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SEPTEMBER/OCTOBER 1995

ECONOMIC PERSPECTIVES
A review from the
Federal Reserve Bank
of Chicago

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Chicago's economic
transform ation: Past and future
Internal organization and economic
performance: The case of large
U.S. commercial banks




FEDERAL RESERVE BANK
OF CHICAGO

i

Contents
Chicago's economic
transformation: Past and future................................................................ 2
G raham S chindler, P h ilip Israilevich,
and G eo ffrey H ew ings

Structural changes and shifts in exports have
reduced Chicago’s sensitivity to macroeconomic
fluctuations. Using a model of Chicago’s
economy, the authors find that this trend is likely
to continue into the future.

Internal organization and economic
performance: The case of large
U.S. commercial banks............................................................................... 10
W illiam C. H unter

This article provides new evidence on the impact
of centralized versus decentralized strategic
decisionmaking, product delivery systems, and
back-office operations on commercial bank costs.

ECONOMIC P ER SP E( Y Y IVES

Septem ber/O ctober, 1995 Volum e XIX, Issue 5

P re s id e n t

ECONOMIC PERSPECTIVES is published by

Michael H. Moskow

the Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors' and do not necessarily reflect the views of
the management of the Federal Reserve Bank.
Single-copy subscriptions are available free of
charge. Please send requests for single- and
multiple-copy subscriptions, back issues, and
address changes to the Public Information Center,
Federal Reserve Bank of Chicago, P.O. Box 834,
Chicago, Illinois 60690-0834, or telephone
(312) 322-5111.
Articles may be reprinted provided the source is
credited and the Public Information Center is sent a
copy of the published material.

S e n io r V ic e P re s id e n t an d D ir e c to r o f R esearch

William C. Hunter
R esearch D e p a rtm e n t

Financial Studies

Douglas Evanoff, Assistant Vice President
Macroeconomic Policy

Charles Evans, Assistant Vice President
Kenneth Kuttner, Assistant Vice President
Microeconomic Policy

Daniel Sullivan, Assistant Vice President
Regional Programs

David R. Allardice, Senior Vice President
Adm inistration

Anne Weaver, Manager
Editor

Janice Weiss
Production

Rita Molloy, Kathryn Moran, Yvonne Peeples,
Roger Thryselius, Nancy Wellman




ISSN 0164-0682

Chicago's economic
transformation: Past and future

G rah a m S c h in d le r, P h ilip Isra ile v ic h ,
and G e o ffre y H e w in g s

A

Hog butcher fo r the world,
Tool maker, stacker o f wheat,
Player with railroads and the
nation’s freight handler;
Stormy, husky, brawling,
City o f the big shoulders.

—Carl Sandburg, “Chicago” (1916)

The charismatic city that Carl Sandburg depict­
ed in 1916 has since undergone a dramatic
transformation. By the late 1970s, deep reces­
sions had all but eliminated much of the ro­
manticism associated with Chicago’s industrial
economy. Indeed, the city and the entire Mid­
west seemed to produce almost daily reports of
manufacturing plant closings and layoffs. The
dire straits of those times appeared to portend
only more gloom for the future. But during the
same period, Chicago was fostering a growing
service sector. By maintaining the growth of
the industries in this sector, Chicago has recon­
structed itself into a strong, thriving economy.
As several recent studies have shown,
Chicago’s economic structure changed dramat­
ically during the 1970s and 1980s, with servic­
es coming to dominate both output and em­
ployment. In fact, by the early 1980s, service
employment had surpassed manufacturing
employment in the metropolitan area, foreshad­
owing a similar transformation nationally a
few years later. Not only did Chicago lead the
nation in this trend, but the relative degree to
which services took over from manufacturing
was more dramatic in Chicago than in the
nation as a whole. Meanwhile, with manufac­
turers retiring old inefficient factories, the

2


relics of what some would call Chicago’s glory
days, and replacing them with establishments
featuring new highly efficient capital, manu­
facturing output exhibited little or no growth in
real terms. With more efficient factories now
in use, labor requirements were not as high as
in the past; accordingly, between 1970 and
1992 manufacturing firms within Chicago cut
over 280,000 jobs.
Chicago’s new economic character has
arisen because of two fundamental changes,
each of which may have different policy impli­
cations. First, through the difficult transitional
period of the 1970s and early 1980s, firms
survived because they became more efficient
and were able to compete in the increasingly
globalized marketplace. Second, the growing
dominance of the service sector has fundamen­
tally altered the composition of Chicago’s
exports. These changes combined to reduce
the importance of the pro-cyclical manufactur­
ing exports in favor of those from the less
cyclically sensitive service industries.
At the same time, Chicago’s interaction
with other midwestern or national economies
has also been affected. Despite the fall of man­
ufacturing’s share of total exports, Chicago’s
Graham Schindler is a research associate, Philip
Israilevich is the associate director, and Geoffrey
Hewings is the director of the Regional Economics
Applications Laboratory (REAL). REAL is a cooper­
ative venture between the University of Illinois
and the Federal Reserve Bank of Chicago. Philip
Israilevich is also a senior economist and research
officer at the Federal Reserve Bank of Chicago. The
authors thank David Allardice, Kathy Moran, and
Janice Weiss for their comments and suggestions.

ECONOMIC PERSPECTIVES

linkages with other economies have strength­
ened. This is due to three key developments:
increased dependence on external markets for
inputs in manufacturing, increased service sec­
tor trade, and altered consumption patterns as a
result of increased residential mobility. In sum,
Chicago’s economy has become less cyclical
and more dependent on the rest of the nation.
Stu d yin g C hicago

A sketch of structural changes such as these
prompts further questions: Which changes are
likely in the future? Which industries were
most important in engendering change, and will
they continue to be prominent in future transfor­
mations? How will the recent changes affect the
economy’s reaction to exogenous shocks? Is it
reacting differently than in the past, and what
might we expect in the future? How might
these changes affect other midwestern econo­
mies? These are the types of questions that
the Chicago Region Econometric Input/Output Model (CREIM) was designed to answer.1
Created by the Regional Economics Applica­
tions Laboratory, CREIM allows us to examine
changes that have taken place in the past and to
forecast those that might occur in the future.
Additionally, it can estimate the direct and
indirect impacts of these changes on various
sectors of the economy.
CREIM combines traditional input/output
analysis with time-series analysis.2 The input/
output component enables a detailed analysis of
purchases and sales between industries, while the
time-series component allows for the analysis of
intertemporal change in the transaction flows of
goods and services. Together, these two compo­
nents produce a detailed analysis of structural
change over time at the sectoral level.3 By taking
into account transaction flows between industries,
we are able to estimate the spillover or indirect
effects within the economy that direct analysis
cannot capture because it examines each sector
irrespective of its effect on other sectors. For
example, fabricated metals production requires
machine tools and steel as inputs; machine tool
companies require steel to build the tools. An
increase in the demand for fabricated metals
products will impact the steel industry in at least
two ways: by increased direct consumption (from
fabricated metals) and increased indirect con­
sumption (from machine tools). In this way, each
sector of the economy is linked to all others,
either directly or indirectly.


