Full text of Business Review (Federal Reserve Bank of Philadelphia) : September/October 1984

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ISSN 0007-7011

Federal Reserve Bank of Philadelphia

SEPTEMBEROCTOBER 1984




The Changing P f°w ®
J he Financial »nd^ j U

\

RegulatorxS S S ^

Risk-Sensitive
Deposit Insurance
Premia;

Antitrust Implications
of Thrifts’ Expanded
Commercial Loan Powers

Some Practical Issues
Janice M. Moulton
Mark J. Flannery
Aris A. Protopapadakis

Federal Reserve Bank of Philadelphia
Ten Independence Mall
Philadelphia, Pennsylvania 19106
SEPTEMBER/OCTOBER 1984

THE CHANGING PROFILE OF THE FINANCIAL INDUSTRY
AND SOME REGULATORY CONCERNS
Recent legislation has lifted many regulations that had stood for fifty years, and has authorized
new powers for financial institutions. Banks, thrifts, and other firms have begun to adapt to this
environment, and they are using their new powers to reshape the industry’s profile. At the same
time, the institutions charged with regulating the financial industry are also adapting. The articles
in this issue o f the Business Review examine some o f the concerns o f regulators in light o f the
emerging profile o f the financial industry. Mark J. Flannery and Aris A. Protopapadakis consider
recent proposals to revamp federal deposit insurance by replacing some o f the regulation with
premia priced to reflect banks’ risk. Finding this approach not significantly different from or better
than the present system, they also identify other means o f increasing banks’ responsiveness to
risk. Janice Moulton looks at the expanded loan powers authorized to thrifts, and, focusing on
Pennsylvania, describes the implications o f increased competition for bank merger analysis.

RISK-SENSITIVE DEPOSIT INSURANCE PREMIA: SOME PRACTICAL ISSUES
Mark J. Flannery and Aris A. Protopapadakis

ANTITRUST IMPLICATIONS OF THRIFTS’ EXPANDED COMMERCIAL LOAN POWERS
Janice M. Moulton

The BUSINESS REVIEW is published by the
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includes twelve regional banks located around the
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Reserve is self-supporting and regularly makes
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operating surpluses.

Risk-Sensitive Deposit Insurance Premia:
Some Practical Issues
Mark
Federal deposit insurance emerged in the United
States in 1933, follow ing a widespread loss of
confidence in the banking system which precipi­
tated an unprecedented number o f bank failures.
The mood o f the day was one in which one bank’s
demise tended to generate concern that others

*M ark J. Flannery is Associate Professor of Finance at the
University of North Carolina, Chapel Hill, and has been a
visiting scholar in the Research Department of the Federal
Reserve Bank of Philadelphia. Aris Protopapadakis is a Research
Officer and Economist in the Research Department of the
Federal Reserve Bank of Philadelphia.




J.Flannery

would fail. Accordingly, depositors would “run”
on their banks in an effort to withdraw funds while
there was still time. Such a banking “ panic” could
cause an otherwise sound bank to fail. Congress
sought to restore public confidence in financial
institutions by creating public deposit insurance
corporations, which substituted the credit o f the
federal government for the credit o f individual
private banks. Federal deposit insurance virtually
eliminated bank panics, but it introduced another
type o f inefficiency. In particular, the way deposit
insurance is priced induces insured institutions to
take on an excessive amount o f risk. To counteract
3

BUSINESS REVIEW

this influence on banks’ choices o f investments,
the federal insurance agencies have imposed a
system o f restrictive regulations designed to limit
insured institutions’ risk-taking.
An optimal insurance system would eliminate
the possibility o f banking panics without distorting
the insured banks’ investment decisions. The
extent to which our present deposit insurance
system achieves these two objectives is a debated
issue. Many bankers (and others) contend that
existing regulations unduly restrict their ability to
undertake reasonable risks. On the other side, the
insurance agencies tend to feel that their traditional
regulations have become insufficient to the task
o f controlling bank risk-taking in today’s financial
environment. As a result, there is growing support
for reform of the current deposit insurance system.
One prominent view o f appropriate reform
would have the federal agencies set deposit in­
surance premium rates to reflect each institution’s
risk, as many types o f private insurance do. Such
“risk-sensitive premia,” it is claimed, would lessen,
or even eliminate, bankers’ incentives to take on
excessive risks, and they would allow restrictive
regulations to be reduced. The two largest federal
insurance agencies (Federal Deposit Insurance Cor­
poration (FDIC) and Federal Savings and Loan
Insurance Corporation (FSLIC)) recently have ex­
pressed their support for changing the way their
insurance premia are set. FDIC has gone so far as
to propose a specific plan for charging higher
insurance premia for banks with larger exposures
to certain types o f risks.
Designing an optimal U.S. deposit insurance
system is a very complicated problem, to which we
have no easy solution. W e do, however, offer some
important observations about the extent to which
risk-sensitive premia set by a federal insurance
agency can be expected to replace successfully the
current system o f regulatory restrictions. Though
the concept o f risk-sensitive premia is theoretically
appealing, some o f its proponents may have exag­
gerated the net effect this reform would have on
private financial decisions. Rather than allowing
the federal government to withdraw from influ­
encing private financial decisions, the introduction
o f risk-sensitive premia would simply require a
different type o f intervention. The difficulties as­
sociated with implementing a system o f risksensitive federal insurance premia make it

4


SEPTEMBER/OCTOBER 1984

unlikely that such a system would be superior to
the current system of restrictive regulations. Instead,
the federal insurors might have to rely more on the
private sector for controlling bank risk-taking in
the current financial environment.
FIXED-PREMIUM DEPOSIT INSURANCE
AND BANK RISK-TAKING
Currently there are three federal insurance
agencies: FDIC for commercial and mutual savings
banks, FSLIC for savings and loan associations,
and the National Credit Union Share Insurance
Fund (NCUSIF) for credit unions. Because each
agency faces similar problems, we will refer to
them collectively as the “ federal insuror,” and
although there are several types o f insured in­
stitutions, we will call them all “banks.”
The federal insuror currently charges all banks
the same premium rate, regardless o f their finan­
cial condition. In return, the agency insures certain
types o f bank deposits against loss in the event o f a
bank’s failure. Despite a statutory limit on its
liability to a failed bank’s depositors, the insuror
has acted in the majority o f cases to protect all
liability-holders via a transaction called “ purchase
and assumption” in which a solvent institution
purchases some or all o f the failed bank’s assets and
assumes its outstanding (insured and uninsured)
liabilities (see CURRENT FDIC INSURANCE PRAC­
TICES). The net result is that most or all bank
liability-holders feel that their deposits are fully
protected by the federal insuror.
Such blanket insurance creates a problem be­
cause it distorts bankers’ incentives to take on risk.
Decisions about risk-taking in the financial sector
generally require an investor to evaluate a trade­
o ff between higher expected profits and greater
risk. As a result, the cost o f funds is higher for
investors engaged in riskier undertakings. For
insured banks, however, depositors believe there
is no need to evaluate or monitor risk because
their deposits are insured de facto by the federal
insuror. They have no incentive to monitor the
risk-taking behavior o f their bank, nor do they
require a rate o f interest that reflects in any way the
riskiness o f bank assets. When a bank’s creditors
(depositors) do not share in the losses that arise
from default, the bank can borrow funds at a rate
independent o f the use to which those funds are
put. The usual market process— whereby riskier
FEDERAL RESERVE BANK OF PHILADELPHIA

Risk-Sensitive Premia

Mark J. Flannery and Aris Protopapadakis

CURRENT FDIC INSURANCE PRACTICES
A discussion o f FSLIC or NCUSIF insurance parallels that o f FDIC. To save space, we refer here only to
FDIC.
FDIC currently charges each bank a gross annual insurance premium o f 1/12 percent (8.3 basis points) o f its
total deposits, without regard for the bank’s financial condition. Legislation requires that, on average, 60
percent o f the premium income (after expenses) be rebated to insured banks. Before 1981, FDIC expense
levels left the average net cost o f insurance at about 4.3 basis points. (The large number o f bank failures in
1981 and 1982 raised the effective insurance cost to 7.7 and 7.1 basis points, respectively.) In return for their
premium payments, FDIC form ally promises to pay a failed bank’s depositors up to $ 100,000 per account (per
bank).
Although the FDIC is not obligated to pay o ff deposit balances above $ 100,000, historically it has handled
most failures in a way that protected all liability-holders (not just depositors up to $ 100,000) from loss. When
an insured bank fails, FDIC has two major options. First, it can “ pay o u t’ to depositors 100 percent o f their
insured funds and leave uninsured liability holders to be paid as general creditors o f the bank under the
bankruptcy laws. Alternatively, FDIC (in cooperation with the other banking regulators) can arrange a
“ purchase and assumption” (P&A) in which another bank purchases some (or all) o f the failed bank assets and
assum es all o f its liabilities. In the course o f this transaction, the FDIC frequently exchanges some o f the failed
bank’s weaker assets for cash at book rather than at market value. Creditors acquire a claim on the new bank
equal to their previous claim on the failed one. Since its inception, FDIC has handled about half o f all insured
bank failures by P&A rather than by straight payout. More importantly, the P&A route has been used in failures
accounting for the vast majority (94.6 percent) o f failed banks’ total deposits. (Prior to the pay-out o f the $517
m illion Penn Square National Bank’s depositors in 1982, the largest bank failure to be handled via payout had
deposits o f $66.9 million). Less than 1.1 percent o f all failed bank liabilities have actually been lost by the
public since FDIC began operations in 1934. It appears therefore that FDIC procedures have made the public
believe a ll bank lia b ilities are insured de facto, even if the de ju r e limit is $100,000 for deposits alone.
To lim it its exposure, FDIC assesses and controls bank risk by a system o f restrictive regulations on
permissible financial activities and by periodic on-site examinations intended in part to ascertain compliance
with these regulations. Each examination produces a summary rating o f the bank’s condition, called the
CAMEL rating (because it is based on federal examiner assessments o f a bank’s Capital, Assets, Management,
Earnings, and Liquidity) which ranges from “ one” (the best condition) to “fiv e ” (the worst). Banks with
relatively poor CAMEL ratings are subjected to additional supervisory oversight, for example, being required
to file frequent, detailed plans for correcting the examiner’s perceived problems. In the extreme, FDIC can
replace managers and order the bank to curtail certain types o f activities.

