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FRBSF
WEEKLY LETTER
Number 94-26, July 22, 1994
Interstate Banking and Risk
Most banks operate in only one state, a peculiar
artifact of historical legal restrictions not found in
other developed countries. In recent years the restrictions have been relaxed; some bank holding
companies operate banks in more than one state,
and a few states have changed or reinterpreted
their laws to allow at least some banks to operate
branches across state lines. (For the western
states, see Weekly Letter 94-15.)
Federal legislation that appears headed for passage would remove most remaining barriers to
interstate banking and branching. Although banking firms can work within existing laws to operate
across state lines, the new legislation probably
will lower the cost of providing banking services
in more than one state, and interstate activity
should increase as a result. Banks may gain from
expanded business opportunities; their customers may receive cheaper, more efficient, and
more convenient service.
A frequently cited public benefit of interstate
branching is that banks may become safer if they
diversify their operations across regions. Good
results in one state or region might offset poor
results elsewhere, for example. Reducing bank
risk is desirable from the perspective of public
policy, since a more stable banking system has
fewer bank failures and smaller deposit insurancelosses. This Letter discusses the potential for
banks to becortle safer through interstate diversification, focussing on prospects for the nine
western states that make up the Twelfth Federal
Reserve District.
Diversification potential
Supporters of interstate branching often assert
that risk reduction follows naturally from geographic expansion. However, the size of any
such benefit depends on how banking markets in
different states are related. One way to get a feel
for diversification's potential is to consider combinations of typical or average banks in different
WESTERn BAnKinG
states: If income would be less variable for such
combinations than for separate banks, then interstate banking and branching can reduce risk.
Hypothetical interstate bank combinations can
be evaluated using variances of banking income
in each state in the Twelfth District and correlations between each pair of states. The relevant
statistics were calculated from the aggregate return on assets (ROA) for each state, for the period
1985-1993. Larger banks were excluded from the
calculations, since these banks already may have
some income generated from out-of-state activities. ("Large" banks were defined to be those
With more than $300 million in assets, although
similar conclusions follow from a $10 billion cutoff.) Assuming that the variability of smaller banks'
ROA largely reflects fundamental economic characteristics of regions, interstate branching will
not change the variances and correlations in the
various states, making these data a useful guide
to expectations about future interstate activity.
Significant risk reduction requires relatively low
correlations between banking conditions in different states; risk falls the most if banking ROA
in two states is negatively correlated-when one
state is down the other tends to be up. The calculations show that hypothetical combinations
of Western banks vary considerably in the degree
to which they reduce risk. Of the 36 possible
pairs of states in the Twelfth District, only three
have significant negative correlations: ArizonaCalifornia, Hawaii-Utah, and Hawaii-Oregon. In
this regard, it is interesting to note that two major
California banking firms (BankAmerica and First
Interstate) have established operations in Arizona, and BankAmerica's Oregon subsidiary has
acquired an institution in Hawaii.
Another 18 pairs of states have correlations that are
not significantly different from zero, suggesting
substantial scope for safer banking through diversification. The remaining 15 state correlations are
Western Banking is a quarterly review of banking
developments in the Twelfth Federal Reserve District. It is published in the Weekly Letter on the fourth
Friday of January, April, July, and October.
FABSF
significantly positive (ranging from 0.3 to 0.7),
thus providing less risk reduction. As an example
of the latter category, banking income in the state
of Washington is highly correlated (in the 0.5 to
0.7 range) with Oregon, Utah, and Idaho; interstate mergers or branching involving these states
may make economic sense, but the potential Tor
risk reduction is less.
Why it works
A closer look at the components of ROA highlights the factors that tend to determine correlations between states. Risk reduction does not
come from diversifying banks' funding sources:
Ratios of interest expenses to assets are very
highly correlated across all states. Apparently, the
interest rates that determine the cost offunds for
banks move similarly throughout the West.
On the other hand, interest income on loans (as a
percentage of assets) generally is not highly correlated ·across states, especially for banks 'vvith less
than $300 million in assets. Loan loss provision
ratios also are relatively uncorrelated across states,
with some correlation coefficients significantly
negative. Thus, interstate banks are safer because
loan portfolios can be diversified across regions.
The effect on risk
The impact of interstate activity on the safety of
individual institutions will vary from bank to
bank. For example, over the 1985-1993 period,
the variance of ROA was highest in Alaska and
Arizona, and most stable in Oregon, Washington, and California. A hypothetical Washington
bank branching into Arizona might become
riskier, because Arizona has been a less stable
banking environment, and the correlation between the two states is so high that diversification
may not offset the added volatility. Such an increase in risk may be important to employees,
unsecured creditors, and others. However, it is
not grounds for concluding that such an expansion is undesirable, since other benefits may
offset the risk effect.
