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Business
Review
Federal Reserve Bank o f Philadelphia
M ay-June 1993




ISSN 0007-7011

Testimony
on the Third District
Economy and
Monetary Policy
Edward G. Boehne

r

The Proconsumer
Argument
for Interstate Branching

Business
Review

The BUSINESS REVIEW is published by the
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2


MAY/JUNE 1993

TESTIMONY ON THE THIRD DIS­
TRICT ECONOMY AND MONETARY
POLICY
Edward G. Boehne
The Committee on Banking, Housing, and
Urban Affairs of the United States Senate
invited the presidents of the 12 Federal
Reserve Banks to Washington, D.C., to
testify about monetary policy and about
the economic conditions in their respec­
tive Districts. The presidents gave their
testimony on March 10 of this year. This
article presents the statement of Edward
G. Boehne, president of the Federal Re­
serve Bank of Philadelphia, about condi­
tions in the Third District.
THE PROCONSUMER ARGUMENT
FOR INTERSTATE BRANCHING
Paul S. Calem
People from New Jersey work in Pennsyl­
vania or maybe New York. People who
live in Connecticut may go to New York
for dinner and a show. And what about
people in Kansas City, Missouri, or Kan­
sas City, Kansas? In our modern world of
rapid transportation, millions of people
cross state lines daily, for work or leisure,
without thinking twice about it. Would it
be more convenient for these interstate
commuters if their banks could establish
interstate branches? Paul Calem thinks
so, and in this article, he presents some
consumer-oriented arguments in favor of
interstate branching.

FEDERAL RESERVE BANK OF PHILADELPHIA

Testimony on the Third District
Economy and Monetary Policy
Thank you for the opportunity to appear
X
before this Committee to discuss District eco­
nomic conditions and monetary policy.
BACKGROUND ON THE THIRD DISTRICT
The Third Federal Reserve District, head­
quartered in Philadelphia, includes the state of

*Edward G. Boehne is president of the Federal Reserve
Bank of Philadelphia. On March 10, he and the presidents
of the other 11 Federal Reserve Banks testified before the
Committee on Banking, Housing, and Urban Affairs of the
United States Senate. This article presents Mr. Boehne's
testimony on the Third District economy and monetary
policy.




Edward G. Boehne*
Delaware, the southern half of New Jersey, and
roughly two-thirds of the state of Pennsylva­
nia. About one-third of New Jersey's popula­
tion and more than 70 percent of Pennsylvania's
population are in the District. The three states
that are either wholly or partially in the District
represent more than 8 percent of the U.S. popu­
lation, employment, and income. The District
itself, although small in size geographically,
represents about 5 percent of the U.S. economy
in terms of population, employment, and per­
sonal income. More than 25 of the Fortune 500
companies are headquartered within the Dis­
trict boundaries.
The largest concentration of economic activ­
3

BUSINESS REVIEW

ity in the District is in the Philadelphia metro­
politan area. The Philadelphia area is the fourth
most populous metropolitan area in the coun­
try, with almost 5 million residents. It ranks
among the 10 largest U.S. markets in both
industrial and commercial office space. The
City of Philadelphia is the fifth largest city in the
country and has the nation's sixth largest down­
town office market.
In general, the economy in the three states of
the District is quite diversified and could be
described as a microcosm of the U.S. economy,
since the nonfarm economy in the three states
mirrors the nation quite closely. The propor­
tions of jobs in most nonfarm categories differ
little from the proportions at the national level.
The two major nonfarm sectors in which the
percentage of jobs diverges significantly from
the national average are business and personal
services and government services. Compared
with the nation, about 2 percent more of the jobs
in the tri-state area are in the private service
industries (including accounting, private edu­
cation, and health care), and about 2 percent
fewer jobs are in the government sector. Agri­
culture and agricultural services contribute
about 1 percent to the total output of the three
states—somewhat less than the U.S. average.
But agriculture remains a major industry in
parts of south Jersey, southern Delaware, and
south central Pennsylvania.
The District used to have a high proportion
of its jobs in manufacturing, but that has
changed. In the early 1970s more than onethird of the jobs in the three states were in
manufacturing— about 7 percent more than at
the national level. As late as 1980 more than
one-quarter of the jobs were in manufacturing,
still higher than the national average. Today
the percentage of jobs in manufacturing in the
Third District states is less than 20 percent and
very close to the national average.
The chemical industry and health services
are more heavily represented in the District
than in the nation. The production of industrial

4


MAY/JUNE 1993

chemicals in the District is concentrated in
Delaware. Pharmaceutical research and pro­
duction, also classified among the chemical
industries, is concentrated in central New Jer­
sey and in the Philadelphia area. The higherthan-average number of jobs in health services
in the District is the result of two factors: the
average age of the population in the District is
higher than that in the nation, and there are
many large medical schools, hospitals, and
health research facilities in the District.
Even though the District as a whole is not
highly dependent on defense spending, certain
parts of the District, such as the areas around
Dover Air Force Base in Delaware and McGuire
Air Force Base in New Jersey, are heavily de­
pendent on defense. In Philadelphia, the Navy
Yard and the Personnel Support and Industrial
Supply Centers employ a large number of work­
ers. In addition, the District has some major
defense contractors, such as Boeing Helicopter
and GE Aerospace (which is currently in the
process of being sold to Martin Marietta).
DISTRICT EMPLOYMENT
AND UNEMPLOYMENT
The Third District economy enjoyed solid
growth during the expansion of the 1980s even
as it continued to shift away from manufactur­
ing and toward services. The history of state
unemployment rates illustrates how the region's
economy performed during most of the 1980s
(Figure 1). In the late 1970s and early 1980s,
unemployment rates in all three states in the
District were regularly at or above the national
average. During the long expansion in the
1980s, unemployment rates in all three states
fell below the national average. By the end of
the decade Pennsylvania's rate was a percent­
age point below the nation's in some months,
and the rates in Delaware and New Jersey were
even further below the national rate. For a time,
Delaware's unemployment rate was below 3
percent, and the rate in New Jersey was be­
tween 3.5 and 4 percent.
FEDERAL RESERVE BANK OF PHILADELPHIA

Testimony on the Third District Economy and Monetary Policy

Edward G. Boehne

during the 1980s.
Unemployment rates in
Unemployment Rates
the District came down rela­
U.S. and Three District States
tive to the national unem­
ployment rate during the
1980s, despite overall job
growth that was slower than
the national average, be­
cause the District's labor
force generally grew more
slowly than that in the na­
tion. With the exception of
D elaw are, labor force
growth in the three states in
the District lagged growth
in the nation. This slower
growth was partly a func­
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
tion of the age distribution
in our District: fewer young
Shaded areas represent recessions.
people entered the labor
Job growth in our District was very good in force than in earlier decades. The number of
the last decade, but not quite as good as the jobs in the three states of the District increased
drop in unemployment rates would suggest. about twice as fast as the slowly growing labor
Combined job growth in the three states of the force during the expansion of the 1980s, so
District was slower than job growth at the many labor markets became very tight near the
national level, although some labor markets end of the expansion.
By the late 1980s, the economy in several
were notable exceptions. Jobs in Atlantic City
and M onmouth/Ocean counties in New Jer­ parts of the District was showing signs of be­
sey, in Lancaster and State College in Pennsyl­ coming overheated. Wages and prices were
vania, and in the state of Delaware, all grew rising faster in the Northeast than in the nation
appreciably faster than the national average. In as a whole. The rate of increase in the regional
Delaware, jobs grew more than one-and-a-half Consumer Price Index for the Philadelphiatimes the national rate. Some of these fast­ Wilmington-Trenton area, for example, was 0.5
growing areas benefited from special circum­ to 1.5 percentage points higher than the CPI
inflation rate for the nation as a whole during
stances.
The introduction of casino gambling in At­ the latter part of the 1980s. The region's infla­
lantic City in the late 1970s, for example, re­ tion rate is now close to the national average.
sulted in very rapid job growth. Atlantic City Inflation and wage costs are not a concern I hear
was the fastest growing labor market in our much about now in the District.
District in the 1980s; jobs increased by more
In contrast to the District's better-than-averthan 35 percent. Delaware experienced a major age performance during much of the 1980s, the
boom as financial service firms moved in to District has suffered a more serious recession
take advantage of the state's 1981 Financial and slower recovery than has the nation in the
Center Development Act. Jobs in the financial 1990s. One of the most frequent complaints I
service sector more than doubled in the state heard in the late 1980s when I met with business



FIGURE 1

5

BUSINESS REVIEW

people was their inability
to find qualified workers.
Now I hear from people
who cannot find jobs. The
job situation turned around
dramatically in the District,
especially in New Jersey.
As measured by the period
in which jobs were gener­
ally declining, the recession
lasted longer in most parts
of our District than in the
nation. Jobs began to de­
cline in our region before
they did in the nation. In
New Jersey the general de­
cline began in early 1989—
more than a year before the
onset of the national reces­
sion. In Pennsylvania the
general decline began three
months before the official
beginning of the recession.
Mirroring the national pat­
tern, jobs continued to de­
cline in the District beyond
the official end of the reces­
sion. In New Jersey, there
has not yet been any sus­
tained job growth.
The job picture follow­
ing this most recent reces­
sion stands in marked con­
trast to the average job
growth after the other re­
cessions since 1970.1 have
included a set of charts
comparing the job growth
in each state in our District
following this recession
with the average growth
following the recessions of
1970,1974-75, and 1981-82
(Figure 2).
T w enty-tw o m onths



MAY/JUNE 1993

FIGURE 2

Job Growth in Recoveries*
Average Recovery** m m m1991-1992 Recovery
mm

Months
Index

0

2

4

6

8

10

12

14

16

18

20

22

Months
Index

* Job growth is measured by payroll employment, indexed at 100 in the last
month of the official recession.
** Average of recoveries from business cycle troughs of November 1970,
March 1975, and November 1982. The recovery following 1980 is not used
because it did not last 22 months.

