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Crim inal Behavior and the Control
O f C rim e: An Econom ic Perspective
Philadelphia Sings the Inflation Blues
Small Bank Survival: Is the W o lf at the Door?
FEDERAL RESERVE BANK of PHILADELPHIA
business rerieie
IN THIS ISSUE . . .
Criminal Behavior and the Control
Of Crim e: An Economic Perspective
. . . Crim e, w hether motivated by the desire
for income or some nonm onetary gain, can
be considered a “ ch o ice," and many econo
mists see that as often no less rational than
everyday decisions individuals make when
shopping or job-hunting.
Philadelphia Sings the Inflation Blues
. . . Blue-collar w orkers in Philadelphia have
been hard hit by inflation as their earnings
failed to keep pace with rising prices.
Small Bank Survival: Is the Wolf at the Door?
. . . Analysis of banking statistics in the Third
District suggests that the entry of large banks
into sm aller com m unities via merger does
not appear to threaten the existence of
sm aller banks.
On our cover: Located in Philadelphia between Front and Second streets and in the shadow of
the Benjam in Franklin Bridge is Elfreth's A lley, believed to be the oldest street in Am erica with
dwellings on both sides. Opened shortly before 1702 and named for Jerem iah Elfreth, the blocklong passageway was the home of carpenters, craftsmen, and printers during colonial times.
Benjamin Franklin, Prince de Talleyrand, and Stephen Girard once resided there. (Photograph bv
Sandy Sholder.)
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FEDERAL RESERVE BANK OF PHILADELPHIA
Criminal Behavior
And the
Control Of Crime:
An Economic
Perspective
By Timothy H. Hannan
ing, in their own estimations, the best choices
among available alternatives. A consumer who
chooses margarine over butter does so either
because to him it tastes better, its price is lower,
or both. Given a choice between bricklaying and
farming, a worker chooses bricklaying either be
cause he would rather lay bricks than plant corn,
because bricklaying pays better, or both. People
try to choose the best options available to them,
and decisions to engage in many different types
of criminal activity may simply be another
example of this type of behavior. Crime, whether
it is motivated by the desire for income or some
nonmonetary gain, can be thought of as a
choice, and as economists would have it, that
choice in many cases may be no less rational
than the everyday choices people make in de
termining what products to buy or what occupa
tions to pursue.
The fact that crime is illegal and carries the
Crime is rational! People who engage in
crimes such as burglary and robbery do so be
cause they are the best “ occupations" available
to them. Sound strange? This is the view of a
small but growing number of economists who
have recently invaded the traditional turf of
sociology and criminology to apply economic
principles to the analysis of criminal behavior.
To refer to crime as rational is not to excuse
those who engage in it. Crime, however, is an
unfortunate fact of life, and if there is an element
of rational choice involved in the decision to
engage in criminal activity, then such informa
tion can prove valuable in determining which
policies are likely to be effective in the control
of crime.
CRIME AS A CH O ICE
Economists have long viewed people as mak
3
NOVEMBER 1974
BUSINESS REVIEW
monetary and nonmonetary in nature. In crimes
such as burglary and robbery, monetary rewards
clearly play a dominant role in determining the
attractiveness of crime relative to other pursuits.
All other things equal, a million-dollar "take" is
better than a hundred-dollar one, just as a
higher-paying occupation is more attractive than
a lower-paying one if everything else about the
two jobs is the same. But nonmonetary gains of
crime can also be important, particularly in the
case of crimes not motivated by the desire for
property or income. Just as people differ in the
degree of satisfaction they derived from bricklay
ing or farming, so too do they differ in their tastes
and attitudes toward criminal activity. Some
people may actually enjoy the thrill of the chase
or impressing friends with the number of cars
they steal or the number of purses they snatch.
Others obviously do not.
There are also significant costs of crime which
may weigh heavily in the decision to engage in it.
One relevant cost, particularly in the case of
property crimes, is the "wage rate" or monetary
gain that individuals can earn in legal employ
ment compared with the amount they can
"earn" in illegal activity. If people choose to
support themselves by criminal activity, they are
forfeiting the wages they could have earned
working on construction sites or waiting on ta
bles. In other words, one of the costs of crime is
the "opportunity cost" of foregone legal earn
ings. Since some people can earn very little in
legal employment, criminal activity is in a very
real sense "cheaper" for them than it is for those
whose legal options are more rewarding, and
involvement in certain types of criminal activity
may vary accordingly.
Other costs may also be incurred in criminal
activity. Both the probability of being arrested
and convicted and the length of jail sentences
meted out to convicted offenders are costs that
directly influence the attractiveness of crime,
and these costs too may vary significantly among
individuals. The probability of an individual
being convicted for an offense w ill clearly de
pend upon his skill in avoiding arrest or his abil
ity to "beat the rap" once arrested. The cost of a
prison sentence may also be greater for some
possibility of a fine or prison sentence need not
imply that the decision to engage in it is irration
al. After all, the world is filled with people who
have voluntarily chosen "risk y" occupations
over relatively safe ones. Jet pilots, steeplejacks,
and matadors all face the possibility of disaster in
their chosen occupations. Yet, to conclude that
their choice is irrational is to disregard the rela
tive gains and costs that they derive from their
chosen occupations. All things considered, a
"dangerous" occupation may be the best avail
able alternative, and the decision to engage in
crime need not be an exception.
It is true, of course, that people are often not
certain of the consequences of their behavior
and may make choices which later prove to be
mistakes. Because they choose a course of action
without full information, some criminals may
incorrectly weigh the advantages and disadvan
tages of engaging in crime, as opposed to pursu
ing the "straight and narrow." A mugger or burg
lar on his first job can be "collared" and sen
tenced to many years in prison. But such an
occurrence may simply be the result of an incorrect
but rational decision made on the basis of in
complete information. Like the test pilot who
crashes or the businessman who goes bankrupt,
the criminal can make rational choices that later
prove to be mistakes.
