Full text of Business Review (Federal Reserve Bank of Philadelphia) : January/February 1982

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

JANUARY FEBRUARY 1982

D e p o s it In su ra n ce
C re a te s a N e e d
for B a n k R egulation

JANUARY/FEBRUARY 1 9 8 2

THE CASINO INDUSTRY
IN ATLANTIC CITY
Thomas P. Hamer
. . . The casinos have increased employ
ment and relieved unemployment, but they
haven’t made Atlantic City a year-round
resort.
DEPOSIT INSURANCE
CREATES A NEED
FOR BANK REGULATION
M ark J. Flannery

. . . Since their depositors are insured,
banks could be tempted to take excessive
risks in the absence of regulation.
Federal Reserve Bank of Philadelphia
100 N o rth S ix th S tre e t
P h ilad elp h ia, P e n n sy lv a n ia 1 9 1 0 6

The BU SIN ESS REVIEW is published by
the Department of Research every other
month. It is edited by John J. Mulhern with
the assistance of Michael McNamara.
Artwork is directed by Ronald B. Williams.
The REVIEW is available without charge.
Please send subscription orders and
changes of address to the Department of
Research at the above address or telephone
(215) 574-6428. Editorial communications
also should be sent to the Department of
Research or telephone (215) 574-6426.
Requests for additional copies should be sent
to the Department of Public Services.
*

The Federal Reserve Bank of Philadelphia
is part of the Federal Reserve System—a

DID THE TAX CUT REALLY CUT TAXES?
A FURTHER NOTE

System which includes twelve regional banks
located around the nation as well as the
Board of Governors in Washington. The
Federal Reserve System was established by
Congress in 1913 primarily to manage the
nation’s monetary affairs. Supporting func
tions include clearing checks, providing coin
and currency to the banking system, acting
as banker for the Federal government, super
vising commercial banks, and enforcing
consumer credit protection laws. In keeping
with the Federal Reserve Act, the System is
an agency of the Congress, independent
administratively of the Executive Branch,
and insulated from partisan political pres
sures. The Federal Reserve is self supporting
and regularly makes payments to the United
States Treasury from its operating surpluses.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Casino Industry
in Atlantic City:
What Has It Done
for the Local Economy?
by Thomas P. Hamer*
“Outside of making A tlantic City the queen that it once was, it [casino gambling] means
employment . . . . People will get off the unemployment lines.” Assemblyman Howard
Kupperman.

“We have to expand to a 52-week economy . . . . we have no year-round attraction
Thomas Coggins, Jr., President, Chamber of Commerce of Greater Atlantic City, t
the promises? How do recent economic data
for Atlantic City and the immediately sur
rounding area compare with what the data
would have been if the casinos had not come
along?
So far as jobs are concerned, the past three
years’ numbers look pretty good. Total aver
age annual employment in Atlantic County
is substantially higher than it would have
been without casinos, and unemployment
insurance claims have stabilized instead of
continuing their earlier upward trend. But
the seasonal employment swings that have
plagued the shore economy as long as resi
dents can remember haven’t gone away.
Atlantic City still booms in the summer and
busts in the winter. If this old resort is going
to make much further progress toward re

Hoopla and hopes surrounded the opening
of the first Atlantic City casino in May of
1978. Nearly four years later, the dice are
rolling at eight more casinos, and several
others are under construction. But some
critics don’t believe that casinos have done
enough for the local economy.
Have the benefits from casinos lived up to
‘ Thomas P. Hamer of Glassboro State College re
ceived his Ph.D. in economics from the Claremont
Graduate School. He specializes in construction and
use of small-area econometric models. The present
article, prepared at the request of the Philadelphia Fed,
applies such a model to the economy of Atlantic City
and its environs.
^Testimony before the New Jersey State Assembly,
State Government and Federal Interstate Relations
Committee, April 14, 1976.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

covery, it will have to cope with seasonality.

in others.
In the lodging industry (actually in Stan
dard Industrial Classification 70, which in
cludes hotels, motels, and other lodging
places), average monthly employent declined
by over 40 percent from 1968 to 1977. Em
ployment in manufacturing overall declined
greatly during the 1973-75 recession, and
although by 1977 durables jobs had recovered
to their former level, jobs in nondurables
were off by a whopping 28 percent. Em
ployment in construction also was severely
affected by recessions, so that despite some
recovery it declined by 12 percent for the ten
years. Transportation and public utilities
employment saw a smaller decline but a
decline nonetheless. These slippages were

THE WAY IT WAS
Stagnation characterized the Atlantic
County economy for the decade before ca
sinos. Employment grew at only a third of
the national rate, and population grew only
marginally. Atlantic City itself lost over 10
percent of its residents. Obviously, the pic
ture wasn’t a bright one when casinos ap
peared on the scene.
Mixed Activity. Of course, not every in
dustry was affected in quite the same way.
Some were stronger, others weaker. Some
were more resistant than others to move
ments in the business cycle. And business in
some industries was much less seasonal than

FEDERAL RESERVE BANK OF PHILADELPHIA

ratio of lodging-industry employment in the
winter to that in the summer decreased from
65 percent in 1968 to 47 percent in 1977,
averaging 55 percent over the decade.
These weaknesses in the Atlantic County
economy showed up clearly in the unemploy
ment figures.2 The monthly unemployment
insurance (UI) claims more than doubled
over the precasino decade, peaking at 8,200
during the 1975 recession (Figure 2). Un
employment claims fluctuated even more
than total employment: on average, winter

hardly offset by gains in trade, services,
finance, and government.
Further, Atlantic City had to deal not only
with stagnation and sensitivity to the busi
ness cycle but also with seasonal fluctuations
(Figure 1). Shore jobs always have been far
scarcer in the winter than in the summer.
Over the ten years before casinos, employ
ment in the winter (first quarter] averaged
only 82 percent of employment in the follow
ing summer (third quarter)—an average sea
sonal change of 12,500 jobs each year.1 In
the lodging industry the pattern was even
more severe, worsening as time passed. The

o
Average monthly insurance claims of county resi
dents who are totally unemployed and eligible under
one of three programs: regular, Federal employee, and
veteran. Extended benefit claims are excluded.

1Average monthly total nonfarm employment.

FIGURE 2

RECESSION COMPOUNDS THE EFFECT
OF SEASONALITY ON UNEMPLOYMENT CLAIMS

SOURCE: State of New Jersey, Department of Labor and Industry.

JANUARY/FEBRUARY 1982

BUSINESS REVIEW

claims outran summer claims by more than
two to one. By 1977, some 4,000 more people
were on unemployment in the winter than in
the summer.
In short, Atlantic City’s deteriorating
facilities and fading attractions drove the
tourists elsewhere. Lodging business fell
off, and other industries declined as well.
The old spa developed a pervasive case of
economic malaise.
To the Rescue. Casinos had been proposed
as a stimulus for the local economy for quite
some time, but their approval came neither
easily nor all at once.
The issue of casinos first appeared on New
Jersey ballots in November of 1974. The 1974
proposal, however, would have let casinos
be licensed anywhere in New Jersey. The
threat of widespread legalized gambling and
the lack of pressing economic need helped
defeat the issue three to tw o.3
By 1976, those campaigning for casinos
were better organized and better financed,
and the issue was focused on Atlantic City
and its economic plight. The 24 months
between the two referenda had seen more
inflation and a soaring unemployment rate.
Backers urged that casinos could provide an
economic fix for the area. Also, the 1976
proposal specified that the potential evils of
legalized gambling were to be contained
within the 12 square miles of Atlantic City.
The voters of New Jersey said Yes to this
proposal and to the hope of turning the city
around.
Memorial Day weekend of 1978 marked
the opening of the Resorts International
Hotel and Casino. Since then casino openings
and employment have accelerated. Caesar’s
Boardwalk Regency broke Resorts’ year
long monopoly in June of 1979. Both of these

facilities were renovated hotels whose erst
while grand ballrooms were stuffed with the
gadgetry of gambling. The delay of new
construction caused Bally’s Park Place casino
not to open until December of 1979. But after
a nine-month lull, four additional casinos
opened in rapid succession: the Brighton
(now the Sands], Harrah’s Marina, and the
Golden Nugget in 1980, and then the Playboy
in 1981. Employment in hotels and other
lodging places leaped from less than 2,000 in
the first quarter of 1978 to over 22,000 in the
first quarter of 1981 (Figure 3). Thus enor
mous economic forces were unleashed in
Atlantic County in a very short period of
time.
Rosy predictions are one thing. But when
the casino stone finally was dropped into the
Atlantic County pond, no one could say for
sure what sort of ripples it would make. The
future isn’t easy to predict, and the best-laid
plans can go astray. Further, local economies
are especially complex and fragile entities—
not least of all when they are in decline.
What has happened to date has come to
pass because of a wide range of influences
interacting with one another. So far as jobs
are concerned, the main mechanism at work
has been the local labor market. And the
workings of this market are likely to be
decisive in determining what happens to jobs
and joblessness in Atlantic County from this
point forward.
THE LABOR MARKET AT WORK
What happens when a new industry ap
pears in a local labor market or an old
industry experiences sudden and spectacular
growth?
One typical effect is the multiplier effect:
people are hired, and as more money is
earned, more is spent. Wage earners will
spend some of their wages where they earn
them, and so these wages will generate
further local employment.
Also, a growth industry is likely to need
more facilities, or at least renovated ones,

