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The competition for deposits and the impact of monetary policy
Journal of Banking and Finance 4 (1980) 17-32. © North-Holland Publishing Company
THE COMPETITION FOR DEPOSITS AND THE IMPACT OF MONETARY POLICY* Harold B. ROSE Group Economic Adviser, Barclays Bank Ltd., London EC3P 3AH, UK
Financial intermediation in Britain can be said to have reached maturity before the war, since when the growth of banks has been critically a question of market share. Until the shift in monetary policy away from direct restriction of bank lending that began about nine years ago, credit restriction added to other factors, like taxation and the bank cartel, limiting the ability of the banks to compete. The author argues that an open-market policy directed toward money supply control need not discriminate against banks. However, the re-introduction of bank lending restrictions through the use of Special Deposits and, even more so, through the use of Supplementary Special Deposits has worked to favour non-bank deposit intermediaries. The distortions caused by the Supplementary Special Deposits not only discriminate against the banks; they are also likely to undermine the use of monetary policy itself. What are required are government policies, especially with regard to the size of the public sector borrowing requirement, that make possible the goal of a non-ttiscriminatory open-market policy, without the need for direct controls on lending by financial institutions.
1. Introduction Every twenty years or so the British Government requires the financial system to present itself for a kind of medical inspection in the form of Committees of Inquiry. At present we have Dr. Wilson in attendance, whereas twenty years ago we had Dr. Radcliffe and nearly thirty years before that Dr. Macmillan. This periodic pre-occupation of Britain with its financial health contrasts oddly with its reluctance to submit industrial and labour problems to a regular check-up despite the obviously much more serious maladies of these parts of the body economic. After all, since the beginning of the century we have had only one comparable full-scale inquiry into the trade union movement; and whereas it is true that some of the problems of British industry have been looked into by various bodies such as NEDC, 1 we have had only one wide-ranging inquiry into British industry (in 1926) of the kind the Government feels to be necessary in the field of finance every generation or so. *This paper was first given as the Ernest Sykes Memorial Lecture 1978 for the Institute of Bankers, London. I am indebted to Mr. M.A. Hodgkinson and Mr. N.P. Newman, who provided me with the statistical material and analysis needed for my talk. 1National Economic Development Council - a government-sponsored body on which trade unions and employer organizations are represented.
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With the Wilson Committee 2 in full swing the question of competition between different types of financial institution and between different types of financial asset has again become a topical one, just as it did at the time of the Radcliffe Committee 3 twenty years ago. My perspective is that of monetary and credit policy, the part possibly played by monetary policy in reducing the market share of the banks and, conversely, the possible implications of the growth of non-bank institutions for monetary policy itself. At the risk of duplicating what has been said elsewhere, however, let me begin by putting the relative growth of the main institutions into broad historical perspective and by mentioning some of the other main factors at work. 2. Financial intermediation and the share of the banks
Before the Second World War the steady spread of the banking habit caused a slow but significant rise in the ratio of bank deposits to total incomes. Bank deposits were equivalent to about two-fifths of gross national product in 1913, and by 1938 this ratio had risen to over one-half. Over the same twenty-five years, however, the share of the banks in the total assets of the main institutions 4 had actually been falling. More rapid rates of growth had been experienced by the Post Office Savings Bank and by life assurance funds, both of which were already remarkably large by the beginning of the century. In the interwar period, as we know, the building society movement 5 grew rapidly along with the housing boom, in contrast to the effect on bank lending of the relatively depressed state of industry. The result was that the proportion of the liabilities of the main financial intermediaries represented by bank deposits fell from about one-half in 1913 to not much more than one-third in 1938. The rise in bank deposits relative to incomes took place despite the fall in the share of the banks in the financial system, because financial institutions collectively were growing more rapidly than the economy as a whole. The total liabilities of the main institutions rose from roughly four-fifths of GNP in 1913 to nearly one and a half times GNP in 1938, with non-bank institutions growing fastest of all. Since the war, financial intermediation has ceased to be an industry of above-average-growth, in the sense that total liabilities of the main financial institutions now represent roughly only 1" 1 times GNP, compared with a 2Committee of Inquiry into the Functioning of Financial Institutions. 3Committee of Inquiry into the Working of the Monetary System 1959. 4Banks, Trustee Saving Banks, building societies, National Savings, life assurance and pension funds, investment and unit trusts. 5Building societies are 'mutual' bodies lending on mortgage terms for house purchase. They lend long-term at variable rates and borrow mainly in the form of nominally short-term depositis at variable rates of interest. They do not 'build' themselves.
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ratio of 1.4 before the war. To a considerable extent this fall has been due to the great inflation since 1973, but only in the early postwar years, when liquidity was abnormally high, has this ratio of financial intermediation significantly exceeded the pre-war figure, which suggests to me that financial intermediation reached a perhaps inevitable stage of 'maturity' forty years ago. If this is the case the question of market shares is one of considerable long-term importance. The share of 'deposit' intermediaries in the total, now about 60 percent, is not very different from what it was before the war. But, whether we define the 'market' to include life assurance and pension funds, or whether we confine our attention to deposit-taking institutions, the share of the banks taken together is considerably lower than before the war; although that of non-clearing banks is well above it. No doubt the decline of the clearing banks' share in the early postwar years, like that of National Savings, 6 represented the working-off of the excess deposit creation of wartime deficit financing and the Corresponding making good by the building socieities of their wartime loss of market share, which they did not recover until 1957. In the 1960s, however, the decline of the share of National Savings actually accelerated, and the ground they lost was won by the building socieities; the clearing banks have merely succeeded in stabilizing their share of the deposit market over a period which, perhaps significantly, more or less coincides with the change in the techniques of monetary control and the abolition of the clearing bank cartel. If we stand back from year-to-year changes, we can discern a number of forces behind the longer-term fall in the share of bank deposits and those of the clearing banks in particular.
3. The main factors at work
Financial maturity.
First, there is in all economies a tendency for the ratio of bank deposits to incomes, especially of current accounts, to go the way of notes and coin as economies develop, at first rising and then, at best, levelling off. It would be going much too far to say, as some economists have been tempted to do, that bank deposits tend to become merely part of the 'small change' of the financial system. Nevertheless, there is a limit to the extent to which the liquidity provided specifically by bank deposits added something by way of convenience, safety and interest earnings to the qualities possessed by notes and coin, at the cost of only a small loss of immediate liquidity, so has the development of other assets come inevitably to compete 6Savings instruments, intended mainly for 'small' savers, issued by the Government. Tax reliefs, however, make some of them attractive particularly to investors with above-average incomes.
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H.B. Rose, Deposits and monetary policy
with bank deposits, certainly as a liquid store of value and, potentially, as a means of payment. Precise figures for non-interest-bearing sight deposits over a long period are not available, but despite a rise in the proportion of adults holding current accounts, 7 the latter's share has fallen from roughly 60 to 44 percent of total resident sterling bank deposits since accurate statistics of these became available in 1963, implying a fall, also, in the ratio of current account deposits to incomes over the same period. The increase in interest rates has played a large part in this, but there may also be a natural tendency to shift from 'transactions' to 'investment' balances as our real incomes rise. If there is a long-term tendency for the share of current accounts to fall, it follows that the banks, and especially the clearing banks, 8 have actually to increase their share of the time-deposit sector, to use the American adjective, if they are to hold their share of the total deposit market. They have succeeded in doing this over the past decade or so, but only just.
Taxation. The second long-term factor has been taxation. In Britain favourable tax treatment has been directed largely at institutions other than the commercial banks. By the end of the nineteenth century, for example, taxation policy had begun deliberately to favour life assurance - a n d to subsidize the Post Office and Trustee Savings Banks 9 - a n d since then the pension funds have come to receive particularly advantageous tax treatment. Of greater importance to shares in the deposit market, of course, is the favourable tax treatment of building societies and of house mortgages, of which the building societies have over 90 percent. This question has already been debated by the banks and building societies, and I have nothing to add here.