None of this denies that some people are more
emotional than others or that rational choice
plays less of a role in some types of crime than it
does in others. Many who engage in the socalled crimes of passion, for example, may be
devoid of all reason and rationality, but it is by no
means obvious that all such offenders act with
complete disregard for the consequences of their
behavior. If this istrue, then viewingthe criminal
as rational can have at least limited applicability
even to the most violent or impulsive of crimes.
CRIME: THE GAINS AND THE COSTS
If this approach has merit, what are the gains
and costs associated with crime that are likely to
influence the individual's decision to engage in
crim inal activity? Consider first the gains of
crime. Criminal gains can be thought of as both
4
FEDERAL RESERVE BANK OF PHILADELPHIA
with a decision to engage in a crime of a given
"payoff," individuals who can earn high in
comes legally should be less likely to succumbto
temptation than those for whom legal oppor
tunities are less rewarding. Put simply, they have
more to lose. This prediction does seem to be
borne out for many types of crimes. Presumably,
bank presidents can rob liquor stores just as well
as can impoverished residents of big-city ghet
tos. Yet, the fact that bank presidents generally
refrain from such activity, w hile ghetto residents
often do not, is at least consistent with economic
prediction.2 Other explanations are clearly pos
sible and cannot be discounted. Yet, the widely
observed fact that low-income people engage in
crimes such as burglary and robbery in higher
proportions than high-income people is conso
nant with the economic view of criminal be
havior.
people than for others. Some people may con
sider imprisonment and the social stigma as
sociated with ita heavy burden, whileothersfind
it more bearable. Perhaps more important, the
enforced unemployment involved in a prison
sentence w ill result in a greater loss in income for
some people than for others. Highly educated
people, for whom high-paying jobs are avail
able, w ill find a prison sentence much more
costly than it is for low-income people, and the
decision to engage in crime may reflect such
influences.1
Thus, the decision to engage in crime can be
viewed as a subjective weighing of gains and
costs, like may other decisions encountered in
daily life. Since the gains and costs associated
with crime vary with a person's attitudes and the
legal and illegal options available to him, differ
ent levels of criminal participation are to be
expected for different types of people. W hile
crime is clearly unattractive to most members of
society, many categories of crime may be, to put
it bluntly, the best available alternative as per
ceived by some individuals (see Box).
The Role of Punishment: Does It Deter? More
support is available in reference to the deter
rence effect of punishment. The role of punish
ment in deterring criminal behavior is an area in
which economists and sociologists have often
parted co m p an y. M any so cio lo g ists and
criminologists have tended to view the criminal
as " sic k " or "abnorm al" and therefore relatively
unresponsive to costs. According to one advo
cate of this position:
THE ECO N OM IC APPROACH:
WHAT DOES IT EXPLAIN?
Theories are all well and good, but is the
economic approach to criminal behavior sup
ported by any evidence from the real world?
What, if anything, can it explain or predict? A l
though theories can never be totally proved by
observing what goes on in real life, the
economist's view of criminal behavior does
seem to jibe well with a number of observable
facts.
The Role of Legal Opportunities. Consider
first the role of legal opportunities in the decision
to engage in criminal activity. Crime can be
thought of as "cheaper" for the low-skilled and
the underem ployed than it is for the more
affluent members of society. Therefore, faced
Certainty of punishment and detection may
deter the normal person who thinks about his
actions and the consequences, but the crim i
nal mind does not operate like a normal mind.
The criminal often acts irrespective of the con
sequences, learning little from experience and
living for the present.3
Economists, of course, lean toward the opposite
view , predicting that the prospect of punish2Certainly people capable of earning high legal incomes
can and do engage in embezzlement and other white-collar
crimes, but this is presumably because the “ payoffs" to such
crimes are often very high and the probabilities of being
caught are often quite low.
’ There are, however, some positive aspects of imprison
ment. Incarceration means free room and board for those
confined, and this feature of imprisonment sometimes seems
to outweigh the costs when, for example, drunks prefer jail to
pounding the pavements on skid row.
3
Joel Meyer, “ Reflections on Some Theories of Punish
ments," lournal of Criminal Law, Criminology and Police
Science 59 (1968): 597.
5
BUSINESS REVIEW
NOVEMBER 1974
DOES CRIME PAY?
The age-old question of whether crime pays has been asked anew by economists and has, in
fact, stimulated a number of recent economic studies. The primary problem with a number of
studies which have attempted to answer this question is that not all of the gains and costs of
crime can be measured. It is not possible, for example, to measure directly the nonmonetary
gains to the criminal of illegal activity or such nonmonetary costs as the loss in freedom
associated with a prison sentence or the stigma suffered by criminals as a result of social
disapproval. Nevertheless, a number of economists have tried to quantify the monetary gains
and costs for a number of crimes and have found that, at least in strict monetary terms, criminal
activity may well represent the best available alternatives for some people.
Such studies are generally limited to calculating the average net income obtained from
certain econom ically motivated crimes and comparing the results with an estimate of the
monetary loss typically suffered from punishment over time. Monetary losses from punishment
are in the form of fines and foregone legal earnings resulting from a prison sentence. The table
below presents one estimate of the monetary gains and costs calculated by economist W illiam
E. Cobb for those people who participated in the crimes of burglary and robbery in Norfolk,
Viginia during the years 1964 and 1966.
Year
Monetary Costs of Punishment
(Fines, plus Income Lost
As a Result of Incarceration)
Monetary Gains
From Theft
1964
1966
$153,813
128,072
$290,339
460,121
These estimates of the monetary costs of punishment are quite low because the typical thief
was expected to command only a low wage in legal employment and suffer from high rates of
unemployment.* Although not all of the gains and costs of crime can be measured, results such
as these lend some support to the view that for some people— particularly those with few
marketable skills— certain types of crime may indeed pay.
