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PROSPERITY AND PERSONAL BANKRUPTCY WALKING THE TIGHTROPE: PUBLIC ASSISTANCE AND W O RK INCENTIVE THE BANK-INCOME DERBY IN THE THIRD DISTRICT AUGUST 1971 Prosperity and Personal Bankruptcy . . . Probing the paradox of personal bank ruptcy amid prosperity points up the need for some fresh thinking and fundamental changes. Walking the Tightrope: Public Assistance and Work Incentive . . . Does it pay to be employed in Penn sylvania? The Bank-Income Derby in the Third District . . . Last year's experience indicates that bank managers might have to look to nontraditional sources of revenue to boost future earnings performance. BUSINESS REVIEW is produced in the Department of Research. Ronald B. Williams is Art Director. The authors will be glad to receive comments on their articles. Requests for additional copies should be addressed to Public Information, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsylvania 19101. FEDERAL RESERVE BANK OF PHILADELPHIA Prosperity and Personal Bankruptcy by Duane G. Harris The year of the c o n s u m e r — 1971! Busi nessmen, economists, and policymakers anxiously await the day when the consumer unleashes his pent-up desires and dollar bills to speed the recovery process. While many people indeed may stampede the depart ment store, auto dealer, and appliance shop, the recent downturn has taken its toll. Even though some consumers may have hoarded their income to spend on a brighter day, others lost out as their income ceased to service the debt they had run up during better times. For many that meant bank ruptcy. Although financial failure is nothing new, recent trends in bankruptcy cases have many people alarmed. During the unparalleled prosperity of the '60's, the number of debtor-relief cases practically doubled, caus ing personal bankruptcies per 1000 house holds to soar above that for the years during the depths of the Great Depression. So, while economic downturns may result in their share of bankruptcies, it is evident that there must be other fundamental causes for the failure trend. The resolution of the paradox of prosperity and personal bank ruptcy, however, lies tangled in the com plexity of bankruptcy law, a host of facts and figures, and a myriad of probable causes for bankruptcy. Yet we must probe the intri cacies of the bankruptcy story if we are to begin to sort out its causes and its costs and benefits to consumers and businessmen. PRELUDE: SOME INS AND OUTS OF DEBTOR RELIEF The roadmap to debtor relief is provided by the Federal Bankruptcy Act with a little help from state statutes. Title 11 of the United States Code gives the detail for indi viduals and corporations seeking financial restitution. Two sections of the Code, which constitute what are commonly referred to as “ straight bankruptcy" and the "wageearner plan," are particularly relevant to financially strapped individuals. Straight bankruptcy is a legal process 3 BUSINESS REVIEW AUGUST 1971 whereby a debtor's assets are collected by the court, sold for cash (except for certain assets which are exempt — see box), and the proceeds distributed among his credi tors. The debtor is discharged from his unsatisfied debts through the straight bank ruptcy process.12 The wage-earner plan, un like straight bankruptcy, presents a blueprint to scale-down or extend an individual's debts. T h e intent of this plan is to permit a wage earner to pay existing debts out of future earnings without being bothered by creditors. (For a more detailed discussion, see Appendix.) Straight bankruptcy has been a much more popular avenue of relief than the wage-earner plan. Since 1955, straight bank ruptcy cases have accounted for over 80 per cent of total personal petitions nation ally and over 90 per cent in all Third District states. WHAT TH EY CANNOT CARRY AWAY To give the bankrupt a running start again after he is absolved of his debts through straight bankruptcy, each state provides a list of assets which are exempt from liquidation. If the bank rupt claims these exemptions, the trustee, who collects the debtor's as sets, sets apart the property and reports its value to the court. Exemptions, however, vary in num ber and value from state to state and reflect the cultural and social heritage of the area. For example, Delaware hardly lets you get away with the clothes on your back — only $50 worth of property including apparel and tools of trade are exempt. Penn sylvania exempts $300 in personal property including wearing apparel; New Jersey, goods to the value of $500 and all apparel. In contrast, Iowa, reflecting an agrarian tradition exempts, among other things, one-half acre in a city or town or, otherwise, a homestead up to 40 acres; all wearing apparel of the debtor and his family; one musket or rifle and shotgun; all private librar ies, family bibles, portraits, pictures, and musical instruments; a seat or pew occupied by the debtor's family in a house of public worship; cemetery plots not exceeding one acre; two cows and two calves, 50 sheep and their wool, six stands of bees, five hogs and all pigs under six months, up to $50 worth of poultry, and enough feed to keep these animals for six months. Also exempt are household items such as bedsteads, bedding, furniture up to $200, a sewing machine, and all spin ning wheels, plus the proper tools of THE GLUT OF PERSONAL FAILURES Bankruptcy petitions filed have increased rapidly, especially in the last 15 years. The number of petitions filed nationally has more than tripled — from nearly 60 thou sand in 1955 to nearly 185 thousand in 1969.2 New Jersey, Pennsylvania, and Dela ware likewise have experienced a sharp growth in the number of bankruptcy cases filed in District Court. In 1969, the number of cases filed in these states respectively doubled, tripled, and quadrupled the num ber filed in 1955. 