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an economic review by the Federal Reserve Bank o f Chicago MBHCs: Evidence after two decades of regulation december 1976 NOTICE The econom ic review of the Federal Reserve Bank of Chicago w ill become a bim onthly publication in 1977. Sub scribers w ill receive six issues per year plus a copy of the bank’s most recent Annual Report. Direct any inquiries to: Public Information Center Federal Reserve Bank of Chicago P.O. Box 834 Chicago, Illinois 60690 (312) 322-5115 MBHCs: Evidence after two decades of regulation 3 Multibank holding companies (MBHCs) have grown at a rapid pace in the recent past. This growth has sustained a bitter controversy regarding the influence o f MBHCs on the structure, conduct, and performance of the nation’s banking system. Some states are currently contemplating relaxation of statutory restrictions on MBHCs while others have passed or have under consideration legislation to further restrict or prohibit MBHC activity. This article spotlights the findings o f recent research on specific issues regarding MBHC banking operations, thereby providing a clearer picture o f the position of MBHCs in today’s financial world. Subscriptions to Business Conditions are available to the public free of charge. For inform ation concerning bulk mailings, address inquiries to Public Inform ation Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690. A rticles may be reprinted provided source is credited. Please provide the bank’s Public Inform ation Center with a copy of any material in w hich an article is reprinted. Business C o n d itio n s, D e c e m b e r 1976 3 MBHCs: Evidence after two decades of regulation The history of the hank holding company movement and the legislative history of the Bank Holding Company A ct of 1956 and its subsequent amendments have been traced in a series o f previous Business Con ditions articles: July 1970, August 1973, February 1975, and April 1975. Although multibank holding com panies have existed for approximately three-quarters o f a century, they main tained a relatively low profile until recent ly . M u ltib a n k h old in g com panies (MBHCs) were established as alternatives to branching systems in many states where branching was prohibited. In the 1940s t he independent bankers associations and others focused attention on holding companies, seeing them as a threat to competition and free enterprise in the banking sector. Ultimately, the Bank Holding Company Act of 1956 was passed, defining a holding company (HC) as a com pany controlling two or more banks. Onebank holding companies, considered in nocuous, were virtually ignored. This definition prevailed through the 1966 amendments to the act, and allowed onebank holding companies to expand unen cumbered into nonbanking areas, a loophole they did not take advantage of for over a decade. In 1966, however, one-bank holding companies began to grow at a rate that can only be described as “ explosive.” As a result, the 1970 amendments to the act redefined a bank holding company to in clude companies controlling only one bank. The rapid expansion program of MBHCs in the early 1970s has sustained the bitter controversy regarding the merits of HCs and has led to attempts to either enact or broaden HC legislation. Despite our historical experience the issues regarding MBHCs tend to be con fused and the available evidence muddled by both opponents and proponents. This article examines the principal issues con cerning the banking aspects of MBHCs in terms of both logic and recent evidence. Such issues include the availability of ser vices, concentration and competition, pric ing, operating efficiency, profitability, bank soundness, allocation of funds, and the benefits of regulations promulgated by the Board of Governors of the Federal Reserve System. A subsequent article will examine the nonbanking aspects of holding companies. Availability of services Incorporated in every multibank holding company application to acquire a banking firm is a statement describing the post-acquisition changes the MBHC plans to introduce and indicating how these changes will benefit the public served by the prospective affiliate. The proposed ser vices frequently include new, improved or expanded types o f credit (e.g., increased consumer credit and the introduction of NOTE: Numbers in brackets [ ] refer to the numerically listed bibliography on pages 8 and 9. Citations are either to studies whose results are described in this article or to scholarly elaborations of topics discussed. 4 specialized business credit) and the estab lishment of trust and international ser vices, and specialized deposit-type services. How frequently the MBHC actually fulfills its preacquisition promises is, at present, a point of conjecture. The effect of MBHC affiliation on the availability of two typically proposed services, trust ser vices and new types of credit, has been tested analytically by a number of researchers. Various measures of the volume or changes in the volume of such services have been examined. For exam ple, increased trust department services might be suggested by an increase in the ratio of trust revenue to total revenue or total assets. One study found that MBHC affiliates have a significantly higher ratio of trust revenue to total revenue than in dependent banks [25], but another found no relation between affiliation and the ratio of trust revenue to total assets [2 1 ]. The evidence on the expansion of credit is clearer. If MBHC affiliation leads to an expansion of consumer credit, the ratios of consumer loans to total assets or total loans should rise. Several studies found this relationship does exist [25, 31, 44, 53]. The expansion of business credit would be reflected in an increase in the ratio of commercial and industrial loans to either total assets or total loans. Evidence indicates that affiliation produces a highly significant increase in