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NONBANK ACTIVITIES OF FIFTH DISTRICT
BANK HOLDING COMPANIES*
Walter A. Varvel

The 1970 amendments to the Bank Holding Company Act, which brought one-bank holding companies under the regulation of the Federal Reserve
System, provided stimulus for the formation of new
bank holding companies, for the acquisition of independent commercial banks by these corporations, and
for the expansion by holding companies into nonbank
activities permitted under Federal regulation,
At
the time of enactment of the amendments, 111 registered bank holding companies controlled 6.6 percent
of insured commercial banks and 16.1 percent of bank
deposits in the United States. By the end of 1978,
2,113 holding companies controlled 27.9 percent of all
domestic banks and 67 percent of bank deposits.1
Liberalization of the criteria for permitting nonbank
activities in 1970 also produced an expansion in bank
holding company investment in nonbank subsidiaries.
It has been estimated that these companies control
nonbank firms with combined assets of $50 to $55
billion, approximately five percent of the total assets
of the commercial banking system [11].
Research on the holding company movement has,
until recently, concentrated on the impact it has had
on bank performance, bank safety and soundness,
and competition in banking markets. Also of interest
is the performance of nonbank subsidiaries and their
effect on the consolidated firm.
Analysis of this
question, unfortunately, has been hampered by data
limitations.
Recently, however, attention has been
devoted to the financial performance
of nonbank
affiliates. After summarizing some of the findings of
this recent research, this article will briefly examine
the economic rationale for bank holding company
diversification.
Finally, it will report on investment
by Fifth District firms in subsidiaries engaged in
nonbanking activities and on the recent relative profit
performances of nonbank affiliates.
* The author would like to acknowledge
the assistance
of the staff of the Board of Governors
of the Federal
Reserve
System
in obtaining
the data used in this
article and the computational
and analytical
assistance
of
Marsha Shuler in completing
it.

Nonbank Activities and Performance
The Board
of Governors of the Federal Reserve System has
authority to allow holding companies to own shares
in any company engaged in activities the Board has
determined to be “so closely related to banking or
managing or controlling banks as to be a proper
incident thereto.”2
In exercising its authority, the
Board has created a list of approved activities.3 To a
large degree, approved activities are limited to those
that national banks are permitted to engage in
directly. The only activities on the list prohibited to
national banks are industrial banking and underwriting credit life, accident, and health insurance. Bank
holding companies, however, have concentrated their
investment in relatively few of these nonbanking
activities. Investment in nonbank lending operations
(finance companies, mortgage banking, leasing and
factoring)
has been particularly
widespread.
In
addition, many companies own subsidiaries engaged
in credit insurance activities and firms that provide
internal services for the holding company and its
affiliates, such as data processing.
A glossary of
nonbank activities engaged in most frequently by
banking organizations accompanies this article.
Several recent studies have evaluated the financial
impact of selected nonbank activities on the parent
corporation.
In general, their findings suggest that
returns to holding companies from these operations
have not matched returns
experienced
by nonaffiliated firms. These conclusions are based upon
comparisons of the performance of nonbank subsidiaries with independent companies in the respective
industries or with industry averages.4 Talley [13],

2 In determining

whether
a particular
activity is a proper
incident to banking, the Board must consider whether its
performance
by an affiliate
of a holding
company
can
reasonably
be expected
to produce benefits to the public,
such as greater
convenience,
increased
competition,
or
gains in efficiency,
that outweigh possible adverse effects,
such as undue concentration
of resources,
decreased
or
conflicts
of interest,
or unsound
unfair
competition,
banking practices.
Bank Holding
Company
Act, Section
4(c)(8).
3 Regulation

1 Annual Statistical
Digest
Governors of the
Federal

2

and internal records,
Reserve
System.
ECONOMIC

Board

of

REVIEW,

4 For a review
NOVEMBER/DECEMBER

Y, Section

225.4(a)

of this literature,
1979

(12 CFR
see [2].

225).

Boczar and Rhoades [1], and Rice [7] examined
the relative performance of affiliated finance companies during 1973-76 and found them less profitable
than independent firms. Finance company subsidiaries experienced an average rate of return on equity
investment of 4.7 percent over the 1974-76 period
while the industry averaged a 9.3 percent yield over
this period. In addition, holding company subsidiaries were found to be more highly leveraged, more
dependent on short-term financing, and more likely to
have a higher cost of funds than their independent
counterparts.
Profitability of finance company affiliates appeared to improve significantly in 1976 and
1977 but it still trailed the industry as a whole [9].
Bank holding company mortgage affiliates were
also found to be less profitable than independent companies and the mortgage industry in general.
The
severity of the 1973-75 recession in the real estate
sector of the economy and its repercussions on mortgage lenders caused mortgage affiliates to suffer
average net losses of 2.4 percent of equity per year
over the 1974-76 period while the industry averaged
losses of only 1.6 percent [9, 13]. Analysis of the
equipment leasing area shows that holding company
subsidiaries outperformed the finance company and
mortgage affiliates of holding companies during 197476, yet they still trailed the leasing industry average.
Leasing subsidiaries averaged an 8.5 percent return
on equity while the industry average was 9.9 percent
[9]. Insurance activities, on the other hand, have
apparently been quite profitable for bank holding
companies. Rice [8] found that affiliates engaged in
insurance underwriting averaged nearly 30 percent
return on equity investment in 1976 and 1977.
In addition to comparing bank holding company
affiliate performance
with independent
companies
within respective industries, Rice [9] analyzed total
industry profit returns for banking and for five of the
leading nonbank activities (consumer finance, sales
finance, mortgage banking, leasing, and life insurance) engaged in by bank holding companies from
1970-76 and found that banking had the highest
return on equity, with an average of 11.1 percent.
The consumer finance industry
realized a 10.1
percent yield, followed by 9.9 percent for equipment
leasing, 9.8 percent for sales finance, 9.3 percent
for life insurance, and 7.7 percent for mortgage
banking.
Nonbank affiliates of holding companies
apparently did not perform as well (relative to
banking) as the industry averages suggest.5
For
5 As Rice points out [9], the relative industry
ances may not accurately
reflect bank holding
performance
since their involvement
in some
activities
is restricted
or altered by Regulation

performcompany
of these
Y.