*See William E. Cobb, “ Theft and the Two Hypotheses," Simon Rottenberg, ed., The Economics of Crime and
Punishment (Washington: American Enterprise Institute for Public Policy Research, 1973), pp. 19-30.
6
FEDERAL RESERVE BANK OF PHILADELPHIA
by viewing the criminal as a rational decision
maker, consider the age-old problem of
recidivism— the repeated relapse into criminal
activity. As is well known, many people con
victed and imprisoned for crim inal offenses
return to the life of crime almost immediately
upon release from confinement. To such people,
the prison gate is a "revolving door" through
which they w ill predictably return time and time
again. Many cite such records of repeated con
victions as evidence that criminal behavior is ir
rational. W hy shouldn't such people recognize
the errors of their ways and realize that crime
doesn't pay?
The answer to this question from an economic
viewpoint is that when expected gains and ex
pected costs are taken into account, crime may
very wel I pay even for the person who has served
several prison sentences. Suppose that prior to
his first conviction, a potential offender subjec
tively weighs the expected gains and costs of
criminal activity and rationally concludes that it
is worthwhile for him to engage in an illegal act.
If after conviction and imprisonment nothing has
happened to reduce those expected gains or
increase those expected costs, it should not be
surprising to see him return to a life of crime after
release from confinement. O f course, the ex
pected gains and costs of an additional offense
can change as a result of a prison sentence.
On the one hand, the cost of an additional
offense may increase if longer prison sen
tences are given to those convicted for a second
time. On the other hand, if the repeat offender
obtains criminal skills in prison that reduce the
probability of his being arrested for a criminal
act, or if his opportunities in legal employment
are reduced because of the stigma of being an
"ex-co n," then the costs of engaging in illegal
acts may actually decline as a result of a prison
term. Thus, the rather high rates of recidivism in
the United States may also be explainable by
viewing as rational the decision to engage in
crime.
THE ECONOM IC APPROACH: THE WHOLE
STORY?
Although the economist's conception of crime
seems to explain a good deal, clearly it cannot
ment, by raising the cost of crime, w ill cause
fewer crimes to be committed.
In the end, this issue can be resolved only by
looking at the evidence, and what evidence is
available seems to substantiate the view that
crim inals, like other people, respond to the costs
of their activities. A number of statistical investi
gations of the question have appeared in recent
years, and nearly all have shown a strong deter
rent effect of punishment, not only for property
crim es, but when investigated for personal
crimes as w e ll.4 In general, crime rates appear to
be more sensitive to the probability of conviction
than to the length of prison sentences, but even
the length of a prison sentence is generally
found to deter crime.
Such findings should hardly be surprising if
one reflects on what usually occurs in the
wake of a natural disaster such as a flood or
hurricane. In such situations, property owners
and enforcem ent authorities are often not
around to protect property against those who
would steal and loot. The probability of being
caught for an offense declines dram atically.
Consequently, stealing and looting often rise
sharply, with even normally law-abidingcitizens
getting into the act. Such a response to the
dramatic reduction in the cost of crime is very
much in line with the economist's view of crim i
nal behavior. In such situations people do not
suddenly become "sic k " or "abnorm al"; they
are simply making different decisions in re
sponse to a rather dramatic change in "prices."
The Problem of Repeaters. As a final example
of something which may be fruitfully explained
4lndeed, a study by Isaac Ehrlich has found that personal
crimes such as rape and murder were deterred by punish
ment just as effectively (or perhaps even more so) than were a
number of property crimes. Many may find it hard to accept
that punishment can actually deter the so-called crimes of
passion, and more research using better data is clearly needed
to settle the issue. For examples of studies which have
attempted to measure the deterrent effect of punishment, see
Isaac Ehrlich, "Participation in Illegitimate Activities: A
Theoretical and Empirical Investigation," Journal of Political
Economy 81 (1973): 521-65; Morgan O. Reynolds, "Crime
for Profit: The Economics of Theft," unpublished Ph. D.
thesis, University of Wisconsin (1971); and David L. Sjoquist,
“ Property Crime and Economic Behavior: Some Empirical
Results," American Economic Review 63 (1973): 439-^16.
7
NOVEMBER 1974
BUSINESS REVIEW
of subways or buses, and many carry only small
amounts of cash. But reducing crime by raising
costs of criminal activity is usually more relevant
for governmental action, and in this area
economics has something to offer both to the
“ get-tough hardliners" and to those who, for
humanitarian reasons, wish to improve the lot of
the criminal offender.
Consider the ways in which criminal activity
can be made more costly to the potential offender.
The first and perhaps most obvious method is
sim ply to raise the direct costs of crim inal
activity— the probabi I ity of arrest and conviction
and the severity of punishment. In other words,
crime can be reduced by devoting more re
sources to police departments and by handing
out stiffer sentences to individuals arrested and
convicted.5 But another means of raising the
costs of crime is also available. Since one of the
costs of participating in criminal acts, particu
larly those motivated by the desire for income, is
the foregone earnings obtainable in legal pur
suits, costs can also be increased by making legal
activity more attractive. This implies that crime
can be reduced by devoting resources to educa
tion and training or by increasing job oppor
tunities in high-crime areas.
Thus, what may appear to be two widely dif
fering approaches to crime control can be
thought of as simply two alternate methods of
raising the costs of crime, and the two ap
proaches need not be mutually exclusive. Both
sets of policies can be pursued simultaneously to
reduce the number of criminal offenses.