FEDERAL RESERVE BANK OF PHILADELPHIA

Testimony on the Third District Economy and Monetary Policy

Edward G. Boehne

into the national recovery, only Delaware has private service-producing industries suffered
more jobs than it did at the end of the recession. little or no net job loss. This time almost 25
The net increase is slightly more than 1 percent, percent of the job losses in our region (between
far short of the more than 6 percent average for first quarter 1990 and first quarter 1992) were in
earlier recoveries. In New Jersey jobs are more the private service-producing industries.
than 2 percent below their levels at the official
Whether in the goods sector or the service
end of the recession, and in Pennsylvania they sector, the job losses this time seem to be more
are still slightly below their levels at that time. permanent, as many firms have undergone
By this time in earlier recoveries, jobs in these major restructuring. Our District has suffered,
two states averaged 2.5 to 5 percent above their or is about to suffer, cutbacks by several large
levels at the trough of the business cycle.
employers. DuPont has gone through a major
Given the extended period of job declines in restructuring that has reduced its work force by
most of our District, it is not surprising that the 6000 in Delaware alone. Last year, Bell Atlantic
percentage loss of jobs has been deeper than the announced reductions of over 1000 positions in
loss at the national level. Recently revised New Jersey and almost 1000 in Pennsylvania.
numbers show that the job declines in the GM is slated to close an auto parts plant in
District were not as severe as earlier numbers Trenton, New Jersey, and an assembly plant in
suggested, but District losses were still steeper Wilmington, Delaware; Sears closed a distribu­
than the national decline. While the U.S. lost tion facility in Philadelphia; and Bethlehem
less than 2 percent of its jobs, Pennsylvania and Steel closed its division in Johnstown, Pennsyl­
Delaware lost 2.4 percent and 2.7 percent, re­ vania, eliminating 1900 jobs.
spectively. New Jersey had the highest per­
The continuing job losses beyond the end of
centage of job losses; the
state lost almost one out of
FIGURE 3
every 14 jobs between 1989
and 1992.
Distribution of Job Losses
Job losses in the District
in Three District States
were spread across every
1990:1 to 1992:1
sector of the economy (Fig­
ure 3). The goods-producGovernment
ing industries took the big­
( 1.1%)
gest hit, as they typically do
in any recession. More than
three-quarters of the jobs
lost in our states were in
construction and manufac­
turing, even though they
account for less than onefourth of the jobs. A larger
than usual percentage of the
job losses in this recession,
however, were in the ser­
vice-producing industries.
In every other recession
during the last 20 years, the



7

BUSINESS REVIEW

MAY/JUNE 1993

the national recession meant that unemploy­ in October 1992 to almost 39 percent in Febru­
ment rates in most of the District did not peak ary of this year. That means that 39 percent
until mid-1992. Except for Delaware, the state more manufacturing firms reported increases
unemployment rates in the District are again in current business activity than reported de­
higher than the national average, as they were creases in activity. A similar index from our
in the 1970s and early 1980s. Pennsylvania did quarterly survey of all types of firms in south­
not quite have the boom times in the 1980s that ern New Jersey rose from 12 percent in the third
New Jersey did, and Pennsylvania hasn't fallen quarter to 34 percent in the fourth quarter.
Consumers in our region are also showing
as far during the past two years either.
Pennsylvania's unemployment rate, which had more faith in the recovery. The Conference
been quite a bit below the national average Board's Consumer Confidence Index for the
during the late 1980s, has more recently been mid-Atlantic region was up in the fourth quar­
very close to the national average. Within ter of last year and again in January, but fell
Pennsylvania and New Jersey we have a wide back a bit in February. This bears close watch­
range of unemployment rates. Some are in the ing because confidence in the region rose twice
5 to 6 percent range; others are over 10 percent. before in this recovery before falling back to
These differences across the states represent low levels (Figure 4).
Retail sales in the region have increased
differences in the mix of industries in these
since their cyclical low in early 1991. The
geographical areas.
The emerging recovery from the recession is improvement has not been as strong in New
uneven across the District. So far the low point Jersey as it has been in Pennsylvania. More­
for jobs in the District's three states combined over, the advance has been uneven over the
was September 1992. Employment was up past two years.
slightly in the fourth quar­
ter for the District as a whole.
FIGURE 4
I must caution, however,
Consumer Confidence
that we have had tempo­
rary improvements in the
Index 1985=100
job picture earlier in the na­
tional recovery only to see
the gains evaporate, so we
continue to closely monitor
the job picture in the region.
OTHER DISTRICT
INDICATORS
Other indicators give
some evidence of a pickup
in economic activity in sev­
eral sectors in the District.
The index of current activ­
ity from the Philadelphia
Fed's monthly Business Out­
look Survey of manufactur­
ers rose from close to zero

8


Source: Conference Board
Shaded area represents recession.

FEDERAL RESERVE BANK OF PHILADELPHIA

Testimony on the Third District Economy and Monetary Policy

Edward G. Boehne

DISTRICT REAL ESTATE
The real estate sector in the District deserves
special mention because a full recovery in that
sector is probably still several years away.
There is no sign yet of a real recovery in the
commercial office market. In the mid-Atlantic
region, office construction, measured in square
feet, is down more than 75 percent from its peak
in 1987. In dollar terms it is down more than 60
percent. Office vacancy rates in the Philadel­
phia market remained high in 1992 despite the
lack of any new construction. Quoted rental
rates in the downtown Philadelphia market
were down in 1992 and were unchanged in the
suburbs.
High vacancy rates, lower rental rates, and
sales of some distressed properties have meant
that purchase prices per square foot in the
Philadelphia area have dropped dramatically.
The average price per square foot for properties
sold dropped from $94 per square foot in 1990

to $43 per square foot in 1992. Many of these
recent sales, however, are distress sales.
On the residential side, in contrast, a recov­
ery has been going on for some time, at least in
parts of the District. However, the increase in
housing starts has been neither steady nor
evenly distributed (Figure 5). The housing
recovery in New Jersey has been particularly
weak; housing starts there are only about 40
percent of their 1987 level. Although some of
the builders in southern New Jersey have re­
cently indicated improvement in activity, they
have also expressed concern that rising lumber
prices (which have gone up 40 to 50 percent in
a few months) could choke off the recent rise in
housing demand in the area.
M ost of the
improvement in housing has been in the single­
family market. With high vacancies and falling
real rents, there has been little incentive to
invest in rental housing. But there are some
signs that the rental market is stabilizing. In
1992 lan dlords offered
fewer incentives, such as
FIGURE 5
one-month's free rent or
Housing Starts
free parking, to renters.
U.S. and Three District States
BANK LENDING
Index 1987=100
IN THE DISTRICT
Bank lending was very
weak in the District in 1990
and 1991, as it was in the
nation as a whole, as the
recession reduced loan de­
mand and as deteriorating
asset quality led banks (and
regulators) to be more con­
servative in evaluating
lending opportunities. Real
estate lending was espe­
cially limited in the face of
declining property values.
The cost of financial inter­
Data are three-month moving averages.
mediation rose because of
Source: U.S. Dept of Commerce for U.S. data; F.W. Dodge for state data
increased capital require­
Shaded area represents recession.
ments and higher deposit




9

BUSINESS REVIEW

insurance premiums, and the deterioration in
loan quality increased the perceived risk of
default. These factors led, despite weak loan
demand, to a widening of spreads between
loan rates charged by banks and their cost of
funds.
I believe that we have started to see signs of
an improved environment for bank lending in
the District. We seem to be moving from a
credit crunch to credit caution. Banks have
increased their capital positions and reduced
their net charge-offs during the past two years,
and nonperforming loans as a percent of total
loans declined last year. Consequently, the
region's banks are now in a better position to
increase their lending as loan demand picks up.
Loans by banks in our region have, in fact,
increased somewhat during the past year in all
categories of lending: real estate, consumer,
and commercial and industrial. Banks also
reported at the beginning of this year that they
are beginning to see stronger loan demand
from middle-market firms and small businesses.
What's more, banks are becoming more active
in seeking out lending opportunities. For ex­
ample, at a recent meeting of builders in south­
ern New Jersey, some bank loan officers at­
tended the meeting—something we had not
seen during the previous two years. (In another
region of the District, one developer even re­
ported receiving a phone call from a banker
asking if the developer was interested in bor­
rowing money!) Banks in the region also are no
longer tightening credit standards, and some
banks reported an easing of their loan terms. I
expect to see further increases in lending over
the next year.
Nonetheless, there remain obstacles to the
resumption of normal borrowing relationships,
especially for small and medium-size busi­
nesses. In particular, we must find ways to
facilitate the so-called "character" loan by eas­
ing up, where prudent, on excessive documen­
tation and other costs that fall disproportion­
ately on small businesses.

