Defined Terms and Documents

CHANGES IN THE BEHAVIOUR OF BANKS AND THEIR IMPLICATIONS FOR FINANCIAL AGGREGATES - July 1989 - RBA

Ric Battellino and Nola McMillan

1. Introduction

This paper looks at the way the behaviour of banks has changed as a

result of deregulation, and the effect this has had on financial

Stevens (1988), which noted that there have been substantial changes

over the past twenty years in the relationships between financial

aggregates and economic activity.

While the effects of deregulation have been most pronounced in the

past few years, important steps towards deregulation were taken as

early as 1973 when the interest rate ceiling on bank certificates of

deposit (CDs) was removed. This began the process of giving banks

greater control over the interest rates they paid on deposits and

opened the way for the change from asset management to liability

management. The move to liability management by banks was

arguably the single most important factor causing the behaviour of

Other major steps in the deregulatory process were the removal of

the remaining interest rate ceilings on bank deposits, the removal of

exchange controls, the floating of the exchange rate, the entry of

banks into the market for overnight funds, and the establishment of

new banks. These steps, which took place in the period 1980 to 1985,

saw further substantial changes in the behaviour of banks, in the

market shares of banks and other financial intermediaries, and in

the overall amount of intermediation. These issues are discussed in Section 3.

Section 4 goes on to look at the way financial intermediaries reacted to

the remaining controls - in particular, at the way in which they altered

their funding patterns in an attempt to avoid the costs of Statutory

Reserve Deposits (SRD). Recent developments, following the

replacement of Statutory Reserve Deposits by non-callable deposits,

are also briefly discussed. The major changes in regulations over the

past twenty years are listed in the Appendix.

2

2. Removal of Interest Rate Controls and the Shift to Liability Management

(a) Interest rate controls and asset management

Up to the early 1970s, there were controls on the interest rates banks

could pay on deposits, on the interest rates they could charge on

loans, and on the maturity of deposits they could raise. (See the

Appendix for a description of controls in force at that time.) In these

circumstances, banks behaved largely as asset managers. They

accepted passively whatever deposits carne their way, since controls

over interest rates limited their scope to go out into the market and

compete for deposits. They then decided how to allocate these funds

among various assets.

On the asset side of their balance sheets, banks adjusted to short run

changes in inflows of deposits by movements in their holdings of

liquid assets and Commonwealth Government securities (LGS).l

During times of large inflows of deposits, LGS assets were run up

and, when deposit inflows slowed or outflows occurred, LGS assets

were run down. On average, banks held a large buffer of LGS in

Fluctuations in holdings of LGS helped to shield advances from

variations in deposit flows. However, in the event of a tightening in

financial conditions, banks eventually were forced to adjust their

advances, as they could not competitively bid for deposits to

replenish their liquid assets. Credit rationing on a non-price basis

was an important part of the adjustment process.

In these circumstances, a tightening of policy tended to have a

substantial and relatively fast effect on the growth of bank deposits.

There were two main channels through which policy could be

tightened. One was the LGS/SRD mechanism. By raising the SRD

ratio, banks could be forced to cut back on holdings of other assets. In

the short run, this usually involved relinquishing LGS but if this

brought them close to the minimum LGS ratio, they would be forced

to restrain lending. This in turn restrained deposits. Alternatively,

policy could be tightened by more active sales of CGS (including

issues of Australian Savings Bonds). This forced up interest rates,

not only on CGS but also more generally. To the extent that sales

were to non-banks, it also directly attracted deposits out of the

banking system as non-banks paid for their securities. Banks were

restricted in their ability to compete for deposits because of controls

over the interest rates they could pay.

Of course, major changes in holdings of LGS assets usually meant changes in

holdings of Commonwealth Government securities (CGS). LGS assets which

earnt no interest, such as notes and coin and exchange settlement funds, were

always kept to a minimum.

banks agreed to keep not less than a certain proportion of their depositors'

funds in the form of LGS assets.

3

Graph 1 illustrates the above adjustment process by reference to the

late 1960s and first half of the 1970s, a period during which banks

on CDs were freed in 1973, banks did not move immediately to make

full use of this freedom; it took some time to adapt behaviour, and

half of the 1970s that clearer signs of liability management began to

emerge.

The top panel of the graph shows two interest rates: the 90-day bank

bill yield (as an indicator of market rates), and the interest rate on

trading bank fixed deposits. The graph covers two periods of policy

tightening, 1970 and 1974. In the first period, the bank bill rate rose

by about 4 percentage points, but the interest rate on deposits rose

only a little, as it was constrained by a ceiling. The gap between

market rates and bank deposit rates closed in 1971 as market rates

fell. The experience was repeated in 1974: the bill rate rose sharply,

but the rate on fixed deposits was again limited by the ceiling.