Inflation. What also needs to be said, however, as the banks have argued, is that the present tax system bears particularly heavily on them because it does not take into account the effect of inflation and their need to maintain sufficient equity capital to support their operations. The point has acquired additional importance in recent years not only because of the rise in the inflation rate but also because the bad debt risk involved in bank lending to the private sector has increased by more than the corresponding risks facing other institutions. I would point to other effects of inflation or, more precisely, of the unexpectedly high rate of inflation. In addition to reinforcing the advantages of borrowing to finance home ownership, inflation has also raised the personal savings ratio, at least over the past four or five years. We have 7Checking accounts, in American terminology. SThe main checking or demand-deposit banks. 9A form of non-proprietory savings bank.
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spent a smaller part of our incomes through borrowing less: and, especially as borrowing for house purchase and improvement has become relatively more advantageous in terms of tax reliefs as the average tax rate has risen, the community has tended to hold down the growth of its borrowing in the form of hire-purchase 1° commitments and bank loans, at least until this year. As against this, inflation and its effect on working capital needs must have raied the corporate sector's demand for bank finance. But in this market the clearing banks have experienced intense competition from the overseas banks, and profit margins have narrowed. On balance, the shift in the composition of borrowing away from the personal sector until 1978 has been to the disadvantage of the clearing banks in particular.
The clearing bank cartel. The fourth factor which needs to be mentioned is the operation of the clearing bank cartel up to 1971. This was an agreement to fix the structure of bank interest rates and, in essence, was an arrangement for limiting competition favoured by the authorities in the belief that it facilitated their control of credit and money rates and also held down the cost of industrial finance. 11 The benefits to the banks of the cartel were taken in the form of a quiet life rather than of high profit margins, but the result was not only to affect competition within the banking system but also to encourage the development of other institutions. To some extent, I believe, the fall in the share of the deposit market held by the clearing banks over the fifty years to 1971 was self-inflicted. For example, the Radcliffe Report drew attention to the way in which, unlike their counterparts abroad, which had fought hard for their share of the market for savings deposits, the clearing banks had stood aside while savings deposits had 'fed the development of building societies, savings banks and other specialised financial intermediaries', with the result that the cartel had 'limited their quantitative share of the total lending in the economy'. I hold the view that the clearing bank cartel proved to be a serious source of weakness of the industry, if only by allowing other institutions to develop unimpeded the foundations of their future expansion. When Radcliffe reported, the building societies were only roughly one-third of the size of the parent clearing banks; but when the cartel was dismantled in 1971, deposits of the building societies were equivalent to some 110 percent of the resident sterling deposits of the clearing banks. With a developing branch network, the building society movement had, so to speak, advanced well beyond its beachhead and was well placed to repel the counter-attack by the clearing banks after 1971, who have succeeded only in stabilizing their share of the total deposit market while that of the building societies has continued to increase. 1°Instalment credit on durable goods. 1For a statement of the official view see the evidence of the Treasury to the Monopolies Commission 1968.
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H.B. Rose, Deposits and monetary policy
4. Monetary policy Let me return to my main theme. The ratio of the total assets of financial intermediaries to national income had practically reached its peak by the outbreak of the Second World War. The share of total 'deposits' in these assets is today somewhat below what it was in 1938; but the share of the banks as a group in total 'deposits' is today much smaller than before the war, this decline being due entirely to the fall in the share of the clearing banks. The questions I want to consider are, first, whether monetary policy, as well as the other factors I have mentioned, has contributed much to the relative decline of the banks in general and the clearing banks in particular and, conversely, whether the growth of the non-bank financial intermediaries, especially the building societies, creates difficulties for monetary policy that might need to be resolved by subjecting these institutions to roughly similar policy restrictions. Concern with the possible role of near-money substitutes played a great part in the Radcliffe Committee's thinking about twenty years ago. The Radcliffe Report doubted the effectiveness of regulating either the quantity of money or, more narrowly, bank loans because the Committee believed that total spending depended much more on a wider notion of 'liquidity,' in which the operations of non-bank intermediaries were thought to play a vital part. This view, which was expressed somewhat tersely in the Report, has been interpreted as implying that lending by non-bank intermediaries, and, therefore, their deposits, would actually tend to expand in response to restrictions on the growth of the money supply in general or bank lending in particular. It therefore follows that my two questions -whether monetary or credit policy tends to make the banks lose market share to the other intermediaries and whether non-bank intermediaries need to be brought under central bank control - a r e very much inter-related.
'Open market" monetary policy. One general answer can be given initially to both questions. It is that much depends on the form taken by monetary policy. If policy aims at controlling the quantity of money and the Government is content to do this solely by allowing interest rates to take whatever levels are needed to sell the necessary quantities of public sector debt, then there, is no compelling reason why the result should be to restrict the banks' share of the total deposit market unfairly or to encourage the growth of other institutions, even though 'money' is defined, as at present, to exclude other deposits which may be similar in many respects to those held with banks. This may at first sight seem rather surprising, in that any restriction of the money supply implies the intention on the part of the authorities to prevent
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the banking system from exploiting to the full its ability to create deposits. The answer is that allowing interest rates to rise freely to restrict the money supply would also tend to restrict the operations of other deposit institutions as well. In general, only if the difference between interest rates offered by the banks and those offered by other institutions moved in favour of the latter would non-bank intermediaries necessarily benefit, and this will occur only if they can pass on a larger increase in their deposit rates to their own borrowers. This might happen if the building societies, for example, decided to end their credit rationing practice - a n d were allowed to - b u t this could only be a once-and-for-all qualification of my argument. The traditional reason for directing monetary policy specifically at the banks is that, collectively, they have been much more able than other institutions to create deposits because bank deposits are used as a means of payment. Nevertheless, this is only a necessary and not a sufficient cause for monetary restriction. The general case for limiting the creation of what we choose to call 'money,' i.e., the sum of notes and coin and bank deposits, is that the money supply and the level of money incomes are thought to be interrelated in a sufficiently stable manner, so that a change in the quantity of money, perhaps after some interval of time, has a sufficiently, if not exactly, predictable effect on total money income. If changes in the quantity of money had no stable long-term effect on incomes there would be little point in controlling it. 12 Although the division of this effect between price and output changes is a matter of controversy, only a minority of economists, located, I believe, mainly in Cambridge, seriously deny that what in the trade is called the 'demand function for money' has sufficient stability to form the basis of a useful and, I would maintain, essential ingredient of economic policy. Moreover, and this is also important, if the relationship between the quantity of money and rates of interest is sufficiently stable, then it also follows that the money supply can be controlled by allowing interest rate movements to facilitate open-market operations. One might call this an 'open market' type of monetary policy. For a time, in 1972-73, when the immediate result of Competition and Credit Control 13 was to unleash an unusually large increase in the quantity of money via an upsurge in bank lending, it looked as if the relationship between money and incomes had completely broken down. This judgment can now be seen to have been premature, at least in the sense that the excess supply of money has been absorbed by higher prices and the velocity of circulation appears to have returned to its more usual trend. What still remains to be seen, I admit, is whether the relationship between money and 12The appropriate focus of monetary policy would then be interest rates. t3This was the name of the 1971 document in which the Bank of England set out its proposals for the abolition of the clearing bank cartel.
