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Federal Reserve Bank of Philadelphia IS S N 0 0 0 7 -7 0 1 1 SEPTEMBER O C TO BER 1982 tiki TROHICS DOC C H 'l NfZ LH\LI II III IU T IJ E I HE IN T E O C T O ii n u \ - n i i D O N I 'I N C u r n n hi io OOOOEO U l ll\ l\ IL I\ The BU SIN ESS REVIEW is published by the Department of Research every other month. It is edited by John J. Mulhern, and artwork is directed by Ronald B. Williams. The REVIEW is available without charge. Please send subscription orders and changes of address to the Department of Research at the above address or telephone (215) 574-6449. Editorial communications also should be sent to the Department of Research or telephone (215) 574-6426. Requests for additional copies should be sent to the Department of Public Services. The Federal Reserve Bank of Philadelphia is part of the Federal Reserve System—a System which includes twelve regional banks located around the nation as well as the Board of Governors in Washington. The Federal Reserve System was established by Congress in 1913 primarily to manage the nation’s monetary affairs. Supporting func tions include clearing checks, providing coin and currency to the banking system, acting as banker for the Federal government, super vising commercial banks, and enforcing consumer credit protection laws. In keeping with the Federal Reserve Act, the System is an agency of the Congress, independent administratively of the Executive Branch, and insulated from partisan political pres sures. The Federal Reserve is self supporting and regularly makes payments to the United States Treasury from its operating surpluses. FEDERAL RESERVE BANK OF PHILADELPHIA Electronics: The Key to Breaking the Interstate Banking Barrier by Joanna H. Frodin* makes deposit taking across state lines eco nomic on a larger scale than it was before. While noneconomic forces—institutional and political—surely will influence the timing and exact form of legal changes, the economic forces for change should prove overriding. Legal limits on interstate banking have stood firm for half a century. These geo graphic restrictions, however, have not prevented the development of certain types of interstate and national banking. Banking institutions have been able to seek profitable opportunities across state lines through a variety of channels. As a result, they have established a substantial interstate presence, primarily in asset services. The demise of interstate limits is progress ing rapidly, and full-service interstate bank ing appears just around the comer. The reason is that innovations in electronic funds and in formation transfer have brought about a fun damental change in the economics of bank ing. Specifically, electronics, which is re ducing the cost of many banking functions, LEGAL BACKGROUND Geographic restrictions on bank branch ing stem from the McFadden Act of 1927 and the Banking Act of 1935, which effectively made state boundaries the ultimate limits to bank expansion. Prior to 1927, national banks could not branch— a prohibition based on a 1911 ruling by the Attorney General that the National Bank Act did not empower national banks to branch. State banks could branch if permitted by state regulations. The McFadden Act allowed a national bank to branch in the city of its location, subject to state laws. The Banking Act of 1935 ex tended such branching statewide, again sub ject to state laws. *Joanna H. Frodin is an Economist in the Banking Section of the Philadelphia Fed’s Research Department. She holds degrees from Bryn Mawr College, the Uni versity of Chicago, and the University of Connecticut. 3 BUSINESS REVIEW SEPTEMBERyOCTOBER 1982 Act Corporations, loan production offices, and partial acquisitions. Edge Act Corporations. For many years, banks have crossed state lines to compete with other banks, U.S. and foreign, for international business through Edge Act Corporations. The 1919 Edge Act permitted banks to establish offices in states other than their home state to finance exports of U.S. goods and other international business. It limited deposit taking to deposits of foreign residents and to those incidental to the export business. Overtime, many U.S. banks found their ability to compete with foreign banks in this area limited by the small number of Edge corporations they could afford to capitalize at the required $2 million each. The International Banking Act (IBA) of 1978 evened out the game with three mea sures. First, it allowed banks to consolidate these corporations into a single Edge Act Corporation, capitalized at $2 million, which could operate separate Edge offices as branches. Second, it liberalized the allow able loan-to-capital ratios. Third, it per mitted foreign banks to establish Edges. By the end of 1980,44 domestic banks (or groups of banks) were operating or waiting for approval to operate a total of 123 Edge offices in approximately 15 cities outside their home states.2 Loan Production Offices. National banks and many state-chartered banks have had the opportunity to expand geographically through loan production offices. Banks may make loans through these out-of-state offices, sub ject to the requirement that the home office approve each loan. Banks have used loan production offices particularly for commer cial lending. In fact, many large banks ser vice a national market for business loans through their loan production offices. Banks have also used traveling loan officers to ser vice the interstate commercial market. Although these two Acts liberalized branching regulations for national banks, they set state lines as boundaries and deferred to the states on the issue of location of banks within a state. McFadden defined a branch as “any place of business . . . at which de posits are received, or checks paid, or money lent.”1 In theory, this definition meant that banks could not pursue opportunities for making loans or taking deposits by physical expansion across state lines. State lines also limit Bank Holding Companies (BHCs] geographically. The Douglas Amendment of 1956 to the Bank Holding Company Act (BHCA] prohibited BHCs from acquiring a commercial bank in another state unless specifically authorized by that state. However, the BHCA did allow BHCs to operate nonbank subsidiaries in approved bank-related activities without specific geographic limits. EARLY INROADS TO AN INTERSTATE ROLE While the McFadden Act and the Douglas Amendment put strict limits on bank branching across state lines and BHC ac quisition of out-of-state banks, many banks have pursued profitable opportunities across state lines via other available routes. Banks have crossed state boundaries primarily with asset services, exploiting legal channels available either to banks directly or to BHCs. Many domestic banking institutions have attained an interstate—indeed, even a nationwide—presence as a result. In addi tion, many foreign banking institutions, initially not subject to the same restrictions, have developed full-service interstate bank ing operations. GEOGRAPHIC EXPANSION BY DOMESTIC BANKS . . . Banks have made use of several avenues to achieve an interstate role, including Edge 2Donald Baer, “Behind Miami’s Surge in Inter national Banking,” E con om ic Review , Federal Reserve Bank of Atlanta, April 1981, p. 12. •^McFadden Act. PL 639, 69th Congress, p.5. 4 FEDERAL RESERVE BANK OF PHILADELPHIA Acquisition. Bylaw, a bank may purchase up to 4.9 percent of another bank’s stock, regardless of the acquired bank’s location. Recently, banks have increased such pur chases in an attempt to be in position for fullscale interstate acquistions. Some banks have made still more extensive commitments. For example, in 1980 Citibank bought non voting preferred stock of Central National of Chicago, the parent of Central National Bank, and received a 15-year option to purchase 27 percent of its common stock in the event that interstate laws change. Chase acquired a similar stake in Equimark Corp. of Pitts burgh. the acquired bank’s state so authorized. Prior to 1980, only two states exercised that option, and their actions have had little effect on interstate expansion. Since 1956, Iowa has allowed a grandfathered out-of-state BHC to make additional acquistions; in 1978, Maine permitted out-of-state BHCs to acquire Maine banks if Maine received reciprocal treatment. Since no other states have granted reciproc ity, Maine’s law has had no real effect (see INDIVIDUAL STATE LAWS). In 1980, South Dakota changed its law to allow limited outof-state BHC entry. Delaware enacted similar legislation in 1981 (see INTERSTATE BANK ING AND THE THIRD DISTRICT overleaf). As of July 1,1982, Alaska allowed unrestrict ed entry of out-of-state BHCs. Grandfathered Institutions. In western and north central states, interstate multibank holding companies, in existence prior to 1956 and “grandfathered” by the Douglas Amendment, have an established and growing presence in full-service banking. Among these regional groups, First Interstate Bancorp, formerly Western Bancshares, is particularly aggressive in interstate banking. It has 22 banks in 11 western states with 900 branches . . . AND DOMESTIC BANK HOLDING COMPANY EXPANSION . . . Banks also have tried to break down inter state barriers through their parent bank holding companies in a variety of ways. Acquisition of Banks. The BHCA actually has provided some leeway for banks to ex pand geographically, both