhat because of 
a second-quarter inflow of low-cost core 
deposits. 
~mproved  outlook? 
The nation's banks are not likely to repeat 
their profits performance of 1978 or 1979, but 
many could still post relatively strong earn-
ings during the remainder of  this year. Bank 
credit may expand somewhat because of the 
phase-out of the credit-restraint program, but 
much of  th is effect wi  II be dissipated because 
of  the conti  nued weakness of econom  ic ac-
tivity. By the same token, slow credit growth 
will reduce competition for lendable funds 
and help stabilize rates on purchased funds at 
relatively low levels. 
In that stable rate environment, banks with 
relatively high-cost liabilities still on the 
books shou Id be able to ru n off those I  iabi  1-
ities and improve their interest margins. (The 
removal of the special reserve requirement 
on managed liabilities also will help reduce 
their effective cost of funds.) Overall, earn-
ings should benefit from a relatively stable 
rate environment and from a wider spread 
between what banks earn and what they pay 
forfunds. 
Barbara Bennett 
Change(%) 
Annual Change in 
Outstanding Loans 
2'0  ~Business 
10 
O~~~~~~--~~~ 
-10 
3 'J!I!?) 'O)SPU!?JJ Ul!'S 
lSL 'ON llW~Bd 
OIVd 
:J9V  lSOd 's'n 
llVW S5Vl) 15MI:I 
SS\11~  lSI:II=I 
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT 
(Dollar amounts in millions) 
Selected Assets and Liabilities 
Large Commercial Banks 
Loans (gross, adjusted) and investments'" 
Loans (gross, adjusted) - total# 
Commercial and industrial 
Real estate 
Loans to individuals 
Securities loans 
U.S. Treasury securities* 
Other securities'" 
Demand deposits - total# 
Demand deposits - ad justed 
Savings deposits - total 
Time deposits - total# 
Individuals, part. & corp. 
(Large negotiable CD's) 
Weeldy Averages 
of Daily Figures 
Member Bank Reserve Position 
Excess Reserves ( +  )/Deficiency (  - ) 
Borrowings 
Net free reserves ( +  )/Net borrowed(  - ) 
'"  Excludes trading account securities. 
#  Includes items not shown separately. 
Amount 
Outstanding 
7/9/80 
136,640 
115,104 
33,310 
46,555 
23,603 
1,001 
6,276 
15,260 
44,564 
32,139 
28,576 
61,615 
53,247 
22,003 
Weekended 
7/9/80 
10 
2 
8 
Change 
from 
7/2/80 
- 186 
- 274 
- 319 
44 
- 76 
48 
20 
68 
221 
1,184 
368 
- 951 
- 791 
- 580 
-
-
-
-
Weekended 
7/2/80 
35 
11 
46 
U018u!4SPM.4Pln  • uo8aJO •  ppPAaN  • o4PPI 
!!PMPH  P!UJOJ!IPJ "  puozPV  •  P>jsPIV 
CD)~<§  ~~~)J~  Jr ~  \QT\2?CS 
~  (\J)  4I\ill~cgr 
~AJr~<§~CQI TI~Jr~lP~~ 
{t \ill~m{tJJ~dI~cm ~~JJ~~<§;~CQI 
Change from 
year ago 
Dollar  Percent 
7,573  5.9 
8,546  8.0 
1,865  5.9 
7,748  20.0 
1,188  5.3 
674  .- 40.2 
1,358  - 1'7.8 
385  2.6 
299  0.7 
75  - 0.2 
2,074  - 6.8 
11,473  22.9 
11,662  28.0 
4,555  26.1 
Comparable 
year-ago period 
4 
281 
285 
Editorial comments may be addressed to the editor (William Burl(e) or to the author .... Free copies of this 
and other Federal Reserve publications can be obtained by calling or writing the Public Infonnation Section, 
Federal Reserve Bank of San Francisco, P,O. Box 7702, San Francisco 94120. Phone (415) 544-2184. 

Roller coaster

http://www.frbsf.org/publications/economics/letter/1980/el80-30.pdf

Roller coaster

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics