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a n e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f C hicago

International banking:
Part I

The overseas branch networks of
U.S. banks grew at impressive rates
in the 1965-75 period. As the banks
acclimated themselves to serving
customers at foreign locations they
became increasingly adept at
providing the full range of financial
services.

Advertising for demand
deposits

An analysis of advertising expen
ditures sheds some light on one way
banks attempt to attract demand
deposits in view of legal restric
tions on price competition.

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Business Conditions, September 1975

International banking: Part
The past decade has witnessed profound
changes in the international banking ac
tivities of U.S. banks as the industry has
responded to the challenges and demands
of a changing environment. This article
traces these activities over the period. A
second article, to appear in the subsequent
issue o f Business Conditions, will focus on
activities o f foreign banks in the United
States.

Expansion of branch networks:
1965-70
The position of the U.S. dollar in inter
national finance, the continued expansion
of international activities of U.S. cor
porations, the rapid growth of world trade,
and the increasing internationalization of
the world’s capital and money markets
presented the U.S. banking industry with
new opportunities. However, the existing
regulatory environment largely shaped
the channels through which U.S. banks
could respond. A set of programs restrain
ing the outflow of funds from the United
States, introduced by the U.S. Government
in 1964-65 in an effort to shore up the coun
try’s balance-of-payments position, ex
erted a strong influence on the inter
national activities of U.S. banks.
The federal government’s capital con
trol program consisted of the Foreign
Direct Investment Program (FDIP), the In
terest Equalization Tax (IET), and the
V olu ntary Foreign Credit Restraint
(VFCR) program. Under FDIP, initiated as
a voluntary program in 1964 and made
mandatory in 1968, U.S. corporations were
limited in the amount of funds that they
could transfer to their corporate affiliates
overseas. At the same time the foreign af

filiates were constrained as to the amount
of locally generated earnings they could re
tain for reinvestment purposes. The IET,
by imposing a tax on yields of securities of
foreign origin, lowered the effective yield of
such securities, making them less attrac
tive to U.S. residents—and thus making it
more difficult for foreigners (including the
foreign affiliates of U.S. corporations) to
finance their capital requirements in the
U.S. market. Under the VFCR program,
administered by the Federal Reserve
Board, the head offices of U.S. banks were
requested to limit their foreign lending to
ceilings that reflected their historical
foreign credit levels.1 The program severe
ly curtailed the capacity of home offices of
U.S. banks to meet the overseas needs of
their large corporate customers.
As a result of these restrictions U.S.
corporations had to rely on external
sources of funds to finance their growing
investments abroad. To accommodate
their corporate customers, U.S. banks es
tablished networks of foreign branches for
purposes of tapping foreign sources of
funds and setting up loan placement and
service facilities. Given the nature of the
impetus, the need and desire to expand
abroad was not limited to the banks that
traditionally engaged in an international
banking business. Up to the early sixties
only U.S. banks located in the coastal
centers—primarily New York City, with
some representation by Boston and San
Francisco—operated overseas branches.
What was especially notable about the
rapid buildup of networks of foreign
branches of U.S. banks in the period 196570 was that banks headquartered in such
'In November 1971 banks were provided with the
option o f adopting a ceiling related to their size.

cities as Chicago, Pittsburgh, Detroit, and
other regional money centers entered
foreign markets aggressively.

Regulation Q
The government’s capital restraint
program was not the only factor that in
duced U.S. banks to establish and expand
their foreign branch networks. Another
regulatory barrier to the activities of U.S.
banks in their home environment played
an equally important role in inducing U.S.
banks to establish a presence abroad.
The Federal Reserve System’s Regula
tion Q places a limit on the rate of interest
U.S. banks are allowed to pay on deposits
received at their offices in the United
States. In 1966 and again in 1969-70 as the
level of U.S. interest rates rose due to the
combined impact of a booming economy
and an increasingly tight monetary policy,
U.S. banks were restrained by Regulation
Q ceilings from paying domestic deposi
tors interest rates that could compete with
the interest return from alternative finan
cial instruments, such as U.S. Government
Treasury bills and short-term unsecured
promissory notes issued by large U.S. cor
porations (commercial paper). Banks ex
perienced a run-off in deposits at domestic
offices because of their inability to compete
effectively for domestic funds. To supple
ment their traditional sources of funds,
U.S. banks found it expedient to turn to
their foreign branches that were not sub
ject to interest rate ceilings and, thus, were
free to compete for funds. Deposits taken in
at overseas branches were transferred
back to the United States for use by the
domestic offices.
London branches, in particular, devel
oped considerable capabilities in attract
ing U.S. dollar-denominated deposits (socalled Eurodollars)2 because of the advan
2Eurodollars are U .S. dollar-denominated de
posits at a non-U.S. resident bank such as, for exam
ple, a London branch of a U .S. bank.

