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Business
Review
Federal Reserve Bank o f Philadelphia
M ay June 1992

ISSN 0007-7011

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Business

Review

The BUSINESS REVIEW is published by the
Department of Research six times a year. It is
edited by Sarah Burke. Artwork is designed
and produced by Dianne Hallowell under the
direction of Ronald B. Williams. The views
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2



MAY/JUNE 1992

WHAT ARE THE COSTS
OF DISINFLATION?
Dean Croushore
Are the long-term benefits of disinflation
worth the short-run costs? Can econo­
mists accurately estimate benefits or costs?
Proponents of disinflation, focusing on
the long run, and opponents, looking at
the short run, respond to these questions
differently. In fact, estimates of the costs
and benefits can vary widely depending
on which type of economic model is used.
BANKING AND COMMERCE:
A DANGEROUS LIAISON?
Loretta J. Mester
The separation of banking and commerce
dates as far back as 1694 when the act that
established the Bank of England prohib­
ited the Bank from dealing in merchan­
dise. The earliest U.S. banks followed
English tradition. Today, with the advent
of entities such as nonbank banks, the
lines of separation have blurred. So, why
not allow commercial firms to own banks,
or even banks to own commercial firms?
Arguments can be made for and against
the mingling of banking and commerce;
however, both the costs and benefits of
such a move are often exaggerated. For
now, it seems that maintaining separate
spheres is prudent, but as the reforms of
the banking act are carried out, questions
about the separation of banking and com­
merce may have to be reconsidered.

FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs of Disinflation?
Dean Croushore*
TX he Federal Reserve can use monetary
policy to reduce the inflation rate, a process
known as disinflation. Are the benefits of
disinflation worth the costs? Proponents of
disinflation argue that the long-run benefits of
price stability, including lower interest rates,
increased economic efficiency, and perhaps
faster economic growth, greatly exceed the
short-run costs. Opponents, of course, claim
the opposite, usually arguing that the short-run
costs in terms of higher unemployment and lost
output would be immense.

*Dean Croushore is Research Officer in charge of the
Macroeconomics Section of the Philadelphia Fed's Research
Department.




Recent legislation introduced into Congress
would force the Fed to disinflate. The Neal
Resolution, introduced in 1989, would require
the Fed to reduce inflation to zero within five
years. It would also make fighting inflation the
Fed's only goal.
How can we evaluate the costs and benefits
of disinflation? Only by writing down explicit
models of the economy and seeing how the
economy is likely to behave when the inflation
rate is reduced. The costs of reducing inflation
can then be compared with estimates of the
benefits of disinflation.
Economists do not have very precise esti­
mates of the benefits of disinflation. In addi­
tion, estimates of the costs of disinflation differ
depending upon the type of economic model
used.
3

BUSINESS REVIEW

BENEFITS OF DISINFLATION
To examine the benefits of disinflation, let's
compare an economy with an inflation rate of 0
percent to an identical economy with an infla­
tion rate of 5 percent.1 There are two benefits to
disinflation that may be large even when the
economy moves from an inflation rate of 5
percent to zero. One benefit comes from reduc­
ing the distortion to savings and investment
that is caused by the interaction of the tax
system with inflation. Another benefit comes
from increasing the availability of mortgage
loans; they are more affordable when inflation
is lower, because the initial mortgage payments
are lower.
Reducing the Distortion Due to the Tax
System. Our tax system is not fully indexed to
inflation. As a result, the effective tax rate on
interest income is much higher when there is
inflation than when there is none. For example,
suppose that when inflation is 5 percent you
put $100 in the bank at an interest rate of 7
percent. Your nominal return is $7, but $5 of
that return just compensates you for inflation,
so your real return is only $2. You must pay
taxes, however, on your nominal, not your real,
return. If your total tax rate is 30 percent, then
you owe the government $2.10 in taxes, which
leaves you with an after-tax return of just $4.90.
But if we adjust for the 5 percent inflation, your
after-tax real return is -$0.10. In other words,
your $104.90 today buys fewer goods than your
$100 did one year ago. Because the government
is actually taxing away more than you've earned

]Our focus here is on the costs of a constant, known level
of inflation. When the inflation rate isn't constant, there are
additional costs because the inflation rate is uncertain.
Some research even suggests that the higher the level of the
inflation rate, the greater will be its variability (see the 1990
study by Laurence Ball of Princeton University and Stephen
Cecchetti of Ohio State University). But to keep things
simple for this article, let's suppose that inflation can be
maintained at any constant rate.


4


MAY/JUNE 1992

in real terms, your effective real (inflationadjusted) tax rate is over 100%.
Throughout much of the 1970s, the effective
real tax rate on interest income exceeded 100
percent. Inflation was very high, and the fact
that taxes were based on nominal interest in­
come rather than on real interest income meant
that real after-tax returns were negative. Even
in recent times, with inflation in the range of 3
to 5 percent, the effective real tax rate remains
fairly high. Eytan Sheshinski of Hebrew Uni­
versity and Columbia University calculates the
effective real tax rate on interest income in the
U.S. at 86 percent in 1985 and 58 percent in 1989.
In addition to these effects on the rate of
return to saving, the tax system contains nu­
merous other distortions that affect the way
firms behave, especially with regard to invest­
ment spending. For example, nominal (not
real) interest payments are deductible, and
depreciation costs are in nominal (not real)
terms. So even a low inflation rate like 5 percent
can reduce investment spending in the economy,
both by reducing saving through a high effec­
tive real tax rate and by discouraging firms
from investment spending. Reducing inflation
would increase investment and lead to a rise in
the nation's capital stock and its future output.
How much better off would the economy be
if it could eliminate the tax system/inflation
distortion? Estimates range from 0.06 percent
of output to 0.62 percent of output per year.2
Unfortunately, there has been no definitive
study that pins down a figure within this range.
As a preliminary estimate, let's assume a per-

2Rao Aiyagari in a 1990 Minneapolis Fed study argues
that the distortion from the interaction of the tax system
with inflation is small, as low as 0.06 to 0.12 percent of GNP
per year. But David Altig and Charles Carlstrom of the
Cleveland Fed, building further on work in their 1991 ar­
ticle, suggest that the distortion may be as high as 0.62
percent of GNP per year, over 10 times as large as Aiyagari's
lowest estimate.

FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs o f Disinflation?

manent gain of between 0.25 and 0.50 percent of
gross national product (GNP) per year if the tax
system/inflation distortion is eliminated by
reducing inflation from 5 percent to 0 percent.3
This is roughly the central tendency of many
different estimates of the benefit of eliminating
the distortion; however, more research on mea­
suring the size of the distortion is clearly needed.
How can this distortion be eliminated? Re­
ducing inflation to zero is one approach. An­
other is to change the tax laws so that only real,
not nominal, returns are taxed. But this second
approach is complex, so much so that the major
tax reform efforts in the 1980s were unable to
address the issue. Perhaps the costs of chang­
ing the tax system exceed the benefits of doing
so. Since further tax reform toward taxing real
rather than nominal returns seems unlikely, the
tax system/inflation distortion can most effec­
tively be reduced by lowering inflation.
Making Mortgages More Affordable. The
other major benefit to disinflation is that it
would increase home ownership. When infla­
tion occurs, there is a tilt to mortgage payments
that makes it more difficult for people to buy
homes. This results from the front-loading of
real payments on loans when inflation is posi­
tive. For example, suppose the interest rate on
a mortgage is 10 percent when inflation is 5
percent. Assuming that the nominal interest
rate moves directly with inflation, suppose
inflation is reduced to 0 percent and the mort­
gage interest rate falls to 5 percent.4 Consider

3This doesn't mean that GNP would be 0.25 to 0.50
percent higher, but rather that the allocation of resources in
the economy would be improved; the value of improving
that allocation of resources is 0.25 to 0.50 percent of GNP.
4In this example, the real interest rate remains at 5
percent whether inflation is 5 percent or zero. Also, the
example ignores the tax benefits that arise because mort­
gage interest is deductible on the federal income tax. Tax
deductibility mitigates the tilt problem but does not elimi­
nate it.




Dean Croushore

the effect of this change on the monthly pay­
ment on a $100,000 30-year mortgage. At a 10
percent mortgage interest rate, the monthly
payment is $880; at a 5 percent interest rate, the
payment is $540. With a 5 percent inflation rate,
the real value of the $880 monthly payment falls
over time.5 But at 0 percent inflation, the $540
*
monthly payment remains constant in real
terms. So the higher inflation rate causes repay­
ment of the mortgage to be front-loaded earlier
in the life of the loan. Inflation causes people to
make higher real payments early in the life of
the loan, rather than making constant real pay­
ments through time.
This effect is compounded by the fact that
lower nominal interest rates make it easier for
people to qualify to take out mortgage loans.
Many lenders require that a mortgage payment
not exceed 28 percent of a borrower's income
when the loan is made. Using this guideline, at
a 10 percent mortgage interest rate, a borrower's
annual income would have to be more than
$37,000 to take out this loan; at a 5 percent
interest rate, the lower monthly payment means
that income would have to be only $23,000.
People could qualify for mortgage loans more
easily if inflation were lower.
There is a way to solve this tilt problem
without reducing inflation. The solution is to
allow price-level-adjusted mortgages (PLAMs).
PLAMs allow the principal value and monthly
payment on a mortgage to move directly with
the price level. They mimic the effects of having
zero inflation. But people may have some
trouble accepting this new type of loan because
it requires negative nominal amortization—the
dollar value of the mortgage rises with infla­
tion. So after 15 years of paying off her mort­
gage, a homeowner might owe more (in dollar

5For example, after 15 years at a 5 percent inflation rate,
the $880 nominal payment is worth only $423 in real (infla­
tion-adjusted) terms; but at 0 percent inflation, the $540
nominal payment is still worth $540 in real terms.

