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A review by the Federal Reserve Bank of Chicago

Business
Conditions
March 1971

Contents
The trend of business—
Postwar business
cycles compared
The challenges for small banks

2
10

Federal Reserve Bank of Chicago

THE

BUSINESS

Postwar business cycles compared

The business slowdown that began in the
third quarter of 1969 is responding stub
bornly to corrective actions. Although re
covery undoubtedly is underway, the current
revival is the most sluggish since World
War II.
Early in 1971, the strongest sectors of
the economy were residential construction,
automobiles, and steel—each of which was
recovering from a relatively low level of ac
tivity. Retail sales rose moderately in Decem
ber, January, and February. But output of
business equipment and defense-related out
put continued to decline. Evidence of a gen
eral uptrend in the economy remained un
clear.
The most comprehensive measure of eco
nomic activity is real gross national product
—total spending on goods and services ad
justed for price changes. Real GNP in the
first quarter of 1971 was up sharply from the
strike-depressed fourth quarter of 1970 and
may have exceeded the rate for the third
quarter of 1969. But the overall performance
of the economy was unsatisfactory. Total
employment, and total factory output re
mained substantially below earlier peaks.
Moreover, employment, factory output, and
new orders for durable goods declined in
February, after an improvement in the two

previous months. Temporary setbacks in a
general economic recovery are not uncom
mon, but the failure of these measures to
continue to rise was a disappointment to
policymakers.
Forecasts of the trend of the total economy
for the remainder of 1971 are in general
agreement that activity will rise, quarter-toquarter, throughout the year. Opinions differ
significantly, however, as to the rapidity of
the prospective uptrend. Even the most ebul
lient projections envisage a considerable mar
gin of unused resources of men, materials,
and facilities throughout 1971.
Until business activity recovers to an ac
ceptable level, the full story of the economic
adjustment that began in 1969 cannot be
told. Nevertheless, sufficient time has elapsed
to permit three general statements: First, the
1969-70 decline in activity was shallow com
pared with declines in earlier postwar cycles;
second, the time taken for a pronounced re
covery to develop has been long; and third,
the persistence of upward price pressures in
the face of unused resources is unprece
dented.
The p o stw a r re co rd

Not all business adjustments are classified
as recessions. For the title to fit, declines in

Business Conditions, March 1971

activity must have sufficient breadth (affect
ing many sectors), duration, and severity.
But these characteristics are matters of de
gree. Since World War II activity has slowed,
or declined slightly, in a number of periods
that were not considered, in retrospect, to
have been recessions. Such dips occurred in
1947, 1951, 1956, 1962, and 1966-67.
Most students of business conditions look
to the National Bureau of Economic Re
search (NBER), a private organization, to
identify recessions. The NBER has deter
mined that recessions began in 1948, 1953,
1957, and 1960. In each case, the evidence
provided by declines in real GNP, industrial
production and employment, and increases in
unemployment is persuasive. Although the
NBER has not offered a final opinion, most
analysts now believe that the decline that
began in 1969 should be counted as the fifth
postwar recession.
Recessions since World War II have dif
fered in the amplitude and duration of de
clines in total activity, and in the rapidity of
the revivals that followed. In the four reces
sions from 1948 through 1961, declines in
real GNP continued for either two or four
quarters. The amount of these declines
ranged from 1.5 to 3.9 percent. Interestingly,
the largest percentage decline was in the
1957-58 period when the downtrend con
tinued for only two quarters, and the smallest
percentage decline was in the 1960-61 period
when the downtrend continued for four quar
ters. The postwar recessions have been mild
compared to business declines of the 1920s
and 1930s when output dropped by one-third
or more.
How does the recent decline in activity
compare with the postwar record? The com
parison is influenced by the auto strike in the
fourth quarter of 1970. Real GNP had in
creased slightly in the second and third

quarters of 1970, and there was a widespread
expectation that the modest uptrend would
continue through the year. If the first quarter
of 1970 had been the low, the 1969-70 de
cline in real GNP would have lasted only two
quarters and amounted to only 1.0 percent.
Taking the fourth quarter as the low, the
decline from the peak was 1.4 percent, but
still slightly less than in 1960-61.
Turning to the recovery phases of postwar
recessions, the record shows variations in the
vigor of these uptrends. One method of gaug
ing the strength of a recovery is to compare
the length of time necessary for real GNP to
rise from the recession low to a level surpass
ing the previous high. In the first three post
war recessions, this phase took three quar
ters. The recovery of real GNP to a new high
took only one quarter in 1961, however, fol
lowing a mild downturn. This achievement
may have been duplicated in the first quarter
of 1971 as activity rebounded from the
fourth-quarter low.
The duration of a business fluctuation can
be measured from a pre-recession peak to the
quarter in which the peak is surpassed—the
entire period of decline and revival. In three
of the postwar recessions, it took five quarters
to regain the earlier peak. In the 1953-55
period, following the end of the Korean War,
the economy took seven quarters to complete
the cycle. If real GNP regained the 1969
quarterly peak in the first quarter of 1971, the
“round trip” will have taken six quarters.
Regaining an earlier peak after a slump is
only an interim goal for a dynamic economy
such as that of the United States. Because the
potential labor force and the capacity of pro
ductive facilities rise from year to year, satis
factory performance of the economy requires
continuous growth in real activity.
Real GNP has grown at an average annual
rate of 4 percent in the postwar period. This

Federal Reserve Bank of Chicago

Business Conditions, March 1971

does not mean, however, that real GNP has
grown at the 4 percent rate from the peak of
one business cycle to another. Only in two of
the postwar cycles— 1953-57 and 1960-69—
did real GNP regain the 4 percent growth
rate before another recession began. To per
mit a comparison of the strength of all post
war recoveries, the accompanying charts
show actual trends relative to both 2 percent
and 4 percent growth rates from pre-recession
peaks in real GNP.
In the first four postwar recessions, the
time required for real GNP to regain a 2
percent rate of growth over the pre-recession
peak varied from six quarters in 1948-50 to
eight quarters in 1953-55. If real GNP rose
at a steady 6 percent annual rate from the
fourth quarter of 1970, the 2 percent growth
rate from the 1969 peak would be achieved
in the fourth quarter of 1971—a period of
nine quarters. But most forecasts of activity
indicate a less rapid recovery, implying that
the 2 percent growth rate from the third
quarter of 1969 will not be achieved until
well into 1972.
Production an d em p lo ym en t

