Barbara Bennett

Joseph Bisignano

English

Research Papers in Economics

January 29,1982
Money-market mutual funds pose an even
thornier problem for those who would divide
financial a.ssets into money and non-money
baskets. After all, money-marketfund bal-
ances can be drawn down by check, which
implies that at least a portion ofthese bal-
ances may be held for transaction motives.
Yet with their relatively high minimum-in-
vestment requirements, money funds' high
yields primarilyappeartobeattractive invest-
ment options. And what about repurchase
agreements (RPs) and Eurodollardeposits?
RPs and Eurodollars offered on a one-day or
continuingcontract basis are certainly used
by corporations toearn an overnight return
on funds that will be used the nextday.
Why the confusion?
The current confusion about which types of
institutions are engaged in "banking" func-
tions and which financial assets are "money"
stems from the public's response to the high
interest rates and high inflation rates ofthe
past decade. Galloping inflation and atten-
dant high interest rates have sharply in-
creased the opportunity cost ofholding idle,
noninterest-earning balances. Households
and businesses alike, therefore, have reduced
theirholdingsofidlebalances byanticipating
better needs for cash in the short-run, and by
managingtheirreceipts and disbursementsto
It may seem a simple matterto include ATS
and NOW accounts in the definitionof
money, since these accounts are so similarto
demand deposits. But since such accounts
pay interestatthe same rate as passbook
savings, depositors will hold some unknown
proportion ofthe funds in this form in lieu of
other "non-money" assets. By broadening
the definition ofmoneyto include ATS and
NOWaccounts, then, the narrow conceptof
money loses some ofits distinctiveness.
instruments include ATS and NOWac-
counts, money-market mutual funds, repur-
chase agreements and Eurodollardeposits.
1
i/
Anotheronce-tidy butnow unravelling dis-
tinction is theonebetween readily spendable
assets and other financial assets held by the
public. Demand deposits, which paid noex-
plicit interest, were once considered the only
transaction instrumentotherthan cash. Now,
a variety ofinstruments pay interest and yet
permit the depositor/investorto use funds
placed in them to purchase goods and ser-
vices with minimal transaction costs. These
The unique role ofbanks has disappeared in
other ways as well. Once engaged primarily
in credit intermediation and interest-rate
maturitytransformation-accepting shorter-
term deposits to fund longer-term loans and
investments-banks have nowbeen forced
by downward-slopingyield curves and
heightened interest-rate volatility to match
the maturities oftheir assets and liabilities.
Some largebanks, forexample, have become
reluctant to fund even a short-term loan un-
less a funding source ofequal maturity is
available. Insome cases, institutionsare even
selling loans directlyto investors, refusing to
accept anyofthe credit risk or interest-rate
risk involvedin carrying loans onthe books to
maturity. As aresult, banks nowlook less and
less like credit intermediaries and more like
finance companies and securities brokers.
The task ofdefining money has become
much morecomplex than in the past, be-
cause several key distinctions upon which
earlier definitions were based are crumbling
in the face ofrapid financial innovation. The
once-tidy distinction between bank and
nonbank firms no longer seems to apply. In
the not-sa-distant past, we could argue that
onlybanks, through theirdeposit-taking and
lendingactivities, created deposits. Today,
with savings-and-loan associations and mu-
tual savings banks offering NOWaccounts,
and with securities brokers and dealers offer-
ing money-market mutual funds, the func-
tional distinctions among banks and other
institutions have become increasingly fuzzy.
Apples, Oranges and Money: II
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maximize the funds available for investing in
short-term instruments.
Banks and other financial institutions, for
their part, have helped their customers to
reduce the level ofidle balances by offering
cash-management services and attractive
short-term instruments for the investment of
temporarily idle funds. During the early
1970's-especiallyduring the 1973-74 per-
iod ofhigh interest rates-banks began to
offer comprehensive packages ofcash-
management services to large corporate
customers. Using automation techniques,
banks were thus able to speed the collection