the ratio of business loans to total loans [25], but a similar rela tion of such credit to total assets was not found [13, 21, 31, 39, 54]. The available evidence suggests that MBHC affiliation produces some slight enlargement in the availability of banking services, but most of the proposed changes have not been examined. Concentration and competition Opponents of MBHCs have long argued that restraints imposed on MBHC Federal Reserve B ank of C h icago growth benefit the public by providing safeguards against an “ undue concentra tion of banking resources” while, at the same time, encouraging competition among banks. To determine the validity of this argument, the concept of concentra tion should be examined and clarified. In economics concentration refers to the proportion of a given type of economic activity performed (and thus “controlled” ) by a few of the largest firms in an industry. Measures frequently used in industry studies to indicate concentration are the share of total assets or sales accounted for by the largest, typically four or eight, firms in the industry. Measures frequently used in studies of financial industries are the share of total assets and total deposits. The phrase “ increased concentration” con notes that a given number of firms now control a larger portion of the measure than previously. Concentration can be viewed at various levels, each corresponding to a different geographic delineation. First, concentration can be viewed in terms of the national economy where one might wish to investigate the magnitude of total U.S. commercial bank deposits held by the largest 1 00 or 2 0 0 banking organizations. Second, concentration can be examined at the state level to find the proportion of state banking deposits held by the three, four, or five largest banking organizations. Third, concentration can refer to the share of assets or deposits held by the largest three, four, or five banking organizations in a local banking market, with the market approximated by a standard metropolitan statistical area (SMSA) or county. These three concepts of concentration are signifi cant for different reasons, and the in ferences drawn from analysis of each of these measures need not be consistent. Nationwide concentration. Measured by the percentage of total domestic deposits held by the 1 0 0 largest banking organizations, nationwide concentration Business C o n d itio n s, D e c e m b er 1976 fell from 49 percent to 47 percent during the 1968-73 period [55], This occurred despite a rapid increase in MBHC formations and acquisitions during this same period, in particular 1970-73. The share of total deposits held by MBHCs increased two and one-half times during the 1968-73 period and doubled in the 1970-73 period. This decline in national concentration reflects the fact that the total growth of the largest banking organizations was less than the growth in total deposits national ly and also less than the total growth of those banking organizations not in the top 100. It appears that national concentration is not, at the present time, a particularly pressing issue. This is not meant to suggest, however, that nationwide concen tration and its relation to MBHCs can be ignored. HC acquisitions did have the effect of raising nationwide concentration in 1973 by approximately 2.3 percentage points above the level that otherwise would have prevailed [55]. Statewide concentration. In the 196873 period concentration at the state level, measured by the percentage of statewide deposits held by the largest five banking organizations, increased in 28 states, declined in 2 2 states, and remained un changed in one state (the District of Colum bia is treated as a state), with the average increase for all states about 1 percentage point [55]. Of those states allowing MBHCs, a larger percentage had increases in concen tration than states which prohibited them. Conversely, the percentage of states ex periencing decreases in concentration was much higher for those states prohibiting MBHCs than for states allowing MBHCs. In short, increases in state concentration tend to occur in states allowing MBHCs, while concentration tends to decline in states prohibiting MBHCs [55]. In the 38 states allowing MBHCs, con centration was higher in 1973 than it would have been in their absence [55]. In 5 creases in concentration occurred most often in unit banking states and least often in statewide branching states, an expected result since MBHC affiliation is an alter native to branching. Additionally, the effect of MBHC acquisitions on concentra tion is greatest in states with previously low or moderate concentration and negligi ble in states with high concentration. Thus, the effect of MBHC acquisition on statewide concentration is fairly clear. Its impact, in general, is either to increase concentration or to moderate its decline and is greatest in unit banking states and states with low to moderate levels of concentration [55]. Local market concentration. Despite the greater publicity given to trends in national and statewide concentration, local market concentration is, from an economic point of view, undoubtedly the most important of the three concentration measures. This is because the term “market” refers to a geographic area where buyers and sellers are in sufficiently close proximity to each other for exchange and competitive interaction to occur. Moreover, it is generally agreed that the greater the degree of concentration within a market thus defined, ceteris paribus, the lower the degree of competition. For this reason the Board of Governors sometimes rejects applications to acquire banks in markets where the HC is already represented. Entry into new markets. An important factor affecting concentration at the local market level is the way MBHCs enter new markets. Three types of entry are available: de novo entry, acquisition of a small bank (foothold entry), and acquisi tion of a leading