1Bankruptcy is not the same as insolvency. Insol vency as defined in Title 11 means that the total present value of all the debtor's property is insuffi cient to pay his debts. In other words, his total liabilities exceed his total assets. Thus, a debtor may be insolvent without being bankrupt. His assets may not cover his liabilities, but until he has initiated judicial proceedings or a court has so adjudged, he is not considered bankrupt. 2 Petitions filed are for fiscal years. 4 FEDERAL RESERVE BANK OF PHILADELPHIA P E R S O N A L P E T IT IO N S A C C O U N T F O R T H E L IO N ’S S H A R E O F B A N K R U P T C IE S . the debtor's trade. And, if the debtor uses a team of horses, mules, or oxen in his livelihood, these animals, along with proper harness and wagon, are exempt. Otherwise, one horse can be kept. Texas exempts 200 acres if not in a town or city along with many other exemptions similar to those mentioned for Iowa. California, which has a more modern revision of the law (1970) and less agricultural influence than Iowa or Texas, allows a homestead of up to $20,000 in actual cash value over and above all mortgages on the property. This applies to the head of a family or persons over age 65; otherwise, up to $10,000 in value is exempt. In addi tion, numerous household items, tools of the debtor's trade, and livestock are exempt. So, just what exemptions are allowed can help set the tone of the lives of the debtor and his family after bank ruptcy.* CHART 1 V O L U N T A R Y N O N B U S IN E S S P E T IT IO N S AS A F R A C T IO N O F T O T A L P E T IT IO N S . Per Cent *Generally, exemptions are allowable only for natural persons and not corporations. Source: Administrative Office of the United States Courts, Tables of Bank ruptcy Statistics, that they now constitute 60 to 80 per cent of total cases (Chart I ) .4* Consequently, the growth in bankruptcy petitions has been predominantly caused by personal failures. But the upsurge may not be so dramatic as it seems. Part of the skyrocketing in crease in personal bankruptcies may merely reflect population growth. Chart 2 traces the pattern in personal failures per 1000 Personal bankruptcy cases3 for the nation as a whole have worked their way upward since 1955 to the point where they now account for over 90 per cent of total peti tions filed (Chart 1). Comparable figures for Third District states show that personal bankruptcies have soared since 1955, so 4 Personal bankruptcies have accounted for a larger 3 Personal bankruptcy cases are considered to be fraction of the total for the nation than for Third those designated by the Administrative Office of the District states in every year since 1955. However, the United States Courts as "nonbusiness." These cases growth in the personal percentage has been much include those of employees and others not in busi more dramatic for New Jersey, Pennsylvania, and ness. Delaware. 5 BUSINESS REVIEW AUGUST 1971 CAUSES OF THE UPSURGE CHART 2 IN C R E A S E S IN P E R S O N A L B A N K R U P T C IE S H A V E O U T S T R IP P E D P O P U L A T IO N G R O W T H . Although it is impossible to isolate con clusively the causes of the dramatic climb in personal bankruptcies without analyzing individual cases in detail, we can make some general comments. The growth in bankruptcies per 1000 households can mean two different things — either a greater por tion of households are becoming insolvent, or more insolvent households are choosing bankruptcy. More Insolvents? Part of the growth on the bankruptcy scene could be caused by more people becoming insolvent. Insolvency results because of inadequate provision for contractual commitments, such as bank loans and installment contracts, or unex pected emergencies, such as medical bills or need for a new roof. A trend to more insol vencies, therefore, could arise because of an increase in fixed commitments relative to resources or a decline in financial buffers against unexpected emergencies. Drawn-out periods of prosperity may in deed breed greater commitments and thin ner buffers. People become convinced that tomorrow will be at least as good as today. They rely on a “ continuing" stream of in come to build their assets and incur more debt because the prospect of default or other trouble seems remote.6 They see no reason to forego the good things in life today when tomorrow will take care of itself. In addition, prosperous times may lead individuals to adjust the mix of assets that they hold. Solvency depends upon the sale value of assets when liquidated. If indi viduals shift the allocation of their income from highly liquid assets, such as checking Number of Personal Petitions Per 1000 Households 1955 1960 1965 1970 Source: “ Sales Management, Survey of Buying Power;” Administrative Office of the United States Courts, Tables of Bankruptcy Statistics. households for the nation and for Delaware Valley states. Unfortunately, we find that taking population into account actually makes the “ growth in personal bankruptcy'' story even more severe, since increases in personal bankruptcies have outstripped household growth.5 5 Cases-per-thousand-households in the Delaware Valley are far below the national average. In 1969, while Third District states showed 0.35 to 0.50 per sonal bankruptcies per 1000 households, the nation recorded a 2.72 figure. 