In most postwar business cycles, quarterly
peaks and troughs in industrial production—
output of mines, factories, and electric and
gas utilities—usually have coincided with
peaks and troughs in real GNP. In percentage
terms, however, the declines in industrial
production have been substantially greater.
Manufacturing output, especially durable
goods, and mining output fluctuate more than
the general economy for a number of reasons.
First, purchases of machinery and equipment,
both by producers and consumers, tend to
be concentrated in periods of prosperity.
Second, manufacturing and mining are more
likely to be interrupted by strikes than are
such activities as services and government.

Third, inventory growth is usually large in
periods of high-level activity, while inven
tories usually are reduced in periods of re
cession.
In postwar recessions, declines in indus
trial production from the peak quarter to the
trough quarter have ranged from 6.6 percent
in 1960-61 to 12.1 percent in 1957-58. In
the fourth quarter of 1970, industrial produc
tion was 6.7 percent below the peak level of
the third quarter of 1969. About half of this
decline probably was associated with the auto
strike. In the first quarter of 1971, industrial
production recovered, but remained below
the level of the third quarter of 1970.
Although industrial production usually re
vives simultaneously with real GNP, it takes
longer, one or two quarters longer, for indus
trial production to return to earlier peaks.
Most current forecasts imply that industrial
production will not regain the peak level of
1969 until well into 1972.
Peaks in wage and salary employment
often occur in the same quarters as peaks in
real GNP. But there is a tendency for em
ployment to lag in the early part of the re
covery phase. Large increases in output per
man-hour, typical in business expansions,
reduce the need to hire additional workers.
Although the recent business expansion
culminated in the third quarter of 1969, total
wage and salary employment continued to
rise through the year, and reached a record
high in the first quarter of 1970. The uptrend
in total employment continued despite de
clines in manufacturing employment. In part,
this development reflects the inability of
many employers to recruit enough workers
during the boom of the late 1960s.
In most postwar recessions, the percentage
decline in total wage and salary employment
has been about the same as the decline in
real GNP. In the fourth quarter of 1970,

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employment averaged 1.3 percent less than in
the first quarter, compared with a peak-totrough decline of 1.4 percent in real GNP.
Declines in both measures were influenced by
the auto strike. It is not yet clear whether
employment is rising in early 1971. For the
year as a whole, employment gains are ex
pected, but not at a rate sufficient to reduce
unemployment significantly.

Unemployment rate increases but
remains below levels reached in
earlier postwar recessions
percent unemployed

U n em p lo ym en t in th e cycle

According to the government definition,
an unemployed person is someone who does
not have a job and who is actively seeking
work. It is possible, therefore, for unemploy
ment and employment to decline simulta
neously, if net withdrawals from the labor
force occur. Similarly, when employment is
rising vigorously, unemployment may also
increase because more wives, students, and
older people decide to seek work, perhaps on
a part-time basis. In most periods of sub
stantial change, however, unemployment
(usually expressed as a percent of the total
labor force) moves in the opposite direction
from employment.
The quarterly low for the unemployment
rate in most postwar business cycles has
coincided with the high for employment, and
the high rate for unemployment with the low
for employment. In upswings, therefore, im
provements in both employment and unem
ployment usually lag behind the recovery in
the general economy.
The recent expansion in activity presents
a special case. Unemployment averaged 3.4
percent of the labor force, both in the fourth
quarter of 1968 and in the first quarter of
1969. This was the lowest rate since the end
of the Korean War in 1953. During 1969,
unemployment rose slightly, while total em
ployment continued to rise.
Unemployment increased sharply in 1970,

*G N P trough.
fG N P surpasses previous peak.

reaching 5.9 percent of the labor force in the
fourth quarter, the highest level since 1961.
In the first quarter of 1971, the average un
employment rate probably was about the
same as in the fourth quarter of 1970. If un
employment does not increase from the
recent level, it would compare favorably with
the peak rates recorded in previous postwar
recessions—7.0 percent in 1949 and 1961
and 7.4 percent in 1958.
But many observers expect the unemploy
ment rate to rise further in 1971, even if
employment increases. A large number of
young people will enter the labor force, and
additional wives may seek jobs to supplement
family income. In addition, the civilian labor
force is being increased by the reduction in
the armed forces—already down more than
500,000 since late 1969—with further cuts
planned for the remainder of 1971.
In flatio n an d la b o r costs

Price inflation has persisted in the past

Business Conditions, March 1971

year, despite declines in activity. Continued
price inflation during business slowdowns
has occurred in the past, but not to the same
degree as in the recent experience.
The implicit deflator for the gross national
product is commonly used as a measure of
the general price level. The deflator is ob
tained by dividing GNP in current dollars by
real GNP expressed in 1958 dollars. Constant
dollar GNP (in 1958 prices) is estimated by
adding the various components of total spend
ing after these have been deflated individually
by appropriate prices indexes.
The average price level (measured by the
GNP deflator) in the fourth quarter of 1970
was up 5.3 percent from a year earlier, and
up 6.5 percent from the third quarter of
1969, the peak level for activity. This was a
faster rate of price increase than in the five
quarters preceding the peak in activity. Ac
celeration of price inflation in a business
decline is unprecedented in the postwar era as
shown in the following table:
Peak in GNP
Year
Quarter
1948
1953
1957
1960
1969

Change in the price level
five quarters
Five quarters
before peak
after peak

4th
2nd
3rd
1st
3rd

(percent)

+ 7.2
+ 1.8
+ 4.9
+ 2.0
+ 6.0

- 2 .5
+ 1.4
+2.7
+ 1.9
+6.5

Even as recently as the first half of 1967,
when the uptrend in activity was halted tem
porarily, the rate of price increase slowed to
a significant degree, only to accelerate as
activity picked up. Price increases in whole
sale markets have been less frequent in recent
months, but the general price level continues
to advance at a rapid pace. Some slowing in
the rate of price inflation is generally ex
pected in the remainder of 1971, but most
forecasters believe that the price level will
rise a least 4 percent for the year as a whole.