Federal Reserve Bank of Chicago

tages these international money-center es
tablishments offered corporate as well as
foreign governmental clients. The overlap
in business hours between London and the
Continent allowed readier access to dollar
deposits located in London than at U.S.
head offices. The vigorous competitive en
vironment and the absence of reserve re
quirements resulted in London branches
paying higher interest rates on dollar
deposits than domestic U.S. offices or Eu
ropean banks paid on local currency
deposits. Also, the branches could pay in
terest on dollar deposits with maturities
less than 30 days—a practice prohibited to
domestic offices under Regulation Q.
In addition, in 1966 the London
branch of a New York bank introduced the
negotiable E urodollar certificate of
deposit, a technique soon adopted by
London branches of other U.S. banks. The
introduction of negotiable Eurodollar
certificates of deposit and the subsequent
development of a secondary market for
them is a classic example of a successful
transfer o f “ fin a n cia l te ch n o lo g y ”
developed earlier by U.S. banks to
meet the challenges of the domestic
environment.
The bottom line result of the combined
impact of the regulatory environment and
of the internationalization of U.S. business
activities was that the number of U.S.
banks with foreign branches went from 11
in 1965 to 79 in 1970, and the number of
foreign branches of U.S. banks rose
dramatically from 180 to 532. The number
of such branches in Continental Europe in
creased from 15 in 1965 to 66 in 1970. For
the most part these branches were
“ downstream” facilities from London
money-center branches, set up as loan
placement and service facilities for large
corporate customers. But branches also
accepted deposits in the local currencies,
thereby acquiring the funds needed for
financing the local requirements of the af
filiates of U.S. corporations.

Business Conditions, September 1975

Overseas branches of U.S. member banks, 1965-75
fas of January 1)
1965

1966

1967

1968

1969

1970

1971

1972

1973

1974

1975

B e lg iu m -L u x e m b o u rg
F rance
G erm an y
G reece
Italy
T he N e th e rla n d s
S w itze rla n d
U n ite d K in g d o m
T o ta l E u ro p e 1

2
4
3
1
1
3
1
17
32

4
4
6
1
1
3
1
21
43

6
4
8
1
1
3
2
21
48

8
6
9
2
2
3
3
24
59

9
7
14
5
2
5
3
32
80

11
11
17
8
3
7
6
37
103

11
12
21
9
4
7
7
41
116

8
15
22
13
6
7
8
45
128

8
17
27
14
7
6
8
49
142

15
15
30
16
8
6
9
52
157

15
17
30
18
10
6
9
55
167

Baham as
C aym an Islands
T o ta l C a rib b e a n 2

—

91
32
166

80
44
166

A rg e n tin a
B razil
C o lu m b ia
Panam a
T o ta l Latin A m e ric a 3

16
15
5
10
78

C h ina , R e p u b lic o f T aiw an
H o ng Kong
Ind ia
Ind one sia
Japan
Lebanon
Persian G u lf4
S in g a p o re
T o ta l A sia 5

—

C o u n try o f lo c a tio n

T o ta l A fric a 6
O verseas areas o f U.S.
G rand to ta l
U.S. m em b er banks
w ith overseas bra nch es

6
5

—

105

94
2
133

17
15
6
12
88

17
15
6
15
102

25
15
8
19
133

33
15
17
21
177

38
15
23
26
235

38
16
26
29
281

38
19
28
29
296

38
21
28
32
322

38
21
32
33
356

37
19
36
33
363

2
6
6

2
8
8

2
10
8

2
12
11
4
14
3
3
8
78

2
13
11
6
15
3
3
9
83

2
13
11
6
15
3
8
11
90

2
15
11
6
17
3
11
11
97

3
19
11
6
21
3
10
11
109

5
23
11
6
25
3
10
14
122

7
24
11
6
31
3
11
18
138

3
—

—

13
3
2

14
3
2
8
55

14
3
3
8
63

14
3
3
8
69

—

45
3

180

211

244

295

373

460

532

577

627

699

732

107

125

'Also includes Austria, Ireland, Monaco, and Romania.
2Also includes Barbados, Haiti, Jamaica, Netherlands Antilles, Trinidad-Tobago, British Virgin Islands, and other
West Indies.
3Also includes Bolivia, Chile,* Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Honduras, Mex
ico, Paraguay, Peru, Uraguay, and Venezuela.
“Includes Bahrain, Qatar, Saudi Arabia, and United Arab Emirates.
5Also includes Brunei, Israel, Korea, Malaysia, Pakistan, Philippines, Thailand, and Vietnam,
in clu d e s Liberia, Kenya, Mauritius, and Nigeria.*
*No resident U.S. branches as of January 1, 1975.