the years 1976 and 1977, return on equity to parent
holding companies from consolidated investments in
nonbank companies were only slightly greater than
half the average return from their bank subsidiaries
(6.3 percent compared with over 11 percent).
Rice
also categorized affiliates into financing and nonfinancing subsidiaries.6
The returns on equity investment from financing and nonfinancing subsidiaries
were 5.0 percent and 26.6 percent, respectively.
Moreover, the nonbank activities of companies with
less than $500 million in assets were more profitable
than for larger holding companies, apparently because these firms held a larger proportionate investment in nonfinancing activities.
In summary, available empirical evidence concludes
that bank holding company profit performance in
major permissible nonbank activities has not, in
general, matched industry standards.
In addition,
average returns to equity from nonbank operations
have been found to be significantly below returns
from bank affiliates.
What then is the economic
benefit or justification for holding company expansion into nonbank activities?
Economic Rationale
It has been suggested that
if “all parent resources invested in nonbank subsidiaries were instead invested in bank subsidiaries
. . ., the BHC’s aggregate income could have been
increased” substantially.7
If this statement were
true, however, one might infer that bank holding
company managements were (1) incompetent, (2)
not interested
in profit maximization,
(3) prohibited from expanding their bank operations, or
(4) positioning for interstate banking. Each of these
inferences, however, has major weaknesses and
none provides a fully satisfactory explanation of observed behavior.
Since economic theory suggests.
that firms benefit from diversification
if the total
profits of the firm are increased or if the firm’s perceived risk exposure is reduced, further examination
is required.
Increased Profits
Traditional
price theory suggests that the optimal quantity of output of a firm is
determined by its marginal revenue and marginal
cost conditions. A profit-maximizing firm will tend to
6 Financing
affiliates
mortgage
companies,
factors.
Nonfinancing
writers
and agencies,
advisory
companies.

were defined to consist of finance
bankers,
leasing
companies,
and
subsidiaries
were insurance
undermanagement
consulting
firms, and

7 This conclusion
is based on the assumption
subsidiaries
could provide the same (average)
the additional
(marginal)
investments
[9].

FEDERAL RESERVE BANK

OF RICHMOND

that bank
return on

3

invest additional resources in any activity up to the
point where the last resource unit just pays for itself,
i.e., where the marginal revenue derived from that
activity is equal to the marginal cost of production
(MR=MC).
It can be argued, of course, that required reserve
ratios and limitations on the aggregate volume of
bank reserves restrict a bank’s ability to increase
output to the point where marginal revenue equals
marginal cost [14]. The prohibition on the explicit
payment of interest on demand deposits together
with interest rate ceilings on other small deposit
categories virtually guarantees that the interest on
bank loans and investments (marginal revenue) will
exceed the marginal cost of such funds, at least in
today’s high interest rate environment.
In addition,
excess reserves held by member banks must be held
in the form of nonearning assets. Banks, therefore,
are usually eager to invest any excess reserves they
may hold. There is not an unlimited supply of low
cost funds, however. In fact, the trend appears to be
toward a drying up of these sources. To an increasing degree, banks have been forced to rely on funds
purchased at market rates of interest to finance expanded lending and investments.
The marginal
revenue - marginal cost analysis, therefore, does appear to be applicable to the banking firm.
Suppose that a bank produces at its profit-maximizing level and earns an average return on equity of
15 percent.
The last (marginal)
unit of banking
services produced, however, brings in revenue that
just covers its cost so that the marginal yield is zero.
Investment beyond this point will actually reduce
total profits since the cost of producing additional
units will exceed additional revenues (MC > MR).
An expansion-minded
firm may then face a choice
between producing more banking services or offering
other services through a nonbank subsidiary (with,
say, a ten percent marginal return on investment).
Which investment should the firm make? In this example, it is clear the firm should diversify through
Investment in the nonbank
the nonbank subsidiary.
subsidiary increases total profits and the investment
yields a higher average rate of return for the total
firm than does expanding the banking operations. If
the existing investment in banking totaled $1000 and
an additional $100 investment is contemplated with
returns in banking and nonbanking of zero and ten
percent, respectively, then the computations in Table I
show that the marginal investment in the nonbank
activity is the more profitable alternative.
The total
profit ( ) equation is:
4

ECONOMIC

REVIEW,

where Wi is the dollar investment in the ith’activity
and Ri is the activity’s average rate of return on investment.
Table I
Total
Alternative
Banking

Profits

Average

Profits

A

Alone

[(1000
Alternative
Banking &
[(1000 x

x .15)

+

(100

x .O)]

=

150

B
Nonbanking
.15)

+

(100 x

.10)]

=

160

Generalizing, for the investment to favor the nonbank subsidiary, it is only necessary for the return
on the marginal investment in the bank to be less
than for the nonbank activity. The determining factor, therefore, is how much the additional or marginal
investment adds to the profits of the consolidated
firm. Average rates of return on prior investments
can give misleading signals for management investment decisions.8
The decision to engage in nonbank activities might
also be described by a model that represents the company as a multiple-product,
price-discriminating
firm [12]. In this model, the firm maximizes profit
by segmenting markets- credit
markets in the special
case of a banking firm-with
distinguishable demand
characteristics
and setting different prices in each
market in order that the marginal revenues in each
market are equal. This behavior may involve limiting
production in the most profitable product markets
and engaging in some marginally profitable activities.
Reduced Risk Theory also suggests that diversification into nonbank activities may reduce risk by
reducing the variability of the consolidated firm’s
profits. This could result from either of two sources:
(1) product-line diversification, or (2) geographic
diversification.
Diversification of the firm’s product
line may reduce holding company risk if nonbank
profits do not vary directly with bank profits. Correlation coefficients can measure the degree to which
bank profits and nonbank profits move together from
year to year.
Other things equal, the lower the
8 One major domestic
bank failure was apparently
due,
at least in part, to bank management
confusing
the concepts of average and marginal
returns
[10].