Auto strike depressed industrial
output, but dip remains mild
compared to past contractions
percent change from cycle peak

number of quarters o ffe r peak in industrial production

Upward price pressures in recent years
have been associated with a rapid rise in
labor costs per unit of output in manufactur
ing. Using the same five-quarter comparison
as for the general price level, the rise in labor
costs accelerated during the recent decline in
business activity. The earlier postwar expe
rience was quite different, as seen in the fol
lowing table:
Peak in GNP
Year
Quarter
1948
1953
1957
1960
1969

4th
2nd
3rd
1st
3rd

Change in labor costs per unit
of output in manufacturing
Five quarters
Five quarters
before peak
after pe

(percent)

+ 4.9
+ 2.2
+4.1
- 0 .4
+ 5.0

- 3 .6
+ 1.9
+2.1
+0.7
+7.8

The trend of labor costs per unit of output
in the late 1950s and early 1960s is even
more favorable than is indicated in the table.

Federal Reserve Bank of Chicago

Although there were moderate increases and
decreases from time to time, labor costs per
unit of output in manufacturing were on a
virtual plateau from the fourth quarter of
1958 to the first quarter of 1966. In these
years, increases in hourly compensation were
offset by gains in output per man-hour.
In recent years, average increases in output
per man-hour have been disappointingly
small, while average increases in worker
compensation have increased sharply. These
trends have been associated with “cost push”
inflation and reduced profit margins.
The w a y a h e a d

The economy is now in the upward phase
of the shallowest business recession of the
postwar period. Before recovery to accept
able levels of activity is achieved, however,
the current business adjustment probably
will be recalled as the longest of the postwar
period. The economy has resisted the stimu
lus of expansionary monetary and fiscal poli
cies. Monetary policy has been stimulatory
for more than a year. Effective income tax
rates were reduced in the first half of 1970
when the 10 percent surcharge was removed.
Social security payments and welfare ex
penditures rose in 1970 and will rise again
in 1971. Wages and salaries have continued
to increase as boosts in compensation have
offset declines in employment and shorter
workweeks. Expansionary forces, however,
have contended with powerful obstacles.
The past year has been marred by wide
spread labor disputes that culminated in the
long auto strike of the fourth quarter. Work

stoppages have slowed increases in personal
income and have hampered efficiency. Labor
disputes had a greater effect on spending for
finished goods in 1970 than in any year since
World War II.
In addition to strikes, total activity has
been restrained by reductions in defense
spending and in the size of the armed forces.
These cutbacks have been reminiscent of the
declines in defense activity associated with
the end of the Korean War.
Another factor contributing to the slug
gishness of the economy has been the adverse
psychology of businessmen, lenders, and con
sumers. The current business adjustment was
preceded by an unparalleled business expan
sion that lasted almost nine years, and ended
in a period of accelerating price inflation. The
shock effect of a decline after such a long
expansion has been pervasive.
The experience of the United States with
price inflation despite growing margins of
unused resources has been duplicated, often
in a magnified form, in most other indus
trialized nations. Throughout the world,
governments are grappling with problems of
economic stabilization that resist the usual
formulas. In some countries, direct controls
over prices and wages have been employed,
usually with indifferent success. Although
steps in this direction have also been dis
cussed in the United States, policmakers in
the United States are proceeding on the
premise that the path to economic recovery
and reduced rates of price inflation can best
be accomplished with minimal restraint on
individual freedom and initiative.

Business Conditions, March 1971

-------

Recessions and depressions
When World W ar II ended in August
1945, widespread apprehension existed con
cerning the possibility of a postwar recession
resembling the extremely sharp downturns
of the 1920s and 1930s. In the business de
cline of 1920-21, industrial production (out
put of mines and factories in physical units)
dropped by almost one-third from the peak
quarter to the low, or “trough,” quarter. In
the downward phase of the “Great Depres
sion,” from 1929 to 1932, industrial produc
tion declined by more than a half. Another
drop of one-third occurred in the 1937-38
decline. Quarterly data for real GNP are not
available for these years, but declines in total
activity presumably were almost as large as
declines in industrial production. Unemploy
ment averaged almost 25 percent of the labor
force in 1932 and 1933, and 19 percent in
1938.
In the Employment Act of 1946, passed in
February, Congress declared it to be “the
responsibility of the Federal Government to
use all practical means . . . to promote
maximum employment, production and pur
chasing power.” The Act also (1) directed
the President to prepare an annual economic
report containing a program for carrying out
the policy; (2) created the Council of Eco
nomic Advisers to the President; and (3)
established the Joint Economic Committee
of Congress to review the economic report.
With minor amendments the Employment
Act of 1946 continues to serve as the govern
ment’s basic guideline for economic policy.
Since 1946, a number of “automatic sta
bilizers”— instituted for the most part in the
late 1930s, but expanded and liberalized
periodically— have helped to maintain pur
chasing power during business contractions.
Among these are unemployment compensa

tion, social security, welfare programs, and
farm income supports. The progressive in
come tax, which takes less proportionately
from the income stream in recessions, also is
classified as an automatic stabilizer.
The automatic stabilizers have performed
a vital function in maintaining purchasing
power and relieving distress among those
groups most severely affected by slumps in
business activity. But these programs have
been supplemented, when deemed appro
priate, by counter-cyclical monetary and
fiscal policy actions. In times of sluggish
activity, the Federal Reserve System has in
creased the availability of money and credit.
In the fiscal sector, government expenditure
programs have been increased, taxes have
been reduced, and lending programs have
been expanded.
The automatic stabilizers and counter
cyclical monetary and fiscal policies have
achieved a large measure of success. Since
World W ar II, business declines have not
approached the amplitude of the recessions
that occurred between the two World Wars.
Many sectors have been affected in these
postwar adjustments, some severely, but de
clines in total activity and employment, and
increases in unemployment have been mod
erate by prewar standards.
Some dictionaries define a “depression” as
a deep, and long-extended, decline in busi
ness activity, and define a “recession” as a
milder form of the same phenomena. In the
late 1930s, the 1937-38 setback commonly
was referred to as a recession to distinguish
it from the decline in activity that started in
1929. In recent years, the term depression
has fallen into disuse, perhaps because of the
limited scope of business adjustments since
World War II.
9