5

MAY/JUNE 1992

BUSINESS REVIEW

terms) than she did initially, although the real
value of the mortgage (adjusted for inflation)
would be less. Again, in considering the ben­
efits of disinflation, we can't assume that these
loans will be available and that people will use
them if inflation remains high. So that leaves
disinflation as the only method of reducing the
tilt problem.
How big are the benefits of reducing the
mortgage-tilt problem? While economists have
recognized the problem's importance, there
has been no concrete estimate of its cost to the
economy. Since housing is such an important
sector of the U.S. economy, and because the
effect of the mortgage-tilt problem over a
person's life cycle is so severe, a reasonable
guess (assuming that the benefits here are some­
what lower than the benefits of eliminating the
tax system/inflation distortion) is that elimi­
nating it by reducing inflation from 5 percent to
0 percent would be valued at 0.15 to 0.30 per­
cent of GNP per year. As with the tax system/
inflation distortion, however, this is a very
rough estimate; more research is needed to nail
it down more precisely.
Other benefits of disinflation are likely to be
quite small in reducing inflation from a moder­
ate level like 5 percent to zero. These benefits
include avoiding real losses by people who
have fixed nominal incomes, reducing the im­
plicit tax on moneyholding, reducing the "shoeleather" costs that arise from running to the
bank more often to try to avoid the implicit tax
on moneyholding, and reducing menu costs
(the costs of changing prices).6
The interaction of the tax system with infla­
tion and the mortgage-tilt problem both reflect
the inability of institutions to adjust to perma­
nent inflation, and their effects may be substan-

tial.7 Reducing inflation from 5 percent to 0
percent by eliminating the interaction of the tax
system with inflation would be worth an addi­
tional 0.25 to 0.50 percent of GNP, and eliminat­
ing the tilt problem may be valued at another
0.15 to 0.30 percent. And there are other, but
smaller, benefits. So, in total, a rough estimate
of the benefits of disinflation (that we can use as
a b en ch m ark for co m p ariso n w ith the costs of

disinflation) is that the benefits to reducing
inflation from 5 percent to zero are worth 0.4 to
0.8 percent of GNP per year. The present value
of 0.4 to 0.8 percent of GNP per year forever is
roughly 24 to 48 percent of 1990 GNP, when
discounted at 4 percent and when GNP grows
at 2.5 percent per year.8 It is this benefit mea­
sure that we must compare (in present-value
terms) with the costs of disinflation. Notice
that the benefits are permanent, while the costs
of disinflation are temporary, so a relatively
small benefit per year may justify fairly large
one-time costs.
THE COSTS OF DISINFLATION
Measuring the costs of disinflation depends
a great deal on the economic model used. Clas­
sical models show low costs, while Keynesian
models show high costs. Debate over which

7If inflation were large enough so that these effects were
severely damaging to the economy, then these institutions
would probably adjust in some way. But at only 5 percent
inflation, the costs of changing the institutions probably
exceed the benefits of doing so, and these institutional
structures persist.
8Mathematically, if the benefits of disinflation are P
percent of GNP per year forever, if GNP grows at 2.5 percent
per year, and the real interest rate is constant at 4 percent,
then the present value of the benefits of disinflation as a
percent of current GNP is given by the formula:

£(1.04)^(1.025/.
6For a full discussion of these benefits of disinflation, see
the 1978 study by Stanley Fischer and Franco Modigliani of
MIT.


6


This sum is 68.333 times p. Accounting for the fact that
disinflation is not achieved for 10 years reduces this to
about 60 times p.

FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs o f Disinflation?

theoretical model best explains macroeconomic
events has raged for many years, with no con­
sensus.
Further complicating matters is the issue of
credibility. Suppose the Federal Reserve tight­
ens monetary policy to reduce inflation. The
resulting reduction in aggregate demand in the
economy causes unemployment to rise. The
Classical model of the economy suggests that
the economy returns to full employment fairly
quickly, while the Keynesian model argues that
sluggish adjustment of wages and prices will
cause a long period of higher unemployment.
But both models show that the speed at which
the economy adjusts depends on how credible
the commitment to disinflation is. If people
believe that the Fed means business and that it
is committed to reducing the inflation rate, they
are likely to take actions that adjust wages and
prices more quickly in response to Fed policy.
But if people doubt that the Fed will really go
through with its disinflation plan (that is, to
keep monetary policy tight despite the shortrun repercussions) and that it might in fact give
up the battle before inflation is defeated, they
will be less willing to adjust in response to the
announced policy change. When policy is cred­
ible, the costs of disinflation will be lower, as
the whole economy moves together to a lower
rate of inflation. But if policy is not credible,
people will wait to see if inflation really de­
clines before changing their wage demands or
interest-rate demands, and the economy will
adjust more slowly.
If the Federal Reserve embarked on a policy
of disinflation, would such a policy be very
credible? Credibility might be enhanced if
something like the Neal Resolution to reduce
inflation to zero in five years became law. The
Fed might also increase its credibility if it were
to announce a planned, multiyear path for key
monetary variables (the money supply and
interest rates) that it was targeting and to project
the macroeconomic consequences (for output
and unemployment) thereof. The plan would



Dean Croushore

probably have to specify details, including how
long it should take to reduce inflation, so that
people could observe its progress and see how
well the Fed was adhering to the plan. This
would make the plan verifiable and thus more
credible.
To develop such a plan, the Fed needs to
know much about the economy's response to a
tightening of monetary policy. If the goal is to
reduce the inflation rate while minimizing the
short-run costs to the economy, the Fed needs
a model of the economy to measure such costs
and evaluate alternative policies. It can use
such a model to evaluate the optimal monetary
policy over time—to find the path of interest
rates and money growth that gives the smallest
costs relative to the benefits of disinflation, and
to find the best time period (5 years? 10 years?)
over which the disinflation should occur.
MODEL-BASED MEASURES
OF THE COSTS OF DISINFLATION
Some previous studies have provided esti­
mates of the costs of disinflation.9 In 1980,
Laurence Meyer of Washington University and
Robert Rasche of Michigan State University ran
simulations to determine the cost of reducing
the inflation rate from 10 percent to 2.5 percent
based on four simple models. They showed
that a Keynesian model had costs of disinflation
that were three to six times as large as those of
a Classical model. They found much uncer-

9Some evidence on the costs of disinflation might come
from looking at past data (rather than using models) to see
how much output growth has changed in the past when
inflation was reduced. Previous studies (see the papers by
Gordon and King, Fischer, Howitt, Okun, and Scarth) find
that GNP must fall 5 percent or more to reduce inflation by
1 percentage point. However, this evidence isn't necessar­
ily relevant to evaluating the response of the economy to a
gradual disinflation, since previous reductions in inflation
have generally come only during recessions. It is possible
theoretically to disinflate without causing a recession, at
least in most models.

7

BUSINESS REVIEW

tainty in the estimates of both benefits and costs
and suggested that additional research was
needed to provide more precise estimates. In a
1982 study, Robert Gordon and Stephen King
of Northwestern University found that, in a
Keynesian model, reducing the inflation rate by
5 percentage points had a total cost of 29 per­
cen t of one y e a r's GN P. H ow ever, a
nonstructural (neither Keynesian nor Classi­
cal) model studied in 1985 by Craig Hakkio and
Bryon Higgins of the Federal Reserve Bank of
Kansas City showed that the long-run benefits
of reducing inflation greatly exceeded the shortrun costs. Their results suggested that the
growth rate of potential GNP is significantly
higher at lower levels of inflation.
Because these studies were all done some
time ago, we need to update them to see if
recent history might have changed their re­
sults. We attempt to do this by empirically
estimating the costs of disinflation in four small
macroeconomic forecasting models:1 (1) a New
0
Classical model, in which rational expectations
play a dominant role in determining the costs of
disinflation; (2) a Monetarist model, in which
money growth is the key determinant of infla­
tion; (3) a Keynesian model, in which slack in
the economy is needed to reduce inflation; and
(4) a hybrid model called PSTAR+ that com­
bines the Monetarist notion that money growth
determines inflation with the Keynesian idea
that changes in interest rates may affect real
output. All of the models are small, consisting
of just three or four equations to determine
output growth, inflation, and one or two other
variables (such as monetary velocity, interest
rates, energy prices, or money growth).
This study uses forecasting models because
this is a policy-evaluation exercise, one in which

10The exact specifications of the models can be found in
my working paper, "The Short-Run Costs of Disinflation."
Citations for all the research referred to in this article can be
found in the "References" section at the end of this article.


8


MAY/JUNE 1992

the Fed must plan a path for monetary policy
that will bring about disinflation and make
forecasts of major macroeconomic variables
along the path.1 First, we estimate each of the
1
models over the period 1959 to 1990.1 Second,
2
we form two forecasts for the next 10 years for
each model.1 One forecast is based on policy
3
designed to maintain inflation at about its cur­
rent level; the other is designed to reduce infla­
tion significantly, but without reducing real
GNP growth below 1 percent at any time. To
calculate the costs of disinflation, we add up the
(discounted) differences over time between the
two forecasts in terms of real GNP.1
4
The PSTAR+ Model. The PSTAR+ (pro-

11One caveat is in order in performing such an exercise— it
is subject to the critique of econometric policy evaluation
made by Robert E. Lucas, Jr., of the University of Chicago.
The Lucas critique suggests that studies like this may not be
fruitful because the type of disinflation we are going to
simulate has not occurred before, yet the models are esti­
mated with past data. As a result, estimating the models on
past data may yield an overestimate of the costs of a slow,
gradual disinflation.
12The models are estimated on data ending in the second
quarter of 1990. This is done, rather than using more recent
data, to keep the recent recession from affecting the results.
13The 10-year horizon stretches out the time period
somewhat, compared with the 5-year horizon of the Neal
Resolution. But spreading disinflation out over a longer
time span allows inflation to fall with less risk of a recession.
14Note that these costs are just the costs to the economy
in terms of lost output for changing from steady, positive
inflation to zero inflation. An additional cost of disinflation
that we haven't discussed is that the government loses
seignorage revenue (which is the profit from printing new
money) when inflation is reduced; this revenue must be
made up by raising taxes, which distort the economy in
different ways. But the amount of lost revenue is small
when inflation is as low as 5 percent, so the size of this cost
is negligible.
In addition, the models used to determine the costs of
disinflation are not complete enough to capture the benefits
of disinflation through the channels described earlier in the
paper. The benefits of disinflation come from reducing

FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs o f Disinflation?

Dean Croushore

nounced P-Star-plus) model is a small macro find the optimal path over time for the federal
model developed by Herb Taylor at the Federal funds rate.
In the PSTAR+ model, the disinflation path
Reserve Bank of Philadelphia. It is based on the
P* model developed in 1989 by Jeffrey Hallman, is obtained by increasing the federal funds rate,
Richard Porter, and David Small, all then of the thus reducing money growth and putting down­
staff of the Board of Governors of the Federal ward pressure on the inflation rate. This pres­
Reserve System, and it incorporates the inter­ sure is maintained until inflation is eliminated.
est-rate spread approach of Bob Laurent of the As inflation declines, the federal funds rate
Federal Reserve Bank of Chicago. The P* analy­ declines as well, so the rise in nominal interest
sis predicts future inflation using the Monetar­ rates is only temporary. The results of simulat­
ist theory that the price level is proportional to ing the model are shown in Figure 1. On the
the money supply in the long
run. Laurent finds that the
FIGURE 1
spread between the federal
PSTAR+ Model Results
funds rate and a long-bond
rate is closely related to sub­
Inflation Rate
sequent GNP growth. This
is a Keynesian idea because
in terest rates a ffect the
econom y's output in the
short run.
To develop a complete
macroeconomic model that
com bines these two ap­
proaches, Taylor adds some
equations that specify other
features of the economy—
money growth depends on
changes in short-term inter­
est rates, and the nominal
long-run interest rate moves
toward the value of a fixed
real rate plus an inflation
premium. The model uses
the federal funds rate as the
tool of monetary policy; to
disinflate, the Fed needs to*

distortions to the economy, which
improves people's well being, but
doesn't necessarily raise output in
the economy. Consequently, we
have dealt with the benefits sepa­
rately from the costs.




9

BUSINESS REVIEW

steady-inflation path, inflation is maintained at
about 4.5 percent. Along the disinflation path,
however, inflation is gradually reduced to zero
over the 10-year horizon. The disinflation pro­
cess drives the real GNP growth rate down
below 2 percent per year for several years. The
GNP gap between the two paths looks substan­
tial, but it is never more than 4 percent of GNP
and it is eventually closed. Disinflation has no
permanent effect on real GNP.
To measure the total cost of disinflation, we
add up the quarterly differences between real
GNP on the steady-inflation path and real GNP
on the disinflation path, discounted at the long­
term real interest rate, which is estimated to be
4 percent. From 1990 to 1999, these differences
amount to about 22 percent of 1990 GNP. Ac­
cording to the PSTAR+ model, the benefits of
lowering the inflation rate permanently from
4.5 percent to 0 percent must be valued at 22
percent of 1990 GNP or more for disinflation to
be worthwhile.
The Monetarist Model. For a prototype
Monetarist model, we use a variant of the
model developed by John Tatom of the Federal
Reserve Bank of St. Louis. His model is based
on the well-known St. Louis model of Leonall
Andersen and Jerry Jordan but differs by taking
account of energy price shocks. While the shifts
in M l velocity of the early 1980s sharply re­
duced the predictive power of the St. Louis
model, Tatom's model has performed some­
what better. In fact, it was found to be superior
to many other small macro models (including
the St. Louis model, some rational-expecta­
tions models, and some Phillips-curve-based
Keynesian models) at a forecasting conference
in 1982.1
5
The core of the model consists of two equa­
tions that determine nominal GNP growth and
inflation. Nominal GNP growth is determined

15See the results in the 1983 paper edited by Laurence
Meyer.

Digitized for 10
FRASER


MAY/JUNE 1992

by money growth, government expenditure
growth, and changes in the relative price of
energy. The inflation rate depends on money
growth and on changes in the relative price of
energy. In this model, the measure of the
money supply M l is the tool of monetary policy,
so the Fed disinflates by slowing down the
growth of M l.
The results of slowing down money growth
in this model are shown in Figure 2. Along the
steady-inflation path, inflation is constant at
just over 3 percent,1 while real GNP settles
6
down to a long-run growth rate of about 3.75
percent. But on the disinflation path, inflation
gradually decelerates to near zero, while the
benefits of disinflation show up as a higher
growth rate of real GNP, which rises to nearly
5 percent. In this model, lower inflation actu­
ally raises real GNP growth.
The costs of disinflation here are very low:
real GNP on the disinflation path is never less
than 1 percent lower than real GNP on the
steady-inflation path. Since disinflation does
affect the long-run growth rate of real GNP in
this model, there are benefits to disinflation
that are quite high: a permanent rise of 1.25
percent in the GNP growth rate. So this model
is quite favorable to disinflation. Discounted
real GNP is higher on the disinflation path than
on the steady-inflation path, so disinflation
pays for itself.1 In addition, since the growth
7

16On the steady-inflation path, inflation in the Monetar­
ist model is 3 percent, and in the PSTAR+ model it's 4.5
percent because the Monetarist model implies that the Fed's
actions to reduce money-supply growth over the past few
years have already put into place some future disinflation.
17Technically, this is because real GNP growth is not
explicitly modeled. There are separate equations determin­
ing nominal GNP growth and inflation; real GNP growth is
computed by subtracting the inflation rate from the nominal
GNP growth rate. Estimation of the model yields the result
that inflation is affected more than nominal GNP growth by
changes in money growth. Thus, a reduction in money
growth leads to an increase in real GNP growth.

FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs o f Disinflation?

Dean Croushore

an effect on real variables. Expected money
growth would affect nominal variables only;
inflation simply rises by the same amount as
expected money growth. Barro tested and
could not reject the hypothesis using both an­
nual and quarterly data.
We base our prototype New Classical model
on the 1980 version of the model used by Barro
and Mark Rush, who were then at the Univer­
sity of Rochester. The model's main equation
forecasts money growth.
The u n exp ected m oney
FIGURE 2
growth variable is calculated
from that equation as the dif­
Monetarist Model Results
ference between predicted
Inflation Rate
and actual money growth.
Real GNP growth depends
on u n exp ected m oney
growth; if money growth is
unexpectedly high, then real
GNP growth increases. In­
flation depends partly on un­
expected money growth, but
it rises one-for-one with ex­
pected money growth in the
absen ce of u nexpected
changes in money growth.
The policy tool used in this
model is the M l growth rate.
The model simulations are
shown in Figure 3. Along
Real GNP Growth Rate
the steady-inflation path,
inflation rem ains at just
above 3 percent.1 But the
8
disinflation path takes ad­
vantage of the fact that an-

rate of real GNP is permanently higher on the
disinflation path, and since it is greater than the
long-term real interest rate of 4 percent, it is
worth bearing any finite cost to achieve this
permanently higher GNP growth rate.
The New Classical Model. Robert Barro,
now at Harvard University, developed a model
for testing rational-expectations hypotheses in
the 1970s. He hypothesized that only unex­
pected changes in money growth would have




18Again, as in the Monetarist
model, the slowdown in money
growth over the past few years is
reflected in a decline in inflation
from 4.5 percent to 3 percent, even
with steady monetary policy in the
future.

11

BUSINESS REVIEW

MAY/JUNE 1992

ticipated money shocks don't affect real vari­ of 4.5 percent, and real GNP grows at just over
ables. Money growth is reduced immediately 3 percent (Figure 4). However, reducing infla­
and kept constant thereafter. As a result, infla­ tion in this model is very difficult because it
tion drops immediately to zero and stays there. takes rising interest rates, not just high interest
There is no cost in terms of lost GNP of pursu­ rates, to reduce GNP growth and inflation. On
ing this policy, as long as the change in mon­ the disinflation path, raising short-term inter­
etary policy is credible and expected.
est rates by 25 basis points each quarter (so that
The Keynesian Model. For a prototype by 1999 the short-term interest rate is over 25
Keynesian model, we use a version of the model percent) reduces inflation to about 3.6 percent.
developed by Ben Friedman of Harvard Uni­ Real GNP growth must be held below 2 percent
versity. He used the model
to examine money's role as
an intermediate target of the
FIGURE 3
Fed and to discuss the rea­
New Classical Model Results
sons for interest rates being
Inflation Rate
so high in the early 1980s. In
the model, real GNP growth
depends on government ex­
penditure growth and on
changes in the long-term in­
terest rate and in import
prices. Inflation is affected
by real GNP growth and by
im port p rice ch an ges.
Money demand growth is
determined by real GNP
growth and by the change in
the short-term interest rate.
And there is a term structure
equation relating the long­
term interest rate to the short­
Real GNP Growth Rate
term interest rate.
The short-term interest
rate is the instrument of
monetary policy. To cause
disinflation, the short-term
interest rate must be in­
creased, causing long-term
rates to rise and reducing
real GNP growth. In this
model, the decline in real
GNP growth then reduces
inflation.
The steady-inflation path
has a long-run inflation rate

12


FEDERAL RESERVE BANK OF PHILADELPHIA

What Are the Costs o f Disinflation?

permanently to achieve disinflation.1 The dis­
9
counted value of the difference in real GNP
from 1990 to 1999 is about 43 percent of 1990

Dean Croushore

GNP. Reducing inflation to zero would cost
about five times as much, more than 200 per­
cent of 1990 GNP.