NOVEMBER/DECEMBER

1979

degree of correlation between bank and nonbank
profits, the lower will be the variability (standard
deviation) of holding company profits.9
A number of recent studies have reported correlation coefficients between banking profits and returns
in nonbank activities most popular with bank holding
companies [3, 4, 5, 9]. These studies have generally
indicated that nonbank profits were not highly correlated with bank profits and that several were negatively correlated, thus implying potential benefits of
product-line
diversification.10
According to these
studies, therefore, some nonbank activities may actually enhance the stability of the consolidated firm’s
profit stream.
Bank holding company risk may also be reduced
through a greater geographic diversification attainable via nonbank affiliates.
As noted earlier, most
permissible activities can be engaged in directly by
commercial banks.
Bank operations, however, are
limited geographically by state and Federal branching statutes. A nonbank affiliate is not so restricted
and is free to expand its geographic base subject to
regulatory approval.
To the extent geographic diversification insulates company profits from localized
economic conditions and contributes to profit stability, firm risk may be reduced. Little evidence is
presently available on the contribution
(if any) of
geographic diversification to reducing risk, however.
Fifth District Performance
Thirty-seven
Fifth
District bank holding companies with total assets of
$45 billion reported $2.2 billion of nonbank assets as
of year-end 1977.11 This figure, representing five
9 The standard
will be:

deviation

(s) of holding

company

profits

percent of total assets, understates the importance of
nonbank operations to some individual firms, however. The nonbank proportion of assets ranged up to
12.6 percent for one of the larger holding companies
in the District. On the other hand, four smaller companies held no nonbank assets at all. Size apparently
had little to do with participation in nonbank activities, however. Nineteen holding companies, ranging
in size from $1.0 billion to over $4.5 billion in assets,
held virtually the same proportion of total assets in
nonbank firms as did the smaller firms. Nine of the
firms held more than six percent of total assets in
nonbank subsidiaries while only two held nonbank
assets that represented more than ten percent of consolidated assets. In terms of capital investment, nonbank operations account for a more substantial share
of bank holding company activities. Nonbank equity
investment represented 8.4 percent of the firms’ total
equity capital.
Table II shows the number of holding companies
owning subsidiaries involved in nonbank activities
along with the proportions of consolidated assets and
total nonbank assets accounted for by each activity.
More Fifth District bank holding companies are active in mortgage banking than in any other nonbank
activity. Twenty-five companies own mortgage subsidiaries holding 1.45 percent of total company assets
and nearly thirty percent of total nonbank assets.
Consumer finance, leasing, and factoring companies

from the analysis since state law has prohibited
holding
company
expansion
in the state.
These are primarily
industrial
firms that acquired
small banking
operations
and therefore,
differ significantly
from other
holding
companies within the District.
All nonbank financial data
were derived
from
Bank
Holding
Company
Annual
Reports filed with the Federal Reserve System.

Table

where wi is the proportion of capital invested in the ith activity,
is the standard deviation of profits in the ith activity, and ci, is
the correlation between profits in the ith and jth activities. Since
bank activities constitute the predominant investment of BHCs
(i.e., they have the largest w1), the correlation between banking
and other activities will dominate the right hand portion of the
above equation.

NONBANK

II

ACTIVITY OF FIFTH DISTRICT BHCs
Number of
BHCs Active

Percent of Total
BHC Assets in
Activity

Percent of
Nonbank Assets
in Activity

11 These BHCs were located in the District of Columbia,
Maryland,
North Carolina, South Carolina, and Virginia.
A total of 55 bank holding companies
controlling
nearly
$55 billion in total assets
are registered
in the Fifth
Federal
Reserve
District.
Some of these, however,
are
themselves
subsidiaries
of holding
companies.
Their
inclusion in the analysis, therefore,
would result in double
counting
of assets.
A few small “grandfathered”
West
Virginia
bank holding
companies
were also excluded
FEDERAL RESERVE BANK

37

Bank Subsidiaries

37

Mortgage

Banking

25

1.45

29.7

Consumer

Finance

16

.88

18.0

Sales Finance

10 Mortgage
banking showed the highest correlation
with
banking while life insurance
and equipment
leasing were
negatively
correlated
and consumer
finance was uncorrelated [9].

BHCs

5

.27

5.5

Commercial

5

.27

5.5

21

.53

10.9

Finance

Leasing

100
95.1

Factoring

4

.60

12.3

Insurance

19

.18

3.7

Data

16

.10

2.1

.60

12.3

Processing

Other

OF RICHMOND

5

also accounted for significant shares of total nonbank
assets, although each Activity represented less than
one percent of total bank holding company assets. A
number of companies also own active subsidiaries
engaged in consumer finance, leasing, insurance, and
data processing-although
the latter two activities do
not represent a substantial share of nonbank assets.
The dominance of subsidiaries engaged in extending
credit is demonstrated by the aggregate 81.9 percent
proportion of total nonbank assets held by mortgage,
finance company, leasing, and factoring subsidiaries.
Analysis of the profitability of bank holding company subsidiaries in the Fifth District supports the
conclusions of previous studies. Compared with bank
affiliates, the financing subsidiaries reported lower
rates of return on equity investment while nonfinancing affiliates reported higher rates of return. Table
III shows the average returns on assets and equity
capital, as well as the equity to assets ratios for each
activity over the 1975-78 period. The non-weighted
average return on equity of financing affiliates was
6.46 percent over the entire period compared with
slightly over twelve percent for the bank affiliates of
holding companies. Within this category, mortgage
subsidiaries reported the lowest returns with an average return on equity investment of 2.55 percent.
Sales finance, factoring, and leasing were the most
profitable of the financing affiliates but each was outperformed by the commercial
banks.
Subsidiaries
involved in insurance activities, on the other hand,
constituted the single most profitable activity, realizing an average annual return on equity of over sixty
percent.
Data processing activities yielded only 7.3
percent return on investment but most of these affiliates simply provide computer support for the corporation itself and are intended as little more than
The few subsidiaries within
break-even operations.
the District that were engaged principally in providing data processing services to the general public, in
contrast, averaged a robust 42 percent return on
equity over the period.
The nonbank affiliates realized substantially higher
net returns on total assets than did the banks. This
is in marked contrast with results obtained when
relative profits are measured by return on equity.
Banking, at .84 percent, was the only activity that
averaged less than one percent return on assets.
Nonbank returns ranged from 1.2 percent for mortgage banking and leasing to over four percent for
consumer finance affiliates and over twenty percent
for insurance subsidiaries.
The apparently contradictory profit ratios reflect
the high degree of leveraging evident in bank oper6