How Much Crime Control? Closely related to
the question of what to do to control crime is the
question of how much should be done to con
trol it. Certainly if enough of the economy's
scarce resources were used to expand police,
court, and correctional activity, or to improve
the legal opportunities of criminal offenders,
crime could be drastically reduced or perhaps
totally eliminated. Does this mean then that gov
ernments should hire a hundred policemen for
every criminal offense, impose extremely long
sentences for all crimes, or spend billions to
make legal pursuits more attractive to criminal
offenders? The answer is clearly “ no." The gain
explain everything. For example, why do some
individuals choose the life of crime, while
others, faced with the same legal and illegal
opportunities, refuse to engage in any illegal
acts? Economists can no more answer this ques
tion than determine w hy some people, faced
with the same set of prices and income, choose
margarine instead of butter w hile others do not;
or why, faced with the same wages, some people
choose bricklaying over farming w hile others
make the opposite choice. “ There's no account
ing for tastes." In the economics of crime, as in
many other areas of econom ics, economists
must accept tastes as given.
Differing tastes for criminal activity do not
negate the usefulness of this approach, any more
than do the differing tastes for margarine refute
the economist's prediction that with a rise in its
price, less of it w ill be purchased. It does, how'ever, leave many tough questions for others to
answer— questions that would seem to be of par
ticular importance in fully explaining the more
violent types of crimes. W hy do the nonmone
tary gains of some crimes differ so sharply from
person to person? W hy are the nonmonetary
“ costs" associated with the loss of freedom or
social disapproval higher for some than for
others? Questions such as these are important,
but best left for sociologists or criminologists to
ponder.
THE QUESTION OF POLICY
From the “ hardliners" to those who advocate
abolishing prisons, there seems to be a great
diversity of opinion concerning what to do about
the soaring crime rate and those who are respon
sible for it. Although the economist's conception
of criminal behavior has its limitations, it can
make policy decisions about crime a little easier
by laying out alternatives a little more clearly.
What Can Be Done to Control Crime? If the
criminal is not totally irrational or “ sick," then
illegal acts can be deterred either by decreasing
the gains to such activity or increasing the costs.
Efforts to reduce the gain to crime are well
known in the private sector: people avoid “ bad"
neighborhoods at night, some take taxis instead
8
FEDERAL RESERVE BANK OF PHILADELPHIA
CONCLUSION
from implementing crime-control measures is
the “ damage" from crime that can be prevented,
and if it could be prevented without cost, then
wiping out all crime would pay.
But crime prevention, like so many other de
sirable things in life, has its price tag. To obtain
less crime, resources must be shifted from other
desirable uses. In addition, punishments may
have to be imposed that are distasteful from a
humanitarian standpoint. Hence, expanding the
various areas of law enforcement or improving
the legal opportunities of offenders can only be
justified up to a point. As a general rule, it will
pay to expand each measure designed to reduce
crime only up to the point where the value of the
additional crimes prevented just equals the in
creased cost or sacrifice associated with doing it.
Beyond this point, reducing crime w ill simply
not be worth the effort.5
The decision to engage in criminal activity
may indeed be rational for many different types
of crimes. If this is true, as many economists
believe, then determining what policies to pur
sue in the fight against crime can be made a little
easier. Policies that either reduce the gain or
increase the costs of criminal activity can be
expected to reduce the number of illegal acts
committed. This means that punishment, con
trary to what many may believe, is justified up to
a point. So, too, are police actions designed to in
crease the probability of being punished for a
criminal act and perhaps also policies aimed at
improving the legal opportunities of criminal of
fenders. Understanding the determinants of
criminal behavior, along with the conditions that
must be met in efficiently allocating scarce re
sources to the control of crime, can provide use
ful conceptual guidelines for the tough decisions
that must be made in dealing with today's soar
ing crime rate.
5Great care must be taken, however, in determining the
relative punishments handed out for various types of crimes.
If, for example, kidnappers are given the death penalty, then
there is no increased punishment for kidnappers who also kill
their victims. Clearly, the penalty structure is a very delicate
creature.
SELECTED BIBLIOGRAPHY
Reynolds, Morgan O . “ The Economics of Criminal A ctivity." Andover,
M ass.: Warner Modular Publications, Module 12, 1973.
Rottenberg, Simon, ed. The Economics of Crime and Punishment.
Washington: American Enterprise Institute for Public Policy Research, 1973.
Tullock, Gordon. “ Does Punishment Deter Crime?" The Public Interest
36 (1 974): 103—
11.
5
9
_
_
_
_
_
_
_
;& ■
•
°'; v
'-%■ b?-
j^ S .
By James J. Bacci and
Robert H. Friedman
—
FEDERAL RESERVE BANK OF PHILADELPHIA
CHART 1
IN THE PAST YEAR PHILADELPHIA AREA CONSUMERS HAVE BEEN
BESIEGED WITH PRICE HIKES. AND WHILE PHILADELPHIA FALLS
BELOW THE URBAN AVERAGE OF PRICE INCREASES FOR CLOTHING
AND TRANSPORTATION . . .
SM
Increase in Transportation Costs
Atlanta
Los Angeles
I] Detroit
ll
San Francisco
Philadelphia
Chicago
0
4
Percent
Increase
6
8
10
12
Honolulu
14
!
St. Louis
New York
0
4
6
Percent Increase*
8
10
12
14
16
* The CPI represents reporting cities from June 1973 to June 1974. The U. S. urban average is taken
from 22 major U. S. SMSAs.
Source: U. S. Department of Labor, Bureau of Labor Statistics.
11
BUSINESS REVIEW
NOVEMBER 1974
CHART 2
IT HAS BEEN AT OR NEAR THE TOP FOR THE TWO LARGEST
EXPENDITURE ITEMS-FOOD AND HOUSING.
