Term structure intermediation by depository institutions

320

E U I W O R K I N G P A P E R N° 85/178

TERM STRUCTURE INTERMEDIATION BY DEPOSITORY INSTITUTIONS

by

Dwight M. Jaffee

This paper was written while the author was a visiting professor at the EUI Economics Department and was participating in the project on "Financial Innovation and Euro­ pean financial integration".

BADIA FIESOLANA, SAN DOMENICO DI FIESOLE

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reproduced in any form without permission of the author

(C) Dwight M. Jaffee Printed in Italy in July 1985 European University Institute

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1. I N T R O D U C T I O N

D e p o s i t t r ansformation, or term s t r u c t u r e i n t e r m ediation, is t he p r o c e s s thro u g h which f i n a n c i a l i n t e r m e d i a r i e s c r e a t e l o n g ­ term loans from s h o r t - t e r m deposits. Al t h o u g h depo s i t

t r a n s f o r m a t i o n is a t r a d i t i o n a l and i m p ortant topic of d i s c u s s i o n for E u r o p e a n banking systems, it has not been e m p h a s i z e d in the

A m e r i c a n b a n k i n g literature. 1 R e c e n t d e v e l o p m e n t s in Ü.S.

capi t a l markets, however, have i m p o rtant imp l i c a t i o n s for the d e p o s i t t r a n s f o r m a t i o n a c t i v i t i e s of U.S. institutions, m o s t i m p o r t a n t l y the thrift institutions. In this paper a f r a m e w o r k and t h e o r e t i c a l model is d e v e l o p e d for a n a l y z i n g t r a n s f o r m a t i o n activities, w h i c h is then a p p l i e d to the actual s i t u t i o n of t hese d e p o s i t o r y institutions. Th e t h e o r e t i c a l model e x t e n d s t he r e c e n t wo r k of J a f f e e [19853 to the case in w hich the i n s t i t u t i o n s act as p r i c e - t a k e r s in loan and d e p o s i t markets. The a p p l i c a t i o n to U.S. t h r i f t ins t i t u t i o n s c o n c e r n s both the po s i t i v e a s p e c t s of t h r i f t i n s t i t u t i o n m a n a g e m e n t and the n o r m a t i v e a s p e c t s of g o v e r n m e n t r e g u l a t i o n of the institutions.

D e p o s i t o r y ins t i t u t i o n s have a v a i l a b l e e s s e n t i a l l y t h r e e a l t e r n a t i v e s t r a t e g i e s r e g a r d i n g the ma t u r i t y c h a r a c t e r i s t i c s of t heir p ortfolio. One strategy, t e r m e d tier matching, r e q u i r e s an e x a c t b a l a n c e of assets and l i a b i l i t i e s at each m a t u r i t y <lr duration) tier. Tier m a t c h e d p o r t f o l i o s have the a d v a n t a g e t h a t t h e r e is no ri s k with rega r d to i nterest rate fluctua t i o n s , but

1. See OE C D [1967, p. 1043 and H e w s o n [19753 for d i s c u s s i o n s of d e p o s i t t r a n s f o r m a t i o n in E u r o p e a n and Eur o p e a n bank i n g markets.

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r e d u c e d if t he tier m a t c h i n g c o n s t r a i n t n a r r o w s the o p p o r t u n i t y set. A s e c o n d strategy, c a l l e d term s t r u c t u r e intermediation. a l l o w s the i n s t i t u t i o n to take a d v a n t a g e of a r b i t r a g e and s p e c u l a t i v e o p p o r t u n i t i e s in the te r m s t r u c t u r e of interest rates, even if the r e s u l t i n g p o r t f o l i o is then m i s m a t c h e d by maturity. Wi t h an a s c ending y ield curve, this leads to the t r a d i t i o n a l d e p o s i t t r a n s f o r m a t i o n s t r u c t u r e with inst i t u t i o n s b o r r o w i n g s h o r t - t e r m and lending long-term. The third strategy, h e d g i n g a l ternatives, involves the use of s p e c i f i c p o s i t i o n s in capital m a r k e t s e c u r i t i e s or f u t u r e s m a r k e t s to o f fset the

int e r e s t r a t e e x p o s u r e of term s t r u c t u r e intermediation. The key q u e s t i o n w i t h hedg i n g s t r a t e g i e s is the cost that must be pa i d in t e r m s of r e d u c e d e x pected p r o f i t s in order to o b tain the desired r e d u c t i o n in risk.

C o m m e r c i a l banks in the U.S. appear in the normal c o u r s e to

o p e r a t e wi t h tier matched portfolios. 2 Banks do m i smatch their

p o r t f o l i o at times, to be sure, but this is judged to be

s p e c u l a t i v e be h a v i o r and is c a r r i e d out only for b rief periods and in r e s p o n s e to what are c o n s i d e r e d unusal mark e t

o p p o r t u n i t i e s . Even in these cases, moreover, the m a g n i t u d e of the m i s m a t c h is limited; the d i f f e r e n c e in du r a t i o n between a s s e t s "and l i a b i l i t i e s is m e a s u r e d in weeks or at most months.

2. See F l a n n e r y and James [1984] and their c i t a t i o n s for

e m p i r i c a l e v i d e n c e c o n f i r m i n g that comme r c i a l bank p o r t f o l i o s are t y p i c a l l y well balanced. Veit and Reiff [1983] p rovides surv e y e v i d e n c e of the use of f u t u r e s m a r k e t s by c ommerical banks to hedge t h e i r interest rate exposure.

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T h r i f t i n s t i tutions in the U.S., in contrast, have op e r a t e d t h r o u g h m o s t of the period since World War II with dra m a t i c a l l y m i s m a t c h e d portfolios, and the d i f f e r e n c e in dur a t i o n bet w e e n a s s e t s and l i a b i l i t i e s is m e a s u r e d in years if not decades. Most thri f t institutions, to be clear, have r e s p o n d e d to the evid e n t and e x t r e m e v o l a t i l i t y in U.S. i n terest rate levels so far during the 1 980s by a t t e m p t i n g to carry out new lending in a tier

m a t c h e d f a s h i o n and/or to hedge the interest rate exposure. But the r e s u l t i n g profit levels have g e n e r a l l y been very low, and new lending s t r a t e g i e s addr e s s the issue of the alre a d y e x isting

p o r t f o l i o i m b alance only by d i l u t i n g its share of the total portfolio.

Th i s m a j o r d i f f e r e n c e b e t w e e n comme r c i a l banks and t h rift i n s t i t u t i o n s is important b e c a u s e it p r o v i d e s an a d d i t i o n a l basis on w h i c h to ev a l u a t e some of the c o m m o n l y offered e x p l a n a t i o n s for why t he t h r i f t i n s t i t u t i o n s o p e r a t e d as they did. One comstQn explanation, for example, is th a t Federal insurance of d e p o s i t s and a lim i t e d d e gree of risk ave r s i o n are the key c o n d i t i o n s

leading to the use of term s t r u c t u r e i n t e r m e d i a t i o n by t h r i f t institutions. Commercial banks, however, also have Federal

depo s i t insurance, and it is u n c l e a r why bank m a n a g e m e n t w o u l d be

more r i s k a v e r s e than t h rift insti t u t i o n m a n a g e m e n t . 3 So Federal

d e p o s i t i n s u r a n c e and the a b s e n c e of risk ave r s i o n are no t s u f f i c i e n t e x p l a n a t i o n s for such t h rift insti t u t i o n behavior.

