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an e c o n o m ic re v ie w b y th e F e d e ra l R e se rv e B a n k o f Chicago Liabilities that banks manage Bank holding companiesconcentration levels in three district states ju n e 1975 Liabilities that banks manage Liability m anagem ent has played an im portant role in enabling the bank ing system to finance the nation s credit needs. B ut individual banks that practice it need a sound im age as well as the ability to p a y com petitive rates. 3 Bank holding companies— concentration levels in three district states 10 There have been an increasing n um ber o f m ultibank holding com pany form ations in Iowa, M ichigan, and Wisconsin. How these have altered the degree o f banking concentration in the states can be assessed in term s o f aggregate and local m arket concentration levels. Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department, Federal Reserve Bank of Chicago, P. O. Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Department with a copy of any material in which an article is reprinted. 3 Business Conditions, June 1975 Liabilities that banks manage Liability m anagem ent, an innovation that m any banks adopted in the past decade to gain a greater measure o f control over their own growth patterns, has come under in creasing scrutiny by bank managements, supervisors, and customers. A s the term implies, liability m anagem ent entails the ability to control the amount o f funds ac quired through certain types o f deposits or borrowings. It enables a bank to make desired loans and investments without selling other assets or depending on customer deposit inflow s to provide the needed funds. Control is achieved by keep ing interest rates on these liabilities com petitive with returns available on alter native investments. In financing the asset expansion o f the past 15 years, “ m anaged” interest-bearing liabilities o f commercial banks rose more rapidly than demand deposits, savings deposits, or capital—the traditional raw materials o f banking. M a jor types o f bank liabilities, some o f the principal characteristics associated with each, and the amount on the books o f the large banks in m ajor cities at the end o f 1974 are indicated on page 4. While all liabilities can be m anaged to some degree, negotiable certificates o f d e p o sit (N C D s) and nondeposit in struments are m ost generally associated with the concept o f liability management. For the same reasons that the practice developed, it is likely that m anagem ent o f liabilities will continue to play an im por tant role in banking if the industry is to m aintain its position as a supplier in the credit markets. Why the concern? Heavy reliance on liability m anage ment was a factor in the liquidity problems that culminated in the failure o f a few large b a n k s l a s t y e a r . T h e s e fa ilu re s demonstrated that a bank’ s ability to roll over some liabilities can be severely im paired as a result o f developments, such as unusual losses, that shake the public’s con fidence in the soundness o f the institution. Should confidence be lost, the magnitude o f the problem —the amount o f funds that would flow out o f the bank and how fast they would be lost—would depend largely on the degree to which the bank relied on short-term uninsured liabilities, especially th ose owed to parties having little knowledge o f the bank’s basic condition. To the extent such outflows exceed holdings o f assets with equally short maturities, a liquidity crisis m ay arise. Liquidity problems associated with liability m anagem ent stem more from characteristics such as the maturity o f the instrument and the holder’s relationship to the bank than from whether the liability is classified as a deposit or debt. There are likely to be both volatile and stable funds in each category. For example, funds ac quired via the sale o f a $2 million NCD to a large corporate investor who is not a loan customer and does not norm ally keep working balances with the bank m ay be more difficult to retain at maturity than an equal amount o f federal funds purchased from correspondent banks. (Federal funds transactions are interbank loans o f im- £» Liabilities of Major U.S. Banks as of June 1, 1975 D e m a n d d e p o s it s Interest rate constraint (p e r c e n t ) Type1 Reserve required Outstanding2 Dec. 31 1974 (p e r c e n t ) 7V-2-1&/2 P r o h ib it e d Other factors affecting use Maturity (b illio n d o lla r s ) O n dem and S erve as h o ld e r s ’ $ 18 5 .2 w o r k in g b a la n c e s a n d a s c o m p e n s a t io n to b a n k fo r s e r v ic e s . S a v i n g s d e p o s it s T i m e d e p o s it s le s s t h a n $ 1 0 0 ,0 0 0 3 5 C a n r e q u ir e 30 d a y s n o t ic e N o m in im u m a m o u n t ; n o s p e c i fi c m a tu r ity ; o w n e r s h ip r e s t r ic t e d . 5 8.5 3-6 b 'h -l '/i 3 m o s .-6 y r s . $ 1 ,0 0 0 m in im u m r e q u ire d f o r r a t e s 42.7 o v e r & ■ p e r c e n t ; b a n k s m a y s et /> m o r e r e s t r ic t iv e c o n d it io n s . N e g o t ia b le C D s o v e r $ 1 0 0 ,0 0 0 3-6 S u sp en d ed M in . 3 0 d a y s W e ll-d e v e lo p e d s e c o n d a r y m a r k e t . 9 3.0 O t h e r t im e d e p o s it s o v e r $ 1 0 0 ,0 0 0 3-6 S u spen ded M in . 3 0 d a y s M a y be co n v e rte d to n e g o tia b le fo r m a t o p t io n o f h o ld e r. 3 3 .9 4 N one N o lim it F ed fu n d s p u rch a se d a n d b o r r o w in g fr o m b a n k s N one N one F ed fu n d s , 1 d a y ; R e p u rch a se a g reem en ts on N one E u r o d o lla r b o r r o w in g N one N o lim it, 1 fo r e ig n M a y b e p u r c h a s e d o n l y fr o m b a n k s (a n d S & L s ) a n d U .S . a g e n cie s . B a n k m u s t o w n s e c u r itie s ; in t e r e s t p a y a b le f o r p e r io d s le s s t h a n 30 days. M in . 