Federal Reserve Bank of Chicago

The challenges for small banks
Expansion of remarks of Mr. Robert P. Mayo,
President of the Federal Reserve Bank of Chicago
at the Group I Iowa Bankers Association Meeting
Sioux City, Iowa
February 12,1971

One of the most persistent and controver
sial questions in American banking concerns
the role—indeed the continued existence—
of the smaller, locally-owned and controlled,
unit bank. Depending on the definition one
chooses to adopt, there are from 2,500 to
over 6,000 such banks in the nation. Their
future is a matter of vital concern to bankers,
the public, and bank supervisory officials.
Those most directly affected are the offi
cers, employees, and stockholders who are
associated with the smaller banks. Naturally,
their lives are intimately affected by the future
performance of such institutions. Their con
cern has found expression in the organization
of numerous state, regional, and national
associations dedicated to the preservation of
“independent banking.” Others with more
than a passing interest in the matter are the
officials of big city banks who would like to
expand their operations, either by branching
or the establishment of a multiple-bank hold
ing company.
Bank supervisory officials have a some
what different interest in the matter. Their
primary concern is with bank solvency as it
affects the stability of the payments mecha

nism. In addition, their decisions to approve
or deny transactions which would consolidate
or eliminate small banks often depend heavily
on what can be learned regarding the ability
of such banks to render adequate services in
the future.
All of these groups, though their interests
differ and in some cases conflict, benefit from
objective knowledge of the situation as it
exists. Public discussion of the merits and
shortcomings of the uniquely American phe
nomenon of the small unit bank has long been
an arena for the exchange of charges and
propaganda by acknowledged self-interest
groups. And on some occasions, the validity
of the propositions offered seems to have
been considered secondary to their effective
ness in convincing the public to support one
point of view or another. My objective will
be to try to lay bare some of the issues. I
make no claim to ultimate answers, but I
think I can help to outline the existing evi
dence in an objective fashion.
Definitions

A logical starting point for such a discus
sion is with a definition of a “small bank.”

Business Conditions, March 1971

Although any definition is necessarily arbi
trary, there is much to be said for designating
as “small” any commercial bank with $5
million or less in deposits. Such a definition
seems to encompass most banks whose size
may present particular problems. It also con
forms to a deposit-size category for which
published data are available.
My basic task is to discuss in general terms
the “viability” of small banks. Here the term
“viability” is not used in the narrow sense of
ability to survive—though that is certainly a
major ingredient of “viability.” I am thinking
of the term more in the broader sense of a
bank’s current profitability and adequacy of
service, and the likelihood that it will be able
to continue rendering such service profitably
a decade or more in the future.
Som e b ack g ro u n d inform ation

The problems of small banks are compre
hensible only within the peculiar framework
of American banking and banking regulation.
The United States’ unit banking system—
comprising more than 13,000 separately in
corporated banking firms, each with its own
board of directors, place of business, and
chief executive officer—is unique in all the
world. In no other country is there such a
profusion of banks. This has been abetted by
an historic aversion to concentrated financial
power—and the associated reluctance in
many states to embrace branch banking. It
has been encouraged further by a permissive
entry policy stemming from competition be
tween federal and state chartering authorities
within our similarly unique dual system of
bank regulation. The seeds of the American
free enterprise system indeed found fertile
ground in the field of banking.
The establishment of new banks took on
a feverish pace in the early decades of this
century, fed by continued population growth.

a broadly-based prosperity, and the unprece
dented demands generated by World War I.
In 1921, the number of commercial banks in
the United States reached an unheard-of
level in excess of 30,000. It soon became
clear that the banking system was far overexpanded. During the generally prosperous
1920s, the return to prewar levels of demand
for foodstuffs and raw materials produced a
virtual agricultural depression that lasted
until World War II. The consequences for
rural banks were disastrous. About 500
banks failed yearly between 1921 and 1929;
the total for the decade was almost 6,000.
With the advent of the depression, the
decade-long ripple of bank failures reached
the proportions of a tidal wave; in the years
1930 through 1933, 8,000 banks failed. The
introduction of federal deposit insurance re
moved the major cause of bank runs, and
tighter regulation and more restrictive entry
policies slowed bank failures to an annoying
trickle after 1933. By the early 1940s, con
solidations and voluntary liquidations com
bined to reduce the number of banks to ap
proximately the present level. Since then
there has been no apparent trend either up or
down, and since 1954 the number of U. S.
banks has not exceeded 14,000 or fallen be
low 13,000.
The number of banks tends to exaggerate
the degree to which banking in the United
States is a diffused, decentralized industry.
As Federal Reserve Governor George W.
Mitchell has noted on several occasions, look
ing only at the number of banks can be mis
leading. As one views the distribution of
banking resources, the picture is quite dif
ferent. Three-quarters of the commercial
banks in the United States are unit banks.
However, they account for less than one-third
of the deposits and serve only one-third of all
banking customers. At the other end of the