ofa corporation's receivables, pool any idle
funds in any ofthe corporation's bank ac-
counts throughout the country, and invest
those pooled funds in overnight repurchase
agreements and othershort-term instruments.
Given the transaction costs associated with
then-available technology, this kind ofcash-
management service was only economical
for very large corporations with sizable
excess balances. Nonetheless, overnight RPs
grew from $2.0 billion in 1970 to $13.6
billion in 1976. At the same time, money-
market mutual funds came into being, pro-
viding even households and smaller firms
with a means ofearning market returns on
their balances. Money-fund balances grew
rapidly to $3.4 billion between 1974 and
'1976. Ofcourse, much ofthe growth in RPs
and money-marketfunds may have reflected
other factors than the investment of idle
transaction balances. Still, that growth un-
doubtedly helps to explain the slower-than-
anticipated growth ofthe money supply
(narrowly defined) during the same period.
Recent innovations
The level ofinterest rates by nowhas far
surpassed the level thatprevailed in 1973-74,
makingcash management an even more
financially rewarding activity for all sizes of
firms as well as households. Thus, we have
seen a vast expansion in the use ofshort-term
instruments as substitutes for noninterest-
earning transaction instruments. Overnight
RPs and Eurodollars, for example, reached
$36.4 billion in September 198"1. Since their
2
introduction in the late 1970s, overnight
Eurodollars, which are dollar-denominated
deposits issued by Caribbean branches of
U.S. banks, have come to be used in much
the same way as RPs-as a vehicle for the
investment oftemporarily idle balances.
The general rise in interest rates and the
growingopportunity cost ofidle balances
thus stimulated the use ofsuch services. In
addition, technological advances made fre-
quent transfers offunds among financial
instruments economically feasible for firms
and households with even relatively small
balances. These lowertransfer costs, com-
bined with the growing financial sophistica-
tion ofsmall firms and households, have led a
numberoffinancial institutions and
data-processing firms to develop cash-
. managementservices forthis market. Money-
market funds are the mostobvious example,
but securities dealers' cash-management
accounts, deposit-sweeping arrangements,
and retail repurchase agreements have also
gained wide popularity.
Individuals and businesses with more than a
fewthousand dollars to invest can obtain a
cash management-type account from secur-
ities firms. Merrill Lynch, the first to introduce
such an account, requires an initial invest-
mentof $20,000 in cash and/orsecurities, in
return for a package ofservices including a
securities margin account, a money-market
fund and a checking account. This approach
has gained many adherents among other
securities firms and insurance companies.
Minimum investment requirements and spe-
cific services vary from firm to firm, but the
most common feature ofthese accounts is a
link whereby excess balances in a checking
account are periodically "swept" into a
higher-yielding money fund.
Lacking a competitive deposit instrument
and faced with the loss ofdeposits to
money-market funds and cash-management
accounts, a numberofbanks have begun to
offer their own deposit-sweeping services.
Although they lose some deposits by sweep-
ing balances in excess ofthe required mini-mum into money-market funds, banks prefer
this type ofarrangementto losing the cus-
tomer relationship entirely. (Alternatively, a
few banks have sought to provide this kind of
service through their own trust departments,
but with limited success.) Minimum balance
requirements are generally high-$2,500 or
more. Once the deposit-sweeping arrange-
mentis in place, the accountholdercan write
checks against the bank account just as he
would with a normal checkingor NOW
account. Should the balance in the bank
account fall below the required minimum,
however, the bank automatically draws
down the money-market fund. Because his
idle balances are used for the automatic
purchaseofmoney-fundshares, the customer
thus can earn a market rate ofreturn on
transaction balances.
Retail RPs
Commercial banks and savings-and-Ioan
associations also havebegun to use retail RPs
as a means ofretaining deposits that would
otherwiseendup in money-market funds or
cash-management accounts. These repur-
chase agreements-which involvethesale of
U.S. governmentsecurities orFederal agency
securities to consumers, along with an