FEDERAL RESERVE


RANK OF CHICAGO

The exp erim en t

To analyze the impact of Chicago’s struc­
tural change over time, we designed an experi­
ment to answer the question, how would a na­
tional recession affect the Chicago economy,
and would the magnitude of this impact change
over time? For ease of exposition, we decided
to take the recession of 1982 as an example.
Using CREIM, we estimated total exports from
Chicago to the rest of the nation for both 1981
and 1982. We calculated that 1982 exports
were 5.5 percent less than 1981 levels; we then
used the magnitude of this export shock to simu­
late a national recession.
The impact on exports from the region
during the 1982 recession was largely concen­
trated in manufacturing industries, with durable
goods hit particularly hard. We estimate that
between 1981 and 1982, exports of primary
metals industries dropped by approximately 33
percent, exports of fabricated metals by about
20 percent. Despite the large export losses in
some sectors, other sectors actually saw exports
rise. Of the 36 sectors in the model, nine of
them, including food and kindred products,
petroleum products, and business services, ex­
hibited export growth between 1981 and 1982.
Of these nine, all the resource and manufactur­
ing sectors saw exports subsequently fall from
those levels by 1983.
In order to ease interpretation of our results,
we did not use the estimated sectoral export
changes, which had varying signs. Rather, we
distributed the total export change from 1981 to
1982—5.9 percent of 1982’s total exports—
across all sectors, weighted by the size of their
estimated exports in 1982. This gave all export
changes the same sign and facilitated interpreta­
tion of the final results. We then used this new
vector of export change to represent an economy­
wide export recession, with the overall magni­
tude equal to that of the 1982 recession, to
shock CREIM. We introduced the recessions
separately into CREIM as a fall in exports of 5.9
percent for the years 1975, 1985, 1995, and
2005. These four observations provided vectors
of changes in output, employment, and so on,
which would determine Chicago’s reaction to
national downturns over time. For the simu­
lated recessions we assumed that only exports
were shocked, not technology; thus, the esti­
mated changes in productivity and wage levels
within Chicago occurred only in response to

3

the reduction in exports, not in
FIGURE 1
some exogenous form due to the
Manufacturing and service output
recession.
index, 1985=100
The recessions introduced
into the model are constant
through time in relative terms
even though exports as a share of
total output are increasing over
time. From 1975 to 2005, ex­
ports’ share of total output is
forecasted to increase from ap­
proximately 30 percent to 37
percent. Thus far, total manufac­
turing output—traditionally con­
sidered the source of most ex­
ports—has remained relatively
constant, while service-oriented
Note: Dashed lines indicate forecasts.
output has grown and is expected
Source: Authors' calculations, simulation using CREIM.
to increase even further (see fig­
ure 1). In fact, manufacturing
exports were between 29 percent and 34 per­
vealed by CREIM over time.6 For example,
cent of total output during this time, while
although the impact on total output exhibits a
service exports grew from 35 percent of total
downward trend, it shows increased sensitivity
output in 1975 to 43 percent in 2005 (see fig­
in 2005 relative to 1995.
ure 2). As a result of this forecasted rise in
The relative impact on total service em­
total exports, the recession vector introduced
ployment decreases during each period. Simi­
into the model as a change in export demand
larly, from beginning to end, total service
relative to total output increased in size from
output change, manufacturing employment
change, and manufacturing output change all
1.8 percent in 1975 to 2.2 percent in 2005.
exhibit modest decreases in their respective
This slight increase in the size of the shock
will impact its nominal effect but not the re­
sizes, although in each of these cases the
change is not monotonic over time. Within
sults, because each sector’s share of the total
impact is fixed.
manufacturing, nondurable output seems to be
The results of the four simula­
tions are presented in tables 1 and
2. Table 1 shows the percent
change, due to a shock, in sectoral
output and employment relative to
their respective values from a base
case simulation where there is no
external shock.4 Table 2 shows
each sector’s contribution to total
output and employment change
caused by the shock.5
Recession im p acts

The two tables suggest many
interesting observations. First, in
table 1, for several sectors, the
changes between one column and
the next are not always in the same
direction. This is because of the
nonlinear movements of multipliers
and input/output coefficients re­


4


ECONOMIC PERSPECTIVES

more sensitive to change than
TABLE 1
durable output in each time peri­
Sectoral effect of shock relative to a base case
od. Nonetheless, employment
(percent change)
sensitivity early on was higher for
1975
1985
1995
2005
durable sectors; in the later fore­
casted years, it is higher for non­
-5.21
-5.80
-5.31
CGRPa
-6.33
durables.
E m ploym ent
The impact on total value
-5.37
-4.67
-4.56
Total
-5.09
added for the Chicago economy, as
-3.72
-3.98
-3.11
-3.55
Resource
measured by gross regional prod­
-5.87
-5.96
-5.89
Agriculture
-5.69
uct, exhibits a continuous reduction
Mining
-5.10
-4.70
-4.73
-5.39
overtime. In the 1975 simulated
-3.02
Construction
-3.25
-3.56
-2.59
recession the economy lost 6.3
-5.38
-5.42
Manufacturing
-5.68
-5.61
percent of gross regional product;
-5.59
-5.48
-5.48
Nondurables
-5.36
-5.87
-5.62
-5.30
-5.37
however, when we apply the reces­
Durables
-4.64
Total services
-5.22
-4.98
-4.50
sion impact in other years, that
-5.65
-5.39
-5.13
-5.16
TCUb
level drops continuously to 5.2
-5.64
-5.32
Trade
-5.51
-5.29
percent in 2005, a reduction of
FIREC
-5.59
-4.73
-4.66
-4.76
nearly 18 percent.7 The size and
-4.64
-4.67
-4.14
-4.32
Services
direction of this fall are not so
-5.02
-4.71
Government
-5.50
-4.73
much an indication that Chicago’s
O u tp u t
economy is becoming more interre­
Total
-5.45
-5.29
-4.99
-5.08
lated over time, but more a result
-3.54
-3.71
-3.17
Resource
-2.76
of the increased diversification of
Agriculture
-5.70
-5.96
-5.85
-5.85
exports away from the cyclically
Mining
-5.39
-5.10
-4.70
-4.73
Construction
-3.25
-3.56
-2.59
-3.02
sensitive manufacturing sectors.
Manufacturing
-5.96
-5.96
-5.76
-5.93
Table 2 shows that over time,
-6.09
-6.12
-6.34
Nondurables
-6.31
the contribution of manufacturing
-5.64
-5.42
Durables
-5.88
-5.38
to total output change decreases
-5.29
-5.09
-4.90
-4.92
Total services
quite steadily from almost 47 per­
-5.64
-5.37
-5.09
-5.12
TCUb
cent in 1975 to less than 35 percent
-5.64
-5.29
Trade
-5.51
-5.32
in 2005. Within manufacturing,
-5.47
FIREC
-5.56
-5.63
-6.01
-4.64
-4.37
-4.12
-4.02
nondurables seem to account for
Services
Government
-5.50
-5.13
-4.83
-4.85
more of the change, trading places
with durables after the first time
aChicago gross regional product.
period. Not surprisingly, durable
b
Transportation, communications, and utilities.
output was greater than nondura­
cFinance, insurance, and real estate.
ble prior to the early 1980s. Dur­
ing the 1980s nondurable output
throughout the period. However, the gap
levels began to match those of durables; by the
between nondurables’ and durables’ contribu­
mid-1990s we expect nondurable output to
tions to employment change shrinks, so that
surpass durable output. This large increase of
by 2005 they make relatively equal contribu­
nondurable output within the Chicago area
tions to total employment change. This is
results from strong nominal growth in its three
largely due to the fall of durables’ share of
largest sectors: food and kindred products,
total manufacturing employment relative to
petroleum and coal products, and chemicals
that of nondurables. This switch is forecasted
and allied products. Additionally, the rubber
and plastic products sector, although only the
to continue so that eventually, nondurable
industries will constitute a majority of manu­
fifth largest nondurable manufacturing sector,
facturing employment (see figure 3). The
exhibits the most dramatic growth in percent­
gap between durable and nondurable shares
age terms.
of manufacturing employment is shrinking
Despite the increased contribution of the
despite the larger productivity gains within
nondurable sectors to output change, their
nondurable industries, specifically in the
contribution to employment change diminishes