activities are funded only if they offer a corre­
spondingly higher expected return— thus becomes
inoperative. Banks can profit by making riskier
investments than they would in the absence o f
federal deposit insurance: if the more risky assets
pay off, the bank owners gain; but if the assets do
not pay o ff and the bank fails, the federal insuror
compensates bank creditors for their losses.
In such an environment, bank owners can in­
crease their expected profits by excessively in­
creasing the riskiness, and thus the expected return,
o f their assets.1This increased risk-taking can take

many forms. Financing relatively risky projects (a
recent example might be energy loans), increasing
the maturity mismatch between the bank’s assets
and liabilities, reducing the asset portfolio’s di­
versification, operating with limited amounts of
capital, and aggressively entering new investment
areas in which the bank has little expertise are but
a few examples o f increased risk-taking. This in­
creased risk-taking represents an example o f a
general implication from economic theory: insur­
ance premia that are unrelated to the risk being
insured affect the insured institution’s risk-taking

1The socially appropriate amount of bank risk-taking would
result if the deposit insuror could eliminate bank “runs," while
pricing deposit insurance in a way that accurately reflected
each bank’s probability of failure. For a more detailed discussion

of why banks tend to undertake (socially) excessive risks under
the current insurance system, see Mark J. Flannery, "Deposit




Insurance Creates a Need for Bank Regulation,’’ this Business
Review. (January-February 1982) pp. 17-27.

5

BUSINESS REVIEW

incentives. In other words, such insurance premia
distort private decision-making. Such a distortion
o f risk-taking incentives affects the economy as a
whole, in addition to the obvious implication that
there will be a larger number o f bank failures.
Banks’ artificially increased incentive for risk­
taking means that some risky projects are funded
that would have looked unattractive otherwise. As
a result, private financial incentives may induce
the economy to undertake more risk than it would
in the absence o f such a distortion.2
The federal deposit insuror has sought to coun­
teract the economic inefficiencies that arise from
such distortions with an extensive system o f re­
strictive regulations governing insured institutions.
(Similarly, private insurance companies often impose
preconditions for insurance, for example, requiring
that an insured warehouse include an adequate
sprinkler system to limit fire damage.) These regu­
lations are designed, in part, to limit banks’ ability
to increase their riskiness in response to fixedpremium deposit insurance. As financial market
conditions changed, banks discovered new kinds
of risk-taking opportunities, and regulators coun­
tered with more regulation in an effort to limit
banks’ ability to take on excessive new risks.
Recent financial market developments raise the
question o f whether regulations will continue to
be sufficient to the task. Banks have entered a new
(and growing) set o f activities (such as insurance
underwriting, brokered CDs, deregulated retail
deposit competition, and discount brokerage) that
many observers view as riskier than traditional
bank operations. Furthermore, a new regulatory
environment has allowed financial markets to
integrate nationwide, as more states allow state­
wide banking, and as interstate mergers and
acquisitions become part of the rescue process for
ailing thrift institutions. These developments have
increased competition among financial institu­
tions, which has increased pressures at all levels

A useful analogy can be drawn with the case o f federal flood
insurance. Without federally subsidized flood insurance, the
cost of living in a flood plain would be higher because each
occupant would fully bear her own losses. Cheap insurance
against flood damage lowers the expected cost o f living in a
flood plain, which induces more people to do so. The result is
that society suffers an excessive amount of flood damage—
more than would be suffered if everyone bore her own losses.

6



SEPTEMBER/OCTOBER 1984

o f government to deregulate the financial system.
(The Depository Institutions Deregulation and
Monetary Control Act o f 1980 and the Garn-St.
Germain Act o f 1982 are examples o f this deregu­
lation trend.) Given the increases in potential bank
risk-taking strategies on the one hand, and the
shrinking arsenal o f regulations on the other, the
federal insuror feels increasingly unable to con­
trol its own risk exposure. It is worried that its
traditional tools for limiting bank risks are obsolete,
and that the current pressures for deregulation
may not allow it to impose sufficient new regu­
lations on banks. If new regulations are not imposed,
distortions to bank risk-taking will grow, with
more bank failures and larger federal insurance
payoffs the likely result.
Because o f these concerns, the FDIC proposes
to change its method o f controlling bank risk.
Rather than rely exclusively on restrictive regu­
lations, the FDIC proposes to vary its deposit
insurance premia in a way that reflects each in­
dividual bank’s risk o f failure (see THE FDIC
PROPOSAL). By charging a risk-related insurance
premium, the FDIC hopes to move in the direction
o f restoring the proper incentives for risk-taking
by financial institutions. This development would,
in turn, reduce the need for regulation. The crucial,
and controversial, question is: To what extent
could risk-related deposit insurance premia actually
substitute for regulation?
SOME DIFFICULTIES WITH A RISK-SENSITIVE
PREMIUM SYSTEM
The FDIC’s proposed system o f risk-related in­
surance premia is one example o f how such a plan
might work. Rather than concentrate on one par­
ticular plan, we will analyze the general arguments
for moving to a fully risk-sensitive deposit insurance
premium system.3 The principal argument in favor
7
An alternative way to reduce the inefficiencies associated
with federal deposit insurance might be privatization of the
deposit insurance system. However, we feel that private
insurors are not fully credible, and that they would not remove
entirely the potential for banking panics. For a more complete,
and sanguine, discussion of a private deposit insurance system,
see Eugenie D. Short and Gerald P. O’Driscoll, Jr., "Deregulation
and Deposit Insurance", Federal Reserve Bank of Dallas Economic
Review (September 1983), pp. 11-22, or Evelyn F. Carroll and
Arthur J. Rolnick, "After Penn Square: The Insurance Dilemma,” in
Proceedings of a Conference on Bank Structure and Competition,
Federal Reserve Bank o f Chicago, 1983.

FEDERAL RESERVE BANK OF PHILADELPHIA

Mark J. Flannery and Aris Protopapadakis

Risk-Sensitive Premia

THE FDIC PROPOSAL
FDIC proposes (in its report “ Deposit Insurance in a Changing Environment” (April 1983), pp. II-9 to II-2 1) a
small step toward risk-sensitive deposit insurance premia. Under current law, FDIC may vary the amount o f
rebate it gives to individual insured banks. In addition to its CAMEL ratings, FDIC proposes to evaluate each
bank’s exposure to interest rate risk and to credit risk as “ normal,” “ high,” or “ very high.” Only banks judged to
have “ normal” risk will receive their full insurance premium rebate (60 percent o f premium income less
expenses). “ High” risk banks will receive a 30 percent rebate and, “ very high” risk banks will receive no rebate
at all. Based on pre-1981 experience, the resulting net insurance costs would then be approximately:
4.3 basis points to normal risk banks,
7.1 basis points to high risk banks,
8.3 basis points to very high risk banks.
Under this scheme, riskier banks will wind up paying higher insurance premia, though some observers doubt
whether the range o f the variation is sufficiently broad to induce substantial changes in behavior from
insured institutions.
To raise a bank’s cost o f increasing bank risk still further, FDIC will begin charging for its cost o f providing
extraordinary supervisory services to banks with relatively poor CAMEL ratings. These added costs— coming
at a time when the bank is probably experiencing other difficulties as w ell— is likely to make banks plan more
carefully to avoid becom ing classified as highly risky.

o f risk-sensitive insurance premia is that such
premia will bring bankers’ assessments o f the
costs and benefits o f risk-taking closer to those
that exist in the unregulated financial markets,
and that regulation will become largely superfluous
as a result. One extreme view o f risk-sensitive
deposit insurance holds that the federal insuror
could remove all restrictive bank regulations by
using insurance premia that mimic accurately
market risk evaluations.4 But an assessment o f the
practical difficulties provides convincing evidence
that the federal insuror cannot hope to set in­
surance premia with the degree o f accuracy required
by this view.
Proponents o f risk-sensitive insurance premia
prefer economic signals to be transmitted via a
pricing mechanism rather than via restrictive regu­
lations. Unfortunately, however, the usual eco­
nomic argument that a pricing system generally
leads to efficient decisions does not apply when a
single party unilaterally sets prices (in this case,
the insurance premia). In the case o f federal

4See Allen H. Meltzer, “Major Issues in the Regulation of
Financial Institutions,” Journal o f Political Economy (August
1967, Part 2), pp. 482-501, or Kenneth E. Scott and Thomas
Mayer, “Risk and Regulation in Banking: Some Proposals for
Federal Deposit Insurance Reform,” Stanford Law Review (May
1971), pp. 857-902. The FDIC’s "Deposit Insurance in a Changing
Environment’ (April 1983) provides a summary of the recent
literature in favor of risk-sensitive premia in its Appendix A.