7 y r s . $ 5 0 0 m in im u m ; in c lu d e d i n c a p it a l s e c u r it ie s N one N one fo r s o m e p u r p o s e s ; b o r r o w in g lim it s . s u b je c t 1 D e p o s it s in s u r e d to $ 4 0 ,0 0 0 ; o t h e r l ia b ilit ie s n o t in s u r e d . 3 G r o s s a m o u n t s d u e t o o w n f o r e ig n b r a n c h e s ; d o e s n o t in - 2L ia b ilit ie s o f m a j o r U .S . b a n k s t o t a le d $ 4 9 0 b illio n o n D e c e m b e r 31, 1974, i n c l u d i n g lia b ilit ie s f o r o u t s t a n d i n g b a n k e r s ’ a c c e p t a n c e s , m o r t g a g e in d e b t e d n e s s , a n d o t h e r lia b ilit ie s n o t s h o w n s e p a r a t e ly . c lu d e E u r o d o lla r s b o r r o w e d d ir e c t ly o r o t h e r r e s e r v a b le E u r o d o ila r b o r r o w in g s . 4 In c lu d e d in c a p it a l a c c o u n t s o f $ 34 b illio n . 3 .6 :t in t e r e s t d a y o r m ore T r e a s u r y a n d U .S . A g e n c y C a p it a l n o t e s a n d d eb en tu res to to j \ ( 4 4.3 \ ' n .a .4 Federal Reserve Bank of Chicago o t h e r , n o lim it C o s t re la te d ra te s. Business Conditions, June 1975 mediately available funds, maturing on the next business day.) An NCD that matures the next day and federal funds p u rch a se d have the same potential volatility. But federal funds purchased from correspondent banks often represent a service to a customer—providing an easy way to fully invest funds already on deposit at the buying bank. The service aspect is especially important when amounts purchased are less than moneymarket denom inations since the seller lacks alternative outlets for liquid invest ment. Yet, an NCD is a deposit, while federal funds generally are considered borrowed funds. While funds “ purchased” in the money markets do tend to be more volatile than the d e p o s its o f local business and household customers, the observer cannot make this distinction on the basis o f the published categories o f bank liabilities. The risk o f sudden outflows is greatest for v e r y s h o r t -te r m , u n in su red , la rg e denom ination liabilities in the hands o f holders who can shift quickly into other assets. But nearly all bank liabilities have to be purchased in one w ay or another. Even customers do not keep funds with the bank except for the service or interest credit that they expect to receive in return. Banks have to pay competitive rates on consumer time deposits and offer corporate customers an incentive to keep excess working balances in the bank instead o f seeking other investments. The necessity for banks to compete ac tively for loanable funds reflects the closer m anagem ent o f cash positions by bank customers. Short-term interest rates rough ly doubled in the decade o f the Sixties, greatly increasing the opportunity cost of holding nonearning cash balances. A s corporations and individuals shifted funds not needed for transactions into interestbearing instruments, demand deposits at banks failed to keep pace with the demand for bank loans. Meanwhile, bank holdings 5 o f securities that could be sold to provide funds for lending had been reduced to near minimum levels—either because sales would have entailed heavy losses or because rem aining holdings were needed as collateral for public deposits. In this en vironm ent m any banks—especially those whose deposits were held by large and f i n a n c ia lly so p h is tica te d corp ora te customers—tailored their liabilities to re ta in and attract funds that would otherwise m ove into m oney market in struments. Thus, despite some potential for sudden outflows, a large proportion o f cer tain liability items, such as NCDs or repurchase agreements (RPs) that are often identified as purchased money, can be as stable as the more traditional sources. Indeed, they represent the same type o f funds that would have been held as demand deposits 15 or 20 years ago. Some banks, however, stepped far outside ex isting customer relationships by bidding for money market funds through brokers. It is clear that there are limits to the ability o f a bank to support asset growth with funds acquired in the m oney markets. These limits are not the same for all banks. Investors do pay attention to the capital position o f the institution issuing the obligation, especially where no collateral is involved. M any o f the large banks that increased their liabilities rapidly during the past 15 years—whether in the form o f deposits or borrow ings—used up much o f their capacity for expansion on their ex isting capital base. However, in times o f uncertainty investors tend to favor the very largest and best-known institutions on the assumption, whether or not justifiable, that size is synonym ous with safety. Smaller banks m ay have to pay a premium for m oney market funds. The vast m ajority o f the nation’s small banks do not have access to the m oney market at all, but their deposit customers m ay be somewhat less interest sensitive. 