RDP 8904: Changes in the Behaviour of Banks and their Implications for Financial Aggregates 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 demand-determined 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 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.