15 quantities if they are to be able to afford higher-priced oil. And they Since the bulk of the oil revenues now seems to be coming into U. S. financial markets, I think that we would be wise to consider having the U. S. government, a multi-government group or an international organization help with recycling and share some of these risks. I believe that the U. S. would be well advised to join with other nations or cooperate with an international body to spread the default risks of the loans and depoliticize both the borrowing and repayment burdens. In this way we would help protect the stability of our banking system in the face of these oil payments flows, as well as improving the efficiency of the overall flows of these funds. G. How can banks, and especially money center banks, be made more responsive to anti-inflationary policy? Some care should be exercised in defining what "more responsive" is. Banks should not simply close down their lending operations when the Chairman of the Board of Governors of the Federal Reserve System announces that the inflation rate is too high. When market interest 16 rates in general and rates on bank liabilities in particular are rising banks should be more reluctant to lend at any interest rate level but should not cut off borrowing completely. In earlier years the latter happened, but the financial system has been beneficially moving away from this technique. One way to improve upon the present situation is to make inflation less profitable to banks. There is no necessary reason why banks should be made better off by inflation, and they only do if the yields on their assets rise faster than those on their liabilities. Present banking structure assures that this will be the case, however, when rapid actual inflation adds inflationary premia to interest rates. Statutes and regulations now prohibit interest on demand deposits and control interest rates on household time deposits, so that a major portion of bank costs is under a very effective system of cost control. Thus when inflation increases and market interest rates rise, bank profits tend to rise automatically, since the yields rise on most of their assets but remain low on most of their liabilities. If bank costs rose by as much as their revenues during an inflation they would be far less in favor of continuing inflation. The way to bring this about is to remove the constraints on the rates which banks pay on their liabilities by removing the prohibition on interest payments on checking accounts and lifting the ceilings which small savers receive on their saving. If this were done competition would lift banks' costs with their revenues and they would cease to benefit from rapid rates of inflation. (The benefits to consumers from receiving more interest on their funds which banks use would also be a substantial benefit, of course.) Chapter III. - Composition of Bank Assets and Liabilities CHANGES IN THE COMPOSITION OF BANK ASSETS AND LIABILITIES BANK CAPITAL ADEQUACY BANK FAILURES "Their Effect on the Liquidity and Solvency of American Banks" by Paul M. Homan Prepared for The United States Senate Committee on Banking, Housing and Urban Affairs January, 1975 52-221 O-75-17 -1 What has been the basis for the recent expressions of concern over the soundness of the American banking system? Regulators and industry leaders alike have been asking some hard questions of themselves in 1974, especially after the failure of Franklin National Bank in October 1974 and the U.S. National Bank, San Diego a year earlier. Were these multibillion dollar institutions oddities in the industry or were the problems incurred by these banks symptomatic of fundamental weaknesses developing in the banking system itself? The jury is still out on these questions, but all current banking studies inevitably focus on the trends affecting the liquidity and capital adequacy of banks and the banking system. Liquidity and capital considerations are essential to the operation of any bank. Moreover, they cannot be separated, for one always affects the other. An old maxim of banking, however, gives liquidity the priority: liquidity can be used as a substitute for inadequate capital, but capital cannot substitute for inadequate liquidity. Later bank capital adequacy and bank failures will be discussed. CHANGES IN THE COMPOSITION OF BANK ASSETS AND LIABILITIES AND THEIR AFFECT ON LIQUIDITY 1946-1960 At the conclusion of World War II, banks were flush with liquid assets, held principally in the form of cash balances and highly marketable U.S. government securities. At the same time, the banks enjoyed a large and relatively stable low cost deposit base. From this financial posture, commercial banks were ideally situated to accommodate the heavy loan demand which resulted from the rapid economic expansion of the late forties and fifties. But despite a large absolute growth in loans, the commercial banking system's share of the total credit market actually declined during this period, reaching a low of 26.5% in 1960.1/ A lagging deposit growth seriously hampered the expansion of lending capacity during the 1950's. Especially hard hit were the large money center banks. For example, during the fifties total deposits at New York reserve city banks rose 31%, compared with 53% at other banks and over 300% at savings and loan associations.27 Inflows of deposits were affected by heavy rate competition from non-bank financial intermediaries, chiefly thrift institutions which enjoyed preferential deposit rate 1/ Alex. Brown & Sons, The Banking Industry, Lessons of 1974, December 1974. 2/ Arnold A. Dill & Monroe Kimbrel, "Other Sources of Funds," The Changing World of Banking, Prochnow and Prochnow, Editors, Harper & Row, 1974. -2 differentials. Moreover, idle demand deposits held by sophisticated individuals and corporations were increasingly channeled into consumer goods, business operations and more lucrative money market instruments. Faced with a prospect for a highly profitable loan business in a period of rising interest rates, while at the same time suffering from sluggish deposit growth, the banks chose to rapidly expand loans at the expense of liquidity. This was accomplished by liquidating securities during the late forties and early fifties. Later, most available liquid funds derived from new deposit growth, retained earnings and equity capital issues were utilized for loan expansion. As a result, the loan to deposit ratio for the commercial banking system rose steadily during the immediate post-war period, reaching a high of 51% in 1960 (Table Two). As the banks entered the 1960's, some way had to be found to expand their lending capacity to meet the still rising and lucratiye loan demand. Further asset shifts by trading off liquid assets for loans were now impossible in significant proportions without exceeding the bounds of prudence. The lack of significant deposit growth was still the overriding factor restricting lending capacity. The dilemma was solved in the decade ahead by increasing use of liability management techniques and a relaxed regulatory environment. 1960-1974 - The Shift to Liability Management Until 1960 bank liquidity theories had concentrated on the composition of bank assets and the various degrees of liquidity in the asset accounts. Theoretically, a bank should be able to meet its demand and maturing obligations with cash whenever necessary. But short of a crisis of confidence and a resulting run on the bank, this ultimate test seldom occurs. For the normal bank, therefore, different levels of liquid and non-liquid assets--ranging from cash to fixed investment in banking premisis--are possible. The degree of liquidity that needs to be maintained on the asset side is largely a function of the composition and maturity structure of the deposit base, the growth rate of the deposit base, and the bank's ability to borrow. Asset growth is affected by the same factors and the ability to attract equity funds. Prior to the sixties excess liquidity tended to be maintained in the banking system because of a lack of flexibility on the liability side of the balance sheet. During times of liquidity stress, banks had access to the traditional federal reserve discount window, but such access was expected to be of short duration. Other borrowing was seriously limited by legal borrowing limits, by discouragement from regulatory authorities, by conservative bank managements, and by a lack of access to national money markets. Banks had no negotiable liability instruments to compete with money market issues of others. Moreover, asset growth was |