interstate and intrastate. One route appears in Section 3(d) of the Douglas Amendment which allowed BHCs to acquire out-of-state banks where INDIVIDUAL STATE LAWS Iowa: This state allows one out-of-state BHC, grandfathered by the Douglas Amendment in 1956, to acquire additional banks in the state, subject to a ceiling of 8 percent of the state’s deposits. Maine: Maine has allowed out-of-state acquisition since 1978 only if there is reciprocity: the home state of the acquiring BHC must give Maine BHCs no less restrictive treatment. Since no other states have enacted reciprocity legislation, no out-of-state BHCs own Maine banks. Maine currently is considering dropping the reciprocity condition to make Maine banks more attractive targets for acquisition. South Dakota: This state passed legislation in 1980 permitting out-of-state BHC activity, subject to certain restrictions. The BHC could acquire, in a location not likely to draw customers from existing banks, a single de novo bank run as a bank and/or a service affiliate. The BHC could not expand beyond a single banking office by merger or acquisition. Citibank moved its credit card operation to Sioux Falls in 1981 to avoid the usury laws and limits on annual fees imposed in New York. Alaska: The Alaskan legislature recently passed a bill authorizing out-of-state BHCs to acquire and to operate full-service banks in Alaska without requiring reciprocity. As of July 1, when this bill went into effect, Alaska’s policy became the most liberal to date. 5 SEPTEMBER/OCTOBER 1982 BUSINESS REVIEW and several hundred automatic teller ma chines (ATMs). Recently, it started the for mation of a nationwide ATM network and announced plans to franchise its name and to sell services nationwide. The first bank to acquire the franchise was the First National Bank in Golden, Colorado, since renamed the First Interstate Bank of Golden. Bank-Related Activities. Considerable expansion, particularly since 1970, has oc curred via the second possible route—bankrelated activities. The BHCA allowed hold ing companies to engage in certain nonbank activities approved by the Federal Reserve Board. While the Act contained no explicit geographic restrictions, two things militated INTERSTATE BANKING AND THE THIRD DISTRICT How does the Third Federal Reserve District, comprising eastern Pennsylvania, southern New Jersey, and Delaware, fit into the interstate banking picture? Has its experience been typical? Two things differentiate the Third District from other districts: location and the banking laws of Delaware. Location. The location of the Third District decidedly has influenced the way interstate pressures have developed. All three states, perhaps with an eye on New York banks, prohibit out-of-state banks from operating loan production offices within their states. However, that restriction does not guard against traveling loan officers. It also does not apply to out-of-state BHC subsidiaries, which are very active in consumer and mortgage finance. With New York the preferred location, only two foreign banks have offices in Philadelphia and only two out-of-state companies have Edges in the Third District. * Two Philadelphia banks, Fidelity and Girard, have Edges in New York. There is no grandfathered interstate banking activity in the Third District, so no pressure comes from that source. Activity of Third District institutions in ATM network development contributes additional, but not unusual, pressure. In general, many banks have faced considerable interstate competition because of their location. The nearness of New Jersey and eastern Pennsylvania banks to New York and of southern New Jersey banks to Philadelphia has produced more interstate competition than in many areas. Specific ally, Third District banks probably have faced more interstate competition from money-market funds than banks in many other areas. The proximity of New York, where many of the major funds are located, presents consumers with extensive radio, TV, and newspaper advertising. Within the district, there is interstate pressure from the sizable Delaware Fund in Philadelphia. The presence of Philadelphia, the fourth largest city in the U.S., in the Third District places it in a strategic position vis-a-vis potential interstate competiton. A Philadelphia bank, Industrial Valley Bank & Trust Co. (IVB), Pennsylvania’s twelfth largest bank, was the target of one of the more extensive recent bank stock acquisiton deals. Marine Midland of Buffalo, N. Y. gave IVB a capital infusion of $24.7 million in exchange for 4.9 percent of its outstanding stock plus the future sale of $22 million of nonvoting preferred stock and warrants to buy another 20 percent of common stock if interstate law changes. Many large Philadelphia banks view themselves as potential takeover targets of New York banks and are planning to fight for survival as independent regional banks or to merge, depending on the assessment of their chances. The reactions of banks to actual or potential interstate competition have differed and will differ reflecting their location and their respective state laws. For instance, both New Jersey and Delaware have statewide branching, while Pennsylvania, in part reacting to ‘ The two foreign banks are Bank Leumi Le Israel and Bank Hapoalim. The two out-of-state institutions with Edge Act Corporations in the Third District are First Maryland International Banking Corporation with an Edge in York and Continental Bank International, a subsidiary of Illinois National Bank & Trust Co. of Chicago, with an Edge in Philadelphia. 6 FEDERAL RESERVE BANK OF PHILADELPHIA interstate pressures, recently changed its law to allow banks to branch two counties away from their home office (instead of one] and to branch into Philadelphia and Pittsburgh. The new law also authorizes limited BHC expansion statewide. The first major development based on this change was the merger of the holding companies of Pittsburgh National Bank and Provident National Bank of Philadelphia into PNC. Delaware. What differentiates the Third from other districts to date is Delaware’s new banking legislation, passed in 1981. Sincel956, under the Douglas Amendment to the BHCA, aBHC has been able to acquire a commercial bank in another state only if specifically authorized to do so by the other state’s laws. The Financial Center Development Act in Delaware now allows such acquisiton subject to certain conditions. The amended section 803 of the Delaware code states that “an out-of-state bank holding company or any subsidiary thereof may acquire and hold all or substantially all of the voting shares of a single bank located in this State” if the acquired institution: is a de novo bank with a single office open to the public; has a minimum capital stock and paid-in surplus of $10 million when it opens and $25 million within one year; employs not less than 100 employees within one year; and “is operated in a manner and at a location that is not likely to attract customers from the general public in this State to the substantial detriment of existing banking institutions located in this State.”! While the new law did limit the scope of out-of-state BHC activities, it represented the most liberal state legislation prior to July 1982. In addition, Delaware abolished its usury ceilings and permitted annual fees for credit card users. Since these changes occurred, Girard Bank of Philadelphia has purchased Farmers Bank of Wilmington, owned by the State of Delaware and the FDIC, and has renamed it Girard Bank Delaware.! Out-of-state BHCs which have acquired de novooffices directly or via a subsidiary are J.P. Morgan, Philadelphia National Bank, Provident National Corp., First Maryland Bancorp, Chase, and Chemical. The Teachers Service Organization, a consumer finance organization in Pennsylvania, has acquired control of the Colonial National Bank of Wilmington to expand into electronic funds transfer. Delaware has been forward looking on two counts. First, the influx of out-of-state banks and the probable entry of foreign banks will bring additional employment yet minimum short-run competi tion under the strict provisions of the Act. Second, if interstate laws are changed, Delaware will be in an excellent position to benefit from the expansion of those banks, as well as its own. Delaware’s move may well have added another to the growing list of pressures on geographic restrictions. tAmendment to Title 5, Delaware Code, House Bill No. 28, House of Representatives, 131st General Assembly, p. 2. tThis specific arrangement depended on additional legislation. against expansion in the period from 1956 to 1970. First, the short list of activities allowed by the Board did not include many with the potential of a large market area. Second, in administering the Act, the Board often de ferred to the spirit of McFadden and put geo graphic limits on holding companies similar to those on banks.3 The 1970 amendment to the BHCA paved the way for a substantial increase in inter state operations. The Fed expanded the number of permissible BHC activities and specifically stated that the Act contained no geographic Jimitsto these activities.4 BHCs 4 Activities permitted by the Federal Reserve for Bank Holding Companies under Section 4(c)(8) include: 1. management consulting for nonaffiliated banks and nonbank depository institutions under cer tain conditions. 2. full payout leasing of personal and certain real property. 