Federal Reserve Bank of Chicago

spectrum, the largest 1 percent of banks ac
count for more than half of total deposits.
The 20 largest banks alone account for nearly
one-third of all commercial bank deposits.
Indeed, it is as though the United States
possessed two banking systems; one, on the
European plan, composed of a relatively few
giant banks with vast international operations
and extensive branching systems; the other,
with five-sixths of the number of banks but
only one-sixth of total deposits. The second
group serves some 7,000 one-bank communi
ties and other small towns and rural areas.
Branch banking has gained at the expense
of unit banking in recent years. On December
31, 1969, in addition to the 13,000-odd head
offices of commercial banks, there were more
than 20,000 branches and limited-service
offices at which some types of banking busi
ness could be transacted. As late as Decem
ber 31, 1950, there were only about 5,000
branches of commercial banks in the United
States. Although some of the increase in the
number of banking offices resulted from the
conversion of independent banks to branches
following mergers, the overwhelming ma
jority—on the order of 80 percent—were
established de novo. But, primarily because
of the differing laws governing branching in
the several states, this growth was concen
trated in certain areas. Unit banks still far
outnumber branch banks. As of December
31, 1969, there were almost 4,000 banks, or
28 percent, operating at least one branch, as
opposed to about 1 percent in 1900 and 10
percent in 1950. But the great majority of the
nation’s banks—more than 10,000—remain
unit banks. Most, though not all, of the 7,000
insured commercial banks with less than $5
million in deposits—our arbitrarily defined
small banks—are among these 10,000.
Although relatively modest in terms of
national totals, the banks at the lower end of

the size scale are still the sole source of bank
ing services for an absolutely large and, even
in relative terms, significant fraction of the
American population. Primarily for this rea
son, their performance in providing these
services is a matter of broad concern with
important implications for public policy.
C u rre n t p ro fita b ility o f sm all b a n k s

Undoubtedly, the simplest argument one
could make for the proposition that small
banks are viable is that they exist. But mere
existence does not indicate whether a bank is
doing a good job relative to some objective
standard of performance that is both tech
nologically feasible and economically attain
able. Both continued existence and observed
profitability can be evidence of a protected
market position rather than “viability.”
Fortunately, there are ways of determining
whether observed profitability is due to pri
marily to desirable economic performance or
to the absence of competition. Therefore, it
may be of interest to look at what the data
show regarding the profitability of small
banks.
There is some question as to which of
several alternative measures of profitability is
most appropriate for assessing the success of
banks. One question concerns the appropriate
base against which profits should be mea
sured. Because capital ratios are subject to
supervisory influences and for that reason
are likely to vary greatly between banks with
little relation to basic economic factors, some
economists prefer to measure profitability
relative to total assets. However, it seems
clear that what bank stockholders are more
interested in, and what bears most directly on
decisions to enter the industry, is the return
on equity. Hence, profitability is better mea
sured in relation to total capital accounts.
Another problem relates to the choice be-

Business Conditions, March 1971

small banks by the
lower
tax rate appli
All U. S. commercial banks
c
a
b
le
to th e f ir s t
Deposit-size (m illio n d o lla rs)
$25,000
of net income
500
50
100
2
5
10
25
Less
1
or
to
to
to
to
to
to
to
than
would be neutralized,
more
25
100
500
2
5
10
50
1
in equilibrium, by the
(p e rc e n t o f to ta l c a p ita l accounts)
entry of additional re
Net current
sources into the mar
operating
ket. For all of these
17.07
18.18
17.67
13.95
15.92
17.73
12.39
17.00
earnings
9.95
reasons, the ratio of
Net income
net income after taxes
13.57
14.59
12.96
13.90
8.62
10.52
11.28
12.73
13.51
before tax es
to to tal cap ital ac
Net income
counts is chosen as the
10.58
10.31
9.35
9.48
9.96
10.17
afte r tax es
6.89
8.23
8.50
best single measure of
S O U R C E : Fed eral Deposit Insurance Corporation.
bank profitability. Net
c u rre n t o p eratin g
earnings and net income before related taxes
tween net current operating earnings and net
will be presented as supplementary data.
income as measures of profitability. Because
Data compiled by the Federal Deposit In
net current earnings are dependent very
surance Corporation for all insured commer
largely on performance during the current
cial banks indicate a marked relationship be
period, while net income figures include se
tween bank size and profitability. This rela
curity transactions and may reflect decisions
tionship is independent of which measure of
based primarily on tax considerations, the
profits is chosen.
former has sometimes been held to constitute
a less objectionable indicator of performance.
The average earnings ratios of the banks in
But portfolio management, as reflected in
the first three size classes (less than $1 mil
profits or losses on sales of securities, is also
lion, $l-$2, and $2-$5 million in deposits—
an important element of banking perfor
or the “small banks” under the definition
mance. Especially if one considers average
mentioned earlier) are lower than those of
profitability over an extended period of time,
the banks in any other size class. The earn
the year-to-year distortions from tax-moti
ings ratios increase in each successive group
vated transactions should tend to wash out.
through the $25-$50 million deposit class.
In this case, the net income figures would be
They decline slightly for the $50-$ 100 mil
expected to give the most comprehensive
lion class, increase again in the $100-$500
picture of bank profitability.
million class, and then decline again in the
Finally, there is the choice between net
$500 million and over class. The earnings
income before related taxes and net income
ratio of the most profitable size class of
after such taxes (primarily the federal cor
banks, the $100-$500 million deposit-size
porate income tax). In a competitive market,
class, was just a shade more than 1Vi times
with investors free to make their decisions on
the ratio for the least profitable class (less
the basis of all economic considerations, it is
than $1 million) and one-fifth larger than the
the net income after taxes that would tend to
ratio for the most profitable of the “small
be equalized. Thus, the advantage given to
bank” size classes ($2-$5 million).