FEDERAL RESERVE


BANK OF CHICAGO

5

TABLE 2

Sectoral share of total change
(percentages)
1975

1985

1995

3.94
1.00
0.17
2.76
29.20
9.95
19.25
66.87
7.12
22.92
10.98
24.71
1.14

4.62
1.12
0.14
3.36
22.13
8.84
13.30
73.24
6.33
22.40
9.85
33.47
1.19

5.02
1.41
0.13
3.49
16.20
7.42
8.77
78.79
6.60
20.09
9.69
41.16
1.25

4.74
0.28
0.68
3.78
46.90
19.15
27.75
48.37
9.09
12.81
11.30
14.11
1.06

5.43
0.32
0.30
4.81
39.02
19.90
19.12
55.55
9.00
13.61
16.17
15.73
1.04

4.95
0.38
0.18
4.39
37.63
20.49
17.14
57.41
9.40
13.85
15.40
17.71
1.05

E m ploym e nt

Resource
Agriculture
Mining
Construction
Manufacturing
Nondurables
Durables
Total services
TCUa
Trade
FIREb
Services
Government
O u tp u t

Resource
Agriculture
Mining
Construction
Manufacturing
Nondurables
Durables
Total services
TCUa
Trade
FIREb
Services
Government

transportation, communications, and utilities.
bFinance, insurance, and real estate.

petroleum and coal products and rubber and
plastic products sectors. At the aggregate
level, manufacturing’s contribution to total
employment change falls from 29 percent in
1975 to 13 percent in 2005 (table 2), undoubt­
edly a result of manufacturing’s declining
share of total employment (see figure 4).
As the Chicago region’s exports are
shocked by national economic movements, the
transmission of the impact from the nation to
the region involves simultaneous changes of
both output and employment. Such effects can
easily be analyzed with the elasticity of relative
productivities:
( x ] - x b)
.
^ N .(xs- x b
)

(xs - x b
.
)

,(ns- n b)

(ns -_ i'
.
)
' i_ n b

)
'(ns- n br
i

'ZN .(Xs- x h/i'
i=l' )


6


- nb
)

where x. and /? are respectively
the output and employment of
sector i. The variable £ is the
ratio of sector Vs share of total
2005
output change divided by its
share of total employment
change. If £ > 1, which indi­
5.37
cates transmission reduction,
1.58
then a change in output of sector
0.13
3.67
i will translate to a relatively
13.04
smaller change in employment;
6.43
the transmission mechanism will
6.61
dampen the impact of an output
81.59
shock on employment. Con­
6.68
17.41
versely, if £ < 1, which is a
8.47
transmission magnification, then
47.64
a change in output of sector i
1.38
will translate to a relatively
larger change in employment;
4.84
that is, the transmission mecha­
0.40
nism will amplify the impact of
0.11
an output shock on employment.
4.33
34.59
Table 3 contains the elasticities
20.48
of relative productivities for all
14.11
the sectors through time.
60.57
For total services, the elastic­
10.25
ity of relative productivities rises
14.56
15.39
from 0.72 to 0.74; for manufac­
19.25
turing £ grows from 1.61 to 2.65.
1.12
Thus while manufacturing is
becoming less sensitive to output
changes, so are services; in that
sector, employment is becoming
less sensitive to changes in out­
put, although it still exhibits transmission mag­
nification. Since manufacturing is cyclical, the
reduced sensitivity of manufacturing employ­
ment to output means that the Chicago economy
will be less sensitive to cyclical changes. Fur­
thermore, although the services sector is less
cyclical, its reduced employment-to-output
sensitivity will further reduce Chicago’s overall
vulnerability to cyclical fluctuations. This
transformation is largely due to the significant
productivity advances in manufacturing, which
have yielded such large gains that the econo­
my’s total productivity is growing faster than
that of services.
Similar analysis can be made of changes
within manufacturing. Both the durable and
nondurable sectors show significant productiv­
ity growth, but that of nondurables is 30 per­
cent to 50 percent higher, accounting for large

ECONOMIC PERSPECTIVES

FIGURE 3

Total manufacturing employment
percent

Note: Dashed lines indicate forecasts.
Source: U.S. Department of Commerce (1995) and authors' calculations,
simulation using CREIM.

competitiveness of Chicago firms
have set the economy in a much
stronger position. Within manu­
facturing, significant productivi­
ty advances seem to account for
most of the decreased sensitivity
to the economic downturns of the
early 1990s. This trend is ex­
pected to continue into the near
future, with nondurables eventu­
ally dominating both manufac­
turing output and employment.
In total, the service transmission
magnification should be strongly
outweighed by the transmission
reduction of the manufacturing
industries, thus reducing Chica­
go’s vulnerability to exogenous
macroeconomic shocks.
Interregional linkages

As older inefficient manufacturing estab­
lishments have been either closed or re-tooled,
firms have lost the deep roots that formerly
held them to the relatively centralized industri­
al areas of Chicago. Thanks to advances in
computers and communications, service indus­
tries no longer need to remain in the central
business district. The allure of lower taxes and
the opportunity to reduce other overhead costs
has led many firms to relocate to suburban
areas in order to cut costs and increase compet­
itiveness. As firms move, people move. In
1990, 62 percent of the six-coun­
ty region’s total population lived
FIGURE 4
outside Chicago proper; in 1970
Manufacturing share of total employment
the number was 52 percent. Dur­
ing this time, the city’s total
percent
population fell by almost
590.000 while its suburbs gained
875.000 people. As the popula­
tion and work force of Chicago’s
six-county region have grown
and spread out, a large portion of
economic activity has moved
into the suburbs and surrounding
regions. This occurred as geo­
graphic consumer spending
zones were pushed across region­
al boundaries. Accompanying
this has come an increase in the
number of people who work
Note: Dashed lines indicate forecasts.
Source: U.S. Department of Commerce (1995) and authors’ calculations,
within the Chicago region but do
simulation using CREIM.
not live within its borders.

output gains despite the continued reduction
in overall employment. The overall effect
becomes obvious in e/. For nondurables, eI
grows from 1.93 to 3.19, while for durables it
increases from 1.44 to 2.14. Thus while Chi­
cago will become less sensitive to exogenous
manufacturing shocks, durable employment
will still remain more susceptible to output
variations than will nondurable employment.
Thus, it appears that the thinning out of
underperforming manufacturing firms in the
1970s and 1980s and the overall increased


FEDERAL RESERVE


BANK OF CHICAGO

7

TABLE 3

Elasticity of relative productivities
1975
Resource
A g ricultu re
M ining
C onstruction
M anufacturing
N ondurables
Durables
Total services
TCUa
Trade
FIREb
Services
G overnm ent

1985

1995

1.203
0.275
3.931
1.368
1.606
1.925
1.442
0.723
1.277
0.559
1.029
0.571
0.933

1.175
0.289
2.177

0.988
0.273
1.462
1.260
2.323
2.760
1.953
0.729
1.425
0.689
1.590
0.430
0.843

1.430
1.763
2.252
1.438
0.758
1.420
0.608
1.641
0.470
0.877

“Transportation, communications, and utilities.
b
Finance, insurance, and real estate.