10


MAY/JUNE 1993

SUMMARY OF DISTRICT ECONOMY
Overall, District economic activity has shown
improvement since September of last year. The
unemployment rate has declined in each of the
District's three states, and employment levels
are up in the District as a whole. Unfortunately,
employment has not risen very much since the
end of the national recession. What's more,
some large firms have announced major layoffs

that will affect our District. The District's
growth has lagged the rest of the nation during
most of the past two years, and I expect this
situation to continue during 1993. Even though
I expect employment to increase in each of the
District's three states, the improvement is likely
to lag behind gains in the nation as a whole.
Among the states in our District, growth in
New Jersey is likely to be weaker than in Dela­
ware and Pennsylvania.
MONETARY POLICY
Let me now turn from the District to mon­
etary policy. The Federal Reserve, against a
background of weak economic growth and
lessening inflationary pressures, has brought
short-term rates down to their lowest levels in
about 30 years. The federal funds rate has
declined by almost 7 percentage points since
early 1989 (Figure 6). Monetary policy began to
ease more than a year before the onset of the
1990 recession; it eased substantially during the
recession; and it continued to ease during the
sluggish recovery. By this point in past reces­
sion/recovery periods, the federal funds rate
had, on average, risen from its low point a few
months after the trough of the business cycle
(Figure 7). In contrast, in this most recent
recession/recovery period the federal funds
rate has continued to decline since the trough of
the recession in March of 1991. This further
decline of short-term interest rates reflects a
continued easing of monetary policy that has
been entirely appropriate given the weak
growth of employment and real GDP through
much of this recovery. Because employment
FEDERAL RESERVE BANK OF PHILADELPHIA

Edward G. Boehne

Testimony on the Third District Economy and Monetary Policy

FIGURE 6

Discount Rate and Federal Funds Rate
1989-1993
Percent

1989

1990

1991

1992

1993

FIGURE 7

Federal Funds Rate Relative to Its Levels
at Recession Troughs
1990-91 Recession vs. Post-War Recessions*
Percent

* Average of recessions from 1960 to 1989, excluding 1980 recession.




and real GDP growth have
been weaker during this re­
covery than in previous
ones, monetary policy has
been unusually accommo­
dative in continuing to bring
down short-term rates to try
to get the economy growing
at a more sustainable pace.
With core inflation (that is,
the CPI excluding food and
energy) somewhat above 3
percent during the past two
years and short-term rates
falling to around 3 percent,
short-term real rates (that
is, short-term rates adjusted
for core inflation) have been
close to or a little below 0
percent since the trough of
the recession, whereas in
previous recessions the real
federal funds rate has typi­
cally risen by now and be­
come positive.
The pattern of declining
short-term interest rates
during this recession/recovery period has been in
marked contrast to the be­
havior of M2 money growth.
M2 growth has been very
sluggish in comparison to
past recoveries despite the
continued easing of mon­
etary policy. Since M2's re­
lation sh ip to econom ic
growth has been changing
in ways that we do not fully
understand, M2 has become
a less reliable guide for mon­
etary policy. Indeed, the
pace of economic activity in
1992 was much faster than
could have been anticipated
li

BUSINESS REVIEW

MAY/JUNE 1993

using the historical relationship between M2, reduced private sector credit demands as the
economy went into recession, contributed to
income, and interest rates.
The pace of economic activity improved these reductions in long-term interest rates.
The decline in actual inflation and in expec­
substantially over the last two quarters of 1992,
and, as noted in Chairman Greenspan's testi­ tations of future inflation was another very
mony to this Committee on February 19, the important contributor to the decline in long­
central tendency of the governors' and Reserve term interest rates over the past several years.
Bank presidents' forecasts is for real GDP to Unlike the expansions of the 1970s, when the
grow 3 to 3.25 percent during 1993, with the rate of inflation rose in stepwise fashion from
unemployment rate continuing to decline to one business cycle to the next, average inflation
around 6.75 to 7 percent. In light of the still rates have not exhibited a tendency to acceler­
substantial degree of slack in the economy, I ate during the long expansion of the 1980s and
would not be concerned by somewhat faster the recovery so far in the 1990s (Figure 8).
Not only did actual inflation remain rela­
growth than this.
Much of the growth in output during 1992 tively low in 1991 and 1992, but expectations of
reflected sharp gains in productivity rather long-term inflation fell as market analysts came
than gains in labor input. This high rate of to believe that the economy would not experi­
productivity growth is welcome news in one ence a resurgence of inflationary pressures.
sense, in that it improves our nation's competi­ Based on a survey of economic forecasters in
tive position in world markets. But these pro­ business and academia, the rate of inflation
ductivity gains over the past two years have expected to prevail over the next 10 years fell
meant that employment has
not risen very much so far
during this recovery. Pro­
FIGURE 8
ductivity gains as large as
Inflation During Business Expansions
those in 1992 are unlikely
Consumer Price Index
to persist in 1993, and con­
sequently I expect that em­
Percent
ployment growth will be
more substantial this year
10
than last.
One factor that will be
especially important in con­
tributing to continued, and
perhaps even stronger,
5
growth during 1993 is the
recent decline in long-term
interest rates. By the end of
last year, long-term inter­
0
est rates had already de­
1955 1960 1965 1970 1975 1980 1985 1990 1995
clined substantially from
their peak in early 1989.
The continued easing of
Note: Average annual inflation rates from business cycle trough to business
monetary policy in 1990,
cycle peak, except for last bar, which shows 1991 trough to end of 1992.
1991, and 1992, along with
Digitized 12 FRASER
for


FEDERAL RESERVE BANK OF PHILADELPHIA

Testimony on the Third District Economy and Monetary Policy

Edward G. Boehne

This has resulted in a significant reduction in
long-term interest rates in recent weeks. This
reduction should be a big help to the housing
market and other interest-sensitive sectors of
the economy during 1993. Consequently, I am
more optimistic about the future path of eco­
nomic growth and employment than I was at
the beginning of the year.
Nonetheless, the economy continues to face
some serious obstacles to growth. A major
concern is that employment is not rising commensurately with the rise in economic activity.
Further increases in employment would help
ensure that an expansion in the economy will be
self-sustaining. In addition, several structural
impediments to the economy remain with us.
The overhang of commercial office space, still
high debt burdens of some households and
firms, substantial cutbacks in defense spend­
ing, and the continued restructuring and lay­
offs of workers by some
firms, all will continue to
hold back the growth of the
FIGURE 9
economy to some extent in
Long-Term Expected Inflation
1993. Keeping long-term
interest rates low will con­
Percent
tinue to be important in
6.0
helping to ease the debt bur­
dens of firms and house­
5.5
holds and in offsetting some
of these other impediments
5.0
to economic growth.
4.5
The objective of mon­
etary policy is to help maxi­
4.0
mize sustainable growth in
output, jobs, and living stan­
3.5
dards. Keeping inflation
low is a necessary ingredi­
3.0
ent for maximizing sustain­
1986
1987
1988
1989
1990
1991
1992
1993
able econom ic and job
growth. Low inflation pro­
motes long-term planning
Source: Expected CPI inflation rate over next 10 years, based on survey of
business and academic forecasters. Prior to 1991/Q 2, Richard Hoey's Deci­
and investment by keeping
sion-Makers Poll; 1991/Q 2-1991/Q 3, Livingston Survey; 1991/Q 4-1993/Q 1,
long-term interest rates low.
Survey of Professional Forecasters (Federal Reserve Bank of Philadelphia).
We now have inflation rates

nearly a full percentage point from about 4.4
percent in early 1990 to 3.5 percent last month
(Figure 9). This reduction in expected inflation
undoubtedly has been a major factor in helping
to reduce long-term bond and mortgage rates.
But at the current 3.5 percent level, long­
term expected inflation is still somewhat above
the actual rate of 3 percent CPI inflation expe­
rienced over the past two years. I expect
inflation will decline below 3 percent in 1993
and 1994, helping to bring expected inflation
down further and helping to keep long-term
interest rates low.
Proposed changes in fiscal policy also have
contributed to low long-term rates. The
Administration's long-term deficit reduction
proposal has received a generally favorable
reaction in financial markets. Evidently, the
markets view it as a credible plan to reduce the
federal government's future demands for credit.




