Chicago Fed History: 1965-1988
For approximately two decades, the Federal Reserve Bank of Chicago had enjoyed a period of general stability. By the mid-1960s, however, there were indications of change. In 1966, the Bank's annual report warned that economic developments in 1967 were "not likely to follow a classic pattern" because a "war effort involving the expenditure of many billions of dollars is taking a growing share of the nation's resources of men and materials." By the end of 1968, the Bank reported that "most interest rates were at a new high in the experience of today's generation."
Constrained by ceilings imposed under Regulation Q, bankers watched helplessly as deposits flowed to competitors who provided higher yields. Seventh District bankers tried to respond to the increased competition. At the end of the decade, approximately 74 percent of District banks were paying the 4 percent maximum rate for savings deposits, according to a 1969 Chicago Fed survey. Many banks changed from quarterly computation of interest to daily or constant compounding, and offered noninterest extras such as "instant" loan privileges.
As interest rates increased, banks stepped up their efforts to avoid restrictions on their activities. While the Federal Reserve was responsible for overseeing multibank holding companies, enterprising bankers discovered that Congress neglected to include one-bank holding companies in the Fed's purview.
By 1970, 1,352 one-bank holding companies held more than one-third of the commercial bank assets in the U.S. Many of these companies engaged in non-financial activities ranging from agriculture to mining operations. In the five Seventh District states, 361 one-bank holding companies controlled 27 percent of the states' deposits. In 1970, Congress closed the loophole in the Bank Holding Company Act, and the Chicago Fed became responsible for overseeing all District banking companies and ensuring that they engaged in activities "closely related to banking."
The end of the 1960s also saw the beginning of the Federal Reserve's responsibility for consumer credit regulation. In 1969, Congress passed the Truth-in-Lending Act and gave the Federal Reserve responsibility for implementing the legislation. From this relatively simple beginning, there was a stampede of consumer credit legislation — 13 separate acts were passed by Congress by the mid-1970s. And in 1977, Congress passed the Community Reinvestment Act, aimed at reducing discriminatory credit practices against low-income neighborhoods,
Banks Go Toe to Toe with New Competition
As the U.S. entered the 1980s, the financial system faced a host of problems triggered by the higher and more volatile interest rates of the 1960s and 1970s. As interest rates increased, banks squirmed under the constraints of Depression-era legislation while new competitors invaded their traditional turf. At the same time, the Federal Reserve found its ability to conduct monetary policy threatened as member banks fled the System to avoid the burden of holding non-interest-bearing reserves.
In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act (MCA) to resolve some of the dilemmas facing the financial services industry. To enable financial institutions to compete more effectively, the Act phased out deposit ceilings and authorized NOW accounts. The Act also addressed the Fed's membership problem by imposing reserve requirements on all depository institutions. At the same time, the MCA required the Fed Banks to price many of their services and offer them to all depository institutions. As one of a number of competitors in the marketplace, the Federal Reserve was to recover "in the long run" the costs of providing priced services.
The MCA had an immediate effect on the Bank — the number of potential customers and institutions required to submit statistical data jumped from 904 member banks to approximately 7,000 banks, savings and loans, and credit unions. To help in the transition, the Bank turned to the private sector when it became time to select a new president in 1981. Silas Keehn, who had previously served as vice chairman of Mellon National Corporation and Mellon Bank N.A. in Pittsburgh, and as chairman of Pullman Incorporated in Chicago, brought to the Chicago Fed the valuable perspective gained in the competitive marketplace.
"It was a time of tremendous challenge and opportunity," Keehn recalls. "The Bank, and the financial services industry as a whole, were experiencing dramatic changes on virtually every front. It's hard to imagine a more exciting time to have started at the Bank." The pricing of Fed services received scant public attention initially compared with interest rate deregulation and uniform reserve requirements. The transition to priced services, however, posed a major challenge to the Reserve Banks and eventually had a ripple effect on institutions and their customers.