bank (i.e., a relatively large bank) in the market. Of the three the acquisition of a leading bank has the greatest potential for anticompetitive effects. Because all HC acquisitions must be approved by the Federal Reserve Board of Governors, which has not hesitated to deny applications where existing or poten 6 tial anticompetitive effects are present, the number of leading bank acquisitions has been minimized [9, 50]. At the other extreme there is little ques tion that the greatest potential for procompetitive effects is through de novo expansion, which either introduces a new competitor into a market or intensifies the already existing competition. This type of entry is the most difficult for the firm since it is expensive, entails considerable risk, and requires considerable time for the es tablishment of a clientele. Indeed, many markets simply may not be conducive to de novo entry. In recent years the number of de novo banks established by MBHCs has increased substantially, but the majority have been in markets where the MBHC is already represented [9, 16]. Because of the problems associated with de novo entry and Board-imposed regulatory constraints on leading bank ac quisitions, the predominant type of entry is foothold entry. This type of entry can have procompetitive effects when the MBHC ac quires a small bank in a market and uses its resources (e.g., management services, advertising, etc.) to strengthen the affiliate and make it a more viable competitor. If this occurs, the rate of growth of deposits and/or the market share of the affiliate will increase. Numerous studies have attempted to ascertain whether banks acquired by MBHCs have grown at the expense of in dependent banks and what the impact of such growth on local market concentration has been. The results are essentially as follows: 1 ) No significant change in the market share of the affiliated banks vis-avis banks remaining independent was found in two studies [2 1 , 62], while, ac cording to two other studies, MBHC entry may have led to a decline in market concen tration [35, 57]; 2) In a study utilizing banking “ districts” (SMSAs and county areas) as proxies for markets in three states, it was found that, although MBHC Federal Reserve B ank of C h icago affilation had minimal impact on concen tration, markets experiencing MBHC ac tivity had lower initial concentration than districts where no MBHC activity occurred [33]; 3) Neither leading bank nor foothold acquisitions by MBHCs were found to have a significant impact on market shares [15]; and 4) Neither the difference in deposit growth rates between affiliated and independent banks [31] nor the difference in the growth rates of acquired banks before and after affiliation was found to be significant [ 1 1 ]. Based on observations at the national and/or state level, adversaries of MBHCs contend that a consequence of allowing this type of organization is an increase in concentration and a reduction in competi tion [12, 23]. While increases in concentra tion at these levels are not unimportant and could potentially lead to problems (perhaps carrying more political than economic overtones), there is no evidence of any relationship between aggregate con centration and local market competition. Rather, with regard to most classes of customers and types o f bank services, the localized geographic market definition is more appropriate for drawing inferences about the impact of changes in concentra tion upon the extent of competition. Moreover, research has not found a signifi cant positive relationship between MBHC affiliation and increases in local market concentration, whether the affiliation is with a leading bank or a bank with a relatively small share of the market, as measured either directly by market share or indirectly by rate of growth of deposits. What local market concentration would be in the absence of the Bank Holding Com pany Act and regulation by the Board of Governors is a different question. One must suspect, however, that local market concentration would be higher in the absence of Board regulation, given the B o a rd ’ s in clin ation to deny anti competitive acquisitions [49]. Business C o n d itio n s , D e c e m b er 1976 Prices of bank services A number of aspects of bank perfor mance are influenced by the degree of com petition (and concentration), the most im portant being the pricing of bank services. In particular, it is generally believed that an increase in concentration produces higher prices (and poorer service) while deconcentration produces lower prices (and perhaps better service). (For some evidence on this see [19]). However, there are several ways this relation between con centration and pricing may be obscured unless several other factors, including MBHC affiliation, are taken into account. One way in which MBHCs may affect the relationship between concentration and prices is through the threat of de novo entry into a market, a threat that is of max imum effectiveness in states not having geographic or home office protection. If the incumbent firms (or a monopoly firm) an ticipate that charging the short-run profit maximizing price will result in profits large enough to induce de novo entry by MBHCs into that market, the incumbent firms may be induced by this “ potential competition” to charge a price less than the profit maximizing one, accept a lower rate of profit in the short run (but perhaps enhancing long-run profitability), and possibly offer more services. In so doing, incumbent banks may be able to forestall entry and maintain their quasi-monopoly status. The threat of entry, nonetheless, has performed a useful purpose in that market performance is now more com petitive. Potential entry by firms not presently competing in the market is not operative in states which prohibit MBHCs or have geographic or home office protection. MBHC affiliation may also affect prices through its effect on bank operating efficiency (as discussed in more detail in the following section). If affiliation im proves the bank’s efficiency, prices charged 7 for bank services by MBHC subsidiaries should fall after affiliation (albeit not necessarily in proportion to the decline in costs) regardless of the market structure involved. Still another way in which MBHC af filiation may affect the prices of bank ser vices is through reduction in risk. By reduc ing default risk through geographic and portfolio diversification and reducing li quidity risk due to deposit variability [2 0 ], affiliation with an MBHC may enable a bank to reduce its liquid assets, thereby releasing funds for higher-yielding loans and lowering the interest rates it charges. Finally, MBHC affiliation can affect prices through its impact on the allocation of funds. Affiliation can improve the flow of funds among the many markets served by an MBHC and allow funds to seek their most profitable uses. MBHC affiliation is not a necessary condition for re distributing credit across markets since in dependent banks can accomplish the same purpose through the federal funds market. It is not possible, a priori, to determine the relative influence of each of the forego ing factors upon the pricing of bank ser vices. It appears, nevertheless, that MBHCs have the potential for charging lower prices than independent banks. Interest rates on loans. Proponents of MBHCs argue that increased operating ef ficiency and a more competitive spirit should result in lower average loan rates being charged by banks affiliated with MBHCs. Studies examining this question have focused on total loans without con sidering the component parts (i.e., con sumer, mortgage, and commercial loans) largely because income data by component are not available. In addition, the mix or composition of loans has not been con sidered. 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E x ten d in g M e rg e r A n a ly sis B e y o n d th e S in g le -M a r k e t F ra m ew o rk . W ash in g ton : B oard o f G o v ern ors o f the F ederal R eserve S ystem , S ta ff E co n o m ic S tu d y (86), 1976. 33. L igh t, J a c k S. “ B an k H old in g C om p a n ies— C on cen tra tion L evels in T hree D istrict S ta tes.” B u sin ess C on d ition s, F ederal R eserve B an k o f C h ica g o , Ju n e, 1975, 10-15. 49. R osen blum , H a rvey. “ A C ost-B en efit A n a ly sis o f the B an k H o ld in g C o m p a n y A ct o f 1956.” U n p ublished paper p resented at the W estern E con o m ic A s s o cia tio n C o n feren ce, S an F ra n cisco, C a lifo rn ia , June, 1976. 34. L igh t, J a c k S. “ E ffects o f H old in g C om p a n y A f filia tion on D e N o v o B a n k s.” In P roceed in g s o f a C o n fere n ce on B a n k S tructu re an d C om p eti tio n . C h ica g o : F ederal R eserve B an k o f C h ica g o , 1976, 83-106. 35. M artell, T erren ce F. a n d H ooks, D on ald L. “ H o ld in g C o m p a n y A ffilia tio n s and E co n om ies o f S ca le.” J ou rn a l o f th e Midwtest F in a n ce A s so cia tio n , 1975, 59-71. 36. M a y e r , R. C h a rles a n d S u ssn a , E dw ard. “ R egistered B an k H old in g C o m p a n y A cq u isi tion : A C ross-S ection A n a ly s is .” J ou rn a l o f F in a n cia l a n d Q u a n tita tiv e A n a ly sis, V III (Septem ber, 1973), 647-61. 37. M cL eary, J o e W . “ B an k H old in g C om p a n ies: T h eir G row th a n d P erform a n ce.” M o n th ly R eview , F ederal R eserve B an k o f A tla n ta , O c tober, 1968, 131-38. 38. M in g o, J o h n J. “ C ap ita l M a n a gem en t and P ro fita b ility o f P rosp ective H old in g C om p a n y B a n k s.” J ou rn a l o f F in a n cia l an d Q u a n tita tiv e A n a ly sis, (June, 1975), 191-203. 39. M in g o, J o h n J. “ M a n a gerial M otives, M arket Structures a n d the P erform a n ce o f H old in g C o m p a n y B a n k s.” E con om ic In q u iry, X IV (S eptem ber, 1976), 411-24. 40. M ote, L arry R. “ T h e P eren nial Issue: B ranch B a n k i n g .” B u s i n e s s C on d ition s, Federal R eserve B an k o f C h ica g o , F ebruary, 1974,1-23. 41. M u llin ea u x, D on a ld J. “ B ra n ch V ersu s U nit B a n k in g: A n A n a ly s is o f R ela tive C osts.” In C h a n g in g P e n n s y lv a n ia ’s B ra n ch in g L a w s: A n E co n o m ic A n a ly sis. T e ch n ica l Papers. P h i l a d e lp h ia : F e d e r a l R eserve B an k o f P h ila d elp h ia , 1973. 42. M u llineaux, D on a ld J . “ E con om ies o f S ca le o f F in a n cia l In stitu tion s.” J ou rn a l o f M o n eta ry E co n o m ics, I (A p ril, 1975), 233-40. 43. M u rphy, N eil B. “ C o st o f B a n k in g A ctiv ities: In tera ction s B etw een R isk and O p eratin g C osts: C o m m en t.” J ou rn a l o f M o n ey , C redit, and B a n k in g , IV (A u gu st, 1972), 614-15. 44. M u rphy, N eil B. an d W eiss, Steven J. “ T h e E ffect o f C on cen tra tion on P erform a n ce: E va lu a tin g S tatistical S tu dies.” M a g a zin e o f B a n k A d m in istra tion , X L V (N ovem b er, 1969), 61-63. 45. P iper, T h o m a s R. T he E co n o m ics o f B a n k A c q u isition s b y R eg ister ed B a n k H old in g C om p a n ies. R esearch R ep ort N o. 48. B oston : Federal R eserve B an k o f B oston , 1971. 46. P iper, T h o m a s R. a n d W eiss, S teven J. “ T he P ro fita b ility o f B an k A cq u isitio n s b y MultiB an k H old in g C om p a n ies .” N ew E n gla n d E co n o m ic R ev ie w , Federal R eserve B an k o f B oston , S e p te m b e r/O cto b e r 1971, 2-12. 47. P iper, T h o m a s R. a n d W eiss, S teven J. “ T he P rofita b ility o f M u ltib an k H old in g C om p a n y A cq u isitio n s.” J ou rn a l o f F in a n ce, X X X IX (M a rch , 1974), 163-74. 50. R osen blum , H a rvey. “ B an k H o ld in g C o m p a n ies— art II,” B u sin e ss C on d ition s, Federal -P R eserve B an k o f C h ica g o , A p ril 1975,13-15. 