13

BUSINESS REVIEW

back to levels of the 1960s, and these levels will
help to keep long-term interest rates low. Re­
ducing the federal budget deficit is another
critical ingredient to achieving low long-term
interest rates. For that reason, the current focus
of fiscal policy on deficit reduction is a welcome

14



MAY/JUNE 1993

development. In combination, these policies—
both fiscal and monetary— will help to support
expansion of the economy while also support­
ing improved living standards and low infla­
tion over the long term.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument
for Interstate Branching
Paul S. Calem*
In te r s ta te banking in the United States, an
impossibility for many years, became a reality
in the 1980s with the passage of state laws
authorizing bank holding companies to expand
across state lines. All but two states now allow
an out-of-state holding company to acquire an
in-state bank, and most large banking organi-

* Paul Calem is a senior economist and research adviser in
the Research Department of the Philadelphia Fed. He
thanks Gary Bosco of the Conference of State Bank Supervi­
sors for providing information on states' branching laws.




zations now have subsidiaries in several states.
However, a significant barrier to interstate ex­
pansion still exists. It is not yet permissible for
individual banks to establish branch networks
that cross state boundaries. Interstate expan­
sion is possible only at the holding company
level.
This remaining obstacle to interstate bank­
ing is critical because it can raise banks' costs of
expanding interstate and also limit the poten­
tial benefits to consumers. Maintaining an
independent, out-of-state subsidiary can be
more costly for an institution than operating a
15

BUSINESS REVIEW

cross-state branch network.1 And branch net­
works provide particular convenience benefits
to consumers. Most important, while consum­
ers can deposit funds into their accounts at any
branch of their bank, they cannot make depos­
its via an out-of-state affiliate of their bank.
Removal of the legal impediments to inter­
state branching surely would lead to the cre­
ation of interstate branch networks, in part
because some bank holding companies cur­
rently operating interstate would choose to
merge subsidiary banks. This geographic ex­
pansion would benefit consumers of banking
services. Consumers in multistate areas would
gain easier access to their bank accounts and
related services. In addition, interstate branch­
ing would be procompetitive. For instance,
blanket repeal of federal interstate branching
restrictions would enable national banks to
enter out-of-state markets by establishing new
branches there.2 Such de novo entry (as op­
posed to entry via acquisition) would tend to
make a market more competitive, especially in
the case of markets that, prior to entry, had been
dominated by a small number of institutions.
As a result, consumers in these markets would
likely be offered more favorable rates and fees.3

1For elaboration on this point, see Mengle (1990) and
Svare (1992).
2 Whether restrictions on interstate branching by na­
tional banks will be repealed without conditions remains to
be seen. Some proposals would repeal existing federal
restrictions but allow individual states to pass laws that
restrict interstate branching. Given such authority, some
states might opt to forbid the establishment of de novo
interstate branches. See Mengle (1990) for discussion of
alternative proposals.
3 The relationship between structure, conduct, and per­
formance in banking markets has been studied extensively.
There is general agreement that markets dominated by a
few institutions tend to be less competitive, with banks in
those markets offering lower deposit rates and having higher
fees and loan rates. See, for example, Calem and Carlino
(1991) and Hannan (1991).

Digitized16 FRASER
for


MAY/JUNE 1993

Despite these potential benefits to consum­
ers, interstate branching proposals have gener­
ally been opposed by consumer advocates.4 In
part, this opposition has arisen because the
benefits have not been thoroughly articulated.
More important, opponents of interstate branch­
ing fear that it would lead to domination of
local markets by large multistate banks. They
are concerned that these institutions would be
less willing to lend to small local businesses and
would be less responsive to community needs
in general.
This article examines the various pros and
cons of geographic deregulation, focusing on
the potential impact of interstate branching on
consumer convenience, competition, and credit
availability. There are, of course, other matters
relevant to interstate branching. For example,
by lowering the costs of geographic expansion,
interstate branching may enable banks to re­
duce the riskiness of their loan portfolios through
further geographic diversification.5 My inten­
tion, however, is to examine only those issues
that directly affect retail and small-business
customers. Indeed, recent debate over inter­
state branching has emphasized such consumer
issues.6
THE CURRENT STATUS
OF INTERSTATE BANKING
Banking deregulation during the 1980s loos­
ened the constraints on interstate banking con­
siderably. Unlike other major regulatory initia­

4 See, for example, the statements by representatives of
the Consumers Union, the Consumer Federation of America,
and the U.S. Public Interest Research Group before the
Subcommittee on Consumer Affairs and Coinage, U.S. House
of Representatives (U.S. Congress 1991).
5 For discussion of this issue and other considerations
related to interstate branching, see Mengle (1990) and U.S.
Congress (1991).
6 See U.S. Congress (1991).

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

tives during this period, such as the lifting of
ceilings on deposit interest rates, interstate
banking reform occurred at the state rather
than the federal level. Since 1956, the Douglas
Amendment to the federal Bank Holding Com­
pany Act has prohibited interstate acquisitions
by bank holding companies, except where au­
thorized by the acquired bank's home state.
During the 1980s, most states changed their
laws to permit entry by out-of-state bank hold­
ing companies.
Only two states, Hawaii and Montana, have
yet to adopt a law allowing entry by an out-ofstate holding company.7 Thirty-five states now
permit entry on a nationwide basis, with the
stipulation (in most cases) that the entering
bank's home state have a reciprocal law. Four­
teen states (plus the District of Columbia) allow
entry on a regional reciprocal basis.8
One significant limitation of these interstate
banking laws is that most states do not allow
out-of-state holding companies to establish de
novo bank subsidiaries in the state. Rather,
entry by out-of-state banking organizations is
restricted to acquisitions of existing banks. Only
19 states allow de novo entry.9
Geographic deregulation during the 1980s

7 Hawaii permits entry by institutions from Guam,
American Samoa, and several other Pacific territories, sub­
ject to reciprocity.
8The District of Columbia also allows entry on a nation­
wide basis for institutions outside the D.C. region that meet
certain community reinvestment and job creation require­
ments. For details on each of the state laws, see "State Laws
Gain Renewed Significance as Congress Stumbles," Bank­
ing Policy Report, January 6,1992, pp. 10-14, and "A Look at
Laws Granting Interstate Powers to Banks," American Banker,
March 20,1992, p. 8.
9 The states allowing de novo entry are Arizona, Colo­
rado (effective July 1,1993), Connecticut, Maine, Maryland,
Massachusetts, Michigan, Minnesota, Nevada, New Hamp­
shire, New Jersey, New Mexico, New York, Ohio, Pennsyl­
vania, Rhode Island, South Dakota, Texas, and Vermont.




Paul S. Calem

resulted in numerous interstate mergers and
acquisitions, transforming the structure of the
banking industry. One dramatic consequence
of this merger activity has been the creation of
so-called "superregionals." Huge multistate
organizations emerged from consolidations
involving two or more large banks, as in the
case of NationsBank Corporation in the South,
or through the acquisition of many smaller
banks by a major institution, as in the case of
Banc One Corporation in the North Central
region.
A list of the 25 largest banking organizations
in the U.S. and the states in which they operate
bank subsidiaries (Table 1) shows that almost
all large banking organizations now have sub­
sidiaries in several states.
Many smaller organizations also have ex­
panded interstate. For example, 14 bank hold­
ing companies headquartered in Pennsylvania
or New Jersey operate out-of-state bank sub­
sidiaries. These institutions (Table 2) range in
size from $240 million to $52 billion in assets;
seven of them have less than $2 billion in assets.
Restrictions on Interstate Branching. While
bank holding companies can now cross state
lines, various legal obstacles preclude inter­
state branching by commercial banks.1 Fore­
0
most among these is the McFadden Act, a
federal law dating from 1927 that rules out
interstate branching by national banks.1 The
1

10 Federally chartered thrifts, on the other hand, are no
longer subject to such a restriction. The Office of Thrift
Supervision, in April 1992, adopted a rule allowing full
nationwide branching for healthy federally chartered sav­
ings and loan institutions.
11 For an overview of the history of branch banking in the
U. S., including further discussion of the McFadden Act, see
Mengle (1990). A loophole in the act allows a national bank
to relocate its headquarters up to 30 miles, even across a
state line. U.S. Bancorp recently exploited this loophole to
branch from Oregon into Idaho. See "Fed Gives Interstate
Issue a Push by Easing Bank Relocation Rule," American
Banker, February 27,1992, p. 1.