Head office borrowing declines
By mid-1970 the incentive to establish
overseas branches for the purpose of secur
ing a deposit-taking facility not subject to
Regulation Q was greatly diminished by
two changes in the regulatory environ
ment. First, effective September 1969, the
Federal Reserve Board placed a 10 percent
reserve requirement on any increase in the
net liabilities of U.S. offices o f member
banks to their overseas branches. Second,
effective June 1970, the Federal Reserve
Board suspended Regulation Q ceilings on
interest rates payable on large denomina
tion certificates of deposits with maturities
of 30 through 89 days.3In the wake of these
changes U.S. banks did not show the same
degree of interest in borrowing from their
branches that they did in 1969—despite the
reoccurrence of tight money conditions in
1973 and 1974. The effect of this diminish
ed borrowing was that the considerable
deposit-generating capabilities of the
overseas branches, particularly those
located in London, were now available to
fund the lending activities of the branches.
This change is put in dramatic perspective
by the following numbers. At the end of
1969 about 40 percent of the $33.7 billion in
net assets (i.e., total assets less interbranch
claims) of overseas branches represented
claims on U.S. head offices. By contrast, in
August 1974, the time of peak utilization of
borrowings from branches by U.S. head of
fices during the period of domestic
monetary tightness of 1973-74, only 5.7 per
cent of the net assets of overseas branches,
totaling $122 billion, were in the form of
claims on head offices.

Adaptation: 1970-73
Beginning in 1970, the overseas
branch networks of U.S. banks found
themselves in a situation where their own
'In May 1973 interest rate ceilings on large CDs
maturing in 90 days or more were suspended.

Federal Reserve Bank of Chicago

funding capability, and the diminshed re
quirements of their head offices, allowed
them the leeway to initiate a more
aggressive credit extension program. In
part, their aggressiveness took the form of
a willingness to accept a diminished net
return on their loans. In part, the new
aggressiveness took the form of in
novations in lending techniques—for ex
ample, floating rate Eurocredits4 and cash
flow financing.5
The 1970-73 period also was one of con
siderable geographic diversification for
U.S. banks with multibranch networks.
The diversification created additional
“ one-stop” facilities for clients with either
local currency needs or external currency
needs. The advantage of the branch
network in meeting the external currency
requirements of clients of an individual
branch can be described as follows: any
branch in the network would be willing to
provide funds to any other branch in the
network at a preferred rate because it
would not have to take into account the
possibility of default. Besides allowing
participation in additional banking
4The floating rate Eurocredit refers to the lending
technique which involves tying the interest rate to an
interbank deposit rate, e.g., the six-month London in
terbank offered rate. Depending upon the borrower’s
creditworthiness and other terms of the credit, a
premium (or spread) is added to the interbank rate. In
the 1970-73 period the maturity of the Eurocredit
lengthened appreciably from a “norm al” period of
three to seven years to a “norm al” period of ten to 12
years with at least one sizable Eurocredit being for 17
years. In addition, there was a considerable narrow
ing of the spread charged over the interbank rate. For
prime borrowers in the developed countries, this
meant a reduction from above 1 percent to a range
between % percent and % percent. For prime
borrowers in the less developed countries, this meant
a reduction from a spread near 2 percent to a range
between '/t percent and 1 percent.
’The use of cash flow financing represented a
departure from the standard practice of assetprotection lending— i.e., the reliance on collateral
security. For a discussion of cash-flow lending by U .S.
banks overseas see Perry, George H. “ Lending to
Foreign Local Companies” in Offshore Lending by
U.S. Commercial Banks, ed. F. John Mathis
(Bankers’ Association for Foreign Trade and Robert
Morris Associates, 1975, pp. 133-150).