3. Most c o m m e r c i a l banks in the U.S. are shareho l d e r - o w n e d , w h e r e a s until re c e n t l y most thrift ins t i t u t i o n s were mutual o r g a n i z a t i o n s . It would appear that this would create, if anything, more risk a v e r s e b e h a v i o r on the part of mututal o r g a n i z a t i o n s .

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A n o t h e r p o s s i b l e e x p l a n a t i o n for the t h r i f t i n s t i t u t i o n behavior is th a t t h r i f t m a n a g e m e n t s y s t e m a t i c a l l y m a i n t a i n s e x p e c t a t i o n s that i n t e r e s t r a t e levels will decline. Here too, however, the

a r g u m e n t is w e a k both bec a u s e such e x p e c t a t i o n s w o u l d ha v e been w r o n g more o f t e n th a n not and b e c a u s e it is u n c l e a r wh y bank and t h r i f t m a n a g e m e n t s w ould s y s t e m a t i c a l l y m a i n t a i n d i f f e r e n t

in t e r e s t ra t e expectations.

The r e s u l t s of this p a p e r p oint in a d i f f e r e n t d i r e c t i o n c o n c e r n i n g t he h istorical r e a s o n s why the t h r i f t s b e h a v e d as they did a nd the c u r r e n t issues of how to deal with th e e x i s t i n g

t h r i f t i n s t i t u t i o n s and their problems. The a n a l y s i s here e m p h a s i z e s t he c r itical role of p r o f i t m a r g i n s a nd p r o f i t

o p p o r t u n i t i e s in u n d e r s t a n d i n g the d i s t i n c t i v e a s p e c t s of thrift i n s t i t u t i o n behavior. Profit o p p o r t u n i t i e s d e p e n d on t he deposit and loan m a r k e t s in which i n s t i t u t i o n s operate, and t h e r e are

i m p ortant d i f f e r e n c e s between c o m m e r c i a l b a n k s and t h r i f t i n s t i t u t i o n s in this regard. It is al s o n o t e w o r t h y that the capital m a r k e t c o n d i t i o n s f a c e d by all d e p o s i t o r y i n s t i t u t i o n s and t he p o r t f o l i o choices a v a i l a b l e to t h r i f t i n s t i t u t i o n s have c h a n g e d d r a m a t i c a l l y in r e c e n t years. The role of p r o f i t margins, c h a n g i n g c a p i t a l market conditions, and a new r e g u l a t o r y

e n v i r o n m e n t are de v e l o p e d in the a n a l y s i s that follows.

The a g e n d a for the paper is as follows. In the fo l l o w i n g S e c t i o n 2 t he t h eory and model of term s t r u c t u r e i n t e r m e d i a t i o n is developed, w h i c h p r ovides the f r a m e w o r k for the analysis. In S e c t i o n 3 the arg u m e n t is made for u n d e r s t a n d i n g the d i f f e r e n t b e h a v i o r of c o m m e r c i a l banks and t h r i f t i n s t i t u t i o n s as a

f u n c t i o n of the prof i t o p p o r t u n i t i e s a v a i l a b l e in their

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r e s p e c t i v e markets. In S e c t i o n 4 the a n a l y s i s is applied to the q u e s t i o n of how the thrift inst i t u t i o n s s h o u l d now oper a t e and of the a p p r o p r i a t e regula t o r y positions.

2. A T H E O R Y OF TERM S T R U C T U R E INTERM E D I A T I O N

D i s c u s s i o n s of term s t r u c t u r e intermediation, or depo s i t

t r a n s f o r m a t i o n , are s u r p r i s i n g l y rare in the A m erican banking and f i n ancial i n t e r m e d i a t i o n literature. This litera t u r e has been t h o r o u g h l y rev i e w e d in r e c e n t surveys by B a l t e n s p e r g e r [19803 and S a n t o m e r o C 1 9 8 4 3 . Only the p a p e r s by N i e h a n s and Hewson C19763 a nd Deshmukh, Greenbaum, and K a n a t a s C19833 even deal with a l t e r n a t i v e m a t u r i t i e s and m u l t i - p e r i o d p l a n n i n g horizons, and t h e i r f o c u s is q u i t e d i f f e r e n t from the p r e s e n t one. Overall, S a n t o i e r o ' s summ a r y that i n terest risk m a n a g m e n t is an area that still, " r e q u i r e s serious mod e l i n g and em p i r i c a l in v e s t i g a t i o n to bring t he a c a d e m i c l i t e r a t u r e up to the institu t i o n a l reali t i e s , " is very apt. 4

The p o r t f o l i o d u r a t i o n litera t u r e also p r oves to be of only limited v a l u e for the issues at hand. The d u r a t i o n litera t u r e is d i r e c t e d p r i m a r i l y at a n a l y z i n g the p o r t f o l i o mat u r i t y s t r u c t u r e t h a t m i n i m i z e s e x p o s u r e to u n e x p e c t e d int e r e s t rate fluctuations, and it g e n e r a l l y does not a n a l y z e the gains in exp e c t e d p r o f i t s

4. S a n t o m e r o C19843, p. 597. Rece n t s t u d i e s of the the p r o v i s i o n of loan c o m m i t m e n t s and the pricing of f l o a t i n g rate loans by

i n t e r m e d i a r i e s r e p r e s e n t a n o t h e r l iterature that d eals with

m a t u r i t y questions. The c o m m i t m e n t papers use option t h eory to

value the c o m m i t m e n t s (Thakor, Greenbaum, and Hong [19813), while th e t r a d e - o f f betw e e n interest rate risk and c r e d i t risk is the f o c u s of the f l o a t i n g rate p a pers (Santomero [19833 >.