3. mortgage banking and servicing loans. 4. consumer credit, industrial bank operation. 3 The Supervision and Regulation o f B an k H olding Companies: An Assessment of O bjectives and Im ple m entation (Washington: Association of Bank Holding Companies, 1978), p. 140. 7 BUSINESS REVIEW SEPTEMBER/OCTOBER 1982 subsequently achieved a sizable interstate presence with offices dealing in consumer finance, mortgage banking, leasing, invest ment advising, management consulting, trust, and reinsurance services. For instance, by 1980 Citicorp had 229 consumer and mort gage finance offices in 55 cities.5 The Fed also allowed interstate expansion of BHCs through acquistion of industrial banks and similar institutions deemed “near-banks.” Only limited expansion has taken place via this route, however, since not all states have such near-banks, which usually tend to be small and few in number even where they do exist. $160 billion in 1981.7 Such multistate, fullservice bank expansion created an anomaly in the U.S. banking structure. Foreign banks could branch across state lines where do mestic banks could not. The International Banking Act, directed at this inequity, forced foreign banks to choose a home state (where they could branch if allowed] for full-service banking, although it did grandfather existing operations. It also limited deposit taking in other states to inter national trade activity—the same restriction applicable to an Edge corporation. Foreign banks have followed domestic banks in cir cumventing branching restrictions by ex panding the number of their Edges. Seven of the sixteen new Edges set up in 1981 belong to foreign banks.8 The IBA notwithstanding, foreign bank development has led to another structural inequity. Foreign banks have been able to acquire banks in desirable locations which interstate and antitrust restrictions put out of reach of domestic banks. One example is the purchase of Marine Midland Bank of New York by the Hong Kong & Shanghai Banking Co. in 1980. Another is the merger of Crocker National Bank of California with Midland Banks of England. In both cases, the foreign parent has obtained an excellent foothold for expansion in the event of a collapse of inter state barriers, and the domestic bank has received a capital infusion to strengthen its competitive position with other U. S. banks. . . . ALONG WITH FOREIGN BANKING INSTITUTIONS . . . Foreign banks and BHCs form one bank ing group with an interstate presence in both asset and liability services. As of March 1982, there were 164 foreign banks in the U .S.; half were operating in more than one state.6 In recent years, they have expanded dramatically, with assets rising from $20 billion in 1972 and $40 billion in 1976 to over 5. 6. 7. 8. 9. 10. commercial finance and factoring. providing trust services/company (fiduciary). investment advisory. investing in community welfare projects. data processing and bookkeeping services. acting as insurance agent or broker where in surance is connected with the extension of credit in community of less than 5,000 people. 11. underwriting credit insurance (reinsurance). 12. armored car and courier services on explicit fee basis. 13. operating credit card company. 14. economic information and advisory. 15. selling traveler’s checks, U .S. savings bonds, and money orders. 16. check verification service—on a case-by-case basis. 17. real estate appraisal. See Carter H. Golembe and David S. Holland, F ed eral Regulation o f B an king (Washington: Golembe Associ ates, 1981), p. 117, on geographic limits. . . . MEAN A SUBSTANTIAL INTERSTATE PRESENCE Taken together, the inroads on interstate and national markets made by banks directly or through BHCs constitute a sizable end run around the geographic boundaries imposed on banking by McFadden and Douglas. Most of this circumvention has occurred through 7 Treasury Bulletin, Capital Movements, Table CM-I1, March 1982. 5 F ed eral R eserve Bulletin, January 1980, p. 3. 6 American Banker, May 24, 1982, p. 1. 6 American Banker, March 26, 1982, p. 60. 8 FEDERAL RESERVE BANK OF PHILADELPHIA expansion of asset services since the law has provided more such opportunities than for liability services. In fact, interstate banking on the asset side of the balance sheet is already here. Traveling officers, loan production offices, Edges, and BHC subsidiaries all represent ways banks have pursued profit in asset holdings across state lines. Addition ally, some banking institutions—foreign banks and grandfathered interstate BHCs— have significant interstate operations in both asset and liability services. These successful efforts to get around geo graphic limits have not brought about any Federal changes in interstate banking laws so far. Despite many banks’ desire to go inter state, the pressure for change has not been sufficient to outweigh that for the status quo and to cause the demise of McFadden and Douglas. Having stood intact for many years, is there any reason why these laws should soon fall? The recent spate of out-of-state acquisitions by banks gives a clue to the answer. Why would banks take these steps unless they perceive high odds that the laws will change? Why should that change occur today or tomorrow rather than yesterday? CROSSING THE LAST BOUNDARY: TAKING DEPOSITS Modifications of the laws are likely be cause a fundamental change in the economics of banking is underway. The catalysts for this change have been developments in elec tronic funds transfer and related computer services which have dramatically improved efficiency and lowered costs. The high op portunity cost of money has spurred more efficient use of funds and adoption of lower cost, electronic media. Electronic developments have enabled the traditional suppliers of financial services— commercial banks—to lower the costs of existing services and to offer new ones. Elec tronics also has spurred nonbank suppliers of financial services to move into retail bank ing markets with substitutes for some bank services. The eventual demise of current geo graphic restrictions will occur because elec tronic transfer is rendering state lines even more meaningless for many bank services, particularly deposit taking. ELECTRONICS AND COMMERCIAL BANKS The greatest challenge to McFadden came in the form of the automatic teller machine (ATM] in the early 1970s. ATMs made deposit taking across state lines possible without new banking offices. Court interpretation of ATMs as equivalent to brick-and-mortar branches, however, upheld the theory of McFadden and stymied immediate develop ment of ATMs in interstate activity. Never theless, banks increased their use of ATMs. Facing large investment costs for computer equipment and uncertain demand for retail electronic services, banks either joined forces with other institutions in sharing facilities, sold services to other institutions, or bought them from a nonbank vendor. X-press of Baybanks, Massachusetts is an example of a shared ATM system, while Mac, operated by Philadelphia National Bank, is one of many proprietary networks formed by a bank that sells services to other banks. Tyme, operated by A.O. Smith, Inc., is a network run by a computer service company. Network forma tion has enabled small and medium institu tions to reap the benefits of economies of scale from large computer systems and to offer the latest in efficient service. Although no deposit taking across state lines is allowed, many networks serve insti tutions in several states (see ATM NET WORKS IN THE THIRD DISTRICT over leaf). A direct challenge to McFadden cur rently is developing with the formation of nationwide ATM systems. At least three dif ferent groups are considering the linkage of existing networks into a nationwide network. Eleven multi-billion-dollar banks have formed a shared network named Cirrus which will link more than 4,000 ATMs nationwide. An other, the Regional Interchange Association (RIA), represents a cooperative effort of sev BUSINESS REVIEW SEPTEMBER/OCTOBER 1982 eral networks to provide internetwork, na tional switching for more than 2,500 ATMs. These networks would provide 24-hour bank ing services on a nationwide basis at a min imal cost to the customer. With existing interstate networks and the potential of national ones, the stage is set for interstate and nationwide deposit taking. Interstate banking on the liability side is a technical reality. With the innovation of electronics in ATMs and related computer services has come a drastic reduction in the cost of transferring funds and information. The economics of deposit taking across state lines has changed from high-cost brick-andmortar branches to low-cost ATM facilities. Such low-cost, electronic funds services and the geographic restrictions of state lines are incompatible. These economic forces should prove too strong for the legal barriers to with stand. transfer have enabled nonbank institutions to move into some traditional retail banking services to take advantage of the current high interest rate environment. The variability of interest rates has created a desire for liquid investments. Money-market mutual funds have met this demand with a variety of inno vative products, among them highly liquid accounts with check writing facilities that pay a market rate. Banks, subject to Regu lations Q and D and unable to pay market interest rates, have experienced a consider able outflow of dollars to money funds.9 While banks