deposit insurance, the insuring agency must identify
the types o f risk banks are exposed to and then
determine the premium that it will attach to each
risk. This closely resembles the current procedure,
which is to identify the relevant banking risks and
then devise regulations that limit the banks’ ex­
posure to each risk to a socially desirable level. In
other words, the insuring agency needs precisely
the same information to set federal insurance
premia as it needs to devise an appropriate set of
restrictive regulations under the current premium
system. There is nothing to suggest that the in­
formation available to bank insurors can be utilized
more effectively with a risk-sensitive premium
than with the current arrangement (or vice versa).
Unless the insurors’ premia exactly equal the risk
premia uninsured depositors would demand in a
perfectly-informed financial market, the federal
insurance system will continue to distort private
risk-taking decisions (for the same reasons we
discuss above). Accordingly, the arguments in
favor o f risk-sensitive deposit insurance premia
suffer several serious shortcomings that must be
recognized in the policy debate.
No Single Insuror Can Expect To Assess Risk
Perfectly. In the real world, differing evaluations
or assessments o f risks and returns are common. A
banker may lend to an applicant whom another
banker has turned down; some investors purchase
shares in a certain stock while others get rid of
those shares; some analysts predict a rise in in­
7

BUSINESS REVIEW

terest rates while others expect a decline. Just like
any other agent in the financial sector, the insuror
must anticipate that its insurance premium formula
will underprice some risks (in the opinion o f the
average insured banker) and overprice others. The
federal insuror’s premia therefore will continue to
distort bank investment decisions. Risks considered
to be underpriced will expand in bank portfolios
while overpriced activities will contract. This result is
similar to the current effect o f flat risk-premia on
bank investments. If imperfect risk-sensitive in­
surance premia are used instead o f restrictive
regulations, individual banks, and the banking
system, may remain riskier than desired. For ex­
ample, suppose the insuring agency overprices the
risk premium for international loans, but under­
prices the risk-premium on home mortgage loans.
Then international loans may shrink but mortgages
will expand relative to their appropriate level.
There is no guarantee that the result would be a
banking system with less risk than we have cur­
rently.
Knowing that it will underprice at least some
types o f risk, but not knowing which ones, the
federal insuror will want to prevent banks from
having large exposures to any one type o f risk. The
most obvious way to avoid large exposure is to
promulgate regulations that prohibit “ extreme”
bank portfolio concentrations. As a practical
matter, therefore, risk-sensitive insurance premia
probably cannot displace restrictive regulations
entirely.
Public Institutions May Have Special Problems.
Another crucial difficulty is related to the nature
of public institutions such as the FDIC, FSLIC, and
NCUSIF. Public institutions’ decisions are subject
to public scrutiny. Such scrutiny can involve lengthy
debates, appeal procedures, and compromises
between economic efficiency and political needs.
Even the most well-meaning and efficient public
institutions move with glacial speed compared to
the rapid assessment o f information and the con­
tinuous reassessment o f risk that takes place in the
financial markets. Therefore, even if the insuring
agency initially manages to assess correctly the
risk categories and their risk-premia, it will not be
able to keep up with subsequent changes in the
market perceptions o f those risk categories. Risk
premia, then, will tend to reflect past realities. The
staff o f such public insurors will tend to price
8



SEPTEMBER/OCTOBER 1984

yesterday’s banking risks, because these risks are
at least documentable from past experience,
making the pricing less controversial. The staff
would be reluctant to assess and project current
and future risks, because such projections involve
judgements that may be controversial and debatable,
and will be regularly challenged in public.
An example that comes readily to mind concerns
loans to less developed countries. Given the recent
history o f such loans, the federal insuror setting
risk-sensitive premia would probably set high risk
premia for existing and future loans to third world
countries, even if the true riskiness o f these loans
were declining. Furthermore, it would take a long
time to reduce these risk premia, even after the
true risks decline. Conversely, political pressures
would have made it very difficult for the federal
insuror to declare loans to countries like Argentina,
Brazil and Mexico to be high risk loans before the
debt crisis erupted, even if the staff had developed
strong indications that the riskiness o f loans to
these countries was on the increase.
Whereas the assessment o f risk in efficient
markets is forward-looking, the federal insuror’s
assessment will be mostly backward-looking.
Existing risks are bound to become mispriced over
time, and it would take a long time to decide
whether, and how, to price new risks.5 This situation
will provide still further impetus toward a system
o f restrictive regulations to supplement the
structure o f risk-sensitive premia.
ALTERNATIVES TO RISK-SENSITIVE PREMIA
The preceding discussion strongly suggests that
risk-sensitive insurance premia will never replace
entirely regulatory restrictions on bank activities.
Furthermore, there is no assurance that the system
o f regulation that accompanies risk-sensitive in­
surance premia will be significantly less intrusive,
or even less extensive, than what exists now. W e
must recognize that risk-sensitive deposit insur­
ance premia represent only a change in the form o f
insuror intrusion on private financial decisions,
not an end to such intrusions. Restrictive regu­

5Furthermore, banks would surely protest risk assessments
they considered excessive more vigorously than those they
considered too low. The result would be a tendency toward an
overall downward bias in risk-sensitive insurance premia,
which is similar to what we have today with fixed premia.

FEDERAL RESERVE BANK OF PHILADELPHIA

Risk-Sensitive Premia

lations and risk-sensitive premia can, at best,
complement one another in the attempt to control
and limit bank risk-taking to a socially appropriate
level.
Many o f the problems identified so far result
from the fact that a single public agency must
anticipate the activities o f a number of private in­
stitutions and respond to them. This fact is in­
dependent o f whether the agency tries to exert
control through prices or through restrictive regu­
lations. The process is administratively costly; it
rarely works smoothly or efficiently. One way to
supplement the federal insuror’s risk assessment
would be to increase the risk exposure o f bank
shareholders and depositors to a limited extent.
Investors then would have a stronger incentive to
monitor and react to banks’ risk exposures, raising
the cost o f funds to banks that choose to pursue
riskier investment strategies.
Increasing Shareholders’ Risk Exposure. The
distortion associated with the current federal
deposit insurance scheme is that shareholders
have unbounded potential for gain when they
increase their portfolio risk, but they can never
lose more than their invested capital. The most
obvious way to increase shareholders’ concern for
bank risk therefore is to raise the proportion o f
their own capital that must be put into the bank’s
investments.6 Because this gives shareholders a
larger potential loss if an investment turns sour,
they will instruct bank managers to take somewhat
less risk. The added bank capital need not neces­
sarily take the form o f additional equity. Similar
results could be achieved if banks issued more
long-term debt subordinated to deposit liabilities.
Investors in such debt instruments are (presumably)
sophisticated enough to evaluate risk correctly, so
the rates banks would pay on this subordinated
debt would fully reflect the probability o f default.
At the same time, the debt’s long maturity would
reduce the likelihood o f destabilizing “runs” if the

6Such a move towards transferring some o f the banking
system's risk to private individuals (and away from FDIC) was
announced in July 1984. The FDIC, the Office of the Comptroller
of the Currency, and the Federal Reserve have proposed to set a
minimum capital standard for all U. S. banks. This new standard
would require “about 700 o f the nation’s approximately 15,000
commercial banks to raise hundreds of millions o f dollars in
new capital" (New York Times, July 11, 1984).




Mark J. Flannery and Aris Protopapadakis

bank encounters subsequent difficulties.
A second way to increase shareholders’ potential
losses would be to reform the insuror’s procedures
for handling troubled banks. History offers several
examples o f federal aid in the form o f subsidized
loans or equity contributions to avert bank failures.
Eliminating or severely restricting such aid would
make shareholders feel less protected from the
results o f their bank’s portfolio risk.
A more drastic way o f shifting risk to bank
shareholders would involve redefining which bank
liabilities the government is willing to insure. The
case for federal deposit insurance is strongest for
short-term, demand-type deposits that can be
withdrawn easily during a crisis o f confidence. If
the government wishes to insure this kind o f
deposit (to protect the financial system from runs
and other disturbances), it can do so without
introducing large distortions. In particular, the
insuror could require that insured, demand-type
liabilities be issued by a distinct subsidiary o f the
banking firm, whose permissible investments
would be limited to short-term, very high quality
securities. Banks could undertake a broad range o f
in vestm en t outside th eir federally-in su red affiliates,

and investors purchasing those uninsured bank
liabilities would know they were subject to default
risk. The net effect would be to reduce bank share­
holders’ ability to borrow via insured deposits at a
riskless rate, so their interest cost (and hence their
profits) would reflect the riskiness o f their invest­
ment portfolios.
Increasing Depositors’ Risk Exposure. The
federal insuror could make large depositors (over
$100,000 per account) more sensitive to bank risk
by handling more bank failures via straight payout
and fewer by “ purchase and assumption” (P&A).
This change would increase the perceived risk o f
uninsured liability holders, and it would help
bring the average rate banks have to pay on un­
insured liabilities in line with the riskiness o f the
bank portfolio. In other words, under existing law,
the insurors could choose to compensate only
insured depositors, letting uninsured depositors
suffer losses in the event o f a bank failure. A
straight payout is not without its drawbacks, how­
ever, because the failed bank’s intangible assets
(like accumulated local lending expertise and
customer relationships) are destroyed in the process.
A P&A has the advantage o f preserving these in­
9