3 All figures shown in the graphs are quarterly averages. Unless otherwise

specified, throughout this paper figures for banks have been adjusted for the

establishment of new banks, which may have caused the switching of assets

and liabilities from non-bank financial intermediaries (NBFis) to banks.

4

20~----------------------------------------~

Bill Rate

1 5

1 0

5~,_/~

Fixed Deposit Rate

0+-~~~--~~~-+--~-+~~~~~~~--~~~

40

30

20

1 0

1 5

12.5

1 0

7.5

5

2.5

0

Growth In Advances

(4 quarters ended)

liquid Assets In Excess of Minimum Requirement

(as percentage of deposlts)/4

moving average

1968 1970 1972 1974

The second panel shows the growth of trading bank deposits and

advances. In each period of tightening, the growth of bank deposits

slowed noticeably. The response was also fairly quick. Growth in

deposits turned down before interest rates reached their peak. The

slowing in advances took longer to emerge; turning points for

advances were at least one quarter behind those for deposits.

5

The bottom panel illustrates trading banks' holdings of liquid assets

in excess of minimum requirements. Comparing this with the

middle panel, it can be seen that banks met slow-downs in deposits

initially by running down their excess holdings of LGS, which had

been built up in periods of sustained deposit growth. Banks' excess

holdings of LGS assets fell to only about 2 per cent of deposits in both

1970 and 1974, compared with average holdings during this period of

about 7 per cent of deposits.

(b) The move to liability management

Two major steps in the removal of interest rate controls on the

banking sector were taken in September 1973, when interest rates

payable on certificates of deposit were freed, and in December 1980

when virtually all other controls on bank deposit interest rates were

abolished. Restrictions on the minimum maturity of CDs and fixed

deposits remained until August 1984.

These changes mainly benefited trading banks, allowing them to

move from passive acceptance of deposits to active management of

deposits. While interest rate controls on savings bank deposits were

also removed, savings banks continued to be constrained in the

interest rates they could pay on deposits by the continuation of a

ceiling on interest rates they could charge for their housing loans.

(This issue is discussed in. Section 2(c) below.) Following the

removal of controls, trading banks could set competitive rates on

CDs and fixed deposits, enabling them to tailor the inflow of deposits

to match the demand for loans. Fixed deposits and CDs began to

account for an increasing share of deposits.

This is illustrated in Graph 2. The proportion of total trading bank

deposits accounted for by fixed deposits and CDs rose from a little

over 40 per cent in the late 1960s to around 70 per cent in the mid

1980s. The major increases took place soon after 1973, when interest

rates on CDs were freed, and after 1980 when controls on fixed

deposits were removed.4

years when current deposits of banks have risen sharply (see Section 2(d)).

6

Graph2.

100~~~~~~~~~~~~~~~~~~~~~100

%

With greater freedom to set interest rates on deposits, banks moved

towards liability management. This is illustrated in Graph 3 which

shows the same series as Graph 1 over the period from 1975 to 1988.

The dominance of liability management is most pronounced in the

1980s. The effects of deregulation of bank interest rates is clear from

the top panel of the graph. After 1980, rates on fixed deposits moved

much more closely in line with bank bill rates. The yield on CDs

was virtually identical to that of bank bills. There were no cases after

1980 where bank deposit interest rates were left well behind by

movements in other short-term interest rates.

From the second panel, it can be seen that from the late 1970s, the

growth rates of bank deposits and advances moved together much

more closely than earlier.s With controls over interest rates

removed, trading banks could manage deposit flows by varying

interest rates on CDs and fixed deposits, so as to keep deposits in line

with the demand for advances.

and that of bank advances. Rather than being a return to the behaviour of the

early 1970s, this was a further refinement of liability management,

involving the use of non-deposit liabilities. This is discussed in more detail in

Section 4 below.

7

Graph 3.

20?-----------------------~------------------~

5

30

25

20

15

10

5

{as percentage of deposits)

8

6

0

1975 1978 1981 1984 1987

The responsiveness of trading bank deposits to a tightening in

financial conditions changed after the first half of the 1970s.

Whereas in the first half of the 1970s they responded quickly (and

well before advances) to a change in interest rates, this was no

8

longer the case in later periods. The policy tightening over 1981/82 is

a good example; despite the sharp rise in interest rates, growth of

deposits did not slow until lending slowed.