51. Schw eitzer, Stuart A . “ E co n o m ie s o f S ca le an d H old in g C o m p a n y A ffilia tio n in B a n k in g .” Southern E co n o m ic J ou rn a l, X X X IX (O ctober, 1972), 258-66. 52. S ilverberg, S ta n ley C . “ B an k H o ld in g C o m p a n ie s and C apital A d e q u a c y .” J ou rn a l o f B a n k R esea rch , V I (A utum n, 1975), 202-7. 53. T a lley , S am uel H. “ D ev elopm en ts in the B an k H old in g C o m p a n y M o v e m e n t.” In P ro c eed in g s o f a C o n fere n ce on B a n k S tructu re an d C om p etitio n . C h ica g o : F ederal R eserve B an k o f C h ica g o , 1972, 1-17. 54. T a lley , Sam uel H. The E ffe c t o f H o ld in g C o m p a n y A cq u isitio n on B a n k P erfo rm a n ce. W ash in g ton : B oard o f G o v ern ors o f the Federal R eserve S ystem , S ta ff E co n o m ic S tu dy (69), 1972. 55. T a lley , Sam uel H. The Im p a ct o f H o ld in g C om p a n y A c q u isitio n s on A g g r e g a te C o n cen tra tio n in B a n k in g. W a sh in g ton : B oard o f G o v e rn o rs o f the Federal R eserve S ystem , S ta ff E co n o m ic Study (80), 1974. 56. V arvel, W alter A . “ A V a lu a tio n A p p ro a ch to B a n k H o ld in g C o m p a n y A c q u is it io n s .” E con o m ic R ev iew , F ederal R eserve B an k o f R ich m on d , J u ly /A u g u s t, 1975, 9-15. 57. W are, R obert F. “ B a n k in g C o n ce n tra tio n in O h io .” E c o n o m i c C o m m e n ta r y , Federal R eserve B an k o f C lev elan d , N ovem b er 24,1975. 58. W are, R obert F. “ C h a ra cteristics o f B an k s A c quired b y M ultiple B an k H o ld in g C o m p a n ie s in O h io .” E co n o m ic R ev iew , Federal R eserve B an k o f C lev elan d , A u gu st, 1971, 19-27. 59. W are, R obert F. “ P e rform a n ce o f B an k s A cq u ired b y M ulti-Bank H o ld in g C o m p a n ie s in O h io .” E con o m ic R ev iew , Federal R eserve B an k o f C levelan d , M a r c h /A p r il, 1973, 19-28. 60. W eiss, Steven J. “ B an k H o ld in g C o m p a n ie s an d P u b lic P o lic y .” N ew E n g la n d E co n o m ic R eview , F ederal R eserve B an k o f B oston , J a n u a ry /F e b ru a ry , 1969, 3-27. 61. W eiss, Steven J. “ F a ctors A ffe ctin g B an k S truc ture C h a n ge: T h e N ew E n g la n d E xp erience, 1963-74.” The N ew E n gla n d E co n o m ic R ev ie w , Federal R eserve B an k o f B oston , J u ly /A u g u s t 1975, 16-25. 62. W hitehead, D a v id D. and K in g , B. Frank. “ M ultibank H o ld in g C om p a n ies a n d L ocal M a rk e t C o n ce n tra tio n .” M o n th ly R ev iew , Federal R eserve B an k o f A tla n ta , A p ril, 1976, 34-43. 10 between average interest on loans and MBHC affiliation will likely be negative. A number of studies have investigated this relation between MBHC affiliation and interest received on total loans. In several studies it was found that affiliates charge lower average rates on all loans than their independent counterparts [2 1 , 30, 37]. Other studies, however, could find no significant relationship between HC af filiation and loan interest rates [31,34,54, 59]. On the other hand, a risk-adjusted average loan interest rate, defined as loan interest minus the loan loss provision, was found to possess a highly significant positive relation with MBHC affiliation [25]. Whether this variable actually measures a riskless loan rate is open to question. On balance, however, the evidence suggests that the effect of MBHC affiliation has in some instances resulted in lower interest charges on loans. Interest rates on deposits. If MBHC af filiation does improve operating efficiency and/or increase competition, affiliates should be able to pay higher interest rates on time and savings deposits than in dependent banks. Evidence indicates that this is indeed the case [13,25,34]. This con clusion must be tentative, however, since the mix of time-to-savings deposits has not been taken into account. Past studies have assumed that affiliate and independent banks have the same proportion of each, which, while satisfactory as a first ap proximation, has not passed the test of statistical scrutiny. If this assumption is not valid, a systematic bias may be in troduced into studies of the relationship between MBHC affiliation and interest on time and savings deposits. For example, if MBHC affiliates are more aggressive than independent banks in their attempts to ac quire time deposits, the average interest rate paid on time and savings deposits will be overstated for affiliates relative to in dependent banks because time deposits generally carry higher interest rates than Federal Reserve B ank o f C h icago savings deposits. Unfortunately, figures on the deposit mix became available only recently, and there is no breakdown of in terest expense between time and savings deposits. Service charges on demand deposits. Several studies have investigated service charges. While the evidence is not totally clear, it appears that MBHC affiliates have higher service charges than indepen dent banks [13,30,31], although one study did find a weak negative relationship [54]. Previous studies have not examined the reasons for the higher service charges. In view of the repeated findings that MBHC affiliates tend to offer more ser vices than independent banks, service charges may constitute reimbursement for these services. Without further evidence, explanations of this relationship amount to little more than informed speculation. Operating efficiency Proponents of MBHCs assert that one advantage of joining an MBHC organiza tion is economies of affiliation, that is, im proved operating efficiency for the ac quired bank. This argument is usually couched in terms o f the affiliate having greater flexibility in deciding whether to “ produce or buy” various productive ser vices. If this argument is correct, the per unit cost (or total cost) for a given level of output should be less for MBHC affiliates than for independent banks. The empirical results, however, do not entirely substan tiate this view. One study reported