RDP 8904: Changes in the Behaviour of Banks and their Implications for Financial Aggregates 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 aggregates. It complements an earlier paper by Bullock, Morris and 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 financial aggregates to change. It is discussed in detail in Section 2 of this paper.

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.