6 6 Since 1955, for example, households have been building up greater and greater consumer debt for each dollar of disposable income received. The ratio of consumer debt to disposable income increased from approximately 0.12 to 0.18 over the 1955-1970 period. FEDERAL RESERVE BANK OF PHILADELPHIA are more mobile, there may be very little stigma attached to going bankrupt today in Philadelphia and starting anew tomorrow in Allentown. If certain creditors have be come more willing to dismiss past bank ruptcies as an obstacle to future credit, then individuals may be less reluctant to take the legal remedy. Or, finally, it might be that the information process about bank ruptcy has become more efficient. More people simply know that bankruptcy is a feasible alternative to their problems. or savings accounts, to less liquid assets, such as consumer durables, they reduce the overall marketability of their asset holdings. Forced sale of assets to meet commitments or emergencies will bring a much lower return when assets are held in the form of durables. Furthermore, most consumer durables generate no income to help pay their way. Although economists long have noted that individuals purchase goods to maximize their utility (satisfaction), when the axe falls, it is mighty hard to pay off the banker with a bag of utility. Thus, long periods of prosperity may breed unguarded optimism and result in increased debt or a mix of assets which will not provide adequate protection upon liquidation. Now, where do we attach the blame? Geraldine blames the devil, but that seems too easy. Undoubtedly, there are many interacting factors which lead people to face tomorrow on a thin string— keep ing up with the Joneses and excessively generous credit, to name two. More than likely, both debtor and creditor have to share the responsibility for an individual's slide into insolvency. THE BANKRUPTCY BURDEN Of course, there are costs to the bank ruptcy process. Debtors pay for bankruptcy through aggravation, loss of reputation, and so on. Creditors may find that they can recover virtually nothing via the bank ruptcy route.7 And the rest of us bear some of the burden also. To the extent that busi ness passes on increased costs because of bad debt losses, we all pay for the debtorrelief process. But so long as the future is uncertain, individuals will have imprecise notions about what's in store for them. And many will be caught in circumstances over which they have no control. If we are to lessen the burden to society of the debtor-relief process, we must be concerned with min imizing the number of cases where relief is necessary and with making the legal proc ess as efficient as possible. It is likely that many individuals fall into financial trouble because of lack of infor mation about credit and proper budgeting. So, measures to streamline the information process are obvious candidates for action against insolvency. Truth-in-Lending legisla tion is one step to help bridge the infor mation and knowledge gap. And there must Or Just More "Bankrupt" Insolvents? Not everyone who is insolvent files a bankruptcy petition. Many people probably struggle along and take care of their debts some how. But the growth in personal bankruptcy could mean that given insolvency, more people now choose to declare bankruptcy. What could cause such a shift in behavior? Possibly, the Puritan Ethic is on the way out, so that hard work and financial responsi bility are becoming less important. With the advent of credit cards, national sales net works, and gigantic credit mechanisms, there is much less need to deal with credi tors face-to-face. Consequently, it may simply be less uncomfortable today to say, "I want out from under." Or it could be that the penalties associ ated with going bankrupt have diminished in recent years. Because we, as a society, 7 For example, in 1969, in 85 per cent of total bank ruptcy cases terminated, there were either no assets to be disbursed after exemptions, or the sale value of the assets was absorbed by the administrative costs of bankruptcy. More than likely, most personal bank ruptcies leave little to be divided among creditors. 