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H.B. Rose, Deposits and monetary policy
interest rates has settled down. I adhere to the view, however, that the recent instability of interest rates owes more to the impact of government policy as a whole on expectations, especially regarding inflation, than to any fundamental instability of money-supply-interest-rate relationships if properly interpreted. The important point is that, as long as the money-supply-money-income relationship is sufficiently stable, or if changes in it are sufficiently predictable, as that in 1972-73 perhaps should have been, it does not matter from the point of view of economic policy that the authorities single out for control by open-market operations a type of financial asset, i.e. bank deposits, that has much in common with deposits in other institutions. The question of what we should regard as 'money' when other deposits besides bank deposits provide a store of value is in this context a semantic one; the practical question is of the effect of controlling the stock of a particular type of asset. In the days before econometric techniques helped to answer the question of what was the result of singling out a particular type of liquid asset for control, arguments as to what should and what should not be regarded as constituting something called 'money' had greater importance than they do today. It should be stressed, however, that it is only a free or open-market type of monetary policy, with interest rates b~ing left entirely free to respond to open-market operations, that can be expected to leave undisturbed the relative long-term rates of growth of different institutions, whose development would reflect relative efficiencies, marketing skills, tax and similar advantages and customer preferences. There would be nothing in such a world to prevent bank deposits from growing faster than, say, building society deposits if the public wished to hold more bank rather than more building society deposits. For the aim of monetary policy is not to prevent us from holding money, but of preventing the creation of a supply of money in excess of that which we would wish to hold at a target level of national money income. There would be nothing inherent in the operation of this type of monetary policy, for example, that would necessarily have enabled the building societies, rather than the banks, to have captured the share of total deposits lost by National Savings since the war and especially since the early 1960s. The general observation that an open-market type of monetary policy need not discriminate against the banks does require at least one qualification, apart from the obvious one that British governments have rarely been content to rely on it. The qualification is that banks are required to hold a minimum ratio of reserve assets, because this facilitates control by the authorities. If this minimum reserve ratio is higher than that which the banks would otherwise wish to hold, the result is to depress bank profits, for the return on reserve assets will be lowered by the element of enforced demand.
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To do them justice, the authorities sought a reserve asset ratio in 1971, like the older liquidity ratio, that reflected bank practice; but it is at least arguable that, with the development of the interbank market, banks would today be content with a lower ratio of what are mainly liquid assets issued by the public sector, to say nothing of Special Deposits. 14 Since 1971, moreover, part of the liquid assets which banks would choose to hold, namely cash in tills, has not been admissible as a reserve asset at all; and the same is true of commercial bills in excess of 2 percent of eligible liabilities.15 The element of discrimination against the banks possibly created by reserve asset requirements might be reduced if it were replaced by a narrower requirement merely to hold m i n i m u m balances with the Bank of England, at least if, unlike the case today, interest were paid on these balances. Whether the reserve asset ratio should be replaced by such a 'cash' ratio system raises wider questions of monetary policy outside the scope of my talk; although I believe that the authorities' traditional case against cash ratio control, that it would cause an undesirable instability of short-term rates, is not as strong as it once might have been. Although a free or open-market monetary policy could be broadly neutral as between institutions, an argument used to be heard to the effect that the existence of a large stock of near-money liquid assets would make this type of policy ineffective. The point made was that the economy's liquidity and interest rates would be less responsive to any given volume of open-market operations because part of their potential effect would be cushioned by the existence of money substitutes. One might accept the analysis but not, I think, its conclusion. As long as near-money assets are not perfect substitutes for money, the fact that nearmoney assets might make the system less responsive to a given volume of open-market operations merely means that these have to be large in scale to achieve any given effect. As long as the relationship between money supply, interest rates and incomes is sufficiently stable, monetary policy of the openmarket type need not be frustrated by the existence of near-money substitutes. Their existence also has the virtue of cushioning accidental or random shocks to the financial system, which would be over-sensitive if our liquidity, to mix metaphors, were always on a knife-edge. In any case, whatever difficulties have beset the attempt of the Bank of England to run an open-market type of monetary policy in recent years cannot be attributed to any sudden development of near-money assets. If anything, the problem is rather that interest rates have become more and not less sensitive to open market operations, because of the interaction between government policy and market expectations. This is presumably the sophisticated case which authorities might offer in defence of their retreat from a free 14Variable compulsory balances with the Bank of England. 15The deposit liabilities against which reserve assets must be held.
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H.B. Rose, Deposits and monetary policy
or open-market policy, as opposed to the plainer one the no Government likes high interest rates.
Bank lending restrictions. Whereas a free or open-market monetary policy should - a n d certainly c o u l d - be more or less neutral as between institutions, a policy that takes the form of discriminatory measures aimed specifically at bank lending is potentially another matter. Until about the time of Competition and Credit Control in 1971, or just before it, policy in Britain had never been aimed directly at a target quantity of money. Instead in postwar Britain the authorities had sought to control short-term interest rates closely, especially because of external considerations, to try and maintain fairly stable long-term rates and to regulate the volume of bank (and hire-purchase) lending. The traditional domestic emphasis of the authorities has always been much more on 'credit' rather than on 'money supply'; although it was never clear exactly what was meant by 'credit' or just what economic theory lay behind what is only a deceptively commonsense idea. In broad terms the effect of official policy from the war until the late 1960s was to allow the creation of whatever quantity of money arose from the Government's interest rate semi-stabilization policy but to influence bank lending through requests to the banks and then, in the 1960s, by the use of Special Deposits as well. The latter amounted to a kind of tax on the banks, by requiring them to bid for additional low-yielding liquid assets to support a given level of lending. Although they retained the use of a market mechanism, Special Deposits come within the category of discriminatory constraints on bank lending and Supplementary Special Deposits, 16 the socalled 'corset', even more so, and even though they are levied directly on bank liabilities rather than on their assets. In looking at the consequences for other institutions of discrimination against the banking system, however, one should distinguish between shortterm and long-term effects. In most periods of bank credit restriction it is hard to find evidence that the result was actually to push up both the lending and the deposits of non-bank intermediaries. The building societies, for example, did not appear to benefit much directly, if at all, during most spells of severe restriction of bank lending in the middle-1950s and in the 1960s. In the earlier part of this long period one reason was that the restriction of bank lending was not always matched by a similar fall in bank deposits, and on some occasions the slowness of building society interest rates to reflect a rise in banking system rates worked to the disadvantage of the building societies. 16These are non-interest-bearing balances with the Bank of England which, when the system is in force as it has been since June 1978, the banks have to hold in increasing amounts if their deposits grow at more than a stipulated rate.
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The generalization that the restriction of bank advances is bound to push up both the lending and the deposits of other institutions at the time is an oversimplification. In the 1950s, and to some extent in the 1960s, the main element of 'give' in the system was provided not so much by the expansion of non-bank deposit intermediaries in general as by disintermediation itself, the diversion of lending through the new issue and commercial bill markets and, probably, through the trade credit mechanism. The share of banks in lending flows was undoubtedly depressed by lending directives, but the immediate effect was to stimulate other lending on a wide front rather than to benefit the main non-bank deposit intermediaries in particular. Part of the diversion of lending, too, was usually in favour of the public sector, including the local authorities. Indeed, in a sense that is the ultimate reason why direct restrictions on bank lending, rather than a freely open-market monetary policy, tend to be preferred by governments. If we take a wider perspective, it is reasonable to suppose that one result of the regime of bank credit restraint, which has been of longer duration than periods of immediate credit 'squeeze', has been to favour non-bank deposit intermediaries. The development of the secondary banks in the 1960s was certainly assisted by the restraints placed on the clearing banks, and so was the expansion of other 'listed' banks. Indeed this was one reason, as we know, for the introduction of Competition and Credit Control. Building societies, too, have probably gained something on balance from the much greater instability imposed on the banking system and the inability of the banks over a long period to exploit to the full the market in personal loans. It may also be the case that restrictions on bank lending to the personal sector tend to stimulate lending by retailers. Not only would this shift some of the profitability of personal sector lending from banks to retailers, but the large retailing groups also have access to finance outside the banking system. The result is probably to depress the long-term share of the banks in the personal lending market. The clearing banks, whose stake in personal lending has always been the highest within the banking system, have suffered most of all.