Despite the fact that a few banks may become
riskier, on average risk will decline. The public
at large will benefit, especially with regard to
deposit insurance. The FDIC, which ultimately
means the taxpayer, bears the liability of potential claims if a bank fails; safer banks reduce this
contingent liability. As a gauge of whether the
potential risk reduction is substantial, consider
two hypothetical alternatives: In one case, the
FDIC insures banks that are diversified within
each Western state but not across states; in the
second, all barriers are removed and all insured
banks are fully diversified across the nine states
of the District. The size of the FDIC liability (calculated from an option model of deposit insurance) declines by 80 percent from the first case
to the second. Thus the risk reduction from full
interstate banking may substantially reduce the
cost of insuring deposits.
Economists can find a black lining in any cloud,
and interstate banking is no exception: The possibility of a certain kind of systemic banking
failure may increase. There is always some danger that chance events could cause many banks
to fail simultaneously, leading to a massive reduction in the provision of banking services to
the economy. Perversely, the probability of such a
"bad draw" m~y rise with interstate banking. As
banks diversify into each others' markets, bank
portfolios may come to look more alike, raising
the odds that all will turn down at the same time.
However, the expected costs of such systemic
effects are unlikely to outweigh the kinds of benefits discussed above.
Conclusion
Removing the remaining barriers to interstate
banking and branching should bring gains due
to enhanced bank efficiency and competition,
and greater convenience for bank customers.
In addition, relatively low correlations between
banking profits in different states present opportunities to reduce risk through diversification.
Cross-state correlations of bank income suggest
that interstate diversification generally will reduce risk, mainly through opportunities to diver. sify bank loan portfolios. Calculations of possibly
substantial gains from a safer, more stable banking system make full interstate banking and
branching attractive.
Mark E. Levonian
Research Officer
REGIONAL BANK DATA
MARCH 31, 1994
(TA8LE HAS 8EEN REVISED TO REFLECT RECENT CHANGES IN 8ANK REPORTINGI
DISTRICT
ALASKA
ARIZ.
CALIF.
HAWAII
IDAHO
NEVADA
FOREIGN
DOMESTIC
LOANS
TOTAL
FOREIGN
DOMESTIC
REAL ESTATE
COMMERCIAL
CONSUMER
AGRICULTURAL
OTHER LOANS
SECURITIES
TOTAL
U.S. TREASURIES
U.S. AGENCIES, TOTAL
U.S. AGENCIES, M8S
OTHER MBS
OTHER SECURITIES
LIABILITIES
DEPOSITS
OREGON
UTAH
WASH.
16,443
332,046
29,130
302,916
160,212
60,941
54,614
5,709
21,440
2,632
5
2,627
1,311
746
426
3
142
22,302
0
22,302
8,700
2,814
7,244
347
3,197
215,681
27,697
187,984
111.486
36,927
23,628
3,010
12,934
14,127
1,381
12,747
7,712
3,130
1,075
34
796
7,846
0
7,846
2,572
1,648
2.490
718
418
9,231
0
9,231
2,562
771
5,305
10
583
19,092
8
19,084
7,810
5,059
4,111
464
1,640
9,607
0
9,607
4,193
1,652
3,008
162
592
31,526
38
31.487
13,866
8,194
7,327
961
1,139
87,963
26,643
41,665
34,574
4,874
14,781
1,793
933
456
399
95
309
10,252
2,574
6,048
5.415
724
905
52,328
15.142
24,839
20,982
3.459
8,887
5,262
2,546
2,204
1,624
38
474
1,759
450
656
393
40
614
4,329
1,509
2.296
1,956
88
436
4,159