Business Conditions, September 1975

markets, the geographical diversification
o f branch loca tion s enhanced the
network’s ability to generate commission
income from financial advisory services—
e.g., investment advisory services to mul
tinational corporations, either U.S. or
third-country based.
The number of U.S. bank branches
located in Europe (outside the United
Kingdom) increased from 66 to 105 in the
1970-73 period. In Asia, U.S. banks added
55 branches to the 83 that were in opera
tion at the beginning of the period. The
geographical dispersion of the additions to
the branch networks is suggestive of a cont in u in g e f fo r t at e n h a n cin g the
downstream capabilities of the networks.
In a related development U.S. banks
sought special relationships with selected
foreign banks, either via participation in
jointly owned consortia banks or by the ac
quisition of shares in the foreign banks
themselves. In a large number of cases the
acquired interest was in a banking institu
tion with a geographic expertise that the
U.S. bank desired in order to compliment
its own capability.
The expansion in the number of U.S.
banks with overseas branches in the
period 1970-73 was made possible by the
Federal Reserve Board allowing a special
type o f foreign branch that became known
as the “ shell” branch.6 The shell branch
permitted smaller U.S. banks to establish a
foreign domicile for the international por
tion of their corporate activities. This
proved advantageous to the banks during
the VFCR period. Following the termina
tion of the VFCR program, the favorable
tax treatment and the absence of reserve
assessments against deposits booked at
the shell branch continues to make this
T h e special nature of shell branches derives
from a provision in the letter from the Federal Reserve
Board to a bank conveying approval of such a branch
starting “ . . . that there is to be no contact with the
local public at the branch, and that its quarters, staff,
and bookkeeping m ay, at least in part, be supplied un
der contract by another party.”

form of branching attractive. At the end of
1974, of the 125 U.S. banks with overseas
branches, 76 had but single branches
located in the Caribbean, either in Nassau
or the Cayman Islands. For these branches
the credit activities of the shell are directed
at interbank money market placements
and purchases of small shares of syn
dicated loans.
Establishment of shell branches was
not limited to small banks. Large banks
also acquired shell branches. When the
shell is a part of an extensive worldwide
banking organization, credit activities of
the shell are directed not only at interbank
placements and purchases of loan shares
but also at funding credits originated
within the network.

Expansion in head office activities:
First half, 1974
The termination of the VFCR program
in January 1974 made possible a sharp in
crease in the level of foreign credits placed
directly by U.S. bank offices (including
U.S. offices of foreign banks). A large
proportion of the $11 billion placed in the
first half of 1974—a 42 percent increase
over the level of outstanding credits at the
end of 1973—apparently took place in
response to increased credit demand from
the banks and/or trading companies of
such oil-importing nations as Japan,
Brazil, Mexico, and—to a lesser e x te n tsome Western European countries. As
banks of these countries drew on credit
lines outstanding with U.S. banks, they
chose dom estic offices rather than
overseas branches because of the slightly
lower costs available in U.S. markets.
Thus, the increase in loans to foreign
banks during the first half of 1974 may
have been a “ one-shot” affair. In the nine
months following June 30, 1974, loans to
foreign banks fell by about $2 billion
despite a continuing positive differential
between Eurodollar interest rates and

domestic U.S. interest rates. Also, of the
$11 billion increase in bank claims against
foreigners, $3.4 billion represented
bankers’ acceptances7 made for the ac
count of foreigners; mainly acceptance
credits created to finance Japanese trade
with countries other than the United
States. However, purchases by U.S. accept
ing banks of their own acceptances for
their loan portfolios amounted to only $700
million during the period. This suggests
that U.S. banks, in a period of strong
domestic loan demand, were prepared to
provide their banks’ names in return for
the acceptance fee (usually IV2 percent of
the face value), but were unwilling to com
mit their funds.
Despite the termination of the VFCR
program and the slight continuing incen
tive to move funds from the United States
to the Eurodollar market in the first half of
1974, the overseas branches of U.S. banks
improved their net creditor position vis-avis their head offices by $500 million.
There is evidence of a two-way flow with
the monies coming in being short term and
the increase in claims of head offices
against branches being somewhat longer
term—these being used to finance branch
positions in the very active Eurocredit
market in the first half of 1974. Overall,
branches increased their claims against
foreigners, excluding banks, by about $9
billion in the first half o f 1974, with about
$1 billion of this in loans to foreign
governm ents, presumably related to
financing of oil-related deficits.
In assessing the developments in the
first part of 1974, it appears clear that the
removal of the VFCR guidelines combined
with favorable credit demand conditions
had considerable impact on the inter
national activities of U.S. banks. Both
head offices and branches of U.S. banks
“Bankers’ acceptances are negotiable drafts
drawn to finance U.S. exports, U.S. imports, or trade
between other countries and are termed “ accepted”
when a bank guarantees payment at maturity.