BUSINESS REVIEW

tangible assets. To make uninsured depositors
sensitive to bank risk-taking, therefore, the insurers
might modify their P&A procedures to transfer
only some fraction o f uninsured liabilities to the
purchasing institution. An important caveat here
is that transferring too much risk to depositors can
cause the type o f bank run federal insurance was
designed to prevent.7
FDIC already has begun to experiment with this
process. For example, it decided to let large de­
positors s u ffe r s o m e lo s s e s in two b ank s th at
failed in March 1984: “ Regardless o f whether other
banks were found to take over the two [failed]
institutions, depositors with accounts larger than
the $100,000 FDIC insurance limit would be treated
as general creditors and wouldn’t be fully protected”
(Wall Street Journal March 21, 1984, page 15).
Revising the P&A process in this way would have
even greater effects on private risk-monitoring if
the statutory insurance limit were lowered from its
current $100,000 level.8 The Banking Act o f 1933

7See Douglas Diamond and Philip H. Dybvig, “Bank Runs,
Deposit Insurance, and Liquidity,” Journal o f Political Economy
(June 1983), pp. 401-419.
8In a related development, FDIC and the Federal Home Loan
Bank Board (FHLBB) recently have attempted to remove most
formal insurance protection from deposits placed in an insured
bank by brokers. Over the past few years, a number of brokerage
firms have arisen to bring together banks needing funds with
depositors outside the banks’ customary geographic market
area. Previously, a bank might borrow via large ($1 million)
certificates of deposits. If these balances were uninsured (at
least de jure), potential depositors would screen carefully the
riskiness of banks to which they lent. Riskier banks could
borrow only by paying relatively high deposit rates. By using a
CD broker, however, the bank could borrow the same amount
(or more) via fully insured $ 100,000 CDs. Customers with large
balances to lend could use brokers to split up their investments
into smaller, fully insured components. The FDIC and FHLBB
proposed a rule that was supposed to take effect October 1,
1984 to address this problem. Under the rule only $ 100,000 per
broker (per bank) would be insured, giving brokers and their
customers a greater incentive to evaluate bank risk. A federal
court judge voided this rule in June 1984, saying that the
regulatory agencies did not have the authority to impose such a
change in insurance coverage.

10



SEPTEMBER/OCTOBER 1984

initially set an insurance limit o f $2,500, which is
roughly equivalent to $10,000 in 1983 dollars.9
With lower insurance limits, depositors would
have more incentive to evaluate bank risk and
demand appropriate compensation in the form o f
higher deposit rates from institutions that were
deemed to carry the greatest risk o f default.
CONCLUSION
Some writers have maintained that risk-sensitive
deposit insurance premia can be substituted e f­
fectively for financial sector regulation to limit
bank risk-taking to an acceptable level. This view,
however, fails to recognize that both risk-sensitive
premia and restrictive regulations require the in­
surers to gather and process the same amount o f
information. Furthermore, a public insuror setting
risk-sensitive premia will necessarily suffer from
the same lags in decision-making that have made
restrictive regulations a cumbersome tool in the
past. Therefore, there is no reason to believe that
the federal insuror can control bank risk-taking
any more effectively with risk-sensitive premia
than it can currently with restrictive regulations.
The potential theoretical advantages o f risksensitive premia must be weighed carefully against
the serious difficulties that arise in practice, and
against the benefits o f alternative schemes that do
not involve risk-sensitive premia.
A partial alternative to public sector controls on
bank risk-taking may be to increase the incentive
for private sector monitoring. Private sector evalu­
ations are likely to be more timely than those
reached in the public domain, regardless o f whether
the latter are transmitted to insured institutions
via premia or regulations. Because of the possibility
o f bank runs, however, the provision o f federal
deposit insurance will probably be accompanied
by direct federal limitations on private risk-taking.
The pending policy issue is how that federal inter­
vention can best be effected.

9Very shortly after FDIC began operations, this limit was
raised to $5,000.

FEDERAL RESERVE BANK OF PHILADELPHIA

Antitrust Implications of Thrifts’
Expanded Commercial Loan Powers
Janice M. Moulton*
With the deregulation o f financial institutions,
thrifts have gained expanded asset and liability
powers, and the distinctions between commercial
banks and thrift institutions have eroded.* Pre­
1
viously, commercial banks were thought to offer a

* Janice M. Moulton is a Research Officer and Economist in
the Research Department o f the Federal Reserve Bank of
Philadelphia, where she heads the Banking and Financial
Markets Section. The author would like to thank Diane Mayer
for excellent research assistance.
1For the purposes of this article, thrift institutions include
savings and loan associations and both mutual and stock
savings banks, but exclude credit unions.




unique cluster o f banking services; they were the
only institutions offering personal checking, com­
mercial checking, and unsecured commercial loans.
Now thrifts’ legal restrictions on offering these
services have been eased, and they are beginning
to compete directly with banks in both commercial
and consumer services.
More direct competition between banks and
thrifts, particularly in commercial loans, has
major antitrust implications. Regulators are charged
with ensuring that bank mergers will not substan­
tially reduce competition in banking markets. The
way that regulators try to keep markets competitive is
to prevent the banking markets from being domi­
11

BUSINESS REVIEW

nated by a few banks, which might use their market
power to raise prices— in particular, interest rates
on loans— or to block the entrance o f new firms.
Before thrifts were authorized these new powers,
the Supreme Court did not consider them to be
competitors o f banks, ruling that thrifts must
“ significantly participate” in commercial lending
and deposit-taking services in order to be included
in what is called the commercial banking line o f
commerce. Now that thrifts look more like banks
in terms of their authorized powers and the services
they offer, regulators are viewing thrifts as in­
creasingly important competitors with banks. The
presence o f thrifts in the commercial banking line
o f commerce makes it easier for a merger between
commercial banks to be approved by bank regu­
lators, since more competitors would be present in
the market. Indeed, regulators recently have ap­
proved some bank mergers— which they would
have denied otherwise— on just these grounds.
Pennsylvania provides a good example o f a state
where thrift competition with banks in making
commercial loans can be important in analyzing
mergers. For many years, Pennsylvania, like other
states in the northeast, has had thrifts that are
active competitors in making loans and attracting
deposits. Moreover, recent changes in the state’s
banking law have encouraged many banks to merge.
The extent o f competition can be assessed using
measures o f thrifts’ commercial loan activities,
from both a market share and a balance sheet
viewpoint. A picture o f some increased thrift
competition emerges, reinforcing the view that a
more comprehensive analysis o f thrift competition is
necessary in assessing the effects o f bank mer­
gers.
ANTITRUST ISSUES
Mergers and Competition. There is one undeni­
able fact about mergers— the merged firm or
holding company is larger than either o f the two
separate firms that existed previously. But whether
the resulting firm acts to reduce competition or to
strengthen it depends on many factors and ulti­
mately involves subjective judgment. Certainly
mergers can have important positive effects on the
way firms compete. Mergers can increase a firm’s
efficiency by facilitating more effective use o f
investment capital and the sharing o f productive
assets, such as computer equipment and technology.
12



SEPTEMBER/OCTOBER 1984

Two firms producing similar services may find
that, by combining their resources, they can offer
a larger volume o f those services at a lower unit
price than either could before. Or perhaps two
institutions find that their services complement
one another’s strengths. Thus the combined insti­
tution may be able to offer higher quality services,
or more o f them. In addition, mergers may indicate
that the new owners believe they can better manage
the institution and increase performance. In these
cases, consumers can benefit from mergers be­
cause customers are likely to receive lower prices,
a greater variety o f products, or better quality or
convenience o f service.
While most mergers have beneficial effects,
there may be mergers which are harmful to com­
petition. Mergers sometimes are used to promote
collusion in a market, especially where a few large
firms sell most o f the product. Collusion occurs
when the parties agree to coordinate their actions
to reduce competition in the market, and thus are
able to exercise market power. Market power is the
“ ability o f one or more firms profitably to maintain
price above competitive levels for a significant
period o f time.”2 When mergers create market
power or facilitate its use, consumers are hurt
because they face higher prices— lower interest
rates on deposits or higher interest rates on loans,
in the case o f banking— lower service levels, or a
restricted menu of products. In addition, resources
are impeded from moving into products where
they would flow if markets were competitive.
The antitrust laws attempt to prevent adverse
competitive effects from occurring in proposed
mergers. Section 7 o f the Clayton Act prohibits
mergers if their “effect may be substantially to
lessen competition, or to tend to create a monopoly”
in any line o f commerce in any section o f the
country.3* It’s up to the regulatory agencies— the
Federal Reserve (Fed), the Federal Deposit Insur­

o
U.S. Department of Justice Merger Guidelines, June 14,1982,
p. 3. Market power also applies to the ability of buyers to lower
the price paid below competitive levels (often called “predatory
pricing”), and to the ability of the buyer or seller to reduce
competition in other respects as well.
3See section 7 of the Clayton Act as amended by the CellerKefauver Act o f 1950. The Supreme Court has interpreted "line
of commerce” to mean the market for the product and “section
of the country” to mean the geographic market.