3This is not to say that there weren’t other issues such
as regulatory control by the state and the impact on the
state’s finances. See Public Hearing before Assembly
State Government and Federal and Interstate Relations
Committee on ACR-126, April 14, 1976, pp. 6-7.

FEDERAL RESERVE BANK OF PHILADELPHIA

FIGURE 3

CASINOS OPEN AT A FASTER PACE

Year and Quarter
1978

1979

1980

1981

I
II
III
IV
I
II
III
IV
I
II
III
IV

Casinos and
Opening Months

Resorts International, May

Caesar’s Boardwalk Regency, June
Bally’s Park Place, December

Sands, August
Harrah’s Marina, November
Golden Nugget, December

Employment in Hotels and
Other Lodging Places (SIC
70) Not Seasonally
Adjusted
1,711
4,065
5,787
5,019
5,459
9,184
12,168
11,842
13,730
14,964
18,058
21,393
22,772

SOURCE: Quarterly employment is the simple average for three consecutive months; employment is
that covered by unemployment insurance. Data are from the State of New Jersey,
Department of Labor and Industry.

and this demand will be reflected in con
struction hiring. The industry will need to
hire its own employees, too, and it will need
to be supplied by vendors. All these newly
employed people will have fatter pay enve
lopes that will finance stronger purchases of
consumer goods and services. Thus employ
ment in wholesale and retail trade, services,
transportation, food processing, and banking
should rise.
Another positive employment effect is
unique to service industries such as lodging,
where the ultimate consumer must come to
the provider. Service industries increase
local foot and road traffic. Buyers who come
to town for one service typically do not
spend all of their money in one place; they
spend some of it in local restaurants, for
example, some in shops, and some in jitneys.
These positive ripples should boost business

at a whole range of service establishments.
Competition for labor, however, can re
duce employment in some industries, off
setting the positive effects somewhat. Work
ers with appropriate skills will dive for the
lucrative construction jobs and other growth
industry jobs, and only employers who are
benefiting from the general expansion will
raise wages to retain workers or attract
replacements. Other employers will be faced
with increasing numbers of unfillable vacan
cies, probably concentrated along industry
lines.
Increased competition for capital and land
also can cut into the demand for labor. Local
employers who don’t benefit from the boom
will have to compete with the expanding
firms for loans at local banks. Those that
can’t get loans may lay people off and slow
down their operations. Some firms even may
7

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

find more profit in closing down and selling
the land at inflated prices than in trying to
stay open. Thus the voracious appetite for
resources in the growing sectors could starve
out the marginal firms. While the gains still
should outweigh the losses, the net positive
effect on employment could wind up being
smaller than anticipated.
Further, more employment may not trans
late into less unemployment. Much of what
happens to residents who are unemployed
when the boom occurs depends on what
other people do. Increased employment
opportunities may bring other residents into
the workforce: housewives, students, and
retirees, for example, may be attracted to
substitute wage earning for housework,
classes, and leisure. Also, nonresidents may
migrate into the area to get the new jobs. If
these resident and nonresident additions to
the workforce are more employable than the
old UI claimants, the number of claims will
not drop. In fact, it could rise if some of the
new additions to the workforce are hired and
then laid off or dismissed.
The seasonality of the shore labor market
also can operate to drive up the number of UI
claims. Employers in seasonal industries
may pay unusually high wages to attract
workers when business is good, in effect
compensating workers for accepting jobs
with a built-in layoff schedule. The workers
will get higher unemployment payments be
cause of their higher wages, and the employer
will feel little compunction at layoff time.
The result will be very high seasonal UI
claims.
A growth industry changes many other
things which affect people’s welfare besides
job prospects. Higher property values, rental
costs, and taxes may induce many pensioners
to take their transfer payment income else
where. Further demographic changes may
come from the influx of younger people and
their families. But changes in employment
and unemployment remain of prime impor
tance to the overall health of the regional

economy, as can be seen in the case of
Atlantic City’s experience with casinos.
CAPTURING THE CASINO EFFECTS
Like other regional economies, that of
Atlantic County is tied closely to fairly wide
spread trends, including national ones. What
happens in the local economy depends in
large part on what happens in the national
economy. Thus any attempt to capture the
effects of casino openings must go beyond
merely making lists of befores and afters in
the local economy. It must ask what would
have happened in Atlantic County without
casinos, and it must rely on information
about both the local economy and the na
tional economy.
To make the relevant comparisons, an
econometric model of the precasino economy
has been constructed to estimate what would
have happened without casinos. Based on
conditions in the precasino years, the model
makes forecasts of employment and of un
employment insurance claims for the twelve
quarters beginning with the first casino open
ing.
Jobs and Joblessness. The forecasted
values of employment and of UI claims
differ considerably from actual historical
values (Figure 4). Compared to what would
have been, the casino industry has meant
large increases in employment in the lodging
industry (as expected), and it has induced
increases in construction as well. Construc
tion of casinos caused a frenzy of activity
that peaked in the last two quarters of 1979,
with employment in the construction industry
running about 5,000 above would-have-been
levels. By the first quarter of 1981, this gain
was down to about 2,000 as fewer casinos
were actively under construction.
Other industries also experienced employ
ment changes over time, and although their
changes were not that much higher than the
forecast to be significant statistically, they
may well have been related to casino growth.
Growth above the forecast levels occurred in
8

FEDERAL RESERVE BANK OF PHILADELPHIA

FIGURE 4

CASINOS BOOST EMPLOYMENT, CUT UI CLAIMS
IN ATLANTIC COUNTY
Total Employment

SOURCE: State of New Jersey, Department of Labor and Industry.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

nondurables manufacturing, transportation,
trade, and other services, especially toward
the end of the casino-building period. And
the largest losses in durables manufacturing
and the government sector coincided with
the peak levels of construction employment.
Adding up the pluses and minuses, the
change in the monthly average of total em
ployment has grown by leaps and bounds.4
For the last quarter of the comparison period
average casino employment was about 21,000

above would-have-been levels (Figure 5),
and the difference in all the other sectors was
about 8,000. Thus the casinos have been
responsible for bringing in over 29,000 new
jobs.
What sort of net effect has this hiring had
on unemployment? The State of New Jersey
reported that 6,134 residents of Atlantic
County made unemployment insurance
claims in the first quarter of 1978. By the first
quarter of 1981 claims had fallen to 5,240.
This may not look like much of a drop, and
some observers have used these numbers as
proof that legalized gambling has not done
enough to help the area. What the model
shows, however, is that casinos kept un
employment insurance claims from rising to
over 8,500 by the first quarter of 1981 from
the continued effects of stagnation and re
cession. Thus despite increases in the labor
force, the original residents of Atlantic

4In the second quarter of 1978, the employment
differences in the five expanding industries of non
durables manufacturing, construction, transportation
and public utilities, trade, and other services far outran
declines. Durables manufacturing, finance, insurance,
and real estate, and government had maximum negative
differences of 1,889 when construction peaked in the
fourth quarter of 1979, but the five gainers were up by
6,574. By the first quarter of 1981, the five gainers were
up by 9,264 while the other three had negative dif
ferences of 1,026.