COMPARING COSTS AND BENEFITS
In a comparison of disinflation costs across
the different models, the Monetarist-type model
shows the lowest cost (actually a negative cost),
the New-Classical-type model shows zero cost,
the Keynesian-type model shows a high cost,
and the PSTAR+ m odel
shows a cost in between the
high and low costs of the
FIGURE 4
other models.
Keynesian Model Results
A m ajor d ifferen ce
Inflation Rate
among the models, which
has much to do with why
they give very different costs
of disinflation, is the theo­
retical basis for how infla­
tion changes. The Monetar­
ist-type and New-Classicaltype models contain infla­
tion equations that allow the
inflation rate to be changed
immediately with a change
in money growth. There is
very little inertia to inflation,
so the policy prescription is
simple: reduce the growth
rate of the money supply
Real GNP Growth Rate
promptly to reduce inflation.
Furthermore, money supply
growth can be reduced with­
out major declines in real
GNP. In the New-Classicaltype model, there's no de­
cline in real GNP at all, as
long as the reduction in
money supply growth is ex­
pected . And in the Monetar­
ist-type model, a gradual
reduction in money supply
growth has only minor ef­
fects on real GNP growth.

19Technically, this results because the only controllable
variable that enters the inflation equation is lagged real
GNP growth. In this model, even in the long run, there is a
direct relationship between inflation and real GNP growth.
So a permanent reduction in real GNP growth is required to
reduce inflation permanently.




13

BUSINESS REVIEW

At the other extreme is the Keynesian-type
model. Its inflation equation contains a lot of
inertia, so it takes sustained downward pres­
sure on inflation to move it to a lower level.
What's more, money growth can't directly af­
fect inflation in the model; instead, inflation can
be reduced only by reducing the growth rate of
real GNP permanently. In this model, then,
inflation reduction is extremely costly in terms
of lost output. However, more recent Keynesian
models that incorporate rational expectations
and allow for credibility effects would likely
show lower costs because such modifications
permit faster, smoother adjustments of the
economy to a change in monetary policy.
In the middle is the PSTAR+ model. There is
a fair amount of inertia in its inflation equation.
But inflation can be reduced in the long run by
slowing money growth. Reducing money
growth raises the federal funds rate, which
reduces real GNP growth. The effect on real
GNP is larger than in the Monetarist-type and
New-Classical-type models but much smaller
than in the Keynesian-type model.
How do the costs compare with the benefits?
We guessed earlier that the benefits of reducing
inflation from 5 percent to 0 percent were about
24 to 48 percent of 1990 GNP, although this is an
imprecise estimate. This range of estimated
benefits is obviously larger than the cost of
disinflation in the Monetarist-type model (a
negative cost) and the New-Classical-type
model (zero cost). For the PSTAR+ model we
found the costs of reducing inflation from 4.5
percent to 0 percent were 22 percent of 1990
GNP, so the costs of reducing inflation from 5
percent to 0 percent are likely to be about 25
percent of 1990 GNP. This is at the lower end
of the range of benefits, so the benefits and costs
of disinflation are close, but the benefits prob­
ably exceed the costs. In contrast, the benefits
of disinflation are far lower than the costs in the
Keynesian-type model (200 percent of 1990
GNP).
Is there any way for policymakers to decide

14


MAY/JUNE 1992

which model is best? The stagflation of the
1970s showed that many of the Keynesian mod­
els used at that time were inadequate, so Mon­
etarist and New Classical models gained more
acceptance. These more recent models of the
economy have lower or no costs of disinflation.
But the changing relationship between money
and GNP in the 1980s has led economists to
question the usefulness of these models as well.
Perhaps hybrid models like the PST AR+ model,
which capture some elements of the competing
theories, are more likely to be accepted. Since
these models are fairly new, we need to see now
they perform over time before we can confi­
dently use them in evaluating monetary policy.
Nevertheless, the thrust of economic research
after the early 1970s has been on models that
have lower costs of disinflation.
One critical issue that remains unresolved
and that would help us assess the costs and
benefits of disinflation is whether inflation af­
fects the growth rate of the economy. If it does,
then the Monetarist-type model is the most
relevant because only in that model does lower
inflation lead to greater economic growth.
Furthermore, if lower inflation raises economic
growth, the benefits of disinflation are very
large and can justify any temporary cost.
Is there any convincing evidence that lower
inflation raises the growth rate of GNP? A few
studies, including a 1982 study by Peter Jarrett
and Jack Selody of the Bank of Canada, as well
as the one by Hakkio and Higgins discussed
earlier, find that reducing inflation raises real
GNP growth. But this result may arise not
because inflation and GNP growth are directly
related, but because the models were estimated
using historical data that included the 1970s,
when inflation was high and large oil price
shocks reduced productivity and growth. The
empirical literature surveyed in a recent article
by Robert F. Lucas of the U niversity of
Saskatchewan suggests that inflation has not
substantially affected real GNP growth in many
countries over many time periods.
FEDERAL RESERVE BANK OF PHILADELPHIA

Dean Croushore

What Are the Costs o f Disinflation?

CONCLUSION
Is disinflation worth the price? Determining
the costs of disinflation depends on the specific
model of the economy one uses. The early
econometric models of the economy were of the
Keynesian type, in which the costs of disinflation
are very large. Those economists who continue
to use Keynesian models similar to the one
discussed here are unlikely to be convinced
that disinflation is worth the price. But more
recent models of the economy, along with theo­
retical developments that suggest the economy
can adjust more quickly and smoothly to changes

in monetary policy, indicate the costs of
disinflation are much lower.
Determining which particular model of the
economy is best for both explaining past events
and forecasting the future is not easily re­
solved. Over time, as economists learn more
about how the economy works, choosing among
the alternative models and their estimated costs
of disinflation should become easier. Because
more recent models suggest that the costs of
disinflation are not nearly as large as previ­
ously believed, support for disinflation has
been growing.

REFERENCES
Aiyagari, S. Rao. "Deflating the Case for Zero Inflation," Federal Reserve Bank of Minneapolis
Quarterly Review (Summer 1990), pp. 2-11.
Altig, David, and Charles T. Carlstrom. "Inflation, Personal Taxes, and Real Output: A Dynamic
Analysis," Journal o f Money, Credit and Banking 23 (part 2, August 1991), pp. 547-71.
Ball, Laurence, and Stephen G. Cecchetti. "Inflation and Uncertainty at Short and Long Horizons,"
Brookings Papers on Economic Activity (1:1990), pp. 215-45.
"Unanticipated Money and Economic Activity," in Rational
Expectations and Economic Policy. Chicago: University of Chicago Press, 1980, pp. 23-48.

Barro, Robert J., and Mark Rush.

Croushore, Dean. "The Short-Run Costs of Disinflation," Federal Reserve Bank of Philadelphia
Working Paper 91-8, March 1991.
Fischer, Stanley. "Contracts, Credibility, and Disinflation," in Stanley Fischer, Indexing, Inflation, and
Economic Policy. Cambridge, Mass.: MIT Press, 1986, pp. 221-45.
Fischer, Stanley, and Franco Modigliani. "Towards an Understanding of the Real Effects and Costs
of Inflation," Weltwirtschaftliches Archiv 114 (1978), pp. 810-33.
Friedman, Benjamin M. "The Value of Intermediate Targets in Implementing Monetary Policy," in
Price Stability and Public Policy. Federal Reserve Bank of Kansas City, 1984, pp. 169-91.
Gordon, Robert J., and Stephen R. King. "The Output Cost of Disinflation in Traditional and Vector
Autoregressive Models," Brookings Papers on Economic Activity (1:1982), pp. 205-42.




15

MAY/JUNE 1992

BUSINESS REVIEW

REFERENCES
(continued)
Hakkio, Craig S., and Bryon Higgins. "Costs and Benefits of Reducing Inflation," Federal Reserve
Bank of Kansas City Economic Review 70 (Jan. 1985), pp. 3-15.
Hallman, Jeffrey ]., Richard D. Porter, and David H. Small. "Is the Price Level Tied to the M2 Monetary
Aggregate in the Long Run?" American Economic Review 81 (September 1991), pp. 841-58.
Howitt, Peter. "Zero Inflation as a Long-Term Target for Monetary Policy," in Lipsey, Richard G., ed.,
Zero Inflation: The Goal o f Price Stability. Ottawa, Ontario: C.D. Howe Institute, 1990, pp. 67-108.
Jarrett, J. Peter, and Jack G. Selody. "The Productivity-Inflation Nexus in Canada, 1963-1979," Review
o f Economics and Statistics 64 (August 1982), pp. 361-67.
Laurent, Robert D. "An Interest Rate-Based Indicator of Monetary Policy," Federal Reserve Bank of
Chicago Economic Perspectives 12 (Jan./Feb. 1988), pp. 3-14.
Lucas, Robert F. "The Case for Stable, But Not Zero, Inflation," in York, Robert C., ed., Taking Aim:
The Debate on Zero Inflation. Ottawa, Ontario: C.D. Howe Institute, 1990, pp. 65-80.
Meyer, Laurence H., ed. A Comparison o f the Predictive Performance of Small Macroeconometric Models.
Center for the Study of American Business Working Paper 78, April 1983.
Meyer, Laurence H., and Robert H. Rasche. "On the Costs and Benefits of Anti-Inflation Policies,"
Federal Reserve Bank of St. Louis Review (Feb. 1980), pp. 3-14.
Okun, Arthur M. "Efficient Disinflationary Policies," American Economic Review 68 (May 1978), pp.
348-52.
Scarth, William. "Fighting Inflation: Are the Costs of Getting to Zero Too High?" in York, Robert C.,
ed., Taking Aim: The Debate on Zero Inflation. Ottawa, Ontario: C.D. Howe Institute, 1990, pp.
81-103.
Sheshinski, Eytan. "Treatment of Capital Income in Recent Tax Reforms and the Cost of Capital in
Industrialized Countries," in Summers, Lawrence H., ed., Tax Policy and the Economy 4.
Cambridge, Mass.: MIT Press, 1990, pp. 25-42.
Tatom, John A. "Energy Price Shocks in a Reduced-Form Monetarist M odel," Federal Reserve Bank
of St. Louis Working Paper 83-003 (1983).
Taylor, Herb. "PSTAR+: A Model for Monetary Policy Evaluation," manuscript, 1991.