FEDERAL RESERVE BANK OF PHILADELPHIA

Thrifts’ Expanded Commercial Loan Powers

ance Corporation (FDIC), and the Comptroller of
the Currency— to interpret this legal framework
and to apply it to the banking business in a way
that denies those few merger proposals that are
anticompetitive, yet does not hinder the many
mergers that do not impair competition.4 When
assessing the competitive effects o f mergers, regu­
lators first must decide on the geographic market
and on which institutions compete there. Deciding
what type o f financial institution to include in the
analysis depends upon how the product or service
line is defined; the more specific the product line
is, the narrower the range o f qualifying financial
institutions. Thus the choice o f competing insti­
tutions affects the chances o f regulatory approval.
Supreme Court Rulings on Bank Competitors.
Supreme Court decisions help guide the regulatory
authorities in determining which institutions are
competitors when applying antitrust laws to banking.
In the 1963 landmark decision, United States vs.
Philadelphia National Bank, the Supreme Court
defined commercial banking for the first time as a
separate line o f commerce. That is, commercial
banks were thought to offer local customers a
c lu s te r o f b a n k in g s e rv ic e s d iffe r e n t fro m an y

other depository institution. At that time, com­
mercial banks were essentially the sole suppliers
o f many banking services, such as business and
personal demand deposits, bankers’ acceptances,
correspondent banking services, and commercial
loans. The court also stressed the customer con­
venience o f buying the unique cluster o f banking
services from the same institution.
The Supreme Court reaffirmed its 1963 decision
that commercial banking is a separate line o f
commerce in United States vs. Phillipsburg National
Bank (1970). This case involved the proposed
merger o f two small commercial banks in New
Jersey whose loan portfolios included a large
amount o f residential real estate loans. Since the

4The Comptroller is the agency responsible when the insti­
tution resulting from the merger is a national bank; the FDIC
handles state-chartered banks that are not members of the
Federal Reserve System; and the Fed handles state-chartered
banks that are members of the Federal Reserve System. Where
relevant, each agency submits advisory opinions to the re­
sponsible agency and to the Justice Department. There is a 30day waiting period before the merger is consummated to allow
the Justice Department time to bring suit under the antitrust
laws.




Janice M. Moulton

portfolios o f these banks were similar to those of
many thrifts, the question was whether local thrifts
could be considered competitors o f small com­
mercial banks. The Courts answer was no, rejecting
any broadening o f the line o f commerce. It empha­
sized again that commercial banks had the authority
to provide a wide range o f banking services un­
available at other types o f financial institutions. In
this way, the court distinguished between banks
and other financial institution competitors based
on the powers authorized to them, rather than on
the extent to which they exercised those powers.
In the 1974 Connecticut National Bank case,
however, the Supreme Court’s decision recognized
that mutual savings banks, particularly in New
England, were indeed “fierce competitors” with
commercial banks in some service lines.5 Yet,
while not requiring equivalent powers in all areas,
the court stressed that thrifts must offer a number
o f personal and commercial banking services in
order to be included as competitors. Further, thrifts
needed to “ significantly participate” in major ser­
vice lines. W hile finding that thrifts did not qualify
yet as competitors in the banking line o f commerce,
th e c o u rt le ft th e d o o r o p e n by a d m ittin g that at
some future time thrifts may become significant
competitors. In setting up preconditions for in­
cluding thrifts, the court anticipated a time when
thrifts might become a routine part of merger
analysis.
Since the last Supreme Court decision in 1974,
sweeping changes have been made in the laws
governing thrift asset and liability powers. Origi­
nally established to encourage savings and to
promote home purchases, thrifts have maintained
a sheltered tax status and have continued to spe­
cialize in residential mortgages.6 But in the last

5United States vs. Connecticut National Bank (418 U.S.664).
6Tax incentives encourage thrifts to hold a high percentage
of their assets in the form of residential mortgages. If savings
and loans have 82 percent o f their loan portfolio in certain
qualifying assets, mainly residential mortgages and U.S. gov­
ernment securities, they receive a bad debt deduction equal to
40 percent of their taxable income. This bad debt allowance is
reduced an additional .75 percent of income for each successive 1
percent drop in qualified assets below the 82 percent level. See
“Tax Barriers to Diversification by Savings and Loan Associa­
tions,” by Herbert Baer, Proceedings of a Conference on Bank
Structure and Competition, Federal Reserve Bank of Chicago,
May 1983.

13

BUSINESS REVIEW

few years, restrictions on thrifts have been relaxed.
Two major pieces o f legislation, the Depository
Institutions Deregulation and Monetary Control
Act o f 1980, and the Garn-St. Germain Depository
Institutions Act o f 1982, have enabled thrifts to
offer commercial loans and other services that
traditionally fell within the domain o f commercial
banks.7 Savings banks (SBs) were authorized to
make commercial loans in 1980, while savings and
loans (S&Ls) follow ed in a more limited way two
years later. Through a series o f steps, S&Ls and SBs
reached a par with each other; on January 1, 1984
both types o f institutions could invest up to 10
percent of their assets in commercial and industrial
(C&I) loans. Moreover, these laws significantly
expanded the powers o f SBs and S&Ls to make
consumer loans and commercial real estate loans,
and to purchase commercial paper and offer trans­
action accounts.
HOW THRIFTS FIT INTO MERGER ANALYSIS
The Supreme Court’s rulings on antitrust appear to
require that thrifts offer a broad cluster o f services
and significantly participate in those services in
order to be included in merger analyses. But beyond
that, while some specific issues have been ad­
dressed by the district courts, there is basically
little guidance on when thrifts offer enough bank­
like services to be included as competitors in the
line o f commerce definition. As a result, now that
thrifts are more like banks in their authorized loan
and deposit powers, and in the services they offer,
it is often difficult to know how to fit thrifts within
the framework o f the courts’ rulings on antitrust
In the face o f these uncertainties, it is the regu­
latory authorities’ responsibility to assess thrift
participation in commercial services and to estab­
lish guidelines for evaluating how important thrifts
are as competitors. The regulatory agencies in­
volved are the Comptroller, the FDIC, and the Fed,
as required by the 1966 revisions to the Bank

SEPTEMBER/OCTOBER 1984

Merger Act. Besides considering various financial
and managerial factors, the agencies are directed
to consider the effect o f the merger on competition,
including any tendency toward monopoly. Only
after evaluating these factors, and finding any
anticompetitive effects to be outweighed by the
convenience and needs o f the community, can a
regulatory agency approve the transaction.
A Structural Approach. When the Fed considers
a merger proposal, its approach has been to fit
th rifts in to th e stan dard fra m e w o rk fo r a n a ly z in g

the competitive effects o f bank mergers. That
framework relies primarily upon a structural test to
evaluate competition. The Supreme Court endorsed
a structural approach in the 1963 PNB case, where
it stated:
. . . a merger which produces a firm controlling an
undue percentage share o f the releva n t m a rk e t and

results in a s ig n ific a n t increase in the con ce n tra tio n
o f firms in that market, is so inherently likely to
lessen com petition substantially that it must be
enjoined in the absence o f evidence clearly
showing that the merger is not likely to have such
anti-competitive effects (374 US at 363). [Italics
added by the author.)

A significant increase in the concentration in a
market usually has been measured by the com­
bined market shares o f the larger firms in that
market. For example, if the merger o f two banks
would increase the combined market shares o f
deposits o f the three or four largest banks from 50
percent to 65 percent o f total deposits, then the
merger would likely be examined closely because
o f the presumed anticompetitive effects o f such
an increase in concentration. The larger the com­
bined market shares o f the three or four largest
banks, the more highly concentrated the market
is.8 Many studies have found a relationship be­
tween the market structure— or number o f firms

o
7 For more information on expanded asset and liability powers
authorized for thrifts under these Acts, see "Recent Develop­
ments in Federal and N ew England Banking Laws," by Joseph
Gagnon and Steve Yokas, New England Economic Review. Federal
Reserve Bank of Boston, (Jan/Feb 1983). Although both these
Acts pertain to federally-chartered thrifts, they also affect
state-chartered SBs and S&Ls in Pennsylvania, which have
parity with federally-chartered institutions.

Digitized 14 FRASER
for


The Justice Department in June 1982, issued new merger
guidelines for a wide range of industries, which rely upon an
alternative measure of concentration in the local banking
market— the Herfindahl-Hirschman index (HHI). This index is
calculated by squaring the market share o f each institution
competing in the market and summing over these institutions.
Unlike the concentration measures o f the top three or four
firms, the HHI includes all institutions in the market and
weights those with large market shares more heavily.

FEDERAL RESERVE BANK OF PHILADELPHIA

Thrifts’ Expanded Commercial Loan Powers

and concentration in a market— and the competi­
tive performance o f the firms in the market.9 This
structural approach is also evident in the Justice
Department guidelines for mergers. Under these
guidelines, mergers between banks with large
market shares, particularly in highly concentrated
markets, may be anticompetitive. The Federal
Reserve’s competitive analysis generally is con­
sistent with Justice’s approach, though the guide­
lines have not been formally adopted by the Fed.
When thrifts are present in the relevant market,
the Federal Reserve fits them into the competitive
analysis by judgmentally shading,or discounting,
the market shares o f commercial banks within the
relevant banking market. This procedure results in
thrifts being included somewhere between 0 and
100 percent. Here’s how shading works. Once the
appropriate banking market is chosen, the share o f
deposits held by each commercial bank in that
market is calculated. Commercial banks are con­
sidered the only competitors in the market and
thrifts aren’t included at all. Next, a second cal­
culation is made o f deposit shares including all
thrift institutions as full competitors within the
relevant market. That is, the deposits held by all
the commercial banks and all the thrifts are summed
together to make the total market pie, which lowers
the measured market shares o f the commercial
banks in the market1 Between these two extremes,
0
judgment is needed to determine to what extent
thrifts should be included as active participants in
the market.
In the past, the judgmental part o f the shading
procedure generally has relied upon supplementary
data on the nature o f thrift activity in the market,
and in general these data have been restricted to
commercial loans and transaction accounts such
as NOW (Negotiable Orders o f Withdrawal) ac­

9For a review o f this literature, see Stephen Rhoades
“Structure-Performance Studies in Banking: A Summary and
Evaluation," Staff Studies No. 92, Board of Governors of the
Federal Reserve System, 1977. See also his more recent paper,
“Structure-Performance Studies in Banking: An Updated Sum­
mary and Evaluation,” Staff Studies No. 119, Board of Governors
o f the Federal Reserve System, August 1982.
10However, the measure of overall market concentration
could actually increase by including thrifts, if the market
contains one or two thrifts that are large relative to the com­
mercial banks.