7 AUGUST 1971 BUSINESS REVIEW involuntary proceedings against him.' Then begins the legal process for the conversion of his property into cash. The court appoints a bankruptcy-court referee, who has powers similar to those of a judge. The referee notifies all creditors, including those who may not have taken part in filing a petition, that a petition has been filed and schedules a meeting or a hearing to examine the debtor. After analyz ing the debtor's position, the creditors try to determine what action they want to take. Some may try to block the petition, and if they succeed, the debtor's liabilities are not relieved. Or they may decide to take what they can get and vote to have the court appoint a trustee who takes control of the debtor's property. In the simplest individual cases in which the debtor has no assets and the creditors do not oppose his petition, the referee will usually discharge the bankrupt after the routine hearing. However, in cases where there are assets or creditor opposition, the trustee is appointed. The trustee is given title to the bankrupt's assets and has the responsibility of selling the assets for cash (except for the assets which are exempt) and rationing the pro ceeds among the creditors. However, some debts, such as taxes and court costs, must be paid out of these proceeds before the creditors get anything. If the debtor is discharged by the court, either after the routine hearing or after the distribution of his assets, he is perma nently released from the debts included in the bankruptcy petition.1 2 be many others. Creditors can take special care to assure that borrowers understand terms of agreement. Employers, credit unions, and other groups can do more to help provide budgeting guidance to inter ested individuals. Both debtors and credi tors can support and utilize the credit counseling activities sponsored by local groups. Providing sources of complete informa tion about financial matters, however, will only go so far. Information must be digested and used. Thus, it is clear that careful use of credit information rests squarely on the shoulders of the consumer. In a free-enter prise system where millions of individuals are making countless independent deci sions, man must rely on his own initiative to guide his decisionmaking. If he chooses to short-cut the information-gathering proc ess, he must live with the consequences — one of which may be insolvency. And if the upsurge in bankruptcies has resulted from a change in attitude about the bankruptcy process, society is faced with a perplexing problem. Either we must readjust our thinking and institutions to accommodate the move to more bankrupt cies, or we must attempt to shift debtor preference away from bankruptcy. But both require fundamental changes — prosperity and personal bankruptcy may remain strange bedfellows for some time to come. ■ APPENDIX THROUGH THE LEGAL MAZE 1However, involuntary proceedings cannot be insti tuted against a wage earner or farmer. 2 Section 35 of Title 11 makes certain exceptions to the total discharge of the debtor. In particular, debts not affected by a discharge include (1) taxes; (2) lia bilities for certain fraudulent acts, willful and mali cious injuries, or immoral conduct; (3) alimony and support orders; (4) claims for wages earned within three months of the filing of the petition; and (5) claims of creditors not notified of the bankruptcy Straight Bankruptcy If and when an individual decides he cannot keep his financial head above water, he can file a petition with the U.S. District Court, asking to become a voluntary bank rupt. Or, if creditors become worried about collecting from a debtor, they may bring 8 FEDERAL RESERVE BANK OF PHILADELPHIA The Wage-earner Plan that he would like to present a plan to scale-down or extend the maturity of his debts. The advantage of this avenue to the debtor is that he can avoid the procedure and stigma of straight bankruptcy. Since a wage earner's only “ asset" may be his future earning power, this provision allows him to turn over that asset to his creditors. When the wage earner presents his plan to the court, a meeting is held to gain approval. If the creditors accept the plan and the court is convinced of its fairness and feasibility, it becomes binding, and the debtor's future earnings are controlled by the court to carry out the plan. He thus systematically meets a revised set of obliga tions to ease the burden of his original debt. A wage earner (an individual whose prin cipal income is derived from wages, salaries, and commissions) can voluntarily file a peti tion which declares that he is insolvent or unable to pay his debts as they mature, and proceeding in time to submit their claims. In addition, creditors may block the debtor's dis charge by proving that the bankrupt is responsible for certain acts, such as an offense punishable by imprisonment, failure to keep or preserve adequate records, or dishonest transfer or concealment of assets, or if he has obtained a previous discharge within six years. If the creditors are successful in blocking the debtor's discharge, then his debts are not forgiven. N O W A V A IL A B L E The Fed in Print, a cumulative index to Federal Reserve Bank reviews, is available on a quarterly basis. It brings Selected Subjects up-to-date. To be placed on the mailing list, send your request to the Department of Public Services, Federal Reserve Bank of Phila delphia, Philadelphia, Pennsylvania 19101. 9 BUSINESS REVIEW AUGUST 1971 Walking the Tightrope: Public Assistance and Work Incentive by Kathleen C. Holmes AS U N E M P L O Y M E N T C O N T IN U E S T O R IS E . . . Per Cent Although the economic downturn in 1970 was mild by historical standards, the rate of unemployment has almost doubled in Penn sylvania — rising from below 3 per cent in 1969 to nearly 6 per cent at last count. If Pennsylvania is like the nation, the number of unemployed heads of households — the chief breadwinners — has also jumped. Source: Pennsylvania Department of Labor and Industry; U. S. Department of Labor, Bureau of Labor Statistics. 