The'corset' (the Supplementary Special Deposit system).17
It can be argued that the recent behaviour of interest rates has made a purely open-market type of monetary policy much more difficult. In one sense this is true, but it does not necessarily follow that the underlying reason is a new instability of moneyholding habits that might justify more direct controls over the banking system. Instead, one can point to the disturbing effects of exchange rate policy and excessive public sector deficits as the main sources of difficulty in controlling the money supply, without which the narrower problems posed for the authorities by expectations in the gilt-edged market would have been 17See previous footnote.
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much less serious. The return of the 'corset', to my mind, was not inevitable; it reflects, rather, the unwillingness of the Government to accept the high interest rates which are really the consequences of its own actions. But whether even the 'corset' can prevent high interest rates, as opposed to changing their pattern, when the total demand for funds is strong is another matter. Because the banking system cannot easily control its total lending to the public sector, the 'corset' becomes in the end a penally high marginal rate of tax on bank lending to the private sector. It is not levied on other intermediaries; and at the end of the day it is not different in principle from old fashioned directives to the banks, especially if a request from the Governor or the prevailing climate of opinion specifically directs lending restraint to the personal sector. Corporate borrowing, too, tends to be diverted, to the commercial bill market for example. There is, however, at least one difference from earlier periods of 'direct' credit restraint. In so far as the 'corset' leads to a fall in the deposit rates of the banks as compared with other rates, it makes it easier for other institutions, such as the building societies, to attract deposits. The 'corset' has a possible discriminatory interest rate effect which the previous systems of credit restriction did not have; although its effect in this direction this year has been disguised by the fact that the building societies have so far chosen to run down their liquid assets rather than to push up their deposit rate faster. Potentially, however, there is little doubt that the 'corset' does more than earlier types of bank lending restrictions to divert deposits to non-bank deposit intermediaries. The other main difference between the 'corset' and earlier forms of credit restriction, and indeed, its very object, is that the 'corset' is more effective in holding back the growth of the money supply. On the other hand, the 'corset' results in a number of distortions of the financial system and therefore makes it more difficult to interpret the effect on spending flows of the check to money supply. The 'corset' may enable authorities to get their published money supply figures right, and this may calm markets for a while; but it is also much harder to say just what the money supply figures are likely to mean in terms of economic consequences. Indeed, the 'corset' may produce the very instability between money supply and spending which previous governments, and the Radcliffe Committee, could use as an argument for rejecting a money-supply policy itself. This is especially likely to be the case if the banks are induced to hold down their interest rates, so that credit rationing by the banks diverts lending elsewhere. In short, like earlier forms of credit restrictions, as the Radcliffe Committee argued, the 'corset' is likely to cause an increase in the velocity of circulation. The 'corset' is no substitute for a healthy diet! One other distortion produced by the 'corset' is worth noting. Because the
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IBELs penalty is does not apply to the discount houses, 19 it is possible for the banks, with the connivance of the authorities, to reduce their IBELs by shifting assets to the discount houses. The money supply is unaffected, but the banks are helped to keep out of the penalty zone. The result is to depress bank assets and profits to the benefit of the discount houses, with no evident national economic benefit. It is as if the 'corset' were applied to only one of a pair of Siamese twins, redistributing fat between them!
5. Summary and conclusions Financial intermediation can be said to have reached maturity before the war, since when the growth of the banks has been critically a question of market share, with the clearing banks in particular having to increase their share of total time-deposits to hold their share of the total deposit market. This the clearing banks have been able to do only over the past eight or nine years, a period corresponding roughly to the shift of monetary policy away from the direct restriction of bank lending. Until the change in monetary policy, credit restriction added to the other factors, like taxation and the cartel, limiting the ability of the banks to compete. While it is hard to discern any consistent swing in favour of other deposit intermediaries during periods of particularly severe credit restraint before 1971, there is little doubt that this was the longer-term effect. In general the Radcliffe Committee, some twenty years ago, was right to draw attention to the way in which discrimination against the clearing banks would merely stimulate the development of other institutions and disintermediation itself and, therefore, prove a relatively ineffective way of influencing spending and incomes. My own view, however, like that of other economists who are prepared to wear at least some part of the 'monetarist' label, is that it is wrong to apply this conclusion to control over the money supply implemented solely through open-market operations, with interest rates free to fluctuate. Apart from the question of reserve asset requirements, in which the public sector, in effect, exploits its monopoly powers, an open-market policy need not discriminate against the banks; and it should be effective in influencing the level of spending and incomes. Whereas the original introduction of the 'corset' in 1973 can be regarded as an understandable interruption of the non-discriminatory policy which Competition and Credit Control was intended to usher in, the repeated application of the 'corset' is quite another matter, especially if, as may be the case today, the garment has to be worn for some time. As I believe that the ~aThe deposit ceiling above which Supplementary Special Deposits have to be made is set in terms of the banks' Interest-Bearing Eligible Liabilities (IBELs).
~gInstitutions holding short paper and financed mainly by borrowing from the banks.
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difficulty of controlling the money supply at tolerable interest rates is fundamentally one of the Government's own making, I cannot sympathise with what is a return, in substance if not in form, to an old-fashioned clamp on bank lending to the private sector. Love laughs at locksmiths, and the 'corset' is no substitute for virtue. The distortions caused by the 'corset' not only discriminate against the banks; they are likely to undermine the use of a money supply policy itself. In recent years the authorities have come to place informal restraints on building society lending, 2° in order to ward off an excessive increase in house prices. To a considerable extent, recent rushes of building society lending have been the result of the pattern of interest rate fluctuations and the swing in building society liquidity ratios. Whether the 'corset' has yet played much of a part in reinforcing building society deposits is doubtful, but the longer the 'corset' and associated restrictions on the banks remain in force the more likely it is that the authorities will be driven by the logic of their own policy to impose tight lending restrictions on the building societies and other institutions, as the Radcliffe Report implied. Table 1 Total financial intermediary liabilities" and the share of deposit-taking financial institutions for selected years.
End year 1913 1921 1930 1938 1948 1958 1968 1977 1978 June
GNP
Estimated total financial intermediary liabilities
(£m)
(£m)
2527 5128 4576 5176 10517 20497 37390 123791 135870 c
2015 4265 5673 7240 18712 26082 55739 142405 149718 a
As ~ or
GNP
Total deposits of deposit taking intermediaries b
As ~ of total liabilities of financial intermediaries
(£m) 80 83 124 140 178 127 149 115 110
1376 3165 3889 4770 14163 16586 29573 82880 87801
68 74 69 66 76 64 53 58 59
aApproximate estimates only of deposits with banks (resident sterling deposits only 1977-78), National Giro, finance houses, Trustee Savings Banks, building societies, National Savings, life assurance and pension funds (all insurance companies 1913-58), investment and unit trust funds. bBanks, National Giro, finance houses, Trustee Savings Banks, building societies and National Savings. CFirst half at an annual rate. dEnd March.
2°The restraint placed on building society lending has so far been very loose as well as applied by 'moral suasion'.
H.B. Rose, Deposits and monetary policy
31
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H.B. Rose, Deposits and monetary policy
To my mind this is undesirable and is entirely the result of the failure to maintain the fiscal and other policies required to make an open-market money-supply policy possible without undue strain. This is not to deny that one day the building societies might have to be made subject to a monetarypolicy type of reserve asset requirement, as distinct from lending controls, if the growth in their size and a widening of their operations make them become still more like the banks. If building society deposits were to become still closer substitutes for bank deposits then, it is true, the selection of bank deposits alone as a target for an open-market money-supply policy might become inadequate. In the meantime, however, what are required are government policies, especially with regard to the size of the public sector borrowing requirement, that make possible the goal of a non-discriminatory open-market policy, without the need for direct controls having to be applied to a range of institutions as the pattern of market shares changes. Nondiscrimination should not be confused with equality of misery. Wilson Committee please note!