agreementto buy them back in the future-
are issued in denominations of less than
$100,000 with maturities of89 days or less.
Although RPs technically are sales ofsecur-
ities with simultaneous agreements to repur-
chase at a later date, investors and issuing
institutions generally treatthem as highly
liquid, secured borrowings. Banks and thrifts
have limited their maximum maturity to 89
days, to comply with recent rulings imposing
interest-rateceilings on longermaturities. Re-
tail RPs are not depc'sit instruments insured
bythe FDICortheFSUC, norare they subject
to deposit interest-rate ceilings.
Technically, retail RPs are not redeemable
upon demand in the same manner as trans-
action accounts or even money-market
funds. However, by keeping the contractual
maturities ofthese instruments short orby
imposing no early withdrawal penalties, a
growing numberofdepository institutions
3
have created retail RP programs that are near-
ly indistinguishable from money-market
funds. In terms ofminimum investment re-
quiremenis and interest rates, retail RPs are
general.ly competitive with money-market
funds. And by requiring an investorto open a
checking or NOWaccount when a retail RP
is purchased, the depository institution can
permit telephone-ordered transfers between
the twoaccounts-a feature money-market
funds cannot offer..
Policy problems
Given all thenewshort-term instruments and
cash-management services that have appear-
ed recently in response to high interest rates,
the pre-1980 definition ofmoney clearly was
not sufficient to divide financial assets into
the proper money or nonmoneybaskets. In
fact, all ofthe new instruments discussed
above almostcertainlyfitintoboth basketsto
onedegree or another. After all, investors'
reasons for placing funds in overnight RPs,
money funds and retaiI RPs encompass both
investment and transaction motives.
For the Federal Reserve System, these defi-
nitional problems are more than semantic.
The Fed's task ofcontrolling money-supply
growth clearly becomes mOre difficult
because ofthe fact that transaction balances
cannot easily be distinguished from balances
held for other purposes. M-1 B's slowgrowth
(relative to spending) in 1981 was due, to
some undetermined extent, to the public's
increasing sophistication in managing its idle
transaction balances. Funds that in the past
wouId have contributed to M-1 growth are
now being placed in instruments that pay
market rates ofreturn. However, we cannot
easily identifytheproportionofthe growth in
these new instruments that is associated with
transaction balances. The Fed, then, must
decide whether the slow growth ofthe tradi-
tional measure oftransaction-balances re-
flects tight monetary policy or simply an
explosion in the growth ofsubstitutes for
transaction instruments. Obviously, the pol-
icy responses are different, depending on the
assessment ofthe sourceofweakness.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRla
(Dollar amounts in millions)
selected Assetsand Liabililies
Large Commercial Danb
Amount
Outstanding
1/13/82
Change
from
1/6/82
Change from
year ago
Dollar Percent
loans (gross, adjusted) and investments* 156.331 36 9.142 6.2
Loans (gross, adjusted) - total# 135,289 - 11 10,643 85
Commercial and industrial 41.689 - 47 4,284 11.5
Real estate 55,888 123 5,303 105
loansto individuals 23,760 - 76 - 118 - 05
Securities loans 2,078 106 775 595
U.s, Treasury S€Curities* 5,837 54 - 933 - 13.8
Othersecurities* 15,205 - 7 - 547 - 35
Demand deposits - total# 42,011 -4,213 - 2,148 1- 4.9
Demand deposits - adjusted 29,985 - 680 - 1,939 - 6.1
Savings deposits - total 31,034 - 145 1,683 5.7
Time deposits - total# 89,549 157 15.248 205
Individuals, part. & corp. 80,576 87 '15,940 24.7
(Large negotiable CD's) 35,735 - 168 7,007 24.4
Weekly Averages
o!Daily Figures
Member Bank Reserve Position
Excess Reserves (+l/Deficiency{-1
Borrowings i/
Net free reserves (+l/Net borrowed(- 1
Weekended
1/13/82
56
131
75
Weekended
1/6/82
64
34
30
Comparable
year~ago period
23
7
15
* Excludes trading account securities.
# Includes items not shown separately.
Editorial commentsmay beaddressed to theeditor (William Burke) or totheauthor....Free copies of this
andotherFederal Reservepublicationscanbeobtained bycallingorwritingthe PublicInformationSection,
Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 544-2184.

Apples, oranges and money: II

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Apples, oranges and money: II

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