17

BUSINESS REVIEW

MAY/JUNE 1993

TA BLE 1

25 Largest Banking Organizations and States
in Which They Operate Bank Subsidiaries
(as of 12/31/92)
Name of Institution

Region3

Total Assets
(millions $)

1 Citicorp

213,701.0

AZ, CA, CO, DE, FL, MD, ME, N V, NY, SD

2 BankAmerica Corp.

180,814.0

AZ, CA, ID, NV, OR, TX, WA

3 Chemical Banking Corp.

134,655.0

DE, NJ, NY, TX

4 NationsBank Corp.

119,805.0

DC, FL, KY, MD, NC, SC, TN, TX, VA

5 J.P. Morgan & Co., Inc.

102,941.2

DE, NY

6 Chase Manhattan

95,862.3

AZ, CT, DE, FL, MD, NY

7 Bankers Trust New York Corp.

72,448.0

DE, FL, NY

8 Banc One Corp.

61,331.6

IL, IN, KY, MI, OH, TX, WI

9 Wells Fargo & Co., Inc.

52,536.9

CA

10 PNC Financial Corp.

51,523.0

DE, KY, NJ, OH, PA

11 First Union Corp.

51,326.6

FL, GA, NC, SC, TN

12 First Interstate Bancorp, Inc.

50,863.1

AK, AZ, CA, CO, ID, MT, NV, NM, OR,
TX, UT, WA, WY

13 First Chicago Corp.

49,281.0

DE, IL, WI

14 Fleet Financial Group, Inc.

47,121.5

CT, MA, ME, NH, NY, RI

15 Norwest Corp.

44,557.1

CO, IA, MN, MT, ND, NE, SD, WI, WY

16 Bank of New York Co., Inc.

41,023.0

DE, NY

17 NBD Bancorp, Inc.

40,843.2

FL, IL, IN, MI, OH

18 Barnett Banks, Inc.

39,631.0

FL, GA

19 SunTrust Banks, Inc.

36,647.2

FL, GA, TN

20 Wachovia Corp.

33,356.1

DE, GA, NC, SC

21 Bank of Boston Corp.

32,346.1

CT, FL, ME, MA, RI

22 Mellon Bank Corp.

31,540.7

DE, MD, PA

23 First Fidelity Bancorporation

31,481.6

NJ, NY, PA

24 National City Corp.

28,963.5

FL, IN, KY, OH

25 Comerica, Inc.

26,660.0

CA, MI, OH, TX

aExcept in the case of PNC Financial and Mellon, the Delaware subsidiaries of institutions listed in the table are
limited-purpose banks.

18



FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

Paul S. Calem

TABLE 2

Banking Organizations Headquartered in NJ or PA That
Have Out-of-State Bank Subsidiaries3
(as of 12/31/92)
Name of Institution

Total Assets
(millions $)

Locations of Subsidiaries

PNC Financial

51,523.0

DE, KY, MA*, NJ, OH, PA

Mellon Bank Corp.

31,540.7

DE, MA*, MD, PA

First Fidelity Bancorporation

31,481.6

CT*, NJ, NY, PA

CoreStates Financial Corp.

23,774.4

NJ, PA

Midlantic Corp.

14,423.1

NJ, NY, PA

UJB Financial Corp.

13,794.6

NJ, PA

Meridian Bancorp, Inc.

12,221.1

DE, NJ*, PA

Susquehanna Bancshares

1,727.9

MD, PA

F.N.B. Corporation, Inc.

1,698.6

OH, PA

Commerce Bancorp, Inc.

1,428.0

NJ, PA

B.M.J. Financial Corp.

655.1

NJ, PA

State Bancshares

557.4

NJ, PA

Vista Bancorp

336.9

NJ, PA

Glendale Bancorporation

236.7

NJ, PA

a Limited-purpose banking subsidiaries are not considered.
*As of this writing, this institution has signed a deal to acquire a bank in this state. Total assets reported in the
table do not reflect this proposed transaction.

Federal Reserve Act applies this constraint to
state-chartered banks that are members of the
Federal Reserve System. Moreover, all but five
states generally prohibit the operation of in­
state branches by out-of-state banks.1
2
Proposals to permit nationwide interstate
branching were considered by Congress dur­
ing 1991. These measures were included as part
of comprehensive proposals to restructure regu­
lation of the banking industry. For instance, the



Treasury Department submitted a banking re­
form bill that would have authorized interstate

12
According to the Conference of State Bank Supervi­
sors, out-of-state banks are allowed to establish branches in
Alaska, Massachusetts, Nevada, New York, and Rhode
Island (but in Massachusetts and Rhode Island, only entry
via branch acquisition is permissible). These laws, in effect,
authorize entry by state-chartered banks that are not mem­
bers of the Federal Reserve System. In addition, "Florida

19

BUSINESS REVIEW

branching by national banks. In addition, the
bill would have allowed banking organizations
to engage in a broader range of financial activi­
ties, and it would have permitted nonfinancial
firms to own banks within a "diversified hold­
ing company" structure. But comprehensive
restructuring was put on hold. Instead, Con­
gress decided to grapple with the more press­
ing issues of deposit insurance reform and
recapitalization of the FDIC's bank insurance
fund.
In 1992, Treasury tried to rally support for a
narrower bill that would have permitted na­
tionwide branching and limited insurance ac­
tivities. Because of disagreements among bank­
ers and between the banking and insurance
industries over the specifics of such a bill, no bill
was introduced. N evertheless, interstate
branching remains a key topic on the banking
reform agenda, one which Congress is likely to
revisit in the future.
INTERSTATE BRANCHING
AND CUSTOMER CONVENIENCE
One need not be an economist to surmise
that branch networks provide convenience in

allows an outsider to branch into the state via merger or
acquisition if its home state has a reciprocal law" (American
Banker, December 16,1992, p. 2.)
I am aware of at least one instance in which a state
regulatory agency approved an interstate branch acquisi­
tion in a state where such transactions are permitted only
under exceptional circumstances. This was the case in
Pennsylvania in February 1992, when the state Department
of Banking and the FDIC allowed Wilmington Trust Com­
pany, a Delaware Bank, to merge with a failed Pennsylvania
bank and operate its sole office as a branch. The department
has not yet ruled on whether current state law would allow
Wilmington Trust to establish additional branches in Penn­
sylvania now that it has obtained a foothold.
There are a few interstate bank branches around the
country that were established before either state or federal
laws forbade them and that have been "grandfathered," i.e.,
permitted to remain in operation. For instance, Midlantic
Bank, a New Jersey bank, operates a "grandfathered" branch
in downtown Philadelphia.

20



MAY/JUNE 1993

the form of greater access to accounts and
related services across the geographic area cov­
ered by the network. Clearly, then, interstate
branching would enhance the convenience of
bank customers who frequently cross state lines.
In addition, interstate branching would benefit
businesses that require banking services at di­
verse locations in more than one state. A
further potential convenience benefit is some­
what more subtle. Economic reasoning and
empirical evidence indicate that interstate
branching will tend to have a favorable impact
on branch coverage, i.e., on the total number of
bank branches serving a given area.
Enhanced Convenience for Consumers in
Multistate Areas. Anyone who frequently
crosses a state line, for work, for shopping, for
business or pleasure, stands to benefit from
interstate branching. Interstate branching
would provide these customers with conve­
nient access to their accounts and related bank­
ing services.
Current restrictions on interstate branching
adversely affect such customers in two ways.
First, these restrictions may keep some banking
institutions from expanding interstate, since
expansion at the holding company level can be
more costly. Second, interstate banking at the
holding company level cannot provide the same
level of convenience as interstate branching. In
particular, a consumer cannot deposit funds
into his or her account through an out-of-state
affiliate of his or her bank, and certain accountspecific services such as check-cashing may not
be obtainable at branches of an affiliate.1
3
Bank branching is important to customers
for a number of reasons. First, small-business
customers are very dependent on branch bank­
ing, both for teller transactions and for special
13
The McFadden Act (as it has been interpreted) also
prevents a bank from accepting deposits through out-ofstate ATMs. Thus, repeal of the act would enable consumers
to deposit funds into their bank accounts at out-of-state
locations through ATMs.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

services such as night depository, account rec­
onciliation, and financial counseling.1 Second,
4
despite teller machine networks, the typical
retail customer regularly visits a brick-andmortar branch to conduct transactions.1 Third,
5
consumers may save on transactions fees by
using automated teller machines located at
branches of their banks, since banks usually
charge higher fees for transactions at ATMs
that are "nonproprietary" (owned by other
banks).1
6
The number of people in the U.S. living and
working in multistate areas who are apt to
benefit from interstate branching is substantial.
Six consolidated metropolitan statistical areas
(CMSAs) and an additional 28 metropolitan
statistical areas (MSAs) cross state boundaries,

14 According to a 1989 survey, more than 20 percent of
small-business owners or officers visit their branch daily on
behalf of the company. Forty percent are in the branch once
a week or more; 88 percent report that branch employees
know them by name; only 3 percent never visit a branch.
Other small-business employees also make frequent branch
visits on behalf of their company. See Trans Data Corpora­
tion (1989a).
15 According to a 1989 survey, 95 percent of consumers
visit a branch at least once each month to conduct transac­
tions. Per household, the average number of trips to a
branch is about three per month; branch visits are more
frequent among higher income households. Close to half of
the respondents (47 percent) reported that they do not use
teller machines, and of these households, almost 60 percent
indicated that "nothing could get them to use an ATM." See
Trans Data Corporation (1989b).
16 According to a 1988 survey, less than 20 percent of
ATM-offering banks and thrifts (having more than $750
million in deposits) charged "us-on-us" transaction fees,
and only 1 percent planned to add such fees in 1989. How­
ever, over 60 percent of such institutions charged for "uson-others" transactions, and 12 percent more planned to
begin charging such fees in 1989. The mean "us-on-us"
transaction fee for institutions charging such fees was 21
cents, while the mean "us-on-other" fee for institutions
charging such fees was 70 cents. See Trans Data Corpora­
tion (1988).