THE COMPETITION FOR DEPOSITS AND THE IMPACT OF MONETARY POLICY* Harold B. ROSE Group Economic Adviser, Barclays Bank Ltd., London EC3P 3AH, UK
Financial intermediation in Britain can be said to have reached maturity before the war, since when the growth of banks has been critically a question of market share. Until the shift in monetary policy away from direct restriction of bank lending that began about nine years ago, credit restriction added to other factors, like taxation and the bank cartel, limiting the ability of the banks to compete. The author argues that an open-market policy directed toward money supply control need not discriminate against banks. However, the re-introduction of bank lending restrictions through the use of Special Deposits and, even more so, through the use of Supplementary Special Deposits has worked to favour non-bank deposit intermediaries. The distortions caused by the Supplementary Special Deposits not only discriminate against the banks; they are also likely to undermine the use of monetary policy itself. What are required are government policies, especially with regard to the size of the public sector borrowing requirement, that make possible the goal of a non-ttiscriminatory open-market policy, without the need for direct controls on lending by financial institutions.
1. Introduction Every twenty years or so the British Government requires the financial system to present itself for a kind of medical inspection in the form of Committees of Inquiry. At present we have Dr. Wilson in attendance, whereas twenty years ago we had Dr. Radcliffe and nearly thirty years before that Dr. Macmillan. This periodic pre-occupation of Britain with its financial health contrasts oddly with its reluctance to submit industrial and labour problems to a regular check-up despite the obviously much more serious maladies of these parts of the body economic. After all, since the beginning of the century we have had only one comparable full-scale inquiry into the trade union movement; and whereas it is true that some of the problems of British industry have been looked into by various bodies such as NEDC, 1 we have had only one wide-ranging inquiry into British industry (in 1926) of the kind the Government feels to be necessary in the field of finance every generation or so. *This paper was first given as the Ernest Sykes Memorial Lecture 1978 for the Institute of Bankers, London. I am indebted to Mr. M.A. Hodgkinson and Mr. N.P. Newman, who provided me with the statistical material and analysis needed for my talk. 1National Economic Development Council - a government-sponsored body on which trade unions and employer organizations are represented.
18
H.B. Rose, Deposits and monetary policy
With the Wilson Committee 2 in full swing the question of competition between different types of financial institution and between different types of financial asset has again become a topical one, just as it did at the time of the Radcliffe Committee 3 twenty years ago. My perspective is that of monetary and credit policy, the part possibly played by monetary policy in reducing the market share of the banks and, conversely, the possible implications of the growth of non-bank institutions for monetary policy itself. At the risk of duplicating what has been said elsewhere, however, let me begin by putting the relative growth of the main institutions into broad historical perspective and by mentioning some of the other main factors at work. 2. Financial intermediation and the share of the banks
Before the Second World War the steady spread of the banking habit caused a slow but significant rise in the ratio of bank deposits to total incomes. Bank deposits were equivalent to about two-fifths of gross national product in 1913, and by 1938 this ratio had risen to over one-half. Over the same twenty-five years, however, the share of the banks in the total assets of the main institutions 4 had actually been falling. More rapid rates of growth had been experienced by the Post Office Savings Bank and by life assurance funds, both of which were already remarkably large by the beginning of the century. In the interwar period, as we know, the building society movement 5 grew rapidly along with the housing boom, in contrast to the effect on bank lending of the relatively depressed state of industry. The result was that the proportion of the liabilities of the main financial intermediaries represented by bank deposits fell from about one-half in 1913 to not much more than one-third in 1938. The rise in bank deposits relative to incomes took place despite the fall in the share of the banks in the financial system, because financial institutions collectively were growing more rapidly than the economy as a whole. The total liabilities of the main institutions rose from roughly four-fifths of GNP in 1913 to nearly one and a half times GNP in 1938, with non-bank institutions growing fastest of all. Since the war, financial intermediation has ceased to be an industry of above-average-growth, in the sense that total liabilities of the main financial institutions now represent roughly only 1" 1 times GNP, compared with a 2Committee of Inquiry into the Functioning of Financial Institutions. 3Committee of Inquiry into the Working of the Monetary System 1959. 4Banks, Trustee Saving Banks, building societies, National Savings, life assurance and pension funds, investment and unit trusts. 5Building societies are 'mutual' bodies lending on mortgage terms for house purchase. They lend long-term at variable rates and borrow mainly in the form of nominally short-term depositis at variable rates of interest. They do not 'build' themselves.
H.B. Rose, Deposits and monetary policy
19
ratio of 1.4 before the war. To a considerable extent this fall has been due to the great inflation since 1973, but only in the early postwar years, when liquidity was abnormally high, has this ratio of financial intermediation significantly exceeded the pre-war figure, which suggests to me that financial intermediation reached a perhaps inevitable stage of 'maturity' forty years ago. If this is the case the question of market shares is one of considerable long-term importance. The share of 'deposit' intermediaries in the total, now about 60 percent, is not very different from what it was before the war. But, whether we define the 'market' to include life assurance and pension funds, or whether we confine our attention to deposit-taking institutions, the share of the banks taken together is considerably lower than before the war; although that of non-clearing banks is well above it. No doubt the decline of the clearing banks' share in the early postwar years, like that of National Savings, 6 represented the working-off of the excess deposit creation of wartime deficit financing and the Corresponding making good by the building socieities of their wartime loss of market share, which they did not recover until 1957. In the 1960s, however, the decline of the share of National Savings actually accelerated, and the ground they lost was won by the building socieities; the clearing banks have merely succeeded in stabilizing their share of the deposit market over a period which, perhaps significantly, more or less coincides with the change in the techniques of monetary control and the abolition of the clearing bank cartel. If we stand back from year-to-year changes, we can discern a number of forces behind the longer-term fall in the share of bank deposits and those of the clearing banks in particular.
3. The main factors at work
Financial maturity.
First, there is in all economies a tendency for the ratio of bank deposits to incomes, especially of current accounts, to go the way of notes and coin as economies develop, at first rising and then, at best, levelling off. It would be going much too far to say, as some economists have been tempted to do, that bank deposits tend to become merely part of the 'small change' of the financial system. Nevertheless, there is a limit to the extent to which the liquidity provided specifically by bank deposits added something by way of convenience, safety and interest earnings to the qualities possessed by notes and coin, at the cost of only a small loss of immediate liquidity, so has the development of other assets come inevitably to compete 6Savings instruments, intended mainly for 'small' savers, issued by the Government. Tax reliefs, however, make some of them attractive particularly to investors with above-average incomes.
20
H.B. Rose, Deposits and monetary policy
with bank deposits, certainly as a liquid store of value and, potentially, as a means of payment. Precise figures for non-interest-bearing sight deposits over a long period are not available, but despite a rise in the proportion of adults holding current accounts, 7 the latter's share has fallen from roughly 60 to 44 percent of total resident sterling bank deposits since accurate statistics of these became available in 1963, implying a fall, also, in the ratio of current account deposits to incomes over the same period. The increase in interest rates has played a large part in this, but there may also be a natural tendency to shift from 'transactions' to 'investment' balances as our real incomes rise. If there is a long-term tendency for the share of current accounts to fall, it follows that the banks, and especially the clearing banks, 8 have actually to increase their share of the time-deposit sector, to use the American adjective, if they are to hold their share of the total deposit market. They have succeeded in doing this over the past decade or so, but only just.
Taxation. The second long-term factor has been taxation. In Britain favourable tax treatment has been directed largely at institutions other than the commercial banks. By the end of the nineteenth century, for example, taxation policy had begun deliberately to favour life assurance - a n d to subsidize the Post Office and Trustee Savings Banks 9 - a n d since then the pension funds have come to receive particularly advantageous tax treatment. Of greater importance to shares in the deposit market, of course, is the favourable tax treatment of building societies and of house mortgages, of which the building societies have over 90 percent. This question has already been debated by the banks and building societies, and I have nothing to add here.