have regained many of these dollars through deposits by money-market funds, they are legitimately concerned at losing direct contact with the retail customer who can now bypass the local commercial bank to a large degree. For the issue of interstate banking, the ELECTRONICS AND NONBANKS R egu latio n Q limits the interest rates banks may pay on deposits; Regulation D covers reserve requirements. Inexpensive computer services and funds ATM NETWORKS IN THE THIRD DISTRICT Two Philadelphia banks have developed extensive ATM systems. Girard Bank, via Girard Services, operates a network of 200 ATMs named George and sells complete data processing services to other financial institutions outside its immediate area. The network includes institutions in Pennsylvania, New Jersey, and Delaware. Recently, it received permission from Banking Com missions in Pennsylvania and Delaware for customers of Girard (Pa.) and Girard (Del.) to withdraw cash from George in either state, although they cannot make deposits. New Jersey does not allow such cross-state interchange. Philadelphia National Bank operates the other large network—Mac (Money Access Center)—for all types of financial institutions. The number of participating institutions recently expanded to 85, 66 of which are in eastern Pennsylvania and 19 in New Jersey. They will operate 400 ATMs, up from 244 in March 1982. Currently, there is no cross-state access, although the capability exists. Three New Jersery institutions, Fidelity Union Bank, The Summit Bancorporation, and First Jersey National Corporation, jointly operate The Treasurer, a smaller network of 60 ATMs. Six banks in Pennsylvania and Delaware agreed in March to join this network of about a dozen insti tutions in anticipation of changes in interstate banking laws. Following the trend of large banks in joining recently formed nationwide networks, Philadelphia National Bank has joined Mac with Plus Systems, Inc. which will provide switching services for a national network. Members of Plus will share some or all of their ATMs with other members’ customers. Other large Philadelphia banks probably will join different nationwide groups, given the existing trend for large competing institutions not to belong to the same network. 10 FEDERAL RESERVE BANK OF PHILADELPHIA rations, loan production offices, traveling officers, and subsidiaries in bank-related activities to create interstate or nationwide markets for their services. While this expan sion has occurred primarily in asset services, foreign banks and grandfathered interstate BHCs have an established and growing inter state presence in full-service banking. Despite a buildup of considerable interstate competi tion and pressure on legal geographic limita tions, the McFadden Act and the Douglas Amendment remain unaltered. Why should changes occur now? The economics of interstate banking has changed dramatically. Electronic transfer of data and funds not only makes interstate asset services cheaper but also renders inter state deposit taking economically feasible for banks on a larger scale. Previously, the cost of brick-and-mortar branching posed an economic barrier to expansion alongside the legal one. Banks now can cross state lines to take deposits at a relatively low cost. Elec tronic developments also have enabled other financial institutions to offer a wide variety of financial services, including deposits, on an interstate and nationwide basis. Small and medium-sized banking institu tions recently have accompanied large banks in a scramble for an interstate presence. These banks have joined or formed ATM networks with an interstate market area, while large banks are joining or organizing nationwide networks. Many medium-sized banks have bought shares of banks in neigh boring states, and some of the nation’s largest banks have made long-run acquisition deals dependent on changes in interstate banking laws. Why would banks take these steps without the ability to take deposits across state lines? Some banks are challenging the law because technological change has made electronic funds transfer a low-cost, viable vehicle for banking services. Electronic funds transfer defies geographic boundaries. The economic argument for interstate banking is irrefut able. Can the legal changes not follow suit? importance of the money-market funds lies in their checkable accounts. It is through this channel that interstate deposit taking is occurring and will expand. While ATMs currently do not figure in these services, the possibility of access to money funds through ATMs or home and business computers is not remote. Thus, interstate deposit taking by money-market funds could occur elec tronically as well as by mail and telephone. Several funds already provide something very close to one-stop financial service. A link with ATMs will help close the gap. Low-cost electronic transfer also is prompt ing the newest threat to interstate barriers. With an enormous nationwide marketing structure and experience in selling insurance, Sears, a national retailer, plans to sell a va riety of financial services. One of its first offerings was a money-market fund based on government securities. Although this fund currently does not offer transactions accounts, the potential exists. Sears made an additional step in mid-June. It opened its 851 customer service counters to check cashing for the cli ents of Dean Witter, the brokerage house it merged with in 1981. In the context of inter state banking, the possibility that Sears might have a "bank” in all its locations with systemwide access challenges the limits of state lines and implies considerable potential competition for many banks. The technology Sears is using will enable other corporations also to go nationwide with marketing of fi nancial services. Interstate banking is a reality whose time has come. If the legal barriers do not fall as the economic ones have, interstate banking will move on a large scale into the nonregulated, nonbank sector, leaving commercial banking to perform a narrower set of services than consumers desire. CONCLUSION Over the years, many banking institutions have taken advantage of the leeway in the law to pursue business opportunities across state lines. They have used Edge Act Corpo 11 The Federal R eserve B ank o f P hiladelphia A CHANGING INSTITUTION IN A NEW ENVIRONMENT We’re keeping pace with your rapidly changing needs. Through on-line systems, where you’re in control, you can: • • • • • transfer your own funds or those of your customer; request funds transfers electronically rather than by telephone; exchange securities directly with other depository insti tutions; review your securities portfolio on a real-time basis, including your activity for the past 60 days; gain access to our on-line processing system for new issues of Treasury securities. To find out more about these and other services call Lou Sanfelice or Bill Herbst at (215) 574-6470. SERVICES OF TOMORROW, TODAY FEDERAL RESERVE BANK OF PHILADELPHIA Delaware Valley Defense Industry Update: Is Better Information the Way to Greater Growth? by John J. Mulhern* One approach to winning more contract dollars would be to try to increase the number of Defense prime contractors in the region. Attention to numbers of prospective prime contractors is warranted, certainly, espe cially in the case of those small businesses that typically foster technical innovation. But there are other routes as well. One such approach is to concentrate on bringing more dollars into the region by capturing very large awards. While dependence on too few large contracts may produce undesirable risks, landing the big contracts also may bring economic benefits to a variety of firms, and small businesses may have opportunities as subcontractors that they would lack as prime contractors to profit from Defense business. The areas of the country that are most successful with Defense business in the years ahead are likely to be those that concentrate not only on increasing the dollar value of their Defense prime contracts, in cluding very large ones, but also on devel oping the subcontractors and suppliers that will keep Defense dollars in the area for an extended period. Using information to link Like many another area of the Northeast, the Delaware Valley continued to be plagued by a sluggish economy overall in 1981. With Defense spending projected to achieve yearover-year real increases, some observers looked to Defense business as a source of economic relief. During the 1970s, when Defense spending was flat or declining, many areas of the country, including Philadelphia, were more concerned with employment at local Defense installations than with Defense contracts. In fact, just about the only game in town was to hang on to the Defense infrastructure—bases, stations, forts, centers, and offices—in an ticipation of a Defense revival later on. Now, though, the situation is different. A contract boom has arrived, and a shift in focus is called for. ‘ John J. Mulhern, who specializes in organization and strategic planning, joined the Department of Research in 1976. He received his Ph. D. from the State University of New York at Buffalo. The author acknowledges the helpful comments of Dr. David L. Blond, Senior Econo mist in the Office of the Secretary of Defense, and the officers and directors of the Philadelphia Chapter, American Defense Preparedness Association. 