FIGURE 5

CASINOS SPUR SPECTACULAR JOB GROWTH
AT ATLANTIC CITY HOTELS
Hotel Employment

FEDERAL RESERVE BANK OF PHILADELPHIA

on, economic linkages could become in
creasingly important for employment and
unemployment in both Atlantic City and
Philadelphia (see SPINOFF EFFECTS ON
PHILADELPHIA).
Seasonality. How about changes from
season to season? Employment in Atlantic
County has generally peaked in the third
quarter and fallen to a low in the first
quarter. Seasonal fluctuations in total em
ployment remain in the range of 80 percent
to 86 percent: in the off season, one or two of
every ten employees will be out of work.
Thus the percentage swings in employment
overall don’t appear to have been modified

County had at least 3,300 fewer claims than
they would have had without casinos in the
first quarter of 1981. This adds up to a
significant benefit for the original residents.
Moreover, if some of the claims were made
by new residents, as seems likely, then the
original residents must have benefited even
more than the numbers might suggest on first
reading.
Further, while the argument for casino
gambling focused first on the welfare of
Atlantic City itself and then on other places
in New Jersey, it would be reasonable to
expect some reverberations on the economy
of Southeastern Pennsylvania. As time goes

SPINOFF EFFECTS ON PHILADELPHIA
Philadelphia is about 60 miles from Atlantic city: it is the closest major metropolitan area. Has
Atlantic City’s resurgence had any effect on Philadelphia’s economy?
While the available information is somewhat sketchy, it doesn’t appear that Philadelphia is
providing a large part of the demand for either labor or supplies. One of the arguments for casino
legislation in New Jersey was that the casino owners would employ local people and make
purchases locally whenever they could—in Atlantic City if possible, otherwise elsewhere in New
Jersey. Thus construction workers were first hired and trained in Atlantic County. To fill expanding
needs, many unemployed union craftsmen, carpenters for example, transferred from other areas of
the state, including the Camden area. But few transferred from Pennsylvania.
New Jersey is given preference also for procurement of hotel materials, furnishings, food, and
beverages. Construction materials and furnishings tend to be one-time purchases from manu
facturers having locations across the country. The continuing purchases of food and beverages
often are made outside Atlantic County for want of wholesale grocers there. Legal requirements
dictate in-state liquor purchases, but casino purchasing agents may buy food in the Philadelphia
area as well as in northern New Jersey. A rough estimate, however, is that only 5 percent to 10
percent of these continuing food purchases come from Pennsylvania.
The demand for bus transportation has skyrocketed as the casinos have striven to bring daytrippers to Atlantic City. Subsidies paid to bus companies by casinos insure high traffic from nearby
metropolitan areas. Given that many of the bus companies and support services are in the
Philadelphia area and elsewhere in Eastern Pennsylvania, the heightened traffic is beneficial. But
in arranging this temporary exodus to the gambling parlors, Atlantic City is competing with
Philadelphia restaurants, night clubs, and theaters for the entertainment dollar.
The proximity of casinos may attract more meetings and conventions to Philadelphia, since
Philadelphia visitors will find it convenient to mix casino play with business. Yet with thousands of
new hotel rooms, a refurbished convention center, and improved air and rail transportation,
Atlantic City could successfully compete with Philadelphia. Conventions and business meetings
might come to Atlantic City leaving Philadelphia with the consolation role of a transportation
center.
While these linkages to the Philadelphia area economy can be identified, they are not easy to
measure in the short run. It remains to be seen whether Philadelphia will gain more than it loses
from having the casinos so close by. Packaging Philadelphia and Atlantic City together for
tourism—a cooperative enterprise—could tilt the balance in favor of an economic benefit for both.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

reflected in a recent release of the U.S.
Department of Commerce which shows that,
in 1979, Atlantic County had a larger per
sonal income growth rate than any other
SMSA in the country.
Casino employees could be hurt, though,
by the seashore’s old nemesis—the employ
ment seasonality that goes with seasonality
in climate. The casinos have to find a way to
beat the weather.
In Nevada, the Reno and Lake Tahoe
areas have severe winters like those in At
lantic City. These two mature gambling
areas also have very severe seasonal fluctu
ations—unlike Las Vegas which, with a
milder climate, has a more nearly constant
level of operation. If the Atlantic City casinos
remain exclusively summertime entertain
ment, then the economic fix they brought
will mean higher employment but also high
seasonal volatility and therefore many lay
offs.
To compensate for the bad winters, the
casinos must draw on the millions of poten
tial customers within a few hundred miles.
Already hordes of private buses are running
day and night to bring in day-trippers, but
these buses may not be enough. Government
action maybe needed to encourage improve
ment of rail and air access to Atlantic City if
the full benefits of higher employment are to
be realized.
In short, while much may remain to be
done in or for the economy of Atlantic
County, the casinos have lived up to their
advance billing—so far. Employment is up,
unemployment restrained. That may not be
everything promised and hoped for, but it’s
far from inconsiderable.

by the advent of legalized gambling.
In the lodging industry the severity of
seasonal fluctuations increased steadily from
1968 to 1977, so that by the end of the period
almost one-half of lodging employees were
out of work in the off season. It would be
nice to be able to say that this seasonality in
the lodging industry has been reduced by the
advent of casinos. But no such reduction can
be discerned.
Finally, seasonal swings in unemployment
insurance claims have become slightly less
severe. Claims in the winter (first quarter)
averaged about two and one-half times as
many as in the summer (third quarter) before
casinos. Now about twice as many claims
are made in the off season. Thus there seems
to have been some improvement, but the
strong seasonality of UI claims hasn’t gone
away.
Seasonality of both employment and un
employment has been made harder to mea
sure by the schedule of casino openings. If
casions opened on a regular basis, say a new
casino every fourth month, the pattern of
seasonality might show through more clearly.
Because openings have not been spaced
evenly, the effect on seasonality is obsure.
But fine measurements aside, seasonality
certainly remains endemic to Atlantic City’s
economy.
IMPLICATIONS FOR POLICY
Compared to what would have been, then,
legalized gambling has created a boom in
Atlantic County. Employment has grown
vigorously instead of stagnating, and un
employment insurance claims have remained
stable rather than rising. These benefits are

FEDERAL RESERVE BANK OF PHILADELPHIA

Technical Appendix
The econometric model is designed for a small region like Atlantic County and has ten structural
equations and one identity. Nine of the equations relate quarterly nonfarm wage and salary
employment in establishments in each of nine industries to the quarterly seasonally adjusted level
of real gross national product (GNP) and to time. The theory is that the level of national economic
activity is pervasive in its effect. That is, it affects the level of employment in the usual export
industries, such as manufacturing, and several others in the county involved in the tourist business,
such as hotels and motels, retail trade, and transportation. Time is used to indicate long-run trends.
The identity is simply the adding up of employment in the nine sectors to give total nonagricultural
employment. The tenth equation explains the unemployment insurance claims of Atlantic County
residents with three variables: total nonfarm employment, the first difference of total nonfarm
employment, and time.
The model is estimated with seasonally adjusted quarterly data from the first quarter of 1968 to
the first quarter of 1978. Forecasts are then produced for the following twelve quarters. The
forecasted values are translated to seasonally unadjusted values for comparison with the historical
values.*
Serial correlation of errors was a significant problem, and therefore a Cochrane-Orcutt type
procedure in the SAS programming package was used.
The estimated equations are:
Quarterly employment
in durable goods

= 1 5 , 033.55 + 9 .0 9 GNP L3 - 310.30 Time
(t = 9 .9 4 )
(t = 8 .3 8 )
(t = -8.46)

m an u factu rin g

Autocorrelation: Rho (1 period lag) = -.33
(t = -2.19)
38 obs.

R2 = .67

F = 3 6 .2 7

Quarterly employment
in nondurable goods
manufacturing

= 38,76 0 .3 4 + 9 .1 3 GNP LI - 587.99 Time
(t = 10.92)
(t = 4 .1 6 )
(t = -7.34)

Autocorrelation: Rho (1 period lag) = -.66
(t = -5.43)
38 obs.

R2 = .75

F = 5 3.86

Quarterly employment in
lodging places

= 29, 936.49 + 4 .2 2 GNP L3 - 418.20 Time
(t —8.73)
( t= 1 .7 0 )
(t = -4.99)

Autocorrelation: Rho (1 period lag) = -.23
(t = -1.46)
38 obs.