Inflation. What also needs to be said, however, as the banks have argued, is that the present tax system bears particularly heavily on them because it does not take into account the effect of inflation and their need to maintain sufficient equity capital to support their operations. The point has acquired additional importance in recent years not only because of the rise in the inflation rate but also because the bad debt risk involved in bank lending to the private sector has increased by more than the corresponding risks facing other institutions. I would point to other effects of inflation or, more precisely, of the unexpectedly high rate of inflation. In addition to reinforcing the advantages of borrowing to finance home ownership, inflation has also raised the personal savings ratio, at least over the past four or five years. We have 7Checking accounts, in American terminology. SThe main checking or demand-deposit banks. 9A form of non-proprietory savings bank.
H.B. Rose, Deposits and monetary policy
21
spent a smaller part of our incomes through borrowing less: and, especially as borrowing for house purchase and improvement has become relatively more advantageous in terms of tax reliefs as the average tax rate has risen, the community has tended to hold down the growth of its borrowing in the form of hire-purchase 1° commitments and bank loans, at least until this year. As against this, inflation and its effect on working capital needs must have raied the corporate sector's demand for bank finance. But in this market the clearing banks have experienced intense competition from the overseas banks, and profit margins have narrowed. On balance, the shift in the composition of borrowing away from the personal sector until 1978 has been to the disadvantage of the clearing banks in particular.
The clearing bank cartel. The fourth factor which needs to be mentioned is the operation of the clearing bank cartel up to 1971. This was an agreement to fix the structure of bank interest rates and, in essence, was an arrangement for limiting competition favoured by the authorities in the belief that it facilitated their control of credit and money rates and also held down the cost of industrial finance. 11 The benefits to the banks of the cartel were taken in the form of a quiet life rather than of high profit margins, but the result was not only to affect competition within the banking system but also to encourage the development of other institutions. To some extent, I believe, the fall in the share of the deposit market held by the clearing banks over the fifty years to 1971 was self-inflicted. For example, the Radcliffe Report drew attention to the way in which, unlike their counterparts abroad, which had fought hard for their share of the market for savings deposits, the clearing banks had stood aside while savings deposits had 'fed the development of building societies, savings banks and other specialised financial intermediaries', with the result that the cartel had 'limited their quantitative share of the total lending in the economy'. I hold the view that the clearing bank cartel proved to be a serious source of weakness of the industry, if only by allowing other institutions to develop unimpeded the foundations of their future expansion. When Radcliffe reported, the building societies were only roughly one-third of the size of the parent clearing banks; but when the cartel was dismantled in 1971, deposits of the building societies were equivalent to some 110 percent of the resident sterling deposits of the clearing banks. With a developing branch network, the building society movement had, so to speak, advanced well beyond its beachhead and was well placed to repel the counter-attack by the clearing banks after 1971, who have succeeded only in stabilizing their share of the total deposit market while that of the building societies has continued to increase. 1°Instalment credit on durable goods. 1For a statement of the official view see the evidence of the Treasury to the Monopolies Commission 1968.
22
H.B. Rose, Deposits and monetary policy
4. Monetary policy Let me return to my main theme. The ratio of the total assets of financial intermediaries to national income had practically reached its peak by the outbreak of the Second World War. The share of total 'deposits' in these assets is today somewhat below what it was in 1938; but the share of the banks as a group in total 'deposits' is today much smaller than before the war, this decline being due entirely to the fall in the share of the clearing banks. The questions I want to consider are, first, whether monetary policy, as well as the other factors I have mentioned, has contributed much to the relative decline of the banks in general and the clearing banks in particular and, conversely, whether the growth of the non-bank financial intermediaries, especially the building societies, creates difficulties for monetary policy that might need to be resolved by subjecting these institutions to roughly similar policy restrictions. Concern with the possible role of near-money substitutes played a great part in the Radcliffe Committee's thinking about twenty years ago. The Radcliffe Report doubted the effectiveness of regulating either the quantity of money or, more narrowly, bank loans because the Committee believed that total spending depended much more on a wider notion of 'liquidity,' in which the operations of non-bank intermediaries were thought to play a vital part. This view, which was expressed somewhat tersely in the Report, has been interpreted as implying that lending by non-bank intermediaries, and, therefore, their deposits, would actually tend to expand in response to restrictions on the growth of the money supply in general or bank lending in particular. It therefore follows that my two questions -whether monetary or credit policy tends to make the banks lose market share to the other intermediaries and whether non-bank intermediaries need to be brought under central bank control - a r e very much inter-related.
'Open market" monetary policy. One general answer can be given initially to both questions. It is that much depends on the form taken by monetary policy. If policy aims at controlling the quantity of money and the Government is content to do this solely by allowing interest rates to take whatever levels are needed to sell the necessary quantities of public sector debt, then there, is no compelling reason why the result should be to restrict the banks' share of the total deposit market unfairly or to encourage the growth of other institutions, even though 'money' is defined, as at present, to exclude other deposits which may be similar in many respects to those held with banks. This may at first sight seem rather surprising, in that any restriction of the money supply implies the intention on the part of the authorities to prevent
H.B. Rose, Deposits and monetary policy
23
the banking system from exploiting to the full its ability to create deposits. The answer is that allowing interest rates to rise freely to restrict the money supply would also tend to restrict the operations of other deposit institutions as well. In general, only if the difference between interest rates offered by the banks and those offered by other institutions moved in favour of the latter would non-bank intermediaries necessarily benefit, and this will occur only if they can pass on a larger increase in their deposit rates to their own borrowers. This might happen if the building societies, for example, decided to end their credit rationing practice - a n d were allowed to - b u t this could only be a once-and-for-all qualification of my argument. The traditional reason for directing monetary policy specifically at the banks is that, collectively, they have been much more able than other institutions to create deposits because bank deposits are used as a means of payment. Nevertheless, this is only a necessary and not a sufficient cause for monetary restriction. The general case for limiting the creation of what we choose to call 'money,' i.e., the sum of notes and coin and bank deposits, is that the money supply and the level of money incomes are thought to be interrelated in a sufficiently stable manner, so that a change in the quantity of money, perhaps after some interval of time, has a sufficiently, if not exactly, predictable effect on total money income. If changes in the quantity of money had no stable long-term effect on incomes there would be little point in controlling it. 12 Although the division of this effect between price and output changes is a matter of controversy, only a minority of economists, located, I believe, mainly in Cambridge, seriously deny that what in the trade is called the 'demand function for money' has sufficient stability to form the basis of a useful and, I would maintain, essential ingredient of economic policy. Moreover, and this is also important, if the relationship between the quantity of money and rates of interest is sufficiently stable, then it also follows that the money supply can be controlled by allowing interest rate movements to facilitate open-market operations. One might call this an 'open market' type of monetary policy. For a time, in 1972-73, when the immediate result of Competition and Credit Control 13 was to unleash an unusually large increase in the quantity of money via an upsurge in bank lending, it looked as if the relationship between money and incomes had completely broken down. This judgment can now be seen to have been premature, at least in the sense that the excess supply of money has been absorbed by higher prices and the velocity of circulation appears to have returned to its more usual trend. What still remains to be seen, I admit, is whether the relationship between money and 12The appropriate focus of monetary policy would then be interest rates. t3This was the name of the 1971 document in which the Bank of England set out its proposals for the abolition of the clearing bank cartel.