10 FEDERAL RESERVE BANK OF PHILADELPHIA MORE PEOPLE DEPEND ON TH E CO M M O NW EALTH. Per Cent Unemployed family heads provide for their wives and children in several ways. Some borrow from friends, relatives, or lending institutions, or fall back on personal savings. For other families, however, the only solution is public aid. Consequently, the number seeking unemployment com pensation has increased. Other jobless work ers, who are ineligible for unemployment compensation, must look to welfare. WELFARE RECIPIEN TS4 4 INDIVIDUALS RECEIVING UNEMPLOYMENT COMPENSATION' 2 0 '-Percentage of Pennsylvanians receiving public assistance payments. “ “ Insured unemployment as a percentage of the insured labor force in Pennsylvania. Source: Pennsylvania Department of Public Welfare; Pennsylvania Depart ment of Labor and Industry. P U B L IC A S S IS T A N C E C A N H E L P . . . Dollars The unemployed worker in Philadelphia with a family of four is eligible for a maxi mum of $301 a month of public assistance. If he qualifies and receives the maximum unemployment compensation of $258, he may still receive $43 in public assistance to bring him up to the $301 level. However, if he is not eligible for unemployment com pensation, the entire $301 may still come from welfare. This $301 in public assistance compares to $462.70 netted by the average worker — for a "work premium" of $162. That is, if he goes back to work full time, he will receive $162 extra a month for his effort, (plus pride, sense of achievement, and other satisfactions he gains from productive activ ity). Of course, this "work premium" will vary, depending on the occupation of the worker and his place on the job ladder. Income From Public Assistance Public Assistance Average Plus Unemployment Wage Earner’s Compensation Spendable Income* Income “ Spendable earnings of production and nonsupervisory worker with three dependents on private nonagricultural payrolls in the United States. Source: Pennsylvania Department of Public Welfare; Pennsylvania Depart ment of Labor and Industry; U. S. Department of Labor, Bureau of Labor Statistics. 11 AUGUST 1971 BUSINESS REVIEW B U T P U B L IC A ID C A N C O N F L IC T W IT H W O R K IN C E N T IV E . Dollars M 5 w 5 o £ 2 ;portati( and c Utiliti. lontract istructit c s h- i Q. ClO oT •Z 8 c flj 5 g iS c — ,s a) t r C TJ o g 0 1 in The size of the "work premium" may pose some problems in formulating public assist ance programs. For higher paid workers in such industries as construction, this is not a difficulty because the "work premium" is large. But for other breadwinners in lowpaying service and trade jobs, and for those people whose wages fall below the average in all industries, the "work premium" is likely to be small, and a significant work in centive problem may arise. Policymakers face a two-pronged dilemma — providing an adequate program of public aid to meet the needs of the unemployed without re ducing incentive to work. ■ ro g -o 75 H </J — OJ (T3 o % i * -Spendable earnings of production or nonsupervisory workers with three dependents on private nonagricultural payrolls in the United States. Source: U. S. Department of Labor. Bureau of Labor Statistics. 12 FEDERAL RESERVE BANK OF PHILADELPHIA The Bank-Income Derby In The Third District by Donald J. Mullineaux were smaller than the estimated increases in 1969.' These measures of earnings are just two of several which appear in a bank's year-end income statement. The fact that interested viewers of the bank-income derby do not all agree on which constitutes the best standard of performance is unfortunate, be cause the order of finish depends on the particular profit gauge chosen. For example, in terms of growth in current operating in come, city member banks clearly bested their country member counterparts and all Bank income in the Third District climbed to record levels in 1970, but the rate of growth of earnings fell short of the sweep ing increases registered in 1969. While the performance of District banks as a group topped the national average, income growth varied widely across different classes of District banks. City member banks increased their earnings much more rapidly than their country and nonmember counterparts, pri marily because of their superior noninterest income gains. RECORD LEVELS, BUT . . . . How well any bank or group of banks performed in 1970 depends on which yard stick is used to measure earnings. For ex ample, current operating income of all banks in the Third District increased 6.3 per cent over the 1969 level, but net income jumped over 11 per cent (see box for defini tions). In both cases, these rates of increase 1 Precise estimates of income growth in 1969 re quire reconstruction of the 1968 income reports to conform with the changes in accounting procedures initiated in that year. For example, if these accounts are not adjusted, current operating income and net income at Third District member banks grew at over 14 and 24 per cent respectively. A rough reconstruc tion of the accounts suggests the actual changes were closer to 23 and 18 per cent, however. 