Bank profitability by deposit-size class, 1968

Federal Reserve Bank of Chicago

group. Although the trend is not altogether
clear, it looks as if the differential may have
widened in the last three years, although a
major revision of the class intervals in 1969
obscures the change during that year.
Whether this is a lasting development re
mains to be seen; but it constitutes a marked
departure from the behavior of the differen
tial between 1954 and 1965, when it ranged
between 2 and 2.6 percentage points.
Changes in the populations of the several
size classes attributable to growth and re
definitions of the class boundaries make im
possible any definite conclusion about
changes through time.
Obviously, the data indicate that small
banks have poorer earnings records. It is of
interest, however, to determine whether this
apparent disadvantage is simply a matter of
accounting, or if real, whether it reflects a
conservative asset policy, a less-than-optimal
pricing policy, or high costs.
There are several possible sources of bias
in the reported earnings data based on the
arbitrariness of accounting procedures. It has

These are significant differences. To the
extent that they can be taken at face value,
they indicate a marked inferiority in earning
power of banks in the smallest size categories.
S e v e n th D istrict m em b er b a n k s

Operating ratio data for member banks of
the Seventh Federal Reserve District show
the same pattern as the national data for in
sured commercial banks. In each year from
1961 through 1969, banks in the two lowest
deposit-size classes had lower ratios of net
income after taxes to capital accounts than
those of banks in larger size classes. The fact
that this situation prevailed in each of the
last nine years suggests that there is very
little chance that it could be the result of
special factors operating in a particular year.
The differential in the ratio of after-tax
income to capital between the largest and
smallest deposit-size classes ranges from
2 to 4.6 percentage points over the nine-year
period. In relative terms, the average rate of
return of the largest group ranges from
1.27 to 1.66 times that of the smallest size

Ratios of net income after taxes to capital accounts
Seventh District member banks
Deposit-size groups (m illion d o lla rs)

Year

Under
2.5

2.5
to
5

1961

7.3

8.3

1962

7.4

8.2

Under
5

15
to
25

10
to
25

15
to
50

5
to
15

5
to
10

9.3

10.8

9.1

£
c

8.8

25
to
50

50
to
100

O ver
50

100
to
500

O ver
500

(p e rc e n t o f to ta l c a p ita l a ccou nts)
Oh

'O
Oh

1963

6.9

8.0

8.1

1964

7.0

8.0

"u5

8.7

1965

7.5

8.5

1966

8.5

1967

6.5

8.9

1968

7.2

8.6

1969

‘ui
_0
u
*
a>

Z
8.7

8.6

C
JO

9.0

9.2

8.5
9.3
9.5
9.0

_0
u

9.9

9.6
10.3
10.6

_0
u
*
01

Z
10.4

Oh
hO
Oh

11.9
9.4

8.3

9.2

c
^o

8.8

9.1

"5
u

*v»
_o

CO
o
C Oh
0 —
a "o
U 0)
*

10.2

-9

11.1

10.8

10.6

11.3

10.7

10.8

1
S
us

9.5

9.6
9.4

•

*
•

10.7

Business Conditions, March 1971

often been suggested, for example, that the
owner-managers of small banks tend to pay
themselves relatively modest salaries while
building up their equity in the banks through
retained earnings. In this way, small banks
may be able to increase overall after-tax
income. In a strict economic sense, the re
turn on capital would be exaggerated and
salary expense underestimated. However, the
existence of such behavior would only
strengthen the conclusions reached above, in
that a correct reporting of salary expense
would make even more pronounced the dif
ferentials in earnings ratios. Others have
suggested the possibility of a systematic,
size-related bias in reporting profits running
in the opposite direction—i.e., that closely
held small firms may pay their owner-man
agers excessively high salaries to avoid
double taxation of dividends. In this case,
their profits would be understated.
Evidence on the salaries paid by banks of
different asset size does not support the
hypothesis that small bank owner-officers
take much of their profit in the form of high
salaries. A 1967 survey indicates that the
median officer’s salary paid by banks with
more than $500 million in assets ranged
from 14 to 33 percent greater than that paid
by banks with assets of less than $100 mil
lion, depending on the age group of the
officers. To be sure, officers’ salaries—and,
for that matter, total salary expense—consti
tute a smaller share of total operating ex
penses for large banks than for small banks.
But this is primarily a matter of a lower ratio
of officers to employees at larger banks. So
it appears that the lower rates of return on
equity earned by small banks are real.
Remarkably enough, these low earnings
ratios do not result from any obvious in
efficiency in utilization of small bank assets.
Although small banks tend to hold from 5 to

15 percent less of their assets in the form of
loans than the largest banks—because of con
servatism, liquidity needs, weak local loan
demand, or deliberate restriction of credit to
maintain its price—this alone would account
for only a very small difference in their rate
of return. Nor is the difference to be found
in differences in gross yields on assets.
Rather than displaying any persistent ten
dency to be consistently either higher or lower
than that of large banks, the average return
on loans of small banks doesn’t seem to
change much. When interest rates are high or
rising, the average rate of return on loans and
on total assets of large banks rises above that
of small banks. The opposite seems to be true
when rates are low or falling.
The ratio of total expenses to total operat
ing revenue also fails to show any consistent
relationship to size. In 1969, Seventh District
member banks with deposits under $5 million
had an average expense/income ratio of
78.26 percent, while those with deposits over
$500 million had an average ratio of 78.72
percent.
C a p ita liza tio n ratio s

With no systematic differences in either
gross yields on assets or the ratio of expenses
to revenue, the lower earnings of small banks
on capital can be attributed to only one
factor— a higher ratio of total capital ac
counts to assets. The data confirm that this is
the case. In 1968, Seventh District member
banks with under $2.5 million in deposits had
an average ratio of total capital accounts to
assets of 11.3 percent, more than IV2 times
as great as that for banks with over $50
million in assets. Accounting changes in 1969
destroyed comparability with the earlier
figures, but the ratio of total capital accounts
and reserves—the base on which return is
now measured—to total assets remains much

Federal Reserve Bank of Chicago

higher for small banks. So far as current
profitability is concerned, the differences be
tween large and small banks are primarily a
consequence of the much higher capitaliza
tion ratios of small banks.
The reasons for these differences in capi
talization ratios are not entirely clear. Oc
cupancy expense ratios do not suggest any
major economies of size attributable to in
divisibility of bank premises. On the other
hand, the great variability in loan loss ex
perience among small banks suggests that
they may be subject to considerably more risk
than are large banks with a larger number of
loans on their books. Small banks may also
be subject to greater risks from deposit
fluctuations, although the most recent evi
dence suggests that this depends heavily on
the observation period one uses in measuring
deposit changes. Finally, differences in capi
talization ratios may be caused partly by