16


FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce:
A Dangerous Liaison?
c

L / everal of the proposals in last year's Trea­
sury Department plan to reform the financial
services industry made it into the FDIC Im­
provement Act passed by Congress at the end
of 1991. But one of the more controversial
provisions did not survive: a recommendation
that commercial firms be allowed to own banks.
Congress hasn't been the only group hard to

*Loretta J. Mester is a Research Officer and Economist in
the Research Department, Federal Reserve Bank of Phila­
delphia.




Loretta ]. Mester*
convince— a recent survey, conducted by CPA
firm Grant Thornton, Chicago, of over 600
senior bank executives indicated that almost 70
percent were against commercial firms' own­
ing banks. Why was this proposal hard to sell?
And what are the costs and benefits of allowing
banks and commerce to mingle?
The arguments for and against commercial
ownership of banks are tied to the regulatory
and deposit insurance structures. Without
necessary changes to the current structures, the
evidence suggests that the potential costs of
allowing banking and commerce to mix out­
17

BUSINESS REVIEW

weigh the potential benefits. But if recently
enacted reforms work as expected, prohibi­
tions against commercial firms' owning banks
and vice versa will need to be reconsidered.1
THE CURRENT LAW
AND A BIT OF HISTORY
Current U.S. law prohibits commercial firms
from owning banks and banks are prohibited
from owning commercial firms. In general,
banks are not allowed to engage in nonbank
activities, and a bank holding company can
own only 5 percent of the voting shares of any
nonbank commercial corporation without regu­
latory approval.
The separation between banking and com­
merce goes all the way back to 1694, when the
act establishing the Bank of England prohibited
it from dealing in merchandise. There was no
explanation for the prohibition, but according
to researcher Bernard Shull, it might have been
because merchants were suspicious that the
Bank could exploit monopoly power granted to
it by the Crown.2 The earliest U.S. national
banks followed the English tradition, so the
separation has existed for nationally chartered
banks in the U.S. since colonial times.
Despite this long history, there is some de­
bate about how traditional the separation be­
tween banking and commerce actually is. While
Congress may have intended to separate bank­

am indebted to two articles that do an excellent job of
presenting the pros and cons of mixing banking and com­
merce: A. Saunders, "The Separation of Banking and Com­
merce," New York University Salomon Center, Working
Paper S-91-19, 1991, and T. Huertas, "Can Banking and
Commerce Mix?" Cato Journal 7 (Winter 1988), pp. 743-62.
Unlike me, both conclude the separation of banking and
commerce should be ended.
2B. Shull has a nice historical piece, "The Separation of
Banking and Commerce: Origin, Development, and Impli­
cations for Antitrust," The Antitrust Bulletin 28 (Spring 1983),
pp. 255-79.


18


MAY/JUNE 1992

ing and commerce all along, it hasn't been
entirely successful. Banks and firms have found
ways of circumventing the policy. For one
thing, individuals have always been allowed to
own a controlling interest in both a bank and a
commercial firm (as long as it isn't a securities
firm). Also, some of the largest banks in the U.S.
were state-chartered banks that actually grew
out of commercial companies. The Bank of the
Manhattan Company (later known as Chase
Manhattan Bank) was created when New York
state permitted Aaron Burr to establish a water
utility company and a bank in 1799. The New
York Chemical M anufacturing Company,
founded in 1823, was granted banking powers
in 1824.
Within a holding company structure, the
Bank Holding Company Act of 1956 (BHCA)
prohibited nonbank corporations from owning
more than one commercial bank. But the main
intention of the Act was to inhibit interstate
banking rather than corporate ownership of
banks. If a nonbank corporation owned only
one bank, it could enter any business except
securities. And there were many one-bank
holding companies— W.R. Grace and Co.,
Macy's, and Goodyear all owned banks. Banks
that converted to one-bank holding companies
could own nonbank companies—for example,
First National City (Citicorp) converted to a
bank holding company in 1968 and entered
many activities.3
In 1970 the BHCA was amended to close part
of the one-bank holding company loophole by
proscribing nonbanks from owning one bank
and by tightening regulations on banks'
"nonbanking" activities. Banks were permit­
ted to perform only those activities that were
closely related to banking and were beneficial

3R. Casey discusses the legislative history in "BankingCommerce Ties: As American as Apple Pie," United States
Banker 101 (January 1991), pp. 13-18.

FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce: A Dangerous Liaison?

Loretta J. Mester

invested in banking rather than other types of
activities. But will permitting commercial
ownership of commercial banks be in society's
best interests?
Advocates of allowing the mix cite several
social benefits such as a reduction in the num­
ber of bank failures or lower costs of producing
bank and commercial products.5* If U.S. banks
were able to become more competitive with
nonbank providers of financial services and
with foreign banks, then the safety and sound­
ness of the U.S. banking system would be
improved. While these benefits potentially
exist, the evidence concerning their magnitude
isn't very compelling.
Additional Capital. The U.S. banking in­
dustry is going through tough times. Bank
failures are at their highest level since the De­
pression, and regulators have increased banks'
capital requirements. Since capital serves as a
cushion for loan losses at banks, extra capital
lowers the expected cost to the FDIC—
and so to
the taxpayer— bank failures. Increasing the
of
capital requirements can also reduce a bank's
taste for excessively risky activities by raising
the amount bank owners have at stake.
One potential benefit of allowing commer­
cial firms to own banks is that by expanding the
field of owners, new capital might be brought
to the banking industry. While this is true, it
POSSIBLE BENEFITS OF
isn't clear that additional capital is needed at
COMMERCIAL FIRMS' OWNING BANKS
Whatever Congress's intent, there is histori­ the industry level—just because individual
cal precedent for commercial ownership of banks may be undercapitalized doesn't mean
banks, and commercial firms are indeed inter­ the banking system as a whole is. Consolida­
ested in owning banks. Some firms that cur­ tion within the industry, which is beginning to
rently own nonbank banks would prefer to happen now, will probably yield enough capi­
own commercial banks, which are able to fund tal to enable the remaining banks to meet their
loans with insured deposits: Sears would turn
its nonbank banks into full-service commercial
banks if allowed, and American Express claims
that it could perform its business more effi­
4See S. Zuckerman, "As Washington Dithers, Nonbanks
ciently if the separation of banking and com­
Advance," American Banker 156 (March 15,1991), p. 1.
merce were ended.4 Presumably, this interest
in owning banks stems from the firms' belief
5See A. Saunders, "The Separation of Banking and Com­
that they could earn a better return if they merce," and T. Huertas, "Can Banking and Commerce Mix?"

to the public. But at the same time another
loophole was opened up—Congress redefined
"bank," for the purposes of bank holding com­
panies, to be an institution that makes commer­
cial loans and accepts demand deposits. Banks
that fulfilled one condition but not the other
could be owned by any other corporation. Thus,
"nonbank" banks emerged.
But in 1987 this nonbank bank loophole was
closed by again redefining "bank" as any insti­
tution with FDIC deposit insurance or any
institution that makes commercial loans and
accepts demand deposits. Those nonbankbanks
already established were grandfathered with
the restriction that their assets could not grow
more than 7 percent in any 12-month period.
There are many examples of nonbank banks:
General Motors owns GMAC Mortgage Cor­
poration, one of the largest mortgage banks;
Ford Motor Company owns Associates Na­
tional Bank, a credit card bank; IBM owns IBM
Credit Corporation, which provides financing
for other commercial firms; American Express
owns three nonbankbanks; and Sears, Roebuck
and Company also owns several nonbankbanks.
Nonbank corporations are still permitted to
own one thrift without growth restrictions—for
example, Ford owns First Nationwide.




19

BUSINESS REVIEW

capital requirements.6 And the commercial
firms most interested in banking probably would
expand their own bank-like operations rather
than buy existing full-service banks if permit­
ted to do so. This would increase the number
of commercial banks, but not the amount of
capital in the industry relative to assets.
Cost Synergies. Another widely claimed
benefit for permitting commercial firms to own
banks is that the combination may lower the
cost of providing services through scale or
scope economies. If the average cost of produc­
ing financial services falls as the scale of opera­
tions increases, then large banks operate more
efficiently than small banks. To the extent that
commercial firms could bring additional capi­
tal into the banking industry to support larger
institutions, allowing commercial firms to own
banks could lead to more efficient production if
there are significant economies of scale in bank­
ing.7 Similarly, combining commercial prod­
ucts with financial products might lower the
cost of production if, for example, inputs are
shared across the products. For instance, a
manufacturing firm and a bank might be able to
use the same computer to keep track of inven­
tory and accounts. If such scope economies
exist, then again it would be more efficient to
allow banks and commercial firms to mix. And
a move toward more efficient production would
benefit society by freeing up resources for other
productive activities.
While theoretically there are potential syner­
gies between banking and commerce, the evi­
dence to date suggests they probably aren't
very significant. Most studies of scale econo­

6A s of December 1991, the ratio of total tier-one capital
to total assets for all domestic banks was 6.6 percent, well
over the required 3 percent.

7If banking and commerce were permitted to mix, it
would be within a holding company structure, and the
average asset size of banks within multibank holding com­
panies is over 10 times that of independent banks.