Janice M. Moulton

counts. If thrifts offer these services, they are
likely to receive more weight in the analysis. That
is, a greater percentage o f thrift deposits would be
included in the shading process, increasing the
chances o f regulatory approval o f the merger.
When analyzing the competitive effects of thrifts
in bank merger cases, the Federal Reserve Board
asks several questions to help build a profile of
thrift activity in a particular market. For example,
what are the market shares held by thrifts in
deposits and in commercial loans? How many
institutions are making commercial loans in the
market? What kinds o f resource commitments to
these activities do their balance sheets suggest?
How big are the thrifts, and does their size relate to
their commercial lending activity? When answering
these questions, it is useful to analyze the data
statewide, as well as at the market and individual
firm levels.
THRIFT C&I LOAN DATA FOR PENNSYLVANIA
The combination o f merger activity and thrift
activity in Pennsylvania makes it an interesting
case-study for assessing thrifts’ role in the com­
petitive effects o f mergers. Pennsylvania has seen
a surge in merger proposals, due in part to recent
changes in the state’s banking law. In 1982 the
state law was amended to increase the number of
subsidiaries a bank holding company could con­
trol from one to four. With this change, a bank
holding company could merge two or more of its
subsidiaries to “make room” for acquiring addi­
tional subsidiaries without exceeding the legal
limit. In fact, many bankers have taken advantage
o f the relaxed law to merge, and others have plans
to do so. Moreover, Pennsylvania has over 200
S&Ls and SBs in the state, dating back to the first
S&L and the first SB in the country. Several dif­
ferent measures of thrift participation are presented
here for Pennsylvania and each provides a slightly
different view o f thrifts’ competition with banks.
What Shares do Thrifts Hold in Deposits and in
Commercial Loans? Traditionally, deposit market
shares have been an important measure o f thrift
competition with banks. Thrifts have always offered
time and savings deposits, and Pennsylvania thrifts
have been authorized to offer transaction accounts
since 1980. By the time and savings deposit
measure, thrifts already have an active presence in
Pennsylvania, with SBs and S&Ls together holding
15

BUSINESS REVIEW

SEPTEMBER/OCTOBER 1984

about 35 percent o f statewide deposits (see Table
1

).

Thrifts are not nearly so active in making com­
mercial loans as in taking deposits, but they are
making some headway: thrifts make almost 7
percent o f all C&I loans made by commercial
banks and thrifts in Pennsylvania, which amounts
to more than $ 1.00 out o f every $20.00 that is lent
(see Table 2). W hile still small, these figures signify
important gains since 1980, especially for SBs.1
1
From 1980 to 1983, in fact, Pennsylvania SBs
increased their share o f statewide C&I loans from
.5 percent to 6.6 percent, primarily because o f one

11The national picture differs somewhat from Pennsylvania’s.
In 1983 thrifts nationally had about 1.5 percent of total C&I
loans. Of that amount, S&Ls have a 0.4 percent share, greater
than what they hold in Pennsylvania. But SBs nationally, with a
share of only 1 percent, are less active than they are in Penn­
sylvania. From 1980 to 1983, the total amount o f C&I loans in
the country has grown by about 50 percent, somewhat more
than in Pennsylvania.

TABLE 1

DEPOSIT MARKET SHARES
IN PENNSYLVANIA3
(Millions $)
1980

%

1983

%

$48,407

60.1

$74,484

64.7

Savings
Banks

12,499

15.6

16,913

14.7

Savings &
Loans

19,681

24.4

23,711

20.6

Commercial
Banks

TOTAL

$80,587

$115,108

aData for national banks and state member banks are
from the Report of Condition filed with the Federal
Reserve, while data for state nonmember banks and
savings banks are from the Report of Condition filed
with the FDIC. Savings and loan data are from the
Statement of Condition filed with the Federal Home
Loan Bank Board. June filings were used from 1980
through 1983. These data are the basis for all subsequent
tables.

Digitized 16 FRASER
for


large institution in the Philadelphia area. S&Ls,
however, experienced only slight growth in market
share, reaching 0.2 percent during 1983. The 33
percent statewide growth in total C&I loans prob­
ably aided the thrifts in obtaining what share they
did. However, commercial banks still do the lion’s
share o f commercial loan business in Pennsylvania,
making over 93 percent o f the state’s C&I loans.
Are More Thrifts Making Commercial Loans? If
thrifts in a market are more likely to make com­
mercial loans, they are judged to be more com­
petitive with banks in their lending. And indeed,
the data in Table 3 show that there are more thrifts
making commercial loans today than there were in
1980. In the case o f SBs, which are few in Penn­
sylvania, twice as many institutions participated
in 1983 as in 1980. For S&Ls, mergers helped to
boost the participation rate from 7 percent to 15
percent during the same period by reducing the
total number o f S&Ls statewide. Nearly all o f the
commercial banks in Pennsylvania make some
form o f commercial loan.
How Important are Commercial Loans on the
Thrifts’ Balance Sheets? Recently, balance sheet
measures o f thrifts’ lending activity have received
greater emphasis because they provide a useful
supplement to deposit market shares in assessing
competition for C&I loans. Balance sheet measures,
such as the ratio o f the volume o f C&I loans to total
loans, are particularly useful when thrifts are
much fewer in number than commercial banks. In
this case, the small loan market share o f the thrifts
compared to commercial banks may obscure the
significant participation o f a few institutions
which could be quite active in bidding for com­
mercial loans. The ratio o f C&I to total loans also
can be used to compare the commitment o f the
average SB to that o f an average S&L or commercial
bank. And within types o f institutions, such a
measure can pick out those thrifts whose port­
folios differ substantially from the norm.
As expected, the portion o f total loans devoted
to commercial loans at thrifts still is relatively low
(Table 4). On average, commercial banks hold 36
percent o f their loans in the form o f C&I loans,
savings banks hold 15 percent, and savings and
loans hold less than 1 percent. In particular, the
savings bank figure reveals stronger lending activ­
ity than is indicated by their loan market share.
Since the total volume o f C&I loans in the state has
FEDERAL RESERVE BANK OF PHILADELPHIA

Janice M. Moulton

Thrifts’ Expanded Commercial Loan Powers

TABLE 2

C&I LOAN MARKET SHARES IN PENNSYLVANIA
(Millions $)
1980
Commercial Banks
Savings Banks a

Savings & Loansb

1981

%

$14,049

$14,886

99.4

810
(71.6)

75
(73.9)

0.5
(0.5)

4

0.03

5.8

1982

94.8

1,276
(76.5)
4.8

0.04

1983

9
6

$17,133

5.2
(0.5)

93.0
6.9
(0.4)
0.03

$18,414

$15,702

$14,128

TOTAL

9
6

9
6

$17,590

93.2

1,236
(114.8)
39.8

6.6
(0.6)
0.2

$18,866

aData in parentheses exclude PSFS from the savings bank numbers.
bW hile a commercial and industrial loan category was available on the call reports, commercial loans for S&Ls were
defined strictly to include unsecured construction loans, wholesale mobile home loans, and other non-consumer loans.
Commercial real estate was excluded from the definition.

TABLE 3

C&I LOANS: PARTICIPATION RATIO FOR
PENNSYLVANIA INSTITUTIONS
(Participants/Total)
1980
Commercial Banks
Savings Banks
Savings & Loans
TOTAL

1981

1982

1983

359/367

346/355

337/344

328/335

3/9

3/9

6/8

6/8

25/247

26/225

29/194

374/611

369/577

363/537

18/258
380/634

NOTE: March 1984 data show 100 percent participation by SBs: o f the two that were not making C&I loans in
1983, one has now begun to do so, and the other has been acquired by a com mercial bank holding
company.

TABLE 4

BALANCE SHEET MEASURE:
COMMERCIAL LOANS AS A PERCENT OF TOTAL LOANS
1980
Commercial Banks
Savings Banks3

Savings & Loans

1981

1982

1983

32.4%

33.0%

36.0%

36.0%

1.0
(1.9)

13.6
(1.7)

15.0
(2.7)

14.9
(4.1)

.02

.03

.02

0.2

aData in parentheses exclude PSFS from the savings bank numbers.