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that ar e g e n e r a t e d with e x p o s e d p o s i t i o n s (Grove [19743 is an e x c e p t i o n ) . Th i s f o c u s of d u r a t i o n t h eory is u n d e r s t a n d a b l e b e c a u s e t h a t l i t e r a t u r e p r o c e e d s on the p r e m i s e of e f f i c i e n t m a r k e t s and e x p o s u r e to in t e r e s t rate risk is i d i o s y n c r a t i c in that setting. The premise of e f f i c i e n t m a r k e t s is not

app r o p r i a t e , however, in s t u d y i n g the b e h a v i o r of financial i n t e r m e d i a r i e s b e c a u s e t h e s e i n s t i t u t i o n s exist e x a c t l y bec a u s e there are m a r k e t imperfections. 5

T h e m o d e l d e v e l o p e d here p r o c e e d s d i r e c t l y from the t r a d i t i o n a l b a n k i n g f i r m literature, as in K l e i n C 1 9713, but brings m a t u r i t y c h o i c e and a m u l t i - p e r i o d p l a n n i n g hori z o n into the a n a l y s i s e xplictly. In a r e c e n t paper, J a f f e e [19853, this t h eory is d e v e l o p e d with the a s s u m p t i o n that the i n t e r m e d i a r y has m o n o p o l y p o w e r in both its loan and d e p o s i t markets. In this

paper, in contrast, it is a s s u m e d that the i n t e r m e d i a r y a c t s as a c o m p e t i t i v e p r i c e - t a k e r in these m a r k e t s as well as in the

g o v e r n m e n t s e c u r i t i e s and r e l a t e d capital markets. W h i l e it

h as be e n an open qu e s t i o n w h e t h e r c o m p e t i t i o n or m a rket power is the b e t t e r a s s u m p t i o n for d e s c r i b i n g d e p o s i t o r y i n t e r m e d i a r y

behavior, a v a r i e t y of r e c e n t i n n o v a t i o n s in U.S. capi t a l markets (discussed below) push s t r o n g l y in the c o m p e t i t i v e direction, and c o m p e t i t i o n a p p e a r s the a p p r o p r i a t e a s s u m p t i o n for present

purposes.

C o n s i d e r an inst i t u t i o n that issues d e p o s i t s (D), makes

loans (A), and takes p o s i t i o n s as eith e r a s s e t s or liab i l i t i e s in

5. This d i s t i n c t i o n b e t w e e n the t r a d i t i o n a l b a n k i n g l iterature and the f i n a n c e l iterature is a l s o made by T a g g a r t [19843.

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<government.) s e c u r i t i e s (S) . Each instru m e n t is a v a i l a b l e in two m a t urities, s h o r t - t e r m (subscript 1) and l o n g -term (subscript 2). A b a l a n c e s h e e t for such an i n s titution is s hown in Table 1,

w h e r e for p u r p o s e s of i l l u s t r a t i o n the s h o r t - t e r m security p o s i t i o n is an a s s e t and the long-term s e c u r i t y p o s i t i o n is a liability. Table 1 B a l a n c e S h e e t At Initial Date (t=0) A S S E T S L I A B I L I T I E S Ai S h o r t - t e r m Loans Di S h o r t - t e r m Deposits Si S h o r t - t e r m S e c u r i t i e s S

2

2

2

The i n s t i t u t i o n ' s p r o f i t s are the int e r e s t r e c e i p t s e a r n e d on the assets, less the int e r e s t e x p e n s e s paid on the l i a b i l i ­ ties, a nd less its o p e r a t i n g c o s t s C. The p e r i o d i c interest y ield on each i n s t r u m e n t is d e n o t e d as the c o r r e s p o n d i n g lower case symbol; thus di is the p e r i o d i c i nterest rate paid on s h o r t - t e r m deposits. T h e s e yields are t r e a t e d as r i s k f r e e or risk a d j u s t e d . 6

Asset p o s i t i o n s are t r e a t e d as a l g e b r a i c a l l y positive, while >

l i a b i l i t i e s are negative; thus A > 0, D < 0, and S < 0.

A p e r i o d an a l y s i s is used in which one p e r i o d (year) is the

m a t u r i t y of the short- t e r m i n s t r u m e n t s and two p e r i o d s is the 6

6. The capi t a l market s e c u r i t i e s and d e p o s i t s can be r e a s o n a b l y taken as risk free. Many loan contracts, however, remain r isky even after c ollateral is included, but this risk can be reduced to an a c t u arial basis and the loan interest ra t e ad j u s t e d f or the ri s k if the inst i t u t i o n m a i n t a i n s a d i v e r s i f i e d po r t f o l i o of such

l o a n s .

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m a t u r i t y of the l o n g -term instruments. The i n s t i t u t i o n m a k e s its initial d e c i s i o n s at t=0 at the b e g i n n i n g of p e r i o d 1, the s h o r t ­ t e r m i n s t r u m e n t s mature at t=l at the end of p e r i o d 1, an d new d e c i s i o n s can be made at t h a t time for p e riod 2, and so forth. Th e p l a n n i n g hor i z o n for d e c i s i o n s made at the b e g i n n i n g of period 1 is equal to the t w o - p e r i o d m a turity of t h e l o n g - t e r m instruments. The an a l y s i s is c a r r i e d out with a t w o - p e r i o d model b e c a u s e it a l l o w s the main p o ints to be d e v e l o p e d wi t h a minimum of notation.

P r o f i t s (P) over the t wo p e riod hor i z o n can be w r i t t e n as:

(1) P = Z2 tiaiAi+ isiSi+ idiDj_] + c(Di + D2> + g ( A i+Si+Di> .

i=l

The s u m m a t i o n of the first t h r e e t erms a c c o u n t s fo r t h e interest i n c o m e and e x p e n s e on the three inst r u m e n t s for b o t h maturities;

r e call that l i a b i l i t i e s are a l g e b r a i c a l l y negative. 7 This

s p e c i f i c a t i o n uses s i m p l e interest, and thus do e s not c o m p o u n d the e a r n i n g s from period 1, but the r e t u r n s on the lo n g - t e r m

i n s t r u m e n t s are m u l t i p l i e d by 2 to acco u n t for t h e i r d o u b l e ­ length h o l d i n g period. The o p e r a t i n g costs <C) are s p e c i f i e d as

p r o p o r t i o n a l to total d e p o s i t s at t=0; that is, C = c (Di+D2> •

The last term in e q u a t i o n (1) c o n c e r n s the n e c e s s a r y

r o l l o v e r at t=l of the s h o r t - t e r m i n s truments th a t m a t u r e at that time. The sum (Ai+Si+Di) is the net s h o r t - t e r m position, g is the a v e r a g e (effective) y i e l d on this p o s i t i o n wh e n it is r o l l e d - o v e r f or p e r i o d 2. The r e turn g is unknown at the initial d a t e t=0.

7. O t h e r s o u r c e s of income, net worth, and initial p o r t f o l i o p o s i t i o n s are all ass u m e d to be zero..

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The role of the rol l o v e r term in the prof i t f u n c t i o n can be

f u r t h e r u n d e r s t o o d by c o n s i d e r i n g the b a l a n c e s h e e t c o n s t r a i n t of

the institution. The b a l a n c e sheet c o n s t r a i n t at t he initial

d e c i s i o n da t e t=0 is:

<2> A i + S i + D i A2 + S2 + D2 = 0 .

Th i s is t he al g e b r a i c sum of all a v a i l a b l e i n s t r u m e n t s and

c o r r e s p o n d s to the bal a n c e s heet shown in T able 1. At the end of p e r i o d 1, however, the s h o r t - t e r m inst r u m e n t s m a t u r e and the b a l a n c e s h e e t will appear: Table 2 T - A c c o u n t B a l a n c e S h e e t after Peri o d 1 <t=l) ASSETS L I A B I L I T I E S A2 L o n g - t e r m L oans D

2

2

r e p r e s e n t s the n e c e s s a r y r o l l o v e r at t=l of the n et v alue of the m a t u r i n g one period positions. The reve n u e or c o s t a s s o c i a t e d wi t h m a i n t a i n i n g this p o s i t i o n d u ring peri o d 2 is a c c o u n t e d for by the last term in the p r o f i t equ a t i o n (1).