20


MAY/JUNE 1992

mies in banking suggest that they are exhausted
at banks of a relatively small size (at around
$100 million in deposits), or if present in larger
banks, they are slight.8 Most studies find no
evidence of scope economies between different
bank products, such as commercial loans and
consumer loans. Since banking and commerce
have for the most part been separated, there
isn't much in the way of empirical evidence on
cost synergies between commercial activities
and bank products. However, in a 1992 empiri­
cal study, I found diseconomies of scope be­
tween traditional commercial bank activities
and nontraditional activities of loan selling and
buying, which resemble investment banking
activities.9 Thus, the evidence doesn't support
the view of significant cost savings from com­
bining banking and other activities.
Revenue Synergies. It may be that consum­
ers would prefer one-stop shopping to save on
transactions and search costs. Combining bank­
ing and commerce may yield enhanced rev­
enue through cross-marketing of bank prod­
ucts and commercial firm products. There is
some evidence of this—for example, many
people get their financing for a new car at the
dealership. But there don't seem to be signifi­
cant revenue synergies or cost synergies—if
there were, we'd expect to see higher profits at
firms that can provide both commercial and
financial activities. While competitive with
commercial banks, nonbank banks have not
really outpaced them. A study by Linda Aguilar,
which compared large bank holding compa­
nies with nonbank banks, showed that nonbank
banks' market share of finance receivables fell
between 1982 and 1987, while that of bank

8See L. Mester, "Production of Financial Services: Scale
and Scope Economies," this Business Review, January/February 1987, pp. 15-25, for a review of the literature.
9See L. Mester, "Traditional and Nontraditional Bank­
ing: An Information-Theoretic Approach," Journal o f Bank­
ing and Finance, forthcoming 1992.

FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce: A Dangerous Liaison

holding companies increased. And nonbank
banks have begun to experience problems with
loan portfolios and profits just as banks have.1
0
Increased International Competitiveness.
Other countries tend to be more liberal in al­
lowing banking and commerce to mix. (See

10See L. Aguilar, "Still Toe-to-Toe: Banks and Nonbanks
at the End of the '80s," Economic Perspectives, Federal Re­
serve Bank of Chicago, January/February 1990, pp. 12-23.

Loretta J. Mester

Banking and Commerce Arrangements in Other
Countries.) So to the extent that commercial and
banking mixes are more efficient, U.S. banks
would be at a disadvantage compared with
foreign banks. But the evidence suggests that
while U.S. banks are no longer on top in terms
of asset or capital size, they still outperform
foreign banks. According to a report by IBCA
Limited, in 1990 only two U.S. banks ranked in
the world's top 50 by asset size, but their aver­
age return on assets and return on equity were

BANKING AND COMMERCE ARRANGEMENTS
IN OTHER COUNTRIES
Germany: Universal banking exists here—
banks can perform commercial and investment banking
activities directly (no holding company structure is required) and insurance and real estate activities
via subsidiaries; banks can own commercial firms directly (but in practice their ownership is small);
commercial firms can own banks (but few do, given the regulations they must meet).
United Kingdom: Clearing banks, including Barclays, Lloyds, Midland, and National Westminster,
engage in commercial and investment banking, and in merchant banking, insurance activities, and
real estate activities via subsidiaries; there is no formal policy separating banking and commerce, but
tradition has encouraged it by restraining bank investments in nonfinancial firm equity, and such
investments are not common; the Bank of England must approve firms taking a 15 percent or greater
stake in a U.K. bank, and individuals who own more than a 5 percent stake in a U.K. bank must report
it to the Bank of England.
Japan: The banking system here was modeled on the U.S. system after World War II, and commercial
and investment banking were separated then; Japanese banks can perform commercial bank activities
and have minority ownership (5 percent or less) in subsidiaries that perform leasing, insurance, credit
card business, and management consulting; until 1987, banks could hold up to 10 percent of the
outstanding shares in any company, but through cross-holdings could effectively hold much more;
a bank can be a main bank in keiretsu (a conglomerate group) and so have large ties to commercial
firms.
The EEC: As of 1992, banks are allowed to do commercial and investment banking activities but not
insurance activities; a bank is limited to 10 percent of its own equity as a stake in an individual
commercial firm, with the total stake in commercial firm equity not to exceed 50 percent of bank
capital; commercial firms may own banks if such action is considered suitable by the national
regulator.
Sources: A. Saunders, "Separation of Banking and Commerce," New York University Salomon Center, Working
Paper S-91-19,1991, and A. Daskin and J. Marquardt, "The Separation of Banking from Commerce and the Securities
Business in the United Kingdom, West Germany and Japan," Issues in Bank Regulation 7 (Summer 1983), pp. 16-24.




21

BUSINESS REVIEW

higher than those of foreign banks ranked in the
top 50 by asset size. And when banks were
ranked in terms of IBCA's real profitability
index (return on equity adjusted for inflation
and differences in equity-to-assets ratios), the
U.S. accounted for 16 of the top 50 banks, more
than any other country.1 So the current separa­
1
tion of banking and commerce in the U.S. doesn't
appear to be too much of a burden on U.S.
banks.
Lower Risk of Failure. Allowing a firm to
diversify into financial services and commer­
cial production might lower the firm's risk.
This would happen if profits in the commercial
line of business could be used to offset losses in
the financial services line of business. Lower
risk would benefit society, since it would mean
fewer bank failures.
The empirical evidence on such diversifica­
tion benefits is mixed.1 In one study, Anthony
2
Saunders and Pierre Yourougou found that
there is a potential for lower risk via diversifi­
cation because when returns on bank stock are
low, returns on commercial firm stock tend to
be high, and vice versa.1 In another study,
3
Robert Eisenbeis and Larry Wall found that
when the returns for commercial banks are
high, the returns to general merchandise stores
are low, and vice versa.1 So potentially, a firm
4
could combine banking and commerce to

MAY/JUNE 1992

achieve a less volatile total return and so be less
likely to fail. But a study by John Boyd and
Stanley Graham and another by these authors
and R. Shawn Hewitt found that allowing bank
holding com panies to expand into the
nonbanking activities of securities or real estate
development increases the probability of fail­
ure and the volatility of the holding company's
returns.1 Eisenbeis and Wall's study found
5
that returns for commercial banks and returns
for food stores are positively correlated.
Even if the potential for diversification ben­
efits exists, it isn't clear that the management of
a bank-commercial holding company would
choose to diversify in ways that reduce risk.
The current fixed-rate deposit insurance sys­
tem and the regulatory system, which has been
slow to close insolvent banks, encourage banks
to take on too much risk. A bank's equity
holders get all the upside benefits if the risk
pays off, but they don't pay more for taking on
more risk. Banks currently pay the same insur­
ance premium regardless of the riskiness of
their portfolios, and while bank supervision is
supposed to control risk-taking, it hasn't been
that successful. Insured depositors have no
incentive to monitor a bank's risk-taking, since
they are paid off whether the bank fails or not.
And often at the larger banks, large depositors,
who are supposedly uninsured, don't demand
much of a risk premium, since typically they
don't suffer losses when a large bank fails.1
6

n See IBCA Limited, Real Banking Profitability, November
1991.
12See A. Saunders, "The Separation of Banking and Com­
merce," for a more detailed review of this empirical evi­
dence.
13A. Saunders and P. Yourougou, "Are Banks Special:
The Separation of Banking From Commerce and Interest
Rate Risk," Journal o f Economics and Business 42 (May 1990),
pp. 171-82.
14R. Eisenbeis and L. Wall, "Risk Considerations in
Deregulating Bank Activities," Economic Review, Federal
Reserve Bank of Atlanta, May 1984, pp. 6-19.


22


15J. Boyd and S. Graham, "The Profitability and Risk
Effects of Allowing Bank Holding Companies to Merge
with Other Financial Firms: A Simulation Study," Quarterly
Review, Federal Reserve Bank of Minneapolis, Spring 1988,
pp. 3-20. And J. Boyd, S. Graham, and R. S. Hewitt, "Bank
Holding Company Mergers with Nonbank Financial Firms:
Effects on the Risk of Failure," Working Paper 417, Federal
Reserve Bank of Minneapolis, January 1992.
16See L. Mester, "Curing Our Ailing Deposit Insurance
System," this Business Review, September/October 1990, pp.
13-24, for a discussion of reforming federal deposit insur­
ance.

FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce: A Dangerous Liaison?

Under recently implemented risk-based capi­
tal standards, banks are required to hold more
capital against riskier assets. While a move in
the right direction, the risk-based capital re­
quirements are not a complete remedy to exces­
sive risk-taking on the part of banks, since the
four risk categories considered are very broadly
defined— for example, all commercial and in­
dustrial loans are assigned to the same risk
category. The recently passed FDIC Improve­
ment Act includes changes to remedy some of
the risk-distorting problems in the current sys­
tem. But several of these changes won't be
implemented immediately. (The FDIC will be
required to charge different insurance premi­
ums based on the riskiness of the bank, but riskbased premiums don't have to begin until 1994.
Recently, however, the FDIC announced that it
plans to implement risk-based premiums next
year.) Until the changes are made, banks will
still have the incentive to take on more risk than
is best for society.
POSSIBLE COSTS
Opponents of allowing banking and com­
merce to mix cite the concentration of resources
this would entail and the risks posed to the
"safety net," which includes the deposit insur­
ance system, the electronic payments system,
and borrowing at the discount window. Most
of these costs apply not only to allowing com­
mercial firms to own banks but also to any
expansion of a bank's permitted activities. We
have heard the safety net arguments before in
the debate about whether banks should be
permitted to underwrite securities.1 The dif­
7
ference here is that if commercial firms were
allowed to own banks, a new set of firms would
become part of the financial services system.
The banking system has been undergoing a

17See A. Saunders, "Securities Activities of Commercial
Banks: The Problem of Conflicts of Interest," this Business
Review, July/August 1985, pp. 17-27.