The third panel shows that banks' excess holdings of LGS have been

much lower, and much more stable, in the 1980s. With the ability to

attract deposits as required, it was no longer necessary, and certainly

not profitable, to maintain excess liquid assets as a buffer against a

tightening of financial conditions. By the early 1980s, excess

holdings were averaging less than 2 per cent of deposits, compared

with an average of about 7 per cent in the first half of the 1970s. In

the two major tightenings of financial conditions in the first half of

the 1980s there was little, if any, change in the excess LGS ratio,

whereas the tightenings in the first half of the 1970s produced major falls.

The experience of savings banks is in sharp contrast to that of trading

banks described above.

The structure of savings bank balance sheets remained cons trained

by regulations for much longer than that of trading banks. Savings

banks did not have the outlet provided to trading banks by the

certificate of deposit.

Prior to August 1982, savings banks were prohibited from accepting

deposits from trading and profit-making bodies and prior to August

1984 could only offer small fixed deposits. These restrictions

effectively barred access to wholesale deposits.

Even more importantly, savings banks were restricted in setting

deposit rates by the continued regulation of the housing loan rate.

The mortgage rate (for loans of less than $100,000 to owneroccupiers)

was subject to a ceiling until April 1986, and loans

outstanding approved before that date are still subject to that ceiling.

These restrictions meant that savings banks often did not have the

freedom to set competitive deposit rates or otherwise significantly

influence the inflow of their deposits until comparatively recently.

Without this ability, savings bank deposits remained very sensitive

to changes in market interest rates. When rates rose, flows of funds

into savings banks quickly dried up. By the same token, when

market interest rates were falling, savings banks were generally slow

9

in reducing their deposit interest rates, preferring instead to take in

deposits to rebuild liquidity.

This is illustrated in Graph 4, which shows the growth of trading

bank and savings bank deposits and the 90-day bank bill rate.

Graph4.

% BANK DEPOSITS AND THE BILL RATE %

40~------------------------------------------------~40

BANK DEPOSITS

30

Trading Banks __ ,_,_, (Growth In 4 quarters ended)

30

20 20

BILL RATE

15 15

10 10

5 5

0 0

1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988

In the first half of the period shown, the experiences of savings

banks and trading banks were similar - deposit growth falling when

market interest rates rose, and picking up when market rates fell.

However, whereas for trading banks this relationship broke down in

the 1980s, it persisted for savings banks, with the result that by the

early 1980s growth in trading bank and savings bank deposits were

following opposite patterns.

For example, as financial conditions tightened in 1984 and 1985,

growth of savings bank deposits fell sharply, with funds attracted

away by the more aggressive behaviour of trading banks. In the

periods of weakening economic activity and falling interest rates in

1983 and 1986, trading bank deposits slowed in line with the growth

of their advances, but growth in savings bank deposits picked up.

10

(d) Implications for monetary aggregates

The implications for M3 of these changes in behaviour of trading

rates of trading bank deposits, savings bank deposits, and M3.

GraphS.

(Growth In 4 quarters ended)

40~--------------~------~--------~------------~40

Trading Banks

30 30

Savings Banks

20 20

1 0 1 0

0 0

1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988

financial conditions were easy (e.g. as in 1972/73) both savings banks

and trading banks experienced large inflows of deposits and growth

of M3 increased. When conditions tightened, as they did in 197 4 for

example, both groups of banks experienced slower growth of deposits

and growth of M3 fell.

In this early period, a tightening in monetary policy tended to have a

fairly quick and predictable effect on M3. Growth started to fall in

the same quarter that interest rates rose. The response of M3

preceded that of lending, with banks initially adjusting by running

down their holdings of LGS, and later adjusting loans and advances.

This behaviour is consistent with the finding by Bullock, Morris and

Stevens (1988) that M3 was a leading indicator of economic activity

in this period, while advances were co-incident.

By the early 1980s, the responsiveness of M3 to changes in financial

conditions was very much reduced. With trading banks having

increased ability to compete for deposits, they were able to maintain

1 1

inflows until the demand for credit fell. M3 therefore responded to

changes in financial conditions only when, and to the extent that,

the demand for bank credit did. Its response was therefore both

slower and smaller than was the case in the early 1970s, when

changes in M3 were related not only to changes in credit but also to

changes in holdings of LGS assets.

The responsiveness of M3 was further reduced by the fact that

savings bank deposits followed a pattern opposite to that of trading

bank deposits. As noted above, this was because savings banks were

still constrained by controls on interest rates and were still operating

as asset managers. As demand for advances increased, trading banks

bid more aggressively for deposits to fund these advances. This did

not fully reflect in M3 as some of the deposits were attracted out of

savings banks, who were forced to run down their liquidity.