ECONOMIC

REVIEW,

Table

III

RETURN ON ASSETS AND EQUITY CAPITAL,
AND EQUITY TO ASSETS RATIOS
BANK AND NONBANK SUBSIDIARIES
1975-1978
Net Income/
Assets
(%)
Bank Subsidiaries

Net Income/
Equity Capital
(%)

Equity/Assets
(%)

.84

12.06

6.9

Mortgage

Banking

1.20

2.55

19.7

Consumer

Finance

29.4

4.26

7.84

Sales Finance

3.07

10.84

18.3

Commercial

1.63

6.34

12.3
21.3

Finance

Leasing

1.20

8.62

Factoring

3.49

8.71

23.6

Insurance

20.88

63.53

47.2

2.10

7.29

58.4

Data

Processing

ations relative to nonbank activities.
Banks fund a
much larger proportion of assets with borrowed funds
(deposits) while nonbank subsidiaries rely more on
capital injected from the parent corporation.
If nonbank subsidiaries were leveraged to the same degree
as their affiliate banks, returns on equity might be
higher.12 Banks have a distinct advantage over nonbank affiliates in their access to a stable, dependable
deposit base. It is difficult to know, therefore,
whether return on assets or return on equity is the
most appropriate
profit measure when comparing
affiliates.
Table III also gives the average equity capital to
total assets ratios for bank and nonbank activities of
Fifth District companies over the 1975-78 period.
The bank ratio averages only 6.9 percent, considerably lower than that of any other activity. The financing affiliates generally had from two to four times
as much equity per asset dollar as the banks, while
the nonfinancing affiliates’ ratios were even higher.
Table IV reports the average rates of return for
the holding companies, bank, and nonbank subsidiaries, respectively, for each year. The earning trend
of the holding companies was dominated by the continual improvement
in profitability
of their bank
affiliates following the 1974-75 recession. The recession affected mortgage affiliates most harshly.
The
average returns on equity were negative in 1975 and
1976. The especially poor average performance in
these years is dominated by severe losses realized by
12 Evidence
from consumer
finance and mortgage
affiliates [l, 13], however, suggest a movement
toward greater
leveraging
was not successful
in improving
profitability.

NOVEMBER/DECEMBER

1979

Table

IV

RETURN ON ASSETS AND EQUITY CAPITAL
BHC, BANK, AND NONBANK

SUBSIDIARIES

(By Year)1
Net Income/Assets

(%)

Net Income/Equity

Capitol

1976

1977

(%)

1975

1976

1977

1978

BHCs

.74

.77

.81

.86

10.42

11.84

12.77

13.72

Banks

.79

.81

.83

.89

11.46

11.38

12.01

13.17

Mortgage

Banking

Consumer

Finance

Sales

Finance

Commercial

Finance

.00

1.32

1.33

1.90

1.18

1.26

9.75

4.76

1.15

4.80

.44
.62

-.14
1.79

1.05

11.13

3.82

Insurance

11.00

24.30

9.63

6.82

ratios represent

the overage

24.60
-7.80

of all BHCs, banks,

The profit ratios also provide some insight on
whether product-line diversification contributed to
stabilizing profit streams of bank holding companies.
Correlation coefficients were computed between rates
of return for banking and each nonbanking activity

6.91
13.68

3.21
5.43

1.13

11.05

2.24

12.41

2.62

25.15

13.74

25.22

84.25

19.01

15.14

-1.34

subsidiaries

losses were over fifty percent of equity per year
company
and over thirty percent for two others.
three firms were eliminated
from the sample, the
return on equity over the four-year
period would
from 2.55 percent to 8.13 percent.

in 1975,

7.90

16.33

1976,

1977, and

5.42

22.74

-14.68

14.82
6.36
-6.68

55.60

83.11

-7.80

1978,

10.16

respectively.

of Fifth District firms over the 1975-78 period. Tentative results (see Table V) suggest that diversification benefits may be difficult to realize in mortgage
banking, consumer finance, and commercial finance,
since these activities demonstrated
relatively high
positive correlations with banking. This is not too
surprising, however, since banks directly engage in
mortgage, consumer, and commercial lending to
major degrees. Insurance activities of Fifth District
companies were also positively correlated with banking. This evidence runs counter to previous findings
that life insurance industry returns were negatively
correlated with banking returns.
It should be remembered, however, that bank holding company insurance activities are restricted by regulation.
The
profit experience of insurance affiliates, therefore,
may differ from the rest of the industry.
It also

Table

V

CORRELATION COEFFICIENTS BETWEEN BANK
AND NONBANK RATES OF RETURN
Correlation

with Banking

Income/Assets

Income to Equity

1.000

1.000

Mortgage

Banking

.839

.950

Consumer

Finance

.408

Banking

Sales Finance
Commercial

13 These
for one
If these
average
improve

2.70

4.08

and nonbank

a few companies.13 Profits of Fifth District mortgage
affiliates improved significantly in 1977 and 1978 but
remained far behind the banks in terms of return on
investment.
Consumer finance companies, with return on equity less than half that of the banks in 1975
and 1976, showed considerable income growth, attaining virtual parity with the banks in 1977 and 1978.
Insurance affiliates consistently turned in the highest
rates of return and were apparently not adversely
affected by the recession. Leasing and data processing show no discernible trend although both performed relatively well during the recession.
No
trend is evident for sales and commercial finance or
factoring subsidiaries.
The small number of companies in these activities within the District cautions
against drawing inferences from their profit performance.
With the single exception of insurance affiliates,
therefore, investment in nonbank subsidiaries were
less profitable than bank activities for Fifth District
holding companies, using return on equity as the
criteria.
Alternatively,
when return on assets is
employed as the profit measure, nonbank operations
were apparently more profitable. than banking.