Small banks have higher capital
ratios
percent

deposit size (million dollars)
Note: Data a re tor Seventh District mem ber ban ks for
16

1970.

regulatory pressures, although there is some
evidence that banks have succeeded in sub
stituting deposit insurance for capital as pro
tection for depositors. Whatever the causes,
however, it is clear that small banks do suffer
a major earnings disadvantage.
Econom ies o f sca le

Although recent operating ratio data do
not indicate any systematic relationship be
tween deposit-size and expense ratios, studies
utilizing economically meaningful measures
of banking output and costs suggest that there
are important, if modest, economies of scale
in the production of commercial banking
services. The results of some of the earlier
of these studies are subject to doubt because
of their uncritical use of operating ratio data,
which—in contrast to the same type of data
for more recent years—seemed to indicate
declining unit costs as size increased.
By measuring size or output by the dollar
volume of deposits or earning assets, these
studies attribute to the economies of large
size some cost savings that are actually the
result of larger average size of transactions.
Consequently, early studies cannot be inter
preted as showing that large banks could
supply at a lower cost the same mix of ser
vices small banks are called on to provide.
Later studies, however, employing such physi
cal measures of output as the number of
accounts and account activity, tend to con
firm the earlier findings of economies of scale
in banking. The most sophisticated of these
studies, published in 1968 as a research re
port by the Federal Reserve Bank of Boston,
states:
If a typical commercial bank were to
expand all its activities (functions or
products) within its existing facilities
by 10 percent, total cost would rise by
9.3 percent.. ..

Business Conditions, March 1971

In other words, costs would increase by less
than output, and unit costs would decline.
The fact that there are economies of scale
in the production of commercial banking
services does not mean that small banks are
destined to disappear through merger or
through competitive extinction. Many small
banks serve markets that are small and geo
graphically isolated. They could grow more
rapidly than the economies of their immediate
areas only if they were permitted to branch
into additional markets. So long as we confine
our attention to unit banks, therefore, there
is no way to increase the size of such banks
to improve efficiency. They may, in fact, be
of optimal size for the markets they serve.
Assuming that small unit banks could be
acquired by large banks and operated as
branches, is it clear that such action would
be economical in all cases? Because of the
difficulties of obtaining appropriate data for
individual branches, this question cannot be
answered definitively. Preliminary evidence
suggests that any cost advantages obtainable
by operating a banking office of a given size
as a branch of a larger bank, rather than as
a unit bank, are modest.
The evidence on economies of scale is
made less ominous than it might appear by
the great variation in performance of banks
within a given size class. Despite the system
atic tendency of small banks to have higher
unit costs than large banks, the most efficient
small banks have lower unit costs than the
average large banks. There will always be a
place for the well-run, efficient, small bank.
The very nature of an average, however, im
plies that small banks displaying exception
ally good performance are offset by other
small banks whose performance is poor.
Except insofar as their owners are willing to
endure less-than-competitive returns in ex
change for the privilege and prestige of con

tinuing in the banking business, the future of
such institutions is bleak.
Future pro blem s

The continued “viability” of many small
banks will depend on how well they are able
to cope with expected increases in what Mr.
Howard Crosse, formerly of the Federal Re
serve Bank of New York, has called “pro
spective costs.” These are the levels of costs
which the bank may reasonably expect to
incur in the near future, as opposed to its
current operating costs. In many cases, be
cause of imperfections in the labor market
or other special conditions, the costs banks
experience currently are far lower than their
“prospective costs.”
A common example is the experienced and
trusted employee who is nearing retirement
age, and who, because of his attachment to
the community and the satisfactions of his
job, has been willing to accept a salary lower
than a man with comparable qualifications
could earn elsewhere. It is very unlikely that
the man in question can be replaced with a
younger man except at a considerably higher
pay scale. The salary differential between
large and small banks is much less for
younger officers more willing and able to seek
alternative employment. To use a term from
a somewhat different context, the replace
ment cost for an older employee is sharply
higher than his original or historic cost.
Failure to take account of such a factor in
planning for the future is the equivalent of
living off one’s capital. The particular ex
ample used to illustrate the problem of in
creasing “prospective costs” is familiar to
bankers in the guise of the “management
succession problem.”
A potentially more dangerous threat to the
continued satisfactory functioning of small
banks is the development of new banking

Federal Reserve Bank of Chicago

services and technology that requires both
specialization of labor and large indivisible
pieces of mechanical or electronic equipment.
It is argued that, because the minimum size of
bank able to take full advantage of costreducing and service-expanding innovations
is quite large, small banks will eventually be
forced to combine, in one way or another,
into larger banking organizations. To state
this view is not to demonstrate its validity.
The fact that only large banks find it
feasible to operate their own computers is not
equivalent to saying that small banks cannot
enjoy the benefits of a computer. Many small
banks already purchase computer services
from independent data processing firms on
a time-sharing basis; some purchase such
services from their large city correspondents.
Incidentally, many banks have found entry
into the computer age to be anything but an
unmixed blessing. Predicted cost reductions
often have not been realized, or have been
realized years later than expected. More
recently, competition in the provision of com
puter services on a time-sharing basis has
developed to the point where few banks are
able to report a profit on this type of business.
Despite these reservations, however, there
remains a presumption, shared by many
within the banking community and else
where, that there are indeed benefits of effi
ciency and improved service to be realized
by combining existing small banks into units
large enough to take full advantage of a con
tinually evolving computer technology.
S ervin g th e com m unity