Federal Reserve Bank of Chicago

expanded their foreign credit activities
rapidly. However, the head offices did not
make use of the placement capacity that
their branches had built up during the
VFCR period.

Consolidation: Second half, 1974
through first half, 1975
By mid-1974 conditions in inter
national banking markets were strained in
the wake of revelations of foreign ex
change losses by several European banks
and the actual failure of the I.D. Herstatt
Bank in Germany. The uncertainties flow
ing from these developments caused some
depositors to become distrustful of place
ments with Eurodollar banks, including
the branches of U.S. banks. The con
siderable differential between Eurodollar
interest rates and domestic U.S. rates that
appeared in the third quarter of 1974 could
be characterized as the premium that
depositors required for the placement of
funds in the Eurodollar market. (The in
terest rate differential was over 200 basis
points on instruments with a three-month
maturity.) This made it extremely attrac-

Head offices became net
creditors of their overseas
branches in 1974
billion dollars

Business Conditions, September 1975

tive for U.S. banks to shift funds from head
offices to branches to support loan activity.
Head offices of U.S. banks became net
creditors of their overseas branches in the
third quarter of 1974, reversing a debtorcreditor relationship that had persisted
since the initiation of the VFCR program
in 1965. The experience of this period
proved beyond doubt that when a wide
differential exists between Eurodollar and
domestic U.S. interest rates, head offices of
U.S. banks, unrestrained by the VFCR
program, would supply the funds required
by the lending activities of their overseas
branches.
In the last quarter of 1974 and the first
quarter of 1975 there was a narrowing of
the interest rate differential between the
Eurodollar market and the U.S. market,
but no full-scale return to the “ normal”
differential established in the first half of
1974. The narrowing was attributable
largely to official statements in the third
quarter that lender-of-last-resort as
sistance would be available under ap
propriate circumstances to Euromarket
participants. As domestic loan demand
weakened late in 1974, U.S. banks,
recognizing the continuing differential
between Eurodollar and U.S. interest
rates, tended to make money market
placements with foreign banks. In addi
tion, U.S. banks so increased their rate of
purchase of their own bankers’ accep
tances and those of other banks, that total
investments in acceptances increased by
$950 million in the fourth quarter of 1974.
In the first quarter of 1975 there was a
notable revival in medium-term Eurocredit
markets as domestic bank loan outstand
ings dropped rapidly in the United States.
The revival in activity in the Eurocredit
market continued through the second
quarter with developing countries, in
cluding certain oil-exporting countries—

Intra-network claims of
overseas branches increased
dramatically in the seventies
billion dollars

su ch as A lgeria and In don esia—
reentering the market as borrowers, and
with U.S. head offices increasing net
claims against overseas branches by
almost $5 billion through the first quarter
and nearly $4 billion in the second quarter.
Branches in the Caribbean and United
Kingdom—really, the money management
centers for the U.S. bank branch net
works—were the initial recipients of the
funds made available by the U.S. head of
fices. These branches, in turn, booked
loans to borrowers in Eurocredit markets
either by entering into syndicated loan
arrangements or by making funds avail
able to downstream branches.
It appears that the U.S. recession with
its accompanying reduction in demand for
domestic credit has been a prime stimulant
to the integration by U.S. banks of their
head offices and overseas branch
networks.
Allen B. Frankel

Federal Reserve Bank of Chicago

\dvertising for demand deposits
Advertising, a form of non-price competi
tion, is particularly interesting in banking
because Regulation Q of the Board of
Governors of the Federal Reserve System
severely circumscribes price (interest rate)
competition. Since payment of interest on
demand deposits is prohibited, studying
advertising illustrates one way banks can
partially compensate for this enforced
absence of price competition.
An analysis of demand deposit adver
tising also helps illustrate how an intuitive
economic hypothesis can be tested against
empirical evidence. The hypothesis is that
interbank variations in intensity of de
mand deposit advertising can be explained
by differences in market structure char
acteristics and individual characteristics
of specific banks. A formal statement of
the hypothesis, embodying 11 such
characteristics, can be tested against the
behavior of a sample of banks.
Much of the data needed to test the
hypothesis comes from reports submitted
by 160 Seventh District member banks par
ticipating in the 1972 Functional Cost
Analysis program sponsored by the
Federal Reserve Bank o f Chicago.1 The