6 Determining the mix The structure o f liabilities that has emerged as a result o f bank competition for loanable funds over the past decade reflects several distinguishable, but in terrelated factors. The m ost im portant are regulatory constraints, relative costs, pro jected needs, and investor preferences. While deposits are still by far the m a jor source o f funds, the com position o f deposits has changed. A t the end o f 1974 all deposits accounted for 81 percent o f total footings o f all com m ercial banks and 88 percent o f all liabilities. Excluding the largest banks, deposits accounted for 86 percent o f assets and 94 percent of liabilities. There is no w ay to tell what proportion o f those deposits represent the working balances and savings from local c o m m u n it ie s — th e k in d o f fu n d s traditionally associated with hard core stability. But most nondeposit and m oney market-type deposit liabilities are issued by the large banks. For the 75 banks with assets o f $1 billion or more, the deposit com ponent excluding N CD s is probably around 50 percent o f assets, com pared to 61 percent for all larger banks. Moreover, a significant portion o f the increase in their assets over the past decade w as financed v ia increases in m oney market-type liabilities (see chart). Regulating liabilities Bank liabilities in the form o f deposits constitute a m ajor portion o f the nation’s money supply, and as such, have always been highly regulated to protect the public interest. In m anaging its liabilities, a bank is restricted to the issuance o f instruments permitted under federal and state statutes and regulations. The rules set limits in terms o f maturity, denom ination, rate o f interest, insurance status or creditor preference, and permitted holder. Deposits at most banks are subject to reserve re- Federal Reserve Bank of Chicago NCDs were the major source for growth at big banks billion dollars Negotiable CDs: negotiable certificates in denominations of $100,000 and over. Other time deposits: time deposits other than savings and large negotiable CDs. Demand deposits: collected demand deposits minus deposits due from banks. Fed funds purchased: purchases net of sales of fed funds to banks plus securities sold under agreements to repurchase plus borrowings other than Eurodollars and from Federal Reserve Banks. Eurodollars and loans sold: gross liabilities to banks’ own foreign branches and Eurodollars borrowed directly plus loans sold outright. quirements and interest rate ceilings based largely on maturity and denom ination. Other liabilities are exempt from these restrictions but closely constrained with resp ect to the “ le n d e r ,” allow able collateral, or overall “ borrow ing lim its” relative to capital stock and surplus. While not all banks are subject to the sam e regu lation s and laws, federal statutes and Federal Reserve System re g u la tio n s govern in g operations o f national and state member banks and Business Conditions, June 1975 parallel interest rate constraints on in sured nonm em ber banks have had the m ost im portant effects on the overall struc ture o f bank liabilities. The distinction between deposits and debt liabilities has become increasingly fuzzy. A number o f bank liabilities current ly are defined as deposits for purposes o f reserve requirements or interest rate ceilings, or both. Demand deposits are deposits against which checks are drawn. They are subject to higher reserve require ment ratios than time deposits, and these ratios are higher for large banks. Paym ent o f interest is prohibited on dom estically owned dem and deposits. Demand deposits are the traditional source o f bank funds, and they accounted for 72 percent o f total com m ercial bank deposits in 1960—before the era o f liability management. By yearend 1974 the share had fallen to 42 percent. Individuals and businesses hold almost three-fourths o f the dollar volume o f de m and deposits, presumably to cover trans actions needs and to pay for banking ser vices. Because banks cannot pay interest on these accounts, they cannot control the volume. T im e d e p o s its in clu d e s a v in g s deposits, time certificates o f deposit, and open accounts. Savings deposits do not have a specific maturity and are subject to the lowest interest rate ceiling and the lowest reserve requirement. Ownership is restricted to individuals, certain nonprofit groups, and public bodies. (An exception to the general rules permits paym ent o f m ax imum time deposit interest rates on savings deposits o f public bodies.) Tim e certificates o f deposit m ay be negotiable or nonnegotiable instruments payable on a certain date not less than 30 days after the date o f deposit. Reserve re quirement percentages vary by maturity and bank size, and interest rate ceilings vary by maturity but currently apply only to deposits in denom inations o f less than $100,000. 7 Time deposits provided the avenue for the initial thrust toward bank competition for funds in the early Sixties. With the development o f a secondary market for NCDs o f $100,000 or more, the outstanding amount o f these obligations, which provid ed corporations an alternative to Treasury bills and com m ercial paper as an outlet for surplus cash, reached $18 billion within five years. Concurrently, most banks, both la rg e a n d sm a ll, were aggressively p r o m o t i n g s a v i n g s a n d sm a lle r denom ination time deposits in competition with other banks and thrift institutions. Legal ceilings on rates paid were rais ed several times to permit banks to con tinue to attract funds in the face o f rising market interest rates. But as the economy showed signs o f overheating in 1966 and again in 1969, the ceilings were held down to dampen the pace o f expansion in bank credit. Unfortunately, this approach not only reduced inflow s o f loanable funds but turned them into outflow s—the process t h a t h a s c o m e to be k n ow n as “ d is in te r m e d ia tio n .” M ost severely affected were the large banks with heavy dependence on NCDs. Faced with this barrier to sources o f funds that had come to be the m ajor base for growth, banks quite naturally m oved to developed sources that were free from such restrictions via the issue o f nondeposit instruments. With some time lag, the banking a u th o ritie s g ra d u a lly ch a n g e d the regulations to prevent circumvention o f in terest rate constraints, but did not com pletely cut o ff the banks’ access to money market