24
H.B. Rose, Deposits and monetary policy
interest rates has settled down. I adhere to the view, however, that the recent instability of interest rates owes more to the impact of government policy as a whole on expectations, especially regarding inflation, than to any fundamental instability of money-supply-interest-rate relationships if properly interpreted. The important point is that, as long as the money-supply-money-income relationship is sufficiently stable, or if changes in it are sufficiently predictable, as that in 1972-73 perhaps should have been, it does not matter from the point of view of economic policy that the authorities single out for control by open-market operations a type of financial asset, i.e. bank deposits, that has much in common with deposits in other institutions. The question of what we should regard as 'money' when other deposits besides bank deposits provide a store of value is in this context a semantic one; the practical question is of the effect of controlling the stock of a particular type of asset. In the days before econometric techniques helped to answer the question of what was the result of singling out a particular type of liquid asset for control, arguments as to what should and what should not be regarded as constituting something called 'money' had greater importance than they do today. It should be stressed, however, that it is only a free or open-market type of monetary policy, with interest rates b~ing left entirely free to respond to open-market operations, that can be expected to leave undisturbed the relative long-term rates of growth of different institutions, whose development would reflect relative efficiencies, marketing skills, tax and similar advantages and customer preferences. There would be nothing in such a world to prevent bank deposits from growing faster than, say, building society deposits if the public wished to hold more bank rather than more building society deposits. For the aim of monetary policy is not to prevent us from holding money, but of preventing the creation of a supply of money in excess of that which we would wish to hold at a target level of national money income. There would be nothing inherent in the operation of this type of monetary policy, for example, that would necessarily have enabled the building societies, rather than the banks, to have captured the share of total deposits lost by National Savings since the war and especially since the early 1960s. The general observation that an open-market type of monetary policy need not discriminate against the banks does require at least one qualification, apart from the obvious one that British governments have rarely been content to rely on it. The qualification is that banks are required to hold a minimum ratio of reserve assets, because this facilitates control by the authorities. If this minimum reserve ratio is higher than that which the banks would otherwise wish to hold, the result is to depress bank profits, for the return on reserve assets will be lowered by the element of enforced demand.
H.B. Rose, Deposits and monetary policy
25
To do them justice, the authorities sought a reserve asset ratio in 1971, like the older liquidity ratio, that reflected bank practice; but it is at least arguable that, with the development of the interbank market, banks would today be content with a lower ratio of what are mainly liquid assets issued by the public sector, to say nothing of Special Deposits. 14 Since 1971, moreover, part of the liquid assets which banks would choose to hold, namely cash in tills, has not been admissible as a reserve asset at all; and the same is true of commercial bills in excess of 2 percent of eligible liabilities.15 The element of discrimination against the banks possibly created by reserve asset requirements might be reduced if it were replaced by a narrower requirement merely to hold m i n i m u m balances with the Bank of England, at least if, unlike the case today, interest were paid on these balances. Whether the reserve asset ratio should be replaced by such a 'cash' ratio system raises wider questions of monetary policy outside the scope of my talk; although I believe that the authorities' traditional case against cash ratio control, that it would cause an undesirable instability of short-term rates, is not as strong as it once might have been. Although a free or open-market monetary policy could be broadly neutral as between institutions, an argument used to be heard to the effect that the existence of a large stock of near-money liquid assets would make this type of policy ineffective. The point made was that the economy's liquidity and interest rates would be less responsive to any given volume of open-market operations because part of their potential effect would be cushioned by the existence of money substitutes. One might accept the analysis but not, I think, its conclusion. As long as near-money assets are not perfect substitutes for money, the fact that nearmoney assets might make the system less responsive to a given volume of open-market operations merely means that these have to be large in scale to achieve any given effect. As long as the relationship between money supply, interest rates and incomes is sufficiently stable, monetary policy of the openmarket type need not be frustrated by the existence of near-money substitutes. Their existence also has the virtue of cushioning accidental or random shocks to the financial system, which would be over-sensitive if our liquidity, to mix metaphors, were always on a knife-edge. In any case, whatever difficulties have beset the attempt of the Bank of England to run an open-market type of monetary policy in recent years cannot be attributed to any sudden development of near-money assets. If anything, the problem is rather that interest rates have become more and not less sensitive to open market operations, because of the interaction between government policy and market expectations. This is presumably the sophisticated case which authorities might offer in defence of their retreat from a free 14Variable compulsory balances with the Bank of England. 15The deposit liabilities against which reserve assets must be held.
26
H.B. Rose, Deposits and monetary policy
or open-market policy, as opposed to the plainer one the no Government likes high interest rates.
Bank lending restrictions. Whereas a free or open-market monetary policy should - a n d certainly c o u l d - be more or less neutral as between institutions, a policy that takes the form of discriminatory measures aimed specifically at bank lending is potentially another matter. Until about the time of Competition and Credit Control in 1971, or just before it, policy in Britain had never been aimed directly at a target quantity of money. Instead in postwar Britain the authorities had sought to control short-term interest rates closely, especially because of external considerations, to try and maintain fairly stable long-term rates and to regulate the volume of bank (and hire-purchase) lending. The traditional domestic emphasis of the authorities has always been much more on 'credit' rather than on 'money supply'; although it was never clear exactly what was meant by 'credit' or just what economic theory lay behind what is only a deceptively commonsense idea. In broad terms the effect of official policy from the war until the late 1960s was to allow the creation of whatever quantity of money arose from the Government's interest rate semi-stabilization policy but to influence bank lending through requests to the banks and then, in the 1960s, by the use of Special Deposits as well. The latter amounted to a kind of tax on the banks, by requiring them to bid for additional low-yielding liquid assets to support a given level of lending. Although they retained the use of a market mechanism, Special Deposits come within the category of discriminatory constraints on bank lending and Supplementary Special Deposits, 16 the socalled 'corset', even more so, and even though they are levied directly on bank liabilities rather than on their assets. In looking at the consequences for other institutions of discrimination against the banking system, however, one should distinguish between shortterm and long-term effects. In most periods of bank credit restriction it is hard to find evidence that the result was actually to push up both the lending and the deposits of non-bank intermediaries. The building societies, for example, did not appear to benefit much directly, if at all, during most spells of severe restriction of bank lending in the middle-1950s and in the 1960s. In the earlier part of this long period one reason was that the restriction of bank lending was not always matched by a similar fall in bank deposits, and on some occasions the slowness of building society interest rates to reflect a rise in banking system rates worked to the disadvantage of the building societies. 16These are non-interest-bearing balances with the Bank of England which, when the system is in force as it has been since June 1978, the banks have to hold in increasing amounts if their deposits grow at more than a stipulated rate.
H.B. Rose, Deposits and monetary policy
27
The generalization that the restriction of bank advances is bound to push up both the lending and the deposits of other institutions at the time is an oversimplification. In the 1950s, and to some extent in the 1960s, the main element of 'give' in the system was provided not so much by the expansion of non-bank deposit intermediaries in general as by disintermediation itself, the diversion of lending through the new issue and commercial bill markets and, probably, through the trade credit mechanism. The share of banks in lending flows was undoubtedly depressed by lending directives, but the immediate effect was to stimulate other lending on a wide front rather than to benefit the main non-bank deposit intermediaries in particular. Part of the diversion of lending, too, was usually in favour of the public sector, including the local authorities. Indeed, in a sense that is the ultimate reason why direct restrictions on bank lending, rather than a freely open-market monetary policy, tend to be preferred by governments. If we take a wider perspective, it is reasonable to suppose that one result of the regime of bank credit restraint, which has been of longer duration than periods of immediate credit 'squeeze', has been to favour non-bank deposit intermediaries. The development of the secondary banks in the 1960s was certainly assisted by the restraints placed on the clearing banks, and so was the expansion of other 'listed' banks. Indeed this was one reason, as we know, for the introduction of Competition and Credit Control. Building societies, too, have probably gained something on balance from the much greater instability imposed on the banking system and the inability of the banks over a long period to exploit to the full the market in personal loans. It may also be the case that restrictions on bank lending to the personal sector tend to stimulate lending by retailers. Not only would this shift some of the profitability of personal sector lending from banks to retailers, but the large retailing groups also have access to finance outside the banking system. The result is probably to depress the long-term share of the banks in the personal lending market. The clearing banks, whose stake in personal lending has always been the highest within the banking system, have suffered most of all.