1.407
1,903
1,638
26
824
3,581
708
1,789
1,097
201
882
4,500
1,374
1,473
1,069
203
1.450
TOTAL
DOMESTIC
471,161
432,264
4,319
4,319
34,160
34,160
309,553
273,158
20,801
18,353
10,140
10,140
14,238
14,238
24,731
24.719
14,932
14,932
38,286
38,245
TOTAL
FOREIGN
DOMESTIC
DEMAND
NOW
MMDA & SAVINGS
SMALL TIME
LARGE TIME
OTHER DEPOSITS
401,650
33,155
368.496
95,837
43,302
142,867
60,077
26,076
336
3,788
0
3,788
1,098
380
1,340
432
495
42
30,065
0
30,065
6,765
3,693
11,613
6,650
1,343
1
268,237
30,838
237,399
65.411
25,222
94.490
34,164
17,909
203
14,518
2,156
12,363
2.489
1,512
4,940
1,940
1.474
8
8,300
0
8,300
1,590
1,120
2,888
2,066
635
0
10,042
0
10,042
2,964
1,452
4,030
913
682
0
20,977
11
20,967
4,583
3.429
6,942
5,099
899
16
11,282
85
11,197
2,449
1,677
3,904
2,399
767
2
34,442
66
34,376
8.488
4,818
12,721
6,413
1,871
65
37,196
44.485
9,771
219,150
492
675
38
722
3,365
3.434
468
33,586
14,676
27,811
7,193
117,303
5.403
1,817
236
7,220
1,662
850
117
3,656
2,940
2,205
454
16,858
2,985
2.429
432
14,569
2,942
1,359
216
8,121
2,730
3,905
605
17,115
0.101
0.131
0.079
0.220
0.232
0.133
0.121
0.143
0.079
0.095
0.129
0.075
0.107
0.127
0.077
0.099
0.118
0.076
0.165
0.178
0.114
0.102
0.119
0.083
0.128
0.144
0.086
0.095
0.118
0.084
8.141
758
86
6
614
60
5,102
497
354
13
187
15
364
17
449
52
278
23
707
76
8,332
2,523
2,332
438
3,039
76
24
27
1
23
605
196
156
33
219
5,288
1,586
1,554
302
1,846
326
135
93
13
85
166
67
34
6
60
454
80
64
47
263
466
133
151
11
171
274
95
60
10
110
678
208
193
15
263
TAXES
NET INCOME
975
1.464
9
19
65
102
592
781
37
61
19
36
96
171
52
91
28
50
78
153
ROA 1% ANNUALIZED)
ROE 1% ANNUALIZED)
NET INTEREST MARGIN 1% ANNUALIZED)
1.16
13.17
4.44
1.52
11.28
4.90
1.11
11.91
4.55
0.95
11.24
4.26
1.10
13.49
3.92
1.33
17.11
4.42
4.16
31.07
6.90
1.35
14.94
4.72
1.26
14.60
4.63
1.48
15.62
4.83
OTHER 80RROWINGS
EaUITY CAPITAL
LOAN LOSS RESERVE
LOAN COMMITMENTS
TIER1 CAPITAL RATIO
TOTAL CAPITAL RATIO
LEVERAGE RATIO
INTEREST
FEES & CHARGES
EXPENSES
TOTAL
INTEREST
SALARIES
LOAN LOSS PROVISION
OTHER
NET CHARGEOFFS, TOTAL
REAL ESTATE
COMMERCIAL
CONSUMER
AGRICULTURAL
PAST DUE & NON-ACCRUAL, TOTAL
REAL ESTATE
CONSTRUCTION
COMMERCIAL
FARM
HOME EQUITY LINES
MORTGAGES
MULTI-FAMILY
COMMERCIAL
CONSUMER
AGRICULTURAL
NUMBER OF 8ANKS
NUM8ER OF EMPLOYEES
-0.10
0.93
1.38
3.91
5.70
22.07
7.75
5.71
1.29
3.01
7.31
2.64
2.64
2.99
2.59
2.48
4.17
3.14
0.00
1.27
2.05
1.55
2.60
2.15
0.00
2.21
2.47
3.75
6.81
10.86
0.77
1.37
0.86
2.71
2.66
1.66
4.84
7.08
30.72
10.14
5.66
1.40
3.63
10.33
3.03
2.95
2.26
2.40
2.79
8.91
2.19
7.51
1.61
2.84
1.43
2.12
2.55
26.81
1.42
1.20
1.90
1.10
5.63
0.32
1.15
3.59
1.32
1.22
3.80
4.72
4.39
15.08
5.10
0.00
0.84
2.71
0.81
4.06
5.43
0.46
1.46
1.90
9.10
2.42
5.92
0.23
1.02
0.28
0.88
1.17
2.99
1.32
1.36
2.22
1.86
12.21
0.78
0.91
0.28
1.52
1.16
3.11
2.22
3.03
12.79
2.23
3.14
1.43
1.09
0.04
1.61
1.32
4.42
698
241,163
8
2,647
38
18.432
419
153,574
17
8,618
20
4,853
20
7,574
45
16,716
46
7,658
87
20,891
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author. ... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.
Research Department
BULK RATE MAil
U.S. POST AGE
PAID
PERMIT NO. 752
San Francisco, Calif.
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120
A
Printed on recycled paper Q
with soybean Inks.
'=' ~
PERCENT OF COMBINED MARKET TOTAL FOR MAY 1994. BY REGION
~
~
~
DEPOSIT TYPE
c.
SL
cu
c.