R2 = .80

F = 6 9 .9 9

*The results of this modeling effort have been tested by Nicholas Carlozzi of the Philadelphia Fed
using seasonally unadjusted data and an alternative model structure. The conclusions reached in
the paper are generally robust to these changes in data and model structure.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

Quarterly employment in
contract construction

= 14, 075.47 + 4.63 GNP LI - 222.41 Time
(t = 4.65]
(t = 2.39)
(t = -3.19)

Autocorrelation: Rho (1 period lag) = -.59
(t = -4.50)
38 obs.

R2 = .28

F = 6 .7 3

Quarterly employment in
transportation and
public utilities

= 8, 172.71 + 2.58 GNP L I - 106.80 Time
(t = 5.56)
(t = 2.70)
(t = -3.12)

Autocorrelations: Rho (1 period lag) =-.64
(t = -4.07)
Rho (2 period lag) =-.21
(t = -1.14)
Rho (3 period lag) =.25
(t = 1 .5 9 )
38 obs.

R2 = .23

F = 5 .1 8

Quarterly employment
in wholesale and
retail trade

= 1 0 , 690.96 + 5 .6 8 GNP L l
(t = 10.30)
(t = 6.61)

Autocorrelation: Rho (1 period lag) = -.47
(t = -3.25)
38 obs.

R2 = .55

F = 4 3 .6 6

Quarterly employment
in finance, insurance, and
real estate

= -1 1 , 586.07 + 207.12 Time
(t = -10.27)
(t = 13.48)

Autocorrelation: Rho (1 period lag) = -.70
(t = -5.97)
38 obs.

R2 = .83

F = 181.80

Quarterly employment in
services (includes mining,
excludes lodging places)

= -1 4 , 387.53 + 3 4 5 .3 0 Time
(t = -4.45)
(t = 7.84)

Autocorrelation: Rho (1 period lag) = -.46
(t = -3.16)
38 obs.

R2 = .63

F = 6 1 .4 9

FEDERAL RESERVE BANK OF PHILADELPHIA

= -24, 035.41 + 4 9 2 .7 2 Time
(t = -9.84)
(t = 14.81)

Quarterly employment
in government

Autocorrelation: Rho (1 period lag) = -.63
(t = -5.00)
38 obs.

R2 = .86

219.35

Quarterly unemployment
insurance claims

= -12, 013.69 + 464.27 Time - 0.28 TOTLl
(t = -2.67)
(t = 5.71)
(t = -2.618)
-0.17 DTOT
(t = -1.88)

Autocorrelation: Rho [1 period lag) = -.50
(t = -3.54)
37 obs.

R2 = .55

F = 13.55

In these equations:
‘Quarterly’ refers to the average of figures for three consecutive months.
GNP LI = quarterly real GNP lagged one quarter,
GNP L3 = quarterly real GNP lagged three quarters,
Time

= a trend variable having a value of 68.00 for the first quarter of 1968 and
incremented by .25 for each successive quarter,

TOT L I = total employment lagged one quarter, and
DTOT

= total employment in the current quarter less total employment lagged
one quarter.

The model results show that employment in some industries was higher with casinos than it
would have been without them (see POSITIVE DIFFERENCES overleaf), while in other industries
employment was lower (see NEGATIVE DIFFERENCES overleaf). As noted in the text, not all the
differences were statistically significant.
The number of unemployment insurance claims also showed negative differences, which were
significant. UI claim numbers in this study have been adjusted to take into account procedural
changes made by the State of New Jersey.
Beginning in January, 1978, the State of New Jersey modified its determination of the number of
UI claimants that are residents of Atlantic County. An improved survey of actual claims led to
increased numbers of claims. Dual procedures were used in 1978, and the difference was an
increase of 144 claims in the quarterly average. The results in this study in terms of UI claims are
made with adjustments for this change. The same difference pattern for 1978 was used for 1979,
1980, and 1981, since the UI claims were stable during this time.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

POSITIVE DIFFERENCES:
HISTORICAL GREATER THAN FORECASTED

Hotel &
Motel

Non
durable
Manufac
turing

Trans
portation
& Public
Utilities

Con
struction

Trade

Services
Except
Hotel &
Motel

Total

1978

II
III
IV

929
1,612
2,573

145
28
144

432
399
1,299

-32
-130
-35

242
602
690

63
-216
832

1,774
2,069
5,324

1979

I
II
III
IV

3,454
6,083
8,098
9,467

269
171
312
-33

2,117
3,380
4,498
4,959

102
195
202
376

361
-516
-967
325

1,776
846
97
947

7,183
9,250
10,767
14,152

1980

I
II
III
IV

11,892
12,122
14,431
19,290

172
185
423
378

2,342
2,440
2,758
2,652

471
459
508
519

983
163
403
2,014

2,336
425
-596
477

17,009
15,248
17,120
23,888

1981

21,247

551

2,122

549

1,341

4,701

29,486

NEGATIVE DIFFERENCES:
HISTORICAL LESS THAN FORECASTED
Durables
Manufacturing

Finance,
Insurance &
Real Estate

Government

Unemployment
Insurance
Claims

1978

II
III
IV

-73
-67
-51

-86
-163
-53

154
2
-76

-511
-402
-809

1979

I
II
III
IV

-118
-200
-339
-465

-206
111
-110
-273

-573
-820
-1,025
-1,151

-1,373
-237
261
-716

1980

I
II
III
IV

-246
-302
-354
-520

-174
-252
-372
-357

-768
9
-81
-565

-1,009
-449
-307
-2,188

1981

-484

-621

-3,332

FEDERAL RESERVE BANK OF PHILADELPHIA

Deposit Insurance
Creates a Need
for Bank Regulation
by M ark ]. Flannery *
an artificial incentive to undertake more risk
than they would in an unregulated and un
insured free market. Bankers insured by the
Federal Deposit Insurance Corporation
(FDIC) can benefit privately by undertaking
risks that the society as a whole considers
excessive.
Restrictive bank regulations can thus be
viewed as an effort to undo (or at least to
limit) the distortive impact of deposit insur
ance on bank decisions. This view of bank
regulation is certainly not all-encompassing,
since numerous regulations pre-date FDIC
and others are not directly related to bank
risk taking. Nonetheless, considering the
impact of FDIC insurance on bank behavior
can often provide a useful framework for
evaluating bank regulations and regulatory
reform.

Many bank managers and owners have
long complained that they are overregulated
by a plethora of government agencies. The
thrust of their complaint is that they could do
a better job—that is, become more profitable
or increase their bank’s market value—if left
unencumbered by regulations limiting port
folio choice, capital adequacy, holding
company formations, deposit rates, and so
forth. They are doubtless correct. Yet banking
in the U .S. possesses institutional character
istics that require at least some of the regula
tions currently in place. In particular, Fed
eral deposit insurance gives insured bankers

*The author, an Assistant Professor of Finance at the
University of Pennsylvania, is affiliated with the Phila
delphia Fed’s Research Department.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

commitment to support FDIC ends here,
many economists and regulators believe that
the Federal Reserve and the Treasury would
continue to provide almost limitless support
to FDIC in the event of serious bank failures.
This gives the taxpaying public a substantial
indirect interest in the FDIC insurance fund’s
viability.3*
Despite the fact that FDIC closely re
sembles private insurance companies in many
regards, FDIC’s fixed-rate premium structure
is unusual, and this constitutes the raison
d’etre for other banking regulations. Private
insurers use a variety of methods to calculate
the level of premia they charge, but all have
the same goal: providing adequate funds to
cover future losses. Setting adequate premium
levels requires an accurate assessment of the
likely losses associated with each contract.
Insurance companies that cover auto
mobiles, homes, and personal property gener
ally charge a premium that varies with the
perceived risk of the activity being under
written. A seventeen-year-old urban male
driver with three recorded accidents pays
more for auto insurance than the elderly
couple who live in a rural area and drive only
on Sundays. Why? Because the insurance
company anticipates that the teenager is
more likely to have an accident and file an
insurance claim. Greater perceived risk
requires higher auto insurance premia if the
company is to stay in business.