sample banks range in size from under $5
million to over $1 billion in total deposits,
with a mean size of $32 million and a me
dian size of $45 million. Sixty-six of the
banks are chartered in Illinois, 20 in In
diana, 29 in Iowa, 21 in Michigan, and 24
in Wisconsin. Ninety-four of the banks are
lo c a te d in Standard M etropolitan
Statistical Areas and 23 are affiliated with
bank holding companies.
Dollars spent on demand deposit
advertising per million dollars of demand
deposits, as reported by FCA participants,
is the measure of advertising intensity for
the purpose of this article. According to an
nual averages for all participants in the
nationwide FCA program, this figure has
risen considerably in recent years. For
banks in the under $50 million category,
this ratio rose 72 percent from 1966 to 1974.
In the larger size categories the increase
was over 100 percent. Although demand
deposit advertising accounts for a small
share of total operating expense—between
lA and % of 1 percent—it represents be
tween 2 and 3 percent of the total costs of
serving demand deposits and about onefourth of the entire advertising budget.

‘The FC A program is designed to provide an ac
curate and meaningful yet simplified cost accounting
framework for commercial banks. Conceptually, the
operations of a bank are broken down into three broad
categories: fund-providing functions, fund-using
functions, and non-fund-using functions. Demand
deposits, for example, are a fund-providing function,
while investments, credit card loans, and mortgage
loans are examples o f fund-using functions.
Thirty-five expense items are reported, one of
which is “publicity and advertising.” A s with most
expense items, some part of total advertising cost is
overhead, meaning it is not chargeable to any par
ticular operating function. FC A allocates these
overhead costs among bank functions by indirect
means. Because this indirect allocation should
properly be attributed to overhead, only those adver
tising expenditures allocated directly by the banks
are used in calculating advertising intensity.

Market structure characteristics

For purposes of this article, a bank’s
market is defined as the county within
which the bank (or its head office) is
located. Two arguments support this
definition, although, in reality, bank
markets rarely coincide with political
boundaries. First, most people transact
their banking business either near their
homes or near their jobs, and data for the
Seventh District show that a large majori
ty of people reside and work in the same
county. Second, the Board of Governors of

Business Conditions, September 1975

the Federal Reserve System frequently
uses county boundaries to approximate
local banking markets.
Several aspects of market structure
would seem to have important influences
on the intensity of deposit advertising.
Among these are the degree of competition
from nonbank financial intermediaries,
the number and size distribution of com
peting banks, the strength of demand for
bank loans, branch-banking restrictions,
and the urban or rural character of the
market. Many interrelationships exist
among these characteristics.
In undertaking an advertising cam
paign, a bank expects to attract deposits
primarily from two sources—from other
banks and from nonbank financial in
termediaries (e.g., savings and loan
associations, credit unions, etc.). The in
fluence of one bank’s advertising on other
banks in its market is called an “ intra
industry effect,” while the influence of a
bank’s advertising on other intermediaries
is called an “ inter-industry effect.”
Considering only inter-industry ef
fects, a monopoly bank is particularly wellsituated to judge the optimal advertising
expenditure since it derives the entire inter
industry benefit. When more than one
bank operates in a market, no bank may
wish to advertise unless it knows how
much its competitors will advertise in
response since nonadvertising banks will
derive some inter-industry benefits from
other banks’ advertisements. If the num
ber of banks in the market is small, or if a
few banks dominate the market, banks
may be able to act as if they were, so to
speak, a monopolist. Therefore, the greater
the concentration of banking resources,
the greater the expected advertising expen
diture by any individual bank.2
Demand for bank loans relative to the
^Concentration is measured by the Herfindahl in
dex. See “ Bank Holding Companies— Concentration
Levels in Three District States,” Business Con
ditions, June 1975, p. 14.

supply of lendable funds determines the
profits to be made on loans and thereby in
fluences a bank’s incentive to advertise to
attract deposits. The best measure of the
strength of loan demand relative to the
supply of funds—the net yield on loans
(average rate of return on loans minus
“ cost of money” )—is not without problems.
In planning their advertising strategies,
banks respond to the expected future rate
of return on loans. The present actual rate
only approximates the yield on loans to be
made in the future. Furthermore, actual
rates of return will tend toward equality
even though banks’ expectations of future
rates may differ widely. Where expected
future rates are very high, banks are en
couraged to compete more intensely for
lendable funds, thus driving down net
profit rates. The converse holds where ex
pected rates are low.
Banks can use non-price means other
than advertising to attract deposits. Prob
ably the most important of these is to es
tablish branch offices, thereby making it
more convenient for customers to deal with
the branching bank than with a com
petitor. Illinois statutory restrictions on
branch banking are considerably more
stringent than those in other Seventh Dis
trict states. Because branching is not an
available alternative, Illinois banks are
likely to advertise more than banks in
other district states.
Advertising intensity may differ ac
cording to whether bank markets are ur
ban or rural. There may be important cost
differences, both because population den
sities are higher in urban areas and
because different advertising media pre
dominate in the two types of areas. Better
transportation reduces economic distances
among banks in urban areas, thereby in
ten sify in g com petition and making
locational differences less important in ur
ban than in rural areas. On the whole, it is
impossible to predict whether urban or
rural banks will advertise more.