The r o l l o v e r c o m p o n e n t of the profit f u n c t i o n i n t r o d u c e s a s t o c h a s t i c elem e n t b e c a u s e its i n terest yield (g> is u n k n o w n at t=0. This is a n a l y z e d with a m e a n / v a r i a n c e f r a m e w o r k in w h i c h the

i n s t i t u t i o n is a s s u m e d to be risk a v erse and to m a x i m i z e e x p e c t e d utility. E x p e c t e d utility U is a fun c t i o n of e x p e c t e d p r o f i t s ECP3 and t he v a riance of p r o f i t s VCPD:

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(3) U = U(ECP3, V [P3 ) , Ui > 0, U 2 < 0.

T he on l y e l e m e n t of u n c e r t a i n t y in the prof i t f u n c t i o n <1> is the int e r e s t rate g at w h i c h m a t u r i n g one p e r i o d inst r u m e n t s can be r o l l e d ov e r for an a d d i t i o n a l p e r i o d at t=l. D e n o t e the e x p e c t e d v a l u e of g (taken at t=0) as g e and the c o r r e s p o n d i n g v a r i a n c e as g s . Then from (1), we have:

(4a) ECP3 = Z2CiaiAi+ isiSj.* idiDj.3 + c (Di+ D

2

i=l

(4b) VCP3 = g s (Ai+Si+Di)2 .

Th e m a x i m i z a t i o n of e x p e c t e d uti l i t y (3) can be set up as a L a g r a n g e a n m a x i m i z a t i o n problem, taki n g into a c c o u n t the balance sheet c o n s t r a i n t (2):

(5) M a x i m i z e L = U (ECP3, VCP3) - A(Ai+ Si+ Di+ A 2 4'S2+D2> »

with ECP3 and VCP3 d e f i n e d in (4). The addit i o n a l c o n s t r a i n t s that a s s e t s be po s i t i v e and that l i a b i l i t i e s be n e g a t i v e are not f o r m a l l y e n f o r c e d in (5), but are included in t he d i s c u s s i o n b e l o w .

2 . A S o l u t i o n s w i t h o u t Capital M a rket S e c u r i t i e s

T h e a n a l y s i s of the m a x i m i z a t i o n problem (5) is s i m p l i f i e d a ».

by f i r s t c o n s i d e r i n g the case in w hich the s e c u r i t i e s p o s i t i o n s Si and S2 ar e set equal to zero. The m a x i m i z a t i o n of (5) is thus c a r r i e d out with respect to the four bala n c e s h e e t p o s i t i o n s Ai, Di, i = 1,2. The f irst order n e c e s s a r y c o n d i t i o n s for an interior m a x i m u m are:

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(6a) 8L/3a i

(6b) 3L/9d i

(6c) 3l/9a2

(6d) 3L/3D2

= <ai+ge )Ui + 2gs (Ai+Di>U2 - ^ = O ;

= <di+ge +c)Ui + 2 g 3 (Ai+Di>U2 = O ;

= <2a2>Ui - X. = 0 ;

= (2 d 2 +c)üi - X = O;

C o n d i t i o n s (6a) and (6b) for Ai and Di show the tr a d e o f f b e t w e e n the m a r g i n a l c o n t r i b u t i o n of t h e s e p o s i t i o n s to e x p e c t e d income in the first te r m and to the v a r i a n c e of income in the s e c o n d term. The m a rginal income term includes the o n e - p e r i o d y i e l d (ai or di), the rol l o v e r y ield for peri o d 2 (ge ) , and for (6b) the

marginal co s t of dep o s i t s ( c ) . C o n d i t i o n s (6c) and (6d> f or A

2

and D

2

c o n t r i b u t i o n to the v a r i a n c e of income s ince t he yields on t hese p o s i t i o n s a re cer t a i n for the two peri o d pla n n i n g horizon.

The i n t e r p r e t a t i o n of t h e s e c o n d i t i o n s is f a c i l i t a t e d by n o ting th a t all p o r t f o l i o s for the i n stitution must be b u i l t from one or more of the p o s i t i o n s s h o w n in Table 3:

T able 3 Pos i t i o n # Asset L i a b i l i t y D e s c r i p t i o n 1 Al Di Tier Matched 2 A2 d2 Tier Matched 3 A2 Dl Long T r a n s f o r m a t i o n 4 Al d2 S hort T r a n s f o r m a t i o n

The i n s t i t u t i o n ' s choice among t h e s e a l t e r n a t i v e s d e p e n d s on the r e l a t i v e v a l u e s of the interest rates on the four instruments.

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The c o n d i t i o n s for each one of the p o s i t i o n s of Table 3 to be part of the optimal s o l u t i o n are now d e v e l o p e d as a f unction of the r e l a t i v e i nterest rate levels.

Tier M a t c h e d Solutions.

D e f i n e Mi, the marginal p r o f i t from t i e r - m a t c h e d ac t i v i t y at tier i, as:

(7) Mi = iai - idi - c , i =1,2.

The first o r d e r c o n d i t i o n s (6) r e q u i r e that Mi = 0 for an

interior Maximum. ® In this ca s e the inst i t u t i o n earns zero

p r o f i t s s i n c e the loan i n terest income just e q uals the sum of the d e p o s i t i n t e r e s t and o p e r a t i n g expenses. It is ass u m e d the

i n s t i t u t i o n does not use t i e r - m a t c h e d po s i t i o n s in this case. This is a l s o a r a z o r - e d g e ca s e s i n c e it r e q u i r e s the exact c o n s t e l l a t i o n of interest rates t h a t sati s f y Mi = 0.

M o r e g e n e r a l l y Mi will n ot equal zero, and tier matched p o r t f o l i o s will occur as c o r n e r solutions. If Mi is pos i t i v e at e i ther m a t u r i t y tier, then the i n s t i t u t i o n ma x i m i z e s pro f i t s by c a r r y i n g o ut the i n t e r m e d i a t i o n w i t h o u t limit. If Mi is negative,

then the i n s t i t u t i o n w i shes to e x p a n d by investing in de p o s i t s and issu i n g loans, but is c o n s t r a i n e d by the c o n d i t i o n that assets be p o s i t i v e and l i a b i l i t i e s be negative. T i e r - m a t c h e d p o s i t i o n s are thus zero w h e n e v e r Mi<^0.