Increase in Food Costs
N Honolulu
Philadelphia
Increase in Housing Costs
Philadelphia
0
8
Percent
Increase
10
12
14
16
18
Percent
Increase
12
•
FEDERAL RESERVE BANK OF PHILADELPHIA
CHART 3
THE RESULTING NET INCREASE IN PHILADELPHIA AREA PRICES
DURING THE PAST YEAR HAS BEEN 12.6 PERCENT, A RATE THAT
FAR SURPASSES OTHER MAJOR URBAN CENTERS.
Increase in Overall CPI
Philadelphia
Detroit
I
Atlanta
I
Honolulu
I
Chicago
i
i
U. S. Urban Average
11.1
New York
■
St. Louis
i
Los Angeles
■
San Francisco
Percent
Increase
13
BUSINESS REVIEW
NOVEMBER 1974
CHART 4
HOWEVER, WAGE HIKES FOR BLUE-COLLAR WORKERS* IN PHILA
DELPHIA HAVE BEEN ABOVE THE URBAN AVERAGE . . .
Increase in Hourly Wages
Increase
* Production Workers on Manufacturing Payrolls.
14
FEDERAL RESERVE BANK OF PHILADELPHIA
CHART 5
AND HAVE PARTIALLY OFFSET THE FAST-ERODING PURCHASING
POWER* OF BLUE-COLLAR WORKERS IN THE NATION’S BIRTH
PLACE.
Loss in Spendable Earnings
Chicago
Atlanta
10
8
Percent
Decrease
Represents Difference Between increase in CPI and Increase in Wages.
15
NOVEMBER 1974
BUSINESS REVIEW
Small Bank
Survival:
Is the Wolf
At the Door?
By Jerome C. Darnell* and
Howard Keen Jr.
,
Talk of changing a state's banking code by
removing geographical barriers to branch opera
tions or to permit multibank holding companies,
and you're sure to evoke a storm of protest from
operators of small, independent banks. They be
lieve that opening the gates to statewide bank
ing, either by branching or holding companies,
w ill mean an early grave for their banks.
In many cases their concern stems from the
conviction that they can't compete head to head
with larger banks— especially those from a big
city. They cite limited access to national money
markets, disadvantages in efficiency of opera
tions, and difficulty in attracting and holding
top-notch management. A further contention is
that city banks w ill siphon funds from local
communities to the money centers, thereby sti
fling the growth and progress of small com
munities. Finally, it's felt that liberalized branch
ing laws w ill lead to an office of big-city banks in
every hamlet, offering higher rates on savings
and skimming the loan cream because they have
larger loan limits.
Are these fears well-founded, or could they be
a fear of the unknown because the status quo will
be shaken? In other words, is there really a wolf
atthedoorof the small banks?1W illth e entry ofa
large city bank through the acquisition of a local
competitor lead to the demise of the remaining
independent ("surviving") banks in town now
*Associate Professor of Finance, University of Colorado.
Research for this article was conducted while the author
served as an economist in the Department of Research of the
Federal Reserve Bank of Philadelphia.
’ For the sake of argument, let us assume a small bank is one
with less than $25 million in deposits. By this standard,
nearly three out of four banks in this country would be
considered “ small banks.” See American Banker, March 19,
1974.
16
FEDERAL RESERVE BANK OF PHILADELPHIA
independent bank of the same size. Larger banks
normally make more loans perdollarof deposits,
and they're in better shape to diversify the risks of
business lending. Any branch office can fall back
on the resources and lending ability of the parent
bank, and this gives it more flexibility than an
independent bank of similar size.
This doesn't have to be a handicap for inde
pendent banks, however. Their resources and
lending talent can be augmented by interbank
relationships such as loan participations with
larger correspondent banks. Moreover, when
smaller banks face expanded loan demand, ex
cess reserves of other banks can be acquired
through the Federal funds market. In this way
independent banks can at least partially offset
any increased lendingflexibility enjoyed by their
local competitors which have become branch
ing offices of a larger bank.
that they are confronted with competition from a
much larger institution? A look at 43 of these
remaining independent banks in Pennsylvania
suggests that, as a whole, their existence was not
threatened when their local competitors were
acquired by larger banks.
PLUSES FOR BIG BANKS
The fear of small banks that they can't successfully compete with their larger rivals has some
basis. Economic logic suggests that the concerns
are real, but even in areas where big banks have
the edge, smaller banks aren't helpless.
Lower-Cost Banking. Within a certain range,
the average cost of producing various banking
services is lower for a large volume of business
than for a smaller volume. In other words, there
are “ economies of scale" that permit more effi
cient (lower-cost) operation by larger banks.
Such relative inefficiency can make it more
difficult for small banks to compete. If it costs
them more to provide various banking services,
this w ill ultimately show up in higher rates on
loans or lower rates paid on savings. Eventual
ly, this w ill lead to relatively slower deposit
growth and below-average profits. In short, they
w ill be hard pressed to compete with more effi
cient banks.
But this isn't to say that only very large banks
are able to enjoy these advantages of lower-cost
operation. Studies of economies of scale in bank
ing suggest that once a bank reaches a level of
$20 to $25 million in deposits it has sufficient
volume to be about as efficient as much larger
banks.2 So concern by the smallest of banks
*
about economies of scale is well-founded, but
banks around the $20 million deposit level may
have less to fear.
Capital and Money Market Competition. Small
banks can be at a disadvantage when competing
for equity capital and for funds in national
money markets. Since there is no active market
for the stock of small banks, raising capital from
sources outside their own service area may be
difficult. Furthermore, the lack of nationwide
connections and recognition that larger banks
enjoy may preclude small banks from tapping
the national money market. This doesn't mean,
however, that small banks are shut out of the ball
park. Small banks can tap the national money
market through correspondent relations with
larger banks.
Management Succession. Securing and retain
ing competent managerial talent can pose a real
competitive problem for the small bank. Larger
banks can attract talent by paying higher salaries
and in turn can spread this overhead cost over a
wider base. W hile this disadvantage can damp
en the competitiveness of small banks, in many
cases it's within their own power to alleviate this
problem.