Individual bank characteristics
While the behavior of banks in a given
market is conditioned by their environ
ment, banks retain many pronounced in
dividual differences. Six such individual
characteristics would seemingly have an
important influence on a bank’s adver
tising expenditure—relative size of the
bank within the market, average account
size, rate of growth of bank deposits,
variability of deposits around their growth
trend, age of the bank, and holding com
pany affiliation.
As has been indicated, one of the im
portant aspects of market structure is the
size distribution of banks. In addition to
the overall degree of concentration within
the market, the relative size of the in
dividual bank may also be important. The
larger a bank’s market share, the larger
the proportion of inter-industry effects it
can expect to enjoy, but the more vulner
able it may feel to competitive inroads from
other banks’ advertising. These influences
operate in opposite directions—the former
tending to increase the bank’s advertising
as its market share increases, the latter to
decrease it. On balance, banks with larger
market shares are expected to advertise
more than their smaller rivals.
Banks differ considerably in their
orientation toward personal or business
deposit accounts, and a specific bank’s
advertising would echo this orientation by
being geared either to retail or to wholesale
customers. Banks actively seeking cor
porate deposits would probably choose
different media from those chosen by
banks aiming at personal accounts. Be
cause banks with many corporate de
positors will have more large accounts,
average account size is included in the
analysis to control for wholesale/retail
orientation.
Given the rate of growth of demand for
bank loans, a bank forecasting a substan
tial rise in deposits will not need to adver

Federal Reserve Bank of Chicago

tise as much as a bank that expects slow
deposit growth. If forecasts are based on re
cent deposit experience, banks whose
deposits have grown rapidly in the past
will advertise less.
The historical growth rate of deposits
may not be sufficient for making reliable
forecasts of expected short-term increases
in bank deposits. Another important piece
of information is the variability of deposits
around their growth trend. The higher the
level of deposit variability, the less reliable
is the long-term growth rate since deposits
are more likely to deviate substantially
from their trend in the short run. This
means that average deposit growth cannot
be relied upon to provide increased lendable funds. Therefore, banks experiencing
high deposit variability can be expected to
advertise more than banks with low
deposit variability.
The need for new banks to make their
existence known and to differentiate
themselves from older competitors tends to
make them advertise more than older
banks. On the other hand, because new
banks can take advantage of recent
demographic shifts, they may enjoy
superior locations. On balance, one would
expect forces favoring higher advertising
intensities by new banks to predominate.
The influence of holding company af
filiation on bank performance is only im
perfectly known. Holding companies cen
tralize some functions in the parent
organization to minimize duplication o f ef
fort by subsidiaries and to take advantage
of any economies o f scale. To the extent
that subsidiary banks benefit from
association with a parent holding com
pany, such banks may enter into a cen
tralized advertising arrangement with
lower advertising intensities.

Regression analysis
Regression analysis is a statistical
technique designed to measure the sepa-

Business Conditions, September 1975

Regression analysis
Empirical economic research seeks to
explain the behavior of one economic
variable in terms of other factors. The
variable to be explained is usually called
the “dependent variable” because its
value is assumed to depend upon other
factors, i.e., “ independent variables.”
The set of relationships used to explain
one or more dependent variables is
called a “ model.” Validation or rejection
of a model hinges on a comparison of the
theoretical description with the actual
behavior of economic agents.
Regression analysis is a technique
used to determine whether changes in
the value of the dependent variable can
be system atically associated with
changes in the values of one or more in
dependent variables. A regression coef
ficient shows the change in the depen
dent variable resulting from a one-unit
change in an independent variable.
Regression techniques can also disen
tangle, to some extent, the influence of
one independent variable from the
simultaneous influences of the others.
Accordingly, regression analysis is a
technique applied when many factors
combine to influence the value of one
variable.
The ability of the independent
variables jointly to explain the depen
dent variable can be measured by the
proportion of the total variation in the
dependent variable systematically as
sociated with variations in the indepen
dent variables. The larger the propor
tion of explained variation, the better
the model “fits,” or accords with, reality.
How well any particular independent
variable explain s the dependent
variable is judged by the size of its
regression coefficient relative to the size
of the coefficient’s standard error. Those
variables whose coefficients are largest

relative to their standard errors are the
most powerful explanatory variables.
The following table presents the
regression results discussed in this arti
cle. The left-hand column lists the in
dependent variables, and the three
right-hand columns present the coef
ficients on these variables in the three
regression equations.