The'corset' (the Supplementary Special Deposit system).17
It can be argued that the recent behaviour of interest rates has made a purely open-market type of monetary policy much more difficult. In one sense this is true, but it does not necessarily follow that the underlying reason is a new instability of moneyholding habits that might justify more direct controls over the banking system. Instead, one can point to the disturbing effects of exchange rate policy and excessive public sector deficits as the main sources of difficulty in controlling the money supply, without which the narrower problems posed for the authorities by expectations in the gilt-edged market would have been 17See previous footnote.
28
H.B. Rose, Deposits and monetary policy
much less serious. The return of the 'corset', to my mind, was not inevitable; it reflects, rather, the unwillingness of the Government to accept the high interest rates which are really the consequences of its own actions. But whether even the 'corset' can prevent high interest rates, as opposed to changing their pattern, when the total demand for funds is strong is another matter. Because the banking system cannot easily control its total lending to the public sector, the 'corset' becomes in the end a penally high marginal rate of tax on bank lending to the private sector. It is not levied on other intermediaries; and at the end of the day it is not different in principle from old fashioned directives to the banks, especially if a request from the Governor or the prevailing climate of opinion specifically directs lending restraint to the personal sector. Corporate borrowing, too, tends to be diverted, to the commercial bill market for example. There is, however, at least one difference from earlier periods of 'direct' credit restraint. In so far as the 'corset' leads to a fall in the deposit rates of the banks as compared with other rates, it makes it easier for other institutions, such as the building societies, to attract deposits. The 'corset' has a possible discriminatory interest rate effect which the previous systems of credit restriction did not have; although its effect in this direction this year has been disguised by the fact that the building societies have so far chosen to run down their liquid assets rather than to push up their deposit rate faster. Potentially, however, there is little doubt that the 'corset' does more than earlier types of bank lending restrictions to divert deposits to non-bank deposit intermediaries. The other main difference between the 'corset' and earlier forms of credit restriction, and indeed, its very object, is that the 'corset' is more effective in holding back the growth of the money supply. On the other hand, the 'corset' results in a number of distortions of the financial system and therefore makes it more difficult to interpret the effect on spending flows of the check to money supply. The 'corset' may enable authorities to get their published money supply figures right, and this may calm markets for a while; but it is also much harder to say just what the money supply figures are likely to mean in terms of economic consequences. Indeed, the 'corset' may produce the very instability between money supply and spending which previous governments, and the Radcliffe Committee, could use as an argument for rejecting a money-supply policy itself. This is especially likely to be the case if the banks are induced to hold down their interest rates, so that credit rationing by the banks diverts lending elsewhere. In short, like earlier forms of credit restrictions, as the Radcliffe Committee argued, the 'corset' is likely to cause an increase in the velocity of circulation. The 'corset' is no substitute for a healthy diet! One other distortion produced by the 'corset' is worth noting. Because the
H.B. Rose, Deposits and monetary policy
29
IBELs penalty is does not apply to the discount houses, 19 it is possible for the banks, with the connivance of the authorities, to reduce their IBELs by shifting assets to the discount houses. The money supply is unaffected, but the banks are helped to keep out of the penalty zone. The result is to depress bank assets and profits to the benefit of the discount houses, with no evident national economic benefit. It is as if the 'corset' were applied to only one of a pair of Siamese twins, redistributing fat between them!
5. Summary and conclusions Financial intermediation can be said to have reached maturity before the war, since when the growth of the banks has been critically a question of market share, with the clearing banks in particular having to increase their share of total time-deposits to hold their share of the total deposit market. This the clearing banks have been able to do only over the past eight or nine years, a period corresponding roughly to the shift of monetary policy away from the direct restriction of bank lending. Until the change in monetary policy, credit restriction added to the other factors, like taxation and the cartel, limiting the ability of the banks to compete. While it is hard to discern any consistent swing in favour of other deposit intermediaries during periods of particularly severe credit restraint before 1971, there is little doubt that this was the longer-term effect. In general the Radcliffe Committee, some twenty years ago, was right to draw attention to the way in which discrimination against the clearing banks would merely stimulate the development of other institutions and disintermediation itself and, therefore, prove a relatively ineffective way of influencing spending and incomes. My own view, however, like that of other economists who are prepared to wear at least some part of the 'monetarist' label, is that it is wrong to apply this conclusion to control over the money supply implemented solely through open-market operations, with interest rates free to fluctuate. Apart from the question of reserve asset requirements, in which the public sector, in effect, exploits its monopoly powers, an open-market policy need not discriminate against the banks; and it should be effective in influencing the level of spending and incomes. Whereas the original introduction of the 'corset' in 1973 can be regarded as an understandable interruption of the non-discriminatory policy which Competition and Credit Control was intended to usher in, the repeated application of the 'corset' is quite another matter, especially if, as may be the case today, the garment has to be worn for some time. As I believe that the ~aThe deposit ceiling above which Supplementary Special Deposits have to be made is set in terms of the banks' Interest-Bearing Eligible Liabilities (IBELs).
~gInstitutions holding short paper and financed mainly by borrowing from the banks.
H.B. Rose, Deposits and monetary policy
30
difficulty of controlling the money supply at tolerable interest rates is fundamentally one of the Government's own making, I cannot sympathise with what is a return, in substance if not in form, to an old-fashioned clamp on bank lending to the private sector. Love laughs at locksmiths, and the 'corset' is no substitute for virtue. The distortions caused by the 'corset' not only discriminate against the banks; they are likely to undermine the use of a money supply policy itself. In recent years the authorities have come to place informal restraints on building society lending, 2° in order to ward off an excessive increase in house prices. To a considerable extent, recent rushes of building society lending have been the result of the pattern of interest rate fluctuations and the swing in building society liquidity ratios. Whether the 'corset' has yet played much of a part in reinforcing building society deposits is doubtful, but the longer the 'corset' and associated restrictions on the banks remain in force the more likely it is that the authorities will be driven by the logic of their own policy to impose tight lending restrictions on the building societies and other institutions, as the Radcliffe Report implied. Table 1 Total financial intermediary liabilities" and the share of deposit-taking financial institutions for selected years.
End year 1913 1921 1930 1938 1948 1958 1968 1977 1978 June
GNP
Estimated total financial intermediary liabilities
(£m)
(£m)
2527 5128 4576 5176 10517 20497 37390 123791 135870 c
2015 4265 5673 7240 18712 26082 55739 142405 149718 a
As ~ or
GNP
Total deposits of deposit taking intermediaries b
As ~ of total liabilities of financial intermediaries
(£m) 80 83 124 140 178 127 149 115 110
1376 3165 3889 4770 14163 16586 29573 82880 87801
68 74 69 66 76 64 53 58 59
aApproximate estimates only of deposits with banks (resident sterling deposits only 1977-78), National Giro, finance houses, Trustee Savings Banks, building societies, National Savings, life assurance and pension funds (all insurance companies 1913-58), investment and unit trust funds. bBanks, National Giro, finance houses, Trustee Savings Banks, building societies and National Savings. CFirst half at an annual rate. dEnd March.
2°The restraint placed on building society lending has so far been very loose as well as applied by 'moral suasion'.
H.B. Rose, Deposits and monetary policy
31
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H.B. Rose, Deposits and monetary policy
To my mind this is undesirable and is entirely the result of the failure to maintain the fiscal and other policies required to make an open-market money-supply policy possible without undue strain. This is not to deny that one day the building societies might have to be made subject to a monetarypolicy type of reserve asset requirement, as distinct from lending controls, if the growth in their size and a widening of their operations make them become still more like the banks. If building society deposits were to become still closer substitutes for bank deposits then, it is true, the selection of bank deposits alone as a target for an open-market money-supply policy might become inadequate. In the meantime, however, what are required are government policies, especially with regard to the size of the public sector borrowing requirement, that make possible the goal of a non-discriminatory open-market policy, without the need for direct controls having to be applied to a range of institutions as the pattern of market shares changes. Nondiscrimination should not be confused with equality of misery. Wilson Committee please note!