that affiliate banks in the $3.5 million to $25 million asset size class, particularly those belong ing to a large HC group, are more efficient, i.e., subject to economies of affiliation [51]. This finding is contradicted somewhat by a second study [41] which found no signifi cant change in cost when an MBHC ac quired a unit bank, but did find a signifi cant increase in cost when an MBHC ac Business C o n d itio n s, D e c e m b er 1976 quired a bank with branches. The latter finding is probably attributable to the duplication of functions involved in com bined branch-holding company systems. Other studies have investigated the same problem by examining different ef ficiency ratios rather than by estimating the cost functions directly. Evidence in dicates that the ratio of total operating ex pense to total assets is significantly higher for affiliates than for independent banks [30,31,34]. Assets, however, are not a good measure of output. The source of this higher cost has been traced to two areas. Several studies dis covered highly significant increases in the ratio of “ other” current expenses to total assets [21, 31, 34, 54]. Exactly why this category is higher for HCs is a question for further consideration, but lends itself to in teresting conjecture. The answer may de pend, in part, on whether MBHCs attempt to maximize the profits of each affiliate bank or of the consolidated HC. The assumption is typically the affiliate, but this need not be the case. The parent has considerable leeway in determining where profits appear by influencing the charges between subsidiaries and between the sub sidiaries and the parent. That is, profits could show up at nonbanking rather than banking subsidiaries, or the parent com pany could withdraw revenue from bank ing affiliates in the form of expenses (par ticularly management fees) instead of or in addition to dividends and, in fact, may prefer to report lower profits at the sub sidiary level and higher profits at the parent level. Whatever the case, this ques tion is a difficult one to answer empirically. MBHCs also incur higher employee benefit costs [30,34]. This is not surprising since one would expect a large banking organization to have a more comprehen sive benefit program for its employees than would an independent bank. Finally, as indicated in the previous section, affiliates seem to pay higher in 11 terest on time and savings deposits, by far the largest single expense for commercial banks. Because high interest rates on deposits reflect more intensive competi tion, rather than inefficiency, a more ap propriate measure of costs for use in deter mining relative operating efficiency might be total operating expense less interest on savings and time deposits. Use of this alternative measure could significantly alter the foregoing results. In short, the preponderance of evidence on operating efficiency suggests that affiliation with an HC entails diseconomies rather than economies. Profitability Having examined the pricing and cost aspects of MBHC affiliation, it is now time to turn our attention to the net of these two—the profitability of MBHC affiliates. A priori, the impact of affiliation on profitability is difficult to assess. On the revenue side MBHC affiliates levy significantly higher service charges on de mand deposits. On the cost side both total o p e r a tin g expense and its m ajor component—interest rates on time and savings deposits—are higher for affiliates. The resultant impact on profits is indeter minate and the evidence does not seem to clarify the picture significantly. A number of studies have examined the profitability of MBHCs through the use of performance ratios. It appears that MBHC affiliation has a negative impact on the ratio of net income to total assets [13, 34]. On the other hand, the results of com parisons of the ratio of net income to equity have been mixed, with one study finding a highly positive relationship with MBHC affiliation [25], but another finding a significant negative relation [34]. Also of interest are two studies [38,39], one of which found that MBHCs tend to purchase banks having earnings-to- 12 capital ratios lower than banks remaining independent [38], which is to be expected since owners of highly profitable banks would be less likely to dispose of their stock than owners of relatively unprofitable banks. Moreover, it has been found that banks tend to have higher net eamings-tocapital ratios after acquisition [39]. Together, these two studies imply that MBHCs have improved the profitability of acquired banks. The higher profit poten tial would explain why MBHCs are willing to pay a premium for an acquisition. In view of the finding of other research, however, that, due to “ overly generous purchase prices,” acquisitions by MBHCs have not increased earnings per share of the parent [46], one must conclude that the average premiums paid have not been justified by post-acquisition performance. The evidence on affiliate profitability, as with several other performance characteristics, is mixed. While sub sidiaries of MBHCs are less profitable than their independent counterparts, it must be kept in mind that MBHCs acquire banks of below-average profitability and tend to improve the level of profitability over time. Whether parent HCs choose to maximize the profitability of the parent or the subsidiary is crucial to the interpreta tion of these findings. Bank soundness and portfolio composition It has often been alleged that MBHCs acquire relatively small banks (implied by foothold entry) frequently afflicted with some internal problem such as under capitalization (implied by the MBHC’s promise to inject new capital into the ac quired bank) or a management or manage ment succession problem. It is also asserted that, once the bank becomes an af filiate, the MBHC can use its resources to solve these problems. It appears, however, that these alleged benefits of affiliation are