The u p s h o t is that t i e r - m a t c h e d p o r t f o l i o s are the optimal s o l u t i o n f or the i n s titution w h e n e v e r Mi > 0, and the i n s titution will c a r r y out the t i e r - m a t c h e d i n t e r m e d i a t i o n with o u t limit. It 8. The s u b s t i t u t i o n of <6b> into (6a> yiel d s Mi=0, and the

s u b s t i t u t i o n of <6d> into (6c) y i e l d s M

2

0

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is evident, of course, that i n s t i t u t i o n s o p e r a t i n g in this

fash i o n will come to do m i n a t e t h e i r d e p o s i t and loan markets, and u l t i m a t e l y they will face an incre a s i n g marginal co s t of dep o s i t s and a d e c l i n i n g marginal r e v e n u e from loans. Th i s is t he case d e v e l o p e d in Jaffee [19853. It is also n o t e w o r t h y that tier matc h e d s o l u t i o n s have no risk, and th u s d o m i n a t e the

t r a n s f o r m a t i o n p o s i t i o n s <3> and (4) in Table 3 even wh e n the t r a n s f o r m a t i o n po s i t i o n s p r o v i d e p o s i t i v e e x p e c t e d utility.

T r a n s f o r m a t i o n S o l u t i o n s .

T r a n s f o r m a t i o n s o l u t i o n s b e c o m e r e l e v a n t as opti m a l

s o l u t i o n s fo r the i n s titution when Mi 0, that is wh e n tier

matched s o l u t i o n are not optimal. By the s u b s t i t u t i o n of (6b) into (6c), the first order c o n d i t i o n for t r a n s f o r m a t i o n p o s i t i o n

(3) with Di and A2 can be written:

(8a) (

2

2

and by the s u b s t i t u t i o n of (6d) into (6a), the f i r s t o r d e r

c o n d i t i o n for t r a n s f o r m a t i o n p o s i t i o n (4) with Ü2 and Ai c an be written :

(8b) (ai + g e -

2

2

2

These c o n d i t i o n s r e p resent the t r a d e o f f betw e e n the mar g i n a l

c o n t r i b u t i o n to exp e c t e d p r o f i t s and the v a r i a n c e of p r o f i t s from the p o r t f o l i o positions. For example, in (8a) the mar g i n a l

c o n t r i b u t i o n to e xpected income is r e p r e s e n t e d in the f i r s t term

by the two p e r i o d return from the loan po s i t i o n A

2

period 1 cost, the rol l o v e r cost, and the o p e r a t i n g c o s t s of the

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d e p o s i t position; and the marginal c o n t r i b u t i o n to profit

v a r i a n c e is r e p r e s e n t e d in the second te r m by the m a g n i t u d e of Dj.. From this point it is useful to f o c u s the d i s c u s s i o n on the case of long t r a n s f o r m a t i o n a l o n e (position 3 in T a b l e 3) since th i s is the ca s e of empirical r e l e v a n c e for the thrift

institutions. P arallel resu l t s can be derived, however, for the c a s e of s hort t r a n s f ormation. It is e v i d e n t from (8a) that a

n e c e s s a r y c o n d i t i o n for long t r a n s f o r m a t i o n (hereafter t r a n s f o r m ­ ation) to be an optimal so l u t i o n is th a t the marginal e x p e c t e d p r o f i t T from t he act i v i t y be positive:

(9) T = 2 a2 - di - g e -c > 0 .

In addition, however, it has be e n a l r e a d y n oted that t r a n s f o r m a t i o n a c t i v i t i e s will be optimal only if the

c o r r e s p o n d i n g t i e r - m a t c h e d p o s i t i o n s are not optimal; th a t is:

(10a) Ml = ai di

-(10b) M2 = 2 a2 - 2d2

C o n d i t i o n s (10) are thus also n e c e s s a r y c o n d i t i o n s for optimal t r a n s f o r m a t i o n a c t i v i t i e s to occur.

The s u b s t i t u t i o n of (10) into (9) yields:

(11a) "■ 2 a 2 - «1 - g e > o

(lib) 2 d 2 ~ di - 9 e > 0

C o n d i t i o n s (11) are an a l t e r n a t i v e s t a t e m e n t of (lO) as n e c e s s a r y c o n d i t i o n s for optimal t r a n s f o r m a t i o n activities. They requ i r e

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e s s e n t i a l l y that there be risk premia in the te r m s tructures of interest rates for dep o s i t s and loans. The i n t u i t i v e idea is that t r a n s f o r m a t i o n po s i t i o n s can be optimal, when t i e r - m a t c h e d

p o s i t i o n s are not, only if such risk p r e m i a e x i s t in the yield c u r v e s .

S u m m a r y .

The e m p i r i c a l implications of the f o r e g o i n g for the

n e c e s s a r y yield s p read c o n d i t i o n s can be s u m m a r i z e d as follows. The n e c e s s a r y c o n d i t i o n s for optimal t i e r - m a t c h e d p o r t f o l i o s are

that Mi > 0, i = l,2 , with Mi def i n e d in e q u a t i o n < 7 ) . If either

one of these c o n d i t i o n s holds, then t i e r - m a t c h e d p o r t f o l i o s are used in un l i m i t e d amounts to gen e r a t e inf i n i t e p r o f i t s for the

i n s t i t u t i o n .

If t i e r - m a t c h e d po r t f o l i o are not profitable, however, then t r a n s f o r m a t i o n p o s i t i o n s would be c o n s i d e r e d by t he institution. The n e c e s s a r y c o n d i t i o n s for optimal long t r a n s f o r m a t i o n (short d e p o s i t s Di to long loans A2> are given by e q u a t i o n s (9) (that the t r a n s f o r m a t i o n a c tivity be profitable) and (11) (that there be risk premia in the term s t r u c t u r e s of d e p o s i t and loan r a t e s ) .

2 . B S o l u t i o n s With Capital Market S e c u r i t i e s

The p o s s i b l e role for risk f e e capital m a r k e t (say Treasury) s e c u r i t i e s as an additional e l e m e n t in the i n s t i t u t i o n ' s optimal p o r t f o l i o is now developed. Two d i s t i n c t f u n c t i o n s of these

s e c u r i t i e s are considered: to meet the dema n d for earning assets or liabilities, and to hedge interest rate exposure.

C o n s i d e r f i r s t such s e c u r i t i e s as an a d j u n c t to optimal

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t i e r - m a t c h e d portfolios. T r e a s u r y s e c u r i t i e s will be inc l u d e d as e a r n i n g a s sets in t i e r - m a t c h e d p o r t f o l i o s only if the yield on the T r e a s u r i e s e x c e e d s the yield a v a i l a b l e on loans. It is apparent, however, t h a t in pr a c t i c e T r e a s u r y s e c u r i t i e s will

yield less than loans. The key r e ason is that loan o r i g i n a t i o n

r e q u i r e s e x p e r t i s e w h e r e a s i n v e s t m e n t in T r e a s u r i e s does not, and the m a rket e q u i l b r i u m would reflect this with lower Tre a s u r y

rates. Tr e a s u r y s e c u r i t i e s thus will not d i s p l a c e loans as e a r n i n g a s sets in the p o r t f o l i o s of d e p o s i t o r y institutions. T r e a s u r y s e c u r i t i e s also will not be held by d e p o s i t o r y

i n s t i t u t i o n s wi t h t i e r - m a t c h e d p o r t f o l i o s as a s sets to s a t i s f y h e d g i n g n e e d s since t here is no interest rate exposure.