Of all the questions having to do with the
present and future role of small unit banks,
none is more important or more difficult to
answer than that of how well they have served
the “convenience and needs” of their communities. Small bank officials are fond of

expounding on the friendly, personal service
rendered by locally-owned banks and citing
evidence that such banks tend to make more
unsecured loans than the cold, businesslike
branches of big city banks. Advocates of
bigger banks and expanding branching are
likely to retort that hard financial facts are a
better basis for allocating society’s scarce
capital than the personal likes and dislikes of
a country bank president, and to go on to cite
figures indicating that large banks consis
tently place a larger proportion of their assets
in loans, which contribute directly to com
munity developments, than do small banks.
There have been a number of studies de
signed to throw some light on how well banks
of various sizes meet the needs of their com
munities. For example, a recent survey of
more than 2,000 banks in the Seventh Dis
trict indicated that only three of 17 non
credit consumer services were more likely to
be offered by small banks than large banks.
These were one-statement banking, insurance
agency, and automatic customer bill payment
services. It was hardly surprising, moreover,
to learn that the most dramatic differences
were in trust services, foreign banking
services, and in-plant banking. Of 19 non
credit business services, only one—insurance
agency services—was offered with greater
relative frequency by small banks. All the
others—including credit information, lock
boxes, bank statement reconciliation, payroll
accounting, business income/expense record
keeping, equipment leasing, managerial ser
vices, and freight traffic services—were of
fered with greater relative frequency by large
banks.
It is obvious that what appears to be a
marked superiority on the part of large banks
in rendering services is primarily a reflection
of the differences in demand between urban
and rural areas. Even if there is a latent de-

Business Conditions, March 1971

mand in small bank markets for such services
as portfolio management, securities registra
tion, freight payment, and trust services, it is
clear that this demand could not be very
great. That being the case, it is doubtful that
a large bank acquiring such a small bank and
operating it as a branch would find it eco
nomic to offer all these services at the branch
office. In many cases—as has become ap
parent to us in the course of processing appli
cations for mergers and holding company
acquisitions in the Seventh District—a prom
ise to provide trust services, for example, at
an office where they were previously unavail
able often means no more than that a cus
tomer inquiring about such services will be
referred to the trust officer at the bank’s head
office. This, obviously, adds nothing to what
a unit bank can do by referring customers
to its correspondent.
What appears to come through from these
data is that the provision of services depends
largely on the banker’s capacity to recognize
the demand for services in his area, and to
fulfill the demand through his ability to turn
the benefits of technology to his own and his
customers’ advantage.
R u ral cre d it n e e d s

To some of your customers, in particular
the farmer, the ability to obtain credit when
and in the quantities he needs it, will be of
much more direct interest and immediacy
than the variety, quality, or even price of
services. For many years, the availability of
bank credit was not a problem. The great
liquidity built up in the postwar years enabled
rural banks to meet demands for agricultural
credit without difficulty. As loan-deposit
ratios and the average size of farms have
continued to grow, however, the situation
has changed; rural banks are reaching the
limits of their lending capacity in two distinct

but related senses.
First of all, most rural banks no longer
have the excess liquidity they did 20 years
ago. Loans have increased at a much faster
pace than deposits.
The other complication faced by rural
banks in servicing the credit needs of their
farm customers is the continuing rise in the
average size of loan requests. After doubling
between 1956 and 1966, the average size of
farm loans has continued to increase at a
comparable rate in more recent years. This
means that a continually growing proportion
of farm loans approach the legal lending
limits of the farmers’ local banks.
These developments, plus projections of
substantial growth in farm credit demands,
suggest that many small banks will find it
difficult to meet the credit needs of their
communities from the banks’ own resources.
Appropriately, attention has been directed
toward devising new means to channel funds
to rural banks. Proposals currently under
consideration call for encouraging banks to
discount farm loans at Federal Intermediate
Credit Banks, expanding seasonal borrowing
privileges at the Federal Reserve discount
window, and providing government guaran
tees for some new type of debt instrument to
be issued by rural banks to make feasible the
development of secondary markets.
But as useful as these types of measures
may be, banks should not rely on them to
rationalize their own inaction in other ways.
As I argued last October in Des Moines,
small banks must respond if we hope to im
prove these credit flows. The correspondent
bank system, for example, is very much alive.
Through aggressive and imaginative use by
both small and large banks this system can
provide an even more efficient channel for
the flow of funds between capital surplus and
deficit areas.

Federal Reserve Bank of Chicago

C o n c lu s io n s

I firmly believe that the viability of the
small bank depends largely on the willingness
and ability of small bank management to
grasp the opportunities available. We can
review, discuss, and evaluate the most sophis
ticated of economic studies, but we would
still come to the conclusion that these are
poor substitutes for the test of the market
place. The only conclusive proof of the con
tinued usefulness of small banks would be
their customers’ demonstrated loyalty in the
face of convenient alternative sources of
banking services. In too many cases, how

B U SIN ESS

C O N D IT IO N S

p u b lish e d

ever, artificial barriers to competition pre
vent such a test from taking place.
We can and should be striving to remove
the obstacles that obstruct the free workings
of the market. Just how this should be done
and to what lengths any liberalization of
the banking laws should be varied are difficult
issues. I do not pretend to know how they
can best be resolved. My intention has been
to go to the roots of what, in my view, are
serious questions affecting the future of the
banking system in the United States. And
with these words, I pass this hot potato back
to you.

m o nth ly b y the F e d e ra l R e se rve B a n k o f C h ic a g o .

G e o rg e W . C lo os w a s p r im a r ily re sp o n sib le fo r the a rtic le , "T h e tre n d o f b u sin e ss—P o stw a r
b u sin ess cycles c o m p a re d ."
Su b scrip tio n s to Business Conditions a r e a v a ila b le to the p u b lic w ith o u t c h a rg e . Fo r in fo r
m atio n co n ce rn in g b u lk m a ilin g s , a d d re s s in q u irie s to the R esearch

D e p a rtm e n t, F e d e ra l

R ese rve B a n k o f C h ic a g o , B o x 8 3 4 , C h ic a g o , Illin o is 6 0 6 9 0 .

A rtic le s m a y be re p rin te d p ro v id e d so urce is cre d ite d . P le ase p ro v id e th e b a n k 's R esearch
D e p artm e n t w ith a co p y o f a n y m a te ria l in w h ic h a n a rtic le is re p rin te d .

Full text of Business Conditions (Federal Reserve Bank of Chicago) : March 1971

FRASER