Loretta J. Mester

restructuring that has required regulatory re­
form to stem abuses. Until the restructuring
and reform are complete, it may make sense to
delay extending the system. This is perhaps the
best argument in favor of the status quo for the
time being; other arguments against mixing
banking and commerce just aren't as strong.
Monopoly Power. One argument for disal­
lowing the entrance of commercial firms into
banking is that it may end up concentrating
banking in the hands of a few large corpora­
tions. These large commerce and banking con­
glomerates would exploit their monopoly
power, so the argument goes, harming their
corporate competitors by denying them the
credit they need to do business and harming
consumers by offering low deposit rates and
high loan rates. Moreover, consumers wishing
to purchase just the banking or just the com­
mercial product from the conglomerate might
be forced to purchase the other product as well.
Again, the empirical evidence on economies
of scale and scope can be brought into the
argument, but this time against this potential
cost. There is little evidence that the banking
industry would become monopolized if com­
mercial firms could own banks. None of the
scale and scope studies suggest that banking
services could be most efficiently produced
with a very few large banks. While commercial
ownership may allow banks to grow larger and
may lead to some consolidation in the industry,
it is unlikely to lead to overconcentration. Even
in smaller local markets there is likely to be a
number of banks competing for business (espe­
cially since there are already bank regulations
that guard against monopolization). And glo­
bal competition would help keep the industry
competitive.1 *
8
As corporations would have access to other
banks and to nonbank credit sources such as the

18See A. Saunders, "The Separation of Banking and Com­
merce," for a discussion of this point.

23

BUSINESS REVIEW

MAY/JUNE 1992

commercial paper market, the commercially
owned bank couldn't effectively restrict credit
to its competitors. Consumers would also be
able to get loans or make deposits at other
institutions, and tie-ins wouldn't be a problem
as long as the firm was not a monopolist in the
market for its commercial product. (If it was,
then the antitrust laws could be used to curb
any anticompetitive problems.) In fact, experi­
ence from the nonbank banks already suggests
that tie-ins wouldn't be a problem. All three
finance subsid iaries owned by the U.S.
automakers, for example, make loans for their
competitors' products.1
9
Other arguments against mixing banking
and commerce are not as easy to dismiss as the
monopoly power argument, at least until finan­
cial system reforms are completed.
Extending the Problem of "Too-Big-to-Fail."
Because failures of large banks could poten­
tially disrupt the payments system, regulators
often treat these failures differently from fail­
ures of small banks. Despite an explicit insur­
ance ceiling of $100,000 per deposit, the FDIC
often, de facto, insures the large depositors and
uninsured creditors of large banks and so bears
most of the cost of excessively risky actions by
these banks. This gives large banks an incentive
to take on more risk than they would otherwise.
The recently enacted FDIC Improvement Act
will curb some of the problem by restricting the
FDIC's ability to protect uninsured depositors
or creditors if it would mean a loss to the
insurance fund. But the provision won't take
effect until 1995, and market participants will
have to see some large banks actually fail before
they believe "too-big-to-fail" is truly dead. Until
then, expanding the size of banks, which is
likely to occur at least to some extent under
commercial ownership, may be costly.

Increased Risk From Affiliate T ransactions.
Although some argue that allowing commer­
cial firms to own banks would lower risk,
others claim it would raise risk, lead to more
bank failures, and increase the FDIC's costs. If
a commercial firm persuades a bank it owns to
pay very large dividends or management fees
to the commercial firm owner or even make
loans to prop up the owner, the bank could be
weakened at the benefit of the commercial
owner. The bank would also suffer if the owner
could make the bank purchase low-quality as­
sets from other affiliates.2 In this way the
0
commercial holding company would be able to
take advantage of the bank's creditors and the
FDIC, since the holding company would have
limited liability if the bank failed.
How likely are these scenarios? Two strat­
egies regulators have for dealing with potential
conflicts of interest between the holding com­
pany and its banks are "firewalls" and the
"source-of-strength" doctrine.
Firewalls. Current provisions of the Federal
Reserve Act (Sections 23A and 23B) limit trans­
actions between affiliates. Section 23A limits
loans to an affiliate to 10 percent of the bank's
capital, and loans to all affiliates combined to 20
percent of capital. And these loans must be
fully collateralized. Section 23B restricts all
interaffiliate transfers to be on the same terms
as those with nonaffiliates—in other words, to
be arm's-length transactions.
In general, these restrictions seem to be work­
ing. But the question is whether these firewalls
will be disregarded in times of stress and
whether they will need to be strengthened if
commercial firms are permitted to own banks.
Even with currently permitted activities, the
firewalls have crumbled at times. Continental
Illinois extended loans to its options subsidiary
over agreed-to limits when the subsidiary got

19T. Pare, "Tough Birds That Quack Like Banks," For­
tune, March 11,1991, pp. 79-84.

20See A. Saunders, "The Separation of Banking and
Commerce," for more on these types of transfers.


24


FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce: A Dangerous Liaison?

Loretta J. Mester

21See A. Cornyn, G. Hanweck, S. Rhoades, and J. Rose,
"An Analysis of the Concept of Corporate Separateness in
BHC Regulation from an Economic Perspective," Proceed­
ings o f a Conference on Bank Structure and Competition, Federal
Reserve Bank of Chicago (May 1986), pp. 174-212.

authorization of the source of strength doctrine
(see The Source-of-Strength Doctrine, pp. 26-27),
the courts have not been very receptive to it,
since this doctrine runs counter to the concept
of corporate separateness. A premise of corpo­
rate law is that each affiliate of a holding com­
pany is a separate corporate entity with limited
liability: if one affiliate gets into trouble, the
resources of another don't need to prop up the
failing affiliate.
Extending the Deposit Insurance Subsidy.
Even if they didn't weaken the bank, transac­
tions between a bank and its corporate parent
would still need to be controlled to prevent the
FDIC from subsidizing the risky activities of
commercial firms. Until the new provisions of
the FDIC Improvement Act take effect, banks
can continue to invest in risky activities with­
out paying a risk premium for their funds. If
commercial firms had access to bank deposits
by affiliate transactions, then the deposit insur­
ance subsidy would be extended to the owners,
creditors, and customers of the commercial
firm. To prevent this, regulators would have to
tighten firewalls or keep a close eye on the risky
activities of the holding company until the
subsidy is removed by reform of the deposit
insurance system. Of course, such extended
regulation may make bank ownership unpalat­
able to commercial firms.
Contagion From Affiliates to Bank. Even
without the source-of-strength doctrine, evi­
dence suggests that the market views a bank
holding company as a single corporate entity,
and indeed, holding companies tend to behave
this way. Management studies suggest that the
management of a parent and its subsidiaries is
usually centralized, and banks have acted to
prop up ailing affiliates even when under no
legal obligation.2 *Last year, when rating agen3

22The FDIC Improvement Act calls for the Federal Re­
serve Board to prescribe standards, effective in a year, to
limit the risks posed by a bank's exposure to another bank
via interbank transactions, such as credit extensions,
interbank deposits, and purchases of securities.

23In the mid-1970s, banks put funds into the real estate
investment trusts they sponsored when the REITs got into
trouble.

into trouble during the October 1987 stock
market crash. Hamilton National Bank of Chat­
tanooga failed in 1976 after an illegally large
amount of poor-quality real estate loans was
transferred from its mortgage bank affiliate to
the commercial bank.2
1
Restrictions on transactions between a bank
and its owner or affiliates are hard for regula­
tors to enforce, since they have less information
than the bank or its holding company. It's
difficult for a regulator to determine whether
the management fees paid by a bank are exces­
sive or whether the transactions are on terms
fair to the bank. Perhaps all transactions be­
tween a bank and its nonbank affiliates could be
banned to stem possible abuses, but if the
firewalls are strengthened too much, any po­
tential synergies and benefits of product diver­
sification would be defeated.2
2
Source o f Strength. Another way the Federal
Reserve, regulator of bank holding companies,
has chosen to alleviate potential conflicts of
interest between a bank and its affiliates is the
"source-of-strength" doctrine. Under this
policy, a bank holding company must serve as
a source of financial strength to its subsidiary
banks and must have adequate capital itself.
The rationale runs this way: if the holding
company knows its funds would be used to
prop up its bank in trouble, then it would have
no incentive to move funds from the bank to the
holding company. Although the FDIC Im­
provement Act moves toward Congressional




25

BUSINESS REVIEW

Banking and Commerce: A Dangerous Liaison?

MAY/JUNE 1992

Loretta ]. Mester

i

The Source-of^ngth Doctrine
i
Although the Fed has followed a source-of-strength policy since the Bank Holding Company Act
was enacted in 1956, the doctrine became official only in 1983. According to Regulation Y:

i
*

"A bank holding company shall serve as a source of financial and managerial strength to its
subsidiary banks and shall not conduct its operation in an unsafe or unsound manner."

1
*

i

acceptable capital restoration plan, and the bank's holding company must guarantee compliance
with the plan. The holding company liability is limited to the lesser of 5 percent of the bank's total
assets at the time the bank became undercapitalized or the amount necessary to bring the bank into
compliance with its capital requirement as of the time the bank falls out of compliance with its
recapitalization plan.

♦

As explained in an April 1987 policy statement, the rationale behind the policy is as follows:

f

♦
"A bank holding company derives certain benefits at the corporate level that result, in part, from
the ownership of an institution that can issue federally insured deposits and has access to
Federal Reserve credit."
/
The Supreme Court was expected to rule on the validity of the Fed's source-of-strength doctrine
when it considered the case of MCorp, a Texas-based bank holding company, during its 1991-92
session. After 20 of MCorp's 25 subsidiary banks failed in 1989, the Fed charged that MCorp had
failed to act as a source of strength to its remaining subsidiary banks. The case reached the Fifth Circuit
Court of Appeals, which ruled that the Fed had no authority to assert the source-of-strength doctrine
under the Bank Holding Company Act and could not order the holding company to transfer funds
downstream to troubled subsidiary banks. On December 3,1991, the Supreme Court overturned the
Appeals Court's decision but did not rule on the validity of source of strength. Instead, the Court
decided the case on the grounds of jurisdiction, ruling that the federal courts cannot block Fed
proceedings before the agency issues a final order. The Court indicated that MCorp can still challenge
the source-of-strength doctrine after the Fed completes its enforcement actions.