17

BUSINESS REVIEW

SEPTEMBER/OCTOBER 1984

increased relative to that o f total loans since 1980,
it is perhaps not surprising that the ratio o f com­
mercial loan volume to total assets has grown for
all three types o f institutions.1 Savings banks
2
substantially altered their portfolios to expand
into commercial loans, however, while S&Ls, on
average, added a limited amount o f commercial
loans to their balance sheet. These averages, of
course, hide considerable variability from one
thrift to another. The ratios for savings banks
range from 20 percent down to 1.5 percent while
those for S&Ls range from 10 percent to negligible
amounts.
Does Size Matter? In recent merger cases, the
Federal Reserve Board has cited the size o f thrift
institutions, along with other factors, as a basis for
assessing the competitive influence exerted by
thrifts.1 If larger thrifts are more likely to engage
3
in commercial lending, for example, then size can
be used to predict whether thrifts are likely to
embark upon a commercial loan program in the
future. This assumption that larger thrifts have
become, or have the potential to become, signifi­
cant bank competitors probably stems from the
belief that larger thrifts are more likely to be in a
better position to exercise their newly authorized
powers. Size may be important because the initial
cost o f setting up a commercial loan department or
o f hiring a full time commercial loan officer may
exceed the expected future earnings o f a small
thrift. And, because small thrifts have fewer de­
posits, they have a lower capacity for making loans
o f any kind. Thus if local thrifts fit this pattern of
behavior, large thrifts would tend to count as stronger
competitors with banks than would smaller thrifts.
What is the relationship between size and com­
mercial lending for thrifts in Pennsylvania? The
evidence suggests that larger thrifts make more
commercial loans, but it is not conclusive for
either SBs or S&Ls. Since there are so few SBs, it is

not clear that any strong conclusion can be drawn.
But it appears that larger savings banks are more
likely to enter the commercial loan business and
to make a greater volume o f loans. The largest SB
in the state, Philadelphia Savings Fund Society
(PSFS) is by far the biggest thrift player in the
commercial loan market.14 With over $ 1 billion in
commercial loans, PSFS has ten times the amount
o f the next largest SB participant and nearly forty
times the loans o f the largest S&L participant.
Generally, savings banks are the largest thrifts in
the state; even the smallest SB made nearly half a
million dollars in C&I loans in 1983.
S&Ls show some tendency for greater size to be
associated with greater commercial loan activity
when they are sorted into size groups (Table 5), but
the relationship is not as strong as the groupings
suggest.1 On the whole, Pennsylvania’s 200 S&Ls
5
are small institutions— only three have more than
$1 billion in deposits and only six S&Ls are as big
as or bigger than the smallest SB, and their median
deposit size is only $55 million. Larger institutions
appear to make a greater volume o f commercial
loans and to have a higher participation rate in
making C&I loans. S&Ls with less than $25 million
in deposits made no C&I loans at all in 1983.
Why Haven’t Thrifts Expanded More? The most
important reason thrifts haven’t used their new
lending powers more probably has been the
weakened financial condition o f thrifts stemming
from the mismatch o f their assets and liabilities in
a period of high interest rates. With the elimination
o f interest rate ceilings on deposits, thrifts were
compelled to pay higher rates on MMDAs, NOW
accounts, and savings certificates in order to
compete with banks, money market mutual funds
and other alternatives for their deposit funds.
Even with large amounts o f funds in passbook
accounts, their costs o f funds went up dramatically.
At the same time, thrifts still were holding a large

12The ratio of C&I loans to total loans for the state increased
from 19.8 percent in 1980 to 23.6 percent in 1983.

14In 1983, PSFS alone held almost 6 percent of the C&I loans
in Pennsylvania. Though PSFS dwarfs the contributions of the
other savings banks in the statewide figures, its volume has
declined by about $ 150 million since 1982, while C&I loans of
other SBs were rising.

13ln the Sun Banks-Flagship merger in Florida, the Federal
Reserve Board concluded that “Based upon the number, size,
and market shares of (thrift) institutions in the ... market, ...
thrift institutions exert a significant competitive influence that
substantially mitigates the anticompetitive effects of this
proposal.” Cited in the Federal Reserve Bulletin. December 1983,
p. 936.

18



15Correlation coefficients were calculated for 1983 deposits
and C&I loans for each type of institution. For commercial
banks, the correlation coefficient is .94; for SBs, it is .98 (.46
excluding PSFS); for S&Ls. it is only .06.

FEDERAL RESERVE BANK OF PHILADELPHIA

Thrifts’ Expanded Commercial Loan Powers

Janice M. Moulton

TABLE 5

SIZE AND C&I LOAN ACTIVITY FOR S&Ls IN PENNSYLVANIA, 1983
Deposits

C&I Loans

(M illions $)

(Thousands $)

S&Ls Making
C&I Loans

Range

Average for Group

Total for Group

Participants/Group Total

$150.2 - 1,867

$401.7

$32,761

13/40

74.5 - 143.8

101.7

4,760

7/40

40.0-

74.4

54.9

2,026

7/40

15.9-

37.7

18.6

263

2/40

3.1 -

15.8

9.7

0

0/34

volume o f long-term fixed-rate mortgages bearing
low interest rates, which meant that their assets,
on average, were yielding considerably less than
what they were paying on deposits.
Another reason why thrifts have been slow to
move into the commercial loan business is the
high start-up costs involved. Thrifts did not have
commercial loan experience, and they have had to
build up their expertise slow ly in-house or else

hire experienced loan officers from commercial
banks. Many smaller and middle-sized institutions
likely have found it too costly to hire a full time
commercial lending officer or establish a depart­
ment; their loan volume isn’t large enough to
justify such an expenditure.1 * Of course, signi­
6
ficant incentives remain for thrifts to continue
their traditional emphasis on residential mortgages.
BROADENING THE SCOPE
OF COMPETITIVE ANALYSIS
Does the modest profile o f thrift commercial
loan activity presented for Pennsylvania mean that

160ther reasons for the modest commercial loan participation
include high default risk on some types o f commercial ventures
over the past few years, variable rate mortgages that reduced
interest rate risk and therefore the need to diversify into
commercial lending, tax incentives that continue to encourage
mortgage lending, and the short time that expanded powers
have been authorized. For a good discussion o f the factors
influencing thrift commercial lending, see “How Quickly Can
Thrifts Move Into Commercial Lending?” by Constance Dunham
and Margaret Guerin-Calvert, New England Economic Review.
(Federal Reserve Bank of Boston, Nov/Dec 1983).




it is unimportant for analyses o f bank mergers?
Certainly not. Though thrifts are just beginning to
act as competitors in this important commercial
area, they have an impact on the analysis in
several ways.
First, mergers are approved mostly upon the
basis o f local banking conditions. Although state­
wide numbers indicate a modest level o f com­
mercial lending activity across Pennsylvania, they
are likely to mask what is going on in particular
areas. Thrifts have stronger lending activity in
metropolitan than in nonmetropolitan markets in
Pennsylvania, and many mergers occur in the more
populated markets. For example, despite the fact
that thrifts make less than 2 percent o f the total
C&I loans in the Pittsburgh market, C&I loans at
savings banks in Pittsburgh are more than 10
percent o f their total loans, indicating a fairly
significant balance sheet commitment to this
lending activity.
Second, individual thrift institutions may be
quite important in particular markets. When looking
at the more specific measures o f thrift competition,
one striking finding is the tremendous variability
in thrift commercial loan behavior. Thrifts which
make commercial loans differ markedly in their
market shares, the amount o f resources on the
balance sheet devoted to commercial loans, and
their size. Because thrifts in a particular market
might behave quite differently, analysis o f the
competitive effects requires a careful look at how
individual institutions use their expanded powers
before forming an overall judgment o f thrift com­
petition in that market.
19

BUSINESS REVIEW

New Ways of Including Thrifts. The courts have
determined that, for antitrust purposes, commer­
cial loans are one o f the most significant services
in which banks and thrifts compete. One approach
to assessing thrift competition would be to add use
o f this expanded power to past strengths that
thrifts have traditionally shown in making resi­
dential real estate loans and in issuing time and
savings deposits. When credit is given to thrifts for
building on the areas where they have been strong
competitors with banks in the past, thrifts look like
more serious competitors today even though they
have made only modest inroads in C&I lending.
Indeed, there is some recent evidence that thrifts
substantially influenced commercial bank be­
havior and performance in Pennsylvania back in
the early 1970s.1
7
Recognizing that banks and thrifts may compete
over a broad range o f services leads to a multi­
service line approach. Recently, the Federal
Reserve’s staff proposed to the Board o f Governors
informal guidelines to bring balance sheet measures
o f the major service lines formally into the shading
process. This approach could be applied to the
commercial loan service line as an example, since
this service alone can justify substantial shading
of commercial bank shares. To analyze the balance
sheet commitment of thrifts to commercial lending,
the average ratio o f commercial loans to total
loans for SBs and S&Ls could be compared to each
other and to the commercial banks. The com­
mercial banks’ ratio would serve as an indicator o f
the strength o f the demand for commercial loans
in that market. For commercial loans, other factors
would include the number o f thrifts actually
making commercial loans, the size o f the thrifts in
the market, and whether the thrifts have established
commercial loan departments, hired a commercial
lending officer, or have plans to do so in the near
future. After considering all such factors for the
thrifts in the relevant market, a judgment would be
made regarding the degree o f competition that
thrifts offer banks in the commercial loan service
line. For example, if thrifts in the market are
deemed to be moderately strong competitors in

17See Timothy Hannan, "Competition Between Commercial
Banks and Thrift Institutions: An Empirical Examination,”
Journal o f Bank Research. Spring 1984, pp. 8-14.