Between 1980 and 1993 the number of
people who held jobs within the six-county
area but who lived outside the area increased
by approximately 32,000. We estimate that by
2010 this figure will increase by an additional
30,000. This means that the regions surround­
ing Chicago, including northern Indiana and
southern Wisconsin, are becoming more de­
pendent on Chicago for their own economic
growth as people earn money in Chicago but
spend most of it in their home communities.
Such a development affects the Chicago econo­
my in several ways. Our estimates suggest that
between 1969 and 1992, those people who
lived outside the Chicago area but held jobs
within it had average annual wages and salaries
of approximately $2 billion (in 1982 real dol­
lars), most of which would be spent outside
Chicago. This has obvious tax consequences
for the six-county region’s local governments,
especially when multiplier effects are consid­
ered. Additionally, the growing number of
nonresident employed raises the pressure on
Chicago firms to increase their relative com­
petitiveness as they are forced to compete for
quality labor. As a result, local issues such as
taxes or transportation will have magnified
impacts on the region as a whole.
The links between Chicago, these commu­
nities, and other parts of the country have
increased in another way as well. As men­
tioned, both exports from and imports into
Chicago, as a percent of total output, have


8


increased. Thus Chicago has
become more reliant on those
regions to purchase its goods,
2005
while those regions rely on Chi­
cago’s products to produce their
0.900
own goods, a portion of which
0.251
will then be purchased in Chica­
0.901
go. For example, a survey of
1.178
fabricated metals establishments
2.653
revealed that in 1992, 23 percent
3.186
of intermediate goods purchases
2.135
0.742
came from other midwestern
1.535
states, and 21.7 percent of sales
0.837
were made to the same region. A
1.816
further 28 percent of sales were
0.404
made to the rest of the United
0.807
States.8 This two-pronged
strengthening of interregional
linkages becomes important
because Chicago’s economic
transformation has fundamental­
ly changed the way the city reacts to economic
stimuli, and this change will now affect other
communities much more than ever before.
Conclusions

Chicago’s economy is not glamorous.
It is not dominated by high-tech businesses or
manufacturing behemoths. Its recent eco­
nomic performance has not been spectacular;
economic growth in the 1980s lagged that of
the United States, although Chicago did see
less of a downturn in the early 1990s. But
during the past 20 years Chicago’s economy
has exhibited significant structural change,
the implications of which are now beginning
to surface. These structural changes appear to
have yielded benefits for both Chicago and
the Midwest.
We have shown that Chicago has been
transformed into an economy highly depen­
dent on the service sector for its growth and
vitality. Service exports have grown relative
to service output as well as to total output.
This relative movement away from manufac­
turing exports helps reduce exposure to man­
ufacturing fluctuations on the macro level,
thus cushioning Chicago from some macro
shocks. But the overall increase of exports as
a percentage of total output means that Chica­
go is now potentially more dependent on the
rest of the Midwest and nation to provide a
demand base for locally produced goods.
This implies an increased exposure to macro

ECONOMIC PERSPECTIVES

fluctuations. But within manufacturing, pro­
ductivity increases have been dramatic, re­
sults of a newly updated capital stock and a
possible shift of intermediate purchases from
other firms within the region to more compet­
itive lower-cost providers outside Chicago.
This effect has strengthened manufacturing’s
transmission reduction effect, the decreased
sensitivity of employment to changes in out­
put, thus decreasing Chicago’s exposure to
the highly cyclical manufacturing sectors.
The economic connections between Chica­
go, the Midwest, and other regions have been
intensifying, with local firms increasingly
relying on external markets to supply interme­
diate goods and to purchase final goods and
services. Other changes have come about on
the consumer side. As population has grown in

the suburbs and other outlying areas dispropor­
tionately to Chicago’s central business district,
more people living outside Chicago have come
to depend on Chicago to supply their jobs.
This implies that neighboring regions now
depend more heavily on Chicago to supply the
funds for consumer demand.
In sum, these findings suggest that Chica­
go’s economy is becoming less sensitive to
exogenous shocks. The combined health of
services and manufacturing seems to be the
largest contributing factor, even though inter­
regional linkages are now obviously much
more important than they once were. This
should indicate that although Chicago’s econo­
my seems strong, the economic health of other
midwestern economies now becomes much
more significant to our own.

NOTES
'We define the Chicago region as the six-county metro­
politan area containing Cook, DuPage, Kane, Lake,
McHenry, and Will counties.

(xs - x 1
.
’)
’Sector f s share of total output change is c ' = ------------'■--' yv /«..«_ rb
\
The impact is similar on employment, n.
^i=i' < -V
fiSee Schindler et al. (1994) for a complete discussion.

2CRE1M, defined in real 1982 dollars, forecasts output,
employment, and income for 36 roughly two-digit SIC
sectors, as well as many other final demand and demo­
graphic variables up to 25 years into the future.
’See Israilevich et al. (1994) and Schindler et al. (1994)
for further details.
JLet x denote output, b denote the base case, and s denote
the shocked case. Then the impact of the shock on
output in percentage terms for sector i, i = 1... N, is
(xs~ x 1
. ;)
m '= ----- -— . The impact is similar on employment, n.

’Although we present results for only four years, the
general results do not change if we examine the data on an
annual basis. Annually, though not continuously, the same
downward trend is clear. Additionally, for the sectoral
results, the tabular information is representative of annual
trends.
“See Carter (1994) for further details.

Yh

REFERENCES
Carter, K.L., “The fabricated metals industry in
Chicago,” University of Illinois at UrbanaChampaign, manuscript, 1994.
Israilevich, P.R., and R. Mahidhara, “Chica­
go’s economy: Twenty years of structural
change,” Economic Perspectives, Federal Re­
serve Bank of Chicago, Vol. 14, No. 2, March/
April 1990, pp. 15-23.
___________ , “Hog butchers no longer: 20
years of employment change in metropolitan
Chicago,” Economic Perspectives, Federal Re­
serve Bank of Chicago, Vol. 15, No. 2, March/
April 1991, pp. 2-13.
Israilevich, P.R., G.J.D. Hewings, M. Sonis,
and G.R. Schindler, “Forecasting structural

FEDERAL RESERVE


BANK OF CHICAGO

change with a regional econometric input-output
model,” Regional Economics Applications Labo­
ratory, University of Illinois at Urbana-Champaign, discussion paper no. 94-T-l, 1994.
Schindler, G.R., P.R. Israilevich, and G.J.D.
Hewings, “Three-dimensional analysis of eco­
nomic performance,” Regional Economics Ap­
plications Laboratory, University of Illinois at
Urbana-Champaign, discussion paper no. 94-P6. 1994.
U.S. Department of Commerce, Bureau of
Economic Analysis, Regional Economic Mea­
suring Division, “Regional economic informa­
tion systems report,” CD-ROM, May 1995.