Conversely, as demand for advances fell, trading banks slowed their

bidding for deposits. Savings banks, however, were willing to accept

large inflows to rebuild their liquidity. Again, therefore, the effects

on M3 of a slowing in demand for advances was muted.

The experience in 1982/83 provides a good illustration. As noted in

Bullock, Morris and Stevens, M3 growth did not slow much during

the recession of 1982/83; the annual growth rate was around 12 per

cent in 1981 when economic activity peaked, and despite a sharp

weakening in output over the following year or two (the most

pronounced in the post-war period), growth of M3 slowed only

marginally to reach a low of about 10.5 per cent in 1982/83.

Throughout this period, growth of M3 generally remained above the

targets in place at that time.

The patterns of trading bank and savings bank deposits illustrate

why this was so. In 1981, when economic activity was strong, growth

in trading bank deposits had been running at an annual rate of about

14 per cent, broadly in line with the growth rate of advances. Then,

between mid 1982 and 1983, growth in trading bank advances and

deposits slowed noticeably as economic activity weakened.

Savings bank deposits, however, followed a very different pattern.

Growth had been quite low in 1981 -around 8 per cent, roughly half

the rate of increase in trading bank deposits. Then, during late 1982

and 1983, as the economy slowed and market interest rates fell,

growth in savings bank deposits picked up sharply. The annual

growth rate reached nearly 25 per cent in late 1983, at a time when

growth in trading bank deposits had fallen to 5 per cent.

1 2

During the next economic cycle - the strengthening in the economy

over 1984 and the weakening over 1986 - trading and savings bank

deposits continued to follow opposite patterns, with M3 following a

middle course, largely unresponsive to economic conditions.6

The interest rate ceiling on savings banks' new housing loans was

removed in 1986, and this appears to be starting to have some effect

on savings bank behaviour. The end of the distinction between

trading and of savings banks could also be expected to change the

behaviour of M3.

Aggregates narrower than M3, such as M1, were largely unaffected by

this change in trading bank behaviour from asset management to

liability management. Because current deposits, which form the bulk

of M1, remained largely non-interest bearing until fairly recently, M1

continued to be responsive to changes in interest rates. Bullock,

Morris and Stevens noted that M1 had a stable relationship with

interest rates up until recently. It has increased faster in recent years

than might have been expected on the basis of past relationships.

This has coincided with an increase in the proportion of current

deposits bearing interest.

This can be seen in Graph 6. The proportion of current deposits

bearing interest has risen from a little over 10 per cent in the early

1980s (a figure that had not changed much over the previous 15

years) to 30 per cent in 1987. The trigger for this rise was the removal

in August 1984 of regulations restricting the payment of interest on

current accounts. Later, an additional factor was the general fall in

the level of interest rates over 1987, which tended to encourage the

holding of current deposits.

6 A mild cycle is apparent in M3 over 1985 and 1986 but, as shown in Section 3

below, part of this would have been due to the increased competitiveness of

banks vis-a-vis non-bank intermediaries following effects of further deregulation.

13

Graph6.

CURRENT DEPOSITS BEARING INTEREST

%

0 0

1968 1970 1972 1974 1976 1978 1980 19821984 1986 1988

3. The Deregulation of the Early 1980s andRe-Intermediation

There was a further major round of deregulation between 1983 and

1985. The changes included: the removal of interest rate ceilings on

overdrafts under $100,000; the removal of the restrictions on

savings banks' ability to accept large deposits from profit-making

bodies and to offer chequeing facilities; and the abolition of

minimum and maximum maturities on savings and trading bank

deposits, which allowed banks to enter the market for overnight

deposits. In addition, exchange controls were removed, the

exchange rate was floated and new banking authorities were granted.

These changes improved the banks' ability to compete in areas

where they were already operating and also allowed them to enter

areas of business that were previously not available. As a result,

banks were able to gain market share at the expense of non-banks - a

process often referred to as re-intermediation.

The removal in August 1984 of the restriction that prevented banks

from raising deposits of less than 14 days was particularly important

and merchant banks in the overnight money market.

14

After August 1984, banks built up their overnight deposits

substantially. Some of these deposits would have come from the

substitution out of longer-term bank deposits but, as the overall size

of the market for overnight deposits has expanded only a little faster

than the general pace of financial intermediation, this effect looks to

have been fairly small. Rather, most of the increase in banks'

overnight deposits probably came from the capture of market share

from merchant banks.

But while the entry of banks into the overnight market was a clear

example of banks gaining at the expense of non-banks, it was only

part of the general increase in the competitiveness of banks.