The p o s s i b l e role for Tre a s u r y s e c u r i t i e s as l i a b i l i t i e s is

more complicated. D e p o s i t o r y inst i t u t i o n s can now carry out

short sales of T r e a s u r y s e c u r i t i e s using b o r r o w e d s e c u r i t i e s and r e p u r c h a s e agreements, but high fees make it unl i k e l y that the cost of such fun d i n g would be c o m p e t i t i v e with d e p o s i t s on an o n g o i n g basis. The institutions, however, can also issue

l i a b i l i t i e s d i r e c t l y in mar k e t s that t rade i n s t r u m e n t s c l o s è l y r e l a t e d to T r e a s u r y instruments, and they a p pear to do so at

least over c e r t a i n m a t u r i t y ranges. Net sales of Federal F u n d s by c o m m e r c i a l b anks r e p r e s e n t the most i m p ortant case, but

c ommercial paper and p r e f e r r e d stock issues by ba n k and t h r i f t h o l d i n g companies, and adva n c e b o r r o w i n g s by t h r i f t i n s titution memb e r s of the Federal Home Loan Banks p e r f o r m a s i m i l a r f u n c t i o n f or l o n g e r - d a t e d instruments. The rates on t hese a l t e r n a t i v e

inst r u m e n t s move with Tre a s u r y rates and are at levels only s l i g h t l y above Treasuries.

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The r o l e o£ Tr e a s u r y s e c u r i t i e s as earn i n g a s sets or

liab i l i t i e s in t r a n s f o r m a t i o n p o r t f o l i o s is e s s e n t i a l l y the same as in t i e r - m a t c h e d portfolios. That is, loans d o m i n a t e T r e a s u r i e s as ear n i n g assets, but T r e a s u r y r e l a t e d i n s t r u m e n t s may do m i n a t e d e p o s i t s as liabi l i t i e s ov e r some m aturity ranges. More

importantly. T r easury s e c u r i t y h o l d i n g s can f u n c t i o n to r e duce t h e i n terest ra t e e x p o s u r e of t r a n s f o r m e d portfolios, u n like the case of t i e r - m a t c h e d positions.

C o n s i d e r an insti t u t i o n that issues the a m o u n t Di of s h o r t ­

term deposits, and invests in an equal amount A

2

loans, with e x pected p r o f i t s and the var i a n c e of p r o f i t s derived from e q u a t i o n s < 4 ) :

< 12) E CP] = <2a2 - di

( 13> VCP] = g s <Di>2 .

The v a r i a n c e in pro f i t s will be r e d u c e d to zero if the

i n s t i t u t i o n pu r c h a s e s s h o r t - t e r m s e c u r i t i e s S i > 0 and issues

long-term s e c u r i t y l i a b i l i t i e s S

2

a b s o l u t e value to D i . E x p e c t e d p r o f i t s E«CP] are then:

<14) E*CP] = <2a2 - di + si - 2s2 - c)Di,

an d the c h a n g e in e x p e c t e d p r o f i t s is:

(15) E*[p]-EtP] = si + g e “ 2s

2-Th i s c h a n g e in e x p e c t e d profits, w h i c h mea s u r e s the e x p e c t e d cost of ca r r y i n g out the hedge, is exac t l y the n e g a t i v e of the risk pre m i u m in the Tre a s u r y term structure.

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The i n s t i t u t i o n will c l e a r l y use this h e d g i n g t e c h n i q u e when the T r e a s u r y ri s k prem i u m is zero, s i n c e the i n s t i t u t i o n can then e l i m i n a t e its i n terest rate e x p o s u r e at z e r o cost. It appe a r s generally, however, the T r e a s u r y yield curve has a risk premium, and the a m o u n t of hedging will decl i n e as this r i s k p r e m i u m

rises. Indeed, there is an u p p e r limit to the size of the risk premium, a b o v e which the i n s t i t u t i o n will c h o o s e not to h e d g e at all. This u p p e r limit is equal in size to the s m a l l e r of t h e risk p r e m i a in the loan an d d e p o s i t yield curves. The ri s k p r e m i a in the loan a nd d e p o s i t m a r k e t s d e t e r m i n e the p r ofit m a r g i n of the institution, and if the cost of h e d g i n g e q u a l s this a m o u n t the i n s t i t u t i o n ' s p r o f i t s have been e l i m i n a t e d (along with its r i s k ) .

This a n a l y s i s of the hedg i n g use of s e c u r i t y p o s i t i o n s

a p p l i e s to both cash m a r k e t hedges, in w h i c h the ca s h m a r k e t s for s e c u r i t i e s are used directly, and to f u t u r e s m a r k e t hedges, in w hich the o r g a n i z e d f u t u r e s m a r k e t s are used. T he c o m m o n a l i t y of t he two h e d g i n g t e c h n i q u e s a r i s e s b e c a u s e th e p r i c i n g of futu r e s c o n t r a c t s is based d i r e c t l y on the forw a r d r a t e s in the c a s h m a r k e t te r m s t r u c t u r e of T r e a s u r y yields. T here is thus no d i f f e r e n c e in p r i n c i p l e b e t w e e n t a king a short f u t u r e s m a r k e t p o s i t i o n in a one period a head contract, and issuing a t w o - p e r i o d T r e a s u r y instr u m e n t as a liability w hile s i m u l t a n e o u s l y

p u r c h a s i n g a o n e - p e r i o d T r e a s u r y instru m e n t as an a s s e t in the cash markets.

As an empirical matter, it appe a r s a fact (see Veit a nd Reif [1983]) th a t neither c o m m e r c i a l banks nor thri f t i n s t i t u t i o n s

ha v e made s i g n i f i c a n t use of f u t u r e s m a r k e t s to hedge t h e i r

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i n t e r e s t rate exposure. This is u n d e r s t a n d a b l e with r e g a r d to c o m m e r c i a l banks since it a p p e a r s they g e n e r a l l y m a i n t a i n tier- m a t c h e d p o r t f o l i o s and thus ha v e no need to hedge int e r e s t rate exposure. It is more c o m p l i c a t e d with rega r d to thrift

institutions, s ince the large m a g n i t u d e of their i n t e r e s t rate e x p o s u r e in unambiguous. The limited use of f u t u r e s c o n t r a c t s by t h r i f t s can be explained, however, if the risk prem i u m in the T r e a s u r y y ield curve equa l s or e x c e e d s the risk p r e m i u m in eith e r the loan or depo s i t yield curves.