funds or cripple the mechanism through which reserves are redistributed within the banking system. Promissory notes, which banks began to issue in 1966, and which are identical with CDs in m any respects, were brought under the deposit d e f i n i t i o n a l o n g w ith a n y oth er obligation “ issued or undertaken . . . as a means o f obtaining funds to be used in its banking business.” Excepted from this 8 definition, and thus rem aining free from the rate ceiling and reserve requirements applicable to deposits were (1) interbank borrowings, which include federal funds transactions; (2) sales o f Treasury and U.S. agency securities under repurchase agreements; and (3) capital notes with maturities o f seven years or more (or that meet certain other criteria). Two other avenues used heavily in the 1969 period o f monetary restraint were Eu rodollar borrow ings (m ainly funds ob tained by dom estic banks through their foreign branches) and com m ercial paper sold by bank holding com panies and channeled to the subsidiary banks via the purchase o f loans. Funds acquired through these arrangements amounted to nearly $20 billion at the end o f 1969. Both these sources remained free o f interest rate ceilings but were made more costly by the application o f reserve requirements. Reliance on nondeposit liabilities declined when interest rate ceilings ceased to inhibit deposit growth, either because market rates fell below ceilings or because the ceilings were raised or suspended. All ceilings on deposits o f $100,000 or more were eliminated by the spring o f 1973 and despite the sharp increases in market in terest rates in the ensuing 15 m onths, ex pansion in NCDs offset the weakness in consumer-type deposits and continued to supply funds for loan expansion, although at high costs both in terms df rates paid and higher reserve requirements assessed on increases in these obligations. Later ad justments in regulations gradually re duced the advantages attached to the use o f certa in lia b ilitie s . For example, d iffe re n ce s in reserve requirements against time deposits, funds acquired through holding com pany commercial paper, and foreign borrow ings are now relatively minor. Recent adjustments have encouraged longer maturities by applying lower reserve requirements to CDs issued for six m onths or more. Federal Reserve Bank of Chicago But som e im p o rta n t differences between deposits and other liabilities that banks m anage persist. Time deposits must remain on deposit for a minimum o f 30 days; nondeposit instruments are not so restricted. There is no reserve requirement or deposit insurance assessment on purchases o f federal funds, repurchase agreements, or notes and debentures. But federal funds can be bought only from domestic banking offices (defined to in clude thrift institutions) and federal agen cies; rep u rch a se agreements require specific types o f collateral; notes must carry maturities o f at least seven years and are subject to borrow ing limits. Demand and supply W ithin th is co m p le x regulatory framework banks can determine the m ix o f their m anaged liabilities. Differences in costs stemming from regulatory treatment are reflected to some extent in the rates offered on various instruments. A n im por tant element affecting the com position o f these liabilities at any given time is a bank’s forecast o f its needs for loanable funds. If strong loan demand is foreseen for three to six m onths ahead, the bank might prefer to provide for those needs by issuing CDs with maturities o f 180 days or more. In general, strong loan demand is often consistent with expectations o f ris ing interest rates—adding to the desirabili ty o f obtaining the needed funds at current rates for a relatively long period o f time. In fact, most bankers do pay attention to achieving a considerable degree o f cor respondence between the maturities o f the assets and the liabilities they are putting on their books, and a large portion o f out standing 90-day CDs finances 90-day loans. On the other hand, expectations o f falling interest rates tend to induce banks to borrow shorter than their commitments in order to reduce their average cost o f funds. Business Conditions, June 1975 Just as im portant to the money manager, however, is the type o f funds available. In this area, too, it is necessary to meet the needs o f the customer— whether a depositor with a surplus balance or an unknown m oney market investor. To offer long maturities when investors want to stay short will either fail to attract funds or require a high interest premium. On any given day the banker will nor m ally accom m odate a variety o f customer preferences within the framework o f the b a n k ’s needs. Thus, the bank may purchase federal funds from correspon dent banks who find that this outlet provides both greater liquidity and, when short-term interest rates are high, a better average return than securities. A state fund w hich holds deposits in the bank may have $100,000 available for two days before it has to be paid out. Under an RP the bank sells a Treasury note to the state and buys it back for delivery two days later at a predetermined higher price that es tablishes the yield to the state. Loans or municipal obligations from the bank’s portfolio cannot be sold in this manner because such transactions are deposits for purposes o f the rules governing rate ceilings, and a two-day term places it in the demand deposit category on which interest paym ents are prohibited. Banks as intermediaries One reason for the extensive set of regulations governing banks is that ex pansion o f bank credit generates new m on ey , an d u n restrain ed monetary growth generates price inflation. But in ad dition to being m oney