Federal Reserve B ank of C h icago somewhat exaggerated. While there is no evidence concerning prior management problems of acquired banks, it is fairly clear that the capital positions of the banks acquired by MBHCs s e l d o m i m p r o v e and f r e q u e n t l y deteriorate, as evidenced by the ratios of several capital measures to either total assets or deposits. In only one study has the ratio of capital to deposits been shown to improve after affiliation, and then only in the third year after acquisition [59]. Several studies, however, have shown that the ratio of equity capital to total assets is significantly lower for affiliated than for independent banks [13, 25, 39]. (Whether affiliated banks had significantly lower capital ratios prior to their affiliation with MBHCs has been examined in only one study, which did not find a significant difference between acquired and indepen dent banks [58].) Moreover, it has been found that affiliation tends to increase the payout ratio (dividends to net income) [2 1 , 25]. A reduction in the equity capital-to total-asset ratio coupled with a higher payout ratio combine to produce substant i a l l y h i g h e r c ur ren t return to shareholders (i.e., the MBHC) per dollar of equity in affiliated .banks. In addition, as noted previously, af filiates have higher “ other” expenses than do independents. If some portion of these “ other” expenses comprise fee payments to the parent company (management, legal, and directors’ fees), then the parent could, in effect, be draining additional profits from the affiliate in this manner [34]. However, it is not clear whether the above findings reflect measurement problems or the MBHC’s ability to shift capital among subsidiaries and between subsidiaries and the parent. Empirical evidence also indicates that MBHC affiliation tends to increase the risk exposure of acquired banks as reflected in the changed composition of the affiliate bank’s asset portfolio [21,25,30,31,34,39, 13 Business C o n d itio n s, D e c e m b er 1976 54]. As the MBHC diversifies geo graphically, its combined portfolio typical ly becomes more diversified than the port folio of each individual affiliate. Because this diversification reduces the parent’s risk, MBHCs tend to encourage each af filiate to assume greater portfolio risk than it otherwise would. Offsetting the in creased risk in its portfolio, the individual affiliate could reasonably expect help from its coaffiliates or its parent should a problem arise. Evidence indicates that following af filiation, banks shift from low-risk, lowreturn assets (e.g., cash and U.S. Govern ment securities) toward higher risk assets such as state and local securities and loans to the private sector, particularly con sumer and business loans. However, since banks are not chartered to act as warehouses for the national debt, the attendant increase in risk from higher loan-to-deposit ratios following affiliation can be viewed as serving the interests of the acquired bank’s existing and potential customers. Allocation of funds The higher loan-to-deposit or loan-toasset ratios of MBHC affiliates suggest that they supply a greater amount of private credit than an independent bank would offer [25, 30, 31, 54]. Assuming that the borrowers’ creditworthiness is un changed, this would tend to reduce loan in terest rates if this extra credit stays in the acquired bank’s market. Credit tends to flow toward markets having a higher net (risk-adjusted) return. If risk is the same in all banking markets, funds will flow toward the market offering the highest in terest rate (i.e., move from credit surplus to credit deficient markets). Therefore, the effect on the market of the newly affiliated bank cannot be foretold. Interest rates may rise, fall, or stay the same, depending upon how much credit flows out of or into a par ticular market. Credit deficient markets would benefit through lower interest rates and greater credit availability, while credit surplus markets might be hurt by higher rates o f interest and lesser credit availability. Nevertheless, this is a necessary condition for an efficient alloca tion of resources to be accomplished. While there may be some real or con trived “moral” objections to this potential “ siphoning o f f ’ of credit, such a value judgment is beyond the scope of this study. Since there is no evidence suggesting credit is being allocated across markets as a result of MBHC affiliation, it can be con cluded that the previously mentioned find ing of lower loan rates resulting from af filiation has resulted from an expansion of credit within the existing market served by acquired banks. This increase, in all likelihood, was funded by selling off U.S. Government and agency securities. Benefits of Board regulation Some benefits have accrued to the public as a result of the Board of Gover nors’ decisions on HC applications. The Board is charged by the act with balancing any anticompetitive effects of a proposed acquisition against the public benefits the acquisition might offer. This biases the Board against approving acquisitions of relatively large banks not only in markets where the MBHC already operates, but also in markets which might be considered attractive for de novo entry. While not all de novo and foothold entry by MBHCs is a result of the threat of Board denial, the Board’s strict interpretation of its mandate regarding the actual and potential com petitive effects of an acquisition has clear ly encouraged these types of entry. Both of them stimulate competition, especially in markets where the MBHC is not already represented [9, 27, 48, 49]. The actions of the Board have con tributed to strengthening the banking 14 system in other ways. For example, many MBHCs have been induced to inject new capital into their bank subsidiaries. While not all such capital injection is attributable to the Board and its policies, it has been es timated that holding companies