Paul S. Calem

and approximately 66 million people reside in
these multistate metropolitan areas, according
to the 1990 U.S. Census.1
7
In addition to benefiting bank customers in
localities that straddle state boundaries, inter­
state branching would be advantageous to cus­
tomers who require banking services at diverse
locations in two or more states, primarily busi­
nesses with multistate operations. Under cur­
rent branching restrictions, such a customer
may be pressed to maintain relationships with
multiple banks. For instance, a business may
have to maintain checking accounts at several
banks, which may complicate the firm's cash
management and increase its fee expenses.1
8
Increased Branch Coverage. The value to a
bank of adding a branch at a particular location
depends on the branch's potential to attract
new depositors and borrowers and its potential
convenience benefits to current customers.
Legal restrictions on branching may prevent
some banks from realizing their full branching
potential. Locations where these banks would
have established branches will be left unserved,
unless other banks are willing and able to locate
there, which will not always be the case.1
9
Under current restrictions on interstate branch­
ing, an out-of-state bank holding company can
create a new bank subsidiary to operate a
branch. But creating a new bank subsidiary can
be more costly and of less convenience value

^Consolidated metropolitan statistical areas and met­
ropolitan statistical areas are constructs defined by the U.S.
Office of Management and Budget.
18 According to Nakamura (1993), "in general, large
firms have multiple relationships with banks. [Surveys of
large corporations] show how complex these relationships
can be." In part, these multiple banking relationships are a
consequence of restrictions on bank branching.
19 Other banks may not attach as much value to the
additional branch or may have to incur higher costs to
operate the branch.

21

BUSINESS REVIEW

than adding a branch to an existing network.
Thus, branching restrictions tend to reduce
total branch coverage. By this reasoning, we
can expect that repeal of interstate branching
restrictions would have a beneficial impact on
branch coverage because banks would estab­
lish branches at previously unserved locations
as they expand interstate.
Empirical support for this line of reasoning
is found in studies that investigate the factors
determining bank branch coverage. Evanoff
(1988) analyzes 1985 data on branch coverage
for each county in the 48 contiguous states. He
finds fewer branches per square mile in states
with legal restrictions on branching, holding
constant other factors such as whether the
county is rural or urban. Similarly, Calem and
Nakamura (1993), using 1990 data and control­
ling for a wide range of factors, find reduced
branch coverage in states with highly restric­
tive branching laws. They find that, on aver­
age, branching restrictions entailed one less
branch in non-MSA counties and 13 fewer
branches in urban counties, holding county
population, population density, and other fac­
tors constant.2
0
INTERSTATE BRANCHING
AND COMPETITION
Some opponents of interstate branching have
argued that b ran ch in g restrictio n s are
procompetitive, as they prevent large banks
from acquiring smaller banks and turning them
into branches. Thus, these restrictions help
keep banking markets from becoming too con­
centrated.2 This argument is less than convinc­
1

20Non-MS A counties in states without restrictive branch­
ing laws had a mean of 9 branches, while MSA counties in
those states had a mean of 58 branches.
21 Market concentration refers to the number and size
distribution of firms in a market. More concentrated bank­
ing markets tend to be less competitive (see footnote 3).


22


MAY/JUNE 1993

ing, for two reasons. First, many of the mergers
or acquisitions that would take place under
in terstate b ran ch in g w ould occur in
unconcentrated markets or would be between
banks operating in distinct markets or between
banks that are subsidiaries of the same holding
company. In general, such consolidations would
not substantially raise concentration in bank­
ing markets. Second, federal bank regulators
and the U.S. Department of Justice have the
authority to block any acquisition or merger
deemed to have anticompetitive effects. Hence,
branching restrictions are not needed to pre­
vent excessive market concentration.2 *
2
On the contrary, economic reasoning sug­
gests that the lifting of interstate branching
restrictions would benefit consumers by fur­
thering competition in banking markets. The
potential for banks to expand their branch
networks across state lines could enhance com­
petition in several ways. First, banks would be
able to engage in nonprice competition more
efficiently; some banks would be freed from
having to provide convenience in forms that
are more costly and less satisfactory than
branching. The cost-savings would be passed
on to consumers through lower prices. Second,
for reasons discussed below, a bank establish­
ing an extensive, multimarket branch network
might opt to institute uniform pricing (uniform
fees and interest rates) across disparate local
markets by aligning prices in concentrated
markets with those in competitive locales. Thus,
branching tends to reduce price differentials
between concentrated and competitive mar-

22
Under the Bank Merger Act and the Bank Holding
Company Act, federal bank regulators must analyze the
competitive effects of proposed mergers and acquisitions of
banks and bank holding companies. If a proposed merger is
expected to have a substantially adverse effect on competi­
tion, the merger application would be denied. In addition,
the Justice Department has the authority under antitrust
statutes to block anticompetitive mergers or acquisitions.

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

kets. Third, in many instances banks will choose
to branch interstate by establishing de novo
branches, thereby reducing concentration in
the targeted markets. Let us elaborate on each
of these arguments in turn.
Branching and Nonprice Competition. In
markets where branching restrictions impose
inconveniences on bank customers, banks may
be compelled, through competition, to partly
"compensate" their customers for these incon­
veniences. Such nonprice competition could
take the form of longer banking hours, more
tellers per branch, or other amenities that would
mitigate the loss of convenience due to limited
branching.
Providing such services drives up bank costs
and results in higher fees and lower deposit
interest rates for bank customers. Neverthe­
less, many bank customers will prefer some
such nonprice "com pensation" for lack of
branching, even if they have to pay for it with
higher fees. Banks would compete for these
customers by providing them with the various
amenities.2
3
In this sense, interstate branching restric­
tions may engender inefficiency in the provi­
sion of banking services, at least in markets that
straddle state boundaries. Such restrictions
may force banks to substitute less suitable and
more expensive forms of convenience for their
customers, who, in turn, would have to pay
higher fees or accept lower deposit interest
rates. With the lifting of such restrictions,
nonprice competition would become more effi­
cient. Through interstate branching, banks
would be able to provide their customers with

Paul S. Calem

greater accessibility and convenience, at a lower
cost.2
4
Branching and Intermarket Price Differen­
tials. For several reasons, a bank having an
extensive, multimarket branch network might
opt to institute uniform pricing across dispar­
ate local markets by aligning prices in concen­
trated markets with those in competitive lo­
cales. One important motive for a bank to
centralize pricing decisions is to economize on
managerial or coordination costs. Uniform
pricing may also enable the bank to save on
advertising costs. In addition, the bank may
want to institute uniform pricing across a
multimarket area as a benefit to customers who
reside in the area's largest banking market (the
regional economic center), many of whom may
regularly visit and conduct transactions at other
localities in the area. A bank may be motivated
to do so if the regional economic center is also
the area's most competitive banking market.2 *
5
To the degree that branching motivates uni­
form pricing across multimarket areas, it tends
to reduce price disparities between concen­
trated and competitive markets. Thus, when
banks can branch freely across local markets,
deposit interest rates in concentrated markets
tend to be higher, and fees and loan rates lower,
than they would be in the absence of branching.
Through branching, competition is "exported"
to concentrated markets. In this way, allowing
banks to b ran ch in terstate w ould be
procompetitive.
The preceding argument establishes in theory
that bank branching furthers competition. But
is this effect of branching on competition sig-

23
Of course, there may be some customers for whom 241 am grateful to Sherrill Shaffer for suggesting the idea
that branching restrictions may cause inefficient nonprice
limited branching imposes minimal inconvenience. These
competition.
customers would not require compensation for lost conve­
nience. A bank may choose to specialize in serving these
25 For a formalization of this argument, see Calem and
customers by defining itself as a "no-frills" bank, offering
Nakamura (1993).
lower fees and /or higher rates but few amenities.