13 SEPTEMBER/OCTOBER 1982 BUSINESS REVIEW Together they affect the local economy by employing thousands of people (mostly civilians] directly. And the number of jobs at installations in the Philadelphia area did grow as Defense tried to speed up its activity in fiscal year 1981. Defense Hires More People . . . The experience of the Defense Logistics Agency’s Defense Contract Administration Service (DCAS) provides one example of the kind of growth that occurred. DCAS, which main tains both a regional headquarters and a management area office in Philadelphia, is responsible for production surveillance, quality assurance, financial services, dis bursements, and other services connected with contracts awarded by Defense Logistics Agency purchasing activities, military de partments, civilian agencies, and foreign governments. The Philadelphia offices saw personnel growth of 5 percent in fiscal 1981, raising their employment from 793 to 835. This increase can be attributed in part to the number of contracts being administered and in part to their degree of complexity.1 Another source of continued high levels of employment was the Philadelphia Naval Shipyard. The Yard’s permanent workforce, which had shrunk to around 7,000 in 1979, prime contractors with nearby subcontractors can be good for the country at large as well as for the region if it promotes production effi ciencies and restrains costs. 1981: A YEAR OF PROMISE Widespread concern with U.S. national security, which had broken the surface in 1979, made itself felt in contract awards and other measures of Defense Department activity in fiscal 1981. Increases in the Defense budgets for 1981 and 1982 had been shaped by the Carter Administration before it left office, and the Reagan Administration moved swiftly to enlarge those increases. Amendments submitted to Congress in March 1981 were a signal of what might follow in the 1983 budget. This signal was confirmed by subsequent Administration proposals. Vendors who were attuned to developments in the Defense market re sponded rapidly to meet new requirements, and in doing so they positioned themselves to compete effectively for Defense business. How well has the Delaware Valley re sponded to growth in the Defense market? So far as employment at Defense Department installations is concerned, the number of people employed locally was up somewhat in 1981, and it probably will stay up for the next two years. Contract activity was higher as well. The region showed a small gain in market share of Defense prime contract awards. These awards opened up new op portunities for firms that wanted to par ticipate in Defense business by subcon tracting and providing supplies to major Defense prime contractors. 1The Defense Logistics Agency provides a variety of logistics support services and supplies that the Armed Services use in common. The Philadelphia DCAS region includes management area offices in Baltimore, Pitts burgh, and Reading as well as in Philadelphia. Employ ment in all regional DCAS offices grew from 1,497 in 1980 to 1,559 in 1981, or about 4 percent. So far in 1982 the numbers appear to be higher—up 9 percent in Phila delphia and 7 percent in the DCAS region overall. (Here as elsewhere in this article, all references to years are to Federal fiscal years.) The numbers given here are author ization numbers, but they do not differ appreciably from actuals. The number of contracts in hand in the DCAS region at the end of 1981 was up by over 8 percent over the previous year and approached 44,000, with face value of nearly $13 billion. The number of separate invoices processed increased to almost 142,000, up from 114,000. (These figures were supplied by the office of the Com mander, Defense Contract Administration Services Region Philadelphia.) DESPITE DOD EMPLOYMENT GROWTH, CONTRACT AWARDS DOMINATE The Philadelphia area houses a large concentration of Defense installations. Some of these installations do the kind of buying that is reported in contract awards, while others are engaged in such functions as manufacturing, research, training, and ad ministration. Many are inside the city. 14 FEDERAL RESERVE BANK OF PHILADELPHIA was up above 9,500 through much of fiscal 1981, right around its Congressionally au thorized ceiling, because of work in progress on the Saratoga and on other ships. These numbers were increased by the addition of about 1,000 temporary workers. Thus the Naval Shipyard has been a sizable employer of skilled labor (see NAVAL SHIPYARD JOBS: WHO GOT THEM?). Looked at in aggregate terms, employment at Defense installations in the Philadelphia area has grown faster than the national rate. According to recent information, DOD employ ment nationwide (military and civilian) was up 1.2 percent in 1981 to 2,300,000.2 The per centage increase in Philadelphia County alone was considerably higher, at 5.7 percent for civilians and 6.1 percent for the total—enough to keep Philadelphia in ninth place among con centrations of Defense direct-hire employees. Although some other places in the region took losses in DOD personnel, Philadelphia showed a solid increase in direct-hire employ ment (see PHILADELPHIA LED THE RE GION . . . overleaf). Over the longer haul, though, it could be d ep artm e n t of Defense, Washington Headquarters Services, Directorate of Information, Operations, and Reports, DIOR Report M 0 2 , “Distribution of Personnel by State and by Selected Locations,” Fiscal Year 1980, p.3, and Fiscal Year 1981, p. 5. NAVAL SHIPYARD JOBS: WHO GOT THEM? Defense installations provide fairly large numbers of jobs, but how effective are they at spreading those jobs around to members of different socio-economic groups? If the Philadelphia Naval Shipyard is representative, they have been very effective. The Yard hires people for all sorts of positions, from work-study trainee to senior executive. At the end of September 1981, 22 percent were general schedule (mainly white collar) employees while 77 percent were craftsmen; laborers made up the remaining one percent. Thus skilled jobs pre dominate. Overall full-time employment stood at 10,040 — an 11 percent change from a year before. * Adding in part-time workers would raise the total over 11,000. Members of minority groups made up a significant and increasing portion of the work force. In October 1980, minorities made up 23 percent of the work force. By August 1981, their numbers had risen to 31 percent.! Further, the Yard continues to operate an aggressive recruitment program to identify minority prospects. The current regulatory authority for the Yard’s effort along these lines is the Department of the Navy FY 1982-86 Affirmative Action Program Plan and Federal Equai Opportunity Recruitment Program PJanissued by Navy Secretary Lehman in February 1982. This document includes: a profile of the Navy civilian workforce (about 300,000 employees) by occupation, level, race, ethnicity, and gender; a report of underrepresentation calculations by civilian labor force and relevant labor force; five-year goals; and, perhaps most interesting, an analysis of the barriers to employment with strategies for overcoming those barriers. The barrier analysis lists 15 internal barriers (for example, “lack of societal encouragement for women and minorities to pursue professional occupations”) and 16 external barriers (“minimal availability of underrepresented group members in applicant pools”). Recruitment strategies — say, “encourage women to apply for positions which have been traditionally held by males only” — are suggested by the Navy to overcome barriers to employment at different levels in different skill groups. ‘ Based on Department of the Navy Minority Census, Date 110380, p. 439 and Date 110781, p. 3149. tCommand Profile, p. 9. 15 SEPTEMBER/OCTOBER 1982 BUSINESS REVIEW opportunities for growth in the longer term. . . . But Contracts Show Larger Gains. Military prime contract awards over $10,000 in the area stood at $2.1 billion in fiscal year 1981, up from about $1.5 billion in 1980 (awards under $10,000 would amount to about another $170 million if the national ratio holds).4 Even in inflation-adjusted terms, the increases were considerable—about 25 per disappointing to bank on DOD employment as a source of growth for the region. The reason is that the Defense establishment, in tune with the rest of the Federal government, plans to reduce personnel ceilings in the years ahead. While the number of direct-hire civilian employees nationally is scheduled to stand at 936,000 in fiscal years 1982 and 1983, it will drop by 6,000 per year thereafter through 1986, falling close to its 1980 level. Part of this reduction is expected to be made up by internal productivity improvements, part of it by contracting out to private firms work of the kind that used to be done by government employees. Overall Federal employment already is declining both in absolute numbers and as a percent of the population.3 For these reasons, privatesector contracting probably offers greater 3James W. Abellera and Roger P. Labrie, “The FiveYear Spending Plan,” A EI Foreign P olicy and D efen se R eview 3 (4,5), p. 17, Table 13. See also T he Budget of the United States G overnm ent, 1983, Special Analysis I: Civilian Employment in the Executive Branch, Feb ruary 1982, p. 13, Table 1-4. 