9

Internal organization and economic
performance: The case of large
U.S. commercial banks

W illiam C. Hunter

Organization theorists have
long been aware of the proj ductivity ramifications of
firms’ organizational strucI tures and innovations. Indeed,
some have asserted that if changes in business
procedures and practices were patentable, their
contributions to the economic growth of the
nation would be as widely recognized as the
influence of mechanical inventions. More
recently, economists have come to realize that
questions about the efficiency of production,
marketing, and finance are bound up with
social questions about organizational structure
and change, culture, and management style and
practice. As is well known, the recent deregu­
lation (and re-regulation) of the U.S. commer­
cial banking industry has had a dramatic im­
pact on the way in which banks produce, price,
and manage their financial services—from
consolidation of operations through mergers, to
the more recent unbundling of traditional pack­
aged services, to the phenomenon of loan sales.
What is less well known, particularly among
academic economists studying the industry, is
the dramatic set of parallel changes taking
place in banks’ internal decisionmaking and
organizational structures. Changes in these
areas will likely have a significant impact on
how efficiently banks produce their financial
services, how effectively they interact with
their customers, and how successfully they
compete in their product markets.
If the tenets of organizational economics
that relate elements of internal organizational
structure to the productive efficiency of firms

10


are robust across industries, then managerial
and public policy prescriptions drawn from
empirical studies of bank production and cost
functions that take account of these influences
should be better informed than those that ig­
nore them. Such knowledge takes on added
importance given the current debate over
whether universal banking as practiced in
many European countries is the most appropri­
ate organizational structure for insuring the
long-term competitiveness of U.S. banks.
This article reports empirical evidence on
the impact of management decisionmaking
characteristics on the productive efficiency of
banks. Specifically, I examine the impact on
bank costs of centralized versus decentralized
decisionmaking, product delivery systems, and
back-office operations. The analysis is based
on data from a sample of 118 large U.S. com­
mercial banks. The results show, first, that
centralized decisionmaking tended to increase
costs. Second, centralized product delivery
systems either increased or had an insignificant
impact on costs. In no case did centralized
product and service delivery systems reduce
costs as envisioned by proponents of central­
ization. Third, centralized back-office opera­
tions significantly reduced costs. This latter
result is consistent with the existence of scale
economies in back-office operations.
W illiam C. Hunter is senior vice president and
director of research at the Federal Reserve Bank
of Chicago. The author owes an enorm ous debt
to Stephen T im m e and thanks John Curran, Trey
H o lling sw orth, Lynn W oosley, and Carolyn Keyser fo r excellent research assistance. A ny re­
m aining errors are the a u thor's responsibility.

ECONOMIC PERSPECTIVES

Organizational stru c tu re and firm
performance

Organizational economics concerns itself
with the study of organizations and organiza­
tional phenomena using concepts taken from
contemporary organizational theory, organiza­
tional behavior, and microeconomics.1 The
fundamental factor distinguishing organiza­
tional economics from traditional microeco­
nomic analysis of the firm is that the former
views the firm as an organization that com­
petes with the market as a mechanism for allo­
cating resources, as opposed to an abstract
entity characterized by a production function
and an objective of profit maximization. Un­
der this view, firms and markets represent
alternative mechanisms for providing the coor­
dination, control, and monitoring required for
the efficient allocation of resources. For a
given organizational form to survive in the
long term, it must provide higher net returns
than alternative institutional arrangements.
Among internal organizational structures,
the ones tending to predominate over time are
those that tend to minimize transaction costs.
According to Alfred Chandler (1977) and Oliver
Williamson (1967, 1975), the optimal structure
from this point of view is the multidivisional
form (M-form) as opposed to the older and more
traditional unitary form (U-form).2
The U-form is a centralized multifunction­
al organizational structure in which the major
active units are functional divisions. That is,
there is specialization by function such as pro­
duction, sales, finance, and research and devel­
opment, with decisionmaking responsibilities
located at the top levels of the organization.
The U-form favors the realization of econo­
mies of scale and the internal specialization of
labor, but as the firm expands this form creates
the following set of problems:
1) bounded rationality—managers cannot act
optimally because they cannot process
large volumes of information;
2) opportunism—the tendency for managers
and employees to engage in behavior bene­
fiting themselves as opposed to stockhold­
ers; and
3) subgoal pursuit—placing short-term non­
profit-maximizing goals ahead of long-term
value-maximizing goals.


FEDERAL
http://fraser.stlouisfed.org/ RESERVE
Federal Reserve Bank of St. Louis

BANK OF CHICAGO

These problems make it difficult for the
firm to achieve global profit maximization.
Compared with decentralized structures, the Uform favors a less efficient pyramidal and
bureaucratic hierarchy within which capital,
labor, and information are allocated. In con­
trast, the M-form substitutes quasi-autonomous
operating divisions for the functional divisions
of the U-form. These operating divisions are
organized mainly along product, brand, mar­
ket, or geographic lines. Each of the divisions
may subsequently be divided along functional
lines to ensure its autonomy or independence
from heavy-handed decisionmaking within
higher levels of the organization. Under the
M-form, strategic decisionmaking occurs in the
general or head office, while operating deci­
sions are assigned to the divisions. This struc­
ture thus affords the divisions a large degree of
autonomy, allowing them to take their own
risks in much the same way that an indepen­
dent firm would. Each division constitutes a
quasi-firm (profit center) managed to achieve a
specific objective.
The M-form combines the best features of
centralization (such as realization of economies
of scale) and decentralization (such as provid­
ing proper incentives for profit maximization).
As such, it creates a superior organizational
structure compared to the U-form and the ex­
ternal market. Williamson's hypothesis essen­
tially states that the M-form organizational
structure favors goal pursuit and least-cost
behavior that is more closely associated with
the neoclassical profit maximization hypothesis
than does the U-form.
Not surprisingly, Williamson’s hypothesis
has been subjected to numerous empirical tests.
Studies by Armour and Teece (1978), Burton
(1988), Cable and Dirrheimer (1983), Cable
and Hirohiko (1985), Norton and Pittman
(1988), Steer and Cable (1978), Riordan and
Williamson (1985), Roberts and Viscione
(1981), Teece (1981), and Thompson (1981)
are only a few of those providing empirical
support. The results favoring the M-form as
the least-cost organizational structure have
generally proved robust not only across indus­
tries, but across countries as well.3 However,
with the exception of the article by Roberts and
Viscione, which examines captive finance
companies, all of the above studies examined
nonfinancial firms. The following sections

11

lay out a test of aspects of the hypothesis
among large U.S. commercial banks.
The internal stru c tu re of
large U .S . banks

Prior to the early 1970s, large banks oper­
ated predominantly with U-form organizational
structures. Functional units at the top reported
directly to the chief executive officer, whose
responsibilities included reconciling functional
subgoals and determining strategic directions.
Since the U-form performs best in a stable and
predictable environment, it is understandable
that the U-form was dominant among large
banks during this period when the economic
and regulatory environments were stable and
predictable.
Since the 1970s, changes in these econom­
ic and regulatory environments have eroded
many of the advantages of the U-form. As a
consequence, large U.S. commercial banks
have to some extent paralleled the transition
from U-form to M-form observed in nonfinancial firms during earlier years.4 The natural
response to the increased competition from
nonbank firms and the geographic and product
deregulation occurring during this period was
for banks to develop explicit marketing func­
tions, thus moving toward the market-oriented
structure observed in most large banks today.
This market-oriented structure is similar in
many respects to the M-form of organization.
The principal characteristic of the marketoriented structure is the elevation of customerand market-based departments to top organiza­
tional levels. Departments are organized
around groups of customers rather than around
banking functions; all products and functions
necessary to serve a particular group of cus­
tomers tend to be housed in one department.
Examples of such departments include corpo­
rate or commercial banking, retail and private
banking, and real estate banking. All of these
departments report to the chief executive offic­
er. The strategy of the market-oriented bank is
essentially to be in the right markets with the
right products at the right time.
Compared with the U-form, the marketoriented structure is less centralized, less spe­
cialized, and somewhat less formalized.5 Con­
flicts are resolved according to the objectives
of the bank instead of those of the individual
functions, and managers have profit responsi­
bilities. Thus, difficulties in coordination and