23

BUSINESS REVIEW

MAY/JUNE 1993

nificant in practice? Empirical evidence indi­
cates that it is. In particular, comparison of unit
banking states to branching states with respect
to within-state, cross-market differences in bank
deposit interest rates indicates larger differen­
tials in unit banking states. This is precisely
what one would expect to find if branching is
accompanied by consistency in pricing across
local markets.
Table 3 reports statistics pertaining to withinstate, cross-market differences in money mar­
ket deposit account interest rates. The statistics
are based on Federal Reserve survey data from
1985.2 We compute the mean and standard
6
error of these interest rate differentials for ran­
domly selected pairs of banks from states that,
in 1985, had severe restrictions on branching
(pairs from "unit banking states"), and we do
likewise for all other pairs (drawn from "branch­
ing states").2 Paired banks are drawn from
7
distinct markets within the same state. As
indicated in the table, cross-market interest
rate differentials are larger in unit banking

26 Data are obtained from the Federal Reserve's 1985
Monthly Survey of Selected
Deposits and Other Accounts.
We report statistics based on
bank MMDA rates averaged
over August, September, and
October.

states.2 This finding is consistent with the view
8
that branching reduces price disparities across
local markets.2 *
9
Additional evidence is found in Mester
(1987). Mester's study examines how competi­
tion among S&Ls varies across local markets in
California. The study presents evidence that
competition is "exported" to concentrated
markets where rival S&L branch networks meet.
Specifically, S&L deposit interest rates are found
to be lower in markets (counties or MS As) that
are highly concentrated, but this effect is less
pronounced if the m arket contains local
branches of statewide institutions.
Interstate Branching and De Novo Entry.
Nationwide interstate branching would fur­
ther stimulate competition to the extent that it
promotes de novo entry. In contrast to entry

28 The difference between the two means is statistically
significant at the 1 percent level.
29 Calem and Nakamura (1993) confirm this finding in
the more rigorous context of a multivariate analysis and
repeat the analysis using 1990 data, obtaining qualitatively
the same result.

TABLE 3

MMDA Interest Rate Differentials
for Randomly Paired Banks

27 As recently as 1985, 13
states had severe restrictions on
bank branching: Colorado, Illi­
nois, Iowa, Kansas, Minnesota,
Missouri, Montana, Nebraska,
N orth D akota, O klahom a,
Texas, West Virginia, and Wyo­
ming. In each of these states,
more than 97 percent of state­
wide deposits were in banks
with fewer than 10 branches.
Since then, each of these states
has eliminated or at least re­
laxed its in-state branching re­
strictions.

Digitized for24
FRASER


(Cross-Market Pairs)
Unit Banking States

Branching States

Mean Rate Differential

.38

.22

No. of Pairs in Sample

48

114

Standard Error

.06

.02

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

Paul S. Calem

via acquisition of an existing bank or branch,
the establishment of a de novo bank or branch
has an immediate, direct impact on market
concentration, increasing the number of com­
petitors.
Would the elimination of the legal constraints
on interstate branching lead to substantial de
novo entry into local banking markets? Very
likely the answer is yes, assuming that these
restrictions are lifted unconditionally or not in
a way that would result in legal obstacles to de
novo entry. De novo entry via branching can be
less costly than entry at the holding company
level via the creation of a new bank subsidiary,
which, in turn, generally is less costly than the
establishment of a new institution directly by
investors. Hence, elimination of legal con­
straints on interstate branching would expand
the number of potential de novo entrants into
any given banking market.3
0
Recent history provides evidence that eas­
ing of geographic constraints on banks is a
stimulus to de novo entry. In a carefully ex­
ecuted, empirical study covering the period
1976-1988, Amel and Liang (1993) find a sub­
stantial, positive relationship between the num­
ber of de novo bank branches established in a
state and the lifting of restrictions on in-state
branching or on entry by out-of-state bank
holding companies.3
1

have on the allocation of credit. Opponents of
interstate branching fear that large multistate
institutions will be less oriented toward small
businesses and will siphon funds away from
local community needs. Therefore, to the ex­
tent that small independent banks are replaced
by these large institutions, small businesses
will suffer.
There may be some truth to the notion that
smaller banks are more oriented toward smallbusiness lending than larger organizations. To
some degree, all banks function as "informa­
tion specialists," uniquely suited to evaluate
credit risks and monitor borrowers.3 Thus,
2
banks in general lend to a more diverse group
of borrowers than, for instance, the bond mar­
ket. Naturally, however, there are differences
among individual banks with respect to their
informational roles. In general, small banks
produce small-business loans more efficiently
than large banks, while large banks have a
comparative advantage at lending to mediumsize or large borrowers.33 Empirical evidence
shows that small businesses depend more
heavily on small or medium-size banks.3
4

IMPACT ON CREDIT ALLOCATION
Much of the controversy surrounding inter­
state branching concerns the impact it may

33 At large banking organizations the lending process
tends to be more streamlined, with lenders relying more
heavily on standardized underwriting formulas. This fa­
vors large and medium-size firms, which are better able to
supply information in a standardized form.
In a large multistate banking organization, local branch
personnel typically have little discretion in their decision­
making, while nonlocal personnel who are less constrained
may be less well informed about or less sensitive to the
needs of the local economy. Community banks, on the other
hand, tend to be more flexible, better able to acquire and
respond to specialized information about small local bor­
rowers.

30 Similarly, repeal of the Douglas Amendment, to allow
a bank holding company to establish a de novo subsidiary in
any state, would eliminate an additional, important barrier
to entry.
31 Amel and Liang also find that de novo bank entry into
local markets declined subsequent to relaxation of state­
wide branching restrictions, presumably because branch
entry is a less costly substitute for bank entry. However,
bank entry did not decline in this case as much as branch
entry increased.




32 See Calem and Rizzo (1992) for discussion of (and
empirical evidence on) the role of banks as information
specialists.

34 For example, according to Danielson (1992), Barnett
Banks (a Florida-based superregional) "claims relation­
ships with 42 percent of Florida companies with annual
25

BUSINESS REVIEW

MAY/JUNE 1993

But are small institutions in danger of disap­
pearing from the banking scene? Large institu­
tions may, indeed, enjoy a cost advantage rela­
tive to small, community banks, in part because
lending to small business may be a more costly
activity (involving higher expenses per dollar
loaned). Also, many small banks may have to
pay more for deposits because they do not offer
the convenience of a branch network (although
others may attract sufficient deposits by offer­
ing more personalized service as a substitute
for convenience). Large banks also may enjoy
economies of scale with respect to advertising
and marketing activities. Nevertheless, small
banks will continue to coexist with large insti­
tutions, even under interstate branching, as
long as they have a critical role to play in smallbusiness lending. That is, small banks would
remain profitable because small businesses
would be willing to pay for their services.
Thus, there is little reason to believe that
interstate branching will bring about the de­
mise of independent community banks. To the
extent that these banks are particularly respon­
sive to the needs of small businesses and local
communities, there will be enduring demand
for their services, and they will continue to
occupy profitable niches.
Indeed, thus far, fears that unfettered geo­
graphic expansion by large banking organiza­
tions would lead to the demise of community
banks have proven groundless. For example,
banks in California have enjoyed unrestricted
statewide branching since 1927, and the state
has had a regional interstate banking law since
1987; five of the 25 largest banking organiza-

tions in the U.S. currently operate subsidiaries
there. Nevertheless, California has 442 bank­
ing institutions having less than $1 billion in
assets, including 343 community banks with
less than $200 million in assets, and these banks
appear reasonably profitable.35 Another ex­
ample is Florida, which has permitted state­
wide branching for most of the last two dec­
ades, and which has had a regional interstate
banking law since 1984.36 As reported by
Danielson (1992), "four superregionals now
control more than half of the state's deposit
base. But these regional giants face stiff compe­
tition from more than 300 community banks."
Community banks have also held their own
vis-a-vis superregionals and other large banks
in North Carolina, which, like Florida, has long
had statewide branching and has had regional
interstate banking since 1984. In North Caro­
lina "roughly 90 banks with assets less than $1
billion registered an average return on assets of
1.05 percent for the first three quarters of last
y ear.... exactly the same as the nine banks with
assets of $1 billion or more."37*
Further, while smaller banks may be some­
what more oriented toward small-business lend­
ing than larger organizations, it is certainly not

sales exceeding $50 million, and with 30 percent of firms
with sales from $5 million to $49 million annually. Its share
with smaller companies, however, is only 12 percent, re­
flecting small bank strengths in this vital market."
Nakamura (1993) argues that smaller banks have a com­
parative advantage at lending to small borrowers. He
summarizes existing empirical evidence and presents new
evidence in support of this view.

36 Until 1990, Florida permitted statewide branching
only through merger.


26


35 Only 18 banking organizations in the state have more
than $1 billion in assets. These numbers are as of December
31,1992.
According to Zimmerman (1990), California's commu­
nity banks earn returns on assets "roughly comparable to
those of larger rivals." According to Zimmerman (1992),
after 1990, as the recession took hold and earnings at Cali­
fornia banks declined across all size categories, larger banks
suffered the steepest declines.

37 See Bill Atkinson, "Small Carolina Banks Thrive in a
Land of Giants," American Banker, February 9, 1993, p. 6.
Another state where community banks have held their own,
despite statewide branching by large banks, is New York.
See King (1985).