1978

11.58

4.65

2.30

.95
.35

1 Reported

-1.38

4.29

21.53

Leasing

Processing

-3.51

1.32

1.89

Factoring
Data

1975

Finance

.153
.931

leasing

-.122

Factoring

-.442

Insurance
Data

Processing

FEDERAL RESERVE BANK OF RICHMOND

.442
-.387

.906
-.020
.590
.004
-.728
.444
-.273

7

should be recalled that holding company profits from
insurance
operations
were substantial,
probably
eliminating any need to find risk-reducing benefits of
diversification.
The remaining nonbank activities
apparently offered Fifth District firms some degree of
reduced risk through diversification, at least over the
limited period under examination.
Leasing and sales
finance activities exhibited either low negative or
positive correlation
with banking, depending on
which profit ratio was analyzed. Factoring and data
processing subsidiaries realized rates of return on
assets and equity that were correlated negatively with
banking-suggesting
reduced variability of profits
for Fifth District holding companies that combined
these activities with banking.
A note of caution
should be injected into the interpretation
of these
results.
Correlation coefficients estimated from industry (or company)
averages using only a few
years data must be considered tentative and cannot
be relied upon as strong supporting evidence.
Too
few data observations are utilized for the estimates
to achieve statistical significance.
To increase the number of observations used in
the calculation of correlation coefficients between
banking and each nonbanking activity, an effort was
made to pool the cross-section and time-series data
included in the analysis [6]. Relevant statistical tests
(F-tests) revealed that this technique was. only appropriate in the estimates involving the consumer
finance and leasing subsidiaries.
The correlation
coefficients estimated using the pooled income to
equity ratios for these two activities were +.042 and
+.278, respectively.
The estimated correlation co-

efficient between banking and consumer finance affiliates was greatly reduced using this technique while
that between banking and leasing was slightly increased.
Summary
In summary,
nearly five percent of
the total assets of Fifth District holding companies
are held in nonbank subsidiaries. Lending operations
such as mortgage banking, finance companies, leasing, and factoring constitute the bulk of this activity,
but many District firms also operate data processing
and credit insurance affiliates.
With the exception
of insurance operations, rates of return on equity
investment in these nonbank subsidiaries have not
matched those generated from bank affiliates in recent
years. This result reflects the lower equity capital to
assets ratios that banks are enabled to maintain due
to their deposit powers.
Rates of return on total
assets, in contrast, have favored nonbank operations.
Lower (average) rates of return on equity investment do not necessarily imply that holding company
diversification into nonbank areas has adversely affected bank holding company performance.
Economic theory and recent experience suggests that
average rates of return can be misleading.
Basic
economic principles show that total profits can be
increased by investing in nonbank areas with lower
average rates of return than banking-provided
nonbank investments yield higher marginal returns than
the banking alternative.
Also, preliminary evidence
suggests that some nonbank activities of bank holding
companies may have contributed
to reducing the
variability of the consolidated firms’ profit streams.

GLOSSARY OF NONBANK
Commercial Finance
Companies
providing
financing of business accounts
receivables
and of sales of
commercial,
industrial,
and farm equipment.
Consumer Finance
Companies
making direct
loans on an instalment
basis to individuals.

cash

Data Processing
Companies
providing
computer
software
services and data processing
consisting
of
the preparation
of reports
from data supplied
by
the customer.
Includes
companies
providing
services solely for the internal operations
of the bank
holding company
system as well as for the general
public.
Factoring
Companies
engaged
in factoring
and
rediscounting
of accounts
receivable,
commercial
paper, and instalment
notes.
Insurance
or broker
subsidiary;

8

Companies
providing
insurance
agent
services for their parent company
or any
providing
insurance
that is directly re-

ECONOMIC

REVIEW,

ACTIVITIES

lated to an extension
of credit or that is provided
solely for the convenience
of the purchaser;
acting
as insurance
underwriter
directly
or as reinsurer
for credit accident
and health
insurance
directly
related
to an extension
of credit by the holding
company
system.
Leasing
Companies
engaged
in the direct leasing
of property
and equipment
to the general public or
to other affiliates
within
the same holding
company.
Mortgage Banking
Companies
originating
and servicing loans secured
by real estate or providing
financing
secured
by real estate for construction
projects.
Sales Finance
Companies
purchasing
instalment
paper which arises from retail sales of passenger
automobiles,
mobile homes, other consumer
goods,
or expenditures
for home improvements.

NOVEMBER/DECEMBER

1979

References
1. Boczar, Gregory and Stephen Rhoades. “The Performance of Bank Holding Company Affiliated
Finance Companies,” Staff
Economic
Studies,
Board of Governors of the Federal Reserve System,
Washington, D. C., August 1977.

8.

“Credit Insurance Underwriting by
Bank Holding Companies During 1976.” (Unpublished staff paper), Board of Governors of the
Federal Reserve System, May 1977.

“The Performance of Bank
2. Curry, Timothy.
Holding Companies,” in The Bank Holding Company Movement to 1978: A Compendium, a Study
by the Staff of the Board of Governors of the
Federal Reserve System, Washington, D. C., 1978,
pp. 95-119.

. “Financial Impact of Nonbank Activities on Bank Holding Companies.” (Unpublished staff paper), Board of Governors of the
Federal Reserve System, June 1978.
“What Really Went Wrong at
10. Rose, Sanford.
Franklin National.” Fortune, October 1974, p. 120.

“Diversification and the Con3. Eiseman, Peter,
generic Bank Holding Company,” Journal of Bank
Research 7 (Spring 1976).

11. Savage, Donald. “A History of the Bank Holding
a Study by the Staff of the Board of Governors of
Company Movement, 1900-78,” in The Bank Hold-

4. Heggestad, Arnold. “Riskiness of Investments in
Nonbank Activities by Bank Holding Companies,”
Journal of Economics and
Business 27
(Spring
1975) : 219-23.

the Federal Reserve System, Washington, D. C.,
1978, p. 21.
12. Shull, Bernard. “Commercial Banks as MultipleProduct Price-Discriminating Firms,” in Deane
Carson (ed.), Banking and Monetary Studies.
Homewood, Illinois: Richard D. Irwin, Inc., 1963,
pp. 351-68.

5. Johnson, Rodney. “Bank Holding Companies Diversification Opportunities in Nonbank Activities,”
Eastern Economic Journal (October 1974).
6. Maddala, G. S. Econometrics.
Hill, 1977, pp. 322-23.

New York: McGraw-

7. Rice,. Michael. “Performance of Consumer Finance
Subsidiaries of Bank Holding Companies 1974 &
1975.” (Unpublished staff paper), Board of Governors of the Federal Reserve System, September
1976.

FEDERAL RESERVE BANK

9.

ing Company Movement to 1978:

A Compendium,

13. Talley, Samuel. “Bank Holding Company Performance in Consumer Finance and Mortgage
Banking." The of Bank Administration.
Magazine
July 1976.
14. Tobin, James. “Commercial Banks as Creators of
Money,” in Deane Carson (ed.), Banking and
Monetary Studies. Homewood, Illinois: Richard D.
Irwin, Inc., 1963.