In general, closer investigation usually shows
that many small banks have not gone all out
to attract and retain high-caliber management.
Often the management succession problem of
Lending Ability. In many cases, a branch of
fice is less restricted in its ability to lend than an
2Frank W ille, "The Community Bank in a Nationwide
System,” An Address before the 43rd Annual Convention of
the Independent Bankers Association of America, San Fran
cisco, California, March 21, 1973.
17
NOVEMBER 1974
BUSINESS REVIEW
a small bank can't be all things to all people. But
a small bank can specialize in personalized ser
vice, in helping to solve community problems,
and in paying close attention to customer needs.
In other words, though a small bank can't
specialize in everything, it can remain competi
tively strong by tailoring its em phasis and
specializing in those things it can do best. In
short, by identifying and concentrating on their
areas of strength, small banks can profitably sur
vive, even in the face of heightened competition
from larger banks.
which small banks complain is the result of low
salaries and the lack of fringe benefits commen
surate with other types of employment. The
days of providing a title in lieu of salaries are
long gone in banking. The small bank that
realizes this can and does compete successfully
for managerial talent.
PLUSES FOR THE SMALL BANK
W hile these structural advantages of larger
banks can give them an edge over their smaller
rivals, small independent banks by no means
lack competitive clout. There are some very
powerful forces working in their favor which can
more than offset other competitive disadvan
tages.
Live and Let Live. Finally, there is a possibility
that in many cases larger banks don't act in pred
atory ways against sm aller rivals. It's been
suggested that the large bank entering the market
through merger with an existing bank may adopt
a “ live-and-let-live" attitude and may not at
tempt to go all out in competing for business in
the local community.4 To do so might eventually
drive the smaller bank out of business, resulting
in a predatory, monopolistic image for the large
banks.
So despite some reasons for believing that the
competitive odds are against small banks, there
are other competitive factors that favor their sur
vival. These factors may offset the negative ones,
and often even tip the competitive scales in favor
of the small bank. O nly by looking at some ac
tual experience can we get a better feel for the
com petitive strength of sm all independent
banks.
Local Personalized Service. Many people are
uneasy about “ bigness," and when it comes to
banking, they prefer to do business with a small,
locally owned bank. The opportunity to deal
personally with a bank officer is worth a lot to
some bank customers, and they prefer this to
dealing with a “ manager" of a branch office. A
local bank's president is generally a respected
man in the community, and some bank custom
ers get a big kick out of dealing with him on a
“ first-name" basis.
Customer Loyalty. Local personalized service
is a product with a high degree of brand loyalty.
This can be a powerful asset of the small inde
pendent bank, especially when customers are
reasonably happy with the banking services
they're getting there. It's doubtful that small dif
ferences in, say, rates paid on savings accounts
w ill induce customers to switch banks. As Paul
Nadler has remarked, “ It is only when there are
decided advantages at the larger unit that people
decide that local loyalty means less than their
pocketbooks."3
PERFORMANCE OF SURVIVING BANKS
When one bank is acquired by another the
operating policies of the new acquisition are
likely to be influenced by the parent bank's way
of doing business. For example, the parent or
ganization may have a different attitude toward
asset mix, capitalization, prices charged, ex
penses or profitability. This could result in
changes at the newly acquired bank that would
Emphasis on Strong Points. Larger banks can
offer a wider range of services to their customers;
4See Paul M. Horvitz and Bernard Shull, “ Branch Banking,
Independent Banks and Geographic Price Discrimination,”
Antitrust Bulletin 14 (1969): 827-44.
3Paul S. Nadler, “ What Happens After the Acquisition?”
Bankers Monthly, May 15, 1973, p. 11.
18
FEDERAL RESERVE BANK OF PHILADELPHIA
make it substantially more competitive. If and
when this happens, any marked change in the
way the remaining independent banks operate
could be a sign that they are feeling pressure
from their renamed rival. For example, if the
newly acquired bank begins paying higher rates
on savings accounts, the surviving bank could
find itself losing deposits. If the loss of deposits
becomes severe, the surviving bank may feel the
pressure to up its savings account rates.
An examination of the operation and perfor
mance of surviving banks after the takeover of a
local competitor compared to before the merger
can shed additional light on this question.
Merger activity in the Pennsylvania portion (the
eastern two-thirds of the commonwealth) of the
Third Federal Reserve District between 1962 and
1970 provides a good testing ground for the
question of small bank survival. In 43 cases,
banks were acquired in towns with relatively few
competitors.5
The acquiring banks in this sample were larger
than both the banks they absorbed and the sur
viving bank, and their balance sheet structure
was different from their newly acquired off
spring. As compared with the banks they ab
sorbed, the larger, acquiring banks in Pennsyl
vania had a substantially lower proportion of
5These banks were located in small towns ranging in popu
lation from 3,000 to 20,000. Twenty-seven of the banks
studied were located in two-bank towns. After the acquisi
tion of one by an out-of-town bank and its subsequent con
version into a branch office, only one independent (surviv
ing) bank was left. Twelve banks were in (six) three-bank
towns (two surviving banks after the merger of one) and four
were in a five-bank town (four surviving banks after the
merger). It is the independent bank that remains after its local
competitor is merged that we are interested in studying. Such
banks will be referred to as “ surviving banks” from here on.
It would be desirable to examine the operating policies,
asset structure, and profitability of the merged banks to see
how they are affected once they are taken over by another.