Deregulation also affected the relationship between banks and their

business through the non-bank subsidiaries they had set up to carry

out business they could not do themselves. This was particularly

the case for banks which had affiliated finance companies, and is

likely to have been a factor in the subdued performance of the

finance company sector since deregulation, where the four largest

corporations are wholly owned by major trading banks.

The overall effects of the many deregulatory changes that took place

are difficult to quantify but their significance can be seen in the shift

of overall market shares between banks and non-banks that took

place around this time.

Until the early 1980s, non-bank borrowing grew much faster than

M3. From 1968 to 1982, growth of non-bank borrowings averaged 22

per cent per year, while growth in M3 averaged 12 per cent.

However after 1981/82, this difference narrowed sharply.

percentage of total deposits held by NBFis and banks, both adjusted

and unadjusted for the effects of asset transfers associated with the

formation of new banks. During the period 1968 to 1982 the deposit

share of banks fell from nearly 80 per cent to about 55 per cent. This

trend has since been halted and partly reversed. The increase in the

in terms of credit rather than deposits. This is because banks have

been providing credit in ways which did not involve raising

deposits, in order to avoid the cost of SRDs (see Section 4 below).

%

1 5

BANK AND NBFI DEPOSIT SHARES

(per cent of total) %

100~------------------------------------------------~100

75 75

25 25

0

1969 1972 1975 1978 1981 1984 1987

4. Changes to SRD arrangements

While there were major changes in the behaviour of banks in the

early 1980s because of deregulation, some aspects of banks' behaviour

continued to be heavily influenced by remaining pockets of

their behaviour to take account of remaining regulations.

The main aspect of regulation that continued to have a major

impact on banks' behaviour was the Statutory Reserve Deposit

forms of funding other than domestic Australian dollar deposits,

and to shift away from direct lending and towards fee-for-service

activities such as bill acceptance and endorsement. Both these

incentives are borne out by the data for recent years which, up to late

1988, showed extremely rapid growth in bank bills on issue and

increased funding by banks through foreign currency and offshore

liabilities.

annual Financial Flow Accounts data; thereafter from data collected under the

Financial Corporations Act.

1 6

These developments had major implications for monetary and

financial aggregates. This is illustrated in Graph 8 by referring to the

growth in M3 and bank lending. Up to 1984, the two growth rates

were largely similar. Thereafter, however, bank lending began to

grow much faster than M3 as banks used non-deposit liabilities to

fund themselves.

GraphS.

BANK LENDING & M3

(Growth In 4 quarters ended)

25.-----------------------~----------------------~25

20 20

15 15

10 10

5 5

0

1980 1982 1984 1986 1988

Broader aggregates were also affected, as can be seen in Graph 9

which shows annual growth rates for four financial aggregates: M3;

broad money; lending to the private sector by all financial

intermediaries (AFI lending); and credit (loans to the private sector

by intermediaries plus bank bills outstanding).

1 7

Graph 9.

30

{Growth In 4 quarters ended)

30

25 Credit 25

20 20

'•"'' I 1'1

5 5

0 0

1984 1985 1986 1987 1988

The graph shows that, over the period from 1984 to 1988, the

monetary aggregates (M3 and broad money) grew at much lower

rates than the lending aggregate which, in turn, grew at a lower rate

than credit. Over the four years, AFI lending grew on average 4

percentage points per year faster than broad money, while credit

grew a little over 3 percentage points per year faster than AFI

lending. The factors behind these disparate growth rates have been

discussed in detail in other papers, in particular Macfarlane (1989)

and regular Reserve Bank Bulletin articles on financial

intermediation. The main ones were that:

banks met an increasing proportion of the public's needs for

finance by securitised loans (bills) rather than funded advances;

and

where banks did fund advances, they used instruments other

than Australian dollar deposits (e.g. foreign currency deposits,

bank bills, and capital).

1 8

The major factor behind these developments was the attempt by

banks to avoid the cost of SRDs. By providing finance through bills,

which could be on-sold in the market, a bank was able to earn a fee

for the service, but avoid the need to fund the loan and therefore

meet the cost of SRDs. Where a funded loan was provided, a bank

could still avoid the cost of the SRD by funding itself by foreign

currency deposits or issuing its own bills. Increases in capital, partly

associated with the entry of new banks, also provided funding for

advances.

Deregulation and development of financial markets made these

processes easier. For example, before 1984 banks were not able to

raise foreign currency deposits. Also, the rapid growth of the bank

bill market made it easier for banks to provide finance through this

means since it enabled them, after discounting a bill, to dispose of it

quickly without moving the prices of these securities. The growth of

the funds-management industry and the increased sophistication of

corporate treasury operations have also provided important avenues

for holdings of bills outside the balance sheets of financial

intermediaries.