4 DIOR Report P12, “Prime Contract Awards Over $10,000 by State, County, Contractor, and Place,” Fiscal Years 1980 and 1981. The region or area is defined as the Philadelphia Standard Metropolitan Statistical A r e a three counties in New Jersey (Burlington, Camden, Gloucester) and five in Pennsylvania (Bucks, Chester, Delaware, Montgomery, Philadelphia). While many of the numbers in this article apply to the SM SA and its counties, the thrust of the article applies to the region more widely conceived—to the 11-county area of the PENJERDEL Council, to the Third Federal Reserve District, and to the Middle Atlantic census division (New Jersey, New York, and Pennsylvania). The De fense budget’s three main buying categories—procure ment, research, and construction—are reflected in con tract awards. Procurement is the largest, at about $65 billion of total obligation authority in F Y 1982. Procure ment dollars go for a wide range of supplies and services including both systems (airplanes, tanks, radars) and commodities (construction materials such as plywood and concrete, industrial materials such as wire rope and bar stock). Research—actually research, development, test, and evaluation— is the next largest buy at about $20 billion. Construction comes next, at around $7 billion of total obligation authority in FY 1982. While small (under $10,000) purchases are not re ported by region, their impact can be considerable. In FY 1981, for example, the Defense Industrial Supply Center in Northeast Philadelphia spent 55 percent of its $510million budget for industrial hardware through small purchases. As a result of the DOD Acquisition Improve ment Program, the limit on the use of simplified pur chase procedures has been raised from $10,000 to $25,000, and many actions under simplified procedures have a fast pay provision. On these actions, contractors may be paid based on an invoice certifying that shipment has been made, even if the shipment has not arrived at its destination. Fast pay can have a strong positive effect on the cash flow of small businesses. PHILADELPHIA LED THE REGION f XT JLlJCir £ .l N a i ! i J.1NI 11171717 VTC17 PERSONNEL GAINS Fiscal Years 1980-1981 1980 1981 Percent Personnel Personnel Change Philadelphia 25,694 27,268 +6.1% Fort Dix 11,918 11,863 - .5 McGuire AFB 6,862 6,747 -1 .7 Dover AFB 6,239 5,995 -3 .9 Warminster 2,376 2,350 -1.1 Horsham & Willow Grove 1,793 1,843 +2.8 Total 54,882 56,066 +2.2 SOURCE: DIOR Report M02, "Distribution of Personnel by State and by Selected Locations,” Fiscal Years 1980 and 1981. Figures are totals for military and civilian personnel for all services and Defense agencies. 16 FEDERAL RESERVE BANK OF PHILADELPHIA cent for large prime contract awards.5 Thus they signal a real positive effect on regional wealth (see NAVY AWARDED THE MOST CONTRACT DOLLARS.) In comparison to the nation overall, though, this area’s growth was less spec tacular. In fiscal year 1980 the national total for large (over $10,000) prime contracts awarded to business firms stood at $68 billion, of which the area had 2.2 percent.6 With the national total at $88 billion in 1981, the region had about 2.4 percent.7 This percentage is larger than the region’s share of the national population (4.7 million out of 226.6 million, or 2.1 percent according to 1980 census data),but while it shows some growth in market share, that growth is small.8 Within the region, the greatest percentage growth in contract award dollars occurred in Pennsylvania’s Chester County and Dela ware County and in New Jersey’s Burlington County. One part of the explanation for higher growth in these counties may be the presence there of some of the area’s largest Defense manufacturing firm s.9 Very large 5Based on a change in the Philadelphia CPI of 10.8 percent. 6DIOR Report P06, “Prime Contract Awards by Region and State, Fiscal Years 1979, 1980, 1981,” p. 5, Table A, Awards Distributed to Regions and States. This NAVY AWARDED THE MOST CONTRACT DOLLARS IN FISCAL YEAR 1981 IN THE figure is used because it is consistent with the county figures for prime contract awards in DIOR Report P12, “Prime Contract Awards Over $10,000 by State, County, Contractor, and Place”—the source used here for local contract award figures. Awards Distributed to Regions and States equals Total Prime Contract Awards minus: Work Performed Outside the United States; Actions of $10,000 or less; and Awards Not Assigned to a State for some other reason [about 3 percent of the total). PHILADELPHIA SMSA 7DIOR Report P06, 1979, 1980, 1981. Millions of Dollars 8U .S. Department of Commerce, Bureau of the Census, 1980 Census of Population andHousing, Standard Metropolitan Statistical Areas and Standard Consoli dated Statistical Areas: 1980, April 1981, PC80-S1-5, p. 1, Table A, and p. 34, Table 1. 9Through fiscal year 1980, the Community Services Administration compiled county data on DOD outlays under five classes of large prime contracts: civil functions; military construction; military research, development, test, and evaluation; military services; and military supplies. It compiled county data also on DOD small contracts (those worth less than $10,000). For fiscal year 1981, prime contracts have been reclassified into three groups for reporting purposes: small military and civil; large civil functions; and large military functions. Further, these numbers are available only as statewide aggre gates. Thus the 1980 county data are the latest that permit even a gross sectoral analysis. In preparing this article, the series consulted most frequently were total obligation authority and prime contract awards. In John J. Mulhern, “The Defense Sector: A Source of Strength for Philadelphia’s Economy” (B usiness R eview , Federal Reserve Bank of Philadel phia, July/Augustl981), the focus was on outlays and, to a lesser extent, shipments—two series well adapted to a retrospective analysis. Business Conditions Digest pro- SOURCE: Compiled from DIOR Report P12, “Prime Contract Awards by State, County, Contractor, and Place," Fiscal Year 1981. Data include only prime contract awards over $10,000. 17 SEPTEMBER/OCTOBER 1982 BUSINESS REVIEW hardware contracts require very large firms— firms that are broad and deep financially, managerially, and technically. The industri ally developed outer counties (all but Glou cester) have such firms. Lower land values and taxes along with changes in production technology and improved transportation fa cilities have operated over a long period of time to make the outer counties more attrac tive to large manufacturing operations. Burlington, Camden, Delaware, and Mont gomery all have firms that compete success fully for major weapon systems contracts, and in the aggregate they handle far more in such contracts than Philadelphia does. Since the big money goes to systems contracts, it goes to the suburban counties. The flow of money to the outer counties doesn’t come to rest, of course, in the treasuries of the large prime contractors. Through their subcontracting and supply purchasing, this money is spread around to a myriad of other firms, both large and small, in central city and suburban locations. Rather than being competitors for smaller firms, these large outfits offer a sizable secondary market over and above the part of the direct market in which smaller firms can be responsive as prime contractors. In short, the outer counties did quite well with Defense contracts in 1981. Six of the seven enlarged their winnings of prime contracts at a nominal rate faster than the national average of 29 percent.10 Although Philadelphia County pulled the area’s aver age down, with a nominal growth rate of only 2.6 percent, it probably could improve its performance by focusing on industrial sec tors where demand is strong, perhaps look ing to the manufacture of components for the large contracting operations in the outlying suburban areas. Thanks to the advent of automated information systems, it has be come possible to isolate the pertinent de mand information at both national and re gional levels. ASSESSING THE DEMAND The Department of Defense issues con tract award reports which give information about past demand. It also generates fore casts of expected demand by industrial sector. This information can help put the experience of the last year into perspective. In 1981, as in the two years prior, the lion’s share of prime contract award dollars nationwide went to purchase aircraft, elec tronics, and missile and space systems. These and four other kinds of hard goods made up more than two-thirds of the dollar value of all large prime contract awards. Indications are that these items will continue to generate the highest dollar value of de mand through 1987. Overall, the Middle Atlantic census di vision, which includes New York as well as Pennsylvania and New Jersey, ranked fourth of nine in value of large prime contract awards in 1981, a step down from third in 1980. Middle Atlantic’s strengths in both dollars and market share lay in aircraft and in electronics and communication equipment. Both of these sectors showed healthy dollar increases, at 26 percent and 16 percent; but again, the changes in market share weren’t all that impressive. In aircraft there was a modest gain of a tenth of a percentage point, in electronics and communications equip ment a loss of seven-tenths of a point. The other hard goods lines showed mixed results (see DEFENSE HARD GOODS . . .). What about the future? While an exact call of anything in the future is a chancey business, the Department of Defense has projected its requirements in a document vides a useful set of leading, intermediate, and final indicators, though these classes have some overlap. For a discussion of the indicators see Glenn H. Miller, Jr. and Stephen L. Able, “Defense Spending and Economic Activity,” Econom ic R eview , Federal Reserve Bank of Kansas City, July/August 1980, pp. 3-14. For a dis cussion of the use of shipment data see Lynn E. Browne and Sarah Gavian, “The Importance of Defense to New England,” N ew England E con om ic Indicators, Federal Reserve Bank of Boston, October 1981, pp. A4-A5. 