3. AN E M P I R I C A L BASIS FOR TI E R MAT C H I N G V E R S U S T R A N S F O R M A T I O N

E m p i rical data are p r e s e n t e d in this sect i o n to e v a l u a t e the p r o p o s i t i o n that c ommercial bank o p e r a t i n g m a r g i n s s i g n i f i c a n t l y e x c e e d t h o s e of thrift institutions, and that this is c o n s i s t e n t w i t h the use of t i e r - m a t c h e d s t r a t e g i e s by the b anks v e rsus the use of t r a n s f o r m a t i o n s t r a t e g i e s by the thrifts. It is w o r t h

n o t i n g at the o u tset that t he data come pr i m a r i l y fr o m r e g u l a t o r y reports, and while this leads to at least s u p e r f i c i a l uniformity, the s t r u c t u r e of these r e p o r t s is far from per f e c t for present purposes. P e r h a p s most importantly, there is little a t t e m p t to r e p o r t v a r i o u s costs and r e v e n u e s by funct i o n a l activities. 9 The da t a cover the cost of deposits, o p e r a t i n g expenses, and the r e t u r n on loans for the t wo c l a s s e s of institutions.

9. The b asic prob l e m a p p e a r s to be that d e p o s i t o r y institutions, at l east in the U.S., c arry o ut very little f u n c t i o n a l cost and r e v e n u e allocation. For example, the Federal Rese r v e S y s t e m has a w i dely used, but v o l u n t a r y s u r v e y and an a l y s i s of f u n c t i o n a l co s t data for member institutions. From a u n i v e r s e of ov e r 14,000

c o m m e r c i a l banks, however, only 608 p a r t i c i p a t e d in the most r e c e n t 1983 survey (Federal R e s e r v e Syst e m [19833).

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3 . A The C o s t of Deposits

T a b l e 4 s hows da t a on the e f f e c t i v e in t e r e s t cost of d e p o s i t s at S a v i n g s and Loan A s s o c i a t i o n s ( S & L s ) , the major

t h r i f t i n s t i t u t i o n group, and at c o m m e r c i a l banks. The r a t e s are c a l c u l a t e d by di v i d i n g the total in t e r e s t paid on d e p o s i t s by d e p o s i t s o u t s t a n d i n g for each group. The data are p r e s e n t e d in f i v e y e a r intervals s t a r t i n g in 1965 and include 1983.

S& L d e p o s i t rates rose s t e a d i l y over the period, r e f l e c t i n g b o t h th e t r e n d in interest rate levels g e n e r a l l y and the

d e r e g u l a t i o n of c e i l i n g s on d e p o s i t rates s t a r t i n g in 1978.

C o m m e r c i a l bank time dep o s i t rates, which are c o m p a r a b l e with S&L d e p o s i t rates, showed a s t able p a t t e r n thr o u g h 1975, with the c o m m e r c i a l bank time depo s i t r a t e s about 1/2 a p e r c e n t a g e point b elow t he S &L rates, r e f l e c t i n g c u s t o m e r p r e f e r e n c e s for

c o m m e r c i a l bank deposits. The d a t a for 1980 and 1983 show a more e r r a t i c pattern.

The co s t of total c o m m e r c i a l bank deposits, not just time deposits, is r e l e v a n t for a n a l y z i n g profit margins. Total bank d e p o s i t s inc l u d e demand d e p o s i t s on which little or no exp l i c i t

i n t e r e s t is paid. The e f f e c t i v e rate on total c o m m e r c i a l bank

deposits, including the low or ze r o cost of d e m a n d deposits, is much b e l o w the S&L cost. The c o m m e r c i a l bank b e n e f i t from demand d e p o s i t s h as been s h r inking to be sure, as shown by the d e c l i n i n g

•»>

p e r c e n t a g e of total d e p o s i t s th a t are d e mand deposits, but the low i n t e r e s t co s t of demand d e p o s i t s beco m e s more v a l u a b l e when nomi n a l in t e r e s t rates are high. As of 1983 the cost of S&L d e p o s i t s e x c e e d e d the cost of total comme r c i a l bank d e p o s i t s by over 3 p e r c e n t a g e points.

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T a b l e 4

E f f e c t i v e Cost of Deposits, Annual P e r c e n t a g e

1965 1970 1975 1980 1983 1. S a v i n g s and Loan A s s o c i a t i o n s 4.25 5. 1 4 6.21 8.78 9.71 C o m m e r c i a l Banks 2. Time D e p o s i t s 3.73 4.48 5.74 9.38 8.29 3. Total D e p o s i t s 1.59 2.18 3.37 6.64 6.54 4. Cl> - (3) 2.66 2. 9 6 2.84 2.14 3.17 M e m o : D e m a n d Deposits /Total Deposits 57 51 41 29 21 S o u r c e s :

S a ving and Loan Associations: O f f i c e of P o licy and E c o n o m i c

Research, Federal Home Loan Bank Board.

C o m m e r c i a l Banks: Bank O p e r a t i n g S t a t i s t i c s . 1970 to 1983,

Fede r a l D e p o s i t Insurance Corporation. Federal R e s e r v e B u l l e t i n . June 1966 f or 1965 data, Board of G o v e r n o r s of the Federal

R e s e r v e System. Data thr o u g h 1975 e x c l u d e for e i g n d e p o s i t s in f o r e i g n b r a n c h offices. Since t h e s e d e p o s i t s are p r e d o m i n a n t l y time deposits, d e mand dep o s i t s as a p e r c e n t a g e of total d e p o s i t s are o v e r s t a t e d in the data shown for 1965, 1970, and 1975. The 1975 v a l u e would have been about 33 per c e n t on the new basis.

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3 . B O p e r a t i n g Costs

The d i f f e r e n c e b e t w e e n c o m m e r c i a l bank and t h rift c osts of d e p o s i t s s h o w n in line 4 of T a b l e 4 will o v e r s t a t e the actual c o m m e r c i a l bank ad v a n t a g e b e c a u s e d e mand deposit acc o u n t s are m o r e c o s t l y to maintain, in c l u d i n g the costs of s e r v i c e s in kind. T a b l e 5 p r o v i d e s data from the Fed e r a l R e s e r v e S y s t e m ' s

F u n c t i o n a l Co s t A n alysis c o n c e r n i n g the f u n c t i o n a l c osts of m a i n t a i n i n g d e m a n d v e rsus ti m e d e p o s i t s (see also foo t n o t e 9). The a l l o c a t e d c o s t s of m a i n t a i n i n g d e m a n d depo s i t a c c o u n t s have r isen from 1.87* to 3.26* of d e m a n d d e p o s i t s outstanding, while t h e a l l o c a t e d c o s t s of m a i n t a i n i n g time dep o s i t s have risen from

.5754 to a b o u t .9654 of time d e p o s i t s outstanding.

Thus in 1983 the costs of d e m a n d d e p o s i t s e x c e e d s the costs of dema n d d e p o s i t s by 2.3* of the r e s p e c t i v e dep o s i t s

o u t s t a n d i n g . If this e x cess co s t is a v e r a g e d over the total

d e p o s i t base, given th a t d e m a n d d e p o s i t s r e p r e s e n t e d 21S4 of total d e p o s i t s in 1983, the cost of total d e p o s i t s rises by .48* <=

2.3* x .21), th a t is about 1/2 of a p e r c e n t a g e point. While this a m o u n t is n ot negligible, c o m m e r c i a l banks still m a i n t a i n e d a m a j o r a d v a n t a g e in total d e p o s i t costs.