These changes in behaviour mean that conventional lending

aggregates, which measure only funded advances, probably

understated the amount of finance facilitated by the financial

intermediaries. Conventional monetary aggregates, which measure

only the extent to which loans are funded through Australian dollar

deposits, understated the provision of finance even more so.

These distortions were substantially reduced following the

announcement of the winding down of the SRD system in the

Treasurer's Budget speech in August 1988. This removed the

disincentive to raising domestic deposits. There have been

significant changes to the monetary aggregates as a result.

In the December quarter 1988 there was a major re-arrangement in

banks' funding patterns, towards domestic deposits and away from

offshore funding and bill lines (See Graph 10). This appears to have

continued in recent months, though to a lesser extent. As a result of

this shift, M3 and broad money have increased at much faster rates

than other financial aggregates.

Over time, however, with the winding down of the SRD system, one

would expect that the growth rate of monetary aggregates would

move into line with that of credit aggregates.

o/o

1 9

Graph 10.8

FINANCIAL AGGREGATES

8r----------------------------------------------------r8

6

4

I

2 II

Broad Money

•••••

I

6

4

2

0

Mar 87 Jun 87 Sep 87 Dec 87 Mar 88 Jun 88 Sep 88 Dec 88 Mar 89

5. Conclusion

Changes in regulations governing banks have allowed a dramatic

change in bank behaviour over the past decade. The removal of

restrictions on interest rates and maturity of liabilities allowed

trading banks to move from being asset managers to being liability

managers. The shift initially was gradual following the 1973

deregulation of the CD, but accelerated following the freeing of other

bank deposits rates in late 1980, and was largely completed post-1984.

For savings banks, this transition started later, as the restrictions on

home-loan rates remained in force even after most other restrictions

had been lifted.

The move from asset management to liability management has

implications for the interpretation of monetary aggregates since,

under liability management, the stock of money tends to be demanddetermined

and a coincident rather than a leading indicator of

economic activity. The analysis by Bullock, Morris and Stevens of

the relationship between financial aggregates and economic activity

establishment of new banks.

20

over the past two decades showed that M3 did in fact change from

being a leading to a coincident indicator.

The change from asset management to liability management also

means that monetary aggregates can be subject to large fluctuations

in response to shifts in the methods of funding by banks. An

example of this was the SRD induced shift away from conventional

deposits to other forms of funding, and the reversal of this following

the change to SRD arrangements last September. The relationship

between monetary aggregates and economic activity could therefore

become unstable, as found by Bullock, Morris and Stevens.

The announced change to SRD arrangements in August 1988

removed a major incentive for banks to avoid funding themselves

through conventional deposits, and brought growth in monetary

aggregates more into line with that of lending and credit aggregates.

21

APPENDIX: CHANGES TO BANK REGULATIONS

This appendix outlines:

(1) a summary of major regulations affecting banks in 1968;

and

(2) subsequent significant changes to these regulations.

Regulations in 1968

The powers given to the Reserve Bank (RBA) under the Banking

Act (1959) were extensively used to control the activities of the

trading and savings banks.

Savings Banks

Savings banks were required to invest:

100 per cent of depositors' funds in cash, deposits with the

Reserve Bank, deposits with and loans to other banks, securities

issued or loans guaranteed by the Commonwealth or a State,

securities issued or guaranteed by an authority constituted by or

under an Act, housing loans or other loans on the security of

assets);

at least 65 per cent of depositors' funds in cash, Reserve Bank

deposits, Commonwealth or State Government securities and

securities issued or guaranteed by Commonwealth or State

Government authorities (llprescribedllassets); and

at least 10 per cent of depositors' funds in deposits with the

assets).

Savings bank deposit rates were fixed, personal loan rates were

subject to the same maximum as trading bank personal loans, and

housing loan rates were subject to the maximum rate on trading

bank overdrafts. There was a restriction of $10,000 on the maximum

interest-bearing amount in any single deposit, and no deposits could

be accepted from trading or profit-making bodies.

22

Trading banks were subject to the SRD ratio, which required a

percentage of Australian dollar deposits to be kept in SRD accounts

with the Reserve Bank. The percentage could be varied as a

monetary policy tool. The interest payable on these accounts was

generally substantially below market rates (and was 0.75 per cent in

1968).1

The major trading banks were parties to the LGS convention, which

provided for 18 per cent2 of depositors' balances to be kept in liquid

assets, comprising notes and coin and deposits with the Reserve

Bank (excluding SRDs), and/ or Treasury notes and other

Commonwealth Government securities. The other trading banks

also had agreements with the RBA to hold certain minimum liquid

assets.