OF RICHMOND

9

ON FISCAL RESPONSIBILITY*
James Parthemos

I gather that the general theme of your proceedings
this year is a thing called “fiscal responsibility” and
that I’m expected to say something about what constitutes “fiscally responsible” behavior on the part of
the Federal Reserve System. This is a subject which
I can tackle with some relish, since I have some
pretty strong convictions about it.
As a beginner, let me try to pin down a fairly precise definition of the term “fiscal responsibility.”
This is necessary, I think, because the term tends to
be interpreted in different ways by different groups,
depending not only on the context but also on the
prejudices of the interpreter.
As accountants you are
concerned chiefly with fiscal responsibility at the
individual firm or program level. The term carries
an important dollars-and-cents
connotation for you
and you are, by training, highly sensitive to the
unhappy results of lapses from this kind of responsibility. That attitude would serve us well if it could
be extended into the public policy area, and sometimes I think it might be a good idea if some training
in accounting were required of all office holders in
this country.
It’s in the area of public policy, unfortunately, that
we have different and, too frequently, conflicting
notions of what constitutes fiscal responsibility.
And
these differences are not confined to the politicians.
They apply as well to the large group of professional
economists who concern themselves with public
policy issues. It’s clear, I think, that “fiscal responsibility” would mean one thing to Milton Friedman
and quite another to John Kenneth Galbraith; one
thing to George McGovern and quite another to, say,
Strom Thurmond.
At one end of some ideological
spectrum the term connotes tight government budgets, without deficits, and with a restrictive view of
At the
the appropriate functions of government.
other, it usually reflects a view that fears of high
levels of government spending and government deficits should not be allowed to impede government
efforts to solve a broad range of social and economic
problems so long as the deficits do not exceed a relatively small fraction of GNP.
The basic difference
*Address
given
before
Accountants,
Spartanburg,

10

the National
Association
South Carolina,
November

ECONOMIC

of
9,

REVIEW,

here, it should be noted, is one regarding the appropriate role of government and, in effect, pits a dollarsand-cents notion of fiscal responsibility in government against some loosely defined notion of social
responsibility of government that transcends dollarsand-cents considerations.
But these are the extremes and serve mainly to
point up my rather strong impression that the term
“fiscal responsibility” has tended to become a political buzz word with relatively little substantive meaning. It is tossed around by both so-called conservatives and so-called liberals, both left wing Democrats
and right wing Republicans, with all sides using
it as a sort of shibboleth to support their respective
positions and to cajole their respective constituents.
We all like to think we are “fiscally responsible,”
much as we like to think we are morally upright.
And we’re all tempted to think that those who disagree with us are “fiscally irresponsible”
just as
we’re tempted to believe that those who don’t share
our moral values may be of dubious morality.
To avoid difficulties that we get into by using
terms so loosely, I’d like to offer you a more specific
definition of fiscal responsibility in public policy, one
that we can establish a concrete criterion for judging.
To do this, it might be useful to make a distinction
between government policy at the Federal level and
that at the level of state and local government.
This
distinction is important, I think, not only because
Federal policies are more pervasive in their immediate effects but also because Federal policies can have
important direct and indirect credit and monetary
effects that are not present in state and local government policies.
In any case, let me focus for the moment on policy
at the Federal level. Here my criterion for judging
the fiscal responsibility or irresponsibility of government policies would be their effects on the value and
the integrity of the dollar, in both its domestic and
its international uses. Policies that take account of
the broad social advantages of maintaining a stable
value of our currency are, in my view, fiscally sound.
Those that assign little or no value to the stability
and integrity of our money I would have to call
What I’m saying here is that
fiscally irresponsible.
policies that promote inflation, or even countenance

NOVEMBER/DECEMBER

1979

its persistence, are irresponsible in the sense that
they are bound to eventuate in hardship for substantial groups in
our society or for virtually all
groups. At worst they can undermine the bases not
only of our economic system but the foundations of
our political and social institutions, including our
position of political and economic leadership in the
free world. But, to emphasize here, the important
point is the crucial significance of the value and the
integrity of the dollar as the criterion for judging
fiscal responsibility.
The remainder of my remarks will be devoted
primarily to fiscal responsibility at the level of Federal government policies which, I believe, is the area
that you’re interested in. In any case, it’s only at the
Federal level that the Federal Reserve System can
play any role in promoting fiscal responsibility.
But
I don’t mean to suggest here that the term “fiscal
responsibility or irresponsibility” has no meaning at
the state and local government level. State and local
governments have been known to persist in policies
and fiscal practices that quite justifiably deserve to
be characterized as irresponsible. We have a number
of contemporaneous cases in point. But the payoff
for fiscal irresponsibility at these levels-in
economic
or political or social terms-is
neither as extensive
nor as dire as that resulting from fiscal irresponsibility at the Federal level. Also, since irresponsible
fiscal behavior at the state and local level has no significance for the stability and integrity of our money,
the criterion for specifying it must be different from
the specifications at the Federal level. At the state
and local level the criterion must be related to the
sustainability of the debt encumbrance imposed on
taxpayers.
Clearly the indebtedness of a state or a
locality can assume dimensions that impose undue
hardships and perhaps also retard economic development through excessive taxes or through defaults
that render capital expansion excessively costly or
even impossible.
Budgetary Policy and the Value of Money With
these background remarks out of the way, let me
return now to the theme of fiscal responsibility in
public policies at the Federal level. And at this point
I’d like to say a few words about deficits in the
Federal budget, which many people seem to equate
with fiscal irresponsibility.
You will note first that a
Federal deficit does not necessarily represent fiscal
irresponsibility
according to my definition of that
term. Let me emphasize the word necessarily.
It is
possible for a deficit to be financed in such a way that
it does not prejudice the integrity or the stability
of the dollar. As a matter of fact, sometimes a deficit
FEDERAL RESERVE BANK