creators, banks— like other financial institutions—are in termediaries, that is, they channel the public’s savings into investments. Liability m anagem ent has permitted the banking system to m aintain the extent o f its participation in the intermediation function, while rem aining responsive to 9 the demand deposit and interest rate im pact o f monetary control actions. Cor porations, individuals, and local units o f governm ent in the aggregate, have a huge amount o f funds available between inflows and outflows o f cash that can be tapped by borrowers. But its ownership is constantly changing. These funds will be invested, either directly in obligations o f borrowers or through financial institutions. An un answered question is how much o f this flow can best serve the econom y’s needs by being allocated to borrowers through bank loans and investments. Data from the Federal Reserve’s Flow o f Funds analysis show a sharp contrast in the effects o f tight m oney on the in termediary role o f commercial banks in 1966 and 1969, when CD rate ceilings were held below market rates, compared with 1973-74 when these ceilings were suspend ed. Credit market funds advanced by banks dropped from 41 percent of total funds raised by nonfinancial sectors in 1965 to 26 percent in 1966, and from 40 per cent in 1968 to 20 percent in 1969. By con trast, this share rose from 42 percent in 1972 to a peak o f 46 percent in 1973 before dropping back to 35 percent in 1974. The reduction last year reflected the adoption o f restrictive loan policies as well as a reduction in business demand for short term credit in the second half. The ability o f the banking system to maintain or expand this share in the future will depend heavily on the ability o f in dividual banks to further increase their m a n a g ed lia b ilitie s . T h ere are no guidelines that can adequately signal what m ay be excessive reliance on m an aged liabilities by any given bank. Because o f the already high degree o f capital leverage in m any o f the nation’s largest banks and their efforts to improve asset quality and liquidity, however, the pace o f expansion is likely to slow until the capital base can be broadened. Jean L. Valerius 10 Federal Reserve Bank of Chicago Bank holding companies— concentration levels in three district states The growth o f multibank holding com panies continues to cause concern am ong some segments o f the banking community. In the Seventh Federal Reserve District multibank holding com panies are a legally sanctioned form o f business organization in Iow a , M ich igan , and W isconsin. Pressures currently exist to permit some form o f multibank organizations in In diana and Illinois. There are convincing arguments on both sides o f the multibank holding com pany issue. Those w ho support the mul tibank form o f organization argue that it benefits the public through econom ies o f scale and other synergistic effects. On the other hand, independent bankers argue that multibank holding com panies pro duce corporations unresponsive to the needs o f the individual customer and the local community. Multibank holding com panies grow by acquiring banks and assim ilating them into a single corporate organization. The proliferation o f multibank structures in a given geographic area—and the conse quent elimination o f independent banks— could increase the concentration o f bank ing resources and m ay lessen competition. Has the increasing number o f mul tib a n k h o ld in g com panies in Iowa, Michigan, and W isconsin altered the degree o f banking concentration in these states? To answer this question, it is help ful to look at the concentration effect from two viewpoints: 1) aggregate concentra tion, which analyzes concentration on a statewide basis; and 2) local market con centration. The aggregate concentration measure is o f less im portance than the local market measure because it gives only a superficial view o f the extent o f com peti tion within a state and ignores the com position and structure o f local markets. Overall, as a banking market becomes more concentrated, price flexibility and level o f competition between banks in the market decline. Aggregate concentration For purposes o f this article, aggregate concentration in a state is defined as the percent o f the total com m ercial bank deposits that are held by the five largest banking organizations in a state— either individual banks or bank holding com panies. (The number five is arbitrarily selected.) I f a bank holding com pany that is one o f the five largest banking organi zations in the state were to acquire an ad ditional bank, aggregate concentration would increase. I f a bank holding com pany that is not am ong the five largest banking organizations were to acquire an ad ditional bank, it would have no effect upon aggregate concentration. The aggregate concentration measure is inadequate in this respect. By the end o f 1973 all five o f the largest banking organizations in Iowa, M ichigan, and W isconsin were either one-bank or multibank holding companies. T o view the trend o f aggregate concentration in these states, the period 1957-74 is used (the Bank Holding Com pany A ct was passed in 1956). A s shown below, over this period aggregate concentration has remained fairly constant within the three states m a in ly b e c a u s e s m a lle r b a n k in g 11 Business Conditions, June 1975 organizations have demonstrated the com petitive ability to maintain their share o f total state deposits: 1957 Iowa M ichigan W isconsin 1961 1968 1974 20.8 52.9 31.5 19.2 50.0 33.3 17.4 48.4 31.9 19.8 47.6 33.4 (percent) Note: A s o f December 31. Multibank holding com panies are currently active in all three states, but this has not alw ays been the case. Iowa