Deposits and loans were subject to maximum interest rates and fixed

deposits were subject to minimum maturities of 3 months and

deposits (of $100,000 and over) for periods of 30 days to 3 months

subject to a maximum rate.

Term and farm loan funds were set up, partly funded by the banks

and partly from the SRD accounts. Term loan funds could be used

for fixed-term lending to the rural, industrial and commercial fields,

and to finance exports. The loans were subject to a minimum term

of 3 years and a maximum term of 8 years. Farm development loans

were made for development purposes to rural producers and were

subject to a maximum term of 15 years.

The SRD ratio was adjusted frequently over the period 1968 to 1981 and ranged

between 3 and 10 per cent. The ratio was last used as a tool of monetary policy

are set out in Table C.S in the Reserve Bank Bulletin.

23

Quantitative Controls

Since the early 1960s, the RBA had used quantitative controls on

bank lending in its monetary policy. Initially, gross new trading

bank approvals were subject to RBA guidelines, with net new

approvals being subject to controls in later periods. In the late 1970s

and early 1980s, growth in trading bank total advances was subject to

control.

Major changes since 1968

1968

May

1969

March

Banks were given approval to undertake lease

financing outside the maximum overdraft arrangements.

Approval was given for banks to issue certificates of

deposit over terms of three months to two years, for

amounts over $50,000, subject to a maximum interest rate.

Savings banks were allowed to introduce progressive

savings accounts at interest rates up to 1 per cent

higher than ordinary deposit accounts. The

maximum amount on which interest could be paid

was set at $10,000.

December- Savings banks were allowed to offer investment

accounts, subject to a minimum balance of $500,

minimum transactions of $100, three months notice

of withdrawal, and a maximum interest rate.

1970

March

April

Savings bank deposit rates could be varied subject to

the maximum rate set by the Reserve Bank.

The maximum interest-bearing amount in any single

savings bank account was increased from $10,000 to

$20,000.

24

October The savings bank prescribed asset ratio was reduced

from 65 per cent to 60 per cent.

December - The maximum term on trading bank fixed deposits

was increased from two to four years.

1971

August

1972

February

1973

The minimum balance on savings bank investment

accounts was reduced from $500 to $100 and the

minimum transaction requirement was dropped.

The maximum interest rate on overdrafts and

housing loans over $50,000 was removed, and

interest rates on these larger loans became a matter

for negotiation between banks and their customers.

Trading banks were given increased freedom to

negotiate interest rates on deposits greater than

$50,000, subject to a maximum rate, for terms

between 30 days and four years.

April The interest-bearing limit on savings bank

investment accounts was lifted from $20,000 to

$50,000.

September - The interest rate ceiling on certificates of deposit was

removed, and the maximum term was extended

from two to four years.

1974

March The interest-bearing limit on savings bank ordinary

and investment accounts was lifted, and the 3-

month notice requirement replaced by one month's

notice, after a 3-month minimum term.

September - The savings bank prescribed asset ratio was reduced

to 50 per cent, and the liquid assets ratio cut to 7.5 per

cent.

1975

January

1976

25

The agreement between banks to maintain a

contrary to the Trade Practices Act.

February The maximum overdraft and housing loan interest

rates were extended to loans drawn under limits of

less than $100,000.

November - The interest rate payable on SRDs was increased to 2.5

per cent.

1977

May

1978

The savings bank prescribed asset ratio was reduced

to 45 per cent.

August The savings bank prescribed asset ratio was reduced

to 40 per cent.

September - The maximum maturity for trading banks' term

loans was increased to 10 years.

October The three-month initial notice requirement on

savings bank investment accounts was reduced to

one month, and the minimum balance requirement

was removed.

1980

February Savings bank statement accounts were introduced.

May Banks could apply to the Reserve Bank to increase

their equity in money market corporations to a

maximum of 60 per cent.

December - Interest rate ceilings on all trading bank and savings

bank deposits were removed.

26

1981

August The mm1mum term on certificates of deposit was

reduced to 30 days.

November - Trading banks could offer line of credit facilities,

comprising a limit to be drawn down at any time

with a minimum monthly amount to be repaid; the

interest rate to be subject to the maximum applying

to personal loans for limits of less than $100,000.

1982

March

May

June

August

The minimum term on trading bank fixed deposits

was reduced from 30 to 14 days for amounts greater

than $50,000, and from three months to 30 days for

amounts less than $50,000. The minimum term for

certificates of deposit was also reduced to 14 days.