10DIOR Report P06, 1979, 1980, 1981, p.2. 18 FEDERAL RESERVE BANK OF PHILADELPHIA known as the Five-Year Defense Program, and these requirements have been analyzed by industrial sector in the Defense Economic Impact Modeling System (DEIMS). Advance procurement commitments for items in the DEIM S forecast will tend to lock in future purchases.11 Further, DOD has become very sensitive to the potentially disruptive effects of unexpected changes in purchase levels and over the last two years has sought to make buying activity more stable as part of its Acquisiton Improvement Program. Thus it appears that the DEIM S model should be a useful predictor of demand for Defense products and services. The February 1982 DEIM S projections indicate that Defense spending on electron ics and communication equipment will show an average annual growth of around 13 per cent through 1987 and that Defense produc tion in this sector will come to over $26 billion (1981 dollars] in the last year of the period. Spending on aircraft and missile systems will be growing at a comparable rate, and 1987 dollar value for the two to gether will total $22 billion. Further, Defense demand in these sectors will grow faster than commercial demand.12 11The effect is to raise the cost of cancelling these commitments. According to Alan Greenspan as quoted in the N ew York Times, June 27,1982: “Once the growth in obligations starts to accelerate, it becomes very difficult to control or slow the growth in total outlays. You cannot reverse commitments without heavy costs. That’s one reason why the proposed cuts in defense have been so minuscule.” 12See David L. Blond, “The Defense Economic Im pact Modeling System,” Office of the Secretary of Defense, January 1982. Sectoral tables from which these figures are drawn include 322 (radio and TV communi cation equipment), 45 (complete guided missiles), and 335 (aircraft). DEIM S tables are available to industry from the Defense Industrial Resources Support Office, Suite 1406, Two Skyline Place, 5203 Leesburg Pike, Falls Church, VA 22041. DEFENSE HARD GOODS SHOW MIXED ACTIVITY IN MIDDLE ATLANTIC DIVISION (Millions of Dollars) Fiscal Year 1980 Divisional Divisional Share Value of National Market Aircraft Missile and Space Systems $2,241 596 Ships 917 Tank-Automotive Weapons Ammunition Electronics and Communication Equipment 14.8% 6.4 Fiscal Year 1981 Divisional Divisional Share Value of National Market $2,825 768 14.9% 6.7 14.7 1,363 17.5 134 4.8 229 5.3 348 26.1 145 8.6 194 9.5 267 11.5 1,936 18.2 2,255 17.5 SOURCE: DIOR Report P06, “Prime Contract Awards by Region and State,” Fiscal Years 1979, 1980,1981, pp. 15-16. Data include only prime contract awards over $10,000. 19 BUSINESS REVIEW SEPTEMBER/OCTOBER 1982 If these forecasts are anywhere near the mark, the lines of Defense business that currently show the most strength in the region could continue to show considerable vigor nationally. Whether the prime contract dollars come to this region and stay here, however, will depend at least in part on what kind of an economic development effort the region is willing to make. Use of demand information and of information on the in dustrial structure of the region both will be prominent parts of a successful development effort. ample, small businesses nationwide received about $14 billion in Defense prime contract awards, and in 1981, about $18 billion.13 In those same years, military subcontract commitments to small businesses from just the 1,100 firms that were required to report (because they held very large prime con tracts) totaled about $11 billion and $13 billion; and no one knows how much else was subcontracted to small businesses.14 Even by a conservative estimate, small businesses did more than two-thirds as much business in subcontracting as they did in prime contracting. For firms in the city of Philadelphia, em phasis on local subcontracting may be par ticularly attractive. Most of the local major primes are outside the city limits. In the first nine months of fiscal 1981, for example, fif teen of the seventeen local prime contractors that were required to participate in the DOD subcontracting program were based outside Philadelphia. They committed about $287 million of the area’s $327-million subcontract program total, a third of which went to small business.15 The city has firms that can per form competitively as subcontractors and sup pliers to these majors. The task is to get local primes and subs together. INFORMATION CAN SPUR LOCAL SUPPLY ACTIVITY In the Defense market as in other markets, buyers must be matched to sellers if business is to be transacted, and this matching de pends on information. Many observers be lieve that improving the information avail able to potential Defense contractors and local policymakers could help distribute the benefits of Defense prime contracts more widely in the region and provide a focus for job training efforts. Concentration and Subcontracting. De fense prime contracting is highly concen trated in the Philadelphia area. Of the $2.1 billion of 1981 large prime contract awards that was divided among over 1,700 area con tractors, for example, over 50 percent of the contract value went to just three hard goods contractors and another 10 percent to an oil company; a little less than 40 percent or roughly $800 million was left for the other 1,700-plus prime contractors (see DEFENSE BU SIN ESS IN THE THIRD FEDERAL RE SERVE DISTRICT). Much of the value of Defense prime con tracts, however, may be subcontracted; the rule of thumb is one-half the value for hard goods awards. If local subcontractors are forthcoming, a high percentage of the sub contract dollars can be kept in the region. Thus subcontracting is a key issue. Subcontracting is good business, espe cially for small concerns. In 1980, for ex Indeed, regional cooperation could play a crucial role in cutting the cost of doing Defense business, because on-site inspection is a feature of many Defense contracts. Quality control and quality assurance pro grams are used by Defense contracting offices to come as close as possible to a zero 13DIOR Report P03, “Prime Contract Awards,” Fiscal Year 1981, p. 2-2. 14DIOR Report P03, Fiscal Year 1981, pp. 8-1, 8-2. Firms are required to report in the subcontracting program mandated by Public Law 95-507 only on contracts which individually are expected to exceed $500,000 ($1 million for construction). Thus a great deal of subcontracting is not reported under this program. 15DIOR Report P14, “Companies Participating in the Department of Defense Subcontracting Program,” first nine months, FY 1981. 20 FEDERAL RESERVE BANK OF PHILADELPHIA defects rate. In order to meet their own contract commitments, prime contractors often require inspections of their subcon tractors’ products or processes down to the lowest tiers. Prime contractors stand to benefit from buying their production inputs locally, since transportation and coordination costs drop sharply as distances between industrial plants become shorter. The con tractor that can avoid frequent and costly inspection trips to distant plants may find himself at a competitive advantage. The opportunities for gains from local subcontracting have been illustrated over the past two years by the Ocean Systems Division of Gould, Inc., which was the eighty-fifth largest Defense prime contractor in 1981. This Cleveland-based firm, which manu factures torpedoes and other underwater devices, developed a program to increase its subcontractor base in its own eight-county area. As a result of the program, subcon tracts were issued to 63 new firms in the first six months, approximately doubling local subcontract commitments from $12 million to $25 million. Gould estimates that the initial cost savings simply from increased competi tion in procurement, not to mention over head savings related to control of the sub contracts, amounted to an average of 27 per cent across the board.16 But building up the local subcontractor networks required coop eration and information. Regional Information Initiatives. There are signs that regional awareness of infor- 16Gould, Inc., Ocean Systems Division, “Make It in Cleveland: A Program of Greater Cleveland Small Busi ness Procurement Conducted by Gould’s Ocean Systems Division,” August 1980. Gould personnel indicate that the number of new subcontractors participating has doubled since the 1980 report. DEFENSE BUSINESS IN THE THIRD FEDERAL RESERVE DISTRICT The states of the Third Federal Reserve District showed mixed results in Defense prime con tracting in fiscal year 1981. In New fersey, 4 of the 7 military hard goods lines showed 1981 awards at a level above $100 million, with electronics and communication equipment leading the pack, followed by missile and space systems, and ships. All these programs showed solid growth in market share, as did the fourthplace program—aircraft. In Pennsylvania, aircraft led the way in awards and showed growth in market share; and five other hard goods programs exceeded the $100-million mark. In Delaware, which immediately adjoins the Middle Atlantic census division, Defense industry takes a somewhat different form. Delaware’s strengths are in petroleum, textiles, and construction rather than in hard goods. With hard goods getting more attention than other items in fiscal 1981, Delaware actually suffered a nominal-dollar loss in value of large prime contract awards in the range of 2 percent, and the number of participating firms dropped a little. But Delaware firms have the capacity to and actually do supply Defense prime contractors with a wide range of products. The divisional and state figures for prime contract awards are reflected clearly in those for the counties of the Philadelphia area. The largest firms were those that specialized in electronics and communication equipment, aircraft, missile and space systems, and oil—Philadelphia’s biggest product in terms of value of shipments.