Unfortunately, in a merger the absorbed bank loses its previ
ous identity. That is, its assets, liabilities, income and ex
penses are consolidated with its parent organization and it is
not possible to track the individual performance of the newly
established “ branch office.” The situation is just the opposite
when holding companies make the acquisition. Individual
banks are not consolidated with the parent. Thus, one can
analyze the changes in operations of banks acquired by
holding companies.
their assets in the form of cash and U.S. Govern
ment securities and had lower capitalization
ratios. By the same token, acquiring banks had
higher loan-to-deposit ratios, the loan portfolios
of the big banks being more heavily oriented
toward consumer and business loans. After the
merger, the acquired bank was part of a banking
organization roughly ten times larger than the
surviving bank.6
The operating performance of surviving banks
was examined using a "before” and "after”
comparison, a common practice in studying
bank acquisitions.7 Sixteen major banking ratios
were selected for analysis— eight balance sheet
ratios and eight ratios from the income and ex
pense statement. It was assumed that three years
would be sufficient time for postmerger impact
to show up in the operating performance of the
surviving banks. Consequently, the ratios were
averaged for each of the 43 banks for the three
years immediately prior to the year in which an
outside bank entered the town through merger
with another bank. In an identical way these
same ratios were averaged for the three years
immediately after the entry of the out-of-town
bank.
Before these statistics could be compared,
how ever, an adjustm ent had to be made.
Changes in the way banks operated in the 1960s
caused most of the ratios to move consistently in
one direction or the other. In other words, there's
a "tim e trend” in the industry which can cloud
the issue in a before-and-after comparison. So
before testing the significance of the differences,
it was necessary to adjust the data to remove the
effects of industry trends (see Appendix).
5
The average deposit size of the surviving banks was $14.5
million. Only six had over $25 million and none were as
large as $50 million. The average size of the out-of-town
entrant was in the neighborhood of $150 million.
7For a similar study using this technique, see Thomas E.
Snider, “ The Effect of Merger on the Lending Behavior of
Rural Banks in Virginia,” Journal of Bank Research, Spring
1973, pp. 52-57. For a suggestion of a more extensive
methodology, see Rodney D. Johnson and David R. Meinster, “ An Analysis of Bank Holding Company Acquisitions:
Some Methodological Issues," Journal of Bank Research,
Spring 1973, pp. 58-61.
19
BUSINESS REVIEW
NOVEMBER 1974
Balance Sheet Ratios: No Tipping of the
Scales. Table 1 gives an indication of the unad
justed average balance sheet ratios of surviving
banks before and after the entrance of an out
sider by way of merger. Minor shifts can be de
tected in most of the ratios. However, after ad
justing for time trends, none of the shifts, either
up or down, was large enough to be significant in
a statistical sense.
W hile all of these ratios showed some change
after a rival's merger, the observed changes were
all so small that they would have to be attributed
to chance or random influences. In a word, the
balance sheet structure of small, surviving banks
did not change significantly after a local com
petitor was merged into a larger, out-of-town
bank.
Income and Expense Ratios: Coffer Un
harmed. Table 2 gives similar information about
income and expense ratios. Here, as with the
balance sheet ratios, once the figures were ad
justed for time trends, no significant changes
showed up in any of the ratios. To be sure, none
of the ratios stood still since all but two moved
upward after the takeover of a competitor. But by
statistical standards, none of the ratios was
different after the merger from before.
TABLE 1
AVERAGE BALANCE SHEET RATIOS OF
SURVIVING BANKS BEFORE AND AFTER
MERGER OF LOCAL COMPETITOR WITH
LARGER, OUT-OF-TOWN BANK
Average Balance Sheet Ratios
Before
Merger
10.0%
Cash Items
After
Merger
9.2%
Total Assets
U. 5. Government Securities
Total Assets
21.7
19.8
State & Local Govt. Securities
10.4
11.8
61.1
60.8
36.7
37.2
22.9
25.5
18.2
17.6
10.9
10.0
Total Assets
Total Loans
Total Deposits
Real Estate Loans
Total Loans
Consumer Loans
Total Loans
Business Loans
Total Loans
Total Capital Accounts
Total Deposits
20
FEDERAL RESERVE BANK OF PHILADELPHIA
TABLE 2
AVERAGE OPERATING RATIOS OF SURVIVING
BANKS BEFORE AND AFTER MERGER OF LOCAL
COMPETITOR WITH LARGER, OUT-OF-TOWN
BANK
Average Operating Ratios
Before
Merger
0.32%
0.34%
3.0
3.4
5.8
6.1
76.5
78.5
3.5
3.9
25.1
22.6
1.1
1.1
7.5
S e r v ic e C ha rges
After
Merger
7.8
Demand Deposits (IPC)
In tere st on D e p o sits
Total Time + Savings Deposits
In tere st a n d Fe e s o n Loans
Total Loans
T o ta l O p e ra tin g E x p e n se s
Total Operating Income
T o ta l O p e ra tin g E x p e n se s
Total Assets
T o ta l W a g es a n d S a la ries
Total Operating Expenses
N et C u rre n t O p e ra tin g In c o m e
Total Assets
N et In c o m e
Total Capital
Deposits: A Key Indicator. Growth in deposits
is an important indicator of a bank's viability.
The ability to attract and retain deposits is essen
tial because they're the raw material of the bank
ing business. In fact, it's been argued that the
deposit growth rate is a reasonable proxy for the
general quality of banking services.8
On this score, the acquisition of a local com
petitor by a larger bank had little effect on the
ability of the surviving banks to attract and hold
deposits. The before-and-after (three-year) aver
ages of deposit growth rates of surviving banks
indicate that there was no substantial speed-up
or slowdown in these rates after the merger. Un
adjusted deposit growth averaged 9.1 percent
“Robert J. Lawrence, The Performance of Bank Holding
Companies (Washington: Board of Governors of the Federal
Reserve System, 1967), p. 21. It would be desirable to com
pare deposit growth rates of surviving banks with those of
their newly acquired rivals. Unlike balance sheet and in
come and expense data, deposits are available on a per-
office basis, but there's still a major problem. Wholesale
transfers of deposits can and do occur between offices of
banking organizations. Consequently, in terms of indicating
the ability to attract and retain deposits, it's not clear how
meaningful these branch-office deposit growth rates would
be.