12


control are corrected by means of a more effec­
tive incentive system and by the elimination of
competition between functional units. These
characteristics make decisionmaking in the
market-oriented structure more decentralized
than it is in the U-form.
As banks shifted to market-oriented struc­
tures during the 1980s, they switched from
decentralized to more centralized delivery
systems. In the centralized delivery system, an
agent (i.e., account representative) handles all
of the needs of the customer with respect to
product and service delivery. That is, the ac­
count representative acts as an intermediary
between the customer and members of the
bank’s functional areas producing such servic­
es as lending, cash management, and trust,
among others. Conversely, in a decentralized
delivery system, employees from each func­
tional area call on and service the customer
directly.
The switch to centralized delivery systems
was motivated by several factors. First, under
decentralized systems, banks often did not
know overall customer profitability since there
was generally limited communication and
coordination between functional areas. Sec­
ond, it was believed that the switch to a cen­
tralized delivery system would increase cus­
tomer perceptions of service quality, since in
centralized delivery systems service problems
are handled by one individual as opposed to
several functional-area specialists. Finally,
centralized delivery systems were thought to be
a more cost-effective way to service customers.
As noted earlier, the market-oriented
structure described above is similar in many
respects to the multidivisional M-form. Both
of them separate strategic decisionmaking from
the decisionmaking of operating divisions
(i.e., decentralization), and both have internal
controls and incentives that eliminate the prob­
lems of opportunism, loss of control, and
bounded rationality that characterize the Uform.6 Thus, the recent transformation in the
banking industry parallels that which occurred
earlier in other industries.
The data

The data on internal organizational struc­
ture used in the analysis were obtained from a
survey and follow-up telephone interviews
conducted by the Federal Reserve Bank of

ECONOMIC PERSPECTIVES

Atlanta with the chief operations
T A B LE 1
officers of the 145 largest U.S.
Structure of 118 sample commercial banks
commercial bank holding compa­
A . Decisionmaking
nies for the period October 1990
through July 1991, as listed on the
N um ber of banks
Percent of to ta l
BANK COMPUSTAT tape. Of the
145 banks surveyed, complete data
50.85
60
Centralized
were collected for 118 banks, ap­
58
49.15
Decentralized
proximately an 81 percent response
rate. The remaining 27 companies
B. Delivery systems
either provided incomplete organi­
Percent of to ta l
Num ber of banks
zational data or were in the process
of changing their internal organiza­
64.41
73
Centralized
tional structure.
35.59
45
Decentralized
For each bank in the sample,
information was obtained on 1)
C. Operations
whether the bank(s) within the
Percent of to ta l
N um ber of banks
holding company operated with
internal structures organized
86.44
102
Centralized
around customer or market groups
16
13.56
Decentralized
versus functional areas; 2) whether
decisions regarding credit adminis­
tration and the pricing of fee-based services
PUSTAT tapes. Financial data on each sample
were centralized at the level of the holding
bank for fiscal years 1989 through 1991 were
company or at the lead bank headquarters;
collected. The average sample bank had ap­
3) whether the delivery of services to customer
proximately $16.0 billion in total assets and
or market groups was centralized within a
$1.6 billion in total costs (total non-interest
single customer contact unit and provided by
costs plus allocated interest expense).
account representatives, or provided on a de­
To facilitate the analysis, I grouped all of
centralized basis by all units producing the
the sample banks into seven categories accord­
services; and 4) whether back-office operations
ing to their organizational characteristics (see
(accounting, computer facilities, advertising,
table 2). Table 3 presents selected summary
etc.) were centralized or decentralized.
statistics for the sample. Note that there were
The survey revealed that all respondents
no banks with organizational form C, and only
were organized around either customers or
one with organizational form D. Data from the
markets. Hence, all sample companies exhibit­
latter bank were used in the estimation of the
ed some characteristics of the M-form organi­
cost function but not in the hypothesis tests.
zational structure. Table 1 summarizes other
results of the survey. As panel A shows, deci­
T A B LE 2
sions regarding credit administration and the
Bank organizational forms
pricing of fee-based services were centralized
in approximately 51 percent of the banks. That
D ecision­
Delivery
is, these decisions were made at the holding
Form
m aking
system s
O perations
company or lead bank headquarters level, not
A
c
c
c
at the division or non-lead-bank level. Central­
B
c
d
c
ized product and service delivery systems were
d
c
C
c
employed at 64 percent of the banks (panel B).
D
d
d
c
Back-office operations were centralized at 86
c
c
E
d
percent (panel C). This finding is consistent
d
d
c
F
with the notion that such centralization yields
c
d
d
G
significant scale economies.
Note: c = centralized; d = decentralized.
Other data needed to conduct the empirical
analysis were taken from the BANK COM­


FEDERAL RESERVE


BANK OF CHICAGO

13

Th e econometric model

where

To examine the impact of internal organi­
zational structure on bank cost and productive
efficiency, I used the following cost function:

where TC is the bank’s total cost of production,
Q is a vector of the products or services pro­
duced, P is a vector of input prices, and ORG
is a vector of inputs that describe the bank’s
organizational structure.
Three binary organizational variables—
DEC, DEL, and OPER (the elements in ORG
in equation 1)—were constructed for each
sample firm. The variable DEC was assigned a
value of 1 if a bank used centralized decision­
making regarding credit administration and the
pricing of fee-based services, zero if these
decisions were decentralized. The variable
DEL was assigned a value of 1 if the delivery
system within a customer or market group was
centralized and provided through an intermedi­
ary agent, zero if it was decentralized and pro­
vided by agents from functional areas. Finally,
the variable OPER was assigned a value of 1 if
back-office operations were centralized, zero if
decentralized.
To estimate the cost function in equation
1, the following second-order translog approxi­
mation to a multiproduct bank cost function
was applied:
(2) InTC = a 0 + I m a m InP + 1/21m I n a m.n InP InP
m
m
n
+ Z,P,lnQ, + \l2Zl.fi.JnQtlnQk
+ I j I m T j.m ip
'*“
'7

InQlnP+ d,,.,DEC
D EC

m

+
+ \ S DKJnPDEC + SoaDEL
+ Zj Sm InO DEL
DEL.J
+ I m SnF m InPm DEL
I
DEL,
+ S ^O P E R + Z S ^ ln Q O P E R
+ ^■APmJnPOPER
+ ^P E C -D E L
+ ^ c.oKSDEC‘OPER
+ S ^ fiE L -O P E R +
for m, n = L, K,
and j, k = C&I, Consumer, R/E, and Other,


14


= total costs (non-interest costs
plus interest expense allocated
to loans),

ecll

(1) TC = i(Q,P,ORG),

TC

= dollar volume of commercial
and industrial loans,

^ C o n su m e r

= dollar volume of consumer
loans,

^ R/E

= dollar volume of real estate
loans,

()ther

= other bank output,
= price of labor (L)

Labor

PCapital

= price of capital (K)

P,
Interest

= interest rate on deposits (I)

DEC

= decisionmaking dummy vari­
able, which equals l if central­
ized and zero otherwise.

DEL

= system of service delivery
dummy variable, which equals
l if centralized and zero other­
wise,

OPER

= back-office operations dummy
variable, which equals l if
centralized and zero otherwise,
and

£

= an error term.