THE FEDERAL DEPOSIT
INSURANCE SYSTEM
Congress introduced nationwide bank
deposit insurance by creating the FDIC in the
Banking Act of 1933.1 Byyearendl980, 98.2
percent of all commercial banks in the U .S.
were insured by FDIC. If an insured bank
fails, FDIC promises to repay its depositors’
losses, up to a maximum of $100,000 per
account. Today, coverage extends to 79.9
percent of all bank deposit balances in the
U.S. In return for this insurance coverage,
each insured bank pays FDIC an annual
premium set by statute at .083 percent of
total deposit balances.2 FDIC uses this in
come to pay its expenses (including any
insurance claims from failed banks’ deposi
tors) and to maintain an adequate insurance
reserve fund. After providing for operating
expenses, losses, and necessary additions to
its reserve fund, FDIC is required to refund
60 percent of its remaining premium income
to insured banks. In recent years, such refunds
have lowered the net cost of FDIC deposit
insurance to .03 percent or .04 percent of a
bank’s total deposits—less than half the
statutory rate.
As with any insurance operation, FDIC’s
reserve fund is its first line of defense in the
event of bank failures. At yearend 1980, this
fund amounted to $11 billion, or 1.16 percent
of total insured deposits. Unlike private
insurers, FDIC also possesses a unique
second line of defense behind its reserve
fund—a $3-billion credit line from the U .S.
Treasury. Although the government’s formal

3An example of this connection between FDIC and
the general public occurred in 1974. During that spring
and summer, Franklin National Bank was in serious
danger of failing. Rather than close the bank and pay off
its insured depositors, FDIC wanted to find another
bank to acquire Franklin National. To keep the troubled
bank afloat while FDIC sought a suitable merger part
ner, the Federal Reserve Bank of New York extended
sizable loans at a below-market interest rate. This
action cost the Federal Reserve Bank an estimated $25
million. Since Federal Reserve operating surpluses are
returned to the Treasury, U .S. taxpayers ultimately
paid this cost. See Joseph F. Sinkey, "The Collapse of
Franklin National Bank of New York,” Journ al o f B an k
Research (Summer 1976), pp. 113-122.

1Although this article explicitly discusses only com
mercial banks, the same arguments apply to savings
and loan associations, mutual savings banks, and credit
unions.
2Note that banks with some accounts in excess of
$100,000 are paying for insurance coverage their de
positors won’t receive. Since larger banks more often
have large customers, the effective cost of their deposit
insurance (per insured deposit dollar] appears higher
than it is for small banks.

FEDERAL RESERVE BANK OF PHILADELPHIA

Life insurance companies assess premia in
a slightly more complicated fashion. Take
the case of term insurance, which pays off
only if the insured dies during the policy’s
term. Term insurance premia increase with
an individual’s age because, according to the
annuity tables, older people are more likely
to die during the contract period, exposing
the insurance company to a loss. Like the
automobile insurer, life insurance companies
charge their higher risk customers more. At
the same time, however, most insurance
companies try to avoid the highest risk
applicants in each age group by requiring
applicants to undergo a physical examination.
People in relatively poor health are denied
coverage.
These examinations protect the insurance
company against a phenomenon known as
adverse selection. A person in poor health
knows he is more likely to die than the
average person his age in the general popu
lation. If all people the same age could
purchase insurance for the same premium,
those in worse health would be more likely to
buy a policy. The average policy holder
would therefore be more likely to die than
the average person in the population, and the
life insurance company would find itself
paying for greater death benefits than it had
expected from its annuity tables.4
FDIC’s premium structure is like the life
insurance company’s in one way: each bank
must initially demonstrate an acceptable
level of financial health in order to qualify
for FDIC coverage. But FDIC also requires
frequent checkups (bank examinations) as a
condition of continued coverage. This need
constantly to reexamine insured banks arises
because the provision of deposit insurance

itself encourages the bank to become riskier
than it was before becoming insured.
DISTORTIONS CAUSED
BY FDIC INSURANCE
Consider first a bank with no deposit
insurance. If it goes bankrupt, the share
holders will lose their entire investment and
depositors will be less than fully repaid.
Knowing this, each potential depositor
should assess the riskiness of a bank’s opera
tions. 5 While a riskier loan portfolio is likely
to mean higher returns for the bank, it also
raises the prospects for bankruptcy. Deposi
tors and stockholders will require compen
sation for bearing that risk in the form of a
higher return on their funds. Thus the willing
ness of bank managers to make risky loans is
held in check by the concern of depositors
and stockholders for the safety of their
funds. Indeed, free market advocates contend
that the ability of people to shift funds from
one bank to another ensures that banks will
undertake a socially correct amount of risk.
Now consider the impact of fixed-premium
deposit insurance on the bank’s risk-taking
decision. It is easiest to begin with an as
sumption that 100 percent of all bank deposits
are covered and banks have no stockholders.6
If the bank fails, FDIC stands ready to repay
depositors in full, so depositors no longer
care how risky the bank’s asset portfolio

5Whether depositors do or can evaluate bank risk is
an entirely different issue, related to the initial reasons
for Federal government provision of deposit insurance.
See Ian McCarthy, “Deposit Insurance: Theory and
Practice,” IM F Staff Papers (September 1980), pp.578600.
o

A large school of thought contends that FDIC in fact
has extended insurance coverage to all bank liability
holders by its decisions to arrange mergers (technically
called a “purchase and assumption”) rather than closing
failed institutions outright. See David B. Humphrey,
“100% Deposit Insurance: What Would It Cost?” Journal
o f B an k Research (Autumn 1976), pp. 192-198 or Gary
Leff, “Should Federal Deposit Insurance Be 100 Percent?”
Bankers Magazine (Summer 1976), pp. 23-30.

4Some insurance companies write policies for people
without requiring a physical. This insurance is more
expensive (has a higher premium) because the company
knows it will suffer adverse selection. Healthy people
are more likely to purchase lower cost policies that
require a physical.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

really is. So long as people retain faith in
FDIC’s ability to make payments, the bank’s
borrowing (deposit) costs are the same no
matter how risky its asset portfolio. One
natural check on bank risk taking has thus
been eliminated. Since riskier assets offer
higher expected returns and since deposit
costs don’t vary with the bank’s perceived
risk, the bank maximizes expected profits by
purchasing the riskiest available assets. This
decision becomes perfectly rational from the
bank’s private perspective once deposit in
surance has been procured. In other words,
banks have a clear incentive to become more
risky when FDIC begins promising to absorb
their default losses (see Appendix).
This example overstates the argument by
ignoring two important considerations. First,
the bank’s deposits and other liabilities are
not fully (100-percent) insured by FDIC.
Some depositors will therefore demand
higher interest rates when the bank’s under
lying portfolio risk rises, making the banker’s
ability to profit by undertaking socially ex
cessive risks smaller than it would be with
100-percent insurance coverage. Second,
banks do have stockholders, and these
owners are concerned about their risk ex
posure. Their aversion to risk will provide
some limit to the manager’s willingness to
make ever riskier loans. FDIC insurance will
still distort the private incentive to bear risk,
however, by reducing the increase in deposit
costs that would normally accompany greater
bank portfolio risk.
Economists refer to distortions such as
those resulting from FDIC deposit insurance
as externalities, since one individual’s actions
affect the well-being of other people. An
externality can be either good or bad. Picking
up litter in a public park, for example,
constitutes a good externality: the clean
view is enjoyed by people other than the dogooder. A factory whose chimney dumps
soot onto nearby residents’ drying laundry is
a bad externality. The factory could burn
cleaner fuel or install stack scrubbers, but

these actions would mean lower profits.7*
The outcome—air pollution—illustrates
how government regulation—pollution con
tr o l-c a n improve overall social welfare
even though it imposes a real burden on
private parties such as factory owners.
Just as factories would ignore their pol
luting effects in the absence of regulation,
banks will ignore the extra risk they impose
on society as a result of not having to be
concerned about the safety of depositors’
funds. In response, bank regulators have
taken steps to limit the risk that insured
bankers are allowed to undertake. Effective
regulations will reduce bank profits relative
to what they would be without regulations
(though with deposit insurance), but society
should be made better off because of the
diminished amount of bank risk taking.
BANK REGULATIONS AS A RESPONSE
TO DEPOSIT INSURANCE
Many types of banking regulations can be
interpreted as efforts to counteract the distortive effects of fixed-premium deposit
insurance. With the introduction of one
distortion (the insurance), others are required
to prevent too great a departure from the
socially ideal result that an unregulated
market mechanism would yield. (The fact
that FDIC received extensive regulatory
powers in conjunction with its insurance

7From the factory owner’s own (selfish) perspective,
spewing soot is the optimal decision. It maximizes her
profits. Suppose, however, it would cost $10 per year to
eliminate the soot, which would make the neighbors
feel $15 better off. The sociallyoptimal decision would
be to eliminate the soot. Pollution control laws are
intended to bring about the desired result. Since the
factory owner finds it privately more profitable to
pollute, her profits will decline as a result of enforcing
these regulations. (If profits do not decline, either the
regulations are ineffective or the factory owner was
operating inefficiently to begin with.) Despite the factory
owner's loss, the society as a whole—factory plus
neighbors—will be made better off under a proper set of
pollution restrictions.