have in jected around $ 2 billion, primarily into un dercapitalized and small banks, largely at the urging of the Board [9]. In somewhat the same vein the management or manage ment succession problems of some banks have been alleviated by acquisitions which might not have been possible had MBHCs been prohibited [9, 27]. A third effect of the Board’s ad ministration of the MBHC act is the in troduction or expansion of bank services by newly acquired subsidiaries. This, it is hoped, will stimulate competition and perhaps economic growth in an area [9,27]. F ederal Reserve B ank of C h icag o and has led to payment of higher interest rates on time and savings deposits. Af filiates also have higher service charges on demand deposits, but this may be due to the provision of more services. T h e r e a p p e a r to be s o m e “ diseconomies” associated with affilia tion, meaning that the per unit cost of a given level of output is higher for affiliated than for independent banks. These higher costs are partly the result of the fact that MBHCs pay higher rates on time and savings deposits, the largest single ex pense category for commercial banks and may partially explain why affiliates are less profitable than independent banks. But there are additional cost elements to be considered. Since the “ other” expense category is one of the costs found to be higher for affiliates and contains a number of expense categories that could be used to Summary and conclusions drain profits from the affiliates to the HC, the significance of these findings depends on whether profit maximization takes While the results found here seem to place at the parent level or the affiliate offer something for everyone—opponents level (or whether profit maximization is and proponents of MBHCs can cite results the appropriate assumption at all). supporting their positions—the weight of Finally, the evidence indicates that the evidence seems to indicate that MBHCs are not as well capitalized as in MBHCs have had a slightly favorable im dependent banks. In addition, risk ex pact upon the banking system. Had HC ac posure is increased through affiliation as quisitions not been regulated since 1956, the MBHC tends to move the affiliate away however, this conclusion might be less from low-risk, low-return assets such as favorable. U.S. Treasury securities toward higherIn brief, MBHCs do seem to offer a risk, higher-return assets. This is not, in slightly wider range of services and in and of itself, necessarily bad since the lowcreased consumer and business credit. risk investments seem to be replaced by in MBHCs increased aggregate national and creased lending, presumably to local state concentration slightly above what it would have been in their absence, with in customers. At the same time the evidence does not creased state concentration occurring 7 * suggest that independent banks have been more often in unit banking states than in harmed appreciably, if at all, by MBHCs. statewide branching states. Where concen In general, independent banks have ex tration is really meaningful—at the local ceeded equivalent-sized MBHC affiliates market level—no significant MBHC im in growth and appear to be more profitable. pact has been found. Pending the availability of more In the area of pricing, MBHC affilia definitive knowledge of the effects of tion seems to have resulted in slightly MBHCs, it does not appear that those reduced interest rates charged on loans Business C o n d itio n s , D e c e m b er 1976 15 states which have adopted a “ go slow” ap proach to MBHCs—whether intentionally or by default—have foregone significant benefits. Each side can “ accentuate the positive,” but at this point it does not appear that the scales are tipped decisively in either direction. Consequently, a cau tious approach to the problem seems to have as much merit as change for change’s sake. But the uncertainty of even this weak generalization suggests the great value of additional research on this continuing issue of public policy. Dale S. Drum INDEX FOR 1976 A g ricu ltu re and farm fin a n ce M onth P ages Soviet agriculture.......................................................... Agricultural highlights: 1976...................................... June August 3-10 9-12 January April 2-19 3-10 B an kin g, cred it, and fin an ce 1975 Annual Report...................................................... Hedging interest rate fluctuations............................. Deposit service—new tool for cash m anagem ent...................................................... How weak are business lo a n s ? .................................. Monetary aggregates com pared ................................ State-owned banks: New wine for old bottles?............................................................ Bank profits and interest rates: 1975 ...................... Bank capital adequacy............................................... Do-it-yourself pensions............................................... Rebound in instalment credit.................................... April May June 11-15 12-15 11-15 July August September October November 3-10 13-15 2-11 10-15 6-15 March 12-15 July December 11-15 3-15 February August November 3-31 3-8 3-5 March May October 3-11 3-11 3-9 B ank h o ld in g com pa n ies Holding companies and deposit va riability........... Effects of holding company affiliation on de novo b a n k s ...................................................... MBHCs: Evidence after two decades of regulation E con om ic co n d itio n s, gen era l Review and outlook 1975-76 ...................................... The upswing retains m om entum ............................. Capital spending upswing ah ead ............................. In tern a tion a l tren d s International banking: Part I I ............. Bankers’ acceptances............................. Promoting U.S. exports through DISCs
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