13 BUSINESS REVIEW AUGUST 1971 HOW SHOULD BANK EARNINGS BE MEASURED? A perusal of a bank's year-end in come statement indicates at least four different measures of income. Not sur prisingly, bankers, accountants, econo mists, and investors disagree over which is the best indicator of earnings per formance. Income before income taxes and securities gains or losses— formerly termed "net operating income" — is simply the difference between operat ing income (interest on investments, fees, service charges, and so on), and operating expenses (wages, benefits, interest on borrowed funds, occupancy and furniture expense). Since 1969, op erating expenses also include a mini mum provision for loan losses. After applicable income taxes are deducted — "income before securities gains and losses" — income can be measured net of the after-tax effects of securities gains or losses — "net income before extraordinary items." Finally, if extra ordinary charges or credits (such as changes in depreciation estimates, sale or abandonment of buildings) are affixed to this figure, and minority in terest in consolidated subsidiaries is deducted, the result is "net income." Since a corporation's profits are usu ally reflected in both the dividend and capital-gains earnings on its equity shares, actual and potential investors in commercial banks are faced with the problem of determining which in come measure to use in evaluating a bank's profit performance. Bankers and most bank-stock analysts have tradi tionally emphasized operating income as the best indicator of earnings ability. They argue that concentration of gains and losses in nonrecurring elements of income in a given year tends to mis represent the economic characteristics of the banking industry by converting a relatively stable earnings stream into a fluctuating earnings stream. Economists point out, however, that changes in the capital value of the in vestment portfolio are a continuing part of investment income and should be considered in evaluating bank-man agement performance. Since 1969, net realized securities gains or losses have been reported in bank-income ac counts. This method of reporting has been criticized, however, because it violates the standard accounting rule that revenues should be attributed to the period in which costs were in curred to produce them. A bank in any given year might add and subtract gains and losses realized on transac tions undertaken several years in the past. In addition, this procedure gives no indication of unrealized capital changes in the investment portfolio. It thus becomes quite difficult to ac curately evaluate current performance of a bank's portfolio management on the basis of published data. Until income-reporting procedures are adjusted to include accumulated capital changes in portfolios, the de bate over the "best" earnings indicator is likely to continue unsettled. 14 FEDERAL RESERVE BANK OF PHILADELPHIA Rising income alone is not a reliable indi cator of a bank's earnings efficiency. Im pressive profit figures may simply reflect overall growth in assets. Therefore, measures of earnings relative to portfolio size and to bank capital are also typically considered in discussions of profitability. Measures of operating income relative to assets were virtually unchanged at member banks in 1970 relative to the previous year, but de clined by a small margin at nonmember banks. For member banks, therefore, the in creases in operating income relative to capital shown in Chart 1 are mostly ac counted for by larger holdings of assets per dollar of capital. While nonmember banks were the only group to suffer a decline in income ratios in 1970, their profitability levels still exceeded those of country mem ber banks. nonmember banks as they chalked up a gain of better than 11 per cent, as shown in Table I. Nonmember banks outperformed country member banks by a margin of 1.5 percentage points.2 If a trip to the winner's circle depends on growth of net income, city banks again emerge on top. However, country member banks take the place posi tion by a margin of almost 5 percentage points over nonmembers.3 2 From the viewpoint of individuals who “ place their bets" in terms of investment dollars, the rele vant comparison is between individual banks rather than classes of banks. Within any bank grouping, some banks perform better than the highest of the observed averages, while the earnings of others grow more slowly than the lowest average of any class of banks. 3 This shift in ranking according to net income is accounted for by the following factors: (1) applicable income taxes were a larger percentage of current operating income at nonmembers than at country banks; (2) nonmembers experienced extraordinary charges of $747 thousand net of tax effects, while country banks had extraordinary gains of $620 thou sand; (3) over $152 thousand was deducted from current operating income of nonmembers as minority interest in consolidated subsidiaries, while country banks had no deduction in this category. Offsetting these factors, securities losses were a slightly larger percentage of operating income at country banks, but in both cases net losses were less than 1 per cent of operating income. TABLE 1 C IT Y M EM BER B A N K S OUTDO BOTH C O U N TR Y M E M B E R S A N D N O N M E M B E R S IN I N C O M E - G R O W T H C O M P E T I T I O N IN 1 9 7 0 . * Third District Member Banks Percentage Change in: ................................. Current Operating Income Net Income All Members City Members Country Members Third District Nonmember Banks 7.0 11.6 3.1 4.6 12.7 14.1 11.6 6.7 *These figures, which