-47 To solve the economic and equity problems posed by bank asset and liability management, I recommend the following: (1) The extension of Federal Reserve System membership to savings institutions. This would, in effect, convert mutual savings banks and savings and loan associations into commercial banks. Such a proposal report. My view on requiring these institutions to become commercial banks is based on the belief that these institutions are too specialized in the nature of their assets (they lend long) and liabilities (they borrow short). If they were to become commercial banks, they could more readily diversify both their assets and liabilities. Most institutions would probably continue to specialize in mortgage loans, but the proposal would insulate the housing industry from the chaos that periodically results when disintermediation forces a sharp and sudden decrease in the normal growth rate of nonbank financial institution reserves. The present efforts of our regulatory agencies to expand the variety of nonbank financial institution liabilities are to be applauded, but I feel that these efforts are merely short run expedients to a long run problem, the disproportionate effect of disintermediation on one industry, housing. (2) The removal of interest rate ceilings on member bank, nonmember bank, and nonbank financial institution deposit liabilities. Interest rate controls, like price controls in general, give rise to a malallocation of resources in the economy. Interest rate ceilings pose no problem so long as credit conditions are easy and the demand for and 16/ The Report of the President's Commission on Financial Structure and Regulation. Reed 0. Hunt, Chairman. Washington D.C., December 1971. -48 supply of funds set the rates paid to savers and charged borrowers at levels beneath the legal ceilings. Once the rates are up to the maximum ceilings, financially astute investors of idle funds will place their funds into those financial instruments whose rates of return are not controlled. The effect is disintermediation and a diversion of funds from the controlled into the uncontrolled financial instruments. It could be argued that instead of freeing interest rates there should be regulation of the entire interest rate structure of the economy. According to my view, this would be a disaster since interest rate differentials would be frozen and could not be quickly adjusted to changes in the demand for various liquid assets. How long will it take for us to recognize that interest rate regulation is ruinous? John Locke, best known for his Two Treatises on Civil Government (1690) and his influence on Thomas Jefferson, already in 1692 argued that a) the level of interest should be determined by the relationship between the amount of money needed and the amount available, b) if the amount needed for trade was great relative to the supply, the interest rate would be high, and c) if the rate of interest were legally to be forced beneath a competitive level, no additional borrowing could take place because 17/ lenders would be unwilling to lend. (3) Small savers who typically hold savings accounts and purchase small denomination CDs should be allowed to compete more effectively for short term government securities and high yield paper issued by businesses. The Treasury should be required to sell its securities 17/ John Locke, Consequences of the Lowering of Interest and Raising the Value of Money, 1692. -49 in less than the customary $10,000 denominations. Currently the funds of small savers, by being channelled to savings institutions, lead to an increased flow of low cost funds to the housing industry and, aside from periods of disintermediation, constitute a subsidy tothat industry. This line of analysis suggests that our monetary authorities need to reexamine their objectives should they counter the cycle or give support to selected industries? My recommendations have focused on the problems arising out of interest rate ceilings and disintermediation. Bank asset and liability management, and the large bank special forms of liability management do not require special legislation. Cyclical increases in velocity that accompany asset and liability management are an inevitable outgrowth of an appropriately restrictive monetary policy. Banks need to have some flexibility to adjust their portfolios so as to maintain their profit positions vis-a-vis firms in other industries. The special forms of liability management that have been developed by large banks can be viewed as an effort to adjust to their high legal reserve requirements. I believe that declining Reserve System membership among some small banks is primarily a result of the lower cost forms in which non-member banks may hold their reserve assets rather than a result of large member bank access to fund advantages. Admittedly this is a judgment that is probably incapable of being empirically verified. 3. Summary of Legislative Recommendations; Comment on Additional Areas of Inquiry for the Senate Banking Committee This paper has focused on non-member bank behavior and bank asset and liability management techniques and their relationship to the -50 general economy during periods of economic expansion and monetary restriction. I have made four legislative recommendations: (1) Non-member banks should be made subject to the same reserve (2) Reserve System membership should be extended to savings (3) Interest rate ceilings on member bank, non-member bank, (4) Small savers should be allowed to compete more effectively In addition I have made a fifth recommendation: Bank asset and liability management, and the large bank special forms of liability management do not require special legislation. There are numerous problems in the area of monetary policy that can be analyzed. However, I have chosen here to comment on those issues that relate most directly to bank regulation. There are a series of additional questions to which the Senate Banking Committee should address itself. Among these are: (1) What should be our monetary policy goals? (2) What should be the criteria for evaluating the performance (3) Does the Federal Reserve correctly use its policy instruments I have not commented on these questions because they take us beyond the John J. Klein Professor of Economics BANKING AND MONETARY POLICY Prepared for The United States Senate Committee on Compendium on Issues on Bank Regulation by William E. Gibson* The Brookings Institution INTRODUCTION This paper analyzes several important changes which have taken place in the character of banking practices and in the nature of the impact of monetary policy in recent years. The analysis is used to answer several important questions about the recent effects of banking on the economy. Because these changes have been quite fundamental, they have far-reaching implications for the conduct of monetary policy and the operation of the U. S. financial system. RECENT DEVELOPMENTS IN THE TRANSMISSION OF MONETARY POLICY In the past few years important changes have taken place in the way in which U. S. commercial banking balance sheets are structured and in the way in which banks operate. These have brought a corresponding change in one of the ways in which monetary policy affects the economy. Briefly, the change has been away from controlling and distributing credit by non-price means when the Federal Reserve has desired slower credit *The author is a member of the Economic Studies Program of The Brookings Institution. The views expressed are those of the author, and not necessarily those of the officers, trustees, or other staff members of The Brookings Institution. 52-221 O 75 16 |