C o m m e r c i a l bank costs may e x c e e d thrift costs in areas o ther than d i r e c t d e m a n d depo s i t costs, r e f l e c t i n g the greater ser v i c e levels g e n e r a l l y pro v i d e d by c o m m e r c i a l banks. The b roadest

measure, w h i c h includes d i r e c t d e m a n d d e p o s i t costs as one

component, is total n o n - i n t e r e s t o p e r a t i n g expenses. The data in T a b l e 6 c o m p a r e the total o p e r a t i n g e x p e n s e s of S&Ls with those of c o m m e r c i a l banks, stated as a p e r c e n t a g e of t heir r e s p e c t i v e tot/al deposits. This o p e r a t i n g co s t r a t i o has shown a strong and

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Table 5

N o n - I n t e r e s t Op e r a t i n g Costs of D e m a n d and Time Deposits As A P e r c e n t a g e of the R e s p e c t i v e Dep o s i t s O u t s t a n d i n g

1970 1975 1980 1983

Demand D e p o s i t s 1.87 2.32 3.03 3.26

Ti m e D e p o s i t s .57 .57 1.01 .96

Source: F u n c t i o n a l Cost A n a l y s i s . Federal Rese r v e System. Data are for the c o m m e r c i a l bank samp l e with d e p o s i t s in e x cess of $200 million. Table 6 N o n - I n t e r e s t O p e r a t i n g Costs As a P e r c e n t a g e of Total Deposits 1965 1970 1975 1980 1983 1. S a v i n g s and Loan A s s o c i a t i o n s 1.30 1.42 1.53 1.67 2.08 2. C o m m e r c i a l Banks 2.27 2.78 2.79 3.15 3.63 3. <2> - Cl) .97 1.36 1.26 1.48 1.55 Sour c e s :

S a v i n g s and Loan Associations: 1984 S a v i n g s I n s t i tutions S o u r c e b o o k . Unit e d States Lea g e u e of S a v i n g s Institutions.

Comme r c i a l Banks: Bank O p e r a t i n g S t a t i s t i c s . 1970 to 1983,

Federal D e p o s i t Insurance Corporation. Federal Res e r v e B u l l e t i n . June 1966 for 1965 data. Board of G o v e r n o r s of the Federal

R e s e r v e System.

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a l m o s t identical g r owth rate for both g r o u p s of i n s t i t u t i o n s since 1965.

By 1983 the commer c i a l bank cost r a t i o to total d e p o s i t s e x c e e d e d the S&L r atio by 1.55 p e r c e n t a g e points. As i n d icated above, a b o u t .5 p e r c e n t a g e p o ints of this a m o u n t can be

a t t r i b u t e d to d i r e c t d e mand dep o s i t costs, leaving a b o u t 1

p e r c e n t a g e p o i n t of costs to r e f l e c t o t h e r special ba n k services. The 1.55 p e r c e n t a g e p o ints of e x c e s s bank o p e r a t i n g c o s t s off s e t s about o n e - h a l f of their 3.17 p e r c e n t a g e point a d v a n t a g e in total d e p o s i t i n terest expense, but still leaves 1.62 p e r c e n t a g e points as a n et c o m m e r c i a l bank a d v a n t a g e in o p e r a t i n g margins.

3 . C Rate of R e t u r n on L o a n s .

The rate of retu r n earned on loans is the last c o m p o n e n t to be c o n s i d e r e d in c o m p a r i n g commercial bank and t h rift operations. For this purpose, mor t g a g e loans and c o m m e r c i a l b u s i n e s s loans are c o n s i d e r e d the primary loan i n s t r u m e n t s of the t h r i f t and c o m m e r c i a l banks respectively. These i n s t r u m e n t s are now c o m p a r e d in t erms of the gross returns a v a i l a b l e on them a fter loan

d e f a u l t losses. It can be noted that e v i d e n c e from the Federal Rese r v e S y s t e m ' s Functional Cost A n a l y s i s i n d i cates that the

e x p e n s e of o r i g i n a t i n g c o m m e r c i a l loans may e x ceed the e x p e n s e of o r i g i n a t i n g m o r t g a g e loans by as much as 1?< of the loan volume. This extra cost of comme r c i a l loans is a l r e a d y included, however, in the bank o p e r a t i n g exp e n s e s just c o n s i d e r e d in 3.B.

Table 7 s h o w s annual ave r a g e v a lues b e t w e e n 1970 and 1984 for a v a r i e t y of interest rate series than can be used in

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Table 7

Average Annual Interest Rates

[13 [23 [33 [43 [53 [63 Year Prime Rate Mortgage Rate [23 - [13 1 Year T r e a s u r y 10 Year Treasury [53 - [43 1970 7.91 8.45 .54 6.48 7.35 .87 1971 5.72 7.74 2.02 4.67 6.16 1.49 1972 5.25 7.60 2.35 4.77 6.21 1.44 1973 8.03 7.96 - .07 7.01 6.84 -.17 1974 10.81 8,92 -1.89 7.70 7.56 -.14 1975 7.86 9.00 1.14 6.28 7.99 1.71 1976 6.84 9.00 2.16 5.52 7.61 2.09 1977 6.83 9.02 2.19 5.71 7.42 1.71 1978 9.06 9.56 .50 7.74 8.41 .67 1979 12.67 10.78 -1.89 9.75 9.44 -.31 1980 15.27 12.66 -2.61 10.89 11.46 .57 1981 18.87 14.70 -4.17 13.14 13.91 .77 ' 1982 14,86 15.14 .28 11.07 13.00 1.93 1983 10.79 13.12 2.33 8.73 11.10 2.37 1984 12.04 13.42 1.38 9.76 12.44 2.68 Aver-age 10.19 10.47 .28 7.95 9.13 1.18

Sources: [13 , [43, and [53 : Federal Res e r v e Bul l e t i n and Annual

Stati s t i c a l Diqest, Board of G o v e r n o r s of the Federal Rese r v e

System. [23: Offi c e of Policy and E c o n o m i c Research, Federal Home Loan Bank B o a r d ( F H L B B ) . The FHLBB m o r t g a g e r a t e s e ries i n cludes 37X a d j u s t a b l e rate m o r t g a g e s in 1983 and a p p r o x i m a t e l y 60*

a d j u s t a b l e rate m o r t g a g e s in 1984. Using e s t i m a t e s of the author, .55 p e r c e n t a g e p o ints in 1983 and 1.05 p e r c e n t a g e points in 1984 are i n cluded in the t a b u l a t e d data to m a i n t a i n c o n s i s t e n c y with the f i x e d - r a t e data of e a r l i e r years. This assu m e s a spread b e t w e e n f i x e d - r a t e s and v a r i a b l e - r a t e s of 1.5 p e r c e n t a g e points in 1983 and 1.75 p e r c e n t a g e poin t s in 1984.

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