Change in Strategy for Electronic Services
The Chicago Fed's first step was to research its new customers and to revise its services strategy, an effort headed by First Vice President Daniel Doyle. Previously, the Fed Banks provided a fairly basic, operationally prudent, array of services. With the advent of pricing, the Chicago Fed worked to offer a wider variety of services at a relatively low price. "As a general rule," Doyle notes, we gave them more options to choose from, more services. There was much more responsiveness to customer needs."
The Bank's electronic services volumes were not expected to drop markedly, because of the lack of close substitutes on the market. The Bank's check-clearing services, however, were expected to face significant competition. Fed-processed check volume did drop with the advent of pricing — approximately 20 percent for the System in the last quarter of 1981, although the Bank's decrease was about half that amount. Some expected the Fed to scale back its operations as a result of lower volumes. Instead, however, the Fed decided to intensify its efforts and let the marketplace determine its role in financial services.
Doyle notes that 1984 was a "crucial year" for priced services. The Bank had failed to meet its volume objectives in the previous year and faced the need to make changes. The Bank cut costs, continued to refine its services, and reorganized departments to centralize responsibility for all aspects of a major product. That year the Chicago Fed recovered some of its lost check business, and the trend shifted toward growth rather than loss.
The MCA affected the Fed's services, and eventually the financial services industry, in several ways. Check-clearing schedules were shortened, new check services were introduced, and relatively low prices were maintained. As required by the MCA, Fed float was recovered through a combination of pricing and more efficient operations.
In electronic services, Automated Clearinghouse (ACH) usage, aided initially by price subsidies, increased substantially. The MCA also enabled the Fed Banks to encourage more efficient online wire transfers through price incentives and the availability of inexpensive computer equipment.
The MCA also had a dramatic effect on the Bank itself. "It produced a much leaner, more efficient, and, I think, more satisfying organization," Doyle observes. "It's one thing to respond to internal standards, it's quite another thing to meet the standards of the marketplace. I think we were very successful."
Oil and Inflation — A Bad Combination
As events unfolded that would eventually lead to the Monetary Control Act, the Seventh District economy underwent a painful readjustment process. The 1970s had provided little respite from the inflation problems that had built up in the late 1960s. Wage and price controls instituted in 1970 were, in the words of the Bank's monthly review, "judged unsatisfactory by virtually everyone." 1974 was labeled a "year of calamity" by the Bank's review, which noted that the U.S. economy was hit by an "unprecedented array of adverse developments" ranging from record price inflation to shortages to the nation's first presidential resignation.
The Federal Reserve tried to curtail the inflationary trend. In 1975, the Fed announced a policy to reduce money growth rates to eliminate inflation, an attempt that generally failed. Four years later, the U.S. was jolted by the second oil price shock of the decade, and experienced its worst inflation in the post-war period. A dramatic gesture was needed.
On Saturday, October 6, 1979, the FOMC gathered for an emergency meeting in Washington, D.C. to discuss the deteriorating economic situation. To avoid publicity, FOMC members were located in different hotels around the city.1 That evening recently appointed Chairman Paul Volcker announced that the Federal Reserve's monetary policy efforts would focus on reaching target levels of bank reserves through open market operations. The announcement was a signal of the Fed's determination to wring inflation from the economy once and for all. The immediate market response was dramatic — a sharp increase in the entire spectrum of interest rates.
The economy began to slow. By the fourth quarter of 1981, GNP was declining at an annual rate of 4.9 percent.2 The recession was particularly tough on the Midwest. The Bank's economic review noted in 1981 that "for almost two years the economy has stumbled on a rocky path marked by soaring inflation, record-high interest rates, and a constant specter of fuel shortages...the Seventh Federal Reserve District has shouldered a disproportionate share of the trouble."
As the Midwest economy faltered, the Bank became involved in cooperative efforts directed at improving the long-run economic performance of the Seventh District. Working with various public and private groups, the Bank participated in a number of economic development projects including studies of the Great Lakes region, the states of Iowa and Wisconsin and the cities of Chicago and Detroit.