1
1

^
1
k
,
i
i
t
l

*

*
The Federal Deposit Insurance Corporation Improvement Act of 1991 moves toward Congressional authorization of source of strength. An undercapitalized bank is required to adopt an

cies lowered Chrysler Corporation's debt rat­
ing, Chrysler Financial's credit rating was low­
ered too. If the market views management as
being the same, then it would view problems in
one affiliate as signaling problems in other
affiliates. This is a problem when one of the
affiliates is a bank because troubles in nonbank
affiliates may cause depositor runs at the bank,
which would jeopardize the payments system.
Runs on individual banks are costly if they
result in the failure of an otherwise healthy
bank, and they are even more dangerous if they
are contagious, causing depositors to lose all
confidence in the banking system itself.
We have evidence of the first type of run. In
1973, Beverly Hills Bancorp, parent of Beverly
Hills National Bank, defaulted on its commer­
cial paper, causing large-scale runs on the bank,

http://fraser.stlouisfed.org/
26
Federal Reserve Bank of St. Louis

which led to its failure. More recently, Sunbelt
Bank and Trust failed in 1984 after some of its
nonbank affiliates failed.2 Less evidence of
4
contagious bank runs exists, but the savings
and loan crises in Maryland and Ohio are
examples.2 And Continental Illinois' troubles
5

24Both examples are from A. Comyn, et al.
^In March 1985, news of losses at Home State Savings
Bank in Cincinnati caused a run at the bank. When the
private state insurance fund that insured Home, the Ohio
Deposit Guarantee Fund, was unable to bail out Home's
depositors, the run spread to other S&Ls insured by this
private fund. A similar panic occurred in Maryland in May
1985. When losses at two S&Ls exceeded the reserves of the
private Maryland Savings-Share Insurance Corporation
which insured them, depositor runs began at other institu­
tions insured by this fund.
FEDERAL RESERVE BANK OF PHILADELPHIA

I

*

»

Several arguments have been made against the Fed's source-of-strength doctrine. The policy
would seem to run counter to the idea that insolvent banks should be closed as soon as possible to
limit the FDIC's losses. To avoid this inconsistency, the policy could be amended to make the bank
holding companies legally liable for any losses incurred by the FDIC in closing or liquidating their
banks, but not force the holding companies to recapitalize their troubled banks to keep them open*
Another potential problem is that the policy may deter corporations, once they are permitted to
do so, from investing in banks or deter bank holding companies from diversifying into nonbank
activities. However, if the diversification reduces risk, then the risk-based insurance premiums and
capital requirements for the well-diversified firm would be lower, encouraging the diversification.
A third problem with the policy is that it runs counter to the idea of corporate separateness. By
encouraging the market to treat a holding company and a bank as a single entity, the policy might
increase the potential for contagion.

T h is was suggested in the House Government Operations Committee 1987 report. Under a cross-guarantee
provision of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, when a depository
institution in a holding company fails, the other depository institutions in the holding company can be required to
reimburse the FDIC for any losses it incurs in resolving the failed institution. However, the FDIC can waive these
cross guarantees. See W. Keeton, "Bank Holding Companies, Cross-Bank Guarantees, and Source of Strength,"
Economic Review, Federal Reserve Bank of Kansas City, May/June 1990, pp. 54-67.

in the spring of 1984 raised the insolvency risk
of other banks by raising their cost of obtaining
large CDs and Eurodeposits.2
6
To use contagion effects as an argument
against commercial firm ownership of banks
presumes that commercial firms are more likely
to fail and so more likely to threaten an affiliate
bank than a financial firm affiliate would be.
Though this could be true, the evidence is
weak. Corporate bond defaults for commercial
firms have not been higher than those for finan-

26See A. Saunders, "Bank Holding Companies: Struc
ture, Performance, and Reform," pp. 156-202 in Restructur
ing Banking and Financial Services in America, W. Haraf and R.
Kushmeider, eds. (American Enterprise Institute: Wash­
ington, D.C., 1988).

cial firms. But having a large parent hasn't
prevented some securities firms from having
more trouble than their smaller, independent
siblings.2
7
Contagion From Affiliates to the Electronic
Payments System. If problems in a nonbank
affiliate cannot be isolated from the bank, they
may be transmitted to the electronic settle­
ments system, which is becoming an increas­
ingly important part of the payments system.
At any point during the day, a bank may have
transferred more money out of the settlements
system than it has received. These daylight

27W. Power, "Struggling Securities Firms Increasingly
Being Bailed Out by Their Rich Owners," Wall Street Journal,
November 14,1990, p. C 7.

27

BUSINESS REVIEW

overdrafts, which currently exceed $140 billion
a day, pose a risk to the financial system, since
the failure of one bank to settle its position
could start a chain reaction in which the credi­
tors of the first bank are pushed into net debit
positions and eventual default, which causes
its creditors to default and so on down the line.
To avoid the reaction, the Fed would need to
intervene and assure payments to all involved.
The potential losses for the Fed would be large.
In effect, the Fed would be rescuing the affili­
ated bank, and indirectly its troubled corporate
owner, to the extent that funds given to the
bank could be transferred to the parent.
One way to protect the payments system is
to control overdrafts. Plans for doing so exist,
but they have not yet been fully implemented.
In 1986, the Fed began a program in which
banks set voluntary caps on their intraday
credit exposure on the Fed's electronic settle­
ments system. In 1989, the Fed proposed to
price these daylight overdrafts and will prob­
ably start charging banks for their overdrafts
sometime in 1993. Until the programs for
controlling payments-systems risk are up and
running and can be evaluated, the potential
exists for problems in nonbank affiliates to
spread to the payments system. This is true for
all nonbank affiliates, not just commercial affili­


28


MAY/JUNE 1992

ates. But extending ownership of banks to
commercial firms would involve a possible
extension of the safety net to commercial firms,
and is probably cause to delay corporate own­
ership of banks.
CONCLUSIONS
Although included in the Treasury's pro­
posal to reform the financial services industry,
commercial firm ownership of banks did not
make it into the recently passed FDIC Improve­
ment Act. I have examined several arguments
for and against commercial ownership of banks.
Similarly, bank ownership of commercial firms
is also arguable. (See Should Banks Own Com­
mercial Firms?) In many cases, validity of these
arguments depends on the ability of regulators
to control possible abuses of the financial sys­
tem by its participants. Without necessary
changes to the current system, the potential
costs of allowing banking and commerce to mix
outweigh the potential benefits. However, as
the reforms contained in the new banking act,
such as risk-based deposit insurance premi­
ums and limits on "too-big-to-fail," are imple­
mented, the prohibitions against commercial
firms' owning banks and vice versa will need to
be reconsidered.

FEDERAL RESERVE BANK OF PHILADELPHIA

Banking and Commerce: A Dangerous Liaison?

Loretta J. Mester

Should Banks Own Commercial Firms?
Currently, banks are not allowed to engage in nonbank activities. Bank holding companies can
hold, at most, 5 percent of the shares of any nonbank commercial corporation and cannot simulta­
neously lend to a commercial firm and hold its equity. As with commercial firm ownership of banks,
a cost-benefit analysis suggests it would be prudent to wait until the FDIC Improvement Act's reforms
to the financial services industry are in place and working before considering bank ownership of
commercial firms.
Potential Benefits. Some argue that allowing banks to own equity would lower the firm's funding
costs and benefit society by permitting more investment and economic growth. If a bank owns equity
in a firm it has lent to, then it is less likely to force the firm into bankruptcy when it encounters
temporary financial problems, because equity ownership gives the bank a share of the upside gain
should the firm turn around in the future. Since the firm's chance of bankruptcy would be lower, the
firm's debtors would charge a lower risk premium, and the firm would thus pay less to fund its
activities.
Equity ownership would also make the bank an insider and so privy to more information than
outside lenders would have. This would make it easier for the bank to monitor the firm, and it would
pass along some of its cost savings to the firm in the form of a lower loan rate. Also, being an insider,
the bank would have a greater say in the management of the firm. In the event the firm does fail, the
actual bankruptcy costs would be lower, since the assets of the firm needn't change hands.
Some empirical evidence supports this view. Albert Ando and Alan Auerbach found that in Japan,
where banks have been allowed to hold large equity positions in commercial firms, the cost of capital
m ay h a v e b e e n as little as h a lf o f th at in th e U .S. in th e 1967-88 p e rio d .3 And a c co rd in g to S u n B ae Kim,
large Japanese firms avoid bankruptcies in situations that would have meant bankruptcy in the U.S.,
and when bankruptcy does occur, reorganizations are less disruptive than in the U.S.b
Potential Costs. The danger of allowing banks to own equities stems from equities' being riskier
investments than debt. Extending the set of permissible activities to include riskier ones increases
banks' opportunity to take on too much risk, which will continue to be a problem until recent reforms
have an impact.
Also, unless the banks have some kind of expertise in the businesses they own, being an insider
may not be beneficial.

aA. Ando and A. Auerbach, "The Cost of Capital in Japan: Recent Evidence and Further Results," Journal o f the
Japanese and International Economies 4 (1990), pp. 323-50.
bS. Kim, "Banking and Commerce," Weekly Letter, Federal Reserve Bank of San Francisco, March 29,1991.




29

FEDERAL
RESERVE BANKO F
PHILADELPHIA
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