FEDERAL RESERVE BANK OF PHILADELPHIA

cushion also exposes the FDIC to greater
risk. A smaller proportional loss on assets
would more readily bring on bankruptcy,
raising the probability of an FDIC payout.
Bank regulations try to prevent this by im
posing minimum capital (net worth) ratios
that all banks must meet to be considered
sound.
The issue of adequate bank capitalization
has been hotly debated and is the subject of
often bitter dispute between bankers and
regulators.9 It should be. If capital regula
tions did not constrain bankers (that is, lower
their expected return on equity), they
wouldn’t complain, but neither would the
regulation be successfully counteracting the
distortive effects of FDIC insurance.
Bank Holding Company Permissible
Activities. In some other countries, banks
are closely affiliated with a myriad of finan
cial and nonfinancial firms via holding
companies or overlapping ownership and
management. In the U .S ., Congress has
limited bank holding companies to activities
“so closely related to banking as to be a
proper incident thereto’’ (Bank Holding
Company Act, 1970 Amendments). While
there may be other reasons for these limita
tions, bank safety is a prime concern. To
allow banks to become closely affiliated
with firms in nonbanking lines of commerce,
the regulators fear, would expose the banking
subsidiary to unacceptable risks of at least
two sorts. First, the public might confuse a
troubled holding company or nonbank sub
sidiary firm with the bank itself and then
withdraw deposits and cause a liquidity
crisis. Second, the bank may extend unsound
loans to other holding company subsidiary
firms in an effort to forestall disaster in the

responsibilities is consistent with this view.)
Not all regulations and portfolio restrictions
arise because of deposit insurance, but it
often provides a useful framework for
evaluating new or existing regulations.
Asset Limitations. Banks are subject to a
large number of restrictions on the type or
quality of assets they may hold in their
portfolios. Banks may not own stocks or
significant amounts of real estate; unsecured
loans may not exceed 10 percent of a national
bank’s net worth (the lending limit); equip
ment leases must be conservatively valued;
the quality of bank loans is evaluated care
fully by bank examiners (see BANK E X
AMINATIONS overleaf). Recently, the Fed
eral regulators promulgated far-reaching re
strictions on bank activities in the financial
futures markets that many industry observers
contend limit banks’ ability to profit in these
markets.8 In each instance, the regulations
limit bank expansion into areas that are
presumed to be relatively risky. Would
bankers be better off (m ore profitable) w ith
out such restrictions? Almost certainly the
answer is Yes. Eliminating regulations won’t
make banks worse off, because they could
choose the same portfolios if they wanted.
If banks choose new portfolios, it must be
because expected profits are higher. Risk
may also be increased, though, and the
intent of these asset restrictions is to prevent
insured banks from undertaking too much
risk from society’s point of view.
Capital Adequacy. A bank whose ac
quisition of risky assets is blocked by regula
tions could increase its shareholders’ ex
pected returns by lowering its equity cushion.
Earnings from the same volume of assets
would then accrue to a smaller number of
shareholders, raising the expected return to
each one. Since bank equity serves as a
buffer to absorb losses, lowering the equity

9For more on this subject, see Ronald Watson, “Insur
ing Some Progress in the Bank Capital Hassle,” Business
Review, Federal Reserve Bank of Philadelphia (July
1974), pp. 3-17, or Robert Taggart, “Regulatory In
fluences on Bank Capital,” New England Economic
Review (September 1977), pp. 37-46.

8Not surprisingly, some of the futures exchanges are
most critical of these regulations.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

BANK EXAMINATIONS AND CAPITAL ADEQUACY
On-site FDIC bank examinations play an important part in identifying bank behavior that is
considered overly risky. An examination evaluates many dimensions of bank operations, including
liquidity, earnings, and the quality of management. In addition, asset quality and capital adequacy
receive considerable attention:
“One of the most important aspects of the examination process is the
evaluation of loans, for, in large measure, it is the quality of a bank’s
loans which determines the risk to depositors.” (FDIC Manual of
Examination Policy, Section H, p. 1.)
“Some qualifications are necessary, but in general the degree of
protection afforded depositors is closely related to the strength of a
bank’s capital position. For this reason many important phases of the
bank examination procedure have as their purpose the determination
and analysis of a bank’s capital.” (FDIC Manual of Examination Policy,
Section D, p. 1.)
Examiners’ loan quality evaluations can heavily influence the level of capital considered adequate
for a particular bank.
Loan losses are a routine, if unpleasant, aspect of any bank’s operations. In recognition of this,
bankers carry a Loan Loss Reserve in the capital account. This Reserve represents the banker’s best
guess of the loans on her books that will not be repaid. If this evaluation is accurate, the bank’s
balance sheet fairly reflects the value of its assets. (In particular, bank capital—the residual
difference between assets and liabilities—is correctly recorded on the balance sheet.) If the Loan
Loss Reserve understates likely future losses, however, the bank’s books tend to overvalue loan
assets and hence overstate the true capital position.
The loan examination process constitutes an effort to verify the adequacy of the Loan Loss
Reserve account. The loan examiner generally selects a subset of the bank’s loan population for
scrutiny, emphasizing relatively large loans and those with recent payment problems. Some
examined loans will (usually) be criticized by the examiner, reflecting her opinion that the loan is
somewhat unlikely to be repaid in full. In other words, the examiner does not consider the asset to be
of bankable quality. The examiners take the bank’s reported (book) capital position and subtract out
a portion of the loans that have been criticized. If the bank’s Loan Loss Reserve was at least
sufficient to cover the examiner’s estimated likely loan losses, there is no change in the bank’s
reported capital position. Otherwise, the bank’s balance sheet overstated the true degree of
protection afforded the depositors (and the FDIC). Examiners may require that some loans be
written off, or that the Loan Loss Reserve account be increased through retained earnings. In any
case, the regulator’s determination of bank capital adequacy will be based on the reported book
capital adjusted for the examiner’s estimate of likely loan and security losses.
This connection between loan evaluation and capital adequacy can sometimes make the bank
examination process acrimonious. Examiners have the primary power to criticize a bank’s activities
as too risky, and this criticism affects the bank’s need for additional capital. Since more capital
reduces the expected rate of return to equity holders, bank management views this process as
intrusive. It is. Banks and FDIC hold differing views on the issue of bank risk taking. On-site
examinations constitute a prime tool by which FDIC monitors and controls its insured banks’
activities.

FEDERAL RESERVE BANK OF PHILADELPHIA

regulated rates. While deposit rate regulation
was introduced as a means of limiting bank
risk exposure, it has instead become a threat
to bank stability. This development was
recognized by Congress when it voted in
March, 1980 to eliminate Regulation Q
ceilings by 1986. (This process has already
begun, under the control of the Federal
Depository Institution Deregulation Com
mittee.)
It is impossible to identify precisely how
much these various regulations reduce the
additional risks banks take in response to
their deposit insurance. The key point, how
ever, is that insurance and regulation are
linked activities. If one side is subjected to
reforms—take deregulation as an ex a m p lethen unless something is done with the
present insurance scheme society will be left
to bear more risk (see REFORMING
DEPOSIT INSURANCE).

nonbanking firms.
Interest Rate Ceilings. Bank competition
for selected types of deposit funds has also
been limited by regulation over the years.
Congress prohibited the payment of interest
on demand deposit (checking) accounts in
1933, and it empowered the Federal Reserve
to set maximum permissible rates payable
on time and savings deposits (Regulation Q).
The initial intent of both these rules was to
limit bank risk taking. Banks were viewed as
bidding against one another for deposit funds,
then being forced to invest in risky assets in
order to earn enough to cover their deposit
costs.
Over the past ten or fifteen years, financial
markets have developed an impressive array
of devices aimed at circumventing Regulation
Q. Faced with this new, unregulated com
petition, banks often become unable to ac
quire deposits in sufficient quantity at the