In estimating the model in equation 2 ,1
imposed the usual symmetry (a = a and
Pjk = Pk) an<^ adding-up and homogeneity
conditions ( I m a = 1 and Irn '0 = X am,n =
x
m
j,m
n
I S
=I 8
=X 8
= 0).
D e fin itio n o f outp uts

All bank cost studies encounter the diffi­
culties associated with the definition of output,
the appropriate level of aggregation of output,
and costs. It is beyond the scope of this article
to resolve whether various categories of depos­
its should be treated as outputs or inputs.7 For
this study, I treated the dollar volume of all
deposits as an input. In addition, using a proxy
variable, I treated clearing balances and other
deposit-related activities as outputs.
Regarding the specific definition of the
outputs in equation 2 ,1 used the criterion of
value added employed by Berger, Hanweck,
and Humphrey (1987) to determine the compo-

ECONOMIC PERSPECTIVES

T A B LE 3

Summary statistics for 118 sample banks
A. 60 banks with centralized decisionmaking
O rganizational
fo rm

N um ber
of banks

Total
assets

Total
costs

(-— billion dollars-— )
A
B

35

$11.59

24

10.49

C

0

D

1

n.a.a
45.60

$0.96
0.80

n.a.a
3.06

Input prices

B. 73 banks with centralized delivery systems
O rganizational
fo rm

N um ber
of banks

Total
assets

Total
costs

(— billion dollars-— )
A

35

C

0

E
F

26

21.91

2.22

12

24.30

2.01

$11.59

n.a.3

$0.96

n.a.a

C. 102 banks with centralized operations
O rganizational
form

N um ber
o f banks

T otal
assets

Total
costs

(-— billion dollars-— )
A
B
E

35

$11.59

24

10.49

26

21.91

G

17

18.45

a Not applicable.

sition of the various output categories. Whole­
sale loans (<2Citl) were defined as the dollar
volume of all commercial and industrial and
security loans. Consumer loans (Qr.
) were
defined as the dollar volume of credit cards
and other personal loans excluding loans se­
cured by residential real estate. Real estate
loans ((2r/h) were defined as all loans secured
by real estate. Other bank output (Q0ther) was
included in an attempt to capture off-balancesheet activities such as loan sales, letters of
credit, securitization, and swaps—activities
that are becoming increasingly important at
U.S. commercial banks. The proxy Q
was
set equal to annual non-interest income includ­
ing service charges received on transaction and
nontransaction deposit accounts. Finally, secu­
rities were excluded from the definition of
output, since in markets exhibiting low infor­
mation costs, banks add only negligible if any
value to these assets. The choice of these four


FEDERAL RESERVE


BANK OF CHICAGO

output measures was tempered by
the objective of examining multi­
product cost attributes within an
econometrically tractable model
of the banking firm. Hence, it
was a maintained hypothesis that
for a given output category, a
single cost function adequately
characterized the production of
each of the activities aggregated
within that category.

$0.96

The price of labor (P )
was defined as salaries plus bene­
fits divided by number of em­
ployees. The price of capital
(Pn ,) was defined as the ratio
of occupancy and fixed asset
expense to net bank premises.
The interest rate on deposits
(P,
) was calculated as the
interest rate paid on all deposits
divided by the sum of all inter­
est-bearing deposits outstanding.
To ta l costs

Total costs (TC) were defined
as total non-interest costs plus
1.46
allocated interest expense. Inter­
est expenses are included since
data limitations require that the
output metric be defined in terms
of dollars of loans and deposits instead of by
the number of accounts. Allocated interest
equaled the product of the ratio of total loans
to earning assets times total interest expense.
The allocation of interest was necessary be­
cause securities are not specified as outputs,
and many banks incur substantial interest costs
in financing their securities portfolio. The
output/cost specification described above is
consistent with the intermediation approach to
examining bank costs; it is preferable when the
issues being examined concern the economic
viability of banks.
0.80
2.22

Hypotheses regarding
organizational fo rm

The variables DEC, DEL, and OPER were
used to test several hypotheses regarding the
impact of organizational form on costs (effi­
ciency).
The first question was whether organiza­
tional factors help explain bank cost structures.

15

Testing this hypothesis involved determining if
the coefficients associated with the organiza­
tional structure variables in equation 2 were
jointly equal to zero. That is, for each organiza­
tional variable i, (i = DEC, DEL, and OPER):
(3) 8 = 8

=8

= 8 , =0.

The second hypothesis related to the im­
pact of centralization on costs. With the pa­
rameter estimates from equation 2, the hy­
pothesis can be stated as
(4) dlnTC/dORG = 8 + X < InQ + X < InP
5
5
+

ORGh = 0.

This equation measures the percentage increase
in total costs (TC) resulting from centralization
of the ith organizational variable holding out­
puts, prices, and other organizational variables
constant.
For the multiproduct firm, ray scale econo­
mies (RSCE) were measured by
(5) RSCE = 'LdlnTC(Q)/dlnQr
where TC{*) is the cost function, (9 represents
the outputs specified in equation 2, and Q is
the vector of outputs. If RSCE equals 1.0,
production of Q exhibits constant returns to
scale, whereas RSCE less than (greater than)
1.0 indicates increasing (decreasing) returns
to scale.
The third hypothesis concerned the impact
of centralization on scale economies and can
be stated as
(6) dRSCE/dORG‘ = X < . = 0.
5
j

ij

This equation measures the impact of central­
ization of the ith organizational variable on
scale economies holding outputs, prices, and
other organizational variables constant.
Em pirical re su lts and im plications

Full information maximum likelihood
(FIML) was used to jointly estimate the model
in equation 2 with factor input share equations.
Using Shepard’s lemma, the share equations
are given by dlnTC/dlnPm= Sm for m = L, K,
,
and /, where Smis the mth input’s share of total
costs. Since the coefficients in the share equa­
tions are a subset of those in the cost function

16



in equation 2, joint estimation should result in
more efficient estimates. However, since
X;Sm= 1, the capital share is dropped from
the joint estimation to avoid singularity.8
Likelihood ratio tests were conducted to
test the hypothesis given in equation 3 regarding
the significance of the organizational variables
in explaining total costs. The chi-square statis­
tics for DEC, DEL, and OPER were 28.41,
46.42, and 32.54, respectively. All test statistics
were significant at the .01 level. These results
suggest that the organizational variables were
significant in explaining the structure of bank
costs as specified in equation 2.
Impact o f centralization on costs

Table 4 reports the tests of the hypotheses
in equation 4. For each test, the impact of
centralization with respect to a given organiza­
tional variable was evaluated holding constant
quantities, prices, and other organizational
variables. Quantities and prices were set equal
to their geometric means for the overall sam­
ple. In this way, variations in costs were at­
tributed to differences in organizational forms.
For each test, the organizational forms associ­
ated with the null and alternative hypotheses
are given. Because some groups lacked suffi­
cient membership, two out of four tests were
conducted for centralized decisionmaking, two
out of four for centralized delivery systems,
and one out of four for centralized back-office
operations.
D ecisionmaking

The results in table 4, panel A suggest
that a change to centralized decisionmaking
significantly increased costs relative to decen­
tralized decisionmaking. For a bank with cen­
tralized delivery systems and operations, a
change from decentralized to centralized deci­
sionmaking increased costs by 3.68 percent
(significant at the .10 level). For a bank with
decentralized delivery systems and centralized
operations, a change from decentralized to
centralized decisionmaking increased costs by
9.57 percent (significant at the .01 level). In
no case did a switch to centralized decision­
making decrease costs. Both of these findings
appear to be economically significant consider­
ing that the average bank’s costs equal $1.4
billion and assets equal $16 billion. For the
average sample bank, a 3.68 (9.57) percent
increase in total costs would be associated with

ECONOMIC PERSPECTIVES

TABLE 4

Impact of centralization on total costs
A.

Impact on total costs from centralized decisionmaking
Organizational structure underlying null hypothesis
(Organizational structure underlying alternative hypothesis)

Test
number

Centralized
decisionmaking

Centralized
delivery systems

Centralized
operations

Number
of firms

Test
statistic

1

yes
(no)

yes
(yes)

yes
(yes)

35
26

3.68%*
(2.07%)a

2

yes
(no)

no
(no)

yes
(yes)

24
17

9.5 7% ***
(2.64%)a

B.