SL
cu
c.
TOTAL DEPOSITS
56
90
64
61
32
43
37
7
27
29
64
45
8
3
9
10
4
12
71
97
61
56
75
95
4
0
6
4
7
1
25
3
34
40
18
4
91
97
88
89
93
90
DEMAND
NOW
SAVINGS & MMDAS
SMALL TIME
LARGE TIME
CB _ COMMERCiAL BANKS:
SL
~
~
c.
SL
cu
c.
SL
cu
c.
SL
8
3
12
11
5
9
49
8.
58
57
23
35
44
8
35
35
73
52
7
4
7
8
4
13
64
91
64
56
54
29
4
32
33
43
17
8
4
4
11
3
11
91
97
89
90
88
90
5
0
4
4
10
5
5L "" SAVINGS & LOANS AND SAVING BANKS;
TYPE OF RETAIL DEPOSIT ACCOUNT OR LOAN
~
cu
72
cu _ CREDIT UNIONS;
cu
~
c.
SL
77
98
78
76
45
86
18
2
14
16
50
14
~
cu
~
~
C8
SL
cu
C8
SL
cu
C8
SL
cu
83
95
85
79
80
77
7
1
5
7
13
9
10
3
10
15
7
14
79
90
82
74
80
70
5
4
1
3
11
10
16
6
16
24
9
21
56
88
65
33
10
22
26
56
52
10
2
12
18
6
2
55
38
46
MAY NOT SUM TO 100% DUE TO ROUNDING
MAY
1992
AUG
1992
NOV
1992
FEB
1993
MAY
1993
AUG
1993
NOV
1993
FEB
1994
MAY
1994
SAVINGS ACCOUNTS AND MMDAS
U.S
DISTRICT
3.57
3.67
3.14
3.29
2.90
3.05
2.80
2.96
2.65
2.78
2.55
2.67
2.48
2.58
2.43
2.56
2.50
2.65
92 TO 182 DAYS CERTIFICATES
U.S
DISTRICT
3.82
3.76
3.36
3.34
3.14
3.14
3.0B
3.01
2.98
2.88
2.96
2.85
2.92
2.81
2.93
2.83
3.28
3.03
2·1/2 YEARS AND OVER CERTIFICATES
U.S
DISTRICT
5.45
5.17
4.87
4.75
4.70
4.49
4.59
4.41
4.45
4.27
4.40
4.19
4.28
4.09
4.35
4.13
4.89
4.58
COMMERCIAL SHORT TERM FIXED'
U.S
DISTRICT
4.87
6.56
4.42
5.38
4.17
4.79
4.16
4.28
3.91
4.19
4.02
4.75
3.95
4.43
4.03
4.95
4.68
6.78
COMMERCIAL SHORT TERM FLOATING'
U.S
DISTRICT
6.56
6.59
5.95
6.29
5.91
6.59
5.85
6.36
5.58
5.40
5.53
6.48
5.56
6.46
5.49
6.36
6.32
6.38
COMMERCIAL LONG TERM FIXED'
U.S
DISTRICT
7.27
8.65
6.28
8.20
5.97
6.44
6.43
9.19
6.02
10.86
6.21
8.05
5.38
6.62
5.41
6.58
6.17
N/A
COMMERCIAL LONG TERM FLOATING'
U.S
DISTRICT
7.06
7.38
6.60
7.63
6.53
8.09
6.38
8.43
6.47
8.55
6.05
8.77
5.70
7.68
5.98
8.16
6.61
N/A
CONSUMER, AUTOMOBILE
U.S
DISTRICT
9.52
9.67
9.15
9.39
8.60
8.76
8.57
8.98
8.17
8.23
7.98
8.09
7.63
7.70
7.54
7.68
7.76
7.86
CONSUMER, PERSONAL
U.S
DISTRICT
14.28
13.80
13.94
13.68
13.55
12.83
13.57
12.67
12.00
13.87
13.45
12.69
13.22
13.00
12.89
12.02
12.96
12.26
CONSUMER, CREDIT' CARD
U.S
DISTRICT
17.97
18.52
17.66
18.46
17.38
18.29
17.26
17.76
17.15
17.60
16.59
17.58
16.30
17.00
16.06
17.17
16.15
17.61
SOURCES: MONTHLY SURVEY OF' SELECTED DEPOSITS, SURVEY OF TERMS OF BANK LENDING, AND TERMS OF CONSUMER CREDIT
MOST COMMON INTEREST RATES ON RETAIL DEPOSITS, WEIGHTED AVERAGE INTEREST RATE ON LOANS
, DATA ARE COMPOUNDED ANNUAL RATES
@FedFRASER