Variables

C oefficients
(standard errors
in parentheses)
Run 1

Run 2

Run 3

Concentration
(numbers equivalent)

-.005
(0.005)

-.008
(0.004)

-.007
(0.004)

Loan yield

0.009
(0.052)

0.013
(0.048)

Loan growth

0.113
(0.087)

Branching restrictions

0.112
(0.078)

Urban area

-.020
(0.067)

Market share

0.001
(0.003)

Average account size

-.002
(0.002)

Deposit growth

0.010
(0.010)

Deposit variability

0.295
(0.066)

Age

0.113
(0.072)

0.099
(0.071)

0.327
(0.047)

0.328
(0.046)

-1.27
(2.15)

Holding company

-.001
(0.092)

(Intercept)

0.261
(0.158)

0.265
(0.133)

0.054
(0.195)

0.276

0.265

0.272

Proportion of
variance explained

rate influences that any number of causal
variables exert on some “ dependent”
variable. Regression analysis, used to ex
amine the hypothesis described in this
paper, indicates that only three charac
teristics (causal variables) discussed in
preceding sections have a significant in
fluence on advertising intensity (the
dependent variable).
Only one individual characteristic of a
bank—as opposed to market structure
characteristics—significantly influences
advertising intensity. Regression analysis
shows that greater variability of deposits
around their growth trend is strongly
associated with higher advertising intensi
ty. For the average bank in the sample, a 10
percent increase in deposit variability
leads to a $15 increase in advertising per
million dollars of demand deposits. The
average amount o f advertising for all
banks in the sample is $430 per million
dollars of deposits.
Market concentration and branching
restrictions also are significant deter
minants of advertising expenditure. Aver
age concentration for the sample ap
proximates a level represented by ten
equal-sized banks. If concentration were to
rise—say, by a decline in the number of
equal-sized banks from ten to nine—results
indicate that advertising expenditures
would rise by $7 or $8 per million dollars of
deposits.3 The empirical results also show
that Illinois banks on average spend $100
more per million dollars of demand
deposits on advertising—a result at
:,If all banks in a market were the same size, the
value of the Herfindahl index of concentration would
be 1 /N , where N is the number of banks. U sing this
arithmetic property, the reciprocal of the Herfindahl
index, the so-called “numbers equivalent,” indicates
how many equal-sized banks generate a level of con
centration comparable to that in the market. For ex
ample, assuming a Herfindahl index of .255, the
numbers equivalent (= l/.2 5 5 ) of 3.9 indicates that
about four equal-sized banks generate the same level
of concentration as five banks with market shares of
40, 20, 15, 15, and 10 percent. Ibid.

Federal Reserve Bank of Chicago

tributed to the inability of Illinois banks to
seek deposits through branching.
Regression analysis also indicates
that demand for loans influences adver
tising expenditures. The best way to
measure demand for loans, relative to the
supply of lendable funds, is by the net rate
of return on loans. This variable, however,
has no statistical association with adver
tising. If the expected growth in demand
for loans is approximated by the actual
rate of increase of loans over a recent
period, a moderately significant associa
tion appears between loan demand and
advertising intensity, but the effect is
small. An especially surprising result of
the analysis is that the other individual
bank characteristics enumerated in
previous sections have so little effect on
bank advertising.

Conclusions
The analysis presented in this article
shows that three factors—branching
restrictions, market concentration, and
deposit variability—are sufficient to ac
count for about 30 percent of the variation
in advertising intensity by a sample of 160
banks. The im portant influence of
branching restrictions clearly indicates
the far-reaching effects that legal con
straints can have on bank behavior. The
significance of concentration shows how
heavily bank behavior is conditioned by
the force of competition from other banks.
The strong relationship between adver
tising and the variability of deposits
around their growth trend shows that the
avoidance of uncertainty strongly in
fluences bank decision making. The fail
ure of other bank characteristics to in
fluence advertising significantly suggests
that banks may, in fact, be much alike in
their advertising behavior regardless of
size, age, and ownership.
Chayim Herzig-Marx

Business Conditions, September 1975

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