FEDERAL RESERVE BANK OF PHILADELPHIA

The Proconsumer Argument for Interstate Branching

the case that large banking organizations have
no stake in lending to small businesses. In fact,
according to Svare (1992), a number of large
interstate banking institutions, such as Albanybased K eyC orp and M in neap olis-based
Norwest, have strategically targeted consum­
ers and small to midsize businesses. These
institutions have sought to maintain flexibility
and a local orientation through decentralized
decision-making.
Large banks also engage in small-business
lending as a way to meet their responsibilities
under the federal Community Reinvestment
Act (CRA). The CRA requires that every bank
meet the credit needs of its entire community,
to a degree consistent with safe and sound
banking practices. Large banks' efforts to com­
ply with the CRA generally include lending to
small businesses and funding community de­
velopment projects.38 These efforts are likely to
increase in the future because regulators are
placing greater emphasis on banks' CRA obli­
gations. If, however, multistate banks come to
dominate some local market and act contrary to
the interests of the local community, that case
can be addressed through regulatory enforce­
ment of the CRA.
While interstate branching may have the
potential to harm local borrowers, it also has
the potential to benefit them. In particular, a
multistate bank may be in a better position to
import funds into a community to finance a
major local project. First, the geographically
diversified bank can tap into its deposit base
outside of the local community as an alterna­
tive to the national funds markets. Second,
larger banks may have access to larger amounts
of funds in the national markets, at lower cost,
as compared with small, community banks,
holding other factors (such as bank capital

Paul S. Calem

ratios) constant.39 Smaller banks may be per­
ceived as greater credit risks by the funds
markets because their asset portfolios tend to
be less diversified and because they are less
well known.40
CONCLUSION
Removal of legal barriers to interstate branch­
ing would benefit consumers of banking ser­
vices. Consumers in multistate areas would
gain more convenient access to their accounts
and related services. In addition, elimination of
these barriers would enhance competition in
banking, benefiting consumers through more
favorable interest rates and fees. Also, inter­
state branching may facilitate the importation
of funds into areas where credit demand is
particularly strong.
Interstate branching raises some concerns
regarding domination of local markets by large
multistate banks that would be less oriented
toward community credit needs. These con­
cerns have been overstated, however. The
evidence indicates that as long as there is suffi­
cient demand for the credit services of commu­
nity banks, there will be a profitable niche for
these banks to occupy. And most large inter­
state organizations will seek to remain respon­
sive to the needs of local customers.
As multistate organizations increase in num­
ber, size, and breadth, a few of them may
become insensitive to community credit needs.

39 For theory and evidence on the relationship between
bank size and access to the federal funds market, see Allen
and Saunders (1986) and Allen, Peristiani, and Saunders
(1989).

40 In addition, small-business borrowers, along with
other small-bank customers, will obtain the convenience
benefits described previously if small banks choose to branch
interstate. It seems very likely that some small banks in
multistate locales will establish out-of-state branches, just
as
38
For a detailed discussion of the CRA and related some small holding companies have chosen to establish
issues, see Calem (1989).
out-of-state subsidiaries (recall Table 2).




27

BUSINESS REVIEW

But through existing regulations governing
community reinvestment, regulators have the
ability to safeguard community interests. On

MAY/JUNE 1993

balance, available evidence indicates that the
removal of interstate branching restrictions
would be advantageous to consumers.

Allen, Linda, and Anthony Saunders. "The Large-Small Bank Dichotomy in the Federal
Funds Market," Journal of Banking and Finance 10 (1986), pp. 219-230.
Allen, Linda, Stavros Peristiani, and Anthony Saunders. "Bank Size, Collateral, and Net
Purchase Behavior in the Federal Funds Market: Empirical Evidence," Journal of Business
62 (1989), pp. 501-515.
Amel, Dean F., and J. Nellie Liang. "The Relationship between Entry into Banking Markets
and Changes in Legal Restrictions on Entry," draft, Board of Governors of the Federal
Reserve System (1993).
Calem, Paul S. "The Community Reinvestment Act: Increased Attention and a New Policy
Statement," this Business Review (July/August 1989), pp. 3-16.
Calem, Paul S., and Gerald A. Carlino. "The Concentration/Conduct Relationship in Bank
Deposit Markets," Review of Economics and Statistics 73 (May 1991), pp. 268-76.
Calem, Paul S., and Leonard I. Nakamura. "Branching Restrictions and Competition in
Banking," draft, Federal Reserve Bank of Philadelphia (1993).
Calem, Paul S., and John A. Rizzo. "Banks as Information Specialists: The Case of Hospital
Lending," Journal of Banking and Finance 16 (December 1992), pp. 1123-41.
Danielson, Arnold G. "Florida: National Banking's Test-Tube Market," Bank Management
68 (September 1992), pp. 30-40.
Evanoff, Douglas D. "Branch Banking and Service Accessibility," Journal of Money, Credit
and Banking 20 (May 1988), pp. 191-202.
King, B. Frank. "Upstate New York: Tough Markets for City Banks," Economic Review,
Federal Reserve Bank of Atlanta (June/July 1985), pp. 30-34.
Hannan, Timothy H. "Bank Commercial Loan Markets and the Role of Market Structure:
Evidence from Surveys of Commercial Lending," Journal of Banking and Finance 15
(February 1991), pp. 133-49.
Mengle, David L. "The Case for Interstate Branch Banking," Economic Review, Federal
Reserve Bank of Richmond (November/December 1990), pp. 3-17.


28


FEDERAL RESERVE BANK OF PHILADELPHIA

REFERENCES (Continued)

The Proconsumer Argument for Interstate Branching

Paul S. Calem

Mester, Loretta J. "Multiple Market Contact between Savings and Loans," Journal of Money,
Credit, and Banking 19 (November 1987), pp. 538-49.
Nakamura, Leonard I. "Commercial Bank Information: Implications for the Structure of
Banking," in Michael Klausner and Lawrence J. White, eds., Structural Change in Banking.
Homewood, Illinois: Business One Irwin, 1993, pp. 131-60.
Svare, J. Christopher. "NationsBank Leads Charge for Interstate Branching," Bank Manage­
ment 68 (June 1992), pp. 36-41.
Trans Data Corporation. "ATMs and Debit Cards: Strategy and Promotion," Wayne, PA
(1988).
Trans Data Corporation. "Serving the Small Business Market," Wayne, PA (1989a).
Trans Data Corporation. "Consumer Financial Relationships," Wayne, PA (1989b).
U. S. Congress, "Impact of Bank Reform Proposals on Consumers," Hearing before the
Subcommittee on Consumer Affairs and Coinage, Committee on Banking, Finance and
Urban Affairs, House of Representatives (April 10,1991).
Zimmerman, Gary C. "Small California Banks Hold Their Own," Weekly Letter, Federal
Reserve Bank of San Francisco (January 26,1990).
Zimmerman, Gary C. "California Banks' Problems Continue," Weekly Letter, Federal
Reserve Bank of San Francisco (April 24, 1992).




29

Philadelphia/RESEARCH
Working Papers
The Philadelphia Fed's Research Department occasionally publishes working papers based on
the current research of staff economists. These papers, dealing with virtually all areas within
economics and finance, are intended for the professional researcher. The papers added to the
Working Papers series thus far this year are listed below. To order copies, please send the number
of the item desired, along with your address, to WORKING PAPERS, Department of Research,
Federal Reserve Bank of Philadelphia, 10 Independence Mall, Philadelphia, PA 19106. For
overseas airmail requests only, a $3.00 per copy prepayment is required; please make checks or
money orders payable (in U.S. funds) to the Federal Reserve Bank of Philadelphia. A list of all
available papers may be ordered from the same address.

No. 93-1

Gerald Car lino and Robert DeFina, "Regional Income Dynamics."

No. 93-2

Francis X. Diebold, Javier Gardeazabal, and Kamil Yilmaz, "On Cointegration and
Exchange Rate Dynamics."

No. 93-3

Mitchell Berlin and Loretta J. Mester, "Financial Intermediation as Vertical Integra­
tion."

No. 93-4

Francis X. Diebold and Til Schuermann, "Exact Maximum Likelihood Estimation of
ARCH Models."

No. 93-5

Yin-Wong Cheung and Francis X. Diebold, "On Maximum-Likelihood Estimation of
the Differencing Parameter of Fractionally Integrated Noise With Unknown Mean."

No. 93-6

Francis X. Diebold, "On Comparing Information in Forecasts From Econometric
Models: A Comment on Fair and Shiller."

No. 93-7

Robert H. DeFina and Herbert E. Taylor, "Monetary Policy and Oil Price Shocks:
Empirical Implications of Alternative Responses."

No. 93-8

Sherrill Shaffer, "Stable Cartels With a Cournot Fringe." (Supersedes No. 90-24)

No. 93-9

Satyajit Chatterjee, Russell W. Cooper, and B. Ravikumar, "Strategic Complementarity
in Business Formation: Aggregate Fluctuations and Sunspot Equilibria."

No. 93-10 George J. Mailath and Loretta J. Mester, "When Do Regulators Close Banks? When
Should They?" (Supersedes No. 91-24)
No. 93-11 Francis X. Diebold and Celia Chen, "Testing Structural Stability With Endogenous
Break Point: A Size Comparison of Analytic and Bootstrap Procedures."
Digitized for30
FRASER


FEDERAL RESERVE BANK OF PHILADELPHIA

3

FEDERAL
RESERVE BA NK O F
PHILADELPHIA
BUSINESS REVIEW Ten Independence Mall, Philadelphia, PA 19106-1574