may be quite responsible from the public policy
standpoint, although my own conviction is that these
times are fewer and further between than a good
many of my professional acquaintances believe. In
any case, it’s clear to me that a deficit can be financed
without any significant effects on the supply of money
or on its value at home or abroad. All that the government has to do is to go out into the market for
loan funds and borrow the necessary money, paying
the market price, out of the money that’s already in
existence. It’s only when the government undertakes
to finance the deficit out of newly created money that
the value and the integrity of the dollar is likely to be
affected. If the deficits are large and sustained over
long periods, the temptation to finance them with
newly created money becomes politically irresistible.
The reason for this is that the resulting large government demands on our money markets would drive
interest rates up to excessive levels and make credit
inordinately expensive for private borrowers, both
businesses and households, and for state and local
governments.
To finesse the public hue and cry that
would result, the government is highly likely to take
what it views as the easy way out and to follow a
course that results in the creation of a large amount
of new money.
But it usually turns out that this is really not the
easy way out. It is only a temporary expedient and,
in effect, simply a means of postponing for a time the
problem of rising interest rates. As the new money
works its way through the economy, prices start
rising; that is, inflation sets in. And as inflation
gathers steam, two things follow that inevitably push
interest rates up. First, higher prices produce an
increase in credit demands on the part of businesses,
households, and state and local governments.
That
is easy to see if you consider what happens to the
demand for mortgage credit when houses that have
been selling for $35,000 go up to say $45,000. The
buyer now has to borrow $10,000 more than was
necessary before the price increase. This has general
application not only to home buyers but also to
consumers in general, to businesses, and to governments, all of whom finance a considerable part of
their current purchases with borrowed money. The
second thing that happens is that suppliers of credit
become more reluctant to lend their money at current
interest rates. This is because the rising prices mean
a steady cheapening of the dollar and lenders know
that they will be repaid in dollars that are less valuable in real terms than the dollars they lend. Hence
they will demand a premium on their money sufficient to compensate for this cheapening of the dollar.
OF RICHMOND

11

So with credit demands up and suppliers more reluctant to lend unless they can get a higher return,
interest rates quite naturally rise. You can fight this
rise for a time by creating more and more new
money, but this becomes like the proverbial dog
chasing its tail. More analogously, it’s like putting
yourself on something like “speed” because the more
new money you create, the greater the necessity for
creating even more.
International

Complications

Over the past dozen
or more years, with the increasing financial integration of the world’s major economies, inflation has
tended to spawn a new and serious financial complication. The cheapening of the dollar at home has a
counterpart in the international exchanges, where the
dollar is traded against foreign currencies.
We’re in
a situation now where a cheapening of the dollar at
home almost inevitably leads to a cheapening of the
dollar abroad.
I say “almost” because whether or
not the dollar declines in value against other currencies of the world depends on whether inflation over
here is proceeding at a pace more rapid than that in
other major countries.
If all the countries of the
world were equally irresponsible fiscally, value relationships among the world’s currencies would be
unaffected. But if we are more fiscally irresponsible
than other countries, then you can expect the value
of the dollar in terms of other countries to decline.
This is, in fact, what has been happening over the
past 18 months, and that should tell us something.
Any sustained decline in the foreign value of the
dollar can have serious implications not only for the
U. S. economy but also for the economies of the
other major countries of the world. Large amounts
of dollars are held by foreign monetary authorities
as reserves, by central banks and foreign banks, by
multinational firms domiciled both here and abroad,
and by wealthy individuals.
A decline in the value
of the dollar means a reduction in the real wealth
of these major holders of dollars and this, of course,
will have an impact on the economic behavior of these
It could, for example, lead to a reduction
groups.
in their spending, which would mean a corresponding
reduction in the level of world trade and investment
and hence in economic activity throughout the trading
world.
Apart from this, any depreciation of the
dollar is matched by an increase in the value of other
key foreign currencies and this raises the dollar
prices of foreign goods. This has important implications both for our economy and foreign economies.
Since it raises the prices of our imports it aggravates
our own rate of inflation. At
the same time it tends
12

ECONOMIC

REVIEW,

to reduce the worldwide demand for the goods of
other important countries, like Germany and Japan,
and makes problems for them. This kind of situation
promotes political attitudes that make for a proliferation of trade barriers among the trading nations of
the world and this too tends to reduce the volume of
world trade to the detriment of all countries. It is for
reasons like this that we cannot reasonably expect to
maintain a position of economic and political leadership in the world in the face of a sustained and progressive decline in the value of the dollar.
Role of the Federal Reserve
Now I’ve gotten
this far and I’ve yet to say anything at all about
where the Federal Reserve System fits into this
picture.
The Federal Reserve, you must know, is
our central bank. It has the power and the authority
to create and destroy money. More correctly, it has
the power and authority to vary the rate at which
new money is being created at any given time. It
should follow from this that if too much new money
is being created and inflation is resulting the Federal
Reserve is, somehow, to blame-or,
at least, that it is
implicated in the crime. And, as a matter of fact,
there are people, some of them highly respected professional experts, who lay the blame directly at our
door.

Now I’m not here to apologize for the Federal
Reserve on this particular score.
But I think we
ought to be careful to give the Fed a fair trial. And
to do this it’s first necessary to appreciate some
unique features of our central banking arrangements.
The Federal Reserve differs in some important respects from other central banks that have the power
to control money and credit. For the most part, the
difference grows out of the greater degree of political
democracy that exists in this country compared with
the other major countries of the world. This can be
seen, I think, when we consider the position of the
Federal Reserve in our political system.
The Constitution of the U. S. vests the monetary
authority in the Congress of the U. S., i.e., in the
elected representatives
of the people.
Monetary
management, of course, is a specialized art that can
hardly be carried out by a body of 535 representatives.
So, through experience that was sometimes
quite painful, Congress early in this century decided
to delegate the task of monetary management to a
central bank, i.e., to the Federal Reserve. But it has
taken pains to insure that the Fed be accountable to
Congress and it is clear that our money cannot be
managed without regard to the Congressional will.
What I’m saying here, of course, is that despite