had only limited multibank holding com pany activity before 1972, when state banking statutes were liberalized. In M ichigan, where bank holding com panies have been extremely active, bank holding companies were illegal until the statutes were chang ed in 1971. W isconsin has a history o f bank holding com pany activity dating back to the 1920s. Given these different backgrounds, it m ig h t be expected that W isconsin’s aggregate concentration would have in creased significantly over time. Aggregate con cen tra tion in M ichigan shows a general decline, but because o f the prolific expansion o f bank holding companies since 1971, it m ight be expected that the 1974 percentage would be higher, not lower, than for previous periods. Statewide aggregate concentration in banking can change drastically over time, but this has not been the case in the three district states. Moreover, it is possible for a large increase to occur in aggregate con centration without similar increases oc curring in local banking markets. For ex ample, a m ultibank holding com pany that expands throughout a state by acquiring Iowa “H” ratios: “H” ratios: adjusted Holding all banks as if for holding company company Percen Banking districts affiliation nonaffiliated effect changi 98 districts total .255 .004 .259 1.5 31 districts with multibank holding company activity .230 .014 .216 6.5 67 districts with no multibank holding company activity .273 .273 .000 0.0 7 urban districts .206 .207 .001 0.5 91 rural districts .004 1.5 .259 .263 In 1972 the Iowa banking statutes were liberalized to allow multibank holding com panies greater freedom to expand. As of December 31, 1974 there were 144 bank holding companies in Iowa and 11 were mul tibank institutions. The holding companies controlled 178 of the 664 commercial banks (26.8 percent), and their aggregate deposits totaled $4.4 billion, about 42 percent of total commercial bank deposits in Iowa. The increase in concentration caused by bank holding company acquisitions has been minimal. The average H ratio for all 98 banking districts is .259 and the holding company effect is .004, an increase in concen tration of 1.5 percent. This increase took place within four of Iowa’s 98 districts, one urban and three rural. Of Iowa’s 98 banking districts 31 ex perienced some multibank holding company activity; i.e., all bank subsidiaries of Iowa’s 11 multibank holding companies are located in these districts. The H ratio of these 31 dis tricts is .230 and, as a subgroup of the total districts, they show the greatest holding company effect (6.5 percent). It is notable that the 31 districts have less banking con centration than the 67 districts where no multibank holding company activity has oc curred. Federal Reserve Bank of Chicago 12 banks in several different markets would not cause increased concentration in specific locally defined markets; however, if this multibank holding com pany were o n e o f th e fiv e la rg e s t b a n k in g organizations in the state, statewide aggregate concentration would be in creased. Alternatively, selected individual markets could becom e increasingly con centrated without changing statewide aggregate concentration. Local banking markets When a bank holding com pany wishes to acquire another bank, the holding com pany must first submit an application to the Board o f Governors o f the Federal Reserve System describing and justifying the acquisition. Each case is carefully analyzed in terms o f its effects on com peti tion and other important issues. It is necessary to delineate the geographic area where competition actual ly occurs in order to determine the extent o f competition between two or more banks. With a relevant banking market—or markets—defined, concentration ratios can be determined. Presumably, there is an inverse relationship between concentra tion levels and competition. It is generally held that the relevant geographic area is more local than an entire state. (The local nature o f banking markets was made clear by the U.S. Supreme Court in U.S. u. Philadelphia N ational B ank in 1963, and was reiterated most recently in U.S. u. M arine Bancorporation and U.S. u. The Connecticut N ational B ank in June 1974.) There are several w ays in w hich bank ing concentration can be increased within a local market. Bank mergers increase Michigan Banking districts 78 districts total 36 districts with multibank holding company activity 42 districts with no multibank holding company activity 16 urban districts 62 rural districts “H” ratios: “H” ratios: adjusted Holding all banks as if for holding company company Percent affiliation effect change nonaffiliated .002 0.5 .425 .427 .316 .517 .269 .465 As of December 31,1974 there were a total of 47 bank holding companies in the state, 19 of which were multibank com panies. Bank holding companies in Michigan controlled 99 of the 347 commer cial banks in the state (28.5 percent), and aggregate deposits were 21.5 billion, about 73 percent of the total commercial bank deposits in the state. Increased concentration of banking resources in Michigan caused by bank holding company acquisitions has been nominal. The average H ratio for all 78 bank ing districts is .427 and the holding company effect is .002, an increase in concentration of .322 .517 .270 .467 .006 .000 .001 .002 1.9 0.0 0.4 0.4 only 0.5 of a percentage point. This increase occurred in only four of Michigan’s 78 bank ing districts, three urban and one rural. Thirty-six of Michigan’s 78 banking dis tricts have experienced some multibank holding company activity; i.e., all bank sub sidiaries of Michigan’s 19 multibank holding companies are located in these districts. The H ratio of these districts is .322 and, as a sub group of the total districts, they