are derived from aggregate profit levels, are adjusted to account for shifts of banks from one category in 1969 to another last year. 15 AUGUST 1971 BUSINESS REVIEW CHART 1 R E T U R N O N C A P IT A L IN C R E A S E D AT M E M B E R B A N K S IN 1 9 7 0 , B U T D E C L IN E D AT NO N M EM B ER BANKS. HIGHER YIELDS ON ASSETS FOR ALL THIRD DISTRICT BANKS Although short-term interest rates suffered their most precipitate declines in the post war period in 1970, banks managed to earn higher average rates of return on all cate gories of portfolio assets (see Table 2). Philadelphia banks earned the highest per centage return on loans and Treasury secur ities, but had the lowest return on “ other securities" (mainly state and local governmentobligations). Nonmember banks earned rates of return that were only slightly above those of country members in all three asset categories. Loans figured prominently in the asset mix of all Third District banks, but the proportion of loans to total assets was down from 1969.4 Country member banks experienced the largest increases in portfolio yields, and, consequently, far outpaced their counter- Per Cent All District Member Banks City Member Banks Country Member Banks NonMember Banks 1969 CURRENT OPERATING INCOME / CAPITAL 1970 CURRENT OPERATING INCOME / CAPITAL 4 City banks led the way, holding more than 60 per cent of total assets in loans; nonmembers, about 58 per cent; and country members, 55.5 per cent. TABLE 2 IN C R E A S E D P O R T FO LIO Y IE L D S S P A R K R E V E N U E G A IN S. Third District Member Banks Percentage Return on: All Members City Members Country Members Third District Nonmember Banks 1969 1970 1969 1970 1969 1970 1969 1970 Loans 7.1 7.8 7.4 8.0 6.8 7.6 7.7 7.8 Treasury Securities 5.1 5.6 5.4 5.7 4.9 5.5 5.3 5.5 Other Securities 4.0 4.3 4.1 3.9 3.9 '4.4 4.2 4.5 16 FEDERAL RESERVE BANK OF PHILADELPHIA made up only about one-third of total ex penses at city banks, compared to over 45 per cent at nonmember and country banks. Rising costs were not restricted to interest payments during 1970. The major compo nent of noninterest expense, salaries and wages plus employee benefits, increased nearly 11 per cent at city banks, 15 per cent at country banks, and a whopping 20 per cent at nonmember institutions. Provisions for loan losses, though a small component of total expenses, surged more than 60 per cent at city banks compared to its 1969 level. This minimum loan-loss contingency ac count rose 17 per cent at country members, but was unchanged at nonmember banks. Other expenses, such as occupancy expense, furniture and equipment, and depreciation showed more moderate increases. These rates of increase in noninterest costs gen erally outstripped those observed in 1969, and were an important factor in slowing earnings growth in 1970. parts in growth of portfolio income. As the profit figures suggest, however, country banks had the most difficult time in mod erating cost increases. BUT COST INCREASES ALSO SHARP While increasing rates of return and larger asset holdings spelled substantial growth in revenues, Third District bankers struggled to allay the erosion of profits caused by rising costs. The average rates of interest paid on time and savings deposits, shown in Chart 2, soared to record levels in 1970 at all three types of banks. The in crease in interest costs per dollar of deposit was noticeably more rapid at country banks than at city or nonmember banks. While Philadelphia banks paid the highest rates, these deposits constituted a much smaller proportion of their total deposits (40 per cent) than at banks in the other groups (59 per cent). As a result, interest on deposits NONINTEREST INCOME GAINS ACCOUNT FOR PHILADELPHIA BANKS' VIRTUOSO PERFORMANCE CHART 2 IN T E R E S T R A T E S O N T IM E D E P O S IT S S K Y R O C K E T E D IN 1 9 7 0 . E S P E C IA L L Y AT C O UNTY BANKS. Did the profit-growth performance of city member banks stem from superior port folio management (better selection of assets and liabilities)? One rough measure of bank portfolio performance, a breakdown of the percentage increase in operating income into changes in interest revenues and costs versus noninterest revenues and costs, in dicates that this may not have been the case.5 Chart 3 shows the changes in non interest revenues and costs in 1970 as a percentage of operating income in the pre vious year. A comparison of the heights of the revenue and cost bars shows that at city members the increase in noninterest costs Per Cent All District Mem ber Banks I City Mem ber Banks County NonMem ber Banks Mem ber Banks I 1969 TIM E DEPOSIT INTEREST / AVERAGE TIM E DEPOSITS 1 97 0 TIM E DEPOSIT INTEREST / AVERAGE TIM E DEPOSITS 5 Since both the income and costs associated with portfolio behavior involve more than consideration of interest, this procedure is clearly a crude reflection of actual portfolio management. 