21
NOVEMBER 1974
BUSINESS REVIEW
annually for three years prior to the merger, and
registered a 10.5 percent annual clip for the three
years following the takeover (the adjusted differ
ence was statistically insignificant).
small banks and appear not to be aggravated by a
larger bank's takeover of a competitor.
The small independent bank should be en
couraged to compete vigorously with large
banks. It provides a valuable alternative in the
marketplace, and a means by which concentra
tion of markets can be kept to a minimum. Fur
thermore, it offers a personal touch that is so
often lacking in today's banking world.
Our look at surviving banks suggests that pub
lic policies on bank entry and expansion may
need to be reviewed.9 The argument is often
made that geographical restrictions on banking
operations are essential. It's charged that unregu
lated expansion by large banks w ill lead to
“ overbanking" and make it impossible for small
banks to survive, resultingeventually in afew big
banks dominating the scene. It's possible that
legal restrictions on bank expansion have only
fostered inefficiency and encouraged a lack of
competitive spirit. By protecting those who are
fully capable of competing, the public may be
harmed economically by paying more for bank
ing services.
Eyes Closed to Rival's Takeover? Do these
results indicate that surviving banks are com
pletely oblivious to a rival's takeover by a larger
out-of-town bank? Perhaps, but a more reason
able interpretation is that the competitive impact
of the new entrant was not so potent that the
surviving bank was forced to make dramatic
changes in its operating policies. Undoubtedly,
“ changes" were made during this period. But
they seem to be more heavily influenced by the
economic and social factors which motivated
change throughout the industry than by the entry
of the new competitor. Accordingly, there's little
apparent reason to believe that competition
from an outside entrant is forcing small banks to
the brink of extinction.
CAN SMALL BANKS SURVIVE?
The merger expansion of large banks into
smaller communities does not appear to create
insurmountable problems for smaller banks, ac
cording to an analysis of various banking ratios
and deposit growth rates. To be sure, small banks
do have problems that are inherent in their size,
which may eventually lead to their selling out.
But these are generally problems common to all
9For the view that caution is required with respect to regu
lations designed to "protect" smaller banks see Robert C.
Holland, Member, Board of Governors of the Federal Re
serve System, "Protecting and Not Protecting the Small Inde
pendent Bank," remarks before the Annual Convention of
the Independent Bankers Association of America, Dallas,
Texas, March 23, 1974.
NOW AVAILABLE:
INDEX TO FEDERAL RESERVE BANK REVIEWS
Articles which have appeared in the reviews of the 12 Federal Reserve Banks have been
indexed by subject by Doris F. Zimmermann, Librarian of the Federal Reserve Bank of Phil
adelphia. The index covers the years 1950 through 1972 and is available upon request from the
Department of Public Services, Federal Reserve Bank of Philadelphia, Philadelphia, Pennsyl
vania 19101.
f
22
FEDERAL RESERVE BANK OF PHILADELPHIA
APPENDIX
STATISTICAL ADJUSTMENTS OF BANK DATA
O ur sample consisted of 43 surviving banks. For each of the 16 ratios and deposit growth
rates of each bank, averages were computed for three years before the merger and for three
years afterjhe merger. This gave us 43 “ before-merger" averages (XB and 43 “ after-merger"
)
averages (XA for each ratio and the deposit growth rates.
)
Flowever, it would have been improper to simply make comparisons of these statistics
because changes had been taking place throughout the banking industry during this period. For
instance, almost all of the banks in Pennsylvania had gradually decreased the proportion of
U.S. Government securities in their asset portfolios, and had reduced their holdings of cash.
Therefore, each of these 86 averages (XB and XA was adjusted to remove the effect of industry
)
trends. This was done by subtracting from it the difference between the industry average at the
time of the merger and this same average at the time of the 1962 mergers. Industry averages are
thoseof all banks in the Pennsylvania portion oftheThird Federal Reserve District with deposits
of $25 million or less.
For example, one surviving bank's average cash-to-assets ratio for the three years prior to a
1969 merger, X B, was 10.5 percent. The industry average (lB for this same period was 8.6
)
percent w hile lB for the 1962 merger period was 12.1 percent. So, on average this ratio
declined 3.5 percentage points [lB(1969) minus lB(1962)] during the period 1962 to 1969. This
effect of industry trends (-3.5 percentage points) was removed by subtracting it from X B. The
adjusted X^in this case is 14.0 percent (10.5 percent plus 3.5). If the industry trend had been
upward (that is, +3.5 percentage points) this would have lowered X B to 7.0 percent.
For each ratio and the deposit growth rates, the 43 adjusted X bs and 43 adjusted XA were
s
averaged to obtain final “ before" and “ after" averages. The significance of the differences
between these averages was checked through the use of t-tests. The implied assumption is that
the “ after" ratios may be different from the “ before" ratios because of the influence of a rival's
merger or because of time trends. By testing the adjusted “ before-and-after" ratios it's assumed
that any significant differences are solely because of the rival's merger and its subsequent
influence on the surviving bank's behavior.
S
Inflation is currently a major problem facing
the U. S. Can policym akers curtail it? If so,
how much w ill their actions "co st" society?
Is inflation "b a d ," and if so, why? Are there
ways of "living with inflation" that cushion
its negative impact on the individual and
society? Six articles reprinted from the Phila
delphia Fed's Business Review address these
questions in detail and seek to promote an
understanding of the problem for both pol
icymakers and the general public.
Copies are available free of charge. Please address all requests to Public Information,
Federal Reserve Bank of Philadelphia, Philadelphia, PA 19105
23
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