Impact on total costs from centralized delivery systems
Organizational structure underlying null hypothesis
(Organizational structure underlying alternative hypothesis)

Test
number

Centralized
decisionmaking

Centralized
delivery systems

Centralized
operations

Number
of firms

Test
statistic

3

yes
(yes)

yes
(no)

yes
(yes)

35
24

0.68%
(2.36%)a

4

no
(no)

yes
(no)

yes
(yes)

26
17

6.5 3% ***
(2.27%)a

C.

Impact on total costs from centralized operations
Organizational structure underlying null hypothesis
(Organizational structure underlying alternative hypothesis)

Test
number

Centralized
delivery systems

Centralized
operations

Number
of firms

Test
statistic

5

|

Centralized
decisionmaking
no
(no)

yes
(yes)

yes
(no)

35
24

-3.97% **
(1.85%)a

Standard error.
* * * * * * Significant at the .10, .05, and .01 levels, respectively.

a reduction in return on assets of 21 (55) basis
points, using a marginal tax rate of 34 percent.
Given that the average sample bank's return on
assets averaged approximately 60 basis points
from 1989 to 1991, these effects are of great
economic significance.
Delivery of services
The results in table 4, panel B indicate that
for banks with centralized decisionmaking and
operations, a change from a decentralized to a
centralized service delivery system had no
significant impact on costs. For banks with
decentralized decisionmaking and centralized
operations, centralization of the service deliv­
ery system increased costs by approximately
6.53 percent (significant at the .01 level). In
neither case did the results suggest a reduction


FEDERAL
http://fraser.stlouisfed.org/ RESERVE
Federal Reserve Bank of St. Louis

BANK OF CHICAGO

in costs. This is in contrast to the notion dis­
cussed above that centralizing a service deliv­
ery system will produce cost savings. Howev­
er, these results and those above should be
interpreted with caution, since other motiva­
tions for centralizing (such as improving the
analysis of customer profitability or the quality
of service) may be at work.
Back-office operations
The results in table 4, panel C suggest that
for a bank with decentralized decisionmaking
and centralized service delivery systems, cen­
tralizing back-office operations reduced costs
by approximately 4 percent (significant at the
.05 level). This finding is consistent with pre­
vious research which reports fairly large scale
economies for back-office operations (see

17

Hunter and Timme 1986, for example). Hence,
one would expect banks to centralize backoffice operations in order to capture these scale
economies.
Impact o f centralization on
scale economies

Using the parameter estimates from equa­
tion 2, the estimated scale economies for a
bank with decentralized decisionmaking, deliv­
ery systems, and back-office operations
equalled 0.945 (significant at the .05 level).
This indicates increasing returns to scale, on
average, for this class of bank. This result is
consistent with the findings of Hunter and
Timme (1986) and Hunter, Timme, and Yang
(1990). Those studies examined scale econo­
mies for large U.S. banks but did not include
organizational variables of the type included in
this study.
Table 5 reports tests of the impact of cen­
tralization on scale economies, the hypothesis
given by equation 6. The test statistics for a
bank with centralized decisionmaking, delivery
systems, and operations were -0.0040, 0.0260,
and -0.0023, respectively. None of the test
statistics was significant at standard confidence
levels. These results imply that centralization
did not have a significant impact on scale econ­
omies, although it did have a significant impact
on bank costs. It appears, then, that cost ineffi­
ciencies dominate the effects of scale econo­
mies in explaining variations in bank costs.
Conclusions

This article provides empirical evidence
on the impact of internal organizational struc­
ture on bank costs. Specifically, I examined
the impact of centralized versus decentralized
decisionmaking, product and service delivery
systems, and back-office operations on bank
costs and productive efficiency. The analysis
used average data from a sample of 118 large
U.S. commercial banks for the years 1989
through 1991. The results can be summarized
as follows. First, centralized decisionmaking
tended to increase costs. Second, centralized
service delivery systems either increased or
had an insignificant impact on costs. In no


18


T A B LE 5

Impact of centralization
on scale economies
Test
num ber

O rganizational
stru ctu re

6

Centralized
decisionm aking

7

Centralized
delivery systems

8

Centralized
operations

Test
s ta tis tic
-0.0040
(1.29)
0.0260
(2.27)
-0.0023
(1.41)

Note: Standard errors in parentheses.

case did centralized service delivery systems
reduce costs as envisioned by proponents of
centralization. Third, centralized back-office
operations significantly reduced costs. This
latter result is consistent with the existence of
scale economies in bank back-office opera­
tions such as accounting, computing, and
advertising.
These results provide new insights into the
determinants of bank cost and efficiency char­
acteristics, highlight the importance of organi­
zational variables in financial firm production,
and point to the need to incorporate these vari­
ables into future bank efficiency studies. The
results do not, however, answer numerous
questions as to why a bank would adopt an
organizational form which (according to the
evidence) increases costs. In this regard, sev­
eral further approaches would appear promis­
ing. First, it may be useful to examine the
impact of organizational structure on other
measures of performance (such as profits,
return on assets, or risk-adjusted holding peri­
od returns) and on bank risk. Second, insight
can be obtained from examining the effects of
organizational forms in a dynamic framework.
Since this article examines data covering only
three years, we cannot know if the results char­
acterize banks in a state of transition, where the
full benefits of the selected organizational
forms would not be fully recognized, or banks
operating in steady state.

ECONOMIC PERSPECTIVES

NOTES
'Among the many noted contributors to the field of orga­
nizational economics, I draw heavily on the works of
Beckmann (1960), Chandler (1977), and Williamson
(1967. 1975).
'Williamson actually describes a range of organizational
forms in his 1975 book. These include the corrupted H-,
U-, and M-forms, and variations of these.
'In these studies, firm internal organizational structure is
classified into categories such as the U-form or M-form,
among others. This classification is entered as a regres­
sor in an equation relating some performance character­
istic (profitability, efficiency, etc.) to firm and market
characteristics generally thought to be determinants of
performance.
4The discussion in this section draws heavily on Channon
(1986) and Donnelly and Skinner (1989).
'Certain activities may remain centralized where definite
economies of scale are thought to exist, such as account­
ing or computing. Thus, movement towards less special­
ization among employees, i.e., requiring that they have
knowledge of various functional areas as well as the
needs of the customer, does not necessarily imply that
the organization loses much in the way of productive
efficiency.

h
While the market-oriented structure has essential fea­
tures of the M-form, the two are not exactly equivalent.
This is because the M-form evolved in the manufactur­
ing sector. Perhaps the best way to describe the marketoriented structure is as the financial-sector equivalent of
the M-form.
'Hunter, Timme, and Yang (1990), examining the largest
U.S. commercial banks, provide separate estimates of
bank cost characteristics, treating deposits first as outputs
and then as inputs. Holding product mix constant and
treating deposits as outputs, they observe returns to scale
which are roughly constant for the average sample bank,
generally mild diseconomies of scale for the larger banks
($3 billion to $25 billion in total assets stated in 1986
dollars), and rather large diseconomies for the largest
banks (more than $25 billion in assets) when analyzed on
a subgroup basis. Holding product mix constant and
treating deposits as inputs, they find significantly increas­
ing scale economies for banks up to $5 billion in assets
and constant scale economies for banks with assets be­
tween $5 billion and $10 billion. Banks with assets
between $10 billion and $25 billion are found to exhibit
mild diseconomies, while the largest banks with more
than $25 billion in assets exhibit significantly large dis­
economies of scale.
8Maximum likelihood estimates are invariant to which one
of the share equations is dropped from the joint estimation.

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BANK OF CHICAGO

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