REFORMING DEPOSIT INSURANCE
If the existing deposit insurance system requires such a myriad of restrictive bank regulations,
why not change the system and remove the regulatory burden? Either of two significant reforms
would eliminate some of the current system’s distortions, but each would be difficult to implement
in practice.
First, Federal deposit insurance could be eliminated entirely. Eliminating FDIC would strengthen
the impact of market forces on bank risk-taking decisions, allowing at least some bank regulations
to be removed. At the same time, however, depositors would find themselves exposed to more risk,
and they would have to evaluate their investment decisions more carefully. Imposing this burden on
small depositors seems to contradict the initial spirit of the Federal insurance program. A middle
course here would reduce the extent of FDIC coverage, for example from $100,000 back down to
$20,000 or $10,000. Deposit costs would then reflect bankers’ asset decisions more closely, while
small savers, for whom investment and information evaluation costs are presumably most
burdensome, would still benefit from insurance protection.
A second possible reform would be to make the insurance premium paid by banks vary according
to the riskiness of their portfolios. (The Federal Savings and Loan Insurance Corporation has
recently announced its intention to pursue a policy of this sort.) Just as automobile insurance
companies charge more to insure unsafe drivers, riskier banks would pay a higher price for
insurance than safe banks. With a perfectly accurate method of assessing the risk of a bank’s
portfolio, a variable premium system would mimic the private market. It would give bankers the
socially correct incentives to undertake risks while extending the benefits of Federal deposit
insurance to bank depositors. The problem here is that any practical system for measuring risk
would be imperfect, overestimating the risk of some activities while underestimating others. (This
is also true of other existing types of insurance.) If bankers and their customers felt a particular
activity was really less risky than FDIC did, the bankers would find it unprofitable to undertake

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

these investments because the expected return would not cover deposit costs plus the variable
insurance premium. Alternatively, an FDIC premium that bankers considered too low for some
particular type of risk would generate too much risk taking of this sort.
Distortions to bank asset portfolios would not disappear under a variable rate system, but they
probably would be smaller. Some existing bank regulations could be modified accordingly or
eliminated. Offsetting these gains, however, would be the increased complexity of determining an
appropriate FDIC premium rate for each bank. Accurately comparing the effects of a risk-related
FDIC premium versus the current system is a formidable task but one that bears further study.

implies that the attendant regulations are
socially bad, only that they are effective. If
bankers felt no pain from regulators’ actions,
the regulations could not be affecting bank
behavior!
Is there too much corrective regulation?
This is a very difficult question to answer. It
requires a careful comparison of society’s
losses (in terms of lower output) from the
restrictions placed on bank decisionmaking
versus the social benefits of a safer financial
environment. To date, no one has made
much of an attempt to grapple with this big
issue. Until some answers are generated, it
will be quite difficult to say how much
regulation (or deregulation) is ideal from
society’s point of view.

CONCLUSION
Bankers benefit substantially from fixedrate FDIC insurance, which allows them to
procure a large supply of funds at a low (that
is, riskless) interest rate regardless of their
assets’ riskiness. Severing the connection
between portfolio risk and deposit costs
leads banks to undertake risks they otherwise
wouldn’t, secure in the knowledge that they
get all the benefits of a good outcome while
suffering less than all of any losses that may
occur. To counteract this distortion, regula
tors impose portfolio restrictions, capital
standards, and so forth on insured banks as a
means of limiting the risk FDIC is forced to
insure against. These regulations limit
bankers’ freedom and may reduce bank
profits. Yet neither of these observations

APPENDIX . . .
24

FEDERAL RESERVE BANK OF PHILADELPHIA

A SIMPLE EXAMPLE OF HOW
FDIC INSURANCE CAN DISTORT
BANK RISK-BEARING
INCENTIVES
This example is set in a highly simplified world. The bank finances its asset acquisitions by
issuing a single type of deposit liability, and it has no net worth. Uncertainty is limited to the fact
that either of two possible states of the world may occur in the future. Bank assets return their higher
value in the good state, and their lower value in the bad state. At the time investments are made,
each future state of the world is considered equally likely to occur. (That is, each has a probability
equal to 1/2.)

EXAMPLE 1: Determining the Deposit Rate and Equity Market Value.
This first example serves to illlustrate the basic components of bank valuation. Assume the bank
buys a one-period asset today for $900. If state number 1 occurs, the bank’s asset will be worth
$1,000, while in the second possible state the asset’s value will be $2,000. The bank finances itself
by issuing a deposit liability of $900, giving it an initial balance sheet:
Assets

Liabilities

900

900
0 Net Worth

At the end of one time period the bank will collect on its assets, pay off the depositors, and go out of
business. The riskless market rate of interest is 6 percent per year.
The value of the firm’s equity can be calculated from the expected value of its future profits,
assuming risk neutrality on the part of the owners and depositors.* First consider the depositors.
Even in the bad future state of the world the bank will be able to pay off depositors their principal
plus interest at the riskless rate ($954). The deposit rate will therefore be 6 percent. Risk-neutral
owners will value the bank’s equity at the net present value of expected future earnings after interest
payments. Ignoring the discount rate:
Value of equity

V (profit in state 1) + V (profit in state 2)
2
2

y2 (1000 - 900 (1.0 6 )) + y 2 (2000 - 900 (1.06))

$546.

In other words, the right to receive this bank’s (uncertain) end-of-period profits would be worth
$546.
* A person is risk neutral if she will take a fair bet. For example, consider a game where the dealer flips a coin,
promising to pay the player $1.00 if heads come up, but nothing in the event of tails. A risk-neutral person would
pay up to 50$ to play this game—the expected (mean) value of the winnings. A risk-averseperson would pay less
than 50$; a risk-loving person would pay (a maximum of) more than 50$.

Now consider the situtation where the firm has the opportunity to buy an additional asset for
$300. The firm will have to borrow $300 to acquire the asset, resulting in the balance sheet,
Assets

Liabilities

900

+300

+300
0 Net Worth

The new asset will be worth $100 in state number 1 and $500 in state number 2, giving it an expected
return of 0 percent [V (100) + Vz (500) = 300, the asset’s purchase price). No one should wish to
z
purchase such an asset when the riskless market rate is 6 percent. Nonetheless, it will be shown that
a bank whose deposits are insured at a fixed premium would be willing to buy this asset.
At the end of the period, the firm’s total assets will be worth $1,100 ($1,000 for the initial asset plus
$100 for the new one) in state number 1 and $2,500 (the initial $2,000 plus $500) in state number 2.
Bankruptcy will result if state number 1 occurs: depositors will not be paid interest (or even repaid
all the principal). FDIC insurance is now valuable to the bank’s owners. Suppose FDIC promises to
repay the bank’s depositors in full (including interest) in return for a $1.00 premium (.083 percent of
the $1,200 deposits). Insured depositors will lend to the bank at the riskless rate of 6 percent, making
the value of equity:
=

y2 (1100 -1200 (1.06) -1) + V (2500 -1200 (1.06) -1)
z

V (1100 - 1273) + V (2500 - 1273).
z
z

Since expenses in the first state of the world are greater than earnings, the owners expect to receive
no return for this period and will default on their obligations—that is, the firm will be declared
bankrupt. (Because of deposit insurance, however, all deposits will still be paid off.) Even though
the firm is worth nothing if state number 1 occurs, owners will bid a positive price for the firm’s
equity because profits will be positive if state number 2 occurs:
Value of equity

Vz (0) + Vz (2500 - 1273)

$613.50.

With deposits insured by FDIC, the owners of the bank will undertake to buy the new asset because
the value of their equity rises from $546 (without the new asset) to $613.50. Why does this occur?
Because the owners receive all the profits in the good state of the world but have only limited liability
in the bad state of the world.

Now suppose the bank’s deposits are not insured. If the bad state of the world occurs, the firm
goes bankrupt and the depositors as a group receive only $1,100 for their $1,200 of deposits. To
compensate for this possible loss, the depositors must be offered a rate of return (R) in the good state
of the world high enough to make their expected return on deposits equal to or greater than the risk
free rate. That is, for deposits of $1,200, depositors must be promised a rate R such that:

Vz (1100) + V z (1200 (1 + R)) J> 1200 (1+.06)

R_> 20.3 percent.

FEDERAL RESERVE BANK OF PHILADELPHIA

Risk-neutral depositors would accept a promised return of 20.3 percent; risk averse depositors
would demand more.
With this higher promised deposit rate, the value of the bank’s equity after it purchases the $300
asset will be:
=

72 (0) + 72 (2500 - 1200 (1+.203) )

$528.02.