Savings banks were allowed to accept fixed deposits

less than $50,000 for terms between 30 days and 48

months.

The requirement of one month's notice of

withdrawal on savings bank investment account was

removed.

The interest rate payable on SRDs was increased to 5

per cent.

The Reserve Bank announced the ending of

quantitative bank lending guidance.

Savings bank specified assets requirement was

reduced to 94 per cent to allow a "free choice" tranche

of 6 per cent.

The 40 per cent prescribed asset ratio and the 7.5 per

cent liquid assets ratio for savings banks were

replaced by the Reserve Assets Ratio (RAR). This

ratio required 15 per cent of depositors' balances be

held in RBA deposits, CGS and cash.

August

1983

27

Savings banks were allowed to accept deposits of up

to $100,000 from trading or profit making bodies.

December - The Australian dollar was floated, and most foreign

exchange controls were removed.

1984

August All remammg controls on bank deposits removed.

This included the removal of minimum and

maximum terms on trading and savings bank

deposits, and removal of restrictions on the size of

savings bank fixed deposits. This allowed banks to

compete for overnight funds in the short-term

money market.

Savings banks were permitted to offer chequeing

facilities on all accounts, and the $100,000 limit on

deposits by a trading or profit making body was

removed.

The 60 per cent limit on banks' equity in merchant

banks was lifted.

September - The Treasurer called for applications for new

banking authorities.

1985

February

April

Sixteen foreign banks were invited to take up

banking authorities.

The remaining ceilings on bank interest rates were

removed, with the exception of owner-occupied

housing loans under $100,000.

28

May The Prime Assets Ratio (PAR) replaced the LGS

convention. Twelve per cent of each bank's total

liabilities in Australian dollars, (excluding

shareholders' funds), within Australia, had to be

held in prime assets, comprising notes and coin,

balances with the Reserve Bank, Treasury notes and

other Commonwealth Government securities, and

loans to authorised money market dealers secured

against CGS. Fund in SRDs up to 3 per cent of total

deposits could also be included as prime assets.

November - Definition of PAR denominator extended.

1986

April

1987

April

1988

August

The interest rate ceiling on new housing loans was

removed. Existing loans remained subject to the

previous maximum interest rate of 13.5 per cent.

The savings bank reserve asset ratio was reduced to

13 per cent.

The Reserve Bank issued guidelines for a risk-based

measurement of banks' capital adequacy, broadly

consistent with the proposals developed by the Bank

for International Settlements.

The Treasurer announced the abolition of the SRD

requirement and the removal of the distinction

between trading and savings banks.

29

September - From 27 September, the SRD ratio was reduced to

zero, and the funds in SRD accounts transferred to

"non-callable deposits". All banks (trading and

savings banks) would be required to hold one per

cent of their liabilities (excluding shareholders funds)

in Australia in the form of non-callable deposits.

The excess of the non-callable deposits over the

minimum requirement would be returned to banks

over a three-year period.

The distinction between savings and trading banks

cannot be totally removed without amendments to

legislation. As an interim step, the "free tranche// of

savings banks was increased from 6 to 40 per cent

effective from 30 September.

- PAR reduced from 12 to 10 per cent. Banking

(Savings Banks) Regulations amended to permit PAR

as it applies to trading banks to replace RAR.

30

Bullock, M., Morris, D., and Stevens, G., (1988), "The Relationship

Between Financial Indicators and Activity: 1968-1987",

Reserve Bank of Australia Research Discussion Paper No.

8805, August.

Bullock, M., Stevens, G., and Thorp, S., (1988), "Do Financial

Aggregates Lead Activity? A Preliminary Analysis",

Reserve Bank of Australia Research Discussion Paper No.

8803, January.

Gramley, L.E., (1982) "Financial Innovation and Monetary Policy",

U.S. Federal Reserve Bulletin, July.

Macfarlane, I.J., (1989), "Money, Credit and the Demand for Debt",

Reserve Bank Bulletin, May.

Phillips, J.G., (1971), "Developments in Monetary Theory and

Policies", The Fifth R.C. Mills Memorial Lecture, Sydney

University Press, April.

Reserve Bank of Australia (1984), "Monetary Aggregates as Monetary

Indicators", Reserve Bank Bulletin, May.

Reserve Bank of Australia, "Financial Intermediation", Reserve

Bank Bulletin, various.

Stevens, G., and Thorp, S., (1989), "The Relationship Between

Financial Indicators and Economic Activity: Some Further

Evidence", Reserve Bank of Australia Research Discussion

Paper No. 8903, July.