NOVEMBER/DECEMBER

1979

the talk of an “independent Federal Reserve,” the
Fed is in fact not independent.
Or, if it is independent, it is in a quite unique sense of that term.
We are certainly not independent of Congress.
If
Congress passed a law requiring us to inflate the
currency at a 10 percent per year rate, it is difficult
to see how we would do otherwise. Also it is not at
all clear that we are entirely independent of the
executive branch of government, i.e., of the President
and the Treasury.
The Federal Reserve Act and its
many amendments give us some specific duties to
perform for the Administration at its command and
at its pleasure.
So whether we have independent
authority to manage money and credit on the basis
of our own judgment and in disregard of Congress
and the Administration is questionable at best.
Now this brings me to the key question that has to
be answered in evaluating the role of the Federal Reserve in this thing that we call “fiscal responsibility”
and which I have’ linked to the necessity of maintaining the stability and the integrity of the dollar.
I have noted that large and persistent deficits in the
Federal budget, if financed through the creation of
new money, must inevitably lead to inflation and to a
cheapening of the dollar both at home and abroad.
I have also noted that the Federal Reserve, as our
central bank, manages the actual operations through
which new money is created. Finally, I emphasized
that the Fed is accountable to Congress and not
altogether independent of the executive.
Now the
question is this: In the face of large and persistent
Federal deficits that exert strong upward pressures
on interest rates, how should the Federal Reserve
react ?
Basically, in such a situation, there are two courses
of action open to the Fed, both of which involve risks
that could prove serious from the standpoint of the
economy’s behavior. First, we could ignore the deficits and let the resulting pressures on interest rates
show through directly and immediately in our money
and credit markets.
This would make money and
credit significantly more expensive for private borrowers and shift resources directly from the private
sector to the public sector. Private businesses would
be hurt and the level of activity in the private sector
would probably suffer since less capital than otherwise would be available to that sector. To the extent
that the private sector makes more efficient use of
resources than government does, the overall performance of the economy would suffer. And of course
with the rigidities that we have in our economy and
in our financial markets, there’s always a good chance
that a strong upward movement in interest rates
FEDERAL RESERVE RANK

could do serious damage to a key sector of the
economy, like construction,
and through such an
effect precipitate a business recession.
In any case,
this particular course of action would not be accompanied by any significant degree of inflation and may
well strengthen rather than prejudice the value of
the dollar abroad.
The second course of action would involve resisting the interest rate
pressures resulting from the
deficits by creating new money. If the deficits were
large and we undertook to finance them entirely
through the creation of new money, the amount of
money in the hands of the spending public would
grow at a rapid rate. At some fairly early stage,
depending on the rate of resources use at the time
the deficits begin, prices would begin to rise. As I
noted earlier, this in itself would produce strong
upward pressures on interest rates, which would reinforce the pressures generated by continuing deficits.
So, in the face of continuing large deficits, efforts
to resist rising interest rates through new money
creation will succeed only in feeding inflation without
moderating upward pressures on interest rates. As a
matter of fact interest rates would probably continue
to rise as the inflation progressed.
And, as I noted,
to the extent that our inflation outdistanced that in
other countries, our dollar would be cheapened in
the foreign exchanges and this too would exacerbate
both our inflation and our interest rate problems.
So it’s clear that any sustained program undertaken
to offset the interest rate effects of large, persisting
Federal deficits through monetary expansion can
lead to no good end. It will inevitably set off a train
of economic and financial developments that will lead
to some kind of economic impasse, a business slump
at best or a major financial crisis at worst.
The moral of the story here is that large, continuing deficits put us on the horns of a painful dilemma.
We either have to accept, without resistance, a sharp
rise in interest rates that shrinks the private sector
and risks a business recession. Or, alternatively, we
can launch a program of monetary expansion to resist
the interest rate pressures, knowing that, if the deficits continue, the program will not only be futile but
will also increase the risks of a serious recession.
The fact of the matter is that when large Federal
deficits persist over a long period, as they have over
the past ten years, the Federal Reserve has no good
options.
My own feeling is that the least bad option is to
ignore the deficits and let the government, like everyone else, pay the going market price for the funds it
needs to borrow-. I think we come out much better
OF RICHMOND

13

when we gear monetary growth to the steadily growing money and credit requirements of the private
sector, without regard to the borrowing needs of the
government except in periods of war or of grave national emergency. But, as either a legal or as a practical matter, it is not clear that we have the authority
to follow such a course. The law, as I said earlier,
saddles us with some responsibilities to the Treasury
in its financing operations. Moreover, Congressmen,
sensitive to the complaints of constituents who depend on borrowed money, don’t like to see interest
rates rise, even when the increases are the inevitable
outcome of budgetary and tax legislation that they
themselves are responsible for. So in the kind of
situation I have been describing all the pressures on
us are in the direction of resisting the rate increases
through monetary expansion.

The Federal

Reserve

Bank of Richmond

These pressures are, of course, of a political nature.
And here, I think, it’s appropriate to raise the question of whether the Fed should or should not knuckle
under to these pressures.
It’s easy to say that we
should not if, in our judgment, knuckling under is
not in the public interest; that we should be “courageous.” Perhaps we should. But we should keep in
mind the point I made about the so-called “independence” of the Fed. We are a creature of, and accountable to, Congress as a Constitutional matter.
Can
we really afford to substitute our own judgment of
the public interest for the Congressional will which;
after all, is supposed to be, in our form of democracy,
a reflection of the will of the people? Is it appropriate for us to do so? These are the kinds of questions
that have to be answered in assessing the Fed’s role
in promoting fiscal responsibility in our society.

is pleased to announce two new publications.

BUYING TREASURY SECURITIES AT FEDERAL RESERVE BANKS
This easy-to-read booklet outlines the step-by-step procedure whereby individuals
can purchase Treasury securities from Federal Reserve Banks. In addition, the
booklet describes the various types of Treasury securities-bills,
notes, and bonds
-available
for purchase.

ESSAYS ON INFLATION
This volume consists of 16 articles on the subject of inflation, 14 of which
originally appeared in the Federal Reserve Bank of Richmond’s Economic Review.
Collectively, the articles summarize the major issues current in contemporary
discussions of the inflation problem. Topics covered include theories of inflation,
models of the inflationary
transmission
mechanism, the relationship
between
inflation and unemployment, the formulation of inflationary expectations, interest
rates and inflation, international aspects of inflation, and alternative anti-inflationary
policy prescriptions.

These publications may be obtained free of charge by writing to Bank and Public
Federal Reserve Bank of Richmond, P. O. Box 27622, Richmond, Virginia 23261.

14

ECONOMIC

REVIEW,

NOVEMBER/DECEMBER

1979

Relations,


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102