17 BUSINESS REVIEW AUGUST 1971 CHART 3 C IT Y B A N K S C A P T U R E D IN C O M E -G R O W T H H O N O R S BY C O V E R IN G M O R E O F T H E IR N O N IN T E R E S T C O S T S W IT H N O N IN T E R E S T REVENUES. Since both these activities require significant amounts of capital and expertise, they are not viable earnings alternatives for smaller banks. Nevertheless, last year's income fig ures do contain a valuable lesson for all bank managers. Since Philadelphia banks have expanded operations in these two specific areas on a large scale only in very recent years, engaging in activities function ally related to banking6 apparently can boost bank earnings significantly within a relatively short period. Per Cent THE FUTURE OF BANK EARNINGS Reserve City Banks III Reserve Country Banks NonMember Banks RATIO OF CHANGE IN NONINTEREST REVENUE TO OPERATING INCOME RATIO OF CHANGE IN NONINTEREST COSTS TO OPERATING INCOME exceeded the rise in noninterest revenues by only 10 per cent of 1969 operating income. At country banks, however, this difference was over 26 per cent. This disparity stemmed primarily from the fact that noninterest rev enues increased much more rapidly at city banks in 1970 than at country member and nonmember banks. Since the difference be tween growth in interest income and in terest cost (as a percentage of operating income) was smallest at Philadelphia banks, this relative gain in noninterest income was clearly the secret to the operating-income growth success of city member banks. The major sources of these noninterest revenue gains for city banks were: (1) net earnings of foreign branches and subsid iaries, and (2) trading account income. The latter earnings represent the return from conducting a market in municipal securities. Bank earnings constitute the raw material of growth in the banking industry— a source of both internal and external finance. A competitive performance by commercial banks relative to other financial and nonfinancial businesses is, therefore, essential to continued growth of the industry. In 1970, as interest rates declined, income from loans and investments rose less rapidly than interest expense. In the first half of 1971, Third District city banks reduced rates on time and savings deposits below legal ceilings. Although some country banks also lowered deposit rates, many continued to pay the highest rates allowed — at least on passbook-type accounts. For these banks, the interest-rate squeeze on earnings will be pitted against an accelerated rate of asset acquisition permitted by the increased rate of monetary expansion during the first two quarters. Banks with large and increasing concen trations of time deposits appear to face the most difficult tasks in maintaining adequate growth in earnings. These banks hesitate to reduce the rate paid on such deposits for fear that competitors will attract not only 6 The activities so closely related to banking as to be a “ proper incident thereto" are currently being determined by the Federal Reserve Board under the 1970 Amendments to the Bank Holding Company Act. 18 FEDERAL RESERVE BANK O F PHILADELPHIA broadening the base of income-earning activity. The experience of city banks in the Third District in 1970 demonstrates how ex pansion into broader areas of financial serv ices can boost earnings performance. ■ their time-deposit dollars but also their more lucrative demand-deposit accounts. Over the longer term, more and more banks are likely to consider moving towards one-bank holding companies as a means of 19 FOR THE R EC O R D ... 2 YEARS AGO YEAR AGO SUM M ARY JUN 1971 Third Federal Reserve District United States Per cent change Per cent change 6 mos. 1971 from June 1971 from year ago mo . ago year ago June 1971 from mo. ago year ago Manufacturing CH A N G ES 6 mos. 1971 from year ago MANUFACTURING CONSTRUCTION'" ............. COAL PRODUCTION . . + 5 1 1 0 -4 3 - 9 + i - 8 - 7 0 - 5 + 2 0 - 8 - 7 1 + 15 + 5 - i - PRICES Wholesale Consumer + 4 0 3 + + 2 + + 3 + -H 1 0 t + + + + 20 9 31 17 41 16f + + + + + - 16 10 26 12 35 It + It ’’ Production workers only ‘’ ’ Value of contracts “ “ “ Adjusted for seasonal variation + 6t + 6t Check Payments1'’* Total Deposits*** Per cent change June 1971 from Per cent change June 1971 from Per cent change June 1971 from Per cent change June 1971 from year ago month year ago ago 0 - 5 + 3 + 5 Atlantic City Trenton + - 7 4 + 22 + 2 + 13 + g ............. Harrisburg . . . . + 6 + + 2 + + 2 + + 3 + + 2 + + 6 + + + 0 1 21 9 25 19 29 17 + 16 + 23 17 + + -j 1 - 7 - 1 + 2 - - 4 + 2 2 - 4 + 6 + + 4 4 + 1 - 3 + 7 + 2 - 7 + 5 Lehigh Valley - 2 - 9 + 2 - 8 - 1 0 - 4 + 2 1 - 4 + 3 0 + 4 0 + 2 - 6 Philadelphia Reading ............. +^ Scranton + 1 15 SMSA's ^Philadelphia year ago month year ago ago + 21 + 4 +n + 32 + 15 + 23 + 4 + 34 .......... - + 3 5 V L York ..................... + 2 + 3 1 + 0 + 15 12 + 24 + 2 + 14 0 + 12 + 5 + 15 23 + 43 + 1 + 20 6 + 2 + 2 + 94 0 + 0 .... + 27 + month ago 0 + Lancaster ........... Wilkes-Barre ................... ............................. Payrolls 3 Johnstown BANKING (All member banks) Deposits ................................ Loans ........................................ Investments ........................... U.S. Govt, securities . Other ..................................... Check payments*** . . . . Employ ment month ago Wilmington . . + 2 Electric power consumed Man-hours, total4 ........... Employment, total Standard Metropolitan Statistical Areas* Banking 9 + 0 - + 32 1 + 8 + 19 + 3 + 20 0 + 9 + 17 - 6 + 8 + 1 + 2 + 20 + 3 + 14 + 3 + 7 + 14 + 3 + 20 14 + 14 + 22 0 + 16 0 + 42 + 5 -38 + 62 + 'Not restricted to corporate limits of cities but covers areas of one or more counties. “ “ All commercial banks. Adjusted for seasonal variation. “ “ “ Member banks only. Last Wednesday of the month.
@FedFRASER