Eventually the national economy began to improve. In his Congressional testimony in July 1982, Volcker reported that "evidence now seems strong that the inflation tide has turned in a fundamental way."3 At year-end 1982, Chicago Fed President Keehn wrote in the Bank's annual report that "there is mounting evidence that long-term economic growth could and would be renewed without igniting inflation."
By 1985, the U.S. economic expansion had reached its fourth year without reigniting inflation. Still the Midwest lagged behind. "It is particularly — and painfully — clear to all of us in the Midwest that the expansion has been uneven in different regions of the country,..." Keehn wrote in 1985. "Despite strong gains in employment nationally, manufacturing jobs continue to decline and the agricultural sector remains extremely depressed."
The outlook for the Midwest finally brightened in 1987. The U.S. entered its sixth year of uninterrupted growth — the longest peacetime expansion in the nation's history. And the Midwest finally shared in the good news — its performance was the best of the decade. For the first time since 1980, overall economic activity in the Midwest outpaced the rest of the nation. "While one year does not make a trend," the 1987 annual report concluded, "there is reason to be optimistic about the prospects for the District's economy as it approaches the 1990s."
Echoes of the Past
Economic troubles, combined with increased competition, began to take a toll on banks in the early 1980s. The number of bank failures increased dramatically compared with previous decades. Agricultural banks, feeling the effects of a severe slump in the farm sector, were especially hard-hit. By 1984, ag bank failures accounted for 32 percent of all bank failures nationally. The large percentage of ag banks in the Seventh District posed "a tremendous challenge for us," said James Morrison, who headed the Bank's Supervision and Regulation Department from 1968 to 1988. With only a few exceptions, however, ag banks' strong capital and stable deposits enabled them to withstand the crisis. By 1986, the decline in ag bank performance began to moderate.
At the other end of the spectrum from the predominately small ag banks, some large money center banks began to experience difficulties in the early 1980s. The uncertainty surrounding the repayment of foreign loans, and the severe slump in certain sectors such as energy, contributed to their problems. The money-center bank problems emphasized the growing complexity of the financial system. A bank run was no longer necessarily a local phenomenon, but could originate in one part of the world with the break of dawn and follow the sun across the globe.
The potential for a worldwide electronic run presented new challenges for the Chicago Reserve Bank. Unlike 1933, however, when regulators were unable to prevent the collapse of two Detroit banks that helped trigger the banking holiday, the Federal Reserve and other regulators had the resources to help prevent, if necessary, a bank from closing.
The rapid plunge in the stock market in October 1987 provided another indication of the financial system's growing complexity. Following the crash, the Fed responded by injecting liquidity into the financial system, by emphasizing its willingness to lend to banks through the discount window, and by extending the hours on FedWire, the Federal Reserve's large dollar transfer system. At the same time, each of the Reserve Banks intensified its monitoring activities to detect signs of further stress. At the Chicago Fed, Bank officials paid particular attention to developments at local exchanges. While the stock market crash in 1987 was perhaps the most notable financial disturbance in 50 years, it also provided a strong indication of the fundamental resilience of the financial markets.
A New View of Banking
As the financial system evolved, so did the Chicago Fed's supervision of banks and bank holding companies. "Our view of banks became dramatically broader in the 70s and 80s," Morrison noted. "Previously, we would check the accuracy of the bank's books and review the loan accounts. Today, there is a broader scope. The interest rate position — what the bank is paying for money and what it is receiving — is much more carefully reviewed. The organization and structure of a bank is looked at more closely. And there is much more emphasis on policy on the assumption that a bank's policy will influence future decisions. Institutions — especially the bigger ones — are monitored on a 'flow basis' throughout the year through statistical reports and examinations. It's a much more complicated process, but we're also dealing with a much more complicated financial system."
Woodrow Wilson's observation on the passage of the Federal Reserve Act is surprisingly apt in 1988. The Chicago Reserve Bank has never had "a clean sheet of paper to write upon." Instead it continues to respond to the challenges of the evolving financial and economic system. This continuing process was symbolically captured by the renovation of the Bank's headquarters building in the late 80s, a project undertaken to satisfy the Bank's needs well into the current century. As always the Bank is preparing to meet, step by step, the challenges of the coming decades.