show the greatest holding company effect (1.9 per cent). However, it is notable that these 36 dis tricts still have less banking concentration than the 42 districts where no multibank holding company activity occurred. Business Conditions, June 1975 13 market concentration if both the acquiring and acquired banks are located in the same m ark et since the acquired bank is eliminated as a banking organization (it usually becom es a branch o f the acquiring bank) and the market share o f the ac quiring bank increases. A bank that opens several new branches within a given market (de novo branching) almost cer tainly will increase its share o f banking d ep osits. A ggressive marketing tech niques or innovations that attract deposits also could increase a bank’s market share at the expense o f its com petitors.1 For the purposes o f this article, the fo cu s is on increased concentration resulting when a multibank holding com- ‘The accumulation of banking resources under the umbrella of common stock ownership by private individuals, known as group-banking, can be a subtle form of market concentration. In states where mul tibank holding companies are prohibited, group banking is an effective substitute: there is no way to outlaw common ownership of banks by individuals. pany acquires more than one bank in a single local market. From a concentration standpoint the effect o f such acquisitions is essentially the same as in bank m erg ers — in d e p e n d e n t b a n k in g organizations are eliminated from the banking market. To exam ine changes in local market concentration, the states first must be divided into locally defined geographic areas. The ideal solution would be to divide the states into the relevant banking markets as they exist in the real world. The com plexity o f delineating such areas, however, is beyond the scope o f this study. A s a convenience, county and multicounty areas are used as proxy markets. (The mul ticounty areas are urbanized Standard Metropolitan Statistical Areas or modified versions thereof.) These proxy markets are herein designated as “ banking districts,” not banking markets. Wisconsin “H” ratios: “H” ratios: adjusted Holding all banks as if for holding company company Percent Banking districts nonaffiliated affiliation effect change 67 districts total .292 .295 .003 1.0 27 districts with multibank holding company activity .206 .210 .004 1.9 40 districts with no multibank holding company activity .349 .349 .000 0.0 7 urban districts .156 .170 .014 8.9 60 rural districts .307 .310 .003 1.0 Despite the state’s long history of accom modating bank holding companies, Wiscon sin holding companies control only 26 per cent of the state’s commercial banks. As of December 31, 1974 there were 65 bank holding companies in the state and of these 24 were multibank companies. Wisconsin’s bank holding companies controlled 160 of the. 620 banks in the state, and their aggregate deposits were $7.7 billion, about 53 percent of the total commercial bank deposits in the state. The increase in concentration of bank ing resources caused by bank holding com pany expansions has been minimal. The average H ratios for all 67 banking districts of Wisconsin is .295 and the holding com pany effect is .003, an increase in banking concentration of only about 1 percentage point. This small increase took place in only six of Wisconsin’s 67 districts, three urban and three rural. Wisconsin’s seven urban districts show the greatest increase in concentration because a large percentage of them ex perienced some holding company effect. However, the overall concentration level of the seven districts is very low, compared to the other subgroups or to H ratios in Iowa and Michigan. 14 The use o f county boundaries is justified on the basis that m any factors that determine political boundaries— e.g., rivers, lake shores, m ountains, the ex istence o f uniform laws and regulations, the central locations o f m ost county seats—are coincident with the factors that determine the geographic limits o f an econom ic banking market. It is also worth noting that the Board o f G overnors o f the Federal Reserve System often defines “ banking markets” in terms o f county and multicounty areas in analyses o f bank holding com pany applications. A number o f quantifiable measures have been used to determine the degree o f concentration within a defined area. The easy-to-compute conventional ratio, used earlier to determine statewide aggregate concentration, is one such measure. However, it is not a totally satisfactory measure for analyzing local markets where all banks are to be considered. The Herfindahl ratio, although more difficult to compute than the conventional ratio, is considered superior to the conventional ratio because it does take into account all firms in the market (see box). A n increase in the Herfindahl ratio (the “ H ” ratio) that is specifically caused by holding com pany activity is defined herein as the holding com pany effect, an effect that com es about only when a multibank holding com pany (or com panies) acquires more than one bank in a specific banking district. The three-state analysis Bank holding com panies in Iowa, Michigan, and W isconsin, including onebank holding companies, control a sub stantial share o f all com m ercial bank deposits in those states. Iow a bank holding com panies control about 42 percent o f the state’s bank deposits; M ichigan holding companies control about 73 percent o f the state’s deposits; and W isconsin holding com panies control about 53 percent o f the state’s deposits. Federal Reserve Bank of Chicago There are 144 bank holding com panies operating in Iowa, 47 in M ichigan, and 65 operating in W isconsin. Despite a substan tially greater number o f bank