20



SEPTEMBER/OCTOBER 1984

commercial lending, they could receive, say, a
weight o f 20 percent— that is, 20 percent o f the
deposits o f each thrift in the market would be
added onto the total commercial bank deposits,
and the market shares would be recalculated using
this larger total deposit figure. Thus, the service
line— in this case commercial loans— would col­
lapse at the end o f the shading process back into
the concept o f the market share o f deposits.
This approach need not be limited to commercial
loans. Each major service line with its ow n char­

acteristics could be analyzed in the same kind o f
way; such an approach could help to ensure con­
sistency across markets. Other service lines might
include consumer loans, commercial and residen­
tial real estate loans, transaction accounts, and
time and savings accounts.1 All together, a thrift
8
weight o f 100 percent would be possible if thrifts
were judged to be strong competitors with banks in
every major service line in the market. More likely,
however, only a proportion o f thrift deposits
would be added to the total deposits o f banks in
the market to calculate the measures o f market
concentration. Even 50 percent inclusion o f thrifts’
deposits could significantly reduce measures o f
concentration in the market, increasing the likeli­
hood o f regulatory approval o f mergers. It should
be noted, however, that some writers have urged
caution in including thrift institutions; they point
out that mergers already resulting in much larger
market shares for banks are permitted, compared
to when commercial banks were considered the
sole competitors.1
9

18A multi-service line approach raises questions about how
much to depart from the traditional line of commerce doctrine.
If regulators judge thrifts to be competitors in some but not all
of the service lines, thrift deposits may be included to a
substantial extent, though thrifts may not be competing with
banks in some important areas. For example, how much can
active thrift competition in consumer loans offset moderate
thrift competition in commercial loans? Closer adherence to a
unique line of commerce would tend to require significant
participation in commercial loans, whether or not the thrift
competes in consumer services. These issues probably will not
be resolved until the Supreme Court again rules on the line of
commerce definition.
19See "Antitrust Laws, Justice Department Guidelines, and
the Limits of Concentration in Local Banking Markets,” by Jim
Burke, Staff Studies No. 138, Board of Governors of the Federal
Reserve System June, 1984, p. 14.

FEDERAL RESERVE BANK OF PHILADELPHIA

Thrifts’ Expanded Commercial Loan Powers

OUTLOOK FOR THRIFTS IN MERGER ANALYSIS
Thrifts are moving close to the point where they
may be considered serious competitors in the
commercial banking line o f commerce. With today’s
complex financial institutions, it’s difficult to
evaluate when thrifts offer sufficient volume and
breadth o f major banking type services to be
considered significant competitors. Both SBs and
S&Ls now are authorized to offer a wide range o f
personal and commercial banking services. Cur­
rently, thrifts are participating in commercial loans
in Pennsylvania in a limited way, but given the
financial difficulties and earnings losses in the
industry, this current level o f activity is not sur­
prising. Still, as a group, thrifts are moving to




Janice M. Moulton

exercise their commercial loan powers more fully
and to compete in more o f the commercial banks’
major service lines, and will probably continue to
do so. And some thrifts are now making greater
inroads into the commercial loan markets to the
point o f affecting competition in local banking
markets. As a result, thrift activity now receives
more weight in the competitive analysis o f bank
mergers, significantly increasing the chances of
regulatory approval o f bank merger applications.
For policymakers, legislators, and the judiciary,
these developments likely will require continued
scrutiny and adjustment in assessing the antitrust
implications for bank mergers o f thrifts’ new lending
powers.

21

...

.

........................................ ........

s

^ a* * * * # "

V's

The Philadelphia Fed’s Research Department occasionally publishes working papers based on the current
research of staff economists. These papers, dealing with virtually all areas within economics and finance, are
intended for the professional researcher. The nine papers added to the Working Papers Series in 1983 are listed
below.
A list of all available papers may be ordered from WORKING PAPERS, Department of Research, Federal Reserve
Bank of Philadelphia, 10 Independence Mall, Philadelphia, Pennsylvania 19106. Copies o f papers may be ordered
from the same address. For overseas airmail requests only, a $2.00 per copy prepayment is required.

1983
No. 83-1

Robert H. DeFina, “ Union-Nonunion Wage Differentials and the Functional Distribution o f Income:
Some Simulation Results from a General Equilibrium Model.”

No. 83-2

Nicholas Carlozzi, “The Structure, Parameterization and Solution of a Multicountry Simulation
Model.”

No. 83-3

Nicholas Carlozzi and John B. Taylor, "International Capital Mobility and the Coordination of
Monetary Rules.” (Reissued in Exchange Rate Management Under Uncertainty, ed. J. Bhandari, MIT Press,
1984.)

No. 83-4

Brian R. Horrigan, “Pitfalls in Analyzing Deficits and Inflation.”

No. 83-5

Herb Taylor, “The Role o f the Discount Window in Monetary Policy Under Alternative Operating
Procedures and Reserve Requirement Systems.”

No. 83-6

Brian C. Gendreau, "Carrying Costs and Treasury Bill Futures.”

No. 83-7

Edwin S. Mills, “Metropolitan Central City Population and Employment Growth During the 1970’s.”

No. 83-8

Gerald A. Carlino, "Declining City Productivity and the Growth of Rural Regions: A Test of Alternative
Explanations.” (Revision forthcoming in the Journal o f Urban Economics. 1984.)

No. 83-9

Simon Benninga and Aris Protopapadakis, "General Equilibrium Properties of the Term Structure of
Interest Rates.”

83-1
UNION-NONUNION WAGE DIFFERENTIALS AND
THE FUNCTIONAL DISTRIBUTION OF INCOME:
SOME SIMULATION RESULTS FROM A GENERAL
equilibrium model
Robert H. DeFina
During the past two decades, a number of studies have
established
for FRASER the ability of unions to obtain wages for their

Digitized


members that exceed the payment to similar, but nonunionized
workers. This article investigates empirically the impact that
this wage differential has on the real incomes o f union labor,
nonunion labor, and capital. The analysis is accomplished by
solving explicitly a numerically specified general equilibrium
system with and without the union wage premium. Comparison
of real factor incomes in each equilibrium yields the desired
information. The findings indicate that union labor gains as a
result o f the differential, while nonunion labor and capital lose.
This outcome is realized both in terms o f real income levels and
in a redistributive sense.

■ W W M IIW

I FEDERAL RESERVE BANK O F PHI1 A D I I PI 1IA

S e le cte d A b stra cts

83-3
INTERNATIONAL CAPITAL MOBILITY AND THE
COORDINATION OF MONETARY RULES
Nicholas Carlozzi
and
John B. Taylor
The paper develops a two-country model with flexible
exchange rates and perfect capital mobility for evaluating
alternative macroeconomic policy rules. Macroeconomic
performance is measured in terms of fluctuations in inflation
and output. Expectations are rational, and prices are sticky;
wage setting is staggered over time. The countries are linked by
aggregate spending effects, relative price effects, and mark-up
pricing arrangements. The model is solved and analyzed
through deterministic and stochastic simulation techniques.
The results suggest that international capital mobility is not
necessarily an impediment to efficient domestic macroeconomic performance. Changes in the expected appreciation
or a depreciation of the exchange rate along with differentials
between real interest rates in the two countries can permit
macroeconomic performance in one country to be relatively
independent o f the policy rule chosen by the other country.
The results depend on the particular parameter values used in
the model and suggest the need for further econometric work to
determine the size of these parameters.

83-4

1983

procedures for short-run money control. It is shown that when
the Fed uses a funds rate operating procedure to control the
money stock, discount window procedures do not affect the
volatility of the money stock. W hen the Fed uses a reserves
operating procedure combined with lagged reserve require­
ments, a relatively liberal discount window policy is shown to
improve money control. With contemporaneous reserve require­
ments, the case for a more restrictive discount window policy is
stronger, though a penalty discount rate does not necessarily
maximize short-run money control.

83-6
CARRYING COSTS AND TREASURY BILL
FUTURES
Brian C. Gendreau
Researchers have consistently found that yields on Treasury
bill futures differ significantly from corresponding forward
rates implicit in the term structure of interest rates. This paper
focuses on the borrowing costs faced by investors as the source
of that difference. Rates o f return attainable on forward bills
created implicitly by financing Treasury bills with term
repurchase agreements are calculated and found to be not
significantly different from yields on Treasury bill futures
contracts. These results suggest that risk premia in the
repurchase market are reflected in Treasury bill futures yields,
and can explain why those yields differ from forward rates.

PITFALLS IN ANALYZING INFLATION AND
UNEMPLOYMENT
Brian R Horrigan
W hen can we know whether deficits cause inflation or
inflation causes deficits? The correlation we observe between
deficits and inflation does not permit an inference about
causality. In steady state, higher inflation is always associated

83-7
METROPOLITAN CENTRAL CITY POPULATION
AND EMPLOYMENT GROWTH DURING
THE 1970s

with higher deficits, regardless of what caused the inflation.
The causal relation between deficits and inflation can only be

by Edwin S. M ills

inferred from a study of disequilibrium situations. In
disequilibrium, the inflation-adjusted deficit is a better
measure o f the stance of fiscal policy than the conventional

This paper studies the determinants of Metropolitan
Central City Population and Employment Growth from 1970 to

deficit.

250,000 population. Central city and suburban population and
employment growth are analyzed in a four-equation model.
Population and employment growth reinforce each other
strongly in central cities. Suburban population growth
stimulates central city employment growth, but suburban
employment growth is at the expense of central city employ­
ment growth. Central city population and employment growth
are affected strongly by variables over which communities
have control. Many eastern and northern central cities could
have replaced decline with substantial growth by better control
of crime and taxes and by improved educational systems.

83-5
THE ROLE OF THE DISCOUNT WINDOW IN
MONETARY POLICY UNDER ALTERNATIVE
OPERATING PROCEDURES AND RESERVE
REQUIREMENT SYSTEMS
Herb Taylor
The paper uses a simple model of the reserves market to
demonstrate
for FRASER the implications of discount window administration

Digitized


1980 using census data for metropolitan areas with at least

FEDERAL
RESERVE BA NK O F
PHILADELPHIA

Business Review
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