Undertaking this new investment without deposit insurance therefore would make the firm’s value
drop below its initial value ($546). The bank would not invest in the asset, which is the socially
correct decision.
These examples could be made considerably more realistic by increasing the number of possible
future states, introducing positive net worth and several classes of depositors, allowing risk-averse
depositors or bank owners, and so forth. None of these changes would alter the basic conclusions.
The important implication of this example is that a bank will undertake risky projects with a fixedpremium insurance program that it would not normally undertake. The bank has an incentive to
take on greater risks because it does not pay FDIC a premium that fully reflects the social cost of the
bank’s risk taking.

SUGGESTED READINGS
The notion that FDIC insurance distorts bank risk-taking decisions has been developed by John
H. Kareken and Neil Wallace, “Deposit Insurance and Bank Regulation: A Partial-Equilibrium
Exposition,” Journal of Business(July 1978), pp. 413-438; Robert C. Merton, “On the Cost of Deposit
Insurance When There Are Surveillance Costs,” Journal of Business (July 1978), pp. 439-452; and
William F. Sharpe, “Bank Capital Adequacy, Deposit Insurance and Security Values,” Journal of
Financial and Quantitative Analysis (November 1978), pp. 701-718.
Reasons for Federal provision of deposit insurance and alternative ways of setting premia for that
insurance are discussed in Kenneth E. Scott and Thomas Mayer, “Risk and Regulation in Banking:
Some Proposals for Federal Deposit Insurance Reform,” Stanford LawReview(May 1971), pp. 857902.

FROM THE PHILADELPHIA FED

Charting
Mortgages

Department of Consumer Affairs
Federal Reserve Bank of Philadelphia

•

This new pamphlet compares
creative mortgage financing
methods with the conventional
mortgages. Copies are available
without charge from the Depart
ment of Public Services, Federal
Reserve Bank of Philadelphia,
100 North Sixth Street, Phila
delphia, Pennsylvania 19106.

FEDERAL RESERVE BANK OF PHILADELPHIA

Did the Tax Cut Really Cut Taxes?
A Further Note
Stephen A. M eyer and Robert ]. Rossana
M echanical errors in converting total in
come into taxable income led to errors in the
tax rate tables in our earlier article. In
particular the marginal tax rates for families
who take the standard deduction were in
correct; the correct marginal tax rates are
lower, across the board, than those we re
ported originally. Similarly, the original
article overstated, slightly, the marginal tax
rates that will apply in 1983 to families who
itemize deductions and understated them for
1981. In this note we provide the correct
marginal tax rates. Tables 3 and 4 presented
here replace Tables 3 and 4 in the earlier
issue of this Review.
Table 3 reports what marginal tax rates
would have been for families who take the
standard deduction, if Congress had not
adopted the 1981 tax package. The rise in
marginal tax rates for families who itemize
would have been virtually the same. As we

The previous issue of this Reviewcontained
our analysis of the three-year personal in
come tax cut adopted in 1981.1 We concluded
that the phased-in twenty-five percent cut in
personal income tax rates will have little
effect on people’s behavior, because few tax
payers will face lower tax rates in 1983 than
they did in 1980, or in 1978. Bracket creep
caused by continuing inflation, plus rising
social security payroll taxes, mean that
families in most tax brackets will face the
same or higher marginal tax rates on a given
real income in 1983 than in 1980 or 1978.
Thus it is unlikely that the personal income
tax cuts adopted in 1981 will improve in
centives to work or save.
■'•Stephen A. M eyer and Robert J. Rossana, “Did the
Tax Cut Really Cut Taxes?” Business Review, Federal
Reserve Bank of Philadelphia, November/December
1981, pp. 3-12.

BUSINESS REVIEW

JANUARY/FEBRUARY 1982

TABLE 3

MARGINAL TAX RATES
WITHOUT TAX CUT
AGI
(1981$)

1978
Fed.
Tot.

1979
Fed.
Tot.

1980
Fed.
Tot.

1981
Fed.
Tot.

1982
Fed.
Tot.

1983
Fed.
Tot.

13000

.19

.25

.18

.24

.18

.24

.21

.28

.21

.28

.21

.28

15000

.22

.28

.21

.27

.21

.27

.21

.28

.24

.31

.24

.31

17000

.22

.28

.21

.27

.24

.30

.24

.31

.24

.31

.28

.35

19000

.25

.24

.30

.24

.30

.28

.35

.28

.35

.32

.39

22500

.28

.32

.39

.32

.39

.37

.44

27500

.32

.37

.43

40000

.42

.43

.49

N.B.

Fed. = Marginal rate from Federal tax code.
Tot. = Sum of Federal marginal rate and social security rate.
Data apply to joint return of four person household using standard deduction. Tax rates are
rounded to the nearest percent.

The few familes in the $40,000 (in 1978
dollars] income group who take the standard
deduction will face a slightly lower marginal
tax rate in 1983 than they did in 1980, in
contrast to the original table.
For families who itemize deductions, those
in the lowest income group will see a slight
drop in their total marginal tax rate from
1980 to 1983, while those in the $15,000 and
$17,000 (in 1978 dollars] groups will face
constant marginal tax rates. Families in the
middle income groups ($19,000 and $22,500
in 1978 dollars] will face higher tax rates.
Higher income families (those in the $27,500
to $40,000 range, in 1978 dollars) will actually
see a slight decline in their marginal tax rates
from 1980 to 1983, contrary to our original
results. But even these families will face
higher marginal tax rates in 1983 than they
did in 1978.
The overall conclusions of the original
article largely remain. Although the 1981 tax

reported in our earlier article, marginal tax
rates would have risen, across the board, had
the 1981 tax bill not been passed. Table 4
provides the correct marginal tax rates, con
tained in the 1981 tax act, that will apply
from 1981 to 1983. We present tax rates for
families who use the standard deduction and
for those who itemize deductions. These
corrections do not change the conclusions in
the original paper to any significant extent.
The corrected tax rates, as well as those
reported in the original paper, show that few
families will face lower marginal tax rates in
1983 than they did in 1980 or in 1978.
Among familes who take the standard
deduction, those in the lowest income groups
that we studied ($13,000 to $17,000 in 1978
dollars] will face the same total marginal tax
rates in 1983 as they did in 1980. Families in
the middle income groups ($19,000 to $27,500
in 1978 dollars] will face higher total mar
ginal tax rates in 1983 than they did in 1980.

FEDERAL RESERVE BANK OF PHILADELPHIA

TABLE 4

MARGINAL TAX RATES AFTER REAGAN TAX CUT
Household Of Four Filing Jointly
(Using Standard Deduction}
AGI
(1978$)

Fed.

1980
Tot.

Fed.

Tot.

Fed.

Tot.

Fed.

Tot.

13000

.18

.24

.21

.27

.19

.26

.17

.24

15000

.21

.27

.21

.27

.22

.29

.20

.27

17000

.24

.30

.24

.30

.22

.29

.23

.30

19000

.24

.30

.28

.34

.25

.32

.25

.32

22500

.28

.32

.38

.28

.35

.30

.37

27500

.32

.37

.33

.35

40000

.43

.48

.44

.40

1982

1981

1983

Household Of Four Filing Jointly
(Itemizing Deductions)
AGI
(1978$)

Fed.

Tot.

Fed.

Tot.

Fed.

Tot.

Fed.

Tot.

13000

.18

.24

.18

.24

.16

.23

.15

.22

15000

.18

.24

.21

.27

.19

.26

.17

.24

17000

.21

.27

.21

.27

.22

.29

.20

.27

19000

.21

.27

.24

.30

.22

.29

.23

.30

22500

.24

.28

.34

.25

.32

.25

.32

27500

.32

.33

.30

40000

.43

.42

.39

.40

N.B.

1981

1980

1982

1983

Tax rates are rounded to the nearest percent.

cut ensures that tax rates in 1983 will be
lower than they would otherwise have been,
tax rates in 1983 will be the same as or higher
than they were in 1980, with few exceptions.

Bracket creep and higher social security
taxes will offset the 25-percent reduction in
personal income tax rates for families in a
majority of brackets.
31

100 North Sixth Street
Philadelphia, PA 19106

Full text of Business Review (Federal Reserve Bank of Philadelphia) : January/February 1982

FRASER