holding com panies in Iowa than either M ichigan or W isconsin, Iow a’s bank holding com panies do not control a greater proportion o f deposits than do holding com panies in the other two states. Surprisingly, the state with the fewest bank holding companies, M ichigan, has the greatest proportion o f Herfindahl Index Among quantifiable methods developed to measure market concentration are the con ventional ratios and the Herfindahl index. Concentration in banking is usually measured by the conventional ratio, which is the percent of deposits controlled by the largest bank or banks. For example, a threebank ratio of .65 describes a market where the three largest banks hold 65 percent of the total market deposits. A more sophisticated measure is the Her findahl Index (H), expressed by the formula: n 2 H = E Si i=l where n = number of banks in the market, and Si = market share of the ith bank. The index attains the maximum value of 1.0 where a single firm operates in a market. The value declines with increases in the number of firms, increases with rising ine quality among any given number of firms, and vice versa. Unlike the conventional ratios that measure the combined market share of an arbitrarily determined number of the largest firms in the market, the Herfin dahl index takes into account all firms in a market, though it is more sensitive to the largest. Thus, to the extent that oligopoly or monopoly power is correlated positively with both fewness of sellers and inequality in their sizes, the Herfindahl index is a more op timum measure of market concentration than the simple percentage ratio. In a five-bank market example, H = (.40)2 + (,20)2 + (.15)2+ (.15)2+ (.10)2where the largest bank holds 40 percent of total market deposits, the second largest bank holds 20 percent, etc.; then H = .16 + .04 + .0225 + .0225 + .01 = .255. 15 Business Conditions, June 1975 its deposits controlled by them. This simp ly indicates that larger banks are members o f bank holding com panies in M ichigan than in Iow a or W isconsin. The percentage o f banks controlled by bank holding com panies in the three states is nearly the same. Bank holding com panies control about 27, 29, and 26 percent o f the total banks in Iowa, M ichigan, and W isconsin, respectively. The relative dis parity in the percentages o f total state deposits controlled by bank holding com panies and the percentages of banks con trolled is another indication o f the higher percentage o f larger banks that are members o f bank holding companies. Although the foregoing illustrates that bank holding com panies have had a great im pact upon the banking structure in the three states, their effect on local market com petition has been slight at best. Careful analysis shows that the number o f banking districts in which a holding com pany effect could be measured was sur prisingly small. Banking concentration caused by holding com pany activity in creased in only four o f Iow a’s 98 banking districts, in four o f M ichigan’s 78 banking districts, and in six o f W isconsin’s 67 bank ing districts. The holding com pany effect increased banking concentration in Iowa about 1.5 percent, in M ichigan only 0.5 per cent, and in W isconsin about 1 percent. The Herfindahl measure reveals that o f the three district states, Iowa has the lowest level o f banking concentration and M ichigan has the highest. (For more detailed inform ation on banking concen tration, see the individual state statistics.) However, some caution should be exercised regarding com parisons am ong the three states because o f differences in intrastate bank structures, the number and size o f b a n k i n g d is tricts , p o p u la tio n and dem ographic factors, and other minor variances. T he primary difference helping to explain the concentration variances am ong the three states is their intrastate bank structures: M ichigan has a total o f 347 banks (1,481 branches); Iowa has 664 banks (385 branches); and W isconsin has 620 banks (326 branches).2 Summary and conclusions The m ajor insight o f this study is that the holding com pany effect o f multibank holding com pany expansion in Iowa, M ichigan, and W isconsin has been minor. Com parisons do show that there is more banking concentration in M ichigan than in W isconsin or Iowa. The differences are primarily due to different branching laws. On a statewide basis, a 1.5 percent increase has occurred in Iowa and 1 percent or less increases have occurred in M ichigan and W isconsin. The expansion o f holding com panies in the three states has contributed little to increased concentration in the proxy banking markets. M ost interested observers m ight sur mise that the expansion o f multibank holding com panies would have had a sub stantial im pact upon competition at the local market level. T his assumption m ight well have been supported by the facts if bank holding com pany acquisitions were not subject to Federal Reserve Board ap proval. The negligible im pact that holding com panies actually have had on increased banking concentration in Seventh District states lends credence to the regulatory acumen o f the Federal Reserve Board. Granted, the record indicates that the Board approves a great majority o f holding com pany applications. However, it would be imprudent for a holding com pany to apply for expansion into an area where a high probability o f denial exists. The B oard’s approval rate does not reflect the silent restraints imposed upon holding com panies by the likelihood that the Board will deny acquisitions entailing signifi cant anticompetitive effects. Jack S. Light -Federal Reserve Bulletin, February 1975. Legal ly, Iowa banks have “banking offices” not branches.
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