* Further, they all showed healthy year-over-year growth, and all but petroleum showed a rising market share. Though not the only centers of Defense-related economic power in the region, these firms and their industries clearly stand out as the major ones at present. * Shipments from Philadelphia’s petroleum refining industry exceeded $2 billion in 1980 according to the 1981 “Survey of Industrial Purchasing Power,” Sales and M arketing M anagem ent, April 27, 1981, p. 84. 21 SEPTEMBER/OCTOBER 1982 BUSINESS REVIEW thin.” 17 Unquestionably, skilled labor is a critical link in the Defense industry chain, and the skills in question are intellectual as well as manual. A recent report of a Defense Science Board task force focused on requirements for professionals with high-level skills in 17 occupations ranging from aero-astronautic engineers to statisticians and actuaries. According to the report, Defense-related requirements are projected to increase by 38 percent over the period of the forecast (19811987), from 229,000 to 316,000 people.18 The task force leader expressed concern in forwarding the report that there would be “definite short-falls in certain disciplines,” but indicated that Defense needs could be met “if market forces work and the growing numbers of students enrolled in the nation’s engineering programs are properly trained and employed.” 19 Shortfalls are in the forecasts also for skilled operators in tradi tional blue-collar trades. For market forces to overcome these shortfalls, information must be available to those who will provide and train the man power as well as to those who want to acquire it. A regional clearinghouse could play a very valuable role in maintaining information on Defense industry manpower demand and in monitoring attempts to meet it, especially in areas of high unemployment such as Philadelphia. A Clearinghouse To Improve Informa tion. Better information also could strengthen the critical subcontracting link. According to interviews by A viation W eek and S pace mation requirements already may be growing in the Delaware Valley—awareness that in cludes the public and private sectors. Late in 1981, for example, the Mayor of Wilmington initiated a Jobs Through Defense Task Force made up of Delaware industry and government leaders to “help Delaware firms determine their potential for beginning or increasing Defense-related work.” After a series of discussion meetings, the Task Force spon sored a procurement conference in February 1982 at which some 250 participants had the opportunity to speak directly with govern ment buyers and advisers. At about the time the Wilmington con ference was being held, the City of Phila delphia began its operational planning with the Greater Philadelphia Chamber of Com merce, the PENJERDEL Council, and the American Defense Preparedness Association —an industry group—for a conference in May with the theme “Selling to Defense in the 1980s.” This conference differed from many previous ones in giving prime con tractors equal billing with DOD representa tives as buyers of goods and services in an attempt to foster interindustry awareness. While these and other conferences have achieved their immediate goals, many ob servers believe that some ongoing organi zation to collect, digest, and disseminate in formation on the Defense economy—a re search institute and clearinghouse for national security resources—ought to be part of the regional economic development agenda. They reason that the pace of Defense acquisition of goods and services has picked up so sharply that the requirement for better data on pro jected spending and on industry opportun ities has become critical to the region’s De fense industry participation. As Charles L. Schultze has noted: “an 80-percent increase in the real volume of military procurement and R&D in the short space of four years will give rise to shortages of skilled labor and specialized components within the Defense industries themselves. Capacity will be strained and managerial oversight stretched 17Charles L. Schultze, “Economic Effects of the Defense Budget,” The Brookings Bulletin 182 (Fall 1981), p. 4. How acute these shortfalls turn out to be will de pend in part on levels of activity in the civilian econ omy. 18“Report of the Defense Science Board Task Force on University Responsiveness to National Security Requirements,” Office of the Under Secretary of De fense for Research and Engineering, January 1982, pp. 3-1, 3-2, 3-3. 19“Report,” p. v. 22 FEDERAL RESERVE BANK OF PHILADELPHIA most of these developments, which would help make firms less vulnerable to fluctu ations in Defense business volume. A clearing house could be helpful here as well. In short, an organization that would take on the responsibility for managing Defense marketing information could catalyze regional participation in Defense business, especially if it could intensify prime contractor inter actions with local subcontractors. Strengthen ing of buyer-seller interactions among local prime contractors and subcontractors not only could perk up the regional economy but also could achieve efficiency gains in provid ing national security—a public good—to the nation at large. And in the process, the di verse industrial base of the region could be modernized and made more competitive in both national and international markets. Other things are important, too. Good transportation systems, attractive living conditions, and all the other features that link jobs to places make a difference for Defense business as well as for other business. But, all other things being equal, regional cooperation in providing market information may well be the key to increased Defense industry participation. T echnology, many aerospace firms that worked for Defense prime contractors either failed or were bought up by other firms during the 1970s. As business volume dropped off at the prime contractors, they took subcontract work back into their own plants to use up their excess capacity. Now many of those old subcontract plants are gone or are doing other work, 20 and some analysts be lieve that, in their absence, serious produc tion bottlenecks could occur. Although firms that have gone through the trauma of losing Defense subcontract business or that are familiar with the history may be reluctant to tool up for Defense work, better market information about both the government sector and the commercial sector could help them improve their planning and reduce their risk. That risk could be reduced further by modernized and more adaptable manufacturing equipment. It has been suggested, for example, that more modern equipment and machinery could be im mediately or more quickly converted to meeting the civilian economy’s needs or to entering world competition.21 Other stabi lizing factors such as multi-year procure ment authority could make it easier for sub contractors to enter Defense business at an acceptable level of risk. Again, improved information as well as management and tech nical assistance may be required to make the RECAP The region appears just to have held its own in Defense business in fiscal year 1981. Work allocated to the Naval Shipyard and other large installations has put more people on the payroll, but the gains in share of Defense prime contract awards have been slight. Systematic efforts to improve market information are just beginning. Local leaders in the private sector and the public sector, though, are far more aware than they were of the role Defense business plays in the region’s economy. With just a little push, they could make a noticeable change in how well the region does with Defense business. ^ “Subcontractors: Shrinking Base of Industry,” A viation W eek and Space T echn ology, July 20, 1981, pp. 14-15. 21“The Industrial Base: Government Must Take the Calculated Risks,” interview with Rep. James J. Blanchard (D-Mich), G overnm en t E xecutive, March-April 1982, p. 50. For a discussion of DOD’s Manufacturing Tech nology and Technology Modernization programs, see "The FY 1983 Department of Defense Program for Re search, Development, and Acquisition,” Statement by the Honorable Richard D. DeLauer, Under Secretary of Defense, Research and Engineering, to the 97th Con gress, Second Session, March 2, 1982, pp. IV-5, IV-6. 23 100 North Sixth Street Philadelphia, PA 19106
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